Economics Revision

Chapter 9: Macroeconomic Performance

Real GDP growth

Inflation

Unemployment

A measure of the total output expenditure or income

of an economy after adjusting for changes in the price
level. The growth of real GDP is the % change in
output during a particular time period, often measured
over a year
The sustained increase in the general level of prices,
measured in the UK by changes in the cost of a basket
of goods & services bought by a typical household
(consumer price index or CPI) weighted according to
the expenditure on each item in the basket
Age arises when someone is out of work and actively
seeking employment. Measured as the total number of
people unemployed or as a % of the workforce

Balance of payments

Records money flows into and out of a country over a

period of time

Current Account

Includes money glows due to trade (the trade balance

broken down to trade in goods and services)
transfers of interest, profit and dividends (the
investment income balance) and transfers of money
by Gov. and international organisations (the transfers
balance)
A measure of the material well-being of a nations and
its people

Standard of Living
Short-run economic
growth

The actual annual % increase in an economys output,

sometimes referred to as actual economic growth

Long-run economic
growth

The rate at which the economys potential output

could grow as a result of changes in the economys
capacity to produce goods and services, sometimes
referred to as potential economic growth
The difference between the actual and potential
output of an economy. It is common practice to refer
to a situation where actual output is below potential
output as a negative output gap. A positive output gap
occurs when, in the short term actual output exceeds
the economys potential output
Exists when forms in the economy are capable of
producing more output than they are actually
producing

Output Gap

Spare capacity
Trend rate of growth

This refers to the average sustainable rate of

economic growth in an economy. For example in the
UK this is about 2.5%.

Short-run aggregate
supply

Shows the level of production for the economy sat a

given price level, assuming labour costs & other factor
input costs are unchanged

Economic cycle

Fluctuations in the level of economic activity as

measured by GDP. Typically there are four stages in
the cycle: recession, recovery, boom & slowdown

Human capital

The knowledge & skills of the labour force

Marginal propensity to
save (MPS)

The proportion of additional national income that is

saved
Change in savings /change in national income

Marginal propensity to
tax (MPT)

The proportion of additional national income that is

taxed
Change in taxation /change in national income

Marginal propensity to
import (MPM)

The proportion of additional national income that is

spent on income
Change in imports /change in national income

Accelerator

The theory of investment that states that the level of

investment depends on the rate of change of national
income

Stocks

The amount of finished goods that firms hold in order

to be able to satisfy increases in demand

Long-run aggregate
supply (LRAS) Curve

The relationship between total supply & the price level

in the long run. The LRAS curve represents the
maximum possible output for the whole economy its
potential output
Economists who believe that markets will clear that
prices & quantities adjust to changes in the forces of
supply & demand so that the economy produces its
potential output in the long run
Economists who believe that market failures will result
in price & quantity rigitied such that the economys
equilibrium output in the long run may be less that its
potential output
All those people of working age who are in
employment or actively seeking work

Classical Economists

Keynesian economists

Labour force
Labour force participation
rate

A measure of the proportion of the population able to

work who are in employment or are actively seeking
work

Capital output ratio

The amount of capital needed to generate each unit of

output

Capital account of the

balance of payments

The section of the balance of payments that records

long-term flow of capital into and out of an economy. It
records purchases & sales of assets & is split into 2
sections, long-term capital flows & short-term capital

flows

Long-term capital flows

Short-term capital flows

Public sector net cash
requirement (PSNCR)

Automatic stabilisers

Economic stability

Crowding out

Flows of money used for investment in assets e.g.

direct investment by a company in setting up
production facilities or portfolio investment through
buying shares in companies
Flows of money that occur to take advantage of
differences in countries interest rates & changes in
exchange rates; sometimes referred to as hot money
The difference between the spending of general Gov.
(central & local Gov.)& their revenue. If expenditure
exceeds revenue, there is a budget deficit. If
expenditure is smaller than revenue, there is a budget
surplus. A budget deficit requires Gov. to borrow
money to make up the shortfall of revenue over
planned expenditure
Changes in Gov. expenditure & taxation receipts that
take place automatically in response to the economic
cycle. E.g. expenditure on unemployment benefits
rises during the recession phase of the business cycle
The avoidance of volatility in economic growth rates,
inflation, employment & unemployment & exchange
rates, in order to reduce uncertainty & promote
business & consumer confidence & investment
When government borrowing reduces the funds
available for private sector investment or raises the
cost of investment by raising market interest rates

Cyclical deficit

A budget deficit that arises because of the operation

of automatic stabilisers

Golden rule

A commitment by the UK Gov. that, over the economic

cycle, it will borrow only to invest & not for current
expenditure

Credibility (principle of
fiscal policy)

A credible fiscal policy framework is one where the

governments commitment to economic stability is
trusted by the public, business & financial markets

Flexibility

A flexibly fiscal policy frame work is one that has the

flexibility to deal with macroeconomic shock, such as
sudden & unexpected changes in AD &/or AS

Legitimacy

One that has widespread support & about which there

is general agreement among the public, business &
politicians

Stability & Growth Pact

(SGP)

An agreement by members of the EU about the way in

which fiscal policy should be conducted to support
Europes single currency. It requires those countries
adopting Europes single currency to abide by the
following rules
- A budget deficit of 3% of GDP or less
- A Gov. debt of 60% of GDP or less

Monetary transmission
mechanism

The way in which monetary policy affects the inflation

rate through the impact it has on other
macroeconomic variables

Price stability

When the general price level does not change or if it

does, the rate of change is low enough not to
significantly affect the decisions of firms & households

Purchasing power of
money

What a unit of currency will but in terms of goods &

services

Signalling function

Changes in demand & supply of goods & services are

signalled to producers & consumers through changes
in absolute & relative price levels

Operational independence When a central bank is given responsibility for the

conduct of monetary policy independent of political

interference. The target for inflation, however, is
normally set by Gov.

Symmetric inflation target When deviations above & below the target are given
equal weight in the inflation target

Asymmetric inflation
target

When deviations below the inflation target are seen to

be less important that deviations above the target

International
competitiveness

The ability of an econ omys firms to compete in

international markets &b, thereby, sustain increases in
national output & income

Unit labour costs

The average cost of labour per unit of output or the

total labour/total output
UCL =
wage costs + non-wage costs
Output per worker (labour productivity)

Relative labour costs

The costs of labour per unit of output of one country

relative to its major trading partners

Market failure

Occurs when market imperfections lead to an

allocation of resources, which is less efficient than it
might be. So, it is essentially the inefficient allocation
of resources of the market mechanism which is used in
the allocation process

Allocative Efficiency

Occurs when the value of consumers place on a

good equals the cost of resources used up in
production
Marginal social benefits = marginal social cost

Key

macroeconomic policy objectives:

A steady & sustainable rate of economic growth
Low unemployment/ Full employment
Low rate of inflation/ Price stability
A satisfactory balance of payments position
A satisfactory budget position (fiscal)
An equitable redistribution of income
Elimination of child poverty
Improved productivity & international competitiveness

Monetary Policy issues

Monetary policy can promote stability & growth in several ways:
Changes in interest rates impact on domestic demand, through
C&I
Net external demand, through exchange rate
The way it does this is through the Monetary Transmission
Mechanism
- Rapid economic growth & accelerating inflation can be
dampened by increases in interest rates
- An economic slowdown and falling rats of inflation can be
tackled with reductions in interest rates
- Monetary policy used to manage the economic cycle and to
smooth out the fluctuations in short-run economic growth that
bring with them instability in other key performance indicators
- Monetary policy could in principle be used to manage AD
Primary objective of monetary policy
Deliver price stability low & stable rates of inflation provide a
framework for economic stability
Inflation erodes the purchasing power of money in doing so,
damages the heart of any economic system

Benefits of Inflation targeting

Transparency & accountability

o Makes the conduct of monetary policy conduct clear.
o Commitment to price stability that is communicated to
firms and households
o The quarterly Bank of England Inflation Report is a highly
detailed assessment of economic trends and the Bank's
best guess about future movements in inflation
Expectations
o It can reduce inflationary expectations if people believe a
low inflation target will be met.
o This will then reflect in the wage demands of people in
work. If employees expect low inflation they may be
prepared to accept a slower growth of pay.
o This reduces the risk of cost-push inflation in the economy.
Flexibility
5

o Symmetric inflation targets gives as much weight to low

inflation as well as high inflation
o There is flexibility contribute to economic stability
Higher levels of capital investment
o In both manufacturing and service industries.
o This is because businesses will not demand such high
nominal rates of return on potential investment projects if
they believe that inflation will remain low and stable.

Disadvantages of inflation targeting

-

Whether it promotes economic stability, growth and

international competitiveness depends mainly, on the C.B.
bringing credibility to the target
To be credible C.B. has to build up a reputation for meeting its
target
In the short run, this can lead to C.B. trading off low economic
growth for low inflation
C.B needs to be good at forecasting inflation Monetary policy
works with time lags 2 years

Quantitative Easing

The Central bank undertakes to buy various assets - commercial

and government bonds from banks. To buy these bonds the
Central Bank issues Central Bank reserves. This is effectively
creating money through electronic means
Banks gain an increase in liquidity because they sell assets for
cash. This increase in banks balance sheets should hopefully
encourage them to lend more.
By buying assets and government bonds. The price of bonds
rises causing interest rates on bonds to fall. These lower rates
should help boost spending
Advantages:
-

Inflation raises the paper value of assets, such as real estate,

stocks, etc. An argument could be made that the current rally in
the stock market we've been witnessing is at least partially
fueled by the Fed's inflation of the money supply.
Adding new money into circulation could potentially provide a
short term boost to the economy, thus providing a generally
positive lift to economic activity as a whole, and hence
benefitting you indirectly.

Disadvantages:
-

Increases the money supply, diluting the value of all currency

over the mid- to long-term. This reduces your individual
purchasing power. Over extended periods of time wage
levels have fallen behind inflation levels, thus resulting
6

in a declining standard of living.

Inflation - When economy recovers it might be difficult to take
out the excess money supply causing uncontrollable inflation.
Increased Treasury bond purchasing by the Fed drives down
interest rates, thus punishing savers and rewarding spenders.
An argument exists that we need more saving and less
consumption in order to restore economic fundamentals, but
this quantitative easing policy works against that premise.
Rising value of paper assets creates an incorrect perception
amongst investors that they're wealthier than they really are,
and can distort spending and savings habits.
Continued quantitative easing degrades confidence in currency,
since it becomes weaker over time. Consumers of our debt
(particularly foreign countries like China) become less willing to
purchase that debt, thus denying financing to our government
(i.e., the government has less money to spend).

Economic stability
-

In recent years attention has switched to economic stability as

an objective of macroeconomic policy
- Instability in any of the key performance indicators creates
uncertainty, which damages long-term economic performance
Government aim for macroeconomic stability this means that
the economy is not vulnerable to significant fluctuations in:
Economic growth
Inflation
Unemployment
Macroeconomic policies to promote stability and growth have
focused on:
A prudent approach to management of the economy
Taking fiscal & monetary policy decisions on the basis of the
long-term interests of the economy rather than short term
political considerations
Ensuring that fiscal and monetary policies support each other
Bringing openness and transparency to decision making through
putting in place rules and targets
Improving the supply-side performance of the economy

The multiplier, the accelerator and their interaction

The process by which any change in a component of AD results in a
greater final change in GDP
- When spending rises, its impact on national income is multiplied
beyond the initial increase in spending
- The size of the multiplier is determined by the size of the
leakages from the circular flow of income
- Visualised using the circular flow of income diagram

The proportion of additional national income that goes to

leakages is known as the marginal propensity to withdraw
(MPW) and is made up of
o The marginal propensity to save
o The marginal propensity to tax
o The marginal propensity to import

K (the multiplier) =
1
Marginal propensity to withdraw
-

Any change in expenditure in the national economy will cause

national income to be amplified (or multiplied)
The concept of the accelerator a theory of investment that
relates the total level of investment to the rate of change of
national income
Investment is needed for 1. Replace the capital stock that is
wearing out
2. To provide new capital stock and give additional productive
capacity meet rising demand
When the economy is in recession no need for firms to
undertake investment to raise productive capacity demand for
output is falling

Supply side policy issues

-

Aim to increase AS in order to increase the economys

productive capacity thereby:
Lower Inflation.
- Shifting AS to the right will cause a lower price level. By making
the economy more efficient supply side policies will help reduce
cost push inflation.
Lower Unemployment
- Supply side policies can help reduce structural, frictional and
real wage unemployment and therefore help reduce the natural
rate of unemployment.
Improved economic growth
- Supply side policies will increase the sustainable rate of
economic growth by increasing AS.
Improved trade and Balance of Payments.
- By making firms more productive and competitive they will be
able to export more. This is important in light of the increased
competition from S.E. Asia.
However there is little use expanding the productive capacity of
the economy, improving incentives, making markets work more
efficiently through deregulation or raising productivity if there is
insufficient demand in the economy.
Supply-side policies are increasingly important to deliver improved
macroeconomic performance in the long run & to improve
international competitiveness

Causes of Inflation
Demand Pull Inflation AD increasing at a faster rate than AS
Consumption rising more rapidly than productive capacity

A large outward shift in AD takes the equilibrium level of national

output beyond full capacity national income creating a positive output
gap. This would then put upward pressure on wage & raw material
costs.

Main causes of demand-pull inflation

1) A depreciation of the exchange rate: increases the price of
imports & reduces the foreign price of UK exports. If consumers
buy fewer imports, while exports grow, AD will rise & there may
be a multiplier effect on the level of demand & output
2) Higher demand from a fiscal stimulus: e.g. a reduction in
direct or indirect taxation or higher Gov. spending. If direct taxes
are reduced, consumers will have more disposable income
causing demand to rise. Higher gov. spending & increased Gov.
borrowing feeds directly into extra demand in the circular flow of
income.
3) Monetary stimulus to the economy: a fall in interest rates
may stimulate too much demand e.g. raising demand for loans
or in causing a sharp rise in house price inflation.
4) Faster economic growth in other countries: providing a
bosst to UK exports overseas. Export sales provide an extra flow
of income & spending into the UK circular flow.

Cost-push Inflation
If there is an increase in the costs of firms then firms will pass this on
to consumers therefore there will be a shift to the left in the AS

Main causes of Cost-push inflation

1) Component costs e.g. an increase in the prices of raw
materials & other components used in the production process of
different industries. This might be because of a rise in world
commodity prices such as oil, copper, and agriculture.
2) Wage Push Inflation Trades unions can bargain for higher
wages, this will lead to an increase in costs for firms If wage
increases more than productivity. It may also cause demand-pull
inflation as consumers spend more. Wage cots often rise when
unemployment is low & also when people expect higher inflation
so they bid for higher pay in order to protect their real incomes.
3) Higher indirect taxes imposed by the government e.g. a
rise in the specific duty on alcohol & cigarettes and an increase
in fuel duties. Depending on the price elasticity of demand &
supply for their products, suppliers may choose to pass on the
burden of the tax onto consumers.

Stagflation & Inflation

Stagflation: is a term used to describe a combination of low

growth, high unemployment AND high inflation.
With high unemployment, consumers have less money to spend.
Add inflation, and the money they do have is worth less and less
every day.
Stagflation is often caused by a supply side shock. For example,
rising commodity prices, such as oil prices, will cause a rise in
business costs and SRAS shifts left/ upwards. This causes a
higher inflation rate and lower GDP.

How to Solve Stagflation?

1) Use monetary policy, higher interest rates to reduce inflation

but, it will cause a bigger fall in GDP.
2) Use monetary policy to increase GDP, but could make inflation
worse. Therefore demand side policies cannot solve stagflation
they can only solve one particular aspect.
The only solution to stagflation is to increase AS through
supply side policies. However, these will take a long time.
Also if the cost push inflation occurs because of a global

10

increase in the price of oil and food, there is little that the
UK government can do about it.
However, often cost push inflation is a temporary affair
e.g. rising energy prices may not continue for ever
(hopefully)

International Competitiveness

International Competitiveness: Means your exports are attractive

to foreigners. You will then have more exports then imports. The
ability for a nation to sell its goods or services to domestic and
international markets.
Measures of international competitiveness
Relative unit labour costs relative to other competing nations,
low costs lead to exports being cheaper and therefore demand
for them will increase.

Composite indices Global competitive index Takes a range of

factors weighs and ranks them. E.g. Education, infrastructure,
health.

Relative productivity measures Relative productivity measures,

relative to productivity per worker per hour worked compared to
other nations. Therefore more produced which will lead to lower
unit costs and lower prices.

Other national factors Level of education, leadership, openness

to trade. Only relevant to that country, therefore difficult to form
any kind of comparison.

Real Exchange ((Nominal rate) x (ratio of UK to foreign prices))

Number of units of foreign currency that can be obtained for a .
Accurately compare UK prices to foreign prices.

Factors Influencing Competitiveness

Real Exchange Rate
How it affects competitiveness:
1 One of the most important factors is a countrys real exchange
rate, which is the nominal exchange rate adjusted for changes in
price levels between economies:
Real exchange rate = nominal exchange rate x

foreign price level

Domestic price level

11

If the nominal exchange rate falls or if the prices of goods

abroad rise relative to the country in question, then there will be
a depreciation in the real exchange rate.
A fall in the real exchange rate will cause an increase in the
competitiveness of a countrys goods, and exports will increase
relative to imports.
In contrast, the real exchange rate will rise if the nominal
exchange rate rises, or if the UK price level rises relative to the
foreign price level.
This appreciation will lead to a fall in the countrys
competitiveness.

Wage and Non-Wage Costs

Wage costs are the most significant cost of production for many
industries. Therefore, if wages are higher in the UK than in China, it is
likely that the prices of the goods in the UK will be higher than those
of China if productivity is ignored.
Non-wage costs are also significant for international competitiveness.
These include:
National insurance contributions paid by employers.
Health and safety regulations.
Environmental regulations.
Employment protection and anti-discrimination laws.
Contributions into company pension schemes.
These non-wage costs are frequently much higher in developed
countries than in developing countries and so have the effect of
reducing the international competitiveness of goods and services from
developed countries.

Regulation
Increases in regulation of industry tend to increase costs of production
for firms. For example, UK firms tend to have lower costs than firms in
France and Germany because regulation is lighter in the UK. Hence
less regulation is likely to increase international competitiveness.
Privatisation and deregulation may lead to decreases in Xinefficiencies and lower costs for producers, therefore increasing
competitiveness, if there is a subsequent decrease in prices.

Productivity

12

Productivity: a measure of productive efficiency, for example labour

productivity.
Labour productivity: output per worker per hour worked.
Rises in the UKs productivity relative to her main trading partners will
increase the UKs competitiveness. In turn this is influenced by:
Education and training: which affects the level of:
Human capital: defined as the knowledge and skills of the
workforce and by
The amount and quality of capital equipment per worker
Research and development: in turn, this might lead to
technological advances which may have dramatic effects of
productivity and competitiveness
Infrastructure: of the country (e.g. roads, railways,
telecommunications, power generating stations and water
supply)
Labour market flexibility: this is affected by factors such as
the ease of hiring and firing workers, willingness of workers to
work part-time or on flexible contracts and the strength of trade
unions

Government Policy
Supply side policies will increase international competitiveness. For
example, improvements in education and training will in the long-term
lead to higher labour productivity. Tax incentives on investment will
lead to more capital-intensive production, which should reduce costs.

Deregulation and Privatisation

Privatisation leads to productivity improvements by reducing Xinefficiency, and can therefore improve the international
competitiveness of a countrys goods.
Deregulation can encourage competitiveness, as it reduces costs and
bureaucracy for producers.

Labour market flexibility

One of the most important policy areas as far as trade and
competitiveness is concerned has been the increased flexibility in
labour markets. This is achieved partly through supply-side policy.
Trade Union Reforms:
1. Introduced by the Thatcher governments during the 1980s.
2. Enabled firms to adopt more flexible working practices.
3. Enabled labour markets to adjust more easily to changes in the
pattern of consumer demand and in the UKs comparative
advantage.

13

Training and education:

4. Increased the skill levels of the labour force.
5. This has improved productivity directly and also encouraged the
growth of economic activities requiring higher skills levels.
6. This has improved British industry and service activity, and
enabled firms to take advantage of new trading opportunities.
7. The EU single market has encouraged British firms to compete
within Europe, where labour markets tend to be less flexible.
8. In this way, the UK has been able to maintain a competitive
edge.
This has also increased the attractiveness of the UK as a destination
for FDI, since foreign multinationals value these characteristics.

Exchange rate policies

The UK government through the Bank of England does not manipulate
the exchange rate to influence international competitiveness.
However, many countries do intervene in foreign currency markets to
aid exporters. The most important example today is China where the
central bank deliberately keeps the Chinese currency (Yuan/Remnimbi)
at an artificially low value to increase the export competiveness of
Chinese industry.

Control of inflation and macroeconomic stability

Countries which fail to control inflation tend to lose international
competitiveness. High inflation leads to rising export prices.
It also leads to further inflation, as workers demand high wage
increases to compensate them for their loss of earning power. Control
of inflation is part of the broader issue of macroeconomic
management.
A stable macroeconomic environment encourages firms to invest and
innovate which will help export performance.

14

Chapter 10: Trade & Integration

World Trade Organisation

Absolute advantage

Reciprocal absolute
advantage
Comparative advantage
Relative opportunity cost
Terms of trade

Trading possibility curve

(TPC)

Factor endowments

Factor intensities
Labour-intensive
production
Capital-intensive
production
Heckscher-Ohlin theory of
international trade

An international body responsible for

negotiating trade agreements & policing the
rules of trade to which its members sign up.
Trade disputes between members are settled by
the WTO
Where one country is able to produce more of a
good or service with the same amount of
resources, such that the unit cost of production
is lower
Where, in a theoretical world of 2 countries & 2
products, each country has an absolute
advantage in one of the 2 products
Where 1 country produces a good or service at a
lower relative opportunity cost than others
The cost of production of one good or service in
terms of the sacrificed output of another good
or service in 1 country relative to another
The price of a countrys exports relative to the
price of its imports. The terms of trade can be
measured using the formula:
Terms of trade=
Index of average export prices
Index of average import prices
*100
A representation of all the combinations of 2
products that a country can consume if it
engages in international trade. The TPC lies
outside the production possibility curve (PPC),
showing the gains in consumption possible from
international trade
The mix of land, labour & capital that a country
possesses. Factor endowments can be
determined by, among other things, geography,
historical legacy & economic & social
development
The balance between land, labour & capital
required in the production of a good or service
Any production process that involves a large
amount of labour relative to other factors of
production
Where the production of a good or services
requires a large amount of capital relative to
other factors of production
A theory that a country will export products
produced using factors of production that are
abundant and import products whose production
requires the use of scares factors

15

Infant industries

Profit margin
Dynamic efficiencies

Knowledge & technology

transfer
Licensing arrangements
Regional trading bloc

Primary commodities
Prebisch-Singer
hypothesis

Developed economies
Developing economies

Liberalisation

Transition economies
Intra-regional trade
Inter-industry trade
Intra-industry trade

Industries in an economy that are relatively new

and lack th4e economies of scale that would
allow them to compete in international markets
against more established competitors
The difference between a firms revenue and
costs expressed as a % of revenue
Efficiencies that occur over time. Int. trade can
lead to changes in behaviour over a period of
time that can increase productive and allocative
efficiencies
The process by which knowledge and
technology developed in one country is
transferred to another, often through licensing
and franchising
An agreement that ideas and technology
owned by one company can be used by
another, often for a charge
Countries in a region that have formed an
economic club based on abolishing tariffs and
non-tarrif barriers e.g. the EU, the North
American Free Trade Area (NAFTA) and the
Association of South East Asian Nations (ASEAN)
Goods produced in the primary sector of the
economy, such as coffee and tin
The argument that countries exporting primary
commodities will face declining terms of trade in
the long run, which will trap them in a low level
of development as more and more exports will
need to be sold to pay for the same volume of
imports of secondary sector or capital goods
Countries with a high level of income per capita
and diversified industrial and tertiary sectors of
the economy e.g. USA, UK, Japan & South Korea
Countries with relatively low income per capita,
an economy in which the industrial sector is
small or undeveloped and where primary sector
production is a relatively large part of total GDP
Reductions in the barriers to international trade,
in order to allow foreign firms to gain access to
the market for goods and services that are
traded internationally
Economies in the process of changing from
central planning to the free market
Trade between countries in the same
geographical area e.g. trade between the UK &
Germany or the USA & Canada
Trade involving the exchange of goods and
services produced by different industries
Trade involving the exchange of goods and
16

Freely floating exchange

rate
Fixed exchange rate
Semi-fixed/semi-floating
exchange rate
Foreign exchange
(FOREX) market
Short-term capital flows

Long-term capital
transactions
External economic shocks

Purchasing power parity

(PPP)

j-curve effect

Marshall-Lerner condition

Hedging
Future markets

services produced by the same industry

A system whereby the price of one currency
expressed in terms of another is determined by
the forces of demand and supply
An exchange rate system in which the value of
one currency has a fixed value against other
currencies. This is often set by the government
Exchange rate system that allows a currencys
value to fluctuate within a permitted band of
fluctuation
A term used to describe the coming together of
buyers and sellers of currency
Flows of money in and out of a country in the
form of bank deposits. Short term capital flows
are highly volatile and exist to take advantage
of changes in relative interest rates
Flows of money related to buying and selling of
assets, such as land or property or production
facilities (direct investment) or shares in
company (portfolio investment)
Unexpected events coming from outside the
economy that cause unpredicted changes in AS
or AD. E.g. might include rapid rises in oil prices
or a global slowdown
The exchange rate that equalises the price of a
basket of identical traded goods & services in 2
different countries. The PPP is an attempt to
measure the true value of a currency in terms of
the goods and services it will buy
Shows the trend in a countrys balance of trade
following a depreciation of the exchange rate. A
fall in the exchange rate causes an initial
worsening of the balance of trade, as higher
import prices raise the value of imports and
lower export prices reduce the value of exports
due to short-run price inelasticity of demand for
imports and exports. Eventually the trade
balance improves. An appreciation of the
currency causes an inverted j-curve effect.
States that for a depreciation of the currency to
improve the balance of trade the sum of the
price elasticities of demand (PEDs) for imports
and exports must be greater than 1
Business strategy that limits the risk that losses
are made from changes in the price of
currencies or commodities
Markets where people and businesses can buy &
sell contracts to buy commodities or currencies
at fixed price at a fixed date in the future
17

Foreign currency reserves Foreign currencies held by central banks in

Bilateral exchange rate
Effective exchange rate

Single currency
Euro area, Eurozone
Expenditure-switching
policies

Expenditure-reducing
policies
Economic integration
Non-tariff barriers (NTBs)
Trade deflection

Free trade area

Customs union

Single market

Economic union
Monetary union
Single European Market

order to enable intervention in the FOREX

markets to affect the countrys exchange rate
The exchange of one currency against another
The exchange rate of one currency against a
basket of currencies of other countries, often
weighted according to the amount of trade done
with each country
A currency that is shared by more than one
country. The euro is shared by 15 countries in
the EU
Term to describe the combined economies of
the countries using the euro
Policies that increase the price of imports and/or
reduce the price of exports in order to reduce
the demand for imports and raise the demand
for exports to correct a current account deficit
on the balance of payments
Policies that reduce the overall level of national
income in order to reduce the demand for
imports and correct a current account deficit on
the balance of payments
Refers to the process of blurring the boundaries
thzat separate economic activity in one nation
state from that in another
Things that restrict trade other than tariffs
Where one country in a free trade area imposes
high tariffs on another to reduce imports but the
imports come in from elsewhere in the free
trade area
An agreement between 2 or more countries to
abolish tariffs on trade between them
An agreement between 2 or more countries to
abolish tariffs on trade between them and to
place a common external tariff on trade with
non members
Deepens economic integration from a customs
union by eliminating non-tariff barriers to trade,
promoting the free movement of labour and
capital and agreeing common policies in a
number of areas
Deepens integration in a single market,
centralising economic policy at the
macroeconomic level
The deepest form of integration in which
countries share the same currency and have a
common monetary policy as a result
A process adopted in the EU that promoted the

18

(SEM)
Monetary policy
sovereignty
Trade creation

Trade diversion

Transaction costs
Price transparency
Stability & growth pact
Automatic stabilisers

Fiscal transfers
Economic convergence

Optimal currency area

free movement of goods, services and capital by

harmonising product standards and removing
remaining non tariff barriers to trade
The ability of a country to pursue an
independent monetary policy
Where economic integration results in high-cost
domestic production being replaced by imports
from a more efficient source within the
economically integrated area
Where economic integration results in trade
switching from a low-cost supplier outside the
economically integrated area to a less efficient
source within the area
The costs of trading, which includes costs of
changing currencies
The ability to compare prices of goods &
services in different countries
Limits agreed to public sector borrowing & the
national debt for those EU countries that are
part of the euro area
Elements of fiscal policy that cushion the impact
of the business cycle without any need for
corrective action by the government. E.g. higher
spending on unemployment benefits and
welfare payments & lower taxation receipts
provide an automatic fiscal stimulus in times of
economic slowdown
Occur where taxation raised in one country is
used to fund government expenditure in
another country
The process by which economic conditions in
different countries become similar. Economists
distinguish between monetary convergence
(e.g. similarities in inflation & interest rates) and
real convergence (e.g. similarities in the
structure of economies). Membership of the
euro are only requires monetary convergence to
have taken place
Refers to conditions that need to be met to
avoid the costs of monetary union. These
conditions include: a high degree of labour
market flexibility, mechanisms for fiscal
transfers, & the absence of external shocks that
impact differently on different economies
(asymmetric shocks)

Fixed Exchange Rate

19

Advantages of a fixed exchange rate

Reduced risk in international trade - By maintaining a fixed

rate, buyers and sellers of goods internationally can agree a
price and not be subject to the risk of later changes in the
exchange rate before contracts are settled. The greater
certainty should help encourage investment.

Introduces discipline in economic management - As the

burden or pain of adjustment to equilibrium is thrown onto the
domestic economy then governments have a built-in incentive
not to follow inflationary policies. If they do, then unemployment
and balance of payments problems are certain to result as the
economy becomes uncompetitive.

Fixed rates should eliminate destabilising speculation Speculation flows can be very destabilising for an economy and
the incentive to speculate is very small when the exchange rate
is fixed.

Reduced cost of trade under freely flowing exchange rate

regimes, businesses face a risk that movements of the
exchange rate can undermine the profitability of trade. As an
insurance against movements in the exchange rate, firms
engaging in international trade hedge their risks by buying
currencies in the future markets. Fixed exchange rates reduce
the need for hedging and this lowers the cost of international
trade.

Discipline domestic firms if exchange rate cannot

depreciate, domestic firms will have to make sure that they
match the productivity improvements of their foreign
competitors & do not allow unit labour costs to increase

Disadvantages of the Fixed Exchange Rate

No automatic balance of payments adjustment - A floating

exchange rate should deal with a disequilibrium in the balance
of payments without government interference, and with no
effect on the domestic economy. If there is a deficit then the
currency falls making you competitive again. However, with a
fixed rate, the problem would have to be solved by a reduction
in the level of aggregate demand. As demand drops people
consume less imports and also the price level falls making you
more competitive.

20

Large holdings of foreign exchange reserves required Fixed exchange rates require a government to hold large scale
reserves of foreign currency to maintain the fixed rate - such
reserves have an opportunity cost.

Loss of freedom in your internal policy - The needs of the

exchange rate can dominate policy and this may not be best for
the economy at that point. Interest rates and other policies may
be set for the value of the exchange rate rather than the more
important macro objectives of inflation and unemployment.

Fixed rates are inherently unstable - Countries within a

fixed rate mechanism often follow different economic policies,
the result of which tends to be differing rates of inflation. What
this means is that some countries will have low inflation and be
very competitive and others will have high inflation and not be
very competitive. The uncompetitive countries will be under
severe pressure continually and may, ultimately, have to
devalue. Speculators will know this and thus creates further
pressure on that currency and, in turn, government.

Freely floating exchange rate

The value of the currency is determined by the forces of D & S with no
gov. intervention in the FOREX markets
The D&S of a currency on the FOREX markets is affected by 3 things
1. Trade e.g. UK goods and services sold in the USA create a
demand for the pound, whereas UK spending on imports from
the Eurozone results in pounds being supplied to the FOREX
markets to buy euros
2. Short-term capital flows funds flow in & out of countries in
the form of deposits in bank accounts can be highly volatile &
depend upon actual & expected interest rates & exchange rates
3. Long-term capital transactions flow of money related to
buying and selling of assets, such as land or property or
production facilities (direct investment) or shares in companies
(portfolio investment)

Advantages of a Floating Exchange Rate

Automatic balance of payments adjustment

21

Any balance of payments disequilibrium will tend to be rectified

by a change in the exchange rate. For example, if a country has
a balance of payments deficit then the currency should
depreciate.
This is because imports will be greater than exports meaning
the supply of sterling on the foreign exchanges will be
increasing as importers sell pounds to pay for the imports.
This will drive the value of the pound down.
The effect of the depreciation should be to make your exports
cheaper and imports more expensive, thus increasing demand
for your goods abroad and reducing demand for foreign goods in
your own country, therefore dealing with the balance of
payments problem.
Conversely, a balance of payments surplus should be eliminated
by an appreciation of the currency.

Freeing internal policy

-

With a floating exchange rate, balance of payments

disequilibrium should be rectified by a change in the external
price of the currency.
However, with a fixed rate, curing a deficit could involve a
general deflationary policy resulting in unpleasant
consequences for the whole economy such as unemployment.
The floating rate allows governments freedom to pursue their
own internal policy objectives such as growth and full
employment without external constraints.

Absence of crises
-

Fixed rates are often characterised by crises as pressure mounts

on a currency to devalue or revalue.
The fact that, with a floating rate, such changes are automatic
should remove the element of crisis from international relations.

Flexibility
-

Post-1973 there were great changes in the pattern of world

trade as well as a major change in world economics as a result
of the OPEC oil shock.
A fixed exchange rate would have caused major problems at this
time as some countries would be uncompetitive given their
inflation rate.
The floating rate allows a country to re-adjust more flexibly to
external shocks.

Lower foreign exchange reserves

22

A country with a fixed rate usually has to hold large amounts of

foreign currency in order to prepare for a time when they have
to defend that fixed rate.
These reserves have an opportunity cost.

Disadvantages of the Floating Rate

Uncertainty
-

The fact that a currency changes in value from day to day

introduces instability or uncertainty into trade.
Sellers may be unsure of how much money they will receive
when they sell abroad or what their price actually is abroad.
Of course the rate changing will affect price and thus sales. In a
similar way importers never know how much it is going to cost
them to import a given amount of foreign goods.
This uncertainty can be reduced by hedging the foreign
exchange risk on the forward market.

Lack of investment
-

The uncertainty can lead to a lack of investment internally as

well as from abroad.

Speculation
-

Speculation will tend to be an inherent part of a floating system

and it can be damaging and destabilising for the economy, as
the speculative flows may often differ from the underlying
pattern of trade flows.

Lack of discipline in economic management

-

As inflation is not punished there is a danger that governments

will follow inflationary economic policies that then lead to a level
of inflation that can cause problems for the economy.
The presence of an inflation target should help overcome this.

Does a floating rate automatically remedy a deficit?

-

UK experience indicates that a floating exchange rate probably

does not automatically cure a balance of payments deficit.
Much depends on the price elasticity of demand for imports and
exports.
The Marshall-Lerner condition says that depreciation in the
exchange rate will help improve the balance of payments if the
sum of the price elasticities for imports and exports is greater
than one.

23

Inflation
-

The floating exchange rate can be inflationary.

Apart from not punishing inflationary economies, which, in itself,
encourages inflation, the float can cause inflation by allowing
import prices to rise as the exchange rate falls.
This is, undoubtedly, the case for countries such as UK where we
are dependent on imports of food and raw materials.

Specialisation and Comparative Advantage

Absolute and Comparative Advantage
Absolute advantage
- Where a producer is best able to make the largest amount of a
particular product using fewer factors of production than others.
- Having absolute advantage in production of a product does not
mean that specialisation in it will lead to gains from trade, and a
producer can have absolute advantage in several products.

Country A has absolute advantage in

wheat, it should export wheat & import
electronic goods

Country B has absolute advantage in

Comparative advantage
- Exists where a producer has the lowest opportunity cost (or
highest output per factor of production) for the production of a
particular product.
- If persons or national economies specialise in production of the
good they have a comparative advantage in, all can benefit
from trade.

24

Country A can produce 10 units of financial

services or 10 units of cut flowers
Country B can produce 4 units of financial
services and 8 units of flowers
It is clear that A is more efficient at
producing both goods than B so
why should it trade
The answer lies in their relative opp.
Cost ratio
Ricardos Theory:
-

Comparative advantage can help to explain some of the

patterns of trade.
For example, the UK both imports and exports cars this may be
because British and, say, German cars have different
characteristics, and each country may choose to specialise in
certain segments of the market, taking advantage of the
economies of scale that are crucial in car production.
Consumers benefit from this, as they then have a wider range of
products to choose from.

It can also explain why MNCs may choose to locate certain parts of
their production process in different areas, reflecting the different
comparative advantages of the different countries.
Criticisms of the model:
-

The model assumes that there is a 2 country, 2 good world this

is massively simplistic.
The model assumes that trade occurs on a one-to-one basis
trade may in fact take place at different prices for the goods,
and rich countries may exert their monopsony power to gain
lower prices.
The model assumes that each market is perfectly competitive
in reality, internal protectionism and monopolies ensure that
markets are not.
The model assumes that there is full employment and
geographical mobility within countries.
It also assumes constant opportunity cost along the PPFs
doesnt take into account economies and diseconomies of scale,
for example.
The model is based on unrealistic assumptions such as constant
costs of production, zero transport costs and no barriers to
trade.
Ricardo theorised in the 19th Century, when there were effective
restrictions on people moving their capital overseas this is not
the case today.
25

Some have said that basing production on comparative

advantage would reduce economic diversity significantly,
leaving them vulnerable to changes in the market.

Balance of payments problems

Record of financial transactions between a country and its trading
partners
Causes of Imbalances on the balance of payments
- Imbalances due to current account deficits
- UKs deficit occurs because of a deficit on the balance of trade
in goods
o Occurs when the countrys expenditure abroad exceeds its
revenue from abroad
o Two main reasons why this arises
- Because the countrys inhabitants have spent more on
goods and services from abroad that overseas residents
have spent on the countrys products
- There has been a net outflow of investment income
o Changes in income at home and abroad if incomes a
falling abroad, demand for the countrys exports is likely to fall.
A rise in incomes at home would also contribute to a deficit. This
is because the countrys inhabitants are likely to buy more
products some imports
o Changes in the exchange rate and structural problems a
rise in the exchange rate may also result in a deficit, as it will
raise export prices and lower import prices.
The causes of a surplus on the current account of the balance
of payments
Occurs when a countrys revenue abroad is greater than its
expenditure abroad.
Many occur for 2 reasons
o The countrys revenue from exports exceeding its
expenditure on imports
o The country is a net earner of investment income
Likely to have a surplus if its products are of high quality,
produced at a low cost and reflect what households want to buy
A fall in the exchange rate can also give rise to surplus, because
a reduction in the value of the currency lowers export prices and
raises import prices
The current account in the balance of payments measures the
perfomance of a country in international trade by measuring the value
of money paid for its imports and the value of money received through
exports.
It also includes the income received by people temporarily working
overseas, flows of money in and out of the country for interest
26

payments, profits and dividends as well as Central Government

payments overseas such as foreign aid and contributions to the EU
(known as current transfers)
So, basically the balance on current account can be calculated
by this equation = balance on visible trade + balance on
invisible trade + income + current transfers.
Visible trade is the trade in goods which can be seen like
oil/machinery..
Invisible trade is the trade in services like banking and tourism
The balance on these trades is the difference between the
exports and imports.

Disadvantages of a current account surplus

-

This means that exports are exceeding imports, which suggests

that the value of the pound might be too low as the demand for
exports is high. If the value of the pound is low, it could cause
imported inflation, as imports will appear more expensive, even
if their prices are not increasing.
Exports are injections into the circular flow of income so this will
increase the amount of money in an economy. This might result
in aggregate demand shifting to the right, which will lead to
demand-pull inflation if producers cannot increase their
production at the same rate.
This might lead to a misallocation of resources as too much
might be allocated for exports resulting in less available for the
domestic market.

27

Chapter 11: Development & Sustainability

Poverty

When income is below the level that

would allow someone to enjoy some
agreed minimum standard of living. The
world bank defines extreme poverty as
living on less that $1 per day (at PPP)
and moderate poverty as living on less
than US$2 per day at PPP

Economic development

The process of improving peoples

economic well-being and quality of life
Countries with GDP per capita of $905 or
less
Countries with GDP per capita of $906 $3,595

Low-income countries

Low middle-middle income

countries
Upper middle-middle income Countries with GDP per capita of $3,596
- $11,115
countries
Countries with GDP per capita of
Higher-income countries
High human development
Medium human
development
Low human development
Human development index
(HDI)

Index of sustainable
economic welfare (ISEW)

Environmental Footprint

$11,116 or more
Where the HDI is 0.8 and above
Where the HDI is between 0.5 & 0.8

Where HDI is less that 0.5

A measure that, recognising limitations
of GDP per capita as a measure,
combines outcomes that might be
valued in the development process: life
expectancy at birth; adult literacy &
percentage of the relevant population
enrolled in primary, secondary and
tertiary education; and GDP per capita in
US$ at PPP
An index, first constructed in 1989 by 2
economists, Herman E. Daly and John B.
Cobb, that adds to national expenditure
things that raise the quality of life (ore
well-being) and deducts things that
reduce well being. Daly & Cobb have
added to and refined the measure to
produce a Genuine Progress Indicator
(GDI)
The effect a person, company, activity,
etc. has on the environment e.g. the
amount of natural resources they use
and the amount of harmful gas they
produce
28

Definition of Development
A process resulting in an improvement in peoples well being
Todaros Definition
The process of development must seek to achieve:

An increase in the sustainability & distribution of basic life sustaining

goods

An increase in the standards of living

An expansion of the economic & social choices available to people

Development can, in part, be achieved by economic growth. Increases
in a nations income can enable greater spending on healthcare,
education & the reduction of poverty
Growth: necessary condition of development BUT the wrong kind of
growth can limit or reduce development
E.g. capital-intensive growth does not generate jobs
Increased income for the wealthy widens the gap between rich & poor
Growth through the depletion of national resources
Harms future generation
Pollution created in the creating of economic growth reduces
standards of living
How is development measured?
UN Millennium Development Goals
MD Goals resulted from 2000
meeting

Goal 1: Eradicate extreme hunger and

poverty
Goal 2: Achieve universal primary
education
Goal 3: Promote gender equality and
empower women
Goal 4: Reduce child mortality
Goal 5: Improve maternal health
Goal 6: Combat HIV/AIDS, malaria and
other diseases
Goal 7: Ensure environmental
sustainability

Sustainable development

29

What is sustainability?
The capacity to provide non-declining future welfare
Development is only sustainable if future generations are left with a
stock of capital at least equal to that used to generate todays output

Examples of unsustainable practices

-

Depleting fish stocks

Pollution of air/water
Loss of natural habitat
Loss of farmland
Depletion of non-renewable resources

Measuring sustainable development

Alternatives GNP/GDP have been proposed to take into account sustainable
economic welfare

MEW (1972) was the first measure of Economic welfare

ISEW is the furthest advanced index of sustainable economic

welfare

Criticisms of GNP main: does not take into account:

1. The value of household labour

2. The welfare effects of income inequality
3. The welfare loss due to environmental degration

And considers defensive expenditures wrongly as contributions to

welfare
The ISEW & forerunners aim to provide a remedy for these & other
shortcomings to provide a move reliable monetary indicator of welfare &
sustainability
ISEW makes a subtraction for air pollution caused by economic activity
It makes an addition to count unpaid household labour e.g. cleaning
Also covers income inequality, other environmental damage &
depletion of environmental assets

ISEW is made up of:

ISEW= personal expenditure
+ Public expenditure
+ Value of unpaid work
+ Increase in man made capital
Private defence
- Environmental damage
- Income inequality
- Decrease in natural capital

Criticism of ISEW

ISEW too subjective & too susceptible to changes in the assumption

which underpin it
Lack of agreement on the choice of adjustments made to GDP
30

Choice of weightings is subjective

Difficult to assign a monetary value to some components

Environmental taxation
Summary of the main advantages of environmental taxes
1. They can provide incentives for behaviour that protects or improves
the environment, and deter actions that are damaging to the
environment.
2. Economic instruments such as tax can enable environmental goals to
be achieved at the lowest cost and in the most efficient way
3. By internalising environmental costs into prices, they help to signal
the structural economic changes needed to move to a more sustainable
economy.
4. They can encourage innovation and the development of new
technology
5. The revenue raised by environmental taxes can also be used to
reduce the level of other taxes, which can help to reduce distortions in
the economy, while raising the efficiency with which resources are used.
The Polluter Pays Principle
The main aim of an environmental tax is to increase the firms private
marginal cost (PMC) until it equates with social marginal cost curve
(SMC).
This will result in a socially efficient level of output.
In the diagram below this would mean setting a tax equal to the
vertical distance cd, which is equal to the level of environmental
damage caused at the optimum level of output.

Evaluation: The Problems with Environmental Taxation

Many economists argue that explicit pollution taxes create further
problems, which lead to government failure and little sustainable
improvement in environmental conditions.

31

The main problems are as follows:

1. Assigning the right level of taxation:
There are problems in setting a tax so that the PMC will exactly equate
with the SMC.
The government cannot accurately value the private benefits and cost
of firms let alone put a monetary value on externalities such as the cost
to natural habitat and the value of human life.
Without accurate information setting the tax at the correct level is
virtually impossible.
In reality, therefore, all that governments and regulatory agencies can
hope to achieve is a movement towards the optimum level of output.
2. Consumer welfare effects (issues of equity):
Taxes reduce output and raise prices, and this might have an adverse
effect on consumer welfare.
Producers may be able to pass on the tax to the consumers if the
demand for the good is inelastic and, as result, the tax may only have a
marginal effect in reducing demand and final output
Taxes on some de-merit goods (for example cigarettes) may have a
regressive effect on lower-income consumers and leader to a widening
of inequalities in the distribution of income.
Having said this, it should be possible for authorities to develop
smart tariffs or taxes where account is taken of the economic impact
of pollution taxes on vulnerable households such as low income
consumers
3. Employment and investment consequences:
If pollution taxes are raised in one country, producers may shift
production to countries with lower taxes.
This will not reduce global pollution, and may create problems such as
structural unemployment and a loss of international competitiveness.
Similarly higher taxation might lead to a decline in profits and a fall in
the volume of investment projects that in the long term might have
beneficial spill-over effects in reducing the energy intensity of an
industry or might lead to innovation which enhance the environment.
Eco-tax reformers often argue that the introduction of pollution
taxes should be revenue neutral so for example, an increase in
environmental taxation might be accompanied by reductions in
employment taxes such as national insurance contributions so that the
employment consequences of higher taxation are minimized
4. It might be more cost effective for governments:
To switch away from pollution taxation to direct subsidies to
encourage greater innovation in designing cleaner production
technologies
5. The impact of green taxes depends crucially on what is
done with the revenues.

32

If they are balanced by reducing other taxes through revenue

recycling, research suggests that green taxes could result in an overall
economic improvement

UK sustainable development
UK performance on sustainable development is currently measured against
4 criteria:
Sustainable consumption & production
Climate change & energy
Natural resource protection & enhancing the environment
Creating sustainable communities & a fairer world
The common and diverse characteristics of developing countries
pg 288
Common characteristics
o Low living standards
o Low levels of labour productivity
o High rate of population growth
o Economic structure dominated by primary sector production
o High degree of market failure
o Lack of economic power in international markets and dependence

33

Chapter 12: The Economics of Globalisation

Globalisation
Foreign direct investment
(FDI)

Multinational companies
(MNCs)
World trade organisation
(WTO)
Transition economy
The International Monetary
Fund (IMF)
World bank
BRIC
Quantitative Easing

The processes that have resulted in evercloser links between the worlds
economies
The establishment of branches and
productive processes abroad, or the
purchase of foreign firms; investment
made by a multinational corporation in a
country other than where its operations
originate
Firms that produce goods and services in
more than one country
A global organisation that regulates world
trade
One that is changing from a centrally
planned to a free market economy
A global organisation that aims to promote
international monetary co-operation and
international trade
A global organisation that provides
development funding
An acronym used to describe the fastgrowing economies of Brazil, Russia, India
and China
Central banks increase the supply of
money by "printing" more. In practice, this
may mean purchasing government bonds
or other categories of assets, using the
new money. Rather than physically
printing more notes, the new money is
typically issued in the form of a deposit at
the central bank. The idea is to add more
money into the system, which depresses
the value of the currency, and to push up
the value of the assets being bought and
to lower longer-term interest rates, which
encourages more borrowing and
investment. Some economists fear that
quantitative easing can lead to very high
inflation in the long term.

WTO (World Trade Organisation)

The primary aim of the WTO is to liberalize trade by
providing governments with a forum for negotiating trade
agreements.

34

 The WTO reports that around 300 cases for settlement of

disputes were brought to the WTO in its first 8 years same
number as in the entire life of the GATT.
Objectives:
Liberalise trade i.e. remove trade barriers this is the primary
function of the WTO.
1 Settling disputes between member countries
2 Provision of a system of trade rules
Principles:
1 Most-favored-nation principle: implies that countries cannot
discriminate between their trading partners. For example, a
reduction in a tariff for one country must be extended to all
countries.
2 National treatment: imported and locally produced products
must be treated equally once the foreign goods have entered
the market.
Effectiveness in liberalising trade:

Since the Second World War, world trade has increased

forty-eight fold in terms of value, and twelve fold in terms
of volume many believe that this is due, at least in part,
to the trade liberalisation of the GATT and WTO.
The WTO has been successful in bringing about
substantial reductions in tariffs on manufactured goods.
For example, industrialised countries tariffs on industrial
goods averaged just 4% by the mid-1990s.
However, it has been less successful in reducing barriers
to the trade in services.
In addition, there has been a growth in the use of nontariff barriers, especially administrative regulations.
This has, to some extent, offset the gains from the
reduction in tariffs.
The DOHA round has not been smooth agriculture is an
especially contentious area, with the USA, the EU and
Japan having large-scale policies in place to support their
own agricultural sectors.
In the case of the EU, some moves have been made
towards reforming the Common Agricultural Policy, but
progress has not been as rapid as developing countries
would like.
Agriculture is especially important for many of the lessdeveloped countries.
The rich world spends over $300bn each year supporting
its farmers more than six times the amount it spends on
foreign aid (2003).

35

Benefits of Globalisation
1. Free Trade
- Free trade is a way for countries to exchange goods and
resources.
- This means countries can specialise in producing goods where
they have a comparative advantage (this means they can
produce goods at a lower opportunity cost).
- When countries specialise there will be several gains from trade:
1. Lower prices for consumers
2. Greater choice of goods
3. Bigger export markets for domestic manufacturers
4. Economies of scale through being able to specialise in certain
goods
5. Greater competition
2. Labour Mobility
-

Increased labour migration gives advantages to both workers

and recipient countries.
If a country experiences high unemployment, there are
increased opportunities to look for work elsewhere.
This process of labour migration also helps reduce geographical
inequality.
This has been quite effective in the EU, with many Eastern
European workers migrating west.
However, this issue is also quite controversial.
Some are concerned that free movement of labour can cause
excess pressure on housing and social services in some
countries.
Countries like the US have responded to this process by actively
trying to prevent migrants from other countries.

3. Increased Economies of Scale.

36

Production is increasingly specialised.

Globalisation enables goods to be produced in different parts of
the world.
This greater specialisation enables lower average costs and
lower prices for consumers.

4. Greater Competition
-

Domestic monopolies used to be protected by lack of

competition.
However, globalisation means that firms face greater
competition from foreign firms.

5. Increased Investment
-

Globalisation has also enabled increased levels of investment.

It has made it easier for countries to attract short term and longterm investment.
Investment by multinational companies can play a big role in
improving the economies of developing countries.

Costs of Globalisation
1. Environmental Costs
-

One problem of globalisation is that it has increased the use of

non-renewable resources.
It has also contributed to increased pollution and global
warming.
Firms can also outsource production to where environmental
standards are less strict.
However, arguably the problem is not so much globalisation as a
failure to set satisfactory environmental standards.

2. Labour Drain
-

Globalisation enables workers to move more freely.

Therefore, some countries find it difficult to hold onto their best
skilled workers, who are attracted by higher wages elsewhere.

37

3. Less Cultural Diversity

-

Globalisation has led to increased economic and cultural

hegemony.
With globalization there is arguably less cultural diversity,
however it is also led to more options for some people.

Quantitative Easing

Yield is a figure that shows the return you get on a bond it is

equal to the interest rate.
When the bond price changes, so does the yield.
If you buy a 100 bond with a 10% yield p.a. - You are getting a
guaranteed 10 p.a.
If you sell that bond for 120, the buyer still gets 10 or a yield
of 8.33%.
If you sell that bond at 80, the buyer still gets 10 or a yield of
12.5%

38

Extract 4: Rare Earths

The Case for China

Protection non-renewable resources are usually regarded as a

special case where the normal rules of free trade are often
abandoned.
For China to rely on rare earths lasting into the long term
limiting output through production quotas could be one
acceptable method to conserve resources.
Note: limiting output in general, not just for export!
Protection of rare earths for future generations- environmental
sustainability The economics on which this is based:
Free trade will tend to reflect private costs.
Countries export goods that they can produce at a relatively
lower opportunity cost.
But these opportunity costs are private costs; they do not take
into account negative externalities
Production and export of rare earths involve negative
externalities and the external costs are not borne by the
importing countries.
So restricting world trade in rare earths based on free market
prices could be justified.
Use negative externality diagram to explain the market failure
and why is could help Chinas sustainability

Price

Marginal
Social
Cost

Costs/
Benefits

Marginal
Private
Cost

P
2
P
1

Marginal Private
Benefit = Marginal
Social Benefit
Q
2

Q
1

Quanti
ty

39

The other side of the argument

The rest of the world is arguing that by limiting /banning the

export of rare earths, China is abusing its monopoly position.
The quota applies to exports not the domestic market will
negative externalities be reduced?
This will give it a monopoly in terms of the manufacturing of
high tech goods that rely on rare earths as a key raw material
There is a potential distortion of the principle of comparative
advantage, whereby the quota alters the cost advantage that
other countries may have built up through specialisation.

Possible Effects of the Quota = Evaluation

-

Efficiency of a policy i.e. will it result in a better use of scarce

resources among competing uses?

Effectiveness in meeting its specific objective i.e. Will it work?

Could something else be better?

Equitable i.e. is it a fair policy or does one group in society gain

or lose more than another?

Application of Economics

Protection of a natural resources for future generations

and Positive Internal multiplier effect for China:

Could attract FDI as firms relocate to China use AD/AS

Question environmental sustainability- will it be efficient?

Reverse External Multiplier effect of the quota on the

rest of the world

1) However, this also means that other countries exports (or

investment) will fall, this will reduce the level of injections into
their, and the world economy- a reverse multiplier.
2) The lower world income in turn leads to a fall in demand for
Chinas exports
Will it be efficient?
Risk of Retaliation:
1. If the WTO agree that China is breaching their rules, other
countries will be allowed to impose retaliatory sanctions against
China, probably tariffs- But their own consumers will suffer.

40

2. A trade war could follow with each country cutting back on

imports from the other.
Result a decline in specialisation and the benefits of trade based
on comparative advantage = lower world standards of living
Will it be effective?
Also a Risk of Global inflation

Other effects

Protection of monopoly power and ability to make supernormal

profits may encourage productive inefficiency in China (Xinefficiency) - leading to a decline in economic and
environmental sustainability it is efficient?
Higher prices from China and no access to their rare earths may
encourage other countries to mine them and could make the
development of alternatives more viable but possibly long term
see next diagram will it be effective?

Chinese export quota

limits supply to global
market
Price

Supply
with
Export
Quota

P
2
P
1

Over time ...research and

exploration will increase global
supply of rare earths outwards
Price shift
World
Supply
Supply
1
S
2
P
1
P
2
D
1

Deman
d
Q
2

Q
1

Quanti
ty

Quanti
ty

Q
1

Q
2

41

Is China changing its strategy?

From: An export-led growth strategy: based on openness and
increased international trade.
Growth is achieved by concentrating on increasing exports, and export
revenue, as a leading factor in the AD of the economy.
Over time, growth in the international market is translated into growth
in the domestic market.
To an import substitution /protectionism) strategy: to encourage
the domestic production of goods, rather than importing them.
It should mean that industries producing the goods domestically
should grow, as will the economy, and then should be competitive on
world markets in the future. Possible: Infant Industry argument
although they are using

Infant Industry Argument

The quota will give newly established firms involved in the

production of new/green technologies the chance to develop,
grow and become globally competitive.
The Protection allows them to develop a comparative
advantage. For example, domestic firms may expand when
protected from competition and benefit from economies of
scale. As firms grow they may invest in real and human capital
and develop new capabilities and skills.
Once these skills and capabilities are developed there is less
need for trade protection, and barriers may be eventually
removed.

42

Extract 1 Summary
Concentrated with inflation in the UK at a time of fragile recovery
In particular the extract concentrates on:
-

The transmission mechanism how interest rate changes affect

growth & inflation
Divisions within the 9 member MPC about whether to bring to an end
a long period of low policy interest rates with the policy rate 0.5%
Questions about whether a period of above-target CPI inflation may
have damaged credibility of the Bank of England as an independent
central bank & threatened economic stability
The importance of inflation expectation in influencing consumer &
business behavior including the price wage spiral
The case for gradually increase UK interest rates at a key stage of the
economic cycle
The case for expanding the programme of quantitative easing to
sustain economic recovery
Lessons from the experience of recession & deflation-affected japan at
the turn of the century
External causes of rising consumer prices in the UK economy i.e.
exogenous inflation shocks
SRAS upwards shift = a form of cost push inflation
The possible longer-term effects of the recession on potential
productivity & trend growth
The amount of spare capacity in the economy output gaps
The conflict between loose monetary policy & tight fiscal policy

43