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FlashCards

The main characteristics of a market economy. Factors that affect demand Factors that affect supply Factors that affect PED Factors that affect PES How are elasticities useful? Solutions a government can use for shortages caused by maximum prices. Advantages and disadvantages of putting a minimum price. (N5S-E) Solutions a government has for overprovision of demerit goods. -------------------------------------------------------------------- Characteristics of perfect competition / monopolistic competition / monopoly / oligopoly Different types of efficiencies. Different goals a firm might have than profit maximization. Disadvantages and advantages of a monopoly versus competition. Options a government has to deal with abusive monopolies. Macroeconomic goals of a country ------------------------------------------------------------------ Problems with using GDP Factors that shift AD Factors that shift SRAS Factors that shift LRAS Examples of Supply Side Policies What are the functions of money? The difficulties of measuring inflation. The costs of inflation. Who are the winners and losers with inflation? The costs of deflation The difficulties in measuring unemployment The costs of unemployment. Strategies to use with natural unemployment. Explain the effect of interest rates on AD, the exchange rate, and the balance of payments.

What HDI measures. Other factors of quality of life. What are the various barriers to development? What are different strategies that can be used in the development of a country? The advantages of education according to Amartya Sen. What are different types of inequalities according to Amartya Sen? What are the different types of aid? What are the problems of giving aid? What problems does corruption cause a society? Problems of being heavily indebted. Advantages and Disadvantages of FDI? Different sources of funds for an LDC to develop. ---------------------------------------------------------------- The advantages of free trade globalization Arguments for protectionism. Who gains and who loses when a country imposes a tariff? Who gains and who loses when a country imposes a subsidy? The types of free trade blocs. The benefits of joining a free trade bloc. Factors that affect floating exchange rates. Effects on different groups of a change in exchange rates. What is counted in the current account and capital account? Problems of a persistent current account deficit Strategies that could be used to reduce a current account deficit Factors that affect the terms of trade. Problems of a deterioration of terms of trade especially for LDC

Note: Remember, in answers it is usually better to go into a few points in depth with examples than list many superficial points. Evaluation will be able to say in the particular situation which are the biggest advantages and disadvantages or most important effects. Note2: These are just bullet points for quick reference. They are not meant to be your only review, only help you focus and notice areas that need further revision. See notes or the textbook or Tutor2u for depth and diagrams. Ways to Show Evaluation Biggest advantages / disadvantages Most important effects Effects on different groups

Long run vs Short run effects Assumptions of the theory / model Macroecononomic goals of a society Stable economic growth Price stability low inflation Full employment low unemployment international balance stable exchange rate, current account balance, manageable international debt reduce poverty increase quality of life and development reduce inequality balance the government budget preserve the environment and culture Factors that shift AD Government spending Direct taxes Change in interest rates Change in exchange rates Business Confidence Stockmarket performance G C C, I (X-M) I C

Demand Side Policies (most countries today use monetary policy exclusively to control inflation) Monetary Policy a shift in interest rates (favored by monetarists) Fiscal Policy using government spending and taxes. (favored by Keynes) Exchange rate policy devaluing the currency to increase exports. (used by China) Effects of raising interest rates Gives incentive for saving thus reducing Consumer expenditure (C) Reduces demand for loans for consumer durables and new housing loans. (C) Homeowners and borrows with variable interest rate loans will have less disposable income and thus spend less. (C) Reduces demand for loans for business investment is reduced. (I) Puts upward pressure on the exchange rate reducing demand for exports (X) and increasing demand for imports (M).

Problems of high interest rates Reducing long term investment reduces long term growth of the LRAS. They are unpopular since the public does not like paying higher interest rates on credit cards and home loans. Export firms may not be able to compete against foreign competition if the exchange rate is high. The trade balance will go into deficit. There is a trade-off in macroeconomic goals. The government will have to pay back the higher interest on the government bonds for the next 20 years. Evaluation of monetary policy Inflation / Economic Growth tradeoff lower interest rates to stimulate the economy risks inflation, high interest rates to slow down inflation risks recession. Time lags 1 to 2 years for the full effects of the interest rate changes to work through the economy. If demand for loans is inelastic monetary policy will be less effective. Evidence shows that in the short run they often are. It is influenced by peoples expectations. (see handout on evaluation of monetary policy.) If the country is in deflation (ie Japan) you can only lower interest rates to 0%. After that other policies must be used.

conclusion - It is impossible to use monetary policiy as a precise means of controlling aggregate demand. It is especially weak when it is pulling against the expectations of consumers and business, an when it is implemented too late. However, if

the authorities operate a tight monetary policy firmly enough and long enough, they should be able to reduce lending and aggregate demand. But there will inevitably be time lags and imprecision in the process. Despite these problems changing interest rates can be quite effective. They can be changed quickly. The time lags are less than for using fiscal policy. Because interest rates are announced publicly it sends a clear message that inflation will be kept under control. Indeed, nowadays most governments and central banks use interest rates as their main strategy to keep AD and inflation under control.

Evaluation of Fiscal Policy Time lags it takes a long time for people to adjust their spending to the new tax rates. government spending often takes planning and it takes a long time for the multiplier effects to work through the economy. Crowding out to spend more the government reduces national savings and thus the supply of loanable funds, causing interest rates (the price of a loan) to rise. Businesses will then invest less, reducing the AD and long term potential growth. Fine Tuning it is very difficult to predict just how much the changes will affect the AD. A reduction in government spending will obviously affect those programs being reduced. Evaluation of Exchange Rate Policy It will only increase exports if the Marshall-Lerner condition is met (combined elasticities of X and M > 1) In the short run if it devalues by buying and selling its currency The government must devote resources to constantly monitoring and adjusting its currency value. The government must ensure that it has enough foreign reserves to maintain the policy. The government may leave itself open to speculator attacks. if it devalues by lowering interest rates then interest rates may not be able to be used for monetary policy. Factors that shift SRAS an increase in the cost of production (wage push, import price push, tax push) Change in wage costs / oil (wage-push) Change in producer taxes (VAT) (tax-push) Change in inflation expectations Higher cost of imported raw materials (import-price push) Factors that shift LRAS -- an increase in the quantity or productivity of the factors of production. Change in size of labor force (more women, elderly working ) Increase in human capital (better educated, healthy workforce) Change in size/quality of capital stock Technological progress / innovation Change in factor productivity of labor / capital Change in natural resources available Change in entrepreneurial skills / govt liberalization Examples of Supply Side Policies Economists agree that in the long run demand side policies will not be effective at increasing national income because the economy will adjust back to the LRAS. The only way to have true economic growth is through an increase of the PPF and LRAS.
Direct Intervention the government makes the changes themselves. Research and Development much R&D is financed directly by governments. New technology leads to new products and more productivity. ie: Nokia Assistance to small firms they may get tax breaks, reduced requirements, or even grants.

Training and Education increases the human resources of the country. Governments may give tax breaks for firms providing training, or fund the training institutions themselves, or give students financial help. Information the government can give technical advice to firms, it can share its own market research, or provide information on available jobs in the economy. Market Oriented gives incentives to individuals and firms. Reducing income taxes -- workers get to keep more of their pay; there is then incentive for people to work longer hours and for more people to work because the take-home wage rate is higher. The opportunity cost of not working is raised. Reducing business taxes - so that they have more money for investment on capital. Or the government can subtract investment from taxable profits for the firm. They can also reduce taxes for businesses research and development costs. Reduce unemployment benefits gives a big incentive for people to get back to work, increasing the labor force. The opportunity cost of not working is raised. Allow international investment foreign investment in domestic firms, both portfolio investment and Foreign Direct Investment (FDI). There used to be rules how much money foreigners could put into or take out of an economy, but most MDCs have gotten rid of them. Increase competition monopolies produce less than competitive markets. By privatizing government businesses and reducing barriers to entry. Also reducing protectionism against foreign firms selling in the country will increase competition. Even if an Indonesian firm is a monopoly in Indonesia, it may now have to compete with Japanese, Chinese, and Korean firms. This will also give it a big incentive to invest and increase productivity to match the international competition.

Costs of Economic Growth Demand Pull Inflation. Overheating -- Very rapid growth (10+ %) can lead to a situation where any increase in AD leads to an increase in price level only, but no additional increase in output. (vertical SRAS curve near the production possibility limit) Environmental trade-offs and Externalities rapid growth often leads to an increase in pollution and a decrease in environmental quality. Culture will also be affected.

Rising inequality

The functions of money medium of exchange store of value unit of account

Inflation erodes the functions of money

Causes of inflation demand pull cost push (wage push, import price push, tax push) quantity theory of money monetarists believe that in the long run all inflation is caused by an increase in the quantity of money. too much money chasing too few goods. who gets the limited goods is the one who pays more inflation. Problems with using price index to calculate inflation (like CPI consumer price index, GDP Deflator) <HL> Weights are for an average family % of income. But a very poor family maybe spends 70% of their income just on food so inflation in food will affect them drastically. Contents of the basket change and the weights must change. We dont use hula hoops anymore. Air travel has become much more important. Quality of the goods in the basket change. Substitution bias consumers switch to low cost substitutes when prices become very expensive. The costs of inflation.

Business Uncertainty Firms may be uncertain about their costs, and they may be unsure how consumers will react to inflation, and therefore they will be cautious and invest less. Loss of export competitiveness. If inflation is higher in our country than in other countries, our products will become relatively more expensive, and foreigners will buy less of them. Reduction of X in the AD. Interest Rates Rise Banks will not want to lose the value of their loans, and therefore will raise interest rates, which will slow down economic growth. The problems of a wage-price spiral price rises can lead to higher wage demands as workers try to maintain their real standard of living. Higher wages over and above any gains in labour productivity causes an increase in unit labour costs. To maintain their profit margins they increase prices. The process could start all over again and inflation may get out of control. When inflation is volatile it can result in an inefficient allocation of resources., consumers and firms are unlikely to have sufficient information on relative price levels to make informed choices about which products to supply and purchase. Menu Costs Firms will need to reprint all their menus and price lists which takes time and manpowerShoe Leather Costs Consumers will need to go out store to store comparing prices again to see what is still a good deal.

Anticipated and Unanticipated inflation: affects the outcome of economic decision making if anticipated,
changes in prices can be accommodated, if unanticipated can cause shocks and problems to arise losers of inflation
(Borrowers win because the value they pay back a currency with less value. Savers with money in the bank Lenders who loaned out money Those on fixed incomes ie pensioners Financially weak

Disinflation a slowdown in the rate of inflation (ie 10% to 5%) Deflation a sustained decrease in price levels (2% to -1%) deflation is quite rare. Japan in the 1990s. Benign Disinflation / Deflation -- caused by an increase in the LRAS there is economic growth and low unemployment. Malignant Disinflation / Delflation caused by a fall in AD and the kind that is feared, broadly based throughout the economy, long lasting, and a symptom of a weak economy stuck in recession. The costs of deflation When prices are falling consumers may tend to wait for the price to drop further to purchase items. This reduction in consumer spending reduces AD and worsens the deflation. Business profits decline resulting in higher business failures and bankruptcies. Output falls and Unemployment rises. The price mechanism is distorted. In deflation firms do not know if consumers are not purchasing because there is a lack of demand, or if they are merely waiting to purchase at a later date. Those in debt lose. Lenders win.. Those of fixed incomes increase their standard of living. A reduced national wealth means a lower standard of living for the citizens. Lower prices increases export competitiveness. Foreigners will buy more of our cheaper exports, increasing X. Deflation is very hard to cure. Monetary policy may be ineffective because interest rates can only be dropped to 0% The costs of unemployment Lost output. Economy will produce below its possibility curve. The hours lost can not be recovered. Firms lose the profits they could have made.

(Source: Tutor2u) Fiscal Costs to the Government The government must pay out more money in unemployment benefits. The government loses tax revenue it could have earned from working citizens. Not only do unemployed receive benefits but they pay no direct income taxes. Since the unemployed spend less they pay less in indirect taxes as well. Workers lose their skills (become deskilled.) This reduces the production potential. The Social Costs of Unemployment Personal: Lower standard of living. Poorer health. Lower life expectancy. Loss of self respect. Frustration, anger, depression. Social: There are links between unemployment rates and crime and divorce rates. IT SHOULD ALWAYS BE REMEMBERED THAT ECONOMICS IS ABOUT HUMAN BEINGS . Short term unemployment is not only not a very bad thing, because workers soon find work again, and often a better job, but it is a good sign that the labor markets are flexible and more responsive to the changing economy. A flexible workforce will lead to more allocative efficiency in the short run and more rapid economic growth in the longer run. Long term involuntary unemployment 6 months to years is a very bad thing for society. Most long term unemployed are out of work for structural reasons.

Causes of Unemployment Real Wage (Classical) Demand Deficient Cyclical -- Keynesian explanation Rise in supply of labor (especially in LDC with rising population, or in LDC where there is increase in education without enough economic growth to provide sufficient new jobs, or in MDC soon after university graduations. Equilibrium / Natural Unemployment Frictional, Seasonal, Structural Problems with measuring unemployment In countries that have no unemployment benefits there would be little incentive to register. In countries that have high benefits people may be registering who are not really looking for work. The government decides who is eligible for benefits. They can then exclude groups and reduce the statistical number unemployed. Some groups they may exclude: School leavers those just graduated and ready to work. Women reentering the job market after taking time off for child raising. People over 55. It is a stock concept. The number of unemployed changes every day.

Unemployment rate does not show distribution. The overall unemployment rate may be low in a country, but particular regions may have very high rates. Or it is often higher for women than men, or for certain ethnic groups. The under 25 and over-55 age groups also have higher rates of unemployment. Countries change how they count so that their unemployment records wont look too high. Disguised unemployment Underemployment

Unemployment in Less Developed Countries - LDCs often have a large labor force, and unemployment may be much worse than the statistics show because of Under employment Where people want to work full time but can only find a few hours work in a week. Disguised Unemployment The same output could be produced with fewer workers. In LDCs many people work on the
family farm or in family business. They are given a job because they are family, but actually they do not produce any extra output. For example, perhaps 5 family members work one field. But they could produce the same output with only 3 people. 2 people are then part of the disguised unemployment they have work but do not add to the national output.

Strategies for Reducing Unemployment Stimulate Economic Growth Demand Side Policies an increase in AD will lead to an increase in national output and thus and increase in ADLabor Supply Side Policies an increase in AS will also lead to an increase in national output. Reduce Market Imperfections Reduce unemployment benefits Reduce the minimum wage Give incentive to people to accept lower wages Lower income taxes. Increase labor flexibility making it easier to hire and fire workers, lower severance pay. Frictional Unemployment -- Create job information centers Structural / Seasonal Unemployment Provide training programs for labor by the government or community Give incentives (tax breaks / subsidies) to employers to invest in training workers facing redundancy. Give incentives to employers hiring older workers. Give incentives for firms to move into a region with high unemployment. Entrepreneurial / small business initiatives soft loans, r&d loans, tax breaks, reduced licenses for startup companies. Help export companies find contacts abroad. Give incentives for MNC / FDI to come into the country. Problems with using GDP as a measurement of national income to compare living standards must be GDP per capita should be adjusted to purchasing power parity may not measure the informal economy which may be a large percentage of the countries economy. gdp/capita is an average it hides the inequality in wealth. demerit goods like cigarettes may count more to the gdp than milk or bread. it does not value environmental quality only counts paid labor (not womens work at home or volunteer labor.) it cant be used to measure a traditional economy. you cant always trust national statistics. when comparing countries the exchange rate into US$ will make the GDP look better or worse. Different types of Efficiencies o Allocative Efficiency When a society uses its factors of production to produce the quantity of different products that leads to the highest utility. Supply=Demand or MC=Demand is allocatively efficient point. o Productive Efficiency Producing output with the least possible input. Producing where AC is at minimum.

o o

Social Efficiency Producing the goods that lead to the best outcome for society. = social demand (smb) = social supply (smc) Markets with externalities may be allocatively but not socially efficient. Dynamic Efficiency The ability of an economy to innovate.

Characteristics of Perfect Competition Products are homogenous (identical) Large number of producers Producers are Price Takers (price is set by market) There are no barriers to entry There is perfect information Firms will earn normal profits only in the long run Market will be allocatively efficient P=mc=demand/ar (over long run) Market will be productively efficient P=ACminimum (over long run) Explain why firms earn normal profits only in the long run Explain shut down price (P=AVC) Characteristics of Monopolistic Competition o Products are differentiated o Large number of independent producers o Producers have some pricing power = can raise price some and not lose all their sales = Demand slopes downward o Use non-price competition o Tends toward normal profits in the long run. o Low barriers to entry o Not efficient but consumers may prefer the product differentiation to complete effieiency. Characteristics of Monopoly o One firm dominates the market o Demand relatively inelastic o Usually earns supernormal profits. o High barriers to entry o May or may not have product differentiation. Disadvantages and Advanatages of a Monopoly / Collusive Oligopoly (see handout for explanation) o Monopolies charge higher (monopoly) prices. o Monopolies produce less than competition (not allocatively efficient = deadweight loss) o Monopolies profit maximizing are not productively efficient. o Monopolies have little incentive to innovate new products (dynamic efficiency) o Monopolies can abuse their monopoly power (ie Standard Oil, Microsoft) o Economies of Scale Monopolies with Economies of Scale can charge lower prices and produce more quantity than competition even when profit maximizing. o Natural Monopolies are not bad (where 2 competing firms would both make subnormal profit) o Monopolies do not always charge monopoly prices. (see next card) o Research and Development - Monopolies can use their supernormal profit for R&D o Consumers often like the standardization of a monopoly (ie Windows OS) Measures governments can take with monopolies o tax the supernormal profits o break up the company into competing parts (ie standard oil, AT&T) o reduce the barriers to entry. o nationalize the firm itself.

subsidize the product to lower prices and increase output.

Goals other than profit maximization (mr=mc) o Good citizen may choose to be good to their employees, community, environment, even though it eats into profits. o Sales Maximization (price low in order to gain high volume and increasing returns to scale = lower LRAC = long run profits) o Loss-Leading pricing (ie PSIII) o Revenue Maximization (produce where mr=0) o Satisficing (earning enough profit without worrying if you are maximizing exactly.) o Predatory Pricing (ie Standard Oil) o Contestable Market (Keep profits low enough not to attract competitors if market is contestable = barriers to entry and sunk costs are not high and exit costs are low. Characteristics of Oligopoly o A few firms dominate the market. = (high market concentration ratio.) 2 firms = duopoly. o High barriers to entry o Firms are inter-dependent. Prices set using game theory. o Prices are usually stable. = kinked demand theory. But there can sometimes be price wars. o Heavy non price competition. o Product differentiation. o Incentive to collude and use price fixing, but this is usually illegal. Can use tacit agreements. Forms of non price competion. o Advertising (increases market demand and makes firms demand more inelastic) o Quality, Service, Location, After-Sales Care, Appearance/Cleanliness, Frequent flyer miles, etc. 3 Conditions necessary for Price-Discrimination (p127 Oxford) o Producer must have some price setting abilitiy (=not perfect competition) o There must be at least 2 groups with different elasticities of demand (ie business travelers / holiday) o The producer must be able to separate the different consumers Producers can separate the market for price discrimination by: o time (ie buy tickets 3 months in advance lower price, buy one week in advance more expensive) o age (students / elderly / children) o gender o location (AIDS drugs are now much cheaper in Africa than U.S., but are not for resale) o Income (lawyers may give discounts or universities financial aid to those who have a hard time paying high price) o Self-discrimination offer first class or super peppermint vente that costs the firm little more but can charge those for whom price is not an issue (ped inelastic) double the price.

Note on Pareto Efficiency and Income Inequality (wikipedia) Pareto efficiency = where one can not be made better off without someone else being made worse off. Pareto efficiency does not require an equitable distribution of wealth. An economy in which the wealthy hold the vast majority of resources can be pareto efficient. Amartya Sen has elaboragted this criticism, noting that markets will often lead to pareto efficiency but not equitable distribution. A simple example is the distribution of a pie among three people. The most equitable distribution

would assign one third to each person. However giving two people half and the third person none is also pareto efficient, since the third person can not be made better off without taking pie away from the first two.

The arguments for free trade globalization (the interlinking of countries economically, but also culturally and politically) cheaper products, for consumers more choice for consumers more quantity for consumers. Can consume beyond their Production Possibility Frontier. increased competition increased efficiency for domestic firms. =cheaper, better quality domestic products. possibility of gaining economies of scale by entering world market for domestic firms. = lower LRAC =cheaper products. increased standard of living (quantity and quality of goods and services available) cheaper raw materials / factors of production for firms lower costs lower prices / lower inflation increased exports by firms = AD growth = economic growth = more jobs / lower unemployment World Bank in 2001 reported that those countries that were more globalized had much higher gdp growth. (see also related arguments for MNC / FDI) peace. countries that trade together rarely go to war against each other. Arguments for protection / anti-globalization (see handout) hurts domestic producers causes structural unemployment difficult to help those workers (see unemployment strategies) doesnt give infant industries a chance dependency / vulnerability (if all your food / fuel is imported what if trade breaks down?) loss of bargaining power for domestic workers (firms outsource or move abroad rather than pay higher wages.) many ldcs have difficulty collecting income taxes, need the tariff revenues which are easier to collect. possible abuse of labor (mnc using child labor) possible environmental damage from moving to or buying from countries that do not have strict environmental laws. loss of culture if flooded with western products and advertising. everyone agrees that dumping (selling below cost of production, usually through subsidies) is harmful for competition. Who gains / loses when a country imposes protectionism local producers gain. tariff / quota domestic consumers lose through higher prices and reduced quantity. subsidy domestic taxpayers lose tariff government gains tax revenue which can be spent for domestic programs. quota other countries (ie Bangladesh textiles) may benefit because chinas output is restricted by the quota. subsidy cotton and sugar producing LDCs are hurt by US and EU subsidies. subsidy non cotton / sugar producing nations benefit from cheap subsidized goods payed by US / EU taxpayers. Types of Free Trade blocs (see book for explanation Oxford p268) Preferential Trading Area Free Trade Area (ie NAFTA) Customs Union

Common Market (ie EU) Currency Union (ie Eurozone) Factors affecting floating exchange rate (Glanville 441-444) A change in Incomes A change in relative prices A change in relative investment prospects A change in relative interest rates Speculation Use of Foreign Reserves How does a change in the exchange rate influence the economy? Changes in the exchange rate can have a powerful effect on the macro-economy affecting variables such as the demand for exports and imports; real GDP growth, inflation and unemployment but as with most variables in economics, there are time lags involved. The scale of any change in the exchange rate. Whether the change in the currency is short term or long term. How businesses and consumers respond to exchange rate fluctuations the concept of price elasticity of demand is important here. Advantages of an appreciation in the currency Cheaper imports for consumers: A strong currency leads to lower import prices this boosts the real living standards of consumers at least in the short run for example an increase in the real purchasing power of consumers when travelling overseas or the chance to buy cheaper computers or motor vehicles from abroad. Lower costs for producers: When the exchange rate is high, it is cheaper to import raw materials, component parts and capital inputs such as plant and equipment this is good news for businesses that rely on imported components or who are wishing to increase their investment of new technology from overseas countries. A fall in import prices has the effect of causing an outward shift in the short run aggregate supply curve. And if a country can now import more productive technology, the LRAS curve may shift out. Lower inflation: A strong exchange rate helps to control the rate inflation because domestic suppliers now face more international competition from cheaper imports and will look to cut their costs and prices accordingly in order not to suffer from a loss of international competitiveness. Cheaper prices of imported foodstuffs and beverages will also have a negative effect on the rate of consumer price inflation. If inflation is lower, then interest rates will be lower will eventually stimulate higher consumer spending and capital investment in the circular flow Disadvantages of a Strong currency Loss of demand for exports as export prices become more expensive. Unemployment may result in the export sector of the economy, especially those exports where demand is highly price elastic, such as the tourism sector. Also, there will be increased unemployment in the economy in general due to slower economic growth. Slower economic growth: If exports fall and imports rise this causes a reduction in aggregate demand (X-M) and reduces the short-term rate economic. Some regions of the economy are affected by this more than others. If exports fall, then so will business confidence and capital investment (I) because investment is partly dependent on the strength of demand. Increase in the trade deficit: The lower price of imports leads to consumers increasing their demand and this can cause a large trade deficit. Exporters lose price competitiveness because they will find it more expensive to sell in foreign markets and face losing market share this can damage profits and employment in some sectors and industries. Business response to the challenge of a high exchange rate: Businesses can and do adapt to a high exchange rate. There are several ways in which industries can adjust to the competitive pressures that a strong currency imposes. Some of the options include: Cutting their export prices when selling in overseas markets and therefore accepting lower profit margins to maintain competitiveness and market share

Out-sourcing components from overseas to keep production costs down Seeking productivity / efficiency gains to keep unit labour costs under control or perhaps trying to negotiate a reduction in pay levels Investing extra resources in new product lines where demand is price inelastic and less sensitive to exchange rate fluctuations. This involves producing products with a higher income elasticity of demand, where nonprice factors such as product quality, design and effective marketing are as important in securing orders as the actual price

The Case for Fixed Exchange Rates The main arguments for adopting a fixed exchange rate system are as follows: Trade and Investment: Currency stability can help to promote trade and investment because of lower currency risk this is one of the reasons why currencies were locked within the Euro Zone in preparation for the launch of the Euro. Disciplines on domestic producers: Since the exporters can not rely on a lower exchange rate to help them sell more, they must keep their costs and prices down and raise labour productivity and focus more resources on research and innovation Reductions in the costs of currency hedging for firms: Because we can never predict what will happen to the market value of a currency, many businesses hedge against this volatility by buying the currency they need in the forward currency markets. With fixed exchange rates, businesses have to spend less on currency hedging if they know that the currency will hold its value in the foreign exchange markets (hedging involves risk)

The Case for floating exchange rates: The main arguments for adopting a floating exchange rate system are: 1. Reduced need for currency reserves: There is no exchange rate target so there is little requirement for the central bank 2. 3. 4. 5.
(e.g. the Bank of England) to hold large scale reserves of gold and foreign currency to use in possible official intervention in the markets Reduced risk of currency speculation: The absence of an explicit exchange rate target reduces the risk of currency speculation. Often, currency market speculators target an exchange rate target that they believe to be fundamentally over or undervalued. Freedom for domestic monetary policy: The absence of an exchange rate target allows short term interest rates to be set to meet domestic macroeconomic objectives such as stabilising growth or controlling inflation. The Bank of England has enjoyed the autonomy that a floating exchange rate gives since it was made independent in May 1997. Floating exchange rates are not always volatile exchange rates - although the sterling exchange rate has been floating, the volatility has not been that great. Businesses have learnt to cope with modest fluctuations helped by having a flexible labour market. Partial automatic correction for a trade deficit: Floating exchange rates offer a degree of adjustment when the balance of payments is in fundamental disequilibrium i.e. a large trade deficit puts downward pressure on the exchange rate which should help the export sector and control demand for imports because they become relatively expensive

Evaluation points for currency appreciation / depreciation 1. 2. 3. Time lags: The macroeconomic effects of currency shifts take time to happen! Currency hedging: Many large companies hedge their currency exposure to protect themselves against volatile currencies so some of the effects of the rising exchange rate might be delayed for a while Growth in other countries: Only 15% of UK trade is with the USA other parts of the world economy are more important including Europe and much depends on what is happening to the Euro exchange rate and also to economic growth in these countries

4. 5. 6.

Responding to the challenge: Businesses can take steps to overcome the effects of a rising currency e.g. by cutting costs / increasing productivity / investing in research/better products whose demand is less sensitive to the effects of currency gyrations Some industries negatively affected by the strong pound more than others: For example the aerospace and pharmaceutical industries whose sales are strongly focused on North America. Much depends on a. b. How long the pound remains this strong against the US dollar it might rise even further! How businesses (especially exporters) respond to the challenges of a less competitive exchange rate in particular the price elasticity of demand for UK exports overseas

Purchasing Power Parity theory states that goods and services should be priced the same in different countries when measured in a common currency and in the long run exchange rates will adjust to reflect this. ie: if a Big Mac costs more in London (in US$) than the U.S. the pound should in the long run depreciate until the prices are equal. Whats included in the current account The current account is a record of the trade of goods and services as well as income earned abroad and net transfers. 1. Trade in Goods / Visibles / Trade Balance = value of exports imports (x-m) export more than import = trade surples import more than export = trade deficit 2. Trade in Services -- tourism, banking services, education, medical, etc 3. Income earned abroad a. interest payments on investment overseas b. workers overseas repatriate their money. (essentially we have sold our labor) 4. Transfer payments a. aid b. workers overseas send money home (remittances) c. dues to UN, IMF, etc Whats included in the capital account? The capital account is a record of investment (purchase of assets) 1. 2. 3. 4. Foreign Direct Investment Portfolio Investment Other Investment (exchanges on currency market, etc.) Official Reserves (higher in countries with fixed exchange rates)

Describe three possible economic consequences of a persistent current account deficit for a country. [May 2005] cost of financing a deficit -- must keep a capital account surplus and pay investment back with interest depletion of foreign exchange reserves reduced AD and economic growth depreciation of the exchange rate if exports are not demanded as an indicator of underlying lack of business competitiveness on government policy e.g. increased protectionism problems of import penetration e.g. unemployment Evaluate methods a government reduce a current account deficit (see handout) devalue exchange rate (but marshall lerner condition must be met, and may be a j curve in short run) protectionism slow down economy to reduce import consumption

promote exports through subsidies, government help nationalistic campaign supply side policies to increase competitiveness. Factors that can cause a change in TT, significance for LDCs

Terms of Trade Oxford p303

Characteristics of a market economy Price and quantity set by supply and demand Private ownership of factors of production businesses started by entrepreneurs. Price Mechanism if consumers are willing to pay higher prices it signals to producers to produce more, if there is limited supply higher prices ration who will get the goods. Entrepreneurs motivated by profit. Market will be allocatively and productively efficient Competition should lead to better quality goods (dynamic efficiency) Market may not produce the best outcome for society if there is market failures. (necessity for govt intervention.) Factors that affect demand advertisement trend fashion change in price of substitute goods change in price of complimentary goods change in income

increase / decrease in population change in expectations season

Factors shift the supply curve change in the price of producer substitutes change in the cost of production change in the availability of the resource change in technology lower costs indirect taxes / subsidy Determinants of price elasticity of demand 1. The degree of necessity. 2. The number and closeness of substitute goods the more substitutes the more elastic. 3. The proportion of income spent on the goods the larger the % the more elastic. 4. The time period the longer the time period the more elastic. 5. Advertising 6. Addiction Determinants of price elasticity of supply 1. How much it costs to increase supply the less it costs the more elastic the supply. 2. How much spare capacity they have more spare capacity the more elastic. 3. The time period short run more inelastic long run more elastic Why do we want to know Elasticities? Business wants to know the Price Elasticities of Demand because it directly affects their revenue. If PED is inelastic they should raise prices to increase revenue. If PED is elastic they should lower prices to increase revenue. Business also wants to know if advertising will make their product more price inelastic. Business should realize that goods which are very price elastic for demand or price elastic for supply will have high swings in price. For example hotel rooms, or commodities like coffee. Business also want to know the Income Elasticities. As income in Indonesia rises they want to know which goods are normal goods for which demand will increase. For example health care and tourism are very income elastic. Business also want to know how their products will be affected by changes in the price of their substitute and compliment goods, and their cross elasticities. Governments also want to know the effects of imposing a tax or giving a subsidy. How much money will the government earn How much money will the subsidy cost Who will pay the tax consumers or producers Who will benefit consumers or producer How will it affect quantity. How will it affect quantity. Evaluation of giving subsidies Subsidies can become expensive and there is an opportunity cost. Subsidies distort market prices this can lead to a misallocation of resources deadweight loss Subsidies can protect and keep inefficient or uncompetitive firms in business, and may delay much needed restructuring Decisions about which groups or industries receive a subsidy can be political Strategies to deal with shortages (when quantity demanded is greater than quantity supplied = price is below equilibrium. Queue / First come first served

Ration Lottery Prioritize Subsidize Government direct provision Reduce Demand

Strategies to deal with surplus (when quantity supplied is greater than quantity demanded = price is above equilibrium. Store the surplus. Sell the surplus at low rates to the rest of the world (dumping). Destroy the surplus. Set Asides. Solutions a government has for demerit goods Government Regulation Ban / Limit safe, but crude. Black markets frequent. ie cocaine. Nationalization - The government takes over the industry. The Government is not a profit maximiser but a maximiser of public utility. Move the victims. Market based Advertising change demand ie cigarettes ban positive, promote health awareness. Subsidize a safer substitute good -- hybrid engines Pigouvian taxes (A.C. Pigou Cambridge) tax reduces quantity supplied closer to social optimum -- but the good is not the problem i. externality must be valued correctly ii. if its inelastic the consumer will end up paying the tax iii. could cause cost push (tax push) inflation Tax the externality much sharper ie tax on pollution emitted gives incentive to firms to switch to cleaner technologies. In London a tax on traffic in city center reduced congestion by 30%. Further market based Tradeable Permits - Cap and Trade Name and Shame Extend Property Rights Coase Theorem

HDI measures Health Adult Life Expectancy at birth

Education Adult Literacy and average number of years of schooling Wealth GDP per capita adjusted to purchasing power parity.

Barriers to development - better to know a few in depth than memorize the whole list bad government war poverty trap health trap education trap debt trap lack of infrastructure corruption natural disasters protectionism by other countries capital flight lack of property rights rapid population growth Benefits to education according to Amartya Sen 1. people like to be educated because life is richer. 2. with education people have the capability to get good jobs and other things that they value. 3. educated people can benefit their whole community. 4. women and other groups are empowered to resist exploitation and stand up for themselves. Strategies for development Debt Relief Reduce Protectionism against LDC ODA Overseas Direct Assistance / Foreign Aid Microcredit Anti-Malarial Bednets Providing access to safe water School Lunch Programs Providing Fertilizer and Seeds Conditional Cash Payment Program (Mexico, Indonesia) Community Empowerment Appropriate Technology Corruption Eradication Commission.

Aid givers: o Bilateral o Multilateral o NGO Types of Aid o loans o grants (money given without needing to be returned) o food aid o equipment o medicine o emergency relief

o o

foreign consultants tied aid (must be used to buy things from the country giving the aid)

Problems of giving aid o Can destroy the local market and create dependency o Conditionality a country must follow certain terms to get the aid. o Corruption o Often not distributed well. o Usually doesnt reach the poorest of the poor. o May not take the peoples desires into account the aid worker knows better o Often give bad advice. o Giving equipment that might put poor labor out of work may be anti-developmental. o Technology given can be inappropriate. o Loans may create a debt trap. o It is very hard to measure if it has been effective. o ** $650 billion has been given to Africa and it is not clear that it has helped at all. Problems Corruption causes in society. o No justice. o People are hurt.. o Loss of FDI MNC dont want to invest in a corrupt environment. o Not allocatively efficient. Deadweight loss to society. Evaluation of Microcredit o One of the only strategies agreed to have been effective. Winner of Nobel Peace Prize. o Helps families break the poverty trap. o It is a long run solution since the family can raise their overall standard of living. o It maintains dignity and does not treat recipients as charity cases. o Raises the status of women since women are given most of the loans and starting the businesses. o It has an opportunity cost to the aid agencies giving. o Microcredit today is beginning to be given by profit firms at high interest rates. o Microcredit in places (India) has become very competitive, different groups competing for funds. The women can be forgotten in the competition. o There should be some guidance on how to set up a business so that it wont fail. Evaluation of trade as a development strategy. If protectionist barriers were taken down and countries could trade they could take earn twice as much as they are being given aid, without being treated as a poor country, and without creating dependency. Those working in new export jobs may earn more money that can break them out of the poverty trap. The country can earn export earnings which can be invested in progress and start economic growth going. However there is no guarantee that export earnings would translate into development. Increased trade would do little to lift most of the poor out of poverty trap or provide better health care. Evaluation of Conditional Cash Transfer o Targets families in the poverty, education, and health traps. o Long term solution targeting the next generation. o Better chance to reach the poorest of the poor.

o o o

There is an opportunity cost. It needs to be consistent. To be effective it can not be started one year and then stopped the next. If the money is given in cities but not kampungs it could lead to unwanted urban migration.

Problem of being in debt. A loan that is used for investment and helps the countrys economic growth can be beneficial. If they are caught in a debt trap though much of the nations income goes to servicing (paying interest) on the debt and not to health and education and other development programs. At times up to half the nations income spent on the interest alone. There is no money left to invest, thus the poor countries remain trapped. The IMF conditions required governments to spend less which meant less education and health and development. Countries in debt often have a hard time getting more loans. In order to gain cash the country may sacrifice its environment and sell off its forests. Different sources of funds that LDCs can use for economic growth and development o Tax reforms (ie Indonesia has increased the amount of taxes it is collecting.) o Increased savings o Loans o Foreign Aid / ODA o Export promotion o FDI Evaluation of FDI / MNC for economic growth and development o It is an injection into the circular flow o It has a multiplier effect o Profits can leak out of the country back to the MNC. o It can create more jobs. o It can put domestic firms out of business. o It can bring in new technology in the country. o It can bring in inappropriate technology that puts people out of work. o It can lead to greater efficiency in the country. o It can change culture. o It can take advantage of cheap labor and weak environment laws o It often gives higher wages, better working conditions, and cleaner environment than domestic firms. o It usually creates economic growth in the cities, but rarely in the kampungs or rural areas. o It can be pulled out suddenly if there are political or economic crisis making situations worse. o Indonesia is desperate to attract more FDI.