a2 economics- unit 4

7/31/2019 A2 Economics- Unit 4

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A2 Economics: The Global Economy

The economics of globalisation

Globalisation entails the processes that have resulted in the ever-closerlinks between the worlds economies e.g. trade, investment and production

Globalisation manifests in two main different ways, global brands andglobal sourcing

Global brands: Brands are increasing their penetration

internationally. The quality of the product will be virtually identical

but the price that you have to pay varies. Coca-Cola, McDonalds, and

Snickers chocolate bars are available in all 5 continents

Global sourcing: This refers to the ways in which MNCs now source

their operations through worldwide production. Local domestic

production has been replaced by manufacturing capacity on a global

scale. This is a consequence of deindustrialisation. Toyota has set upmanufacturing and assembly plants worldwide. These plants assemble

vehicles from local as well as globally sourced parts

International financial flows: These are becoming far greater.

Countries such as China are financing a chunk of their fast economic

growth from inward flows of international capital

Cheap labour: For rich developed countries, goods are increasingly

being manufactured abroad in developing countries such as India and

China. This is because developing countries have a cost advantage in

the form of cheap labour

I.T and communications development: This has shrunk the timeneeded for economic agents to communicate with each other.

Software programmers are effectively just as near as a clients office

located in London or say India

Factors promoting globalisation

Reduced protection in word economy: WTO has reduced the degree

of protection in world trade. Tariffs and other trade-curbing factors

are inconsistent with globalisation. The global economy is now has a

number of regional trading blocs such as the EU, CARICOM which haveestablished mutually beneficial links between one another

Reduced capital movement restrictions: This is essential for

business capital to move freely within the global economy. Exchange

control has been gradually dismantled, allowing FDI to flow between

developed economies and those that are emerging/developing

Developments in IT:The technological change over the past

generation has enabled firms to communicate via the Internet and has

promoted global economic relations. Global supply chains that

produce and sell their product can now be managed very effectively

Liberalisation of domestic markets: In line with reduction inprotection, many of the worlds economies, China especially, have


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been more receptive to FDI from developed economies and in forming

partnerships with MNCs enabling MNCs to directly purchase

businesses in other parts of the world

A fall in real transport costs: Unit transport costs particularly for sea

transport have been falling increasing the viability for businesses to

source on a global basis. Bulk distribution of products in containers bysea and to a much a lesser extent by air, has increased year on year.

Economies of scale can be gained as vessels are aircraft have increased

in size

The impact of globalisation

The world economy is now more integrated through the growth of

trade and increasing dependency

For developing economies globalisation has produced certain benefits:Higher living standards for more peopleEnjoyment of global brands

Spreading best practice and technology faster

Improved medical supplies that could increase life expectancy

Increased liquidity of capital allowing investors in developing

countries to invest in developed countries

Increase flow of communications allow vital information to be shared

by corporations across the globe

Global mass media ties the world together

Globalisation has its critics:Increased likelihood that an economic disruption in one nation will

affect other nations due to increased dependency

It is a new imperialism led that accentuates the gap between the poor

and rich and leads to exploitation of works in developing countries

Leads to environmental problems. A company may want to build

factories abroad as environmental laws are weaker. Third world

countries may cut down more trees to sell wood to richer countries

MNCs and FDI

McDonalds and Coca-Cola are amongst the largest MNCs withmanufacturing and retail outlets in many countries in the world

MNCs provide FDI to the economies in which they operate This is investment that is necessary to produce or sell a good or service in

a foreign country

FDI involves capital flows between countries FDI should not be confused by portfolio investment which is the purchase

of shares by foreign investors in businesses that are located in another

country

The activities of MNCs and the effects of FDI has been the subject of muchdebate and discussion by economist and politicians


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Benefits and costs of FDI

Many benefits are obtained by the receiving economy of investment:Injection into circular flow of income: leads to the multiplier

effect for the economy, in particular creating more total

expenditure and important employment creation. Longer term, theinjection of FDI increases the economys potential output

Effects of the balance of payments: FDI is a credit item on the

financial account of the BofP. This could be a short-term inflow, or

a sustained one once the business is established. For example, the

investment of multinational hotel in the Caribbean islands

generates further income through the increase increased flows of

tourists and payments received by local carriers

An increase in tax revenue: the MNC contributes to tax receipts

and expenditure taxes on their purchases of their goods and

services. Also, MNCs provide additional tax revenue throughpurchase of local services and corporation/profit taxes

Improved productivity: This may result from pressure on local

suppliers to improve their efficiency

Technology transfer and the acquisition of specialist

equipment: Developing economies receive the benefit of up-to-

date technology and products that have been developed by MNCs

in their home market

There are various disadvantages and risks associated from FDI inflows:The employment created may be only short term and could be

less than expected: The reason for that is that MNCs have littleaffinity to the overseas economies in which they have invested.

Companies may pull out of a country transferring production to

another location. The MNCs may employ workers from their own

country in the top management lobs resulting in employees from

the host country filling lower paid positions

MNCs may invest in labour-saving technology: This may not

seem appropriate in a recipient country with high unemployment

and large amount of surplus labour

Net effects on the balance of payments being less than

anticipated: The profits earned in a host economy beingrepatriated and count as a debit item in the invisible section of the

current account of that country. Over time, the outflows of such

profits may well exceed the initial capital injection

Taxes received by the government may be less that expected:

as a result of fewer than expected new jobs. Account should also be

taken of any government subsidies that might have been given to

the MNCs in order to encourage them to set up in the first instance

Productivity gains and technology transfer effects could be

very limited depending on the type of FDI

Environmental costs associated with certain types of FDI,

especially mineral extraction and natural gas production


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FDI in some respects is a mixed blessing thus not all governmentswelcome MNCs with open arms

Other financial flows

Hot money flows around the world to take advantage of changes andexpected changes in interest and exchange rates

These movements can be disruptive as the money may only stay in thecountry for a short time before it is move to a more profitable opportunity

elsewhere

Portfolio investments are longer term. There are a number of factors thatattract people to purchase the shares and government bonds of another

country- relative interest rates and anticipated profit levels

These are influenced by a government policies and changes in the level ofeconomic activity Other investment includes loans made to other countries at commercial

rates. Firms in other countries may seek loans from abroad if the interest

rate charged are more favourable than can be obtained at home

Developing countries may receive foreign aid in the form of loans atfavourable rate. Most cases, foreign aid has led to the net outflow of funds.

More is paid in servicing and repaying past debt than is received in aid

For some developing countries, more money is now coming fromremittances, the pay sent home from people working abroad, than from

foreign aid, FDI or from sales of exports

Remittances tend to be least volatile source of foreign currency fordeveloping countries

World Trade Organisation

WTO: a global organisation that regulates world trade It is established to promote free trade and provides a forum for discussing

trade issues, established agreed rules and even assesses if these rules are

broken

WTOs mission is to help trade flow smooth, freely, fairly and predictable This should produce a trading system wit the following characteristics

Non-Discrimination

1. Most favoured nation treatment- countries cannot grant aspecial favour (lower rate of duty or duty access free) to one

WTO member over another i.e. all countries treated equal basis

2. National treatment- treating foreigners and locals equally.Under this, imported and locally produced goods should be

treated equally after they have reached the domestic market.

This does not prohibit a country imposing tariffs on imported

goods, but it does mean that the goods compete on same basis

thereafter. Principle applies to services- foreign firms trying toset up operations elsewhere should be treated in exactly the


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same way as domestic firms wishing to expand their

operations

Free Trade: This can be done by lowering trade barriers, tariff

and non-tariff barriers. This will enable goods/services to flow

more openly and fairly between members, providing benefits of

gains from trade

Predictability:The will help provide a stable business

environment whereby firms will feel secure that trade barriers will

not be raised at some future date. This will create a business

environment where investment is encouraged, jobs are created

and consumer welfare is increased. This is relevant for businesses

moving to developing economies, where there are likely to be

concerns over future political stability and economic prospects

Promoting fair competition: The WTO system allows tariffs and,

in some circumstances, other forms of protection. Once a

restriction has been imposed by a member, WTO agreementsmean thereafter should be free and fair competition in the market.

This must not be distorted by further constraints on foreign items

Special provision for developing countries: WTO has sought to

assist the development of developing countries. WTO has sought to

give such countries time and flexibility to implement various

agreements. The agreements build upon the principles special

assistance and trade concessions for developing countries

WTO agreements

The Uruguay Round agreements are the basis of the current WTO system The Uruguay Round covered three main areas:

Tariff Cuts: Developed country members agreed a 40% in their

tariffs on industrial products, to be phased over 5 year period from

1995. This reduced the average tariff from 6.3% to 3.8%. They

agreed that fewer imported products should be charged at higher

duty rates

More binding tariffs: This is a commitment by a member not to

raise tariffs above the listed rate. Developed countries increase the

no. of bound line products to 99%, while developing countries

increased it to 73%. These agreements provide more security for

traders and investors

Agriculture: Substantial progress was med to remove all non-

tariff restrictions on agricultural world trade. Most of these

restrictions were converted to tariffs (tariffication). Tariffs

applying to products from developing countries have been

progressively reduced and commitments have been received from

developed countries to reduce export subsidies for agricultural

products. The Uruguay Round represents the first time that such

an agreement has been reached in principle

The Doha Round


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The current round of talks, the Doha Round was launched in 1999 andcompleted in 2006. It covered a variety of areas:

In manufacturing, further reduction in tariff barriers were

negotiated

In services, access to the markets was a key issue. In many service

markets non tariff barriers were key to restricting trade

First world countries were particularly concerned to tighten up

intellectual property rights in face of widespread piracy. Whilst,

third world countries wanted their rights over plant derived

compounds and folklore protected

There was an agreement to tighten up the role of WTO in settling

trade disputes

International Monetary Fund

IMF is a global organisation that aims to promote international monetarycooperation and international trade

Set up 1945 at Bretton Woods Conference Helps promote the health of the world economy following World War

Two. Non-members: Cuba and North Korea. Members: 184

The IMFs purposes and responsibilities are:To promote international monetary co-operation

To facilitate the expansion and balanced growth of international

trade

To provide exchange stability

To assist in the setting up a multilateral system of payments

To make resources available to members experiencing BofP

difficulties, provided adequate safeguards are provided

IMF has three main functions known as surveillance, technical assistanceand lending

The first two have the aim of promoting global growth and economicstability by encouraging countries to adopt sound economic policies

The third function is used where member countries experience difficultyin financing their balance of payments

Technical assistance and training are offered by IMF to help members todesign and implement effective economic policies

This assistance provides advice on monetary, fiscal and exchange ratepolicies especially. This has been widely taken up my emerging transition

economies

Many IMF members have severe balance of payment problems. In thiscase, the IMF lends money to such countries to ease their immediate

positions

It is important that recipients work closely with the IMF to avoid similarproblems in the future

Anti-globalisation supporters condemn the IMF for favouring militarydictatorships that are friendly towards the US and EU MNCs


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Some economists are concerned about the pro Keynesian approach fordealing with the BofP disequilibria. They believe supply side polices

rather than devaluation are the best way of alleviating structural

imbalance

The IMF has also been blame for some serious economic problems In 2001 in Argentina, it is generally believed that IMF induced budget

restrictions and the privatisation of important natural resources were

responsible for the economic crises that ensued

World Bank

World Bankis a global organisation that provides developing funding. This includes financial support for internal investment projects such as

improving infrastructure and constructing new heal facilities

Rose out of the Bretton Woods agreements It is best described as the World Bank Group as it has five constituent

agencies:International Bank for Reconstruction and Development (IBRD)

International Finance Corporation (IFC)

Multilateral Investment Guarantee Agency (MIGA)

International Centre for Settlement of Investment Disputes (ICSID)

IBRD and IDA provide low- or no interest loans and grants that do nothave favourable access to international credit markets

Loans cover areas such as:Health and education- to enhance human development in a

country- for improving sanitation and combating aids

Agriculture and rural development- for irrigation programmes andwater supply projects

Environmental protection- for reducing pollution and for ensuring

that there is compliance with pollution regulations

Infrastructure- roads, railways, electricity

Governance for anticorruption reasons

It has been accused of being a US/EU dominated agency for supportingtheir own political and economic interests

Though its advocacy for free market reforms, its policies have beencriticised as being harmful to some countries, especially where shock

therapy has been introduced too quickly In spite of this, World Bank has had a considerable impact in assiting the

worlds poorest economies


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Macroeconomic performance

The recent macroeconomics performance of the UK economy

The 4 key indicators build up the picture of macroeconomic performance

Economic growth in the short-run and the long-run

Short-run economic growth: the actual output percentage increase in aneconomys output (actual economic growth)

Long-run economic growth: the rate at which the economys potentialoutput could growth as a result of changes in the economys capacity to

produce goods and services (potential economic growth)

A shift of the PPC curve to the right shows long run economic growth asthe economys maximum possible output has increased

Movement from point A to B shows short run economic growth Short run economic growth occurs because more of the economys

resources are being used- few people are unemployed, more machinery is

being used to produce goods and services

Total output moves closer to the PPC curve Long run economic growth occurs when there is an increase in quality of

quantity of the nations resources of land, capital, entrepreneurship,

labour

This increase the potential output of the economy The difference between actual and potential output is called the output

gap


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In the short run, if actual output > potential output positive output gap This is likely to generate inflationary pressure If actual output < potential output, the economy has spare capacity The economy can expand its output without creating inflationary

pressure. A negative output gap exists

It is hard to measure the potential output accurately and the output gapcan only be an estimate

This reduce the reliability of the output gap as a measure in judginginflationary pressures

Causes of economic growth in the short run

Economic growth in the short run is more variable than in long run Trend rate of growth: the average rate of economic growth measured

over a period of time, normally over the course of the economic cycle

Changes in AD

An economy with spare capacity can experience economic growth asresult of an increase in AD

An increase in AD to AD1 results in real GDP rising from Yto Y1 There is positive economic growth. A reduction in AD would cause

negative economic growth

AD = C + I + G + (X M)

Changes in short run AS

SRAS shows the level of production for the economy at a given price level,assuming labour costs and other factor input cost are unchanged

Changes in the costs of production cause the SRAS to shift. An increase incosts of production, shift to the left. Decrease causes shift to right

Changes in costs of production arise from changes in:Labour costs: lower wage rates reduce the costs of production forfirms, allows them to reduce prices. SRAS shifts to the right,

increasing real GDP to Y1

Other input prices: the price of raw materials and capital. If these

prices fall, lowers costs of production. SRAS right, GDP increases

Taxes and regulations: Changes in the taxation/regulation of a

business will have an impact on business costs therefore shift the

SRAS curve. Most regulation increase business costs, SRAS curve

shift to the left and real GDP is reduced


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The economic cycle

Economic cycle: fluctuation in the level of economic activity measured inreal GDP. 4 stages in this cycle- recession, recovery, boom, slowdown

Some economics argue that economic instability influence the rate atwhich the economy grows

Long periods of unemployment can lead to hysteresis and consequentloss ofhuman capital (knowledge and skills of the labour force)

When the economy returns to a positive output gap, it does so at a slowerrate of economic growth due to the loss of productivity and it becomesmore difficult to raise output

Thus, the economys trend rate of growth may be reducedRecovery- when economic growth becomes positive after

recession

Boom- when rate of economic growth excess rate of growth of

potential GDP so the output gap is narrowed

Slowdown-when the rate of economic growth begins to fall to

zero

Recession-when rate of economic growth becomes negative and

real GDP falls The economic cycle is not as regular as above This is because each of the stages will vary in length and severity Some recessions are short lived, some are prolonged and deep There are three main causes of the business cycle:

The multiplier and accelerator effects and their interaction

The role of stocks (inventories)

Monetary explanations of the economic cycle

The multiplier, the acceleration and their interaction

Multiplier effect: the process by which any change in a component of ADcauses a greater final change in GDP

The size of the multiplier is determined by the size of the leakages(saving, taxation and expenditure on imports) from the circular flow of

income

Tracing expenditure follows that output and income will increase by thesame amount in order to restore equilibrium between AD and AS

The proportion of additional national income that goes to leakages isknown as the marginal propensity to withdraw (MPW) and is made up of:

Marginal propensity to save (MPS)Marginal propensity to tax (MPT)


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Marginal propensity to import(MPM) The value can be calculated using the formula:

Since half of any increase in national income leaks out of the circular flow,the MPW is 0.5

The follows that any change in expenditure in the national economy wilcause national income to be multiplied

This concepts goes some way to explain the upswings and downswings ofthe business cycle

But what causes expenditure to change in the first places This is where the concept of the acceleration comes into play Accelerator: the theory of investment that states that the level of

investment depends on the rate of change of national income

Investment is needed for two reasons- to replace the capital stock that iswearing out and to provide new capital stock to give additional

production capacity to meet rising demand

The National Income Multiplier says that an initial increase in spendingcan cause further rounds of spending. Therefore, the final increase in

National Income is greater than the initial spending (or injection ofMoney)

Recession- there is no need for firms to undertake investment to raiseproductive capacity as demand for output is falling

Hence there is likely to be little if any investment in the economy In times of rising national income firms will require additional capacity

and thus investment will rise

This increase may be larger in % terms than the increase in nationalincome

The key point is that investment depends on the rate of change of nationalincome not on its level

Thus investment is a volatile component of AD Investment can for example fall when the rate of growth of the economy

slows down and this will tend to lower domestic demand

The last point illustrate the way in which the multiplier and theacceleration may interact to generate periods in which real GDP rises

more and more rapidly (the boom phase of the economic cycle)

And the situation in which a slowdown in the economic growth becomes aperiod of falling real GDP (the recession phase of the economic cycle)

Once actual output reaches potential output, the economy reaches itsceiling and economic growth must slow down


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There must be a floor to economic activity as firms must invest aminimum amount to replace worn-out or obsolete capital and there is

minimum level of consumption for households

These ceilings and floors represent the turning points in the economiccycle- booms and recessions eventually come to an end

The interaction between multiplier and the accelerator is a theoreticalexplanation of the determinants of the economic cycle

The economic cycle is far from predictable and the fluctuations ineconomic activity not as regular as diagram would suggest

The acceleration is not a description of economic reality. There are anumber of limitations to the theory:

If firms have spare capacity rising demand can be met without

rising investment

The theory of the acceleration ignores the crucial role that

confidence and expectations play in investment decisions- firms

will not respond immediately to rising demand by raisinginvestment if they are uncertain about whether the rising demand

will be sustained in the future

Firms can exercise chose over investment to replace machinery

that is wearing out and they may delay such investment

Investment decisions are planned well in advance of changes in

economic activity and can be difficult to halt or postpone

The multiplier effect of changes in investment may be small it does

not have a large impact on AD and thus economic growth

External or random shocks to the economy can be just as

important a cause of the economic cycle as the relationshipbetween the accelerator and the multiplier

Fiscal and monetary policy changes may help to smooth out the

economic cycle and policy makers may be able to over-ride the

accelerator and multiplier effects

These limitations focus mainly on the size of the accelerator andmultiplier effects and the extent to which they are predictable

The interaction of the multiplier and the accelerator is not the onlydeterminant of the economic cycle, however

Other explanations of the economic cycle

Another explanation involves the behaviour of stocks With time lags in production, it is not always possible for firms to

immediately increase output in order to meet higher demand

Thus firms hold stocks of finished and semi-finished goods As with investment, the amount of stocks held by firms tends to fluctuate

over the course of the economic cycle which contributes to the cycle itself

When economy recovering from recession- confidence of firms is fragile.Firms will be reluctant to take on new workers or to increase their

investment when they are unsure about whether demand will continue to

rise in the future


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As a result, they will tend to sell their stocks of finished goods instead ofproducing new output

The recovery phase of the economic cycle will see a rise I output that isless than the rise in demand and the output growth will thus be slow

But the stock of finished goods is limited As demand continues to rise, the confidence of firms will grow and they

will start to build up there stock levels from current production

This will boost output and create additional demand in the economythrough the multiplier effect

During this time the growth of output will exceed the growth of demandas firms re-stock

Once stock levels have been rebuilt, output growth will slow down tomatch the growth in demand

This slowdown in output will bring about the end of the growth phase ofthe economic cycle in line with the multiplier-accelerator theory above

Stock levels will now start to increase as demand falls Eventually firms will cut back production to stop stock levels growing, the

economy will enter the recession phase of the economic cycle and firms

will run down their stocks of finished goods

The cycle will start all again once firms cannot satisfy demand from theirstocks

Both theories of the economic cycle suggest that the pattern of rising andfalling real GDP is inbuilt into the economic system

The economic cycle occurs due to regular fluctuations of AD- this is theresult of decisions of consumers and firms based on their expectations of

the future

Causes of economic growth in the long run

Changes in LRAS

LRAS: the relationship between total supply and the price level in thelong run. The LRAS curve represents the maximum possible output for

the whole economy- its potential output

Classical economists: economists who believe that the markets will clearin the long run, with prices and quantities adjusting to changes in the

forces of supply and demand so that the economy produces its potentialoutput in the long run. The economys LRAS curve is thus vertical

Keynesian economists:economists who believe that market failures willresults in price and quantity rigidities such that the economys

equilibrium output in the long run may be less than its potential output

Economic growth in the long run is caused by an increase in potentialoutput of the economy. This is determined both by the quantity and

quality of the factors of production

An increase in both the quantity and quality of land, labour, capital willcause economic growth. In this case, the LRAS curve will shift to the right

For example, if there is an expansion in the labour force it will be possiblefor the economy to produce a higher level of output


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The quantity of the labour force

Increasing the size of the labour force can be achieved in a no. of ways:Increases in the size of the population

Increases in the labour force participation rate

Immigration

Labour force: all those people of working age who are in employment oractively seeking work

Labour force participation rate: a measure of the proportion of thepopulation able to work who are in employment of who are actively

seeking work

The biggest growth in labour force participation has come from anincrease in the number of women entering the workforce

Changes in tax and benefit system in the UK have also encouraged peopleto seek work by making more and more welfare benefits, such as Working

Families Tax Credit, dependent on employment

Raising the retirement age may be politically unpopular but it may be aneconomic necessity in Europe in the not too distant future

Immigration increases the size of an economys labour force but alsoincreases the size of the population

Unless immigration contributes to productivity there might be littlebenefit in terms of GDP per capita

Recent enlargements of the EU have increase the size of the labour forcefor those economies that have not restricted the free movement of labour

from central and eastern Europe

If immigrant workers stay on a temporary basis there may be no long-term increase in the productive capacity of the economies to which such

workers migrate

The quality of the labour force

The labour force can be made more productive through education andtraining

This raises the workers human capital by equipping people with moreskills and technical knowledge

Human capital is important because it enables workers to cope with thedemands of employment

Of increasing importance is the ability of the labour force to be flexible inthe tasks that they can do (functional flexibility) and being able to adapt


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to changes in the labour market by acquiring skills for new jobs

(occupational flexibility)

The problem with policy makers is how to deliver this increased humancapital

The cost of education and training can be very high There is the issue of whether this should be provide by the government of

by the market

There is the question of what education and training should be provided UK compares favourably with Germany and France in terms of the % of

the labour force with the highest qualifications

Increasing the quality of labour force through investment in humancapital is important for economic growth in the long run but it is not clear

what should be provided. Time lags should also be considered

Investment in human capital takes time to materialiseThe quantity and quality of capital stock (Harrod-Domar model)

An economys potential output is increase by an increase in thequantity/quality of the factors of production

Increasing the quantity of capital stock will increase the economysproductive capacity

This requires investment in various types of capital It is not just the amount of investment that determines the potential

output of the economy, it is also the quality of the investment

The productivity of investment is measured by the economys capitaloutput ratio

This is the amount of capital needed to generate each unit of output Technological advance increase the productivity of investment because it

require less capital being required to produce each unit of output

Consequences of economic growth

If a governments are to pursue economic growth as a policy objective,they need to be aware of any conflicts it may have with other objectives

Growth and inflation

The consequences of economic growth for inflation depend very much onthe nature of economic growth

Chinas economic growth has averaged around 9.6% over the last twodecades, yet until 2007 its inflation rate remained below 3%

Economic growth will cause higher rates of inflation, if growth isgenerated by increases in AD that are not matched by increases in AS

At the simplest level, a rise in AD causes a movement up the LRAS causingprice level to increase

The closer the economy is to its maximum capacity, the more that thehigher AD causes prices to rise


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This is because the shortages of inputs push up production costs. Thisincreases the no. of firms with little spare capacity to need the demand

and labour shortages result in higher wage bills for firms

As the gap between actual and potential output narrows inflationarypressure increases

It is possible to avoid this by increasing the economys productivecapacity. If the AS can be shifted to the right (LRAS 1) AD can rise without

inflationary pressures building up (a price level of P).

Non inflationary economic growth is the goal of macroeconomic policy

In 2007, Chinas official rate of inflation more than trebled and manyeconomists were expecting it to increase to over 6% in 2008

Growth, Employment and Unemployment

The link between economic growth and employment is recognised bypolicy makers as central to improving macroeconomic performance

In 2005, the EU relaunched its Lisbon Strategy as a growth and hobsstrategy committing member states to raising investment in research and

development and labour force participation rates

By 2006 the number of people in employment in Ireland had increase byalmost 60% since 1995, whereas over the same period employment in

Belgium increased by only 11%

The Irish economy grew by 7.3% per annum over the period, whileaverage annual economic growth in Belgium was barely over 1%

Since the demand for labour is derived demand, the number of peopleemployed is closely related to output

Increases in real GDP will ten to increase the demand for labour and sothe level of employment will rise

The relationship between output and jobs can be represented with aninverted employment curve on an AD/AS diagram

In the short run, increase in output (Y to Y1) increase the number ofpeople employed (L to L1). In the long run,, raising labour force


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participation rates through capital investment would shift the LRAS to the

right and raise employment

Increasing labour productivity may result in some reduction inemployment in the short run, because firms may choose to produce the

same output with fewer workers

This can be represented by pivoting the employment curve to show lesslabour employed at each level of GDP

In the long run, however, it is likely to generate more jobs as AD increase Higher employment might be expected to reduce employment but this is

not always the case as the labour force itself is changing

Increases in the working age population and in the no of people activelyseeking work can mean that rising employment coincides with rising

unemployment

The consequences of economic for unemployment also depends upon thenature of growth and on the causes of unemployment

Economic growth generated by increases in AD is likely to reduce cyclicalunemployment, but may have little impact on unemployment arising fromproblems related to the supply of labour, such as structural/frictional

unemployment

Growth and the balance of payments

An increase in AD caused by rising consumption is likely to affect the BofPnegatively

This is because the demand for imports are likely to increase worseningthe current account position

The effect will be more pronounced if the demand for imports is incomeelastic

On the other hand, if growth is export led, the current account is of theBofP will show an improvement

Supply side improvements- increases in productivity, innovation andcapital investment which contribute to long-run economic growth are less

likely to worsen the balance of payments

Increases in productivity will tend to increase internationalcompetitiveness by lowering unit labour costs and reducing the impact of

growth on imports

Higher capital investment will increase the productive potential of aneconomy resulting in a greater ability of domestic firms to meet higher

levels of domestic demand

Capital account: the section of the BofP that records the long-term flowof capital into and out of an economy. It records purchases and sales of

assets and is split into two sections: long term capital flows and short

term capital flows

If growth causes the current account to worsen, this may be compensatedby a capital account surplus

Traditionally, the BofP has been viewed as a constraint on economicgrowth


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Thirlwalls Law states that the rate of economic growth consistent withBofP equilibrium is equal to:

Growth and the governments fiscal position

Governments fiscal position refers to the balance between governmentexpenditure and revenue from tax receipts

Public Sector Net Cash Requirement (PSNCR): the difference betweengovernment expenditure and revenue from tax receipts

In a boom, tax receipts will tend to rise even without action by thegovernment to raise tax rates or widen the tax base

The higher level of economic activity will bring the government more taxrevenue Higher employment results in more income tax revenue, higher

expenditure by consumers results in more revenue from expenditure and

higher levels of profit result in greater levels of corporation tax receipts

Government spending will tend to fall during this period because there islikely to be lower unemployment in the boom phase of the economic cycle

This reduces the about that has to be spent on JSA In a recession, taxes will fall and government spending will increases These changes are automatic and thus are called automatic stabilisers

because they have the effect of dampening down a boom and cushioning

the effect of a recession

Automatic stabilisers: changes in government expenditure and taxationreceipts that take place automatically in response to the economic cycle

A budget surplus will tend to emerge during the boom phase of theeconomic cycle and a deficit to materialise in a recession.

Governments will have to borrow to make up the shortfall during arecessions but they should be able to repay this borrowing during the

boom years form the budget surplus

The PSNCR therefore vary over the economic cycle The existence of this fiscal cycle reduces the size of the multiplier effect

and dampens down the economic cycle , if the automatic stabilisers areallowed to work

Policy issues- growth, economic stability and international competitiveness

Last ten years, economic stability has become an objective ofmacroeconomic policy

Economic stability: the avoidance of volatility in economic growth rates,inflation, employment and unemployment and exchange rates, in order to

reduce uncertainty and promote business and consumer confidence and

investment


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Economic stability has become a more prominent macroeconomic inrecent years due the consequences of instability

It is argued that instability in any of the key indicators leads touncertainty which damages the countrys long term economic

performance

Uncertainty about demand and prices will undermine both consumer andbusiness confidence

A lack of consumer confidence discourages consumption which may causethe recession to prolong

Business are likely to invest during times of uncertainty Macroeconomic policies to promote stability and growth have focused on:

A prudent approach to the management of the economy

Taking fiscal and monetary policy decisions on the basis of the

long-term interests of the economy rather than the short term

political interests

Ensuring that fiscal monetary policies support each other

Bringing openness and transparency to decision making through

putting in place rules and targets

Improving the supply side performance of the economy

Fiscal policy issues

The governments budget will move into surplus in time of economicboom and into deficit in time of recession as a result of automatic

stabilisers

Governments must avoid the temptation to spend surpluses and to try toclaw back deficits to balance the books- leads to more pronounced

economic cycle

If governments raise spending and cuts taxes because the budget is insurplus they run the risk of raising AD during the course of the boom

phase of the economic cycle

High levels of government borrowing can reduce the amount of financeavailable for private sector investment

The private sector is then crowded out and private sector investment fallsreducing the economys long term rate of economic growth

High government borrowing will tend to push of interest rates

The aim of UK fiscal policy is to balance the governments budget, butover the course of the economic cycle

Short term political considerations are not supposed to drive decisions ongovernment expenditure and taxation

To promote economic growth, UK fiscal policy focuses on measures thatwill raise the productive capacity of the economy by shifting out the LRAS

curve

In times of recession, a government will have to borrow money to makeup for the shortfall of tax receipts over government expenditure

But they should not borrow more than this cyclical deficitto fundcurrent expenditure


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In other words, government borrowing is only justified if it arisesautomatically because of the economic cycle or is used for investment-

this is the golden rule of UK fiscal policy

Cyclical deficit: a budget deficit that arises because of the operation ofautomatic stabilisers

Differentgovernments have different approaches to designing fiscalpolicy to promote economic stability and growth

The broad principle are credibility, flexibility and legitimacy but thereare different approaches to what rules and targets should be met

Credibility: a credible fiscal policy framework is one where thegovernment commitment to economic stability is trusted by the public,

business and financial markets

Flexibility:a flexible fiscal policy framework is one that has the flexibilityto deal with macroeconomic shocks such as sudden changes in AD/AS

Legitimacy: a legitimate fiscal policy framework is one that haswidespread support and about which there is general agreement amongthe public, business and politicians

The problem with the UKs approach is that it requires accurateestimation of productive capacity of the economy and the economys long

term economic growth rate- difficult to estimate

Governments would also have to be able to forecast the likely trend inactual economic growth to set spending and taxation for the years ahead

The members of the Eurozone have abide the Stability and Growth Pact SGP: an agreement by members of the EU about the way in which fiscal

policy should be conducted to support Europes single currency. It

requires those countries adopting Europes single currency to abide by

the following rules:

A budget deficit of 3% of GDP or less

A government debt of 60% of GDP or less

Such rules are simpler to interpret and measure, but lack flexibility If an economy was in a recession, its government budget deficit will rise

and may fall foul of the 3% limit

SGP includes a financial penalty for economies that breach the rules- thiswould add to their credibility and legitimacy

However, the penalties make it harder to an economy to bring a deficitdown and because they lack flexibility might make the economic cycle

more pronounced that it would otherwise if the automatic stabilisers of

fiscal policy were allowed to operate

Fiscal policy rules are no guarantee that governments will get these thingright or stick to their own rules

Unless fiscal policy is run independently of government, there is alwaysrisk that politicians will take risks with fiscal policy and destabilise the

economic cycle

Politician are likely to be vote maximisers and favour fiscal expansionover fiscal prudent

To be effective there must be penalties attached to the rules


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Fiscal policy rules and targets may also encourage creative fiscalaccounting whereby governments find ways around the rules by changing

the way expenditure

People may lose confidence in the government to stick to the rules or therules themselves are worthless

If this happens the whole credibility of government fiscal policy is eroded Monetary policy issues

Can promote economic stability in many ways Changes in interest rates have an impact on domestic demand through

consumption and investment, and on net external demand through the

exchange rate

The way in which it does so is called the monetary transmissionmechanism

Monetary transmission mechanism: the way in which monetary policyaffects the inflation rate through the impact it has on othermacroeconomic variables

Rapid economic growth and accelerating inflation can be dampened byincreases in interest rates and an economic slowdown and falling inflation

rates can be talked with reductions in interest rates

Monetary policy can be used to manage the economic cycle and smoothout the fluctuations in short-run economic growth that bring with them in

other key performance indication

In short, monetary policy could be used to manage AD The primary objective of monetary policy is to promote price stability It is argue that low and stable rates of inflation provide a framework for

economic stability

Inflation erodes the purchasing power of money This damages the heart of any economic system- the exchange of money

for goods and services

If wage growth starts to increase to compensate for the value of money,there is a very real danger that inflation will get out of control

Prices also serve a signalling function in a market economy Changes in prices should reflect changes in demand and supply and send

out messages for resources to be allocated and reallocated to the goods

and services that consumers most want Inflation is sometimes described as a noise that distorts the signalling

function and thus the market system doesnt function so well

Variation rates of inflation create economic uncertainty that discouragessavings and investment, crucial for long term economic growth

High relatives rates of inflation also damage internationalcompetitiveness in the long term, affecting output and jobs

The role of monetary policy is therefore to deliver low and stable rates ofinflation

Central banks have been given responsibility to deliver price stability andhave given operational independence from governments


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This makes the monetary policy less susceptible to short-term politicalconsiderations and more likely to operate in the long-term interest of the

economy

The inflation target itself varies between countries Targets can be symmetric or asymmetric Symmetric inflation target: when deviations above and below the target

are given equal weight in the inflation target

Asymmetric inflation target: when deviations below the inflation targetare seen to be less important than deviations above the target

Inflation targeting has a number of benefits for growth and stability:Transparency and accountability- an inflation target makes the

conduct of monetary policy clear. There is a firm commitment to

price stability that is communicated to firms and households

Expectations- an inflation target that is credible directly affects

expectations of inflation. If people expect the inflation target to

met, they will build this expectation into their behaviour and thiswill do much to bring about the inflation rate they expect. Firms

will be confident in their investment plans if they expect future

inflation to be low. This will raise productive capacity of the

economy and reduce likelihood and demand-pull inflation

Flexibility- the design of symmetric inflation targets gives as

much weight to low inflation as it does to high inflation. This

means that a degree of flexibility is built into the monetary policy,

which can contribute to economic stability. For example, if

inflation was predicted to fall below the bottom range of set, then

the central bank is likely to reduce interest rate to raise AD.Without this symmetry, there might be a bias towards reducing

inflation at the cost of slower economic growth and higher

unemployment

There are a no. of problems with inflation targeting Whether it promotes economic stability, growth and international

competitiveness depends on the central bank bringing credibility to the

target

To be credible, the central banks has to build up a reputation for meetingits target

This can lead to central banks trading of low economic growth for lowinflation

In order to be successful in hitting its target, central banks have to begood at forecasting inflation. Monetary policy works with time lags

An increase in todays interest rate might have its full effect on inflationuntil up to two year later

Even the best forecasts cannot anticipate unforeseen events. Untilrecently, the economies that have used inflation targeting have been

remarkably stable

The real test of inflation targeting is whether it can deliver economicstability and growth at a time when global economic conditions are

themselves unstable


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Supply-side policy issues

Supply side policies aim to increase AS in order to increase the productivecapacity, thereby helping to prevent inflation, reduce structural/frictional

unemployment and improve the economys long run rate of economic

growth and its trade position The shift in the LRAS increases real GDP to Y1 and allows future to

increase in AD, raising real GDP still further to Y2

All this occurs without any increase in the price level- there is no trade-offbetween growth and inflation or price stability

Some economies argue that the period of sustained, non-inflationaryeconomic growth in the UK since 1992 has been the consequence of

supply side improvements to the economy

Some economist believe that supply side policies are not the panacea It is little use expanding the productive capacity of an economy if there is

a deficiency of demand within the economy For example, if AD were at AD0, supply side improvements would have no

effect on real GDP or the price level

Despite this, supply-side policies are increasingly seen as important todeliver improved macroeconomic performance in the long run and to

improve international competitiveness

International competitiveness: the ability of an economys firms tocompete in international markets and thereby sustain increase in national

output and income

During the 1990s, Ireland attracted high level of investment frommultinational companies, it economic growth exceeded the rest of Europe

The Irish economy continued to grow rapidly, but this growth hid anemerging competitiveness problem from about 2000. This can be seen by

Irelands growing current account deficit problem

A countrys international competitiveness is determined by both theprices and the quality of its goods and services. These include

The costs of production

Productivity

The exchange rate

Relative unit labour costs can therefore change for three reasonsA change in the cost of labour compared to other countries

A change in productivity compared to other countries

A change in the exchange rate

Unit labour costs: the cost of labour per unit of output Relative unit labour costs: the cost of labour per unit of output of one

country relative to its major trading partners


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The problem with this measures of international competitiveness is that ittakes no account of quality factors

Quality factors that could affect international competitiveness mightinclude:

Design of products

Delivery dates

After-sales service

Reliability

Marketing

In the case of Ireland, declining international competitiveness appears toboil down to problems related to poor growth in productivity, high

growth in inflation and costs and a rising exchange rate

At the top of the pyramid is sustainable growth in living standards- comesfrom past improvements in competitiveness

Next in the pyramid are the factors that determine currentcompetitiveness including business performance, productivity, prices and

costs and labour supply. Last in the pyramid are the policy inputs

There are three key things that the council believe determines futureproductivity:

The business environment- this determines the cost and ease of

doing business in Ireland and includes the impact of taxation,

regulation, the degree of market competition, the extent of labour

market regulations, the cost of raising finance on business

Physical infrastructure- this determines productivity and costs

and includes transport, energy and IT infrastructure that is

affected by levels of investment by firms and government

Knowledge infrastructure- education, training and research and

development affects the quality of the labour force and of the

products firms are able to produce

Supply side policies might require higher government expenditure butsome require fiscal and monetary policy to deliver the conditions for

long-run economic growth and a stable macroeconomic environment

These policies will not deliver immediate results

a2 economics- unit 4

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