Determinants of Economic Growth and Role of Monetary Policy

Question One 

The aggregate demand/ aggregate supply (AD/AS) diagram is an essential economic tool that shows how investment, inflation, unemployment, and monetary policies influence the growth rate of a nation’s Gross Domestic Product (GDP). The Reserve Bank of New Zealand (RBNZ) anticipates that in 2020, there will be a decline in global growth, which will result in reduced demand for New Zealand exports. Consequently, there will be a decline in the GDP of New Zealand. The reduction in export demands of New Zealand products is represented in Figure 1 below. 

Figure 1.1 : AD-AS Diagram 1-A shift in aggregate demand while SRAS and LRAS are constant. 

Explanation 

AD 1 represents the standard demand level when the global growth level is average. At E 1 , the GDP is at level Y 1 , and the demand for exports is high. However, a decline in the global consumption rate of New Zealand’s exports because of global disruptions, such as Corona Virus 2019, will result in inward shift of demand for exports from AD 1 to AD 2 . The country’s GDP will fall from Y 1 to Y 2 and the new GDP equilibrium will be E 2 from E 1 . Hence, a reduction in world activity will mean lower demand for New Zealand’s exports from AD 1 to AD 2 . 

Question Two 

A decline in interest rates will result in increased investment rates. The change in investment because of reduced interest rates is represented in Figure 1.2 below: 

Figure 1.2 AD-AS Diagram 2-Change in investment when interest rates reduce (Lumenlearning.com (a), 2020) 

Explanation 

A reduction in interest rates in the economy will result in increased investment rates in the economy. The rate of aggregate supply in the economy will shit to the right from SRAS 0 to SRAS 1 . The GDP level increases from Y 0 to Y 1 . Aggregate supply in the economy will also shift from SRAS 1 to SRAS 2 , further enhancing the GDP to level Y 2 . An outward shift of the SRAS level results in downward pressure on prices; hence, the cost of output will fall from P 0 to P 2 when interest rates are low, and investment rates increase. Moreover, the new GDP equilibrium shifts from E 0 to E 2 . 

Question 3 

RNBZ may consider maintaining interest rates at a lower level for the foreseeable future to prevent an economic recession that may result from the global disruption caused by Corona Virus 2019. Maintaining low-interest rates will result in low inflation rates, as presented in Figure 1.3 below (a). However, failure to institute corrective policies will result in a decline in GDP, as in figure 1.3 (b). 

Figure 1.3 AD-AS Diagram 3-Inflation influences in the economy (Lumenlearning.com (b), 2020). 

Explanation 

In Figure 1.3 (a), RNBZ has maintained a low-interest rate to stimulate household consumption even when New Zealand experiences a global disruption. Hence, in the future, New Zealand’s aggregate demand will shift outwards from AD 0 to AD 1 . Consequently, the country’s GDP will increase from Y 0 to Y 1 . However, RNBZ may fail to have a corrective policy to improve New Zealand’s GDP. High-interest rates in the economy will result in an inward shift of the nation’s demand curve from AD 0 to AD 1 . Consequently, GDP equilibrium will fall from E 0 to E 1 , and the country will have a decline in GDP from Y 0 to Y 1 . 

Question 4 

Robust global growth implies that nations globally have the monetary power to purchase products from other countries for consumption or use as raw materials. Additionally, states must have a stable GDP, low unemployment rates, and reduced inflation levels for them to be classified as experiencing economic growth. When nations have a steady growth rate, they have surplus funds for importing products from other countries. Hence, robust global growth will result in nations globally having increased demands for New Zealand’s products. Consequently, the export levels of New Zealand will increase. 

Additionally, the dollar exchange value influences the number of exports that a country has. When a nation has a high dollar value, other nations may view its products as expensive and will not purchase them. Consequently, a low dollar value implies that the products from a country are affordable; hence, other nations will buy them. In the case study provided, New Zealand has a low dollar value. Thus, other nations will purchase more products from New Zealand because they are affordable, which will boost the latter’s export rates. 

Question 4 (ii) 

When a nation has capacity and labor constraints, the country's businesses have attained their maximum output levels and cannot produce any extra amount. The demand for products may be higher than output, which creates a gap in the market demand for products that exceed supply. Capacity may result from labor constraints, where firms have less labor to handle production, or lacks skilled workers to enhance production. Interest rates also influence the nation's investment levels. Hence, RNBZ anticipates that New Zealand will experience an influx of investors to fill the high demand gap that results from capacity and labor constraints. 

Moreover, low-interest rates result in enhanced investment levels because people will borrow loans for investment purposes and repay them at lower rates. Hence, low-interest rates in New Zealand will result in increased investment levels. 

Question 5 

The GDP of a country constitutes government spending, export earnings, business investments, investments, and residential construction and housing spending. When the levels of government spending increase, the economy has increased income, which stimulates growth in household demand because individuals have enough money to purchase products (Eltahir, 2014). Moreover, high export earnings imply that the country's production levels are high, and workers earn high wages. Furthermore, increased business investments indicate that more people are employed in new ventures, and hence, more individuals in the nation have purchasing power. Finally, solid residential construction and housing spending show that people have the financial ability to purchase residential homes. Thus, the demand levels in the country would increase as represented in figure 1.4 below. 

Figure 1.4 Aggregate changes in demand curve from higher export earnings, business investments, government spending, and investment, residential construction and housing spending remaining solid (Khan Academy, 2020). 

Explanation 

Higher export earnings, business investments, government spending, and investment, residential construction, and housing spending remaining solid will shift the demand curve to the right from AD 1 to AD 2 while SRAS and LRAS are constant. Consequently, New Zealand will experience increased GDP growth from Y 0 to Y 1 , and the real GDP equilibrium will shift from E 0 to E 1 . 

Question 6 

When RNBZ tightens the labor market, the level of unemployment in New Zealand will reduce, as presented in figure 1.5 below. 

Figure 1.5 Change in cyclical unemployment from fiscal policies (Lumenlearning.com (a), 2020). 

Explanation 

The tightening of the labor market will imply that more unemployed people have acquired jobs and are compensated enough to increase their demand, as presented in figure 1.5 (a). Consequently, there will be increased supply because more people are employed in firms to produce products for export and local consumption. Hence, the SRAS will shift to the right as from SRAS 1 to SRAS 2 . The cyclical unemployment level may be represented by E 1 , which is lower than the initial unemployment rates at E 0 . 

References 

Eltahir, Y. (2014). Aggregate demand & aggregate supply: Formulating equations and their policy implications.  Journal of American Science 2014 ,  10 (2), 235-240. Retrieved from https://www.researchgate.net/publication/335714079_Aggregate_Demand_aggregate_Supply_Formulating_Equations_and_their_Policy_Implications 

Khan Academy. (2020). How the AD/AS model incorporates growth, unemployment, and inflation (article). Retrieved from https://www.khanacademy.org/economics-finance-domain/macroeconomics/aggregate-supply-demand-topic/macro-changes-in-the-ad-as-model-in-the-short-run/a/how-the-ad-as-model-incorporates-growth-unemployment-and-inflation-cnx 

Lumenlearning.com (a) (2020).  Business cycles and growth in the AD–AS model | Macroeconomics . Retrieved from https://courses.lumenlearning.com/wmopen-macroeconomics/chapter/growth-and-recession-in-the-as-ad-diagram/ 

Lumenlearning.com (b) (2020).  Reading: Growth and recession in the AS–AD diagram | Macroeconomics [Deprecated] . Retrieved from https://courses.lumenlearning.com/macroeconomics/chapter/growth-and-recession-in-the-as-ad-diagram/