Download © Economics Online 2011

© Economics Online 2011
© Economics Online 2011
Globalisation

Globalisation is the integration of markets in the world economy.
Markets where globalisation is particularly common include:
1. Financial markets, including capital, money and insurance
markets.
2. Commodity markets, such as markets for oil and coffee.
3. Product markets, such as markets for motor vehicles and
consumer electronics.
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Globalisation
Factors leading to globalisation
1.
2.
3.
4.
Developments in transport and communications – for example, the
internet has enabled fast and 24/7 global communication.
Common technology - global firms use common IT systems helping to
integrate their global operations.
Capital mobility - when capital can move freely from country to country,
it is easier for firms to locate and invest abroad, and repatriate profits.
Free and open trade – the relative success of the World Trade
Organisation (WTO), and the collapse of communism.

Over the last 30 years, trade openness, which is defined as the ratio of
exports and imports to national income, has risen from 25% to around 40%
for industrialised economies, and from 15% to 60% for emerging economies.
(Source: The Bank of England, 2006)
5.
Growth of powerful multi-national companies (MNCs) - there has been a
rise in significance of ‘global brands’
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Globalisation
The benefits of globalisation for firms
1.
2.
3.
4.
Access to larger markets so that firms can benefit from increased
demand, and economies of scale.
Worldwide access to the cheapest sources of raw materials, which
make firms more cost competitive.
Increased profit for shareholders of MNCs.
Avoidance of regulation by locating production in countries with
softer regulatory regimes, such as those in some developing
economies.
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Benefits to countries:
1.
2.
3.
4.
5.
If trade is free, then countries can benefit from the application of the
principle of comparative advantage.
New trade can be created, a process called trade creation.
Benefits of inward investment to recipient countries, such as sharing
knowledge between firms in different countries.
The macro-economic benefits of increased investment.
Job creation in the more competitive countries.
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The costs of globalisation
1.
2.
3.
4.
5.
The over-standardisation of products through global branding, such
as Microsoft’s Windows, leading to a lack of product diversity.
Diseconomies of scale for large firms, such as difficulties coordinating the activities of firms that operate in many countries.
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.
Loss of jobs in domestic markets because of increased, and in some
cases unfair free trade.
Loss of jobs caused through structural unemployment, causing a
widening gap between rich and poor within a particular country.
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The costs of globalisation
6.
Increased risks associated with interdependence of economies:
Because countries are increasingly dependent on each other, a negative
shock in one country can quickly spread to other countries – e.g. the
recent credit crunch.
b. Over-specialisation - countries can become over-reliant on producing a
limited range of goods for the global market. Many LDCs suffer by overspecialising in a limited range of products, such as agriculture and
tourism.
a.
7.
8.
9.
Possible increased inequality as richer nations benefit relative to
poorer nations, as suggested in the Kuznets Curve.
Increased trade associated with globalisation has increased
pollution and helped contribute to CO2 emissions and global
warming. It has also accelerated the depletion of non-renewable
energy resources, such as oil.
The increased risks of globalisation partly explains the popularity of
regional trading blocks, and the rise of protectionism.
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Inequality and development
The Kuznets curve
Globalisation may
widen the gap
between rich and poor
countries.
 The greatest inequality
can be observed as
countries 'take-off' in
their development,
leading to considerable
wealth creation for the
few, who quickly gain
from development,
relative to others.

Inequality
Inequality increases
in the early stages of
development
Kuznets
Curve
Development
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Foreign direct investment (FDI)


FDI is the flow of real capital between countries, and is undertaken by
private sector firms and by governments.
A large proportion of FDI is associated with cross-border mergers
between private firms.
The benefits to firms of investing abroad
1.
2.
3.
4.
5.
6.
Reduction in transport costs - locating within a foreign market
reduces transport costs to that market, especially for ‘bulk increasing’
products.
Access to the country’s markets.
Access to cheap labour and to skilled labour.
Access to local knowledge and expertise.
Exploitation of economies of scope, especially managerial economies,
where fixed management costs can be spread between territories.
Avoidance of barriers to trade, such as tariffs and quotas.
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Investment income
7.
Increased investment income - outward investment can lead to
increased overseas investment income for a country, such as:
Profits from overseas subsidiaries.
2. Dividends from owning shares in overseas firms.
3. Interest payments from lending abroad.
1.

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.
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Inward investment

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 country’s capital account. FDI represents
an inflow, or credit, on the capital account.
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Who invests?
The USA, France and
the UK are the three
most important
international investors,
and recipients of
investment.
FDI Flows 2009 $(US)Bn
Source: UNCTAD
5000
4500
$4,302
4000
3500
Outward FDI
Inward FDI
$3,120
3000
2500
2000
1500
$1,719
$1,651
$1,378
$1,132
1000
$1,125
$701
500
0
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$834 $912
$850
$596
$804
$463
Share of EU inward investment
EU inward investment



The UK receives 22% of
all inward investment
into the EU (2003).
There are over 18,000
different investors into
the UK, with 1.8m
people are directly
‘supported’ by inward
investment.
Overseas firms account
for around 40% of the
top 100 UK exporters.
Source – HSBC, 2005
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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
de-globalisation.
6000
5000
United States
FDI Investors, 1998 - 2009 $Bn
Source: UNCTAD
France
United Kingdom
4000
Germany
3000
2000
1000
RECESSION
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
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Why is FDI volatile?

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.
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Short questions
1.
2.
Analyse the likely effects on a developing country of your choice of a
fall in inward FDI (at least four points).
Why is FDI volatile?
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Liberalisation and protectionism

1.
2.
Two opposing forces have shaped the changing pattern of world
trade over the last 200 years.
Trade liberalisation - this is the process of making trade free of
barriers such as tariffs and quotas.
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.
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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.
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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.
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 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.
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 Consider the simple example of
two countries producing only
two goods:
 Using all its resources,
Country A can produce 10m
cars or 5m vans, and Country
B can produce 20m cars or
7.5m vans.
Country A
Country B
Cars
10m
20m
Vans
5m
7.5m
 Should they trade?
 Economic theory suggests
that they should trade
because both countries have
a comparative advantage.
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Using PPFs to show ‘advantage’
 Production possibility
frontiers can be used to
illustrate cost advantage.
 Country B’s PPF is further
outward and indicates it
has an absolute advantage
in both goods.
 But it has a comparative
advantage in cars because
it can produce twice as
many, so B should
specialise in producing
cars.
Cars
Comparative
Absolute advantage
advantage
Twice as
productive
Vans
0
Only 50% more
productive
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Numerical example
 If countries do not
specialise, and allocate
resources evenly to both
goods, world output is:
 Cars = 10 + 5 = 15
 Vans = 3.75 + 2.5 = 6.25
 = 21.25 million units
 If countries specialise and
employ the principle of
comparative advantage:
 Cars = 20
 Vans = 5
 = 25 million units
 However, this analysis
does not take into account
how transport would
increase the costs of trade.
Cars
20
15
10
5
2.5
Vans
0
1.0
© Economics Online 2011
2.5
3.75
5
7.5
 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.
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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.
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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
4. Welfare loss associated with loss of trade for domestic producers (loss
of producer surplus).
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Motives for protection
Why engage in protection?

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.
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Motives for protection
7.
8.
9.
Some countries may protect themselves from trade to help ‘save’
their environment -such as from CO2 emissions caused by increased
freight transport.
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.
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

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Methods of protection
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.
b.
c.
d.
e.
Quotas - which are physical limits on the volume of imports.
Public procurement policies – where national governments favour local
firms, such as where a country’s police or ambulance service purchase
only locally produced vehicles.
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.
Health and safety – such as banning imports of unsafe electrical goods.
Excessive bureaucracy – such as deliberately delaying goods at ports and
airports, or unnecessarily complex and length paperwork associated
with trade.
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Quotas




A quota is a physical
limit on imports.
The no-trade price and
quantity are P and Q.
The free trade price and
quantity are P1 and Q1.
A quota of Q2 - Q limits
imports and allows
domestic firms to supply
more, and the price is
pushed up to Pq.
Imports fall to the quota
level, and total supply is
Q4.
Price
The effect of the quota is to shift the
domestic supply curve to the right, by
the amount of the quota
Domestic
supply
Domestic
supply +
quota
P
Pq
P1
Domestic
Domestic
supply
supply
0
World supply
Domestic supply

QUOTA
QUOTAImports
Q2
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Q
Q4
Domestic
Demand
Q1
Quantity
Tariffs

Tariffs are taxes on imported products, usually in an ad valorem
form. They are also called ‘customs duties’.
The impact of tariffs
1.
2.
3.
4.
5.
6.
Domestic consumers face higher prices and lower consumer surplus.
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.
There is a distortion of the principle of comparative advantage.
There is the likelihood of retaliation from exporting countries, which
could trigger a costly trade war.
However, in the short run tariffs may protect jobs, infant and
declining industries, and strategic goods.
Selective tariffs may also help reduce a trade deficit, and reduce
consumption of de-merit good , such as imported tobacco.
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The Tariff diagram
Without trade, domestic
price and quantity are P and
Q.
 If an economy opens up to
world supply, price falls to
P1, Q increases to Q2 domestic producers’ share
falls to Q1!
 The imposition of a tariff
causes price to rise, imports
to fall, domestic producer’s
share of the market, and
producer surplus, to
increase.

Price
However, consumer surplus falls by
more than producer surplus
increases - even adding in tariff
revenue there is still a net loss. The
net welfare loss is represented by the
triangles X and Y.
Domestic
Supply
Consumer
Surplus
P
P2
Producer
Surplus
World Supply + Tariff
Tariff Revenue
World Supply
P1
Domestic
Domestic
supply
supply
0
Q1
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Imports
Q4
Q
Domestic
Demand
Q3
Q2
Quantity
Costs and benefits of trading blocs
The main benefits for members of blocs:
1.
2.
3.
4.
5.
6.
Members can specialise, knowing that they have free access to
others member’s markets. This means there is a more complete
application of the principle of comparative advantage.
Easier access to each other’s markets means that trade between
members is likely to increase - trade creation.
Producers can benefit from the application of scale economies,
which will lead to lower costs and lower prices for consumers.
Jobs may be created in member economies.
Protection from countries outside the bloc
Firms inside the bloc can be protected from cheaper imports from
outside.
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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
Q3 to Q2.
Trade is created, from Q1
to Q2.
Welfare is gained (X + Y)
Price
Domestic
Supply
P
World Supply + Tariff
P1
World
World Supply
Supply
P2
Domestic
supply
Domestic
supply
0
Q3
© Economics Online 2011
Imports
Q4
Q
Domestic
Demand
Q1
Q2
Quantity
Costs and benefits of trading blocs
Trading blocs can generate the following costs:
1.
Loss of benefits of free trade

2.
Retaliation and trade disputes

3.
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.
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.

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© Economics Online 2011
Stages in economic integration
Full economic
integration
A common market, a single currency, central
bank, and common monetary and fiscal policies
Monetary Union
(MU)
Members share a single currency, central
bank, and have a common monetary policy
Common market –
aCustoms
single
market
Preferential
Free
trade
Union
area
trade
area
(FTA)
(CU)
(PTA)
Members eliminate tariffs on all resources,
allowing
free
movement
labour
and capital,
Members
Members
eliminate
tariffsofon
all goods
andservices,
common
micro-economic
policies
eliminate
and
tariffsand
have a common
onon
external
some
all goods
goods
tariff to non-members
© Economics Online 2011
Regional trading blocs (RTBs)

1.
A trading bloc is a group of countries that protect themselves from
imports from non-members. There are several types:
Preferential Trade Area (PTA)

2.
Members eliminated tariffs on some goods
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)

© Economics Online 2011
Regional trading blocs (RTBs)
3.
Customs Unions
These also aim to reduce or eliminate tariffs between members
 But they do have a common external tariff - a common external tariff
means that members must set the same level of tariff against a nonmember

4.
Common Market

Members eliminate tariffs on all resources, allowing free movement of
labour and capital, and common micro-economic policies
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The European Union (EU)
The EU - originally called Common
Market – was formed in 1957,
following the Treaty of Rome.
 The EU has evolved through stages of
integration.
 The aim was to create one market for
all products, capital and labour, by
eliminating trade barriers.
 By 2007, following continuous
enlargement the EU had 27 members.

© Economics Online 2011
Austria
Germany
Norway
Belgium
Greece
Poland
Bulgaria
Ireland
Portugal
Cyprus
Italy
Romania
Czech
Republic
Latvia
Spain
Denmark
Lithuania
Slovenia
Estonia
Luxembourg
Slovakia
Finland
Malta
Sweden
France
Netherlands
UK
The Common Agricultural Policy (CAP)


The EU protects its farmers and growers through its Common
Agricultural Policy (CAP).
Through the CAP European farmers received annual subsidies of
around €43 billion (2010).
The evolution of CAP




CAP was created to ensure continuous food supplies for Europe, and
to provide a fair income for European farmers.
Price support schemes, such as guaranteed prices, were first
introduced in 1962.
By the mid 1980s, over-production created massive surpluses and
this led to major reforms, including the use of set-aside programmes.
By the early 1990s there was a movement away from guaranteed
prices towards direct subsidies to farmers, irrespective of the output
they produced.
© Economics Online 2011
The Common Agricultural Policy (CAP)



The Fischler Reforms, of 2003, continued the process of decoupling
subsidies and farm output, and introduced a green element to CAP,
forcing farmers to meet environmental and animal welfare
standards.
Single Farm Payments (SFP) were introduced in 2005, and set-aside
programmes were abolished in 2009.
The UK receives a controversial rebate against payments into the EU
to compensate for that fact that it receives relatively little income
from CAP in comparison with France and Spain.
© Economics Online 2011
European monetary union and the single currency

1.
2.
3.
2.
3.
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 Euro
area – no country has the ability to alter its own interest rate.
ECOA11
© Economics Online 2011
The case for the Euro
1.
Transparency

2.
Lower transaction costs

3.
Trade between members is more likely to increase because of the greater
confidence of trading with a member in comparison with a non-member.
Job creation

6.
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 creation

5.
There are no commissions to financial intermediaries.
Certainty and investment

4.
The prices of goods, services and materials can be compared and workers
can compare wages, and move to take advantage of higher wages.
With greater trade there should be more jobs.
Discipline

Members cannot use devaluation to ‘hide’ domestic inflation.
© Economics Online 2011
The case against the Euro
1.
Loss of economic sovereignty

2.
Convergence problems

3.
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.
Only one interest rate

Having only one interest rate is not sensible when dealing with a diverse
range of economies and economic circumstances.
© Economics Online 2011
The case against the Euro
4.
Asymmetric shocks
These are external shocks that have an unequal impact on an economy.
The following are examples of recent asymmetric shocks:
1. ‘September 11th’ did not affect all Euro area countries evenly.
2. The collapse of the Argentinean peso in the late 1990s mainly
affected Spain.
3. The handover of Hong Kong to China led many to leave and
relocate to the UK, rather than other European countries.
4. The recent financial crisis affected some economies more than
others (especially those with large financial service sectors).
 In this type of circumstance it is argued that one interest rate (or
common macro-economic policy) will not be appropriate.

© Economics Online 2011
‘Tests’ for membership

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.
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The World Trade Organisation (WTO)


The WTO was formed in 1995, and has its headquarters in Geneva. It
replaced the General Agreement on Tariffs and Trade (GATT) which
was formed in 1947. By 2008 there were 153 member countries.
The purpose of the WTO is to:
To promote free and fair trade through multilateral talks and
negotiations
2. To arbitrate between countries who are in dispute
1.
© Economics Online 2011
The World Trade Organisation (WTO)
Evaluation

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’.
© Economics Online 2011
The Doha Round



The Doha Round of trade talks began in 2001, with major summit
meetings in Mexico (2003), Hong Kong (2005) and Geneva (2004,
2006, and 2008)
The Doha round of talks was also called the development round
reflecting its emphasis on trying to promote free trade for the
benefit of developing nations.
The Cancun talks focussed on:
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.
1.

The talks collapsed because:

The US and EU’s failed to agree reductions in agricultural support and
because some developing countries did not want to agree new
investment rules which make it easier for multinationals to invest.
© Economics Online 2011
The Doha Round



Since the collapse - the USA and EU have returned to bilateral
agreements with favoured nations, rather than multilateral WTO
agreements. This highlights a fundamental weakness of the WTO the failure to promote multilateralism.
The failure of the Doha round 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
© Economics Online 2011
© Economics Online 2011
UK competitiveness
What is competitiveness?

Competitiveness means the ability of a country to compete
effectively in global markets. Competitiveness is closely related to
productivity.
Measuring competitiveness

1.
2.
3.
Competitiveness can be measured in a number of ways, including:
Relative export prices - relative export prices are one country’s
export prices in relation to other countries, expressed as an index.
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.
Unit labour costs - unit labour costs are the cost of labour per unit of
output.
© Economics Online 2011
The World Economic Forum Competitiveness Index

The World Economic Forum lists the following indicators of
competitiveness:
1. Effective institutions - which create an economic environment in which
businesses can develop, and consumers have confidence. These should
be ‘sound, honest and fair’.
2. Effective infrastructure – which provides effective transport and energy
supplies.
3. A sound macro-economic environment, including sound public finances,
and low and stable inflation.
4. A healthy and educated labour force, with an emphasis on higher
education, and the continuous upgrading of skills.
© Economics Online 2011
5. Efficient goods markets, with high levels of competition, and low levels
6.
7.
8.
9.
10.
11.
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.
© Economics Online 2011
UK export competitiveness

Export price competitiveness – this refers to how well a country’s
exports compare in terms of price. This is affected by a number of
factors, including:
Relative UK inflation - even small annual differences can build-up over
time and become significant.
 The relative real exchange rate (RER) – which is the nominal exchange
rate deflated by an index of prices. For example, if the Sterling Index
appreciated by 7% and UK prices rose by 2%, the RER is 107/102 x 100 =
105, i.e. the ‘real’ value of Sterling rose by 5%.
 Labour costs per unit - including wage and non-wage costs.

© Economics Online 2011
Labour productivity

There are two commonly
used indices of
productivity:

130
120
GDP per worker.
2. GDP per hour worked.
1.

140
110
The UK performs relatively
poorly against its major
competitors.
The main causes of the
UK’s poor performance
are lack of investment in
real capital and human
capital.
100
90
80
70
© Economics Online 2011
Index of productivity
UK = 100 (2009)
Source: ONS
The productivity gap




Which ever measure of productivity is used it is clear that the UK lags
behind most of its major competitors.
The difference between the productivity of countries like the USA,
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.
© Economics Online 2011
Factors causing the productivity gap
The productivity gap

1.
According to research by the Economic and Social Research Council
(ESRC, 2004) the UK’s productivity gap is caused by:
The level of capital investment
The level of investment per head in the UK is lower than in other
advanced economies.
 A shortage of skilled labour means that machinery is less effectively
used. Relatively low wages means less incentive for UK firms to
substitute capital for labour.

2.
Information technology

The ESRC found that the use of IT in Europe lags behind that in the USA
because of lower levels of competition, higher levels of regulation and
less desire to change management practices to incorporate more IT.
© Economics Online 2011
Factors affecting UK productivity
3.
Innovation and technology transfer

4.
The lack of competition in Europe may help explain the lower levels of
R&D as compared with the USA.
Skills and human capital development

The ESRC found that that a relative lack of skills in the UK is a primary
cause of the UK’s productivity gap. This appears especially problematic
in terms of management skills. It is argued that the best graduates go
into finance, accounting and consultancy rather than into management.
© Economics Online 2011
Flexible labour markets



The share of total UK
employment composed of
part-time work is high.
This may act as a
disincentive to invest in
labour, and not allocate
sufficient resources to
training and development.
However, labour market
flexibility is commonly
seen as providing
advantages in terms of
lower unemployment and
inflation.
50
45
40
35
30
25
20
15
10
5
0
© Economics Online 2011
% part-time employees, EU, 2009
Source: Eurostat, 2009
Investment per head

Investment per head in
the UK is relatively low.
9000
Investment per head ($) 1990 - 2001
8500
8000
7500
7000
6500
6000
5500
© Economics Online 2011
UK’s manufacturing investment

Many economists attribute the poor level of UK investment in
manufacturing over the last 20 years to:
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
1.
© Economics Online 2011
Investment and interest rates
The demand for capital is
inversely related to
interest rates. For
example, at 4%, the level
of investment is £25b.
 At lower interest rates, say
3%, the profitability, also
called efficiency, of capital
is higher, and demand is
greater, at £50b.
 Conversely, lower interest
rates stimulate
investment.

Interest
rates
4%
3%
Marginal
Efficiency of
Capital (MEC)
Q
£25b
© Economics Online 2011
£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
Keep UK close to its
trend rate of growth
(2.5%) by:
 Monetary policy
 Fiscal policy
To:
 Reduce inflation
 Stabilise the
exchange rate
Improve
infrastructure
Improve
productivity
 Integrated transport
links – e.g. Cross rail
 Subsidies to public
transport
 Reduce congestion
POLICIES TO
IMPROVE
COMPETITIVENESS
Stabilise the
macro
economy
Improve
education and
skills
© Economics Online 2011
 Incentives to learn
 Subsidise university
education
 Subside infant education
– e.g. ‘Sure Start’
 Individual learning
accounts
 Government schemes –
e.g. Learn Direct website
Policies to help improve competitiveness


1.
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:
Improving labour productivity by:
Increasing spending on education and training to help develop skills and
close any skills gap, but this is expensive and takes time.
 Promoting a more flexible labour market, such as reducing trade union
power, encouraging part-time work, encouraging new business startups, 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.

© Economics Online 2011
Policies to help improve competitiveness
2.
Improving competition in product markets, by
Deregulation - but some regulation is needed to protect consumers and
workers from unfair practices.
 Privatisation - but there are few industries left in the UK to privatise.
 Reducing monopoly power - but it can be argued that monopoly power
helps generate dynamic efficiency.
 Bringing down barriers to entry - but this is very difficult as some
barriers are ‘natural’ ones, such as economies of scale.

© Economics Online 2011
Policies to help improve competitiveness
3.
Improving the level of investment in the UK, by a range of measures
including:





Investment grants
Investment subsidies
Encouraging new product development - these measures may be
helpful, with no major conflicts associated with them, though, as always,
spending by government has to be funded.
Keeping interest rates as low as possible - but the danger with this is
that low interest rates could trigger an increase in household spending
(C) causing demand pull inflation.
Reducing the interest rate elasticity of investment - so it is easier to raise
interest rates without negatively affecting investment, for example, by
investment grants and tax relief on investment.
© Economics Online 2011
Policies to help improve competitiveness
4.
Creating a stable macro-economic environment, including:
Keeping inflation under control, through a mixture of monetary and
fiscal measures. However, higher interest rates deter investment, and
could harm competitiveness in the long run.
 Keeping sterling stable.

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.
© Economics Online 2011
© Economics Online 2011
The importance of exchange rates
Exchange rates are important for a trading economy:
1. They represent a cost to firms when they have to pay commission on
changing £s for other currencies.
2. They create a risk to those firms that hold assets in currencies other
than £s.
3. They affect the price of exports, which form a significant part of
aggregate demand (AD), and the price of imports, hence they affect
the balance of payments.
4. The Monetary Policy Committee (MPC) of the Bank of England may
take the exchange rate into account when setting short term interest
rates. Changes in the exchange rate have another transmission route
into the economy, via their effect on interest rates.
© Economics Online 2011
Measuring exchange rates
Exchange rates can be measured in two ways:
1.
2.
A bi-lateral rate – which is the rate of exchange of one currency for
another, such as £1 exchanging for $1.75.
A multi-lateral rate – which is the value of a currency against more
than one currency. Multi-lateral 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.
Sterling’s average is measured by the Sterling Trade Weighted Index.
 This tracks changes over time, starting with a base year index of 100.
 The index is weighted to reflect the relative importance of different
countries in terms of UK trade.

© Economics Online 2011
Exchange rate regimes

1.
2.
3.
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:
Floating - where currencies are allowed to move freely up and down
according to changes in demand and supply.
Fixed - where currencies are tied to a precious metal such as gold, or
being anchored to another currency, like the US Dollar.
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.
© Economics Online 2011

Under a floating system a currency can rise or fall due to changes in demand
or supply of currencies on the foreign exchange market.
The UK has
stocks of £
The value of the
pound is determined
in the foreign
exchange market, and
depends upon relative
demand and supply
€
£
Foreign exchange
market
EXPORTS
When the UK
imports it must
supply pounds
and buy euros
More EXPORTS
shifts the
demand for a
currency to the
right
£
£
€
IMPORTS
IMPORTS
€
More IMPORTS
Supply ofshifts
pounds the
(determined by imports)
supply of a
currency to the
right
£/€
Demand for pounds
(determined by exports)
© Economics Online 2011
France has
stocks of Euro
When the UK
exports
other countries
must buy pounds
Changes in exchange rates
In a floating regime
exchange rates reflect
demand and supply. The
price of one currency is
expressed in terms of
another currency.
 For example, an
increase in exports
would shift the demand
curve for sterling to the
right, and raise the
exchange rate.

£=$
The equilibrium exchange rate
exists at the rate where demand
and supply equate
S (derived from
imports)
£1 = $1.60
£
£1 = $1.50
D (derived from
exports)
Q
Q
© Economics Online 2011
Exchange rates and interest rates
Changes in interest rates
affect a country’s currency.
Higher interest rates lead to
an increase in demand for
financial assets, and an
increase in the demand for
a currency.
 Lower interest rates reduce
speculative demand for
assets and reduce demand
for a currency. These
speculative flows are called
hot money.

£=$
S (derived from
imports)
£
£1
D (derived
from exports)
Q1
© Economics Online 2011
Q
Q
Fixed exchange rates
The IMF system

In 1944, at Bretton Woods, New Hampshire (USA), the International
Monetary Fund (IMF) was formed and a system of fixed rates
introduced. The IMF was one of three pillars to support the
development of post-war economies – the other two being The
General Agreement on Tariffs and Trade, later to become the World
Trade Organisation, and the World Bank.
The system involved:
1.
2.
The US Dollar (US$) as the anchor for the system with the US$ given
a specific value in terms of gold
Other currencies were given a value in terms of the $, such as £1 =
$2.40c
© Economics Online 2011
Fixed exchange rates
But the system collapsed in 1971 because of:
1.
2.
3.
4.
The build up of US debts abroad, mainly to fund the war in Vietnam
Inflation in the USA
Growing doubts about the stability of the $
Speculative activity against the $ - speculators frantically sold $ until
US President, Richard Nixon, took the US out of the system
© Economics Online 2011
Managed regimes
Managed regimes
combine market forces
and intervention to
achieve a ‘desired’ rate,
such as the European
Exchange Rate
Mechanism (ERM), which
operated from 1979 to
1999.
 Currencies were
managed to keep their
value inside an agreed
band.
If the exchange rate rose too high
interest rates would have to fall to
create an outflow of hot money, or
central banks would sell currency

If the exchange rate fell too
much interest rates would
have to rise or central banks
would buy currency
+ 2.25*%
Time
- 2.25*%
© Economics Online 2011
Evaluation of regimes
Benefits of floating exchange rates
1.
Flexibility and automatic adjustment.


2.
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.
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.
© Economics Online 2011
Evaluation of regimes
Benefits of fixed exchange rates
1.
Stability for firms

2.
Predictability and confidence

3.
Exporting firm’s prices are more stable, as are importing firm’s costs. This
is the main reason the Chinese Yuan was fixed against the US Dollar for
nearly 20 years.
Firms can plan ahead – hence they are likely to invest more. Confidence is
a necessary condition for investment.
Discipline

Policy makers cannot devalue the currency in an attempt to hide inflation
or a balance of payments deficit - remember, keeping a currency low
would reduce export prices abroad and nullify any domestic inflation as
well as providing a boost to exports. Policy makers cannot revalue to keep
a currency artificially high - to reduce imported cost-push inflation.
© Economics Online 2011
Recent UK Exchange rates
Sterling fell during 2005, but
rose between 2006 and
2007. However, with the
onset of the global recession
sterling fell back reflecting
the UK’s exposure to the
recession.
 Between 2005 and 2010
sterling lost 20% of its value.

120
Sterling Effective Exchange Rate
Jan 2005 = 100
Source: Bank of England
115
110
105
100
95
90
85
80
75
70
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2
2005
© Economics Online 2011
2006
2007
2008
2009
2010
© Economics Online 2011
Development and growth
Growth and development
 Economic growth refers, narrowly, to increases in economic welfare, whereas
economic development refers, more widely, to economic, political and social
progress.
 Economic growth is an important and necessary condition for development,
but it is not a sufficient condition. Growth alone cannot guarantee
development.
Freedom and development
 According to the influential development economist, Amartya Sen,
development is about creating freedom for people, and about removing
obstacles to greater freedom.
 Obstacles to freedom, and hence to development, include poverty, lack of
economic opportunities, corruption, poor governance, lack of education and
lack of health.
© Economics Online 2011
Indicators of development
The Human Development Index (HDI)
 The HDI was introduced in 1990 to provide an accepted way of measuring
economic development.
The HDI has two main features:
1. A scale from 0 (no development) to 1 (complete development).
2. An index, which is based on three criteria:
1. Longevity - measured by life expectancy at 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 example, Romania was 0.76.
4. Above 0.8 means very high development – Finland was 0.87 in 2010.
© Economics Online 2011
HDI for selected countries, 2010
Source: hdr.undp.org
HDI for selected
countries:
1.00
0.90
0.80
0.70
Very high
0.60
High
0.50
0.40
Medium
0.30
Low
0.20
0.10
0.00
© Economics Online 2011
Life expectancy
A variety of factors may
contribute to differences in
life expectancy, including:
 The stability of food supplies
 War and natural disasters
 The incidence of disease
According to the World Bank:
 Over the past 30 years, life
expectancy in developing
countries as a whole
increased by 10 years –
however the changes have
not been evenly distributed.
 Heavily indebted countries
lag behind the rest of the
developing world.
.
85
Life expectancy - years
Source: World Bank
80
75
70
65
Euro area
European Union
Europe & Central Asia
(all income levels)
East Asia & Pacific (all
income levels)
East Asia & Pacific
(developing only)
60
Europe & Central Asia
(developing only)
55
Arab World
50
Heavily indebted poor
countries (HIPC)
45
© Economics Online 2011
Literacy
Adult literacy rates
 Adult literacy can be broadly defined as the percentage of those aged 15 and
above who are able to read and write a short, simple, statement on their
everyday life.
 More extensive definitions of literacy includes those based on the
International Adult Literacy Survey.
 This survey tests ability to understand printed text, to interpret documents
and perform basic arithmetic.
© Economics Online 2011
GDP per capita
GDP per capita
 GDP per capita is the commonest indicator of material standards of living, and
hence is included in the index of development.
Evaluation of GDP measures:
 GDP statistics are widely used for comparing economic performance of
developing countries, but they can be criticised because:
1. Average GDP per head may increase, but the distribution of income may get wider.
Mean averages can be misleading, and median figures may be more useful.
2. Citizens may work longer hours - in which case some of the growth may occur
because of increased work rather than through greater productivity.
3. Citizens may do more unpaid work in one country - but this is not likely to be
recorded.
4. Prices of similar products may be different - figures must be adjusted to take into
account different purchasing power of the local currency. The process of
undertaking this conversion is called adjusting to create Purchasing Power Parity
(PPP).
© Economics Online 2011
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.
© Economics Online 2011
Measure of economic welfare (MEW)
Nordhaus and Tobin
 In 1972, Yale economists William Nordhaus and James Tobin introduced their
Measure of Economic Welfare (MEW)* as an alternative to crude GDP.
 MEW adjusts national income to include the value of leisure time and the
amount of unpaid work in an economy.
 It also includes the value of the environment damage caused by industrial
production and consumption, which reduces the welfare value of GDP.
 *Nordhaus, WD and Tobin, J (1972) Is Growth Obsolete? Economic Growth,
National Bureau of Economic Research, no 96, New York.
The Index of Sustainable Economic Welfare
 The Index of Sustainable Economic Welfare (ISEW), develops MEW by
adjusting GDP further by taking into account a wider range of harmful effects
of economic growth, and by excluding the value of public expenditure on
defence.
© Economics Online 2011
Purchasing power parity
Purchasing power parity (PPP)
 The alternative to using market exchange rates is to use purchasing power
parities (PPPs).
 The purchasing power of a currency refers to the quantity of the currency
needed to purchase a given unit of a good, or common basket of goods and
services.
 Purchasing power is determined by the relative cost of living and inflation
rates.
 Purchasing power parity means equalising the purchasing power of two
currencies by taking into account these cost of living and inflation differences.
The Big Mac Index
 This index, devised by The Economist magazine, calculates how many units of
a local currency are needed to purchase a Big Mac. Exchange rates can then
be adjusted according to how much local currency is required.
© Economics Online 2011
© Economics Online 2011
Types of growth theory
Growth theories
 Growth theories attempt to explain the necessary conditions for growth to
occur, and to weigh up the relative importance of particular conditions.
 Early growth theories attempted to find general determinants of growth
which could be applied to all cases of growth.
 Modern theories accept that conditions for growth change over time, and
vary between countries and regions.
© Economics Online 2011
Linear stage theory
Rostow’s linear stage theory
 One of the first growth theories was that proposed by American economic
historian W. Rostow in the early 1960s.
 Rostow argued that economies must go through a number of developmental
stages. He argued that these stages followed a logical sequence:
Rostow’s stages are:
Mass consumption
Drive to maturity
Take off
Pre-take off
Traditional society
Citizens enjoy high and rising consumption per head.
Ongoing movement towards development
Positive growth rate
Increased savings ratio
Dominated by agriculture and barter exchange
© Economics Online 2011
The Harrod-Domar growth model
The Harrod-Domar Model
 The importance of savings is central to the work of Harrod and Domar.
 According to this theory there are two determinants of the rate of growth:
1. The capital-output ratio - which shows how much new capital (e.g. £10) is needed
to create a given amount of new national output (e.g. £2).
2. The savings ratio - which shows how much is saved (e.g. £10) from a given amount
of national income (e.g. £100)
 The model indicates how these two ratios affect the rate of 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 develop is caused by the failure to save, and
accumulate capital.
© Economics Online 2011
Savings and capital-output ratios
Saving is income not spent on current consumption it provides the flow of funds
necessary for capital accumulation, which is needed for economic growth.
The savings ratio indicates the ratio
of savings to national income
£100
Some income
is saved
£20
£40
Savings
Income
£80
£20
Households
savings ratio
S
20
40
Y
100
Income
MORE CAPITAL MEANS MORE
circulates from
The higher the savings and capital output
OUTPUT AND HIGHER Spending
Factors Incomes
Goods
firms to
ratio, the greater the growth in output
ECONOMIC GROWTH
households
Income
£4
£16
Output
£20
£40
Capital
Firms
The capital-output ratio (O/K)
indicates how much capital is
needed to create new output
Saving allows capital
accumulation
© Economics Online 2011
O
16
4
C
20
40
Capital (K)/output ratio
Evaluation of stage theory
 The theories of Rostow, Harrod and Domar, and others consider savings as a
sufficient condition for growth and development.
 If income is low, savings will not be accumulated. According to Rostow, saving
between 15 and 20% of income is enough to provide the basis for growth.
 Although saving is regarded as highly significant, modern growth theory takes
into account a broad set of growth factors.
 Other criticisms of stage theory point to general weakness in terms of the
unrealistic assumptions of these models, such as perfect knowledge, stable
exchange rates, and constant terms of trade.
 Modern theory tends to see savings as a necessary but not sufficient
condition for growth.
© Economics Online 2011
Structural change models
The Lewis model
 The Lewis model is also known as the two sector model, and the surplus
labour model.
 It focused on the need for countries to transform their structures, away from
traditional agricultural economic activity, with low productivity of labour
towards industrial activity, with high productivity of labour.
Agriculture
Agriculture
Industry
Industry
Labour
© Economics Online 2011
 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
© Economics Online 2011
Evaluation of the Lewis model
Limited benefits of industrialisation
 Despite the logic of the Lewis approach the benefits of industrialisation may
be limited because:
1. Profits may leak out of the economy and find its way to developed economies
- capital flight.
2. Capital accumulation may reduce the need for labour in the urban industrial
sector.
3. The model assumes competitive product and labour markets, which may not
fully exist.
4. Urbanisation creates urban squalor with unemployment replacing
underemployment.
5. Only a small elite may benefit from industrialisation.
© Economics Online 2011
Clark-Fisher’s structural change model
 As early as 1935 Allan Fisher had noted that economic progress led to the
emergence of a large service sector.
 The Clark-Fisher hypothesis states that development will eventually lead to
the majority of the labour force working in the service sector.
 This is because high income elasticity of demand for services – as income rise
demand for services increases and more employment and national output are
allocated to service production.
 Lower productivity in the service sector (with less ability to apply new technology),
so prices of services rise relative to primary and secondary goods. This means an
increasing share of national consumption is allocated to the service sector.
AgricultureAgriculture
Agriculture
Labour
Industry
Industry
Labour
© Economics Online 2011
Services
Dependency theory
 Dependency theory became popular in the 1960’s as a response to research
by Raul Prebisch.
 Prebisch found that increases in the wealth of the richer nations appeared to
be at the expense of the poorer ones.
What did dependency theory advocate?
 Dependency theory advocated an inward looking approach to development
and an increased role for the state in terms of:
 Imposing barriers to trade
 Making inward investment difficult
 Promoting nationalisation of industries
© Economics Online 2011
Dependency theory
Why did it lose favour?
 Although still a popular theory in history, dependency theory has disappeared
from the mainstream of economic theory in recent years.
 This is largely as a result of the emergence Far Eastern economies, especially
India.
 The inefficiencies of state involvement in the economy, and the growth of
corruption, have been dramatically exposed in countries that have followed
this view of development, most notably a number of African economies,
including Zimbabwe.
© Economics Online 2011
Neo-classical theory
Three different Neo-classical approaches to development have emerged:
1. The free market approach - markets alone are sufficient to generate
maximum welfare.
2. The public choice approach - an extreme Neo-classical model which stresses
that all government is ‘bad’ and leads to corruption and the gradual
confiscation of private property.
3. The market friendly approach - while markets work, they sometimes fail to
emerge, and government has a role to compensate for three main market
failures; missing markets, imperfect knowledge and externalities.
Neo-classical economists believe that, to develop, countries must:
1.
2.
3.
4.
Liberate markets
Encourage entrepreneurship (risk taking)
Privatise state owned industries
Reform labour markets (such as reducing the powers of trade unions)
© Economics Online 2011
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.
© Economics Online 2011
New growth theory
New growth theory
 A central proposition of New Growth theory is that, unlike land and capital,
knowledge is not subject to diminishing returns.
The importance of knowledge
 The development of knowledge is seen as a key driver of economic
development.
 The implication is that, in order to develop, economies should move away
from an exclusive reliance on physical resources to expanding their
knowledge base, and support the institutions that help develop and share
knowledge.
 Government should invest in knowledge and human capital, and the
development of education and skills.
 It should also support private sector research and development and
encourage FDI, which will bring new knowledge with it.
© Economics Online 2011
© Economics Online 2011
Income and wealth
Introduction
 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 in developing economies
 Land and natural resources, livestock
© Economics Online 2011
Measuring inequality
Measuring inequality
 Inequality can be quantified by looking at the distribution of income or
wealth.
1. The distribution of wealth is likely to be much greater than income because
wealth is built up over many decades, and for some families, over centuries.
2. The distribution of income is relatively easier to measure - valuing wealth is
difficult because much wealth is hidden from view and wealth changes its
value over time.
The Gini co-efficient and 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 coefficient ranges from 0 to 1 - the closer to one, the greater the inequality.
 The Gini Index is the Gini coefficient, expressed as a percent - the closer to
100%, the greater the degree of inequality.
© Economics Online 2011
The Lorenz curve
The Lorenz Curve
 A Lorenz curve shows the %
of income earned by a given
% of the population.
The Gini co-efficient is calculated by
comparing the area from the curve to
the 450 line and the area from the axis
to the 450 line. The closer to 1, the
greater the inequality
Cumulative
Income (%)
100
90
80
% of
Pop
% of Y for ‘perfect
distribution’
% of Y in
Country X
70
20
20
2
50
40
40
10
40
60
60
25
30
80
80
45
100
100
100
60
20
10
© Economics Online 2011
10
20
30
40 50 60 70 80 90 100
Cumulative Population (%)
Comparing countries
Comparing countries
 The further the Lorenz Curve
from the 45 degree line, the
less equal (wider) the
distribution of income.
Cumulative
Income (%)
100
Changes in the Lorenz curve (and Gini
co-efficient) can be used to assess the
effectiveness of policies designed to
reduce poverty and narrow the
distribution of income.
90
80
% of Y in
Country X
% of Y in
Country Y
20
2
1
40
10
5
60
25
15
80
45
30
100
100
100
% of Pop
70
60
50
40
30
20
10
10
© Economics Online 2011
20
40
60
80
100
Cumulative Population (%)
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.
 Definitions of relative poverty vary considerably, but many countries use the
following:
– The poor are those living on ‘..less than 60% of median income..’.
© Economics Online 2011
Estimated absolute poverty
Absolute poverty, by region
People Living in Absolute Poverty
 Taking the international poverty
line, as a region, Asia has the
highest population living in
poverty.
 However, as a region of the
world, Sub-Saharan Africa has
the highest level of poverty as a
proportion of total population,
at over 60%.
 The second poorest region is
Latin America, with 35% of its
population poor.
(millions, and %)
1400
1200
23%
1000
800
25%
600
400
62%
200
28%
35%
0
Total
World
Asia
SubSahara
North
Africa
Source – United Nations
© Economics Online 2011
Latin
America
Inequality and development
The Kuznets curve
Economic
development may
widen the gap
between rich and
poor countries.
 The greatest
inequality can be
observed as
countries 'take-off' in
their development,
leading to
considerable wealth
creation for the few,
who quickly gain
from development,
relative to others.

Inequality
Inequality increases
in the early stages of
development
Kuznets
Curve
Development
© Economics Online 2011
Media – Video on poverty
© Economics Online 2011
© Economics Online 2011
© Economics Online 2011
Inefficiencies
 A significant limit to economic growth and development is inefficiency
in the use of scarce resources:
1. Productive inefficiency (not producing at lowest possible average
cost.)
 This may be because of the failure to apply technology to production, or
because of the inability to achieve economies of scale. Opening up the
economy to free trade may help reduce this type of inefficiency.
2. Allocative inefficiency – when competition is restricted, or when
production is in the hands of the state, prices might not reflect the
marginal cost of production.
3. ‘X’ Inefficiency – also arises from an absence of competition and is
associated with inefficient management.
 In all cases, opening up to free trade may promote competition and
reduce inefficiency.
© Economics Online 2011
Imbalances
Not all sectors of an economy are capable of growth.
 For some countries, too many scarce resources may be allocated to
sectors with little growth potential. This is especially the case when
countries specialise in agriculture and primary commodities.
 In these sectors there is little opportunity for economic growth
because the impact of real and human capital development is small,
and marginal factor productivity is very low.
 Most development theorists argue for a drive for agricultural
efficiency to allow resources to move to high productivity uses.
© Economics Online 2011
Population constraints
 A high rate of population growth may constrain economic growth.
 At first, growth creates positive externalities, such as better health
and education, which lead to a decline in the death rate, but no
change, or an increase, in the birth rate.
 Over time life expectancy rises, but the age distribution remains
skewed at the lower, dependent age. More and more of the
population are dependent consumers, with proportionately fewer
producers.
 The short-term gains from growth are quickly eroded as GDP per head
actually falls.
 Only when the birth rate falls will GDP per head rise.
© Economics Online 2011
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.
© Economics Online 2011
Lack of financial capital
 Many developing economies do not have sufficient financial capital to
engage in public or private investment because:
1. Growth is insufficient to allow savings to accumulate.
2. High interest rates needed to encourage more saving will deter
investment.
3. Public debts may be too large.
4. Private investment may be crowded out by public sector borrowing.
5. An absence of credit markets in many developing economies, which
discourages both lenders and borrowers.
© Economics Online 2011
Poor governance
 Some developing economies suffer from corruption and poor
governance:
1. Theft of public funds by politicians or government employees.
2. Theft and misuse of overseas aid.
3. In some developing economies bribery is the norm, which seriously
undermines the operation of the price mechanism.
© Economics Online 2011
Missing markets
Credit markets
 Missing markets usually arise because of information failure. Lenders in
credit markets may be unaware of the full creditworthiness of
borrowers. This pushes up interest rates for all borrowers.
 Low risk individuals are deterred from borrowing, and credit markets in
developing economies may be completely missing.
 Microfinance is increasingly used to reduce this problem in developing
economies.
Insurance markets
 Similarly, insurance markets may be under-developed, with few
insurers wishing to accept ‘bad’ risks. Insurance premiums are driven
up, and ‘good’ entrepreneurs may not be prepared to take such
uninsured risks.
 The result – new businesses fail to develop.
© Economics Online 2011
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
© Economics Online 2011
Lack of education
 Human capital development requires investment in education.
Education is a merit good, and as such the long term benefit to the
individual, and to society, is under-perceived.
 For many in developing economies, the return on human capital
development is uncertain in comparison with the return on
immediate employment on the land so there is little incentive to
become educated.
© Economics Online 2011
Over-exploitation of environmental capital
 The long term negative effect of the excessive use of resources may
be less clear than the short term benefit.
 This means that there is a tendency for countries not to conserve
resources. But this can have an adverse effect on growth rates in the
future.
© Economics Online 2011
Barriers to trade
 One important constraint to economic development is the denial of
access to the markets of the more developed, industrialised,
countries.
 Developed counties may impose tariffs and quotas and other
protectionist measures individually, or more commonly as a member
of a trading bloc.
© Economics Online 2011
© Economics Online 2011
Developing agriculture and primary products
 Many developing countries specialise in agricultural and other primary
products.
 Indeed, the principle of comparative cost advantage suggests that
specialising in commodities and products with the lowest opportunity
cost will provide the best opportunity for economic development.
 However, over-specialisation, particularly in terms of primary
production, can be highly risky. A country can be locked into slow
development if it specialises in a few primary products because:
1. Primary products have low valued added and receive a small share of
global income
2. Yields from land are likely to be 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 by global shocks
© Economics Online 2011
Low elasticity
 Low income elasticity of basic commodities
 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.
© Economics Online 2011
Falling terms of trade - The Prebisch-Singer hypothesis
 A country’s terms of trade indicate how high a country’s export prices
are in relation to their import prices, and is expressed as:
Index of export prices
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.
© Economics Online 2011
Falling incomes
 Incomes have fallen
because, in the long term
the supply of food has
increased because:
S
Price
 The greater use of new
technology and better
P
yields.
 New entrants into markets
(like Vietnam into the
coffee market) have also
helped shift the market
supply curve to the right.
A
Revenue
B
P1
Revenue
D
Q
0
© Economics Online 2011
Q
Q1
Unstable prices
 The cobweb diagram best
explains the tendency for
price instability.
 Initially, we can assume a
stable equilibrium price.
 Followed by a negative
supply shock (e.g. bad
weather).
 Price is now driven up to
P1.
 Next year, planned output
rises to Q2, but this drives
price down to P2.
 The process continues
until the price is so low
that producers leave the
market.
S3
S1
S2
Long Run Supply
S
Price
P1
P
P2
D
0
Q
Q3
© Economics Online 2011
Q1 Q Q2
Protectionism
 Relying on agricultural improvements as a driver for development is
also risky because of protectionist policies adopted in many
developed countries.
 The world’s two largest economies, the US and EU, are difficult to
penetrate given the high level of support and protection for their
farmers, with many agricultural tariffs in excess of 50%.
© Economics Online 2011
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.
© Economics Online 2011
Promoting industrialisation
 Many development theorists, including the Fisher, Clark and Lewis,
highlight the significance of increasing factor productivity through
industrialisation.
 The Lewis model, also known as the two sector model, and the
surplus labour model, focused on the need for countries to transform
their structures, away from traditional agricultural economic activity,
with low productivity of labour towards industrial activity, with high
productivity of labour.
Agriculture
Agriculture
Industry
Industry
Labour
© Economics Online 2011
Evaluation of the Lewis model
 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.
© Economics Online 2011
Inward looking policies
 An inward looking strategy dominated thinking in the post-war period
– this approach can be described as interventionist, centralist and
protectionist, and guided policy making in many African and Latin
American countries.
 The general economic strategy was import substitution. The industries
targeted were those which provided the largest quantity of imports.
 Inward looking strategies also involved heavy subsidies to domestic
producers as well as limiting the activities of MNCs.
© Economics Online 2011
The benefits of inward looking policies
 Inward looking policies generated some clear short term benefits
including:
1. Protecting infant industries.
2. Protecting declining industries.
3. Generating employment.
4. Increasing incomes.
5. Preserving traditional ways of life.
© Economics Online 2011
Outward looking policies – embracing globalisation
 A number of important global events have forced countries to
become more outward looking, including:
1. The realisation that decades of using an inward looking strategy had
not resulted in growth rates necessary to close the development gap
between countries.
2. With the collapse of communism the opportunity arose for many
countries to introduce more outward looking policies.
3. The benefits of globalisation cannot be exploited with an inward
looking approach.
 Outward looking policies typically include:
1. Trade liberalisation and market reforms.
2. Membership of the WTO.
3. Encouraging FDI.
4. Encouraging inflows of human capital.
© Economics Online 2011
The benefits of outward looking policies
1.
2.
3.
4.
5.
6.
Welfare gains from tariff removal.
Trade creation as a result of free trade.
The greater spreading of risks.
Greater positive feedback effects from growth.
Greater competition and increased efficiency of domestic firms.
More able to cope with globalisation and external shocks.
© Economics Online 2011
The promotion of tourism
 Many countries have promoted tourism as a means of achieving
development.
The benefits of promoting tourism include:
1. A strong multiplier effect following the injection of FDI which
accompanies the development of a country as a tourist destination.
(Hotels, infrastructure). This can be significant due to the high
marginal propensity to consume (mpc) in developing economies.
2. Job creation through the initial development phase, and following the
ongoing development of tourism.
3. The creation of a more balanced and diversified economy, with a
developing service sector – often seen as a key indicator of economic
progress.
4. Positive externalities as a result of the development of infrastructure.
© Economics Online 2011
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.
© Economics Online 2011
© Economics Online 2011
Official Development Aid (ODA)
 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 $150b needs to be spent to
meet the Millennium Development Goals agreed in 2000.
© Economics Online 2011
Official Development Aid (ODA)
 The USA is the single
biggest provider of
development aid in
absolute terms.
 Denmark is the largest
provider in terms of % of
GDP allocated.
30
25
ODA Spending ($b, 2009)
Source OECD, 2009
20
15
10
5
0
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
© Economics Online 2011
ODA Spending (% GDP) 2009
Source: OECD, 2009
Government assistance
Evaluation
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 country’s GDP.
3. A large amount of bi-lateral aid has strings attached, called tied aid –
such as ‘aid for contracts’ to the donor countries to undertake
development related work, such as the construction of infrastructure.
4. Some critics argue that aid can be disastrous, and can trap poorer
countries into a life of aid dependency.
© Economics Online 2011
Non-Governmental Organisations (NGOs)
What are NGOs?
 NGOs are not-for-profit organisations that act as a pressure group to
represent members interests or the interests of specific groups.
What are their benefits?
 The UN Industrial Development Organization (UNIDO) analysed the
role of NGOs and suggested that they provided the following
benefits::
1.
2.
3.
4.
5.
There is local accountability
Independent assessment of the issues
The provision of expertise
The provision of information
Awareness-raising of problems and issues
 Source: UNIDO (1997)
© Economics Online 2011
The IMF
The IMF
 The IMF and World Bank were set up following the Bretton Woods
conference in 1944.
The role of the IMF
 The IMF was initially established to promote international monetary
co-operation, which was seen as a key condition for post-war
reconstruction and global development and security.
 It has a number of specific objectives which relate to economic
development, including:
1. Promoting exchange rate stability.
2. Providing short term loans to ease any balance of payments problems.
3. Forcing borrowing countries to improve their macro-economic
performance through prescribed macro-economy stabilisation policies
and through programmes of structural adjustment.
© Economics Online 2011
The World Bank
 The World Bank is one of the United Nations specialised agencies. Its
role is to provide funds for economic reconstruction and economic
development for developing economies.
 The World Bank can make low and no interest loans and grants. As well
as making loans it is also one of the world’s largest providers of aid.
More specifically it attempts to:
1. Encourage structural adjustment – such as policies to promote trade
liberalisation and capital mobility.
2. Encourage supply-side reforms, such as privatisation and de-regulation.
3. Provide targeted aid for poverty reduction.
4. Set specific priorities for countries.
5. Since 2000 its major focus has been to try to help achieve the UN’s
Millennium Development Goals.
© Economics Online 2011
Assessment of the World Bank
1. Not enough understanding of specific local problems and constraints.
2. Difficult to empower local governments to take responsibility – they
often see the World Bank as an outsider.
3. Long term debt can undermine the best intentions of the recipients of
aid and the World Bank.
4. Assistance can create the problem of moral hazard – countries
receiving aid performing less effectively because they know there is
an ‘insurance’ against this under-performance.
See Video
© Economics Online 2011
Assessment of the IMF
1. Stabilisation policies can result in short term conflicts, such as higher
unemployment following tighter demand management.
2. Tough lending constraints can create too much austerity, and push
countries into even further poverty.
3. Decision making is dominated by the powerful G8 countries, though
each member country can vote, voting is based on a quota system,
and the USA has around 17% of the voting power. (IMF, 2005).
4. Because of growing criticism about its role in the global economy the
IMF has become more transparent in an attempt to show that it is not
simply a vehicle to promote the interests of the USA and other
powerful G8 countries.
5. There is also the potential problem of moral hazard.
© Economics Online 2011
United nations ‘millennium goals’
The United Nations
 The United Nations Millennium Development Goals provided an
agenda for reducing poverty. For each goal one or more targets were
set, mostly for 2015
1. Eradicate extreme poverty and hunger.
2. Achieve universal primary education.
3. Promote gender equality and empower women.
4. Reduce child mortality.
5. Improve maternal health.
6. Combat HIV/AIDS, malaria and other diseases.
7. Ensure environmental sustainability.
8. Develop a global partnership for development.
© Economics Online 2011
Excessive debt
 Foreign debt is created when a country has creditors residing abroad.
Debts could be owed to foreign individuals, organisations,
governments, and banks, and to the World Bank and IMF.
 Debt can be unsustainable if it represents a large % of current exports.
The World Bank considers foreign debt to be unsustainable if the ratio
of debt to exports exceeds 150%.
© Economics Online 2011
Excessive debt
 Excessive international debt can occur for two basic reasons:
1. Failure of domestic policy, such as:
 Failure of macro-economic management
 Ineffective control of public 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
 Rises in interest rates
 Natural disasters
© Economics Online 2011
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
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 freeup 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.
© Economics Online 2011
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.
© Economics Online 2011
© Economics Online 2011
Macro-economic policy
 Economic policy is the deliberate attempt to increase economic
welfare. Since the late 1920s, economists have recognised that there
is a role for government in managing the macro-economy.
 During the late 1930s and early 1940s Cambridge economist John
Maynard Keynes set the policy ground rules for his, and later,
generations of policy makers.
 Keynes was able to demonstrate that a market economy could
become trapped in a downward spiral of falling economic activity and
diminishing economic welfare.
© Economics Online 2011
Macro-economic policy
For Keynes, the key questions were:
What could trigger a fall in economic activity?
What processes would stop economic activity from rising back
after a period of recession?
What policies should governments adopt to bring a recession to
and end and to begin the process of stimulating growth?
© Economics Online 2011
Macro-economic policy objectives
Following Keynes, modern policy makers favour setting
clear policy objectives, such as achieving:
1. Stable prices – the desire to keep increases in average prices as
small and as gradual as possible.
2. Stable and sustainable economic growth – the desire to see national
income grow in real terms in a sustainable way.
3. Full employment – the desire to keep the labour force fully
employed in productive work.
4. A balance of payments with the rest of the world – the desire for a
country to ‘pay its way’ in the world.
5. Control of public sector finances.
6. Care for the environment – the desire to protect the environment
from misuse, overuse and degradation.
7. An equitable (fair) distribution of income between rich and poor
without creating disincentives to work.
© Economics Online 2011
The trade cycle
Booms lead to:
 Many macroeconomic problems
Change in
DEMAND SIDE
POLICY
real national
arise from the
Monetary policy
income
underlying instability
Fiscal policy
of the trade cycle. Exchange rate policy
Regulates aggregate demand
 Changes in real
to stabilise the trade cycle
national income tend
to be cyclical. It is
desirable that this
Trend rate
cycle is stable rather
Busts lead to:
than unstable.
• SUPPLY
Goods deflation
SIDE POLICY
House price deflation
 Comparing actual • Incentives
• Welfare
Labour surpluses
to work
growth with the trend
• Education
Unemployment
and skills
rate is useful for policy
term
growth
• Promotes
Excessivelong
debt
burden
purposes.
• Public sector debt
© Economics Online 2011
•
•
•
•
•
•
•
Goods and service inflation
House price inflation
Wage inflation
Labour shortages
Falling savings
Excessive credit
Trade difficulties
Time
Policy Building Blocks
Productivity &
efficiency
SUPPLY- SIDE POLICY
Flexibility
Stable prices
Education and
skills Stable growth
Incentives
Privatisation &
competition
Supply side
Monetary
Fiscal
De-regulation
POLICY
OBJECTIVES
Taxation
Government
spending
Sustainable growth
Full employment
Money
supply Exchange
Interest
Equity
rates
rates
Balance of payments
MONETARY
FISCAL
Stabilise
after
shocks
Labour market
reform
Sustainable
public finances
DEMAND
SIDE POLICY
© Economics Online 2011
Manage the
trade cycle
© Economics Online 2011
© Economics Online 2011
Global shocks
 A major problem associated with increased globalisation is the
increased risk of suffering from demand and supply shocks.
 Globalisation means that economies are increasingly interconnected,
and while this can create considerable benefits, it also presents
national economies with considerable risks.
 One risk is that a shock originating in one part of the world, or in one
industry or market, can quickly ripple across a whole region or the
whole global economy, leaving economic turmoil in its wake.
© Economics Online 2011
Types of shock
 There are a number of different types of shock, including:
1. Temporary - such as a terrorist attack.
2. Permanent – such as an oil shock, which permanently alters the
market for motor vehicles.
3. Exogenous – these shocks are outside of the control of a country’s
policy makers.
4. Policy induced – such as reducing interest rates too quickly, creating
an inflationary shock.
5. Asymmetric - affecting one region or industry differently from
another.
6. Symmetric - affecting all regions or industries in the same way.
© Economics Online 2011
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.
© Economics Online 2011
© Economics Online 2011
Unstable prices
What is wrong with unstable prices?



Price stability is usually regarded as the single most important
economic objective.
Price stability is increasingly important for economic success in the
global economy. For the UK, price stability means ensuring that the
price level increases gradually, by no more than 3% per year, and that
prices do not rise by less than 1%..
The official UK target is 2%, though there is a safety margin of +/- 1% policy makers are forced to intervene if inflation falls outside these
margins.
© Economics Online 2011
The problem of inflation

1.
The problems caused by inflation include:
Erosion of the value of money and assets.

2.
Loss of competitiveness and balance of payments difficulties

3.
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.
This occurs because inflation stimulates imports, which appear relatively
cheaper, and discourages exports, which appear more expensive to
overseas households and firms.
Redistribution of income, from lenders to borrowers

Borrowers do better at times of rising prices because the real value of
their repayments falls over time. Lenders need to charge a higher interest
rate to compensate for the falling value of the repayments to them, and
for the loss of liquidity suffered as the value of repayments fall.
© Economics Online 2011
Why is inflation a problem?
4.
Uncertainty and falling investment

5.
Administrative costs

6.
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.
Unemployment

7.
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.
Inflation can lead to a loss of jobs through its affect on costs. As costs rise
firms may substitute labour with new technology.
Distortion of the price mechanism

Markets work best when prices go up and down – if prices keep rising
resource allocation is distorted.
© Economics Online 2011
Why is inflation a problem?
8.
Creation of money illusion

Inflation may lead people to make irrational decisions. For example, if
money wages rise workers may decide to work longer hours, but if
inflation erodes the value of the wage rise they have been ‘fooled’ into
working longer.
© Economics Online 2011
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.
2.
3.
4.
5.
Earnings rising above
productivity.
Cheaper credit following
a fall in interest rates.
Sudden fall in the savings
ratio.
Rise in public sector
borrowing.
Housing boom creating
equity withdrawal.
Price
Level
As the economy
approaches
full employment
excessive AD
pulls up prices
LRAS
SRAS
P1
P
AD
Y
© Economics Online 2011
Yf
Y1
National
Output (Y)
Changes in the savings rate




The savings rate (ratio)
shows the % of national
income which is saved,
rather than spent.
Sudden changes in the
savings ratio are an indicator
of future changes in
spending and AD, and can be
a prelude to inflation or
deflation.
A rise in the savings ratio
often indicates a fall in
consumer confidence.
A fall in the savings ratio
indicates a rise in confidence
and spending, which can
trigger inflation.
10
UK savings rate
Source: ONS
8
6
4
2
0
2004
2005
-2
© Economics Online 2011
2006
2007
2008
2009
2010
Cost push inflation

Price
Level
Rising costs push the SRAS
upwards, but the LRAS is
not affected. Common
causes include:
1.
2.
3.
4.
Oil price shocks, caused by
wars or decisions by OPEC
to restrict output.
Increases in farm prices
following a series of bad
harvests.
Increases in wage costs.
A fall in the exchange rate,
which increases the price
of all imports.
LRAS
SRAS
SRAS
P1
P
AD
Y1
© Economics Online 2011
Y
Yf
National
Output (Y)
Exchange rates and cost push inflation
What happens if exchange rates fall?



A fall in the exchange rate will mean that more currency is required
to purchase a given quantity of imports. After a time lag this is likely
to feed its way into the retail prices of imported products.
Given that around 35% of the CPI basket of finished consumer goods
and services are imported, the general effect of a fall in the exchange
rate is to raise the CPI.
In addition, imported raw materials are also more expensive so costs
of production will rise for those firms that source their inputs from
abroad.
© Economics Online 2011
Why is deflation a problem?

1.
If the price level falls an economy experiences price deflation.
Deflation can cause the following economic problems:
Delayed consumption

2.
Consumers may delay consumption, waiting for prices to fall even further.
This can have a negative impact on AD, output and incomes.
Rising real interest rates

Because nominal interest rates cannot fall below zero, falling prices cause
real rates to rise. For example, if nominal interest rates are 3% and
inflation is 1%, real interest rates are 2%. But if the price level falls by 1%,
real interest rates (3 – [- 1]) rise to 4%.
© Economics Online 2011
Why is deflation a problem?
3.
A rise in debt burdens and a deterrent to borrowing

4.
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.
Recession

This is because economic confidence falls as households and firms save
rather than spend. Long term recession following deflation is often called
the Japanese disease, given that, for a long period during the 1990s,
Japan seemed trapped in a deflationary spiral.
© Economics Online 2011
Causes of deflation

Following a positive supply
shock:
AD expands from A to B.
Prices fall and consumers
expect prices to fall
further, delaying
consumption - AD shifts
to the left. Firms now cut
prices to boost sales and
reduce stocks.
 As confidence and wages
fall, consumption falls
further. Real interest
rates rise, and savings
rise.
Investment falls due to a negative accelerator
effect. This creates a downward deflationary
spiral, which is very hard to get out of.
Price
Level

LRAS
SRAS
Deflation tends to
occur when the
economy’s capacity
(indicated by the AS
curve) grows at a
faster rate than AD.
P
P1
AD
Y2
© Economics Online 2011
Y
Y1
National
Income (Y)
© Economics Online 2011
Unemployment

The level of unemployment has been a key economic objective ever
since the mass unemployment experienced in the 1930s.
The costs of unemployment
1.
2.
3.
4.
5.
6.
Opportunity cost
Waste of resources
The Chancellor loses revenue
Erosion of human capital
Lower incomes
Externalities
© Economics Online 2011
UK unemployment


Both claimant count
and the ILO survey
show that UK
unemployment fell to
record lows by 2007.
However, since the
recession of early
2008, unemployment
has risen consistently.
8.50
8.00
7.50
UK (ILO) Unemployment rate (%)
Year-on-year, seasonally adjusted
Source: ONS
7.00
6.50
6.00
5.50
5.00
4.50
4.00
3.50
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
2007
© Economics Online 2011
2008
2009
2010
Types of unemployment
1.
Cyclical

2.
Structural

3.
Structural unemployment occurs when certain industries decline as a
result of long term changes in market conditions. This may the result of
globalisation.
Regional

4.
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.
When structural unemployment affects local areas of the economy it is
called regional unemployment.
Classical

Classical unemployment is caused when wages are too high. This view of
unemployment dominated economic theory before the 1930s.
© Economics Online 2011
Types of unemployment
5.
Seasonal

6.
Frictional

7.
Frictional unemployment, also called search unemployment, occurs when
workers lose their current job and are in the process of finding another one.
Voluntary

8.
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.
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.
The natural rate of unemployment

This is a term associated with New Classical and monetarist economists. It is
defined as the rate of unemployment that still exists when the labour
market it in equilibrium, and includes seasonal, frictional and voluntary
unemployment.
© Economics Online 2011
Structural unemployment and mobility

Labour immobility is likely to increase structural unemployment. This
is because the industries which are growing and are short of labour
cannot soak-up surplus labour from declining industries if labour is
immobile. There are three main types of labour immobility.
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.
1.
© Economics Online 2011
© Economics Online 2011
NAIRU




NAIRU - the Non-accelerating Inflation Rate of Unemployment - can be
said to exist when demand deficient unemployment is zero.
It is the unemployment that still exists if the economy is operating at
its full potential.
It is composed of structural, frictional and voluntary unemployment. It
is usually assumed that it is the level of unemployment when the
economy is at its Long Run Phillips Curve.
In the 1980s it was generally thought that NAIRU in the UK was around
7%,but effective supply-side policy during the 1990s and 2000’s
reduced NAIRU to around 5%. (Source: ONS).
© Economics Online 2011
Why is there still unemployment when the economy is in
equilibrium?

1.
2.
There are two rival views:
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.
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:
© Economics Online 2011
New Keynesian theory of persistent unemployment
1.
2.
3.
Wage rigidities – in reality wages are slow to adjust to changes in
the demand and supply of labour, and markets do not clear
quickly.
Efficiency wage theory – firms must set wages above market
clearing to ensure a supply of ‘good’ workers.
Insider-outsider theory – some workers are permanently
excluded from participating in labour markets.
© Economics Online 2011
© Economics Online 2011
The importance and role of money
What is money?


Money is anything that is acceptable in the settlement of a debt. For
something to be used as money it should be portable, divisible,
durable and stable in value.
The advent of money as a medium of exchange replaced the need for
exchange through barter - in modern economies notes and coins are
only a small fraction of total money, with most money being in the
form of bank accounts.
© Economics Online 2011
The importance and role of money
Money supply

1.
Money can be created in two ways:
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.

2.
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.
Issuing Treasury bills - the second way new money can be created is
when the government borrows from the money market by issuing
Treasury Bills, which add to money supply. Banks see these Bills as
good as cash, and continue to make the same amount of loans to
their customers despite the fact they have lost liquidity by buying the
Bills from the Treasury.
© Economics Online 2011
Measures of the money supply

Money can be officially measured in narrow terms or broad terms
Narrow money

M0 (M nought) is the official measure of narrow money in the UK and
consists of notes and coins in circulation outside the Bank of England
plus bankers' operational deposits with the Bank. The main reason for
looking at M0 is because of its link with high street spending, and
inflation. MO is also called high powered money because of its strong
impact on the economy.
Broad money

M4 is broad money and is MO plus private bank deposits, both current
accounts and deposit accounts.
© Economics Online 2011
A certain amount of money is required for
transactions. This is not affected by
interest rates, so is vertical and perfectly
inelastic with respect to interest rates
The demand for money
Why do households and
firms wish to hold their
wealth in a monetary
form?
 According to Keynes’
Liquidity Preference
Theory people require
money – liquidity - for
three reasons:

1.
2.
3.
Interest
rates
The precautionary demand is also
unrelated to interest rates
Transactions
Financial assets are an alternative
Demand
to holding money – the
Precautionary
demand speculative demand is inversely
related to interest rates
To engage in
transactions
As a precaution
To engage in
speculative actions
Speculative
demand
Liquidity
Preference
(total demand)
Q
© Economics Online 2011
Money markets and interest rates
If we add in the money
supply we can find the
equilibrium interest rate.
For example, the money
market will clear when
interest rates are 5% with the supply of money
(M) equalling the demand
(L).
 The money supply is
controlled by the Bank of
England, and is
independent of interest
rates.

Interest
rates
Money Supply
(M)
5%
Liquidity
Preference
(L)
M
© Economics Online 2011
Q
Changing interest rates
Short-term interest rates
are set by the Monetary
Policy Committee (MPC).
 Open Market Operations
are also used to create a
shortage or surplus of
money by selling or buying
securities, thus altering the
money supply to ensure
that the desired interest
rate is achieved.

Interest
rates
Money
Supply
Monetary equilibrium is reestablished at a higher
interest rate by open market
operations – in this case
securities are sold to the
money markets to ‘soak up’
money in the system
6%
5%
Liquidity
Preference
Q
M1
M
© Economics Online 2011
Monetarism


‘Monetarism' is closely associated with ‘Classical economics’.
Monetarism is an economic philosophy which believes that economic
prosperity depends upon understanding the link between money and
the real economy (prices, output and employment), and the effective
control of the money supply.
Although monetarism dates back to English philosophers of the 18th
Century its modern origins lie largely with the work of two
economists:
Irving Fisher of Yale University, writing in the early 20th century, and
 Milton Friedman of Chicago University, writing in the late 20th century

© Economics Online 2011
Monetarists, like Friedman, believe that:
1.
2.
3.
4.
Money can be defined - money is defined as ‘anything generally
acceptable with which to settle a debt’.
Money can be controlled - monetary authorities can increase or
decrease the amount of money in the economy.
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.
Inflation and deflation are always and everywhere a monetary
phenomenon - changes in money are always the cause of price
changes.
© Economics Online 2011
Money and inflation - The Fisher equation


Fisher proposed that there was a stable and predictable relationship
between the quantity of money in circulation in an economy, and the
price level, using his famous equation:
MV = PT, where:
M = the stock of money
 V = the velocity of circulation
 P = average prices
 T = the number of transactions



If we assume V and T are constant - as an economy approaches full
employment - then changes in M must lead to the same proportional
changes in P.
The policy implication is that the monetary authorities should ensure
that money supply is controlled effectively – controlling the money
supply means stabilising prices!
© Economics Online 2011
Modern monetary policy
The Monetary Policy Committee.



Monetary policy in the UK is undertaken by the Bank of England’s
Monetary Policy Committee (MPC). The MPC has nine members, four
of whom are appointed by the Chancellor. It meets each month to
discuss current and future monetary policy options. The MPC has one
goal – to hit its inflation target of 2%.
The inflation target is symmetrical – a rate of inflation below the target
is considered as bad as a rate of inflation above the target.
Changing official interest rates is the most visible of the MPC’s tools.
© Economics Online 2011
Modern monetary policy
The official rate


The interest rate the MPC fixes is called the official rate – this is the
rate that the Bank of England will charge for short-term loans to
other banks or financial institutions.
Other rates of interest in the economy, such as mortgage rates, will
adjust in line with changes to the official rate.
© Economics Online 2011
Monetary policy
Why isn’t the inflation target zero?

1.
2.
There are two reasons why the inflation target is set above zero:
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.
Inflation cannot be measured with perfect precision, and it is safer to
have a positive inflation target as this provides a margin of safety.
© Economics Online 2011
How do interest rates work?

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
spending.
© Economics Online 2011
5.
6.
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.
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.
© Economics Online 2011
Summary of the monetary transmission mechanism
Market
RISE
interest rates
Official
RISE
interest rate
Asset
prices
FALL
Domestic
Domesticdemand
demandTIGHTENS
inflation
Expectations
WORSEN
Exchange
APPRECIATE
rates
Import prices
Import
- cost
prices
inflation
FALL
© Economics Online 2011
Inflationary
Total
PRESSURE
inflation
EASED
 In recent years interest rates
have been adjusted to reflect
changing conditions.
 2000 – 2005
7
6
 Rates fell quickly to their
lowest level for 25 years, to
help stimulate demand.
UK interest rates
(%) Official base rate
Source: Bank of England
5
4
 2006-2007
 Rates were pushed up into a
neutral zone at around 5.5%.
 2008 – 2011
 Rates fell to their lowest
recorded level of 0.5% to deal
with the recession.
Quantitative easing was also
needed to deal with the
severe liquidity shortage.
3
2
1
0
2005
© Economics Online 2011
2006
2007
2008
2009
2010
 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.
© Economics Online 2011
 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.
© Economics Online 2011
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 England’s Monetary Policy Committee is independent from
government and can make decisions free from political interference.
3. Flexibility
 Interest rates can be changed on a monthly basis, and this contrasts with
discretionary fiscal policy which cannot be introduced as such regular intervals.
4. A rapid effect on expectations
 While the ‘full’ effects of interest changes may not be experienced for up to a
year, there is often an immediate effect on confidence. The time-lag on output is
estimated to be around one year, and on the price level, around two years.
© Economics Online 2011
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.
© Economics Online 2011

Other criticisms of quantity controls
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.
1.
© Economics Online 2011
Monetary Policy in Europe
The European Central Bank (ECB)

The ECB meets on a monthly basis to determine two things:
1.
2.




The level of interest rates across the Eurozone - those 16 countries that
share the Euro
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.
© Economics Online 2011
© Economics Online 2011
The public sector - government expenditure

Central and local government – the public sector - spends money for
a variety of reasons. These include:
1.
2.
3.
4.
5.
6.

To supply goods and services that the private sector would fail to, such
as public goods, merit goods, and welfare payments and benefits.
To achieve supply-side improvements in the macro-economy, such as
spending on education and training to improve labour productivity.
To reduce the likelihood or effects of negative externalities, such as
pollution controls.
To subsidise specific industries which may need, for one reason or
another, financial support that would not be available from the private
sector.
To help redistribute income and achieve more equity.
To inject extra spending into the macro-economy, to help achieve
increases in aggregate demand and economic activity. Such a stimulus is
part of discretionary fiscal policy.
Local government is very important in terms of the administration of
spending, such as spending on the NHS and on education.
© Economics Online 2011
Fiscal policy
What is fiscal policy ?

Fiscal policy is the deliberate adjustment of government spending,
borrowing or taxation to help achieve desirable economic objectives.
Types of fiscal policy

There are two types of fiscal policy, discretionary and automatic.
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.
1.
© Economics Online 2011
Government Spending

The main areas of
UK government
spending in 2010,
which totalled
£681bn, were:
1.
2.
3.
4.
5.
Social
‘protection’
National Health
Education
Public Order
Defence
Health
18%
Education
12%
Law and
Order
7%
Defence
7%
Housing
5%
Interest
6%
Social
protection
35%
© Economics Online 2011
Borrowing
6%
Central and Local government borrowing

If revenue is insufficient to pay for expenditure then government
must borrow. Local authorities can borrow if their revenue from the
Council Tax and central government support is insufficient to meet
their spending.
Borrowing requirements


If the borrowing requirements of both central and local government
are added together the amount of borrowing required is called the
public sector net cash requirement (PSNCR). The need to borrow
varies greatly with the business cycle.
The previous Chancellor’s golden rules for borrowing were:
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 non-investment spending, such as the wages of public
sector workers.
1.
© Economics Online 2011
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.
What is the national debt?

The national debt is the cumulative
amount of annual borrowing.
Hypothetical example to illustrate
how the ‘National Debt’ is calculated.
£Billions
2008
2009
2010
2011
Government
spending
500
550
600
650
Revenues
480
520
560
600
Borrowing
20
30
40
50
National
Debt
20
50
90
140
What causes a rising national debt?


Tax revenues fall and government
spending rises as the economy
slows down or goes into recession.
Householders and firms spend less,
so less VAT is collected, and
householders and firm receive less
income, so revenues from income
taxes fall.
© Economics Online 2011
Is a rising national debt a problem?

Yes, if:
1.
It is a high share of GDP.
It is persistent and not selfcorrecting.
It could be inflationary as
money must be created to
pay for the deficit.
This may cause downward
pressure on the exchange
rate.
It may require taxes to rise
causing a disincentive effect.
FDI may be deterred.
It requires government
spending to be reduced.
2.
3.
4.
5.
6.
7.
10.0
Public debt as % GDP
Source: UK Treasury
8.0
6.0
4.0
3
2.0
0.0
European stability pact limit
-2.0
-4.0
© Economics Online 2011
Central and local government spending
Changing the level of public spending


Using public spending to stimulate economic activity has been a key
option for successive governments since Keynes argued that public
spending should rise during a recession.
There are two types of spending:
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.
1.
© Economics Online 2011
Evaluation of discretionary public spending
The advantages of using public spending
1.
2.
3.
4.
Public spending can be increased to help stimulate the macroeconomy by increasing the level of AD.
If the spending is on capital items, then infrastructure can be
improved, and this can help improve competitiveness and economic
growth.
Spending on infrastructure also provides an external benefit to the
rest of the economy.
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.
© Economics Online 2011
Evaluation of government spending
The disadvantages of using public spending
1.
2.
3.
4.
There may be a considerable time-lag between spending and the
benefits of spending.
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.
Crowding-out – critics of a large public sector point to the crowding
out of the more efficient private sector.
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.
© Economics Online 2011
Crowding out theory


Crowding out is the process of squeezing out the efficient private
sector as a result of public sector expansion.
We can identify two types of crowding out.
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.
1.
© Economics Online 2011
The public sector – revenue and taxation
Why raise revenue?

Governments receive revenue from a number of sources, including:
Taxation – of which there are two types of taxes:
 Direct, which are taxes on factor incomes, such as personal income
tax and corporation tax
 Indirect, which are taxes on spending, such as Value Added Tax VAT
 National insurance contributions (NIC) - is a compulsory contribution
from both employer and employee.
 Charges, such as the congestion charge and parking charges.
 Licences, such as TV and driving licences.
 Privatisation of state assets.

© Economics Online 2011
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

© Economics Online 2011
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.
Tobacco
duty
2%Fuel duties
Stamp
duties
2%
Tax sources (2010)
Source: HM Treasury
7%
Corporation
tax
9%
Income tax
37%
VAT
18%
NICs
25%
© Economics Online 2011
Automatic Stabilisation
Fiscal drag


If we assume that direct tax rates are progressive – which occurs
when the % of income going in taxes increases with income – and
that welfare benefits are paid to the poor and unemployed – then
rapid increases in national income would be slowed down
automatically.
Fiscal drag means as incomes rise in a boom the impact of rising
incomes for the better off is reduced as they pay proportionately
higher taxes, and the impact of rising incomes on the poor and
unemployed is reduced as they come off benefits, and start to pay
tax. The effect is that the increase in disposable income is
moderated.
© Economics Online 2011
Automatic stabilisation – fiscal boost
Fiscal boost


Similarly, a potentially rapid and deep decrease in national income
would be ‘held back’ through fiscal boost. Fiscal boost means as
incomes fall in a recession the impact of falling incomes for the
better off is ‘softened’ as they pay proportionately lower taxes, and
retain more post-tax income.
The impact of falling income is to increase unemployment, but rather
than experience a complete collapse in personal income, the
unemployed and poor receive benefits, and spend more than they
would have without such benefits – hence a downturn in the
economy is also ‘moderated’
© Economics Online 2011
The effects of fiscal drag and fiscal boost
Fiscal drag and boost

Fiscal drag reduces the
rate of growth of
national income,
whereas fiscal boost
limits the contraction
of national income.
6
Progressive taxes
reduce the rate of
growth in the economy
Without
stabilisers
5
4
3
With
stabilisers
2
1
0
-1
-2
Progressive taxes and
benefits stop the
economy contracting
too quickly
-3
-4
2000
2002
© Economics Online 2011
2004
2006
2008
2010
Discretionary changes to tax rates
Altering tax rates


In addition to automatic stabilisation taxes can be deliberated raised
or lowered to control or expand household spending, and AD. This is
called discretionary fiscal policy.
Income tax can be adjusted in a number of ways, such as by
changing:
The tax free allowance – all income earners are allowed to earn an
amount of income before they start to pay tax.
2. The basic tax rate - for example, the basic rate could be increase from its
current level of 20%.
3. The number of tax bands – for example, in 2009 a new higher rate band
of 50% was added.
4. The range of income in each band – each band could be widened or
narrowed by increasing or reducing the range of income in each band.
1.
© Economics Online 2011
Evaluation of taxation – the advantages
Evaluation - the advantages of using taxes
1.
2.
3.
4.
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.
Taxation has the ability to automatically help stabilise the macroeconomy , through fiscal drag and boost, which can provide a natural
shock absorber to economic shocks.
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.
Tax policy can also be used to help re-distribute income, and help
achieve equity.
© Economics Online 2011
Taxes and Equity



In terms of achieving equity, indirect taxes like VAT are regressive
and create an inequitable burden. The largest burden being on the
poor and low paid.
Income tax and other direct taxes can be made progressive and can
help achieve equity - but they may have a disincentive effect, leading
to inefficiency.
Hence, equity and efficiency are in conflict - the best resolution is a
mix between direct and indirect to achieve a balance between the
needs of equity and efficiency.
© Economics Online 2011
Evaluation of taxation – the disadvantages
The disadvantages of using taxes
1.
2.
3.
4.
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.
Households may alter their savings following tax changes, so the
effect on household spending of an increase or decrease in taxes
may be weak.
There may be considerable time-lags between changing taxes and
changes in household spending.
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.
© Economics Online 2011
The disincentive effect of direct taxes
The Laffer curve
Laffer proposed that at
tax rates of 100% and
0% the government
would receive no
revenue. At 100% tax,
no one would work, and
at 0% tax no tax would
be paid.
 However, between O%
and 100% tax rate the
government derives a
tax yield.
 Clearly, as tax rates rise
a disincentive effect
must begin at some
point .
Tax
Revenue

Disincentive
effect
Laffer
Curve
Tax Rate
0
© Economics Online 2011
100%
Income and substitution effects

However, the disincentive effect will only work under certain
circumstances – to understand this we must distinguish the income
and substitution effects.
1.
2.

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’
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.
© Economics Online 2011
© Economics Online 2011
The Phillips Curve
 In 1958 AW Phillips published
research showing the
relationship between wage
inflation and unemployment
rates in the UK, between 1860
and 1958.
 He plotted annual rates on a
scatter diagram and found the
line of best fit. It appeared to
show an inverse and stable
relationship between wage
inflation and unemployment.
Inflation
(%)
1922
1927
1926
1924
1923
1925
Unemployment
(%)
© Economics Online 2011
 The plotted line became
known as the Phillips
Curve - other countries
found similar curves for
their own economies.
 The curve suggested that
changes in the level of
unemployment have a
direct and predictable
effect on the level of
inflation.
Inflation
(%)
P1
P
The Phillips
Curve
U1
© Economics Online 2011
U
Unemployment
(%)
 The accepted explanation
during the 1960’s was that
a fiscal stimulus would
trigger the following:
 An increase in the
demand for labour as
government spending
generates growth.
 The pool of unemployed
would fall.
 Firms compete for fewer
workers by raising wages.
 Workers have greater
bargaining power.
 Higher wages push up
wage costs and prices are
increased.
Inflation
(%)
P1
The Phillips
Curve
P
U1
© Economics Online 2011
U
Unemployment
(%)
 It became accepted that
policy makers could exploit
the trade off - a little more
unemployment meant a
little less inflation.
 During the 1960s and 70s
governments around the
world would select a rate
of inflation they wished to
achieve. This policy
became known as ‘stopgo’, and relied strongly on
fiscal policy to create the
required expansions and
contractions.
Inflation
(%)
However, by the end of the 1970s
the stable and inverse relationship
began to break down. As policy
makers exploited the relationship,
it began to break down.
P
P1
The Phillips
Curve
U
© Economics Online 2011
U1
Unemployment
(%)
The breakdown of the Phillips Curve
By the mid 1970s it appeared
that the Phillips Curve trade Inflation
(%)
off no longer existed in its
original form.
 American economists
Friedman and Phelps offered
one explanation:
1. There was a series of short
run Phillips Curves and a long
run Phillips Curve.
2. This was fixed at the natural
rate of unemployment (NRU)
referred later to as NAIRU.

Long Run Phillips
Curve
Short Run Phillips
Curves
© Economics Online 2011
NRU
The Natural Rate of
Unemployment
Unemployment
(%)
What happened? The New Classical View
Assume the economy starts
at point A (the NRU) and the Inflation
(%)
government creates a
stimulus through a monetary
expansion -more money in
the economy.
 Initially the economy moves
to B, but money illusion has
been fooling everyone!
When firms realise this the
reduce their demand for
labour back to the previous P2
level.
 The economy moves to C –
back to the NRU, but with
P1
higher inflation, at P1.

Long Run
Phillips Curve
D
B
E
C
Short Run
Phillips Curves
A
P
U1
© Economics Online 2011
NRU
The Natural Rate of
Unemployment
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 push for
higher money wages.
 As a result, wage costs rise and
the SRAS shifts up to SRAS1
and the economy now moves
back to Y, but with a higher
price level, at P2.

Price
Level
LRAS
SRAS1
SRAS
P2
P1
P
AD1
AD
Y
© Economics Online 2011
Y1
National
Output (Y)
© Economics Online 2011
Supply-side policy


Supply side policy includes any policy that improves an economy’s
ability to produce. There are a number of individual actions that a
government can take to improve supply-side performance, including:
Measures to improve labour productivity and flexibility, such as:
Using the tax system to stimulate output, rather than to alter demand.
This commonly means lower direct tax rates, such as lower Income tax
and lower Corporation tax. This should act as an incentive to join the
labour market, or to work harder.
2. Greater competition in labour markets - through legislation to eliminate
restrictive practices, and remove labour market rigidities, such as the
protection of employment. For example, as part of supply-side reforms
in the 1980s, trade union powers were greatly reduced by a series of
measures including limiting their ability to call a strike, and enforcing
secret ballots of union members prior to strike action.
1.
© Economics Online 2011
Supply-side policy
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 supplyside 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.
3.
© Economics Online 2011

Measures to improve competition and product market efficiency:
Government assistance to firms to encourage firms to use new
technology, and to undertake innovation, such as through grants, or
through the tax system.
2. De-regulation of product markets to bring down barriers to entry, and
encourage new entrants. The effect of this would be to make markets
more competitive and increase efficiency. Promoting competition is
called competition policy.
3. Privatisation of state industry is also a central part of supply-side policy,
and can contribute to the spread of an enterprise culture.
4. The supply side can also be improved if there is dynamic entry of new
firms. Small businesses are often innovative and flexible, and can be
helped in a number of ways, including start-up loans and tax breaks.
1.
© Economics Online 2011
The effects of supply-side policy
Successful supply-side
policy will shift the LRAS
curve to the right.
 This can help reduce
inflation in the long term
because of efficiency
and productivity gains.
 Such policies create jobs
and growth through
their positive effect on
productivity and
competitiveness, which
also improves the
balance of payments.
Price
Level

The shift to the right in the
LRAS curve creates the
possibility of a lower price
level and more output and
jobs in the longer term
LRAS
LRAS1
Actual
equilibrium in
the short run
is determined
by the position
of SRAS in
relation to AD
SRAS
P
P1
AD
Y
© Economics Online 2011
Y1
National
Income (Y)
© Economics Online 2011
Conflicts of objectives


1.
Conflicts of policy objectives occur when, in attempting to achieve one
objective, another objective is sacrificed.
There are numerous potential conflicts, including:
Full employment vs low inflation
The conflict between employment and prices is the most widely studied in
economics.
 If policy makers attempt to undertake job creation by injecting demand
into the economy - by expansionary fiscal or monetary policy - there is a
danger that inflation will be driven up. This conflict is best explained by
reference to the Phillips Curve.
 It is likely that the trade-off still exists, despite the UK economy
approaching full employment and prices still remaining stable in recent
years.

© Economics Online 2011
Conflicts of objectives
2.
Economic growth vs stable prices

3.
Economic growth vs a balance of payments

4.
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 and negative externalities

Economic growth can generate both consumption and production
externalities.
© Economics Online 2011
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.
© Economics Online 2011
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.

© Economics Online 2011