UK Economy in A Global Context

The UK Economy in a global context
Globalisatio n FD I Liberalisatio n Protectionis m Integratio n WT O Competitivenes s Exchange rates Balance of payments Development indicators Development theories Poverty and inequality Constraints to development Development strategies Policy objectives and policies Global shocks Inflatio n Unemploymen t Monetary policy Fiscal policy Supply side policy
Economi cs Online
Economics Online 2011
Economi cs Online
Globalisation
Globalisation
Economi cs Online
Globalisation is the integration of markets in the world economy. Markets where globalisation is particularly common include: 1. Financial markets, including capital, money and insurance markets. 2. Commodity markets, such as markets for oil and coffee. 3. Product markets, such as markets for motor vehicles and consumer electronics.
Globalisation
Factors leading to globalisation
Economi cs Online
1. Developments in transport and communications for example, the internet has enabled fast and 24/7 global communication. 2. Common technology - global firms use common IT systems helping to integrate their global operations. 3. Capital mobility - when capital can move freely from country to country, it is easier for firms to locate and invest abroad, and repatriate profits. 4. Free and open trade the relative success of the World Trade Organisation (WTO), and the collapse of communism.
Over the last 30 years, trade openness, which is defined as the ratio of exports and imports to national income, has risen from 25% to around 40% for industrialised economies, and from 15% Economics Online 2011 to 60% for emerging economies. (Source: The Bank of
Globalisation
The benefits of globalisation for firms
Economi cs Online
1. Access to larger markets so that firms can benefit from increased demand, and economies of scale. 2. Worldwide access to the cheapest sources of raw materials, which make firms more cost competitive. 3. Increased profit for shareholders of MNCs. 4. Avoidance of regulation by locating production in countries with softer regulatory regimes, such as those in some developing economies.
Economi cs Online
Benefits to countries: countries

1. If trade is free, then countries can benefit from the application of the principle of comparative advantage. 2. New trade can be created, a process called trade creation. 3. Benefits of inward investment to recipient countries, such as sharing knowledge between firms in different countries. 4. The macro-economic benefits of increased investment. 5. Job creation in the more competitive countries.
The costs of globalisation
Economi cs Online
1. The over-standardisation of products through global branding, such as Microsofts Windows, leading to a lack of product diversity. 2. Diseconomies of scale for large firms, such as difficulties co-ordinating the activities of firms that operate in many countries. 3. Increased power and influence MNCs - MNCs can move their investments between territories MNCs can be local monopsonies of labour, and push wages lower than the free market equilibrium. 4. Loss of jobs in domestic markets because of increased, and in some cases unfair free trade. 5. Loss of jobs caused through structural unemployment, causing a widening gap between rich and poor within a particular country. 6.
The costs of globalisation
Economi cs Online
6. Increased risks associated with interdependence of economies:

a. Because countries are increasingly dependent on each other, a negative shock in one country can quickly spread to other countries e.g. the recent credit crunch. b. Over-specialisation - countries can become overreliant on producing a limited range of goods for the global market. Many LDCs suffer by over-specialising in a limited range of products, such as agriculture and tourism.
8. Possible increased inequality as richer nations benefit relative to poorer nations, as suggested in the Kuznets Curve. 9. Increased trade associated with globalisation has increased pollution and helped contribute to CO2 emissions and global warming. It has also accelerated Economics Online 2011 the depletion of non-renewable energy resources, such as oil.
Inequality and development

The Kuznets curve
Globalisation may widen the gap between rich and poor countries. The greatest inequality can be observed as countries 'take-off' in their developme nt, leading to considerabl
I e q u a l ty i cre a se s i th e e a rl sta g e s o f n i n n y d e ve l p m e n t o
Economi cs Online
I e q u a l ty n i
K u zn e ts C u rve
D e ve l p m e n t o
Economi cs Online
Foreign direct investment (FDI)
Foreign direct investment (FDI)
Economi cs Online
FDI is the flow of real capital between countries, and is undertaken by private sector firms and by governments. A large proportion of FDI is associated with crossborder mergers between private firms.
The benefits to firms of investing abroad

1. Reduction in transport costs - locating within a foreign market reduces transport costs to that market, especially for bulk increasing products. 2. Access to the countrys markets. 3. Access to cheap labour and to skilled labour. 4. Access to local knowledge and expertise. 5. Exploitation of economies of scope, especially managerial economies, where fixed management costs can be spread between territories. Economics Online 2011 6. Avoidance of barriers to trade, such as tariffs and
Investment income
Economi cs Online
7. Increased investment income - outward investment can lead to increased overseas investment income for a country, such as:
1. Profits from overseas subsidiaries. 2. Dividends from owning shares in overseas firms. 3. Interest payments from lending abroad.
FDI in the balance of payments accounts
The initial outflow is a debit on the capital account, and the investment income is entered as a credit on the current account.
6.
Inward investment
Economi cs Online
1.
2. 3.
4. 5. 6.
Countries receiving inward investment gain through: An increase in GDP, initially through the FDI itself, followed by a positive multiplier effect on the receiving economy. The creation of jobs. An increase in productive capacity this can be illustrated by a shift to the right in the Aggregate Supply (AS) or the Production Possibility Frontier (PPF). Producers have access to the latest technology from abroad. Less need to import because goods are produced in the domestic economy. The positive effect on the countrys capital account. FDI represents an inflow, or credit, on the capital Economics Online 2011
Economi cs Online
Who invests?
The USA, France and the UK are the three most important international investors, and recipients of investment.
Economi cs Online
Share of EU inward investment

EU inward investment
The UK receives 22% of all inward investment into the EU

(2003).
There are over 18,000 different investors into the UK, with 1.8m people are directly supported
Source HSBC, 2005

Economi cs Online
Volatility
During the global recession, FDI fell as liquidity tightened and confidence took a severe hit. Some argue that this may trigger a period of deglobalisation.
R EC ESSI ON
Why is FDI volatile?
Economi cs Online
1. 2. 3. 4. 5. 6. 7. 8. 9.
FDI is highly volatile - possible causes are: Fluctuations in exchange rates. Fluctuations in interest rates and other monetary policy. Changes in the trade cycle growth in an economy may encourage FDI, but recession will deter it. Expectations about the future. Changes in business regulation tighter or looser. Changes in the level of business taxes. Relative wage rates and changes in the minimum wage. Inducements and incentives by host countries. Changes of government and political stability.
Short questions
Economi cs Online
1. Analyse the likely effects on a developing country of your choice of a fall in inward FDI (at least four points). 2. Why is FDI volatile?
Economi cs Online
Trade liberalisation and protection
Liberalisation and protectionism
Economi cs Online
Two opposing forces have shaped the changing pattern of world trade over the last 200 years. 1. Trade liberalisation - this is the process of making trade free of barrierssuch as tariffs and quotas. 2. Protectionism - protectionism is the process of erecting barriers to trade.
Protectionism may be on the increase as a result of the global economic crisis and recession.
International specialisation
The fundamental principals of free trade
Economic production in market economies is based on two fundamental principles, first analysed by Adam Smith in the late 18th Century. These are: 1.The division of labour, where production is broken down into small, interconnected tasks. 2.Specialisation, where factors of production are given unique jobs, can be applied to individuals, firms and countries.
Specialisation is the basis of free trade

1. Countries trade because they do not have all the goods, services and resources they need, and buy imports. 2. To pay for these imports countries must export goods, services and resources that other countries need. 3. Countries can become increasingly specialist in producing particular goods, services and resources, and this makes them more efficient over time. 4. Efficiency reduces costs and gives the country a cost advantage, which makes it more competitive.
Comparative advantage
It can be argued that world output will increase when the principle of comparative advantage is applied by countries to determine what goods and services they should specialise in producing. Comparative advantage is a term associated with 19th Century English economist David Ricardo. Ricardo argued that countries should specialise in producing goods for which they have a comparative advantage. Absolute advantage means being more productive and competitive than another country comparative advantage concerns how much better is one country than another.
Comparative advantage
Consider the simple example of two countries producing only two goods: Using all its resources, Cars Country A can produce 10m cars or 5m vans, and Vans Country B can produce 20m cars or 7.5m vans. Should they trade? Economic theory suggests that Economics Online 2011 they should
Country A
Country B
10m
20m
5m
7 . 5m
Using PPFs to show advantage

Production possibility frontiers can be used to illustrate cost advantage. Country Bs PPF is further outward and indicates it has an absolute advantage in both goods. But it has a comparative advantage in cars because it can produce twice as many,
Cars
Comparative Absolute advantage
Twice as productive
Co
un
tr
Cou
ntr
y A
Vans Only 50% more productive
Numerical example
If countries do not specialise, and allocate resources evenly to both goods, world output is:
Cars = 10 + 5 = 15 Vans = 3.75 + 2.5 = 6.25 = 21.25 million units
Cars
20
15
Co
un
tr
10
Co
5
un
tr
2.5
Vans
0 1.0 2.5 3.75 5 7.5
If countries specialise and employ the
Opportunity cost ratios

We saw earlier that the gradient of a PPF reflects the opportunity cost of increasing production of one good in relation to another - the lost output of X as a result of increasing output of Y. If two countries PPFs, in terms of two goods, have different gradients then they must have different opportunity costs. Only when the gradients are different will one country have a comparative advantage, and only then will trade be beneficial.
The benefits and costs of free trade

The benefits
1. Applying the principle of comparative advantage means producing in higher volumes for the export market as well as the domestic market, which leads to the benefit of economies of scale. 2. Increased competition and lower world prices. 3. Welfare gains (including increased consumer surplus). 4. Trade creation. 5. The breakdown of domestic monopolies. 6. Increased quality of goods and services. 7. More employment as (efficient) domestic firms can sell to the global market and jobs are created.
8.
The costs
1. Over-specialisation - workers risk losing their jobs when world demand changes (structural unemployment). 2. Exhaustion of non-renewables. 3. Industries can be destroyed, including: 1.Infant industries 2.Declining industries 3.Inefficient industries 4.Strategic industries 8. Welfare loss associated with loss of trade for domestic producers (loss of producer surplus).
Motives for protection

Why engage in protection?
Economi cs Online
1.
2. 3. 4. 5. 6.
Despite the arguments in favour of free trade protectionism is still widely practiced. The main arguments for protection are: To protect sunrise industries - also known as infant industries, such as those involving new technologies. To protect sunset industries - also known as declining industries, such as steel production. To protect strategic industries - such as energy, water, steel, and armaments. To protect a resource which is non-renewable, as in the case of oil. To deter unfair competition such as to protect from dumping at prices below cost. To save jobs. Economics Online 2011
Motives for protection
Economi cs Online
7. Some countries may protect themselves from trade to help save their environment -such as from CO2 emissions caused by increased freight transport. 8. Most economists argue that there are dangers in over-specialisation. The recent global crisis has led to more nationalism, and raised concerns about free trade and globalisation. 9. The theory of comparative advantage is too unrealistic to apply to the real world, and fails to take into account:
Transport costs Exchange rates Imperfect competition Imperfect knowledge
Methods of protection
Economi cs Online
There are two types of protection: 1. Tariffs - tariffs are taxes, or duties, on imported goods designed to raise the price to the level of, or above the existing domestic price. 2. Non-tariff barriers which include all other barriers, such as:
a. Quotas- which are physical limits on the volume of imports. b. Public procurement policies where national governments favour local firms, such as where a countrys police or ambulance service purchase only locally produced vehicles. c. General subsidies to domestic firms, which can be used to help reduce price and deter imports this financial support can also be in the form of an export subsidy, making it easier for firms to export. safety such as banning imports of d. Health andEconomics Online 2011
Quotas
limit on imports. The no-trade price and quantity are P and Q. The free trade price and quantity are P1 and Q1. A quota of Q2 Q limits imports and allows domestic firms to
The A quota is a quota is to shift the domestic supply curve to the right, by effect of the Price physical quota
Domestic supply Domestic supply + quota
P Pq P1
Domesti c Domest supply ic supply
QUOTA QUOTA Imports

Q Q4 Q1
Dome stic supp ly
World supply Domestic Demand
Q2
Quantity
Tariffs
Economi cs Online
Tariffs are taxes on imported products, usually in an ad valorem form. They are also called customs duties.
The impact of tariffs

1. Domestic consumers face higher prices and lower consumer surplus. 2. Domestic producers receive higher prices and higher producer surplus but there is likely to be an overall net welfare loss, which can be seen later. 3. There is a distortion of the principle of comparative advantage. 4. There is the likelihood of retaliation from exporting countries, which could trigger a costly trade war. 5. However, in the short run tariffs may protect jobs, Economics Online 2011 infant and declining industries, and strategic
The Tariff diagram
Without trade, y more than producer surplus increases - even adding in tariff revenue there is still a net Price Y. domestic price
and quantity are P and Q. If an economy opens up to world supply, price falls to P1, Q increases to Q2 - domestic producers share falls to Q1! The imposition of a tariff causes price to rise, imports to fall, domestic producers
Domestic Supply
Consumer Surplus P P2 P1
Domestic Domestic supply supply
Producer Surplus
World Supply + Tariff
Tariff Revenue
World Supply
Imports
Q4 Q Q3 Q2
Domestic Demand
Q1
Quantity
Costs and benefits of trading blocs

The main benefits for members of blocs:
Economi cs Online
1. Members can specialise, knowing that they have free access to others members markets. This means there is a more complete application of the principle of comparative advantage. 2. Easier access to each others markets means that trade between members is likely to increase trade creation. 3. Producers can benefit from the application of scale economies, which will lead to lower costs and lower prices for consumers. 4. Jobs may be created in member economies. 5. Protection from countries outside the bloc 6. Firms inside the bloc can be protected from cheaper imports from outside. Economics Online 2011 7.
Trade creation
With a tariff, domestic price and quantity are P1 and Q1. Domestic market share is 0 Q4, and imports are Q4 Q1. If an economy joins a customs union it must eliminate tariffs. This increases imports, from
Price
Domestic Supply
P P1 P2
Domestic supply
X Domestic supply
Q3 Q4
Y Imports
Q Q1
World Supply + Tariff World Supply World Supply
Domestic Demand Q2
Quantity
Costs and benefits of trading blocs

Trading blocs can generate the following costs: costs
1. Loss of benefits of free trade
Economi cs Online
World trade is distorted, and comparative advantage cannot be fully exploited at the global level. The development of one regional trading bloc is likely to stimulate the development of others, which can lead to trade disputes, such as those between the EU and NAFTA, including the long running EU/US steel dispute, banana wars, and the Boeing (US)/Airbus (EU) dispute.
2. Retaliation and trade disputes
5. Inefficiencies and trade diversion

Inefficient producers inside the bloc can be protected from more efficient ones outside the bloc. Trade is diverted from efficient global producers. Economics Online 2011
Economi cs Online
Economic integration
Stages in economic integration
Economi cs Online
A Full economica single currency , central bank, and common monet common market, policies integration
Members share a single currency , central bank, and have a common Monetary policy Union ( MU )
Integration
Members eliminate tariffs on all resources , allowing free movement of labour and ca Common market policies Members eliminate tariffsMMembersrsgoodsn a tetariffs o n some have a common exter onm m ffs Pre fe single Customs n tiel all eliminate ta ri on all Free a re Unionb e e li i and services , and trade area a goods members market
( CUa tra dFTA))re a e ( PTA )
Regional trading blocs (RTBs)

A trading bloc is a group of countries that protect themselves from imports from non-members. There are several types: 1. Preferential Trade Area (PTA)
Economi cs Online
Members eliminated tariffs on some goods
2. Free Trade Areas (FTAs)

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

Regional trading blocs (RTBs)

3. Customs Unions
Economi cs Online
These also aim to reduce or eliminate tariffs between members But they do have a common external tariff - a common external tariff means that members must set the same level of tariff against a nonmember
5. Common Market
M e m b e rs e l m i a te ta ri o n a l re so u rce s, i n ffs l a l o w i g fre e m o ve m e n t o f l b o u r a n d ca p i l l n a ta , a n d co m m o n m i -e co n o m i p o l ci s cro c i e
6.
The European Union (EU)

Austria Germany Greece Ireland Italy Latvia Lithuania
Economi cs Online
Norway Poland Portugal Romania Spain Slovenia
The EU - originally called Common Market was formed in 1957, following the Treaty of Rome. The EU has evolved through stages of integration. The aim was to create one market for all products, capital and labour, by eliminating trade barriers. By 2007, following continuous enlargement the EU had 27 members.
Belgium Bulgaria Cyprus Czech Republic Denmark Estonia Finland France
Luxembourg Slovakia Malta Sweden
Netherlands UK
The Common Agricultural Policy (CAP)

Economi cs Online
The EU protects its farmers and growers through its Common Agricultural Policy (CAP). Through the CAP European farmers received annual subsidies of around 43 billion (2010). CAP was created to ensure continuous food supplies for Europe, and to provide a fair income for European farmers. Price support schemes, such as guaranteed prices, were first introduced in 1962. By the mid 1980s, over-production created massive surpluses and this led to major reforms, including the use of set-aside programmes. By the early 1990s there was a movement away from guaranteed prices towards direct subsidies to farmers, irrespective of the output they produced.
The evolution of CAP
The Common Agricultural Policy (CAP)
Economi cs Online
The Fischler Reforms, of 2003, continued the process of decoupling subsidies and farm output, and introduced a green element to CAP, forcing farmers to meet environmental and animal welfare standards. Single Farm Payments (SFP) were introduced in 2005, and set-aside programmes were abolished in 2009. The UK receives a controversial rebate against payments into the EU to compensate for that fact that it receives relatively little income from CAP in comparison with France and Spain.
European monetary union and the single currency
Economi cs Online
1. 2. 3. 5.
6.
The main features of Monetary Union include: A single currency, the Euro - introduced in 2000, with national currencies scrapped in 2002. An independent central bank, the European Central Bank (ECB) - responsible for monetary stability in the Euro Area (Euro-16). The co-ordination of macro-economic policies - the aim of policymakers is to converge the Euro economies. The Stability Pact - all members agree to keep their budget deficits under control. Under the rules deficits must be no more than 3% of GDP. This rule was designed to limit the use of fiscal policy which might de-stabilise the economy and weaken the Euro. A single interest rate - the ECB sets interest rates for the whole Economics Online 2011 no country has the Euro area ability to alter its own interest rate.
ECOA11
The case for the Euro

1. Transparency
Economi cs Online
The prices of goods, services and materials can be compared and workers can compare wages, and move to take advantage of higher wages. There are no commissions to financial intermediaries. Firms can predict the cost of imported raw materials and can set the price of their exports. This means can plan ahead and are more likely to invest. Trade between members is more likely to increase because of the greater confidence of trading with a member in comparison with a non-member. With greater Economics Online 2011 should be more jobs. trade there
2. Lower transaction costs
3.
Certainty and investment
4. Trade creation
5. Job creation
The case against the Euro

1. Loss of economic sovereignty
Economi cs Online
The Bank of England will not be free to stabilise the UK economy by using interest rates they are under the control of the ECB. The UK will find it hard to converge with Europe, because of the uniqueness of the UK housing market, and because of the closeness of the UK trade cycle to the USA, rather than the EU. Having only one interest rate is not sensible when dealing with a diverse range of economies and economic circumstances.
2. Convergence problems
3. Only one interest rate
The case against the Euro

4. Asymmetric shocks
Economi cs Online
These are external shocks that have an unequal impact on an economy. The following are examples of recent asymmetric shocks: 1. September 11th did not affect all Euro area countries evenly. 2. The collapse of the Argentinean peso in the late 1990s mainly affected Spain. 3. The handover of Hong Kong to China led many to leave and relocate to the UK, rather than other European countries. 4. The recent financial crisis affected some economies more than others (especially those with large financial service sectors). In this type of circumstance it is argued that one interest rate (or common macro-economic policy) Economics Online 2011appropriate. will not be
Tests for membership
Economi cs Online
1. 2.
3. 4. 5.
Under the previous Labour government, five conditions were laid down for membership of the Euro area: Economic convergence - the trade cycles of the UK and Euro area should be in alignment. Flexibility- joining should not harm the flexible product and labour markets of the UK in comparison with the EU. Investment - joining should not discourage domestic investment and FDI. Financial services the City should not suffer. Growth and jobs - membership should be good for growth and job creation.
Economi cs Online
The World Trade Organisation (WTO)
Economi cs Online
The WTO was formed in 1995, and has its headquarters in Geneva. It replaced the General Agreement on Tariffs and Trade (GATT) which was formed in 1947. By 2008 there were 153 member countries. The purpose of the WTO is to:
1. To promote free and fair trade through multilateral talks and negotiations 2. To arbitrate between countries who are in dispute

Evaluation
Economi cs Online
1.
2. 3. 4. 5.
Since its formation there have been over 60 separate agreements between members. Trade liberalisation clearly brings many economic and political benefits, but many claim that the WTO: Has failed to tackle ethical issues, such as the use of child labour and poor working conditions in developing economies. Has failed to tackle environmental issues, such as the depletion of global fish stocks. Takes too long to arbitrate and settle disputes. Favours the powerful developed nations over weaker developing ones. Has failed to promote multi-lateralism.
The Doha Round
Economi cs Online
The Doha Round of trade talks began in 2001, with major summit meetings in Mexico (2003), Hong Kong (2005) and Geneva (2004, 2006, and 2008) The Doha round of talks was also called the development round reflecting its emphasis on trying to promote free trade for the benefit of developing nations. The Cancun talks focussed on:
1. Reducing agricultural subsidies and industrial tariffs imposed by developed nations which limit the market access of developing nations. 2. Harmonising competition rules within different countries. 3. Help to poor countries.
The talks collapsed because:
The US and EUs failed to agree reductions in agricultural support and because some developing countries did not want to agree new Economics Online 2011 investment rules which make it easier for
The Doha Round
Economi cs Online
Since the collapse - the USA and EU have returned to bilateral agreements with favoured nations, rather than multilateral WTO agreements. This highlights a fundamental weakness of the WTO - the failure to promote multilateralism. The failure of the Doha round means that rich countries protect themselves from goods produced by the poor by 2005, average agricultural tariffs imposed by the USA and EU were 60%, against average industrial tariffs of only 5% (Source: WTO, 2005) See Video
Economi cs Online
UK competitiveness
UK competitiveness
What is competitiveness?
Economi cs Online
Competitiveness means the ability of a country to compete effectively in global markets. Competitiveness is closely related to productivity.
Measuring competitiveness
Competitiveness can be measured in a number of ways, including: 1. Relative export prices - relative export prices are one countrys export prices in relation to other countries, expressed as an index. 2. Labour productivity - labour productivity for a country is usually expressed as GDP per worker, or it can also be measured in terms of GDP per hour of employment. 3. Unit labour costs - unit labour costs are the cost of labour per unit of output. Economics Online 2011 4.
Economi cs Online
The World Economic Forum Competitiveness Index
The World Economic Forum lists the following indicators of competitiveness:

1.
2.
3.
4.
Effective institutions - which create an economic environment in which businesses can develop, and consumers have confidence. These should be sound, honest and fair. Effective infrastructure which provides effective transport and energy supplies. A sound macro-economic environment, including sound public finances, and low and stable inflation. A healthy and educated labour force, with an emphasis on higher education, and the continuous upgrading of skills.
Economi cs Online
5.
6.
7.
8. 9.
10.
11.
Efficient goods markets, with high levels of competition, and low levels of regulation. Efficient labour markets, which are flexible, and provide effective incentives to work and effort. An effective financial market, which provides a flow of capital to business, effectively manages financial risk, and is trustworthy and transparent. The readiness of firms to adopt new technology. The size of global markets enables firms that are willing to trade to gain from economies of scale. Business sophistication, which relates to the level of business networks, supporting industries, and advanced business processes. Continuous innovation, which counteracts diminishing returns to existing technology.
UK export competitiveness
Economi cs Online
Export price competitiveness this refers to how well a countrys exports compare in terms of price. This is affected by a number of factors, including:
Relative UK inflation - even small annual differences can build-up over time and become significant. The relative real exchange rate (RER) which is the nominal exchange rate deflated by an index of prices. For example, if the Sterling Index appreciated by 7% and UK prices rose by 2%, the RER is 107/102 x 100 = 105, i.e. the real value of Sterling rose by 5%. Labour costs per unit - including wage and nonwage costs.
Economi cs Online
Labour productivity
There are two commonly used indices of productivity:

1. GDP per worker. 2. GDP per hour worked.
The UK performs relatively poorly against its major competitors. The main causes of the UKs poor Economics Online 2011
The productivity gap
Economi cs Online
Which ever measure of productivity is used it is clear that the UK lags behind most of its major competitors. The difference between the productivity of countries like the USA, Japan and Germany and the UK, is called the productivity gap. In most other areas of economic performance the UK out-performs Germany and Japan, but not in the case of productivity. One clear problem for the UK is the level of educational achievement. According to the Office for National Statistics (ONS) an estimated 4.5 m people have no qualifications.
Factors causing the productivity gap

The productivity gap
Economi cs Online
According to research by the Economic and Social Research Council (ESRC, 2004) the UKs productivity gap is caused by: 1. The level of capital investment
The level of investment per head in the UK is lower than in other advanced economies. A shortage of skilled labour means that machinery is less effectively used. Relatively low wages means less incentive for UK firms to substitute capital for labour.
3. Information technology
The ESRC found that the use of IT in Europe lags behind that in the USA because of lower levels of competition, higher levels of regulation and less desire to change management practices to incorporate more IT. Economics Online 2011
Factors affecting UK productivity

3. Innovation and technology transfer
Economi cs Online
The lack of competition in Europe may help explain the lower levels of R&D as compared with the USA. The ESRC found that that a relative lack of skills in the UK is a primary cause of the UKs productivity gap. This appears especially problematic in terms of management skills. It is argued that the best graduates go into finance, accounting and consultancy rather than into management.
5. Skills and human capital development
Economi cs Online
Flexible labour markets
The share of total UK employment composed of part-time work is high. This may act as a disincentive to invest in labour, and not allocate sufficient resources to training and development. However, labour Economics Online 2011 market
Economi cs Online
Investment per head
Investment per head in the UK is relatively low.
UKs manufacturing investment
Economi cs Online
Many economists attribute the poor level of UK investment in manufacturing over the last 20 years to:
1. A relatively low savings ratio - high consumer debt levels, which reduce aggregate savings levels. 2. Relatively high interest rates - according to the MEC diagram, demand for investment contracts when rates are high because of the higher opportunity cost of investing. Typically UK rates are higher than those of the USA, Japan and the EU area. 3. More attractive investment alternatives, including: Foreign investment Shares Property The service sector
Investment and interest rates

The demand for capital is inversely related to interest rates. For example, at 4%, the level of investment is 25b. At lower interest rates, say 3%, the profitability, also called efficiency, of capital is higher, and demand is greater, at
Interest rates
4%
3%
Marginal Efficiency of Capital (MEC)
25b
50b
Policies to improve competitiveness

Public investment in new technology Tax incentives for firms to invest Improve education and skills Promote flexible labour markets Measures to improve competition
Improve productivity
Improve infrastructure
POLICIES TO IMPROVE COMPETITIVENESS
Integrated transport links e.g. Cross rail Subsidies to public transport Reduce congestion
Keep UK close to its trend Stabilise rate of growth (2.5%) by: Monetary policy Fiscal policy To: Reduce inflation Stabilise the exchange rate
the macro economy Improve education skills
Incentives to learn Subsidise university and education Subside infant education e.g. Sure Start Individual learning accounts Government schemes e.g. Learn Direct website
Policies to help improve competitiveness
Economi cs Online
Choosing the right policy depends on identifying the cause of the lack of competitiveness each country may have different problems that they need to address. Policy options for the UK could include: 1. Improving labour productivity by:
Increasing spending on education and training to help develop skills and close any skills gap, but this is expensive and takes time. Promoting a more flexible labour market, such as reducing trade union power, encouraging parttime work, encouraging new business start-ups, but this also takes time and the increase in flexibility can reduce worker security and lead to lower wages and lower labour costs. This could also deter investment in labour.

2. Improving competition in product markets, by
Economi cs Online
Deregulation - but some regulation is needed to protect consumers and workers from unfair practices. Privatisation - but there are few industries left in the UK to privatise. Reducing monopoly power - but it can be argued that monopoly power helps generate dynamic efficiency. Bringing down barriers to entry - but this is very difficult as some barriers are natural ones, such as economies of scale.


3. Improving the level of investment in the UK, by a range of measures including:

Economi cs Online
Investment grants Investment subsidies Encouraging new product development - these measures may be helpful, with no major conflicts associated with them, though, as always, spending by government has to be funded. Keeping interest rates as low as possible - but the danger with this is that low interest rates could trigger an increase in household spending (C) causing demand pull inflation. Reducing the interest rate elasticity of investment - so it is easier to raise interest rates without negatively affecting investment, for example, by investment grants and tax relief on investment. Online 2011 Economics

4. Creating a stable macro-economic environment, including:
Economi cs Online
Keeping inflation under control, through a mixture of monetary and fiscal measures. However, higher interest rates deter investment, and could harm competitiveness in the long run. Keeping sterling stable.
Conclusion
Perhaps the best way to improve UK competitiveness is through a mixture of policies designed to help improve labour productivity, product market competitiveness and long term investment all of which will improve both price and non-price competitiveness.
Economi cs Online
Exchange rates
The importance of exchange rates

Exchange rates are important for a trading economy:
1.
Economi cs Online
2.
3.
4.
They represent a cost to firms when they have to pay commission on changing s for other currencies. They create a risk to those firms that hold assets in currencies other than s. They affect the price of exports, which form a significant part of aggregate demand (AD), and the price of imports, hence they affect the balance of payments. The Monetary Policy Committee (MPC) of the Bank of England may take the exchange rate into account when setting short term interest rates. Changes in the exchange rate have another transmission route into the economy, via their effect on interest rates.
Measuring exchange rates

Exchange rates can be measured in two ways:
Economi cs Online
1. A bi-lateral rate which is the rate of exchange of one currency for another, such as 1 exchanging for $1.75. 2. A multi-lateral rate which is the value of a currency against more than one currency. Multilateral rates indicate the average value of a currency. This is achieved by using an index which reflects changes in one currency against a basket of other currencies.
Sterlings average is measured by the Sterling Trade Weighted Index. This tracks changes over time, starting with a base year index of 100. The index is weighted to reflect the relative importance of different countries in terms of UK trade.
Exchange rate regimes
Economi cs Online
An exchange rate regime is a system for determining exchange rates for specific countries, for a region, or for the global economy. Throughout history, three basic regimes have existed: 1. Floating - where currencies are allowed to move freely up and down according to changes in demand and supply. 2. Fixed - where currencies are tied to a precious metal such as gold, or being anchored to another currency, like the US Dollar. 3. Managed - where a currency partly floats and is partly fixed, such as happened between 1990 and 1992, when Sterling was managed in the Exchange Rate Mechanism (ERM) of the European Monetary System.
Floating rates
Economi cs Online
Under a floating system a currency can rise or fall due to changes in demand or supply of currencies on the foreign exchange market.
e of the pound is determined in the foreign exchange market , and depends upon relative de The UK has France has stocks of supply stocks of Euro
EXPORTS
Foreign exchange market
IMPORTS IMPORTS
the UK imports it must supply When the UK exports pounds other countries and buy euros / / must buy pounds Supply of pounds ore EXPORTS shifts the demand for a More IMPORTS the(determined by supply of a currency to the currency to shifts the imports) right right
Demand for pounds (determined by exports)
Economi cs Online
Changes in exchange rates

In a floating regime exchange rates reflect demand and supply. The price of one currency is expressed in terms of another currency. For example, an increase in exports would shift the demand curve for sterling to
= $
The equilibrium exchange rate exists at the rate where demand an equate
from imports)
S (derived
1 = $1.60 1 = $1.50
from exports) Q Q
D (derived
Economi cs Online
Exchange rates and interest rates

Changes in interest rates affect a countrys currency. Higher interest rates lead to an increase in demand for financial assets, and an increase in the demand for a currency. Lower interest rates reduce speculative demand for assets and
= $
S (derived from imports)
1
D (derived from exports) Q1 Q
Fixed exchange rates

The IMF system
Economi cs Online
In 1944, at Bretton Woods, New Hampshire (USA), the International Monetary Fund (IMF) was formed and a system of fixed rates introduced. The IMF was one of three pillars to support the development of post-war economies the other two being The General Agreement on Tariffs and Trade, later to become the World Trade Organisation, and the World Bank.
The system involved:

1. The US Dollar (US$) as the anchor for the system with the US$ given a specific value in terms of gold 2. Other currencies were given a value in terms of the $, such as 1 = $2.40c
Fixed exchange rates

But the system collapsed in 1971 because of:
Economi cs Online
1. The build up of US debts abroad, mainly to fund the war in Vietnam 2. Inflation in the USA 3. Growing doubts about the stability of the $ 4. Speculative activity against the $ - speculators frantically sold $ until US President, Richard Nixon, took the US out of the system
Economi cs Online
ange rate rose too high interest rates would have to fall to create an outflow of hot mone
Managed regimes
Managed regimes combine market exchange rate fell too much interest rates would have to rise or If the forces and intervention to achieve a desired rate, such as + 2.25*% the European Exchange Time Rate Mechanism (ERM), which - 2.25*% operated from 1979 to 1999. Currencies were Economics Online 2011 managed to
Evaluation of regimes
Benefits of floating exchange rates
1. Flexibility and automatic adjustment.
Economi cs Online
Under a floating regime deficits and surpluses will lead to adjustments in the exchange rate, which alter relative import and export prices in the future. So, imports and exports can readjust to move the balance of payments back towards a desirable equilibrium. Exogenous shocks can occur from time to time floating exchange rates can help the readjustment process.
2. Freedom
Policymakers are free to devalue or revalue to achieve specific objectives, such as stimulating jobs and growth - by devaluation to stimulate exports - and reducing inflationary pressure - by revaluation to reduce import prices.
Evaluation of regimes
Benefits of fixed exchange rates
1. Stability for firms
Economi cs Online
Exporting firms prices are more stable, as are importing firms costs. This is the main reason the Chinese Yuan was fixed against the US Dollar for nearly 20 years. Firms can plan ahead hence they are likely to invest more. Confidence is a necessary condition for investment. Policy makers cannot devalue the currency in an attempt to hide inflation or a balance of payments deficit - remember, keeping a currency low would reduce export prices abroad and nullify any domestic inflation as well as providingEconomics Online 2011 exports. Policy makers a boost to cannot revalue to keep a currency artificially
2. Predictability and confidence
3. Discipline
Economi cs Online
Recent UK Exchange rates

Sterling fell during 2005, but rose between 2006 and 2007. However, with the onset of the global recession sterling fell back reflecting the UKs exposure to the recession. Between 2005 and 2010 sterling lost 20% of its value.

Economi cs Online
Indicators of development
Development and growth

Growth and development
Economi cs Online
Economic growth refers, narrowly, to increases in economic welfare, whereas economic development refers, more widely, to economic, political and social progress. Economic growth is an important and necessary condition for development, but it is not a sufficient condition. Growth alone cannot guarantee development.
Freedom and development

According to the influential development economist, Amartya Sen, development is about creating freedom for people, and about removing obstacles to greater freedom. Obstacles to freedom, and hence to development, include poverty, lack of economic opportunities, corruption, poor governance, lack of education and lack of health.
Indicators of development
The Human Development Index (HDI)
Economi cs Online
The HDI was introduced in 1990 to provide an accepted way of measuring economic development.
The HDI has two main features:

1. A scale from 0 (no development) to 1 (complete development). 2. An index, which is based on three criteria:
1. Longevity - measured by life expectancy at birth 2. Knowledge - measured by adult literacy and number of years in school 3. Standard of living - measured by real GDP per head at Purchasing Power Parity
What the figures mean

1. An index of 0 0.49 means low development - for example, Nigeria was 0.42 in 2010. 2. An index of 0.5 0.69 means medium development for example, Indonesia was 0.6. 3. An index of 0.7 to 0.79 means high development for Economics Online 2011 example, Romania was 0.76.
Economi cs Online
HDI for selected countries:
Very high High Medium Low
Life expectancy
A variety of factors may contribute to differences in life expectancy, including:
The stability of food supplies War and natural disasters The incidence of disease
Economi cs Online
According to the World Bank:

Over the past 30 years, life expectancy in developing countries as a whole increased by 10 years however the
Literacy
Adult literacy rates
Economi cs Online
Adult literacy can be broadly defined as the percentage of those aged 15 and above who are able to read and write a short, simple, statement on their everyday life. More extensive definitions of literacy includes those based on the International Adult Literacy Survey. This survey tests ability to understand printed text, to interpret documents and perform basic arithmetic.
GDP per capita

GDP per capita
Economi cs Online
GDP per capita is the commonest indicator of material standards of living, and hence is included in the index of development.
Evaluation of GDP measures:

GDP statistics are widely used for comparing economic performance of developing countries, but they can be criticised because:
1. Average GDP per head may increase, but the distribution of income may get wider. Mean averages can be misleading, and median figures may be more useful. 2. Citizens may work longer hours - in which case some of the growth may occur because of increased work rather than through greater productivity. 3. Citizens may do more unpaid work in one country - but this is not likely to be recorded. 4. Prices of similar products may be different - figures must be adjusted to take into account different purchasing power of the local currency. The process of undertaking Economics this conversion is Online 2011 adjusting to create Purchasing called
Economi cs Online
5. Negative externalities may be greater in one country countries with higher GDP may have the higher levels of pollution. 6. Non-marketable transactions public and merit goods are not generally bought and sold in markets, so the value of these to a national economy tend to be underestimated. 7. The size of the hidden economies can vary - using crude GDP statistics for diverse countries could be misleading. 8. Conversion to a common currency - converting GDP figures to a common currency may give misleading figures. Exchange rates for closed economies may be under or over valued.
Measure of economic welfare (MEW)

Nordhaus and Tobin
Economi cs Online
In 1972, Yale economists William Nordhaus and James Tobin introduced their Measure of Economic Welfare (MEW)* as an alternative to crude GDP. MEW adjusts national income to include the value of leisure time and the amount of unpaid work in an economy. It also includes the value of the environment damage caused by industrial production and consumption, which reduces the welfare value of GDP.
*Nordhaus, WD and Tobin, J (1972) Is Growth Obsolete? Economic Growth, National Bureau of Economic Research, no 96, New York.
The Index of Sustainable Economic Welfare

The Index of Sustainable Economic Welfare (ISEW), develops MEW by adjusting GDP further by taking into account a wider range of harmful effects of economic growth, and by excluding the value of public Economics Online 2011 expenditure on defence.
Purchasing power parity

Purchasing power parity (PPP)
Economi cs Online
The alternative to using market exchange rates is to use purchasing power parities (PPPs). The purchasing power of a currency refers to the quantity of the currency needed to purchase a given unit of a good, or common basket of goods and services. Purchasing power is determined by the relative cost of living and inflation rates. Purchasing power parity means equalising the purchasing power of two currencies by taking into account these cost of living and inflation differences.
The Big Mac Index

This index, devised by The Economist magazine, calculates how many units of a local currency are needed to purchase a Big Mac. Exchange rates can then be adjusted according to how much local currency is required.
Economi cs Online
Growth and development theories
Types of growth theory

Growth theories
Economi cs Online
Growth theories attempt to explain the necessary conditions for growth to occur, and to weigh up the relative importance of particular conditions. Early growth theories attempted to find general determinants of growth which could be applied to all cases of growth. Modern theories accept that conditions for growth change over time, and vary between countries and regions.
Linear stage theory

Rostows linear stage theory
Economi cs Online
One of the first growth theories was that proposed by American economic historian W. Rostow in the early 1960s. Rostowargued that economies must go through a number of developmental stages. He argued that these stages followed a logical sequence:
Citizens Rostows stages are: Mass
consumption Drive to maturity Take off
head.
enjoy high and rising consumption per
Ongoing movement towards development Positive growth rate Increased savings ratio Dominated by agriculture and barter exchange
Pre - take off Traditional society
The Harrod-Domar growth model

The Harrod-Domar Model
Economi cs Online
The importance of savings is central to the work of Harrod and Domar. According to this theory there are two determinants of the rate of growth:
1. The capital-output ratio - which shows how much new capital (e.g. 10) is needed to create a given amount of new national output (e.g. 2). 3. The savings ratio - which shows how much is saved (e.g. 10) from a given amount of national income (e.g. 100)
The model indicates how these two ratios affect the rate of growth
1. The higher the savings ratio, the higher the rate of growth 2. The higher the capital-output ratio, the higher the rate of growth
Economies must save and invest a certain proportion of their income to grow at a certain rate failure to Economics Online failure to save, and develop is caused by the 2011
Savings and capital-output ratios
Economi cs Online
cu rre n t co n su m p ti n i p ro vi e s th e fl w o f fu n d s necessary for capital accumulation o t d o growth.
savings The savings ratio indicates the ratio of savings to national ratio income Some income is saved 10 0 2 8 Income Income 0 4 2 S a0 n vi gs S Y 20 40 10 0
Households
me circulates Incom MORE OUTPUT AND HIGHER ECONOMIC from MORE CAPITAL MEANS firms to The higher the Spendi savings and capital output ratio, the greater the Factor Goods households GROWTH output s es ng
Income
20 20
Firms
1 Output O u u tp 4 6 t
4 2 t Capita C a0p i l al
O C
1 4 6 2 4 0 0
output ratio (O/K) indicates how much capital is needed to create new Capital ( K )/ output Saving allows capital accumulationratio output
Evaluation of stage theory
Economi cs Online
The theories of Rostow, Harrod and Domar, and others consider savings as a sufficient condition for growth and development. If income is low, savings will not be accumulated. According to Rostow, saving between 15 and 20% of income is enough to provide the basis for growth. Although saving is regarded as highly significant, modern growth theory takes into account a broad set of growth factors. Other criticisms of stage theory point to general weakness in terms of the unrealistic assumptions of these models, such as perfect knowledge, stable exchange rates, and constant terms of trade. Modern theory tends to see savings as a necessary but not sufficient condition for growth.
Structural change models

The Lewis model
Economi cs Online
The Lewis model is also known as the two sector model, and the surplus labour model. It focused on the need for countries to transform their structures, away from traditional agricultural economic activity, with low productivity of labour towards industrial activity, with high productivity of labour. 1.
Agricultur Agricultur e e Labou r
Industr Industr y y
Economi cs Online
In the Lewis model the line of argument runs:

1.Agriculture generally under-employs labour 2.The marginal productivity of labour is virtually zero 3.So transferring workers out of agriculture does not reduce productivity 4.Labour is now free to work in the more productive urban industrial sector 5.Industrialisation is now possible 6.Profits are recycled into more and more industrialisation 7.Capital accumulation is now possible 8.Once this occurs development sustains itself
Evaluation of the Lewis model

Limited benefits of industrialisation
Economi cs Online
Despite the logic of the Lewis approach the benefits of industrialisation may be limited because: 1. Profits may leak out of the economy and find its way to developed economies - capital flight. 2. Capital accumulation may reduce the need for labour in the urban industrial sector. 3. The model assumes competitive product and labour markets, which may not fully exist. 4. Urbanisation creates urban squalor with unemployment replacing underemployment. 5. Only a small elite may benefit from industrialisation.
Clark-Fishers structural change model
Economi cs Online
As early as 1935 Allan Fisher had noted that economic progress led to the emergence of a large service sector. The Clark-Fisher hypothesis states that development will eventually lead to the majority of the labour force working in the service sector.
This is because high income elasticity of demand for services as income rise demand for services increases and more employment and national output are allocated to service production. Lower productivity in the service sector (with less ability to apply new technology), so prices of services rise relative to primary and secondary goods. This means an increasing share of national consumption is allocated to the service sector.
Agriculturr A g ri l Agricultur cu tu e e e Labou r
Industr I d u str n y y Labou r
Service s
Dependency theory
Economi cs Online
Dependency theory became popular in the 1960s as a response to research by Raul Prebisch. Prebisch found that increases in the wealth of the richer nations appeared to be at the expense of the poorer ones.
What did dependency theory advocate?

Dependency theory advocated an inward looking approach to development and an increased role for the state in terms of:
Imposing barriers to trade Making inward investment difficult Promoting nationalisation of industries
Dependency theory
Why did it lose favour?
Economi cs Online
Although still a popular theory in history, dependency theory has disappeared from the mainstream of economic theory in recent years. This is largely as a result of the emergence Far Eastern economies, especially India. The inefficiencies of state involvement in the economy, and the growth of corruption, have been dramatically exposed in countries that have followed this view of development, most notably a number of African economies, including Zimbabwe.
Neo-classical theory
Three different Neo-classical approaches to development have emerged:
Economi cs Online
1. The free market approach - markets alone are sufficient to generate maximum welfare. 2. The public choice approach - an extreme Neo-classical model which stresses that all government is bad and leads to corruption and the gradual confiscation of private property. 3. The market friendly approach - while markets work, they sometimes fail to emerge, and government has a role to compensate for three main market failures; missing markets, imperfect knowledge and externalities.
Neo-classical economists believe that, to develop, countries must:

1. Liberate markets 2. Encourage entrepreneurship (risk taking) 3. Privatise state owned industries Economics Online 2011 4. Reform labour markets (such as reducing the powers of
Economi cs Online
Liberalisation
There is a broad consensus between Neo-classical economists that free trade can help stimulate growth and development by: 1. Encouraging FDI. 2. Encouraging the application of economies of scale. 3. Increasing competition and breaking down domestic monopolies. 4. Creating a low inflation, stable, macro-economic environment. 5.
New growth theory

New growth theory
Economi cs Online
A central proposition of New Growth theory is that, unlike land and capital, knowledge is not subject to diminishing returns.
The importance of knowledge

The development of knowledge is seen as a key driver of economic development. The implication is that, in order to develop, economies should move away from an exclusive reliance on physical resources to expanding their knowledge base, and support the institutions that help develop and share knowledge. Government should invest in knowledge and human capital, and the development of education and skills. It should also support private sector research and development and encourage FDI, which will bring new knowledge with it. Economics Online 2011 1.
Economi cs Online
Poverty and inequality
Income and wealth

Introduction
Economi cs Online
One clear feature of less developed countries is the impoverishment of a large proportion of their inhabitants, caused by a lack of income, either through unemployment, under-employment, or low wage employment.
Types of income
The types of income that can be earned are: 1. Earned income, from selling labour in the labour market, including:
Wages, which is the largest source of income Salaries and commission, which represents a very small fraction of income, in comparison with more developed economies
2. Unearned income, such as

Rents from land ownership and interest from lending money (i.e. credit)
Common types of wealth Economics Online 2011 in developing economies
Measuring inequality
Measuring inequality
Economi cs Online
Inequality can be quantified by looking at the distribution of income or wealth. 1. The distribution of wealth is likely to be much greater than income because wealth is built up over many decades, and for some families, over centuries. 2. The distribution of income is relatively easier to measure valuing wealth is difficult because much wealth is hidden from view and wealth changes its value over time.
The Gini co-efficient and index

The Gini co-efficient or index is a mathematical devise to compare income distributions over time and between economies. The co-efficient is calculated by comparing the area under the Lorenz curve and the area from the 450 line to the right hand and bottom axis. The co-efficient ranges from 0 to 1 - the closer to one,2011 greater the inequality. Economics Online the
Economi cs Online
The Lorenz curve
fficient is calculated by comparing the area from the curve to the 450 line and the area fr The Lorenz Curve inequality Cumulative Income (%) A Lorenz curve 100
% of Pop % of Y for perfect distribution 20 40 60 80 100 20 40 60 80 100
shows the % of income earned by a given % of the population.

% of Y in Country X 2 10 25 45 100
90 80 70 60 50 40 30 20 10
y tl o n ec i rf b ut pe i f s tr o e di n Li ual eq
fo ve ur y X C z ntr en u o r Co L r
10 80
20 30 40 50 60 90 Cumulative Population (%) 100
70
Economi cs Online
Comparing countries
Comparing Gini co-efficient) can be used to assess the effectiveness of policie Cumulative the Lorenz curve (and countries Income (%) income. The further the
Lorenz Curve from the 45 degree line, the less equal (wider) the % ofdistribution ofin Y in % of Y Country X Country Y income.1 2
10 25 45 100 5 15 30 100
100 90 80 70 60 50 40 30 20 10
% of Pop 20 40 60 80 100
60
10
20
40 80 100 Cumulative Population (%)
Lo
re n Co z C un ur tr ve y Y f or
Lo r
en Co z C un ur tr ve y X f or
ly ct ion fe t er ibu p f s tr o i ne l d Li ua eq
Economi cs Online
Poverty
What is poverty?
1. Absolute poverty
The simplest definition of being poor is being unable to subsist, and being deprived of basic human needs, such as food, drink, shelter and clothing. A common monetary measure is ..receiving less than $2 a day. It is also possible to establish an international poverty line, at, say $700 per person per year, and then compare countries by estimating the purchasing power equivalent of that sum in terms of the countries own currency.
2. Relative poverty
It can be argued that poverty is best understood in a relative way what is poor in New York is not the same as what is poor in Calcutta. Most relative definitions suggest that poverty is the inability to reach a minimum accepted standard of living in a particular society. Economics Online 2011 Definitions of relative poverty vary considerably, but
Estimated absolute poverty

Absolute poverty, by region
Taking the international poverty line, as a region, Asia has the highest population living in poverty. However, as a region of the world, SubSaharan Africa has the highest level of poverty as a proportion of total population, at over 60%. The second poorest region is Latin America, with 35% of its population Economics Online 2011
Economi cs Online
23%
25%
62% 28% 35%
Source United Nations
Inequality and development

The Kuznets curve
Economic developm ent may widen the gap between rich and poor countries. The greatest inequality can be observed as countries 'take-off' in their developm ent,
Inequality increases in the early stages of development
Economi cs Online
Inequalit y
Kuznets Curve
Development
Economi cs Online
Media Video on poverty
Economi cs Online
Constraints to development
Im b a la n ce s In e fficie n ci es
Economi cs Online
P o p u la tio n
T ra d e b a rrie rs E n v iro n m e n ta l d e p re cia tio n
Constraints to development
L a ck o f ca p ita l L a ck o f e d u ca tio n
M issin g m a rk e ts
C o rru p tio n
Inefficiencies
A significant limit to economic growth and development is inefficiency in the use of scarce resources: 1. Productive inefficiency (not producing at lowest possible average cost.)
Economi cs Online
This may be because of the failure to apply technology to production, or because of the inability to achieve economies of scale. Opening up the economy to free trade may help reduce this type of inefficiency.
2. Allocative inefficiency when competition is restricted, or when production is in the hands of the state, prices might not reflect the marginal cost of production. 3. X Inefficiency also arises from an absence of competition and is associated with inefficient management. Economics Online 2011
Imbalances Not all sectors of an economy are capable of growth.
Economi cs Online
For some countries, too many scarce resources may be allocated to sectors with little growth potential. This is especially the case when countries specialise in agriculture and primary commodities. In these sectors there is little opportunity for economic growth because the impact of real and human capital development is small, and marginal factor productivity is very low. Most development theorists argue for a drive for agricultural efficiency to allow resources to move to high productivity uses.
Population constraints
Economi cs Online
A high rate of population growth may constrain economic growth. At first, growth creates positive externalities, such as better health and education, which lead to a decline in the death rate, but no change, or an increase, in the birth rate. Over time life expectancy rises, but the age distribution remains skewed at the lower, dependent age. More and more of the population are dependent consumers, with proportionately fewer producers. The short-term gains from growth are quickly eroded as GDP per head actually falls. Only when the birth rate falls will GDP per head rise.
Economi cs Online
Aging population
An aging population is also a potential constraint on growth, as more workers leave the labour market, tax rates rise, and government spending on healthcare increases. Resulting public debt may limit the possibility of fiscal expansion during a recession.
Lack of financial capital
Economi cs Online
Many developing economies do not have sufficient financial capital to engage in public or private investment because: 1. Growth is insufficient to allow savings to accumulate. 2. High interest rates needed to encourage more saving will deter investment. 3. Public debts may be too large. 4. Private investment may be crowded out by public sector borrowing. 5. An absence of credit markets in many developing economies, which discourages both lenders and borrowers.
Poor governance
Economi cs Online
Some developing economies suffer from corruption and poor governance: 1. Theft of public funds by politicians or government employees. 2. Theft and misuse of overseas aid. 3. In some developing economies bribery is the norm, which seriously undermines the operation of the price mechanism.
Missing markets Credit markets
Economi cs Online
Missing markets usually arise because of information failure. Lenders in credit markets may be unaware of the full creditworthiness of borrowers. This pushes up interest rates for all borrowers. Low risk individuals are deterred from borrowing, and credit markets in developing economies may be completely missing. Microfinance is increasingly used to reduce this problem in developing economies.
Insurance markets
Similarly, insurance markets may be underdeveloped, with few insurers wishing to accept bad risks. Insurance premiums are driven up, and good entrepreneurs may not be prepared to take such uninsured risks. Economics Online 2011 The result new businesses fail to develop.
Economi cs Online
Absence of property rights

In many developing economies it is not always clear who owns property, especially land. Given this, there is no incentive to develop the land because of the free-rider problem.
Absence of a developed legal system

In many developing economies there is absence of a developed legal system in the following areas:
1.Property rights are not protected 2.The right to start a business is limited to a small section or a favoured elite 3.Consumer rights are not protected 4.Employment rights do not exist 5.Competition law is limited or absent
Lack of education
Economi cs Online
Human capital development requires investment in education. Education is a merit good, and as such the long term benefit to the individual, and to society, is under-perceived. For many in developing economies, the return on human capital development is uncertain in comparison with the return on immediate employment on the land so there is little incentive to become educated.
Over-exploitation of environmental capital
Economi cs Online
The long term negative effect of the excessive use of resources may be less clear than the short term benefit. This means that there is a tendency for countries not to conserve resources. But this can have an adverse effect on growth rates in the future.
Barriers to trade
Economi cs Online
One important constraint to economic development is the denial of access to the markets of the more developed, industrialised, countries. Developed counties may impose tariffs and quotas and other protectionist measures individually, or more commonly as a member of a trading bloc.
Economi cs Online
Development strategies
Developing agriculture and primary products
Economi cs Online
Many developing countries specialise in agricultural and other primary products. Indeed, the principle of comparative cost advantage suggests that specialising in commodities and products with the lowest opportunity cost will provide the best opportunity for economic development. However, over-specialisation, particularly in terms of primary production, can be highly risky. A country can be locked into slow development if it specialises in a few primary products because:
1.Primary products have low valued added and receive a small share of global income 2.Yields from land are likely to be inconsistent 3.Price instability can make it hard to survive, and to invest in new technology 4.Countries are more likely to be adversely affected Economics Online 2011 by global shocks
Low elasticity
Low income elasticity of basic commodities
Economi cs Online
As world incomes rise proportionately less income is allocated to primary products, with low income elasticity, and more is allocated to manufactures and services.
Low price elasticity of basic commodities

Many commodities tend to be price inelastic, such as foods, beverages and basic clothing, and prices have tended to fall in the long run in relation to manufactures. This means that commodity exporting countries have tended to suffer, and as export prices fall relative to import prices of manufactures, the terms of trade of many developing economies fall This means they have to export increasingly more commodities to pay for the same volume of imported manufactures, including both consumer and capital goods.2011 Economics Online
Falling terms of trade - The Prebisch-Singer hypothesis
Economi cs Online
A countrys terms of trade indicate how high a countrys export prices are in relation to their import prices, and Index of export prices is expressed as:
Index of import prices
X 100
The Prebisch-Singer hypothesis states that:

Over time the terms of trade for commodities and primary products deteriorates relative to manufactured goods. This implies it is economically unsound to rely on agriculture to secure growth and development. This means that, just to keep up with developed economies, and maintain the existing development gap, countries relying on producing and exporting primary products, whose terms of trade decline, must continually increase output.
Falling incomes
Incomes have fallen because, in the long term the supply of food has increased P because:
Economi cs Online
S
Price
The greater use of new technolo gy and Revenue better yields. P1 New entrants Revenue into markets (like 0 Q Q1 Vietnam into the Economics Online 2011 coffee
B
D
Q
Unstable prices
The cobweb diagram best explains the tendency for price instability. Initially, we can assume a stable equilibrium price. Followed by a negative supply shock (e.g. bad weather). Price is now driven up to P1. Next year, planned
Economi cs Online
Price
S3
S1
S2
Long Run Supply S
P1 P
P2
D 0
Q3 Q1 Q Q2
Protectionism
Economi cs Online
Relying on agricultural improvements as a driver for development is also risky because of protectionist policies adopted in many developed countries. The worlds two largest economies, the US and EU, are difficult to penetrate given the high level of support and protection for their farmers, with many agricultural tariffs in excess of 50%.
Economi cs Online
Development of agriculture
Most development theories conclude that improvements in agriculture are crucial to development prospects. Agriculture can be developed by a range of policies, including: 1. Extending property rights to workers. 2. Land reform and improvement programmes. 3. Applying technology to food production. 4. Preserving environmental capital. 5. Joining trading blocs.
Promoting industrialisation
Economi cs Online
Many development theorists, including the Fisher, Clark and Lewis, highlight the significance of increasing factor productivity through industrialisation. The Lewis model, also known as the two sector model, and the surplus labour model, focused on the need for countries to transform their structures, away from traditional agricultural economic activity, with low productivity of labour towards industrial activity, with high productivity of labour. 1. Agricultur Industr
A g ri l r cu tu e e
Labou r
I d u str n y y
Evaluation of the Lewis model
Economi cs Online
Despite the logic of the Lewis, approach the short term benefits of industrialisation may be limited because: 1. Profits may leak out of the economy and find their way back to developed economies a process called capital flight. 2. Capital accumulation may reduce the need for labour in the urban industrial sector. 3. The model assumes competitive product and labour markets, which may not exist. 4. Urbanisation creates urban squalor with unemployment replacing underemployment. 5. Only a small elite may benefit from industrialisation.
Inward looking policies
Economi cs Online
An inward looking strategy dominated thinking in the post-war period this approach can be described as interventionist, centralist and protectionist, and guided policy making in many African and Latin American countries. The general economic strategy was import substitution. The industries targeted were those which provided the largest quantity of imports. Inward looking strategies also involved heavy subsidies to domestic producers as well as limiting the activities of MNCs.
T h e b e n e fits of inward looking policies
Economi cs Online
Inward looking policies generated some clear short term benefits including: 1. Protecting infant industries. 2. Protecting declining industries. 3. Generating employment. 4. Increasing incomes. 5. Preserving traditional ways of life.
Outward looking policies embracing globalisation
Economi cs Online
A number of important global events have forced countries to become more outward looking, including: 1. The realisation that decades of using an inward looking strategy had not resulted in growth rates necessary to close the development gap between countries. 2. With the collapse of communism the opportunity arose for many countries to introduce more outward looking policies. 3. The benefits of globalisation cannot be exploited with an inward looking approach. Outward looking policies typically include:
1.Trade liberalisation and market reforms. 2.Membership of the WTO. 3.Encouraging FDI. 4.Encouraging inflows of human capital.
The benefits of outward looking policies

1. Welfare gains from tariff removal. 2. Trade creation as a result of free trade. 3. The greater spreading of risks. 4. Greater positive feedback effects from growth. 5. Greater competition and increased efficiency of domestic firms. 6. More able to cope with globalisation and external shocks.
Economi cs Online
The promotion of tourism
Economi cs Online
Many countries have promoted tourism as a means of achieving development.
The benefits of promoting tourism include:

1. A strong multiplier effect following the injection of FDI which accompanies the development of a country as a tourist destination. (Hotels, infrastructure). This can be significant due to the high marginal propensity to consume (mpc) in developing economies. 2. Job creation through the initial development phase, and following the ongoing development of tourism. 3. The creation of a more balanced and diversified economy, with a developing service sector often seen as a key indicator of economic progress. 4. Positive externalities as a result of the development of infrastructure. Economics Online 2011
Economi cs Online
The problems of relying on tourism include:

1. Tourist revenue may go to firms in the country from which the tourists come (travel agents and tour operators). 2. Development of a parallel hidden economy, with transactions unrecorded and tax revenue lost. 3. Negative externalities, such as:
Overcrowding Loss of areas of natural beauty Historic and special sites may be over-exploited by tourism Too much pressure on the local infrastructure
4. Diversion of resources from necessary industries, such as from food production. 5. Tourist revenue may be unreliable.
Economi cs Online
Financing development
Official Development Aid (ODA)
Economi cs Online
ODA comes in two basic types: 1. Long term aid to relieve poverty 2. Short term humanitarian aid for relief following disasters The UK allocated around 0.5% (7.3bn) of its GDP to development assistance, but has agreed to implement the UN Millennium aid goal of 0.7% of GDP by 2015. By 2009 total ODA had reached $120b, equivalent to 0.33% of global GNP. (Source: UN, 2009). The UN has estimated that and extra $150b needs to be spent to meet the Millennium Development Goals agreed in 2000.
Official Development Aid (ODA)

The USA is the single biggest provider of development aid in absolute terms. Denmark is the largest provider in terms of % of GDP allocated.
Economi cs Online
Government assistance Evaluation
Economi cs Online
1. Aid is probably more useful if it is targeted for specific causes, such as the eradication of a specific disease, and to relieve the immediate effects of natural disasters. 2. However, aid spending only represents a small % of global GDP and donor countries GDP, and received aid only represents a small % of the recipient countrys GDP. 3. A large amount of bi-lateral aid has strings attached, called tied aid such as aid for contracts to the donor countries to undertake development related work, such as the construction of infrastructure. 4. Some critics argue that aid can be disastrous, and can trap poorer countries into a life of aid dependency.
Non-Governmental Organisations (NGOs) What are NGOs?
Economi cs Online
NGOs are not-for-profit organisations that act as a pressure group to represent members interests or the interests of specific groups.
What are their benefits?

The UN Industrial Development Organization (UNIDO) analysed the role of NGOs and suggested that they provided the following benefits::
1.There is local accountability 2.Independent assessment of the issues 3.The provision of expertise 4.The provision of information 5.Awareness-raising of problems and issues
Source: UNIDO (1997)
The IMF The IMF
Economi cs Online
The IMF and World Bank were set up following the Bretton Woods conference in 1944.
The role of the IMF

The IMF was initially established to promote international monetary co-operation, which was seen as a key condition for post-war reconstruction and global development and security. It has a number of specific objectives which relate to economic development, including:
1.Promoting exchange rate stability. 2.Providing short term loans to ease any balance of payments problems. 3.Forcing borrowing countries to improve their macro-economic performance through prescribed Economics Online 2011 macro-economy stabilisation policies and through
The World Bank
Economi cs Online
The World Bank is one of the United Nations specialised agencies. Its role is to provide funds for economic reconstruction and economic development for developing economies. The World Bank can make low and no interest loans and grants. As well as making loans it is also one of the worlds largest providers of aid. More specifically it attempts to: 1. Encourage structural adjustment such as policies to promote trade liberalisation and capital mobility. 2. Encourage supply-side reforms, such as privatisation and de-regulation. 3. Provide targeted aid for poverty reduction. 4. Set specific priorities for countries. 5. Since 2000 its major focus has been to try to help achieve the UNs Millennium Development Goals.
Assessment of the World Bank
Economi cs Online
1. Not enough understanding of specific local problems and constraints. 2. Difficult to empower local governments to take responsibility they often see the World Bank as an outsider. 3. Long term debt can undermine the best intentions of the recipients of aid and the World Bank. 4. Assistance can create the problem of moral hazard countries receiving aid performing less effectively because they know there is an insurance against this under-performance. 5. See Video 1.
Assessment of the IMF
Economi cs Online
1. Stabilisation policies can result in short term conflicts, such as higher unemployment following tighter demand management. 2. Tough lending constraints can create too much austerity, and push countries into even further poverty. 3. Decision making is dominated by the powerful G8 countries, though each member country can vote, voting is based on a quota system, and the USA has around 17% of the voting power. (IMF, 2005). 4. Because of growing criticism about its role in the global economy the IMF has become more transparent in an attempt to show that it is not simply a vehicle to promote the interests of the USA and other powerful G8 countries. 5. There is also the potential problem of moral hazard.
United nations millennium goals The United Nations
Economi cs Online
The United Nations Millennium Development Goals provided an agenda for reducing poverty. For each goal one or more targets were set, mostly for 2015 1. Eradicate extreme poverty and hunger. 2. Achieve universal primary education. 3. Promote gender equality and empower women. 4. Reduce child mortality. 5. Improve maternal health. 6. Combat HIV/AIDS, malaria and other diseases. 7. Ensure environmental sustainability. 8. Develop a global partnership for development.
Excessive debt
Economi cs Online
Foreign debt is created when a country has creditors residing abroad. Debts could be owed to foreign individuals, organisations, governments, and banks, and to the World Bank and IMF. Debt can be unsustainable if it represents a large % of current exports. The World Bank considers foreign debt to be unsustainable if the ratio of debt to exports exceeds 150%.
Excessive debt
Economi cs Online
Excessive international debt can occur for two basic reasons: 1. Failure of domestic policy, such as:
Failure of macro-economic management Ineffective control of public finances A currency artificially set too high, leading to export problems Excessive spending on propping up a failed regime Civil war, diverting scarce resources from production to defence, as in the case of many African economies
2. The effects of destabilising real and financial shocks, such as:

Collapse in commodity prices, affecting exporters Oil shocks, affecting importers of oil Exchange rate instability Economics Online 2011 Rises in interest rates
Economi cs Online
Debt forgiveness
In 1996 the IMF and World Bank launched the Heavily Indebted Poor Countries Initiative (HIPCI). The G8 Gleneagles Agreement in July 2005 the G8 countries met at Gleneagles, Scotland, to agree a package of debt relief, mainly for Africa. The package, lasting through to 2010, was dependent upon African governments continuing to introduce democratic reforms, and to improve standards of governance (especially increased transparency and accountability.) The package is formally known as the Multilateral Debt Relief Initiative, and involves providing 100% debt relief for a number of heavily indebted countries, providing they implement certain economic reforms. Economics Online 2011
Debt forgiveness The case for debt forgiveness
Economi cs Online
1. Debt can be a considerable burden for a country, which can lock it into poverty, and impede its progress towards greater development. 2. Debt servicing creates a great opportunity cost for countries reducing or totally forgiving debt could help reduce poverty and free-up resources for other uses, such as education and infrastructure. 3. By removing debt repayments, more national income is available for generating growth, and will generate jobs. 4. Creditor countries might gain from more export earnings in the long run as countries now relieved of their debt can grow, and import more.
Economi cs Online
The case against

1. Debt relief may send out the wrong signals to potential and existing borrowers. For example, by providing an insurance policy, relief creates the problem of moral hazard, so debtors to not take proper steps to prevent debt problems. 2. Borrowers do not have a chance to learn from their mistakes. 3. Cancelling debt is bad for the lenders, who may be forced to raise interest rates to try to recoup lost revenues. This in turn has a negative effect on other borrowers. 4. Banks in developing economies may lay off workers, hence a downward multiplier effect. 5. Lost revenues could have been used to help other developing economies.2011 Economics Online
Economi cs Online
Macro-economic policy objectives
Macro-economic policy
Economi cs Online
Economic policy is the deliberate attempt to increase economic welfare. Since the late 1920s, economists have recognised that there is a role for government in managing the macro-economy. During the late 1930s and early 1940s Cambridge economist John Maynard Keynes set the policy ground rules for his, and later, generations of policy makers. Keynes was able to demonstrate that a market economy could become trapped in a downward spiral of falling economic activity and diminishing economic welfare.
Macro-economic policy For Keynes, the key questions were:
Economi cs Online
What could trigger a fall in economic activity? What processes would stop economic activity from rising back after a period of recession? What policies should governments adopt to bring a recession to and end and to begin the process of stimulating growth?
Macro-economic policy objectives
Economi cs Online
Following Keynes, modern policy makers favour setting clear policy objectives, such as achieving:
1.Stable prices the desire to keep increases in average prices as small and as gradual as possible. 2.Stable and sustainable economic growth the desire to see national income grow in real terms in a sustainable way. 3.Full employment the desire to keep the labour force fully employed in productive work. 4.A balance of payments with the rest of the world the desire for a country to pay its way in the world. 5.Control of public sector finances. 6.Care for the environment the desire to protect the environment from misuse, overuse and Economics Online 2011 degradation.
The trade cycle

Booms lead to :
Economi cs Online
Goods and service inflation Many macroHouse price inflation economic Wage inflation Change in real Labour shortages problems DEMAND SIDE POLICY national Falling savings Monetary policy arise from income Excessive credit Fiscal policy the Trade difficulties Exchange rate policy underlying Regulates aggregate demand to stabilise the trade BO cycle instability OM of the trade cycle. Changes in Trend rate real Busts lead to : Time Goods deflation national SUPPLY SIDE POLICY Incentives deflation incomeHouse price work Welfare to Labour surpluses Education and tend toUnemployment skills be Excessive debt burden cyclical. Promotes long term It growth BUS Public sector debt is desirable T that this cycle is Economics Online 2011 stable
Policy Building Blocks

Flexibilit y
Economi cs Online
SUPPLY- SIDE Stable prices POLICY Education and Incentive

s skills De-regulation
Productivity & efficiency
Privatisation & competition
Stable growth Labour market
Supply side Monetary Fiscal

Taxatio n
reform Sustainable growth
POLICY OBJECTIVES
Government spending Interest rates
supply
Full employment Money Equit Exchange yrates
Stabilise after shocks
FISCA L
Balance of MONETAR payments Y Manage the trade Sustainable public cycle DEMAND finances SIDE
POLICY
Economi cs Online
Macro-economic problems
Economi cs Online
Global shocks
Global shocks
Economi cs Online
A major problem associated with increased globalisation is the increased risk of suffering from demand and supply shocks. Globalisation means that economies are increasingly interconnected, and while this can create considerable benefits, it also presents national economies with considerable risks. One risk is that a shock originating in one part of the world, or in one industry or market, can quickly ripple across a whole region or the whole global economy, leaving economic turmoil in its wake.
Types of shock
Economi cs Online
There are a number of different types of shock, including: 1. Temporary - such as a terrorist attack. 2. Permanent such as an oil shock, which permanently alters the market for motor vehicles. 5. Exogenous these shocks are outside of the control of a countrys policy makers. 6. Policy induced such as reducing interest rates too quickly, creating an inflationary shock. 7. Asymmetric - affecting one region or industry differently from another. 11.Symmetric - affecting all regions or industries in the same way.
Economi cs Online
7. Financial - a shock starting in the financial markets, such as a sudden change in the exchange rate, or the collapse of a major credit bank. The recent global financial crisis is an example. 8. Supply side - a cost shock, such as a sudden increase in commodity prices. 9. Demand side - a sudden change affecting AD, such as a collapse in consumer confidence, or a sudden rise in house prices.
Economi cs Online
Unstable prices Inflation and deflation
Unstable prices
What is wrong with unstable prices?

Economi cs Online
Price stability is usually regarded as the single most important economic objective. Price stability is increasingly important for economic success in the global economy. For the UK, price stability means ensuring that the price level increases gradually, by no more than 3% per year, and that prices do not rise by less than 1%.. The official UK target is 2%, though there is a safety margin of +/- 1% - policy makers are forced to intervene if inflation falls outside these margins.
The problem of inflation

The problems caused by inflation include: 1. Erosion of the value of money and assets.
Economi cs Online
A rise in the price level means, ceteris paribus, that money can buy fewer goods. If assets are stored in a monetary form, inflation means that asset values fall.
3. Loss of competitiveness and balance of payments difficulties
This occurs because inflation stimulates imports, which appear relatively cheaper, and discourages exports, which appear more expensive to overseas households and firms. Borrowers do better at times of rising prices because the real value of their repayments falls over time. Lenders need to charge a higher interest rate to compensate for the falling value Economics Online 2011 of the repayments to them, and for the loss of
4. Redistribution of income, from lenders to borrowers
Why is inflation a problem?

4. Uncertainty and falling investment
Economi cs Online
Inflation creates negative effects on business confidence and costs, and as firms expect interest rates to rise to deal with inflation. Lower investment reduces productivity and dynamic efficiency of domestic firms. Shoe leather costs are the extra effort that must be made by households and firms to seek out low prices. Menu costs are associated with having to regularly re-price products to bring them in line with general inflation. Inflation can lead to a loss of jobs through its affect on costs. As costs rise firms may substitute labour with new technology. Markets work best when prices go up and down if prices keep rising resource allocation is distorted.
6. Administrative costs
8. Unemployment
9. Distortion of the price mechanism
Why is inflation a problem?

8. Creation of money illusion
Economi cs Online
Inflation may lead people to make irrational decisions. For example, if money wages rise workers may decide to work longer hours, but if inflation erodes the value of the wage rise they have been fooled into working longer.
The causes of price instability - demand pull inflation
Demand pull inflation is caused by rising monetary demand following an increase a component of AD, such as:
1. Earnings rising above productiv ity. 2. Cheaper credit following a fall in interest
As the economy approaches full employment excessive AD pulls up prices LRAS
Price Level
SRAS
P1 P
AD Y
Yf
Y1
National Output (Y)
Economi cs Online
Changes in the savings rate

The savings rate (ratio) shows the % of national income which is saved, rather than spent. Sudden changes in the savings ratio are an indicator of future changes in spending and AD, and can be a prelude to inflation or deflation. A rise in the Economics Online 2011 savings ratio
Cost push inflation
Rising costs push the SRAS upwards, but the LRAS is not affected. Common causes include:
1. Oil price shocks, caused by wars or decisions by OPEC to restrict output. 2. Increases in farm prices following a
Price Level
LRAS
SRAS
SRAS
P1
AD Y1
Yf
National Output (Y)
Exchange rates and cost push inflation

What happens if exchange rates fall?
Economi cs Online
A fall in the exchange rate will mean that more currency is required to purchase a given quantity of imports. After a time lag this is likely to feed its way into the retail pricesof imported products. Given that around 35% of the CPI basket of finished consumer goods and services are imported, the general effect of a fall in the exchange rate is to raise the CPI. In addition, imported raw materials are also more expensive so costs of production will rise for those firms that source their inputs from abroad.
Why is deflation a problem?
Economi cs Online
If the price level falls an economy experiences price deflation. Deflation can cause the following economic problems: 1. Delayed consumption
Consumers may delay consumption, waiting for prices to fall even further. This can have a negative impact on AD, output and incomes. Because nominal interest rates cannot fall below zero, falling prices cause real rates to rise. For example, if nominal interest rates are 3% and inflation is 1%, real interest rates are 2%. But if the price level falls by 1%, real interest rates (3 [- 1]) rise to 4%.
2. Rising real interest rates
Why is deflation a problem?
Economi cs Online
3. A rise in debt burdens and a deterrent to borrowing

Debt burdens rise for households that have borrowed in the past. Many debts are fixed, such as fixed mortgages and personal loans, so they do not fall as prices fall. Falling prices for firms also creates a debt burden problems. This is because economic confidence falls as households and firms save rather than spend. Long term recession following deflation is often called the Japanese disease, given that, for a long period during the 1990s, Japan seemed trapped in a deflationary spiral.
5. Recession
tment falls due to a negative accelerator effect. This creates a downward deflationary spir of.
Causes of deflation
Following a positive supply shock:
Price Level
Deflation tends to occur when the economys capacity (indicated by th LRAS AD SRAS expands from A to B. Prices fall and A consum P ers expect B prices to fall P1 further, delaying AD National consum Income (Y) Y2 Y Y1 ption AD Economics Online 2011 shifts to
Economi cs Online
Unemployment
Unemployment
Economi cs Online
The level of unemployment has been a key economic objective ever since the mass unemployment experienced in the 1930s.
The costs of unemployment

1. Opportunity cost 2. Waste of resources 3. The Chancellor loses revenue 7. Erosion of human capital 9. Lower incomes 10.Externalities 10.
Economi cs Online
UK unemployment
Both claimant count and the ILO survey show that UK unemploy ment fell to record lows by 2007. However, since the recession of early 2008, unemploy
Types of unemployment
1. Cyclical
Economi cs Online
This is unemployment as a result of a downturn in AD. Unemployment levels of 3 million were reached in the UK in the recessions of 1980-82 and 1990-92. In the most recent recession, unemployment rose to over 2.5 million. Structural unemployment occurs when certain industries decline as a result of long term changes in market conditions. This may the result of globalisation. When structural unemployment affects local areas of the economy it is called regional unemployment. Classical unemployment is caused when wages are Economics Online 2011 too high. This view of unemployment dominated
2. Structural
3. Regional
4. Classical
Types of unemployment
5. Seasonal
Economi cs Online
Seasonal unemployment is created because certain industries only produce or distribute their products at certain times of the year. Industries where seasonal unemployment is common include farming and tourism. Frictional unemployment, also called search unemployment, occurs when workers lose their current job and are in the process of finding another one. This type of unemployment is less easy to identify, and is defined as a situation when workers choose not to work at the current equilibrium wage rate. For one reason or another, workers may elect not participate in the labour market. This is a term associated with New Classical and Economics Online 2011 monetarist economists. It is defined as the rate of
6. Frictional
7. Voluntary
8. The natural rate of unemployment
Structural unemployment and mobility
Economi cs Online
Labour immobility is likely to increase structural unemployment. This is because the industries which are growing and are short of labour cannot soak-up surplus labour from declining industries if labour is immobile. There are three main types of labour immobility.
1. Geographical where workers are not willing or able to move from region to region, or town to town. This is made worse by immense house price variation between regions. 2. Industrial- where workers are not willing or able to move between industries, such as from engineering to broadcasting. 3. Occupational where workers find it difficult to change jobs within an industry. Again, a lack of skills or knowledge can deter individuals from re-training.
Economi cs Online
NAIRU
NAIRU
Economi cs Online
NAIRU - the Non-accelerating Inflation Rate of Unemployment - can be said to exist when demand deficient unemployment is zero. It is the unemployment that still exists if the economy is operating at its full potential. It is composed of structural, frictional and voluntary unemployment. It is usually assumed that it is the level of unemployment when the economy is at its Long Run Phillips Curve. In the 1980s it was generally thought that NAIRU in the UK was around 7%,but effective supply-side policy during the 1990s and 2000s reduced NAIRU to around 5%. (Source: ONS).
1.
Economi cs Online
Why is there still unemployment when the economy is in equilibrium?

There are two rival views: 1. The New Classical view - this view argues that unemployment at equilibrium exists because people choose not to work its is voluntary . These economists often refer to the natural rate of unemployment (NRU) rather than NAIRU. 2. The New Keynesian view is that all unemployment is involuntary - they have three different explanations as to why unemployment persists, even when there is no demand deficiency:
New Keynesian theory of persistent unemployment
Economi cs Online
1. Wage rigidities in reality wages are slow to adjust to changes in the demand and supply of labour, and markets do not clear quickly. 2. Efficiency wage theory firms must set wages above market clearing to ensure a supply of good workers. 3. Insider-outsider theory some workers are permanently excluded from participating in labour markets.
Economi cs Online
The Financial Sector, Monetary Theory and Monetary Policy
The importance and role of money

What is money?
Economi cs Online
Money is anything that is acceptable in the settlement of a debt. For something to be used as money it should be portable, divisible, durable and stable in value. The advent of money as a medium of exchange replaced the need for exchange through barter in modern economies notes and coins are only a small fraction of total money, with most money being in the form of bank accounts.
The importance and role of money

Money supply
Economi cs Online
Money can be created in two ways: 1. New bank lending - new cash deposits by customers can trigger a multiple credit expansion by the banks money increases when fresh loans are made to customers. How much extra credit can be created is given by the credit multiplier, which is 1/Cash Ratio.
For example, if the cash ratio is 0.1, then the credit multiplier is 1/0.1 = 10. So a fresh cash deposit of 1,000 could lead to fresh advances to customers of 10,000.
2. Issuing Treasury bills - the second way new money can be created is when the government borrows from the money market by issuing Treasury Bills, which add to money supply. Banks see these Economics Online Bills as good as cash,2011 and continue to make the
Measures of the money supply
Economi cs Online
Money can be officially measured in narrow terms or broad terms Narrow money
M0 (M nought) is the official measure of narrow money in the UK and consists of notes and coins in circulation outside the Bank of England plus bankers' operational deposits with the Bank. The main reason for looking at M0 is because of its link with high street spending, and inflation. MO is also called high powered money because of its strong impact on the economy. M4 is broad money and is MO plus private bank deposits, both current accounts and deposit accounts.
Broad money
u n t o f m o n e y i re q u i d fo r tra n sa cti n s. T h i i n o t a ffe cte d b y i te re st ra te s, so i ve rti s re o s s n s ca ra te s
The demand for money
Why do Interest households rates and firms T h e p re ca u ti n a ry d e m a n d i a l u n re l te d to i te re s o s so a n wish to hold ra te s their wealth Tra n sa cti n s o in a D em and monetary Fi a n ci la sse ts a re a n a l rn a ti ca u h o nd i g m o n e y th e sp e cu l ti d e m n a te ve to tio l a r n a ve Pre form? ra te s y dem and According to Keynes Liquidity Preference S p e cu l ti a ve dem and Theory Li u i i q d ty people Pre fe re n ce require ( total dem and) money liquidity - for Q three reasons: Economics Online 2011
1. To
Money markets and interest rates

If we add in the money supply we can find the equilibrium interest rate. For example, the money market will clear when interest rates are 5% - with the supply of money (M) equalling the demand (L). The money supply is
Interest rates
M oney S u p p l (M ) y
5% Li u i i q d ty Pre fe re n ce (L) M
Changing interest rates
Interest rates
Short-term interest rates are set by M oney the e d a t a h ig h e r i te re st ra te u py lyp e n m a rke t o p e ra ti n s in th i ca se s Monetary S b po l b ri m i re - e sta b l sh i u s i n o s Policy syste m Committee (MPC). Open Market Operations are 6 % also used to 5% create a shortage or Li u i i q d ty surplus of Pre fe re n ce money by selling or buying Q securities, thus M1 M altering the Economics Online 2011 money supply
Monetarism
Economi cs Online
Monetarism' is closely associated with Classical economics. Monetarism is an economic philosophy which believes that economic prosperity depends upon understanding the link between money and the real economy (prices, output and employment), and the effective control of the money supply. Although monetarism dates back to English philosophers of the 18th Century its modern origins lie largely with the work of two economists:
Irving Fisher of Yale University, writing in the early 20th century, and Milton Friedman of Chicago University, writing in the late 20th century
Economi cs Online
Monetarists, like Friedman, believe that:

1. Money can be defined - money is defined as anything generally acceptable with which to settle a debt. 2. Money can be controlled - monetary authorities can increase or decrease the amount of money in the economy. 3. Changes in money have a direct and measurable effect on the rest of the economy - money supply has a significant affect on household and firms spending. 4. Inflation and deflation are always and everywhere a monetary phenomenon - changes in money are always the cause of price changes.
Money and inflation - The Fisher equation
Economi cs Online
Fisher proposed that there was a stable and predictable relationship between the quantity of money in circulation in an economy, and the price level, using his famous equation: MV = PT, where:
M = the stock of money V = the velocity of circulation P = average prices T = the number of transactions
If we assume V and T are constant - as an economy approaches full employment - then changes in M must lead to the same proportional changes in P. The policy implication is that the monetary authorities should ensure that money supply is controlled effectively controlling the money supply means stabilising prices!
Modern monetary policy

The Monetary Policy Committee.
Economi cs Online
Monetary policy in the UK is undertaken by the Bank of Englands Monetary Policy Committee (MPC). The MPC has nine members, four of whom are appointed by the Chancellor. It meets each month to discuss current and future monetary policy options. The MPC has one goal to hit its inflation target of 2%. The inflation target is symmetrical a rate of inflation below the target is considered as bad as a rate of inflation above the target. Changing official interest rates is the most visible of the MPCs tools.
Modern monetary policy

The official rate
Economi cs Online
The interest rate the MPC fixes is called the official rate this is the rate that the Bank of England will charge for short-term loans to other banks or financial institutions. Other rates of interest in the economy, such as mortgage rates, will adjust in line with changes to the official rate.
Monetary policy
Why isnt the inflation target zero?
Economi cs Online
There are two reasons why the inflation target is set above zero: 1. A positive rate allows real interest rates to become negative at times of weak demand. Real interest rates are nominal interest rates less the inflation rate. Nominal interest rates can never be negative as banks will always charge for borrowing from them. It may be helpful for the Bank of England to make real interest rate negative at times of a deep recession - so having a positive inflation target allows this to happen. 2. Inflation cannot be measured with perfect precision, and it is safer to have a positive inflation target as this provides a margin of safety.
How do interest rates work?
Economi cs Online
1.
2.
3. 4.
Interest rates are set to achieve a target inflation rate it can take up to two years for a change to fully work. Changes transmit their way to AD in the following ways: Consumer demand is affected because changes in interest rates affect savings, which indirectly affect spending. For households or firms with existing debt, such as a mortgage, a change in rates affect repayments, and hence individuals have more (or less) cash after servicing there debts. Changes in rates affect the cash-flow firms and households. In the case of new debt to fund spending, borrowing is also encouraged (or discouraged) following interest rate changes. Interest rates also affect consumer and business confidence, and Economics Online 2011 spending.
Economi cs Online
5. Asset values are also affected by interest rates a fall will tend to make firms more profitable and they may pay higher dividends to shareholders, which can trigger an increase in spending. 6. Finally, interest rates may affect the exchange rate, which can also influence export demand - a rise in interest rates may push-up the exchange rate, pushing up export prices and reducing overseas demand. Changes in the exchange rate also affect the price of imports, which also affect the inflation rate.
Summary of the monetary transmission mechanism

Market interest rates RISE
Economi cs Online
Asset prices FALL
Domestic demand inflation Domestic demand TIGHTENS
Official RISE interest rate

Expectations WORSEN
Inflationary inflatio Total PRESSUR
Exchange rates APPRECIATE Import
prices - cost inflation Import prices FALL
Recent UK interest rates

In recent years interest rates have been adjusted to reflect changing conditions. 2000 2005
Rates fell quickly to their lowest level for 25 years, to help stimulate demand.
2006-2007
Rates were pushed up into a neutral zone Economics Online 2011 at around
Quantitative easing
Quantitative easing is a process whereby the Bank of England, under instructions from the Treasury, buys up existing bonds in order to add money directly into the financial system. The process of doing this is called open market operations, and it is regarded as a last resort when low interest rates fail to work. When interest rates approach zero, but an economy remains stubbornly in recession, further interest cuts are impossible. This is the position that faced central bankers in early 2009. Interest rate policy in these circumstances becomes impotent as nominal interest rates cannot fall below zero.
Quantitative easing involves the following steps:

The Bank of England purchases existing corporate and government bonds held by banks and corporations with electronic money, rather than notes and coins. These funds are credited to the bank and become a reserve asset. This means that, via the credit multiplier, banks can lend out to corporate and individual customers.
Evaluation of monetary policy

The advantages
1. Powerful and direct impact
Evidence shows that interest rates have a direct and powerful effect on household spending - the evidence suggests that UK consumers are interest rate elastic.
2. Independence
The Bank of Englands Monetary Policy Committee is independent from government and can make decisions free from political interference.
3. Flexibility
Interest rates can be changed on a monthly basis, and this contrasts with discretionary fiscal policy which cannot be introduced as such regular intervals.
4. A rapid effect on expectations

While the full effects of interest changes may not be experienced for up to a year, there is often an immediate effect on confidence. The time-lag on output is estimated to be around one year, and on the price level, around two years.
Evaluation of monetary policy

The disadvantages
1. Time lags
There are still time lags to see the full effects, and there are some negative effects.
2. Trade-offs
Raising interest rates can negatively affect: 1. Investment spending 2. The housing market 3. The exchange rate and hence the balance of payments
3. The dual economy

There is also the problem of the dual economy - are high rates set for the booming service sector, or low rates for the depressed manufacturing and export sector?
4. Difficult to control money

The money supply is difficult to control in practice, so controlling interest rates is preferable.
5.
Economi cs Online
Other criticisms of quantity controls

1. A large proportion of money is bank lending it is difficult in a free market economy to restrict the ability of banks to lend. 2. If an economy is in the so-called liquidity trap changes in the money supply have little affect on the real economy because they have little effect on interest rates this has existed in Japan over the last 10 years.
Monetary Policy in Europe

The European Central Bank (ECB)
Economi cs Online
The ECB meets on a monthly basis to determine two things:

1. The level of interest rates across the Eurozone those 16 countries that share the Euro 2. The quantity of money in circulation
The primary purpose of the ECB is to control Eurozone inflation so that the value of the Euro remains constant and strong. It also provides liquidity to the system when needed. If an EU country joins the Euro zone its central bank cedes much of its power to the ECB. The aim of the ECB is to keep inflation below 2%, but as close to 2% as possible to avoid deflation.
Economi cs Online
The Public Sector and Fiscal Policy
The public sector - government expenditure
Economi cs Online
Central and local government the public sector spends money for a variety of reasons. These include:
1. To supply goods and services that the private sector would fail to, such as public goods, merit goods, and welfare payments and benefits. 2. To achieve supply-side improvements in the macro-economy, such as spending on education and training to improve labour productivity. 3. To reduce the likelihood or effects of negative externalities, such as pollution controls. 4. To subsidise specific industries which may need, for one reason or another, financial support that would not be available from the private sector. 5. To help redistribute income and achieve more equity. 6. To inject extra spending into the macro-economy, Economics Online 2011 to helpachieve increases in aggregate demand
Fiscal policy
What is fiscal policy ?
Economi cs Online
Fiscal policy is the deliberate adjustment of government spending, borrowing or taxation to help achieve desirable economic objectives. There are two types of fiscal policy, discretionary and automatic.
1. Discretionary policy refers to policies which are decided, and implemented, by one-off policy changes. 2. Automatic stabilisation, where the economy can be stabilised by processes called fiscal drag and fiscal boost.
Types of fiscal policy
Government Spending
Economi cs Online
The main areas of UK governm ent spending in 2010, which totalled 681bn, were:
1. Social p r o t e c ti
Health 18%
Education 12%
Law and Order 7% Defence 7% Housing 5% Interest 6%
Social protection 35%
Borrowing 6%
Central and Local government borrowing
Economi cs Online
If revenue is insufficient to pay for expenditure then government must borrow. Local authorities can borrow if their revenue from the Council Tax and central government support is insufficient to meet their spending. If the borrowing requirements of both central and local government are added together the amount of borrowing required is called the public sector net cash requirement (PSNCR). The need to borrow varies greatly with the business cycle. The previous Chancellors golden rules for borrowing were:
1. Firstly, to balance the books over a trade cycle, and 2. Secondly, only to borrow to fund capital projects, such as road building, and not to fund noninvestment spending, such as the wages of Economics Online 2011 public sector workers.
Borrowing requirements
Economi cs Online
Fiscal deficits and the National Debt

What are fiscal deficits?
Fiscal deficits occur when the revenue received by government is less than spending during a financial year.
Hypothetical example to illustrate how the Nation calculated .
Billions 2008
Government spending Revenues 500 480 20 20
2009 550 520 30 50
2010 600 560 40 90
2011 650 600 50 140
What is the national debt?
The national debt is the Borrowing cumulative amount of annual borrowing. National
Debt
What causes a rising national debt?
Tax revenues fall and government spending rises as the economy slows down or goes into recession. Economics Online 2011 Householders and firms
Economi cs Online
Is a rising national debt a problem?
Yes, if:
1. It is a high share of GDP. 2. It is persistent and not selfcorrecting. 3. It could be inflationary as money must be created to pay for the deficit. 4. This may cause downward pressure on the exchange rate. 5. It may require taxes to rise causing a disincentive effect.
European stability pact limit
Central and local government spending

Changing the level of public spending
Economi cs Online
Using public spending to stimulate economic activity has been a key option for successive governments since Keynes argued that public spending should rise during a recession. There are two types of spending:
1. Current spending, which is expenditure on wages and raw materials. Current spending is short term, and has to be renewed each year. 2. Capital spending, which is spending on physical assets like roads, bridges, hospital buildings and equipment.
Evaluation of discretionary public spending

The advantages of using public spending
Economi cs Online
1. Public spending can be increased to help stimulate the macro-economy by increasing the level of AD. 2. If the spending is on capital items, then infrastructure can be improved, and this can help improve competitiveness and economic growth. 3. Spending on infrastructure also provides an external benefit to the rest of the economy. 4. Public spending can be targeted to achieve a wide range of economic objectives, such as reducing unemployment, achieving more equity, road building, action against poverty, and re-building city centres.
Evaluation of government spending

The disadvantages of using public spending
Economi cs Online
1. There may be a considerable time-lag between spending and the benefits of spending. 2. In trying to promote growth or reduce unemployment government spending can be inflationary. There is a potential trade off between unemployment and inflation, first analysed by A.W. Phillips. 3. Crowding-out critics of a large public sector point to the crowding out of the more efficient private sector. 4. A major constraint to government spending across the EU, is the Stability Pact which limits government borrowing to no more than 3% of national income, and accumulated public debt to no more than 60% of the value of national income.
Crowding out theory
Economi cs Online
Crowding out is the process of squeezing out the efficient private sector as a result of public sector expansion. We can identify two types of crowding out.
1. Financial crowding out - if the public sector expands and needs to borrow from the financial sector long term interest rates may be driven up. This leads to a reduction in private sector investment. 2. Resource crowding out - in a similar way, as the public sector expands there is an increase in the demand for other resources which drives up their price, including wages and rents hence the private sector suffers.
The public sector revenue and taxation

Why raise revenue?
Economi cs Online
Governments receive revenue from a number of sources, including:
Taxation of which there are two types of taxes: Direct, which are taxes on factor incomes, such as personal income tax and corporation tax Indirect, which are taxes on spending, such as Value Added Tax -VAT National insurance contributions (NIC) - is a compulsory contribution from both employer and employee. Charges, such as the congestion charge and parking charges. Licences, such as TV and driving licences. Privatisation of state assets.
Economi cs Online
Local government revenue

Local authorities in the UK have the power to raise revenue via a local tax called the Council Tax. However, council taxes rarely cover all local spending, and local authorities must rely on subsidies from central government . Reform of local authority finances has been proposed, with the following options being considered:
A local income tax A local sales tax Specific local charges, like the London Congestion Charge
Economi cs Online
Tax revenue sources

Tax revenues in 2010
Tax revenues clearly show the importance of income tax, national insurance and VAT as the three major sources of tax revenue for the UK Treasury.
Automatic Stabilisation
Fiscal drag
Economi cs Online
If we assume that direct tax rates are progressive which occurs when the % of income going in taxes increases with income and that welfare benefits are paid to the poor and unemployed then rapid increases in national income would be slowed down automatically. Fiscal drag means as incomes rise in a boom the impact of rising incomes for the better off is reduced as they pay proportionately higher taxes, and the impact of rising incomes on the poor and unemployed is reduced as they come off benefits, and start to pay tax. The effect is that the increase in disposable income is moderated.
Automatic stabilisation fiscal boost

Fiscal boost
Economi cs Online
Similarly, a potentially rapid and deep decrease in national income would be held back through fiscal boost. Fiscal boost means as incomes fall in a recession the impact of falling incomes for the better off is softened as they pay proportionately lower taxes, and retain more post-tax income. The impact of falling income is to increase unemployment, but rather than experience a complete collapse in personal income, the unemployed and poor receive benefits, and spend more than they would have without such benefits hence a downturn in the economy is also moderated
Economi cs Online
The effects of fiscal drag and fiscal boost

Fiscal drag and boost
Economic growth %
Fiscal drag reduces the rate of growth of national income, whereas fiscal boost limits the contraction Progressive taxes and of national income.
Progressive taxes reduce the rate of growth in the eco Without

stabili sers
With stabili sers
benefits stop the economy contracting too quickly
Discretionary changes to tax rates

Altering tax rates
Economi cs Online
In addition to automatic stabilisation taxes can be deliberated raised or lowered to control or expand household spending, and AD. This is called discretionary fiscal policy. Income tax can be adjusted in a number of ways, such as by changing:
1. The tax free allowance all income earners are allowed to earn an amount of income before they start to pay tax. 2. The basic tax rate - for example, the basic rate could be increase from its current level of 20%. 3. The number of tax bands for example, in 2009 a new higher rate band of 50% was added. 4. The range of income in each band each band could be widened or narrowed by increasing or reducing the Online 2011 of income in each band. Economics range
Evaluation of taxation the advantages

Evaluation - the advantages of using taxes
Economi cs Online
1. Indirect taxes can be targeted very specifically to alter behaviour, such as to reduce pollution by imposing polluter pays taxes, or to reduce cigarette smoking by imposing special taxes on tobacco. 2. Taxation has the ability to automatically help stabilise the macro-economy , through fiscal drag and boost, which can provide a natural shock absorber to economic shocks. 3. Discretionary changes in direct taxes can help regulate AD which can be implemented at times when shocks are severe, or when other policies are ineffective. 4. Tax policy can also be used to help re-distribute income, and Economicsachieve equity. help Online 2011
Taxes and Equity
Economi cs Online
In terms of achieving equity, indirect taxes like VAT are regressive and create an inequitable burden. The largest burden being on the poor and low paid. Income tax and other direct taxes can be made progressive and can help achieve equity - but they may have a disincentive effect, leading to inefficiency. Hence, equity and efficiency are in conflict - the best resolution is a mix between direct and indirect to achieve a balance between the needs of equity and efficiency.
Evaluation of taxation the disadvantages

The disadvantages of using taxes
Economi cs Online
1. Changing tax rates, allowances and bands, is highly complex in comparison with changing interest rates, with only small adjustments being made each year in the annual budget. 2. Households may alter their savings following tax changes, so the effect on household spending of an increase or decrease in taxes may be weak. 3. There may be considerable time-lags between changing taxes and changes in household spending. 4. Higher taxes may have a disincentive effect on work and enterprise, as some individuals alter their perception of the relative costs and benefits of work, in comparison with leisure.
The disincentive effect of direct taxes

The Laffer curve
Laffer proposed that at tax rates of 100% and 0% the government would receive no revenue. At 100% tax, no one would work, and at 0% tax no tax would be paid. However, between O% and 100%
Tax Revenue
Economi cs Online
Disincentive effect
Laffer Curve
0
Tax Rate 100%
Income and substitution effects
Economi cs Online
However, the disincentive effect will only work under certain circumstances to understand this we must distinguish the income and substitution effects.
1. The substitution effect - this suggests that, following an increase in direct taxes, substitutes to work (i.e. leisure) seem more attractive and people will work less also called the Laffer effect 2. The income effect - this suggests that an increase in taxes will reduce people's real income and they need to work harder to achieve the same real income
These two effects are contradictory if the income effect is greater than the substitution effect, an increase in taxes will lead to more labour being supplied. However, if the substitution effect is greater an increase in taxes will lead to less labour being supplied.
Economi cs Online
The Phillips Curve
The Phillips curve and fiscal policy

The Phillips Curve
In 1958 AW Phillips published research showing the relationship between wage inflation and unemployment rates in the UK, between 1860 and 1958. He plotted annual rates on a scatter diagram and found the line of best fit. It appeared to show an inverse and stable relationship between wage
Inflation (%)
1922
1927 1926 1924 1923 1925
Unemploymen t (%)
The Phillips curve

Inflation The plotted line (%) became known as the Phillips Curve - other countries found similar curves for their own economies. The curve suggested P1 that changes in the level of unemploymen t have a direct P and predictable U1 effect on the level of Economics Online 2011 inflation.
The Phillips Curve U Unemploymen t (%)
Explaining the Phillips curve

The accepted explanation during the 1960s was that a fiscal stimulus would trigger the following:
An increas e in the demand for labour as govern ment spendin g generat es growth. The pool Inflation (%)
P1
T h e P h ilp s li C u rve
U1
Unemploymen t (%)
Exploiting the Phillips curve
Inflation It became (%) accepted that policy makers could exploit the trade off a little more d of the 1970s the stable and inverse relationship began to break down . As policy makers unemployment meant a little less inflation. During the 1960s and 70s governments around the P world would select a rate of inflation they wished to P1 T h e P h ilp s li achieve. This C u rve policy became known as Unemploymen U U1 stop-go, and t (%) relied strongly Economics Online 2011 on fiscal policy
The breakdown of the Phillips Curve

By the mid 1970s Inflation it appeared (%) that the Phillips Curve trade off no longer existed in its original form. American economists Friedman and Phelps offered one explanation: 1. There was a series of short run Phillips Curves and a long run Phillips Curve. 2. This was fixed at the natural rate of unemployment Economics Online 2011 (NRU) referred
Long Run Phillips Curve
Short Run Phillips Curves
NRU The Natural Rate of Unemployment
Unemployment (%)
What happened? The New Classical View

Assume the economy starts Inflation (%) at point A (the NRU) and the government creates a stimulus through a monetary expansion -more money in the economy. P2 Initially the economy moves to B, but money P1 illusion has been fooling everyone! When firms P realise this the reduce their demand for Economics Online 2011 labour back to
Long Run Phillips Curve
C A
Short Run Phillips Curves
U1
NRU Unemployment The Natural Rate of (%) Unemployment
Using AD/AS to show the Phillips Curve Effect

The New Classical view
Assume the economy starts with an output gap, at Y. An increase in government spending will increase the money supply and increase AD, leading to a rise in income and a fall in unemployment. But, households will successfully predict the higher inflation, and build these expectations into their wage bargaining. They
Price Level
LRAS SRAS1 SRAS
P2 P1 P AD1 AD Y
Y1
National Output (Y)
Economi cs Online
Supply side policy
Supply-side policy
Economi cs Online
Supply side policy includes any policy that improves an economys ability to produce. There are a number of individual actions that a government can take to improve supply-side performance, including: Measures to improve labour productivity and flexibility, such as:
1. Using the tax system to stimulate output, rather than to alter demand. This commonly means lower direct tax rates, such as lower Income tax and lower Corporation tax. This should act as an incentive to join the labour market, or to work harder. 2. Greater competition in labour markets - through legislation to eliminate restrictive practices, and remove labour market rigidities, such as the protection of employment. For example, as part of Economics Online 2011 reforms in the 1980s, trade supply-side
Supply-side policy
Economi cs Online
3. Measures to improve labour mobility will also have a positive benefit on labour productivity, and on supply-side performance. 4. Better education and training to improve skills, flexibility, and mobility also called human capital development is also an important supply-side policy option, and one favoured by recent UK governments. 5. The adoption of performance related pay in the public sector is also seen as an option for government to help improve overall productivity. 6. Similarly, government can encourage localised rather than centralised pay bargaining. National pay rates rarely reflect local conditions, and reduce labour mobility.
Economi cs Online
Measures to improve competition and product market efficiency:

1. Government assistance to firms to encourage firms to use new technology, and to undertake innovation, such as through grants, or through the tax system. 2. De-regulation of product markets to bring down barriers to entry, and encourage new entrants. The effect of this would be to make markets more competitive and increase efficiency. Promoting competition is called competition policy. 3. Privatisation of state industry is also a central part of supply-side policy, and can contribute to the spread of an enterprise culture. 4. The supply side can also be improved if there is dynamic entry of new firms. Small businesses are often innovative and flexible, and can be Economics Online 2011 helped in a number of ways, including start-up
The effects of supply-side policy

Price to the right in the LRAS curve creates the possibility of a lower price level and more Level term Successful supply-side Actual equilibrium in the short run is determined by the
policy will shift the LRAS curve to the right. This can help reduce inflation in the long term because of efficiency and productivity gains. Such policies create jobs and growth
LRAS
LRAS1
SRAS
P P1
A B
AD
Y
Y1
National Income (Y)
Economi cs Online
Conflicts of policy objectives
Conflicts of objectives
Conflicts of policy objectives occur when, in attempting to achieve one objective, another objective is sacrificed. There are numerous potential conflicts, including: 1. Full employment vs low inflation
Economi cs Online
The conflict between employment and prices is the most widely studied in economics. If policy makers attempt to undertake job creation by injecting demand into the economy - by expansionary fiscal or monetary policy - there is a danger that inflation will be driven up. This conflict is best explained by reference to the Phillips Curve. It is likely that the trade-off still exists, despite the UK economy approaching full employment and prices still remaining stable in recent years.
Conflicts of objectives
2. Economic growth vs stable prices
Economi cs Online
This conflict is similar to the employment/inflation trade-off, and can be understood through the Phillips Curve and the AD/AS model. Using the AD/AS model, if an economy grows too quickly through a fiscal or monetary stimulus of aggregate demand - then aggregate supply may not be able to respond and prices are driven up. As an economy grows import spending is stimulated relative to export sales. Policy makers have to be aware that a dash for growth could lead to balance of payments problems. Economic growth can generate both consumption and production externalities.
4. Economic growth vs a balance of payments
5. Economic growth and negative externalities
Economi cs Online
Other conflicts:
5. Flexibility vs equity
In attempting to achieve a flexible economy that is, one that copes with globalisation the distribution of income may widen. For example, a flexible economy can be partly achieved by having a flexible labour market, and to achieve this there may be an increase in part-time employment and a reduction in worker protection and job security. However, it can also be argued that, in the long term, the reduction in unemployment associated with flexibility more than compensates for the rise in part-time work and job insecurity.

Economi cs Online
6. Crowding-out public sector vs private sector

Crowding-out is a conflict between the public and private sector. For example, public sector borrowing to compensate for market failures and provide public and merit goods, might drive up long term interest rates and crowd-out private sector investment. The desire to achieve short term stability might put at risk the prospects for long term growth.

UK Economy in A Global Context

Caricato da

Informazioni sul documento

Descrizione originale:

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

UK Economy in A Global Context

Caricato da

Copyright:

Formati disponibili

The UK Economy in a global context

Economics Online 2011

Economics Online 2011

Economics Online 2011

Economics Online 2011

Benefits to countries: countries

Economics Online 2011

The costs of globalisation

The costs of globalisation

6. Increased risks associated with interdependence of economies:

Inequality and development

Economics Online 2011

Foreign direct investment (FDI)

Economics Online 2011

Foreign direct investment (FDI)

The benefits to firms of investing abroad

FDI in the balance of payments accounts

Economics Online 2011

Economics Online 2011

Share of EU inward investment

The UK receives 22% of all inward investment into the EU

Source HSBC, 2005

Economics Online 2011

Why is FDI volatile?

Economics Online 2011

Trade liberalisation and protection

Economics Online 2011

Liberalisation and protectionism

Economics Online 2011

Economics Online 2011

Specialisation is the basis of free trade

Economics Online 2011

Economics Online 2011

Using PPFs to show advantage

Comparative Absolute advantage

Vans Only 50% more productive

Economics Online 2011

If countries specialise and employ the

Economics Online 2011

Opportunity cost ratios

Economics Online 2011

The benefits and costs of free trade

Economics Online 2011

Motives for protection

Motives for protection

Economics Online 2011

QUOTA QUOTA Imports

Dome stic supp ly

World supply Domestic Demand

Economics Online 2011

The impact of tariffs

The Tariff diagram

World Supply + Tariff

Economics Online 2011

Costs and benefits of trading blocs

World Supply + Tariff World Supply World Supply

Economics Online 2011

Costs and benefits of trading blocs

2. Retaliation and trade disputes

5. Inefficiencies and trade diversion

Economics Online 2011

Stages in economic integration