Macroeconomics
Circular flow of income
National output = national income = national expenditure
Physical flow: of real things, such as Goods,
services, labour, land and capital
Monetary flow: money used to buy physical things
Injections: exports, investment and government
spending, go directly to firms
Withdrawals: imports, savings and taxes, made by
households or firms
Multiplier affect: the actual change of national
income is greater than the initial injection as money
travels around the circular flow of income, the size
of the multiplier depends on the rate at which the
money leaks from the circular flow
Aggregate demand (AD)
Total spending on goods and services, AD = C + I + G + (X-M)
Consumption: Consumers' expenditure on goods and services, largest component of AD, affected by
income, interest rates, consumer confidence, wealth effects, taxes and unemployment
Investment: spending on capital goods e.g. equipment and new buildings to produce consumer goods,
it effects the supply-side as well as AD. It is affected by risk, government incentives and regulation,
interest rates, access to credit, technical advances, business confidence.
Government Spending: spending on state-provided goods and services including public goods and
merit goods, it is affected by the economy and political priorities. Transfer payments such as benefits,
state pensions and job-seekers allowance are not included in current government spending because
they are a transfer from one group (taxes) to another (pensioners)
X-M: Exports are goods and services are an inflow of demand (injection) Imports of goods and services
are a withdrawal of demand (leakage) Net exports is X-M. When net exports is positive, there is a trade
surplus (adding to AD) Affected by:
- Exchange rate: in the LR imports increase and exports fall as the value of a currency increases. In the
SR imports and exports are inelastic so theres a time lag before countries switch to substitutes
- World economy: net exports fall as real income rises for a country, strong growth in other countries
leads to more exports
- Protectionism: in the SR, tariffs and quotas increase net exports and reduce imports, in the LR exports
fall as firms have less of an incentive to be efficient
- Non-price factors: such as quality, technological advances, politics
Average propensity to consume (APC) = consumption/total income
Average propensity to save (APS) = amount saved/ total income
Marginal propensity to consume (MPC) = change in consumption/change in income
Marginal propensity to save (MPS) = change in saving/change in income
Multiplier = 1/(1-MPC) or 1/MPW (MPC + MPW =1)
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Aggregate supply
Measures the volume of goods and services produced within the economy at a given price level, it
represents the ability of an economy to produce goods and services either in the short term or in the long
term.
Short-run aggregate supply: (SRAS) shows total planned output in the economy when prices can
change but all other factors of Production are constant. The curve is shifted by:
- Factors of production costs: e.g. rental costs,
- Commodity prices: Changes to raw material costs and other components e.g. the price of oil
- Exchange rates: causes fluctuations in the prices of imported products. A fall (depreciation) in the
exchange rate increases the costs of
importing raw materials and component
supplies from overseas
- Government taxation and subsidies: An
increase in taxes to meet environmental
objectives (known as green taxes) will cause
higher costs and an inward shift in the SRAS
curve
- The price of imports: Cheap imports or a
reduction in an import tariff on imports or an
increase in the size of an import quota will
boost the supply available at each price level
- Accelerator effect: when an increase in
national income and demand leads to firms
performing at full capacity which results in a
proportionately larger rise in capital
investment spending.
Long run aggregate supply: (LRAS) shows total planned
output when factors of Production can change, it is a measure
of a country’s potential output and the concept is linked strongly
to that of the production possibility frontier. The curve is shifted
by:
-Expanding the labour supply: incentives for new jobs, inward
migration
-productivity of labour and capital: through supply side
policies and more capital
-Occupational and geographical mobility of labour: reduces
structural unemployment
-Capital stock: increase the level of capital investment,
research and development spending by firms
-Business efficiency: by promoting greater competition within
and between markets
Keynesian LRAS: at low levels of output AS is
completely elastic, as there’s a lot of spare capacity so
output can increase without a rise in the price level, as
GDP increases, supply bottlenecks cause am increase
in costs (supply of labour, raw material costs). The
curve becomes vertical when the economy is at full
capacity, AS is completely inelastic
Increasing LRAS shifts the curve to the left, this has
no effect at AD1 (recession) but increases GDP while
keeping the PL the same at AD4 (boom)
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Macro-Economic objectives
Stable low Inflation - UK target of 2% for the consumer price index, currently 2.4%
Sustainable economic growth - growth of real gross domestic product, currently 1.3% in the U.K,
sustainable by keeping inflation low and reducing environmental impacts
Low unemployment - currently 4% in the U.K, aim of a situation where all those able and available can
find meaningful work
Reduced trade deficit on the balance of payments - currently $106.3 Billion ~3.4% of GDP
Other Macro-Economic objectives include:
- Raising living standards (using HDI and GDP per capita)
- Reducing poverty
- Improving environmental quality
- Reducing wealth inequality
Some objectives are normative statements due to differing opinions on the impacts, for example
reducing wealth inequality could remove incentives to make more money
Inflation: sustained rise in the average price of goods and services over a period of time, leads to a fall
in the value of money. Measured by the Retail price index (RPI) is the change in prices of a “basket of
goods” each good is weighted depending on the proportion of income spent on each item. And the
Consumer price index (CPI) which excludes mortgage interest payments and council tax. They are used
to determine wages, state benefits and pensions
Macro-Economic stability: occurs when there is low volatility in key indicators such as prices, jobs,
economic growth, interest rates, investment and trade.
Conflicts in Macro- economic objectives
Unemployment vs inflation: There is a trade off, in
the short run, between unemployment and inflation. In
a period of high growth – jobs are created, causing
unemployment to fall. But, as unemployment falls, it
can put upward pressure on wages, leading to
inflation.
The Phillips curve suggests there is a trade off
between these two objectives. For example, a cut in
interest rates leads to higher Aggregate Demand
(AD). Higher AD leads to higher growth (Lower
unemployment) but also higher inflation. Therefore
the Phillips curve trade-off moves from A to B.
It is possible to reduce both inflation and unemployment. If successful supply-side policies are used, you
can reduce structural unemployment without causing wage inflation. Also, if the growth is sustainable,
inflation will remain low.
Economic growth vs sustainability (environment)
Higher GDP leads to higher levels of pollution and consumption of non-renewable resources, as does
industrialisation as more resources are used at a non sustainable rate. However, it is possible to
counteract this with the development of clean energy production, capping the use of non renewable
resources and creating legislation that limits pollution.
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Economic growth vs current account balance
When economic growth is led by consumer spending it causes a deficit in the current account. This is
because as consumer spending rises, there is a rise in import spending, high economic growth may
increase inflation and make exports less competitive. However, if economic growth is export-led, then
there can be an increase in economic growth without causing a current account deficit
Economic growth vs inflation
If growth rate is above the long run trend rate of
growth it causes inflationary pressures to increase, if
growth is very quick, there may be supply
constraints pushing up commodity prices. This can
lead to a recession as the government increased
interest rates to try and control inflation. However, it
is possible to have economic growth without causing
inflation. If growth is sustainable (close to the long
run trend rate) then LRAS will increase at the same
rate as AD, and there will be no inflation.
Economic growth vs inequality
Rapid economic growth can lead to high increases in pay of people in top-paying jobs, Increasing wealth
including rising property prices, Growing gaps between urban and rural areas and the linked effects of
inequality in health and education. Inequality depends on the extent to which a government has a
welfare and tax system in place to provide an income safety-net and also a desire to redistribute rising
incomes and wealth so that the benefits of growth can be more equitably shared out.
Economic growth vs budget deficit
In order to reduce the budget deficit, higher taxes and lower spending are needed, However, this
tightening of fiscal policy will lead to a fall in AD and lead to lower economic growth. If the government
wants to boost the rate of economic growth it could pursue expansionary fiscal policy (tax cuts/spending
rises). This should increase aggregate demand and help economic growth, but the budget deficit will rise
Fiscal policy
A governments policy regarding taxation and public spending, it uses government spending and taxation
to influence AD, it aims to stimulate economic growth and stabilise the economy. In the UK, the
government spends most of their budget on pensions and welfare benefits, followed by health and
education. Income tax is the biggest source of tax revenue in the UK.
Objectives of fiscal policy:
- Improve macro-economic performance e.g. reduce unemployment, improve BOP or to reduce inflation
- Achieve a more desirable redistribution of income
- Correct market failure e.g. provision of merit goods.
Use of fiscal policy to manipulate AD
Classical economists: think that the government should maintain balanced budgets whatever the state
of the economy as extra spending would crowd out private sector investment. If the government
increased spending, this would displace private sector spending, giving zero net impact (increase in G is
offset by fall in C and I), whether in boom or recession.
Keynes: argued that crowding out did not take place in a depression e.g. post-war government used
fiscal policy to manage demand and nemployment in those years was low
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Monetarist: thought classical economists before the war were
correct as crowding out cancelled the impact of fiscal policy
Today: AD should be stimulated through monetary policy.
Fiscal policy is best used to deal with other objectives of the
government e.g. correcting market failure/inequality
Automatic stabiliser: a mechanism which reduces the impact
of changes in the economy or national income. Automatic
stabilisers are tax revenues, welfare spending, and budget
balance.
Active fiscal policy: deliberate attempts to use government
spending and taxation to expand or contract the economy
Accelerator effect: when an increase in national income
(GDP) results in a proportionately larger rise in capital
investment spending
Fiscal drag: the effect inflation has on average tax rates. If tax allowances are not increased with
inflation, as people's incomes increase with inflation then they will be moved up into higher tax bands, so
they are worse off as inflation has cancelled out their pay rise and their tax bill is higher.
Crowding out: when increased government borrowing reduces investment. Financial crowding out
happens when government expenditure diverts financial resources away from the private sector, which
deters private sector investment and consumption since it is more expensive to borrow.
Tax revenue: when the economy is booming, there is an increase in tax revenues which takes money
out of the circular flow due to the progressive tax system.
Welfare spending: A growing economy requires lower spending on benefits, whereas a shrinking
economy will see welfare spending rise.
Budget balance: During a recession, the government normally has a budget deficit, and a budget
surplus in a boom, Therefore, manipulating injections and withdrawals to reduce the amount of AD.
Expansionary fiscal policy: (Reflationary) Aims to increase AD. Governments
increase spending or reduce taxes to do this. It leads to a worsening of the
government budget deficit, and it may mean governments have to borrow more
to finance this. This policy is likely to be used during a recession when there is a
negative output gap as it will increase economic growth and reduce
unemployment but also increase inflation and worsen the current account on
the balance of payments, because as income increases, less is spent on
imports.
Deflationary fiscal policy: (contractionary) Aims
to decrease AD. Governments cut spending or raise taxes, which reduces
consumer spending. It leads to an improvement of the government budget
deficit, this policy is likely to be used during a boom when there is a
positive output gap as it will reduce economic growth and increase
unemployment but also reduce price levels and improve the current
account on the balance of payments, because as income falls less is spent
on imports
Value added tax: (VAT) Indirect tax, Standard rate - 20% since 2011,
reduced rate of 5% on domestic fuel and power, sanitary products etc, some products 0% tax
Proportional Tax System: everyone pays the same proportion of their income as tax. The tax rate does
not change with an increase or decrease in income. E.g. national insurance
Regressive Tax System: results in a decrease in the tax rate as income increases. In a regressive tax
rate system, the individuals with lower income pay a higher proportion of their income as tax. E.g. VAT
Progressive taxes: allow for a re-distribution of income from rich to the poor, poor people have a high
marginal propensity to consume and so any money given to the poor will have a greater impact on
society than if it is given to the rich. However, giving to the rich more increases investment, and stimulate
entrepreneurship E.g. income tax
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Laffer curve
- Shows optimum tax rate
- Disagreements on location of optimal level
- France forced to drop 75% supertax after Meagre returns
Cyclical and structural budget deficits and surpluses
Cyclical fiscal balance: The size of the fiscal deficit is influenced by the
state of the economy: in a boom, tax receipts are relatively high and
spending on unemployment benefit is low. In a recession, tax revenues fall and spending on
unemployment benefits increases.
Structural fiscal balance: The structural deficit is that part of the deficit which is not related to the state
of the economy. This part of the fiscal deficit will not disappear when the economy recovers. A structural
factor might be the long-term effects of an ageing population or perhaps the underlying level of personal
and corporate tax avoidance.
Budget deficit
- increased borrowing
- Higher debt interest payments
- Increased aggregate demand
- Higher taxes and lower spending; austerity
- Increased interest rates, due to increased borrowing
- Crowding out - This occurs when increased government borrowing reduces investment. Financial
crowding out happens when government expenditure diverts financial resources away from the private
sector. If it spends more, it may need to borrow more – to raise this finance, it may need to increase
interest rates. However, this deters private sector investment and consumption since it is more
expensive to borrow
Budget surplus
retire the debt; reducing overall levels of debt
Refund the surplus funds to taxpayers, reducing taxes
More government spending
Preparing for next downturn in economic cycle
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Current spending: on providing public services, e.g. NHS salaries, road maintenance
Capital spending: new public infrastructure e.g. new motorways, flood defence, military equipment
Strengths and weaknesses of fiscal policy to manage demand
Conflicting policies: fiscal policy has conflicting impacts on macroeconomic policies and so cannot
always be used (unemployment and inflation)
Size of multiplier: measures the final change in national income that results from a deliberate change in
either government spending and/or taxation. The larger the multiplier the larger the impact
Fine tuning: using fiscal policy to nudge the economy towards a precise level of national income
Recognition lags: time taken for policy-makers to recognise a need for changes in spending or taxation.
Imperfect information: Key data on the economy is often delayed and subject to revisions.
Time lags: It takes time to implement an appropriate policy response. Tax cuts can feed through quickly
but new capital expenditure is slow e.g. roads
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Monetary Policy
The government can influence the economy through interest rates, money supply and exchange rates.
Monetary policy Committee: (MPC) sets interest rates in order to meet the inflation target set by the
government, has a symmetrical target (2% +/- 1%) the Bank of England’s independence means it can’t
be affected by political myopia, the bank has to write to the chancellor if it does not meet its target
How do interest rates affect AD:
Housing market: A fall in IR will decrease mortgages and increase demand for houses, which increases
price of houses, also causes the wealth effect, which increases consumption, and AD
Wealth effect: when the price of their asset rises, people feel wealthier, If IR increased, the demand for
houses would fall, which would decrease the wealth effect.
Investment: An increase in IR will lead to a fall in investment as the cost of borrowing increases.
Saving: An increase in interest rates will increase savings (withdrawal)
Exchange rate: Higher IR attract foreign investment, increasing the demand and value of the currency.
Consumer durables: An increase in IR will decrease the demand for goods
Negative interest rates: gets banks lending, reduces real interest rates
Using Interest Rates to Control AD:
- Too much AD in economy (Demand Pull Inflationary Pressure) leads to an Increase in interest rates to
reduced AD and prices
- Low AD in economy, leads to a reduction in interest rates to Increased AD, there needs to be spare
production capacity in the economy or inflation will occur
- Low interest rates can be ineffective when business confidence is low, when purchasing power
decreases, high level of unpaid debt, deflation, contrasting fiscal policy, when low interest rates distort
pension funds, cause asset bubbles
The Exchange Rate: Governments can’t directly influence Exchange Rates but can use Interest rates to
affect the exchange rate of the pound
High interest rate: Overseas customers place money in UK banks (savings) to get a better return,
which Increases demand for the pound and makes it stronger
Low interest rate: Less people place money in UK banks from overseas which reduces the demand for
the pound, making it weaker
Money Supply: An Increase in money supply leads to an Increase in AD which puts pressure on
suppliers and causes Demand Pull Inflation
Expansionary Monetary Policy: A fall in Interest rates leads to a Increase in AD and Increased Inflation
Contractionary Monetary Policy: A rise in Interest rates reduces AD and Inflation
Quantitative easing: when the central bank purchases existing government bonds (gilts) to pump
money directly into the economy, it increases economic activity, encourages bank lending and
investment, increases the inflation rate and lowers interest rates. It is used as a last resort to stimulate
an economy, if reducing short term interest rates fails to encourage spending. If interest rates fall to near
zero, then cash is saved rather than spent, resulting in liquidity being trapped, nominal interest rates
cannot fall below zero. Works by raising asset prices, starting with government bonds, and then
spreading out through the wider economy which boosts bank assets and current bank lending and
creates a positive wealth effect for asset holders, the most immediate effect is asset prices of these
existing assets (gilts) rise, while yields decrease, which encourages investing in other assets with a
higher yield, such as corporate bonds and shares (equities). Lower yields push down borrowing costs for
business, which can act as a stimulus to borrowing and spending. Leads to increased household and
corporate spending, more confidence, increase in AD, achieve inflation target (2%).
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Key functions of money
- medium of exchange: allows goods and services to be traded without bartering
- Store of value: an asset who’s value can be used at a later date
- Unit of account: expressed in an understandable way, easily comparable
- Standard of deferred payment: value of a debt payed back as a loan in the future
Characteristics of money:
- durable
- Portable, convenient and easy to use
- Divisible into smaller denominations
- Valuable and hard to counterfeit
- Must be generally accepted by a population
Central banks: provides banking and financial services for its country’s government, as well as
implementing government monetary policy and issuing currency
- Monetary policy: setting main monetary policy interest rate, quantitative easing (increasing money
supply by buying bonds/debt), exchange rate intervention, aim for government set inflation target (2%)
and avoiding deflation, keep annual rate of consumer prices inflation (CPI) to within 1% off target
- Financial stability: overseeing the financial system so that there’s an efficient flow of savings, loans
and confidence in the market, maintain stability, aim economy towards exports and investment
- Polices: last resort lender to banking system, manage liquidity in commercial banks, oversee payment
systems used by banks/ credit card companies and handling government debt
Commercial banks: deposit taking and lending, provides services to corporate and individual
customers, make profits through small, short term, liquid deposits from retail savers and transforming
them into business loans and mortgages, also manage cash, provide debit and credit cards and trade
finance.
- They are licensed deposit takers and lenders, and use deposited money to loan at at higher interest
rate to pay operating expenses and for profit through the “spread” on their assets
- Also make profits from providing deposit security, currency trading, business advice, and finance
Investment banks: provides a wide range of specialisation services for competitions and large
investors, their aim is to advice on securities issues and other forms of capital raising, provide advice on
mergers, acquisitions and corporate restructuring and trading on commercial markets
Building society’s: owned by members not shareholders, focused on offering mortgages and savings
Bond: A type of security that is sold by firms (corporate) or governments as a way for the firm or
government to borrow money at a certain interest rate. In return the investor gets a certain interest rate
for the duration of the bond. It has a maturity rate of over a year so is illiquid. Bonds sold are as secure
as the seller, government bonds (gilts) are the most secure, and then corporate bonds.
Government bonds: fixed interest securities, so the bond is payed at a fixed annual rate, yield is
calculated by interest/current value
Assets: cash, loans, securities (bonds), fixed assets, balances at the Bank of England
Liabilities: customer deposits, money owed to bond holders, money owed to other banks
Liquidity risk: banks attract short term deposits, and often lend for longer periods of time, as a result
commercial banks cannot liquidate all their assets, to reduce this risk banks try to attract limber term
deposits and hold liquid assets as capital reserves
Credit risk: risk to commercial banks of lending to borrowers who are unable to repay their loans, this
can be controlled by safeguarding and research into borrowers credit rating, and prudential regulation
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Financial crisis: A disturbance to financial markets, falling asset prices, inability to pay off debt
Market bubbles: due to speculation as people aim to make a profit by buying cheap assets and selling
them for a higher price, bubbles occur when prices are much greater than an assets worth, when
investors lose confidence they sell their assets causing a fall in price
Insolvency crisis: when debt is higher than income, so the agent is unable to pay back the debt and the
interest (unsustainable debt) requires debt restructuring / debt relief
Illiquidity crisis: when debt is not unsustainable but it has large amounts of this debt coming to maturity
and it is not able to roll it over, Illiquidity can lead to insolvency
Liquidity ratio: determines how able a company is to pay off short-term obligations. How much of total
assets can be liquidated quickly
Capital ratio: ratio between the equity capital and risk-weighted assets of a bank, determines a bank’s
financial strength. Assets are weighted, where physical cash has zero risk and credit carries more risk
Causes:
- years of low interest rates
- Asymmetrical information (one party knows more than the other)
- Adverse selection: when a seller would prefer not to sell to the most likely buyers( health insurance)
- Moral hazard: when someone is more willing to take a risk because someone else will have to pay the
consequences (bank bail outs)
- Lax supervision am deregulation of the financial system (regulatory failure)
- Excessive risk taking, sub prime lending, distorted incentives of credit rating agencies
- Global current account imbalances and global savings abundance
- Irrationality and animal spirits leading to financial bubbles
- The Global Financial Crisis: before the crash, asset prices were high economic demand was booming,
many Risky bank loans and mortgages, especially in the US where government securities were
backed by subprime mortgages so borrowers had poor credit histories. After House prices crashed in
the US in 2006, It led to Banks losing huge funds, which required bailouts.
Impacts:
- Taxpayers: higher taxes to bail out financial institutions
- Depositors: loss of savings if banks collapse, only up to maximum secured value
- Creditors: do not get paid back on debts owed
- Shareholders: loss of equity (value of shares)
- Employees: loss of jobs, lower wages, cyclical unemployment
- Government: Increased deficit, harder to get loans
- Higher cost of credit: commercial banks become more risk averse, rise interest rates on high risk loans
- Falling asset prices: weaken bank balance sheets and mean they have less money to lend out, banks
restrict credit to rebuild capital, causes a fall in consumer spending, AD, and confidence
- Desire to maintain higher lending of bank liquidity causes a fall in lending to SME which decreases
entrepreneurship, more lending to larger stable businesses
- Fall in share prices lowers capital of listed companies, less investment
Regulation:
- Ensures banks are transparent to institutions and individuals who conduct business with them
- Prudential Regulation Authority: (PRA) promotes safety and stability and ensures policyholders are
protected, responsible for specific financial markets.
- Financial Conduct Authority: (FCA) funded by the firms it regulates, ensures banks are honest,
protect consumer interests, and promote competition which is in the interests of consumers.
- The Financial Policy Committee: (FPC) regulates risk in banking, removes systemic risks, ensures
the financial system is stable and policies unregulated parts and loose credit. Publishes financial
stability reports, can instruct banks to alter their capital reserves
- Prudential regulation: safeguarding the financial system. Micro-prudential involves regulation of
individual firms such as banks and insurance companies. Macro-prudential regulation safeguards the
system as a whole
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Supply side policies
Aim to increase am economy’s trend growth rate (increase LRAS) by expanding productive potential or
increase the trend rate of growth. Policies involve making structural changes to the economy to make it
more efficient and Productive, by creating incentives and encouraging entrepreneurship.
Free market supply-side policies: aim to increase efficiency by removing things that interfere with the
free market (tax cuts, privatisation)
Interventionist supply-side policies: aimed at correcting market failure ( spending on education, R&D
subsidies, infrastructure improvements)
Examples of supply side policies:
Industrial policies:
- Privatisation: The sale of nationalised industries from the public sector to the private sector.
- Deregulation: The removal of regulations in order to promote competition, removes barriers to entry
to make markets contestable, reduces 'red tape' or bureaucracy, which increases costs of production.
- Trade liberalisation: removing or reducing trade barriers, allows free flow of goods and capi
- Internal markets: contracting out is a substitute for privatisation, the taxpayer continues to finance
hospitals and schools, but they 'earn' the money based on many patients and pupils they attract.
- Tax incentives: tax breaks or subsidies to reinvest
Labour market policies:
- Lower rates of income tax: progressive taxation, creates labour markets incentives. Reducing state
welfare benefits creates incentives to choose low-paid employment in preference to claiming benefits.
- Labour market flexibility: reduce the power of trade unions, Introducing short-term contracts,
reducing legislation or non-wage costs, introducing profit-related and performance-related pay. Can
lead to even greater poverty and inequality for ordinary workers in an increasingly casualised and
exploited part-time labour force.
- Improving the training of labour: apprenticeships allow people to gain practical skills and
qualifications, improves productivity and occupational mobility.
Financial and capital market polices:
- Deregulating financial markets: Creating greater competition among banks, opening up the UK
financial markets to overseas institutions, this increases the supply of funds and reduce the cost of
borrowing for UK firms and encourages inward investment
- Promoting entrepreneurship: enterprise culture, reduced taxation and encouraged risk taking.
- Reducing public spending: to free resources for private sector use and avoid crowding out
Benefits:
- increase an economies trend growth rate
- Makes it easier for a government to achieve its macroeconomic objectives
- Reduces cost push inflation as lower costs and greater efficiencies are achieved
- Improves the current account of the balance of payments by improving international competitiveness
Costs:
- takes a long time to come into effect, cannot be used for a quick fix,
- Can have unintended consequences such as financial deregulation (1986 Big Bang) which can cause
excessive risk taking and recession
- Unpopular with the public as they can be unfair such as benefit cuts
- Less job security from trade union reforms
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Globalisation
The process by which national economies have become increasingly integrated and interdependent, The
OECD defines globalisation as:
"The geographic dispersion of industrial and service activities, for example research and development,
sourcing of inputs, production and distribution, and the cross-border networking of companies, for
example through joint ventures and the sharing of assets."
Characteristics of globalisation
- Greater trade: in goods and services both between nations and within regions
- An increase in capital transfers: including the expansion of foreign direct investment (FDI) by transnational companies (TNCs)
- Global brands: serve markets in high and low income countries, take advantage of comparative
advantage
- Spatial division of labour: for example out-sourcing and off shoring of production and support
services as production supply-chains has become more international.
- labour migration: within and between countries which allows for specialisation
- New nations joining the world trading system: China and India joined the WTO in 1991, Russia
joined the WTO in 2012
- Shifts in economic power: fast changing shifts in the balance of economic and financial power from
developed to emerging economies and markets – i.e. a change in the centre of gravity in the world
economy
- Increasing spending: on investment, innovation and infrastructure across large parts of the world
Drivers of globalisation:
- Containerisation: the costs of ocean shipping has decreased substantially due to bulk shipping,
-
which makes markets more contestable as manufacturing prices are lower to prices in the export
market
Technological change: reducing the cost of transmitting and communicating information (death of
distance)
Economies of scale: domestic markets may be too small to satisfy selling needs in an industry;
larger international corporations can export at lower costs due to larger production scales
Opening up of financial markets: the removal of capital controls facilitating foreign investment
Differences in tax systems: countries adjusting their tax systems to attract foreign direct investment,
exploits comparative advantage
Less protectionism: non-tariff protection such as import licensing and controls are gradually
removed; there has been a rise in protectionism in last few years due to financial crisis
Benefits from Globalisation
- Greater division of labour: businesses and countries specialise in areas of comparative advantage
- Cheaper goods: Deeper relationships between markets across borders enable and encourage
producers and consumers to reap the benefits of economies of scale
- More perfect competition: Competitive markets reduce monopoly profits and incentivise businesses
to seek cost-reducing innovations and improvements in what they sell – this leads to an improvement
in dynamic efficiency
- More economic growth: emerging markets in developing countries can lead to the eradication of
poverty and an increase in wage rates, it can also provide employment opportunities, many of the
world's poorest countries have achieved higher rates of economic growth and reduce the number
living in extreme poverty
- Greater product variety: as production and retail costs are lower a larger variety of goods can be
provided to a much larger market, improving quality of life
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Costs of Globalisation
- Inequality: rising inequalities in income and wealth, shown by a rise in the Gini-coefficient and a
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growing rural–urban divide in developing countries such as China, India and Brazil. This leads to
political and social tensions and instability.
Inflation: Strong demand for food and energy has caused a steep rise in commodity prices. Food
price inflation has placed millions of the world's poorest people at risk.
Macroeconomic Instability: globalisation creates a boom in share prices and property valuations
due to rapid investment, the bursting of speculative bubbles has negative effects on poorer &
vulnerable nations.
Threats to the Global Commons: irreversible damage to ecosystems, land degradation,
deforestation, loss of bio-diversity and the fears of a permanent shortage of water are afflicting millions
of the most vulnerable people
Trade Imbalances: Some countries are running enormous trade surpluses and these imbalances are
creating tensions and pressures to introduce protectionist policies
Standardisation: A loss of economic and cultural diversity as giant firms and global brands dominate
domestic markets in many countries.
Dominant Global Brands: Competition could reduce if global businesses with dominant brands and
superior technologies take charge of key international markets.
Race to the bottom: In order to attract inward investment nations may be tempted to lower corporate
taxes, relax health and safety laws and limit basic welfare safety nets which can lower quality of life
and neglect human rights
Comparative advantage theory: when one country can produce a good or service at a lower
opportunity cost than another, so it can produce the good relatively cheaper than other countries, if
countries specialise in producing goods where they have a lower opportunity cost – then there will be an
increase in economic welfare.
Foreign direct investment: when a company owns another company in a different country, foreign
companies are directly involved with day-to-day operations in the other country and therefore bring
money, knowledge, skills and technology.
Positives for MEDCs
•
•
•
•
•
•
Negatives for MEDCs
• Could lead to wide spread unemployment
• Loss of skills
Movement of polluting industries away from
• Negative multiplier effect
their country
• Large gap between skilled and unskilled
Growth in LEDC’s may lead to demand for
exports from MEDCs
workers who may experience extreme
Cheaper imports can keep the cost of living
redeployment differences
• deindustrialisation of some areas, such as
down benefiting the retail sector
Labour market flexibility and efficiency
the North
Development of new technologies leading
to investment
Help to reduce inflation
Positives for LEDC's and NIC's
• Development of new industries
• Increased employment
• Helps to reduce development gap
• Increased FDI and investment which can
lead to improved services such as
infrastructure, health care and education
• Increased exports helps BoPs, and increases
income and GDP
• New technologies
Negatives for LEDC's
• Rapid urbanisation and rural-urban
migration
• Westernised approach to economy
• Increased environmental damage due to
polluting industries
• Exploitation of labour
• Disruptive social impacts
• Over-dependant on one industry
• Destabilises food supplies, less agriculture
• Health and safety issues because of tax
legislation
12
International trade:
- Free trade is Trade without artificial barriers (e.g. tariffs, import tax, anti-competitive subsidies)
- Exchange: countered supply goods and services that they can produce cheaply and buy products
from other countries they would find relatively expensive to produce
- Specialisation: benefits from trade are increased if there are economies of scale from production and if
countries specialise their resources in producing certain commodities
- Maximises the output which can be gained from world resources and so contributes to the reduction of
scarcity.
Benefits of free trade:
- Stimulant of economic growth: exports are injection of AD, multiplier and accelerator effect on
national income, greater factor mobility
- Cheaper production costs: specialisation, economies of scale, reduced regulation
- Dynamic efficiency gains: improved technological innovation, transfer of ideas and innovation
- Increased competition: pressure on suppliers to keep prices down and dilution of monopoly power
and improved efficiency, leads to more consumer choice
- Better use of scarce resources: (exploitation of comparative advantage)
- Market contest-ability: trade promotes increased competition particularly for domestic monopolies
that would otherwise face little competition. Trade is also a spur for higher labour productivity
- Rising living standards and a reduction in poverty: free trade leads to faster growth over the long
run and have higher per capita income than those that remain closed. Growth through trade directly
benefits the world's poor although free trade is not necessarily equitable
Disadvantages of free trade:
- Increased job outsourcing: reducing tariffs on imports means manufacturing moves from
-
industrialised countries to Industrialising countries due to an increase in cheap labour, the emergence
of TNCs, incentives from governments and increasingly footloose types of manufacturing (can be
manufactured anywhere)
Theft of intellectual property: Many developing countries don't have laws to protect patents and
inventions, and existing laws aren't always strictly enforced.
Crowd out domestic industries: small firms can't compete with subsidised businesses which benefit
from economies of scale in the developed countries. (Infant industry theory) This aggravates
unemployment, crime, and poverty.
Poor working conditions: Multi-national companies may outsource jobs to emerging market
countries without adequate labor protections
Degradation of the global commons: Emerging market countries often don’t have many
environmental protections. Free trade leads to depletion of timber, minerals, and other natural
resources.
Destruction of native cultures and sovereignty: Indigenous cultures can be destroyed and many
suffer disease and death when resources are polluted.
Reduced tax revenue: Many smaller countries struggle to replace revenue lost from import tariffs and
fees.
Increased wealth inequality: richer nations have quaternary and tertiary industries while developing
nations have primary and secondary industries
Competitive advantage: when a business or country produces better quality goods and services at
lower costs or prices than rival, due to research and development leading to innovation, quality of
marketing and product design and quality of after sales service.
Efficiency: If a country is efficient at producing a good, output should be high in relation to the resources
used and price should be low. Goods which another nation cannot produce efficiently should have a high
price. Goods will be bought from the more efficient nation rather than from the less efficient.
Open economy: Trade in goods and services as well as a free flow of financial capital and labour
resources
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Absolute advantage - when one country is able to produce more goods more cheaply in absolute terms
than another country. Country A has an absolute advantage in wheat and B in machines (because they
can produce more of it than they can with the other product).
Comparative advantage - when one country is
able to produce a good more cheaply, in
comparison to other goods produced
domestically, than another country. It was first
developed by Divid Ricardo in 1817. It is a
principle of economics which states that trade
between two countries will be mutually
beneficial as long as their domestic opportunity
costs of production differ and one country is
more productively efficient. If each nation
specialises according to its comparative
advantage, both nations can benefit in the
sense of gaining more goods than they could
have without trade. (Large scale division of
labour)
If both countries PPF curve have the same gradient then the opportunity costs are the same and no
country has comparative advantage and there is no gains from trade.
Assumptions of comparative advantage:
- Perfect mobility of factors of production - resources used in one industry can be switched into another
without any loss of efficiency
- Constant returns to scale (i.e. doubling the inputs in each country leads to a doubling of total output)
- No externalities arising from production and/or consumption
- Transportation costs are ignored
Factors determining comparative advantage:
- The quantity and quality of factors of production available. If an economy can improve the quality of its
labour force and increase the stock of capital available it can expand the productive potential in
industries in which it has an advantage.
- Investment in research & development (important in industries where patents give some firms
significant market advantage)
- Movements in the exchange rate. An appreciation of the exchange rate can cause exports from a
country to increase in price. This makes them less competitive in international markets.
- Long-term rates of inflation compared to other countries. Low inflation causes goods and services
produced by to become relatively more expensive over time. This worsens their competitiveness and
causes a switch in comparative advantage.
- Import controls such as tariffs and quotas that can be used to create an artificial comparative
advantage for a country's domestic producers- although most countries agree to abide by international
trade agreements.
- Non-price competitiveness of producers (e.g. product design, reliability, quality of after-sales support).
Competitive advantage: when a business or country produces better quality goods and services at
lower costs or prices than rival, due to research and development leading to innovation, quality of
marketing and product design and quality of after sales service.
Efficiency: If a country is efficient at producing a good, output should be high in relation to the resources
used and price should be low. Goods which another nation cannot produce efficiently should have a high
price. Goods will be bought from the more efficient nation rather than from the less efficient.
Open economy: Trade in goods and services as well as a free flow of financial capital and labour
resources
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Protectionism
Tariffs: a tax or duty that raises the price of imported products and causes a contraction in domestic
demand and an expansion in domestic supply. Aim to protect domestic industries from overseas
competition
When taxes are included then it leads to price increasing and makes S1 move to S2 and demand
decreases to D2. Therefore imports decrease and tax revenue increases
The welfare loss to society occurs because price has increase so people are forced out of the market as
they cannot afford the product. Overall the government is subsidising domestic producers. In the long
run it is detrimental as they are exposed to competition x-inefficiency
Due to imports being more expensive,
consumers will switch to local goods which will
increase employment. As this goes against
comparative advantage structural change is
slowed. Tariffs can also lead to other countries
introducing tariffs and therefore a tariff war can
occur (political weapon)
Advantages:
- Increases government revenue
- Less demerit goods produced
- Decreases imports – Protects domestic
producers
- Decreases dumping
Disadvantages:
- Increased prices: bad for domestic
consumers
- Less competition: firms may become less
efficient
- Decreased consumer welfare
- Tariff wars may arise
Trading blocs
Regional trading bloc: a group of countries within a geographical region that protect themselves from
imports from non-members. Trading blocs are a form of economic integration
Preferential Trade Areas: (PTAs) countries within a geographical region agree to reduce or eliminate
tariff barriers on selected goods imported from other members of the area.
Free Trade Areas: (FTAs) two or more countries in a region agree to reduce or eliminate barriers to
trade on all goods coming from other members.
Customs Union: involves the removal of tariff barriers between members, plus the acceptance of a
common (unified) external tariff against non-members. This means that members may negotiate as a
single bloc with 3rd parties, such as with other trading blocs, or with the WTO.
Economic union: A common market with a customs union, The participant countries have both common
policies on product regulation, freedom of movement of goods, services and the factors of production
(capital and labour) and a common external trade policy.
Monetary union: two or more states sharing the same currency e.g. European Union
Bilateral trade: the exchange of goods between two nations promoting trade and investment. The two
countries will reduce or eliminate tariffs, import quotas, export restraints, and other trade barriers
Multilateral trade: commerce treaties between three or more nations. The agreements reduce tariffs
and make it easier for businesses to import and export. Since they are among many countries, they are
difficult to negotiate.
15
Common Market: (single market) when member countries trade freely in all economic resources, not
just tangible goods. This means that all barriers to trade in goods, services, capital, and labour are
removed (four freedoms of EU) Non-tariff barriers are also reduced and eliminated. Must be a
harmonisation of micro-economic policies, and common rules regarding monopoly power and other anticompetitive practices. There may also be common policies affecting key industries, such as the Common
Agricultural Policy (CAP) of the European Single Market (ESM).
Advantages
- Free trade within the bloc: members encouraged to specialise and a wider application of
comparative advantage.
- Market access and trade creation: means that trade between members is likely to increase. Trade
creation exists when free trade enables high cost domestic producers to be replaced by lower cost,
and more efficient imports. Because low cost imports lead to lower priced imports, there is a
'consumption effect', with increased demand resulting from lower prices.
- Economies of scale: lead to lower costs and lower prices for consumers.
- Jobs: created as a consequence of increased trade between member economies.
- Protection: Firms inside the bloc are protected from cheaper imports from outside, such as the
protection of the EU shoe industry from cheap imports from China and Vietnam.
Disadvantages
- Loss of benefits: The benefits of free trade between countries in different blocs is lost.
- Distortion of trade: reduce the beneficial effects of specialisation and the exploitation of comparative
advantage in world trade
- Inefficiencies: Inefficient producers within the bloc can be protected from more efficient ones outside
the bloc. E.g CAP,
- Trade diversion: when trade is diverted away from efficient producers outside the trading area.
Retaliation: The development of one regional trading bloc is likely to stimulate the development of
others. This can lead to trade disputes, such as those between the EU and NAFTA, including the recent
Boeing (US)/Airbus (EU) dispute.During the 1970s many former UK colonies formed their own trading
blocs in reaction to the UK joining the European common market.
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World Trade Organisation
The WTO: a multi-lateral organisation and is the only global international organisation dealing with the
rules of trade between nations. They aim to promote free trade, help producers of goods and services,
exporters, and importers conduct their business, allow nations to gain from specialisation and
comparative advantage will arise.The WTO is biased to LEDC’s
Advantages
- promotes peace: disputes are handled constructively
- Lower prices: Free trade cuts the costs of living, raises income, stimulates economic growth and
provides more choice of products and qualities
- Protection: Governments are shielded from lobbying (attempting to influence the decisions of
officials)
- Fair trade: Allows for regional reductions in protectionism, led to an increase in trading blocs (EU)
some poorer countries are allowed to join with existing protectionism measures. E.g. India joined with
tariffs still in place.
Disadvantages
- Increased non-tariff barriers: can’t be proved so they are difficult to stop
- Unrealistic Policy: Free trade policy is based on the assumption of government non-intervention, It
-
also requires the pre-condition of perfect competition, as there is no world government it relies on
negotiations and so can’t be enforced
Non-Cooperation of Countries: Free trade policy works smoothly if all the countries cooperate with
each other and follow this policy, some countries decide to gain more by imposing import restrictions
Economic Dependence: Free trade increases the economic dependence on other countries for
certain essential products such as food and raw materials, can lead to political slavery.
Dumping: goods are sold at very cheap rates and even below their cost of production in order to
capture the foreign markets.
Harmful Products: may be produced and traded, so trade restrictions are necessary to check the
import of such products
Harmful to Less Developed Countries: as less developed countries find it difficult to compete with
the economically advanced countries, gains of trade are unequally distributed depending the terms of
trade which are favourable for developed countries, less developed countries cannot protect infant
industries under free trade.
Commercial imports and exports of goods
17
Unemployment: the number of people of working age who don’t have jobs but are actively seeking work
Natural rate of unemployment: when AD for labour equals AS, voluntary/frictional unemployment
Frictional: voluntary/transitional, caused by people moving between or searching for jobs. Incomplete or
inaccurate information may lead to frictional unemployment
Structural: due to a change in the pattern of demand and production, occurs due to changes in structure
of the economy such as deindustrialisation. Creates a mismatch of skills (occupational immobility) also
occurs due to growth of international competition such as china utilising their comparative labour
advantages.
Geographical: The inability of labour to move to where jobs exist
Seasonal: Casual unemployment resulting from seasonal fluctuations in demand, Occurs when workers
are made redundant on a short-term basis in tourism, catering and construction
Cyclical/demand deficient: Unemployment due to a lack of AD, occurs during a recession as labour is
a derived demand and there is a fall in real national output
Involuntary: Workers willing to accept a job at the going rate but are not offered one
Real wage: When real wages are above their market clearing level, creating an excess supply of labour.
Occurs when wages are set above the market clearing level so supply is greater than demand
Unemployment trap: Where the income tax and benefit system reduces the net increase in income
people can expect from taking paid work. Therefore they would choose not to take a job
Deindustrialisation: A fall in the proportion of national output accounted for by the manufacturing sector
of the economy
Claimant count: people who claim Jobseekers benefits. Excludes over 60’s and government training
schemes
Costs:
- Waste of scarce resources, lost potential output as the economy is operating below its maximum
output.
- Reduces consumer spending as confidence falls, higher MPS, AD goes down
- Higher government spending on benefits, tax revenues will fall.
- Hysterias effect: generates long-term unemployment, damage to skills and employability.
- Increased crime, divorce rates, poorer health and lower life expectancy
- Regions with consistently high unemployment see falling real incomes, increased inequalities of
income and wealth.
Benefits:
- keeps real wage rates down, reduced bargaining power of workers.
- Reduce inflationary pressure.
- Reduced environmental damage and pressure on non-renewable resources if it leads to slower
growth of consumption and production.
Government policies to reduce unemployment
Demand side:
- Expansionary Fiscal policy, increases AD as firms have more money to invest
- Monetary policy: make credit more readily available, increase investments
- Regional policy: stimulate economic activity in worst affected areas, offer employment subsidies or tax
reductions to firms relocating in such areas.
Supply side:
- Improved education and vocational training to increase skills
- Geographical immobility of labour: reduced by improving process of job search, databases and that
there is cheap accommodation where the jobs are.
- Reducing welfare benefits increases incentives, and lower marginal tax rates could be offered to those
who enrol on appropriate training courses.
- Market flexibility: firms find it easier to hire/fire labour, reduced bargaining power, less structural
unemployment
- Technological and infrastructure improvements to increase output and employment
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Capital flows
Capital flows involve the purchase of assets, such as property, assets and government bonds
Reasons for capital flows:
- quick profits: shifting capital to try and take advantage of currency appreciation and depreciation
- Trade finance: loans, foreign grants and investment
- Banks: lending money to increasingly profitable businesses in foreign countries
- Individual transfer funds: for holidays, tax evasion, banking, remittances
- Foreign direct investment: firms can make a profit by investing in foreign firms
- Portfolio investment: for profit motive, partially due to speculation, government loans are a big part
of this
Benefits of Capital Flows:
- Increased Aggregate Demand: As a component of
AD, higher Investment will boost AD, causing
improved economic growth which will lead to lower
levels of unemployment. However, as a percentage of
total Aggregate Demand, inward investment from
MNCs are quite small. Therefore, the impact on AD is
limited. The effect on AD depends on the situation of
the economy, if the economy is close to full capacity,
increased AD may cause inflation.
-Increased productive capacity: Inward investment
increases Aggregate Supply, with new factories
increasing productive capacity, which enables an
increase in economic growth without inflation.
-Technological improvements: MNCs also introduce
new working practices that increase labour productivity.
-Surplus on the Financial Account of the Balance of
Payments: Capital inflows can finance a current account
deficit through attracting capital flows, which enables
households to import more goods and services.
-Lower Prices for Consumers: Investment from foreign
firms means goods are produced more efficiently and
lead to lower prices for domestic firms.
- Finance public sector debt: foreigners buying UK government bonds make it easier and cheaper for
the UK to finance government borrowing.
Disadvantages of capital inflows:
- Potential Capital outflows: if foreign firms increase their capital holdings in the UK, then the U.K.
-
becomes more dependent on other economies. However, it is not possible to insulate the UK
economy from global effects.
Domestic firms lose out to multinational firms: local shops may lose out to bigger chains, leads to
an increased homogenisation of products
Tax avoidance: large multinationals move to countries with the lowest corporate tax rates, the power
of multinational companies to choose the lowest corporate tax rates encourages tax competition which
causes global corporate tax rates to fall in recent decades
Distorted asset markets: Capital inflows can also include the purchase of property and assets which
increases their price, in the property market, it has had the effect of pushing property prices above
long-term price to income ratios making them less affordable for average workers.
Money laundering: foreign money gained by illegal or semi-illegal ways is laundered by investing in
UK property.
19
Balance of Payments: records financial transactions between the UK and the international economy.
Any transactions involving the UK and foreign citizens are calculated in sterling. If the UK has a deficit on
its current account then this could be financed by a surplus on the capital and financial accounts.
Individual sections of the BOP can be in surplus or deficit but the overall balance of payments must
always sum to zero, net errors and omissions are included to ensure that the account does balance.
The BOP is split into three sections:
- Current account: measuring trade in goods and service
- Capital account: transfers such as aid given to foreign countries for capital projects, and the
acquisition and disposal of non-produced, non-financial assets such as land, copyrights and patents
- Financial account: investment flows into and out of the country.
The Current Account
- The current account primarily measures net trade in goods and services. It records the flow of money
between countries not the movement of goods and services.
- The trade in goods: the visible balance and records trade in tangible products
- Trade in service: the invisible balance and measures trade in intangible services.
- Net income: flows of income into and out of the UK, primary income flows, consists of profits, interest
and dividends from other countries as well as remittance
- Net current transfers: secondary income flows, consists of aid, debt relief, military grants and U.K.
payments to the EU
The Financial Account
- Foreign Direct investment: (FDI) flows of foreign direct investment. This involves the transfer of
ownership of UK and foreign businesses e.g. the setting up of a branch of a UK company abroad and
the expansion of a foreign owned firm in the UK, inward investment is positive for the UK Account s
- Portfolio investment: the sale and purchase of UK shares and government securities.
- Banking flows: Short-term monetary flows, known as “hot money flows” takes advantage of exchange
rate changes, will be a credit item on financial account
The Capital Account
- Capital transfers: foreign grant, debt forgiveness or cancellation
- Acquisition/ disposal of non-produced, non-financial assets: the purchase or sale of particular assets
e.g. land, patents, copyrights, franchises and leases purchased or sold by a foreign embassy.
Causes of a current account deficit.
A current account deficit means the UK is spending more on foreign goods and services, than the
spending by foreigners on UK goods and services.
- Strong consumer demand: when real household spending grows quicker than the supply-side of the
economy, leading to a increase in demand for imported goods and services
- High income elasticity of demand for imports: demand for imports grows quickly when consumer
demand is robust.
- Strong exchange rate: reduces the UK price of imports causing an expenditure switching effect away
from domestically produced goods
- Weakness of the global economy: slow growth in the Eurozone has damaged UK export growth.
Nearly 50-60% of UK manufactured goods and services are to fellow members of the EU.
- Comparative advantage: trade balances are affected by shifts in the international economy e.g. the
rapid growth of China who has a cost advantage in exporting manufactured products.
- Availability of imports: cheaper imports from foreign countries cause a substitution effect
- Supply side deficiencies: impact the price and non-price competitiveness of British products in global
markets, non-price competitiveness factors such as design and product quality are now more important
for trade than merely price alone
- Productivity gap: linked to low investment and also to the existence of a skills-gap between UK
workers and employees in many other countries (structural factors)
- Little innovation: low rate of business sector spending on research and development.
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Policies to reduce a current account deficit
Devaluation:
reducing the value of the currency against others, If there is a devaluation of the currency, the price of
imported goods increases and quantity demanded of imports falls, Exports become cheaper, and there
will be an increase in the quantity of exports which leads to an improvement in (X-M) and therefore the
current account on the balance of payments. However, it does depend upon the elasticity of demand for
exports and imports and UK firms need to have spare capacity in order to satisfy extra demand for
abroad
The Marshall Learner Condition: a devaluation
will improve the balance on the current account, on
the condition that the combined elasticity’s of
demand for imports and exports is greater than one.
If (PED x + PED m > 1) then a devaluation will
improve the current account.
If (PED x + PED m < 1) then an appreciation will
worsen the current account.
The J Curve effect: In the short term, demand for
imports and exports tends to be inelastic. Therefore,
after a devaluation, the current account tends to get
worse before it gets better. However, over time,
demand becomes more price elastic and the current
account improves.
Inflation: devaluation can lead to inflation, so
imports become more expensive. Higher inflation reduces the countries competitiveness, therefore the
improvement in the current account might only be temporary.
Uncertainty: changes in the exchange rate lead to uncertainty in the trade market. Firms involved in
importing and exporting find it difficult to estimate profit margins as they do not know the exchange rate
Import controls:
- Overt controls such as Tariffs, Quotas or Embargo’s
- Health and Safety legislation: Harsh health and safety standards often differ from those operating in
the exporting countries and can raise exporters’ costs, do decrease supply.
- Customs procedures: increased paperwork at borders create delays which increase difficulty and costs
- Export subsidies: subsidising domestic industries to protect from foreign competition.
Disadvantages: Direct controls interfere with specialisation of labour as they can reduce another
country’s comparative advantage, which leads to retaliation or trade wars
Supply side policies:
- Education and health care: increases competitiveness, needed for future economic growth and
global competitiveness, particularly in scientific fields such as engineering, medicine, finance and
business
- Scientific research and development: Exports have increasingly depended on scientific innovative
new technologies. Copyright and patent protection means one country will increase exports
- Transportation and communication infrastructure: To remain competitive in the global economy
domestic firms must have efficient transportation and communication infrastructure available.
Supply side policies improve the balance of payments by making UK products more competitive, hence
reducing imports and increasing exports, however such policies can be socially divisive and take a long
time to have any impact on the economy.
21
Deflation:
Deflation: a reduction in the level of economic activity in an economy. It involves a fall in aggregate
demand which can lead to falling incomes, loss of jobs, falling profits, less spending and a recession.
By reducing the level of economic activity, the level of spending decreases, imports decrease, and the
current account improves. Deflation can also result in a fall in the UK price level which will make exports
more competitive on the foreign market, hence higher export sales. The higher our Marginal Propensity
to Import the more imports will fall when national income decreases.
Advantages: useful when the economy has a current account deficit at the same time when it is
overheating with high aggregate demand and high inflation, therefore deflation will improve the account
deficit while reducing inflation and AD
Disadvantages: output and wealth will fall due to a fall in production, employment and economic growth
will fall due to a decrease in businesses confidence and investment.
Spare Capacity: any extra demand created for domestic firms must be accommodated by domestic
industries, firms need to have spare capacity in order to satisfy extra demand for abroad, exports need
to have elastic price elasticity of supply.
Exchange Rates:
Floating Exchange Rate System: determined by market forces. If demand for the currency rises, so will
the exchange rate, if supply increases, exchange rate will fall. Due to PPP, the price of one good should
cost the same in another country, because the exchange rate will adjust until a unit of currency can buy
exactly the same amount of goods and services as a unit of another currency.
Advantages:
- will automatically adjust so supply equals demand, which will eliminate balance of payments deficits or
surpluses without any government intervention.
- No need for a central bank to keep foreign reserves
- reduces speculation, because speculators might lose and so do not take the risk.
Disadvantages:
- causes instability, which will deter investment and trade.
- can lead to inflation, a fall in demand for currency and a fall in exchange rate will make a country
- competitive but makes imports more expensive, which in the long run will lead to more cost-push
inflation.
- Speculation on future movements can lead to major changes in the rate.
Fixed Exchange Rate System: This is one where the parity of the currency is pegged against other
currencies. If the parity comes under threat by market forces, the central bank (controlled by the
government) will step in to maintain he value by buying or selling the currency and/or changing its rate of
interest.
Advantages:
- stability for firms and households, this will increase investment and trade.
- act as a constraint on domestic inflation.
Disadvantages:
- A government must have sufficient reserves to intervene to maintain the price of its currency.
- A country’s firms may be uncompetitive if the exchange rate is fixed at too high rate.
- The government must make intervention priority. This may mean it undertakes policies which damage
the domestic economy
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Factors determining a currency’s value:
- Inflation Rates: A country with a lower inflation rate than another's will see an appreciation in the
value of its currency.
- Interest Rates: Increases in interest rates cause a country's currency to appreciate because higher
interest rates provide higher rates to lenders, which increases FDI
- Country’s Current Account / Balance of Payments: A deficit in the current account due to importing
more products than it exports causes depreciation.
- Government Debt: A country with government debt is less likely to acquire foreign capital, leading to
-
inflation. Foreign investors will sell their bonds in the open market if the market predicts government
debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.
Terms of Trade: A country's terms of trade improves if it exports more than it imports which causes a
higher demand for the country's currency and an increase in its currency's value.
Political Stability & Performance: A country with less risk for political turmoil is more attractive to
foreign investors, so there is an increase in foreign capital, which leads to an appreciation in the value
of its domestic currency.
Recession: When a country experiences a recession, its interest rates are likely to fall, so its currency
weakens in comparison to that of other countries, therefore lowering the exchange rate.
Speculation: If a country's currency value is expected to rise, investors will demand more of that
currency in order to make a profit in the near future. As a result, the value of the currency will rise due
to the increase in demand.
Effects of a devaluation:
- cheap Exports: exports will be more competitive, increases demand for exports.
- Expensive Imports: means imports, such as petrol, food and raw materials will become more
expensive
- Increased aggregate demand: devaluation could cause higher economic growth. Part of AD is (X-M)
therefore higher exports and lower imports should increase AD
- Inflation: expensive Imports cause cost push inflation, increased AD causes demand pull inflation
- Improvement in the current account: With exports more competitive and imports more expensive,
exports will increase and imports will decrease which will reduce the current account deficit.
- Wages: A devaluation in the Pound makes the UK less attractive for foreign workers, U.K. firms may
have to push up wages to keep foreign labour.
- Falling real wages: In a period of stagnant wage growth, devaluation can cause a fall in real wages if
the inflation rate is higher than wage increases, then real wages will fall.
Purchasing Power Parity: is the exchange rate needed to buy the same quantity of products in each
country.
The Big Mac Index: looks at the implied PPP exchange rates between countries and the actual
exchange rates and uses this data to see if a currency is under or over-valued against the US dollar.
Economic development
Economic Growth: a steady growth in the productive capacity of the economy, resulting in a growth of
national income
Economic Development: The sustained, concerted actions of policymakers and communities that
promote the standard of living and economic health of a specific area.
Objectives:
Economic Growth: Sustainable Growth, Stable Inflation, High Employment, Maintaining Balance of
Payments Current Account, Low income inequality
Economic Development: Provision of Basic needs, high Standards of Living
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Measurements:
Economic Growth: GDP(Total value of goods and services provided in a year), Real GDP (adjusted for
inflation), GNP(gross domestic product plus the net income from foreign investments)
Economic Development: HDI, access to healthcare and safe water, child mortality, Birth rate, Mortality
rate, Human poverty index, equality, education
GNP: easy for comparisons, monetary indicator only, requires a common basket of goods
HDI: (GNP per capita, life expectancy, literacy rate, mean years of schooling) includes monetary and
social indicators, all equally weighted, only available since 1990
HPI: many social indicators excluded by HDI, focuses on deprivation, hard to weight
Constraints: population age structure, financial and human capital, political instability and corruption,
missing markets, barriers to trade, infrastructure, fund allocation
Costs: high inflation, Pollution, income and regional inequality, balance of Payments deficit, destruction
of the commons
Limits to Growth and development:
- Lack of infrastructure: difficult to attract FDI, makes trade and investment harder and more risky
- Income distribution: creates a poverty trap, low GDP per capita means little saving by individuals,
which limits investment and prevents economic growth from occurring.
- Corruption and war: diversion of resources by government, can lead to a inefficient allocation of
resources and restrains development, leads to a destruction of infrastructure and people.
- Population growth: rapid population growth means income per capita falls, due to high birth rates
and slowing death rates which strains an economy
- Diseases: reduce the working population, loss of highly skilled workers and productivity, Resources
are diverted from growth to treating diseases and improving health.
- Education: Countries with little education investment and low school enrolment are likely to have low
productivity and little economic growth.
- Debt servicing: LEDCs borrowed in 1980s. Since then, fall in value of their currency, compared to $,
so have to pay back more; oil prices have increased.
- Capital flight: companies and individuals place cash, buy shares and assets abroad, contributing to
savings gap, and reduces tax to government.
- Trade: due to sanctions or ideological reasons, reduces development and slows growth due to a lack
of comparative advantage
Influencing growth and development
Role of international institutions and non-government organisations (NGOs)
- World Bank: loans to member countries, promotes economic and social progress by raising
productivity and reducing poverty, supports education, helping the rebuilding of countries after natural
disasters.
- International Monetary Fund (IMF): promotes monetary cooperation between nations, helps free
trade, promotes exchange rate stability,
- NGOs: funded by governments, firms or private individuals, voluntary groups which aim to raise the
voices of ordinary citizens focus on particular issues such as human rights, healthcare or environment.
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Market-orientated strategies: make the economy more free, with minimum government intervention.
- Trade liberalisation: reducing protectionist barriers, such as tariffs, quotas or regulations. World GDP
increases which improves living standards and economic growth.
- Promotion of FDI: flow of capital from one country to another, to gain an enterprise in the country,
FDI can increases employment, encourage innovation ams promote long term sustainable growth. o
- Removal of government subsidies: There could be an inefficient allocation of resources because
the market mechanism is not able to act freely.
- Floating exchange rate systems: The value of the exchange rate in a floating system is determined
by the forces of supply and demand.
- Privatisation: assets are transferred from the public sector to the private sector, firms operate
efficiently, which increases economic welfare. Because of a profit incentive, increased allocative
efficiency as goods are better quality, revenue is raised for the government.
Interventionist strategies: government intervenes in the market to influence growth and development.
- Development of human capital: improved productivity, innovation and skills, businesses struggle to
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expand where there are skills shortages, a country can move their production up the supply chain
from primary products, to manufactured goods and to services, which can earn them more.
Protectionism: reduce a trade deficit because imports fall due to tariffs and quotas on imports,
protects infant industries, usually short term until the industry develops, protectionism could distort the
market and lead to a loss of allocative efficiency, and a loss of consumer welfare due to higher prices
and less variety, firms have little incentive to lower costs of production, could start tariff wars
Managed exchange rates: currency fluctuates, but it does not float on a fully free market as the
central bank of the country buys and sells currencies to try and influence their exchange rate.
Infrastructure development: Improving transport, energy, water and telecommunications, reduces
travel times, increases labour mobility, makes trade easier
Joint ventures: between two firms based in multiple countries, allow the firm to participate in
international trade, transfer of technological knowledge, open up new markets for small firms
Buffer stock schemes: government intervention to reduce price volatility, increases consumer
welfare by ensuring fair prices, High administrative and storage costs.
Other strategies:
- Industrialisation: (Lewis model), in agriculture, there is a surplus of unproductive labour in
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developing economies, Workers from agriculture are attracted to the higher wages in the
manufacturing sector, profits are invested into more fixed capital for the business so demand for
labour increases since the productive capacity of firms has increased, in reality, profits might not be
reinvested into the firm, capital investment might replace labour, and there could be an immobility of
labour.
Development of tourism: diversifies the economy, more attractive to FDI, develops infrastructure.
However, little revenue is retained in the country, issue of overcrowding and the loss of habitats,
Income from tourism is likely to be unstable, since it relies heavily on the business cycle in developed
countries.
Development of primary industries: due to comparative advantage in production.
Fairtrade schemes: ensure that farmers can receive a fair price for their goods, helps support
community development and social projects, working conditions meet a minimum standard.
Aid: reduce human capital inadequacies or to pay off debt. It can improve infrastructure, which can
help make the country more productive, benefits of aid are limited by corrupt leaders, the size of the
aid payment and the potential for the recipient country to become dependent on aid.
Debt relief: partial or total forgiveness of debt, with high levels of debt financial resources are
diverted from infrastructure, education and healthcare
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Wealth and income
Wealth: a stock concept, a measurement of an individuals, firms or country’s assets at a given time,
assets include shares houses, land etc
Income: a flow concept, a flow of money going to factors of Production, wages/salary is income to
labour, rent is income going to land, Income is earned through wages, benefits, rent, interest
Factors affecting the distribution of income:
- Factors of Production: earning from labour has not risen as fats as earning from land and
entrepreneurship, rent rising faster than wages
- Earned vs unearned Income: assets generate income with little effort required, higher wealth
increases unearned income
- Wage-salary differentials: difference between top and bottom earners, increasing in recent years
- Globalisation and migration: Increased freedom of movement of goods and labour has widened the
gap between rich and poor, Increased competition exerts downward pressure on wages
- Welfare benefits: government intervention reduces income inequality, can create a poverty cycle as
people earn more through benefits than by working (unemployment trap)
- Skills and qualifications: high demand skills earn more than lower skilled jobs, lifetime earnings of
graduates are higher than dropouts
Factors affecting distribution of wealth:
- Capitals gains: Increased value of an asset, increases with wealth as richer people are more likely to
own their own house and have more assets
- Pension assets: money in pension, non-marketable
- Inheritance, gift, luck: old money (inherited rather than earned) or wealth from winning the lottery
- Taxation: both income and wealth are taxed, income tax is much more than wealth tax, wealthy are
often able to avoid losing wealth through taxes due to accountancy loopholes
- Income inequality: High earners can better save and earn interest, and build up higher wealth
- Although everyone is becoming richer is absolute terms, the richer have more assets and wealth to
invest and increase their income and wealth
- When am economy grows, business owners become richer
Equality: everyone gets the same e.g, same wage
Equity: distribution seen as fair, normative statement, e.g. CEO
earns more than a junior member of staff, but not to an obscene
amount
Lorenz curve: way of graphically showing level of income
inequality in a population. The closer the Lorenz curve is to the line
of equality the more equal the distribution of income is, the relative
size of the gap is called the Gini Coefficient which is:
A/(A+B) it is between 0 and 1, with higher values meaning
inequality is greater and 0 meaning perfect equality
Intervention:
- Taxation: Progressive taxes take a higher percentage of the income or wealth of the rich to make the
distribution more equal, Regressive taxes such as V.A.T. take a higher percentage of the income of
the poor and thus make the distribution more unequal
- Monetary Benefits: either means-tested or universal
- Means-tested: working families tax credit, only available to those who can prove their income is
below a certain level
- Universal: Benefits available to everyone in a particular group, regardless of income
- Provision of goods & services: e.g. health care, education, school meals, Gives all citizens equality
of opportunity
- Legislation and labour market policy: Introduction of a NMW, anti-discrimination, supply side
policies such as training serve to reduce income inequality
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