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Macroeconomics
3.4 Aggregate economic activity
3.4 MACROECONOMICS 2 - Aggregate economic activity
Circular Flow Model
The Circular Flow Model shows the relationship between various sectors in the economy.
The two sector Circular Flow model shows the relationship between households and firms.
Households provide resources (natural resources (land), human resources (labour), Capital
(man-made goods used to produce other goods) and Entrepreneurship (people who take
risks in business)) in exchange for income (rent for land, wages for labour, interest for
capital and profit for entrepreneurship). These resources are then processed by firms and
given to households in exchange for consumption spending.
The third sector is the government. They charge income tax to households, which is the
main source of the government’s income. Firms also pay GST as they collect GST for the
government. Hopefully if they made a profit, they have to pay GST. They use this to
provide goods and services such as health and education which firms can not provide.
They also give Transfer Payments (benefits) to households for lower income earners in
exchange for nothing. The government also provides subsidies to firms for various reasons
including keeping prices down in a natural monopoly, bringing the market to the social
equilibrium and making the firm competitive for trade.
The fourth sector is the overseas sector. This arises out of international trade. Since we
are concerned about the money flow only, import payments go out and export receipts
come in.
The leakages of the circular flow model are:
 Savings
 Import Payments
 Taxes (Direct and Indirect)
The injections of the circular flow model are:
 Investment
 Export Receipts
 Transfer Payments
 Subsidies
 Government spending
Consumption Spending
Goods and services
Direct Tax
(Income Tax)
Households
Government
Transfer
Payments
Import
Payments
Indirect Tax
(GST)
Firms
Subsidies
Overseas
Export
Receipts
Resources (land, labour, capital & entrepreneurship)
Income (rent, wages, interest & profit)
Savings
Financial Intermediaries
Investment
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Macroeconomics
3.4 Aggregate economic activity
Gross Domestic Product (GDP)
The Gross Domestic Product is the final market value of all goods and services produced
for sale within a country in one year.
There are three ways to calculate GDP:
 Expenditure Method
 Income Method
 Production approach
Expenditure Method
Final household consumption expenditure (C)
This is spending by households on goods and services. This does not include
buying a new house; this is included in investment spending.
Gross fixed capital formation (I)
This is spending on fixed assets by households (house), firms (factories and
machinery) and the government (roads and new schools).
Government final consumption expenditure (G)
This includes government services which are not sold on the market (defence,
police, education and health).
Net Exports (X-M)
This includes exports of goods & services minus imports of goods & services (as
imports are other countries’ expenditure & shouldn’t be included in our GDP).
Changes in inventories (ΔR)
This is the change in the value of goods held.
Statistical discrepancy
The transactions making up GDP are estimated independently, using diverse data
sources. The combination of survey & other measurement errors and timing
differences in various components results in a difference between the estimates.
Income Method
Compensation of employees (W)
This is made up of wages, salaries and taxable allowances.
Gross operating surplus (P)
This corresponds to accounting profit before deducting company taxes, dividends,
bad debts and net interest.
Consumption of fixed capital (D)
This measures the decline in value of fixed assets used in production as a result of
physical deterioration and normal obsolescence.
Taxes on production and imports (T)
This is GST and tariffs.
MINUS Subsidies (S)
Production approach
The production approach uses the value added at each stage of production.
Exclusions from GDP
 Illegal activities are excluded (e.g. selling drugs)
 Payments in kind (services given in exchange for services or nothing)
Nominal and Real GDP
Nominal GDP refers to the value of output at current market prices whereas 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 economic growth in real terms and
determine increases in our standard of living. To calculate Real GDP:
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3.4 Aggregate economic activity
The multiplier
Marginal propensity to consume (MPC) is the proportion of the last unit of income spent on
consumption. For example, if 80 cents of the last dollar of income is used for consumption
expenditure, then MPC = 0.8. Marginal propensity to save (MPS) is the proportion of the
last unit of income that is saved. If 20 cents of the last dollar is used in this way, then MPS
= 0.2. MPC plus MPS always equals 1.
Individuals’ income can either be consumed or saved. The portion that is spent becomes
income for someone else. They save a portion of this and spend the rest. In this way the
process repeats itself & incomes spread throughout the economy. The expansion process
is governed by both the portion spent & the part withdrawn (saved).
The multiplier process:
In this example, MPC is
0.8. The initial spending
increases economic activity
by the full $100m. Then in
subsequent rounds,
spending increases by
$80m, then $64m, then
$51.2m, then $40.96m.
This process continues until the changes in incomes become so small that they can be
ignored. In this example, GDP will eventually increase by $500m. Any given increase or
decrease in spending will cause a more than proportionate change in GDP, that is, a
multiplied effect. We use the term ‘multiplier’ to imply that a change in GDP will be a
multiplied change of the change that caused it.
Basic Multiplier:
We can calculate the multiplied effect on the level of income using the formula below:
The change in income (or GDP) = change in spending x multiplier
= $100m x 5
= $500m
The full multiplier:
When we consider the full economy and all the sectors, we consider all withdrawals from
the spending stream (savings, import payments and tax). The marginal propensity to tax
(MPT) is the proportion of the final unit of income being applied to tax. Marginal propensity
to import (MPM) is the proportion of the final unit of income being applied to imports.
For example, if c=0.2, t=0.25 and m=0.05, the multiplier is:
If the government wants to eliminate a deflationary gap of $100m and the MPC is 0.8, the
initial amount that they need to increase their spending by is only $20m (as the multiplier
would be 5).
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3.4 Aggregate economic activity
Balance of Payments
The Balance of Payments is a statistical statement that records all the transactions of one
country with the rest of the world. It’s divided into three accounts: the current account, the
capital account and the financial account. The balance of payments has a double-entry
system; hence the total balance of payments will be zero.
The current account
The current account records transactions in goods, services, income and current transfers.
The balance on the current account is the sum of all the credit entries (exports) minus the
sum of debit entries (imports).
Goods:
Export of goods minus import of goods, for example, cheese, wool,
timber, oil, chemicals and equipment.
Services:
Export of services minus import of services, for example, transport,
insurance, tourism, royalties and government services.
Income:
Income from investment abroad minus Income from foreign
investment, for example dividends, interest and profit transmitted
between countries. It is important to note that this is the income
earned from investment only and not the original principal amount
invested (that is in the financial account).
Current Transfers:
Current transfers inflow minus current transfers outflow. This
includes one sided transactions. The double-entry system requires
the balance of payments to have an entry to off-set the gift, so this is
the account for it. Some examples of current transfers are gifts,
foreign aid and money sent to family and friends overseas.
The capital account
The capital account covers transactions in capital transfers and acquisition disposal of nonproduced, non-financial assets. Capital transfers include migrants’ transfers, or the assets
that people bring with them when they move from one country to another. An example of a
non-produced non-financial asset is land, and of acquisition and disposal, buying and
selling. To work out the balance of the capital account, minus capital account outflows from
capital account inflows.
The financial account
The balance on the financial account is foreign investment in New Zealand minus New
Zealand investment abroad. The financial account records transactions involving a
country’s claim on (assets) and liabilities to the rest of the world. Together the financial
account and capital account explain how the current account is financed. In the financial
account increases in assets and decreases in liabilities are recorded as credit transactions;
and decreases in assets and increases in liabilities are recorded as debit transactions.
Financial account transactions are classified according to the type of investment they relate
to.
Direct Investment
Direct Investment is where investment by foreigners in companies in
New Zealand or investment by New Zealanders in companies
overseas is more than 10%. This includes equity capital, reinvested
earnings and other capital.
Portfolio Investment Portfolio investment is where investment is less than 10%. This will
include equity securities (for example shares) and debt securities
(bonds and notes or money market instruments).
Other Investment
This is other investment including loans, trade credits (accounts
receivable and payable), deposits and other assets and liabilities.
Reserve Assets
These are held by the RBNZ, such as foreign currency reserves &
special drawing rights with the International Monetary Fund (IMF).
Net errors and omissions
This is the balancing figure. This arises because data is collected from various sources.
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3.4 Aggregate economic activity
Terms of Trade
The terms of trade for a country is the ratio of its export prices to its import prices,
expressed as an index relative to a base year. The terms of trade can be calculated using
the formula below:
1000 is the base year in which the percentage changes are calculated from. For example if
the terms of trade index was 1233 relative to a base year, terms of trade was 23.3% higher
than the base year. For percentage changes that are not relative to a base year, use this
formula:
A numerical increase in the terms of trade is deemed favourable and a numerical decrease
is deemed unfavourable. However an increase in terms of trade does not directly correlate
to an increase in the current account. This is because terms of trade is concerned with
prices only, whereas the current account is concerned about the total value of exports and
imports (i.e. price times quantity). There is very little New Zealand can do to influence
terms of trade because of the fact that we are a small country, so we must accept the
prevailing prices on the world markets.
Exchange Rate
An exchange rate is the price at which one currency exchanges for another.
Fixed Exchange Rate
This is where an exchange rate is fixed between the national currency and some key
currency considered relatively stable.
With a fixed exchange rate, the money supply changes when there is a change in the
current account or if the government is financing a deficit. For example, receipts from the
sale of exports will increase an exporter’s bank account. Therefore bank reserves increase
causing a primary expansion of money supply and later a secondary expansion of money
supply. If the current account has a deficit, the effect would be the opposite. Domestic
money supply would decrease as more money is going overseas.
Floating/Flexible Exchange Rate
A Floating/Flexible Exchange Rate is determined in the market of foreign exchange. The
Exchange Rate is determined entirely by the demand and supply for the New Zealand
dollar. Since demand and supply conditions change constantly, so will the New Zealand
Exchange Rate. This may be a clean float where the government does not intervene in the
foreign exchange market. However they may have a dirty float where the government acts
to influence the exchange rate, for example buying billions of dollars worth of another
country’s currency.
With a Floating/Flexible Exchange Rate, the domestic money supply stays constant. This
is because for every buyer of foreign exchange, there is a seller. Therefore bank reserves
do not change.
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3.4 Aggregate economic activity
Appreciation of the Exchange Rate
An appreciation of the exchange rate is when there is a
rise in the price of one currency in terms of another. For
example if $NZ1.00=$A0.80 has changed to
$NZ1.00=$A0.82, the New Zealand dollar has appreciated
against the Australian dollar. This is normally caused by
an increase in the demand for the New Zealand dollar.
Causes of appreciation:
 Increase in export receipts
 Increased tourists coming to New Zealand
 Increased foreign investment
 Low inflation in New Zealand, making New Zealand
exports more competitive
Effects of appreciation:
 Discourages exports as New Zealand exports become more expensive than other
countries and therefore New Zealand exports are less competitive when priced in
overseas currency.
 Encourages imports as imports need less New Zealand dollars to buy imports.
Consumers will find that prices are cheaper.
Depreciation of the Exchange Rate
A depreciation in the exchange rate is when there is a
decrease in the price of one currency in terms of another.
For example if $NZ1.00=$A0.80 has changed to
$NZ1.00=$A0.78, the New Zealand dollar has depreciated
against the Australian dollar.
Causes of depreciation:
 Increase in import payments
 Increased New Zealand tourists going overseas
 Increased investment overseas
 High inflation in New Zealand, making New Zealand
exports less competitive
Effects of depreciation:
 Encourages exports as New Zealand exports become less expensive than other
countries and therefore New Zealand exports are more competitive when price in
overseas currency.
 Discourages imports as imports need more New Zealand dollars to buy imports.
Consumers will find that prices are more expensive.
Effect of interest rates in the foreign exchange market
When interest rates change, this has a double effect on the
foreign exchange market. For example, if interest rates
increase. There would be an increase in demand for the
New Zealand dollar (shifting the demand curve to the right)
as overseas investors would earn more money here
compared to other countries. There would also be a
decrease in the supply of the New Zealand dollar (shifting
the supply curve to the left) as New Zealanders are more
likely to save more money in their bank accounts. Overall
this causes an appreciation of the exchange rate. If interest
rates decreased, the opposite would happen.
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3.4 Aggregate economic activity
Money
In the past, people were self-sufficient and provided nearly all their own needs and wants.
As individuals specialised they no longer produced everything for themselves, so they
would barter items for those they required. Now people are mutually reliant on others for
certain goods and services which is called interdependence. With interdependence, people
need a more convenient system of exchange to swap their production as the problem with
bartering is finding someone with exactly what you want to swap. This problem is called
the “double coincidence of wants”. Money developed because markets required a means
of exchange, to remove the difficulties of the barter system. Goods and services are now
exchanged for money, which is a universally acceptable commodity; money is then used to
buy whatever is wanted.
Money acts as a:
 Medium of exchange (goods and services can be traded without a double coincidence
of wants)
 Unit of account (money allows goods and services to be priced)
 Store of value (money can be saved and used at a later date)
 Mean of deferred payment (money allows debts to be recorded)
Money must have the following characteristics:
 It must be acceptable (people must have confidence that it can be used to buy other
goods and services)
 It must be scare in relation to demand
 It must be portable (it must be convenient to carry around)
 It must be divisible (change must be able to be given when purchases are made)
 It must be durable (it is important that it won’t rot, rust, grow old, or wear out)
Without any of these characteristics, something can not be classed as money.
Measurements of Money
M1 (Narrow money supply) includes notes, coins and transaction accounts operable by
cheque and/or EFTPOS. This category has perfect liquidity because it can be used directly
as a means of exchange and is referred to as the official money supply. And, because
money held as M1 accounts generally gives little or no interest, people tend to keep only a
small portion of their wealth in these types of accounts.
M2 (Near money supply) includes M1 plus other on-call funds at registered banks and other
M3 institutions that are not operable by cheque and EFTPOS, for example savings
accounts. Near money is not as liquid because it requires an intermediate step to change
these funds into narrow money and use them as a means of exchange. For instance,
before using funds from a savings account you may have to take a trip to the bank,
complete a withdrawal slip and withdraw the cash, or you may have to make a phone call to
the bank to arrange for the funds to be transferred to a cheque account.
M3 (Broad Money supply) includes M2 plus term deposits or investment accounts held by
the public at registered banks and other M3 institutions (for example buildings societies
(e.g. Southern Cross Building Society) and savings institutions (e.g. PSIS)). This includes
all other types of accounts used as a store of value, but still relatively easily converted to
cash. People put money into these types of accounts because better rates of interest are
paid on them, and they are more secure. But money in these accounts must be converted
to narrow money before it can be used for transactions. There is often a penalty on
withdrawing money before the end of the term of the deposit that may involve a loss of
interest that could have been earned. Some deposits classified as M3 can still be quite
liquid, for instance, telephone accounts.
It is important to note that credit cards are not money as you are borrowing money from
credit card companies when you make purchases.
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3.4 Aggregate economic activity
Demand for money
The demand for money curve is downward sloping, as at lower
interest rates more money is held because it is not worthwhile to
save more money and at higher interest rates it is more
worthwhile to save more money.
Transaction demand for money
The transaction demand for money is derived from the level of
national income and aggregate demand. Anything that will lead
to a change in aggregate demand in the economy will change
the transactions demand for money. The more goods and
services that are demanded in the economy, the more money
will be demanded. An increase in the transaction demand for
money would cause the Money demand curve to the right.
Asset demand for money
There are two types of asset demands of money - speculative
and precautionary.
A speculative purpose is to buy an asset and wait for it to gain
value to sell in the future.
A precautionary purpose is to hold cash for unforeseen
circumstances, for example repairs on a car and medical
expenses.
This would cause a movement in the demand for money curve.
This is because an increase in the interest rate will decrease
the demand for money as the opportunity cost of holding wealth
in the form of non-interest-bearing cash deposits increases.
Supply for money
The supply curve for money is fixed at a particular point in time
because it is controlled by the Reserve Bank of New Zealand.
It is independent of the level of interest and is therefore shown
as a straight line.
The money market
The price of money is the base interest rate and is determined
by the intersection of MD and MS. If the rate of interest was at
r, the quantity of money demanded would be at Q, whereas the
quantity supplied is at Q’. There is excess supply of money
and interest rates would fall to r’. This effect would happen in
the opposite direction if the interest rate was lower than the
intersection of the MD and MS curves.
The rate of interest is very important in determining the level of
activity in the economy. Low interest rates will encourage
consumers to borrow and increase the level of consumption,
and when rates are low, businesses are more willing to borrow
to finance their investment plans. For instance, if interest rates
are too low there may be too much economic activity; the
economy may overheat, and this will put pressure on price
levels to rise.
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3.4 Aggregate economic activity
Nominal and Real money supply
The nominal money supply is the value of the stock of money in dollars. The real money
supply is the purchasing power of the stock of money expressed in base year dollars. The
real money supply is the nominal money supply divided by the price level. As per normal,
to find the real growth of money supply percentage, take the nominal growth in the money
supply percentage and minus the inflation rate.
Nominal and Real interest rates
The nominal rate of interest is the price paid for the use of money. The real rate of interest
is the rate of return after inflation (the price level) has been allowed for. The real rate of
interest may be calculated by subtracting the rate of inflation from the nominal rate of
interest.
The Reserve Bank of New Zealand
The Reserve Bank of New Zealand (RBNZ) is New Zealand’s central bank.
Its major roles include:
 The issuing of notes and coins
 Holding the major registered bank settlement cash deposits
 A banker to the government
 Maintaining a sound and efficient banking system
 Implementing Monetary Policy
 Determining which banks can be registered
 Supervising the banking system
Registered Banks
A bank can only call itself a bank if it is registered with the RBNZ. Registered banks
operate transaction accounts, provide loans, transfer funds and undertake foreign
exchange transactions.
A bank must:
 Have authorised capital of $30 million of which a minimum of $15 million is fully paid up
 Demonstrate expertise in the conduct of banking
 Have a willingness to co-operate with the RBNZ
M3 Institutions
Non-banks include all other financial institutions that are not registered banks, such as
finance corporations that offer hire purchase on vehicles and home appliances (e.g. UDC),
building societies (e.g. Southern Cross Building Society) and savings institutions (e.g.
PSIS). These M3 institutions compete with the registered banks but do not have settlement
cash deposits with the RBNZ. Also, they cannot use the word ‘bank’ in their name.
Settlement Cash deposits
Every day there are millions of transactions using the banking system; between customers
of the same bank; between customers of different banks; and between customers and the
government. To ensure the banking system operates efficiently, each bank must have an
adequate settlement cash deposits at the RBNZ. If they do not have enough money to
deposit with the RBNZ, they are able to borrow money from the RBNZ, with an interest rate
payable 0.25% above the OCR. The RBNZ will also pay banks interest of 0.25% below the
OCR for any money deposited with them. By using these Settlement Cash deposits, only
the net amounts outstanding between the banks will need to be settled using these
settlement cash deposits instead of settling debts with each other for every single
transaction.
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3.4 Aggregate economic activity
Monetary Policy
The Policy Target Agreement (PTA) is an agreement between the Minister of Finance and
the governor of the RBNZ to keep inflation between 1-3%. High inflation is undesirable
because:
 People on fixed incomes (pensioners and beneficiaries) are disadvantaged as their
purchasing power decreases leading to a more unequal distribution of income
 People tend to buy assets which rise in value more than inflation such as property and
antiques which do not stimulate the market
 People spend more money now as things will be more expensive in the future, therefore
savings are discouraged, leading to less investment as there is less money available to
borrow, which leads to decreased GDP, leading to decreased employment
 Planning and investment is more uncertain from changing prices, so it is discouraged
 It harms exporters as our prices are higher comparatively to other countries
If inflation is high, the RBNZ needs to contract the money supply in the economy. This is
known as a contractionary monetary policy. With a reduced money supply, people have
less money available to spend, so therefore AD decreases, reducing the rate of inflation.
If inflation is low, the RBNZ needs to expand the money supply in the economy. This is
known as an expansionary monetary policy. With an increased money supply, people have
more money available to spend, so therefore AD increases, increasing the rate of inflation.
To control the rate of inflation, the RBNZ has various tools than it can use.
Official Cash Rate (OCR)
This is the most common tool used by the RBNZ. This is reviewed 8 times a year, with four
of those announcements accompanied by a Monetary Policy Statement. The OCR is the
interest rate set by the RBNZ for registered banks. The RBNZ will pay interest at 0.25%
lower than the RBNZ to registered banks for their settlement cash deposits. The RBNZ is
prepared to lend registered banks 0.25% above the OCR if registered banks need to
borrow from the RBNZ to fund their settlement cash deposits.
The OCR therefore influences the retail interest rates set by banks. Since banks have to
pay 0.25% above the OCR to borrow from the reserve bank, it would only be worthwhile to
lend money to the public if the bank charges the public an interest rate above 0.25% above
the OCR in order to cover their interest payments and earn a profit. Also, since the bank
only earns 0.25% below the OCR for deposits with the reserve bank, they would not give
the public more than this interest rate for their deposits.
Interest rates hugely affect the money supply in the
economy. If interest rates rise, savers have more
incentive to move their money from M1 accounts to M3
accounts as the opportunity cost of interest not earned is
higher. Therefore savers have less M1 type money to
spend on day to day transactions. Also borrowing money
is more expensive for investors. Therefore they would
borrow less money which also decreases money supply.
The opposite effect would happen if interest rates fell.
Open Market Operations (OMO)
The RBNZ can also control money supply through buying and selling government stock. If
money supply needs to decrease, the RBNZ would sell government stock. This would
decrease the bank accounts of stock holders, so therefore money supply has decreased.
Similarly if money supply needs to increase, the RBNZ would buy government stock. This
would increase the bank accounts of stock holders, so therefore money supply has
increased.
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3.4 Aggregate economic activity
The business of banking
Banks accept deposits from customers and can make profits by advancing (lending) money
through loans, overdrafts and mortgages on the deposits they collect. Based on past
experience banks keep a ratio or portion of the deposits as reserves to satisfy customers
who wish to make withdrawals to carry out their day-to-day transactions. If banks kept no
reserves they would be unable to meet the customers’ requirements. The portion of
deposits that banks keep is known as prudential reserve. Banks keep these reserves as
either till money, settlement cash deposits held at the RBNZ or Reserve bank bills with less
than 28 days to maturity.
In New Zealand, the prudential reserve is 20% of the deposits made at each bank. For
example, if a bank had received a deposit of $100,000, they would keep $20,000 as the
prudential reserve and loan out the remaining $80,000. However, if another customer
withdrew $10,000 this decreases deposits down to $90,000. The $90,000 worth of
deposits the bank now has requires prudential reserves of $18,000 (20% of $90,000).
Prudential reserves will fall to $10,000 as the $10,000 required by the customer comes out
of the prudential reserves of $20,000. To satisfy its own requirements the bank needs to
increase reserves by $8,000.
The credit creation process and credit multiplier
When a back accepts deposits they keep some of the deposit as reserves (0.r is the
reserve ratio) and advance the rest. As this money is spent it comes back into the banking
system as someone else’s deposits. Some of this new deposit is kept as reserves and the
rest advanced. This process continues until the new deposit becomes so small I can be
ignored. The credit creation process is shown below, assuming an initial deposit of $100
million and banks having a reserve ratio of 20%
The value of the credit creation multiplier is an indicator of the final change in bank deposits
which will stem from the initial change.
The formula is:
where 0.r is the reserve ratio.
In the above example, the credit creation multiplier is 5.
Further we can work out the growth in the money supply.
The formula is: Credit creation multiplier times the initial deposit in the money supply.
In the above example it is 5 x $100 million = $500 million.
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3.4 Aggregate economic activity
Primary expansion
Primary changes occur when the registered bank gains new reserves and there are five
main ways this can happen.
Switching in and out of cash
The public deposit more money than they withdraw. The registered banks deposit
this as extra cash in their settlement cash deposits at the Reserve Bank, thus
increasing reserves. A primary contraction of money supply will occur when the
public withdraws more cash than is deposited.
Government budget translations
This happens when the government is financing a monetised deficit which
increases money supply (see below for a description of a monetised deficit).
Public debt policy
When the government wants to borrow money off the public, it will instruct the
RBNZ to sell government stock, treasury bills or retail stock. These can be
purchased by the public and registered banks. Government stock is a type of IOU
stating a fixed sum of money will be paid to the owner at a later date. Some stock
pays a rate of interest called the ‘coupon rate’ while others are sold at a ‘discount
rate’ if the stock is sold before the maturity date. Sales of government stock will
reduce bank reserves as the money is going towards the government. When the
government stock matures, bank reserves increase as the government is obliged to
pay back the money to stock holders, using its RBNZ account. To avoid this from
happening, the government can sell more government stock.
Open market operations (OMO)
The RBNZ can also sell and purchase government stock to influence the amount of
reserves of the banking system. In this case, the RBNZ holds onto the money. This
can be part of their monetary policy.
Foreign exchange transaction with a fixed exchange rate
With a fixed exchange rate, there is not an equal amount of buyers and sellers of
foreign currency. Export receipts are surrendered to the RBNZ, increasing
reserves, and for import payments the RBNZ has to purchase overseas reserves
from the banking system, decreasing reserves.
Secondary expansion
Whenever a primary expansion of the monetary base occurs, banks will be holding more
reserves as a percentage of total deposits than prudence will require. Banks are then able
to lend more through the credit creation process. This will equal the total credit created in
the economy minus the primary expansion.
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3.4 Aggregate economic activity
Monetised deficit
Borrowing from the RBNZ
This occurs when the government borrows internally from the RBNZ. A budget deficit will
have the net effect of increasing transaction accounts balances at registered banks
because these represent extra funds the government has spent on the public. This is also
shown as an increase in deposits made by the registered banks at the RBNZ. To cover
these payments, government deposits at the RBNZ drop by the same amount (or the
government goes into overdraft with the RBNZ, i.e. the government printing more money).
With this increase in reserves, registered banks can lend more money causing a secondary
expansion of the money supply. This is highly inflationary.
Borrowing from overseas with a fixed exchange rate
Borrowing from overseas with a fixed exchange rate will also be inflationary. With a fixed
exchange, money coming into the country goes through the banking system. When the
government borrows from banks overseas to finance its deficit, the funds raised are
credited to the government’s account at the RBNZ. When these funds are spent they
increase the domestic money supply.
Overall a monetised
deficit occurs if the
increase in demand for
money in the money
market is accompanied
by an increase in the
money supply. Interest
rates stay constant.
Impact on inflation is
higher.
Non-monetised deficit
Borrowing from the public
A non-monetised budget deficit occurs in the primary increase in the money supply, which
the deficit will cause, is neutralised or offset by funding the deficit. This is done through
borrowing from the public or from the registered banks. Government sells securities, either
to the public (e.g. Kiwi Bonds) or to registered banks. Fully funding the deficit means
selling sufficient securities to fully offset the injection, and the net impact on the money
supply is zero. The increase in the demand for money will result in an increase in the
interest rate, and this will reduce the effect of the injection.
Borrowing from overseas with a floating exchange rate
Borrowing from overseas under a floating exchange rate will have no impact on the
domestic money supply. The deficit budget leads to an increase in aggregate demand,
which will increase the transactions demand for money. The increase in money demand
with no corresponding increase in the supply of money will push up interest rates in the
money market. The rise in interest rates will have the effect of increasing savings, reducing
consumption and investment spending. These changes combine to reduce the increase in
the level of aggregate demand so that inflationary pressures are not so great.
Overall the increase in
the demand for money is
not accompanied by an
increase in money
supply. Therefore
interest rates rise.
Impact on inflation is
lower.
13
Macroeconomics
3.4 Aggregate economic activity
Aggregate Demand
Aggregate Demand is the quantity of output
purchased at a given price level in the whole
economy. The AD curve shows the real
output purchased at different price levels,
holding money supply and other factors
constant. The AD curve slopes downwards
to the right. As the price level increases,
aggregate demand for all goods and services
will decrease.
An increase in the price level (inflation) will
cause a movement along the AD curve.
A shift to the left is caused by a decrease in:
 Consumption spending (caused by lower disposable incomes through decreased wage
rates and/or increased income taxes (P.A.Y.E); or interest rates increasing as they less
money left over to spend on goods and services)
 Investment spending (caused by decreased spending on capital goods which relates to
an increase in interest rates as firms are able to afford to borrow less money)
 Government spending (if the government decides to have a budget surplus which is
spending less compared to tax revenue; this is caused by increasing income tax
(P.A.Y.E) or decreasing government spending; to a achieve a desired decrease, the
government has to keep in mind the multiplier, so if they want to decrease economic
activity by $40 million and the multiplier is 4, they only need to decrease spending by
$10 million)
 Net Exports (Exports minus Imports) (if the exchange rate appreciates because Exports
would decrease as they seem more expensive for overseas buyers and Imports would
increase as they seem cheaper for domestic buyers of overseas goods and services;
from this, the net export figure would decrease)
A shift to the right is caused by an increase in:
 Consumption spending (caused by higher disposable incomes through increased wage
rates and/or decreased income taxes (P.A.Y.E); or interest rates decreasing as they
more money left over to spend on goods and services)
 Investment spending (caused by increased spending on capital goods which relates to a
decrease in interest rates as firms are able to afford to borrow more money)
 Government spending (if the government decides to have a budget deficit which is
spending more compared to tax revenue this is caused by increasing income tax
(P.A.Y.E) or decreasing government spending; to a achieve a desired increase, the
government has to keep in mind the multiplier, so if they want to increase economic
activity by $40 million and the multiplier is 4, they only need to increase spending by
$10 million)
 Net Exports (Exports minus Imports) (if the exchange rate depreciates because Exports
would increase as they seem cheaper for overseas buyers and Imports would decrease
as they seem more expensive for domestic buyers of overseas goods and services;
from this, the net export figure would increase)
14
Macroeconomics
3.4 Aggregate economic activity
Aggregate Supply
Aggregate Supply is the quantity of
output that producers are willing to
supply at a given price level in the whole
economy. The AS curve shows the real
output that firms are willing to supply at
each price level. The AS curve slopes
upwards towards the right. As the price
level increases, aggregate supply for all
goods and services will increase.
A shift to the left is caused by:
 Increased wage rates that the firm
has to pay to employees
 The cost of imports rising due to a
depreciating exchange rate
 The cost of a related good in production increasing
 Decreased productivity by employees
 Indirect taxes increasing (e.g. GST and excise tax)
 Technology failing to work
 Uneducated workforce
 In summary, anything that will decrease production or that increases costs
A shift to the right is caused by:
 Decreased wage rates that the firm has to pay to employees
 The cost of imports falling due to a appreciating exchange rate
 The cost of a related good in production decreasing
 Increased productivity by employees
 Indirect taxes decreasing (e.g. GST and excise tax)
 New technology
 Better educated workforce
 In summary, anything that will increase production or that decreases costs
The slope of the AS curve depends on the degree to which the economy is operating at
less than full capacity and the ability of production units to expand output in the short run.
On the relatively flat part of the AS curve, firms are willing to increase output with a small
increase in the price level, as they have idle capacity. The slope becomes steeper as
much larger increases in prices are needed to induce firms to invest or add extra shifts and
pay overtime. Production costs rise as inputs become more scarce and diminishing returns
set in as the last employees are less likely to be as proficient as earlier workers. As the
economy approaches capacity, the more difficult it is to increase output as there is less
spare capacity. There may be hold-ups and bottlenecks, so price rises. Thus the AS curve
rises as the economy reaches its full capacity. A movement along the AS curve is caused
by a change in the price level.
The full employment (YF) or long-run AS curve shows that all resources are fully employed
and that firms are working to their capacity. This curve will shift outwards when new
technology is developed or if new resources are discovered.
15
Macroeconomics
3.4 Aggregate economic activity
AD/AS Model
The intersection of the AD and AS
curve shows the point at which the
economy is operating. This causes
a deflationary gap if the
intersection of the AD and AS
curves is before full employment.
This is because to reach full
employment, producers have to
supply more goods to the market
which would shift the AS curve to
the right causing deflation. An
inflationary gap happens when the
intersection of the AD and AS
curves is after full employment.
Here firms would compete for
scarce labour, which means they
would have to offer higher wages,
causing inflation.
Inflation
Inflation is the general increase in the price level. Disinflation is when the rate of inflation is
decreasing. Deflation is when price levels are decreasing.
Cost push inflation is caused by an increase in the
costs of production. This shifts the aggregate
supply curve to the left. As a result, price level
(inflation) increases and Real GDP decreases.
Demand pull inflation is caused by an increase in
aggregate demand. This shifts the aggregate
demand curve to the right. As a result, price level
(inflation) increase and Real GDP increases.
16