Inflation Lesson Two A• Reflection – Inflation Lesson One

• Understand Savings and Investment, Interest Rates and Economic Activity, Fiscal Policy, and Net Exports

Savings and Investment

• Why do we save?

• Why do we invest in the share market or term deposits?

• What will affect our level of savings and investment?

Savings and Investment

• When present consumption is sacrificed, it is called savings (income is not spent, a.k.a if you buy shares, or put money in the bank etc)

• When current consumption is forgone, there is a prospect of a greater level of consumption in the future, and the possibility of a higher standard of living.

Investment Spending

• Investment spending will often require borrowing, so the level of investment is dependent on the level of savings i.e. savings makes investment possible.

• Investment spending (capital accumulation or formation) occurs when an economy adds to the stock of capital goods.

The Level of Savings and Investment

• The level of savings in an economy depends on factors such as household levels of disposable income, attitude towards the economy and interest rates.

• The level of investment in an economy will depend on factors such as the state of the economy, business confidence and interest rates.

Interest Rates and Economic Activity

• Interest rates are either the reward for saving or the cost for borrowing.

• When interest rates increase, then it is likely that households will be encouraged to save more and spend less, this will cause aggregate demand to shift inward [to the left], and reduce inflation.

• When interest rates increase, individuals pay more for mortgages and credit cards, consumption and spending decreases and the aggregate demand curve shifts inwards [to the left], easing inflationary pressures.

Interest Rates and Economic Activity

• Interest rates represent the cost of borrowing i.e. it is the price which must be paid for the use of funds necessary to provide capital goods.

• As interest rates rise, the level of investment by firms will decrease because the cost of borrowing has risen. This will cause aggregate demand to shift inward and inflation to fall.

Interest Rates and the New Zealand Dollar

• How do you think interest rates effect the New Zealand dollar

Interest Rates and the New Zealand Dollar

• Interest rates also impact on the value of the New Zealand dollar.

• When interest rates are high in New Zealand relative to overseas then New Zealand investors will find New Zealand a relatively more attractive place to keep their money.

• This causes a smaller outflow of the New Zealand dollar and there is a decrease in the supply of it, this causes the New Zealand dollar to appreciate.

Interest Rates and the New Zealand Dollar

• Overseas investors will be attracted by the returns in New Zealand, and demand for the New Zealand dollar will increase again, causing the dollar to appreciate further.

• As 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, thus their incomes decrease.

Interest Rates and the New Zealand Dollar

• The overall result is less demand-pull inflation. Imports will also be cheaper also as the New Zealand dollar appreciates, so there will be less cost-push inflation.

Fiscal Policy

• What does the word fiscal and policy make you think of?

Fiscal Policy

• Fiscal Policy is the name given to changes in levels of government income (revenue) and expenditure in order to influence the level of economic activity (aggregate demand).

• The Government announces the changes to its income and expenditure in the Budget announced by the Minister of Finance.

Fiscal Policy – Government Income

• Government income comes from various sources including taxation (direct tax and indirect tax), fees, fines and investment income.

• Direct taxes are levied on earned income or wealth and paid directly by the taxpayer (individual or company) to the Government, for example, income tax, taxes on wealth and company tax.

Fiscal Policy – Indirect Taxes

• Indirect taxes are taxes collected by a third party and passed onto the Government.

• Indirect taxes are charged on goods and services when they are purchased by people, for example goods and services tax (GST), sales tax, custom duties (imposed on imports) and excise taxes (a tax imposed on a limited range of products, for example fuel, cigarettes and alcohol)

Fiscal Policy - Growth

• When the economy experiences growth, Government revenue from direct and indirect taxes tends to increase.

• As firms increase output and employ additional workers or pay overtime to existing workers, household incomes rise and they more income (direct) tax.

• As household consumption spending increases firms will collect more indirect tax.

Fiscal Policy – Government Budget Deficit

• A Government budget deficit is where Government spending exceeds income. This is expansionary fiscal policy which is used during a recession, depression or period of stagnant economic activity.

• It involves either increasing Government spending, increasing transfers or decreasing direct or indirect taxes or both.

• The price level (inflation), employment and output would all increase as aggregate demand would shift outwards to the right.

Fiscal Policy – Government Budget Surplus

• A budget surplus occurs when the Government’s income is greater than its expenditure. It could involve a decrease in Government spending, decreasing transfer payments, and increasing both direct and indirect taxes.

• This contractionary fiscal policy will reduce levels of spending and result in a decrease in aggregate demand which will dampen the level of economic activity output, growth may fall and the price level falls.

Net Exports• A downturn in net exports due, say, to a worldwide downturn in economic

activity (a recession / depression), would mean a decline in export income. Fewer workers would be employed in export-related industries and incomes would fall.

• The aggregate demand curve would shift inwards [to the left], causing the price level, output, and employment all to decrease. Changes in net exports will have a multiplied effect on New Zealand’s national income (GDP).

• Changes in the quantity of exports and imports have an influence on New Zealand’s economic growth, employment and price level.

• As net exports increase, aggregate demand shifts outward, increasing the levels of output, employment and the price level.