Theme 4 - Economics

Globalisation is the ever-increasing integration of the world’s local, regional and national economies into a single, international market.

It involves the free trade of goods and services, the free movement of capital and labour and the free interchange of technology and intellectual capital.

With the spread of globalisation came more trade between nations and more transfers of capital including FDI (foreign direct investment). Moreover, brands developed globally and labour has been divided between several countries. There is more migration and more countries participate in global trade, such as China and India, as well as higher levels of investment. Additionally, countries have become more interdependent, so the performance of their own country depends on the performance of other countries. This could be seen in 2008 and 2009 when the effects of the global credit crunch spread across the globe. 

Trade in goods: Developing countries have acquired the capital and knowledge to manufacture goods. The efficient forms of transport make it easier and cheaper to transfer goods across international borders. Some developing countries have the cost advantage of cheaper labour, so MNCs move their production abroad. This causes developed countries to trade with these developing countries, so they can access the same manufactured goods.

Trade in services: For example, the trade of tourism, call centre services, and software production (particularly from India) has increased from developing countries to developed countries.

Trade liberalisation: The growing strength and influence of organisations such as the World Trade Organisation (WTO), which advocates free trade, has contributed to the decline in trade barriers

Multinational Corporations (MNCs): MNCs are organisations which own or control the production of goods and services in multiple countries. They have used marketing to become global, and by growing, they have been able to take advantage of economies of scale, such as risk-bearing economies of scale. The spread of technological knowledge and economies of scale have resulted in lower costs of production.

International financial flows: For example, the flow of capital and FDI across international borders has increased. Also, the foreign ownership of firms has increased. There has been more investment in factories abroad. The removal of capital controls has facilitated this increase.

Communications and IT: The spread of IT has resulted in it becoming easier and cheaper to communicate, which has led to the world is more interconnected. There are better transport links and the transfer of information has been made easier.

Containerisation: This has resulted in it becoming cheaper to ship goods across the world. This causes prices to fall, which helps make the market more competitive. Containerisation means that goods are distributed in standard-sized containers, so it is easier to load and cheaper to distribute using rail and sea transport. This helps to meet world demand. However, it is mainly MNCs which have been able to exploit this, and it could result in some structural unemployment. 

Individual countries

• There could be trade imbalances between countries. For example, the US runs a large current account deficit with China, who has a large current account surplus.
• Within individual countries, there could be income and wealth inequalities if the benefits and costs of globalisation are not evenly spread. Inequality between countries can also increase, as some countries gain more from globalisation than others.
• Culture could spread across the globe. Some might say this has weakened culture and that there has been a loss of cultural diversity due to global brands. However, others will argue that the spread of culture has been positive and helped to improve their quality of life. 

Governments

• Some governments might lose their sovereignty due to the increase in international treaties. Individual states would find it hard to resist the force of them, and if countries become members of organisations, they will have to abide by their rules. 

Producers and consumers

• Consumers and producers can earn the benefits of specialisation and economies of scale as firms become larger.
• Firms operate in a more competitive environment, which encourages them to lower their average costs and become more efficient. This makes goods cheaper.
• Producers can also make their average costs lower by switching production to places with cheaper labour. The spread of technology has resulted in firms being able to employ the most advanced machines and production methods.
• Globalisation leads to a general increase in world GDP, which increases consumer living standards and helps lift people out of absolute poverty. However, it is hard to calculate the proportion of growth which was due to globalisation. 
• This rise in average consumer incomes could offset some of the lower costs of production for firms. This is especially due to increased demand from China, which has contributed to the increase in price of commodities, and therefore pushed up the price of raw materials.
• Some consumers gain more from globalisation than others. Globally, there are fewer people in extreme poverty, but this has not been the case in Sub-Saharan Africa. There could be increased inequality.

Workers

• Workers can take advantage of job opportunities across the globe, rather than just in their home country.
• However, there could be structural unemployment. For example, in the UK after the collapse of the shipbuilding and mining industries, there was a lot of structural unemployment. This is because it was more efficient for manufacturing to occur abroad, so production shifted to lower labour cost nations.
• However, it could be argued that countries would have had the change from agriculture to manufacturing to services anyway and globalisation simply sped it up.
• When production shifts to lower labour cost countries, the creation of jobs could be seen as either beneficial or harmful.

The environment

• Although industrialisation and increased consumer living standards might lead to more pollution through increased production and increased car use.
• Some of the negative impacts on the environment could include deforestation, water scarcity and land degradation. 

Countries can specialise in the production of certain goods. For example, Norway is one of the world’s largest oil exporters. Countries trade to get the goods and services they are unable to produce.

• A country has absolute advantage in the production of a good or service if it can produce it using fewer resources and at a lower cost than another country.
• Comparative advantage occurs when a country can produce a good or service at a lower opportunity cost than another country. This means they have to give up producing less of another good than another country, using the same resources. It is occurs when their opportunity cost of production is lower.

Country A can produce 30 units of wine and 10 units of wheat with their resources, and country B can produce 32 units of wine and 20 units of wheat.

It can be seen that country B has an absolute advantage in producing both products (it can produce more of both with the same resources). The greatest difference between the productions is with wheat, so country B should produce wheat and country A should produce wine. The opportunity cost of production is reflected in the gradient of the PPF. If more of one good is produced, less of the other good can be produced. 

The theory of comparative advantages assumes a perfectly competitive market. In reality, this is likely to be different, which results in the full benefit of specialisation not happening. Specialising fully could also lead to structural unemployment since workers might not gain the transferable skills they need to change between sectors, or they are simply unable to change.

Comparative advantage does not consider the exchange rate when considering the cost of production for both countries. Therefore, if the price of one good increase, it is more worthwhile producing that good, even if the country has a comparative advantage in the other good.

Moreover, comparative advantage is derived from a simple model with two countries; the global trade market is significantly more complex than this.

It can be argued that comparative advantage is no longer a relevant concept. Countries do not only produce a handful of goods and services like the theory suggests. Rather, a wide variety of goods and services are produced, and there is very little specialisation. This is helped by the advancement of technology

Advantages:

• Greater world output, so there is a gain in economic welfare.
• There could potentially be higher quality, since production focusses on what people and businesses are best at.
• Consumers have a greater variety of goods and services to choose from.
• Lower average costs, since the market becomes more competitive, which reduces prices.
• There is an outward shift in the PPF curve.
• More opportunities for economies of scale 

Disadvantages:

• Less developed countries might use up their non-renewable resources too quickly, so they might run out.
• Countries could become over-dependent on the export of one commodity, such as wheat. If there are poor weather conditions, or the price falls, then the economy would suffer.
• There could be more structural unemployment, since production moves abroad.
• Some countries might become stuck in the production of one good or service, so they cannot develop further.

Comparative advantage: There has been a recent growth in the exports of manufactured goods from developing countries to developed countries. This is because developing countries have gained an advantage in the production of manufactured goods, due to their lower labour costs, so production shifted abroad. 

Impact of emerging economies: The collapse of communism has meant that more countries, especially developing countries, are participating in world trade. International trade is arguably more important for developing countries than in developed countries.

Growth of trading blocs and bilateral trading agreements: With more trading blocs, trade has been created between members, but diverted from elsewhere. Trade creation occurs when a country consumes more imports from a low cost producer, and fewer from a high cost producer. Trade diversion occurs when trade shifts to a less efficient producer. They shift trade from one group to another.

Changes in relative exchange rates: The exchange rate affects the relative prices of goods between countries, which is an important factor in determining whether consumers buy goods. A rise in the exchange rate of a country will decrease its exports and shift trade to another country.

The terms of trade measures the volume of imports an economy can receive per unit of exports. It is calculated by the index price of exports over the index price of imports.

Terms of trade above 100 are improving, whilst those below 100 are worsening.

An example calculation is:

- The index price of exports increases by 15%. The index price of imports increases by 20%.

The terms of trade are (115/120) x 100 = 95.83. This means that the terms of trade has reduced, so the economy gets fewer imports per unit of exports.

In general, anything which affects the price of a country's imports or exports will affect its terms of trade. Therefore, it is affected by the demand and supply for its imports and exports. An increase in the price of exports or a decrease in the price of imports will cause an improvement in the terms of trade; this is said to be favourable. A decrease in export prices or rise in import prices will lead to a deterioration of the terms of trade; an unfavourable movement.

Exchange rates, inflation and changes in tastes impact the demand and supply in the short run. In the long run, productivity impacts the terms of trade.

Incomes affect the terms of trade since it impacts the demand for goods and services. For example, a rise in world income leads to a rise in demand for tourism so a country with a strong tourist industry would see an improvement in terms of trade as the price of exports increase.

If a country employs a protectionist measure, then the terms of trade will improve because imports are restricted. This is providing other countries do not retaliate. 

Improving terms of trade mean the economy can import more goods for each unit of export. This can help reduce the effects of cost-push inflation since import prices are falling relative to export prices. It could also help improve standards of living for consumers in the country.

Worsening terms of trade mean that for every import, the country has to export more. It could make the price of new technology more expensive, which might limit productivity. It could lead to a fall in living standards, and because it is more difficult to earn foreign currency, it becomes harder to pay foreign debt.

The impact on the balance of payments depends on the elasticity of demand and the Marshall Lerner condition. If goods and services are price elastic, an improvement in the terms of trade will lead to a worsening on the current account. 

Free trade area: This is where countries agree to trade goods with other members without protectionist barriers. For example, the North American Free Trade Agreement (NAFTA) is a free trade area. They allow members to exploit their comparative advantages, which increases efficiency.

Customs union: Countries in a customs union have established a common trade policy with the rest of the world. For example, they might use a common external tariff. They also have free trade between members. The European Union is an example of a Customs Union.

Common market: This establishes free trade in goods and services, a common external tariff and allows free movement of capital and labour across borders. When the EU was established, it was a Common Market. EU citizens can work in any country in the EU.

Monetary unions: Members of a monetary union share the same currency. This is more economically integrated than a customs union and free trade area. The Eurozone is an example of this. A common central monetary policy is established when a monetary union is formed. Monetary unions use the same interest rate so member countries have to respond similarly to external shocks or policy changes.
 

Trade creation and trade diversion: With more trading blocs, trade has been created between members, but diverted from elsewhere. Trade creation occurs when a country consumes more imports from a low-cost producer, and fewer from a high-cost producer. Trade diversion occurs when trade shifts to a less efficient producer.

Reduced transaction costs: Since there are no barriers to trade or no border controls, it is cheaper and simpler to trade. 

Economies of scale: Firms can take advantage of a larger potential market in which to trade. By specialising, firms and countries can exploit their comparative advantages, and the gains of efficiency and advanced technology can be reaped. 

Enhanced competition: Since firms operate in a more competitive market, they become more efficient and there is a better allocation of resources. There could be the long run benefits of dynamic efficiency too. However, not all members may experience this. 

Migration: By being a member of a Customs Union, the supply of labour is increased, which could help fill labour shortages. However, this might mean some countries lose their best workers. 

The WTO promotes world trade through reducing trade barriers and policing existing agreements. It also settles trade disputes, by acting as the judge, and organises trade negotiations.

Every member of the WTO must follow the rules. Those who break the rules face trade sanctions. In addition to trade in goods, the WTO covers the trade in services and intellectual property rights.

They hold a series of talks called rounds, where they attempt to come to agreements. The problem is that all countries must agree to any new rules so every country has the power to veto an agreement.

As of 2015, there are 161 member states in 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 CAP.

Conflicts between blocs could lead to a rise in protectionism. A common external tariff contradicts the WTO’s principles, since although there is free trade between members, protectionist barriers are imposed on those who are not members.

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 limits 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 common external tariff 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 trade bloc. 

Protectionism is the act of guarding a country’s industries against foreign competition, by imposing restrictions on free trade.

If a country employed several protectionist measures, then a trade deficit would reduce. This is because they will be importing less due to tariffs and quotas on imports.

Infant industries might need protecting. These are industries which are relatively new and need support. Protectionism is usually short term until the industry develops, at which point the industry can trade freely. It is based on the concept of new industries facing high start-up costs, which fall as the industry develops. In order to help the industry survive, it receives support.

Protectionism could be used to correct market failure. It can deal with demerit goods and protect society from them.

Governments might want to protect domestic jobs and avoid them being offshored.

Some countries might impose trade restrictions as a form of retaliation against trade barriers imposed by other countries.

Tariffs: Tariffs are taxes on imports to a country. It could lead to retaliation, so exports might decrease. The impact of tariffs is that the quantity demanded of domestic goods increases, whilst the quantity demanded of imports decreases. Tariffs result in higher prices for consumers and a loss in consumer surplus.

Quotas: A quota limits the quantity of a foreign produced good that is sold on the domestic market. It sets a physical limit on a specific good imported in a set amount of time. It leads to a rise in the price of the good for domestic consumers, so they become worse off. 

Subsidies to domestic producers: This makes domestic goods relatively cheap compared to imports. It encourages domestic production to increase, as shown by a right shift in the supply curve, and the average price falls.

However, it depends on how the subsidy is spent. In the EU, the Common Agricultural Policy subsidises domestic farming. This helps the UK retain some sort of primary sector. The subsidy might encourage a surplus to be produced, which could be wasteful. It also depends on government finances, and it should be considered whether the industry is worth subsidising or not. 

Voluntary export restraints (VERs): This is when two countries make an agreement to limit the volume of exports to one another over a period of time. They are used when governments want to protect domestic industries from competing imports. It is usually suggested by the exporting country, to avoid even less flexible trade barriers being imposed. 

Embargoes: This is the complete ban on trade with a particular country. It is usually politically motivated. 

Excessive administrative burdens (‘red tape’): Excessive administration increases the cost of trading, and hence discourages imports. It makes it difficult to trade with countries imposing red tape, and is particularly harmful for developing countries which are unable to access these markets. It is harder to notice this type of protectionism. 

Protectionism could distort the market and lead to a loss of allocative efficiency. It prevents industries from competing in a competitive market and there is a loss of consumer welfare. Consumers face higher prices and less variety. By not competing in a competitive market, firms have little or no incentive to lower their costs of production.

It imposes an extra cost on exporters, which could lower output and damage the economy.

Tariffs are regressive and are most damaging to those on low and fixed incomes, which could increase income and wealth inequality. However, taxes could raise more revenue for the government, which could be used to redistribute income to the poor or improve public services.

There is a risk of retaliation from other countries, so countries might become hostile.

Protectionism could lead to government failure. It means that inefficient, domestic producers are kept in production whilst efficient, foreign ones lose out.

It would be best to switch the resources to where they could be used more efficiently. 

Many of the impacts of protectionism are on individuals, for example, higher prices for consumers or keeping inefficient producers in business. 

The balance of payments is a record of all financial transactions made between consumers, firms and the government from one country with other countries.

It states how much is spent on imports, and what the value of exports is.

Exports are goods and services sold to foreign countries and are positive in the balance of payments. This is because they are an inflow of money.

Imports are goods and services bought from foreign countries, and they are negative on the balance of payments. They are an outflow of money. 

The current account

This includes all economic transactions between countries. The main transactions are the trade in goods and services, income and current transfers. Income transfers are from the net earnings on foreign investment as well as net cash transfers. They include salaries and dividends. Current transfers are transfers that have no return, such as aid and grants. It includes the payments the UK makes for being a member of the EU. They have traditionally been negative for the UK, due to these contributions and because of overseas aid. 

The capital account and financial account

Capital transfers involve transfers of the ownership of fixed assets. The financial account involves investment. For example, direct investment, portfolio investment and reserve assets are part of the financial account.

A current account surplus means there is a net inflow of money into the circular flow of income. The UK has a surplus with services, but a deficit with goods.

The UK has a net current account deficit. This means the UK spends more on imports from foreign countries, than they earn from exports to foreign countries. This is caused by:

• Appreciation of the currency: a stronger currency means imports are cheaper and exports are relatively more expensive, which means the current account deficit would worsen.
• Economic growth: when consumer incomes increase, demand increases. This could increase demand for imports. This is especially true of a country such as the UK, where consumers have a high propensity to import.
• More competitive: if a country becomes more internationally competitive, such as with lower inflation or if there is economic growth in export markets, exports should increase. This could cause the current account deficit to improve, or increase the current account surplus.
• Deindustrialisation: In the UK, the manufacturing sector has been declining since the 1970s. The goods that the UK previously made domestically now have to be imported, which worsens the deficit.
• Membership of trade union: The UK has traditionally had negative current transfers, since fees are paid for membership of the EU.

• If there is a deficit on the current account, income tax could be increased. This will reduce the amount of disposable income consumers have, which will reduce the quantity of imports. However, it might also impact domestic growth, since consumers will also spend less on domestic goods.
• Governments could also reduce their spending. This would reduce AD and lead to less imports. It forces domestic firms into increasing exports, which helps improve the disequilibrium.
• Fiscal policy could be effective in the short term, but not so much in the long term. As soon as the policy measures end, household are likely to revert their expenditure back on imports.
• If taxes are imposed on trading partners, there is the risk of retaliation, which could reduce demand for exports, too.
• Governments might have imperfect information about the economy, so it could lead to government failure.
• If there is a current account deficit, the bank might lower interest rates to cause depreciation in the currency. This causes exports to become cheaper, but it could be inflationary for the domestic economy. Moreover, hot money might flow out of the country, since investors are not receiving a high return on their investment. However, it is hard to control the supply of money in reality. Moreover, there is a significant time lag with changing the interest rate and seeing an effect. 

Supply-side policies could help increase productivity with increased spending on education and training, which could result in the country becoming more internationally competitive. This could lead to a rise in exports. However, this incurs significant time lag, so it is not effective as an immediate measure. In the long term, this can be an effective policy.

Supply-side policies could also help make the domestic economy attractive to investors.

The domestic economy could be made more competitive through deregulation and privatisation, which will force firms to lower their average costs. However, privatisation could result in monopolies being formed, which will not increase efficiency.

If governments provide subsidies to some industries to encourage production, there could be retaliation from foreign countries that see this as an unfair protectionist policy. 

• International trade has meant countries have become interdependent. Therefore, the economic conditions in one country affect another country, since the quantity they export or import will change. A surplus or deficit on the current account could indicate an unbalanced economy, and it could mean the country is too reliant on other economies for their own growth. It could be difficult to attract sufficient financial flows in order to finance a current account deficit. This could make it unsustainable in the long run. 
• An imbalance suggests that the UK is reliant on the performance of other countries. If export markets, such as the EU, become weak, UK economic performance will be affected. This was seen during the 2008 financial crisis.
• It could become difficult to finance the deficit in the long run. They become a problem if the government can't repay their foreign currency debt. 
• In the Eurozone, current account deficits are of greater concern because the countries have a fixed exchange rate. This means they cannot devalue the currency to restore their level of international competitiveness.
• A surplus indicates low consumer spending and a low savings ratio. It also means consumers are enjoying fewer goods than they otherwise could, lowering living standards.
• The significance depends why they have the deficit. For example some countries may be happy to have a deficit as it allows them to have a financial account surplus and they may need to import essentials. 

The exchange rate of a currency is the weight of one currency relative to another.

Floating: The value of the exchange rate in a floating system is determined by the forces of supply and demand. The demand for a currency is equal to exports plus capital inflows. The supply of a currency is equal to imports plus capital outflows.
 

Fixed: A fixed exchange rate has a value determined by the government compared to other currencies. In a fixed exchange rate system, the supply of the currency can be manipulated by the central bank, which can buy or sell the currency to change the price to where they want. In the diagram, the supply has been increased by selling the currency so more is on the market. The currency depreciates as a result, which makes exports more competitive

Managed: Managed exchange rate systems combine the characteristics of fixed and floating exchange rate systems. The currency fluctuates, but it doesn’t float on a fully free market. This is when the exchange rate floats on the market, but the central bank of the country buys and sells currencies to try and influence their exchange rate. 

Revaluation: This is when the currency’s value is adjusted relative to a baseline, such as the price of gold, another currency or wage rates.

Appreciation: when the value of a currency increases. Each pound will buy more dollars, for example.

Devaluation: This is when the value of a currency is officially lowered in a fixed exchange rate system.

Depreciation: when the value of a currency falls relative to another currency, in a floating exchange rate system. 

Inflation: A lower inflation rate means exports are relatively more competitive. This increases demand for the currency. This causes the currency to appreciate.

Speculation: If speculators think a currency will appreciate in the future, demand will increase in the present, since they believe a profit can be made by selling the currency in the future. 

Other currencies: If markets are concerned about major economies, such as the EU, the currency might rise. This happened with the Swiss Franc in 2010 when markets were worried about the EU economy.

Government finances: A government with a high level of debt is at risk of defaulting, which could cause the currency to depreciate. This is since investors start to lose confidence in the economy, so they sell their holdings of bonds.

Balance of payments: When the value of imports exceeds exports, there is a current account deficit. Countries which struggle to finance this, such as through attracting capital inflows, have currencies which depreciate as a result.

International competitiveness: An increase in competitiveness increases demand for exports, which increases demand for the currency. This causes an appreciation of the currency.

Governments might try and influence their currency, such as by maintaining a fixed exchange rate.

Interest rates: An increase in interest rates, relative to other countries, makes it more attractive to invest funds in the country because the rate of return on investment is higher. This increases demand for the currency, causing an appreciation. This is known as hot money. 

Quantitative easing: This is used by banks to help to stimulate the economy when standard monetary policy is no longer effective. This has inflationary effects since it increases the money supply, and it can reduce the value of the currency. QE is usually used where inflation is low and it is not possible to lower interest rates further. 

Foreign currency transactions: The Bank of England uses this to manage the UK’s gold and foreign currency reserves, as well as managing the MPC’s pool of foreign currency reserves. It involves buying and selling foreign currency to manipulate the domestic currency. 

• A devalued currency makes exports cheaper and imports more expensive. It could increase economic growth as a result. However, inflation is likely to increase due to the higher costs of imports and demand-pull inflation from the increase in AD.
• The current account is likely to improve since there are fewer imports and more exports.
• When firms know that the value of the currency is lower relative to another currency, it allows them to plan investment, because they know that they will not be affected by harsh fluctuations in the exchange rate.
• However, the government and the central bank do not necessarily know better than the market where the currency should be and the balance of payments would not automatically adjust to economic shocks.
• It can be costly and difficult for the government to hold large reserves of foreign currencies in order to maintain a devalued currency.
• It also depends on the PED of exports and imports. Inelastic exports will not increase significantly if price falls.
• If the main trading partners are in a recession, then demand for exports is likely to be low, and depreciating the exchange rate is unlikely to affect it. 

The current account of the balance of payments (a reference to Marshall-Lerner condition and J curve effect) 

A reduction in the exchange rate causes exports to become cheaper, which increases exports. This assumes that the demand for exports is price elastic. It also causes imports to become relatively expensive. This means the UK current account deficit would improve.

The Marshall-Lerner condition states that a devaluation in currency only improves the balance of trade if the absolute sum of long-run export and import demand elasticities is greater than or equal to 1. 

The J-curve effect occurs when a currency is devalued. Since devaluing the currency causes imports to become more expensive, at first the total value of imports increases, which worsens the deficit. Eventually, the value of exports decreases, which leads to a reduction in the trade deficit.

When the currency is devalued, there may be a time lag in changing the volume of exports and imports. This could be due to trade contracts and the price inelasticity of demand for imports in the short run, whilst consumers search for alternatives. In the long run, consumers might start purchasing domestic products, for example, which helps improve the deficit. 

Economic growth and employment/unemployment 

Exchange rate affects AD because they affect the price of exports and imports. If the exchange rate appreciates, AD is likely to fall since imports become cheaper and exports become more expensive. Households are likely to switch from buying domestically produced goods to imports. However, this depends on the inflation rate. A lower domestic inflation rate, compared to other countries, might mean that consumers still purchase domestic goods. It also depends on the price elasticity of demand for domestic goods and imports. The UK has a high marginal propensity to import, so households are still likely to import goods, even if the pound appreciates.

A weaker exchange rate is likely to increase exports. This means that domestic firms can increase their sales and increase their profits. Jobs might be created as a result. If it is cheaper to import goods, because the value of the exchange rate increased for example, then jobs in the domestic industry might be lost since demand falls. 

Rate of inflation

A depreciation in the exchange rate is likely to be inflationary due to the increase in the price of imported raw materials. Production costs for firms increase, which causes cost-push inflation. Moreover, since AD will be increasing due to the higher level of exports, there could be upward pressure on the average price level.

Foreign direct investment (FDI) flows

FDI is the flow of capital from one country to another, in order to gain a lasting interest in an enterprise in a foreign country. A depreciation in the currency means the country’s wages and production costs have fallen relative to other countries. This makes the country more internationally competitive and it is likely to attract more FDI.

The effects of exchange rates on imports and exports can be remembered using the acronym SPICED: Strong Pound Imports Cheap Exports Dear

International competitiveness is the ability of a nation to compete successfully overseas and sustain improvements in real output and living standards.

Countries can compete with price and non-price competitiveness. For example, the quality of goods and services and the rate of innovation can change how competitive a country is. 

Relative unit labour costs

The unit labour cost is how much labour costs per unit of output. Generally, the cheaper the relative unit labour costs, the more competitive the country in manufacturing. However, higher prices could compete if a niche market is targeted or by using product differentiation.

Relative export prices

This is the ratio of one country’s export prices relative to another country, and it is expressed as an index. The lower the relative export price, the more competitive the country. 

Ability to attract FDI from MNCs: If a country can attract more FDI, it increases its productive capacity. This can help produce long term growth and raise living standards. The ability to attract FDI depends on: stability in the economy and financial system; the tax rate; and the potential to trade e.g. UK has free trade with the EU. 

Ability to produce or attract entrepreneurs: Entrepreneurs help develop new ideas and stimulate innovation. This keeps a country ahead with technology and gives them an edge in the market, which makes them more competitive. 

Ability to attract (skilled) labour from abroad: This might fill a skills gap in, for example, IT or biotechnology, and improves the quality of the labour force. If there are skills gaps, firms face higher costs. 

Unit labour costs: Unit labour costs rise when wages increase at a faster rate than productivity. China’s large population means wages are generally low, but the rise of the middle class and consumer spending is pushing wages up. National minimum wages can raise costs.

Exchange rate: A depreciation in the real exchange rate makes exports relatively cheaper, so a country becomes more internationally competitive. If the price of imports increases as a result of a devaluation, then the cost of raw materials would increase, which would be particularly damaging to small firms. It could increase the cost of exports as the cost of production rises. 

Quantity and quality of skills possessed by a nation’s workers: This refers to the skills of human capital. If there are limited skills, the economy cannot expand its productive potential. The more skilled the workforce, the more productive it is. It also means goods and services are of better quality, which improves international competitiveness.

Flexibility of labour: Part time and temporary contracts help limit a firm’s costs, which lowers unit labour costs. Additionally, if the labour market is flexible and geographically or occupationally mobile, it can better respond to economic shocks and changes in demand or supply, which can help improve competitiveness. 

Tax policies e.g. low income tax: A lower tax rate provides an incentive to earn more, since consumers and firms know they will keep more of their income. A low income tax might attract more skilled labour, too. 

Economic stability: If inflation is low and stables, firms are more able to plan their investment and spending, because they know what future prices will be. Deflation or high and uncontrollable inflation makes it hard to plan for the future. For example, the UK government could try and reform the banking sector so it is more resilient to shocks.

Regulation: Excessive regulation (red tape) can make it hard for firms to invest, and it could raise their average costs of production. Low regulation should help to encourage investment and innovation, so domestic firms can become more internationally competitive. 

Rate of innovation: This is calculated by the proportion of GDP invested in new capital. If a country innovates more, they are likely to develop new, more advanced technology that can help them become more competitive. It could increase the quality of the goods and services produced.

Interest rates: It can be considered whether the UK’s low-interest rates have helped the international competitiveness of the UK. It has encouraged spending, which increased AD and growth. It also encourages firms to invest. However, it can be seen as a deterrent for foreign investors, since they get a low return on investment. The increase in AD might cause demand-pull inflation, which could make UK goods more expensive than elsewhere. This might increase imports if they are cheaper than domestic goods, which could worsen the current account deficit. 

Benefits of being internationally competitive

• Being internationally competitive is vital in light of the global economy. It allows countries to export more goods. This will help to increase AD as well as bring about a current account surplus.
• If a country becomes more competitive, such as Germany, they can gain a reputation for their exports, which might make them more price inelastic. As a result, they might be able to demand higher prices for their goods and services.
• By operating in a competitive market, firms can reach out to more consumers. They will be able to gain more revenue and make a larger profit. This can also help firms gain economies of scale, which can help lower their average costs of production. 

Problems of being internationally competitive

• The economic importance of education and health spending could be considered. It could help improve the skills and productivity of human capital which can make the country more internationally competitive.
• Being innovative is not always successful, and it could lead to funds being wasted.
• A lower tax rate might mean the government receives fewer tax receipts, which could limit public spending. It depends on how important public services are to each country, however. 

Absolute poverty is defined as living below subsistence. This means that the person is unable to meet their basic needs of food, clean water, sanitation, health, shelter and education. The World Bank uses a measurement based on the number of people living on less than $1.90 per day.

Relative poverty is measured by comparison to the average in the country. In the UK, those with below 60% of the median income are considered to be in relative poverty. In the US, a basket of goods which maintains the average standard of living in society is used. Relative poverty can be seen as one way of measuring income inequality. 

Inequality in wages or unemployment

Recently, more part-time and temporary jobs have been available rather than full-time jobs. This leaves people underemployed, and it limits how much they can earn. It was especially a problem during the Global Financial Crisis.

The changing structure of the UK economy to services as a result of deindustrialisation has meant some jobs have been lost. This could cause structural unemployment and hysteresis. This is a type of structural unemployment, where someone is out of work for a long time, so their skills deteriorate. This makes it harder to find a job, and it leads to long-term unemployment.

The highest paid workers have seen their wages increase significantly more than those on lower wages. The larger wage differentials increase relative poverty.

Government policy

In the UK, taxes have become more regressive over the last 50 years whilst state benefits have fallen in relative value. Public sector workers have had low wage increases and even falling real wages due to the austerity policy. This increases relative poverty.

Disease, malnutrition and other health problems

Health issues can make it hard to get a job, especially in a country where jobs are scarce and rarely available. People are likely to take a lot of time off work and it can deter MNCs from investing in a country. This can leave people without an income and it can push people into absolute poverty. It is especially an issue in countries in Sub-Saharan Africa.

Wars, conflicts and natural disasters

This might push people to flee their homes, as well as destroying anything they owned. It could leave people homeless and force them into extreme poverty. 

Corruption and political oppression

Countries with corrupt leaders might have higher levels of poverty. It is likely to be relative poverty since the leaders might keep most of the wealth.

Trade unions

Unions tend to represent lower paid workers. The decline in their power since the 1970s and 1980s has meant that these workers have been unable to bargain for higher wages which have caused a rise in relative poverty.

Economic growth

Growth and development in developing countries mean that absolute poverty has fallen. The state is able to provide support for those who are unable to benefit from the growing economy as they have a larger tax base. 

Wealth is defined as a stock of assets, such as a house, shares, land, cars and savings. Wealth inequality is the unequal distribution of these assets.

Income is money received on a regular basis. For example, it could be from a job, welfare payments, interest or dividends. When income is unevenly distributed across a nation, income inequality is said to exist. 

The Lorenz curve measures the distribution of income and wealth in a country. The line of perfect equality shows the distribution of income when the richest x% of the population owns x% of the cumulative income.

The Lorenz curve shows the actual distribution of income and wealth. The one in the diagram shows a significant level of inequality. The richest 20% own a higher proportion of income than the poorest. 

The Gini coefficient gives a numerical value for inequality and is derived from the Lorenz curve. It is calculated by the areas: A                                                                                                                                                        A+B

A value of 0 indicates perfect equality, so everyone has the same income and wealth. A value of 1 is perfect inequality i.e. all of the wealth in the country is concentrated in the hands of one individual or household. 

Inequality in wages

Recently, more part-time and temporary jobs have been available rather than full-time jobs. This leaves people underemployed, and it limits how much they can earn. It became a problem during the Great Recession. The wage gap between skilled and unskilled workers has increased in the UK recently. Jobs in the low-skilled service industries, especially in the public sector, tend to pay less than jobs in the private sector.                                                                                                    Workers might be discriminated against due to age, disabilities, gender and race.

Welfare payments and taxes

State pensions and welfare payments tend to increase less than wages, even though they are index-linked to inflation. This means that those on benefits see a smaller real increase in their income compared to those in jobs. This increases inequality. Moreover, recently welfare payments have been cut. Although this might encourage some people to find jobs, many people might be unable to work, so it lowers their income more.                                                                                  In the UK, some taxes are regressive, which means that those on lower incomes bear a larger burden of the tax. This can increase inequality. 

Unemployment

This can cause relative poverty (and therefore increase income inequality), and it is particularly detrimental where no one in a household is working, since they are left to rely on state benefits.

Changes to the UK tax system

Over the last 2-3 decades, the UK has switched towards indirect taxes, which tend to be more regressive. The top income tax rate fell from 83% in 1979 to 40% in 1988, and it is still at this rate today. The basic income tax rate fell from 33% to 22%, which helps workers keep more income. However, the benefits of this disproportionately favour the richest households. This has led to an increase in income inequality.

Inequality between countries

Globally, there is inequality between countries. Some of this is caused by certain social groups being excluded and marginalised based on ethnicity, gender, sexual orientation and disabilities. The gap in wealth, which grew during the Industrial Revolution, led to inequality in power, and consequently was a causal factor in the exploitation of poorer countries.

Kuznets hypothesis states that as society moves from agriculture to industry, so it develops, inequality within society increases, since the wages of industrial workers rises faster than farmers. Kuznets curve is shown below. 

Then, wealth is redistributed through government transfers and education. He essentially argued that inequality in poor countries is just a transitional phase, and once nations become economically developed, inequality reduces.

Thomas Piketty famously discredited this theory in 2014 by arguing that the capitalist free market system inevitably leads to continued inequality. The rate of return on capital increases, so as the rich get richer with higher returns on their investments, inequality increases. 

Capitalism is a society where capital is privately owned and workers are paid wages by private firms. There is minimal government intervention and resources are distributed according to the market.

In a capitalist society, entrepreneurs take risks and are driven by the profit motive. Profits are a reward to take risks. Therefore, inequality is essential to encourage entrepreneurs to take risks.

Inequality motivates workers, which encourages them to learn new skills and work hard. A higher wage reflects higher productivity in a capitalist society, which results in wage inequality.

Capitalism leads to monopoly power. Monopolies can exploit consumers with higher prices, and exploit their consumers with lower wages. This allows them to earn even higher profits. 

Inheritance is passed down generations, which means wealth is often concentrated in the hands of a few families. Those who inherit lots have more wealth. There can be income redistribution and wage equality through government intervention. For example, inheritance tax means rich families cannot keep their entire wealth. 

Essentially, the price mechanism and the free market ignore equality. To evaluate, it can be argued that inequality exists but the degree of inequality may vary. 

The components of HDI are education, life expectancy and standard of living, measured by real GNI at purchasing power parity (PPP) per capita.

It measures the economic and social welfare of countries over time.

The education component combines the statistics of the mean number of years of schooling and the expected years of schooling.

The lift expectancy component uses a life expectancy range of 25 to 85 years.

The standard of the living component measures GNI adjusted to PPP per capita. GDP was used instead of GNI, but to account for remittances and foreign aid, GNI is now used, since it reflects average income per person.

The average world HDI rose from 0.48 in 1970 to 0.68 in 2010. This was mainly due to the growth of East Asia, the Pacific and South Asia.

A value close to 1 is indicative of a high level of economic development.

A value close to 0 suggests a low level of development. 

• HDI does not consider how free people are politically, their human rights, gender equality or people’s cultural identity.
• HDI does not take the environment into account. It could be argued that this should be included to focus on human development more.
• HDI does not consider the distribution of income. A country could have a high HDI but be very unequal. This can mean many people might still be in poverty.
• HDI does allow for comparisons between countries to be made, based upon which countries are generally more developed than other countries.
• It provides a much broader comparison between countries than GDP does. Education and health are important development factors to consider, and it can provide information about the country’s infrastructure and opportunities. It also shows how successful government policies have been. 

Human Poverty Index (HPI)

This measures life expectancy, education and the ability of citizens to meet basic needs. There are two types: HPI-1 and HPI-2. The former measures poverty in developing countries and the latter measures poverty in developed countries.

In HPI-1, the longevity part of the index measures the probability of living to the age of 40. The education component considers the adult literacy rate. The ability of citizens to meet basic needs is measured by the percentage of underweight children and the percentage of people not using improved water sources.

For HPI-2, the probability of not surviving to at least the age of 60 is used. The percentage of adults who do not have literacy skills is calculated, and poverty is calculated by those living below the poverty line. This is below 50% of median income. 

Gender-related Development Index (GDI)

This measures the relative inequality between men and women. It combines HDI with a consideration of gender. For example, it will consider differences in life expectancies, income and education between genders.

Primary product dependency

Primary products are raw materials in industries such as agriculture, mining and forestry. For countries whose main exports are primary products, their ability to pay foreign debts and for imports relies on this.

Several developing countries rely on these primary products as a significant part of their economy. One issue with this is the volatility of commodity prices that can make it hard for workers to plan for the future, and it means incomes of farmers are fickle and hard to predict.

A fall in the price leads to a fall in export incomes, which can make it hard to fund their infrastructure and education. Moreover, relying on primary products is not necessarily sustainable, since they could be over extracted and run out. 

Savings gap: Harrod-Domar model

In many developing countries, there is only limited wealth, which means money cannot be put aside for the future, and they can only afford to spend in the short run. Consumers have to focus on their immediate needs, including food and safe water, to ensure they can survive. 

The Harrod-Domar model states that investment, saving and technological change are required in an economy for economic growth. The rate of growth increases if the savings ratio increases. This leads to increased investment and technological progress, which leads to higher productivity.

The rate of growth is calculated by the savings ratio/capital-output ratio in the Harrod-Domar model. Growth increases with more saving or a small capital-output ratio. 

The limitations of the model are that there is a low marginal propensity to save in some countries, or that there might be a poor financial system. Funds might not lead to borrowing and investment. There could also be inefficiency in the workforce.

Moreover, the paradox of thrift could be considered. An increase in savings could lead to an increase in investment. However, an increase in savings means there is a reduction in spending, which leads to a fall AD. 

Foreign currency gap

A foreign currency gap exists when the country is not attracting sufficient capital flows to make up for a deficit in the capital account on the balance of payments. In other words, the value of the current account deficit is larger than the value of capital inflows.

Capital flight

This is when capital and money leave the economy through investment in foreign economies. It is triggered by an economic threat, such as hyperinflation or rising tax rates. It can worsen an economic crisis and cause a currency to depreciate.

Demographic factors

The population can impact the growth and development of a country. There is a link between keeping birth rates down and fighting hunger, poverty and environmental damage. Rapid population growth has complicated efforts to reduce poverty and eliminate hunger in Africa. 

Debt

The debt crisis emerging in the developing world threatens the fight against poverty and inequality.

Access to credit and banking

Without a safe, secure and stable banking system, there is unlikely to be a lot of saving in a country. This makes investment difficult.

Infrastructure

Poor infrastructure discourages MNCs from setting up premises in the country. This is since production costs increase where basic infrastructure, such as a continuous supply of electricity, is not available. 

Absence of property rights

Weak or absent property rights mean entrepreneurs cannot protect their ideas, so do not have an incentive to innovate. 

Education/skills

This is important for developing human capital. Adequate human capital ensures the economy can be productive and produce goods and services of a high quality. It helps generate employment and raise standards of living

Poor governance/civil war

This could hold back infrastructure development and is a constraint on future economic development. It could destroy current infrastructure and force people into poverty.

Vulnerability to external shocks

For example, an earthquake prone country is likely to find it hard to develop their infrastructure, and people might be pushed into poverty. Nepal was already one of the poorest countries in the world, but the Nepal earthquake in 2015 pushed more people into poverty. 

These are measures which make the economy more free, with minimum government intervention. 

Trade liberalisation: Free trade is the act of trading between nations without protectionist barriers, such as tariffs, quotas or regulations. World GDP can be increased using free trade, since output increases when countries specialise. Therefore, living standards might increase and there could be more economic growth. It will allow firms to grow as they can export more. However, if firms are unable to compete globally, they will collapse. This will cause a loss of jobs and limit development and growth. Therefore, the impact depends on whether the firms are able to compete internationally or not.

Promotion of FDI: FDI is the flow of capital from one country to another, in order to gain a lasting interest in an enterprise in the foreign country. FDI can help create employment, encourage the innovation of technology and help promote long term sustainable growth. It provides LEDCs with funds to invest and develop, helping to overcome the savings gap. It allows a transfer of knowledge, bringing production and management techniques which help to improve labour productivity. However, they often repatriate their profits and exploit the workers, by paying low wages and offering poor conditions. The country may suffer from externalities.

Removal of government subsidies: Government subsidies could distort price signals by distorting the free market mechanism. A free market economist would argue that this could lead to government failure. There could be an inefficient allocation of resources because the market mechanism is not able to act freely. It also has a negative effect on the government budget and could cause excessive debts. However, they can be an effective way to minimise absolute poverty and ensure a minimum standard of living. Removing the subsidies can be politically unpopular and some governments have even been thrown out for attempting to do so. 

Floating exchange rate systems: The value of the exchange rate in a floating system is determined by the forces of supply and demand. The government does not have to worry about gold and foreign currency reserves. However, the currency will be volatile and this will make it difficult for importers and exporters.

Microfinance schemes: Microfinance involves borrowing small amounts of money from lenders to finance enterprises. It increases the incomes of those who borrow and can reduce their dependency on primary products. There could be a multiplier effect from the investment of the loan. They are small loans for usually unbankable people. It allows them to break away from aid and gives borrowers financial independence. Many borrowers are women. Microfinance loans detach the poor from high interest, exploitative loan sharks. They could help businesses to be set up, reducing the issue of the savings gap. However, money is often not spent on sustainable methods of development and simply increases the informal economy. Most people are unable to pay their loans back, relying on new loans to repay old ones.

Privatisation: This means that assets are transferred from the public sector to the private sector. The government sells a firm so that it is no longer in their control. Free market economists will argue that the private sector gives firms incentives to operate efficiently, which increases economic welfare. This is because firms operating on the free market have a profit incentive, whilst nationalised firms do not. Firms have to produce the goods and services consumers want as they are in the free market. This increases allocative efficiency and might mean goods and services are of a higher quality. By selling the asset, revenue is raised for the government. However, this is only a one-off payment. It is important that it is not privatised as a monopoly.

The government intervenes in the market to try and influence growth and development using interventionist strategies

Development of human capital: By developing human capital, the skills base in the economy would improve. This would improve productivity and allow more advanced technology to be used, since workers will have the necessary skills. Businesses struggle to expand where there are skills shortages. It also limits innovation. By developing human capital, the country can move their production up the supply chain from primary products, to manufactured goods and to services, which can earn them more. Better education also improves quality of life. This can be difficult to do and is expensive.

Protectionism: Protectionism can help reduce a trade deficit. This is because they will be importing less due to tariffs and quotas on imports. This will help to increase AD. It can protect infant industries and allow them to develop. It can create jobs in the short run. However, protectionism could distort the market and lead to a loss of allocative efficiency. It prevents industries from competing in a competitive market and there is a loss of consumer welfare. Consumers face higher prices and less variety. By not competing in a competitive market, firms have little or no incentive to lower their costs of production. Tariffs are regressive and are most damaging to those on low and fixed incomes. There is also the risk of retaliation from other countries, so countries might become hostile.

Managed exchange rates: Managed exchange rate systems combine the characteristics of fixed and floating exchange rate systems. The currency fluctuates, but it does not float on a fully free market. This is when the exchange rate floats on the market, but the central bank of the country buys and sells currencies to try and influence their exchange rate. It provides more stability than a floating system but requires less intervention.

Infrastructure development: Examples of physical infrastructure include transport, energy, water and telecommunications. Higher supply costs delay businesses and it reduces the mobility of labour. Infrastructure has many positive social benefits, and so the government should provide it. However, they may not have the funds to provide infrastructure and projects often suffer from bribery and corruption. The project may cause environmental damage. Some argue that intermediate technology, which uses local materials and can be fixed locally, is better than large scale infrastructure.

Promoting joint ventures with global companies: This occurs when a partnership is formed between two firms based in multiple countries. Joint ventures open up new markets for small firms, so they can distribute their products to customers. This saves them time and funds. It also spreads their risk, which is important in industries where developing a product is expensive. They have all the benefits of FDI, without the negatives of exploitation and some of the profits remain in the country

Buffer stock schemes: In the agriculture market, governments might intervene with a buffer stock system to reduce price volatility. Governments buy up harvests during surpluses and then sell the goods onto the market when supplies are low. However, historically, these have been unsuccessful. It helps incomes of farmers to remain stable, because fluctuations in the market are reduced and it increases consumer welfare by ensuring prices are not in excess. However, governments might not have the financial resources to buy up the stock. Moreover, storage is difficult and expensive, since agricultural goods do not last long, and there are administrative costs. It can cause inefficiency, as suppliers produce as much as they want since they know the government will buy it at whatever price.

Industrialisation: the Lewis model

The Lewis model is an explanation of how a developing country which focuses on agriculture could move towards manufacturing. It is based on the assumption that in agriculture, there is a surplus of unproductive labour in developing economies. The model assumes that in the manufacturing sector, wages are fixed. Workers from agriculture are attracted to higher wages in the manufacturing sector. In the manufacturing sector, entrepreneurs charge prices above the wage rate, which allows them to make profits. It is assumed these profits are invested into more fixed capital for the business. The demand for labour increases since the productive capacity of firms has increased. Since there is surplus labour in the agricultural sector, this labour is employed in the manufacturing sector. This grows the manufacturing sector to the extent that the economy moves from agriculture to manufacturing. This is from a traditional state to an industrialised state. However, in reality, profits might not be reinvested into the firm. Moreover,  capital investment might replace labour, so the demand for labour could fall instead. Also, it is not always easy for labour in the agricultural sector to move to the manufacturing sector. There could be urban poverty if there are not enough jobs in the cities.

Development of tourism

Tourism can create thousands of jobs and help shift a developing country away from dependence on primary products. Developing countries tend to have a high marginal propensity to consume, which could create a multiplier effect. It helps to diversify the economy and it could make the country more attractive to FDI, as well as developing their infrastructure. Tourism can also be a way of earning foreign currency for developing countries. The low technology and labour intensive work in tourism is suited to LEDCs. However, little revenue is retained in the country, since travel agents and hotel owners are likely to repatriate their profits. Moreover, there is the issue of overcrowding and the loss of habitats. Income from tourism is likely to be unstable since it relies heavily on the business cycle in developed countries. Locals could feel stigmatised by tourism, especially if they cannot afford the luxuries that the tourists have. There could also be some environmental damage, such as pollution.

Development of primary industries

Some developing countries have an abundance of raw materials, so some governments might choose to exploit this advantage and develop the industry so the country can have a comparative advantage in its production. Moreover, primary industries, especially those allied to farming, form the livelihoods of the bulk of the population. It is sometimes the only source of income for most families. Therefore, it is important that the industry is supported. However, there are issues involving primary product dependency.

Debt relief

Debt relief is the partial or total forgiveness of debt. In developing countries, debt is considered to be a principal cause of poverty, since it causes human suffering and misery, and it hampers development. With high levels of debt, financial resources are diverted from infrastructure, education and healthcare. Debt forgiveness can allow a country to import more and increase the population’s standard of living. It improves government finances, so public services could be funded instead. However, if debt is forgiven, it could encourage more borrowing in the future. Moreover, there could be corruption.

Fairtrade schemes

Fairtrade schemes ensure that farmers can receive a fair price for their goods. Supermarkets buy a guaranteed quantity at a price above the market equilibrium. This helps farmers since they have a guaranteed income and certainty about their sales, so they can plan for the future. Fairtrade can help support community development and social projects, as well as ensuring working conditions meet a minimum standard. It encourages sustainable production, promotes environmental protection, and stops the use of child labour. Critics say the impact of Fairtrade schemes is insignificant. It could distract from other policies and development, and it could make producers not part of Fairtrade worse off. This is since it divides the market into Fairtrade and non-Fairtrade markets. It could be argued that by distorting price signals, Fairtrade is less efficient. Fairtrade could make farmers reliant on the sale of their produce, but it promotes self-sufficiency and encourages them to be independent. It has its limitations, but it provides a sense of community, working with farmers, rather than for them.

Aid

Consumers in LEDCs have a lower propensity to consume than save, due to their limited incomes. Capital inflows, including those in the form of aid, can help fill this savings gap. Aid provides temporary assistance to a country, such as humanitarian aid offered to countries after conflicts or natural disasters. Aid could also be a grant for a project that a country might not have the funds for. Aid could be used to reduce human capital inadequacies or to pay off debt. It can improve infrastructure, which can help make the country more productive. However, the benefits of aid are limited by corrupt leaders, the size of the aid payment and the potential for the recipient country to become dependent on aid.

The World Bank and IMF are sometimes called the Bretton Woods Institutions. They aim to provide structure and stability to the world’s economic and financial systems. Almost every country is a member of both institutions. The governments of each member nations own and direct the institutions.

The World Bank mainly focuses on development. The IMF tries to keep payments and receipts between countries logical and ordered. 

World Bank: The World Bank can loan funds to member countries, and its aim is to promote economic and social progress by raising productivity and reducing poverty. The World Bank is involved in several projects globally, such as providing microcredit, supporting education, and helping the rebuilding of countries after earthquakes.

International Monetary Fund (IMF): The IMF aims to promote monetary cooperation between nations, and monetary problems can be consulted in the institution. It also aims to help free trade globally, so jobs are supported. The IMF promotes exchange rate stability, and tries to avoid competitive depreciation in the currency. Members can also borrow from the IMF, such as if they need to correct an imbalance in the balance of payments or to pay off the national debt. In order to gain loans, countries have to promise to undertake reform, including reducing imports and government spending. These aim to ensure the country does not face similar problems in the future.

NGOs: NGOs could be funded by governments, firms or private individuals, but they are not part of governments or for-profit businesses. They are voluntary groups which aim to raise the voices of ordinary citizens. Usually, they focus on particular issues such as human rights, healthcare or the environment. They can lobby the government to make changes, raise funds and undertake projects in developing countries, such as the establishment of schools.

Financial liquid assets are exchanged in a financial market. For example, the stock market and the bond market are two examples of financial markets.

• To facilitate saving: Financial markets provide somewhere for consumers and firms to store their funds. 
• To lend to businesses and individuals: The transfer of funds between agents is aided by financial markets. The funds can be used for investment or consumption.
• To facilitate the exchange of goods and services: The transfer of real economic resources is facilitated in a financial market. Financial markets can make it easier to exchange goods and services from the physical market, by providing a way that buyers and sellers can interact and transfer funds. 
• To provide forward markets in currencies and commodities: The currency market is another kind of financial market. They are used to trade one currency for another currency. Currencies can have speculative attacks taken on them, which can affect the value of the exchange rate. In commodity markets, investors trade primary products, such as wheat, gold and oil. Future contracts are a method for investing in commodities. This involves buying or selling an asset with an agreed price in the present, but delivery and payment in the future.   A forward market is an informal financial market where these contracts for future delivery are made.
   

Asymmetric information: Before the 2008 crash, asset prices were high and rising, and there was a boom in economic demand. There were risky bank loans and mortgages, especially in the US where government securities were backed by subprime mortgages. This means the borrowers had poor credit histories, and after house prices crashed in the US in 2006, several homeowners defaulted on their mortgages in 2007. Banks had lost huge funds and required assistance from the government in the form of bailouts. There was asymmetric information since banks were not aware of how risky the loans were. Since the crisis, banks have become more risk-averse, so there are tougher requirements to get a loan or mortgage.

Moral Hazards: A moral hazard is a situation where there is a risk that the borrower does things that the lender would not deem desirable because it makes the borrower less likely to repay a loan. It usually occurs when there is some form of insurance for the mistake. For example, if a house is insured, a borrower might be less careful because they know any damage caused will be paid for by someone else.

Banks might take more risks if they know the Bank of England or the government can help them if things go wrong. The financial crisis has been regarded as a moral hazard, due to the degree of risk taking. 

Externalities: Externalities are the effects of an economic transaction on a third party who is not directly involved in the transaction.

A pecuniary externality leads to an inefficient allocation in the market, through prices rather than resources.

For example, a pecuniary externality could lead to the under-provision of liquidity in the banking model. In the 2008 financial crisis, illiquidity contributed to volatility and government intervention.

Liquidity refers to trading activity. Liquid assets are those which can be bought and sold easily.

Illiquidity refers to assets that cannot be sold easily without a loss in value. Usually, this is because there are insufficient investors willing to buy the asset. Systematic risk in financial markets can be seen as a negative externality.

Systematic risks are the risk of damage of the economy or the financial market. For example, it could be the risk of the collapse of a bank. Since this costs firms, consumers, the economy and the market, it is akin to a negative externality.

Speculation and market bubble: A market bubble occurs when the price of an asset is predicted to rise significantly. This causes it to be traded more, and demand exceeds supply so the price rises beyond the intrinsic value. The bubble then ‘bursts’ when the price steeply and suddenly falls to its ordinary level. This causes panic and investors to try and sell their assets.

It results in a loss of confidence and it can lead to an economic decline or depression.

Market rigging: This is the act of firms coming together to interfere in a market, with the intention to stop it working as it is supposed to so that the firms can gain an unfair advantage.

The Libor Scandal is an example of this. It was discovered that banks were inflating or deflating their interest rates to make a profit from a trade or to make them seem more financially reliable.

Loans such as mortgages, student loans and other financial products use Libor as a reference rate. This means that manipulating the rate, as the banks were doing, can negatively affect consumers and the financial market.

The central bank manages the currency, money supply and interest rates in an economy. For example, the European Central Bank (ECB), the Bank of England and the People’s Bank of China are central banks.

Implementation of monetary policy: The central bank takes action to influence the manipulation of interest rates, the supply of money and credit, and the exchange rate. In the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money. They are independent of the government, and the nine members meet each month to discuss what the rate of interest should be. Interest rates are used to help meet the government target of price stability since it alters the cost of borrowing and reward for saving. The bank controls the base rate, which ultimately controls the interest rates across the economy. 

Banker to the government: The central bank provides services to the Central Government. It collects payments to the governments and makes payments on behalf of the government. It maintains and operates deposit accounts of the government. The central bank also manages public debt and issues loans. The Bank can also advise the government on finance, including the timing and terms of new loans. 

Banker to the banks – lender of last resort: The Bank of England is considered to be a lender of last resort. If there is no other method to increase the supply of liquidity when it is low, the Bank of England will lend money to increase the supply. If an institution is risky or is close to collapsing, the Bank might lend to them. This is when they have no other way to borrow money. It can protect individuals who deposit funds in a bank and might otherwise lose them. It also aims to prevent a ‘run on the bank’, which is when consumers withdraw their bank deposits in a panic because they believe the bank will fail. Usually, banks will avoid borrowing from the lender of last resort, because it is suggested the bank is experiencing a financial disaster.

Role in regulation of the banking industry: Governments might regulate banks with regulation and guidelines. This helps to ensure the behaviour of banks is clear to institutions and individuals who conduct business with the bank. Some economists argue that the banks have a huge influence on the economy; if they failed it would have huge consequences. Therefore, it is important to regulate the banking industry. The UK banking industry is regulated by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). The FCA regulates financial firms to ensure they are being honest to consumers and they seek to protect consumer interests. The FCA also aims to promote competition which is in the interests of consumers. The PRA promotes the safety and stability of banks, building societies, investment firms and credit unions, and ensures policyholders are protected. 

Current government expenditure is spending which recurs. This is on goods and services which are consumed and last for a short period of time. For example, it could be on drugs for the health service.

Capital government expenditure is spent on assets, which can be used multiple times. For example, it could be government expenditure on roads or building a school.

Transfer payments are welfare payments from the government. They aim to provide a minimum standard of living for those on low incomes. No goods or services are exchanged for transfer payments. Examples of transfer payments in the UK include Job Seeker's Allowance, Income Support, child benefit and the state pension.

These are in place to ensure people have a basic standard of living and to help reduce the level of inequality in society. Transfer payments are a means for the government to redistribute income from the rich to the poor. 

In the UK, the government spends most of their budget on pensions and welfare benefits, followed by health and education. Education spending in the UK has remained relatively constant. This is because it is protected so it does not fall, but it also does not increase much either.

Social security payments are payments from the government to assist those who have low incomes. After the war, people saw this as necessary, so there has been a general increase in spending. Defence spending in the UK is falling. This is the area the government spends least on.

As a country grows, the government tends to spend a higher percentage of GDP. This is because they have larger tax revenue, due to higher incomes and wealth and efficiency in the collection. Citizens in high-income countries also demand more from their governments. The amount spent by the government also depends on government aims and views in the country.

The Global Financial Crisis led to huge increases in government spending as governments had to increase welfare spending and bail out the banks. The UK government is now following a period of austerity in order to bring about a balanced budget. This means that government spending is falling.

Ageing populations in Europe and Japan will mean there is more pressure on government spending, due to higher pension bills and higher levels of care needed.

Productivity and growth

Governments can spend money on supply-side policies to improve human capital and boost long-run growth. Human capital is important for competitiveness. The government could invest in youth apprentice schemes, for example, to make people more employable and productive from a young age. Education and training can mean higher value products can be made and productivity can be improved. Fiscal policy aims to stimulate economic growth and stabilise the economy. The government could influence the size of the circular flow by changing the government budget and spending and taxes can be targeted in areas which need stimulating. However, many free-market economists argue that government spending is wasteful and causes inefficiency. Thus, they prevent growth. They believe that funds would be better spent by the private sector.

Living standards

They can greatly improve living standards by correcting market failure, providing public goods and reducing absolute poverty. The political system means that funds should be spent where people want them to be, although this is not necessarily the case. Some argue that the government's inefficiency will reduce overall output and thus reduce living standards.

Crowding out

Governments might have to fund their spending using taxes or running a budget deficit. This leaves fewer funds in the private sector for firms to use, since the government is borrowing money, which crowds them out of the market. When the government borrows a lot of money, interest rates might increase. This discourages spending and investment in the private sector. This reduction in private sector investment is the ‘crowding out’ of investment. Sometimes, crowding out refers to the government provision of a good or service, which would otherwise be provided by the private sector. However, in times of high unemployment, government spending could lead to 'crowding in' as it encourages investment through the multiplier. 

Level of taxation

The tax rate might increase if government debt gets too high. If confidence is lost in the government’s ability to repay the debt, governments might have to raise interest rates to encourage investors to buy bonds, so that they can finance the debt. It could lead to higher taxes and austerity measures, especially if the debt becomes uncontrollable. In some countries, the government is able to finance spending through other means, for example, oil revenues.

Equality

Redistributive policies and welfare payments, such as Income Support, could be used to help those on the lowest incomes. Also, government spending on housing and the provision of public services, such as education and healthcare, helps provide equal opportunities for people from all income backgrounds. This ensures that even those on low incomes can afford a good standard of healthcare and education. By providing these services, the government ensures that all members of society can achieve a minimum standard of living.

A proportional tax has a fixed rate for all taxpayers, regardless of income. It is also called a flat tax. For example, all taxpayers might have to pay 20% income tax rate. The incidence of taxes is equal, regardless of the ability of the taxpayer to pay. It could encourage people to earn higher incomes, because the rate of tax paid does not increase.

A progressive tax has an increase in the average rate of tax as income increases. As income increases, the proportion of income taxed increases. For example, in the UK income tax is progressive. This should help reduce inequality because those on lower incomes pay less tax. The tax is based on the payer’s ability to pay. Higher income households are more able to pay higher rates of tax than lower income households. Generally, direct taxes are more progressive.

A regressive tax does not relate to income but means those on lowest incomes have a higher average rate of tax. In other words, the proportion of income paid as tax is higher for those on lower incomes than those on higher incomes. For example, as a percentage of income, the London Congestion Charge and Council Taxes are higher for those on lower incomes. This leads to a less equitable distribution of income. Generally, indirect taxes are more regressive. The economic effects of changes in direct and indirect 

A proportional tax has a fixed rate for all taxpayers, regardless of income. It is also called a flat tax. For example, all taxpayers might have to pay 20% income tax rate. The incidence of taxes is equal, regardless of the ability of the taxpayer to pay. It could encourage people to earn higher incomes, because the rate of tax paid does not increase.

A progressive tax has an increase in the average rate of tax as income increases. As income increases, the proportion of income taxed increases. For example, in the UK income tax is progressive. This should help reduce inequality because those on lower incomes pay less tax. The tax is based on the payer’s ability to pay. Higher income households are more able to pay higher rates of tax than lower income households. Generally, direct taxes are more progressive.

A regressive tax does not relate to income but means those on lowest incomes have a higher average rate of tax. In other words, the proportion of income paid as tax is higher for those on lower incomes than those on higher incomes. For example, as a percentage of income, the London Congestion Charge and Council Taxes are higher for those on lower incomes. This leads to a less equitable distribution of income. Generally, indirect taxes are more regressive. 

Incentives to work: Higher marginal rates of tax may discourage people from working as they will gain less of what they have earned. Free market economists believe lower taxes will lead to individuals working longer hours, accepting promotions and joining the workforce. High taxes will encourage the top earners to move abroad. Income taxes have the biggest effect on incentives. However, there is no strong evidence to suggest this. It can be argued people would work longer hours with higher taxes in order to maintain their income.

The Laffer curve: This shows how much tax revenue the government receives at each level of tax. Up until the point ‘T’, as tax rates increase, government tax revenue increases. After point ‘T’, people do not think it is as worthwhile working, and the lack of incentive to work leads to falling tax revenue. ‘T’ is the optimum tax rate where the government can maximise their revenue. Laffer argued that if tax rates are too high, they provide a disincentive to work. Revenue from indirect taxes is uncertain as they depend on consumer spending patterns. 

Income redistribution: There can be income redistribution and wage equality through government intervention. For example, inheritance tax means rich families cannot keep their entire wealth. A progressive tax system will increase equality. Since direct taxes are more progressive than indirect taxes, a move from indirect to direct taxes will increase equality.

Real output and employment: Direct taxes affect AD; a fall in direct taxes will cause a rise in AD. Indirect taxes affect SRAS; a fall in indirect taxes will increase SRAS. Some taxes can affect LRAS because of their impact on work incentives or investment. The impact on output and employment, therefore, depends on which taxes are implemented and the impact they have.

The price level: Indirect taxes could cause cost-push inflation. Indirect taxes could increase the cost of goods such as cigarettes or fuel if producers choose to pass the costs onto the consumer. Since the demand for cigarettes and fuel are relatively price inelastic, producers are likely to pass the cost of the tax onto consumers. The price level will also be affected by the changes to AD and AS which affect output and employment.

The trade balance Taxes could be imposed on imports into a country. These are tariffs and they make it more expensive to import goods, which should, in theory, improve the trade balance. However, other countries might retaliate, so exports might decrease as well.

FDI flows: Governments can provide a competitive tax environment to encourage FDI  so that the market is profitable, fair and has macroeconomic stability. Taxes should also be consistent and predictable, so they are business friendly. This would encourage FDI flows. High, fickle taxes are likely to discourage FDI flows, since investors will choose to invest elsewhere

Discretionary fiscal policy is a policy which is implemented through one-off policy changes. Discretionary fiscal policy involves deliberate changes in government expenditure and taxes with the intention of influencing aggregate demand. Keynes believed that during recessions, governments should increase their spending, and finance this with more borrowing.

Automatic stabilisers are policies which offset fluctuations in the economy. These include transfer payments and taxes. They are triggered without government intervention.

A government has a fiscal (budget) deficit when expenditure exceeds tax receipts in a financial year.

The national debt is the amount of money the government has borrowed at one time through issuing securities by the Treasury. 

Cyclical deficit is a temporary deficit, which is related to the business cycle. A deficit might occur during recessions when governments increase spending to stimulate the economy.

Structural deficit This is a deficit which is due to an imbalance in the revenue and expenditure of the government, so it exists at every point in the business cycle.

The business cycle

Governments are likely to spend more during recessions. This is to try and stimulate the economy. Spending might be increased on welfare payments since more people will be unemployed and on low incomes. Moreover, tax revenues from income tax and VAT will be lower, since people will be earning and spending less. 

Interest payments

If interest rates increase on government debt, the amount the government pays in interest payments increases, so the deficit might increase. 

Privatisation

An industry is privatised when the government sells the industry to the private sector. This provides them with a one-off payment, which could improve the budget deficit. 

The national debt is the accumulation of the government deficit over time. It is the total amount the government owes.

If the government is continuously running a deficit, the size of the debt increases.

If the government reduces the size of their deficit, the rate of increase of the total debt is slower, but the debt is still increasing.

It is only when the government runs a budget surplus that the size of the national debt decreases. Currently, the UK government is trying to reduce the size of the deficit and eventually run a budget surplus by 2019-2020, at which point they will start paying off the debt. 

The cost of borrowing could increase since by borrowing money, the government is increasing demand for credit in the economy.

If confidence is lost in the government’s ability to repay the debt, governments might have to raise interest rates to encourage investors to buy bonds, so that they can finance the debt.

It could lead to higher taxes and austerity measures, especially if the debt becomes uncontrollable.

A fiscal deficit could be inflationary if it increases AD. 

More government spending could lead to crowding out of the private sector. This leaves fewer funds in the private sector for firms to use, since the government is borrowing money, which crowds them out of the market.

Measures to reduce fiscal deficits and national debts

• Budget deficits could be reduced with less government spending and higher taxes. However, this could lead to lower economic growth, which might cause government finances to worsen since tax revenue falls. Moreover, if taxes are too high, people could be discouraged from working, since they are not keeping much of their income.
• Economic growth could be promoted to help reduce a deficit. This would increase revenue from taxes without needing to raise the rate of tax. For example, consumers would spend more, which raises revenue from VAT. However, this is not effective is the government has a structural deficit.
• Governments can issue bonds to raise finance. This is not considered to be an effective long term solution to eliminate government debt. However, it can help the government avoid raising taxes in the short run. The government has to pay interest to the investors who buy the debt, which has to be repaid at some point.
• Governments could choose to default on their debt if it is no longer manageable. However, this can make accessing credit in the future difficult. For example, Russia and Argentina have defaulted on their debts in the past.
•  Saudi Arabia used the sale of oil to reduce the debt burden from 80% of GDP to 10.2% of GDP between 2003 and 2010.

Measures to reduce poverty and inequality

• Over the past century, sustained economic growth has helped reduced pre-War poverty in Britain, since wealth, was redistributed to the poorest. 
• China’s rapid economic growth between 1985 and 2001 helped 450 million people be lifted out of poverty. Similarly, India had strong economic growth in the 1980s and 1990s and has had significant falls in poverty rates.
• Governments could employ progressive taxes, such as higher rates of income tax for the richest earners. This puts most of the tax burden on high-income earners, and it allows the government to reduce regressive taxes and raise welfare payments. However, this could reduce incentives to work harder and earn more, and it could result in a fall in government revenue, as shown by the Laffer curve.
• The US has a progressive tax system, but the welfare state is not effective at redistributing income. In countries such as Finland and Scandinavia, the tax system is less progressive, but the government collects a lot more tax revenue, which they are effective at redistributing.
• In developing countries, governments might improve human capital by making education more widely available. Moreover, they might try and diversify the economy in order to stimulate economic growth and job creation. For example, countries such as Sri Lanka and tried to develop their tourism industry. 

Changes in interest rates and the supply of money

• Governments could use monetary policy to stimulate the economy and raise government revenue. For example, governments in the UK, the US and the EU have used low-interest rates. This can encourage spending and investment, in order to try and boost economic growth.
• Central banks can also pump money into the economy electronically to try and stimulate the economy. This is quantitative easing (QE). QE is usually used where inflation is low and it is not possible to lower interest rates further.
• It has been used by the European Central Bank to help stimulate the economy. Since the interest rates are already very low, it is not possible to lower them much more. The bank bought assets in the form of government bonds using the money they have created. This is then used to buy bonds from investors, which increases the amount of cash flowing in the financial system. This encourages more lending to firms and individuals since it makes the cost of borrowing lower. The theory is that this encourages more investment, more spending, and hopefully higher growth. A possible effect of this is that there could be higher inflation. 

Measures to increase international competitiveness

• International competitiveness is the ability of a nation to compete successfully overseas and sustain improvements in real output and living standards.
• Generally, the cheaper the relative unit labour costs, the more competitive the country in manufacturing. For example, countries such as China, India and Bangladesh have lower labour costs than countries such as the UK and US, which means that a lot of production requiring manufacturing, such as textiles, clothes and technology, has moved abroad.
• However, countries such as Germany are famous for producing high quality engineered goods, such as cars, so consumers might be willing to pay more for them.
• China has previously used currency manipulation in order to increase their international competitiveness. They devalued the Renminbi in order to make their relative export price lower. However, this is not a policy-relevant for countries with floating exchange rates, such as the UK.
• Unit labour costs rise when wages increase at a faster rate than productivity. China’s large population means wages are generally low, but the rise of the middle class and consumer spending is pushing wages up.
• The UK government has tried to increase competitiveness by lowering the corporate tax rate from 21% to 20% in 2015. Moreover, the UK government has established the ‘Red Tape Challenge’, which aims to simplify regulation for businesses.

Due to globalisation, the world’s economies are increasingly interdependent. This means that economic shocks in one part of the world affect many countries.

It is estimated that shocks in the global economy accounted for about 2/3 of weaknesses in UK output after the financial crisis.

For example, economic decline in the Eurozone negatively affected the UK’s exports, since Eurozone countries form a large proportion of UK trading partners. 

The UK MPC reacted to this by lowering interest rates to 0.5%, the historic low, in order to encourage economic growth. Since this was the lowest that interest rates could realistically go, the bank started using QE to try and stimulate economic activity.

Moreover, worsening conditions in the Euro area meant that UK banks faced higher funding costs. In order to support them, the government introduced the Funding for Lending Scheme, which aimed to lower these costs and provide cheap funding to banks and building societies.

Following the vote for Brexit, the chancellor has set aside around £3bn (as of 2018) to deal with the effects. Interest rates were originally lowered to improve confidence. They have been raised slightly in order to deal with the inflation following the fall in the pound. 

The regulation of transfer pricing

• Transactions between companies in the same multinational group form up a significant proportion of global trade.The price of these transactions is known as transfer pricing.
• This price is set up in accordance with tax rules that determine the rate of tax on profits in different countries.
• Sometimes, transnational companies exploit these rules so they can reduce the amount of tax they have to pay. They could say that their activities have been in countries with low tax rates, for example, to reduce how much tax they pay. Companies can relocate parts of their company such as financial assets and intellectual property to low tax rate countries. This means that profits are taxed at a low rate.
• In the UK, companies which do not allocate sufficient profits to the UK, in accordance to rules, are challenged by HMRC. This means they have managed to earn billions of pounds in tax. 

Limits to government ability to control global companies

• The tax rules are complex and difficult to apply and regulate. There could be costs to HMRC to challenge firms which do not declare their profits truthfully. Although HMRC managed to secure £4.1 billion in tax revenue for the UK Exchequer, this might have taken a long time to sort out. 

Inaccurate information

Some policies might be decided without perfect information. This might require a full cost-benefit analysis, and it could be time-consuming and expensive. For example, government housing policies are long term and have failed several times in the past. However, it is impractical for governments to gain every bit of information they need, so assumptions are made. 

Risks and uncertainties

With government policies, consumers react in unexpected ways. A policy could be undermined, which could make government policies expensive to implement since it is harder to achieve their original goals. 

Inability to control external shocks

For example, the financial crisis was unexpected and uncontrollable and meant policies employed by policymakers did not have the intended effects.