Exam Revision (ECONOMICS)
Hello, this is my study guide. It's not complete, but it's got a large portion of IB econ
in here.
Economics Syllabus: http://ibeconomist.com/wp-content/uploads/2015/08/IBEconomics-Syllabus.pdf
(EXTREMELY USEFUL LIKE SO HELPFUL LIKE SHEEEESH)
Topic: Basics Ideas and Themes
Course: Economics
Foundations of Economics: Scarcity, Choice and Opportunity Cost (Trade Offs),
Central Themes
Main Ideas
Interdependence
Efficiency
Change
Intervention
Sustainability
Equity/Equality
Scarcity: the economic problem where one has limited means of resrouces to satisfy
accomplish unlimited desires.
OPporunity Cost: The value of the next best alternative forgone
Choice and Opportunity Cost: PPC (production possibility curve) edge shows that
one cannot create more of a good without making less of another
Central Themes:
The extent of GOVERNMENT INTERVENTION in resource allocation.
The THREAT TO SUSTAINABILITY due to current resource allocation trends
The extent to which the goal of ECONOMIC EFFICIENCY may conflict with the
goal of EQUITY
The distinction between ECONOMIC GROWTH and ECONOMIC DEVELOPMENT
Topic: Microeconomics
Course: Economics
Use Real World Examples for stuff like theoretical, however can use Realistic
Examples for theoretical (e.g. demand)
UNIT 1.1
Competitive Markets: Demand and Supply
Demand Definition: The quantity of a good or service that consumers are willing
and able to buy at a given piece during a specific time period.
Law of Demand: As price of a good increases, the quantity demanded of the good
decreases, vice versa, ceteris paribus.
Determinants of Demand: Price vs Non-Price (Income, substitutes,
complements,tastes and preferences, future expectations of future prices or future
incomes)
Supply Definition: The quantity of a good or service that producers are willing and
able to offer to consumers at a given price during a speciifc time period
Law of Supply: As price of a good increases the quantity demanded of the good
increases, vice versa, ceteris paribus.
Determinants of Supply: Price vs Non-Price (Cost of Production, substitutes,
complements, government intervention, supply shock)
HL - Demand and Supply Functions:
QD = a-b*P
QS = c+d*P
UNIT 1.1
Market Equilibrium + Efficiency
Equilibrium Definition: A situation that occurs at the price where quantity
demanded equals the quantity supplied.
HL - Finding Market Equilibrium: Find price by setting QD=QS, then use P in
equations to find QD and QS.
Price Mechanism, and role of price in resource allocation: Price has signalling
and incentive functions, and the price mechanism is the organizing principle around
which resources are allocated in the free market.
rise in price signals to producers and consumers that there is a shortage,
incentivizing producers to produce more due to the potential for higher profit
at greater quantities, and disincentives consumers to keep consuming at the
same quantity due to the rise in costs making the good more expensive.
Marginal Benefit Definition: The additional utility or satisfaction derived by an
increase or a decreased in the amount of an item consumed or an activity enjoyed.
Marginal Cost Definition:
Consumer Surplus Definition: The benefit consumers receive when they pay a
price below what they are willing to pay for.
Producer Surplus Definition: The benefit producers receive when they receive a
price above the one at which they were willing to supply the good
Pareto Efficiency Definition: A situation where one is operating at the edge of the
PPF such that no economic changes can make one individual better off without
making at least one other individual worse off.
Allocative Efficiency Definition:
A situation that is achieved when society produces enough of a good such that
community surplus is maximized.
OR a situation that is achieved when society produces enough of a good such
that marginal cost equals marginal benefit.
UNIT 1.2
Elasticities: PED, XED, YED, PES + Applications
PED Definition: A measure of the responsiveness of the quantity demanded of a
particular good to a change in its own price.
FORMULA (similar idea for other elasticities): PED = % change in QD / % change
in P
PED situations:
For normal demand curves, the PED varies as we move across the quantity
demanded
Elastic (PED>1) to Unitary (PED=1) to Inelastic (1>PED>0)
However, it is possible to have curves where PED constantly =0,1,infinity
PED=0 means no change in QD as price changes, hence graph is vertical line
PED=infinity means a big QD change when price change is infinitesimal, hence
graph is a horizontal line
Important Clarifications:
*PED is not the slope, but slope = PED * QD/P
*The terms elastic or inelastic should be used to refer to a portion of a demand
curve, or a price/quantity range within the demand curve.
*Graphs that are shallower are more elastic at any given price, and steeper graphs
are more inelastic at any given price.
Determinants of PED: number and closeness of substitutes, level of necessity, time
period, proportion of income spent.
Applications: Revenue maximization to get PED=1 (however greater revenue =/>
greater profit)
PED of primary commodity VS manufactured goods:
Primary Commodities: An output of the primary sector that is most often used as
an input in the production of other goods and services
Manufactured good: a Good that is produced with primary or intermediate goods
Primary commodities inelastic, manufactured goods more elastic. Since supply of
commodities is unstable, can cause large price fluctuations, thus with low PED, total
revenue increase when supply falls, and revenue increases when supply increases.
XED Definition: A measure of the responsiveness of consumers of one good to a
change in the price of a related good.
XED Situations: Substitutes (XED>0), Complements (XED<0), Unrelated (XED=0)
Applications: Greater XED magnitude leads to greater demand shifts, knowing XED
allows firms to judge how demand will change for their good or another good.
YED Definition: A measure of the responsiveness of the quantity demanded of a
particular good to a change in consumers' incomes.
YED Situations: Normal Good (YED>0), Inferior Good (YED<0). Furthermore both
types of goods can then be split again into income elastic or income inelastic goods.
Applications:
e.g. during a slowing economy, Inferior good producers will use YED to
determine the extent of the increase in sales, whereas Normal or superior good
producers will use YED to determine the extent of fall in sales.
Also YED can be used to find how the primary, secondary and tertiary sector
are affected as countries develop
PES Definition: a measure of how much the quantity supplied of a good changes in
response to a change in the price of that good.
FORMULA: PES = % change in QS / % change in P
Determinants: Time Period, Mobility of Factors of Production, Amount of Spare
Capacity, Ability to Store Stock
Applications:
Commodities have inelastic PES, which also contributes towards price and
revenue instability.
Knowing PES and PED also allows for government to know tax incidence
Knowing PES allows for govt to know effectiveness of subsidy
UNIT 1.3
Government Intervention: Indirect Taxes, Subsidies, Max and
Minimum Price
Direct Taxes: A charge on a proportion of ones income which is payed to the
government.
Indirect Taxes: A charge placed by the government on a good or service that is
passed onto the consumer in the form of a higher price.
Taxes can be specific tax, or ad valorem tax (GST)
Carbon Tax: an indirect tax which targets goods with negative externality of
production
HL - Tax Incidence on Consumers and Producers: The way the tax is split on
consumers and producers depends on PED vs PES.
1. When PED is similar to PES, then the tax is split fairly similarly,
2. when PED > PES then the tax is incurred mostly by consumers,
3. When PED < PES then the tax is taken mostly by the producers
Tax Diagram:
Total Tax Revenue: a+b+e+f
Consumer Tax Burden: a+b
Producer Tax Burden: e+f
Loss in Consumer Surplus: a+b+c
Loss in Producer Surplus: d+e+f
Welfare Loss: c+d
Subsidy: A government payment to producers attempting to encourage production
by covering a part of the cost of productions.
*Government provision is same graph and stuff as subsidy
HL - Similar Idea of Subsidy Incidence (not in the textbook): Yeah just think
about it.
Subsidy Diagram:
Total Cost of Subsidy: b+c+d+e+f+g+h
Previous Spending: e+f+i+j+l
Consumer Spending after Tax: i+j+k+l+m
Increase in Consumer Surplus: e+f+g
Increase in Producer Surplus:
Maximum Price Definition: When the government legally sets the maximum price
producers can sell at, below the equilibrium price, in order to prevent producers to
sell their product above it.
Minimum Price Definition: When the government legally sets the minimum price
producers can sell at, above the equilibrium price,
This is if the government doesnt buy the surplus
*minimum wage is a minimum price in the labour market
Tradable Permits: a maximum amount of some type of pollutant that can be
produced by a firm
UNIT 1.4
Market Failure: Externalities, Merit and Public Goods, Common
access Resources, Asymmetric information
Definition of Market Failure: When the market fails to naturally achieve a socially
optimal equilibrium quantity where MSB=MSC through the price mechanism, due to
the presence of an external condition which prevents the condition of
MPB=MSB=MPC=MSC from being met.
MPC Definition: The extra cost for firms to produce one more unit of a good.
MSC Definition: The extra cost for society when one more unit of a good is
produced.
MPB Definition: The extra benefit to consumers of consuming one more unit of a
good.
MSB Definition: The extra benefit to society when one more unit of a good is
consumed.
Positive Externalities Definition: When the production/consumption of a
good/service has beneficial effect on a third party.
Merit Goods Definition: Goods that are considered beneficial for society as they
produce positive externalities when consumed, and are usually under-provided in a
free market.
Negative Externalities Definition: When the production/consumption of a
good/service has a harmful effect on a third party.
Demerit Goods Definition: Goods that are considered harmful to society as they
produce negative externalities when consumed, and are usually over-provided in a
free market.
Welfare loss / deadweight loss: benefits lost by society because of resource
misallocation.
Types of Goods (4 types):
Rivalrous
Non-Rivalrous
Excludable
Private Resource
Quasi-public goods
Non-Excludable
Common Access
Resource
Public Goods
Rivalrous: One person's use makes less of it available for others
Excludable: People can be excluded from using it by charging a price
Public Goods Definition: Goods that are both non-rivalrous and non-excludable,
which would not be produced by private firms in a free market as no individual
would pay for them due to the free rider problem.
free rider problem: someone has to produce the good, however nobody will
because it is impossible for the producer to charge a price for using a good
*All Public Goods are merit goods, however not all merit goods are public goods.
Private Goods Definition: Goods that are both rivalrous and excludable.
Common Access Resources: Goods that are rivalrous, but non-excludable.
Tragedy of the Commons: As the nature of CARs means there is an inability
to charge for them, there will naturally be an overuse/consumption. Can be
thought of as a negative externality of consumption to future generations.
Additional Forms of Market Failure:
HL: Asymmetric Information, Monopoly Power
Asymmetric information: a type of market failure occuring when one party to a
transaction has more infromation than the other party leading to allocative
inefficiency.
Topic: Microeconomics (HL)
Course: Economics
UNIT 1.5
Costs, Revenues and Profit
Short Run: when at least one factor of production is fixed in amount and cost,
usually capital
it is not any psecific period of time, may be a few months or a few years, firms
always operate in the short run
Long Run: when all factors of production are variable.
Firms plan for the long run even though they operate in the short run
Total Product: the total production of a firm
Average Product: the average production of a worker in a form
Marginal Product: the additional production that is added onto the total by each
additional employee
Production in the short run experiences the law of diminishing returns:
when additional variable factors are added to a fixed factor to increase output,
there will be a point where the marginal output for each additional unit of
variable input begins to decrease.
In the short run, firms experience: increasing returns, diminishing returns, negative
returns
Costs - Marginal Cost, Average Cost, Total Cost
accounting costs / explicit costs: cost of land labour and capital
Implicit cost: opportunity cost that is invovled in the production process
Economic Costs: the sum of implicit costs and explcit costs
Fixed Costs: costs that do not vary with output
Variable Costs: Costs that vary with output
Total cost: the sum of fixed and variable costs
Average Total Cost: total cost per unit of output
Average Variable Costs
Average Fixed Costs
Marginal Cost: Additional cost of production an extra unit of output
MC hits AVC and ATC at their lowest points
In the long run, all FoP's are variable, so firms can increase all their inputs in the long
run, shifting SRATC to the right, at first:
right and down (increasing returns to scale -> economies of scale)
right and horiztonal (constant returns to scale)
right and up (decreasing returns to scale/diseconomies of scale)
this pattern traced out by SRATC forms the LRATC: a cost curve showing the
relationship between average cost of a firm and the quantity of output it produces
as varies all its inputs.
Economies of scale: when increases in the size of a firm leads to falling average
costs
Specialization of labour or management
Technical economies of scale
bulk-buying bargaining power
Financial economies (easier to get financed by banks)
Diseconomies of scale: when increases in the size of a firm leads to rising average
costs (when firms become too large)
problems in management due to poor coordination
communication problems
morale and motivation problems
Total Revenue: Amount earnt by selling output of Q units at price P
Average Revenue: Revenue earnt per unit of output
Marginal Revenue: Extra Revenue earnt by selling an additional unit of output
Price = AR = MR = D (PC)
Price = AR = D (M, MC, O)
Economic Profit: total revenue minus total economic costs
Abnormal profit: when economic profit is positive
Normal profit: when economic profit is equal to zero (just enough for a firm to
keep it in business)
Economic Loss: when economist costs are greater than total revenue
Goals of Firms: Profit Max, Growth Max, Revenue Max, Profit Satisficing
Profit Maximization occurs when MR=MC or when TR-TC is at a maximum.
when Q too small, MR>MC
when Q too big, MC>MR
When Q is right, MC=MR, cannot increase profit anymore.
Growth Maximization: goal of growing firm size to achieve economies of scale or
greater market power
focus on increasing Q, at the expense of lower profits, but LR goal is still to
profit max
Revenue Maximization: aims to produce at Q where MR=0
impression of success by selling a lot
can be used by executives at board meetings to get promotion
Profit Satisficing: When a firm sacrifices the goal of maximizing profit to satisfy
different stakeholders
environmental NGO's
shareholders
consumers
government
UNIT 1.5
Perfect Competition
Assumptions:
infinite number of small firms selling homogeneous products
no barriers of entry or exit
perfect information
Model: Firms have no market power, are price takers determined by D and S, and
will see all the output it wants at that P.
Profit Maximization SR/LR
Firms will try to maximize profit or minimize loss in the short run, Always produce at
Q where MR=MC.
P is what changes (determined by D and S), cost curves stay the same.
Break even price: the price at which the firms just makes normal profit
Shut-down price: the price at which the firms AVC = P
if it shuts down, then its losses will just equal its fixed costs
if it can produce at Q while making losses less than fixed costs, then should
continue
if it produces at Q while making more losses than fixed costs, it should shut
down
In the long run all firms in perfect competition earn no economic profit, as the
market establishes a new equilibrium at which there is no economic profit.
Benefits:
Allocative and Productive Efficiencies
Low prices for consumers
Consumers decide what and how much will be produced
Disadvantages:
No R&D for innovation, stays same
no product variety
unrealistic
UNIT 1.5
Monopoly
Assumptions:
single firm which dominates the entire market
no close substitutes
high barriers of entry (economies of scale, legal barriers, aggressive tactics,
brnading)
imperfect information (specialized information about production technqieus
unavailable to potential rpdocuers)
Model: Firms are price makers, however cannot control both Q and P, so they can
dictate price by controlling Quantity they produce.
Profit maximization/Loss Minimization: Firms will maximize profit and minimize
losses at MC=MR.
Revenue Maximization: Alterntaiavely, if firms intend to maxmize revenue, they will
produce at MR=0.
Sales maximization: Flood the market to develop customer loyalty before charging
higher prices AC=AR
Firms can obtain abnormal profits in both the SR and LR, due to the high barriers oe
entry, if however they are making a loss, must get government help if they want to
continue.
Natural Monopolies: A monopoly with high fixed costs but low variable costs, such
that if it utilizes economies of scale it can satisfy the demand of an entire market.
having multiple firms producing at the same level of output would do so at a
higher average cost, so not in the interest of society to do that. (i.e. water,
electricity and natural gas)
Benefits of Monopoly:
Research and Development
Greater consumer choice, possible lower prices
Economies of Scale
Natural Monopolies
Disadvantages of monopoly:
Higher prices for consumers
Productively and Allocatively inefficient
No consumer power
Monopoly Power: Ability of a firm to raise the price above the price of competitors
leads to resource misallocation and welfare loss
As a rule: free unregulated monopolies should be illegal, monopolies are only
allowed to exist mainly if they are natural monopolies under regulation.
Policies to limit Monopoly Power: (for M and O)
Regulation: controlling price
Legislation: prevent collusion or formation of monopolies
difficult to legally prove collusion
vague laws allow for different interpretations
Nationalisation: transfer of ownership to Govt
however leads to inefficiencies as govt are not driven by goal of profit max.
Break up of firms with monopoly power
Policy to regulate Natural Monopoly: Average Cost Pricing (where D=ATC)
inefficient
consumers better off
keeps firms normal profit
Price discrimination: selling a product at different prices to different consumer
groups, where the price differences are not due to different costs of production.
Conditions:
some type of monopoly power
firms must be able to separate consumer groups so there is no possibility of
resale
time, age, gender, geographical location
Different consumer groups must have different PEDs
Allows for higher revenues and profits.
UNIT 1.5
Monopolistic Competition
Assumptions:
large number of firms of varying sizes
product differentiation
no or low barriers of entry
Model: Amount of product differentiation is proportional to amount of monopoly
power, so firms will use both price and non-price competition to compete.
Graph: Slightly slanted D and MR, but not as much as M or O.
Price Competition: competition between firms to attract customers by lower price
of good
Non-price competition: competition between firms to attract customers by
product differentiation
Profit Maximization/Loss minimization: Where MR=MC, however only in the
short run
In the long run, normal profit due to little or no barriers of entry, which allows
firms to enter, changing the elasticity of D until normal profit
UNIT 1.5
Oligopoly
Assumptions:
small number of large firms
high barriers of entry
firms can sell homogenous (oil) or differentiated (car) products
interdependence among firms (actions of one affect all others)
Because firms are interdependent, they must either compete or collude, which is
shown by Game theory:
The Prisoners Dilemma:
price competition should be avoided
the incentives to collude
price rigidity
Collusive Oligopoly: come together to set agreements on price and/or output
Formal Collusion: collusion between firms (cartel) allows them to behave as if
they were a monopoly
generally illegal, but Organization of Petroleum Exporting Counrties
(OPEC) is one.
Tacit or Informal Collusion: a cooperation between oligpolistic firms to
restrict competition and fix prices without a formal agreement
price leadership (one firm sets a price, other firms accepts the leaders rpice)
limit pricing (set price lower than profit maximizing price to discourage
new firms)
Non-collusive Oligopoly: when firms do not set any agreements to set price or
output.
Generally, oligopolistic firms do not collude to set prices and/or output, but there is
still price rigidity in oligopolistic markets which can be shown by kinked demand
curve:
Suppose there are two firms, Y and Z, producing output Q* and P*.
if Y raises price, Z will not raise its price as it can capture market share. This makes
the demand for Y's products elastic above price P* (due to cheaper substitutes),
resulting in lower revenue. Thus Y will not raise price.
if Y lowers price, Z will also follow suit to avoid losing market share. This makes the
demand for Y's products inelastic (as there are also subsitutes at same price), results
in lower revenue. Thus Y will not lower price.
*The firms profit maximize by producing at MR=MC, however due to the kinked
demand, MR will be "broken", thus allowing for firms with different costs (MC) to
profit-maximize at the same Q and P.
Concentration Ratio: a measure of how much of the total market output the top 5
or 8 firms share. indication of how much monopoly power they have.
Efficiency with each type of Competition
Perfect Comp
Monopolistic
Comp
Oligopoly
Monopoly
Productive
Eff
SR - No if
making loss
No
No
No
(Q at lowest
point on ATC)
or profit
LR - Yes
Allocative Eff
(Q where
Yes
No
No
No
No
A little bit,
Yes
Yes
S=D, when
firm has no M
power at all)
Dynamic Eff
(R&D can be
used for
depends on
size of firm
innovation,
LRATC
concept)
Social
Depends
No
No
No
Yes
Yes
Maybe
No
Efficiency
(social
optimal
quantity)
X-Efficiency
(try to lower
ATC, through
management,
and
inefficient
workers, only
in highly
competitve
marekts)
Summary (but by no means all of it)
Topic: Macroeconomics
Course: Economics
UNIT 2.1
Measuring National Economic Performance: Circular Flow
Model, GDP/GreenGDP/GNP/GNI, The Business Cycle
Circular Flow Model Diagram:
brown lines = closed economy
brown lines - red lines + green lines = open economy
Factor Payments (payments in return for the four factors of production): wage,
interest, rent, profit.
Transfer Payments: payments
GDP: the total value of goods and services produced domestically in a country, over
a period of time.
Expenditure approach (amount spent C+I+G+(X-M))
Income approach (the four factor payments: rent, wage, interest, profit)
Output approach (adding up all output values from different sectors)
Green GDP: measure of GDP that accounts for costs of environmental destruction
GNI: GDP + Net Factor Income from Abroad (also called GNP)
GDP per capita is a measure of output per person, whereas GNI per capita is
a better indicator of living standards.
You can have nominal values of GNI/GDP, but also real values which are inflation
adjusted.
Benefits of GDP/capita or GNI/capita:
can make comparisons over time or with other countries to make conclusions
about standard of living
LImitations of GDP/ capita or GNI/capita:
Unofficial markets are unrecorded.
Do not include unsold output
Doesn't consider quality of life
Doesnt consider ditribution of income
Doesn't consider the negative exteranlities (however Green GDP takes into
account environment destruction)
The Business Cycle: a cycle of phases that economies typically tend to go through
Leakages and Injections cause the fluctuations of inflationary and deflationary gaps.
Leakages - Savings, Taxes, Import Spending
Injections - Investment, Government Spending, Export Spending
Recession is a persistent fall in real GDP in an economy, where unemployment tends
to increase. Two consecutive quarters of negative GDP growth is considered a
recession.
Demand Side policies - reduce short term fluctuations
Supply side - aim to increase steepness of the long term strend
UNIT 2.2
Aggregate Demand and Aggregate Supply
Aggregate Demand Definition: the total planned spending on goods or services in
an economy over a period of time.
Components of AD: C+I+G+(X-M)
C: All spending by consumers to buy goods and services in the country
Investment: All spending by firms to buy capital goods
Shifts in AD: C+I consumer/business confidence, interest rates, wealth, tax rates,
level of household/corporate indebtedness, G government spendings, nX exchange
rates, protectionism
income: The amount of money earnt by an individual per year
Wealth: the total value of the accumulated assets minus liabilities, that are owned
by an individual
stuff like houses and stocks
Aggregate Supply Definition: The total planned level of output produced in an
economy over a period of time.
Shifts in AS: input costs, business taxes, subsidies, supply shocks
The Keynesian, sticky wage model: no automatic adjustment to restore Yfe. Also
going towards the max capacity, resources become scarcer, and as a result price
increases.
The Neo-classical model, flexible wage model: In the LR, wages adjust to restore
output back to Yfe
Both are sticky wages in the short run, Keynesian is wages inflexible
downwards due to minimum price (wage) and labour unions etc.
Deflationary Gap: the difference between real output and full output due to a low
Aggregate demand.
Inflationary Gap: the difference between real output and full output due to a high
Aggregate demand.
Neoclassical LR: suppose an economy is initially at point x, but it experiences a fall
in AD due to recession, therefore equilibrium price level will decrease, and actual
output will decrease, resulting in a deflationary gap. As there is spare capacity in the
economy, costs of inputs may become cheaper over time, e.g. workers due to being
unemployed will be willing to accept lower wages), thus the decrease in costs of
production will increase the aggregate quantity supplied at each and every price
level. Resulting in a rise in AD, back until full output where an economy can
sustainably produce at.
Keynesian Sections:
a horizontal section - it is horizontal because there is spare capcity at lower levels of
output since no problem of scarcity combined with wage-price inflexibility.
an upwards sloping section - becuase approaching potential output, there are less
free available resources to be used, thus firms more willing to purchase certain
inputs will cause their resource prices to increase.
A vertical section - because all resouces are employed to their maximum extent, it is
not possible to produce any additional output. (this is Ymax, not Yfe)
Keynesian: since resource prices and products are infelxible downwards, the
economy cannot be restored in the long run. e.g. labour unions and minimum wage.
UNIT 2.3
Macroeconomic Objectives: Unemployment, Low Inflation,
Economic Growth, Equity in Income Distribution
THe four macroeconomic Objectives overview:
Always trade offs, governmnet prioritizes certain objectives at different times, e.g:
economic growth may cause uneven distribution of income
unemployment rate vs inflation rate
economic growth vs maintaining a low and stable inflation rate
Unemployment Types, Causes and Consequences:
Unemployment refers to people of working age who are actively looking for a job
but who are not employed
Difficulties in measurement:
Under-employment refers to people of working age with part-time jobs when
they would rather work full time, or with jobs that do not make full use of their
skills
Hidden employment: Discouraged workers who give up looking for a job
after a long time are not counted
Average Measurement: it ignores ethnic, regional, age, gender disparities.
Labour: is DERIVED from demand
Unemployment rate: # of unemployed / Labour force *100
Natrual Rate of Unemployment: the rate of unemployment that exists when the
efconomy is producing at the full employment level of output
Cyclical Unemployment: Unemployment caused by falling AD in a recession.
Frictional: Short-term unemployment, when people move between jobs
Seasonal: Short-term unemployment, affecting workers whose jobs change with the
season, tourism industry Queenstown.
Structural Unemployment: Unemployment due to a mismatch between skills
available and skills demanded.
Technology change
Structural Change of an economy
Geographical Change
Consequences of Unemployment:
economic:
Loss of income
Fall in real output -> lower income tax
Higher tax revenue spent transfer payment -> budget deficit
Greater income inequality
Social:
Increased social unrest and crime rates
Increased homelessness
Increased stress levels -> poorer health
Increased indebtness -> more borrowing
Demand Side good for Cyclical Unemployment, but monetary ineffective for deep
recession
Supply-side good for frictional and seasonal
Supply side maybe good for structural if it is used to teach skills, but bad if it creates
a mismatch
Supply side also is good for frictional, if provide ifnormation services, or reduces
transfer payments to the unemployed
Inflation Types, Causes and Consequences:
Inflation: a sustained increase in the average price level in the economy.
Cost push inflation: inflation caused by falling aggregate supply
Demand pull inflation: inflation caused by rising aggregate demand
Deflation: a sustained decrease in the average price level of an economy.
Deflation caused by LRAS
Deflation caused by AD
Primarily measured using CPI (measuring price of a basket of good and services
consumed by an "average" household)
Underlying rate is another measure of inflation based on a basket of goods and
services without food or oil (which are highly volatile prices).
PPI measures changes in prices of FoP, good for predicting future inflation
Consequences of high inflation:
Redistributive effects - lenders lose, borrowers win
fixed income worse, variable income fine
Lower business and consumer confidence
Worse export competitiveness
Uncertainty can cause greater unemployment (against the theory of philips)
Cost push worse than demand pull due to risk of stagflation
Consequences of deflation:
Increase in unemployment due to fall in AD
deflationary spiral
Lenders win, borrowers losers. -> firms bankruptcy
Greater export competitiveness
AD fall is worse than LRAS, however no way to distinguish between either, so both
can cause negative things
Benefits of low and stable inflation:
allows price mechanism to work
high consumer and business confidence
no signifcant losers (borrowers vs lenders)
predictable, safe.
required to achieve other objectives (equitable distribution in income,
sustainable economic growth, low unemployment)
Trade Off between Unemployment and Inflation (Philips Curve):
Philips Curve shows inverse relationship, trade off
SRPC shift left if SRAS shift right, vice versa
No trade off long run, unless LRPC shift left if SRAS shift right
However cost-push, stagflation and increasing LRAS do not show the trade off
Economic Growth types, Causes and Consequences:
Economic Growth: growth in real GDP over a period of time, usually expressed as a
percentage change in real GDP
generally refers to growth in actual output, but there is also grwoth in potential
output
Actual Growth: increase in AD, resulting in greater actual output, movement
towards the PPC
Potential Growth: increase in LRAS, greater maximum output that a country can
sustainably produce, PPC increase
Importance in investment of economic growth:
physical capital (increased quantity and quality)
human capital (higher quality of labour)
natural capital (better quality and quantity of nautral resources)
Aside from productivity, increasing quantity will increase LRAS (e.g. immigration),
however without investment it would be unsustainable in the long run.
Consequences of economic growth
Potential benefits:
Greater incomes
Better Living standards (however, may not occur, if growth is based on military
goods or luxury goods)
Lower unemployment
Potential negatives:
Higher Inflation (if AD grows faster than AS, or if it is only AD growth)
Inequitable income if the rich get the majority of the profits
Unsustainability (if growth is based on technologies and methods that pollute)
Trade Deficit:
Can be positive if growth comes from exports
Can be negatives if import consumption increases
HL: Calculating EConomic Grwoth:
growtih is expressed as a percentage between two
economic growth = (rGDP2 - rGDP1)/rGDP1
EQuity in Income Disgtribution:
Income equity: It is a very normative concept that is difficult to define and measure,
however often intepreted to refer to equality in economics.
Income inequality: The opposite of equity, when
Due to unequal ownership of factors of production, there may not be an
equitable distribution of income.
Lorenz Curve: Visual representation of income distribution in a population.
further away from line of absolute equality, the more unequal toe income
distribution
Gini coefficient = A/A+B: measures the proportion of area A and B, where 0 is best,
and 1 is worst.
Progressive taxes: proportion of income paid as tax increases, as income increases
(direct tax)
argument is that it discinceitves work (laffer curve), however counterargument
is that any additional work would only result in extra money, however it may
not be enough extra money for the amount of work put in
Regressive taxes: proportion of income paid as tax decreases, as income increases
(indirect tax)
Proportional taxes: proportion of income paid as tax is same as income increases.
Methods to promote equity in income distribution:
progressive taxes + transfer payments
govt provision or subsidy into merit goods and public goods
Price controls for minimum wage
Relationship between Equity and efficiency: typical markets fail to provide both
equality while being allocatively efficient, however if one successfully employs an
equitable system of taxes and government spending, then one is more likely to
achieve a more equal distribution of income, reudce poverty, increase producvitiy
and achieve other macro objectives.
Poverty
Absolute Poverty: a condition when a household's income level is below a
predefined minimum income level considered necessary to satisfy basic needs.
Reltiave Poverty: a level of household's income that is considered relatively lower
than the median level of income in a country.
Causes of Poverty:
low incomes
high unemployment
lack of human cpaital
Consequences of Poverty:
low living standards
lack of access to healthcare and education
Consequences create a cycle of Poverty
Cycle1 (for poor people): Whereby a family in poverty will be unable to provide for
a child who grows up in poverty -> disadvantaged in education and skills and
malnutrition -> low productvtiy -> difficult to have a job -> low paying incomes ->
unable to provide their own child.
Cycle2: (for poor countries): Low incomes -> low levels of savings -> low levels of
investment -> low levels of economic grwoth -> low incomes
UNIT 2.4
Fiscal Policy
Fiscal Policy: the manipulation of taxes and spending by the government to achieve
macroeconomic objecitves.
used in the shot run to minimum fluctations in business cycle, to maintain low
stable inflation and low unemployment which is good for sustainable
economic growth
Government revenue: taxes, sales of goods and services that they own.
Government budget: government expenditure is composed of current expenditure,
capital expenditure, transfer payments
surplus, deficit, balanced
deficits lead to greater public (government) debt, surpluses lead to less public
debt
Automatic Policies/ Automatic Stabilizers: Progressive Taxes, Unemployment
benefits
point is to limit the size of economic fluctuations immediately while
government decides on policies to implement.
Discretionary Fiscal Policy:
Expansionary Fiscal - increase G, lower Taxes
Contractionary Fiscal - Increase Taxes, lower G
Expansionary Fiscal may also increase LRAS if G is spent on investment, or if firms
increase investment
Evaluation of Fiscal Policy:
Benefits
automatic stabilizers
direct impact on AD
more effective in recession than monetary
can increase LRAS
Negatives
Time delays (time needed to settle on a policy and to implmenet it, as well as
time taken for policy to start contributing)
Political (may do the things that are more popular, rahter than what is best)
Cannot be used incrementally (unlike monetary)
Expansionary Fiscal negative
Crowding out - if the government borrows money to increase G, Dmoney
increases, interest rate increase, higher savings less borrowing, fall in C and I,
effect of policy reduced.
however keynesians would argue crowding out is minimal, since economy
isn't operating at full capacity, resources can be found easily
Doesnt work in cost push inflation
Unfavourable due to tax
Potential Inflation
Budget Deficit
HL:Keynesian Spending Multipler
Keynesian Multipler is 1/(1-MPC), because it is a multiplied effect on AD due to a
change in government spending.
the spending of one individual is the income of another, any change in
spending will lead to a chain reaction of income changes, and thus spending
changes, to continue in a cycle.
MPC is a representation of how much of the money earnt will be respent on the
economy rather than lost as savings, taxes or imports,
Keynesians are for this approach as they are not convinced that the self-correcting
economy can easily return to full employment, however neoclassicals are not.
neoclassicalists believe that any short term gains in lower unemployment will
eventually vanish and the result of the fiscal policy will only be inflation. Instead
neoclasiccalists focus on increase supply side policies and focus on reudcing time
taken to return to full employment.
UNIT 2.5
Monetary Policy
Monetary Policy: the use of interest rates and money supply by the central bank to
influence aggregate demand
Central Bank: Bank for the government, banker for commercial banks, responsible
for interest rates and exchange rates
Interest Rates: The reward for saving and the cost of borrowing expressed as a
percentage of the amount saved or borrowed.
determined by the money market, inelastic money supply (fixed by central
bank)
Monetary Policy Methods:
Buying or selling bonds to decrease or increase money supply (Open market
Operations) MAIN METHOD
Changing the rate charged on loans by central banks to commercial banks
(Discount Rate/ Official Cash Rate)
Changing the amount of deposits that banks must hold available at all times
(Reserve Requirement)
Market for Loanable Funds: shows the hypothetical market between the real
interest rate in a country and the supply and demand of money from households
and firms for private investment. Money supplied by households who save money in
commercial banks, Money demanded by firms who borrow from banks to finance
investments.
Money market: Money supply by the central bank is perfectly inelastic, money
demand by commercial bank
Expansionary Monetary mechanism
a. CB buy bonds on the open market from private banks, private banks now has
greater supply of money a, greater quantity of money for banks to lend -> less risk
associated -> lower IR rate.
b. Low IR rate is carried over into market for private investment / lonable funds.
MOvement along D, as lower IR encourages greater quantity demanded of funds for
investment.
c. THe increased investment and consumption shifts AS to AD2, leading to an
increase in output, an increase in price level, and a decrease in unemployment.
Evaluating Expansionary Monetary Policy
Strengths
speed and ability for readjustment
no politics involved
no crowding out
Weakness
ineffective for big recessions (investors reluctant to borrow even when IR is 0%)
time lags exist (with time for policy to go into effect)
ineffective when Demand for investment is inelastic
Evaluating Contractionary Monetary Policy
Strengths
Speed and ability for readjustment
no politics
Weaknesses
Time lags to change consumer behaviour during high inflation
Worsens cost-push inflation
UNIT 2.6
Supply-Side Policy
Supply-side Policy Definition: policies intended to increase the producitve capcity
(LRAS) of the economy
only way to directly create sustainable long term growth, fiscal and monetary
are both demand side short run
Market-based Supply-side Policies: based on instituional changes in the economy
to develop free competitive markets that promote economic growth to increase the
productive capcity of the economy.
Increase Competition: Privatization, Deregulation, Antimonopoly regulation,
Free Trade
Labour Market Reform: Reduce Labour Union power, Abolish Minimum wage,
Reducing Unemployment Benefits
INcentive Related: Lower indirect and direct taxes
Interventionist Supply-side Policies: Based on govermnet intervention in the
economt intended to directly increase the productive capcity of the economy.
Investment in human, infrastructure, technology, and specific industries
important for growth (growing semiconductor industry in China).
Both types of supply side create LRAS shift:
lower inflation
lower unemployment
Improved economic growth
Better trade and balance of payments
Evaluation of Interventionist
Strengths
Direct support for areas needed for growth
Results in improved equity in income distribution
Weakness
Long time
Government spending opp. costs
Budget deficit, public debt
May lead to inefficient government sector
if G makes poor choices, could worsen
Evaluation of Market Based
Strengths
No risk of government failure
no deficits or debts
no opp costs
Weakness
Long time
Policies encouraging competition unable to regulate and only can incentivise
no direct impact guaranteed
unintended negative effects
environment and pollution
Unemployment
Structural (Supply Side [intervntionist more direct and thus more likiey to affect it vs
market-based])
long term problem
Cyclical (Demand-side policies [fiscal vs monetary], [keyensian vs neoclassic])
can be really devastating
Frictional + Seasonal (Supply-side interventionist [SR only])
Short term, not too serious, just don't want too much of this
Inflation
lenders, borrowers
more income inequality
price mechanism fail
uncertainty
worse export competitiveness
Demand Pull Inflation (extreme is hyperinflation) (fiscal vs monetary)
Cost-push inflation (extreme is stagflation) (fiscal vs supply side [monetary
ineffective])
Deflation
lenders, borrowers
cyclical unemployment + deflationary spiral
greater real value of debt -> bankrupt and indebt
uncertainty
Caused by fall in AD, or rise in SRAS. (risk of deflationary spiral + bankruptcies)
(demand-side policies)
Short Unexpected inflation is bad, short unexpected deflation is good. (real value of
incomes). However, expected high inflation or deflation are both bad.
Economic Growth
increase in actual output (only be demand side, or some interventionist supply side)
increase in potential output (only by supply side, or by fiscal investment)
(sustainable growth, income distribution, inflation, standard of living, unemployment)
Poverty/Equity in income distribution
(equity in income, can improve poor workers, but may disincentivize rich workers)
Philllips Curve, Keyensian Multiplier, Lorenz Curve + Gini Coefficient, Labour Market,
Money Market, Market for Loanable Funds
Demand-side policies: short-term demand management with focus on eliminating
short-term economic fluctuations. Achieve low cyclical unemployment and low
stable rate of inflation.
Keynesian Multipler is 1/(1-MPC), because it is a multiplied effect on AD due
to a change in government spending.
Crowding Out: By govt borrowing money from Central Bank, D for Money
increases, leading to higher interest rates, less incentive for C and I, lower C and
I, AD effect weakened.
Supply-side policies: essential for creating potential growth and increase potential
output.
Topic: International Trade
Course: Economics
UNIT 3.1
Benefits of Free Trade, Absolute Advantage, WTO,
Protectionism
Free Trade: International trade with no government intervention imposing trade
restrictions.
Benefits of trade:
greater choice and lower prices for consumers
more efficient allocation of resources globally
Benefits for producers who grow in size due to this expansion for economies of
scale
increased competition
exchange of ideas and technology
both countries can acquire needed resources
Absolute and Comparative Advantage (HL)
Absolute Advantage: when a country can produce more of a good with fewer
resources than another country.
Theory of Absolute Advantage: if two or more countries specialize in producing
and eporting goods in whcih they have an absolute advantagem they will enjoy
increased production and consumption of the goods.
However, even when one country has an absolute advantage over both goods,
speicalisation will still benefit both countries
Comparative Advantage: when a country can produce a good at a lower
opportunity cost than another country.
Theory of Comparative advantage: if two or more countries specialize in
producing and exporting the goods in which they have a lower opportunity cost,
they will both enjoy increased production and consumption of the goods.
Comparative advantage exists because: different countries have different
endowments (natural resources, FoPs, technologies)
Limitations of Theory:
Assumes Free trade and No transporation costs
Risks of exccessive specialization
Developing countries would be unable to diversify their economies
Trade Protection: Government intervention in international trade involving the
imposition of trade barriers to limit imports and protect the domestic economy.
Tariffs: a tax imposed on imported goods
a = increase in producer surplus
b+d=welfare
c = tax revenue
a+b+c+d=loss in consumer surplus
Tariffs are used by governments wanting to impose trade barriers, because they
provide tariff revenues
Quotas: a restriction on the quantity of imports
a+b+c+d = loss in consumer surplus
a+b+c = gain in producer surplus
d = welfare loss/deadweight loss
Quotas are used by governments who have a strong export sector, because their
exporters usually get the quota revenues.
Subsidies: payment by the government to firms to lower costs of production and
price
a +b = size of subsidy
a = gain in producer surplus
b = deadweight loss
Subdides are prefered by economists, because no fall in living standards compared
to tariffs, consumers unaffected.
Evaluation of types of Trade Protection
Tariffs
Quotas
Subsidies
domestic producers gain, workers gain
domestic consumers worse off (higher P, lower Q)
consumers unaffected
government gains tariff
revenue
government must pay
subsidy
government unaffected
Inefficiency in domestic production
Global Allocative Inefficiency, shown by welfare losses
Risk of retaliation and trade wars
less risk
higher imported price of inputs
same input prices
Administrative barriers: "hidden protection" because it is not alawys obvious they
are imposed for restricting imports but they are. e.g. (unecesary beuacratic
procedures and rules that imports must follow to be admitted into a country)
Evaluation of trade protection:
For trade protection
protect domestic employment
protects infant industries (new industries which needs protection as it cannot
yet utilise economies of scale to compete with imports.)
protects strategic industries (defense goods, raw materials)
Allows developing countries to diversify their economies
prevent Anti-dumping (dumping is the selling of exports in international
markets at a price lower than ATC)
used to fix a trade-deficit
Against Trade Protection
however, it is allocatively inefficient
invites retaliation and leads to strained relationships between countries
by protecting industries, they may become inefficient
difficult to remove protection after firms become dependent
administrative barriers invite a lot of passive aggressive interaction
World Trade Organization
WTO: an international organization with the objective of promoting free trade
among countries around the world
provides a set of trading rules that all members must follow when trading
it acts as a form to member countries to talks and negotiate trade to achieve
free trade
it acts as a mediator to settles disputes between members
UNIT 3.2
Exchange Rates
Exchange Rate: the value of one currency expressed in terms of another currency
Floating Exchange Rate: an exchange rate that is determined entirely by demand
and supply of the currency, without govt intervention.
Demand for NZD is due to US residents wishing to make payments to New Zealand,
in order to
buy new zealand goods and services
buys stocks and bonds in NZ
make FDI in NZ
travel to NZ
To buy NZD, US residents must sell USD.
The demand for NZD is equivalent to the supply of USD.
Supply of NZD is due to NZD residents wishing to make payments to US, in order to
buy US goods and services
buy stocks and bonds in US
make FDI in US
travel to US
To buy USD, NZ Residents must sell NZD.
The demand of USD is equivalent to the supply of NZD
The market for NZD, measures the price of USD per NZD.
Currency appreciation: an increase in the value of a currency in a floating exchange
rate system
increased foreign D for exports
decreased D for imports
lower relative inflation rate
increased interest rates
increased FDI
expectations of appreciation
Central Bank buys own currency (Increases D)
Currency depreciation: a decrease in the value of a currency in a floating exchange
rate system
decreased D for exports
increased D for imports
higher relative inflation rate
lower interest rates
decreased FDI
expectations of depreciation
Central bank sells own currency (Increases S)
Evaluating consequences of changes in exchange rates
Appreciation + (overvalued currrency)
fall in net exports
cheaper imports and inputs
AD decreases
fall in both types of inflation
unemployment increases
effect on output and growth depends
AD decreases, however, imported inputs are cheaper, so SRAS increases
Worse off trade balance
Foreign debt decreases, easier to repay debt
Depreciation + (undervalued currency)
increase in net exports
AD increases
increase in both types of inflation
unemployment decreases
effect on output and grwoth depends
AD increases, however imported inputs are costlier, so SRAS decreases
Better trade balance (Marshall-lerner + J-curve)
foriegn debt increases, harder to repay
Stakeholders to consider
consumers
firms
workers in export and import industries
foreign countries
Fixed Exchange Rates: an exchange rate fixed by a country's government or central
bank at a certian level in terms of another currnecy through constant intervention
devaluation: a purposeful decrease in the exchange rate of currnecy
must be done through decreasing D or own currency, or increasing S of other
currency
decrease D - lower interest rates
increase S - CB can sell own currency,
revaluation: an purposeful increase in the exchange rate of currency
must be done through increasing D of own currency, or by decreasing S of
other currency
increase D - central bank raise interest rates or buy own currnecy, govt can
borrow from abroad
decrease S - government limit imports or limit amount of forex that can be
bought by reisdents
Managed Exchange Rates: exhange rates mostly determiend by demand and
supply of currency, but central bank will intervene to avoid short term fluctuations
most economically developed countries do this, more stable, but have to be
pretty big, NZ too small cant do this.
UNIT 3.3
Balance of Payments
Balance of Payments: a record of all financial transactions made between
consumers, businesses and the government in one country with other nations.
consists of the current account, capital account, financial account and
balancing item to sum to zero.
balancing item accounts for errors to make it sum to zero
At equilibrium exchange rate, Demand for a currency = Supply of a currency ,
so total inflow = outflow, therefore BoP is zero.
Credit Item: any item of the balance of payments involving an inflow of funds into
the country
Debit item: any item on the balance of payments involving an outflow of funds
from the country
Account surplus: when inflows (money in) greater than outflows
Account deficit: when outflows (money out) greater than inflows
Current account
Balance of trade of goods and services (largest component)
value of exports of g+s mins value of imports of g+s.
Net income from abroad
receipts from abroad minus factor payments abroad
Current transfers
receipts from abroad minus remittances and gifts
Financial account
Direct investment: inflows minus outflows of funds used for investment in
physical capital. (inflows is FDI)
Foreign Direct Investment: investment by a firm from one country in the
physical capital offered in another country.
Portfolio investment: inflows minus outflows of funds used for investment in
financial capital (stocks and bonds)
reserve assets: foreign exchange held by the central bank. (bank sells forex to
buy domestic currency, vice versa).
Capital account (least important)
Capital Transfers: inflows and outflows relating to debt forgiveness, gift and
inheritance taxes,
Transactions in non-produced, non-financial assets:
sales and purchases of tangible assets, such as patents, copyrights, rights
to natural resources.
Current Account Deficit causes Downwards pressure on exchange rates
Current Account Deficit -> Greater Outflows (imports) than Inflows (exports) -> fall
in foreign demand for exports -> D for our currency falls -> at current exchange
rate, there is excess S -> fall in exchange rate -> exports attractice, imports
unattractive -> new lower equilibrium exchange rate
Current Account Surplus causes Upwards pressure on exchange rates
Current Account Surplus -> Greater Inflows than Outflows -> Increase in demand for
exports -> D for our currency rises -> at current exchange rate, there is excess D ->
rise in exchange rate -> exports less attractive, imports more attractive -> new
higher equilibrium exchange rate
Current account balance is not always bad:
current account deficit could occur during a period of inward investment, which will
creat jobs and investment in the economy (US did this to invest in its economy for a
long time).
also ana ccount deficit would create a depreciation which should automatically
reduce the level of the deficit
additionally, a current account deficit may indicate a strong economy, which is why
investors want to invest
Implications of persistent current account deficits
net Outflow in current account means that financial and capital accounts must
balance with an inflow
By increasing financial account:
higher interest rates (to attract financial account inflow) -> decrease C and I
foreign ownership of assets (due to FDI), loss of control over its own assets
Governmnet must increase borrowing from abroad -> high indebtness
poor international credit ratings
govt must pay off interest -> opportunity cost
future generations must repay loans -> lower standard of living
and by trying to reduce current account flow
contractionary fiscal policies (to reduce export outflow) -> lower economic
growth
Depreciating Currency -> leads to cost-push inflation
To reduce current account deficit (want to increase exports, decrease imports)
expenditure switching policies: policies that switch consumption away from
imports towards domestic production
trade protectionsim
depreciate the currency
expenditure reducing policies
contractionary demand-side policies
supply-side policies
improves competitiveness
Implications of persistent current account surpluses
net Inflow in current account must be balanced by outflows in financial and capital
accounts
higher economic growth (from large volumes of exports)
Lower unemployment
large demand for exports -> Appreciating Currnecy -> reduced export
competitiveness -> net exports decreasing
Lower consumption -> lower standards of living
lower domestic investment, since investment is being used abroad to create
outflow
more ownership of foreign assets
Marshal-Lerner Condition: PED(exports) + PED(imports) > 1
The methods of appreciating or depreciating a currency, very often, only improve a
trade imbalance after a time delay. The reason being in the inelastic PED for imports
and exports, over the initial period of time thus they may not immediately reduce
the imbalance.
At first, this tends to happen: PED(exports) + PED(imports) < 1, so the trade
imbalance initially will worsen:
depreciation will lead to a larger trade deficit
appreciation will lead to a larger trade surplus
then typically: PED(exports) + PED(imports) > 1, then the method would work:
depreciation will lead to a smaller trade deficit
appreciation will lead to a smaller trade surplus
J-curve (graphical representation of the Marshall-Lerner condition)
Depreciation at first worsens trade deficit, but as PED becomes more elastic,
reduces trade deficit
Similarly, appreciation should work the other way (but its not in IB i think)
UNIT 3.4
Economic Integration
Economic Integration: is the growing relations and cooperation between countries
arising from trade, or other agreements that link their economies together.
----------- Levels of economic integration (ecah one is a step up)
Preferntial Trade Agreement: an agreement between two or more countries to
remove or reduce trade barriers only on certain agreed markets
bilaterail: between 2 countries
multilaterial: between many countries, due to it being a rule under the WTO
Trading Blocs
Free Trade Area: An agreement to remove trade barriers on any goods or services
between a group of countries.
Customs Unions: An agreement to remove trade barriers on any goods or services
between a group of countries, as well as a common trade policy towards countries
outside the group.
Common Market: An agreement to remove trade barriers on any goods or services
between a group of couontries, as well as a common trade policy towards countires
outside of a group, and the free movement of labour and capital between member
countries.
Monetary Union: Members of a common market, who also adopt a common
currency and common central bank.
Complete Economic Integration: A monetary union with a central government
(fiscal + monetary union)
--------Evaluating Trading Blocs:
Benefits
all the benefits of free trade between member countries
Trade creation: the replacement of higher-cost domestic products by lowercost imported products due to the formation of a trading bloc.
Disadvantages
trading blocs is allocative inefficient compared to global free trade
loss of national autonomy (at higher levels)
developing countries can be manipulated
less developed countires benefit less
Trade diversion: the replacement of lower-cost imported products by highercost imported products due to the formation of a trading bloc
Evluating Monetary Union:
Benefits:
Less risk of exchange rate changes
all benefits of free trade but expeirneced more strongly due to less
mismatches
greater economic growth
increased foreign investment
Disavnatages:
Loss of ability to conduct own monetary policy
Loss of own ability to deal with trade imbalances through exchange rates
Clashes with being able to form your own fiscal policies
personalized fiscal should be partnered with personalized monetary, but it
cant
UNIT 3.5
Terms of Trade (HL)
Terms of Trade: average price of exports divided by the average price of imports
times 100
an indication towards how much imports can be bought by how much exports
Formula: ToT = (index of average export prices)/(index of average import prices)
*100
Improvement in ToT: increase in ToT, as average export prices increase, or average
import prices decrease.
Indicates more imports can be bought with same exports
Deterioration in ToT: decrease in ToT, as average export prices decrease, or average
import prices increase.
Indicates that less imports can be bought with the same exports
Causes of changes in ToT in the short term
changes in factors of global demand (such as global consumer tastes)
changes in factors of global supply (global favorable weather for agriculture)
changes in relative inflation rates
if A has higher Inflation rates, prices of their exports becomre more
expensive, so ToT improve for A, but countries that import from high
inflation country A are worse off.
changes in exchange rate (appreciating or depreciating)
depreciation/devaluation leads to rise in import prices, thus ToT
deteriorates, vice versa.
Causes in the long term
changes in human producvitity
changes in technological productvity
change in income levels
as incomes increase over time -> demand increases HOWEVER, dependent
on YED -> develoed countries with high YED experience greater ToT
improvements. developing countries with primary commodities low YED
experience deteriorating ToT. (Deteriotation of LEDC's)
Effects of changes in the terms of trade on trade balance (short term)
If ToT changes are caused by changes in global demand:
the ToT and trade balance both improve of deteriorate
exporting countries and importing countries experience the opposite
effects
If Tot changes are caused by changes in global supply:
the effects on the trade balance depend on the PED of the good that is being
exported or imported
e.g. say PED>1 for a manufacture good, which has increased supply ->
lower prices for that manufactured goods -> ToT imrpvoes for importing,
ToT deteriorates for exporting Countries -> but proportionally greater
quantity demand for good -> larger inflow for exporting, larger outflow
for importing -> trade balance improve for exporting, trade balance
deteriorate for importing.
If ToT changes are caused by exchange rate changes:
effects on the trade balance depend on the Marshal lerner Condition
depreciation -> higher import prices -> ToT deteriorates -> drop in
quantity of imports demanded (but proportionately smaller is marshal
lerner doesn't hold) -> overall increase in outflows -> worse trade deficit.
The Woes of Developing Countries
Effects of Short term fluctuations in the ToT
developing countires primarily export primary commodities tned to have a more
flutuating ToT due to the inelastic PED and PES of primary commodities. because
any changes in quanttiy caused by a shift in S or D will cause a larger change in price.
fluctuating ToT leads to fluctuating revenues for producers and export
lower business condience and greater need for government policies
also as ToT improves when price rises, it is hard for governments to diversify
their economy, but instead become more dependent on commodity exports
Effects of long term deterioration
developing countires have commodities which are low YED, so demand for
goods from these countries grows very slow compared to manufacture goods
of developed countries. Therefore demand for manufacture goods drives up
prices in develoepd countriese relative to poorer countries, results in worse off
ToT over time.
Furthermore, this problem of ToT deterioration is exacerbated by:
Technological advance in developed countries makes agricultural production
cheaper, thus goods from developing countries also must become cheaper.
Monopoly power of Oligpolistic firms allow them to charge higher prices for
manufacture products. worse off Tot
Consequences of deteriorating ToT: means a country must keep exporting more
and more over time to maintain the same quantity of imports.
growing difficult to import
persistent trade deficit, problems with that
growing indebtness
greater poverty and income inequality
due to deteriorating terms of trade, poorer countries must export more for
less import, leading to greater income and output transfered to richer
countries, as a result there is a global redistribution of output and income
to the richer countries
lower govenrment revenue and ability
stuck to keep providing primary commodities
Topic: Economic Development
Course: Economics
UNIT 4.1, 4.2