Macroeconomic Diagrams

Definition• Aggregate Demand

• The total expenditure on the national output at different values of the price level over a given period of time.

• C onsumption or spending by households• I nvestements = spending by firms on goods• G overnment Spending• X-M = Export minus Imports => net amount spent on economy’s

output by rest of world• Aggregate Supply

• Total output of goods and services, which all firms in the economy are willing and able to supply at different price levels over a period of time.

Reason for Shifts• Aggregate Demand

• Reduction in income tax• Consumption increase

• Reduction in interest rates• Consumer spending and corporate investment increase

• Increase in government spending• Boosting demand certain products, increasing earnings in sector

• Improved competitiveness performance• Boosting export sales

0

Aggregate Demand Increase

Output

Pric

e Le

vel

D

D1

S

P

P1

Q Q1

Reasons for Shift• Aggregate Supply

• Increase in short-run AS• Reduction in Indirect Tax• Reduction in Wage costs• Reduction in raw material & import costs• Favorable weather conditions

• Decrease in short-run AS• Reverse of everything said.

0

Aggregate Demand Decrease

Output

Pric

e Le

vel

D

D1

S

P

P1

Q Q1

International EconomicsReasons for Trade

Factor endowments• Factors of production that a country has available to produce

goods and services • Australia has minerals

Specialization• Exists where country specializes in production of goods and services

where they have a comparative advantage in production. Trade to get goods and services in which they do not specialize.

Absolute Advantage• Good exists where a country is able to produce more output than

other countries using same inputs of factors of production.

Comparative Advantage• A good exists where a country is able to produce a good at a

lower opportunity cost of resources than another country.

Automobiles Comparative Advantage between Japan and China

Apparel

Thousand units

100

Uni

ts

5

5 20

1

0

Japan

China

Free Trade & Protectionism

Free Trade • International trade takes place without any barriers, such as tariffs,

quotas, and subsidies.

0

Free trade in an economy

Price

Quantity

Sworld

SDomestic

D

Pworld

PEq

QeQ1 Q2

Tariff• Duty that is placed upon imports to protect domestic industries

from foreign competition and to raise revenue for government

Sworld

SDomestic

D

PEq

0

Price

Pworld

QeQ1 Q2 Quantity

Tariff diagram

STariffPTariff

Q3 Q4

Deadweight Loss

Quota• Import barrier set upper limits on quantity or value of imports that

may be imported into a country.

Sworld

SDomestic

D

PEq

0

Price

Pworld

QeQ1 Q2

STariffPTariff

Q3 Q4

Windfall gain by foreign producersLoss

Quantity

Subsidy• An amount of money paid by the government to a firm, per unit of

output, to encourage output and to give firm an advantage over foreign competitors.

Voluntary Export Restraint• Voluntary agreement between an exporting country and an

importing country that limits volume of trade in particular product.

Infant Industry Argument• Propose new industries should be protected from foreign

competition until they are large enough to compete in international markets.

Dumping • Selling of a good in another country at a price below its unit cost

of production.

Anti-Dumping• Legislation to protect an economy against import of a good at a

price below its unit cost of production.

Economic Integration & WTO

Free Trade Area• Exists when agreement is made between countries agree to trade

freely among members of the group, but are able to trade with countries outside free trade area in whatever ways they wish.

Customs Union• Agreement made between countries, where countries agree trade

freely among themselves, and they also agree to adopt common external barriers against any country attempting to import into the customs union.

Common Market• Customs union with common policies on product regulation, and

free movement of goods, services, capital, and labor.

Trade creation• A benefit of greater economic integration• Entry of country into a customs union leads to the

transfer of production from a high cost producer to a low cost producer

Trade Creation

A

B

C High cost Producer

BLow Cost Producer

Tariffs

Trading Bloc

Before

Trade Creation

A

B

C High cost Producer

BLow cost Producer

After

Trade Diversion• A disadvantage of greater economic integration• Entry of country into a customs union leads to the

transfer of production from a low cost producer to a high cost producer

Trade Diversion

AC

High cost Producer

B

DLow cost producer

Before

Trade Diversion

A

C High cost Producer

B

Trade Barriers

DLow cost producer

After

WTO• World Trade Organization

• International body that sets rules for global trading and resolves disputes between its member countries. Also hosts negotiations concerning reduction of trade barriers between member nations.

Balance of Payments

Balance of Payments• Record of value of all transactions between residents of a country

with residents of all other countries over given time period.

Balance of Trade• Measure of revenue received from exports of tangible goods minus

expenditure on imports of tangible goods over a given time period.

Current Account• Measure of flow of funds from trade in goods and services, plus net

investment income flows (profit, interest, and dividends) and net transfers of money (foreign aid, grants, and remittances)

Visible TradeImports and Exports of

Goods

Invisible TradeImports and Exports of Services

Net Transfers

Current Account

Capital Account• Measure of buying & selling assets between countries. Assets are

often separated to show assets that represent ownership and assets that represent lending.

Net Transfers of Capital

Net Investme

nt and loans

Changes in

National Reserves

Capital Account

(Financial Account)

Current Account Surplus• Where revenue from exports of goods and services and income

flows is greater than expenditure on import of goods and services and income flows over given time period.

ProsForeign investments made overseas will generate interest and profit

National Saving for future consumption

ConsPolitical tension (one country’s surplus is another’s deficit)

Tax loss as overseas investments taxed by foreign governments

Resources are being diverted abroad

Investment aboard and not at home

Current Account Deficit

• Where revenue from export of goods & services & income flows is less than expenditure on import of goods & services & income flows over given time period.

Pros

Foreign Investment increases output

Cons

Long term loss of confidence

Foreign ownership of assets

Foreign exchange reserves depleted

Correcting a Current Account Deficit

Short Term Strategies

Manipulate Exchange RateDevalue currency

Expenditure-switching policies Less expenditure on imports through Protectionism & Devaluation

Expenditure-reducing policiesReduce AD through deflationary fiscal and monetary policies

Long Term Strategies

Supply-side policies Increase LRAS to increase productivity

Correcting a Current Account Surplus

Manipulate Exchange Rate Appreciate currency

Expenditure-switching policies More expenditure on imports through removal of Protectionism

Expenditure-increasing policiesIncrease AD through inflationary fiscal and monetary policies

Marshall-Lerner Condition• Depreciation, or devaluation, of a currency will only lead to

improvement in current account balance if elasticity of demand for exports plus elasticity of demand for imports is <1.

J-Curve

Exchange Rates and Terms of Trade

Exchange Rate• Value of one currency expressed in terms of another.

Fixed Exchange Rate System

Government intervention to maintain a fixed exchange rate

Floating (Flexible) Exchange Rate

System

Supply and Demand determine the exchange rate

Managed Exchange Rate

System

Exchange rate generally allowed to

float but governments intervene to avoid

sudden fluctuations

Appreciation/Depreciation

Appreciation Increase in value of one currency in terms of another currency in afloating exchange rate system

DepreciationFall in value of one currency in terms of another currency in floating exchange rate system

Revaluation/Devaluation

RevaluationIncrease in value of currency in a Fixed Exchange rate system.

DevaluationDecrease in value of currency in a Fixed Exchange rate systemRevaluation

Purchasing Power Parity Theory

• States that under floating exchange rate, exchange rates adjust to offset differential rates of inflation between countries that are trading partners in order to restore BoP equilibrium.

Terms of Trade• Index that shows value of country’s average export prices relative to

their average import prices.

Improving TOTExport prices rise more relative to Import prices or if Export prices fall relatively less than Import prices

Deteriorating TOTImport Prices Rise more relative to Export prices or if Import Prices fall relatively less than Export prices.

Terms of Trade

Improving TOTRise in Standard of Living but International Competitiveness can be jeopardized (Your exports are more expensive)

Deteriorating TOT Fall in Standard of Living but International Competiveness improves (Your exports are cheaper)

Elasticity of Demand of Exports• Measure of responsiveness of quantity demanded of exports when

there is a change in relative price of exports.

Increase in Demand for $

0Quantity of $

Pric

e of

$ in

Yen

$10

$20

S

D

D1

Elasticity of Demand for Imports• Measure of responsiveness of quantity demanded of imports when

change in relative price of imports.

0

Pric

e of

$ in

Yen

$10

$20

S1

D

S

Quantity of $