Theme 4 Flashcards
Globalisation
The ever-increasing integration of countries around the world.
The process through which an increasingly free flow of ideas, people, goods, services and capital leads to the integration of economies and societies.
Globalisation arises from growing world markets and increasing international trade and entails increasing interdependence between countries.
Key aspects of globalisation
-Trade to GDP ratios are increasing for most countries
-Expansion of Financial capital flows between countries.
-Foreign Direct Investment and cross border M and A
-Rising number of global brands - including from emerging countries
-Deeper specialisation of labour- components come from many nations
-Global supply chains and new trade and investment routes e.g. south- south trade
-Increasing levels of international labour migration and migration within countries
-Increasing connectivity of people and businesses through mobile and WiFi network
International Trade
The flow of goods and services between countries ie importing and exporting
Import
Is a good or service brought in one country that was produced in another
Export
A good/service sold to another country (money coming into the UK)
Visible and invisible imports and exports
Visible are physical products whereas Invisible are services such as tourism
Top UK Export and Import Countries
(data from 2022)
Imports:
USA
Germany
China
Netherlands
France
Exports:
USA
Germany
Netherlands
Ireland
France
The EU accounted for 41% of UK exports and 52% of Imports in 2023.
UK main exports: Cars, Gold, Crude Petroleum, Gas Turbines
Why has globalisation increased over the past 50 years
-Developments in IT, transport and communications have accelerated the pace of globalisation over the past 40 years. The internet has enabled fast and 24/7 global communication, and the use of containerisation has enabled vast quantities of goods and commodities to be shipped across the world at extremely low cost.
-More recently, the rise of social media means that national boundaries have, in many ways become irrelevant as producers use new forms of communication and marketing, including micro-marketing, to target international consumers. The widespread use of smartphones has also enabled global shoppers to have easy access to ‘virtual’ global markets.
-The rise of new electronic payments systems,, including e-Wallets, pre-pay and mobile pay, e-Invoices and mobile pay apps, also facilitate increased global trade.
-Increasing em>capital mobility has also acted as a stimulus to globalisation. When capital can move freely from country to country, it is relatively straightforward for firms to locate and invest abroad, and repatriate profits.
-The development of complex financial products, such as derivatives, has enabled global credit markets to grow rapidly.
-Increased trade which has become increasingly free, following the collapse of communism, which has opened up many former communist countries to inward investment and global trade. Over the last 30 years, trade openness, which is defined as the ratio of exports and imports to national income, has risen from 25% to around 40% for industrialised economies, and from 15% to 60% for emerging economies.[1].
-The emergence of footloose multinational and transnational companies (MNCs and TNCs) and the rise in the significance of global brands such as Microsoft, Apple, Google, Sony, and McDonalds, has been central to the emergence of globalisation. The drive to reduce tax burdens and avoid regulation has also meant the establishment of complex international business structures.
IMF
The International Monetary Fund (IMF) is a specialized agency of the United Nations that works to promote global monetary cooperation and financial stability. It was founded in 1944 as part of the Bretton Woods agreement and is headquartered in Washington, D.C. The IMF provides financial assistance to member countries facing balance of payments difficulties, and works to promote global economic growth and development through policy advice and technical assistance. The IMF has played a central role in addressing economic crises around the world, such as the Asian financial crisis of the late 1990s and the global financial crisis of 2008-2009. The IMF is funded by member countries and managed by a Board of Governors and a Board of Directors.
World Bank
The World Bank is an international financial institution, just like the IMF. It provides loans, grants, and technical assistance to developing countries to support their economic development. The World Bank was created in 1944 as part of the Bretton Woods agreement, along with the IMF. It has a larger scope than the IMF, with a broader focus on poverty reduction and development, rather than just financial stability. The World Bank is also a larger organization, with more than 10,000 employees, compared to around 2,800 at the IMF. The World Bank operates through five institutions.
The World Bank has faced criticism for its governance structure, which is seen as undemocratic and unrepresentative of the interests of developing countries. There have been calls for reform of the governance structure, including greater representation for developing countries and more transparency and accountability in decision-making.
WTO
The WTO was established in 1995 and was preceded by the General Agreement on Tariffs and Trade (GATT).
It helps to promote free trade by persuading countries to lower their import tariffs and other barriers to open markets including widespread use of import licences, export subsidies and other non-tariff barriers
Membership of the WTO has expanded with the successful admission of China, India and latterly, Russia to the WTO as events of global significance.
Rapid increase in trade
-Bretton Woods international monetary system making payments between countries safer and easier.
-Trade Liberalisation/ work of WTO in reducing trade barriers and opening up markets.
-Falling transport costs- the use of shipping containers (containerisation) has vastly reduced shipping costs and transit times. Air freight prices have fallen dramatically.
-Increased flows of FDI- tax incentives/grants have helped bring foreign direct investment into countries. China/India have made it easier for foreign businesses to set up operations in their countries.
-Technology improvements - not least the internet. Advances in technology have made it easier to organise and co ordinate business operations
-Trade blocs- ie EU- enables free trade between neighbouring countries
-Breakdown of old political orders- particularly China- entry into the global economy.
Impact of Globalisation on countries and government
-Rising incomes from all the new jobs created > rising tax revenue collected
-Economic growth and improved standard of living
-Better quality of jobs as MNCs invest in new factories and training
-Increased migration to where the new jobs are created- ensures skill gaps in countires can be filled
-Potentially improved Balance of Payments
-Technology and skills transfer due to MNCs improves quality of labour and production processes of domestic firms leading to improved productivity
-Reduced poverty/ potentially reducing inequality
BUT
-Lead to decline of traditional industries leading to structural unemployment
-Increased living standards may not be equally felt in an economy or between economies
-Much depends on the quality/quantity and sustainability of jobs.
Globalisation- effect on Individuals/ consumers
-Increased choice and quality of jobs
-Increased choice and quality of goods and services
-Lower prices
-Potentially improved innovation
-May help lift people out of poverty/increase standards of living
BUT
-Income may not be equally distributed accross the population
-May lead to a reduction in locally produced goods/reduced culture
Globalisation- effect on Enviroment
-Increased awareness of issues surrounding the environment- While many of the environmental effects of globalisation have been negative, its rise has led to an increase in environmental awareness around the world.
-Greater connectivity and higher rates of international travel have made it easier than ever for people to see the effects of deforestation, habitat loss, and climate change on the environment. This, in turn, contributes to new laws, rules and procedures that limit negative effects.
-Greater interdependence and cooperation between countries may make globally environmental policies achievable as well as tech and processes.
BUT
-Increased Transport of Goods: Shipping products globally can harm the environment by increasing emissions, destroying habitats, and spreading invasive species.
-Economic Specialization: While specialization fosters trade and cooperation, it can quickly deplete natural resources.
-Decreased Biodiversity: Habitat loss and climate change among other factors—have led to population decline across organisms.
-Resource Depletion- greater production of goods requires the use of finite resources
Globalisation - impact on producers
-Lower costs as producers can access products from a range of countries
-Increased competition means producers need to try and aim for productive efficiency at the MES(lowest unit cost)
-Increased sales may lead to increased scale and economies of scale
-Lower transportationn costs/ better comms have enabled businesses to benefit from production in low cost countries and more complex supply chains
-Tax avoidance- firms can base their central operations in a country that pays low or no tax even though they operate in many countries
BUT
-Greater competition
-Businesses may gain a poor reputation due to ethical/environmental concerns
-Greater interdependence between countries can make businesses vunerable to external shocks ie tsunami/ Ukraine war
Globalisation impact on workers
-Jobs may be more diverse and fulfilling than previous jobs
-Potentially better jobs and pay is likely to be higher as FDI may lead to more complex jobs and multinationals are more able/ likely to afford higher pay rates than local companies
-Easier for labour to migrate to other countries to gain better paid jobs
-Higher economic growth > rising employment > increased wages/improved living standards
-Skills and technology transfer
BUT
-Can cause structural changes/ unemployment. Some industries workers have become unemployed- ie ship building and mining in the UK.
-Exploitation by some MNCs…. Race to the bottom. Due to cost management, jobs may be low skilled and conditions may be poor
-Need to consider the quality of jobs and working conditions and sustainability of jobs (footloose capitalism)
Greater interdependence and economies
-One of key issues with greater interdependence is how robust the global economy is to shocks:
-oil prices
-pandemic
-Ukraine war
-financial crisis and the credit crunch
-fine in boom but what about recession?
Specialisation
Occurs when an economy focuses on a narrower range of goods and services.
Economies make the most of their resources by concentrating on what they do the best (this is known as comparative advantage)
However this will only be of real benefit if the economy can trade the surplus and buy the goods and services they need but do not produce
The advantage can be enhanced by economies of scale. The increased export revenue can be used to buy cheap imports.
The choice of specialisation is dependent upon the quality and quantity of the factors of production of each country.
Absolute advantage
When a country can produce a good or service at a lower cost than another or it can produce the same amount with less resources
Comparative advantage
Helps explain the benefits of specialisation and trade between individuals, firms and countries
It arises when one party can produce a good or service at a relatively lower opportunity cost than another party
In simpler term, its about assessing which activity a party is relatively more efficient at producing compared to other activities.
The concept was introduced by British economist David Ricardo in the early 19th century as part of his theory of international trade.
Comparative advantage- Opportunity Cost
The decision to produce any good or service has an opportunity cost, which is the amount of another good or service that might otherwise have been produced. Given a choice of producing one good or another, it is more efficient to produce the good with the lower opportunity cost, using the increased production of that good to trade for the good with the higher opportunity cost.
The lowest opportunity cost determines which country will specialise in which good (this determines the good that the country is relatively more efficient at). Only trade if the opportunity cost of production differs between countries.
The law of comparative advantage states that the overall output can be increased if individuals specialise in producing the goods in which they have a comparative advantage.
It is an explanation of why trade leads to economic growth,even when a country has an abolsute advantage in the production of several products.
When is it beneficial for 2 countries to trade?
- There needs to be a suitable rate of exchange.
- To exploit Comparative advantage and for each country to benefit, the rate of exchange must lie between the OC ratios of the goods.
Rate of exchange example
In the previous example the opportunity cost ratios were
- For every 1 unit of beef, Australia forego 0.8 of tobacco.
- For every 1 unit of beef, Malawi forego 1.5 units of tobacco.
* Therefore for every 100 units of beef, Australia would forego 80 units of tobacco, for every 100 units of beef, Malawi would forego 150 units of tobacco.
For Aus only worth selling beef to Malawi if they get more than they could’ve made themselves ie 80 units of tobacco.
For Malawi only worth buying from Aus if it is less than 150 units of tobacco otherwise they may as well carry on making it themselves
Advantages of country specialisation/ having a comparative advantage
-Higher exports: Total production of goods and services is raised and quality can be improved.
-Variety- Consumers have access to a greater choice of higher quality products. Prices are likely to be lower which may lead to higher real income.
-A bigger market: Specialisation and global trade increase the size of the market offering opportunities for economies of scale.
-Lower costs may lead to businesses gaining further competitive advantage and consumers benefitting from lower prices.
-Increases productivity and living standards across the world.
-Competition and lower prices: Increased competition acts as an incentive to minimise costs, keep prices down plus also to innovate.
-Deeper specialisation which could lead to economies of scale.
Disadvantages of country specialisation/ having a comparative advantage
-Potentially increased risk as all resources are directed towards one or two areas- over-reliance/ dependence. Economies also rely on other countries producing goods and services that are not specialised.
-Increase in structural unemployment when demand for a good falls/global patterns change.
-May suffer from resource depletion if a country specialises in production.
-Increased carbon emissions due to additional transportation. Other negative externalities.
-It it too risky to become wholly dependent on another country for strategic industries ie food production.
-Inequality. Not every country benefits to the same extent.
Limitations of Comparative advantage - assumptions underlying theory
-Perfect knowledge- consumers may not know where best price is.
-Constant Opporutnity Cost- assumes opportunity cost of producing one good in terms of the other remains constant for both countries.
-No Transport costs- to buy from other countries ie Australia, may have comparative advantage but miles away.
-two countries and two goods- assumes only 2 countries
-No economies of scale- not consistent between countries- which may increase gain from trade.
-Rates of inflation ignored
-No Import controls- Tariffs or quotas on CA countries.
-Non-price competitiveness ignored - other countries may produce better quality, functioning products which dominate over price.
- Exchange rate movement ignored
- Research and Development investment ignored- differences in products because of differences in research into innovation. Countries that don’t have comparative advantage could put loads of money into R&D allowing them to create a new product-> patent it-> gain a monopoly in market.
- Factor mobility between industries ( geographical and occupational mobility) workers are assumed to be equally productive in whatever industry/ job they do and can switch work easily.(FoP are perfectly mobile)
-No externalities from production or consumption
-Labour is homogenous
-Ignores strategic industries
-Assumes both countries have equal/mutual benefit.
Absolute and Comparative advantage using PPFs
If two lines (countries) on PPF country whose line falls further down either axis has a comp advantage in that product as gives up less of other product for more of this one.
Slope represents opportunity cost of producing different goods. Shallower gradient (slope) relative to x- axis means that country has lower opposition cost in producing x axis good. Steeper slope means that country has lower opp cost in producing the good on the y axis.
(example of sheet)
Patterns of Trade
A country’s pattern of trade refers to the mix of goods and services that it imports and exports in international trade.
It also refers to the mix / range of which counties that are most important for a nation in their trade relationships – for example, the UK and the EU.
It reflects the specialisation and comparative advantage that a country has in producing certain products
Some countries have a highly diversified export base with the capability and capacity to export a very wide range of products
Others are heavily reliant on a narrow base of exports or might be highly reliant on trade with just one or a few other countries.
Developed Countries such as the UK will export more high-value services such as Legal consultancy and Health management and import more low-value goods such as clothes and food.
Whereas Developing economies hold a comparative advantage in low value goods and import the high value services
Trade Agreements Affect on Patterns of Trade
A trading bloc could involve the signing of free trade agreements and preferential trade agreements, this will divert trade away from the outside to within the bloc because of the lower cost of production within the bloc.
Intra- Industry Trade
Components bought from all over the world, e.g. UK imports cars whilst also exporting cars made with components all over the world.
China change in patterns of trade
Chinas comparative advantage has shifted to increased value goods and services.
Used to be an assembly country but now comparative advantage shifted to other NEE such as Bangladesh who hold an advantage in clothing.
China now have started buying companies- investing wealth in order to go up the value chain.
Factors Influencing Patterns of Trade
-Comparative Advantage: Countries tend to export goods and services in which they have a comparative advantage and import those in which they have a comparative disadvantage. This principle is a fundamental driver of international trade patterns.
-Impact of Emerging Economies: The rise of emerging economies has had a profound impact on global trade patterns. These countries often become major exporters of manufactured goods and services, altering the dynamics of global trade. They can both compete with and complement established economies.
-Growth of Trading Blocs and Bilateral Trading Agreements: These agreements can significantly impact trade flows. Within trading blocs, member countries often enjoy reduced tariffs and trade barriers, leading to increased trade among them. Bilateral agreements can create preferential trading relationships between specific countries, boosting trade in specific sectors.
-Changes in Relative Exchange Rates: Changes in exchange rates can have a direct impact on trade. A depreciation of a country’s currency can make its exports cheaper and more competitive on the international market, leading to increased exports. Conversely, a stronger currency can reduce exports and increase imports.
These factors do not operate in isolation but interact with each other to shape global trade patterns. For example, changes in exchange rates can affect the competitiveness of emerging economies’ exports, and the growth of trading blocs can influence the ability of countries to leverage their comparative advantages within those blocs.
Reasons for changes in patterns of trade - Comparative advantage
If countries develop a cost advantage in the production of certain goods, the POT would change to reflect these changes (as they would be exporting more of what they specialise in). Advanced countries tend to specialise in hi tech services/products whereas developing economies tend to specialise in land/labour intensive production
The BRICS economies
A group of countries that were identified as experiencing rapid economic growth and closing the gap on the developed economies. These economies have moved into sectors that were previously the province of the advanced economies, while the advanced economies have shifted into service/ quaternary sectors.
Emerging economies
An emerging economy is one in which the country is becoming a developed nation often driven by relatively high economic growth and a rapid expansion of trade and investment flows. An emerging economy is one that can’t yet be classified as ‘developed’ and is investing heavily in its productive capacity.
Reasons for change in patterns in trade - Emerging economies
The rise of emerging economies, such as China, India, Brazil, and others, has had a significant impact on the global pattern of trade in recent decades. These countries have become major players in international trade, both as exporters and importers, and have changed the traditional patterns of trade among developed countries.
One way in which emerging economies have influenced global trade is through their increasing share of world exports and have seen an increase in world merchandise exports. So emerging economies have become more integrated into the global trading system and are increasingly important players in international trade.
Another way in which emerging economies have influenced global trade is through their changing trade patterns. For example, China has become a major exporter of manufactured goods, particularly electronics and machinery, and has displaced other countries in these sectors.
merging economies have also become important importers of goods, particularly in sectors such as energy, minerals, and food as living standards increase.
Suggests that emerging economies are not just important exporters, but also major consumers of goods from other countries.
Reasons for change in patterns of trade - Trading blocs + trading agreements
Trading blocs (areas with free trade) encourage trade between member countries ie the EU currently has 27 members, in 1950 it had 6 members. Trade patterns grow within trade blocs as trade diverts to lower cost producers. There is an increased competitiveness in trading within the bloc and a decrease outside the bloc. EU accounts for 38% of world trade.
Reasons for change in patterns of trade- Changes in relative exchange rates
If the £ strengthens you can buy more foreign goods. But for other countries, our goods become dearer. And Vice Versa. Over time exchange rates adjust to maintain relative international competitiveness. This could affect POT.
UK trade in figures - Exports
Goods- Cars, Mechanical power generators, medicinal + pharmaceutical products, crude oil, aircraft.
Services- Other business services, Financial services, Travel services.
Main countries UK exports to - USA, Germany, Ireland, Netherlands, France.
Exports 2016 vs 2024:
Total: £575.6 billion vs £854.4 billion
Goods: 52% vs 44%
Services: 48% vs 56%
UK trade in figures - Imports
Goods- Cars, refined oil, medical+pharmaceutical, mechanical power generators, crude oil.
Services- Business services (other), travel services, transport services, intellectual property.
Main countries UK imports to - USA, Germany, Netherlands, France, China.
Imports 2016 vs 2024:
Total: £613.4 billion vs £896.3 billion
Goods: 72% vs 64%
Services: 28% vs 36%
The Terms of Trade
The relationship between the prices at which a country sells its exports and the prices paid for its imports. Refers to the average price of a country’s exports in relation to its imports- it measures the amount of imports a country can buy with a unit of export.
Terms of Trade Formula
Index of Export Prices/ Index of import prices x100
Uses same principal as measuring inflation- considering a basket of exported goods and their prices that are weighted based on the most popular (ie by revenue). The same for imports. This is then converted into a index.
How prices affect Terms of Trade
If export prices rise relative to import prices, there has been an improvement in the terms of trade. A unit of export buys relatively more imports. If import prices rise relative to export prices, there has been a deterioration in the terms of trade. A unit of exports can buy less imports than before. Therefore the country has to sell more exports to buy the same level of imports.
Terms of Trade Assumptions
If you have improving terms of trade the price of exports has increased and/or the price of imports has decreased. The opposite for deterioration.
If you are given information for one but not for the other- assume prices are constant.
Deterioration = Fall in living standards and Vice Versa.
The theory assumes levels of exports remain the same, huge assumption. Therefore this MAY lead to a fall or rise in living standards.
Impact - Short Term Factors influencing Terms of Trade
- Demand and supply for Exports and Imports - Increased Demand Due to changes in tastes and fashions is likely to increase prices of exports and therefore TofT have improved and revenues of businesses.
- Exchange rate - a fall in the exchange rate should cause a depreciation in the terms of trade. This is because a decline in the exchange rate will make exports cheaper therefore a unit of exports can buy less imports. An appreciation of the exchange rate should improve the terms of trade because exports will rise in price and imports become cheaper- therefore a unit of export can buy more imports.
-Relative inflation rates in different countries- Higher UK inflation would cause (at least temporarily) an improvement in the terms of trade as UK export prices would be rising faster than import prices. (Though inflation is likely to cause a depreciation in the exchange rate in the long run, which will cause exports to then fall in price) But whether it actually benefits the economy depends on the elasticity of demand.
Impact - Long Term Factors influencing Terms of Trade
-Competitiveness of firms- Export prices will be affected by productivity. If a business improves productivity then it is likely to reduce the costs of production and therefore, selling prices may be reduced, worsening of TofT. Same for Improvements in Technology.
-Changes in incomes could lead to consumers purchasing different types of goods ie if world income rises, demand for tourism increases and therefore countries with strong tourism industries will see an improvement in TofT.
Is improvement in TofT a good or bad thing - Due to Inflation
In reality in the long run if inflation is causing our prices to rise then demand will drop for exports so we will sell less. If imports are dropping in price we will buy more. This will create a large BoP deficit and the net inflow of money will be less than outflows of money so overall loss. Competitiveness of UK and goods sold decrease - lower revenues, limited growth, reduced standards of living depends on how key exports are. Depends on PED. AD will decrease.
Is improvement in TofT a good or bad thing - Appreciation of exchange rate
But competitiveness of UK goods may decrease in global market. Long run loss of demand and loss of revenue.
Is improvement in TofT a good or bad thing - Increased demand for UK goods and services
If have absolute/ comparative advantage then have inelastic demand so good thing. Demand casued by increase in price a positive thing. Revenues have also gone up.
Trading Blocs
An Agreement between a group of countries that promotes trade between member states. Through reducing protectionism, aim is for trade creation betweem themselves.
Free Trade
No restrictions to buying and selling between countries ie no charges to import/ export.
Why has international trade increased?
-Reduction of trade barriers. The role of the WTO has helped reduce trade barriers, through rounds of negotiation, helping trade to run smoothly and encouraging economic growth.
-Increasing FDI- Foreign Direct Investment. This occurs when businesses or governments invest in other countries.
-Political change. A good example here is the collapse of the Soviet Empire and rule in Eastern Europe which has opened up these areas to international business.
-BRICS- Brazil, Russia, India and China - four of the fastest growing nations! The potential is still large but slowing.
-Improvements in communication and transportation links with countries. The ability to move products at a vastly cheaper cost ( significantly through containerisation) has led to major increase in trade.
Preference Area -> Economic Monetary Union
Preference area - Members offer preferential treatment ie low tariffs but retain independent policies to non member states.
Free trade area - no trade barriers between member states but independent trade policies to non members.
Customs market- as before and also a common trade policy to non member states.
Common union- free movement for all factors of production, such as labour and capital. Plus common policies ie CAP/ common fishing policy.
Economic Monetary Union- Members adopt a single currency (plus single official interest rate).
Regional Trade agreements
Trade Agreements between at least 3 countries i.e. ASEAN (10 countries)
Bilateral trade agreements
Trade Agreements between 2 countries or trading blocs i.e. EU and Japan in 2018.
Free Trade Area
Arises when a group of countries come together and agree not to impose tariffs or quotas on trade in goods between them
Customs union
In a customs union (a more advanced form of free trade area) the members also agree to impose a common tariff/ policies on imports coming from the outside world.
Common market
Same as a customs union but with the free movements of labour and capital. European Economic Community (EEC) is a well known example and was formed in 1958.
Monetary Union
Monetary Union e.g. Eurozone- All members use the same currency ie the Euro, formed in 2002. (17/28 members). Deeper economic integration than others. They formed the EU central bank and the EU commission to synergize monetary and economic policies among member countries. Interest rate is the same in all countries of the monetary union. Budget deficits cannot exceed 3% of GDP.
The Transition to Economic Monetary Union
In terms of the eurozone, it was considered essential that those joining it would need to have “converged” in their economic characteristics ie the monetary conditions of the economies need to be reasonably close. To be eligible to join, countries had to have
- Low and similar rates of inflation
- Long term interest rates of no more than 2% above the average of the countries
- Stable exchange rates with no need for realignment within the previous 2 years
- A budget deficit of no larger than 3% of GDP
- National debt no more than 60% of GDP
- Stable Price Levels and a strong and stable financial system.
Monetary Union Advantages
-Monetary efficiency gains encouraging trade. Gains from reduced transaction costs and reduction in uncertainty (no longer need to anticipate exchange rate changes). The gains very much depend on the degree of integration between nations and the amount of trade.
-Increased trade potentially from the above.
-Price transparency/ increased convenience for consumers,
-Increase in attractiveness for FDI because of greater stability in trade.
-Stability, security, easier to therefore plan for the future.
-Increase in Exports can lead to Economic growth (5% Ireland) potentially leading to benefits such as an increase in employment.
Monetary Union Disadvantages
-Loss of independent monetary policy (therefore it is particularly important that the economic cycles of economies are well synchronised).
-Loss of exchange rate flexibility.
-Cost of leaving very high.
-Imposes restrictions on fiscal policy on member states, like budget deficits and public debt.
Policies introduced in the European Union
1960 - EFTA (European Free Trade Association) promotes free trade and economic integration with european countries not in the EEC.
1962- Common Agricultural Policy gives EEC countries joint control over food production - enough food for everyone and famers earn a good living.
1963- Yaounde Convention signed promoting cooperation and trade with 18 former colonies in Africa.
1968- Remove customs duties on goods imported from each other allowing free cross-border trade, Also apply same duties on imports from outside countries.
-1975- the European Regional Development fund created- transfer money from rich to poor regions.
1986- Although customs duties disappeared in 1968, trade is not flowing freely across the borders between member countries. The main obstacles are differences in national regulations. The Single European Act launches a vast 6-year programme to sort these out and thus create a single market.
1993-The single market and its 4 freedoms are established – the free movement of people, goods, services and money. Hundreds of laws have been agreed since 1986 covering tax policy, business regulations, professional qualifications and other barriers to open frontiers.
1994- European Economic Area extends single market to countries in EFTA.
1999- The euro is introduced in 11 countries for commercial and financial transactions only.
2002- Euro notes and coins become the legal currency in 12 EU countries (Greece joined the euro zone in 2001 and more follow after 2002).
2010- Following the economic crisis that began in 2008, several countries encounter problems with public finances. The 16 EU countries that use the euro back a plan to help them deal with their deficits. The EU helps several countries confront their difficulties and establishes a Banking Union to ensure safer and more reliable banks.
2020- The COVID-19 pandemic triggers a major public health emergency and economic slowdown. The EU and its member countries work together to support healthcare systems, contain the spread of the virus, and secure vaccines for people in the EU and beyond. EU leaders agree the largest stimulus package ever financed from the EU budget with the focus on a green and digital recovery as the EU works towards climate neutrality by 2050.
Impact of Brexit on the UK economy - Travel Disruptions
Leaving the EU’s single market introduced new barriers such as tariffs, customs checks and differences in regulation that have complicated trade between the UK and the EU (protectionism that reduces trade).
* Exports and imports: UK exports to the EU have fallen significantly. Similarly, imports from the EU faced disruptions, leading to supply chain issues and increased costs for businesses and consumers. These changes have resulted in a decrease in trade volume and efficiency, affecting sectors heavily reliant on EU trade.
* Trade agreements: the UK has pursued new trade agreements with non-EU countries. While these deals aim to offset losses from reduced EU trade, establishing new trading relationships takes time and may not fully compensate for the benefits of easier access to the EU market.
Impact of Brexit on the UK economy - FDI
Brexit has affected the attractiveness of the UK as a destination for
FDI. Uncertainty over future trade relationships and the potential for regulatory differences have made investors cautious. Many multinational companies have either delayed investments or relocated parts of their operations to other EU countries to maintain access to the single market. This shift affects job creation, innovation, and economic growth in the UK.
Lower inward FDI reduces injections into the circular flow of income.
Impact of Brexit on the UK economy - Labour Market effects
Brexit has had a profound impact on the labour market. The end of
“free movement between the UK and the EU has led to significant changes in labour dynamics.
* Immigration: the introduction of a points-based immigration system has reduced the number of EU migrants coming to the UK.
* Wages and employment: labour shortages have driven up wages in some sectors, benefiting workers but increasing costs for businesses. These higher costs can lead to higher prices for consumers and potential inflationary pressures.
Impact of Brexit on the UK economy - Economic growth and productivity
*GDP growth: the UK’s GDP growth has been slower compared to other advanced economies. Uncertainty and disruptions have dampened business investment and consumer confidence, contributing to a lower growth path. Some estimates suggest the UK’s GDP could be several percentage points lower in the long term due to Brexit.
Will result in a smaller shifts outward of the PPF.
* Productivity: business investment in capital and innovation has been slow, partly due to uncertainties and trade barriers. Lower investment levels can lead to slower productivity growth, a crucial driver of long-term economic growth.
Impact of Brexit on the UK economy - Inflation and consumer prices
- Exchange rate fluctuations: the value of the pound Sterling dropped sharply after the Brexit vote and has remained volatile (depreciation). A weaker pound makes imports more expensive, contributing to higher inflation. Consumers face increased prices for goods and services, affecting household budgets.
- Supply chain disruptions: new trade barriers and logistical challenges have disrupted supply chains, leading to shortages and higher costs for businesses.
These disruptions often result in increased prices for consumers.
Trade Creation
Occurs when there is an increase in the total amount of goods and services traded because of reduced trade restrictions within a trading bloc. Typically it is an increase in trade caused by moving from a high cost producing country to a lower cost country. Trade creation stimulates an increase in trade within the customs union and ought to lead to a more efficient allocation of resources leading to higher consumer and producer welfare
Trade Diversion
Occurs when a trading bloc reduces imports from non - member countries, enabling businesses within member countries to increase sales inside the trading bloc. This typically will have the effect of diverting trade away from lower cost counties/more efficient!
Trade creation examples
-Existing Situation- Country A buys goods from higher cost country: Country A imposes a tariff of 50% on imported cars. As a consequence all cars sold in Country A were produced domestically.
-Country A becomes part of a trading bloc- As a result of this the common external tariff is 50% but within member countries it is free. Country A now imports some cars from lower-cost producers that are member countries.
-Trade Creation - Trade has moved to lower cost producers and consumers benefit from cheaper prices.
Trade Diversion examples
Before Joining a Customs Union - * This occurs when consumption shifts from a lower cost producer to a higher cost.
* Before entry to the EU, the UK had low or zero tariffs on imported food items. It bought from the lowest cost producer say New Zealand for lamb.
Country A joins Customs Union - * After joining the EU a much larger tariff was imposed on food items as part of the common external policy.
As a result it became cheaper to buy from other EU countries such as France. However France is a higher cost producer than NZ.
Trade Diversion - * Trade is diverted from the lower cost producer New Zealand to the higher cost producer - ie France
Advantages of trading blocs on the economy
-Increased trade, standards of Iiving, economic growth
-Potentially increased FDI
-Increased Labour supply - and free movement of labour - increased employment opportunities, increased disposable income and spending, economic growth
-Increased economic leverage with other trading partners
-Increased specialisation and expertise
-Job creation
-Trade creation
-Technology and skills transfer
-Catch up effects - countries joining a rich trading bloc can benefit from inward investment - increased trade can increase standard of living
-Access more marekts
-External Tariff walls protect businesses within trading blocs.
-Increaed consumer surplus - high cost to a low cost producer
Disadvantages of trading blocs on the economy
*Partial loss of sovereignty over Iaws. With an economic monetary union there will be a loss of independent monetary policy.
* Adoption of laws that may make a country less competitive outside of the trading bloc
* Not all laws will be beneficial to each country. (And some laws can be seen as ridiculous and bureaucratic.)
* Trade diversion
* High degree of interdependence - if partners within the trading bloc goes into recession it is likely to impact other countries
* Increasing reliance and interdependence on each other.
* Retaliation/disputes between other trading blocs
* No protection for domestic firms - potentially structural unemployment as resources move from uncompetitive industries.
* Reaching agreements may be difficult and time consuming.
The WTO
The WTO is a multilateral organisation, the WTO policies trade in goods and services.
* The World Trade Organisation seeks to promote free trade by persuading countries to lower import tariffs and other barriers to open markets including less use of import licences, export subsidies and other non-tariff barriers including state aid.
* Membership of the WTO has expanded with the successful admission of China, India and latterly, Russia to the WTO all regarded as events of global economic significance.
* WTO membership accounted for 98 per cent of world trade in 2014 compared with 91 per cent in 1995.
* The WTO has a role in settling trade disputes between nations
* The formation of regional trade blocs is challenging the WTO.
It is an International organisation which sets rules for trade between nations. There are 164 members currently with the aim of facilitating a reduction of protectionism/ trade liberalisation. Also aims to ensure countries adhere to the agreements theyve signed up to + acts as a negotiator between countries.
Example of WTO disputes
One recent dispute was in 2018 when the US imposed tariffs of 25% on Steel and 10% on Aliminium on national security grounds. Prompting imediate responses from the EU, Canada and Mexico. Key issues revolved around whether national security could be involved as a legit justification for these tariffs and whether the US actions violated its WTO commitments. As of late 2023 the dispute was still ongoing with various countries seeking remedies through the WTO dispute resolution mechanisms.
Another dispute involving America was when, in 2019, the WTO said the US was justified to retaliate against the EU on $5.4 billion worth of goods in retaliation for support granted to Airbus. The EU was authorised a year later by the WTO to levy additional custom duties on $4bn worth of American products arguing that the US had supported Boeing unfairly as well.
Benefits of the WTO
-Access to markets
-Encouragement of FDI
-Support for developing countries
-Promotes good governing
-Rules make life easier for all - WTO system is based on rules rather than power and this makes life easier for all trading nations. WTO reduces some inequalities giving smaller countries more voice, and at the same time freeing the major powers from the complexity of having to negotaiate trade agreements with each of the member states. For business it makes trade simpler, cutting company costs and increasing confidence in the future and this in turn means more job opportunities and better goods and services for customers.
-Free Trade Cuts the cost of Living: Protectionism is expensive, it raises prices, WTO lowers trade barriers through negotiation and applies the principle of non-discrimination. The result is reduced cost of production (becuase imports used in production are cheaper) and reduced prices of finished goods and services, and ultimately a lower cost of living.
-Trade raises income for a country and promotes economic growth Through WTO trade barriers are lowered and this increases imports and exports thus earning the country foriegn exchange thus raising the country’s income. Trade also stimulates job creation.
-Helps promote peace within nations: Peace is partly an outcome of two of the most fundamental principle of the trading system; helping trade flow smoothly and providing countries with a constructive and fair outlet for dealing with disputes over trade issues. Peace creates international confidence and cooperation that the WTO creates and reinforces.
-Disputes are handled constructively: As trade expands in volume, in the numbers of products traded and in the number of countries and company trading, there is a greater chance that disputes will arise. WTO helps resolve these disputes peacefully and constructively. If this could be left to the member states, the dispute may lead to serious conflicts, but lot of trade tension is reduced by organizations such as WTO.
-It provides more choice of products and qualities: It gives consumer more choice and a broader range of qualities to choose from. Could also reduce prices, benefitting consumers further.
The system encourages good governance: The WTO rules discourage a range of unwise policies and the commitment made to liberalize a sector of trade becomes difficult to reverse. These rules reduce opportunities for corruption.
Negatives of the WTO
-Number of trade disputes settled inadequate given number of disputes
-Failure to confront ethical issues - ie child labour
-Failure to tackle environmental issues
-Failure to promote multilateralism- many countries and trading blocs favour bilateral discussions with partners and competitors as they are fully focused and can be completed. Countries prefer to bypass the WTO and deal directly.
-Free Trade benefits developed countries more than developing countries. It is argued, developing countries need some trade proteciont to be able to develop new industries. The WTO have sought to maintain the same rules for developing countries preventing them from protecting new industries. (This is known as the infant industry argument)
-Diversification. Arguably developing countries who specialise in primary products (e.g. agricultural products) need to diversify into other sectors. To diversify they may need some tariff protection, at least in the short term. Many of the existing industrialised nations used tariff protection when they were developing. Therefore, the WTO has been criticised for being unfair and ignoring the needs of developing countries.
- Takes too long to arbitrate and settle disputes -Ineffective - takes a long time to resolve - in the mean time barriers to trade are still happening.
- Not an even playing field - arguably it allows rich countries to benefit the most- -Favoures the powerful ie EU and USA
Functions of The World Trade Organisation
Two main functions are
- To encourage countries to lower protectionist barriers and thus increase trade between countries. It exists to bring about trade liberalisation which is achieved mainly through the various rounds of talks.
- To ensure that countries act according to various trade agreements they have signed. Any country or group of countries can file a complaint with the WTO who will attempt to resolve the dispute through negotiations between the two parties. Ultimately though the complaint can go to a panel of experts who will deliver a judgement. If the losing country does not abide then the other country can impose the same damage to trade that it has suffered.
Key Roles for the World Trade Organisation
- Conductor role: Members of the WTO have produced a set of rules that apply to international trade; the WTO ensures that these rules are followed. The WTO organizes ‘rounds’ of negotiations to be able to develop new rules (for example, in response to the rise of trade in services), but these can take well over a decade to be agreed upon, as there needs to be a consensus amongst members.
- Tribunal role: This role involves settling disputes between members. Member are encouraged to sort out disputes by themselves, but occasionally the WTO needs to convene a panel of experts.
- Monitor role: The WTO reviews the trade policies of its members to make sure that
WTO rules are being applied fairly and consistently. - Training role: The WTO provides training to government officials in (mostly) developing countries, to help them engage in trade with other WTO members
Protectionism
The act of guarding a country’s business from foreign competition, by imposing restrictions on free trade.
Why might a country use Protectionism?
-Reduce Trade Deficit/ BoP ( as Imports are reduced)
-Protect Infant Industries (like babies, need support, high costs at start)
-Retaliation (to other countries policies)
-Protect Jobs
-Raise government tax revenue (usually secondary benefit, not main objective)
-Response to dumping
-Protect Strategic Industries
4 Main Ways the Government protects the businesses in thier country
-Tariffs
-Quotas
-Subsidy
-Other
Tariffs
A tariff is a tax imposed on imported goods. The effect is to raise the price to the consumer, leading to a fall in demand. This may mean that consumers will switch consumption from imports to domestically produced subsitutes.
Tariff Diagram - Before Tariff
- We assume other countries can supply at a lower price and it is assumed that price is elastic - the country can import as much as they want at the going world price. With free trade domestic suppliers will produce at Q2. Domestic demand will be at Q3. The difference is filled with imports due to domestic demand being higher than domestic supply.
Tariff Diagram - After Tariff
Tariff is introduced by the government, increasing world prices. At this price, there is likely to be a contraction in demand but also an extension of supply as businesses are encouraged to produce more at this increased price. Imported goods will reduce, and domestic supply will increase. Increased Prices for domestic consumers, however. The shaded box is the government revenue from importing tariffs.
Positives of Introducing Tariffs
On the face of it the government has achieved its objectives:
-Imports reduced
-Domestic businesses have increased supply
-Domestic Jobs have been maintained/ potentially increased
-Government had gained also from increased tax revenue
Drawbacks of Introducing Tariffs
-Consumers are worse off as they pay a higher price for the good
-They consume less and there is a loss of consumer surplus.
So therefore:
-Consumer surplus has reduced
-Producer Surplus has increased
-However there is deadweight loss to society
Deadweight loss
-Cost to society created by market inefficiencies, which occurs when supply and demand are out of equilibrium
Tariffs - Society
-Consumers are worse off- this is represented by the various shaded areas below the Pw = tariff supply line.
-Some of the previous consumer surplus has been redistributed to others in society ie government revenue and producer surplus.
-But there is still a welfare loss represented by two red triangles
-In other words societies worse off by the imposition of a tariff as consumers are in reality paying a higher price for there goods.
-NB The impact of the tariff will depend upon the elasticity of demand and supply in the domestic market
Quotas
An Import quota is a limit on the total quantity of a product can be supplied to a market. An import quota therefore restricts the supply of an imported product. By cutting market supply the price of the imported product is likely to rise and black market may develop. Quotas limit market access to imported.
Quota Diagram
Other countries are prepared to export any amount at the world price (assumption) without a quota, domectic producers would be prepared to supply at S0 and demand at D0 at the world price.
By imposing a quota, total supply is now given by Sd + quota which is domestic supply + the quota of imports allowed into the economy from country A.
Arguments to use tariffs
-To protect strategic industries or sectors from foreign competition ( CAP/ Defence).
-To protect jobs maybe in struggling/less efficient industries- sunset industries (however this is likely to be just putting off the inevitable and certainly goes against the theory of comparative advantage)
-To raise tax revenue
-To deter dumping. (selling a product at a price below cost). Consumers may be pleased to get goods at such a good price, but a firm competing with dumped imports will struggle. The WTO permits anti-dumping policies in order to deter unfair competition.
-Infant industries argument - if protected at the start, industries may be able to grow and reap the benefits of Economies of Scale and compete effectively in the long term without protection.
Arguments against the use tariffs
-Reduction in choice for UK consumers plus goods and services are more expensive - a welfare loss for consumers.
-May increase revenues. But likely to cause retaliation from the exporting country ie trade wars. This is likely to mean that everyone is worse off! Whilst the WTO is committed to reduce trade barriers, it allows retaliation in the form of countervailing duties
-May protect UK jobs but likely to be limited if firms do not become competitive on an international scale. This may just delay the inevitable structural change that is necessary. For countries to develop new sources of comparative advantage there is bound to be a transitional period where old industries contract and new industries emerge. Effectively the government is subsidising inefficient local producers.
-Whilst it may give firms time to become more competitive, it may make domestic firms complacent and productivity/ efficiency gains are not realised. This may lead to x-inefficiency and an inability to compete in the global market
-Where the tariff is put on a good and that is price inelastic it will have minimal effect. This may be because domestically produced goods are inferior to the imports. Therefore demand may not increase domestically produced goods.
-You might also want to introduce some game theory into your analysis and evaluation - to what extent is a persistent trade war a sub-optimal outcome from those countries involved?
Quota Surplus
There is a reduction in quantity imported ,a supply extension, and a contraction of demand.
Consumer surplus decreases and producer surplus increases. So domestic producers gain and consumers lose.
Winners and Loser - Quotas
-Domestic producers gain through selling at a higher price
-Producers exporting from Country A gain, they benefit from the higher price they are able to charge due to the quota. Alternatively; the government may issue licences for domestic businesses to buy the products at the world prices and sell at the new domestic prices. This would be a further gain for domestic businesses.
-There is a welfare loss to the country however, due to the higher prices if there is also if there is also a gain in the yellow box.
-Like a tariff, quotas can lead to X-inefficiency in domestic firms and keep workers employed in unproductive sectors where the country doesn’t have a comparative advantage
X - inefficiency
*X Inefficiency occurs when a firm lacks the incentive to control costs. This causes the average cost of production to be higher than necessary.
* Like a tariff, quotas can lead to X-inefficiency in domestic firms and keep workers employed in unproductive sectors where the country doesn’t have a comparative advantage. This also contributes to a loss to society.
The impact of protectionist policies
Protectionist policies have a number of effects on economic agents in a country.
These effects differ according to which policy is in operation, but are most clearly illustrated with reference to the imposition of a tariff, which is the most common form of protectionist policy.
* Consumers: in general, consumers are likely to be worse off as a result of protectionist measures.
In the case of a tariff, consumer surplus is lower after a
tariff, as consumers must pay a higher price for the good, and will consume less.
* Producers: producers in the domestic economy will gain from protection, as they will receive higher producer surplus (at the expense of consumers). However, their incentives to produce efficiently will be low, so in the long run they may never become able to compete effectively in world markets. The infant industry benefits are rarely delivered.
* Governments: when a government imposes a tariff, it gains by the revenue that it raises. This may be valuable for the government of a developing country that faces problems with raising revenue through other forms of taxation, because of the lack of an administrative structure. Short term as retaliation cancels out gain from tax.
* Living standards: for society as a whole, the imposition of a tariff carries a deadweight welfare loss, so overall well-being is lower with a tariff in place.
* Equality: protectionist measures entail a redistribution of resources, from consumers to producers, so there may be an increase in inequality in the society.
Producer Subsidy
A payment by the government to help domestic businesses become more competitive (i.e. help lower their prices)
Subsidy
-A subsidy will encourage production. However, unlike a tariff, consumers can still purchase the good at the world price.
-There is likely to be a reduced dependence on imported goods
-However, the government obviously has to pay for this and these funds carry an opportunity cost (opportunity cost should be specific to the area I’m talking about, say the money might be better spent on supply side to improve productivity for example)
-Furthermore, the subsidy may not ensure any increased efficiency happens, is it worth propping up an inefficient industry?
-It may also encourage a surplus to be produced - wine lakes and butter mountains - referring to the large stockpiles of agricultural products that were created by the CAP.
CAP Surplus
-The EUs common agricultural policy contained a number of subsidies for wine products, leading to a supply glut; this surplus forced an overhaul of EU farm policies.
In 2007 it was reported that for the previous several vintages, European countries had been producing 1.7 billion more bottles of wine than they sold.
Non Tariff Barriers
Technical barriers to trade
-A technical barrier to trade (TBT) is any regulation, standard or procedure that could make exporting goods to another country more difficult.
-Safety/product standards. Putting stringent standards onto imported goods and therefore deterring imports.
-If standards are set so high it may mean that exporters cannot meet these standards
Examples
-Until recently China ruled that all avocados coming from countries such as Kenya had to be frozen to -30 deg and peeled before shipping.
-Within the African Continental Free Trade Area, businesses must contend with 55 separate natural standards, 55 test certificates and 55 national inspection procedures. This slows to speed at which trade takes place.
Undervalued exchange rate
-Keeping the exchange rate undervalued. China sets its own exchange rate and has been accused of setting it artificially low. The effect of this is to make imports more expensive and exports cheaper. Therefore Chinese made goods would be more competitive in the domestic market and overseas market.
Brief Impact of a quota
Increase in domestic supply- reduced imports leads to natural domestic, less supply from abroad. Incentivised by higher price.
Decrease in domestic demand - increase in price, restriction on no. imports available, some wont pay higher prices
Imports decrease - quota decrease amount of imports
No change in government tax revenues - no direct increase, no additional increase, may be an indirect impact of producers selling more
Domestic producer revenue/producer surplus increase- selling at a higher price
Decrease in foreign producer revenue - reduction in sales
-Consumer surplus decrease - paying higher price.
Brief Impact of a tariff
Increase in domestic supply- world supply reduced, domestic fill gap. Incentives for domestic firms to produce more, higher prices.
Decrease in domestic demand - price goes up, causing demand to contract.
Imports decrease - tariff reduces imports, makes them more expensive, demand switches from imports to domestic.
Increase in government tax revenues - additional prices goes to government, in SR, In LR, retaliation could cancel out
Domestic producer revenue/ producer surplus increase- selling at a higher price
Decrease in foreign producer revenue - reduction in sales, fewer exports
Consumer surplus decrease - paying higher price, band of consumers arent willing to pay, can reduce standards of living, reduction in disposable income.
The Impact of Protectionism
-Consumers are generally likely to be worse off. Depending on the type it may reduce consumer surplus, choice and increase prices. This may result in falling standards of living as increased prices may mean less disposable income for other goods and services (particularly if it is a necessity). There may be a loss of allocative efficiency. However may benefit from governments increased tax revenue or potentially increased jobs leading to more disposable income.
Much will depend upon whether good quality additional jobs are created.
-Producers will gain due to higher producer surplus. Demand may transfer now from the more expensive imports to relatively cheaper domestically produced goods and services. However this is not guaranteed - domestic companies still may not be price competitive and in the long run; due to complacency/ competition or a lack of innovation they may not be able to compete globally. There may be a loss of productive efficiency. There may be a lack of incentive to increase and improve production etc
-Government may gain tax revenue in the short run which may benefit both consumers and producers as more revenue can be ploughed back into better infrastructure, education etc. There may also be GDP growth in the short term. But in the longer term this could lead to retalliation and trade wars and gains may not be sustainable. It may also be an expensive use of public funds ie subsidies and involve opportunity costs.
- Living standards - overall lower due to a lack of choice and increased prices. This may impact those on Iow incomes to a greater extent (regressive as will take up a larger proportion of their income) particularly if these goods are necessities. This may increase inequality.
All Depends upon:
-Size of the increase of a tariff for example
-Price elasticity of demand for imports
-The extent to which the measure improved competitiveness of domestic producer over the long term.
Balance of payments
A record of all financial transactions between economic agents of the UK and all other countries.
Must always balance to zero, this is because it has to pay for everything it consumes and funds in some way - to fund a current account deficit, a country must be selling assets to foreign investors/ or borrowing from other countries.
But often there is some inaccuracy which is covered by net errors and ommisions.
Balance of Payments - Current account
The current account balance is the sum of a country’s balance of trade in goods and services, net income from abroad, and net current transfers. Includes following components:
Trade Balance: The balance of trade accounts for the difference between the value of a country’s exports (goods sold to other countries) and imports (goods purchased from other countries).
Services: This category covers trade in services, such as tourism, financial services, transportation, and consulting.
Income: Income includes earnings from investments, such as dividends, interest, and profits, received by residents from foreign investments and paid to foreign investors by domestic entities.
Transfers: Transfers encompass unilateral transfers of money or goods between countries, such as foreign aid, remittances from expatriates, and gifts.
A positive current account balance indicates the nation is a net lender to the rest of the world, while a negative current account balance indicates that it is a net borrower from the rest of the world.
There are a number of factors that can contribute to a country’s current account balance. These factors include:
The relative prices of goods and services in different countries.
The exchange rate between different currencies.
The level of tariffs and other trade barriers.
The level of economic growth in different countries.
The current account balance can have a number of implications for a country’s economy. A current account deficit can lead to economic slowdown, as it means that the country is buying more goods and services than it is selling. It can also lead to inflation, as the country has to borrow money from other countries to finance its purchases.
Balance of Payments - Financial account
The financial account on a country’s balance of payments includes transactions that result in a change of ownership of financial assets and liabilities between a country’s residents and non-residents. It details how a country’s residents and entities interact with foreign assets and liabilities. This includes:
1.Net balance of foreign direct investment flows (FDI)
2.Net balance of portfolio investment flows (e.g. inflows/outflows of debt and equity)
3.Balance of banking flows (e.g. hot money flowing in/out of a country’s commercial banks)
4.Changes to the value of reserves of gold and foreign currency
Balance of Payments - Capital account
The capital account records financial transactions that involve the acquisition or disposal of non-financial assets, such as real estate, patents, and copyrights, between a country and the rest of the world. It also includes capital transfers, which involve the transfer of assets for specific purposes, like debt forgiveness.
Primary Income
Profits, dividends, and interest receipts arising fro UK ownership of overseas assets. Plus employment income from abroad.
Secondary Income
International transfers ( by government or individuals), ie remittances from foreign workers to their families in their home countries or international aid. Usually negative as leaving country
Credit
Money coming in
Debit
Money going out
Current account deficit/ surplus
If spending more on imports than earnings from exports, this would be known as a current account deficit. If spending less on imports than earning from exports, this would be known as a current account surplus.
UK Current account
UK has been running a trade deficit in goods for several decades. Major imports include machinery, vehicles, and petroleum, with exports including cars, pharmacuetical products and chemicals. Deficit widended due to Brexit and Covid. 2022-23 UKs goods trade deficit around £150-200 billion annually.
UK has run a surplus in services, largest contributer being financial services, professional services and digital services. With EU and US being significant consumers of UK services. Brexit did impact as some accesss to Europe market restricted, but UK still remains a major global financial hub. The UKs trade in services has consistently been in surplus with value of service exports often excedding £100 billion annually in recent years.
Overall UK generally runs a current account deficit(3-5% of GDP), due to it importing more goods+services than it exports, but deficit offset slightly by surplus in services. Deficit financed by influx of foreign investment, primarily in form of portfolio and direct investment.
2023:
-£188 Bn Deficit in goods
-£173 Bn Surplus in services
-£15 Bn deficit overall
Current Account Deficit
If a country has a current account deficit, it can only do so by running a surplus on the financial/ capital account. Effectively, what is happening is that in order to fund the current account deficit, the UK is selling assets to foreign investors and borrowing from abroad.
Causes of a current account deficit
Demand Side:
-Strong domestic growth- increased incomes lead to increase in consumption of imports.
-Recession Overseas- reduction in incomes abroad, reducing demand for exports.
-Strong Exchange rate- imports cheaper and exports more expensive, widening the gap.
Supply Side:
-Non-Price Competitiveness: Low investment/ R&D spending, Poor quality/ reliability/design/branding
-Poor Price competitiveness - High relative inflation, High unit labour costs
-Structural Causes - Low productivity, insufficient investment in capital which then limits a nation’s export capacity
All to do with lack of competitiveness of domestic exports- reducing demand abroad.
-Depletion of resources- exporting resources that deplete
Negative Consequence of Current Account deficit
-Lower AD- likely that trade balance is negative, so net exports reduced, reducing AD. As AD shifts to left there can be high unemployment, reduced living standards and low growth in economy.
-Debt Burdens- in order to finance deficit. Increased debt can lead to currenct crisis as if investors believe that the country will not be able to continue financing its deficit (unsustainable), they may pull out capital (capital flight), causing the currency to depreciate sharply. Depreciation worsened by savers moving money further as loosing value. Ultimately can lead to the financial crisis as cannot finance deficit due to weakness of pound. Increase in external debt is risky expecially if interest rates increase.
-Downward pressure on exchange rate- if importing more, selling currency to buy foreign goods and assets, then overall supply of currency increasing. Theoretically worsened exchange rate should better deficit but if deficit in first place could be a sign of uncompetitiveness of goods regardless (non price factors). Could instead suffer from higher costs of imported raw materials, which could lead to stagflation (increased cost for businesses, increasing inflation and reducing growth). Depreciating exchange rate can also lead to higher cost push inflation and a deterioration in terms of trade.
If only a small proprotion of GDP can usually finance comfortably with debt, but if balloons out of proportion isssues can occuer, especially number two.
Correcting current account deficit
- Expenditure Switching Policies-
Objective: Shift consumption from foreign to domestic goods to reduce imports and increase exports.
Policies:
-Devaluation/Depreciation of the Currency:
Devaluation (in a fixed exchange rate system) or depreciation (in a floating exchange rate system) makes domestic goods cheaper for foreigners and foreign goods more expensive for domestic consumers.
Example: The UK’s Brexit vote in 2016 led to a depreciation of the pound, which made UK exports cheaper.
Marshall-Lerner Condition: For devaluation to improve the current account, the sum of the price elasticities of demand for exports and imports must be greater than one. (cant be an inelastic good)
-Tariffs and Quotas:
Imposing tariffs or quotas on imports makes them more expensive or limits their quantity, encouraging consumers to buy domestically produced goods
-Subsidies for Exporters:
Providing subsidies to domestic exporters can help lower their costs and make their products more competitive in the global market.
-Encouraging domestic residents to buy domestic goods, for example, “buy british campaign”.
Can quickly adjust trade balance but can lead to retaliation and inflationary pressures due to more expensive imports. Expenditure switching policies could lead to retaliation from other countries as well.
- Expenditure Reducing Policies
Objective: Reduce overall expenditure in the economy, including spending on imports.
Policies:
-Fiscal Policy:
Cutting government spending or increasing taxes to reduce the disposable income of consumers, leading to lower consumption, including imports.
-Monetary Policy:
Increasing interest rates to reduce borrowing and spending. Higher interest rates also attract foreign investment, leading to a higher demand for the domestic currency.
Example: Turkey raised interest rates in 2021 to combat a current account deficit and inflation.
Can reduce import demand but could lead to decrease in AD, recession, unemployment, reduced living standards and reduced economic growth (Conflicting macroeconomic objectives)
- Supply-Side Policies
Objective: Improve the competitiveness of domestic industries by enhancing productivity, reducing costs, and encouraging innovation.
Policies:
-Investment in Infrastructure:
Improving transportation, communication, and energy infrastructure to reduce production costs and increase export competitiveness.
-Education and Training:
Investing in human capital to enhance labor productivity and competitiveness in high-value industries.
-Deregulation:
Reducing regulatory burdens on businesses can lower costs and encourage investment and exports.
enhance long term competitivenss without immediate negative side effects on consumers but slow to implement, could take years. Cost to government - opportnity cost -cost of training for example ( might not have a significant effect.
Are Trade Deficits Sustainable
-Probably not - selling assets or borrowing from abroad has future implications for the current account as there will be outflows of investment income and debt repayments.
However:
-Depends on how the deficit is financed - borrowing or capital flows
-Depends on the cause of deficit- high growth or uncompetitiveness
-Depends on quantity of foreign assets
-Can a country devalue its currency?
Positive consequences of current account deficit
-The reason could be due to rapid economic growth drawing in more imports
-The UK has had a persistent deficit since the mid 1980s. Countries with large current account surplus have not necessarily done better, eg. Japan had a long period of stagnation.
-In era of globalisation, financial flows are easier to attract and therefore the deficit is financed by these capital inflows.
-If the current account was too large, there should be a depreciation in the exchange rate to restore the balance. A current account deficit is a bigger concern in a fixed exchange rate (like Euro) because there is no option of depreciation.
Current Account Surplus
When a country exports of goods, services, income and transfers exceed its imports. Implies a country is earning more than it is spending internationally.
e.g. Germany, China, Japan, Netherlands
Causes of a Current Account Surplus
Demand Side:
-High incomes abroad (booming economies)- increasing demand for exports
-Low incomes at home- reduce demand for imports, decrease expenditure on imports.
-Weak exchange rate/exhange rate manipulation(kept low)- imports reduce, exports increase
-High interest rates- decrease imports due to more saving.
Supply Side:
-Low relative inflation- exports more competitive as are relatively cheaper
-Low unit labour costs- high productivity, weak trade unions, low minimum wage. Making exports more price competitive.
-Competitive advantage- non price factors
-Strong investment- technology etc- keep prices low, lower costs further
-Gains in comparative advantage- specialise in exporting goods, exports increase
-New resource discoveries- sell around the world - ie Russia have high reserves of oil and gas.
Consequences of a current account surplus
-Trade surplus so (X-M) positive, Increase in AD, Growth will increase, unemployment decrease BUT demand-pull inflation triggered.
-Appreciation of the exchange rate - as more demand for currency than supply of it, as more exports than imports, could lead to long term reversion back to balance.
-Financial account deficit - in order to balance BoP, may have to buy up debt/bonds of Current Account deficit countries, if these countries get into financial trouble can make assets worthless, leading to difficulties.
-May harm international relations- could gain a surplus due to excessive protectionism, managing the exchange rate. May lead to retaliation fro deficit countries- trade war triggered.
-Sign of unbalanced economy- if a country’s reliant on exports/trade for growth, all of production will be for sales overseas, could lead to lack of production for domestic consumers leading to low consumer spending. Therefore if export demand was to fall, no other avenue for growth as consumer spending low.
A sustained improvement in Balance of Payments requires:
-UK businesses to seek and exploit markets overseas
-Focusing on their comparative advantage
-Higher levels of R&D
-Improved efficiency and productivity in export sectors and those parts of British industry that are exposed to international competition.
Exchange rate
The value of one currency expressed in terms of another currency.
If the strengthening/appreciating exchange rate, the pound will buy more of a foreign currency. SPICED
If weakening/depreciating exchange rate will buy less of a foreign currency.WIDEC
-There is no such thing as ‘the’ exchange rate.
-If sterling depreciating against the dollar if could still be appreciating against the Euro or the Japanese Yen.
-If sterling depreciating against the Dollar it means the dollar is appreciating against the pound.
Exchange rate impact on UK and US
If product sold in UK the UK price will be constant, however the price will fluctuate depending on exchange rate for US consumers. Therefore price wise there is no affect on the UK exports but large affect for US importers. However there could be a decrease/increase in demand due to price changes therefore there will be an impact on UK exporters.
Similarily if its sold in the UK and being imported, changes in the exchange rate will lead to increases/decreases in demand for imports into the UK.
Winners + Losers from a depreciating exchange rate
Winners:
-Businesses exporting into international markets
-Estate agents selling prime London property
-London eye- which attracts a significant number of foreign tourists
Losers:
-Businesses importing into international markets
-Businesses earning substantial profits in overseas currencies
-Overseas businesses trying to compete in the domestic market
-British people living in France+Spain on Sterling pensions
-UK airline buying fuel from abroad in US dollars
A depreciation of the exchange rate will generally:
- Lead to an increase in the value of exports as these become more competitive
- A fall in the value of imports as these become more expensive
- An improvement in the current account on the balance of payments
- But much will depend on the price elasticities of imports and exports, the size of the depreciation, the amount imported/exported.
- Also consider time lags.
How might a currency depreciation affect international competitiviness
-A depreciation is a fall in the external value of a currency inside a floating exchange rate system.
-Consider for example, a depreciation of the UK pound against the Euro. The pound might fall from Euro 1.50 to Euro 1.20 a drop of 20%.
-This makes UK exports relatively cheaper in overseas markets. Relative export prices fall leading to improved competitiveness.
-In addition, the UK price of imported products will increase. £1 buys will buy fewer Euros. For example, imported cars will be more expensive.
-A rise in import prices will make domestic producers in the UK appear relatively more competitive purely in cost and price terms.
Evaluation of the impact of exchange rates
-The Size of the Change
-The longevity of the change ie short or long term trend
-Whether businesses import or export significantly
-PED of imports and exports
Free Floating exchange rate system
In a floating exchange rate system, the exchange rate is determined by supply and demand in the foreign exchange market. Appreciates and Depreciated depending on Demand and Supply.
Governments and central banks do not actively intervene to fix the rate, allowing it to fluctuate freely.
UK, US, Australia and the 19 countries in the EU monetary union operate a free-floating exchange rate system.
Fixed Exchange Rate System
In a fixed exchange rate system, the government or central bank sets a specific exchange rate and is committed to maintaining it.
To keep the rate stable, authorities may buy or sell their own currency as needed.
Saudi Arabia, Hong Kong and Iraq all operate a fixed exchange rate system.
Managed Exchange rate system
A managed exchange rate system is a hybrid approach where authorities occasionally intervene to influence the exchange rate. It is a floating ER but with some govt intervention if they feel necessary.
While there’s some flexibility, there’s also a commitment to maintain a certain degree of stability.
Brazil, Japan, India and New Zealand all operate on this system
Pegged Exchange Rate
A fixed exchange rate system is a type of exchange rate regime in which a currency’s value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.
There are two main types of fixed exchange rate systems:
-Crawling peg: Under a crawling peg, the value of the currency is adjusted gradually over time, usually in small increments. This is done to keep the currency’s value in line with inflation or other economic factors.
-Fixed peg: Under a fixed peg, the value of the currency is fixed at a specific rate and is not allowed to fluctuate. This is the most rigid type of fixed exchange rate system.
Purpose is to stabilise the value of a currency, keeping it at a fixed rate (against the dollar for eg) to avoid fluctuations.
Revaluation
In fixed systems
A revaluation is an increase in the official exchange rate of a currency set by the government or central bank. It is a deliberate policy move to strengthen the currency’s value
Devaluation
In fixed systems
Devaluation is a deliberate policy action by a government or central bank to reduce the official exchange rate of its currency. This makes exports cheaper and imports more expensive.
Appreciation
In free-floating systems
Appreciation refers to a natural increase in the value of a currency due to market forces, such as increased demand for the currency in the foreign exchange market (perhaps due to higher interest rates attracting foreign capital) or a decrease in the supply of the currency (perhaps decreased spending on imports).
Depreciation
In free-floating systems
Depreciation occurs when a currency’s value decreases in the foreign exchange market due to market forces, such as decreased demand for the currency (fall in the demand of exports - e.g. downturn in US economy) or increased supply of the currency (perhaps due to rise in spending on imports - e.g. consumer boom).
Factors Influencing Floating exchange rates
Market forces drive floating exchange rates, influenced by:
-Interest Rates: Higher interest rates attract foreign capital, increasing demand for the currency.
-Economic Data: Economic indicators like GDP growth, inflation, and employment affect currency demand.
-Political Stability: Political events can impact investor confidence and currency values.
-Trade Balance: Trade surpluses or deficits can affect a currency’s value
-Quantitive easing- since QE has the effect of increasing money supply, it is likely that this will cause a depreciation in the country’s exchange rate.
-Net investment - An increase in FDI is likely to lead to an appreciation of the ER as there is an increase in demand for £s.
-Speculation - If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise.
Therefore movements in the exchange rate do not always reflect economic fundamentals, but
are often driven by the sentiments of the financial markets.
For example, if markets see news which makes an interest rate increase more likely, the value of the pound will probably rise in anticipation.
Inflation affect on Exchange rates
If Inflation is relatively lower than elsewhere then exports will become more competitive and there will be an increase in demand for the Pound to buy UK goods. Also, foreign goods will be less competitive and so UK citizens will supply less pound to buy fewer foreign imports. Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency. If inflation high then will have opposite effect however automatic stabilisers in a free floating system would ajdust for changes in inflation reducing the effect in the long run. For example if relative inflation is high in the UK this may mean that UK goods are less competitive. Overtime there is less demand for UK goods and therefore less demand for the currency. This is likely to lead to a depreciation (making goods more competitive) of the ER and therefore adjusting for inflation.
Interest Rates affect on Exchange rates
- Increase in the UK interest rates
-Better return on Uk savings accounts
-Hot money flows in to take advantage of higher interest rates
-Increase in demand for the pound
-Appreciation in the value of the pound.
If UK interest rates increase relative to elsewhere it becomes more attractive to deposit money in UK, as better return on savings. Therefore demand for sterling will rise and a appreciation of the ER. This is known as hot money flows and is an important short term determinant of the value of of a currency.
Therefore if a countries central bank wises to increase the value of its currency, it may increase the interest rates.
Currency Demand
-Demand for a currency is an inflow of money into an economy.
-Demand for a currency is derived from demand for a country’s exports of goods and services and from speculators looking to profit from changes in currency values and from currency volatility and benefit from high interest rates (hot money).
Currency Supply
An outflow of money into an economy. The supply of a currency is determined by the level of domestic demand for/ expenditure on imported goods and services from abroad.
FIxed Exchange rate system - currency reserves
- In order to keep the currency within this band then the central bank will have to buy and sell currency
-Dependent on the level of currency reserves held in the central bank
-These can run out very quickly
-UK suffered a currency crisis in the 50s,60s and 70s
-If countries run out of reserves they could ask the IMF
Process of Devaluation
Achieved by selling the domestic currency in the foreign exchange market and buying other countries. Consequently, a country’s exports can gain a comparative advantage as exports become relatively cheaper with a devalued pound, the demand for exports rises and imports falls, thus improving the balance of payments. Can be seen as a measure of protectionism (ie China). However, if countries retaliate with other barrier of trade.
By selling reserves of the pound and buying foriegn currency there is an increase in supply of pounds on the market, which devalues the pound.
Free Floating Exchange Rates- Advantages
-Monetary Policy Autonomy: have greater flexibility in conducting an independent monetary policy. This means that they can adjust interest rates and the size of quantitative easing to address domestic economic conditions such as growth, inflation and unemployment without being constrained by exchange rate considerations.
-Shock Absorption: Free-floating exchange rates allow countries to absorb external economic shocks (such as oil price increase) more effectively. If a country faces an economic crisis, such as a recession, the exchange rate can act as a shock absorber by helping to rebalance the economy. For example, a recession might cause the exchange rate to depreciate which acts as a boost to export businesses and domestic firms facing import competition.
-Trade Balance Adjustment: A floating exchange rate can help correct trade imbalances over time. If a country is running a large trade deficit, its currency’s depreciation can eventually make its exports more price competitive and imports more expensive, leading to a narrowing of the deficit. This depends on the price elasticities of demand for exports and imports along with the elasticity of supply of domestic firms.
-Currency reserves: When operating a free-floating exchange rate system, the central bank does not need to hold large foreign currency reserves because there is no specific currency target, financial capital can flow freely across countries seeking the best returns
-Less risk of currency becoming significantly over/undervalued as markets determine the value
Free Floating Exchange Rates- Disdvantages
-No guarantee floating exchange rates will be stable
-Exchange Rate Volatility: One of the most significant drawbacks of a free-floating system is the potential for exchange rate volatility. Currencies can experience rapid and unpredictable fluctuations, which can introduce uncertainty for businesses engaged in international trade and investment as well as the government and can be detrimental to attracting inward investment.
-Currency Risk: The volatility of exchange rates introduces currency risk for businesses and investors.
-Inflation Pass-Through: Exchange rate fluctuations can lead to changes in import prices, which can impact domestic inflation. A significant depreciation of the currency can contribute to imported inflation and erode real purchasing power.
-Loss of Exchange Rate as a Policy Tool: While countries gain monetary policy autonomy, they lose the ability to manage the exchange rate as a deliberate policy tool. This can limit the direct influence of exchange rates on trade and competitiveness.
-Can be affected by speculation rather than patterns of trade
-A lower (more competitive) exchange rate does not necessarily correct a persistent current account deficit - consider the J curve and the importance of non-price competitiveness in influencing demand for exports and imports
Fixed Exchange Rates- Advantages
-Price Stability: A fixed exchange rate system provides a high degree of price stability since fluctuations in the exchange rate are minimised. This stability can help control inflation (especially when imports are needed for the production process) and provide a predictable environment for businesses and consumers.
-Trade Confidence: Businesses can plan for transactions without worrying about sudden currency value changes, making cross-border trade more predictable and manageable. Confidence for inward investment also.
-Reduced Exchange Rate Risk: Fixed exchange rates eliminate the currency risk associated with fluctuating exchange rates. This stability can be particularly beneficial for companies engaged in long-term contracts, investments, and trade.
-Foreign Investment: A stable exchange rate can attract foreign investment. Investors may be more inclined to invest in a country with predictable currency values, reducing the risk associated with currency fluctuations.
-Reduced need to engage in and costs of ‘currency hedging’ for businesses such as airlines
-Less speculation in the currency market as the currency is fixed and unlikely to change dramatically.
Fixed Exchange Rates- Disadvantages
-Lack of Flexibility: One of the main drawbacks of a fully fixed exchange rate system is the lack of flexibility in responding to external economic shocks. Countries cannot independently adjust their exchange rates to address changing economic conditions such as stimulating GDP growth.
-Loss of Monetary Policy Autonomy: The country may be forced to adopt monetary policies that are not necessarily suited to its specific economic circumstances.
-Balance of Payments Issues: In a fixed exchange rate system, a country’s balance of payments must be maintained through other means, such as fiscal policy or controls on capital flows. Persistent imbalances can lead to pressures on the currency peg.
-Dependence on Reserves: To maintain a fixed exchange rate, a country needs to have sufficient foreign exchange reserves. If reserves are inadequate, the country might struggle to defend the peg during times of market stress. Especially in a developing country.
-Difficult for countries to use a competitive devaluation of their fixed ER - this creates political tensions and might lead to a protectionist response.
-Devaluation of a fixed ER can lead to cosh push inflation which has regressive effects on poorer families for example, when imported food costs more. Inflation may erode any price benefits export businesses may have gained from devaluation.
Managed Exchange Rates- Advantages
The merits of a managed float system are numerous. Firstly, it provides a balance between the extremes of a fixed exchange rate and a completely floating exchange rate. This balance allows for a degree of stability in the exchange rate, which can be beneficial for international trade and investment. It reduces the risk of sudden and dramatic changes in the exchange rate, which can be disruptive to economic activity.
Secondly, a managed float system allows for some flexibility in monetary policy. The central bank has the ability to intervene in the foreign exchange market to influence the exchange rate. This can be useful in managing inflation and promoting economic growth. For example, if the central bank wants to stimulate the economy, it can lower the exchange rate to make exports cheaper and imports more expensive, thereby encouraging domestic production.
Thirdly, a managed float system can act as a buffer against speculative attacks on the currency. If speculators believe that the currency is overvalued, they may sell the currency in large quantities, causing a sharp depreciation. However, under a managed float system, the central bank can intervene to support the currency and prevent a sharp depreciation.
Managed Exchange Rates- Disadvantages
One of the main criticisms is that it can lead to manipulation of the exchange rate. Governments may be tempted to devalue their currency to gain a competitive advantage in international trade. This can lead to ‘currency wars’, where countries compete to devalue their currencies, which can be destabilising for the global economy.
Another criticism is that a managed float system can be unpredictable. The exchange rate is influenced by a combination of market forces and central bank intervention, which can make it difficult to predict. This unpredictability can create uncertainty for businesses and investors, which can deter international trade and investment.
Lastly, managing the exchange rate can be costly. The central bank needs to hold large reserves of foreign currency to intervene in the foreign exchange market. These reserves can be expensive to maintain and can tie up resources that could be used elsewhere in the economy. Many smaller and relatively poorer countries do not have these.
Central banks intervening on their own may have little or no market power against the sheer weight of speculative buying and selling in global currency markets (turnover > $6 trillion a day)
Changing interest rates to influence a currency might conflict against other macroeconomic objectives - raising interest rates to support a currency might stifle growth
Motivations for Appreciation and Depreciation of a currency in managed and fixed Exchange Rate countries
Central bank might attempt to bring about a depreciation to:
-Improve the balance of trade or improve the current account by making exports more price competitive
-Reduce the risk of a deflationary recession - a lower currency increases export demand and increases the domestic price level by making imports more expensive
-Rebalance the economy away from consumption towards higher exports and capital investment
Or to bring about an appreciation of the currency:
-To curb demand-pull inflationary pressures
-To reduce the prices of imported capital and technology or essential inputs to enhance long run growth potential
Impact of Exchange Rate Changes
-The Current Account of the Balance of Payments: A depreciation/devaluation will increase the competitiveness of a country’s goods and services by causing a fall in the foreign currency price of its exports and an increase in the domestic price of its imports, likely to improve the CA deficit.
Marshall-Lerner Condition: A depreciation of the domestic currency will improve the trade balance if the sum of price elasticities of demand for exports and imports is greater than 1.
J Curve Effect: In the short term, a depreciation may initially worsen the trade balance before improving it, as it takes time for demand elasticities to adjust.
-Economic Growth and Employment/Unemployment:
A weaker currency following a depreciation/devaluation can boost exports as demand for the country’s goods and services increases, stimulating economic growth and potentially reducing unemployment.
-Rate of Inflation:
A depreciating currency can lead to higher import prices, contributing to inflationary pressures. Also the price of imported raw materials and manufactured goods will increase following a depreciation/devaluation (cost plus inflation). This could have inflationary consequences because firms’ costs would increase and a wage price spiral could ensue. This may affect living standards if wages do not keep up with inflation.
-Foreign Direct Investment (FDI) Flows:
A fall in the value of the £ is likely to lead to increased FDI as foreign firms will be able to spend less in their own currency to purchase UK assets
Although if the exchange rate is continually falling, this might put them off as it shows the economy is volatile/risky.
Decisions to buy businesses often take years to be negotiated so may not be affected by short term changes in the ER.
An appreciation would have the reverse impact
J Curve
The ‘J Curve effect’ shows the possible time lags between a falling currency and an improved trade balance
J Curve explained
-Suggests that in the short run demand for imports/exports tends to be inelastic. This is because it takes time for firms to change to different suppliers and contracts might also be in place. Consumers also take time to adjust to the changes.
-Therefore a devaluation will actually lead to a worsening of the current account position and the Marshall Lerner condition is not met.
-However in the longer run demand tends to adjust more to price changes, and the Marshall-Lerner condition may be satisfied
Marshall-Lerner Condition
-The Marshall-Lerner condition is an economic principle that specifies the circumstances under which a depreciation or devaluation of a country’s currency will improve its trade balance.
-According to this condition, currency depreciation will only improve the trade balance if the combined price elasticity of demand for exports and imports is greater than one, is elastic (ignoring the minus).
-This makes sense, because if your googs are price inelastic, then a price difference does not change demand significantly. Hence, neither will be a devaluation.
e.g. If PED for exports is -0.3
and if PED for imports in -0.5
In this case a devaluation of the currency should worsen the current account (0.3 + 0.5 =0.8)
International competitivenesss
Refers to the ability of a country to sell its goods/services abroad. Involves:
-Price (or cost) competitiveness
-Non-price competitiveness- product quality, innovation, design, reliability, branding and brand loyalty
Can be measured through relative unit labour costs or relative export prices
Factors influencing international competitiveness
-Rate of inflation relative to competitors
-Relative unit labour cost which is heavily dependent on productivity
-Non- wage costs relative to those of competitors
Factors influencing international competitiveness - Rate of Inflation relative to competitors
If increasing, this has effect of higher export prices, reducing AD, reducing international competitiveness, unless product/ services highly inelastic
Factors influencing international competitiveness - Relative unit labour cost
Labour costs per unit of output (total labour costs/ total output) e.g. min wage, productivity, trade unions, supply of labour (availability of skilled labour), demand for labour, automation(can go either way), migration, labour pool, average wage/salaries
If labour costs are higher than other countries, may mean costs of production are higher and therefore prices are higher.
May not have an effect as PED - if inelastic, can pass on extra cost to buyer will little effect on competitiveness.
Factors influencing international competitiveness - Productivity
-Output per worker per unit of time
-If a countrys productivity lags behind others - an increase in unit costs
Lack of capital investment, education levels, workplace culture, skills gaps (education not tailored to gaps) and falling real wages. Cause changes in production.
Factors influencing international competitiveness - Non Wage costs of employment
As well as paying wages, employers may have to pay other costs when they employ workers, increasing unit cost of labour
-healthcare insurance, holiday pay, national insurance, pension, sick pay, maternity pay
-Much higher in some countries than others, can therefore affect international competitiveness
Factors influencing international competitiveness - Regulation and Legislation
-Cost of meeting enviromental regulation
-Enviromental taxes e.g. carbon taxes and waste taxes
-Employment protection laws and health and safety laws
-Competition legislation (likely to improve competitiveness as may reduce monopolies. promote competition)
In order to comply, need to understand the regulation, this involves cost such as labour costs - specialist help
Increased regulation leads to increased costs for firms, usually passed onto consumers in higher prices (or take smaller share of profit) , reducing competitiveness
What are the advantages of international competitiveness?
-Export-led growth: An increase in exports generates an increase in economic activity resulting in economic growth. Higher business profits can lead to further investment from businesses, potentially further benefitting exports etc.
2. Unemployment decreases: Economic growth leads to an increase in employment, income & wage growth
3. Current account surpluses: exports are likely to be greater than imports & the government does not have to concern itself with difficult policy decisions aimed at reducing a large deficit
4. Increased overseas foreign direct investment (FDI): It provides finance for firms to invest in overseas assets which in the long-term means they are able to increase their income & profit
5. Standards of living improve: as incomes tend to rise with economic growth, households gain purchasing power & access to a wider variety of goods/services. Reductions in extreme poverty.
6. Higher tax revenue as incomes and profits increase may be used to improve infrastructure, training and employment further improve IC.
What are the problems of international uncompetitiveness
- The reverse!
- Government policies: with a current account deficit & a lack of international
competitiveness, governments will focus more of their resources on gaining ground ie
spending on supply side policies. Any policy
action creates opportunity- cost & trade offs.
Absolute Poverty
Absolute Poverty: Absolute poverty is a measure of poverty that focuses on a fixed, minimum standard of living necessary for basic survival. Exists when a persons continued daily existence is threatened because they have insufficient resources to meet their basic needs.
It is usually expressed in terms of income or consumption below a certain threshold. It has a specific threshold, often set as the income required to meet basic needs such as food, shelter, and clothing. The threshold is relatively constant.
Low in the UK, but does exist, predominantly seen in developing countries
Relative Poverty
Relative Poverty: Relative poverty, on the other hand, is a measure that considers a person’s income or resources in comparison to the overall standard of living within their society. It is more concerned with inequality and social exclusion (not having sufficeint income to participate in the normal social life of the country).
The threshold for relative poverty varies as it depends on the distribution of income or resources in a particular society. People are considered relatively poor if their income falls significantly below the median or average income in their society.
Most poverty in developed countries tends to be relative, in 2021/22, 11 million people (17%) were in relative poverty in the UK
Measuring Absolute poverty
a. Income-Based Approach: This measures poverty based on income or consumption levels relative to a fixed poverty threshold. Common approaches include:
Poverty Line: A specific income level below which individuals or families are considered to be in absolute poverty, % of people living below line. The world bank has defined an International Poverty Line and currently is set at $1.90 a day. Additional poverty thresholds have been added to show poverty in lower-middle income countries ($3.10 a day) and upper- middle income countries ($5.50 a day).
Basic Needs Approach: Assessing whether individuals can afford essential goods and services such as food, shelter, education, and healthcare.
b. Cost of Basic Needs (CBN): Calculating the cost of a basket of goods and services necessary for basic survival and determining whether individuals can afford it
Measuring relative poverty
a. Percentiles: Relative poverty can be assessed by comparing an individual’s income or wealth to specific percentiles of the income distribution.This concerns inequalities of income and wealth in a country. Living below a certain income threshold e.g. people falling below 60% of median income in the UK are said to be in relative poverty (or being at risk of poverty).
Those households that experience this in the current and at least 2 out of the 3 previous years are said to be in persistent poverty.
b. Income Inequality Indices: These indices, such as the Gini coefficient or the Palma ratio, quantify income distribution and help identify relative poverty. Higher values indicate greater income inequality.
c. Subjective Measures: Surveys and questionnaires can also be used to assess how individuals perceive their economic well-being relative to others in society.
Causes of Changes in Absolute Poverty and Relative Poverty
Economic Factors:
-Economic Growth: Increases in a country’s overall income and GDP can reduce absolute poverty by providing more resources to meet basic needs.
Income Inequality: Rising income inequality can lead to an increase in relative poverty, even in economically prosperous societies.
-Real wages not keeping up with inflation
Social and Demographic Factors:
-Population Growth: Rapid population growth can strain resources and lead to an increase in absolute poverty.
-Age and Gender: Vulnerable groups such as children and women are often more prone to poverty due to factors like limited access to education and employment opportunities.
Government Policies:
-Social Safety Nets: Effective social welfare programs can reduce both absolute and relative poverty by providing support to those in need. Uneployment rate effects, safety nets can reduce effect. Also whether these are index linked (keep up with inflation) like pensions.
-Social housing
-Taxation and Redistribution: Progressive tax systems and income redistribution policies can help mitigate income inequality and reduce relative poverty. Increases can influecne who may fall below 60% median.
-Poor healthcare and education
Global Factors:
-Globalization: Economic globalization can impact poverty levels through changes in trade, investment, and labor markets.
-Foreign Aid: International aid and development programs can contribute to poverty reduction in developing countries.
-High FDI can increase employment and lead to economic growth but depends on quantity and quality of employment- which sector and type of job.
The Income Gap
-Alongside the % falling below the poverty line, it is also important to know how far below
-The income gap measures the distance between household income and the poverty line
Poverty in the UK
Statistics from 2021/22
-1/5 (14mill) people in UK in poverty, highest group was children (1/3) and smallest was pensioners (1/6)
-6 million people in very deep poverty- averaging out at 59% below the poverty line
-Average person in poverty - 29% below the line
-Poverty rate of part-time workers (20%) was double full time workers (10%)
Median Income in 2023 was £34,500
Poverty across the globe
- Around 63% of people older than 15 who live in extreme poverty have no schooling or only some basic education
-Children and youth account for 2/3 of the worlds poor
-Extreme poverty largely concentrated in sub- Saharan Africa - 25% of world population live in fragile contexts, characterised by impoverished conditions and dire circumstances. Expected to grow to over 50% by 2030.
Financial Markets
Financial markets are places where buyers and sellers come together to trade financial assets, such as stocks, bonds, currencies, and derivatives. These markets serve as intermediaries between those who need capital (borrowers) and those who have capital to lend (investors). They facilitate the exchange of financial assets and enable companies, governments, and individuals to raise funds and invest their savings. Stock markets and the bond market are two of financial markets.
Difference between Debt and Equity
Equity Finance - Finance from shareholders through the issue of new shares/stock which carry voting
Debt Finance - Borrowing money - requires paying interest (on loans) and may also need security
Key roles of financial markets
-To Facilitate saving- Financial markets provide somewhere for consumers and firms to store their funds. Savings are rewarded with interest payments from the bank to encourage saving. By pooling the savings of many individuals, financial institutions can allocate these funds to support loans and investments, thereby stimulating economic activity.
-To Lend to Businesses and Individuals - The transfer of funds between agents is aided by financial markets which allows consumption and investment. Banks and Building societies act as financial intermediaries – taking money from one party (savers) to lend to another (borrowers). Asses the creditworthiness of borrowers to determine conditions of loan. This intermediation process facilitates economic growth by directing funds to productive uses, such as funding business expansion or financing home purchases.
-To facilitate the exchange of goods and services - Financial institutions provide a wide range of payment and transaction services that facilitate the exchange of goods and services in the economy. This includes offering checking accounts, electronic fund transfers, debit and credit card services, and online payment systems. By providing a secure and efficient means of transferring funds, financial institutions play a vital role in supporting everyday economic transactions.
-To provide forward markets in for example currencies and commodities - Currencies and commodities are open to speculation. Future or forward markets involve buying/selling a commodity/currency today with an agreed price in the present but a delivery and payment in the future, by locking in future prices, this reduces uncertainty and the risks associated with international trade and commodity markets.
-To provide a market for equities - Financial institutions often serve as intermediaries in the equity market. Equity markets involve the trade of shares of publicly traded companies. It is also called a stock market. Equity markets provide access to capital for firms, and allow investors to own part of a business. Returns on the investment are usually in the form of dividends. A dividend is a share of the firm’s profits. This function supports capital formation and efficient allocation of resources.
Commercial banks
A bank that offers financial services to the general public and to companies.
Central Bank
A public institution that serves the country’s banking system. It is responsible for implementing monetary policy, managing the currency of a country/ies, and controlling the money supply. As well as maintaining financial stability. For example, Bank of England, Federal Reserve, European Central Bank for all member nations of the Euro Area
Currency/Foreign exchange markets (Forex)
The buying and selling of foreign currencies
Commodity markets
Buying and selling of goods taken from the primary market ie raw materials.
Examples of commodities
Crude oil, coal, copper or iron ore, agricultural products such as wheat, coffee beans or cotton.
Bonds
Bonds are issued by governments and corporations when they want to raise money. By buying a bond, you’re giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year.
Stock markets
The buying and selling of shares/stock.
Equity
Finance from selling shares/the value of shares issued by a company
Human Development
Process of improving people’s well-being and quality of life, involving improvements in standards of living, reduction in poverty, improved wealth and education, increased freedom and choice.
Growth vs Development
-Growth refers to an increase in GDP which can contribute to development through jobs, reducing poverty, profits reinvested in tech, tax revenue to spend on health.
-Development- However increase in GDP could be from one sector ie Nigeria Oil not developing everyone’s well being
-However, negative externalities from GDP growth could affect health (decreased standards of living)
-Inequality from growth whcih isnt development
Developing economies characteristics
-Mainly primary sector work
-Low productivity
-Low level of saving/investment
-High population growth
-China (52% manufacturing + farming)
Advanced economies characteristics
-Most work in the tertiary sector
-Education - high levels of literacy
-Longer life expectancy
-Good infrastructure
-UK (79.5 % of GDP service based)
Is GDP a good measure of economic standard of living
FOR
-Correlation with standards of living - increased production, increased wages, increased employment
-Measured frequently and widely, can be used for comparison between countries
-Does act as an indicator of economic productivity
-Singal growth which can correlate with better infrastructure and services
BUT
-The hidden economy - excludes non-market transactions such as voluntary labour and illegal markets, leading to underestimation of output - Hidden economy in UK worth around £200 billion and represents around 10% of our GDP.
-Distribution of wealth - does not consider uneven distribution of wealth and inequalities
-May not be sustainable if scarce resources being used up (Dubai) - environmental cost of growth
-Quality of life considerations - purely quantitative and does not measure qualitative aspects of life, leisure, satisfaction or personal happiness. Work life balance for example
-Ignores living conditions, such as pollution/congestion, doesn’t account for economic inefficiencies.
HDI
Human Development Index developed by the UN to measure and rank countries level of social and economic development:
-health - life expectancy
-education - average and expected years of schooling
-standards of living - GNI per capita
HDI - Health and Literacy
Healthy workers are more likely to be productive. Countries where malaria, aids and other diseases are prominent, affect the workforce and productivity of the whole economy.
Literacy- Literacy rate is the % of the population, aged 15+ who can read and write a short statement on their everyday lives. Strong link between literacy and economic growth.
Is HDI to compare levels of developement
FOR
-Easy to collect and standardise across nations
-Uses an index which can easily track development over time
-Looks at well being which is a growing concern for many countries
BUT
-Long life expectancy doesn’t mean high quality of life ie West has high stress and mental illness
-Average schooling years doesn’t mean schooling is world class, like the UK
-Two countries can have the same HDI index but can be very different still
-Externalities, crime and corruption aren’t mentioned.
Other indicators of development
Human poverty index (HPI) – measures life expectancy, education and ability to meet basic needs
Gender-related development index (GDI) – measures relative inequality between men and women, combines HDI with a consideration for gender
Factors influencing growth and development - economic factors
-Primary product dependency
-Volatility of commodity prices
-Savings gap: Harrod-Domar model
-Foreign currency gap
-Capital flight
-Demographic factors
-Debt
-Access to credit and banking
-Infrastructure
-Education/skills
-Absence of property rights
Factors influencing growth and development - economic factors - Primary Product Dependency
The concept of “Primary Product Dependency” refers to an economic situation in which a country heavily relies on the export of primary products or commodities, such as agricultural goods, minerals, or raw materials, as a significant source of revenue and foreign exchange earnings.
Relying on primary products makes it difficult to encourage development:
-Natural disasters can wipe out production of the primary product and so means that
farmers are left with no income. They are often non-renewable , which means the
country will suffer when they run out of the product.
-They tend to have a low-income elasticity of demand , which means as people get
wealthier, they don’t continue to increase the amount of primary products they buy
whereas they are likely to increase their demand for manufactured goods. The
Prebisch Singer Hypothesis suggests the long run price of primary goods declines
in proportion to manufactured goods, which means those dependent on primary
exports will see a fall in their terms of trade. However, in recent years, there has been
a rise in the prices of some key commodities , such as food (following growth in population) and a fall in prices of
some manufactured goods due to the expansion to places like China.
-Another issue caused by this is the Dutch disease . This is when a country becomes
a significant commodity producer in a short amount of time, causing an increase in
demand for the currency (to enable people to buy the goods) which pushes its value
up. This increases export prices and leads to a reduction in competitiveness of the
economy, causing a fall in output in other areas. This occurred for the non-oil sectors
in Venezuela and Nigeria .
-Some countries have been able to use primary products to develop, for example
Saudi Arabia and oil . It is suggested that countries should use primary product
revenue to invest in manufacturing etc.
-Not all primary products have a low income elasticity of demand, for example
diamonds.
-One example of a country that suffers from this is Ghana . Gold, cocoa and oil
account for 75% of their total exports and they had to ask the IMF for a loan in 2014
due to their unsustainable balance of payments deficit.
Factors influencing growth and development - economic factors - Volatility of Commodity Prices
There is a disincentive to invest in primary products because:
-Small profit margins when exporting as there is little added value (i.e a potato compared to a packet of Walkers Sensations)
-Natural disasters can wipe out work
-Volatility of commodity prices increases the uncertainty of income
-Primary products tend to have inelastic demand and supply curves which means
relatively small changes in demand or supply leads to huge fluctuations in price.
-These large changes in price mean that producers’ income and the country’s
earnings are also rapidly fluctuating, making it difficult to plan and carry out long
term investment as well as meaning that producers can see their income fall very
rapidly, causing poverty.
Factors influencing growth and development - economic factors - Savings Gap: Harrod- Domar model
-The Savings Gap is a concept in economics that relates to the difference between the amount of savings needed to finance a country’s desired level of investment and the actual level of domestic savings available.
-High levels of poverty in developing countries makes it incredibly difficult to save and invest so they borrow with high interest (to fund investments). Also limited access to foreign capital.
-Harrod-Domar model states that economic growth is directly linked to level of savings and the efficiency with which capital can be deployed.
-Increased savings leads to increased investment, higher capital stock, higher economic growth, increased savings…
-Saving rate of Africa is around 17%. Average for middle income countries is around 31%. More expensive for Africa to get funds since they have higher borrowing costs. This slows down capital investment.
-However, there are problems with this model. Economic growth is not the same as
economic development. It is difficult for individuals to save when they have little
income and borrowing from overseas causes problems with debt. It is possible that
investment could be wasted .
Factors influencing growth and development - economic factors - Foreign Currency Gap
-Capital outflows are greater than capital inflows, expenditures on imports exceeds earnings from exports. Imbalance can lead to shortage of currency reserves.
-Due to a dependency on exports of primary products (little added value) and imports of high added value goods (manufactured)
-Also due to borrowing to fund investment rather than using savings
-Prebish-singer hypothesis – long-run decline in TOT for countries that depend on primary product exports. Should use export revenue to diversify to keep X more than M
-As a result, there can be a currency depreciation fueling inflation, a lack of foreign exchange reserves so cant pay for essential imports , reduced FDI, overall macro instability - deficit, unemployment, inflation.
-Can address through export diversification, promoting domestic imports, foreign aid, remittances, FDI (however may be a lack of confidence), Exhcnage rate management.
Factors influencing growth and development - economic factors - Demographic factors/ Education/ Skills
-Countries with fast growing populations usually have a fall in GNI per capita. Higher population growth means the economy has to grow at same rate to maintain living standards. Unlikely in developing countries.
-Increase in number of children puts pressure on education system and less may receive a good education (and work instead). The population of Africa is expected to more than double by 2050, complicating
efforts to reduce hunger.
-Poor education within countries means low skilled workers, so low productivity, Ethiopia 49% literacy. China invested heavily, benefitting in LR.
Factors influencing growth and development - economic factors - Capital Flight/ Absence of Property Rights
-Refers to people moving their savings abroad, prehaps due to a lack of confidence in a country’s stability
-Due to lower tax rates or higher interest rates abroad (less tax rev for UK Govt.)
- If money was placed in banks within the country,
then credit could be created by banks for consumers and businesses to spend.
-Political instability and absence of property rights therefore people less willing to risk their investment > less development
-Property rights are where individuals are allowed to own and decide what happens to
certain resources. A lack of rights mean that individuals and businesses c annot use
the law to protect their assets, leading to reduced investment. They will be
unwilling to buy machinery, build factories or establish brands.The loss of property rights in Zimbabwe led to economic collapse.
Factors influencing growth and development - economic factors - Debt
-During the 1980s, many developing countries took out low interest loans in US dollars from developed countries.
-As interest rates and the US dollar rose in value, countries struggled to pay the increasing debts. Aid they receive from developed
countries, meaning money is flowing from developing to developed countries .
-Took almost 20 years for these countries to resolve their debt problems. This means they have less money to spend on services for their population and
they may need to raise taxes , which limits growth and development.
Borrowing for growth makes sense, just as firms borrow to expand, but the problem
occurs when governments take on too much debt and do not spend it well.
Factors influencing growth and development- economic factors - Access to credit and banking
-The UK and other developed countries have systems for banking and stock markets, we can buy equity, save, invest, borrow, grow investments
-These opportunities don’t exist to the same extent in developing countries or may be harder to access for all.This means those in developing
countries cannot access funds for investment and they struggle to save for the
future .
-Some families may use loan sharks , who give high interest rates and leave
individuals permanently in debt.
Factors influencing growth and development- economic factors - Infrastructure
Well-developed and extensive infrastructure correlates with developed countries. The following areas will support development:
-Motorways/roads
-Railways
-Ports
-Airports
-Broadband
-Gas/electric/water utilities
-Low levels of infrastructure make it hard for businesses to trade and set up within
the country, for example if there are a lack of roads. It makes their services and
production less reliable.
-However, the development of infrastructure can be expensive and tends to conflict
with environmental goals
-India is a good example of country suffering from poor infrastructure. For example,
they saw power blackouts in 2012 and this damages their potential tourism industry.
About half their roads are not paved and they need to invest around $400bn in the
power sector.
Factors influencing growth and development- non-economic factors - Health
-An ageing population can put pressure on health services as this increases number of dependants when they reach old age
-Vaccines and good sanitisation
Factors influencing growth and development- non-economic factors
These can restrict development and usually beyond the influence of economic policy
-War – disruption of trade and loss of human and physical capital
-Geographical – climate and access to coasts can affect ability to grow crops and access trade routes. Fertilisation and building upwards
-Corruption – Economic policy not being applied in the interests of society:
Corrupt govt, bribes to private sector/not enforcing regulation on some, misallocation of resources, Govt. Failure, slow doen development.
-Disease – HIV/Aids/Covid/Ebola affect human capital
Remittances and the savings gap
-Remittances can play a significant role in reducing the savings gap in a developing country. Additional income can be used to cover basic needs which can free up other income for savings and investment increasing financial inclusion, which can reduce a countries reliance on external borrowing, reducing debt burden and allocates more resources to productive investments. While remittances offer significant benefits, it’s important to note that they may also have some drawbacks, such as dependency on external income sources and potential exchange rate risks. Nonetheless, when managed effectively, remittances can help developing countries bridge their savings gap and promote economic development.
Real-World Example: In the Philippines, a significant recipient of remittances, many families use remittance income to invest in small enterprises, such as sari-sari stores (small neighborhood convenience stores) or agricultural projects. These investments contribute to local economic development and job creation.
Real-World Example: In Bangladesh, remittances from overseas workers have played a crucial role in funding development projects. The country has been able to reduce its dependency on foreign loans for infrastructure development due to the inflow of remittances.
Primary product dependency - positive aspects
-Natural Resource Endowment: Countries rich in natural resources often have a comparative advantage in producing primary products, which can lead to export-led growth and income generation.
-Export Earnings: Exports of primary products can generate substantial foreign exchange earnings, which can be used to finance imports of capital goods, technology, and other essential items for economic development.
-Employment: The primary sector, which includes agriculture, forestry, and mining, can provide employment opportunities for a large portion of the population, particularly in developing countries.
-Government Revenue: Taxation and royalties from the extraction and export of primary products can provide governments with significant revenue streams that can be used for public investment and social programs.
Primary product dependency - Negative aspects
-Price Volatility: Primary products often experience price volatility due to factors like weather conditions, global supply and demand fluctuations, and changes in commodity markets. This volatility can expose countries to economic instability.
-Limited Diversification: Overreliance on primary products can hinder economic diversification. A lack of diversification makes an economy vulnerable to external shocks and reduces its ability to adapt to changing market conditions.
-Dutch Disease: A significant inflow of revenue from primary product exports can lead to an appreciation of the country’s exchange rate. This can harm other sectors of the economy by making non-primary exports less competitive, a phenomenon known as the Dutch Disease.
-Environmental Concerns: The extraction and production of primary products can have adverse environmental impacts, including deforestation, soil degradation, and pollution, which can harm the long-term sustainability of an economy.
-Income Inequality: Dependency on primary products can exacerbate income inequality, as the benefits often accrue to a select few, while many in rural areas engaged in primary production may experience low incomes and limited access to social services.
-Vulnerability to External Shocks: Economic downturns in major trading partners or disruptions in global supply chains can significantly affect countries dependent on primary product exports.
Primary product dependency - Strategies to address
-Diversification: Encouraging diversification into manufacturing, services, and high-value-added industries can reduce reliance on primary products.
-Value Addition: Adding value to primary products through processing and manufacturing can increase export earnings and create higher-skilled jobs.
-Investment in Human Capital: Improving education and skills training can help transition the workforce from primary sectors to more diverse, knowledge-based industries.
-Infrastructure Development: -Investing in infrastructure, such as transportation and energy, can facilitate economic diversification and reduce production costs in other sectors.
-Risk Management: Implementing risk management strategies, such as hedging against commodity price fluctuations, can help mitigate the negative effects of price volatility.
-Environmental Sustainability: Implementing sustainable practices in resource extraction and agricultural production can ensure long-term resource availability and reduce environmental degradation.
Potential benefits from rapid population growth
-A young median age and fast natural population growth contributes to an expanding population of working age which can increase long-run aggregate supply (LRAS) causing an outward shift of the PPF.
-Providing per capita incomes are rising, then population growth increases the size of domestic markets - encouraging economies of scale in production and increased capital investment spending by businesses.
-More people in work leads to a widening of the tax base to help improve government finances & public services
Potential drawbacks from rapid population growth
-Many young people entering the labour market creates challenges in providing sufficient jobs in the formal economy to prevent a large increase in youth unemployment.
-Fast-growing population holds back the annual growth of per capita incomes. This makes it harder to satisfy everyone’s basic needs and wants and can lead to rising malnutrition.
-Rapid population growth puts increasing pressure on the natural environment including demand for water and energy and can threaten biodiversity
Market- Orientated Strategies Influencing growth and development
-Trade Liberalisation
-Promotion of FDI
-Removal of government subsidies
-Floating exchange rate systems
-Microfinance schemes
-Privatisation
Market- Orientated Strategies Influencing growth and development - Trade liberalisation
-Opening up an economy to the free market- aiming for export-led growth
-Creates opportunity to exploit a country’s comparative advantage
-Firms encouraged to invest and innovate, increase efficiency and compete…only then will they survive in the LR
Market- Orientated Strategies Influencing growth and development - Promotion of FDI
-FDI is investment by one private sector company in one country into another
private sector company in another . It includes direct acquisition of a foreign firm, construction of a facility, investment in a joint venture with a local firm or licensing of
intellectual property.
-Creates employment leading to multiplier effect and helps promote long-term sustainable growth.
-It provides LEDCs with funds to invest, helping to overcome the savings gap.
-Transfer of knowledge helping to improve labour productivity.
-However, they often send back their profits and exploit workers with low wages and offering poor conditions. The country may suffer from negative externalities. Such as environmental damage and exploitation.
-Although it is different from a loan because if the investment fails, it is the company who has to deal with it and the country does not owe money to foreigners.
-However, country will also lose some sovereignty and become dependent on another firm. Local competition may find it hard to set up and compete and the best jobs often go to imported labour, leaving only low skilled jobs for locals.
- India has benefited greatly from FDI. The Make In India initiative liberalised FDI policy and led to a 48% increase in FDI in a range of sectors, including
pharmaceuticals, manufacturing and railways.
Market- Orientated Strategies Influencing growth and development - Removal of govt. subsidies
-Subsidies can support domestic industries (infant industires) and reduce absolute poverty
-However, artificially low equilibrium prices encourage inefficiency. Could be ineffective if lead to inefficiency.
-Subsidies have a big opportunity cost for governments, and may lead to high debt, consider a LIC with high costs of borrowing.
It’s unpopular to do this, so when does the government stop subsidising? Perhaps when market prices are falling themselves so less noticable to people.
Market- Orientated Strategies Influencing growth and development - Floating exchange rate systems
-The value of the exchange rate in a floating system is determined by the forces of supply and demand.
-The government does not have to worry about keeping enough currency reserves.
-Although, the currency will be volatile and this will make it difficult for importers and exporters to make future decisions, potentially affecting economic growth
Market- Orientated Strategies Influencing growth and development - Microfinance schemes
-Small scale loans to entrepreneurs. Allows them to break away from aid.
-Don’t have access to banking
-Developing countries have weak financial sectors, so improving banking can support businesses and plug the savings gap
Take little collateral and use group lending, pre-loan saving requirements and a guaranteed access to future loans in present ones repaid fully and promtly.
The scheme tends to target groups who would be less likely to otherwise receive
loans, for example women.
However, South Africa has shown the problems that can occur with this system. It has become a method of financing consumption spending and unemployment means that most people do not have the funds necessary to ensure repayment of their loan, meaning they have to sell off family assets, borrow from friends and family or simply take out new loans to repay the old ones
Market- Orientated Strategies Influencing growth and development - Privatisation
-Assets are sold from the public sector to the private sector.
-The private sector gives firms incentives to operate efficiently, which increases economic welfare.
-This is because firms operating on the free market have a profit incentive, as opposed to nationalised govt. run firms
-Increases allocative efficiency
-Selling off a firm, particularly if it is loss making, will improve government finances and reduce levels of debt.
-However, if the firm is privatised as a monopoly there will be no competition within the market.
Interventionist Strategies Influencing growth and development
-Development of human capital
-Protectionism
-Manage exchange rates
-Infrastructure development
-Promotion of joint ventures with MNCs
-Buffer stock schemes
Interventionist Strategies Influencing growth and development - Development of human capital
-Businesses struggle to expand where there are skills shortages + limits innovation
-Developing human capital (through schools or vocational training) allows a country to move from primary product dependency, to manufactured goods and to services (which have more added value)
-However, costs a lot and takes time
Interventionist Strategies Influencing growth and development - Protectionism
-Imposing tariffs and quotas can help protect businesses that are struggling to compete
-This will create jobs in the short run and will allow the industry to develop, perhaps to the extent where the barriers can be removed , and the industry can compete globally.
-However, is this a sustainable approach, will the protected businesses become complacent and inefficient
+ Reduce a trade deficit
-Loss of consumer surplus
-Risk of retaliation
-Regressive (affects low and fixed incomes the most)
-Countries lose out from the benefits of specialisation and comparative advantage
-X-inefficiencies
Interventionist Strategies Influencing growth and development - managed exchange rates
-This is when the exchange rate floats on the market, but the central bank of the country buys and sells currencies to try and influence their exchange rate.
-They can introduce high exchange rates for the import of essential products and lower exchange rates for others. There could be an even lower one for exports. A high exchange rate for essential products will mean that the price within the country is low, which helps to reduce poverty if the goods are consumer goods and encourages investment if they are capital goods. A lower exchange rate for other imports will mean that the price of these goods within the country is higher, discouraging their import and encouraging consumers to buy from domestic producers.
-More stability than a floating system and requires less intervention
Interventionist Strategies Influencing growth and development - Infrastructure development
-Private sector will only invest in infrastructure (transport, energy, water) if it is profitable to them (which is it usually isn’t) and these are under provided in a free market system, free rider plus high costs etc.
-Economic and social benefits with improved infrastructure so govt will fund this
-Huge opportunity cost, particularly a probelm is LIC, funding debt, may be more expensive. May not have funds
Interventionist Strategies Influencing growth and development - Promotion of joint ventures with MNCs
-Lead to capital inflows, creating jobs and increasing output
-Increased profits generated in country, could be used for investment
-Transfer of knowledge
Interventionist Strategies Influencing growth and development - Buffer stock schemes
-Developing countries rely on primary products which we know have volatile prices
-So the government will keep extra stocks reserved to set a maximum and minimum price
-E.g. In periods of excess supply (bumper harvest) govt. will buy up the extra stock and stock pile it
-When there is a shortage, govt. will release the stock, increase supply to maintain stable prices
-it stabilises prices and thus encourages investment since producers can plan for the long term. It also prevents sharp falls in prices, meaning that producers are kept from falling into absolute poverty, and prevents sharp rises in prices, meaning that consumers are able to afford the good. It can solve some of the issues relating to primary product dependency
-However, costly to buy up the stock and to store it as well (perishable)
-Causes inefficiency as suppliers will produce as much as they want as they know the govt. will come along and buy it
-The Ivory Coast and Ghana implemented a buffer stock scheme for cocoa in 2017 due to low prices
Other Strategies Influencing growth and development - Industrialisation
The Lewis model assumed that developing countries had dual economies with a traditional agricultural sector, which had low wages, low productivity, underemployment and low savings, and a modern industrial sector, with high levels of investment and urbanisation.
-Most labour is deployed on the land in agriculture in developing countries
-Lewis argues there is excess supply of labour here and that the same output can be produced with less workers
-Therefore there is no opportunity cost for these workers to leave and work in manufacturing (higher added value)
-Those who moved to the urban areas would have higher incomes and thus more savings for investment
-However, transferring labour to manufacturing would require training and education
-Some industries can be capital intensive and not create many jobs
-There is no excess labour in peak periods i.e summer
-Migration has led to urban poverty replacing rural poverty as the industrial
sector is unable to provide jobs for all those who have moved. Improvements in technology will lead to a reduced demand for labour
Other Strategies Influencing growth and development - Development of primary industries
-Invest further in the industry to strengthen comparative advantage
-Use income generated from primary products to diversify into markets where added value is higher.
-i.e Chile started exporting more than 2,800 different products to more than 120 countries
-However, primary products are volatile and primary product dependency causes many issues. Primary industries also suffer from corruption.
Other Strategies Influencing growth and development - Development of tourism
-Use income generated from primary products to diversify into markets where added value is higher.
i.e Dubai – 50 years from a desert to what it is now…
-The income elastic nature of tourism means that as the global economy grows, demand for the industry will increase even further, allowing the developing country to continue development. However, it also means that they will suffer in times of
recession
-Tourists represent a source of foreign currency , which will fill the currency gap. so countries will be able to fund their imports without negative consequences. However,
holidaymakers’ demands for products from their home countries mean that the tourism industry is associated with an increase in imports and so may not help the foreign currency gap at all
-Countries are likely to attract investment from transnational hotel companies, who will also bring knowledge with them. It can help to fund improvements in infrastructure , as tourism requires reliable electricity, airports, clean water etc. and so the government have an incentive to provide this. This investment will have a multiplier effect through the economy.
- Jobs are created locally since the tourism industry relies on low skilled workers who know the local area, rather than to high skilled workers which may be sourced from abroad. It is very labour intensive.
-The government will see higher tax revenues due to higher income and higher profits. It can provide funds to allow countries to diversify.
But seasonal and involve low skilled and low paying jobs, may have negative impact on environment and culture.
Other Strategies Influencing growth and development- aid and debt relief
-Reduces absolute poverty, fill savings gap, foreign exchange gap and creates a multiplier effect (contributing to increased globalisation and trade)
-Debt relief involves cancelling a countries debt
-A lot of debt in 1970s due to persistent current account deficits
-Many countries suffer from high-interest repayments to loans, limiting growth. By cancelling it will allow more money spent on the provision of services and infrastructure to aid development.
-However, this could lead to a dependency culture and expectation of cancelled debts, creating moral hazard
-Corrupt governments could use this in appropriately or the donor trying to secure favours in the future
Other Strategies Influencing growth and development- International organisations and NGOs
-The world bank- Set up in 1944 to promote economic development and reduce poverty.
Provide low interest loans
Interest free credit and grants for developing countries. Also funded 12,000 development projects since 1947 through interest-free loans and grants
-International Monetary Fund (IMF)- Set up in 1945 to ensure stability of the international monetary systems.
Each country has a quota on the amount of financial resources they have to make available to the IMF.
These resources are then provided to offer loans to poor countries to fight poverty.
-When providing loans, the IMF insists that countries make macroeconomic reforms to resolve the problems. The IMF has received criticism for this because it causes
problems for countries. Usually, it involves reducing imports and increasing exports which reduces the amount of resources available for domestic consumption. It can also be in the form of lower government spending
-However, countries are not forced to turn to the IMF for help but many do because the alternative is defaulting on their loans , which would cause even more
problems than the reforms do. The reforms intend to help countries to overcome issues and should allow a country to develop in the long term; they are not meant to be a punishment.
-World Trade organisation - Promotes liberalisation of trade and fair trade. Supports governments in negotiating trade deals and removing trade barriers
Also acts as arbitrator in issues of dispute in court
-NGOs- Private organisations and charities that support objectives such as reducing poverty, protect the environment, sustainable economic growth e.g.
Water aid
Cancer research UK
The prince’s trust.
Can provide direct assistance but work alone can never solve problem, needs government intervention.
Other Strategies Influencing growth and development- Fair Trade schemes
-A fair price typically means that agreements are made to buy a guaranteed amount of produce over a period of time at a price which is above the market price when the agreement was made. This gives producers stability and raises their income .
-The system means that child labour is not used and that production is sustainable and does not occur at the expense of environmental degradation. It also enables increased savings and provides financial support.
-It is argued that the system has an insignificant impact on the developing world. It benefits the Fairtrade producers but can leave others worse off since non-Fairtrade producers see a fall in demand. In the long term, the higher price for Fairtrade goods will increase supply and thus this could bring price back down, but this will depend on the price elasticity of supply.
-Another issue is that higher incomes reduces the incentive to diversify and keeps farmers engaged in low profit activities. On the other hand, it can be argued that it allows parents to send their children to school (whether because it provides the funds necessary or means children are no longer expected to stay at home to work the land) and this will allow them to gain skills which in the future will allow them to move away from agriculture.
Market Failure in the Financial sector - Speculative bubbles
A bubble exists when the market price of a financial asset is driven above what it should be.
Almost all trading in financial markets is speculative and this leads to the creation of market
bubbles , where the price of a particular assets rises massively and then falls. They tend to occur because investors see the price of an asset is rising and so decide to purchase this asset as they believe the price will continue to rise and will profit them in the future. This leads to prices becoming excessively high and eventually enough investors decide that the price will fall, so they sell their assets and panic sets in, causing mass selling. This is known as herding behaviour, which amplifies speculation. Moreover, the financial market has also caused market bubbles in the housing market by lending too much in mortgages and increasing demand for houses. When this bubble bursts, for example due to a rise in real interest rates, there is a fall in demand for houses and a negative wealth effect, reducing AD, and banks are left with loans that will not be repaid in full. Other bubbles included the dot com bubble in the 1990s and the Wall Street Crash in 1929.
Stages of a financial bubble
-Displacement stage- excitement grows about a new product
-Prices boom as demand surges and limited (inelastic) supply causing market prices to spike higher
-Euphoria as more investors look to take advantage of (irrational exuberance)
-Profit taking stage- some investors sell as they realise prices are out of line with fundementals
-Panic - this herd mentality switches to desperate selling and prices fall fast inflicting big losses.
Market Failure in the Financial sector - Market rigging
Form on anti-competitive behaviour. This is where a group of individuals or institutions collude to fix prices or exchange information that will lead to gains for themselves at the expense of other participants in the market. This could involve fixing a price such as the rigging of interest rates in the Libor scandal of 2008, financial institutions were accused of fixing the London Interbank Lending Rate (LIBOR), one of the most important rates in the world. Monopoly power is usually assumed to damage consumer and social welfare.
Market Failure in the Financial sector - Asymmetric information
-When there is an imbalance of information between agents.
-One problem with the financial sector is that financial institutions often have more knowledge compared to their customers , both consumers and other institutions. This means they can sell them products that they do not need, are cheaper elsewhere or are riskier than the buyer realises. The Global Financial Crisis was partially caused by banks selling packages of prime and subprime mortgages, but advertising them as all prime mortgages . Those buying these packages suffered from asymmetric information and it is unlikely they would have bought them if they knew the risk involved. Additionally, there can be asymmetric information between financial institutions and regulators . The institutions have little incentive to help regulators understand their business and this causes difficulties for the regulators so may allow institutions to undertake harmful activities.
-A borrower also has better information about whether they can afford to repay a loan than the lender, however increase in access to credit ratings etc has reduced this information gap.
Market Failure in the Financial sector - Moral Hazard
Exists in a market when an individual or organisation takes greater risks than they should do because they know that they are either covered by insurance, or that the government will protect them for any damage incurred as a result of the risks. ‘Banks too big to fail’ 2008 crash.
Firstly, it will occur where individual workers take adverse risk in order to increase their salary . Any problems they cause will be the problem of the company and not the problem of the individual, the worst that can happen is to lose their job whilst the company may lose millions of pounds. The Global Financial Crisis was caused by moral hazard, when employees sold mortgages to those who would not be unable to pay them back. By selling more mortgages,
they would see higher salaries and bonuses but would not see the negative effects if the loan was not repaid. On top of this, financial institutions may take excessive risk because they know the central bank is the lender of last resort and so will not allow them to fail because of the impact it would have on the economy.
Market Failure in the Financial sector - Externailites
There are a number of costs placed on firms, individuals and the government that the financial market does not pay . One example of this is the cost to the taxpayer of bailing out the banks after the 2007-8 financial crisis. Even higher than this, was the long-term cost to the economy of the crisis due to its effects on demand and growth. Moral hazard also shows some external costs.
Public expenditure
-Refers to government spending on behalf of a country citizens
Types of public expenditure:
-Capital expenditure - LT investment, ie HS2, new hospitals, new airport runway
-Current - day to day expenditure on goods and services ie medicines for NHS
-Transfer payments - payments to individuals without an exchange of goods or services, i.e child benefits, JSA
Impact on the economy of changes in public expenditure (as a % of GDP)
-Productivity and growth - Spending on infrastructure such as roads, healthcare and education leads to improved supply side performance of an economy. However, free market economists believe that reducing public expenditure will lead to spending in the private sector, leading to increased productivity and efficiency
-Living standards - With no public expenditure, there would be market failure. Absolute poverty would exist more than it does as some individuals who can’t earn an income won’t be able to survive. Unless they receive favours
-Crowding out - Refers to lower private sector investment spending due to public expenditure. Governments might have to fund its spending by borrowing through issuing bonds. This leaves fewer funds in the private sector for firms to use, since the government is borrowing money, which crowds them out of the market. Also, interest rates on bonds may be increased to attract investors. Discouraging spending and investment in the private sector further. Also, if higher G spending funded by tax, then less consumption and investment so less private sector spending
-Level of taxation- If public expenditure is high, then levels of taxation would be high too to fund this (unless huge levels of borrowing). Free market economists prefer low levels of expenditure to allow free enterprise to grow and make an economy more productive
-Equality - Spending on education can help to create equal opportunities for all i.e closing the gap for disadvantages pupils (progress 8)
Reasons for changes over time in the level of public expenditure
-The economic cycle- during slow economic growth or a recession, there may be increased spending on welfare (in a developed country). During growth, the government tends to spend a higher percentage of GDP. This is because they have larger tax revenue, due to higher incomes and wealth and efficiency in collection. Tax payers may also demand more spending as they are paying more in tax
-Changing in age distribution- There is greater pressure on the health systems in developed countries where life expectancy is relatively longer. This also increases pension bills. Ageing population such as Japan, whose BR is falling. Population due to shrink 1/3 in 50 years, only 2% of babies born outside marriages compared to over 40% in UK.
-Changing expectations - Improvements in technology increase our expectations on for example, how it’s used in health and education and other areas
-Financial crisis/war - Government may have to spend on bailing out banks (like during the 2008 financial crisis) and increase welfare spending for many that lost jobs. Followed by a period of austerity in order to bring about a balanced budget. After the war, people saw spending as necessary, so there had been a general increase in spending (about 60% of GDP)
-Economic Philosophy - USA is a market orientated country, so they rely less on public expenditure to provide services such as healthcare – they buy health insurance
Public Sector current reciepts
In 2024-25, we expect the public sector’s income to amount to £1,148.7 billion. Taxes 89% of total.
-Approx, £480bn income tax (Income tax: £277 billion, NIC: £179 billion), £170bn VAT
Discretionary Fiscal Policy
A deliberate manipulation of govt expenditure and taxes to influence the economy, expansionary and deflationary policies
Automatic FIscal Policy
Automatic stabilisers, reduce the impact of changes in the economy on national income; government spending and taxation are automatic stablisers. In a recession, benefits increase as more people are unemployed and so the benefits are a stabiliser as it means that the overall fall in AD is reduced, preventing too much change in the economy. On the other hand, during a boom, tax increases as people have more jobs and higher incomes, and this tax reduces disposable income so decreases consumption and AD, meaning that demand doesn’t grow too high.
● These automatic stabilisers cannot prevent fluctuations; they simply reduce the size of these problem and there can be negative aspects to these stabilisers. Benefits may act as a disincentive to work and lead to higher unemployment whilst high levels of tax can decrease the incentive to work hard.
Fiscal deficit vs national debt
The national debt is the sum of all government debts built up over many years whilst
a fiscal deficit is when the government spends more than it receives that year.
Cyclical vs structural deficit
Cyclical deficit occurs during a downturn as tax revenues would be falling and welfare payments will be increasing. Not as serious, as this type of deficit should disappear when the economy has an upturn.
Structural deficit is a deficit regardless of of where in the economic cycle an economy currently is therefore regarded as more serious problem than cyclical deficit
Factors affecting size of fiscal deficit
-Economic cycle- during periods of recession, fiscal deficits usually increase (cyclical) due to less tax revenues collected and increased welfare payments. VAT collected will be less due to less spending. Opposite during a boom- tend to have smaller deficits or even surplus
-Political priorities and unplanned events- unforeseen circumstances ie the financial crisis of 2008- the govt had to spend billions to bail out banks. The impact of coronavirus in 2020-21 - spending on furlough, vaccine research etc
-Privatisation- provides a one off payment, which could improve budget deficit
-Government policy- if a govt inclined towards policies that require high levels of borrowing, this will lead to increase national debt. But may not be a bad thing as if for example, borrowing is being spent on HS2/ Crossrail, which in the LR will boost productive potential of the economy. Although, if borrowing is used for current spending such as higher wages for public sector workers then it might be easier to argue that this spending is not a good choice.
Factors that influence size of national debt
-Interest rates- An increase in government borrowing may lead to rise in i/r, as demand for money increases relative to supply. The price of this borrowed money (the interest). So this would lead to increased interest rates so reduced AD. Remember there are lots of i/r , the central bank only sets the base rate
-Inflation rates - if the government needs money because tax receipts dont cover expenditure they can either borrow money or print money. If print- lead to increased AD, growth with higher inflation. If borrow- this means govt spending more as % of GDP and the private sector spends less. Therefore no increase in AD and little impact on inflation
-Debt servicing - as debt increases, do does the interest that needs to be paid on it- this comes out of the fiscal spend each year (current spending). Higher debt= higher interest payments= hgiher fiscal deficit. Stay away from debt as much as possible
-Intergenerational equity - ‘Govt borrowing today has ti be paid back tomorrow’. The ‘paybackers’ will be future generations, people who arent even born yet. However if this debt is to finance e.g. HS2/ Crossrail and incestments then are likely to benefit future generations then it might be sufficient. Although a country with higher debt is not attractive to MNCs so may redice FDI
-Credit Rating- Private investment companies give countries a credit score. The best rating is AAA and the worse is D. Credit ratings then affect the level of interest at which the govt can borrow. Size of debt is a big factor but financial history can also affect credit score e.g. USA and UK have never defaulted
Base Rate
(in the UK) the interest rate set by the Bank of England for lending to other banks is used as the benchmark for interest rates generally.
Key Roles of the Central Bank
-Implementation of Monetary Policy - Central banks have the primary responsibility for formulating and implementing monetary policy, which involves managing the money supply and interest rates to achieve specific economic objectives, such as price stability and economic growth.
-Banker to the banks- lender of last resort - if banks run into liquidity problems they may be able to borrow directly from the central bank. This ensures a stable and resilient financial system.
-Banker to the government ie handling the accounts of government departments and helping with debt issuance and management
-Regulating the banking industry through the Prudential Regulation Authority- ie setting the amount of reserves a bank has to hold. Prudential supervision involves assessing and ensuring the financial soundness of these institutions to prevent financial instability which ensures safe and secure banking. After the financial crash regulations changed to ensure more robust checks and measures were put in place.
-Issuing secure bank notes, supervising payment services (eg Visa) and running core systems that allow people, businesses and banks to make large transactions (eg CHAPS)
The Lender of Last Last Resort Function
Lender of last resort is a role central banks play in times of financial distress. When other financial institutions are unable to provide loans, the central bank steps in to lend money to banks and other financial institutions. This prevents liquidity crises and helps to maintain financial stability.
-Emergency lending: Central banks provide emergency loans to financial institutions in times of crisis to prevent their collapse and limit systemic risk.
-Discount window: They also provide short-term loans to banks at a slightly higher interest rate than the market rate. This is known as the discount window.
-Collateral requirements: Central banks require collateral from financial institutions as a condition for lending. This helps to mitigate the risk of default.
-Reputation: Central banks are known as the lender of last resort due to their ability to provide loans in times of crisis, which can help to prevent financial panics.
-2007, Bank of England lent to Nothern Rock when it faced a run on deposits
-In 2008, during the global financial crisis, the U.S. Federal Reserve (Fed) acted as the lender of last resort to several financial institutions, including Bear Stearns, Fannie Mae, and Freddie Mac.
Central Bank as Banker to the government
Central banks have several important roles as the “banker to the government”:
-Issuing government bonds: Central banks can issue and sell government bonds on behalf of the government to finance its budget and borrow money.
-Managing government debt: Central banks can help governments manage their debt by buying and selling government bonds in the market, helping to stabilize prices and maintain liquidity.
-Providing advice: Central banks often provide economic and financial advice to governments, helping them to make informed decisions about fiscal policy and other issues.
Basically, central banks act as the government’s financial advisors, lenders, and money managers all rolled into one!
The Prudential Regulation Authority (PRA)
-Prudential Supervision: The PRA is responsible for prudential supervision of banks, building societies, credit unions, insurers, and designated investment firms. Prudential supervision involves assessing and ensuring the financial soundness of these institutions to prevent financial instability.
-Setting and Enforcing Prudential Standards: The PRA establishes prudential standards and requirements that financial institutions must adhere to. These standards encompass capital adequacy, liquidity, risk management, governance, and other aspects of an institution’s financial stability. The PRA enforces these standards to ensure that financial firms maintain appropriate levels of financial resources to withstand economic and financial shocks.
Use of Macroeconomic policies in a global context - reduce fiscal deficits and national debts
To decrease the national debt, the UK government has been using a policy of austerity since 2010, where they attempt to decrease spending. It would also be possible to increase taxes . Both of these are unpopular, could limit growth, and reduce living standards and income equality. Free market economists say that spending can be reduced by cutting out waste, but it is highly unlikely that these efficiency savings will make a significant difference. Sweden used spending cuts and tax increases to balance their budget in the 1990s. ● On the other hand, opposition parties offer an alternative in the form of demand stimulus by high spending , which will cause economic growth and therefore bring about higher tax revenues. This will allow for budget surpluses and eventually a reduction of national debt.
● Another approach is to simply rely on automatic stabilisers to allow the economy to grow so national debt/fiscal deficit will reduce as a percentage of GDP. This is mainly the approach that the US took after the Global Financial Crisis and their economy recovered fairly quickly. By 2015, the fiscal deficit as a percentage of GDP was similar in the US and UK.
● One way to reduce national debt would be for the government to default on their loans but the economic cost of this is so large that governments only default if it is the only option. Russia and Argentina have defaulted on their debts in the past.
Use of Macroeconomic policies in a global context - reduce poverty and inequality
-Free market forces unlikely to create an equal society, leading to abolsute or relative poverty. Some redistribution from rich to poor needed, Those on the right argue that high incomes and profits are essential to provide an incentive, whilst those on the left argue that those on low incomes need to be supported.
-A progressive tax system could be used, improving distribution of income. Inheritance tax can reduce inequality as reduces money being passed on however can be avoided through careful tax planning. Laffer curve shows disincentive effects of increasing tax also.
-Government spending in form of benefits and transfer payments, 30% of govt expenditure. Could reduce incentive to work, especially if not much of a difference.
-Reduce wage differentials- national min wage will improve incomes of the poor whilst max wage or pay ratios will reduce incomes of rich. However min can cause unemployment and max, brain drain. Benefits such as sickness benefits and medical care, effectively increase wages also. TUC friendly legislation could allow wages for workers to rise, improving equality.
-Improvements in education and training opportunities will prevent poorer children setbacks and increase earning potential, but in LIC could cause brain drain as leave for HIC where higher incomes.
-Price controls on essentail goods such as housing, electricity will increase spending power of the poor but could also lead to market failure.
-Free market economists use concept of trickle down, arguing that increasing incomes of rich will lead to increase in the incomes of the poor, increased spending by the rich creates jobs. Also believe that inequality necessary to encourage hard work and provide an incentive.
-Law of diminishing marginal utility suggests that redistribution increases total utility, higher spending of an individual the less satisfaction they gain from spending an extra pound. £10 a week to a poorer family increases satisfaction more than to a rich family.
Use of Macroeconomic policies in a global context - Changes in interest rate and supply of money
-May do for domestic reasons, such as to control inflation, or due to global issues such as low E/R or change in world commodity prices.
- A fall inthe bank rate is likely to increase the supply of money because it will mean there is more demand for loans.
● There is no simple relationship between the supply of money and inflation and it can be argued that central banks don’t have complete control over the money supply because they cannot control the ability of the financial system to create credit. The globalisation of the financial market has also made it increasingly harder to control domestic money supply.
● The consensus is that central banks should allow inflation caused by supply side shocks but manage demand side inflation .
● Following the financial crisis of 2007-08, some central banks were concerned with deflation rather than inflation and this led to the policy of quantitative easing. For example, the Bank of England and the European Central Bank used this policy. This is because interest rates were so low they could not be reduced much further (0.5%)
Use of Macroeconomic policies in a global context - International competitiveness
● The government can improve competitiveness by taking action to increase any of the factors which affect competitiveness.
● Supply side measures will improve productivity and flexibility and can involve taxes and deregulation. They can encourage competition, forcing firms to be efficient and thus competitive within the global market. They can place an emphasis on quality of products and use tax incentives to encourage incentives. Education will improve the skills of the workforce and help improve flexibility. The UK government has established the ‘Red Tape Challenge’, which aims to simplify regulation for businesses.
● Exchange rate policies may be used, and they may control inflation and macroeconomic stability. For example, China devalues their currency in order to reduce export prices .
● They can join the WTO or sign trade agreements .
Use of Macroeconomic policies in a global context - External Shocks
Due to globalisation, the world’s economies are increasingly interdependent . Macroeconomic policies can be used to combat the effects of negative shocks to the economy. One example could be a commodity price shock , for example where oil prices greatly increase. The government could use expansionary policy to reduce the impact of a fall in GDP or they could use deflationary policy to reduce the impact on inflation. Another example may be a financial crisis , where the government can use expansionary policy to increase AD. It is estimated that shocks in the global economy accounted for about 2/3 of weakness in the UK output after the financial crisis, due to the impact on trade.
Following Brexit, interest rates were lowered to improve confidence but then raised to deal with inflation caused by the falling value of the pound. The chancellor has set aside around £3bn to deal with the effects of Brexit and around £35bn will be spent in order to leave the EU.Changes in exchange rates can cause inflation within the country or could cause a fall in growth and a poor balance of payments, both of which the government can attempt to solve through various methods. Political instability in the UK or in other countries is likely to impact the economy, and will mean the government needs to take action.
Use of Macroeconomic policies in a global context - Transnational companies
● TNCS can bring huge gains to an economy through their creation of jobs, the tax revenue they raise, the knowledge they bring and the investment they undertake.
● However, they can have a negative economic and social impact by destroying local culture, affecting the environment and withdrawing more in profits than they inject through investment. They also have a history of influencing politicians to take decisions that will favour their interests and are involved in tax avoidance.
● In the EU and the USA, it is illegal for TNCs operating in their country to use bribery or corrupt practices anywhere in the world and they can be fined for doing so.
● Some developing countries don’t allow TNCs to set up in their country without first setting up a joint company with a local partner , meaning that some profits are retained within the country and knowledge/technology is transferred. Many governments use import contracts with TNCs, meaning that at least some part of the value of the order must be manufactured in the country.
Use of Macroeconomic policies in a global context - Regulation of transfer pricing
●Transfer pricing is one way for firms to engage in tax avoidance . This can occur if a firm produces a good in one country an then transfers it to another to make it into another good which it then sells.
● If taxes are higher in the first country than the second country, they can set a low price on the product made in the first country. The overall aim is to increase their profit made in the low tax country and decrease it in the high tax country and so overall reduce their tax bill .
● In the UK, companies which don’t allocate sufficient profits here are challenged by HMRC and this has led to billions of pounds earnt in taxes .
● The Transfer Pricing Guidelines were introduced by the OECD in 1995 , providing guidelines on cross-border services, intangibles, cost contribution arrangements and advance pricing guidelines; these were modified in 2010. They aim for the price to be the same as if the two parties were independent of each other; the ‘arm’s length’ principle.
Use of Macroeconomic policies in a global context - Ability to control global companies
● It is difficult for individual governments to control TNCs . Small countries may earn less in revenue than a TNC earns in profits. Highly educated, successful executives are able to use a vast number of resources to find a solution which will benefit them.
● The EU suffers from legal tax avoidance schemes, such as the ‘Dutch sandwich’ and the ‘double Irish’ , where costs, revenues and profits are routed through Ireland, the Netherlands or Luxemburg and then sent to a tax haven like the Bahamas or the Cayman Islands. It is suggested that for every £1 gained in extra taxes by Luxemburg, other countries are collectively losing possibly £1000 in tax revenues.
● Solutions to taxation are extremely difficult as they require worldwide agreement. However, any solution which would benefit a country like the UK would lead to great losses for countries like the Bahamas, Ireland and Luxembourg . There is also division within countries , for example in the USA between the Democrats and Republicans. This division allows TNCs are able to prevent any agreement they do not like through immense lobbying. Any solutions are also time consuming and costly.
Use of Macroeconomic policies in a global context - Problems facing policy makers
● Inaccurate information: Short term information, such as GDP figures for the previous month, are often inaccurate and so may mean that the government is unable to see if there are problems within the economy. Trying to cut down on tax evasion and avoidance is difficult as the government does not have the full picture on the level of avoidance, who it is that is avoiding the tax and the best way to reduce it. The Bank of England makes its decisions based on past data but it is possible trends in the economy may be changing so past data gives an inaccurate picture of where the economy is currently heading. With interest rates so low for such a long period, past data is unlikely to give an accurate representation of the current economic climate which makes it difficult for the Bank to know which action to take. Full cost-benefit analyses can be time consuming and costly and it is impractical for the government to gain every single bit of information they need.
● Risks and uncertainties: The government cannot accurately predict the future and so it is difficult for them to know whether extra spending is necessary etc. They can’t know the full impact of their decisions as consumers often react unexpectedly and this could undermine government policy. Managing risk is an essential part of good decision making.
● External shocks: The government is unable to control and prepare for these external shocks; the best they can hope to do is lessen their impact. Since every situation is different, it may be difficult to know the best method to solve the problem. Policies employed by policy makers may not have their intended impacts and it may undermine current policies in place, for example Brexit has delayed government plans to balance the budget.
Wealth inequality
-Wealth refers to the total value of assets owned by an individual or household, including real estate, investments, savings, and possessions.
-Wealth inequality measures the unequal distribution of these assets among individuals or households.
-It reflects disparities in accumulated financial resources and net worth.
-Wealth is likely to be more unequal distributed than income because assets that make up wealth can be accumulated over time. People who are wealthy now can generate an income from those assets and as long as income exceeds expenditure, they are able to build up a stock of assets. This accumulation of wealth can occur over successive generations through inheritance
Income Inequality
-Income represents the flow of money received by individuals or households over a specific period, usually annually.
-Income inequality measures the uneven distribution of income among individuals or households.
-It reflects disparities in earnings from wages, salaries, investments, and government transfers.
Measurements of Income Inequality
The Lorenz Curve:
-The Lorenz curve is a graphical representation of income distribution in a population.
-It plots the cumulative percentage of income received by the lowest to the highest earners.
-A perfectly equal distribution forms a 45-degree line (line of equality).
-The greater the deviation of the Lorenz curve from the line of equality, the higher the income inequality.
The Gini Coefficient:
-The Gini coefficient is a numerical index that quantifies income inequality.
-It ranges from 0 (perfect equality) to 1 (perfect inequality).
-A higher Gini coefficient indicates greater income inequality.
-It is calculated using the area between the Lorenz curve and the line of equality.
Causes of Income and wealth inequality within and between countries
Within-Country Factors:
-Education: Disparities in access to quality education can lead to differences in skills and income.
-Labour Market: Wage differentials based on skills, experience, and demand for certain jobs contribute to income inequality.
-Wealth Accumulation: Those with access to investment opportunities and assets accumulate more wealth over time. Those on higher incomes will be able to biuld up stock of assets as have more disposable money to spend on them. Richer people can undertake more risky investment with hgiher ROR. Inheritance often allows high levels of rent. Those with high levels of rent can earn rent and interest and see incomes increased.
-Government Policies: Taxation, social safety nets, and welfare policies can either mitigate or exacerbate inequality.
Between-Country Factors:
-Globalization: Uneven benefits of globalization, such as outsourcing and offshoring, can widen income disparities between countries.
-Historical Factors: Colonialism, trade imbalances, and unequal access to resources have left lasting impacts on global wealth distribution.
-Geopolitical Factors: Conflicts, wars, and political instability can hinder development and exacerbate inequality among nations.
Impact of Economic Change and Development on Inequality
Economic Change:
-Economic growth can either reduce or exacerbate inequality depending on how it is distributed.
-Inclusive growth policies that target marginalized groups can reduce income inequality.
Development:
-Developing countries often experience a Gini coefficient reduction as they progress, but this is not guaranteed.
-The focus should be on equitable development, including access to education, healthcare, and infrastructure.
The Kuznets hypothesis says that as society develops and moves from agriculture
to industry, inequality increases as the wages of industrial workers rises faster than
farmers. Then, wealth is redistributed through taxation and government spending and
so inequality falls.
However, Piketty discredited this theory by arguing that inequality rises as the
country develops as the rate of return on capital grows, so the rich get richer and
inequality increases.
Significance of Capitalism for Inequality
Capitalism, as an economic system leads to income inequality because of wage differentials. Wages vary as they are based on demand and supply, and demand and supply vary for different jobs, has both positive and negative impacts on income and wealth inequality:
-Positive: Capitalism can incentivize innovation, entrepreneurship, and wealth creation, which can benefit society as a whole. Equality can never be fully achieved as without incentive, economy wont grow, essential for capitalism to grow
-Negative: Unregulated capitalism can lead to income and wealth concentration among the elite, increasing inequality.
-Government interventions and policies play a critical role in shaping how capitalism impacts inequality.
