macro econs (pink book) Flashcards
Econ growth definition
increase in real value of the goods and services produced by an economy over time. Governments aim to achieve sustained, sustainable, and inclusive economic growth to better the SOL around the world
what is needed for sustained econ growth + definitions
actual growth: increase in national output produced in an economy over a given period of time (measured by percentage annual increase in real GDP)
potential growth: long run expansion of a country’s productive potential. It reflects the increase in the capacity of the economy to produce
AD change lead to actual growth explanation + graph
Rise in AD due to C, I, G or X-M
This will create shortage in goods and services and stimulate firms to increase the production of output via adopting more FOP. This leads to a rightward shift of AD curve from AD1 to AD2. This triggers the multiplier process creating many rounds of increase in induced consumption as one persons spending is another person income and income generates more spending. The multiplier process ends when the initial autonomous increase in AD is fully withdrawn in the form of savings, taxes and import expenditure where sum of injections = sum of withdrawals.
graph 1
AS change lead to actual growth explanation + graph
A fall in COP encourages firms to expand output at every price level. This is represented by a downward shift of the AS curve from AS1 to AS2 where RNY increases from Y1 to Y2.
graph 2
Actual growth explanation using PPC graph
Movement of a point outwards from within the PPC to closer on the PPC curve
graph 3
Potential growth explanation using AD/AS curve + PPC
PPC: Outward shift of the PPC curve as the maximum amount of consumer and capital goods that the economy can produce at full employment increases
graph 4 and graph 5
Sustained growth explanation using AD/AS + graph
(just read)
For there to be sustained economic growth, actual growth must be accompanied by potential growth. Without an expansion of AS and potential output, rises in actual output will end once all spare capacity has been used up. Once full employment of labour and resources is reached at Yf1, any further increases in AD from AD1 to AD2 will only increase prices from P1 to P2. Actual output remains fixed at Yf1.
graph 6
Inclusive economic growth definition + explanation (just read for explanation)
rate of growth that is sustained over a period of time, is broad based across economic sectors and creates productive employment opportunities for the majority of the country’s population
When an economy achieves sustained economic growth in both its AD and productive capacity, the economy can potentially experience inclusive growth. Any autonomous increase in AD will lead to the multiplier effect. As one persons spending is another persons income, many sectors in the economy can experience a rise in induced demand and spending. This creates productive employment opportunities in these broad range of sectors across the economy, lifting income for many.
However, to ensure that the growth is inclusive, the economy must also take income distribution into consideration and ensure that any growth does not lead to worsening income and wealth inequality. As an economy grows and develops, because the fruits of growth may not be equitably distributed. Gini coefficient would rise and the government plays a crucial role in driving inclusive and equitable growth.
Sustainable growth definition + explanation (just read for explanation)
rate of growth that can be maintained without creating other significant economic problems such as depleted resources and environmental problems particularly for future generations. It also implies a positive and stable rate of growth over an extended period of time.
When an economy achieves sustained economic growth via continued growth in both AD and productive capacity, the economy can potentially experience sustainable growth as the govt and private sectors are more able and willing to spend on sustainable practices with increased tax revenue and income. (eg. public spending and private investments in renewable energy and clean transport infrastructure can directly reduce greenhouse gas emissions and pollution. This also reduces reliance on finite fossil fuels ensuring future generations have access to essential resources and REDUCES THE LONG TERM ENVIRONMENTAL IMPACT ON AN ECONOMY and prevents the productive capacity from declining rapidly over the long run)
Benefits of econ growth (4)
- Higher mSOL
- assuming population size remains unchanged, people will have higher purchasing power to due rise in real GDP per capita
- since more final goods and services are produced due to rise in RNY and made available for consumption to the average individual, mSOL improves
- actual growth also stimulates investments and potential growth
- as RNY increases, savings will increase as higher income induces higher savings
- will lead to an increase in supply of loanable funds in the credit market
- this will cause interest rates and cost of borrowing to fall and more investment projects will be undertaken leading to more actual growth
- stable growth also leads to increased business confidence and provide greater incentive for firms to invest
- higher capital expenditure allows the economy to expand its productive capacity and potential growth results
- sustained growth is achieved and there will be a continuous rise in RNY leading to higher mSOL - Higher nmSOL
- with higher income, people can afford better quality healthcare allowing for an increase in life expectancy and fall in infant mortality rate
- people are more able to take more time off for education, reflection and self fulfilment
- as the society gets richer, it will have a higher capacity to care for the environment and the less fortunate - Decrease in demand deficient/cyclical unemployment
- economic growth helps to create jobs as more goods and services are being demanded and produced, leading to higher induced demand for labour - Higher capacity for redistributing income and helping the poor
- rapidly growing economy can afford to be more generous to the disadvantaged
- rise in income leads to more tax revenue, enabling the government to spend more on transfer payments and subsidies to alleviate poverty and ensure social mobility
- lead to more inclusive growth
Cons of econ growth + graph (3)
- Overheating of economy and demand pull inflation
- result in tradeoffs with other macro goals such as stable and low inflation
- rapid increases in AD and actual growth can overheat the economy
- overheating occurs when AD rises excessively as the economy approaches full employment where resources are increasingly scarce, causing inflationary pressures in the economy
- a very large increase in eqm real output from Y0 to Y1 will be experienced as AD rises from AD0 to AD1 along the keynesian range of the AS curve due to the vast availability of untapped resources in the economy
- However, if AS remains constant with no increase in productive capacity, resources will become increasingly scarce. Further rises in AD from AD1 to AD2 then AD3 along the intermediate to AD4 on the classical range would lead to smaller and smaller extents of increases in real output over time.
- If AD goes on to rise beyond AD3 to AD4, real output cannot rise further to grow in a sustained manner as productive capacity is constrained at Yf with full employment of resources
- graph 7
- when AD rises rapidly while AD and productive capacity remains constant, the excess demand for goods must be met with the over employment of resources (eg. work extra shifts) which is hard to sustain as overemployment of resources cannot be supported indefinitely and will only lead to increases in GPL but not RNY and lead to demand pull inflation
- inflation can then hurt export competitiveness and cause uncertainty for investors and in turn, export revenue and investment will fall - Unequal and inequitable distribution of income
- propagates inequality
- real beneficiaries of growth tend to be the skilled and minority rich who already have the savings that enable new wealth accumulation and material gains from their financial investments
- this group will see a disproportionally bigger rise in their rental incomes and wealth when the economy grows
- inclusive growth is not achieved and reduces social cohesion
- can have adverse impact on nmSOL such as health, education and job security leading to alienation
- excessive wealth and income inequality gives rise to unequal access to opportunities and lead to reduced social mobility - Negative externalities and environmental costs
- encourage the creation of artificial needs and wants where consumers are induced to buy things that they have no intrinsic need for
- the greater the rate of growth and consumption, the greater the use of raw materials, leading to higher costs on the environment
- eg. large scale burning of fossil fuels is increasing the CO2 content in the atmosphere, creating harmful greenhouse effects, land clearing leads to haze, rising sea levels
- generates negative externalities on third parties, lowering their nmSOL
- lead to decrease in AS in the long run and hence unsustainable rate of future economic growth
what is desirable growth
healthy economic growth rate is neither too fast to create high inflation nor too slow to create recession
it should be sustained, sustainable and inclusive in nature
stable annual growth rate of around 2-3% for an advanced economy is ideal
what is undesirable growth
undesirable rate of economic growth involves declining or negative growth
declining growth: real GDP increasing but at a slower rate
negative growth: fall in real GDP which can arise due to a fall in autonomous AD or fall in AS
Causes of weak/negative economic growth (undesirable)
AD factors
AD factors:
- fall in AD will result in surpluses in goods and services which will lead to an increase in inventories in warehouses and firms will respond by reducing the production in the next time period, leading to a fall in RNY
- triggers the reverse multiplier process which will lead to a MTP fall in RNY due to many rounds of fall in induced consumption as a fall in spending by one person will lead to a loss in income for another person and less income leads to less spending.
- can be domestic (CIG) /international (X-M) factors
Causes of weak/negative economic growth (undesirable)
AS factors (5)
- Lack of fixed capital investment
- Private sector firms spend on new capital formation such as building new factor plants or buying new machinery, increasing I
- to keep increasing RNY at a satisfactory rate, economies must also spend on replacing its worn out and obsolete capital with the most up to date and technologically advanced equipment
- hence, the productive capacity and AD grows (QQT)
- when more capital stocks are made available for each worker, capital deepening, which is the increase in capital to labour ratio, is achieved
- productivity of labour would increase, leading to lower unit costs of labour and higher productive capacity to achieve economic growth
- hence lack of fixed capital investment will limit both actual and potential growth leading to weak or sluggish growth
- for capital stock to expand, a high savings rate in the country is needed to provide cheap and readily available funds for borrowing, especially when there is a lack of foreign investment
- however, savings rate is low in many developing countries (eg. high rates of poverty, high level of social security benefits that has reduced the need to rely on savings for rainy days), making it difficult to generate enough savings to provide funds to finance I projects - Lack of/fall in quantity or quality of natural resources
- increase in QQ (eg. discovery of new mineral deposits) will increase productive capacity and shift AS curve right
- destruction and depletion of non renewable resources and degradation of natural environment can threaten potential economic growth
- natural disasters like wildfires and human disasters like wars can destroy large areas of land
- unsustainable growth strategies can also lead to fall in QQ of natural resources reducing AS over time - Lack of investment in human capital
- workers are effective inputs if they are well educated, trained, healthy and motivated
- quality of labour can be improved through education and training
- as output per worker increases with labour productivity, the nations productive capacity will rise, pushing AS curve rightwards leading to potential growth
- assuming constant wages, the rise in productivity lowers COP leading to rise in AS and shifts downwards, leading to actual growth - Lack of tech advancement
- invention and innovation results in developments of new products and more efficient production of existing ones, leading to economic growth
- this can open new I opportunities as development in one industry can spread to related industries and set off a chain reaction
- average COP would fall as output per input increases with innovation hence both AS and AD will increase
- countries will little investment in tech will see slow growth with the use of archaic production methods and equipment
- rate of tech progress depends on success of scientists and innovators so there is great uncertainty with high costs and hence usually need institutional support (eg. govt subs) for research - Structural rigidities
- refers to a lasting feature in an economy caused by a set of institutions which prevents a market from operating freely
- eg. European countries have laws restricting businesses ability to lay off workers (contracts of indeterminate) which create job security but also labour market rigidity as firms find it hard to control costs especially during recessions making them more prone to closure
- eg. strong trade union results in high degree of coordination of wage bargaining processes and minimum wage setting hence firms face high labour costs and severance payouts making it hard and costly to hire and fire
- eg. Greece has strong barriers to entry involving excessive regulations that deter foreign investment
- many countries undergo structural reforms but this can lead to the vulnerable having to cope with the cost of adjustments
consequences of weak/negative economic growth (5)
- Higher unemployment
- rise in cyclical unemployment will occur when an economy is facing negative growth/recession
- technical recession: fall in real GDP for 2 consecutive quarters
- firms will hire fewer FOPS to produce reduced level of output
- unemployment will lead to forgone output, strain on govt budget (lower tax revenue, higher payouts), social issues, hysteresis - Lower SOL and savings
- assuming no change in population, during a recession, there is a fall in RNY which shows a fall in purchasing power of an average individual
- households earn and consume less when they are not working and hence the lower ability to consumer goods and services causes mSOL to deteriorate
- lower tax revenue to to lower income taxes, corporate income taxes and consumption taxes means less funds are available for govt spending on social services which lowers nmSOL
- no excess income to save and might even need to draw past savings to ride through economic hardship, which affects future SOL - Slower long term economic growth rates due to pessimistic outlook
- workers fear further loss of jobs/loss of income
- consumer confidence declines and consumers tend to save/cut down on expenditure
- also leads to a fall in investor confidence and firms expect lower profitability on their future sales and cut back on risky investments so I falls
- fall in C and I lead to further fall in AD resulting in deepening of the recession
- lower rate of I and capital production will slow econ growth - Lower inflation rate
- if a country is suffering from overheating and high inflation, a slower growth rate may slow donw the rate of price increases - Influences on BOP position
- with recession, fall in RNY reduces purchasing power
- consumers hence consume FEWER NORMAL GOODS and services, including imports
- net exports increase and improves trade balance in the current account
- but a recession may worsen investment sentiments and cause foreign investors to withdraw their investment funding and relocate businesses from the country and result in a net outflow of capital funds, thus worsening the capital and financial account fo the BOP
- net impact depends on relative sizes of impact on BOT and kfa
Causes of unsustainable economic growth + a bit on consequences
- weak environmental protection laws and lower environmental protection standards to drive rapid growth and compete for FDI
- subsidies that encourage excessive use of fertilisers and pesticides which pollute and destroy the environment or encourage overharvesting of already depleted fish stocks - rapid urbanisation and industrialisation
- deforestation, resources depletion and unsustainability
- global biodiversity continues to decline due to habitat loss
- land degradation and desertification worsens due to deforestation and poor agricultural practices
- increased fossil fuel consumption for industrialisation and growth means increasingly polluted air and water
- cost of health damage caused by air pollution amounts to $8.1 trillion a year about 6.1% of global GDP
- poor, elderly, and young children from poor families are the most affected
- uncontrolled growth of motor vehicles, reliance on more polluting fuels for power generation and specialisation in more polluting industries also play a part in hindering sustainable growth
summary of consequences
- resource depletion
- climate change
- loss of biodiversity
- health issues
- global inequality
Consideration of sustainable growth (just read)
concerns have led countries to consider sustainable development and growth as their policy goal which involves a commitment to less wastefulness, greater conservation and socially responsible ways to allocate natural resources
2021 Glasgow COP26 meeting had more than 40 countries agree to gradually phase out the use of coal and many also vowed to end deforestation while pledging $19 billion in financing which will go to developing countries to restore damaged land, tackle wildfires and support indigenous communities
SG green plan 2030 –> by 2030, at least 20% of schools will be carbon neutral and over 50% increase in nature park land with cycling paths tripling in length and rail network expanded
causes and consequences of non inclusive economic growth + SG examples
Causes:
- economic restructuring from low value added, labour intensive production to high value added capital intensive production would bring about economic growth
- benefits capital owners at the expense of low skilled workers, widening the income gap and worsening inclusivity
- globalisation can boost export oriented industries while hurting industries that produce goods substitutable by imports, generating greater income disparity
- insufficient effort by govt to redistribute income and wealth
- try to be eco friendly and shut factories but never help the employees find new jobs
Consequences:
- high income and wealth inequality
- low income and social mobility
- lack of social cohesion due to inadequate growth opportunities for all
Singapore examples
- SG faces challenges in narrowing its income gap due to globalisation, increased competition and lack of relevant skills of low skilled workers
- productivity gains also declined to due higher reliance on foreign labour inputs
- Sg govt believes that productivity driven growth is the means to deliver inclusive economic growth and has put in place policies to help increase the productivity of workers (eg. measures to alleviate the economic burden on the lower income groups and facilitate social mobility via tax rebates and increased subsidies on healthcare and education)
Definition of unemployment
Situation where people who are available for work and are actively seek work cannot find jobs
Full employment:
situation where all FOPS are fully and efficiently utilised (production lies on the PPC curve)
Types of unemployment (just list)
- Demand deficient/cyclical
- Structural
- Frictional
Demand deficient/cyclical unemployment
Unemployment caused by a fall in AD (associated with recessions where national income falls for at least 2 consecutive quarters or undergoes a steep slowdown in growth)
- lack of demand for labour derived from lack of demand of goods and services in the economy
- due to fall in AD from AD1 to AD2, it leads to a contraction of output across many industries and a lower level of national output at Y2 is produced instead of Y1
- firms will hire fewer FOPs including labour to cut costs and maintain profits (labour shedding/down sizing)
- more workers are laid off creating spare capacity and higher unemployment
Structural unemployment (4)
Unemployment due to a mismatch of skills between the unemployed and the skilled needed by producers seeking labour
usually long term and chronic and may exist even when the economy is not in recession and may be due to
- Changes in pattern of demand
- change in tastes and preferences or invention of new and better substitutes
- production gradually decreases in the affected industry (making it a sunset industry)
- unemployed workers struggle to relocate to a new industry where very different skills are needed
- eg. closure of mines in US, UK and China leaving miners struggling to find work due to boom in natural gas as alternative source of electricity - Foreign competition
- globalisation allows developing countries (eg. China/India) to provide cheap labour due to large population size (eg. clothing manufacturing)
- attracted many companies from developed countries to relocate their manufacturing facilities to these developing nations and workers then become unemployed - Changes in tech and occupational immobility
- with advancement in tech, workers must upgrade their skills to complement the methods of production and be productive but this is difficult and takes time
- new tech can also substantially increase productivity allowing companies to reduce their labour demand without affecting overall output
- though job vacancies may exists, firms will only offer jobs to workers with the relevant skills
- many jobs are left vacant due to occupational immobility which is the lack of ability/willingness of people to take up new jobs as they dont have the right skills (eg. unwillingness to receive training/ineffectiveness of training due to steep learning curves) - Geographic immobility
- lack of ability/willingness of people to relocate within a country to find jobs
- eg. decline in South Wales coal mining industry led to high unemployment in Welsh valleys but the miners didnt want to relocate to other regions in England with coal mining activities
- could be due to changes in cost of living/financial costs associated with moving or because of family and social ties
Frictional unemployment
unemployment of workers when they take time to search for jobs and remain jobless in the meantime
- due to IMPERFECT INFORMATION of existing market conditions
- workers are ignorant of all available job opportunities and the work they entail while firms do not know what labour is available for them to choose from hence time is needed to find the right job match
- occurs for new entrants to the labour force and for people transitioning between jobs
- inevitable and always exists
- usually not severe and lasts only a short duration
- can be improved using different platforms (eg. LinkedIn)
Consequences of unemployment
- Forgone output/income in the economy and lower living standards
- wastage of scarce labour resources that lead to a loss of potential output for the economy
- produce within instead of on PPC
- societys mSOL is compromised as lower quantity of goods and services are available for consumption
- loss of production means lower household income so households have lower purchasing powers leading to lower mSOL
- also creates stress and lower ability to purchase essential services like healthcare, decreasing nmSOL
- consumer spending is generally lower so there will be a lower production level as firms produce less in response to lower demand so there is greater spare capacity and investment levels will fall - Strain on government budget
- govt receives lower tax revenue and incurs higher expenditure
- personal income tax: unemployed dont pay
- consumption tax: lower consumption due to lower income
- corporate income tax: firms pay less as they are less profitable
- higher expenditure on unemployment benefits and other welfare payments
- need to spend more on managing social prblems like crime - Social problems
- affects nmSOL with higher incidences of deviant behaviours (eg. theft, alcoholism, depression)
- stress levels are also higher and self esteem and personal relationships may deteriorate
- could subsequently worsen economic problems as business sentiments may be hurt, lowering investments - Hysteresis (demand deficient unemployment)
- condition where unemployment persists even when the demand deficiency that caused it no longer exists
- dd unemployment is usually short turn and will be reduced by the upward swing of the business cycle but impact of unemployment may be long term
- protracted unemployment could deskill and demoralise retrenched workers such that they are not readily employable even when the economy recovers
- lead to loss in productivity and reduction of productive capacity and loss of potential output
Inflation definition + calculation
situation where there is a sustained increase in the general price level
calculated by
(CPI current year - CPI initial year) / CPI previous year x 100%
Terms associated with inflation
(read all but what is STAGFLATION)
Mlid/low inflation: inflation rate that is single digit and does not distort relative prices severely (target of around 2-3%)
Galloping inflation: price level increasing at a higher rate at double or triple digits, causing money to lose its value at a rapid rate
Hyperinflation: extremely high (more than triple digit) rate of inflation (people lose confidence in the currency which will then cease to function as a medium of exchange)
Disinflation: Slowing rate of price increases or falling inflation
Deflation: Falling prices or negative inflation
Stagflation: A period of rising prices coupled with no/negative growth in real GNP/GDP and high/rising unemployment
Anticipated inflation: steady and expected (mild/low inflation)
Unanticipated inflation: volatile and unexpected
- makes it difficult for indivs and businesses to correctly predict the rate of inflation
Causes of inflation (short)
Demand pull
Cost push
Demand pull inflation + graph
sustained increase in GPL caused by persistent rises in AD, usually associated with a booming economy
- reflected by continuous shifts of the AD curve to the right
- The economy is initially in eqm with the price level at P0 and output at Y0
- When AD rises due to any one of its components, it is reflected by a rightward shift of AD curve from AD0 to AD1
- The increase in AD will create shortages in the economy because current spending exceeds current production levels at the initial GPL P0
- Assume that the economy is initially operating along the intermediate range of the AS curve, firms respond to the rise in demand partly by raising prices and partly by increasing output
- As the economy approaches full employment, FOPs like labour and raw material become scarcer
- The competition for scarce resources will then cause firms to bid up factor prices
- As each additional unit of output becomes costlier to produce, prices have to increase to ensure that production remains profitable
- The increase in RNY is thus accompanied by an increase in GPL from P0 to P1
- For inflation to occur, the increase in GPL must persist over a period of time
- By multiplier, AD will increase again (eg. if export led boom causes households and firms to have more confidence in the future, they will have incentive to buy more and invest more now and hence cause AD to increase further from AD1 to AD2 due to rise in C and I and in turn, GPL will increase further to P2, resulting in higher demand pull inflationary pressures)
- how much firms raise prices demands on how much spare capacity there is
- at lower levels of RNY, firms can easily expand output to meet increases in demand without increasing prices much
- as the economy operates closer to full employment, each additional unit of output becomes costlier to produce as a much higher price is required to ensure that production remains profitable
graph 8
Cost push inflation
sustained increase in GPL caused by persistent falls in AS, independent of the level of AD
- reflected by continuous upward/leftward shifts of the AS curve
- if there is an increase in the COP due to increase in price of oil etc. an important factor input in the production of many goods and services, AS will fall
- this creates shortages at the prevailing price level and firms will take the opportunity to raise prices
- the increase in GPL will cause RNY to fall due to the wealth, interest rate and international trade effects
- the GPL will rise till the shortage is eliminated at the higher eqm price of P1 and lower eqm RNY of Y1
- For inflation to occur, the increase in GPL must persist over time
- if workers expect prices to continue to increase, they will start asking for higher nominal wages to maintain their purchasing power and hence cause further rise in COP (assuming rise in nominal wage > rise in productivity)
- reflected by further upward shift of AS curve to AS2 and GPL will increase further to P2 leading to higher cost push inflationary pressures
graph 9
Sources of cost push inflation
impt phrase:
to maintain profit margins, firms will pass the increase in costs to consumers in terms of higher prices and if sustained, cpi will occur
- Exhaustion of raw materials
- as the supply of natural resources fall, the price of them will rise
- as they are major FOPs, it will increase the COP
- to maintain profit margins, firms will pass the increase in costs to consumers in terms of higher prices and if sustained, cpi will occur - Import induced inflation
- inflation due to higher import prices due to supply shortages or currency depreciation
- depreciation means that price of imported raw materials will increase in terms of SGD and increase the COP
- to maintain profit margins, firms will pass the increase in costs to consumers in terms of higher prices and if sustained, cpi will occur
- depreciation will also cause the price of imported final goods and services to rise, leading to higher cost of living
- extra damaging for import reliant countries - Wage push inflation
- wages constitute the greatest part of total costs
- market power for trade unions is so great that they can obtain wage increases that are GREATER THAN THE INCREASE IN LABOUR PRODUCTIVITY
- lead to increase in cost of production and firms will pass the increase in costs to consumers in terms of higher prices and if sustained, cpi will occur
- WAGE PRICE SPIRAL: wage increase cause price of goods to increase and to prevent real wages from falling, wage earners try to push their nominal wages up to catch up with rising prices, creating a vicious cycle - Profits push inflation
- dominant firms use their market power to push up prices well above their COP and independent of consumer demand - Tax push inflation
- rise in GST has the effect of increasing COP
- to maintain profits, firms will pass the increase in costs to consumers in terms of higher prices and if sustained, cpi will occur
Benefits of low and stable inflation (6)
- Promotes investment and economic growth
- firms find it easier to predict changes in COP and can forecast profits more accurately which makes long term planning easier
- with greater certainty, firms will be more willing to enter long term contracts as they do not expect prices of FOPs to increase quickly in the future
- Investment will increase hence AD rises and RNY increases, achieving actual growth via multiplier
- Increase in investment will lead to an increase in capital stock and increase productive capacity, achieving potential growth
- Outward shift of AS curve
- Potential growth also dampens inflationary pressures
- SUSTAINED GROWTH ACHIEVED - Promotes international competitiveness and improves BOT and BOP
- International competitiveness: price competitiveness and quality of exports, the attractiveness of the host country in attracting inward FDI and in attracting foreign talent
- If domestic inflation is lower relative to foreign inflation, this improves the price competitiveness of the domestic country’s exports
- Foreign countries will increase their demand for the relatively cheaper exports and raise export revenue
- Domestic households will demand less of the relatively more expensive imports and will substitute them with domestically produce substitutes, reducing import expenditure
- BOT in the current account and BOP of the country will improve
- if country is initially operating with a BOT deficit, the country’s BOT deficit will be reduced and this will improve the country’s current account and BOP
- Low and stable inflation rates results in greater certainty in the real returns on an investment and encourages foreign investors to enter the economy hence higher level of inward FDI which will cause the country’s kfa position to improve and BOP improves - Promotes sustained economic growth and lower unemployment
- if households expect prices to rise slowly, they will not have the incentive to hold back consumption hence I, X and C rises which leads to a rise in AD
- If the economy is operating below full employment and with sufficient excess capacity, the increase in AD will lead to a MTP increase in RNY due to multiplier
- Demand deficient unemployment also falls as there is more derived demand for labour
- Increase in investments then increases capital stock which leads to higher productive capacity (AS curve shifts outwards), achieving potential growth - Economic agents can take actions to protect themselves to maintain current and future SOL
- Cost of inflation can be minimised
- eg. savers can put their funds in financial institutions that offer a nominal interest rate that is at least equal to the expected inflation rate
- as long as nominal interest rates rise in line with actual inflation rates, the future value of savings can be maintained
- low inflation environment encourages domestic savings
- workers will also be better able to negotiate contracts that ensure nominal wage increments keeps up with inflation
- as long as nominal wage rate rise faster or in line with inflation rates, real wage rates and purchasing power and SOL can rise/be maintained - Improve efficiency in resource allocation
- economic agents can recognise changes in relative prices between different goods and services without being confused by changes in the overall price level allowing them to allocate resources more efficiently
- also promotes the efficient use of productive investment (eg. in machinery) as people do not have to spend a substantial quantity of time and resources in search for mechanisms to defend themselves from high inflation
- time and resources are channelled to productive investments which lead to better allocation of resources and actual and potential growth - Increase leeway for monetary policy
- MP: use of money supply/interest rates to change the level of economic activity
- If economy is heading towards a recession but inflation rate is still positive, the Central bank can stimulate spending and boost growth by lower its nominal interest rate below the inflation rate to make the real cost of borrowing negative to stimulate borrowing
- real ir = nominal ir - ir
- moderate level inflation ensures that nominal interest rates stay sufficiently above 0 so that the bank can cut the nominal interest rates below the inflation rate if needed
Costs of high and unstable inflation (8)
- More difficult to protect mSOL
- inflation reduces the value of money and the higher the inflation, the more significant teh fall in purchasing power
- means hardship for households whose nominal incomes do not keep pace with the increase in prices (eg. retirees)
- if nominal income remains unchanged, the loss of purchasing power leads to a significant fall in households ability to buy goods and services over time and then experience a significant deterioration in their mSOL over time
- real income = nominal income - inflation rate - Reduces investment
- cripples long term business planning as it creates uncertainty about future prices of FOPs and profitability of investments
- firms less willing to take risks and investment falls, hence capital stocks fall and productive capacity falls (leftward AS shift) leading to fall in potential growth
- households unsure of the future value of their savings and have less incentive to save
- less savings hence less supply of loanable funds and interest rates will rise leading to a fall in investment as fewer projects will yield an expected rate of return that is greater than or equal to the higher interest rates and potential growth falls - Reduces international competitiveness and worsens BOP
- if domestic inflation rises relative to foreign inflation, it reduces price competitiveness of domestic country’s exports
- foreign countries will reduce demand for the relatively. more expensive exports and X falls
- domestic households will demand more relatively cheaper imports and M will rise
- hence BOT position worsens and if the country was operating with a deficit, it would increase further
- if kfa account originally in deficit, it worsen the BOP deficit
- also increases uncertainty and reduces business confidence and discourages inward FDI as high prices lead to increased costs and lower profits
- if kfa originally in deficit, the deficit will worsen and BOP worsens - Difficulty in sustaining economic growth
- fall in I and X decreases AD and leads to MTP fall in RNY due to multiplier hence actual growth falls
- fall in I also limits growth of productive capacity and AS hence potential growth falls
- increased speculative activity as severe inflation encourages a diversion of efforts away from productive activities
- “shoe leather cost”: opportunity cost of time and effort that people spend trying to counteract the effects of inflation (eg. keep going to bank to deposit money and wear out shoes)
- with high inflation, households have incentive to engage in unproductive activities like investment in residential housing
- diverting investment funds into assets does not benefit the economy as it represents investment in non productive assets
- will also fuel an unsustainable increase in residential housing prices
(people borrow from banks to finance their purchasing of housing due to exaggerated expectations of gains but when prices eventually collapse, they will default on their loans and lead to banking crisis) - Arbitrary redistribution of income worsening income distribution
a. Fixed vs Variable income
- Fixed income earners: nominal income remains constant and does not increase with inflation (pensioners/fixed salaried workers)
- their real income will fall rapidly
- Variable income earners: Rising prices means higher profits and price of goods and services rise faster than the rise in costs of production (Businessmen, producers)
- greater dividends paid out to equity holders
- worsen pay gap
b. Strong vs weak trade union
- Wage earners in declining industries/without strong trade unions may be hurt if their nominal incomes dont rise as fast as inflation rate
c. Debtors vs creditors
- Unanticipated inflation benefits debtors at the expense of creditors as inflation reduces the real burden of the debt as the sum is less in terms of purchasing power
- if inflation rate is expected, banks can take it into account when working out the interest rate for the loan
d. Holders of financial vs physical/real assets
- Holders of physical assets benefit from inflation as the money value of these assets changes directly with GPL
- increase in overall price level often leads to an increase in the value of these physical assets
- Holders of financial assets (eg. fixed interest earning securities like govt bonds) lose out as income received in real terms declines as the interest payments are not adjusted for inflation
- Significant “menu costs”
- Menu costs: Cost of constantly revising and reprinting price lists as firms have to constantly adjust the prices of goods and services
- lead to rise in COP hence AS shifts up, worsening cost push inflation as firms pass on the higher COP to consumers in the form of higher prices - Hinders efficient resource allocation
- High and unexpected inflation makes it hard to distinguish between changes in the price of a specific product and changes in overall price level
(mistake rise in overall price level for an increase in the price of his own product and erroneously devote more resources to produce it) - Wage price spiral
- if hyperinflation develops, firms will constantly raise prices to cover their soaring costs
- workers will demand huge pay rises to stay ahead of the rising cost of living and price and wages chase each other in an ever rising inflationary spiral
Causes of deflation
fall in AD
- fall in C, I, G, X-M
or
increase in AS
- fall in price of FOPs
- development of tech
Why is deflation not undesirable (2)
(due to increase in AS)
- If the money income of an individual remains constant, fall in GPL leads to an increase in purchasing power and hence ability to consume more goods and services so SOL increases
- When it is due to workers and firms being more productive, lowering COP
What is likely to be one of the consequences of inflation
reduction in real value of national debt
What is deflation
Sustained decrease in GPL
Why is deflation undesirable
(due to fall in AD)
- Deflationary spiral can develop which affects economic growth and employment
- if households expect prices to fall in the future, they will hold back purchases now and this leads to a fall in C and a leftward shift of AD
- if firms expect sales to fall in the future, they will cut back on investment now which will lead to leftward shift of AD
- fall in AD leads to fall in RNY due to multiplier and actual growth will fall
- if a recession results, then demand deficient unemployment will rise as labour is a derived demand
- deflation can lead to a spiral where consumers reduce expenditure in anticipation of falling prices which reduces profitability of companies and some may end up shutting down, increasing unemployment and a further fall in consumer spending - Increase real burden of debts
- nominal interest rate of debt is fixed so when income and prices fall, real burden of debt increases
- consumers less willing to borrow from banks to buy big ticket items (fall in C, AD and RNY) - Deflation harder to solve than inflation
- real interest rate = fixed nominal interest rate - inflation rate
- to combat high inflation, Central bank can raise nominal interest rates as high as needed
- if economy is heading towards a recession but inflation rates are still positive, central bank can stimulate spending by lowering nominal interest rate below the inflation rate to make the real cost of borrowing negative (stimulate investment and consumption since firms and consumers can borrow free money)
- this is hard if inflation itself is 0 or negative as the bank cannot lower nominal interest rates below 0 as it would mean reducing savers bank balances every month and would prompt them to withdraw their deposits from banks
- impossible for the bank to intervene using interest rate policy
- deflation makes the real cost of borrowing higher, affecting interest sensitive spending by firms and households
- no leeway for MP to work (deflation trap)
What does external stability include
Stability in exchange rate and favourable BOT (no large and persistent BOP deficits and surplus)
Definition of exchange rate
price of one country’s currency in terms of another currency
Types of exchange rate systems
Free floating ER system
Fixed ER system
Managed float ER system
Free floating ER system
the market exchange rate is determined by the interaction of market demand for and supply of a country’s currency
NO intervention by Central Bank and rate is fully determined by DD and SS forces in the forex market
- Qd = Qs
Explain demand and supply of currency for free floating ER system + graph
Demand (3 main sources)
- foreign firms/consumers that buy goods and services produced in US
- foreign firms/households that want to invest in US through FDI (buy/build production facilities etc) or portfolio investment (buy financial assets issued in US)
- Currency traders who expect the US dollar to appreciate against other foreign currencies
graph 10
- demand curve for the US dollar in the forex market is downward sloping hence a fall in price of the domestic US$ will lead to an increase in Qd of US$
- when the price of US$ falls, Qd rises as US exports become cheaper, cost of investment in US is lower and speculators buy more units of US$ at a low price expecting the US$ to rise in value in the future
Supply (3 main sources)
- US firms/consumers that buy goods and services produced by the rest of the world
- US firms/households that want to invest in the other countries either through FDI or foreign portfolio investment
- Currency traders who expect the US$ to depreciate against foreign currencies in the future
graph 10
- supply curve is upward sloping and a rise in price of US$ leads to an increase in Qs
- if price of US$ rises, exports from SG become cheaper in US$, investment in SG costs less in US$ hence US residents will buy more exports and invest more in SG, increasing Qs of US$ as they sell more US$ in exchange for S$ to finance such expenditure
Factors affecting the exchange rate of a currency
- Change in the demand for a currency
a. Change in demand for US G&S by foreigners
- during economic expansion in SG, incomes of SG residents will rise and demand by SG citizens for US goods will increase
- leads to increase in demand for US dollars as more US$ are required by the SG firms/consumers to pay for the higher volume of imports from US
- demand curve for US$ shifts right and US$ will appreciate against S$
b. Change in relative interest rate between countries
- if interest rate in US rises relative to other countries’ interest rates, the returns from investing in US financial assets are RELATIVELY higher
- raises the demand for US financial assets and hence US$ and US$ appreciates
c. Change in expectations of currency traders
- expectations influenced by political stability, interest rate, fiscal policies etc
- if they think the US$ is going to appreciate against S$, they will sell S$ and buy US$ so demand for US$ increases and appreciates
- Change in supply of a currency
a. Change in demand for foreign produced goods and services by US citizens
- change in taste and preferences
- increase demand for imports, increasing the supply of the US$ in the forex market, shifting SS curve right and US$ depreciates
b. CHange in relative interest rates between countries
- If interest rates in US fall relative to that in SG, it will be more desirable for US residents to invest in SG financial assets
- supply of US$ in forex market increases and depreciates
c. Change in expectation of currency traders
- If they think US$ will depreciate against S$, they will sell their holdings of US$ to buy S$
- supply of US$ in forex market increases and depreciates
DD SS explanation of exchange rate
eg. Increase in demand for US$ causes DD curve to shift from D0 to D1. At original price P0, there is a shortage as QD > Qs in the forex market. This exerts an upward pressure on the price of US$ and the price of US$ will increase to the new equilibrium price P1 where the shortage is eliminated
Hence the price of US$ has appreciated against the S$.
Fixed ER system + graph
central bank intervenes in the forex market to control the exchange rate at a fixed rate by using its foreign reserves to influence the demand and supply of its domestic currency eg. China
graph 11
- increase for demand of Chinese exports will cause demand for yuan to rise in the forex market
- demand for yuan shifts from DD0 to DD1
- in a free market, the yuan would have appreciated against the US$ from e0 to e1.
- the Chinese central bank can fixed the exchange rate at e0 by increasing the supply of yuan in the forex market by buying more USD
- by selling more yuan, the supply of yuan then increases from SS0 to SS1 which prevents the yuan from appreciating to e1
- DEVALUED exchange rate of e1 is maintained
Managed float ER system + graph
system of flexible exchange rates but where the central bank intervenes to prevent excessive fluctuations in its ER
there is an acceptable band whereby the exchange rate is allowed to fluctuate in the forex market before intervention by the central bank begins
graph 12
- to prevent depreciation below El, the monetary authority of SG will intervene directly in the forex market to buy SGD and sell USD
- to prevent appreciation above EU, the monetary authority of SG will intervene directly in the forex market to sell SGD and buy USD
Exchange rate stability
avoidance of excessive fluctuations in exchange rates
more unstable under free float ER system
Consequences of exchange rate stability (1 good 3 bad)
- Reduction in uncertainty about ER can lead to improvement in kfa and promote sustained economic growth
- a country can choose to peg its domestic currency to another foreign currency to create a stable atmosphere for foreign investment
- foreign investors will know what their investment value is (less uncertainty on ROI)
- increases inward FDI and improves kfa and hence BOP
- when inward FDI includes setting up new factories and building new plants, productive capacity will increase and potential and actual growth is achieved - Fixed ER regimes can lead to severe financial crises because they are hard to maintain in the long run
- cannot maintain peg because central bank is running out of foreign reserves
- investors scramble to get their money out of the country and convert it to foreign currency
- wave of currency depreciation and stock market declines
- eg. Mexico 1995, peso depreciate by 30% - Foreign reserve accumulations entail opportunity costs
- most industrialised countries mandate that foreign reserves accumulated should be invested in highly liquid assets like short term financial bonds/govt securities (can convert these assets to cash easily)
- they yield relatively low rates of return compared to alternative uses of these funds - Fixed ER regimes can be inflationary if domestic country tries to maintain an ER below the free market ER
- eg. China try to maintain external value of yuan below the free market ER by selling domestic currency and buying foreign currencies in the forex market
- injects liquidity into the chinese economy
- if the chinese economy is already operating close to full employment, the increased liquidity will aggravate inflationary pressures in China
Balance of trade
value of the difference between export revenue and import expenditure over a given period of time
part of the current account and is often the largest component of a country’s BOP
Balance of payment
record of a country’s international transactions which involve flows of money between residents of a country and the rest of the world
favourable BOP position: avoidance of large and persistent BOT deficit/surplus
How to calculate BOP (table thing)
A = current account balance
B = capital and financial account balance
C = net erros and omissions
D = Overall balance (A-B+C)
E = Reserves assets account = D
For free floating ER system, D and E both = 0
For managed float ER, D = E and actions of central bank will be recorded in the official reserves account (subset of reserves assets account)
foreign reserves are reflected under reserve assets account
Causes of BOT deficit/surplus (5 + sub points)
- Changes in global conditions
a. Cyclical changes in global demand
- If there is a recession the US, the loss in incomes and consumer confidence will reduce the ability of US residents to buy SG exports
- Demand for SG exports will fall ASSUMING US’S DEMAND FOR SINGAPORE EXPORTS HAS A POSITIVE INCOME ELASTICITY (YED > 0)
- the higher the value of income elasticity, the greater the fall in demand for SG exports
- Hence SG’s BOT will worsen
- if SG was initially operating with a BOT surplus, SG’s BOT surplus in the current account will fall
- if import expenditure rises above export revenue, SG BOT surplus will turn into a deficit
b. Sustained economic growth in the importing country
- with sustained rise in real GDP, the ability and willingness of a country’s residents to purchase imported G&S will rise
- BOT will worsen and if SG was initially operating with a BOT surplus, SG’s BOT surplus in the current account will fall
- if import expenditure rises above export revenue, SG BOT surplus will turn into a deficit
- extent of increase in import expenditure depends on marginal propensity to import (proportion of additional unit of income that will be spend on imported goods) of that country
- if MPM is high, rise in income will have a larger effect on the CA deficit
- Change in international competitiveness
a. Changes in comparative advantage
- eg. SG lose its comparative adv in low and medium end manufacturing to Vietnam/China as they can produce with lower opportunity cost due to abundant labour and demand for these shifted away from SG
- reduced export revenue in SG trade balance
- but SG has developed new areas of comparative adv (eg. medical, financial field) such that global demand for these G&S have shifted to SG
- the increase in X revenue overcomes the effect of falling exports hence increasing BOT surplus
b. Changes in taste and preferences
- affected by pattern of demand for exports
- if a country is slow to adapt to change in taste and preferences, the demand for its exports will be competed away by other countries
- if export revenue falls below import expenditure, a BOT deficit will occur and persist till the country can reallocate its resources to adapt to these structural changes
c. Changes in relative inflation rates between countries
- if domestic inflation rises relative to foreign inflation, this reduces the price competitiveness of the domestic country’s exports
- foreign countries will reduce their demand for the relatively more expensive exports
- domestic households will demand more of the relatively cheaper imports
- BOT position in the CA of the BOP will worsen
- Changes in exchange rates
- affect the international competitiveness of exports
- overvalued currency/appreciation of a country’s domestic currency against foreign currencies reduces export competitiveness
- eg. appreciation of pound means more units of foreign currencies are needed to buy one pound making UK exports more expensive in terms of foreign currencies, causing a fall in its quantity as foreigners ability to buy UK G&S falls. the extent to which quantity of UK exports fall depends on the price elasticity of demand for exports (PEDx)
- appreciation of the pound also causes imports to be relatively cheaper in terms of domestic currency leading to an increase in quantity for imports as UKs ability to buy foreign G&S increases. whether import expenditure will fall or rise depends on the price elasticity of demand for imports (PEDm)
- according to the marshall lerner condition, so long as the sum of PEDx and PEDm > 1, an appreciation will worsen the value of net exports, worsening UKs BOT
- a depreciation will improve the BOT if the MLC holds - Govt policies
- Protectionism (policies sheltering domestic industries from foreign competition through the imposition of trade barriers on imports) tends to improve the BOT of countries who implement protectionist policies, while worsening the BOT of the exporting countries
- eg. import tariffs (same price received by foreign sellers, tax goes to govt, price rises, quantity falls and imports fall)
- industrial policies can involve heavy importation of tech and capital goods which will worsen BOT - Random factors/shocks
- unanticipated and unpredictable factors like war/natural disaster that destroy infrastructure can worsen BOT
- exports will fall due to cessation of production activities halting exports but the country will also increase imports to rebuild the economy
- BOT will worsen
kfa
includes records of long term fixed capital movements (direct investment flows eg. FDI) and short term capital flows (portfolio investment flows eg. hot money)
inflow/outflow of FDI is a key determinant of the kfa position
in countries like SG, short term financial flows also take up a large proportion of the account
Causes of kfa net inflow/outflow of funds summary
Long term fixed capital flows affected by:
- changes in expected rate of return
- international competitiveness
- global demand conditions
Short term capital flows affected by:
- changes in relative interest rates
- expected exchange rates
- exchange control regulations
Causes of kfa net inflow/outflow of funds summary (5)
Long term fixed capital flows (FDI)
- Changes in expected rate of return
- this takes into account the cost of production, the amount of govt subsidies and tax policies
- the lower the COP, the greater the subsidies, the lower the corporate tax rates, the greater the political stability and better infrastructure available, the greater the expected returns and greater the business confidence and the greater the inflow of FDIs
- If the expected rate of return on investment projects falls relative to that in other countries, there will be a fall in profitability and less inflow of FDIs
- local businesses may choose to invest directly abroad, resulting in FDI outflows
- kfa will worsen
- if there originally is a net inflow in kfa, the inflow might deteriorate or turn into an outflow - Changes in relative inflation rates between countries
- if inflation rate increases and becomes relatively higher than other investment destination countries, COP will increase and there will be uncertainty of profits
- unstable prices will discourage FDI inflows while encouraging FDI outflow to countries with lower and more stable inflation rates
- kfa will worsen
- if there originally is a net inflow in kfa, the inflow might deteriorate or turn into an outflow - Changes in global demand conditions
- FDI flows into countries with rising consumer demand
- increasing consumer demand boosts confidence of foreign investors
- if a country experiences a trend of increasing economic growth associated with rising affluence/increasing population, foreign investors will be attracted to set up production factories in light of expectations of profits
- will also invest in countries with a large export base (eg. SG) to export their products to many foreign consumers
- growing consumer/export demand will improve kfa
- if there is already a net inflow, it will grow and if it was an outflow, it might become a net inflow
Short term capital flows (hot money )
- Changes in relative interest rates
- fall in country’s domestic interest rates would result in short term net capital outflow (hot money)
- speculators will prefer to withdraw money from the banks and deposit them in other countries to reap greater returns
- kfa will worsen - Changes in expected exchange rates
- destabilising speculation and capital flight might occur when depreciation is expected
- sell domestic currency to purchase foreign currencies in order to exchange for more units of domestic currency in the future
- kfa will worsen
extra point (just read)
exchange control regulations that limit the amount of foreign currencies that locals can buy using domestic currency
- if this is removed, locals can exchange for foreign currencies to invest abroad (diversification) and hence there is more hot money outflow and kfa worsens
Consequences of BOT deficit (3)
- Implications on economic growth and SOL
- with a deficit, the country is paying more for its imports than it is earning through exports
- leads to a fall in AD and hence a fall in RNY, hurting actual growth via multiplier and job creation, hurting SOL
- influences exchange rates because with a deficit, there is relatively less demand for its currency leading to a depreciation of the domestic currency
- weaker currency makes import prices higher and lowers SOL as people will have to pay more for imported goods, eroding their purchasing power - Implication on equity
- BOT deficit can be financed by running a kfa surplus or running down foreign reserves
- if the country borrows from foreign countries to finance its CA deficit, the external debt (principal debt + interest owed) need to be paid back and will hurt economic growth and SOL
- large and persistent BOT deficit means future generations will be burdened with high debt levels and large interest payments leading to intergenerational inequity as large foreign debt burden falls on households in the next generation in return to increased consumption today - Opportunity costs
- when repaying external debt interest owed to foreigners might be better used in supporting development policies (eg. investment in health and education)
- use of foreign reserves also pose similar issues about the opportunity cost of alternative uses of foreign reserves
Consequences of BOT surplus (3)
impact depends on the SIZE of BOT surplus
- Implications on economic growth and SOL
- with a surplus, the country is earning more from its exports than it is spending on imports
- leads to rise in AD and a rise in RNY via multiplier assuming spare capacity, generating actual growth and job creation
- higher demand for currency causing currency to appreciate, making imports cheaper, allowing greater purchasing power and hence better SOL
- BUT a country may have a large BOT surplus because of a weak economy (consumer spending on imports is low) which will not reflect higher material welfare as consumption of goods is still low - Accumulation of foreign exchange reserves
- if BOT surplus leads to overall BOP surplus, it can lead to the accumulation of foreign exchange reserves
- with a managed float/fixed ER system, the relatively higher demand for the country’s currency will create pressure for the currency to appreciate
- however, to prevent the currency from appreciating too quickly, the country’s central bank has to sell its currency in exchange for foreign currency in the forex market , resulting in the accumulation of foreign exchange reserves - Possible retaliation by trade partners
- can be a controversial political issue if other countries feel the surplus is a result of an undervalued exchange rate
- when a country’s currency is undervalued, its trade balance will improve at the expense of its trade partners balance
- deficit countries may be forced to impose import control which will reduce the imports to their country and reduce the trade deficit
- eg. BOT deficit in US attributed to large imports of cheap Chinese products hence US pressured China to let the yuan appreciate and imposed tariffs on their products
Explain how a BOP surplus is formed + graph 13
Inflow of funds (affect demand)
- foreigners must buy USD to purchase US exports
- foreign investors must convert foreign currencies to USD to conduct FDIs in US
Outflow of funds (affect supply)
- US residents have to exchange USD for foreign currencies in the forex market to purchase imports, increasing supply of USD in forex
Assume that the BOP in the US is in eqm initially
- if interest rates in the US rose relative to interest rates in foreign countries, there will be short term capital flow into US as foreigners deposit their money in US in search of higher returns on their savings
- causes an INFLOW INTO THE KFA
- leads to an increase in demand for USD as deposits need to be saved in the local currency
- US citizens will also reduce their flow of short term investments overseas as they would want to keep their deposits in US
- reduces the supply of USD in the forex as less USD is being exchanged for foreign currencies to be deposited overseas
- demand for USD rises from DD1 to DD2 while supply falls from SS1 to SS2, creating a shortage of USD in the forex market
- BOP then goes into a surplus as there is net inflow of funds to the kfa in the BOP
graph 13
Free floating ER system impact on BOP position + graph
The BOP will always be in equilibrium as a BOP surplus/deficit will automatically be eliminated via adjustments by the ER mechanism (via appreciation/depreciation)
eg. after formation of BOP surplus
- surplus is only temporary
- due to shortage, there is an upward pressure on the US exchange rate that causes the USD to appreciate against foreign currencies
- as USD appreciates, exports from US become more expensive in terms of foreign currency while imports become cheaper for US citizens
- ASSUMING MARSHALL LERNER CONDITION HOLDS such that sum of PEDx and PEDm > 1, the BOT worsens as the USD appreciates
- this adjustment occurs until a new eqm exchange rate is reached at e2 and the WORSENING BOT (part of CA) OFFSETS THE BOP SURPLUS arising from the net inflow of funds in the kfa
- a BOP surplus is corrected by the appreciation of the exchange rate and vice versa
graph 13
Fixed ER system impact on BOP position
central bank uses its foreign exchange reserves to influence the DD/SS of its currency
eg. Assume BOP in China is in eqm initially
- a rise in demand for Chinese exports would improve BOT and lead to BOP surplus
- rise in demand for exports will also lead to an increase in demand for yuan which will cause a shortage at the original ER
- upward pressure on yuan and to prevent appreciation, the chinese central bank has sto sell yuan and buy more foreign currency in the forex market leading to the accumulation of foreign reserves
- under this system, the BOP disequilibrium is not corrected and BOP can remain ins a persistent surplus/deficit for as long as the exchange rate remains fixed below/above free market eqm rate
Managed float ER system impact on BOP position
If the BOP diseqm results in an appreciation/depreciation of the currency within the allowable exchange rate band/target band, the ER adjustment in the forex market will correct the BOP diseqm
However, if the BOP diseqm puts a pressure on the currency to appreciate/depreciate beyond the acceptable band, the central bank will intervene
will result in the persistence of the BOP deficit/surplus and cause movements in the official foreign reserves to accommodate the BOP diseqm
BOP deficit and exchange rate
In freely floating ER system, BOP deficit will be temporary as it will be automatically eliminated by the depreciation of the ER
In fixed/managed float ER system, the BOP deficit will persist
- To fix its ER ABOVE the free market level, the central bank sells foreign currencies and buy its domestic currency to prevent its domestic currency from depreciating
- central bank is running down on its official foreign reserves to accommodate its BOP deficit
- the rundown on foreign reserves compromises the country’s ability to ward off potential speculative attacks on its domestic currency in the future
- if the reserves run out, the central bank will have to relax its control of the currency and let it depreciate and this would reduce the consumers ability to import G&S and producers ability to import raw materials
- can borrow foreign currencies from international financial institutions but this creates external debt that needs to be repaid
BOP surplus and exchange rate
In freely floating ER system, BOP surplus will be temporary as it will be automatically eliminated by the appreciation of the ER
In fixed/managed float ER system, the BOP surplus will persist
- to fix ER BELOW the free market eqm, the central bank buys foreign currencies and sells its domestic currency to prevent its domestic currency from appreciating
- central bank is accumulating official foreign reserves to accommodate its BOP surplus
- build up of official foreign reserves can lead to greater confidence in the economy to ward off potential speculative attacks on the domestic currency in the future
- the undervaluation of the ER represents a forgone opportunity for citizens to consume more imports, depressing SOL (price of imports relatively higher, Qd falls)
- can be accused of being a currency manipulator that engages in unfair trade practices
- deficit countries may be forced to resort to imposing import controls which will reduce imports to their country and reduce trade deficit
just read
weak currency good for export heavy countries (eg. china)
strong currency good for import dependent countries (eg. SG)
Implication of appreciation of exchange rate
Bad
- “Dutch Disease” effect (rise of one sector lead to fall of another)
- Discovery of natural gas in Netherlands helped to turn its BOT deficits into surplus through increasing export revenue from natural gas exports
- but this led to an appreciation of Dutch currency, making dutch goods more expensive for foreign consumers
- Dutch manufacturing industry found it hard to compete in the world market because of its loss of competitiveness
- countries that rely on natural resources to drive its growth may thus have difficulty ensuring that its growth is inclusive and sustainable
- increase in exploitation of natural resources accompanied by the decline in the manufacturing sector tends to lead to higher unemployment as the manufacturing sector is typically more labour intensive
For depreciation
good: exports are more competitive
bad: higher imported inflation
just read (free float ER system)
Assume BOP in US is in eqm initially
- foreign investors find US attractive for FDI, then more capital will flow into the country caused by an increase in foreign ownership of domestic assets leading to an inflow of funds into the kfa
- this increases demand for the currency which would result in an appreciation of the exchange rate and result in the US experiencing a worsening BOT assuming MLC holds
graph 13
- adjustment of price of USD will occur until a new eqm exchange rate is reached at e2 and the worsening BOT offsets the BOP surplus rising from the net inflow of funds in the kfa and the BOP surplus would eventually be corrected
alternatively, if US’s appeal to foreign investors fade resulting in an outflow of funds from the kfa, resulting in a worsening of the BOP, the US dollar would weaken and depreciate due to a fall in demand for the currency and the BOT would improve assuming MLC holds and BOP would be in eqm eventually
just read
surplus in country A = deficit in country B/C/D
For country A, surplus is sustained by fixing ER below free market value so exports are artificially cheap to further increase trade surplus that results in the deficit of country B/C/D and lead to protectionist measures
