Economics Revision

Chapter 9: Macroeconomic Performance

Real GDP growthA measure of the total output expenditure or income of an economy after adjusting for changes in the price level. The growth of real GDP is the % change in output during a particular time period, often measured over a year

InflationThe sustained increase in the general level of prices, measured in the UK by changes in the cost of a basket of goods & services bought by a typical household (consumer price index or CPI) weighted according to the expenditure on each item in the basket

UnemploymentAge arises when someone is out of work and actively seeking employment. Measured as the total number of people unemployed or as a % of the workforce

Balance of paymentsRecords money flows into and out of a country over a period of time

Current Account Includes money glows due to trade (the trade balance broken down to trade in goods and services) transfers of interest, profit and dividends (the investment income balance) and transfers of money by Gov. and international organisations (the transfers balance)

Standard of Living A measure of the material well-being of a nations and its people

Short-run economic growthThe actual annual % increase in an economys output, sometimes referred to as actual economic growth

Long-run economic growth The rate at which the economys potential output could grow as a result of changes in the economys capacity to produce goods and services, sometimes referred to as potential economic growth

Output GapThe difference between the actual and potential output of an economy. It is common practice to refer to a situation where actual output is below potential output as a negative output gap. A positive output gap occurs when, in the short term actual output exceeds the economys potential output

Spare capacityExists when forms in the economy are capable of producing more output than they are actually producing

Trend rate of growthThis refers to the average sustainable rate of economic growth in an economy. For example in the UK this is about 2.5%.

Short-run aggregate supplyShows the level of production for the economy sat a given price level, assuming labour costs & other factor input costs are unchanged

Economic cycleFluctuations in the level of economic activity as measured by GDP. Typically there are four stages in the cycle: recession, recovery, boom & slowdown

Human capitalThe knowledge & skills of the labour force

Marginal propensity to save (MPS)The proportion of additional national income that is saved Change in savings /change in national income

Marginal propensity to tax (MPT)The proportion of additional national income that is taxed Change in taxation /change in national income

Marginal propensity to import (MPM)The proportion of additional national income that is spent on incomeChange in imports /change in national income

AcceleratorThe theory of investment that states that the level of investment depends on the rate of change of national income

StocksThe amount of finished goods that firms hold in order to be able to satisfy increases in demand

Long-run aggregate supply (LRAS) CurveThe relationship between total supply & the price level in the long run. The LRAS curve represents the maximum possible output for the whole economy its potential output

Classical EconomistsEconomists who believe that markets will clear that prices & quantities adjust to changes in the forces of supply & demand so that the economy produces its potential output in the long run

Keynesian economistsEconomists who believe that market failures will result in price & quantity rigitied such that the economys equilibrium output in the long run may be less that its potential output

Labour forceAll those people of working age who are in employment or actively seeking work

Labour force participation rateA measure of the proportion of the population able to work who are in employment or are actively seeking work

Capital output ratioThe amount of capital needed to generate each unit of output

Capital account of the balance of paymentsThe section of the balance of payments that records long-term flow of capital into and out of an economy. It records purchases & sales of assets & is split into 2 sections, long-term capital flows & short-term capital flows

Long-term capital flowsFlows of money used for investment in assets e.g. direct investment by a company in setting up production facilities or portfolio investment through buying shares in companies

Short-term capital flowsFlows of money that occur to take advantage of differences in countries interest rates & changes in exchange rates; sometimes referred to as hot money

Public sector net cash requirement (PSNCR)The difference between the spending of general Gov. (central & local Gov.)& their revenue. If expenditure exceeds revenue, there is a budget deficit. If expenditure is smaller than revenue, there is a budget surplus. A budget deficit requires Gov. to borrow money to make up the shortfall of revenue over planned expenditure

Automatic stabilisersChanges in Gov. expenditure & taxation receipts that take place automatically in response to the economic cycle. E.g. expenditure on unemployment benefits rises during the recession phase of the business cycle

Economic stabilityThe avoidance of volatility in economic growth rates, inflation, employment & unemployment & exchange rates, in order to reduce uncertainty & promote business & consumer confidence & investment

Crowding outWhen government borrowing reduces the funds available for private sector investment or raises the cost of investment by raising market interest rates

Cyclical deficitA budget deficit that arises because of the operation of automatic stabilisers

Golden ruleA commitment by the UK Gov. that, over the economic cycle, it will borrow only to invest & not for current expenditure

Credibility (principle of fiscal policy)A credible fiscal policy framework is one where the governments commitment to economic stability is trusted by the public, business & financial markets

FlexibilityA flexibly fiscal policy frame work is one that has the flexibility to deal with macroeconomic shock, such as sudden & unexpected changes in AD &/or AS

Legitimacy One that has widespread support & about which there is general agreement among the public, business & politicians

Stability & Growth Pact (SGP)An agreement by members of the EU about the way in which fiscal policy should be conducted to support Europes single currency. It requires those countries adopting Europes single currency to abide by the following rules A budget deficit of 3% of GDP or less A Gov. debt of 60% of GDP or less

Monetary transmission mechanism The way in which monetary policy affects the inflation rate through the impact it has on other macroeconomic variables

Price stabilityWhen the general price level does not change or if it does, the rate of change is low enough not to significantly affect the decisions of firms & households

Purchasing power of moneyWhat a unit of currency will but in terms of goods & services

Signalling functionChanges in demand & supply of goods & services are signalled to producers & consumers through changes in absolute & relative price levels

Operational independence When a central bank is given responsibility for the conduct of monetary policy independent of political interference. The target for inflation, however, is normally set by Gov.

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

Asymmetric inflation targetWhen deviations below the inflation target are seen to be less important that deviations above the target

International competitiveness The ability of an econ omys firms to compete in international markets &b, thereby, sustain increases in national output & income

Unit labour costs The average cost of labour per unit of output or the total labour/total output UCL = wage costs + non-wage costs Output per worker (labour productivity)

Relative labour costsThe costs of labour per unit of output of one country relative to its major trading partners

Market failure Occurs when market imperfections lead to an allocation of resources, which is less efficient than it might be. So, it is essentially the inefficient allocation of resources of the market mechanism which is used in the allocation process

Allocative Efficiency Occurs when the value of consumers place on a good equals the cost of resources used up in productionMarginal social benefits = marginal social cost

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

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

Benefits of Inflation targeting Transparency & accountability Makes the conduct of monetary policy conduct clear. Commitment to price stability that is communicated to firms and households The quarterly Bank of England Inflation Report is a highly detailed assessment of economic trends and the Bank's best guess about future movements in inflation Expectations It can reduce inflationary expectations if people believe a low inflation target will be met. This will then reflect in the wage demands of people in work. If employees expect low inflation they may be prepared to accept a slower growth of pay. This reduces the risk of cost-push inflation in the economy. Flexibility Symmetric inflation targets gives as much weight to low inflation as well as high inflation There is flexibility contribute to economic stability Higher levels of capital investment In both manufacturing and service industries. This is because businesses will not demand such high nominal rates of return on potential investment projects if they believe that inflation will remain low and stable.

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

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

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

Disadvantages:

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

Economic stability In recent years attention has switched to economic stability as an objective of macroeconomic policy Instability in any of the key performance indicators creates uncertainty, which damages long-term economic performance Government aim for macroeconomic stability this means that the economy is not vulnerable to significant fluctuations in: Economic growth Inflation Unemployment

Macroeconomic policies to promote stability and growth have focused on: A prudent approach to management of the economy Taking fiscal & monetary policy decisions on the basis of the long-term interests of the economy rather than short term political considerations Ensuring that fiscal and monetary policies support each other Bringing openness and transparency to decision making through putting in place rules and targets Improving the supply-side performance of the economy

The multiplier, the accelerator and their interaction The process by which any change in a component of AD results in a greater final change in GDP When spending rises, its impact on national income is multiplied beyond the initial increase in spending The size of the multiplier is determined by the size of the leakages from the circular flow of income Visualised using the circular flow of income diagram The proportion of additional national income that goes to leakages is known as the marginal propensity to withdraw (MPW) and is made up of The marginal propensity to save The marginal propensity to tax The marginal propensity to import

K (the multiplier) = 1Marginal propensity to withdraw

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

Supply side policy issues Aim to increase AS in order to increase the economys productive capacity thereby:Lower Inflation. Shifting AS to the right will cause a lower price level. By making the economy more efficient supply side policies will help reduce cost push inflation.Lower Unemployment Supply side policies can help reduce structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment. Improved economic growth Supply side policies will increase the sustainable rate of economic growth by increasing AS.Improved trade and Balance of Payments. By making firms more productive and competitive they will be able to export more. This is important in light of the increased competition from S.E. Asia.

However there is little use expanding the productive capacity of the economy, improving incentives, making markets work more efficiently through deregulation or raising productivity if there is insufficient demand in the economy. Supply-side policies are increasingly important to deliver improved macroeconomic performance in the long run & to improve international competitiveness

Causes of InflationDemand Pull Inflation AD increasing at a faster rate than ASConsumption rising more rapidly than productive capacity

A large outward shift in AD takes the equilibrium level of national output beyond full capacity national income creating a positive output gap. This would then put upward pressure on wage & raw material costs.

Main causes of demand-pull inflation

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

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

Main causes of Cost-push inflation1) Component costs e.g. an increase in the prices of raw materials & other components used in the production process of different industries. This might be because of a rise in world commodity prices such as oil, copper, and agriculture. 2) Wage Push Inflation Trades unions can bargain for higher wages, this will lead to an increase in costs for firms If wage increases more than productivity. It may also cause demand-pull inflation as consumers spend more. Wage cots often rise when unemployment is low & also when people expect higher inflation so they bid for higher pay in order to protect their real incomes. 3) Higher indirect taxes imposed by the government e.g. a rise in the specific duty on alcohol & cigarettes and an increase in fuel duties. Depending on the price elasticity of demand & supply for their products, suppliers may choose to pass on the burden of the tax onto consumers.

Stagflation & Inflation Stagflation: is a term used to describe a combination of low growth, high unemployment AND high inflation. With high unemployment, consumers have less money to spend. Add inflation, and the money they do have is worth less and less every day. Stagflation is often caused by a supply side shock. For example, rising commodity prices, such as oil prices, will cause a rise in business costs and SRAS shifts left/ upwards. This causes a higher inflation rate and lower GDP.How to Solve Stagflation?1) Use monetary policy, higher interest rates to reduce inflation but, it will cause a bigger fall in GDP.2) Use monetary policy to increase GDP, but could make inflation worse. Therefore demand side policies cannot solve stagflation they can only solve one particular aspect. The only solution to stagflation is to increase AS through supply side policies. However, these will take a long time. Also if the cost push inflation occurs because of a global increase in the price of oil and food, there is little that the UK government can do about it. However, often cost push inflation is a temporary affair e.g. rising energy prices may not continue for ever (hopefully)

International Competitiveness International Competitiveness: Means your exports are attractive to foreigners. You will then have more exports then imports. The ability for a nation to sell its goods or services to domestic and international markets.

Measures of international competitiveness Relative unit labour costs relative to other competing nations, low costs lead to exports being cheaper and therefore demand for them will increase.

Composite indices Global competitive index Takes a range of factors weighs and ranks them. E.g. Education, infrastructure, health.

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

Other national factors Level of education, leadership, openness to trade. Only relevant to that country, therefore difficult to form any kind of comparison.

Real Exchange ((Nominal rate) x (ratio of UK to foreign prices)) Number of units of foreign currency that can be obtained for a . Accurately compare UK prices to foreign prices.Factors Influencing Competitiveness

Real Exchange Rate

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

Real exchange rate = nominal exchange rate x foreign price level Domestic price level

If the nominal exchange rate falls or if the prices of goods abroad rise relative to the country in question, then there will be a depreciation in the real exchange rate. A fall in the real exchange rate will cause an increase in the competitiveness of a countrys goods, and exports will increase relative to imports.

In contrast, the real exchange rate will rise if the nominal exchange rate rises, or if the UK price level rises relative to the foreign price level. This appreciation will lead to a fall in the countrys competitiveness.

Wage and Non-Wage Costs

Wage costs are the most significant cost of production for many industries. Therefore, if wages are higher in the UK than in China, it is likely that the prices of the goods in the UK will be higher than those of China if productivity is ignored.

Non-wage costs are also significant for international competitiveness. These include: National insurance contributions paid by employers. Health and safety regulations. Environmental regulations. Employment protection and anti-discrimination laws. Contributions into company pension schemes.

These non-wage costs are frequently much higher in developed countries than in developing countries and so have the effect of reducing the international competitiveness of goods and services from developed countries.

RegulationIncreases in regulation of industry tend to increase costs of production for firms. For example, UK firms tend to have lower costs than firms in France and Germany because regulation is lighter in the UK. Hence less regulation is likely to increase international competitiveness.

Privatisation and deregulation may lead to decreases in X-inefficiencies and lower costs for producers, therefore increasing competitiveness, if there is a subsequent decrease in prices.

Productivity

Productivity: a measure of productive efficiency, for example labour productivity. Labour productivity: output per worker per hour worked. Rises in the UKs productivity relative to her main trading partners will increase the UKs competitiveness. In turn this is influenced by:

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

Government Policy

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

Deregulation and Privatisation

Privatisation leads to productivity improvements by reducing X-inefficiency, and can therefore improve the international competitiveness of a countrys goods.

Deregulation can encourage competitiveness, as it reduces costs and bureaucracy for producers.

Labour market flexibilityOne of the most important policy areas as far as trade and competitiveness is concerned has been the increased flexibility in labour markets. This is achieved partly through supply-side policy.

Trade Union Reforms:1. Introduced by the Thatcher governments during the 1980s.2. Enabled firms to adopt more flexible working practices.3. Enabled labour markets to adjust more easily to changes in the pattern of consumer demand and in the UKs comparative advantage.

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

This has also increased the attractiveness of the UK as a destination for FDI, since foreign multinationals value these characteristics.

Exchange rate policies

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

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

Chapter 10: Trade & Integration

World Trade OrganisationAn international body responsible for negotiating trade agreements & policing the rules of trade to which its members sign up. Trade disputes between members are settled by the WTO

Absolute advantageWhere one country is able to produce more of a good or service with the same amount of resources, such that the unit cost of production is lower

Reciprocal absolute advantageWhere, in a theoretical world of 2 countries & 2 products, each country has an absolute advantage in one of the 2 products

Comparative advantage Where 1 country produces a good or service at a lower relative opportunity cost than others

Relative opportunity costThe cost of production of one good or service in terms of the sacrificed output of another good or service in 1 country relative to another

Terms of tradeThe price of a countrys exports relative to the price of its imports. The terms of trade can be measured using the formula:Terms of trade= Index of average export pricesIndex of average import prices *100

Trading possibility curve (TPC)A representation of all the combinations of 2 products that a country can consume if it engages in international trade. The TPC lies outside the production possibility curve (PPC), showing the gains in consumption possible from international trade

Factor endowmentsThe mix of land, labour & capital that a country possesses. Factor endowments can be determined by, among other things, geography, historical legacy & economic & social development

Factor intensitiesThe balance between land, labour & capital required in the production of a good or service

Labour-intensive productionAny production process that involves a large amount of labour relative to other factors of production

Capital-intensive productionWhere the production of a good or services requires a large amount of capital relative to other factors of production

Heckscher-Ohlin theory of international tradeA theory that a country will export products produced using factors of production that are abundant and import products whose production requires the use of scares factors

Infant industriesIndustries in an economy that are relatively new and lack th4e economies of scale that would allow them to compete in international markets against more established competitors

Profit marginThe difference between a firms revenue and costs expressed as a % of revenue

Dynamic efficienciesEfficiencies that occur over time. Int. trade can lead to changes in behaviour over a period of time that can increase productive and allocative efficiencies

Knowledge & technology transferThe process by which knowledge and technology developed in one country is transferred to another, often through licensing and franchising

Licensing arrangementsAn agreement that ideas and technology owned by one company can be used by another, often for a charge

Regional trading blocCountries in a region that have formed an economic club based on abolishing tariffs and non-tarrif barriers e.g. the EU, the North American Free Trade Area (NAFTA) and the Association of South East Asian Nations (ASEAN)

Primary commoditiesGoods produced in the primary sector of the economy, such as coffee and tin

Prebisch-Singer hypothesisThe argument that countries exporting primary commodities will face declining terms of trade in the long run, which will trap them in a low level of development as more and more exports will need to be sold to pay for the same volume of imports of secondary sector or capital goods

Developed economiesCountries with a high level of income per capita and diversified industrial and tertiary sectors of the economy e.g. USA, UK, Japan & South Korea

Developing economiesCountries with relatively low income per capita, an economy in which the industrial sector is small or undeveloped and where primary sector production is a relatively large part of total GDP

LiberalisationReductions in the barriers to international trade, in order to allow foreign firms to gain access to the market for goods and services that are traded internationally

Transition economiesEconomies in the process of changing from central planning to the free market

Intra-regional tradeTrade between countries in the same geographical area e.g. trade between the UK & Germany or the USA & Canada

Inter-industry tradeTrade involving the exchange of goods and services produced by different industries

Intra-industry tradeTrade involving the exchange of goods and services produced by the same industry

Freely floating exchange rateA system whereby the price of one currency expressed in terms of another is determined by the forces of demand and supply

Fixed exchange rateAn exchange rate system in which the value of one currency has a fixed value against other currencies. This is often set by the government

Semi-fixed/semi-floating exchange rateExchange rate system that allows a currencys value to fluctuate within a permitted band of fluctuation

Foreign exchange (FOREX) marketA term used to describe the coming together of buyers and sellers of currency

Short-term capital flowsFlows of money in and out of a country in the form of bank deposits. Short term capital flows are highly volatile and exist to take advantage of changes in relative interest rates

Long-term capital transactionsFlows of money related to buying and selling of assets, such as land or property or production facilities (direct investment) or shares in company (portfolio investment)

External economic shocksUnexpected events coming from outside the economy that cause unpredicted changes in AS or AD. E.g. might include rapid rises in oil prices or a global slowdown

Purchasing power parity (PPP)The exchange rate that equalises the price of a basket of identical traded goods & services in 2 different countries. The PPP is an attempt to measure the true value of a currency in terms of the goods and services it will buy

j-curve effectShows the trend in a countrys balance of trade following a depreciation of the exchange rate. A fall in the exchange rate causes an initial worsening of the balance of trade, as higher import prices raise the value of imports and lower export prices reduce the value of exports due to short-run price inelasticity of demand for imports and exports. Eventually the trade balance improves. An appreciation of the currency causes an inverted j-curve effect.

Marshall-Lerner conditionStates that for a depreciation of the currency to improve the balance of trade the sum of the price elasticities of demand (PEDs) for imports and exports must be greater than 1

HedgingBusiness strategy that limits the risk that losses are made from changes in the price of currencies or commodities

Future marketsMarkets where people and businesses can buy & sell contracts to buy commodities or currencies at fixed price at a fixed date in the future

Foreign currency reservesForeign currencies held by central banks in order to enable intervention in the FOREX markets to affect the countrys exchange rate

Bilateral exchange rateThe exchange of one currency against another

Effective exchange rateThe exchange rate of one currency against a basket of currencies of other countries, often weighted according to the amount of trade done with each country

Single currencyA currency that is shared by more than one country. The euro is shared by 15 countries in the EU

Euro area, EurozoneTerm to describe the combined economies of the countries using the euro

Expenditure-switching policiesPolicies that increase the price of imports and/or reduce the price of exports in order to reduce the demand for imports and raise the demand for exports to correct a current account deficit on the balance of payments

Expenditure-reducing policiesPolicies that reduce the overall level of national income in order to reduce the demand for imports and correct a current account deficit on the balance of payments

Economic integrationRefers to the process of blurring the boundaries thzat separate economic activity in one nation state from that in another

Non-tariff barriers (NTBs)Things that restrict trade other than tariffs

Trade deflectionWhere one country in a free trade area imposes high tariffs on another to reduce imports but the imports come in from elsewhere in the free trade area

Free trade areaAn agreement between 2 or more countries to abolish tariffs on trade between them

Customs unionAn agreement between 2 or more countries to abolish tariffs on trade between them and to place a common external tariff on trade with non members

Single marketDeepens economic integration from a customs union by eliminating non-tariff barriers to trade, promoting the free movement of labour and capital and agreeing common policies in a number of areas

Economic unionDeepens integration in a single market, centralising economic policy at the macroeconomic level

Monetary unionThe deepest form of integration in which countries share the same currency and have a common monetary policy as a result

Single European Market (SEM)A process adopted in the EU that promoted the free movement of goods, services and capital by harmonising product standards and removing remaining non tariff barriers to trade

Monetary policy sovereigntyThe ability of a country to pursue an independent monetary policy

Trade creationWhere economic integration results in high-cost domestic production being replaced by imports from a more efficient source within the economically integrated area

Trade diversionWhere economic integration results in trade switching from a low-cost supplier outside the economically integrated area to a less efficient source within the area

Transaction costsThe costs of trading, which includes costs of changing currencies

Price transparencyThe ability to compare prices of goods & services in different countries

Stability & growth pactLimits agreed to public sector borrowing & the national debt for those EU countries that are part of the euro area

Automatic stabilisersElements of fiscal policy that cushion the impact of the business cycle without any need for corrective action by the government. E.g. higher spending on unemployment benefits and welfare payments & lower taxation receipts provide an automatic fiscal stimulus in times of economic slowdown

Fiscal transfersOccur where taxation raised in one country is used to fund government expenditure in another country

Economic convergence The process by which economic conditions in different countries become similar. Economists distinguish between monetary convergence (e.g. similarities in inflation & interest rates) and real convergence (e.g. similarities in the structure of economies). Membership of the euro are only requires monetary convergence to have taken place

Optimal currency areaRefers to conditions that need to be met to avoid the costs of monetary union. These conditions include: a high degree of labour market flexibility, mechanisms for fiscal transfers, & the absence of external shocks that impact differently on different economies (asymmetric shocks)

Fixed Exchange Rate Advantages of a fixed exchange rate Reduced risk in international trade - By maintaining a fixed rate, buyers and sellers of goods internationally can agree a price and not be subject to the risk of later changes in the exchange rate before contracts are settled. The greater certainty should help encourage investment. Introduces discipline in economic management - As the burden or pain of adjustment to equilibrium is thrown onto the domestic economy then governments have a built-in incentive not to follow inflationary policies. If they do, then unemployment and balance of payments problems are certain to result as the economy becomes uncompetitive. Fixed rates should eliminate destabilising speculation - Speculation flows can be very destabilising for an economy and the incentive to speculate is very small when the exchange rate is fixed. Reduced cost of trade under freely flowing exchange rate regimes, businesses face a risk that movements of the exchange rate can undermine the profitability of trade. As an insurance against movements in the exchange rate, firms engaging in international trade hedge their risks by buying currencies in the future markets. Fixed exchange rates reduce the need for hedging and this lowers the cost of international trade. Discipline domestic firms if exchange rate cannot depreciate, domestic firms will have to make sure that they match the productivity improvements of their foreign competitors & do not allow unit labour costs to increase

Disadvantages of the Fixed Exchange Rate No automatic balance of payments adjustment - A floating exchange rate should deal with a disequilibrium in the balance of payments without government interference, and with no effect on the domestic economy. If there is a deficit then the currency falls making you competitive again. However, with a fixed rate, the problem would have to be solved by a reduction in the level of aggregate demand. As demand drops people consume less imports and also the price level falls making you more competitive. Large holdings of foreign exchange reserves required - Fixed exchange rates require a government to hold large scale reserves of foreign currency to maintain the fixed rate - such reserves have an opportunity cost. Loss of freedom in your internal policy - The needs of the exchange rate can dominate policy and this may not be best for the economy at that point. Interest rates and other policies may be set for the value of the exchange rate rather than the more important macro objectives of inflation and unemployment. Fixed rates are inherently unstable - Countries within a fixed rate mechanism often follow different economic policies, the result of which tends to be differing rates of inflation. What this means is that some countries will have low inflation and be very competitive and others will have high inflation and not be very competitive. The uncompetitive countries will be under severe pressure continually and may, ultimately, have to devalue. Speculators will know this and thus creates further pressure on that currency and, in turn, government. Freely floating exchange rate The value of the currency is determined by the forces of D & S with no gov. intervention in the FOREX marketsThe D&S of a currency on the FOREX markets is affected by 3 things 1. Trade e.g. UK goods and services sold in the USA create a demand for the pound, whereas UK spending on imports from the Eurozone results in pounds being supplied to the FOREX markets to buy euros 2. Short-term capital flows funds flow in & out of countries in the form of deposits in bank accounts can be highly volatile & depend upon actual & expected interest rates & exchange rates 3. Long-term capital transactions flow of money related to buying and selling of assets, such as land or property or production facilities (direct investment) or shares in companies (portfolio investment)

Advantages of a Floating Exchange RateAutomatic balance of payments adjustment Any balance of payments disequilibrium will tend to be rectified by a change in the exchange rate. For example, if a country has a balance of payments deficit then the currency should depreciate. This is because imports will be greater than exports meaning the supply of sterling on the foreign exchanges will be increasing as importers sell pounds to pay for the imports. This will drive the value of the pound down. The effect of the depreciation should be to make your exports cheaper and imports more expensive, thus increasing demand for your goods abroad and reducing demand for foreign goods in your own country, therefore dealing with the balance of payments problem. Conversely, a balance of payments surplus should be eliminated by an appreciation of the currency. Freeing internal policy With a floating exchange rate, balance of payments disequilibrium should be rectified by a change in the external price of the currency. However, with a fixed rate, curing a deficit could involve a general deflationary policy resulting in unpleasant consequences for the whole economy such as unemployment. The floating rate allows governments freedom to pursue their own internal policy objectives such as growth and full employment without external constraints. Absence of crises Fixed rates are often characterised by crises as pressure mounts on a currency to devalue or revalue. The fact that, with a floating rate, such changes are automatic should remove the element of crisis from international relations. Flexibility Post-1973 there were great changes in the pattern of world trade as well as a major change in world economics as a result of the OPEC oil shock. A fixed exchange rate would have caused major problems at this time as some countries would be uncompetitive given their inflation rate. The floating rate allows a country to re-adjust more flexibly to external shocks. Lower foreign exchange reserves A country with a fixed rate usually has to hold large amounts of foreign currency in order to prepare for a time when they have to defend that fixed rate. These reserves have an opportunity cost.Disadvantages of the Floating RateUncertainty The fact that a currency changes in value from day to day introduces instability or uncertainty into trade. Sellers may be unsure of how much money they will receive when they sell abroad or what their price actually is abroad. Of course the rate changing will affect price and thus sales. In a similar way importers never know how much it is going to cost them to import a given amount of foreign goods. This uncertainty can be reduced by hedging the foreign exchange risk on the forward market. Lack of investment The uncertainty can lead to a lack of investment internally as well as from abroad. Speculation Speculation will tend to be an inherent part of a floating system and it can be damaging and destabilising for the economy, as the speculative flows may often differ from the underlying pattern of trade flows. Lack of discipline in economic management As inflation is not punished there is a danger that governments will follow inflationary economic policies that then lead to a level of inflation that can cause problems for the economy. The presence of an inflation target should help overcome this. Does a floating rate automatically remedy a deficit? UK experience indicates that a floating exchange rate probably does not automatically cure a balance of payments deficit. Much depends on the price elasticity of demand for imports and exports. The Marshall-Lerner condition says that depreciation in the exchange rate will help improve the balance of payments if the sum of the price elasticities for imports and exports is greater than one. Inflation The floating exchange rate can be inflationary. Apart from not punishing inflationary economies, which, in itself, encourages inflation, the float can cause inflation by allowing import prices to rise as the exchange rate falls. This is, undoubtedly, the case for countries such as UK where we are dependent on imports of food and raw materials.

Specialisation and Comparative Advantage

Absolute and Comparative Advantage

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

Country A has absolute advantage in wheat, it should export wheat & import electronic goods Country B has absolute advantage in electronic goods, it should export them & import wheat

Comparative advantage Exists where a producer has the lowest opportunity cost (or highest output per factor of production) for the production of a particular product. If persons or national economies specialise in production of the good they have a comparative advantage in, all can benefit from trade.Country A can produce 10 units of financial services or 10 units of cut flowersCountry B can produce 4 units of financial services and 8 units of flowers It is clear that A is more efficient at producing both goods than B so why should it trade The answer lies in their relative opp. Cost ratio

Ricardos Theory:

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

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

Criticisms of the model:

The model assumes that there is a 2 country, 2 good world this is massively simplistic. The model assumes that trade occurs on a one-to-one basis trade may in fact take place at different prices for the goods, and rich countries may exert their monopsony power to gain lower prices. The model assumes that each market is perfectly competitive in reality, internal protectionism and monopolies ensure that markets are not. The model assumes that there is full employment and geographical mobility within countries. It also assumes constant opportunity cost along the PPFs doesnt take into account economies and diseconomies of scale, for example. The model is based on unrealistic assumptions such as constant costs of production, zero transport costs and no barriers to trade. Ricardo theorised in the 19th Century, when there were effective restrictions on people moving their capital overseas this is not the case today. Some have said that basing production on comparative advantage would reduce economic diversity significantly, leaving them vulnerable to changes in the market.

Balance of payments problemsRecord of financial transactions between a country and its trading partners

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

The current account in the balance of payments measures the perfomance of a country in international trade by measuring the value of money paid for its imports and the value of money received through exports. It also includes the income received by people temporarily working overseas, flows of money in and out of the country for interest payments, profits and dividends as well as Central Government payments overseas such as foreign aid and contributions to the EU (known as current transfers) So, basically the balance on current account can be calculated by this equation = balance on visible trade + balance on invisible trade + income + current transfers. Visible trade is the trade in goods which can be seen like oil/machinery.. Invisible trade is the trade in services like banking and tourism The balance on these trades is the difference between the exports and imports.

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

Chapter 11: Development & Sustainability

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

Economic developmentThe process of improving peoples economic well-being and quality of life

Low-income countriesCountries with GDP per capita of $905 or less

Low middle-middle income countries Countries with GDP per capita of $906 - $3,595

Upper middle-middle income countriesCountries with GDP per capita of $3,596 - $11,115

Higher-income countriesCountries with GDP per capita of $11,116 or more

High human developmentWhere the HDI is 0.8 and above

Medium human development Where the HDI is between 0.5 & 0.8

Low human developmentWhere HDI is less that 0.5

Human development index (HDI)A measure that, recognising limitations of GDP per capita as a measure, combines outcomes that might be valued in the development process: life expectancy at birth; adult literacy & percentage of the relevant population enrolled in primary, secondary and tertiary education; and GDP per capita in US$ at PPP

Index of sustainable economic welfare (ISEW)An index, first constructed in 1989 by 2 economists, Herman E. Daly and John B. Cobb, that adds to national expenditure things that raise the quality of life (ore well-being) and deducts things that reduce well being. Daly & Cobb have added to and refined the measure to produce a Genuine Progress Indicator (GDI)

Environmental FootprintThe effect a person, company, activity, etc. has on the environment e.g. the amount of natural resources they use and the amount of harmful gas they produce

Definition of DevelopmentA process resulting in an improvement in peoples well being

Todaros DefinitionThe process of development must seek to achieve: An increase in the sustainability & distribution of basic life sustaining goods An increase in the standards of living An expansion of the economic & social choices available to people

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

How is development measured?UN Millennium Development Goals MD Goals resulted from 2000 meeting Goal 1: Eradicate extreme hunger and poverty

Goal 2: Achieve universal primary education

Goal 3: Promote gender equality and empower women

Goal 4: Reduce child mortality

Goal 5: Improve maternal health

Goal 6: Combat HIV/AIDS, malaria and other diseases

Goal 7: Ensure environmental sustainability

Goal 8: Develop a global partnership for development

Sustainable development

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

Examples of unsustainable practices Depleting fish stocks Pollution of air/water Loss of natural habitat Loss of farmland Depletion of non-renewable resources

Measuring sustainable development

Alternatives GNP/GDP have been proposed to take into account sustainable economic welfare MEW (1972) was the first measure of Economic welfare ISEW is the furthest advanced index of sustainable economic welfare

Criticisms of GNP main: does not take into account:1. The value of household labour2. The welfare effects of income inequality3. The welfare loss due to environmental degration

And considers defensive expenditures wrongly as contributions to welfare

The ISEW & forerunners aim to provide a remedy for these & other shortcomings to provide a move reliable monetary indicator of welfare & sustainability ISEW makes a subtraction for air pollution caused by economic activity It makes an addition to count unpaid household labour e.g. cleaning Also covers income inequality, other environmental damage & depletion of environmental assetsISEW is made up of:ISEW= personal expenditure + Public expenditure + Value of unpaid work + Increase in man made capital Private defence - Environmental damage - Income inequality - Decrease in natural capital

Criticism of ISEW ISEW too subjective & too susceptible to changes in the assumption which underpin it Lack of agreement on the choice of adjustments made to GDP Choice of weightings is subjective Difficult to assign a monetary value to some components

Environmental taxation Summary of the main advantages of environmental taxes1. They can provide incentives for behaviour that protects or improves the environment, and deter actions that are damaging to the environment.2. Economic instruments such as tax can enable environmental goals to be achieved at the lowest cost and in the most efficient way3. By internalising environmental costs into prices, they help to signal the structural economic changes needed to move to a more sustainable economy.4. They can encourage innovation and the development of new technology5. The revenue raised by environmental taxes can also be used to reduce the level of other taxes, which can help to reduce distortions in the economy, while raising the efficiency with which resources are used.

The Polluter Pays Principle The main aim of an environmental tax is to increase the firms private marginal cost (PMC) until it equates with social marginal cost curve (SMC). This will result in a socially efficient level of output. In the diagram below this would mean setting a tax equal to the vertical distance cd, which is equal to the level of environmental damage caused at the optimum level of output.

Evaluation: The Problems with Environmental Taxation Many economists argue that explicit pollution taxes create further problems, which lead to government failure and little sustainable improvement in environmental conditions.

The main problems are as follows:1. Assigning the right level of taxation: There are problems in setting a tax so that the PMC will exactly equate with the SMC. The government cannot accurately value the private benefits and cost of firms let alone put a monetary value on externalities such as the cost to natural habitat and the value of human life. Without accurate information setting the tax at the correct level is virtually impossible. In reality, therefore, all that governments and regulatory agencies can hope to achieve is a movement towards the optimum level of output.2. Consumer welfare effects (issues of equity): Taxes reduce output and raise prices, and this might have an adverse effect on consumer welfare. Producers may be able to pass on the tax to the consumers if the demand for the good is inelastic and, as result, the tax may only have a marginal effect in reducing demand and final output Taxes on some de-merit goods (for example cigarettes) may have a regressive effect on lower-income consumers and leader to a widening of inequalities in the distribution of income. Having said this, it should be possible for authorities to develop smart tariffs or taxes where account is taken of the economic impact of pollution taxes on vulnerable households such as low income consumers

3. Employment and investment consequences: If pollution taxes are raised in one country, producers may shift production to countries with lower taxes. This will not reduce global pollution, and may create problems such as structural unemployment and a loss of international competitiveness. Similarly higher taxation might lead to a decline in profits and a fall in the volume of investment projects that in the long term might have beneficial spill-over effects in reducing the energy intensity of an industry or might lead to innovation which enhance the environment. Eco-tax reformers often argue that the introduction of pollution taxes should be revenue neutral so for example, an increase in environmental taxation might be accompanied by reductions in employment taxes such as national insurance contributions so that the employment consequences of higher taxation are minimized

4. It might be more cost effective for governments: To switch away from pollution taxation to direct subsidies to encourage greater innovation in designing cleaner production technologies

5. The impact of green taxes depends crucially on what is done with the revenues. If they are balanced by reducing other taxes through revenue recycling, research suggests that green taxes could result in an overall economic improvement

UK sustainable developmentUK performance on sustainable development is currently measured against 4 criteria: Sustainable consumption & production Climate change & energy Natural resource protection & enhancing the environment Creating sustainable communities & a fairer world

The common and diverse characteristics of developing countries pg 288Common characteristics Low living standards Low levels of labour productivity High rate of population growth Economic structure dominated by primary sector production High degree of market failure Lack of economic power in international markets and dependence

Chapter 12: The Economics of Globalisation

Globalisation The processes that have resulted in ever-closer links between the worlds economies

Foreign direct investment (FDI)The establishment of branches and productive processes abroad, or the purchase of foreign firms; investment made by a multinational corporation in a country other than where its operations originate

Multinational companies (MNCs)Firms that produce goods and services in more than one country

World trade organisation (WTO)A global organisation that regulates world trade

Transition economyOne that is changing from a centrally planned to a free market economy

The International Monetary Fund (IMF)A global organisation that aims to promote international monetary co-operation and international trade

World bankA global organisation that provides development funding

BRICAn acronym used to describe the fast-growing economies of Brazil, Russia, India and China

Quantitative Easing Central banks increase the supply of money by "printing" more. In practice, this may mean purchasing government bonds or other categories of assets, using the new money. Rather than physically printing more notes, the new money is typically issued in the form of a deposit at the central bank. The idea is to add more money into the system, which depresses the value of the currency, and to push up the value of the assets being bought and to lower longer-term interest rates, which encourages more borrowing and investment. Some economists fear that quantitative easing can lead to very high inflation in the long term.

WTO (World Trade Organisation) The primary aim of the WTO is to liberalize trade by providing governments with a forum for negotiating trade agreements. The WTO reports that around 300 cases for settlement of disputes were brought to the WTO in its first 8 years same number as in the entire life of the GATT.

Objectives: Liberalise trade i.e. remove trade barriers this is the primary function of the WTO.Settling disputes between member countriesProvision of a system of trade rules

Principles:Most-favored-nation principle: implies that countries cannot discriminate between their trading partners. For example, a reduction in a tariff for one country must be extended to all countries.National treatment: imported and locally produced products must be treated equally once the foreign goods have entered the market.

Effectiveness in liberalising trade:

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

Benefits of Globalisation1. Free Trade Free trade is a way for countries to exchange goods and resources. This means countries can specialise in producing goods where they have a comparative advantage (this means they can produce goods at a lower opportunity cost). When countries specialise there will be several gains from trade:1. Lower prices for consumers2. Greater choice of goods3. Bigger export markets for domestic manufacturers4. Economies of scale through being able to specialise in certain goods5. Greater competition2. Labour Mobility Increased labour migration gives advantages to both workers and recipient countries. If a country experiences high unemployment, there are increased opportunities to look for work elsewhere. This process of labour migration also helps reduce geographical inequality. This has been quite effective in the EU, with many Eastern European workers migrating west. However, this issue is also quite controversial. Some are concerned that free movement of labour can cause excess pressure on housing and social services in some countries. Countries like the US have responded to this process by actively trying to prevent migrants from other countries.3. Increased Economies of Scale. Production is increasingly specialised. Globalisation enables goods to be produced in different parts of the world. This greater specialisation enables lower average costs and lower prices for consumers.4. Greater Competition Domestic monopolies used to be protected by lack of competition. However, globalisation means that firms face greater competition from foreign firms.5. Increased Investment Globalisation has also enabled increased levels of investment. It has made it easier for countries to attract short term and long-term investment. Investment by multinational companies can play a big role in improving the economies of developing countries.

Costs of Globalisation1. Environmental Costs One problem of globalisation is that it has increased the use of non-renewable resources. It has also contributed to increased pollution and global warming. Firms can also outsource production to where environmental standards are less strict. However, arguably the problem is not so much globalisation as a failure to set satisfactory environmental standards.2. Labour Drain Globalisation enables workers to move more freely. Therefore, some countries find it difficult to hold onto their best skilled workers, who are attracted by higher wages elsewhere.3. Less Cultural Diversity Globalisation has led to increased economic and cultural hegemony. With globalization there is arguably less cultural diversity, however it is also led to more options for some people.

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

Extract 4: Rare Earths The Case for China Protection non-renewable resources are usually regarded as a special case where the normal rules of free trade are often abandoned. For China to rely on rare earths lasting into the long term limiting output through production quotas could be one acceptable method to conserve resources. Note: limiting output in general, not just for export! Protection of rare earths for future generations- environmental sustainability The economics on which this is based: Free trade will tend to reflect private costs. Countries export goods that they can produce at a relatively lower opportunity cost. But these opportunity costs are private costs; they do not take into account negative externalities Production and export of rare earths involve negative externalities and the external costs are not borne by the importing countries. So restricting world trade in rare earths based on free market prices could be justified. Use negative externality diagram to explain the market failure and why is could help Chinas sustainabilityP1Q2Marginal Social CostMarginal Private Benefit = Marginal Social BenefitMarginal Private CostQ1P2QuantityPriceCosts/ Benefits

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

Possible Effects of the Quota = Evaluation Efficiency of a policy i.e. will it result in a better use of scarce resources among competing uses? Effectiveness in meeting its specific objective i.e. Will it work? Could something else be better? Equitable i.e. is it a fair policy or does one group in society gain or lose more than another?

Application of Economics Protection of a natural resources for future generations and Positive Internal multiplier effect for China: Could attract FDI as firms relocate to China use AD/AS Question environmental sustainability- will it be efficient? Reverse External Multiplier effect of the quota on the rest of the world1) However, this also means that other countries exports (or investment) will fall, this will reduce the level of injections into their, and the world economy- a reverse multiplier.2) The lower world income in turn leads to a fall in demand for Chinas exports Will it be efficient?Risk of Retaliation:1. If the WTO agree that China is breaching their rules, other countries will be allowed to impose retaliatory sanctions against China, probably tariffs- But their own consumers will suffer.2. A trade war could follow with each country cutting back on imports from the other. Result a decline in specialisation and the benefits of trade based on comparative advantage = lower world standards of livingWill it be effective?Also a Risk of Global inflation

Other effects Protection of monopoly power and ability to make supernormal profits may encourage productive inefficiency in China (X-inefficiency) - leading to a decline in economic and environmental sustainability it is efficient? Higher prices from China and no access to their rare earths may encourage other countries to mine them and could make the development of alternatives more viable but possibly long term see next diagram will it be effective?Q2Over time ...research and exploration will increase global supply of rare earths outwards shiftP2Supply with Export QuotaChinese export quota limits supply to global marketQuantityD1P2DemandSupplyS2World Supply 1Q2Q1P1Q1P1QuantityPricePrice

Is China changing its strategy?From: An export-led growth strategy: based on openness and increased international trade. Growth is achieved by concentrating on increasing exports, and export revenue, as a leading factor in the AD of the economy. Over time, growth in the international market is translated into growth in the domestic market.

To an import substitution /protectionism) strategy: to encourage the domestic production of goods, rather than importing them. It should mean that industries producing the goods domestically should grow, as will the economy, and then should be competitive on world markets in the future. Possible: Infant Industry argument although they are using

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

Extract 1 Summary

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

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

1