Greece
Bailouts
Greece was the first eurozone country to require a bailout, receiving 110bn euros last may from the IMF and the EU. It may also require another bailout, with talks of a figure around 172bn being required for the second rescue package. This second bailout is a rather contentious issue however, with Germany and the ECB disagreeing on the requirements that will have to be met in order for Greece to receive the aid.
Reasons for the bailouts
The biggest problem for the Greek government is that of tax evasion leading to a high budget deficit and therefore high overall debt. One in three Greeks are regularly evading tax, and the government's budget deficit is around 22m euros annually; interestingly around the same amount that the government is losing in tax revenue due to the high levels of evasion.
Another of the problems was that Greece were effectively lying about the levels of debt they had, meaning that the EU authorities didn't know how severe their problem was, and so by the time they were made aware it was too late. This calls for a reform of the way in which government deficits are measured and the transparency of the government's budget condition.
Ireland
Bailouts
Ireland took 85bn euros last year from the EU and the IMF. It has also had a total of 5 bank bailouts, and there is a risk of default if the banking sector doesn't stabilise.
Reasons for bailouts
Ireland had the highest levels of growth out of any EU country before the recession, and it fell the hardest (as shown in fig 2.1 of the extract). One argument as to why Ireland was hit so hard in the global recession is that it did not have any sort of control over monetary policy or its exchange rate. While it is true that this should affect all EU countries, Ireland was growing much faster than them so the effects were more pronounced.
Portugal
Bailouts
Portugal has already been bailed out.. (I think.. It seems hard to find out about..) and there is talk of a second one being needed, despite claims for a long time by the Portuguese that it wouldn't be necessary.
Reasons
One of the reasons Portugal has experienced a worse downturn than most in the global recession is due to the condition in the economy of its main trading parter (Spain). This only goes part-way to explaining the problem, another reason would be the reliance on tourism; the demand for which has fallen sharply in the recession as it is a luxury item that people don't feel they need when their incomes fall.
Spain
Bailouts
Spain has yet to be bailed out, despite fears that it may need one in the future, and despite the recent poor economic performance. One of the major fears of the EU is that they probably couldn't afford to bail out an economy as big as Spain's.
Potential reasons
The reasons why Spain may require a bailout are not to do with bad governance, more to do with bad luck (as well as over-reliance on certain sectors). It was thought that more than 1/10 Spanish people were employed in the construction sector, and another large proportion were employed in the tourism industry; both of which were hit hard by the recession for the same reasons as Portugal's tourism sector - it's heavily income-elastic.
Also, Portugal's worsening economy is doing Spain no favours.
Italy
Bailouts
None yet, and the Italian government are adamant that they will not be needing one.
Possible reasons
Italy, like the rest of the PIIGS, is suffering from reduced levels of international competitiveness. It also has a high tourism sector, just like Spain, and the president has freely admitted that the aim of achieving the target of "zero percent deficit and GDP ratio" looks a "long way off"
EDIT: Here's an interesting link I was shown by a friend:
http://www.economist.com/node/18836230
It highlights some of the problems, especially with Greece, and goes into more detail about the bailouts
Wednesday, 15 June 2011
Tuesday, 7 June 2011
Supply-side policies.
I'm going to be doing a list of every supply-side policy (that I can think of) with brief analysis and one evaluative comment.
Education increases the adaptability of the workforce, making labour markets more flexible by improving the transferable skills of the workers.
But it is very costly to implement, and comes with a time-lag. Also any effects on AS depend on the quality of the education provided.
Training raises the MRP (or productivity) of each worker, increasing AS by reducing unit labour costs as well as increasing output.
But it suffers from similar problems to education, it is quite expensive, and the time-delay means that there's a chance that once the workers have been fully trained may no longer be needed (example: people trained to write in shorthand, just before technology replaced it.)
Subsidies can be used to increase the productivity of firms, or help increase their price competitiveness by paying a part of the cost of production (thus increasing AS).
But it may lead to a dependence of the firms on the subsidies, which makes them inefficient.
Reducing trade union power helps to reduce the levels of bargaining power that workers have over employers, which makes labour markets more flexible as firms can hire and fire workers when necessary without fear of repercussions.
But many people would argue it's not fair for workers, and may reduce their productivity (as they could get depressed or less motivated to work if they feel their employer is exploiting them).
Reducing import tariffs, especially of raw materials. This would have the effect of reducing the costs of production for firms.
But there was probably a reason the tariffs were there in the first place, perhaps to improve the balance of trade, which would worsen, as imports would increase (providing they are price-elastic).
Reducing unemployment benefits should help reduce unemployment (through the unemployment trap).
But it may reduce consumption.
Improving transport infrastructure would improve labour mobility and reduce transport costs to firms.
But it's costly and can take a long time.
While there are more, these are the first ones that came to my head.. Lots of the other ones have rather boring evaluative comments.. "time lag, high cost"...
Education increases the adaptability of the workforce, making labour markets more flexible by improving the transferable skills of the workers.
But it is very costly to implement, and comes with a time-lag. Also any effects on AS depend on the quality of the education provided.
Training raises the MRP (or productivity) of each worker, increasing AS by reducing unit labour costs as well as increasing output.
But it suffers from similar problems to education, it is quite expensive, and the time-delay means that there's a chance that once the workers have been fully trained may no longer be needed (example: people trained to write in shorthand, just before technology replaced it.)
Subsidies can be used to increase the productivity of firms, or help increase their price competitiveness by paying a part of the cost of production (thus increasing AS).
But it may lead to a dependence of the firms on the subsidies, which makes them inefficient.
Reducing trade union power helps to reduce the levels of bargaining power that workers have over employers, which makes labour markets more flexible as firms can hire and fire workers when necessary without fear of repercussions.
But many people would argue it's not fair for workers, and may reduce their productivity (as they could get depressed or less motivated to work if they feel their employer is exploiting them).
Reducing import tariffs, especially of raw materials. This would have the effect of reducing the costs of production for firms.
But there was probably a reason the tariffs were there in the first place, perhaps to improve the balance of trade, which would worsen, as imports would increase (providing they are price-elastic).
Reducing unemployment benefits should help reduce unemployment (through the unemployment trap).
But it may reduce consumption.
Improving transport infrastructure would improve labour mobility and reduce transport costs to firms.
But it's costly and can take a long time.
While there are more, these are the first ones that came to my head.. Lots of the other ones have rather boring evaluative comments.. "time lag, high cost"...
Sunday, 5 June 2011
Why is Spain’s generous welfare system seen as a problem?
The extract mentions that Spain, fearing the social consequences of high unemployment as a result of the recession, has opted to increase unemployment benefits. This means that annual government spending on unemployment benefits now account for over 3% of Spain's total GDP. That figure is huge when put in context; especially when we consider that the stability and growth pact (as discussed in an earlier post) allows no more than a 3% total spending deficit annually.
This is certainly seen as a rather large problem, as high levels of government spending are difficult to sustain, as they have to be financed with lots of borrowing. Similarly, the money could be spent on something else, such as healthcare (opportunity cost is a common criticism of any government spending).
Furthermore, a generous welfare state often leads to dependence of people on those benefits, as well as a reluctance to find work - known as the unemployment trap. The unemployment trap is a big problem for governments as the dependence it creates can easily lead to longer-term unemployment problems, with people becoming used to being unemployed, as well as becoming unemployable as they lose their skills, along with the routine of getting up to work etc.
This is certainly seen as a rather large problem, as high levels of government spending are difficult to sustain, as they have to be financed with lots of borrowing. Similarly, the money could be spent on something else, such as healthcare (opportunity cost is a common criticism of any government spending).
Furthermore, a generous welfare state often leads to dependence of people on those benefits, as well as a reluctance to find work - known as the unemployment trap. The unemployment trap is a big problem for governments as the dependence it creates can easily lead to longer-term unemployment problems, with people becoming used to being unemployed, as well as becoming unemployable as they lose their skills, along with the routine of getting up to work etc.
Saturday, 4 June 2011
Flexible/inflexible labour markets
For businesses to perform efficiently, one of the requirements is a flexible labour market.
For a labour market to be flexible, a number of conditions have to be met. Firstly, wage flexibility on the part of the workers needs to exist. This means that workers are willing to accept lower wages in times of recession etc, and that firms are willing to grant higher wages if MRP increases or something similar. In practice, this is one of the hardest conditions of a flexible labour market to be met; often wages are described as "downwards sticking", which highlights the reluctance of the workers to accept low wages in the fear that they may never rise back up.
The other conditions of a flexible labour market are somewhat more common. The second condition is high levels of labour mobility, including a workforce rich in transferable skills (to eliminate occupational immobility), and enough information and transport opportunities for people to get work in other areas of the country (to minimise geographical immobility). High levels of labour mobility can be achieved by investing in supply-side policies such as education and transport infrastructure.
Finally, for complete flexibility in the labour market, workers have to be willing to work more or less hours when needed, or to switch to a shorter or longer term contract. In reality, this condition of flexible labour markets is rarely fully achieved, because people normally have other commitments that mean that they can't simply switch to part-time without considerable warning.
For a labour market to be flexible, a number of conditions have to be met. Firstly, wage flexibility on the part of the workers needs to exist. This means that workers are willing to accept lower wages in times of recession etc, and that firms are willing to grant higher wages if MRP increases or something similar. In practice, this is one of the hardest conditions of a flexible labour market to be met; often wages are described as "downwards sticking", which highlights the reluctance of the workers to accept low wages in the fear that they may never rise back up.
The other conditions of a flexible labour market are somewhat more common. The second condition is high levels of labour mobility, including a workforce rich in transferable skills (to eliminate occupational immobility), and enough information and transport opportunities for people to get work in other areas of the country (to minimise geographical immobility). High levels of labour mobility can be achieved by investing in supply-side policies such as education and transport infrastructure.
Finally, for complete flexibility in the labour market, workers have to be willing to work more or less hours when needed, or to switch to a shorter or longer term contract. In reality, this condition of flexible labour markets is rarely fully achieved, because people normally have other commitments that mean that they can't simply switch to part-time without considerable warning.
Friday, 3 June 2011
Explain the Prebisch Singer Hypothesis
(Since i had no idea what this was, i thought i should maybe do a bit of research on it).
The Prebisch Singer hypothesis is an economic theory developed by Raul Prebisch and Hans Singer. The theory states that the terms of trade between primary goods and manufactured products deteriorate over time. What this means is that countries that export primary goods that do not have the means to manufacture goods to export will lose out in the long-run, as their goods will become relatively cheaper than the manufactured ones. A common explanation for the phenomenon is the observation that the income elasticity of demand for manufactured goods is greater than that for primary products - especially food. Therefore, as incomes rise, the demand for manufactured goods increases more rapidly than demand for primary products.
The worry with this is that the main exporters of primary goods are developing countries. If we take this hypothesis as fact, then that does not bode well for developing countries because it means that any hope of ever industrialising without borrowing large amounts (which is hard with a low credit rating) are slim - as they will not be making much profit on their exports, while being faced with higher costs of imports.
How is human development measured?
Human development is a relatively new concept; it is the main focus to "development economics" - a modern branch of economics. While human development used to be measured simply by increases in real GDP per capita, economists have now realised that this is not particularly accurate. This is because for human development to increase, it is necessary to increase the overall welfare and living standards for the people in the economy, and GDP per capita merely shows increased average income (which tells us nothing about the quality of life, the distribution of the income, the liberty of the citizens... etc.).
The more accepted measure of human development, then, is the HDI (Human Development Index). Measuring the HDI is rather more complicated than GDP per head, as it involves giving a score (between 0-1) for each of the 3 main indicators of human development, and then averaging them to get the HDI score for a country. The three areas are: life expectancy at birth; adult literacy rates/number of people in education and finally the GDP per head. It is believed that the HDI is a more accurate measure of human development because it takes into account more than just incomes.
It is not, however, without its criticisms. The first problem with the HDI is that it only measures 3 indicators of human development; there is no mention of the range of products available to consumers, or the condition of the government/freedom of the people. This ties in with the theory of human development that states that for an economy to be truly developed, the population have to be able to freely make a wide range of economic choices. The counter-argument to this is that if there were, say, 10 different indicators in the HDI then it wouldn't give an accurate picture of the change in development, as it would be very difficult for countries to improve all 10 areas.
The second criticism of the HDI is that it gives an equal weighting to each indicator, where some would argue that perhaps less should be given to GDP per head and more should be given to literacy rates or the other way around. This also ties in with the argument that says that the indicators should be more specific; it's no good having 100% of the population in education if the quality of that education is bad. Similarly, life expectancy may be high, but at what cost? Perhaps cigarettes, alcohol, fast food, fizzy drinks (things people like) are banned, meaning that the population are more healthy, but in no way meaning they are happier. Finally, the measure of GDP per capita has the same problem as mentioned earlier - it doesn't show income distribution.
The more accepted measure of human development, then, is the HDI (Human Development Index). Measuring the HDI is rather more complicated than GDP per head, as it involves giving a score (between 0-1) for each of the 3 main indicators of human development, and then averaging them to get the HDI score for a country. The three areas are: life expectancy at birth; adult literacy rates/number of people in education and finally the GDP per head. It is believed that the HDI is a more accurate measure of human development because it takes into account more than just incomes.
It is not, however, without its criticisms. The first problem with the HDI is that it only measures 3 indicators of human development; there is no mention of the range of products available to consumers, or the condition of the government/freedom of the people. This ties in with the theory of human development that states that for an economy to be truly developed, the population have to be able to freely make a wide range of economic choices. The counter-argument to this is that if there were, say, 10 different indicators in the HDI then it wouldn't give an accurate picture of the change in development, as it would be very difficult for countries to improve all 10 areas.
The second criticism of the HDI is that it gives an equal weighting to each indicator, where some would argue that perhaps less should be given to GDP per head and more should be given to literacy rates or the other way around. This also ties in with the argument that says that the indicators should be more specific; it's no good having 100% of the population in education if the quality of that education is bad. Similarly, life expectancy may be high, but at what cost? Perhaps cigarettes, alcohol, fast food, fizzy drinks (things people like) are banned, meaning that the population are more healthy, but in no way meaning they are happier. Finally, the measure of GDP per capita has the same problem as mentioned earlier - it doesn't show income distribution.
Why is trade seen as such an important source of growth?
International trade describes the purchase and sale of goods and services between counties. Pascal Lamy, leader of the World Trade Organisation, believes that trade is one of the most important ways of achieving long-term growth. Ricardo's theory of comparative advantage highlights one of the key benefits of international trade, namely that specialisation and trade leads to mutual gain for the countries involved. Comparative advantage says that even if England has absolute advantage in the production of two goods, they can still trade Zimbabwe given that that Zimbabwe has a lower opportunity cost of production for one of the goods. After trading, then, both the UK and Zimbabwe would be producing more goods than they were before, and, assuming they were producing at full capacity, that means they would be producing outside their PPC.
Trade, therefore, increases productive capacity, as well as overall production, which is the definition of growth. There are other benefits to trade, including increases in domestic efficiency as markets become more competitive. International trade (particularly between developing and developed countries) can lead not only to better political relations, but also to technological advancements being made by the developing country as a result of importing technology that they don't perhaps have the resources to innovate themselves.
Sunday, 29 May 2011
Balance of payments deficit
The balance of payments consists of the capital account, the current account and any errors/omissions.
While overall, the balance of payments will always balance due to its nature, parts of it can be in deficit. In the UK, for example, we have a current account deficit due to our large deficit of trade in goods; despite our considerable surplus in trade in services (mainly financial). This deficit is accounted for by a surplus on the capital account. The UK is a successful, developed economy which means that it attracts a large amount of foreign investment and flows of hot money. These lead to the surplus on the capital account which balance the UKs balance of payments.
The extent to which imbalances in the balance of payments matter depends on what causes the imbalance. The UK, despite having a current account deficit, would be seen as a relatively healthy economy in terms of the balance of payments. Lots of developed economies have similar deficits on their current account, especially if they are not export led economies. An imbalance is a worry if it stems from the over-importation of consumer goods such as toys etc. This can be more harmful than if a country is importing capital goods to increase employment or productivity. These types of current account deficit are known as benign and malign deficits. Malign deficits are difficult to justify - as they no doubt have to be offset by borrowing, which is clearly undesirable.
While overall, the balance of payments will always balance due to its nature, parts of it can be in deficit. In the UK, for example, we have a current account deficit due to our large deficit of trade in goods; despite our considerable surplus in trade in services (mainly financial). This deficit is accounted for by a surplus on the capital account. The UK is a successful, developed economy which means that it attracts a large amount of foreign investment and flows of hot money. These lead to the surplus on the capital account which balance the UKs balance of payments.
The extent to which imbalances in the balance of payments matter depends on what causes the imbalance. The UK, despite having a current account deficit, would be seen as a relatively healthy economy in terms of the balance of payments. Lots of developed economies have similar deficits on their current account, especially if they are not export led economies. An imbalance is a worry if it stems from the over-importation of consumer goods such as toys etc. This can be more harmful than if a country is importing capital goods to increase employment or productivity. These types of current account deficit are known as benign and malign deficits. Malign deficits are difficult to justify - as they no doubt have to be offset by borrowing, which is clearly undesirable.
Problems with comparative advantage and specialisation
Comparative advantage is the economic theory of international trade developed by Ricardo. It says that even when one country can produce far more products than another country if it devotes all of its resources to one, the opportunity cost of those products may be higher in a developed country than in a developing country. So despite the USA being able to produce both more bananas and more cars than Brazil, Brazil would probably have to sacrifice less cars in order to make bananas than the USA. This is the theory that gives most countries a basis for trade. Trade should not take place where one country can produce more of both at the same opportunity cost as another country, eg. Where the USA can produce 100 bananas for every 10 cars, and Brazil can produce 10 bananas for every 1 car.
Comparative advantage, then, suggests that specialisation is the key to international trade success.
One of the problems with comparative advantage is that it assumes that there are no barriers to trade/protectionist measures or any transport costs. In reality, these two would add to or take away from the cost of trading, therefore making a weaker/stronger case for trade. The model of comparative advantage also assumes that there are only two countries involved, and they make only two goods, which is, of course, not the case. Similarly, Ricardo's theory assumes that countries can switch production from one thing to another without any sort of cost or time delay. It could be seen as a criticism of the theory of comparative advantage that it suggests that specialisation important for countries. While specialisation in some instances is good, it can mean that an economy becomes dependant on trade, and isn't self-sufficient. This may not be a problem, but if tastes change or if the market takes a turn for the worse for the country's main export, then the entire welfare of the country could be compromised.
The final criticism of the theory is that it leaves out the fact that international trade and international politics are strongly linked. The UK does lots of trade with the EU because of the lack of trade barriers; but another of the UK's main trade partners is the USA, who can implement as many trade barriers as they wish (not to mention that the US is around 4,000 miles away.) The reason for this is because international relations with the USA are strong, and as a strong trade partner, we would be inclined to continue trading with them so as not to compromise our relationship (even if that means real/opportunity cost to the UK.)
Comparative advantage, then, suggests that specialisation is the key to international trade success.
One of the problems with comparative advantage is that it assumes that there are no barriers to trade/protectionist measures or any transport costs. In reality, these two would add to or take away from the cost of trading, therefore making a weaker/stronger case for trade. The model of comparative advantage also assumes that there are only two countries involved, and they make only two goods, which is, of course, not the case. Similarly, Ricardo's theory assumes that countries can switch production from one thing to another without any sort of cost or time delay. It could be seen as a criticism of the theory of comparative advantage that it suggests that specialisation important for countries. While specialisation in some instances is good, it can mean that an economy becomes dependant on trade, and isn't self-sufficient. This may not be a problem, but if tastes change or if the market takes a turn for the worse for the country's main export, then the entire welfare of the country could be compromised.
The final criticism of the theory is that it leaves out the fact that international trade and international politics are strongly linked. The UK does lots of trade with the EU because of the lack of trade barriers; but another of the UK's main trade partners is the USA, who can implement as many trade barriers as they wish (not to mention that the US is around 4,000 miles away.) The reason for this is because international relations with the USA are strong, and as a strong trade partner, we would be inclined to continue trading with them so as not to compromise our relationship (even if that means real/opportunity cost to the UK.)
Monday, 23 May 2011
Analyse ways in which Spain can improve its long run growth potential.
Spain has experienced continuing losses of international competitiveness over the past decade or so, and it is clear that in order to regain competitiveness, they will have to impose measures to improve their long run growth.
The first way Spain can increase its long-run growth potential is to improve the human capital of its workers so that they are more productive in their current industries. The government could achieve this by training the population. A similar strategy would be to improve the education that the state provides. The effect of this would be to improve the adaptability of the work force, reducing unemployment due to labour immobility. Reducing unemployment should be seen as an important task for the government of Spain, as it has been very high for quite a long time, which can lead to serious social problems, as well as causing workers to become unemployable.
One of the main reasons why Spain has poor growth at the moment is that a large sector of its economy is based around construction, and industry in which there is currently large amounts of supply, but very little demand for the houses they are constructing. Therefore it could be a good idea for the Spanish government to subsidise a new type of industry, such as technology manufacturing, which clearly has a place in the future of global trade.
Spain, along with the rest of the PIIGS, has relatively high unit labour costs. This can be a cause of lack of international competitiveness, and it should be an objective of the government to reduce these costs if it wants to increase its long run growth potential. One way of doing this would be to reduce the National Minimum Wage (NMW), in order to reduce wages.
The first way Spain can increase its long-run growth potential is to improve the human capital of its workers so that they are more productive in their current industries. The government could achieve this by training the population. A similar strategy would be to improve the education that the state provides. The effect of this would be to improve the adaptability of the work force, reducing unemployment due to labour immobility. Reducing unemployment should be seen as an important task for the government of Spain, as it has been very high for quite a long time, which can lead to serious social problems, as well as causing workers to become unemployable.
One of the main reasons why Spain has poor growth at the moment is that a large sector of its economy is based around construction, and industry in which there is currently large amounts of supply, but very little demand for the houses they are constructing. Therefore it could be a good idea for the Spanish government to subsidise a new type of industry, such as technology manufacturing, which clearly has a place in the future of global trade.
Spain, along with the rest of the PIIGS, has relatively high unit labour costs. This can be a cause of lack of international competitiveness, and it should be an objective of the government to reduce these costs if it wants to increase its long run growth potential. One way of doing this would be to reduce the National Minimum Wage (NMW), in order to reduce wages.
What is meant by real interest rates?
Real interest rates are interest rates - inflation
It is important to calculate real interest rates because if inflation is higher than the interest rates, then real interest rates may be negative (as described in the extract). When real interest rates are negative, people's money is losing value (even when in banks) which can lead to higher spending, as people want to spend their money before it de-values, which can be disastrous as it may lead to even higher inflation rates.
It is important to calculate real interest rates because if inflation is higher than the interest rates, then real interest rates may be negative (as described in the extract). When real interest rates are negative, people's money is losing value (even when in banks) which can lead to higher spending, as people want to spend their money before it de-values, which can be disastrous as it may lead to even higher inflation rates.
Saturday, 21 May 2011
Explain the concept of a “loose monetary policy”.
The term "loose monetary policy" in this context describes how monetary policy (such as interest rates and quantitative easing) were geared more towards promoting growth than restricting it to control the price level, this would suggest that they had a low base rate of interest and were perhaps engaging in high levels of quantitative easing.
The problem with this was that Portugal, Italy, Ireland, Greece and Spain all experienced high levels of inflation which led to a loss of international competitiveness that can be traced back to 1999. The high inflation levels led to a lack of competitiveness as prices in those countries were rising faster than those in other countries, which meant that their goods were relatively more expensive and therefore less competitive. Normally, a country in this situation would opt to increase interest rates, however, as the interest rates for the euro area are set centrally, it can be difficult to cater for the needs of everyone.
The problem with this was that Portugal, Italy, Ireland, Greece and Spain all experienced high levels of inflation which led to a loss of international competitiveness that can be traced back to 1999. The high inflation levels led to a lack of competitiveness as prices in those countries were rising faster than those in other countries, which meant that their goods were relatively more expensive and therefore less competitive. Normally, a country in this situation would opt to increase interest rates, however, as the interest rates for the euro area are set centrally, it can be difficult to cater for the needs of everyone.
Thursday, 19 May 2011
Explain how, in normal circumstances, inflation results in a reduction in the exchange rate.
Inflation is defined as a sustained rise in the price level. Inflation is generally undesirable for a country; while low and stable inflation does little harm, high levels of inflation have many negative implications such as fiscal drag, price uncertainty and inflationary noise. Most central banks have an interest rate target that they use their control over monetary policy to achieve (changing interest rates, quantitative easing and OMOs).
One of the effects of inflation is also to reduce the exchange rate. This occurs in normal circumstances as international competitiveness reduces due to prices rising relative to other countries. As investment in the country decreases, the demand for the currency follows suit and the exchange rate deteriorates.
Another way in which the exchange rate and the inflation rate are related is when the exchange rates are fixed against another currency. Say the pound was fixed against the dollar, and the dollar's inflation increased, the inflation rate for the pound would increase the same amount, this is because as the value of the dollar falls, the value of the pound falls. The pound's inflation rates would also also, then, be tied to the dollar's.
One of the effects of inflation is also to reduce the exchange rate. This occurs in normal circumstances as international competitiveness reduces due to prices rising relative to other countries. As investment in the country decreases, the demand for the currency follows suit and the exchange rate deteriorates.
Another way in which the exchange rate and the inflation rate are related is when the exchange rates are fixed against another currency. Say the pound was fixed against the dollar, and the dollar's inflation increased, the inflation rate for the pound would increase the same amount, this is because as the value of the dollar falls, the value of the pound falls. The pound's inflation rates would also also, then, be tied to the dollar's.
Saturday, 7 May 2011
The Stability and Growth Pact
The Stability and Growth Pact is an agreement between the 17 members of the euro area that aims to promote price stability as well as facilitate the growth of all of the members. The pact says that no one member should have a government spending deficit of more than 3% of GDP annually, and that total government debt not be more than 60% of GDP. The idea is that it limits fiscal irresponsibility that could lead to inflationary pressure on the euro.
There are many criticisms of the stability and growth pact, as some say that it lacks flexibility due to the fact that it is over a year rather than over the course of an economic cycle. This could be seen as unfair as governments regularly need to borrow more money during times of recession, money that they can then pay back during boom. Another criticism is that it seems to be somewhat unenforceable - especially in the larger countries like Germany and France who have both run "excessive" deficits for a long time.
Some of the difficulties of reducing government debt and spending deficits in the EU in order to comply with the stability and growth pact are outlined in the most recent post made on this blog. http://econ.economicshelp.org/
There are many criticisms of the stability and growth pact, as some say that it lacks flexibility due to the fact that it is over a year rather than over the course of an economic cycle. This could be seen as unfair as governments regularly need to borrow more money during times of recession, money that they can then pay back during boom. Another criticism is that it seems to be somewhat unenforceable - especially in the larger countries like Germany and France who have both run "excessive" deficits for a long time.
Some of the difficulties of reducing government debt and spending deficits in the EU in order to comply with the stability and growth pact are outlined in the most recent post made on this blog. http://econ.economicshelp.org/
Why is it necessary for interest rates to be set centrally in a monetary union?
In a monetary union such as the eurozone, interest rates are always set by a central bank and the rate they choose applies for the whole area. The reason the rate has to be the same in each country is because if one country had a higher rate of interest than all of the others, then it could well lead to a lack of convergence of the economic cycles, as high levels of interest rates would restrict growth in one economy where another economy may have low levels and be growing quickly. The reason given by the ECB is that it is in their interest to promote "Price Stability" and a single interest rate makes this much easier, mainly because interest rates are a tool used to control inflation.
Sunday, 1 May 2011
The characteristic features of a recession
A recession in economics is defined by a period of at least 2 quarters of negative GDP growth. There was a global recession between 2008-2009, which most countries are now out of - but there are a number still in recession, including Portugal.
A recession is caused by a fall in GDP, from a reduction in AS, AD or both. The causes of a reduction in AD are a reduction in any of the components of C+I+G+(X-M). A fall in AS comes from increases in the costs of production such as a rise in unit labour costs, or a fall in the quality of education/training, as well as a number of other factors.
Recessions tend to lead to reductions in confidence which can further reduce consumption or investment spending. In a recession, however, governments tend to borrow more money which leads to increased public spending in an attempt to offset the reduction in consumption or investment. Spain said during its recession that they feared the social consequences of high unemployment (one of the things caused by a recession) and therefore increased benefits, which put an extra strain on government spending. Sometimes recession is caused by a reduction in exports which may be due to a world recession or a drop in world confidence.This should lead to a reduction in exchange rates which would reduce the price of exports and hopefully lead to a boost in AD.
Prolonged recession may be due to a serious lack of international competitiveness such as was experienced in Portugal recently. This is most likely due to high unit labour costs resulting from either an unproductive workforce or an underdeveloped industrial sector. In Portugal, the rate of young people leaving school was around 60% which probably led to a reduction in productivity of the labour force, and therefore a reduction in international competitiveness.
A recession is caused by a fall in GDP, from a reduction in AS, AD or both. The causes of a reduction in AD are a reduction in any of the components of C+I+G+(X-M). A fall in AS comes from increases in the costs of production such as a rise in unit labour costs, or a fall in the quality of education/training, as well as a number of other factors.
Recessions tend to lead to reductions in confidence which can further reduce consumption or investment spending. In a recession, however, governments tend to borrow more money which leads to increased public spending in an attempt to offset the reduction in consumption or investment. Spain said during its recession that they feared the social consequences of high unemployment (one of the things caused by a recession) and therefore increased benefits, which put an extra strain on government spending. Sometimes recession is caused by a reduction in exports which may be due to a world recession or a drop in world confidence.This should lead to a reduction in exchange rates which would reduce the price of exports and hopefully lead to a boost in AD.
Prolonged recession may be due to a serious lack of international competitiveness such as was experienced in Portugal recently. This is most likely due to high unit labour costs resulting from either an unproductive workforce or an underdeveloped industrial sector. In Portugal, the rate of young people leaving school was around 60% which probably led to a reduction in productivity of the labour force, and therefore a reduction in international competitiveness.
Friday, 29 April 2011
The ways in which membership of the euro area constrains national economic policy
There are currently 17 members of the euro area - all of whom are also in the EU. It is obligatory that members of the EU be in the eurozone, however they do have to meet certain requirements. There are 10 EU member states that do not use the euro as their sole currency, of these 10, 7 have yet to meet the requirements and will join when they meet them, and the other 3 (including the UK) have opted out.
There are reasons for these opt-outs, as membership of the euro area does constrain national economic policy in a number of ways. The first and most obvious way is the loss of control over monetary policy once you join a monetary union (such as the eurozone). Monetary policy in the euro area is conducted by the European Central Bank (ECB), which is located in Frankfurt. The ECB controls the base interest rate for the euro, and also holds reserves which it can use to bail out failing members of the eurozone if necessary to help the economic well-being of the other members. The governments of the individual countries don't miss out on anything, as the interest rates for their currencies (if they didn't use the euro) would probably be controlled by a central bank anyway. The problem, then, lies with the difficulty the ECB has in setting an interest rate that is suitable for all of the members of the euro area. There are 17 different members, with different economic and social structures, which can lead to a lack of convergence in their economic cycles (as discussed in the case study). Simplified, the lack of convergence means that while one country may be experiencing a period of economic boom, another country in the euro area may be in a recession. The "booming" country may want high interest rates in order to control the price level, while the country in recession would want exactly the opposite. This delicate balancing act is very difficult and is often criticised.
Also, as I have mentioned in previous posts, the euro area operates with a non-symmetrical inflation target which means that there is not the same emphasis put on increasing the inflation rate if it is too low, as there is on reducing it when it is too high. In my opinion this is a flaw in the system of the euro area, as it tends to lead to higher-than-necessary interest rates which does indeed lead to low price leves, but often at the cost of low economic growth and high unemployment.
Furthermore, certain signals that should be given off by changes in the exchange rate are often dampened in a monetary union the size of the euro area; one country's economic performance does little to affect the overall exchange rate of the euro. Ireland complained following their deep recession that, if they had their own currency, their large increases in AD would have led to high levels of appreciation of that currency and could have slowed down the level of export-led growth (as long as the demand for their exports was price elastic) and possibly helped give some early-warning signs to the government that a recession was on the horizon.
There are reasons for these opt-outs, as membership of the euro area does constrain national economic policy in a number of ways. The first and most obvious way is the loss of control over monetary policy once you join a monetary union (such as the eurozone). Monetary policy in the euro area is conducted by the European Central Bank (ECB), which is located in Frankfurt. The ECB controls the base interest rate for the euro, and also holds reserves which it can use to bail out failing members of the eurozone if necessary to help the economic well-being of the other members. The governments of the individual countries don't miss out on anything, as the interest rates for their currencies (if they didn't use the euro) would probably be controlled by a central bank anyway. The problem, then, lies with the difficulty the ECB has in setting an interest rate that is suitable for all of the members of the euro area. There are 17 different members, with different economic and social structures, which can lead to a lack of convergence in their economic cycles (as discussed in the case study). Simplified, the lack of convergence means that while one country may be experiencing a period of economic boom, another country in the euro area may be in a recession. The "booming" country may want high interest rates in order to control the price level, while the country in recession would want exactly the opposite. This delicate balancing act is very difficult and is often criticised.
Also, as I have mentioned in previous posts, the euro area operates with a non-symmetrical inflation target which means that there is not the same emphasis put on increasing the inflation rate if it is too low, as there is on reducing it when it is too high. In my opinion this is a flaw in the system of the euro area, as it tends to lead to higher-than-necessary interest rates which does indeed lead to low price leves, but often at the cost of low economic growth and high unemployment.
Furthermore, certain signals that should be given off by changes in the exchange rate are often dampened in a monetary union the size of the euro area; one country's economic performance does little to affect the overall exchange rate of the euro. Ireland complained following their deep recession that, if they had their own currency, their large increases in AD would have led to high levels of appreciation of that currency and could have slowed down the level of export-led growth (as long as the demand for their exports was price elastic) and possibly helped give some early-warning signs to the government that a recession was on the horizon.
Thursday, 28 April 2011
The concept of "Purchasing Power Parity"
Purchasing Power Parity (PPP) is a theory of long-term equilibrium exchange rates based on the relative price levels in two countries. In other words, it shows the difference in actual value of a currency in terms of what you can buy with it. PPP is measured by taking the price of a basket of goods in one country and comparing it with the price of the same basket in another country.
It would be assumed that the nominal exchange rate and PPP would be relatively similar. However, we can normally see a marked difference in PPP-adjusted exchange rates compared to nominal rates. India, for example, has a GDP per capita of $1,100 if we are using the nominal exchange rate, however when the figures are PPP adjusted, the GDP per capita is closer to $3,000.
PPP figures are based on the "law of one price" which assumes that something costs the same amount wherever you go. If we take a Big Mac in France and a Big Mac in England, it is assumed that relatively they should cost the same amount, and then we can compare them directly to get PPP adjusted exchange rates between England and France. If Big Macs are just genuinely cheaper in France, this can skew the results as it means the law of one price does not apply. It has been said, however, that because PPP measures are made using a large "basket" of goods, that even where the law of one price does not apply, the results shouldn't be affected too much and this is normally not a worry.
A further problem to measuring PPP is the fact that some products are simply not available in certain countries, and they therefore cannot be used for comparison. Therefore as a general rule, countries with similar economic structures and similar trends of consumption tend to have more accurate PPP-adjusted exchange rate figures. Similarly, in some (mainly poor or developing) countries any statistics can be rather difficult to attain as the government records are not necessarily sound.
It would be assumed that the nominal exchange rate and PPP would be relatively similar. However, we can normally see a marked difference in PPP-adjusted exchange rates compared to nominal rates. India, for example, has a GDP per capita of $1,100 if we are using the nominal exchange rate, however when the figures are PPP adjusted, the GDP per capita is closer to $3,000.
PPP figures are based on the "law of one price" which assumes that something costs the same amount wherever you go. If we take a Big Mac in France and a Big Mac in England, it is assumed that relatively they should cost the same amount, and then we can compare them directly to get PPP adjusted exchange rates between England and France. If Big Macs are just genuinely cheaper in France, this can skew the results as it means the law of one price does not apply. It has been said, however, that because PPP measures are made using a large "basket" of goods, that even where the law of one price does not apply, the results shouldn't be affected too much and this is normally not a worry.
A further problem to measuring PPP is the fact that some products are simply not available in certain countries, and they therefore cannot be used for comparison. Therefore as a general rule, countries with similar economic structures and similar trends of consumption tend to have more accurate PPP-adjusted exchange rate figures. Similarly, in some (mainly poor or developing) countries any statistics can be rather difficult to attain as the government records are not necessarily sound.
Wednesday, 27 April 2011
Explain the concept of a "Soft Currency"
A hard (or strong) currency is one that can be used to trade internationally and that is a stable store of value. Hard currencies are normally present in politically and economically strong countries, with stable government and low inflation. It is expected that hard currencies will not depreciate in value against other currencies, as this would be a characteristic of soft currency.
Soft currencies, conversely, are the opposite of hard currencies. A soft currency is expected to de-value compared to over time and is normally the currency of developing countries such as Zimbabwe. The Zimbabwean dollar was a good example of a soft currency, as their inflation rates were as high as 3714% per year, which was in part due to, and in part led to the printing of money. Currencies such as the Zimbabwean dollar are rarely used for international trade or for keeping large stores of.
There were fears at first that the euro would be a soft currency, but such fears were not realised and this is probably no surprise - given the nature of the economies who use it as well as the highly specific entry requirements. There also seems to be quite effective management of the currency by the European Central Bank. Their interest rates are higher than those set by the central bank in the UK, and eurozone growth is higher than that in the UK, which puts the EU in a better position than ourselves. Also, the ECB clearly doesn't want any countries to drag the currency down, such as Portugal, as they are choosing instead to take very drastic measures such as bailouts as well as setting strict fiscal policy guidelines to those countries that fail to manage their own economies successfully.
Soft currencies, conversely, are the opposite of hard currencies. A soft currency is expected to de-value compared to over time and is normally the currency of developing countries such as Zimbabwe. The Zimbabwean dollar was a good example of a soft currency, as their inflation rates were as high as 3714% per year, which was in part due to, and in part led to the printing of money. Currencies such as the Zimbabwean dollar are rarely used for international trade or for keeping large stores of.
There were fears at first that the euro would be a soft currency, but such fears were not realised and this is probably no surprise - given the nature of the economies who use it as well as the highly specific entry requirements. There also seems to be quite effective management of the currency by the European Central Bank. Their interest rates are higher than those set by the central bank in the UK, and eurozone growth is higher than that in the UK, which puts the EU in a better position than ourselves. Also, the ECB clearly doesn't want any countries to drag the currency down, such as Portugal, as they are choosing instead to take very drastic measures such as bailouts as well as setting strict fiscal policy guidelines to those countries that fail to manage their own economies successfully.
Monday, 25 April 2011
Assess the extent to which a rise in imports may affect macroeconomic performance
Analysis (how it will be detrimental to macroeconomic performance)
-Short run: C+I+G+(X-M). An increase in M will reduce AD. (diagram)
-It’s a leakage from the circular flow
-Could increase unemployment as domestically produced goods are replaced by cheaper imported substitutes
-Means our BoP is worse
Evaluation (how it may help performance)
-Could lead to lower prices and increased variety of goods (as long as it’s not just the price that has increased
-May reduce inflation
-If it’s combined with a subsequent rise in exports, then we could reap all the rewards as well as not losing out on AD
-May kill off inefficient industries that shouldn’t have existed
-Could be due to a time of economic boom which in itself is good
The role of the IMF
The International Monetary Fund (IMF) is the organisation that oversees the macroeconomic policy of all of its members (most of the world), it particularly focusses on policy that affects exchange rates or the balance of payments; because its goals include stabilisation of international exchange rates as well as trying to facilitate growth and development. Members pay a certain amount that goes into a pool which is then used to bail out failing members - a sort of "insurance" system.
The IMF conducts its work by publishing reports on its members. One of these reports was published in 2009 on the Spanish economy and mentioned that Spain needed to introduce policies to improve its international competitiveness, as their wage and unit-labour costs were outpacing the other countries in the euro area.
The IMF conducts its work by publishing reports on its members. One of these reports was published in 2009 on the Spanish economy and mentioned that Spain needed to introduce policies to improve its international competitiveness, as their wage and unit-labour costs were outpacing the other countries in the euro area.
The difficulties of reducing large public sector deficits such as those in Ireland, Italy and Greece
The EU says that its members can have a deficit of no more than 3% of GDP per year, and that total government debt should not exceed 60% of GDP. These are seen now as more of guidelines than actual rules, as most of the member states have broken one or both of them (including Germany).
Currently, Italy, Ireland and Greece are running huge public sector deficits, due to their generous welfare systems along with highly-paid public sectors - not to mention the tax evasion that is rife in Greece - which are having to be financed by large amounts of borrowing, subsequently increasing total government debt. Because the EU sets out guidelines of the amount of borrowing that is acceptable, once an economy begins to exceed these, they are warned that if they cannot control their borrowing through either increases in taxation or reductions in public spending (austerity measures) then the central bank will take control of their fiscal policy and make the cuts for them, as well as potentially bailing them out. This happened in Portugal, where they were dangerously close to "defaulting" which is effectively a declaration of bankruptcy and saying that you are unable to repay your loans. Defaulting is best avoided.
While raising taxation and/or cutting public spending sounds like a relatively straightforward way of reducing the deficit, it is not. It is very difficult to increase taxation or reduce government spending without harming economic growth, and just after a global recession, this can be disastrous, as it could lead to a double-dip recession. Cutting government spending would harm economic growth in the short run as government spending is a component of AD, it would also affect long run potential growth as it may lead to schools having to close or public sector jobs being lost. Increasing taxation would also harm growth by reducing levels of investment by firms or reducing consumption as people have less disposable income (income after tax), both of these are also components of AD. In Spain, as it says in extract 3, they "feared the social consequences of high unemployment" which may be brought about through public sector cuts, this led to them increasing unemployment benefits which puts a further strain on the government budget.
Furthermore, if a government chooses to continue with high levels of public expenditure in order to grow out of the recession before deciding to make cuts, they may risk losing their credit rating, currently the UK has a AAA credit rating, and because the government is doing lots to reduce our deficit, it seems that we will keep it. Spain, however, recently had its rating reduced for the banking sector to AA. The effect of a lower credit rating means that you are considered less likely to re-pay the debt you owe, which means lenders will most probably increase the interest rates they ask for in order to outweigh the risk of lending.
In conclusion, it is the risk to economic growth, as well as the social consequences that make reducing large deficits very difficult. It is, however, necessary if a country wishes to continue to be able to borrow at low interest rates in the future.
Currently, Italy, Ireland and Greece are running huge public sector deficits, due to their generous welfare systems along with highly-paid public sectors - not to mention the tax evasion that is rife in Greece - which are having to be financed by large amounts of borrowing, subsequently increasing total government debt. Because the EU sets out guidelines of the amount of borrowing that is acceptable, once an economy begins to exceed these, they are warned that if they cannot control their borrowing through either increases in taxation or reductions in public spending (austerity measures) then the central bank will take control of their fiscal policy and make the cuts for them, as well as potentially bailing them out. This happened in Portugal, where they were dangerously close to "defaulting" which is effectively a declaration of bankruptcy and saying that you are unable to repay your loans. Defaulting is best avoided.
While raising taxation and/or cutting public spending sounds like a relatively straightforward way of reducing the deficit, it is not. It is very difficult to increase taxation or reduce government spending without harming economic growth, and just after a global recession, this can be disastrous, as it could lead to a double-dip recession. Cutting government spending would harm economic growth in the short run as government spending is a component of AD, it would also affect long run potential growth as it may lead to schools having to close or public sector jobs being lost. Increasing taxation would also harm growth by reducing levels of investment by firms or reducing consumption as people have less disposable income (income after tax), both of these are also components of AD. In Spain, as it says in extract 3, they "feared the social consequences of high unemployment" which may be brought about through public sector cuts, this led to them increasing unemployment benefits which puts a further strain on the government budget.
Furthermore, if a government chooses to continue with high levels of public expenditure in order to grow out of the recession before deciding to make cuts, they may risk losing their credit rating, currently the UK has a AAA credit rating, and because the government is doing lots to reduce our deficit, it seems that we will keep it. Spain, however, recently had its rating reduced for the banking sector to AA. The effect of a lower credit rating means that you are considered less likely to re-pay the debt you owe, which means lenders will most probably increase the interest rates they ask for in order to outweigh the risk of lending.
In conclusion, it is the risk to economic growth, as well as the social consequences that make reducing large deficits very difficult. It is, however, necessary if a country wishes to continue to be able to borrow at low interest rates in the future.
An explanation of the functions of the European Central Bank.
The European Central bank (ECB) was started in 1998 and, like all central banks, exists to control monetary policy over a given area, in this case, the Eurozone.
The ECB's main function is to keep the price level down. The inflation target for the Eurozone is 2%, and the current rate of inflation in the euro area is 2.7% (March 2011). This suggests that the price level is too high, and trends have shown that it is only increasing. This means that the ECB is expected to use its control over monetary policy to stem this rising interest rate, which it is clearly doing, as on the 7th of April the ECB announced that it would increase euro-area interest rates to 1.25% from 1%.
As well as controlling interest rates, another part of monetary policy is the amount of money printed and injected into the economy as quantitative easing. This can be used to boost AD, but can come at the cost of high levels of inflation, as it involves increasing the supply of money, which will reduce its value.
It has been said, and can be found in the introduction of the stimulus that low base interest rates set by the ECB coupled with high inflation rates in Ireland, Spain and Greece led to negative real interest rates, which put huge amounts of pressure on the banking sector and resulted in very high levels of borrowing and low levels of saving (as money was de-valuing). This is an example of one of the difficulties faced by the ECB, as it has to try and set one set of monetary policies that appeals to everyone. Critics of the system may say that it shouldn't be difficult, as by now the economic cycles of the Eurozone countries should have converged, but clearly they have not, and, as the stimulus mentions, there is risk of a "two-speed" euro area developing.
The ECB's main function is to keep the price level down. The inflation target for the Eurozone is 2%, and the current rate of inflation in the euro area is 2.7% (March 2011). This suggests that the price level is too high, and trends have shown that it is only increasing. This means that the ECB is expected to use its control over monetary policy to stem this rising interest rate, which it is clearly doing, as on the 7th of April the ECB announced that it would increase euro-area interest rates to 1.25% from 1%.
As well as controlling interest rates, another part of monetary policy is the amount of money printed and injected into the economy as quantitative easing. This can be used to boost AD, but can come at the cost of high levels of inflation, as it involves increasing the supply of money, which will reduce its value.
It has been said, and can be found in the introduction of the stimulus that low base interest rates set by the ECB coupled with high inflation rates in Ireland, Spain and Greece led to negative real interest rates, which put huge amounts of pressure on the banking sector and resulted in very high levels of borrowing and low levels of saving (as money was de-valuing). This is an example of one of the difficulties faced by the ECB, as it has to try and set one set of monetary policies that appeals to everyone. Critics of the system may say that it shouldn't be difficult, as by now the economic cycles of the Eurozone countries should have converged, but clearly they have not, and, as the stimulus mentions, there is risk of a "two-speed" euro area developing.
The extent to which free trade will be beneficial Europe
The EU is a monetary union, not a free-trade area, like NAFTA, however there is free trade in the EU.
Free trade seeks to utilize the theory of comparative advantage to achieve mutual benefit from those involved. The theory of comparative advantage says that through specialisation and trade, countries can produce outside their productive capacity and PPC (production possibility curve) and produce up to their TPC (trading possibility curve). Theoretically, then, where there is comparative advantage, there is a potential for mutual benefit from trading. The theory of comparative advantage doesn't, however, take into account transport costs or any trade barriers such as tariffs, so in order to fully benefit from comparative advantage, there needs to be a free trade agreement such as the one in the EU, which suggests that the EU benefits from these advantages.
There are, however, drawbacks. Firstly, the initiation of a free trade agreement, while it will create new trade partners (trade creation), can harm trade with countries outside the free trade area (trade diversion). Secondly, international trade leads to higher levels of competition in the market, and can therefore "kill off" under-performing industries, as well as infant industries. This could have been part of the problem for Spain in 2009, as some of their industries may have been functioning well at a domestic level, but after the increased competition entered from overseas, such industries could no longer remain competitive and were forced to close. This would lead to higher reliance on imports for the Spanish economy, and could also lead to a long-term lack of competitiveness as infant industries that would grow and become competitive lose the help they would normally get from the government in the early stages of development.
A further problem of free trade in areas such as Europe is that if one economy enters a recession, it can affect the entire free trade area, especially if the share a currency such as the euro. This is because as soon as one country in the eurozone starts to underperform, foreign investors will lose confidence in the whole area and stop investing which would lead to a lack of FDI and limit AS. As this starts to happen, confidence within the trade area starts to decline and less products get traded as well as businesses losing confidence and not investing in development and research. Such confidence problems can quickly spread throughout economies that are so closely integrated. The quote on p11 of the stimulus from a speech by Pascal Lamy illustrates that "Internatonal trade was a casualty of the global recession and world trade shrank by 12% in 2009." Which supports my point.
To conlcude, while free trade is useful in increasing the productive capacity of all economies in the free trade area, it can be dangerous to integrate too closely with other economies as it is easy for one failing country to drag all of the others down.
Free trade seeks to utilize the theory of comparative advantage to achieve mutual benefit from those involved. The theory of comparative advantage says that through specialisation and trade, countries can produce outside their productive capacity and PPC (production possibility curve) and produce up to their TPC (trading possibility curve). Theoretically, then, where there is comparative advantage, there is a potential for mutual benefit from trading. The theory of comparative advantage doesn't, however, take into account transport costs or any trade barriers such as tariffs, so in order to fully benefit from comparative advantage, there needs to be a free trade agreement such as the one in the EU, which suggests that the EU benefits from these advantages.
There are, however, drawbacks. Firstly, the initiation of a free trade agreement, while it will create new trade partners (trade creation), can harm trade with countries outside the free trade area (trade diversion). Secondly, international trade leads to higher levels of competition in the market, and can therefore "kill off" under-performing industries, as well as infant industries. This could have been part of the problem for Spain in 2009, as some of their industries may have been functioning well at a domestic level, but after the increased competition entered from overseas, such industries could no longer remain competitive and were forced to close. This would lead to higher reliance on imports for the Spanish economy, and could also lead to a long-term lack of competitiveness as infant industries that would grow and become competitive lose the help they would normally get from the government in the early stages of development.
A further problem of free trade in areas such as Europe is that if one economy enters a recession, it can affect the entire free trade area, especially if the share a currency such as the euro. This is because as soon as one country in the eurozone starts to underperform, foreign investors will lose confidence in the whole area and stop investing which would lead to a lack of FDI and limit AS. As this starts to happen, confidence within the trade area starts to decline and less products get traded as well as businesses losing confidence and not investing in development and research. Such confidence problems can quickly spread throughout economies that are so closely integrated. The quote on p11 of the stimulus from a speech by Pascal Lamy illustrates that "Internatonal trade was a casualty of the global recession and world trade shrank by 12% in 2009." Which supports my point.
To conlcude, while free trade is useful in increasing the productive capacity of all economies in the free trade area, it can be dangerous to integrate too closely with other economies as it is easy for one failing country to drag all of the others down.
Sunday, 24 April 2011
What is "hot money" and why does it matter for the exchange rate?
Hot money is money invested in an economy by foreign investors. Unlike FDI, it is not a long-term investment, quite the opposite. Hot money is a short-term concept that revolves around speculation of interest rates and exchange rates.
We can see that flows of hot money affected the economies of Spain and Greece in 2009 as they had a period of negative real interest rates fuelled by a low base rate (set by the ECB) and high levels of inflation which led to a reduction in foreign investment as their money was de-valuing. This could have contributed to their economic decline.
Hot money tends to be invested by rich developed countries in poorer countries that have higher interest rates in order to capitalise on the increased returns from banks etc. Speculation is the key to determining the flows of hot money, and if interest rates are expected to rise, then more people will invest. This means that the flows are erratic and difficult to predict. This can affect the balance of payments by making it much more unstable, as economies can react badly to huge changes in capital flows. Sudden inflows of capital in the short term can lead to appreciation of the exchange rate which can, if persistent, lead to a lack of competitiveness of their exports.
We can see that flows of hot money affected the economies of Spain and Greece in 2009 as they had a period of negative real interest rates fuelled by a low base rate (set by the ECB) and high levels of inflation which led to a reduction in foreign investment as their money was de-valuing. This could have contributed to their economic decline.
Hot money tends to be invested by rich developed countries in poorer countries that have higher interest rates in order to capitalise on the increased returns from banks etc. Speculation is the key to determining the flows of hot money, and if interest rates are expected to rise, then more people will invest. This means that the flows are erratic and difficult to predict. This can affect the balance of payments by making it much more unstable, as economies can react badly to huge changes in capital flows. Sudden inflows of capital in the short term can lead to appreciation of the exchange rate which can, if persistent, lead to a lack of competitiveness of their exports.
Saturday, 23 April 2011
Is GDP per capita the most appropriate measure of economic success?
GDP (Gross Domestic Product) is the sum of all the goods and services produced in an economy. GDP per capita is GDP/population. GDP per capita has been the accepted way of measuring economic success, but with the emergence of a number of other measures such as the HDI, the question is being raised: Is it the best measure of economic success?
GDP per capita is effective as it is a globally accepted measure that is relatively simple to measure and understand, it is a useful measure of wealth in an economy, and while higher average wages normally leads to higher levels of happiness and fewer problems such as lack of basic necessities, GDP per capita is not necessarily the best measure of economic success.
One problem with using GDP per capita to measure a country's economic well-being is that it is an average, and doesn't show income disparity. A more appropriate way of measuring equality is the Gini coefficient. For example, the USA has a high GDP per capita, $45,000, but its Gini coefficient is around .45 which means there is a very large amount of inequality.
The second flaw in the GDP per capita measure is that it doesn't take into account the informal economy. Because GDP is measured on tax revenue for the government, produce on which tax is not paid doesn't get factored in, but does still contribute to the wealth of the population. Mexico, for example, has a GDP per capita of only $8,000, but estimates of the informal economy suggest this figure could be around 50% larger.
Finally, GDP could be seen as a less credible measure of economic success as it does not measure the sustainability of the growth. It is a measure of economic activity, rather than a projection method, which means it could be due to unsustainable overuse of resources or poor allocation of investment.
While it is an easy and accurate economic measurement, GDP per capita is, in many cases, inappropriate for measuring economic success. Better methods would be a combinations of things such as the gini coefficient and the HDI as well as other measures of happiness among the population.
GDP per capita is effective as it is a globally accepted measure that is relatively simple to measure and understand, it is a useful measure of wealth in an economy, and while higher average wages normally leads to higher levels of happiness and fewer problems such as lack of basic necessities, GDP per capita is not necessarily the best measure of economic success.
One problem with using GDP per capita to measure a country's economic well-being is that it is an average, and doesn't show income disparity. A more appropriate way of measuring equality is the Gini coefficient. For example, the USA has a high GDP per capita, $45,000, but its Gini coefficient is around .45 which means there is a very large amount of inequality.
The second flaw in the GDP per capita measure is that it doesn't take into account the informal economy. Because GDP is measured on tax revenue for the government, produce on which tax is not paid doesn't get factored in, but does still contribute to the wealth of the population. Mexico, for example, has a GDP per capita of only $8,000, but estimates of the informal economy suggest this figure could be around 50% larger.
Finally, GDP could be seen as a less credible measure of economic success as it does not measure the sustainability of the growth. It is a measure of economic activity, rather than a projection method, which means it could be due to unsustainable overuse of resources or poor allocation of investment.
While it is an easy and accurate economic measurement, GDP per capita is, in many cases, inappropriate for measuring economic success. Better methods would be a combinations of things such as the gini coefficient and the HDI as well as other measures of happiness among the population.
Causes of cyclical instability in an economy such as the UK
While economic growth in the long run may be a smooth curve that trends upwards, in the short-term there are large, regular fluctuations in growth. This is due to the economic cycle, which is the trend for economies to experience high levels of growth, then a slowdown followed by recession, and finally, a recovery.
Cyclical instability can occur due to shocks to either demand or supply.
Demand side shocks are unexpected events that influence the demand in the economy, they can be caused by other countries as the UK trades with countries from all over the world. They can be caused by:
-Significant rise or fall in the exchange rates in the short term
-Changes in the rate of economic growth with trading partners
-Shifts in AD
-A boom in capital expenditure
Supply side shocks affect the costs and prices of supply and changes may be due to
-Technological changes
-Natural disasters which may limit the supply of crops etc and therefore change their prices
-Political situations that may affect the price of goods such as oil and gas. An example of this can be seen when Russia cut off the supply of gas to Ukraine for political reasons
Cyclical instability can occur due to shocks to either demand or supply.
Demand side shocks are unexpected events that influence the demand in the economy, they can be caused by other countries as the UK trades with countries from all over the world. They can be caused by:
-Significant rise or fall in the exchange rates in the short term
-Changes in the rate of economic growth with trading partners
-Shifts in AD
-A boom in capital expenditure
Supply side shocks affect the costs and prices of supply and changes may be due to
-Technological changes
-Natural disasters which may limit the supply of crops etc and therefore change their prices
-Political situations that may affect the price of goods such as oil and gas. An example of this can be seen when Russia cut off the supply of gas to Ukraine for political reasons
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