What is National Final)

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EconomicsNotes for Book 5A

Tong Ka Kit

10/11/2011


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What is national income?

National income measures the money value of the flow of output of goods and services produced within an economyover a period of time.

National income is also used as an indicator of Rate of Economic Growthchange in per cent of real GDP Economic development Change in Living standards

What is GDP?

GDPtotal value of output of all resident producing units in a domestic economy over a period of time usually ayear

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

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

where C= Consumers/ Household expenditureI=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 thatwill not be resold or used in production within the year.

Intermediate goods and services are not included in order to avoid double countingConsumption expenditure Household expenditure on goods and services Consumption good expenditures include purchases ofnon-durable goods, and purchases ofdurable goods, including the

purchases of all kinds ofpersonal services.

GDP=C+I+G+(X-M)

O=E=Y


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

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 valuewhich 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.

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

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 otherPer 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.

Growth rate

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

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

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

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

Per Capita GDP=

GNP = GDP + Net property income abroad (Y from abroadY paid abroad)

% rate of =

%


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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 fromoverseas 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 pricesprevailing in the same period.

Take no account of thechange 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 aparticular time (a base period, or base year).

Take account ofchanges 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 risein prices with inflation

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. Investmentincrease 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

Real figure=


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

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

To address some of these issues, GDP/GNP needs to be calculated in per capita terms2. 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 power3. State sector

Military expenditure of GDP has effects on economic development, which does not imply high livingstandard

Per capita real consumption is alternative indicatormeasure the average quantity of goods andservices 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 INCOMEMEASURED BY THE TOTAL INCOME(Y)


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

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

Government Expenditure(G) Government Taxation(T) Import (M) Export (X) Saving(S) Investment(I)Leakages/Withdrawals (W)

Saving(S) Government Taxation(T) Import (M)Injection (J)

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

FACTRO INCOME (Y)GOODS + SERVICE(OUTPUT)

Public sector

International Trade sector

Private sector

Increase economic activity

Reduce economic activity

Leakages/ Withdrawal(W)

Saving (S)

Taxation(T)

Imports(M)

Injections(J)

Investment(I)

Exports(X)

Government

COMPLEX MODEL OF THE CIRCULAR FLOW

Real flow

Mone flow

Suppose the GDP deflator of an

economy decreases from 100 to

90. This implies that

A. Its GDP decreases by 10%

B. The general price level

decreases by 10 %

C. Peoples real income

increases by 10 %

D. Peoples living standard

decreases by 10 %.


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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

(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

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)

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.

Costs of unemployment

Unemployment is an indicator of the level of economic activity, which is a lagging indicator. It affects economicswelfare.

It reduces income and leads to a fall in living standard of the unemployed. They may experience substantialpoverty.

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)

Labour force = Employed + Unemployed

Percentage of unemployed =

100 %

Underemployment rate =

100 %


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2010-2011 Economics notes National income

1

Unemployment cannot reflect the changes in economics welfare. Underemploymentan 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 ofunemployment.

Value of leisure timethe unemployed have more leisure. Types of unemployment

Frictional & Transitional unemploymentcaused by geographical & occupational immobility of labouror lack of knowledge (information failure)

Seasonal unemploymentthe unemployment rate may be slightly higher seasonally due to the increase inlabour force or reduce in demand in the market

Structural unemploymentcaused by the change in technology or the rigidity of labour market or thechange 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 shouldbe 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 whichdetermine the weights

(n.b. Base year = 100)

Expenditure weights based on a basket of goods and servicesImplicit Price Deflator of GDP

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

=

%

CPI =

100 %

Implicit price deflator of GDP =

100 %


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(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, theprice 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 ofGDP 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 changesaccording 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.

CPI can better reflect the effect of price changes on consumers, thus, it is a better indicator of the cost living because itonly 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 takesaccount 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

Inflation in 2008 =

100 %


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

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

3. Unit of accountit enables us to compare the relative prices of goods and services by measuring the values of goods4. 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, realestate, 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 otherassets 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 astable 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 mucheasier.

2. Scarce with a stable valueit must be able to store value and have a stable value that economic agents could rely on.3. 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 canserve 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. Divisibleit can divide into smaller units for small transaction.6. PortableEasy to carry

Money supply

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

Cheques, Credit cards, Octopus, EPS and online payment systems are the payment technologies, but they are notmoney. 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

Fish are not good units of account

mainly because they are not

A. DurableB. Scare

C. Homogeneous

D. Portable


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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 bythe 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

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

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.

MV=PT


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1. M1: Cash held by public + Demand deposits2. M2: M1+ saving and time deposits + NCEs (in licensed banks)3. M3: M2+ Deposits (in restricted license banks and deposit-taking companies)

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

Introduction of banking

The banking system of a region is composed of Commercial Banks.Types of Bank s

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

2. 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 Banks1. Governments banker

It manages governments account and government debt2. Issue notes and coins

Which of the following is an

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.

C. Credit cards do not have any of

the functions of money.

D. Credit cards are the standard of

the standard of deferred payment

Money Supply = Cash held by the public + Deposit

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

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.

D. Both HK$M1 and HK$M2 will

decrease.


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

3. 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 stability4. 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 abank.

It maintains the financial stability5. Monitor/ Supervise/ Manage/ Regulate/ Control the financial system6. Accept Deposit form commercial banks

It provides operational balances7. Provide short term loans8. 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 It accepts deposit and provides loans / makes investment It borrows and lends money in order to make profit.

2. 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 marketpost 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.

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

activit .


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2. Infrastructure Well-developed transport system and communication network

(e.g. telephone and internet etc.)

Financial infrastructure Establishment of capital market

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

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 creditcreation.

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 ofnot 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.

Assets Liabilities

Cash reserves $500 Deposits $1000

Loans $500

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 Minimumreserve ratio. (e.g. 20%)

Reserve asset ratio=

100%

Below is the balance sheet of Bank A.

Assets Liabilities

Reserves $1000 Deposits $2500

Loans $1500

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


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For example, for $1000 deposited, $200 is kept in the reserve, which isFractional 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 itscomposition.

(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. Wheneverybody 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 ofMONEY 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 depositAssets Liabilities

Reserves $1,000 Deposits $1000

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 Liabilities

Reserves $1,000

Loans $800

(+800)

Deposits $1800

(+800)

3. Third round of depositAssets Liabilities

Reserves $1,000

Loans $1,440

(+640)

Deposits $2,2440

(+640)

Bank holds 20% reserves, and lends the $640 excess reserves to the public. The public deposit all thecash, $640 to the bank.


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=

=

= ( ) = % =

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?

=

=

= ( ) ( )

= =

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 Not all loans are returned as deposits Credits/ Deposits creation is limited Cash drain reduces the reserves

b. Banks are likely to have excess reserves

To reduce risk in making loansc. 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 reserveshortage is caused by the customers withdrawals.

Deposit contraction implies that there is a reduction in deposits and money supply due to the recalling of loansfrom banks. Because of reserve shortage, banks have to recall loans to hold the minimum reserve ratio.

Monetary Policy

Ms=Cash in circulation + Deposits (=reservemultipliers)

Deposits=Reserves

= Reserves Banking multiplier

=

=

Excess reserves = Actual reservesRequired reserves


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Monetary Policy is the attempt by monetary authorities to control the rate of growth of money supply and/ or thelevel 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 ofmonetary 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 decreaseof 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 termloans.

An increase in discount rate will increase the cost of capital of banks and hence decreasing the size ofmonetary base.

A decrease in discount rate will decrease the cost of cost of borrowing, and hence providing moreincentives 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 loansmore 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 sufficientfunds, 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 amacroeconomic level.

There are two types of monetary Policy Expansionary Monetary Policy: Central bankincreases 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 ofpurchase of government bonds.

Contractionary Monetary Policy: Central bankreduces 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 willincrease.

It would lead to a change in foreign exchange, leading to a depreciation of exchange rate. The price of importincrease 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 maycreate 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 willdecrease.

Overall,ContractionaryMonetarypolicy would lead to a decrease of GDP/ National income, a rise ofunemployment, 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 Kongdollars, 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 beinflationary)

Price adjustment of particular goods (e.g. tea/ rice) only changes relative prices (e.g. price of tea relative tothat of coffee). This is not inflation.

Inflation means being a general rise in prices and deflation means being a general fall in prices. Inflationmeans 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 purchasenational 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 sameextent but that real income returns to its original level in the long run.


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An increase in money supply will lead to an increase in price level, which firms will increase output due to theincentives 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 levelin 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 nominalincome 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 ofexchange, 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 pricelevel 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 thechanges 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).

Realised real interest rate is measured in terms of goods; nominal interest rate is measured in terms of money.The Fishers equation

Inflation affects realized real interest rate when entering loan agreement borrowers and lenders will take inflationinto account.

If the interest expected inflation is 3%, borrowers will need to pay an extra 3% on top of the real interest rate tocompensate lenders for the loss of spending power caused by inflation, called an inflation premium.

Realized Real Interest Rate = Nominal Interest RateActual Rate of Inflation

Nominal Interest Rate = Real Interest Rate + Anticipated Inflation Rate


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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 ofmoney decreases. As a result, leaders lose and borrowers gain.

Ifthe inflation rate is lower than expected, the realized rate interest rate will increase because the purchasingpower 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 budgetsurplus (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 liquidityTransaction 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 transactiondemand 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.


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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 assetdemand 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)

The nominal money balance means the total amount of money at face value, whereas the real money balancemeans 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 rateof growth of GDP.

Equilibrium interest rate

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

Nominal Money Balance = Face Value

=


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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 equilibriumChange in the interest rate

Due to an increase in GDP, it causes an increase inmoney 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 a decrease in GDP, it causes a decrease inmoney demand and a decrease in interest rate, shifting

the money demand to the left.

Due to the purchase government bonds from thepublic, 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, itcauses an increase in money supply, but a decrease in

interest rate, shifting the money supply to the left.

Expansionary Monetary Policy

Expansionary monetary policy is designed to increaseeconomic activities

An increase in issuance of money, purchase ofgovernment bonds, lowering the minimum ratio,

and lowering the discount rate will increase moneysupply, but a fall in interest rate.

Contractionary Monetary Policy

Contractionary monetary policy is designed todecrease economic activities.

A decrease in quantity of banknotes, sale ofgovernment bonds, raising the minimum ratio, and

raising the discount rate will decrease moneysupply, 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 demandand supply fall.

=


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Fall in interest rate

Change in money supply is greater than the changein 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 changein 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 Kongfinancial 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 thegovernment 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 potentialoutput, 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, bettingduty, 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 andproperty 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 Name of tax Content

Direct taxes Salaries tax Salaries earned and pensions received personally in Hong Kong

Profits tax Profits from enterprises earned in Hong Kong

Property tax Property owners rental income earned form land or properties in Hong Kong

Indirect Taxes Duties Hydrocarbon oil, liquor with an alcoholic strength of more than 30% of volume, methyl alcohol

and tobacco

Rates Occupation of properties. The amount is based on rental valuation.

Betting duty Legal gambling activities in Hong Kong, including horse racing, Mark Six and soccer gambling

Stamp duty Assignments of immovable properties, leases and stock transactions

First registration tax Vehicles first registered for use in Hong Kong

Method of calculation of tax rate

The types tax scheme (e.g. progressive or proportional or regressive tax scheme) is classified by the tax rate/ theproportion 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. Ordinarysalary earners pay a progressive tax.

Proportional Tax: when taxable income increases, the tax rate remains unchanged. It is an example of directtax. 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 isimposed 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 itreaches 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 totaltaxable 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

=

%

Taxable Income = Total IncomeTax AllowanceTax Deductions


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The government can redistribute income through tax revenue to provide inexpensive services for disadvantagedgroups (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 payless, 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 incomedistribution. 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 whichcurrencies exchange.

Under a pure flexible exchange rate system (floating exchange rate), exchange rates are determined entirely bymarket forces without government intervention

Under a fixed exchange rate system, exchange rates are determined by the authority. (e.g. Exchange rate of US$ interms 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 countryneeds 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 itsown 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 oftime. Receipts should balance to Payments.

There are two accounts in the BalanceofPayment (BoP). Current Account Capital and Financial AccountCurrent account

Current account consists ofvisible trade (e.g. tangible goods), invisibletrade (e.g. services), factor income,current transfers.

Balance of visible trade

If the balance of visible trade is positive, it has a surplus on visible trade. It indicates that the export of goods isgreater 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 issmaller than import of goods. (i.e. X


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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 servicesis 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 ofservices is smaller than import of services. (i.e. X


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If there are no other transaction, the balance of payment domestic country is equal to the current accountBalanceof 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 accountbalance 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 Ireserve 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 = ExportsImports (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.

Trade Surplus (e.g. China)

When net export is greater than 0 (i.e. NX>0), it iscalled current account surplus. (i.e. positive trade balance) Capital and financial account will be smaller than 0(i.e. KA


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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


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According to David Ricardo, the theory of comparative advantage to show that even though one country had anAbsolute 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. 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 thisgood.

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


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Country B exports Good X only if the export price is greater than the domestic cost, and country B gains0.2Y; 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. Termof 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

Which country will

export Y?

Gain of Country A Gain of Country B

1Y=1X No trade / /

1Y=2X No trade 0 3X

1Y=3X Country A 1X 2X

1Y=4X Country A 2X 1X

1Y=5X No trade 3X 0X

1Y=6X No trade / /

Advantages of international trade

Trade enables countries to exchange for other goods that they cannot produce locally because of the difference infactor 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 foreigncurrency 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 currencywill 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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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. 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)2. Import Tariffs: it is a tax on imported goods Price of import will rise and quantitydemanded will reduce. Supply ofimportreduces. Domesticproducer will gain with the increase in output and importsurcharge. (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. Quantitydemanded of domestic producers will rise.

To exporters, the subsidy reducesprice of domestic producers. The competitiveness and its output will beincreased 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 atequilibrium 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 higherprice 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. Domesticeconomy 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. Quantitysupplied of domestic output would rise from 60 to 100. Quantitydemanded of domestic output would fall from 60 to 20.


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As a result, Country A as a price taker has akinked supply curve.

The export volume is equal to the domesticquantity supplied minus domestic quantity

demanded (i.e. between 20 units and 100

units)

Since the domestic price rises, domesticconsumers will lose but domesticproducers

will gain.

Consumersurplusfalls (i.e. loss of area B) Producersurplusrises (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 akinked supply curve.

The import volume is equal to the domesticquantity demanded minus domestic quantity

supplied (i.e. between 20 units and 100 units)

Since the domestic price falls, domesticconsumers will gain but domestic producers

will lose.

Consumer surplus rises (i.e. gain of areaB+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 countrys

economic welfare.

Effects of tariffs

Assume that Country A impose a tariffof $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)


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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. Consumer surplus falls (i.e. loss of area

B+C+D+E)

Producer surplus rises (i.e. gain of areaB)

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

area C+E)

There is a net economic welfare losssince 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 allocativeinefficiency and over-production, leading to a deadweight loss.

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

Effect of Quotas

Assume that Country A imposes a quota of 35 units (i.e. 75-40 units) andassigns 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 supplycurve.

Domestic price rises by $t above theinternational price.

Quantity supplied domestically increasesby 20 units. (i.e. 40-20 units)

Quantity demanded domesticallydecreases by 25 units (i.e. 100-75 units)

Import volumefall from 80 units to 35units (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.


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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) 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, leadingto a deadweight loss.

Area E, where marginal benefit of output is greater than the international price, causes theunder-consumption, leadingto 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 otherbarriers to open markets.

The WTO was established in 1995 and was preceded by another international organisation known as the GeneralAgreement 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 andintellectual property.

The highest policy-making body of the WTO is the Ministerial Conference, where government representatives ofmember 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 thecommitments 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 itsmember 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 andAPEC), 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 seekeconomic 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 anddevelop markets for trade in goods and services.


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Trade and Industry Development, The Hong Kong Export Credit Insurance Corporation, the Hong KongProductivity 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 MemberEconomics 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 pricelevels.

In a closed economy, there is no international trade. Aggregate demand consists of the Private Consumptionexpenditure by households, Investment expenditure, and government expenditure.

In an open economy, aggregate demand includes net export because of international trade. (i.e. net export=Exports-Imports)

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 quantitydemanded 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 andconsumption.

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 ofinterest.

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.

AD=C+I+G

AD=C+I+G+(X-M)


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A depreciation of its currency and its real exchange rate will increase the net exports, where domestic outputbecomes 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.

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/ investmentexpenditure and net exports while government expenditure remains unchanged) because ofwealth / 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

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

Price of one unit of foreign

good

Price of one unit of

domestic good

Price of one unit of foreign

good

D$200 F$400 D$100 F$400

Real exchange rate of

the domestic currency

=

Real exchange rate of

the domestic currency

=

=


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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 moneywages for real wages.)

Long run: when all price can be fully adjust, there is no excess demand or excess supply. There are nomisconceptions in long run.

Long run aggregate supply

We assume that production resources, technology and productivity remain unchanged in both short run andlong 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 isequal 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 leveland 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 thatthe relative price has not changed.

Reason that LRAS curve is vertical


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In the long run, an economys production of goods and services or potential GDP depends on its supplies oflabour, 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, theLRAS curve is vertical.

Long run equilibrium

1. Long run equilibrium exists where the quantity of output supplied anddemanded 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.

2. In long run, aggregate output does not change, but aggregate demand andprice level changes.

If there is an increase in aggregate demand, it causes Ad curve to shift to the rightfrom AD1 to AD2.

Price level would increase from P1 to P2 and the aggregate output remainsunchanged 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.

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