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Opportunity cost and the basic economic problem Definition Opportunity cost: the cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen) Production: the act of creating output, a good or service which has value contributes to the utility of others Producer: people who make and sell goods/services Consumption: The final purchase of goods and services by individuals Consumer: Individuals who purchase the good/services to satisfy their wants and needs Consumption Expenditure : Spending of consumers Exchange: A marketplace in which securities, commodities, derivatives and other financial instruments are traded Trade: An economic activity that involves multiple parties participating in the voluntary negotiation and then the exchange of one's goods and services for desired goods and services that someone else possesses. Entreprenuers: individuals who, rather than working as an employee, runs a small business and assumes all the risk and reward of a given business venture, idea, goods, or service offered for sale. Human resources: the company department charged with finding, screening, recruiting and training job applicants, as well as administering employeebenefit programs. Also known as Labor. Natural resources: resources occurring in nature that can be used to create wealth Also known as Land. Examples include, seas and rivers. Factors of Production; Definition : inputs that are used in the production of goods or services in the attempt to make an economic profit. The factors of production include land, labor, capital and entrepreneurship. Factors 1. Land Land refers to the resources available including the seas nad rivers, forests and deserts all manner of minerals from the ground; chemicals from the air and earth’s crust.
2 2. Labor Labor refers to the physical and mental effort produced by people to make goods/services. The size and ability of a economy’s labor force are very important in determining the quantity and quality of the goods/services produced. The greater the number of workers the better educated and skilled they are, the more an economy can produce. 3. Enterprise Enterprise refers to the ability to run a production process, employ and organize resources in a firm (an organization that owns a factory or a number of factories and even shops, where goods/services are produced).
4. Capital Capital refers to already-produced durable goods that are used in production of goods or services. It is not wanted for itself but for its ability to help in producing other goods. It is also known as man-made resources. Division of labor/Specialization Definition: A system whereby workers concentrate on performing a few tasks (instead of finishing the entire product by themselves) and then exchange their production for other goods/services Advantages 1. More goods/services can be produced When workers become specialists in the jobs they do, repetition of the same operation increases the skill and speed of the worker and as a result more is produced. 2. Full use is made of everyone’s abilities With the division of labor there is greater chance that people will be able to do those things at which they are best and which interest them the most. 3. Time is saved Time is wasted when a worker has to switch from one task to another. Time can also be saved when training people. It would take many years to train someone to be able to build a car, for example, but a person can be trained quickly to fulfill one operation in the production process. 4. It allows the use of machinery As labor is divided up into specialist tasks, it becomes worthwhile to use machinery which allows a further saving in time and effort. For example, cars are painted by machines instead of by hand. This, in turn, allows machinery to take over people’s jobs leaving many unemployed. Disadvantages 1. Work may become boring A worker who performs the same operation every day is likely to be unsatisfied/low morale. To combat this, many firms play music to their labor forces, or allow them to have a rest during part of each hour. Longer rest hours and annual holidays may also be introduced although this will shorten the working week. 2. People become too dependent on each other
3 Specialisation and divisiol of labour means that people come to rely on others for the provision of goods/services. For example, people who produce food rely on the provision of tractors, fertilizers, etc. 3. Workers may feel alienated Workers may feel unimportant because they can no longer see the final result of their efforts. Some firms are trying to reverse this by introducing workers to a greater variety of tasks 4. Standardization of goods Goods produced under a system of specialization are usually turned out in vast numbers and share the same design. Whether this is a disadvantage depends on people’s opinion. For example, there is probably variation in the color and design in clothes to please most people. However, it is not possible to please everyone because in most factories it would be difficult and expensive to change the production process to suit one person’s wants since most factories practice mass production in order to produce the greatest number of goods in the lowest cost possible. What is economics? Economics is the social science that analyzes the production, distribution, and consumption of goods and services. It studies how individuals, governments, firms and nations make choices on allocating scarce resources to satisfy their unlimited wants. Economics can generally be broken down into: macroeconomics, which concentrates on the behavior of the aggregate economy; and microeconomics, which focuses on individual consumers.
Market Systems Definition: Market: One of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. It consists of all those people or firms who wish to exchange a given good or service. Market system: Any systematic process enabling many market players to bid and helping bidders and sellers interact and make deals. It is not just the price mechanism but the entire system of regulation, qualification, credentials, reputations and clearing that surrounds that mechanism and makes it operate in a social context. Price mechanism: Refers to the consumers and producers who negotiate prices of goods or services depending on demand and supply. This is also known as market forces.
Types of market systems
Market system Definition
Free economy An economy in which
Mixed economy An economic system in which
Planned economy An economic system in which
4 decisions regarding investment, production and distribution are based on supply and demand and the prices of goods and services are determined in a free price system. Capital return. Capital flows to where it will get the greatest return, expanding the total size of the economy to its maximum level. Supply and Demand. Supply and demand are closely linked: Someone who has a good idea or product can quickly put it into the market so that it is available to those who want it. Conversely, when a certain type of product is desired by enough people, it is a simple matter for someone to provide it. Economic freedom. In a market economy, it is easier for someone with initiative and virtue to create a better life for themself and their family; economic freedom makes it eaiser to transform hard work and perseverance into material wealth. Unequal wealth distribution. a small percentage of society has the wealth while the majority lives in poverty. No economic stability. greed and overproduction cause the economy to have wild swings ranging from times of robust growth to cataclysmic recessions. both the state and private sector direct the economy, reflecting characteristics of both market economies and planned economies. decisions regarding production and investment are embodied in a plan formulated by a central authority, usually by a government agency.
Provides fair competition. The presence of private enterprise ensures that there is fair competition in the market, and the quality of products and services are not compromised. Well regulated. Market prices are well regulated. The government with its regulatory bodies ensure that the market price do not go beyond its actual price. Efficient use of resources. Optimum utilization of national resources. In a mixed economy, the resources are utilized efficiently as both government and private enterprises are utilizing them. It does not allow monopoly at all. Barring a few sectors, a mixed economy does not allow any monopoly as both government and private enterprises enter every sector for business.
Stability. Long-term infrastructure investment can be made without fear of a market downturn leading to abandonment of a project. Meeting collective objectives. Planned economies may be intended to serve collective rather than individual needs. The government can harness FOP to serve the economic objectives of the state. Advantages over free economy. It is not subject to major pitfalls of market economies and markedoriented mixed economies. A planned economy does not suffer from business cycles, does not experience crises of overproduction. It does not result in asset bubbles – massive misallocations of resources.
Inefficient. It's efficiency property reduces in progressively higher degree, the more its mixed nature embraces more and more of government / state intervention and State planning and reduces the reliance on competitive market economy management mechanisms. Less reliance on competition.Mixed economy
Inefficient resource distribution. Planners cannot detect consumer preferences, shortages, and surpluses with sufficient accuracy and therefore cannot efficiently coordinate production. Suppression of economic democracy and selfmanagement. Without economic democracy there can be troubles with the
5 Too competitive. A competitive environment creates an atmosphere of survival of the fittest. This causes many businesses to disregard the safety of the general public to increase the bottom line. system has a natural tendency to move further and further away from reliance on competitive market mechanism to greater and greater bureacratic controls and interventions. Encourage state monopolies. Mixed economy systems tend to encourage more state monopolies, higher and higher tax to GDP ratio and dominant public finances, making the government a large economic player as compared to corporate or individual entities. Canada, Germany, UK flow of knowledge as is shown with the initiative for backyard furnaces and other efforts in the Great Leap Forward.
USA, Japan, Brazil
China, Cuba, North Korea
The ownership of the factors of production controls: What is produced Where to produce How to produce – the method of production (labour intensive/ capital intensive) How much goods and services to produce Economic sectors Primary: The extraction of natural resources e.g. oil drilling, quarrying, forestry Secondary: The manufacturing of goods using natural or man-made resources e.g. car assembling, property construction, toy manufacturing Tertiary: The provision of services to consumers or producers e.g. education, accounting, marketing Quaternary: The provision of R&D, software development and information processing e.g. research into fiber optics, development of search engines. Production – Productivity & Wealth Creation Definition Productivity: A measure of the efficiency of production. It is the amount of output that can be produced from a given amount of resources Labor productivity: the amount of goods and services that a worker produces in a given amount of time Production Possibility Frontier: A graph that compares the production rates of two commodities that use the same fixed total of the factors of production. Profit = Revenue – Cost ( Productivity (↑ CELL; FOP) ↓ Cost)
6 Productivity Labor productivity = Output ÷ No. of workers o E.g. Firm A: 10 units of labor & 20 units of output Firm B: 20 units of labor & 60 units of output Ways to increase productivity may mean: Using same number of Factors of Production to produce more output Using less Factors of Production to produce same amount of output. What is increased productivity = lower business cost Increased productivity means greater wealth for owners of firms and the economy (in general) PPF shift outwards (economic growth)
productivity of land
Increased use of fertilizers – Fertilizers allow previously barren land to produce crops, and fertile lands to improve higher yields Improved drainage – Reduces soil erosion and assists in the reduction of phosphorus in streams. It allows crops such as hay, corn and soybeans to produce higher yields. Improved irrigation – In dry areas, improved irrigation will allow plants to receive more water and produce a higher yield. Increased use of machinery – Machinery such as tractors help take in the yields much more quickly. Introduced genetically-modified high-yield crops – Genetically-modified crops produce higher yield as they can be altered to fight against pests, herbicides, cold, disease or drought. Build multi-functioned buildings (e.g. skyscrapers) - By building multi-functioned buildings, land can be allocated more efficiently as buildings such as skyscrapers can accommodate a wide range of business activities
How to improve productivity of labour Implement division of labor – Division of labor allows production to be more efficient.
Increase use of machinery (to aid tasks) – Machinery allows the increase of production as well as the quality of the finished product to be better. Specialization – There is a higher output. Total output of goods and services is raised and quality can be improved. A higher output at lower costs means more wants and needs might be satisfied with a given amount of scarce resources. Skill training – Skills training increase productivity. In addition to learning how to complete new tasks and take on more responsibility, employees can learn advanced techniques to help those complete everyday tasks more efficiently. Also, it improves job satisfaction of the employee. Investing time and money in employees’ skills make them feel valued and appreciated, and it challenges those to learn more and get more involved in their jobs. Higher job satisfaction ultimately results in reduced turnover and higher productivity. Motivate workers with financial incentives (pay raises, profit sharing), increase job satisfaction (better working environment)
Nationalization Definition: The process of taking an industry or assets into government ownership by a national government or state. It usually refers to private assets, but may also mean assets owned by lower levels of government, such as municipalities, being transferred to the public sector to be operated and by the state. Advantages The ability of the state to direct investment in key industries The distribution of state profits from nationalized industries for the overall national good The ability to direct producers to social rather than market goals Greater control of the industries by and for the workers The benefits and burdens of publicly funded research and development are extended to the wider populace Disadvantages Costly management. The management of the nationalized industry is complicated and unwieldy. There are numerous departments and paid persons i.e. directorate, regional office conduct its management. Lack of decision making. All the necessary matters are decided by various official and committees. In case of conflicting views, quick decision cannot be made for the urgent matters which are dangerous in business. Lack of efficiency. Nationalized industries are managed by salaried persons who are generally found less efficient as compared with privately owned concerns. There is also lack of flexibility and adaptability which are asset of private ownership. Bureaucracy. There is extensive and rigid procedure of the state machinery by which event is dealt. Such stipulated rules has made the process of work very complicated which results in delay and loss of initiative. Absence of profit motive. The salaried persons are not concerned with profit. Therefore, nationalized undertaking hardly run successfully due to lack of personal interest Chances of loss. The loss of the nationalized enterprises is regarded as the loss of the nation. So the structure of nationalized economy will greatly affected by the failure of such scheme.
8 Limited investment. Investors hesitate to invest large sum of money due to risk of nationalization. Therefore the volume of investment remains limited in private sector.
Privatization Definition: The incidence or process of transferring ownership of a business, enterprise, agency, public service property from the public sector (the state or government) to the private sector (businesses that operate for a private profit) or to private non-profit organizations. Advantages Increased efficiency. Private companies and firms have a greater incentive to produce more goods and services for the sake of reaching a customer base and hence increasing profits. A public organization would not be as productive due to the lack of financing allocated by the entire government's budget that must consider other areas of the economy. Specialization. A private business has the ability to focus all relevant human and financial resources onto specific functions. A state-owned firm does not have the necessary resources to specialize its goods and services as a result of the general products provided to the greatest number of people in the population. Improvements. Conversely, the government may put off improvements due to political sensitivity and special interests—even in cases of companies that are run well and better serve their customers' needs. Capital. Privately held companies can sometimes more easily raise investment capital in the financial markets. While interest rates for private companies are often higher than for government debt, this can serve as a useful constraint to promote efficient investments by private companies, instead of cross-subsidizing them with the overall credit-risk of the country. Investment decisions are then governed by market interest rates. State-owned industries have to compete with demands from other government departments and special interests. In either case, for smaller markets, political risk may add substantially to the cost of capital. Disadvantages Job Loss. Due to the additional financial burden placed on privatized companies to succeed without any government help, unlike the public companies, jobs could be lost to keep more money in the company. Natural monopolies. Privatization will not result in true competition if a natural monopoly exists. Profit. Private companies do not have any goal other than to maximize profits. A private company will serve the needs of those who are most willing (and able) to pay, as opposed to the needs of the majority. Goals. The government may seek to use state companies as instruments to further social goals for the benefit of the nation as a whole.
Demand theory Definitions Demand: The ability and willingness to pay a price to purchase a good/service Quantity demanded: The total amount of goods or services that are demanded at any given point in time. Ceteris Paribus: The relationship between both the price and the quantity demanded of an ordinary good. Effective demand: the demand for a product or service which occurs when purchasers are constrained in a different market
Notional demand: The demand that occurs when purchasers are not constrained in any other market Individual demand: The ability and willingness of a consumer to purchase a good/service Derived demand: Demand for one good or service occurs as a result of the demand for another intermediate/final good or service Types of income Real. Income of an individual or group after taking into consideration the effects of inflation on purchasing power. Disposable. Amount of money that households have available for spending and saving after income taxes have been accounted for. Disposable personal income is often monitored as one of the many key economic indicators used to gauge the overall state of the economy. Discretionary. Amount of an individual's income that is left for spending, investing or saving after taxes and personal necessities (such as food, shelter, and clothing) have been paid. Discretionary income includes money spent on luxury items, vacations and non-essential goods and services.
Factors that affect the demand for goods/services Good's own price. The basic demand relationship is between potential prices of a good and the quantities that would be purchased at those prices. Generally the relationship is negative meaning that an increase in price will induce a decrease in the quantity demanded. This negative relationship is embodied in the downward slope of the consumer demand curve. In other words, the lower the price, the higher demand, ceteris paribus Price of related goods. The principal related goods are complements and substitutes. A complement is a good that is used with the primary good. Examples include hotdogs and mustard, beer and pretzels, automobiles and gasoline. If the price of the complement goes up, the quantity demanded of the other good goes down. The other main category of related goods is substitutes. Substitutes are goods that can be used in place of the primary good. If the price of the substitute goes down, the demand for the good in question goes down. Personal Disposable Income. In most cases, the more disposable income (income after tax and receipt of benefits) you have the more likely you buy. Any changes in the level of income tax rates and allowances are therefore likely to result in a change in the quantity of goods/services demanded. In a normal good, demand for a product tends to rise as incomes rise. If the demand tends to fall as incomes rise the product is said to be an inferior good. Tastes, preference or habits. The greater the desire to own a good the more likely you is to buy the good. There is a basic distinction between desire and demand. Desire is a measure of the willingness to buy a good based on its intrinsic qualities. Demand is the willingness and ability to put one's desires into effect. It is assumed that tastes and preferences are relatively constant. For example, if consumers around the world are demanding good/services that are environmentally-friendly, the derived demand for those goods/services
10 will increase. Advertising also plays a part. Persuasive and informative advertising tends to increase brand awareness and as a result, increase the demand for the good/service. Consumer expectations about future prices and income. If a consumer believes that the price of the good will be higher in the future he is more likely to purchase the good now. If the consumer expects that her income will be higher in the future the consumer may buy the good now. In other words positive expectations about future income may encourage present consumption. Seasonal demand. A hot summer can boost sales of cold drinks and ices while a cold winter can boost the demand for fuel for heating. Higher interest rates can increase the demand for savings schemes but reduce the amount of money people want to borrow, including mortgages for house purchases. Population change. An increase in population tends to increase the demand for many goods and services in a country. For example, in a country where there is an aging population, demand for walking sticks and retirement homes may increase. Location of consumers. There is unequal distribution of income and wealth in different areas of the country. In a richer area of the country, the demand for superior goods will be higher in an area of low income. Price Elasticity of Demand Definition: PED. A measure used to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. The elasticity of the demand curve will also affect the amount of revenue as the price changes
Formula PED = % change in Quantity Demanded % change in Price PED = (New QD – Old QD) x100 (New P – Old P) x 100
Inelastic : The PED value is between 0 and -1. It tends to have few substitutes, is necessities, and/or can be addictive, e.g., alcohol, cigarettes, or petrol. Elastic : The PED value is between -1 and -∞. It has a lot of substitutes and may be an inferior good. Revenue Definition: Revenue is the amount received by the producer from the sale of the goods or service. It is calculated by the multiplying the price charged by the quantity sold (R = P x Q). The only difference between revenue and profit is the costs Price elasticity of Supply Definition:
PES: A measure used to show the responsiveness, or elasticity, of the quantity supplied of a good or service to a change in its price. The PES is always a positive number Formula PED = % change in Quantity Supplied % change in Price PED = (New QS – Old QS) x100 , (New P – Old P) x 100
Inelastic : The PED value is between 0 and 1. It tends to have few substitutes and takes time to alter the quantity of production. Elastic : The PED value is between 1 and ∞.
Note: The amount supplied is not always equal to supply and may create shortages and surplus. Economies of scale Definition: Economies of scale: Diseconomies of scale: The cost advantages that an enterprise obtains due to expansion. The forces that cause larger firms and governments to produce goods and services at increased per-unit costs.
Advantages of large-scale production Internal Lower average unit costs. Scale of production because of a change in the way a firm is run. For example, larger firms can afford more effective advertising. They can spread the cost of advertising over a larger number of products. Efficiency. For example companies can shut down small firms and open one large firm and paying fewer managers to run it. Another is technological economies, meaning that larger firms can buy more efficient and larger machinery and equipment, leading to lower average unit costs Research and Development. Firms can afford to spend large amounts on research and development Purchasing. They can afford to buy materials in bulk and therefore the unit costs are cheaper as they may be given discounts for buying in large quantities.
External ` Geographical advantage. An area has an excellent reputation for producing a particular good/service or a pool of skilled labour may develop in an area where many firms are concentrated. This helps reduce training costs and probably makes recruitment easier.
12 Risk-bearing economies. When borrowing from a large loan, the company can use assets from profitable firms are collaterals and spread the risk of the loan over several firms. Firms may cooperate with each other. Similar and related firms. There may be firms in the area in related industries with similar expertise and knowledge.
Disadvantages of large-scale production Managerial deos. Breakdown of communication as firms get too large. This can lead to a delay in making decisions. Labor deos. Decrease in staff morale as it is difficult to retain close personal contact with staff because of the size of the organization Jobs may be broken down into specialist parts and the workers may find their jobs too repetitive and boring.
Advantages of small firms Flexibility. Small firms can adapt readily to consumer needs, designing products to meet individual requirements, whilst some products cannot be mass produced. Industrial relations. The boss of the small firms tends to have a wide general knowledge of the performance of their employees, and may have a friendly relationship. This could increase morale and motivation. There is also less chance of poor productivity as there are less people in small firms. Customer relations. Likewise, small firms are more likely to know their customers and to be able to offer personalized services to their customers. Personal attention is more feasible in small businesses, such as private music/sports tuition. Local monopoly. Some firms supply only to a small market, and specialist businesses are not interested in these markets.
Public and Merit Goods In a mixed economy the government exists alongside the free market to provide certain goods and services. These tend to be public goods and merit goods because a free market would either fail to provide them or not provide them in sufficient quantities. Public Goods These are things like street lighting, coast guard, police, fire brigade, and the army. It is clear that people want streets to be lit and to be kept safe from attack so why doesn’t the market react and satisfy these wants? Why do you believe that private firms would be reluctant to provide these? They have two distinctive features: They are nonrivalry, meaning that anyone can use it, and they are non-excludable, meaning that they can’t stop people from using it and it is difficult to prevent “free riders”.
13 Merit Goods Merit goods are not provided enough by the private sectors because it is not profitable. They are things like healthcare, education, libraries, sports centers, country parks, public housing, and public hospitals. Public housing and hospitals are public because the people who use these facilities have no or low income to afford it. Again, people want to be kept well and want to be educated. The market can provide these goods; ESF is a private education provider whilst in the USA healthcare is almost exclusively carried out by the private sector. Why then in many countries do governments step in and provide healthcare?
Trade Unions Definitions Trade Unions: An organization of workers that have banded together to achieve common goals, promote and protect the interests of their member. Collective bargaining: a process of negotiations between employers and a group of employees aimed at reaching agreements that regulate working conditions and pay. Open shop : A firm that can employ unionized and non-unionized labour Closed shop : All workers in a place of work have to be union members. The closed shop is outlawed in some countries because it gave unions too much power to dictate who a firm could employ Shop Steward: One of the firm’s employees who is granted time off, during working hours, to deal with trade union matters. In some larger companies, a shop steward may be employed full-time on industrial relations. His or her Wage Councils: These organisations set minimum wages (not National) for their relevant industries. Wage councils have declined dramatically in numbers since 1979. Employment Laws: Laws passed by the government or the European Union that set out rules of behaviour for workers, employers and trade unions with regard to employment Single union agreement: An agreement between an employer and a union such that the union will represent all the workers at a particular workplace. This means that one union can represent all the workers, whatever their occupation, in the same workplace. Industrial relations: The relationships between employees and employers Trade Unions Past and Present – The change of trade unions Since their establishment, the membership and influence of trade unions continued to grow until the early 1980s. The Conservative government at that time responded to public anger over strikes by introducing laws that restricted the unions’ activities. In addition, rising unemployment and the decline in the manufacturing industries (that formed the traditional base of the unions) have reduced union membership. The increase in part-time jobs and the increased number of women working have also had an impact on union membership. In the past, neither of these groups have been strong supporters of trade unions. In addition, the
14 1980s and 1990s have seen a dramatic increase in the number of self-employed people - who are not usually unionized. In response, unions have tried to improve their image by making their services more appealing and relevant to today’s world - e.g. the ATL union (Association of Teachers and Lecturers) has a “no strike” policy. Many unions now offer their members loans, mortgages, insurance, credit cards, discount holiday vouchers and discount car hire. Today, some trade unions also provide grants for college courses, or arrange retraining programmes (the process of developing new skills), for their members who have been made redundant. In addition, they also provide representatives for members in cases of redundancy, grievance, disciplinary hearings and legal action (e.g. on equal pay). Trade Union Membership Around the World According to the International Labour Organisation, only 25% of the world’s 1.3bn workers were members of trade unions in November 1997. However, since the ILO also concluded that trade unions are adjusting to the realities of today, it is likely that trade union membership will increase over the next ten years. In a recent ILO survey of 92 countries, only 14 had a unionised workforce of over 50% (and 48 countries had less than 20%). Results of selected countries are shown below Trade Union Density in selected countries (ILO): Country Sweden Italy South Africa Australia UK Germany New Zealand Japan USA South Korea France 1995 density 91.1 44.4 40.9 35.2 32.9 28.9 24.3 24.0 14.2 12.7 9.1 % change since 1985 +8.7 -7.4 +130.8 -29.6 -27.7 -17.6 -55.1 -16.7 -21.1 +2.4 -37.2
Source: adapted from ILO Labour Report 1997 Types of Trade Unions Although the number of trade unions and the number of members in unions have declined steadily since 1979, we can still distinguish between four different types of trade unions: 1. Craft Unions These are the oldest type of unions, which were formed originally to organize workers according to their particular skill. For example, engineers and printers formed their own respective unions. Today, the GPMU (Graphical, Paper and Media Union) has members working in the printing, paper, publishing and media industries. The decline in the demand for some particular crafts has led to many of the older unions to recruit semi-skilled and unskilled workers.
2. Industrial Unions These unions attempt to organise all workers in their industry, irrespective of their skills or the type of work done. The National Union of Mineworkers (NUM) is an example. National Union of Teachers (NUT), Trade Union Congress (TUC) 3. General Unions These unions are usually prepared to accept anyone into membership - regardless of the place they work, the nature of work, or industrial qualifications. These unions have a very large membership of unskilled workers. The TGWU (Transport and General Workers Union) is a very large General Union in the UK. Their members include drivers, warehouse workers, hotel employees and shop workers. 4. ‘White Collar’ Unions Also called non-manual unions and professional associations, these recruit professional, administrative and clerical staff (salaried workers) and other non-manual workers. They are very strong in teaching, banking, the civil service and local government. The Role/Functions/Aims of Trade Unions The primary role of Trade Unions is to protect the workers’ interests. Examples include: Collective pay bargaining – trade unions are able to operate openly and are recognized by employers, they may negotiate with employers over wages and working conditions. Subscription – Early trade unions, like Friendly Societies, often provided a range of benefits to insure members against unemployment, ill health, old age and funeral expenses. In many developed countries, these functions have been assumed by the state; however, the provision of professional training, legal advice, support for members that are mad redundant and representation for members is still an important benefit of trade union membership. Political activity – Trade unions may promote legislation favorable to the interests of their members or workers as a whole. To this end they may pursue campaigns, undertake lobbying, or financially support individual candidates or parties (such as the Labour Party in Britain) for public office. Industrial action – Trade unions may enforce strikes or resistance to lockouts in furtherance of particular goals.
Aims of the Trade Union Defending their employee rights and jobs Securing improvements in their working condictions, including hours of work and health and safety of work Improving their pay and other benefits, including holiday entitlements Improving sick pay pensions and industrial injury benefits Encouraging firms to increase worker participation in business decision making
16 Developing and protecting the skills of Union members. Aims of the workers: Workers will aim to maximize: Higher Wages – matching inflation (index-link salaries to CPI) Job security – no sacking without notice or reasons Working conditions - Health & Safety; working hours Career progression opportunities: Training and up-to-date information Health and Safety at work Perks, Health insurance, pensions, car, education allowance
Aims of the employers For the employer, targets to maximise may include: Profits Sales Lower costs
Industrial disputes Definition: Disputes with the workforce and/or their representatives - and any resulting industrial action - are costly and damaging to both the business and workers. Causes 1. Economic Cause Demand for increase in wages on account of increase in all-India Consumer Price Index for Industrial Workers. Demand for higher gratuity and other retirement benefits. Demand for certain allowances such as: House rent allowance, medical allowance, demand for paid holidays and reduction of working hours, Better working conditions, etc.
2. Personnel Causes. Sometimes, industrial disputes arise because of personnel problems like dismissal, retrenchment, layoff, transfer, promotion, and more vacations etc. 3. Indiscipline. Industrial disputes also take place because of indiscipline and violence on the part of the workforce. The managements to curb indiscipline and violence resort to lock-outs 4. Misc. causes. Some of the other causes of industrial disputes can be workers' resistance to rationalization, introduction of new machinery and change of place, non-recognition of trade union, rumors spread out by
17 undesirable elements, working conditions and working methods, lack of proper communication behaviour of supervisors to inter-trade union rivalry. How collective bargaining is organized Definition: the process whereby representatives of the workers (in a particular industry) negotiate say pay settlements - with representatives of the employers (in that industry). Generally, an individual worker is in a weak bargaining position - the main purpose of a trade union is to remove this weakness by “forcing” the employer to negotiate with the representatives of his/her work force. Trade unions are autonomous bodies - they have complete freedom to act in their own interests. Most unions, however, are affiliated to the Trade Union Congress (TUC), which is the largest trade union. It has an important role in bringing trade unions’ points of views on a national scale, possibly affecting government decisions - e.g. the TUC have been at the forefront of the National Minimum Wage negotiations. If the more powerful unions make full use of their bargaining strength, they could succeed in getting larger and/or more frequent wage increases than the weaker unions. This highlights the importance of “unionisation” within trade unions - the larger and more united the union, the better the bargaining position, ceteris paribus. How is it organized Collective bargaining is organized depending on the relationship between a union and firms that employ unionized labor. In a open shop, a firm can employ unionized and non-unionized labor In a closed shop all workers in a place of work have to be union members. The closed shop is outlawed in some countries because it gave unions too much power to dictate who a firm could employ. A union could also call the entire workforce in a firm/industry out on strike. In these ways, a union may act like a monopoly and restrict the supply of labour so as to force up the market wage for a job/occupation. A single union agreement allows a union to represent all the workers, whatever their occupation, in the same workplace. This is usually in return for certain commitments from the union on pay or production levels, and for agreeing not to take strike action. Negotiating with a single union rather than several at a time is much easier for a firm. The Challenges facing Trade Unions Decline of manufacturing industries Growth in part-time employment Switch from male to female employment (in terms of percentage increases. Co-operation with management Government legislation (which seeks to reduce union influence)
The Basis for Wage Claims
18 Trade union demands for higher wages are normally based on one or more of the following: 1. 2. 3. 4. A rise in the cost of living (e.g. due to inflation) has reduced the real income of their members. Workers in comparable occupations have received a wage increase. The increased profits in the industry justify a higher return to labour. The productivity of labour has increase How can Trade Unions raise wages? 1. Restricting the Supply of Labour Unions can restrict the supply of labour in an industry, for instance, by pushing for longer apprenticeships or tough examination (entry) requirements. This increases the wage rate in the industry from W1 to W2 in the diagram below.
S2 W2 W1
However, a problem has arisen - the quantity of labour able to enter the industry is restricted by Q1 to Q2. 2. Increasing the Demand for Labour Unions can influence the demand for labour by use of productivity deals. They try to persuade workers to increase productivity (which in turn helps to increase the Marginal Revenue Product of Labour - recall that the MRPL is the demand for labour). In return, trade unions negotiate wage increases for their members, justified by their increased productivity.
Productivity deals have the effect of raising the MRPL curve from D1 to D2, thereby raising wages from W1 to W2. The advantages of this method are that productivity deals help to
19 W1 D2 = MRPL2 D1 = MRPL1 Q1 Q2 Employment
Externalities Calculations Social Costs = Private + External Costs Social Benefits = Private + External Benefits Definition Social costs and benefits are therefore the costs and benefits incurred by the entirety of society (producer, consumer and third party) as a result of the production and/or consumption of a good or service. Private costs and benefits are the costs and benefits incurred by individuals directly involved in the production and/or consumption of a good or service.
Where no market failure exists social costs would be equal to private costs. If external benefits exist more of the said good should be produced and consumed (it is being underconsumed or under-produced) thus the market system is not supplying the optimum resource allocation. If external costs exist than less of the said good should be produced and consumed (it is being consumed or produced in excessive quantities) thus the market system is not supplying the optimum resource allocation. Firms and individuals will not consume/produce any good or service unless the private benefit of their activity exceeds the private cost incurred in their activity.
The government will make sure that: Merit goods (goods with external benefits) are encouraged (to prevent under-consumption or underproduction from occurring.) Demerit goods (goods with external costs) are discouraged (to prevent over-consumption or overproduction from occurring.) Demerit goods do not have prices which account for their external costs. Smoking and alcohol are examples of demerit goods. The government will: Subsidize merit good producers to reduce the costs of production and thereby encourage production of such goods whilst causing prices to be lowered as a result of the increase in supply and the decrease in prices of production caused by subsidization. Tax demerit good producers to increase the costs of production and thereby discourage production of such goods whilst causing prices to increase as a result of the decrease in supply caused by taxations as well as by the increase in the price of production. Sometimes the government may choose to nationalize certain industries that are producing externalities to regulate and control them and so force them to produce at the socially optimum level.
Laws and regulations –Limits on the level of emissions of certain chemicals through use of the law and a fining system to punish firms for infringement. Ban on the use of certain chemicals which may result in significant external costs through use of the law and a fining system to punish any infringement. Forcing firms to internalize all costs: Pollution permits (these can be traded to firms who can then pollute more at a reasonable price). Pollution permits are given out to firms by the government before any trading is done. (Equivalent and derived from the Carbon Credits used internationally to restrict national pollution). But this scheme is costly (administration costs are high) to implement, it is difficult to measure pollution levels accurately, rich firms may simply buy their permits off poorer firms and so pollution may not have been decreased at all, it is hard to calculate how many pollution permits to give out. If external benefits exist then the public would be willing to pay more for a certain good to assure that it is produced at the socially optimum level. (Increase in demand, extension along the supply curve). If external costs exist that the public would be willing to pay more to assure that it is produced at the socially optimum level. (Decrease in supply, contraction along the demand curve.)
Government Regulation These are used to: Promote competition. Resolve externalities where market failure exists: Provision of public goods. Taxing demerit goods. Enforce law and order. Influence the location of firms: Prevent overcrowding in cities. Prevent regions from being neglected. Governments do not desire oligopolistic or monopolistic markets as such markets are uncompetitive when compared with competition based markets. Often, a government will restrict the formation of such markets by:
Breaking up larger firms into smaller ones Providing incentive for other firms to set up in the market Preventing merges that may prove detrimental to competition
How does the government regulate private enterprises? Investigate existing monopolies and suggesting ways in which competition may be introduced into these monopolist-dominated markets. Investigate proposed mergers and prevent such merges from taking place if they are believed to be detrimental to competition. Influencing the Location of Firms: Why is this done? o Some regions may be economically depressed, usually due to the decline of a traditional industry (this may lead to regional unemployment). o Some regions may be overcrowded with too much pollution, traffic congestion, insufficient housing and public services as a result of too many firms choosing to set up in the said regions.
21 How is this done? Give firms incentives to set up in depressed regions: Low loan interest rates. Grants for the construction of infrastructure. Grants for the training of workers. Tax holiday/allowance. Low rent/free premises. By building and improving the infrastructure present in the said depressed region. Persuade firms in congested regions to move to depressed regions (stop granting licenses to operate in a congested region). Monopoly Definition: A monopoly is a situation where the market is dominated essentially by one firm. The legal definition of “monopoly” is a firm that has 25% or more market share in the market. Advantages and Disadvantages of Monopolies Advantages Firms usually makes higher profits The firm can use profits to invest in new or improve upon existing products Price Maker because does not face any competitors Economies of Scale: Increased output will allow average unit prices of production to drop. This can be passed onto consumers in the form of lower prices, so customers may be more inclined to buy the firms products in the future. A firm may become a monopoly through efficiency; A monopoly is thus a sign of success and not inefficiency. Disadvantages Consumers may have to pay higher prices due to lack of competition Consumers have less choice because market is dominated by the monopolistic firm. Less innovation of products Firms may not be efficient with allocation and utilization of resources because they do not have any pressure to reduce costs. Oglipoly What is it? An oligopoly exists when there are several dominate firms in one market. If there are only two sellers in one market than that the market structure of the said market is a duopoly which is a special case of an oligopolistic market. Examples include the petroleum industry, TV broadcasting industry (duopoly in HK), supermarket industry and the banking industry.
Please note that, as a general rule of thumb, even if a market has hundreds of providers, if the top 3 –7 providers together possess 50% or more of the market’s total market share then that market is said to be oligopolistic.
Main Features A few sellers dominate market supply/or a few sellers supply a major part of the total market supply irrespective of the total number of smaller suppliers in the market The same goods but which are heavily differentiated by use of advertising, branding and other such methods.
These firms produce similar but heavily differentiated products; this differentiation makes the goods look different to the consumer. (Heterogeneous goods) These firms engage in many forms of non-price competition but rarely deign to involve themselves in price based competition as such competition can lead to price wars which only benefit the consumers and no one else. Brand image is often very important for such firms. (Coke and Pepsi test).
1. Oligopolistic firms will advertise a lot more than monopolists in the attempt to build a strong brand image and to differentiate their goods from the products of their competitors. 2. If one firm has a better brand image, even with an inferior product, the said firm may be able to sell more of its product than another firm with a worse brand image. Entry into such markets is restricted either because of governmental decrees or because of the huge startup capital or technology requirements needed in order to open shop in the said market. Furthermore, because of the furious level of competition between existing oligopolistic firms, these firms generally produce at a very low price, a feat which would be very difficult for smaller firms which do not wield the same level of economies of scale as the larger oligopolistic firms. Market information is restricted and often incomplete as no firm knows what another competitor will do. To combat this, such firms often collude to form cartels (trade agreements) and conduct themselves with all the advantages, and disadvantages, of monopolists. These agreements are generally illegal. The actions of one firm will affect what the other competing oligopolistic firms will do as such firms will react very quickly to the actions of a competitor. (Sellers are highly interdependent). Barriers to Entry Existing firms are well established and have strong brand images. Existing firms enjoy economies of scale and are much more efficient. Existing firms enjoy customer confidence. The government may have issued rules that govern entry, sometimes for a certain number of years, into a certain market. These rules would have been put in place to encourage entrepreneurs to enter into a market where one would require large startup capitals. (Mobile phone industry in China). Pricing Strategies: Price wars. Price Leadership: When the dominate firm in a market determines the price of a good other firms have no choice but to follow their example or lose market share unless they choose to lower their prices even further and risk a price war. Sometimes they will even collude to prevent price wars from happening. Price collusion: Forming a cartel. Predatory pricing otherwise known as destruction pricing. Advantages Economies of scale (low average cost achieved on account of a high level of output). Excess (abnormal or supernatural) profits. Promotes research and development because these firms can spread the potential costs involved in R&D over a much larger range of income sources thus lowering the risk of R&D. Disadvantages Lower output levels and higher prices as these firms control such things Less choice for consumers. The need for government regulation to prevent oligopoly firms from overusing their powers.
23 Economic growth Definition Recovery: The period where the economy moves between a recession and a boom. Boom: This period is fast economic growth. Output is very high due to increase in demand, and unemployment is very low. Additionally, consumers may be confident about the economy so this may lead to extra spending Recession: Economic Growth slows down and level of output may have a negative impact. Unemployment increases and consumers are likely to save instead of spend, so there is less money circulating in the economy. Slump: A period where output starts to decrease. Consumer confidence may also begin to deplete. GDP: The total or national output of a country over a period of time.
GDP It measures the total amount of income earned in a macro economy – national income. Changes used to measure economic growth – Real change in GDP over time. National Output = National Income = National Expenditure Total value of output produced by all domestic firms within economy. GDP = Consumption + Government Expenditure + Investment + Net imports Some of the output income will flow overseas, as people from other countries may achieve output in your economy GDP is measured in terms of money. However, money is subject to change in its value and inflation. To solve this problem, the real value of output or GDP is adjusted for inflation so we know how much is really generated from economic growth and how much is simply due to rising prices.
Inflation Definition Inflation: A general and sustained rise in the level of prices of goods and services – prices of vast majority of goods and services on sale to consumers keeps rising over time. Stagflation: Persistent high inflation combined with high unemployment and stagnant demand in a country's economy. Hyperinflation: Prices rise at phenomenal rates in short periods of time, rendering money worthless. Usually, the inflation rate is in double digits Deflation: The prices of goods and services fall. This is usually negative inflation. Disinflation: Fall in the rate of inflation. Ideas Price change over time (inflation) is always given per period of time. Deflation can be a cause for concern – deflation will usually occur when demand for goods and services are falling, causing firms to lose profits, profits and reduce workforce.
24 This will reduce household incomes, causing further reduction in goods and services. The value of debts held by people and firms will rise in real terms as prices fall and burden of making loan repayments rises. Eventually the economy goes into recession. How to measure inflation Measured by • CPI (Consumer Price Index)
RPI (Retail Price Index) 1. A base year or starting point is chosen. This becomes the standard against which price changes are measured. 2. A list of items bought by an average family is drawn up. This is facilitated by the Living Costs and Food Survey. 3. A set of weights are calculated, showing the relative importance of the items in the average family budget the greater the share of the average household bill, the greater the weight. 4. The price of each item is multiplied by the weight, adjusting the item's size in proportion to its importance. 5. The price of each item must be found in both the base year and the year of comparison (or month).
This enables the percentage change to be calculated over the desired time period.
Calculating the CPI/RPI:
Indices express change in prices of a number of different products as a movement in a single number. Average of ‘basket’ of products in first year calculation or base year is given the number 100. If on average the basket rises overall by 25% next year, then index becomes 125. If in second year it rises another 10%, then 125 x 1.1 = 137.5 – 37.5 becomes average price rise in two year period. To construct a CPI, a sample of households are taken and surveyed – their spending patterns observed for 12 months which is the base year. The proportion of income spent on each category is recorded. Average prices of different goods and services (minus fuel and food) are recorded from a sample of shops. The proportion of income spent on each category is used to weight average prices of each type of good/service to find their weighted average prices. This shows how big an impact a change in price of a particular type of good or service will have on cost of living for the average household. The proportional of household income spent on a certain type of good/service is multiplied by the average price of the good/service purchased in the category, to generate its weighted average price – these weighted prices are then all added together, which is the overall average price for goods and services in the basket. The weighted total price of the basket can be compared each year to work out percentage changes in average consumer prices.
Uses of CPI/RPI Data: 1. As economic indicator – CPI is widely used measure of price inflation, and therefore is measure of changes in cost of living. Governments try to control inflation using macro-economic policies. The CPI will be used by workers to seek wage increases, and used by entrepreneurs in business making concerning purchases and setting wage and prices. 2. As a price deflator – Rising prices reduce purchasing power, value, of money. Rising prices can therefore affect real value of wages, profits, pensions, savings, interest payments, tax revenues and other economic variables important to people and decision making. CPI therefore used to deflate other economic series to
25 calculate real inflation-free values. i.e. wages go up 10% but inflation is 15%, therefore real wages fallen by almost 5% less. 3. Indexation – involves tying certain payments to rate of increase in CPI. E.g. pensions may be indexed. Similarly, savings may be index-linked, meaning interest rate is set equal to CPI, protecting real value of people’s savings. Many workers may also be covered by collective bargaining agreements that tie wage increases to CPI changes. Government may also index threshold at which people start to pay tax or higher tax rates to stop people paying more or less tax. Problems with Price Indices: Over time typical household basket of goods and services will change. CPI needs to take account of this, but deciding how and when to make them can be difficult. Changes due to: o Fashion and taste o Introduction of new goods and services o Change in population and household size due to migration, birth/death rates, marriage timing and numbers etc. o Similarly CPI needs to take into account changes in quality of goods and services over time, how and where households buy goods and services such as internet and new shops. o International comparisons of CPIs are hard to make due to different household compositions and spending patterns. o Argued that exclusion of food, energy, house prices and income taxes means CPI cannot accurately measure change of living cost. Inflation Economists today tend to agree main cause of inflation is ‘too much money chasing too few goods.’ This means people are able to increase spending on goods and services faster than producers can supply goods and services, boosting aggregate demand and forcing prices up. A government can allow supply of money to increase in an economy by issuing more money or allowing banking system to create more credit – lending more to people and firms. A government may do so to : o Increase total demand in economy to reduce unemployment. o In response to increase in demand for goods and services for goods. o In response to workers demand for higher wages, or rise in other production costs. o As money supply rises, people’s purchasing powers rise and inflation can occur. o To stop excessive inflation, a monetary rule government’s should follow is to only allow supply of money to expand at same rate as increase in real output or real GDP over time. o If money supply increases faster than output, then inflation will occur. o Stagflation – when inflation and unemployment are both high and increasing – often due to rising living costs causing increased demand for higher wages and less labour demand. Causes of inflation Increase in Money Supply – an increase in money supply would increase the spending power of the average consumer, thus increasing demand and hence pushing up prices. This then causes inflation. Demand Pull Inflation – When aggregate demand is increased, firms are no longer able to meet demand in production and thus prices inflate. To finance this, firms may borrow more or money supply increased. Cost Pull Inflation – When the cost of producing goods is increased, firms may want to offset these increased costs to consumers to keep a certain level of profit, thus the extra cost is added to price of the good or service, causing inflation. Wage Price Spiral is when workers demand higher and higher wages, causing cost push inflation and prompting them to ask for higher wages again.
Imported Inflation – rising prices in one country may be exported to another country through international trade in many different goods and services. Many countries have been able to enjoy stable inflation as China’s large supply of goods and services is produced through cheap labour. Consequences and Costs of Inflation: Personal Costs: o Reduce purchasing power o Real income falls o People like pensioners and students on fixed incomes will suffer from inflation. o Low paid and non-unionized workers often fail to get sufficient rises to stop real income falling. o Professional workers may ask for wage increases that protect or cause increases in real wage levels. o Savers and lenders may be hurt by inflation rate if interest is less. o People who borrowed may benefit. o Demand-pull inflation increased spending can boost company profits, while cost-push may reduce profits. Rising profits could yield more tax, however government may have to pay more for goods and services. o Economical Costs: Possible unemployment – purchasing power drops, less demand Some people save more, reducing economic activity and overall output Causes goods and services to become uncompetitive internationally Benefits: Economic growth Reduce debt values – falling value of money reduces real debt values Higher stock value Values of fixed assets could rise – financial security Possible increased employment Stimulate technological advancement
Economic Growth and Inflation Most governments hope that they can achieve steady economic growth without it causing acceleration in demandpull and / or cost-push inflationary pressures. The dangers of a booming economy is that inflationary pressures build and that the economy must slow down or fall into recession for these inflation risks to be controlled.
During the early part of the last decade, the British economy enjoyed a period of steady growth and relatively low and stable inflation In 2007-08 the trade-off between growth and inflation worsened Inflation surged higher – mainly because of external factors such as high food and oil prices The economy suffered a steep descent into recession following the global financial crisis In early 2009 the economy experienced recession and higher inflation – some economists warned of a lengthy phase of “stagflation” conditions Inflation fell back largely because of the recession. But in 2010 and into 2011, inflation has been rising again whilst GDP growth has been weak with the risk of a second downturn (a “double-dip”)
Stagflation Stagflation is a period of economic stagnation accompanied by rising inflation. In other words, both of these key macro objectives are worsening. It can happen when an economy goes into a downturn or a recession but when other external forces are bringing out higher inflation. The obvious example of this is when recession is afflicting a country but the prices of imported products are surging causing prices to rise and real incomes and profits to fall. The rise in the cost of imports can be shown by an inward shift in the short run aggregate supply curve leading to a contraction in real national output and an increase in prices. One of the dangers of stagflation is that the fall in real incomes causes consumer and investment spending to fall and thus the rate of economic growth suffers too (a deterioration in a third objective of policy). Wage demand may also pick up as people experience rising prices. The central bank needs to consider appropriate policy responses to this. Too severe a tightening of monetary policy for example will help to curb inflation but risk causing a deep recession. The combination of deflation and a sustained drop in economic output is termed an economic depression An improvement in aggregate supply can help to resolve the growth – inflation trade off. We see in the diagram how aggregate supply has moved outwards and this allows aggregate demand (C+I+G+X-M) to operate at a higher level without threatening a persistent increase in the general price level (inflation).
28 Overcoming a conflict between economic growth and inflation – increases in AD and AS
Conflicts between objectives – the economics of deflation
Deflation is a sustained fall in the prices of goods and services, and thus the opposite of inflation. Increased attention has focused on the impact of price deflation in several countries in recent years – notably in Japan (inflation -0.3% in 2010) and in some Euro Area countries such as Ireland Greece where prices have been falling, national output has dropped and unemployment has been rising.
29 It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP. But deflation can be caused by rising productive potential, which leads to an excess of aggregate supply over demand.
Greece has suffered from a severe rise in unemployment (right hand scale) and is now seeing her relative living standards fall. A deflationary depression is a risk for Greece Possible damaging consequences of persistent price deflation Holding back on spending: Consumers may postpone demand if they expect prices to fall further in the future. Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on consumer confidence and people’s willingness to spend. This is especially the case with mortgage debts and other big loans. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices. If inflation is negative, the real cost of borrowing increases and this can have a negative effect on investment spending by businesses Lower profit margins: Lower prices hit revenues and profits for businesses - this can lead to higher unemployment as firms seek to reduce their costs by shedding labour. Confidence and saving: Falling asset prices including a drop in property values hits wealth and confidence – leading to declines in AD and the threat of a deeper recession. Resolving the threat of price deflation Using expansionary Monetary Policy o Interest rates: Deep cuts in interest rates can be made to stimulate the demand for money and thereby boost consumption o Quantitative Easing – printing money in the hope that, by injecting it into the economy, people and companies will be more likely to spend. Using expansionary Fiscal policy o Keynesian economists believe that fiscal policy is a more effective instrument of policy when an economy is stuck in a deflationary recession and a liquidity trap o The key Keynesian insight is that a market system does not have powerful self-adjustments back to full-employment after there has been a negative economic shock. Keynes talked of persistent underemployment equilibrium – an economy operating in semi-permanent recession leading a persistent gap between actual demand and the potential level of GDP.
Keynes argued that this justified an exogenous injection of aggregate demand as a stimulus to get an economy on the path back to full(er) employment and to prevent deflation. Unemployment Definition Frictional Unemployment: Occurs as workers change jobs and spend time without jobs during this period. Seasonal Unemployment: Occurs when consumer demand for certain goods and services are seasonal, and as a result people are only employed during periods of time. Cyclical Unemployment: Occurs when there is too little demand for goods and services in the economy during a recession, and firms are producing less as a result, employing less labour as a result. Structural Unemployment: Occurs when the labour market is unavailable to provide jobs for all workers because of a mismatch between the worker’s skills and the skill requirement of the jobs. It arises from long-term changes in the structure of the economy, as entire industries close down due to lack of demand for goods and services they produce. Workers who become unemployed and have skills no longer needed are occupationally immobile. Voluntary Unemployment: Voluntary unemployment includes workers who reject low wage jobs whereas involuntary unemployment includes workers fired due to an economic crisis, industrial decline, company bankruptcy, or organizational restructuring. International labour organization The International Labour Organization (ILO) measure of unemployment assesses the number of jobless people who want to work, are available to work and are actively seeking employment. It is used internationally so comparisons can be made between countries. It also enables consistent comparisons over time. The ILO measure is calculated using data from surveys of a country’s labour force; it can therefore be subject to sampling differences between one country and another. It differs from the claimant count unemployment tmeasure, which only includes people claiming unemployment-related welfare benefits. The ILO measure gives a higher figure than the claimant count measure as it includes those who are classified as available for work but who are not claiming jobless benefits. The ILO measure may include students who are actively seeking work but may not qualify for jobless benefits. Similarly, second earners within a household may be reluctant to claim jobless benefits but would be classified as unemployed under the ILO measure as they are available for work. Government Policy Definition Monetary policy: The process by which the government, central bank, or monetary authority of a country controls the supply of money, availability of money, and cost of money or rate of interest, in order to attain growth and stability of the economy. Fiscal policy: Government policy that attempts to influence the direction of the economy through changes in government taxes or through some spending.
Expansionary policy: Contractionary policy: Government macroeconomic objectives and policies Most of the governments round the world have four main objectives. These are Keep inflation under control Maintain a low level of unemployment Achieve a high level of growth rate Maintain a healthy balance of payments. Government Economic Policies Government influences the economy through its economic policies. These are Fiscal Policy It is related with taxes and government spending. This policy is there to control inflation and demand in the economy. Usually government collects money in the form of taxes and spends money through its development expenditure such as building roads, bridge, defense, transports etc. Government constantly monitors the aggregate demand in the economy. Inflation rate gives the correct measure of the aggregate demand in the economy. When the aggregate demand in the economy is high, prices rise, this shows that the economy is spending too much. In this case, the government will lower is expenditure budget and cut back on investment spending, such as on road construction and hospital equipment. On the other hand the government might also increase the taxes, which would take spending power out of the economy by leaving consumers and businesses with less income to spend. In the opposite scenario, when the economy is heading for a recession and unemployment is rising, the government might increase its expenditure plans. There might be a reduction in taxes so as to leave consumers and businesses with higher disposable incomes. Monetary Policy Monetary Policy is related with a change in interest rates by the government or the Central bank. When the forecast for inflation is that it will rise above the targets set by government, then the Central Bank will raise its base rate and all other banks and lending institutions will follow. It is usually done when the economy is at the boom stage of the business cycle. A higher interest rate will result in…business will not be able to expand as they have to pay more interest to the bank for their loans and they have less profit left. Businesses that are planning to take loan for expanding may postpone their decisions and wait for a cut in interest rates. Consumers demand will also fall as they will not be getting cheap loans to pay for the buying new houses and luxury items. If inflation is low and is forecasted to remain below governments targets, then the Central Bank may decide to reduce interest rates. Supply side policies It includes all those policies which aim at improving the efficient supply of goods and services. These might include: Privatization Imparting training and improving the education level of the workforce resulting in higher skills. Increase competition in all industries by removing entry barriers, thus leading to more efficiency.
32 Factors causing a change in components of AD Change in consumption A change in consumption is caused by any of the following factors Changes in income: Income increases consumption increases and vice versa. Changes in interest rates: Fall in interest rates will make borrowing money cheaper. Consumers will now be tempted to take loans and purchase goods and services. Consumption will rise. On the other hand if the interest rates increase, borrowing becomes expensive. Consumers will be more tempted to save rather than spend. Consumption will fall. Changes in wealth: A rise in house prices or the value of stock and shares makes a person feel wealthy. Consumers feel more confident and tend to spend more . Changes in consumer confidence: Higher consumer confidence is likely lead to increased consumption. Change in Investment Interest Rates: If interest rates are low firms will find it easy to borrow funds for investment. Investment increase when interest rates fall. Changes in National Income: If the national income increases, firms will have to invest further to increase output (induced investment). Technological change: Regular changes in technological front demand firms to invest in order to keep up with the changes and remain competitive. Business Confidence: The economic environment in an economy is a major factor in determining the investment level. When an economy is showing signs of healthy growth, firms will have positive expectation and will invest in expanding their facilities and to meet higher demands in the future. During troughs firms will be more conservative in their investments and thus AD will be affected. Change in Government Expenditure Government Expenditure depends on Macroeconomics objectives: If the government is considering increasing employment then it might increase its spending on public projects. Condition of the economy: During phases of slow economic growth, government is more likely to increase its spending in order to stimulate the economy. Changes in net exports Exports are domestic goods bought by foreigners. Exports will rise when Foreigners income rise Exchange rate of the exporting country is falling. The economy follows a more liberal trade policy i.e. free trade increase Inflation rate in the economy is comparatively lower than its trading partners. Imports are the goods bought from foreign country. Imports will rise when Domestic income rises. This is because people will increase their consumption and thus imports will increase. Exchange rate of the importing country increase. Now it becomes cheaper for the country to purchase from outside as their currency is stronger than their trading partners. If the economy is following a liberal trade policy i.e. free trade increases. Inflation rate is high Possible conflict between macroeconomic objectives It is rare for a country to achieve all of its main objectives at the same time Frequently conflicts appear between the different aims and as a result, choices might have to be made about which objectives are to be given greatest priority.
This will vary from one country to another since the needs of different nations will differ according to their stage of economic development.
Here are some possible policy conflicts: Inflation and unemployment: Falling unemployment might create demand-pull and cost-push inflationary pressures leading to a fall in the value of money Economic growth and environmental sustainability: Rapid economic growth and development frequently puts extra pressure on scarce environmental resources threatening the sustainability of living standards in the future Economic growth and inflation – an overheating economy may suffer accelerating inflation which then has negative effects on trade performance, business profits and jobs Economic growth and the balance of payments: Strong GDP growth fuelled by high levels of consumer demand for goods and services might lead to a worsening of the trade balance. This is particularly true when an economy has a high marginal propensity to import. Unemployment and inflation – the Phillips Curve concept
Falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemployment to rise If a Government wanted to reduce the unemployment rate, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the product markets. The key to understanding this trade-off is to consider the possible inflationary effects in both labour and product markets from an increase in national income, output and employment.
The labour market: As unemployment falls, labour shortages may occur where skilled labour is in short supply. This puts pressure on wages to increase and prices may rise as businesses pass on these costs to their customers. Other factor markets: Cost-push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass. When an economy is booming, so does the derived demand for components and raw materials.
Product markets: Rising demand can lead to suppliers raising prices to increase their profit margins. The risk of rising prices is greatest when demand is out-stripping supply-capacity leading to excess demand (i.e. a positive output gap.)
Fiscal policy The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy: Aggregate demand and the level of economic activity. The pattern of resource allocation. The distribution of income. How fiscal policy work High rate of inflation High rate of inflation is caused by too much aggregate demand in the economy. Government will use deflationary fiscal policy. Government will try to influence aggregate demand by reducing its public spending. The government will spend less on construction of roads, bridges and other public spending and thus aggregate demand will fall. On the other hand, Government may increase the tax rates. An increase in tax rates will take away the extra disposable income out people’s pocket resulting in a lower demand.
Low rate of inflation In an economic recession, aggregate demand, output and employment all tend to fall. Now the Government wants to increase employment in the economy, it can attempt to do so by increasing aggregate demand. The Government will increase the public spending resulting in a rise in aggregate demand. Government may reduce the tax rates so that people have more disposable income to spend and instigate demand in the economy.
Role of fiscal policies The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy: Aggregate demand and the level of economic activity. The pattern of resource allocation. The distribution of income. AD=C+G+I+(X-M)
36 As we can see in the above equation that G (Government Expenditure) is a component of AD, it can be used by Government to influence AD in the economy. The government can use expansionary or deflationary fiscal policy to get the desired results. Let’s discuss each policy in detail. Expansionary fiscal policy Expansionary fiscal policy is used to increase the Aggregate demand in the economy. If the economy is having a deflationary gap, the government can use expansionary fiscal policy to reduce the gap or totally eliminate it. Deflationary gap Deflationary gap is the difference between full level of employment and the actual level of output of the economy. We can see in the diagram below, that the economy is operating a level ‘a’ below the Yf (full level of employment).
The consequence is that due to deflationary gap all the resources of the economy are not being used in the optimum level and they are idle. This results in unemployment and low level of output. This is not desirable for any government. In order to reduce/eliminate the deflationary gap, the government uses expansionary fiscal policy. Government will either increase its spending or reduce taxes (or both) in order to stimulate the aggregate demand. Increase Government spending will result me more projects being funded by the government and thus employment and output will increase. Even a lower tax rate will result in more disposable income for households and encourage consumption. Increased G and C will lead to higher AD. However, this might also lead to higher prices/inflation in the economy. Contractionary fiscal policy Contractionary fiscal policy involves the reduction of government spending and increase taxes as a measure to control inflation/AD in the economy. With reduced government spending, the AD will fall and thus reduce pressure on the economic resources and the average price level in the economy will come down. Similarly, increased taxes will take away the excess disposable income from the households and result in a fall in AD. Contractionary fiscal policy is thus used to reduce the inflationary gap. Inflationary gap Inflationary gap is when the Aggregate demand exceeds the productive potential of the economy. As we can see through the diagram, the economy is operating at a level above the full employment level of the output. Due the
37 limitation of the economy to fulfil this increased demand the average price level in the economy increases resulting in inflation.
Problems of fiscal policy Reduce incentive to work Raising taxes on income and profits reduce work incentives, employment and economic growth. An effort to reduce aggregate demand may cause disincentives to work, if this occurs there will be a fall in productivity and Aggregate supply could fall. Adverse effect of lowering Public Spending Reduced government spending to Increase Aggregate demand could adversely affect public services such as public transport and education causing market failure and social inefficiency. ‘Crowding out’ effect With an increase in government expenditure, there will be greater competition for limited resources. This will offset private investments resulting in shrinking of the private sector. Inaccurate forecasting If the Government’s estimate or forecasting is wrong or inaccurate the fiscal policy will suffer. For example, if a recession is expected and the government practices deficit budget, and yet the recession turns out to be a boom, this will cause inflation. Implementation of the Policy Planning for the spending is done once by most of the governments. If there is a delay in the implementation of the fiscal policy, it might reduce the effectiveness of the policy. Thus the time lag is important. Poor Information Fiscal policy will suffer if the government has poor information. e.g. If the government believes there is going to be a recession, they will increase AD, however if this forecast was wrong and the economy grew too fast, the government action would cause inflation.
38 Time Lags If the government plans to increase spending this can take a long time to filter into the economy and it may be too late. Spending plans are only set once a year. There is also a delay in implementing any changes to spending patterns. Budget Deficit Expansionary fiscal policy (cutting taxes and increasing G) will cause an increase in the budget deficit which has many adverse effects. Higher budget deficit will require higher taxes in the future and may cause crowding out (see below Other Components of AD If the government uses fiscal policy its effectiveness will also depend upon the other components of AD, for example if consumer confidence is very low, reducing taxes may not lead to an increase in consumer spending. Depends on Multiplier Change in injections may be increased by the multiplier effect; therefore the size of the multiplier will be significant. Monetary Policy Monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy. An expansionary policy increases the total supply of money in the economy and is traditionally used to combat unemployment in a recession by lowering interest rates. Lowered interest rates encourage the household and the firms to increase their consumption and investment respectively. This will shift the AD to the right and result in higher real output and more employment.
Contractionary policy decreases the total money supply and involves raising interest rates in order to combat inflation. The result will be that investment will fall, and consumption will fall. All of these changes will shift the AD to the left.
It is argued that an increase in the money supply causes an increase in the rate of inflation. Maintaining a low and stable inflation is one of the main macroeconomic objectives of the Government. Government does so by controlling the supply of money to the economy. This policy is known as monetary policy. Monetary policy in any country is usually controlled by the Central Bank of that country. The Central bank alters the interest rates in the economy after assessing the inflationary pressures in the market. Monetary Policy tools Central Bank has three tools of monetary policy: Open market operations Open market purchases: The central bank buys government securities to increase the monetary base. Open market sales: The central bank sells government securities to decrease the monetary base. Open market operations have a number of advantages: They are under the direct and complete control of the central bank They can be large or small. They can be easily reversed. They can be implemented quickly Discount loans When a bank receives a discount loan from the central bank, it is said to have received a loan at the “discount window.” The Central Bank can affect the volume of discount loans by setting the discount rate: A higher discount rate makes discount borrowing less attractive to banks and will therefore reduce the volume of discount loans. A lower discount rate makes discount borrowing more attractive to banks and will therefore increase the volume of discount loans. Discount lending is most important during ?nancial panics: When depositors lose con?dence in the ?nancial system, they will rush to withdraw their money. This large deposit out?ow puts the banking system in great need of reserves. The central bank stands ready to supply these reserves by making discount loans. In such situations, the central bank acts as a lender of last resort. Changes in reserve requirements The portion (expressed as a percent) of depositors' balances banks must have on hand as cash. This is a requirement determined by the country's central bank. It affects the money multiplier; changes in the required reserve ratio can lead to changes in the money supply. This is also referred to as the "cash reserve ratio" (CRR).
40 How money supply works Money supply includes all the notes and coins in circulation with the public plus the money with banks. It also includes the deposits in banks and building societies. The later is more significant supply of money and is usually the target of Governments monetary policy. The ways through which Government controls the money supply are: Open market operations Government usually sells treasury bills and bonds to raise money. Private individuals invest in these bonds and bills in order to get a healthy rate of interest. This reduces the deposits with banks and the money supply. Variation of legal reserve requirements Usually, the commercial banks have to maintain a certain percentage of their assets as deposit with the Central Bank. When the Central Bank wants to reduce money supply it will increase the limit of the deposit kept by the banks. The commercial banks are left with less money to lend to their customers. Central banks Central Banks are charged with regulating the size of a nation’s money supply, the availability and cost of credit, and the foreign-exchange value of its currency. Regulation of the availability and cost of credit may be designed to influence the distribution of credit among competing uses. The principal objectives of a modern central bank in carrying out these functions are to maintain monetary and credit conditions conducive to a high level of employment and production, a reasonably stable level of domestic prices, and an adequate level of international reserves. Function of a Central Bank A central bank usually carries out the following responsibilities: Implementation of monetary policy. Controls the nation's entire money supply. The Government's banker and the bankers' bank ("Lender of Last Resort"). Manages the country's foreign exchange and gold reserves and the Government's stock register; Regulation and supervision of the banking industry Setting the official interest rates- used to manage both inflation and the country's exchange rate - and ensuring that this rate takes effect via a variety of policy mechanisms Role of taxation in promoting equity Tax is a fee charged ("levied") by a government on a product, income, or activity. Why taxes are imposed? There are different reasons for imposing taxes. To finance government expenditure. One of the most important uses of taxes is to finance public goods and services, such as street lighting and street cleaning. To reduce consumption of goods that creates negative externalities. To control the amount of imported goods i.e. tariffs Used as a part of fiscal policy to control aggregate demand in the economy. To control income inequality. Classification of taxes Progressive taxes A progressive tax is a tax imposed so that the tax rate increases as the amount subject to taxation increases. In simple terms, it imposes a greater burden (relative to resources) on the rich than on the poor. It can be applied to individual taxes or to a tax system as a whole. Progressive taxes attempt to reduce the tax incidence of people with a lower ability-to-pay, as they shift the incidence disproportionately to those with a higher ability-to-pay. The result is people with more disposable income pay a higher percentage of that income in tax than do those with less income.
41 Regressive Tax The opposite of a progressive tax is a regressive tax, where the tax rate decreases as the amount subject to taxation increases. It imposes a greater burden (relative to resources) on the poor than on the rich. Regressive taxes attempt to reduce the tax incidence of people with higher ability-to-pay, as they shift the incidence disproportionately to those with lower ability-to-pay. Proportional Tax A proportional tax is one that imposes the same relative burden on all taxpayers—i.e., where tax liability and income grow in equal proportion. In simple terms, it imposes an equal burden (relative to resources) on the rich and poor. Proportional taxes maintain equal tax incidence regardless of the ability-to-pay and do not shift the incidence disproportionately to those with a higher or lower economic well-being. Types of taxes Direct Taxes It is a tax paid directly to the government by the persons on whom it is imposed. Examples Tax imposed on peoples’ income-Income tax Tax on wealth – wealth Tax Tax on firm’s profits.- corporate tax Indirect Taxes Indirect tax is a tax collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the consumer). The intermediary later files a tax return and forwards the tax proceeds to government with the return. Indirect taxes are generally included in the price of goods and services, so are less obvious to those paying the taxes than direct levies. Thus indirect taxes are also known as expenditure tax or consumption based tax. Examples GST (Goods and service tax) VAT (Value added tax) Consumers are charged a percentage of tax while purchasing a good/service and then the seller pays the tax collected to the Government. Other measures to promote equity The governments also undertake expenditures to promote income equity. These include Subsidies Provide directly, or to subsidize, a variety of socially desirable goods and services. These include health care services, education, and infrastructure that include sanitation and clean water supplies. Transfer payments Government provides various kind of assistance to low income groups in the society. The objective is to support them in maintaining a reasonable standard of living and to lower inequality. These payments are given directly to these groups in the form of monetary help. Examples include Social Security, unemployment compensation, welfare, and disability payments. Government policy to control inflation Government uses a number of policies to deal with the different types of inflation. These are:
42 Demand Side policies-to control demand pull inflation Deflationary fiscal policy: This involves an increase in taxes and lowering of government spending. Increasing taxes will result in lower disposable income for household and thus less consumption. Moreover, increased taxes will result in lower profits for firms and thus less investment by firms. All these factors will lower the AD in the economy. Deflationary monetary policy: It involves rising of interest rates and reducing money supply. Higher interest rates mean higher loan and mortgage repayments. This will deter households and firms to borrow, leading to fall in consumption and investment respectively. Supply side policies-to control cost push inflation It includes all those policies which aim at improving the efficient supply of goods and services. These might include: Privatization Imparting training and improving the education level of the workforce resulting in higher skills. Increase competition in all industries by removing entry barriers, thus leading to more efficiency. Exchange rate policies to control imported inflation This involves increasing the value of currency to reduce imported inflation. Increase currency rate will also lead to fall in demand for exports (component of AD). International aspects Definition Exchange rate: The price of one’s currency in terms of another currency Foreign exchange market: The market where currencies are bought and sold. Exchange control: Limits on the amount of foreign currency available to importers, which consequently limit imports Appreciation: The rise in value of a currency against others. Exports will become more expensive abroad and imports cheaper at home. Depreciation: The fall in value of a currency against others. Exports will become cheaper abroad and imports expensive at home. Devaluation: Depreciation brought about the government, normally by a government which fixes the value of its currency. Exports: The movement of goods or commodities out of the country. Imports: The movement of goods or commodities into the country. Protectionism: Policy of protecting domestic industries against foreign competition by means of tariffs, subsidies, import quotas, or other handicaps placed on imports. Free trade: A system of trade policy that allows traders to trade across national boundaries without interference from the respective governments.
43 Globalisation What is it? It is the increasing integration of countries’ individual economies. It is the global movement towards trade, financial and communications integration through the development of free trade, free flow of capital, and the freedom to tap into cheaper foreign factor markets. (Official definition) Benefits
Most efficient form of production: Because firms will choose to produce where costs are lowest. Stimulates the economy, particularly that of LEDCs, by drawing in more foreign direct investment. Employment opportunities Opening jobs.
Training • Introduces skills and technology to nations through a company’s implementations of such: This increases the productivity of a nation’s workforce, etc. • Opening new industries in LEDCs such as the white phosphorus mining industry in Yemen. • Increases competition: Lowers prices Less inflation. Better quality goods. Better efficiency. Costs • Environmental damage. Because the company is so powerful that it can afford to operate inefficiently for conveniences sake. • Creates uncertainty: Foreign firms own most of the market share in a country, not domestic firms. • May choose to source their resources from abroad and not from locally: Thus local resource producers will go out of business. • Human rights abuses. Infringements on indigenous rights. • Terrorism. • Investments in nations facing political sanctions as a result of their wrong-doings. • Leaching from government funds: Large MNCs may be too important for a government to allow to go bankrupt thus whenever said MNC is facing troubles they will be given aid by their government. • Price manipulation. • Labour abuse: Child labour. Bad working conditions. Poor healthcare. Sweat shops. Bad wages. Restrictions to resting hours. Anti-Labour-Union policies. • Using tactics detrimental to competition: Predatory pricing. Monopoly power.
44 • Tax evasion: Through transfer pricing. • Using illegal methods and materials to produce goods and services. Or to force people to buy their goods or services: Great American Streetcar scandal. • Blocking of technologies: Bribery. Blocking battery technology for hybrid cars so one can sell more oil. Concealment of imports. Causing trade deficit: Wal-Mart is accused of being one of the largest sources of the trade deficit in the USA. Objections Third world debt. Debt in the developing, less developed or least developed third world countries in Africa, Asia, Latin America and the Middle East. Globalization is leaching resources from these countries and the revenue generated from this leaching is not fed back into these countries. Furthermore, with population growth causing the needs and wants of these countries to also grow, these countries are falling into debt in order to pay for these needs and wants. • Animal rights. • Child labour. • Anarchism. • Anti-capitalist Exchange rates Demand for and Supply of a currency This is what determines exchange rate in a free-floating exchange rate system: When a currency has strong demand it will appreciate in value. In contrast, when there is a large scale selling of a currency it will depreciate. Demand for a currency: Exports and imports of goods/services o If a country has a decline in export industries and earnings, yet its people continue buying imports, the exchange rate is likely to fall. This is possibly not true for countries such as Hong Kong which are dependent on imports of oil and food. o Fewer exports will mean less demand for the currency to pay for them, so the demand for the currency will decrease. o This will lead to depreciation o When a currency has depreciated, this makes the countries’ exports cheaper abroad. o Thus, exports should become more competitive overseas. Price elasticity of demand for imports o When a currency depreciates, imports become more expensive. o If the demand for imports is price elastic, this should lead to a fall in expenditure on imports o This situation is found where imports compete with home-produced alternatives. o When countries import necessities, such as food and oil, demand tends to be price inelastic so expenditure rises when the currency falls. • Pure speculative demand. o Speculators often purchase currencies that they think will appreciate in value against their own currency. • Official buying of the currency by the central bank. o This might be done for investment or speculation or security or other reasons.
45 • Comparatively higher domestic interest rate. o Thus savers will be likely to convert their own money into your currency to save in your nation and enjoy the comparatively higher domestic interest rates you offer.
Supply of a currency Imports of goods and services. Outflows of direct investment. Outflows of portfolio investment. Speculative selling of the currency. Official selling of the currency by the central bank. Rate of interest abroad. Appreciation and Depreciation • Foreigners will tend to save money in one’s nation. Thus the demand for one’s currency rises which can cause one’s currency to appreciate in general. • Depreciation means that the value of the currency in terms of other currencies goes down: • If the USD depreciates against the RMB then it will take fewer RMB to buy each USD. • If 1 Euro was worth HKD 10.2 at the start of the year. • It may depreciate if the Greek government declared that it would withdraw from the Eurozone and go back to using the Drachma in order to depreciate their currency. • This will cause others to lose confidence in the Euro and speculation will cause people to sell the Euro. • This may end up causing the Euro to depreciate to HKD 7 per Euro. • In this case the Euro has depreciated against the HKD because it now takes more Euros to purchase each HKD. • But the HKD has appreciated against the Euro because it now takes fewer HKD to buy 1 euro Advantages of a Strong Currency Lower import prices – This boosts living standards of consumers. An increase in the real purchasing power of HK residents traveling overseas for business and leisure purposes. Cheaper to import raw materials, components and capital inputs – causes an outward shift in short-run aggregate supply. Improvement in the terms of trade (lower import prices). Helps to control RPI inflation – Domestic producers face stiff international competition and must keep their prices down. Lower inflation allows the MPC/HKMA to keep nominal interest rates at a lower level than if the exchange rate was weak. An increase in a country’s relative position in international league tables showing real GDP per capita when expressed in a common currency: Even if one’s GDP, as measured in one’s own currency, is no more than previously, because one’s currency has appreciated in value, the GDP of one’s nation will also increase when it is translated into another currency. Disadvantages of a Strong Currency • Cheaper imports lead to rising import penetration and large trade deficit: • Import penetration means that a larger portion of the goods and services provided by a nation’s firms is now provided by foreign firms. • Exporters also lose price competitiveness and market share thus causing a trade deficit. • Damaged profit and employment in some sectors to which exporting is the key means of generating revenue. • Negative impact on economic growth (exports – injections of aggregate demand, imports - leakages of wealth form the circular flow of income).
46 • Some regions which have a higher than average dependency on exporting industries are more affected than others. Balance of Payments on Current Accounts What is it? It is a set of accounts that record a country’s international transactions and which (because double entry bookkeeping is used) is always in balance with no surplus or deficit shown on the overall basis. It serves to highlight a country’s competitive strengths and weaknesses and helps in achieving balanced economic growth. Because the international market is so large it is unlikely to adhere to the business cycle. Therefore, a country which has a healthy BoP account will likely have balanced growth because the levels of investment, consumption and capital of the international market is unlikely to fluctuate much and will grow steadily. The demand from the international market is unlikely to fluctuate much and will grow steadily therefore investment and capital will also grow steadily (this growth happens because people are getting richer, world population is growing, etc.). Capital in this case should indicate the money invested in businesses to generate income: If investments grow so too will capital because capital is the money already invested and investments are the source of capital. The Balance of Payments Account The current account, capital account and financial account. The capital and financial accounts used to known collectively as the capital account. The BoP is always balanced When the news talks about a BoP surplus or deficit they are usually referring to the net transactions of the Current Account or just the Balance of Trade. Calculated by subtracting the total value of imports from the total value of exports BoT is Balance of Trade Positive figure (surplus) – Value of imports < Value of exports. Negative figure (deficit) – Value of imports > Value of exports. A negative BoP indicates that a country’s exports are not competitive enough to compete with those produced by other countries: Thus there is a net leakage of wealth from the country. Correcting trade imbalances Large trade imbalances, whether a big deficit or a big surplus, can cause problems for a national economy. Problems with a trade surplus There may be political and economic pressure on the government from other countries to reduce its trade surplus so they can reduce their trade deficits Exporting firms will enjoy significant overseas revenues – profits and wages may rise – but the increase in demand may cause demand-push inflation A surplus causes the value of the currency to appreciate or stay high, and may eventually reduce demand for exports and cause a loss of jobs.
47 Problems with a trade deficit If more money is paid out for imports than is earned from exports then this loss of money from an economy may mean less can be spent on domestic goods and services. Domestic firms facing a fall in demand for their products may cut back production and their demand for labour resulting in higher unemployment. The value of the exchange rate will fall, causing imports to become more expensive and resulting in imported inflation. If demand for price-inelastic goods or services falls, more money will be paid out for imports and the demand for domestically-produced goods/services will decrease. The trade deficit might be a symptom of a declining industrial base, with fewer firms in the economy over time producing goods and services for export. Economic growth and trade balance A period of fast growth may come into conflict with the balance of payments. Much depends on the income elasticity of demand for traded goods and services. In the case the UK, the evidence is that consumers have a high propensity to consume imports; the income elasticity of demand is strongly positive. Say for example, real disposable incomes grow by 3% and that the income elasticity for imports = +2.5. That would lead to a 7% rise in the volume of imports. Unless there is a corresponding rise in exports, we expect to see a worsening of the balance of trade (i.e. a widening trade deficit). In a recession, this effect works in reverse as demand for imported products including raw materials, components and ready to consume goods and services declines. The trade balance will improve although the root cause is a drop in economic activity. Correcting trade balances 1. Do nothing, as a floating exchange rate will correct it. Trade deficits and surpluses can be self-correcting if allowed to adjust freely. 2. Fiscal policy A contractionary fiscal policy is when the government may cut public expenditure and raise taxes to reduce the total demand in their economy so people have less to spend on imports. This will help reduce the trade deficit. However, a fall in demand may also affect domestic firms, who may cut output and employment in response to the fall in demand An expansionary fiscal policy is when the government lowers tax rates and raise public expenditure. This boosts spending on imports and help to correct a trade surplus. However, it may also help domestic firms if demand for their goods and services also rises, and may help to halt any decline in the industrial base. 3. Monetary policy An expansionary monetary policy is when the government attempt to attract more inwards investments to their economy to help offset a trade deficit by raising interest rates. Higher interest rates will also make borrowing more expensive and reduce the demand for loans by consumers and firms that may be used to pay for goods and services supplied overseas. A contractionary monetary policy is when the government lowers interest rates to help correct for a trade surplus by lowering the cost of borrowing from firms and consumers, and will lower the return overseas investors can expect on their inward investments in the economy so that they invest elsewhere instead. 4. Protectionism This is when a country uses trade barriers such as tariffs to make imports more expensive or limit the amount of imports in order to correct a trade deficit.
48 Visible and Invisible Visible Trade Visible trade involves trading of goods which can be touched and weighed. Examples include trade in goods such as Oil, machinery, food, clothes etc. Visible Trade consists of Visible exports: Selling of tangible goods which can be touched and weighed to other countries. Visible imports: Buying of tangible goods which can be touched and weighed from other countries. Balance of trade It is the difference between the value of visible exports and value of visible imports of a country. If the value of visible exports is more than visible imports the country will have a surplus balance of trade. If the value of visible imports is more than visible exports the country will have an Unfavourable balance of trade. Invisible trade Invisible trade involves the import and export of services rather than goods. Example include services such as insurance, banking, tourism, education. If a UK student comes to Singapore to study, it would be invisible export for Singapore as it is earning foreign exchange by providing educational services. If a Singapore citizen travels to UK for a holiday. It will be invisible import for Singapore and invisible export for UK. Balance of invisible trade It is the difference between the value of invisible exports and value of invisible imports of a country. Comparative advantage The theory of comparative advantage states that a country should specialise in the production of good or service in which it has lower opportunity cost and it should import commodities which have a higher opportunity cost of production. Example Suppose for example we have two countries of equal size, Northland and Southland. Both produce and consume two goods, Food and Clothes. The productive capacities and efficiencies of the countries are such that if both countries devoted all their resources to Food production, output would be as follows: Northland: 100 tonnes Southland: 200 tonnes If all the resources of the countries were allocated to the production of clothes, output would be: Northland: 100 tonnes Southland: 100 tonnes Assuming each has constant opportunity costs of production between the two products and both economies have full employment at all times. All factors of production are mobile within the countries between clothing and food industries, but are immobile between the countries. The price mechanism must be working to provide perfect competition. Southland has an absolute advantage over Northland in the production of Food. Both countries are equally efficient in the production of clothes. There seems to be no mutual benefit in trade between the economies. The opportunity costs shows otherwise. Northland's opportunity cost of producing one tonne of Food is one tonne of Clothes and vice versa. Southland's opportunity cost of one tonne of Food is 0.5 tonne of Clothes. The opportunity cost of one tonne of Clothes is 2 tonnes of Food. Southland has a comparative advantage in food production, because of its lower opportunity cost of production with respect to Northland. Northland has a comparative advantage over Southland in the production of clothes, the opportunity cost of which is higher in Southland with respect to Food than in
49 Northland. To show these different opportunity costs lead to mutual benefit if the countries specialize production and trade, consider the countries produce and consume only domestically. The volumes are: Food Northland Southland World total 50 100 150 Clothes 50 50 100
Production and consumption before trade This example includes no formulation of the preferences of consumers in the two economies which would allow the determination of the international exchange rate of Clothes and Food. Given the production capabilities of each country, in order for trade to be worthwhile Northland requires a price of at least one tonne of Food in exchange for one tonne of Clothes; and Southland requires at least one tonne of Clothes for two tonnes of Food. The exchange price will be somewhere between the two. The remainder of the example works with an international trading price of one tonne of Food for 2/3 tonne of Clothes. If both specialize in the goods in which they have comparative advantage, their outputs will be: Food Northland Southland World total 0 200 200 Clothes 100 0 100
Production after trade World production of food increased. Clothing production remained the same. Using the exchange rate of one tonne of Food for 2/3 tonne of Clothes, Northland and Southland are able to trade to yield the following level of consumption: Food Northland Southland World total 75 125 200 Clothes 50 50 100
Consumption after trade Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both benefited, and now consume at points outside their production possibility frontiers. Assumptions in Example 2 Two countries, two goods o The theory is no different for larger numbers of countries and goods, but the principles are clearer and the argument easier to follow in this simpler case. Equal size economies o Again, this is a simplification to produce a clearer example. Full employment
50 If one or other of the economies has less than full employment of factors of production, then this excess capacity must usually be used up before the comparative advantage reasoning can be applied. Constant opportunity costs o A more realistic treatment of opportunity costs the reasoning is broadly the same, but specialization of production can only be taken to the point at which the opportunity costs in the two countries become equal. This does not invalidate the principles of comparative advantage, but it does limit the magnitude of the benefit. Perfect mobility of factors of production within countries o This is necessary to allow production to be switched without cost. In real economies this cost will be incurred: capital will be tied up in plant (sewing machines are not sowing machines) and labour will need to be retrained and relocated. This is why it is sometimes argued that 'nascent industries' should be protected from fully liberalised international trade during the period in which a high cost of entry into the market (capital equipment, training) is being paid for. Immobility of factors of production between countries o Why are there different rates of productivity? The modern version of comparative advantage (developed in the early twentieth century by the Swedish economists Eli Heckscher and Bertil Ohlin) attributes these differences to differences in nations' factor endowments. A nation will have comparative advantage in producing the good that uses intensively the factor it produces abundantly. For example: suppose the US has a relative abundance of capital and India has a relative abundance of labor. Suppose further that cars are capital intensive to produce, while cloth is labor intensive. Then the US will have a comparative advantage in making cars, and India will have a comparative advantage in making cloth. If there is international factor mobility this can change nations' relative factor abundance. The principle of comparative advantage still applies, but who has the advantage in what can change. Negligible Transport Cost o Cost is not a cause of concern when countries decided to trade. It is ignored and not factored in. Assume that half the resources are used to produce each good in each country. o This takes place before specialization Perfect competition o This is a standard assumption that allows perfectly efficient allocation of productive resources in an idealized free market.
Absolute advantage A country has an absolute advantage over another in producing a good, if it can produce that good using fewer resources than another country. For example if one unit of labor in Australia can produce 80 units of wool or 20 units of wine; while in France one unit of labor makes 50 units of wool or 75 units of wine, then Australia has an absolute advantage in producing wool and France has an absolute advantage in producing wine. Australia can get more wine with its labor by specializing in wool and trading the wool for French wine, while France can benefit by trading wine for wool. Example 1 Country A can produce one widget using one unit of labour. Country B can produce one widget using two units of labour. Country A has an absolute advantage over Country B in producing widgets. Example 2 Country A has 100 units of labour. It uses 20 to produce 80 units of Parachutes, and 80 to produce 20 units of Barbie dolls.
51 Country B has 100 units of labour. It uses 40 to produce 100 units of Barbie dolls, and 60 to produce 20 units of Parachutes. If the countries maximized their potential, Country A could produce 400 units of Parachutes, and country B could produce 250 units of Barbie dolls. Through trade, the two countries would achieve a more efficient allocation of resources and increase their prosperity.
Free trade Definition: International trade left to the mechanisms of demand and supply without influence of protectionist methods. Reasons for Free Trade Domestic Non-availability o A nation trades because it lacks the raw materials, climate, specialist labour, capital or technology needed to manufacture a particular good. Trade allows a greater variety of goods and services. Cost effectiveness o It is cheaper to buy from other countries rather than producing themselves. Benefits of Trade Lower prices for consumers o When there is free trade, consumers can free to buy goods from the producer who is willing to sell at the lowest prices. Hence consumers gain from lower prices. Greater choice for consumers o With free trade, consumers have access to variety of goods and services from different producers across the globe. This means more choice. Ability of producers to benefit from economies of scale o Producers have access to a larger market thus they can produce more at lower cost and benefit from economies of scale. Ability to acquire needed resources o Through free trade producers can not only sell in a large market but also gain from purchasing from suppliers across the world. More efficient allocation of resources o When there is free trade, the most efficient producers get the opportunity to produce due to their cost efficiency. This leads to productive efficiency. Increased competition o In free trade producers from different regions can compete with each other in terms of price, quality and variety. Increased competition leads to efficient allocation of resources. Source of foreign exchange o Free trade involves the transaction of goods and services between nations. In order to purchase goods from abroad (imports), we need foreign currency. This is possible through exporting of goods to other countries.
52 Free Trade diagrams
Protectionism methods The chief protectionist measures, government-levied tariffs, raise the price of imported articles, making them less attractive to consumers than cheaper domestic products. Import quotas, which limit the quantities of goods that can be imported, are another protectionist device. Tariffs A tariff is a tax on foreign goods upon importation. Tariff rates vary according to the type of goods imported. Import tariffs will increase the cost to importers, and increase the price of imported goods in the local markets, thus lowering the quantity of goods imported.
53 Quotas An import quota is a type of protectionist that sets a physical limit on the quantity of a good that can be imported into a country in a given period of time. This leads to a reduction in the quantity imported and therefore increases the market price of imported goods. Quotas, like other trade restrictions, are used to benefit the producers of a good in a domestic economy at the expense of all consumers of the good in that economy. Administrative Barriers Countries are sometimes accused of using their various administrative rules (eg. regarding food safety, environmental standards, electrical safety, etc.) as a way to introduce barriers to imports. Embargo An embargo is the prohibition of commerce and trade with a certain country, in order to isolate it and to put its government into a difficult internal situation, given that the effects of the embargo are often able to make its economy suffer from the initiative. Subsidies Government subsidies (in the form of lump-sum payments or cheap loans) are sometimes given to local firms that cannot compete well against foreign imports. These subsidies are purported to "protect" local jobs, and to help local firms adjust to the world markets.
Anti-dumping legislation Supporters of anti-dumping laws argue that they prevent "dumping" of cheaper foreign goods that would cause local firms to close down. However, in practice, anti-dumping laws are usually used to impose trade tariffs on foreign exporters. Externalities, Market Failure and Import Controls Protectionism can also be used to take account of externalities and dealing with de-merit goods. Goods such as alcohol, tobacco and narcotic drugs have adverse social effects and are termed de-merit goods. Protectionism can safeguard society from the importation of these goods, by imposing high tariff barriers or by banning the importation of the good altogether.
54 Non-Economic Reasons Countries may wish not to over-specialise in the goods in which they possess a comparative advantage. One danger of over-specialisation is that unemployment may rise quickly if an industry moves into structural decline as new international competition emerges at lower costs. The government may also wish to protect employment in strategic industries, although clearly value judgments are involved in determining what constitutes a strategic sector. The recent trade dispute arising from the decision by the United States to introduce a tariff on steel imports is linked to this objective. The US steel tariff was declared unlawful by the WTO in July 2003 and eventually the United States was pressurized into withdrawing these tariffs in the late autumn of 2003. Tariffs are not usually a major source of tax revenue for the Government that imposes them. In the UK for example, tariffs are estimated to be worth only £2 billion to the Treasury, equivalent to only around 0.5% of the total tax take. Developing countries tend to be more reliant on tariffs for revenue. Economic Arguments against Import Controls Protectionism – hurting customers Tariffs, non-tariff barriers and other forms of protection serve as a tax on domestic consumers. Moreover, they are very often a regressive form of taxation, hurting the poorest consumers far more than the better off. In the EU for instance, the nature of existing protection means that the heaviest taxes tend to fall on the necessities of life such as food, clothing and footwear. According to Professor Jagdish Bhagwati, “the fact that trade protection hurts the economy of the country that imposes it is one of the oldest but still most startling insights economics has to offer.” The folly of protection has been confirmed by a range of studies from around the world. These indicate that that it has brought few benefits but imposed substantial costs. Among the main criticisms of protectionist policies are the following: Market distortion: Protection has proved an ineffective and costly means of sustaining employment. a. Higher prices for consumers: Trade barriers in the form of tariffs push up the prices faced by consumers and insulate inefficient sectors from competition. They penalise foreign producers and encourage the inefficient allocation of resources both domestically and globally. In general terms, import controls impose costs on society that would not exist if there was completely free trade in goods and services. It has been estimated for example that the recent tariff and other barriers placed on imports of steel into the US increased the price of every car produced there by an average of $100 b. Reduction in market access for producers: Export subsidies, depressing world prices and making them more volatile while depriving efficient farmers of access to the world market. This is a major criticism of the EU common agricultural policy. In 2002 the EU sugar regime lowered the value of Brazil, Thailand and South Africa’s sugar exports by over $700 million – countries where nearly 70 million people survive on less than $2 a day. Loss of economic welfare: Tariffs create a deadweight loss of consumer and producer surplus arising from a loss of allocative efficiency. Welfare is reduced through higher prices and restricted consumer choice. Regressive effect on the distribution of income: It is often the case that the higher prices that result from tariffs hit those on lower incomes hardest, because the tariffs (e.g. on foodstuffs, tobacco, and clothing) fall on those products that lower income families spend a higher share of their income. Thus import protection may worsen the inequalities in the distribution of income making the allocation of scarce resources less equitable Production inefficiencies: Firms that are protected from competition have little incentive to reduce production costs. Governments must consider these disadvantages carefully Little protection for employment: One of the justifications for protectionist tariffs and other barriers to trade is that they help to protect the loss of relatively low skilled and low paid jobs in industries that are coming under sever international competition. The evidence suggests that, in the long term, tariffs are a
55 costly and ineffective way of protecting such jobs. According to the DTI study on trade published in 2004, since 1997 UK employment in textiles manufacturing has fallen by 45%, in clothing manufacture by nearly 60%, and in footwear manufacturing by around 50% - and this despite the protection afforded to European Union textile manufacturers. The cost of protecting each job runs into hundreds of thousands of Euros for the EU as a whole. Might that money have been spent more productively in other ways? Often there is a huge opportunity cost involved in imposing import tariffs. Trade wars: There is the danger that one country imposing import controls will lead to “retaliatory action” by another leading to a decrease in the volume of world trade. Retaliatory actions increase the costs of importing new technologies Negative multiplier effects: If one country imposes trade restrictions on another, the resultant decrease in total trade will have a negative multiplier effect affecting many more countries because exports are an injection of demand into the global circular flow of income. The negative multiplier effects are more pronounced when trade disputes boil over and lead to retaliation. diagram below shows the welfare consequences of imposing an import tariff
In a new study of the benefits of global trade and investment published in May 2004, the UK Department of Trade of Industry outlined their opposition to import controls (protectionism) Higher taxes and higher prices Protectionism imposes a double burden on tax payers and consumers. In the case of European agriculture, the cost to tax payers is about €50 billion a year, plus around €50 billion a year to consumers via artificially high food prices – together the equivalent of over £800 a year on the annual food budget of an average family of four. Furthermore huge distortions in international agriculture markets prevent the world’s poorest countries from trading in the products they are best able to produce. Continuing barriers to trade are costing the global economy around $500 billion a year in lost income. Protectionist policies rarely achieve their aims. They can be costly to administer and they nearly always provide domestic suppliers with a protectionist shield that encourages inefficiencies leading to higher costs. Protectionism is a ‘second best’ approach to correcting for a country’s balance of payments problem or the fear of rising structural unemployment. And import controls go against the principles of free trade enshrined in the theories of comparative advantage. In this sense, import controls can be seen as examples of government failure arising from intervention in markets.
56 Economic nationalism Economic nationalism is a term that has become used more frequently in recent years. It is used to describe policies which are guided by the idea of protecting a country's home economy, i.e. protecting domestic consumption, jobs and investment, even if this requires the imposition of tariffs and other restrictions on the movement of labour, goods and capital. Economic nationalism may include such doctrines as protectionism and import substitution. Examples of economic nationalism include China's controlled exchange of the yuan, and the United States' use of tariffs to protect domestic steel production. The term gained a more specific meaning in 2005 and 2006 after several European Union governments intervened to prevent takeovers of domestic firms by foreign companies. In some cases, the national governments also endorsed counter-bids from compatriot companies to create 'national champions'. Such cases included the proposed takeover of Arcelor (Luxembourg) by Mittal Steel (India). And the French government listing of the food and drinks business Danone (France) as a 'strategic industry' to pre-empt a potential takeover bid by PepsiCo (USA). Sample IGCSE Questions 1. When the exchange rate of a currency depreciates, the balance of trade improves. Do you agree with this statement? Give reasons for your answer. (6) Depreciation is referred to as the decrease in the value of currency relative to another country. It is often linked with the balance of trade, the amount of exports subtracted by the amount of imports. When the balance of the trade improves, this means the value of exports is greater than the value of imports; a trade surplus. This means that the value of exports is cheaper overseas so people are able to buy more of the country’s exports so demand for the good increases and thus they would have higher purc hasing power to buy your good. This causes the country to export more. Another reason is that because of depreciation, imports become more expensive so demand for imports decreases as prices for imports rise. However, exports may not rise if another country has depreciated its currency even further or produced that good at a lower cost. Exports may not even increase if there are a lot of substitutes for the good, such as coffee beans. If the exports are inelastic, there is little change in quantity demanded. Countries like Hong Kong are dependent on food and oil, they are forced to pay a higher price and quantity demanded will not fall too much. In general, currency depreciation should improve the balance of trade. 2. Apart from depreciation of the currency, identify and briefly explain two measures that a government may use to increase exports. (4) a. Demand-side policy promotion of products made in the country, for example, The British Council has an annual trade fair on British goods to attract more buyers. Similarly, for Hong Kong, it is the Hong Kong Trade and Development Council (HKTDC). b. Supply-side policy Subsidies to export companies to lower production cost and increase supply. For example, China’s subsidies to solar panel producers. 3. To what extent is international borrowing by a developing country likely to lead to an increase in the standard of living? Give reasons for your answer. (6) International borrowing is when countries or government borrowing money from banks overseas. Standard of living is the welfare of individuals. One example of international borrowing is when the Chinese government borrowed from the International Monetary Fund (IMF) to build the Three Gorges Dam. By building this dam, it allows people in China to have access to clean water which reduces cholera and other water-borne diseases outbreaks and increases their health. Another added benefit of building this dam is
57 that it is a hydroelectric plant and produces a large supply of electricity to power businesses and therefore increase productivity. Irrigation can also be provided by the dam to improve the marginal agricultural areas. Thus, farmers in these areas can produce more agricultural products and increase their standard of living. Another important benefit is that by building this dam, it creates jobs for construction workers as well as engineers, architects and many others. However, international borrowing results in high interest rates and in the long-term, debt. The disadvantage of building a dam is that the surrounding wildlife and habitat will be destroyed and some people will be relocated and thus, this will decrease their standard of living. In conclusion, for the majority of the people, the standard of living will increases due to international borrowing. 4. How does combatting inflation affect the exchange rates? (6) Raising benchmark interest rates is the preferred plan of action when it comes to the central bank's fight against inflation. It's the easiest and simplest strategy, and the results can sometimes be quicker compared to other methods. All a monetary body does, in this instance, is increase the benchmark that most commercial and retail banks refer to when creating client loans. These products include mortgage, student and car loans, along with commercial loans for businesses. Once these rates rise, the cost of money increases. This isn't a good thing for customers or companies. (For more on the relationship between interest rates and inflation. Global investors constantly search for high interest rate returns combined with relatively low risk. The same goes for foreign exchange investors. So, when a central bank elects to raise rates, you can be sure that demand for that currency will rise. For example, the Australian dollar benefited from this phenomenon beginning in June 2010. The central bank of Australia raised rates several times between late 2009 and early 2011. By January 2011, the Australian dollar had risen by 26% compared to the U.S. dollar in response As the Australian economy rebounded quickly amid a slumping global economy, the country's central bank was forced to raise rates more than once – by 25 basis points each time – in order to fight inflation. The decisions led to higher demand for the Aussie, especially against the U.S. dollar, during that time. An equally effective strategy for central banks is to raise the reserve requirements of banking institutions. When a central bank elects to raise the reserve requirements, is limiting the amount of money or cash in the system - referred to as the monetary base. An increase in the reserve requirement increases the minimum cash reserve that a commercial bank is governed to hold, so this adjustment prevents the bank from lending out that cash. This restriction of money will slow the rise in prices as there will be less money chasing the same expensively priced goods (hopefully suppressing demand). The Chinese government favors this policy due to its own semi-fixed currency policy. Since the beginning of 2011, the People's Bank of China has elected to raise the reserve requirement three times – increasing the rate by 50 basis points each time. The decision to raise reserve requirements should eventually slow down the inflation of a nation's currency. More often than not, such a decision also helps to fuel the foreign exchange rate's upward trend in value due to speculators. So, the central bank's decision holds significance for the foreign exchange investor. By increasing the reserve requirement, the central bank is acknowledging that inflation is a problem and is aggressively dealing with it. However, this could increase a currency's attractiveness to forex investors, as they anticipate another round of reserve requirement increases. As the supply of money thins - a result of higher reserves held by banks - speculation helps to support and even propagate a higher currency valuation (thus lowering inflation). Referring back to the Chinese yuan, the effects of speculative demand are apparent: The currency gained by almost 4% following a series of reserve rate increases from June 2010 to January 2011, as speculators anticipated further reserve quota increases for Chinese domestic banks.
58 5. Changes in rate of exchange meant that exports of good from Egypt decreased a they became more expensive in other countries a. Explain what is meant by a rate of exchange. (3) A rate of exchange is the rate at which one currency can be exchanged for another on the global foreign exchange market. It is therefore the market price of one currency in terms of another currency, for example, the price of euros in terms of US dollars b. If exports from Egypt become more expensive, how might that affect production and employment both in Egypt and in countries importing Egyptian goods? (7) If exports from Egypt become more expensive, global demand for them is likely to fall. Unless global demand is price inelastic this will lose revenue and their profits will fall. In response, exporters may cut back their production and reduce their employment of labour. If exports are a major source of revenue for Egypt, this could result in a significant loss of income and high unemployment. In the country importing Egyptian goods there could be inflation, especially if the Egyptian goods make up a significant proportion of total imports and are used by firms in the production of other goods and services. However, consumers in this country may be able to buy similar products from domestic producers instead. Domestic firms are likely to respond by increasing their output and demand for labour rise. However, if consumers also switch some of their demand to other imported goods from other countries then the potential for growth and employment in their country will be reduced. c. Describe the structure of balance of payments on current account of a country (4) The balance of payments of a country records international transactions with other countries. The current account within the balance of payments records payments made to other countries for visible and invisible imports and payments received from overseas from the sale of visible and invisible exports. The balance of trade is therefore the difference between the value of goods exported and the value of goods imported by a country. The balance of invisibles is the difference between the value of services purchased by overseas firms and residents and the value of services purchased from by domestic firms and residents. The current account also records income flows into and out of a country including wages earned by residents working overseas or paid out to migrant workers from overseas, and any international payments of interest, profits and dividends. It also records current transfers including payments of taxes and excise duties by visiting residents of other countries, or similar payments mad overseas. d. Discuss what might lead to an improvement in the current account of a country (6)