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OCR A2 - The Global Economy

Unit F585

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The examination for this unit is based on pre-released material

In July 2011 the material concerns the problems of the PIIGS

The exam lasts for 2 hours and there are 60 marks available

This gives roughly 2 minutes per mark - don’t spend lots of time on low mark questions

All questions are compulsory

The mark allocation for the individual questions on the paper are as follows

1(a) 4 marks

1(b) 6 marks

1(c) 10 marks

2(a) 4 marks

2(b) 6 marks

2(c) 10 marks

3 20 marks

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With most exam boards

The following are required to achieve a particular grade:

Grade A* - 90% = 72 marks

Grade A - 80% = 64 marks

Grade B - 70% = 56 marks

Grade C - 60% = 48 marks

Grade D - 50% = 40 marks

Grade E - 40% = 32 marks

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The pre-release material has 4 extracts:

Extract 1: Recession in the euro area economies 2008 – 2009

Extract 2: Portugal, Italy, Ireland, Greece and Spain – the PIIGS

Extract 3: The future of the Spanish economy

Extract 4: International trade, international trade negotiations and developing economies

A few general observations to assist examiners around my age

Write clearly and use black ink – Economics examiners are elderly and myopic

Never attempt to correct a diagram – clearly cross it out and draw it again

Draw diagrams neatly and large (you are not paying for the paper)

Always use a ruler/your debit card – it gives a better impression to the examiner

Questions will be drawn from all areas and you must be prepared using your knowledge gained from the course to answer them

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With essay type questions there are 5 levels

The paper is synoptic:

This means that you can be tested on anything you have done in economics

Level 4 (a) 16-20 marks – requires excellent analysis, evaluation and includes a final paragraph giving a judgement on the question asked

Level 4 (b) 11-15 marks - a balanced discussion of the question but without the level of evaluation & final judgement shown in 4(a)

Level 3 5-10 marks – some analysis but is likely to be weak and one sided

Level 2 3-4 marks – some application of knowledge and understanding of the question but lacking economic analysis

Level 1 1-2 marks - For limited knowledge and understanding

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The level achieved and the mark obtained within the level is determined by the quality of the answer as judged against 4 criteria

Markers are required to identify these criteria as they occur in the response

Criteria

Knowledge and Understanding (K) – of concepts, appropriate economic terminology, definitions and theories relevant to the Q

Application (Ap) –applying the data given in the texts to the economic theories, terminology, concepts relevant to the question

Application (Ap) in the essay Qs involves making reference to the experience of the UK, EU or world economies

Remember in the global paper you are supposed to have a knowledge of UK economic experience and performance over the past 10 years

Analysis (An) – this is where you build up your argument, explaining and developing your theories and arguments and proving a logical chain of reasoning leading to your conclusion

Diagrams and any formula constitute analysis

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Judgement/Evaluation (E) – here, you will look at alternative points of view or consider occasions/circumstances in which there may be different outcomes

In your evaluation you should make extensive use of words/phrases such as “as compared to”, “whereas”, “however”, “on the other hand”

Make comparisons explicit not implicit – an evaluative statement

E.g. “Whilst on the one hand UK membership of the Euro would reduce the risk to UK importers and exporters of exchange rate fluctuations it would mean that the UK would lose the valuable ability to control the domestic economy through adjustments to interest rates”

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To score a high mark – Levels 4 and

Answer the question set, not the question you wish had been set

All 4 criteria must be addressed to some extent

Good An and E applied to the Q and making use of the data provided is essential & you need to spend most time on questions that reward thi

Failure to provide evaluation/judgement will reduce your marks

Make extensive use of diagrams throughout – these will score high on An and enable you to present theories clearly and concisely

If in doubt of the relevance of a diagram put it in – you will not lose anything

Examiners use the phrase “evaluative tone” which applies to the overall presentation of an answer

It is better to provide E throughout your response (using the key words and phrases), rather than attempt all your E at the end

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To achieve the very highest marks the answer:

Should establish the underpinning theoretical framework at the outset

i.e. If the question asks for the factors affecting the UK exchange rate do not leap straight into a list of factors; instead point out that the ER is determined by the D for and S of £ and then explain how the factors you wish to discuss affect the value of the £, e.g. Exports will affect the demand for £

Must be balanced; it must look at both sides of the argument

Whilst it will not be expected that each side will be addressed in equal depth and at equal length there should be significant discussion of both sides

Should come to a conclusion which briefly summarises the issues/arguments and comes to a final judgement, preferably with reference to the data provided in the extracts

Don’t forget that your evaluation and judgement must be rooted in your analysis or it is only assertion and will not attract top marks

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How to apply the criteria

Assume the following question:

The Extract (lines 35-36) argues that 'a more ambitious set of common macro-economic policies would help speed recovery in the Eurozone'.

Using the data and your economic knowledge, assess the impact on the UK economy of recovery in the Eurozone as a whole. (25 marks)

“Macro economic policies are designed to...” (explain that they are designed to stabilise and increase GDP in the economy) (K)

“Recovery would mean closing the negative output gap..” (K)

“As Extract A indicates current macro policies have led to slower rates of growth” (Ap)

(Analysis could take many forms, e.g)

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The implications for economic growth

The impact on employment/unemployment – possible diagram to cover 1st two points

The consequences for the balance of payments on current account

The effects on the £/€ exchange rate

The greater likelihood of avoiding a period of deflation

The dangers of inflationary pressures building up

The further development of the SEM in a period of recovery and increasing prosperity

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Evaluation could come in the form of:

The possible significance of a slow recovery – could mention PIIGS at this stage

The possible supply problems if recovery is too rapid

Whether the UK can take advantage of EU recovery

Whether the advantage lies more with the rest of the EU in terms of exporting to the UK than for the UK exporting to the rest of the EU

The significance of EU recovery for the UK relative to recovery taking place elsewhere in the world, i.e. in markets which have significance for the UK

Whether or not recovery has implications for the movement of labour in and out of the UK and how this affects the UK labour market

Now provide a final conclusion/judgement which could be along the lines of:

Whether increased economic activity in the eurozone would or would not have A beneficial or negative effect

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Let us consider certain aspects of the pre-release material

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Recession in the Euro area economies

Introduction

Key terms:

Recession – 2 quarters ( 6 months) of negative growth – a diagram opportunity is presented

GDP

0Time

TrendActual

A

Z

X

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Convergence in economic cycles The lack of convergence of economic cycles means that countries in the Euro Area were not at the same stages of their business cycle - Boom Slowdown Recession Recovery

The problem faced by the European central bank – setting the Rate of interest (ROI)

This lack of convergence really gets to the heart of the problem of the PIIGSGDP

0Time

Convergence

Spain

Germany

Needs increasing ROI

Needs falling ROI

A

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Can the ROI set by the ECB be too low – yes/no – be prepared to defend either view

ECB sets nominal policy interest rate for Euro area as a whole

Clear target for price stability – annual rate of consumer price inflation of 2%

Asymmetric nature of ECB inflation target – a good analytical/evaluatory point

Rate of inflation in anyone countries will depend on where it is in their business cycle

Demand-led boom with ↑ wage costs will have a higher rate of inflation than a country experiencing slower growth and where cost-push inflationary pressures are lower

If inflation > ROI then real ROI is negative

Consider what policies a government should follow under these conditionsMeasuring economic convergenceUse of nominal – monetary- and structural – supply side indicators Nominal convergence indicators : Price inflation – the annual % change in the consumer price index Short term ROI – e.g. policy interest rates set by a nation’s central bank The size of the Budget deficit The level of the national debt Measures of exchange rate stability

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Real convergence indicators: Trend growth rate of GDP

Labour market - structural unemployment - NAIRU

Growth of labour productivity – i.e. output per person employed Trade balances - share of GDP taken up by trade

Capital investment as a share of GDP

Housing market - rates of home ownership and the size of the rented property sector Cost/price competitiveness - index of relative unit labour costs in manufacturing industry and annual changes in output prices

Importance of convergence Necessary to occur if the Eurozone is to be a optimal currency area (OCA)

A key point to consider here in any judgement is could the PIIGS have created convergence by following deflationary policies or would it have been politically impossible?

A case of government failure?

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While not specifically mentioned in the specification the theory of an Optimal Currency Area provides and analytical frame work through which to view the PIIGS

Remember you will not be penalised by examiners for having extra knowledge and understanding – just a lack of it

What is a OCA?

The following may help you to grasp the essentials:

A geographical region in which it would maximize economic efficiency to have the entire region share a single currency - where the benefits of a single currency outweigh the disadvantages

Assume Wales experiences an asymmetric shock (coal mines close down)

Causes recession in Welsh economy - ↑ unemployment ↓ inflation

As a separate entity Wales would ↓ ROI and depreciate its currency

But in reality unemployed Welsh workers can move to Midlands or London

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UK firms can invest in Wales to take advantage of lower labour costs and surplus labour

There are not many geographical barriers to moving between areas within the UK.

Now assume asymmetric shock in Greece:

More difficult for Greek workers to move to Germanylanguage barriersattachment to native countrypoor information regarding job availability etc

German firms would have much more reluctance to invest in Greece due to language difficulties and poor perception of the Greek work ethic and inappropriate fiscal policies

So there may be a difference between the UK and EU as a OCR as indicated below

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↑ unemployment in Wales - UK parliament would ↑ subsidies to Wales

How willing would German tax payers be to buy Greek bonds and bailout Greece

A further example considers The North American Free trade area - NAFTA

If California went bankrupt it would be bailed out by US federal aid

The US would be very reluctant to bail out Mexico if it went bankruptThe USA is an optimal currency areaMexico, US, and Canada, the North American Free Trade area is not

Consider where the Ezone fits

The criteria for a successful currency union are:1. Labour mobility across the region:

Physical ability to travel - visas, workers' rights, etc.

Lack of cultural barriers to free movement - such as different languages

Institutional arrangements - ability to have pension rights transferred In Eurozone, capital is mobile, labour mobility is low, when compared to US.

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2. Openness

Capital mobility and price and wage flexibility across the region Market forces automatically distribute money and goods to where they are needed

Does not work perfectly as there is no true wage flexibility in the Eurozone

3. Automatic fiscal transfer mechanism

To redistribute money to areas/sectors which have been adversely affected

Usually takes the form of taxation redistribution Politically difficult to implement - better-off regions rarely give up their revenue easily

Current EU arrangements ad-hoc and not built in

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4. Similar business cyclesAllows the central bank to promote growth in downturns and to contain inflation in booms

If business cycles do not converge then optimal monetary policy may diverge

Union participants may be made worse off under a joint central bank

Europe scores well on some of the measures characterising an OCA

Countries highly integrated - high % trade with fellow currency union members but:lower labour mobility than the United StatesCannot rely on fiscal federalism to smooth out regional economic disturbances May be an optimal currency area in Benelux countries and France and GermanyDifficult when including members such as the profligate Greeks, Italians and Irish

Key issue is the degree of geographical mobility, government intervention and degree of economic convergence

Be prepared to use this theory in your answer to questions – it provides a framework for analysis and an area for evaluation

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The OCR theory prompts the following question

How far do you agree with the view that countries that are not economically convergent should not be allowed inside the single currency area? 20 marks

Plan an answer

A currency union works best with a small cluster of highly integrated and similar countries

The reasons for keeping them outThe PIIGS have not exercised the same budgetary controlsDuring boom times they have run up huge fiscal deficitsThis has caused a loss of confidence among investors and speculators in international bond marketsPIIGS have seen the interest rates they pay on their loans rise sharplyGreece can no loner afford to borrow on the bond markets PIIGS are now forced to borrow form more fiscally prudent states & the IMF

Why should they be allowed to joinMet initial criteriaNot totally their fault – German economy saves rather than spends – limited national trade multiplier effectEuropean Commission should have exercised more oversightGiven the right policies convergence could occur

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Your evaluation could be along the lines of

How far the problem caused by the PIIGS is likely to affect support for the Euro

Whether exit from the zone would benefit the PIIGS or other members

Whether given current conditions there currencies can converge

These problems faced by the PIIGS have given rise to the concept of a 2 speed Euro area

You need to be conversant with this idea

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A two speed Euro area -

Variation in the average growth rates achieved by countries inside the currency union Some suffering years of slower growth & high unemployment & ↓ living standards PIIGS likely to continue to experience difficulties in ↓ fiscal deficits & ↓ increase in government debt

Why is this a problem for monetary union:

↓ standard of living in under-performing Euro Area countries

High and rising unemployment

Recession = ↓ tax revenues & huge ↑ budget deficits as a share of national income Sovereign debt crisis - emergency bail-outs from IMF & EU members

Deflationary conditions attached to the emergency financial support

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Brings about reductions in living standards for millions of people in these countries ↓ in public support for the Euro - threat to stability of the single currency system

No discussion of recession is complete without a consideration of the shape that it may take

The most outrageous example was probably given by the cartoonist in the mail who referred to “the dead cat bounce”

I shall limit my discussion to the idea of the “double dip”

The situation where an economy goes back into recession without achieving trend growth

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AD ↑ from AD- to AD1 and rises to FE level at AD but falls back to AD1

With the aid of a diagram explain the possible causes of a double dip recession

Price level

0

AS

FE

AD

AD1

X

AD-

Z Real output

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Possible causes of a double dip:

Another external economic shock – collapse in major overseas export markets

↓ consumer confidence – so ↓ consumption – unemployment; ↑ debt; ↓ house prices

↓ business confidence – negative expectations - production cut-backs; ↓ investment ↑ exchange rate - ↓ international competitiveness – ↑ Euro against the US dollar Govt. policy - e.g. tightening of policy too soon - ↑ ROI or ↓ fiscal stimulus - Japan

Inability to borrow – pressure from Bond markets forcing expenditure cut

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At this stage of the proceedings it may be as well to remind ourselves of the stages of integration in an endeavour to decide whether monetary union is a step too far

Knowledge of this area should assist with both analysis and evaluation

It also contains a number of diagrams that are extremely relevant

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Monetary union – common market with a single currency – a stage of integration

Economics Blocs – Stages of integration - you should be aware of these:

The degree of economic integration can be categorized into six stages:1. Preferential trading area2. Free Trade area3. Customs union4. Common Market5. Economic and monetary union6. Complete economic integration

1. Preferential trading area Gives preferential access to partcipating countries Done by reucing tariffs but not completely abolising them First stage of economic integration Line between PTA and free trade area blurred

2. Free Trade area – UK was a member of EFTA before it joined the EEC All members abolish tariffs with other members All members individually free to set external tariff with non-members Aim of FTA is so that trade can grow – specialisation – comparative advantage Leads to a problem known as trade deflection

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Trade Deflection:Free trade area leads trade deflection because of the differences in trade barriersDiagram above right shows four counties A, B, C, D in a free trade area All four trade with country E but all impose different tariffsLowest tariff imposed by A at 10% and the highest by D at 50%All exports from E will be directed into the area through A - tariff is the lowest Trade will be deflected to A - frustrates tariff policies of the other membersThey may introduce rules of origin so that tariffs can be charged on goods traded inside the area that originate from non member countries.

Trade deflection

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3. Customs unionFTA with a common external tariff Aim is to ↑ economic efficiency & closer political ties between the members

4. A common marketThis is acustoms union with common policies on: Product regulationFreedom of movement of the factors of production – capital labour enterprise

May lead to a single market - efforts made to remove barriers in terms of:Physical (borders)Technical (standards)Fiscal (taxes)

These barriers obstruct the freedom of movement of the four factors of productionRemoval of barriers requires political will and common economic policies

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Single market :

Full freedom of movement for all the factors of production ↑ efficientcy/ productivity

Very competitive environment, making the existence of monopolies more difficult

Inefficient companies will suffer a loss of market share and may have to close down

Efficient firms can benefit from economies of scale, ↑competitiveness and lower costs

Consumers benefit: Competitive environment brings cheaper products More efficient providers of products and also increased choice of products Businesses in competition will innovate to create new products

However membership of a single market brings both gains and losses:

1. Trade creation – you need to be able to construct & explain this diagram:

When ↑ trade results from the ↓ trade barriers like tariffs and quotas

Country buying goods from a low cost rather than a high cost country Consumers benefit because they are able to buy from a cheaper source

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Trade Creation

↑ in trade due to ↓/elimination of tariffs and quotas

0

Price

W1

Domesticdemand

Domestic supply

W

Price + tariff

Price minus tariff

E B A C Quantity

W1 – price before joining – Demand OA supply OB

W price after joining – Demand ↑ to OC supply ↓ to OE

Trade creation EB + AC

Before I go any further make sure you can explain the important areas on the diagram

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As a result of membership there are certain losses – it is not all sweetness and light!

The problem of Trade diversion:

Country has to buy from high cost rather than low cost producer

UK before it joined the EU bought food buy from low cost producers

After entry + common external tariff - cheaper to buy food from other EU countries

The higher the tariffs imposed before entry more likely that trade creation rather than trade diversion will take place

Net gains will tend to be larger, the greater the volume of trade between the countries in the common market

You need to be able to construct the diagram and fully explain it

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Trade diversion

↑ in prices as producers in common market less efficient

0

Price

Domesticdemand

Domestic supply

EB AC Quantity

EU price

World price

At world price demand OA and supply OB

Price ↑ demand ↓ to OC supply ↑ to OE

Explanation of the effects will complement the diagram and increase the marks

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Other areas to consider as a result of joining a single market

Economies of scale:Dynamic gains - occur over time - result from the economies of scale

Major reason for entry - size of the potential market - economies of scale

European Union has 430 million inhabitants compared to 57 million for the UK

Single market ↑cross border mergers to exploit the economies of scale

EU fairly homogenous and rich market - similar high income EOD products

Competition:Domestic industries will face greater competition

↑ competition → dynamic efficiencies - innovation, reduced costs, reduced prices Gains in productive and allocative efficiency

Danger of oligopolistic control occurs through cross border mergers

Competition Commissioner has enforced competition policy

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Transfers of resources:

Contributions may be spent on an area that does not directly benefit the contributor e.g. the UK and the common agricultural policy

Net transfer of resources = static losses and gains

Dynamic economies - attract inflows of capital and labour making them more dynamic

Customs unions - not as efficient as world wide free trade

Single market - negative impact on some sectors due to ↑ international competition

Your job in a question would be to decide whether the benefits outweigh the disadvantages

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5. Economic and monetary union – a single market with a common currency

Given that you have seen the problems of EMU you might like to consider whether integration should have stopped with a single market

The final stage of integration

6. Complete economic integration

Integrated units have no control of economic policy:

Full monetary union

Fiscal policy harmonisation

Economic integration most common within countries - rather than within supranational institutions

So a question for you to plan is

Assess the view that Europe should have remained a free trade area rather than embracing monetary union

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There are a number of areas that you can analyse and evaluate

Free trade area:All members abolish tariffs with other members

Trade between the members would flourish – benefits of EOS, MES, specialisation

comparative advantage – trade creation diagram could be drawn

All members individually free to set external tariff with non-members

Countries could impose tariffs against external countries where trade diversion was taking place

Possible danger of trade deflection but remedied by rules of origin

No loss of monetary control

Central bank free to set optimum ROI for the country

Enables currency to float in accordance with market forces

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Monetary union – a single market with a common currency

Advantages

Price transparency -make price comparison easier may lead to ↓ prices

↑ FDI due to ↑ currency stability & increased potential market size

Potentially ↓ ROI, ↓ Govt interference, credible commitment to low inflation

But :Loss of an independent monetary policy

Inability to choose a different short term inflation/unemployment trade off

Inability to react to country specific economic shocks

'Real' misalignment

Asymmetric policy sensitivity

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Evaluation

PIIGS could have made it work using appropriate fiscal policies

Given that its an un-optimal currency area – can it work?

Deficit countries likely to struggle along with grudging help from surplus countries

Would an independent monetary policy solve their problems

Lets look at the PIIGS problems in more detail

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The potential costs of a Single currency to the PIIGS Loss of an independent monetary policy

Members pass control of monetary policy to the European Central Bank

ECB would set ROI for area as whole rather than for any one country within the EMU

This has several implications:

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Effectively the ROI was too low leading to rapid increase in short run economic growth

Fig 3 AD/AS and growth

Trend growth = full employment (FE)

Growth below trend: A negative output gap – AD1 Economy is inside the PPB ↑ in C+I+G+(X-M) shift AD1 to AD

Growth above trend: Positive output gap –AD2 Inflation increasing ECB ROI to low for PIIGS

Price level

Real output0

AS

FE

AD

AD1

AD2

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Normally increased inflation would lead to a depreciation of the currency

But in the Euro Area, a country with a relatively high rate of inflation cannot expect a depreciation of their exchange rate to restore lost competitiveness

The PIIGS should have run a deflationary fiscal policy when AD was ↑ too rapidly

They will have to achieve this in other ways such as a better supply-side of the economy or lower wages

Part of their decline in competitiveness stems from these economies having a ‘fixed’ exchange rate against other members of the euro area.

If the PIIGS had their own currency, they could let the value fall to a level that would make the country's tradable goods sectors competitive.

Evaluate the view that PIIGS economic performance would improve by a currency devaluation and leaving the Euro Area (20)

What issues could be considered and analysed in answer to this question

Need to reduce wage costs to compete with Germany

Rather than facing trade union anger over continuous wage deflation devaluation might be preferable

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Price of $’s in Euros

D & S of $’s

Demand for $

Supply of $’s

1 D1 for $’s

S1 of $’s

2

0

Equilibrium where $1 = €1

↑ price of UK goods →↓ US demand and ↓ supply of $’s – S-S1

PIIGS import more of the relatively cheaper US goods - demand for $’s ↑ - D-D1

↓ supply of $’s and ↑ in demand →↑ in the price of $s

The overall effect of these changes is that the dollar has appreciated to $1 = €2.

How inflation would depreciate the value of a currency

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The effect of the inflation

Depreciation of the €, PIIGS exports have become cheaper and imports dearer

Less revenue is received from the sale of exports, as they have fallen in price

Terms of trade move against the PIIGS

Overall depreciation should benefits the PIIGS - Marshall-Lerner condition

BOP will benefit - the depreciation will lead to ↑ inflationary pressure in the PIIGS Could lead to a rising inflationary spiral – could they control it

If prices are forced up the benefits of the initial depreciation will be lost

The need for spare capacity

Considerations to bear in mind when using devaluation as a policy weapon:Cost push inflation - ↓ £ → ↑ price of imports – food, raw materials, fuelJ-curve effect

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Fig 12 - The J-Curve

Following devaluation the account will get worse before it gets better

Takes time for foreign buyers to realise PIIGS goods are cheaper and ↑ expenditure

Long term contracts fix prices

Short run - volume of exports remain the same and less will be spent on them

More will be spent on imports until consumers find substitutes

The short run demand for exports and imports will tend to be inelastic

0

BOP +

BOP -

Time

J

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2. Other policy options by using supply side measures – outlined later

Second part of question – leaving the Euro area

Advantages

Regain monetary independence

Avoid years of grinding wage deflation to reduce unit labour costs

Bring wage costs into line with workers productivity

But:

Euro took years to introduce

PIIGS central banks would have to introduce new notes and coin FAST

Bank runs as depositors shift money abroad to avoid losses – caps on withdrawal

Cut off from foreign credit – banks would be reluctant to lend until currency stable

Legal challenges – depositors with large losses might sue as in Argentina

Foreign banks and pension funds would suffer effective default

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Evaluation/judgement

Will the depreciation set off inflationary pressures that PIIGS are unable or unwilling to contain or will there be a rising inflationary spiral given the power of trade unions

Will the increased inflation wipe out the benefits of the initial depreciation

Will the country be likely to increase welfare benefits as imported food prices increase

Long run versus short run – how long will it take for the J curve effect to produce a surplus balance

Are all the PIIGS able to benefit from increased international trade as opposed to the loss of intra community trade that they will suffer?

Would costs of leaving Euro be greater than benefits

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What unites these five economies is a loss in competitiveness compared to the rest of the euro area and to economies outside the euro area.

2 measures of competitiveness

↑ output prices feeds through to ↑ retail prices

↑ in relative unit labour costs

Both show a decline in the competitiveness of the PIIGS

Why

ECB unable to set a rate that controlled inflation throughout the zone

High relative rate of inflation can lead to a loss of competitiveness for a country:

Export sectors get priced out of market

Imported goods relatively cheaper taking a rising share of consumer demand

Causes of increases in producer prices

1. The exchange rate

2. Changes in indirect taxes

3. Changes in international commodity prices

4. Changes in wage costs

5. The strength of demand and the economic cycle

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Unit labour costs - labour costs per unit of production

Two factors determine changes in this measure 1. The rate of increase in average wages / earnings in the labour market

2. The rate of increase in labour productivity (i.e. output per worker employed)

If wages rise by 5% & productivity ↑ 2% unit labour costs will rise by 3% Relative unit labour costs - relative to those of another country Depreciation of £ against € makes UK relative labour costs cheaper than they were

↑ relative unit labour costs - indicator of a ↓ cost competitiveness within Euro Area

The data in Fig 2.3 shows ↑ in relative costs led to ↑ in the size of their trade deficits in the years before the global financial crisis

How do these countries reduce their relative costs↓ average wages - pay freeze or an actual cut in their wages and take home pay ↑ productivity – improve labour efficiency

Using a diagram analyse the likely effects of an increase in output prices and labour costs 6 marks – Don’t forget this is cost push inflation

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↑ labour costs and output prices are likely to create cost push inflation

SRAS shifted left leading to a higher level of prices and a lower level of output

Possibly shifting the economy to a negative output gap - ↑unemployment & ↓GDP

Cost push inflation

Supply side pressure

Price level

Real output

P

0

AD

P1

A B

SRAS

SRAS1

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Extract 3 – The Spanish economy

Numerous problems

1. Collapse of construction bubble leading to ↑ unemployment - huge numbers of people directly & indirectly involved in

construction

Banks exposed to property sector as they hold unsaleable property as collateral

Spanish government encouraging banking mergers

Negative accelerator effects

Negative multiplier effects – far reaching effects – migration

Unbalanced economy - Dependence on tourism/property = derived demand from rest of Europe

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2. Very high level of welfare payments

60% of their previous wage for 18 months after losing their job

Guaranteed benefits of €420 per month for the long-term unemployed

Pensions far more generous than UK

Help to newly married €250 per month for 5 years

Welfare benefits and the rate of unemployment

Replacement ratio – % of Y replaced by benefits when unemployed

2/3rds wage for 18 months

Disincentive effect on working

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Effect on incentives to actively search for work

↑ voluntary unemployment – make sure you know what this is

↑ frictional unemployment – don’t need to take first job to come along

↑ structural unemployment – no rush to retrain or move to where jobs are

Social consequences of ↑ unemployment

Estimated 40% of under 25’s

20% of working population

↑ relative poverty if no wage earner

↑ social unrest - loss of social cohesion damaging the fabric of society

↑ in unemployment-related crime ↑ stress related health problems and family breakdown

↑ social costs of rising level of debt – hits poor high rates

Failure of labour market = ↑ negative externalities

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3. Product market reforms urgently needed especially in utility industries

Lack of contestability allows high costs and prices

↑ costs of living for consumers and output costs for producers

Fiscal costs of recession

1. ↓ tax receipts

2. ↑ benefit expenditure

3. Fiscal stimulus

1+2+3 = very large and growing budget deficit

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Large budget deficits incurred by the PIIGS have increased their economic problems

Evaluate the view that governments should always balance their budgets

Explanation of term budget balance and the stance a government might take:

Neutral fiscal stance is where the government runs a balanced budget

Expansionary fiscal policy government uses a budget deficit (G>T) to ↑ AD

Contractionary/deflationary fiscal policy - budget surplus (G<T) to ↓AD Influencing the level of AD in the economy is referred to as demand management

Governments do this to smooth out fluctuations in the economic cycle

Automatic stabilisers – the cyclical deficit

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Auto stabilisers should balance out over the duration of the cycle

Spain - large welfare state, big public sector as % total GDP automatic stabilisers have ↓ impact of the recession on her GDP

GDP

Time

TrendActual

Govt,Y from tax increasingGovt. expenditure on benefits falling= Cyclical surplus

Govt Y from tax decreasingGovt. expenditure on benefits increasingCyclical deficit

0

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In the past, governments attempted ‘fine-tuning:

∆ government spending/taxation, to make precise adjustments to the level of AD

Governments now accept that fiscal policy cannot be used so precisely

Automatic stabilisers adjust automatically to minimise fluctuations in the economic cycle - e.g. spending on unemployment benefits fall when economic activity is buoyant

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Structural budget deficit

Structural budget deficit - changes in the structure of economic activity or govt. policy

↑govt. expenditure due to lax policies when economy expanding

↑numbers dependent on welfare benefits

↑ structural deficit implies ↑ taxes and/or reduce public spending

Public sector net cash requirement (PSNCR) - government spending > revenue

To finance the gap between revenue and spending government ↑borrowing

↑Govt, structural deficit may mean less available for fiscal stimulus

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Auto stabilisers take AD- to AD

Fiscal stimulus required to get from AD to AD1

If government has a large structural deficit may not be able to afford the stimulus

Govts. that ↑ the structural deficit in times of boom are risking problems when the economy contracts

Price level

Real output

AS

AD-

AD

FE

AD1

0

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Don’t forget that governments might not easily be able to reduce a cyclical deficit

A large Structural deficit and an ↑cyclical deficit may present them with the following problems: 1 Financing the deficit -substantial interest payments which will be a leakage - Oflow 2 government borrowing ↑ National Debt - spend more in debt interest payments

3 Fiscal ‘crowding-out ↑ budget deficit leads to higher interest rates and taxationreduces private sector expenditure - consumption and investment spending ↓

Contrast this with the benefits of a budget deficit

1 A stimulus to growth:Crowding inAdditional capital spending, roads/schools ↑ LRASCan boost the long-run supply-side capacity of the economy

2 Demand management - ↑ aggregate demand, avoiding a large negative output gap.

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Evaluation points:

Will a cyclical deficits/surpluses balance over the period of the cycle

Risk that governments will ↑ handouts in good times leading to ↑ structural deficits

Re- election may be more important than sound economic policy – govt. failure

Possible damage to supply side of the economy of increasing benefits

Opportunity costs of increasing PSNCR

Problems with Bond markets and increasing national debt

Will deficit benefit the supply side or just increase AD

Short run effects versus long run effects

Perhaps a final judgement that the deficit has helped prevent a worse depression but has left PIIGS with huge deficits to manage

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Spain has had to introduce a period of fiscal austerity to ↓ their budget deficit

Retirement age has risen to 67 from 65

↓ government spending - wage cuts for civil servants and frozen welfare payments

make it easier to lay off employees and reduce redundancy packages.

Spain urgently needs to increase its LRAS – its trend growth rateThis means labour market reforms to improve efficiency of factor marketsProduct market reforms – where there is a lack of competition & contestability

Aims of supply-side policies↑ supply and efficiency of labour↑ skills of the labour force – investment in human capital↑ mobility of labour – geographical & occupationalRemove barriers that stop wages reaching equilibrium levels – reduce TU poweEncourage flexible working practices

What are the policies1. Labour market measures:

Lower rates of income tax - create incentives to work

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Supply-side economists argue:

high income tax rates create disincentives to worknegative impacts on national income and the government’s total tax revenueThis effect is illustrated by the Laffer Curve

Tax revenue is maximised at 35 %↑ in the average tax rate has a negative effect on total tax revenue

Government income from tax

% of Y taken in tax0 10070

A

35

B

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↓ benefit payments to make voluntary unemployment less affordable

Welfare benefits can also be made more difficult to claim

Tax relief on Y from renting out accommodation - ↑geographical mobility

Welfare to work strategy to ↑ levels of employment and participation

National Minimum Wage to ↑ incentives to supply labour rather than live off benefits

2. Education and trainingTo increasing the productivity of labour

Should ↑ LRAS & ↓. unit labour cost per unit of output ↑ international competitiveness.

3. Trade union reforms TU’s –↑ the wages of their members by restricting the supply of workers↑ labour costs ↓ efficiency & market flexibility ↓ international competitiveness

4. Reform employment laws↓ govt. regulation of labour market to lower non-wage costs of employing workersEncourage short term contracts and part time labourEncourage profit related payEncourage employee share ownership

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5. Product market measures

Supply-side policies in product markets to ↑competition and efficiency

Private ownership of formerly public owned organisations:

Leads to greater productive efficiency

Reduced drain on the public purse

Deregulation: This is very important for Spainremoval of barriers to entry in an industry

Creates competitive markets where there had previously been a state monopoly

Contracting out the delivery of public services

Opening up of capital markets

Removal of barriers to the flow of capital

EU single market measures

Improving consumer information

Tougher competition policy

Forces firms to be more dynamically efficient

Reduces the ability of firms to abuse a dominant market position

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6. Measures to encourage entrepreneurship and capital spending:Loan guarantees for new start-ups

Reducing rates of corporation tax for small businesses

Allowing tax relief on profits used for investment purposes

Regional policy assistance in depressed areas

7. Policies to encourage enterprise↓ taxation & govt. spending

↓ corporation tax to increase investment

Incentives to encourage FDI

Encouraging business start ups

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Consequences of policies

Boost long term growth

↑ prosperity in long run

Helps to achieve all macro-economic objectives simultaneously

↑ employment

↓ cost push inflation by increasing efficiency

↑international competitiveness

We can show the effects of these policies diagrammatically but remember they take time to have an effect

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Supply-side growth and macroeconomic policy objectivesSupply-side growth offers the possibility of: steady, non-inflationary, sustainable growth - improvement in the current account inflation and current account problems under control even if AD rising

LRAS – LRAS1 national income rises from OA to OBGovt can allow AD to ↑ without creating inflationary pressure

Price level

Real output

LRAS

AD

0

P1

LRAS1

P

AD1

A B

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An alternative diagram

↑ AD from AD to AD1 ↑ inflation PL to PL1

A supply side increase allows ↑ real output with lower prices PL-

Price level

Real output

AS

FE

AD-

AD

AD1AS1

PL

PL1

PL-

Fe10

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In a rapidly-changing world there needs to be a high level of flexibility as patterns of demand change bringing about changes in the pattern of employment

Analyse the determinants of a flexible labour market – 6 marks

Labour market flexibility↓ natural rate as labour moves from declining industries to growing industries

Labour markets need to - adapt to change, respond to economic signals created by wage differentials

Flexible labour market characterised by:

Mobility of labour - adaptable, capable of learning new skill

Training and retraining opportunities must be availableMust be possible for employers to hire people with the skills they needLabour force must have good basic educational foundations Employers must be able to get rid of workers Employment protection laws but make employers less likely to hire in the first place

Short term contracts - workers able and willing to adapt to employers requirements.

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Labour market rigiditiesUK labour markets more flexible than EuropeLess employment protectionUnemployment benefits last for only a short time so incentive to work greaterMore inequality in the UK income distribution Characteristics of inflexible labour markets :-

Employment protection legislation

Generous unemployment benefits - reduce the incentive to work Relatively high minimum wages

Trade unions powerful↑ wages above their free market equilibrium level negotiate binding contracts, which may discourage employment

Structural unemployment caused by occupational and geographical immobility of labour

Workers in jobs for which they are not best suited

Disincentives to look for and take paid work – unemployment & poverty traps

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Competition and contestability

Make sure you understand some of the features and characteristics of a contestable market:

1. Low entry barriers and exit costs which affects the ease of short-term “hit and run

entry”

2. High levels of product differentiation between competing businesses and brands

3. The ability to price discriminate – charging different prices to different consumers for the same products

4. The cost structure of a market such that the minimum efficient scale is not a large percentage of market demand allowing many firms to enter and be competitive

5. There is interdependence between firms (similar to a competitive oligopoly)

Barriers to market contestability exist when there are sunk costs. These are costs that have been committed by a business cannot be recovered once a firm has entered the industry

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Extract 4 – Pascal Lamy emphasises the importance of international trade

Free Trade and Protection

Free trade – absence of protection - based on Comparative Advantage

Worlds’ resources used more efficiently when countries specialise in producing those goods and services in which they have a comparative advantage

Comparative advantage – opportunity cost of producing the good in one country is less than elsewhere

Benefits obtained by importing from countries where the opportunity cost is lower

Concentrating on exporting something in which a country has a comparative advantage

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Worldwide specialisation based on comparative advantage = efficient resource use Competition/economies of scale should lead to dynamic efficiencies Theory states that countries should specialise in the production of those goods where they have the greatest comparative advantage, or least comparative disadvantage

Assume 2 areas Europe and Australia, both producing food and clothing. Australia EuropeProduct units per hour units per hourfood 6 2 clothing 3 1.5

Australia produces more of both goods in less time - has an absolute advantage

Benefits of Trade Australia Europe

Product units per hour units per hourFood 6 3Clothing 4.5 1.5

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Case for trade - all countries taken together will gain in terms of increased production, economic efficiency, and welfare

No guarantee gains equally distributed some countries may feel that it is their interest to restrict trade

Arguments for protectionThe infant industry argument

Cushion home employment

Prevent dumping - anti dumping measure may be a technique of protection

Improve Balance of payments

Protect employment levels Avoid "unfair" competition – NIC’s exploit labour by paying low wages

Arguments against protection. Retaliation - reduces world trade to the detriment of all

Props up inefficient producers’ - do not face efficient competition

Welfare loss to consumers

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World price before tariff is OP domestic demand OC domestic supply OB

Tariff ↑ price increases to P+T domestic demand ↓ to OA domestic output ↑ to OE

Imports ↓ from BC to EA Total consumer welfare has fallen by P, P+T,F,G

Domestic suppliers gain P,P+T,H,J at the expense of consumers

HFKL represents the revenue from the tariff – the amount imported times the price

Net loss - triangles JHL and FGK - tariff has reduced welfare as a whole

Fig 5 Welfare loss

Price

Quantity

Domestic demand

Domestic supply

World price

0

P

P+TTariff price

CB E A

J

H

L

F

KG

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The rise of protectionism Where govts to impose restrictions on trade in goods and servicesAim is to cushion domestic businesses and industries from overseas competition

Types. Tariffs - a tax that ↑ price of imports

Quotas - quantitative limits on the level of imports allowed Voluntary Export Restraint - two countries make an agreement to limit the volume of their exports to one another over an agreed period of time Embargoes - a total ban on imported goods Intellectual property laws (patents and copyrights) Preferential state procurement policies –govt. favours local/domestic producers Export subsidies - ↓costs of domestic producers – dumping

Domestic subsidies – to loss makers - car manufacturers or loss-making airlines Import licensing - governments grants importers the license to import goods

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Exchange controls - limiting foreign exchange that can move between countries.

Financial protectionism – credit crunch – banks prioritise loans to domestic business

Competitive devaluations - government intervenes to keep currency artificially low

Be ready to make a judgement on the arguments for and against protection for any particular country

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International Organisations

The World Trade Organisation (WTO)WTO - global international organisation dealing with the rules of trade between nations

WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments

Aim is to ↓ tariffs and other types of protection through “rounds” where countries try to agree to reduce tariff levels

To help producers of goods/services, exporters/importers conduct their business

Multi-lateral agreements using the principle of “most favoured nation status”

If a country agrees a tariff reduction with one country it has to accept the reduction with all others

This can be contrasted with bi-lateral agreements where the country only agrees trading terms with another country and does not extend it to others

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Main functions of the WTO are:

To oversee implementing and administering WTO agreements

To provide a forum for negotiations To provide a dispute settlement mechanism

The goals behind these functions are:

Raising standards of living Ensuring full employment Ensuring large and steadily growing real incomes and demand

Expanding the production of and trade in goods and services These objectives are to be achieved while allowing for the optimal use of the world's resources in accordance with the objective of sustainable development, and while seeking to protect and preserve the environment

The preamble also specifically mentions the need to assist developing countries, especially the least developed countries, secure a growing share of international trade

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Multi-lateral agreements

Ensure consumers/producers security of supply

Exporters know that foreign markets will remain open to them

WTO decisions taken by consensus - ratified by members' parliaments

Agreements = legal ground-rules for international commerce - contracts, guaranteeing member countries important trade rights

Bind governments to keep their trade policies within agreed limits to everybody’s benefit

Trade friction is channelled into the WTO's dispute settlement process

Under certain circumstances countries may retaliate & resort to protection

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Criticism of the WTO:

Protestors argue WTO is secretive and influenced by big MNC’s

TU’s - WTO rules enforce imports from countries with lower health/safety standards MNC’s- can move their capital leading to job loss in developed countries

Agricultural conglomerates are forcing small local based farmers out of business

Indigenous people too are being forced off their land

WTO - forced members to repeal laws that limit the free movement of capital Developed countries hypocrisy:

WTO ↓ tariff and non-tariff barriers on manufactured goods – goods that the developing countries have absolute advantages in producing

Goods LDC’s mainly produce are heavily protected by tariffs and subsidies

WTO not reformed tariffs/subsidies that protect farmers in developed countries - CAP

MNC’s use WTO rules to close pirate operations in LDC’s - life saving drugs

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More possible questions

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Examine the view that the benefits of monetary union outweigh the disadvantages – 20 marks

Introduction

EMU - step on the road to a US of Europe - single currency - ECB

Number of elements to EMU:

1. Independent central bank - regulates the ROI and monetary policy Lender of last resort for the European banking system Criticised as over secretive - minutes of meetings are not published.

2. Euro, which is now the sole operational currency.

3. Growth and Stability Pact limited the budget deficit to 3% of GDP

AnalysisThe potential benefits of a single currency: Reduced transaction costs

Reduced exchange rate uncertainty Increased intra-EMU competition – enlarged market

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Increased volume of sales

Further economies of scale

Increased inward direct investment

Lower interest rates

Rise in competition & competitiveness

Lower costs

Higher productivity

Increased growth, employment & income

Improvement in the supply side

End to competitive devaluation

Greater price transparency

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The potential costs of a Single currency Loss of an independent monetary policy

Unable to devalue to maintain competitiveness

Pass control of monetary policy to the European Central Bank

Loss of power to choose a different short term inflation/unemployment trade off

Inability to react to country specific economic shocks – inflexible labour markets

Loss of exchange rate control

'Real' misalignment - economic development too low to maintain a single currency Asymmetric policy sensitivity – UK and mortgages

Too deflationary – The ECB has adopted a target inflation rate of < 2% HICP

ECB is slower to react to falling growth rates than the BOE or the Federal Reserve

Lack of economic convergence – UK's economic cycle does not match Europe's Stability and Growth Pact – difficult if the economy moves into a deep recession

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The problem of mis-alignment

Straight line shows desired economic convergence

The trade cycles are shown as horizontally opposed

UK in recession while Euroland in boom - different monetary policies are appropriate

0

GDP

Euroland

UK

Time

91

Evaluation/judgement:

Costs greater where:

there is a lack of economic convergence

Countries suffer differently from asymmetric shocks

There is a lack of flexibility & mobility in factor markets

Concern that the Euro area is not an optimal currency area

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Comment on the extent to which “the positive impact of national stimulus packages is at best temporary” (Extract 4) (10)

Type of stimulus package is introduced – for example:

Temporary scrappage schemes - cars, boilers and other consumer durables

Temporary cuts in direct or indirect taxation for example a reduction in VAT

Temporary increases in state sector spending – labour subsidies – Germany

Whether government finances will allow continued stimulus

Whether the multiplier effect is strong – depending on:

Type of stimulus - Tax cuts or higher government spending? Who benefits from tax reductions

What consumers do with income from tax cuts

Credit crunch – can firms borrow to take advantage of increasing national income

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Will the budget deficit lead to a Balance of payments deficit where money flows out

If budget deficit increases will central bank increase the ROI

Is there spare capacity in the economy (size of the output gap)

Expectations on consumers and businesses

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6. Comment on the extent to which a reduction in global trade barriers in manufacturing and agricultural goods can help a developing country (10)

Introduction

Explanation of global trade barriers

Reasons for global barriers

Both developed and undeveloped countries use barriers

Benefits of free international trade & their limitations

Terms of trade

Analysis

Diagram of tariff barriers

Numerical example of benefits of free trade

Outline the problems that the country might incur - ↑ unemployment ↑ BoP deficit

Evaluation

Are advantages > costs

May depend on individual circumstances of the country

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Analyse the benefits of having a fixed rather than a floating exchange rate (6)

Advantages of fixed rates:Business knows - price they will receive from exports and price of raw materials Government has to follow economic policies that will maintain the fixed rateLimit the fluctuations of the trade cycle - countries cant gain by depreciating

Disadvantages of fixed rates:Need periodic revision - some countries need to devalue while others to revalue Government might need to run a perpetual deflationary policy - ↓growth Speculation - countries that have persistent BOP deficits

Advantages of floating rates:Market system - the Forex market changes the rates automaticallyContinuous adjustment - reflects purchasing power of one currency against anotherReduced speculative pressure, as countries cannot be forced to devalue

Disadvantages of floating rates :No guarantee floating rate will solve Balance of Payments problems - PEOD Effect on domestic inflation - when the currency depreciates Currency appreciation - exports dearer - imports cheaper – deindustrialisationUncertainty - Since the removal of exchange controls massive capital flows can occur