Econ 101

Question 1

Backwardation

Answer 1

When a commodity is valued more highly in a spot market (that is, when it is for delivery today) than in a futures market (for delivery at some point in the future). Normally, interest costs mean that futures prices are higher than spot prices, unless the markets expect the price of the commodity to fall over time, perhaps because there is a temporary bottleneck in supply.

Question 2

Contango

Answer 2

When spot prices are lower than futures prices. Opposite of Backwardation.

Question 3

Balance of payments

Answer 3

The total of all the money coming into a country from abroad less all of the money going out of the country during the same period. This is usually broken down into the current account and the capital account.

Question 4

Current account

Answer 4

The current account includes: the value of exports and imports of physical goods, receipts and payments for services, private transfers (such as money sent home by expatriate workers), and
*official transfers, such as international aid.

Question 5

Basel 1 and 2

Answer 5

An attempt to reduce the number of bank failures by tying a bank’s capital adequacy ratio to the riskiness of the loans it makes. For instance, there is less chance of a loan to a government going bad than a loan to, say, an internet business, so the bank should not have to hold as much capital in reserve against the first loan as against the second.

Question 6

Beta

Answer 6

Beta measures the sensitivity of the price of a particular asset to changes in the market as a whole. If a company’s shares have a beta of 0.8 it implies that on average the share price will change by 0.8% if there is a 1% change in the overall market. (Some economists think Beta is invalid).

Question 7

Bretton Woods

Answer 7

A conference held at Bretton Woods, New Hampshire, in 1944, which designed the structure of the international monetary system after the second world war and set up the imf and the world bank. It was agreed that the exchange rates of IMF members would be pegged to the dollar, with a maximum variation of 1% either side of the agreed rate. Rates could be adjusted more sharply only if a country’s balance of payments was in fundamental disequilibrium. In August 1971 economic troubles and the cost of financing the Vietnam war led the American president, Richard Nixon, to devalue the dollar. This shattered confidence in the fixed exchange rate system and by 1973 all of the main currencies were floating freely, at rates set mostly by market forces rather than government fiat.

Question 8

Capital controls

Answer 8

government-imposed restrictions on the ability of capital to move in or out of a country. Examples include limits on foreign investments in some country’s financial markets.

Question 9

Capital flight

Answer 9

When capital flows rapidly out of a country, usually because something happens which causes investors suddenly to lose confidence in its economy.

Question 10

Capital intensive

Answer 10

A production process that involves comparatively large amounts of capital; the opposite of labor intensive.

Question 11

Classical economics

Answer 11

The dominant theory of economics from the 18th century to the 20th century. Classical economists, who included Adam smith, believed that the pursuit of individual self-interest produced the greatest possible economic benefits for society as a whole through the power of the invisible hand. They also believed that an economy is always in equilibrium or moving towards it.

Question 12

Command economy

Answer 12

When a government controls all aspects of economic activity (Ex: Communism).

Question 13

Commoditization

Answer 13

The process of becoming a commodity. Microchips, for example, started out as a specialized technical innovation, costing a lot and earning their makers a high profit on each chip. Now chips are largely homogeneous: the same chip can be used for many things, and any manufacturer willing to invest in some fairly standardized equipment can make them. As a result, competition is fierce and prices and profit margins are low. Some economists argue that in today’s economy the faster pace of innovation will make the process of commoditization increasingly common.

Question 14

Communism

Answer 14

A form of economic life that would ideally be organised to achieve ‘from each according to his abilities, to each according to his needs’.

Question 15

Cost of capital

Answer 15

The amount a firm must pay the owners of capital for the privilege of using it. This includes interest payments on corporate debt, as well as the dividends generated for shareholders

Question 16

Crony capitalism

Answer 16

An approach to business based on looking after yourself by looking out for your own.

Question 17

Deflation

Answer 17

Falling prices

Question 18

Disinflation

Answer 18

A fall in the rate of inflation. This means a slower increase in prices but not a fall in prices, which is known as deflation.

Question 19

Dollarization

Answer 19

When a country’s own MONEY is replaced as its citizens’ preferred currency by the US dollar.

Question 20

Econometrics

Answer 20

Mathematics and sophisticated computing applied to economics. Econometricians crunch data in search of economic relationships that have statistical significance.

Question 21

Efficient market hypothesis

Answer 21

You can’t beat the market. The efficient market hypothesis says that the price of a financial asset reflects all the information available and responds only to unexpected news.

Question 22

Price Elasticity

Answer 22

Measures how much the quantity of SUPPLY of a good, or DEMAND for it, changes if its PRICE changes. If the percentage change in quantity is more than the percentage change in price, the good is price elastic; if it is less, the good is INELASTIC.

Question 23

Equity risk premium

Answer 23

The extra reward investors get for buying a SHARE over what they get for holding a less risky ASSET, such as a government BOND. Modern financial theory assumes that the premium will be just big enough on AVERAGE to compensate the investor for the extra RISK. However, studies have found that the average equity premium over many years has been much larger than appears to be justified by the average riskiness of shares.

Question 24

Fiscal drag

Answer 24

Fiscal drag is the tendency of revenue from taxation to rise as a share of GDP in a growing economy. Tax allowances, progressive tax rates and the threshold above which a particular rate of tax applies usually remain constant or are changed only gradually. By contrast, when the economy grows, income, spending and corporate profit rise. So the tax-take increases too, without any need for government action. This helps slow the rate of increase in demand, reducing the pace of growth, making it less likely to result in higher inflation. Thus fiscal drag is an automatic stabilizer, as it acts naturally to keep demand stable.

Question 25

Foreign direct investment

Answer 25

Investing directly in production in another country, either by buying a company there or establishing new operations of an existing business. This is done mostly by companies as opposed to financial institutions, which prefer indirect investment abroad such as buying small parcels of a country’s supply of shares or bonds.

Question 26

Frictional unemployment

Answer 26

That part of the jobless total caused by people simply changing jobs and taking their time about it, because they are spending time on job search or are taking a break before starting with a new employer. There is likely to be some frictional unemployment even when there is technically full employment, because most people change jobs from time to time.

Question 27

Milton Friedman

Answer 27

Economist who praises the free market not just for its economic efficiency but also for its moral strength. For him, freedom–economic, political and civil–is an end in itself, not a means to an end.

Question 28

Fungible

Answer 28

Something is fungible when any one single specimen is indistinguishable from any other. Somebody who is owed $1 does not care which particular dollar he gets.

Question 29

Gilts

Answer 29

Government bonds

Question 30

Gold standard

Answer 30

A monetary system in which a country backs its currency with a reserve of gold, and allows currency holders to exchange their notes and coins for gold.

Question 31

Hot money

Answer 31

Money that is held in one currency but is liable to switch to another currency at a moment’s notice in search of the highest available RETURNS, thereby causing the first currency’s EXCHANGE RATE to plummet. It is often used to describe the money invested in currency markets by speculators.

Question 32

Income effect

Answer 32

A change in the DEMAND for a good or service caused by a change in the INCOME of consumers rather than, say, a change in consumer tastes.

Question 33

Inelastic

Answer 33

When the SUPPLY or DEMAND for something is insensitive to changes in another variable, such as PRICE.

Question 34

Invisible hand

Answer 34

Adam SMITH’s shorthand for the ability of the free market to allocate FACTORS OF PRODUCTION, goods and SERVICES to their most valuable use. If everybody acts from self-interest, spurred on by the PROFIT motive, then the economy will work more efficiently, and more productively, than it would do were economic activity directed instead by some sort of central planner. It is, wrote Smith, as if an ‘invisible hand’ guides the actions of individuals to combine for the common good.

Question 35

J-curve

Answer 35

The shape of the trend of a country’s trade balance following a DEVALUATION. A lower EXCHANGE RATE initially means cheaper EXPORTS and more expensive IMPORTS, making the current account worse (a bigger DEFICIT or smaller surplus). After a while, though, the volume of exports will start to rise because of their lower PRICE to foreign buyers, and domestic consumers will buy fewer of the costlier imports. Eventually, the trade balance will improve on what it was before the devaluation. If there is a currency APPRECIATION there may be an inverted J-curve.

Question 36

Keynesian

Answer 36

A branch of ECONOMICS, based, often loosely, on the ideas of KEYNES, characterized by a belief in active GOVERNMENT and suspicion of market outcomes. It was dominant in the 30 years following the second world war, and especially during the 1960s, when FISCAL POLICY became bigger-spending and looser in most developed countries as policymakers tried to kill off the BUSINESS CYCLE. During the 1970s, widely blamed for the rise in INFLATION, Keynesian policies gradually gave way to monetarism and microeconomic policies that owed much to the NEO-CLASSICAL ECONOMICS that Keynes had at times opposed. Even so, the idea that PUBLIC SPENDING and TAXATION have a crucial role to play in managing DEMAND, in order to move towards FULL EMPLOYMENT, remained at the heart of MACROECONOMIC POLICY in most countries, even after the monetarist and supply-side revolution of the 1980s and 1990s.

Question 37

Laffer curve

Answer 37

Legend has it that in November 1974 Arthur Laffer, a young economist, drew a curve on a napkin in a Washington bar, linking AVERAGE tax rates to total tax revenue. Initially, higher tax rates would increase revenue, but at some point further increases in tax rates would cause revenue to fall, for instance by discouraging people from working. The curve became an icon of supply-side ECONOMICS. Some economists said that it proved that most governments could raise more revenue by cutting tax rates, an argument that was often cited in the 1980s by the tax-cutting governments of Ronald Reagan and Margaret Thatcher. Other economists reckoned that most countries were still at a point on the curve at which raising tax rates would increase revenue. The lack of empirical evidence meant that nobody could really be sure where the United States and other countries were on the Laffer curve.

Question 38

Laissez-faire

Answer 38

Let-it-be ECONOMICS: the belief that an economy functions best when there is no interference by GOVERNMENT. (hint: It doesn’t work)

Question 39

Liquidity trap

Answer 39

When MONETARY POLICY becomes impotent. Cutting the rate of INTEREST is supposed to be the escape route from economic RECESSION: boosting the MONEY SUPPLY, increasing DEMAND and thus reducing UNEMPLOYMENT. But KEYNES argued that sometimes cutting the rate of interest, even to zero, would not help. People, BANKS and FIRMS could become so RISK AVERSE that they preferred the LIQUIDITY of cash to offering CREDIT or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policymakers.

KEYNESIANs reckon that in the 1930s the economies of both the United States and the UK were caught in a liquidity trap. In the late 1990s, the Japanese economy suffered a similar fate. But MONETARISM has no place for liquidity traps. Monetarists pin the blame for the Great DEPRESSION and Japan’s more recent troubles on other factors and reckon that ways could have been found to make monetary policy work.

Question 40

Marginal

Answer 40

The difference made by one extra unit of something. Marginal revenue is the extra revenue earned by selling one more unit of something. The marginal PRICE is how much extra a consumer must pay to buy one extra unit. Marginal UTILITY is how much extra utility a person gets from consuming (or doing) an extra unit of something. The marginal product of LABOUR is how much extra OUTPUT a firm would get by employing an extra worker, or by getting an existing worker to put in an extra hour on the job. The marginal PROPENSITY to consume (or to save) measures by how much a household’s CONSUMPTION (SAVINGS) would increase if its INCOME rose by, say, $1. The marginal tax rate measures how much extra tax you would have to pay if you earned an extra dollar.

The marginal cost (or whatever) can be very different from the AVERAGE cost (or whatever), which simply divides total costs (or whatever) by the total number of units produced (or whatever). A common finding in MICROECONOMICS is that small incremental changes can matter enormously. In general, thinking ‘at the margin’ often leads to better economic decision making than thinking about the averages.

Question 41

Marshall Plan

Answer 41

Probably the most successful programme of INTERNATIONAL AID and nation building in history. It was named after General George Marshall, an American secretary of state, who at the end of the second world war proposed giving aid to Western Europe to rebuild its war-torn economies. North America gave around 1% of its GDP in total between 1948 and 1952; most of it came from the United States and the rest from Canada. The Americans left it to the Europeans to work out the details on allocating aid, which may be why, according to most economic analyses, it achieved more success than latter day aid programmes in which most of the decisions on how the MONEY is spent are made by the donors. The main institution through which aid was administered was the Organisation for European Economic Co-operation (OEEC), which in 1961 became the OECD. Nowadays, whenever there is a proposal for the international community to rebuild an economy damaged by war, such as Iraq’s in 2003, you are sure to hear the phrase ‘new Marshall Plan’.

Question 42

Marx, Karl

Answer 42

Much followed, and much misunderstood, German economist (1818–83). His two best-known works were the Communist Manifesto, written in 1848 with Friedrich Engels, and Das Kapital, in four volumes published between 1867 and 1910. Most of his economic assumptions were drawn from orthodox CLASSICAL ECONOMICS, but he used them to reach highly unorthodox conclusions. Although claimed and blamed as the inspiration of some of the most virulently anti-market governments the world has ever seen, he was not wholly against CAPITALISM. Indeed, he praised it for rescuing millions of people from “the idiocy of rural life”. Even so, he thought it was doomed. A shortage of DEMAND would concentrate economic power and wealth in ever fewer hands, producing an ever-larger and more miserable proletariat. This would eventually rise up, creating a “dictatorship of the proletariat” and leading eventually to a “withering away” of the state. Marx thought that this version of history was inevitable. So far, history has proved him wrong, largely because capitalism has delivered a much better deal to the masses than he believed it would.

Question 43

Mercantilism

Answer 43

The conventional economic wisdom of the 17th century that made a partial come-back in recent years. Mercantilists feared that MONEY would become too scarce to sustain high levels of OUTPUT and employment; their favoured solution was cheap money (low INTEREST rates). In a forerunner to the 20th-century debate between KEYNESIANS and MONETARISTS, they were opposed by advocates of CLASSICAL ECONOMICS, who argued that cheap and plentiful money could result in INFLATION. The original mercantilists, such as John Law, a Scots financier (and convicted murderer), believed that a country’s economic prosperity and political power came from its stocks of precious metals. To maximise these stocks they argued against FREE TRADE, favouring protectionist policies designed to minimise IMPORTS and maximise EXPORTS, creating a TRADE SURPLUS that could be used to acquire more precious metal. This was contested for the classicists by ADAM SMITH and David Hume, who argued that a country’s wealth came not from its stock of precious metals but rather from its stocks of productive resources (LAND, LABOUR, CAPITAL, and so on) and how efficiently they are used. Free trade increased EFFICIENCY by allowing countries to specialise in things in which they have a COMPARATIVE ADVANTAGE.

Question 44

Misery index

Answer 44

The sum of a country’s INFLATION and UNEMPLOYMENT rates. The higher the score, the greater is the economic misery.

Question 45

Modern portfolio theory

Answer 45

One of the most important and influential economic theories about finance and INVESTMENT. Modern portfolio theory is based upon the simple idea that DIVERSIFICATION can produce the same TOTAL RETURNS for less RISK. Combining many financial ASSETS in a portfolio is less risky than putting all your investment eggs in one basket. The theory has four basic premises.

Investors are RISK AVERSE.

SECURITIES are traded in efficient markets.

Risk should be analysed in terms of an investor’s overall portfolio, rather than by looking at individual assets.

For every level of risk, there is an optimal portfolio of assets that will have the highest EXPECTED RETURNS.

Question 46

Monetarism

Answer 46

Control the MONEY SUPPLY, and the rest of the economy will take care of itself. A school of economic thought that developed in opposition to post-1945 KEYNESIAN policies of DEMAND management, echoing earlier debates between MERCANTILISM and CLASSICAL ECONOMICS. Monetarism is based on the belief that INFLATION has its roots in the GOVERNMENT printing too much MONEY. It is closely associated with Milton MILTON FRIEDMAN, who argued, based on the QUANTITY THEORY OF MONEY, that government should keep the MONEY SUPPLY fairly steady, expanding it slightly each year mainly to allow for the natural GROWTH of the economy. If it did this, MARKET FORCES would efficiently solve the problems of INFLATION, UNEMPLOYMENT and RECESSION. Monetarism had its heyday in the early 1980s, when economists, governments and investors pounced eagerly on every new money-supply statistic, particularly in the United States and the UK.

Many CENTRAL BANKS had set formal targets for money-supply growth, so every wiggle in the data was scrutinised for clues to the next move in the rate of INTEREST. Since then, the notion that faster money-supply growth automatically causes higher inflation has fallen out of favour. The money supply is useful as a policy target only if the relationship between money and nominal GDP, and hence inflation, is stable and predictable. The way the money supply affects PRICES and OUTPUT depends on how fast it circulates through the economy. The trouble is that its VELOCITY OF CIRCULATION can suddenly change. During the 1980s, the link between different measures of the money supply and inflation proved to be less clear than monetarist theories had suggested, and most central banks stopped setting binding monetary targets. Instead, many have adopted explicit inflation targets.

Question 47

Monetary neutrality

Answer 47

Changes in the MONEY SUPPLY have no effect on real economic variables such as OUTPUT, real INTEREST rates and UNEMPLOYMENT. If the CENTRAL BANK doubles the money supply, the PRICE level will double too. Twice as many dollars means half as much bang for the buck. This theory, a core belief of CLASSICAL ECONOMICS, was first put forward in the 18th century by David Hume. He set out the classical dichotomy that economic variables come in two varieties, nominal and real, and that the things that influence nominal variables do not necessarily affect the real economy. Today few economists think that pure monetary neutrality exists in the real world, at least in the short run. Inflation does affect the real economy because, for instance, there may be STICKY PRICES or MONEY ILLUSION.

Question 48

Moral hazard

Answer 48

One of two main sorts of MARKET FAILURE often associated with the provision of INSURANCE. The other is ADVERSE SELECTION. Moral hazard means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for.

Question 49

Natural rate of unemployment

Answer 49

the lowest rate of UNEMPLOYMENT at which the jobs market can be in stable EQUILIBRIUM.

Question 50

Nominal value

Answer 50

The value of anything expressed simply in the MONEY of the day. Since INFLATION means that money can lose its value over time, nominal figures can be misleading when used to compare values in different periods. It is better to compare their real value, by adjusting the nominal figures to remove the inflationary distortions.

Question 51

Null hypothesis

Answer 51

A statement that is being put to the test. In ECONOMETRICS, economists often start with a null hypothesis that a particular variable equals a particular number, then crunch their data to see if they can prove or disprove it, according to the laws of STATISTICAL SIGNIFICANCE. The null hypothesis chosen is often the reverse of what the experimenter actually believes; it may be put forward to allow the data to contradict it.

Question 52

Output gap

Answer 52

How far an economy’s current OUTPUT is below what it would be at full CAPACITY. On average, INFLATION rises when output is above potential and falls when output is below potential. However, in the short run, the relationship between inflation and the output gap can deviate from the longer-term pattern and can thus be misleading. Alas for policymakers – because nobody really knows what an economy’s potential output is, the size and even the direction of the output gap can easily be misdiagnosed, which can contribute to serious errors in MACROECONOMIC POLICY.

Question 53

Phillips curve

Answer 53

In 1958, an economist from New Zealand, A.W.H. Phillips (1914-75), proposed that there was a trade-off between INFLATION and UNEMPLOYMENT: the lower the unemployment rate, the higher was the rate of inflation. Governments simply had to choose the right balance between the two evils. He drew this conclusion by studying nominal wage rates and jobless rates in the UK between 1861 and 1957, which seemed to show the relationship of unemployment and inflation as a smooth curve.

Economies did seem to work like this in the 1950s and 1960s, but then the relationship broke down. Now economists prefer to talk about the NAIRU, the lowest rate of unemployment at which inflation does not accelerate.

Question 54

NAIRU

Answer 54

the lowest rate of unemployment at which inflation does not accelerate.

Question 55

Plaza Accord

Answer 55

On September 22nd 1985, finance ministers from the world’s five biggest economies - the United States, Japan, West Germany, France and the UK - announced the Plaza Accord at the eponymous New York hotel. Each country made specific promises on economic policy: the United States pledged to cut the federal deficit, Japan promised a looser [economics-term KEY-“MONETARY POLICY”]monetary policy[/economics-term] and a range of financial-sector reforms, and Germany proposed tax cuts. All countries agreed to intervene in currency markets as necessary to get the dollar down. Perhaps not surprisingly, not all the promises were kept (least of all the American one on deficit cutting), but even so the plan turned out to be spectacularly successful. By the end of 1987, the dollar had fallen by 54% against both the D-mark and the yen from its peak in February 1985. This sharp drop led to a new fear: of an uncontrolled dollar plunge. So in 1987 another big international plan, the Louvre Accord, was hatched to stabilise the dollar. Again specific policy pledges were made (the United States to tighten fiscal policy, Japan to loosen monetary policy). Again the participants promised currency intervention if major currencies moved outside an agreed, but unpublished, set of ranges. The dollar promptly rose.

Question 56

Price/earnings ratio

Answer 56

A crude method of judging whether SHARES are cheap or expensive; the ratio of the market PRICE of a share to the company’s earnings (PROFIT) per share. The higher the price/earnings (P/E) ratio, the more investors are buying a company’s shares in the expectation that it will make larger profits in future than now. In other words, the higher the P/E ratio, the more optimistic investors are being.

Question 57

Prisoners’ dilemma

Answer 57

A favourite example in GAME THEORY, which shows why co-operation is difficult to achieve even when it is mutually beneficial. Two prisoners have been arrested for the same offence and are held in different cells. Each has two options: confess, or say nothing. There are three possible outcomes. One could confess and agree to testify against the other as state witness, receiving a light sentence while his fellow prisoner receives a heavy sentence. They can both say nothing and may be lucky and get light sentences or even be let off, owing to lack of firm evidence. Or they may both confess and probably get lighter individual sentences than one would have received had he said nothing and the other had testified against him. The second outcome would be the best for both prisoners. However, the RISK that the other might confess and turn state witness is likely to encourage both to confess, landing both with sentences that they might have avoided had they been able to co-operate in remaining silent. In an OLIGOPOLY, FIRMS often behave like these prisoners, not setting PRICES as high as they could do if they only trusted the other firms not to undercut them. As a result, they are worse off.

Question 58

Prospect theory

Answer 58

A theory of ‘irrational’ economic behaviour. Prospect theory holds that there are recurring biases driven by psychological factors that influence people’s choices under uncertainty. In particular, it assumes that people are more motivated by losses than by gains and as a result will devote more energy to avoiding loss than to achieving gain. The theory is based on the experimental work of two psychologists, Daniel Kahneman (who won a nobel prize for economics for it) and Amos Tversky (1937-96). It is an important component of BEHAVIOURAL ECONOMICS.

Question 59

Reserve ratio

Answer 59

The fraction of its deposits that a BANK holds as RESERVES

Question 60

Reserve requirements

Answer 60

Regulations governing the minimum amount of RESERVES that a BANK must hold against deposits.

Question 61

Sharpe ratio

Answer 61

A rough guide to whether the rewards from an INVESTMENT justify the RISK, invented by Bill Sharpe, a winner of the NOBEL PRIZE FOR ECONOMICS and co-creator of the CAPITAL ASSET PRICING MODEL. You simply divide the past RETURN on the investment (less the RISK-FREE RATE) by its STANDARD DEVIATION, the simplest measure of risk. The higher the Sharpe ratio is the better, that is, the greater is the return per unit of risk. However, as it is a backward-looking measure, based on what an investment has done in the past, the Sharpe ratio does not guarantee similar performance in future.

Question 62

Smith, Adam

Answer 62

The founder of ECONOMICS as we know it. Born in Kirkcaldy, Fife, Adam Smith (1723-90) was educated at Glasgow and Oxford, and in 1751 became professor of logic at Glasgow University. Eight years later he made his name by publishing the THEORY OF MORAL SENTIMENTS. His 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations, is the bible of CLASSICAL ECONOMICS. He emphasised the role of specialisation (the DIVISION OF LABOUR), TECHNICAL PROGRESS and CAPITAL INVESTMENT as the main engines of economic GROWTH. Above all, he stressed the importance of the INVISIBLE HAND, the way in which self-interest pursued in free markets leads to the most efficient use of economic resources and makes everybody better off in the process.

Question 63

Socialism

Answer 63

The exact meaning of socialism is much debated, but in theory it includes some collective ownership of the means of production and a strong emphasis on equality, of some sort.

Question 64

Sovereign risk

Answer 64

The RISK that a GOVERNMENT will default on its DEBT or on a loan guaranteed by it.

Question 65

Stagflation

Answer 65

Term coined in the 1970s for the twin economic problems of STAGNATION and rising INFLATION. Until then, these two economic blights had not appeared simultaneously. Indeed, policymakers believed the message of the PHILLIPS CURVE: that UNEMPLOYMENT and inflation were alternatives.

Question 66

Sterilized intervention

Answer 66

When a GOVERNMENT or CENTRAL BANK buys or sells some of its RESERVES of foreign currency this can affect the country’s MONEY SUPPLY. Selling reserves decreases the supply of the domestic currency; buying reserves increases the domestic money supply. Governments or central banks can sterilize (that is, cancel out) this effect of foreign exchange intervention on the money supply by buying or selling an equivalent amount of SECURITIES. For example, if the GOVERNMENT increases reserves by buying foreign currency the domestic money supply will increase, unless it sells securities such as TREASURY BILLS to mop up the extra DEMAND.

Question 67

Structural unemployment

Answer 67

The hardest sort of UNEMPLOYMENT to cure because it is caused by the structure of an economy rather than by changes in the economic cycle. Contrast with cyclical unemployment, which can, in theory if not always in practice, be cut without sparking INFLATION by stimulating faster economic GROWTH. Structural unemployment can be reduced only by changing the economic structures causing it, for instance, by removing rules that limit LABOUR MARKET FLEXIBILITY.

Question 68

Supply-side policies

Answer 68

Increasing economic GROWTH by making markets work more efficiently. In the 1980s, Ronald Reagan and Margaret Thatcher championed supply-side policies as they attacked KEYNESIAN DEMAND management. Pumping up demand without making markets work better would simply lead to higher INFLATION; economic growth would increase only when markets were able to operate more freely. Thus they pursued policies of DEREGULATION, LIBERALISATION and PRIVATISATION and encouraged FREE TRADE. To reduce UNEMPLOYMENT, they tried to increase the EFFICIENCY of the jobs market by cutting the rate of INCOME TAX and attacking legal and other impediments to LABOUR MARKET FLEXIBILITY. The results of these programmes are much debated. In particular, the belief, apparently supported by the LAFFER CURVE, that cutting tax rates would increase tax revenue did not always stand up well to real-world testing. Even so, it is now recognised that supply-side reforms are a crucial element in an effective economic policy.

Question 69

Third way

Answer 69

An economic philosophy espoused by some leftish political leaders in the late 20th century, including Bill Clinton and Tony Blair. According to the rhetoric, it is not CAPITALISM and not SOCIALISM, but a third (pragmatic) way. Many have therefore found it rather hard to pin down. It was earlier used to describe Sweden’s economic model.

Question 70

Trade-weighted exchange rate

Answer 70

A country’s EXCHANGE RATE with the currencies of its trading partners weighted by the amount of trade done by the country in each currency.

Question 71

Transfer pricing

Answer 71

The PRICES assumed, for the purposes of calculating tax liability, to have been charged by one unit of a multinational company when selling to another (foreign) unit of the same firm. FIRMS spend a fortune on advisers to help them set their transfer prices so that they minimise their total tax bill. For instance, by charging low transfer prices from a unit based in a high-tax country that is selling to a unit in a low-tax country, a firm can record a low PROFIT in the first country and a high profit in the second. In theory, however, transfer prices are supposed to be set according to the arm’s-length principle: that they should be the same as would be charged if the sale was to a business unconnected in any way to the selling firm. But when there is no genuinely independent market with which to compare transfer prices, what an arm’s length price would be can be a matter of great debate and an opportunity for firms that want to lower their tax bill.

Question 72

Unemployment trap

Answer 72

When unemployed people who receive benefits, either from the GOVERNMENT or from private CHARITY, are deterred from taking a new job because the reduction or removal of benefit if they do will make them worse off. Also known as the POVERTY TRAP, it can be addressed, to an extent, by continuing to pay benefit for a while to unemployed people returning to work. (See WELFARE TO WORK.)

Question 73

Value at risk

Answer 73

Value at risk models, widely used for RISK MANAGEMENT by BANKS and other financial institutions, use complex computer algorithms to calculate the maximum that the institution could lose in a single day’s trading. These models seem to work well in normal conditions but not, alas, during financial crises, which is arguably when it is most necessary to know how much value is at RISK.

Question 74

NAIRU

Answer 74

Non-Accelerating Inflation Rate of Unemployment – refers to a theoretical level of unemployment below which inflation would be expected to rise. (Ex: If NAIRU is 5%, then an unemployment rate below 5% would spur inflation growth, while unemployment at 5% would result in steady inflation, and an unemployment rate above 5% would see a decrease in the rate of inflation).

It is the specific level of unemployment that is evident in an economy that does not cause inflation to increase. In other words, if unemployment is at the NAIRU level, inflation is constant. NAIRU often represents the equilibrium between the state of the economy and the labor market.