Unit 6 - Serin Yildiz - 2009 Globalisation the consequences of reductions in cost of distance

The process enabling financial and investment markets to operate internationally, largely as a result of deregulation and improved communications. The world economy becoming increasingly integrated. National economies becoming increasingly interdependent. More freedom of movement of goods, services, capital technology and labour among countries. It is not new, but the product of the industrial revolution. Effects Rapid growth in world trade over 2nd half of 20th century More open economies meaning governments find it increasingly difficult to manage their own macro-economies via fiscal and monetary policy. Global shocks have greater impact (oil and commodity price changes) high oil prices and collapse of US sub-prime mortgage market put an end to the noninflationary consistent expansion (NICE) decade in UK economic management (which was helped by low unemployment and global growth, along with cheap goods from emerging markets) Changing market structures manufacturing and services (call centres) moving to third world countries with abundance of cheap labour. A major contributor to UKs deindustrialisation. Relative (proportional) and absolute (volume) declines in manufacturing output and employment. (1971 (7.1m) >2008 (3.0m)) The service sector grew from 11.4m to 23m meanwhile. A rise in long term manufacturing unemployment. Exchange rates more unstable (financial deregulation, easier to move money), and of growing significance as a determinant of demand and of a countrys international competitiveness. Governments less able to control currencies (sheer volume now traded dwarfs any possible move by the govt.) and manage economies. Regionalisation world is dividing into regional trading blocs. Widening income gap between top earners in companies and ordinary workers. One reason is weaker trade union power in older industrial economies in the face of industrial decline and cheap labour in Asia and LA.

Good More efficient allocation of resources, specialisation, improvement of living standards for many poor countries, lower prices ( C-surplus), faster economic growth, benefits of technological transfer to 3rd world. Bad Increasing inequality (many left behind in G), growth unsustainable environmentally, impact on global warming, depletion of no-renewable resources, exploitation by MNCs who now have arguably too much power. Reasons for Globalisation Reduction in trade barriers Avg. tariff down from 60% to 4% since the end of WW2 (GATT, WTO, regional trading blocs especially the expansion of the EU) Capital more mobile (inward flows to 3rd world, but some outward floes from emerging markets Russia, China) Labour more mobile long-term migration trends (but there still is not an international labour market, except in a few select occupations)

Growth of MNCs (a cause or consequence?): economies of scale, global brands and market, knowledge and innovation, huge market power and increasing political power (WTO tends to favour US and EU MNCs) Reduction in transport costs and increases in the speed of travel more efficient technology, reduced insurance, more frequent, bigger tankers, airplanes Technological developments to improve spread of information and reduce costs IT revolution, internet (enables offshore call centres, internet sales, trading in goods, services and financial assets) Privatisation of formerly state-owned monopoly utility companies opportunities for foreign investors, increased competition. Political stability no world or European wars for over 60 years, end of east-west divide in Europe. China and India more open Emerging market economies, China, India, the BRICSs they have embraced globalisation and integrated themselves into the economic and trade systems, stepping up the pace of globalisation Evaluate- Some has been long-term (colonisation), some very recent (internet, E.Europe workers to UK) Links between the factors (transport and technology)

Protectionism
Methods of protectionism Tariffs on imports Quotas on imports Subsidy to domestic producers Currency control Non-tariff barriers Voluntary export restraints (VERs) [EU 11% of car market from Japan] disliked as it restricts competition and is an entry barrier to new competition with carved up market Health + Safety and Environmental standards Government procurement policy govt. choosing to use domestic suppliers Export tariffs and quotas (rice) Welfare Implications of Tariffs (n.b diagram for a price-taking importing country) E.g. US steel tariffs 2003 (60%) No Tariff P in USA is Pw Buy Q4 of steel US suppliers supply Q1 (Q4-Q1) is imported With Tariff - P rises to Pwt - Buy Q3 of steel (contraction) - US suppliers supply Q2 (expansion) - (Q3-Q2) is imported (contraction)

Is it good or bad for economic welfare? Consumer surplus Reduction Domestic producers of steel Gain Government Gains World producers of steel Lose out (fall in wp)

B: steel at too high an opportunity cost. Both B + D are enough evidence of reduction in welfare. Losers lose more than gainers gain However - preserves industry + jobs (good in economic downturn) Elasticities The less elastic P and S are, the less imports will be reduced (less impact) but tax revenues will increase more. Justifications for Protectionism? Think about short run/ long run issues, developed/ developing country differences, whether it makes a difference if at full employment. But any protectionism distorts markets to some extent and lessens the degree of specialisation as advocated by the theory of comparative advantage. Selective Protection (one industry or market) Help develop infant industry a potentially viable industry (LR acquire EoS, possible comparative advantage. However, misallocation of resources (not if not at FE)? Industry becomes dependent on protectionism, inefficient. Preserve a declining market while workers are re-trained, new jobs arise, impact of UE on whole community. Cross subsidisation? Prevent dumping Subsidised exports - distortion, intent to remove competition from market to establish or protect monopoly position [SR CS][LR choice, P, Q, competition innovation] EU surplus (CAP) beneficial for many countries who do not have comparative + in producing dumped goods, but not for those that do. But a firm may produce too much and it could be more economical to sell cheap than store.

Retaliation against another countrys tariffs or quotas the fear of retaliation makes many govts very reluctant to impose them (threat as a bargaining position). But may lead to escalation and two wrongs dont make a right. Protect an industry from unfair cheap labour competition working for very low wages, long hours, low standards (environmental, no social security etc) Ought to not buy goods instead putting workers and businesses out of work. But on the whole, the cheap goods reflect comparative advantage, as the economy develops wages will rise. Raise tax revenue for govt. not a significant part of revenue for rich countries, but poorer counties, where no tax is paid depend on this income. Preserve traditional way of life money isnt everything, preserving identity is as important. Optimal tariff argument The set of tariffs that maximises our domestic real income. A monopolist or monopsonist (price-maker) can improve the nations terms of trade through restricting supply of X or D of M. This will the world P of M and P of X, benefiting your own economy. Strategic, health and political motives

Quotas Quota limits imports to 2m Supply Sd + 2m Supply curve has gone from horizontal (perfectly elastic) to a diagonal ( elastic) Price will increase because supply is limited and domestic suppliers supply more.

Same as tariff, consumers lose out (P, Q) Domestic supply expands (Q1Q2) Imports contract (Q2Q3) 2 million (from Q1Q4) Demand contracts (Q4Q3) Bad for other countries supplying steel and domestic firms using steel In a tariff situation, area C is a gain in tax revenue which is likely to benefit community, but in quota NO BENEFIT.
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If demand is inelastic quota is more effective but tariff is better for govt. LR domestic suppliers have no incentive to maintain productive efficiency (no outside competition)

The World Trade Organisation (WTO) Formed in 1947 with aim to reduce general level of tariffs and other restrictions and distortions. Succeeded in reducing tariff levels on manufactures (not for agriculture) from over 40% to 4%; helping create 15-fold rise in volume and 66-fold rise in value of world trade. GATT worked to reduce discrimination (most favoured nation treatment when removing discrimination, have to give all counties the best terms of any trading partners) in countries trade policies.

MULTILAREALLISM not bilateralism National treatment goods imported from counties that have signed the treaty must be treated the same as domestic ones for indirect tax purposes and regulations Temporary protection is permitted for sectors of economies facing special difficulties and for B of P crises (very vague statement) Aim to give developing nations exports predictable and growing access to markets.

Criticisms of the WTO Free Trade benefits developed countries more than developing countries. Developing countries need some trade protection to be able to develop new industries (Infant industry protectionism) Many criticise the WTOs philosophy that the most important economic objective is the maximisation of GDP often ignoring negative externalities. Free trade ignores cultural and social factors. Arguably a reasonable argument for restricting free trade is that it enables countries to maintain cultural diversity Its structure enables the richer countries to win what they desire; Big problems remain Agriculture developed countries still highly protectionist, duties avg. 40% (CAP, USA $70b annual farm support package 2002) Trade-restricting health and safety regulations to be outlawed. Textiles duties avg. 15%. Multifibre Arrangement restricted access (bilateral quotas which reduced competition) to developed countries for 30 years damaging to 3rd world exporters. From 2005, supposed to be open access for textiles, damaged some countries who had guaranteed quotas but only in the short run. Services General Agreement on Trade and Services 95 USA and EU stand to gain Intellectual Property Rights Patents, royalties, copyrights, trademarks (incentive to invest + research) Agreements to end pirating, prevalent in Far East and very damaging to developed countries. Often used as an excuse by Western countries (US) for other tariffs. Environmental Protection and Workers Rights Riots at 2000 Seattle WTO conference. WTO accused of being under influence of developed nations and MNCs in upholding moves to enforce similar standards on developing nations. Attitude to change many still regard lowering trade barriers as a concession to others and a threat to livelihoods. China admitted in 2003 on condition of ending X subsidies, M quotas, and piracy Banana Wars WTO back USE in declaring EUs favourable treatment of African and Caribbean bananas discriminatory.

Proliferation of Regional Trading Blocs over 90. Potentially a lot of discrimination and a return to bilateral carving up of markets, restricting outside access.

The current WTO negotiations are known as the Doha round. The Doha Development Agenda is being negotiated. Key areas include reductions in agricultural protectionism, the proposed elimination of tariffs on manufactured goods, raising the share of world trade accounted by services and greater flexibility in intellectual property rights (AIDS drugs more cheap). Original aim was to focus on problems faced by developing countries and encourage them to reduce agricultural tariffs. USA and EU have recently announced further large subsidies for agriculture, making trade agreements much more difficult. - Anti-globalists believe free trade is bad for poor countries, whose share of world trade has halved in last 20years, while 59 poorest countries incomes/head have fallen. Cancun Meeting 2003 collapsed with no agreement. Rich countries continue protectionist stance while expecting poor countries to adopt free trade. G20 (inc. India, China, Brazil) bargained collectively with rich countries to get better terms. Hong Kong 2005 minor, insignificant resolutions Sources of conflict between the WTO and RTBs WTO permits them to favour their fellow members, but would prefer not to have them. Common external tariffs distort trades and conflicts with principle with principles of multi-lateralism and non-discrimination (however - trade creation) Fear that they will resort to protectionism during recession (escalation and trade war) High levels of protection of agriculture by rich nation RTBs (production subsidies and surplus dumping) (slowness of EU to co-operate with Doha Round) Tendency to proliferate bilateral agreements, forcing unfavourable terms on poorer countries (Cancun breakdown) Often co-operation with WTO by lowering tariff quotas is followed by extension of non-tariff quotas (health, safety, technical standards) What happens to countries left out? However, potential dynamic benefits of them could benefit all to some extent (multiplier effect). Also, a strong case for regional arrangement to promote trade and provide larger markets among developing nations (Africa) (not too distorting if common tariff is low) If poorer countries join RTBs (LA countries to NAFTA) they may get unfavourable terms imposed upon them. Agricultural Protectionism As a general rule, the more the countrys comparative disadvantage in agriculture, the more it protects farming ( cost) Two typical problems farmers face: Fluctuating prices + incomes D inelastic; S v. inelastic in SR but shifts its position by large amounts D shift for many agricultural (+ mineral) commodities + inelastic S

Poor harvest - S Q1; so that P rises to P1. If producers plan their period 2 production under the expectation that this high price will continue, then S Q2; P therefore falls to P2 when they try to sell all their output. Notice that as this process repeats itself, oscillating between periods of low S with high P and then high S with low P, the P and Q spiral inwards and the economy converges to the equilibrium P where S and demand cross.

If the slope of the S curve is greater than the slope of the D curve (in absolute value), then the fluctuations decrease in magnitude with each cycle, so a plot of the P and Q over time would look like an inward spiral, as shown in the diagram. This is called the stable or convergent case. If the slope of the S curve is less than the slope of the D curve (in absolute value), then the fluctuations increase in magnitude with each cycle, so that P and Q spiral outwards. This is called the unstable or divergent case. Long run downward trend in real price of food (+ mineral) products. Low YED Rightward shift of S ( productivity)

CAP SCHEMES (intervention + subsidising output has changed) decoupling breaking the link between the amount produced and the amount of subsidy given. Market forces now play a bigger part; farmers have to diversify and innovate. Farmers now get lump sum to look after land.
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As world P EU levy so P stays the same. The lower the P, the more inefficient and distortive the variable import levy scheme becomes ( deadweight loss) Farmers get (consumers lose out)

consumer surplus Opportunity cost of subsidising? Cost of storage Encourages to over-produce - quality, more land used. Environmental impact of rewarding high output? Farming sector is protected from competition and there is therefore less incentive to invest or innovate.

Regional Trading Blocks The difference between free trade agreements + customs unions Free trade area (NAFTA, EFTA), free trade (no tariff/quota) between members (may not be all goods and services). No restriction on an individual nations policy towards non-members Entrepot trade import to one country to export to another IMPORT DEFLECTION (countries may find it hard to differentiate tariffs.

Customs Union, free trade between members (all goods, not necessarily services), COMMON EXTERNAL TARIFF Preferred by WTO as there is less discrimination The benefits or loses will be greater the more that is traded for a customs union

Balance of Payments, Competitiveness and Exchange Rates

Balance of Payments - a systematic record of all economic transactions taking place between the country and other countries 1. Goods and services 2. Net factor income 3. Unilateral transfers 4. Long term capital (FDI/portfolio) 5. Short term capital (hot money flows) 6. Short term official capital There are 2 major categories of accounts in the BoP: Current a/c - balance of exports and imports of goods and services, net income from investments and overseas workers, and unilateral transfers (nothing in return, e.g. Foreign aid, Gifts etc.) Capital a/c Long run capital transactions (direct/portfolio [no control]), short run capital transactions, official reserve movements. Recent UK BoP experience North Sea oil 79 onwards, helped trade in goods but strengthened currency Manufacturing increasingly uncompetitive, first deficit 1983 deindustrialisation Oil surplus finances manufacturing deficits Current balance improves after 1992 combined effect of recession and Decline in current balance after 1997s rise in effective exchange rate with continuing strong consumer demand

I income strong enough to finance deficit in goods and services until 99 deficit since then, oil making diminishing contribution. Latest figures show 2008 Q deficit 7.7b, about 2.1% of GDP, shrinking as we slide into recession. Will the depreciated pound reduce it further?

Measures of Competitiveness Productivity measures Output/worker Hours/worker Output/hour worked Total factor productivity Q relative to the employment of all factors of production International competitiveness measures Relative unit labour costs - in labour cost relative to other countries Real effective exchange rate nominal effective ER X (UK P level/Overseas P level) competitiveness will improve if ER weakens, or UK P grows slower than overseas P Appraisal of UK competitiveness and of government attempts to improve it UK share of world manufacturing - 41% 1850 5% 2000 Increasing import penetration of UK markets Relative decline of manufacturing in share of UK output and employment Declining current balance, manufacturing never in deficit until 1983, and not in surplus since. Increasing reliance on investment income from overseas to finance trade deficits Output/worker 30% better in US, 10% in France (Germany similar, Japan lower) UK compensates relative to Fr and Ger by working more hours/capita Fr and Ger have best Q/worker (30 + 20% better respectively) gap closing. UK growth of productivity not too bad in recent decades P660 Since 1990, UK rise in unit labour costs have lessened (10% 2.5%) Competitiveness measured by real effective exchange rate improved 20% 19881995, but has since worsened due to . Will have recently improved with Reasons for relatively poor UK productivity and competitiveness Overvalued (recently and historically). Cant do much as BoE is independent with the sole objective of keeping inflation at 2%. The BoE cant influence in the currency market due to the sheer volume of traded each day making its activity insignificant. Reduced will help but we no longer have a big enough manufacturing base to benefit significantly, Old industry is unlikely to reappear unless is expected to be weak for the very long term. (how elastic is our demand for imports J-curve) Inflation Higher than competitors until late 1990s. Independent monetary policy should ensure this is no longer an issue. Weakened TU have helped, recession/migrants should keep wage pressures down in SR. Poor productivity Poor stock capital, long history of under-investment by UK relative to Ger and Fr. Lower paid and longer hour economy, using capital more intensively. Ger has 50% more capital stock/ worker hour than UK. UK has problem in low tech industries as labour too expensive to compete with NICs, while havent invested enough in high tech industry. Solution more investment ( saving, improve financial system, reduce short-termism [derivatives, securities, property], supply-side policies, incentives (tax breaks but no guarantee of good use/quality of research [waste of money, opportunity cost], R+D may have been done anyway), policy to encourage

MNCs into UK (influential in improving UK working and management practices [Nissan, Toyota]) Impact of new EU entrants, FDI to UK. Lagging behind in R+D but with a large service sector where this is limited, statistics may not be very helpful. Solution tax breaks + technical education. Low quality workforce + labour market liquidity. High functional illiteracy, as full employment nears avg. productivity as increasingly less-qualified workers gain jobs. Solution education, new deal etc. Too little competition and too much regulation lack of incentive to productivity (non-traded sector). Lack of competition in UK retailing means lack of pressure on manufacturers. Setting up a business in the UK is multiple times harder than in other countries. Solution competition act, deregulation act, privatisation. Taxes on businesses. Not so much tax rates but the costs of complying with tax laws, claiming rebates etc. (complex, costly bureaucracy). Social insurance. UK manufacturing industry is too broad. Lack of economies of scale, comparative advantage theory. Clearly no quick fix solution, they have built up over time (under-investment, lack of competition) and will only be solved in the LR. Even if our productivity growth rate remains faster than competitors, it will take time to equal their absolute levels. Balance of Payment Adjustment Policy Expenditure switching - Any policy to switch UK spending to home produced goods or overseas spending towards UK X. Protectionism increases tariff/quotas/non-tariff barriers Not an option EU membership, WTO obligation Doesnt help May hinder X ( costs), retaliation, welfare of world, negative multiplier, D for X Supply side policies to improve competitiveness Devalue (deliberate policy [fixed ER system] or depreciate [market forces in floating ER] the exchange rate. Not a policy option market forces determines , BoE targets inflation, could buy or sell but dont have enough power to influence the market. Expenditure reduction Any policy that reduces AD (deflationary policies) Monetary policy - IRs But - BoE targets inflation, and effect on ER. Fiscal policy - T, G But - incentive to work, invest etc., effect on supply-side policies Let it sort itself out leave it to market forces Exchange rate depreciation
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Elasticities If demand is inelastic, the increase in price will not affect D significantly. The total value of M will increase

1. PED in the UK elastic

2. PED in Germany elastic If inelastic, P will not be met by a sufficient and thus X revenue will fall overall. 3. PES in UK elastic 4. PES in Germany elastic If they couldnt reduce their S, there could a build up of inventory. Could lead to dumping in the UK market etc. Everything should be as elastic as possible!

be

Marshall Lerner conditions For a currency devaluation to lead to an improvement in the trade balance, the sum of price elasticity of X and M (absolute values [modulate number] must be greater than 1. PED X + PED M > 1. Empirical evidence suggests that D for X and M tend to be inelastic in the SR. Therefore a devaluation often worsens the current account in the short run. J-Curve
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D and S are inelastic in SR Both are elastic in LR In SR, prices dont change for an number of reasons; need to sell inventory (of old prices), many things are bought forward, contracts etc.

Other issues concerning devaluation/depreciation - Risk of increasing inflation rate especially if devalues at near full-employment (erosion of competitive edge) - M prices - AD rises (X-M ) with AS inelastic - Knock on effect on wages and govt expenditure because of rising cost of living - Demand for M may be inelastic in the LR. The trade balance may not at all improve but only continue to get worse. More successful in improving competiveness in big county/little trade as it benefits more from cheap currency and small impact from change in ER (US trades 8% of GDP) than small country/lots of trade with more risk, big impact from change in ER (Belgium trades 70% of GDP) UKs depreciation of Sterling 1992-6 successful because of ideal accompanying conditions 3m unemployed, supply-side policies, introduction of inflation target.

Introduction to Foreign Exchange Market

What determines the D for sterling? Reasons to demand a currency To buy UK exports of good and services

To travel to UK (tourism/business) Receipts of income from overseas investment To invest in UK FDI

Current account

LR capital flow acquiring stocks, shares in UK companies Hot money inflow relative IRs Expected future currency movements (speculative flow 95% of currency trade)

In the LR the demand curve is normal (downward sloping). However in the SR, there is often a perverse demand curve because of speculation. If demand for X is inelastic, the value of our X will fall if our currency depreciates (Marshall-Lerner conditions). On the diagram above Q represents value of X, rather than volume of X (In UK, two major Xs are financial services and oil, both very inelastic in SR) What determines the S of sterling? UK demand for M

Travelling abroad Paying Y abroad Outward FDI LR capital flow acquiring stocks, shares in foreign companies Hot money outflow

Reverse S curve possible too if you expect to rise further, you will not sell
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If both curves are perverse then if P is above equilibrium then there is a shortage of S and an excess D, pushing the P further up When at equilibrium (on the diagram, it means that the overall total currency flow is equal. It does not say anything about the current account or trade balance. In principle the difference between a floating

system and a fixed system Suppose B/E cuts IRs (for some domestic reason) D shifts leftwards or S rightwards

Floating system D shifts to the left, 1.20 1.00, new Eq. Fixed system D shifts leftwards, at 1.20 D for = 400bn, S of = 400bn, so B/E buys 100bn by selling reserves In a floating system, you have the freedom to use IRs to achieve macroeconomic objectives. This is not the case in fixed ER systems

Determination of a freely floating exchange rate The Purchasing Power Parity (PPP) Theory (LR) The nominal ER will adjust to keep the real ER at the PPP rat

In the LR, if a country has a higher rate of inflation than another, the nominal rate will fall. This is because, the higher UK inflation will mean UK X are less competitive D for X and a shift of D D1 Whats more, D for M (S S1) as domestic goods are less competitive

The result is a new lower Eq (nominal rate has fallen)

Why might it not work (perfectly)? - Other factors affecting trade flows - Transport costs - Protectionism - Non-traded goods + services (would be better to use P of traded goods) - Non-price competition changes Short run movement - Hot money (relative IRs and speculation) What is the best exchange rate regime? Criteria Does it facilitate trade and specialisation? Does it provide a smooth process for B/P deficit/surplus adjustment? Does it promote financial discipline (not lead to inflation)? Is it robust? Floating Advantages Competitiveness is maintained whatever the rate of domestic inflation according to the PPP theory Discretion to use monetary policy to pursue the 3 domestic economic objectives, leaving ER changes to achieve external balance. Automatic two-way pressure, B/P adjustment market forces move countries to eq. (in surplus, D shifts right, currency strengthens, international competitiveness) Good for large countries with small % GDP traded (USA) Disadvantages - PPP doesnt hold for SR. Speculators can move ER significantly above or below PPP for several years (uncompetitive overvalued [UK two-speed economy], inflationary undervalued) - Hence govts rarely ignore ER when making IR decisions can indulge in dirty floating to manipulate ER - Automatic B/P adjustment does not guarantee current account eq. because of weight of speculative pressure - Volatility ER over shoot eq. causing large fluctuations in rates and discouraging growth of trade. Businesses prefer fixed protect margins, plan for I, R+D (but can buy forward contracts) - Automatic adjustment only works if elasticities are right (Marshall-Lerner conditions) - Proved very inflationary at firsts, with governments no longer concerned with inflation monetary policy relaxed to pursue growth (vicious circle of inflation depreciation inflation developed) - Bad for small country trading large % of GDP (Belgium) Fixed Advantages - Stability, certainty, promoting investment, trade and specialisation - Imposes monetary discipline on govts (inflation competitiveness, B/P deficit) Disadvantages - No discretion over monetary policy, IRs used to keep currency within permitted band, can mean inappropriate IRs for domestic purposes (17% in UK 1992 despite 3m UE)

Poor on B/P adjustment, one-way pressure on deficit country only, relied on govts willingness to take correct expenditure reduction policies (but unwilling to AD) chronic surpluses and deficits Deflationary bias as deficit nations forced to AD, while no reciprocal obligation for surplus country to AD Large stocks of reserves needed for central banks to support currencies and finance deficits until adjustment occurred (the vast amounts of hot money and speculation today mean govts could have little affect on exchange rate) Risk of importing inflation from other countries

Economic and Monetary Union of the European Union EMU A monetary union is a situation where several countries shares a single currency The EMU consists of 3 stages coordinating economic policy and culminating with the adoption of the Euro

16 member states of the EU have entered the 3rd stage and have adopted the euro as their currency. The UK, Denmark and Sweden have not accepted the third stage. European Central Bank in charge of monetary policy.

The Stability and Growth Pact is a political agreement laying out the rules for the budgetary discipline of the member states. It is designed to contribute to the overall climate of stability and financial prudence underpinning the success of EMU.

An annual budget deficit no higher than 3% of GDP A national debt lower than 60% of GDP or approaching that value.

The Pact has been criticised by some as being insufficiently flexible and needing to be applied over the economic cycle rather than in any one year. They fear that by limiting governments' abilities to spend during economic slumps it may hamper growth. On the contrary, other critics think that the Pact is too flexible. The pact has proved not to be enforceable against big countries such as France and Germany, which, ironically, were the biggest promoters of it when it was created

Convergence criteria are the criteria for EU member states to enter the third stage of EMU and adopt the . The purpose of setting the criteria was to maintain the price stability within the Eurozone even with the inclusion of new member states. There are four main criteria:

1. Inflation rate: No more than 1.5% higher than the three lowest inflation member
states of the EU. 2. Government finance: Annual government deficit must not exceed 3% of GDP at the end of the preceding fiscal year. Only exceptional and temporary excesses would be granted for exceptional cases.

Government debt must not exceed 60% of GDP at the end of the preceding fiscal year. mechanism under the European Monetary System 2 consecutive years and should not have devaluated its currency during the period.

3. Exchange rate: Applicant countries should have joined the exchange-rate

4. Long-term interest rates: The nominal long-term interest rate must not be more than
2% higher than in the 3 lowest inflation member states. Benefits of Joining the Euro (micro - trade, efficiency, competitiveness) 1. Transaction (frictional) costs: There will be no longer a cost involved in changing currencies; benefiting tourists and firms who trade within the EURO area. It has been estimated that this benefit will be equal to 1% of GDP so will be quite significant. 2. Price Transparency: With a common currency it will be easier to compare prices in different European countries because they would all be in Euros. This enables firms to source cheaper raw material and consumers to buy cheaper goods ( price differentials and competition) 3. Eliminating ER risk. Volatile swings in the exchange rate can destroy the profitability of exports. This undermines business confidence in investing. Business confidence should improve leading to greater trade and economic growth. 4. Improvement in Inflation Performance. The ECB which sets interest rates for the whole area will be committed to keeping inflation low, countries with traditionally high inflation will benefit from this. However this point is debatable. 5. Euro could emerge as a global trading currency 6. Inward investment from outside the EU as firms take advantage of lower transaction costs within the EU area. Recently the Chairman of Nissan said the UK would lose inward investment if it stayed out of the Euro 7. Micro-economic integration is furthered 8. The financial sector could benefit. It would be easier to conduct banking and insurance with a single currency. It would be easier to trade German shares on the London stock market Costs of Joining the Euro (macro) 1. Cost of replacing currencys and adjusting machines, however this is a one off cost 2. Loss of autonomy over economic policy. With the ECB setting a common interest rate for the whole area, countries have lost an important part of their Monetary policy

This is a major problem if a countries economy is at a different stage in the business cycle. For instance Ireland and Spain were growing quite fast and needed IRs to control inflation than other countries that need IRs. On the other hand the German economy is performing quite badly growth is very slow and interest rates are too high In 1992 the UK benefited from leaving the ERM in order to have lower interest rates and come out of recession. This showed that countries economies may not have converged and a single policy could be harmful

Loss of Devaluation as economic management policy. As well as losing an independent Monetary policy countries cannot use their ER. If we join when sterling is overvalued, our X will be uncompetitive. Also govts couldnt devalue the ER to overcome balance of payments problems. Countries will lose some independence over Fiscal Policy. This is because of the growth and stability pact. Weaker countries joining could be detrimental to the inflation rate. Asymmetric Shocks. If one country experienced an external shock it might need a different response. But this is not possible with a common currency. E.g. German reunification required higher interest rates in order to help reduce inflation but this was not good for many other countries. Disadvantage of specialisation some countries are affected more than others when D for goods changes

An oil shock would affect net importers like France more than Norway and the UK who export a lot. Monetary Policy will have different effects in different countries (UK is sensitive to changes in the IR because many people have mortgages) The has been quite unstable against $, whilst has been quite stable. Joining the could therefore increase ER instability against over currencies The ECB is less transparent in their decision making. They do not produce monthly minutes, this makes IR changes less predictable

3. Eurozone is not an optimal currency area, countries are too diverse (labour markets, GDP/capita, growth, inflation). The labour market is not very flexible (language and cultural differentiation, nationalism) Also, France with its high levels of social security benefits, and Germanys inflexible labour market - high NAIRU. Unemployment types/causes Frictional non-serious changing from job to job short term, will always exist (time taken looking for job, interviews, moving, living off redundancy etc.) A little is good for economy, keeps wages , flexibility in market Seasonal constant fluctuation in D for labour every year (tourism, agriculture, construction) often fits with S of labour from students Structural long term/permanent shift of D away from type of labour, industry may not be there any more. Often regional or localised, downward multiplier. Immobility occupational, geographical (house price differentials, longer and harder to move + buy houses)

Wage rigidities if D shifts from D D1 but wages stay at w, then S remains at Q, but D falls to Q1 (Q-Q1 = UE in certain industry. Cyclical (d-deficiency) Keynesian approach - AD. Classical approach - wages (s-side), to level of demand - w1 in diagram above

Unemployment lower and growth higher in UK than in most of continental Europe. UK successful combination of s-side policies to encourage incentives, deregulation, more flexible labour market, symmetrical inflation target, beneficial impact of globalisation (downward pressure on wages and costs because of competition and new technology), higher level of economic activity, FDI into UK. Anglo-Saxon Model market forces, deregulation, s-side efficiency, flexibility Fr, Ger + others suffer from Eurosclerosis labour market inflexible due to high employers social security payments, high UE benefits and state pensions, strong trade unions ( wages, obstructing new productivity raising tech) excessive red tape and regulation (restricted shop and banking hours) Social Market Economy more welfare protection, more regulation, inflexible EMU SGP and asymmetrical inflation target held Eurozone AD lower than UK or USA. But US and UK harder hit by credit crunch too little financial regulation, flexible labour markets shed labour quicker, but should be able to pick up quicker on recovery (however European economies will retain capacity better) Disequilibrium unemployment when people would take a job at the going rate/wage, but the jobs are not available (d-deficient or high wage UE). In the diagram above, with wages unchanged at w, the market does not clear (doesnt reach eq and SD) However, the diagram assumes that those who leave the industry find work elsewhere. Is S more inelastic? In some cases workers may go back to home country etc. Equilibrium unemployment Natural rate of unemployment. N.A.I.R.U. nonaccelerating inflation rate of unemployment Classical economists - unemployment that occurs even though the market clears, it occurs when people are not prepared to take a job at the going wage.

Higher wages (all other things being equal) will lead to a smaller distance between AJ and LF Q*W* = equilibrium wage + employment Q1-Q* = natural or voluntary UE

How to reduce? Shift LF to the left Dont count certain groups as part of the workforce (over 60, <18, disability) Shift AJ to the right Reduce welfare benefits e.g. JSA (or tougher conditions)

Reduce cost of taking a job (help with childcare, transporting, training, making the market more flexible [housing etc] CERTAIN SUPPLY SIDE POLICIES Shift LD to the right (smaller gap between AJ and LF) Not by AD (NO G, T, IR) Supply-side policies to raise productivity (training, education, health care, tax breaks)

The Philips Curve Long-term trade-off between inflation and unemployment. Why? As the economy moves towards the PPF, there is pressure on scarce resources such as labour (wage rates forced up as firms compete for workers). Knowledge of this apparent inverse relationship began to have implications on government policy. Using d-management (fiscal + monetary policy) governments could target inflation or UE, but not both. AD UE + nominal wages but P as firms mark up prices in the face of costs Stop-go period after elections G, IR etc. Not good for I held back LR growth rates Monetarist/classical No LR trade-off between inflation and UE. However much you AD, you will UE in the SR but given time UE will revert back to where it was (NAIRU)

The Expected Augmented Philips-Curve The movement along SRPC from AB would result in shortages in the economy which would pull prices up. The P leads people to seek wage demands that give them a real i.e. above inflation. This would costs for businesses (AS shifts to the left putting economy at C). Firms would P and

shed labour. The net result being that UE would be back at where it was before but with inflation at 3%.

The in D for goods and services is soon leads to inflation, and so any in employment will quickly be wiped out as people realise that there hasnt been a in real wages. -

Suppose B/E IRs AD AD1, P0 P1 Suppliers expand Q (Q0Q1) Suppliers and workers are subject victims of money illusion the tendency of people to think in normal rather than real terms. After adjustment of wages and P, SRAS shifts to the left and suppliers revert back to profit maximising position Real output is back at Q0 but prices have risen to P2 SRAS is only what will happen to AD when wages and prices have not adjusted

LRAS means once wages and prices have fully adjusted If you try and run the economy below NAIRU by boosting AD, inflation accelerates To get UE, NAIRU s-side policies (LRAS shifts outwards) improve productivity, efficiency, incentives in the labour market Why SRAS horizontal in recent years? Cheap M Good monetary policy ( inflation/expectations) Leftward shift of NAIRU If AD rises from increased investment or government spending on supply-side policies, then LRAS shifts outwards and real output Public Spending The level of government involvement in the economy has grown significantly in recent decades. A major distinction needs to be drawn between the following - Transfer payments where income is taken from one person in tax and given to another as benefits (JSA, disabled benefits) - General government spending on goods and services (building motor ways, paying wages to teachers and nurses, defence expenditure) Major components of UK public spending 07-08 are Social security 161.9bn NHS 104bn Education 77bn

Defence 32bn Debt interest 30bn Biggest rises since 1980s in public order (50%), health (35%, social security (33%), education (18%) Biggest falls in housing (48%) and defence (23%)

Difficulties in controlling public spending Cyclical factor (UE changes), beyond govts. control (cannot stop booms + slumps esp. with interdependence and globalisation). In a downturn tax receipts but spending on benefits Expectations of improving standards of public services Health service a victim of its own success (LE), rising cost of new treatment Demographic changes - spending on pensions Hard to efficiency in public sector (not producing a measurable output at a market price, hard to find inefficiencies, TUs have strong presence in public sector) Poor state of public services and infrastructure after years of under-funding Problems over initiatives designed to role of state: private involvement in LR may costs more money for the govt. Unexpected spending Wars, natural disasters, global crises (credit crunch) Impacts of government spending D-side all govt. spending AD (injection), multiplier (depends on propensity to consume), role in D management. S-side Improves infrastructure, health, education, New Deal etc. helps to raise incentive, inefficiency and push AS outwards But productivity is hard to measure and improve in public sector, so may make s-side less efficient (Bureaucracy?) Crowding out workers and financially, from productive private unproductive public ( wage rigidities, labour flexibility) Redistribution Benefits in kind have progressive impact and help redistribute wealth Cash benefits conflict between universal benefits (OAP, child benefit) which are flat rate and means tested benefits, withdrawn as Y (Y support, working tax credits)

The Budget The Fiscal Stance Balanced budget G=T, neutral impact (no multiplier) on AD or money supply Budget or fiscal deficit +ve public sector net borrowing (PSNB). G>T, AD, expansionary or reflationary (loose fiscal policy). Either money supply (inflationary?), or sell govt bonds (gilts) to avoid monetary expansion, which requires IRs as the P . This can lead to crowding out the private sector, and IRs also reduces C + I, as well as (X-M) Fiscal policy ineffectual in AD Budget or fiscal surplus - -ve PSNB. G<T, AD, deflationary budget. Either money supply or IRs as B/E repays bond holders. National debt shrinks (but C + I)

Discretionary D-management - Chancellor purposely unbalances budget to AD Structural They may certain types of spending or taxation in order to achieve certain economic objectives e.g. recent rises in health and education spending.

Cyclical Automatic or built-in fiscal stabilisers. As growth slows, certain elements of G automatically rise, while some T falls as a % of GDP. ( T from C + Y, but benefits) This preserves some consumption Swing from a surplus to a deficit in UK has both cyclical and structural elements. A discretionary element has now been added as fiscal stimulus is used in attempt to end recession.

Prudence The two rules The Golden Rule Govt will not be net borrower (expect to finance I [future gains]) over whole trade cycle (flexibility). This doesnt preclude deficits if growth is below long run trend as long as there are surpluses when growth is faster. The Sustainable Public Debt Rule National debt not to exceed 40% of GDP. These rules act as a framework for fiscal discipline, promoting business confidence. Furthermore, prevent budget being cause of inflation, assist the B/E in its objective, reduce the risk of crowding out, and avoid the national debt being too great a burden on future generations. These are different to those of the Eurozone under the SGP. Budget deficit not to > 3% of GDP (reduces ability of govt to combat economic cycles and help stabilise economy), National debt mustnt > 60% GDP. Modern use of Fiscal Policy Limited D-management role until onset of credit crisis. Automatic stabilisers play their part in dampening down swings in the trade cycle. Day to day management of D to meet inflation target left to monetary policy. Recession sees return of discretionary fiscal stimulus, party because of weakness of monetary policy once nominal rates hit zero, reluctance to lend and deflation threatening Chancellor does use fiscal policy for other goals however; s-side, redistribution, environmental. FISCAL better for stimulating (low confidence), MONETARY better for stemming D-side determines how fast economy grows; S-side determines potential to grow.

Taxation Structure Mixture of direct (paid out of income/wealth) and indirect (when doing a piece of economic activity) taxation. More heavily weighted towards direct (most of 576bn revenue come from these [income T 160bn, NI 105bn, Corp T 52bn], rather than indirect [VAT 84bn, ex. duties 42bn) than most other major EU countries.

Progressive T rate as Y, reduces inequality Proportional Same rate whatever Y (NIC 11% over most Y levels) Regressive T rate as Y, help redistribute from rich to poor, but can be poor for work incentives. Marginal T rate (MTR) the proportion of an extra pound of Y that is paid in T (main concern when considering impact on work incentive) Average T rate (ATR) proportion of total Y paid in T (of most relevance when considering Ts impact on living standards

Tax Base How much Y, wealth, or spending is subject to T (tax-free allowance, tax-breaks T base). The smaller the base, the higher the rate needed to collect same amount of revenue.

How to judge a tax? Adam Smiths 4 canons of taxation Low cost relative to yield Clear and certain to T payer Convenient to the T payer (if not - cost to firms [esp. small businesses] and more likely to evade Levied according to individuals ability to pay (equity) Today we also consider - Impact on work incentives, I incentives, S incentives - Impact on environment - Impact on distribution of Y and wealth - Distortion of economic activity (unintended consequences) - Easily evaded or avoided? Honest people have to pay more - Affected by inflation? Fiscal drag As Y , individuals are pushed into higher income tax brackets, and average tax obligations , dampening spending - Act as an automatic stabiliser of economic activity? - Compatible with EU rules?

Substitution effect a wage (from T) will result in willingness to work as it the return from working and opp. cost of leisure. Income effect a wage (from T) will result in hours worked as the worker has more disposable Y and buys more goods and services, including leisure. At a low wage rate, it is thought that the substitution effect is likely to outweigh the Y effect (to raise their standard of living) Once the wage rate has reaches a certain level, then the Y effect may outweigh the substitution effect (the worker is now able to buy more leisure) Many workers are not in the position to alter their working hours however (SR/LR?)

Poverty trap As Y, welfare benefits are withdrawn, and/or the individual may start to pay T. The net gain can be little or even negative. E.g. X earns extra 1, loses 50p in benefits, and has to pay income tax and NIC = 30p, only 20p is net gain and so effective marginal rate of tax is 80% Unemployment trap individual is a little better off, or even worse off getting a job than staying unemployed because of loss of benefits and taxation (disincentive to work). Could benefits but poverty, or T or rate of welfare benefit withdrawal, but expensive Laffar Curve As T rate , the rate of growth of T revenue falls because of the disincentive effects of tax As T rate above t*, an in the T rate discourages economic activity so that T revenue falls

This curve also represents what happens to hours worked as the wage rate rises. Labour supply is greatest at w*, where the Y effect = substitution effect

Other direct taxes Corporation T (28%, lowest in G7, with many allowances for I, R+D etc.), Inheritance (40% of estate over 312k, little impact on AD as was not being spent but incentive to save), Capital Gains T (similar Y T rate, on difference between P paid and P sold, after adjusting for inflation). Indirect taxes (tend to be regressive) VAT general sales tax on goods and services, 17.5% 15% until 2010 18.5%. Zero rated on wide range of essentials (public transport, food, childrens clothes, books, and banking services), avoiding it being too regressive. Ad valorem helps keep it roughly proportional. Excise duties (alcohol, cigarettes, fuel) - strongly regressive because of low YED, some ad valorem elements, but most are specific/unit Ts. Indirect T revenue without creating disincentive to work, could be argued high ones incentive to work (work more to obtain standard of living desired) Since 1979 Govt has moved burden of T significantly away from direct, towards indirect, enabling marginal T rate, improving work incentive. Tax system less progressive, but in the LR, incentives may T revenue, giving the govt more ability to redistribute. use of indirect T for environmental, wealth and other social objectives: excise duties, climate change levy, congestion charge, vehicle emissions, air passengers FDI What attracts FDI into the EU? Size of EU market (27 countries, nearly 500m people) High avg. Y level of market (but could be offset by production costs [regulations, labour flexibility, wages, non-wage costs]) Absence of trade barriers Overcome external tariffs (the more restrictive, the more likely to come to EU) Euro - transaction costs, no currency risk (but not all in ) To a particular country in EU? - Skills of the workforce/management (although can bring own workers) - Productivity wage + salary levels relative to other countries ( wages are fine if highly skilled and productive) - Infrastructure transport and energy costs (UK poor railway system, airport congestion) [how much this matters depends on industry, labour intensive? heavy energy usage?] - Tax system levels of business T, profits T, labour T (NICs), transparency, certainty, complexity - Grants and incentives - Rules and regulation (red tap) environmental, labour, planning - Euro or not? Who are you trying to sell to? Transaction costs are not too great - Labour flexibility Impact on economy (25% of UK manufacturing I)

Employment (S-side, D-side) D for labour (regional aspect) Less likely to bring new skills and technology to developed countries, but will still be beneficial skills, management, capital - productivity Multiplier (but leakages? profits + wages overseas) Prices Should competition, and give incentives to P (but if near FE may be more inflationary competing for best workers, sites, resources) X-M Should be +ve impact but depends on who selling product to (importing all components, then selling in UK will worsen it, investment Y flow) Govt finance - T revenue (but MNCs clever at avoiding T) Exchange rate will value of (but hot money movements are more determining in the SR value, although it will strengthen it LR as D for )