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Internal Assessment 91227 (Growth and the Environment) Marie Poff (12VT)

Sustainable economic growth is usually defined as an increase in Real Output (the production of goods and services in an economy), but at a rate that can be maintained for the future without creating other significant negative effects. It is measured as the annual percentage change in real GDP, which can be measured using the expenditure method, which is the sum of the market value of purchases of all final goods and services produced in the economy; consumption spending (C), investment (I), government spending (G), and net exports (X-M). Increasing economic growth can be achieved by either increasing the output from existing resources or increasing the quantity of resources available to a country. The discovery of new resources will result in an increase in growth, but may only be short-term because the new resource may be depleted. Growth can also be achieved through an increase in the quality or quantity of human resources. The quality of a worker is generally equal to their output per worker, or productivity, and can be increased by education or training courses. Growth is a desirable objective because it means the economy is expanding, and the productive capacity of an economy is increasing as firms increase output. As well as this, households tend to receive higher household incomes, and this usually means an increase in GDP per capita and therefore a higher standard of living. Growth is an objective of Government economic policy because it is one of the keys to a higher standard of living, as well as resulting in higher government revenue, which can be used to improve roads, schools, etc, without resorting to an increase in tax rates. However economic growth can also lead to high levels of inflationary pressure as the general price level increases, (shown on graphs as PL).Some inflation is necessary to ensure that growth of an economy and encourage producers, but high rates of inflation lowers the real value of wages (as commodities cost more and money is worth less) and savings, and in fact can reduce the standard of living. This would also impact on producers as the price of raw materials increase, thus increasing the costs of production. Inflation can also cause firms to invest in more speculative investment instead of adding to capital equipment. This would result in a decrease in the productive capacity of firms, and effectively the economy, because efficiency is lowered when capital is not maintained, and output and economic growth is therefore stunted. Therefore if the rate of inflation is above 1-3% some measures must be taken in order to ensure inflation does not impact negatively on an economy. In terms of employment, growth usually creates greater employment opportunities for individuals as output increases. Therefore unemployment decreases, and it is not usually necessary to introduce additional policies as long as the rate of inflation is being maintained.

This report will be focussing on three different policies with the common aim of increasing economic growth, and reducing any significant negative effects on inflation or employment. The three types of policies will be Monetary, Fiscal, and Supply-side. Please not that this report does cover any ideas on trade or the effects these policies will have on trade.

First Policy: (Refer to Graphs 1 and 2)

A monetary policy is used to control the price of money and credit available to an economy, and is managed by the Reserve Bank of New Zealand (RBNZ). The Official Cash Rate (OCR) is the interest rate for registered banks on their settlement cash deposits, and is one of the RBNZs main tools in influencing the call rate and interest rates. The OCR will generally influence market interest rates to change as the OCR does, and changes in interest rates will impact on the level of savings, investments, consumption spending and the exchange rate, and therefore on the level of inflation, employment and growth in an economy. Tight monetary policy is used to reduce the level of economic activity when it is unsustainable, whereas loose monetary policy is used when economic activity is below potential, and can be used to increase economic growth. This first policy to increase economic growth will be a loose monetary policy. Adopting a loose monetary policy means that the RBNZ will decrease the OCR, and this will lead to a decrease in short-term market interest rates. As interest rates fall savings are likely to decrease because households will be getting a lower return on funds set aside, and therefore will be saving less. Savings are income not spent, and therefore as savings decrease, consumption spending (C) will increase as households spend instead of saving. As well as causing an increase in business confidence due to consumption spending increasing, a loose monetary policy will also increase investment (I). Investment is the addition to capital resources, and lower rates of interest will make investment projects more appealing for firms as the cost of investment will have decreased while business confidence will have increased. The increase in both (C) and (I) will result in an increase in aggregate demand (AD). The AD curve will shift to the right from AD to AD1, and Real GDP will shift from Y to Y1, thus increasing output and economic growth. A further point is that an increase in investment will result in a more sustainable economic growth, because investment will help ensure economic growth in the future. Although some investment is necessary to replace capital goods that are depreciating (which as they become obsolete or worn will decrease productivity), investment in new technology, or research and development, will enable existing resources to be used more efficiently to increase productivity, and so will increase an economys productive capacity (PPC to PPC1), thus increasing growth. However it is also important to note that resources are limited, and in an economy can be used to produce either consumer goods (purchased by households for immediate consumption) or capital goods (man-made items of capital equipment used to produce other goods and services). An increase in investment (ie addition to capital resources), could mean that consumer goods are forgone because more capital goods are being produced. This could result in a lower standard of living now, however in the future will enable an economy to increase its level of productivity in the future as well. However NZs economy is probably around Point A (graph 2), ie not working at full capacity, so it is very likely that even if there is an increase in investment into capital goods, Point A will simply move closer to the production possibility curve (A shift to B). This means that investment should not result in a decrease in consumer goods or standard of living, but will ensure sustainable economic growth into the future. A further point to note is the fact that a decrease in savings might actually result in less funds available for investment, because as financial institutions get their funds from household savings, the level of funds available for investment relates directly to the level of savings. However it is highly unlikely that a financial institution would not be able to supply enough funds to producers for investment, as they will still be receiving funds from interest payments on previous investment loans, and households will continue to save, even if consumption spending increases. Another result of the increase in economic growth due to a decrease in the OCR, is an increase in the price level, ie demand-pull inflation. This is shown on Graph 1 as an increase in the price level (PL to PL1), due to AD shifting to AD1. The increase in inflationary pressure due to this policy shouldnt cause significant problems however, because one of the obligations of the RBNZ is to keep the inflation rate between 1-3%. Therefore they should be aware of exactly how much of an effect the loose monetary policy can have on inflation, and so will be able to raise the OCR enough to increase economic growth while still staying within their obligations of keeping inflation rate between 13%.

However if required to reduce inflationary pressure, it is possible to introduce a supply side policy intended to increase aggregate supply (AS) and thus reduce inflationary pressure, while still maintaining an increase in Real GDP, ie economic growth. An effective supply side policy would be to relax restrictions and costs on producers, such as red-tape requirements on building consents, thus reducing compliance costs and total cost of production for producers. This will result in a shift from AS to AS1 (Graph 1) because producers will be able to supply more using the same amount of resources, and this will result in an increase in Real GDP from Y to Y1, as well as achieving a decrease in price level from Pl to PL1. This would ensure economic growth, while also reducing inflationary pressure. Finally, no additional policy to reduce unemployment should be required. This is because as well as an increase in Real GDP signifying increased economic growth, it also means that there is an increase in output. An increase in output means that more jobs are created as firms demand for labour increases to cope with this increased output, and therefore increases household incomes and reduces unemployment.

Second Policy: (Refer to Graph 3)

Fiscal Policy refers to the influence on economic activity in an economy (aggregate demand) of the changes in government income (revenue) and expenditure. Government revenue is sourced from taxation (both direct and indirect), fees, fines, and investment income. An expansionary fiscal policy is when government spending exceeds income, causing a budget deficit due to a net injection to increase AD, and results in an increase in price level and economic growth. Contractionary fiscal policy is when the governments income is greater than the expenditure, and results in a budget surplus. The purpose of this policy is to decrease economic activity output, and cause the price level and economic growth to fall. The second policy to increase economic growth will be an expansionary fiscal policy by decreasing income tax rates. The decrease in income tax rates means the households will have more disposable income (income after tax), because the tax taken from their net income has decreased. This will usually result in an increase in consumption spending (C), because households will have more income to spend. This will cause an increase in aggregate demand (AD) (the curve will shift from AD to AD1), and will cause an increase in Real GDP (Y to Y1), thus there will be an increase in economic growth. At first this means that the government is receiving less revenue, but usually when an economy experiences growth, government revenue from tax tends to increase. This is because firstly, as consumption spending increases firms will be collecting more indirect tax for the government, and secondly because the increase in output (Y to Y1) due to an increase in AD may lead to firms employing additional workers or paying overtime to cope with the increased output, and so household incomes would increase. This would then result in an increase in revenue for the government, due to the increased amount of income tax as household incomes rise. Although this policy does increase economic growth, it also causes demand-pull inflation as price levels rise from PL to PL1. An additional policy may be needed to combat the negative effects of this, such as a tight monetary policy to control inflation. A tight monetary policy means the RBNZ will increase the OCR rate, and thus increase short-term market interest rates. This will result in an increase in savings, while causing a decrease in consumption spending (C) because households will be encouraged to save not spend due to the high rate of return on their savings. This policy will also result in a decrease in firms investment as business confidence drops with the decrease in consumer demand/consumption. Overall the level of aggregate demand will fall (from AD1 to AD2), thus reducing price levels from PL1 to PL2, ie reducing inflationary pressure. The effect of this policy on employment is much the same as Policy One, because the increase in AD results in economic growth and therefore should create more job opportunities due to the higher level of output (Y) and therefore firms higher demand for labour. Therefore no additional policy to reduce unemployment should be required as price stability is already being maintained by the additional policy described above.

Third Policy: (Refer to Graph 4)

A supply-side policy is intended to increase aggregate supply in an economy by increasing productivity and efficiency, and thus increasing economic growth. In recent years the government has been more focussed on the deregulation of industry rather than providing or supporting production of certain goods and services, for example, opening the banking sector to competition, floating the NZD and removing controls on interest rates. A further example is the new labour laws, the Employment Relations Act 2000, which increased flexibility in the labour market. The main advantage of supply side policies is that they can achieve economic growth with little or no inflationary pressure; although prolonged deflation is not good either so a balance of demand and supply side policies that creates growth with a little inflationary pressure is best. The AS curve will shift to the right if costs of production fall (e.g. wage rates decrease, cost of raw materials decrease); the exchange rate appreciates or a fall in world prices results in a fall in the cost of imported raw materials or components; there is an increase in productivity as a result of new technology or a more educated workforce; or there is a decrease in indirect tax rates or other Gvt charges. The third policy will be a supply-side policy, and will reduce Indirect tax on imported input goods only, so that the costs of production for NZ producers decrease. Lower indirect tax means that the cost of raw materials has decreased, and therefore the AS curve will shift to the right (from AS to AS1) as production costs fall and firms increase output, with a result of an increase in production and growth, but with a decrease in the price level. These lower costs of production will then cause imports to increase, as firms demand for the cheaper imported input goods will have increased, thus causing the AD curve to shift to the left (AD to AD1). However this effect is only short-term, because the change in price level makes NZ more attractive to buyers overseas, and thus exports increase, and therefore will cause AD to shift to the right (AD1 to AD2), thus increasing output and economic growth. So while domestic demand may fall this can be offset if overseas economies are booming, and there is an increase in demand for NZ exports. As exporters incomes rise, AD will also increase, resulting in increased growth and output. In summary, initially net exports decrease (due to increase in imports), but eventually the increase in exports will cause the AD curve to shift to the right, causing an increase in output (Y to Y1) and economic growth. On a side note, removing subsidies or phasing out tariffs means that although the cost of imported raw materials would have fallen, NZ firms have to become more efficient to compete with cheaper overseas markets. If domestic firms cannot cope with overseas competition they will close down, output will fall, and production will fall. Economic growth will fall with a fall in the price level. That is why it is necessary for this policy to only decrease indirect tax on imported input goods that will be used to increase output and economic growth, and not simply removing trade barriers. A further point is that though this policy increases economic growth and real output, it also causes an eventual increase in inflationary pressure (PL to PL2). Therefore it may be necessary to use either a Contractionary fiscal policy and increase direct tax rates, which would result in a decrease in consumption spending and investment, or an expansionary fiscal policy and decrease income tax rates, depending on the fluctuating price level due to the shifts of both the AS and AD curves. However this should be unnecessary because of the nature of the shifts that could occur due to the supply-side policy. This is because the initial shift of the AS curve to the right will decrease the price level, and then the consequent shift of the AD curve to the left would also decrease inflationary pressure. However this will be offset by the eventual shift of the AD curve to the right, and therefore the price level should only increase a small amount, and there will be no need for an additional policy. In terms of employment, this policy will eventually result in an increase in output and economic growth, which should result in more job opportunities as production increases. However the AS curve does shift to the left initially, thus decreasing output, and this may increase unemployment for a short time until the AD curve eventually shifts to the right, and output increases thus resulting in an increase in firms demand for labour. Overall however, this policy does not impact well on employment because of the period where output decreases, and therefore the government may have to spend more in transfer payments to households as unemployment levels rise. A possible policy to counteract this in the short-term would be to increase spending on the infrastructure industries, which encourages

producers to invest in capital goods to raise productive capacity to meet government demands. This investment will make production more efficient and cost-productive, as an increased output could be achieved with the same input, thus increasing output and therefore creating job opportunities. With this additional policy promoting efficiency in the economy more households will be employed, thus reducing unemployment until the first supply-side policy achieves economic growth.

CONCLUSION: In summary, each of the three policies described above will eventually result in an increase in economic growth, with differing effects and additional policies. The first policy described is a loose monetary policy, and is used to manipulate interest rates so that the levels of consumption spending and investment increase, thus increasing AD to AD1 (Graph 1), and causing a rise in economic growth. The negative effects of this policy are few; the impact on inflation should be insignificant because the RBNZ should know how high to raise the OCR while keeping between an inflation rate of 1-3%, but if necessary a supplyside policy to restrict restrictions on producers can be used to reduce inflationary pressure. There should be no negative effects on employment from this policy, because it will result in economic growth and increased output, and therefore increased demand for labour, thus increasing job opportunities and reducing unemployment. An added benefit of this policy is that it encourages investment into capital, thus increasing the productive capacity (PPC to PPC Graph 2) of an economy by increasing efficiency and productivity. Although this may mean that jobs may be replaced with machinery, this is offset by the fact that the increase in output will create more jobs due to the increase in demand for labour. This increase of productive capacity will also have a long-term beneficial effect on the economy however, and will help maintain sustainable economic growth in the future. The second policy is an expansionary fiscal policy, and decreases income tax rates so that households have more disposable income. This results in higher consumption spending and will cause an increase in AD to AD1 (Graph 3) and economic growth. Although at first the government is initially losing revenue, the consequent increase in growth and economic activity means that the government will receive higher revenue from increased income and consumption spending in the long-term. To combat high inflationary pressures an additional tight monetary policy is introduced and will increase interest rates (by increasing the OCR), so to encourage more saving and less consumption spending, and thus decreasing aggregate demand. The effect of this third policy on employment is positive, because the increase in economic growth increases job opportunities and reduces unemployment. This policy may not have as great an impact on economic growth as the first policy however, because firstly, it mainly affects consumption spending directly, and doesnt encourage investment in capital formation, which would help ensure economic growth in the future. The third policy is a supply-side policy, and reduces the indirect tax rates on imported input goods, so that costs of production for NZ producers will decrease, thus shifting the supply curve to the right (AS to AS1 Graph 4). Imports will then increase as firms increase output (because they can now produce more for the same input cost), shifting the AD curve to the right (AD to AD1). Then however exports will increase as the consequent change in price level makes NZ more attractive to overseas buyers, thus finally resulting in an increase in AD (AD1 to AD2) and therefore an increase in output and economic growth. The impact of this policy on inflation is to have quite fluctuating price levels, that if necessary will be controlled by fiscal policies by either increasing or decreasing income tax rates. In terms of employment, this policy does eventually result in an increase in output, but until exports increase, unemployment levels may become quite high. Therefore an additional policy would be an increase in government spending on infrastructure to increase job opportunities and promote efficiency in the economy. This third policy doesnt seem very stable or encouraging to producers or consumers due to the fluctuating price and output levels, and so probably wouldnt be a suitable policy to introduce to the economy. A final point before conclusion of this report is that periods of high economic growth can result in the accelerated use of scarce resources and can cause damage to the environment, making it unusable for future growth. Therefore policies must be introduced that can keep growth levels sustainable, because as production and consumption increase, pollution and congestion, as well as the depletion of non-renewable resources like fossil fuels will increase, and so growth must be kept at a sustainable level. The Resource Management Act 1991 promotes sustainable management of natural and physical resources, so that they do not become depleted or have adverse effects on the environment. Policies like these mean producers must obtain a resource Consent, which takes up time and costs, resulting in some projects having to slow down or even stop. The effect of this on growth in the short-term is to slow

it down, but in the long-term ensures preservation of the environment, thus also ensuring sustainable economic growth into the future. In conclusion the first policy; which included a loose monetary policy that decreased interest rates, and a supply-side policy that relaxed restrictions and therefore lowered cost of production on producers to encourage them to increase output, is probably the best policy for sustainable economic growth. The increase in investment which increases the productive capacity of the economy will have a long-term beneficial effect, as it will not only encourage economic growth in the short-term, but will help maintain sustainable future economic growth in the long-term as well. By Marie Poff (12VT)