A2 Economics: The Global Economy

The economics of globalisation

Globalisation entails the processes that have resulted in the ever-closer

links between the worlds economies e.g. trade, investment and production
Globalisation manifests in two main different ways, global brands and
global sourcing
Global brands: Brands are increasing their penetration
internationally. The quality of the product will be virtually identical
but the price that you have to pay varies. Coca-Cola, McDonalds, and
Snickers chocolate bars are available in all 5 continents
Global sourcing: This refers to the ways in which MNCs now source
their operations through worldwide production. Local domestic
production has been replaced by manufacturing capacity on a global
scale. This is a consequence of deindustrialisation. Toyota has set up
manufacturing and assembly plants worldwide. These plants assemble
vehicles from local as well as globally sourced parts
International financial flows: These are becoming far greater.
Countries such as China are financing a chunk of their fast economic
growth from inward flows of international capital
Cheap labour: For rich developed countries, goods are increasingly
being manufactured abroad in developing countries such as India and
China. This is because developing countries have a cost advantage in
the form of cheap labour
I.T and communications development: This has shrunk the time
needed for economic agents to communicate with each other.
Software programmers are effectively just as near as a clients office
located in London or say India

Factors promoting globalisation

Reduced protection in word economy: WTO has reduced the degree

of protection in world trade. Tariffs and other trade-curbing factors
are inconsistent with globalisation. The global economy is now has a
number of regional trading blocs such as the EU, CARICOM which have
established mutually beneficial links between one another
Reduced capital movement restrictions: This is essential for
business capital to move freely within the global economy. Exchange
control has been gradually dismantled, allowing FDI to flow between
developed economies and those that are emerging/developing
Developments in IT: The technological change over the past
generation has enabled firms to communicate via the Internet and has
promoted global economic relations. Global supply chains that
produce and sell their product can now be managed very effectively
Liberalisation of domestic markets: In line with reduction in
protection, many of the worlds economies, China especially, have
 been more receptive to FDI from developed economies and in forming
partnerships with MNCs enabling MNCs to directly purchase
businesses in other parts of the world
A fall in real transport costs: Unit transport costs particularly for sea
transport have been falling increasing the viability for businesses to
source on a global basis. Bulk distribution of products in containers by
sea and to a much a lesser extent by air, has increased year on year.
Economies of scale can be gained as vessels are aircraft have increased
in size

The impact of globalisation

The world economy is now more integrated through the growth of

trade and increasing dependency
For developing economies globalisation has produced certain benefits:
Higher living standards for more people
Enjoyment of global brands
Spreading best practice and technology faster
Improved medical supplies that could increase life expectancy
Increased liquidity of capital allowing investors in developing
countries to invest in developed countries
Increase flow of communications allow vital information to be shared
by corporations across the globe
Global mass media ties the world together
Globalisation has its critics:
Increased likelihood that an economic disruption in one nation will
affect other nations due to increased dependency
It is a new imperialism led that accentuates the gap between the poor
and rich and leads to exploitation of works in developing countries
Leads to environmental problems. A company may want to build
factories abroad as environmental laws are weaker. Third world
countries may cut down more trees to sell wood to richer countries

MNCs and FDI

McDonalds and Coca-Cola are amongst the largest MNCs with

manufacturing and retail outlets in many countries in the world
MNCs provide FDI to the economies in which they operate
This is investment that is necessary to produce or sell a good or service in
a foreign country
FDI involves capital flows between countries
FDI should not be confused by portfolio investment which is the purchase
of shares by foreign investors in businesses that are located in another
country
The activities of MNCs and the effects of FDI has been the subject of much
debate and discussion by economist and politicians
Benefits and costs of FDI

Many benefits are obtained by the receiving economy of investment:

Injection into circular flow of income: leads to the multiplier
effect for the economy, in particular creating more total
expenditure and important employment creation. Longer term, the
injection of FDI increases the economys potential output
Effects of the balance of payments: FDI is a credit item on the
financial account of the BofP. This could be a short-term inflow, or
a sustained one once the business is established. For example, the
investment of multinational hotel in the Caribbean islands
generates further income through the increase increased flows of
tourists and payments received by local carriers
An increase in tax revenue: the MNC contributes to tax receipts
and expenditure taxes on their purchases of their goods and
services. Also, MNCs provide additional tax revenue through
purchase of local services and corporation/profit taxes
Improved productivity: This may result from pressure on local
suppliers to improve their efficiency
Technology transfer and the acquisition of specialist
equipment: Developing economies receive the benefit of up-to-
date technology and products that have been developed by MNCs
in their home market
There are various disadvantages and risks associated from FDI inflows:
The employment created may be only short term and could be
less than expected: The reason for that is that MNCs have little
affinity to the overseas economies in which they have invested.
Companies may pull out of a country transferring production to
another location. The MNCs may employ workers from their own
country in the top management lobs resulting in employees from
the host country filling lower paid positions
MNCs may invest in labour-saving technology: This may not
seem appropriate in a recipient country with high unemployment
and large amount of surplus labour
Net effects on the balance of payments being less than
anticipated: The profits earned in a host economy being
repatriated and count as a debit item in the invisible section of the
current account of that country. Over time, the outflows of such
profits may well exceed the initial capital injection
Taxes received by the government may be less that expected:
as a result of fewer than expected new jobs. Account should also be
taken of any government subsidies that might have been given to
the MNCs in order to encourage them to set up in the first instance
Productivity gains and technology transfer effects could be
very limited depending on the type of FDI
Environmental costs associated with certain types of FDI,
especially mineral extraction and natural gas production
 FDI in some respects is a mixed blessing thus not all governments
welcome MNCs with open arms

Other financial flows

Hot money flows around the world to take advantage of changes and
expected changes in interest and exchange rates
These movements can be disruptive as the money may only stay in the
country for a short time before it is move to a more profitable opportunity
elsewhere
Portfolio investments are longer term. There are a number of factors that
attract people to purchase the shares and government bonds of another
country- relative interest rates and anticipated profit levels
These are influenced by a government policies and changes in the level of
economic activity
Other investment includes loans made to other countries at commercial
rates. Firms in other countries may seek loans from abroad if the interest
rate charged are more favourable than can be obtained at home
Developing countries may receive foreign aid in the form of loans at
favourable rate. Most cases, foreign aid has led to the net outflow of funds.
More is paid in servicing and repaying past debt than is received in aid
For some developing countries, more money is now coming from
remittances, the pay sent home from people working abroad, than from
foreign aid, FDI or from sales of exports
Remittances tend to be least volatile source of foreign currency for
developing countries

World Trade Organisation

WTO: a global organisation that regulates world trade

It is established to promote free trade and provides a forum for discussing
trade issues, established agreed rules and even assesses if these rules are
broken
WTOs mission is to help trade flow smooth, freely, fairly and predictable
This should produce a trading system wit the following characteristics
Non-Discrimination
1. Most favoured nation treatment- countries cannot grant a
special favour (lower rate of duty or duty access free) to one
WTO member over another i.e. all countries treated equal basis
2. National treatment- treating foreigners and locals equally.
Under this, imported and locally produced goods should be
treated equally after they have reached the domestic market.
This does not prohibit a country imposing tariffs on imported
goods, but it does mean that the goods compete on same basis
thereafter. Principle applies to services- foreign firms trying to
set up operations elsewhere should be treated in exactly the
 same way as domestic firms wishing to expand their
operations
Free Trade: This can be done by lowering trade barriers, tariff
and non-tariff barriers. This will enable goods/services to flow
more openly and fairly between members, providing benefits of
gains from trade
Predictability: The will help provide a stable business
environment whereby firms will feel secure that trade barriers will
not be raised at some future date. This will create a business
environment where investment is encouraged, jobs are created
and consumer welfare is increased. This is relevant for businesses
moving to developing economies, where there are likely to be
concerns over future political stability and economic prospects
Promoting fair competition: The WTO system allows tariffs and,
in some circumstances, other forms of protection. Once a
restriction has been imposed by a member, WTO agreements
mean thereafter should be free and fair competition in the market.
This must not be distorted by further constraints on foreign items
Special provision for developing countries: WTO has sought to
assist the development of developing countries. WTO has sought to
give such countries time and flexibility to implement various
agreements. The agreements build upon the principles special
assistance and trade concessions for developing countries

WTO agreements

The Uruguay Round agreements are the basis of the current WTO system
The Uruguay Round covered three main areas:
Tariff Cuts: Developed country members agreed a 40% in their
tariffs on industrial products, to be phased over 5 year period from
1995. This reduced the average tariff from 6.3% to 3.8%. They
agreed that fewer imported products should be charged at higher
duty rates
More binding tariffs: This is a commitment by a member not to
raise tariffs above the listed rate. Developed countries increase the
no. of bound line products to 99%, while developing countries
increased it to 73%. These agreements provide more security for
traders and investors
Agriculture: Substantial progress was med to remove all non-
tariff restrictions on agricultural world trade. Most of these
restrictions were converted to tariffs (tariffication). Tariffs
applying to products from developing countries have been
progressively reduced and commitments have been received from
developed countries to reduce export subsidies for agricultural
products. The Uruguay Round represents the first time that such
an agreement has been reached in principle

The Doha Round

 The current round of talks, the Doha Round was launched in 1999 and
completed in 2006. It covered a variety of areas:
In manufacturing, further reduction in tariff barriers were
negotiated
In services, access to the markets was a key issue. In many service
markets non tariff barriers were key to restricting trade
First world countries were particularly concerned to tighten up
intellectual property rights in face of widespread piracy. Whilst,
third world countries wanted their rights over plant derived
compounds and folklore protected
There was an agreement to tighten up the role of WTO in settling
trade disputes

International Monetary Fund

IMF is a global organisation that aims to promote international monetary

cooperation and international trade
Set up 1945 at Bretton Woods Conference
Helps promote the health of the world economy following World War
Two. Non-members: Cuba and North Korea. Members: 184
The IMFs purposes and responsibilities are:
To promote international monetary co-operation
To facilitate the expansion and balanced growth of international
trade
To provide exchange stability
To assist in the setting up a multilateral system of payments
To make resources available to members experiencing BofP
difficulties, provided adequate safeguards are provided
IMF has three main functions known as surveillance, technical assistance
and lending
The first two have the aim of promoting global growth and economic
stability by encouraging countries to adopt sound economic policies
The third function is used where member countries experience difficulty
in financing their balance of payments
Technical assistance and training are offered by IMF to help members to
design and implement effective economic policies
This assistance provides advice on monetary, fiscal and exchange rate
policies especially. This has been widely taken up my emerging transition
economies
Many IMF members have severe balance of payment problems. In this
case, the IMF lends money to such countries to ease their immediate
positions
It is important that recipients work closely with the IMF to avoid similar
problems in the future
Anti-globalisation supporters condemn the IMF for favouring military
dictatorships that are friendly towards the US and EU MNCs
 Some economists are concerned about the pro Keynesian approach for
dealing with the BofP disequilibria. They believe supply side polices
rather than devaluation are the best way of alleviating structural
imbalance
The IMF has also been blame for some serious economic problems
In 2001 in Argentina, it is generally believed that IMF induced budget
restrictions and the privatisation of important natural resources were
responsible for the economic crises that ensued
World Bank

World Bank is a global organisation that provides developing funding.

This includes financial support for internal investment projects such as
improving infrastructure and constructing new heal facilities
Rose out of the Bretton Woods agreements
It is best described as the World Bank Group as it has five constituent
agencies:
International Bank for Reconstruction and Development (IBRD)
International Finance Corporation (IFC)
Multilateral Investment Guarantee Agency (MIGA)
International Centre for Settlement of Investment Disputes (ICSID)
IBRD and IDA provide low- or no interest loans and grants that do not
have favourable access to international credit markets
Loans cover areas such as:
Health and education- to enhance human development in a
country- for improving sanitation and combating aids
Agriculture and rural development- for irrigation programmes and
water supply projects
Environmental protection- for reducing pollution and for ensuring
that there is compliance with pollution regulations
Infrastructure- roads, railways, electricity
Governance for anticorruption reasons
It has been accused of being a US/EU dominated agency for supporting
their own political and economic interests
Though its advocacy for free market reforms, its policies have been
criticised as being harmful to some countries, especially where shock
therapy has been introduced too quickly
In spite of this, World Bank has had a considerable impact in assiting the
worlds poorest economies
Macroeconomic performance

The recent macroeconomics performance of the UK economy

The 4 key indicators build up the picture of macroeconomic performance

Economic growth in the short-run and the long-run

Short-run economic growth: the actual output percentage increase in an

economys output (actual economic growth)
Long-run economic growth: the rate at which the economys potential
output could growth as a result of changes in the economys capacity to
produce goods and services (potential economic growth)

A shift of the PPC curve to the right shows long run economic growth as
the economys maximum possible output has increased
Movement from point A to B shows short run economic growth
Short run economic growth occurs because more of the economys
resources are being used- few people are unemployed, more machinery is
being used to produce goods and services
Total output moves closer to the PPC curve
Long run economic growth occurs when there is an increase in quality of
quantity of the nations resources of land, capital, entrepreneurship,
labour
This increase the potential output of the economy
The difference between actual and potential output is called the output
gap
 In the short run, if actual output > potential output positive output gap
This is likely to generate inflationary pressure
If actual output < potential output, the economy has spare capacity
The economy can expand its output without creating inflationary
pressure. A negative output gap exists
It is hard to measure the potential output accurately and the output gap
can only be an estimate
This reduce the reliability of the output gap as a measure in judging
inflationary pressures
Causes of economic growth in the short run

Economic growth in the short run is more variable than in long run
Trend rate of growth: the average rate of economic growth measured
over a period of time, normally over the course of the economic cycle

Changes in AD

An economy with spare capacity can experience economic growth as

result of an increase in AD
An increase in AD to AD1 results in real GDP rising from Y to Y1
There is positive economic growth. A reduction in AD would cause
negative economic growth

AD = C + I + G + (X M)

Changes in short run AS

SRAS shows the level of production for the economy at a given price level,
assuming labour costs and other factor input cost are unchanged
Changes in the costs of production cause the SRAS to shift. An increase in
costs of production, shift to the left. Decrease causes shift to right
Changes in costs of production arise from changes in:
Labour costs: lower wage rates reduce the costs of production for
firms, allows them to reduce prices. SRAS shifts to the right,
increasing real GDP to Y1
Other input prices: the price of raw materials and capital. If these
prices fall, lowers costs of production. SRAS right, GDP increases
Taxes and regulations: Changes in the taxation/regulation of a
business will have an impact on business costs therefore shift the
SRAS curve. Most regulation increase business costs, SRAS curve
shift to the left and real GDP is reduced
The economic cycle

Economic cycle: fluctuation in the level of economic activity measured in

real GDP. 4 stages in this cycle- recession, recovery, boom, slowdown

Some economics argue that economic instability influence the rate at

which the economy grows
Long periods of unemployment can lead to hysteresis and consequent
loss of human capital (knowledge and skills of the labour force)
When the economy returns to a positive output gap, it does so at a slower
rate of economic growth due to the loss of productivity and it becomes
more difficult to raise output
Thus, the economys trend rate of growth may be reduced
Recovery- when economic growth becomes positive after
recession
Boom- when rate of economic growth excess rate of growth of
potential GDP so the output gap is narrowed
Slowdown- when the rate of economic growth begins to fall to
zero
Recession- when rate of economic growth becomes negative and
real GDP falls
The economic cycle is not as regular as above
This is because each of the stages will vary in length and severity
Some recessions are short lived, some are prolonged and deep
There are three main causes of the business cycle:
The multiplier and accelerator effects and their interaction
The role of stocks (inventories)
Monetary explanations of the economic cycle

The multiplier, the acceleration and their interaction

Multiplier effect: the process by which any change in a component of AD

causes a greater final change in GDP
The size of the multiplier is determined by the size of the leakages
(saving, taxation and expenditure on imports) from the circular flow of
income
Tracing expenditure follows that output and income will increase by the
same amount in order to restore equilibrium between AD and AS
The proportion of additional national income that goes to leakages is
known as the marginal propensity to withdraw (MPW) and is made up of:
Marginal propensity to save (MPS)
Marginal propensity to tax (MPT)
 Marginal propensity to import (MPM)
The value can be calculated using the formula:

Since half of any increase in national income leaks out of the circular flow,
the MPW is 0.5

The follows that any change in expenditure in the national economy wil
cause national income to be multiplied
This concepts goes some way to explain the upswings and downswings of
the business cycle
But what causes expenditure to change in the first places
This is where the concept of the acceleration comes into play
Accelerator: the theory of investment that states that the level of
investment depends on the rate of change of national income
Investment is needed for two reasons- to replace the capital stock that is
wearing out and to provide new capital stock to give additional
production capacity to meet rising demand
The National Income Multiplier says that an initial increase in spending
can cause further rounds of spending. Therefore, the final increase in
National Income is greater than the initial spending (or injection of
Money)
Recession- there is no need for firms to undertake investment to raise
productive capacity as demand for output is falling
Hence there is likely to be little if any investment in the economy
In times of rising national income firms will require additional capacity
and thus investment will rise
This increase may be larger in % terms than the increase in national
income
The key point is that investment depends on the rate of change of national
income not on its level
Thus investment is a volatile component of AD
Investment can for example fall when the rate of growth of the economy
slows down and this will tend to lower domestic demand
The last point illustrate the way in which the multiplier and the
acceleration may interact to generate periods in which real GDP rises
more and more rapidly (the boom phase of the economic cycle)
And the situation in which a slowdown in the economic growth becomes a
period of falling real GDP (the recession phase of the economic cycle)
Once actual output reaches potential output, the economy reaches its
ceiling and economic growth must slow down
 There must be a floor to economic activity as firms must invest a
minimum amount to replace worn-out or obsolete capital and there is
minimum level of consumption for households
These ceilings and floors represent the turning points in the economic
cycle- booms and recessions eventually come to an end
The interaction between multiplier and the accelerator is a theoretical
explanation of the determinants of the economic cycle
The economic cycle is far from predictable and the fluctuations in
economic activity not as regular as diagram would suggest
The acceleration is not a description of economic reality. There are a
number of limitations to the theory:
If firms have spare capacity rising demand can be met without
rising investment
The theory of the acceleration ignores the crucial role that
confidence and expectations play in investment decisions- firms
will not respond immediately to rising demand by raising
investment if they are uncertain about whether the rising demand
will be sustained in the future
Firms can exercise chose over investment to replace machinery
that is wearing out and they may delay such investment
Investment decisions are planned well in advance of changes in
economic activity and can be difficult to halt or postpone
The multiplier effect of changes in investment may be small it does
not have a large impact on AD and thus economic growth
External or random shocks to the economy can be just as
important a cause of the economic cycle as the relationship
between the accelerator and the multiplier
Fiscal and monetary policy changes may help to smooth out the
economic cycle and policy makers may be able to over-ride the
accelerator and multiplier effects
These limitations focus mainly on the size of the accelerator and
multiplier effects and the extent to which they are predictable
The interaction of the multiplier and the accelerator is not the only
determinant of the economic cycle, however

Other explanations of the economic cycle

Another explanation involves the behaviour of stocks

With time lags in production, it is not always possible for firms to
immediately increase output in order to meet higher demand
Thus firms hold stocks of finished and semi-finished goods
As with investment, the amount of stocks held by firms tends to fluctuate
over the course of the economic cycle which contributes to the cycle itself
When economy recovering from recession- confidence of firms is fragile.
Firms will be reluctant to take on new workers or to increase their
investment when they are unsure about whether demand will continue to
rise in the future
 As a result, they will tend to sell their stocks of finished goods instead of
producing new output
The recovery phase of the economic cycle will see a rise I output that is
less than the rise in demand and the output growth will thus be slow
But the stock of finished goods is limited
As demand continues to rise, the confidence of firms will grow and they
will start to build up there stock levels from current production
This will boost output and create additional demand in the economy
through the multiplier effect
During this time the growth of output will exceed the growth of demand
as firms re-stock
Once stock levels have been rebuilt, output growth will slow down to
match the growth in demand
This slowdown in output will bring about the end of the growth phase of
the economic cycle in line with the multiplier-accelerator theory above
Stock levels will now start to increase as demand falls
Eventually firms will cut back production to stop stock levels growing, the
economy will enter the recession phase of the economic cycle and firms
will run down their stocks of finished goods
The cycle will start all again once firms cannot satisfy demand from their
stocks
Both theories of the economic cycle suggest that the pattern of rising and
falling real GDP is inbuilt into the economic system
The economic cycle occurs due to regular fluctuations of AD- this is the
result of decisions of consumers and firms based on their expectations of
the future

Causes of economic growth in the long run

Changes in LRAS

LRAS: the relationship between total supply and the price level in the
long run. The LRAS curve represents the maximum possible output for
the whole economy- its potential output
Classical economists: economists who believe that the markets will clear
in the long run, with prices and quantities adjusting to changes in the
forces of supply and demand so that the economy produces its potential
output in the long run. The economys LRAS curve is thus vertical
Keynesian economists: economists who believe that market failures will
results in price and quantity rigidities such that the economys
equilibrium output in the long run may be less than its potential output
Economic growth in the long run is caused by an increase in potential
output of the economy. This is determined both by the quantity and
quality of the factors of production
An increase in both the quantity and quality of land, labour, capital will
cause economic growth. In this case, the LRAS curve will shift to the right
For example, if there is an expansion in the labour force it will be possible
for the economy to produce a higher level of output
The quantity of the labour force

Increasing the size of the labour force can be achieved in a no. of ways:
Increases in the size of the population
Increases in the labour force participation rate
Immigration
Labour force: all those people of working age who are in employment or
actively seeking work
Labour force participation rate: a measure of the proportion of the
population able to work who are in employment of who are actively
seeking work
The biggest growth in labour force participation has come from an
increase in the number of women entering the workforce
Changes in tax and benefit system in the UK have also encouraged people
to seek work by making more and more welfare benefits, such as Working
Families Tax Credit, dependent on employment
Raising the retirement age may be politically unpopular but it may be an
economic necessity in Europe in the not too distant future
Immigration increases the size of an economys labour force but also
increases the size of the population
Unless immigration contributes to productivity there might be little
benefit in terms of GDP per capita
Recent enlargements of the EU have increase the size of the labour force
for those economies that have not restricted the free movement of labour
from central and eastern Europe
If immigrant workers stay on a temporary basis there may be no long-
term increase in the productive capacity of the economies to which such
workers migrate

The quality of the labour force

The labour force can be made more productive through education and
training
This raises the workers human capital by equipping people with more
skills and technical knowledge
Human capital is important because it enables workers to cope with the
demands of employment
Of increasing importance is the ability of the labour force to be flexible in
the tasks that they can do (functional flexibility) and being able to adapt
 to changes in the labour market by acquiring skills for new jobs
(occupational flexibility)
The problem with policy makers is how to deliver this increased human
capital
The cost of education and training can be very high
There is the issue of whether this should be provide by the government of
by the market
There is the question of what education and training should be provided
UK compares favourably with Germany and France in terms of the % of
the labour force with the highest qualifications
Increasing the quality of labour force through investment in human
capital is important for economic growth in the long run but it is not clear
what should be provided. Time lags should also be considered
Investment in human capital takes time to materialise

The quantity and quality of capital stock (Harrod-Domar model)

An economys potential output is increase by an increase in the

quantity/quality of the factors of production
Increasing the quantity of capital stock will increase the economys
productive capacity
This requires investment in various types of capital
It is not just the amount of investment that determines the potential
output of the economy, it is also the quality of the investment
The productivity of investment is measured by the economys capital
output ratio
This is the amount of capital needed to generate each unit of output
Technological advance increase the productivity of investment because it
require less capital being required to produce each unit of output

Consequences of economic growth

If a governments are to pursue economic growth as a policy objective,

they need to be aware of any conflicts it may have with other objectives

Growth and inflation

The consequences of economic growth for inflation depend very much on

the nature of economic growth
Chinas economic growth has averaged around 9.6% over the last two
decades, yet until 2007 its inflation rate remained below 3%
Economic growth will cause higher rates of inflation, if growth is
generated by increases in AD that are not matched by increases in AS
At the simplest level, a rise in AD causes a movement up the LRAS causing
price level to increase
The closer the economy is to its maximum capacity, the more that the
higher AD causes prices to rise
 This is because the shortages of inputs push up production costs. This
increases the no. of firms with little spare capacity to need the demand
and labour shortages result in higher wage bills for firms
As the gap between actual and potential output narrows inflationary
pressure increases
It is possible to avoid this by increasing the economys productive
capacity. If the AS can be shifted to the right (LRAS1) AD can rise without
inflationary pressures building up (a price level of P).
Non inflationary economic growth is the goal of macroeconomic policy

In 2007, Chinas official rate of inflation more than trebled and many
economists were expecting it to increase to over 6% in 2008

Growth, Employment and Unemployment

The link between economic growth and employment is recognised by

policy makers as central to improving macroeconomic performance
In 2005, the EU relaunched its Lisbon Strategy as a growth and hobs
strategy committing member states to raising investment in research and
development and labour force participation rates
By 2006 the number of people in employment in Ireland had increase by
almost 60% since 1995, whereas over the same period employment in
Belgium increased by only 11%
The Irish economy grew by 7.3% per annum over the period, while
average annual economic growth in Belgium was barely over 1%
Since the demand for labour is derived demand, the number of people
employed is closely related to output
Increases in real GDP will ten to increase the demand for labour and so
the level of employment will rise
The relationship between output and jobs can be represented with an
inverted employment curve on an AD/AS diagram

In the short run, increase in output (Y to Y1) increase the number of

people employed (L to L1). In the long run,, raising labour force
 participation rates through capital investment would shift the LRAS to the
right and raise employment
Increasing labour productivity may result in some reduction in
employment in the short run, because firms may choose to produce the
same output with fewer workers
This can be represented by pivoting the employment curve to show less
labour employed at each level of GDP
In the long run, however, it is likely to generate more jobs as AD increase
Higher employment might be expected to reduce employment but this is
not always the case as the labour force itself is changing
Increases in the working age population and in the no of people actively
seeking work can mean that rising employment coincides with rising
unemployment
The consequences of economic for unemployment also depends upon the
nature of growth and on the causes of unemployment
Economic growth generated by increases in AD is likely to reduce cyclical
unemployment, but may have little impact on unemployment arising from
problems related to the supply of labour, such as structural/frictional
unemployment

Growth and the balance of payments

An increase in AD caused by rising consumption is likely to affect the BofP

negatively
This is because the demand for imports are likely to increase worsening
the current account position
The effect will be more pronounced if the demand for imports is income
elastic
On the other hand, if growth is export led, the current account is of the
BofP will show an improvement
Supply side improvements- increases in productivity, innovation and
capital investment which contribute to long-run economic growth are less
likely to worsen the balance of payments
Increases in productivity will tend to increase international
competitiveness by lowering unit labour costs and reducing the impact of
growth on imports
Higher capital investment will increase the productive potential of an
economy resulting in a greater ability of domestic firms to meet higher
levels of domestic demand
Capital account: the section of the BofP that records the long-term flow
of capital into and out of an economy. It records purchases and sales of
assets and is split into two sections: long term capital flows and short
term capital flows
If growth causes the current account to worsen, this may be compensated
by a capital account surplus
Traditionally, the BofP has been viewed as a constraint on economic
growth
 Thirlwalls Law states that the rate of economic growth consistent with
BofP equilibrium is equal to:

Growth and the governments fiscal position

Governments fiscal position refers to the balance between government

expenditure and revenue from tax receipts
Public Sector Net Cash Requirement (PSNCR): the difference between
government expenditure and revenue from tax receipts
In a boom, tax receipts will tend to rise even without action by the
government to raise tax rates or widen the tax base
The higher level of economic activity will bring the government more tax
revenue
Higher employment results in more income tax revenue, higher
expenditure by consumers results in more revenue from expenditure and
higher levels of profit result in greater levels of corporation tax receipts
Government spending will tend to fall during this period because there is
likely to be lower unemployment in the boom phase of the economic cycle
This reduces the about that has to be spent on JSA
In a recession, taxes will fall and government spending will increases
These changes are automatic and thus are called automatic stabilisers
because they have the effect of dampening down a boom and cushioning
the effect of a recession
Automatic stabilisers: changes in government expenditure and taxation
receipts that take place automatically in response to the economic cycle
A budget surplus will tend to emerge during the boom phase of the
economic cycle and a deficit to materialise in a recession.
Governments will have to borrow to make up the shortfall during a
recessions but they should be able to repay this borrowing during the
boom years form the budget surplus
The PSNCR therefore vary over the economic cycle
The existence of this fiscal cycle reduces the size of the multiplier effect
and dampens down the economic cycle , if the automatic stabilisers are
allowed to work

Policy issues- growth, economic stability and international competitiveness

Last ten years, economic stability has become an objective of

macroeconomic policy
Economic stability: the avoidance of volatility in economic growth rates,
inflation, employment and unemployment and exchange rates, in order to
reduce uncertainty and promote business and consumer confidence and
investment
 Economic stability has become a more prominent macroeconomic in
recent years due the consequences of instability
It is argued that instability in any of the key indicators leads to
uncertainty which damages the countrys long term economic
performance
Uncertainty about demand and prices will undermine both consumer and
business confidence
A lack of consumer confidence discourages consumption which may cause
the recession to prolong
Business are likely to invest during times of uncertainty
Macroeconomic policies to promote stability and growth have focused on:
A prudent approach to the management of the economy
Taking fiscal and monetary policy decisions on the basis of the
long-term interests of the economy rather than the short term
political interests
Ensuring that fiscal 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

Fiscal policy issues

The governments budget will move into surplus in time of economic

boom and into deficit in time of recession as a result of automatic
stabilisers
Governments must avoid the temptation to spend surpluses and to try to
claw back deficits to balance the books- leads to more pronounced
economic cycle
If governments raise spending and cuts taxes because the budget is in
surplus they run the risk of raising AD during the course of the boom
phase of the economic cycle
High levels of government borrowing can reduce the amount of finance
available for private sector investment
The private sector is then crowded out and private sector investment falls
reducing the economys long term rate of economic growth
High government borrowing will tend to push of interest rates
The aim of UK fiscal policy is to balance the governments budget, but
over the course of the economic cycle
Short term political considerations are not supposed to drive decisions on
government expenditure and taxation
To promote economic growth, UK fiscal policy focuses on measures that
will raise the productive capacity of the economy by shifting out the LRAS
curve
In times of recession, a government will have to borrow money to make
up for the shortfall of tax receipts over government expenditure
But they should not borrow more than this cyclical deficit to fund
current expenditure
 In other words, government borrowing is only justified if it arises
automatically because of the economic cycle or is used for investment-
this is the golden rule of UK fiscal policy
Cyclical deficit: a budget deficit that arises because of the operation of
automatic stabilisers
Different governments have different approaches to designing fiscal
policy to promote economic stability and growth
The broad principle are credibility, flexibility and legitimacy but there
are different approaches to what rules and targets should be met
Credibility: a credible fiscal policy framework is one where the
government commitment to economic stability is trusted by the public,
business and financial markets
Flexibility: a flexible fiscal policy framework is one that has the flexibility
to deal with macroeconomic shocks such as sudden changes in AD/AS
Legitimacy: a legitimate fiscal policy framework is one that has
widespread support and about which there is general agreement among
the public, business and politicians
The problem with the UKs approach is that it requires accurate
estimation of productive capacity of the economy and the economys long
term economic growth rate- difficult to estimate
Governments would also have to be able to forecast the likely trend in
actual economic growth to set spending and taxation for the years ahead
The members of the Eurozone have abide the Stability and 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 government debt of 60% of GDP or less
Such rules are simpler to interpret and measure, but lack flexibility
If an economy was in a recession, its government budget deficit will rise
and may fall foul of the 3% limit
SGP includes a financial penalty for economies that breach the rules- this
would add to their credibility and legitimacy
However, the penalties make it harder to an economy to bring a deficit
down and because they lack flexibility might make the economic cycle
more pronounced that it would otherwise if the automatic stabilisers of
fiscal policy were allowed to operate
Fiscal policy rules are no guarantee that governments will get these thing
right or stick to their own rules
Unless fiscal policy is run independently of government, there is always
risk that politicians will take risks with fiscal policy and destabilise the
economic cycle
Politician are likely to be vote maximisers and favour fiscal expansion
over fiscal prudent
To be effective there must be penalties attached to the rules
 Fiscal policy rules and targets may also encourage creative fiscal
accounting whereby governments find ways around the rules by changing
the way expenditure
People may lose confidence in the government to stick to the rules or the
rules themselves are worthless
If this happens the whole credibility of government fiscal policy is eroded

Monetary policy issues

Can promote economic stability in many ways

Changes in interest rates have an impact on domestic demand through
consumption and investment, and on net external demand through the
exchange rate
The way in which it does so is called the monetary transmission
mechanism
Monetary transmission mechanism: the way in which monetary policy
affects the inflation rate through the impact it has on other
macroeconomic variables
Rapid economic growth and accelerating inflation can be dampened by
increases in interest rates and an economic slowdown and falling inflation
rates can be talked with reductions in interest rates
Monetary policy can be used to manage the economic cycle and smooth
out the fluctuations in short-run economic growth that bring with them in
other key performance indication
In short, monetary policy could be used to manage AD
The primary objective of monetary policy is to promote price stability
It is argue that low and stable rates of inflation provide a framework for
economic stability
Inflation erodes the purchasing power of money
This damages the heart of any economic system- the exchange of money
for goods and services
If wage growth starts to increase to compensate for the value of money,
there is a very real danger that inflation will get out of control
Prices also serve a signalling function in a market economy
Changes in prices should reflect changes in demand and supply and send
out messages for resources to be allocated and reallocated to the goods
and services that consumers most want
Inflation is sometimes described as a noise that distorts the signalling
function and thus the market system doesnt function so well
Variation rates of inflation create economic uncertainty that discourages
savings and investment, crucial for long term economic growth
High relatives rates of inflation also damage international
competitiveness in the long term, affecting output and jobs
The role of monetary policy is therefore to deliver low and stable rates of
inflation
Central banks have been given responsibility to deliver price stability and
have given operational independence from governments
 This makes the monetary policy less susceptible to short-term political
considerations and more likely to operate in the long-term interest of the
economy
The inflation target itself varies between countries
Targets can be symmetric or asymmetric
Symmetric inflation target: when deviations above and 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 than deviations above the target
Inflation targeting has a number of benefits for growth and stability:
Transparency and accountability- an inflation target makes the
conduct of monetary policy clear. There is a firm commitment to
price stability that is communicated to firms and households
Expectations- an inflation target that is credible directly affects
expectations of inflation. If people expect the inflation target to
met, they will build this expectation into their behaviour and this
will do much to bring about the inflation rate they expect. Firms
will be confident in their investment plans if they expect future
inflation to be low. This will raise productive capacity of the
economy and reduce likelihood and demand-pull inflation
Flexibility- the design of symmetric inflation targets gives as
much weight to low inflation as it does to high inflation. This
means that a degree of flexibility is built into the monetary policy,
which can contribute to economic stability. For example, if
inflation was predicted to fall below the bottom range of set, then
the central bank is likely to reduce interest rate to raise AD.
Without this symmetry, there might be a bias towards reducing
inflation at the cost of slower economic growth and higher
unemployment
There are a no. of problems with inflation targeting
Whether it promotes economic stability, growth and international
competitiveness depends on the central bank bringing credibility to the
target
To be credible, the central banks has to build up a reputation for meeting
its target
This can lead to central banks trading of low economic growth for low
inflation
In order to be successful in hitting its target, central banks have to be
good at forecasting inflation. Monetary policy works with time lags
An increase in todays interest rate might have its full effect on inflation
until up to two year later
Even the best forecasts cannot anticipate unforeseen events. Until
recently, the economies that have used inflation targeting have been
remarkably stable
The real test of inflation targeting is whether it can deliver economic
stability and growth at a time when global economic conditions are
themselves unstable
Supply-side policy issues

Supply side policies aim to increase AS in order to increase the productive

capacity, thereby helping to prevent inflation, reduce structural/frictional
unemployment and improve the economys long run rate of economic
growth and its trade position
The shift in the LRAS increases real GDP to Y1 and allows future to
increase in AD, raising real GDP still further to Y2
All this occurs without any increase in the price level- there is no trade-off
between growth and inflation or price stability
Some economies argue that the period of sustained, non-inflationary
economic growth in the UK since 1992 has been the consequence of
supply side improvements to the economy
Some economist believe that supply side policies are not the panacea
It is little use expanding the productive capacity of an economy if there is
a deficiency of demand within the economy
For example, if AD were at AD0, supply side improvements would have no
effect on real GDP or the price level

Despite this, supply-side policies are increasingly seen as important to

deliver improved macroeconomic performance in the long run and to
improve international competitiveness
International competitiveness: the ability of an economys firms to
compete in international markets and thereby sustain increase in national
output and income
During the 1990s, Ireland attracted high level of investment from
multinational companies, it economic growth exceeded the rest of Europe
The Irish economy continued to grow rapidly, but this growth hid an
emerging competitiveness problem from about 2000. This can be seen by
Irelands growing current account deficit problem
A countrys international competitiveness is determined by both the
prices and the quality of its goods and services. These include
The costs of production
Productivity
The exchange rate
Relative unit labour costs can therefore change for three reasons
A change in the cost of labour compared to other countries
A change in productivity compared to other countries
A change in the exchange rate
Unit labour costs: the cost of labour per unit of output
Relative unit labour costs: the cost of labour per unit of output of one
country relative to its major trading partners
 The problem with this measures of international competitiveness is that it
takes no account of quality factors
Quality factors that could affect international competitiveness might
include:
Design of products
Delivery dates
After-sales service
Reliability
Marketing
In the case of Ireland, declining international competitiveness appears to
boil down to problems related to poor growth in productivity, high
growth in inflation and costs and a rising exchange rate
At the top of the pyramid is sustainable growth in living standards- comes
from past improvements in competitiveness
Next in the pyramid are the factors that determine current
competitiveness including business performance, productivity, prices and
costs and labour supply. Last in the pyramid are the policy inputs
There are three key things that the council believe determines future
productivity:
The business environment- this determines the cost and ease of
doing business in Ireland and includes the impact of taxation,
regulation, the degree of market competition, the extent of labour
market regulations, the cost of raising finance on business
Physical infrastructure- this determines productivity and costs
and includes transport, energy and IT infrastructure that is
affected by levels of investment by firms and government
Knowledge infrastructure- education, training and research and
development affects the quality of the labour force and of the
products firms are able to produce
Supply side policies might require higher government expenditure but
some require fiscal and monetary policy to deliver the conditions for
long-run economic growth and a stable macroeconomic environment
These policies will not deliver immediate results