Economic Concepts

FOR USE AS WHY GOVERNMENT SPENDING IS BAD

After a level of 20% (the growth-maximising level) government spending becomes detrimental to economic growth.

This is due to inefficiency cost, negative multiplier cost (as government needs more money from private sector to finance spending, so private sector investment falls, less multiplier and accelerator effect) and market distortion costs (as government spending programs/subsidies leads to a market where the ‘third party payer’ problem exists, and inefficiency occurs as people become less concerned about price. This can be explained through the behavioural penalty cost, which explains that government spending discourages economically viable decisions from being made. The behavioural subsidy cost also means that government spending encourages destructive choices; for example, welfare programs can be thought to subsidise economically undesirable decisions because they encourage people to choose leisure over work.

EV OF THE RAHN CURVE

Economic growth is not always a government priority;they must also consider minimising inequality, inequity and mainitaining the environment in a reasonable and clean state. Thus they shoudl consider the tradeoff, and whether growth is always the most important aspect.

A representation of the relationship between tax levels and government revenue.

It states that up to a optimal point, as the level of tax increases, the level of government revenue increases. However after this optimum level, as the level of tax increases, the level of government revenue decreases.

The point that is the 'opitmum' is unknown, and so can only be reached by trial and error.

A representation of the relationship between unemployment and the job vacancy rate

The position on the curve can indicate the current state of the economy in the business cycle. The recessionary periods are indicated by high unemployment and low vacancies, corresponding to a position on the lower side of the 45 degree line, and likewise high vacancies and low unemployment indicate the expansionary periods, above the 45 degree line.

During a recession, it is possible that government spending increases and this has a perverse effect.

People know that that at some point the govt spending will be reversed via increases in taxation and lower govt spending programs due to the long term financing source of the deficit. Expectationally, people will not spend and invest more, because they will save for when they think the govt will stop fiscal easing.

Firms and consumers don't want to invest more and accumulate higher debt levels by investing in an environment of gov spending and low taxes because they know that in the LR they will have to pay it back, therefore considered not a sustainable investment.

The money would be spent by the gov in the form of subsidies and then possibly saved and not used to stimulate (illustrates that the transmission mechanism is broken).

The opportunity cost of using this money is that it could've been used directly by the private sector borrowing (crowding out argument).

This means the gov is borrowing more, increasing the fiscal deficit and increasing bond yields and threatening its credit rating for no noticeable increase in growth or economic recovery in investment or consumption.

Compounded by increased uncertainty about the length and overall fiscal implications of a crisis and sufficiency of commitment devices/credibility of commitment to reduce spending in the future.

This concept was originally derived in 1960s by W.W Rostow. It contains 5 stages, and was orginally applied to the Asian Tigers.

Traditional Society: Subsistent, agricultural based economy, with intensive labor and low levels of trading.

Preconditions to Take-off: Manufacturing begins to develop.

Take-off: Short period of intensive growth, industrialization.

Drive to Maturity: Standard of living rise, use of technology increases, and the national economy grows and diversifies.

Age of High Mass Consumption: Economy flourishes in a capitalist system, characterized by mass production and consumerism.

EV: The model fails to recognise that countries may have other priorities other than growth; for example, at reducing inequality. (Whilst Singapore has high levels of growth, it also has high levels of inequality)

The model makes some assumptions:

-There is a surplus of unproductive labour in the agricultural sector.

-These workers would be attected to the growing manufacturing sector, where there are fixed higher wages.

- Firms in the manufacturing sector make a profit because the price>the fixed wage rate.

- These profits are reinvested into the business in the form of fixed caoital.

- Firms' productive capacity increases, greater demand for labour, people taken from surplus frm agricultural sector until surplus is used up.

- Economy has offically moved traditional to industrialized.

EV: It assumes all profits will be reinvested but that might not happen, reinvestment may take place in the form of fixed capital but capital is labour saving, so demand for labour may fall, surplus is assumed to easily move to manufacturing but depends on occupational mobility, wage levels may not always be fixed; e.g; influence from trade unions etc.

The Lorenz Curve shows the % of income earned by a given % of the population.

Perfectly equal distribution lies at a 45 degree angle.

The further the Lorenz Curve is from the 45 degree line, the less equal is the distribution of income.

The gini coefficient/index is a statistical device that is used to compare income distributions over time and between economies. The closer the value is to 100, the greater the degree of inequality.

It is worked out as A/(A+B)

Ricardo's theory of comparative advantage exists when a country can produce a good or service with a lower opportunity cost than another country.

This is because countries have different factor endowments of labour, land and capital, Countries will specialise and export those products which use intesively the factors of production of which they are most endowed.

If each country specialises in those goods and services which they have an advantage in, then total output and economic welfare can be increased.

Factors that affect comparative advantage include;

Quantity/Quality of factors of productions available.

Investment in research and development

Movements in the exchange rate and long term rates of inflation

Tarriffs and Quotas

If the govt borrows too much, the BoE may increase Interest rates.

As the fiscal deficit increases, it becomes harder to pay back debts. It’s a more risky proposition. Gov bond yields will increase to reflect this increase in risk. As govt bond yields rise, LRIR will rise also. This can lead to a decline in investment, as IRs are higher, meaning a lower rate of return.

Given risky global environment with EMs and other liquidity issues and also since post crisis, MEC  (marginal efficiency of capital) curves may be more inelastic, meaning it takes large cuts in IRs to make investing worthwile. Investment projects that were previously just on the edge will no longer be undertaken because its less profitable, and hurdle rates are higher.

Higher bond yields also makes it more difficult for the government to finance their debt, as debt will accumulate at a faster pace as the govt has to pay back more to bond holders, increasing the deficit as a result. This can turn into a cycle. Links to Rahn Curve.

This could have knock on effects for unemployment and productivity of the UK economy (leading to losses in competitiveness).    

When government spending fails to increase overall aggregate demand because higher government spending causes an equivalent fall in private sector spending and investment. For example, the UK is approaching full capacity at output gap negative of 1.5% but predicted to reach full capacity in 2018. This is reflected though NAIRU, 5.1% unemployment and skills gaps. As capacity of the economy shrinks and the govt continues to spend, they get the lion's share of resources and the increase in demand. Due to govt buying so much, the costs of resources are driven up and makes them less affordable and profitable for firms. Lack of access to resources due to unavailability and high price can lead to a lack of productivity. If private firms cannot invest due to the price of resources, then they will not be able to increase capacity and therefore grow. The economy will suffer inflation as the capacity remains the same, especially since the public sector is largely services. (Although in current economic climate, this might not be such a bad thing as we are in disinflation and not seeing significant increases in the price of goods and services). 

Also because govt borrowing so much, less money available for firms to borrow, so less available AND higher LRIR means there could be a significant decline in investment. Also govt borrows money from private sector in form of bonds, so private sector, if they buy bonds as the govt needs them to in order to finance the increased spending,has less money to spend themselves on increased investment, employment and productivity--> damaging to economic growth

However, if the economy was at full capacity, the increased government spending would tend to crowd out the private sector leading to no net increase in AD from switching from private sector spending to government sector spending.

Devised by Krugman, moral hazard is “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.”.

Moral hazards can occur if there is asymmetry of information (one party having more information than the other) or if two parties face different incentives (this especially applies to insurance).

Moral hazard was particularly an issue during the bank bailouts of the subprime mortgage crisis, and to fix this, the government decided not to bail out Lehman Brothers, as to set an example to other banks.

Tax avoidance; Using loopholes in the law to reduce the amount of tax being paid. (Panama)

Tax evasion; Deliberately not paying taxes through illegal means. (Offshore havens)

An issue associated with these two things is that ta gaps are created; governments collect less tax revenue than expected leading to a shortfall in tax revenue. This is often particularly a problem for developing countries with poor tax infrastructure.

Hauser’s law: Federal tax revenue and marginal tax rates were studied during the years of 1950 to 2007, and it was observed that whilst the top individual tax bracket varied greatly (from 90% in 1950 to around 45% in 2005) the tax revenue as a percentage of GDP remained at about 19.5% throughout the 57 years. This demonstrates that varying the top tax bracket does not have a significant adverse/negative effect on government revenue as a whole, and so can be changed.

EV: Laffer Curve

Originally devised by Eichengreen & Hausmann (and Panizza) in 1999.

It is associated as an issue that (all) emerging markets face.

It has two components to it: domestic and international.

Domestic original sin: An inability to borrow domestically long-term at fixed rates in local currency.

International Original Sin: A situation in which most countries cannot borrow abroad in their own currency.

Bonds are essentially debt investments (loans), and are usually preferred over stocks in bear markets.

When the bond price increases, the bond yield decreases and vice versa.

Both high bond prices and bond yields are good things for different parties; If you are a bond buyer, you want high yields. On the other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond goes up.

Theoretically, the longer the bond has to mature, the higher the yield would be.

Inflation however, erodes the purchasing power of a bonds future cash flow. If there is speculation that infaltion will rise, IR's and yield will rise to make up for the loss of purchasing power.

If IR's fall, the coupon (the amount the bondholder recieves as interest payments) of the bond increases, and if they rise it decreases.

Can be used as  evaluation to trade imbalances.

The trade balance initially worsens following a devaluation or depreciation of its currency.

The higher exchange rate will at first correspond to more costly imports and less valuable exports, leading to a bigger initial deficit or a smaller surplus.

Due to the competitive, relatively low-priced exports, however, a country's exports will start to increase.

Local consumers will also purchase less of the more expensive imports and focus on local goods.

The trade balance eventually improves to better levels compared to before devaluation.

The Marshall-Lerner condition, which states that a currency devaluation will only lead to an improvement in the balance of payments if the sum of PED for imports and exports is greater than one.

EV: J-curve

The UK has inelastic price elasticity of demand for imports and so will continue demanding imports despite the increase in their price. This will lead to an increase in the value of imports which will worsen the current account deficit.

It works by the central bank creating money electronically, which is used to buy securities such as govt and corportate bonds.

The aim of this theoretically, is to increase bank investment (by increasing liquidity and bank reserves via commercial bonds being sold to the central bank) and increase inflation (as buying govt bonds causes the bond price to rise, which leads to a decrease in the long term IRs, which should encourage economic activity).

QE is seen as a solution to the liquidity trap and deflation.

EV: Could lead to perverse effects, as seen by the market reaction to Draghi declaring that QE in the Eurozone would be coming to a swift end.

UK bond yields fell from 3% to 1.5% during the period of quantitative easing (£375) from 2009-12. This made government borrowing cheaper, and in theory encourages more profitable investment. However, bank lending was very slow to recover, suggesting quantitative easing was relatively ineffective in boosting bank lending.

The Lawson Boom is an example of when inflation proved to be detrimental to the economy, as during the late 1980s the UK enjoyed a period of fast economic growth and rapid economic expansion, with inflation hitting 9.5% in 1990.

However inflation increased, and the inflationary rate proved to be unsustainable and in 1991 the UK entered a deep recession with negative growth.

The magnitude in the fall of the value of the sterling could be influential in determining the levels of exports/imports which would affect AD (C+G+I+(X-M)), which would in turn affect inflation.

Chakrabarti and Scholnick’s Benchmark Model of 2002 argued that the depreciation of a currency would lead to increased FDI inflows as immediately after the devaluation, the currency would be relatively cheaper, meaning investors would view the foreign asset as relatively cheap compared to its future expected price (as they think the currency is undervalued at that point in time).

Thus the opposite can be argued to be true, and an appreciation in a host country’s currency would raise expectations about the future level of the exchange rate by less than the the amount of the current appreciation, creating an expectation of a future devaluation of the currency.

Thus FDI inflows would be reduced, as investors believe that they would be able to buy the foreign asset for a cheaper price in the future.

This applies to 'floating' currencies, where the exchange rate is determined by demand and supply.

Simply put, if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market.

A floating exchange rate is constantly changing.

EV:

Technically no exchange rate is completed 'floating' as central banks will intervene before the autocorrection occurs.

A demonstration of the trade-off between inflation and unemployment.

Capital is fixed in the short run. Thus output can only be increased by increasing the variable factor of production, which is labour. Thus labour costs rise. As business costs affect SRAS, SRAS shifts to the left. There is a temporary reduction in unemployment, but a permanent increase in prices, meaning fiscal stimulus doesn't work. Thus is LRAS is perfectly inelastic, the only way of improving living standards is by increasing LRAS, which can only occur by supply side reforms.

The phillips curve argument would be used as evaluation to the use of fiscal stimuli from the govt.

According to the trickle-down theory, if tax rates are lower, people have an incentive to work more because they get to keep more of the income they earn.  They then spend or invest that income, and either of these activities will improve everyone’s prosperity, not just the prosperity of those in the highest income brackets. In the end, the government may actually collect more income despite the lower tax rates because of the additional work performed. This was a key part of Reaganomics.

EV: The Matthew Effect (EV against how economic growth decreases poverty)

'The rich get richer and poor get poorer'.

It refers to the idea that people accumulate economic capital.

High income earners have a high marginal propensity to save. Therefore, the increased disposable income from a tax cut does not filter into other sections of the economy because it is saved not spent. Instead higher incomes may be used to accumulate wealth; this wealth accumulation leads to further capital gains and income from assets – leading to even higher levels of income and wealth inequality.

The Harod Domar Model suggests that economic growth rates depend on two things: Level of Savings (higher savings enable higher investment) & Capital Output Ratio (efficiency of investment).

States that the rate of growth of GDP = Savings ratio / capital output ratio

Can be linked to 'Savings Gap', as it argued that in developing countries saving rates would be low if left to the free markets, so govt should intervene to increase the savings rate.

EV of the Harod Domar Model:

The model was originally based on the economic environment of industrailised countries post depression years, and fail to account for the difficulty of increasing savinfs ratios in developing countries as well as labour productivity, technological innovation and levels of corruption.

Countries such as Thailand are examples of countries who have experienced rapid growth rates despite a lack of savings.

Increasing capital stock can lead to diminishing returns.