Economics:
Chapter 1:
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Basics:
− Fundamental economic problem – we have scarce resources trying to satisfy unlimited wants
− This results in the problem of scarcity (wants and needs are in excess of resources available)
and therefore the inevitability of choices at all levels (individuals, firms and gov.)
− Scarce resources (factors of production):
o Land – natural resources in an economy (surface of earth, lakes, rivers, forests and
mineral deposits). Reward is rent (income)
o Labour – human resources available in an economy. Reward is wage/salary
o Capital – man-made aid to production. Reward is interest
o Enterprise/entrepreneur – organises production and is willing to take risks. Reward is
profit
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Production and consumption:
− Production – process of creating goods and services in an economy
− Consumption – process by which consumers satisfy their wants
− Economic goods – goods which require resources to be produced and obtained which
therefore causes an opportunity cost
− Free goods – goods which require no resources to be produced and obtained and therefore
have no opportunity cost (eg: sunlight)
•
Opportunity cost – cost expressed in terms of the best alternative option that is given up
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Basic questions:
− What to produce – because we cannot produce everything
− How to produce – how to get max use out of available resources and keep costs low (ethical
choices as well)
− For whom to produce – cannot satisfy everyone’s wants
•
Ceteris paribus – refers to a situation where all other things remain equal
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The margin:
− A small change in one economic variable will lead to further small changes in other variables
− Looking at things in this marginal way allows us to predict what the impact of a change might
be
•
Time:
− Short run – time period where a firm can only change some but not all factor inputs
− Long run – time period where all factors of production are variable
− Very long run – time period when all key inputs into production are variable (eg: technology,
gov. regulations and social considerations)
•
Positive and normative statements:
− Positive – one that is based on actual evidence/facts
− Normative – based on opinion (subjective about what should happen)
•
Specialisation and exchange:
− Specialisation – process where individuals, firms and economies concentrate on producing
goods and services they have the advantage in
− This results in exchange of goods and services
•
Division of labour:
− Where manufacturing process is split into a sequence of individual tasks
− Although it raises output it may cause dissatisfaction amongst the workforce as they become
deskilled and bored with monotonous work
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Resource allocation in different economic systems:
− Economic structure – way in which an economy is organised in terms of sectors (primary,
secondary, tertiary and quaternary)
− Economic system – means by which choices are made in an economy (market,
command/planned and mixed)
− Market economy:
o Most decisions on how resources are allocated are taken through market forces
(demand and supply)
o Prices act as an indicator of market value of particular resources (short supply and high
demand means high prices and vice versa)
o Market mechanism – where decisions on price and quantity are made based on
demand and supply alone
o What to produce – price mechanism; how to produce – least cost combination; for
whom to produce – purchasing power
o Adam Smith came up with ‘invisible hand’ (price system)
o Efficiency, consumer sovereignty, quick response and profit incentive
o Gov. has very restricted part to play, very few public goods present, info failure,
overconsumption of demerit goods, negative externalities and unemployment of
resources
− Planned economy:
o Resource allocation decisions are taken by a central body (gov.)
o Central planners determine the collective preferences of consumers and manufacturing
enterprises
o Unemployment not an issue
o Gov. helps with redistribution of income, planning long-term growth of an economy
and takes responsibility for the ownership of most productive resources and property
o No profit motive like there is in market, provision of public goods, merit goods
encouraged and demerit discouraged and vulnerable groups are protected
o May be no incentive to work, low production, low competition and therefore low
efficiency, too many capital goods and lack of consumer sovereignty
− Advantages of a mixed economy:
o Price mechanism allowed to operate in many areas allowing for rationing, signalling
and transmission of preference
o Gov. is able to intervene in the market (eg: max and min pricing)
o Some industries may be nationalised by gov.
Issues with transition:
− Transitional economy – one which is moving from a planned economy to mixed where market
forces have greater importance (it can be the other way around)
•
•
•
− Inflation may occur, industrial unrest, fall in output, unemployment, balance of payments
deficit and reduction in welfare services
− Certain products may be under-provided and under-consumed (some may be the opposite)
− Some products won’t be provided at all
− Consequences of info failure
Benefits of transition:
− Price mechanism
− Prices indicate consumer preferences
− Private sector ownership and decision making with little gov. intervention
− Competition can lead to greater efficiency
Production possibility curves (PPCs):
− Representation of max level of output an economy can achieve when using all of its existing
resources
− It illustrates the choices open to an economy and the opportunity cost
− When calculating opportunity cost you put the good you’re calculating the opportunity cost of
at the bottom (eg: calculate the opportunity cost of red lipstick – red will be at the bottom of
the fraction line. If the answer is 3 then you need to give up 3 of the other colour to produce 1
more red lipstick)
−
−
−
−
−
Point X is not achievable
Point A is achievable but means there is unemployment if resources or there is inefficiency
Moving from C to D to B involves a reallocation of resources
Factor mobility – ease by which factors of production can be moved around
It’s curved because it represents increasing opportunity cost (extra production of one good
involves an ever-increasing sacrifice of another as less suitable economic measures have to be
diverted into the production of the former, increasing marginal cost and decreasing
productivity)
− Straight line is when opportunity cost is constant (same sacrifice each time)
− Investment – creation of capital goods in the process of production
− Capital consumption – capital required to replace that which is worn out
− Looking at opportunity cost:
•
Shifts in PPCs:
− Gaining or losing resources as well as a change in quality of resources and technical knowledge
can cause shifts
− Economic growth caused by increased quality or quantity of resources (expansion):
o Increased labour supply
o Improvements in human capital
o Improved resource management
o Privatisation – adds extra on to what gov. can do (eg: if eskom became privatised)…
increased pop. and demand
− When only the ability to produce one product has improved (could be a technological
breakthrough):
− PPC contraction due to fall in resources or a change in the available technology:
•
Money:
− Anything that is generally acceptable as a means of payment
− Functions:
o Medium of exchange
o A unit of account
o Standard for deferred payment (offering credit)
o A store of wealth/value
− Characteristics:
o Durability
o Portability
o Divisibility
o Uniformity – all the same… eg: all R50 notes are the same
o Limited supply and acceptability
− Barter – direct exchange of one product for another (instead of money).
− Advantages over barter:
o Avoids double coincidence of wants
o Permits evaluation
o Enables giving change
o Eases saving
− Cash and bank deposits
− Cheques
− Near money – non-cash assets that can be quickly turned into cash
− Liquidity – extent to which there is an adequate supply of assets that can be turned into cash
to pay off debts
•
Classification of goods and services:
− Free goods – ones with zero opportunity cost because consumption is not limited by scarcity
− Private goods (economic goods):
o consumed by someone for their own benefit and not available to anyone else
o excludability – it is possible to exclude someone from consumption
o rivalry – consumption by one person reduces the availability for others
− Public goods:
o One that is non-excludable and non-rival and for which it is usually difficult to charge a
direct price
o Free rider issue – someone does not pay to use public good (eg: one person pays to
produce a lighthouse and lots of other people benefit from it without paying for it)
•
Merit and demerit goods:
− Merit good – one that has a positive side effect when consumed
− There is info failure (where people don’t have full or complete info and don’t realise how
good/bad a product is). Eg: education
− Demerit goods – one that has adverse side effects when consumed
− Eg: junk food
Chapter 2:
• Price mechanism:
− The way in which resources are allocated in a market economy
− The profits of a good/service affect demand and supply
− There are 3 types:
1. Signalling- prices act as a signal to producers & consumers
2. Rationing- if producer wants to retain exclusivity, they may limit supply (which drives
its price up and restricts its demand)
3. Transmission of preferences- if consumers don’t buy product due to not liking it or its
price then this message will be transmitted back to producer
•
Demand:
− Quantity of a product that a consumer is willing to buy at various prices in a certain time frame
− Demand (&supply) are also referred to as market forces or the invisible hand
− Law of demand: rise in price, fall in demand
− Notional demand- want to buy a good but don’t actually have the ability to do so (notional
demand for sports cars is high but ability to buy is low)
− Effective demand- demand that is supported by the ability to pay
− Products in joint demand are consumed together (complements)
− Products in alternative demand are those whose consumption reduces the need for the other
product (substitutes)
− Demand curve: (represents relationship between quantity demanded and price)
− Contractions/extensions are movements along the curve due to price changes
− Shifts are movements of the whole curve due to changes in conditions (change in demand)
− Factors influencing demand:
o Disposable income (Increase will increase the demand). As income increases demand
for normal goods will rise and demand for inferior good will decrease
o
o
o
o
o
•
Price and availability of substitutes and complements
Fashion, tastes and attitudes
Pop. structure
Taxes and subsidies
Price speculation (Buying an asset in hope that its worth will increase in the future)
Supply:
− The quantity of a product producers are willing and able to produce and sell at different prices
per time period
− Law of supply- rise in prise, rise in supply
− Notional/effective supply (same as demand but on the producing side of the economy)
− Joint/alternative supply (same but on supply side)
− Supply curve:
− Factors influencing supply:
o Costs of production
o Size and nature of industry (if it is growing then more will be supplied)
o Price of related products (be aware of competitors)
o Gov. policy (taxes and subsidies)
o Climate and technology
o Availability of resources
•
Elasticity:
− Price elasticity of demand:
o Measures the responsiveness of the quantity demanded to a change in price (lower
elasticity gives a steeper gradient of the demand curve)
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
o PED=
o
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
PED values:
▪
▪
▪
▪
>1 - Elastic (quantity does change)
<1 - Inelastic (quantity doesn’t change)
-∞ - Perfectly elastic (all that is produced is sold at a given price)
0 – Perfectly inelastic (change in price has no effect on quantity demanded)
▪
o
−
=1 – unitary (change in price is relatively the same as change in quantity
demanded)
Factors affecting PED:
▪
Range and attractiveness of substitutes (if price rises and it is easily substituted
then it will be an elastic product)
▪
Relative expense of product (rise in price will decrease purchasing power of
consumer’s income and therefore demand)
▪
Time (if it’s only short term then consumers may not change spending patterns
but may change them if it’s long term)
▪
Degree of necessity
Income elasticity of demand:
o How quantity demanded changes due to a change in income
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
o YED=
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
o (-)ve value means it is an inferior good
o (+)ve value means it is a normal good
−
Cross elasticity of demand:
o How quantity demanded for one product changes due to a change in price of another
related product
%𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝐴
o XED=
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝐵
o (-)ve value means they’re complements
o (+)ve value means they’re substitutes
−
Business relevance of demand elasticities:
o PED helps understand how changes in price impact consumer expenditure, sales
revenue and gov. indirect tax receipts
o Knowing YED helps forecast future demand for a range of goods & services (eg:
incomes rising in China has caused an increase in demand for cars)
o If YED for normal good is >1 then demand will be expected to grow more rapidly than
consumers’ incomes
o If YED is (-)ve in the case of inferior goods the demand will be expected to fall when
economy is doing well and rise when in a recession
o XED will identify which products are most complementary (business can then create a
pricing structure for these goods that generates most revenue)
o
−
−
To increase revenue elastic goods should decrease in price and inelastic goods should
increase in price
Limitations of elasticities:
o Irrelevant and unreliable data
o Unrealistic assumptions
o Leaving out product capacity and total cost
Price elasticity of supply:
o How quantity supplied changes with the price of the product
o
o
o
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
PES=
%𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
Values are same as PED
Factors influencing PES:
▪
Ease with which businesses can accumulate or reduce stocks (easier they can do
this the higher the PES)
▪
Ease with which they can increase production (in short run businesses with
spare productive capacity will tend to have higher PES). AKA allocative efficiency
▪
Time (over time business can increase their productive capacity/ firms may
leave industry which increases the flexibility of supply)
▪
o
Number of firms in market
Business relevance of PES:
▪
Shows how quickly and easily businesses can respond to changes in market
conditions (if a business has spare capacity it can quickly hire more factors of
production)
▪
▪
Helps make decisions on how much stock to hold
Can help business decide on the factors of production it’s going to need
•
Interaction of demand and supply:
− Equilibrium price: price where demand and supply are equal, where the market clears
(equilibrium quantity is the amount traded at this price)
− Disequilibrium: situation where demand and supply aren’t equal
− Prices signal surpluses/shortages, ration resources to uses and transmit preferences by
encouraging producers to produce according to demand
•
Consumer and producer surplus:
− Consumer surplus – the difference between the value a customer places on units consumed
(price they’re willing to pay) and the payment needed to actually purchase that product. It
arises because some consumers are willing to pay more than the given price for all but the last
unit they buy – because there’s no more they can buy… so there’s nothing above this point
−
Producer surplus: the difference between the price a producer is willing to accept and what is
actually paid.
Chapter 3:
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Government intervention usually takes place when there is market failure (where the free market
doesn’t make the best use of scarce resources)
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Max and Min prices:
− Max prices – a fixed price that the market must not exceed (below equilibrium price)
− Max prices create a shortage as the producers cannot supply as much
− Max prices usually on:
o Cheap essentials
o Rent control
o Services provided by utilities (water, gas and electricity)
o Transport fares (especially where a subsidy is being paid)
− Max prices may result in corruption forming and a black market for certain products being
made
− Min prices – fixed price that the market must not go below (above equilibrium)
− This creates a surplus (min prices aim to reduce consumption in order to enhance the
consumers’ welfare) and gov. action may be required to buy the excess or restrict production
− Imposed on:
o Demerit goods
o Wages in certain occupations
o Certain types of imported goods where domestically produced close substitutes are
available
− Min prices may result in smuggling and unemployment increasing
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Taxes:
− They are charges imposed on people and businesses by gov.
− Purpose is to:
o Raise money for gov. spending (public goods, administration, welfare benefits,
subsidies)
o Reduce demerit goods and increase merit goods
o Redistribute income
o Release resources
o Discourage imports
o As an intervention to correct market failure
− Adam Smith’s canons of taxation (classifying “good” tax):
o Equitable- those who can afford it should pay more
−
−
−
−
−
o Economic- revenue should be > than cost of collection
o Transparent- tax payers should know exactly what they’re paying
o Convenient- easy to pay
Direct taxes – one that taxes the income of people and firms (cannot be avoided). Eg: income
tax, corporation tax on profits and national insurance contributions paid by employers and
employees
Direct taxes may help create economic stability but can discourage saving and effort
Indirect taxes – a tax that is levied on goods and services (can be avoided for the most part).
Eg: value-added tax (VAT) on goods and services, excise duties (taxes imposed on goods
produced within a country… as opposed to customs duties on goods that are imported) on
fuel, alcohol and tobacco products.
Indirect taxes help redistribute income, are difficult to evade, discourage imports and
discourage demerit goods but reduce consumer surplus, may move demand abroad and
distort choice (effect depends on PED)
Two main types of indirect taxes:
o Ad valorem taxes – they are a proportion or % of the price charges by a retailer (VAT or
general sales tax (GST used in USA))
o Specific tax – a fixed amount per unit purchased (Used to tax fuel, cigarettes and
alcohol). It is based on a measurable quantity such as per litre)
− Incidence – the extent to which the tax burden is borne by the producer/consumer/both
− Extent to which the producer is able to pass on tax by raising prices depends on the elasticity
of demand (more inelastic it is the easier it is to pass on the burden to the consumers… which
explains why things like fuel are so heavily taxed)
− Average rate of taxation is the average % of total income that is paid in taxes (all forms of tax
are included in calculation)
− More equitable for poorer income groups to have a lower average rate of tax
− Marginal rate of tax is the proportion of an increase in income that is paid in tax… amount of
additional tax paid for every dollar increase in income (in a progressive tax system the
marginal rate will be greater than the average rate… resulting in a more equal distribution of
income)
− Proportional tax – tax that takes the same proportion/% from all who have to pay
− Progressive tax – takes a higher % from those with higher incomes
− Regressive tax – takes a greater % from those with lower incomes
− Negative income tax – people below a certain level of income receive money from gov. rather
than paying taxes)
•
Subsidies:
− Direct payments made by gov. to producers
− It creates a fall in cost for supplier
− Reasons:
o Keep down the market price of essential goods
o Encourage greater consumption of merit goods
o Contribute to a more equitable distribution of income
o Provide services that free market won’t supply
o Raise producer’s income
o Decrease imports by paying subsidies to local suppliers
o Provide opportunity for exporters to sell more
•
Transfer payments:
− A hand-out or payment made by the gov. to certain members of the community (come from
tax revenue)
− Main recipients are vulnerable groups (elderly, disabled, unemployed and the very poor)
− Transfers income from those able to work and pay taxes to those who can’t
− Examples:
o Old age pensions
o Unemployment benefits
o Housing allowances
o Food coupons
o Child benefits
− Aim to redistribute income and decrease poverty but unemployment benefits and those alike
may create a disincentive to work (may receive more than when they’re working)
•
Direct provision of goods and services:
− Providing certain services free of charge to customers
− If these services are equally used by all citizens, then the lowest income groups gain the most
as a % of their income (lowers inequality)
− Most common include health care and education
− Criticisms include: the market overprovides (especially where no direct charge is made),
resources aren’t allocated efficiently and some say many consumers can afford to pay (and the
money could be used elsewhere or tax could be reduced)
•
Nationalisation and privatisation:
− Nationalisation – when gov. takes over private sector business and transfers it to public sector
− Arguments to support nationalisation:
o Long-standing socialist view that certain services (eg: railways, bus service, airports and
electricity) are for the benefit of the public and should therefore be provided by the
public sector
o Any profits are reinvested in business to benefit the public
o Employees feel a sense of ownership and work hard to ensure financial viability
o Nationalised industries are more likely to provide loss-making services for social
reasons
o Helps reduce income inequalities
o Private monopolies are prevented
o Avoids wasteful duplication
o Cost-benefit analysis is involved
− However, it may be inefficient, it is non-competitive, a SOE (state-owned enterprise) monopoly
may develop and there is limited scope for an increase in long term investment
− Privatisation- sale of state-owned sector business to private sector
− Privatisation also includes:
o Deregulation through the removal of barriers to entry (which had protected public
sector from outside competition)
o Franchising to give a private sector owner the right to operate a particular service
(franchise might be an exclusive one or competition may be experienced)
− Advantages of privatisation:
o Can help widen share ownership amongst the pop. and among the employees
o Benefits to consumers: lower prices, wider choice and better quality
o Sale of nationalised industries generates income for gov.
o More efficient than SOE
o Enterprise is encouraged
− However, private monopolies may occur, regulations may be needed, unemployment may
increase and wasteful duplication can occur
− Gov. failure occurs when gov. intervention reduces economic performance rather than
increasing (failing to correct market failure) due to:
o Imperfect information
o Policy conflicts
o Political mileage (doing it simply for political gains)
o Corruption
Chapter 4:
•
Aggregate demand and aggregate supply:
− Aggregate demand: total spending on an economy’s goods and services at a given price level in
a given time period
− AD=C+I+G+(X-M)
− C- consumption (AKA consumer expenditure)
− I- investment (spending by private sector firms on capital goods)
− G- gov. spending
− (X-M)- net exports
− Why the AD falls when price level rises:
o The wealth effect- rise in price level reduces the amount of goods a person’s wealth
can buy (purchasing power)
o The international effect – rise in price level reduces demand for exports (they become
expensive) and increases demand for imports
o The interest rate effect – rise in price level increases demand for money to pay these
higher prices… this increases interest rate and results in a reduction in consumption
and investment
− Examples causing a shift to the right of AD (changes in non-price level influences that cause an
increase in demand):
o Rise in consumer confidence
o Cut in income tax
o An increase in wealth
o Rise in money supply
o Increase in pop.
o Rise in business confidence (increased investment)
o Cut in corporation tax
o Advances in technology
o Increase gov. spending to stimulate economic activity and win political support
o Fall in exchange rate (weaker currency – it depreciates and is worth less compared to
other countries)
o Rise in quality of domestically produced products
o Increase in incomes abroad (exports increase)
− Movements along the curve are due to changes in price alone
− Aggregate Supply – total output (real GDP) that producers in an economy are willing and able
to supply at a given price level and time period
− Short-run AS – total output of an economy that will be supplied when there has not been
enough time for the prices of factors of production to change
− Long-run AS – total output of a country supplied in the period when prices of factors of
production have fully adjusted
− As prices increase producers are willing to supply more. Three possible reasons for this positive
relationship:
o The profit effect – as price level rises the prices of FOP don’t change in the short run
(the gap between output and input prices increases) and profit increases
o The cost effect – although wages and raw materials don’t increase in cost in the short
run, avg costs may rise with increased output (to cover any extra costs involved in
higher output producers will require higher price)
o The misinterpretation effect – producers may confuse changes in price levels with
changes in relative prices (may think that a rise in the price they receive for their
products means that their own product is becoming more popular and they may
produce more)
− Shifts in the SRAS curve:
o Change in price of FOP – rise in wage rates that’s not matched by an increase in labour
productivity (shifts the curve to the left)
o Change in taxes on firm – reduction in corporation tax or indirect taxes causes an
increase in SRAS
o Change in factor productivity/quality of resources – rise in labour/capital productivity
causes an increase in AS in short and long run
o Change in quantity of resources – in short run the supply of inputs may be affected by
supply side shocks like natural disasters (these may not have a long run effect on
productive potential). The factors that cause an increase in quantity of resources in
long run will also increase SRAS
− The LRAS curve:
o Keynesian (follower of a certain economist who maintains that gov. intervention is
needed to achieve full employment):
▪ The elastic part of the graph at low rates of output shows that outputs can be
raised without increasing price level (not at full capacity)
▪ As output rises the firm begins to experience shortages of inputs (wages, raw
material prices and price of capital goods increases)
▪ Economy then reaches max output that it can produce with the existing
resources (inelastic part)
o New classical economists (they think the LRAS is vertical and that the economy will
move towards full employment without gov. intervention):
▪ Have it as a vertical line because they believe the economy will operate at full
capacity
− Shifts in LRAS curve:
o Both Keynesian and new classical economists agree that shifts are caused by change in
quantity and/or quality of resources (factor productivity)
o Causes of an increase in quantity of resources in long run:
▪ Net immigration – increase size of labour force
▪ Increase in retirement age
▪ More women entering workforce
▪ Net investment – if gross investment exceeds depreciation (capital goods that
have to be replaced) there will be additions to capital stock
▪ Discovery of new resources
▪ Land reclamation
o Causes of increase in quality of resources:
▪ Improved education and training
▪ Advances in technology
− Interaction of AD and AS:
o Equilibrium level of output and price level are determined by where AD=AS (known as
the macroeconomic equilibrium)
•
Inflation:
− A sustained increase in an economy’s price level (and therefore an increase in the cost of
living)
− Creeping inflation: low and stable rate (eg: 2%) is no problem (it encourages firms to produce
more)
− Hyperinflation: exceptionally high rate of inflation (eg: >50%) … people can lose confidence in
the currency and they may resort to barter. In these cases the currency usually has to be
replaced with a new currency unit
− Hyperinflation reduces purchasing power, makes a country’s exports uncompetitive, creates a
redistribution of income (those with fixed income are badly affected), creates menu and shoe
leather costs and creates uncertainty in an economy). However, if prices rise more than costs
firms’ profits will increase, may encourage expansion which decreases unemployment and
borrowers will gain as their debt will be less in real terms
− Measuring inflation:
o Use consumer price indices:
▪ Select a base year (usually a standard year where nothing unusual happened)
and it is given a value of 100… the base year is changed on a regular basis
▪ Carry out a survey to find people’s spending patterns
▪ Attach weights (to reflect how a greater proportion of income is spent on
certain things) to each category made after survey (eg: on average households
spend 25% of their expenditure on food)
▪ Find out price changes
▪ Multiply weights by price changes which gives you the consumer price index
(CPI)
− Money values vs real values:
o Money values (AKA nominal values) are the values of the prices operating at the time
o Real values have been adjusted for inflation (if prices double, the quantity that can be
bought will be halved)
o To convert money to real values the figures are multiplied by the price index in the
current year divided by the price index in the base year (take away interest from how
much the value increased by)
− Causes of inflation:
o Cost-push inflation:
▪ Caused by an increase in costs of production
▪
▪
Wages may increase more than labour productivity
Wage-price spiral may occur: workers gain increased pay causing prices to
increase and then they seek another increase in pay to restore the real value
▪ Increase in real material costs and fuel (this may occur due to a fall in exchange
rate and therefore an increase in import prices)
▪ Increase in indirect/corporation tax
o Demand-pull inflation:
▪ Caused by increases in AD not matched by equivalent increases in AS
▪
Rise in AD will have a greater impact on price level the closer the economy is to
full capacity
▪ Increases in AD may result from a consumer boom, rise in gov. spending, higher
business confidence or an increase in net exports
▪ Monetarists (economists who argue that inflation is caused by excessive growth
in money supply) say the key cause of higher AD is increases in money supply. If
money supply grows faster than output it will drive up price level
− Consequences of inflation:
o Reduction in net exports (decreases products’ international competitiveness) which
increases import expenditure and decreases export revenue
o An unplanned redistribution of income (if interest doesn’t rise with inflation borrowers
will gain and lenders will lose)
o Menu costs – costs involved in changing prices (eg: price tags)
o Shoe leather costs – costs involved in moving money from one financial institution to
another in search of highest rates of interest
o Fiscal drag – occurs when income of people and firms are pushed into a higher tax
bracket due to inflation… can be argued that this is a cost of inefficient tax system and
not inflation (AKA bracket creep)
o Discouragement of investment
o Inflationary noise – when inflation causes consumers to confuse price signals (an
increase in price of a product may not mean it’s become more expensive relative to
other products… price may have risen less than inflation making it cheaper)
o Inflation causing inflation – if consumers and workers expect inflation to occur, they
may act in a way that causes more inflation (workers may demand higher wages
resulting in increased costs and cost-push inflation)
− Potential benefits of inflation:
o Stimulating output – low and stable inflation caused by increased AD makes firms feel
optimistic about the future. If prices rise by more than cost, profit will increase
o Reduce the burden of debt – real interest rates may fall or even become negative with
inflation. A reduction in debt burden can stimulate consumer expenditure and lead to
higher output and employment
o Prevent some unemployment – with zero inflation firms may have to cut labour force.
Inflation enables them to keep nominal wages the same or increase them by less than
inflation
− Factors affecting the consequences of inflation:
o The cause of inflation (Demand-pull inflation is likely to be less harmful than cost-push
(demand-pull is associated with rising output and cost-push with falling output))
o Its rate (slower inflation causes less damage)
o Whether the rate is accelerating or stable (accelerating or fluctuating inflation causes
uncertainty)
o Whether the rate is the one that has been expected (unexpected inflation can cause
uncertainty and discourage consumer expenditure and investment)
o How the rate compares with that of other countries (if inflation is lower than that of
competing country their goods may become internationally more competitive)
•
Deflation and disinflation:
− Deflation: a sustained fall in price level (negative inflation)
− Disinflation: a fall in the inflation rate (still positive)
− Deflationary policies are there to reduce AD
− Deflation results in a rise in real money value
− Causes and consequences of deflation:
o Deflation increases the burden of debt (real interest rates will rise… the money you
owe is worth a lot more in terms of other goods in the country because price levels
have decreased), may increase real rate of interest and result in menu costs
o “Good deflation” is caused by an increase in AS (advances in technology may lower cost
of producing… as output increases so does employment and the international
competitiveness of a country’s products)
o “Bad deflation” is when price is driven down by a fall in AD (output falls which may
result in an increase in unemployment). This can cause a deflationary spiral –
consumers may delay purchases expecting prices to fall, then suppliers see lower
demand and may not invest/reduce the no. workers they have… this reduces demand
even more and decreases economic activity
•
Balance of payments:
− A record of a country’s economic transactions with the rest of the world over a year
− Money in is credit (+) and money out is debit (-)
− Changes in country’s price level causes a change in its balance of payments position which can
affect exchange rates
− Some accounts have deficit and some have surplus
− Components of the balance of payments:
o Current account:
▪ A record of the trade in goods and services, investment income and current
transfers
▪ Trade in goods – exports (credit) and imports (debit) of things like cars and
clothing. This can also be called the balance of trade (or visible balance or
merchandise balance) and it is calculated by deducting import revenue from
export revenue (a surplus is when export revenue>import revenue)
▪ Trade in services – export and import of services (shipping, tourism, banking,
insurance) which can be called invisibles
▪ Income – from profits, interest and dividends earned on direct investment
abroad and foreign earnings on investment in the country (dividends paid on
foreign shares by residents in country appear as credit while interest paid to
foreigners on bank accounts they hold in the country are debit items)
▪ Current transfers – covers payments made and receipts received for things that
don’t involve the exchange of a good/service (eg: gov. transfers from
international financial aid, transfers by private individuals such as remittances
which can form a large credit item)
▪ A current account deficit means total debit items exceed total credit items
o Capital account:
▪ Record of capital transfers (eg: machinery, etc. moving in and out of country)
and the acquisition and disposal of non-produced, non-financial assets
▪ Includes things like gov. debt forgiveness, money brought in and taken out by
migrants, sales and purchases of copyrights, patents and trademarks
o Financial account:
▪ Record of the transfer of financial assets between the country and rest of the
world
▪ Direct investment – building of a factory in another country and takeover of
existing firm in another country (debit items). Setting up of a new plant or the
takeover of a firm in the country by foreign firm (credit items).
▪ Portfolio investment – purchases and sale of gov. bonds and shares that don’t
involve legal control of a firm (property and financial portfolio (foreign
exchanges in other countries))
▪ Other investments – covers shorter-term movements of financial investment
like bank loans
▪ Reserve assets – gov. holding of gold, foreign exchange reserves, etc. They are
kept to settle international debts and to influence the foreign exchange rate.
Additions to reserves are debit items while reductions are credit items (because
if central bank sells some of its foreign currency it will gain its own currency in
exchange so there will be a flow of currency into the country)
▪ All three types of investment (direct/portfolio/other) generate investment
income that appears on the income section of the current account
o Net errors and omissions: (AKA balancing item)
▪ Figure used to ensure the balance of payments balances
▪ Should always balance because for every credit there should be a debit
▪ A deficit on current account should be matched by an equal surplus on the
capital and financial accounts
▪ Mistakes can be made which is why there is this part of the BOP… if all the other
accounts add up to -$2 million then $2mil more must have come into country
than what was recorded – the net errors and omissions figure would them be
+$2 mil
− Causes of disequilibrium:
o Current account deficit:
▪ Growing domestic economy – when increasing output firms may import more,
firms sell more in own country and therefore decrease exports (this isn’t seen as
a problem because growing economy is likely to attract foreign investment
which leads to credit items in the financial account that balance the debit items
in current account… it is short-term and self-correcting)
▪ Declining economic activity in trading partners – country buying your exports
may experience a recession and decrease their import expenditure. Current
account deficit that arises from either a change in economic cycle of domestic
economy or economies of trading partners is called cyclical deficit (not really a
problem as it is relatively short-term and self-correcting)
▪ Structural problems – cause a long-term deficit that becomes a problem. Can
result from overvalued exchange rate, high inflation rate, low labour and capital
productivity. It is not self-correcting
o Financial account deficit:
▪ Not necessarily a problem because it will give rise to an inflow of profits,
interest and dividends in future years
▪ More of a concern if it’s from a long-term lack of confidence in country’s
economic prospects – foreign owners of firms/shares in country may sell these
in large quantities (which reduces tax revenue and employment… may lead to
recession)
o Other causes:
▪ Imports>exports and financial account is in deficit
▪ Large surplus on current account creating an overall surplus
▪ Lack of confidence in particular economy (few capital inflows)
▪ Increase in spending power may increase money spent abroad and not locally
− Consequences of current account deficit and surplus:
o Deficit allows residents of a country to consume more than the country produces
(sometimes referred to as living beyond their means)
o Country will have to finance deficit by attracting investment or borrowing (this will
create a future outflow of money in the form of investment income)
o Increase in deficit may decrease AD which slows economic growth and causes
unemployment
o Surplus means country not living as high a standard of living as possible
o High level of demand and increase in money supply may generate inflationary pressure
o Other countries experiencing deficits may put pressure on countries with large
surpluses to reduce their surplus
− Other consequences:
o Deficit causes a decrease in value of currency
o Domestic:
▪ Change in money supply
▪ Confidence and foreign direct investment (FDI) changed leading to a change in
AD, employment and growth
▪ Changes in standard of living
▪ Changes in gov. policies
o External:
▪ Change in exchange rate
▪ Gov. pressured to change protectionist measures
•
Exchange rates:
− The price of one currency in terms of another currency (nominal foreign exchange rate)
− If your currency rises (gets stronger) then it is more expensive for others to buy your exports
and it is cheaper for you to import
− Trade weighted exchange rates – the price of one currency against a basket of currencies (the
currencies in the basket are weighted according to their country’s relative importance to the
main currency you are focused on) … AKA a multinational exchange rate
− Real effective exchange rate – currency’s value in terms of its real purchasing power… shows
the prices of domestic products in terms of foreign products (takes price changes and
exchange rate changes into account)
− Fall (weakening) in country’s exchange rate would make its exports more price competitive (if
country is experiencing high inflation, then its export prices may increase)
− Real exchange rate=
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 𝑥 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥
𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒
− Determination of exchange rates:
o Floating: (eg: the UK)
▪ Determined my market forces of demand and supply
▪ Reasons why currency traders will buy the domestic currency: purchase
goods/services from country, invest in the country and speculate on making
profit if the value of the currency rises in the future
▪ Following graph shows how decrease supply of a currency will increase its value
▪
Fall in value of currency is known as a depreciation (could increase inflationary
pressure as it will cause an increase in the cost of importing)
▪ Rise in value (caused by an increase in demand and/or decrease in supply) is
known as an appreciation
▪ Advantages of a floating exchange rate: exchange rate should move to restore a
balance on the current account (eg: if current account is in deficit then demand
for currency will fall while supply increases… if there is elastic demand for
exports and imports then export revenue will rise and import expenditure will
fall), because gov. doesn’t get involved no reserves need to be held and can be
used elsewhere
▪ Disadvantages of floating: significant fluctuations may occur, changes in
exchange rate may make it hard to estimate how much will be earned on
exports and spent on imports (may discourage trade and investment), may
remove pressure on gov. to maintain price stability and no guarantee that it will
restore balance on current account
o Fixed: (eg: Bahamas)
▪ Set by the gov. and maintained by central bank (not determined by demand and
supply)
▪ Controlled by intervening in the foreign exchange market and/or changing rate
of interest
▪
▪
▪
▪
▪
▪
▪
Hot money flows – flows of money moved around the world to take advantage
of changes in interest rates and exchange rates
If there is downward pressure (depreciation) on exchange rate because the
supply of the currency is increasing on the foreign exchange market the central
bank will take action and possibly increase the rate of interest which would
raise the exchange rate (central bank could buy enough of the money to shift
the demand curve to the right and keep the same equilibrium)
If the fixed rate is overvalued the central bank may run out of reserves while
trying to keep the exchange rate at the fixed level (if the rate is close to the
long-run equilibrium they will not have this problem as they will only have to
offset short-run fluctuations)
Needing to keep so many reserves creates an opportunity cost, gov. may also
sacrifice other policy objectives to maintain fixed exchange rate
Devaluation – reduction in the value of the fixed exchange rate
Revaluation – raise the fixed rate
Fixed rate creates certainty which promotes international trade and investment,
also imposes discipline on gov. to keep inflation low (so that loss of
international competitiveness doesn’t put downward pressure on exchange
rate)
o Managed float: (eg: South Africa)
▪ Exchange rate is influenced by state intervention
▪ Both floating and fixed (usually allowed to be determined between a given
band… upper and lower limits)
▪ Ways to manage involve using monetary policies (using interest rates to affect
“hot money” flows) and buying domestic currency for an appreciation or selling
it (which would in turn increase foreign currency reserves as you are buying
other currencies) for a depreciation (AKA direct intervention in the currency
market)
▪ Having a high interest rate attracts foreign investment and increases demand
and value of the currency… but lower interest rates are unattractive and
therefore cause a decrease in demand and value of currency
•
Factors underlying changes in foreign exchange rates:
− Changes in demand for and supply of currency causes a change in price of currency (floating
system) and upward/downward pressure on a fixed exchange rate
− Demand increases if a higher value of exports is being sold… foreigners may want to buy more
of the currency if they want to invest in the country’s firms due to the country’s economic
prospects improving
− Foreigners may also purchase more of currency in order to open accounts in country’s banks in
order to benefit from higher interest rates or to set up branches in the country (because of rise
in labour productivity)
− Speculation – people think the value of the currency will rise and they buy the currency in
hopes to make profit but this increases demand which will increase the value of the currency/
put upward pressure on it… an increase in supply will bring price down/put downward
pressure on it
− Value of a fixed/managed rate may be changed if gov. sees that market forces constantly put
an upward/downward pressure on it
− Gov. may also change rate to meet a macroeconomic aim (may decrease it enough to create a
competitive advantage in order to improve its current account position/ may set high rate to
reduce inflationary pressure)
•
Effects of changing foreign exchange rates on domestic and external economy:
− A depreciation/devaluation:
o Makes exports cheaper (in terms of foreign currencies) and imports more expensive
o May enable domestic firms to sell more products (both at home and abroad)
o Locals may now buy domestically produced products and not expensive imports
o Foreigners may choose to buy from this country rather than their own
o Rise in net exports increases AD, which may increase output and employment (may
give rise to inflationary pressure… as economy approaches full capacity resources will
become scarce and bid up)
o Costs of production will be pushed up because the cost of imported raw materials rises
o Lower exchange rate doesn’t always guarantee a reduced current account deficit… the
outcome depends on PED for both imports and exports (if demand of exports is elastic
a fall in exchange rate will cause a rise in export revenue and a reduction in import
expenditure which will reduce a current account deficit
o Marshall-Lerner condition – when combined elasticities are required to exceed 1 for
current account position to be improved by a fall in exchange rate
o The greater the combined PED for exports and imports is the smaller the fall in
exchange rate is required to improve current account position
o If PED<1 a revaluation of exchange rate would be a better strategy
o The J-curve effect (fall in exchange rate causing a rise in current account deficit before
it reduces due to the time it takes for demand to respond) is related to the MarshallLerner condition:
o In some cases, exchange rate will worsen current account position before it starts
improving (in short term the demand for imports and exports may be relatively
inelastic). Takes time to recognise price change and to search for alternative products.
In longer term demand becomes more elastic and current account position may move
from deficit to surplus
− Appreciation/revaluation:
o Makes exports more expensive and imports cheaper
o Can result in a fall in demand for domestic products
o Lower AD results in a rise in unemployment and slow down economic growth
o Causes a reduction in inflationary pressure if economy is operating close to/at max
capacity
o Lower costs of imports shift AS to the right and also reduces rate of inflation. This lower
cost of imports also increases competitive pressure on domestic firms
o May increase current account deficit/reduce current account surplus (outcome
depends mainly on PED for imports and exports)
o If combined PED>1 only then will a current account surplus be reduced. A rise in
exchange rate may increase current account surplus in short run before reducing it in
the longer run
•
Terms of trade:
− Numerical measure of the relationship between export and import prices
𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒𝑠
− Terms of trade index=
𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑖𝑚𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒𝑠
− Ratio is calculated from avg. prices of many goods and services that are traded internationally
(prices weighted by relative importance of each product traded)
− If index increases – favourable movement/improvement in terms of trade (fewer exports have
to be sold to buy any given number of imports)
− Causes of changes in terms of trade:
o Rise in export prices relative to import prices causes a favourable movement (and vice
versa)
o Increase in demand for exports increases the prices (cause a favourable movement)
o Rise in country’s relative inflation rate would increase export prices relative to import
o Devaluation is sometimes called a deliberate deterioration of its terms of trade
(deliberate attempt to reduce export prices and increase import prices in order to
make country’s products more internationally competitive)
− Impact of changes in the terms of trade:
o If price of exports increases due to increase in demand it will be beneficial as more
domestic products will be sold
o But if the cause is due to a rise in costs the demand will fall and export revenue may
decline
o Fall in export prices relative to imports should increase export revenue relative to
import expenditure (remember terms of trade is measure of export and import prices
not export and import values)
− Balance of trade is different – it is the difference in value of the exported and imported goods
and services)
•
Absolute and comparative advantage:
− Absolute advantage:
o Used in context of international trade – situation where for a given set of resources
(equal amount) one country can produce more of a particular product than another
country
o If each country specializes in what they have absolute advantage in and trade, based on
opportunity cost ratios, total output will rise and both countries will be able to
consume more products
− Comparative advantage:
o Situation where a country can produce a product at a lower opportunity cost than
another country
o Some countries purchase products abroad that their producers could produce with
fewer resources… Allows local producers to concentrate on producing those products
that they are even better at producing
o In the graph country B is more efficient at producing both goods but most efficient in
good B (has the comparative advantage in producing good B) …can make 3 times as
many of B but only 2 times as many of A
o Country B’s opportunity cost of producing good B (20/15=4/3) is lower than that of
country A (10/5=2)
o Country A has the comparative advantage in good A because it can produce them at a
lower opportunity cost
o Even though this is true it doesn’t provide full explanation for global trade because
many countries want to avoid overspecialisation, transport costs may offset
comparative advantage, exchange rate may not lie between opportunity cost ratios and
gov. may impose trade restrictions
o Also, no guarantee that workers and other resources will be able to switch from making
one good to another due to wanting to specialize
o Producers may also continue producing a product even if another country has
comparative advantage and may try to convince gov. to implement trade restrictions in
order to stop imports from that country
•
Free trade:
− International trade that isn’t restricted by tariffs and other protectionist measures
− Allows efficient allocation of resources with countries being able to concentrate on products
they have comparative advantage in (increases world output and employment and therefore
living standards)
− Factor endowment – availability and quality of resources
− Competition caused by free trade results in firms keeping prices and costs down and quality up
(consumers enjoy better and cheaper products)
− Having an international market to sell to means firms can increase output and benefit from
economies of scale
− Trading possibility curve – shows effects of a country specialising and trading
•
Trade blocs:
− Regional group of countries that have entered into trade agreements
− Free trade areas:
o Trade bloc where member gov. agrees to remove trade restrictions among themselves
o Members are allowed to determine their own external trade policies towards nonmembers
− Customs unions:
o Free trade between member countries and a common external tariff on imports from
non-members
− Economic unions:
o Free trade between members, common external tariff and some economic policies
which may include common currency
o Restrictions also removed from movement of capital and labour as well
o Eg: EU
o Full economic union is the final stage of integration and involves members having same
currency and following all the same economic policies
− Monetary unions:
o Economies operating the same currency
o Eg: members of the euro area
•
Trade creation and diversion:
− Trade creation – high-cost domestic production is replaced by more efficiently produced
imports from within customs union
− Allows members to specialise in products they have comparative advantage in
− Helps lower prices and benefit from economies of scale (output increases due to larger
market)
− With tariff price is at P2 and consumption is at Q3 (Q4 is supplied domestically and Q4-Q3 is
imported)
− When country joins trade bloc it can import with no tariff
− Price goes to P1 and amount consumed is Q2 (Q1 domestically produced and Q1-Q2 is
imported)
− Consumers gain from lower price and increased quantity consumed
− Domestic producers lose as sales fall and they gain a lower price
− However, they may be able to shift resources to making products that are more price
competitive relative to those of member countries because of tariff removal
− Domestic gov. will lose out on tariff revenue but there is a welfare gain
− Lower price increases consumer surplus (page 107)
•
Trade diversion:
− Trade with a low-cost country outside a customs union is influenced by higher-cost products
supplied from within
− Members of a trade bloc buy imports from less efficient countries (within trade bloc) rather
than from more efficient countries outside trade bloc – less efficient allocation of resources
− Outside countries will lose as they will not be able to trade on equal terms
•
Protectionism:
− Protecting domestic producers from foreign competition
− Restricts free trade
− Methods of protectionism and their impact:
o Tariffs:
▪ Tax imposed on imports and exports
▪ AKA customs duties
▪ Taxing exports helps raise revenue and increase supply of product on domestic
market
▪ Taxing imports may also raise revenue and discourage consumption of imports
(makes them more expensive and less competitive)
▪ Can be specific (fixed sum per unit) or ad valorem (a % of the price)
▪
▪
▪
Benefits domestic suppliers (output from Q1 to Q4)
Domestic consumers lose (price rises to P2 and consumption from Q2 to Q3)
Tariff more effective for raising revenue if demand for imports is price
inelastic and more effective for protecting domestic industry if it’s elastic
▪
▪
May not make domestic products more price competitive if the price+tariff
is still less than price of domestic product. Or if firms selling the imports
absorb the tariff and don’t raise price
May lead to retaliation
o Quota:
▪ Limit on imports or exports
▪ Usually on quantity but can also be on value that can be purchased each year
▪ Restricting supply drives up prices (disadvantage to consumers)
▪ Unlike tariff it doesn’t raise revenue… the sellers receive extra amount per unit
paid (sometimes licenses are sold to foreign firms to sell some of the quota)
o Exchange control:
▪ Restrictions on the purchases of foreign currency
▪ Limits on the amount of foreign exchange that can be purchased in order to buy
imports
o Export subsidies:
▪ Subsidies given to firms that export and to domestic firms that compete with
imports
▪ In both cases domestic firms experience a fall in cost (increase output and lower
their price… making them more competitive)
▪ Losers will be foreign firms and domestic taxpayers (also creates opportunity
cost because money could be used elsewhere)
▪ Consumers benefit in short-run but not in long-run if more efficient foreign
firms are driven out of business and subsidised domestic firms raise prices
▪ Firms may also become dependent on subsidy rather than trying to become
more competitive
o Embargoes:
▪ Ban on imports/exports
▪ To decrease imports of demerit harmful goods
▪ May arise from a political dispute
o Voluntary export restraints (VERs):
▪ Limit placed on imports reached with the agreement of the supplying country
▪ Exporting country may be pressured into it or they may make an agreement
with the importing country to also limit its exports of another product
o Economic and administrative burdens (“red tape”):
▪ Discourage imports by requiring importers to fill out time consuming forms
▪ May also set artificially high product standards to restrict foreign competition (if
standards are so high you cannot import the products and they therefore
cannot export products (other countries))
▪ This restricts consumer choice
o Keeping exchange rate below its market value:
▪ Gives domestic producers competitive advantage
▪ May lead to other gov. lowering their exchange rates
− Arguments in favour of protectionism:
o To protect infant industries (AKA sunrise industries):
▪ Can be difficult to identify which ones will actually grow and gain comparative
advantage
▪ Also risk that the infant industry will become reliant on protection (may not feel
pressure to lower its costs)
o Protect declining (sunset) industries:
▪ If they lose their comparative advantage and go out of business quickly then
unemployment will suddenly rise
▪ If it is granted protection and it is slowly removed unemployment may be
avoided (some retire and others find new jobs)
▪ Risk that industry resists reductions (leads to inefficiency)
▪ Eg: if steel industry loses comparative advantage and car industry has a
comparative advantage… a tariff on steel will make car industry have much
higher costs
o Protect strategic industries:
▪ Eg: weapons, fuel and food
▪ May not want to be dependent on foreign supplies for these products (trade
dispute of military conflict may occur)
o Prevent dumping:
▪ Dumping – selling products in foreign markets at a price below the cost of
production in order to gain control of the market
▪ Benefits consumers in short run… but in long run they may drive out domestic
producers and become a monopoly then raise prices
▪ Foreign firms may be able to cover the costs of dumping with previous
supernormal profits (charging high prices in their home markets or receiving
subsidy from their gov.)
▪ Can be difficult to judge whether dumping is taking place or if they’ve gained a
comparative advantage
o To improve terms of trade:
▪ If country purchases a large proportion of another country’s exports of a
product it may be able to force down its prices
▪ By imposing trade restrictions, it can lower demand and in turn lower price
(allows it to purchase more imports for the same number of exports)
▪ If country accounts for a significant proportion of world’s supply of product,
quotas on exports may improve terms of trade (restricting supply drives up
price and increases purchasing power of exports)
▪ Actions like this distort trade and can decreases global output… may also
provoke retaliation
o Improve balance of payments:
▪ Improve current account position (tariffs encourage consumers to switch from
imports to domestic products)
▪ May provoke retaliation (if foreign gov. decides to impose their own trade
restrictions then not only will imports fall but exports will too)
▪
If country’s products are not internationally competitive because of strategic
problems them trade restrictions will only provide short-term boost to current
account
o Provide protection from cheap labour:
▪ Restrictions imposed on products from countries with low wages
▪ Not a very strong argument because low wages don’t always mean that the
country will be able to produce products more cheaply as labour productivity
may be low
▪ If low wages are actually linked to low costs, then it indicates the country has
competitive advantage
▪ Moral arguments for imposing trade restrictions on products produced using
slave or child labour (other approaches may also work better especially if
restrictions cause wages to be driven down even more)
o Gov. may also impose trade restrictions to persuade another gov. to reduce its trade
protection
o Gov. may also seek to protect certain industries to avoid the risks of overspecialisation
Chapter 5:
•
Aims of macroeconomic policies:
− Full employment
− Low and stable inflation
− BOP equilibrium
− Steady and sustained economic growth
− Avoidance of exchange rate fluctuations
•
Types of policies:
− Fiscal policy:
o Use of taxation and gov. spending to influence AD
o Reflationary/expansionary fiscal policy is there to increase AD (gov. spending increasing
and/or cutting tax rates or tax base)
o Deflationary/contractionary is the opposite
o Changes in gov. spending can be due to changes in gov. policy or result of changes in
economic activity
o Discretionary fiscal policy – deliberate changes in gov. spending and taxation
o Gov. can also allow automatic stabilisers – changes in gov. spending and tax that occur
to reduce fluctuations in AD without any alteration in gov. policy (eg: during a recession
gov. spending on unemployment benefits automatically rises because there are more
people unemployed. Tax revenue will fall as profits, income and expenditure decline)
o Operating below full employment at Y (gap between gov. spending and tax. As GDP
rises gov. spending on benefits falls and tax revenue rises)
o The budget position:
▪ Budget – annual statement in which the gov. outlines plans for its spending and
tax revenue
▪ Budget surplus – tax revenue> gov. spending
▪ Budget deficit – tax revenue< gov. spending
▪ Cyclical budget deficit – budget deficit caused by changes in economic activity
(due to automatic stabilisers… gov. isn’t concerned because it is likely to
balance as economic activity increases)
▪ Structural budget deficit – caused by an imbalance between gov. spending and
tax (causes concern because gov. is committed to too much spending relative to
tax and will not disappear as GDP rises)
− Monetary policy:
o Uses of interest rates, direct control of money supply and exchange rate to influence
AD
o Reflationary/expansionary increase AD and involve a cut in interest rates, an increase in
money supply and a reduction in foreign exchange rate (imports are cheaper because
your currency gets stronger)
o Contractionary/deflationary does the opposite – rise in interest rates, decrease in
money supply and increase in foreign exchange rates
o Monetary policies are usually implemented by central bank of country/area
o Exchange rate measures include gov. decisions on what type of exchange rate system
and if managed/fixed system then what rate to set it at
− Supply side policy:
o Designed to increase AS by improving the workings of product and factor market
o Reduce gov. intervention/in some cases increasing it
o Cutting corporation tax (encourage investment which increases AD and AS)
o Cutting income tax (encourage workers to work for longer hours, accept more
responsibility and take promotions. Also persuade workers to stay in labour force
longer and encourage more to join labour force)
o Reduce welfare payments (encourage unemployed to find jobs)
o Increase spending on education and training (increases its quality which helps increase
skills, productivity, flexibility and mobility)
o Increasing spending on infrastructure (reduce transport costs)
o Trade union reform (increase workers’ flexibility and mobility and cut down on number
of days lost through strikes)
o Privatisation (believe firms will operate more efficiently)
o Deregulation (remove barriers to entry and laws and regulations that increase a firm’s
costs of production)
o Provision of gov. subsidies (lower costs of production and increase output)
•
Policies to correct BOP disequilibrium:
− Expenditure switching policies:
o Designed to encourage people to switch from buying foreign-produced products to
domestically produced products (will lead to a fall in supply of the country’s currency
on the foreign exchange market which leads to upward pressure on the exchange rate)
o Would also include policy measures that persuade foreign households and firms do buy
more of their exports (leads to a rise in demand for the currency on the market which
also leads to upward pressure on the exchange rate)
o Not designed to reduce spending, just switch it
o Fall in import expenditure and rise in export earnings
− Expenditure dampening policies:
o Designed to reduce imports and increase exports by reducing demand
o Reduction in spending results in fewer imports
o Domestic producers will find that their domestic market is ‘dampened’ (may try to
make up for lost sales by selling abroad)
− Fiscal policy:
o If country has a deficit on the current account of its BOP it may use fiscal policy
o Rise in income tax reduces disposable income which results in less imports (and less
spending on domestic products)
o Lower gov. spending directly reduces demand which may reduce imports and puts
pressure on firms to increase exports (expenditure dampening)
o Gov. could impose tariff on imports or increase existing tariff (expenditure switching) …
works well when there are good domestic substitutes
o Effectiveness:
▪ May alter current account position in short term but are unlikely to produce a
long-term solution (households and firms will likely go back to spending the
same on imports relative to exports when the policy is stopped)
▪ Raising taxes has adverse effects – lowers demand which may increase
unemployment and slow economic growth. Can also create disincentive effects
so may reduce AS
▪ Imposing tariffs against a fellow member in a trade bloc is not an option
▪ Imposing increasing tariffs on other countries may provoke retaliation and may
reduce pressure on domestic firms to become more efficient
− Monetary policy:
o Reducing growth of money supply may be used as expenditure dampening/switching
o If country has low rate of inflation and current account deficit its central bank may
reduce interest rates in order to put downward pressure on floating exchange rate
(products become more internationally competitive but there is a risk it may generate
inflationary pressure)
o Higher interest rate may act as a dampening policy measure (reducing demand for
imports and reducing inflationary pressure) but could cause an increase in exchange
rate
o Gov. may alter exchange rate as an expenditure switching measure
o If country has current account surplus and fixed exchange rate it may revalue its
currency
o Effectiveness:
▪ Hard to control money supply – commercial banks have strong incentives to
increase lending and may seek to get round any limits the central bank seeks to
impose on their lending
▪ Trying to control certain forms of money may lead to new forms of money being
used
▪ Time lag between changing interest rates and its full effect being transmitted to
macroeconomy (some economists say as long as 18 months) … but can be less
than that of fiscal policy measures
▪
Some households and firms are more likely to cope with change in interest rate
(eg: rise in interest rates harms borrowers but benefits savers)
▪ Higher interest rate may have an effect on unemployment and economic
growth (same as deflationary fiscal policy)
▪ Rise in interest rate may discourage foreign direct investment as it would raise
the firms’ costs and the firms may expect demand to fall in the country
▪ Lowering exchange rate will not work if demand for exports and imports is price
inelastic or if the relative quality of the country’s products falls
▪ Not likely to be a long-term solution to BOP problems (one exception is if gov.
decides to stop maintaining an exchange rate above/below market level)
− Supply side policy:
o May reduce current account and financial account deficit by making domestic products
more price competitive and by making domestic markets more attractive to invest in
o Deregulation and privatisation may increase pressure on domestic firms to keep costs
low, improve quality and to become more responsive to change in demand
o Increased spending on education and training and increased investment may increase
exports and encourage foreign direct investment
o More skilled labour force and better capital equipment reduces relative price of
domestic output and raises quality (increases domestic firms’ share of home market
and global market) … may also attract foreign multinational companies to set up
branches in the country (expect high quality at low cost)
o Trade union reform may enable domestic firms to work with more flexibility and so be
more responsive to change in demands
o Effectiveness:
▪ Some may not be very effective in short term (increased spending on education)
▪ Outcome of supply side measures is uncertain (eg: providing more education
and training may not work if it is not of high quality or if it develops unnecessary
skills)
▪ Privatisation won’t increase efficiency if monopolies develop
▪ Subsidies to firms may not result in a decrease in price if the firm doesn’t pass
on the subsidy to the consumers. Subsidies may also cause retaliation as foreign
gov. see it as unfair competition
•
Policies to correct inflation:
− To correct demand-pull inflation:
o Deflationary fiscal and monetary policy measures
o Income taxes increase, threshold at which people start paying taxes may be reduced
and tax base may be widened (tax base is the total amount of assets/income that can
be taxed by tax authority)
o Gov. may cut their spending
o Main policy used is monetary and focusing on interest rates
o Central bank raises interest if inflation is rising above target range (cost of borrowing
rises which discourages large-scale purchases (houses and cars), saving increases which
has spending as its opportunity cost, higher interest rate may attract hot money which
increases the external value of a floating exchange rate)
o This will put downward pressure on domestic prices (domestic firms face increased
competitive pressure at home and abroad and lower imported material costs)
o To reduce risk of demand-pull inflation in longer term gov. uses supply side measures
o If increases in AS can keep up with AD a country can enjoy higher output (higher real
GDP) without experiencing inflation
o Effectiveness of these policies:
▪ Raising income tax may backfire – workers may seek higher wages to maintain
disposable income which can lead to increase costs for firms (this creates costpush inflation)
▪ Higher income tax may also create disincentive – workers may leave labour
force
▪ Commercial bank usually keeps interest rates same as central bank but no
guarantee that they will raise rates when central bank does
▪ If consumers are optimistic about the future they may not decrease spending
even with increased interest rates (same for rise in income tax)
▪ Increasing interest rates may not increase investment because it means it’s
more expensive to borrow the money they want to invest
▪ Gov. may be worried that their labour force will go abroad if they raise income
taxes above that of rival countries
▪ If a country operates a fixed exchange rate it is difficult to raise interest rates
because it puts upward pressure on exchange rate
▪ Supply side policies benefit all gov. objectives in long run but may cause
inflation in short run (eg: increased spending on education and cuts in income
tax may increase AD before AS)
− To correct cost-push inflation:
o Increase exchange rate in order to reduce cost-push inflation (reduces raw material and
capital costs and is likely to put pressure on domestic firms to find ways to cut their
costs)
o Supply side policies such as increased spending on training to increase productivity and
reduce costs or reduce upward pressure on labour costs; lower corporation tax can
encourage buying more efficient capital equipment and puts downward pressure on
price rises and provide subsidies to firms facing things like higher fuel costs so they
don’t have to raise their prices or so they use some of the subsidy to buy more efficient
capital equipment
o Effectiveness:
▪ Rise in exchange rate may not reduce inflation if foreign producers keep price of
their exports unchanged in the country’s currency. Domestic firms may not
respond to increased competitive pressure to keep down their cost and price
rises
▪ Increasing skills won’t lower costs if their pay increases more than productivity
▪ Lower corporation tax may not increase investment if firms are pessimistic
about future
▪ Gov. subsidies may increase AD through rise in gov. spending but may not
increase AS if firms don’t respond positively by using them to increase efficiency
•
Policies to correct deflation and their effectiveness:
− Gov. will only correct bad deflation
− To reverse fall in AD and price level gov. employ reflationary fiscal and monetary policies
− Increase gov. spending, cut tax, reduce interest rates and/or increase money supply
− Rise in gov. spending will be most effective because firms and households may be pessimistic
in time of deflation and so may not spend more even if their disposable income increases and
it becomes cheaper to borrow
− When interest rates are low it may be nearly impossible to reduce them anymore and any cuts
will therefore be ineffective
− Central banks may increase money supply which increases the amount commercial banks can
lend – banks may be reluctant to lend because they may think there is an absence of
creditworthy borrowers