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Economics - Notes IB
Economics - Notes IB
Economics - Notes IB
Market: A platform where buyers and sellers come together to carry out
economic transactions.
Demand: the amount of a good a consumer or group of consumers are willingly
and able to buy.
● As prices increase, demand for a certain good decrease (and vice versa)
Ceteris paribus (assuming everything else remains the same).
Total market demand can be found through addition of total demand of all goods within the market
Supply
The quantity of a good or service that producers are willing to offer for sale at a given price during a specific time
period, ceteris paribus.
● As price increases, more of a certain good is supplied by a firm. This is because firms exist to maximise profit
and are thus more willing to give a certain good at a higher cost.
● LIke demand, to find the market supply of a good, one needs to add up all the individual supply for different
supplies of a good.
● Increase/decrease in price can cause a movement across the supply curve, while a non-price factor will cause all
supply to shift. These non-price factors include:
○ Cost of production: If the cost of maintaining the factors of production increases, some firms may no
longer be willing or able to provide as much of a certain good at a certain cost as they gain less of a
profit, thus shifting the supply curve to the left. (Capital, enterprise, land, labour)
○ Productivity: If firms are able to use fewer resources in the production process, it will spend less on
production. For example, effective management, or utilizing machinery/better technology.
○ Expectations: Companies will make decisions about what to supply based on their expectations of
future prices. If a product is perishable, then a company might wait until demand is high before
producing
● Taxes + subsidies: Businesses see taxes as increase in cost of production and subsidies as a decrease in
cost of production, and as such, this will affect the amount of a good a firm will be able to produce.
● Price of related goods: If producers have a choice regarding what to produce, they will usually use their
limited resources to produce more of a good in demand than a good that is not wanted.
Equilibrium
The point where demand=supply. Where the amount of a good that people wish to buy and the amount of a good that
suppliers wish to supply are the same. The market will remain that way until there is an outside disturbance which will
change it.
Self Righting system: When a market acts freely, the price acts as a signal to all market actors, and will always push
the price back to the equilibrium.
(the equilibrium is found to be the intersection of D and S)
The key to the market’s ability to allocate resources can be found in the
role of prices as signals and prices as incentives.
Price rise
1. As demand increases, there is an upward pressure on price. This is
due to how some individuals aren’t able to buy the good they
want, and are willing to offer more.
2. The increase in price signals to everyone that a shortage has
emerged.
3. Price therefore rises as producers are incentivized to produce
more as they earn greater profits. At the same time this causes
consumers to ration their income.
4. More resources are ultimately distributed to the creation of these goods.
Price fall
1. As demand decreased, there is a downward pressure on price. This is due
to how supplies are unwilling to incur an extra cost.
2. The drop in price acts as a signal to everyone that a surplus has occurred.
3. Firms will therefore ration their resources as they are incurring excess
costs. Lower costs will incentivize consumers to spend more.
4. Less resources are ultimately distributed to the creation of these goods.
Market efficiency
Consumer surplus: the benefit gained by consumers from paying a price that is
lower that which they are prepared to pay
Currently, good A is being sold at the market price. However, there are some
consumers who are willing to pay more for good A. As such, these consumers
gain extra satisfaction from paying for a price that is lower than what they are
willing to pay. It is the difference between what the consumers are willing to pay ,
and what they actually have to pay.
Producer surplus: The benefit gained by the producer from selling a good that is
higher than which they are prepared to supply it at.
Currently, good A is being sold at the market price. However, there are some
suppliers who are willing to provide the good at a lower cost than the market
price. They gain in the fact that they have made a gain in terms of what they
would have accepted for them in the first place .
Essentially, it is the difference between what a supplier is willing to provide a good at , and what they actually have to
provide
Allocative efficiency: When resources are optimally allocated, and when utility
/community surplus is maximised. The market is producing the amount wanted
by society, and maximising utility to all parties.
● If we move right of the equilibrium point, we find that the marginal social cost of producing certain goods
exceeds the benefits derived from it, and as such, it is inefficient to produce quantities of that amount, as the
utility of producing falls as it increases, incurring a deadweight loss.
● If we move left of the equilibrium point, we find that the marginal social benefit exceeds the marginal social cost
of producing. However, we must take into account the total utility gained from selling this certain product. If
we produce at a quantity to the left of Qe, it will result in a loss of potential utility, creating a deadweight loss.
● The total utility gained is at it’s greatest when it’s at the equilibrium point.
Price elasticity of demand: The responsiveness of the quantity demanded to changes in the price of a good or service.
The value is always negative because of the negative correlation between the changes in price and the quantity
demanded.
If PED is 1, that good is unit elastic. That means that when there is a percentage change in price, there will be an equal
percentage change in quantity demanded.
0<PED<1: Inelastic demand. Percentage change in price greater than percentage change in quantity.
1<PED : Elastic demand. Percentage change in price greater than percentage change in quantity.
PED=0: Any change in price is met with no change in quantity demanded. Horizontal demand curve.
PED= Infinity. Any change in price leads to an infinite change in quantity demanded. If price increases by 1%, no one will
consume it, while if price decreases by 1%, every single consumer will want to consume it. Vertical demand curve.
● Substitutes: Consumers will be more responsive to a change in the price of a good if there are a large number
of substitutes, vice versa if there are little.
● Proportion of income: Demand for goods that make up a large proportion of consumer’s income will tend to be
more elastic, since they will lose/gain a lot if the price of a good decreases/increases. This is in comparison to a
good that cost very little.
● Luxury/necessity: goods which are necessities will have less elastic demand because of how consumers are not
able to do without it. Addictive goods will also be considered necessities, thus, meaning they less elastic
demand.
● Time to respond: if the time given for consumers to respond is little, there will be little change as consumers will
not have enough time to respond or identify substitutes.
● Type of good: primary commodities are usually more inelastic, and manufactured goods are elastic. (check notes
up ahead)
Across a curve, the PED is not constant. At higher prices,
the PED is more responsive, while at lower prices, the
PED is less responsive.
- This is because when prices are high and
quantities are low, the percentage change in Q is
relatively large, while the percentage change in p is
relatively small.
Applications:
- Producers can use this to find the point where they can maximise revenue. A firm producing at an inelastic range
of the demand curve can always benefit by reducing its output and increasing its price since consumers will be
not very responsive to the change in price, and thus total revenue will increase, as the decrease in consumers
will not be proportional to the rise in price.
- Vice versa for a firm producing at the elastic range of the demand curve, which can decrease the cost of it’s
good in order to increase its total revenue. Thus firms can use the PED to know how to maximise total
revenue.
This phenomenon is due to the fact that at lower prices, the goods represent a lesser amount of the consumer’s
income, because the good has lost its luxury status .
● PED is also important as taxed goods are usually inelastic, in order to allow the government to tax inelastic
goods and earn adequate revenue from it, otherwise if they tax an elastic good, then they might cause demand
to decrease by a large amount, and will cause an industry to go bankrupt, reaping little tax revenue.
Cross price elasticity of demand
Measures the responsiveness of a particular good to a change in the price of a related good. Depends on the closeness
of the relationship between two goods.
However, a negative XED indicates two goods are complements. As the price of good B decreases, the percentage
demanded for good A will increase as well because good B has become cheaper. An elastic negative XED indicates that
the two are goods are strong complements of each other.
Applications:
- If the substitutes are produced by a single business, the degree of XED needs to be considered. For example, if
the value of XED is high between sprite and coke, then the company will not decrease the price of one of the
goods because it will came at the expense of another.
- Substitutes produced by rival businesses: Predict the amount of profit they make if their rivals drop their price,
and to see whether or not it will benefit if they do so.
- Businesses producing complementary goods will often collaborate in order to take advantage of sales, and to
help reap extra benefits. It can also be used to predict the effect of taxation on one of the goods.
● Understanding YED helps businesses and government to analyse the effects of changing income. For example, if
a business produces a normal good, they will scale back production if they know a recession is coming on. This
will allow firms to produce in an expanding market. The higher the YED, the greater the expansion.
● Governments can also recognize the effects of varying income elasticities of demand for different goods. A
government’s decision to increase or decrease income tax will affect disposable income and will therefore
directly affect the demand for goods and services in a nation. A government must therefore consider these
factors to make an informed choice.
○ Governments can also use YED to predict the effect of economic growth on the sectors within an
economy. Typically, agricultural sectors will shrink while manufactured sector will grow. This will
therefore allow the government to see which industries may need support.
● A measure of how much the supply of a product changes when there is a change in the price of the product.
Determinants of PES
● How much costs rise as output is increased. If total costs rise significantly, then producers will not have a great
incentive to increase supply. As such, PES depends on:
○ The existence of unused capacity: if a firm has significant resources which it has not properly used, then
it will be able to increase output easily. While on the other hand, if a firm is producing at full capacity it
will not be able to produce more.
○ The mobility of factors of production: If a firm has factors of production which can be utilized to
produce different goods, then PES will be relatively elastic.
● Time period considered. In the immediate time period, producers are not really able to increase their supply,
especially if it is a natural resource such as tomatoes or potatoes. However, in the long run, firms may be able
to increase the quantity of all of the factors, and as such, it would be much more elastic in this case.
● Ability to store stock: if the firm is able to store high levels of this particular good, then they will be able to react
to price increases. (higher PES)
Commodities
● PED for natural resources (commodities) are relatively low. This is because producers of a certain good are the
ones who purchase natural resources, and they usually have very few choices in this regard. THey have a set
amount of resources to produce, and so wouldn’t overspend either, and will not buy extra even if prices
decrease. They are also necessities, with little to no substitutes.
● PES for commodities tend to be more inelastic as it is very hard for producers to quickly reallocate resources as
it takes time to grow these goods.
Manufactured goods:
● PES for manufactured goods tend to be more elastic as it is easier to increase supply.
● Manufactured goods for consumers tend to have a more elastic PED as there are many substitutes available to
them.
Government intervention
In order to solve some problems within the economy, the government can implement various policies in order to curb
them. These policies can:
● Increase government revenue
● reduce consumption of a certain good that are harmful for the individual. Taxing these goods will reduce
consumption. Improve the allocation of resources.
Taxation:
Effects of taxes:
● Consumers suffer: Consumers pays a higher price and receive less of the product
● Government benefit: taxes collected will increase government revenue, and thus be spent on infrastructure.
○ Can be used to correct a market failure.
- Convenient to pay, easy to pay at the time of purchase.
● Less workers hired in the process. (harmful to industries). Producers incur extra costs, produce less, and are
less likely to make a large profit.
○ Regressive. Will affect poor more than it will affect the rich, and thus, incur inequality
Market period: the period right after the change in price takes place.
When a tax is introduced, the consumer and the producer burdens some of it. Here, the tax is one that is P1 to X, with
the producer and consumer burdening half of it.
Subsidies
A subsidy is a payment made by the government to a firm for the purpose of increasing the production of a good.
Governments may do this to :
● increase the consumption of a good by lowering the price, as it is lower, increasing demand. (positive
externality)
● Supporting a certain industry, especially one which is struggling . Will help guarantee supply for products that
the government believes is necessary. Such as basic food or a power source, or an industry which hires a large
number of people.
● Give greater incentive to produce goods which leave a positive externality, and reduce market failure:
subsidies to the solar industry are intended to promote the growth of solar power.
● Affect the balance of payment deficit by lowering the price of domestic products.
Impact of subsidy
Here, the government has introduced a subsidy of AB. This means that for
each unit of output the firm is willing and able to produce, it receives a lower
rice than the original by the amount of the subsidy.
- Equilibrium quantity produced and consumed increases from Q* to
Q(ab)
- Equilibrium price falls for consumers
- Price received by producers increases from p* to P.
- Entire shaded area represents the cost of the subsidy.
- Overallocation of resources, as the MC (s1) is to the left of the current
supply curve.
Price controls
Price floors
Minimum prices set by the government for a certain commodity and service that it believes that is being sold at a price
that is too low. Used to protect suppliers who need more funds for the production of their good.
Examples include:
● Agricultural price support
● Minimum wage
● Therefore, a surplus will exist if the price floor is above the equilibrium
price.
● The price floor will mean that resources are being used which could be
devoted to other things.
Firms: firms are worse off, as they face higher cost of production due to higher labour costs.
Workers: some workers gain by having access to a higher salary, but some lose their job.
Consumers: consumers are negatively affected, because the increase in labour costs leads to decrease in supply of
products, causing higher product prices and lower quantities.
It could be argued that minimum wage may mean that firms respond without firing workers, but by cutting back on their
non-monetary payment. Labour productivity may also increased due to an increased incentive.
Price ceiling:
Maximum price set by the government for a certain commodity and service that it believes is necessary. Used to
protect consumers.
A shortage exists here, as there will be many who want the good who are now
unable to obtain it.
Consequences:
- Consumers: consumers who are able to buy the good at the lower price are better off, and helps prevent
consumer exploitation/negative effects during inflation.
- However some customers will be unhappy as they will not have access to the goods.
- Producers: producers are worse off, because the price ceiling means they sell a smaller quantity of the good.
- Helps maintain competitiveness in overseas market.
- Government: no gains or losses, as no budget is used. However, they may lose political popularity, and have
to deal with black markets.
Examples include:
● Rent control, in order to allow housing to be available to those with a low income.
● Rice bread and other staple food, which is necessary for people with lower income.
Market failure
Any situation where the allocation of resources is not efficient.
a situation where the quantity of demanded by consumer equates to the quantity supplied by producers. This is called
allocative inefficiency, and it involves the over-allocation or the under-allocation of resources.
Pareto optimality: THe point where no one can be made better off without making someone else worse.
Externalities: when someone outside of a transaction (a third party) enjoys the benefit or costs.
Marginal social benefit (MSB) : The benefit individuals and society as a whole receive from the consumption of one
more unit of a certain good.
Marginal social cost (MSC) : The cost individuals and society as a whole pay for the consumption of one more unit of a
certain good.
The MPB and MPB refers to the benefits and costs to individuals involved within the transactions. If these differ from
marginal private benefit and marginal private cost, then there are externalities.
If MSC= MSB, there are no externalities, because ultimately, society as a whole do not receive extra or pay for anything
more. This is called the social optimum.
Negative production externalities (negative change in supply): The cost third parties suffer from the production of a
certain good or service (producer). For example, a coal produces a significant amount of air pollution which could take a
toll on the health of others.
Because the consumption of coal produces extra costs to society, the marginal
social costs is higher up, reflecting the full cost of production which takes into
account the entirety of society.
This is not a shift in the supply curve, but rather a “true” reflection of the supply
curve. Therefore to cover every single cost to society , the cost of the good should
be higher. Therefore, we can conclude that production is higher and price is
lower than it should be in , and that total marginal social costs are greater than
total marginal social benefit. Because p* Q* represents the optimum
production, anything from that represents the deadweight loss and is a
negative externality, as the marginal cost to society of producing more than
Q* is one that is greater than the marginal benefit of doing so.
Potential solutions:
Taxes : By taxing a good, the MPC, will shift to the left. This will mean that more of the negative effects to society are
covered by an increase in price. This tax covers a portion of the externality cost, meaning that the total loss to society
is not as large. In addition to this, increasing a price will also decrease production (e.g Carbon tax)
● Internalizes externalities: costs are now paid by consumers/producers. Allows firms who would have not
previously paid a high cost to face the damage they are producing, cutting down on output.
● Gives incentive for firms to further cut down their use of polluting technologies, and innovate into cleaner
energy as this will mean they pay less.
● Provides firms with flexibility: Some industries will find it difficult to reduce pollution levels dramatically. Tax
will give them flexibility, and prevents them from losing large quantities of revenue. This will mean that they will
ot become uncompetitive and potentially leave the nation.
● Hard to put a value on the effect of pollution and to quantify . It is also difficult to identify which firms are
polluting and to what extent the firms are causing the pollution.
● Firms may simply ignore the tax and continue polluting due to low price elasticity of demand.
● Cost of measuring the pollution
Legislation and regulation: Laws and regulations may be enacted which will decrease the spillover costs. Thus, this
will move the MSC closer to the MPC in an effort to reduce the production of negative externalities. However, a
government may also implemented measures to charge firms more heavily,, shifting MPC closer to MSC. ideally they
will want MSC=MPC.
● Simple and implemented easily. The technical difficulties in enforcing a tax, and deciding the cost of a tax
make it more practical to involve regulations.
● Forces firms to comply.
● Do not allow externality to be internalized, creating no market incentive to further reduce their level of
pollution upon the legislated amount. Unable to make distinctions between firms that have higher costs of
pollution and lower costs of pollution.
● Economic hardship for firms who cannot immediately comply with the regulation. Might severely reduce
competitiveness/revenues earned.
● Hard to set up and police the regulations which would have been put up. Black markets may arise.
Negative consumption externalities: (negative change in demand)
External costs can occur on the consumption, where a person’s use of a product
affect other adversely. The benefit of a certain good that is enjoyed by a consumer is
greater than society’s benefit. This is because that although the consumer may enjoy
consumption, others will have to pay some of the costs of consumption, meaning MSB
is less. (Cigarettes. )
If the market were able to incorporate all the associated costs with the consumption
of this good, it would demand fewer of the item, and also value them less. The
welfare loss is that of the MSB and the MSC.Anything produced past Q has a
MSC>MSB, resulting in a welfare loss. THIs is the amount of output that is
overproduced relative to the social optimum.
Potential solutions:
Legislation: Government can ban the consumption of goods with high spillover costs to society. (E.G: ban on harmful
drugs). Shifts MPB towards the MSB, reduces the size of the externality
● (given above)
Taxation: In order to internalize the externality, governments may tax the good. A tax would increase the MPC, and
shift it to the left, thus reducing consumption, and bringing the point of production
closer to the optimum level of production at Q2. leads to greater allocative
efficiency, as it reduces the welfare loss.
● Internalizes externality. Creates incentive for consumers to change
their consumption, as they are directly facing the cost.
● Produces government revenue which can be spent on advertising
campaigns.
● Inelastic demand of cigarettes tend to mean that taxes do not
manage to reduce quantity demanded by a lot, and so a heavy tax
will need to be applied, will not be politically favorable.
● Some people may consider cigarettes, necessities, unable to forego them, and thus simply lower their
standard of living.
● May lead to black markets/strengthening of crime
Advertising and persuasion: Governments can persuade consumers to change their behavior. This can be done through
advertising the negative effects of the consumption of the good. This will result in a shift in the MPB, as consumers will
find the good less desirable than before. The price decreases, as does quantity consumed, with less influence than a
specific tax.
● Simpler, and less difficult to assess extent of damage.
● Less resentment towards the government/does not affect living standard/state of businesses.
● Cost of government advertising campaigns, meaning there are less funds available for use elsewhere.
● May not have much effect, as some teenagers still continue to smoke despite knowing the dangers.
The MSC, which is the true cost to society, is lower at every point than the
private cost being experienced by the firm. This suggests, that total utility
will be maximised to society as a whole if the good is produced at point
Q1, and at the current state, the market is inefficiently allocating
resources. society would enjoy the extra benefit of production. This can
be seen through the pink triangle, which is the potential welfare gain.
Potential solutions:
● Subsidies: The government can actively encourage extra production
through providing a small payment to a firm. This will shift the MPC,
downward, lowering the price, allowing for more consumers to enjoy the
production, and resulting in an equilibrium price that will be closer to the optimal point.
● Direct government provision: Governments often engage in research and development for new technology,
(medicine). The government can also directly provide training for workers, thus resulting in the MPC shifting
downwards as more goods are being produced for every cost.
Left alone, the market will produce Q. However the optimum point is at Q1. If
society’s true value for the good was included, the price would be higher than
it is. As such, it demonstrates that society would gain considerably by
providing more of this good as by producing at this new price, they will have
reached a point where they would have maximised utility. The amount of
potential welfare gain is the pink triangle, and it illustrates the loss of social
benefit due to this underproduction.
Merit goods: goods that are held to be desirable for consumers, but which are underprovided by the market. May be
underprovided due to consumer ignorance, positive externalities and low levels of income and poverty.
Potential solutions:
● Subsidies: Governments could provide money to the firm, and thus it will shift the MSC downwards, thus making
the new price closer to the socially efficient level of the good.
○ However, there might be problems related to the cost of such a move. Some developing nations will not
have the money necessary. Difficulty in analysing size of externality .
○ Susceptible to political pressure, as different groups will compete to receive benefits.
● Use of positive advertising, which will shift the MPB curve to the right and thus closer to the MSB.
○ High cost to advertising for something which may not necessarily work. (e.g: in cases within developed
countries where people simply lack the resources to put their children through schooling)
○ In addition to this , the effect may only be effective in the long run, and the benefits will be minimal in
the short run.
● Direct government provision: (public health) Increases MPC/MSC/Supply, shifting it outward.
○ Involve the use of government funds. Choices must be made on which goods to provide
○ Difficulty in analysing size of externality
○ Susceptible to political pressure, as different groups will compete to receive benefits.
Public goods:
Public good: goods which are non rivalrous and non excludable in nature. E.G: National defence
Non-Rivalrous: Consumption of good does not prevent others from enjoying it
Non-Excludable: Producer cannot prevent particular individuals from enjoying
The fact that these goods are non-excludable means that no-profit maximising firm will be able to benefit form
producing a good they cannot sell at some price. This failure to produce this good results in a market failure as no
resources are allocated to produce this good.
Free rider problem: When people can enjoy the use of a good without paying for it. (non-excludability)
Solutions
- Direct provision of the good: The government will have to directly finance the production of the goods the
private market will be unable to produce.
The nature and the inability to charge for them may encourage overuse/over-consumption, which will eventually lead to
depletion of the resources. For example, it is in the interest of fishermen to take as many fish as they want, as every
extra fish will add marginal utility for the individual. Hence, people continue to fish as the benefits to the individual
outweigh the external cost to the whole group.
Sustainability: Fulfilling the needs of those in the present without reducing the ability to meet the needs of
future generations.
Solutions:
- Clean technologies: Use of renewable resources such as solar power , wind power etc. can be used to help
encourage sustainable development. Government can encourage this through subsidising research into this
technology, or provide a subsidy to a firm if they utilize clean technology.
- Cap and trade, regulation and taxation (mentioned above)
A problem facing the enforcement of these sort of regulations is the lack of cooperation, as laws may be different from
place to place.
Macroeconomics
Economic activity:
Households: Consumers
- Owners of land, labour, capital and entrepreneurship. Firms repay them through wages, rent and interests.
Firms
- Buys factors of production and uses them to produce goods and service. Households repay them through
household expenditure (consumer spending)
The circular flow of income shows that in any given time period:
the value of output produced in an economy= total income needed to produce that output= expenditure made on
purchasing output
Leakage>Injection
- Fewer goods are purchased, firms cut back on their output/buy fewer factors of production, unemployment
increases, and household income is decreased.
injection>Leakage
- Size of the circular flow increases. Consumers demand more goods and service, firms begin to produce more,
demanding more factors of production, unemployment decreases and household income increases.
GDP/GNP
Gross domestic product: The market value of all final goods and services produced in a country over a time period. (This
means that it includes foreign firms producing in a domestic firm)
As the circular flow of income implies expenditure=income=output, the GDP can be measured in the following three
ways:
Expenditure method.
Method counts the total spending on final goods and services within a given year.
- Final refers to goods and services that are ready for final use, and be contrasted with intermediate goods and
services.
GDP= consumption (all purchases by households) + Investment (Spending by firms on capital goods/ spending on new
construction) + Government spending + net export (exports- Imports)
Income approach:
If all spending on goods and services within a market must be income to firms and individuals receiving payment, it is
possible to arrive at an accurate GDP by counting the income received by individuals within a certain year. It measures
the returns for the factors of production, which means wages, interest, rent, payment as well as business taxes (as it
represents production) and fixed capital consumption
Output approach:
Government measures the value added at every level of production, thus using it to see how much the goods and
services produced within a country is worth. Only value added is counted to avoid double counting.
GNI : total income received by the residents of the country/value of all final goods and services produced by the factors of
production supplied by the country’s residents.
- Measure the flow of income based on actual ownership of productions. This means that it will
include domestic firms production abroad, and not include foreign firms producing domestically.
GNI= GDP + net property income from abroad
Real GDP : nominal GDP adjusted to remove the influence of changes in price.
Nominal GDP: GDP at current price levels.
Per capita GDP: reflects productivity of a certain country. GDP per population. Is useful as a measure of standard of
living, as it provides an indication of how much of total output can be attributed to one person.
Why measures of the value of output cannot accurately measure standards of living
● Negative social behaviors and transactions are added to the GDP. (Composition of the output is a mystery). No
distinctions about how much they actually contribute to the standard of living.
● Cannot reflect achievement in levels of education, health and life expectancy: These contribute massively to an
improved quality of life, which can be brought on by technological improvements.
● No information about income distribution: High GDP may be simply in the hands of a few.
Green GDP: Seeks to estimate a country’s aggregate output while also factoring in any output losses created by
environmental harm. However it is difficult as this harm is hard to quantify.
Business Cycle:
The trend line shows how in the long term , economy is growing.
This is because of an increase in population and an improvement in
technology.
Aggregate demand:
Total demand/output for a particular nation’s goods and services at a range of price levels at a particular period of time.
. (THe same as the GDP)
● Consumption: Measures all spending by domestic households on goods and services during a particular period
of time.
● Investment: Measures the total spending by firms on capital equipment as well as labour. The level of
investment in a nation is a function of the national output.
● Government spending (G): Government spending on goods and services. (transfer paying such as state pensions
and job seekers allowance are not included, as they are not a payment to a factor of production for any output
produced, these simply increase consumption, NOT FACTORS OF PRODUCTION. .)
● Net export (X-M): The total income earned from the sale of exports to foreigners minus the total amount spent
by a nation’s households on goods and services from other countries. Trade deficit and trade surplus can be
seen through this.
As AD increases,there is an injection into the flow of income, thus resulting in a rise
Investment:
- Interest rates: If interest rates rise, firms will be less willing to consume
- Business confidence: How confident firms are about their future sales. They will spend more.
- Technology: When new technology arises, firms will spend more on new technology.
- Degree of business tax: A high business tax means firms will have less incentive to spend on consuming goods.
- Corporate indebtedness:
Government spending
- Depends on the government’s fiscal policies, (the use of taxes and spending to stimulate or contract the level of
AD), and the government’s political/economic priorities
Net export:
- Incomes abroad: If a major trading partner’s incomes fall, then exports will also fall for that country.
- Exchange rates: lower exchange rate will mean people are more willing and able to consume the good
- Protectionism: If a country has a very protectionist approach, such as trade barriers, then most likely, there will
be less exports.
Aggregate supply:
Total amount of goods and services that all the firms in all the industries in a country will produce at every price level
in a given period of time.
Short run: All input prices are fixed (all costs of production are fixed)
Long run: Factors of production are all flexible
2. Indirect taxes/subsidies: Taxes will move to the left, subsidies will move it to right.
3. Supply shock: A change which suddenly disrupts the supply of a good. Unfavorable weather or war will result in
supply curve shifting left.
-Shifts in either AD or AS will change the level of output, and thus, affect the economy.
- When Aggregate supply shifts inwards, it will lead to a situation where output decreases (real GDP) and prices rise.
This is known as stagflation, and is a term coined in the 1970s to describe the oil price increase by OPEC.
- Aggregate demand will affect the output of the economy, and the general price level experienced.
- As the definition of long run incorporates a chance in price, wages will change constantly to match output price.
As price level rises or falls, firms’ profits remain the same, so they no longer have any incentive to
increase/decrease output.
- As AD shifts outwards , when firms profits increase, firms therefore increase quantity of output produced by
moving upwards along the SRAS curve.
- In order to produce this, firms have to hire more workers/capital. This increases scarcity, and results in
the rise of wages/rent etc. This results in the shift of the SRAS curve inwards, and the firm is back at the
original point.
- As AD falls from AD2 to AD3, initially, we will see a decrease in output as Aggregate demand shrinks. Firms
therefore cut back on labour and wages/payments for other factors of production.
- Due to unemployment, and a decrease in the wages of workers , the supply curve thus shifts outwards
as it becomes easier for firms to hire and workers become willing to accept lower wages. This returns
output to the maximum amount.
This is based on the assumption of wage and price flexibility in the long run. Ultimately only price level is affected.
Keynesian model
The monetarist model depends on wage flexibility, which Keynes argued
against. He described the concept of downward wage rigidity which arises
from :
- Labour contracts fix wage rates for certain periods of time
- Minimum wage legislation
- Worker and labour unions resist wage cuts.
Because of this, firms will avoid lowering prices because that would reduce
their profits. The inability for wages to change means supply does not shift,
This inflexibility in both wages and price is represented by the horizontal
section of the the AS curve. This implies the economy can be stuck in a
deflationary gap for quite a while.
- On the other hand, when demand rises from AD1 to AD1, the price levels do not increase by a large amount, as
there is a large extent of spare capacity for the firm. Firms can easily produce more without affecting their
production costs, thus meaning that they do not really need to raise prices.
After this, there is an inflexible part of this curve. This demonstrates how an increase in output produced will lead to a
large increase in price level. A bottleneck appears, and there is no longer spare capacity. Wages and prices within the
economy rises, and firms will have to increase price in order to maintain their profit margins.
- The completely vertical point of the curve comes when all labour and resources are used. Real GDP cannot
increase because firms are using the maximum amount of labour, and can only pass on the excess demand as an
added cost.
Equilibrium output occurs at any point there is an intersection between LRAS and LRAD.
Keynesians model the short run analysis, when costs are unable to change, and aggregate demand is too low to buy
enough output to reach the potential output. This increase in AD may not be inflationary.
1. Increase in quantities of factors of production: if the quantity of a factor of production increases, the LRAS and
Keynesian curve increases. The economy is now able to produce more real GDP.
2. Improvement in the quality of factors: Improvements in resource quantity shifts the LRAS and AS curves to the
right. (greater level of health, education etc.)
3. Improvement in technology: an improvement in technology of production means that the factors of
productions can be used more efficiently, and more output can be produced with the given resources available
in the economy (fertilizer) .
4. Institutional changes: Altering the degree of public/private ownership, the degree of government regulation,
competition, bureaucracy etc. can affect the way /efficiency of resources used within an economy.
Long term growth: increases in output brought on by a rise in potential output (LRAS)
Short run growth: increases in AD or SRAS which bring about rise in output
Unemployment
An unemployed person is someone who is of working age who is actively looking for a job but who isn’t employed.
Unemployment and underemployment means that the economy is wasting scarce resources by not using them fully. (in
underemployment, some resources which were used for training and education are wasted when people are forced to
work at a job that does not make use of their skills)
Unemployment rate can be calculated through:
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
× 100
𝐿𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒
It can be said to be used to measure the wellbeing of workers in a nation.
Unemployment rate’s limitations (factors which make the unemployment rate an inaccurate measure) :
So called hidden unemployment can exist within an economy, and make it more difficult for economists to measure this
value.
- Hidden Unemployment for individuals who are out of job but have given up the search for work. This
undermines a serious problem, and may mean in the long term, what may appear to be a decrease in
unemployment may just be a discouraged workforce.
- Another form of hidden unemployment refers to those working in the underground economy/informal
sector.
- Underemployment: the label ‘ employed’ does not take into account the number of hours or the level of
income one earns. Part time workers who would like to be full time are considered employed, despite how
they feel they are underemployed, and are barely able to make ends , or are unable to fully fulfill their potential.
- Some people may be overqualified for certain jobs, and their dissatisfaction with their job is not
reflected, nor is the loss of potential output.
- Difficulty in measuring unemployment amongst different social groups: certain regions, genders, ethnic groups
or ages may suffer greater than others.
Consequence of unemployment:
Economic costs
○ Loss of real GDP: since fewer people work than are available to work, the amount of output produced is lower.
The country is producing within it’s ppc curve, and it is not being productive with it’s resources.
○ Loss of income for unemployed people: people who are unemployed do not have an income from work, and
they will be worse off financially, weakening demand further, and meaning they will suffer from a lower
standard of living.
○ Loss of tax revenue and increased cost for unemployment benefits, forcing a budget deficit and resulting in a
opportunity cost
○ Unequal distribution of income: since certain groups may be harder hit than others, the effect of income
inequality and poverty tends to be concentrated amongst groups which are already disadvantaged to begin
with. This may lead to social tensions and unrest.
○ Unemployed people may have difficulty finding work in the future due to the loss of skills, even in economically
favorable times.
Personal costs:
○ Decreased household income/purchasing power. Inability to sustain standard of living
○ Stress/psychological illnesses, and demotivation. May result in the breakdown of family, family
tensions and a lower self esteem.
Social costs:
○ Increased poverty and crime/Homelessness
Types of unemployment
Frictional unemployment: People who are in between jobs or have just entered employment and do not have a job.
Seasonal unemployment: people who are unemployed due to the fact that their job depends on the seasons, and so are
unemployed otherwise .
a. If workers cannot be matched to the firms who demand jobs very quickly, frictional unemployment
would last. Due to incomplete information and logistical errors, it becomes difficult for this to take
place. Can be corrected via improved information flow.
Structural unemployment: When a worker loses his job due to the changing structure of the nation’s economy, the
individual becomes structurally unemployed. For example, when a developing country moves from an agricultural base
to a manufacturing base. ( When oil demand falls in the 1980s, or
the automation of the car industry in the US during Obama’s
administration)
b. Change in demand for particular labour skills: This
can be due to new technology which make a
certain job redundant, or the fact that a certain
industry within the economy might be declining.
Change in consumer tastes may also contribute to
this. This leads to a mismatch between the labour
skills demanded and supplied by workers.
c. Changes in the geographical location of jobs:
When a large firm or industry moves from one
region to another, there is a resulting fall in
demand. This results in a mismatch
Structural unemployment is a serious type of unemployment because it tends to be long term. Governments can include
measures to encourage workers to retrain or obtain new skills etc.
Natural rate of unemployment:
Structural, seasonal and frictional employment that is considered ‘natural’ and an unavoidable part of the economy.
Unemployment that exists when the economy is still producing at maximum capacity. Thus a shift in the LRAS is due to a
decrease in these factors.
- Recessionary gap: Natural rate<Unemployment
- Inflationary gap: unemployment<natural rate.
Inflation
Inflation: The persistent increase in the average price level of goods and services in a nation over a minimum of two
quarters.
Deflation: Decrease in the general price level over time.
Disinflation: Decrease in the rate of inflation.
Food and oil is not part of the CPI due to their price volatility. This is done through considering the core cpi which does
not include this.
Producer price index: A basket of goods made up primarily of intermediate products such as capital, raw materials and
energy. Increase in PPI will affect AS, and the costs of production of firms.
Consequences of inflation
Disadvantages:
- Greater uncertainty: inability to predict what inflation will be in the future mean people will be less inclined to
make economic decisions. Firms cannot make future plans about cost and revenue due to uncertainty, and be
unwilling to invest. This could negatively affect AD
- Reduced purchasing power: For individuals whose income does not rise, there is a loss in purchasing
power/standard of living due to a decreased real value. Especially hurting fixed income earners.
- Reduction of competitiveness: High inflation means goods are less attractive to foreigners due to their
comparatively higher price. Will negatively affect AD within an economy.
- Savers and Lenders hurt: Higher rates of inflation will hurt people who will save money, due to a decrease real
value in savings, and also hurt lenders due to interest rate being lower in real terms.
- Fiscal drag: individuals who demand a higher income may find themselves dragged into a higher tax bracket,
thus meaning they lose out more.
- The inflationary spiral:
1. When demand pull inflation occurs, the economy produces beyond it’s full level of employment.
2. The expectation of high demand means workers demand higher wages in order to offset the decline in
real wages caused by higher prices. (Known as inflation expectations)
3. This results in an increasing scarcity in factors of production, which will lead to cost push inflation.
4. This inflation means an increase in spending, due to a decreased value in interest rate, and a reduction
in the value of previous debt accumulated, leading to more demand pull inflation.
Benefits:
- Provides greater working incentive: while the increase in wages less than inflation rate might not actually mean
an increase in real income, this provides a greater incentive for workers to work harder.
- Benefits firms: Firms can increase wages at a value where it is still lower than the inflation rate. This will allow
them to save money, investing it in other areas to promote growth or to help it survive if future recessions
occur.
- Promotes stable levels of consumption: By having a continually stable rate of inflation, consumers are
incentivised to keep on spending due to decreased interest rate and the expectation of high price. This will help
generate growth, create income etc.
Types of inflation:
- Demand pull inflation:
An increase in demand will lead to an increase in the nation’s price level. An excess of aggregate demand over
aggregate supply at the full employment level of output. Caused by an increase in aggregate demand.
- The degree to which inflation increases price depends on the point on the SRAS. If it is near full levels of
employment, an increase in demand will simply push prices up,
- However, if the economy is in a recession, an increase in aggregate demand will result in a relatively small
increase in price level.
- Policy makers need to be aware of the point in the economy at which it is currently producing, which means
that if it is a recession, a increase in aggregate demand will be highly beneficial.
Deflation:
(in japan from 1999 to 2006)
Supply side deflation: Occurs when aggregate supply shifts outwards, and the economy has become more productive.
This increases employment, output and the real income of households.
● Can arise from a rightward shift in the LRAS, so that the new equilibrium occurs at a lower price level.
● This is ‘good’ deflation as it is associated with economic expansion, rising income and output and growth.
Consequences:
● Redistribution effect: opposite of inflation.
● Deflationary spiral:
1. Consumers postpone making purchases as they expect prices to fall.
2. The real value of interest rate increase, and the real size of debt increases. This further disincentivizes
spending.
3. Firms receive less revenue, and lay off workers.
4. Consumption decreases.
● Bankruptcy: as the real value of debt increases, individuals cannot pay back banks. This leads to large financial
institutions going bankrupt, and causing a financial crisis.
However, in the long run, an increase in GDP is achieved when the nation’s full employment level of output increases
(when LRAS shifts outwards as a result in an improvement in the quality/quantity
of resources) .
Without an increase in AS, the economy's ability to grow is restrained to the full-
employment level by it’s limited supply of land, labour and capital. A nation’s
LRAS, reflects its production possibilities given its existing stock of resources.
Income inequality:
Due to the inequality in the ownership and the cost of the factors of production, income inequality eixsts between
different parties. Others who possess little education, and skills which aren’t economically productive will recieve less.
Transfer payments: receiving income or funds without any provision of good/services or ‘work’ . Government payments
to vulnerable groups within society to help with income distribution.
- Old age pensions, child allowances, unemployment benefits.
Governments often provide goods directly, or subsidise a variety of socially desirable goods and services. This is
because it is underprovided by the market, or too costly, as governments must ensure this is accessible to the lower
class as they are considered basic human rights. (free primary school care, and the NHS within the UK)
Class of taxations
- Proportional tax: tax for which the percentage remains constant as income increases. The rich will pay more
tax than the poor in absolute terms, but the burden of the tax is equal.
-
- Regressive tax: Tax for which a larger burden is placed on lower income households. Indirect taxes are
considered regressive tax, because both parties pay the same amount in absolute terms, and due to the lower
income of those with low income, this is a greater percentage.
- Progressive tax: tax for which percentage increases as income increases
- Most income/direct tax
2. Increasing transfer payments: a payment made or income received in which no good or services are being paid for.
- Poor benefit significantly: Increase standard of living. Including universal benefit (transfer payments) and means
tested benefit (benefit which will be taken away once someone exits poverty)
- Increased risk of poverty trap: Low incentive to leave poverty, as they no longer have access to employment
benefits. Greater strain on public fund.
3. Legislation:
- Anti-discrimination, hiring/firing mechanisms: Reduce the unequal distribution of income, making it more
difficult for firms to lay off labourers.
- Reduces negative externality: This form of government intervention can be used to correct misallocation of
resources or loss of social surpluses.
- Costly to businesses: Firms may shut down due to high cost, increasing unemployment. Firms may also leave to
different nations.
- Cost of enforcing
4. Government spending/training
- Reduces poverty
- Increase productivity of the economy in the long run: Labourer becomes more skilled, shifting LRAS outwards,
allowing higher wages/higher standard of living. Tackles the root cause of poverty.
- Extremely expensive
- Long time to take an effect
The Lorentz curve
Graphical representation of a country’s income distribution, where the x axis
represents the percentage of the population which owns a certain percentage of the
total income within a nation.
The gini coefficient: The ratio of (A/A+B) is known as the Gini coefficient. Gini index
is this value multiplied by 100. The lower the gini coefficient, the lower the
inequality.
Absolute poverty: percentage of a population that falls below a defined ‘poverty line’ \
Relative poverty: poverty defined through the comparison to a median income within a society.
Causes of poverty:
- Low incomes
- Unemployment: without a steady source of income individuals are more likely to become poor, as
unemployment benefits are usually smaller in comparison.
- Lack of human capital: low levels of education and skills translate into low incomes due to the positive
correlation between education and income. Firms are unwilling to provide a high amount of wage for low levels
of capital.
Consequences of poverty:
- Low living standards: low living standards stemming from the inability to purchase goods and services due to
low wage
- Lack of access to health care/education: low income mean inability to improve human capital. This leads to
perpetually low human capital, productivity and incomes.
Economic policies
Government revenue is derived from taxation and the sale of government owned resources.
Government expenditure:
- Current expenditure: government spending on day-to-day items that are recurring. (goods that are used
/consumed). Medical, education supplies etc.
- Capital expenditure: Public investment on the introduction of physical capital.
Government budget
Government expenditure> Tax revenue= Deficit
Revenue> expenditure= Surplus
Fiscal policy: Government manipulation of taxes and expenditures with the goal of increasing or decreasing the level
of aggregate demand in an economy.
Automatic fiscal policies
Automatic ‘ built in’ functions of the economy which help reduce the severity of a recession or boom.
Economic Growth:
- Government spending on social protection, personal social services and health will naturally decrease due to
how fewer people will be collecting benefits went economic growth is high
- Tax revenues will also increase as a result with higher income and expenditure. The more progressive the
greater this effect.
- Less government spending and more tax automatically decreases aggregate demand, offsetting inflationary
pressures.
Recession
- Government spending on social protection, personal social services and health will naturally increase with
more people collecting benefits
- Tax revenues (both personal and firms) will decrease as a result of lower income and lower profits, reducing the
severity of the recession. The more progressive the greater this effect.
- More government spending and less tax which slightly increases aggregate demand, offsetting demand
deficiency.
Both of these reduces the extent of inflation/recession, and slows down these processes.
- Such a move can also impact aggregate supply. There will be an increased incentive for firms to invest in R and
D, and purchases capital goods, which will shift LRAS. This can be further stimulated by a decrease in tax rates,
which will make investing attractive.
Direct stimulus
There can also be a direct effect on LRAS through fiscal policy.
- Government spending on infrastructure as well as on research can improve technology, and the capital available
within a nation.
- Government spending on human capital can also be used to help boost the productivity of the work force.
Deals with inflation and low economic activity, and can help bring outback to full employment.
Crowding out
- When a government runs a budget deficit when it
attempts to stimulate an economy and reduce
unemployment, the problem of ‘ crowding out’ arises.
- To run a budget deficit, the government has to borrow
money, which is achieved through selling government
bonds such as treasury bonds or bills. (loans from banks to
the government)
- This results in an increase in demand for loans from
banks, meaning that less are left for consumers, which
pushes up interest rates.
Higher interest rates reduces incentive for corporations and individuals to invest. As such, when an injection is made,
even though public spending increases, private spending also decreases, meaning that the total rise in aggregate
demand does not largely increase.
Neoclassical economists argue that crowding-out ultimately will offset the expansionary effects of a tax cut, combined
with an increase in government spending. However, during 2008-2009, due to the extremely large reserve of loanable
funds due to the low confidence of consumers, where supply of loanable funds rapidly increased (uncertain
consumers) and consumer demand for loans was incredibly low.
Time lags:
- The time taken for policies to be recognized (which can take months or years) mean that the economy might
already out of recession by the time such policies take effect.
Political influence:
- Governments may offer fiscal policy simply based on maintaining a higher votership, which may not in fact make
sense economically. Unsuitable tax policies may be enacted which include an increase in government
spending and a decrease in tax , even at the point of full employment.
- President’s bush fiscal stimulus package was enacted during a recession including a very high tax rebate. This
lack of government spending pushed the economy greater into recession .
Monetary policy:
Central bank: Government institutions which are free from political interference, which controls the supply of money
within an economy, acting as the government’s bankers
- Banker to government:
- Holds the government’s cash and makes payments for them
- Manages government borrowing, sells bonds to commercial banks and the public
- Regulator of commercial banks
- Holds deposits and makes loans in times of needs to banks.
- Lender of last resort.
Interest rate: Percentage charged to consumers when loans are made. The price
of money.
- As interest rate falls, demand for goods decrease. This demand depends on the
desire for parties within an economy to buy essential goods and services (consumption
and investment) . Decreases due to higher associated cost, resulting in AD shifting left.
- Supply for money is a fixed line determined by the central bank. It is not
affected by changes in interest rate.
Monetary policy; Using interest rate to change the demand within an economy.
Contractionary and expansionary monetary policy refers to policy which reduces and increases aggregate demand
respectively. Change in money supply followed by shift in AD. ‘
Like other forms of fiscal policy: How much this will actually affect price levels depends on the point at which demand
is increasing along the SRAS CURVE.
Inflation targeting
Many countries will aim for a certain rate of inflation. They will do this through the manipulation of the interest rates,
rather than focusing on the maintenance of both high employment and low inflation.
- Time lags: However, despite the quick implementation, there are still delays related to the elasticity of demand
for investment, and may take a while for individuals to change their consumption habits. Lag until problem
takes effect.
- Investors reluctant to borrow: During a time of deep recession, consumer and investor confidence is at a low
point. This means that even with low interest rates, individuals and firms do not spend as they doubt their
ability to pay back loans. Banks may also fear that consumers will not pay back, and so are unwilling to give out
money. (happened in great depression of the 1930s)
- Inability to due with supply side instability/stagflation (mentioned earlier on)
Inflation control:
The spread of inflation during the 1970s meant that because of the unpopularity of tax increases, reducing inflation
would be in the hands of the central bank, which would be controlled via interest rates. Maintaining a low level of
inflation ( a target inflatioN) over full employment.
Supply side policies
Aims at positively affecting the production side of an economy by improving the quantity or quality of the factors of
production. (shifting LRAS)
Both types of supply side policy aim at shifting supply curve to the right, achieving growth in potential output.
Encouraging competition
Greater competition forces firms to reduce cost, contributing to greater efficiency in production and improving the
allocation of resources as well as the quality/quantity of the good/service. This improves the productivity of pre-existing
equipment, shifting LRAS to the right.
- Deregulation: Regulations can act as a disincentive for firms to hire workers. A reduction in the number and
severity of the regulations will help increase the aggregate supply. Reduction in the red-tape firms need to face,
as well as any government control on taxes/prices.
- Trade liberalisation: freer trade will increase competition between firms, and also allow the market to become
more efficient, allow for greater allocative efficiency. This will result in greater incentive to invest and compete,
and also allow greater profits.
- Privatisation: transfer of firms from public to private hands. Results in a larger emphasis on earning profits,
improving management and operation, thus giving a greater incentive to produce efficiently, and produce
goods of higher quality without bureaucracy . (Britain and UK in the 1980s).
Increases flexibility of wages, so it can go back to the equilibrium level and producing at full level as fast as possible.
Lowering business tax: Affect AD and AS (increase through investment spending) . Firms have greater resources to
pursue R and D, improving quality etc. Will also promote research and development. The fact that corporations keep a
larger portion of profits mean that they will have more incentive to produce efficiently.
Reduced welfare benefit: increases incentive of workers to remain employed, and thus, contribute to the economy
rather than remaining unemployed and relying on the government.
Strengths:
- Reduces inflationary pressure, causes the shift of aggregate supply and allows for greater production. This
means that it can deal with inflationary pressure
- Low cost to government: Low government spending needs to be made to change regulation/legislation within
an economy, and does not burden the government budget.
- Raises efficiency and productivity: will allow producers to produce at more allocatively efficient levels, and
forces them to keep costs low and to produce efficiently. Workers are also incentivised to become more
productive, and thus, efficiency is maximised in the long term. Lower prices, and more choice.
- May attract more FDI, leading to growth
.
Limitations:
- Conflict with equity:
- Unemployment may result due to the firm’s desire to become more efficient. Increases in job
insecurity, a progressive tax system, as well as a reduction in welfare mean those living in poverty will
have a lower standard of living
- Under-provision of infrascture:
- Labour may be exploited to inhumane conditions due to the lack of government regulation, and may be
forced to live a harsh lifestyle to meet ends meet.
- Changing hands from public to private hands may simply mean that because these firms have
monopoly power, they will not feel the need to change the quality of goods. This may mean that the
cost of the product increases beyond what is affordable, damaging and harming lower income groups.
- Negative externalities:
- Environmental and social problems arising from deregulations: Increased in wage gap and worker
exploitation in the name of firm efficiency. Pollution, dangerous workplace and unsafe products.
- Time lag: Will take several years to take effect
Industrial policies:
Government policies designed to support the growth of the industrial sector of an economy
- Providing subsidies, tax exemption or business guidance for small and medium sized firms. May also include
business advice. Allows for efficiency, capital formation and more employmen tpossibilties
- Support for ‘Infant industries’ using the above methods which can be used to stimulate regional growth
Limitations:
- High costs of re-training (could be argued that the training programs do not match the actual demand within
the economy), and corresponding opportunity cost. Extremely high costs when building infrastructure, which
can be subject to corruption and large amount of waste (three gorges dam)
- Time lags: will often take a long time before the actual effect of an overhaul in supply can be felt (especially
training), in which within that time, the economy may have already recovered.
- Entrenched corporate interests. Where industries go complacent or uncompetitive due to government
protectionist policies, draw resources away from competitive parts of the economy, and does not produce high
quality products, meaning they might become over reliant and a burden. Government may choose the wrong
sector to support. Promotes inefficiency.
- Corruption
- Inefficiency may also arise from too much bureaucracy
Most economists believe that interventionist and market-based policies should complement each other, and a mix of
policies should be used according to a country’s economic and social conditions. It is unlikely that any policy can yield
positive results without some negative consequences. It also depends on the state of the country, and whether or not
it’s developing or developed.
International trade
Buying and selling of goods and services across country borders: International trade
- Imports: Buying of goods from sellers outside the coutry
- Exports: selling goods and services to buyers outside the country
Before tariff, the country accepted the world’s supply at Pw. At this
price, domestic suppliers produce Q1, and because demand is at Q4,
the remaining demand is filled with foreign imports. (Q1 to Q4).
The price of other country’s rise by the amount of the tariff. There is a
increase in the quantity supplied by domestic producers (Q2) ,
decrease in quantity supplied by the foreign producer, along with
total quantity demanded.
Consumers: worse off due to higher price, and can only buy a smaller quantity.
- Is a form of regressive tax and it burdens low income earners
- Loss of consumer surplus (f) as the wheat is not purchased, which would have previously been available.
Domestic producers/employment: better off as they receive a higher price and can sell larger quantities, resulting in
decrease in unemployment within nation due to the increase in output.
Government: gains tariff revenue. As consumers have to pay this added price onto the goods, this money is transferred
from the tax to government hands.
Increases inefficiency: increase in domestic output results in production by comparatively inefficient domestic firms,
where there is a wastage of resources (indicated by the supply of the country being lower than that of the world) as
foreigners are able to produce the same good at a lower cost.
- This is a global misallocation of resources, and this results in a global welfare loss which is caused by
inefficient production (d) and a decrease consumption of a particular good (f)
Quota
- Enforcing a limit to the quantity of a good that can be imported over a
particular time.
The government limits the amount of the good that can be imported to
Q3, Q2.
- This shifts the supply of the good from Sd to Sdq, while the world supply
curve becomes irrelevant. This is the total amount of the good within
society. The new equilibrium is formed.
- The government distributes licences to governments of exporting
countries, which means exporting countries can buy the good at price
pw, and then sell at Pq, allowing for a gain in revenue for them.
-Domestic consumers hurt
-Domestic producers/laborers better off
- Domestic income distribution becomes worse
-exporting country may be worse off.
- Global inefficiency: decrease in consumption and the shift of production
towards inefficient domestic firms creates a misallocation of resources.
Subsidy
- Can be split into production subsidy (subsidy to compete with
imports) and export subsidy (subsidy to compete with foreign
domestic products.
- The implementation of the subsidy increases the ability of
domestic producers to produce more at every given price, shifting
the supply downwards, forming a new intersection.
Administrative barriers
Governments can employ various obstacles to trade in form of legislation. Includes inspections, valuation and a high
level of bureaucracy. Also involves the enforcement of safety regulations.
Protectionism
When countries try to protect some industries from unpredictability and the threat of foreign competition.
Questionable arguments
- Government revenue: Custom duties can provide a source of money for governments, which can be spent on
infrastructure or funding economic objectives.
- Problem may lie with inefficient tax system, which might have an impact on income distribution.
Affects allocative efficiency.
- Balance of payments deficit: can be used to overcome BOT. Could result in trade retaliation, worsening the
problem. Only works in the short term, does not deal with the actual problem of the deficit.
- To prevent the dumping of foreign goods: when one country exports at a price below the cost of production.
This means that exporters are attempting to steal away domestic consumers, eventually raising the price when
domestic firms go out of business. Thus, it is justifiable in these situations to protect domestic industries.
- To protect domestic employment: They will keep local jobs safe from foreign competition. By having to produce
greater output, unemployment falls.
- However, this means that unemployment increases in the foreign country. Retaliation may occur,
causing damage domestically. Macroeconomic policies can be considered instead .
The case against Protectionism
Misallocation of resources: Countries that protect declining industries compel their consumers to pay higher prices
than is normally needed. This draws income to inefficient producers, which draw more workers and capital. Resources
are spent on a politically connected firm rather than an efficient firm.
Dangers of retaliation/Trade war: Trade can grind to a halt and economic growth can decrease as a result of two
countries establishing extremely strict regulations to each other.
Potential for corruption : Higher tariffs mean more revenue for certain producers, which creates a very high incentive to
bribe lawmakers.
Increased cost of production: Protected firms may soon realise that their revenue comes from being protected, and
spend more energy in persuading the public of this. They have less of an incentive to modernize/innovate or to lower
their prices. Consumers face higher cost due to this complacency, (inefficiency) harming the ability of domestic firms
to produce (reducing potential output) while also lowering standard of living for consumers and decreasing choice.
Exchange rates
Floating exchange rates: where the value of a currency is determined by the demand and supply for currency on the
foreign exchange market.
Therefore, in a market those demanding AUD are those who have $US
and want $A. (those who own a foreign currency and want the
domestic currency)
- This will decrease/increase depending on the amount
of good or service a foreign country is demanding from
Australia.
Those supplying AUD are those who own the domestic currency and
want the foreign currency (in order to obtain US dollars, they will have
to exchange AUS, thus increasing the supply on the foreign exchange
market) .
- This will decrease/increase depending on the amount of foreign good Australians are demanding
Factors affecting exchange rate
- Demand for goods and service/FDI: as demand for a country’s exports increase, there is an increase in the
demand for a country’s currency, as this is needed to purchase foreign goods. The opposite is true for a foreign
market demanding domestic goods.
- This can be self correcting. For example, if the value of a foreign currency is low, then demand for the
goods will increase due to the lower price, increasing the value of the currency.
- Speculation: Holders of foreign currency also speculate on future value, as buyers will buy currency hoping it will
appreciate, and sell it when it has reached peak value.
- Relative interest rates: If the interest rate to depositors (savers) increase,individuals and banks will be attracted
to this higher relative interest rate, and a chance to drastically increase profits. This will increase the demand for
the currency, as there needs to be a conversion in currencies for deposits. This is called ‘Capital inflow’.The
opposite is true.
- Income: If there is a greater income tax, those subjected with this higher income tax will have a ‘decreased
supply of currency’, lowering exchange rates. The demand for foreign currency will also decrease, due to the
lower pool of resources available for consumers.
- Relative rate of inflation
Appreciation: Increase in value of one currency against another, making domestic goods more
expensive, imported goods cheaper, but increasing purchasing power.
Advantages:
- Less expensive imports: Increased value means that buying imports is relatively less expensive than before. A
country can enjoy cheaper foreign consumer goods, and capital goods. Help both firms with importing raw
materials, and consumers in maintaining a higher standard of living.
- Competitive pressure on domestic exporters: Domestic firms seeking to export to other countries are at a price
disadvantage. This will force firms to innovate and cut costs.
Disadvantages
- Greater imports hurt domestic production and export levels are reduced: Both domestic goods and improted
goods may be hurt. If these industries cannot match the exchange rate, their share of the market and their sales
may drop. Leading to unemployment.
Reduces inflationary pressure, helping with economic growth. Reduce exports and real GDP, likely to further reduce
employment. The balance of trade is likely to move to a deficit.
Depreciation: Decrease in value of one currency against another. Makes domestic goods cheaper,
imported goods more expensive, and decreases purchasing power.
Advantages:
- Expansion of domestic industries: Foreign consumers will see exports as cheap, and so are likely to import
more. This raises revenues in these exporting companies and could increase employment. The relative increase
in the price of imported goods will also seek to benefit domestic firms, and if resources are spent on capital AS
can rise/shift . Allows for economic growth. (Reduces domestic unemployment: as more people will consume
good/service, output will be increased, and employment will rise. )
Disadvantages
- Imported inflation:when countries need to import significant levels of raw materials, a decrease in exchange
rate can bring ‘imported inflation’, where the high cost of imports mean that the goods and services available
for citizens can become expensive. (cost push inflation/ not demand pull, as demand is for foreign goods)
- Reduced purchasing power: Certain individuals might lose out if goods/services are provided largely by foreign
firms.
- Less competitive pressure: firm might become stagnant and reliant on exchange rate.
Increase inflationary pressure, which may slow down economic growth. However, this is also likely to increase exports
real GDP, the balance of trade, as well as adding to employment.
Government intervention:
Within a fixed exchange rate system, the value of a currency is pegged into the value of another. The central bank
determines this value and enacts constant intervention to maintain this established rate. This is done by buying and
selling currency reserves, and making adjustment via monetary policy.
Other methods include limiting imports, having exchange control (the amount of foreign currency that can be bought
by domestic residents)
Currency valuation
When the supply and demand meet, and a country holds a currency above or below that equilibrium.
Overvalued currencies: Developing countries may wish to import capital goods or materials at a cheaper price, and so
high rates will enable this. However it hurts exports, leading to a trade balance deficit. Overvaluation can also hurt
domestic industries, which now face competition from cheap import.
Undervalued currencies: By keeping exports cheap, it can improve exports and reduce attractiveness of imported goods,
while encouraging inflation. Countries use this to gain access to greater amounts of foreign exchange, and to
accelerate economic growth. However, this may be viewed by competitors as an unfair trade promotion, leading to
trade wars.
Direct investment (known as foreign direct investment): Measure of the purchase of long-term physical assets, where
the purchaser is aiming to gain a lasting interest in a company in another economy.
- Includes inflows due to direct investment of foreigners domestically,
- Outflows due to locals investing overseas.
Portfolio investment abroad: A measure of stock and bond purchases, which are not direct investments since they do
not lead to lasting interest in a company.
- When domestic investors sell shares to foreigners (and thus meaning the domestic government
borrow money) , there is an inflow of financial capital, increasing the financial account.
- When domestic investors buy foreign bonds (and thus lending money out to foreign governments) this
is an outflow of financial capital, decreasing the financial account.
- If a foreign firm decides to invest domestically, there is an inflow within the financial account. However,
there is then an outflow in the current account if the foreign firm repatriates the profit from the
investment)
Reserve assets: Reserve assets of gold and foreign currencies, which all countries hold and are itemized in the official
reserve account. Used to influence the value of the currency.
- If a nation sells the foreign currency and buys it’s domestic currency, this is a inflow and thus, a credit in the
account.
- If a nation sells it’s domestic currency to buy foreign currency, this is an outflow and will appear as a debit.
The current account balance is matched by the sum of the capital account balance and the financial account balance
(including errors and omissions) .
Interdependence of current and financial account
- If there is a current account deficit, there must be a financial account surplus which provides domestic citizens
with the foreign exchange it needs to pay for the excess imports over exports.
- If there is a current account surplus, the country will have an increasing amount of foreign exchange, which it
can use to buy assets abroad, while also adding to their reserve asset, causing a deficit in the financial account.
Economic integration
Economic cooperation between countries and coordination of their economic policies.
Preferential trade agreements: agreement between two or more countries to lower trade barriers between each other
on goods/services. However, can also take the form of other issues such as labour standards, intellectual property etc.
Trading Blocs
Bilateral trade agreements: trade agreement between two countries
Multilateral trade agreements: trade agreements between many countries.
Trading bloc: a group of countries that have agreed to reduce tariffs and other barriers to promote free trade.
- Free trade area: a group of countries that agree to gradually eliminate trade barriers between members.
Includes NAFTA and ASEAN.
- A product may be imported into a FTA by a country that has a lower external trade
barrier, and then sold to countries within the FTA with higher external barriers. Lack of coordination
arising from different non-member policies can cause disagreements, and complicated rules regarding
the origin of goods need to be put into place.
- Customs union: a group of countries that works to eliminating trade barriers within members, while also
having a common policy towards non-member countries. Includes CEFTA (central European free trade agreement) .
- All members act as a group in trade negotiations and agreements with non-member.
Thus, may lead to disagreements and arguments due to differing economic needs.
- Common market: continue to have a common external policy, while also eliminating all restrictions on the
movement of factors of production within the common market. (labour and capital are of importance). Examples include
the EEC (European economic community)
- However, means that government must give up certain policy making authority,
requiring greater policy coordination between member nations
Advantages
- Increased competition: Imports increase, forcing domestic producers to compete with foreign good/services.
This will mean lower prices for consumers, greater variety and higher quality as firms will try to reduce cost.
- Increased investment: enlarged markets often give rise to increased investment by firms that want to take
advantage of greater market size. Multinational corporations from external nations will have an incentive to invest as
they can sell their good/service free of tariff or other protection imposed by the block to goods from the outside.
- Improved allocation of resources (only applies for common market) : If a certain region is more profitable to
invest in, this will lead to capital gravitating to this country. Resources will be provided to maximise economic gain
within a greater geographical region. Disparity as more economically developed countries will receive higher quantity
of skilled labourers.
- Political advantage: reduced hostility between member nations, and become more interdependent through
increased trade etc.
Disadvantage
- Creates obstacles to achieving free trade with all nations: the creation of blocs may limit the WTO’s goal of
free trade for all. This would lead to a worse global allocation of resources, lower global output, and a loss of
competition.
- Unequal distribution of gains and possible losses: Countries in a trading bloc may not necessarily gain equally
from it’s operation, which might cause internal conflict. (
- Loss of economic sovereignty: the need for coordination means that countries are limited in certain economic
actions and thus may sacrifice economic well being for the bloc.
Monetary union
Occurs when the member countries of a common market adopt a common currency and a common central bank
responsible for monetary policy. Includes the EU.
Advantage
- Single currency eliminates exchange rate risk and uncertainty: Benefits non-member importers as it
eliminates large fluctuations, and opens up the possibility to trade in other member nations without fear of fluctuations.
- Eliminates uncertainty, benefiting importers, exporters and encouraging trade and inward investment amongst
members. This allows for a more efficient allocation of resources.
- Encourages price transparency: consumers and firms can more easily see price difference quickly and
accurately across countries, allowing the promotion of competition and efficiency. Puts pressure to lower prices, but can
increase prices as well.
- Removes transaction costs of currency conversion: according to the rules of a bloc, some countries cannot
spend given a certain level of debt.
- Low rate of inflation give rise to low interest rate, allowing more investment and greater output: a single
currency committed to maintaining price stability will allow for growth
- Larger influence in world affairs
Disadvantage
- Loss of exchange rate as a mechanism for adjustment: If there is a trade deficit, the currency will not naturally
depreciate. Members countries also cannot use devaluation/depreciation as a method to make their goods more
competitive.
- Loss of monetary policy as economic policy: Each country is unable to carry out it’s own monetary policy to
influence the rate of interest and hence, making it difficult to deal with specific issues in it’s borders. This in turn could
also mean that the policy undertaken by the central bank of the customs bloc could even harm a specific nation due to
the varying needs of nations. (A low interest rate will likely to be determinantal to a country experiencing high inflation.)
- Convergence requirement: Certain customs union has restrictions imposed on the fiscal spending certain
nations can do, further limiting their ability to alter the economy. Reduces automatic stabilizers.
Economic Developments
Economic growth: an increase in real GDP over the previous year.
Development: An improvement in the general social and economic conditions.
- A reduction in poverty,
- the raising of incomes, and a reduction of income inequality.
- improvement of general living standards
- Increasing employment opportunities.
1. Resources extraction: Many poor countries (such as mining in Chile, and Burma) lack the resources needed to
extract resources. Because these are capital intensive, they auction rights to multinational corporations. This
profit is then leaked into a foreign country rather than their own nation.
a. many of the gains in capital are limited to a specific industry.
2. Agricultural commodities: These markets are extremely volatile, depending on weather.
a. Increased productivity stemming from developed countries use of machinery, has suppressed prices,
b. Protectionist policies of foreign nations.
Resource rich countries become heavily dependant on production and exports of primary commodities, leading to short
term volatility in prices, poor fiscal performance, and long term deteriorating terms of trade. Relative to other goods
(YED is extremely low) so even when world income levels rise, they remain at the same price, while manufactured
goods.
Corruption can also occur, where resources are not use efficiently to help improve the general standards of living in a
nation.
War might mean the disruption of any government social services, or a failure for the institution to implement policies.
Differences:
- Natural resources endowments/Climate: countries vary with respect to the natural resources they possess
- History: Experiences as colonies have influences on one’s economic development. ‘ The systems the colonisers
put in place to extract resources while maintaining their own dominance, rather than to encourage economic
development, have often proved tragically difficult to reform’
- Political systems/Stability: The elite can affect the way in which a country is run, and these differ between
developing countries. A stable government is needed for effective decision making and implementation of
policies.
- Instability creates uncertainty within economic policy, property rights, and taxation, which makes
domestic/foreign investment less favorable.
- Instability leads to outflow of financial capital as people seek safety for their assets.
- Political instability increases vulnerability to hunger and famine, depriving governments of capacity to
provide relief.
Measuring development
GDP per capita: Level of output per person within a country’s border.
GNI per capita: level of income received by residents in a country per person. Better indicator of the standards of living
of a country.
The difference in these two values depend on the inflows/outflows of income. Foreign workers who send their wages
back home increases difference between GNI and GDP, while domestic workers oversea decreases the difference.
Developing countries
- While the difference is small for developed countries, multinational corporations will often send profits back
hope (profit repatriation), making GNI smaller than GDP for developing nations.
- However, in some scenarios, there might be large remittances sent home by workers, but the output produced
within the country are low.
PPP: the amount of a country’s currency that is needed to buy the same quantity of local goods and services that can be
bought with US$1 within the US.
Developing countries: GDP figures based on PP are higher than those based on exchange rate. Goods and services tend
to be lower in countries with lower per capita GDP.
Developed country: GDP figures based on PPP are lower than those based on exchange rate. Goods and services tend to
be higher in countries with higher per capita GDP.
This suggests that within developing countries, the standard of living is underestimated. PPP is used to eliminate the
influence of price differences on the value of output or income.
Health indicators
Life expectancy at birth: Number of years one can live, calculated as the average number of years of life in a population.
Infant mortality: Number of infant death from the time of births
More resources are provided to the necessary services and appropriate living conditions for the population. However,
other factors, such as adequate public health service with a broad reach , safe resources, a high level of education and
an absence of serious income inequality all result in greater health.
- Limited resources are not always the most important cause of poor health outcomes. Most countries can do
more with their resources to meet economic development goals, allocating resources towards provision of
social/merit goods.
It can also be said that it is bad to only consider one indicator of health, as life expectancy and infant mortality both
reflect different aspects.
Education indicators
Adult literacy rate: percentage of people 15+ who can read and write
Primary school enrolment: Percentage of school age children enrolled in primary school.
However, these education indicators do not take into account the quality of instruction and the duration of a typical
student’s education. Secondary education is not accounted for as well, which could mean that although basic education
may be provided, a move into competitive sectors may still be difficult. Typically, the higher the economic output, the
more educated citizens are.
Composite indicators
Indicators which take into account more than one measure. An example of this is the UNDP’s human development
report, carried out every year. This is measured by:
- Healthy long lives: measured by life expectancy at birth
- Access to knowledge: mean years of schooling and expected years of schooling
- Decent standard of living: GNI per capita
Each dimension is expressed as a value between 0 and 1. The HDI is the average of these three values.
Generally, more developed countries have a higher HDI figure, however, there are exceptions, due to the limitations of
these form of measures, as expressed earlier.
- Countries can be inefficient with resources, resulting in a lower HDI than GNI/GDP.
- If GNI<HDI (efficient with resources), and it will be worth trying to understand what causes this.
- HDI<GNI (not accompanied by equivalent improvement in education and healthcare). Under providing merit
goods, and benefit is not maximised for population.
Many studies have shown that East asian countries, which have invested heavily in education have experienced superior
growth and development. Overemphasis on tertiary education leads to a brain drain, where university graduates move
to different countries, and increase foreign productivity.
- Internal brain drains also occur:
- where highly educated individuals cannot find employment (under-employment)
- Skilled individuals may work in the private sector rather than the public sector.
- Research and development may focus on the needs of developed countries which offer higher rewards.
Appropriate Technology
Appropriate technology is technologies suited to particular conditions within the country.
Labour intensive technology: technologies which use more labour in relation to capital. Results in local employment, the
use of local skills, and aids income/poverty alleviation, reducing use of foreign exchange.
Capital intensive technologies: displace workers, and increasing unemployment, reducing incomes. Requires skill which
may be difficult to acquire, and requires use of extensive foreign exchange. (used within developed countries)
As most new technologies are used and developed within developed nations, which have different conditions to
developing nations, there is a real danger of utilizing inappropriate technology.
However, Commercial banks often only cater to wealthy borrower. This is due to ;
- Lack of collateral: material possession which the bank will seize upon failure to repay loan
- Lack of stable income: due to volatility of agricultural prices, and the existence of unstable informal
markets.
- Influenced by local elites and politics: power is vested in higher ups within society.
Microcredit
Credits in small amount to people who do not ordinarily have access to credit.
- Provides small loans to individuals , allow people to invest in small capital equipment; start up a small business,
which in turn can allow for stable incomes
- Mostly lent to women, as they suffer from discrimination and are more likely to invest in businesses.
Problems:
- Business failure: poor individuals often lack the skills needed to run a business. This will mean the business will
go bankrupt, and poor people will have a debt on top of their poverty.
- Government disincentive: a government may see microloans as a substitute for policies dealing with poverty.
Poor people may have to pay for their own healthcare and education, and will also may lack certain
infrastructure if government intervention is withheld.
- High interest rate: Loan sharks may enter the market with very high interest rates due to poor government
regulation, and thus may not lead to any meaningful improvement in standard of living.
Empowerment of women:
Empowerment: eliminating deprivations and creating conditions of equal opportunities for both genders.
- Poor countries tend to be conservative, and do not offer the resources to further education. Men are also
prioritised, and thus, labour efficiency is not maximised.
- Women also face lower wages, thus leading to a lower standard of living.
Benefits of empowerment
- Improved quality of human resources:
- Lower birthrate: more work outside of home means that women often do not have as many chidren. This
lowers the burden on the incomes of the family.
- Improvements in child health: as child bearers, increased education of women (e.g learning about basic hygiene
and nutrition) will help reduce child mortality and improve health.
Income distribution
Trade strategies
Import substitution
- Country begins to manufacture simple consumer goods for the domestic market to promote it’s domestic
industry, while promoting protectionist measures. Latin American countries.
- Used as an opportunity to expand industry/Modernise
- However, can lead to inefficiency, corruption etc. (refer to notes on protectionism)
Export promotion:
Government providing targeted help to strategic industries, which encouraged higher skill levels in order to boost trade,
and fund further growth into foreign markets. East Asian Tigers.
- Includes industrial policies (investment grants, production subsidies), and state control of financial institutions
to allow for lower interest rates.
- Investment into research and development in order to encourage more capital, and greater growth.
(appropriate technology)
- Money from exports used to invest heavily in education and research to increase labour productivity.
- Increased employment
Trade liberalisation:
Removal of trade barriers to achieve free trade within an economy. Involves privatisation, deregulation, lifting
restrictions, moving towards free exchange rates etc. However, this is a limited tool for development:
- Strict trade policies of developed nations: No government support, sunrise firms are unable to compete with
MNCs, and therefore prevent development.
- Economic/trade liberalisation creates winners and losers: Those with pre-existing skills will benefit, as jobs will
go to those who will most efficiently use the resources. However, those without skills, lack collateral, or who live
in geographical isolation will suffer as they are unable to attain jobs when against high competition.
Bilateral free trade agreements: Agreements that take place between developing/developed countries. It provides
developing countries with access to the market of the developed country and the prospect of gaining such access.
However:
- Developing countries must cut tariffs greater than those required in WTO agreements. This puts even greater
competitive pressure on domestic firms, and may even destroy efficient firms.
- If developing countries from FTAS are competing within the same developed nation, they advantage they gain
is lost, as they all have to compete with each other for access.
- Weaker bargaining power in the WTO compared to a trading bloc.
Diversification
Reallocation of resources into new activities that broaden the range of goods or services that is produced.
- Sustained increase in exports: Diversifying into markets where there is a sustained increase in global demand.
Success depends in entry into higher value-added markets for manufactured goods.
- Development of technological capabilities/skills : allows for higher income, education, skills etc.
- Reduced vulnerability to volatility/long-term price declines: pre-existing income reduces the effect of
fluctuating export prices/terms of trade.
- Ability to use domestic primary commodities: countries that already possess the necessary raw materials can
work to stimulate industry. ‘Vertical diversification’
Capital Liberalisation
Free movement of financial capital in and out of a country. Through the elimination of exchange controls (restrictions on
changing currency)
- Reducing exchange control: allows for trade to occur in competitive markets, where prices determined in free
markets acts as signals to convey information. Allows for efficient resource allocation in current account assets.
- Increased exchange control: increased exchange control exists within the financial account.
- Prevents capital flight (large scale transfer of funds to another country), as it results in the loss of
financial capital that could be invested domestically.
- Avoid currency speculation.
- Assist in monetary policy: if a low interest rate is used domestically, domestic firms will want to invest
overseas, resulting in depreciation. By restricting investment this will not happen.
A nation must have stable interventionist policy oriented, strong financial institutions, and policies that work to avoid
fluctuations if they are to allow for liberalisation.
Foreign aid
Aid: A flow of concessional capital given by developed to developing countries that is non-commercial (at a more
favorable rate than the market rate)
ODA : Aid given by the official government
Unofficial development assistance: Aid given by non-governmental organisation. (nations are meant to only be partially
reliant)
Humanitarian aid: Aid consisting of food, medical and emergency relief aid.
Development aid: aid consisting of grants, concessional long-term loans, support for schools/hospitals, programme
support for education/financial sector. Aimed to help developing nations achieve economic growth/development.
Tied aid: aid that is given on the condition that it is used to buy goods and services by donor nations.
- Recipient nations may consume capital-intensive technologies inappropriate for their own economic
situation:
- Recipient nations cannot seek lower price alternatives for goods and services they are forced to buy from
donor countries. This will result in inefficiency, a loss in value of aid, and a higher opportunity cost.
International debt
Foreign debt: refers to eternal debt (total amount of debt) incurred by borrowing from foreign creditors.
- Debt occurs as it allows nations to pay for an excess of imports over exports.
- Nations spend money on capital goods, which will accelerate growth and allow them to pay back a loan over
the long term.
Debt rescheduling: New loans by commercial banks to domestic banks but on better terms.
Criticism of HIPC
- Level of debt reduction considered insufficient
- Moral hazard: When people don’t bear the full brunt of their error, it encourages people to take risks again
Multilateral assistance
World bank: Development assistance organisation that extends long term loans to developing nations for the purpose of
promoting economic development/structural change.
International monetary fund: established jointly with world bank. Established loans on commercial terms, and stabilize
macroeconomic policies within nations.
- World bank dominated by rich nations
- Conditional lending: Deprives nations with the ability to control their own domestic economic activities,
resulting in the imposition of inadequate or unsuitable policies.
- Extensive use of market-oriented supply side policy: Both organisations are dominated by free-trade
economists from the United states, which places an emphasis on trade liberalisation, lax government
intervention, balanced budgets, high interests rate and reduced wages (to prevent further reducing in external
debt and balance of payment problems) .They want to maintain a steady exchange rate.
- This often lowers economic growth, creating a recession with increasing levels of poverty. Cuts in
government spending on merit good and food subsidies, imposition of fees for schooling/health care
along with increased poverty from liberalisation often results in detrimental results.
Interventionist policies: policy based on government intervention in markets intended to correct market deficiencies
and create an effective economic environment.
Strengths:
- Investment in human capital: Education and health are major factors behind increases in productivity that
contribute to economic growth, and they also directly lead to greater economic and human development.
- Provision of infrastructure: can be used to correct market failures/ decrease income inequality. Increases
productivity, and improves standard of living. Role for government in order to ensure the provision of the
appropriate infrastructure with appropriate access.
- Stable macroeconomic environment: includes price stability, full employment, a budget deficit, a reasonable
balance of trade. Divergence away from volatile, commodity economies. A free market cannot provide this on
it’s own, and it’s important to help economic decision makers plan their future, ensuring confidence within both
consumption and investment. Necessary for investment in capital, leading to economic growth.
- Provision of a social safety net:in order to lower income inequality, the government can secure enough income
to ensure basic needs. This prevents negative externalities, ensuring that standards of living remain adequate.
Weakness
- Excessive bureaucracy: too many rules and red tape can lead to high administrative costs and inefficiency,
resulting in unproductivity./ Planning specific public provisions of merit goods may run into problems, resulting
in a highly bureaucratic and inefficient waste of resources.
- High cost
- Corruption: the abuse of public office for private gain. When it takes the form of payment, it acts as a tax that
makes private investment more costly, reducing the overall level of investment. It can also act as a regressive
tax for the poor, taking money away from things which could improve the standard of living/provide public
goods. It can also weaken sustainable development, and result in the pursuit of uneconomic policies.
Good governance
Economic growth depends on the effectiveness of governments, and the interaction between society and government.
Better governance is related to more investment and greater economic growth.
Providing a balance
- Very strong government intervention in the market has been discredited as a strategy for economic growth:
very strong government intervention leads to misallocations, inefficiencies and results in lower rate of growth.
- Market led economic development strategy, does not take into account the special set of circumstances faced
by developing countries: If pursued over an extended period, it is likely to only lead to limited progress in
economic growth and development and increase inequality, as a result of persistent poverty (due to lack of
investment in education, health, infrastructure which are unfavorable to MNC and market-led development
strategies) .
- Most economists support the idea of protectionism of domestic industries within poor countries through the
use of industrial policies, protecting infant industries.
- Developing countries are more likely to lack the necessary institutions needed for markets to work well. As
such, a relatively large degree of government intervention is necessary. However, as the market matures,
government can allow market forces to control.