Economics Theme 4 Revision

  • Created by: remybray
  • Created on: 11-02-18 16:38

Comparative and absolute advantage

  • Comparative advantage - exists when a country has 'margin of superiority' in production, i.e. where the marginal cost of production is lower. Where a country can produce a good or service at a lower opportunity cost, we say that such a country has a comparative advantage in that good or service
  • E.g. India is the world's largest banana producer with 20% of overall production. India has a comparative advantage when it comes to bananas, because they are endowed with the inputs required to produce bananas - a hot climate and plenty of rain. Th opportunity cost of producing bananas would be much higher in the UK; as a result of the cooler climate and less rainfall, resources would have to be used (which could be utilised elsewhere) to create the necessary conditions for growing bananas - i.e. large temperature controlled warehouses and watering facilities.
  • The law of comparative advantage states that overall output can be increased if individuals specialise in producing the goods in which they have a comparative advantage.This will also bring advantages from division of labour and economies of scale. When countries specialise they then produce a surplus which they can trade. Countries will usually specialise in and export products, which require the inputs with which they are most abundantly endowed.
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Comparative and absolute advantage

The Ricardian comparative advantage (trade) model has very strict assumptions, some of which are not realistic:

1. Fixed endowment of resources (no growth or technological change)

2. Comparison is between no trade and perfectly free trade 

3. No transportation costs of imports/exports

How the results of the model change when the assumptions change:

  • Fixed endowment of resources - changing as opposed to fixed technology: With changing technology, countries must keep an eye on dynamic (long-run) comparative advantage as well as static (short-term) comparative advantage, e.g. comparative advantage may change if technology changes. This then has implications for specialising if in the future you may lose your comparative advantage
  • Tariffs or non-tariff barriers: Where tariffs are levied this may make the lowest cost producer more expensive. This will depend on the size of the tariff. Where tariffs are high, e.g. agricultural goods coming into the EU, then comparative advantage won't apply and lower cost producers will lose out
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Comparative and absolute advantage

  • Transportation costs: Some goods will not be traded because it costs too much to transport them. So the comparative advantage will not apply. Also need to consider environmental issues

What determines comparative advantage?

  • The quantity and quality of factors of production available, i.e. skilled labour or climate
  • Investment in research and development which can drive innovation and invention
  • Fluctuations in the real exchange rate, which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers
  • Import controls such as tariffs, export subsidies and quotas - and other forms of protectionism - these can be used to create an artificial comparative advantage for a country's domestic producers
  • The non-price competitiveness of producers - standard of product design and innovation, product reliability, quality of after-sales support
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Comparative and absolute advantage

Comparative advantage is often a self-reinforcing process:

1. Entrepreneurs in a country develop a new comparative advantage in a product either because they find new ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets

2. Rising demand and output encourages the exploitation of economies of scale; higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry etc...

3. The expansion of an industry leads to external economies of scale

  • Absolute advantage - exists when a country, individual, company or region can produce a good or service at a lower cost per unit than the cost at which any other entity produces that good or service
  • Specialisation may bring dangers. E.g. if by specialising a country allows some sectors to run down. Suppose a country came to rely on imported food, and allowed its agricultural sector to waste away. If the country then became involved in a war, or for some other reason was unable to import, there would be serious consequences.
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Terms of trade

  • Terms of trade - measures a country's export prices in relation to its import prices (the ratio of export prices to import prices)
  • Index of export prices / Index of import prices X 100
  • When the terms of trade rise above 100 they are said to be improving and when they fall below 100 they are said to be worsening. The terms of trade can also be expressed in terms of the number 1, with figures above 1 indicating an improvement, and those below 1 a worsening.
  • It can be interpreted as the amount of import goods an economy can purchase per unit of export goods
  • If export prices rise relative to import prices we say there has been an improvement in the terms of trade - a unit of export buys relatively more imports
  • If import prices rise relative to export prices we say there has been a deterioration in the terms of trade.
  • A rise in the terms of trade creates a benefit in terms of how many goods need to be exported to buy a given amount of imports. It can also have beneficial effect on domestic cost-push inflation as an improvement indicates falling import prices relative to export prices.
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Terms of trade

  • Increasing terms of trade are particularly beneficial if components are imported in order to then produce exported goods
  • However, countries may suffer in terms of falling export volumes and a worsening balance of payments
  • The danger of an improving terms of trade is that it can worsen the balance of trade if domestic and overseas consumers are elastic in their response to the relative export and import price changes
  • A worsening terms of trade indicates that a country has to export more to purchase a given quantity of imports.
  • According to the Prebisch-Singer hypothesis, this fate has befallen many developing countries given the general decline in commodity prices in relation to the price of manufactured goods.
  • LDCs may experience short-run volatility in prices of its exports, e.g. with agricultural goods the supply is volatile and with minerals and raw materials, demand fluctuates with the economic cycle in developed countries (importers of raw materials). Instability of prices means instability of export revenues, so if the country is relying on export earnings to fund its development path, to import capital equipment or to meet its dept repayments, such volatility in earnings can constitute a severe problem
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Terms of trade

  • For LDCs, the terms of trade may also deteriorate in the long run. As real incomes rise in developed countries, the demand for agricultural goods can be expected to rise relatively slowly. At relatively high income levels, the proportion of expenditure devoted to foodstuffs tends to fall and the demand for luxury goods rises. This suggests that the demand for agricultural goods shifts relatively slowly through time.

Limitations of 'terms of trade'

  • Terms of trade calculations do not tell us about the volume of the countries' exports, only relative changes between countries. To understand fully the impact (standards of living) and source of changes in exports and imports, it is necessary to consider changes in the volume of trade, changes in productivity and FDI.
  • The price of exports from a country can be heavily influenced by the value of its currency, which can in turn be heavily influenced by the interest rate in that country. If the value of currency of a particular country is increased due to an increase in interest rate (hot money), one can expect the terms of trade to improve. However, this may not necessarily mean an improved standard of living for the country since an increase in the price of exports perceived by other nations will result in a lower volume of exports. 
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Terms of trade

  • As a result, exporters in the country may actually be struggling to sell their goods in the international market even though they are enjoying a (supposedly) high price.
  • In the real world of over 200 nations, trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant.
  • Many LDCs see themselves as trapped by their pattern of comparative advantage, rather than being in a position to exploit it. A potential change in this pattern was in 2007/8, with food prices rising rapidly. Countries in a position to export these commodities would benefit from the rise in prices (increase in their terms of trade). However, there are many LDCs that need to import these commodities and for them terms of trade deteriorated.
  • Two swedish economists, Eli Hecksher and Bertil Ohlin, argued that a country's comparative advantage would depend crucially on its relative endowments of factors of production. If a country has abundant labour force but scarce capital, then its natural comparative advantage would lie in the production of goods that require little capital but lots of labour. 
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Globalisation

  • Globalisation - a process by which the world's economies are becoming more closely integrated
  • "The process through which an increasingly free flow of ideas, people, goods, services and capital leads to the integration of economies and societies"

Causes:

1. Developments in ICT - The ability of businesses to communicate and handle data has developed significantly. This means communication can occur on a global scale, i.e. email and internet. Communications technology has developed rapidly with the growth of the internet, enabling firms to compete more easily in global markets. The emergence of email, video-conferencing and skype allow for instant communication across the globe; making it easier for firms to communicate within their organisations (avoiding diseconomies of scale) and to communicate with other firms, fuelling the integration of firms and economies

2. Transport developments - Real unit transport costs in the global economy have been falling so it becomes possible for firms to supply on a global scale, e.g. bulk distribution of products in containers by sea, specialist global logistics carriers. Falls in the cost of air travel encourage transport. Ships/vessels can carry more. Improvements in transportation and

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Globalisation

lower transport costs have enabled firms to fragment their production process to take advantage of varying cost conditions in different parts of the world and mean the law of comparative advantage can be applied. 

3. Reduction in protectionism in the world economy - The WTO (which replaced GATT) has sought to reduce protectionism in the world economy. The reduction of tarigs from 40% in 1940 to 5%, on average, in 2000 means we are at a model closer to free trade, which may mean countries specialise in goods where they have a comparative advantage. As countries specialise and trade, this increases interdependence between countries. 

Larger markets and the growth of free trade encourage firms/indivduals to innovate as they have a potentially larger market. This increases profits and offers producers the chance to benefit from economies of scale. Trade in the world today is characterised by trading blocs and while it doesn't offer complete free trade, there is an absence of tariffs between members. This also increases the size of markets to firms and again this can encourage firms to expand output. The emergence of agreements between trading blocs, e.g. NAFTA indicates increasing integration between individual blocs. 

China joined the WTO in 2001, and has had a major impact on global markets. This affected confidence with which other countries could trade with, and invest in China.

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Globalisation

4. Multinational companies - reduced international capital restrictions and increased FDI

Multinational corporation (MNC) - a company whose production activities are carried out in a number of countries

The removal of controls which disrupt the free flow of business capital within the global economy has assisted globalisation. MNCs have grown partly as a result of the creation of trade blocs. They have base, head office in their home country and subsidiaries in other countries thereby increasing the co-operation betwen countries. MNCs want to increase sales, profits and shareholder value. Globalisation provides that opportunity. The barriers to international business are lower and falling - it is much easier to expand into new territories and Governments want to encourage domestic businesses to expand overseas (results in a flow of profits back into the domestic economy).

5. Deregulation of financial markets - There have been moves towards removing restrictions on the movement of financial capital between countries. Many countries have removed capital controls, thereby making it easier for firms to operate globally. This has been reinforced by developments in technology that enable financial transactions to be undertaken more quickly and efficiently

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Globalisation

Consequences/Effects:

  • Increase in trade which may increase wealth, may also lead to a more efficient global allocation of resources if trade follows comparative advantage. Leads to higher allocative efficiency. The increased scale of production may also lead to productive efficiency and the additional competition may eliminate x-inefficiency and encourage dynamic efficiency to out-compete rivals. 
  • Closer integration will lead to larger markets, which will tend to encourage large firms, e.g. MNCs which can produce on a large scale to benefit from EoS. Such firms may have an incentive to invest more in R&D leading to more innovation and developments in products and processes. Closer integration may also leading to a single currency, e.g. Euro
  • The state of other economies can have a knock-on effect on the UK economy. Recession in the US would mean fewer UK exports are likely to be sold to the US, lowering real GDP (downward multiplier).
  • Industries that take advantage of a larger market are more likely to employ skilled workers, and so the wages of skilled workers will rise faster than unskilled workers in a period of globalisation.
  • Increased competitive pressures on British businesses in tradable goods and industries. This helps lower the prices of goods  and has a downward impact on inflation
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Globalisation

  • Growth in the importance of multinational firms - high levels of FDI (both inwards and outwards). Some MNCs engage in FDI because they want to sell their products within a particular market, and find it preferable to produce within the market rather than elsewhere (market seeking). Second, MNCs may undertake investment in a country in order to take advantage of some key resource. This might be a natural resource such as oil and or natural gas, or a labour force with certain skills, or simply cheap unskilled labour (resource seeking). Third, MNCs may simply review their options globally, and decide that they can produce most efficiently in a particular location. This might entail locating just part of their production chain in a certain country (efficiency seeking). The opening up of China to foreign investment has proved a magnet for MNCs wanting to gain access to this large and growing market. In addition, non-European firms have been keen to gain entry to the EU's Single Market, which has encouraged substantial flows of FDI into Europe. 

FDI can bring potential gains in employment, tax revenue, capital and technology, with consequent beneficial impact on economic growth (multiplier effect). However, these may not always be as strong as had been hoped. In particular, if profits are repatriated to shareholders elsewhere in the world, then the long-term impact of FDI may be diluted, rather than feeding back into economic growth. For LDCs, the tax concessions negotiated by foreign MNCs may reduce the benefits, and the technology may not be appropriate.

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Globalisation

  • May help trade-off between unemployment and inflation. Cheaper prices for many international commodities and finished manufactured goods have helped to control inflation in recent years and therefore reduce inflationary expectations
  • Interdependce can increase due to closer economic integration, e.g. Eurozone
  • Increase in external costs, e.g. pollution from trade. There are negative externalities such as increase in pollution and loss of traditional cultures. It is also argued that nations have an incentive to lower their environmental standards in order to attract MNCs, by enabling low-cost production. Environmental damage can arise from transport of goods in trade, e.g. CO2 emissions from air travel. However, money generated from exports can be used for sustainable development. If a country is more efficient in production, it may use less energy and so the impact on the environment is not as bad.
  • Could lead to increased inequality between rich and poor countries.
  • External shocks - one of the issues concerning a more closely integrated global economy is the question of how robust the global economy will be to shocks. In other words, globalisation may be fine when the world economy is booming, as all nations may be able to share in the success. But if the global economy goes into recession, will all nations suffer the consequences? There a number of situations that might cause the global economy to take a downturn: oil prices, financial crises, credit crunches.
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Globalisation

Financial crises - given the increasing integration of financial markets, a further concern is whether globalisation increases the chances that a financial crisis will spread rapidly between countries, rather than being contained within a country or region. 

Credit crunch - in 2007-08, commercial banks in several countries found themselves in financial crisis. This followed a period in which relatively low interest rates had allowed a bubble of borrowing. When house prices began to slide, many banks in several countries found that they had overextended themselves, and had to cut back on lending. This affected a number of countries, and there was a danger that the financial crisis would affect the real economy, leading to a recession. This was a recession that would affect all countries around the globe because of the new interconnectedness of economies. It became apparent that no single country could tackle the problem alone, as measures taken to support the banks in one economy had rapid knock-on effects elsewhere. Once this was realised, co-ordinated action was taken, and in October 2008 the central banks of several countries reduced their bank rates together.

  • Structural change in industries can occur as less competitive industries collapse leading to unemployment. 
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The pattern of world trade

  • High involvement of the EU in world trade, accounting for 36% of imports and 34% of exports (2011). 
  • Trade flows between developed countries - and more advanced developing countries - have tended to dominate world trade, with the flows between developing countries being relatively minor. This is not surprising, given that by definition the richer countries have greater purchasing power.
  • However, the degree of openness to trade of economies around the world varies. Some countries, especially in East Asia, have adopted very open policies towards trade, promoting exports in order to achieve export-led growth. In contrast, some countries (including a number in Latin America) have been much more reluctant to become dependent on international trade, and have adopted a more closed attitude towards trade. 
  • Open economies, which are highly trade dependent and export only a small range of products to few markets, are impacted more when it comes to global downturns. This helps to understand the wider economic and social effects of the 2009 global downturn. The recession has affected developing countries in many different ways including the following:
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The pattern of world trade

  • Declines in foreign direct investment especially reductions in access to loans from banks – some developing countries have set up their own ‘sovereign wealth funds’ to offset this, such as investing in real estate, stocks and commodity markets.
  • Falls in export revenues due to lower demand (and falling prices) for commodities and a sharp reduction in demand for manufactured goods from many emerging market countries; causing volatility in export prices and export revenues for developing countries. Much of the strong GDP growth enjoyed by developing nations was due to rising demand for and prices of primary commodities which improved the terms of trade of developing exporters – remember, many developing nations are Primary Product Dependent (PPD). This reversed from the middle of 2008 onwards although there are signs of a rebound in export revenue since the spring of 2009.
  • Recession has cut export prices – but another key effect has been increased volatility of prices – this increases revenue uncertainty for commodity-dependent countries and acts as a barrier against much-needed capital investment
  • Increased unemployment, under-employment and reduced incomes. Many workers are made redundant and are forced into lower-income jobs in the informal sector (not taxed or monitored by the government – cash in hand) and rural sectors (China is a good example).
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The pattern of world trade

  • A decline in remittances (sending money back to their home country) from overseas migrants working in developed countries – the World Bank has forecast that remittance flows to developing countries will decline by 7-10 percent in 2009. The World Bank estimates that there are over 250 million people living overseas who send some of their earned income back - remittances to all countries topped $305bn in 2008.
  • A recession in global tourism – often a significant share of GDP for many poorer nations.
  • Weaker growth and rising unemployment puts huge pressure on government finances and in many countries there is not a widespread social welfare system as a safety net.
  • Some countries have been hit by multiple macroeconomic shocks. A good example is Nigeria – whose export revenues have declined following a 70% fall in crude oil prices, a sharp fall in domestic share prices (which has made funding investment – to increase AD - tougher) – both of which contributed to a depreciation of the naira by 20% which has worsened their terms of trade, increased the cost of servicing foreign debts and increased the prices of imported foods.
  • Overall the recession has worsened prospects for developing countries meeting the Millennium Development Goals. The World Bank has estimated that up to 90 million extra people worldwide (62 million in Asia) will live in extreme income poverty (less than US$1.25 per day) in 2009 as a result of the global economic slowdown
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Argument for and against free trade

  • Free trade means that trade is undertaken across international boundaries without protectionism, e.g. tariffs, quotas. 
  • The argument of free trade (also referred to as trade liberalisation) tends to centre on Ricardo's theory of comparative advantage. 
  • Trade allows consumers wider access to a range of goods and services and consumers may also be able to buy goods which cannot be produced domestically.
  • Supporters argue that free trade will promote efficiency. This will benefit total world output as those most efficient in the production of a good/service concentrate on producing that and so maximising output from a given level of resources, i.e. productive efficiency. The effect of competition will encourage producers to minimise costs. International trade will also promote allocative efficiency, i.e. producers producing what consumers want. 

Arguments in favour of free trade:

  • Competition is increased and gives incentives to producers to be more efficient - allocatively and productively
  • Rising living standards and a reduction in poverty - countries that are more open to trade grow faster over the long run than those that remain closed. Growth directly benefits 
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Argument for and against free trade

the world's poor especially when poorer countries have fair access to international markets to allow them to benefit from the gains from specialisation and exchange

  • Welfare gains - Neo-liberal economists believe that trade is a 'positive-sum game' - all countries engaged in open trade and exchange stand to gain. Wider choice of goods
  • Economies of scale - trade allowes firms to exploit economies (marketing economies, advertising economies) by operating on a larger scale, leading to lower average costs of production that can be passed onto consumers, these lower prices mean an increase in consumer surplus.
  • Market contestability - trade promotes increased competition particularly for those domestic monopolies that would otherwise face little real competition
  • X-inefficiency reduction from innovation - trade enhances choice and stimulates product and process innovations bringing better products for consumers and enhances the standard of living
  • Access to new technology - trade is an important mechanism by which countries can have access to new technologies
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Argument for and against free trade

Arguments against free trade:

  • Infant industry argument - younger firms often do no have the economies of scale that their older competitors from other countries may have, and thus need to be protected until they can attain similar economies of scale
  • Distortion of trade - trading blocs are likely to distort world trade, and reduce the beneficial effects of specialisation and the exploitation of comparative advantage
  • Inefficiencies and trade diversion - inefficient producers within the bloc can be protected from more efficient ones outside the bloc. E.g. inefficient European farmers may be protected from low-cost imports from developing countries. Trade diversion arises when trade is diverted away from producers with a comparative advantage who are based outside the trading area.
  • Retaliation - the development of one regional trading bloc is likely to stimulate the development of others. This can lead to trade disputes, such as those between the EU and NAFTA, including the recent Boeing (US)/Airbus (EU) dispute. 
  • Ricardo's three assumptions evaluation 
  • Over specialisation - may lead to diseconomies of scale
  • Agriculture-reliant on one crop vulnerable if there is a bad harvest/sudden shift in demand
  • Structural unemployment if an industry is closed
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Argument for and against free trade

  • No longer independent if rely on goods from other countries
  • Environmental issues of transporting goods
  • Costs (e.g. transport and labour) can outweigh comparative advantage
  • Not all countries can benefit, e.g. land-locked countries and sub-saharan Africa
  • If country loses comparative advantage, nothing to fall back on
  • Countries which import a lot are in a weak position if there is any international conflict
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Trading blocs

  • An important influence on the pattern of world trade has been the establishment of trading blocs in different parts of the world. These are intended to encourage trade among groups of nations. Examples are ASEAN (an organisation of 10 countries in South East Asia), MERCOSUR (five countries in Latin America), NAFTA (Canada, the USA and Mexico) and the EU.
  • Bilateral trade agreement - trade agreement between two jurisdictions (two states or between a bloc and a state). Multilateral trade agreement - between more than two.
  • Free trade area - where all tariffs and quotas are removed between member countries but each member country is able to impose its own barriers on goods it imports from outside the bloc
  • Customs union - a group of countries that agree to to free trade with each other, but also adopt a common external tariff (CET) on imports from non-members outside of the bloc
  • Common market - when member states agree to free trade and adopt a CET. Additionally, they now allow free movement of capital and labour, as well as product standards and regulations are common between member countries
  • Economic union - economies within a bloc are fully integrated, in the same way that different regions are within a country. Additionally, it implies that there is some degree of fiscal union and/or monetary union
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Trading blocs

  • Economic and monetary union - member states use the same currency and operate under the same monetary policy, with a central bank dictating interest rates/quantitative easing for all. e.g. ECB and the Euro
  • Fiscal union - decisions about the collection and expenditure of taxes are taken by a central institution for all member states. Individual countries cannot dictate their own taxation/spending. Highest level of trade bloc integration - total economic integration.

Trade creation is where a trade bloc leads to a greater specialisation according to comparative advantage and thus a shift in production from higher cost to lower cost sources of production - where a trade bloc diverts consumption towards a comparative advantage. Previously, the country with a comparative advantage would face tariffs/non-tariff barriers on their exports but the trade bloc reduces/eliminates these.

Trade diversion is where a trade bloc diverts consumption from goods produced at a lower cost outside the union to goods produced at a higher cost but (tariff-free) within the bloc.

net gain will occur if trade creation exceeds trade diversion. 

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Trading blocs

This will depend on:

  • Relative costs of production in countries concerned
  • Level of tariffs prior to the formation of the trade bloc, where the tariffs were high prior to the formation of the bloc, the bloc is more likely to create trade
  • Level of the CET, where this is high trade is more likely to be diverted to a higher cost producer away from a lower cost producer

Evaluation of trade creation

  • Maybe a need to protect infant industries
  • Tariffs can be used to counteract dumping
  • Question assumptions behind Ricardo's law of comparative advantage
  • Environment issues of flying/shipping goods around the world
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Trading blocs

Positive effects of trade blocs:

  • Access to a larger market means economies of scale can be exploited, as output increases. However, this could lead to diseconomies of scale
  • Increased access to a greater supply of labour workforce. Free movement of labour increases supply of labour and therefore pushes wages down (reducing costs of production), therefore it increased the amount of skilled labour. A more productive workforce reduces costs of production, as fewer workers are required. The quality of output should also increase. A trade bloc would increase the geographical mobility of workers between nations, as there are fewer/no barriers disrupting their movement (in some types of trade bloc)
  • However, this could cause a 'brain drain' from less developed countries to more developed countries where the employment opportunities are greater (Bulgaria and Poland to UK). This is negative for the source countries as they are losing (usually young) skilled workers and consumers - thus reducing the productive capacity of the economy (fall in quantity of labour)
  • External economies of scale 
  • Incentive to increase investment and to introduce new technology to meet demands of the new larger markets
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Trading blocs

  • Reducing monopoly power and increasing competitive pressure: Increases price and non-price competition; reducing levels of X-inefficiency. However, growth of multinationals may restrict competition e.g. create barriers to entry for smaller firms (infant industry argument) due to economies of scale being more difficult for smaller firms to exploit
  • Increase in FDI - positive multiplier for the area the firm invests in
  • Trade creation means that countries specialise in producing the goods in which they possess a comparative advantage, taking advantage of the inputs in which they are endowed with in their country is globally efficient as countries are each using fewer resources. They also reap the benefits of specialisation - becoming more an more efficient in terms of producing the goods, reducing their costs and the price it is sold for
  • Impact upon the environment - depends on where the goods were purchased from before the trade bloc existed. Trading with other countries in a trade bloc can be negative for the environment, if goods were previously purchased domestically. However, if goods were pruchased from a country many miles away (further away than countries in the trade bloc) then a trade bloc may be comparatively beneficial, as goods are now imported from countries in the trade bloc nearby.
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Trading blocs

Negative effects of trading blocs:

  • Adjustment costs - a firm or industry that finds itself less competitive than others in the trade bloc could face closure, which could lead to unemployment. Such structural unemployment could have a damaging impact on the local economy. 
  • Regional multiplier effects - multiplied effects on employment/unemployment, impact on structure of the workforce (young/qualified leave and old/less qualified remain), region becomes a less attractive destination for new investment, infrastructure deteriorates
  • Monopoly/oligopoly power - the formation of the single market may encourage the development of monopoly power across the European market, with potential to exploit consumers: higher prices and less choice (increase standardisation of goods and services)
  • The emergence of regional trading blocs - disputes that tend to develop between blocs
  • Multinational corporations - may drive out local businesses 
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Monetary unions

Benefits of entry:

  • Price transparency - With a common currency, it will be easier to compare prices in different European countries because they would all be in Euros. This enables firms to source cheaper raw material and consumers to buy cheaper goods. Information is improved, as sellers cannot hide behind exchange rates so there is an incentive to improve efficiency
  • UK exporters wold face more exchange rate certainty - an appreciation in sterling can make UK exports uncompetitive. If the UK has the euro it will mean there will be no need to be concerned about fluctuations between the pound and the euro. Reduced fluctuations increase stability and confidence which is important for investment and growth. Therefore with a single currency business confidence should improve leading to greater trade and economic growth. However, firms can hedge against exchange rate movements to insure against rapid fluctuations. 
  • Higher inward investment (FDI) - it is argued that staying out of the Euro means that the UK attracts less FDI because foreign firms want to invest in the Eurozone. Inward investment may increase from outside the EU as firms take advantage of lower transaction costs within the EU area. This would bring about the following benefits: multiplier effect on 
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Monetary unions

national economies, transfers of human and technological capital, employment, trade benefits and tax revenue. However, there may be more significant factors that influence where multinationals invest than the euro: well-trained labour force, regulations, e.g. health and safety, patents and copyright, access to the market, access to technology and suppliers, corporation tax, tax concessions, grants, subsidies. Also, it is relatively easy to convert pounds to euros so it may not be such a barrier to trade and companies hold accounts in different currencies, e.g. euro, dollars, pounds

  • Lower transaction costs - Some people argue that staying out of the Euro is equivalent to exporters facing a tariff when they trade inside the EU - some estimates have placed transaction costs at 0.4% of GDP. This impacts small businesses more, as larger businesses can get better rates as they tend to purchase currencies in large quantities and so benefit from bulk buying (Eos). With a single currency, there will be no longer a cost involved in changing currencies; this will benefit tourists and firms who trade within the Euro area. This benefit will be roughly equal to 1% of GDP so is quite significant. Some studies have suggested that the Euro has led to a 6% increase in tourism. However, transaction costs are a relatively small % of overall business costs.
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Monetary unions

  • Improved trade - Supporters of the Euro argue that greater price and cost transparency/no exchange rates encourages intra Eurozone trade. The ECB state exports and imports of goods within the euro area rose from about 27% of GDP in 1999 to around 32% in 2006. 
  • Improvement in inflation performance - The ECB which sets interest rates for the whole Eurozone area will be committed to keeping inflation low; countries with traditionally high inflation should benefit from this greater inflationary discipline. However, this point is debatable as countries outside the Euro have maintained low inflation, and arguably the ECB have concentrated too much on low inflation to the detriment of growth and unemployment. In response to a small degree of cost-push inflation, the ECB raised interest rates, showing to markets they were willing to risk core-inflation falling below target, despite low growth or recession in parts of the Eurozone. The Bank of England by contrast, tolerated a higher rate of inflation because they felt more important to avoid a double-dip recession.

 

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Monetary unions

Disadvanatages of entry:

  • Changeover costs from joining the Euro - costs of changing account systems, menu costs (vending machines, catalogues, printing new shop labels), installation of new payments systems and customer confusion
  • Higher prices - potential loss of consumer welfare if suppliers increase prices when converting from sterling to euro
  • Loss of monetary policy control - If the UK were to join the Eurozone, the UK government would no longer be able to use monetary policy for internal domestic purposes, to respond to their own independent economy. Entering the Eurozone means losing an instrument to influence the macroeconomy; the current 'one-size fits all' monetary policy across the Eurozone may work against a country if their economic cycle is not convergent with the Eurozone. Interest rates are set by the ECB according to what the ECB believes is right for all member countries. This could prove to be harmful for a country if their economic cycle is not synchronised with other members. E.g. if the union as a whole is experiencing good economic growth and so has increased interest rates to combat inflation, but an individual member country (e.g. Greece) is suffering from low economic growth or a recession. This would create a conflict as it would not be possible to
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relax interest rates in order to allow Greece's aggregate demand to recover, which could worsen the state of its economy. ECB interest rates may be unsuitable for the UK economy. E.g. if the Euro economy recovers before the UK economy, interest rates may increase too quickly and harm the UK's recovery

However, the loss of control over economic policy is not such a problem if all economies within the monetary union converge - in terms of economic structure (growth, inflation etc)

  • Housing market structure - the nature of the UK housing market means that the UK is very sensitive to interest rates. In the UK, 63% of the population has a mortgage, which is greater than most European countries (Germany - 40%, France - 52%, Switzerland - 38%). As opposed to the fixed-rate mortgages common in Europe, in the UK the emphasis is on variable rate mortgages. This means a small increase in interest rates has a big effect on consumer spending. If interest rates are wrong it can either cause an inflationary boom or a deeper recession. As a result, changes in interest rates have disproportionately strong effects in the UK, relative to the Eurozone, on household wealth and consequently economic growth.
  • Eurozone debt crisis - The great recession of 2008-11 showed the vulnerability of Euro 
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member countries to a common monetary policy. Being in the Eurozone, countries are able to borrow much more easily and do not have to worry about their currency being devalued - lenders believed that Germany would pay any debts if countries were unable to. Although all member countries operate under a common monetary policy, individual member states are still able to set their own fiscal policies. E.g. Greece consistently spent more than its tax revenues, resulting in huge budget deficits each year. To finance this, Greece simply kept borrowing money from other Eurozone members. This led to a situation where countries within the Eurozone were highly intertwined with each other. In 2009, when the credit crunch occurred, Greece was no longer able to borrow money to pay off previous loans and defaulted. This resulted in a knock on effect throughout the whole Eurozone, placing downward pressures on the value of the Euro and reducing business confidence. The UK's decision not to join the Euro avoided becoming intertwined in the crisis and currently there is no system in place to prevent somethign similar from happening again.

  • No lender of last resort - In the Euro, the ECB is unwilling to act as lender of last resort (ECB is unwilling to buy government bonds if there is a temporary liquidity shortage). This causes greater pressure on government bond yields and puts pressure on countries to pursue austerity (spending cuts) which create lower economic growth.
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  • Loss of ability to devaluate currency in recession - In the Euro, there is no possibility to devalue. If you have higher inflation than other European countries (e.g. higher wage growth, lower productivity growth) you will soon become uncompetitive. Since the start of the Euro, several countries have experienced rising labour costs. This has made their exports uncompetitive. Usually, their currency would devalue to restore competitiveness. However, in the Euro, you can't devalue and you are stuck with uncompetitive exports. This has particularly been a problem for countries like Portugal, Italy and Greece.Their decline in competitiveness has led to lower exports and lower economic growth, contributing to their decline in tax revenues. From 2008-10, the UK benefited from a 20% devaluation in sterling which helped to restore competitiveness. Without this devaluation, the recession could have been worse.

In order to join the Euro, the country joining must pass an 'economic convergence criteria' - meaning that macroeconomic indicators of the Eurozone and the applicant country need to be similar, as this will make the likelihood of success higher. Especially if they are to operate under a common monetary policy, you wouldn't want an economy that is in deep recession to join whilst the Eurozone is experiencing strong growth.

 

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Convergence criteria for joining the Euro:

1. Stable prices - inflation must not be more than 1.5% higher than the average in the three member countries with the lowest rate of inflation

2. Stable exchange rate - the national currency must have been stable relative to other EU currencies for a period of 2 years prior to entry into the monetary union 

3. Sound government finance - total government debt must not exceed 60% of GDP. The annual budget deficit must not be greater than 3% of GDP.

4. Interest rate convergence - 5-year treasury bond interest rate must not be more than 2 percentage points higher than the average of Eurozone members (3 countries with lowest rate)

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World Trade Organisation

  • The World Trade Organisation (WTO) is the only global institution that deals with the rules of trade, providing guidelines and a platform for its members to resolve trade disputes.
  • It is an organisaiton for opening up trade, a forum for governments to negotiate trade agreements, a place for them to settle trade disputes, and it operates a system of trade rules. 
  • Essentially, the WTO is a place where member governments try to sort out the trade problems they face with each other

Underlying the WTO are a set of principles:

1. Most favoured nation principle - which implies that countries cannot discriminate between their trading partners. E.g. a reduction in a tariff for one country must be extended to all. Some exceptions are allowed. E.g. countries can set up a free trade agreeement that applies only to goods traded within the group - discriminating against goods from outside. 

2. National treatment principle - imported and locally produced products must be treated equally once the foreign goods have entered the market. Charging a tariff on an import is not a violation of national treatment.

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3. Freer trade: gradually, through negotiation - lowering trade barriers (custom duties/tariffs, import bans, quotas). By the mid 1980s, with the WTO's assistance, industrial countries' tariff rates on industrial goods had fallen steadily to less than 4%. The WTO agreements allow countries to introduce changes gradually, through 'progressive liberalisation'

4. Predictability - With stability and predictability, investment is encouraged, jobs are created and consumers can fully enjoy the benefits of competition - choice and lower prices. In the WTO, when countries agree to open their markets for goods or services, they 'bind' their commitments. For goods, these bindings amount to ceilings (upper limits) on future customs tariff rates. The system tries to improve predictability and stability in other ways as well - by discouraging the use of quotas and other measures used to set limits on quantities of imports. Also, to make countries' trade rules as clear and public ('transparent') as possible. Many WTO agreements require governments to disclose their policies and practices publicly within the country or by notifying the WTO.

5. Promoting fair competition - the principles of the MFN and national treatment are designed to secure fair conditions of trade. Many of the other WTO agreements aim to support fair competition: in agriculture, intellectual property, services, etc.

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6. Encouraging development and economic reform - the WTO allows some developing countries some preferential treatment, as the WTO members have a large proportion of developing countries. The WTO system contributes to development. Over 3/4 of WTO members are developing countries and countries in transition to market economies. Between 1986-1994, over 60 of these countries implemented trade liberalisation programmes on their own accord. Better-off countries should accelerate implementing market access commitments on goods exported by the least-developed countries, and it seeks increased technical assistance for them. More recently, developed countries have started to allow duty-free and quota-free imports for almost all products from least-developed countries

Possible conflicts between regional trade agreements and the WTO:

  • Trading blocs might distort world trade or adversely affect those who do not belong to them. There could be an inefficient allocation of resources as a result of policies such as the EU Common Agricultural Policy
  • Conflicts between blocs could lead to a rise in protectionism. A CET contradicts the WTO's principles, since although there is free trade between members, protectionist barriers are imposed on those who are not members
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  • Some countries might argue that the WTO is too powerful, or that it ignores the problems of developing countries. This could be since developed countries do not trade completely freely with developing countries, which limites their ability to grow
  • Setting up a customs union or a free trade area could be seen to violate the WTO's principle of having all trading partners treated equally. This is especially if a CET is applied. However, they can complement the trading system and the WTO strives to ensure that non-members can trade freely and easily with the members of a trading bloc
  • When an economic union, such as the EU, imposes a CET on goods from outside the bloc - this can lead to trade diversion. This conflicts with the aims of the WTO as the CET is an example of protectionism and is not free trade. Furthermore this also contradicts with the WTO's most favoured nation principle and the national treatment principle
  • The extent to which trade blocs will conflict with the aims of the WTO will depend upon the size of the CET.
  • However, where there were tariffs before the formation of a trade bloc, the elimination of the tariff between members will create trade. Where those tariffs were previously of higher value: then trade will be created, meeting the aims of the WTO
  • The extent to which the growth of trade blocs meets the aims of the WTO will depend on the level of rivalry between trade blocs and the level of tariffs they put on each others' goods.
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The WTO agreements uphold the principles, but they also allow exceptions:

  • Actions taken against dumping (anti-dumping)
  • Subsidies and special 'countervailing' duties to offset the subsidies
  • Emergency measures to limit imports temporarily, designed to 'safeguard' domestic industries
  • 'Dumping' a product is when a company exports a product at a price which is lower than the price it normally charges in its home market. This may be seen as unfair competition and as a result many governments take action against dumping in order to defend their domestic industries.
  • The WTO agreement focuses on how governments can or cannot react to dumping, i.e. it disciplines anti-dumping actions, and it is often called the 'Anti-Dumping Agreement'
  • The WTO agreement allows some governments to act against dumping where genuine injury to the competing domestic industry is occuring.
  • Typically anti-dumping action means charging extra import duty on the particular product from the particular exporting country in order to bring its price closer to the 'normall value' or to remove the injury to domestic industry in the importing country
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Criticisms of the WTO:

  • Free trade benefits developed countries more than developing countries. It is argued, developing countries need some trade protection to be able to develop new industries. The WTO have sought to maintain the same rules for developing countries, preventing them from protecting new industries (infant industry argument)
  • Diversification - arguably developing countries who specialise in primary products need to diversify into other sectors and to diversify they may need some tariff protection, at least in the short term. Many of the existing industrialised nations used tariff protection when they were developing. Therefore, the WTO has been criticised for being unfair and ignoring the needs of developing countries
  • Environment - free trade has often ignored environmental considerations, e.g. free trade has enabled imports to be made from countries with the least environmental protection. Arguably the WTO should do more to promote environmental considerations, and disregard increasing GDP as the most important economic objective
  • Free trade ignores cultural and social factors. Some criticise the WTO for enabling the domination of multinational companies which reduce cultural diversity and tend to swamp local industries and firms
  • Undemocratic - its structure enables richer countries to win what they desire
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Protectionism

  • Protectionism - the use of economic policies to deliberately regulate (and often disrupt) trade between countries, mainly to reduce imports. Protectionism is commomly used in order to protect the interests of domestic firms from the threat of foreign rivals
  • Tariffs - a tax imposed on imported goods with the intention of making the import more expensive than the domestically produced good and/or to raise revenue for the government. By imposing a tariff, it is likely that this will raise its final price to the consumer. Such a rise in price will lead to demand falling for imports, also therefore helping domestic producers. Some consumers will switch consumption from imported goods to domestically produced substitutes, therefore reducing leakages from the economy and growing domestic firms.
  • However, not all the effects of the tariff are favourable for the economy. Consumers are certainly worse off, as they have to pay a higher price for the good; there is a loss of consumer surplus. Some of what was formerly consumer surplus has been redistributed to others in society: the government has gained tariff revenue, producers gain producer surplus.
  • There is also a deadweight loss to society. These areas were formerly a part of consumer surplus, but are now lost. Overall society is worse of as a result of the tariff. 
  • The impact of the tariff will depend upon the elasticity of demand and supply in the domestic market
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  • Quotas - a physical limit on the quantity of imports. A complete ban is called an embargo. Imposing a limit on the quantity of goods imported into a country will increase the share of the market available for domestic producers. 
  • Subsidies: to export producers - governments give subsidies to exporters to lower their costs of production and give them a competitive advantage over international rivals. E.g. the US aircraft manufacturer Boeing has accused European governments of subsidising Airbus, the European aircraft manufacturer.
  • To domestic firms - governments can help to reduce imports by giving subsidies to domestic firms that compete with imports. This is not usually done by giving subsidies directly to the producer, but rather the government could give cheap loans or tax breaks on investment in order to compete more effectively against imports.
  • The downside of this approach is that these funds need to be raised from elsewhere in the economy, thus distorting the allocation of resources in other markets. Furthermore, it is not clear that subsidising exports in this way provides any better incentives for efficiency than the tariff approach. If governments wish to encourage firms to become more efficient in order to compete, a better approach might be to subsidise education and training, or R+D to improve production techniques.
  • Non-tariff barriers - e.g. by imposing strict regulations; this raises the costs to importers 
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because they have to adapt their products to the product standards set. Countries may also make it difficult for importers by putting large amounts of red tape on imports and/or importers may have to get licenses in order to import; allow imports through only designated ports and airports; officials may take months to clear paperwork on imports, causing shipments to be delayed for months at ports because customs officials have to check products

  • Dumping - it occurs when manufacturers export a product to another country at a price either below the price charged in its home market or below its costs of production. 
  • Countervailing duties - an import duty is imposed on an import, in order to offset a reduction of its price as a result of an export subsidy in the country of origin. This counteracts dumping

Arguments against protection:

  • Reduction in economic welfare - see tariff diagram. 
  • Impact on protected firms - less competition; less efficiency; less innovation; more complacency; resistance to the removal of protection. Unit costs rise
  • Dangers of retaliation and tariff war 
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Arguments used to justify protectionism:

  • Infant industries - allows younger companies to become established, as they are unable to benefit from economies of scale compared to older firms
  • The problems of industries faced with 'dumping'
  • The problems of declining industries faced with competition from abroad, and the need to ease that pace of decline. 
  • Macro-economic concerns of government, particularly in relation to unemployment and trade deficits. 
  • Current account deficit on the balance of payments - reducing imports should reduce the trade deficit
  • The desire to protect key, strategic industries such as agriculture and defence
  • Increased demand for domestic goods, so that imports are reduced and domestic consumption is increased
  • Employment could be preserved by protecting domestic industries from foreign competitors

It can be argued that protectionism is beneficial in the short-run in order to protect small, infant industries (especially in developing countries) from larger and cheaper international 

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imports. The protectionist policies allow these industries to grow and establish themselves, becoming large enough to be able to exploit economies of scale. In the long run, once this has been achieved, protectionism could be dropped and the industry is now able to compete with international imports and also has access to a wider, international market.

Impacts of protectionism on a micro level:

  • Consumers - tends to harm the interests of consumers. Either they are unable to buy goods at a lower price than goods produced domestically, or they suffer restrictions on the range of goods being offered to them for sale. Protectionist policies also tend to raise the price of domestically produced goods, as these goods may be produced using components that are imported and thus may face tariffs/quotas etc. This could cause cost-push inflation. Import restrictions limit competition faced by domestic producers - less incentive to become more efficient and lower costs or produce new, innovative products
  • Producers - if domestic markets are threatened by imports, then protectionist policies can help keep out imports. This means higher output, higher sales and higher profits for domestic firms. Equally, if they benefit from measures to encourage exports, then their output and profits should be higher. However, some domestic firms could suffer. If tariffs
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imposed on raw materials or components used in manufacturing, then producers will suffer because they have to pay higher prices. This could increase their costs and make them less price competitive compared to foreign car manufacturers abroad

  • Workers - if protectionist policies were not implemented, then firms would reduce jobs or shut down altogether. However, it could be argued that workers in the long-term would be better off if production did close down as a result of foreign competition. The market would reallocate resources into industries where the country was able to compete. New jobs would then be created which had greater job security
  • Governments - in the short-run they can benefit from higher tax revenues raised by tariffs. If jobs are protected, they don't lose the taxes paid by those workers that would have been made redundant. In the long-term, governments may however lose out if protectionist policies result in an inefficient economy where growth is restricted. Their tax revenues will be smaller and they may have to pay out more in welfare benefits.
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Balance of payments

Current account - an account identifying transactions in goods and services between the residents of a country and the rest of the world, together with income payments and international transfers

  • Trade in goods (visible trade) - include the import and export of finished goods (cars, computers), semi-finished goods (parts and components), and commodities (oil, tea, coffee). This has traditionally shown a deficit for the UK. As reserves of oil in the North Sea have run down, the UK has become a net importer of oil. Imports of cars and other consumer goods have persistently exceeded exports
  • Trade in services (invisible trade) - financial services, tourism, consultancy. This has recorded a surplus in every year since 1966.
  • Income from profits and incomes - investment income refers to any income made from investing abroad, and includes profits, such as those from business activities located abroad; interest received from UK financial investments and loans abroad, and dividends from owning shares in overseas firms. Payments to individuals who are residents of a country, and are employed in another, are also included in this (remittance)
  • Transfers - includes transfer payments arising from gifts between residents of different countries, donations to charities abroad, and overseas aid. The largest item is transfers with EU institutions
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Capital account - account identifying transactions in (physical) capital between the residents of a country and the rest of the world. It is relatively small

  • The most significant aspect of the capital account is FDI (foreign direct investment), when a foreign company buys capital to set up in another country.
  • Another aspect concerns migration. If someone migrates to the UK, that person's status changes from being a non-resident to being a resident. His or her property then becomes part of the UK's assets, and a transaction has to be entered into the BoP accounts..
  • Migrants' capital transfers are not transactions between two parties, but transfers ofmoney that can arise from the migration of individuals from one economy to another, e.g. money that accumulates in bank accounts
  • Internationally, after inward FDI, migrants' capital transfers are now the second largest source of capital inflows to emerging markets and developing countries and they provide an increasingly important means of helping to fund the current account deficits 
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Balance of payments

Financial account - an account identifying transactions in financial assets between the residents of a country and the rest of the world

  • The most important aspect of the financial account is FDI - the physical capital purchased for FDI would appear in the capital account, but if a controlling interest in a foreign company purchased (>10%) then this would appear on the financial account
  • The other main aspects are government-owned assets such as transactions in financial assets (gold, bonds, foreign currency reserves)
  • If a country runs a current account deficit, it can do so only by running a surplus on the financial and capital accounts - sometimes achieved by the government/central bank selling bonds, acquiring loans, selling foreign currency reserves and/or selling gold
  • Flows of hot money appear on the financial account - investors taking advantage of higher interest rates or speculators may convert their money into sterling if they believe the alue of the pound is going to rise

The overall BoP has to equal zero. If there is a deficit on the current account, then the financial account and capital account has to amend this by having a surplus so that the overall BoP account is equal to zero.

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In reality though this rarely happens. With fluctuating exchange rates, the change in the value of money can add to BoP discrepancies. When there is a deficit in the current account, which is a balance of trade deficit, the difference can be borrowed or funded by the capital account.

The financing of a deficit is achieved by - which is recorded in the financial account:

  • Selling gold or holdings of foreign exchange
  • Borrowing from other central banks or the IMF or selling bonds
  • Dividends from FDI investment abroad (most likely for UK)

A surplus will be disposed of by - which is recorded in the financial account:

  • Buying gold or currencies and/or paying off debts/paying back bonds which have matured

In theory, the capital and financial account balance should be equal and 'opposite' to the current account balance, but in practice this is only achieved by the use of a balancing item called net errors and omissions. This device compensates for various errors and omissions in the BoP data, and which brings the final BoP account to zero. It is the sum of all transactions that fail to be officially recorded by accountants and statisticians compiling the BoP record. 

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Some of these items are missed because of individuals and firms, who should be submitting accurate information to the government, fail to do so because they are tryin to avoid tax or are engaging in other illegal activities.

A current account deficit can be a problem if:

  • It is persistent - if it is ongoing, may imply a lack of competitiveness
  • It forms a large share of GDP (greater than 5% is the perceived maximum)
  • There are no compensating inflows on the capital account

Causes of a current account deficit:

  • Excessive growth - if the economy grows too quickly, and rises above its own trend rate (in the UK is around 2.5%), then domestic output (AS) may not be able to cope with domestic aggregate demand. As a result, imports increase
  • High export prices - occur if a country's inflation is higher than that of its competitors, or if its currency is over-valued which will reduce its price competitiveness
  • Non-price factors - poorly designed products, poor marketing or bad reputation for reliability discourage exports
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  • Poor productivity - an economy might not be producing enough from its scarce factors of production. Labour productivity plays an important role in a country's competitiveness and trade performance, and the UK has suffered from poor productivity
  • Low levels of investment in real capital - caused by excessive long-term interest rates, or low levels of R+D
  • Low levels of investment in human capital - lack of investment in education and training, which reduce skill levels relative to competitor countries and force countries to produce low value exports
  • Primary product dependency - prices of these goods can be volatile on world markets

Evaluation points - when deficity is arguably not a problem

  • Type of imports - if imports are raw materials or machinery (capital) they may lead in the long run to a more competitive economy and cause export revenue to increase.
  • Size of the deficit - argued that it is ok as long as it doesn't exceed 5% of GDP.
  • Inflation - an increased demand for imports reduces inflationary pressures due to its dampening effect on AD. The consumption of imports is also likely to increase living standards for consumers especially in the short term as they enjoy holidays abroad, foreign made clothes, cars, etc
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  • Exchange rate - a current account deficit, in theory, can self-correct, as a deficit on the current account will lead to a fall in the value of the currency. If the deficit is caused by an increase in imports, the supply of pounds will increase, and the value of the exchange rate will fall. Theoretically therefore, a deficit eventually leads to a weakening exchange rate and increased exports - self-correcting itself. However in practice because PED tends to be inelastic in the short run the current account balance is likely to get worse before it improves (J-curve)

Why might countries have a current account surplus?

  • Low valued exchange rate - China has been accused of undervaluing its exchange rate to enhance competitiveness
  • Competitiveness - low labour costs, e.g. China, or high quality, innovative goods, e.g. Germany. Productively+allocatively efficient , benefitting from EoS, reducing costs
  • High domestic savings ratio - increased saving of people will mean less demand for imports, e.g. China high savings ratio means more money is held with financial institutions, e.g. banks, and this money can be lent by banks to firms for investment. US and UK have high MPCs, resulting in high levels of personal debt and more imports
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  • Protectionism - some countries adopt protectionist policies on imports
  • Foreign direct investment - some countries may attract FDI into their country and export goods. The UK is a popular destination for FDI and they benefit from companies basing themselves in the UK and then exporting to the rest of the world. The government may try to make their country appealing to foreign investors to encourage FDI (lower taxes, good transport network, etc)

Why the UK current account is in deficit:

  • High consumer spending (MPC) in UK in recent years (2003-7) leading to an increase in demand for imports due to increased borrowing, growth of house prices, increased wealth
  • Lack of competitiveness: UK has high unit labour costs due to higher wages, lower productivity in the UK compared to India/China. Productivity is lower due to lack of education/training/skills. Post-Brexit, the pound is weaker - we import far more than we export, so the cost of imports has increased. 
  • Growth of China/India as industrial powers leading to cheaper imports
  • Lack of investment in R+D and lack of development of high value service/goods sector
  • Higher costs for UK business compared to foreign firms, e.g. minimum wage, regulations
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Balance of payments

Policies to correct a current account deficit - Direct controls (a government measure that is imposed on the price or quantity of a single product of factor of production. E.g:

  • Maximum price, minimum/maximum wage, quota on quantity of imports, limit the amount of currency a citizen can buy (capital controls), maximum interest rate that payday lenders can charge to their borrowers, limiting the amount an individual can borrow for a mortgage

Advantages:

  • Can be introduced or changed quickly+easily - effects can be rapid
  • Can be more discriminatory than monetary and fiscal controls
  • Can be variation in the intensity of the operations of controls from time to time in different sectors

Disadvantages:

  • Can sometimes suppress individual initiative and enterprise
  • Disrupting the free market can sometimes reduce incentive to innovate
  • May induce speculation which may have destabilising effects
  • Need an honest, flexible, pragmatic+efficient administrative organisation to be effective
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Other methods to reduce current account deficit:

  • Allow exchange rate manipulation, i.e. depreciate your own currency's exchange rate - which may bring about a surplus in the current account. Depends on whether the Marshall-Lerner condition is met. If so, the J-curve effect will occur
  • Measures taken by governments/surplus countries to stimulate domestic consumption, eg. tax cuts, reduction in incentives to save. Tax cuts may be spent on imports or saved  instead of spent on domestically produced goods (depends on MPC/MPM)
  • Measures taken by the US and UK governments/deficit countries to promote saving and reduce spending on imports, e.g. tax free saving schemes. These measures may be ineffective if interest rates are low and consumers continue to spend. May also be less effective if MPM (marginal propensity to import) is low
  • Supply side measures in US and UK/deficit countries to increase productivity and competitiveness, e.g. investment incetives; cuts in corporation tax; investment in education+training. These measures might involve extra public expenditure; might result in increased inequality (cuts in benefits); time lags
  • Contractionary fiscal and monetary policy. Might cause an increase in unemployment
  • Protectionist measures, e.g. subsidies, tariffs. Risk of retaliation 
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  • Expenditure reducing policies - aim to reduce the real spending of consumers. Fiscal policy can be used (e.g. a rise income tax that reduces disposable income). Higher interest rates would dampen consumer spending and reduce economic growth.
  • Expenditure switching policies - encourage consumers to switch their spending away from imports towards spending with domestic firms. Occurs if the relative price of imports (relative to domestic goods) can be raised, or if the relative price of UK exports (relative to the price of goods in foreign countries) can be lowered. Measures include:
  • Tariffs or other import controls – but UK is bound by its commitments to the WTO.
  • Policies that reduce the rate of inflation in the economy below that other international competitors leading to a gradual improvement in price competitiveness.
  • A depreciation of the exchange rate which increases the price of imports and reduces the foreign price of exported goods and services. 
  • J-curve effect - A depreciation in the exchange rate does not necessarily mean there will be an improvement in the current account. One reason for this concerns the elasticity of supply of the domestic exporters. If domestic producers do not have spare capacity, or if there are time lags in supplying extra exports, then the production of exports will be unable to expand in the short-term, and so the impact of a low-value exchange rate upon exports will be limited. Initially therefore, it may be that the current account will worsen, as exporting firms cannot respond quickly enough. 
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Only when domestic firms have had enough time to expand their output to meet the demand for exports, does the current account begin to improve.

  • There is reason to explain the lag-time in improvement of the current account – as shown on the J-Curve. In many cases exports may be supplied under contracts that cannot be immediately renegotiated – contracts that are hedged (typically 6-18 months) involve an exchange rate agreement between suppliers and firms. Furthermore, people and firms may wait to see whether the devaluation is long-term or just temporary before they switch to the new, cheapest supplier.
  • Marshall Lerner condition - Providing that the sum of elasticity of demands for imports and exports is greater than one, then the trade balance will improve over time. Devaluation causes a quantity effect and a price effect. At the new exchange rate, the quantity effect on the trade balance will be positive because exports tend to increase and imports decrease. However, there is also a negative price effect, because export prices (in terms of foreign currency) have fallen and import prices (in terms of domestic currency) have risen. The trade balance (measured in revenue terms) will improve only if the quantity effect fully offsets the price effect – in other words, the Marshall-Lerner condition holds true. If it does, then the J-Curve demonstrates the impact upon the current account.
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Exchange rates

  • Currency is bought and sold on the foreign exchange markets (Forex markets).

Reasons why currencies are bought and sold:

  • International trade in goods and services - exports create a demand for currency while imports create a supply of currency
  • Inward FDI to an economy creates a demand for its currency. Outward FDI from an economy creates supply
  • Speculation from investors trying to make a profit in Forex markets

Factors influencing the demand and supply of currencies: 

  • Exports - when demand for exports increases, demand for the currency increases. This causes the exchange rate to rise (appreciation). If British exports to the USA increase, American firms will need to buy more pounds than before to pay for them - hence an increase in exports will increase the demand for pounds, the value of the pound would therefore rise
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Exchange rates

  • Imports - when demand for imports rises, the supply of the currency increases. This causes the exchange rate to fall (depreciation). If imports from the USA increase, British firms will need to buy more dollars than before in order to pay for them. They will buy these dollars with pounds. Hence an increase in UK imports will increase the supply of pounds. Hence the supply curve will shift right and the value of the pound will fall

  • Interest rates - when the interest rate rises, this increases demand for the currency, due to the flow of hot money into the country. Thus, a change in the interest rate causes the exchange rate to move in the same direction. If the rate of interest in the UK increases, foreign investors are likely to switch their savings into UK bank accounts in order to benefit from a higher return on their savings (flows of hot money). An increase in this flow will increase the demand for pounds, shifting the demand curve to the right and increasing the value of the pound.

  • Foreign direct investment - if there is an inflow of funds for long-term investment in the UK, the demand for the pound will rise. Purchasing equity stake requires the need to convert their currency into pounds. E.g. Japanese investment in car factories in the UK will increase the demand for pounds.
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  • Speculation - speculation is the single most important determinant today of the minute by minute price of the pound. Speculators are seeking to take a profit from buying and selling currencies (known as FX or Forex markets). If speculators expect the value of a currency to rise, they increase their demand for it, which in turn causes the value of the currency to rise. If speculators believe that the value of the pound is going to fall against the dollar, they will sell pounds and dollars. Therefore, an increase in the supply of the pound will cause a shift right and reduce the value of the pound. This is known as the Tinkerbell Effect, used when describing things that are thought to exist only because people believe in them. Speculation causes the exchange rate to move in the direction in which it is expected to move. E.g. such an instance occurred after Brexit, when the pound fell against the dollar by 10% straight after the referendum was announced - the lowest level for 31 years.

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Floating exchange rates

  • The value is set by the market through supply and demand for that currency relative to other currencies, without any intervention by central banks or government.
  • Thus, floating exchange rates change freely, the value being influenced by market forces

Fixed exchange rate

  • A currency has a fixed value against another currency or commodity.
  • E.g. the gold standard, which operated in the 19th and 20th centuries - this was the act of fixing the value of all major currencies against the value of gold. The value of the currencies were all fixed to that of gold, which in itself has a variable market value depending upon global demand and supply for gold. The purpose of this was to maintain a level of consistency between all of the currencies that were a part of the gold standard.
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  • Today, some currencies use a system in which the price of their currency is fixed against the value of another currency - usually the US dollar or Euro - the choice of which is linked to foreign trade, in that you would fix your currency to that of your largest trading partners
  • Another example is when the UK, along with all 72 allied nations during WW2, once operated with a fully-fixed exchange rate from 1944-1972 - known as the Bretton Woods System, in which all currencies were fixed against the US dollar
  • A more recent example would be that of the Swiss Franc - which fixed its currency from September 2011 to January 2015. The Swiss currency was fixed at 1.20 against the euro; the move to stop fixing itself against the euro was thought to be in response to planned quantitative easing and the Eurozone debt crisis, which would push the value of the euro down even further. Upon removing this system, the Swiss Franc soared by 30%
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Managed exchange rate

  • Primarily the forces of demand and supply determine the value of a currency, but the government also plays some part in determining the exchange rate of the currency
  • It can do this by either intervening directly and buying/selling the currency using the foreign currency reserves held by its central bank. It can intervene indirectly, e.g. by raising or lowering interest rates which then influence the free market demand and supply of the currency
  • With a purely free floating exchange rate system, there is the possibility of huge movements in the value of currencies. Hence most governments intervene in some way to stabilise exchange markets - in terms of buying/selling their own currency.
  • However, the Bank of England hasn’t intervened since since 1997.
  • The amount to which a government intervenes can vary hugely, according to the country involved - usually the management intervention is to reduce volatility in the value of the currency.
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Managed exchange rate

  • Primarily the forces of demand and supply determine the value of a currency, but the government also plays some part in determining the exchange rate of the currency
  • It can do this by either intervening directly and buying/selling the currency using the foreign currency reserves held by its central bank. It can intervene indirectly, e.g. by raising or lowering interest rates which then influence the free market demand and supply of the currency
  • With a purely free floating exchange rate system, there is the possibility of huge movements in the value of currencies. Hence most governments intervene in some way to stabilise exchange markets - in terms of buying/selling their own currency.
  • However, the Bank of England hasn’t intervened since since 1997.
  • The amount to which a government intervenes can vary hugely, according to the country involved - usually the management intervention is to reduce volatility in the value of the currency.
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  • They may also intervene to change the value of the currency because they feel this is in the national macroeconomic interest. E.g. a central bank may sell its currency to reduce the value because it wants to help exporters become more internationally price competitive and to reduce imports (as they are now more expensive). 

Managed exchange rate: semi-fixed

  • The exchange rate can operate within upper and lower parameters - usually within a certain percentage each way
  • The UK operated a semi-fixed system from 1990-1992, when it was a member of the ERM (European Exchange Rate Mechanism) - the idea being that the pound operate to with 6% either way of the European Currency Unit
  • In order for a country to stay within its parameters, the government/central bank must buy/sell currency (or alter interest rates) to influence the exchange rate value. The UK spent £27bn propping up the pound over 2 years whilst in the ERM
  • ERM II was introduced in 1999 for EU member states that had not yet joined the
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euro. It is designed to ensure exchange rate stability between the euro and prospective members of the single currency. Each ERM currency is given a central exchange rate against the euro with a maximum fluctuation band of +/- 15%. Once a country has been in ERM for 2 years without any devaluation outside the permitted band, it meets one of the key convergence criteria for entering the Eurozone. If a country’s currency is close to falling outside the permitted bands the ECB and the central bank of the country affected will intervene by buying and selling currency to try to stabilise the exchange rate. 

Government intervention in currency markets:

  • Foreign currency transactions - one way to intervene is through buying and selling of currency. If the central bank wants to raise the value of the currency, it will buy its own currency in exchange for foreign currencies. If it wants to lower their own exchange rate, it will sell its own currency.
  • E.g. Black Wednesday in 1992 - the Bank of England was defending a high value of the pound against a currency that would become known as the euro. Foreign
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  • exchange speculators bet against the pound, selling pounds and pushing the price down. In order to try and keep the value of the pound up, the Bank of England retaliated by buying more of the pound. Selling got so great that on Black Wednesday (16th September 1992), after the treasury had already spent £27bn of reserves in propping up the pound, the Bank of England stopped defending the pound and let market forces set the value. Subsequently, the value of the pound against other currencies fell by over 15%
  • Changing the interest rate - if the central bank raises interest rates, this makes financial investments in the country more attractive, but also it makes existing holders of UK savings more reluctant to sell, reducing the supply of pounds on the market. Greater demand for the pound and reduced supply will then increase the value of the pound. In addition - for the UK, a rise in interest rates will reduce both consumption and investment, therefore if households and firms have reduced their spending it also means that they will reduce the level of imports (especially if they have a high MPM). Fewer imports mean a lower supply of pounds onto foreign exchange markets - leading to a rise in value of the pound
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  • Depreciation - the value of a currency falls because of market forces
  • Devaluation - the value of the currency officially falls - due to direct government intervention
  • Appreciation - the value of a currency rises because of market forces
  • Revaluation - the value of the currency officially rises - due to direct government intervention
  • A devaluation and revaluation can only occur when a government has fixed their currency
  • If a government influences market forces (buying and selling) for their currency - this resulting outcome is known as appreciation/depreciation. Because, although the government has intervened, ultimately it is indirectly and market forces have still decided the outcome - only fixed systems (direct intervention) can bring out devaluation and revaluation

Advantages of floating exchange rates:

  • Reduced need for currency reserves
  • Useful instrument of economic adjustment - e.g. depreciation can provide a boost to
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  • exports and therefore stimulate growth during a recession and when there is a risk of deflation

  • Self-correction following a trade deficit - if the deficit is caused by an increase in imports, the supply of pounds will increase (as UK residents will need to supply pounds to receive foreign currency to pay for the imports) and the value of the exchange rate will fall. Equally, when the current account deficit is caused by a fall in exports the demand for the currency falls. Theoretically therefore, a deficit eventually leads to a weakening exchange rate and increased exports - self-correcting itself. Much depends on the price elasticity of demand and supply of exports and the price elasticity of demand for imports (Marshall Lerner condition and J-curve effect)
  • Less opportunity for currency speculation

  • Freedom for domestic monetary policy - the absence of an exchange rate target allows policy interest rates to be set to meet domestic macroeconomic objectives such as controlling inflation or stabilising the economic cycle. Countries locked into

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  • a single currency system such as the Euro do not have the same freedom to manage interest rates to meet their main macroeconomic aims
  • Developed economies, such as the UK, US, Norway, Australia and Canada, have benefitted from the independence, regarding domestic monetary policy, provided by a free-floating system. The absence of any currency intervention has enabled these countries to use policy interest rates to try to meet inflation, growth and employment targets. The lack of intervention allows the exchange rate market to work efficiently, unhindered by government failure

Advantages of fixed exchange rates:

  • Trade and investment - currency stability can promote trade and investment because of less currency risk. Overseas investors will be more confident that the returns from their investments will not be destroyed by violent fluctuations in the value of a currency, which ultimately improves FDI and improves competitiveness
  • Some flexibility permitted - some countries are tempted to engage in competitive devaluations - in order to make their currency more competitive, relative to rival nations
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  • Reductions in the costs of currency hedging - businesses have to spend less on currency hedging if they know that the currency will hold its value in the foreign exchange markets
  • Disciplines on domestic producers - easier for producers to keep their costs down and prices down - may encourage attempts to raise productivity and focus on research and innovation
  • Reinforcing gains in comparative advantage - if one country has a fixed exchange rate with another, then differences in relative unit labour costs will be reflected in changes in the rate of growth of exports and imports - as countries will simply revert to other countries with a lower unit labour cost, thus exploiting the law of comparative advantage and its associated benefits
  • Often emerging, trade dependent nations, such as Ethiopia, Kenya, Angola and Vietnam, benefit from their managed systems by enabling their export industries to remain competitive. The managed system may also help establish a more stable currency in the long-run, which may encourage FDI aiding development.
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UK Exchange Rate

The depreciation of sterling might be explained by:

  • The steep cuts in policy interest rates by the BoE, which has reduced the expected rate of return of putting foreign money into UK bank accounts - UK BoE base rate remains historically low.
  • The currency markets have downgraded their expectations for the near-term performance of the UK economy, believing that Britain is more exposed than most to the fall-out from the global credit crunch. More recently this has included the exposure of many UK commercial banks to loans to Spain, Portugal, Italy and Greece - countries at risk of defaulting on some of their loans.
  • Britain continues to operate with a large trade deficit in goods at a time of recession (when we would expect the deficit to diminish because of lower demand for imports). This suggests that sterling as a currency was over-valued in 2007-08 (it climbed well above $2 to the £1) and that some adjustment was overdue.
  • Brexit seemingly caused the pound to fall dramatically the day after the referendum (June 24th), which could be put down to a fall in confidence. However, many analysts feel that the pound’s market value was too high anyway and that Brexit was simply a catalyst for the inevitable: the pound falling back to levels which are more accurate.
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Advantages of a depreciation of the pound:

  • A cheaper currency makes British export businesses more competitive in overseas markets. Firms selling products in foreign markets can either cut their selling prices to boost the volume of orders. Or they can keep prices constant and enjoy a higher profit margin on each product exported. 
  • A lower pound ought to bring about a re-balancing of the economy away from a high level of imports (M) towards exports (X) - helping to lower the trade deficit and providing a net injection of demand into the circular flow. There is plenty of spare capacity in the economy for export industries to be able to meet higher demand from abroad - as the output gap is currently negative.
  • A rebound in exports will be good news for manufacturing firms selling UK products overseas, the UK tourist industry, farmers (who get their EU subsidies paid in Euros) and other businesses who supply export sectors. A rise in exports can lead to positive multiplier and accelerator effects on the level of real national income
  • If the falling pound causes some extra inflation, this may not be a bad thing if it leads to a reduction in the real value of the UK’s national debt.
  • Overall, a cheaper currency acts as a useful “shock absorber” for the economy and can help to bring the economy out of recession.
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Disadvantages of a depreciation of the pound:

  • A lower pound increases the sterling price of importing technology which can hit investment spending and affect long run productivity and supply (LRAS).
  • There are some inflationary dangers from a sharp fall in the currency - commodities and components from overseas are also more expensive causing an inward shift in SRAS. Higher inflation may make it more difficult for the Bank of England to maintain a policy of low short-term policy interest rates.
  • Exports ought to be more competitive with a lower pound - but the timing of the depreciation has not been ideal. In 2009 global trade in goods and services fell away by nearly 10%, so demand in many of the UK’s major export markets was weak just at the time when we might have seen a rebound in UK exports.
  • A weak currency can make it more difficult for the government to attract the inflows of foreign money required to buy the huge value of new bonds that the government is issuing to fund its £155bn annual budget deficit. There are fears that expectations of a further fall in sterling might lead to a bout of “capital flight” from the UK.
  • Currency weakness can sometimes lead to a currency crisis with a collective loss of confidence in the foreign exchange markets. Generally a weaker currency is 
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  • broadly-speaking good news for an economy during a time of economic weakness. Certainly there are plenty of countries inside the Euro Zone who would quite like to have a more competitive exchange rate to boost their export industries but they have locked their economies to the Euro. Flat UK exports suggest that foreign demand for UK products has not yet responded elastically to the lower pound. Perhaps we are simply not supplying enough of the goods and services that the rest of the world wants to buy.
  • Evaluation: Whether or not a weak currency is good for a current account balance depends upon the Marshall-Lerner Condition. The Marshall-Lerner condition states that a currency devaluation will only lead to an improvement in the balance of payments if the sum of demand elasticity for imports and exports is greater than one; this then creates the ‘J Curve’ effect on a diagram
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International competitiveness

  • Refers to the ability of a country (their firms) to provide goods and services which provide better balue than their overseas rivals. 
  • There is constant threat from foreign competition, so it is essential for business to strive to improve competitiveness
  • International competitiveness is also important in order to encourage FDI.
  • How internationally competitive a country is depends upon the quality/price of exports, as well as how appealing it is for foreign companies to set-up there

Measures of competitiveness

  • Relative unit labour costs - unit labour costs are total wages divided by real output. It is the cost of employing labour divided by the amount that the labour produces.
  • If UK relative labour costs rise, it shows that the UK is becoming less internationally competitive. 
  • Relative export prices - the export prices of UK goods and services compared to the export prices of the UK's main trading partners, usually expressed as an index. 
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Factors influencing competitiveness:

  • Exchange rates - a rise in the UK's exchange rate is likely to make UK goods (exports) less price competitive abroad and imports more expensive. The extent to which there is a change in competitiveness depends on the PED of the good. If PED is inelastic, the less impact a change in price/exchange rate will have on quantity demanded
  • Hedging - a way for a company to minimise or eliminate foreign exchange risk. Hedging will lock in an exchange rate with suppliers so that the exchange rate is agreed for a fixed perios into the future (usually 6-18 months) - keeps costs consistent to improve confidence and help firms plan ahead
  • Of all exports that are produced, 40% of the inputs are made from components which are imported. Therefore, the exchange rate can greatly impact the costs of exports.
  • Productivity (output/number of workers) - rises in the UK's productivity (relative to its main trading partners) will increase its competitiveness - will lead to firms cutting their prices, making its goods more internationally price competitive
  • Infrastructure - the building of ports, roads, broadband, airports. railways, etc can greatly improve the productivity of a country. Supply of labour increases for firms as employees can commute and therefore wages could fall (higher supply) and firms can employ the best/most productive talent, as this increases geographical mobility. Attracts FDI
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  • Wage and non-wage costs - if wages and non-wage costs (company pensions, NICs, etc) rise, relative to its main competitors, then the UK will become less internationally competitive. Increases in wage costs are likely to lead to increases in prices, because staffing costs make up a huge % of a firm's overall costs
  • Regulation - government regulation e.g. laws on health+safety or for environment protection can increase costs for firms and make it harder to compete against other countries with less strict rules. A safe working environment, although more costly in the short term, may reduce costs in the long term if it reduces accidents and stimulates motivation. Strict laws on pollution and a minimum wage would also increase costs.
  • Quality - firms which can produce reliable and better-quality products than their rivals will have a competitive advantage. Much of the UK's manufacturing sector in recent years has only survived because, althought it cannot compete in terms of price, the UK has produced unique and better-quality products
  • Research and development - the extent to which firms engage in R+D may influence their long-term international competitiveness. Unique and high-quality products can be developed when dynamic efficiency is high. R+D may also help to reduce costs of production if it leads to cheaper methods of production
  • Taxation - low taxes on profit (corporation tax) encourage investment and innovation, which lead to improved competitivness. Taxation is Important in attracting FDI
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Benefits of being internationally competitive:

  • Current account surplus - exports are likely to be larger than imports. A surplus frees them frm the constraints that a large deficit may face. 
  • FDI - a competitive economy is likely to attract inflows of FDI. Foreign companies might want to exploit their competitiveness and benefit from high productivity, low taxation, low regulations, good infrastructure, etc. This increased FDI brings about employment, multiplier effects and new knowledge, skills and technology to benefit domestic firms
  • Employment - exports are likely to be high and so is FDI; therefore this creates employment in the domestic economy and reduces unemployment. Domestic firms that export are likely to hire more labour to help meet the increased demand for their exports
  • Economic growth - greater demand for exports will lead to increased AD. With this increase in exports comes investment from firms and ultimately increased LRAS. The increasing employment will have a positive multiplier effect, causing further rounds of spending and further increases in AD
  • Higher domestic purchasing power - consumers in the economy are likely to benefit. Their incomes are likely to rise faster because of higher economic growth causing greater demand for labour. They will be able to buy goods+services that are lower in price and more attractive to buy than if the country were less internationally competitive
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Problems associated with being less internationally competitive:

  • For low and middle-income countries, the competitive benefit of low wage costs are likley to be eroded as the country becomes more developed and wage rates rise at a relatively high rate
  • Other costs, such as the price of land and materials bought from other domestic firms, are likely to rise as a country becomes more developed and demand for such keeps increasing
  • A current account surplus could lead to a rise in the exchange rate, making exports more expensive to foreign buyers and imports cheaper for domestic buyers (because when exports are purchased, demand for the currency increases, pushing the value of the currency up)
  • As an economy develops and experiences increasing economic growth, the pay and condition demands of workers is likely to increase. Ulitmately meaning that regulations increase (minimum wage, increased health+safety etc), making costs of production increase; therefore making the economy less competitive and less attractive for FDI. Current FDI by firms may leave the country and move onto the country with the newly created competitve advantage.
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International competitiveness

Policies to improve competitiveness:

  • Education and training - will increase the skills of the workers and occupational mobility, increasing their productivity and so, other things being equal lowers their unit labour costs and so increasing competitiveness. Training can be costly and the benefits of training will be felt in the long run, in the short run training can be expensive and workers may temporarily see a fall in their output while they are being trained. Productivity can be hard to measure, this is especially true of managers whose role is more to coordinate, plan and motivate and these things are less tangible to measure.
  • Tax concessions - to firms who re-invest their profits; this can lead to more innovative products and so boost competitiveness. It could also lead to more innovative processes therefore lowering average costs. Spending on R&D may not always lead to successful innovative products. The success of the R&D will depend on the effectiveness of the researchers. It also depends on size of tax concessions; furthermore, tax concessions may mean the government has a fall in tax revenue (possible budget deficit increase).
  • Cuts in unemployment benefits - JSA maybe reduced encouraging people to find work, an increase is supply of labour could force the equilibrium wage down so reducing unit labour costs. More applicable to lower skilled sectors. Increase in inequality+poverty as lower income groups will have benefits reduced. Increase in crime and others social problems.
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  • Government investment in social infrastructure - transport systems, telecommunications, water, electricity to improve the infrastructure; this could reduce transport costs and improve competitiveness. This could be particularly significant for developing countries. Governments may not have the finance to pay for such a policy or may have to borrow large amounts of money to fund such projects; recent examples such as HS1 (Eurotunnel) have experienced financial problems, even going as far as being temporarily nationalised in 2009. Projects such as HS2, Crossrail and Heathrow expansion have angered local residents, who have either had to vacate their homes or will experience excess noise.
  • Privatisation of key industries - cause firms to be more efficient as they have an incentive to reduce costs in order to maximise profits. This combined with an increase in competition should give firms the necessary incentive to cut costs and prices. UK goods become more competitive if energy prices, telecommunication costs are lower. There is not much scope to privatise firms further due to the extensive programme of Thatcherism during the 1980s. Some firms when privatised become private monopolies and if the regulators are too weak customers can be exploited and firms will pay higher prices for energy, water and telecommunications, which will increase their costs making UK exports less competitive.
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International competitiveness

  • Policies to encourage the growth of small firms - improve competitiveness by increasing competition. This could be done by government’s offering cheaper loans or subsidies, or even tax breaks to ensure that small firms survive and grow. Small firms often sell to local markets and so it is unlikely they will significantly affect UK exports. Furthermore, they may even be simply acquired by larger companies – defeating the whole point.
  • Lower the power of trade unions - likely to reduce pay demands and workers strikes this combines to lower unit labour costs making UK firms more competitive. May not be relevant to the UK as trade union power has already been reduced significantly - little scope to reduce union power further. This may also have implications upon productivity, as staff with a lower morale who feels that they aren’t sufficiently represented, may increase unit labour costs.
  • Exchange rate policies - Depreciate/devalue exchange rate in order to make UK exports cheaper and imports more expensive. BoE could engineer this by selling pounds and buy foreign currency; or it could reduce exchange rates to reduce demand for the pound, depreciating the exchange rate. Interest rates are set by MPC so this would not be an example of a government policy. Expensive imports could increase cost-push inflation and reduce competitiveness.
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International competitiveness

  • Macroeconomic stability - low inflation - this is a stable environment conducive for investment and therefore growth. It is on this basis that supply side policies can be made. Monetary policy in 2011 not effective in reducing inflation as inflation was caused by factors outside the control of UK policy makers e.g. price of commodities imported from abroad increased leading to increased inflation. There were also some cases of extreme weather conditions which reduced the supply of agricultural goods and this increased the price of food which led to inflation.

Supply side policies

  • To improve productivity - Training and education programmes to enhance skills, improve management; Policies to encourage R&D to develop technology and to innovate e.g. tax concessions for firms who re-invest profits; Infrastructure projects – CrossRail, Heathrow expansion etc.; Reduce the power of trade unions so they are less likely to strike (reducing productivity) and also less likely to demand higher wages which will increase unit labour costs. 
  • At firm level - Develop systems of performance related pay e.g. bonuses; Improved management who can create an environment which motivates the staff.
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International competitiveness

  • To enhance competition - Deregulation removes rules and barriers to entry, making the market more contestable, and so this allows new firms to enter the industry and increase competition. This gives firms the incentive to become more productively and allocatively efficient and therefore more competitive e.g. banks, buses. This is not so effective where there is a natural monopoly, may only be applicable to certain markets. Also may not be effective in markets with strong brand loyalty or where other barriers exist.
  • Privatisation improves competition and increase incentives for more efficiency
  • Encourage the growth of small firms to increase competition 
  • Demand side policies to create low inflation - Prudent fiscal policy and a responsible monetary policy to achieve a low inflation environment is a pre- requisite for a policy to boost competitiveness.
  • Exchange rate policy - Depreciate/devalue exchange rate in order to make UK exports cheaper and imports more expensive. However depreciation of the currency will mean imports are more expensive and this can lead to inflation which could lower the competitiveness of UK goods if UK firms imported raw materials that are now more expensive.
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Evaluation of policies

Supply-side policies:

  • Cut income tax - will have the effect of increasing disposable income which will have effects on AD e.g. increase the demand for imports
  • Cutting unemployment benefits – will increase income inequality.
  • Education and training are long term policies (only work after a lag, can be expensive, who pays firm, individual or government)

Exchange rate policy:

  • J-curve- depreciation only improves current account in the long run as PED is more elastic in long run
  • Imports are more expensive where they import raw materials it will lead to cost – push inflation. Higher import prices can feed through to higher prices- cancel out the gain from depreciation

Protectionism: Retaliation; Loses advantages of free trade; Can distort trade by not following law of comparative advantage

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The role of central banks

  • Central bank - the banker to the government, performing a range of functions, which may include issue of coins and banknotes, acting as banker to commercial banks and regulating the financial system
  • Bank of England (UK); Federal Reserve Bank (USA); European Central Bank (Eurozone); Bank of Japan (Japan); People's Bank of China (China)
  • Acting as a banker to the government - most central banks act as the bank to their government - a notable exception is the ECB. The individual central banks of Eurozone nations still exist and can issue euro notes/coins, but they must receive ECB approval first. In terms of acting as a bank for the government, the exact nature of services offered by central banks differs from country to country. In the UK, the BoE was responsible for managing the national debt by issuing Treasury Bills, but this role was transferred in 1998 to a new body, the UK Debt Management Office. Central banks may handle the accounts of government departments and make short-term advances to the government. If a government has 'national savings' then these would be deposited within the central bank
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The role of central banks

  • Acting as a banker to commercial banks (lender of last resort) - central banks tend to force the largest banks operating in their counrty to deposit money with them. Private banks that want to deposit money can do so with their central bank, they would even earn interest on these deposits. With negative interest rates, these are not designed to impact on consumers but are set for banks depositing with their central bank. If banks are charged to store their money, then it is hoped that they will be encouraged to instead lend the money out to businesses and consumers, therefore stimulating aggregate demand
  • The key role of central banks in relation to other banks is to act as Lender of last resort. Banks can face liquidty (cash flow) crises for two reasons:
  • A bank at the end of a day's trading can run out of liquid assets to pay money it owes. This is a short-term liquidity problem and does not mean the bank is in fundamental trouble
  • However, the bank may face fundamental problems because too many of its assets (loans/mortgages it has given out) have fallen in value. E.g. during the 2007-8 financial crisis, sub-prime lending meant that money was lent to customers that could no longer keep up with their repayments; too many of these loans turned into 'bad debts' and were never repaid, leading to their mortgage assets defaulting. Poor lending (sub-prime lending) combined with a housing bubble left many banks exposed to bad debts and cash flow problems - the income that the banks relied upon from their customers' repayments stopped.
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The role of central banks

  • The central bank then becomes the lender of last resort in a very different sense - it lends money to prevent them from collapsing
  • Some argue that acting as lender of last resort results in moral hazard - banks know that they can engage in highly profitable, high-risk activities in the short term because if they ultimately make large losses, then the central bank will bail them out.
  • On the other hand, if the central bank did not act as a lender of last resort then the bank could fail. One bank failing would almost certainly see customers of other banks panicking and trying to withdraw all of their money - seen during the Great Depression and to some extent at Northern Rock in 2008 (known as a 'run on the banks'). The whole banking system could fail because banks only keep a small fraction of their assets in relatively liquid assets. The cost to the macroeconomy of a whole banking system failing would be far larger than the cost of a central bank bailing out one or a few banks which were in difficulties. Lending drives investment and consumption - AD would be very vulnerable
  • Regulator of the financial system - different countries regulate their financial system in different ways. In some countries, central banks are responsible for regulating the financial system of their economies. There are also international bodies and agreements that attempt to regulate parts of the global financial system. In the UK the BoE is 
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The role of central banks

responsible (alongside the government) to regulate the financial system, the Financial Policy Committee (FPC) at the BoE takes on this responsibility.

Three main purposes for financial regulation:

  • Financial institutions require monitoring or they may engage in a wide range of activities that would harm their customers. There are large incentives for banks to sell products to customers that either give the customers no benefit or actually harm their financial interests (e.g. PPI - Payment Protection Insurance - often banks sold it to their customers without fully explaining what it covered, and some banks/lenders even lied to customers telling them it was a compulsory element of a loan or added it without consent)
  • Financial instituitons have an incentive to engage in risky activities which give them short-term profits, but could lead to their collapse. It is important to regulate these activities so that collapses can be proactively prevented, as opposed to simple reactive bailouts.
  • The whole financial system needs to be regulated to prevent it from collapse. The risk of the whole system collapsing is called systematic risk - the danger that the failure of small parts of the system will lead to the collapse of the whole of the financial system
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The role of central banks

Example - liquidity ratio (money reserves)

  • In order to avoid liquidity (cash flow) problems, regulations can be set regarding the minimum ratio of liquid assets held by the bank, relative to the liabilities (outgoings/bills) that the bank has to pay. The larger the liquidity ratio (leverage ratio), the larger the 'buffer' when it comes to dealing with unforeseen customer withdrawals or customer defaults on loan repayments. 
  • Banks and other financial institutions want these ratios to be as low as possible. A higher liquidity ratio means that fewer funds can be loaned out to businesses/consumers, therefore they cannot receive the interest on this money - meaning lower profits for the bank. 
  • Central banks often carry out 'stress tests' of banks to see if they would have enough money to survive a variety of economic shocks e.g. Eurozone collapse, falling house prices and falling GDP

Example - mortagage guidelines

  • Applicants now have to be able to show that their finances could cope with interest rate 
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increases of up to 4%, as this could add several hundred pounds to their monthly outgoings - in which case the applicant would still need to show that they could afford repayments

  • This measure by the BoE to make the criteria for approving a loan more thorough was in order to help avoid sub-prime lending that was a catalyst for the 2008 Global Financial Crisis
  • Another measure was for the BoE to limit how many mortgages a bank can approve depending on the applicant's income. The current regulation is that no more than 15% of a bank's approved mortgages can be given to applicants that are borrowing more than 4.5x their annual income
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Supply-side policies

  • Market-based policies - policies designed to remove barriers to allow for the efficient working of free markets. These barriers may limit output and raise prices. Market-based policies are those that allow for the market to operate effectively on its own, with the only involvement from the state being policies designed to allow for the efficient working of the free market. 
  • The role of the government in market-based viewpoints/strategies is limited since it basically interferes with the market clearing mechanism. E.g. in real wage unemployment, people are out of work because a price floor (minimum wage) is set preventing the market from reaching equilibrium. A market-based solution would be to simply lower or remove the minimum wage to allow supply of and demand for labour to intersect and rid the economy of real-wage unemployment. Another example would be reducing JSA to increase the willingness of workers to take jobs.
  • Interventionist policies - policies designed to correct market failure. This means the government intervening in free markets to change the outcome from that which it would otherwise have been. E.g. free markets may underprovide education. Interventionist policies are those policies that involve the state directly intervening in the market in order to produce better outcomes.
  • Returning to the real-wage unemployment discussion above, interventionists believe 
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removing the minimum wage would be unacceptable. To address this problem, Keynesians advocate for interventionist strategies like minimum wages plus unemployment benefits as a safety net for the most vulnerable (i.e. lowest paid workers) in society

Examples of market-based policies:

Managing macroeconomy -

  • Reduce taxes, income and corporate
  • Deregulate and privatise to create private firm profit incentive, make business easier
  • Reduce or eliminate minimum wage, union power
  • Reduce unemployment benefits to force unemployed to look harder+take available jobs

Economic growth and development - 

  • Export-led growth
  • Floating exchange rate regime
  • Free trade
  • Allow FDI to flow in 
  • IMF/WB SAPs
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Examples of interventionist policies:

Manging macroeconomy - 

  • Use taxpayer money to fund government spending (if needed)
  • Provide vocational training
  • Fund government job database
  • Subsidise firms to educate and train workers
  • Subsidise workers willing to move region with jobs
  • Encourage R+D to stimulate investment through tax breaks to firms or through payments to universities
  • Construct new/better infrastructure

Economic growth and development - 

  • Import substiution
  • Managed exchange rate regime
  • Protectionism
  • Regulation and nationalisation
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Monetary policy

  • Towards the end of the 2008 global financial crisis, despite inflation reaching an above-target of 4%, the BoE's MPC need to combat recession led to interest rates being reduced 0.5% in March 2009. Having fallen to this level, there was no scope for further reductions, so the Bank announced that it would start to inject money directly into the economy, effectively switching the instrument of monetary policy away from the interest rate and towards the quantity of money.
  • This would be achieved by a process known as quantitative easing, by which the Bank purchases assets such as government and corporate bonds, thus releasing additional money into the system through the banks and other financial institutions from which it buys the assets. The intention being that this would allow banks to increase their lending, and help to stimulate flagging aggregate demand
  • QE is used by the BoE to stimulate the economy as the UK is experiencing low growth and high unemployment. Through the BoE's buying bonds, this encourages banks to look elsehwere for investment - so to replace the government bond investments, which have been bought by the BoE, they lend to private individuals and firms
  • The BoE's monetary policy of lowering interest rates to 0.5% since March 2009 has not fully worked because: banks haven't always passed on the lower rates to consumers; banks have lent less out due to the credit crunch; there have been severe cut backs in government spending and increases to taxation leading to a loss of jobs in public sector
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Impact upon exchange rates:

  • Higher interest rates in the UK, compared with other financial centres around the world, will tend to attract funds to the UK. These funds tend to be short-term, volatile and sensitive to changes in conditions (e.g. relative interest rates) - referred to as hot money
  • The movement of funds to the UK - attracted by higher interest rates - will lead to a rise in demand for pounds in the foreign exchange market. The price of the £ will rise. The exchange rate rises/the £ becomes stronger. This means that export prices rise, and import prices fall.
  • Where the PED for imports and exports is greater than one, an appreciation of the pound will lead to a deterioration of the trade balance (x-m), which will cause a fall in AD
  • The rise in the exchange rate would be beneficial in the battle against inflation - import prices (of raw materials, components, capital goods, consumer goods) fall; and pressure is placed on exporting firms to reduce costs, as their goods are now less price competitive compared to other countries.
  • Higher interest rates therefore help to restrain inflation both by the impact on AD and the impact on the exchange rate
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Evaluation of monetary policy:

  • External factors outside of UK - monetary policy may be less effective in a globalised world where inflation in the UK can be caused by factors outside of the currency, e.g. high commodity prices/oil prices. So changes in domestic interest rates have little effect
  • Transmission mechanism - there is a long and complicated chain of linkages, variables and exogenous shocks that enables a change in monetary policy to affect inflation. The complexity and uncertainty of these variables calls in question the effectiveness of monetary policy upon inflation
  • Base rate not passed on - base rate may not be passed on by banks to buisnesses and individuals, because banks are still largely motivated by making profit from their lending
  • Credit crunch - during 2008/9, despite interest rates being at 0.5%, banks were cautious and reluctant to lend after the financial crisis - known as the 'credit crunch'
  • Time lags - interest rate changes subject to time lags (usually 6-24 months)
  • Lots of groups are influenced - interest rates hit homeowners, investment and exports. In particular, homeowners are subject to a change in interest rates, as the UK has many variable mortgages
  • Relative interest rates - have to consider relative interests of other economic areas such as USA and EU - as this can encourage/discourage flows of hot money
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  • Accuracy of the data the MPC receives - problem that the data is received after a time lag. It may also suffer from inaccuracies
  • Effect of hot money on exports - if the exchange rate increases and demand for the pound increases, (due to hot money), exports will become less competitive
  • Magnitude of interest rate change - if change is small it may not affect the business much
  • Businesses may not need loans - so changes in interest rates don't affect them as much
  • Customers do not need loans/credit - the business may sell cheaper products which don't require credit (a loan). This will mean that all businesses selling more luxury/expensive goods and services will be impacted more - as people tend to purchase using loans/credit
  • Rental households - households who rent are affected less as their rent is a set fee

Quantitative easing explained:

  • The process by which a central bank creates money and uses this to buy government bonds. Purchasing of the bonds from banks and financial institutions (who initially bought the bonds to make a return on their investment) gives them more liquidity (cash - they've received from selling their bonds)
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  • The impact of the BoE purchasing/demanding large quantities of bonds is that the price of these government bonds increases, which therefore reduces the yield on government bonds. One impact of this is that banks and financial instiutions start buying corporate bonds instead - the extra demand for these corporate bonds reduces the yield and allows firms to raise finance/issue bonds at a lower coupon rate/interest rate. Making it cheaper to raise finance and so encourages investment - one way in which QE encourages spending
  • Another way QE increases spending in an economy is that the cash that banks and financial institutions receive from the central bank has to be invested somewhere, so they instead opt to lend more to businesses and consumers - this increase in the supply of loans will bring interest rates down, as banks compete against each other (in terms of interest) in order to attract customers

Why does QE lead to lower market interest rates?

  • QE leads to the purchasing of government bonds, increasing the demand and so the price
  • Lowering their % rate of return (yield/price of bond) sufficiently so that investors would be
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  • pushed into holding other bonds with similar risk characteristics but more attractive returns (e.g. corporate bonds) - Which lowers the rate of return on corporate bonds
  • The lower rate of return (coupon rate) on government bonds then ultimately causes lower interest rates on high street loans and mortgages etc. as government bonds become a less attractive investment and banks seek elsewhere to put their money
  • In practice the assets/bonds that the BofE buys are government bonds already owned by banks and financial institutions. This doesn't mean the government is issuing new bonds that the BoE is then buying, they will be buying government bonds that are held by banks. As the central bank is purchasing them and therefore pushing up the demand for these bonds, they are increasing their price and reducing the attractiveness of these bonds (the yield/return is fixed - so increasing bond prices means that you are paying more to receive the same yield/return - therefore reducing the attractiveness)

Forward guidance:

  • A relatively new strategy implemented by Mark Carney - when the BoE provides assurances about the future levels of interest rates. In order to maintain confidence and support investment planning, the BoE may say that interest rates will remain low or at 
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current levels for a certain period of time.

  • This gives a certain degree of stability to businesses and consumers.
  • A drawback is that it reduces future policy flexibilty of the BofE - if they go against their own forward guidance, then it undermines future confidence of further forward guidance decisions. If there is a macroeconomic shock, the bank may need to alter interest rates and so forward guidance would put them in a difficult situation
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Fiscal policy

  • Fiscal policy is used to influence aggregate demand within an economy
  • A fiscal stimulus (expansionary) policy involves increasing government spending and reducing taxation, whereas contractionary fiscal policy (austerity) involves reducing government spending and increasing taxation (VAT, corporation, NICs, income)
  • Budget deficit - when government spending > tax revenue during a year
  • National debt - the accumulation of budget deficits over time

Evaluation of fiscal policy:

  • Government borrowing - it means that the national debt will be increased - so this will increase spending on debt interest in the longer run. In 2014 the government spent £51bn on debt interest repayments - increased taxation and reduced gov spending in the future
  • Subject to time lags - by the time the policy takes effect, conditions may have changed: information lags - collecting, collating+presenting data; decision-making lags - management structure, bureaucracy; implementation lags - tax cuts usually occur during March and Autumn budgets; impact lags - multiplier effect takes a long time
  • Multiplier - measuring the full impact of the multiplier is difficult, it depends greatly upon the marginal propensity to consume. It can be years before all rounds of spending have been completed
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  • Inflexible - constrained by manifesto and promises to voter. It is politically difficult to choose from switching spending from one group of society to another. The government may have contractual agreements (PFI contracts) and so these cannot be easily stopped
  • Crowding out effect - if the government is running a budget deficit, they will have to finance this by either borrowing or by issuing bonds - these two methods of raising finance can negatively impact upon the private sector's ability to obtain loans

Crowding out - government bonds:

  • If the government increases borrowing by selling bonds to the private sector (private individuals, pension funds or other business). If the private sector buys these government securities they will not be able to use this money to fund private sector investment. Therefore, government borrowing crowds out private sector investment

Crowding out - government borrowing (loans):

  • If the government borrows from banks within the economy, this may result in private sector firms/individuals being 'crowded out' and unable to obtain loans. 
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  • Banks would rather purchase low-risk government bonds - as they are highly likely to get their money back and receive regular payments
  • Banks then do not feel the need to lend anymore to riskier firms and individuals in the private sector.
  • If the government finances spending through borrowing (through loans), then a side effect is to put upward pressure on interest rates. As increased demand for loans may increase interest rates offered by banks.  Again, this increase in interest rates would 'crowd out' the private sector. 
  • Most evidence in the UK suggests that the crowding out effect does little to disrupt increases in AD. Especially as the UK does not even tend to borrow (loans) to finance debt, they issue bonds. 

Consequences for the UK economy of a budget deficit:

  • National debt will be increased - so this will increase spending on debt interest in the longer run. The government will likely need to increase taxation in the future or reduce government spending - so this will act as a constraint for future fiscal policy certainly in terms of an expansionary policy
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  • Effects of increased taxation - lower disposable income; reduced incentives to work/invest; higher prices, inflation if indirect taxes (adds to costs of production); this could make UK goods less competitive; effect on distribution of income - more unequal if indirect taxes 
  • Effects of reduced government spending - run down public services; lower benefits; effect on distribution of income (poor are often reliant on benefits); lower AD - negative multiplier
  • Consequences of budget surplus - some of the national debt can be paid off and so this will reduce the amount the government needs to spend on debt interest. There is future scope for tax cuts or increased government spending

Problems arising specifically from fiscal stimulus/expansionary:

  • The budget deficit for 2014/15 is £105 billion (approx 6.5% of GDP for 2014/15). Total national debt for the UK (March 2015) was £1.25 trillion or 75% of GDP
  • This means that in the future taxation will be increased and government spending reduced, in order to try and reduce the deficit. This may have adverse consequences on AD - increased tax may reduce investment incetives, less expenditure may affect health and education so conflicting with supply side policies
  • So a budget deficit acts as a constraint on future fiscal policy
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Factors that affect government spending:

  • Automatic stabilisers - during a recession, spending tends to automatically increase (higher JSA and benefits) and tax revenue decreases (falling income tax, corporation and VAT receipts). If there is a recession the government may increase spending to boost AD
  • Population issues will affect government spending - an ageing population will mean an increase in spending on pensions, healthcare and welfare services. An increase in population will prompt a further increase on government spending as more local facilities will be needed, e.g. housing, schools, hospitals etc.
  • If there is conflict, government will spend more on defence or protection from terrorism
  • Increase in spending to meet environmental targets
  • Intervening in NHS and state education, provision of merit goods
  • Increase spending if increase in crime (e.g. police)
  • Government philosophy - typically a Labour government would spend more and have a larger public sector whereas a conservative government would spend less and encourage more private ownership
  • Financial crises, such as 2008 when Gordon Brown had to 'bail out the banks'
  • Governments will spend less if they have a lot of public debt
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Macroeconomic policies

SEE NOTES 'Macroeconomic policies in a global context'

Measures to control global companies

  • Multinational companies (MNCs) benefit the world economy through their ability to exploit economies of scale and are a key part in the process of globalisation.
  • Some also have knowledge, through R+D and practical experience, which smaller companies are unlikely to have. This then creates new products or lower prices.
  • National economies often welcome the activities of multinationals because they can create jobs, income, exports, and tax revenues. Transfers of knowledge as well as FDI in building new manufacturing plants or opening new subsidiaries can also be beneficial
  • However, MNCs can also have a negative economic and social impact.
  • Some MNCs such as oil and mining companies can have a negative impact on the local and global envrionment. MNCs in industries such as goods and entertainment are accused of destroying local culture and loss of national identity. They can exploit countries with weak government by taking out of a country far more in profits than they give back in terms of building backs for economic development. MNCs have a long history of using 
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legal and illegal means to influence politicians and state officials to take decisions that will favour their interests rather than the interests of the local people and the country. Many have also structured their business to pay the minimum amount of tax possible by shifting revenues and profits into low tax countries

  • Transfer pricing - an accountancy technique used by multinational companies for reducing taxes on profits by selling goods at a low price internally from a high-tax country to another part of the same company in a low-tax country.
  • Regulations on transfer pricing try to ensure that MNCs internally selling between subsidiaries must charge a price that is in line with the market value. One subsidiary cannot artificially increase the price charged to another subsidiary (in a different country) in order to shift profits from one country to another.
  • Controlling MNCs is difficult for individual governments. Many small developing countries have a lower GDP than the total revenues of a single, large, multinational company. Large MNCs are run by highly educated, successful executives who can draw off considerable experience and resources to find solutions which will benefit them. Individual countries may be run by far less gifted individuals who don't have the resources to understand the impact a MNC is having on their economy
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  • In the EU, some MNCs use legal tax avoidance schemes called the 'double Irish' and the 'Dutch sandwich' - which works by routing costs, revenues and profits through Ireland, the Netherlands and Luxembourg before sending them to a tax haven such as the Bahamas or the Cayman Islands. Ireland, Luxembourg and the Bahamas are major beneficiaries of such tax schemes. The problem is that every other EU country is a major loser as is the USA where many MNCs are based.
  • In the EU and USA it is illegal for MNCs operating in their countries to use bribery or corrupt practices. A US based MNC can be fined heavily by the US government for using bribery to increase sales in vulnerable countries, e.g. Nigeria
  • A number of developing countries don't allow MNCs to set up in their countries without first setting up a joint venture with a local partner - meaning that the MNC joins forces with a local business, but still retains separate legal identities. This means at least some of the profits made are retained within the country. Also there is a transfer of knowledge and technology to local partners - in future this might create local competition to the MNC
  • Many contracts between governments and MNCs involve clauses where the MNC has to manufacture at least some of the order in the country.
  • In the case of widespread tax avoidance, a solution requires a worldwide agreement on taxing MNCs. The tax regime for company profits is losing the government large amounts of tax revenues - but the US government cannot agree a solution between 2 parties
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Problems facing policy makers

  • Inaccurate information - the information that policy makers hold can sometimes be inaccurate - the information may be difficult to collect. E.g. first estimates of GDP figures for the previous month can be inaccurate by several %. This is because it is not possible to collect accurate data within such a short time span. Another example is tax evasion - some governments today are making it a priority to collect taxes from individuals and companies who are illegally evading tax. The problem is, by the nature of tax evasion, the government can only estimate how much extra revenue this might raise. It will have no clear picture of how much money is invested in illegal schemes
  • Risks and uncertainties - the future is always uncertain to some degree. The reality is that it is difficult to predict the outcome
  • External shocks - external shocks cannot be controlled by national governments. In 1974-75 for example, the world experienced its first oil crisis as OPEC increased the price of oil from $2 a barrel to $11 a barrel. This created large inflationary pressures in oil-importing countries such as the UK which contributed to the 25% inflation experienced in the UK in 1975. IN 2007-08, economies were thrown into the worst recession since the 1930s by the financial crisis. The risk of external shocks are increasing over time as globalisation deepens - so it's harder for policy makers to control events and pursue their policies successfully
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Public expenditure

  • Capital expenditure - spending on capital goods, e.g. schools, roads and other durable goods. These goods will be consumed over a period of time greater than a year
  • Current expenditure - recurring expenditure to run the public service and use the social capital that has been put in place. This expenditure will usually be consumed within a short amount of time, such as heating of schools, light for hospitals, petrol for deliveries and stationary for schools.
  • Transfer payments - are mainly welfare payments made to individuals, such as the state pension and child benefit. They are payments by government for which there is no direct corresponding output. Hence transfer payments are not included in the measurement of GDP. Also included are debt interest payments (interest payments on loans and/or the % owed on issued bonds). Often transfer payments are referred to as a type of current expenditure.
  • A government can have a budget deficit just on its current expenditure; it is not raising enough taxes to pay for its day-to-day expenditure. This is generally considered to be the worst type of deficit because it will have borrow to simply pay day-to-day costs; if these costs are comprised of a large debt interest, then governments would be borrowing even more to simply pay back interest on their debts! Tomorrow’s taxpayers will have to pay for today’s expenditure.
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  • However, it is considered reasonable by many to borrow for capital expenditure. Taxpayers in the future will benefit from capital expenditure made now (social infrastructure like schools, railways etc.) and so future generations should be made to pay their share of capital expenditure made now.
  • Government spending can be categorised into whether they are:
  • Exhaustive – spending which uses resources and directly create output. Capital Expenditure and Government Final Expenditures are Exhaustive Expenditures. These items are included in the ‘G’ component of aggregate demand and therefore are included in GDP calculations.
  • Non-exhaustive – they do not directly absorb resources or create output. Transfer payments are non-exhaustive as recipients earn income without any exchange of goods or services. These items of government spending are excluded from GDP (AD) calculations.

Significance of a budget deficit or increased national/government debt?

  • Depends on whether the deficit can be financed or not.
  • Depends on what the government has spent the money on to cause the deficit - e.g. education and training expenditure will hopefully have longer term benefits
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  • A high budget deficit will in the longer run lead to reduced government spending and higher taxation. Austerity measures or cut backs to government spending / increase taxation lead to an increase in unemployment especially in the public sector but also in the private sector - aggregate demand will fall. Austerity measures have also led to governments reducing their spending on pensions and the retirement age has also increased in some countries.
  • Governments around the world including the Eurozone are adopting austerity measures which many argue are not working as economic growth is low and unemployment increasing
  • The austerity measures have led to protests and unrest in parts of the Eurozone e.g. Greece and some might say the UK as riots broke out in August 2011. The UK has very high levels of youth unemployment.
  • Increased national debt is significant because of the cost of servicing the debt e.g. debt interest in 2014/15 was £50bn, this means less can be spent on education and health.
  • At the extreme end a high budget deficit may lead to a loss of the AAA credit rating which further leads to a loss of confidence meaning lenders and will increase their interest rates and so the cost of the deficit escalates.
  • Governments may need to sell bonds to finance the debt. In order to make the bonds more
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  • attractive to investors the interest rate on the bonds may be bid up and this could lead to an increase in the base rate. An increase in the base rate will lead to a fall in private sector investment (private sector is crowded out).

Austerity:

  • Government austerity measures include higher taxes and spending cuts. The aim is to reduce a country's deficit - the amount it spends every year over and above what it earns.
  • Following the financial crisis, government debt levels rose sharply. With companies, in particular financial institutions, making less money during the ensuing recession, tax revenues fell. There was widespread agreement among leaders and international institutions that introducing austerity measures was the best way to tackle the debt crisis.
  • Austerity measures are hugely unpopular with the public, as they typically result in cuts to public services, higher retirement ages and reduced public sector wages and pensions.
  • Another criticism is that austerity stifles growth. "Austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues," 
  • Some point to the US, which has chosen not to cut spending as far and as fast. But while 
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  • the US's economy has grown faster than say, the UK's, its economic growth rate is nevertheless slowing and unemployment is still high, leading others to argue that the US's approach has not necessarily been more successful.
  • Some say that spending should be targeted at boosting growth, create jobs, and encourage investment in order to ultimately increase tax revenues. 
  • Whilst many others question the logic of imposing high taxes upon ordinary citizens, when large multinational companies like Amazon and Google engage in tax evasion which costs governments many billions of pounds in revenue each year.

Comparing GDP to Debt ratios:

  • Political ideology plays a part in the role of the government in the economy, with socialist countries tending to see a stronger role for the state in intervening (spending and taxation for instance) in the economy.
  • For many developing countries, tax collection is a challenge, with no effective administration system in place. Developed countries like Italy and Greece have poor methods of collecting tax and fail to receive large portions of their revenue.
  • In developing countries tax collection problems are compounded when many people are 
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  • living on low incomes or in absolute poverty. Furthermore, where subsistence activity is significant, taxation cannot be effectively implemented; there is a tendency for the lower-income countries to therefore display relatively low tax revenue relative to GDP. As a consequence, these governments have very little scope to be able to play a significant role within the economy – in terms of either spending or taxation. Another possibility to fund expenditure would be to print money, but increasing the supply of money in this way can bring about disastrous consequences in the form of hyperinflation, such as Zimbabwe in the late 2000s.
  • Tax revenues could be low for the reasons for discussed; it is not alwas because of massive expenditure. The ability to collect tax revenues will influence spending and inhibit the ability to provide social infrastructure and introduce policies to combat poverty.
  • Governments are also aware that foreign firms may take account of relative tax rates in different countries when deciding where to locate their investment. Countries that are keen to attract foreign direct investment (FDI) may thus feel pressured to keep corporation tax rates relatively low in the hope of attracting inflows of investment.
  • Developing countries may take on large debts to finance capital spending on social infrastructure; with the intention of providing a framework for growth and the provision of necessities, such as water and sewage systems or public transportation links
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  • Whereas developed countries may tend to spend more on current expenditures, due to infrastructure already having been built; hospitals, schools and transport systems require upkeep, maintain and staff costs.
  • A far better indication of a government’s debt is to express it in terms of a percentage of GDP - This provides perspective and sustainability in terms of the size of the debt.
  • Although the debt may not fallen in nominal terms, the situation can improve when compared to the size of the economy. Or, if the government increases the size of the national debt through spending then it can be arguably justified if the increased in GDP is greater than the increase in national debt. As a result of the multiplier effect, the initial government injection causes a larger increase in GDP or government spending on infrastructure increases international competitiveness and encourages more exports and FDI.
  • GDP to debt ratios are very important and more accurate than nominal terms, because although it may seem like a ‘small’ debt in nominal terms is not a problem for an economy – it would be unsustainable if the economy in question only had a small GDP.
  • Japan has the worst GDP to debt ratio (230%), followed by Greece (160%) and Italy (130%). US = 105%, UK = 90%. 
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  • A falling value of a currency increases the value of the national debt. A falling exchange rate will increase the debt burden for government and for banks with external debts (external meaning any debts that a owed to foreigners with a difference currency).
  • The UK experienced the lowest exchange rate in 31-years following Brexit - if the government pays back their debts (ie. the interest on bonds and when bonds mature) in another currency, then we will need more pounds to settle the debt 

3 main sources of government funding:

  • Government revenue - Tax revenues; Non-tax revenue (e.g. property income, administration fees, fines); Capital revenue (sales of assets, shares or stocks – such as selling off shares owned in banks)
  • Foreign Grants: all non-repayable inflows from government or international organisations, including budget support, project grants or debt relief. This would include funds for development projects from the World Bank.
  • Net external finance: repayable Government financing transactions with resident and non-resident individuals, enterprises as well as other governments and international organisations. This includes government bonds (most important to developed countries like the UK), loans (from the IMF) and other liabilities
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Factors affecting the size and composition of government spending:

  • The higher the level of income, the greater the amount of tax that can be raised. 
  • The higher the level of income, the better the administrative and enforcement system and tax infrastructure in place, therefore, the better that country’s ability to assess and collect the right amount of tax which can then be used to spend. This means, tax assessment is more scrupulous and transparent; hence, less subject to manipulation and corruption.
  • The higher the level of income, the more exigent (‘demanding’) the citizens become. There are therefore higher expectations placed on government regarding the delivery of quality service and social infrastructure (e.g. good roads, healthcare, education, social housing as well as better levels of welfare support). All these require a higher level of public expenditure.
  • During periods of recessions, the larger the size of government spending (automatic stabilisers). Also likely to affect the composition/make up of government spending.
  • Large national debts means that lenders are less willing to extend funding to the government and inevitably limits both the size and growth of government spending. Countries’ who’s national debt that is a large percentage of GDP and are having trouble paying back debts, may also have their credit rating reduced, thus increasing the interest rate they have to pay and reducing the willingness of lenders
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  • Any fiscal rules that are imposed - For example, the ‘golden rule’ means that additional borrowing could only be used for capital expenditures. Thus, a fiscal rule could place a limit to how much government could spend. Additionally, a fiscal rule outlining that there must be a proportionally larger amount of capital spending, could therefore also indirectly impact upon current expenditure – as the government could simply just reduce current expenditure to levels below capital spending. Or indeed cut current expenditure to fund more capital spending.
  • Countries with free market leanings will have a smaller state involvement, hence, a lower level of government spending
  • The older the population, greater the component of healthcare and pension payments in total government spending. Economies with a high dependency ratio (the dependency ratio is a measure showing the number of dependents (aged 0-14 and over the age of 65) to the total population (aged 15-64)) are likely to spending more of healthcare, pensions and child benefit – these groups are also unlikely to be currently contributing much in terms of government revenue, placing greater pressure upon the government.
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  • The cyclically adjusted budget deficit takes into account changes in the business cycle and spending associated with this (cyclical budget deficit).
  • Government revenue consists mainly of taxes and social contributions that are levied on different types of income and expenditure. Therefore, it tends to rise and fall in line with fluctuations in economic activity.
  • By contrast, and with the notable exception of unemployment benefits, the bulk of government spending is largely unaffected by the economic cycle (structural).
  • Consequently, all other things being equal, government budget balances tend to improve during economic upturns and worsen during economic downturns. The purpose of cyclical adjustment is to make a correction for the influence of the economic cycle on the public finances and arrive at a measure that better reflects the underlying, or structural, causes of the budget deficit.
  • Budget deficits may be cyclical or structural; cyclical meaning that automatic stabilisers come about as a result of an economic downturn, unemployment benefits and other benefits increase and tax revenues decrease – these changes are not due to any government action. 
  • Whereas a structural deficit is related to discretionary spending by the government, in which they actively decide to spend more/reduce tax – which is not linked to the economic cycle
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  • Using government receipts and debt to cover current expenditures is generally considered to be inefficient and unfair.
  • The rationale is that if current expenditures are large (relative to government receipts raised) then the state is viewed to be living beyond its means. Not only is it not raising enough taxes to cover current expenditures, it is also having to borrow to pay for current spending. This means, costly borrowed resources will be used to finance activities which have little or no equivalent impact upon GDP (non-exhaustive expenditures).
  • Moreover, this debt will have to be shouldered by future generations, raising issues of inter-generational sustainability
  • Using government receipts and debt to cover capital expenditures is generally considered to be efficient and fair.
  • Future taxpayers are likely to benefit from investment in social infrastructure; hence, it is fair that they contribute to pay for capital spending made now.
  • Government spending can have a significant impact on people’s living standards - In the case of public and merit goods, the private sector is likely to underprovide these goods and services. Government spending is likely to counter that market failure and by doing so, help raise economic welfare and quality of life. Government spending also prevents absolute poverty as the safety nets ensure avoidance of negative externalities.
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  • Government spending can be economically efficient (ie. Raise productive, allocative and reduce x-inefficiencies) The argument is that the public spending can be lower cost than private spending. The reasons are:
  • Public sector is a large spender and can take advantage of purchasing and financial economies of scale of scale when negotiating contracts when compared to several much smaller, fragmented private firms.
  • Public sector provides goods and services that the private sector is sometimes unwilling to provide (therefore are more likely to respond to consumers’ demands = allocative efficiency)
  • The counterargument to this is that the public sector may not have the financial discipline of the private sector, which tends to be interested in controlling costs in order to maximise private profits. Another counterargument is that the disincentive effects of taxation and welfare (e.g. reduced consumption and unwillingness to find work) spending may outweigh the potential benefits from higher government spending.
  • A further counterargument is that whenever the government spends, decisions about how to spend taxpayers’ money is made by politicians and civil servants and not taxpayers themselves. There is therefore a principal-agent problem which may lead to a loss in welfare of the principal (taxpayer).
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  • An additional argument for government spending is that it leads to increases in productivity and long-term growth because there are areas that the private sector may be unwilling to spend on: E.g. efficient road systems, high quality education, comprehensive healthcare systems, spending on R+D, regional spending

PSNCR and PSDR

  • The Public Sector Net Cash Requirement (PSNCR), formerly known as the Public Sector Borrowing Requirement (PSBR), is the official term for the Government budget deficit in the United Kingdom, that is to say the rate at which the British Government must borrow money in order to maintain its financial commitments.
  • Alternatively a contractionary fiscal policy may lead to a situation where tax receipts exceed government spending - this is called a budget surplus.
  • Where there is a budget surplus a PSDR (public sector debt repayment) will exist. In this instance PSDR is the money that the government has left over which it can use to pay off some of the national debt. 
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Significance of government spending upon different areas of the economy

  • Living standards and equality - If there were little or no government spending, there would be significant market failure. The private sector is likely to underprovide everything from roads, street lights (public goods), to education. Government expenditure is also vital in the prevention of absolute poverty. In low-income countries, governments do not have the resources to transfer income to those most in need. The result is malnutrition, insanitary drinking water and very poor-quality housing which can result in death. Public expenditure also pays a key role in terms of welfare and benefits payments, in order to provide protection for workers if they lose their job and have no savings to fall back upon. Though not every country has a welfare system, those that do prevent the unemployed and those on low incomes from not being able to afford basic necessities; welfare systems also provide support in the form of child benefit, to ensure that livings standards remain high and that inequality is minimised. The extent of the welfare system depends on the country, the UK for instance has an extensive ‘welfare state’ that provides not only benefits but also a NHS in which the state provision of healthcare means that medical services are free for all citizens, dramatically improving living standards and helping to support equality.However, there is a debate about how much government can contribute to living standards and the extent to which equality is a desirable economic objective
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  • Crowding out - The negative of expansionary fiscal policy, the crowding out effect, in which the issuing of new bonds discourages financial institutions and banks from lending to riskier private firms and individuals. In addition, if the government increases government spending by £1, then it is logical to assume that this displacement must lead to £1 less of private sector spending. This could be damaging in that the government is providing goods and services that the private sector could provide more efficiently, as governments can be inefficient when it comes to allocating resources – this is because it lacks the motive of profit. Whereas private sector firms will be incentivised to reduce x-inefficiency and improve productive and dynamic efficiency (by innovating to beat the competition), the government increases costs and reduces choice. Hayek also was critical of governments as they lacked the correct information that private firms possess, resulting in a government that does not produce goods and services at the correct price and/or quantity (allocatively inefficient). It is arguably better therefore to reduce state involvement and not ‘crowd out’ the private sector, which could use the resources at its disposal more efficiently. 
  • However, public sector spending may not always crowd out the private sector. One such example are transfer payments, as there is no corresponding output associated with transfer payments. Therefore exhaustive spending might crowd out the private sector, whereas non-exhaustive spending may not.
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  • Crowding In - An alternative argument, to counteract crowding out, would be the opposite effect of crowding in - This means that extra government spending actually leads to more private sector spending through the multiplier effect. An initial injection of government spending may well lead to further rounds of private sector spending, ultimately leading to the private sector producing more goods (one person’s spending is another person’s income). In addition, the government may invest in capital expenditure for the private sector to utilise. This has been a strategy implemented in China. Governments provide productive capacity (LRAS) for demand to grow into, this creates a platform and capacity for private sector to operate within – for example, by the government building roads, factories, education and office space the private sector can then easily utilise these factors of production and produce output.
  • Taxation - If the government is spending a high proportion of GDP, this can only be sustainable in most cases if tax revenues are also a high proportion of GDP. High levels of tax can have disincentive effects if taxes are poorly structured – such as income tax that is so high it discourages workers seeking a job, or corporation tax that disincentives business ventures as too much profit will be taxed. However, if we the Laffer Curve – then when the tax level is set at the optimum, the government can receive significant tax revenues without disincentivising firms and workers.
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  • Productivity and Growth - Free market economists argue that public sector spending is often wasteful and inefficient. Therefore, cutting public spending is likely to increase productivity and growth if these resources are transferred to the more efficient private sector. A contrary argument is that the public sector provides goods and services vital to productivity and growth which the private sector would otherwise not do. Either because they are public goods (non-rival and non-excludable); or because the equilibrium price would be too high and many people would not be able to access goods and services with significant positive externalities. Examples of government spending increasing growth and productivity:
  • An efficient road system encourages trade and specialisation and lowers costs for firms.
  • A high quality education system increases the human capital of the working population today and in the future.
  • A comprehensive health care system means that workers suffer fewer days lost from serious illness.
  • Well target benefits system can encourage those out of work to gain jobs.
  • Spending on long-term R&D will give make the economy more internationally competitive.
  • Regional aid will help revitalise areas of the country with relatively high unemployment and low GDP.
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Taxation

  • Indirect tax – specific (fixed tax amount on each unit of output, regardless of the price) and ad valorem (tax is calculated as a percentage of the selling price e.g. VAT). Indirect tax is a tax collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (the consumer). The intermediary (retail store) forwards the collected tax to the government.
  • Direct tax -  is collected directly by government from the person/business on which it is imposed – PAYE (income tax), corporation tax and national insurance contributions(NICs)

Economic effects of changes in direct and indirect tax rates:

  • Incentives to work and tax revenues - High marginal rates of tax (the rate of tax on £1 earned) discourage economic activity. Lowering certain taxes will therefore raise the level of economic activity and increase aggregate supply. 
  • Free market economists believe that the supply of labour is relatively elastic. A reduction in marginal tax rates on income will lead to a significant increase ‘work’. This could mean individuals working longer hours, being more willing to accept promotion, being more geographically mobile, or simply being prepared to join the workforce.
  • Work is, arguably, an inferior good (an inferior good is a good whose quantity demanded decreases when consumer income rises) - whilst leisure, its alternative, is a normal good.
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  • The higher an individual’s income, the less willing he or she is to work - so a cut in marginal tax rates will have a negative income effect - as the worker will be less willing to work. However, a cut in marginal tax rates will have a positive substitution effect because the relative price of work to leisure has changed in favour of work (ie. the worker will be more willing to work, as they can keep more of what they earn).
  • Free market economists believe that the substitution effect of a tax cut is more important than the income effect and hence tax cuts increase incentives to work. If cutting marginal income tax rates encourages people to work harder and earn more, then in theory it could be that tax revenues will increase following a tax cut.
  • The Laffer curve plots tax revenues again tax rates (%) and as tax rates increase, the rate of growth of tax revenue falls because of the disincentive effect of tax.
  • Changes in tax and benefit rates also can have incentive effects for those in work and on low incomes or for those unemployed – such benefit and unemployment traps disincentive people returning for work if their benefits are too high/taxation too high. 
  • The Laffer curve can be applied to many different taxes (income tax, excise duties, corporation tax) and the reason why revenues fall beyond an optimum level can be imaginatively applied for high marks.
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  • Income distribution - The impact of a change in tax rates upon income distribution depend upon the tax:
  • If VAT is increased or alcohol and/or cigarette duties are increased, the distribution of income is likely to become less equal. This is because VAT and duties are regressive taxes (they take a larger percentage of the incomes from those that earn less)
  • If there is a rise in the top of rate of income tax, then the distribution of income is likely to become more equal. This is because the rise in tax revenues will be paid by top-income earners and not by lower-income earners. Increasing the tax free allowance for bottom earners will also reduce the distribution of income.
  • If the rate of corporation tax rises, then the distribution of income is likely to become more equal. This is because a rise in corporation tax (the share of profits going to the government) is likely to lead to a fall in dividend payments to shareholders. Shares are disproportionally owned by those on high incomes. So the income of high earners is likely to fall.
  • Real output, the price level and employment - Aggregate demand: Income tax and NICs (paid by both employees and employers) affect AD. A rise in income tax rates will reduce household disposable income. Households will then spend less, bringing about a fall in consumption and reducing the output demanded at any given price level. Shifting AD to the left
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  • The impact of this upon real GDP and the price level depends upon where the economy is in terms of LRAS. If the economy is close to full capacity (inelastic section of LRAS) then the price level will fall proportionately greater than the fall in real GDP. Investment (component I) will also be impacted negatively if C falls, as expenditure on working capital will also subsequently fall (fewer raw materials and components will need to be purchased – as sales fall).
  • Aggregate supply: Some taxes, such as VAT, duties and Employers’ NICs raise costs for firms. A rise in indirect taxation effectively increases costs of production, shifting SRAS to the left. It may be that the subsequent increase in prices (passed onto consumers by firms – in order to pay indirect taxation) may result in a ‘wage-price spiral’, as the (cost-push) inflationary pressure leads to workers trying to secure higher wages to cover the loss of real earnings they have suffered from the rise in the price level from cost-push inflation. This would increase costs of production further for firms (SRAS shifts left) and so further cost-push inflation occurs. In terms of direct taxation (corporation tax) this may impact the level of capital expenditure by firms, if they retain less of their profit then investment in machinery, factories etc. may fall (negatively impacting LRAS).
  • The trade balance (x-m) - An increase in taxes on households will reduce their disposable income. This, in turn, will reduce their consumption – including their spending on imports (depending on elasticity) Hence the trade balance will improve.
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  • Equally, the cut in consumption from increasing taxation will reduce AD – therefore with AD falling from what it otherwise would have been, firms will need less capacity to meet demand and so they will need to invest less. This is what would be expected from the accelerator theory of investment (theme 2 – as firms see consumption increasing, they increase capital expenditure to increase their capacity in order to meet this demand). Some of the cut in investment will come from cuts in imports of capital equipment. Hence the trade balance in the short term will improve. In the long term, it could deteriorate if less investment makes domestic firms less internationally competitive over time.
  • If direct taxation on firms decreased (corporation tax) then increased investment in capital and R&D may occur, which could lead to firms being more internationally price competitive as they develop new, cheaper and more efficient ways of producing exports. This R&D may also increase dynamic efficiency; therefore innovation improves non-price competitiveness of firms and so increases the appeal of exports. With these outcomes, the economy may see an increase in the level of exports and so an improvement in the trade balance. It may also be that imports are reduced as consumers switch away from imports and switch towards the cheaper and higher quality domestic goods, all resulting from the increased innovation and capital expenditure from the lower taxation.
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  • FDI flows - Foreign Direct Investment (FDI) is normally defined as investment by a foreign company where the foreign company acquires 10% of more of the shares of the domestic company. For a country, it represents a way to increase investment in their own economies and to boost output and employment. For governments, it represents a way of increasing tax revenues because the ongoing operations will pay a variety of taxes – everything from VAT, corporation tax, taxes on labour employed (NICs) and even the people they employ will pay income tax. 
  • Some countries have chosen to encourage FDI flows by offering lower rates of tax on investment. In particular, some countries have deliberately lowered their rates of corporation tax, the tax on company profits. The justification is that any loss of tax revenues will be more than offset by increased economic growth, the multiplier effect and prosperity resulting from the investment. Also, in the long term, the government may collect more in tax despite the rate of tax being lower because if the investment had not been made at all, then no tax would have been payable. In addition, FDI creates employment and so it is possible that many workers would be been jobless without the FDI and so not paying income tax and VAT (through reduced consumption) they’re also no longer claiming benefits, so tax reductions for foreign companies is justifiable from a fiscal perspective.
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  • The problem with ‘tax competition’ between nations is that it can become a ‘race to the bottom’. If enough countries lower their taxes in an attempt to attract FDI, lower taxes will eventually have little impact on a firm’s decision about where to make the investment. However, countries will see significantly lower tax revenues because all the existing firms in the country will now be paying lower tax. 
  • Progressive tax - Where the proportion of income paid in tax raises as the income of the taxpayer rises. Direct taxes on income tend to be progressive because of the way they are structured. Those on very low incomes pay no income tax (tax free allowance) whilst those on very high incomes pay a higher rate of tax than those on lower incomes.
  • Regressive tax - Where the proportion of income paid in tax falls as the income of the taxpayer rises. Indirect taxes, such as VAT and excise duties, tend to be regressive. As incomes increase, households tend to spend less as a proportion of income and save more. The result is that taxes on spending fall (as a % of income) as income rises.
  • Proportional tax - Where the proportion paid in tax remains the same while the income of the taxpayer changes (although the actual amount paid increases as income increases).
  • The more progressive the tax, the greater the link with ability to pay the tax and the more likely it is to result in a redistribution of resources from the better off in society to the less well off
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  • The largest tax by revenue for the government is income tax which raises approximately 25% of all government revenue. The three largest taxes (income tax, NICs and VAT) raise approximately 60% between them. If corporation tax, local authority taxes (council tax and business rates) and excise duties (mainly on petrol, alcohol and tobacco) are added to these, then these taxes contribute over 80% of government revenues.

Why has there been a shift from direct to indirect taxes in the UK:

  • Less disincentives (to work and invest) compared to increasing direct taxes e.g. income and corporation, which increases the marginal rate of taxation, and can discourage people to work more hours or invest.
  • Take account of negative externalities, e.g. fuel duties, domestic fuel VAT
  • Reduce consumption of demerit goods
  • Cheaper to collect
  • More difficult to evade
  • Give consumer choice as reducing direct tax e.g. income tax gives individuals more choice as they have a higher disposable income and can have more freedom in choosing how to spend their money
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However:

  • Inflationary as increasing VAT, excise duties have the immediate effect of increasing prices (increases costs of production), also cuts in direct taxes e.g. income tax means there will be an increase in consumption.
  • Measuring externalities presents problems, it is difficult to quantify external costs
  • Leads to a more unequal distribution of income as indirect taxes act regressively i.e. they take a greater proportion of a lower person’s income
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The financial sector

  • A financial market is any convenient set of arrangements where buyers and sellers can buy or trade a range of services or assets that are fundamentally monetary in nature. 
  • Financial markets exist for two reasons. One is to provide services demanded by households, firms and government. For example, households want to be able to spend money using a credit card. Firms want to be able to pay their suppliers. Governments want to be able to borrow money.
  • However, financial markets also exist because they allow participants to speculate and realise financial gains. Foreign exchange traders (Forex) betting on which way a currency might move in the next few seconds are not providing a service to a customer. They are gambling in the hope of making a profit.
  • The combination of speculation and provision of genuine services means that financial markets are prone to regular crises that cause significant damage to the economy. 
  • Financial markets have a number of important roles to play in an economy:
  • Saving - Financial assets, such as money or stocks and shares, are a way of transferring spending power from the present into the future. Financial institutions will give a return on savings in the form of interest, then lend out the deposit at a higher interest rate to make a profit. Therefore facilitating saving is an important for an economy to operate and a key role of financial markets.
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  • Lending to firms and households -  Banks connect those who want to save with those who want to borrow, as deposits are then given out by financial institutions in the form of loans, mortgages, overdrafts etc. Households, firms and governments all borrow money. For example, a household might borrow money on a credit card to finance the purchase of a new television. A firm might borrow money to buy equipment. A bank might borrow to lend more profitably to another financial institution. Or it may borrow money to finance government spending which is not paid for by its receipts from taxes.
  • Facilitating the exchange of goods and services - Financial institutions play a vital role in creating payment systems for goods and services. Central banks, for example, print money and create coins (known as ‘minting’). Retail banks offer cheque, debit card and credit card services. More hidden from view are institutions which process trillions of cheque transactions per year. Visa, Amex and MasterCard are companies which offer credit card services to banks, retailers and individuals – transferring money to from bank account into another to pay for goods. Banks and bureau de changes buy and sell foreign currencies and also transfer money from one account into another bank account in a different country and a different currency.
  • Providing forward markets in currencies and commodities - The parties initially agree to buy and sell an asset for a price agreed upon today (the forward price), with delivery
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  • and payment occurring at a future point, the delivery date.
  • Firms sometimes want to buy or sell forward. For example, farmers may want to sell the crop they are sowing at a guaranteed price. Producers would engage in forward buying as they may want to even out price fluctuations. Yhis would be advantageous to the producer, as they can be certain of their future costs and future costs could actually be higher than the agreed price – but they could also be lower, so there is a danger of increasing their costs! Forward markets exist in both commodity markets (wheat, cocoa, soya beans, copper, nickel, oil etc.) and also foreign exchange markets, such as dollars or euros which can be bought and sold forward too.
  • Forward buying/selling contracts are very similar to ‘futures contracts’ or simply ‘futures’ – the big difference being that forward contracts are not traded amongst investors. The original use of futures contracts was to reduce the risk of price or exchange rate movements by allowing parties to fix prices in advance for future transactions. This could be advantageous when (for example) a party expects to receive payment in foreign currency in the future, and wishes to guard against an unfavourable movement of the currency during the interval before payment is received.
  • However, futures contracts/forward buying and selling also offer opportunities for speculation in that a trader who predicts that the price of an asset will move in a particular
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  • predicts that the price of an asset will move in a particular direction can contract to buy or sell it in the future at a price which (if the prediction is correct) will yield a profit.
  • Forward buying is similar to hedging, but hedging is associated with an agreed price between a firm and a supplier for all purchases of a particular good for a fixed amount of time whereas forward buying is about agreeing a purchase price today which is then payable upon delivery in the future.
  • Providing a market for equities (stocks and shares) - Equities are the shares of companies (in the US, shares are called ‘stocks’ – hence the name stock exchange). Issuing shares, or equity finance, can be an important way in which companies, particular those that are growing in size, can finance their expansion. Those buying new shares will get a share of profits made by the company (known as a dividend). However, few would buy new shares if they could never sell them again. Locking up money forever in shares would be a very large risk for a saver. Not being able to sell means that the shares would be completely illiquid. Stock markets provide a way in which owners of shares can sell them to others. They create liquidity in the market. The greater the number of shares issued, the more buyers and sellers in the market, therefore the greater the liquidity. Having markets for second-hand shares therefore encourages buyers to purchase new shares when they become available.
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The financial sector

Different types of financial institutions:

  • Retails banks: These provide a variety of services to households and individuals - for example, most households in the UK have at least one member who has a bank account. Wages or benefits are paid into the account. Withdrawals can be made in cash by taking money out of a cash machine (for example). Regular bills are paid using standard orders and direct debits. A variety of savings accounts will be offered giving interest. The retail bank will also provide a range of services from overdrafts, loans and mortgages to credit cards, foreign exchange and insurance. Retail banks make a profit out of borrowing money at low rates of interest or zero rates of interest and lending it out again at higher rates of interest. They also charge for their services – such as mortgage and financial advice.
  • Commercial banks: These are banks which provide a variety of services to businesses. They lend to businesses and allow them a secure place to put their funds. Commercial banks also provide ways for firms to receive and send money from: customers (payment for goods and services), suppliers (paying for raw materials), businesses (paying other businesses for their goods and services) and workers (payment of wages). Firms can improve their cash flow by using a short-term overdraft or fund capital expenditure expansion by taking out a loan or mortgage.
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  • Investment banks: Unlike retail and commercial banks, these do not take deposits. As part of the Dodd–Frank Wall Street Reform, some institutions were forced to separate the riskier investment banking services from commercial banking. They trade in foreign exchange, commodities, bonds and shares. They also advise companies on how to raise finance, including the issuing of new shares – they also advise on mergers and takeovers of companies, as well as potentially providing loans to fund such ventures.
  • They also trade in derivatives (assets that derive their value from the performance of an underlying entity or asset) CDOs (collateralised debt obligations) are one example of a derivative, in that their value is derived from the underlying performance/value of mortgage repayments
  • CDOs were a key factor during the 2008 Global Financial Crisis, CDOs are lots of mortgages bundled up together – whoever owns the CDO owns the right to receive all of the mortgage repayments included in the CDO. Many of these CDOs were purchased by investors (who received the right to receive monthly mortgage repayments) and were not fully aware of the risks involved, as many of the mortgage repayments within the CDO were coming from borrowers with a high risk of defaulting (known as sub-prime lending). 
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  • Subsequently the CDOs stopped providing an income, as mortgages were no longer repaid – usually when this happens the property that the mortgage is secured on would be sold to cover the outstanding mortgage owed to the lender, but because so many people defaulted this led to a large increase in supply of housing being sold – therefore reducing the price of housing to such an extent that the value of the property no longer covered the outstanding mortgage owed - a key cause of the 2008 Financial Crisis.

DIfferent types of financial markets:

  • Money markets: A money market provides short-term borrowing and lending, usually defined as up to one year. For example, the UK government borrows short-term by issuing Treasury Bills (Gilts/bonds) that mature after only 91 days. Bills of exchange are a form of borrowing by companies. Essentially they are promises by companies to pay for goods and services they have already received, at a fixed point in the future such as 91 days. These then get traded by firms that have delivered the goods and want their money immediately – the firm delivering the good sells it for less than the value of the whole debt, so although they receive less money, they receive their money immediately; the purchaser of the debt makes a small profit in the future when the debt is paid by the original company purchasing the good.
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The financial sector

  • A very important money market is the interbank market where banks lend between themselves. At the end of every trading day, some banks will have a surplus of money whilst others will need to borrow money to balance their books. The interest charged for short-term lending between banks is known as the LIBOR rate – it stands for ‘London Interbank Offered Rate’.
  • Capital Markets: Capital markets provide longer-term financing, usually defined as being more than one year. The main assets traded on capital markets are bonds and shares (called stocks in the US). Bonds are long-term loans issued by firms and governments. The UK National Debt represents how many bonds the UK government has issued; a bond could be a anywhere from 91 days to 50 years – with the purchaser of the bond receiving interest for the duration of the bond’s life until maturity, when the government pays back the original amount paid for the bond. Bonds are a way for governments and firms to borrow long term. The advantage to those who buy bonds is that they can be traded second hand on bond markets. They can therefore sell their bonds before the maturity date. There are a number of stock markets around the world where companies are listed (London Stock Exchange, New York Stock Exchange, Tokyo Stock Exchange, Frankfurt Stock Exchange etc.). This means that their second-hand shares are traded on those stock markets.
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  • Less than one per cent of all trading on capital markets is of new borrowing through bonds or new shares. Almost all trading is of second-hand bonds and shares. Almost all trading on the second-hand bond and shares markets is speculative activity by financial institutions (such as investment banks) trying to make a short-term profit.
  • Foreign exchange markets (Forex):This is where different currencies are traded. These could be ‘spot markets’ where currency is traded now, or they could be ‘forward markets’ or ‘futures markets’ where currencies are traded for a date in the future. A small fraction of the trades represent demand and supply for currency arising from physical transactions, such as the exports of goods or individuals buying foreign currency to go on holiday. There are also transactions that relate to transfers of money between countries, such as foreign direct investment (FDI). However, the majority of dealings of foreign exchange markets are speculative with financial institutions like investment banks trying to make a short-term profit. This information can be used as evaluation for the impact of imports, exports and FDI influencing the value of a country’s currency.
  • Commodity markets: Markets such as the London Metal Exchange or the Chicago Mercantile Exchange are where commodities are traded. Contracts may be ‘spot’ or futures contracts. As with capital and foreign exchange markets, most commodity trades are speculative in nature
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  • Derivatives markets: Derivatives markets are those which trade financial assets that derive their value from the values of other financial assets. Many capital market, foreign exchange and commodity market transactions are derivatives. Derivate markets can (in theory) reduce financial risks in markets – as derivate assets could derive their price from safe assets and maintain stability and reduce risk. The 2007-08 financial crisis showed that in practice they can be enormously destabilising. Clients of investment banks, for example, were being sold derivatives (mortgage CDOs) that they thought were low risk, when they were in fact high risk. Investment banks themselves were creating new types of derivative without fully understanding the possible risks they could create for markets.
  • Insurance markets: Insurance markets are where individuals, firms and governments can buy insurance. Part of the insurance market is the reinsurance market. This market is where an insurer reduces its risks on the insurance it has sold to customers. It does this by itself taking out insurance on the risk. This way, no insurance company carriers too much risk  – the risk has been spread between many companies.
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The financial sector

Market failure in the financial sector:

  • Asymmetric Information - One problem is that financial institutions frequently have more knowledge than their customers (particularly as the average consumer knows little about the complex nature of financial products) or have more knowledge compared to other financial institutions. In the case of Payment Protection Insurance (PPI), UK banks in the 1990s and 2000s sold tens of millions of insurance contracts to customers who were taking out a loan, mortgage or credit card. Banks failed to find out whether the insurance was appropriate for most customers. Those customers didn’t understand what they were being sold. Nor did they realise they could buy the same product for a fraction of the price from another insurer.
  • Another example of asymmetric information was the securitisation in the USA of mortgages. A bank would give a mortgage to a home-owner, that mortgage would then be sold off to another financial company that would buy mortgages to create a collection/pool/bundle of mortgages (called a Collateralised Debt Obligation – CDO). The mortgages represented an asset to the financial company because homeowners owed it money and were making regular payments. So the financial company could the rights to that stream of income. Financial institutions then sold these mortgage-backed securities 
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The financial sector

  • (a security, or securitisation is the practice of pooling/bundling together various types of contractual debt – a CDO is a mortgage-backed security. Securitisation could occur with loans, credit cards and even student loans). However, some financial institutions sold these mortgage-backed securities as ‘low risk products’ despite knowing that there were problems with some of the mortgages. This was because some of these mortgages were sub-prime mortgages, sold to customers who would have difficulties in making repayments. By manufacturing complex products, sellers of the securities made it very difficult, if not impossible, for buyers to understand what they were buying. Mortgage-backed securities were a major cause of the 2007-08 financial crisis.
  • There can also be asymmetric information between financial institutions and regulators. Financial institutions have little incentive to help regulators understand their business. As with many natural monopolies (particularly utility companies such as water, gas and electricity), it is in their interests to get regulators to see their businesses from their point of view – this can result in regulatory capture – which is a form of government failure that occurs when a regulatory body, created to act in the public interest, instead advances the commercial or political concerns of special interest groups that dominate the industry or sector it is charged with regulating. Furthermore, financial institutions have proved to be very powerful and successful political lobbyists to ensure that the power of regulators is minimised
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  • Moral Hazard - Moral hazard occurs when an economic agent makes decisions in their own best interest knowing that there are potential adverse risks, and that if problems result, the cost will be partly borne by other economic agents. One example of moral hazard in financial institutions relates to the taking of short-term risk. In investment banking, traders and senior executives can earn very large bonuses for generating profits for the bank. This encourages these workers to take excessive short-term risks without considering what might happen in the long-term.
  • In investment banking, there is widespread knowledge of risk. However, incentives tend to be structured (such as the bonuses) to encourage the making of short-term profit rather than encouraging workers to take a long-term perspective.
  • In the 2007-08 financial crisis, moral hazard was used in the context of financial institutions themselves. Financial institutions, such as banks, were accused of pursuing short-term profit by taking excessive risk because they knew that if things went wrong, they would be bailed out by governments. 
  • Speculation and market bubbles - Almost all trading in financial markets is speculative. This, in itself, creates problems including the creation of market bubbles. A market bubble occurs when the price of a particular asset is driven to an excessive high and then collapses.
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  • Market bubbles are often caused by ‘herding’ behaviour, this occurs when investors see the price of an asset rising and some decide that this is an indication that prices will rise even further and so they buy into the market. More and more investors become convinced that they too must buy – The Tinkerbell Effect. Eventually the price becomes too high. Enough investors decided that it is time to cash in and collect their profits and sell, causing the price to begin falling. Panic sets in and large numbers of investors try to sell too. The result is a price collapse. Herding behaviour exists because investors, instead of looking at the underlying value of an asset, base their actions on what other investors are doing. Combined with The Tinkerbell Effect, speculation and market bubbles can have very negative consequences.
  • In the UK, financial markets have helped create successive bubbles in the housing market. By lending too much into the property market, financial institutions have created too much demand for houses. This had led to unsustainable increases in the price of housing. Then something happens to burst the bubble. It could be a large rise in interest rates, for example. This makes it more difficult for those with existing mortgages to make repayments and increases the number of households that are forced to default on their debts. It also reduces demand for new mortgages as some home buyers are priced out of the market. This leads to a fall in demand for houses and a fall in house prices.
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  • The fall in house prices leads to ‘negative equity’ as some highly geared households owe more on their mortgage than the new, lower value of the house they have bought (so they are paying off a mortgage that is greater than the value of the property itself). This in itself cause households to default – this then reduces house prices further, as banks try to sell the property to recoup the mortgage they have lent, but the increase the supply of properties being sold reduces prices further. Banks are left with mortgages that are not going to be repaid in full and are left with an asset (the house) that they cannot sell to recoup their losses. The collapse in house price also leads to falls in consumption and therefore aggregate demand. Household wealth has fallen (wealth effect) whilst households that have not defaulted on their mortgage have less to spend because of increased mortgage payments due to higher interest rates (as in this scenario, the increasing interest rates led to the bursting of the bubble). Less demand for houses means fewer new houses being built and less employment amongst housing related services, such as builders and estate agents.
  • The UK is particularly prone to housing bubbles partly because too few new houses are being built (roughly 90,000-150,000 per year – economists estimate that 250,000 are needed to stabilise prices) and partly because such a high proportion of households own their houses (roughly 65% in the UK – much higher than Europe).
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The financial sector

  • Market Rigging - Financial markets are prone to market rigging. This is where a group of individuals or institutions collude to fix prices or exchange information that will lead to gains for themselves at the expense of other participants in the market. Market rigging has always been present in financial markets because it is very difficult to detect and because participants have been likely to suffer few penalties if caught (even if they do, the rewards may outweigh the potential penalties). 
  • An example of market rigging is insider trading. This is when an individual or institution has knowledge about something that will happen in the future (inside knowledge). This knowledge is not shared with other participants in the market. Based on the knowledge, an asset is bought or sold to make a profit. 
  • In various countries, some kinds of trading based on insider information is illegal. This is because it is seen as unfair to other investors who do not have access to the information, as the investor with insider information could potentially make far larger profits that a typical investor could not make. The rules governing insider trading are complex and vary significantly from country to country. The extent of enforcement also varies from one country to another. The definition of insider in one jurisdiction can be broad, and may cover not only insiders themselves but also any persons related to them, such as family members. A person who becomes aware of non-public information and trades on that basis may be guilty
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  • Market rigging can also refer to individuals or institutions fixing the price of a commodity, a currency an interest rate (see LIBOR rigging scandal) or an asset – usually within a cartel situation. Cartels could collude and suddenly agree to large trades in currency, for example, and shift the value of a currency. The change in value doesn’t need to be much for a trader to benefit by buying or selling related financial derivatives (that derive their value from the currency).
  • Externalities - Financial markets create significant negative externalities – these are costs borne by third parties, such as other firms, individuals and governments not actually involved in the original transaction within the financial market. For example, the cost to the UK taxpayer of supporting UK financial institutions during the 2007-08 financial crisis was, at its peak, £1.162 trillion. With a UK population of 61.8 million in 2008, this meant that the financial markets were being supported with £18,803 per person in the UK. 
  • In countries like Ireland and Greece, taxpayers will never recoup the full cost of their governments bailing out their financial institutions. The worldwide cost of bailing out financial institutions, however, is just a fraction of the cost of lost output due to the financial crisis of 2007-08. 
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