Model Essay: Assess the UK’s entry to the Eurozone

The European Monetary Union is a set of trading agreements that extends a common market by adding fixed exchange rates between states in the form of a single currency.

The UK is already a member of the European Union and the European Economic Area – which has in place a common market (European Single Market) between 25 European states.

This means that the UK already experiences no tariffs or quotas between ESM trade space, and has coordinated protectionist policies with EU members for outside of the Union (for example CAP).

There are many benefits to a European Monetary Union. Firstly, it eliminates transaction costs between member states. This makes both imports and exports cheaper within the union, so the UK may be able to balance its payments more effectively. However, these only represent a small proportion of the total cost, and an even smaller proportion of GDP.

Furthermore, a monetary union will ensure price transparency across the union. This means that the same goods sold in different countries in the union will be easily comparable, and therefore information will be more symmetric. This will act in such a way to boost competition, as consumers will now be able to seek out the best deals due to the fact that they don’t have to compare exchange rates. This will also be compounded as there are no import or export duties, so prices will be almost entirely transparent – less shipping and handling charges.

Also, there will be easier trading conditions across the zone, which may benefit companies by further increasing economies of scale. However, this may be a negligible benefit due to the fact the common market is already in place, so the market was already extremely easy to penetrate. Also, further economic integration may create the ability to create firms so big that the principal-agent situation, X-inefficiently, and monopoly power may become serious issues, and diseconomies of sale might arise along with a net loss of consumer welfare. But, this may provide larger amount of revenue for the EMU governments, and perhaps the governments who control TNCs.

There will also be a potential boost to FDI in EMU countries, due to this economic potential. However, evidence suggests that this has not occurred to the extent that the EU though it would, as the UK has benefited just as much through FDI after the creation of the EMU.

The UK chancellor in 1997, Gordon Brown, created 5 economic tests that had to be met for the UK to enter the European Monetary Union. These were:

1. Are the business cycles of the UK and European economies converging?
2. Are the economies flexible enough to cope with external shocks?
3. Will the EMU encourage FDI into the UK?
4. Will joining the EMU benefit the financial services sector of the UK?
5. Will joining the EMU promote higher economic growth?

As I have discussed previously, points 3 to 5 are passed by entry EMU. He said that the British and European economies were converging, but not yet fully converged, and he was worried about the flexibility of the economies. For example, in the early 1990s, Germany and the UK were in a recession while France was experiencing strong economic growth. The Brown Treasury decided points 3 to 5 would be dependant on the success of points 1 and 2.

The reason for this dependency is due to the lack of monetary control within the union. Interest rates would be set for the entire EMU, not just one country. This means that if one state is experiencing strong economic growth, while an other is recessing, monetary policy can not be changed to benefit both. Game theory may come into play, were the needs of the Union are maximised before the needs of the state. Brown was perhaps right to be worried about this, as shown by the huge financial crisis in Greece at the moment. This is caused by a huge public debt partly growing due to a large current account deficit. Deficits like these would be harder to pay off in the EMU, due to the fact that the exchange rate is floating for the entire Union instead of the state, so it would settle at a Union equilibrium which may be at odds to what the UK would desire.

So, to conclude, while there are some economic benefits to the UK’s entry into the EMU, these are somewhat outweighed, by the potential dangers due to the lack of economic cycle convergence and flexibility.

Edexcel Economics Unit 4 Past Papers, Mark Schemes and Examiner’s Reports

Well, the exam’s tomorrow. I hope you’re ready – if you need some more revision check the directory to catch up on old posts.

There’s only been one paper before now, plus the sample paper, but here it is, complete with mark scheme and examiner’s report.

Sample Assessment Material: http://bit.ly/jt7kAZ

June 2010
Paper: http://bit.ly/ixrvGP
Mark Scheme: http://bit.ly/mKloth
Examiner’s Report: http://bit.ly/iq6zmV

Good luck!

 

 

 

 

 

Strategies to promote growth and development

A range of strategies may be used to promote growth and development but there is no one simple prescription: each country is individual, having a different history, geography and natural resources. Consequently, policies which may appear to have worked in one country may not be successful in another. In practice, it is likely that a combination of strategies may be required, with the particular blend being dependant on the characteristics needs of the country in question. Various strategies are outline below. As with the previous section, the emphasis is on developing countries, but some of these strategies may be relevant to developed economies.

Aid

The term ‘aid’ is used to describe the voluntary transfer of resources from one country to another or to loans given on concessionary terms i.e. below the market level of interest. Official development assistance relates specifically to aid provided by governments and it excludes aid given by voluntary agencies. Aid may also be given for emergency relief, such as in the case of the recent Japanese earthquake and following tsunami. This kind of aid is usually not contentious and so the focus here is on aid given for more general purposes.

The UN goal for the amount of aid offered by developed countries (agreed in 1970) is 0.7% of GDP.

There are various types of aid:

• tied aid: this is aid with conditions attached. For example, there might be a requirement to buy goods from the donor country or the aid might be given on the condition that there are economic or political reforms
• bilateral aid: aid given directly from one country to another
• multilateral aid: this occurs when countries pay money to an international agency who then distributes it to countries based on certain criteria.

The arguments for aid

These include:

• the reduction in absolute poverty
• filling the savings gap
• providing funds for infrastructure – essential if the country is to industrialise. Aid, therefore will increase AD and investment will have a multiplier effect on GDP. In thern, this will help promote sectoral investment
• improving human capital through promotion of healthcare, education, training and expertise (e.g. the training of teachers and doctors). In some countries, aid might be used to help the prevention and treatment of aids.
• aid might contribute to increased globalisation and trade, both of which are frequently associated with growth and development
• the reduction of world inequality

The arguments against aid

There are powerful arguments against the use of aid, expect in the case of emergency aid, some of which are given below:

• It results in a dependency culture (i.e the recipients of aid become dependant on it and therefore do not pursue appropriate macroeconomic policies to achieve independent growth and development
• Aid might not benefit those for whom it is intended (e.g. it could be diverted into military expenditure or it could be lost as a result of corruption)
• There is no clear evidence that aid contributes to the reduction of absolute poverty or to growth and development
• Right-wing economists argue that aid distorts marker forces and results in an inefficient allocation of resources, while left-wing economists regard aid as a form of economic imperialism by which donor countries aim to secure political influence over the countries to which they give aid.
• Aid in the form of concessional loans involves the payment of interest, in which case there will be an opportunity cost for the developing countries.

Debt cancellation

The burden of debt bears heavily on some countries, e.g. the Gambia, Mali, Nicaragua, Bolivia and Malawi.

The debt is usually owed to all or some of the following: the IMF, the World Bank, governments and banks in developed countries.

The problem is that servicing the debt may account for a disproportionate amount of public expenditure, to the extent that resources available for expenditure on health and education are severely limited. As a result, pressure to cancel the debts of the poorest countries has increased. Under the Heavily Indebted Poor Countries (HIPC) initiative and the Multilateral Debt Relief Initiative (MDRI), the World Bank provides debt relief to these countries. The HIPC initiative was started with the aim of reducing the external debts of the poorest and most heavily indebted countries in the world to sustainable levels. Changes were made in 1999 to make the process quicker and deeper and to strengthen the links between debt relief, poverty reduction and social policies. In 2005, the HIPC initiative was enhanced by the MDRI in order to speed up progress in meeting the Millennium Development Goals (MDGs).

The MDRI allows for 100% relief on eligible debts by three international instituations – the World Bank, the IMF and the African Development Fund (AfDF) for countries completing the HIPC initiative process. In addition, in 2007 the Inter-American Development Bank (IaDB) also decided to provide additional (beyond HIPC) relief to the five HIPC in the Western Hemisphere.

Arguments for the cancellation of debt

These arguments include the following:

• Developing countries would have more foreign currency with which to buy imported capital and goods from developed countries.
• To the extent that the money release from debt cancellation is used for the purchase of capital goods, then there is the prospect of higher economic growth in the future.
• In turn, this means that developing countries would be able to buy more goods from richer countries.
• It would help reduce absolute poverty
• It would help reduce both the savings gap and the foreign exchange gap
• It might help to conserve the environment (debt for nature swaps)

Arguments against the cancellation of debt

These arguments include the following:

• In comparison with aid, it is likely to take much longer to agree a debt cancellation programme.
• Unless conditions are attached to debt cancellation, there is no guarantee that the government of these countries will peruse sound macroeconomic policies (i.e. there is a moral hazard problem)
• Corruption might mean that the benefits of debt cancellation are channelled to government officials rather than the poor.
• Shareholders of banks in the developed world may bear some of the burden of debt cancellation
• It may be much less effective than the introduction of policies to reduce protectionism in developed countries.

Investment in growth and development

Human capital

Human capital can play a significant role in growth and development. However, evidence suggests that investment in primary education in developing countries yields a higher return than other forms of education

Agriculture

The problem associated with primary product dependency and agriculture in particular, as discussed in a previous article. However, some developing countries have achieved growth and development based on investing in agriculture. The case for focusing on agriculture is that the country may have a comparative advantage in the production of agricultural goods and so resources are more efficiently allocated to that use. Such a comparative advantage should be viewed in a dynamic context (i.e. as the country experiences growth, the government may use its tax revenues to spend on education. As a result of such a dynamic, the country may gain a comparative advantage in other products.

Some countries have specialised in producing agricultural products with a high income elasticity of demand. e.g. Peru produces asparagus, Chile produces blueberries, wine and papaya. Consequently, during periods of economic growth they have benefited from significant increases in demand.

Manufacturing industry 

It has traditionally been assumed that development is synonymous with industrialisation, i.e. that developed requires an increasingly large manufacturing sector. The structural change/dual sector model requires a move away from traditional agriculture (characterised by subsistence, low productivity and barter) to more productive manufacturing (characterised by high productivity and monetary exchange)

Key features of the Lewis model

• This model describes the transfer of surplus labour from a low productivity (subsistence) agricultural sector to a high productivity industrial sector.
• Lewis thought that, because of the excess supply of workers, the marginal productivity of agricultural workers might be close to, or at, zero. This is based on the law of diminishing returns.
• With MP zero, then the opportunity cost of transferring workers from the agricultural to the industrial sector would be zero
• Industrialisation will be associated with investment (possible from transnational companies), which will increase productivity and profitability. If profits are reinvested, further growth will occur
• The share of profits as a percentage of GDP will increase, as will the savings ratio, providing more funds for investment and continued economic growth

Criticisms of the Lewis model

• Profits made in the industrial sector might not be invested locally, especially if  firms are owned by transnational countries.
• Reinvestment might be made in capital equipment, with the result that extra labour is not required.
• Empirical evidence suggests that the assumption of surplus labour in the agricultural sector  and full employment of the industrial sector is invalid.

Tourism

Some countries have developed on the basis of investment in tourism. Clearly there are advantages to this strategy over primary product dependency, not least that demand is likely to be income elastic. The expansion of tourism has strong attractions for developing countries.

Advantages of tourism

• It is a valuable source of foreign currency as tourists spend money on goods and services provided within the local economy.
• Tourism is likely to attract investment by transnational hotel chains
• In turn, this will increase GDP via the multiplier
• Jobs will be created, both as a result of investment in the tourist and leisure industries and also as a result of the multiplier effects in the economy
• All of the above will help to increase the tax revenues of the government, which may be used to improve public services
• It can help to preserve the national heritage of the country
• Improvements in infrastructure may be made, for example, road links to hotels, new airports

Drawbacks of tourism

There are some serious drawbacks associated with tourism:

It may be associated with a significant increase in imports, not only for the capital equipment required to build hotels and facilities but also to meet the demands of tourists for specialised goods, such as food. Further, the balance of payments might be adversely affected by the reparation of profits to shareholders of TNCs.

In times of recession, the fall in demand may be more than proportionate, assuming that demand is income elastic

Employment may only be seasonal in nature. Further, jobs created may be low skilled and low paid if the TNCs provide their own managers and professional staff

Tourism is subject to changes in fashion. In the developed world, Spain has suffered from a significant downturn in tourism in recent years, as Europeans now prefer more exotic locations

There may be significant external costs (e.g. increase in waste, pollution of beaches, water shortages for local people, as the needs of tourists are prioritised. The damage to the environment cause by tourists might result in restrictions (e.g the restrictions on the number of tourists allowed each day to the Galapogos, visitors to Machi Picchu are limited by the requirement to have a guide)

Inward-looking/outward-looking strategies

Te strategies adopted by countries to construct a path towards diversification and industrialisation have taken a variety of forms.

Inward looking strategies are characterised by:

• import substitution (i.e. replacement of imports with domestically produced manufactured goods)
• protectionism

The aim of inward-looking strategies is to enable a country to diversify in a controlled way until it has built a strong domestic base. Clearly, this approach will be most effective where a country’s domestic market is large enough to enable industries to benefit from economies of scale. Once achieved, industry will be strong enough to cope with foreign competition.

However, there are some drawbacks to this approach:

• comparative advantage is distorted and so resources will not be allocated effectively
• the lack of competition could result in inefficiency

In contrast, outward looking strategies are characterised by:

• free trade
• deregulation of capital markets
• promotion of foreign direct investment
• devaluation of exchange rates

The disadvantages of these policies have been considered in previous articles. In practice, many countries have used a combination of strategies.

Interventionist approaches

For at least 30 years after the Second World War, most developing countries experienced significant degrees of government intervention. This approach was characterised by the following:

• import substitution policies
• nationalisation
• farmers forced to sell their produce to state controlled boards at low prices
• price subsidies on many goods regarded as necessities
• over-valued exchange rates (aimed at keeping down the cost of imports)

By the end of the 1970s, there was increasing disillusion with such interventionist policies, which were associated with:

• low rates of economic growth
• resource and allocative inefficiency because of the absence of the profit motive
• government failure
• corruption by civil servants associated with increased government intervention
• increasing fiscal deficits (associated with subsidies and nationalised industries)
• increasing balance of payments deficits on current account (associated with over-valued currencies)

Free-market approaches

The perceived failure of interventionist strategies and the election of right-wing governments in the USA and the UK resulted in the adoption of free-market and outward-looking strategies. The key components of these strategies are:

free market analysis: assumes markets are efficient and therefore the best way to allocate resources

public choice theory: based on the assumption that politicians, civil servants and governments use their power for their own self-interest

In particular the free market approach is characterised by:

• trade liberalisation
• market liberalisation
• supply-side policies
• structural adjustment programmes

Since the turn of the decade, there has been some modification of this approach in recognition of the fact that imperfections exist in product and labour markets, for example:

• asymmetric information
• externalities
• absence of property rights
• investment decisions

There is therefore a need for governments to intervene in a market-friendly way (e.g. by developing in infrastructure, education, health) and to provide a favourable climate for enterprise.

Microfinance

Microfinance is a means of providing extremely poor families with small loans (microcredit) to help them engage in productive activites or grow their tiny businesses. In particular, it can help the poor to increase income, build business and therefore save more, and reduce vulnerability to external shocks.

The pioneer of microfinance was Mohammed Yunus, who established Grameen Bank in Bangladesh.

• The key features of microfinance schemes are as follows:
• In contrast to developed lending, microcredit inisits on repayment
• Interest is charged to cover the costs involved
• The focus is on groups whose alternative source of finance are limited to the informal sector, where the interest charged would be prohibitively high

The main clients of microfinance are:

• women, who form 97% of the clients
• the self-employed, often household based entrepreneurs
• small farmers in rural areas
• small shopkeepers, street vendors ans service providers in urban areas

Criticisms of microfinance

Concerns have been raised about the repayment rate, collection methods and questionable accounting practices.

On a larger scale, some argue that an overemphasis on microfinance to combat poverty will lead to a reduction of other assistance to the poor, such as official development assistance  or aid from NGOs.

Fair trade

The aim of fair trade schemes is to address ‘the injustice of low prices’ by guaranteeing that producers receive a fair price. It means paying producers an above-market price for their produce, provided they meet particular labour and productive standards. This premium is passed back to the producers to spend on development programmes.

The market for fair-trade products has been growing rapidly, and there are now over 2,500 product lines

Benefits of fair-trade schemes

• Producers receive a higher price
• Extra money is available to spend on education, health, infrastructure clean water, conversion to organic farming and other development programmes in the producer’s country
• There are smaller price fluctuations, allowing producers to be shielded from market forces.
• The extra money can be used to improve the quality of the products
• Producers are enabled to diversify their products

Criticisms of fair trade

• Distortion of market forces: low prices are due to overproduction and producers ought to recognise this a signal to switch to other crops. Further, the artificially high price encourages more producers to enter the market, driving down individual supernormal profits which will limit the money available for investment
• Certification is based on normative views on the best way to organise labour, for example, in the case of coffee, certification is only available to cooperatives of small producers.
• Guaranteeing a minimum price provides no incentive to improve quality
• It is an inefficient way to get money to poor producers: consumers pay a large premium for fair trade goods, but much of this goes to the supermarkets in profits.
• It may create a dependency trap for producers.

The role of international financial institutions

The International Monetary Fund

The original role of the IMF was to increase liquidity and to provide stability in capital markets through a system of convertible currencies pegged to the dollar. It also lent to countries with temporary balance of payments deficits on current account

In the 1970s, there were significant oil price shocks and many countries – especially developing countries – suffered as a result of rapid inflation, huge balance of payments deficits and deb crises. As a result, most currencies were allowed to float (i.e. the peg to the dollar was broken). The IMF extended its role to include involvement in economic development and poverty reduction. To ensure repayment of loans, the IMF imposed restrictions on conditions on the economic policies to be followed by developing countries – stability programmes – to achieve internal and external balance. In practice, these were similar to structural reduction programmes.

In 2006, the IMF was given a new role – to conduct multilateral surveilance of the global economy and to suggest steps that the leading nations should take to promote it. It was also required to ensure more balanced growth and to reduce global imbalances.

In 2009, the G20 summit authorised the IMF to issue $250bn in new special drawing rights (SDRs). An SDR is sometimes referred to as the IMF’s currency but it is, in fact, the IMF’s unit of account.

The value of an SDR is defined as the value of a fixed amount of yen, dollars, pounds and euros, expressed in dollars at the current foreign exchange. These SDRs represent a potential claim on other country’s reserves, for which they can be exchanged for voluntarily. On the other hand, countries with high foreign currency reserves can buy SDRs from countries that require hard currency.

The International Bank for Reconstruction and Revelopment (IBRD)

More commonly known as the World Bank, its original role was to provide long-term loans for reconstruction and development to nations that has suffered in the Second World War.

In the 1970s, its role changed to setting up agricultural reforms in developing countries, giving loans and providing expertise.

In 1982, Mexico defaulted on its loan repayments. As a result the World Bank now imposes structural adjustment programmes (SAPs), which set out the conditions on which loans are given. The aim is to ensure the debtor countries do not default on the payment of debts.

SAPs were base on free market reforms, (e.g trade liberalisation, removal of state subsidies on food, privatisation and reduction in public expenditure to reduce budget deficits) However, these free market reforms were criticized because they:

• did little to help the world’s poor
• failed to promote development
• increased inequality
• caused environmental degradation
• resulte in social and politcal chaos in many countries

The widespread criticism of SAPs and the devastating effect which they had on some developing countries resulted in the World Bank changing its focus to concentrate on poverty reduction strategies, with aid being directed towards:

• countries following sound economic practices
• healthcare; broadening education
• local communities rather than central government

The future of the IMF and the World Bank

The roles of the IMF and the World Bank are currently blurred: both have a role in the developing world and in poverty reduction and it is suggested that they should be reformed to reflect the changing needs of the global economy. Critics of the institutions as they currently operate suggest the following:

• The IMF should be slimmed down and should undertake short-term lending to crisis-hit countries
• The World Bank should act as a development agency and undertake credit appraisal of the creditworthiness of recipient countries

The role of non-governmental organisations

The work of NGOs has bought community based development to the forefront of strategies to promote growth and development (i.e. the focus has moved away from state managed schemes). The key characteristics of community-based schemes are:

• local control of small scale projects
• self relience
• emphasis on using the skills avalible
• environmental sustainablity

Limits to growth and development

Economic growth is measured in terms of changes in real GDP. However, economic development cannot be defined so precisely. It is a multidimensional concept which refers to changes in living standards and welfare over time. Unlike economic growth, economic development is a normative concept dependant on value judgements. In order to provide some measure of development, various composite measures are used. The most common of these is the human development index (HDI), which includes GDP per head (measured at PPP), health (measured in terms of life expectancy) and education (measured in terms of school enrolment ratio and literacy rate). However, this is a narrow measure of development because it ignore a range of other indicators such as:

• the proportion of the population with access to clean water
• the proportion of the working population employed in agriculture
• energy consumption per person
• proportion of households with internet access
• mobile phones per thousand of population

Constraints on growth an development

While all countries face restraints on growth and development, there is an enormous difference in the scale of the constraints affecting developed and developing countries. Further, the problems facing any particular developing or developed country vary considerably. It is important to have some knowledge of particular countries in order to give relevant examples. This article and the next will focus primarily on problems facing developing countries.

Primary product dependency

Primary products may be divided into hard commodities, such as copper, tin and iron ore and soft commodities, such as most agricultural crops – wheat, palm oil, rice and fruit. A range of issues face countries dependant on primary products, including the following:

• Price fluctuations: given their price inelasticity of supply and demand, any demand side or supply side shock will cause a significant price change
• Fluctuations in producers incomes and foreign exchange earnings: since demand is price inelastic, then a fall in price will cause total revenue to fall and in turn, the foreign currency earnings from exports to fall
• Difficulty of planning investment and output: the price fluctuations cause uncertainty, which is a deterrent to investment
• Natural disasters: extreme weather can cause severe disruption to primary products, especially soft agricultural ones
• Protectionism by developed countries: for example, the huge subsidies given to US cotton farmers have created great difficulty for Indian cotton farmers, who are unable to compete; the EU’s Common Agricultural Policy has meant there is no free access to European markets for food from developing countries
• Low income elasticity of demand for primary products: the Prebisch-Singer hypothesis states that the terms of trade between primary products and manufactured goods tend to deteriorate over time.

The Prebisch-Singer hypothesis

This theory suggests that countries that export commodities will be able to import less and less for a given level of exports. Prebisch and Singer examined data over a long period of time and found that the data suggested a decline in the terms of trade for primary commodity exporters. A common explanation for this is that the income elasticity of demand for manufactured goods is greater than that for primary products – especially food. Therefore, as incomes rise, the demand for manufactured goods in increases more rapidly than demand for primary products and so the prices of manufactured goods rise relative to the prices of primary products, so causing a decline in the terms of trade for countries dependant on the export of primary products due to increasing general incomes.

The theory may be criticised on the following grounds:

• First, some countries have developed on the basis of their primary products (e.g. Botswana diamonds)
• Second, if a developing country has a comparative advantage in a primary product, then its resources will be more effectively used by the specialisation of that product.
• Third, primary products rose sharply until the middle of 2008 while the prices of many manufactured goods were falling.

Some economists argue that, in the case of food, prices are likely to increase as world population grows and incomes in China and India rise, so  causing higher demand for food more traditionally eaten by those in developed countries.

Similarly, the outlook for countries such as Bolivia is good. Nearly half the world’s known reserves of Lithium lie in Bolivia, which is used to make batteries for hybrid and electric vehicles. Given the decline in oil production and subsidies being given to electric car manufacturers, demand for lithium can be expected to rise sharply in the future.

In contrast, countries producing copper, such as Chile, were faced with a 50% price fall in the middle of 2008 and 2009.

Savings gap

The Harrod-Domar model suggests that that savings provide the funds which are borrowed for investment purposes. Therefore, economic growth depends on:

• the level of saving and the savings ratio
• the productivity of investment.

It suggests that economic growth depends on labour and capital. Developing countries have a large amount of labour, so it is a lack of physical capital that holds back economic growth and therefore development.

Therefore, economic growth requires policies that encourage saving or generate technological advances, which enhance the productivity of capital.

Human capital may also be as important as economic capital, but without investment to finance this growth cannot be achieved.

However, savings may be difficult to manipulate, as raising interest rates would make lending harder, and outweighing the benefit of savings in the short run, but perhaps is better solution in the long run. Also, an increase in exchange rates would increase currency value, making exports less competitive, and therefore further reducing marginal propensity to save due to a loss of income.

Many developing countries have a low GDP per capita and consequently they hold inadequate savings to finance the investment seen as essential to achieve economic growth.

Low incomes means low propensity to save, low savings means low investment, low investment means low capital accumulation, which in turn leads to low incomes.

Foreign exchange gap

Associated with the savings gap, many developing countries face a shortage of foreign exchange. This is when a country’s balance of payments on current account deficit is greater than the value of capital inflows. This may be the result of:

• dependence on export earnings from primary products
• dependence on imports of capital goods and other manufactured goods
• servicing debt
• capital flight

Capital flight

This occurs when individuals or companies decide to place cash deposits in foreign banks or buy shares or other assets from foreign countries. This has serious implications, for example:

• it contributes the savings and foreign exchange gap, and consequently:
• it restricts economic growth
• it reduces the tax base because the country looses any tax payable on these assets

Debt

Many developing countries borrowed money at times of low interest rates, only to find that they are struggling to service the debt some years later. Debt has become a problem for a variety of reasons, including:

• risky decisions to borrow money to finance major investment projects at a time when the world economy was strong and/or the prices of goods which they were exporting were high
• an increase in oil prices
• a fall in the value of currencies of developing countries, which increased the burden of foreign debt
• loans taken out to finance expenditure on military equipment

Corruption, poor governance and civil wars

Corruption is usually defined as the use of power for personal gain. It may take a variety of forms including bribery, extortion and diversion of resources to the governing elite. Corruption acts as a constraint on development when it causes an inefficient allocaiton of resources.

Poor governance implies that the rulers of a country have adopted policies that result in the country’s resources being allocated inefficiently. Government failure (where government intervention creates a net welfare loss) might also be evident as part of poor governance.

Civil wars, such as those which have occurred in Sudan and the Democratic Republic of the Congo, disrupt growth and development. Indeed, in so far as they actually cause destruction of infrastructure and the death of many people, they may in fact negate any progress made in previous years.

All the above issues can deter both domestic investment and foreign direct investment and so limit the possibilities for growth and development.

Population issues

Population growth is particularly rapid in some of the poorest countries in the world. Meanwhile, population is falling in some developed countries.

Population growth may be analysed in relation to the views of Thomas Malthus, who predicted at the end of the eighteenth century that famine was inevitable because population grows at an exponential rate, whereas food production grows at an linear rate. Although his predictions were proved to be incorrect for Britain in the nineteenth century, some economists believe that they are still relevant for some of the poorest developing countries. In these countries, population growth is faster than GDP growth, with the result that GDP per capita is falling

Human capital inadequacies

A country where education standards are poor and where there is low school enrolment is likely to experience a low rate of economic growth due to low productivity. It will also act as a deterrent to transnational companies to invest in the country due to the costs involved in educating and training workers.

A particular problem for some countries is the prevalence of HIV and AIDS; when an adult develops AIDS, he or she will be forced to give up work. This means that the children might be withdrawn from school, either because the school fees can no longer be afforded, or they are required to work to support the family. A further problem arises if teachers contract work, forcing them to give up work. The training of workers may also be disrupted by AIDS, particularly if a transnational  country is involved and decides that it it no longer profitable to operate in the country. The combined effect of these problems is to reduce the quality and quantity of education and training.

Poor infrastructure

Infrastructure covers the whole range of structures that are essential for an economy to operate smoothly. Infrastructure includes the following:

• transport
• telecommunications
• energy supply
• water supply
• waste disposal

Clearly, poor infrastructure will make it difficult to attract domestic and foreign investment and thus present a significant obstacle to growth and development. On the other hand, a country rich in a natural resource demanded by other countries might benefit from FDI; a transnational company might provide some infrastructure to the country in order to facilitate its business development. For example, new roads to transport goods from production areas to international links, which would benefit the entire country.

Poverty and inequality

Measures of poverty

Absolute poverty

According to the World Bank, people are considered to be living in absolute poverty if their incomes fall below the minimum level to meet basic needs such as food, shelter, clothing, access to clean water, sanitation facilities, education and information. This minimum level is usually called the poverty line. The World Bank has set the international poverty line at $1.25 at 2005 GDP measured at purchasing power parity.

One of the key Millennium Development Goals is to halve the number of people living in absolute poverty by 2015. Although the poverty line is designed to provide an objective measure of poverty, the World Bank recognises that what constitutes a minimum level of income to meet basic needs is likely to vary over time and between societies.

Relative poverty

People are considered to be living in relative poverty if they are living below a certain income threshold in a particular country. It may be measured by calculating the percentage of the population living below 60% of median income. Therefore, the concept of relative poverty is:

• Highly subjective
• Subject to change over time
• Not comparable between countries

Relative poverty arises from inequality (see below)

Composite measures of poverty

A composite measure of poverty, devised by the UN as a measure of deprivation, is provided by the human poverty index (HPI). There are in fact two indices, the first of which, HPI-1, is a measure of deprivation in the poorest countries of the world. There are three elements in this index:

• The percentage of people not expected to reach the age of 40
• The percentage of the population that are illiterate
• The average percentage of children who are underweight and the percentage of the population who do not have access to safe water and healthcare

To provide a measure that is more appropriate to developed countries, HPI-2 has been developed. This has the following elements:

• The percentage of the population not surviving to age 60
• Percentage of adults lacking functional literacy skills
• Percentage of population below income poverty line (60% below median average income)
• Rate of long-term unemployment (lasting 12-months or more)

A cube root of the arithmetic mean of the factors is taken to find both HPI-1 and HPI-2.

Measurements of inequality

Factors influencing inequality

A variety of factors influence the degree of inequality in a country, including the following:

• education and training
• wage rate
• inheritance
• ownership of assets
• pension rights
• unemployment
• social benefits
• the tax system

The Lorenz curve

The degree of inequality can be measured using a Lorenz curve, which plots the cumulative percentage of the population against the cumulative percentage of total income. The 45° line represents perfect equality, such as the ‘poorest’ 10% of the population receive 10% of the income. The Lorenz curve represents an unequal distribution of income.

The areas A and B are used to calculate the Gini coefficient.

Gini coefficient

This is a measure of the degree of inequality in a country. It is calculated as follows:

Where A represents the area between perfect equality and the Lorenz curve, and B represents the total  area under the Lorenz curve.  The Gini coefficient will have values between 0 and 1, with 0 representing absolute equality, and 1 absolute inequality

Consequences of inequality 

Inequality is often regarded as an inevitable cost of economic growth. However, it may be argued that inequality itself may be a constraint on growth and development because:

• the very poor will have no collateral and so will be unable to start their own business
• absolute poverty could remain high in countries where inequality is high
• those on low incomes will have a low marginal propensity to save, so limiting funds available for investment, while those on high incomes may spend a large amount of their incomes on imported goods or may transfer their incomes to other countries (capital flight)
• there may be socially undesirable consequences of inequality, such as an increase in crime rate

International competitiveness

A country’s international competitiveness refers to its ability to sell its goods and services in domestic and international markets at a price an quantity that is attractive in those markets. Competitiveness may be measured in terms of price or non-price factors. The non-price factors included quality, design, reliability and availability.

Measures of international competitiveness

These measures include:

relative unit labour costs: the measurement of labour costs in one country relative to those in another country. To make international comparisons, the figures are converted into a single currency and expressed as an index number

relative productivity measures: e.g. output per worker per hour worked

composite indices: such as the global competitiveness index produced by the World Economic Forum. This is based on 12 pillars of competitiveness, as follows:

• institutions
• labour market efficiency
• infrastructure
• financial market sophistication
• macroeconomic stability
• technological readiness
• health and primary education
• market size
• higher education and training
• business sophistication
• goods market efficiency
• innovation

The top 15 rankings for 2010-11 were:

1. Switzerland
2. Sweden
3. Singapore
4. United States
5. Germany
6. Japan
7. Finland
8. Netherlands
9. Denmark
10. Canada
11. Hong Kong SAR
12. United Kingdom
13. Taiwan SAR
14. Norway
15. France

Factors influencing international competitiveness 

Real exchange rate

Competitiveness is determined by a variety of factors, but one of the most important is a country’s real exchange rate, which is the nominal exchange rate adjusted for price levels between economies.

More precisely:

real exchange rate = nominal exchange rate x foreign price level ÷ domestic price level

It is also known as the purchasing power. There will be a depreciation in the real exchange rate if the nominal exchange rate falls or price of foreign goods rise relative to domestic prices. Therefore, a fall in the real exchange rate will cause an increase in the competitiveness of a country’s goods.

In contrast, if there is a rise in nominal exchange rate or a fall the price of foreign goods relative to the domestic price of goods, then real exchange rate will rise. This will cause a decrease in the competitiveness of a country’s goods.

Wage costs and non-wage costs

Wage costs are the most important cost of production for many industries. Consequently, if wages are higher in the UK than in China, it is likely that the prices of goods in the UK will be higher than those in China if productivity is ignored.

Non-wage costs are also significant for international competitiveness. These include:

• National insurance contributions paid by employers
• Heath and safety regulations
• Environmental regulations
• Employment protection and anti-discrimination laws
• Contributions into company pension schemes

These non-wage costs are frequently much higher in developed countries than in developing countries and so have the effect of reducing the international competitiveness of goods and services of developed countries.

Other factors

• Labour productivity: usually defined as the output per worker per hour worked. In turn, this is influenced by:
• education and training: which influences the level of:
• human capital: defined as the knowledge and skills of the workforce and by:
• the amount of quality of capital equipment per worker
• research and development: in turn this may lead to technological advancement which may have dramatic effects on productivity and therefore competitiveness
• infrastructure: of the country e.g. road, rail, telecoms, power generation, water supply
• labour market flexibility: this is affected by factors such as the easer of hiring and firing workers, willingness of workers to work part-time or on flexible contracts and the strength of trade unions

Measures and policies in increase competitiveness

Firms can improve the competitiveness of their products by investing in new capital equipment with the aim of raising productivity. They could also improve their design and the quality of their products through research and development.

Governments can try to improve their competitiveness through a variety of supply-side policies, of particular relevance are the following:

• measures to increase occupational mobility such as education and training schemes
• macroeconomic stability  – low and steady inflation rate, sound public finances, relatively stable exchange rate, steady economic growth
• public sector reform aimed at reducing red tape
• government expenditure to improve infrastructure
• privatisation
• incentives for investment such a tax breaks if companies use profits for investment rather than for dividends.

It is not correct to suggest that the UK government could devalue its currency because the pound is a floating currency. Also, since the Bank of England is independent from government, the government cannot engineer a deprecation  of the pound through a reduction in interest rates because control over interest rates does not lie in government hands.

The significance of international competitiveness

A fall in international competitiveness is likely to be reflected in deterioration in the trade of goods balance in the balance of payments. In turn, this could result in an increase unemployment, especially in industries in which exports are significant. A fall in exports could have a negative multiplier effect on GDP, so causing a reduction in economic growth.

The balance of payments and exchange rates

The components of the balance of payments

The balance of payments is a record of all financial transactions between one country and other countries. When there is an inflow of foreign currency into the UK, this is recorded as a positive item, whereas when there is an outflow of foreign currency this is recorded as a negative item.

The main components of the balance of payments are the current account and the capital and financial account.

The current account is composed of the following:

• The trade in goods balance: this is the value of goods exported minus the value of goods imported
• The trade in services balance: this is the value of services exported minus the value of services imported
• The income balance: this is income flows into the country from non-residents minus income flow out of the country from residents to non-residents. e.g. income refers to compensation to employees and investment income
• Current transfers: refers to items such as food aid and the EU’s Common Agricultural Policy. i.e. items that do not generate a direct return

The capital and financial account

This comprises transactions associated with changes of ownership of the UK’s foreign financial assets and liabilities. A key factor influencing the financial account is foreign direct investment. Also included are portfolio investment of shares and bonds, changes in foreign currency reserves, and short-term capital flows, sometimes termed as ‘hot money’ flows, associated with speculation

The balance on this account should exactly offset the current account balance. However, in practice, there is a significant component comprising errors and omissions.

Current account deficits and surpluses

For many years, the UK has had a deficit on the current account. In particular, the trade in goods balance has deteriorated over a number of years.

The main reasons for the UK’s deficit in its trade in gods balance are:

• the high value of sterling 1996-2008
• continuous economic growth 1992-2008 – the UK has a high marginal propensity to import so rising real incomes have led to a significant increase in imports
• relatively low productivity of the UK’s workers resulting in higher average costs
• the relocation of manufacturing to countries with lower labour costs
• the ‘Chindia’ effect: the industrialisation and economic opening of China and Indian has led to a flood of cheap imports into the UK

Surpluses on the trade in services have been insufficient to offset the deficits on the trade in goods balance

The implications of global imbalances

Like the UK, the USA has experienced large current account deficits, while in contrast, China has experienced huge current account surpluses. Whether such a global imbalance can be sustained in the long run is a major question. In the one hand, if the deficits are easily financed by inflows on the current account, there may be no cause for concern. Further, under a system of floating exchange rates over time, there should be an automatic adjustment (i.e. deficit would cause exchange rate to fall). On the other hand, continuous deficits by the USA have, in effect, been financed by the Chinese, which may not be a sustainable option in the long run. Further, exchange rate adjustments might occur suddenly, as when the value of the pound fell by 27% between July 2008 and March 2009.

The influence of exchange rates

The exchange rate is the rate at which one currency exchanges for another; in other words it is the price of one currency in terms of another. e.g. £1 = $1.61.

Causes of changes in the exchange rate

A variety of factors can influence the value of a country’s currency (under a system of floating exchange rate), including the following:

• Relative inflation rates: if the country’s inflation rate is higher than that of its major competitors, according to purchasing power parity (PPP) analysis, it would be expected that the value of the currency would fall. The PPP rate is the rate at which a particular product would be sold at the same price in the UK and abroad when expressed in a common currency
• Relative interest rates: if the UK has higher interest rates than that of other countries, then foreigners with surplus balances are likely to place them in UK banks, so increasing the demand for sterling and causing the value of the pound to increase.
• The state of the economy: for example, of the UK economy is performing well, then this will increase the confidence of speculators and foreign investors, who will buy sterling, so causing its value to rise.
• The balance of payments on current account: if there is a persistent deficit on the current account, then the supply of the currency would be high relative to the demand for it, and the value of the currency would be expected to fall. In practice, this factor is not significant because the flows of money associated with trade are small compared to ‘hot money’ flows and other transactions recorded in the current account.
• Political stability: in developing countries, instability may cause a loss of confidence in the country’s currency
• Speculation: the exchange rate might be affected by speculation concerning a range of possible events, including factors such as the future state of the economy, a change in government or impending strikes. For example, if it is expected that the economy will recover from a recession much more quickly than originally thought then speculators may buy sterling, so pushing up its value

Effects of a change in the exchange rate of a currency

Suppose that the value of the pound against the dollar falls, e.g. from £1 = $2 to £1 = $1.50. There are two effects:

• It will make the price of goods exported from the UK decrease in the country of sale. For example, a bottle of UK whisky costing £20 would have sold for $40 in the USA but will now sell for $30.
• It will make the price for goods imported into the UK increase. For example, a $10 bottle of Californian wine would have been price at £5 in the UK but will now cost £6.67.

The Marshall-Lerner condition

For there to be a fall in the current account, the Marshall-Lerner condition needs to be met. This is that the sum of all the price elasticities of demand for imports and exports be greater than 1.

The J curve effect 

It is possible that there could be a time lag before the full effects of the depreciation of the currency work through the economy, such that in the short run, the sum of the price elasticities of demand be less than 1, but greater than 1 in the long run. The gives rise to the J-curve effect

Initially, the current account deteriorates, since demand for imports is price inelastic because of contracts or stocks. Also,the demand for exports may be inelastic because it takes time for consumers to adjust to price changes. In the longer term, demand for both imports and exports may become more elastic and, if the Marshall-Lerner condition is fulfilled, the current account will improve.

European Monetary Union

The euro was launched on 1 January 1999. Initially, there were 11 members of the Euro Zone; a further five countries had joined by 2009. Denmark and the UK agreed an opt-out clause. Furthermore, many of the newer members and Sweden, do not meet the convergence criteria, set out below:

• The fiscal deficit has be be below 3% of GDP
• The public sector net debt must be less than 60% of GDP
• Countries must have an inflation rate within 1.5%  of the three EU countries with the lowest inflation rate
• Long-term interest rates must be within 2% of the three lowest interest rates in the EU.
• Exchange rates must be kept within ‘normal’ fluctuation margins of Europe’s exchange rate mechanism.

In addition, 1997 the Blair government, with a Brown-controlled Treasury, formulated 5 economic tests that would justify Britain’s entry into the European Monetary Union. These were:

1. Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?
2. If problems emerge, is there sufficient flexibility to deal with them?
3. Would joining the EMU create better conditions for firms making long-term decisions to invest in Britain?
4. What impact would entry to the EMU have on the competitiveness of the UK’s financial services industry, particularly the City’s wholesale markets?
5. In summary, would joining EMU promote higher growth, stability and a lasting increase in jobs?

They came to the conclusion that these tests were not met in 1997, nor in reanalysis in 2003. In 1997 it was decided that UK economy was neither sufficiently converged with that of the rest of the EU, nor sufficiently flexible, to justify a recommendation of membership at that time. Under reanalysis, the conclusions in 2003 were:

1. There has been significant convergence since 1997, but there remained some structural differences, particularly in the housing market.
2. While UK flexibility had improved, they could not be confident that it is sufficient.
3. Euro membership would increase investment, but only if convergence and flexibility were sufficient.
4. The City would benefit from Eurozone membership.
5. Growth, stability and employment would increase as a result of euro membership, but only if convergence and flexibility were sufficient.

The sterling-euro exchange rate was also an important issue in 2003, if the pound was over-valued against the Euro then clearly the UK would have to interest in joining. Furthermore, due to the recent sovereign debt (PSND) crisis within the EU, in countries such as Greece, Ireland and Portugal, the UK is probably in a better position as it has been able to control its interest rates separately. However, during the uncertainty of the global credit crisis that cause PSND issues, euro membership was looking attractive.

The main advantages of monetary union

• Elimination of transaction costs i.e commission charged on the exchange of currencies. However, these represent a very small proportion of GDP.
• Price transparency: it is easy to compare price of goods across countries which have adopted the Euro. Competition within the Eurozone should therefore increase and the likelihood of price discrimination should diminish. However, there is still evidence of price differences in the Eurozone.
• Easier trading conditions for firms inside the eurozone, which might enable them to further economies of scale
• Encouragement to transnational companies to invest in euro zone countries as opposed to the countries of non-members. However, the evidence that this has happened is weak.

The main disadvantages of monetary union

• Loss of independent monetary policy, i.e. countries no longer have the ability to set their own interest rates. The interest rate is set by the European Central Bank (ECB). This means that the needs of individual countries are placed second to the needs of the euro zone as a whole
• The ECB’s inflation target of below 2% is more stringent than that of the Bank of England. A criticism is that this policy is less flexible and more deflationary than that of the UK
• Loss of exchange rate flexibility against other countries that have adopted the Euro
• Transition costs – menu costs.
• Meeting the requirements of the growth and stability pact might result in a slower rate of economic of economic growth, which could in turn result in a higher level of unemployment. For example, countries are no supposed to run fiscal deficits higher than 3% of GDP. In practice, this rule has not been adhered to, however.

Globalisation

The meaning of globalisation

There is no precise definition of the term globalisation, and it is used to refer to a variety of ways in which countries are becoming more and more closely integrated, not just in the economic sense, but also culturally and politically.

However, one of the best definitions of globalisation in the economic sense is by Peter Jay, the BBC’s economics corrospondent in 1996: ‘The ability to produce any good or service anywhere in the world, using raw materials, components, capital and technology from anywhere, sell the resulting output anywhere and place the profits anywhere’.

It should be understood that globalisation is not a new phenomenon because there have been many period in history when there was considerable integration between countries: for example, during the height of the Roman empire. However, the pace of global integration has increased considerably over the last 30 years.

Characteristics of globalisation

• An increase in trade as a proportion of GDP
• Increased movements of financial capital between countries
• Increased international specialism and division of labour. It is increasingly common for parts and components of products to be made in different countries and for assembly to occur in another country
• The growing importance of MNCs and TNCs – multinational and transnational companies – and foreign direct investment (FDI)

Factors contributing to globalisation

A variety of factors have contributed to increased economic integration if countries.

One of the most significant is the fall in transport costs. In real terms, the price of transporting goods has fallen significantly, enabling good to be imported and exported more cheaply. Coupled with this has been a decline in the cost of communications. In particular, the cost of using the internet has fallen greatly over the last 20 years, and its availability has increased.

The lowering of trade barriers since the Second World War has been a major factor in the growth of world trade. The World Trade Organisation (WTO), formerly the General Agreement on Tariffs and Trade, has been responsible for negotiating reductions in tariffs and other barriers to trade in rounds of talks, the most recent of which was the Doha round.

Both the collapse of communism and the opening of China to world trade have contributed to globalisation. Countries which were previously not open to FDI became much more integrated into the world trading system. TNCs have taken advantage of the reduction in trade barriers and the development of the internet to organise trade on a global scale.

Benefits and disadvantages of globalisation

Benefits

Free trade enables the application of the law of comparative advantage, which suggests that, when countries specialise in goods in which they have a comparative advantage (i.e.  goods can be produced at a lower opportunity cost) then world output and living standards will increase. It is evident that the growth in world trade in both goods and services has been associated with increased growth in real GDP.

• For consumers, globalisation may mean a wider  choice of goods at a lower price
• For producers, there are likely to be benefits in terms of lower production costs as a result of offshoring and also economies of scale

Disadvantages and problems

Globalisation has been criticised on the basis that it has promoted exploitation of workers, children, farmers and the environment. Similarly, health and safety laws and regulations are usually less demanding in developing countries.

The external costs associated with trade are becoming increasingly apparent, especially in relation to environmental degradation which results in global warming. Consumers are also becoming more aware of ‘food miles’. It mat be argued, therefore, that increased trade is not sustainable in terms of the environment.

Globalisation has also been associated with increased inequality. For example, rich countries have much greater access to the internet than poor countries. Given that much wealth creation is dependant on readily available information the poorest developing countries are at a severe disadvantage.

Some argue that the liberalisation of financial markets has been associated with global instability, as evidenced by the financial crisis in Asia at the end of the 1990s, and more recently the global credit crunch following the collapse of confidence in the banking system. It is also argued that the global imbalances currently experienced (i.e. the current account deficits in the USA and surpluses in China) are unsustainable.

The global financial crisis that became particularly evident in 2008 has led to a development sometimes described as deglobalisation, in which countries adopt protectionist policies in an attempt to protect domestic employment. Obviously thi leads to the decline in specialisation and trade. Examples of protectionism in 2009 include the subsidies given to the car industry in the USA; the increased tariffs on imported cars in Russia, and the EU raising duties on imported Vietnamese shoes

International trade

Globalisation has led to a phenomenal increase in world trade. One measure is to consider exports as a proportion of world GDP.

The pattern of world trade has also been greatly affected by the entry of China as a major manufacturer.

The basis of free trade law: the law of comparative advantage

The law states that, even if one country has an absolute advantage in the production of all goods, it can still benefit from specialisation and trade, if it specialises in the production of goods in which it has a comparative advantage.

A country has a comparative advantage in producing a product if the opportunity cost of producing it is less than its potential trading partner.

Say the UK take 5 hours to make cheese, and China 1. Also, the UK takes 15 hours to make cars, but China 2. China clearly has an absolute advantage in producing both cars and cheese.

However, look at the opportunity cost. The UK gives up 3 cars if it producing 1 cheese. China gives up 2 cars if its producing 1 cheese. Therefore China has a comparative advantage in cheese production.

The UK gives up 1/3 a car if it produces one cheese, and China gives up 1/2. So, the UK has a comparative advantage in car production.

Therefore, the UK should specialise in producing cars, and China should produce cheese.

For trade to be beneficial, the terms of trade must lie between opportunity cost ratios. In other words, the UK will only trade for cheese with china if the price is above 1/3 of a car, and China will only trade if it is below 1/2 of a car.

Terms of trade = (index of export prices / index of import prices) x 100

You should note that, if opportunity costs were the same, then there would be no benefit from specialisation and trade.

However, widespread acceptance of the law of comparative advantage amount economists and the benefits of free trade, various criticisms can be made:

• Free trade is not fair trade i.e. the rich countries might exert their monopsony power to force producers in developing countries to accept low prices.
• The law of comparative advantage is based on unrealistic assumptions such as constant costs of production, zero transport costs, and no barriers to trade.

Limits of free trade: the case for protectionism

The term protectionism refers to measures designed to limit free trade. Arguments supporting the need for protectionism might include the following:

• To protect infant industries: this argument might be particularly relevant to developing countries that are in the process of industrialisation. Without protection, infant industries might be unable to compete because they have yet to establish  themselves and are too small to benefit from economies of scale.
• To protect geriatric industries: these are industries that might demand protection so that they have time to restructure and rationalise production so that they can become competitive again. Typically, these occur in developed economies that are loosing their comparative advantage.
• To ensure employment protection: cheap imports might threaten jobs in the domestic economy and workers might demand that the government takes action to limit imports.
• To prevent dumping: the term dumping refers to goods exported to another country below at a price below the average cost of production. It is a form of predatory pricing and, if it can be proved, it is illegal under WTO rules. This is one of the few arguments in favour of protectionism that can be justified under economic theory because it unfairly distorts comparative advantage
• To correct a balance of payments deficit on current account: restrictions on imports might help to reduce the imbalance of between the value of import and the value of exports. However, under the floating exchange rates system, it is possible that this correction will happen automatically
• To restrict imports fro counties whose health and safety regulations and environmental regulations are less stringent: some argue that developing countries have an unfair comparative advantage because production is not under the same laws and regulations as developed countries, so enabling them to produce at lower average cost
• For strategic reasons: a country might introduce protectionist policies on goods of strategic importance in time of war so that it is not dependant on imports. Food, defence equipment and energy are items frequently used as examples of such goods.
• To raise tax revenues: tariffs may be an important source of tax revenue for developing countries.
• In retaliation: barriers to trade may be imposed by a country because another country has restricted the imports of its goods.

Types of protection/import barriers

There are numerous ways by which free trade can be prevented. The most common are tariffs, quotas and subsidies to domestic producers and administrative regulations. In countries where the exchange rate is not freely floating, the authorities might also hold down the value of the currency artificially to give their good a competitive advantage. e.g. China.

Tariffs

Before the tarrif is imposed:

• the price paid by consumers is P1, domestic output is Q1, imports are Q1 to Q2.

Once the tariff is imposed:

• the price paid by the consumer increases to P2, reducing consumer surplus
• domestic output rises to Q4,  increasing producer surplus
• imports fall to Q4Q3
• tax revenue collected by the government is KLMN
• net deadweight welfare loss is the loss in consumer welfare that is not made up for by producer welfare or government revenue – X and Y

Quotas

Import quotas place a physical restriction on the amount of goods that can be imported. They have a similar effect as tarrifs, in that the price of imported goods will rise and domestic producers should gain more business. However, unlike tariffs, the government does not gain any extra revenue.

Subsidies to domestic producers

Grants given to domestic producers artificially lower their production costs, so enabling their goods to become more competitive. Subsidies therefore act as a barrier to trade

Administrative regulations

These take a variety of forms, including labelling, heath and safety regulations, environmental standards and documentation on country of origin. In effect, such regulations increase the costs of foreign producers and so act as a barrier to trade.

The case against protectionism

There are several problems with protectionism including:

• Inefficient resource allocation: trade barriers distort comparative advantage and reduce specialisation, which will result in lower world output and therefore reduce living standards
• Higher prices and less choice for consumers
• Less incentive for domestic producers to become more efficient in order to compete on a global scale
• Difficulty of removing trade barriers. Once such barriers are introduced, it might prove to be difficult to remove them because of the adverse effect on domestic producers

The World Trade Organisation

The primary aim of the World Trade Organisation (WTO) is to liberalise trade i.e. to lower trade barriers. It does this by providing governments with a forum for negotiating trade agreements. Since the creation of the General Agreement of Tariffs and Trade (GATT), which was the forerunner of the WTO, there have been eight rounds of talks, with the ninth round – the Doha Development Agenda – still being negotiated (since 2001).

In addition to promoting free trade, the WTO performs other functions including:

• Most favoured nation principle: which implies that counties cannot discriminate between trading partners. For example, a reduction in tariff for one country must be enacted for all countries
• National treatment: imported and locally produced goods must be treated equally once the foreign goods have entered the market.

While the WTO has been successful at bringing about substantial reductions in tariffs on manufactured goods e.g. industrialised country’s tariffs averaged around 4% by the mid 1990s, it has been less successful in reducing barriers to the trade in services. Further, there has been a growth in the use of non-tariff barriers, especially administrative regulations, which has, to some extent, offset the gains from the reduction in tariffs.

Trading blocs

Regional trading blocs are intergovernmental associations that manage and promote trade activities for specific regions of the world. Trading blocs may take several forms:

• Free trade areas. Trade barriers are removed between member countries, but individual countries can still impose tariffs and quotas on countries outside of an area. An example is in the North Atlantic Free Trade Area.
• Customs unions. The characteristics of customs unions include free trade between member states and a common external tariff on all goods imported from outside the bloc. An example is the European Union
• Common market. These are customs unions but with the added dimension that it is not only goods and services that can be moved freely within the area, but also factors of productions (especially labour). For example, the European Economic Area.
• Monetary unions. These are customs unions that adopt a common currency. For example, the Eurozone

Trading blocs and the WTO

The existence of trading blocs has two significant consiquences:

• trade creation – trade occurs that otherwise wouldn’t have happened. This is a result of the removal of trade barriers and therefore increased specialisation and trade according the the law of comparative advantage
• trade diversion – trade changes from with members from outside of the union to inside of the union. This is due to the tariffs imposed on countries outside of the union, and the removal of tariffs inside of the union – from the lower-cost to the higher cost countries. Therefore this is an inefficient allocation of resources.

Nevertheless, it may be argues that the growth in both the number and size of trading blocs has contributed to the WTO goal of promoting free trade.

Public finance

There are four elements of public finance to be considered:

1. Public expenditure
2. Taxation
3. Public sector net borrowing
4. Public sector net debt

Public expenditure

Expenditure by central and local government can be categorised into three distinct types:

• Current expenditure: This is the day-to-day expenditure on goods and services, e.g. salaries of teachers, nurses and drugs used by the NHS
• Capital expenditure: This relates to expenditure on long term investment projects, such as new hospitals and roads
• Transfer payments. These are payments that are made by the state to individuals in the form of benefits where there is no production in return.

The objectives of public expenditure include the provision of public goods, defence and internal security; the provision of goods and services which yield external benefits and/or where there may be information gaps and asymmetric information, for example health and education; the redistribution of income; and expenditure to deal with external costs such as pollution, and waste.

Analysis of pubic expenditure

The following synoptic issues arise when considering public expenditure:

• Given the amount of pubic expenditure is likely to be restricted in any one year, then an increase in one area will involve an opportunity cost
• Increasing expectations relating to healthcare and education are associated with real incomes, so it could be inferred that demand for these services is income elastic
• An increase in public expenditure represents an injection into the circular flow of income and so will have a multiplier effect on GDP. Not only will aggregate demand increase but expenditure on areas such as eduction, infrastructure and health may cause an increase in LRAS.
• Part of public expenditure might be used for dealing with external costs.
• Public expenditure could result in government failure, where government involvement causes a net welfare loss

In addition, there is the issue of crowing out, which might result from increased public expenditure. This might take two forms: resource and financial. Resource crowding out occurs when the economy is operating at full employment and an increase in public expenditure results in insufficient resources being available to the private sector. Financial crowding out is when increased borrowing or tax cuts are funded by increased private sector borrowing, so increasing the demand for loanable funds and driving up interest rates.

The size and pattern of public expenditure

Factors influencing the size and pattern of government expenditure include:

• The level of GDP: incomes increase, the demand for many government provided services such as health and education rises more than proportionately because demand for them is income elastic.
• The size and age distribution of the population: an increase in the size of the population (e.g through immigration) is likely to place extra pressure on public services, while an ageing population will increase demand for medical services and social security for the elderly.
• Political priorities: the Labour government placed a particular emphasis on improving the quality of health and education services
• Redistribution of income: expenditure on those in relative poverty and those will disabilities has increased significantly in recent years. For example, there has been an increase in means-tested benefits such as family tax credits and pensioner’s credits.
• Discretionary fiscal policy: the credit crunch has led to the ressurection of fiscal policy as a means of managing the economy
• Debt interest: the massive increase in fiscal deficits from 2008 is leading to sharp rises in public sector debt. In turn this will result in higher interest payments on the national debt.

Taxation

Taxes may be divided into two types: direct and indirect. Direct taxes are those levied on income and wealth and the tax burden cannot be passed onto anyone else. Indirect taxes are those levied on expenditure.

The main direct taxes are income tax, corporation tax, and capital gains tax, while indirect taxes include VAT, excise duties and tariffs.

There are three broad categories of taxes: progressive, proportional and regressive.

• Progressive: proportion rises as expenditure increases.
• Proportional: proportion constant as income increases.
• Regressive: proportion declines as expenditure increases.

Analysing the effects of taxation

While analysing the effects of taxation, the following synoptic issues should be considered:

• An increase in taxes may represent a leakage from the circular flow and so would have a downward multiplier effect in GDP
• An increase in direct tax on a product would cause a leftward shift in the supply curve, The incidence of tax on producers and consumers depends on the PED.
• Indirect taxes might be applied to products that cause external costs.
• An increase in indirect taxes could cause inflation via a wage-price spiral. For example, if VAT is increased, prices rise. This could be inflationary if it results in workers demanding higher wages to compensate for the increase in prices.

A more detailed consideration of tax changes is given below:

The net effect of a change in income tax rates

If income tax rates are changed there will be a variety of effects on an economy. Given the increase in fiscal deficits and national debts of many countries, its seems likely that taxes will be raised. For example, in the UK, there will be a 50p income tax rate from April 2010, and a rise of VAT to 20% was implemented in 2011. Higher income tax rates could have the following effects:

• Income distribution: the tax system is more progressive, making income distribution less equitable
• Incentives to work: May create significant disincentives.
• Tax revenues: Depends on placement on Laffer curve.
• Level of economic activty: cause fall in disposable income. Reduction in propensity to consume, so less consumption.  Fall in AD. Disincentives of tax may cause shift in AS to left.

An increase in VAT could have the following effects:

• On income distribution: regressive tax. Income distribution less even
• Incentives to work. May cause people  to work harder so that they can maintain their standard of living
• Tax revenues: Raising indirect taxes would increase tax revenues to the government so ling as the demand for products and services affected is price inelastic.
• Rate of inflation: an increase in VAT will raise the price of most goods and services. If workers and trade unions respond by demanding wage increases to compensate for price rises, then an inflationary wage-price spiral could result.
• Level of economic activity: a rise in VAT would act as a leakage from the circular flow, increased by the multiplier. The real incomes would fall, so causing a fall in AD. Costs would rise leading to a fall in AS.

Public sector borrowing and debt
Public sector net borrowing or fiscal deficit

Public sector net borrowing is the difference between public expenditure and tax revenue.

The PSNB is significant for the following reasons:

• Excessive borrowing could be inflationary because AD would be increasing
• Public sector net debt must not exceed 3% to meet the criteria of entry to the Euro
• Taxen as a percentage of GDP given an indication of the size of the state sector relative to the whole economy. This might have some significance for foreign direct investment (FDI), since high taxes may act as a deterrent.
• Until 2009, borrowing could only be for capital expenditure over the course of the by business cycle to meet the requirements of the Golden Rule.

Public sector net debt

PSNB, formerly known as the national debt, is the culmative total of past government borrowing.

• To meet the sustainable investment rule, this should not exceed 40% of GDP and to meet the conditions of entry to the Euro it should not exceed 60% of GDP.
• As with the PSNB, the absolute size of the PSND is less significant than its size relative to GDP, because this provides an indication of how readily it can be serviced.
• Until 2007, the PSND was below 40% of GDP, but the global financial crisis had a massive effect. In 2008, it rose to 47% of GDP and is currently at 60%.

Do large national debts matter?

Some argue that, if the money is being used to finance improvements of infrastructure and other capital projects, then a large PNSD might be justified because it would keep increasing a country’s future productive potential, so making it easier to repay in the future. However, certain problems may arise:

• There is an opportunity cost for future generations: interest payments on the national debt mean that less money will be available for public services.
• Crowding out: if the increasing size of PSND is an indication of the increasing size of the public sector, resource or financial crowding out may occur
• Danger of inflation: if the rising PSND has been caused by successive PSNB deficits, then there is a danger that inflationary pressures will develop, since injections will be rising relative to leakages.

In the long run, future governments might be forced to raise taxes and cut public expenditure so that the national debt can be reduced.

Macroeconomic policy instruments

Macroeconomic policies are usually divided into demands-side (monetary and fiscal policy) and supply side policies. For 30 years or so, until the financial crisis of 2008, monetary policy was geared towards combating inflation, while fiscal policy was aimed at achieving the governments fiscal objectives. Supply-side policies were used to secure economic growth and the government’s other macroeconomic objectives. In this unit it is important to adopt a critical approach to the effectiveness of these policies.

Monetary policy

Monetary policy refers to the use of interest rates, money supply and exchange rate in order to influence the level of economic activity in a country.

There are various aspects of monetary policy:

• Inflation targets. These are used by many countries in order to maintain a low rate of inflation. In the case of the UK, there is a target of 2%, although the rate may vary up to 1% either side of this, while the European Central Bank has a target maximum inflation rate of 2%. Until 2007, inflation targeting was generally regarded as an effective way of controlling inflation, although countries without inflation targets did not seem to have significantly higher rates of inflation. However, following the financial crisis, many economists have argued that an inflation target based on the CPI is too narrow. Instead there should be targets relating to other variables, such as asset prices. In order to prevent asset price bubbles from occurring.
• Interest rate changes. These are used to achieve the inflation target. e.g. if the inflation rate is predicted to rise above its target, then the Bank of England increases the base rate. However, the use of interest rates has various disadvantages. i.e. time lag, business costs rise, exchange rate may increase, making a countries goods less competitive.
• Quantitative easing. This is sometimes mistakenly referred to as printing money. In practice, it relates to the action of the Central Bank in buying up government and corporate bonds from commercial banks and other financial institutions. This has the effect of increasing their deposits, thereby giving them more ability to to lend to private and business customers. However, some argue that this policy is unlikely to be effective if the banks are risk averse and remain unwilling to lend unless the loan is risk-free. There is also a danger that the increase supply of money in the economy could unleash as serious bout of inflation. An increase in the supply of money could also cause a depreciation of the exchange rate which, in turn, would result in net exports and so increase AD.

Fiscal Policy

Fiscal policy refers to the use of government expenditure and taxation in order to influence the level of economic activity in a country. From the 1980s to 2008, its primary role was to stable public finances. However, from 2008 it has once again assumed a role macroeconomic management not only in the UK, but also in China, the USA and various other countries. Some key features of fiscal policy include:

• Automatic stabilisers: relate to the fact that some forms of government expenditure and revenues from some taxes change automatically in line with GDP and the state of the economy. These stabilisations reduce fluctuations caused by the business cycle. Examples include progressive taxation and welfare payments such as unemployment
• Discretionary fiscal policy: refers to deliberate changes in taxes and public expenditure designed to achieve the governments macroeconomic targets. For example, the global economic crisis has led to many countries introducing a fiscal stimulus to prevent severe recession. Typically, these have included an increased public expenditure on infrastructure; green technology, targeted subsidies to distressed industries and tax cuts.

Fiscal policy might be effective if the value of the multiplier is high and can have an immediate impact if indirect taxes, such as VAT, are reduced. However, there may be significant time lags. For example, government expenditure on investment projects, such as new hospitals, is unlikely to have an impact for a considerable time because land must be purchased and planning applications approved.

Further, if there is a contractionary fiscal policy in which direct taxes are increased, there could be disincentive effects, while higher tax rates might reduce incentives to work. It is also difficult to determine the magnitude of changes in public expenditure in advance because the value of the multiplier may not be known.

Supply side policies

Supply side policies are a broad range of policies aimed at increasing aggregate supply by increasing competition, increasing incentives and cutting costs. Essentially these are microeconomic policies since they target specific markets, e.g. labour, product or capital markets.

Labour market

Policies aimed at the labour market include:

• reduction in trade union power: e.g. making strikes without a secret ballot illegal, making sympathy strikes illegal
• reduction in unemployment benefits: which would increase the incentive for unemployed workers to take jobs
• improvements in human capital: increased provision and quality of education and training designed to increase the productivity of the workforce
• reduction in employment protection legislation: making it easier to hire and fire workers, which contributes to a more flexible workforce
• reduction in income tax rates: the aim of these tax cuts is to increase incentive to work and may be analysed using the Laffer curve

Product market

• privatisation, deregulation, contracting out:
  privatisation –  involves the sale of state-owned enterprise to the private sector usually through the form of shares. This policy has been adopted across the globe and in the case of developing countries, privatisation has been a condition for loans given by the IMF.
  deregulation – when the government removes official barriers to competition e.g. licences and quality standards
  contracting out – when parts of services operated by the public sector are put out to tender so that the private sector can compete for the business
• Trade liberalisation: relates to the free movement of goods and services within an economy. Removal or reduction in trade barriers, and the adoption of policies that allow free capital flow between countries, so making it more attractive for transnational companies to invest in the country.
• promotion of new/small firms: for example, through tax breaks, short-term loans for new businesses and loan guarantees.

Capital market

• Deregulation of the financial markets: such as the reduction of restrictive practices in the city and stock exchange
• reduction in corporation tax: or reduction in tax allowances on investment by firms

Criticism of supply side policies

• Increased inequality: it is argued that they are based on the premise that the rich will work harder if you pay them more, and the poor will work harder if you pay them less
• Time lags: some of the measures take a long time to have any impact on the supply side of the economy i.e. primary education reform
• The incentive of tax cuts may be over estimated: in the USA, tax cuts resulted in an increase in labour supply of less than 1%. Similarly, there is little evidence that tax cuts have any significant effect on productivity
• Ineffectiveness: if aggregate demand is low, these policies may have no effect
• Adverse effects of deregulation: competition may lead to undesirable consequences. For example, the deregulation of the financial markets resulted in excessive risk-taking, and the near collapse of the banking system

Problems faced by policy makers

Policy makers face a variety of problems when implementing policy:

• Inaccurate information: for example, information regarding GDP, the balance of payments on current account and retail sales is notoriously inaccurate and subject to subsequent revisions
• Risks and uncertainties: for example, there is considerable uncertainty over the effect of quantitative easing. Some monetarist economists argue that it could risk unleashing a massive bout of inflation because of the increase in money supply, while others consider the previous experiences in other countries suggests it will have little impact on the economy.