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Katikati College Economics – Year 12 Name: DEFINITIONS BOOKLET TOPIC ONE - Achievement Standard 2.1 – Describe inflation and its causes and effects using economic models. (External) Achievement Standard 2.4 – Process, present and analyse statistical data in relation to given issues. (Internal) Achievement Standard 2.5 – Describe government policies in relation to economics issues. (External) TOPIC TWO - Achievement Standard 2.2 – Describe international trade and its causes and effects using economic models. (External) Achievement Standard 2.4 – Process, present and analyse statistical data in relation to given issues. (Internal) Achievement Standard 2.5 – Describe government policies in relation to economics issues. (External) TOPIC THREE - Achievement Standard 2.3 –Describe economic growth and its causes and effects using economic models. (External) Achievement Standard 2.4 – Process, present and analyse statistical data in relation to given issues. (Internal) Achievement Standard 2.5 – Describe government policies in relation to economics issues. (External) 1 Topic One Definitions from AS 2.1 (external) Key Concepts Definitions Individual price rise Occurs when the price of a particular product rises. Causes of an increase in price of a product. Changes in conditions of demand that cause an increase in demand (e.g. price rise of a substitute, or price decrease of a complement) or changes in condition of supply that cause a decrease in supply (e.g. increase in costs of production, increase in indirect tax). Rate of inflation % (or change in general price level) = Change in index numbers x 100 original index number Rise in the general price level A general price rise occurs when the average level of prices increases, for example, the CPI rises for 1 000 to 1 035, the average level of prices has risen by 3.50%. Consumer Price Index (CPI) A weighted index which measures the movements in price of a typical basket of household good and services that represent the expenditure pattern of the average household. It is used as a measure of inflation (or a change in the general price level). Inflation A rise in the general level of prices of a period of time. Disinflation Occurs where the rate of inflation is falling, i.e. the price level is rising but by a smaller percentage than before Deflation Occurs when there is a fall in the general price level. Creeping inflation A constant, slow, annual increase in the rate of inflation. Hyperinflation (Galloping or runaway inflation) A situation in which the price level rises at a very rapid rate. The value of money declines rapidly and people lose confidence in the currency. Equation of exchange MV = PQ is an expression that is used in the quantity theory of money, where M = money supply V = velocity of circulation P = value or price of each transaction/price level in an economy Q = real output/volume of transactions/number of goods purchased Quantity theory Asserts that if the money supply increases, the inflation will increase assuming that V and Q are unchanged (constant). Limitations of the quantity theory of money The equation assumes that V and Q are unchanged but this can change, e.g. if V and Q change then increases in M may cause an increase in Q while P remains unchanged, so increases in M do not necessarily lead to increases in P. Aggregate demand Total demand in the economy. Equivalent to national income: AD = C + I + G + (X –M) 2 Aggregate supply Total production of al firms in the economy. The AD curve shows the relationship between total goods/services demanded and the PL. As the price level increases, AD for all goods/services will decrease. Shifts of the AD curve depend on the level of ‘spending’ by the major sectors of the economy. This includes changes in income tax rates, savings or expectations about future inflation levels. Decisions about levels of government spending and transfer payments will also shift the AD curve. Interest rate changes have a major impact on the ADF curve because they influence the level of spending by households and investment by firms. A shift of AS curve is mainly related to ‘costs’ of production. Especially nominal wages; imported raw materials, e.g. oil; sales tax/GST or company tax; new technology and levels of productivity; the level of capital stock and the level of the labour force. YF or long-run AS curve (drawn as a vertical line) Shows each firm is producing its capacity output and there is full employment. New technology or the discovery of new resources will cause the YF curve to shift outwards. The AS curve shows the real output firms are willing to supply at each PL. The slope of the AS curve depends on which part of the AS curve you are working on. AS PL At low levels of output firms are willing to increase output with a small increase in PL because they have ideal capacity in the short-run. At high levels of ouput (closer to YF the curve reflects: the need to bid scarce resources away from other industries, pay overtime and diminishing returns. Real output (GDP) YF The AD/AS model showing deflationary (recessionary) gap, i.e. AD and AS curves intersect below YF. AS PL (price level) The axis shows changes in inflation Deflationary (or recessionary) gap YF Real output (GDP) This axis shows changes in employment output. 3 Cost-push inflation Describes a situation where the process of rising prices is initiated and sustained by increasing costs which push up the general price level. Demand-pull inflation Demand-pull inflation is a situation where demand exceeds supply at current prices, so prices are pulled up by aggregate demand. Savings The part of disposable income not spent on current goods and services, e.g. buying shares, putting funds aside into term deposits or putting goods aside for future use. Investment When firms purhcase capital goods. Impact if the New Zealand dollar appreciates Exporters’ incomes are likely to fall because they are less price competitive and sell less or they exchange their foreign currency for fewer New Zealand dollars, so their incomes decrease. The overall result is less demand-pull inflation. Imports will also be cheaper as the New Zeqaland dollar appreciates, so there will be less cost-push inflation. Interest rates and economic activity A fall in interest rates will encourage households to borrow and increase the level of consumption and businesses are more likely to carry out their investment plans. Overall economic activity is likely to increase and put pressure on price levels to increase. Trade (business) cycle The recurring fluctuations in economic activity tht an economy experiences over a number of years from boom to depression to recovery again. The business cycle Positive Boom (Peak) Boom (Peak) Recession Downswing Contration Real GDP % change Expansion Upswing Recovery Time Trough (Depressions) Negative Boom A phase of the business cycle characterised by a peak in economic activity with unemployment falling and possible inflationary pressure. Recession A falling-off in economic activity characterised by decreasing levels of investment and output and rising levels of unemployment. 4 Depression A phase of the business cycle characterised by a severe decline in the level of economic activity. Output and investment will be at very low levels and there is a high rate of unemployment. Impact of inflation on savings Inflation increases the price of goods and services requiring a greater portion of household income, this will reduce level of savings. As the future purchasing power of savings may fall, households will be less inclined to save. Impact of inflation on fixed incomes e.g. beneficiaries, pensioners The purchasing power of the income of households whose income fails to keep pace with increasing prices will fall. Impact of inflation on firms Risings prices can make it more difficult for firms to plan or budget and this creates uncertainty about the future prospects for firms, so investment is likely to fall. If firms are unable to pass on the increase in costs to consumers, profits may fall and cause business to close down. Impact of inflation on trade Inflation in New Zealand at higher rates than our trading partners can resuce the quantity of exports sold as they become less price competitive. Local firms may struggle to compete against cheaper imported products. If export receipts are less than import payments then the current account is likely to be a greater deficit or smaller surplus. Definitions from AS 2.4 (internal) Key Concepts Definitions Inflation See page 2 Disinflation See page 2 Deflation See page 2 Consumer Price Index (CPI) See page 2 Definitions from AS 2.5 (External) Key Concepts Definitions Fiscal policy The government’s budgetary policy in which it alters its spending and revenue to achieve its economic objectives. Government budget surplus The government raises more in revenue than it spends. This will cause the economy to contract and reduce inflationary pressures. Monetary policy Action taken by the Reserve Bank to influence interest rates, the money supply and the availability of credit. Influences the level of economic activity in order to achieve price stability. 5 Tight monetary policy Used when the level of economic activity is too great and there is inflationary pressure in the economy, e.g. increasing the OCR. Official Cash Rate (OCR) The Office Cash Rate (OCR) is the main monetary policy used by the Reserve Bank. The OCR is the interest rate set by the Reserve Bank; it will pay interest at 0.25% lower than the OCR to registered banks for their settlement cash deposits and the Reserve Bank is prepared to lend to registered banks at 0.25% above the OCR if registered banks borrow from the Reserve Bank to fund their settlement cash deposits. Therefore, the OCR will influence the level of interest rates and is the current key tool used by the Reserve Bank to maintain price stability. Interest Rates and the AD/AS model Higher interest rates affect private sector consumption because they mean individuals pay more on mortgages and credit cards. People have less to spend. AD will shift inwards. Private sector investment is when firms buy capital goods, often requiring a loan. When interest rates rise these increased costs will mean less investment spending on new capital by firms. AD will shift inwards. Topic Two Definitions from AS 2.2 (external) Key Concepts Definitions Regional trade Trade between region in the same country under the same government using the same currency. International trade Trade across national borders. Onshore service A service provided by the exporting country to foreign buyers on its own shore, e.g. tourism, education to foreign students. Offshore services A service provided by the exporting country to users overseas, e.g. international air travel, insurance. Changes in New Zealand’s trading pattern New Zealand has developed a wider variety of products to meet the demand of overseas’ markets and found a greater range of markets to sell to. Balance on goods Export of goods minus import of goods, e.g. meat, wool, chemicals, machinery, oil, coffee. Balance on services Export of services minus import of services, e.g. education, tourists, transport, insurance. Balance on income Includes dividends, interest, profit transmitted between countries. Balance on current transfers Gifts, foreign aid. Balance on current account Balance on goods, services, income and current transfers. Balance on capital Capital account inflow minus capital account outflow. 6 account Balance on financial account Foreign investment in New Zealand minus New Zealand investment abroad. Comparative advantage A trade theory which states that a country should specialize in the production of those goods that it is relatively more efficient at producing (in terms of costs and/or resources used). The theory is based on the following assumptions: two goods only, no transport costs, free trade, mobility of resources within a country and constant costs – no diminishing returns; i.e. a straight-line production possibility curve. Why New Zealand has a comparative advantage in the production of primary goods We have good growing conditions, suitable climate and soils compared with other countries. New Zealand has greater technical expertise, especially in the production of primary products (dairy, forestry) than many other countries. The closeness of our major cities to ports, good transport links and lower production costs add to New Zealand’s comparative advantage. Basis of trade using a production possibility curve Given favourable trading terms a country can consumer goods and services beyond its current production possibilities. The following analysis demonstrates this. By specializing entirely on the production of capital goods, the quantity OX is produced. The economy retains the quantity OB for its own use and exports the rest BX. In return, it imports the quantity of OA of consumer goods. This trade position shows that the consumption of point D is achievable. This allows a country to consume a greater quantity of consumer goods and capital goods than would have been possible without trade. Production possibility curve for a country Consumer Goods A a pi Importsta l g o o O da s pi ta l g Reasonso why, on the two-country model, o d s D a A possible combination of pi capital goods and consumer ta goods available to a country l with trade. g o o d s B X Capital goods a Exports a pi pi ta ta l So the relative prices in each lcountry can be compared. g g o o o o d d s s 7 prices are measured in the same currency. The two-country model is useful for illustrating changes to these items. Prices in either country, quantities exported and imported, quantities demanded and supplied in either country. Factors not shown by the Trade barriers, exchange rates, political influences and economic disasters, the effects of other countries trading or changes in transport two-country model costs. Whether the twocountry model is appropriate for illustrating international trade. The two-country model simplifies international trade, it is useful for illustrating the impact of changes in supply and demand on world prices, exports and imports. OR, the two-country model as shown is inappropriate because New Zealand is too small to influence the world price in mot commodities. Firm A single business. Industry The sum of all firms which produce one type of product. Sunrise industry A growth (expanding) industry where prospects and profits are likely to be improving. Sunset industry A declining industry where resources will be shifted away into other industries where their prospects are better and the returns to the owners are higher. Definitions from AS 2.4 (internal) Key Concepts Definitions Exchange rate Price at which one currency exchanges for another. The trade-weighted index (TWI) A measure of the value of New Zealand dollar in terms of a weighted average of the currencies of our major trading partners. Appreciation Price of New Zealand dollar rises in terms of another currency. Depreciation Price of New Zealand dollar falls in terms of another currency. Impact of appreciation on export/import and why the reaction The New Zealand dollar is worth more so that New Zealand-made goods and services cost more and become less competitive overseas. Exports are likely to decrease. Imports will cost less so are likely to increase. Terms of trade Ratio of export price index to import price index, expressed as an index relative to a base year. Terms of trade formula Export price index x 100 Import price index Changes in terms of trade Depends on relative movements of export prices to import prices. A numerical increase is deemed favourable. A numerical decrease is deemed unfavourable. 8 Definitions from AS 2.5 (external) Key Concepts Definitions Free trade Trade between countries without government intervention. Protectionism Government measures that limit trade between countries. Arguments for free trade Allows producers to gain access to a wider range of markets and consumers a wider range of products at lower prices. Arguments for protectionism Allow infant industry to develop, strategic (essential) industry that need to be preserved in the interests of national security. Government policy on trade The New Zealand government has liberalized trade phasing out and lowering tariffs and removing subsidies. 9 Topic Three Definitions from AS 2.3 (external) Key Concepts Definitions GDP The value of all goods/services produced for sale within a country in a year. Nominal GDP The value of output at current market prices. Real GDP Refers to nominal GDP adjusted for price changes relative to some base year. It is the changes in Real GDP that allow us to measure growth in real terms or increases in the standard of living. Measures of economic growth Real income, productive capacity and net social welfare. Real income Refers to actual economic output, i.e. the total number of goods and services produced by an economy. Productive capacity Measures an economy’s economic potential, rather than looking at the actual output of an economy. Net social welfare Focuses on economic factors (output of goods and services) as well as non-economic factors such as quality of life factors. Leakages A withdrawal within the circular flow model, e.g. savings, taxes and import payments. Injections An addition to money in the circular flow model, e.g. consumption spending, investment, government spending, and export receipts. Savings That part of disposable income not spent on current goods and services, e.g. buying shares or putting funds aside into superannuation schemes. Investment The creation or purchase of new capital by firms or government, e.g. building a new factory or constructing a new motorway. Transfer payment A payment made by government with no exchange (nothing is received in return) e.g. income support or the domestic purposes benefit. Expenditure method formula Private final consumption plus government final consumption plus gross fixed capital formation plus changes in inventories plus exports minus imports plus statistical discrepancy. Final government consumption expenditure Covers services provided by government which are not sold on the market, e.g. defence, police, education. It does not include transfer payments or investment spending. Final household consumption expenditure Spending by households on goods and services. Gross fixed capital Investment in fixed assets by firms (e.g. on factories or new 10 formation equipment) and government (e.g. on works like the building of dams and universities). Net exports (exports – imports) Much of production has an imported component and some of what is produced in New Zealand is sold overseas. Income method formula Gross operating surplus plus compensation of employees plus taxes on production and imports minus subsidies. Gross operating surplus Operating surplus plus consumption of fixed capital. Operating surplus Profit before deducting taxes, dividends; it can be taken to be net profit. Compensation of employees Financial compensation for labour supplied, e.g. wages, salaries and taxable allowances. Consumption of fixed capital (depreciation) Measure the decline in value of fixed assets used in production, as a result of physical deterioration and normal obsolescence. It is a cost of production, valued at replacement cost. Production Possibility curve (PPC) Shows maximum output combinations using resources efficiently, best possible use with a given existing level of technology and resources. It is not possible to produce enough to satisfy all wants so the PPC reflects scarcity. Any point inside the curve is under-utiisation or inefficient use of resources. There is also no opportunity cost as you move from a point inside the curve to a point on the curve. A point outside the curve is impossible with existing resources/technology. New technology or the discovery of new resources will shift a PPC outward. Capital goods Consumer goods Capital goods (or producer goods) Man-made goods to produce other goods and services. Production of these will increase future production but means fewer consumer goods now. Consumer goods Goods that households or individuals use in order to satisfy needs and wants. Production of these now mean fewer capital goods now and may lower future productive capacity of an economy. Straight line production possibility curve Illustrates the principle of constant costs. As the production of a good increases, the opportunity cost of producing additional units is unchanged. The resources are equally efficient in the production of either good. Shoe a’’ Shoe ‘b’ 11 Bowed outwards (concave) production possibility curve Illustrates the principle of increasing costs. As the production of a good expands, the opportunity cost of producing additional units increases. Some of the resources used are better suited to the production of one good, and some to the production of the other good. Causes of growth The discovery of new resources or investment. Positive effects of growth Lower levels of unemployment and more job opportunities. Government tax revenue should increase. Household incomes should increase and should lead to an increase in the material standard of living. Negative effects of growth Accelerated use of resources and the detrimental effect on the environment. New technology used to achieve growth may result in job losses and disruption of family life as individuals seek employment in other regions. Possible health problems as individuals over-indulge due to higher incomes e.g. obesity. Definitions from AS 2.4 (internal) Key Concepts Definitions Real GDP per capita Real GDP Total population Shows what one individual in an economy could have access to, provided real GDP was evenly distributed. For a country with an increase in Real DDP per capita this indicates that there has been economic growth in excess of population growth. Exclusions from DGP or why DFP might understate true value of economic activity. Insufficient information – illegal activities or payments in kind (no records kept) which form part of the black or informal or underground economy are excluded. Non-market activities have no value attached to these activities because they do not pass through a market so are excluded, e.g. do-ityourself work, unpaid work done by a houseperson. Definitions from AS 2.5 (external) Key Concepts Definitions Resource Management Act 1991 The purpose of the Resource Management Act 1991 (RMA), was to promote sustainable management of natural and physical resources, so they would not be jeopardized or their use would not have adverse effects on the environment. 12 Supply-side policies The application of microeconomic policies intended to increase aggregate supply. 13