economics notes: unit 6 - foreign - uk in global economy

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Copyright © Kevin Bucknall Module 2881 Unit 6, The UK in the Global Economy: “Globalisation and Protection” 6-1. AN INTRODUCTION TO GLOBALISATION AND PROTECTION The gains from trade is the same concept as “why nations trade” and these gains lie behind the trend towards increasing globalisation. Comparative advantage. To simplify greatly, it means that a country does what it is best at! This is the main source of the gains from trade. A country will lack something that it cannot produce for itself, e.g., bananas in Britain. So a country trades to get what it lacks but wants. This is a minor reason. There is a gain in the variety of goods and services offered and wider consumer choice if one can buy from abroad. The country pays for the imports by exporting what it produces. Generally, international trade increases incomes, fosters economic growth, improves the standard of living, and allocates resources better, both within a nation and globally. The globalisation process Globalisation comes about by a reduction in protection, especially by the developed countries, and the general freeing up of markets. Globalisation involves countries specializing in what they are good at and exporting in exchange for goods or services they are poorer at. It requires a reduction in protection in order to allow the increase in trade which is necessary. It also needs the freer movement of capital and the ability to invest in another country. A company in country “A” can then either set up a factory or firm in a different country, “B”, or else buy an existing one there. As an example, the British company Lever Brothers has operating companies and factories on every continent in the world, has a research laboratory in China (among other places), and is a genuine and long-established multinational company. The motives for reducing protection are: To increase a country’s efficiency in production and hence improve the domestic standard of living, resource allocation and growth.

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Notes in introductory economics - foreign trade and the balance of payments. This is a chapter from "An Introduction to Economics", a free book by Kevin Bucknall available for download.

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Page 1: Economics notes: Unit 6 - Foreign - UK in Global Economy

Copyright © Kevin Bucknall

Module 2881 Unit 6, The UK in the GlobalEconomy: “Globalisation and Protection”

6-1. AN INTRODUCTION TO GLOBALISATION AND PROTECTION

The gains from trade is the same concept as “why nations trade” and these gains liebehind the trend towards increasing globalisation.

• Comparative advantage. To simplify greatly, it means that a country does what itis best at! This is the main source of the gains from trade.

• A country will lack something that it cannot produce for itself, e.g., bananas inBritain. So a country trades to get what it lacks but wants. This is a minorreason.

• There is a gain in the variety of goods and services offered and wider consumerchoice if one can buy from abroad. The country pays for the imports by exportingwhat it produces.

Generally, international trade increases incomes, fosters economic growth, improves thestandard of living, and allocates resources better, both within a nation and globally.

The globalisation process

Globalisation comes about by a reduction in protection, especially by the developedcountries, and the general freeing up of markets. Globalisation involves countriesspecializing in what they are good at and exporting in exchange for goods or servicesthey are poorer at. It requires a reduction in protection in order to allow the increase intrade which is necessary. It also needs the freer movement of capital and the ability toinvest in another country. A company in country “A” can then either set up a factory orfirm in a different country, “B”, or else buy an existing one there. As an example, theBritish company Lever Brothers has operating companies and factories on everycontinent in the world, has a research laboratory in China (among other places), and is agenuine and long-established multinational company.

The motives for reducing protection are:

• To increase a country’s efficiency in production and hence improve the domesticstandard of living, resource allocation and growth.

Page 2: Economics notes: Unit 6 - Foreign - UK in Global Economy

• To reap the gains from trade (comparative advantage).

• To help the poor countries of the third world. This is not really an important motive! The goods that the third world wishes to sell are often kept out of

developed countries by high levels of protection in order to assist their ownproducers. Imports of agricultural produce in particular are often heavilyrestricted for the sake of a relatively small number of farmers.

• Pressure from multi-national corporations on the various governments to allowfreer movement of goods and capital (in order to increase their own profits).

International Exchange

This really means why countries trade! If Britain can run an insurance service morecheaply, say, than New Zealand, then it should do so, and sell it to the world (Lloyds ofLondon does this). In this example, we would buy back something, for instance muttonand lamb. It is not necessary or even desirable to try to balance exports and imports witha single country. We wish to balance multi-laterally, on a global basis.

The global trading pattern:

The developed world trades more with itself than with third world countries, which seemssurprising to some.

But this is reasonable really! Because:

• Income elasticities are high for services and fancy expensive manufacturedproducts, but low for raw materials (revise elasticities and what this means inUnit 1 if you are a bit hazy). The developed world has high incomes, so itimports such things as video cassette recorders and TV sets from Japan.However, few poor developing countries produce such items. Instead they tend toproduce raw materials and agricultural products, such as bananas, coconuts, sugar,sisal and hemp all of which have low income elasticities. Where poor countriesdo export hi-tech goods, like TV sets from China, these are inevitably made injoint-ventures, set up with foreign capital and know-how and owned in part byforeign developed countries anyway. Many Japanese products are now made inthird world countries like China, as Japan has exported much of its manufacturingcapacity, a process known there as “hollowing out” the economy.

• Comparative advantage and wider consumer choice mean that, if we take motorcars as an example, the Germans make Mercedes and BMW; the French makeCitroens and Peugeots; the Italians make Ferraris and Alfa Romeos …. and theyall sell motorcars to each other.

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• The demand for primary produce (often produced in third world countries) growsonly slowly, so trade with third world countries does not expand rapidly. At thesame time, technological improvements in the rich world often reduce thequantity of raw material needed. As an example, Brazil produces much iron orebut less of this goes into a typical motor car built in the UK now than it did fiftyyears ago.

• An additional factor on the demand side is that most developed countries protecttheir domestic agriculture, which severely limits the amounts that poor countriescan sell to them (remember?)

• The long-term price of many primary products does not increase much, in part forthe three reasons above which limit the growth in demand. A further reason lieson the supply side: output of primary produce has increased over time. This ispartly through increases in yield but also because of the extra supply coming fromnewly developing third world countries as they increase their exports. Withreasonably rapid growth in supply and little growth in demand, the long termprice must fall. At best it will increase but slowly.

Trade Protection and Trade Liberalisation

Trade protection means reducing or preventing imports from foreign countries by meansof measures like tariffs, quotas and non-tariff barrier (ntb’s).

• An import tariff is a tax, e.g., 20 per cent (being set as a percentage it is referredto as an ad valorem levy) or £30 (as a set absolute amount it is called a specificlevy) which is placed on each item imported.

• A quota is a fixed quantity, such as 20 tons; only that amount in total can beimported.

• Ntb’s, as they are usually called, are often rather subtle and clever ways ofreducing imports by the tricky use of laws or regulations. As an example, healthregulations may be used to reduce or prevent wheat imports; or peculiar safetyregulations, such as the minimum distance between brake pedal and clutch pedalin a motor vehicle, may be invented and used to prevent the import of certainvehicles.

Note that in order to reduce protection we:

• Reduce or eliminate tariffs (so importers pay less or nothing).• But increase quotas (so a larger physical amount may be imported).

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Reasons for protection

• The infant industry argument. This justifies the protection of a new industryduring its early years, in order to allow it to establish and grow behind tariff wallsand quota barriers. Once it is mature, then the protection can be withdrawn. Thisis a respectable argument – but a common problem is that the infants rarely admitto being grown up and protection may continue indefinitely! Eventually, the lackof competition becomes a disadvantage rather than a help and the industry usuallycontinues to be permanently inefficient by international standards.

• Protection in order to level the playing field by keeping out cheap imports. Thisis a poor argument usually

o it goes against the principle of comparative advantage;o it reduces a nation’s flexibility in resource allocation (it freezes industries

as they are);o it lowers the standard of living (people cannot buy from the cheapest

source so must pay more for the good which leaves less money to spendon other things);

o it slows economic growth (if an industry becomes inefficient, it will hardlygrow fast); and

o it may also reduce exports (if the industry is poor, it is unlikely to be ableto sell to others).

• The danger of war. The case goes that we should protect our agriculture or basicindustries in case we are ever cut off by war. There is something in it as apolitical slogan but it is not a very respectable economic argument – few wars inthe future will involve long years of submarine blockades of the UK! The natureof war has changed with the huge technical advances in the military area sinceWorld War Two.

• In order to help some special group, e.g., farmers. The sugar beet industry in theEuropean Union is heavily protected which keeps out much cane sugar from poorcountries and means that as consumers we all pay more for our sugar than weneed.

The movement to reduce protection since late 1970s – why did this occur?

• At that time many developed economies were not in the best of shapes becausevarious long-standing government and other restrictions had led to resourcemisallocation, a lack of motivation, and slow economic growth, which held downthe lower standard of living. There were heavy restrictions in the labour markets,the capital markets and sometimes the goods markets. The growth ofbureaucracy, the emergence of the “nanny state” to look after individualscarefully, and many years of left-wing governments had led to this. The motives

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of the latter had been good, but there were several alleged and clearly undesirableside-effects e.g., lack of competition, lack of personal incentives and someerosion of the desire to succeed.

• There was a rise in economic theories promoting competition and free markets(“the Chicago School” and Milton Friedman) and these eventually became widelyaccepted. The data since suggest that they were right: lower tariffs do increaseper capita income as well as trade.

• Political – Prime Minister Margaret Thatcher and President Ronald Reagan cameto power and liked the idea of competition and freer markets. They felt that theireconomies were stifled by over-restrictions and hence uncompetitive. They, or atleast their advisors, saw that this encouraged slow growth, resource misallocationand lower standards of living. This was a “timing” factor perhaps and it justmight have happened anyway a little later?

• The collapse of the communist Soviet Union and Eastern Europe in and after1989. This happened following many decades of central planning of the domesticeconomy. Such countries cut themselves off from the international community(known as autarky) which reduced competition and they had fallen well behindinternational standards in many areas. After the collapse of the Berlin Wall in1989 and the events that followed, most of these countries moved out into theglobal area and adopted market mechanisms to try to restore and rejuvenate theireconomies.

• China moved into the global arena after 1978 and slowly but steadily began toadopt many market policies, although without ending communism or totallydismantling central planning. As a result, China is now a weighty player in globalmarkets and its cheap exports keep the level of international inflation lower.

• The other “tiger economies” (Hong Kong, South Korea, Taiwan and Thailandespecially) grew rapidly on a policy of free trade and the use of marketmechanisms and people around the world noticed this – and began to copy thepolicies.

• Technology changed. The rapid rise and spread of computers mean that globalmarkets, especially in finance, are feasible - and inevitable?

• Multi-national corporations rose, and they tend to think globally rather than on anational basis.

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Why protection hurts the people in the world

Less competition means a tendency for people, companies, and industries to rest ontheir laurels and take it easy. This encourages a nation not to reduce or eliminateslow-growth industries whose products are less in demand or are not competitive withother nations.

As a result we may find:

• Resources become increasingly misallocated for what people wish to buy.

• A lower standard of living because consumers cannot buy products at the lowestprice.

• Growth becomes slower because companies do not strive hard to improve theirproducts, production methods, or technologies.

• Exports are lower than they might be, as the nation is not as good as some othercountries with which we cannot compete. This limit on exports hits third worldcountries in particular. Much of the tariff reduction and quote increase that hasoccurred so far has been primarily to assist the rich developed nations. Relativelylittle has been done in areas that would help the poorer countries.

• There is less foreign trade in the world as a whole – so we have less comparativeadvantage being followed. This means slower world growth, and a lower globalstandard of living.

• The foreign exchange rate may be poorer, as the country is not exporting as wellas it might.

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6-2. TRADING BLOCS AND THE WORLD TRADE ORGANISATION (WTO)

Trade blocs are of three kinds – these are listed in order, weakest to strongest:

1. Free trade areas: these have no internal tariffs or quotas on trade between themembers, but each country can set its own level of tariffs against the rest ofworld. Recent examples are the North American Free Trade Association(NAFTA) which joined together the USA, Canada and Mexico in 1994.

2. Customs unions: these also eliminate tariffs between members but in additionthey set a common external tariff against rest of world that each member countrymust observe.

3. Common Markets: these cover much more than customs unions or tariffs andquotas. They can, and usually do:

a. Include laws that free up labour and capital movement between themembers.

b. Harmonise taxes which means that one country cannot be too far out ofline with the others.

c. Adopt some common monetary measures, such as all using the samecurrency. The Euro began in 2002 for most of the EU members but theUK has so far chosen not adopt it.

d. Set up a fixed exchange-rate between the members.

Really the members of a common market are moving in the direction of being onebig economy, while retaining their own nationality.

Why set them up?

• To gain economies of scale.

• To compete with bigger nations, e.g., the EU against the USA.

• Political motivation (not our concern in this course).

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There are two sorts of gains - static gain and dynamic gain

The static gain is the one-off benefit which a country usually obtains at the moment thatit joins.

• Trade creation versus trade diversion

Whenever any trading bloc is set up, or any country joins an existing bloc, there isa trade creation effect. This allows the most efficient producer to expand and sellits produce to the others, so all benefit to some degree. The producer gains alarger market and can reap economies of scale. The consumers gain because theprice will be lower and the quality probably higher than they previously enjoyed.This trade creation feature is always beneficial, and is often referred to as being apositive effect.

There is also a trade diversion effect. This is what occurs when the countryjoining ceases to buy from and sell to its traditional partners and starts to buy andsell within the group. Unlike trade creation, trade diversion can be either positiveor negative. If a country previously imported from the best and cheapest producerin the world, but after joining the organisation is now only allowed to buy withinthe bloc, it has a harmful or negative effect.

So if a country joins a trading organisation it has to hope that both diversion andcreation are positive, or else that the gains on trade creation are bigger than anylosses on trade diversion! (Remember that these are all static gains).

The dynamic gain is the continuing benefit over time of more dynamism as a result of:

• the increased competition;

• the larger market allowing the economies of scale to run for ever;

• a more mobile and probably better motivated labour force;

• and increased capital flexibility.

• All of these lead to greater efficiency in production.

These dynamic gains are always positive, that is to say, continuing benefits will steadilybe achieved.

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The World Trade Organisation (WTO)

The WTO replaced the General Agreement on Tariffs and Trade (GATT) as a result ofthe Uruguay Round of negotiations (1986-94). You can see that it took eight years togain international agreement!

The aim of the WTO is to increase the amount of world trade by means such aspromoting tariff cuts, increasing and perhaps eliminating quotas, and minimizing, orbetter yet solving, disputes between members. The WTO holds occasional meetings tonegotiate further reforms.

The WTO will not allow a nation in a recession to increase its tariffs or reduce the size ofthe quotas it sets. In other words, it is not allowed to increase the level of its protection.This rule is believed to have helped avoid the sort of harsh global economic slump thatwe saw in the 1930s.

Present contentious and unresolved issues are:

• Agricultural trade is still restricted by the developed world (which hurts many poordeveloping countries).

• Developing countries feel left out of the WTO progress and many believe that theyare discriminated against by the rich developed countries. It is often seen in the thirdworld as a sort of rich man’s club that has accepted poorer members but ratherignores them.

• The concern in the West about working conditions and human rights in some poordeveloping countries is a touchy issue. Poor countries usually want to get richer first,then worry about things like working conditions later. They often resent beinglectured to by the rich club members and told that they should not do the things thatearlier made the rich rich!

The WTO is attacked by radicals – often physically - at international gatherings,such as the one in Seattle in 1999.

The stated grounds for attack are that the WTO promotes globalisation and globalcapitalism. The extreme radicals dislike these for both political and socio-economicreasons:

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The political views of the radicals (not economics but related to it)

• The radicals are strongly antagonistic towards capitalism as the preferred economic-political system.

• The radicals are usually anti the USA, which is seen as the leader of the system.

• Some radicals are against the banks generally and international banking in particular.

• And some radicals seem to be pro communism; or pro anarchy; or pro nature andgoing back to living in more primitive ways that are seen as natural rather thanartificial.

The socio-economic views of the radicals,

Many believe that the process of globalisation has led to the world’s poor people andpoor countries becoming even poorer, and therefore it is bad and must be resisted. Theyoften argue that the world’s income distribution has altered in favour of the rich.

Actually, in many cases people in the poorer countries are wealthier absolutely, but theyare poorer relatively to the rich. What often happens is that nearly everybody has gotricher but the rich have got richer faster and so the gap is widening. Those at the bottomimprove a bit but those at the top improve a lot more. It must be admitted that noteverybody gains: a tiny minority who happen to be unlucky, situated in the wrong placein the country, or who are physically or mentally challenged always seem to lose. Theonly way they can improve their lot is for their government to step in and help them.Few governments in poor countries feel that they can afford to do this yet and it mustwait until the country is more developed.

Where the people are absolutely poorer – and this does happen - it is almost alwaysthe result of one or two things (and sometimes both):

• Bad governments that have adopted poor economic policies (Zimbabwe, theSudan, Nigeria).

• Wars, rebellions, or coups (sadly common in much of Africa).

So it is often politics and people that cause it rather than capitalism or the rich nations.

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The case that the weather causes the problems

Now and then the poverty and problems are the result of bad or changing weatherconditions, which lead to drought or floods that in turn cause famine and death. But suchsevere results mostly occur in an area that is undergoing war, rebellion, or revolt.

More stable countries suffer from weather problems too but they can usually cope withthem without major and long running disaster. It rather looks as if the military orpolitical turmoil is the main factor involved where suffering is both intense andprolonged.

It is common and understandable for bad governments to blame freak weather, or globalwarming, or international capitalism, or indeed any thing they can think of to explainaway their own mistakes.

Be warned that the cause of such problems is a contentious issue which is much debated.These views are mine, based on many years of living in third world countries, anddecades of studying the problems. But I might be wrong! You should consider theevidence, think about it, and then make up your own mind.

Since I wrote the above paragraphs, the evidence of global warming has becomestronger and clearer. There is still dispute, but the majority of scientists working inthat area now appear to accept that global warming is a reality. Some dire warningshave appeared. Currently, the worst worst situations still occur where war, civil waror insurrection, or gross economic mismanagement raise their truly ugly heads.

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6-3. THE BALANCE OF PAYMENTS

This was introduced in Unit 3but I repeat a bit here, then expand it to consider how wecan deal with problems in it.

• What is the balance of payments?

The balance of payments is a record of a country’s economic transactions with other(foreign) countries. It includes the trade in goods and services, reveals how we pay forthis, or if did not pay it tells us what we still owe. It also includes other financial flows,like foreign investment and company dividend payments.

1. The current account.

2. The capital account.

3. The financial account.

4. The international investment position.

THE CURRENT ACCOUNT

This course focuses heavily on the current account, which includes:

• Trade in goods.• Trade in services.• Income from working abroad, and from investments abroad.• Current transfers: central government and private.

We used to consider the balance of payments was divided into two: thecurrent account and the capital account. In 1998 a new method of presentingour international situation was introduced which contains four categorieswithin the balance of payments.

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The UK Balance of Payments, 2003 in £ millions – The Current Account(Simplified)

CREDITS DEBITS BALANCEGOODS

Food, beverages & tobacco 10,827 21,099 - 10,272Basic materials 3,325 6,125 -2,800Oil and other fuels 16,478 11,128 5,350Semi-manufactures 54,244 55,751 -1,507Finished manufactures 101,961 138,255 -36,294Other goods 868 1,594 -726

Total Goods 187,703 233,952 -46,249

SERVICESTransportation 11,424 16,679 -5,255Travel 13,673 29,443 -15,770Financial services 13,244 3,277 9,967Other services 49,965 25,060 24,905

Total services 88,306 74,459 13,847

INCOMEEmployment from abroad 1,116 1,059 57Income from investments 125,250 101,922 23,328

Total income 126,366 102,981 23,385

CURRENT TRANSFERSCentral government transfers 4,173 10,942 -6,769Other sectors 8,886 11,860 -2,974

Total current transfers 13,059 22,802 -9,743

CURRENT ACCOUNT TOTAL 415,434 434,194 -18,760

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The Ten Economic Goals and the Effects on the Balance of Payments

WHAT MIGHT OCCUR THE EFFECTS WE MAY EXPECT TO SEEIf we grow faster. The B of P worsens, as growth sucks in imports to

sustain production + higher incomes mean consumersbuy more foreign goods and services (these are generallyincome elastic).

If the standard of livingrises.

The B of P worsens as consumers buy more foreigngoods/services.

If resource allocationimproves.

The B of P probably improves, as the country is doingwhat it is best at.

If income distributionbecomes more equal.

The B of P probably improves, as the rich reduce theirpurchases of foreign goods/services but other incomeswill not rise enough to suck in many more imports.

If inflation increases. The B of P worsens as our exports fall and imports rise.If unemploymentincreases.

The B of P is probably a bit better as incomes are lower,which means consumers demand fewer imports.

Value of currencychanges.

If the pound gets weaker it encourages our exports anddiscourages imports, so the B of P probably improves.Note that the currency may be weak because the B of Pis already poor!

What can we do if the balance of payments gets into a “fundamentaldisequilibrium” state?

A fundamental disequilibrium state means that:

• imports are considerably more than exports; and• there is a persistent balance of payments deficit; and• there is no likelihood that this situation will change.

The IMF will only allow major changes in exchange rates or special action to help thebalance of payments if the country can persuade the IMF officials that there actually is afundamental disequilibrium.

There are three possible ways of tackling this:

1. Via the exchange rate system – if the exchange rate is fixed (like China whichcurrently fixes the yuan against the US dollar) we might alter our exchange rate

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(although countries are bound by the IMF agreement as long as they are members.This solution is not applicable to the UK as our exchange rate floats (see below).

2. Via demand side management of the domestic economy. Lowering the level ofaggregate demand would provide short term help by reducing imports andpossibly freeing up some goods and services for exports.

3. Via supply side management of the domestic economy. Pushing out the long runsupply curve would provide permanent help.

The first way of tackling a balance of payment problem: changing the foreignexchange rate

The exchange rate methods that a country might have adopted

1. Floating.2. Fixed.3. Managed.

1. Floating rates:

These are normal for most countries these days; floating rates are currently in force forthe UK.

The supply of and demand for the pound determines its value.

1. The demand for pounds comes from foreigners who wish to buy British goods orinvest in Britain.

2. The supply of pounds comes from the British, as we buy goods or services fromabroad or we send money abroad to invest there.

This is the normal supply and demand curve situation: if we increase our imports, thesupply of pounds increases, so the value of the pound starts to fall.

Page 16: Economics notes: Unit 6 - Foreign - UK in Global Economy

0 Quantity of pounds

Price of poundin dollars

S1S2

P1P2

Q2Q1

D

When this happens, a second element might swing into action. Speculators might jumpin and sell pounds, hoping the fall will continue so that they will be able to buy themback later at a lower rate. Should speculators sell in this way, it will drive the pound evenlower.

2. Fixed rates (the regime a country might have adopted):

The government sets the value of the currency in the foreign exchange market. It isusually set well out of line with the foreign exchange rate that the market woulddetermine – there is no point otherwise because it can simply be left to the market Thismethod is not used much, except by a few communist countries.

Linking the rate to another country fixes it in a kind of way, but as the value of the othercountry’s currency alters, so does yours! Malaysia currently links to the US$ whichhelps it to stabilise its export and import prices for the USA and set them for othercountries in international contracts.

With our floating rate: if the balance of payments deteriorates, the foreign exchange rateworsens automatically – thus making our exports cheaper and imports dearer, so it shouldautomatically correct the imbalance in time.

With a fixed FX rate: with “a fundamental disequilibrium” the country could devalue – ifthe IMF will let it! Secret meetings would normally be held and the government wouldtry to persuade the IMF officials that there really is a “fundamental disequilibrium”.

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A small digression: what can affect the balance of payments (and hence the value ofthe currency)? (Note: you may need this for the exam).

1. Our demand for imports.2. The demand of others for our exports.3. Our inflation rate compared with that of others.4. Our rate of interest compared with that of others.5. Speculative capital flows.

Our demand for imports: if we import more, the balance of payments on current accountweakens and pounds flow abroad. This increase in the supply of the pound reduces itsvalue. The normal supply and demand curve analysis applies, as in the diagram above.

The demand of others for our exports: if foreign countries increase their demand for ourexports, our balance of payments improves and the value of the pound rises. The othercountries demand pounds in exchange for their currency, as they have to pay us in poundsin the end.

Our inflation rate compared with that of others: if other countries inflate more slowlythan we do, our exports become relatively dear (so we can sell less), and our importsbecome relatively cheap (so we import more), with the result that the balance ofpayments deteriorates. This causes the pound to fall in value. You can see that when wepay for the extra imports it puts more pounds on the market, while selling fewer exportsmeans we earn less foreign exchange.

Our rate of interest compared with that of others: if our interest rates rise (and no othercountries match it) then foreigners send more money to us to earn a higher rate of interestand hence a bigger income. The influx of foreign capital then increases the value of thepound and strengthens the balance of payments.

Speculative capital flows: “hot money” can race around the world seeking the highestrate of interest commensurate with safety and risk. As the world gets wealthier andmultinational corporations increase, the size of the flow gets larger. If hot money racesinto a country, it strengthens the balance of payments and increases the value of thatcountry’s currency. The real danger will come later when it races out again! The valueof the currency could then fall sharply and the balance of payments could weakenrapidly. The total effect can be very destabilizing. The IMF will usually lend money tohelp a country offset the sudden flood out.

3. Managed rates of exchange (the regime a country might have adopted):

This system is much like the floating one. The difference is that the value is notcompletely free to move for ever. The government may step in (should it feel like it) toshore up the foreign exchange rate if it starts to fall. It does this by buying pounds, using

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the foreign exchange and gold reserves to do so. If the value of the pound begins toincrease, the government may judge it right to step and moderate the increase by sellingpounds on the international market. This would then increase the foreign exchangereserves.

Although Britain has a floating exchange rate system, in the past the government hasbeen known to intervene to protect the value of the pound by buying and selling foreignexchange. The rate of interest set by the Bank of England also affects the value of thecurrency, as you will recall, because relatively high rates of interest attract foreign moneyto be placed on deposit here. The government is influential in deciding on what rate willbe set. We know how the voting on the Committee went but the internal arguments arenormally secret.

The second way of tackling a balance of payments deterioration: demand sidemanagement

Reducing the level of aggregate demand can have a short term effect and help the balanceof payments.

If we see the balance of payments weakening, perhaps because of high levels of domesticconsumption and imported consumer goods, the government can reduce the level ofaggregate demand, take the heat out of the economy, slow growth or even reverse it,increase unemployment, and reduce inflation. This will help the balance of payments byreducing imports and also by releasing goods for export that are no longer consumedhere.

Price IndexSAS1

90.0AD2

AD1

GDP1GDP20

100.0

Real GDP

110.0

Page 19: Economics notes: Unit 6 - Foreign - UK in Global Economy

Generally, this would be a short term response to a sudden crisis – the governmentchooses to squeeze the economy because too much is going wrong within the ten goals.

The third way of tackling balance of payment problems: supply side management

Changes on the supply side tend to be a long term thing and it is not a tool that cansuddenly be wielded in a crisis to give quick results. It is a theoretical possibility but anation is usually well advised to keep trying to push out the supply curve anyway as partof an ongoing process.

If we can increase the long run aggregate supply curve (the vertical part of the SAScurve) it pushes down prices as well as increases output. This means our exports getabsolutely cheaper, so we are able to sell more, and hence the balance of payments willimprove. We also import less because our imports are relatively dearer now whencompared with home produce.

SAS1

AD1

P1P2

GDP1 Real GDP

0

SAS2Price Index

GDP2

Here we see the SAS curve moving to the right (an increase in the underlaying rate ofeconomic growth) and gross domestic product increasing.

Other than the initial increase in growth and the improvement in the balance of payments,we would see benefits for some other goals too: there would be an increase in thestandard of living (as prices fall and as incomes rise); and we can also expect an increasein the number of people employed.

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6-4. THE EUROPEAN MONETARY UNION (EMU).

When a member of the European Union (EU) joins the EMU its central bank loses somepower.

It gives up:

• The ability to determine monetary policy and fix interest rates; it accepts the oneset for all the members of EMU.

• The management of the exchange rate of its own currency. The countryhenceforth uses Euros which are set to the national currency at a fixed rate.

The UK is not currently a member of EMU but it is a member of the EU.

The costs of joining EMU

• The UK would lose some sovereignty and power – we would be in the hands ofthe decision makers for the EMU countries.

• If what is decided about the interest rate is good for most of the EU, but happensto bad for us, we would lose. It might mean that if we were in a recession but theother members were booming, interest rates might be set to curb the boom. Thiswould be inappropriate for our situation and it might force us to stay in recessionor even worsen it. Germany was like this in 2003 and still is. It is unlikely thatthe average rate of interest set for all will be perfect for everyone: it will almostcertainly be set too high for some, and too low for others.

The benefits of joining

• We would have a fixed price of our exports to and imports from Europe. Wewould not have to undertake currency exchange each time we import and exportinvolving other members. We would also not have to worry about the possibilityof future currency movements, as there would not be any.

• This means that there would be fewer shocks and fewer risks, as business peoplewould know what price they would get when they sell.

• This should lead to an increase in trade, lead to a reallocation of resources alongcomparative advantage lines, help to increase the standard of living, speed upeconomic growth, encourage more employment and help the balance of payments.

Page 21: Economics notes: Unit 6 - Foreign - UK in Global Economy

• We would still be able to use fiscal policies to counteract undesirable changes inour economy.

Fiscal policy for those in the EMU

Fiscal policy can be set independently by the members – but some suggest that in thelong term, tax rates will have to be roughly similar, if not identical (tax harmonization).

What would happen if a country’s tax rates were well out of line with the others?

• Labour or capital might flow from the high tax regime country to one wheretaxation is lower.

• People might appeal to the EU or courts to obtain equal treatment under an EU-wide piece of legislation and if successful could get a different tax rate applied.

It seems probable, however, that different countries would be able to retain their own taxrates safely as long as they were not seriously out of line.

Opposition to joining the EMU

Many people are against joining the EMU, just as many are for it. The economic casewas presented above. Currently, the political opposition to joining is a worry to thegovernment, which has been going slow on the issue for some years.

Remember! This is an economicscourse and exam, not a political one. This means thatyou can mention that there is both political support and opposition but you should not gointo much detail. For you own information here are a few points.

• Many people who have the vote fear that we would lose autonomy, which is true(see above).

• The Conservative press is largely against joining.

• Prime Minister Tony Blair seems to be nervous about public reaction; the currentChancellor of the Exchequer, Gordon Brown, might be in favour of joining, buthe has seems to have concerns that it would limit his power over the economy. Inaddition, some allege there is a long-standing rivalry between these twopoliticians for power and influence and internal Labor Party factionalismcomplicates the issue.

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• Some people suffer from xenophobia and feel that we cannot trust foreigners ingeneral.

• Some believe that we cannot trust the bureaucrats in Brussels to do the right thing.

• Some believe we should only join when the conditions are right; this can bemeeting the Five Tests of Gordon Brown, or merely a way of ensuring that wenever join, by permanently claiming that conditions are still not right.

The five tests are concerned with:

• Convergence: is our economic cycle, as well as our rates of interest, in line with the othercountries in Europe?

• Trade and investment: would our firms get better access to capital and export markets inEurope and would European and other investment increase in Britain?

• Flexibility: has the EU sufficient flexibility to cope with problems like inflation?

• Finance and the City of London: will the financial sector do well in the EU, especiallywith the single currency?

• Economic growth and employment: will we do better if we join?

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6-5. PUBLIC EXPENDITURE IN THE UK

What determines the size of public expenditure?

• Where the country is in the economic cycle – if we are in recession (around thefloor or trough in the diagram below) the government may choose to spend moreand increase the “G” component of aggregate demand (consumption + investment+ government) thus pushing out the aggregate demand curve.

GrossDomesticProduct

0 Time in years

Peak, orCeiling

Floor, ortrough

Downswing BoomGDP

Upswing Slump

This is shown in the diagram below.

Price Index

Real GDP

SAS1

AD2

AD1

0 GDP1 GDP2

100.0

Conversely if we are in a boom, the government may choose to spend less, reduce the“G” component of aggregate demand and pull back the aggregate demand curve, thusreducing public expenditure. You can see the results in the diagram below. The levelof gross domestic product falls from GDP1 to GDP2 and the rate of inflation fallsfrom P1 to P2.

Page 24: Economics notes: Unit 6 - Foreign - UK in Global Economy

Real GDPGDP1

SAS1

AD2

AD1

GDP20

Price Index

P1

P2100.0

• If the government fears there is about to be an international recession or believesthere could be events that could lead to a downturn or downswing, they mightincrease spending to offset it. There might, say, be a fear that investment orconsumption is about to fall.

• The government gets elected on its policies. If their manifesto stated they wouldincrease expenditure and solve certain problems, perhaps for instance to fix thetransport system, then they really should be spending if democracy is to meananything.

• The government’s general attitude, e.g., Old Labour taxes and spends more thanNew Labour or than the Conservative Party.

The budget deficit or surplus

If the budget is in deficit, it means that public expenditure exceeds government revenuewhich comes largely from taxation. The government may have to borrow to cover thedifference.

It is acceptable to run a budget deficit, if for instance, the government is deliberatelytrying to increase the level of aggregate demand, expand the economy, and lead us intoan upswing. The policy of the current Chancellor of the Exchequer, Gordon Brown, is tobalance the deficits and surpluses over the whole economic cycle but he does not aim todo so in any one year.

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Public borrowing

The “public sector net cash requirement” (PSNCR) is what the government must borrowin order to fill the deficit gap. The gap, if any, includes the total accounts of the centralgovernment, local governments and the public corporations.

How is the PSNCR measured?

• The nominal PSNCR is the simple addition of the financial accounts of the abovethree sectors.

• The seasonally adjusted PSNCR takes account of our place in the economic cycle– the deficit and PSNCR increases naturally in a recession because thegovernment is paying out more to the unemployed and at the same time, taxrevenue is lower owing to the lessened economic activity.

• The PSNCR as a percentage of GDP is a useful measure;

o it helps us to judge how “large” it is in context;o and also to compare our situation with that in other countries. We keep

our eye on the other EU countries in particular.

Does government borrowing matter?

There are both advantages and disadvantages in the government borrowing money. Allgovernments do it!

The advantages

• By borrowing and building things like roads, bridges, and docks (known as socialoverhead capital) and providing better education or health for the people it canspeed up future economic growth. This will make it easier to pay back what isbeing borrowed now, as well as what was borrowed in the past, because societywill be richer.

• The extra expenditure (“G”) might prevent a fall in national income and so thegovernment will not forgo the tax revenue it would otherwise have lost, or have tospend more on the unemployed.

• Borrowing prevents the government from having to raise taxes now.Governments that increase the rate of tax tend not to be popular and thegovernment wishes to be re-elected!

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The disadvantages

• When the government borrows it tends to increase the rate of interest rate offeredand this might crowd-out private investment. Those who save might divert theirsavings towards the government and away from industry or the banks (who lend itto industry). A reduction in investment can harm future growth prospects.

• The sum borrowed has to be repaid (or else the level of national debt increases,which is in itself not particularly bad). If the government raises taxes to do this,not only will it be unpopular, it would reduce consumption and the standard ofliving, and might reduce investment which could be detrimental to long termgrowth.

• When the government repays its earlier borrowings, whatever sum it repayscannot then be spent on what is deemed important at that time.

• To some extent, the disadvantages and advantages depend on what thegovernment decides to spend the borrowed money on and how effectively itspends it.

Gordon Brown’s “Golden Rule”.

The Chancellor Gordon Brown decided that it is safe and desirable for the government toborrow in order to spend on investment for the future, but not to borrow to cover currentconsumption. He believes that the consumption component of government expendituremust be financed by taxation.

He also tries to balance out borrowing and spending over the economic cycle, so thegovernment can borrow for a few years of recession but should then pay it back in timesof boom.

Public expenditure and income distribution

Generally, when a government wishes to redistribute income it prefers this to be towardsthe poor rather than the rich, and it often does this via the social security system.

The problems with trying to redistribute income include:

• The really poor, sleeping in doorways etc, may not know about the benefits thatare available or even qualify for them (a fixed address may be required forinstance) so they do not benefit from the intended redistribution. The neediestpeople can miss out.

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• The sheer complexity of the rules mean that many who qualify do not apply forstate benefits – so the poor and aged do not get all they should. This is a widelyrecognised problem that still awaits solution. Some other people, often the elderlywho were brought up to fear “accepting charity”, may refuse on principle to take ahandout from the state, even when desperately poor. The means test in order todetermine exactly how poor they are also deters some, perhaps many.

• The middle class tends to be good at getting its share because is educated andvocal, when compared with those at the bottom end of society.

• The rich tend to be able to avoid a lot of income tax, and other taxes, in a varietyof ways. They are able to buy the advice of experts, set up trusts, live abroad forpart of the year and avoid tax, or simply conceal the income they obtain. The trueburden of taxation often seems to fall on the group in the middle rather than thericher top end of society.

• A special problem is that governments have a tendency to subsidise groups whichare seen for some reason as desirable, whether the members are rich or poor.Farmers are a particular example of this, where extremely poor hill farmers inWales receive a subsidy and so do the large, rich farms owned by millionairefamilies who use managers rather than sweat themselves.

• Government may also change the tax system to favour a particular group e.g., toincrease or reduce the help for those paying mortgages. Such action alters incomedistribution.

• Logic suggests that we should not subsidise groups at all, but should simplyidentify the poor and those who need help - and then help them. Subsidising therich seems bizarre and wrong. Subsidising things rather than people seemspeculiar, e.g. council houses, but this is done and rarely questioned. The result isan anomalous situation where many really poor are excluded from the benefits ofcheap public housing, and some recipients of it are now moderately wealthy butare still subsidised.

• In the United States under President Bush, many rich people have received substantial windfall income increases owing to changes in the tax system

apparently designed to benefit the wealthy. It is uncommon in Britain forgovernments to alter the rules to favour the rich rather than the poor, althoughPrime Minister Thatcher did this.

• It is perhaps more common for lethargy or inaction to allow the rich to be favoured. As an example, the current Labour government has refused to increase

the rates of income tax on the rich. Further inaction has maintained the cut-offpoints in the tax system, so that many quite ordinary people who might bedescribed as “comfortable” rather than rich have now moved up into the top ratetax bracket.

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• As a further example in the UK, governments for a long time have refused toclose certain legal loopholes that favour the rich, such as the current rules thatallow low rates of income tax for those living in the Channel Islands. Naturally,the millionaire population of these islands is well above average, as large numbersof rich people have moved to live there in order to preserver their wealth andavoid paying taxes to help run the country.

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6-6. INWARD FOREIGN INVESTMENT BY MULTINATIONALCORPORATIONS

These were introduced in Unit 2 – go back and revise if you have forgotten. It is nowtime to increase our knowledge of how they operate.

The case for MNC’s investing in the UK and the rest of Europe

The EU likes MNC’s and the investment that they bring in:

• They bring in skills.• They create jobs (this is usually well-publicised when a new factory is opened.)

• They add competition to a smaller economy.• They help to increase output.

• This pushes out the long run aggregate supply curve and is a good source ofeconomic growth.

• They add to the capital available and the technology they bring is probablymodern and very advanced. (Recall that increased capital plus technicaladvances are the main source of growth in most developed countries.)

• They generally add dynamism to the economy.

The case against MNC’s

There is a lot of myth and story-telling and the case against sometimes looks a bitspeculative rather than hard-fact based but here goes.

• They take their profits in the lowest tax regime country in which they operate. Itis easy to do, as they simply sell from one branch in high-tax country “A” at a lowprice (so making little or no profit there) to a branch in a low-tax country “B”which then makes high profits as a result – and of course pays little tax. Thisprocess is called “transfer pricing”.

• They have often proved to be either corrupt or behaving in ways that border uponcorruption, in order to help themselves and improve their position and profits.

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• They may favour their head-office home base country over the interests of thelocal nations in which they operate.

• They will prevent cheap versions of their patented goods being made in poor thirdworld countries, even if the people are dying of aid. (This is not an economicargument.)

• They successfully pressure national governments to water down environmentaland tax laws so as to favour their own profits.

Page 31: Economics notes: Unit 6 - Foreign - UK in Global Economy

6-7. EXTERNAL SHOCKS AND THE GLOBAL ECONOMY

All large shocks have an impact on the world level of economic activity, e.g., higher oilprices; the war in Iraq in March 2003; or the Asian financial crisis of 1997.

All questions about external shocks can be tackled in the same general way:

1. The impact of the event on the ten major economic goals. (You will need tothink about them and apply them to your particular case. If you jot all tendown, say in the margin of your exam question paper, you can ensure that youdo not miss any out).

2. The transmission of the event and its consequences around the world, which isgreater and faster than it used to be as a result of globalisation. Remember thatthe exports of one country are the imports of another. The flows of liquidcapital might also be affected. Naturally, some countries will be affected morethan others.

3. You can almost always use the diagram of the determination of nationalincome by means of aggregate demand and supply to show the domestic effectsof any major external shock.

But clearly there will be differences in what will happen and not all events have exactlythe same results.

You might be asked about the effects on the UK specifically, or the question could bemore general and concerned with the effect on a wider area; always tailor your answerto the question asked.

As an example, let us examine the effects of the current war in Iraq following theinvasion by British and American troops on our national economy.

• All wars increase the level of aggregate demand and tend to have an inflationaryeffect.

War means increased demand for many things, e.g., steel, armaments, the defenceindustry generally, and hospital and medical equipment. This means an instantincrease in the level of aggregate demand.

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The effect of war on the macro economy: an increase in aggregate demand and inflation.

Price Index SAS1

AD10 Real GDP

AD2

GDP1 GDP2

103.0

110.0

100.0

The invasion and occupation mean an increase in aggregate demand in the UK, a boost inoutput, with an associated increase in the level of employment, and extra inflationarypressures, as in the diagram above. (The figures are assumed and the movementexaggerated, in order to show the effects). The level of gross domestic product increasesfrom GDP1 to GDP2, and inflation rises from 3.0 percent to 10.0 per cent.

• It also pushes up the price of oil because of the extra demand for oil to use in the war.In the case of the Iraq war, there is the additional fear that the war may drift on for along time and later could involve invasion into other countries in the Middle East.This means an increase in the price of petrol, as you or your parents will probably bewell aware if you have a vehicle to run.

If the economy starts off in recession before the war:

The war can be helpful as it brings the economy out of the recession. This happened inWorld War Two in 1939 when the British economy was stimulated, as was the Americaneconomy. There is a strong school of thought that says the efforts in the USA to boosttheir economy throughout the severe slump of the 1930s failed and only the advent ofwar stimulated a recovery. The diagram below shows an economy such as in the USA inthe 1930s. An increase in demand would increase output and end the slump.

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Starting a war in the middle of a recession

110.0

100.0

90.0

0

AS1Price Index

AD2AD1

GDP1 GDP2Real GDP

Demand increases, output expands, which means more jobs become available to thosewho are unemployed. Inflation does not increase as there is much spare capacity whenwe start.

But if the economy starts off at full employment:

You will notice in the diagram below that no increase in output is possible, so theincreased demand because of the war all spills over into a higher rate of inflation.

It is arguable that Britain had a strong and buoyant economy on the eve of the invasion ofIraq, and so the full employment diagram below is perhaps the more relevant one.

Starting a war when we already are close to full employment

Real GDPGDP1 &GDP2

108.0

111.0

Real GDP

Price Index SAS1

AD2AD1

100.0

Page 34: Economics notes: Unit 6 - Foreign - UK in Global Economy

The length of time involved

A short war can sometimes be helpful to an economy, especially when starting in arecession or slump. The initial increase in demand is real and boosts national income butbeing short the war is over quickly and the uncertainties vanish. On the other hand, thewar diverts resources to engage in war that could be allocated to areas such as health,education, the private standard of living, pensions, or investment for future growth, sothere is a real cost to society.

A long war is generally harmful. If it is conducted in part on home territory there will bemuch destruction of buildings and property. In these days of increased terrorism, there islikely to be some damage wherever the war is fought. The war can breed new uncertainties,divert investment towards the armaments industries away from consumer goods andservices, which reduces the standard of living, as well as add to inflationary pressures.

A long time ago, a major recession was common after the end of a major war.

This seems to have happened over all human history, including the First World War(1914-18) Post-war there was a sudden fall in the level of aggregate demand. It wasdifficult to reallocate resources quickly to the sort of goods and services demanded inpeace time and in addition the vast influx of discharged soldiers meant severeunemployment.

There is now less of a danger of this happening: because of the work of Keynes we knowthat government can increase the level of aggregate demand to offset the automatic fallthat peace brings. This is how we avoided the emergence of a slump after the SecondWorld War (1939-45) in the UK, the rest of Europe, and in the United States.

It is also now much quicker and easier to reallocate resources than it once was, whichwill help us after any major conflict in the future. This is the result of the changes begunby Prime Minister Margaret Thatcher after 1979 in the labour markets and financialmarkets and perhaps to a lesser extent to the freedom given to the Bank of England toreduce interest rates to stimulate investment and consumption.

To list the ten goals with possible effects from the invasion of Iraq war:

• Economic growth: is boosted in the short term; but probably slowed in the longerterm as resources go to waging war, rather than investing for the future.

• Allocation of resources: towards war goods and away from peace-time goods, such as education or health.

• Inflation: the war worsens the inflationary pressures; this is particularly noticeable inthe price of petrol.

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• Standard of living: reduces a bit; or at least not increases as much as it wouldotherwise have done.

• Distribution of income: moves towards the suppliers of armaments, munitions,uniforms and the like, as well as to the firms that reconstruct the Iraq economy whenthe war is over.

• Balance of payments: possibly harmed a little, as we probably had to import a fewthings with which to wage war; plus we probably lost a few exports as the goods orservices were diverted to Iraq. The net effect is probably small?

• Value of the pound: probably not affected much.

As another example of an external shock and how to tackle it, let us look at theeffects of a sustained rise in the price of crude oil.

Unlike the previous example which was focused on the demand side, a sustained rise inthe price of oil is a supply side problem. Such a price increase passes on through thegeneral economy quickly because of the immediate increase in the price of transport andfuel. This increases the costs of virtually all producers and pushes up their micro supplycurves. In turn, this means an immediate shift upwards in the aggregate supply curve.

Note: the figures are all assumed in order to demonstrate the principle involved.

Price Index

Real GDP

SAS2 SAS1

0

100.0

110.0

101.5

GDP2 GDP1

The results can be read off the diagram: we see inflation increasing from 1.5 per cent to10.0 per cent and the level of national income falling from GDP1 to GDP2. There is little

Page 36: Economics notes: Unit 6 - Foreign - UK in Global Economy

a government can do under the circumstances. It is unable to increase the level ofaggregate demand to tackle the fall in output and the associated rise in unemployment,because we are already close to full capacity working and all we would see after ademand increase would be even more inflation. The only hope is to work on increasingthe general level of efficiency in the economy and stimulating people’s motivation towork harder, i.e. to push the long run supply curve outward to the right. This by itsnature is a slow process. For those governments of countries that are oil producers, suchas the UK, it might make sense to promote the search for more oil beds, but this option isnot open to most countries, as they totally lack oil.

Higher oil prices affect the supply of some things more than others, for example theyhave a disproportionate effect on the prices of petrol, bitumen and chemical fertilizerproduction all of which use crude oil as a major raw material. Such products suffer asubstantial rise in price when the price of crude oil increases. The fear of a general worldrecession is likely to emerge and then grow.

So the rise in the price of crude oil helps those countries that are oil producers, and harmsall oil importers. It can be particularly damaging to many third world countries as theyrely on imports of chemical fertilizer for their agricultural production which is a largeproportion of the economy. The agricultural output is used to feed the people and inmany cases to provide much-needed exports.

Notice that if you memorise and learn to manipulate the diagram for the determination ofnational income via aggregate demand and supply how useful it is. You can use it whentackling a great number of questions. And this is true not only in the exam room!

To list the ten goals with some possible effects from a substantial rise in the price ofoil:

• Economic growth: this is harmed, as fuel and transport cost increase, forcing theshort run aggregate supply curve upward.

• Allocation of resources: (not a lot to say here).

• Inflation: the oil price rise worsens any inflationary pressures.

• Standard of living: reduced a bit. To the extent that the tax on petrol is linked tothe price of crude oil, the retail price of oil tends to rise immediately.

• Distribution of income: moved away from users of motor vehicles as they paymore for their petrol. The government also receives an increase in revenue fromthe automatic tax increase.

• Balance of payments: possibly helped a little, as the UK enjoys net exports offuels.

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• Value of the pound: probably not affected all that much? The adverse effect ongrowth might be offset by a positive effect from the balance of payments.

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