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NSS Understanding and Interpreting the Economics Curriculum Session 2 Macroeconomics part of the NSS Economics Curriculum 9 April 2009 (Thu) Agenda Topic F Topic G Measurement of Economic Performance National Income Determination and Price Level (Max. 10 mins. Q&A) Topic H Money and Banking Topic I Macroeconomic Problems and Policies (Max. 10 mins. Q&A) Break (15 mins.) Topic J International Trade and Finance Elective 2 Q&A Session (F) Measurement of Economic Performance • • • • National income General price level Unemployment and underemployment rates Recent trends (F) Measurement of Economic Performance - National income (i) National income as a general term for aggregates like Gross Domestic Product (GDP) and Gross National Product (GNP) (F) Measurement of Economic Performance - National income (ii) Gross Domestic Product (GDP) • Definition of GDP • Concept of resident producing units (RPUs) • Items included / excluded in calculating GDP (F) Measurement of Economic Performance - National income • The three approaches to measure GDP: production approach (value-added approach), income approach, expenditure approach • Use the circular flow model to explain why GDP can be measured by 3 different approaches (F) Measurement of Economic Performance - National income • Expenditure approach • Y = C + I + G + NX • Classification of the components • GDP by expenditure components in HK • Simple transformation of the equation • (e.g. Y – C – G = I + NX => S - I = NX, where S is the national saving) (F) Measurement of Economic Performance - National income • Production / value-added approach • Sum of value-added of all production activities by RPUs • Value-added = value of output – intermediate consumption • GDP by economic activities in HK (F) Measurement of Economic Performance - National income • • Income approach (N.B. Components of GDP compiled under the income approach NOT required) (F) Measurement of Economic Performance - National income • GDP at current and constant market prices • • Meaning of GDP at current market prices (Nominal GDP) • Problem of using Nominal GDP : Nominal GDP for different years are not exactly comparable with each other in terms of volume. Meaning of GDP at constant market prices (Real GDP) (F) Measurement of Economic Performance - National income • GDP at factor cost • Meaning of GDP at factor cost • GDP at factor cost = GDP at market prices – indirect taxes + subsidies (F) Measurement of Economic Performance - National income • • per capita GDP • per capita GDP = GDP / population • both nominal and real Growth rate of GDP • Calculate the year-on-year change • Growth rate of nominal GDP, real GDP, per capita nominal GDP, per capita real GDP, etc. (F) Measurement of Economic Performance - National income • (N.B. Other measures related to GDP NOT required) • Net Domestic Product (NDP) NOT required (F) Measurement of Economic Performance - General price level (iii) GNP as GDP plus net income from abroad • Definition of GNP • GNP = GDP + NIA • Meaning of residents • Meaning of NIA and examples (F) Measurement of Economic Performance - General price level • • (N.B. Other measures related to GNP NOT required) GNP at constant market prices, GNP at factor cost, NNP, etc. NOT required (F) Measurement of Economic Performance - General price level (iv) Uses and limitations of national income statistics as an indicator of economic welfare and for international comparison • (N.B. Human development index NOT required) • HDI is required in Elective 2 (F) Measurement of Economic Performance - General price level • General price level as measured by Consumer Price Index and implicit price deflator of GDP (N.B. Construction of CPI and implicit price deflator of GDP NOT required) (F) Measurement of Economic Performance - General price level • • Calculate the rate of change in the general price level (inflation rate) by CPI and GDP deflator Compare CPI and GDP deflator in terms of coverage, weighting, etc. (F) Measurement of Economic Performance - Unemployment and Underemployment rates Unemployment and underemployment rates as measured in terms of the percentage of unemployed and underemployed persons in the labour force (F) Measurement of Economic Performance - Unemployment and Underemployment rates • Unemployment rate number of unemployed 100% = labour force • • Meaning of unemployed in economics (those who want a job but failed to find one) – Topic I Meaning of unemployed in compiling unemployment rate NOT required (F) Measurement of Economic Performance - Unemployment and Underemployment rates • Underemployment rate number of underemplo yed 100% = labour force • Meaning of underemployed in economics (those who involuntarily work less than a specified working hours) – Topic I (F) Measurement of Economic Performance - Recent trends Recent trends of national income, general price level and unemployment in Hong Kong • Interpret numerical / graphical data involving GDP deflator, CPI, and those national income statistics that are required in the curriculum (G) National Income Determination and Price Level • AS-AD model • Aggregate demand • Aggregate supply • The determination of level of output and price (G) National Income Determination and Price Level Aggregate demand (i) Reasons for a downward sloping AD curve • Wealth effect : • P decreases Wealth increases (in real terms) Consumption expenditure increases (G) National Income Determination and Price Level • • Interest rate effect : • P decreases Real interest rate decreases Investment expenditure increases Exchange rate effect : • P decreases exports becomes relatively cheaper and imports becomes relatively more expensive net exports increases (G) National Income Determination and Price Level (ii) Determinants of aggregate demand: • Private consumption expenditure, which in turn depends on disposable income, the desire to save, wealth (value of assets), interest rate, etc • Investment expenditure, which in turn depends on business prospect, interest rate, etc. (G) National Income Determination and Price Level (ii) Determinants of aggregate demand: • Government expenditure • Net exports, which in turn depends on the economic conditions of trading partners, exchange rate, etc (G) National Income Determination and Price Level • (N.B. Derivation of the AD curve, magnitude of the shift in the AD curve and factors affecting the slope of the AD curve NOT required) • Why is AD curve downward sloping? Factors that cause a shift in AD curve • (G) National Income Determination and Price Level Aggregate supply (i) Reasons for an upward sloping short run AS curve • • • • sticky-wage model sticky- price model worker-misperception model imperfect-information model (G) National Income Determination and Price Level (ii) Reasons for a vertical long run AS curve • As the price level rises / falls, real production remains constant at the full-employment level. Due to flexible prices, the same level of real production is generated at every price level. (G) National Income Determination and Price Level (iii) Factors affecting short run and long run AS curve • Factors affecting SR AS curve • Cost shocks • Government policies (changes in taxes, regulations) • Other factors, like weather condition (G) National Income Determination and Price Level • • Factors affecting LR AS curve • Factors affecting aggregate supply: factor endowments (labour, capital, land) and technological changes, etc (N.B. Explanation by the Phillips curve and magnitude of the shift of the AS curve NOT required) (G) National Income Determination and Price Level The determination of level of output and price (i) Determination of the equilibrium level of output and price level in the AS-AD model • (N.B. Quantity Theory of Money NOT required) (G) National Income Determination and Price Level (G) National Income Determination and Price Level (ii) Changes in the equilibrium level of output and price level caused by change(s) in the AD and/or AS • Both SR and LR effects (G) National Income Determination and Price Level (iii) Relationship between employment and output level • Output increases more resources are needed employment increases • (N.B. Interest rate is treated as exogenously determined) 10 Minutes Q&A (H) Money and Banking • • • • • • Money Banks: functions and services Money supply Money demand Determination of interest rate in the money market Hong Kong as a financial centre (H) Money and Banking Money (i) Definition of money • Anything that is generally accepted as a medium of exchange (ii) Nature and functions of money • Nature of money : scarce, homogeneous, stable in value, divisible into smaller denominations (H) Money and Banking • Functions of money: • Medium of exchange • Store of value • Unit of account • Standard of deferred payments (H) Money and Banking Banks: functions and services (i) Commercial banks and central bank • Commercial banks • Function of commercial banks : • Channel savings to investment • Services provided by commercial banks • Central bank • Functions of a central bank (H) Money and Banking (ii) Licensed banks, restricted licence banks and deposit-taking companies in Hong Kong • Features in terms of minimum capital requirements and types of deposits that could accept (iii) How central banking functions are performed in Hong Kong (H) Money and Banking Money supply (i) Definitions of money supply in Hong Kong • M1, M2 and M3 (H) Money and Banking (ii) Credit creation/contraction and the banking multiplier • Required reserve ratio, maximum banking multiplier • Calculate maximum change in money supply, deposits, loans, etc. • Assumptions made in calculating the maximum change • Meaning of monetary base • Describe the process of credit creation / contraction (H) Money and Banking Money demand (i) Meaning of transactions demand for money and asset demand for money • MT : holding money for making transaction (buying goods and services) • MA : holding money as a form of holding assets (H) Money and Banking (ii) Money demand as a function of nominal interest rate and income • Increase in income more transactions needed to be made demand more transaction balances to make transactions • Md is a positive function of income (H) Money and Banking • • Cost of holding money is the nominal interest rate (holding money gives up the opportunity of earning interest from holding interest earning assets – bonds) Md is a negative function of nominal interest rate Return of holding money and other benefits of holding money (H) Money and Banking Determination of interest rate in the money market • Interaction of money supply and money demand • Alternative models of explaining the determination of interest rate (e.g. loanable fund theory) NOT required (H) Money and Banking Hong Kong as a financial centre (i) Factors contributing to its development as a financial centre (ii) Effects on the Hong Kong economy (I) Macroeconomic Problems and Policies • • • • • Business cycles Inflation and deflation Unemployment Fiscal policy Monetary policy (I) Macroeconomic Problems and Policies • Business cycles: a description of the short run fluctuations in real GDP around the long run trend (N.B. Theories of business cycles NOT required) • Features of the 4 phrases of a business cycle (I) Macroeconomic Problems and Policies Inflation and deflation (i) Definitions of inflation and deflation • Inflation: persistent increase in the general price level • Deflation: persistent decrease in the general price level (ii) Relationship between nominal and real interest rates • Nominal interest rate = real interest rate + expected inflation rate (I) Macroeconomic Problems and Policies (iii) Redistributive effects • Explain why debtors will gain and creditors will lose (illustrated with example) with unanticipated inflation • Explain why debtors will lose and creditors will gain (illustrated with example) with unanticipated deflation • Explanation by comparing expected real interest rate and realized real interest rate (I) Macroeconomic Problems and Policies (iv) Inflation and Quantity Theory of Money • • • (N.B. Velocity of circulation of money assumed to be constant) Quantity equation / equation of exchange • Mv ≡ Py Meaning of velocity of circulation : ratio of nominal GDP to money stock (I) Macroeconomic Problems and Policies • Short-run QTM • Assumes: v constant • Prediction: • % change in money supply = % change in nominal income • Both P and y may change (I) Macroeconomic Problems and Policies • Long-run / Classical QTM • Assumes: • (1) v constant • (2) y constant at full-employment (classical assumption) • Prediction: • Only P will change (change in money supply cannot affect income ; money is neutral) • % change in money supply = % change in price level (I) Macroeconomic Problems and Policies Unemployment (i) Meaning of unemployment • • See Topic F Inflationary income gap: Y>Yf when the economy has an ‘excess demand’ for labour (ii) Meaning of underemployment • See Topic F (iii) Cost of unemployment • • • to the unemployed to society (N.B. Phillips curve NOT required) (I) Macroeconomic Problems and Policies Fiscal policy (i) Meaning of fiscal policy • Policies that involve changes in government expenditures (G) and/or taxes (T) to achieve certain economic goals • Definition of budget; surplus budget, deficit budget and balanced budget (I) Macroeconomic Problems and Policies • Taxation: • Principles • Adam Smith’s 4 taxation principles • Economy • Equity • Certainty • Convenient • Taxation principle in HK : source principle (I) Macroeconomic Problems and Policies • Classification • Direct and indirect taxes • Meaning of direct and indirect taxes • Progressive, proportional and regressive taxes • Meaning of progressive, proportional and regressive taxes • Effects of the above types of taxes on income equality (Topic E) (I) Macroeconomic Problems and Policies • Public expenditure: classification by function • (N.B. With special reference to Hong Kong) • Education, Social Welfare, Health, Security, Infrastructure, Economic, Housing, Environment and Food, Community and External Affairs, Support • Public expenditure as percentage of GDP • http://www.budget.gov.hk (I) Macroeconomic Problems and Policies (ii) Effect of fiscal policy on the level of output and price • Explain the effects of expansionary fiscal policy, contractionary fiscal policy, and balanced budget change in G and T on price level and output with the AD-AS model (I) Macroeconomic Problems and Policies Monetary policy (i) Meaning of monetary policy • • Changes in Ms and / or interest rate in affecting the economy Monetary tools (methods in affecting the Ms or interest rate) • Open market operations, discount rate, required reserves ratio, printing money • Brief discussion of monetary policy in HK (ii) Effect of monetary policy on the level of output and price 10 Minutes Q&A Break (J) International Trade and Finance • • • Free trade and trade barriers Brief introduction to the balance of payments account Exchange rate (J) International Trade and Finance Free trade and trade barriers (i) Absolute advantage; comparative advantage and gains from trade • (N.B. Illustration by the production possibility frontier NOT required) (J) International Trade and Finance • • • • • Meaning of absolute advantage and comparative advantage Identify which country has an absolute and a comparative advantage (illustrated with numerical data) Calculate the gains from trade (illustrated with numerical data) State the principle of comparative advantage PPF is required in Elective 2 (J) International Trade and Finance (ii) Using the pattern of trade in Hong Kong to illustrate the principle of comparative advantage (J) International Trade and Finance (iii) Importance of trade to Hong Kong's economy • Verbal description of the importance of trade to HK • Importance of trade to HK as reflected by the ratio of exports and imports to GDP (J) International Trade and Finance (iv) Trade barriers: Types • Tariff, quota, import surcharge, embargo, etc. Effects of tariff and quota on price and output for a small open economy • Discussion on effects of trade barriers is limited to tariff and quota ONLY (J) International Trade and Finance P S Pw+ t Pw A B C D D Tariff Q (J) International Trade and Finance P P’ Pw S SQ SQ : domestic supply + supply of imported goods with quota A B C D D Quota Q (J) International Trade and Finance (v) Trade barriers faced by Hong Kong and attempts to overcome them • Trade promotion • Role of the HKSAR Government • Role of international economic institutions (e.g. World Trade Organisation) (J) International Trade and Finance • Brief introduction to the balance of payments account Current account • • Main components of the current account: goods, services, income and current transfers (N.B. Sub-classification of these components NOT required) (J) International Trade and Finance • Capital and financial account • • • (N.B. Sub-classification of this account NOT required) Balance of Payments is always balanced in accounting sense Meaning of BoP surplus and deficit (J) International Trade and Finance Exchange rate (i) Meaning of exchange rate • (N.B. Graphical analysis NOT required) • Exchange rate: price of a foreign currency in terms of domestic currency • Meaning of appreciation and depreciation, revaluation and devaluation (J) International Trade and Finance (ii) Effect of a change in the exchange rate on import price and export price • Appreciation of domestic currency fall in import price and rise in export price (iii) Brief introduction to the linked exchange rate system in Hong Kong • Brief history • Note-issuing mechanism (currency broad system) • (N.B. Mechanism of maintaining the linked exchange rate NOT required) Elective 2 • • Extension of trade theory Economic growth and development Elective 2 Extension of trade theory (i) Illustration of comparative costs and gains from trade with the aid of production possibilities frontier • (N.B. The use of indifference curve NOT required) Elective 2 • • • • • Slope of PPF as the marginal cost of producing good X Illustration of comparative costs with the aid of PPF Determination of production point Determination of consumption point NOT required (because IC NOT required) Show the gains from trade Elective 2 (ii) Comparative advantage and its relation to globalization • Meaning of globalization (focus on the economic aspects) • Comparative advantage and its relation to globalization (e.g. Mainland China as ‘the world factory’) Elective 2 Economic growth and development (i) Measurement of economic growth and development • Changes in real GDP • Changes in per capita real GDP • Changes in human development index Elective 2 • Human development index • 3 Dimensions: • A Long and Healthy life (as measured by life expectancy at birth) • Knowledge (as measured by adult literacy rate, the combined gross enrollment ratio for primary, secondary and tertiary schools), and • A decent standard of living (as measured by GDP per capita in purchasing power parity) • http://www.undp.org/ Elective 2 (ii) Factors affecting growth of an economy • Inputs: physical capital, human capital, natural resources, technological change Elective 2 • • • Policies: saving and investment, foreign direct investment, trade, education, population, property rights, research and development (N.B. The analytical framework of aggregate production function and the theories and models of economic growth NOT required) A descriptive approach Elective 2 (iii) The desirability and costs of economic growth • Current versus future consumption • Trade off between current and future consumption • Growth, living standard and income distribution • Resources exhaustion, pollution and sustainable development Elective 2 (iv) International/regional comparison • Interpret graphical and numerical data Q&A Session