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Macro-economics
The national economy pages introduce macro-economic
concepts, models, and theories, and explains how macro-
economic problems are analysed, and policies evaluated.
Macro-economic theory
Macro-economics is traditionally broken down into macro-
economic theory and macro-economic policy. Macro-economic
theory involves the construction and use of models of the
whole, macro, economy. Economists build such models so that they can explain the structure of an economy, and the role
and significance of the parts that make up this
structure. Macro-economic models also help the economist
understand how the separate components of the macro-
economy are related.
Macro-economic models are also used to help economists and
policy makers make predictions, or forecasts, about the
economy, and about the effect of changes in one economic
variable, such as exchange rates, on other variables, such as
prices and output.
Macro-economic policy objectives
Macro-economic policy refers to how governments and other
policy makers compensate for market failures in order to
improve economic performance and well-being. Improvements
in performance begin with the setting of policy objectives,
which include the achievement of sustainable economic growth
and development, stable prices and full employment. Some of
the objectives set are potentially in conflict with each other,
which means that, in attempting to achieve one objective,
another one is sacrificed. For example, in attempting to achieve full employment in the short-term price inflation may
occur in the longer term.
Policy targets
In order to achieve policy objectives, policy makers will set
targets to aim for. Targets are often fixed, and widely known,
such as the current UK inflation target of 2%, but they may
also be flexible and less widely known, such as exchange rate
and employment targets.
Policy instruments
Once policy objectives and targets are established, policy
makers need to choose between alternative policy tools, or
instruments. These instruments are the levers of control of the
macro-economy and include monetary instruments such as
interest rates, and fiscal instruments such as tax rates and
government spending.
Policy disagreements
Policy disagreements occur for a number of reasons. Macro-
economic policy is often shaped by long held normative beliefs
about what is essential, and this influences the choice of model,
objective, target, and instrument. For example, some
economists put the eradication of poverty above the
maximisation of corporate profits, and this will strongly
influence their belief about how the tax system should be used.
In addition, different economists may use different economic
models and forecasting techniques, and this may lead them to
disagree about the need for, size of, or timing of policy
changes.
Market Failures
Types of market failure
A market failure is a situation where free markets fail to
allocate resources efficiently. Economists identify the
following cases of market failure:
Productive and allocative inefficiency
Markets may fail to produce and allocate scarce resources in
the most efficient way.
Monopoly power
Markets may fail to control the abuses of monopoly power.
Missing markets
Markets may fail to form, resulting in a failure to meet a need
or want, such as the need for public goods, such as defence,
street lighting, and highways.
Incomplete markets
Markets may fail to produce enough merit goods, such as
education and healthcare.
De-merit goods
Markets may also fail to control the manufacture and sale of
goods like cigarettes and alcohol, which have less merit than
consumers perceive.
Negative externalities
Consumers and producers may fail to take into account the
effects of their actions on third-parties, such as car drivers,
who may fail to take into account the traffic congestion they
create for others. Third-parties are individuals, organisations,
or communities indirectly benefiting or suffering as a result of
the actions of consumers and producers attempting to pursue
their own self interest.
Property rights
Markets work most effectively when consumers and producers
are granted the right to own property, but in many cases
property rights cannot easily be allocated to certain resources.
Failure to assign property rights may limit the ability of
markets to form.
Information failure
Markets may not provide enough information because, during a
market transaction, it may not be in the interests of one party to
provide full information to the other party.
Unstable markets
Sometimes markets become highly unstable, and a stable
equilibrium may not be established, such as with certain
agricultural markets, foreign exchange, and credit markets.
Such volatility may require intervention.
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Inequality
Markets may also fail to limit the size of the gap between
income earners, the so-called income gap. Market transactions
reward consumers and producers with incomes and profits, but
these rewards may be concentrated in the hands of a few.
Remedies
In order to reduce or eliminate market failures, governments
can choose two basic strategies:
Use the price mechanism
The first strategy is to implement policies that change the
behaviour of consumers and producers by using the price
mechanism. For example, this could mean increasing the price
of harmful products, through taxation, and providing subsidies for the beneficial products. In this way, behaviour is changed through financial incentives, much the same way that
markets work to allocate resources.
Use legislation and force
The second strategy is to use the force of the law to change
behaviour. For example, by banning cars from city centers, or
having a licensing system for the sale of alcohol, or by
penalising polluters, the unwanted behaviour may be
controlled.
In the majority of cases of market failure, a combination of
remedies is most likely to succeed.
Exchange rate policy
The exchange rate of an economy affects aggregate demand
through its effect on export and import prices, and policy
makers may exploit this connection.
Deliberately altering exchange rates to influence the macro-
economic environment may be regarded as a type of monetary
policy. Changes in exchanges rates initially work there way
into an economy via their effect on prices.
For example, if 1 exchanges for $1.50 on the foreign
exchange market, a UK product selling for 10 in the UK will
sell for $15 in New York. If the exchange rate now appreciates,
so that 1 buys $1.60, the UK product in New York will now
sell for $16. Assuming that demand in New York is price
inelastic, this is good news for UK exporters because revenue
in USDs will rise. However, if demand is elastic in New York,
the effect of the appreciation of the Pound would be damaging
to UK exporters.
If the UK also imports goods from the USA, the rise in the
exchange rate would mean that a $10 US product is now
cheaper in London, falling from 6.67p to 6.25p. Importers do
relatively well from the appreciation of the pound, in that the
cost of imported raw materials or finished goods falls.
Therefore, whenever the exchange rate changes there will be a
double effect, on both import and export prices. Changes in
import and export prices will lead to changes in import and
export volumes, causing changes in import spending and
export revenue.
Exchange rates can be manipulated so that they deviate from
their natural equilibrium rate. To stimulate exports, rates would
be held down, and to reduce inflationary pressure rates would
be kept up. While the Bank of England does not specifically
target the exchange rate, the Monetary Policy Committee
(MPC) will take exchange rates into account. Clearly, the MPC
would prefer a relatively high rate, as this reduces the price of
imports and works against inflationary pressure. However, the
MPC must keep an eye on export competitiveness, and, if rates
rise excessively, UK exports will become uncompetitive.
How exchange rates are manipulated
Exchange rates can be manipulated by buying or selling
currencies on the foreign exchange market. To raise the value
of the pound the Bank of England buys pounds, and to lower
the value, it sells pounds. Rates can also be manipulated
through interest rates, which affect the demand and supply of
Sterling via their effect on inflows of hot money. Altering
exchange rates is commonly regarded as a type of monetary
policy.
Effects of a reduction in the exchange rate
Assuming the economy has an output gap, a reduction in the
exchange rate will reduce export prices, and, assuming demand
is elastic, export revenue will increase.
A fall in the exchange rate will also raise import prices, and
assuming elasticity of demand, import spending will fall. The
combined effect is an increase in AD and an improvement in
the UK balance of payments.
Cost push inflation
A fall in the exchange rate is inflationary for a second reason -
the cost of imported raw materials adds to production costs and
creates cost-push inflation.
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Evaluation of exchange rate policy
The main advantage of manipulating exchange rates is that,
because a large share of UK output is traded internationally,
changes in exchange rates will have a powerful effect on AD.
For example, lowering exchange rates, called devaluation, can:
1. Raise aggregate demand
2. Increase national output (GDP)
3. Create jobs, amplified through the multiplier effect
4. In addition, assuming the demand for imports and exports are price sensitive (price elastic), devaluation
will lead to an improvement in the balance of
payments - although this can also lead to inflation
Alternatively, raising exchange rates (revaluation) can:
1. Help reduce excessive aggregate demand
2. Keep inflation down
3. Although the export sector may suffer and jobs might be lost
On balance, UK policy makers in recent years have preferred
to allow the financial markets to determine exchange rates,
rather than manipulate them for policy objectives. The last time
exchange rates were directly targeted was between 1985 and
1992, when the UK shadowed movements in the Deutschmark,
and then, from 1990 to 1992, when the UK became a member
of the exchange rate fixing Exchange Rate Mechanism
(ERM).
Sustainable growth
Economic growth occurs when real output increases over time.
Real output is measured by Gross Domestic Product (GDP) at
constant prices, so that the effect of price rises on the value of
national output is removed.
Sustainable economic growth means a rate of growth which
can be maintained without creating other significant economic
problems, especially for future generations. There is clearly a
trade-off between rapid economic growth today, and growth in
the future. Rapid growth today may exhaust resources and
create environmental problems for future generations,
including the depletion of oil and fish stocks, and global
warming.
Periods of growth are often triggered by increases in aggregate
demand, such as a rise in consumer spending, but sustained
growth must involve an increase in output. If output does not
increase, any extra demand will push up the price level.
Growth based on debt
In terms of sustainability, it may be argued that growth based
on short-term public debt, rather than long term productivity, is
unsustainable - hence worries about the build-up of sovereign
debt in Europe.
PPFs and economic growth
For an economy to continue to grow in the future, it needs to
increase its capacity to grow. An increase in an economys productive potential can be shown by an outward shift in the
economys PPF.
Standards of living
Gross domestic product per capita is often regarded as the key
indicator of the standards of living of the citizens of an
economy, and of their economic welfare, though broader
measures of economic welfare are increasingly used in
preference to narrow GDP measures.
Measuring growth
GDP is the official base measure of output used in most
economies, including the UK. Gross measurements record the
output of all goods and services, including capital goods which
have been purchased to replace existing capital goods.
Replacing capital is called capital consumption, or
depreciation. The alternative to Gross output is Net output,
which indicates that depreciation is taken into account and
deducted from the gross measurement.
Domestic product is the value of all UK goods and services
produced, including those produced for export. It does not
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include property income which flows into and out of the UK
economy. Property income refers to income from various types
of investment abroad, such as profits and dividends. When this
is added, the measure becomes national product, called Gross
National Product, GNP.
Growth can be measured as an annual percentage increase in
real GDP, and in terms of a general trend. The trend rate of
growth is the long term non-inflationary average rate of growth
for an economy. In the UK it is around 2.5% per year.
Why is stable growth an economic objective?
If growth rises significantly above or below the trend rate, the
economy is experiencing excessive growth or low growth. If
the rate becomes negative for at least 2 quarters in succession,
the economy is in recession.
The trade (growth) cycle
Changes in real national income tend to be cyclical, but it is
desirable that this cycle is stable rather than unstable. Unstable
growth is popularly called boom and bust.
Although an economys growth is cyclical in nature, the underlying trend can be derived from annual growth statistics. Trends can be calculated by using a technique called
moving averages. The UK trend rate over the last 25 years is
around 2.5%.
Excessive growth can lead to:
1. Goods and service inflation
2. House price inflation
3. Wage inflation
4. Labour shortages
5. Falling savings
6. Excessive credit
7. Trade difficulties
Low or negative growth can lead to:
1. Goods deflation
2. House price deflation
3. Labour surpluses
4. Unemployment
5. Excessive debt burden
6. Public sector debt
Predicting turning points
Changes, or turning points, in the level of national income can
be predicted and confirmed using economic indicators. Leading
indicators typically monitor changes in interest rates, business
confidence and new housing starts-ups - all of which provides
clues to the next turning point in an economys growth cycle. Changes in these indicate that GDP is likely to change in 12 to
18 months time. The OECDs main indicator, the Composite Leading Indicator (CLI), tracks deviations from the long-term
trend, which provides an early warning system for policy
makers.
A short leading indicator can be used to monitor changes in
consumer credit and new car registrations. A lagging indicator
monitors changes in unemployment and real investment and
confirms that the turning point has occurred. All indicators help
policy makers decide when to implement a policy and by what
degree.
The advantages of growth
Economic growth is associated with a number of material
benefits which increase economic welfare. These include the
following:
Higher GDP per capita
A rise in real national income means that wages and profits are
likely to rise. Assuming a stable population, this will raise GDP
per capita.
More public and merit goods
A growing economy means that the public sector can receive
more tax revenue and more resources can be allocated to public
and merit goods, such as more roads, hospitals and schools.
Positive externalities
Public and merit goods generate considerable external benefits.
More hospitals and schools mean a healthier and better-
educated population, which generates other economic benefits
in terms of the effectiveness of the labour force, and increases
in long-term aggregate supply.
More employment
Growth is clearly likely to stimulate demand for labour, and it
is likely that more people will be employed and fewer
unemployed.
The disadvantages of growth
Economic growth also brings some costs which reduce
economic welfare, including:
Negative externalities
As production and consumption increase, negative
externalities, such as pollution and congestion, are likely to
arise. There is also the likelihood of increased depletion of
non-renewable resources, such as fossil fuels.
Inflation and balance of payments difficulties
Too rapid a rate of growth can also lead to two significant
economic problems: inflationary pressure and a balance of
payments deficit, as imports rise to satisfy an increasingly
active household sector.
Widening income gap
Growth can also widen the distribution of income, because
some groups may benefit much more than others. Certainly in
the UK, the relative income gap has widened during the growth
years of 1992 to 2008.
Limitations of using GDP per capita over time
There are several limitations of using GDP statistics for
comparing changes in economic well-being over time,
including:
Changes in the distribution of income
Average GDP per capita may rise over time, but the
distribution of income may widen. For example, a rise in the
mean average income per head can be misleading because the
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average may rise because just a few of the population increase
their personal income. Indeed, the mean average can rise, but
the median, the mid-point in a range of numbers, can fall.
Differences in hours worked
People may be working longer hours, in which case some of
the growth may be through increased work, rather than through
increased efficiency.
Unpaid work is not recorded
People may undertake unpaid work, and this may not be
officially recorded.
Price changes
Prices are unlikely to remain constant over time, so GDP
figures must be converted to at constant prices and measured
from a base year. This process is called indexing and is required to avoid the distorting effects of inflation.
Negative externalities
The quality of life may suffer as GDP increases, although this
is not included in GDP statistics. For example, more driving
raises GDP, but also adds to CO2 emissions, which can reduce
the quality of life.
Changes in the quality of products
Over time the quality of products tends to increase, so a given
amount of income per capita in 2010 may purchase a higher
quality product than it did in 2000. This is certainly true with
high-technology consumer products, like PCs, laptops and
mobile phones.
Limitations of using GDP statistics for international
comparisons
Limitations of using GDP statistics for international
comparisons include:
Differences in the distribution of income
Although two countries may have similar GDP per capita
figures, the distribution of income in each country may be very
different.
Differences in hours worked
As when comparing a country over time, the number of hours
worked to generate a given level of income may be quite
different. For example, workers in the UK tend to work longer
hours than those in France, and this would falsely inflate the
GDP figures in the UK relative to France.
International price differences
International prices will also vary. This is significant because
an individual's purchasing power is based on price in relation to
income. To solve this problem, GDP statistics can be re-
calculated in terms of purchasing power. The purchasing power
of a currency refers to the quantity of the currency needed to
purchase a given unit of a good, or common basket of goods
and services. Purchasing power is clearly determined by the
relative cost of living and inflation rates in different countries.
Achieving purchasing power parity means equalising the
purchasing power of two currencies by taking into account cost
of living and inflation differences.
For example, if we simply convert GDP in Japan to US dollars
using market exchange rates, relative purchasing power is not
taken into account, and the validity of the comparison is
weakened. By adjusting rates to take into account local
purchasing power differences, known as PPP adjusted
exchange rates, international comparisons are more valid.
Difficulty of assessing true values
The true value of public goods and merit goods, such as
defence, education and transport infrastructure is largely
unknown. This means that it is difficult to compare two
countries with very different levels of spending on these goods
and assets.
The unofficial economy
Similarly, the existence of a large unofficial economy may
make comparisons based on official GDP very misleading. For
example, comparing the official GDP of the UK and Russia
may be misleading because of the size of Russia's unofficial
economy. While all countries have unofficial economies, their
size and significance can vary considerably.
Currency conversion
GDP figures for different countries must be converted to a
common currency, such as the US dollar, and this may give
misleading figures. For some countries, exchange rates against
the US dollar may be unrepresentative of the true value of the
currency, especially where international trade is relatively
small. In such cases, converting to US dollars may significantly
under-value national output. This explains why conversion to
purchasing power parity is often preferred to conversion to US
dollars.
Sustainable development and quality of life
In recognising that economic welfare is not simply about
economic growth, in 1999 the UK government introduced a
policy for sustainable development, and refined this further in
2005.
Sustainable development is considered in four main categories
using 20 main indicators, and 68 indicators in total. The
categories are:
1. Sustainable consumption and production
2. Climate change and energy
3. Natural resource protection and enhancing the environment
4. Creating sustainable communities and a fairer world
National income
National income is the total value a countrys final output of all new goods and services produced in one year. Understanding
how national income is created is the starting point for
macroeconomics.
The national income identity
This relationship is expressed in the national income identity,
where the amount received as national income is identical to
the amount spent as national expenditure, which is also
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identical to what is produced as national output. Throughout
macroeconomics the terms income, output and expenditure are
interchangeable.
See also: the circular flow of income
National income accounts
Since the 1940s, the UK government has gathered detailed
records of national income, though the collection of basic data
goes back to the 17th Century. The published national income
accounts for the UK, called the Blue Book, measure all the economic activities that add value to the economy.
Adding value
National output, income and expenditure, are generated when
there is an exchange involving a monetary transaction.
However, for an individual economic transaction to be
included in aggregate national income it must involve the
purchase of newly produced goods or services. In other words,
it must create a genuine addition to the value of the scarce resources. For example, a transaction that involves selling a
second-hand good, and which was new two years ago does not
add to national income, though the original production and
purchase does. Transactions which do not add value are called
transfers, and include second-hand sales, gifts and welfare
transfers paid by the government, such as disability allowance
and state pensions.
The creation of national income
The simplest way to think about national income is to consider
what happens when one product is manufactured and sold.
Typically, goods are produced in a number of 'stages', where
raw materials are converted by firms at one stage, then sold to
firms at the next stage. Value is added at each, intermediate,
stage, and, at the final stage, the product is given a retail selling
price. The retail price reflects the value added in terms of all
the resources used in all the previous stages of production.
Final output
In accounting terms, only the value of final output is recorded.
To avoid the problem of double counting, only the value of the
final stage, the retail price, is included, and not the value added
in all the intermediate stages - the costs of production, plus
profits. In short, national income is the value of all the final
output of goods and services produced in one year.
Example
For example, consider the production of a motor car which has
a retail price of 25,000. This price includes 21,000 for all the
costs of production (6,000 for components, 10,000 for
assembly and 5,000 for marketing) plus 4,000 for profit. To
avoid double-counting, the national income accounts only
record the value of the final stage, which in this case is the
selling price of 25,000.
When goods are bought second-hand, the transaction does not
add new value and will not be included in national output. If
second-hand goods are included, double-counting will occur,
and this would falsely inflate the value of national income.
For example, if the car in question is sold in two years time for 15,000 it would provide the owner with money, but the sale
will not add to national income. If it were included in national
income, it would make the value of the car 35,000 - the initial
25,000 plus the second hand value of 15,000. This is clearly
not the case, so any future second-hand sales are not included
when valuing national income. Such second-hand transactions
are called transfers.
Calculating national income
Any transaction which adds value involves three elements expenditure by purchasers, income received by sellers, and the
value of the goods traded. For example, if a student purchases a
textbook for 30, spending = 30, income to the bookseller =
30, and the value of the book = 30. All of the transactions in
an economy can be looked at in this way, giving us three ways
to measure national income.
There are three methods of calculating national income:
1. The income method, which adds up all incomes received by the factors of production generated in the
economy during a year. This includes wages from
employment and self-employment, profits to firms,
interest to lenders of capital and rents to owners of
land.
2. The output method, which is the combined value of the new and final output produced in all sectors of the
economy, including manufacturing, financial services,
transport, leisure and agriculture.
3. The expenditure method, which adds up all spending in the economy by households and firms on new and
final goods and services by households and firms.
Chained value measurement
The components of national output are valued according to
their importance to the overall economy. The weights used
were based on estimates made every 5 years, but, from 2003,
an annual adjustment to the weightings was introduced to
improve the reliability of the weighting - a process called
annual chain linking. This allowed for a more up-to-date, and
therefore a more accurate measure of changes to the level of
national income.
The main components of UK National Income
In 2010, UK Gross National income at current prices was
1,458 billion, up from 1,392 in 2009.
The percentage contribution of different components in the
three different measures are shown below:
National Income, by 'type' of income:
GDP - Income method, 2010, BnTaxes - subsidies,
179Other - inc rents, 168Corporate profits,
307Wages and salaries, 799Taxes - subsidiesOther
- inc rentsCorporate profitsWages and salaries
With around 30m workers in the UK, and over 2m firms*,
wages and profits contribute the majority of income in the UK.
(*2.15m according to the ONS)
National output, by sector of the economy:
GDP - Output method, 2010, BnConstruction,
90Water and services, 148Energy, 172Government
inc education, 261Health activities, 104Distribution
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and transport, 238Manufacturing, 131Mining,
28Agriculture, 7.5ConstructionWater and
servicesEnergyGovernment inceducationHealth
activitiesDistribution
andtransportManufacturingMiningAgriculture
In terms of output, services dominate the UK economy, with
manufacturing a distant second. However, this is a typical
profile for a developed economy the more developed the economy the more that income is allocated towards purchasing
services rather than manufactured goods.
National spending, by sector
GDP - Expenditure method, 2010, BnImports,
%A3476bnExports, %A3436bnInvestment,
%A3224bnGovernment, %A3338bnNon-profit
organisations, %A338bnHousehold spending,
%A3900bnImportsExportsInvestmentGovernmentNo
n-profitorganisationsHouseholdspending
In terms of spending, UK households account for the majority
of spending, export spending the next most
important. Spending on capital goods by firms, and spending
on public goods, merit goods, and transfers by government
accounts for the rest.
Source - ONS
Gross Domestic Product - GDP
Gross Domestic Product (GDP) is the most important
aggregate of national income for accounting purposes, and for
economic analysis. In the UK, GDP is derived from the gross
value added (GVA) of all the UK's individual producers,
industries or sectors over one year, using the 'output' method.
Current and constant prices
As the level of economic activity between households and
firms increases, output is also likely to increase. However,
under certain circumstances the price level may also be driven
up.
The nominal value of national income, or any other aggregate,
is the value of national output at the prices existing in the year
that national income is measured - that is, at current prices. In
simple terms the nominal value of national income can be found by multiplying the quantity of output by the retail
(market) price of this output.
If demand increases at an unsustainable rate, resources become
increasingly scarce, and firms will raise prices. Similarly,
wages are likely to rise as the labour market clears and
unemployment falls. The more that workers are needed the
higher the wage rate. This will act as an incentive for workers
to enter this industry. The combined effect of higher wages and
prices is that the nominal value of national output may be
driven up, rather than its real value.
To find the real value of changes in output under inflationary
conditions, the effects of any general price increase (price
inflation) must be taken into account. This is done by holding
prices constant from a starting measure, called the base year.
Example
For example, if, in a hypothetical economy, 100 pens are
produced and sold for 1 each in year 1, the nominal value of
these transactions is 100. If, in year 2, inflation pushes prices
up to 1.20p per pen, but, as in year 1, only 100 pens are sold,
the nominal value at current (year 2) prices will rise to 120.
However, the nominal value has only risen because of
inflation, so to adjust the nominal value to find the real value
we take the constant price of 1 which is the price of pens at the start of our measurement in the base year, year 1. However,
if in year 3 110 pens are sold at 1.20, the nominal value at
current prices will be 132 (an increase of 32%), but the real
value at constant (year 1) prices will be only 110 (a real
increase of only 10%). Therefore, to arrive at real values the
economist must take out the effects of price inflation by
holding prices constant in terms of the prices existing in the
base year.
Recent changes to UK national income
After a sustained period of rising national income from the
previous recession, which ended in 1992, the UK, like most
other advanced economies, entered a recession in the third
quarter of 2008. The recession lasted until the fourth quarter of
2009. Growth returned in 2010, but, following negative growth
in the fourth quarter of 2010, the UK economy failed to recover
fully, with growth in the third quarter of 2011 a modest 0.5%,
with a further drop to 0.2% in the last quarter of 2011.
Performance indicators
The performance of an economy is usually assessed in terms of
the achievement of economic objectives. These objectives can
be long term, such as sustainable growth and development, or
short term, such as the stabilisation of the economy in response
to sudden and unpredictable events, called economic shocks.
Economic indicators
To know how well an economy is performing against these
objectives economists employ a wide range of economic
indicators. Economic indicators measure macro-economic
variables that directly or indirectly enable economists to judge
whether economic performance has improved or deteriorated.
Tracking these indicators is especially valuable to policy
makers, both in terms of assessing whether to intervene and
whether the intervention has worked or not.
Useful indicators include:
1. Levels of real national income, spending, and output. National income, output, and spending are three key
variables that indicate whether an economy is
growing, or in recession. Like many other indicators,
income, output, and spending can also be measured in
per capita (per head) terms.
2. Growth in real national income.
3. Investment levels and the relationship between capital investment and national output.
4. Levels of savings and savings ratios.
5. Price levels and inflation.
6. Competitiveness of exports.
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7. Levels and types of unemployment.
8. Employment levels and patterns of employment.
9. Trade deficits and surpluses with specific countries or the rest of the world.
10. Debt levels with other countries.
11. The proportion of debt to national income.
12. The terms of trade of a country.
13. The purchasing power of a country's currency.
14. Wider measures of human development, including literacy rates and health care provision. Such
measures are included in the Human Development
Index (HDI).
15. Measures of human poverty, including the Human Poverty Index (HPI).
The circular flow of income
National income, output, and expenditure are generated by the
activities of the two most vital parts of an economy, its
households and firms, as they engage in mutually beneficial
exchange.
Households
The primary economic function of households is to supply
domestic firms with needed factors of production - land, human
capital, real capital and enterprise. The factors are supplied by
factor owners in return for a reward. Land is supplied by
landowners, human capital by labour, real capital by capital
owners (capitalists) and enterprise is provided by
entrepreneurs. Entrepreneurs combine the other three factors,
and bear the risks associated with production.
Firms
The function of firms is to supply private goods and services to
domestic households and firms, and to households and firms
abroad. To do this they use factors and pay for their services.
Factor incomes
Factors of production earn an income which contributes to
national income. Land receives rent, human capital receives a
wage, real capital receives a rate of return, and enterprise
receives a profit.
Members of households pay for goods and services they
consume with the income they receive from selling their factor
in the relevant market.
Production function
The simple production function states that output (Q) is a
function (f) of: (is determined by) the factor inputs, land (L),
labour (La), and capital (K), i.e.
Q = f (L, La, K)
The Circular flow of income
Income (Y) in an economy flows from one part to another
whenever a transaction takes place. New spending (C)
generates new income (Y), which generates further new
spending (C), and further new income (Y), and so on. Spending
and income continue to circulate around the macro economy in
what is referred to as the circular flow of income.
The circular flow of income forms the basis for all models of
the macro-economy, and understanding the circular flow
process is key to explaining how national income, output and
expenditure is created over time.
Injections and withdrawals
The circular flow will adjust following new injections into it or
new withdrawals from it. An injection of new spending will
increase the flow. A net injection relates to the overall effect of
injections in relation to withdrawals following a change in an
economic variable.
Savings and investment
The simple circular flow is, therefore, adjusted to take into
account withdrawals and injections. Households may choose to
save (S) some of their income (Y) rather than spend it (C), and
this reduces the circular flow of income. Marginal decisions to
save reduce the flow of income in the economy because saving
is a withdrawal out of the circular flow. However, firms also
purchase capital goods, such as machinery, from other firms,
and this spending is an injection into the circular flow. This
process, called investment (I), occurs because existing
machinery wears out and because firms may wish to increase
their capacity to produce.
The public sector
In a mixed economy with a government, the simple model
must be adjusted to include the public sector. Therefore, as
well as save, households are also likely to pay taxes (T) to the
government (G), and further income is withdrawn out of the
circular flow of income.
Government injects income back into the economy by spending
(G) on public and merit goods like defence and policing,
education, and healthcare, and also on support for the poor and
those unable to work.
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Including international trade
Finally, the model must be adjusted to include international
trade. Countries that trade are called open economies, the households of an open economy will spend some of their
income on goods from abroad, called imports (M), and this is
withdrawn from the circular flow.
Foreign consumers and firms will, however, also wish to buy
domestic products, called exports (X), and this is an injection
into the circular flow.
The multiplier effect
Every time there is an injection of new demand into the
circular flow there is likely to be a multiplier effect. This is
because an injection of extra income leads to more spending,
which creates more income, and so on. The multiplier effect
refers to the increase in final income arising from any new
injection of spending.
The size of the multiplier depends upon households marginal decisions to spend, called the marginal propensity to consume
(mpc), or to save, called the marginal propensity to save (mps).
It is important to remember that when income is spent, this
spending becomes someone elses income, and so on. Marginal propensities show the proportion of extra income allocated to
particular activities, such as investment spending by UK firms,
saving by households, and spending on imports from abroad.
For example, if 80% of all new income in a given period of
time is spent on UK products, the marginal propensity to
consume would be 80/100, which is 0.8.
The following general formula to calculate the multiplier uses
marginal propensities, as follows:
1/1-mpc
Hence, if consumers spend 0.8 and save 0.2 of every 1 of
extra income, the multiplier will be:
1/1-0.8
= 1/0.2
= 5
Hence, the multiplier is 5, which means that every 1 of new
income generates 5 of extra income.
The multiplier effect in an open economy
As well as calculating the multiplier in terms of how extra
income gets spent, we can also measure the multiplier in terms
of how much of the extra income goes in savings, and other
withdrawals. A full open economy has all sectors, and therefore, three withdrawals savings, taxation and imports.
This is indicated by the marginal propensity to save (mps) plus
the extra income going to the government - the marginal tax
rate (mtr) plus the amount going abroad the marginal propensity to import (mpm).
By adding up all the withdrawals we get the marginal
propensity to withdraw (mpw). The multiplier can now be
calculated by the following general equation:
1/1- mpw
Applying the multiplier effect
The multiplier concept can be used any situation where there is
a new injection into an economy. Examples of such situations
include:
1. When the government funds building of a new motorway
2. When there is an increase in exports abroad
3. When there is a reduction in interest rates or tax rates, or when the exchange rate falls.
The downward or 'reverse' multiplier
A withdrawal of income from the circular flow will lead to a
downward multiplier effect. Therefore, whenever there is an
increased withdrawal, such as a rise in savings, import
spending or taxation, there is a potential downward multiplier
effect on the rest of the economy.
Economic integration
There are several stages in the process of economic integration,
from a very loose association of countries in a preferential
trade area, to complete economic integration, where the
economies of member countries are completely integrated.
A regional trading bloc is a group of countries within a
geographical region that protect themselves from imports from
non-members in other geographical regions, and who look to
trade more with each other. Regional trading blocs increasingly
shape the pattern of world trade - a phenomenon often referred
to as regionalism.
Stages of integration
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Preferential Trade Area
Preferential Trade Areas (PTAs) exist when countries within a
geographical region agree to reduce or eliminate tariff barriers
on selected goods imported from other members of the area.
This is often the first small step towards the creation of a
trading bloc. Agreements may be made between two countries
(bi-lateral), or several countries (multi-lateral).
Free Trade Area
Free Trade Areas (FTAs) are created when two or more
countries in a region agree to reduce or eliminate barriers to
trade on all goods coming from other members. The North
Atlantic Free Trade Agreement (NAFTA) is an example of
such a free trade area, and includes the USA, Canada, and
Mexico.
Customs Union
A customs union involves the removal of tariff barriers
between members, plus the acceptance of a common (unified)
external tariff against non-members. This means that members
may negotiate as a single bloc with 3rd
parties, such as with
other trading blocs, or with the WTO.
Common Market
A common market is the first significant step towards full
economic integration, and occurs when member countries trade
freely in all economic resources not just tangible goods. This means that all barriers to trade in goods, services, capital, and
labour are removed. In addition, as well as removing tariffs,
non-tariff barriers are also reduced and eliminated. For a
common market to be successful there must also be a
significant level of harmonisation of micro-economic policies,
and common rules regarding monopoly power and other anti-
competitive practices. There may also be common policies
affecting key industries, such as the Common Agricultural
Policy (CAP) and Common Fisheries Policy (CFP) of the
European Single Market (ESM).
Economic Union
Economic Union is a term applied to a trading bloc that has
both a common market between members, and a common trade
policy towards non-members, but where members are free to
pursue independent macro-economic policies.
Monetary Union
Monetary union is the first major step towards macro-economic
integration, and enables economies to converge even more
closely. Monetary union involves scrapping individual
currencies, and adopting a single, shared currency, such as the
Euro for the Euro-16 countries, and the East Caribbean Dollar
for 11 islands in the East Caribbean. This means that there is a
common exchange rate, a common monetary policy, including
interest rates and the regulation of the quantity of money, and a
single central bank, such as the European Central Bank or the
East Caribbean Central Bank.
Video
Fiscal Union
A fiscal union is an agreement to harmonise tax rates, to
establish common levels of public sector spending and
borrowing, and jointly agree national budget deficits or
surpluses. The majority of EU states agreed a fiscal compact in
early 2012, which is a less binding version of a full fiscal
union.
Economic and Monetary Union
Economic and Monetary Union (EMU) is a key stage towards
compete integration, and involves a single economic market, a
common trade policy, a single currency and a common
monetary policy.
Complete Economic Integration
Complete economic integration involves a single economic
market, a common trade policy, a single currency, a common
monetary policy (EMU) together with a single fiscal policy, tax
and benefit rates in short, complete harmonisation of all policies, rates, and economic trade rules.
Foreign Direct Investment (FDI)
FDI refers to the flow of capital between countries. According
to the United Nations Conference for Trade and Development
(UNCTAD), FDI is 'investment made to acquire lasting
interest in enterprises operating outside of the economy of the
investor.'*
FDI is distinguished from 'portfolio' investment in that, as well
as being 'lasting', it means that the investor has control over the
assets invested in. A single flow of capital between two
countries is described as outward for the investing country and
inward for the recipient country. FDI is undertaken by both
private sector firms and governments.
FDI associated with cross-border mergers and aquisions can be
horizontal - where the firms are at the same stage of
production; vertical - where firms are at different stages of
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production; and conglomerate - where firms are in different
industries.
*Source: UNCTAD.ORG : http://www.unctad.org
The growth of FDI has accompanied the rise of globalisation.
According to the World Investment Report, FDI flows in 2013
increased to $1.45 trillion, with developing countries
increasing their share of inflows to (a record level of) 54 per
cent, with Asia now ahead of both the EU and USA.
The benefits of investing abroad
Investing overseas can generate many benefits to multinational
organisations, including:
1. Transport costs can be reduced by locating manufacturing plant within a consuming country. This
is especially important for bulk increasing products,
such as motor vehicles.
2. Inward investors gain easier access to a countrys markets, especially where the product can be made
with local ingredients. For example, it makes clear
commercial sense for McDonalds to establish local
restaurants that use local ingredients, rather than
export ingredients from the USA. In addition,
investing firms gain access to a range of resources,
including cheap or skilled labour and local knowledge
and expertise.
3. Firms that build factories and plant in other territories can exploit of economies of scope, such as spreading
fixed management costs between territories, or where
plant in one territory can be used to produce output for
many territories.
4. Firms based outside one trading bloc can avoid barriers to trade such as tariffs and quotas, as in the
case of Japanese car producers, such as Toyota and
Nissan, locating in the EU.
Investment income
Outward investment can lead to increased overseas investment
income for a country, including:
1. Profits from overseas subsidiaries.
2. Dividends from owning shares in overseas firms.
3. Interest payments, from lending abroad, such as lending by UK banks.
FDI in the balance of payments accounts appears in two ways:
1. The initial outflow of FDI is entered as an outflow (debit) on the capital account
2. The resulting investment income is entered as an inflow (credit) on the current account.
Inward investment
Countries receiving inward investment gain in a number of
ways, including:
1. An increase in GDP, initially through the FDI itself, but this will be followed by a positive multiplier effect
on the receiving economy so that the final increase in
national income is greater than the initial injection of
FDI.
2. The creation of jobs.
3. An increase in productive capacity, which can be illustrated by a shift to the right in the Aggregate
Supply (AS) or the Production Possibility Frontier
(PPF).
4. Producers have access to the latest technology from abroad.
5. Less need to import because goods are produced in the domestic economy.
6. The positive effect on the countrys capital account - FDI represents an inflow (credit) on the capital
account.
7. FDI is a way of compensating for the lack of domestic investment, and can help 'kick-start' the process of
economic development.
Global FDI
Global FDI has declined as a result of the financial crisis and
global recession.
Comparative advantage
It can be argued that world output would increase when the
principle of comparative advantage is applied by countries to
determine what goods and services they should specialise in
producing. Comparative advantage is a term associated with
19th Century English economist David Ricardo.
Ricardo considered what goods and services countries should
produce, and suggested that they should specialise by
allocating their scarce resources to produce goods and services
for which they have a comparative cost advantage. There are
two types of cost advantage absolute, and comparative.
Absolute advantage means being more productive or cost-
efficient than another country whereas comparative advantage
relates to how much productive or cost efficient one country is
than another.
Example
In order to understand how the concept of comparative
advantage might be applied to the real world, we can consider
the simple example of two countries producing only two goods
- motor cars and commercial trucks.
Comparative advantage
12
Using all its resources, country A can produce 30m cars or 6m
trucks, and country B can produce 35m cars or 21m trucks.
This can be summarised in a table.
In this case, country B has the absolute advantage in producing
both products, but it has a comparative advantage in trucks
because it is relatively better at producing them. Country B is
3.5 times better at trucks, and only 1.17 times better at cars.
However, the greatest advantage - and the widest gap - lies
with truck production, hence Country B should specialise in
producing trucks, leaving Country A to produce cars.
Economic theory suggests that, if countries apply the principle
of comparative advantage, combined output will be increased
in comparison with the output that would be produced if the
two countries tried to become self-sufficient and allocate
resources towards production of both goods. Taking this
example, if countries A and B allocate resources evenly to both
goods combined output is: Cars = 15 + 15 = 30; Trucks = 12 +
3 = 15, therefore world output is 45 m units.
Opportunity cost ratios
It is being able to produce goods by using fewer resources, at a
lower opportunity cost, that gives countries a comparative
advantage.
The gradient of a PPF reflects the opportunity cost of
production. Increasing the production of one good means that
less of another can be produced. The gradient reflects the lost
output of Y as a result of increasing the output of X.
Having a comparative advantage in X, Country A sacrifices
less of Y than Country B. In terms of two countries producing
two goods, different PPF gradients mean different opportunity
costs ratios, and hence specialisation and trade will increase
world output.
Only when the gradients are different will a country have a
comparative advantage, and only then will trade be beneficial.
Identical PPFs
13
If PPF gradients are identical, then no country has a
comparative advantage, and opportunity cost ratios are
identical. In this case, international trade does not confer any
advantage.
Criticisms
However, the principle of comparative advantage can be
criticised in a several ways:
1. It may overstate the benefits of specialisation by ignoring a number of costs. These costs include
transport costs and any external costs associated with
trade, such as air and sea pollution.
2. The theory also assumes that markets are perfectly competitive - in particular, there is perfect mobility of
factors without any diminishing returns and with no
transport costs. The reality is likely to be very
different, with output from factor inputs subject to
diminishing returns, and with transport costs. This
will make the PPF for each country non-linear and
bowed outwards. If this is the case, complete
specialisation might not generate the level of benefits
that would be derived from linear PPFs. In other
words, there is an increasing opportunity cost
associated with increasing specialisation. For
example, it may be that the maximum output of cars
produced by country A is only 20 million (compared
with 30), and the maximum output of trucks produced
by country B might only be 16 million instead of 21
million. Hence, the combined output from trade might
only be 46 million units (instead of the 51 million
units initially predicted).
4. Complete specialisation might create structural unemployment as some workers cannot transfer from
one sector to another.
5. Relative prices and exchange rates are not taken into account in the simple theory of comparative
advantage. For example if the price of X rises relative
to Y, the benefit of increasing output of X increases.
6. Comparative advantage is not a static concept - it may change over time. For example, nonrenewable
resources can slowly run out, increasing the costs of
production, and reducing the gains from trade.
Countries can develop new advantages, such as
Vietnam and coffee production. Despite having a long
history of coffee production it is only in the last 30
years that it has become a global player. seeing its
global market share increase from just 1% in 1985 to
20% in 2014, making it the world's second largest
producer.
7. Many countries strive for food security, meaning that even if they should specialise in non-food products,
they still prefer to keep a minimum level of food
production.
8. The principle of comparative advantage is derived from a highly simplistic two good/two country model.
The real world is far more complex, with countries
exporting and importing many different goods and
services.
9. According to influential US economist Paul Krugman, the continual application of economies of scale by
global producers using new technology means that
many countries, including China, can produce very
cheaply, and export surpluses. This, along with an
insatiable demand for choice and variety, means that
countries typically produce a variety of products for
the global market, rather than specialise in a narrow
range of products, rendering the traditional theory of
comparative advantage almost obsolete.
14
10. However, the underlying principle of comparative advantage can still be said to give some shape to the pattern of world trade, even if it is becoming less
relevant in a globalised world.
Trade liberalisation
Two opposing forces have shaped the changing pattern of
world trade over the last 200 years; the promotion of free trade
and the protection against free trade. Trade protection is the
process of erecting barriers to trade, such as taxes on imports,
called tariffs, and trade liberalisation is the process of making
trade free from such barriers.
The advantages of free trade
It can be argued that free trade creates the following
advantages:
Specialisation and comparative advantage
Free trade encourages countries to specialise and benefit from
the application of the principle of comparative advantage.
Increased world output
If countries specialise and trade, world output is likely to
increase as scarce resources will be used more efficiently. Mass
production will generate considerable economy of scale, which
reduce average costs.
Increased competition and lower prices
Free trade increases competition, which generates further
benefits, including lower prices, greater use of new technology
and technology transfer between countries. Free trade will also
encourage the breakdown of domestic monopolies, and provide
greater choice for consumers and firms.
Higher quality
Open economies are likely to see an increase in the quality of
products available as overseas firms compete on non-price
factors, such as design and reliability.
Terms of trade
A countrys terms of trade measures a countrys export prices in relation to its import prices, and is expressed as:
For example, if, over a given period, the index of export prices
rises by 10% and the index of import prices rises by 5%, the
terms of trade are:
110 x 100 / 105
= 104.8
This means that the terms of trade have improved by 4.8%.
When the terms of trade rise above 100 they are said to be
improving and when they fall below 100 they are said to be
worsening.
Improving terms of trade
If a country's terms of trade improve, it means that for every
unit of exports sold it can buy more units of imported goods.
So potentially, a rise in the terms of trade creates a benefit in
terms of how many goods need to be exported to buy a given
amount of imports. It can also have a beneficial effect on
domestic cost-push inflation as an improvement indicates
falling import prices relative to export prices.
However, countries may suffer in terms of falling export
volumes and a worsening balance of payments.
The danger of an improving terms of trade is that it can worsen
the balance of trade if UK and overseas consumers are elastic
in their response to the relative export and import price
changes.
Worsening terms of trade
A worsening terms of trade indicates that a country has to
export more to purchase a given quantity of imports. According
to the Prebisch-Singer hypothesis, this fate has befallen many
developing countries given the general decline in commodity
prices in relation to the price of manufactured goods. However,
globalisation has tended to reduce the price of manufactured
goods over the past 15 years, so the advantage that
industrialised countries had over developing countries may be
falling.
The impact of globalisation has tended to halt the decline in the
terms of trade of developing economies.
The WTO
The WTO attempts to promote free and fair trade an increasingly difficult task, which it undertakes with varying
success. The WTO was established in 1995 when it replaced
the General Agreement on Tariffs and Trade (GATT). It has its
headquarters in Geneva, Switzerland and, by 2012, had 153
member countries, including China, which was the last major
nation to join.
The purpose of the WTO is to promote free and fair trade
through multilateral talks and negotiations, and to arbitrate
between countries that are in dispute. The WTO itself claims
that, unlike GATT that preceded it, its rules of trade have been
worked out by the direct involvement of all countries, and not
just a few powerful ones.
Evaluation of the WTO
Trade liberalisation clearly brings many economic and political
benefits, but many argue that the WTO has had limited success
in certain areas. The main criticisms are:
Too few agreements
Critics argue that the number of trade disputes settled through
the WTO's DSU (Dispute Settlement Understanding) is
inadequate given the number of disputes. However, the number
of settlements did rise from 20 in 1990 to 157 in 2007. But
still, by January 2008, only 136 of the 370 cases had reached
the full panel process.
(Sources: UNCTAD and WTO).
Failure to confront ethical issues
Many argue that the WTO has failed to confront ethical issues,
such as the use of child labour and poor working conditions in
developing economies.
Failure to tackle environmental issues
15
Similarly, many argue that it has failed to tackle environmental
issues, such as the depletion of global fish stocks,
deforestation, and climate change.
Takes too long to arbitrate
Critics also complain that the WTO takes too long to arbitrate
and settle disputes. For example, it can take over five years
from the initial receipt of a complaint from one member to the
final panel ruling.
See: Example of WTO process
Favours the powerful
Critics also argue that the WTO has an inbuilt bias favouring
developed and powerful nations and trading blocs such as the
USA and the EU, and operating against weaker, developing
ones.
Failure to promote multilateralism
Despite the WTO operating as a multilateral organisation,
many member countries and trading blocs favour bilateral
discussions with partners or competitors. This is because
bilateral negotiations can be fully focussed and relatively quick
to complete. The result is that many countries prefer to bypass
the WTO process, and deal directly with other countries. The
failure of the most recent round of WTO negotiations, the
Doha round, is widely regarded as evidence of the inherent
problems of multilateral discussions. While the WTO is likely
to argue that it encourages such agreements when they do not
have a negative impact on third parties, it is very difficult to
find cases where third-party countries are not, at least
indirectly, negatively affected by a specific bilateral agreement.
The Doha round
The most recent round of talks is the Doha Round, which
began in 2001, with major summit meetings in Cancun,
Mexico, Hong Kong, and Davos in 2003, 2005, and 2007
respectively. The Doha round of talks is also called the
development round, reflecting its emphasis on promoting free
trade for the benefit of developing nations. In particular, the
Cancun talks focussed on three areas: reducing agricultural
subsidies and industrial tariffs imposed by developed nations,
which limit the market access of developing nations;
harmonising competition rules within different countries; and
helping poor countries.
The talks collapsed for a number of reasons. Significantly,
while the US and EU failed to agree reductions in agricultural
support, many developing countries refused to agree new
investment rules which would make it easier for multinationals
to invest in their countries. Since the collapse, the USA and EU
have returned to bilateral agreements with favoured nations,
rather than entering into multilateral agreements. This
highlights a major limitation of the WTO in not gaining a
complete consensus that multilateral negotiations should be the
method of choice of its members.
The failure of the Doha round means that the rich countries of
the world still protect themselves from goods produced by the
poor nations. By 2005, average agricultural tariffs imposed by
the USA and EU were 60%, against average industrial tariffs of
only 5%*.
Trade protectionism
Trade protection is the deliberate attempt to limit imports or
promote exports by putting up barriers to trade. Despite the
arguments in favour of free trade and increasing trade
openness, protectionism is still widely practiced.
The motives for protection
The main arguments for protection are:
Protect sunrise industries
Barriers to trade can be used to protect sunrise industries, also
known as infant industries, such as those involving new
technologies. This gives new firms the chance to develop,
grow, and become globally competitive.
Protection of domestic industries may allow they to develop a
comparative advantage. For example, domestic firms may
expand when protected from competition and benefit from
economies of scale. As firms grow they may invest in real and
human capital and develop new capabilities and skills. Once
these skills and capabilities are developed there is less need for
trade protection, and barriers may be eventually removed.
Protect sunset industries
At the other end of scale are sunset industries, also known as
declining industries, which might need some support to enable
them to decline slowly, and avoid some of the negative effects
of such decline. For the UK, each generation throws up its own
declining industries, such as ship building in the 1950s, car
production in the 1970s, and steel production in the 1990s.
Protect strategic industries
Barriers may also be erected to protect strategic industries,
such as energy, water, steel, armaments, and food. The implicit
aim of the EUs Common Agricultural Policy is to create food
security for Europe by protecting its agricultural sector.
Protect non-renewable resources
Non-renewable resources, including oil, are regarded as a
special case where the normal rules of free trade are often
abandoned. For countries aiming to rely on oil exports lasting
into the long term, such as the oil-rich Middle Eastern
economies, limiting output in the short term through
production quotas is one method employed to conserve
resources.
Deter unfair competition
Barriers may be erected to deter unfair competition, such as
dumping by foreign firms at prices below cost.
Save jobs
Protecting an industry may, in the short run, protect jobs,
though in the long run it is unlikely that jobs can be protected
indefinitely.
Help the environment
Some countries may protect themselves from trade to help limit
damage to their environment, such as that arising from CO2
emissions caused by increased production and transportation.
Limit over-specialisation
Many economists point to the dangers of over-specialisation,
which might occur as a result of taking the theory of
comparative advantage to its extreme. Retaining some self-
16
sufficiency is seen as a sensible economic strategy given the
risks of global downturns, and an over-reliance on international
trade.
In addition to the economic arguments for protection, some
protection may be for political reasons.
Economic development
Economic development is a broader concept than
economic growth and reflects social and economic
progress and requires economic growth. Growth is an
important and necessary condition for development, but it
is not a sufficient condition. Growth alone cannot
guarantee development.
Indicators of development
The extent to which a country has developed may be assessed
by considering a range of narrow and broad indicators,
including per capita income, life expectancy, education, and
the extent of poverty.
The Human Development Index (HDI)
The HDI was introduced in 1990 as part of the United Nations
Development Programme (UNDP) to provide a means of
measuring economic development in three broad areas - per
capita income, health and education. The HDI is used to track
changes in the global position of specific countries over time.
Each year the UNDP produces a development report providing
an update of changes during the year, along with a report on a
special theme, such as global warming and development, and
migration and development.
The introduction of the index was an explicit acceptance that
development is a considerably broader concept than growth and
should include a range of social and economic factors.
The HDI has two main features:
A scale from 0 (no development) to 1 (complete development).
A composite index based on three equally weighted
components:
1. Longevity, measured by life expectancy at birth
2. Knowledge, measured by adult literacy and number of years children are enrolled at school
3. Standard of living, measured by real GDP per capita at purchasing power parity
What the figures mean:
An index of 0 0.6 means low development - for example, in 2006 Ethiopia had an index number of
0.38 while in Bangladesh it was 0.51
An index of 0.61 0.85 means medium development for example, in 2006 Croatia had an index of 0.85, while Brazil and the Ukraine had 0.80 and 0.79
respectively.
An index of greater than 0.90 means high development - for example, the HDI for France and
the UK in 2006 were 0.95 and 0.94. respectively.
The HDI is a very useful means of comparing the level of
development of countries. GDP per capita alone is clearly too
narrow an indicator of economic growth, and fails to indicate
other aspects of development, such as enrolment in school and
longevity. Hence, the HDI is seen as a broader and more
encompassing indicator of development than GDP, though
GDP still provides one third of the index.
Life expectancy
A variety of factors may contribute to differences in life
expectancy, such as the stability of food supplies, war and the
incidence of disease and natural disasters.
According to World Bank figures, between 1980 and 1998
average life expectancy rose from 61 to 67 years, with the
largest increases occurring in low and middle income
countries. However, the changes are not evenly distributed, and
in many countries in sub-Saharan Africa, life expectancy is
falling due to the AIDS epidemic.
(Source: www.worldbank.org/depweb/)
Adult literacy
Adult literacy is usually defined as the percentage of those
aged 15 and above who are able to read and write a simple
statement on their everyday life.
More extensive definitions of literacy include those based on
the International Adult Literacy Survey. This survey tests the
ability to understand text, interpret documents, and perform
simple arithmetic.
GDP per capita
GDP per capita is the commonest indicator of material
standards of living, and hence is included in the index of
development. It is found by measuring Gross Domestic Product
in a year, and dividing it by the population.
Evaluation of the HDI
Despite the widespread use of the HDI, there are a number of
criticisms that are often made. These include:
1. The HDI index is for a single country, and as such does not distinguish between different rates of
development within a country, such as between urban
and traditional rural communities.
2. Critics argue that the equal weighting between the three main components is rather arbitrary.
3. Development is ultimately about freedom, and there is nothing in the index which directly measures this. For
example, access to the internet might be regarded by
many as a freedom which improves the quality of
individual's lives.
4. As with GDP per capita, the more narrow measure of living standards, there is no indication of the
distribution of income.
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5. In addition, the HDI excludes many aspects of economic and social life that could be regarded as
contributing to or constraining development, such as
crime, corruption, poverty, deprivation and negative
externalities.
6. GDP is calculated in terms of purchasing power parity, and this value can frequently change.
Poverty
The alleviation of poverty is increasingly seen as a
fundamental economic objective. Poverty creates many
economic costs in terms of the opportunity cost of lost output,
the cost of welfare provision, and the private and external costs
associated with exclusion from normal economic activity.
These costs include the costs of unemployment, crime, and
poor health. In addition, the poor have little disposable income,
and so cannot spend and generate income for firms and jobs for
other individuals.
Widespread poverty is also an important constraint preventing
economic development.
There are two ways to define poverty:
Absolute poverty
Absolute poverty is poverty that is unrelated to a particular
economic or social context. In other words it is a general
definition of poverty which is valid at all times and for all
economies. Agreeing such a definition is extremely hard to do.
One straightforward definition of absolute poverty is being unable to subsist that is, unable to eat, drink, have shelter and clothing. A common universal measure of extreme poverty
is .receiving less than $1.25 a day. Extreme poverty if defined
as not being able to buy enough food to survive.
Relative poverty
It can be argued that poverty is best understood in a relative
way what is poor in New York is not the same as in Mumbai.
One approach is to look at deprivation, the poor being defined as those who are deprived from the benefits of a
modern economy, such as clean water and education.
The Human Poverty Index - HPI
The Human Poverty Index (HPI), which was introduced in
1997, is a composite index which assesses three elements of
deprivation in a country - longevity, knowledge and a decent
standard of living.
There are two indices; the HPI 1, which measures poverty in developing countries, and the HPI-2, which measures poverty
in OCED developed economies.
HPI-1 (for developing countries)
The HPI for developing countries has three components:
1. The first element is longevity, which is defined as the probability of not surviving to the age of 40.
2. The second element is knowledge, which is assessed by looking at the adult literacy rate.
3. The third element is to have a decent standard of living. Failure to achieve this is identified by the
percentage of the population not using an improved
water source and the percentage of children under-
weight for their age.
As a region of the world, Sub-Saharan Africa has the highest
level of poverty as a proportion of total population, at over
60%. The second poorest region is Latin America, with 35% of
its population living in poverty.
HPI-2 (for developed - OECD countries)
The indicators of deprivation are adjusted for advanced
economies in the following ways:
1. Longevity, which for developed countries is considered as the probability at birth of not surviving
to the age of 60.
2. Knowledge is assessed in terms of the percentage of adults lacking functional literacy skills, and;
3. A decent standard of living is measured by the percentage of the population living below the poverty
line, which is defined as those below 50% of median
household disposable income, and social exclusion,
which is indicated by the long-term unemployment
rate.
Part 2: IS Curve
This video is the second in a set of four explaining
the Hicks-Hansel model of Keynes' theory of Aggregate
Demand, specifically the IS-LM interpretation. This model
is very important to short run macroeconomics and
attempts to explain shifts in the aggregate demand curve.
These topics are usually taught in an intermediate
Macroeconomics class, and these videos are intended as
a visual aid to further your understanding of the
models.This video covers the investment demand curve,
integrates investment into the aggregate demand curve,
introduces the IS-curve and provides an overview of the
factors that determine the slope and position of the IS
curve. If you did not view the introductory video, you can
find it here
The I - S stands for Investment and Saving and the IS
curve displays the equilibrium in the goods and service
market for various interest rates.
Investment
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To begin we revisit the aggregate demand equation.
While investment was previously considered to be
exogenous, we're going to see how it relates to interest
rate, so it becomes endogenous and loses the bar above
the variable.
There is, however, still a portion of investment that is
unaffected by interest rate. It is represented by "I-bar"
and called exogenous investment. Next we have interest
rate, represented by "i". And as you see by the minus
sign, investment is negatively related to the interest rate.
The degree to which firms adjust investment spending
relative to the interest rate is called interest sensitivity
which is represented by "b". This coefficient will be
anywhere between zero and one.
Investment Curve
Now we'll examine this relationship graphically.
Investment is on the x-axis and interest rate is on the y-
axis. Typically the independent variable (in this case,
investment) is put on the Y-axis, but we will be using
interest rate as the independent variable when we graph
the IS curve, so it's put here now for consistency.
Exogenous investment determines the initial level. Again,
a higher interest rate results in lower investment
spending. A high interest rate means firms reduce their
investment spending to avoid high interest payments. A
low interest rate means firms can increase their capital
spending and pay relatively low interest.
Slope & Position
The slope of the investment curve is determined by the
interest sensitivity coefficient. A high interest sensitivity
results in a more gradual slope. In this case, there is a
drastic increase in investment spending in reaction to a
relatively small reduction in the interest rate, because of
the higher sensitivity.
The position of the curve is determined by the exogenous
investment. An increase would result in an outward shift
of the curve.
Incorporated Investment into the Aggregate Demand
Equation
19
Now we're going to incorporate this investment function
into the aggregate demand equation. Recall in the first
video we separated the components into exogenous and
endogenous to arrive at this formula. Investment was
previously grouped with the exogenous components, but
our new formula has endogenous as well as exogenous
components. The "I-bar" will go back into the exogenous
group, while the interest and sensitivity coefficient move
to the back of the equation.
Review: AD for aggregate demand. A-bar for exogenous
demand, lower case c is the marginal propensity to
consume. lower case t for tax rate, Y for income, lower
case b for interest sensitivity and i for interest rate. You
will notice that all of the lower case variables are rates
between zero and one.
Aggregate Demand Curve with Investment
We're going to display this function graphically, and just
as before the 45 degree line where aggregate demand =
income is our equilibrium criteria. Here is upward sloping
demand function. Higher levels of national income lead to
higher levels of aggregate demand. The y-intercept is
given by exogenous demand minus interest rate *
sensitivity. The intersection of the lines gives us the
equilibrium level of national income.
Reduction in Interest Rate
A reduction in the interest rate results in an upward shift
in the aggregate demand curve. This results in a higher
equilibrium level of national income. So the interest rate
went down and the equilibrium income went up.
Increase in Interest Sensitivity
An increase in interest sensitivity results in a downward
shift in both aggregate demand curves. The downward
shift is more pronounced for the curve with the higher
interest rate (i-1). This means that the distance between
the two resulting equilibrium levels of income is larger.
IS Curve
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Now we can move on to the IS Curve, which denotes the
equilibrium levels of national income for different interest
rates. Just as we did in the previous slide, we will be
graphing the aggregate demand curve for different
interest rates in the top graph. The bottom graph also has
income on it's x-axis and will show the different interest
rates.
Here is the curve for interest rate #1. The equilibrium
level of income is the same for both graphs. When we put
interest rate #1 on our bottom graph we have the first
point of our IS curve. The second aggregate demand
curve has a lower interest rate, so its parallel and higher
up. On the lower graph the intersection of interest rate #2
and equilibrium income #2 produce the second point of
the IS curve. This could be repeated for every different
interest rate in this range to produce the IS curve. Since
this model only uses linear curves, we need a minimum
of two points to graph the IS curve. There you have it, at
any point on this IS curve the goods & services market is
in equilibrium.
Slope of IS Curve - Interest Sensitivity
Now we're going to discuss the determinants of the IS
curve's slope. Holding other factors constant, an increase
in interest sensitivity will result in a more grad
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