1. Characteristics and Causes of Globalisation
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Globalisation: The increasing integration and interdependence of local, regional, and national
economies of the world, culminating into a single international market
Characteristics of Globalisation:
o Increase in Trade as a proportion of GDP
▪ Exports and Imports as a percentage of GDP has increased for most countries
▪ Exports as a share of world GDP has increased
▪ Developing Countries now export most of low level manufactured goods
▪ Trade in services has increased significantly
▪ Supply chains have become more global
o Increase in Importance of Transnational Companies and Foreign Direct Investment
▪ Transnational company: A company that has operations in more than 1 country
• Large transnational companies can mobilize their technological
expertise, global branding and economies of scale to take advantage of
a larger global market
▪ Foreign Direct Investment: A company buys or sets up a firm in a foreign
country
• In an increasingly globalised market, countries begin to remove
restrictions on foreign investments leading to an increase in FDI
o Increase in Migration
▪ The fall in transportation costs and improvements in education allows people to
move more freely between countries as well as immigrating from one country
to another
Causes of Globalisation:
o Trade Liberalisation
▪ Countries in general are more open to trading with more and more countries
than in recent history
▪ The establishment of the World Trade Organisation has helped reduce
protectionist polices in countries around the world
o Increased number and size of Trading Blocs
▪ Trading Bloc: A group of countries that have agreed to reduce or eliminate trade
barriers amongst themselves through regional trade agreements
▪ EU, NAFTA, ASEAN, UNASUR
o Major Political Changes
▪ Opening up of China towards a more market-oriented economy has helped
China become a more export driven economy
▪ The fall of the Soviet Union allowed its former member states to be more open
towards global trade
o Reduced Cost of Transportation and Communication
▪ Costs of transportation in all modes has fallen significantly in recent years
allowing for global trade to be more economical for firms
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Improvements in transportation technology and infrastructure also makes
global trade more efficient
▪ Improvements in information and communication technology allows consumers
and firms from all over the world to transact business
Increased Significance of TNCs
▪ TNCs account for the majority of global trade as well as most of FDI
▪ Reasons for FDI
• Earn Higher Revenues through expanding markets for goods and
services
• Minimise Costs through taking advantage of cheaper costs, lower tax
rates, avoiding trade barriers, and economies of scale
▪ Impact of FDI on Recipient Countries
• Mostly positive through greenfield foreign direct investment
• Greenfield: creates a firm or a new production facility in a foreign
country
o Usually leads to economic growth
o Improves the quality of Human Capital and Physical Capital by
boosting productivity through knowledge and techonoligical
transfer
o Existing firms may also benefit from increased business brought
about by the transnational
o Generates more competition in the market which will benefit
local consumers
o FDI may also involve improving the infrastructure of the
recipient country
o Governments may enjoy higher tax revenues
o FDI may bring inflows to a country’s balance of payments
• Possible negative effects
o FDI mostly creates low level jobs for local workers
o If FDI only brings new jobs for already skilled local workers this
could worsen income inequality in that country
o Competition with local firms may lead to job losses from those
firms that fail to compete with the TNC
o Domestic firms may not actually enjoy technological transfer if
the TNC refuses to share
o TNC may exploit local workers
o Some TNCs engage in tax avoidance and FDI may not lead to
greater tax revenues
o TNCs are known for bribing government officials to gain
contracts and access to resources
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TNCs may also damage the environment in the recipient
countries
Non greenfield FDI only involves changes in ownership and the
TNCs may only be interested in maximizing profits which are
then repatriated rather than invested back into the local
economy or the firm
Countries that heavily rely on FDI may lose the ability to make
governing decisions independently of the TNC’s activities
2. Effects of Globalisation
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Benefits of Globalisation
o Increased Economic Growth
▪ Globalisation can increase both actual and potential growth
▪ Export driven growth lead to AD right shift and higher GDP
▪ Exposure to foreign competition forces firms to be more productively efficient
as well dynamically efficient which would have positive benefits to LRAS
▪ Migration fills skill gaps in economies as well as creates jobs for existing
population
o Increased Tax Revenue
▪ Increased economic growth generally leads to increased incomes for both
workers and firms which will then lead to increased tax revenue for government
▪ Tariffs from imported goods and services are also a source of tax revenue
o Economies of Scale
▪ Larger global market allows exporting firms to achieve lower average costs
through internal and external economies of scale
o Lower Prices and Higher Consumer Surplus
▪ Globalisation generally allows consumers to enjoy lower prices for goods and
services
• Firms lower their costs by accessing cheaper labour, and economies of
scale
• Lowering tariffs reduce the price of imported goods for consumers
▪ Prices of some other goods however have increased because higher economic
growth in exporting countries will also increase demand for other products such
as commodities
• If the supply for these commodities are inelastic, increases in demand
are not equally matched by increases in supply leading to strong
increases in price
o More Consumer Choice
▪ Allowing consumers to choose between foreign and domestic goods and
services gives consumers more choice
▪ However some goods could also be homogenized if they are produced by the
same TNC
o Higher Living Standards
▪ All of the above should lead to rising living standards for a country that is
benefitting from globalisation
Costs of Globalisation
o Displaced Workers
▪ The shift of certain industries to developing countries has displaced many
workers in developed countries causing structural unemployment
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Increased migration from developing countries also increases competition for
workers in developed nations driving down wages
Exploitation of Workers
▪ Globalisation effectively increases the supply of unskilled labour which weakens
the bargaining power of unskilled workers
▪ Large firms may take advantage of this and negotiate unfair work conditions and
remuneration for low skilled labour
▪ TNCs may also seek to shift production to countries with weaker employee
protection legislation and exploit the local workers
Environmental Impact
▪ Increased consumption and production of goods and services inevitably requires
greater consumption of natural resources and greater greenhouse gas emissions
which may lead to significant environmental damage
▪ The concentration of certain industries in certain places will also lead to the
concentration of environmental damage in that region
Loss of Tax Revenue
▪ TNCs have a reputation of engaging in tax avoidance: using loopholes in tax
systems to reduce their tax liabilities
• Genuine Production and Transfer Pricing: reduce profits in high tax
country by selling input at an artificially low price to its production
facility at the low tax country which then earns the majority of the profit
• Set up a subsidiary company in a low tax jurisdiction and giving
ownership of key production elements so that it could charge fees to
subsidiaries in high tax jurisdictions
• Transfer all production facilities to a low tax country
Increased Income Inequality
▪ Low skilled workers in developed countries face competition from low skilled
workers in developing nations and thus decreases their wages. This leads to
increased income inequality in developed nations
▪ If TNCs mainly hire skilled workers in the foreign entity this could lead to
increased income inequality in the developing country as well
Domestic Economic Policy influenced by TNCs
▪ TNCs from developed nations have experience in resources in lobbying and
bribing government officials.
▪ Foreign governments may fail to enact economic policies that benefit the public
interest rather than that of the TNC
Loss of Native Culture
▪ Globalisation helps spread the culture of developed nations into developing
nations and encouraging others to adopt that culture leading to a loss of native
culture
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Nation states that are small and poor may lose sovereignty to larger more
developed nations due to the increasing interdependence
It is difficult to say clear cut whether globalisation has done more good than harm or vice-versa
3. Specialisation and Comparative Advantage
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Absolute Advantage
o When a country can produce a greater quantity of a good than another country using
the same amount of factor inputs
o When a country can produce a good/service more cheaply than another country is able
to
o Can be represented using a PPF or a table of costs
o Countries should specialise in the goods and services for which they have an absolute
advantage and trade for export. Both countries will gain economic efficiencies as a
result
Comparative Advantage
o Even if a country has absolute advantage in all goods/services over another country
both countries can still gain from specialisation and trade
o When a country can produce a good/service at a lower opportunity cost in terms of
other goods and services than that of another country is able to produce
o Opportunity Cost: If a country produces one extra unit of a good, how many units of
production of the other good does it need to sacrifice
o Countries should specialise/partially specialise in the production of good/service in
which they have a comparative advantage and trade
o Both countries will gain from specialisation and trade as the differing opportunity costs
means that there is a range of prices for which trade will be mutually beneficial
o However if opportunity costs are identical for both countries there are no gains to
specialisation and trade
Causes of Comparative Advantage
o Differences in labour productivity among countries, differences in skills and education
o Differences in endowments of factors of production (land, labour, capital) lead to
different prices for each factor of production. Where the price of a factor of production
is low, comparative advantages exist for goods and services that use that factor of
production intensively
o Comparative advantages can change over time due to changing quality and quantity of
factor endowments of countries
Benefits of Specialisation and Trade
o Countries are able to achieve a higher standard of living from trade as it allows them to
consume greater quantities of goods and services than without trade
o Specialisation leads to the expansion and concentration of production in goods and
services that have comparative advantages. Firms can take advantage of economies of
scale in production and lower average costs of production.
o Consumers will benefit from lower prices for goods and services as well as consume
higher quantities of goods and services and experience an increase in consumer surplus.
Consumers will also gain from greater consumption choices
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Gains in productivity can also lead to long-run growth. Trade encourages more
competition which forces firms to be more efficient as well as innovative leading to mor
economic growth
o Exports can be used as an engine for achieving economic growth
Costs of Specialisation and Trade
o Overdependence on foreign trade makes an economy more vulnerable to external
shocks in demand and supply conditions as well as political turmoil. Small countries in
particular are even more vulnerable
o Specialisation due to comparative advantages may lead to the shut down of industries
that can’t compete with foreign firms. This leads to job losses as well as significant
structural unemployment if those unemployed struggle to find work in other industries.
o Trade may increase income inequality between countries as well as within a country.
Low skilled countries will be forced to continue producing low value exports while
importing high valued goods from high skilled countries. Benefits from trade may also
only benefit the rich elite in a country.
o Trade can be unsustainable if it leads to the degradation of the environment through
increased transportation of goods and services between countries as well as increased
consumption of natural resources
o Trade may also lead to a loss of sovereignty due to international trade treaties
o Trade could perhaps lead to an import of foreign cultures at the expense of the native
culture
Assumptions and Limitations of Comparative Advantage
o There is free trade and no protectionism
o There are no transport costs of trade
o Constant Costs of factor inputs as well as absence of economies of scale.
o Two-good economies
o There are no significant differences in the consumption preferences over the two goods
between the two countries
o The goods produced and traded are homogenous
o Factors of production are assumed to be perfectly mobile between the production of
the two goods
o There is perfect knowledge across countries between buyers and sellers
4. Patterns and Volume of World Trade
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Patterns of Trade refers to:
o What types of goods and services do countries export and import amongst themselves?
What goods and services are actually traded across borders?
▪ Some countries specialise in the export of certain goods and services and must
rely on imports of others
o Which countries are most involved/least involved in global trade?
▪ Some countries tend to dominate world trade and some countries tend to only
trade amongst themselves
o How do trade volumes compare between different countries and over time?
▪ As economies grow do they trade more or less with other countries?
Causes of changes in patterns of trade
o Impact of emerging countries
▪ Emerging countries are developing countries that are experiencing high rates of
economic growth as well as income
▪ To some extent their growth may be fuelled by exports to developed economies
due to comparative advantages
▪ Emerging economies may also change in the type of goods they export over
time
▪ However as the economy grows its demand for more expensive imports from
developed nations will also increase
▪ As comparative advantages shrink, emerging economies may change from being
recipients of FDI to providers of FDI to less developed nations
▪ China has been the largest driver in the changes in patterns of trade over the
last 50 years
o Changes in comparative advantages
▪ Changes in comparative advantages leads to changes in the type of exports and
imports
o The fall in transportation and communication costs
▪ globalised the supply change leading to greater exploitation of comparative
advantages in almost every stage of the supply chain fragmenting the pattern of
trade across multiple countries for even a single good
o Growth of trading blocs and bilateral trading agreements
▪ The formation of bilateral trading agreements and trading blocs tend to increase
trade between the countries in the agreement at the expense of trade with
countries that are not part of the bloc or agreement
o Changes in relative exchange rates
▪ Appreciation/Depreciation in exchange rate will lead to exports becoming more
expensive/cheap and imports becoming more cheap/expensive and thus
changing the quantity of both
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Short term exchange rate changes do not significantly alter the pattern of trade
as much as long term changes in exchange rates
Changes in level of trade protectionism
▪ Trade barriers erected by countries can be used to target imports from certain
countries
▪ Removal of trade barriers on the other hand can be used to encourage imports
and exports between countries
5. Terms of Trade
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(Index of) Terms of Trade is the ratio of index of export prices to index of import prices
o Index = weighted average of prices of both exports and imports
o Improvement/deterioration in the ToT refers to the increase/decrease in ToT
o Change in price of a single good/service will only have a significant impact on the ToT if
it is a major component of all exports/imports
Factors that influence the terms of trade
o Relative inflation rates
▪ Higher inflation in a country indicates that export prices are rising faster than
import prices and hence an improvement in the ToT
o Relative Productivity rates
▪ A rise in productivity leads to a fall in the prices of goods and services
▪ If productivity rises faster in a country than others, the prices of exports will
decrease more than the prices imports leading to a deterioration of the ToT
o Relative Labour costs
▪ Rise in labour costs will lead to rise in export prices and hence an increase in the
ToT
o The exchange rate
▪ Appreciation/Depreciation in exchange rate will lead to a fall/increase in import
prices leading to an improvement/deterioration of the ToT
o Commodity prices
▪ Some countries depend heavily on the export and import of primary
commodities
▪ Exporting countries will experience an improvement/deterioration in ToT when
prices rise/fall
▪ Importing countries will experience the opposite effect
o Changing income
▪ As world income rises, demand for tourism will rise too leading to and increase
in the price of exports (services) and an improvement in the ToT
Effects of changes in terms of trade on the balance of trade
o Whether a change in terms of trade improves or deteriorates the balance of trade
depends on the price elasticity of exports and imports
o Exports
▪ Price Elastic: Rise/fall in price leads to improvement/deterioration in terms of
trade but greater fall/increase in quantity demanded of exports leads to
deterioration/improvement in balance of trade
▪ Price Inelastic: Rise/fall in price leads to improvement/deterioration in terms of
trade but smaller fall/increase in quantity demanded of exports leads to
improvement/deterioration in balance of trade
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Imports
▪ Price Elastic: Rise/fall in price leads to deterioration/improvement in terms of
trade but greater fall/increase in quantity demanded of imports leads to
improvement/deterioration in balance of trade
▪ Price Inelastic: Rise/fall in price leads to deterioration/improvement in terms of
trade but smaller fall/increase in quantity demanded of imports leads to
deterioration/ improvement in balance of trade
Effects of changes in terms of trade on the economy
o ToT effects on balance of trade (Aggregate Demand) can lead to changes in GDP and
economic growth/decline and thus have an impact on overall living standards as well as
unemployment
o ToT changes can also have implications for inflation
▪ Fall/rise in export prices can lead to increased/decreased demand for exports
and thus causing/relieving demand pull inflation
▪ rises/fall in import material prices can lead to rise/fall in cost-push inflation due
to higher/lower costs for producers
6. Trade Liberalisation and Trading Blocs
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World Trade Organization
o The aftermath of the Great Depression saw countries resort to protectionist policies
causing a complete collapse of world trade and perhaps leading to WWII
o As a result, the General Agreement on Tariffs and Trade was formed after WWII with 23
countries signing it and agreeing to not increase the level of trade protectionism
o The World Trade Organization succeeded the GATT in 1995
o It has two main goals
▪ Reduce restrictions on free trade
• Encourage trade liberalisation and reducing protectionist measures
• However any single member country can stop any trade deal
• Trade deals can be blocked due to political issues
▪ Ensure member countries follow trading rules
• Enforce rules that member countries have agreed to
• Discourage unfair practices such as export subsidies and dumping
products at below cost
• Countries can file complaints to the WTO about possible violations by
other countries
• If the violating country refuses to comply, the other country can
reciprocate with protectionist measures
Trading Blocs
o A group of countries that have signed a regional trade agreement (RTA) to reduce trade
barriers amongst themselves
o Bilateral Trade Agreements: between two countries or two trading blocs
o Multilateral: three or more countries or blocs
o Three types of trading blocs
▪ Free Trade Areas
• All tariffs and quotas are removed on trade in goods between member
countries
• However each country can impose its own tariffs and quotas on goods it
imports from countries outside the trading bloc and have its own trade
policy with non-members
• Different trade policies with non-members means that countries will
need to enforce stringent custom controls to make sure non-member
countries are not using other member countries to avoid tariffs
▪ Customs Unions
• Free trade within the trading bloc
• Common External tariff on goods coming from outside the bloc
• Member countries cannot have their own independent trade policy for
non-member countries
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The entire union acts as a single unit when negotiation any trade
agreements with non-member countries or other trading blocs
▪ Common Markets and Economic Unions
• Customs unions that also have the free movement of labour and capital
within the area
• Economic Union: Common markets where member countries are fully
integrated
o Fiscal union: in economic unions, there is a central body for
taxation and spending
o Also there would be fiscal transfers between wealthier
countries and poorer countries inside the union
o However individual countries will lose control over fiscal policies
as there are rules concerning the size of fiscal deficits and
national debt
o Monetary Union: The countries within the common market use
the same currency for market transactions
o Member countries will no longer have to worry about exchange
rate risks when conducting trade between each other
o However countries will lose control of monetary policy over
interest rates and money supply
▪ Examples of trading blocs:
• European Union: 28 member countries that is a customs union that
aims to become a full economic union
• North American Free Trade Agreement: USA, Canada, and Mexico free
trade area
• The Association of Southeast Asian Nations: Free trade area that
includes 10 member countries in South East Asia that allows each
country to set its own tariffs on imports but minimal tariffs on goods
that have 40% ASEAN content value. Aim is to become a common
market
• Union of South American Nations: union of two South American trading
blocs (CAN) and Mercosur. Aim is to become a single market
• Comprehensive and Progressive Agreement for Trans-Pacific
Partnership
Benefits of Trading Blocs
o Trade Creation
▪ Removal of trade barriers causes a country to switch its purchases of imports
from a high cost country to a low cost country, achieving greater economic
efficiency
o Increased Competition
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Increased competition from foreign firms will force firms to be more productive,
efficient and innovative
▪ This will lead to lower prices, higher quantity and better quality products for
consumers
▪ Also with an economic union, there will be greater price transparency and less
price discrimination
▪ In the long run it is also possible that competition leaves the market and settles
in an oligopolistic structure which may bring dynamic gains but also possibly at
the expense of static efficiency
o Economies of Scale
▪ Removal of trade barriers increases the size of the market and the industry for
firms which will open up opportunities to exploit economies of scale and lower
average costs and benefitting consumers as well
▪ This could also be achieved through cross-border mergers and takeovers
▪ However, the scope of these gains also depends on how homogenized the
products and tastes of consumers are
▪ More homogeneous products and consumers will lead to greater scope for
economies of scale
o Elimination of Transaction Costs
▪ When exchanging currencies through financial institutions, firms and individuals
are charged a transaction costs. These can be avoided when there is a common
currency.
▪ Furthermore, trade between countries can be done without any exchange rate
risk which eliminates the costs of hedging
o Movement of Factors of Production
▪ Neoclassical economists argue that when factors of production are allowed to
freely move, this should enable economies to converge in terms of growth
▪ Less developed countries generally have a comparative advantage in lower
factor of production prices and attract firms to draw resources away from
developed parts to the less developed
Costs of Trading Blocs
o Trade Diversion
▪ Removal of trade barriers with a country in the bloc leads to switching from
buying imports from a low cost country outside the bloc and to a higher cost
country inside the bloc. This leads to economic inefficiency
▪ Generally assume removal of trade barriers leads to more creation than
diversion
o Loss of Individual Fiscal, Monetary and Trade Policy
o Increased Competition may lead to dynamic inefficiency
▪ A race to bottom for prices evaporates profits that could be reinvested in
improvements
o Movement of Factors of Production
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Growing economic divergence between developed and less developed parts
Factors of production leave the less developed periphery for the developed
centre
Conflicts between Trading Blocs and WTO
o Trading Blocs only encourages trade between the members but not all countries as the
WTO would rather have and therefore weaker economic gains are achieved
o Trading blocs go against the WTO’s most-favoured clause that states a country that cuts
tariffs for one country must do so for all WTO member countries
o Trading Blocs can engage in trade wars between each other leading to an quick
escalation of protectionism
o Developing countries are usually not part of trading blocs which leads to greater
divergence between developed and developing nations
o Trading Blocs make the WTO redundant
7. Trade Restrictions
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Protectionism: the use of trade restrictions to regulate trade between countries usually to
reduce imports and increase exports
Reasons for Trade Restrictions
o Protect Infant and Industries
▪ Infant industry: an industry that is in the early stages of development and
cannot compete favourably against more mature foreign rivals
▪ In the short run this is a valid argument as it gives time for the infant industry to
learn best practices and achieve economies of scale
▪ However in the long-run the industry should be weaned off the protective
barriers and compete directly with foreign competition
▪ Sometimes infant industries have difficulties accessing finance as well
▪ If there are long-run comparative advantages then the protectionist policies are
allocatively efficient
▪ Generally difficult to identify infant industries that will be successful in the longrun
▪ Protection also could lead to lack of motivation to become more efficient
o Protect Geriatric Industries
▪ Geriatric Industry: an industry that is in decline and cannot compete with those
abroad
▪ In the short-run, it is justified if it gradually winds down the industry and gives
time for the economy to reallocate resources to other uses without suffering
from the sudden shock of a collapse in supply and demand
▪ In the long-run, it is only justified if the industry could be invested to be made
competitive again and there are long-run comparative advantages
o Protect Domestic Industries and Employment
▪ Domestic Industries may not be able to compete with foreign competitors on
price
▪ Without protection, the industries will be forced to close down leading to
massive unemployment in the industry
o To Protect National Security
▪ Reliance on imports for certain strategic goods may pose a national security
threat should those exporting countries become hostile
o To prevent Dumping
▪ Duping: sale of goods below their cost of production by foreign firms at a loss
▪ Reasons for dumping
• The goods may have failed to find ample demand in the market and
firms are willing to take a loss and sell them at a distressed price
• The firm may have overproduced in the short run and is willing to sell at
a loss as long as variable costs are covered
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May be engaged in predatory pricing to drive out competition and
monopolize market
To correct a current account deficit
▪ Government may use protectionist policies to reduce the value of imports
relative to exports in an attempt to improve a current account deficit
▪ Tariffs on elastic imports for example
▪ However tariffs could also make imported materials for firms more expensive
leading to higher prices for export goods and loss of price competitiveness.
To raise revenue
▪ Import tariffs can be a lucrative source of revenue for governments
▪ They are relatively easy to collect provided that the customs infrastructure is in
place and smuggling can be sufficiently prevented
To Help Diversify and Economy
▪ Developing countries need to diversify their economies in order to grow and
mitigate the risks of the economy
▪ Overreliance on a particular low value export commodity will not be able deliver
significant growth and exposes economy to significant price risks
▪ Any new industry in the economy will most likely be unable to compete with
foreign firms and will need trade protectionist policies to survive.
Tariffs
o A tax on imported goods (import duty/customs duty)
o Diagram:
▪ Pre-tariff equilibrium: domestic supply and demand and world supply
▪ World supply is perfectly elastic at world price
▪ Assume world price is below autarkic price
▪ Tariff raises world supply and decreases imports, increases price, decreases
equilibrium quantity
▪ Areas: CS, PS, tariff revenue, deadweight loss, foreign firm revenue
Non-Tariff Barriers
o Quotas: A limit on the quantity of imports
▪ Diagram:
▪ Quota pushes up price paid, decreases quantity and increases domestic
production while leading to decreased import
▪ Assume country is originally an importer
▪ Areas: CS, PS, Foreign Surplus, DW loss to country, overall DW loss
o Subsidies
▪ Used to increase exports and reduce imports
▪ Export Subsidies
• Government provides a subisidy to the firm for goods that are exported
to foreign countries
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This encourages firms to sell their goods and services abroad and be
able to sell at a lower price in foreign markets
▪ Domestic Subsidies
• Payments provided to domestic firms that reduce their costs of
production and giving them an advantage when competing against
foreign imports
• Could take the form of indirect subsidies such as low cost loans, tax
relief and investments
o Administrative Barriers
▪ Different product standards can be used to obstruct the entry of imports
▪ Force importers to go through lengthy legal procedures such as paperwork in
order to sell their goods
o Exchange Rate Manipulation
▪ Governments could manipulate their exchange rates through interest rates and
money supply movements to artificially lower their currency values in order to
encourage exports and discourage imports
Impact of trade protectionism
o Consumers
▪ Generally lose to protectionist policies
▪ Higher prices, lower quantity, less choices, less innovation
o Producers
▪ Domestic firms can gain or lose from these policies
▪ Firms that compete with imports gain from higher prices and higher quantity
produced
▪ Protection lessens the need for firms to innovate and over the long run become
even less competitive
▪ Firms that require imports will lose out from higher costs
o Workers
▪ Workers in industries that compete with imports gain as their employment is
protected
▪ However they may also lose as they fail to acquire new skills
o Government
▪ Generally benefit such as from tariff revenues, higher income tax revenues and
greater political support in the short run
▪ However protectionist policies may lead to inefficiencies over time
o Living Standards
▪ Maintains similar living standards in the short run but inefficiencies in the longrun mean that living standards may be lower than what would have been
possible without the policies
o Equality
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Short run there is greater equality particularly if the policies protect workers in
low income industries
▪ However over the long-run the misallocation of labour would lead to lower
growth and lower income growth than possible if they invested in human capital
Generally speaking free trade is preferred to trade protection as it is economically efficient
compared to protectionism
8. Balance of Payments
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Balance of Payments records all monetary transactions between residents of one country and
residents of other countries
Inflows of domestic currency is recorded as credits (+)
Outflows of domestic currency is recorded as debits (-)
For every transaction there is an equal amount of credits and debits and therefore the balance
of payments always has to be zero (in balance)
Two major components of the BoP
o Current Account
▪ Records all transactions relating to the purchase and sale of goods and services
(Balance of Trade)
▪ Records all transactions involving cross border income flows related to the
international ownership of assets and transfers of money between residents
and non-residents (Primary and Secondary Income)
o Capital and Financial Account
▪ Capital Account:
• Records transactions for non-produced, non-financial assets and capital
transfers between residents and non-residents
• Examples: purchase and sale of existing fixed assets and debt
cancellation
• A very small part of the two accounts
▪ Financial Account:
• Records all transactions relating to the change of ownership of financial
assets and liabilities
• FDI: a controlling interest of more than 10% of shares in a foreign
company including any reinvested earnings
• Portfolio Investments: Purchase of foreign shares less than 10% as well
as purchase of debt securities
• Other investments: Trade Credit, loans, currency and bank deposits
• Reasons for flows on the financial account
o Speculators want to make a quick profit through purchase and
sale of financial assets. Speculators help correct market prices
for financial assets
o Foreign currency loans can be made to help finance trade
o Individuals demand foreign currencies for holidays abroad
o High net worth individuals may decide to open foreign bank
accounts to shelter their income from taxation
o Portfolio investments and Foreign direct investment can lead to
earning profits overseas
Balance on FA = Bal on Cap A + Bal on Curr A
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A country with a current account deficit must be financed by a financial account surplus
A country with a current account surplus must be lending to the rest of the world
through a financial account deficit
Official data is usually not balanced and a balancing entry is used to cover the shortfall
o Balancing item is usually caused by inaccurate data reported by firms and individuals or
illegal hidden transactions
Countries with consistent neutral/positive/negative CA: France Chile/China Germany Saudi
Arabia/ US UK
Causes of Current Account Surpluses and Deficits
o Natural Resources
▪ Some countries are abundant with natural resources that are demanded by
most other countries which then become an major source of exports leading to
large current account surpluses
o Underlying Competitiveness
▪ Certain industries in countries have acquired a competitive edge against foreign
firms which leads to significant exports as well as large current account
surpluses
▪ These industries may have an advantage in lower costs, better product quality
and design, as well as greater labour productivity
o Exchange Rates
▪ Some governments interfere in currency markets to maintain a low exchange
rate for their domestic currency which consistently gives their exports a price
advantage and foreign imports a disadvantage. This leads to persistent
surpluses
▪ Some governments keep their exchange rates artificially high to reduce the
price of imports for consumers and firms but this will lead to persistent deficits
o Domestic Demand
▪ If a country consistently has high aggregate demand due to reasons such as low
interest rates and growing income then there is a great tendency to import
foreign goods and lead to persistent deficits.
o Overspending by Consumers and Government
▪ Overspending implies spending beyond the income one is receiving
▪ Very often deficits in the private sector and public sector are related to the
current account deficit
▪ Private sector may be spending too much on imports leading to twin deficits
▪ Public sector deficits may be financed by current account deficits when
foreigners recycle the currency
o Commodity Prices
▪ Commodity exporting countries will experience current account
surpluses/deficits when the prices of the exporting commodity rises/falls
o Inflation
▪
•
A country that consistently experiences relatively high rates of inflation will find
their goods and services uncompetitive in the international market and
experience consistent current account deficits
o Demographics
▪ Younger individuals have a greater higher marginal propensity to consume as
well as import than older individuals which may contribute to current account
deficits and surpluses
Measures to Reduce Imbalances on the Current Account
o Expenditure Switching Policies: Policies aimed at encouraging consumers and firms to
substitute more expensive foreign imports with cheaper domestically produced
goods/exports
▪ Manipulating the Exchange Rate
• Governments can intervene in currency markets and devalue their
currency
• This would make exports more competitive and imports more expensive
and hopefully bring a current account deficit into surplus
• The combined elasticities of imports and exports need to be greater
than one in order for the devaluation to be effective (Marshall-Lerner
condition)
• In the short term, the deficit may worsen but in the long run the deficit
will improve (J-curve effect)
• If the imports and exports are mainly bought on quality and not price
competitiveness then the devaluation would most likely be unsuccessful
• If imports of raw materials or inputs are necessary for production, the
devaluation would lead to cost-push inflation that is further
exacerbated by rise in wages and ultimately spiralling into higher export
prices that are no more price competitive than before
• Two ways of devaluation: increase money supply or reduce interest
rates
• Reduction of interest rates may also lead to increased domestic
borrowing that finances imports
▪ Trade protectionism
• Trade barriers serve to discourage domestic consumers and firms from
purchasing imports and encouraging purchases of domestically
produced goods and services
• However it does nothing to make exports competitive and by shielding
them from competition can make them less competitive over time
• Furthermore, countries can retaliate with similar policies
o Expenditure Reducing: Policies that aim to decrease imports demanded through
affecting aggregate demand
▪ Deflationary policies: Aimed at reducing AD
•
•
•
Increasing taxes or interest rates
More effective if MPM is high and leads to a significant fall in price level
to make exports competitive and imports expensive
▪ Currency Controls
• Governments can restrict/limit foreign exchange transactions making it
difficult for consumers and firms to purchase foreign currency and
thereby limiting their consumption of imports
• However black markets may emerge to get around the restrictions
• There is also scope for corruption through bribing government officials
to obtain foreign currency illegaly
o Supply Side Policies
▪ If a country increases its productivity more significantly than others it could gain
a cost advantage in exports and reduce the country’s reliance on imports as well
▪ However these are mostly long-run effects and the current account deficit will
most likely remain in place in the short run
▪ Furthermore other countries with more resources are in a better position to
increase productivity
Global Trade Imbalances
o One country’s deficit is another’s surplus
o Sum of all current accounts in the world is 0
o Persistently large current account deficits can be problematic:
▪ If foreigners are no longer willing to finance them and the country can no longer
enjoy the same living standards as before
▪ Persistently large deficits also may be a sign of persistent lack of
competitiveness of exporting industries which may lead to increasing
unemployment
▪ If imports do not decrease, the domestic currency will have to depreciate and it
may lead to inflation
▪ It may not be a large problem if:
• The borrowed funds help finance long term growth that would improve
the productivity of the country’s industries and lead to future surpluses
that will help pay back the deficits
• Foreigners are still willing to lend at a low interest rate to finance it and
if the country has the capability to repay it
• If most of the borrowing is done in the domestic currency of which it
has total control
o Consistently large surpluses may also not be a good thing
▪ They are saving too much and may not be enjoying as high a living standard as
possible
▪ If the foreign currency received is not wisely invested then the surpluses are
wasted
9. Exchange Rate Systems
•
•
•
•
•
Exchange Rate: The rate at which one currency can be converted into another
o Price of 1 unit of the home currency in terms of foreign currency
o X FC/1HC
Effective Exchange Rate or Trade Weighted Exchange Rate
o An index that represents the value of the home currency against a group of currencies
each of which is weighed by the value of trade with the home country
Currencies are traded on the foreign exchange market where equilibrium exchange rates are
determined mostly by demand and supply for each currency absent any government
intervention
Reasons for purchasing currencies
o It is needed in the purchase of international goods and services between countries.
Demand for exports lead to a demand of home currency by foreigners; Demand for
imports lead to a demand for foreign currency by domestic agents
o Cross-border investments such as FDI and Portfolio investments also drive demand for
different currencies
o Speculators in foreign exchange markets buy and sell currencies for the sole purpose of
profiting from changes in exchange rates
Demand and Supply Diagram for the market for home currency
o Horizontal axis: Units of home currency (quantity)
o Vertical axis: units of foreign currency per one unit of home currency (exchange rate)
o Demand:
▪ The quantity of home currency non-residents are willing and able to purchase at
a given time period for different levels of exchange rate ceteris paribus
▪ It is downward sloping because as the home currency depreciates, exports
become cheaper for foreigners and will demand more of the home currency to
buy the exports
o Supply:
▪ The quantity of home currency residents are willing and able to supply at a
given time period for different levels of exchange rate ceteris paribus
▪ It is upward sloping because as the home currency appreciates, imports become
cheaper for residents and will demand more of the foreign currency to buy the
imports
o Additionally speculators also contribute to the downward sloping demand and upward
sloping supply.
o Where supply equals demand is the equilibrium exchange rate and quantity of home
currency traded
o Governments can affect the equilibrium exchange rate by intervening in the foreign
exchange markets directly or indirectly
▪
▪
Direct: Governments through the central bank can buy and sell its currency in
exchange for gold or foreign currency reserves. Additionally it could also restrict
the purchase/sale of the home currency
• If the government would like a higher exchange rate it can decrease the
supply of home currency by buying the home currency and selling its
foreign exchange reserves by the excess supply amount
• If the government would like a lower exchange rate it can increase the
supply of home currency by selling the home currency and buying
foreign exchange reserves by providing the excess demand amount
• Defending a high exchange rate could exhaust all of the central banks
reserves and when those reserves are exhausted, it can no longer
defend a high exchange rate
• Currency Controls: governments can enforce a strict limit to the
quantity of home currency that can be bought and sold as well as the
exchange rates. This serves to strictly control the exchange rate as well
as capital flows in and out of the country. There may be two exchange
rates, one for imports of consumer goods and one for investment
goods. A lower investment goods rate may encourage firms to buy
productive foreign capital at a cheap price. However currency controls
may also lead to the development of black markets as well as corruption
Indirect: Central banks can adjust interest rates to affect the exchange rate as
well
• Increases in interest rates will attract both domestic and foreign savings
away from foreign investments, leading to both an increase in demand
as well as a decrease in supply. The exchange rate appreciates
• Decreases in interest rates will encourage both foreign and domestic
savings to search for higher returns elsewhere leading to both an
increase in supply and a decrease in demand. The exchange rate
depreciates
• Increases/decreases in interest rates leads to a fall/rise in aggregate
demand which leads to a fall/rise in income which leads to a
fall/increase in demand for imports which then leads to a decrease in
supply/increase in supply of home currency which finally leads to an
appreciation/depreciation of the exchange rate
• Interest rates have the advantage that they are not limited by the
quantity of reserves in the central bank but they do have a lower bound
of zero
• Quantitative Easing: By purchasing financial assets in the market, central
banks are also effectively lowering interest rates for those financial
assets. If the assets are purchased from banks, banks will have more
money to lend and will lower interest rates for commercial borrowing.
•
•
The fall in interest rates drives foreign and domestic savings away
leading to an increase in supply and decrease in demand for home
currency and a depreciation of the exchange rate
Types of Exchange Rate Systems
o Fixed Rate Systems
▪ The home currency has a fixed conversion rate with all other currencies or a
particular commodity
▪ The central bank authority must have sufficient reserves to complete any
transaction at those fixed rates
o Managed Rate Systems
▪ Hybrid system where most of the times exchange rates are purely determined
by supply and demand
▪ At times the government would intervene to affect the exchange rate
▪ Adjustable Peg system
• In the short term currency is fixed or pegged against each other and do
not change much
• In the long term the currency value changes along with economic trends
• Bretton Woods System: Each country fixed their exchange rates against
each other with an allowed band for exchange rate deviations. If the
bands are crossed then the central bank would intervene
▪ Crawling Peg System
• Adjustable Peg with a band that moves regularly over time
▪ Managed or Dirty Float
• Exchange rates are freely floating most of the times but the government
and the central bank will occasionally intervene to stabilize the
exchange rate so that it does not disrupt international trade
o Floating Rate Systems
▪ Exchange rate is purely determined by market forces and no government
intervention at all
Factors that Affect Floating Exchange Rates
o Relative Interest Rates
▪ Increases/decreases in relative interest rates leads to increase/decrease in
demand and an appreciation/depreciation of exchange rate
o Relative Inflation Rates
▪ Nominal Exchange rate: current market exchange rate
▪ Real Exchange rate: the exchange rate based on a comparison of the costs of
two identical consumption basket in different countries
▪ Nominal is not necessarily the same as real especially in the short run where
there are speculative activities and government intervention of foreign
exchange markets
▪
o
o
o
o
o
Purchasing Power Parity Theory: In the long run exchange rates move in line
with inflation rates between economies
▪ A country that is experiencing higher/lower inflation rates than other countries
should see its currency depreciate/appreciate by the inflation rate differential
against other countries
▪ Reasoning: If home inflation is higher/lower than other countries, then over
time exports would become less/more competitive while imports become
more/less competitive leading to a decrease/increase in exports and an
increase/decrease in imports which leads to a decrease/increase in demand for
home currency as well as an increase/decrease in supply of home currency
▪ The causes of inflation rate differential is most likely attributed to differences in
labour productivity over time. More/less productive labour leads to
lower/higher costs and ultimately lower/higher inflation.
Current Account Surpluses and Deficits
▪ Rise in exports demanded leads to greater home currency demanded and
appreciation
▪ Rise in imports demanded leads to greater home currency supplied and
depreciation
▪ Credits lead to depreciation, debits lead to appreciation
Overall Health of the Economy
▪ A healthy economy attracts foreign capital investments and hence more home
currency demanded and appreciation
▪ A collapsing economy drives out foreign capital investments and hence more
currency supplied and depreciation
Capital Flight Risk
▪ Capital flight is when there is a rapid movement of large sums of money out of a
country usually due to significant economic and/or political turmoil
▪ Capital flight leads to significant depreciation of the home currency due to
increased supply
Expectations and Speculation of Exchange Rates
▪ Speculators attempt to make profits by making bets on exchange rate changes
▪ If they expect the exchange rate to appreciate/depreciate they will increase the
demand/supply of the currency by buying/selling the home currency
▪ In the short run changes in exchange rates are mostly driven by speculation
▪ In the long run changes in exchange rates are mostly driven by economic
fundamentals such as exports, imports, and foreign capital movements
Prices of Commodities
▪ Many countries have a heavily reliance on exporting commodities and importing
all other essential goods and services
▪ Commodities tend to have a very inelastic demand which results in increases in
total export revenues when prices rise and decreases in total export revenues
when prices fall
▪
▪
A rise in the value of exports leads to a rise in demand for home currency and
appreciation of exchange rate
A fall in the value of exports leads to a fall in demand for home currency and
depreciation of exchange rate
10. The impact of Changes in Exchange Rate
•
•
Revaluation/Devaluation vs Appreciation/Depreciation
o Revaluation/Devaluation: When the government officially announces that it will
raise/decrease the peg level of the home currency; Whether the actual market
exchange rate changes to the new peg depends on how committed the government is
to the new level by using its intervention tools
o Appreciation/Depreciation: When the market exchange rate actually rises/falls due to
market supply and demand forces or government intervention in the market
The consequences of changes in exchange rates
o The current account and the BoP
▪ Generally speaking a depreciation/appreciation will lead to a rise/fall in the
value of exports and a fall/rise in the value of imports and an overall
improvement/worsening of the current account
▪ To be more precise it depends on the price elasticities of exports and imports
▪ Marshall-Lerner Condition
• If the combined price elasticities of imports and exports is greater than
1 then a depreciation will improve the current account
• Otherwise it will worsen the current account through devaluation and
the correct policy to apply would be revaluation
• Reasoning:
o For a depreciation:
▪ The foreign currency price of imports did not change
but the home currency price increased
▪ Elastic import demand means volume decreases even
more then price rises
▪ Total Home currency value of imports fall
▪ The home currency price of exports did not change but
the foreign currency price decreased
▪ Export volume will increase no matter what
▪ Home currency value of exports will increase
▪ Improvement in Current account
▪ However, it should be noted that firms can adjust their prices in foreign
countries in response to exchange rate changes and therefore the demand may
not change as much.
▪ If firms in both countries do not adjust their foreign prices the effect of a
depreciation/devaluation will still be positive on the home currency current
account
• Foreign exports prices did not change so volume is the same but
foreign earnings are now higher in home currency terms therefore the
home currency value of exports are now higher
•
o
o
o
Foreign import prices at home currency do not change so there is no
change in volume and there is no change in home currency value of
imports
▪ J-Curve Effect
• The improvement in the current account do not take place immediately
after a devaluation/depreciation
• In the Short run, demand for both imports and exports are very
inelastic and so the quantity of imports and exports don’t change. As a
result the depreciation reduces the home currency value of exports and
increases the home currency value of imports, leading to a
deterioration of the current account
• Inelastic demand is usually due to contractual obligations as well as lack
of time to find alternatives
• In the long-run foreign and domestic consumers will respond more to
the devaluation/depreciation and the current account will improve
The rate of inflation
▪ Devaluation usually leads to inflation
• Imported Cost-push inflation caused by rising costs of inputs to
domestic production. In fact it can even dissipate any price
competitiveness gained through devaluation.
• Demand-pull inflation could also occur since increased export demand
and decreased import demand leads to a rightward shift of AD
• Likewise a revaluation/appreciation is most likely going to lead to lower
inflation
o The degree of cost-push also depends on whether foreign firms
will adjust their prices
o The degree of demand-pull also depends on the elasticities of
imports and exports, the more elastic, the stronger the effect
Economic Growth
▪ Depreciation/Devaluation usually leads to rise in real GDP and economic
growth through AD effects in the Short run. The opposite effects for
Appreciation/Revaluation.
▪ Supply effects should also be considered
▪ Long run effects only present if there is a channel through investments
Unemployment
▪ Depreciation/Devaluation leads to increase in output which generally leads to a
fall in unemployment. The opposite generally holds true for
appreciation/revaluation
▪ Also the effects would be most felt in industries that export goods, compete
with imports as well as uses imports
▪ Supply effects should also be considered as well
o
FDI
▪
o
Depreciation/Devaluation may lead to FDI as it is cheaper to invest in foreign
currency terms and there may be potential for large long-run gains. Foreigners
may also be attracted to lower costs of production as well
▪ However if the currency is continually falling then foreigners will be
discouraged to invest as all the returns from investment would be eroded by
exchange rate losses
Competitive Devaluations
▪ Devaluations may be perceived as a policy tool to spur economic growth at the
expense of other’s through export import channel
▪ Other countries may retaliate with similar devaluations
▪ Highly interlinked economies may also devalue together when one of its main
trading partners devalues
11. International Competitiveness
•
•
•
Competitiveness: The ability of a firm or a country to compete with international peers in the
global market
Measures of Competitiveness
o Relative Productivity Rates
▪ Labour Productivity
• Output per hour of labour worked (real GDP per hour worked)
• Rise in relative labour productivity: output per labour hour of one
country is rising faster/falling more slowly than another’s
• Rise/Fall in relative labour productivity leads to greater international
competitiveness
▪ Multifactor Productivity: Output measured against labour hours and capital to
present an overall picture of productivity of all inputs
o Relative Unit Labour Costs
▪ Unit labour costs: Total wages divided by real output
▪ High/low unit labour costs means more/less international competitiveness
▪ Depends on two factors, wages and labour productivity
• Higher/lower wages leads to higher/lower unit labour costs
• Higher/lower labour productivity leads to lower/higher unit labour costs
▪ Usually measured in index form and compared to other countries (Relative unit
labour costs)
o Relative Export Prices
▪ An index that measures the export prices of a country relative to those of its
main trading partners
▪ Rise in relative export prices indicates that the country’s export prices have
risen more quickly/fallen less quickly then those of its main trading partners and
therefore is losing international competitiveness
▪ Same analysis holds for fall in relative export prices
Factors that influence Competitiveness
o Productivity
▪ Rise in productivity leads to fall in unit labour costs and export prices which will
increase competitiveness
o Quality of Human Capital
▪ Improvement in quality of human capital leads to increase in labour productivity
as well as a fall in unit labour costs and export prices and ultimately more
competitiveness
▪ It could also affect non-price competitiveness through greater innovation and
product quality
o Exchange Rates
▪ Fall/Rise in exchange rates leads to greater/less competitiveness of exports
▪ This doesn’t take into account of foreign firm pricing responses
•
▪ Only relates to price competitiveness but not non-price competitiveness
o Wage and Non-Wage Costs
▪ Higher/lower wages lead to higher/lower unit labour costs and less/more
competitiveness
▪ Same analysis holds for non-labour costs such as pensions, insurance, etc.
o Regulations
▪ Stricter regulations tend to increase costs of production and less
competitiveness
o Quality of Infrastructure
▪ High quality infrastructure can increase competitiveness through lower
transportation costs and more reliable electricity supply which ultimately lowers
costs
o Non-Price Factors
▪ Better design, branding, and quality can be a source of competitiveness that is
more exclusive and doesn’t depend on price and cheaper costs
Measures to Increase Competitiveness
o Education and Training Policies
▪ Governments can tailor education and training policies that aim to increase the
productivity of labour in the country
▪ It could make education more accessible for the population
▪ It could improve the quality of education for students by designing a curriculum
that meets the needs of the labour market
▪ It could also improve the educational facilities and infrastructure
▪ It could also use incentives to encourage people to get themselves trained
▪ Cash strapped governments will be less able to implement these policies
o Investment Incentives
▪ Productivity can be increased if more resources are devoted to research and
development
▪ Governments can use tax incentive policies to encourage firms to devote
resources to R and D
▪ It could also finance some of these efforts themselves directly through grants
o Privatisation and Deregulation
▪ Privatisation and deregulation would encourage more competition in a market
and incentivize firms to be efficient and innovative
▪ Deregulating labour markets should also work to reduce wages
o Devaluations/Depreciation
▪ Depreciation of exchange rate leads to greater price competitiveness but it is
also seen as protectionism prone to retaliation
o Trade Liberalisation
▪ Removing trade barriers exposes domestic firms to foreign competition and
drives them to be more efficient and innovative
o Taxation
▪
•
•
Reducing taxes on profits encourages firms to invest and improve in non-price
competitiveness
▪ High taxes could also be used to finance infrastructure and education projects
that also lead to greater competitiveness
Benefits of being internationally competitive
o Current Account Surpluses
▪ Current account surpluses from exports gives the country funds to invest in
foreign countries and acquire assets
o Foreign Exchange Reserves
▪ Current account surpluses lead to an accumulation of foreign exchange reserves
for purchasing essential imports and interventions in currency markets
o Foreign Direct Investment
▪ Competitive economy attracts foreign investment into market to benefit from
local consumption or use as an export base
▪ Foreign investments can be used to transfer latest technology and best practices
o Employment
▪ Competitive economies usually experience higher output and economic growth
and higher employment along with its benefits
o Economic Growth
▪ Self explanatory
o Wage Growth
▪ High demand for exports and economic growth should also lead to higher wage
growth
o Higher Domestic Purchasing Power
▪ Greater productivity should lead to lower costs and prices for goods and
services and ultimately greater purchasing power of wages
Difficulties of Sustaining International Competitiveness
o Competitiveness can be lost over time
▪ Wages will grow over time when developing countries grow which may
eliminate previous cost advantages
▪ Prices of other factors of production would also rise over time after
experiencing robust growth and eliminate previous cost advantages
▪ Current account surpluses should put pressure to exchange rate to rise
eliminating price competitiveness
▪ Trade barriers may be erected by other nations to eliminate competitive
advantage of exporting nation
12. Poverty
•
•
•
Absolute Poverty:
o The condition where basic necessities for survival are not even sufficiently consumed.
o Characteristics:
▪ Suffer from hunger and malnutrition
▪ Lack stable access to clean water, sanitation and health services
▪ Lack access to education
o Poverty Line: A minimum level of income per day needed to escape extreme poverty
▪ Most common measure for absolute poverty
▪ Varies from country to country
▪ Global poverty line uses the poverty lines of the 15 poorest countries
▪ Lower middle-income poverty line and upper middle income poverty lines for
lower and upper middle income countries
o Absolute Poverty is almost non-existent in developed countries as there are strong
social safety nets in place
o However, poverty lines and income may not be the most accurate measure of poverty
Multidimensional Poverty Index
o Poverty index that measures three dimensions of poverty: health, education, and
standard of living
o Education: years of schooling, child school attendance data
o Health: Child mortality, nutrition data
o Standard of Living: availability of electricity, sanitation, access to drinking water,
housing, assets owned, etc.
o A composite number between 0 and 1; The higher the value the higher the poverty
o Some countries may have high income but do not perform well in other dimensions
o The composite number may be very difficult to interpret however; two countries with
the same score may perform well/poorly in different dimensions
Relative Poverty
o The condition where an individual is relatively poorer than another within the same
country.
o Where there is high/low relative poverty there is high/low inequality
o Exists in any economy, developed nor developing
o Two methods of measuring relative poverty:
▪ Compare poorest incomes with median household income in a country
• EU: Proportion of households living on less than 60% of median
household income and total number of people in those households
• OECD: the ratio of number of people living in households with incomes
below half the median household income to the total population
• Other measures may focus on the ratio between median income and
other poorest income quintiles, deciles, etc.
▪
•
Consider what goods and services people have to buy in a country in order not
to be considered poor
• There is a minimum acceptable basket of goods that people have to buy
in order to be considered not poor
• The goods and services may differ across countries
Factors that affect Absolute and Relative Poverty
o Economic Growth
▪ Economic growth leads to lower unemployment which leads to a fall in absolute
poverty
▪ However it should also depend on the level of wages received by workers
▪ Also there are groups of people who cannot work such as the elderly and the
disabled
▪ Relationship with relative poverty is uncertain; it could either rise or fall and
affect different groups of workers in different ways
▪ Governments could also redistribute the gains of growth to different income
groups
o Education and Training
▪ Can lead to long term economic growth through improvements in quality of
human capital
▪ Should lead to lower levels in absolute and relative poverty because it not only
helps people find jobs but also better paid jobs through improvements in
productivity
▪ Governments should therefore improve access to high quality education to
reduce poverty
▪ A lack of access to education and educational achievement on the other hand
leads to increases in both absolute and relative poverty
▪ Poverty cycle in which children born into poverty are unable to escape it
o Welfare Benefits
▪ Financial help provided by the government to help poor people afford a
minimum standard of living
▪ It should lead to decreases in absolute and relative poverty
▪ Tend to be more generous in advanced economies due to abundant financial
resources of governments
o Tax Structure
▪ A progressive tax system reduces relative poverty as it charges a higher tax as
more income is earned
▪ Regressive taxes such as VAT and excise taxes worsen relative poverty
▪ Taxation revenues can be redistributed by government in the form of greater
welfare benefits for the poorest and better education and health services which
can reduce absolute and relative poverty as well
▪ However the tax collection system needs to be robust
o
o
o
Structural Change in the Economy
▪ Changes to the overall composition of the economy between primary,
secondary, and tertiary sectors can also have implications for poverty
• Primary sector jobs such as farming tend to be the least productive in
terms of value and consequently workers in those sectors tend to live in
absolute and relative poverty
• As an economy shifts up through the value chain workers’ wages will
increase and absolute and relative poverty will fall
▪ Changes in the distribution of jobs between formal and informal sector
• Informal sector jobs tend to have significantly lower pay as well as less
employee protection and development
• As more jobs move from the informal to the formal sector, there should
be a reduction in both absolute and relative poverty
▪ Changes in economic system
• Modern Command economies tend to have lower relative poverty but
perhaps higher absolute poverty due to greater redistribution of wealth
and income but lower economic growth
• Market economies tend to have higher relative poverty but perhaps
lower absolute poverty due to higher economic growth driven by
competitive market forces
Foreign Aid
▪ Voluntary transfer of resources from one country usually a rich nation to
another poorer nation out of sympathy
▪ It can help reduce absolute poverty in the short term if the aid provided are
basic goods and services
▪ More effective foreign aid should be directed towards longer term projects such
as infrastructure, education, and health
▪ One problem with foreign aid is that there is opportunity for corruption and
misuse of resources by government officials
Civil Wars and Conflicts
▪ Civil wars and conflicts unambiguously leads to absolute and relative poverty
through the destruction of physical and human capital
▪ Sometimes the causation is reversed where high levels of poverty leads to
internal conflicts
13. Inequality
•
•
•
Income vs Wealth
o Income
▪ A flow variable, the money earned by factors of production during a period of
time
▪ Income inequality refers to the unequal distribution of these monetary rewards
between factors of production
o Wealth
▪ A stock variable that measures the amount of valuable resources an individual
has possession of at a point in time
• Examples:
• Property wealth in the form of residential and commercial property
• Physical wealth in the form of tangible assets other than property such
as cars, jewellery, etc.
• Financial wealth in the form of financial assets such as stocks, bonds,
bank accounts, etc.
• Private pension wealth
▪ Wealth inequality refers to the unequal distribution of an economy’s resources
between individuals
▪ Methods of wealth accumulation
• Saving and not consuming income
• Increases in asset prices
• Inherited wealth
▪ Wealth inequality leads to income inequality as wealth is used to generate
income
Measuring Inequality
o Lorenz Curve
▪ A curve plot that is used to show the level of income/wealth inequality in a
country
▪ Vertical axis: Cumulative percentage of income/wealth
▪ Horizontal axis: Cumulative percentage of households
▪ 45 degree line: Perfect equality
▪ As the line bends downwards towards the lower right corner, there is greater
inequality
▪ Gini Coefficient: the ratio of the area between 45 degree line and actual Lorenz
curve to the total area underneath 45 degree line
• 0 to 1, the closer to 1 the more inequality; sometimes multiplie by 100
and reported as an index out of 100
Causes of Income Inequality
o Within a country
▪
▪
▪
▪
▪
▪
▪
Globalisation
• Large supply of unskilled labour from foreigners have driven down
wages of unskilled labour in advanced economies, further driving the
wedge between unskilled and skilled labour
• Growing demand for unskilled labour in less developed nations will also
drive up wages for unskilled labour in those countries, reducing income
inequality
• However, FDI establishments also tend to pay higher wages than local
firms which can create income inequality
Technological Advances
• Technological advances in automation have made low skilled jobs
redundant and high skilled jobs more relevant
• This will reduce the ages of low skilled workers and increase those of
high skilled workers, further driving income inequality
Education Training and Skills
• Differences in access to good education leads to large differences in
skillset which ultimately leads to differences in income
Types of Job
• The rise in underemployment through part-time jobs and short term
contracts leads to increased income inequality despite economic growth
• The rise in informal sector jobs versus formal sector jobs also
contributes to increased income inequality
Labour Market Deregulation
• Removing government controls and regulations in the labour market
generally leads to greater income inequality
• This is because it increases the possibility of unskilled workers accepting
lower wages in the labour market through the weakening of trade
unions and removal of minimum wages
Tax and Welfare Benefits
• Taxes and Benefit can be used to redistribute income between
individuals in society
• Progressive taxation and spending on welfare benefits can be used to
reduce income inequality
• Regressive taxation policies and cuts to welfare spending can be used to
increase income inequality
• Underdeveloped tax systems and governments that lack financial
resources may find it difficult to use these policies
Economic Systems
• Changes from command driven to market driven systems generally lead
to increases in income inequality
•
o
Deregulation of markets generally leads to a decrease in wages for low
skill workers
• The privatisation and deregulation of industries could lead to the
emergence of a wealthy oligarchic class
▪ The rise of the top 1%
• In advanced economies there has been increased income inequality and
a greater spotlight on the wealthiest households the top 1% which seem
to have captured most of the economic gains in recent years
• Explanations:
o Capital income has been capturing a greater share of national
income compared to labour
o High income earners tend to have a greater share of capital in
the economy which then leads to higher capital income as well
o Social factors such as marriage between families of similar
income levels
o Tax rules have been designed to favour capital income
treatment
Between countries
▪ Differences in Resource Endowment
• Differences in the quantity and quality of factors of production leads to
differences in output per capita and thus income per capita
• Some countries have advantages in possessing abundant natural
resources which lowers their costs
• Some countries have greater amounts and quality of human capital
which leads to differences in productivity and hence wages
• Differences in physical capital also leads to differences in labour
productivity and differences in income
▪ Differences in Sectoral share of GDP
• High primary sector share leads to low income for country
• High Tertiary and Secondary sector share leads to higher incomes
• High informal sector share leads to lower incomes as well
▪ Differences in Infrastructure
• Poor infrastructure reduces the productivity of labour and hence their
incomes
▪ Differences in the amount of FDI
• Low investment from more developed nations make it difficult for
developing nations to learn best production techniques and increase
productivity, thus keeping labour unproductive
▪ The degree of Trade liberalisation
•
•
•
Higher degree of trade liberalisation can lower import production costs
as well as increase export competitiveness which should generally lead
to greater productivity and income
▪ Difference in Governance
• Corrupt and incompetent governments tend to misallocate resources in
the economy and discourages investment within the country leading to
low incomes for most citizens
Causes of Wealth Inequality
o Within a country
▪ Differences in Income
• Income inequality drives wealth inequality since income can be used to
acquire wealth and vice versa
▪ Differences in Inheritance Laws
• Children of wealthy individual tend to inherit the wealth of their parents
• Some countries enforce inheritance taxes that try to reduce wealth
inequality
▪ Differences in Age groups
• Younger people tend to have less accumulated wealth than older
people
▪ Almost all causes of income inequality leads to wealth inequality because of the
close relationship between the two. (Education, tax policies, type of job, labour
market regulation, technological changes, globalisation)
o Between countries
▪ Historical causes: Less developed nations tend to be former colonies that may
have had most of their wealth extracted by other nations
▪ Immigration: Wealthy individuals in developing nations tend to hold citizenship
in other advanced wealthy countries
▪ Different economic systems lead to different distribution of wealth
Impact of Inequality
o Incentives to be more enterprising
▪ Certain level of inequality is necessary for entrepreneurship because the
possibility of large profits encourages people to innovate and take risks
▪ High inequality could also discourage entrepreneurship if it leads to low
expectations among the majority in disadvantaged classes and the privileged
class is no longer threatened and no longer required to be enterprising
o Incentives to work harder
▪ Same as enterprise, but now in relation to providing labour
o Savings
▪ Reduction in income inequality can lead to lower overall savings because as
income is redistributed to poorer households. Poorer households have a higher
marginal propensity to consume than rich households
o
•
•
Education
▪ Rising income and wealth inequality leads to large differences in the quality and
type of education accessed by different income/wealth groups
▪ Wealthy families will choose to send their children to attend expensive and
exclusive private schools that have greater resources and generally higher
quality teaching
▪ Poorer families will mostly send their children to public schools that lack
resources.
▪ The result is that children of wealthy families are able to receive a better and
more rewarding education than those of poorer families
▪ This reinforces the poverty cycle through different educational outcomes and
continues to drive greater wealth and income inequality
o Migration
▪ Income and wealth inequality will encourage people to migrate to places where
there are higher incomes and higher wealth
▪ This occurs both at a national and international scale
o Life Expectancy
▪ As income inequality increases there tends to be a fall in life expectancy
▪ Income inequality can lead to greater absolute poverty either through reducing
the ability to obtain survival necessities as well adopting poor health and
educational decisions
Impact of Economic Change and Development on Inequality
o Kuznets Curve:
▪ Inequality rises during the early stages of economic development but then falls
▪ The early stages reflects the effects of industrialization driving income inequality
between primary sector workers and secondary and tertiary sector workers
▪ Over time better education and increased productivity will lead to a gradual
convergence of wages and reduced inequality
▪ This relationship seems to be outdated in light of significant inequalities in
modern advanced economies
▪ This relationship depends on government policies to promote growth and
mitigate income inequality
Capitalism and Inequality
o In a market driven economy, equality is not a primary concern of economic agents
o Land, capital, and entrepreneurship tend to take a larger portion of income than labour
in capitalist economies as they tend to be more scarce
o This inequality in income ultimately leads to inequality in wealth as well between those
who own wealth and those who don’t
o Thomas Piketty: concentration of wealth does not disappear naturally
14. Public Expenditure
•
•
•
•
Two types of Government Spending
o Capital Expenditure
▪ Government spending on investment goods that are consumed over a period of
time longer than one year
o Current Expenditure
▪ Government spending on consumption goods and services that are consumed
within a year, transfer payments, and debt interest
• Transfer payments: welfare payments that do not have any
corresponding output
• Debt interest: Interest paid on National Debt
▪ Ideally, current expenditures should not be financed with borrowing. A budget
deficit on only current expenditures is not desirable.
2 ways of measuring the size of government spending
o Government spending as a percentage of GDP
o Government spending per capita
The pattern of public expenditure
o The composition of government spending: what types of goods and services are
purchased by the government?
o Most common types of goods and services are:
▪ Social protection: benefits to the poor, sick, and disabled
▪ Health services: state hospitals and clinics
▪ Education: public schools and universities
▪ Public Safety: Police, prisons, fire safety
▪ Defence: military spending
▪ Housing: public housing
▪ Environment: parks and environmental protection measures
▪ Debt Interest: interest on national debt
Factors that affect the size and pattern of public expenditure
o Average income of a country
▪ Countries with higher/lower average income generally have higher/lower public
expenditures
▪ Lower incomes imply a lower tax base for governments to finance its
expenditures
▪ Furthermore poorer countries usually have less developed tax systems and
codes as well as a relatively large informal sector which leads to lost tax
revenues
o Changes in GDP of a country
▪ During periods of high economic growth the government may pursue
contractionary fiscal policy to tame aggregate demand and inflation; likewise
welfare payments tend to be lower.
▪
•
During periods of economic decline or recession, the government may pursue
expansionary fiscal policy to increase aggregate demand and welfare payments
may increase as well due to rising unemployment.
o Age composition of population
▪ An aging population with a large proportion of retirees generally leads to a
falling GDP as well as higher welfare payments, consequently rising government
expenditures
▪ A high birth rate also leads to a larger proportion of children whose education
and health that also partially depend on sufficient government provision leading
to a rise in government expenditures
▪ A rise in working age population leads to a rise in GDP and may help to keep
government spending as a percentage of GDP to stay constant
o Expectations of the population
▪ As income and living standards of the population rises, citizens would have
greater expectations about the quantity and quality of the goods and services
such as education, infrastructure, health, etc. provided by the government
leading to rises in government expenditure
o Economic Philosophy and Ideology
▪ Countries of similar income levels and development have government
expenditure levels that vary significantly
▪ These differences can be explained through differences in views about the role
of government as well as economic philosophy
▪ Efficiency of the public sector
• Countries that have a lower government spending may hold views that
government provision of goods and services are less efficient than
private sector provision
▪ The debate on austerity
• After the GFC, fiscal responsibility has been a widely debated issue
among European countries. As part of the conditions of receiving
financial support from ECB, IMF, and World Bank, governments of hard
hit countries have been required to significantly reduce their fiscal
deficits through cuts in government spending
• However austerity can lead to a deepened recession that
simultaneously reduces tax revenues and is politically unpopular in
countries as well.
▪ Disincentive effects of taxation and welfare
• Some economists argue that high level of taxes and welfare payments
discourage labour supply and thus leads to lower GDP and higher
government spending
The effects of the size of public expenditure
o Productivity and Economic Growth
▪
▪
o
o
No clear consensus
Governments are generally viewed as inefficient providers of goods and services
which leads to lower productivity and economic growth
▪ Free market economists believe that if resources were transferred from public
sector to private sector, there will be greater increases in productivity and
economic growth
▪ However, it can easily be argued that inefficiency also exists in private sector
▪ Furthermore, certain goods and services provided by the government can have
very direct and positive benefits towards productivity and growth such as:
• Education provision
• Healthcare for population
• Direct provision in research and development
• Spending on public goods such as infrastructure
Crowding Out
▪ In an economy that is near or at full employment, increases in government
expenditure may lead to competition of scarce resources between public and
private sector
▪ If the public sector successfully obtains resources that would have been
otherwise consumed by the private sector than there is crowding out
▪ Can be shown as movement along PPF of public and private sector goods
▪ Implies that government spending multiplier is low and efforts to increase GDP
through expansionary fiscal policy is unsuccessful
▪ If expansionary fiscal policy is financed through borrowed funds then this could
also lead to an increase in interest rates that can negatively impact private
spending on consumption and investments
Crowding In
▪ Crowding out may not necessarily occur:
• Transfer payments do not have a corresponding output and do not
consume any resources but rather they can fuel private sector spending
on actual output
• If unemployment is high and slack is high throughout the economy,
there is no competition for resources and there will be a stronger
multiplier effect through fiscal expansion that actually encourages
private sector consumption of idle resources (crowding in)
o Start form inside the PPF and move towards the frontier with
increased spending on public and private goods
• If government spending is on investment goods or supply side
improvements there can be long term improvements to the productive
capacity of the economy and the private sector as well. This leads to
future increases in private sector spending and overall economic growth
o Start at a lower PPF and move northeast towards a higher PPF
15. Taxation
•
•
•
•
Reasons for Taxation
o To finance government expenditures
▪
o To correct market failures such as externalities
o To manage macroeconomic variables of an economy
o To redistribute income
Direct vs Indirect Taxes
o Direct: A tax that is paid directly from private individuals to the government
▪ Income tax
▪ Corporation profit tax
▪ Capital gains tax
▪ Social Security contributions
o Indirect: A tax that is levied on goods and services and is paid by consumers to
producers and collected by the government from the producers
▪ Value added taxes
▪ Excise taxes
▪ Custom duties
Progressive vs Regressive vs Proportional Taxes
o Progressive: the proportion of income paid in tax rises as income of the individual rises
▪ Income tax is progressive in most countries as higher income brackets are taxed
at progressively higher marginal rates
▪ Corporation taxes are also progressive since like income tax there are also
progressive marginal rates and also shares of corporations tend to be owned by
higher income individuals in society
▪ Capital Gains taxes are progressive because there is an allowance for tax
exemption and they are mostly applicable to the wealthier individuals who have
accumulated large amounts of assets
o Regressive: the proportion of income paid in tax falls as income of the individual rises
▪ VAT: As incomes increase, individuals tend to spend less and save a higher
proportion of their income. Thus the proportion of income paid in tax falls as
income rises
▪ Excise taxes: Both high and low income individuals pay the same amount of tax
for consuming the same amount of goods.
o Proportional: the proportion of income paid in tax remains constant as income of the
individual rises
Average vs Marginal Taxes
o Most countries have a tax allowance which represents the maximum level of income
that is non-taxable
o Above the allowance there are tax brackets for which the marginal tax rate varies
o Marginal tax rate: the tax rate on the next dollar earned in income
o
o
•
Average tax rate: the tax rate on total income; total tax paid/ total income
Progressive/Regressive marginal taxes implies that average tax rate is always
lower/higher than the marginal tax rate
Effects of Taxation
o Incentives to Work
▪ Free market economists believe that taxes disincentivizes work and economic
activity because it reduces the rewards from providing labour
▪ They also believe that labour supply is relatively elastic meaning any
increase/decrease in marginal taxes should lead to correspondingly higher
decreases/increases in labour supplied
▪ Labour is an inferior good while leisure is a normal good
• Higher income leads to less labour supplied or more leisure demanded
(income effect)
• Rises/Fall in marginal tax rate leads to a fall/rise in the opportunity cost
of leisure which leads to more/less leisure demanded and less/more
labour supplied. (Substitution effect)
• Free market economists believe the substitution effects are stronger
than the income effect for labour
▪ Laffer Curve
• Increasing tax rates up to a certain point will maximize tax revenues
after which further increases in tax rates disincentivizes work and
reduces tax revenues
• Is it realistic? Does increasing rates by a certain few percentage points
reduce labour supply? Do reductions in tax rates actually lead to
increases in tax revenues
o Income Distribution
▪ Increases/decreases to progressive direct taxes such as income, capital gains,
and corporation taxes should generally lead to a more equal/unequal
distribution of income
▪ However increases in these taxes also encourages high income earners and
corporations to seek tax avoidance schemes that weaken the effect on income
distribution
▪ Increases/decreases to regressive indirect taxes such as VAT and excise taxes
should generally lead to a more unequal/equal distribution of income
o Output, Price Level, and Unemployment
▪ Changes in certain taxes can lead changes in macroeconomic variables such as
output, price level, and unemployment
▪ Direct taxes such as income tax, corporation tax, and capital gains tax operate
through aggregate demand
•
o
o
An increase/decrease in the tax leads to a decrease/increase in
aggregate demand and leads to a short run decrease/increase in output,
a rise/fall in unemployment, and a fall/rise in price level
• The long-run effects of these taxes depends on the position of LRAS
o If the new output aligns with the long run output then the
effects will remain in the long run
o If the new output is different from the LRAS output then
eventually changes in SRAS and AD will restore the long run
equilibrium
▪ Indirect taxes such as VAT, excise taxes, social security contributions of
employers operate through aggregate supply
• Increases/decreases in those taxes leads to a fall/rise in SRAS which
leads to a fall/rise in output, a rise/fall in unemployment, and a rise/fall
in price level in the short run
• The long run effects depends on the position of the LRAS
o If the new output aligns with LRAS then that is the new long-run
equilibrium
o Otherwise, changes in SRAS and AD will restore the equilibrium
position
Trade Balance
▪ Increases in taxes will reduce the disposable income of households and profits
of firms. Also the increase in taxes would dampen the expectations of firms in
the future leading to a fall in both consumption and investment.
▪ Part of this fall in consumption and investment demand will come from
imported goods and capital. The final effect is to reduce imports and improve
the trade balance.
▪ The lowered price level from reduced Aggregate demand will also make exports
more competitive.
▪ However reduced imported capital could damage the long run productivity
growth of the country and make the country’s goods less internationally
competitive and resulting in a deterioration of the trade balance
FDI
▪ FDI generally raises the economic activity in the country and increases output
and employment
▪ Thus FDI could lead to an increase in tax revenues for the government through a
variety of channels, VAT, income tax, tax on profits, etc.
▪ However, one of the methods to attract foreign capital is to offer tax incentives.
▪ This could lead to countries slashing taxes in order to compete for foreign
capital
▪ However, tax liability is only one consideration for foreign capital and other
factors may be more important when deciding whether to invest in the country
▪
▪
Furthermore, MNCs are able to use tax avoidance strategies to minimize their
taxes even without the tax incentives.
Thus the effects of changes in taxes on FDI flows is rather ambiguous
16. Public Sector Borrowing and Public Sector Borrowing
•
•
•
•
•
•
•
•
Fiscal Deficit: When government spending is larger than its income during a particular year. The
shortfall is usually measured as a percentage of GDP
o Current Budget Deficits: When government revenues do not even cover current
expenditure of the government
▪ During recessions and slumps a current budget deficit may be a result of
expansionary fiscal policies and automatic stabilizers and are understandable
▪ During booms governments should avoid running current deficits and strive for
current surplus
▪ The government should be allowed to run overall deficits for its capital
expenditure as these expenses can have long term productivity benefits for the
economy
o Primary Deficit: The deficit excluding interest payments (Actual deficit-debt interest
payments)
▪ Governments with primary deficits may find it difficult to borrow additional
funds
o Cyclical Deficit/surpluses: Deficits/surpluses that occur through the changes in
government spending and revenues over the trade cycle
o Structural Deficit/surpluses: Deficit/surpluses that occur regardless of the trade cycle
▪ Cyclically adjusted deficit
▪ Structural deficits are problematic as they mean that the national debt is likely
to increase over time
▪ However distinguishing between the two types are difficult
o Actual deficit/surplus = Cyclical deficit/surplus + Structural deficit/surplus
Fiscal Surplus: When government spending is less than its income during a particular year.
National Debt: The accumulated and outstanding borrowed amounts of the government;
Deficits increase the debt over time and surpluses can be used to reduce the debt.
Fiscal balances are usually measured in absolute money terms and a percentage of GDP
The percentage GDP measure is more useful as it gives an indication on the ability to repay the
debt
National debt as a percentage of GDP can vary widely across countries.
o Advanced economies can have percentages in excess of 100
o Resource rich exporting economies can have very low percentages
Government borrowing is achieved through issuing government bonds to investors who receive
regular interest payments. Major purchasers of these bonds include pension funds, insurance
companies, banks, individuals, as well as foreigners
Factors that Affect the size of deficits and surpluses
o State of the economy
▪ Size of deficits will change along with the level of GDP and the trade cycle
▪ 4 phases of the trade cycle: boom (peak) , recession (slide down), slump
(bottom), recovery (rebound)
▪
▪
▪
▪
▪
o
o
o
o
o
During a boom, the cyclical deficit/surplus should be at its lowest/highest
During a slump, the cyclical deficit/surplus should be at its highest/lowest
This implies that the actual deficit/surplus is at its lowest/highest during a boom
Actual deficit/surplus is at its highest/lowest during a slump
Why does the cyclical deficit change?
• Automatic Stabilisers: tax and welfare policies that automatically adjust
the amounts received and paid by the government according to the
state of the economy
• When the economy is in a boom/recession, incomes tend to be
high/low and unemployment tends to be low/high which leads to
high/low tax revenues and low/high welfare payments.
• These stabilizers tend to reduce/increase the deficit during good/bad
economic times
• They are called stabilizers as they smooth out business cycles by
tempering fluctuations in AD
• Discretionary Fiscal Policy: Government spending that the government
has an option on whether to spend or not
• During recessions governments may pursue expansionary discretionary
fiscal policy to stabilize aggregate demand and unemployment leading
to a rise in the cyclical deficit
• During booms governments may pursue contractionary discretionary
fiscal policy to stabilize aggregate demand and price levels leading to a
fall in the cyclical deficit
Demographic Factors
▪ Aging populace means lower GDP and higher elderly welfare payments and
spending on provision of goods and services for the elderly leading to rising
deficits
Fiscal Responsibility
▪ By choice or by force, certain countries have adopted much more conservative
fiscal budgets that aggressively reduce the fiscal deficits
Taxation policies
▪ The larger the size of the tax base the easier it is for a government to reduce the
deficit
▪ Improving the efficiency in tax collection as well as taking a stronger stance
against tax avoidance and evasion may also help reduce deficits
Economic Development
▪ Deficits may be caused by governments efforts to boost economic development
Price of Commodities
▪ Certain governments receive a significant portion of revenue from the sale and
export of commodities. Price falls can lead to deficits and price rises can lead to
surpluses
o
•
Debt Interest
▪ As the size of the national debt grows the interest paid will grow as well leading
to a widening deficit all else equals
▪ Another way debt interest affects the size of deficits is the rate of interest paid
on the national debt
▪ Higher/Lower interest rates leads to higher/lower interest payments and hence
the greater/lower the deficit
▪ The rate of interest paid depends on
• The market rate of interest for similar bonds
• The credit rating of the government assessed by credit rating agencies
▪ If the interest rate falls substantially, for whatever reason, it is possible that the
debt interest expense can fall despite the increase in national debt
o Unforeseen events
▪ When unforeseen natural disasters and crises occur governments may be forced
to respond by increasing government expenditures in the overall interest of
society
▪ Examples: providing aid and relief to those affected by floods and earthquakes;
nationalising banks during a severe financial crisis
▪ These expenditures lead to sudden increases in the fiscal deficit
Impact of Fiscal Deficits and National Debt
o Interest Rates and Debt Servicing
▪ A rise in fiscal deficit usually leads to an increase in the national debt which
generally leads to a rise in market interest rates as there is an increase in
demand for loanable funds
▪ The rise in interest rates could lead to crowding out of private borrowers
▪ However interest rates may not necessarily rise
• Government borrowing size is small
• Quantitative easing policies are able to increase the supply of money
and depress interest rates
• Governments can also borrow from foreigners while not affecting
domestic interest rates
• Private borrowing tends to be depressed during a recession and there is
excess supply of funds. There will not be crowding out in such a
situation but perhaps crowding in.
o Debt Servicing
▪ Rises in national debts are most likely to increase debt servicing payments
provided interest rates do not fall considerably
o Intergenerational Equity
▪ Fiscal Deficits and the national debt indicates that spending on goods and
services of the current and previous generation exceeded their means and
income.
▪
o
This represents transferring the costs of overconsumption of previous
generations to future generations
• National debt must then be paid off from income of future generations
through higher taxation, reducing their consumption of goods and
services
• Governments may also need to enforce fiscal austerity and reduce
spending in the future which may include reduced spending on thing
such as infrastructure, welfare, health, education
▪ However there is disagreement whether this actually occurs for several reasons:
• Positive inflation over time means that the real value of debt decreases
• If deficits and debt is used to finance long term investments that have
long term benefits, future generations will benefit as well
• Government bonds from national debt can be held as assets which
increases the wealth of future generations as well
Foreign Direct Investments
▪ Countries with large fiscal deficits will generally struggle to obtain foreign
currency to repay foreign loans
▪ Furthermore large fiscal deficits usually indicate an economy is going through a
recession of the trade cycle and will find it difficult to attract foreign direct
investments
17. Macroeconomic Policies
•
•
•
Macroeconomic Policies used by Governments
o Fiscal Policy: Use of taxation and government spending
o Monetary Policy: Changes to the money supply and interest rates
o Exchange Rate policy: Interventions in currency markets to manipulate exchange rates
o Direct Controls: Governments can use measures that directly affect the price or quantity
sold of a good or service in the market
▪ Price floors and price ceilings
▪ Minimum and maximum wages
▪ Tariffs and quotas on imports
▪ Capital controls on foreign exchange transactions
▪ Maximum interest rates for loans
▪ Maximum borrowing amount for mortgages
o Supply-Side Policies: Policies that aim to increase LRAS through raising the productive
capacity of the economy
▪ There is some overlap with other policies above
Government Objectives of this chapter
o Reducing Fiscal deficits and National debt
o Controlling the inflation rate
o Responding to external shocks
o Reducing poverty and inequality
Policies that aim to Reduce Fiscal Deficits and National Debts
o Growing fiscal deficits and national debts can have significant negative effects
▪ The difficulties of financing the debt will inevitably require cut backs in
government spending and increases in taxes that will hurt the standard of living
of the country
▪ Consequently for many debt strapped countries further financing from lenders
such as foreign governments, IMF, World Bank have required implementation of
austerity budgets
o Fiscal Austerity
▪ Cuts to public spending and/or increases in taxes
• In the immediate short term welfare of citizens is significantly
decreased especially those who are poor and disadvantaged, furthering
income inequality
• Cuts in spending in key areas such as education, health, and
infrastructure can decrease the long term growth potential of the
economy
• Austerity makes a recession more deep and more painful
• A dollar cut in spending/A dollar increase in taxes does not lead to a
dollar improvement in the deficit since cuts in spending will decrease
aggregate demand and overall income which leads to fall in tax
•
•
revenues. On the other hand, increases in tax also reduces aggregate
demand and leads to unemployment and increased welfare spending
• Some economists argue that the public sector is inherently inefficient
and shifts to private sector provision of those goods and services will
ultimately benefit consumers
• Alternatively the government could do nothing and allow automatic
stabilizers to do their job and the economy to eventually recover.
However this is very risky politically, depends on an actual recovery
materialising, and only works if the fiscal deficit is entirely cyclical
• Many struggling European economies had austerity imposed on them
by creditors such as the IMF, World Bank, European Central Bank, etc.
• Other economies that had greater control of their fiscal and monetary
policies were able to avoid austerity
o Use fiscal surplus to redeem government bonds and pay off outstanding national debt
o Balancing the budget while achieving economic growth can reduce the deficit as a
percentage of GDP
o Achieving inflation that reduces the real value of debt
o Quantitative Easing can be used to redeem government bonds outstanding in the
market and reduce the national debt held outside the government
o Governments can default at worst
Policies to Control Inflation
o Generally monetary policy is used to target a particular rate of inflation through
affecting interest rates
▪ Central banks can adjust its bank rate at which it lends to commercial banks
which then affects other interest rates throughout the economy
▪ If inflation is too high/low the central bank would raise/decrease interest rates
decrease/increase aggregate demand
▪ Interest rates also control inflation through the exchange rate mechanism. A
rise in interest rates leads to higher demand of domestic currency by foreigners
and an appreciation of the domestic currency. This leads to cheaper imports and
lower exports which reduces aggregate demand
▪ However, central banks should avoid controlling inflation that is caused by
supply side factors
▪ If interest rates are already at zero, and if inflation is too low then there is very
little scope for reducing interest rates any more
o Quantitative Easing can be used to reduce interest rates and encourage private lending
to achieve inflation
Policies to Respond to External Shocks in the Global Economy
o Supply shocks from changes in global commodity prices
▪ There will be a shift in SRAS and perhaps the LRAS as well depending on the
nature of the shock and the expected duration of its effects
▪
•
A negative supply side shock would lead to lower output, higher unemployment,
and higher price level
▪ The government could respond by using reflationary fiscal or monetary policy
and restore unemployment and output despite higher prices
▪ If the government is more concerned about inflation it may choose to use
deflationary fiscal or monetary policy to tame inflation and allow SRAS to
increase and restore equilibrium output. However this can come at a significant
cost of unemployment in the short run
o Demand Shocks
▪ A significant shock to aggregate demand can cause great disruption to the
economy in terms of inflation, output and unemployment
▪ The GFC of 07-08 was a very significant decrease in aggregate demand caused
by an overall collapse of the housing market which led to a significant decrease
in wealth as well as the complete breakdown of credit markets. The result was
rapidly falling prices, high unemployment and reduced GDP
▪ The government could use policies to reduce the fall in aggregate demand
• Monetary Policy
o Central Bank could cut base interest rates to increase demand
for credit financed consumption and investments
o Quantitative Easing policies could increase the money supply
and depending on the type of financial assets purchased could
lower more specific interest rates to encourage borrowing and
lending
o However some argue that QE has done little to increase lending
but rather it has only led to asset price inflation in financial
markets
o Furthermore low interest rates has hurt savers tremendously
• Fiscal Policy
o Governments could reduce taxes and increase its own
discretionary spending to soften the fall in AD
o However many governments were already running high fiscal
deficits and were unable or unwilling to use reflationary fiscal
policies
Policies to Reduce Poverty and Inequality
o Policies that increase economic growth
▪ Reflationary fiscal and monetary policies that increase GDP usually leads to a fall
in absolute poverty
▪ Supply side policies that deliver long term economic growth should also help in
reducing absolute poverty
o Fiscal policies that are targeted to those who are most in need will help reduce income
inequality
▪
▪
▪
o
o
o
Welfare payments for the poorest groups
Provision and subsidies of basic goods and services to the poorest
Progressive Tax System
• However it may also reduce economic growth by disincentivizing work
• It may also encourage high income earners to resort to tax avoidance
Direct Controls that aim to redistribute income
▪ Price ceilings for necessities may make these goods and services more
affordable for the poorest and reduce poverty
• However there may be excess demand as a result and black markets
may arise
▪ Minimum wage legislation can help improve the incomes of the poorest people
and prevent exploitation
• However there may be an excess supply of labour as a result
▪ Maximum wages can also reduce income inequality by capping wages of the
highest paid worker
• Some argue that this will lead to a loss of top level talent for firms
▪ Most effective if they don’t cause to much distortion in the market
Some economists argue that as long as there is economic growth, income inequality
should not be a concern and governments shouldn’t try and redistribute income. As the
wealthy become more wealthy, even the poorest will be better off because economic
growth trickles down to everyone in the economy. As long as everyone has become
wealthier it shouldn’t matter that some became more wealthy than others.
Others argue that by the law of diminishing marginal utility taking resources from the
wealthiest, who have low marginal utility, and redistributing them to the poorest, who
have high marginal utility, improves overall economic welfare and efficiency.
18. Impact and Problems of Macroeconomic Policies
•
•
Measures to control TNCs
o Even though TNCs provide significant economic benefits such as FDI in developing
countries, foreign exchange, technology transfer, etc. they also bring with them
negative effects such as
▪ Possible environmental damage
▪ Erosion of local cultures and identity by importing foreign cultures
▪ Exploitation of foreign labour
▪ Extract significant profits from the country leaving little benefits behind for the
local economy by using tax avoidance methods
o Governments can regulate Tax avoidance by negotiating fairer tax treaties with TNCs as
well as enacting more stringtent tax laws that prevent TNCs from using these loopholes
o Governments could also cooperate on more transparent reporting between countries to
prevent TNCs from abusing differences in tax systems across countries, but this require
significant cooperation
o Governments can also regulate transfer pricing practices that shift profits to
international subsidiaries in lower tax jurisdictions
o Governments could also hold TNCs accountable for illegal actions abroad such as bribing
government officials of a foreign country
o Governments could require firms to participate in joint ventures in order to operate in
the country which will make sure not all profits are extracted away by the TNC
o Governments could require a certain level of production from the TNC to be earmarked
for exports in order to help obtain foreign currency reserves
o Governments could also include clauses that require a certain percentage of local
content in the production of goods and services so that the TNC does not simply rely on
imported material and labour
o However the bargaining power between TNCs and governments are not always equal
especially developing nations leading to unfair deals for those countries
o Large governments also struggle at times to control TNCs especially regarding tax
avoidance
Impact of Policy Changes on Different Economies
o Local Regional Economies
▪ Some policies have a greater impact on certain regional economies in the
country than others.
▪ For example an infrastructure project in an area would bring the most direct
impact and benefits to the location of the project
o National Economies
▪ Some policies will have an impact on the entire country as a whole
▪ Examples include tax rate changes and interest rate changes
o Global Economies
▪
•
Some countries are so large and important in international markets such that
their policies have effects on other countries as well
▪ When a large importer imposes trade barriers or an exporter decreases world
supply
▪ When a large country changes its interest rates or enacts significant changes to
fiscal policies
▪ Even small country policy changes will have effects on other countries especially
its major trading partners
Problems Facing Policy Makers
o Inaccurate Information
▪ Often times macroeconomic variables are measured imprecisely and are
constantly revised over time which leads to difficulties in fine-tuning policies
▪ Sometimes, data is simply inaccessible and estimation is the only method, such
as estimating how much tax revenue is lost to tax evasion
▪ Relying on past data also does not always lead to accurate predictions of the
future
o Risks and Uncertainties
▪ Uncertainty about future events make estimation of policy impacts more
difficult especially how economic agents will respond to shocks in the economy
o External Shocks
▪ External shocks are shocks that cannot be controlled by governments such as
natural disasters and trade disputes between large nations
▪ In a globalised economy, countries are becoming more vulnerable to external
shocks.
19. Measures of Economic Development
•
•
•
•
Economic Growth: Simply the rate of change in national output or national income such as GDP
or GNI
o It is only a proxy for living standards of a country’s citizen and is not a completely
accurate nor representative measure
Economic Development: The change in the quality of life and wellbeing of the citizens of a
country
o Measured generally across three dimensions: health, education, income (material living
standards)
o Some measures of economic development also take income distribution into account
for overall degree of income inequality
o Economic Growth does not necessarily lead to Economic development or economic
development for most citizens
Classification of Countries
o By Income: Group countries based on level of income per capita using PPP exchange
rates (GDP/GNI per capita)
▪ High-income: US, Western Europe, Canada, Australia, NZ
▪ Middle-income: China, and most developing countries
▪ Low-income: Most African countries
o By Development: Group countries based on level of economic development using
measures of ED
▪ Developed, Developing, Less Developed
▪ More or less results in the same classifications as by income
o Emerging Countries
▪ Middle-income countries which could become high-income countries in the next
20 or 30 years. Also called Newly Industrialised Countries (NICs)
o BRIC countries
▪ Brazil, India, Russia, and China. Large countries that had very high growth
prospects in the beginning of the 2000’s
o Tiger Economies
▪ Asian economies that have experienced very high rates of growth in the last half
of the 20th century and have achieved relatively high level of economic
development: South Korea, Singapore, Hong Kong, and Taiwan
Characteristics of Developing Countries
o Low per capita incomes:
▪ Countries that do not enjoy a high standard of living tend to have relatively low
average incomes as measured by GDP/GNI per capita
o Physical Capital is scarce:
▪ Developing Countries tend to have lower quantities and lower quality of
physical capital such as infrastructure, machinery, equipment, etc.
▪
o
o
o
o
o
o
o
This also leads to lower levels of labour productivity as well as lower wages and
income as a result
Human Capital is also scarce:
▪ People in developing countries tend to have lower levels of educational
attainment such as average years of schooling, literacy rate, and as a result
labour tends to be less skilled compared to labour in developed nations.
▪ Furthermore, in developing nations there is a wider disparity in educational
attainment between the genders
Relatively low levels of health and high mortality
▪ People in developing countries tend to have poorer health and higher mortality
rates compared to developed countries
▪ This is usually due to a lack of hygiene education, access to health
infrastructure, and even nutrition
Relatively high rates of population growth
▪ Less developed nations tend to have lower population growth rates
▪ In less developed nations, children are a source of labour for mostly unskilled
work
▪ In developed nations, children are a significant cost to parents
High levels of unemployment and underemployment
▪ High population and low productivity leads to greater unemployment and
underemployment in less developed nations
Structure of the economy:
▪ Less developed nations tend to have a relatively larger agricultural and primary
sector and smaller secondary and tertiary sector
▪ Middle income nations have mostly replaced their agricultural sectors towards
secondary manufacturing sectors
▪ Developed nations are predominantly tertiary services sector
▪ Less developed nations also tend to have a relatively larger informal sector
Weak Institutions:
▪ Developed countries have competent governments, stable legal system and
developed financial markets (strong institutions)
▪ Less developed countries tend to have incompetent and corrupt governments,
weak legal systems that fail to sufficiently protect the rights of its citizens as well
as fragmented financial system
Environmental Damage:
▪ A large agricultural sector combined with low quality factors of production leads
to greater environmental damage during production in less developed nations
▪ Developed nations have access to more efficient production methods as well as
better quality factors of production which can minimize environmental damage
during production
▪ However developed nations also tend to have higher levels of consumption
which will also damage the environment
•
Measures of Economic Development
o Even though GDP/GNI is a very convenient measure to assess the level of development
it is imperfect and hence other measures are needed to give a better representation.
o Human Development Index
▪ A composite index based on three dimensions: health, education, and income
▪ Health: life expectancy at birth
▪ Education: Mean years of schooling of adults aged 25 years and over; Expected
years of schooling that current five-year-olds can expect to receive over their
lives
▪ Income: GNI per capita at PPP exchange rates
▪ Each dimension is given a score from 0 and 1, the closer to 1 the higher the
development attained
▪ The composite index is then the geometric mean of all three dimensions with
equal weighting
▪ Four overall development classifications: Very high (0.8+), High (0.7-0.79),
Medium (0.5-0.69), and Low (0-0.49)
▪ Advantages:
• It is a more accurate measure of economic development than GDP/GNI
per capita as the three dimensions of development are more directly
measured and incorporated in the calculation
• The use of the geometric mean implies that continued improvements in
any one dimension only results in diminishing improvements in
development
• HDI is fairly easy to calculate and provides a useful tool for policy
makers to assess the overall development of their country
▪ Limitations:
• Income distribution and inequality is not incorporated in its calculation
• The quality of education is not measured
• High life expectancy does not necessarily mean good health; developed
nations also have certain segments of the population that suffer from a
variety of illnesses and diseases.
• Other omitted factors: quality of housing, types of jobs, hours worked,
environmental damage
o Inequality Adjusted Human Development Index
▪ A modification of the HDI that also takes into account of inequality
▪ Each of the three measures in the original HDI is adjusted by the degree of
inequality using the Atkinson index which will reduce the development score
the greater the degree of inequality
▪ However IHDI also suffers from many of the same issues as HDI as it omits
certain aspects of development
o Other Measures of development:
▪
o
Percentage of Adult Male Labour In Agriculture
• Developing countries tend to have a high proportion of adult males
employed in low value primary sectors such as agriculture
• As an economy develops labour especially adult males will flow towards
secondary and tertiary sectors.
• This is also boosted by the tendency to urbanize as the country
industrializes and more labour will leave the rural areas.
• Also more capital intensive methods will be adopted in agriculture
decreasing the demand for labour
▪ Access to Clean Water
• As a country develops, a greater share of the population should have
access to clean water which leads to improved health, reduces poverty,
and indirectly towards better educational attainment for young people.
▪ Energy Consumption Per Capita
• As a country develops there tends to be an increase in energy
consumption per capita in both production and consumption.
• Production shifts to more energy intensive manufacturing and services,
and higher incomes and better infrastructure allows the populace to
afford more energy consumption.
▪ Access to Internet Per Thousand of the Population
• Having access to the internet helps connect individuals within a country
and those from another.
• It allows for greater access to information which can directly or
indirectly lead to better health, better education, and even higher
incomes
• More developed nations offer greater access to the internet to its
people than less developed nations
▪ Access to Mobile Phones Per Thousand of the Population
• Like the internet, access to mobile phones can enable people to enjoy
better living standards through improved access to information as well
as services.
▪ Access to Doctors Per Thousand of The Population
• Greater access to doctors generally leads to better health outcomes for
the population
• Less developed nations usually lack sufficient doctors and nurses.
• Better health can lead to better education as well as higher incomes
No one indicator will provide the best measure of development. A variety of sensible,
and easy to calculate measures should be considered together when measuring
development.
20. Constraints on Growth and Development
•
Factors that constrain growth and development for less developed and developing countries:
o Commodities
▪ Many developing countries are highly dependent on exports of commodities
▪ Dependency is measured by commodity export as a proportion of overall GDP
as well as the number of people employed in commodity production
▪ A high natural resource endowment logically should provide a comparative
advantage for the country and help lead to economic growth and development
▪ However this hasn’t materialised for most countries leading to the phenomenon
known as Natural Resource Curse
• Volatile Commodity Prices
o Commodities have price inelastic demand which leads to large
swings in prices during supply shocks, which then leads to large
changes in export revenues for the country
o The high level of risk discourages investment
o Prolonged period of stable prices may also lead to
overinvestment and overdependence in those sectors which
reinforces the high level of risk to the economy
• Overdependence in Primary Sector
o Primary commodities tend to be income inelastic as compared
to manufactured goods and services. As a result as world
income grows, the price of commodities will increase more
slowly than that of manufactured goods and services
o Prebisch-Singer Hypothesis: in the long run the prices of
commodities will fall compared to all other goods, and countries
dependent on commodity exports will see a worsening of their
terms of trade. Consequently those nations will be relatively
poorer than others that produce manufactured goods and
services.
o Countries that experience short term favourable prices should
make investments that help diversify their economy and reduce
dependence on commodity exports
o Dutch Disease: favourable prices and demand of commodity
exports leads to currency appreciation which leads to loss of
competitiveness and even collapse of other sectors
• Commodity Resources in the country may be in the hands of few
privileged elites who only seek to maximize their own rewards while the
rest of the population gain very little from the export of those
commodities.
o They may bribe government officials to reduce their taxes and
operating costs
o
o
o
They may also pay very little regard to environmental damage
as well as fair labour practices
Savings Gap, Foreign Currency Gap, Capital Flight
▪ Harrod-Domar Growth Model: The most important drivers of economic growth
are productivity investments as well as technological growth
▪ Investments in physical and human capital improve the overall productivity of
all factors of production and ultimately lead to increased output and economic
growth
▪ Adopting more advanced technology also improves productivity of the existing
factors of production and also lead to greater output and economic growth
▪ However sufficient levels of investment and obtaining technology requires
sufficient savings and foreign currency
▪ Savings are necessary for domestic investment otherwise there would be no
funds available. Developing countries tend to have low savings as most people
struggle to survive and consume most of their income.
▪ Worsening terms of trade with more developed nations also leads to insufficient
foreign currency reserves necessary for the import of better technology
▪ Thus there is a savings and foreign currency gap for most developing countries
and may need foreign aid to help fill both gaps
▪ However increasing investments and imports of more advanced technology
does not necessarily lead to economic growth if the investments are wasted on
unproductive uses and the technology imported is not suitable for the local
population and environment
▪ Furthermore, foreign aid can be expropriated through corrupt government
officials.
Demographic Factors
▪ Aging population reduces the quantity of labour from the economy and also
puts greater pressure on health services and welfare systems. This could lead to
a reduced standard of living from less access to quality health services as well as
lower disposable income from higher taxes needed to fund health services and
elderly benefits.
▪ High birth rates and a large population of young people are also problematic as
they could put greater pressure on education resources in the economy and
lead to a decrease in the quality of education which could then lead to a
significant unemployment and underemployment problem when they enter the
labour force. Also having more children increases the financial burden of
families decreasing the availability of savings in the economy
▪ High unemployment and underemployment may encourage young people to
migrate to more developed nations to seek work. While most of these migrants
do send remittances back to their home country and in the process obtain
foreign currency reserves for their home country it is not a viable long term
solution as they tend to work in low skilled jobs which do not earn a significant
amount and furthermore it leads to a significant decrease in the local labour
force as well as a loss of talent leading to a possible ‘brain drain’ should they not
return
o
o
o
o
Debt
▪
In the later half of the twentieth century, many developing countries obtained
foreign currency loans to fill in their savings and foreign currency gaps for
investments and imports of technology and capital
▪ However many of these loans turned bad as the countries squandered the
obtained funds or the investments did not become profitable
▪ Some of these developing countries defaulted on those foreign currency loans
which led to a severe aftershock for other developing countries as they saw
their interest rates increase due to fears of default.
▪ The result was disastrous as it led to high loan servicing costs that actually led to
outflows of foreign currency and significant devaluations to local currency and
high inflation
▪ Private household debt can also become a problem if it becomes to great such
that households need to reduce their consumption to service the debt. This can
lead to reduced economic growth in the long-run
Access to Credit and Banking
▪ Developed nations tend to have more robust and well integrated financial
markets compared to developing nations.
▪ Households and firms in developing nations tend to have poor access to finance
and as a result are unable to make necessary investments to improve
productivity or put their savings to more productive uses.
▪ Often times individuals requiring finance will need to obtain it from informal
loan sharks who charge interest rates that are very high.
▪ The lack of access to banking and finance can put a strain on economic growth
and development
Infrastructure
▪ Having sufficient high quality infrastructure can lead to improvements in
productivity, efficiency as well as overall development
▪ Infrastructure such as roads, canals, bridges, and power networks can lead to
decreases in costs for firms and improved productivity
▪ Infrastructure such as railway systems, better schools, better sanitation
facilities, can also lead to increases in income as well as improved health and
education
▪ Developing countries generally lack infrastructure for economic growth and lack
the funds to finance it due to low incomes and low tax revenues.
Lack of Education and Skills
▪ Access to education has improved in developing countries however there can
still be improvements to the quality of education accessed.
▪
o
Developing countries may lack the resources to improve the quality of
education
Non-Economic Factors
▪ Corruption
• Governments that have a reputation for behaving dishonestly and
fraudulently discourages both domestic and foreign investment
• Corrupt governments can also lead to tax evasion further depleting the
governments resources for promoting economic development
▪ Poor Governance
• Incompetent governments, too much bureaucracy and regulation like
corruption fail to give confidence necessary for investments
▪ Civil Wars
• Civil Wars destroy the physical and human capital of a country and
discourages investment leading to low possibility of economic
development and growth
▪ Migration
• Migration leads to a loss of labour and human capital for a developing
country but could also be a source of foreign exchange
▪ Terrorism
• Like Civil War, terrorism can stifle economic development
▪ Diseases
• Countries severely affected by diseases struggle to grow
▪ Geographical Location
• Landlocked countries without access to ports may find it difficult to
export their goods and services to foreign countries
▪ Gender Inequality
• The lack of schooling for girls compared to boys has significant impact
for development
• It can affect the mortality rates from childbirth, the birth rate of the
country, as well as the educational attainment of children
• All of which are improved if girls are offered equal access to education
as boys
21. Measures to Promote Growth and Development
•
•
There are two general strategies for governments to help achieve economic development
o Market Oriented Strategies: Policies that rely on free market
o Interventionist Strategies: Policies that require the government to play a major role in
the allocation of resources
Market Oriented Strategies
o Trade Liberalisation
▪ Remove or reduce trade barriers between countries
▪ Removal of barriers may encourage export-led growth of incomes
▪ Removal of barriers also introduces foreign competition for domestic producers,
forcing them to become more efficient
▪ Furthermore, it encourages specialisation amongst countries according to
comparative advantages leading to a more efficient allocation of resources in
the global economy
▪ Trade liberalisation may also give developing countries an opportunity to import
technology as well as capital equipment. Combined with lower wages, obtaining
these technologies and equipment could result in comparative advantages for
the developing nations to encourage export growth
▪ However, trade liberalisation does not guarantee all countries will gain and the
transition will most likely not be smooth as industries have to reorganize and
workers around the world may be displaced
▪ Industries that relocate to cheaper developing economies has caused a lot of
structural unemployment in developed economies
o Promotion of Foreign Direct Investment
▪ FDI provides countries with much-needed investments as well as foreign
currency reserves, filling savings and foreign currency gaps for a country
▪ It also provides a transfer of knowledge and technology that improves the
physical and human capital of a developing country
▪ As a result, FDI can lead to significant increases in productivity which would lead
to economic growth as well as development
▪ Most important factors for attracting FDI are business friendly regulations and
political stability, good infrastructure, and low tax rates
▪ However using low taxes to encourage FDI can be problematic as it may lead to
loss of tax revenues for government that may be spent on other dimensions of
development
o Removal of Government Subsidies
▪ Many developing countries provide subsidies for essential items such as food or
fuel that low income households need to purchase. These subsidies are
attempts to reduce poverty as well as to gather political support
▪
o
o
o
Other subsidies target goods and services to encourage output, exports, and
investments. These subsidies attempt to achieve economic growth as well as
employment in certain industries
▪ However, there are problems with subsidies
• They can be poorly targeted and benefit both rich and poor households
• Cash payments for the poor households may be a better alternative
then subsidies
• Subsidies may be supporting inefficient producers
• Subsidies are expensive and consume resources from the fiscal budget
that could be better spent elsewhere for economic development
• Subsidies are also a source of corruption between government officials
and firms
▪ Price inelastic demand of subsidized goods leads to large increases in prices
when subsidies are removed. The best time for subsidies to be removed is when
the market price is falling at the same time due to other supply and demand
circumstances
Privatisation of nationalised industries
▪ Free market economists believe that state owned enterprises tend to be
inefficient due to protection from competition and support from the state.
▪ Privatising these firms and industries will expose them to competition and force
them to become more efficient which should benefit society overall
▪ Running state owned enterprises also have a significant cost on the fiscal budget
which takes away resources from other alternatives that could boost
development
▪ However if privatisation leads to a private monopoly inefficiencies may persist
▪ Furthermore the privatisation process is also an opportunity for corruption such
as selling off those firms to family and friends.
Floating Exchange Rates
▪ If a governments pursue a floating exchange rate policy, they will no longer
intervene in foreign currency markets to manipulate exchange rates and will no
longer hold reserves.
▪ This allows the currency to depreciate through free market forces which should
improve the competitiveness of its exports
▪ However it can lead to volatile exchange rates which increases the risk of export
and import industries earnings
▪ The effect of volatile exchange rates extends to volatile output, economic
growth, unemployment as well as inflation
Developing a Financial Sector
▪ People in poor countries tend to have very little access to financing because
most banks find it unprofitable to operate in those countries
▪
•
The underdeveloped financial sector is a hindrance to growth as it stifles
investment
▪ Even when there is access, the financial costs (interests, collateral) tend to be
very high for lenders which discourages investment
▪ Microfinance Schemes are a partial solution
• Schemes started by NGOs where loans of small amounts are provided to
people (especially women) in developing countries and the interest
rates are lower than from traditional banks or informal loan sharks
▪ However microfinance loans are of very insignificant amounts to have
meaningful impact on economic growth and people may still struggle to repay
these loans because they were impoverished to begin with.
▪ Digital banking is another possible solution to provide greater access to
financing for individuals since it significantly reduces the costs for the bank by
eliminating the need to set up a physical branch
Interventionist Strategies
o Development of Human Capital
▪ Improvements in human capital leads to greater productivity of labour and
greater innovation which in the long run increases the competitiveness and
productivity of the economy leading to economic growth as well as
development
▪ The most direct way to improve human capital is for governments to invest
heavily in the education of its citizen and young people through provision of
schools, training of teachers, making education more accessible and affordable,
etc.
▪ The type of education to invest in should also be considered. For developing
economies, primary education and secondary education should be encouraged
first so that the overall level of human capital is increased. Investments in
advanced level or tertiary education may be inefficient as they only benefit the
talented few and may result in over-education as jobs that require those skills
simply do not even exist in the market.
▪ The quality of education should also be considered and not simply just the
quantity
o Protectionism
▪ Import Substitution: Policy that attempts to promote economic growth through
replacing imports with domestically produced goods and services by adopting
trade barriers against the imports as well as supporting domestic producers.
▪ The reduction of reliance of imports and increase in investments can lead to an
increase in aggregate demand leading to economic growth while also bolstering
the balance of payments as well as foreign exchange reserves
▪ Developing countries may try to adopt this strategy to diversify away from
primary sector and move up the value chain towards manufacturing and
services sector
▪
o
o
This could be used to support infant industries that may be competitive in the
long run
▪ In the short run it could create more jobs for the country and improve its
current account
▪ In the long run however if the protection and investment is given to the wrong
industries there will be a loss of all efficiencies in the long run
▪ Overall the strategy hasn’t always been successful
Managed Exchange Rates
▪ Governments can intervene actively in foreign exchange markets to manage the
exchange rate of its currency to promote economic growth and development
▪ High exchange rates can reduce the cost of imports for both consumption and
capital goods which could improve the current living standards as well as the
productivity of the economy
▪ Low exchange rates can be used to increase price competitiveness in foreign
markets and promote export led growth.
▪ Alternatively the government may also consider using different exchange rates
for imports and exports.
• High import exchange rate can reduce the costs of imports for
consumers and firms
• Low exchange rates for exports can increase export competitiveness
• For this to work the central bank must enforce strict capital controls
which may be very difficult
• Black markets of goods and services as well as foreign exchange may
emerge undermining the policy
▪ Fixing exchange rates may also be not practical as it requires responding to
currency speculation in markets that can be very costly both in terms of foreign
currency reserves as well as even in output, and unemployment
▪ Furthermore, identifying the ideal exchange rate may be difficult
▪ Finally, there is opportunity for corruption of government officials who can
profit from the fixed exchange rate arrangements
Infrastructure Development
▪ Infrastructure not only represents increased demand for goods and services but
also increased overall productivity of economy, leading to economic growth in
both short run and long run
▪ Governments can actively increase spending in infrastructure such as roads,
bridges, railways, ports, schools, etc.
▪ However this approach may not be feasible for governments that lack the
financial resources or the expertise
▪ Alternatives may be to allow private sector companies to finance and run the
infrastructure projects or use public private partnerships
▪
o
o
However, private companies will only be interested in these projects only if it is
profitable
▪ Private companies may be more efficient than governments when it comes to
producing these infrastructure goods
▪ There is a risk that these infrastructure goods are poorly built and poorly chosen
as well as the risk of corruption of government officials who benefit more than
the economy as a whole from these investments
Promote Joint Ventures with TNC’s
▪ Although FDI theoretically can bring lots of benefits, there is always a risk that
the TNCs involved will try to exploit the weaker developing nations and try to
extract as much benefits from the projects and leaving very little for the
developing nation
▪ One way to avoid this problem is to require TNCs to partner with local firms in a
joint venture so as to ensure a reasonable portion of the profits from the
investment remain in the local economy
▪ Part of the agreement may also include the transfer of knowledge and
technology to the local firm as well
Buffer Stock Schemes
▪ The inelastic demand of commodities exposes those industries in developing
nations to the risk of volatile prices and export revenues
▪ Buffer Stock scheme is a mechanism operated by a group of exporting countries
that try to stabilise the world price of those commodities
▪ It can also be operated within a country that is able to strictly control exports
and imports
▪ Specifics of the mechanism:
• There is a maximum and minimum price that the government(s) would
allow the commodity to trade within
• If the price is too low, the governments step in to buy in excess supply,
building a buffer stock, to increase demand and ensure the price
remains within the band
• If the price is too high, the governments would sell part of its buffer
stock (excess demand), to increase supply and lower the price to within
the band
• In order for the scheme to work, stocks must rise and fall over time. If
stocks only rise, the scheme may become to costly to continue, if stocks
only fall, eventually there would be no stocks left.
• Operation can be described using a supply and demand diagram
▪ Advantages of Buffer Stock scheme
• By stabilising prices, it reduces the volatility risk of commodity export
industries and encourages longer term investments
•
•
It also helps reduce poverty of commodity producers most of whom are
low income households
• Consumers will also benefit from less price volatility
▪ Problems of Buffer Stock scheme
• Operation of scheme is very costly in many ways from the purchase of
stocks, administration, all the way to storage and transportation costs
• Scheme may not be feasible if the commodity deteriorates quickly
• They can be difficult to coordinate as inevitably there are producers
which would like to free-ride the benefits of the scheme without
contributing to it
• Minimum prices are generally set to high in the scheme leading to
buildup of stocks and eventually the collapse of the scheme when stocks
are sold off at depressed prices
• In the short term there may be gains for producers but when the
scheme collapses there may be long term losses
• If the scheme is funded by the government then other alternative uses
of the money must be foregone
• The eventual sell-off may depress world prices that it affects producers
in other countries as well leading to greater poverty around the world
Other Strategies
o Industrialisation
▪ Expansion of manufacturing sector and contraction of agriculture
▪ Most developed countries have gone through a process of industrialisation and
thus it could be argued that industrialisation is a cause of economic growth and
development
▪ Lewis Structural Dual Sector Model
• The migration of labour from low productivity sector rural agriculture to
higher productivity sectors in urban manufacturing and services is the
key to economic growth and development
• Marginal workers in rural agriculture have very little marginal output
and productivity and should be transferred to higher productivity
manufacturing in urban areas
• The rate of transfer of labour depends on the rate of capital
accumulation in the higher productivity sector (i.e the rate of
investment)
• If investment rate in higher productivity urban sectors is high then the
rate of transfer would be higher as well
• Theory suggests that the government should promote industrialisation
by promoting urban industries and helping labour transfer from rural to
urban industries
•
o
o
o
Forced industrialisation may end up wasting scarce resources if the
investments were poorly done and poorly chosen
• Marginal workers in urban areas are sometimes also unproductive and
leading to low incomes as well
▪ Some would argue that industrialisation is a result of economic development
rather than a cause
▪ Higher incomes in urban areas attract labour to migrate but large scale
migration could also cause urban poverty
Development of Tourism
▪ Tourism is an export of services and is generally quite income elastic
▪ As world GDP and incomes grow, demand for tourism will increase significantly
as well
▪ It is a labour intensive industry that also does not require significant
investments in human capital and special skills and is an easy way to increase
employment in a country and reduce poverty as well
▪ Promotion of tourism could improve the current account balance of a country as
well as building up foreign exchange reserves that can fill the foreign currency
gap for imports
▪ Tourism spending can have a local multiplier effect that brings about economic
growth.
▪ However, dependence on tourism may lead to the country being more
vulnerable to external shocks
▪ Tourism can also lead to environmental damage in the country
Development of Primary Industries
▪ Most developing nations have a comparative advantage in the production of
primary commodities
▪ However long-term reliance on these industries are unlikely to lead them to
economic growth and development due to volatile prices and low income
elasticity
▪ Governments should take advantage of export revenues and use them to help
diversify the economy and reduce dependence on the primary commodities
▪ Governments should also avoid the Dutch disease whereby a high exchange rate
caused by high demand for commodity exports affects the competitiveness of
non-commodity exports and industries
▪ Furthermore, primary industries are a source of corruption by government
officials as well as labour exploitation
Debt Relief
▪ In the 1970’s and 1980’s many developing countries took out foreign currency
loans that they struggled to repay later on resulting in poor economic growth.
Many of the lenders responded by forcing austerity measures on the borrowing
countries which further depressed growth and development
▪
o
To the extent that repayment of these loans is not feasible, debt forgiveness
may need to be considered in order to restore economic growth
▪ Debt Relief or Forgiveness may be desirable because:
• The overall size of the loans is not too large for the lending countries
• Debt forgiveness can relax the austerity policies forced on the countries
and reduce absolute poverty by freeing up resources for the
government
• Debt forgiveness also helps reduce the foreign currency gap of the
country and allow it to use its reserves more productively than repaying
loans
• When interest payments become larger than the original loaned
principal it becomes unfair for the poor countries to continue servicing
the debt
• It is also unfair to ask the current generation of taxpayers to pay for the
policy mistakes of previous generations
▪ However, Debt relief can also be undesirable
• It can lead to moral hazard where borrowing countries do not need to
bear the consequences of failure to repay loans and encourage
irresponsible borrowing and policy making
Foreign Aid
▪ Aid in the form of money or goods and services provided by one or more
countries to another
▪ Many types of foreign aid:
• Grants: aid that is not expected to be repaid by the donor country;
usually given during natural disasters
• Loans: Aid that is expected to be repaid with interest; it may be at
commercial interest rates in the market or it could be at lower rates
• Tied Aid: Aid that have conditions attached such as the intended use of
the money, the content requirements of a project, and the policies that
a government must enact
• Bilateral Aid: Aid that is given by one country and received by another
• Multilateral Aid: Aid that is given by an international agency or a group
od countries and received by one country
▪ Benefits of Foreign Aid
• Foreign aid can help reduce absolute poverty in the short term
• Foreign aid can help fill savings and foreign exchange gaps of a country
to help spur investments and imports of foreign capital
▪ Problems of Foreign Aid
• Aid received may be misused by governments and benefit only a narrow
group of interests in the economy
•
•
Corrupted government officials may take the aid received to enrich
themselves
• Tied aid may have conditions attached that are not necessarily in the
best interests of the recipient
• Loan interest may be very costly for the country
• Aid may promote a culture of dependency and fail to develop the
country
International Financial Institutions
o International Monetary Fund (IMF)
▪ An institution set up after the World War 2 to promote international monetary
cooperation, exchange rate stability as well as financial assistance to countries
with balance of payments problems.
▪ When financial assistance is provided to countries, the IMF may also insist that a
country implement macroeconomic reforms as well such as fiscal austerity
▪ The IMF also provides economic forecasts, analysis, and advice to countries
o World Bank
▪ An institution set up to help promote economic development in poor and
middle income countries
▪ They mainly provide low-interest loans and grants to developing countries for
education, health, infrastructure purposes
▪ Some argue that the World Bank promotes Western Imperialism by encouraging
poor choices of investments
o Non-Governmental Organisations
▪ Non-profit organisations that are separate from governments and other
commercial entities.
▪ They provide direct assistance to developing countries in the form of project
work
▪ They can also be pressure groups that encourage governments to adopt policies
that promote economic development
▪ They are rather small and their impact tends to be rather insignificant