© economics online 2012economics online 20121. © economics online 2012economics online 20122

© Economics Online 2012 1

Globalisation

FDI

Liberalisation

Protectionism

Integration

WTO

Competitiveness

Balance of payments

Exchange rates

Inflation

Unemployment

Fiscal policy

Monetary policy

Supply side policy

The UK Economy in a global context

Development indicators

Development theories

Development strategies

Constraints to development

Policy objectives and policies

Global shocks

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Globalisation



Globalisation

Globalisation is the integration of markets in the world economy. Markets where globalisation is particularly common include:1. Financial markets, including capital, money and insurance

markets.2. Commodity markets, such as markets for oil and coffee.3. Product markets, such as markets for motor vehicles and

consumer electronics.



Globalisation

Factors leading to globalisation1. Developments in transport and communications – for example, the

internet has enabled fast and 24/7 global communication.2. Common technology - global firms use common IT systems helping to

integrate their global operations.3. Capital mobility - when capital can move freely from country to country,

it is easier for firms to locate and invest abroad, and repatriate profits.4. Free and open trade – the relative success of the World Trade

Organisation (WTO), and the collapse of communism. Over the last 30 years, trade openness, which is defined as the ratio of

exports and imports to national income, has risen from 25% to around 40% for industrialised economies, and from 15% to 60% for emerging economies. (Source: The Bank of England, 2006)

5. Growth of powerful multi-national companies (MNCs) - there has been a rise in significance of ‘global brands’



Globalisation

The benefits of globalisation for firms1. Access to larger markets so that firms can benefit from increased

demand, and economies of scale.2. Worldwide access to the cheapest sources of raw materials, which

make firms more cost competitive. 3. Increased profit for shareholders of MNCs.4. Avoidance of regulation by locating production in countries with

softer regulatory regimes, such as those in some developing economies.



Benefits to countries:1. If trade is free, then countries can benefit from the application of the

principle of comparative advantage.2. New trade can be created, a process called trade creation.3. Benefits of inward investment to recipient countries, such as sharing

knowledge between firms in different countries. 4. The macro-economic benefits of increased investment.5. Job creation in the more competitive countries.



The costs of globalisation

1. The over-standardisation of products through global branding, such as Microsoft’s Windows, leading to a lack of product diversity.

2. Diseconomies of scale for large firms, such as difficulties co-ordinating the activities of firms that operate in many countries.

3. Increased power and influence MNCs - MNCs can move their investments between territories - MNCs can be local monopsonies of labour, and push wages lower than the free market equilibrium.

4. Loss of jobs in domestic markets because of increased, and in some cases unfair free trade.

5. Loss of jobs caused through structural unemployment, causing a widening gap between rich and poor within a particular country.



The costs of globalisation

6. Increased risks associated with interdependence of economies:a. Because countries are increasingly dependent on each other, a negative

shock in one country can quickly spread to other countries – e.g. the recent credit crunch.

b. Over-specialisation - countries can become over-reliant on producing a limited range of goods for the global market. Many LDCs suffer by over-specialising in a limited range of products, such as agriculture and tourism.

7. Possible increased inequality as richer nations benefit relative to poorer nations, as suggested in the Kuznets Curve.

8. Increased trade associated with globalisation has increased pollution and helped contribute to CO2 emissions and global warming. It has also accelerated the depletion of non-renewable energy resources, such as oil.

9. The increased risks of globalisation partly explains the popularity of regional trading blocks, and the rise of protectionism.



De-globalisation

The effects of the financial crisisSince the financial crisis, recession and Euro zone debt crisis, the volume of world trade and investment flows has fallen. Some have called this process de-globalisation.

Features of de-globalisation Inward looking attitude and policies Increased protectionism Reduction in trade ‘openness’ (ratio of exports plus imports/GDP) Reduction in FDI



Inequality and development

The Kuznets curve Globalisation may

widen the gap between rich and poor countries.

The greatest inequality can be observed as countries 'take-off' in their development, leading to considerable wealth creation for the few, who quickly gain from development, relative to others.

Kuznets Curve

Inequality increases in the early stages of

development

Development

Ineq

ualit

y



Foreign direct investment (FDI)



Foreign direct investment (FDI)

FDI is the flow of real capital between countries, and is undertaken by private sector firms and by governments.

A large proportion of FDI is associated with cross-border mergers between private firms.

The benefits to firms of investing abroad1. Reduction in transport costs - locating within a foreign market reduces

transport costs to that market, especially for ‘bulk increasing’ products.

2. Access to the country’s markets.3. Access to cheap labour and to skilled labour.4. Access to local knowledge and expertise.5. Exploitation of economies of scope, especially managerial economies,

where fixed management costs can be spread between territories.6. Avoidance of barriers to trade, such as tariffs and quotas.



Investment income

7. Increased investment income - outward investment can lead to increased overseas investment income for a country, such as: 1. Profits from overseas subsidiaries.2. Dividends from owning shares in overseas firms.3. Interest payments from lending abroad.

FDI in the balance of payments accounts The initial outflow is a debit on the capital account, and the investment

income is entered as a credit on the current account.



Inward investment

Countries receiving inward investment gain through:1. An increase in GDP, initially through the FDI itself, followed by a

positive multiplier effect on the receiving economy.2. The creation of jobs.3. An increase in productive capacity – this can be illustrated by a shift

to the right in the Aggregate Supply (AS) or the Production Possibility Frontier (PPF).

4. Producers have access to the latest technology from abroad.5. Less need to import because goods are produced in the domestic

economy.6. The positive effect on the country’s capital account. FDI represents an

inflow, or credit, on the capital account.



Who invests?The USA, France and the UK are the three most important international investors, and recipients of investment.

USA

FRANCE UK

GERMANY

NETHERLANDS

CHINA

SWITZERLA

ND0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

$4,302

$1,719$1,651

$1,378

$850 $834 $804

$3,120

$1,132 $1,125

$701$596

$912

$463

FDI Flows 2009 $(US)Bn Source: UNCTAD

Outward FDI Inward FDI



Share of EU inward investment

EU inward investment The UK receives 22% of

all inward investment into the EU (2003).

There are over 18,000 different investors into the UK, with 1.8m people are directly ‘supported’ by inward investment.

Overseas firms account for around 40% of the top 100 UK exporters.

UK

Fran

ce

Holla

nd

Spai

n

Germ

any

Italy

0

5

10

15

20

25

%

Source – HSBC, 2005



VolatilityDuring the global recession, FDI fell as liquidity tightened and confidence took a severe hit.Some argue that this may trigger a period of de-globalisation.

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 20090

1000

2000

3000

4000

5000

6000 FDI Investors, 1998 - 2009 $BnSource: UNCTAD United States

France

United Kingdom

Germany

RECESSION



Why is FDI volatile?

FDI is highly volatile - possible causes are:1. Fluctuations in exchange rates.2. Fluctuations in interest rates and other monetary policy.3. Changes in the trade cycle – growth in an economy may encourage

FDI, but recession will deter it.4. Expectations about the future.5. Changes in business regulation – tighter or looser. 6. Changes in the level of business taxes.7. Relative wage rates and changes in the minimum wage.8. Inducements and incentives by host countries.9. Changes of government and political stability.



Trade liberalisation and protection



Liberalisation and protectionism

Two opposing forces have shaped the changing pattern of world trade over the last 200 years.

1. Trade liberalisation - this is the process of making trade free of barriers such as tariffs and quotas.

2. Protectionism - protectionism is the process of erecting barriers to trade. Protectionism may be on the increase as a result of the global economic

crisis and recession.



International specialisationThe fundamental principals of free trade Economic production in market economies is based on two

fundamental principles, first analysed by Adam Smith in the late 18th Century.

These are:1. The division of labour, where production is broken down into

small, interconnected tasks.2. Specialisation - where factors of production are given unique jobs

- can be applied to individuals, firms and countries.



Specialisation is the basis of free trade1. Countries trade because they do not have all the goods, services and

resources they need, and buy imports.2. To pay for these imports countries must export goods, services and

resources that other countries need.3. Countries can become increasingly specialist in producing particular

goods, services and resources, and this makes them more efficient over time.

4. Efficiency reduces costs and gives the country a cost advantage, which makes it more competitive.



Comparative advantage It can be argued that world output will increase when the principle of

comparative advantage is applied by countries to determine what goods and services they should specialise in producing.

Comparative advantage is a term associated with 19th Century English economist David Ricardo.

Ricardo argued that countries should specialise in producing goods for which they have a comparative advantage.

Absolute advantage means being more productive and competitive than another country – comparative advantage concerns how much better one country is than another.



Comparative advantage Consider the simple example of

two countries producing only two goods:

Using all its resources, Country A can produce 10m cars or 5m vans, and Country B can produce 20m cars or 7.5m vans.

Should they trade?

Economic theory suggests that they should trade because both countries have a comparative advantage.

Country A Country B

Cars

Vans

10m 20m

7.5m5m


Vans

Cars


Using PPFs to show ‘advantage’

Production possibility frontiers can be used to illustrate cost advantage.

Country B’s PPF is further outward and indicates it has an absolute advantage in both goods.

But it has a comparative advantage in cars because it can produce twice as many, so B should specialise in producing cars.

0

Country B

Country A

Twice as productive

Only 50% more productive

Absolute advantageComparative advantage


Vans

Cars


Numerical example If countries do not

specialise, and allocate resources evenly to both goods, world output is:

Cars = 10 + 5 = 15 Vans = 3.75 + 2.5 = 6.25 = 21.25 million units

If countries specialise and employ the principle of comparative advantage:

Cars = 20 Vans = 5 = 25 million units

However, this analysis does not take into account how transport would increase the costs of trade.

0

Country B

Country A

2.5

5

10

20

5 7.5 3.75

2.5

15

1.0



Opportunity cost ratios We saw earlier that the gradient of a PPF reflects the opportunity cost

of increasing production of one good in relation to another - the lost output of X as a result of increasing output of Y.

If two countries’ PPFs, in terms of two goods, have different gradients then they must have different opportunity costs.

Only when the gradients are different will one country have a comparative advantage, and only then will trade be beneficial.

Copper ore

(tonnes)

Tablet computers

(m)


Opportunity cost and PPF gradients

Countries should specialise in producing goods for which they have the comparative advantage.

Take the example of two countries that can produce either computers or copper ore.

Production possibility frontiers illustrate their maximum outputs.

0

Mythica

Atlantis

20

10

20

40

40 50 30

30

10

50

+ 10

- 10

- 5

What happens if both countries increase their

output of copper ore by 10 m tonnes?

Atlantis sacrifices the least (-5) with Mythica sacrificing 10,

hence Atlantis has the comparative advantage in

copper production.


Copper ore

(tonnes)

Tablet computers

(m)


Opportunity cost and PPF gradients

If we reverse the analysis, Mythica loses the least by increasing its output of computers.

Hence, to achieve the best outcome for both countries, each should specialise and trade with the other country.

0

MythicaAtlantis

20

10

20

40

40 50 30

30

10

50

+ 10

- 20 - 10

Mythica sacrifices the least (- 10) with Atlantis

sacrificing 20, hence Mythica has the

comparative advantage in computer production.



The benefits and costs of free trade

The benefits 1. Applying the principle of comparative advantage means producing in

higher volumes for the export market as well as the domestic market, which leads to the benefit of economies of scale.

2. Increased competition and lower world prices.3. Welfare gains (including increased consumer surplus).4. Trade creation.5. The breakdown of domestic monopolies.6. Increased quality of goods and services.7. More employment as (efficient) domestic firms can sell to the global

market and jobs are created.



The costs1. Over-specialisation - workers risk losing their jobs when world

demand changes (structural unemployment).2. Exhaustion of non-renewables.3. Industries can be destroyed, including:

1. Infant industries2. Declining industries3. Inefficient industries4. Strategic industries

4. Welfare loss associated with loss of trade for domestic producers (loss of producer surplus).



Motives for protection

Why engage in protection? Despite the arguments in favour of free trade protectionism is still

widely practiced. The main arguments for protection are:1. To protect sunrise industries - also known as infant industries, such as

those involving new technologies.2. To protect sunset industries - also known as declining industries, such

as steel production.3. To protect strategic industries - such as energy, water, steel, and

armaments. 4. To protect a resource which is non-renewable, as in the case of oil.5. To deter unfair competition – such as to protect from dumping at

prices below cost.6. To save jobs.



Motives for protection

7. Some countries may protect themselves from trade to help ‘save’ their environment -such as from CO2 emissions caused by increased freight transport.

8. Most economists argue that there are dangers in over-specialisation. The recent global crisis has led to more ‘nationalism’, and raised concerns about free trade and globalisation.

9. The theory of comparative advantage is too unrealistic to apply to the real world, and fails to take into account: Transport costs Exchange rates Imperfect competition Imperfect knowledge



Methods of protectionThere are two types of protection:1. Tariffs - tariffs are taxes, or duties, on imported goods designed to

raise the price to the level of, or above the existing domestic price.2. Non-tariff barriers – which include all other barriers, such as:

a. Quotas - which are physical limits on the volume of imports.b. Public procurement policies – where national governments favour local

firms, such as where a country’s police or ambulance service purchase only locally produced vehicles.

c. General subsidies to domestic firms, which can be used to help reduce price and deter imports - this financial support can also be in the form of an export subsidy, making it easier for firms to export.

d. Health and safety – such as banning imports of unsafe electrical goods.e. Excessive bureaucracy – such as deliberately delaying goods at ports and

airports, or unnecessarily complex and length paperwork associated with trade.


Price

Quantity


Domestic supply Imports

Quotas

A quota is a physical limit on imports.

The no-trade price and quantity are P and Q.

The free trade price and quantity are P1 and Q1.

A quota of Q2 - Q limits imports and encourages domestic firms to supply more as the price is pushed up to Pq.

Imports fall to the quota level, and total supply is Q4.

Domestic supply

Domestic Demand

Q

P

Q1

P1

0

World supply

Q2

QUOTA

Domestic supply +

quota

Pq

Dom

estic

su

pply

Q4

Imports (QUOTA)

Domestic supply

The effect of the quota is to shift the domestic supply curve to the right, by

the amount of the quota

X

Y

X

Y

X to Y is the expanded domestic supply as a result of the price increase

from P1 to Pq



Tariffs

Tariffs are taxes on imported products, usually in an ad valorem form. They are also called ‘customs duties’.

The impact of tariffs1. Domestic consumers face higher prices and lower consumer surplus. 2. Domestic producers receive higher prices and higher producer

surplus – but there is likely to be an overall net welfare loss, which can be seen later.

3. There is a distortion of the principle of comparative advantage.4. There is the likelihood of retaliation from exporting countries, which

could trigger a costly trade war.5. However, in the short run tariffs may protect jobs, infant and

declining industries, and strategic goods.6. Selective tariffs may also help reduce a trade deficit, and reduce

consumption of de-merit good , such as imported tobacco.


Price

Quantity


The Tariff diagram

Without trade, domestic price and quantity are P and Q.

If an economy opens up to world supply, price falls to P1, Q increases to Q2 - domestic producers’ share falls to Q1!

The imposition of a tariff causes price to rise, imports to fall, domestic producer’s share of the market, and producer surplus, to increase.

Domestic Supply

Domestic Demand

Q

P

World Supply

Q1

P1

Q2

Consumer Surplus

Producer Surplus

World Supply + TariffP2

Q3Q40

Tariff Revenue

ImportsDomestic supply

Domestic supply

X Y

However, consumer surplus falls by more than producer surplus

increases - even adding in tariff revenue there is still a net loss. The

net welfare loss is represented by the triangles X and Y.



Costs and benefits of trading blocs

The main benefits for members of blocs:1. Members can specialise, knowing that they have free access to

others member’s markets. This means there is a more complete application of the principle of comparative advantage.

2. Easier access to each other’s markets means that trade between members is likely to increase - trade creation.

3. Producers can benefit from the application of scale economies, which will lead to lower costs and lower prices for consumers.

4. Jobs may be created in member economies.5. Protection from countries outside the bloc6. Firms inside the bloc can be protected from cheaper imports from

outside.


Price

Quantity


Trade creation

With a tariff, the prevailing domestic price and quantity are P1 and Q1.

Domestic market share is 0 – Q4, and imports are Q4 – Q1.

If an economy joins a customs union it must eliminate tariffs. This increases imports, from Q3 to Q2.

Trade is created, from Q1 to Q2.

Welfare is gained (X + Y)

Domestic Supply

Domestic Demand

Q

P

World Supply

Q3

P2

Q2

World Supply + TariffP1

Q1Q40

ImportsDomestic supplyDomestic

supply

X Y World Supply



Costs and benefits of trading blocs

Trading blocs can generate the following costs:1. Loss of benefits of free trade

World trade is distorted, and comparative advantage cannot be fully exploited at the global level.

2. Retaliation and trade disputes The development of one regional trading bloc is likely to stimulate the

development of others, which can lead to trade disputes, such as those between the EU and NAFTA, including the long running EU/US steel dispute, banana wars, and the Boeing (US)/Airbus (EU) dispute.

3. Inefficiencies and trade diversion Inefficient producers inside the bloc can be protected from more

efficient ones outside the bloc. Trade is diverted from efficient global producers.



Economic integration



Stages in economic integration

Preferential trade area (PTA)

Members eliminate tariffs on some goods

Free trade area (FTA)

Members eliminate tariffs

on all goods

Customs Union (CU)

Members eliminate tariffs on all goods and services, and have a common

external tariff to non-members

Monetary Union (MU)

Members share a single currency, central bank, and have a common monetary policy

Full economic integration

A common market, a single currency, central bank, and common monetary and fiscal policies

Inte

grati

on

Common market – a single market

Members eliminate tariffs on all resources, allowing free movement of labour and capital,

and common micro-economic policies



Regional trading blocs (RTBs)

A trading bloc is a group of countries that protect themselves from imports from non-members. There are several types:

1. Preferential Trade Area (PTA) Members eliminated tariffs on some goods

2. Free Trade Areas (FTAs) Members eliminated tariffs on all goods But they do not have a common external tariff against non-members Example - North Atlantic Free Trade Area (NAFTA) (USA, Canada and

Mexico)



Regional trading blocs (RTBs)

3. Customs Unions These also aim to reduce or eliminate tariffs between members But they do have a common external tariff - a common external tariff

means that members must set the same level of tariff against a non-member

4. Common Market Members eliminate tariffs on all resources, allowing free movement of

labour and capital, and common micro-economic policies

5. Further integration Bloc members can also integrate further by adopting a common

currency and common monetary system, including a common central bank and monetary policy (as in the Eurozone).

Beyond this, members can create a fiscal union or fiscal pact, with common taxation and spending policies



The European Union (EU)

The EU - originally called Common Market – was formed in 1957, following the Treaty of Rome.

The EU has evolved through stages of integration.

The aim was to create one market for all products, capital and labour, by eliminating trade barriers.

By 2007, following continuous enlargement the EU had 27 members.

Austria Germany Norway

Belgium Greece Poland

Bulgaria Ireland Portugal

Cyprus Italy Romania

Czech Republic Latvia Spain

Denmark Lithuania Slovenia

Estonia Luxembourg Slovakia

Finland Malta Sweden

France Netherlands UK



The Common Agricultural Policy (CAP)

The EU protects its farmers and growers through its Common Agricultural Policy (CAP).

Through the CAP European farmers received annual subsidies of around €43 billion (2010).

The evolution of CAP CAP was created to ensure continuous food supplies for Europe, and

to provide a fair income for European farmers. Price support schemes, such as guaranteed prices, were first

introduced in 1962. By the mid 1980s, over-production created massive surpluses and

this led to major reforms, including the use of set-aside programmes. By the early 1990s there was a movement away from guaranteed

prices towards direct subsidies to farmers, irrespective of the output they produced.



The Common Agricultural Policy (CAP)

The Fischler Reforms, of 2003, continued the process of decoupling subsidies and farm output, and introduced a green element to CAP, forcing farmers to meet environmental and animal welfare standards.

Single Farm Payments (SFP) were introduced in 2005, and set-aside programmes were abolished in 2009.

The UK receives a controversial rebate against payments into the EU to compensate for that fact that it receives relatively little income from CAP in comparison with France and Spain.



The European monetary system

The main features of the European Monetary System include:1. A single currency, the Euro € - introduced in 2000, with national

currencies scrapped in 2002.2. An independent central bank, the European Central Bank (ECB) -

responsible for monetary stability in the Euro Area (Euro-17).2. A single interest rate - the ECB sets interest rates for the whole Euro

area – no country has the ability to alter its own interest rate.3. The European Financial Stability Facility – introduced in 2010 in

response to the Eurozone debt crisis.4. The co-ordination of macro-economic policies - the aim of

policymakers is to converge the Euro economies.5. The Stability Pact - all members originally agree to keep their budget

deficits under control. Under the rules deficits must be no more than 3% of GDP. This rule was designed to limit the use of fiscal policy which might de-stabilise the economy and weaken the Euro.



The case for the Euro

1. Transparency The prices of goods, services and materials can be compared and workers

can compare wages, and move to take advantage of higher wages.

2. Lower transaction costs There are no commissions to financial intermediaries.

3. Certainty and investment Firms can predict the cost of imported raw materials and can set the price

of their exports. This means can plan ahead and are more likely to invest.

4. Trade creation Trade between members is more likely to increase because of the greater

confidence of trading with a member in comparison with a non-member.

5. Job creation With greater trade there should be more jobs.

6. Discipline Members cannot use devaluation to ‘hide’ domestic inflation.



The case against the Euro

1. Loss of economic sovereignty The Bank of England will not be free to stabilise the UK economy by

using interest rates – they are under the control of the ECB.

2. Convergence problems The UK will find it hard to converge with Europe, because of the

uniqueness of the UK housing market, and because of the closeness of the UK trade cycle to the USA, rather than the EU.

3. Only one interest rate Having only one interest rate is not sensible when dealing with a diverse

range of economies and economic circumstances.


© Economics Online 2012

The case against the Euro4. Asymmetric shocks

These are external shocks that have an unequal impact on an economy. The following are examples of recent asymmetric shocks:

1. September 11th did not affect all Euro area countries evenly.2. The collapse of the Argentinean peso in the late 1990s mainly

affected Spain.3. The handover of Hong Kong to China led many to leave and relocate

to the UK, rather than other European countries.4. The recent financial crisis affected some economies more than

others (especially those with large financial service sectors). In this type of circumstance it is argued that one interest rate (or

common macro-economic policy) will not be appropriate. In essence, the Eurozone is an asymmetrical group of countries, with a

variety of cultures, incomes, institutions, labour markets practices and languages. All of which limit convergence and weaken the effectiveness of the bloc.



‘Tests’ for membership

Under the previous Labour government, five conditions were laid down for membership of the Euro area:

1. Economic convergence - the trade cycles of the UK and Euro area should be in alignment.

2. Flexibility - joining should not harm the flexible product and labour markets of the UK in comparison with the EU.

3. Investment - joining should not discourage domestic investment and FDI.

4. Financial services – ‘the City’ should not suffer.5. Growth and jobs - membership should be good for growth and job

creation.



The World Trade Organisation (WTO)




The WTO was formed in 1995, and has its headquarters in Geneva. It replaced the General Agreement on Tariffs and Trade (GATT) which was formed in 1947. By 2012 there were 155 member countries.

The purpose of the WTO is to:1. To create a set of rules for countries to follow as they engage in trade

(‘trade rules’).2. To promote free and fair trade through multilateral talks and

negotiations.3. To arbitrate between countries who are in dispute.




Evaluation The WTO came into being as a result of over 60 separate agreements

between members. Trade liberalisation clearly brings many economic and political benefits, but many claim that the WTO:

1. Has failed to tackle ethical issues, such as the use of child labour and poor working conditions in developing economies.

2. Has failed to tackle environmental issues, such as the depletion of global fish stocks.

3. Takes too long to arbitrate and settle disputes.4. Favours the powerful developed nations over weaker developing

ones.5. Has failed to promote ‘multi-lateralism’.



The Doha Round

The Doha Round of trade talks began in 2001, with major summit meetings in Mexico (2003), Hong Kong (2005) and Geneva (2004, 2006, and 2008)

The Doha round of talks was also called the development round reflecting its emphasis on trying to promote free trade for the benefit of developing nations.

The Cancun talks focussed on:1. Reducing agricultural subsidies and industrial tariffs imposed by

developed nations which limit the market access of developing nations.2. Harmonising competition rules within different countries.3. Help to poor countries.

The talks collapsed because: The US and EU’s failed to agree reductions in agricultural support and

because some developing countries did not want to agree new investment rules which make it easier for multinationals to invest.



The Doha Round

Since the collapse - the USA and EU have returned to bilateral agreements with favoured nations, rather than multilateral WTO agreements. This highlights a fundamental weakness of the WTO - the failure to promote multilateralism.

The failure of the Doha round meant that rich countries continue to protect themselves from goods produced by the ‘poor’ – agricultural tariffs imposed by the USA and EU have averaged 60%, compared with average industrial tariffs of only 5% (Source: WTO)



UK competitiveness



UK competitiveness

What is competitiveness? Competitiveness means the ability of a country to compete

effectively in global markets. Competitiveness is closely related to productivity.

Measuring competitiveness Competitiveness can be measured in a number of ways, including:1. Relative export prices - relative export prices are one country’s export

prices in relation to other countries, expressed as an index.2. Labour productivity - labour productivity for a country is usually

expressed as GDP per worker, or it can also be measured in terms of GDP per hour of employment.

3. Unit labour costs - unit labour costs are the cost of labour per unit of output.



The World Economic Forum Competitiveness Index The World Economic Forum lists the following indicators of

competitiveness:1. Effective institutions - which create an economic environment in which

businesses can develop, and consumers have confidence. These should be ‘sound, honest and fair’.

2. Effective infrastructure – which provides effective transport and energy supplies.

3. A sound macro-economic environment, including sound public finances, and low and stable inflation.

4. A healthy and educated labour force, with an emphasis on higher education, and the continuous upgrading of skills.



5. Efficient goods markets, with high levels of competition, and low levels of regulation.

6. Efficient labour markets, which are flexible, and provide effective incentives to work and effort.

7. An effective financial market, which provides a flow of capital to business, effectively manages financial risk, and is trustworthy and transparent.

8. The ‘readiness’ of firms to adopt new technology.9. The size of global markets enables firms that are willing to trade to gain

from economies of scale.10. Business sophistication, which relates to the level of business networks,

supporting industries, and advanced business processes.11. Continuous innovation, which counteracts diminishing returns to existing

technology.



UK export competitiveness

Export price competitiveness – this refers to how well a country’s exports compare in terms of price. This is affected by a number of factors, including: Relative UK inflation - even small annual differences can build-up over

time and become significant. The relative real exchange rate (RER) – which is the nominal exchange

rate deflated by an index of prices. For example, if the Sterling Index appreciated by 7% and UK prices rose by 2%, the RER is 107/102 x 100 = 105, i.e. the ‘real’ value of Sterling rose by 5%.

Labour costs per unit - including wage and non-wage costs.



Labour productivity There are two commonly

used indices of productivity:1. GDP per worker.2. GDP per hour worked.

The UK performs relatively poorly against its major competitors.

The main causes of the UK’s poor performance are lack of investment in real capital and human capital. Japan UK

Canada

Germany

France Italy

G7 (Ex U

K) US70

80

90

100

110

120

130

140

Index of productivityUK = 100 (2009)

Source: ONS



The productivity gap

Which ever measure of productivity is used it is clear that the UK lags behind most of its major competitors.

The difference between the productivity of countries like the USA, France and Germany and the UK, is called the productivity gap.

In many other areas of economic performance the UK out-performs its major competitors, but not in the case of productivity.

One clear problem for the UK is the level of educational achievement. According to the Office for National Statistics (ONS) an estimated 4.5 m people have no qualifications.



Factors causing the productivity gap

The productivity gap According to research by the Economic and Social Research Council

the UK’s productivity gap is caused by:1. The level of capital investment

The level of investment per head in the UK is lower than in other advanced economies.

A shortage of skilled labour means that machinery is less effectively used. Relatively low wages means less incentive for UK firms to substitute capital for labour.

2. Information technology The ESRC found that the use of IT in Europe lags behind that in the USA

because of lower levels of competition, higher levels of regulation and less desire to change management practices to incorporate more IT.



Factors affecting UK productivity

3. Innovation and technology transfer The lack of competition in Europe may help explain the lower levels of

R&D as compared with the USA.

4. Skills and human capital development The ESRC found that that a relative lack of skills in the UK is a primary

cause of the UK’s productivity gap. This appears especially problematic in terms of management skills. It is argued that the best graduates go into finance, accounting and consultancy rather than into management.



Flexible labour markets The share of total UK

employment composed of part-time work is high.

This may act as a disincentive to invest in labour, and not allocate sufficient resources to training and development.

However, labour market flexibility is commonly seen as providing advantages in terms of lower unemployment and inflation. Neth

erlands

Sweden

Germany UK

Denmark

Ireland

EU27

France

Italy

Spain

Greece

0

5

10

15

20

25

30

35

40

45

50

% part-time employees, EU, 2009 Source: Eurostat, 2009



Factors affecting labour market flexibility

1. Mobility of labour This includes occupational mobility - the willingness and ability to move

from one job to another; geographical mobility - moving from one region or location to another; and industrial mobility - moving between industries.

2. The extent of labour migration Allowing or encouraging labour to migrate between countries will

increase labour market flexibility in the recipient country.

3. Wage flexibility Wage flexibility includes relative wage flexibility - which relates to the

adjustment of wage rates between sectors of an economy, or between regions - and real wage flexibility - the flexibility of real wages (nominal wages adjusted for inflation) to adjust to economic shocks.



Factors affecting labour market flexibility

4. Making work pay If the reward gap between work and non-work is too small, there may be

little incentive to work. Hence, excessively generous unemployment benefits may reduce labour market flexibility.

5. Skills and training Multi-skilled workers may be able to adjust their working patterns or

workloads to suit changing demand conditions. Training, and training subsidies, can similarly improve labour mobility.

6. Barriers to entry and exit If barriers to entry exist - such as the requirement for excessive

qualifications, or due to trade union restrictive practices - or barriers to exit - such as lengthy contracts or notice periods - labour will become less flexible.



7. Ability to hire and fire Excessive legislation to limit the ability of firms to hire and fire will

reduce flexibility.

8. Information If labour is better informed about job vacancies, or about opportunities

for promotion, workers can respond more effectively to changes in the requirements of firms.

9. Flexi-work If firms are able to offer a flexible working environment and flexible

working patterns, including flexi-hours jobs, overall labour market flexibility will improve. This is also called working-time flexibility.

10. The amount of part-time and temporary work The labour market is more flexible when there is a larger proportion of

part-time work relative to full-time work. Flexibility also improves when temporary contracts can be used.



Investment levels

Many economists attribute the poor level of UK investment in manufacturing over the last 30 years to:1. A relatively low savings ratio - high consumer debt levels, which reduce

aggregate savings levels.2. Although interest rates have been very low since 2008, the UK’s interest

rates have been relatively high compared with major competitors. The Marginal Efficiency of Capital (MEC) diagram can be used to show that demand for investment contracts when rates are high because of the higher opportunity cost of investing. Typically UK rates are higher than those of the USA, Japan and the EU area.

3. More attractive investment alternatives, including: Foreign investment Shares Property The service sector


Interest rates

Q


Investment and interest rates

The demand for capital is inversely related to interest rates. For example, at 4%, the level of investment is £25b.

At lower interest rates, say 3%, the profitability, also called efficiency, of capital is higher, and demand is greater, at £50b.

Conversely, lower interest rates stimulate investment.

4%

£25b

3%

£50b

Marginal Efficiency of

Capital (MEC)



Policies to improve competitiveness

POLICIES TO IMPROVE

COMPETITIVENESS

Improve productivity

Improve infrastructure

Improve education and

skills

Stabilise the macro

economy

Integrated transport links – e.g. Cross rail

Subsidies to public transport

Reduce congestion

Public investment in new technology

Tax incentives for firms to invest

Improve education and skills

Promote flexible labour markets

Measures to improve competition

Incentives to learn Subsidise university

education Subside infant education

– e.g. ‘Sure Start’ Individual learning

accounts Government schemes –

e.g. Learn Direct website

Keep UK close to its trend rate of growth (2.5%) by: Monetary policy Fiscal policyTo: Reduce inflation Stabilise the

exchange rate


Policies to help improve competitiveness

Choosing the right policy depends on identifying the cause of the lack of competitiveness – each country may have different ‘problems’ that they need to address.

Policy options for the UK could include:1. Improving labour productivity by:

Increasing spending on education and training to help develop skills and close any skills gap, but this is expensive and takes time.

Promoting a more flexible labour market, such as reducing trade union power, encouraging part-time work, encouraging new business start-ups, but this also takes time and the increase in flexibility can reduce worker security and lead to lower wages and lower labour costs.

This could also deter investment in labour.




2. Improving competition in product markets, by Deregulation - but some regulation is needed to protect consumers and

workers from unfair practices. Privatisation - but there are few industries left in the UK to privatise. Reducing monopoly power - but it can be argued that monopoly power

helps generate dynamic efficiency. Bringing down barriers to entry - but this is very difficult as some barriers

are ‘natural’ ones, such as economies of scale.




3. Improving the level of investment in the UK, by a range of measures including: Investment grants Investment subsidies Encouraging new product development - these measures may be

helpful, with no major conflicts associated with them, though, as always, spending by government has to be funded.

Keeping interest rates as low as possible - but the danger with this is that low interest rates could trigger an increase in household spending (C) causing demand pull inflation.

Reducing the interest rate elasticity of investment - so it is easier to raise interest rates without negatively affecting investment, for example, by investment grants and tax relief on investment.




4. Creating a stable macro-economic environment, including: Keeping inflation under control, through a mixture of monetary and

fiscal measures. However, higher interest rates deter investment, and could harm competitiveness in the long run.

Keeping sterling stable. Eliminating or controlling excessive public sector debt. Large debts must

be funded by borrowing which can lead to inflationary pressure. Debts can also reduce confidence and lead to a reduction in credit ratings, leading to increases in long term interest rates.

Conclusion Perhaps the best way to improve UK competitiveness is through a

mixture of policies designed to help improve labour productivity, product market competitiveness and long term investment – all of which will improve both price and non-price competitiveness.



Exchange rates



The importance of exchange rates

Exchange rates are important for a trading economy:1. They represent a cost to firms when they have to pay commission on

changing £s for other currencies.2. They create a risk to those firms that hold assets in currencies other

than £s.3. They affect the price of exports, which form a significant part of

aggregate demand (AD), and the price of imports, hence they affect the balance of payments.

4. The Monetary Policy Committee (MPC) of the Bank of England may take the exchange rate into account when setting short term interest rates. Changes in the exchange rate have another transmission route into the economy, via their effect on interest rates.



Measuring exchange rates

Exchange rates can be measured in two ways:1. A bi-lateral rate – which is the rate of exchange of one currency for

another, such as £1 exchanging for $1.75.2. A multi-lateral rate – which is the value of a currency against more

than one currency. Multi-lateral rates indicate the ‘over-all’ value of a currency. This is achieved by using an index which reflects changes in one currency

against a basket of other currencies. Sterling’s average is measured by the Sterling Trade Weighted Index. This tracks changes over time, starting with a base year index of 100. The index is weighted to reflect the relative importance of different

countries in terms of UK trade. This index is also known as the effective exchange rate.



Exchange rate regimes

An exchange rate regime is a system for determining exchange rates for specific countries, for a region, or for the global economy. Throughout history, three basic regimes have existed:

1. Floating - where currencies are allowed to move freely up and down according to changes in demand and supply.

2. Fixed - where currencies are tied to a precious metal such as gold, or being anchored to another currency, like the US Dollar.

3. Managed - where a currency partly floats and is partly fixed, such as happened between 1990 and 1992, when Sterling was managed in the Exchange Rate Mechanism (ERM) of the European Monetary System.



Floating rates Under a floating system a currency can rise or fall due to changes in demand

or supply of currencies on the foreign exchange market.

When the UK imports it must supply poundsand buy euros

When the UK exports

other countriesmust buy pounds

The UK has stocks of £

France has stocks of Euro

€£

£ €

€ £

The value of the pound is determined

in the foreign exchange market, and depends upon relative

demand and supply

£/€ Supply of pounds (determined by imports)

Demand for pounds (determined by exports)

Demand for pounds (determined by exports)

Foreign exchange market IMPORTSEXPORTSEXPORTS IMPORTS

More EXPORTS shifts the

demand for a currency to the

right

More IMPORTS shifts the supply of a currency to

the right



Changes in exchange rates

In a floating regime exchange rates reflect demand and supply. The price of one currency is expressed in terms of another currency.

For example, an increase in exports would shift the demand curve for sterling to the right, and raise the exchange rate.

Q

£ = $

D (derived from exports)

£

Q

S (derived from imports)

£1 = $1.50

£1 = $1.60

The equilibrium exchange rate exists at the rate where demand

and supply equate


Exchange rates and interest rates

Changes in interest rates affect a country’s currency. Higher interest rates lead to an increase in demand for financial assets, and an increase in the demand for a currency.

Lower interest rates reduce speculative demand for assets and reduce demand for a currency. These speculative flows are called hot money.

Q

£ = $

D (derived from exports)

£

Q

S (derived from imports)

£1

Q1


Fixed exchange rates

The IMF system In 1944, at Bretton Woods, New Hampshire (USA), the International

Monetary Fund (IMF) was formed and a system of fixed rates introduced. The IMF was one of three pillars to support the development of post-war economies – the other two being The General Agreement on Tariffs and Trade, later to become the World Trade Organisation, and the World Bank.

The system involved: 1. The US Dollar (US$) as the anchor for the system with the US$ given

a specific value in terms of gold2. Other currencies were given a value in terms of the $, such as £1 =

$2.40c



Fixed exchange rates

But the system collapsed in 1971 because of:1. The build up of US debts abroad, mainly to fund the war in Vietnam2. Inflation in the USA3. Growing doubts about the stability of the $4. Speculative activity against the $ - speculators frantically sold $ until

US President, Richard Nixon, took the US out of the system



Managed regimes

Managed regimes combine market forces and intervention to achieve a ‘desired’ rate, such as the European Exchange Rate Mechanism (ERM), which operated from 1979 to 1999.

Currencies were managed to keep their value inside an agreed band.

Time

+ 2.25*%

- 2.25*%

If the exchange rate rose too high interest rates would have to fall to create an outflow of hot money, or central banks would sell currency

If the exchange rate fell too much interest rates would have to rise or central banks would

buy currency


Evaluation of regimes

Benefits of floating exchange rates1. Flexibility and automatic adjustment.

Under a floating regime deficits and surpluses will lead to adjustments in the exchange rate, which alter relative import and export prices in the future. So, imports and exports can readjust to move the balance of payments back towards a desirable equilibrium.

Exogenous shocks can occur from time to time – floating exchange rates can help the readjustment process.

Floating exchange rates as seen as shock absorbers, along with flexible labour markets and progressive taxes and benefits.

2. Freedom Policymakers are free to devalue or revalue to achieve specific objectives,

such as stimulating jobs and growth - by devaluation to stimulate exports - and reducing inflationary pressure - by revaluation to reduce import prices.



Evaluation of regimes

Benefits of fixed exchange rates1. Stability for firms

Exporting firm’s prices are more stable, as are importing firm’s costs. This is the main reason the Chinese Yuan was fixed against the US Dollar for nearly 20 years.

2. Predictability and confidence Firms can plan ahead – hence they are likely to invest more. Confidence is

a necessary condition for investment, growth and economic development.

3. Discipline Policy makers cannot devalue the currency in an attempt to hide inflation

or a balance of payments deficit - remember, keeping a currency low would reduce export prices abroad and nullify any domestic inflation as well as providing a boost to exports. Policy makers cannot revalue to keep a currency artificially high - to reduce imported cost-push inflation.



Recent UK Exchange rates Sterling fell during 2005, but

rose between 2006 and 2007. However, with the onset of the global recession sterling fell back reflecting the UK’s exposure to the recession.

Between 2005 and 2012 sterling lost 20% of its value.

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

2005 2006 2007 2008 2009 2010 2011

70

75

80

85

90

95

100

105

110

115

120

Sterling Effective Exchange RateJan 2005 = 100

Source: Bank of England


© Economics Online 2012 91© Economics Online 2012

The Balance of Payments




Balance of payments

A balance of payments means that revenue from selling goods and services abroad equals expenditure on imports of goods and services.

The balance of payments is an official record – account - of these payments. Statistics on imports and exports have been gathered in the UK since 1687.

As an official record, the balance of payments is broken down into two accounts - the current account and the capital and financial account.



Balance of payments

The current account The current account is made up of the following payments:

1. Trade in goods (‘visibles’) - which includes the import and export of: Finished goods, such as cars, computers. Semi-finished , such as parts for assembly. Commodities, such as oil, tea and coffee.

2. Trade in services, such as financial services, tourism and consultancy3. Investment income, which includes:

Overseas profits, such as those from business activities of subsidiaries located abroad.

Interest received from UK financial investment and loans abroad. Dividends from owning shares in overseas firms.

4. Financial transfers, such as gifts, donations to charity and overseas aid



Current account (2010) The Current Account for

2010 showed that the UK had a deficit of £38b.

ITEMCredits

(£b)Debits

(£b)Balance

(£b)

Goods 227 310 -83

Services 158 109 49

Income 173 143 30

Transfers 16 31 -14

TOTAL 576 594 -18

The UK’s major goods imports are:1. Electrical machinery 2. Cars and transport equipment3. Mechanical machinery4. Clothing 5. Petrol

Source – ONS



The capital and financial account

This account measures the flows of capital and finance, including:1. Real foreign direct investment (FDI) - such as a UK firm setting up a

manufacturing plant in South Africa.2. Portfolio investment - such as UK citizens buying shares in an overseas

firm in anticipation of a long term return.3. Short-term speculative flows, called hot money - where speculators invest

abroad to seek out the highest short-term return.4. Official financing - which occurs when a central bank buys or sells

currencies, securities and other assets to create an inflow or outflow in the accounts. In an accounting sense the Bank of England must ensure that the account balances.



Official financing

The balancing item Gathering accurate data is a huge challenge, and is impossible

without a device called the balancing item. There are inevitable errors in data collection as well as omissions. To

allow for these, government statisticians employ ‘the balancing item’, which can be defined as the device used to compensate for errors and omissions in the balance of payments data, and which brings the final balance of payments account to zero.



When is a current account deficit a problem?

A deficit is a problem if:1. It is persistent.2. It forms a large share of GDP.3. There are no compensating inflows.4. The economy has low reserves.5. The economy has a poor record of repaying debt.



Economic growth and trade performance

There is a strong connection between a growing economy and trade deficits.

The strong inverse connection between a growing economy and trade deficits can be seen in the graph.

Economic growth above trend rate accelerates the worsening of the trade balance.

1986 1989 1992 1995 1998 2001 2004 2007 2010-3

-2

-1

0

1

2

3

4

5

6

-50

-40

-30

-20

-10

0

10

Growth

Trade in goods and services

Growth (%) Trade Balance

£B

Trend rate

Above trend rate

Worsening deficit

2.5



A current account deficit




Causes of current account deficits

There are a number of possible causes of a persistent current account deficit, including the following:

1. Excessive growth If the economy grows too quickly, and rises above the ‘trend rate’ for an

economy , which in the UK is around 2.5%, then domestic output (AS) cannot cope with domestic demand (AD).

2. High export prices, which could occur if: Inflation is higher than in other countries, or its currency is too high,

making exports expensive and imports cheap (i.e. the currency is over-valued).

3. Non-price factors discouraging exports, including: Badly designed products, poor marketing or a worsening reputation for

reliability.



Causes of current account deficits

4. Poor productivity An economy might not be producing enough from its scarce factors of

production. Labour productivity plays an important role in a country’s competitiveness and trade performance.

5. Low levels of investment in real capital This could be caused by excessive long term interest rates, or low levels

of research and development.

6. Low levels of investment in human capital This involves a lack of investment in education and training, which

reduce skill levels relative to competitor countries and force countries to produce low value exports.



Dealing with a current account deficit There are four basic strategies for dealing with a persistent deficit.1. Deflating demand

Deflating demand means deliberately reducing consumer spending, or reducing its rate of growth through tighter fiscal or monetary policy.

As a by-product of this, imports are likely to fall – hence deflating demand is said to work by expenditure reduction. This policy targets general spending, and if imports are dependent on spending, then imports will fall as spending falls.

The connection between spending and imports is called the marginal propensity to import, which is expressed as:



Dealing with a current account deficit

Evaluation1. The main criticism of deflationary policy is that, as spending-power must

fall, personal incomes and standards of living will also fall. This can trigger demand deficient unemployment.

2. For the above reasons deflation is politically unpopular. Voters are much more likely to be concerned with recession and unemployment than with a balance of payments deficit!

3. It is also difficult to predict the precise effect of a fall in spending on imports – this requires an accurate calculation of the marginal propensity to import.


Injections & Withdrawals

Real Y

104

Deflating domestic income

The cross diagram shows the relationship between income and trade.

The export line is horizontal as exports are determined by overseas income. The import line is upward sloping, given a positive marginal propensity to import.

Deflation reduces spending, and income, which falls to Y1 so that imports fall but exports are left unaffected.

X (Exports)

M (Imports)

Y

At Y there is a deficit

Y1

At Y1 the deficit is reduced

BALANCE


Devaluation

2. Devaluation This means deliberately reducing the value of a country’s currency. It

works by expenditure switching. A fall in the exchange rate will reduce export prices, causing overseas

consumers to switch to UK products - hence leading to a rise in export demand.

It will also lead to an increase in import prices, causing UK consumers to switch away from imports to domestically produced products. This will lead to a fall in import demand.

Evaluation1. Devaluation relies on the assumption that the sum of price elasticity of

demand for imports and exports is elastic (>1) - the Marshall-Lerner condition. However, this may not be satisfied in the short run, or even the longer run.



Devaluation

2. Devaluation may also trigger cost-push inflation - a fall in the value of a currency will increase the price of imported goods, in terms of the domestic currency.

3. Devaluation may be interpreted as a hostile move against other countries, and may lead to retaliation by competitors, so that no long term benefit is derived by the devaluing country.



Import and export elasticity To understand the effects of devaluation it is necessary to reconsider price

elasticity of demand, and Marshall-Lerner condition its affect on revenue and spending.

Price Price

Q Q

Demand for IMPORTS

Demand for EXPORTS

D

P

Q2

D

Q

P1P1

P

Q1 Q1Q Q2

Devaluation raises import

prices

New import spending

when demand for imports is elastic

New import spendingwhen demand for

imports is inelastic

New export revenue if demand for

exports is elastic

New export revenue if export demand

is inelasticImport spending

before thedevaluation

Inelastic

Elastic

Elastic

Inelastic

Export revenuebefore the

devaluation

Clearly, the optimal situation is to devalue when price elasticity of demand for both imports and exports is elastic

– import spending falls and export revenue rises!

Devaluation reduces

export prices



The ‘J’ Curve



109

The ‘J’ Curve

Assuming the Marshall-Lerner condition is satisfied devaluation will improve the balance of payments.

If it is not satisfied, devaluation will worsen the balance of payments.

A J-Curve effect will exist when the Marshall-Lerner condition is met in the long run but not the short run.

Time

Balance of Payments

(-)

(+)

2008 2009 2011

Deficit

Surplus

If PEDm is elastic then the fall in the demand for imports is proportionately

greater than the price rise – import spending will fall. If PEDx is elastic, the fall in export prices is proportionately

less than the rise in export revenue. The net effect is an improvement in the

balance of trade.


Direct controls

3. Direct Controls A third option to help reduce a current account deficit is to impose direct

controls on imports by erecting barriers against imports or by providing assistance to exporters. Specific measures include: Tariffs Non-tariff barriers, such as quotas, subsidies to domestic firms and

discrimination against imports and in favour of domestic firms Evaluation

In the short run trade barriers may help to reduce imports and help improve the current account. However, retaliation is a likely response, and any short term gains will be eroded away. So direct controls are not an effective long term solution to a current account deficit.



Supply-side policy

4. Supply-side policy Finally, supply side policy could be used to help improve an economy’s

ability to produce. There are a number of specific individual actions that a government could take to improve supply-side performance, including measures to improve labour productivity and labour market flexibility.

Evaluation Supply-side policy can provide a highly effective policy framework for

long term improvement in competitiveness and current account performance. The major problem is that supply-side policy may take decades to work and is not a ‘quick fix’.



Indicators of development



Development and growth

Growth and development Economic growth refers, narrowly, to increases in economic welfare, whereas

economic development refers, more widely, to economic, political and social progress.

Economic growth is an important and necessary condition for development, but it is not a sufficient condition. Growth alone cannot guarantee development.

Freedom and development According to the influential development economist, Amartya Sen,

development is about creating freedom for people, and about removing obstacles to greater freedom.

Obstacles to freedom, and hence to development, include poverty, lack of economic opportunities, corruption, poor governance, lack of education and lack of health.



Indicators of development

The Human Development Index (HDI) The HDI was introduced in 1990 to provide an accepted way of measuring

economic development.

The HDI has two main features: 1. A scale from 0 (no development) to 1 (complete development).2. An index, which is based on three criteria:

1. Longevity - measured by life expectancy at birth2. Knowledge - measured by adult literacy and number of years in school3. Standard of living - measured by real GDP per head at Purchasing Power Parity –

What the figures mean1. An index of 0 – 0.49 means low development - for example, Nigeria was 0.42 in

2010.2. An index of 0.5 – 0.69 means medium development – for example, Indonesia was

0.6.3. An index of 0.7 to 0.79 means high development – for example, Romania was 0.76.4. Above 0.8 means very high development – Finland was 0.87 in 2010.



HDI for selected countries:

Norw

ayAu

stra

liaNew

Zea

land

Unite

d St

ates

Irela

ndNet

herla

nds

Cana

daSw

eden

Germ

any

Japa

nSw

itzer

land

Fran

ceIsr

ael

Finl

and

Icela

ndBe

lgiu

mDe

nmar

kSp

ain

Greec

eIta

ly

Unite

d Ki

ngdo

mAr

genti

na

Russ

ian

Fede

ratio

nKa

zakh

stan

Chin

aEg

ypt

Indi

aPa

kista

nGha

naM

ozam

biqu

eZi

mba

bwe

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

HDI for selected countries, 2010Source: hdr.undp.org

Very high

High

Medium

Low



Life expectancy

A variety of factors may contribute to differences in life expectancy, including: The stability of food supplies War and natural disasters The incidence of disease

According to the World Bank: Over the past 30 years, life

expectancy in developing countries as a whole increased by 10 years – however the changes have not been evenly distributed.

Heavily indebted countries lag behind the rest of the developing world.

.1980198319861989199219951998200120042007

45

50

55

60

65

70

75

80

85 Life expectancy - yearsSource: World Bank

Euro area

European Union

Europe & Central Asia (all income levels)

East Asia & Pacific (all income levels)

East Asia & Pacific (developing only)

Europe & Central Asia (developing only)

Arab World

Heavily indebted poor countries (HIPC)



Literacy

Adult literacy rates Adult literacy can be broadly defined as the percentage of those aged 15 and

above who are able to read and write a short, simple, statement on their everyday life.

More extensive definitions of literacy includes those based on the International Adult Literacy Survey.

This survey tests ability to understand printed text, to interpret documents and perform basic arithmetic.



GDP per capita

GDP per capita GDP per capita is the commonest indicator of material standards of living, and

hence is included in the index of development.

Evaluation of GDP measures: GDP statistics are widely used for comparing economic performance of

developing countries, but they can be criticised because:1. Average GDP per head may increase, but the distribution of income may get wider.

Mean averages can be misleading, and median figures may be more useful.2. Citizens may work longer hours - in which case some of the growth may occur

because of increased work rather than through greater productivity.3. Citizens may do more unpaid work in one country - but this is not likely to be

recorded.4. Prices of similar products may be different - figures must be adjusted to take into

account different purchasing power of the local currency. The process of undertaking this conversion is called adjusting to create Purchasing Power Parity (PPP).



5. Negative externalities may be greater in one country - countries with higher GDP may have the higher levels of pollution.

6. Non-marketable transactions – public and merit goods are not generally bought and sold in markets, so the value of these to a national economy tend to be underestimated.

7. The size of the hidden economies can vary - using crude GDP statistics for diverse countries could be misleading.

8. Conversion to a common currency - converting GDP figures to a common currency may give misleading figures. Exchange rates for ‘closed’ economies may be under or over valued.



Measure of economic welfare (MEW)

Nordhaus and Tobin In 1972, Yale economists William Nordhaus and James Tobin introduced their

Measure of Economic Welfare (MEW)* as an alternative to crude GDP. MEW adjusts national income to include the value of leisure time and the

amount of unpaid work in an economy. It also includes the value of the environment damage caused by industrial

production and consumption, which reduces the welfare value of GDP. *Nordhaus, WD and Tobin, J (1972) Is Growth Obsolete? Economic Growth,

National Bureau of Economic Research, no 96, New York.

The Index of Sustainable Economic Welfare The Index of Sustainable Economic Welfare (ISEW), develops MEW by

adjusting GDP further by taking into account a wider range of harmful effects of economic growth, and by excluding the value of public expenditure on defence.



Purchasing power parity

Purchasing power parity (PPP) The alternative to using market exchange rates is to use purchasing power

parities (PPPs). The purchasing power of a currency refers to the quantity of the currency

needed to purchase a given unit of a good, or common basket of goods and services.

Purchasing power is determined by the relative cost of living and inflation rates.

Purchasing power parity means equalising the purchasing power of two currencies by taking into account these cost of living and inflation differences.

The Big Mac Index This index, devised by The Economist magazine, calculates how many units of

a local currency are needed to purchase a Big Mac. Exchange rates can then be adjusted according to how much local currency is required.



Growth and development theories



Types of growth theory

Growth theories Growth theories attempt to explain the necessary conditions for growth to

occur, and to weigh up the relative importance of particular conditions. Early growth theories attempted to find general determinants of growth

which could be applied to all cases of growth. Modern theories accept that conditions for growth change over time, and vary

between countries and regions.



Linear stage theoryRostow’s linear stage theory One of the first growth theories was that proposed by American economic

historian W. Rostow in the early 1960s. Rostow argued that economies must go through a number of developmental

stages. He argued that these stages followed a logical sequence:

Rostow’s stages are:

Traditional society Dominated by agriculture and barter exchange

Pre-take off Increased savings ratio

Take off Positive growth rate

Drive to maturity Ongoing movement towards development

Mass consumption Citizens enjoy high and rising consumption per head.



The Harrod-Domar growth model

The Harrod-Domar Model The importance of savings is central to the work of Harrod and Domar. According to this theory there are two determinants of the rate of growth:

1. The capital-output ratio - which shows how much new capital (e.g. £10) is needed to create a given amount of new national output (e.g. £2).

2. The savings ratio - which shows how much is saved (e.g. £10) from a given amount of national income (e.g. £100)

The model indicates how these two ratios affect the rate of growth1. The higher the savings ratio, the higher the rate of growth2. The higher the capital-output ratio, the higher the rate of growth

Economies must save and invest a certain proportion of their income to grow at a certain rate – failure to develop is caused by the failure to save, and accumulate capital.


Factors Incomes Spending Goods

Households

Firms


Savings and capital-output ratios

SavingsSavings

CapitalOutput

Saving is income not spent on current consumption - it provides the flow of funds necessary for capital accumulation, which is needed for economic growth.

The capital-output ratio (O/K) indicates how much capital is needed to create new output

Capital

IncomeIncome

The savings ratio indicates the ratio of savings to national income

Output

savings ratio

Capital (K)/output ratio

£100 £80 £20

£20£4

£20 S

Y

20

100

O

K

4

20

£40 40

100

£4016

40£16

The higher the savings and capital output ratio, the greater the growth in output

Income circulates from

firms to households

Some income is saved

Saving allows capital accumulation

Income

MORE CAPITAL MEANS MORE OUTPUT AND HIGHER ECONOMIC GROWTH



Evaluation of stage theory

The theories of Rostow, Harrod and Domar, and others consider savings as a sufficient condition for growth and development.

If income is low, savings will not be accumulated. According to Rostow, saving between 15 and 20% of income is enough to provide the basis for growth.

Although saving is regarded as highly significant, modern growth theory takes into account a broad set of growth factors.

Other criticisms of stage theory point to general weakness in terms of the unrealistic assumptions of these models, such as perfect knowledge, stable exchange rates, and constant terms of trade.

Modern theory tends to see savings as a necessary but not sufficient condition for growth.



Structural change models

The Lewis model The Lewis model is also known as the two sector model, and the surplus

labour model. It focused on the need for countries to transform their structures, away from

traditional agricultural economic activity, with low productivity of labour towards industrial activity, with high productivity of labour.

Agriculture IndustryAgriculture Industry

Labour



In the Lewis model the line of argument runs:1. Agriculture generally under-employs labour2. The marginal productivity of labour is virtually zero3. So transferring workers out of agriculture does not reduce productivity4. Labour is now free to work in the more productive urban industrial sector5. Industrialisation is now possible6. Profits are recycled into more and more industrialisation7. Capital accumulation is now possible8. Once this occurs development sustains itself



Evaluation of the Lewis model

Limited benefits of industrialisation Despite the logic of the Lewis approach the benefits of industrialisation may

be limited because:1. Profits may leak out of the economy and find its way to developed economies

- capital flight.2. Capital accumulation may reduce the need for labour in the urban industrial

sector.3. The model assumes competitive product and labour markets, which may not

fully exist.4. Urbanisation creates urban squalor with unemployment replacing

underemployment.5. Only a small elite may benefit from industrialisation.



Industry

Clark-Fisher’s structural change model As early as 1935 Allan Fisher had noted that economic progress led to the

emergence of a large service sector. The Clark-Fisher hypothesis states that development will eventually lead to

the majority of the labour force working in the service sector. This is because high income elasticity of demand for services – as income rise

demand for services increases and more employment and national output are allocated to service production.

Lower productivity in the service sector (with less ability to apply new technology), so prices of services rise relative to primary and secondary goods. This means an increasing share of national consumption is allocated to the service sector.


Labour

IndustryAgriculture Services

Labour



Dependency theory

Dependency theory became popular in the 1960’s as a response to research by Raul Prebisch.

Prebisch found that increases in the wealth of the richer nations appeared to be at the expense of the poorer ones.

What did dependency theory advocate? Dependency theory advocated an inward looking approach to development

and an increased role for the state in terms of: Imposing barriers to trade Making inward investment difficult Promoting nationalisation of industries



Dependency theory

Why did it lose favour? Although still a popular theory in history, dependency theory has disappeared

from the mainstream of economic theory in recent years. This is largely as a result of the emergence Far Eastern economies, especially

India. The inefficiencies of state involvement in the economy, and the growth of

corruption, have been dramatically exposed in countries that have followed this view of development, most notably a number of African economies, including Zimbabwe.



Neo-classical theory

Three different Neo-classical approaches to development have emerged:1. The free market approach - markets alone are sufficient to generate

maximum welfare.2. The public choice approach - an extreme Neo-classical model which stresses

that all government is ‘bad’ and leads to corruption and the gradual confiscation of private property.

3. The market friendly approach - while markets work, they sometimes fail to emerge, and government has a role to compensate for three main market failures; missing markets, imperfect knowledge and externalities.

Neo-classical economists believe that, to develop, countries must:1. Liberate markets2. Encourage entrepreneurship (risk taking)3. Privatise state owned industries4. Reform labour markets (such as reducing the powers of trade unions)



Liberalisation There is a broad consensus between Neo-classical economists that free trade

can help stimulate growth and development by:1. Encouraging FDI.2. Encouraging the application of economies of scale.3. Increasing competition and breaking down domestic monopolies.4. Creating a low inflation, stable, macro-economic environment.



New growth theory

New growth theory A central proposition of New Growth theory is that, unlike land and capital,

knowledge is not subject to diminishing returns.

The importance of knowledge The development of knowledge is seen as a key driver of economic

development. The implication is that, in order to develop, economies should move away

from an exclusive reliance on physical resources to expanding their knowledge base, and support the institutions that help develop and share knowledge.

Government should invest in knowledge and human capital, and the development of education and skills.

It should also support private sector research and development and encourage FDI, which will bring new knowledge with it.




Inefficiencies

Imbalances

Population

Lack of capital

CorruptionMissing markets

Environmental depreciation

Trade barriers

Lack of education

Poverty and inequality



Inefficiencies

A significant limit to economic growth and development is inefficiency in the use of scarce resources:

1. Productive inefficiency (not producing at lowest possible average cost.)

This may be because of the failure to apply technology to production, or because of the inability to achieve economies of scale. Opening up the economy to free trade may help reduce this type of inefficiency.

2. Allocative inefficiency – when competition is restricted, or when production is in the hands of the state, prices might not reflect the marginal cost of production.

3. ‘X’ Inefficiency – also arises from an absence of competition and is associated with inefficient management.

In all cases, opening up to free trade may promote competition and reduce inefficiency.



Imbalances

Not all sectors of an economy are capable of growth. For some countries, too many scarce resources may be allocated to

sectors with little growth potential. This is especially the case when countries specialise in agriculture and primary commodities.

In these sectors there is little opportunity for economic growth because the impact of real and human capital development is small, and marginal factor productivity is very low.

Most development theorists argue for a drive for agricultural efficiency to allow resources to move to high productivity uses.



Population constraints A high rate of population growth may constrain economic growth. At first, growth creates positive externalities, such as better health and

education, which lead to a decline in the death rate, but no change, or an increase, in the birth rate.

Over time life expectancy rises, but the age distribution remains skewed at the lower, dependent age. More and more of the population are dependent consumers, with proportionately fewer producers.

The short-term gains from growth are quickly eroded as GDP per head actually falls.

Only when the birth rate falls will GDP per head rise.



Aging population An aging population is also a potential constraint on growth, as more

workers leave the labour market, tax rates rise, and government spending on healthcare increases. Resulting public debt may limit the possibility of fiscal expansion during a recession.



Poverty and inequality One clear feature of less developed countries is the impoverishment

of a large proportion of their inhabitants, caused by a lack of income, either through unemployment, under-employment, or low wage employment.

Types of income The types of income that can be earned are:1. Earned income, from selling labour in the labour market, including:

Wages, which is the largest source of incomeSalaries and commission, which represents a very small fraction of

income, in comparison with more developed economies

2. Unearned income, such asRents from land ownership and interest from lending money (i.e. credit)



Measuring inequality

Inequality can be quantified by looking at the distribution of income or wealth.

1. The distribution of wealth is likely to be much greater than income because wealth is built up over many decades, and for some families, over centuries.

2. The distribution of income is relatively easier to measure - valuing wealth is difficult because much wealth is hidden from view and wealth changes its value over time.

The Gini co-efficient and indexThe Gini co-efficient or index is a mathematical devise to compare income

distributions over time and between economies.The co-efficient is calculated by comparing the area under the Lorenz curve

and the area from the 450 line to the right hand and bottom axis. The co-efficient ranges from 0 to 1 - the closer to one, the greater the inequality.

The Gini Index is the Gini coefficient, expressed as a percent - the closer to 100%, the greater the degree of inequality.



The Lorenz curve

The Lorenz Curve A Lorenz curve shows the %

of income earned by a given % of the population.

100

90

80

70

60

50

40

30

20

10

Cumulative Income (%)

Cumulative Population (%)

Line of p

erfectl

y equal

distrib

ution’

Lorenz C

urve fo

r

Country X

10 20 30 40 50 60 70 80 90 100

% of Pop

% of Y for ‘perfect distribution’

% of Y in Country X

20 20 2

40 40 10

60 60 25

80 80 45

100 100 100

The Gini co-efficient is calculated by comparing the area from the curve to the 450 line and the area from the axis

to the 450 line. The closer to 1, the greater the inequality



Comparing countries

Comparing countries The further the Lorenz Curve

from the 45 degree line, the less equal (wider) the distribution of income.

100

90

80

70

60

50

40

30

20

10

Cumulative Income (%)

Cumulative Population (%)

Line of ‘p

erfectl

y equal

distrib

ution’

Lore

nz Curve

for

Country X

10 20 40 60 80 100

% of Pop % of Y in Country X

% of Y in Country Y

20 2 1

40 10 5

60 25 15

80 45 30

100 100 100 Lore

nz Curve

for

Country Y

Changes in the Lorenz curve (and Gini co-efficient) can be used to assess the effectiveness of policies designed to

reduce poverty and narrow the distribution of income.



Poverty What is poverty?1. Absolute poverty

The simplest definition of being poor is ‘…being unable to subsist…’, and being deprived of basic human needs, such as food, drink, shelter and clothing. A common monetary measure is ‘..receiving less than $2 a day…’.

Extreme poverty is defined as a situation where individuals cannot afford to eat a sufficiently nutritious diet.

It is also possible to establish an international poverty line, at, say $700 per person per year, and then compare countries by estimating the purchasing power equivalent of that sum in terms of the countries own currency.

2. Relative poverty It can be argued that poverty is best understood in a relative way – what is poor in

New York is not the same as what is poor in Calcutta. Most relative definitions suggest that poverty is the inability to reach a minimum

accepted standard of living in a particular society. Definitions of relative poverty vary considerably, but many countries use the

following:– The poor are those living on ‘..less than 60% of median income..’.



Estimated absolute poverty

Absolute poverty, by region Taking the international poverty

line, as a region, Asia has the highest population living in poverty.

However, as a region of the world, Sub-Saharan Africa has the highest level of poverty as a proportion of total population, at over 60%.

The second poorest region is Latin America, with 35% of its population poor.

Total World

Asia Sub-Sahara

North Africa

Latin America

0

200

400

600

800

1000

1200

1400

People Living in Absolute Poverty (millions, and %)

23%

25%

62%

28%35%

Source – United Nations

148



149

Inequality and development

The Kuznets curve Economic development

may widen the gap between rich and poor countries.

The greatest inequality can be observed as countries 'take-off' in their development, leading to considerable wealth creation for the few, who quickly gain from development, relative to others.

Kuznets Curve

Inequality increases in the early stages of

development

Development

Ineq

ualit

y



Lack of financial capital

Many developing economies do not have sufficient financial capital to engage in public or private investment because:

1. Growth is insufficient to allow savings to accumulate.2. High interest rates needed to encourage more saving will deter

investment.3. Public debts may be too large.4. Private investment may be crowded out by public sector borrowing.5. An absence of credit markets in many developing economies, which

discourages both lenders and borrowers.



Poor governance

Some developing economies suffer from corruption and poor governance:

1. Theft of public funds by politicians or government employees.2. Theft and misuse of overseas aid.3. In some developing economies bribery is the norm, which seriously

undermines the operation of the price mechanism.



Missing markets

Credit markets Missing markets usually arise because of information failure. Lenders in

credit markets may be unaware of the full creditworthiness of borrowers. This pushes up interest rates for all borrowers.

Low risk individuals are deterred from borrowing, and credit markets in developing economies may be completely missing.

Microfinance is increasingly used to reduce this problem in developing economies.

Insurance markets Similarly, insurance markets may be under-developed, with few insurers

wishing to accept ‘bad’ risks. Insurance premiums are driven up, and ‘good’ entrepreneurs may not be prepared to take such uninsured risks.

The result – new businesses fail to develop.



Absence of property rights In many developing economies it is not always clear who owns

property, especially land. Given this, there is no incentive to develop the land because of the

free-rider problem.

Absence of a developed legal system In many developing economies there is absence of a developed legal

system in the following areas:1. Property rights are not protected2. The right to start a business is limited to a small section or a favoured elite3. Consumer rights are not protected4. Employment rights do not exist5. Competition law is limited or absent



Lack of education

Human capital development requires investment in education. Education is a merit good, and as such the long term benefit to the individual, and to society, is under-perceived.

For many in developing economies, the return on human capital development is uncertain in comparison with the return on immediate employment on the land so there is little incentive to become educated.



Over-exploitation of environmental capital

The long term negative effect of the excessive use of resources may be less clear than the short term benefit.

This means that there is a tendency for countries not to conserve resources. But this can have an adverse effect on growth rates in the future.



Barriers to trade

One important constraint to economic development is the denial of access to the markets of the more developed, industrialised, countries.

Developed counties may impose tariffs and quotas and other protectionist measures individually, or more commonly as a member of a trading bloc.



Development strategies



Developing agriculture and primary products

Many developing countries specialise in agricultural and other primary products.

Indeed, the principle of comparative cost advantage suggests that specialising in commodities and products with the lowest opportunity cost will provide the best opportunity for economic development.

However, over-specialisation, particularly in terms of primary production, can be highly risky. A country can be locked into slow development if it specialises in a few primary products because:

1. Primary products have low valued added and receive a small share of global income

2. Yields from land are likely to be inconsistent3. Price instability can make it hard to survive, and to invest in new

technology4. Countries are more likely to be adversely affected by global shocks



Low elasticity

Low income elasticity of basic commoditiesAs world incomes rise proportionately less income is allocated to primary

products, with low income elasticity, and more is allocated to manufactures and services.

Low price elasticity of basic commoditiesMany commodities tend to be price inelastic, such as foods, beverages

and basic clothing, and prices have tended to fall in the long run in relation to manufactures.

This means that commodity exporting countries have tended to suffer, and as export prices fall relative to import prices of manufactures, the terms of trade of many developing economies fall

This means they have to export increasingly more commodities to pay for the same volume of imported manufactures, including both consumer and capital goods.



Falling terms of trade - The Prebisch-Singer hypothesis

A country’s terms of trade indicate how high a country’s export prices are in relation to their import prices, and is expressed as:

The Prebisch-Singer hypothesis states that:Over time the terms of trade for commodities and primary products

deteriorates relative to manufactured goods. This implies it is economically unsound to rely on agriculture to secure growth and development.

This means that, just to keep up with developed economies, and maintain the existing development gap, countries relying on producing and exporting primary products, whose terms of trade decline, must continually increase output.

Index of export pricesIndex of import prices

X 100



Falling incomes Incomes have fallen

because, in the long term the supply of food has increased because: The greater use of new

technology and better yields.

New entrants into markets (like Vietnam into the coffee market) have also helped shift the market supply curve to the right.

Q

Price

D

P

Q

S

P1

Q10

AA

BB

Revenue

Revenue



Unstable prices

The cobweb diagram best explains the tendency for price instability.

Initially, we can assume a stable equilibrium price.

Followed by a negative supply shock (e.g. bad weather).

Price is now driven up to P1.

Next year, planned output rises to Q2, but this drives price down to P2.

The process continues until the price is so low that producers leave the market. Q

Price

D

P

Q

S

P1

Q10

S1 S2

Q2

P2

S3

Q3

Long Run Supply



Protectionism

Relying on agricultural improvements as a driver for development is also risky because of protectionist policies adopted in many developed countries.

The world’s two largest economies, the US and EU, are difficult to penetrate given the high level of support and protection for their farmers, with many agricultural tariffs in excess of 50%.



Development of agriculture Most development theories conclude that improvements in

agriculture are crucial to development prospects. Agriculture can be developed by a range of policies, including:1. Extending property rights to workers.2. Land reform and improvement programmes.3. Applying technology to food production.4. Preserving environmental capital.5. Joining trading blocs.



Promoting industrialisation Many development theorists, including the Fisher, Clark and Lewis,

highlight the significance of increasing factor productivity through industrialisation.

The Lewis model, also known as the two sector model, and the surplus labour model, focused on the need for countries to transform their structures, away from traditional agricultural economic activity, with low productivity of labour towards industrial activity, with high productivity of labour.


Labour



Inward looking policies

An inward looking strategy dominated thinking in the post-war period – this approach can be described as interventionist, centralist and protectionist, and guided policy making in many African and Latin American countries.

The general economic strategy was import substitution. The industries targeted were those which provided the largest quantity of imports.

Inward looking strategies also involved heavy subsidies to domestic producers as well as limiting the activities of MNCs.



The benefits of inward looking policies

Inward looking policies generated some clear short term benefits including:

1. Protecting infant industries. 2. Protecting declining industries.3. Generating employment.4. Increasing incomes.5. Preserving traditional ways of life.



Outward looking policies – embracing globalisation

A number of important global events have forced countries to become more outward looking, including:

1. The realisation that decades of using an inward looking strategy had not resulted in growth rates necessary to close the development gap between countries.

2. With the collapse of communism the opportunity arose for many countries to introduce more outward looking policies.

3. The benefits of globalisation cannot be exploited with an inward looking approach.

Outward looking policies typically include:1. Trade liberalisation and market reforms.2. Membership of the WTO.3. Encouraging FDI.4. Encouraging inflows of human capital.



The benefits of outward looking policies

1. Welfare gains from tariff removal.2. Trade creation as a result of free trade.3. The greater spreading of risks.4. Greater positive feedback effects from growth.5. Greater competition and increased efficiency of domestic firms.6. More able to cope with globalisation and external shocks.



The promotion of tourism

Many countries have promoted tourism as a means of achieving development.

The benefits of promoting tourism include:1. A strong multiplier effect following the injection of FDI which

accompanies the development of a country as a tourist destination. (Hotels, infrastructure). This can be significant due to the high marginal propensity to consume (mpc) in developing economies.

2. Job creation through the initial development phase, and following the ongoing development of tourism.

3. The creation of a more balanced and diversified economy, with a developing service sector – often seen as a key indicator of economic progress.

4. Positive externalities as a result of the development of infrastructure.



The problems of relying on tourism include:1. Tourist revenue may go to firms in the country from which the tourists

come (travel agents and tour operators).2. Development of a parallel hidden economy, with transactions

unrecorded and tax revenue lost.3. Negative externalities, such as:

OvercrowdingLoss of areas of natural beautyHistoric and special sites may be over-exploited by tourismToo much pressure on the local infrastructure

4. Diversion of resources from necessary industries, such as from food production.

5. Tourist revenue may be unreliable.



Financing development



Official Development Aid (ODA)

ODA comes in two basic types:1. Long term aid to relieve poverty2. Short term humanitarian aid for relief following disasters The UK allocated around 0.5% (£7.3bn) of its GDP to development

assistance, but has agreed to implement the UN Millennium aid goal of 0.7% of GDP by 2015.

By 2009 total ODA had reached $120b, equivalent to 0.33% of global GNP. (Source: UN, 2009).

The UN has estimated that and extra $150b needs to be spent to meet the Millennium Development Goals agreed in 2000.



Official Development Aid (ODA)

The USA is the single biggest provider of development aid in absolute terms.

Denmark is the largest provider in terms of % of GDP allocated. Austr

alia

Denmark Ita

ly

Canad

a

Netherl

ands

Spain

Japan UK

German

y

France USA

05

1015202530

ODA Spending ($b, 2009)Source OECD, 2009

Italy

Japan USA

Australi

a

Canad

a

German

y

France

Spain UK

Netherl

ands

Denmark

0.000.100.200.300.400.500.600.700.800.901.00

ODA Spending (% GDP) 2009Source: OECD, 2009



Government assistance

Evaluation1. Aid is probably more useful if it is targeted for specific causes, such as

the eradication of a specific disease, and to relieve the immediate effects of natural disasters.

2. However, aid spending only represents a small % of global GDP and donor countries GDP, and received aid only represents a small % of the recipient country’s GDP.

3. A large amount of bi-lateral aid has strings attached, called tied aid – such as ‘aid for contracts’ to the donor countries to undertake development related work, such as the construction of infrastructure.

4. Some critics argue that aid can be disastrous, and can trap poorer countries into a life of aid dependency.



Non-Governmental Organisations (NGOs)

What are NGOs? NGOs are not-for-profit organisations that act as a pressure group to

represent members interests or the interests of specific groups.

What are their benefits? The UN Industrial Development Organization (UNIDO) analysed the

role of NGOs and suggested that they provided the following benefits::

1. There is local accountability2. Independent assessment of the issues3. The provision of expertise4. The provision of information5. Awareness-raising of problems and issues

Source: UNIDO (1997)



The IMF

The IMF The IMF and World Bank were set up following the Bretton Woods

conference in 1944.

The role of the IMF The IMF was initially established to promote international monetary

co-operation, which was seen as a key condition for post-war reconstruction and global development and security.

It has a number of specific objectives which relate to economic development, including:

1. Promoting exchange rate stability.2. Providing short term loans to ease any balance of payments problems.3. Forcing borrowing countries to improve their macro-economic

performance through prescribed macro-economy stabilisation policies and through programmes of structural adjustment.



The World Bank The World Bank is one of the United Nations specialised agencies. Its

role is to provide funds for economic reconstruction and economic development for developing economies.

The World Bank can make low and no interest loans and grants. As well as making loans it is also one of the world’s largest providers of aid. More specifically it attempts to:

1. Encourage structural adjustment – such as policies to promote trade liberalisation and capital mobility.

2. Encourage supply-side reforms, such as privatisation and de-regulation.3. Provide targeted aid for poverty reduction.4. Set specific priorities for countries.5. Since 2000 its major focus has been to try to help achieve the UN’s

Millennium Development Goals.



Assessment of the World Bank

1. Not enough understanding of specific local problems and constraints.2. Difficult to empower local governments to take responsibility – they

often see the World Bank as an outsider.3. Long term debt can undermine the best intentions of the recipients of

aid and the World Bank.4. Assistance can create the problem of moral hazard – countries

receiving aid performing less effectively because they know there is an ‘insurance’ against this under-performance.

See Video


http://web.worldbank.org/WBSITE/EXTERNAL/NEWS/0,,contentMDK:20040639~menuPK:34494~pagePK:116743~piPK:36693~theSitePK:4607,00.html


Assessment of the IMF

1. Stabilisation policies can result in short term conflicts, such as higher unemployment following tighter demand management.

2. Tough lending constraints can create too much austerity, and push countries into even further poverty.

3. Decision making is dominated by the powerful G8 countries, though each member country can vote, voting is based on a quota system, and the USA has around 17% of the voting power. (IMF, 2005).

4. Because of growing criticism about its role in the global economy the IMF has become more transparent in an attempt to show that it is not simply a vehicle to promote the interests of the USA and other powerful G8 countries.

5. There is also the potential problem of moral hazard.



United nations ‘millennium goals’

The United Nations The United Nations Millennium Development Goals provided an

agenda for reducing poverty. For each goal one or more targets were set, mostly for 2015

1. Eradicate extreme poverty and hunger.2. Achieve universal primary education.3. Promote gender equality and empower women. 4. Reduce child mortality.5. Improve maternal health.6. Combat HIV/AIDS, malaria and other diseases.7. Ensure environmental sustainability.8. Develop a global partnership for development.



Excessive debt

Foreign debt is created when a country has creditors residing abroad. Debts could be owed to foreign individuals, organisations, governments, and banks, and to the World Bank and IMF.

Debt can be unsustainable if it represents a large % of current exports. The World Bank considers foreign debt to be unsustainable if the ratio of debt to exports exceeds 150%.



Excessive debt

Excessive international debt can occur for two basic reasons:1. Failure of domestic policy, such as:

Failure of macro-economic management Ineffective control of public financesA currency artificially set too high, leading to export problemsExcessive spending on propping up a failed regimeCivil war, diverting scarce resources from production to defence, as in the

case of many African economies

2. The effects of destabilising real and financial shocks, such as:Collapse in commodity prices, affecting exportersOil shocks, affecting importers of oilExchange rate instabilityRises in interest ratesNatural disasters



Debt forgiveness In 1996 the IMF and World Bank launched the Heavily Indebted Poor

Countries Initiative (HIPCI). The G8 Gleneagles Agreement – in July 2005 the G8 countries met at

Gleneagles, Scotland, to agree a package of debt relief, mainly for Africa. The package, lasting through to 2010, was dependent upon African governments continuing to introduce democratic reforms, and to improve standards of governance (especially increased transparency and accountability.)

The package is formally known as the Multilateral Debt Relief Initiative, and involves providing 100% debt relief for a number of heavily indebted countries, providing they implement certain economic reforms.



Debt forgiveness

The case for debt forgiveness1. Debt can be a considerable burden for a country, which can lock it into

poverty, and impede its progress towards greater development.2. Debt servicing creates a great opportunity cost for countries –

reducing or totally forgiving debt could help reduce poverty and free-up resources for other uses, such as education and infrastructure.

3. By removing debt repayments, more national income is available for generating growth, and will generate jobs.

4. Creditor countries might gain from more export earnings in the long run as countries now relieved of their debt can grow, and import more.



The case against 1. Debt relief may send out the wrong signals to potential and existing

borrowers. For example, by providing an insurance policy, relief creates the problem of moral hazard, so debtors to not take proper steps to prevent debt problems.

2. Borrowers do not have a chance to learn from their mistakes. 3. Cancelling debt is bad for the lenders, who may be forced to raise

interest rates to try to recoup lost revenues. This in turn has a negative effect on other borrowers.

4. Banks in developing economies may lay off workers, hence a downward multiplier effect.

5. Lost revenues could have been used to help other developing economies.



Macro-economic policy objectives



Macro-economic policy

Economic policy is the deliberate attempt to increase economic welfare. Since the late 1920s, economists have recognised that there is a role for government in managing the macro-economy.

During the late 1930s and early 1940s Cambridge economist John Maynard Keynes set the policy ground rules for his, and later, generations of policy makers.

Keynes was able to demonstrate that a market economy could become trapped in a downward spiral of falling economic activity and diminishing economic welfare.



Macro-economic policy

For Keynes, the key questions were: What could trigger a fall in economic activity?What processes would stop economic activity from rising back

after a period of recession?What policies should governments adopt to bring a recession to

and end and to begin the process of stimulating growth?



Macro-economic policy objectives

Following Keynes, modern policy makers favour setting clear policy objectives, such as achieving:

1. Stable prices – the desire to keep increases in average prices as small and as gradual as possible.

2. Stable and sustainable economic growth – the desire to see national income grow in real terms in a sustainable way.

3. Full employment – the desire to keep the labour force fully employed in productive work.

4. A balance of payments with the rest of the world – the desire for a country to ‘pay its way’ in the world.

5. Control of public sector finances.6. Care for the environment – the desire to protect the environment

from misuse, overuse and degradation.7. An equitable (fair) distribution of income between rich and poor

without creating disincentives to work.



The trade cycle

Many macro-economic problems arise from the underlying instability of the trade cycle.

Changes in real national income tend to be cyclical. It is desirable that this cycle is stable rather than unstable.

Comparing actual growth with the trend rate is useful for policy purposes.

Time

Change in real national

income

Trend rate

Booms lead to:• Goods and service inflation• House price inflation• Wage inflation• Labour shortages• Falling savings• Excessive credit• Trade difficulties

Busts lead to:• Goods deflation• House price deflation• Labour surpluses• Unemployment• Excessive debt burden• Public sector debt

DEMAND SIDE POLICYMonetary policyFiscal policyExchange rate policyRegulates aggregate demand to stabilise the trade cycle

SUPPLY SIDE POLICYIncentivesWelfare to workEducation and skillsPromotes long term growth



Policy Building Blocks

DEMAND SIDE POLICY

MONETARYFISCAL

Taxation Government spending

Interest rates

Money supply

Productivity &

efficiency

Flexibility

Stabilise after

shocks

Manage the trade

cycle

Exchange rates

SUPPLY- SIDE POLICY

Privatisation & competition

De-regulation

Labour market reform

Incentives Education and skills

POLICY OBJECTIVES

Stable prices

Stable growth

Sustainable growth

Full employment

Balance of payments

Sustainable public finances

Supply sideMonetaryFiscal

Equity



Macro-economic problems



Global shocks



Global shocks

A major problem associated with increased globalisation is the increased risk of suffering from demand and supply shocks.

Globalisation means that economies are increasingly interconnected, and while this can create considerable benefits, it also presents national economies with considerable risks.

One risk is that a shock originating in one part of the world, or in one industry or market, can quickly ripple across a whole region or the whole global economy, leaving economic turmoil in its wake.



Types of shock

There are a number of different types of shock, including:1. Temporary - such as a terrorist attack.2. Permanent – such as an oil shock, which permanently alters the

market for motor vehicles.3. Exogenous – these shocks are outside of the control of a country’s

policy makers.4. Policy induced – such as reducing interest rates too quickly, creating

an inflationary shock.5. Asymmetric - affecting one region or industry differently from another.6. Symmetric - affecting all regions or industries in the same way.



7. Financial - a shock starting in the financial markets, such as a sudden change in the exchange rate, or the collapse of a major credit bank. The recent global financial crisis is an example.

8. Supply side - a cost shock, such as a sudden increase in commodity prices.

9. Demand side - a sudden change affecting AD, such as a collapse in consumer confidence, or a sudden rise in house prices.



Unstable prices Inflation and deflation



Unstable prices

What is wrong with unstable prices? Price stability is usually regarded as the single most important

economic objective. Price stability is increasingly important for economic success in the

global economy. For the UK, price stability means ensuring that the price level increases gradually, by no more than 3% per year, and that prices do not rise by less than 1%..

The official UK target is 2%, though there is a safety margin of +/- 1% - policy makers are forced to intervene if inflation falls outside these margins.



The problem of inflation

The problems caused by inflation include:1. Erosion of the value of money and assets.

A rise in the price level means, ceteris paribus, that money can buy fewer goods. If assets are stored in a monetary form, inflation means that asset values fall.

2. Loss of competitiveness and balance of payments difficulties This occurs because inflation stimulates imports, which appear relatively

cheaper, and discourages exports, which appear more expensive to overseas households and firms.

3. Redistribution of income, from lenders to borrowers Borrowers do better at times of rising prices because the real value of

their repayments falls over time. Lenders need to charge a higher interest rate to compensate for the falling value of the repayments to them, and for the loss of liquidity suffered as the value of repayments fall.



Why is inflation a problem?4. Uncertainty and falling investment

Inflation creates negative effects on business confidence and costs, and as firms expect interest rates to rise to deal with inflation. Lower investment reduces productivity and dynamic efficiency of domestic firms.

5. Administrative costs Shoe leather costs are the extra effort that must be made by households

and firms to seek out low prices. Menu costs are associated with having to regularly re-price products to bring them in line with general inflation.

6. Unemployment Inflation can lead to a loss of jobs through its affect on costs. As costs rise

firms may substitute labour with new technology.7. Distortion of the price mechanism

Markets work best when prices go up and down – if prices keep rising resource allocation is distorted.



Why is inflation a problem?8. Creation of money illusion

Inflation may lead people to make irrational decisions. For example, if money wages rise workers may decide to work longer hours, but if inflation erodes the value of the wage rise they have been ‘fooled’ into working longer.


Price Level

National Output (Y)


The causes of price instability - demand pull inflation

Demand pull inflation is caused by rising monetary demand following an increase a component of AD, such as:1. Earnings rising above

productivity.2. Cheaper credit following

a fall in interest rates.3. Sudden fall in the savings

ratio.4. Rise in public sector

borrowing.5. Housing boom creating

equity withdrawal.

Yf

LRAS

AD

Y Y1

P

P1

SRAS

As the economy approaches

full employment excessive AD pulls up prices



Changes in the savings rate

The savings rate (ratio) shows the % of national income which is saved, rather than spent.

Sudden changes in the savings ratio are an indicator of future changes in spending and AD, and can be a prelude to inflation or deflation.

A rise in the savings ratio often indicates a fall in consumer confidence.

A fall in the savings ratio indicates a rise in confidence and spending, which can trigger inflation.

2004 2005 2006 2007 2008 2009 2010

-2

0

2

4

6

8

10

UK savings rateSource: ONS


Price Level

National Output (Y)


Rising costs push the SRAS upwards, but the LRAS is not affected. Common causes include:1. Oil price shocks, caused by

wars or decisions by OPEC to restrict output.

2. Increases in farm prices following a series of bad harvests.

3. Increases in wage costs.4. A fall in the exchange rate,

which increases the price of all imports.

Yf

LRAS

AD

YY1

P

P1

SRAS

Cost push inflation

SRAS



Exchange rates and cost push inflation

What happens if exchange rates fall? A fall in the exchange rate will mean that more currency is required

to purchase a given quantity of imports. After a time lag this is likely to feed its way into the retail prices of imported products.

Given that around 35% of the CPI basket of finished consumer goods and services are imported, the general effect of a fall in the exchange rate is to raise the CPI.

In addition, imported raw materials are also more expensive so costs of production will rise for those firms that source their inputs from abroad.



Why is deflation a problem?

If the price level falls an economy experiences price deflation. Deflation can cause the following economic problems:

1. Delayed consumption Consumers may delay consumption, waiting for prices to fall even further.

This can have a negative impact on AD, output and incomes.

2. Rising real interest rates Because nominal interest rates cannot fall below zero, falling prices cause

real rates to rise. For example, if nominal interest rates are 3% and inflation is 1%, real interest rates are 2%. But if the price level falls by 1%, real interest rates (3 – [- 1]) rise to 4%.



Why is deflation a problem?

3. A rise in debt burdens and a deterrent to borrowing Debt burdens rise for households that have borrowed in the past. Many

debts are fixed, such as fixed mortgages and personal loans, so they do not fall as prices fall. Falling prices for firms also creates a debt burden problems.

4. Recession This is because economic confidence falls as households and firms save

rather than spend. Long term recession following deflation is often called the Japanese disease, given that, for a long period during the 1990s, Japan seemed trapped in a deflationary spiral.


Price Level

National Income (Y)


Causes of deflation

Following a positive supply shock: AD expands from A to B.

Prices fall and consumers expect prices to fall further, delaying consumption - AD shifts to the left. Firms now cut prices to boost sales and reduce stocks.

As confidence and wages fall, consumption falls further. Real interest rates rise, and savings rise.

LRAS

AD

Y Y1

P

P1

SRAS

Y2

Deflation tends to occur when the

economy’s capacity (indicated by the AS

curve) grows at a faster rate than AD.

A

B

Investment falls due to a negative accelerator effect. This creates a downward deflationary

spiral, which is very hard to get out of.

209



Unemployment



Unemployment

The level of unemployment has been a key economic objective ever since the mass unemployment experienced in the 1930s.

The costs of unemployment 1. Opportunity cost2. Waste of resources3. The Chancellor loses revenue4. Erosion of human capital5. Lower incomes6. Externalities



UK unemployment

Both claimant count and the ILO survey show that UK unemployment fell to record lows by 2007.

However, since the recession of early 2008, unemployment has risen consistently.

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q42007 2008 2009 2010 2011

4.00

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.00

8.50

9.00

UK (ILO) Unemployment rate (%)Quarterly - Year-on-year -

Seasonally adjustedSource: ONS



Types of unemployment

1. Cyclical This is unemployment as a result of a downturn in AD. Unemployment

levels of 3 million were reached in the UK in the recessions of 1980-82 and 1990-92. In the most recent recession, unemployment rose to over 2.5 million.

2. Structural Structural unemployment occurs when certain industries decline as a result

of long term changes in market conditions. This may the result of globalisation.

3. Regional When structural unemployment affects local areas of the economy it is

called regional unemployment.

4. Classical Classical unemployment is caused when wages are too high. This view of

unemployment dominated economic theory before the 1930s.



Types of unemployment

5. Seasonal Seasonal unemployment is created because certain industries only produce

or distribute their products at certain times of the year. Industries where seasonal unemployment is common include farming and tourism.

6. Frictional Frictional unemployment, also called search unemployment, occurs when

workers lose their current job and are in the process of finding another one. 7. Voluntary

This type of unemployment is less easy to identify, and is defined as a situation when workers choose not to work at the current equilibrium wage rate. For one reason or another, workers may elect not participate in the labour market.

8. The natural rate of unemployment This is a term associated with New Classical and monetarist economists. It is

defined as the rate of unemployment that still exists when the labour market it in equilibrium, and includes seasonal, frictional and voluntary unemployment.



Structural unemployment and mobility

Labour immobility is likely to increase structural unemployment. This is because the industries which are growing and are short of labour cannot soak-up surplus labour from declining industries if labour is immobile. There are three main types of labour immobility.1. Geographical – where workers are not willing or able to move from

region to region, or town to town. This is made worse by immense house price variation between regions.

2. Industrial - where workers are not willing or able to move between industries, such as from engineering to broadcasting.

3. Occupational – where workers find it difficult to change jobs within an industry. Again, a lack of skills or knowledge can deter individuals from re-training.



NAIRU



NAIRU NAIRU - the Non-accelerating Inflation Rate of Unemployment - can be

said to exist when demand deficient unemployment is zero. It is the unemployment that still exists if the economy is operating at its

full potential. It is composed of structural, frictional and voluntary unemployment. It

is usually assumed that it is the level of unemployment when the economy is at its Long Run Phillips Curve.

In the 1980s it was generally thought that NAIRU in the UK was around 7%,but effective supply-side policy during the 1990s and 2000’s reduced NAIRU to around 5%. (Source: ONS).



Why is there still unemployment when the economy is in equilibrium? There are two rival views:1. The New Classical view - this view argues that unemployment at

equilibrium exists because people choose not to work – its is voluntary . These economists often refer to the natural rate of unemployment (NRU) rather than NAIRU.

2. The New Keynesian view is that all unemployment is involuntary - they have three different explanations as to why unemployment persists, even when there is no demand deficiency:



New Keynesian theory of persistent unemployment

1. Wage rigidities – in reality wages are slow to adjust to changes in the demand and supply of labour, and markets do not clear quickly.

2. Efficiency wage theory – firms must set wages above market clearing to ensure a supply of ‘good’ workers.

3. Insider-outsider theory – some workers are permanently excluded from participating in labour markets.



The Financial Sector, Monetary Theory and Monetary Policy



The importance and role of money

What is money? Money is anything that is acceptable in the settlement of a debt. For

something to be used as money it should be portable, divisible, durable and stable in value.

The advent of money as a medium of exchange replaced the need for exchange through barter - in modern economies notes and coins are only a small fraction of total money, with most money being in the form of bank accounts.



The importance and role of money

Money supply Money can be created in two ways:1. New bank lending - new cash deposits by customers can trigger a

multiple credit expansion by the banks – money increases when fresh loans are made to customers. How much extra credit can be created is given by the credit multiplier, which is 1/Cash Ratio. For example, if the cash ratio is 0.1, then the credit multiplier is 1/0.1 =

10. So a fresh cash deposit of £1,000 could lead to fresh advances to customers of £10,000.

2. Issuing Treasury bills - the second way new money can be created is when the government borrows from the money market by issuing Treasury Bills, which add to money supply. Banks see these Bills as good as cash, and continue to make the same amount of loans to their customers despite the fact they have lost liquidity by buying the Bills from the Treasury.



Measures of the money supply

Money can be officially measured in narrow terms or broad terms Narrow money M0 (M nought) is the official measure of narrow money in the UK and

consists of notes and coins in circulation outside the Bank of England plus bankers' operational deposits with the Bank. The main reason for looking at M0 is because of its link with high street spending, and inflation. MO is also called high powered money because of its strong impact on the economy.

Broad money M4 is broad money and is MO plus private bank deposits, both current

accounts and deposit accounts.


Interest rates

Q


The demand for money Why do households and

firms wish to hold their wealth in a monetary form?

According to Keynes’ Liquidity Preference Theory people require money – liquidity - for three reasons:

1. To engage in transactions

2. As a precaution3. To engage in

speculative actions

Speculative demand

Transactions Demand

Precautionary demand

Liquidity Preference

(total demand)

A certain amount of money is required for transactions. This is not affected by

interest rates, so is vertical and perfectly inelastic with respect to interest rates

The precautionary demand is also unrelated to interest rates

Financial assets are an alternative to holding money – the

speculative demand is inversely related to interest rates


Interest rates

Q


Money markets and interest rates

If we add in the money supply we can find the equilibrium interest rate. For example, the money market will clear when interest rates are 5% - with the supply of money (M) equalling the demand (L).

The money supply is controlled by the Bank of England, and is independent of interest rates.

Money Supply (M)


(L)

5%

M


Interest rates

Q


Changing interest rates

Short-term interest rates are set by the Monetary Policy Committee (MPC).

Open Market Operations are also used to create a shortage or surplus of money by selling or buying securities, thus altering the money supply to ensure that the desired interest rate is achieved.

Money Supply


5%

M

6%

M1

Monetary equilibrium is re-established at a higher

interest rate by open market operations – in this case securities are sold to the

money markets to ‘soak up’ money in the system



Monetarism

‘Monetarism' is closely associated with ‘Classical economics’. Monetarism is an economic philosophy which believes that economic prosperity depends upon understanding the link between money and the real economy (prices, output and employment), and the effective control of the money supply.

Although monetarism dates back to English philosophers of the 18th Century its modern origins lie largely with the work of two economists: Irving Fisher of Yale University, writing in the early 20th century, and Milton Friedman of Chicago University, writing in the late 20th century



Monetarists, like Friedman, believe that:1. Money can be defined - money is defined as ‘anything generally

acceptable with which to settle a debt’.2. Money can be controlled - monetary authorities can increase or

decrease the amount of money in the economy.3. Changes in money have a direct and measurable effect on the rest of

the economy - money supply has a significant affect on household and firms spending.

4. Inflation and deflation are always and everywhere a monetary phenomenon - changes in money are always the cause of price changes.



Money and inflation - The Fisher equation

Fisher proposed that there was a stable and predictable relationship between the quantity of money in circulation in an economy, and the price level, using his famous equation:

MV = PT, where: M = the stock of money V = the velocity of circulation P = average prices T = the number of transactions

If we assume V and T are constant - as an economy approaches full employment - then changes in M must lead to the same proportional changes in P.

The policy implication is that the monetary authorities should ensure that money supply is controlled effectively – controlling the money supply means stabilising prices!



Modern monetary policy

The Monetary Policy Committee. Monetary policy in the UK is undertaken by the Bank of England’s

Monetary Policy Committee (MPC). The MPC has nine members, four of whom are appointed by the Chancellor. It meets each month to discuss current and future monetary policy options. The MPC has one goal – to hit its inflation target of 2%.

The inflation target is symmetrical – a rate of inflation below the target is considered as bad as a rate of inflation above the target.

Changing official interest rates is the most visible of the MPC’s tools.



Modern monetary policy

The official rate The interest rate the MPC fixes is called the official rate – this is the

rate that the Bank of England will charge for short-term loans to other banks or financial institutions.

Other rates of interest in the economy, such as mortgage rates, will adjust in line with changes to the official rate.



Monetary policy

Why isn’t the inflation target zero? There are two reasons why the inflation target is set above zero:1. A positive rate allows real interest rates to become negative at times

of weak demand. Real interest rates are nominal interest rates less the inflation rate. Nominal interest rates can never be negative as banks will always charge for borrowing from them. It may be helpful for the Bank of England to make real interest rate negative at times of a deep recession - so having a positive inflation target allows this to happen.

2. Inflation cannot be measured with perfect precision, and it is safer to have a positive inflation target as this provides a margin of safety.



How do interest rates work? Interest rates are set to achieve a target inflation rate - it can take up to

two years for a change to fully work. Changes transmit their way to AD in the following ways:

1. Consumer demand is affected because changes in interest rates affect savings, which indirectly affect spending.

2. For households or firms with existing debt, such as a mortgage, a change in rates affect repayments, and hence individuals have more (or less) cash after servicing there debts. Changes in rates affect the cash-flow firms and households.

3. In the case of new debt to fund spending, borrowing is also encouraged (or discouraged) following interest rate changes.

4. Interest rates also affect consumer and business confidence, and spending.



5. Asset values are also affected by interest rates – a fall will tend to make firms more profitable and they may pay higher dividends to shareholders, which can trigger an increase in spending.

6. Finally, interest rates may affect the exchange rate, which can also influence export demand - a rise in interest rates may push-up the exchange rate, pushing up export prices and reducing overseas demand. Changes in the exchange rate also affect the price of imports, which also affect the inflation rate.



Import prices FALL

Domestic demand TIGHTENS

Import prices - cost inflation

Domestic demand inflation

Summary of the monetary transmission mechanism

Market interest rates

Asset prices

Expectations

Exchange rates

Official interest rate Total

inflationRISE

RISE

FALL

WORSEN

APPRECIATE

Inflationary PRESSURE

EASED



Recent UK interest rates

In recent years interest rates have been adjusted to reflect changing conditions.

2000 – 2005 Rates fell quickly to their

lowest level for 25 years, to help stimulate demand.

2006-2007 Rates were pushed up into a

neutral zone at around 5.5%. 2008 – 2011

Rates fell to their lowest recorded level of 0.5% to deal with the recession. Quantitative easing was also needed to deal with the severe liquidity shortage.

2005 2006 2007 2008 2009 2010 2011 20120

1

2

3

4

5

6

7UK interest rates

(%) Official base rateSource: Bank of England



Quantitative easing

Quantitative easing is a process whereby the Bank of England, under instructions from the Treasury, buys up existing bonds in order to add money directly into the financial system.

The process of doing this is called open market operations, and it is regarded as a last resort when low interest rates fail to work.

When interest rates approach zero, but an economy remains stubbornly in recession, further interest cuts are impossible.

This is the position that faced central bankers in early 2009. Interest rate policy in these circumstances becomes impotent as nominal interest rates cannot fall below zero.



Quantitative easing involves the following steps: The Bank of England purchases existing corporate and government bonds held by

banks and corporations with electronic money, rather than notes and coins. These funds are credited to the bank and become a reserve asset. This means that, via the credit multiplier, banks can lend out to corporate and

individual customers.



Evaluation of monetary policy

The advantages1. Powerful and direct impact

Evidence shows that interest rates have a direct and powerful effect on household spending - the evidence suggests that UK consumers are ‘interest rate elastic’.

2. Independence The Bank of England’s Monetary Policy Committee is independent from

government and can make decisions free from political interference.3. Flexibility

Interest rates can be changed on a monthly basis, and this contrasts with discretionary fiscal policy which cannot be introduced as such regular intervals.

4. A rapid effect on expectations While the ‘full’ effects of interest changes may not be experienced for up to a

year, there is often an immediate effect on confidence. The time-lag on output is estimated to be around one year, and on the price level, around two years.



Evaluation of monetary policy

The disadvantages1. Time lags

There are still time lags to see the full effects, and there are some negative effects.2. Trade-offs

Raising interest rates can negatively affect:1. Investment spending 2. The housing market 3. The exchange rate and hence the balance of payments

3. The ‘dual’ economy There is also the problem of the dual economy - are high rates set for the

booming service sector, or low rates for the depressed manufacturing and export sector?

4. Difficult to control money The money supply is difficult to control in practice, so controlling interest rates is

preferable.



Other criticisms of quantity controls1. A large proportion of money is bank lending – it is difficult in a free

market economy to restrict the ability of banks to lend.2. If an economy is in a liquidity trap, changes in the money supply have

little affect on the real economy because they have little effect on interest rates – this has existed in Japan over the last 10 years, and more recently in Europe and across large parts of the global economy.



Monetary Policy in Europe

The European Central Bank (ECB) The ECB meets on a monthly basis to determine two things:

1. The level of interest rates across the Eurozone - those 17 countries that share the Euro

2. The quantity of money in circulation The primary purpose of the ECB is to control Eurozone inflation (to

keep it below 2%, but as close to 2% as possible) so that the value of the Euro remains constant and strong.

It also provides liquidity and capital to the system when needed, as in the case of Ireland and Greece. In return the Bank (along with other creditors, such as the IMF) may request that specific policies are implemented – formally called structural adjustment programmes (SAPs).

If an EU country joins the Euro zone its central bank cedes much of its power to the ECB.



The Public Sector and Fiscal Policy



The public sector - government expenditure

Central and local government – the public sector - spends money for a variety of reasons. These include:1. To supply goods and services that the private sector would fail to, such

as public goods, merit goods, and welfare payments and benefits.2. To achieve supply-side improvements in the macro-economy, such as

spending on education and training to improve labour productivity.3. To reduce the likelihood or effects of negative externalities, such as

pollution controls. 4. To subsidise specific industries which may need, for one reason or

another, financial support that would not be available from the private sector.

5. To help redistribute income and achieve more equity.6. To inject extra spending into the macro-economy, to help achieve

increases in aggregate demand and economic activity. Such a stimulus is part of discretionary fiscal policy.

Local government is very important in terms of the administration of spending, such as spending on the NHS and on education.



Fiscal policy

What is fiscal policy ? Fiscal policy is the deliberate adjustment of government spending,

borrowing or taxation to help achieve desirable economic objectives.

Types of fiscal policy There are two types of fiscal policy, discretionary and automatic.

1. Discretionary policy refers to policies which are decided, and implemented, by one-off policy changes.

2. Automatic stabilisation, where the economy can be stabilised by processes called fiscal drag and fiscal boost.



Government Spending

The main areas of UK government spending in 2010, which totalled £681bn, were:1. Social

‘protection’ 2. National Health 3. Education 4. Public Order 5. Defence

Social protection

35%

Health18%

Education12%

Law and Order

7%

Defence7%

Housing5%

Interest 6%

Borrowing6%



Central and Local government borrowing

If revenue is insufficient to pay for expenditure then government must borrow. Local authorities can borrow if their revenue from the Council Tax and central government support is insufficient to meet their spending.

Borrowing requirements If the borrowing requirements of both central and local government

are added together the amount of borrowing required is called the public sector net cash requirement (PSNCR). The need to borrow varies greatly with the business cycle.

The previous Chancellor’s golden rules for borrowing were:1. Firstly, to balance the books over a trade cycle, and2. Secondly, only to borrow to fund capital projects, such as road building,

and not to fund non-investment spending, such as the wages of public sector workers.



Fiscal deficits and the National DebtWhat are fiscal deficits? Fiscal deficits occur when the

revenue received by government is less than spending during a financial year.

What is the national debt? The national debt is the cumulative

amount of annual borrowing.

What causes a rising national debt? Tax revenues fall and government

spending rises as the economy slows down or goes into recession.

Householders and firms spend less, so less VAT is collected, and householders and firm receive less income, so revenues from income taxes fall.

£Billions 2008 2009 2010 2011

Government

spending500 550 600 650

Revenues 480 520 560 600

Borrowing 20 30 40 50

National Debt

20 50 90 140

Hypothetical example to illustrate how the ‘National Debt’ is calculated.



Is a rising national debt a problem? Yes, if:1. It is a high share of GDP.2. It is persistent and not self-

correcting.3. It could be inflationary as

money must be created to pay for the deficit.

4. This may cause downward pressure on the exchange rate.

5. It may require taxes to rise causing a disincentive effect.

6. FDI may be deterred.7. It requires government

spending to be reduced.

19791981

19831985

19871989

19911993

19951997

19992001

20032005

20072009

2011

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

Public debt as % GDPSource: UK Treasury

European stability pact limit

3



Central and local government spending

Changing the level of public spending Using public spending to stimulate economic activity has been a key

option for successive governments since Keynes argued that public spending should rise during a recession.

There are two types of spending:1. Current spending, which is expenditure on wages and raw materials.

Current spending is short term, and has to be renewed each year. 2. Capital spending, which is spending on physical assets like roads,

bridges, hospital buildings and equipment.



Evaluation of discretionary public spending

The advantages of using public spending1. Public spending can be increased to help stimulate the macro-

economy by increasing the level of AD.2. If the spending is on capital items, then infrastructure can be

improved, and this can help improve competitiveness and economic growth.

3. Spending on infrastructure also provides an external benefit to the rest of the economy.

4. Public spending can be targeted to achieve a wide range of economic objectives, such as reducing unemployment, achieving more equity, road building, action against poverty, and re-building city centres.



Evaluation of government spending

The disadvantages of using public spending1. There may be a considerable time-lag between spending and the

benefits of spending. 2. In trying to promote growth or reduce unemployment government

spending can be inflationary. There is a potential trade off between unemployment and inflation, first analysed by A.W. Phillips.

3. Crowding-out – critics of a large public sector point to the crowding out of the more efficient private sector.

4. A major constraint to government spending across the EU, is the Stability Pact which limits government borrowing to no more than 3% of national income, and accumulated public debt to no more than 60% of the value of national income.



Crowding out theory

Crowding out is the process of squeezing out the efficient private sector as a result of public sector expansion.

We can identify two types of crowding out.1. Financial crowding out - if the public sector expands and needs to

borrow from the financial sector long term interest rates may be driven up. This leads to a reduction in private sector investment.

2. Resource crowding out - in a similar way, as the public sector expands there is an increase in the demand for other resources which drives up their price, including wages and rents – hence the private sector suffers.



The public sector – revenue and taxation

Why raise revenue? Governments receive revenue from a number of sources, including:

Taxation – of which there are two types of taxes: Direct, which are taxes on factor incomes, such as personal income

tax and corporation tax Indirect, which are taxes on spending, such as Value Added Tax -VAT

National insurance contributions (NIC) - is a compulsory contribution from both employer and employee.

Charges, such as the congestion charge and parking charges. Licences, such as TV and driving licences. Privatisation of state assets.



Local government revenue Local authorities in the UK have the power to raise revenue via a local

tax called the Council Tax. However, council taxes rarely cover all local spending, and local

authorities must rely on subsidies from central government . Reform of local authority finances has been proposed, with the

following options being considered: A local income tax A local sales tax Specific local charges, like the London Congestion Charge



Tax revenue sources

Tax revenues in 2010 Tax revenues clearly

show the importance of income tax, national insurance and VAT as the three major sources of tax revenue for the UK Treasury.

Income tax37%

NICs25%

VAT18%

Corporation tax9%

Fuel duties

7%

Tobacco duty2%

Stamp duties2%

Tax sources (2010)Source: HM Treasury



Automatic Stabilisation

Fiscal drag If we assume that direct tax rates are progressive – which occurs

when the % of income going in taxes increases with income – and that welfare benefits are paid to the poor and unemployed – then rapid increases in national income would be slowed down automatically.

Fiscal drag means as incomes rise in a boom the impact of rising incomes for the better off is reduced as they pay proportionately higher taxes, and the impact of rising incomes on the poor and unemployed is reduced as they come off benefits, and start to pay tax. The effect is that the increase in disposable income is moderated.



Automatic stabilisation – fiscal boost

Fiscal boost Similarly, a potentially rapid and deep decrease in national income

would be ‘held back’ through fiscal boost. Fiscal boost means as incomes fall in a recession the impact of falling incomes for the better off is ‘softened’ as they pay proportionately lower taxes, and retain more post-tax income.

The impact of falling income is to increase unemployment, but rather than experience a complete collapse in personal income, the unemployed and poor receive benefits, and spend more than they would have without such benefits – hence a downturn in the economy is also ‘moderated’



The effects of fiscal drag and fiscal boost

Fiscal drag and boost Fiscal drag reduces the

rate of growth of national income, whereas fiscal boost limits the contraction of national income.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010-4

-3

-2

-1

0

1

2

3

4

5

6 Progressive taxes reduce the rate of

growth in the economy

Progressive taxes and benefits stop the

economy contracting too quickly

Economic growth %

Without stabilisers

With stabilisers



Discretionary changes to tax rates

Altering tax rates In addition to automatic stabilisation taxes can be deliberated raised

or lowered to control or expand household spending, and AD. This is called discretionary fiscal policy.

Income tax can be adjusted in a number of ways, such as by changing:1. The tax free allowance – all income earners are allowed to earn an

amount of income before they start to pay tax.2. The basic tax rate - for example, the basic rate could be increase from its

current level of 20%. 3. The number of tax bands – for example, in 2009 a new higher rate band

of 50% was added.4. The range of income in each band – each band could be widened or

narrowed by increasing or reducing the range of income in each band.



Evaluation of taxation – the advantages

Evaluation - the advantages of using taxes1. Indirect taxes can be targeted very specifically to alter behaviour,

such as to reduce pollution by imposing polluter pays taxes, or to reduce cigarette smoking by imposing special taxes on tobacco.

2. Taxation has the ability to automatically help stabilise the macro-economy , through fiscal drag and boost, which can provide a natural shock absorber to economic shocks.

3. Discretionary changes in direct taxes can help regulate AD – which can be implemented at times when shocks are severe, or when other policies are ineffective.

4. Tax policy can also be used to help re-distribute income, and help achieve equity.



Taxes and Equity

In terms of achieving equity, indirect taxes like VAT are regressive and create an inequitable burden. The largest burden being on the poor and low paid.

Income tax and other direct taxes can be made progressive and can help achieve equity - but they may have a disincentive effect, leading to inefficiency.

Hence, equity and efficiency are in conflict - the best resolution is a mix between direct and indirect to achieve a balance between the needs of equity and efficiency.



Evaluation of taxation – the disadvantages

The disadvantages of using taxes1. Changing tax rates, allowances and bands, is highly complex in

comparison with changing interest rates, with only small adjustments being made each year in the annual budget.

2. Households may alter their savings following tax changes, so the effect on household spending of an increase or decrease in taxes may be weak.

3. There may be considerable time-lags between changing taxes and changes in household spending.

4. Higher taxes may have a disincentive effect on work and enterprise, as some individuals alter their perception of the relative costs and benefits of work, in comparison with leisure.


Tax Revenue

Tax Rate


The disincentive effect of direct taxes

The Laffer curve Laffer proposed that at

tax rates of 100% and 0% the government would receive no revenue. At 100% tax, no one would work, and at 0% tax no tax would be paid.

However, between O% and 100% tax rate the government derives a tax yield.

Clearly, as tax rates rise a disincentive effect must begin at some point . 0 100%

Laffer Curve

Disincentive effect



Income and substitution effects

However, the disincentive effect will only work under certain circumstances – to understand this we must distinguish the income and substitution effects.1. The substitution effect - this suggests that, following an increase in direct

taxes, substitutes to work (i.e. leisure) seem more attractive and people will work less – also called the ‘Laffer effect’

2. The income effect - this suggests that an increase in taxes will reduce people's real income and they need to work harder to achieve the same real income

These two effects are contradictory – if the income effect is greater than the substitution effect, an increase in taxes will lead to more labour being supplied. However, if the substitution effect is greater an increase in taxes will lead to less labour being supplied.



The Phillips Curve


Inflation (%)

Unemployment (%)


The Phillips curve and fiscal policy

The Phillips Curve In 1958 AW Phillips published

research showing the relationship between wage inflation and unemployment rates in the UK, between 1860 and 1958.

He plotted annual rates on a scatter diagram and found the line of best fit. It appeared to show an inverse and stable relationship between wage inflation and unemployment.

1922

1923

1924

1925

19261927

Inflation (%)

Unemployment (%)


The Phillips curve

The plotted line became known as the Phillips Curve - other countries found similar curves for their own economies.

The curve suggested that changes in the level of unemployment have a direct and predictable effect on the level of inflation.

The Phillips Curve

U

P

P1

U1

Inflation (%)

Unemployment (%)


Explaining the Phillips curve

The accepted explanation during the 1960’s was that a fiscal stimulus would trigger the following:

An increase in the demand for labour as government spending generates growth.

The pool of unemployed would fall.

Firms compete for fewer workers by raising wages.

Workers have greater bargaining power.

Higher wages push up wage costs and prices are increased. The Phillips

Curve

U

P

P1

U1

Inflation (%)

Unemployment (%)


Exploiting the Phillips curve

It became accepted that policy makers could exploit the trade off - a little more unemployment meant a little less inflation.

During the 1960s and 70s governments around the world would select a rate of inflation they wished to achieve. This policy became known as ‘stop-go’, and relied strongly on fiscal policy to create the required expansions and contractions.

The Phillips Curve

U

P

P1

U1

However, by the end of the 1970s the stable and inverse relationship

began to break down. As policy makers exploited the relationship,

it began to break down.

Inflation (%)

Unemployment (%)


The breakdown of the Phillips Curve

By the mid 1970s it appeared that the Phillips Curve trade off no longer existed in its original form.

American economists Friedman and Phelps offered one explanation:

1. There was a series of short run Phillips Curves and a long run Phillips Curve.

2. This was fixed at the natural rate of unemployment (NRU) referred later to as NAIRU.

Short Run Phillips Curves

Long Run Phillips Curve

NRUThe Natural Rate of

Unemployment

Inflation (%)

Unemployment (%)


What happened? The New Classical View

Assume the economy starts at point A (the NRU) and the government creates a stimulus through a monetary expansion -more money in the economy.

Initially the economy moves to B, but money illusion has been fooling everyone! When firms realise this the reduce their demand for labour back to the previous level.

The economy moves to C – back to the NRU, but with higher inflation, at P1. Short Run

Phillips Curves

Long Run Phillips Curve

NRUThe Natural Rate of

Unemployment

A

B C

U1P

P1

D EP2

Price Level

National Output (Y)


Using AD/AS to show the Phillips Curve Effect

The New Classical view Assume the economy starts

with an output gap, at Y. An increase in government

spending will increase the money supply and increase AD, leading to a rise in income and a fall in unemployment.

But, households will successfully predict the higher inflation, and build these expectations into their wage bargaining. They push for higher money wages.

As a result, wage costs rise and the SRAS shifts up to SRAS1 and the economy now moves back to Y, but with a higher price level, at P2.

LRAS

AD1

Y Y1

P

P1

SRAS1

AD

P2

SRAS


Supply side policy



Supply-side policy

Supply side policy includes any policy that improves an economy’s ability to produce. There are a number of individual actions that a government can take to improve supply-side performance, including:

Measures to improve labour productivity and flexibility, such as:1. Using the tax system to stimulate output, rather than to alter demand.

This commonly means lower direct tax rates, such as lower Income tax and lower Corporation tax. This should act as an incentive to join the labour market, or to work harder.

2. Greater competition in labour markets - through legislation to eliminate restrictive practices, and remove labour market rigidities, such as the protection of employment. For example, as part of supply-side reforms in the 1980s, trade union powers were greatly reduced by a series of measures including limiting their ability to call a strike, and enforcing secret ballots of union members prior to strike action.



Supply-side policy

3. Measures to improve labour mobility will also have a positive benefit on labour productivity, and on supply-side performance.

4. Better education and training to improve skills, flexibility, and mobility – also called human capital development – is also an important supply-side policy option, and one favoured by recent UK governments.

5. The adoption of performance related pay in the public sector is also seen as an option for government to help improve overall productivity.

6. Similarly, government can encourage localised rather than centralised pay bargaining. National pay rates rarely reflect local conditions, and reduce labour mobility.



Measures to improve competition and product market efficiency:1. Government assistance to firms to encourage firms to use new

technology, and to undertake innovation, such as through grants, or through the tax system.

2. De-regulation of product markets to bring down barriers to entry, and encourage new entrants. The effect of this would be to make markets more competitive and increase efficiency. Promoting competition is called competition policy.

3. Privatisation of state industry is also a central part of supply-side policy, and can contribute to the spread of an enterprise culture.

4. The supply side can also be improved if there is dynamic entry of new firms. Small businesses are often innovative and flexible, and can be helped in a number of ways, including start-up loans and tax breaks.


Price Level

National Income (Y)


The effects of supply-side policy

Successful supply-side policy will shift the LRAS curve to the right.

This can help reduce inflation in the long term because of efficiency and productivity gains.

Such policies create jobs and growth through their positive effect on productivity and competitiveness, which also improves the balance of payments.

LRAS

AD

Y

P

P1

A

B

LRAS1

The shift to the right in the LRAS curve creates the

possibility of a lower price level and more output and

jobs in the longer term

Y1

Actual equilibrium in the short run is determined

by the position of SRAS in

relation to AD

SRAS

278



Conflicts of policy objectives



Conflicts of objectives

Conflicts of policy objectives occur when, in attempting to achieve one objective, another objective is sacrificed.

There are numerous potential conflicts, including:1. Full employment vs low inflation

The conflict between employment and prices is the most widely studied in economics.

If policy makers attempt to undertake job creation by injecting demand into the economy - by expansionary fiscal or monetary policy - there is a danger that inflation will be driven up. This conflict is best explained by reference to the Phillips Curve.

It is likely that the trade-off still exists, despite the UK economy approaching full employment and prices still remaining stable in recent years.



Conflicts of objectives

2. Economic growth vs stable prices This conflict is similar to the employment/inflation trade-off, and can be

understood through the Phillips Curve and the AD/AS model. Using the AD/AS model, if an economy grows too quickly - through a fiscal or monetary stimulus of aggregate demand - then aggregate supply may not be able to respond and prices are driven up.

3. Economic growth vs a balance of payments As an economy grows import spending is stimulated relative to export

sales. Policy makers have to be aware that a dash for growth could lead to balance of payments problems.

4. Economic growth and negative externalities Economic growth can generate both consumption and production

externalities.



Other conflicts:5. Flexibility vs equity

In attempting to achieve a flexible economy – that is, one that copes with globalisation – the distribution of income may widen. For example, a flexible economy can be partly achieved by having a flexible labour market, and to achieve this there may be an increase in part-time employment and a reduction in worker protection and job security.

However, it can also be argued that, in the long term, the reduction in unemployment associated with flexibility more than compensates for the rise in part-time work and job insecurity.



6. Crowding-out – public sector vs private sector Crowding-out is a conflict between the public and private sector. For example, public sector borrowing to compensate for market failures

and provide public and merit goods, might drive up long term interest rates and crowd-out private sector investment.

The desire to achieve short term stability might put at risk the prospects for long term growth.


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