Global Economics - Typepad · Growth and development theories 76 Linear growth theories 77...

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Global Economics

© Economics Online 2012

Global Economics

A2 Economics UNIT FOUR

George Higson

Economics Online

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Global Economics


ContentsInternational trade

9 Why do countries trade?9 The advantages of trade10 The disadvantages of trade10 The principle of comparative advantage11 PPFs and trade 12 Opportunity cost ratios13 Criticisms

Patterns of trade

15 Growth in the world economy

Globalisation

16 What is globalisation?16 Why has globalisation increased?16 The advantages of globalisation17 The disadvantages of globalisation18 The impact of globalisation on the UK economy

Foreign Direct Investment (FDI)

21 Thebenefitsofinvestingoverseas21 Investment income21 Inward investment21 UK FDI22 The volatility of FDI23 TheeffectsofFDIonexchangerates

Trade liberalisation

25 Free trade and protectionism25 The advantages of free trade

Trade protection

26 The motives for protection27 Methods of protection28 Tariffs28 Theimpactoftariffs29 TheTariffdiagram

Economic Integration

31 Trading blocs31 Economic and Monetary Union32 The EU 33 The main disadvantages of trading blocs34 Case study - trade creation34 Case study

Common Agricultural Policy

39 Reform of CAP

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The WTO

41 The Doha round

The balance of payments

44 The current account 45 Financingdeficitsandsurpluses45 The Balancing Item46 UK trade performance46 Recenttradefigures47 Causesofacurrentaccountdeficit47 Policiestoreduceadeficit48 Deflatingdemand48 Devaluation50 The ‘J’ Curve50 Direct controls50 Supply-side policy

The terms of trade

52 What are the terms of trade?52 Improving terms of trade53 Worsening terms of trade

Exchange rates

55 Measuringexchangerates55 TheSterlingTradeWeightedIndex55 Exchangerateregimes56 Floatingexchangerates56 Changesinexchangerates56 The demand for currency56 The supply of currency 57 Exchangeratesandinterestrates57 Equilibriumexchangerates58 Managed regimes58 Exchangecontrols58 Advantagesoffloatingexchangerates58 Advantagesoffixedregimes59 RecentUKExchangerates

UK competitiveness

61 Types of competitiveness62 Labour productivity62 The productivity gap62 Factorsaffectingproductivity63 TheWorldEconomicForumCompetitivenessIndex63 Flexiblelabourmarkets63 Wageflexibility63 Investment63 The UK’s investment record64 Investment and interest rates64 UK’s investment in manufacturing

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Policies to improve competitiveness

66 Improving labour productivity66 Improvingcompetitioninproductmarkets66 Improving the level of investment 66 Creating a stable macro-economic environment66 Conclusion

Global economic problems

68 Short term problems68 Longertermproblems

Economic development

69 TheHumanDevelopmentIndex(HDI)72 Lifeexpectancy72 Adult literacy72 GDP per capita72 Evaluation of the HDI73 Evaluate the HDI as an indicator of economic development.74 MeasureofEconomicWelfare(MEW)74 TheIndexofSustainableEconomicWelfare(ISEW)74 Purchasing Power Parity

Growth and development theories

76 Linear growth theories77 Structural change theories78 Development of a tertiary sector79 Balanced and unbalanced growth79 Dependency theory80 Keynesian view80 New Classical view80 New growth theory

Inequality

83 Income and wealth83 Does inequality serve a purpose?84 Measuring inequality of income84 The Lorenz curve84 TheGinico-efficientandindex85 Howdoesdevelopmentaffectinequality?

Poverty

87 Absolute poverty87 Relative poverty87 TheHumanPovertyIndex-HPI87 HPI-1(fordevelopingcountries)87 HPI-2(fordeveloped-OECDcountries)

Constraints on development

89 Inefficiency89 Imbalances

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89 Population90 Lackofrealcapital90 Corruption90 Inadequatefinancialmarkets90 Theprincipal-agent(landlord-tenant)problem91 Absence of property rights91 Absence of a developed legal system91 Under-investment in human capital91 Over-exploitationofenvironmentandnon-renewableresources91 Too many resources91 Protectionism

Costs of growth

93 Negativeexternalities93 Exhaustionofenvironmentalcapital93 Urban squalor

Policies to promote development

94 Inwardlookingpolicies94 Outwardlookingpolicies94 Developing particular sectors95 The Prebisch-Singer hypothesis96 Remedies for unstable prices97 Development of agriculture98 Tourism98 The advantages of tourism98 The disadvantages of tourism99 Structural adjustment policies99 The ‘Washington Consensus’

Financing development

101 ExternalfinancethroughFDI101 Government assistance101 OfficialDevelopmentAid(ODA)101 Non-governmentalorganisations(NGOs)101 WhatarethebenefitsofNGOs?102 Microfinance

Policies to improve growth and stability

104 Policies to promote short term stability104 Policies to promote sustainable growth

Fiscal policy revisited

106 Thepurposeofgovernmentexpenditure106 Centralandlocalgovernment(publicsector)spending107 Typesoffiscalpolicy107 Central government borrowing107 Local government borrowing108 Borrowing,andthefinancialcrisis108 FiscaldeficitsandtheNationalDebt108 Theadvantagesofdiscretionarypublicspendingasafiscaltool

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109 The disadvantages of public spending110 The Phillips Curve110 ExplainingthePhillipscurve111 ThebreakdownofthePhillipscurve112 Doesthetrade-offstillexist?

Fiscal stabilisers and discretionary tax policy

115 Fiscal drag115 Fiscal boost115 Discretionarychangestotaxrates115 Theadvantagesofusingtaxes116 Thedisadvantagesoftaxpolicy

A closer look at money and monetary theory

119 Money supply120 Measuring the money supply120 The demand for money121 Modernmoneymarkets121 Monetarism121 Moneyandinflation-TheFisherequation122 Controlling the money supply

Monetary policy

123 The Monetary Policy Committee123 The Repo rate123 Whytheinflationtargetisnotzero123 Howdoesinterest-ratepolicywork?125 Recent UK interest rates125 Theeffectofareductionininterestrates126 The advantages of interest rate policy126 The disadvantages of interest rate policy126 Quantitative easing

Monetary Union

129 The euro-system130 The EFSF 130 Advantages of the Euro130 The disadvantages of the Euro131 ‘Tests’ for membership132 Euro area interest rates

The financial crisis

134 Origins134 Securitisation134 Toxicassets134 Asymmetric information135 Bankingcollapse135 Policy options135 Nationalisation

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Exchange rate policy

138 Howareexchangeratesmanipulated?138 Effectsofareductioninthepound138 Evaluationofexchangeratepolicy

Supply-side policy

141 Improving productivity of factors141 Improvingtheperformanceoffirms142 Theeffectsofsupply-sidepolicy142 Evaluation - the advantages142 The disadvantages

Economic conflicts

144 Fullemploymentvslowinflation144 Economic growth vs stable prices144 Economic growth vs a balance of payments144 Economicgrowthvsnegativeexternalities144 Flexibilityvsequity144 Crowding-out – public sector vs private sector144 Globalisationandpolicyconflicts

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International trade

Why do countries trade?Countries trade with each other when, on their own, they do not have the resources, or capacity to satisfy their own needs and wants. By developing and exploiting their domestic scarce resourc-es, countries can produce a surplus, and trade this for the resources they need.

Clear evidence of trading over long distances dates back at least 9,000 years, though long dis-tance trade probably goes back much further to the domestication of pack animals and the inven-tion of ships. Today, international trade is at the heart of the global economy and is responsible for much of the development and prosperity of the modern industrialised world.

Goods and services are likely to be imported from abroad for several reasons. Imports may be cheaper, or of better quality. They may also be more easily available or simply more appealing than locally produced goods. In many instances, no local alternatives exist, and importing is es-sential. This is highlighted today in the case of Japan, which has no oil reserves of its own, yet it is the world’s fourth largest consumer of oil1, and must import all it requires.

The production of goods and services in countries that need to trade is based on two fundamen-tal principles, first analysed by Adam Smith in the late 18th Century2 - these being the division of labour and specialisation.

Division of labour

In its strictest sense, a division of labour means breaking down production into small, intercon-nected tasks, and then allocating these tasks to different workers based on their suitability to undertake the task efficiently. When applied internationally, a division of labour means that coun-tries produce just a small range of goods or services, and may contribute only a small part to finished products sold in global markets. For example, a bar of chocolate is likely to contain many ingredients from numerous countries, with each country contributing, perhaps, just one ingredi-ent to the final product.

Specialisation

Specialisation is the second fundamental principle associated with trade, and results from the division of labour. Given that each worker, or each producer, is given a specialist role, they are likely to become efficient contributors to the overall process of production, and to the finished product. Hence, specialisation can generate further benefits in terms of efficiency and productivity.

Specialisation can be applied to individuals, firms, machinery and technology, and to whole coun-tries. International specialisation is increased when countries use their scarce resources to pro-duce just a small range of products in high volume. Mass production allows a surplus of good to be produced, which can then be exported. This means that goods and resources must be imported from other countries that have also specialised, and produced surpluses of their own.

When countries specialise they are likely to become more efficient over time. This is partly be-cause a country’s producers will become larger and exploit economies of scale. Faced by large global markets, firms may be encouraged to adopt mass production, and apply new technology. This can provide a country with a price and non-price advantage over less specialised countries, making it increasingly competitive and improving its chances of exporting in the future.

The advantages of trade

International trade brings a number of important benefits to a country, including:

Higher volumes and economies of scaleIn producing for the export market, higher volumes can be obtained which can lead to the ap-plication of economies of scale.

1 The top five consumers are: USA, EU, China, Japan and India. Source: https://www.cia.gov/library/publications/the-world-factbook/rankorder/2174rank.html

2 An Inquiry into the Nature and Causes of the Wealth of Nations, by Adam Smith. London: Methuen and Co., Ltd., ed. Edwin Cannan, 1904. Fifth edition - commonly known as The Wealth of Nations

Output

Costs

Q1

Long runaverage cost

curve

Lowercost

Economiesof

scale

Copyright: www.economicsonline.co.uk

Increased output from overseas sales

Q

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International trade

Why do countries trade?Countries trade with each other when, on their own, they do not have the resources, or capacity to satisfy their own needs and wants. By developing and exploiting their domestic scarce resourc-es, countries can produce a surplus, and trade this for the resources they need.

Clear evidence of trading over long distances dates back at least 9,000 years, though long dis-tance trade probably goes back much further to the domestication of pack animals and the inven-tion of ships. Today, international trade is at the heart of the global economy and is responsible for much of the development and prosperity of the modern industrialised world.

Goods and services are likely to be imported from abroad for several reasons. Imports may be cheaper, or of better quality. They may also be more easily available or simply more appealing than locally produced goods. In many instances, no local alternatives exist, and importing is es-sential. This is highlighted today in the case of Japan, which has no oil reserves of its own, yet it is the world’s fourth largest consumer of oil1, and must import all it requires.

The production of goods and services in countries that need to trade is based on two fundamen-tal principles, first analysed by Adam Smith in the late 18th Century2 - these being the division of labour and specialisation.

Division of labour

In its strictest sense, a division of labour means breaking down production into small, intercon-nected tasks, and then allocating these tasks to different workers based on their suitability to undertake the task efficiently. When applied internationally, a division of labour means that coun-tries produce just a small range of goods or services, and may contribute only a small part to finished products sold in global markets. For example, a bar of chocolate is likely to contain many ingredients from numerous countries, with each country contributing, perhaps, just one ingredi-ent to the final product.

Specialisation

Specialisation is the second fundamental principle associated with trade, and results from the division of labour. Given that each worker, or each producer, is given a specialist role, they are likely to become efficient contributors to the overall process of production, and to the finished product. Hence, specialisation can generate further benefits in terms of efficiency and productivity.

Specialisation can be applied to individuals, firms, machinery and technology, and to whole coun-tries. International specialisation is increased when countries use their scarce resources to pro-duce just a small range of products in high volume. Mass production allows a surplus of good to be produced, which can then be exported. This means that goods and resources must be imported from other countries that have also specialised, and produced surpluses of their own.

When countries specialise they are likely to become more efficient over time. This is partly be-cause a country’s producers will become larger and exploit economies of scale. Faced by large global markets, firms may be encouraged to adopt mass production, and apply new technology. This can provide a country with a price and non-price advantage over less specialised countries, making it increasingly competitive and improving its chances of exporting in the future.

The advantages of trade

International trade brings a number of important benefits to a country, including:

Higher volumes and economies of scaleIn producing for the export market, higher volumes can be obtained which can lead to the ap-plication of economies of scale.

1 The top five consumers are: USA, EU, China, Japan and India. Source: https://www.cia.gov/library/publications/the-world-factbook/rankorder/2174rank.html

2 An Inquiry into the Nature and Causes of the Wealth of Nations, by Adam Smith. London: Methuen and Co., Ltd., ed. Edwin Cannan, 1904. Fifth edition - commonly known as The Wealth of Nations

Output

Costs

Q1

Long runaverage cost

curve

Lowercost

Economiesof

scale


Increased output from overseas sales

Q

Greater competition and lower price

Trade increases competition and lowers prices, which generates efficiency and welfare gains.

Limiting the power of domestic monopolies

Trade can limit the power of domes-tic monopolies and make them be-come more efficient.

Higher quality products

Competition from overseas firms can increase the quality of goods and services.

More employment

Trade can create jobs as domestic firms can sell to a bigger global mar-ket.

The disadvantages of tradeDespite the benefits, trade can also bring some disadvantages, including:

Over-specialisation

Trade can lead to over-specialisation, with workers at risk of losing their jobs should world de-mand fall or when goods for domestic consumption can be produced more cheaply abroad. Jobs lost through such changes cause structural unemployment. The recent financial crisis has ex-posed the inherent dangers in over-specialisation for the UK, with its reliance on the financial services sector.

Infant industries cannot grow

Certain industries do not get a chance to grow because they face competition from more estab-lished foreign firms, such as new infant industries, which may find it difficult to establish them-selves.

Loss of identity

Local producers, who may supply a unique product tailored to meet the needs of the domestic market, may suffer because cheaper imports may destroy their market. Over time, the diversity of output in an economy may diminish as local producers leave the market.

Diseconomies of scale

In producing for the export market domestic firms may experience diseconomies of scale, includ-ing difficulties in controlling quality and co-ordinating production, and this may result in increas-ing average costs of production.

The principle of comparative advantageIt can be argued that world output will increase when the principle of comparative advantage is applied by countries to determine what goods and services they should specialise in producing. Comparative advantage is a term associated with 19th Century English economist David Ricardo3. Ricardo considered what goods and services countries should produce, and suggested that they should specialise by allocating their scarce resources to produce goods and services for which they have a comparative cost advantage. There are two types of cost advantage – absolute, and comparative. An absolute advantage means being more productive or cost-efficient than another country whereas comparative advantage relates to how much more productive or cost efficient one country is than another.

Example

In order to understand how the concept of comparative advantage might be applied to the real

3 On the Principles of Political Economy and Taxation, by David Ricardo, 1817

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world, we can consider the simple example of two countries producing only two goods - motor cars and commercial trucks.

PPFs for two countries and two goods

Country A Country B

Good X Cars

Good Y Trucks

Good X Cars

Good Y Trucks

35 35 0

30 0 30 3

25 1 25 6

20 2 20 9

15 3 15 12

10 4 10 15

5 5 5 18

0 6 0 21

Using all its resources, country A can produce 30m cars or 6m trucks, and country B can produce 35m cars or 21m trucks. This can be summarised in a table.

In this case, country B has the absolute advantage in producing both products, but it has a comparative advantage in trucks because it is relatively better at producing them. Country B is 3.5 times better at trucks, and only 1.17 times better at cars.

PPFs and trade Country B’s PPF is further out than Country A, which indicates Country B has an absolute advantage in both goods - however, the greatest advan-tage - and the widest gap - lies with truck production, hence Country B should specialise in producing trucks, leaving Country A to produce cars.

Increased output

Economic theory suggests that, if coun-tries apply the principle of compara-tive advantage, combined output will be increased in comparison with the output that would be produced if the two countries tried to become self-suf-ficient and allocate resources towards production of both goods. Taking this example, if countries A and B allocate resources evenly to both goods combined output is: Cars = 15 + 15 = 30; Trucks = 12 + 3 = 15, therefore world output is 45 m units.

ATC

AR

MC


30 m 35 m

6 m 21 m

Country A

CountryB

TRUCKS

CARS

Using all their resources, country A and Bcan produce the following maximum output

of cars and trucks

B

Cars

A

Trucks

30

21

6

Country B is3.5 times moreproductive at

truck production

Country B is only 1.17 times moreproductive at car production

Copy

right

: ww

w.e

cono

mic

sonl

ine.

co.u

k35

B

X cars

A

Y trucks

3

12

21

15

SELF SUFFICIENCYIf both countries become self-su�cient, and allocate theirscarce resources evenly, they will produce the following

combined output: B = 12y + 15x; A = 3y + 15xOutput = 15y + 30x (= 45m units)

SPECIALISATION and TRADEIf both countries specialise, based on their comparative

advantage, world output will be: B = 21y + 0x; A = 0y + 30x

Output = 21y + 30x (= 51m units)


30

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However, if the two countries specialise and employ the principle of comparative advantage, combined output is: Cars = 30; Trucks = 21, therefore world output is 51 m units.

Opportunity cost ratiosIt is being able to produce goods by using fewer resources, at a lower opportunity cost, that gives countries a comparative advantage.

The gradient of a PPF reflects the oppor-tunity cost of production. Increasing the production of one good means that less of another can be produced. The gradi-ent reflects the lost output of Y as a result of increasing the output of X.

Having a comparative advantage in X, country A sacrifices less of Y than country B. Different PPF gradients mean different opportunity costs ratios, and hence spe-cialisation and trade will increase joint output.

Only when the gradients are different will a country have a comparative advantage, and only then will trade be beneficial.

Identical PPFs

If PPF gradients are identical, then no country has a comparative advantage, and opportunity cost ratios are identical. In this case, international trade does not confer any advantage.

B

X

A

Y

3

10

+ 5

15

12

4

15

- 1

- 3

In this case, to get +5 of X (10 to 15) country B must give up 3 units of Y (15 to 12) while country A only gives up 1

unit of Y (4 to 3). Hence, the opportunity costof producing 1 unit of X for A is - 0.2Y (-1/+5) and

for B it is - 0.6Y (-3/+5). This meansthat A should produce as much Xas it can and B should produce Y.


5 20

B

X

A

Y

2

10

+ 5

8

6

4

15

- 2

- 2

Constant opportunity cost means thatno country has a comparative advantage,

hence trade would not be bene�cial. In this case, to get +5 of X (10 to 15), both

countries must give up 2 units of Y. Hence, the opportunity cost is identical, at - 0.4 units

of Y for 1 unit of X.


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Criticisms However, the principle of comparative advantage can be criticised in a several ways:

1. It may overstate the benefits of specialisation by ignoring a number of costs associated with trade. These costs include transport costs and any external costs associated with trade, such as air and sea pollution.

2. The theory also assumes perfect mobility of factors without any diminishing returns. The real-ity may be very different.

3. Output from factor inputs is likely to be subject to diminishing returns. This will make the PPF for each country non-linear and bowed outwards. If this is the case, complete specialisation might not generate the level of benefits that would be derived from linear PPFs. In other words, there is an increasing opportunity cost associated with in-creasing specialisation. For example, it may be that the maximum output of cars produced by country A is only 20 million (compared with 30), and the maximum output of trucks pro-duced by country B might only be 16 million instead of 21 million. Hence, the combined output from trade might only be 46 million units (in-stead of the 51 million units initially predicted).

4. Complete specialisation might create structural unemployment as some workers cannot transfer from one sector to another.

5. Relative prices and exchanges rates are not taken into account in the simple theory of com-parative advantage. For example if the price of X rises relative to Y, the benefit of increasing output of X increases.

6. Comparative advantage is not a static concept - it may change over time. For example, non-renewable resources can slowly run out, increasing the costs of production, and reducing the gains from trade.

7. Many countries strive for food security, meaning that even if they should specialise in non-food products, they still prefer to keep a minimum level of food production.

8. Finally, the principle of comparative advantage is derived from a simple two good/two coun-try model. The real world is far more complex, with countries exporting and importing many different goods and services.

However, the principle of comparative advantage clearly does ‘shape’ the pattern of world trade, although most countries do try to spread their risks by diversifying into a range of goods and services, even when they do not have a clear comparative advantage.

B

X cars

A

Y trucks

3

12

21

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30

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Questions

1) Consider the example of a newly emerging economy like the Ukraine:

a) What are the benefits of increasing the specialisation of its factors of production?

b) What are the possible disadvantages of specialisation?

c) How should the Ukraine government, and firms in the Ukraine, assess which products should be chosen to specialise in?

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Patterns of trade

Growth in the world economyThe global economy has grown continuously since the Second World War. Global growth has been accompanied by a change in the pattern of trade, which reflects ongoing changes in struc-ture of the global economy. These changes include the rise of regional trading blocs and closer integration between member economies, deindustrialisation in many advanced economies, the increased participation of former communist countries, and the emergence of China and India.

Trading blocs

The emergence of regional trading blocs, where members freely trade with each other, but erect barriers to trade with non-members, has had a significant impact on the pattern of global trade. While the formation of blocs, such as the European Union and NAFTA, has led to trade creation between members, countries outside the bloc have suffered from trade diversion.

Decline in manufacturing

Like several advanced economies, the UK’s trade in manufactured goods has fallen relative to its trade in commercial and financial services. Many of these advanced economies have experienced deindustrialisation, with less national output generated by their manufacturing sectors.

The collapse of communism

The collapse of communism led to the opening-up of many former-communist countries. These countries have increased their share of world trade by taking advantage of their low production costs, especially their low wage levels.

Rise of the newly industrialised countries

Newly industrialised countries like India and China have dramatically increased their share of world trade and their share of manufacturing exports. China, in particular, has emerged as an economic super-power. China’s share of world trade has increased in all areas, and not just in clothing and low-tech goods.

For example, in 1995, the US had captured nearly 25% of global trade in hi-tech goods, while China had only 3%. By 2005, the US share had fallen to 15%, while China’s share had risen to 15%.4

4 Source: European Central Bank - ECB, Occasional Paper - China and India’s Role in Global Trade and Finance, 2008.

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Globalisation

What is globalisation?Globalisation refers to the integration of markets in the global economy. Markets where glo-balisation is particularly common include financial markets, such as capital markets, money and credit markets, and insurance markets, commodity markets, such as markets for oil, coffee, tin, and gold, and product markets, such as markets for motor vehicles and consumer electronics.

Why has globalisation increased?The pace of globalisation has increased for a number of reasons:

Communications

Developments in ICT, transport and communications have accelerated the pace of globalisation over the past 30 years. The internet has enabled fast and 24/7 global communication, and the use of containerisation has enabled vast quantities of goods and commodities to be shipped across the world at very low cost.

Capital mobility

Increasing capital mobility has also acted as a stimulus to globalisation. When capital can move freely from country to country, it is relatively straightforward for firms to locate and invest abroad, and repatriate profits.

Financial products

The development of complex financial products, such as derivatives, has enabled global credit markets to grow rapidly.

Free trade

Trade has become increasingly free, following the collapse of communism, which has opened up many former communist countries to inward investment and global trade. Over the past 30 years, trade openness, which is defined as the ratio of exports and imports to national income, has risen from 25% to around 40% for industrialised economies, and from 15% to 60% for emerg-ing economies.

Rise of multinationals

The growth of multinational companies (MNCs), and the rise in the significance of global brands like Microsoft, Sony, and McDonalds, has been central to the emergence of globalisation.

The advantages of globalisationGlobalisation brings a number of potential benefits to international producers, including:

Accesstomarkets

Access to larger markets means that firms may experience higher demand for their products, as well as benefit from economies of scale, which leads to a reduction in average production costs.

Access to resources

Globalisation enables worldwide access to sources of cheap raw materials, and this enables firms to be cost competitive in their own markets and in overseas markets. Seeking out the cheapest materials from around the world is called global sourcing. Because of cost reductions and in-creased revenue, globalisation can generate increased profits for shareholders.

Profits

Because of cost reductions and increased revenue, globalisation can generate increased profits for shareholders.

Avoidance of regulation

Firms can avoid regulation by locating production in countries with ‘softer’ regulatory regimes,

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such as in Less Developed Countries (LCDs).

Inward investment

Globalisation has led increased flows of inward investment between countries, which have cre-ated benefits for recipient countries. These benefits include the sharing of knowledge and tech-nology between countries.

Job creation

In the long term, increased trade is likely to lead to the creation of more employment in all coun-tries that are involved.

The disadvantages of globalisationSet against these advantages are a number of possible disadvantages of globalisation, including:

Product standardisation

The over-standardisation of products through global branding is a common criticism of globalisa-tion. For example, the majority of the world’s computers use Microsoft’s Windows operating sys-tem. Clearly, the standardisation of computer operating systems and platforms creates consider-able benefits, but critics argue that this leads to a lack of product diversity, as well as presenting barriers to entry to small, local, producers.

Diseconomies of scale

Another disadvantage for large firms involved in globalisation is the possibility of diseconomies of scale, such as difficulties associated with coordinating the activities of subsidiaries based in several countries.

Power of multi-nationals

The increased power and influence of multinationals is also seen by many as a considerable disadvantage of globalisation. For example, large multinational companies can switch their in-vestments between territories in search of the most favourable regulatory regimes. MNCs can operate as local monopsonies of labour, and push wages lower than the free market equilibrium.

De-industrialisation

Globalisation can also increase the pace of deindustrialisation, which is the slow erosion of an economy’s manufacturing base.

Loss of jobs

Jobs may be lost in domestic markets because of increased competition from foreign firms and because, in some cases, this competition is unfair. Unfair competition may arise when, for ex-ample, foreign firms discount their export prices below the true cost of production, or where governments give subsidies for firms to export. There may also be a loss of jobs due to structural changes resulting from globalisation, causing structural unemployment, and widening the gap between rich and poor within a particular country.

Increaserisks

One of the most serious criticisms of globalisation is the increased risk associated with the inter-dependence of economies. As countries are increasingly dependent on each other, a negative economic shock in one country can quickly spread to other countries. For example, a downturn in car sales in the UK affects the rest of Europe as most cars bought in the UK are imported from the EU. The Far East crisis of the 1990s was triggered by the collapse of just a few Japanese banks.

Most recently, the collapse of the US sub-prime housing market triggered a global crisis in the banking system as banks around the world suffered a fall in the value of their assets and reduced their lending to each other. This created a liquidity crisis and helped fuel a severe downturn in the global economy.

Over-specialisation, such as being over-reliant on producing a limited range of goods for the glob-al market, is a further risk associated with globalisation. A sudden downturn in world demand for one of these products can plunge an economy into a recession. Many developing countries suffer

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by over-specialising in a limited range of products, such as agriculture and tourism.

Increased inequality

Globalisation generates winners and losers, and for this reason is likely to increase inequality as richer nations benefit relative to poorer nations.

Negativeexternalities

Increased trade associated with globalisation has increased pollution and helped contribute to CO2 emissions and global warming. Trade growth has also accelerated the depletion of non-renewable resources, such as oil.

The impact of globalisation on the UK economyThe main issues arising from globalisation for the UK are:

Growth

Assuming the UK maintains its competitiveness, globalisation is likely to increase UK growth in the long term because aggregate demand (AD) is likely to increase through increased exports (X), and aggregate supply (AS) is likely to increase because of higher levels of investment, both do-mestic and foreign direct investment (FDI). However, growth in the short term may become more unstable as the global economy becomes increasingly interconnected. The recent financial crisis is evidence that unstable growth is a possible consequence of globalisation. Some economists have also argued that globalisation has increased the process of deindustrialisation in the devel-oped countries, including the UK.

The impact of the financial crisis and Eurozone debt crisis can be seen in the performance of the UK economy since 2008.

Employment

Long term, jobs may be destroyed in the manufacturing sector and created in the service sector, hence creating structural unemployment, which could widen the income gap within countries. The net effect of the impact on employment depends upon the speed of labour market adjust-ment, which itself depends upon mobility and flexibility. Improvements in labour productivity may be needed to close the productivity gap.

Prices

Increased competition is likely to reduce the price level, for traded manufactures. Because UK firms can source from around the world costs may be held down, and this may be passed on in terms of reduced domestic and export prices.

1.10

1.03

0.94

2.31

0.03 -0.33

-0.64

-3.00

-0.57

-0.3

0.4 0.2

1.2 0.8

-0.5

0.5 0.2

0.5 0.2

-3.50-3.00-2.50-2.00-1.50-1.00-0.500.000.501.001.502.002.503.00

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2007 2008 2009 2010 2011

GDP % change (quarterly) Source: ONS GDP % change

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Global Economics


Trade

The volume of both imports and exports is likely to increase, with trade representing an increas-ing proportion of GDP. The effect on the balance of payments is uncertain and depends upon relative growth rates, inflation, competitiveness, and the exchange rate.

19

Global Economics


Questions

1. What factors have contributed to globalisation?

2. Evaluate the likely impact of globalisation on a country of your choice.

20

Global Economics


Foreign Direct Investment (FDI)FDI refers to the flow of capital between countries. According to the United Nations Conference for Trade and Development (UNCTAD), FDI is ‘investment made to acquire lasting interest in en-terprises operating outside of the economy of the investor.’5 A single flow of capital between two countries is described as outward for the investing country and inward for the recipient country. FDI is undertaken by both private sector firms and governments.

The benefits of investing overseasInvesting abroad can generate many benefits to multinational organisations, including:

Lower transport costs

Transport costs can be reduced by locating manufacturing plant within a consuming country. This is especially important for bulk increasing products, such as motor vehicles.

Accesstomarketsandresources

Inward investors gain easier access to a country’s markets, especially where the product can be made with local ingredients. For example, it makes clear commercial sense for McDonalds to es-tablish local restaurants that use local ingredients, rather than export ingredients from the USA. In addition, investing firms gain access to a range of resources, including cheap or skilled labour and local knowledge and expertise.

Economies of scope

Firms that build factories and plant in other territories can exploit of economies of scope, such as spreading fixed management costs between territories, or where plant in one territory can be used to produce output for many territories.

Avoidance of trade barriers

Firms based outside one trading bloc can avoid barriers to trade such as tariffs and quotas, as in the case of Japanese car producers, such as Toyota and Nissan, locating in the EU.

Investment incomeOutward investment can lead to income for the investor including, profits from overseas sub-sidiaries, and dividends from owning shares in overseas firms. Investment income also includes interest payments from lending abroad, such as when a UK bank lends to a firm in India.

FDI appears in the balance of payments account of a country in two ways: firstly, the initial out-flow of FDI is entered as an outflow (debit) on the capital account, and secondly the resulting investment income is entered as an inflow (credit) on the current account.

Inward investmentCountries receiving inward investment gain in a number of ways, including; an increase in their GDP, initially through the FDI itself, and then followed by a positive multiplier effect on the receiv-ing economy so that the final increase in national income is greater than the initial injection of FDI.

Receiving countries also gain from the creation of jobs as a direct and indirect result of the inward investment. In addition, overseas producers have access to the latest technology from abroad. In a wider sense, receiving countries gain because there is less need to import because goods are produced in the domestic economy.

UK FDIThe UK is a leading investor abroad, and a principal beneficiary of inward investment. The UK consistently receives over 20% of all inward investment into the EU.

There are over 18,000 different investors into the UK, with1.8m people are directly ‘supported’ by

5 United Nations Conference for Trade and Development (UNCTAD)

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inward investment. Overseas firms account for approximately 40% of the top 100 UK exporters6.

Global FDIIn 2009, the world’s top three countries involved in FDI were the USA,

France, and the UK. In the majority of cases, these countries invest more abroad than they receive.

The one exception to this is China, who received more inward investment than they invested.

The volatility of FDIFigures for FDI indicate a high degree of volatility. The fall in FDI during 2008 illustrates well how volatile it can be, and gives some clues as to the underlying causes of volatility, such as:

Downturn in global economy

Changes in the global economy can greatly af-fect FDI flows. This was clearly the case in 2008, when the financial cri-sis and global recession caused investors to cut back on planned over-seas investment.

Currency instability

Sterling is a relatively unstable currency, unlike the US dollar and Euro, and sudden changes, as occurred during 2003, could have deterred some investors. Investment requires a stable economic environment and currency fluctuations create uncertainty, which is a general deterrent to investment.

Poorexpectations

Poor expectations can arise for a number of reasons, especially concerns about the overall state of the economy in which the investment will take place. Investment tends to be higher when their are positive expectations about the future.

Better alternatives

Better investment prospects elsewhere are likely to reduce flows into an economy. During the 2000’s emerging economies like China, India and Eastern Europe were beginning to become ex-tremely attractive to global investors. In Eastern Europe, for example, countries such as Poland, the Czech Republic, and Slovakia increasingly took advantage of their low labour costs and low

6 Source: UNCTAD, 2006.

$4,302

$1,719 $1,651

$1,378

$850 $834 $804

$3,120

$1,132 $1,125

$701 $596 $912

$463

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000 FDI Flows,$(US)Bn Source: UNCTAD, 2009

Outward FDI Inward FDI

0

1000

2000

3000

4000

5000

6000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

FDI Investors, 1998 - 2009 $Bn Source: UNCTAD

United States

France

United Kingdom

Germany

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Global Economics


company tax rates. For example, in Poland, profits taxes were just 19% and total labour costs were approximately £3.00 per hour, considerably below the average national minimum wage in Western Europe and the USA. Indeed, as Western Europe de-industrialises, Eastern Europe is rapidly industrialising, due mainly to inward investment as large multinationals such as Sony, Peugeot and VW7.

While the recent global recession has created considerable difficulty for Eastern Europe, the long-term trend is for increased FDI relative to Western Europe

The effects of FDI on exchange ratesThe effect of overseas investment on an economy is to raise demand for its currency and push up its value – its exchange rate.

This will have both positive and negative effects on an economy, such as the UK. The higher value of a currency is beneficial for domestic inflation, as foreign products require less currency, and are, therefore, cheaper when paid for in domestic cur-rency.

In addition, an increase in a country’s currency will lead to an improvement in its terms of trade, which are the ratio of export to import prices. (See: Terms of Trade).

However, a higher currency reduces competitiveness and exports may suffer, worsening the balance of payments. Even so, the positive value of FDI to the balance of payments is probably likely to be more significant than any increase in the ex-change rate that would follow.

7 Source Merrill Lynch, April 2004.

Quantity

£/$exchange

rate

Q

£1

S

D

D1

Q1

£


Increases in FDI raise thedemand for a currency, leading

to an increase in the exchange rate

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Global Economics


Questions

1) Assess the likely impact of a fall in FDI into the UK economy.

2) Examine how a change in FDI affects the exchange rate of an economy.

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Global Economics



Free trade and protectionismTwo opposing forces have shaped the changing pattern of world trade over the last 200 years; the promotion of free trade and the protection against free trade. Trade protection is the process of erecting barriers to trade, such as taxes on imports, called tariffs, and trade liberalisation is the process of making trade free from such barriers.

The UK is an extremely open economy with a long history of promoting trade openness. By 2009, trade accounted for around 60% of the UK’s national income8.

The advantages of free tradeIt can be argued that free trade creates a number of important advantages, which are very similar to the benefits of globalisation, these being:

Specialisation and comparative advantage

Free trade encourages countries to specialise and benefit from the application of the principle of comparative advantage.

Increased world output

If countries specialise, and trade, world output is likely to increase as scarce resources will be used more efficiently.

Increased competition and lower prices

Free trade increases competition, which generates further benefits, including lower prices and the breakdown of domestic monopolies, which increases choice for consumers.

Higher quality

Open economies are likely to see a rise in the quality of products available as overseas firms com-pete on non-price factors, such as design and reliability.

8 Source: Statistics.gov, 2009

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Trade protectionTrade protection is the deliberate attempt to limit imports or promote exports by putting up barriers to trade. Despite the arguments in favour of free trade, and increasing trade openness, protectionism is still widely practiced.

The motives for protectionThe main arguments for protection are:

Protect sunrise industries

Barriers to trade can be used to protect sunrise industries, also known as infant industries, such as those involving new technologies. This gives new firms the chance to develop, grow, and be-come globally competitive.

Protection of domestic industries may allow they to develop a comparative advantage. For exam-ple, domestic firms may expand when protected from competition and benefit from economies of scale. As firms grow they may invest in real and human capital and develop new capabilities and skills. Once these skills and capabilities are developed there is less need for trade protection, and barriers may be eventually removed.

Protect sunset industries

At the other end of scale are sunset industries, also known as declining industries, which might need some support to enable them to decline slowly, and avoid some of the negative effects of such decline. For the UK, each generation throws up its own declining industries, such as ship building in the 1950s, car production in the 1970s, and steel production in the 1990s.

Protect strategic industries

Barriers may also be erected to protect strategic industries, such as energy, water, steel, arma-ments, and food. The implicit aim of the EUs Common Agricultural Policy is to create ‘food secu-rity’ for Europe by protecting its agricultural sector.

Protect non-renewable resources

Non-renewable resources, such as oil, are a special case where the normal ‘rules’ of free trade are often abandoned. For countries aiming to rely on oil exports lasting into the long term, such as the oil-rich Middle Eastern economies, limiting output in the short term through production quotas is one method employed to conserve resources.

Deter unfair competition

Barriers may be erected to deter ‘unfair’ competition, such as ‘dumping’ by foreign firms at prices below cost.

Save jobs

Protecting an industry may, in the short run, protect jobs, though in the long run it is unlikely that jobs can be protected indefinitely.

Help the environment

Some countries may protect themselves from trade to help limit damage to their environ-ment, such as that arising from CO2 emissions caused by increased production and transport.

Limit over-specialisation

Many economists point to the dangers of over-specialisation, which might occur as a result of taking the ‘theory’ of comparative advantage to its extreme. Retaining some self-sufficiency is seen as a sensible economic strategy given the risks of global downturns, and an over-reliance on international trade.

In addition to the economic arguments for protection, some protection may be for political rea-sons.

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Methods of protectionThere are two types of protection; tariffs, which are taxes, or duties, on imported goods designed to raise the price to the level of, or above the existing domestic price, and non-tariff barriers, which include all other barriers, such as quotas and export subsidies.

Quotas

A quota is a limit to the quantity coming into a country. With no trade, equilibrium market price in the country will exist at the price which equates domestic demand and domestic supply, at P, and with output at Q. However, the world price is likely to be lower, at P1, than the price in a country that does not trade. If the country is opened up to free trade from the rest of the world, the world supply curve will be perfectly elastic at the world price, P1. The new equilibrium price is P1 and output is Q1.

The domestic share of output is now Q2, compared with Q, the self-sufficient quan-tity. The amount imported is the distance Q2 to Q1.

In an attempt to protect domestic produc-ers, a quota of Q3 may be imposed on im-ports.

This enables the domestic share of output to rise to Q3 and causes the price to rise to P2, with total output falling to Q4. The amount im-ported falls from Q2 to Q1, to Q3 to Q1.

One of the key differences between a tariff and a quota is that the welfare loss associ-ated with a quota may be greater because there is no tax revenue earned by a govern-ment. Because of this, quotas are used less frequently than tariffs.

In addition to quotas, other non-tariff barri-ers include:

Governmentfavouringdomesticfirms

Countries can protect their domestic indus-tries by employing public procurement poli-cies, where national governments favour local firms. For example, national or local governments may purchase supplies of mili-tary or medical equipment from local firms.

Domestic subsidies

Governments may also give subsidies to domestic firms, which can then be used to help reduce price and deter imports. This financial support can also be in the form of an export subsidy, pro-viding an incentive for firms to export.

Health and safety grounds

National governments can also use health and safety regulations to discriminate against import-ed products, such as banning the import of a product on health or safety grounds, while local producers do not have to pass such stringent tests.

Quality standards

In a similar way, governments can set tough quality standards that may be difficult for overseas

Quantity

Price

Q

P

D(domestic)

S (domestic)

World Supply

Q1 Q2Domestic

P1

Q3

QUOTA


Quantity

Price

Q

P

D (domestic)

S (domestic)

World Supply

Q1 Q2Domestic

P1

Q3

QUOTA

S1

Q4

P2


27

Global Economics


producers to meet.

Bureaucracy

Excessive bureaucracy associated with the process of importing and exporting may also restrict trade. For example, goods may be deliberately held-up at ports and airports, and there may be unnecessarily complex and lengthy paperwork associated with international transactions.

Exchangerates

Monetary protection involves countries deliberately devaluing their exchange rate to stimulate exports and deter imports.

TariffsTariffs, or customs duties, are taxes on imported products, usually in an ad valorem form, levied as a percentage increase on the price of the imported product. Tariffs are one of the oldest and most pervasive forms of protection and barrier to trade.

The impact of tariffsThe imposition of tariffs leads to the following:

Higher prices

Domestic consumers face higher prices, which also means that there is a loss of consumer sur-plus. However, there is a gain in domestic producer surplus as producers are protected from cheap imports, and receive a higher price than they would have without the tariff. However, it is likely that there is an overall net welfare loss (see below.)

Distortion

There is a potential distortion of the principle of comparative advantage, whereby a tariff alters the cost advantage that countries may have built up through specialisation.

Retaliation

There is the likelihood of retaliation from exporting countries, which could trigger a ‘costly’ trade war.

However, in the short run tariffs may protect jobs, infant and declining industries, and strategic goods. Tariffs may also help conserve a non-renewable scarce resource. Selective tariffs may also help reduce a trade deficit, and reduce consumption of de-merit goods, such as imported tobacco and alcohol.

28

Global Economics


The Tariff diagramWithout trade, the domestic price and quantity are P & Q.

If a country opens up to world supply, price falls to P1, and output increases from Q to Q2. As a result, domestic producers’ share falls to Q1 and imports now dominate, with the quantity imported Q1 to Q2.

The imposition of a tariff shifts up the world supply curve to World Supply + Tariff.

The price rises to P2, and the new output is at Q3. Domestic producers share of the market rise to Q4, and imports fall to Q4 to Q3 ( K - L). The result is that domestic pro-ducers have been protected from cheaper imports from the rest of the World.

Given that domestic consumers face high-er prices, they also suffer a loss of consum-er surplus. In contrast, domestic producers increase their producer surplus as they re-ceive a higher price than they would have without the tariff.

Increased market share also means that jobs will be protected in the domestic econ-omy.

Net welfare loss

However, it is likely that there is an overall net welfare loss.

The tariff diagram suggests that the reduc-tion in consumer surplus is greater than the increase in producer surplus. Even when adding the tariff revenue (area K,L,M,N) there is still a net loss.

The net welfare loss is represented by the triangles X and Y.

Quantity

Price

Q

P

D (domestic)

S (domestic)

World Supply

Q2 Q1

P1

Q4 Q3

P2 World Supply + tari�K

M

L

N


Quantity

Price

Q

P

D (domestic)

S (domestic)

World Supply

Q2 Q1

P1

Q4 Q3

P2 World Supply + tari�

X Y

K

M

L

N

tari� revenue


29

Global Economics


Questions

1) Evaluate the case for and against the EU imposing tariffs on imported shoes from China and Vietnam.

2) In 2009, the Chinese government reduced export taxes to zero. Explain the purpose of the policy change, and consider its likely effect.

30

Global Economics


Economic IntegrationThere are several stages in the process of economic integration, from a very loose association of countries in a Preferential Trade Area, to complete economic integration, where the economies of member countries are completely integrated.

Trading blocsA regional trading bloc is a group of countries within a geographical region that protect them-selves from imports from non-members in other geographical regions, and who look to trade more with each other. Regional trading blocs increasingly shape the pattern of world trade - a phenomenon often referred to as regionalism.

Preferential Trade Area

Preferential Trade Areas (PTAs) exist when countries within a geographical region agree to reduce or eliminate tariff barriers on selected goods imported from other members of the area. This is often the first small step towards the creation of a trading bloc. Agreements may be made be-tween two countries (bi-lateral), or several countries (multi-lateral).

Free Trade Area

Free Trade Areas (FTAs) are created when two or more countries in a region agree to reduce or eliminate barriers to trade on all goods coming from other members. The North Atlantic Free Trade Agreement (NAFTA) is an example of such a free trade area, and includes the USA, Canada, and Mexico.

Customs Union

A 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 negoti-ate as a single bloc with 3rd parties, such as with other trading blocs, or with the WTO. Having a common external tariff means that all members must share the same trade policy in relation to a non-member. For example, if two members, A and B, trade with a non-member, C, they must have the same tariff against C.

CommonMarket

A ‘common market’ is the first significant step towards full economic integration, and occurs when member countries trade freely in all eco-nomic resources – not just tangible goods. This means that all barriers to trade in goods, services, capital, and labour are removed. In addition, as well as removing tariffs, non-tariff barriers are also reduced and eliminated. For a common mar-ket to be successful there must also be a signifi-cant level of harmonisation of micro-economic policies, and common rules regarding monopoly power and other anti-competitive practices. There may also be common policies affecting key industries, such as the Common Agricultural Policy (CAP) and Common Fisheries Policy (CFP) of the European Single Market (ESM).

Economic and Monetary UnionEconomic Union

Economic Union is a term applied to a trading bloc that has both a common market between members, and a common trade policy towards non-members, but where members are free to pursue independent macro-economic policies.


Preferential Trade Area

Free Trade Area

Common Market

Customs Union

Monetary Union

Fiscal Union

Independent Economy

Political Union

INCR

EASI

NG

INTE

GRA

TIO

N

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Global Economics


Monetary Union

Monetary union is the first major step towards macro-economic integration, and enables econo-mies to converge even more closely. Monetary union involves scrapping individual currencies, and adopting a single, shared currency, such as the Euro for the Euro-17 countries, and the East Caribbean Dollar for 11 islands in the East Caribbean. This means that there is a common ex-change rate, a common monetary policy, including interest rates and the regulation of the quan-tity of money, and a single central bank, such as the European Central Bank or the East Caribbean Central Bank.

Fiscal Union

A fiscal union is an agreement to harmonise tax rates, to establish common levels of public sec-tor spending and borrowing, and jointly agree national budget deficits or surpluses. The majority of EU states agreed a fiscal compact in early 2012, which is a less binding version of a full fiscal union.

Economic and Monetary Union

Economic and Monetary Union (EMU) is a key stage towards compete integration, and involves a single economic market, a common trade policy, a single currency and a common monetary policy.

Complete Economic Integration

Complete economic integration involves a single economic market, a common trade policy, a sin-gle currency, a common monetary policy together with a single fiscal policy, tax and benefit rates – in short, complete harmonisation of all policies, rates, and economic trade rules.

The EU The EU is the world’s largest trading bloc, and second largest economy, after the USA. The EU was originally called the Economic Community (or common market) after its formation following the Treaty of Rome in 1957. The original six members were Germany, France, Italy, Belgium, Nether-lands, and Luxembourg.

The initial aim was to create a single market for goods, services, capital, and labour by eliminat-ing barriers to trade and promoting free trade between members. In terms of dealing with non-members, common tariff barriers were erected against cheap imports, such as those from Japan, whose goods were artificially cheap because of an undervalued yen.

The advantages for members of blocsThe main advantages for members are:

Free trade within the bloc

Knowing that they have free access to each other’s markets, members are encouraged to special-

EU - 27

Austria Germany Norway

Belgium Greece Poland

Bulgaria Ireland Portugal

Cyprus Italy Romania

Czech Republic Latvia Spain

Denmark Lithuania Slovenia

Estonia Luxembourg Slovakia

Finland Malta Sweden

France Netherlands UK

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Global Economics


ise. This means that, at the regional level, there is a wider application of the principle of compara-tive advantage.

Marketaccessandtradecreation

Easier access to each other’s markets 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

Producers can benefit from the application of scale economies, which will lead to lower costs and lower prices for consumers.

Jobs

Jobs may be ‘created’ in member economies.

Protection against non-members

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.

The main disadvantages of trading blocsTrading blocs can generate the following disadvantages:

Lossofbenefitsfromfreetrade

The potential benefits of free trade between countries in different blocs are lost, meaning that countries may not be able to fully exploit their comparative advantage.

Distortion of trade

Similarly, trading blocs are likely to distort world trade, and reduce the beneficial effects of spe-cialisation and the exploitation of comparative advantage.

Inefficienciesandtradediversion

Inefficient producers within the bloc can be protected from more efficient ones outside the bloc. For example, inefficient European farmers may be protected from low-cost imports from devel-oping countries. Trade diversion arises when trade is diverted away from efficient producers who are based 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. The EU and US have a long history of trade disputes, including the dispute over US steel tariffs, which were declared illegal by the WTO in 2005. In addition, there are the so-called ‘beef wars’ with the US applying £60m tariffs on EU beef in response to the EU’s ban on US beef treated with hormones; and complaints to the WTO of each other’s generous ag-ricultural support. During the 1970s many former UK colonies formed their own trading blocs in reaction to the UK joining the European common market.

Examples of EU protection

The Case of Sugar

There is considerable, and controversial, financial support for EU sugar producers, with EU sub-sidies of around £400 per tonne9. The initial aim of the subsidy was to enable the huge EU sugar surplus to be exported at the prevailing world price, which was around 4p a pound in 2005, com-pared to the EU price of 15p. Approximately 5m tonnes of excess EU sugar are ‘dumped’ on world markets each year. The EU imposes both quotas and tariffs on non-EU sugar imports, including 200% tariffs on sugar cane from non-EU countries. There are lower tariffs on sugar from certain

9 Source: Asia Times.

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favoured countries like Mauritius10.

TheCaseofTextiles

Since the 1970s, the EU has imposed quotas and tariffs on textile imports. During 2005, the EU blocked imports of textiles from China because it had exceeded its quota for clothing items such as T-shirts, knitwear and dresses.

Case study - trade creation

When customs unions are established the flow of trade between countries involved in the new union and those outside will be affected. Customs unions eliminate barriers to trade between members, which is assumed to provide a considerable incentive to increase trade between mem-bers and to reduce trade between members and non-members. It is often easiest to appreciate the effect of a customs union by considering what happens when one country joins an existing union.

Outside a union, and operating independently, a single nation will look to exploit its compara-tive advantage. In a free trade environment, countries will trade with who they like, attempting to exploit their comparative cost advantage though specialisation. They will export goods they produce most efficiently, and import goods from low-cost countries who have exploited their own comparative cost advantage to produce cheap exports. In a situation where countries do not trade freely, by imposing tariffs, or by favouring one country over in terms of tariff levels, trade will be distorted and the pattern of trade will change. Inefficient producers may be may be pro-tected and encouraged, at the expense of more efficient imports.

The creation of a customs union, with common external tariffs, will further alter the existing pat-tern of trade flows. The assumption is that before the union, members imposed different tariffs on different countries to protect their own industries. Taking a hypothetical example from an actual historical period, we shall assume that, prior to joining the European ‘common market’ in 1973, the UK could produce butter at 130p per kilograms (kg), on average. At the same time, New Zealand could produce the same quantity for 100p, and Denmark could produce it for 120p. Hence, prior to the formation of a customs union, New Zealand has a comparative advantage in butter, and is the most efficient. Denmark is the second most efficient producer, and the UK is the least efficient.

Let us assume that, in order to protect its inefficient farmers equally, the UK imposes differential tariffs on New Zealand and Denmark in order to raise the imported price above its own (high cost) butter. For example, imposing a high 32% tariff on ‘very’ low priced New Zealand butter would raise its price to 132p per kg (100p to 132p), as would imposing only a 10% tariff on low priced Danish butter (120p to 132p). We will also assume that, with these tariffs in place, a total demand of 30m kg tonnes of butter exists in the UK each year, with UK farmers supplying 20m kg (the maximum it can produce), and New Zealand and Danish farmers supply 5m kg each.

Trade creation

Once a union is created, members agree to eliminate tariffs between themselves. The effect of this is that, facing lower priced, zero-tariff, imports from members, consumers increase their de-mand for these goods, and new trade will be created – a process called trade creation. The terms trade creation and trade diversion are closely associated with Chicago School economist Jacob Viner11

For example, if Denmark and the UK form a customs union, tariffs on Danish butter must now be reduced, and once they are completely removed, the free market price of 120p will be highly attractive to UK consumers. UK consumers will now consume more butter in total because aver-age butter prices will have fallen with the removal of tariffs on Danish butter, and total demand for butter rises. For example, total output and consumption might increase to 32m tonnes (up by 2m), with UK farmers down from 20m to 15m, New Zealand exports collapsing to just 2m,

10 Sources: Oxfam Report, 2004 and the Times, April 2004.

11 The Customs Union Issue, 1950

34

Global Economics


and Denmark increasing its output and sales of butter to the UK to 10m (from 5m to 10m). Total consumption has gone up from 30m (20 + 5 + 5), to 32m (15 + 2 + 15). The additional 2m tonnes of butter produced and consumed is the new trade created as a result of the removal of barriers by union members.

Furthermore, this will enable a dynamic reaction within Denmark and the UK. Over time, as coun-tries (Denmark and the UK) become more integrated, increased trade will generate further effi-ciency gains, such as through the application of economies of scale. Prices may fall even further, relative to those of non-member countries, and the process of trade creation continues. For ex-ample, with increased sales, Denmark can specialise further in butter production, and produce on large scale, bringing prices down even further (perhaps nearer to the New Zealand level). In addition, the UK can now free up its resources, and move them out of butter production and into goods and services for which the UK has a comparative advantages over Denmark. Hence, over time, trade creation will continue as a positive long-term effect of a customs union.

Trade diversion

The major loser in this is the previous trading partner left outside the bloc - less trade now exists between new members and their old trading partners. The process of efficient producers losing out to inefficient ones is referred to as trade diversion. For example, after Denmark and the UK form a customs union, New Zealand, which was the most efficient butter producer, suffers a loss of sales to the UK, from 5m to 2m, with trade diverted from New Zealand to Denmark. However, there is some debate about the use of the term trade diversion. In its simplest form it means any trade diverted away from efficient global producers as a result of the creation of a customs union. Other economists regard trade diversion as relating to the long-term loss of trade resulting from inefficient producers (such as Denmark, in our hypothetical example) becoming more efficient following membership of the union. For example, if the price of Danish butter falls from 120p to 95p as a result of trade expansion within the union, it is now 5p cheaper than New Zealand in the open market, and more trade may now be diverted away from the formerly highly efficient New Zealand. Whichever definition is accepted, it is clear that in this case the union has distorted trade.

Finally, we also need to consider the loss of tariff revenue that might follow the diversion of trade from non-member countries. Given that, in our simple example, imports from New Zealand have fallen causing a loss of tariff revenue, and tariff revenue from Danish butter has been eliminated, it is necessary to weigh up the welfare gains and losses from the formation of the customs union. There is no simple answer to this, and it is quite possible that a union could result in either a net loss, or a net gain.

We can conclude that small countries (such as New Zealand, in our hypothetical case) may be at a considerable disadvantage by not joining a customs union, or free trade area. In fact, they are certainly likely to, as the above analysis would indicate. Indeed, New Zealand is a key partner in the Cairns group, which was formed in 1986 by 14 agricultural exporting coun-tries, largely as a response to increased European protection associated with its Common Agricultural Policy (CAP).

Diagram to show a simple case of trade cre-ation

With a tariff imposed prior to the forma-tion of a customs union with Denmark, UK farmers supply 0 – Q4, and Q4 to Q3 is imported. The net welfare loss would be X + Y. Following the union, the tariff is aban-doned and the market share of UK farm-ers falls to 0 – Q1, and imports from Den-mark increase from Q4 – Q3, to Q1 to Q2.

The welfare gain is X + Y, and the trade created is Q3 to Q2.

Quantity

Priceof butter

Q

P

UK demandfor butter

UK supplyof butter

Danish supply

Q2 Q1

P1

Q4 Q3

P2 Danish supply + tari�

X Y

K

M

L

N

Welfare gained and trade created bymembers of a customs union

tradecreated


35

Global Economics


Questions

1. Distinguish between free trade areas (FTAs) and customs unions.

2. Why do you think trading blocs have come to dominate world trade over the last 40 years?

3. What do you think are the two main advantages and two main disadvantages of trading blocs?

4. Outline the likely economic effects on the UK of a decision to withdraw from the EU.

5. Outline the role of the WTO in terms of trading blocs.

6. In May 2009 the US chip manufacturer, Intel, was fined a record £950m by the European Commission for abusing its dominant position and illegally engaging in anti-competitive behaviour against another US based chip manufacturer, AMD (Advanced Micro Devises). Intel was found guilty of offering generous rebates to a number of computer manufacturers for purchasing their chips, including Acer, Dell, and HP. Intel has roughly 70% of the global market share of chip production.

a. To what extent is Intel a monopoly supplier?

b. With reference to the data, explain what is meant by ‘abuse of dominant position’.

c. Evaluate the effectiveness of fines as a deterrents to anti-competitive behaviour.

d. To what extent could it be argued that European competition policy is simply an example of protectionism?

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Global Economics


Case studyMythica became an independent state in 1925, and is blessed with large amounts of land, a warm climate, and a hardworking labour force. By the late 20th Century, Mythica had become self suffi-cient in wheat, which is widely used to make bread – one of the staple foods of Mythica. Mythica’s economists calculated that it had a comparative advantage in wheat production compared with distant countries, like the Federation of Camelot, but not compared with its close neighbours. Unfortunately, during the mid 20th Century, Mythica was at war with its closest neighbours, Utopia and Atlantis, and this war lasted for over 10 years. After the war, Mythica invested large amounts in developing its own agricultural sector, along with other industries, just in case it went to war again. Politicians believed that ‘food security’ was of paramount importance to Mythica. However, there was growing belief that it should also diversify into other areas, such as tourism. With its fantastic scenery, good beaches, and cheap land to build hotels, many believed that tourists would flock to Mythica, especially from the Federation of Camelot. Mythicans are fairly well edu-cation, and speak the language of the Federation. By 2000 some 30% of the Mythican population still worked on the land, and 20% worked in wheat production, but tourism was beginning to de-velop. By 2001 the domestic demand and supply schedule for wheat was:

After much discussion, in 2003 Mythica joined with Utopia and Atlantis to form a ‘free trade’ area. Mythica started to import wheat from the other two countries, both of which have a comparative advantage in wheat production. By 2004, the free trade price of wheat from Utopia and Atlantis was $2,000 per tonne, irrespective of the quantity imported. This was clearly good for Mythican consumers. However, within 2 years imports of wheat rose and the domestic share of wheat pro-duced by Mythican farmers fell.

By 2007, wheat farmers in Mythica had formed an organisation, opposed to wheat imports from Utopia and Atlantis. They argued that jobs in Mythica were totally related to the volume of sales (for every 20m tonnes sold, 0.5m workers were employed.)

The farmers went to the Mythican parliament to argue that tariffs should be imposed on all im-ports. Parliament agreed to implement a $1,000 per tonne tariff, after farmers threatened to go on strike.

a. What is meant by saying that Mythica had a comparative advantage in the produc-tion of wheat, compared with the Federation of Camelot?

b. What is meant by ‘food security’?

a. To what extent does the evidence suggest that Mythica has a comparative advan-tage in tourism?

b. What is meant by a ‘free trade area’ – contrast this with a ‘customs union’.

c. Why are some Mythicans worried about free trade with Utopia and Atlantis?

d. Draw an accurate graph to show:

Demand and supply of wheat

Price per tonne ($)

Domestic demand (M)

Domestic supply (M)

1000 400 100

2000 350 150

3000 300 200

4000 250 250

5000 200 300

6000 150 350

7000 100 400

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Global Economics


i. The self-sufficient price of wheat in Mythica.

ii. The free trade price of wheat, and the relative share of imports and domestic pro-duction.

iii. The price after the tariff, along with the (new) relative shares of imports and do-mestic production.

iv. The effect of the tariff on Mythica’s economic welfare.

v. What are the dangers in specialising in wheat production?

vi. Apart from specialising in wheat and/or tourism, describe and evaluate one other development strategy.

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Global Economics


Common Agricultural PolicyThe EU protects its farmers and growers through its Common Agricultural Policy (CAP). European farmers receive CAP subsidies of around £48 billion each year, and these subsidies account for nearly 50% of the entire EU spending budget12.

Evolution of CAPCAP was created by the Treaty of Rome (1957) to ensure food supplies for Europe, and provide a fair income for European farmers.

Why support farmers and growers?

Farmers suffer from three potential problems:

Falling income

Farm incomes have fallen because of increasing global food production, and higher yields follow-ing the application of new technology in the developing world, and new entrants into the market.

Unstable prices

Farm prices are notoriously unstable, largely because of random supply shocks, such as poor weather and disease.

Loss of power

Farmers and growers have lost power to the large supermarket chains, which can exert their mo-nopsony power in pushing farm prices down.

As a result, farmers are often regarded as a special case for government support. Food is a stra-tegic good, and governments around the world often view food security as a key economic ob-jective. The introduction of CAP, in Europe, was seen as an important step in establishing food security for Europe. Price support schemes, such as guaranteed prices, were first introduced in 1962, and became the main means of supporting European farmers. So effective was the support to farmers, over-production was encouraged, resulting in the infamous wine lakes, butter moun-tains, and the $2 a-day cow.

Reform of CAPBy the mid 1980s, over-production led to sweeping reforms, including the use of set-aside pro-grammes. Set-aside programmes, which involved the voluntary setting aside of land in an at-tempt to reduce agricultural surpluses, were introduced into the UK in 198813. Other measures were introduced during the 1980s and 1990s to limit production, including fixed quotas for milk production, with penalties for over-production. These measured, combined with ‘set-aside’ grad-ually reduced the huge surpluses14.

By the early 1990s, there was a movement away from guaranteed prices toward direct subsidies to farmers, irrespective of the output produced. Subsidies are, of course, a form of protection and trade barrier. The Agenda 2000 reform encouraged EU farmers to diversify and to re-structure their farms so that they could become more competitive in world markets. Included in this reform package was a reduction in subsidies for selected agricultural products, including cereals, milk, and beef. This would encourage European farmers to become more price-competitive, and en-able Europe to increase its export of agricultural products.

The UK receives a controversial rebate against payments into the EU to compensate for that fact that it receives relatively little income from CAP in comparison with France and Spain15.

12 Source: OECD, 2010

13 Source: Defra, 2009

14 Source: European Commission

15 Additional source: The Times, June 2005

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Global Economics


Questions

1. What is CAP, and what was its main objective when it was established?

2. What policies were introduced in the 1980s and 1990s to limit agricultural surplus-es?

3. Draw a diagram to show the effects of export subsidies by the EU.

4. In what way might farm subsidies create moral hazard?

5. Outline the likely effect of EU enlargement on EU agriculture.

6. What is the probable impact of globalisation on EU agriculture?

7. Why does the EU ‘social’ labour market model make further reform of CAP difficult?

8. To what extent is CAP an example of government failure?

9. What is the likely effect of CAP being completely abandoned?

40

Global Economics


The WTOThe World Trade Organisation (WTO) attempts to promote free and fair trade – an increasingly difficult task, which it undertakes with varying success. The WTO was established in 1995 when it replaced the General Agreement on Tariffs and Trade (GATT). It has its headquarters in Geneva, Switzerland and, by 2012, had 153 member countries, including China, which was the last major nation to join.

The purpose of the WTO is to promote free and fair trade through multilateral talks and negotia-tions, and to arbitrate between countries that are in dispute. The WTO itself claims that, unlike GATT that preceded it, its rules of trade have been worked out by the direct involvement of all countries, and not just a few powerful ones.

Trade liberalisation clearly brings many economic and political benefits, but many claim that the WTO has had limited success for a number of reasons:

Too few agreements

Critics argue that the number of trade agreements settled through the WTO is inadequate given the number of disputes. However, the number of settlements has risen from 20 in 1990 to 157 in 200716.

Failure to confront ethical issues

Many argue that the WTO has failed to confront ethical issues, such as the use of child labour and poor working conditions in developing economies.

Failure to confront environmental issues

Similarly, many argue that it has failed to confront environmental issues, such as the depletion of global fish stocks, deforestation, and climate change.

Takestoolongtoarbitrate

Critics also complain that the WTO takes too long to arbitrate and settle disputes.

Favours the powerful

Critics also argue that the WTO has an inbuilt bias favouring developed and powerful nations and trading blocs such as the USA and the EU, and operating against weaker, developing ones.

Failure to promote multilateralism

Despite the WTO operating as a multilateral organisation, many member countries and trading blocs favour bilateral discussions with partners or competitors. This is because bilateral negotia-tions can be fully focussed and relatively quick to complete. The result is that many countries prefer to bypass the WTO process, and deal directly with other countries. The failure of the most recent round of WTO negotiations, the Doha round, is widely regarded as evidence of the inher-ent problems of multilateral discussions. While the WTO is likely to argue that it encourages such agreements when they do not have a negative impact on third parties, it is very difficult to find cases where third-party countries are not, at least indirectly, negatively affected by a specific bi-lateral agreement.

The Doha roundThe most recent round of talks is the Doha Round, which began in 2001, with major summit meetings in Cancun, Mexico, Hong Kong, and Davos in 2003, 2005, and 2007 respectively. The Doha round of talks is also called the development round, reflecting its emphasis on promoting free trade for the benefit of developing nations. In particular, the Cancun talks focussed on three areas: reducing agricultural subsidies and industrial tariffs imposed by developed nations, which limit the market access of developing nations; harmonising competition rules within different countries; and helping poor countries.

The talks collapsed for a number of reasons. While the US and EU failed to agree reductions in

16 Source: UNCTAD.

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Global Economics


agricultural support, many developing countries refused to agree new investment rules which would make it easier for multinationals to invest in their countries. Since the collapse, the USA and EU have returned to bilateral agreements with favoured nations, rather than entering into multilateral agreements. This highlights a major limitation of the WTO in not gaining a complete consensus that multilateral negotiations should be the method of choice for its members.

The failure of the Doha round means that the rich countries of the world still protect themselves from goods produced by the poor nations. By 2005, average agricultural tariffs imposed by the USA and EU were 60%, against average industrial tariffs of only 5%17.

17 Source: WTO, 2005

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Global Economics


Questions

1. Contrast multilateralism and bilateralism.

2. Evaluate the effectiveness of the WTO.

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Global Economics


The balance of paymentsTo maintain a balance of payments with the rest of the world is a macro-economic objective. In simple terms, if the balance of payments balances, then the combined receipts from selling goods and services abroad, together with investment income from abroad, equals the combined expenditure on imports of goods and services, and investment income going abroad. The bal-ance of payments is also an official account of these payments, published in a document called the ‘Pink Book’. Statistics on UK imports and exports have been gathered in the UK since 1687.

As an official record, the balance of payments is divided into two accounts - the current account and the capital and financial account.

The current account The current account is composed of the following payments:

Trade in goods

These items include the import and export of finished goods, such as cars, and computers; semi-finished goods, such as parts and components for assembly, and commodities, such as oil, tea and coffee.

Trade in services

Trade services include financial services, tourism, and consultancy.

Investment income

Investment income, which includes overseas profits, such as those from business activities of subsidiaries located abroad; interest received from UK financial investment and loans abroad and; dividends from owning shares in overseas firms.

Transfers

Transfers in items such as gifts, donations to charity and overseas aid.

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Global Economics


The Capital and Financial AccountThe Capital and Financial Account measures the flows of capital and finance between the UK and the rest of the world. Types of flow include:

Real foreign direct investment (FDI), such as a UK firm setting up a manufacturing plant in South Africa.

Portfolio investment, such as UK citizens buying shares in an overseas firm in anticipation of a long-term return.

Short-term speculative flows, often called hot money, where speculators invest abroad in or-der to seek out the highest return in the short run. For example, a UK fund manager working for a major UK investment bank buying shares in a US ‘hi tech’ firm in the hope of making a ‘quick’ return. Speculators may quickly sell shares and other financial assets if a short-term profit has been made. Much of the short-term investment flows relate to trade in financial derivatives.

Official financing, which occurs when govern-ments, or their agents, buy or sell currencies, securities and other assets to create an inflow or outflow in the ‘balance of payments’ accounts. For example, when a deficit occurs it may need to be financed by the Bank of England acting for the government. In an accounting sense the Bank of England must ensure that the account balances – the ‘bottom line’ must always equal zero.

Financing deficits and surplusesThe‘financing’ofadeficitisachievedby:

z Selling gold or holdings of foreign ex-change, such as US Dollars, Japanese Yen or European Euros, or:

z Borrowing from other Central Banks or the International Monetary Fund (IMF).

Asurpluswillbedisposedofby:

Buying gold or currencies.

Paying off debts.

The Balancing ItemIn theory, the Capital and Financial Account balance should be equal and opposite to the Cur-rent Account balance so that the overall account balances, but in practice this is only achieved by the use of a balancing item. The balancing item is defined as the device used to compensate for errors and omissions in the balance of payments data, and which brings the final balance of payments account to zero.

UK Balance of payments (2010)

UK Accounts (£m)

Current Account Trade in goods -98462 Trade in services 58778 Total trade -39684 Income Compensation of employees -389 Investment income 23428 Total income 23039 Current transfers General government -14887 Other sectors -5194 Total current transfers -20081 Current balance -36726 Capital balance 3708 Financial account Direct investment 21804 Portfolio investment 10434 Financial derivatives 32490 Other investment -17141 Reserve assets -6070 Net financial transactions 41517 Net errors and omissions -8499

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Global Economics


UK trade performanceWith the exception of 1997, in every year since 1987 the UK has recorded a trade deficit in goods and services. The trade deficit reached a peak of £45.5 billion in 2010. The deficit tends to follow a cyclical pattern, as shown in the chart.

Adeficitcanbeaproblemif:

z It is a persistent deficit that does not self-correct over time.

z The deficit forms a large share of GDP.

z There are no compensating inflows of investment income or inward capital ac-count flows.

z The central bank has low reserves.

z The economy has a poor record of repaying debt.

Recent trade figuresIn the UK, there is a strong connection between a growing economy and trade deficits. Soon after the economy went into recession in 1990, the trade deficit began to fall quickly. However, as the economy came out of recession and into a period of strong growth from 1993, the trade deficit began to rise quickly, and continued to rise through the next 15 years. As can be seen, the recent recession, which started in late 2008, caused the deficit to fall back.

-60

-50

-40

-30

-20

-10

0

10

20 UK Current Account 1990 - 2010, £b Source: Pink Book

-20

-15

-10

-5

0

5

10

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

2005 2006 2007 2008 2009 2010 2011

Trade in goods and services, and current account 2005 - 2011 (Quarterly, seasonally adjusted) £b

Source: ONS

Goods and services

Current Account

46

Global Economics


Causes of a current account deficitThere are several possible causes of a persistent current account deficit, including the following:

Excessivegrowth

If the economy grows too quickly and rises above its own trend rate, which in the UK is around 2.5%, then domestic output (AS) may not be able to cope with domestic aggregate demand. When national income rises above its trend rate it is likely that income elas-ticity of demand for luxury imports such as motor cars is relatively high, so that imports rise relative to exports.

Deindustrialisation

An increasing trade deficit may be a symptom of long-term de-industriali-sation. The UK started to lose its manu-facturing base in the 1970s, and this process has continued over the last 30 years.

Highexportprices

High export prices will occur if a country’s inflation is higher than its competitors, or if its currency is over-valued which will reduce its price competitiveness.

Non-price competitiveness

Non-price factors can discourage exports, such as poorly designed products, poor marketing or a worsening reputation for reliability.

Poor productivity

An economy might not be producing enough from its scarce factors of production. Labour pro-ductivity, which is defined as output per worker, plays an important role in a country’s competi-tiveness and trade performance, and the UK has suffered from poor productivity. The productiv-ity gap is the gap between the UK’s relatively poor productivity performance and that of the UK’s leading competitors.

Low levels of investment in real capital

This could be caused by excessive long-term interest rates, or low levels of research and develop-ment.

Low levels of investment in human capital

This involves a lack of investment in education and training, which reduces skill levels relative to competitor countries and forces countries to produce low value exports.

The rise of alternative global suppliers

While the UK has slowly deindustrialised, emerging economies like China and India have in-creased their share of world trade, with their firms benefitting from access to new technology and from economies of scale. This has reduced the likelihood of smaller UK manufacturers selling abroad, while at the same time increased the likelihood of UK households and firms importing from these economies.

Policies to reduce a deficitThere are four basic strategies for dealing with a persistent deficit.

Time

Changes inreal national

income


Trend rate of g

rowth

Trade surplusoccurs when

growth isbelow trend

Trade de�cit occurs when

growth isabove trend

Actual rateof growth

47

Global Economics


Deflating demandDeflating demand means deliberately reducing consumer spending, or reducing its rate of growth, through fiscal contraction, such as raising direct taxes, or by monetary contraction, such as rais-ing interest rates or reducing the availa-bility of credit. As a by-product of this, im-ports are also likely to fall, hence deflating demand is said to work by a process called expenditure reduction. This policy tar-gets general household spending, and given that imports are dependent on spending, then imports will fall as spending falls. The connection between spending and imports is called the marginal propensity to import, which is expressed as:

Evaluation:

The main criticism of deflationary policy is that, as spending-power must fall, per-sonal incomes and standards of living will also fall, and this can trigger demand deficient unemployment. However, different deflationary policies may result in different effects. For example, raising interest rates may work more quickly than raising tax rates.

For the above reasons deflation is politically unpopular. Voters are much more likely to be con-cerned with recession and unemployment than with trade deficits so politicians are unlikely to prioritise the reduction of a balance of payments deficit.

It is also difficult to predict the precise effect of a fall in spending on imports, which requires an accurate calculation of the marginal propensity to import.

The cross diagram

The cross diagram can be used to illustrate how deflation works. The cross diagram shows the relationship between injections and with-drawals and national income, Y.

The export line is horizontal because it is determined by overseas GDP and not domestic GDP.

The import line is upward sloping, as-suming a positive marginal propensity to import (mpm) this means that as income (Y) increases, imports (M) will increase. For example, if the mpm is 0.4, then a £1 increase in income leads to an increase in imports of 40p. The higher the mpm, the steeper the gradient of the import line. Deflating demand, therefore, reduc-es income and spending with income (Y) falling to Y1, so that imports (M) fall but exports (X) are left unaffected.

DevaluationThe second policy option to improve the current account is devaluation, which involves the de-liberate reduction in the value of a country’s currency. It works by expenditure switching, which means that the policy encourages consumers to alter the distribution of their spending, rather than the total level of spending.

National income(real GDP)

PriceLevel

Y

P

AD

AS

P1

Y1

AS1

P2

AD1


Change in Imports

Change in Income

MarginalPropensityto Import

=

Y (real GDP)

Importsand

exports

Y1

+

X (exports)

M (imports)

Y-

de�cit

balance

GDP contracts

imports fall

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Global Economics


A fall in the exchange rate will, ceteris paribus, reduce export prices encouraging overseas con-sumers to switch to UK products. This is likely to lead to a rise in export demand. Devaluation will also lead to an increase in import prices, encouraging UK consumers to switch away from imports to domestically produced products. This will lead to a fall in import demand.

Equilibriumexchangerates

An ‘equilibrium’ exchange rate is the specific at which export revenue and import spend-ing are equal.

At too high a currency level, say at ‘£’, import spending, QM is greater than export revenue, at QX. This is because imports appear cheap in the UK, and exports appear expensive abroad. Devaluation will allow export revenue to increase and import spending to fall, mov-ing the economy towards a balance. Those in favour of a floating exchange rate regime ar-gue that allowing exchange rates to float will enable trade to balance more quickly.

Evaluation

Devaluation relies on the assumption that the sum of price elasticity of demand for im-ports and exports is elastic (>1), the so-called Marshall-Lerner condition. However, this may not be satisfied in the short run, or even the longer run.

Devaluation may also trigger cost-push inflation, where a fall in the value of a currency will in-crease the price of imported goods, in terms of the domestic currency.

Devaluation could be interpreted as a hostile move against other countries and may lead to retali-ation by competitors, so that no long term benefit is derived by the devaluing country.

Importandexportelasticity

To understand the Marshall-Lerner condition, it is necessary to reconsider price elasticity of de-mand. It should be noted that imports and exports refer to the value of spending on imports and the value of revenue from exports. The value of these payments is derived from the prices of imports and exports multiplied by the quan-tity of imports and exports. For example, if country A sells 100 tonnes of steel to coun-try B for A$1000 per tonne, export revenue earned by A is A$100,000. If we assume that the exchange rate of A$ against B$ is 4-1, then country B will have paid B$250 per tonne and spent B$25,000 in total. If the exchange rate of country A now falls to 5/1, the impact of this on A’s export rev-enue depends on how many tonnes it now sells at the cheaper rate. Country B will now only have to pay B$200 per tonne following devaluation, a fall from B$250, to B$200, of 20%. If demand is elastic, say (-) 2.0, then the 20% devaluation will lead to a 40% increase in demand, from 100 tonnes to 140 tonnes. The result is that payments from B to A rise from B$25,000 to (140 x 200) B$28,000. The Marshall-Lerner rule simply says that so long as the combined elasticities of demand for imports and exports are greater than 1, devaluation will im-prove the balance of payments on current account.

The cross diagram

We can also use the cross diagram to illustrate the impact of devaluation.

Assuming the Marshall-Lerner condition, the export line will shift up, and, the import line will shift

Quantity

£/allother

currencies

Q1

£

Importspending

Exportrevenue

£1

QX QM

Y (real GDP)

Importsand

exports

+

X (exports)

M (imports)

Y-

de�cit

balance

If the Marshall-Lerner condition is satis�ed, import spending falls and export revenue

rises following a devaluation, and the current account moves nearer to a balance

49

Global Economics


down.

At the existing GDP (Y) the deficit will be smaller.

The ‘J’ CurveThe J-Curve shows what can happen to a country’s balance of payments when it devalues its cur-rency.

If we assume the Marshall-Lerner con-dition is satisfied, devaluation will im-prove the balance of payments. If the condition is not satisfied, devaluation will worsen the balance of payments.

The J-Curve effect exists because the condition is met in the long run but not the short run. In the short run, house-holds and firms may not respond imme-diately to a change in price caused by a change in the exchange rate. There are a number of reasons for this:

1. Consumers may wait and see if the price rise is sustained.

2. Businesses may find it difficult to switch to or from an overseas supplier. It may take some search time to find alternatives.

3. Households and firms do not purchase consumer durables very often, so changes in exchange rates only take effect when decisions to purchase are made.

4. Consumers may be loyal to overseas’ brands.

5. Price is not the only factor that affects demand for imports - there are many other non-price factors, such as quality and design.

Direct controlsA third option to help reduce a current account deficit is to impose direct controls on imports by erecting barriers against imports or by providing assistance to exporters.

Specific measures include tariffs and non-tariff barriers, such as quotas, subsidies to domestic firms and discrimination against imports and in favour of domestic firms.

Evaluation

In the short run, trade barriers may help to reduce imports and help improve the current ac-count. However, retaliation is a likely response, and any short-term gains will be eroded away. Therefore, direct controls are not generally considered an effective long-term solution to a cur-rent account deficit.

Supply-side policyFinally, supply-side policy could be used to help improve an economy’s ability to produce. There are several actions that a government can take to improve supply-side performance. These meas-ures include improving labour productivity and labour market flexibility.

Evaluation

Supply-side policy can provide a highly effective policy framework for long term improvement in competitiveness and current account performance. The main problem is that supply-side policy may take decades to work and is not a quick-fix.

Time

Importsand

exports

+

-

de�cit

2006 2007 2008 2009 2010 2011 2012 2013 2014

surplus

50

Global Economics


Questions

1. Which account would the following transactions be entered in?

a. The sale of £2b worth of UK motor vehicles to Australia.

b. Australian tourists spending £200m in the UK.

c. The import of £1b computer products from the USA.

d. The import of £250m worth of coffee beans from Brazil.

e. The purchase of shares by a UK citizen, worth £10m, in a Brazilian firm.

f. The payment of dividends to a German citizen who owns shares in a UK firm.

2. What factors account for the rising UK Current Account deficit?

3. Evaluate alternative policies to reduce a Current Account deficit.

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Global Economics


The terms of trade

What are the terms of trade?A country’s terms of trade measures a country’s export prices in relation to its import prices, and is expressed as:

For example, if, over a given period, the index of export prices rises by 10% and the index of im-port prices rises by 5%, the terms of trade are:

When the terms of trade rise above 100 they are said to be improving and when they fall below 100 they are said to be worsening.

Improving terms of tradeIf a country’s terms of trade improve, it means that for every unit of exports sold it can buy more units of imported goods. So potentially, a rise in the terms of trade creates a benefit in terms of how many goods need to be exported to buy a given amount of imports. It can also have a ben-eficial effect on domestic cost-push inflation as an improvement indicates falling import prices relative to export prices.

However, countries may suffer in terms of falling export volumes and a worsening balance of payments.

The UK’s terms of trade

The UK’s terms of trade have generally improved over the last 20 years, indicating that export prices have has been rising relative to import prices. This is partly caused by the fact that globali-sation has tended to have less impact on the export price of UK invisibles, in comparison to its effect on the price of its visible imports.

Index of Export Prices

Index of Import PricesX 100

110

105X 100 = 104.8

88

90

92

94

96

98

100

102 UK terms of trade, 1990 - 2010 Source: Statistics.gov, 2009 (Base year 2003)

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Global Economics


The danger of an improving terms of trade is that it can worsen the balance of trade if UK and overseas consumers are elastic in their response to the relative export and import price changes.

Worsening terms of tradeA worsening terms of trade indicates that a country has to export more to purchase a given quantity of imports. According to the Prebisch-Singer hypothesis, this fate has befallen many developing countries given the general decline in commodity prices in relation to the price of manufactured goods. However, globalisation has tended to reduce the price of manufactured goods over the past 15 years, so the advantage that industrialised countries had over developing countries may be falling.

The impact of globalisation has tended to halt the decline in the terms of trade of developing economies.

53

Global Economics


Question

1. Analyse the likely effect of a rise in the UK terms of trade on the Current Account balance.

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Global Economics


Exchange ratesExchange rates are extremely important for a trading economy such as the UK. There are several reasons for this, including:

1. Exchange rates represent a cost to firms, which arises when commission is paid on the exchange of one currency for another.

2. Exchange rate changes create a risk to those firms that hold assets in currencies other than Sterling.

3. Exchange rates affect the price of exports, which form a significant part of aggre-gate demand, and the price of imports, and hence the balance of payments.

4. The Monetary Policy Committee of the Bank of England will often take the ex-change rate into account when setting short term interest rates, hence changes in the exchange rate have another transmission route into the economy, via their effect on interest rates.

Measuring exchange rates Exchange rates can be measured in two ways:

Bi-lateral rates

A bi-lateral rate is the rate of exchange of one currency for another, such as £1 exchanging for $1.50.

Multi-lateral rates

A multilateral rate is the value of a currency against more than one other currency. Economists calculate multi-lateral rates to understand what is happening to the exchange rate, on average. This is achieved by using an index that reflects changes in one currency against a basket of other currencies.

The Sterling Trade Weighted IndexIn the UK, Sterling’s average rate is measured by the Sterling Trade Weighted Index. This index tracks changes over time, starting with a base year index of 100, and is weighted to reflect the relative importance of different countries in terms of UK trade.

It has come in for criticism because the weights get adjusted too infrequently, and changes to the pattern of UK trade take too long to be included in revised weightings. In the early 2000’s, many observers argued that the index required modification, including the Chief economist at the HSBC, who argued that the index understated Sterling’s strength by around 5%18. As a result of these criticisms, in 2005 the Bank of England introduced a new version of the index which ad-justs more rapidly to changes in trade patterns.

Exchange rate regimesAn exchange rate regime is a system for determining exchange rates for specific countries, for a region, or for the global economy. Throughout history, three basic regimes have existed:

Floating

A floating regime is one where currencies are allowed to move freely up and down according to changes in demand and supply.

Fixed

Fixed rates are currency values which are tied to a precious metal such as gold, or anchored to another currency, like the US Dollar.

18 Source: The Times, March 2004

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Global Economics


Managed

Managed exchange rates exist when a currency partly floats and is partly fixed, such as hap-pened between 1990 and 1992, when Sterling was managed in the Exchange Rate Mechanism (ERM) of the European Monetary System. This system preceded the European Euro (€), which was launched in 1999.

Floating exchange ratesUnder a floating system a currency can rise or fall due to changes in demand or supply of curren-cies on the foreign exchange market.

Changes in exchange ratesChanges in the exchange rate in a floating system reflect changes in demand and supply of cur-rencies. On a demand and supply diagram, the price of a currency such as Sterling (£) is expressed in terms of the other currency, such as the USD ($).

For example, an increase in UK exports to the USA will shift the demand curve for Sterling to the right and push up the exchange rate of the pound against the US dollar.

The demand for currencyThe ‘demand’ for currencies is derived from the demand for a country’s exports, and from specu-lators looking to make a profit on changes in currency values.

The supply of currency The supply of a currency is determined by the domestic demand for imports from abroad. For example, when the UK imports cars from Japan it must pay in yen (¥), and to buy yen it must sell (supply) pounds. A large proportion of short term trade in currencies is by dealers who work for large financial institutions. The London foreign exchange market is the World’s single largest in-ternational exchange market.

Example

If we assume the UK and France both produce goods that the other wants they will wish to trade with each other. However, French producers need to be paid in Euros and British producers need to be paid in Pounds. Both need to be paid in their own local currency so that they can pay their own production costs in their local currency. Because of this, they must go to the foreign exchange market to exchange their local currency for the foreign currency they need. The market will create an equilibrium exchange rate for each currency, which will exist where demand and supply equate.

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Exchange rates and interest rates Changes in interest rates affect a country’s currency. Higher interest rates lead to an increase in the demand for a country’s financial assets, and an increase in the demand for a currency.

Lower interest rates in one country relative to other countries leads to an increase in supply, as speculators sell in order to buy the currency associated with rising interest rates. These specula-tive flows are called hot money.

Equilibrium exchange ratesAn ‘equilibrium’ exchange rate is the spe-cific rate where export revenue and import spending are equal.

At currency ‘£’, import spending equals ex-port revenue, at ‘Q’. At a higher rate, say at £1 imports now appear cheap in the UK, and spending increases to Qm, and exports ap-pear expensive abroad, and fall to Qx. This opens up a trade gap (Qx to Qm).

Those in favour of a floating exchange rate regime argue that allowing exchange rates to float will enable trade to balance more quickly.

Quantity

£/$exchange

rate

Q

£1

S

D

S1

Q1

£

Quantity

£/$exchange

rate

Q

£1

S

D

D1

Q1

£


Higher relative interest rates increasethe speculative demand for a country’s assets

and increases the demandfor a currency

Quantity

£/allother

currencies

Q1

£

Importspending

Exportrevenue

£1

QX QM

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Fixed exchange ratesA fixed exchange rate regime involved currencies being fixed against a precious metal or against another currency, or basket of currencies.

The IMF system

The International Monetary Fund (IMF) was conceived in 1944, at Bretton Woods, New Hampshire (USA) and became operational in 1945. Its aim was to stabilise the world economy through a sys-tem of fixed exchange rates. The IMF was one of three pillars to support the development of post-war economies, the other two being GATT (The General Agreement on Tariffs and Trade), later to become the WTO (World Trade Organisation), and the International Bank for Reconstruction and Development, later to be called the World Bank.

The IMF system involved the US$ as the anchor for the system with the US$ given a specific value in terms of gold, and other currencies were given a value in terms of the US$, such as £1 = $2.40c.

However, the system collapsed in 1971 for a number of reasons, including the build up of US debts abroad as a result of the need to fund the war in Vietnam. In addition, inflation in the USA and growing doubts about the stability of the US$ caused intense speculative activity against the US$. Speculators frantically sold US$s during 1971 until President Nixon, took the US out of the system.

Managed regimesManaged regimes involve a mixture of free market forces and intervention. A recent example is the European Exchange Rate Mechanism (ERM), which operated from 1979 to 1999. In this system, currencies were kept inside an agreed band of (+/-) 2.25% for most members. This was achieved by the monetary authorities either raising or lowering interest rates, or by buying or selling currency.

Exchange controlsSome currencies are subject to exchange controls, which mean that the relevant Central Bank will only allow buying and selling through its own system, rather than be subject to fluctuations as-sociated with fully floating rates. Although most countries abandoned these controls many years ago, some, like China and Cuba, still practice very strict exchange rate control.

Advantages of floating exchange ratesFlexibilityandautomaticadjustment

Over time, an economy may experience changes in imports and exports, and this can lead to a balance of payments disequilibrium (deficit or surplus). Under a floating regime, the deficits and surpluses will lead to adjustments in the exchange rate, which alter relative import and export prices in the future. Therefore, imports and exports can readjust to move the balance of pay-ments back towards a desirable equilibrium. Exogenous shocks, like the financial crisis of 2008-09, can occur from time to time and floating exchange rates can help the readjustment process.

Freedom

Policy makers are free to devalue or revalue to achieve specific objectives, such as stimulating jobs and growth and reducing inflationary pressure.

Advantages of fixed regimesStabilityforfirms

Exporting firm’s prices are more stable, as are importing firm’s costs. This is the main reason the Chinese Yuan has been fixed against the USD for nearly 20 years, creating a very stable frame-work for Chinese manufacturing.

Predictabilityandconfidence

Firms can plan and are likely to invest more - confidence is a necessary condition for investment.

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Discipline

Another advantage of fixed exchange rates is that policy makers cannot devalue the currency in an attempt to hide inflation or a balance of payments deficit. Deliberately holding a currency down would reduce export prices abroad and nullify any domestic inflation, as well as providing a boost to exports. In addition, policy makers cannot revalue to keep a currency artificially high to reduce imported cost-push inflation.

Recent UK Exchange ratesAfter leaving the European Exchange rate mechanism (ERM) in 1992, Sterling fell rapidly against the Euro-area currencies, reaching a low in 1996.

From 1996 to 2006, the UK economy prospered, with un-employment falling, household spending rising, but with inter-est rates also rising. At that stage Sterling was ‘underval-ued’, and speculators sought to buy Sterling. High levels of FDI also helped push Sterling to re-cord levels, peaking in 2000.

This coincided with a weak-ness in the newly launched Euro, with speculators unsure about whether it would work. Between 2003 and 2008, the Euro regained much of its value against Sterling, the main global weakness being the US Dollar.

Following the global financial crisis of 2008-09, Sterling fell against most major currencies. This was the result of speculators believing that the UK economy would be hit particularly hard given the significance of its financial sector to overall economic performance.

70

75

80

85

90

95

100

105

110

115

120

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

2005 2006 2007 2008 2009 2010 2011

Sterling Effective Exchange Rate Jan 2005 = 100

Source: Bank of England

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Questions

1. Using diagrams, explain what would happen to Sterling, other things being equal, if:

a. There are more tourists into the UK.

b. Foreign speculators sell Sterling.

c. UK interest rates rise relative to those of the UK’s trading partners.

2. Analyse one likely effect of a fall in the value of Sterling on a particular market in the UK micro-economy. You will need a diagram to support this answer.

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UK competitivenessIn an increasingly market-driven global economy, a national economy needs to be competitive to develop and prosper.

Competitiveness means the ability of a country to compete effectively in global markets.

Measuring competitiveness

There is no single method of determining competitiveness, hence it can be assessed in a number of ways, including:

1. Relative export prices, which are one country’s export prices in relation to other countries, expressed as an index.

2. A country’s terms of trade, which is an index of the ratio of a country’s export and import prices.

3. Labour productivity, which is usually expressed as GDP per worker, or GDP per hour of employment.

4. Unit labour costs, which are the average costs of labour per unit of output.

Types of competitivenessPrice competitiveness

Price competitiveness refers to how well UK exports compare in terms of price. This is affected by a number of factors, including:

1. Relative UK inflation - even small annual differences can build-up over time and become significant. Inflation is one of the key reasons why the UK motor industry went into decline from the late 1970s.

2. The relative real exchange rate (RER) – which is the nominal exchange rate deflated by an index of prices. In the UK it is measured by dividing the trade weighted Sterling Index by the RPI (or the Consumer Price Index – CPI), x 100. For example, if the Sterling Index rises by 7% and UK prices rise by 2%, the RER is 107/102 x 100 = 105, hence the ‘real’ value of Sterling rose by 5%.

3. Labour costs - including wages and non-wage costs such as employer contributions to pensions. High labour costs often force countries into producing high quality prod-ucts where price is less significant than quality. This is certainly the case with Germany, and its leading motor car brands (BMW, VW, Audi and Mercedes-Benz).

Non-price competitiveness

Non-price competitiveness refers to how well UK exports of branded goods and services do in overseas markets in aspects of competition not associated with price, such as:

1. Product quality and design.

2. Business innovation, research and development (R&D), especially new product de-velopment.

3. Product reliability.

4. The strength or weakness of local brands.

5. The effectiveness of marketing in overseas markets.

6. Levels of productive and dynamic efficiency of firms.

7. Levels of ‘x’ inefficiency, including poor management, excessive bureaucracy, and

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government failures.

8. How effective the economic and political system is in allowing markets to form: are there ‘missing or incomplete markets’?

9. Investment in new technology, which helps improve quality and reliability

10. Investment in human capital, which improves skill levels and reduces skill short-ages – low skills, and labour shortages, can both seriously reduce competitiveness.

Labour productivityThere are two commonly used indices of productivity: GDP per worker and GDP per hour worked. Using either measure yields the same result - namely that the UK performs badly against its prin-cipal competitors. The main causes of the UK’s poor performance are lack of investment in real capital and human capital.

The productivity gapWhichever measure of productivity is used it is clear that the UK lags behind most of its major competitors. The difference between the productivity of countries like the USA, Japan and Ger-many, and the UK, is called the productivity gap. In many other areas of economic performance the UK out-performs Germany and Japan, but not in the case of productivity. One clear problem for the UK is the level of educational achievement. According to the Office for National Statistics (ONS) an estimated 4.5 m people in the UK have no formal qualifications. It also estimated that at any one point in time up to 135,000 job vacancies cannot be filled because of a skills shortage19.

Factors affecting productivityAccording to research by the Economic and Social Research Council (ESRC), productivity in the UK is affected by the following:

Competitionintheproductmarket

The level of competition in product markets raises innovation and productivity for three reasons: entry or the threat of entry into a market forces incumbents to become more efficient and inno-vate; entry and exit forces firms with low productivity to leave the market; incumbents may copy the more efficient and innovative new entrants.

The level of capital investment

The level of investment per capita in the UK is considerably lower than in other advanced econo-mies. The ESRC considered a number of possible causes, including the growing skills shortage – because skilled labour is in short supply, capital machinery may be less effectively used. In addition, because wage costs are relatively low in the UK, there is less incentive for UK firms to substitute capital for labour, unlike in Germany for instance, where labour is relatively expensive.

Information technology

It is clear that the widespread use of IT in the USA has raised productivity levels there. The ESRC suggests that the use of IT in Europe lags behind that in the USA because of lower levels of com-petition, higher levels of regulation and less desire to change management practices to incorpo-rate more IT.

Innovation and technology transfer

Again, the lack of competition in the UK and European product markets may help explain the lower levels of R&D as compared with the USA.

SkillsandHumanCapitalDevelopment

The ESRC argues that a relative lack of skills in the UK is a primary cause of the UK’s productivity gap. The lack of management skills appears particularly acute. It is argued that the best graduates go into finance, accounting, and consultancy rather than into management.

19 Source: ONS, 2005

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Skillsshortagesandskillsgaps

A skills shortage is a situation where there is a shortage of individuals in the labour market with the skills necessary to meet labour market demand. A skills gap means that current employees do not have the necessary skills that employers require.

The World Economic Forum Competitiveness IndexAccording to the World Economic Forum (2010) there are several indicators of competitiveness, including:

• Effective institutions - which create an economic environment in which businesses can develop, and consumers have confidence. These should be ‘sound, honest and fair’.

• Effective infrastructure – which provides effective transport and energy supplies.

• A sound macro-economic environment, including sound public finances, and low and sta-ble inflation.

• A healthy and educated labour force, with an emphasis on higher education, and the con-tinuous upgrading of skills.

• Efficient goods markets, with high levels of competition, and low levels of regulation.

• Efficient labour markets, which are flexible, and provide effective incentives to work and effort.

• An effective financial market, which provides a flow of capital to business, effectively man-ages financial risk, and is trustworthy and transparent.

• The ‘readiness’ of firms to adopt new technology.

• The size of global markets enables firms that are willing to trade to gain from economies of scale.

• Business sophistication, which relates to the level of business networks, supporting indus-tries, and advanced business processes.

• Continuous innovation, which counteracts diminishing returns to existing technology.

Flexible labour marketsThe share of total UK employment composed of part-time work is extremely high compared with other advanced economies, making it a highly flexible labour market. In comparison, the EU has a greater % of temporary work and self employment.

All these types of employment have risen at the expense of full-time permanent employment.

Wage flexibilityFlexible wages can also create the right economic environment for economic growth.

InvestmentAnother significant determinant of competitiveness is investment per head. Investment leads to improved productivity, reduced inflationary pressure, hence improved price competitiveness, and improved quality, design and reliability of products.

The UK’s investment recordInvestment is a key determinant of economic growth, productivity and competitiveness.

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The level of investment is determined by:

z The level of undistributed profits, which are profits retained by firms, rather than distributed to shareholders.

z The level of savings, which provides a flow of funds for investment and helps de-press interest rates.

z Interest rates, given that investment is inversely related to interest rates (see be-low.)

z The level of business tax – lower business taxes may be an incentive to invest if firms are given tax allowances for the investment the investment they undertake.

z Business confidence - investment is a sacrifice and firm’s expectations of profits have a powerful influence on investment decisions.

z Changes in national income, via the accelerator effect.

z In addition, other factors affect FDI, such as human capital accumulation and in-vestment incentives to overseas organisations.

Investment and interest ratesThe marginal efficiencyofcapital

The demand for investment is negatively re-lated to interest rates. For example, at a rate of interest of 6%, the level of investment is £25b.

At a lower interest rate, such as 4%, the profit-ability (efficiency) of capital is higher, and de-mand for capital is greater, at £50b.

Conversely, lower interest rates stimulate in-vestment. Hence, the demand curve for invest-ment slopes down from left to right.

UK’s investment in manufacturingThe poor level of UK investment in manufactur-ing over the last 20 years can be attributed to:

A relatively low savings ratio

Low savings and high consumer borrowing and debt levels reduce the supply of funds for invest-ment in manufacturing as well as raise long term interest rates.

Relatively high interest rates

According to the MEC diagram, demand for investment contracts when rates are high because of the higher opportunity cost of investing. Typically, UK rates are higher than those of the UK’s main competitors, including the USA, Japan, and the EU area.

More attractive investment alternatives

Alternatives to manufacturing investment in the UK may be very attractive, including foreign di-rect investment, shares, property, and the service sector.

Questions

1. What factors help determine a country’s competitiveness?

2. During the last 12 months, the value of Sterling has risen against the US Dollar. Examine the likely effect of this on UK:

Capital investment

InterestRates

MarginalE�ciency of

Capital

3%

6%

£25b £50b

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a. Competitiveness

b. Inflation

c. Employment

3. “Investment is the key to improving a country’s competitiveness in the long run.” To what extent do you agree with this assertion?

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Policies to improve competitivenessChoosing the right policy depends on identifying the cause of the lack of competitiveness. The causes of poor competitiveness vary between countries and over time.

Policy options include:

Improving labour productivityLabour productivity can be improved by increasing spending on education and training to help develop skills and close any skills gap. However, this is expensive and takes time. Government may also promote a more flexible labour market, such as reducing trade union power, encourag-ing part-time work, and encouraging new business start-ups. However, this also takes time and the increase in flexibility can reduce worker security and lead to lower wages.

Improving competition in product marketsThe level of competition in product markets can also be improved by deregulation to reduce bar-riers to entry, though this has its limits as some regulation is needed to protect consumers and employees from unfair practices. In addition, privatisation of industry is also likely to improve competitiveness, but there are few industries left in the UK to privatise. Finally, reducing monop-oly power through regulation and competition policy are strategies that can be effective in creat-ing a more dynamic and competitive micro-economy. However, it can be argued that monopoly power helps generate some dynamic efficiency, and the advantages of economies of scale might be lost if monopolies are broken up.

Improving the level of investment Competition may be increased by investment grants and subsidies, and by tax incentives to en-courage new product development. Keeping interest rates low is also a strategy that would en-courage investment. In addition, keeping them as stable as possible would increase certainty and reduce risk. However, the danger with too low interest rates is that they could trigger an increase in household spending (C) causing demand-pull inflation, which would worsen, rather than im-prove, competitiveness. The Bank of England does not directly target UK competitiveness. Finally, investment may be stimulated by reducing the interest rate elasticity of investment, which means it is easier to raise interest rates without a negative effect on investment. This could be achieved by investment grants and tax relief on investment.

Creating a stable macro-economic environmentKeeping inflation under control, through a mixture of monetary and fiscal measures, is also cen-tral to an effective competitiveness strategy. However, the higher interest rates used to stabilise prices can deter investment, and could damage competitiveness in the long run. Keeping Sterling stable would also create less uncertainty and would give firms more confidence to invest.

ConclusionPerhaps the best way to improve UK competitiveness is through a mixture of policies designed to help improve labour productivity, product market competitiveness and long term investment. All these measures will improve both price and non-price competitiveness. In addition, the macro-economy also needs to be stabilised to create the right environment for investment.

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QuestionEvaluate alternative policies to improve the competitiveness of the UK economy.

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Global economic problemsThe global economy faces a number of serious challenges in the 21st Century. Globalisation has benefitted most participants, but the increasing interconnectedness of the global economy has created a number of problems.

Short term problemsSome global problems are short term, such as the recent recession caused by the credit crunch and related banking crisis. Most global shocks are relatively short term and may be self-correct-ing. Other apparently short run events can have long lasting effects, such as the oil shocks of the 1970s, which permanently altered the global market for oil.

Longer term problems Other global problems are longer term, and may require a strategic approach to finding solutions. These problems include global inequality and unequal economic development, global poverty, the exhaustion of non-renewable resources, depletion of the environment and global warming, and systemic problems associated with inadequate regulation of financial markets.

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Economic developmentEconomic development is a broader concept than economic growth, and reflects social as well as economic progress. Growth is an important and necessary condition for development, but it is not a sufficient condition. Economic growth alone cannot guarantee development.

One of the most compelling definitions of development is that given by Amartya Sen. According to Sen, development is about creating freedom for people, and removing obstacles to greater freedom. Greater freedom enables people to choose their own destiny. Obstacles to freedom, and hence to development, include poverty, lack of economic opportunities, corruption, poor governance, lack of education and lack of health20.

Indicators of development

A variety of economic and social indicators may be used to indentify differences between devel-oped and developing countries, including

z GDP per capita.

z Unemployment and underemployment.

z Life expectancy at birth.

z Population growth.

z Level of educational achievement.

z Enrolment in education.

z Energy consumption per head.

z Levels of absolute and relative poverty.

z Employment patterns, such as the proportion of the population working on the land and the country’s dependency on primary products.

z Structural change, such as a rise in the relative importance of service sector, or a rise in the proportion of GDP accounted for by trade.

The Human Development Index (HDI)The HDI was introduced in 1990 as part of the United Nations Development Programme (UNDP) to provide a means of measuring development in three broad areas - per capita income, health, and education. The HDI is used to track changes in the global position of specific countries over time, with each country given an HDI ranking.

Each year the UNDP produces a development report providing an update of changes during the year, along with a report on a special theme, such as global warming and development, and mi-gration and development.

The introduction of the index was an explicit acceptance that measurements of development should include a broad range of social and economic factors.

TheHDIhastwomainfeatures:

A scale from 0 (no development) to 1 (complete development).

A composite index based on three equally weighted components:

• Longevity, measured by life expectancy at birth

• Knowledge, measured by adult literacy and number of years children are enrolled at school

20 Source: Development as Freedom, Amartya Sen: 2001, Oxford University Press

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• Standard of living, measured by real GDP per capita at purchasing power parity

Whatthefiguresmean:• An index of 0 – 0.6 means low development - for example, in 2010 the African state of

Chad had an index number of 0.32.

• An index of 0.61 – 0.85 means medium development – for example, in 2010 Russia had an index of 0.75.

• An index of greater than 0.90 means high development - for example, the HDI for Sweden in 2010 was 0.94.

The HDI is a very useful means of comparing the level of development of countries. GDP per capita alone is clearly too narrow an indicator of economic growth, and fails to indicate other aspects of development, such as enrolment in school and longevity. Hence, the HDI is a broader and more encompassing indicator of development than GDP, though GDP still provides one third of the index.

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HDIfiguresforselectedcountries

0.295

0.316 0.322 0.328 0.336 0.343 0.349 0.353 0.359

0.733 0.735 0.739 0.739 0.744 0.745 0.748 0.755 0.756 0.760

0.863 0.895 0.897 0.898 0.898 0.901 0.903 0.904 0.905 0.908 0.908 0.908 0.910 0.910

0.929 0.943

NigerBurundi

MozambiqueChad

Sierra LeoneCentral African…

EritreaGuinea-Bissau

MaliGeorgia

VenezuelaAlbania

LebanonCosta Rica

KazakhstanGrenada

Russian FederationBelarus

Trinidad and TobagoUnited Kingdom

DenmarkKorea (Republic of)

Hong Kong, China (SAR)Iceland

JapanSwitzerland

SwedenGermany

New ZealandCanadaIreland

NetherlandsUnited States

AustraliaNorway

HDI for elected countries 2011, Source: HDR

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Life expectancyA variety of factors may contribute to differences in life expectancy, such as the stability of food supplies, war and the incidence of disease and natural disasters.

According to World Bank figures, between 1980 and 1998 average life expectancy rose from 61 to 67 years, with the largest increases occurring in low and middle income countries. However, the changes are not evenly distributed, and in many countries in sub-Saharan Africa, life expectancy is falling due to the AIDS epidemic21.

Adult literacyAdult literacy is usually defined as the percentage of people aged 15 and over who are able to write a short, simple statement about their everyday life. More extensive definitions of literacy include those based on the International Adult Literacy Survey. This survey tests the ability to un-derstand text, interpret documents, and perform simple arithmetic.

GDP per capitaGDP per capita is the commonest indicator of material standards of living, and hence is included in the index of development. GDP per capita is found by measuring Gross Domestic Product in a year, and dividing it by the population.

Evaluation of the HDIDespite the widespread use of the HDI, there are a number of criticisms that are often made. These include:

z The HDI index is for a single country, and as such does not distinguish between different rates of development within a country, such as between urban and traditional rural communities.

z Critics argue that the equal weighting between the three main components is rath-er arbitrary.

z Development is ultimately about freedom, and there is nothing in the index that directly measures this. For example, access to the internet might be regarded by many as a freedom that improves the quality of individual’s lives.

z As with GDP per capita, the more narrow measure of living standards, there is no indication of the distribution of income.

z In addition, the HDI excludes many aspects of economic and social life that could be regarded as contributing to development as well as excluding those that may con-strain development, such as crime, corruption, poverty, deprivation, and negative ex-ternalities.

z GDP is calculated in terms of purchasing power parity, and this value can frequent-ly change.

21 Source: www.worldbank.org/depweb/

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Question

Evaluate the HDI as an indicator of economic development.

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Measure of Economic Welfare (MEW)During the late 1960s, many economists began to question the over-reliance of governments and agencies on narrow, exclusively GDP-based measures of economic welfare. It was at this time that the negative environmental effects of uncontrolled economic growth began to be considered, prompting the search for a wider measure of welfare, not exclusively based on raw GDP figures.

Nordhaus and Tobin

In 1972, Yale economists William Nordhaus and James Tobin introduced their Measure of Eco-nomic Welfare (MEW)22 as an alternative to crude GDP. MEW took national output as a starting point, but adjusted it to include an assessment of the value of leisure time and the amount of unpaid work in an economy, hence increasing the welfare value of GDP. They also included the value of the environment damage caused by industrial production and consumption, which re-duced the welfare value of GDP. MEW can be seen as the forerunner of later attempts to create a sophisticated index of sustainable development.

The Index of Sustainable Economic Welfare (ISEW)The Index of Sustainable Economic Welfare (ISEW), develops MEW by adjusting GDP further by taking into account a wider range of harmful effects of economic growth, and by excluding the value of public expenditure on defence.

Purchasing Power ParityWhen making comparisons between countries which use different currencies it is necessary to convert values, such as national income (GDP), to a common currency.

This can be done it two ways:

1. Using market exchanges rates, such as $1 = ¥200, or:

2. Using purchasing power parities (PPPs)

Marketexchangerates

Using market exchange rates creates two main difficulties:

22 Nordhaus, WD and Tobin, J (1972) Is Growth Obsolete? Economic Growth, National Bureau of Economic Research, no 96, New York.

Measure of economic welfare (MEW)

MEW Value ofGDP

Value ofunpaid work

Value ofleisure time

Value ofenvironmental

damage= + + -

Index of Sustainable Economic Welfare (ISEW)

ISEW Personalexpenditure

Value ofunpaid work

Publicexpenditure(Ex defence)

Value ofenvironmental

damage= + + - Private

defence-

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• Firstly, market exchange rates can quickly change, which artificially changes the value of the variable in question, such as GDP. For example, a one-month appreciation of the US$ by 5% against the Japanese Yen would reduce the dollar value of the Japanese economy by 5%. Clearly, this is more to do with changes in the exchange rate than changes in the underlying state of the Japanese economy.

• Secondly, market exchange rates are determined by demand and supply of currencies, which reflect changes in imports and exports of traded goods and services. However, not all countries trade the same proportion of their income and output, so currency values are not determined on a consistent basis.

Purchasing power parity

The alternative to using market exchange rates is to use purchasing power parities (PPPs). The purchasing power of a currency refers to the quantity of the currency needed to purchase a given unit of a good or common basket of goods and services. Purchasing power is determined by the relative cost of living and inflation rates in different countries. Purchasing power parity means equalising the purchasing power of two currencies by taking into account these cost of living and inflation differences.

For example, if we convert GDP in Japan to US dollars using market exchange rates, relative pur-chasing power is not taken into account, and the validity of the comparison is weakened. By adjusting rates to take into account local purchasing power differences, known as PPP adjusted exchange rates, international comparisons are more valid.

PPPsandmarketexchangeratescompared

The World Bank produces a report every three years comparing countries in terms of PPPs and US$. As can be seen, when PPPs are used, the gap between the richer and poorer countries is considerably narrowed.

TheBigMacIndex

This index, devised by The Economist, calculates how many units of a local currency are needed to purchase a Big Mac. Exchange rates can then be adjusted according to how much local cur-rency is required.

For example, if 200 Japanese yen (¥) are required to buy a Big Mac in Tokyo, and $2 are required in New York, the ‘value’ of currencies are $1 = ¥100. This can be used to adjust the value of Japanese GDP, so that if GDP in Japan is ¥100 trillion, its value will be $1 trillion.

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Growth and development theoriesGrowth and development theories attempt to explain the conditions that are necessary for growth and development to occur, and to weigh up the relative importance of particular conditions. Early growth theories attempted to find general determinants of growth that could be applied to any instance under consideration. By looking at patterns of growth the hope was to discover some of the laws or principles which govern growth at all times and in all countries. Modern theories tend to accept that conditions for growth change over time, and are often more critical of the attempts to generate one-size-fits-all growth theories.

Linear growth theoriesRostow

One of the first growth theories was that proposed by American economic historian Walt Rostow in the early 1960s. As a vigorous advocate of free market capitalism, Rostow argued that econo-mies must go through a number of developmental stages towards greater economic growth. He argued that these stages followed a logical sequence; each stage could only be reached through the completion of the previous stage.

Stages

1. Traditional society, dominated by agriculture and barter exchange, and where sci-ence and technology are not understood or exploited.

2. Pre-take-off stage, with the development of education and an understating of sci-ence, the application of science to technology and transport, and the emergence of entrepreneurs and a simple banking system, and hence rising savings.

3. Take-off, with positive growth rates in particular sectors and where organised sys-tems of production and reward replace traditional methods and norms.

4. The drive to maturity, with an ongoing movement towards a diverse economy, with growth in many sectors.

5. The stage of mass consumption, where citizens enjoy high and rising consumption per head, and where rewards are spread more evenly.

Rostow’s work, like many other accounts of growth, points to the significance of the accumulation of savings to achieve economic ‘take-off’. In this case, the accumulation of savings is seen as a necessary condition for the movement from ‘traditional’ to ‘developed’ societies.

Harrod and Domar

The importance of savings and investment is also central to the work of Harrod and Domar. Ac-cording to this theory, and those derived from Harrod and Domar’s work, there are two determi-nants of the rate of growth of a country. The first looks at the relationship between changes in the capital stock of a country, that is its capital investment, and its output, called the capital-output ratio. This shows how much new capital, such as £10, is needed to create a given amount of new national income, such as £2.

The second element of the model considers the relationship between savings and national in-come is called the savings ratio, and this shows how much is saved, such as £10, from a given amount of national income, such as £100. The model indicates how these two ratios affect the rate of growth. Essentially, the higher the savings ratio, the more an economy will grow; and the higher the capital-output ratio, the higher the rate of growth.

For Harrod and Domar, economies must save and invest a certain proportion of their income to grow at a certain rate – failure to develop is caused by the failure to save, and accumulate capital. For take-off to happen, savings must be accumulated.

Savings and investment

The simple circular flow model indicates the connection between savings which provides a flow of funds, and for investment, which requires abstinence from consumption in order that resources

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can be freed up for investment. Investment itself is an injection back into the circular flow, and increases the economy’s capacity to produce more output in the future.

Savings and capital-output ratios

The savings ratio indicates the ratio of savings to national income. The capital-output ratio indi-

cates how much capital is needed to generate a given amount of national output.

Evaluation of linear stage theory

The theories of Rostow, Harrod and Domar, and others consider savings to be a sufficient condi-tion for growth and development. In other words, if an economy saves, it will grow, and if it grows, it must develop. Aggregate savings are largely determined by national income, so if income is low, savings will not be accumulated. According to Rostow’s theory, saving between 15% and 20% of income (a savings ratio of 0.15 – 0.2) would be enough to provide the basis for growth. If this level of saving is maintained, growth would also be sustained.

The major criticisms of this approach are:

z Although saving is regarded as highly significant, modern growth theory takes into account a broad set of growth factors.

z Other criticisms of stage theory point to general weakness in terms of the unreal-istic assumptions of these models, such as perfect knowledge, stable exchange rates, and constant terms of trade.

z Most analysis was based on the reconstruction of Europe after World War II, but many developing countries do not have Europe’s institutions, attitudes, financial mar-kets, levels of education, and work ethic, as found in Europe, North America and the rest of the developed world.

z Modern theory tends to see savings as a necessary but not sufficient condition for growth.

Structural change theoriesThe Lewis Model

The Lewis23 model, presented in 1955, dominated development theory between the 1960s and 1970s. It is also known as the two sector model, and the surplus labour model. It focused on the need for countries to transform their structures, away from agriculture, with low productivity of labour, towards industrial activity, with a high productivity of labour.

In the Lewis model the line of argument runs:

z An economy starts with two sectors - a rural agricultural sector and an urban in-dustrial sector. Agriculture generally under-employs workers and the marginal produc-tivity of agricultural labour is virtually zero.

23 Named after William Arthur Lewis, who first introduced his model in The Theory of Economic Growth. 1955

Savings and Capital-Output ratio

Withdrawals

Factors OutputIncome (Y)

Households

Firms

HouseholdSpending (C)

SAVING (S)

CAPITAL (I)

Injections

SAVINGSRATIO

SAVINGS

INCOME

CAPITAL -OUTPUT

RATIO

OUTPUT

CAPITAL

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z Therefore, transferring workers out of agriculture does not reduce productivity in the whole economy.

z Labour is then released for work in the more productive, urban, industrial sector.

z Industrialisation is now possible, given the increase in the supply of workers who have moved from the land.

z Industrial firms start to make profits, which can be re-invested into even more industrialisation, and capital starts to accumulate.

z As soon a capital accumulates, further economic development can sustain itself.

Evaluation of the Lewis model

Though highly influential at the time, and despite the considerable logic of the model the move-ment of workers from the land to industry may not generate the level of benefits Lewis sug-gested, because:

z Profits may leak out of the developing economy and find their way to developed economies through a process called capital flight.

z Capital accumulation may reduce the need for labour in the urban industrial sec-tor.

z The model assumes competitive labour and product markets, which may not exist in reality.

z Urbanisation may create problems, such as poverty, squalor and ‘shanty towns’, with unemployment replacing underemployment.

z The financial benefits from industrialisation might not trickle down to the majority of the population.

Development of a tertiary sectorClark-Fisher

As early as 1935, Allen Fisher had suggested that economic progress would lead to the emer-gence of a large service sector, which followed the development of a primary and secondary sector. Later, in 1940, Colin Clark developed this theme to create the Clark-Fisher development theory, also called the Fisher-Clark model.

The Clark-Fisher model shares some characteristics of early linear stage models and later struc-tural change models. In this model, structural change must occur for economic progress to occur in capitalist economies. Their work is still very relevant to modern explanations of development and the importance of a large service sector as an indicator of development. The Clark-Fisher hy-pothesis states that development will eventually lead to the majority of the labour force working in the service sector.

Why does a service sector emerge after industrialisation?

According to this model, there are two essential reasons why a service sector will emerge.

High income elasticity of demandThere is generally a high income elasticity of demand for services, especially leisure, tourism and financial services. As incomes rise, demand for services increases and more employment and national output are allocated to service production. For example, in the UK and many developed economies over two-thirds of all workers are employed in the service sector (for the UK it is around 72%).

Low productivity of labourSecondly, productivity in the service sector is lower than in the manufacturing sector because it is harder to apply new technology to many services. This means that, over time prices of services rise relative to primary and secondary goods.

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The effect of high income elasticity of demand and low productivity is that an increasing propor-tion of national income and consumption is allocated to the service sector.

Victor Fuchs

In the 1960s and 1970s, American economist Victor Fuchs also focussed on the service sector, and attempted to develop a general theory of economic development by looking, in particular, at changes that were happening within the American economy during that period. In particular he looked at changing patterns of employment associated with the rise of a service sector, and, like Clark-Fisher, took this to be a key indicator of economic progress. Increasingly, growth in service sector employment could be seen across western economies.

This, he argued, also contributed to the slow-down in economic growth rates in more developed economies. As the Clark-Fisher model had proposed, productivity growth in the service sector would tend to be much slower than for the manufacturing sector. He argued that the service sector itself would need to go through a kind of ‘industrialisation’ process if growth rates were to be maintained. The rise of the importance of the internet and the new economy could be said to be evidence for how new technology has affected the service sector. Fuchs also pointed to the increased participation of females in the labour force as being an important contributory factor to service sector development - families with working wives tend to spend more of their income on services.

Balanced and unbalanced growthOne of the earliest debates in development economics was about whether development would proceed more effectively with balanced or unbalanced growth. The theory of balanced growth was that as an economy grew it needed all sectors to grow to support each other. The intercon-nectedness of different sectors implied that growth was required across the economy at a con-stant rate.

This view suggested a clear role for government in supporting those sectors that might not ‘natu-rally’ grow, or might lack investment from the private sector. If all parts of the economy need to grow, then government should support those sectors that might naturally respond to general growth. For example, government could support education given its linkages with other indus-tries, or fund the development of new internet platforms or technologies.

Big push

Big push theories are a development of the balanced growth approach. A big push might be needed by a government to help the economy grow in a balanced way. For example, if the motor industry is growing naturally, it might be necessary for the state to nationalise the steel industry to ensure that it grows to meet growth in the demand for vehicles.

In contrast, unbalanced growth theory, which is associated with the German born political econo-mist Albert Hirschman, suggests that overall growth is faster when it is unbalanced. If growth is unbalanced, resource prices will rise in those areas where output growth is relatively slow, and this will act as a signal for investors to allocate funds to opening up these bottlenecks. An imbal-ance is likely to result in greater investment and growth because it leads to a more efficient al-location of resources. The role of government should be to help support those industries with the strongest linkages to the growth industries. For example, if the steel industry is growing, the government should invest in rail transport to help move the steel around the country and to the ports for export.

Dependency theoryDependency theory became popular in the 1960’s as a response to research by Raul Prebisch. Prebisch found that increases in the wealth of the richer nations appeared to be at the expense of the poorer ones.

In its extreme form, dependency theory is based on a Marxist view of the world, which sees glo-balisation in terms of the spread of market capitalism, and the exploitation of cheap labour and resources in return for the obsolete technologies of the West. The general view of dependency theorists is that there is a dominant world capitalist system that relies on a division of labour be-tween the rich ‘core’ countries and poor ‘peripheral’ countries. Over time, the core countries will exploit their dominance over an increasingly marginalised periphery.

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Dependency theory advocated an inward looking approach to development and an increased role for the state in terms of imposing barriers to trade, making inward investment difficult and promoting nationalisation of key industries.

Although still a popular theory in history and sociology, dependency theory has disappeared from the mainstream of economic theory since the collapse of Communism in the early 1990s. The considerable inefficiencies associated with state involvement in the economy and the growth of corruption, have been dramatically exposed in countries that have followed this view of develop-ment, most notably a small number of African economies, including Zimbabwe.

Keynesian viewDuring the 1970s, dependency theory gave way to a less extreme Keynesian view of development in terms of the role of government. The Keynesian view was that national governments have a positive role in terms of creating the right environment for growth. During the 1960s and 1970s, there was a widespread consensus that intervention generated better outcomes than a laissez-faire approach to development. The belief was that markets would fail to produce economic de-velopment, and that resources should be ‘commanded’, rather than allocated through the price mechanism. The dominant view was that a high level of central control was needed to help co-ordinate activity and plan output so that resources could be directed to where they were most needed. In particular, this involved the planning and control of major utilities, including energy, water, and transport

New Classical viewDuring the 1980s, mainstream economic theory rejected Keynesianism and returned to its Classi-cal market roots, with its emphasis on market freedom and a limited role for the state. Both the IMF and World Bank quickly began to adopt this New-classical perspective.

Three different New-classical approaches emerged.

1. The free-market approach, where markets alone are assumed to be sufficient to generate maximum welfare.

2. The public-choice approach, which is an extreme New-classical model which em-phasises that all government is ‘bad’ and leads to corruption and the gradual confisca-tion of private property.

3. The market-friendly approach, which suggests that, while markets work, they some-times fail to emerge, and a government has an important role in compensating for three main market failures: missing markets, imperfect knowledge, and externalities.

New-classical theorists rejected the Keynesian view which dominated the 1970s. Despite differ-ences of emphasis, they tend to agree that development is best left to markets. In particular, New-classical economists believe that, to develop, countries must liberate their markets, encour-age entrepreneurship (risk taking), privatise state owned industries, and reform labour markets, such as reducing the powers of trade unions.


There is a broad consensus between New-classical economists that free trade can help stimulate growth and development by encouraging inward investment and the application of economies of scale and economies of scope, increasing competition and breaking down domestic monopolies and creating a low inflation environment.

New growth theoryA central proposition of New Growth Theory24 is that, unlike land and capital, knowledge is not subject to diminishing returns.

24 There are several versions of New Growth Theory, but most focus on the importance of knowl-edge and technology, and how diminishing returns to technology are compensated for by the positive external spillovers which arise from knowledge and technology.

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Theimportanceofknowledge

Indeed, the development of knowledge is seen as a key driver of economic development. The implication is that, in order to develop, economies should move away from an exclusive reliance on physical resources to expanding their knowledge base, and support the institutions that help develop and share knowledge.

Governments should invest in knowledge because individuals and firms do not necessarily have private incentives to do so. For example, while knowledge is a merit good which generates posi-tive external effects, and acquiring it does not deny anyone else that knowledge, its usefulness to individuals and firms may be considerably undervalued, and yet knowledge can generate increas-ing returns and drive economic growth. Government should, therefore, invest in human capital, and the development of education and skills. It should also support private sector research and development and encourage inward investment, which will bring new knowledge with it.

The role of the public sector

Because public investment in social capital is subject to market failure, New Growth theorists argue that government should allocate resources to compensate for this failure.

Utilities and infrastructure

Essential utilities like electricity, gas, and water are natural monopolies, and in many countries are provided by the public sector. However, if these utilities are under-supplied due to inadequate public funds, the private sector will suffer and growth will be limited. This is because the industrial sector relies on energy and water for its production and distribution, without which it will not produce efficiently or competitively. The accumulation of private capital, therefore, depends up the correct level of expenditure by government.

Similarly, New Growth theorists argue that government should also finance, or seek finance for, infrastructure projects, such as road, rail, sea, and air transport. Such projects involve the crea-tion of quasi-public goods, and the theory of market failures tends to suggest that they would be ‘under-supplied’ without government. The huge fixed costs and the difficulty of charging users prevents the private sector supplying, and the state may choose to act like a producer and finan-cier, and provide necessary legislation for and co-ordination of such projects.

These projects also generate positive externalities, and as such justify government involvement. For example, an improved infrastructure increases the likelihood of tourist revenue as well as reducing production costs.

Property rights, legal documentation and development

Peruvian economist, Hernando de Soto has been credited with raising global awareness of the significance of the establishment of property rights to the development of modern economies. One important aspect of this is the documentation of legal rights of ownership, which enable businesses to gain credit and function effectively. In many less developed countries such docu-menation is limited, leading to the emergence of large hidden economies and the suppression of formal business activity. The absence of formal property rights is seen as a fundamental cause of poverty and a constraint on economic development.

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Questions

1. Distinguish between economic growth and economic development.

2. How important is the accumulation of saving to a country’s economic growth?

3. Contrast balanced and unbalanced growth.

4. Evaluate New Growth theory.

5. Evaluate the role of government in facilitating economic growth and development.

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InequalityA fundamental issue facing the global economy is the widening poverty gap between the devel-oped and less developed world, and the widening distribution of income within countries and geographical regions.

Income and wealthImpoverishment has several causes, including low of income as a result of unemployment, under-employment, or low wage employment. It may also be caused by a failure of government to pro-vide a welfare safety-net in the event of the above.

The types of income that can be received are:

Earned income

Income can be earned from selling labour, including wages, which are the largest source of in-come, and salaries and commission, which represent a very small fraction of income in compari-son with more developed economies.

Unearned income

Some income is unearned, such as rents from land ownership and interest from lending money. This is much less available in less developed economies.

Wealth in developing countries

In developing countries, wealth is commonly derived directly from land and natural resources and includes the land itself and livestock. Physical property and financial assets represent a rela-tively small proportion of wealth in a developing country.

Equity and inequality

Equity means fairness or evenness, and achieving it is considered an economic objective. Despite the general recognition of the desirability of fairness, it is often regarded as too normative a concept because it is difficult to define and measure. For most economists, equity relates to how fairly income and opportunity are distributed between different groups in a given society.

The opposite of equity is inequality, and this can arise in two main ways:

Inequality of outcome

Inequality of outcome from economic transactions occurs when some individuals gain much more than others do from an economic transaction. For example, individuals who sell their la-bour to a single buyer, a monopsonist, may receive a much lower wage than those who sell their labour to a firm in a highly competitive market. Inequality of income is an important type of in-equality of outcome.

Inequality of opportunity

Inequality of opportunity occurs when individuals are denied access to institutions or employ-ment, which limits their ability to benefit from living in a market economy. For example, children from poor homes may be denied access to high quality education, which limits their ability to achieve high levels of income in the future.

Does inequality serve a purpose?Market economies rely on the price mechanism to allocate resources. This means that resources, including labour, are allocated prices that reflect demand and supply. Changes in demand and supply affect prices, which create incentives and provide signals to factor owners. For example, rising wages act as an incentive to labour to become more employable, and provide a reward for those that do. Therefore, inequality acts as an incentive to improve, and specialise in those goods and services that command the highest reward.

However, critics of unregulated market economies raise doubts about the need for such vast dif-ferences in income that exist and that considerably smaller differences will still create a sufficient incentive to reward effort and ability.

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Measuring inequality of incomeInequality can be quantified by looking at the distribution of income or wealth. The distribution of wealth is likely to be much greater than income because wealth is built up over many decades, and for some families, over centuries. The distribution of income is relatively easy to measure - valuing wealth is more difficult. This is because wealth is often hidden from view, and because it changes its value over time

The Lorenz curveA Lorenz curve shows the % of income earned by a given % of the population. A ‘perfect’ income distribution would be one where each % received the same % of income. Perfect equality is, for exam-ple, where 60% of the population gain 60% of national income. In the above Lorenz curve, 60% of the population gain only 20% of the income; hence, the curve diverges from the line of perfect equality of income.

The further away the Lorenz curve is from the 450 line, the less equal the dis-tribution of income.

In the example, the curve for country Y is further away from the line of equal dis-tribution than the curve country X, im-plying a wider distribution of income. As can be seen, for country Y, only 10% of income is received by 60% of the population, compared with 20% for country X.

The Gini co-efficient and indexThe Gini co-efficient, or index, named af-ter the Italian statistician, Corrado Gini, is a mathematical devise to compare income distributions over time and be-tween economies.

The Gini index can be used in conjunc-tion with the Lorenz curve. It is calcu-lated by comparing the area under the Lorenz curve and the area from the 450 line to the right hand and bottom axis. The co-efficient ranges from 0 to 1 - the closer to one, the greater the inequality.

The Gini Index is the Gini coefficient, ex-pressed as a percentage - the closer to 100%, the greater the degree of inequal-ity.

CumulativePopulation (%)

CumulativeIncome (%)

60

Lorenz curve

45degree

20

60

Line of perfectly equal distrib

ution


CumulativePopulation (%)

CumulativeIncome (%)

60

Lorenz curveshowing an increase

in inequality

45degree

20

60

Line of perfectly equal distrib

ution

10


Country XCountry Y

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How does development affect inequality?According to the Kuznets25 Hypothesis, after Nobel winning economist Simon Kuznets, the rela-tionship between inequality and development can be illustrated as an inverse ‘U’ – the Kuznets curve.

At low levels of development in a pre take-off phase, the majority of the population will work on the land and be relatively poor, with only a small gap between rich and poor. As the economy takes-off, some individuals will gain considerably, relative to others, as in the case of Russia’s super rich followed by Russia’s growing middle class. These groups will exploit their advantage and open up a considerable gap between themselves and the poorest groups.

Eventually, as the economy develops, more resources are exploited and allocated to the poorest groups. This re-distribution is achieved through progressive taxes and wel-fare payments, and job creation.

25 Contained in numerous works by Kusnets, including in 1971: Economic Growth of Nations: Total Output and Production Structure. Cambridge: Belknap Press of Harvard University Press.

Degree of development

GiniIndex

Greatestinequality

KuznetsCurve

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QuestionDoes inequality serve any useful purpose?

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Poverty There are two ways to define poverty:

Absolute povertyDefining absolute poverty means trying to agree a general definition of poverty which is valid at all times and for all economies – this is difficult to do.

The simplest definition of being poor is ‘…being unable to subsist…that is, being unable to eat, drink, have shelter and clothing. A common monetary measure of absolute poverty is ‘..receiving less than $1 a day…’. (In 2008, the World Bank revised this figure to $1.25 a day.) It is also possible to establish an international poverty line, at, say $500 per person per year, and then compare countries, by estimating the purchasing power equivalent of that sum in terms of the countries own currency.

Relative povertyIt can be argued that poverty is best understood in a relative way – what is poor in New York is not the same as what is poor in Calcutta. Many relative definitions of poverty conclude that it is the inability to reach a minimum accepted standard of living in a particular society. Another approach is to look at deprivation - the poor being defined as those who are deprived from the benefits of a modern economy.

Definitions of relative poverty vary considerably, but the definition of the UK government is typi-cal for developed countries – this states that the poor are those living on ‘..less than 50% of me-dian income..’.

If we take the ‘international poverty line’ as a guide, then, as a region, Asia has the highest num-bers of its population who are poor. However, as a region of the world, Sub-Saharan Africa has the highest level of poverty as a proportion of total population, at over 60%. The second poorest region is Latin America, with 35% of its population poor.

The Human Poverty Index - HPIThe Human Poverty Index (HPI), which was introduced in 1997, is a composite index which as-sesses three elements of deprivation in a country - longevity, knowledge and a decent standard of living. There are two indices, the HPI – 1, which measures poverty in developing countries, and the HPI-2, which measures poverty in OCED developed economies.

HPI-1 (for developing countries)There are three elements to the HPI – 1.

1. The first element is longevity, which is defined as the probability of not surviving to the age of 40.

2. The second element is knowledge, which is assessed by looking at the adult literacy rate.

3. The third element is to have a decent standard of living. Failure to achieve this is identi-fied by the percentage of the population not using an improved water source, and the percentage of children under weight for their age. Both indicate being deprived from a decent standard of living.

HPI-2 (for developed - OECD countries)The elements of the HPI – 2 are:

• Longevity, having a long and healthy life, and the indicator for this is the probability at birth of not surviving to the age of 60;

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• Knowledge – the percentage of adults lacking functional literacy skills;

• A decent standard of living – the percentage of the population living below the poverty line, which is defined as those below 50% of median household disposable income, and social exclusion as measured by the long term unemployment rate.

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Constraints on developmentThe pace of development can be slowed down, or even reversed, by various factors affecting the economy. Some of these constraints can be dealt with through economic and social policy, while others may be difficult to resolve. The constraints on development include the following:

InefficiencyAn important limit to economic growth is the efficiency by which scarce resources are used.

Productiveinefficiency

Producers in less developed countries may not be able to produce at the lowest possible average cost. This may be because of the failure to apply technology to production, or because of the in-ability to achieve economies of scale. Opening up the economy to free trade may help reduce this type of inefficiency, and encourage technology transfer.

Allocativeinefficiency

When developing economies remain closed to competition, or when they are dominated by local monopolies, or where production is in the hands of the state, prices might not reflect the mar-ginal cost of production. Opening up the economy to free trade, and privatisation of industry may help promote a more competitive environment, and reduce allocatively inefficiency.

‘X’Inefficiency

X inefficiency can arise when there is a lack of competition in a market. This primarily associated with inefficient management, where average cost is above its minimum. Competition is limited in many developing economies, and resources are often allocated by government, or controlled by a few large organisations, as in the case of Mexico. This means that inefficient management is common.

Socialinefficiency

Social inefficiency exists when social costs do not equate with social benefits. This can arise when externalities are not taken into account. For example, under-spending on education creates social inefficiency. Some of these inefficiencies are the result of the economy not allowing market forces to operate, while others are the result of market failures. Negative externalities like pollution are often largely uncontrolled in less developed parts of the world, and this imposes a constraint on the sustainability of development.

ImbalancesNot all sectors of an economy are capable of growth. For some developing economies, too many scarce resources may be allocated to sectors with little growth potential. This is especially the case with the production of agriculture and commodities. In these sectors, there is little oppor-tunity for economic growth because the impact of real and human capital development is small, and marginal factor productivity is very low. Failure to allocate scarce resources to where they are most productive can impose a limit on development.

PopulationPopulation is a considerable constraint on economic growth, either, and most commonly, be-cause there is too a high rate of population growth for the country’s current resources, or be-cause the population is growing too slowly or declining as a result of war, famine, or disease. Many economists see population growth as the single biggest issue facing developing countries. The line of argument runs as follows:

At first, the take-off phase of development and economic growth creates positive externalities from the application of science and technology to healthcare and education and this leads to a decline in the death rate, but no decline, or even an increase, in the birth rate. Over time life expectancy rises, but the age distribution remains skewed, with an increasing number of depend-ents in the lower age range. As a result, the number of consumers relative to producers increases.

The short-term gains from growth are quickly eroded as GDP per capita actually falls, hence, only when the birth rate falls will GDP per capita rise. In this case, there is a positive role for govern-

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ment in terms of encouraging a lower birth rate.

Lack of real capitalMany developing economies do not have sufficient financial capital to engage in public or private investment. There are several reasons for this, including the following:

Low growth

Growth is not sufficient to allow scarce financial resources to be freed up for non-current ex-penditure.

Lackofsavings

A general lack of savings is often seen as the key reason why financial capital is in short supply. High interest rates to encourage saving will, of course, deter investment.

Debts

In the case of public sector funding, spare public funds are often used to repay previous debts, so there are less available funds for capital investment by government. This is often called the problem of debt overhang. The recent sovereign debt crisis has highlighted the problems faced by countries with large public debts, and how such debts limit the ability of government to inject spending into a developing economy.

Crowding out

In addition, because many developing economies have large public sectors, private investment may be crowded out by public sector borrowing. This means that government may borrow from local capital markets, if they exist, which causes a relative shortage of capital and raises interest rates.

Absenceofcreditmarkets

Finally, there is an absence of credit markets in many developing economies, and this discour-ages both lenders and borrowers. Credit markets often fail to form because of the very high risks associated with lending in developing countries. This is one reason for the importance of micro-finance initiatives commonly found across India, Pakistan and some parts of Africa. (See below).

CorruptionSome developing economies suffer from corruption in many different sectors of their economies. Corruption comes in many forms, including the theft of public funds by politicians and govern-ment employees, and the theft and misuse of overseas aid. Bribery is also alleged to be a persis-tent threat, and tends to involve the issuing of government contracts. In some developing econo-mies, bribery is the norm, and this seriously weakens the operation of the price mechanism.

Inadequate financial marketsMissing markets usually arise because of information failure. Because of asymmetric information, lenders in credit markets may not be aware of the full creditworthiness of borrowers. This pushes up interest rates for all borrowers, even those with a good credit prospect. Low risk individuals and firms are deterred from borrowing, and a lemons problem arises, with only high risk indi-viduals and firms choosing to borrow. Thus, the credit market in developing economies is under-developed or completely missing, with few wishing to borrow, and with those who wish to lend expecting high loan defaults and hence charging very high interest rates.

Insurancemarkets

In a similar way to credit markets, insurance markets may be under-developed, with few insurers willing to accept ‘bad’ risks. Insurance charges (premiums) are driven up and ‘good’ entrepreneurs will not be prepared to take such uninsured risks. The result being that new businesses fail to develop.

The principal - agent (landlord - tenant) problemIn agriculture in particular, the principal-agent problem existing between landlord (principal) and

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worker (agent) creates asymmetric information and moral hazard. Workers may not bother to work hard. With low pay rates, the risks of being caught ‘shirking’ are small – the loss of pay is not a big enough incentive to work hard and efficiently.

Absence of property rightsIn many developing economies it is not always clear who owns property, especially land. Given this there is no incentive to develop the land because of the ‘free-rider’ problem. As noted by de Soto, there may be a lack of proper documentation regarding ownership of land and property, which significantly limits the ability of individuals and businesses to own, exploit and develop physical assets and technology.

Absence of a developed legal systemIn many developing economies, there is an absence of a developed or appropriate legal system in the following areas:

z Property rights are not protected

z The right to establish a business is limited to a small section or a favoured elite

z Consumer rights are not protected

z Employment rights do not exist

z Competition law is limited or absent

Under-investment in human capitalHuman capital development requires investment in education. Education is a merit good, and the long term benefit to society is often considerably under-perceived, and therefore, under-consumed. For many in developing economies, the return on human capital development is un-certain compared to the immediate return from employment on the land. Therefore, there is little incentive to continue in full-time education.

The solution is to reduce information failure by promoting the benefits of education and using the market system to send out effective signals to encourage people to alter their behaviour. For example, loans, grants and aid can be made conditional upon funds being allocated to provide ‘free’ education and books, or to fund teacher training, or to raise the wages of teachers so that more will train in the future.

Over-exploitation of environment and non-renewable resourcesThe long-term negative effect of the excessive use of resources may be less clear than the short-term benefit. This means that there is a tendency for countries not to conserve resources. How-ever, this can clearly have an adverse effect on growth rates in the future.

Too many resourcesEvidence suggests that some countries with the greatest scarce resources do not necessarily exploit them effectively, and may fail to develop fully. This might be because over-abundance cre-ates a kind of Dutch disease - a complacency which can exist when a country has high quantities of valuable resources. This means that there is a tendency to squander any comparative advan-tage, and the potential benefits of the resources are lost. Over-abundance creates a disincentive to be efficient - the reverse of what has happened to Japan, which has very limited oil reserves, and needs to be efficient in the production of manufactures to enable it to import the oil it needs.

One issue is that the allocation of property rights may be difficult when resources are so vast. Fur-thermore, there are likely to be inefficiencies associated with government failure as government attempts to dominate the economy and the exploitation of resources.

ProtectionismOne significant constraint on the economic prosperity of less developed countries is the protec-

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tionism adopted by some developed one. Developed counties can impose tariffs, quotas, and other protectionist measures individually, or more commonly as a member of a trading bloc.

Questions

1. Taking the example of a country that you have researched, describe the main ob-stacles that exist to further economic development.

2. How significant is population growth to the continued development India?

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Costs of growthWhile growth improves a country’s chances of development, it also creates a number of economic and social costs:

Negative externalitiesAs growth increases, production and consumption increase and there are likely to be consider-able external costs as a result, such as deforestation, and the knock-on effects such as increased flooding; desertification of regions suffering over-production; pollution of rivers; depletion of non-renewable resources and long term climate change.

Exhaustion of environmental capitalThe environment is a scarce resource and a factor of production, which resembles capital. If the environment is over-exploited and miss-used, future development prospects will be restricted. A lack of property rights over often-vast areas of land means that there is no incentive to conserve such resources. This impacts on the poor, who suffer most from polluted drinking water and loss of agricultural land.

Urban squalorUrbanisation tends to go hand in hand with economic growth and an exodus from the land to the cities, as can be witnessed in much of India, China, and Latin America. The resulting squalor is one of the most widely recognised costs of rapid economic growth. The urban slums that exist in many parts of the developing world today closely resemble those that existed in large cities in the UK, and across Europe, at the end of the 18th Century because of rapid industrialisation.

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Policies to promote developmentIn trying to develop, countries can look either inwards or outwards.

Inward looking policiesInward looking strategies were typical of the general approach to development which dominated thinking after the Second World War. This approach is interventionist and protectionist, and guid-ed policy making in many African and Latin American countries, and in some countries still does.

The underlying economic strategy was import substitution, which meant encouraging the devel-opment of domestic industry ‘under cover’ of protective barriers, such as tariffs and quota. The in-dustries targeted were those that provided the largest quantity of imports. Therefore, in the case of Japan, import substitution meant developing strong motor vehicle and consumer electronics industries. Inward looking strategies also involved the heavy subsidisation of domestic producers as well as limiting the activities of multi-nationals.

Thebenefitsofinwardlookingpolicies

Inward looking policies did generate some short-term benefits, such as the protection of infant and declining industries; job creation; increased income and preserving traditional ways of life. However, the consensus is that the challenges of globalisation require a more outward looking approach.

Outward looking policiesAn outward looking strategy is seen as a more modern approach to development, and one that relies less on government intervention. A number of important global events forced many de-veloping countries to become outward looking, including a rising development gap between countries adopting inward and outward looking policies. In addition, the collapse of communism created an opportunity to adopt more outward looking policies. Those that have adopted them, including India and China, clearly benefitted from increasingly outward looking policies in terms of growth rates and reduced poverty.

Typical outward looking policies include trade liberalisation and market reforms; encouraging FDI; promoting trade through exhibitions and trade fairs; and hosting global sporting and entertain-ment events, such as China’s Olympic Games in 2008.

Thebenefitsofoutwardlookingpolicies

The benefits of outward looking policies are derived from the benefits of free trade. For example, free trade brings welfare gains from tariff removal and increased competition and efficiency. In addition, outward looking countries may be better able to cope with globalisation and with exter-nal shocks. However, the financial crisis and its after-effects have forced many national govern-ments to re-think their policies and to minimise the risks of an outward looking approach.

Developing particular sectorsOne strategy for a country looking to develop is to try to develop one of its sectors. Most growth and development theorists have recognised that there is a strong correlation between the level of development of an economy, and the proportion of its national output being generated by dif-ferent sectors. Development theory suggests that the greater the significance of agriculture, the less the level of development. Conversely, the more prominent the service sector, the greater the level of development.

Primarymarkets

Many developing countries specialise in agricultural and other primary products. Indeed, the principle of comparative cost advantage suggests that specialising in commodities and products with the lowest opportunity cost will provide the best opportunity for economic development. However, over-specialisation, particularly in terms of primary production, can be highly risky.

A country may remain under-developed if it specialises in producing a few primary products. There are several reasons for this.

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Low value-added un-branded products

Primary products, such as food and commodities, are bought and sold in markets which are virtu-ally perfectly competitive. This means that products are un-branded and homogeneous, with a low valued added, and therefore low-priced. As a result, the sale of such commodities generates a relatively small share of global income, so the rewards to factor inputs will also be limited. This does not create an economic environment in which entrepreneurs can flourish and take risks to accumulate short-term supernormal profits.

Inconsistent yields

Yields from land are likely to be inconsistent because of variations in growing conditions.

Price instability

Price instability, which is an inherent feature of primary markets, can make it extremely hard for producers to survive. It also deters investment in new technology, which requires a stable macro-economic environment.

Susceptibilitytoglobalshocks

If countries rely on producing a small range of agricultural products, they are more likely to be adversely affected by global shocks.

Unfavourable elasticity

Primary products have low income and price elasticity, which means that, as world incomes rise, proportionately less income is allocated to primary products, and more is allocated to manufac-tured goods, and services. In addition, commodity prices often fall in relation to manufactures but, because of the relatively low price elasticity, sales revenue falls when prices fall. In addition, export prices of commodities sold by developing countries tend to fall relative to import prices of manufactures from developed countries, hence the terms of trade of many developing econo-mies fall. This means they have to export increasingly more commodities to pay for the same volume of imported manufactures, including both consumer and capital goods.

The Prebisch-Singer hypothesisA country’s terms of trade indicate how high a country’s export prices are in relation to their im-port prices, and is expressed as:

Thehypothesisstatesthat:

Over time the terms of trade for commodities and primary products deteriorates relative to man-ufactured goods. This hypothesis contributed to the general view that it was dangerous to rely on agriculture to secure growth and development. This means that, just to keep up with developed economies and maintain the existing development gap, countries relying on producing and ex-porting primary products, whose terms of trade decline, must continually increase output.

The hypothesis also provided the basis for an inward looking approach, which encouraged coun-tries to switch to manufacturing, and undertake import substitution. This means encouraging countries to stop importing goods with increasing terms of trade, and develop their own indus-trial base so that they can produce these goods for themselves.

Falling farm incomes

In the long run, the income of many primary producers has fallen because the global supply of food has risen. This is the result of a greater use of new technology and better crop yields, and because of new entrants into the global marketplace, such as the entry of Vietnam into the coffee market.

Unstable prices

The cobweb diagram best explains the tendency for price instability of agricultural products. Ini-tially, we can assume a stable equilibrium price.

Index of Export Prices

Index of Import PricesX 100

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There then follows a negative supply shock, such as a crop disease, bad weather, political unrest or a war.

Short run supply (Q1, at S1) ends up significantly less than planned (Q) and the price is pushed up to P1. In the following year, planned output rises to Q2, but this drives price down to P2. The pro-cess continues until the price is so low that producers are driven out of the market.

There is clearly a significant information failure – farmers and growers are not fully aware of the impact of their decisions in one year on the price of products in the following year.

Remedies for unstable pricesBufferstocks

Buffer stocks are stores of produce that have not yet been taken to market. They can help stabilise price by taking surplus output and putting it into a store. Alter-natively, with a bad harvest, stock is re-leased from storage. A target price can be achieved through intervention buying and selling. Buffer stocks can stabilise farm prices at the target price, and help stabilise farmers’ incomes.

Evaluationofbufferstocks

While buffer stocks can help stabilise price, there are a number of disadvan-tages, including the following additional costs to society, such as initial building costs, extra storage, insurance, and man-agement.

A further problem is that not all products can easily be stored because they are per-ishable. Buffer stocks also rely on starting with a good harvest so that the surplus can be put into storage. Without stocks in the system, it is not possible to react to a poor harvest by releasing stock.

Critics also argue that they distort the operation of free markets and prevent the price mechanism working effectively. Finally, there is the potential problem of moral hazard – buffer stocks provide in-surance against poor harvests and may encourage producers to be inefficient.

Guaranteed prices

‘Guaranteeing’ a price to producers (at P1 in the diagram), irrespective of the output they produce, is another way of stabilis-ing prices and incomes.

However, they can also be criticised be-cause they encourage over-production, creating a surplus of Q2 to Q1. In addi-tion, guaranteeing prices can promote inefficiency - why should farmers bother to be efficient if they are guaranteed a

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buyer? This is another example of moral hazard. There are also extra costs of storage or disposal.

Set-Aside programmes

Set-aside schemes involve paying farmers and growers to ‘take land out of production’. They are used widely in the EU and USA. Set-aside can be effective because it can prevent surpluses hap-pening in the first place, and hence avoid storage, distribution, and management costs.

Exportsubsidies

An export subsidy involves farmers and growers being paid a subsidy to export their surpluses at artificially low prices. However, other countries can retaliate, and impose tariffs because it can be argued that this is unfair competition.

Quotas

Producers can be told how much to produce, to avoid over or under production in response to shocks. It can be argued that they are effective, because prevention is better than cure. However, there is a potential ‘Prisoner’s Dilemma’, where farmers cheat by over producing because they predict that other farmers will also over produce.

Betterinformationaboutfutureshocks

Better use of the internet and computer technology can also be used to provide farmers with information about weather and other potential shocks. However, small producers in developing countries are unlikely to be affected. A government can also provide special education, such as establishing special agricultural colleges, and providing courses to educate and train farmers and growers.

Development of agricultureMost development theories conclude that improvements in agriculture are crucial to develop-ment prospects. Agriculture can be developed by a range of policies, including extending prop-erty rights to individuals so that they have an incentive to be more productive. It may also be necessary to promote land reform and improvement programmes.

Commodity Agreements

Commodity agreements are arrangements between producing and consuming countries to sta-bilise markets and, from the producer’s perspective, raise average prices. These agreements are common in many markets, including coffee, tea, and sugar.

Example-TheInternationalCocoaAgreement

In 2003 an agreement was made between the seven main cocoa exporting countries; Cameroon, Ivory Coast, Gabon, Ghana, Malaysia, Nigeria and Togo, and the main importing countries ; fifteen EU members, plus Russia, the Slovak Republic and Switzerland. The main purpose of the ‘agree-ment’ was to promote the consumption and production of cocoa on a global basis. The agree-ment was planned to last until 2010, and a new agreement was duly put in place in 2010.

As well as promote cocoa as a prod-uct, the agreement attempts to sta-bilise cocoa prices, which are prone to considerable volatility, as seen in the graph. These agreements often involve intervention schemes, such as buffer stocks, and usually only last for a few years, whereupon they have to be re-negotiated. They are different from cartels such as OPEC, largely because they involve both producer and consumer coun-tries.

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TourismMany countries have promoted tourism as a means of achieving development, including Cuba. To ease the problem of falling revenues from sugar, and from the dramatic reduction in aid following the collapse of the Soviet Union in the early 1990s, Cuba turned to tourism. This included encour-aging the building of hotels by foreign firms and the development of certain holiday resorts, such as Varadero.

The advantages of tourismMultipliereffects

Given the high marginal propensity to consume (mpc) in developing economies, the injection of tourist revenue can, through a multiplier effect, have wide repercussions on economic activity, including job creation.

Infrastructure

The development of a tourist industry requires the construction of infrastructure, including air-ports and roads. Once available for use, transport costs can fall, and the efficiency of domestic producers can increase.

Encouraging FDI

A growing tourist industry encourages further inward investment associated with the provision of services.

Currency

Tourism can be a highly effective at generating foreign exchange, especially in comparison with low-value commodities.

Diversification

Tourism can help create a more balanced and diversified economy, with a developing service sec-tor which is often seen as a key indicator of economic progress.

The disadvantages of tourismThe disadvantages of tourism include the following:

Little revenue is retained

Tourist revenue may go to firms based in other countries, such as travel agents and tour opera-tors. The owners of the hotels may reside abroad, with profits going out of the country.

Dual economy

Tourism may lead to the emergence of an unofficial parallel economy, often with the unofficial part being based on the US$, as in the case of Cuba. Given the nature of these cash economies, very little tourist spending ends up as tax revenue. This means that the governments of many developing countries do not receive sufficient revenue from tourism to spend on infrastructure, education, and healthcare.

Negativeexternalities

Tourism can generate a number of negative externalities, including the costs of overcrowding; the loss of areas of natural beauty; the over-exploitation of historic sites; excessive demands on local infrastructure and the diversion of resources from key industries, such as food production.

Instability

Tourist income is a potentially very unstable source of income. Sudden changes in the level of tourism can occur for a number of reasons, including changes in national incomes in developed economies. Tourism has a high income elasticity of demand meaning that spending is very sensi-tive to the business cycle.

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In addition, tourist travel is susceptible to health, security, and safety scares, such as Severe Acute Respiratory Syndrome (SARs), which adversely affected travel to China, and Canada during 2004, terrorist attacks, and natural disasters like the Asian tsunami.

Changes in exchange rates can also make the tourist markets unstable. For example, the fall in Sterling between 2007 and 2009 increased the price of foreign holidays, and caused more UK holiday makers to take their holiday at a UK destination.

Lastly, changes in taxes, such as changes in airport taxes, carbon taxes, and changes in duty-free allowances can all influence demand for tourism.

Structural adjustment policiesStructural adjustment policies (SAPS) attempt to encourage developing economies to put greater emphasis on market forces and market reforms. Such policies are closely associated with free-market economics, which became highly influential during the late 1970s and 1980. The theory of structural adjustment profoundly influenced the development of international financial or-ganisations like the World Bank and IMF during the 1980s. Since then, both the IMF and World Bank require structural adjustment as a condition for lending to developing countries. Structural adjustment policies have two main features:

Economic stabilisation

SAPs attempt to stabilise the macro-economic environment to help an economy cope with glo-balisation and external shocks. Such policies include:

z Tight monetary policy, including raising interest rates, or controlling the quantity of money.

z Fiscal prudence, including reducing the level of subsidisation by the state; control-ling the size of the public sector; and cutting back on the level of public sector pay.

z Exchange rate depreciation, to give a boost to exports.

Structuralpolicies,including:

z Liberalising trade by removing barriers which protect domestic firms, to enable countries to discover their true comparative advantage, and specialise in producing goods and services with the lowest opportunity cost.

z Privatisation of state industries to generate micro-economic efficiency gains, and encourage inward investment as overseas banks, firms and private citizens look to in-vest in the newly privatised industries. This would create a positive multiplier effect on the domestic economy.

z Measures to increase capital mobility, such as eliminating ‘capital controls’ which stop foreign firms withdrawing capital, and encouraging the development of stock mar-kets.

The ‘Washington Consensus’The Washington Consensus is a phrase used to describe the general preference of the USA ad-ministration and many of its political allies, and, critically, the IMF and World Bank, for structural reforms to accompany any loans or aid. The ‘consensus’ can be summarised as the view that countries looking to develop and benefit from loans, grants, aid and political support, should adopt the following policies:

z The widest use possible of market forces to allocate scarce resources, including the privatisation of utilities.

z Free trade and an export orientation.

z Improvements in education and healthcare.

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z Sound fiscal policies.

Issues concerning structural adjustment

Structural adjustment policies often involve considerable austerity for people already highly impoverished. In addition, fiscal prudence may mean governments reducing spending on long term projects involving education and healthcare, with a loss of positive externalities associated with health and education. Recently, both Greece and Italy have had to impose an austerity pro-gramme as part of the conditions imposed by the IMF and European Financial Stability Facility.

In addition, privatisation does not necessarily help stabilise an economy and can raise prices and reduce employment. The liberalisation of capital markets can create exchange rate vola-tility which can destabilise an economy in the short run. The recent credit crunch has clearly highlighted the risks associated with free trade in capital and finance, and from globalisation in general. However, supporters of structural adjustment stress that in the long-run growth and development are much more likely to emerge when the principles of structural adjustment are fully applied to developing countries.

Question Essay – Evaluate alternative polices to promote the development of an economy with which you are familiar.

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Financing development

External finance through FDIForeign Direct Investment (FDI) refers to the flows of real capital between countries that accom-pany overseas investment decisions. A single flow of capital between two countries can be de-scribed as ‘outward’ for the investing country and as ‘inward’ for the recipient country. Both pri-vate sector firms and by governments undertake FDI.

Government assistanceGovernments can help provide financial aid for developing economies, called foreign aid, in two ways; from bi-lateral aid, which is assistance directly from one country, and from multi-lateral aid, which means giving assistance to more than one country, usually through an agency or through charities.

Official Development Aid (ODA)There are two basic types of ODA - long term aid to relive poverty and short term humanitarian aid for relief following disasters. In 2007, the UK’s development assistance totalled just over £6 billion, approximately 0.36% of its GDP26. The UK has agreed to implement the UN Millennium aid goal of 0.7% of GDP by 2015. The USA is the single biggest provider of development aid.

Evaluation

Targeting aid for specific purposes is probably the most useful type of aid, such as the eradication of a specific disease like malaria, and to relieve the immediate effects of natural disasters, such as the Far East and Japanese tsunamis. However, aid spending only represents a small % of global GDP and received aid only represents a small % of the recipient country’s GDP.

Bilateral aid may have strings attached, in which case it is referred to as tied aid. For example, aid may be dependent on the recipients allocating contracts to the donor countries, such as contracts to build infrastructure.

Some critics, such as Peter Bauer (Lord Bauer), have argued that aid can be disastrous, and can trap poorer countries into a life of aid dependency. The late Lord Bauer, of Cambridge and the LSE, was one of the UK’s strongest advocates of free trade to promote development, and the ap-plication of the price mechanism to mobilise resources to finance development, and as such was a strong critic of overseas aid.

Non-governmental organisations (NGOs)NGOs are not-for-profit organisations that act as pressure groups, representing the interests of members, or the interests of other groups. NGOs frequently advocate particular policies, and promote these in discussions with governments and their agencies. The world’s oldest and larg-est NGO is the International Red Cross, whose main aim is to provide humanitarian aid to war or disaster affected countries.

What are the benefits of NGOs?The UN Industrial Development Organization (UNIDO) analysed the role of NGOs and suggested that they provided a number of key benefits, including:

Accountability

There is local accountability of locally based NGO, such as the 250 independent NGOs operating in Kenya.27 Independence

NGOs are independent of government and can arrive at independent assessments of the needs

26 Source: DFID - The Department for International Development, 2010

27 Source: www.nonprofitexpert.com

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of a country.

Informationandexpertise

NGOs can undertake research, provide information and expertise, and attempt to raise aware-ness of the needs of developing countries28.

Microfinance Because of the lack of a financial infrastructure, development in many countries is very slow. Microfinance initiatives encourage people to lend small amounts to others to enable them to set up small businesses.

Microfinance initiatives (MFIs) started in Bangladesh in the early 1980s, and became so popular that they are common in many areas of the developing world, especially India and Africa. The first bank to specialise in small micro-loans was the Grameen Bank in Bangladesh.

28 Source: UNIDO

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Questions

1. Evaluate the effectiveness of overseas development aid.

2. Why do some economists criticise development aid?

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Policies to improve growth and stabilityEconomic stability enables other macro-economic objectives to be achieved, such as stable prices and stable and sustainable growth. It also creates the right environment for job creation and for a balance of payments. This is largely because stability creates certainty and confidence and this encourages investment in technology and in people.

Unfortunately, an unintended consequence of globalisation is the increased likelihood of eco-nomic shocks, including supply side shocks like oil and commodity price shocks, and demand side shocks like the credit crunch and subsequent financial crisis.

Policies to promote short term stabilityFiscal stabilisers

Built-in automatic fiscal stabilisers, which include progressive taxes and escalating welfare pay-ments, provide a shock absorber to stabilise an economy following an economic shock. The com-bined effect of these is to create fiscal drag during periods of unusually strong growth, and fiscal boost during periods of very weak growth or negative growth. Negative or positive demand side shocks can be stabilised more quickly when automatic stabilisers are built-in to the tax-benefit system.

Floatingexchangerates

Floating exchange rates are also seen as an automatic stabiliser. In the event of either a negative demand or supply side shock affecting an economy, the exchange rate will fall as currency traders sell the currency, leading to a fall in export prices and an automatic increase in competitiveness. Assuming foreign demand is price elastic, export revenue will rise, and, via an upward multiplier effect, aggregate demand will bounce back.

Flexiblelabourmarkets

The third automatic stabiliser is flexible labour markets. In the events of a demand side shock, like the credit crunch, aggregate demand will fall and firms will experience a fall in demand for their products. If the labour market is inflexible, workers may be made redundant and as their spending falls national income will fall further, and, with a strong downward multiplier effect, the economy may plunge into a recession. However, with a more flexible labour market a number of flexible responses can occur, which stabilises the economy. For example, instead of making workers redundant, pay can be reduced so that unemployment is avoided. In addition, full-time workers can work part-time, again avoiding full-blown unemployment. Finally, a more flexible and mobile workforce can move quickly from areas or industries with low demand to areas or industries with higher demand.

Monetary policy

In addition to these automatic stabilisers, short-term stability can be maintained by altering mon-etary conditions, such as raising or lowering interest rates, or by expanding or contracting the money supply. Most national economies, and monetary unions, review monetary policy on an ongoing basis, often monthly, to raise, lower, or keep on hold base interest rates.

Policies to promote sustainable growthSustainable economic growth occurs because of increases in aggregate demand and supply. However, long-term sustainable growth ultimately depends on supply-side improvements be-cause balance of payments and inflationary problems are less likely when the productivity of factors improves. Policies to promote growth include:

Technology policy

Technology policy refers to policies where government provides incentives for private firms to invest into new technology. These incentives could be in the form of grants, cheap loans, or tax relief.

Human capital development

Investment in human capital by allocating more resources to education and training is widely regarded at critical to the success of developing and developed economies. Human capital de-

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velopment provides key skills and knowledge to enable increases in productivity and efficiency.

Reducing red-tape and de-regulation

A key driver of growth for both developed and developing countries is FDI, and this can be en-couraged by reducing red tape and unnecessary regulation to create a more business friendly environment, and opening up markets to overseas investors.

Providing incentives

National governments can provide incentives for individuals to start their own business and for small businesses to expand.

Taxreform

Designing or redesigning the tax and benefit system to increase the labour activity rate and to encourage work and discourage idleness are clearly important options for all countries wishing to improve their supply-side performance.

Increasing competitiveness and contestability

Another important stimulus to supply-side growth is to increase the degree of competitiveness in the micro-economy by promoting contestability, reducing barriers to entry, and by deregulating markets to encourage new entrants.

Newmarkets

Sustainability can also be achieved by encouraging the formation of new markets which exploit new technology or new trading methods. The newly emerging markets for waste and carbon credits, and the development of carbon offsetting schemes, are recent examples of how new markets can emerge, with or without government support.

Infrastructure

Long-term development of infrastructure projects is also central to the promotion of long terms growth and development in a globalised environment. Better infrastructure enables output to be transported at lower cost, as well as generating jobs and other positive externalities.

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Fiscal policy revisitedThe public sector, which involves government spending, revenue raising, and borrowing, has a crucial role to play in any mixed economy.

The purpose of government expenditureGovernment spends money for a variety of reasons, including:

z To supply goods and services that the private sector would fail to do, such as pub-lic goods like defence, roads and bridges; merit goods, such as hospitals and schools; and welfare payments and benefits, including unemployment and disability benefit.

z To achieve supply-side improvements in the macro-economy, such as spending on education and training to improve labour productivity.

z To reduce the negative effects of externalities, such as pollution controls.

z To subsidise industries which may need financial support, and which is not avail-able from the private sector. For example, transport infrastructure projects are unlikely to attract private finance, unless the public sector provides some of the high-risk fi-nance, as in the case of the UKs Private Finance Initiative – PFI. During 2009, the UK gov-ernment provided huge subsidies to the UK banking sector to help deal with the finan-cial crisis. Agriculture is also an industry which receives large government subsidies.

z To help redistribute income and achieve more equity.

z To inject extra spending into the macro-economy, to help achieve increases in ag-gregate demand and economic activity. Such a stimulus is part of discretionary fiscal policy.

z Local government is extremely important in terms of the administration of spend-ing. For example, spending on the NHS and on education are administered locally, though local authorities. Approximately 75% of all public spending is by central govern-ment, and 25% is by local government.

Central and local government (public sector) spendingUsing public spending to stimulate economic activity has been a key option for successive govern-ments since the 1930s when British economist, John Maynard Keynes, argued that public spend-ing should be increased when private spending and investment were inadequate. There are two types of spending:

1. Current spending, which is expenditure on wages and raw materials. Current spend-ing is short term and has to be renewed each year.

2. Capital spending, which is spending on physical assets like roads, bridges, hospital buildings, and equipment. Capital spending is long term, as it does not have to be re-newed each year; it is also called spending on ‘social capital’.

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Spending in 2010

The main areas of UK government spending in 2010, which totalled £668, were:

z Social protection

z Health

z Education

z Public order and safety

z Defence

Approximately 75% of all public spending is by central government, and 25% is by local govern-ment.

Types of fiscal policyFiscal policy is the deliberate adjustment of government spending, borrowing or taxation to help achieve desirable economic objectives. It works by changing the level or composition of aggregate demand (AD).

There are two types of fiscal policy, discretionary and automatic.

1. Discretionary policy refers to policies that are implemented through one-off policy changes.

2. Automatic stabilisation, where the economy can be stabilised by processes called fiscal drag and fiscal boost.

Central government borrowingGovernment must borrow if its revenue is insufficient to pay for expenditure - a situation called a fiscal deficit. Borrowing, which can be short term or long term, involves selling government bonds or bills. Bonds are long-term securities that pay a fixed rate of return over a long period until maturity, and are bought by financial institutions looking for a safe return. Treasury bills are issued into the money markets to help raise short-term cash, and last only 90 days, whereupon they are repaid.

Local government borrowingIf the revenue from the council tax and central government support is insufficient to meet spend-ing commitments, local authorities can also borrow by issuing bonds. Only around 25% of local authority spending is financed by local revenue raising, 75% coming from central government and by borrowing29.

Public sector net borrowing

If the borrowing requirements of both cen-tral and local government is combined, the amount of borrowing required is called the public sector net borrowing (PSNB). The need to borrow varies considerably with the business cycle.

During periods of economic growth, tax yields rise and spending on welfare pay-ments fall, pushing the public finances towards a surplus. During periods of eco-nomic slowdown, tax yields fall and welfare payments rise, pushing the economy to-wards a fiscal deficit.

29 Source: Local Government Association

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In 2009, the government introduced a new measure of public sector borrowing, called Public Sec-tor Net Borrowing Ex (PSNBEx). This measure excludes payments to the financial sector to ease the credit crisis

Tests for borrowing

The previous Chancellor under the Labour Government set up two golden rules for sustainable investment - firstly, to balance the books over a trade cycle, and secondly, only to borrow to fund capital projects, such as road building.

Borrowing, and the financial crisisAccording to the Institute for Fiscal Studies (IFS), the central government net borrowing require-ment in 2009, of approximately £150b, was almost double initial estimates. The main reason for this overshoot was the rescue package for the banking sector, following the global financial crisis. This package included £37b for recapitalisation of the main banks, RBS, Lloyds and HBOS and £21b to the Bank of England to help refinance the financial services sector30.

Government borrowing for 2010-11 is estimated by the IFS to be £139.4 billion.

Fiscal deficits and the National DebtFiscal deficits occur when the revenue received by a government is less than spending during a financial year. These deficits will create the need to borrow by selling government securities - bills and bonds.

What is the national debt?

The national debt is the cumulative amount of annual borrowing that occurs when government spending is greater than revenue.

What causes a rising national debt?

A rising national debt can happen when tax revenues fall and government spending rises as the economy slows down or goes into recession, or when householders and firms spend less, so less VAT is collected, and householders and firm receive less income, so revenues from income taxes fall.

The advantages of discretionary public spending as a fiscal toolStimulate the macro-economy

Public expenditure can be used to help stimulate the macro-economy at times of low and nega-

30 Source: IFS, 2009

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0 Public debt as % GDP

Source: UK Treasury

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tive growth. This works by increasing the level of aggregate demand, and can compensate for failings in other components of aggregate demand, such as a fall in household spending on con-sumer goods and firms spending on capital goods. It can also be used to complement monetary policy or when monetary policy has proved ineffective. This could be the case when interest rates are already low, but the economy still needs stimulating, as occurred throughout the advanced economies following the financial crisis and consequent global recession.

Improving infrastructure

If the spending is on capital items, then infrastructure can be developed, which can help improve competitiveness and economic growth. Infrastructure projects are usually far too expensive for the private sector to tackle on its own.

Positiveexternalities

Spending on infrastructure, healthcare, and education also provides an external benefit to the rest of the economy which can have long run effects in comparison with reductions in interest rates, which are often short term.

Targeting

Public spending can be targeted to achieve a wide range of specific economic objectives, such as reducing unemployment, achieving more equity, road building, action against poverty, and re-building city centres.

The disadvantages of public spendingTime lags

There may be a considerable time-lag between spending and the benefits that arise. For example, a decision to increase spending on education will take many months and maybe years imple-ment, and many years or decades to see the full benefits. Indeed, the full benefits may never be measured and recorded because of information failure.

Inflationaryeffects

In trying to promote growth or reduce unemployment government spending can be inflationary, especially if the government has to borrow from the financial markets or if the spending is rising too quickly, as might occur if public sector pay increases without an efficiency gains. Monetarist economists, such as Milton Friedman, are anti-fiscal in their approach to demand management, preferring to regulate aggregate demand by controlling the quantity of money in circulation. Gov-ernment spending, they argue, in inherently inflationary, so the best role for government, also suggested by the New-classical economists, is to improve supply-side performance, especially labour productivity. New-classical economists, such as Robert Lucas, highlight what see as the general failure of government to influence consumer behaviour. Markets tend to clear effectively if left alone, hence a government should not interfere in the working of markets. If government does interference, say by increasing spending, and this is expected, then people will expect an inflationary effect, and will bargain for higher wages. The increase in wages shifts the AS curve to the left, with no gain in aggregate output. If people understand how policy operates, its effect on the real economy will be much weaker.

In what often appears a rather odd assertion, new-Classical economists argue that demand man-agement only works when it is unanticipated by firms and households. The New-classical ap-proach is highly critical of relying on past events to predict the future. If policy-makers rely exclu-sively on gathering and using past statistics, they are unlikely to make very accurate predictions. They argue that the only way to influence economic performance in the long run is by improving the conditions of supply rather than trying to create economic growth by increasing demand.

Debt burdens

Borrowing to fund spending will add to the national debt and can create an excessive debt bur-den for future generations.

Trade-offs

There is a potential trade off between unemployment and inflation, first analysed by A.W. Phil-lips in the 1950s. If the aim of public spending is to create jobs, there is the strong possibility that prices will be driven-up and any growth in jobs will only be temporary as the economy quickly

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readjusts to the previous level of unemployment!

The Phillips CurveThe Phillips curve shows the relationship between unemployment and inflation in an economy. Since its ‘discovery’ by British economist AW Phillips, it has become an essential tool to analyse macro-economic policy.

Background

Fiscal demand management became the general tool for managing the trade cycle after 1945. The consensus was that policy makers should stimulate aggregate demand (AD) when faced with recession and unemployment, and constrain it when experiencing inflation. It was also generally believed that economies faced either infla-tion or unemployment, but not together - and whichever existed would dictate which macro-economic policy objective to pursue at any given time. In addition, the accepted wisdom was that it was possible to target one objective, without having a negative effect on the other. However, following publication of Phillips’s research in 1958, both of these assumptions were called into question.

Phillips analysed annual wage inflation and unemployment rates in the UK for the pe-riod 1860 – 1958, and then plotted them on a scatter diagram. The data appeared to demonstrate an inverse and stable re-lationship between wage inflation and un-employment. Later economists substituted price inflation for wage inflation and the Phillips curve was born. When economists from other countries undertook similar research, they also found very similar curves for their own economies.

Explaining the Phillips curveThe curve suggested that changes in the level of unemployment have a direct and predictable effect on the level of price in-flation. The accepted explanation during the 1960’s was that a fiscal stimulus, and increase in AD, would trigger the following sequence of responses:

z An increase in the demand for la-bour, as government spending gener-ates growth.

z The pool of unemployed will fall.

z Firms must compete for fewer workers by raising nominal wages.

z Workers have greater bargaining power to seek out increases in nominal wages.

z Wage costs will rise.

z Faced with rising wage costs, firms pass on these cost increases in higher prices.

Unemployment(%)

In�ation(%)

Phillips Curve


Unemployment (%)

In�ation(%)

6%

2%

5% 3%

B

APhillipsCurve


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The breakdown of the Phillips curveBy the mid 1970s, it appeared that the Phillips Curve trade off no longer existed - there no longer seemed a stable pattern.

American economists Friedman and Phelps offered one explanation. There is not one Phillips curve, but a series of short run Phillips Curves and a long run Phillips Curve, which exists at the natural rate of unemployment (NRU). Indeed, in the long-run, there is no trade-off between un-employment and inflation.

Thenew-Classicalexplanation–theimportanceofexpectations

Although there are disagreements be-tween new-Classical economists and mon-etarists, the general line of argument about the breakdown of the Phillips curve runs as follows.

Firstly, assume that the economy starts from an equilibrium position at point A, with inflation currently at zero, and unem-ployment at the natural rate of 8% (NRU = 8%). Secondly, given the public’s concern with unemployment, assume the govern-ment attempts to expand the economy quickly by way of a fiscal (or monetary) stimulus, so that AD increases and unem-ployment falls.

Initially, the economy moves to B, and there is a fall in unemployment to 3% (at U1) as jobs are created in the short term. Having more bargaining power, workers bid-up their nominal wages. As wage costs rise, prices are driven-up to 2% (at P1). The effects of the stimulus to AD quickly wear out as inflation erodes any gains by households and firms. Real spending and output return to their previous levels, at the NRU.

According to the new-Classical view, what happens next depends upon whether the price infla-tion has been understood and expected – in which case there is no money illusion – or whether it is not expected – in which case, money illusion exists. If workers have bid-up their wages in nomi-nal terms only, they have suffered from money illusion, falsely believing they will be better off – in this case, the economy will move back to point A at the NRU, but with inflation only a temporary phenomenon. However, if they understand that price inflation will erode the value of their nomi-nal wage increases, they will bargain for a wage rise that compensates them for the price rise. Again, the economy will move back to the NRU (with unemployment at 8%), but this time carrying with it the em-bedded inflation rate of 2% an move to point C. The economy will hop to SRPC2 (which has a higher level of expected infla-tion – i.e. 2%, rather than 0%). Any further attempt to expand the economy by in-creasing AD will move the economy tem-porarily to D. However, in the long-run the economy will inevitably move back to the NRU.

The conclusion drawn was that any at-tempt to push unemployment below its natural rate would cause accelerating in-flation, with no long-term job gains. The only way to reverse this process would be to raise unemployment above the NRU so that workers revised their expectations of inflation downwards, and the economy moved to a lower short-run Phillips curve.

Unemployment (%)

In�ation(%)

P26%

P12%

NAIRU8%

U13%

B

A

Long runPhillipsCurve

C

D

Short runPhillipsCurves


PriceLevel

Y

P

AD

AS

P1

Y1

AS1

P2

AD1

LRAS

A

B

C


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UsingAD/AStodemonstratethePhillipsCurveeffect

This process can also be explained through AD-AS analysis. Assume the economy is at a stable equilibrium, at Y. An increase in government spending will shift AD from AD to AD1, leading to a rise in income to Y1, and a fall in unemployment, in the short term.

However, households will successfully predict the higher price level, and build these expectations into their wage bargaining.

As a result, wage costs rise and the AS curve shifts up to AS1 and the economy now moves back to Y, but with a higher price level of P2.

New Keynesian interpretation

New Keynesians avoid using the term ‘natural rate’ of unemployment. The Long Run Phillips Curve exists at the Non-Accel-erating Inflation Rate of Unemployment (NAIRU), which is the rate of unemploy-ment at which inflation will stabilise - in other words, prices will rise at the same rate each year.

Does the trade-off still exist?Between 1993 and 2008, unemployment fell to record lows, but inflation did not rise, as predicted by the Phillips curve. Many economists explain this by pointing to the successful supply-side policies that have been pursued over the last 20 years. The effectiveness of such policies has meant that the economy can continue to expand without inflation.

Indeed, many argue that the long run Phillips Curve still exists, but that for the UK it has shifted to the left.

RecentUKInflationandUnemployment

Recent statistics support the view that the extreme trade off between unemployment and infla-tion that occurred in the past no longer exists.

Effective supply side reforms have meant that the UK can expand without experiencing inflation. The improvements in labour market flexibility have helped, along with increased labour immigra-tion – both of which have eased pressure in the labour market at times of growth.

The independence of the Bank and England has also played a role in ‘reducing expectations’ of inflation and weakening the link between current and future inflation. However, this does not necessarily mean that a Phillips Curve no longer exists. Between 2007 to 2009, the Phillips Curve relationship appears to have re-established itself, with unemployment rising and inflation falling. However, between 2009 and 2011, the UK experience ‘stagflation’, with high unemployment and rising inflation.

Crowding out

Crowding-out theory is closely associated with the economists Bacon and Eltis31, who looked at the apparent de-industrialisation of the UK economy during the 1960s and 1970s. Crowding out can be defined at the process of ‘squeezing’ out the privately owned manufacturing sector by the expansion of the public sector. It is argued that crowding out occurs because of the inherent scar-city of financial and real resources. The more the (inefficient) public sector uses scarce resources, the less resources are available for the more efficient and productive private sector.

31 Bacon, R, and Eltis,W, 1976: Britain’s Economic Problem - too few producers, McMillan

Unemployment (%)

In�ation(%)

P26%

P12% B

A


C

D

Short runPhillipsCurves


E�ective supply-side policyhas shifted the LRPC to the left

and reduced NAIRU

NAIRU5%


NAIRU10%

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Bacon and Eltis identified two types of crowding out.1. Financial crowding out - if the public sector expands and needs to borrow from the financial sector interest rates may be driven up. This leads to a reduction in private sector investment.

2. Resource, or physical, crowding out - in a similar way, as the public sector expands there is an increase in the demand for other resources which drives up their price, in-cluding wages and rents – hence the private sector suffers.

Political constraints

A major constraint to government spending across the EU is membership of the Stability and Growth Pact which limits government borrowing to no more than 3% of national income in any one year, and accumulated public debt should not exceed 60% of the value of national income. The purpose of the Stability Pact was to prevent euro area countries weakening the value of the Euro by printing money, which occurs when governments borrow from the money markets. In the late 1990s, the UK Chancellor imposed a different constraint – that borrowing is acceptable if it funds capital, rather than current public sector spending – the so-called golden rules. However, a large number of EU countries have exceeded the debt limits laid down in the Stability Pact, and have debt levels that require considerable austerity to bring them under control.

Sovereign debt

The financial crisis led Greece, Italy, Ireland and Portugal to seek considerable financial support from the EU’s financial stability fund. In 2010, Greece needed a massive bail-out from other mem-bers of the euro area to cope with debts which were estimated to be running at over 120% of GNP.

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Questions

1. What are the advantages of increasing public spending at a time of economic slow-down?

2. What causes an increase in the national debt?

3. Is a rising national debt an economic problem?

4. Evaluate policies designed to reduce the national debt.

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Fiscal stabilisers and discretionary tax policyRevenue is required by central and local government in order to pay for its spending commit-ments. The main source of revenue is taxation, and taxes can be used to stabilise the economy in two main ways - through the automatic stabilisers of fiscal drag and boost, and by discretionary tax policy.

Fiscal dragIf we assume that direct tax rates are progressive, which occurs when the % of income going in taxes increases with income, and welfare benefits are paid, then any increase in national income will be slowed down automatically. This process is called fiscal drag.

Fiscal drag occurs in two ways. Firstly, when incomes rise, aggregate demand will not rise at the same rate because the ‘better off’ pay proportionately higher taxes, and spending growth is con-strained. Secondly, the effect on the poor and unemployed is reduced as they come off benefits, and start to pay tax. The effect is that the increases in disposable income are moderated.

Fiscal boostConversely, a decrease in national income is also moderated through fiscal boost. Fiscal boost means that as incomes fall the impact for the better off is ‘softened’ as they pay proportionately lower taxes, and retain more post-tax income.

Without welfare benefits, falling incomes will create more unemployment and poverty. However, because the unemployed and poor receive benefits, and spend more than they would have with-out such benefits, the downturn in the economy is also ‘moderated’.

Discretionary changes to tax ratesIn addition to automatic stabilisation, taxes can be raised or lowered to control or expand house-hold spending and aggregate demand, which is referred to as discretionary fiscal policy.

Income tax can be adjusted in a number of ways, such as by changing:

z The tax free allowance – all income earners are allowed to earn an amount of income before they start to pay tax. For example, the personal tax free allowance in the UK in 2009 was £6,475. Therefore, to stimulate demand, this allowance could be increased to give households more disposable income.

z The basic tax rate - in 2009 this was 20%. ‘Basic rate’ means the rate that affects most income earners.

z The number of tax bands – for example, in 2009 there were three bands: 0 - £2320 of taxable income from savings is taxed at 10%; £0 – £34,800, taxed at 20% tax, and over £34,800 is taxed at 40%, which is the higher tax rate. By adding new ‘lower’ or ‘higher’ bands the level of consumption and the distribution of income can be altered.

z The range of income in each band – each band could be widened or narrowed by increasing or reducing the range of income in each band.

It should be noted that changes in individual taxes, and taxes rates, would have a short-term discretionary effect as well as altering the long-term structure of taxes and the ability of the economy to automatically self-correct after a shock.

The advantages of using taxesDiscouraging unwanted behaviour

Indirect taxes can be targeted to alter behaviour, such as to reduce polluting activities by the use of polluter-pays taxes, or to reduce cigarette and alcohol consumption by special duties on tobacco and alcohol.

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Encouraging wanted behaviour

Indirect taxes can also encourage desirable behaviour, like the consumption of more merit goods such as education and healthcare. In this case, tax rates can be reduced to zero, and production and supply could be subsidised.

Supply-side incentives

The tax system can also be used to en-courage work and effort and increase the activity rate of labour. In the 1980s Ameri-can economist, Art Laffer, considered the impact of higher taxes on incentives. Laf-fer proposed that at tax rates of 100% and 0% the government receives no revenue. At 100% tax, no one would work, and at 0% tax, no tax would be paid. However, between 0% and 100% tax rate the gov-ernment derives a tax yield, the graph for which became known as the Laffer curve.

Clearly, as tax rates rise a disincentive ef-fect begins. There is a substitution effect as leisure becomes more attractive and work less attractive.

However, the disincentive effect will only work under certain circumstances. To un-derstand this we must distinguish the income and substitution effects. The substitution effect suggests that, following an increase in direct taxes, substitutes to work, namely leisure, seem more attractive and people will work less, often called the Laffer effect. The income effect sug-gests that an increase in taxes will reduce people’s real income, and they will need to work harder to achieve the same level of real income.

These two effects are contradictory. If the income effect is greater than the substitution effect, an increase in taxes will lead to more labour being supplied. However, if the substitution effect is greater an increase in taxes will lead to less labour being supplied. Laffer’s legacy is the raised awareness that increasing taxes to pay for public spending may, through its disincentive effect, lead to long-term supply side problems.

Automatic stabilisation

In the short and medium term, taxation can be used to automatically stabilise the macro-econo-my through fiscal drag and boost. These processes act as a natural shock absorber to economic shocks.

Additional measures to stimulate aggregate demand

Discretionary changes in direct taxes can help regulate aggregate demand when shocks are se-vere, or when other policies are ineffective, as in the financial crisis of 2008-2009. As part of an emergency package, many national governments reduced taxes, like VAT, so that they could give an extra boost to their ailing economies.

Redistribution of income

Tax policy can also be used to help redistribute income, and help achieve equity. In terms of achieving equity, indirect taxes like VAT are regressive and create an inequitable burden, the larg-est burden being on the poor and low paid. Income tax and other direct taxes can be made pro-gressive and can help achieve equity, but they may have a disincentive effect leading to inefficien-cies. Hence, because equity and efficiency are in conflict, the best resolution is a ‘mix’ between direct and indirect to achieve a balance between the needs of equity and efficiency.

The disadvantages of tax policyComplexity

Changing tax rates, allowances and bands, is highly complex, especially in comparison with chang-

Tax rate

TaxRevenue

0%

La�erCurve

100%Optimum tax rate


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ing interest rates. Because of this, changes are relatively infrequent, with only small adjustments made each year in the annual budget. Only under dramatic circumstances, as in the financial crisis, are tax changes put into effect.

Avoidance

Households may increase or reduce their savings following tax changes, so the final effect of an increase or decrease in taxes on household spending may be weak. Taxes can be avoided in other ways, and this avoidance may contribute to the rise of an unofficial hidden economy.

Time lags

There may be considerable time-lags between changing taxes and changes in household spend-ing or other behaviour. Demand for many products is price and income elastic, so demand may not respond quickly or by a great amount to changes in indirect and direct taxes. An obvious ex-ample of this is taxation of fuel, where, despite taxes representing around 75% of the retail price of petrol, demand remains stubbornly high.

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Questions

1. Assuming the economy is in an initial equilibrium at X, identify where the new equi-librium will be if:

a. There is a rise in public sector borrowing

b. There is a rise in government subsidies to the motor industry

c. The government spends less on defence

d. The basic rate of income tax is raised

e. The VAT rate is cut from 17.5% to 15%.

2. Analyse the likely impact on the UK economy of an increase in government spend-ing on higher education.

3. What are automatic stabilisers and how do they work?

4. What are the main disadvantages of an increase in income tax, assuming the econ-omy has an output gap?

5. What are the main disadvantages of an increase in government spending not matched by an increase in taxation?

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A closer look at money and monetary theoryMoney is any asset that is acceptable in the settlement of a debt. For an asset to be widely used as money, it should be portable, divisible, durable and stable in value. Some assets fulfil the role of money much better than other ones. Gold and silver have frequently been used as money, given their divisibility into bars and coins. The introduction of paper money by the Chinese marked a significant development in the evolution of money, especially given the ease with which different denominations could be created, and the portability of paper money in comparison with gold or coinage.

The advent of money as a ‘medium’ of exchange replaced the need for exchange through bar-ter and enabled producers and factor owners to specialise and sell their output for money. The money earned could then be used to trade with other producers and factor owners. It is clear that the evolution of money as a medium of exchange, and as a store of wealth, had a consider-able impact on the development of modern economic commerce, international trade, and global prosperity.

In modern economies, notes and coins represent only a small fraction of the total money supply, with most money being in the form of digital bank accounts.

Money supplyMoney is created in a number of ways, including the following:

Money is created whenever banks give new loans to customers, triggered by new cash deposits in their bank. New bank deposits can create a multiple credit expansion throughout the banking system, increasing liquidly and enabling fresh loans to be made as a multiple of the original de-posit. In effect, money increases when fresh loans are advanced to customers. The formula to calculate how much extra credit can be given is called the ‘credit multiplier’ and is:

For example, if the cash ratio is 0.1, the credit multiplier is 1/0.1 = 10, and a fresh cash deposit of £1,000 could lead to fresh advances to customers of £10,000. This is because the new deposit of £1000 need only represent 10% of total monetary assets. This means that each new £1 received by the bank could be used to generate £10 of credit in the form of advances to other customers.

Secondly, issuing Treasury bills can also add to the money supply, and this happens when the government borrows from the money market by issuing Treasury bills. Banks treat these bills as being ‘as good as cash’, and continue to make the same amount of loans to their customers. This is despite the fact they have lost liquidity by buying bills from the Treasury. The net effect is that money supply in the economy increases.

Thirdly, the central bank, the Bank of England, can print new money if the normal flow of liquidity is disrupted, as in the recent financial crisis. The Bank can use this new money to buy up exist-ing government debt, including bonds held with private firms, so injecting new liquidity into the system. This process is called quantitative easing.

1

CASH RATIO

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Measuring the money supplyMoney is officially measured in narrow and broad terms.

Narrow money and broad money

M0 (M nought) is the official measure of narrow money in the UK, and consists of notes and coins in circulation outside the Bank of England, plus bankers’ operational deposits with the Bank of England. The main reason for identifying M0 is its close link with high street spending, and infla-tion. M0 is also called high powered money because of its strong impact on the economy.

M4 is the favoured measure of broad money and includes bank deposits. M4 is composed of MO, plus private current and deposit accounts.

The demand for moneyAccording to Keynes’ Liquidity Preference theory, people demand money (liquidity) and hold their wealth in a monetary form for three reasons:

1. To engage in real transactions

2. As a precaution in the event of unexpected spending

3. To engage in speculative investment

The different components of the demand for money can be plotted against interest rates. Both the transactions demand and the precautionary demand are unrelated to interest rates and are shown as vertical curves. However, according to Keynes’ li-quidity preference theory, the speculative demand for money - that is, the desire to hold money to gain a speculative return as an alternative to other forms of specula-tion - is inversely related to interest rates.

Keynes illustrated the concept by consider-ing the demand for money as an alterna-tive to holding government bonds, which have fixed rates of interest. Bond prices and general interest rates are inversely re-lated, so that a rise in the interest rate on new bonds issued will lead to a fall in the price of existing bonds. A speculator will only buy existing bonds at a fixed (lower) rate if the price of existing bonds falls to make it worthwhile and a realistic alterna-tive to buying new bonds at a higher fixed rate. Therefore, if we look at the specula-tive demand for money, at very low inter-est rates, speculators tend to predict that the next movement in interest rates is up-wards, and, therefore, the next movement in bond prices is downwards. Because of this speculators will prefer to hold their assets in a monetary (liquid) form rather than in bonds, which would result in a speculative loss. Therefore, at low interest rates the speculative demand for money is very high and approaching infinite elastic-ity. Clearly, government bonds are not the only alternative to money, but the concept is still relevant. The liquidity preference curve for an economy, that is the combined demand for money for tor transactions, as a precau-

Quantity of money

InterestRates

TransactionDemand

SpeculativeDemand

PrecautionaryDemand


Quantity of money

InterestRates

MoneySupply

LiquidityPreference

5%

Q


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tion, and for speculative purposes, is downward sloping against interest rates.

Money supply

If we add the money supply, we can find the equilibrium interest rate. In simple Keynesian theory, the supply of money is unaffected by interest rates, so the money supply curve (M) is vertical, as shown. Money market interest rates will be the rate that brings demand and supply into equilib-rium. For example, the money market may clear when interest rates are 5% - with the supply of money (M) equalling the demand for money (L). The money supply is controlled by the Bank of England, and is independent of interest rates.

Modern money marketsThe UK money market includes banks, building societies, and specialist securities dealers who buy and sell money. The Bank of England controls the market, and regulation is shared between the Bank of England, the Treasury, and the Financial Services Authority (FSA).

MonetarismMonetarism is closely associated with Classical economics and is an economic philosophy which believes that economic prosperity depends upon understanding and manipulating the link be-tween money and the real economy - that is, prices, output and employment. In addition, mon-etarism stresses the effective control of the money supply as the main method of stabilising the macro-economy.

Although monetarism dates back to English philosophers of the 18th Century, its modern origins can be traced to the work of Irving Fisher of Yale University, writing in the early 20th century. Modern quantity theorists32, including Milton Friedman of Chicago University, developed Fisher’s work further.

Monetarists, such as Friedman, believed that:

z Money can be defined - money is defined as ‘anything generally acceptable with which to settle a debt’.

z Money can be controlled - monetary authorities can increase or decrease the amount of money in the economy.

z Changes in money have a direct and measurable effect on the rest of the economy - indeed, the money supply has a significant effect on the spending of households and firms.

z Inflation and deflation are always and everywhere a monetary phenomenon - changes in money are always the cause of price changes.

Money and inflation - The Fisher equationFisher proposed that there was a stable and predictable relationship between the quantity of money in circulation in an economy, and the price level, using his famous equation:

MV = PT, where:

z M = the stock of money

z V = the velocity of circulation

z P = average prices

z T = the number of transactions

If we assume V and T are constant, as the economy approaches full employment, then changes in M must lead to the same proportionate changes in P.

32 Quantity theory holds that controlling the money supply is the most effective way to regulate monetary conditions.

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The main policy implication is that the monetary authorities should ensure that money supply is effectively controlled, because controlling the money supply means that average prices can be stabilised.

Controlling the money supplyDespite the difficulties of directly manipulating the economy through interest rates, especially in a recession, authorities usually find that, under normal economic conditions, it is easier and more effective to influence interest rates than control the money supply. There are several reasons for this.

Moneyisdifficulttodefineandcontrol

Money is not always easy to measure, or at least it is not easy to agree which measure to use. Any asset could be used to settle debts, so new forms of money can be introduced that cannot easily be controlled.

Unpredictableeffects

Changes in the money supply, or a component of the money supply, do not always have a predict-able effect on the inflation rate. One explanation for this is contained in Goodhart’s Law33. This states that, once a particular instrument is used for policy purposes, the relationship between the instrument, such as MO, and the objective, stable prices, begins to weaken. As soon as a mon-etary authority attempts to regulate the money supply to reduce inflationary pressure, the stable relationship that might have existed between money (M) and prices (P) will break down, and at-tempting to control M is likely to fail. Therefore, rather than control the money supply, which is perhaps uncontrollable, monetary authorities control monetary conditions by setting short term interest rates, which work via their effect on the demand for money, rather than supply.

33 After Charles Goodhart, CBE, FBA, Professor Emeritus at the London School of Economics and former Advisor to the Bank of England

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Monetary policyModern monetary policy has been shaped by the different schools of economic theory that emerged over the past 100 years. Monetary policy involves altering interest rates or the supply of money in the economy. Many economists consider that the manipulation of exchange rates is a form of monetary policy, given that exchange rates are affected by changes in interest rates.

The Monetary Policy CommitteeMonetary policy in the UK is the responsibility of the Bank of England’s Monetary Policy Com-mittee (MPC). The MPC has nine members, four of whom are appointed by the Chancellor. The MPC has one goal, to hit its inflation target of 2% . The inflation target is symmetrical, meaning that a rate of inflation below the target is considered as problematic as a rate of inflation above the target.

Changing official base interest rates is the most ‘visible’ tool used by the MPC, whose team of economists meet each month to discuss current and future monetary policy options.

The Repo rate‘Repo’ is short for repurchase agreement, and the repo rate is the rate at which the Bank of England buys back securities it has previously sold in the money markets. The money markets include banks, building societies and specialist securities dealers. Altering the repo rate affects short-term liquidity in the monetary system, which quickly has an effect on all other rates. Other rates of interest in the economy, such as mortgage rates, will adjust in line with changes to the official rate.

Why the inflation target is not zeroAccording to the Bank of England, there are two reasons why the inflation target is set above zero:

Real interest rates can become negative

A positive rate allows real interest rates to be-come negative at times of weak demand. Real interest rates are nominal rates, less the infla-tion rate. Nominal interest rates can never be negative, as banks will always charge for lending. If inflation is 0%, nominal and real interest rates must be the same, hence, like nominal rates, real rates cannot be negative. It may be helpful for the Bank of England to make real interest rate negative at times of a deep recession, so having a positive inflation target allows this to happen.

Safety margin

Inflation cannot be measured with perfect precision, and it is safer to have a positive inflation target as this provides a margin of safety.

How does interest-rate policy work?Interest rates are set so that the inflation target can be met in the future. In fact, it takes up to two years for a rate change to affect inflation, so the Bank of England must try to predict the state of the economy two years in advance!

Interest rates transmit their way to aggregate demand in the following ways:

z Changes in the official rate affect all markets rates, such as overdraft, mortgage, and credit card rates. Consumer demand is affected in a number of ways including af-fecting savings, which indirectly affect spending, and spending itself. For households or firms with existing debt, such as a mortgage, a change in rates affect repayments, and hence individuals have more (or less) cash after servicing their debts. Changes in rates

In�ation target

0%

2%

4%5%

- 1%

1%

3%

- 3%- 2%

In�ationrates

Target = 2% (+/-1%)


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affect the cash-flow firms and households.

z In the case of new debt to fund spending, borrowing is also encouraged, or dis-couraged, following interest rate changes. Interest rates also affect consumer and busi-ness confidence, and spending.

z Asset prices are also affected by interest rates. For example, a fall in rates will tend to make firms more profitable and they may pay higher dividends to shareholders, which can trigger an increase in spending. Similarly, a rate fall makes property more attractive, increasing the value of property and household wealth.

z Changes in the official rate also affect general expectations and confidence, which alters consumer and corporate behaviour. For example, a rise in rates indicates a tight-er monetary stance and has a negative impact on consumer and corporate sentiment, leading to the postponement of discretionary spending.

z Finally, interest rates may affect the exchange rate, which can also influence ex-port demand. For example, a rise in interest rates may raise the exchange rate, pushing up export prices and reducing overseas demand.

z Changes in the exchange rate also affect the price of imports, which also affect the inflation rate, through its effect on imported costs. For example, a fall in the exchange rate increases import prices and creates cost-push inflation. In this case, a rise in inter-est rates will push up the exchange rate and ease any cost-push inflationary pressures.

Summary of the transmission mechanism of monetary policy34:

34 Bank of England

AssetPrices

TOTALDEMAND

EXTERNALDEMAND

DOMESTICINFLATION

Expectations

MarketRates DOMESTIC

DEMAND

IMPORTPRICES

In�ationO�cial Rate

ExchangeRate


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Recent UK interest ratesIn recent years, interest rates have been frequently adjusted to reflect changing macro-economic conditions.

• 1999 – 2000 - rates were relatively high at 6% to re-strict demand.

• 2000 – 2003 - rates fell quickly to their lowest lev-el for 25 years, helping to stimulate demand.

• 2003 - 2007- rates were pushed up into a neutral zone at around 5%, but by 2007, they were edging up towards the restrictive zone.

• 2008 - 2012 - rates were slashed to levels unprec-edented in modern times, in response to the deep-ening recession.

The effect of a reduction in interest ratesIf we assume the economy has an output gap then a reduction in interest rates by the Bank of England will, ceteris paribus, increase aggregate demand.

This occurs because:

z Savings fall

z New borrowing rises

z Costs of servicing existing debts falls

z Confidence rises

z Greater export demand

z Asset values rise

z Business investment is also likely to rise

Pushingratestoolowisinflationary

Assuming the economy is at or very near to full employment, a reduction in interest rates by the Bank of England may over-stimulate ag-gregate demand beyond the capacity of the economy to respond in the short run. In this case, the effect is mainly on the price level rather than output and jobs.

Therefore, interest rates can be used to help stabilise the macro-economy, and help create stable growth and stable prices. Policy induced shocks need to be avoided, so changes in interest rates tend to be small – usually 0.25% at a time. However, the depth of the recession in 2008, and its speed of onset, forced the Bank of England to reduce rates more quickly than in ‘normal’ eco-nomic times.

0

1

2

3

4

5

6

7

2005 2006 2007 2008 2009 2010

UK interest rates (%) Official base rate

Source: Bank of England


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The advantages of interest rate policyPowerful and direct

Evidence shows that interest rates have a direct and powerful effect on household spending, the evidence suggesting that UK consumers are interest rate elastic.

Independent

The Bank of England’s Monetary Policy Committee is independent of government and can make decisions free from political interference.

Easy to implement

Interest rates can be changed on a monthly basis, which contrasts with changes in discretionary fiscal policy, which cannot be made at such regular intervals.

Quickeffectonconfidence

While the full effects of interest changes may not be experienced for up to two years, there is often an immediate effect on confidence. The time-lag affecting output is estimated to be around one year, and on the price level, around two years.

The disadvantages of interest rate policyThere are still time lags to see the full effects, and there are some other negative effects, includ-ing:

Investmentcansuffer

Investment spending is inversely related to interest rates, and higher rates increase the oppor-tunity cost of investment. Longer term, economic growth will suffer if high interest rates persist.

Thehousingmarketcansuffer

The housing market is very sensitive to changes in interest rates, so individual changes tend to be small, partly so as not to have an excessive effect on housing.

The dual economy

There is also the problem of the dual economy. Should rates be set high to control the inflating service sector, or low rates for the depressed manufacturing and export sector? Unlike previous recessions, in the current recession all sectors of the economy have been suffering in a similar way, so rates have been set at historically low levels without any fear of inflation.

The liquidity trap

Reducing interest rates in a recession may be ineffective because of the so-called liquidity trap. This theory is associated with Keynes, and his analysis of the Great Depression. In a recession interest rates will fall towards zero, as in the UK during 2009, following the financial crisis. In this case, banks and other financial intermediaries prefer to hold cash rather than make loans. Therefore, while borrowing may be stimulated, liquidity is not released through the system - it is ‘trapped’ and unavailable. This acts to deepen a recession and weaken the real economy. In this case, authorities may have to by-pass the banks and pump money directly into the public’s hands. Allocating spending vouchers is one way this could be achieved. This is often referred to a ‘heli-copter’ or ‘parachute’ money. More formally, the process is called quantitative easing.

Quantitative easingQuantitative easing is a process whereby the Bank of England, under instructions from the Treas-ury, buys up existing bonds in order to add money directly into the financial system. The process of doing this is called open market operations, and it is regarded as a last resort when low interest rates fail to work.

When interest rates approach zero, but an economy remains in recession, further interest cuts are impossible. This situation faced central bankers in early 2009. Interest rate policy in these circumstances becomes impotent, as nominal interest rates cannot fall below zero. This, together with cash hoarding by individuals, corporations and commercial banks, resulted in liquidity being

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trapped in the banking system. In this situation, quantitative easing may be necessary to boost liquidity and stimulate lending.

Quantitative easing involves the following steps:

z The Bank of England purchases existing corporate and government bonds held by banks and corporations with ‘electronic money’, rather than notes and coins.

z These funds are credited to the bank and become a reserve asset.

z This means that, via the credit multiplier, banks can lend out to corporate and individual customers.

z The hope is that lending starts to flow, which will lead to an increase in household and corporate spending, and aggregate demand. This, it is argued, will help pull an economy out of recession.

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Questions

1. Why is the UK’s inflation target not zero?

2. Explain how changes in interest rates affect aggregate demand.

3. For the UK economy, what is the approximate ‘neutral zone’ for interest rates?

4. What is the estimated time lag between change of interest rates and a change in the price level?

5. Why is it generally considered beneficial for interest rates to be changed by a small amount at a time?

6. Explain the problem of the ‘dual economy’ and how it affects interest rate deci-sions.

7. What is the ‘liquidity trap’?

8. What is Goodhart’s Law?

9. Do changes in interest rates primarily affect the supply of money or the demand for money? Explain your answer.

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Monetary UnionMonetary union is a key stage in the process of economic integration. The main features of Euro-pean Economic and Monetary Union (EMU) include:

A single European Currency

The Euro € was introduced in 2000 with national currencies scrapped in 2002. The framework of rules for entry into the Euro area was laid down in the Maastricht Treaty in 1992. This treaty also created the rules for membership of the European Union (EU) in general.

The euro-systemThe euro-system has several elements.

TheEuropeanCentralBank(ECB)

The European Central Bank (ECB) is responsible for all monetary policy in the euro area (euro-zone), and the National Central Banks (CBs) of the 17 member countries (2011). Other European countries are free to join the euro area if they meet the criteria laid down in various treaties. The two most important criteria for entry are that the applicant country has demonstrated price sta-bility, and that its public finances are well managed

The ECB meets on a monthly basis to determine two things:

1. The level of interest rates across the Euro area - the 17 countries that share the Euro

2. The quantity of money in circulation

The primary purpose of the ECB is to control euro area inflation so that the value of the euro remains constant and strong. It also provides liquidity into the system when needed. If an EU country joins the euro area, its central bank cedes most of its power to the ECB.

The European monetary institutions are fundamentally anti-fiscal, and greatly influenced by the monetarist view. Europe’s view can be summarised as:

z Fiscal policy is less useful than monetary policy to help stabilise the macro-econ-omy.

z Too much borrowing will harm the stability of the Euro, hence the Stability Pact.

z Fiscal policy is less useful than supply-side policy to help create long-term growth.

Co-ordination of macro-economic policies

Co-ordination of policy was designed to enable the original 12 economies of the euro area to con-verge. A key feature of this was the Stability Pact, which involved members agreeing to keep their economies stable, and keeping their budget deficits under control. The agreed limit for a deficit was that it must be no more than 3% of GDP. This restriction was designed to prevent any unnec-essary fiscal stimulus which might de-stabilise the economy, even in the face of high unemploy-ment. However, several countries, including Germany, France, and most notably, Greece, have broken this rule, and this has cast serious doubts about the ability of the euro area to maintain this rule.

Single interest rate

The ECB sets interest rates across the whole Euro area-17, and no single Na-tional Central Bank has the ability to alter interest rates itself.

Asymmetricinflationtarget

Unlike the Bank of England’s inflation tar-

ECB In�ation target

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get, which is symmetrical, the ECB target is asymmetrical. This means that while inflation cannot rise above 2%, there is no lower figure below which it must not fall. Critics argue that this creates an in-built recessionary bias, with no specific policy intervention required if deflation occurs. In the UK, the target is 2% +/- 1, so that an inflation rate of less than 1% triggers a monetary stimulus.

The European Financial Stability Facility

The EFSF was formed to help stabilise the European economies after the financial crisis, recession and sovereign debt crisis, and now forms a key element of the reformulated euro-system.

Thefiscalcompact

In attempt to prevent EU countries from running up further debts, the majority of the EU states signed a fiscal compact which opened up their domestic budgets to collective scrutiny. It remains to be see how successful this measure will be, and whether its leads to a full fiscal union.

Advantages of the EuroThere are several significant benefits of having a single currency area. These are primarily derived from the benefits of fixed exchange rates, and include the following:

Transparency

Tourists can compare prices more accurately, as can firms when comparing prices of raw materi-als.

Lower transaction costs

Transaction costs are reduced because there are no commission payments to financial interme-diaries.

Certainty and investment

The Euro creates certainty because firms can predict the cost of imported raw materials and can set the price of their exports, which means they can plan, and are more likely to invest.

Trade creation

Trade between members of a single currency area is likely to increase because of the benefits of sharing a currency.

Jobcreation andprotection

Increased trade is likely to generate jobs in those industries that experience increased exports.

Disciplineagainstinflation

Members cannot take the easy option (devaluation) to get out of economic difficulty.

The disadvantages of the EuroLoss of economic sovereignty

Once a country become a member of the euro area, national central banks, including the Bank of England, lose their ability to use interest rate policy to achieve independent macro-economic objectives. Following the financial crisis and global recession, recession-hit countries like Greece were not able to reduce interest rates unilaterally. Nor, of course, did they have the flexibility to devalue.

Difficultyofconversion

Many European countries, including the UK, may never be able to converge fully with the euro area. In the UK in particular, convergence is difficult because of the uniqueness of its housing market and financial services sector, and because of the closeness of the UK’s trade cycle to that of the USA. In addition, the UK labour market is highly flexible in comparison with France, Ger-many, and Spain, which also makes convergence difficult.

Onecapdoesn’tfitall

Having only one interest rate is not sensible when dealing with a diverse range of economies

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and economic circumstances., including the more prosperous northern European states, and the poorer southern ones.

Theweaknessofanasymmetricaltarget

Having an asymmetrical inflation target means that the ECB must only intervene if the rate is exceeded, and not if inflation falls below the target rate. Critics argue that, as a result, there is a built-in deflationary bias.

Dealingwithasymmetricshocks

Asymmetric shocks are external shocks that have an unequal impact on an economy, or region like the EU. The following recent shocks did not have an equal effect across Europe:

z The handover of Hong Kong to China by the UK in 1997 led to an exodus from Hong Kong to the UK, and not to the rest of Europe, and helped fuel a mini-housing boom in parts of London;

z The September 11th 2001 attacks on New York did not affect all Euro area countries evenly;

z The collapse of the Argentinean peso in 2002 mainly affected Spain.

z The recent credit crisis, which has not affected all economies equally.

In these types of circumstance, it is argued that one interest rate will not be appropriate. A re-gion experiencing a negative shock would require lower interest rates in comparison with other regions.

‘Tests’ for membershipIn 2003, the UK Chancellor (Gordon Brown) laid down five conditions for the UK to join the Euro area. These were:

Economic convergence

The trade cycles of the UK and Euro area should be in alignment.

Flexibility

Joining should not harm the flexible product and labour markets of the UK in comparison with the EU.

Investment

Joining should not discourage domestic investment and FDI.

Financial services

The City (the financial centre) should not suffer as a result of membership of the euro area.

Growth and jobs

Membership should be good for growth and job creation.

Given the strength of the case against joining the euro area, it is doubtful whether, even if these tests are met, the UK will scrap the pound in the near future. However, the recent financial crisis has re-opened the debate about whether the benefits of joining a currency area outweigh the costs.

The Euro debt crisis

The build-up of sovereign debt from 2009 created the Eurozone’s single biggest issue. The Euro-system was put under considerable economic stress, and led to the fiscal compact in early 2012. This forced members to submit their domestic budgets to EU scrutiny, and was another step towards closer integration of EU countries.

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Euro area interest ratesEuro area interest rates have moved between 1% and 4% since the financial crisis of 2008, after remaining static at 2% for over two years.

Even before the financial crisis, the one-size-fits-all approach had been running into difficulty. This was largely because of increasing differences in the performance of the various euro area countries, including differences in growth rates, fiscal deficits, trade balances, and house prices.

0

1

2

3

4

5

2005 2006 2007 2008 2009 2010 2011

Eurozone interest rates (%) Fixed rate tenders

Source: ECB

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Questions

1. Describe the main features of monetary union.

2. Discuss the case for and against the UK adopting the European Euro.

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The financial crisisThe financial crisis had its origin in the US housing market, though many would argue that the house price collapse of 2007 - 2009 is a symptom of a problem running much deeper, revealing a fundamental weakness in the global financial system.

OriginsFrom the 1970s onwards, banks in the Unites States and UK started to widen the scope of their business models by selling off their own credit risk to third parties. Increasingly they became reli-ant on computer-based systems for assessing that risk. Many have argued that personal judge-ment, perhaps the key attribute of the traditional bank manager, gave way to decision making by computer software.

Relaxation of the rules regarding capital movements between countries, widespread de-regula-tion of financial markets during the 1980s, and a number of banking mergers also dramatically changed the global financial landscape at the end of the 20th Century.

During the 1970s and 1980s, increasingly complex financial products were developed and traded, providing a speculative income for traders and a method of spreading the risks associated with financial trades. New financial products, such as ‘derivatives’, ‘options’, and ‘swaps’, joined more traditional products, like mortgages and bank loans, in an ever-widening array of financial goods and services. In addition, this period saw the increasing securitisation of assets, most notably mortgages.

SecuritisationThe increasingly complex nature of financial products did not deter banks from diversifying through increased securitisation. Securitisation, which started in the US and spread to the UK in the late 1980s, is the creation of asset-backed debt. The assets used generate a flow of income, and the commonest asset is a mortgage, from which a regular flow of income is generated. In recent years a much wider variety of assets has been used, including income from credit cards and even from pub chains and football stadia35 One particular feature of the 2008 - 2009 financial crisis was the difficulty faced by many insurers, including the American giant, AIG. AIG, and other insurers, became heavily involved in insuring other institutions against credit defaults. Specifi-cally, investors who wish to protect themselves against defaults on mortgage-backed securities may buy credit default swaps (CDSs). As an insurance against credit default, CDSs are bought and resold, and may end-up on the balance sheet of a wide variety of financial institutions. It has been estimated that, if one player in the market were to go bankrupt, it could take a decade to untan-gle the complex network or contracts between the financial institutions and intermediaries. It is primarily for this reason that the US Federal Reserve bailed out AIG and Bear Sterns.

Toxic assetsA bank or other financial institution, like all firms, must create a balance sheet which values its assets and liabilities, and from which it can calculate its net assets and its capital.

The value of a bank’s assets, that is, what it owns, is largely determined by how ‘healthy’ the debts are that borrowers must repay. A fundamental problem of the highly globalised financial markets at the time of the US housing crisis was that many of the mortgage backed debts on the balance sheets of the banks have turned out to be extremely ‘unhealthy’, referred to as toxic debts. The problem of the toxic debts, resulting from loans made to the sub-prime housing market, became more severe because banks could not quickly or accurately calculate their exposure to these debts. This was largely a result of the highly complex nature of their investments, including those related to derivatives and options.

Asymmetric informationWhat is clear is that financial markets failed partly because of the problem of asymmetric infor-mation. In the context of financial markets, this means that parties to a transaction do not have

35 Source: HM Customs and Excise.

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access to the same quantity and quality of information. Considerable information is needed in order to assess potential risk and reward, and to make a rational decision about whether to pur-chase a financial product or not, and how much to pay for it.

The emergence of complex derivative products in the early 1980s, and the increased popularity of securitisation in the late 1980s, increased the inefficiency of many financial transactions. This inefficiency was the result of one party, usually the seller, possessing much better information than the other party, usually the buyer. Furthermore, with the rise in the importance of specialist third parties, like hedge fund managers, the actual buyer and seller may be unaware of the actual risks associate with a given transaction, and oblivious to the source of the investment income. Therefore, in 2007, when the mortgage market started to collapse in the USA, the scale of the problem remained largely hidden.

This failure of information could also be referred to as an example of the ‘principal-agent’ prob-lem, though many of the ‘agents’ involved were indeed fairly ignorant themselves!

Banking collapseAs the scale of banking losses were announced, and following the failure of leading investment banks like Lehman Brothers, growing uncertainly prevented the banks from lending to each other as they would normally do, and encouraged them to retain as much liquidity as they could. The result was that banks were failing to fulfil a key banking function, namely to make loans and en-sure the adequate flow of liquidity into the economy.

Policy optionsThere were three fundamental issues facing policy makers:

1. How best to control or regulate banks

2. How to get liquidity into the global system

3. How to deal with the after-effects of the banking crisis

NationalisationOne response to the banking crisis was to nationalise a number of key banks, including North-ern Rock, and part-nationalise others, including the Lloyds Banking Group and the Royal Bank of Scotland (RBS). Many others have been heavily supported by their governments by extensive ‘re-capitalisation’.

Regulation

Since 2001, financial market regulation has been in the hands of the Financial Services Authority (FSA). The aim of the FSA is to ‘promote efficient, orderly and fair markets and to help retail con-sumers achieve a fair deal.’36

Given that asymmetric information is a serious problem in financial markets, regulatory reform will involve the promotion of a more transparent system, with financial institutions forced to pro-vide higher quality information on risks.

Some critics of the US regulatory system allege that it is too rules-based and should move towards the European model of principles-based regulation. With rule-based regulation, the regulators interpret the rules as laid down in law, and there is little room left for judgement or interpreta-tion. Under a principles-based system, as well as having extensive rules, the general principles of regulation are contained in legislation. It is argued that this gives extra powers to regulators to assess the behaviour of financial or other institutions in terms of whether the general principles are being adhered to.

The London G20 Summit, held in April 2009, recommended the establishment of a Financial Sta-bility Board to provide an early warning system of problems in the global financial markets. It also proposed scrutiny of the activities of hedge funds.

36 Source: FSA

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ATobintax

A Tobin tax, or financial transactions tax, is a special tax on currency transactions, designed to penalise excessive short-term speculation in the currency markets. Advocates have suggested that such a tax could be imposed on a wider range of financial transactions to reduce speculation in financial markets and help restore some stability. A Tobin tax is also referred to as a securities transaction tax

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Questions

1. Summarise the causes of the recent global financial crisis.

2. Evaluate alternative policies to limit the economic damage caused by the financial crisis and subsequent global recession.

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Exchange rate policyThe exchange rate of an economy affects aggregate demand through its effect on exports and imports, and policy makers can exploit this connection. Exchange rates can be manipulated so that they deviate from their natural rate. Many economists regard exchange rate manipulation as a type of monetary policy.

Rates need to be held down to stimulate exports, and pushed up to reduce inflationary pressure. While the Bank of England does not specifically target the exchange rate, the MPC will consider exchange rates. Clearly, during times of inflationary pressure the MPC would prefer a relatively high rate as this reduces the price of imports and works to dampen inflationary pressure. Howev-er, the MPC must keep an eye on export competitiveness, and if rates move too high UK exports will become uncompetitive.

How are exchange rates manipulated?Exchange rates can be manipulated by buying or selling currencies on the foreign exchange mar-ket. To raise the value of the pound the Bank of England buys pounds, and to lower the value, it sells. The Bank of England can influence exchange rates through its Exchange Equalisation Account (EEA). This account, which holds the UK’s gold and foreign currency reserves, and its holdings of IMF Special Drawing Rights (SDRs), was specifically established in 1932 to stabilise the value of the pound, though its role is now much wider. Rates can also be manipulated through interest rates, which affect the demand and supply of Sterling via their effect on inflows of hot money.

Some currencies are subject to exchange controls by the relevant national central bank. This means that the central bank will only allow buying and selling through their own system, rather than be subject to the level of fluctuation associated with fully floating rates. Although most coun-tries abandoned exchange controls many years ago, some, like China and Cuba still practice ex-change rate control, though controls in China were relaxed in 2006.

Effects of a reduction in the poundAssuming the economy has an output gap, a reduction in Sterling will reduce export prices, and, assuming demand is elastic, raise export revenue. It will also raise import prices, and assuming elasticity of demand is greater than one, reduce import spending. The combined effect is an in-crease in AD and an improvement in the UK balance of payments.

Evaluation of exchange rate policyThe main advantage of manipulating exchange rates is that, because a large share of UK output is traded internationally, changes in exchange rates will have a powerful effect on aggregate de-mand.

For example, lowering exchange rates - devaluation - can:

z Raise aggregate demand

z Increase national output (GDP)

z Create jobs, amplified through the multiplier effect

z Assuming the demand for imports and exports are price sensitive (price elastic), lead to an improvement in the balance of payments, though this can also lead to infla-tion

Alternatively, raising exchange rates - revaluation - can:

z Help reduce excessive aggregate demand

z Keep inflation down

z Though the export sector may suffer and jobs can be lost

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On balance, UK policy makers in recent years have preferred to allow the financial markets to determine exchange rates, rather than manipulate them for policy objectives. The last time ex-change rates were directly targeted was between 1985 and 1990, when the UK shadowed move-ments in the Deutschmark, and then, from 1990 to 1992, became a member of the exchange rate fixing Exchange Rate Mechanism (ERM). However, in the Euro area-17, there is a much greater emphasis on keeping the exchange rate stable, as this is a central pillar of Euro area policy.

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Questions

Data responseThe UK economy has had a long history of balance of payments problems, or more accurately, problems with its ‘current account’. Of course, in accounting terms, the balance of payments for any country must always equal zero, but it is adjustments that are made through ‘official financ-ing’ that tell the true story of whether a country is in deficit or surplus. Some economists argue that a current account deficit – if sustained over the long term – is an indication of an unhealthy economy which cannot ‘pay its way’ in the world. Other economists wonder whether deficits actu-ally matter at all.

Having a floating exchange rate can, many argue, provide a stabilising mechanism against exter-nal shocks, such as the recent financial crisis, but exchange rate flexibility has its critics.

1. Why might ‘deficits’ matter to a country in terms of its ‘current account’? (6)

2. Analyse the possible causes of a persistent current account deficit. (8)

3. Evaluate two policy options to correct a current account deficit. (10)

4. Assess the arguments for and against floating exchange rates. (10)

5. Evaluate policies, other than exchange rate flexibility, which can help stabilise the UK economy in the event of an external shock. (16)

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Supply-side policySupply side policy includes any policy that improves an economy’s productive potential and its ability to produce. There are several individual actions that a government can take to improve supply-side performance.

Improving productivity of factorsMeasures to improve factor productivity, which is defined at the output generated by factors inputs, include the following:

Reducingdirecttaxes

Using the tax system to provide incentives to help stimulate factor output, rather than to alter demand, is often seen as central to supply-side policy. This commonly means reducing direct tax rates, including income and corporation tax. Lower income tax will act as an incentive for unem-ployed workers to join the labour market, or for existing workers to work harder. Lower corpora-tion tax provides an incentive for entrepreneurs to start and so increase national output.

Greatercompetitioninthelabourmarket

Other supply-side policies include the promotion of greater competition in labour mar-kets, through the removal of restrictive practices, and labour market rigidities, such as the pro-tection of employment. For example, as part of supply-side reforms in the 1980s, trade union powers were reduced by a series of measures including limiting worker’s ability to call a strike, and by enforcing secret ballots of union members prior to strike action.

Better labour mobility

Supply-side policy can also involve measures to improve labour mobility, which will also have a positive effect on labour productivity, and on supply-side performance.

Better education and training

Better education and training to improve skills, flexibility, and mobility – also called human capital development. Spending on education and training is likely to improve labour productivity and is an essential supply-side policy option, and one favoured by recent UK governments. A govern-ment may spend money directly, or provide incentives for private suppliers to enter the market. Government may also set and monitor standards of teaching, and force schools to include a skills component in their curriculum.

Performance related pay

The adoption of performance-related pay in the public sector is also seen as an option for govern-ment to help improve overall productivity.

Localised pay

Government can encourage local rather than central pay bargaining. National pay rates rarely re-flect local conditions, and reduce labour mobility. For example, national pay rates for Postmen do not reflect the fact that in some areas they may be in short supply, while in other areas there may be surpluses. Having different rates would enable labour to move to where it is needed most.

Improving the performance of firmsMeasures to improve competition and efficiency in product markets, especially in global markets, are also a significant part of supply-side policy. Examples of measures include:

Technology policy

Government may also help to improve supply-side performance by giving assistance to firms to encourage them to use new technology, and to undertake innovation. This can be done through grants, or through the tax system.

De-regulation and competition policy

Deregulation of product markets may be implemented to bring down barriers to entry, encour-age new and dynamic market entrants, and improve overall supply-side performance. The effect

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of this would be to make markets more competitive and increase efficiency. Promoting competi-tion is called competition policy.

Privatisation

Privatisation of state industry was a central part of supply-side policy during the 1980s and 1990s, and helped contribute to the spread of an enterprise culture. As long as privatisation is accompa-nied by measures to promote competition, there are likely to be efficiency gains for the firm, and productivity gains for the employees.

Incentivesfornewfirms

Supply side performance can also be improved if there is a constant supply of new firms. Small businesses are often innovative and flexible, and can be helped in a number of ways, including start-up loans and tax breaks.

The effects of supply-side policySuccessful supply-side policy will shift the AS curve to the right.

Evaluation - the advantagesSupply-side policies can help reduce inflationary pressure in the long term because of efficiency and productivity gains in the product and labour markets.

They can also help create real jobs and sustainable growth through their posi-tive effect on labour productivity and competitiveness. Increases in competi-tiveness will also help improve the bal-ance of payments.

Finally, supply-side policy is less likely to create conflicts between the main objectives of stable prices, sustainable growth, full employment and a balance of payments. This partly explains the popularity of supply-side policies over the last 25 years.

The disadvantagesHowever, supply-side policy can take a long time to work its way through the economy. For ex-ample, improving the quality of human capital, through education and training, is unlikely to yield quick results. The benefits of deregulation can only be seen after new firms have entered the market, and this may also take a long time.

In addition, supply-side policy is very costly to implement. For example, the provision of educa-tion and training is highly labour intensive and extremely costly, certainly in comparison with changes in interest rates.

Furthermore, some specific types of supply-side policy may be strongly resisted as they may reduce the power of various interest groups. For example, in product markets, profits may suf-fer as a result of competition policy, and in labour markets the interests of trade unions may be threatened by labour market reforms.

Finally, there is the issue of equity. Many supply-side measures have a negative effect on the distribution of income, at least in the short-term. For example, lower taxes rates, reduced union power, and privatisation have all contributed to a widening of the gap between rich and poor.


PriceLevel

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Question Evaluate supply side policy as a means of achieving long-term sustainable economic growth

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Global Economics


Economic conflictsConflicts of policy objectives occur when, in attempting to achieve one objective, another objec-tive is sacrificed. There are numerous potential policy conflicts, including:

Full employment vs low inflationThe conflict between employment and prices is the most widely studied in economics. If policy makers attempt to undertake job creation by injecting demand into the economy, by expansion-ary fiscal or monetary policy, there is a danger that prices will be driven up. This conflict is best explained by reference to the Phillips Curve. It is likely that the trade-off still exists, despite the UK economy approaching full employment and prices still remaining stable in recent years.

Economic growth vs stable pricesThis conflict is similar to the unemployment-inflation trade-off, and can be understood through the Phillips Curve and the AD/AS model. If, through a fiscal or monetary stimulus of aggregate de-mand, the economy grows too quickly, aggregate supply may not be able to respond and prices may be driven up.

Economic growth vs a balance of paymentsAs an economy grows, import spending is stimulated relative to export revenue. Policy makers have to be aware that a ‘dash for growth’ could lead to balance of payments problems.

Economic growth vs negative externalitiesSustainable growth is defined in terms of the extent to which current economic growth rates do not cause unnecessary damage to the environment, especially in the future. Economic growth does, of course, generate both consumption and production externalities, such as rising carbon emissions and global warming, excessive waste, and the depletion of global fish stocks.

Flexibility vs equityIn attempting to achieve a flexible economy, which is one that copes with globalisation, the distri-bution of income may widen. For example, a flexible economy can be partly achieved by having a flexible labour market, but to achieve this there may be an increase in part-time employment and a reduction in worker protection and job security.

However, in the long term, the reduction in unemployment associated with flexibility may more than compensate for the rise in part-time work and job insecurity.

Crowding-out – public sector vs private sectorCrowding-out is another widely studied conflict. The belief in the existence of crowding-out has greatly shaped economic policy over the last 20 years. Crowding-out is essentially a conflict be-tween the public and private sector. For example, public sector borrowing to compensate for market failures, and provide public and merit goods, might drive up long-term interest rates and ‘crowd-out’ private sector investment. Therefore, the desire to achieve short-term stability might put at risk the prospects for long-term growth.

Globalisation and policy conflictsThe rise of globalisation has meant that economic shocks from one part of the world can quickly spread around the global economy. The recent financial crisis is a case in point. The intercon-nectedness of the global economy creates problems for domestic policy makers, as the source of inflation or unemployment may be the global economy, and outside of the control of domestic governments.

Many argue that automatic shock absorbers, including flexible labour markets, progressive taxes and benefits, and a floating exchange rate, are critical for the success of a country actively partici-pating in the global economy.

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Global Economics


Question Essay – Why are certain economic policy objectives in conflict with other ones?

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