Economics

Notes for Book 5A

Tong Ka Kit 10/11/2011

What is national income?

National income measures the money value of the flow of output of goods and services produced within an economy over a period of time. National income is also used as an indicator of Rate of Economic Growth change in per cent of real GDP Economic development Change in Living standards

What is GDP?
GDP total value of output of all resident producing units in a domestic economy over a period of time usually a year Note that only the final goods are included and intermediate goods are excluded Resident producing unit: individual/ organization using a specific economy as a centre of economic interest For organizations, resident producing units refer to those that ordinarily operate in the region. For individuals, resident producing units refer to people who normally live in the region (including those who have already or will soon have lived there for at least one year), regardless of their nationalities. (e.g. foreign domestic helpers)

Circular flow of income

O=E=Y
It shows the relationship between output, income and expenditure There are three methods of measuring GDP: Expenditure methodtotalizes all final expenditures on goods and services Output methodaggregates the value of final output of goods and services produced domestically Income methodaggregate the value of factor income

Expenditure Approach of GDP

GDP=C+I+G+(X-M)
where C= Consumers/ Household expenditure I=Investment expenditure G=Government Consumption expenditure X=Exports of Goods and Services M=Imports of Goods and Services Final goods and services are goods and services that have been purchased for final use of goods and services that will not be resold or used in production within the year. Intermediate goods and services are not included in order to avoid double counting

Consumption expenditure
Household expenditure on goods and services Consumption good expenditures include purchases of non-durable goods, and purchases of durable goods, including the purchases of all kinds of personal services.

Determinants of C Income (disposable incomechange in income tax + effective income change in interest rate) Consumer confidence + expectation (e.g. inflation) Interest rates -> saving Level of debt Wealth

Investment expenditure
Capital investment of Gross Domestic Capital Formation It includes fixed investment on goods and inventory investment Fixed investment It includes purchases of new equipment, factories, and other nonresidential housing It includes the cost of replacing existing investment goods that have become worn out or obsolete -> DEPRECIATION Depreciation is the loss in the value of capital goods through usage and time caused by the wearing out of capital Purchasing existing assets (e.g. second hand goods) are excluded as we are only interested in current production Change in inventory Inventory goods are final goods waiting to be sold that firms have on hand at the end of the year Inventory goods would change values over time so that GDP only takes account of the change in the value of the inventory goods Inventory goods will eventually yield a flow of consumption or production services.

Gross Investment= Net Investment + Depreciation

Determinants in I Rate of interest loadable funds theory Costs of borrowing Opportunity of retained profit

Business confidence (VIX) Government policy (e.g. taxationcorporation/profit tax, free trade) Macroeconomic climate (e.g. property market)

Government expenditure
Expenditure by Government departments on goods and services which do not have a commercial price The output value is measured by the cost of inputs (e.g. labour cost and raw material etc.) Government expenditure excludes capital expenditure (e.g. roads, building) -> but includes in investment expenditure Note that transfers payments (e.g. unemployment benefits, old age pensions etc.) are not included since they do not reflect any contribution to current output. Transfers of ownership do not reflect an increase in current production as no output has been produced.

Net exports
Exports are goods and services produced domestically but sold to foreigners (e.g. domestic export and re-exports) Imports are goods and services produced by foreigners but sold domestically

Expenditures on exports are added to total expenditures, while expenditures on imports are subtracted from total expenditures

Output Approach of GDP

Total output account for each of the three sectors of an economy (e.g. primary, secondary, tertiary) This adds up the value by a firms production as added value which is the value of the firm s output minus the value of input Value added is the increase in the value of a product at each successive stage of the production process. GDP is the sum of all value added output of all resident producing units within an economy over a period of time.

GDP=value of Final Goods + Services at market prices Indirect tax + Subsidies

Value added means Gross output value Intermediate consumption It excludes the intermediate goods (i.e. water, gas, electricity are intermediate goods)

GDP at market price =GDP at factor cost + Indirect tax - Subsidies

where GDP at factor cost is the sum of value added of all resident producing units The presence of indirect taxes and subsidies distorts market prices The true measure of value of a good or service is the factor costs, the cost of all the factors of production, before any indirect taxes and subsidies

Income Approach of GDP

It aggregates all factors of income including Income from people employment and in self-employment Profits of private sector companies Rent income from land

It excludes private transfers of money from one individual to other

Per Capita GDP

Used to compare the living standard of different period or regions can eliminate the factor of population different The increase in GDP may be the result of an increase in the population rather than an increase in the value of domestic output in real terms.

Per Capita GDP=

Growth rate
Used to measure the growth rate of an economic development in a given period of time % rate of =

What is GNP?
Gross National Product (GNP) is the market value of all final goods and services produced in a given period of time GNP also means that total income earned by residents from engaging in economic activities in a given period of time GNP = GDP + Net property income abroad (Y from abroad Y paid abroad)

Difference between GDP and GNP

GDP includes goods and services produced by residents and foreigners within a nations boundaries GNP includes goods and services produced outside a nations boundaries by the nations own citizens and firms Some of this factor income earned by foreigners is remitted back home and deducted from resident factor in coming from abroad (e.g. stocks and shares investment in foreign countries, income earned from a contract in Japan) Factor income from and paid abroad includes compensation of employees and investment income earned from overseas by domestic residents (inflow) or paid by domestic residents to foreign residents (outflow). It does not include in local GDP but in GNP.

GDP measures the output value or income created by all local resident producing units, including the salaries of Hong Kong residents and non-residents. GNP only includes the income of Hong Kong residents.

Nominal GDP and Real GDP

Nominal GDP (or GDP at current price) is a measure of output over a certain period of time value in the prices prevailing in the same period. Take no account of the change in the value of money through inflation or deflation It is affected by the change in quantity produced (what we intend to know for measuring economic growth) and price of output Real GDP (or GDP at constant prices) is a measure of output of a certain period valued at the prices existing at a particular time (a base period, or base year). Take account of changes in the spending power of money It reflects changes in output only

Nominal GDP is difficult to identify whether the increase is due to an increase output produced or to a general rise in prices with inflation Real figure= It is also called GDP deflator

Use of national income

National income statistics (i.e. Real GDP) indicate the levels of economic activity in an economy. It can be used to compare the economic growth of an individual economy over the course of time It can measure and evaluate the economic development of an economy (e.g. Investment increase future output to boost future consumption, Economic growth ) It used to measure economic structure change and to analyse such change It can measure and test the impact of specific economic policies

Limitation of national income

Economic welfare refers to the living standard or the quality of life of the residents. However, it cannot be reflected by nominal GDP 1. Difference in population

The rate of growth of the population/ changes in the sex and age structure of the population does not reflect in the nominal GDP.

Smaller population, lower price level and greater proportion private consumption expenditure in GDP imply a higher living standard of the residents.

2.

To address some of these issues, GDP/GNP needs to be calculated in per capita terms

Purchasing power The amount of goods and services that a given amount of money can buy If income remains the same, but the price of goods and services have increased, a persons purchasing power has fallen. Thus, inflation reduces a households purchasing power

3.

State sector Military expenditure of GDP has effects on economic development, which does not imply high living standard Per capita real consumption is alternative indicatormeasure the average quantity of goods and services consumed by a resident

4.

Hidden /Unofficial economy (non-monetised economy) It means that reported GDP underestimates actual GDP. Some aspects are excluded in national income Self-provided goods+ services (e.g. labour of housewives, childcare by grandparents) Illegal production activities (e.g. gambling, prostitution, drugs) Unreported economic activities (e.g. private tutorials, taxi driver)

5.

Value of leisure time It cannot reflect the value of leisure time. Some works longer hours and some works lesser hours with similar income. Thus, it does not reflect difference in labour productivity

6.

Externalities Either Positive externalities (e.g. education) or Negative externalities (e.g. pollution) are not accounted for in GDP data

7.

Income distribution It can reflect the general living standard as GDP does not take account of the income inequality. Inequality in income and wealth is not reflected in the GDP data

Circular flow of income

Circular flow of income: it shows the relationship of production, consumption and exchange Firms decide what to produce and how to produce and Households consume all outputs (for whom to produce)

Real flow
Factors of production (input) are owned by household + supplied to firms Firms produce the output of goods + services using the factors of production =NATURAL INCOME MEASURED BY THE VALUE OF OUTPUT(O)

Money flow
Firms pay household incomes (ie. wages, rent, interest) to household who own the inputs = NATIONAL INCOME MEASURED BY THE TOTAL INCOME(Y)

Household buy all the output produced by the firm-> household expenditure =NATIONAL INCOME MEASURED BY EXPENDITURE(E)

So

OUTPUT(O)=INCOME(Y)=EXPENDITURE(E)

Leakages/ Withdrawal(W)

COMPLEX MODEL OF THE CIRCULAR FLOW

Saving (S) Taxation(T) Imports(M)

GOODS + SERVICE (OUTPUT)

FACTRO INCOME (Y)

Injections(J)

Real flow Money flow

Investment(I) Exports(X) Government

Government Expenditure(G) Government Taxation(T) Import (M) Export (X) Saving(S) Investment(I)

Public sector Private sector International Trade sector

Leakages/Withdrawals (W)
Saving(S) Government Taxation(T) Import (M)
Suppose the GDP deflator of an economy decreases from 100 to 90. This implies that A. Its GDP decreases by 10%

Increase economic activity

Injection (J)
Investment(I) Export (X) Government Expenditure(G)

Reduce economic activity

B. The general price level decreases by 10 % C. Peoples real income increases by 10 % D. Peoples living standard decreases by 10 %.

What is unemployment?
Unemployment means a person is unable to find a job although he is able and willing to work. Employed population includes Self-employed, Employees, Employers, Working for family firm, Paid apprentices. Non-labour force (dependent population) includes: For those under 15, Retired, Permanently disabled Labour force = Employed + Unemployed (n.b. Seasonal unemployment means the unemployment rate may be slightly higher seasonally due to the increase in labour force or reduce in demand in the market.)

Measuring unemployment
Percentage of unemployed =

100 %

The unemployment rate is the percentage of unemployed people in the labour force, which is a lagging indicator. Youth unemployment (15-19) is the highest among any age groups. They are inexperience and unskilled, which is lack of human capital. They are more likely to lose jobs in recessions or not easy to find jobs, but more likely to change jobs. These workers do not accumulate the human capital and they are more likely to involve in crime or political unrest.

Underemployment
Some of the unemployed would like to work long hours (e.g. Full time rather than Part time) Underemployment rate = Unemployment takes no account of underemployment. Hong Kong measures underemployment An employed person who involuntarily works less than 35 hours a week and is able to work more.

100 %

Costs of unemployment
Unemployment is an indicator of the level of economic activity, which is a lagging indicator. It affects economics welfare. It reduces income and leads to a fall in living standard of the unemployed. They may experience substantial poverty. The unemployed may lose their self-esteem and brings stress, which affects mental and physical health. It will lead to the problem of domestic violence and crime, which affect social stability. The unemployed are deskilling (loss of human capital). It reduces output and waste of a limited resource. It has adverse effects on growth of productivity.

(n.b. Financial assistance for the unemployed is only a transfer of wealth but not a cost to society. However, a drop in personal income is the cost to the individual as well as part of the cost to society. The loss is reflected in national income)

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Economics notes

National income

Unemployment cannot reflect the changes in economics welfare. Underemployment an employed person who involuntarily works less than 35 hours a week and is able to work more False report of unemploymentfinancial assistance for the unemployed may encourage false reports of unemployment. Value of leisure timethe unemployed have more leisure. Types of unemployment Frictional & Transitional unemploymentcaused by geographical & occupational immobility of labour or lack of knowledge (information failure) Seasonal unemploymentthe unemployment rate may be slightly higher seasonally due to the increase in labour force or reduce in demand in the market Structural unemploymentcaused by the change in technology or the rigidity of labour market or the change in economic structure Cyclical unemploymentcaused by the fluctuation of business cycle Real wage unemploymentcaused by the government policy (e.g. NMW)

The General Price level

Along with unemployment, inflation is a key macroeconomic objective. Mild inflation that leads to price stability should be around one to three per cent. General Price level is the aggregate price of the good and services in the economy. (n.b. Not OutputM does not take account of output) We use indices CPI (Consumer Price Index)/ RPI (Retail Price Index) GDP deflatorto calculate Real GDP or GDP at constant price)

Consumer Price Index

CPI measures the change in consumer price of goods and services It measures a representative combination of goods and services called a fixed baskets of goods and services.

In Hong Kong, CPI as a weighted average of a basket of goods and services based on Household Expenditures surveys which determine the weights CPI = (n.b. Base year = 100) Expenditure weights based on a basket of goods and services

100 %

Implicit Price Deflator of GDP

Implicit price deflator of GDP measures price change of all types goods + services included in GDP (output) Implicit price deflator of GDP =

100 %

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Economics notes

National income

(n.b. Nominal GDP= CURRENT OUTPUTCURRENT PERIOD PRICES & Real GDP= CURRENT OUTPUTBASE YEAR PRICES) The price is higher than in the base year if the implicit price deflator of GDP is greater than 100. In contrast, the price is lower than in the base year if the implicit price deflator of GDP is smaller than 100.

Difference between the CPI and the implicit price deflator of GDP
CPI measures the price changes of a fixed basket of consumer goods and services and Implicit price deflator of GDP measures the basket of goods and services included in GDP, including consumer goods, capital goods, government goods, imported goods and exported goods. CPI changes the basket of goods and services once per five years. Implicit price deflator of GDP changes according to the output of different time periods.

Measurement of inflation/ deflation

Inflation is a general, persistent and sustained rise in the general price level. Deflation is a general persistent and sustained fall in the general price level. Inflation in 2008 =

100 %

CPI can better reflect the effect of price changes on consumers, thus, it is a better indicator of the cost living because it only takes account of consumer price instead of the whole economy activity.

Implicit price deflator of GDP can better reflect the overall price changes of all goods. It is much changeable as it takes account of the general price level so that it is a better indicator of measuring inflation.

Cost of livingpurchasing power

Purchasing power of money is the quantity of goods and services which can be purchased with a unit of money Inflation reduces the purchasing power of money and deflation increases the purchasing power of money. If CPI increases, the inflation will increase and the cost of living will increase as a result. However, CPI can over-substitute inflation + cost of living. Substitution Bias Consumers substitute relatively cheaper goods for more expensive goods when cost of living increases in order to maintain living standard with a small increase in expenditure. (e.g. frozen food replacing fresh food) Quality Bias Due to the change in technology, the quality of goods and services increase (e.g. cars) but there is no change in prices. It maintain living standard with the same or even less spending.

What is money?
Money is any generally accepted means of payment for delivery of goods or a medium of exchange. Money is a form of asset and it acts as a store of value. Money is the medium of exchange for trading goods + services. Thus, money facilitates specialisation + trade. Problem of barter is the huge time cost and transaction cost. A double of coincidence of wants are needed of barter. Inflation will distort the money as a unit of account. The value of goods is expressed in terms of money.

Function of money
2

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Economics notes

National income

Medium of exchangeit allows economic agents to exchange goods without the need for barter. The values of goods are expressed in terms of money.

2.

Store of valueindividual can choose to forgo consumption now and save to increase their spending power in the future. It stores the purchasing power and can be used for our convenience at anytime.

3. 4.

Unit of accountit enables us to compare the relative prices of goods and services by measuring the values of goods Standard of deferred paymentit allows payment for goods and services consumed today in the future. (e.g. outstanding accounts, wages, mortgage and instalment) Money is not the only asset used as a store of value. We can also store the purchasing power with shares, bonds, real estate, gold or jewellery etc.

Money has the highest liquidity among all assets (i.e. liquidity refers to the ability of an asset to be exchanged for other assets or goods within a short period of time and without a big loss.)

The use of money as a unit of account can greatly reduce the number of exchange, making transactions much easier Changes in relative prices cause switches in demand as consumers respond to the incentive of lower price for some goods and services.

Properties of money
The idea form of money should have at six properties of money as below, including generally accepted, scare with a stable value, durable, homogeneous and easily recognised, divisible and portable. 1. Generally acceptedit avoids the need for double coincidence of wants (e.g. barter) and makes transaction much easier. 2. 3. Scarce with a stable valueit must be able to store value and have a stable value that economic agents could rely on. Durableit must not be easily perishable or difficult to store, which could be used in transaction at any time. It can be able to store value for a long time. 4. Homogeneous and easily recognisedits value should keep the same standard and easily be identified, which can serve well as a unit of account and a standard of deferred payment. (n.b. if it is not homogeneous, there would be arguments about the quantity and quality of the goods to be paid, which could not serve well as an unit of account.) 5. 6. Divisibleit can divide into smaller units for small transaction. PortableEasy to carry Fish are not good units of account mainly because they are not A. Durable

Money supply
Cash and deposits are mediem of exchange. They are money. e.g. banknotes, notes

B. Scare C. Homogeneous D. Portable

Cheques, Credit cards, Octopus, EPS and online payment systems are the payment technologies, but they are not money. They are money substitutes. Credit cards are loans to card holders. Banks pay the money to the shop, not the credit card. Octopus need to pay the cash first before the payment. Cheques are the payment instruction to banks.

Fishers equation of exchange

3

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Economics notes MV=PT

National income

where M=supply of money, V=velocity of circulation, P=price, T=number of transaction Since the velocity of circulation (V) and number of transaction (T) should be equal, the inflation can be controlled by the growth of Money Supply. Money supply means the total amount of money within a boundary. Cash held by the public It does not include the cash in the banking system, because it does not circulate in the market for payment purposes. It is used for transactions and precaution. Deposits Deposits-taking institutions are known as authorised institutions, including licensed banks (e.g. HSBC), restricted licence banks (e.g. GE Capital) and deposit-taking companies (e.g. Public Finance limited). Since there is a rise of payment technologies, they reduce the cash to deposit ratio as they are not money.

1.

Demand deposits It usually bears no interest with higher liquidity. Depositors use cheques to pay and they accepted by licensed banks.

2.

Savings deposits It usually bears interest. Depositors can withdraw their deposits at any time. They are accepted by licensed banks
Which of the following about money is correct? A. It must have intrinsic value. B. It must be backed up by law to be the medium of exchange. C. It must be convertible into some precious metal. D. It must be generally accepted as the medium of exchange.

3.

Time deposits It has a fixed maturity period. It cannot be withdrawn before the maturity. It has lower liquidity but bears higher interest. They are accepted by all authorised institutions

4.

Negotiable certificate of deposit (NCD) It has a fixed maturity period. Holders can transfer the NCDs to other freely. They are accepted by all authorised institutions.

Measuring money supply

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Economics notes

Which of the following is an

National income

accurate description of credit cards? A. Credit cards are media of exchange. B. The popularity of credit cards will not reduce the cash to deposit ratio.

1. 2. 3.

M1: Cash held by public + Demand deposits M2: M1+ saving and time deposits + NCEs (in licensed banks) M3: M2+ Deposits (in restricted license banks and deposit-taking companies)

C. Credit cards do not have any of the functions of money. D. Credit cards are the standard of the standard of deferred payment

M1 is a narrow definition of the money supply.

M1 has relatively high liquidity, comparing with M2 and M3, which has higher power. Money could easily be used for transactions. It emphasizes the function of money as a medium of exchange. It emphasizes the function of money as a medium of exchange. M2 and M3 are broader definitions of the money supply. Money could also be used for transaction if that is

necessary.

Total money supply

Money Supply = Cash held by the public + Deposit

Total Money Supply = Money Supply of HK dollars + Money Supply of foreign currencies

Introduction of banking
The banking system of a region is composed of Commercial Banks.

Suppose in a bank in Hong Kong, Mary withdraws HK$3,000 from her savings account and changes it for US dollars in cash. Which of the following statements about the Hong Kong dollar money supply is correct? A. HK$M1 will increase while HK$M2 will remain unchanged. B. HK$M1 will remain unchanged while HK$M3 will decrease. C. Both HK$M1 and HK$M3 will remain unchanged.

Types of Bank s
1. Central bank (e.g. Bank of England, Federal Reserve of the US) 2. It is usually an state-owned and non-profit making institution. It monitors the monetary system and control the money supply of the economy

Commercial Bank (e.g. HSBC) It is usually a profit making private institution It consists of licensed bank, restricted licensed bank, deposit-taking bank

Function of Central Banks

1. Governments banker 2. It manages governments account and government debt 5

Issue notes and coins

D. Both HK$M1 and HK$M2 will decrease.

2010-2011 3.

Economics notes It controls the money supply of the economy It ensures the circulation and money stability of its value

National income

Operate Monetary Policy It set money supply target by setting the value of price (e.g. interest rate and the reserve asset rate) It provides price stability

4.

Acts as a lender of the last resort It provides capital if a bank has difficulty in order to prevent a run on a bank, financial collapse and collapse of a bank. It maintains the financial stability
Which of the following about the central bank functions performed in Hong Kong is correct? A. The Hong Kong Bank is responsible for the central clearance of the banking system. B. The Exchange Fund acts as the governments banker. C. The Hong Kong Monetary Authority carries out monetary policies for the government. D. The Hong Kong Association of Banks supervises banking activity.

5. 6.

Monitor/ Supervise/ Manage/ Regulate/ Control the financial system Accept Deposit form commercial banks It provides operational balances

7. 8.

Provide short term loans Act as a clearing house It settles payments with other banks It provides discount window services

9.

Formulate monetary policies Target of inflation rate, interest rate and money supply

Hong Kong Monetary Authority

Hong Kong does not have a central bank. Hong Kong Monetary Authority carry out the most functions of central banks. It manages the asset of the Exchange Fund It executes monetary policies It formulates and implements regulatory policies for financial institutions. It maintains the linked exchange rate

Functions of Commercial Bank

1. Financial intermediaries 2. It accepts deposit and provides loans / makes investment It borrows and lends money in order to make profit.

Facilitate transaction It enables the trading and commerce at all level of economic activity

3.

Provide a range of service (e.g. bond, share, credit card, foreign currency, letter of credit, cheques)

Why Hong Kong as an international financial centre?

1. Huge China market post 1980 opening market Chinas modernization-> industrialisation Hong Kong is a trading entreport, acting as middle man Demand of commercial and finance service in Hong Kong increases (e.g. Trade, banking, insurance, foreign exchange), as China is currently in the state of industrialisation, which requires for capital. 6

2010-2011 2. Infrastructure

Economics notes

National income

Well-developed transport system and communication network (e.g. telephone and internet etc.)

Below is the balance sheet of Bank A. Assets Reserves Loans $1000 $1500 Liabilities Deposits $2500

3.

Financial infrastructure Establishment of capital market

Judicial systemlegal system Rule of law is important to the development of financial centre Freedom of speech

If a depositor withdraws $200 cash from the bank, the banks reserves will _____, and its deposits will _______immediately. A. Fall to $800 remain unchanged B. Fall to $800 fall to $2300 C. Remain unchanged fall to $2300 D. Remain unchanged fall to $2200

4.

Government policy Support private enterprise Free flow of information (Data Protection) Freedom of entry and exit to Hong Kong investors (free capital market) No foreign exchange control (no restrictions on currencies/ money / capital) Low rate of tax/ Simple tax structure

Bank credit
Central banks key task is to use monetary policy to control inflation and establish price stability Monetary policy involves the control of rate of growth of money supply, the control of the credit/ deposits, and the change of interest rate. A rise in bank loans increases deposits and the money supply, which is known as deposit creation or credit creation. To analyse monetary policy, we look at the balance sheet, the reserve asset system, and credit or deposit creation Banks are middleman between savers/depositors and borrowers Banks make money by paying depositors a lower rate of interest than what they charge borrowers If banks are creating credit by lending money to borrowers, they have a potential problem of not being able to pay their depositors. The danger is the run of bank and collapse of confidence. As a result, banks are required to keep reserves to meet the demand for cash from the depositors Problem for the bank is that the larger the reserves, the smaller the profit. Banks have an interest in keeping the reserve as low as possible so that the bank can lend money as much as possible.
100%

Reserve asset ratio=

Assets Cash reserves Loans $500 $500 Deposits

Liabilities $1000

Above is the balance sheet of the bank after making loans Total assets still equal total liabilities.

Minimum ReserveFractional Reserve system

To maintain the financial stability, protecting the depositors, and the public interest, banks require to have a Minimum reserve ratio. (e.g. 20%) 7

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Economics notes

National income

For example, for $1000 deposited, $200 is kept in the reserve, which is Fractional Reserve System Excess reserves is the Actual Reserve minus the Required Reserve (=Minimum Fractional Reserve) (e.g. minimum reserve ratio is 20%, reserve is $500, then the excess reserve is equal to $500 minus 20% of $1000, which is $300)

Excess reserve provides banks with greater security, as they need to bear lower risk. If the minimum reserve ratio is low, the risk will increase to the banks, but the profit is high. There is an inverse relationship between the risk to the bank and the reserve asset, but excess reserve means lower profit. The risks include the bank run and the bankrupt if it lacks of liquid asset.

Banks must comply with the governments minimum reserve requirement.

Money supply and 100% Reserve banking

With 100%-reserve banking, the existence of banks does not affect the money supply. It only changes its composition. (i.e. in an economy without banks, the money supply equals the currency in circulation.) For example, if the government has only issued $1,000 cash, this $1,000 is the whole of the money supply. When everybody deposits their cash in the bank and the minimum reserve ratio is 100%, the money supply will not change.

Deposit creation under a fractional reserve system

Fractional or reserve assets banking enable banks to create credit or deposits. The amount by which credit can be created is determined by the banking of MONEY MULTIPLIER. This is a reciprocal of the reserve assets ratio. Assume that the minimum reserve ratio is 20%. Assume that banks choose not to hold excess reserves Assume that there is sufficient demand for loans in society. (No cash spare) The public chooses not to hold cash, and there is no cash drain (or cash leakage) in the process of deposit creation. 1. Initial deposit Assets Reserves 2. Second round of deposit Bank holds 20% reserves, and lends the $800 excess reserves to the public. The public deposit all the cash, $800 to the bank. Assets Reserves Loans (+800) 3. Third round of deposit Assets Reserves Loans (+640) Bank holds 20% reserves, and lends the $640 excess reserves to the public. The public deposit all the cash, $640 to the bank. 8 $1,000 $1,440 Deposits (+640) Liabilities $2,2440 $1,000 $800 Deposits (+800) Liabilities $1800 $1,000 Deposits Liabilities $1000

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Economics notes

National income

= = Deposits=Reserves

= )= %=

= Reserves Banking multiplier

The deposits equal the reserves times the reciprocal of the reserve ratio, which is called the banking multiplier. If banks do not make any loans, the deposits will not increase. The reserve ratio is 100% and the banking multiplier is 1. =

What is monetary base?

Ms=Cash in circulation + Deposits (=reservemultipliers)

= = ( = ) = = ( )

The sum of currency in circulation and reserves is known as monetary base. In reality, the fractional reserve system is likely to have the following assumptions. a. A cash drain is likely to happen b. Not all loans are returned as deposits Credits/ Deposits creation is limited Cash drain reduces the reserves

Banks are likely to have excess reserves Excess reserves = Actual reserves Required reserves To reduce risk in making loans

c.

Demand for loans may be insufficient The public may not be willing to borrow all excess reserves from banks.

Reserve shortage and deposit contraction

Reserve shortage implies that the actual reserves of the banks are less than the required reserves. The reserve shortage is caused by the customers withdrawals. Deposit contraction implies that there is a reduction in deposits and money supply due to the recalling of loans from banks. Because of reserve shortage, banks have to recall loans to hold the minimum reserve ratio.

Monetary Policy

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Economics notes

National income

Monetary Policy is the attempt by monetary authorities to control the rate of growth of money supply and/ or the level of interest rate in order to achieve certain macroeconomic objective. (e.g. Economic Growth, Price Stability, Full Employment)

Monetary Policy should run conjunction with fiscal policy. Monetary authorities have a range of monetary policy tools Issuance/printing of money If there are more banknotes, the money supply will increase either in the circulation or in the bank deposits.

Minimum Reserve Ratio/ Requirement If the reserve ratio reduces the banks ability to create credits or deposits, the money supply will fall. However, if banks hold excess reserves, the change of the ratio may not affect the money supply.

Open Market Operation Purchase of government bonds If the government buy the bonds from public, the money supply will increase.

Sale of government bonds If the government sells bonds to the public, the reserves in the bank will decrease, causing the decrease of money supply It will soak up the liquidity, and reduce the money supply in circulation vice versa.

Discount Rate (also known as base rate) Discount rate is the rate of interest that the central bank charged the commercial banks for short term loans. An increase in discount rate will increase the cost of capital of banks and hence decreasing the size of monetary base. A decrease in discount rate will decrease the cost of cost of borrowing, and hence providing more incentives for commercial banks to borrow from central bank and create more deposit. The money supply will increase as a result.

Money supply and the control of interest rate

The smaller cash drain from the banks, the more deposits and money banks can create. If banks find making loans more risky, or are more conservative in making loans, the reserve ratios will increase, and the ability to create credits and deposits will decrease, hence the money supply will fall. The central bank does not have complete control on the money supply. Money supply and the interest rate are inversely related. (e.g. Central Bank sells bonds to reduce money supply, capital flows into central bank. Supply of loanable funds decreases and the market interest rate will rise) Raising the reserve requirement ratio may not be effective in supressing credit growth if the banks hold sufficient funds, have large amount of excess reserves and lend the money that is off the balance-sheet.

Change in deposits = Change in reserves

Maximum changes in loans = Change in deposits (1-Minimum reserve ratio)

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Types of monetary policy

Monetary Policy and Fiscal Policy are the two main policy tools for the management of the economy on a macroeconomic level. There are two types of monetary Policy Expansionary Monetary Policy: Central bank increases the money supply and decrease the interest rate. It lowers the interest rate. It lowers the minimum reserve ratio. It increases issuance of banknotes. It opens the market operation of purchase of government bonds.

Contractionary Monetary Policy: Central bank reduces the money supply and increase the interest rate. It increases the interest rate. It increases minimum reserve ratio. It opens market operation of the sale of government bonds. It decreases issuance of banknotes

Effects of an Expansionary Monetary Policy

Expansionary Monetary Policy increases the consumption and investment so that the money supply will rise. Since there is a reduction of cost for borrowing and the change in opportunity cost of saving, the consumption will increase. Since there is a change in opportunity cost of retained profit and less incentive to save, the investment will increase. It would lead to a change in foreign exchange, leading to a depreciation of exchange rate. The price of import increase and the price of export decreases. (i.e. interest rate is the major determinant of investment) Overall, expansionary policy would lead to an increase of GDP/ National income, a fall of unemployment, but may create inflation, causing a rise of price level.

Effects of a Contractionary Monetary Policy

Contractionary Monetary Policy decreases the consumption and investment so that the money supply will decrease. Overall, Contractionary Monetary policy would lead to a decrease of GDP/ National income, a rise of unemployment, but may create deflation, causing a fall of price level.

Hong Kongs monetary policy

Hong Kong cant control her interest rate or money supply because of its peg of the HK dollars against US dollars at $7.8, called link exchange rate system. Monetary Policy involves the sale/ purchase of HK dollars and/or US dollars to maintain the peg at $7.8. If value of Hong Kong dollars pushes the ceiling of $7.8, the Hong Kong Monetary Authority will sell Hong Kong dollars, leading to an increase in money supply and a rise in price level (e.g. inflation). It makes HKD depreciate. If value of Hong Kong dollars pushes the floor of $7.8, the Hong Kong Monetary Authority will purchase Hong Kong dollars, leading to a decrease in money supply and a fall in price level (e.g. deflation). It makes HKD appreciate.

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Inflation and Deflation

Inflation can be defined as a persistent and sustained rise in the general price level (or average price) Deflation can be defined as a persistent and sustained fall in the general price level (or average price) It is not a once and for all change in price (e.g. increase in general sale tax is not inflation, but it can be inflationary) Price adjustment of particular goods (e.g. tea/ rice) only changes relative prices (e.g. price of tea relative to that of coffee). This is not inflation. Inflation means being a general rise in prices and deflation means being a general fall in prices. Inflation means that the value and spending power of money decreases. Deflation means that the value and spending power of money increases. Most economists argue that the inflation is a Monetary Phenomenon.

Quantity theory of money

This theory can be used to show how inflation is a monetary phenomenon. Fisher equation of exchange argues that a change in money supply will lead to a change in prices.

Nominal income and real income

Real income refers to the total output of society Nominal income refers to the monetary value of that output. (i.e. output/ real income Price level)

Velocity of circulation (V)

Velocity of circulation refers to average number of times a unit of money is circulated over a period of time to purchase national output. According to circulation flow of income, one mans expenditure is another mans income. = = Y Y is total market value of current output. is the total expenditure of output. There are two assumptions in the Classical QTM. Velocity of circulation of money is stable Real income is constant Unemployment in market causes nominal wages to fall, leading to an increase in the demand for labour. Price for labour falls to the equilibrium level at full employment. Real income is determined by the quantity and quality of production. Since the quantity and quality of production remain unchanged, real income is assumed to be constant. According to the quantity theory, the velocity of circulation (V) and the real income (Y) is constant, an increase in money supply would lead to the increase in general price level (i.e. inflation rate) at the same extent in the long run. =

QTMshort term effects

It suggests that an increase in money supply in the short run will lead to an increase in nominal income at the same extent but that real income returns to its original level in the long run. 12

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An increase in money supply will lead to an increase in price level, which firms will increase output due to the incentives for more profits.

As a result, firms employ more labour and the cost of production, like wages, the real wage will increases. An increase in money supply would lead to an increase in real income, total output and price level in the short run because of misconception of money, sticky wage and price.

In the long run, firms reduce output and labour to its original level. (i.e. they recognise that an increase in nominal income is the result of inflation.)

Given MV=PY with V is constant, an increase in money supply will lead to a rise in real income in the long run. In the short run, when the money supply keeps rising, both the price level and real income will rise. Hence, the inflation rate will be smaller than the growth rate of the money supply.

Monetary phenomenoninflation
Classical QTM suggests that a persistent increase in the money supply causes inflation. Money is a medium of exchange, and we hold money mainly for transactions purposes. When the money supply increases, the total demand for goods will rise. Since there is no change. In output, the price level will rise. If the money supply and output increase at same magnitude, there will be no inflation.

Real and Nominal interest rate

Interest is the price of earlier consumption of goods. Nominal interest is calculated in terms of money Real interest is calculated in terms of goods (or the purchasing power of money)

Changes in price level and real interest rate

Loan agreements are made in nominal terms. However, it is the changes in real interest rate which indicates the changes in spending power. The real interest rate is affected by the inflation rate. If the price level remains unchanged, the nominal interest is equal to real interest. If there is any change in the level of price level (i.e. it is measured by CPI), the real interest and the nominal interest are different. (e.g. Nominal interest rate = 10%, Inflation = 5%, Real interest = 5%) If the inflation offsets the nominal interest return completely, the purchasing power remains unchanged. Nominal interest is the interest calculated in terms of money, whereas real interest is the interest calculated in terms of goods (or the purchasing power of money). Realized Real Interest Rate = Nominal Interest Rate Actual Rate of Inflation Realised real interest rate is measured in terms of goods; nominal interest rate is measured in terms of money.

The Fishers equation

Nominal Interest Rate = Real Interest Rate + Anticipated Inflation Rate Inflation affects realized real interest rate when entering loan agreement borrowers and lenders will take inflation into account. If the interest expected inflation is 3%, borrowers will need to pay an extra 3% on top of the real interest rate to compensate lenders for the loss of spending power caused by inflation, called an inflation premium.

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Redistributive effects
Redistributive effects of a change in purchasing power of money are caused by inflation or deflation. When an unanticipated inflation (or deflation) is higher than expected, then some incomes are transferred to other groups in society. The failure to correctly anticipate the change in price leads to a redistribution of income.

Lenders and Borrowers

If the inflation rate is higher than expected, the realised rate interest rate will fall because the purchasing power of money decreases. As a result, leaders lose and borrowers gain. If the inflation rate is lower than expected, the realized rate interest rate will increase because the purchasing power of money increases. As a result, leaders gain and borrowers lose.

Employers and employees

If there is unanticipated inflation, the rise in the price level will reduce the real wages. If there is unanticipated deflation, the fall in the price level will increase the real wages. There is a transfer from employers to employees.

Government and the public

If there is inflation, the nominal income for taxpayers will rise under a progressive tax system. (i.e. progressive tax means when taxable income increases, the tax rate increases.) If government fails to raise salaries in line with inflation, then the real expenditure will fall and thus a rise in budget surplus (or a fall of deficit)

Deferred Payment
Contractual arrangement involves contractual arrangement If the inflation reduces the real value of the contract for the firms and the firms has to absorb the loss in inflation. The firm may build inflation calculations into contract.

Demand for money

Demand for money means the quantity of money in an asset portfolio. An asset portfolio can include money shares, bonds, shares, property etc. Holding money is because of the transaction demand and its store of value and its liquidity

Transaction demand
Money is used as a medium of exchange Transaction demand for money means the demand for money as a medium of exchange, which is positively related to a change in income. An increase in real income will lead to an increase in consumption expenditure, and an increase in the transaction demand for money. Hence, the money supply will increase. Conversely, a decrease in real income will lead to a decrease in consumption expenditure, and a decrease in the transaction demand for money. Hence, the money supply will decrease.

Store of value and its liquidity

Money has a non-monetary return, which the risk of holding money is low and the value is stable except the inflation and high liquidity. Cost of holding money means the return forgone from holding other assets. 14

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It forgoes nominal interest rate and return on shares. The lighter the nominal interest rate on bonds, the higher the opportunity cost of holding money. Asset demand for money means the demand for money as a store of value, which is negatively related to nominal interest rate. An increase in nominal interest rate will lead to an increase in the cost of holding money, hence reducing the asset demand for money. Conversely, a decrease in nominal interest rate will lead to a decrease in the cost of holding money, hence increasing the asset demand for money.

Effects of a change in price level on the demand of money

Main reason for holding money is for transactions The decision on how much to hold depends on the purchasing power of money (i.e. its real value) Nominal Money Balance = Face Value =

The nominal money balance means the total amount of money at face value, whereas the real money balance means the total amount of money at real value or in terms of purchasing power. If there is inflation, the nominal demand for money to the same extent all other factors being equal.

Other effects of money demand

Technology A change in payment technologies (e.g. telephone/ electronic) will decrease the cash transactions and the cost of converting asset ratio cash. The Money demand is reduced. Risk If there is an increase in risk of holding other asset (e.g. shares), then the demand of money will increase

Inflation expectation If the expected inflation increases, it will lead to an increase in nominal interest rate and cost of holding cash. The demand for money will decrease. It is wise not holding cash whereas there is an increase in anticipated inflation.

Determination of interest rate in money market

Demand for money
Demand of money is downward sloping, which is inversely related to rate of interest. If the interest rate is high, the money of demand is low; if the interest rate is low, the money of demand is high. An increase in income will cause money demand to increase and shift to the right. A fall in income will cause money demand to decrease and shift to the left. Supply of money seems to be perfectly inelastic in terms of rate of interest (i.e. a change in rate of interest rate has no effect on money supply. A change in rate of growth of money supply should be accommodation with the rate of growth of GDP.

Equilibrium interest rate

Market interest rate is the price of money determined by the interaction of money supply and money demand 15

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If the money supply is greater than the money demand, it will lead to a fall in interest rate. It is Excess Supply. If the money demand is greater than the money supply, it will lead to an increase in interest rate. It is Excess Demand. The market will self-adjust and self-correct automatically back to the equilibrium

Change in the interest rate

Due to an increase in GDP, it causes an increase in money demand and an increase in interest rate, shifting the money demand to the right. (i.e. Incomes rise, an increase in money demand leads to a rise in interest rate)

Due to the purchase government bonds from the public, it causes a decrease in money supply, but an increase in interest rate, shifting the money supply to the right.

Due to the sale of government bonds to the public, it causes an increase in money supply, but a decrease in interest rate, shifting the money supply to the left.

Due to a decrease in GDP, it causes a decrease in money demand and a decrease in interest rate, shifting the money demand to the left.

Expansionary Monetary Policy Expansionary monetary policy is designed to increase economic activities An increase in issuance of money, purchase of government bonds, lowering the minimum ratio, and lowering the discount rate will increase money supply, but a fall in interest rate.

Contractionary Monetary Policy Contractionary monetary policy is designed to decrease economic activities. A decrease in quantity of banknotes, sale of government bonds, raising the minimum ratio, and raising the discount rate will decrease money supply, but an increase in interest rate.

Change in money supply and money demand

Overall effect on the monetary depends on changes in money supply and rate of interest. No change in interest rate Change in money supply is equal to the change in money demand either both demand and supply rise or both demand and supply fall. =

16

Fall in interest rate Change in money supply is greater than the change in money demand either both demand and supply rise or both demand and supply fall.

Increase in interest rate Change in money supply is smaller than the change in money demand either both demand and supply rise or both demand and supply fall.

Government Budget
Fiscal budget refers to financial statement of the government expected revenue and expenditure. (i.e. Hong Kong financial year, from 1st April to 31st March) The actual outcome can be different from the expectations. (i.e. budget deficit means a rise in sovereign or national debt) There are three types of budgets Budget surplus refers to estimated revenue is greater than estimated expenditure Balanced budget refers to estimated revenue is equal to estimated expenditure Budget deficit refers to estimated revenue is smaller than estimated expenditure

The outcome depends on what actually happen: Fiscal surplus refers to actual revenue is greater than actual expenditure Fiscal deficit refers to actual revenue is smaller than actual expenditure

(i.e. Fiscal refers to tax revenue and government expenditure) Fiscal (or Budget) Stance may be overall balance over the course of business cycle. There is no need for the government to greatly change its tax or expenditure system. (e.g. In recession, the tax revenue should be smaller than the government expenditure; In boom, the tax revenue should be greater than the government expenditure) Government should establish a balanced budget over the cycle. However, when the economy is producing its potential output, all resources are fully employment, where government expenditure is greater than tax revenue, there is a Structural Deficit.

Government Revenue
According to Adam Smith , Cannors of taxation in 1776, the ideal tax system should be: Equitytax should be proportional to income. (ability to pay) Certaintythe taxpayers must know about the calculation method, amount, deadlines and payment method. Tax is the responsibility of taxpayers. Conveniencetax should be convenient for the tax payers. Economytax collections should be the minimum Efficiencytax should have minimum side effects, which taxes should ideally not distort or change economic behaviour, which leads to disincentives to work or save or invest.

Tax burden and Tax base

Indirect tax means that the tax burden can be passed onto the third parties. (e.g. duties, stamp duty, rates, betting duty, first registration tax etc.)

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Direct tax means that the tax burden cannot be passed onto the third parties. (e.g. salaries tax, profit tax and property tax)

Tax base means that area of economic activity subject to taxation Broad tax base refers to many areas are taxed and tax revenue is more stable Narrow tax base refers to few areas are taxed and tax revenue is less stable

The tax on income is a direct tax, while the tax on goods and services is an indirect tax. In general, tax base of indirect taxes tends to be broader. The revenue from indirect tax is more stable. As direct tax revenues greatly increases in times of economic boom, and greatly decrease in times of downturn, the revenue from direct taxes is relatively unstable

Major direct taxes and indirect taxes in Hong Kong

Types
Direct taxes

Name of tax
Salaries tax Profits tax Property tax

Content
Salaries earned and pensions received personally in Hong Kong Profits from enterprises earned in Hong Kong Property owners rental income earned form land or properties in Hong Kong Hydrocarbon oil, liquor with an alcoholic strength of more than 30% of volume, methyl alcohol and tobacco

Indirect Taxes

Duties

Rates Betting duty Stamp duty First registration tax

Occupation of properties. The amount is based on rental valuation. Legal gambling activities in Hong Kong, including horse racing, Mark Six and soccer gambling Assignments of immovable properties, leases and stock transactions Vehicles first registered for use in Hong Kong

Method of calculation of tax rate

=

Taxable Income = Total Income Tax Allowance Tax Deductions

The types tax scheme (e.g. progressive or proportional or regressive tax scheme) is classified by the tax rate/ the proportion of tax payment in taxable income. (i.e. Tax rate has the same meaning of the proportion of tax payment in taxable income increases) Progressive Tax: when taxable income increases, the tax rate increases. It is an example of direct tax. Ordinary salary earners pay a progressive tax. Proportional Tax: when taxable income increases, the tax rate remains unchanged. It is an example of direct tax. Companies need to pay profits tax or/and property tax rate. Regressive Tax: when taxable income increases, the tax rate decreases. It is an example of indirect tax. It is imposed on goods and services. (e.g. taxes on alcoholic beverages)

When the tax rate is zero, the tax revenue is zero. The tax revenue will increase along with the tax rate until it reaches the optimum level and it falls afterwards. When the tax rate is 100%, the tax revenue is zero as no tax payers have no incentives to work or invest.

Increasing the direct tax rates will lower work and investment incentives. This will lead to a decrease in total taxable income. As a result, tax revenue would not increase.

The effects of tax on income redistribution

Tax can narrow the gap between the rich and the poor 1

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The government can redistribute income through tax revenue to provide inexpensive services for disadvantaged groups (e.g. low income earners or unemployed).

The government can also increase progressive income tax so that higher income earners pay a higher tax rate.

Salaries Tax can help achieve a more equal income distribution The government can narrow the tax base by increasing the basic tax allowance. Low income earners need to pay less, and more even distribution of income is achieved.

Reducing the tax rates of all tax bands () can lessen the tax burden of ordinary salary earners. Raising the standard tax rate to charge higher tax on high salary earners can achieve a more even income distribution. Raising the standard rate or create more thresholds.

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Exchange rate
The exchange rate of foreign currency is the price of it in terms of the domestic currency/ the price at which currencies exchange. Under a pure flexible exchange rate system (floating exchange rate), exchange rates are determined entirely by market forces without government intervention Under a fixed exchange rate system, exchange rates are determined by the authority. (e.g. Exchange rate of US$ in terms of HK$, US$1=HK$7.78, and Exchange rate of HK$ in terms of US$, HK$1=US$0.12) Under a floating exchange rate system, a rise in the exchange rate is called Appreciation. Under a floating exchange rate system, a fall in the exchange rate is called Depreciation. In 1983, Hong Kong has adopted a linked exchange rate system to maintain the stability of the exchange rate between the HKD and the USD in the market. If the exchange rate of the HKD against the USD rises, it is Revaluation. (e.g. US$1:HK$6.8) If the exchange rate of the HKD against the USD falls, it is Devaluation. (e.g. US$1: HK$8.8) When banks issue banknotes, they have to pay an equal value of USD based on the linked rate to buy Certificates of Indebtedness from the Hong Kong Monetary Authority. This guarantees that each unit of HKD banknotes is backed up by foreign exchange reserves. It maintains the price stability. Hong Kong suffers from Renminbis appreciation since HKD depreciated together with the USD due to the peg. People need to bear high inflation. If country has a trade deficit (Export is smaller than Import) and the fixed exchange rate, then the deficit country needs to change the internal price (i.e. deflation) in order to maintain the competitiveness. With floating foreign exchange rate, the trade deficit country can change its external price. (e.g. appreciation of its own currency when it has trade surplus and depreciation of its currency when it has trade deficit)

Balance of payment
Balance of payment records all external transactions of one country with the rest of the world over a period of time. Receipts should balance to Payments. There are two accounts in the Balance of Payment (BoP). Current Account Capital and Financial Account

Current account
Current account consists of visible trade (e.g. tangible goods), invisible trade (e.g. services), factor income, current transfers. Balance of visible trade Balance of visible trade=Exports of goods Imports of goods If the balance of visible trade is positive, it has a surplus on visible trade. It indicates that the export of goods is greater than import of goods. (i.e. X>M) If the balance of visible of trade is negative, it has a deficit on visible trade. It indicates that the export of goods is smaller than import of goods. (i.e. X<M) Balance of invisible trade Balance of invisible trade=Exports of services Imports of services 3

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If the balance of invisible trade is positive, it has a surplus on invisible trade. It indicates that the export of services is greater than import of services. (i.e. X>M)

If the balance of invisible of trade is negative, it has a deficit on invisible trade. It indicates that the export of services is smaller than import of services. (i.e. X<M)

Balance of invisible trade is the net receipt brought by the transactions of services. Relative importance of goods and services depends on extent of development (e.g. Primary/Secondary/ Tertiary Production), structural change and value added (e.g. Germanys manufacture).

Visible trade and invisible trade refer to as the balance of trade. The deficit or surplus of balance of trade reflects the competitiveness of an economy against the rest of the world.

Factor income Factor income consists of all forms of investment (e.g. interest, rent, dividends, remuneration) Net Factor Income = Factor Income from abroad (inflow) Factor Income paid abroad (outflow) Current transfer Current transfer consists of unilateral transfer (i.e. only involve one party) of goods and services without any economic value being received. (e.g. gifts, donations from residents to non-residents, remittances) Current Account Balance = Visible trade balance + Invisible trade balance + Net factor income + Net current transfer

Capital and financial Account

Capital Account records all financial transactions and capital transfers between residents and non-residents and changes of reserves. It includes the purchase/ sale of assets (or capital transfers). Capital Transfer between residents and non-residents External Transactions in no-produces, non-financial asset External Investment Change in reserves assets

Balance of Payment
Balance of Payment is of all external transactions (excluded reserve assets) Balance of payment is equal to 0. (i.e. BoP=0) It is positive if the balance of payment has a surplus; it is negative if the balance of payment has a deficit. Balance of payment deficit reduces reserve assets. Conversely, balance of payment surplus increases reserve assets.

Balance of Payment Deficit and Surplus

Balanced Balance of Payment means that the receipts of an economy are equal to its payments in its external transactions excluding reserve asset transactions. Balance of payment deficit means that the payments of an economy are larger than its receipts in its external transaction excluding reserve asset transactions. It means its reserve assets will decrease. Balance of payment surplus means that the receipts of an economy are larger than its payments in its external transactions excluding reserve asset transactions. It means its reserve assets will increase. All payments are in a domestics currency. Domestic currency imports $1000 of goods, it has to pay $1000 to foreign country in its currency. If it does not have this currency, it pays via the reserves. 4

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If there are no other transaction, the balance of payment domestic country is equal to the current accountBalance of payment deficit of $1000.

Foreign country received $1000, reserve asset rises $1000 and it has Balance of Payment surplus $1000. Since the payment on imports equal to the receipt received from the sale of assets, the Balance of Payment of the domestic country will be balanced, and its reserve assets will remain unchanged. The current account and the capital and financial account offset each other. In other words, the current account balance and the capital and financial account balance have exact equal vales but in opposite signs.

According to the accounting rules, an increase in reserve assets is indicated by a negative sign, and a decrease I reserve assets is indicated by a positive sign.

National income identity and balance of payment

Assuming no factor income flows or current transfer Current account balance = net export (NX) Net export = Exports Imports (deficit; surplus; balances) Net export +Capital Account (KA)=0 The current account balance and the capital and financial account balance (KA) will offset each other.

NX=-KA
Trade Surplus (e.g. China) When net export is greater than 0 (i.e. NX>0), it is called current account surplus. (i.e. positive trade balance) Capital and financial account will be smaller than 0 (i.e. KA<0). It is called capital and financial account deficit. Capital and financial account deficit will offset the current account surplus. It is net capital outflow. National saving ( ) is larger than domestic investment (I). It is outward investment. (i.e. )

Trade Deficit (e.g. U.S.A) When net export is smaller than 0 (i.e. NX<0), it is current account deficit (i.e. negative trade balance) Capital and financial account will be greater than 0. (i.e. KA>0) It is called capital and financial account surplus. Capital and financial account surplus will offset the current account deficit. It is net capital inflow. National saving ( ) is smaller than domestic investment (I). It is inward investment. (i.e. )

Trade balance When net export is equal to 0 (i.e. NX=0), it is balanced current account. Capital and financial account will be equal to 0. (i.e. KA=0) Capital and financial account balance is zero, showing no net capital inflow or outflow. National saving ( ) equals domestic investment(I). (i.e. = )

Derivation of the equation of national income identity

Current account balance is the difference between domestic saving and domestic investment. (i.e. In the expenditure approach, national income (Y) equals total expenditure. (i.e. Y=C+I+G+NX) National income is also the sum of private consumption expenditure, private saving ( = ) ) and public saving ( ) (i.e. = ) ) and tax revenue (T). (i.e. = )

Governments budget surplus is tax revenue minus government consumption expenditure (i.e. T G) National saving is equal to the government saving (

=
5

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When net export is greater than 0 (i.e. NX>0), the national saving is greater than the investment (i.e. When net export is smaller than 0 (i.e. NX<0), the national saving is smaller than the investment (i.e. When net export is equal to 0 (i.e. NX=0), the national saving is equal to the investment (i.e. = )

International Trade
Trade is mutually beneficial under voluntary exchange. Exports will be sold at a profit. Imports are purchased because they reflect demand and are not produced locally. This may be because the local economy lacks the necessary factors of production. Countries that specialise in producing goods and services use the resources that they have. This reflects difference in FACTOR ENDOWMENT. International trade is an exchange of goods and services. The international price of this exchange is called the TERMS OF TRADE. (TOT) Terms of trade shows the quantity of imported goods which can be exchange for unit of exported goods.

(e.g. Country A exports crops $10/unit and Country B exports clothes $5/unit Term of trade for Country A=2 units of clothes and Term of trade for Country B=0.5 units of crops) As a result, Term of Trade indicates the exchange rate. =

If the index rises, this indicates an improvement in the terms of trade. Conversely, if the index falls, this indicates deterioration in the terms of trade. Note that a rise in export prices compared to import prices may be a good or bad thing. It depends on the cause or the Price Elasticity of Demand for export (and import).

Absolute Advantage
Countries have different rates of productivity and efficiency levels in producing different goods. Absolute Advantage (AA) can be established by comparing productivity rates. In other words, it is determined by productivity. (e.g. Country A may be able to produce more computers using the same quantity of inputs as another country. Country A has an Absolute Advantage and its competitor has an absolute disadvantage.) Absolute Advantage is determined by productivity.

(i.e. it is a multitude of factors but factor endowment for a country is an important starting point.) Difference in factor productivity reflects difference in factor endowment. The advantages can only be realised through complete specialisation and trade and exchange with a stable monetary system. As a result, each country is better off since an increase in total output and total consumption.

Comparative Advantage
Principle of Absolute Advantage was conceived by Adam Smith, who showed how the world output would increase by specialisation and trade based on the difference in productivity. Comparative Advantage means that a country has a comparative advantage in producing Good X if it can produce it at a lower opportunity cost than other countries. If one country has an absolute advantage in the production of all goods, the technologically advanced country will still trade with the technologically inferior country. 6

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According to David Ricardo, the theory of comparative advantage to show that even though one country had an Absolute Advantage it could still benefit from specialised and trade based on differences in opportunity cost.

Assume that there is no transport/ transport cost and it is a perfect competition. Country A and Country B could only produce either Good X or Good Y because of the limited resources. For each unit of resources, Country A has a higher level of output in both X and Y. However, the international trade is determined by opportunity cost and not productivity. Good X (units) Country A Country B 50 10 Good Y (units) 25 2

And that one countrys comparative advantage lies, where the opportunity cost in producing the same goods as another is lower.

As a result, they should specialise and trade in this good.

Country B has a lower opportunity cost in producing Good X, she has a Comparative Advantage in producing Good X. (0.2Y<0.5Y)

Country A has a lower opportunity cost in producing Good Y, she has a Comparative Advantage in producing Good Y. (2X<5X)

Trade Model of Comparative Advantage

There are few assumptions: Only two trading countries A and B They trade good X and Y Output/ Resources are fixed. They trade by barter (i.e. double coincidence of wants) There are no trade costs The market is perfect competition If countries specialise and trade where they have comparative advantage and import where they have a

(i.e. 50X=25Y & 10X=2Y) Country A

Unit cost of X

Unit cost of Y

= =

Country B =

comparative disadvantage then the world output will increase and all trading partners gain. Country A specialises in Y and exports Y and imports X. Country A has lower Opportunity Cost in producing Y. Country B specialises in X and exports X and imports Y. Country B has lower Opportunity Cost in producing X. These calculations exclude transactions (foreign exchange) and transaction costs. If both countries trade 1 unit of X, country A produced 1 unit less of X gains 0.5Y; country B produced 1 unit more of X gives up 0.2Y. If country A reduces output by 1X and imports from country B then total costs reduce by 0.3Y (or total output increases by 0.3Y) As a result, international trade in mutually beneficial as specialises where opportunity cost is lower reduces global costs. Term of Trade determines the distribution of the gains Assume Term of Trade: 1X=0.4Y 7 1 unit of X 1 unit of Y 2X 5X Country A 0.5Y Country B 0.2Y

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National income

Country B exports Good X only if the export price is greater than the domestic cost, and country B gains 0.2Y; Country A imports Good X only if the import price is smaller than the domestic cost, and country A gains 0.1Y.

The trade is mutually beneficial only if the trade is voluntary and each party has a comparative advantage. Term of trade also must lie between the opportunity cost of the respective countries. Transport and transaction costs are excluded in the calculation of the gains.

Example
Suppose the domestic costs of Country A and Country B are as follows: Country A: 1Y = 2X (i.e. 1X=0.5Y) Country B: 1Y = 5X (i.e. 1X=0.2Y) Terms of trade 1Y=1X 1Y=2X 1Y=3X 1Y=4X 1Y=5X 1Y=6X Which country will export Y? No trade No trade Country A Country A No trade No trade / 0 1X 2X 3X / / 3X 2X 1X 0X / Gain of Country A Gain of Country B

Advantages of international trade

Trade enables countries to exchange for other goods that they cannot produce locally because of the difference in factor endowment. Countries are specialised in producing goods according to absolute advantage and comparative advantage. Division of labour/ Specialisation could increase the productivity Trade reduces economic cost that enhances the economies of scale. (improve living standards globally) Trade enhances technological interflow among countries and increase global productivity. Trade enhances the competition so that quality and production technology could be improved.

International trade and exchange rate

When the exchange rate of the domestic currency rises (i.e. appreciation), the export price in terms of foreign currency will rise, and the export volume will fall. The import price in terms of domestic currency will fall, and the import volume will rise. When the exchange rate of the domestic currency fall (i.e. depreciation), the export price in terms of foreign currency will fall, the quantity demanded increases. Thus, the exports volume will increase. The import price in terms of domestic currency will rise, and the import volume will fall.

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Economics notes

National income

Trade barriers
It is an idea that trade barriers like tariffs/ quotas protect domestic producers and reduce foreign competition. Free trade based on comparative advantage benefit all but since gold and foreign currency reserves can be accumulated (e.g. China 3 trillion) through a trade surplus on the current account. This trade surplus appears as strong argument in favour of protectionism.

Types of trade barriers

1. 2. Import Quotas: it places a maximum import volume of goods. Supply of import will reduce and demand for domestically produced products will rise. It could implement partial or total Embargo (i.e. Ban trade) Import Tariffs: it is a tax on imported goods Price of import will rise and quantity demanded will reduce. Supply of import reduces. Domestic producer will gain with the increase in output and import surcharge. (i.e. imposition of an additional costs on import.) 3. Subsidies to domestic producers To import-competing producers, a production subsidy could reduce cost of production and prices of domestic output. Quantity demanded of domestic producers will rise. To exporters, the subsidy reduces price of domestic producers. The competitiveness and its output will be increased internationally as a result. 4. Foreign exchange controls: government control on the exchange rate and the supply of foreign currencies. It restricted the supply of foreign currency and the demand for foreign import.

Winners and Losers with free trade

1. A small country is a price-taker, which has no market power. (i.e. price is at equilibrium level and the total social surplus is maximised and there is an allocative efficiency where P=MC)

International price and comparative advantage

Domestic and interantional price reflect different opportunity cost (i.e. they reflect different production costs) and this determines comparative advantage. If the international price is gerater than the domestic price, domestic producers will export at the higher price because of maximising of the profit. Domestic economy has comparative advantages. In the international price is smaller the domestic price, domestic consumers will purchase imports. Domestic economy has comparative disadvantages.

Gains and losses of an exporting country

Assume that domestic price is smaller than the international price Domestic price would rise to the international level P2. Quantity supplied of domestic output would rise from 60 to 100. Quantity demanded of domestic output would fall from 60 to 20.

2010-2011

Economics notes As a result, Country A as a price taker has a kinked supply curve.

National income

The export volume is equal to the domestic quantity supplied minus domestic quantity demanded (i.e. between 20 units and 100 units)

Since the domestic price rises, domestic consumers will lose but domestic producers will gain.

Consumer surplus falls (i.e. loss of area B) Producer surplus rises (i.e. gain of area B+D) Total social surplus rises (i.e. gain of area D) Since producers gains are larger than consumers losses, export trade can improve a countrys economic welfare.

Gains and losses of the importing country

Assume that domestic price is greater than international price. Domestic price would fall to the international level. Quantity supplied of domestic output would fall. Quantity demanded of domestic output would rise from 60 units to 100 units. As a result, Country A as a price taker has a kinked supply curve. The import volume is equal to the domestic quantity demanded minus domestic quantity supplied (i.e. between 20 units and 100 units) Since the domestic price falls, domestic consumers will gain but domestic producers will lose. Consumer surplus rises (i.e. gain of area B+D) Producer surplus falls (i.e. loss of area B) Total social surplus rises (i.e. gain of area D) Since consumers gains are larger than producers losses, import trade can improve a economic welfare. countrys

Effects of tariffs
Assume that Country A impose a tariff of $t. Domestic price rises by $t above the international price. Quantity supplied domestically increases by 20 units. (i.e. 40-20 units) Quantity demanded domestically decreases by 25 units (i.e. 100-75 units) Import volume fall from 80 units to 35 units (i.e. (100-25)-(75-40)units) 10

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Economics notes Tariffs have redistributional effects. Since the domestic price rises, domestic consumers will lose but domestic producers will gain, which results in overall reduction in economic welfare. The government will also benefit from an increase in tax revenue.

National income

Consumer surplus falls (i.e. loss of area B+C+D+E)

Producer surplus rises (i.e. gain of area B)

Government gains area D (i.e. $35t) Total social surplus falls (i.e. loss of area C+E)

There is a net economic welfare loss since there are dead weight loss in the area C and E.

Area C, where marginal cost of output is greater than the international price, causes the allocative inefficiency and over-production, leading to a deadweight loss.

Area E, where marginal benefit of output is greater than the international price, causes the under-consumption, leading to a deadweight loss.

Effect of Quotas
Assume that Country A imposes a quota of 35 units (i.e. 75-40 units) and assigns the quota free of charge to some domestic producers. . Holders of the quotas can import goods at the international price. When the domestic price is greater than the itnernational price, all 35 units of the quota are imported. Quota produces a double kinked supply curve. Domestic price rises by $t above the international price. Quantity supplied domestically increases by 20 units. (i.e. 40-20 units) Quantity demanded domestically decreases by 25 units (i.e. 100-75 units) Import volume fall from 80 units to 35 units (i.e. (100-25)-(75-40)units) Quotas have redistributional effects. Since the domestic price rises, domestic consumers will lose but domestic producers will gain, which results in overall reduction in welfare. 11

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Economics notes The quota holders will gain from the imposition of the quota. Consumer surplus falls (i.e. loss of area B+C+D+E) Producer surplus rises (i.e. gain of area B) Quota holders suplus rises (i.e.gain of area D) Total social surplus falls (i.e. loss of area C+E)

National income

There is a net economic welfare loss since there are a deadweight loss in the area C and E. Area C, where marginal cost of output is greater than the international price, causes the allocative inefficiency and over-production, leading to a deadweight loss.

Area E, where marginal benefit of output is greater than the international price, causes the under-consumption, leading to a deadweight loss.

In reality, economic welfare may suffer greater losses under a quota system.

The World Trade Organization (WTO)

The World Trade Organisation helps promote free trade by persuading countries to abolish import tariffs and other barriers to open markets. The WTO was established in 1995 and was preceded by another international organisation known as the General Agreement on Tariffs and Trade (GATT). Membership of the WTO has expanded to 151 member countries in 2007. It has evolved into a complex web of agreements covering everything from farm goods and textiles to banking and intellectual property. The highest policy-making body of the WTO is the Ministerial Conference, where government representatives of member countries meet at least once every two years to discuss international trade agreement. The agreements detail the principles of free trade and the exceptions allowed. These agreements mainly include the commitments of member countries to reduce trade barriers, open up service markets and protect intellectual property rights. The agreements also specify the mechanism for settling trade disputes, and require high transparency from its member countries in trade related policies.

Major functions and structure

Organise multilateral trade negotiations regularly to eliminate trade barriers and discriminatory measures. Ensure the execution of international trade agreements in order to promote international trade. Help settle trade disputes between governments that have breached trade agreements. Help developing and undeveloped countries to integrate into the world trade system.

Hong Kongs attempts to overcome trade barriers

By free trade policies, trade promotion and participation in international economic institutions (e.g. WTO and APEC), Hong Kong can reduce the trade barriers and promote trade. As a free port in the world, Hong Kong Economic and Trade Offices are set in many cities world-wide to seek economic and trade benefits from major trading partners (e.g. European Union and the US) and enhance bilateral trade relations. The Hong Kong Trade Development Council (HKTDC) helps the industrial and commercial sectors to promote and develop markets for trade in goods and services.

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Economics notes

National income

Trade and Industry Development, The Hong Kong Export Credit Insurance Corporation, the Hong Kong Productivity Council and Hong Kong Science and Technology Parks are also set up to promote and support the development of industries and trade.

Hong Kong joined Asia-Pacific Economic Cooperation (APEC) in 1991. APEC is a regional forum where Member Economics have high-level dialogues about commerce and trade affairs, and aims to achieve free trade and investment in industrialized countries by 2010 and in developing countries by 2020.

Aggregate Demand
Aggregate Demand refer to the quantity of domestic output (i.e. goods and services) demanded at different price levels. In a closed economy, there is no international trade. Aggregate demand consists of the Private Consumption expenditure by households, Investment expenditure, and government expenditure. AD=C+I+G In an open economy, aggregate demand includes net export because of international trade. (i.e. net export=ExportsImports) AD=C+I+G+(X-M) Aggregate demand curve shows the quantity of domestic output demanded at different price levels.

Reasons that the aggregate demand downward sloping

Price has a negatively relationship with the aggregate output. When the prices fall, aggregate quantity demanded increases. Wealth effects When prices fall(i.e. money and financial assets), the real value of wealth increases because it can be used to buy more goods and services. Consumers will have greater purchasing power and feel wealthier. Hence, there is an increase in consumption expenditure and a fall in aggregate quantity demanded. Wealth is positively related to the aggregate quantity demanded and consumption. Interest rate effects When prices fall, households need to hold less money and therefore convert more money into interest-bearing assets, increasing the real money supply. An increase in the real money supply would cause a fall in interest rates. Firms and households can borrow more to invest and increase investment expenditure. Consumption and investment expenditure are negatively related to the rate of interest. Exchange rate effecta fall in the real exchange rate increase net exports due to a fall in price level When prices fall, interest rate falls and investors will seek higher returns by investing abroad, increasing net capital outflow. 13

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A depreciation of its currency and its real exchange rate will increase the net exports, where domestic output becomes relatively cheaper to foreign countries. It increases aggregate quantity demanded.

Real exchange rate is the price of domestic goods relative to the price of foreign goods.
=

2007Exchange rate: Domestic currency D$1=Foreign currency F$2

2008Constant exchange rate but a lower domestic price level

Price of one unit of domestic good

D$200 Real exchange rate of the domestic currency

Price of one unit of foreign good

F$400

Price of one unit of domestic good

D$100 Real exchange rate of the domestic currency

Price of one unit of foreign good

F$400

e.g. a fall in the domestic price level leads to a fall in the real exchange rate of the domestic currency from 1 to 0.5. This means the price of domestic goods falls from 1 unit of foreign goods to 0.5 unit, which will increase exports and decrease imports. Thus, both net exports and the quantity of output demanded will increase. In conclusion, there is a fall in domestic price level (i.e. rise in private consumption expenditure/ investment expenditure and net exports while government expenditure remains unchanged) because of wealth / interest rate/ exchange rate effect, leading to an increase in quantity of output demanded. Thus, the aggregate demand curve slopes downwards.

Factors of the changes in aggregate demand

Change in the price level would lead to a movement along the aggregate curve. Changes in the other factors are determined by the change in the component of aggregate demand (i.e. AD=C+I+G+X-M)A change in those other factors will shift the whole Aggregate Demand curve to the left or right. (e.g. improvement in business and consumer confidence lead a right shift of aggregate demand curve; conversely, fear of recession lead to the left shift of aggregate demand curve) Right shift of aggregate demand caused by consumption expenditure A rise in real disposable income A rise in consumer expectation or economic prospects A fall in personal taxation A rise in welfare payment A fall in interest rate A fall in saving rate Right shift of aggregate demand caused by investment expenditure A fall in interest rate A fall in profit tax rate A rise in economic prospects Right shift of aggregate demand caused by government expenditure A rise in education/health/housing expenditure Right shift of aggregate demand caused by net export A rise in national income of foreign country, changing the demand for domestic goods and services A fall in exchange rate of the domestic currency 14

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Aggregate supply
Aggregate supply refers to quantity of output supplied at different levels of prices in the economy. Aggregate supply shows the relationship between price level and aggregate output. There are differences between short run and long run Short run: when market prices for inputs in factors price (e.g. wages) cannot fully adjust, market will have excess supply or excess demand. People might incorrectly interpret price changes. (i.e. they confuse money wages for real wages.) Long run: when all price can be fully adjust, there is no excess demand or excess supply. There are no misconceptions in long run.

Long run aggregate supply

We assume that production resources, technology and productivity remain unchanged in both short run and long run. Aggregate output (or supply) in long run is equal to the potential output. Potential output means the output of the economy of full employment (YF) This is affected by: A change in labour supply (e.g. immigration/ ageing population) A change in labour productivity (e.g. a rise in productivity would lead to a rise in potential output) Discovery of natural resources or improvement of uses of existing resources (e.g. oil) A development of technology (e.g. new technology would lead to a rise in productivity and potential output)

Long run aggregate supply and potential output

In long run, price can fully adjust and the market can clear. Full employment is equal to equilibrium in labour market when prices are fully flexible and there is no price misperception about level.

Long run aggregate supply

` Long run aggregate supply shows the relationship between the price level and potential output Potential output is determined by: Quantity of resources Quality of resources Nature of technology available (n.b. it is not affected by the change in price level) Long run aggregate supply curve is vertical (at the potential output)..

Assumptions of long run aggregate supply

In the long run, both prices and wages are fully flexible, and there is no misperception about the price level. A change in price level will not change the relative price because all money prices, including the wage rate, will change by the same proportion. A change in price level will not affect the production decisions of firms and workers because they know that the relative price has not changed.

Reason that LRAS curve is vertical

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National income

In the long run, an economys production of goods and services or potential GDP depends on its supplies of labour, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.

Since the price level does not affect the potential GDP or aggregate output, the LRAS curve is vertical.

Long run equilibrium

1. 2. Long run equilibrium exists where the quantity of output supplied and demanded matches the potential output of the economy. They are all equal. The equilibrium price level is equal to P1 and the equilibrium output is equal to Y1. Long run free market economies self-adjust back to the equilibrium. In long run, aggregate output does not change, but aggregate demand and price level changes. If there is an increase in aggregate demand, it causes Ad curve to shift to the right from AD1 to AD2. Price level would increase from P1 to P2 and the aggregate output remains unchanged since the LRAS curve is vertical. 3. In long run, aggregate output is determined by the aggregate supply. A change in quantity or quality of economic resources and a change in technology (e.g. increase in population and labour supply, capital accumulation) would lead to an increase in economic growth. An increase in economic growth would increase the potential output from Y1 to Y2, shifting LAS curve to the right from LRAS1 to LRAS2. There will be a fall in the price level from P1 to P2. An increase in economic growth would increase the aggregate demand, shifting AD curve to the right from AD1 to AD2 so that the price level will remain unchanged (i.e. if the AD curve and the LRAS curve shift by the same extent.)

Short run aggregate supply

In the long run, aggregate output is equal to the potential output and it is unaffected by the price level. In the short run, a change in price level can cause changes in aggregate output. The short run aggregate supply shows the relationship between the price level and quantity of output supplied (or real national income). Short run aggregate supply is upward sloping. The reasons are: Sticky price theory: when price level falls unexpectedly, firm does not adjust the price of its product quickly. Its relative price rises. There is loss in sales and firm will lower the quantity of gods and services supplied in the short run. Sticky wage theory: when price level falls unexpectedly, nominal wages do not immediately adjust to the lower price level. Employment and production become less profitable (due to the increase in production cost) and firms lower the quantity of goods and services supplied in the short run. 16

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Misperception theory (or money illusion): when price level falls unexpectedly, suppliers are misled to believe that the real price of their product falls. Firms respond by decreasing the quantity of goods and services supplied in the short run. The labour supply will fall.

In the short run, the change in price level may cause aggregate output to deviate from the potential output. This is because there is money misperception (i.e. confusion of nominal value of real prices) and the wages and prices are sticky, which could not be adjusted flexibly.

In the long run, aggregate output will return to the potential output( =the equilibrium point)

If the price level falls in short run, the actual output is smaller than potential output. Conversely, if the price level increases in short run, the actual output would be greater than the potential output.

In long run, it is a flexible economy, wages and prices can fully adjust and economic agents do not confuse nominal and real wages. As a result, the economy returns to the equilibrium point.

Shifts of the short run aggregate supply curve

A change in money prices of factors or change in expected price would cause a shift in short run aggregate supply.

Change in money price of inputs/factors: if the marginal cost increases, a firm will decrease output at any price. Firms produce less output due to higher production costs (e.g. high wages), shifting SRAS curve to the left from SRAS1 to SRAS2. Aggregate output falls from Y1 to Y2.

A change in expected price level: actual price remains unchanged, but the expected/real price falls. Workers think that real wages increase and labour supply increases. Meanwhile, the firms believe that there is an increase in real price. As a result, the output will increase in real price, shifting SRAS curve to the right from SRAS1 to SRAS2.

When there are changes in the quantity of resources, a decrease in productivity or technology cause LAS curve and SARS to shift to the left.

Short run equilibrium

Short run equilibrium occurs when the quantity output demanded equals to the quantity of output supplied, where there is no excess supply and excess demand.

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In the short run, the price level and aggregate output are determined by aggregate demand and short-run aggregate supply.

In short run, an increase aggregate demand caused by a change in the component of aggregate demand (Y=C+I+G+X-M) would lead to a rise in price level and a rise in aggregate output, shifting AD curve to the right from AD1 to AD2.

In short run, an increase aggregate supply caused by the change in technology or quality and quantity of labour would lead to a fall in price level, but a rise in aggregate output, shifting SRAS curve to the right from SRAS1 to SRAS2.

Conversely, a fall in aggregate demand will lead to a fall in both price level and aggregate output, shifting AD curve to the left.

Conversely, a fall in aggregate supply would lead to a rise in price level, but a fall in aggregate output, shifting SRAS curve to the left.

Short run and long run equilibrium

The long run equilibrium should be equal to the short run equilibrium, where AD curve and the SRAS curve intersect at a point on the LRAS curve The long run aggregate output is equal to potential output (=full employment), which is independent of the price level. The aggregate demand is equal to short-run aggregate supply. Deviation from long-run equilibrium means the short-run equilibrium aggregate output is lower than or higher than the potential output. Short run deviations from the long run (lower than the potential output) Actual output is smaller than the potential output, and it creates a deflationary gap. Prices level falls and unemployment rate increases. This is because a rise in factor costs or a fall in consumption/ investment/ government/ net exports expenditure. In long run, the market adjusts the price level and aggregate output automatically. It moves to the long run equilibrium point c, but at a lower price level. Consumers would benefit from lower price level, but the producers will lose.

Short run deviations from the long run (higher than the potential output) Conversely, actual output is larger than the potential output, and it creates an inflationary gap. Prices level increases and unemployment rate decreases. This is because the excess aggregate demand or a fall in factor costs. 18

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National income

Consumers would lose from a rise in price level, but the producers will gain from the lower costs.

Fluctuations caused by changes in aggregate demand

The effects of a fall in aggregate demand In short run, a fall in aggregate demand would shift AD curve to the left from AD1 to AD2. Interception between AD curve and SRAS curve determines the new short run equilibrium at Y2. Price level would fall from P1 to P2 and aggregate output would decrease from Y1 to Y2. The actual output Y2 is lower than the potential output Y1. There is a deflationary gap between Y1 and Y2, causing a rise in unemployment rate. In long run, both prices and wages could be fully flexible, and there is no misperception about price level. It would lead to an increase an aggregate supply, shifting SRAS curve to the right from SRAS1 to SRAS2. The price level would further decrease from P2 to P3 and the aggregate output would increase from Y2 to Y1. Interception between AD curve and LAS curve determines the new long run equilibrium at Y1. The actual output would be equal to the potential output at Y1, where the deflationary gap would disappear. The effects of a rise in aggregate demand In short run, a rise in aggregate demand would shift AD curve to the right from AD1 to AD2. Interception between AD curve and SRAS curve determines the new short run equilibrium at Y2. Price level would increase from P1to P2 and aggregate output would increase from Y1 to Y2. The actual output Y2 is higher than the potential output Y1. There is an inflationary gap between Y1 and Y2, causing a fall in unemployment rate. In long run, both prices and wages could be fully flexible, and there is no misperception about price level. It causes a fall in aggregate supply, shifting the SRAS curve to the left from SRAS1 to SRAS2. Interception between AD curve and LAS curve determines the new long run equilibrium at Y1. The actual output would be equal to the potential output at Y1, where the inflationary gap would disappear. In conclusion, changes in aggregate demand affect both the price level and aggregate output in short run. In long run, changes in aggregate demand only affect the price level.

Fluctuations caused by changes in short-run aggregate supply

Short-run aggregate supply is affected by the changes in costs, changes in expectation on price. In long run, there is no change in technology, costs, resources and price expectations. With a constant long run aggregate supply, any change in short run aggregate supply will affect both the price level and aggregate output, but only in the short run. A fall in short-run aggregate supply A rise in price of resources (=production costs) would shift SRAS curve to the left from SRAS1 to SRAS2. In short run, the price level increases from P1 to P2 and the aggregate output fall from Y1 to Y2 19

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National income

Actual output Y2 is smaller than the potential output Y1. There is an excess supply in the factor market. As a result, the surplus in the factor market would decrease the aggregate supply over time, shifting SRAS curve to the right from SRAS2 to SRAS1 and returning to the original level at long run equilibrium point c.

Actual output is equal to the potential output at Y1. There is no excess supply.

A rise in short-run aggregate supply A fall in price of resources (=production costs) would shift SRAS curve to the right from SRAS1 to SRAS2. In short run, the price level falls from P1 to P2 and the aggregate output increases from Y1 to Y2 Actual output Y2 is larger than the potential output Y1. There is excess demand in the factor market. As a result, the shortage in the factor market causes an decrease in aggregate supply, shifting SRAS curve to the left and returning to the original level at the equilibrium point c. Actual output is equal to the potential output at Y1. There is no excess demand. Stagflation means the economic recession accompanied with higher price levels. The higher prices may lead to supply shock, leading a fall in total output. It creates a stagflation. In long run, the economy should return to the original level, where the price level will fall back and the aggregate output will increase back. However, if prices keep rising, firms will cut production and productivity may fall as a result. It increases the prices level and a fall in aggregate output, leading to a serious stagflation.

Business cycle and macroeconomic policy

Business cycle refers to the recurrent short run fluctuations in real GDP around the long run trend. It is measured in terms of the rate of change of real GDP, which is a major indicator of economic performance. It consists of recession, trough (=bust), recovery (=expansion) and peak (=boom). Recession: it is a sustained decline in economic activities. (=zero or negative growth in real GDP in 6 months) Consumption and investment falls due to the economic slowdown so that it leads to a fall in output and real GDP. It increases the unemployment rate, but there is a deflationary pressure. Trough: it is the point where consumption, investment, and aggregate output reach the lowest level. The unemployment is the highest and there is a deflation in this stage. Recovery: it is a stage where the economy recovers with an increase in economic activities. Real GDP and aggregate output rise with a fall in unemployment rate. The consumption and investment rise, leading to an increase in price level and an inflationary pressure. Peak: it is a stage where the economy activities peak (=the highest). There is a high growth rate of real GDP. The consumption and investment rise. There is an inflationary pressure, leading to a fall in unemployment. In theory, high real GDP leads to a lower unemployment rate and a high inflation rate; conversely, low real GDP leads to a high unemployment rate and a low inflation rate. As long as the growth rate of real GDP is positive, the real GDP is on the rise. Therefore, there is not enough information to tell whether the economy is in recession even if the growth rate of real GDP is falling. As long as the growth rate of real GDP is negative, the real GDP is on the decline. Therefore, there is not enough information to tell whether the economy is in recovery even if the growth rate of real GDP is rising. Macroeconomic policy refers to the measures a government adopts to achieve economic objectives. The objectives of macroeconomic policy are to: 20

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Economics notes Maintain full employment and reducing economic fluctuation: Stabilize the prize level Narrow the wealth gap Stabilize the exchange rate Expansionary fiscal policy aims to increase the economic activities through increasing the government expenditure or/and reducing taxation. Policy tools include increasing government expenditure, cutting salaries or increasing transfer payments, cutting profits tax.

National income

It could increase the investment expenditure or/and consumption expenditure or/and government expenditure so as the aggregate demand.

An increase in expenditure (C or I or G) would lead to an increase in aggregate demand, shifting the AD curve to the right from AD1 to AD2.

In the short run, the price level would increase from P1 to P2 and the aggregate output would increase from Y1 to Y2.

In the long run, it can eliminate a deflationary gap between Y1 and YF. It increases aggregate demand, shifting AD curve to the right from AD1 to AD2.

Price level increases from P1 to P2 and aggregate output increases from Y1 to YF. The actual output is equal to the potential output at YF. A deflationary gap disappears. Contractionary fiscal policy aims to decrease the economic activities through decreasing the government expenditure or/and increasing taxation.

Policy tools include decreasing government expenditure, raising salaries or decreasing transfer payments, raising profits tax.

It could decrease the investment expenditure or/and consumption expenditure or/and government expenditure so as the aggregate demand.

A decrease in expenditure (C or I or G) would lead to an decrease in aggregate demand, shifting the AD curve to the left from AD1 to AD2.

In the short run, the price level would decrease from P1 to P2 and the aggregate output would decrease from Y1 to Y2.

In the long run, it can eliminate an inflationary gap between Y1 and YF. It decreases aggregate demand, shifting AD curve to the left from AD1 to AD2. Price level decreases from P1 to P2 and aggregate output decreases from Y1 to YF.

The actual output is equal to the potential output at YF. An inflationary gap disappears.

Expansionary monetary policy aims to increase the economic activities through the manipulation of money supply or interest rate. It is often used when the economy is at the recession. It aims to reduce deflation.

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National income

Policy tools include issuing banknotes, purchasing or redeeming government bonds, lowering the discount rate and lowering the required reserved ratio.

Aggregate demand would increase, causing an increase in price level and aggregate output. The actual output is equal to the potential output is YF. The deflationary gap between Y1 and YF disappears. Contractionary monetary policy aims to decrease the economic activities through the manipulation of money supply or interest rate. It is often used when the economy is at the peak. It aims to reduce inflation and balance of payment deficit. Policy tools include reducing the quantity of banknotes, selling government bonds, raising the discount rate and raising the required reserved ratio.

Aggregate demand would fall, causing a fall in price level and aggregate output. The actual output is equal to the potential output is YF. The inflationary gap between Y1 and YF disappears.

Effects of money demand

Assume that the money supply is fixed, where the Ms curve is vertical. If there were an increase in interest rate from r1 to r2, the money demand would increase, shifting to the right from MD1 to MD2.

A rise in interest rate would cause a fall in the investment and consumption expenditure, leading to a decrease in aggregate demand, shifting the AD curve to the left from AD1 to AD2.

In the short run, the price level would fall from P1 to P2 and the aggregate output would decrease from Y1 to Y2.

Conversely, if there were a decrease in interest rate from r1 to r2, the money demand would decrease, shifting to the left from MD1 to MD2.

A fall in interest rate would cause an increase in the investment and consumption expenditure, leading to an increase in aggregate demand, shifting the AD curve to the right from AD1 to AD2.

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In the short run, the price level would rise from P1 to P2 and the aggregate output would increase from Y1 to Y2.

Effect of money supply

Assume that the money supply is fixed, where the Ms curve is vertical. A rise in the money supply from Ms1 to Ms2 would cause a fall in interest rate from r1 to r2. A fall in interest rate would lead to an increase in investment and consumption expenditure, causing an increase in aggregate demand, shifting the AD curve to the right from AD1 to AD2.

In the short run, the price level would rise from P1 to P2, and the aggregate output would increase from Y1 to Y2.

Conversely, a fall in money supply from Ms1 to Ms2 would cause an increase in interest rate from r1 to r2. A rise in interest rate would cause a decrease in the investment and consumption expenditure, leading to an increase in aggregate demand, shifting the AD curve to the left from AD1 to AD2.

In the short run, the price level would rise from P1 to P2 and the aggregate output would increase from Y1 to Y2.

Effects of fiscal policy on aggregate supply Lowering income tax will increase aggregate supply because it increases working incentive and cause labour supply to rise, leading to a rise in potential output, shifting both SRAS curve and LRAS curve to the right. Conversely, raising income tax will decrease aggregate supply because it decreases working incentive and cause labour supply to decrease, leading to a fall in potential output, shifting both SRAS curve and LRAS curve to the left. Moreover, the government expenditure on public health, medical services, education and other investment projects may increase the aggregate supply by helping to accumulate capital and raise productivity. Yet, not all government expenditure can increase aggregate supply. For example, increasing the unemployment assistance will reduce the cost of unemployment, leading to an increase in unemployment rate. The labour supply will fall, and aggregate supply will fall as well. Combined effects of changes in aggregate demand and aggregate supply 1. Budget deficit

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Economics notes

National income

An increase in government expenditure and lowering income tax, both aggregate demand and aggregate supply will increase, shifting AD curve and SRAS curve to the right. It is budget deficit, where estimated revenue is small than the estimated expenditure.

Aggregate output will increase from Y1 to Y2, but the price level is uncertain.

If the magnitude of the increase in aggregate supply is greater than the increase in aggregate demand, the price level will fall.

If the magnitude of the increase in aggregate demand is greater than the increase in aggregate supply, the price level will increase.

If the magnitude of the increase in aggregate demand is equal to the increase in aggregate supply, the price level will remain constant.

2.

Budget Surplus A decrease in government expenditure and raising income tax, both aggregate demand and aggregate supply will decrease, shifting AD curve and SRAS curve to the left. It is budget surplus, where estimated revenue is greater than the estimated expenditure.

3.

Aggregate output will decrease from Y1 to Y2, but the price level is uncertain. Balanced budget A balanced budget, where the estimated revenue is equal to the estimated expenditure would cause an increase in government expenditure, leading to an increase in aggregate demand.

However, it may involve of raising or cutting tax, the effect of price level and aggregate output would be uncertain.

Limitations of macroeconomic policy

There is the risk of misjudgement due to lack of perfect in formation. It is questionable whether the government can always gather enough information to accurately identify and deal with the problems. There is the problem of time lag between identification of the problem, time to formulate a policy, time to implement the policy. Note that time lag of implementing monetary policy is shorter. However, fiscal policy often requires more time to implement, so time lag of fiscal policy is longer. Monetary policy has a higher reversibility than fiscal policy, where the monetary authorities can always reverse the policy by adjusting the money supply or the interest rate, but it is more difficult to reverse fiscal policy. There are conflicts between different economic objectives.

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