The Balance of Payments

An introduction to globalisation and protection The gains from trade is the same concept as “why nations trade” and these gains lie behind the trend towards increasing globalisation. • Comparative advantage. To simplify greatly, it means that a country does what it is best at! This is the main source of the gains from trade. • A country will lack something that it cannot produce for itself, e.g., bananas in Britain. So a country trades to get what it lacks but wants. This is a minor reason. • There is a gain in the variety of goods and services offered and wider consumer choice if one can buy from abroad. The country pays for the imports by exporting what it produces. Generally, international trade increases incomes, fosters economic growth, improves the standard of living, and allocates resources better, both within a nation and globally. The globalisation process Globalisation comes about by a reduction in protection, especially by the developed countries, and the general freeing up of markets. Globalisation involves countries specializing in what they are good at and exporting in exchange for goods or services they are poorer at. It requires a reduction in protection in order to allow the increase in trade which is necessary. It also needs the freer movement of capital and the ability to invest in another country. A company in country “A” can then either set up a factory or firm in a different country, “B”, or else buy an existing one there. As an example, the British company Lever Brothers has operating companies and factories on every continent in the world, has a research laboratory in China (among other places), and is a genuine and long-established multinational company. The motives for reducing protection are: • To increase a country’s efficiency in production and hence improve the domestic standard of living, resource allocation and growth. • To reap the gains from trade (comparative advantage). • To help the poor countries of the third world. This is not really an important motive! The goods that the third world wishes to sell are often kept out of developed countries by high levels of protection in order to assist their own producers. Imports of agricultural produce in particular are often heavily restricted for the sake of a relatively small number of farmers. • Pressure from multi-national corporations on the various governments to allow freer movement of goods and capital (in order to increase their own profits). International Exchange This really means why countries trade! If Britain can run an insurance service more cheaply, say, than New Zealand, then it should do so, and sell it to the world (Lloyds of London does this). In this example, we would

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buy back something, for instance mutton and lamb. It is not necessary or even desirable to try to balance exports and imports with a single country. We wish to balance multi-laterally, on a global basis. The global trading pattern: The developed world trades more with itself than with third world countries, which seems surprising to some. But this is reasonable really! Because: • Income elasticities are high for services and fancy expensive manufactured products, but low for raw materials(revise elasticities and what this means in Unit 1 if you are a bit hazy). The developed world has high incomes, so it imports such things as video cassette recorders and TV sets from Japan. However, few poor developing countries produce such items. Instead they tend to produce raw materials and agricultural products, such as bananas, coconuts, sugar, sisal and hemp all of which have low income elasticities. Where poor countries do export hi-tech goods, like TV sets from China, these are inevitably made in joint-ventures, set up with foreign capital and know-how and owned in part by foreign developed countries anyway. Many Japanese products are now made in third world countries like China, as Japan has exported much of its manufacturing capacity, a process known there as “hollowing out” the economy. • Comparative advantage and wider consumer choice mean that, if we take motor cars as an example, the Germans make Mercedes and BMW; the French make Citroens and Peugeots; the Italians make Ferraris and Alfa Romeos …. and they all sell motorcars to each other. • The demand for primary produce (often produced in third world countries) grows only slowly, so trade with third world countries does not expand rapidly. At the same time, technological improvements in the rich world often reduce the quantity of raw material needed. As an example, Brazil produces much iron ore but less of this goes into a typical motor car built in the UK now than it did fifty years ago. • An additional factor on the demand side is that most developed countries protect their domestic agriculture, which severely limits the amounts that poor countries can sell to them (remember?) • The long-term price of many primary products does not increase much, in part for the three reasons above which limit the growth in demand. A further reason lies on the supply side: output of primary produce has increased over time. This is partly through increases in yield but also because of the extra supply coming from newly developing third world countries as they increase their exports. With reasonably rapid growth in supply and little growth in demand, the long term price must fall. At best it will increase but slowly.

The balance of payments • What is the balance of payments?

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The balance of payments is a record of a country’s economic transactions with other (foreign) countries. It includes the trade in goods and services, reveals how we pay for this, or if did not pay it tells us what we still owe. It also includes other financial flows, like foreign investment and company dividend payments. We used to consider the balance of payments was divided into two: the current account and the capital account. In 1998 a new method of presenting our international situation was introduced which contains four categories within the balance of payments. 1. The current account. 2. The capital account. 3. The financial account. 4. The international investment position. THE CURRENT ACCOUNT This course focuses heavily on the current account, which includes: • Trade in goods. • Trade in services. • Income from working abroad, and from investments abroad. • Current transfers: central government and private. The Ten Economic Goals and the Effects on the Balance of Payments WHAT MIGHT OCCUR THE EFFECTS WE MAY EXPECT TO SEE The B of P worsens, as growth sucks in imports to sustain production + higher incomes mean consumers buy more foreign goods and services (these are generally income elastic). The B of P worsens as consumers buy more foreign goods/services.

If we grow faster.

If the standard of living rises. If resource allocation improves. If income distribution becomes more equal.

The B of P probably improves, as the country is doing what it is best at. The B of P probably improves, as the rich reduce their purchases of foreign goods/services but other incomes will not rise enough to suck in many more imports.

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If inflation increases. If unemployment increases. Value of currency changes.

The B of P worsens as our exports fall and imports rise. The B of P is probably a bit better as incomes are lower, which means consumers demand fewer imports. If the pound gets weaker it encourages our exports and discourages imports, so the B of P probably improves. Note that the currency may be weak because the B of P is already poor!

What can we do if the balance of payments gets into a “fundamental disequilibrium” state? A fundamental disequilibrium state means that: • imports are considerably more than exports; and • there is a persistent balance of payments deficit; and • there is no likelihood that this situation will change. The IMF will only allow major changes in exchange rates or special action to help the balance of payments if the country can persuade the IMF officials that there actually is a fundamental disequilibrium. There are three possible ways of tackling this: 1. Via the exchange rate system – if the exchange rate is fixed (like China which currently fixes the yuan against the US dollar) we might alter our exchange rate (although countries are bound by the IMF agreement as long as they are members. This solution is not applicable to the UK as our exchange rate floats (see below). 2. Via demand side management of the domestic economy. Lowering the level of aggregate demand would provide short term help by reducing imports and possibly freeing up some goods and services for exports. 3. Via supply side management of the domestic economy. Pushing out the long run supply curve would provide permanent help. The first way of tackling a balance of payment problem: changing the foreign exchange rate The exchange rate methods that a country might have adopted 1. Floating. 2. Fixed. 3. Managed. 1. Floating rates: These are normal for most countries these days; floating rates are currently in force for the UK. The supply of and demand for the pound determines its value. 1. The demand for pounds comes from foreigners who wish to buy British goods or invest in Britain.
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2. The supply of pounds comes from the British, as we buy goods or services from abroad or we send money abroad to invest there. This is the normal supply and demand curve situation: if we increase our imports, the supply of pounds increases, so the value of the pound starts to fall.

When this happens, a second element might swing into action. Speculators might jump in and sell pounds, hoping the fall will continue so that they will be able to buy them back later at a lower rate. Should speculators sell in this way, it will drive the pound even lower. 2. Fixed rates (the regime a country might have adopted): The government sets the value of the currency in the foreign exchange market. It is usually set well out of line with the foreign exchange rate that the market would determine – there is no point otherwise because it can simply be left to the market This method is not used much, except by a few communist countries. Linking the rate to another country fixes it in a kind of way, but as the value of the other country’s currency alters, so does yours! Malaysia currently links to the US$ which helps it to stabilise its export and import prices for the USA and set them for other countries in international contracts. With our floating rate: if the balance of payments deteriorates, the foreign exchange rate worsens automatically – thus making our exports cheaper and imports dearer, so it should automatically correct the imbalance in time. With a fixed FX rate: with “a fundamental disequilibrium” the country could devalue – if the IMF will let it! Secret meetings would normally be held and the government would try to persuade the IMF officials that there really is a “fundamental disequilibrium”. A small digression: what can affect the balance of payments (and hence the value of the currency)?(Note: you may need this for the exam). 1. Our demand for imports. 2. The demand of others for our exports. 3. Our inflation rate compared with that of others. 4. Our rate of interest compared with that of others. 5. Speculative capital flows. Our demand for imports: if we import more, the balance of payments on current account weakens and pounds flow abroad. This increase in the supply of the pound reduces its value. The normal supply and demand curve analysis applies, as in the diagram above.
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The demand of others for our exports: if foreign countries increase their demand for our exports, our balance of payments improves and the value of the pound rises. The other countries demand pounds in exchange for their currency, as they have to pay us in pounds in the end. Our inflation rate compared with that of others: if other countries inflate more slowly than we do, our exports become relatively dear (so we can sell less), and our imports become relatively cheap (so we import more), with the result that the balance of payments deteriorates. This causes the pound to fall in value. You can see that when we pay for the extra imports it puts more pounds on the market, while selling fewer exports means we earn less foreign exchange. Our rate of interest compared with that of others: if our interest rates rise (and no other countries match it) then foreigners send more money to us to earn a higher rate of interest and hence a bigger income. The influx of foreign capital then increases the value of the pound and strengthens the balance of payments. Speculative capital flows: “hot money” can race around the world seeking the highest rate of interest commensurate with safety and risk. As the world gets wealthier and multinational corporations increase, the size of the flow gets larger. If hot money races into a country, it strengthens the balance of payments and increases the value of that country’s currency. The real danger will come later when it races out again! The value of the currency could then fall sharply and the balance of payments could weaken rapidly. The total effect can be very destabilizing. The IMF will usually lend money to help a country offset the sudden flood out. 3. Managed rates of exchange (the regime a country might have adopted): This system is much like the floating one. The difference is that the value is not completely free to move for ever. The government may step in (should it feel like it) to shore up the foreign exchange rate if it starts to fall. It does this by buying pounds, using the foreign exchange and gold reserves to do so. If the value of the pound begins to increase, the government may judge it right to step and moderate the increase by selling pounds on the international market. This would then increase the foreign exchange reserves. Although Britain has a floating exchange rate system, in the past the government has been known to intervene to protect the value of the pound by buying and selling foreign exchange. The rate of interest set by the Bank of England also affects the value of the currency, as you will recall, because relatively high rates of interest attract foreign money to be placed on deposit here. The government is influential in deciding on what rate will be set. We know how the voting on the Committee went but the internal arguments are normally secret. The second way of tackling a balance of payments deterioration: demand side management Reducing the level of aggregate demand can have a short term effect and help the balance of payments. If we see the balance of payments weakening, perhaps because of high levels of domestic consumption and imported consumer goods, the government can reduce the level of aggregate demand, take the heat out of the economy, slow growth or even reverse it, increase unemployment, and reduce inflation. This will help the balance of payments by reducing imports and also by releasing goods for export that are no longer consumed here.
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Generally, this would be a short term response to a sudden crisis – the government chooses to squeeze the economy because too much is going wrong within the ten goals. The third way of tackling balance of payment problems: supply side management Changes on the supply side tend to be a long term thing and it is not a tool that can suddenly be wielded in a crisis to give quick results. It is a theoretical possibility but a nation is usually well advised to keep trying to push out the supply curve anyway as part of an ongoing process. If we can increase the long run aggregate supply curve (the vertical part of the SAS curve) it pushes down prices as well as increases output. This means our exports get absolutely cheaper, so we are able to sell more, and hence the balance of payments will improve. We also import less because our imports are relatively dearer now when compared with home produce.

Here we see the SAS curve moving to the right (an increase in the underlaying rate of economic growth) and gross domestic product increasing. Other than the initial increase in growth and the improvement in the balance of payments, we would see benefits for some other goals too: there would be an increase in the standard of living (as prices fall and as incomes rise); and we can also expect an increase in the number of people employed.

Trade protection and trade liberalisation
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Trade protection means reducing or preventing imports from foreign countries by means of measures like tariffs, quotas and non-tariff barrier (ntb’s). • An import tariff is a tax, e.g., 20 per cent (being set as a percentage it is referred to as an ad valorem levy) or £30 (as a set absolute amount it is called a specific levy) which is placed on each item imported. • A quota is a fixed quantity, such as 20 tons; only that amount in total can be imported. • Ntb’s, as they are usually called, are often rather subtle and clever ways of reducing imports by the tricky use of laws or regulations. As an example, health regulations may be used to reduce or prevent wheat imports; or peculiar safety regulations, such as the minimum distance between brake pedal and clutch pedal in a motor vehicle, may be invented and used to prevent the import of certain vehicles. Note that in order to reduce protection we: • Reduce or eliminate tariffs (so importers pay less or nothing). • But increase quotas (so a larger physical amount may be imported). Reasons for protection • The infant industry argument. This justifies the protection of a new industry during its early years, in order to allow it to establish and grow behind tariff walls and quota barriers. Once it is mature, then the protection can be withdrawn. This is a respectable argument – but a common problem is that the infants rarely admit to being grown up and protection may continue indefinitely! Eventually, the lack of competition becomes a disadvantage rather than a help and the industry usually continues to be permanently inefficient by international standards. • Protection in order to level the playing field by keeping out cheap imports. This is a poor argument usually o it goes against the principle of comparative advantage; o it reduces a nation’s flexibility in resource allocation (it freezes industries as they are); o it lowers the standard of living (people cannot buy from the cheapest source so must pay more for the good which leaves less money to spend on other things); o it slows economic growth (if an industry becomes inefficient, it will hardly grow fast); and o it may also reduce exports (if the industry is poor, it is unlikely to be able to sell to others). • The danger of war. The case goes that we should protect our agriculture or basic industries in case we are ever cut off by war. There is something in it as a political slogan but it is not a very respectable economic argument – few wars in the future will involve long years of submarine blockades of the UK! The nature of war has changed with the huge technical advances in the military area since World War Two. • In order to help some special group, e.g., farmers. The sugar beet industry in the European Union is heavily protected which keeps out much cane sugar from poor countries and means that as consumers we all pay more for our sugar than we need. The movement to reduce protection since late 1970s – why did this occur? • At that time many developed economies were not in the best of shapes because various long-standing government and other restrictions had led to resource misallocation, a lack of motivation, and slow economic growth, which held down the lower standard of living. There were heavy restrictions in the labour markets, the
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capital markets and sometimes the goods markets. The growth of bureaucracy, the emergence of the “nanny state” to look after individuals carefully, and many years of left-wing governments had led to this. The motives of the latter had been good, but there were several alleged and clearly undesirable side-effects e.g., lack of competition, lack of personal incentives and some erosion of the desire to succeed. • There was a rise in economic theories promoting competition and free markets (“the Chicago School” and Milton Friedman) and these eventually became widely accepted. The data since suggest that they were right: lower tariffs do increase per capita income as well as trade. • Political – Prime Minister Margaret Thatcher and President Ronald Reagan came to power and liked the idea of competition and freer markets. They felt that their economies were stifled by over-restrictions and hence uncompetitive. They, or at least their advisors, saw that this encouraged slow growth, resource misallocation and lower standards of living. This was a “timing” factor perhaps and it just might have happened anyway a little later? • The collapse of the communist Soviet Union and Eastern Europe in and after 1989. This happened following many decades of central planning of the domestic economy. Such countries cut themselves off from the international community (known as autarky) which reduced competition and they had fallen well behind international standards in many areas. After the collapse of the Berlin Wall in 1989 and the events that followed, most of these countries moved out into the global area and adopted market mechanisms to try to restore and rejuvenate their economies. • China moved into the global arena after 1978 and slowly but steadily began to adopt many market policies, although without ending communism or totally dismantling central planning. As a result, China is now a weighty player in global markets and its cheap exports keep the level of international inflation lower. • The other “tiger economies” (Hong Kong, South Korea, Taiwan and Thailand especially) grew rapidly on a policy of free trade and the use of market mechanisms and people around the world noticed this – and began to copy the policies. • Technology changed. The rapid rise and spread of computers mean that global markets, especially in finance, are feasible - and inevitable? • Multi-national corporations rose, and they tend to think globally rather than on a national basis. Why protection hurts the people in the world Less competition means a tendency for people, companies, and industries to rest on their laurels and take it easy. This encourages a nation not to reduce or eliminate slow-growth industries whose products are less in demand or are not competitive with other nations. As a result we may find: • Resources become increasingly misallocated for what people wish to buy. • A lower standard of living because consumers cannot buy products at the lowest price.
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• Growth becomes slower because companies do not strive hard to improve their products, production methods, or technologies. • Exports are lower than they might be, as the nation is not as good as some other countries with which we cannot compete. This limit on exports hits third world countries in particular. Much of the tariff reduction and quote increase that has occurred so far has been primarily to assist the rich developed nations. Relatively little has been done in areas that would help the poorer countries. • There is less foreign trade in the world as a whole – so we have less comparative advantage being followed. This means slower world growth, and a lower global standard of living. • The foreign exchange rate may be poorer, as the country is not exporting as well as it might.

Trading blocs and the world trade organisation (WTO) Trade blocs are of three kinds – these are listed in order, weakest to strongest: 1. Free trade areas: these have no internal tariffs or quotas on trade between the members, but each country can set its own level of tariffs against the rest of world. Recent examples are the North American Free Trade Association (NAFTA) which joined together the USA, Canada and Mexico in 1994. 2. Customs unions: these also eliminate tariffs between members but in addition they set a common external tariff against rest of world that each member country must observe. 3. Common Markets: these cover much more than customs unions or tariffs and quotas. They can, and usually do: a. Include laws that free up labour and capital movement between the members. b. Harmonise taxes which means that one country cannot be too far out of line with the others. c. Adopt some common monetary measures, such as all using the same currency. The Euro began in 2002 for most of the EU members but the UK has so far chosen not adopt it. d. Set up a fixed exchange-rate between the members. Really the members of a common market are moving in the direction of being one big economy, while retaining their own nationality. Why set them up? • To gain economies of scale. • To compete with bigger nations, e.g., the EU against the USA. • Political motivation (not our concern in this course). There are two sorts of gains - static gain and dynamic gain The static gain is the one-off benefit which a country usually obtains at the moment that it joins.
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• Trade creation versus trade diversion Whenever any trading bloc is set up, or any country joins an existing bloc, there is a trade creation effect. This allows the most efficient producer to expand and sell its produce to the others, so all benefit to some degree. The producer gains a larger market and can reap economies of scale. The consumers gain because the price will be lower and the quality probably higher than they previously enjoyed. This trade creation feature is always beneficial, and is often referred to as being a positive effect. There is also a trade diversion effect. This is what occurs when the country joining ceases to buy from and sell to its traditional partners and starts to buy and sell within the group. Unlike trade creation, trade diversion can be either positive or negative. If a country previously imported from the best and cheapest producer in the world, but after joining the organisation is now only allowed to buy within the bloc, it has a harmful or negative effect. So if a country joins a trading organisation it has to hope that both diversion and creation are positive, or else that the gains on trade creation are bigger than any losses on trade diversion! (Remember that these are all static gains). The dynamic gain is the continuing benefit over time of more dynamism as a result of: • the increased competition; • the larger market allowing the economies of scale to run for ever; • a more mobile and probably better motivated labour force; • and increased capital flexibility. • All of these lead to greater efficiency in production. These dynamic gains are always positive, that is to say, continuing benefits will steadily be achieved. The World Trade Organisation (WTO) The WTO replaced the General Agreement on Tariffs and Trade (GATT) as a result of the Uruguay Round of negotiations (1986-94). You can see that it took eight years to gain international agreement! The aim of the WTO is to increase the amount of world trade by means such as promoting tariff cuts, increasing and perhaps eliminating quotas, and minimizing, or better yet solving, disputes between members. The WTO holds occasional meetings to negotiate further reforms. The WTO will not allow a nation in a recession to increase its tariffs or reduce the size of the quotas it sets. In other words, it is not allowed to increase the level of its protection. This rule is believed to have helped avoid the sort of harsh global economic slump that we saw in the 1930s. Present contentious and unresolved issues are: • Agricultural trade is still restricted by the developed world (which hurts many poor developing countries).
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• Developing countries feel left out of the WTO progress and many believe that they are discriminated against by the rich developed countries. It is often seen in the third world as a sort of rich man’s club that has accepted poorer members but rather ignores them. • The concern in the West about working conditions and human rights in some poor developing countries is a touchy issue. Poor countries usually want to get richer first, then worry about things like working conditions later. They often resent being lectured to by the rich club members and told that they should not do the things that earlier made the rich rich! The WTO is attacked by radicals – often physically - at international gatherings, such as the one in Seattle in 1999. The stated grounds for attack are that the WTO promotes globalisation and global capitalism. The extreme radicals dislike these for both political and socio-economic reasons: The political views of the radicals (not economics but related to it) • The radicals are strongly antagonistic towards capitalism as the preferred economic- political system. • The radicals are usually anti the USA, which is seen as the leader of the system. • Some radicals are against the banks generally and international banking in particular. • And some radicals seem to be pro communism; or pro anarchy; or pro nature and going back to living in more primitive ways that are seen as natural rather than artificial. The socio-economic views of the radicals, Many believe that the process of globalisation has led to the world’s poor people and poor countries becoming even poorer, and therefore it is bad and must be resisted. They often argue that the world’s income distribution has altered in favour of the rich. Actually, in many cases people in the poorer countries are wealthier absolutely, but they are poorer relatively to the rich. What often happens is that nearly everybody has got richer but the rich have got richer faster and so the gap is widening. Those at the bottom improve a bit but those at the top improve a lot more. It must be admitted that not everybody gains: a tiny minority who happen to be unlucky, situated in the wrong place in the country, or who are physically or mentally challenged always seem to lose. The only way they can improve their lot is for their government to step in and help them. Few governments in poor countries feel that they can afford to do this yet and it must wait until the country is more developed. Where the people are absolutely poorer – and this does happen - it is almost always the result of one or two things (and sometimes both): • Bad governments that have adopted poor economic policies (Zimbabwe, the Sudan, Nigeria). • Wars, rebellions, or coups (sadly common in much of Africa). So it is often politics and people that cause it rather than capitalism or the rich nations.
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The case that the weather causes the problems Now and then the poverty and problems are the result of bad or changing weather conditions, which lead to drought or floods that in turn cause famine and death. But such severe results mostly occur in an area that is undergoing war, rebellion, or revolt. More stable countries suffer from weather problems too but they can usually cope with them without major and long running disaster. It rather looks as if the military or political turmoil is the main factor involved where suffering is both intense and prolonged. It is common and understandable for bad governments to blame freak weather, or global warming, or international capitalism, or indeed any thing they can think of to explain away their own mistakes.

Why is the government involved in the economy Some abbreviations used: X = exports M = imports B of P = balance of payments GDP = gross domestic product
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INTRODUCTION 1. Why does the government become involved in the economy? Since John Maynard Keynes’ work, published in the 1930s, we know how we can intervene to reduce unemployment etc., – we have a good theoretical model that helps us to understand how the economy works. Increasingly since World War Two (1939-45) it is seen as a task of the government to intervene and work more actively to improve things in general. Interventionism is now expected. The natural working of the economy can sometimes give undesirable or unacceptable results, such as mass unemployment or inflation. Because what is happening, or government fears is about to happen, is not wanted. For example, inflation is felt to be too high or there is a fear that it will increase; or balance of payments is worsening. Note: since the time of Prime Minister Margaret Thatcher (UK) and President Ronald Reagan (US), in the late 1970s and the 1980s, efforts have been made to reduce the amount of government intervention. However, it sometimes seems rather difficult to reduce the share of government in the gross domestic product. The use of freer markets has definitely increased – but the government share of GDP seems to have increased too. 2. At the micro level: the government wishes to make the market mechanism work better. What main areas of the micro-economy does the government look at or tackle? Monopoly elements or market dominance. Externalities. Public goods. Public goods. Merit goods. De-merit goods. Information failures. Factor immobility. Undesirable income and wealth distribution. That is, the government looks at all the major elements that we are studying! 3. At the macro level : the government wishes to modify some important areas. What does the government look at or tackle at the macro level? Inflation (usually they prefer a low figure, e.g. below 3% ). Unemployment (they usually prefer it to be low, e.g., below 4%). Economic growth (they usually prefer it to be reasonably high, e.g., above 2.5%). Balance of payment (they usually prefer a balance of exports and imports, or perhaps a small export surplus). The value of the currency which means the price of the pound in international markets (politicians usually prefer it to be high, although a lower figure means that industry benefits as our export goods will be cheaper and so easier to sell abroad). Allocation of resources (they usually prefer a market solution but it can be whatever the government feels it wants).
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Distribution of income (the Labour Party usually prefers a narrow distribution; the Conservative Party perhaps wider? But New Labour seems to accept that a wider distribution of income is quite acceptable). Standard of living (they usually prefer high). Taking care of the environment (a relatively new area of concern). Unwanted fluctuations in any of the above, e.g., if any are felt to be undesirable at the level they are at, the government may step in and try to alter and improve the How can government try to manage the economy? There are two main ways: fiscal policy and monetary policy. Fiscal policy = taxation largely, plus some subsidies. This label also includes government spending these days; once it was separated out in text books as “direct action”, “government spending” or a similar phrase. Monetary policy = changing the money supply or the rate of interest to alter the level of aggregate demand. NOTE: Since 1997 this power was removed from government and given to the Monetary Policy Committee of the Bank of England. The government is represented on this and can strongly influence its decisions but not control it. Both main ways of managing have certain implications attached: Fiscal policy: tends to have strong resource allocation effects, for example if the government increases the tax on cigarettes, it hits smokers only; if it increase income tax, it ignores those on low incomes who do not pay this tax. Fiscal changes are usually done in an annual budget in April – so a desired change can be slow to implement, as we may have to wait until April to announce it! Some changes to come might be leaked beforehand. In addition to the budget proper, the country may have a mini-budget around October. Once a change is announced in the budget, the effect is virtually immediate. Monetary policy: the government no longer can do this directly – despite its ability to influence the views of the Monetary Policy Committee. The effects of monetary policy may be slow and it can take between 6 months and 18 months to get the full impact of interest rate changes. What does government actually do? 1. It may try to increase aggregate demand: it might do this if it feels that unemployment is too high, and inflation is reasonably low; or the standard of living could safely be increased; or economic growth could be higher. - To increase demand:
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- Fiscal policy: government could decrease some or all (unlikely!) taxes; and/or spend more government money (the “G” in “C+I+G” which is the domestic component of aggregate demand). - Monetary policy: government could lower the rate of interest by persuading the Monetary Policy Committee to act. 2. Alternatively, it may try to reduce aggregate demand: it might do this if it feels that inflation is too high, the employment level is too high, or the balance of payment is poor (imports exceed exports), i.e., we are in the middle of a boom and the government wishes to moderate it. 3. Supply side: the government might try to push the aggregate supply curve out and to the right. This would reduce inflationary pressure. The government cannot attain all its goals at the same time because We are not yet smart enough to know how to do this! (And probably never will be.) Some goals contradict others: to get more of one, we must have less of the other – there is a “trade off” between the two. Mathematically, it is theoretically not possible to attain ten goals with only two policy instruments. Examples of what we cannot get at the same time because of conflict High growth with a good balance of payments (fast growth sucks in imports). Low inflation with low unemployment - but we are better at this than we once were! High growth with more equal income distribution. Economic growth naturally causes a widening of income distribution as those who are better, luckier, more intelligent, stronger, better connected, happen to be in the right place at the right time….. pull ahead of the pack. The government may choose to step in to try to equalise it more (New Labour has so far chosen not to do so). It is possible that a wider income distribution actually assists the attainment of higher economic growth (which is part of the supply side view). In other words, the goals interact. The pursuit of one goal can harm (or sometimes assist) the attainment of a different goal. We live in a complex world! Much of the rest of unit 3 is simply explaining the details of the above. What each item is; how we define individual items; what the government does with them and how it does this; what diagrams we can draw to illustrate the workings of the economy and then use them to analyse what is currently happening or what might be done if some other equilibrium position is desired. Inflation

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We need to understand how to measure things like the level of inflation, the level of unemployment, the balance of payments and the size of gross domestic product. Why? If we are to see how well the economy is doing we need to be able to measure the degree of success. If we want to know if government should intervene or not – and if so, whether it might wish to expand or to contract the economy. And, in general terms, we need to understand how we measure so that we know exactly what we are talking about! We need the information about measurement methods for use when answering exam questions. Finally, we need to understand how we measure to make sense of the actual models we use later. THE RETAIL PRICE INDEX Inflation is an important economic goal and it matters to a lot of people. For such reasons, we have to know how much prices are changing or have already changed, which means that we have to take measurements in some way. It is clearly impossible to go to each shop in the country and price each item once a month! So we have devised an index to simplify the task. We take a “basket” of goods and services, typical of what people buy, and price these goods and services at a base date. Then we look to see what has happened to the prices of the individual things in the basket since then and tot them up. The government has done this since 1947. Details: over 600 goods and services go in the basket; once a month we take over 120,000 samples of prices of these 600+ items. This is a bit tricky: the supermarkets, corner shops, 24/7 stores and so forth all have different prices and in addition some areas like London are dearer than others. Then the statisticians “weight” the items – e.g. housing and transport are more important than salt in people’s budgets, so the important things are weighted more heavily than the unimportant ones. If the price of salt rises by twenty percent it really will not affect us much! But if bus or train fares went up by that percentage it surely would…. If the average rise of all the items, after weighting, is found to have been 0.5% over the month, the government tells us that; it usually also tell us what annual rate of inflation this would represent and how it compares with the same month of the previous year. At June 2004, the Retail Price Index was up 1.6 per cent over the previous twelve months. The “RPIX” (which stands for the Retail Price Index Excluding Mortgage Interest Repayments – quite a mouthful!) is a separate measure, which excludes mortgage interest repayments. This is the one that the Monetary Policy Committee focuses on for its policy target, and aims for a rate of 2.5%. Limitations of the RPI

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Not everyone is average, and consumes that exact basket of goods and services, so the RPI does not exactly fit all (but it is close for most!). Pensioners and millionaires obviously have different spending patterns and neither will fit exactly. Pensioners have their own index calculated. Many goods are “intermediate goods”, e.g., machines to make machines, so these are excluded because they are not “retail”. The underlaying rate of inflation, which includes the changing prices of everything, can be different from that reported in the RPI. The basket gets out of date: o As people change their consumption habits (e.g., there is more foreign travel now than in the 1960s – but rather less after the September 11 New York terrorist bombing). o New goods and services come onto the market (e.g., DVD players) that were not in the old baskets – so we have to update the basket periodically. This is done each Spring. o But after we make such a change, strictly we cannot compare the new price index with the earlier ones, because it covers slightly different goods and services, or we might have altered the weightings used. We still make the comparisons however! The index does not reflect any quality improvements and these steadily occur. It is better to think of the RPI as an “estimate” rather than a hard accurate figure. The RPI does not measure the standard of living. It excludes things that have an important impact on this, such as changes in tax; changes in leisure time; changes in the physical space available for enjoyment; and changes in the quality of goods and services. Uses of the Retail Price Index Unions look at it and may base their wage claims on it. The government looks at it, to decide if there is a need to intervene and manage the economy (our main interest!). Journalists look at it, to write articles explaining to people what is happening and their comments and advice might be considered by the government. Economists look at it, to help them understand what happening and of course to advise others. Investors look at it, to help decide whether to invest, when to invest, and where to invest. It is used in international comparisons to evaluate the performance of the UK and compare it with other countries. It is used to calculate the price rise allowed for some privatised industries that are tightly controlled. These were once state-owned public utilities such as the gas and electricity supply companies. The energy sector is controlled by Ofgem.

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The RPI is often used loosely as a measure of inflation – although it only reflects retail prices and indeed not all of those. What is inflation? Inflation means persistently rising prices; the term is not normally used by economists (although it may be by the person in the street) for a one-off price rise, for instance if the government increases the level of VAT. What can cause inflation? Demand pull = demand exceeds supply at prevailing prices. Cost push = a shortage of raw materials causes their price to rise; these force up the costs of our producers. Rising import prices can similarly push up our manufacturing costs, as can wage-push inflation. Hybrid inflation = a mixture of the first two. Either starts the process off, then the other jumps in; they may then alternate in an on-going process. Government policy can do it, forcing us up the Philips Curve (more later); or the government might increase spending before elections to put more people into work and gain support (this is really a special form of demand pull). We will investigate the problem through our aggregate supply and demand model later. Some Problems with inflation Those on fixed incomes lose out (pensioners, students…). This also changes income distribution. Those on sticky incomes lose (often public service workers, as it is not easy to increase their wages). If inflation is too high, it puts entrepreneurs and business people off, so they will not invest as much. Less investment now means slower growth in future. Benefits of inflation Moderate inflation can encourage entrepreneurs and business to take risks and invest, leading to a higher growth rate and less unemployment. We are used to inflation and seem to feel comfortable with it. We are not sure what to do if we face deflation (generally falling prices), e.g., Japan has been stuck in recession since 1990 and also deflating in the last few years. There are signs in 2004 that this may be ending. Problems with low price rises or even deflation Low rates of inflation = the situation we are in now (2004). It may turn into a long-run recession with the danger that we could get stuck, like Japan.

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If this happens, we get low rates of growth, high unemployment and possibly the development of international protectionism and “beggar my neighbour” policies. When the economy is growing slowly it makes it harder for the government to introduce changes; with fast growth, everything is buoyant, government revenue is up and they can do a lot. When it is harder for the government to make changes it may mean that downturns in the economy are likely to be more severe and long lasting. The ability to use monetary policy gets weaker when prices are not increasing much – it is harder to stimulate the economy by reducing interest rates. Benefits of low price rises Consumers gain, as goods and services rise little in price. Fixed income (and sticky income) people gain; groups such as pensioners and students are helped. A low rate of inflation encourages investment, as people can make a paper profit easily. Risks are reduced if everyone knows what prices to expect. Unemployment Why do we measure unemployment? Unemployment is seen as a social evil, that should be tackled – we need to know the level of unemployment to see how well the economy is doing. The government needs to know so it can intervene if necessary. Government may decide to alter the level of aggregate demand or institute special policies e.g., sponsored training schemes, or expand jobs in the public sector. We need to know the level of unemployment for social welfare purposes. The government need to budget and wants a forecast of future payment levels to the unemployed and other social security benefits. Types of unemployment and the role of the state in tackling them Other than giving unemployment pay to those who have paid for their stamps (national insurance), we usually do better by tackling the cause of the unemployment if we can. These causes can be: Deficient demand. Structural. Cyclical. Frictional. Deficient demand If the cause is deficient aggregate demand: the government can simply increase demand. Structural unemployment
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At any one time, some industries are dying and have surplus labour with skills that fit that industry; and some industries are growing and are short of people, particularly those with the necessary new skills. A major cause of structural unemployment is a change in demand in consumer markets, together with the time lag needed to educate and reeducate people. In addition to changes on the demand side, some technology changes on the supply side mean we also need new skills, for example computer scanner repair workers. We always see a mismatch between the skills workers have and the skills employers need, because society is constantly changing. Note: manufacturing is a dying area and service industries a growing one in all developed societies. This has strong implications for the type of education we need and the training in particular skills. To tackle structural unemployment the government may: a) Provide information on what jobs are available as well as likely in the future. This can be done via job centres, advertising on TV, informing careers advisors in schools and the like. b) Help people to move away from the area of low job opportunity in which they live. Some possibilities include: subsidise travel to look for work; pay all the costs of selling the house and buying a new one elsewhere; allow people in council accommodation in different local authorities easily to exchange dwellings; make all pensions transferable between companies. A major problem is the house cost around the South-East of England. Prices are so high compared with the North. A minor problem is that welfare payments allow people to stay where they happen to be born, even if there is no work there for them. People often do not or will not move: Some people do not want to move away from their families, friends and social groups or clubs of which they are members. Some people often unaware of the possibilities elsewhere (lack of knowledge). Local accents are strong and they fear they might be laughed at or not find work easily even if do move – with some justification. Sheer inertia. c) We may need to train and later retrain adults through life to gain new skills. Some possibilities include: subsidise retraining for the worker and for the company they currently work in; tax breaks given to those who gain a needed skill; allow the worker time off work with full pay; or “bribe” people with cash handouts. This would seem a more desirable way and less disruptive socially than moving people to new areas where they may be unhappy. Cyclical unemployment This is due to the business cycle. We can try to iron out booms and slumps to reduce this type of unemployment.
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Frictional unemployment These are people in the process of changing jobs and who are briefly and temporarily unemployed. We need do little or nothing here. The 1998 Labour “New Deal” This was partly to tackle unemployment, partly to tighten up on “dole bludgers” and persuade people to go back to work. The unemployed now have three choices: Stay in school or go back to school. Find a job. Join a recognised training scheme. Their benefits can be cut off if they do not do one of these. “Full employment” This does not mean “no one is unemployed”! There will always be frictional unemployment; some people will never work because of mental or physical incapacity. Lord Beveridge, in 1944, felt that 3% was roughly “full employment” (made up of 1% frictional, 1% seasonal, and 1% because of overseas factors like a fall in demand for some of our exports). Now we prefer to focus on the “natural rate of unemployment”, which is the level where the rate of inflation does not increase (but there still is inflation). This is abbreviated to “NAIRU”, “the non accelerating rate of unemployment”; there is a bit of confusion around this term, as some writers use it to mean the level where prices are constant, i.e., there is no inflation at all, rather than there is some inflation but which is steady. We will look at NAIRU later in more detail when we examine the Phillips Curve below. Demographic and social changes and employment (some points that might prove useful for exams – you never know!) An ageing population: fewer workers exist to support the greater number of living retirees which will lead to an increasing burden on the working population. The population pyramid: this is usually a “normal” shape, i.e., it is like a pyramid. However, in developed countries such as the UK, the base is narrowing as fewer babies are being born. The government response has been to encourage people make more provision for their own old age and save more. Stakeholder pensions (2001+) encourage people to take out their own private pension plan; Independent Savings Accounts, better known as ISA’s (1998+) mean people do not pay tax on savings in an ISA account or on shares held in an ISA account. Women have increased their share of the workforce. Generally they take part-time work more than men. This is partly because they prefer it as they may have children to cope with; for many, however, they take it because it is all that they can get.

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There is a problem hidden in the overall unemployment statistics in that many of the unemployed are full time males; while many of the newly created jobs are for part- time women workers. The participation rate. This is the proportion of the working age group (15-60 or 1565) that choose to work, i.e. are in work or actively seeking work. The share of women has increased! Technological change and unemployment Manufacturing industry is declining as service industries expand (these are now 70% of GDP in the UK). This means that some old skills may be out of date and are no longer needed, while the demand for new skills is high and also constantly changing. Age effects: the old learn new skills slowly if at all, so demand for them is low. One result is that it is harder for them to find a job; firms just hire younger workers. There is a normal distribution curve of intelligence (half the population is below it by definition!). In a modern society, heavily based on services and with many automated machines, the less intelligent people have fewer and fewer jobs to go for (there is less demand for their services using muscle) but the demand for the intelligent ones steadily increases. The long term prospects of those born slightly dim through no fault of their own does not look good, especially if they lack a natural talent. If someone is born with an ability to cut hair, they will probably be OK, in fact do rather well. But those with a low IQ and no natural skills may find it quite hard. There is probably a social problem in the offing here. Economic growth What is economic growth and how is it measured? Economic growth is the increase in output of the value of goods and services in the country, usually measured over the period of one year. In a developed country we typically get a figure like 2.5% or 3.1% - but for a fast- growing poor country like China, it may be as much as 7%-10%. We can see growth as a movement of the production function in an outward direction. (Here we have chosen to look at growth over four years but annual growth rates often interest us more.) ppc = production possibility curve. Starting at C on ppc1, economic growth causes the production possibility curve to shift out to ppc2, to a new equilibrium position at D.

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Only two good are shown - but it works for any number – I cannot draw four-dimensional (or more) diagrams; I am not even good at 3D! Nominal and real economic growth Nominal growth includes price changes and, if there has been any inflation, it exaggerates the measured rate of growth. Clearly, if all prices were to double but output were to remain the same, it is not true to think that we have a hundred percent growth rate! “Nominal rate of growth” = change in GDP over the year (e.g., 2.9%). “Real rate of growth” = GDP minus the rate of inflation; e.g., if inflation is 1.4%, the real growth rate is (2.9 1.4) = 1.5%. Growth as an indicator of the standard of living Growth is often seen as most desirable, especially by governments. Growth is one of the ten economic goals (remember these?) and higher growth is often thought to be better, although some people criticise high growth rates for their effects on the environment. A high growth rate is limited, or perhaps can be even misleading, as an indicator of improved living standards. Growth over time within one country: limitations as a measure. NB these points are also virtually identical with problems in the use of GDP per capita as a measure of the standard of living. Economic growth excludes much that goes into the standard of living – e.g., the environment (air or water pollution, availability of parks and green space; or the numbers unemployed). The hours worked are not examined: if we all double our hours worked and GDP rises by 5%, it looks good with 5% “growth” - but most would agree that we are actually a lot worse off! Leisure is excluded from measurements of economic growth. Free services or goods are excluded: for example, the work of housewives or househusbands; all voluntary service like teaching computing for Age Concern; looking after a relative as a carer; and the free exchange of labour in service swap schemes such as babysitting clubs.

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A change in GDP can be caused by changes in aggregate demand – if demand falls in one year, growth can be negative – then if demand increases, growth bounces back strongly. This kind of yo-yo effect can be most misleading and careful selection of starting and stopping years can yield opposite results! Examine the diagram below. If we choose the years T1 and T2, we get a strong growth rate on Line 1. Contrast this with choosing years T3 and T4 on Line 2: there is a negative growth rate! Be most careful when listening to politicians when they are talking about changes over time; some of them have a nasty habit of selecting those years that favour the argument that they wish to make!

We need to measure “the underlaying rate of growth” to make a sensible comparison over time. This measures what the economy could produce if demand was enough to buy all that was produced. Measuring economic growth should be done on a per capita basis – if GDP increases 2 per cent but population increases 4 per cent, people are definitely worse off on average. We know that environmental damage is excluded. A related problem is interesting! If we damage the environment, then spend £100 million putting it back the way it was, the GDP actually increases by £100 million - and on paper we are “better off” and we have growth! Crime is naturally excluded from GDP as it is not desirable – but if crime increases and we spend £100 million on more police to combat it, then again the GDP rises by £100 million and on paper we are “better off”. Few would actually feel this to be a real improvement perhaps. As we enjoy economic growth, it is quite possible for income distribution to have got worse! It is true we have growth, but the standard of living could have fallen for the majority of the population. Comparing growth between countries can mislead Slow growth can often conceal a better situation. As an example, let us consider the UK and Egypt. Suppose growth in the UK is 2.2% p.a., but in Egypt 3.3% p.a. This looks good for Egypt, but in reality: - That country started off so much poorer that the extra one percent growth probably added much less to their output than the UK achieved. - People probably worked much longer hours in Egypt. - The population growth in Egypt would almost certainly exceed that of the
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UK, so the improvement per head in Egypt could be less than in the UK. - The death rate in Egypt is higher, life expectancy shorter, and the standard of living is much lower than in the UK. Countries do not always measure their growth rate in identical ways, although they should for proper comparisons. The quality of statistical accuracy varies between countries – the UK figures are better, for instance, than the Cambodian ones. Much more free family work is done in poor developing countries than in richer developed ones – so the figures miss out much real production that takes place in the poor countries. “The unofficial sector” or “the black economy” is not picked up in the statistics, and the size of this differs between countries, e.g., the black economy is thought to be much bigger in Italy than in Denmark. Exchange rates can distort the picture; e.g., if France used to exchange US$1 for 10 francs and the exchange rate changes to $1=5 francs, measuring the GDP of France in dollars, looks as if there has been a doubling of GDP as 10 francs now buys $2! What causes growth? = the sources of growth It is useful to consider this under the headings of Land, Labour, and Capital + Remainder O = f (L, N, K) + R (Recall we did this earlier). A) Land factors Natural resource endowments – if a country has diamonds or oil etc, it helps! But the land factor is not enough to give growth on its own, and it is the least important of the growth factors. B) Labour factors Labour skills and abilities = education and training. The more of these, the better for growth but it should be of the right kind. India, for example, has been accused of training far too many lawyers and not enough agricultural specialists. Labour enthusiasm or motivation – the more of this, the better for growth. However, it is not easy to know how to stimulate motivation. Declaring war on someone usually seems to increase it although the British invasion of Iraq did not seem to be popular or have a motivational effect. Labour numbers – the more the better if they have the skills etc. and the country does not start out with a large labour surplus. More workers are less useful in China or India than they would be in the UK or the USA. Managers’ ability, training, and enthusiasm. The higher the better. C) Capital factors
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More machinery and equipment = good for growth. Higher rates of investment = good for growth, because it means more machines etc will be available. Remember that social investment like docks and harbours can pay off too. Higher rates of saving = good for growth because the country can invest more (in the short term it could harm output if it means that consumers are suddenly not spending as much, but it is generally good for the long term). Technical progress = good for growth and is the main source of growth in rich developed countries. Desirability of growth = the case for growth or the benefits of growth Growth means we can increase the standard of living, increase GDP per head, and spend more on things like welfare, transport, education and health for example. The growth we achieved in the past is the source of our present living standards, health levels, and lack of illiteracy etc. Growth means we are able to tackle all our existing problems more easily, because we have the increased resources to do so. We probably need growth for instance, to put right any environmental deterioration. Growth means if we run into a new problem, it is easier to cope with; we are growing and thus have more surplus to devote to this problem. Undesirability of growth = the case against growth It causes environmental degradation by its very nature. Blind pursuit of growth means we may often ignore the real problems we are facing. This objection to growth is sometimes a crude “Back to nature” romanticism – growth is somehow immoral or bad. Urban congestion, high levels of stress in people, marital breakdowns, generational conflicts and the like may be caused by or at least worsened by our efforts to grow faster. Growth by developed countries has forced poverty on poor countries (probably a poor case - although the balance of division of gains does favour the wealthy and powerful). Poor countries generally are getting richer than ever before - except where civil wars, invasion or totally unsuitable economic policies have damaged or destroyed the economy. Africa is currently a case in point, with people either slaughtered or starving now or in the past in countries like the Sudan, the Democratic Republic of the Congo, Rwanda, Idi Amin’s Uganda, Charles Taylor’s Liberia and Mugabe’s Zimbabwe. A few final points about growth Generally economists favour growth, although we are aware of the damage it can cause. If you are asked in an exam, it is usually better to decide in favour of growth, after pointing out the various problems that might be associated.
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The point that without growth it is harder to improve the world we live in has merit and is often worth mentioning. And you can say that careful watching and action by government may be highly desirable or essential to put right any undesirable side effects from growth. Aggregate demand This model is the representation of the whole macro economy and this is the diagram we use to analyse any changes in it. It is crucial that you understand this model and be able to draw it from memory. (Always draw the two axes first and label them – then put in the curves and label them too! Having done this you can then start to move the curves around. Remember! Examiners see too many unlabelled diagrams.) Some standard abbreviations: Y = income; C = consumption; I = Investment; G = Government; X = exports; M = imports; r = rate of interest; Y = income; L = land; N = labour; K = capital; Ms = money supply; Md = money demanded. What is aggregate demand? Aggregate demand is the sum total of all planned expenditures by the people and government. = Consumption + Investment + Government expenditures + Exports – Imports = C + I + G +(X – M) The aggregate demand diagram

NB. The labels on the axis! This diagram is not the same as the micro demand curve! But if you can cope with the micro one, this one works in a generally similar fashion. The broken lines merely indicate a gap in the number line – you need not draw these but it impresses a bit if you do! Henceforth I am dropping the break lines in the diagrams, mainly because the diagrams look cleaner that way. The amount demanded varies at different prices: the lower the price index the more is demanded (the AD curve slopes downward left to right) because of:
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• The wealth effect (“the real balance effect”). This says that as prices fall, we are wealthier because we can buy more with the same amount of money. Think about it! If all prices were to halve while you read this page, the money you have in your pocket and elsewhere would buy twice as much. • The interest rate effect (higher inflation means a higher interest rate, which means less investment and fewer houses are demanded, as well as smaller quantities of other long life assets). • The foreign trade effect. As our prices rise we are able to sell fewer exports because they are relativel y expensive; and we buy more imports which are now– relatively cheaper. If w slide up the aggregate demand curve we can see what happens as the country suffers more inflation – we demand less in real terms. Q. What can cause a shift of the aggregate demand curve? A. Anything that affects C, I, G or X, M For example: • A change in attitudes: if we experience a reduced desire to save, it means we consume more, so the “C” part increases. • If the government reduces income tax or other taxes on consumption, we will consume more, so “C” increases. • A fall in interest rates would lead to an increased demand to buy long-life assets which are usually bought with borrowed money. This means investment rises; perhaps business people buy new machinery which means the “I” part increases. • An increase in the money supply would reduce the rate of interest, again meaning people invest more so “I” increases. • If the government decides to spend more it means the “G” part increases. Aggregate supply What is aggregate supply? Aggregate supply is the sum total of planned production. In the diagram it is often called the Short Run Aggregate Supply Curve (SAS). The Long Run Aggregate Supply curve is the vertical part only of the SAS curve. (And see below p.128 for an alternative diagram)

It is that shape because rising prices encourage producers to expand their output as they believe that they will make extra profits.
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3. THE EQUILIBRIUM LEVEL OF NATIONAL INCOME This is determined by aggregate supply and aggregate demand.

Guess where the equilibrium is? Right! At the intersection of AD and SAS1. What can increase aggregate demand? (which of course = C + I + G + X - M) A. Anything that affects C or I or G or X or M can change the aggregate demand curve! Examples: • An increased desire to consume more (an increase in C). • An increase in government spending (an increase in G). • An increase in export sales (an increase in X). How do we show an increase in SAS? Push it out to the right = more is supplied at any given price level.

What can push out the SAS curve to the right? • An increase in the quantity of factors of production. • Better quality of factors. • Better ways of using or combining the factors (L, N, K) + R. Some things that can push out the SAS curve: • New technology is introduced (= better K). • Investment increases (= more K). • Productivity increases (perhaps workers work harder, or managers try harder, take new training courses, or work longer hours). • More migrant workers enter the UK (= an increase in the supply of N).
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• An increase in the hours worked by labour (= an increase in the supply of N). • Better education or health of workers and managers (= better quality “N”). • An increase in Direct Foreign Investment from abroad (= more K; and possibly better K). • A reduction in taxes placed on firms and companies. Macroeconomic policy – What the government does or tries to do As you know, there are about ten major economic goals for all countries (the main four goals for many governments are asterisked, but each government chooses for itself). Their actual order depends on the priorities of the government of the day. • Resource allocation. • Economic growth.* • Standard of living. • Income distribution. • Inflation.* • Unemployment.* • Balance of payments.* • Value of the currency internationally. • Protecting the environment. • Avoiding unwanted fluctuations in any of the above. Even if a country has no policy on some of them, the issues do not go away! NOTE: this is a useful list to remember. Any event can be analysed using this list as a framework for thinking. For example, the effects of an earthquake; or a new government after a general election; or a new tax being introduced. Any such event will have an effect on some, perhaps nearly all, of these goals. If you learn the goals and think of them, it can save you overlooking valuable points when preparing your essays or answering questions in the exam room. There are trade offs between goals; we cannot get them all at once – e.g., if the economy is growing fast it usually means: • Higher prices. • The balance of payments deteriorates (imports increase). • Income distribution widens. • The currency may strengthen (if people around the world believe the growth is permanent and the economy will continue to be dynamic). • Or it may weaken (if people believe the economy is out of control and inflation will continue). • The environmental situation may worsen, e.g., there might be more air and water pollution, or traffic delays could be longer.

MONEY
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Definition: money is anything generally acceptable in payment of a debt. It can be (and has at various times and places been) things like sea shells, cigarettes, or bottles of rum. But these are very rare instances! The functions of money (= what is it for?): • A medium of exchange • A unit of account • A standard of deferred payment • A store of value Classification of money (There are lots: M0-M12 or so) There are many ways of measuring the money supply – but only two really matter to us. 1. M0 = narrow money = notes, coins and bank balances deposited at the Bank of England; in May 2004 it was £41 billion. M0 had a growth rate of 6.0 per cent over the twelve months to July 2004 (provisional figure). 2. M4 = broad money = M0 + all sterling deposits with banks and similar organisations (those that the Bank of England allows to take customer deposits); at April 2004 it was £1,095 billion, that is, it’s much larger than M0. As a result, many observers focus on M4 as the main one to be looked at. M4 had a growth rate of 9.7 per cent over the twelve months to September 2004 (provisional figure). [Remember! It is useful to scatter the odd statistic in your exam answers – it can impress the marker that you are interested and aware. That can gain you marks if s/he is uncertain whether you really understand something; it can help you get the benefit of any doubt.] M4 contains: • Notes & coins. • Operational balances at the Bank of England = bankers’ balances = bank deposits at Bank of England with which each bank can settle its debts to the others. • Sight deposits = current accounts = no-notice accounts (can be withdrawn immediately). • Retail deposits = all bank deposits less than £50,000 + building society deposits which require less than 1 month notice. • Wholesale deposits = deposits £50,000. • Time deposits = bank accounts requiring notice. The demand for money Keynes postulated three demands for money to hold (rather than use to buy bonds). This is called “the liquidity preference theory”. 1. Transactions demand = to buy things with in normal daily life. 2. Precautionary demand = in case anything goes wrong, it is good to have some cash around for the sudden emergency. 3. Speculative demand = to buy bonds when one is ready to do so. This demand is our focus of attention.
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When the price of bonds is high, the rate of interest must be low (why? See below “Monetary Policy”), so people expect bonds to fall in price; therefore it is sensible to hold money (demand money) to buy the bonds later. So at low rates of interest, more money to hold is demanded. This gives us a normal shaped demand curve.

Monetarists v Keynes In the 1950s and the early 1960s, developed countries followed theKeynesian view. This held that money was not very important in determining the price level; and it was believed that interest rate changes did not work well to alter spending (which was roughly true back then, although it was based on the situation in the Great Depression through which Keynes lived). Then the Monetarists emerged – led by Milton Friedman – and they said that the supply of money really did matter. They used an old formula: MV = PT Which said that moneytimes velocity (its turn-over) = price leveltimes transactions (which is a truism i.e., it is always true whatever level these items actually take). But they went further. If we believe that velocity (V) is stable (that it does not change much) then a change in M = a change in PT. When we are at full employment, we know that we cannot increase T (by definition! We are unable to produce more), so a change in M must cause a change in P! For this reason, it was asserted that the supply of money really does matter, and monetary policy was held to be the main one to use. In the 1960s, Keynesians still felt that fiscal policy was best; but the monetarists wanted to use monetary policy instead. By the 1980s, the monetarists dominated policy making all over the developed world and it looked like the Keynesians might have lost the argument. However, with the passage of time we found that it was really hard to control the money supply accurately, so the monetarists retreated a bit. Now: there is no real conflict; there is an amalgam of the two views! At the full employment position, for policy purposes the monetarists dominate; but at low levels of aggregate demand, the Keynesians are predominant! Some important variables in controlling the economy • The labour market: if this is flexible (which means that wages can rise and fall easily; and people can be hired and fired easily) monetarism works well. - But if the labour market is rigid, the Keynesian approach seems to work better.

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- In the UK, the labour market is more flexible than it once was (and more flexible than in much of Europe), so monetarism has improved as an approach to use. • Time lags: these are longer on the money side – there may be up to two years before the full effects of a change in the supply of money have worked through. With fiscal policy, the changes are almost instantaneous. • The shape of the marginal efficiency of capital curve (which is the investment demand curve). If this is very steep, then even a large change in the rate of interest will not alter the level of investment much. (see Diagram A) • The shape of the liquidity preference curve. If it is very flat, monetarism will not work well, because the rate of interest cannot be reduced much – if the money supply is increased by the Bank of England, people just hold on to the extra money (see Diagram B).

• General expectations about the future A): If people expect higher inflation, then we can have rising pricesand rising unemployment at the same time. The use of monetary policy, and possibly a strict use, may be needed to break these expectations. • General expectations about the future B): If business people feel very pessimistic and are perhaps on the edge of panic, the MEC can continually drift to the left. This means that nothing works much when we try to increase the level of GDP, because all the efforts to increase aggregate demand can be offset by shifts in the MEC curve! • General expectations about the future C): If business people are hugely optimistic (which means the MEC may shift out rapidly to the right), we may need a strong combination of fiscal and monetary to rein it in.
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• Where we happen to be in the trade cycle matters too. – In a slump, and there is lot of unemployment, Keynesian and fiscal policy works best (i.e., we probably will not use monetary policy, especially on its own). – In a boom, when we have inflation, we are in the monetarist zone - and monetary policy works well. – Usually we are in the middle zone! So we tend to use a mix of both fiscal and monetary policies. Government should try to aim them both in the same direction for consistency and to avoid mixing their signals. They are not always able to do this, however, because the government has different departments and many different goals, and this fact may pull some policies in opposite directions.

Fiscal policy Why the government raises revenue through taxation: • To cover its expenditure. • To redistribute income, usually from the richer towards the poorer. • To reallocate resources. • To change consumption patterns (reduce cigarette consumption?). • To control the economy (our main interest here). As you know, there are two major policy instruments available to control the economy: fiscal policy and monetary policy. The government uses these to try to alter level of national income (GDP), from where we think it currently is, to where the government would prefer it. (Because of time lags in the data, we are never really sureexactly where we currently are!)

Here, the level of GDP may be thought too low, so the government may wish to increase aggregate demand and “fine-tune” the economy. What is fiscal policy? Fiscal policy means the use of taxation (and maybe a few subsidies which are a sort of “negative tax”) to alter the level of aggregate demand. Fiscal policy aims at consumption (C) and/or investment (I) and or government (G)
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G is not easy to turn on and off for fine-tuning purposes. The government is unable to reduce pensions by fifty percent in order to reduce its total expenditure! Nor can it suddenly stop building a motorway which is ninety per cent finished. In other words, much of government expenditure is not really discretionary at all. Changes in government expenditure are generally thought of as part of fiscal policy; otherwise we have to see it as “direct government intervention”. Some textbooks may call it that or use a similar phrase like it. If the government wishes to increase the level of GDP is means reducing some tax rates, or perhaps abolishing some tax completely, in an effort to increase C or I. Fiscal policy can also have a strong affect on income distribution. The main aim of any government here is to redistribute income towards those who are felt to be deserving. These are often the poorer, but groups like farmers in all developed countries and, under President Bush the oil producers in the United States, seem quite adept at getting income to move their way. What taxes has the country got? This is purely descriptive stuff! I suggest you read it up for yourself in the latest textbook and keep you eyes on what is in decent newspapers. Each country is very different and changes its tax system quite regularly. Few books can be up to date. A bit of fiscal detail: A “direct tax” is placed on directly on people or companies, e.g., income tax, company tax or a capital gains tax, and such taxes can be hard to avoid. In principle they should be impossible to avoid, but in practice the rich and the powerful trans-national corporations can often minimise the tax they pay and that to a rather surprising extent. The other type of tax is an “indirect tax” Indirect taxes are mainly placed on spending; this means that if one does not buy the item, then one does not pay the tax, i.e. it is something of a voluntary tax! In the UK, valueadded tax (VAT at the standard rate of 17.5%) is well-known; but we also have “duties”, such as the tobacco tax and the excise duty on alcohol. To increase the level of aggregate demand the government could reduce the rate of any or all taxes, like VAT, income tax, corporation tax etc. But such a change is normally only done in the annual budget, or sometimes in a mini-budget around October, half way through the fiscal year. So if we are considering the timing, fiscal policy is not very flexible! Monetary policy can be altered at any time, although if interest rates are altered it will normally be on the first Thursday of the month. Direct versus indirect taxation Direct tax: • This can reduce the incentive to work if it is set at high levels (the view of Prime Minister Thatcher and President Reagan). • A direct tax can be legally avoided although this can be quite difficult (taxevasion is always illegal).
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• A direct tax, like income tax, can be made progressive. This means that we can tax the rich proportionately more than the poor. On paper, income tax may look progressive but in practice it is often not so. Income tax is easily and legally avoided by the really rich, but the poorer and those in the middle are forced to pay. For really rich people, income tax appears to be rather regressive. Indirect tax: • This is seen as regressive as it can hit the poor more than the rich because it is a higher proportion of their (low) income. The poor also tend to smoke more than the rich, so the tobacco tax seems particularly regressive. • One can avoid paying an indirect tax if one does not buy the item, e.g., as a reformed smoker I no longer pay tobacco tax or the VAT on cigarettes. Fiscal changes can strongly affect the distribution of income; monetary policy changes affect the distribution of income less, because they are as more general in impact. How the government might increase the level of national income by lowering tax The government might choose to reduce, say, the level of corporation tax, in an effort to encourage business optimism. This could shift the marginal efficiency of capital curve to the right and thereby increase the amount of investment undertaken. The increased investment would then cause gross domestic product to rise. (See the diagrams below). Pushing out the MEC curve

The government is aiming at increasing the “I” part of C + I + G + X – M The increase in investment pushes up the aggregate demand curve and real GDP increases.

If the government were to reduce, say, the level of personal income tax, it is aiming at the “C” part of aggregate demand.
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Automatic stabilisers Automatic stabilisers are built into the system and modify its effects – they work a bit like a thermostat in a central heating system. Automatic stabilisers do not require government action or initiative; they just come into play naturally. An example is progressive income tax - any increase in income is moderated, because the tax automatically rises as income increases. Automatic stabilisers can help counteract the ups and downs of the business cycle. They cannot prevent swings, but they do moderate them. A FEW POINTS YOU SHOULD KNOW PSNCR = the “Public Sector Net Cash Requirement” which is the difference between government spending and tax revenue. Government sells bonds in order to raise money to cover the PSNCR; but to do this it will need to raise interest rates to attract more bond buyers. Raising interest rates can make private investment more expensive so it can get crowded out! If revenues are greater than expenditures, we have a surplus, which can be used as a “Public Sector Debt Repayment” (PSDR) to buy back government bonds and reduce the level of national debt. What determines if there is a surplus or a deficit? • The part of the trade cycle we are in. During a boom, government revenues are high (the receipts from income tax and some other taxes increase); and on the expenditure side, payments of social security benefits will be lower. Both these factors mean we can see a surplus. • The passage of time – government spending tends to increase over time. • Changes in the political demands of the people. If people want pensions to be higher, unemployment pay to be greater, and/or family benefits to be improved, this will lead to more expenditure. A deficit is then more likely. • Government attitude – if the government wants more investment for future growth, it might try to cut PSNCR as this would help to keep interest rates down. (If the government borrows it has to increase the rate of interest which reduces private investment; as it is trying to encourage investment, the government may try not to borrow). NB Fiscal policy is the only onedirectly available to the government now. You will recall that the government gave the right to run monetary policy and set interest rates to the Bank of England in 1997. Some problems of using fiscal policy • The measures adopted may not be in line with the Bank of England’s monetary policy measures. • Fiscal changes are only undertaken once a year in the budget – inflexible. There may be leaks in advance of what the government will be doing in April next! At best we can have an extra “mini budget” around October to improve flexibility. • We cannot easily stop and start government spending – takes years to plan and push through a motorway for example; social services expenditure is not easily reduced (very unpopular!)
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• We are not sure where we are and sometimes are uncertain as to what direction we should be aiming for (should we increase or decrease GDP?) because of data and other lags. This applies to monetary policy too. • Government can be bound by its earlier promises, e.g., the current Labour Government promised not to increase income tax rates. It is difficult to use fiscal policy if one is not allowed to increase taxes! • This throws the burden of adjustment entirely onto monetary policy– and it is in the hands of the Bank of England rather than the government itself. • The desire for fiscal harmonisation within the European Union may mean that tax rates will be controlled in Brussels in part or whole at some time in the future. This would reduce our power to use fiscal policy. • There is an old question of whether or not high income tax is a disincentive to work harder or longer. If it does act as a disincentive to effort, we know that tax rates have been reduced in recent years, so we should have seen an explosion of new effort. Have we? Casual observation suggests that it has not, so perhaps there is no strong disincentive. • Accurate prediction of deficits and surpluses in the budget are very hard to do! • Altering the level of tax may sometimes lead to unwanted redistribution effects. • Unpopular fiscal change can lead to a fall in business confidence which could cause a reduction in investment and almost certainly alter the assumptions upon which the original fiscal change was based! • Borrowing to meet a deficit can crowd out private investment (reducing growth; changing the framework within the government was working; and almost certainly altering the assumptions within which the borrowing was to occur). NB there has been no real test of fiscal policy since the government gave away its power over monetary policy as the economy has grown reasonably steadily and well. The crunch is yet to come. Only when a system is put under pressure do the hidden weaknesses emerge!

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