OHP MASTERS
of
LECTURE PLANS
and
KEY DIAGRAMS
in
ESSENTIALS OF
ECONOMICS
John Sloman
Introduction
Economic Issues
ii
WH A T D O
ECONOMISTS STUDY?
Economic problems
• production and consumption
• scarcity: the central economic
problem
Macroeconomic issues
• growth
• unemployment
• inflation
• balance of payments problems
• cyclical fluctuations
Microeconomic issues
• choices: what, how and for whom
• the concept of opportunity cost
• rational economic decision making:
marginal costs and marginal
benefits
iii
Introduction
The production possibility curve
• what the curve shows
• microeconomics and the p.p. curve
– choices and opportunity cost
– increasing opportunity cost
• macroeconomics and the p.p. curve
– production within the curve
– shifts in the curve
The circular flow of income
• firms and households
• real and money flows
• goods and factor markets
• macroeconomics: the total flows
• microeconomics: individual
iv
markets
v
Chapter
1
Markets, Demand and Supply
6
1.1
ECONOMIC SYSTEMS
Classifying economic systems
• methods of classification
• classification by degree of government
control
• other methods of classifying economic
systems
The command economy
• features of a command economy
• planning:
– consumption and investment
– matching of inputs and outputs
– distribution of output
Advantages of a command economy
• high investment, high & stable growth
• social goals pursued
• low unemployment
Problems of a command economy
• problems of gathering information
• expensive to administer
• inappropriate incentives
• shortages and surpluses
7
1.1 (cont.)
The free-market economy
• demand and supply decisions
• the price mechanism:
– shortages and surpluses
– equilibrium price
– response to changes in demand and
supply
• the interdependence of markets
– effect of a rise in demand
• in market for that good
• in factor markets
• in other goods markets
• in other factor markets
Competitive markets
• perfectly competitive markets
• everyone is a price taker
• why study perfect markets?
8
1.2
DEMAND
The relationship between demand and
price
• the law of demand
• the income effect
• the substitution effect
The demand curve
Other determinants of demand
• tastes
• number and price of substitute goods
• number and price of complementary
goods
• income
• distribution of income
• expectations
Movements along and shifts in the
demand curve
9
1.3
SU PP LY
The relationship between supply and
price
The supply curve
• why supply curves generally slope
upwards
Other determinants of supply
• costs of production
• profitability of alternative products
(substitutes in supply)
• profitability of goods in joint supply
• nature and other random shocks
• aims of producers
• expectations of producers
Movements along and shifts in the
supply curve
10
1.4
THE DETERMINATION
OF PRICE
Equilibrium price and output
• response to shortages and surpluses
• significance of 'equilibrium'
Demand and supply curves
• effect of price being above equilibrium
• effect of price being below equilibrium
• equilibrium: where D = S
Effects of shifts in the demand curve
• movement along supply curve and new
demand curve
Effects of shifts in the supply curve
• movement along demand curve and
new supply curve
11
1.5
THE FREE-MARKET ECONOMY
Advantages of a free-market economy
• transmits information between buyers
and sellers
• no need for costly bureaucracy
• incentives to be efficient
• competitive markets responsive to
consumer wishes
Problems of a free-market economy
• competition may be limited: problem of
market power
• inequality
• the environment and other social goals
may be ignored
The mixed economy
• types of intervention
– taxes and subsidies
– legislation and regulation
– direct provision by government
12
Chapter
2
Markets in Action
13
2.1
PRICE ELASTICITY OF DEMAND
Defining price elasticity of demand (Pd)
• The responsiveness of demand to
change in price
Measuring price elasticity of demand
• %QD / %P
• use of proportionate or percentage
changes
• the sign (positive or negative)
• the value (greater or less than one)
Determinants of price elasticity of
demand
• number and closeness of substitute
goods
• the proportion of income spent on the
good
• the time period
14
2.2
PRICE ELASTICITY OF DEMAND
AND CONSUMER EXPENDITURE
Defining total consumer expenditure
• TE = P ×Q
• Illustrating TE graphically
Effects of a price change: elastic
demand
• P rises: TE falls
• P falls: TE rises
Effects of a price change: inelastic
demand
• P rises: TE rises
• P falls: TE falls
Special cases
• Pd = 0
• Pd =
• Pd = –1
Applications to price decisions
15
2.3
PRICE ELASTICITY OF SUPPLY
Meaning of price elasticity of supply
Measuring price elasticity of supply
• %QS / %P
• elastic and inelastic supply
Determinants of price elasticity of
supply
• amount that costs rise as output
increases
• time period
16
2.4
OTHER ELASTICITIES
Income elasticity of demand
• measurement
• determinants
– degree of “necessity”
– rate at which people are satisfied
– level of income
• applications
Cross-price elasticity of demand
• measurement
• determinants
• applications
17
2.5
MARKETS AND ADJUSTMENT
OVER TIME
Short-run and long-run adjustment
• short- and long-run demand and
supply curves
Speculation
• stabilising speculation
• destabilising speculation
Uncertainty and risk
• defining risk and uncertainty
• reducing risks by holding stocks
18
2.6
MARKETS WHERE PRICES
ARE CONTROLLED
Equilibrium price and the absence of
shortages and surpluses
Minimum prices
• justification
• effects
• dealing with resulting surpluses
Maximum prices
• justification
• effects
• dealing with resulting shortages
• rationing
• black markets
19
Chapter
3
The Supply Decision
20
3.1
SHORT-RUN COSTS
Short-run and long-run changes in
production
• fixed and variable factors
• the short run
• the long run
Production in the short run
• the law of diminishing returns
Costs and inputs
• costs and the productivity of factors of
production
• costs and the price of factors
• fixed and variable costs
21
3.1 (cont.)
Total cost
• total fixed cost (TFC)
• total variable cost (TVC)
• total variable cost and the law of
diminishing returns
• total cost (TC = TFC + TVC)
Average and marginal cost
• marginal cost (MC) and the
law of diminishing returns
• the relationship between the marginal
and total cost curves
• average fixed cost (AFC)
• average variable cost (AVC)
• average (total) cost (AC)
• relationship between average and
marginal cost
22
3.2
LONG-RUN COSTS
Production in the long run
• returns to scale
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
• economies of scale
– specialisation and the division of
labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
– multi-stage production
– organisational economies
– spreading overheads
– financial economies
• diseconomies of scale
• external economies of scale
• external diseconomies of scale
23
3.2 (cont.)
Long-run average costs
• shape of the LRAC curve
• assumptions behind the curve
Long-run marginal costs
Relationship between long-run and
short-run average costs
• the envelope curve
Long-run cost curves in practice
• the evidence
• minimum efficient plant size
Decision making in different time periods
• very short run
• short run
• long run
• very long run
24
3.3
R EVE N U E
Defining total, average and marginal
revenue
Revenue curves when firms are price
takers (horizontal demand curve)
• average revenue (AR)
• marginal revenue (MR)
• total revenue (TR)
Revenue curves when price varies with
output (downward-sloping D curve)
• average revenue (AR)
• marginal revenue (MR)
• total revenue (TR)
• revenue curves and price elasticity of
demand
Shifts in revenue curves
25
3.4
PROFIT MAXIMISATION
Using total curves
• maximising the difference between TR
and TC
• the total profit curve
Using marginal and average curves
• stage 1: profit maximised where
MR = MC
• stage 2: using AR and AC curves to
measure maximum profit
Some qualifications
• long-run profit maximisation
• the meaning of ‘profit’
• loss minimising: still produce where
MR = MC
• short-run shut-down point:
P = AVC
• long-run shut-down point:
P = LRAC
26
Chapter
4
Market Structures
27
4.1
THE DEGREE OF COMPETITION
Classifying markets by degree of
competition
• number of firms
• freedom of entry to industry
• nature of product
• nature of demand curve
The four market structures
• perfect competition
• monopoly
• monopolistic competition
• oligopoly
Structure conduct performance
28
4.2
PERFECT COMPETITION
Assumptions
• firms are price takers
• freedom of entry
• identical products
• perfect knowledge
Short-run equilibrium of the firm
• price
• output
• profit
Long-run equilibrium of the firm
• all supernormal profits competed
away
• LRAC = AC = MC = MR = AR
Incompatibility of economies of scale
with perfect competition
29
4.3
MONOPOLY
Defining monopoly
Barriers to entry
• economies of scale
• product differentiation, brand
loyalty
• lower costs for an established firm
• ownership/control of key factors
• ownership/control over outlets
• legal protection
• mergers and takeovers
• aggressive tactics
• intimidation
The monopolist's demand curve
• downward sloping
• MR below AR
Equilibrium price, output and profit
• equilibrium output, where MC = MR
• equilibrium price, given by D curve
• measuring profit
30
31
4.3 (cont.)
Disadvantages of monopoly
• high prices / low output: short run
• high prices / low output: long run
• lack of incentive to innovate
• X-inefficiency
Advantages of monopoly
• economies of scale
• profits can be used for investment
• promise of high profits encourages
risk taking
Contestable markets
• importance of potential competition
• a perfectly contestable market
• contestable markets and natural
monopolies
• importance of costless exit
Contestable markets and the public
interest
32
4.4
MONOPOLISTIC COMPETITION
Assumptions of monopolistic
competition
Equilibrium of the firm
• short run
• long run
• under-utilisation of capacity in the
long run
Non-price competition
The public interest
• comparison with perfect
competition
• comparison with monopoly
33
4.5
OLIGOPOLY
Key features of oligopoly
• barriers to entry
• interdependence of firms
Competition versus collusion
Collusive oligopoly: cartels
• equilibrium of the industry
• allocating and enforcing quotas
Tacit collusion
• price leadership: dominant firm
• price leadership: barometric
• rules of thumb
Factors favouring collusion
The breakdown of collusion
34
4.5 (cont.)
Non-collusive oligopoly: game theory
• alternative strategies: maximax and
maximin
• simple dominant strategy games
• the prisoners' dilemma
• more complex non-dominant
strategy games
Non-collusive oligopoly: the kinked
demand curve theory
• assumptions of the model
• stable prices
• limitations of the model
Oligopoly and the public interest
• advantages
• disadvantages
• difficulties in drawing general
conclusions
35
4.6
PRICE DISCRIMINATION
Meaning of price discrimination
Conditions necessary for price
discrimination to operate
Advantages to the firm
Profit-maximising prices and output
under price discrimination
Price discrimination and the public
interest
• competition
• profits
36
Chapter
5
Wages and the
Distribution of Income
37
5.1
LABOUR MARKET TRENDS
Shift from agricultural and
manufacturing to service-sector
employment
Rise in part-time employment
Rise in female participation rates
Rise in temporary employment
Downsizing
38
5.2
WAGE DETERMINATION
IN A PERFECT MARKET
Perfect labour markets
• everyone is a wage taker
• freedom of entry
• perfect knowledge
• homogeneous labour
The supply of labour
• why upward sloping?
• the position of the supply curve
– the number of qualified people
– non-wage benefits
– desirability and availability of
alternative jobs
• elasticity of supply of labour
– the mobility of labour
39
5.2 (cont.)
The demand for labour: marginal
productivity theory
• the profit-maximising approach
• the marginal cost of labour (MCL)
• the marginal revenue product of
labour (MRPL)
• the profit-maximising level of
employment for a firm
• derivation of the firm's demand
curve for labour
Wages and profits under perfect
competition
40
5.3
WAGE DETERMINATION
IN IMPERFECT MARKETS
Power in labour markets
Firms with monopsony power in
employing labour
• MCL > W
• effects on wages and employment
Unions with monopoly power
• unions facing competitive
employers
• effects of wage increases on
employment
Bilateral monopoly
• no unique equilibrium
• relationship between wages and
employment
• collective bargaining
– union threats and promises
– employers' threats and
promises
– role of government
41
5.3 (cont.)
The efficiency wage hypothesis
• Higher wage rates may lead to
higher productivity
– less 'shirking'
– reduced labour turnover
– self-selection
– morale
Flexible labour markets
• the flexible firm
• functional flexibility
• numerical flexibility
• core workers
• peripheral workers
• implications for the distribution of
income
42
5.4
CAUSES OF INEQUALITY
Inequality in the UK
• income distribution before and after
taxes and benefits
• distribution of income by source
• distribution of wages by occupation
• distribution of wages by sex
The causes of inequality
• differences in ability
• differences in attitude
• differences in qualifications
• differences in hours worked
• differences in pleasantness of jobs
• differences in power
• differences in the demand for goods
• discrimination
• differences in household
composition
• inequality of wealth
• degree of government support
• unemployment
43
5.5
THE REDISTRIBUTION
OF INCOME
Taxation
• progressive, regressive taxes and
proportional taxes
• problems in using taxes to
redistribute incomes
– income taxes
– taxes on goods and services
• taxation and incentives
– income and substitution
effects
– raising the higher rates of tax
– raising the basic rate
– reducing tax allowances
Benefits
• cash benefits
– means-tested benefits
– universal benefits
• benefits in kind
• benefits and the redistribution of
income
• the problem of the poverty trap
44
Chapter
6
Market Failures
and Government Policy
45
6.1
MARKET FAILURES:
EXTERNALITIES
AND PUBLIC GOODS
Society's microeconomic objectives
• equity
• social efficiency
– marginal social benefits and
costs
– production where MSB = MSC
Externalities
• External costs of production
MSC > MC
• External benefits of production
MSC MB
Public goods
• non rivalry
• non-excludability
46
6.2
MARKET FAILURES:
MONOPOLY POWER
The demand curve under monopoly
Deadweight loss under monopoly
• consumer and producer surplus
– consumer surplus
– producer surplus
– total surplus
• the effect of monopoly on total
surplus
Other problems with monopoly
Possible advantages from monopoly
47
6.3
OTHER MARKET FAILURES
Ignorance and uncertainty
Immobility of factors and time lags in
response
Protecting people's interests
• dependants
• the principal–agent problem
– the problem of asymmetric
information
– the need for monitoring
• poor economic decision making by
individuals
– merit goods
Macroeconomic goals
How far can economists go in
advising governments
48
6.4
GOVERNMENT INTERVENTION:
TAXES AND SUBSIDIES
The use of taxes and subsidies
• to correct externalities
– the optimum size of a tax
– the optimum size of a subsidy
• to correct for monopoly
– use of lump-sum taxes
Advantages of taxes and subsidies
Disadvantages of taxes and subsidies
• infeasible to use different tax and
subsidy rates
• lack of knowledge
49
6.5
GOVERNMENT INTERVENTION:
LAWS AND REGULATION
The use of laws and regulation
Advantages of legal restrictions
• simple to understand
• safer when size of problem is
potentially great
• quick to implement
• a good way of dealing with
imperfect information
Disadvantages of legal restrictions
• a ‘blunt weapon’
50
6.5 (cont.)
Types of regulation
The system of regulation in the UK
• UK regulatory bodies
• price-cap regulation
– the RPI – X formula
Advantages of the UK system
• discretionary
• flexible
• incentive for firms to reduce costs
Disadvantages of the UK system
51
6.6
OTHER FORMS OF
GOVERNMENT INTERVENTION
Changes in property rights
• the problem of limited property
rights
• extending property rights
• limitations of this solution
Provision of information
Direct provision of goods and
services
• the provision of public goods
• need to evaluate costs and benefits
of publicly provided goods
• the provision of other goods and
services by the government
– social justice
– large positive externalities
– dependants
52
– ignorance
53
6.7
MORE OR LESS
INTERVENTION?
Drawbacks of government
intervention
• shortages and surpluses
• poor information
• bureaucracy and inefficiency
• lack of market incentives
• shifts in government policy
• voters' ignorance
• unrepresentative government
• lack of freedom for the individual
Advantages of the free market
• automatic adjustments
• dynamic advantages of capitalism
• high degree of competition even
under monopoly/oligopoly
54
Judging the arguments
55
Chapter
7
Aggregate demand and supply
and macroeconomic objectives
56
7.1
MACROECONOMIC OBJECTIVES
Distinction between microeconomics
and macroeconomics
The major macroeconomic issues
• economic growth
• unemployment
• inflation
• balance of payments and exchange
rates
– balance of payments deficits
and surpluses
– exchange rate movements
57
7.2
THE CIRCULAR FLOW OF
INCOME
The inner flow
Withdrawals
• net saving
• net taxes
• import expenditure
Injections
• investment
• government expenditure
• export expenditure
58
7.2 (cont.)
The relationship between injections
and withdrawals
• the links between them
• planned injections may not equal
planned withdrawals
Equilibrium in the circular flow
The circular flow and the four
macroeconomic objectives
59
7.3
ECONOMIC GROWTH
Actual and potential growth
Economic growth & the business
cycle
• fluctuations in actual growth
• the phases of the business cycle
• the business cycle in practice
– the irregularity of the cycle
– the length of the phases
– the magnitude of the phases
Causes of actual growth
• aggregate demand
• aggregate demand relative to
potential output
60
7.3 (cont.)
Causes of potential growth
• increases in the quantity of factors
– capital
– labour
– land and raw materials
– problem of diminishing returns
• increases in factor productivity
Policies to achieve growth
• demand-side and supply-side
policies
• market-orientated and
interventionist policies
61
7.4
UNEMPLOYMENT
The meaning of 'unemployment'
Official measures of unemployment
• claimant unemployment
– do claimant statistics give a true
picture of unemployment?
• standardised unemployment
(ILO/OECD)
Unemployment and the labour market
• the aggregate demand and supply
of labour
• equilibrium in the model
• disequilibrium unemployment
• equilibrium unemployment
62
7.4 (cont.)
Disequilibrium unemployment
• real-wage (classical) unemployment
• demand-deficient (cyclical)
unemployment
• unemployment arising from a
growth in the labour supply
Equilibrium unemployment
• frictional (search) unemployment
• structural unemployment
– changing pattern of demand
– technological unemployment
– regional unemployment
• seasonal unemployment
63
7.5
AGGREGATE DEMAND
A N D SU PPLY
The aggregate demand curve
Why aggregate demand curves slope
downwards
• import effect
• interest rate effect
• savings effect
The aggregate supply curve
Equilibrium
Effect of a shift in the aggregate
demand curve
64
7.6
INFLATION
Defining inflation
The costs of inflation
• redistribution
• uncertainty
• balance of payments
• resources used to cope with
inflation
Types of inflation
• demand pull
• cost push
– wage push
– profit push
– import-price push
• structural (demand shift)
• expectations and inflation
Policies to tackle inflation
• demand-side policies
• supply-side policies
65
Chapter
8
The Determination of
National Income and the
Role of Fiscal Policy
66
8.1
THE EQUILIBRIUM LEVEL OF
NATIONAL INCOME
Effect on national income of a change
in injections and/or withdrawals
• J>W
• W>J
The Keynesian diagram: the
withdrawals and injections approach
• the withdrawals curve
• the injections curve
• equilibrium
The Keynesian diagram: the income
and expenditure approach
• the 45º line
• the expenditure curve
• equilibrium
67
8.2
THE MULTIPLIER
The multiplier: introduction
• the circular flow of income and
effects of changes in injections
• definition of the multiplier: Y/J
Withdrawals and injections approach
• graphical analysis: shift in the J
line
• the formula: 1 / mpw
or: 1 / (1 – mpcd )
Income and expenditure approach
• graphical analysis: shift in the E line
68
8.3
THE KEYNESIAN ANALYSIS OF
UNEMPLOYMENT AND INFLATION
'Full-employment' national income
'Gap' analysis
• the deflationary gap
• the inflationary gap
• policy implications
Inflation and unemployment together
• inflationary pressures before the
full-employment level of income
• implications for shape of AS curve
The Phillips curve
• the shape of the curve
• the position of the curve
• policy implications of the curve
• the breakdown of the curve
• recent relationship between inflation
and unemployment
69
8.4
KEYNESIAN ANALYSIS OF
THE BUSINESS CYCLE
The accelerator
• changes in national income and
induced investment
• the accelerator effect
• the instability of investment
The multiplier / accelerator interaction
Fluctuations in stocks
The course of the business cycle
• why do booms and recessions
persist?
– time lags
– 'bandwagon' effects
• why do booms and recession come
to an end?
– ceilings and floors
– echo effects
– the accelerator
– random shocks
– changes in government policy
70
8.5
THE ROLE OF FISCAL POLICY
The purpose of fiscal policy
• correcting a fundamental
disequilibrium
• fine tuning
Deficits and surpluses
• central government deficits and
surpluses
• public-sector deficits and surpluses
• the PSNCR
• the national debt
The use of fiscal policy
• automatic fiscal stabilisers
• discretionary fiscal policy
71
8.6
THE EFFECTIVENESS OF
FISCAL POLICY
Factors determining the effectiveness
of fiscal policy
• accuracy of forecasting
• effect on J and W
• effect of changes in J and W on
national income
• timing of the effects
• effects on the various macro
objectives
Discretionary policy: problems of
forecasting the magnitude of effect
• effects of changes in government
expenditure
• crowding out
• effects of changes in taxes
• size of the multiplier and accelerator
effects
• random shocks
72
8.6 (cont.)
Discretionary policy: problems of
timing and time lags
• various time lags
• policy may be destabilising
Side-effects of discretionary policy
• cost inflation
• welfare and distributive justice
• incentives
A rules-based approach to fiscal policy
• a ‘steady-as-you-go’ policy
• the EU Stability and Growth Pact
• UK Labour government’s ‘Golden
Rule’
73
Chapter
9
Money and Monetary Policy
74
9.1
THE MEANING AND
FUNCTIONS OF MONEY
The functions of money
• medium of exchange
• means of storing wealth
• means of evaluation
• means of establishing value of
future claims and payments
What should count as money?
• narrow definitions of money
• broad definitions of money
75
9.2
THE FINANCIAL SYSTEM
IN THE UK
Role of banks in the monetary system
• deposits and loans
• liabilities and assets
• retail and wholesale deposits and
loans
Liabilities
• sight deposits
• time deposits
• certificates of deposit
• repos
Assets
• cash and balances with the Bank of
England
• short-term loans
• longer-term loans
76
9.2 (cont)
Liquidity and profitability
• profitability
• liquidity
• the liquidity ratio
The Bank of England
• note issue
• management of government's
borrowing programme
• provides liquidity to the banks
• operates monetary and exchange
rate policy
The London money market
• the discount and repo markets
• last-resort facilities
• the parallel money markets
77
9.3
THE SUPPLY OF MONEY
Definitions of the money supply
• monetary base
• broad money
Definitions in the UK
The creation of credit
• simple illustration
• the bank multiplier
• the real world
Causes of increases in money supply
• banks reduce liquidity ratio
• inflow of funds from abroad
• PSNCR and its financing
Money supply: exogenous or
endogenous?
78
9.4
THE DEMAND FOR MONEY
The motives for holding money:
liquidity preference
• transactions motive
• precautionary motive
• speculative motive
Demand for money and interest rates
• active balances
• idle balances
• the liquidity preference curve: L
79
9.5
MONETARY EQUILIBRIUM
Equilibrium in the money market
• equilibrium interest rate where D & S
of money are equal
Equilibrium in the foreign exchange
market
• increased money supply leads to
lower interest rates
• lower interest rates lead to a lower
exchange rate
Effects of changes in money supply on
national income:
• effect on interest rates
• effects of changes in interest rates
on investment
• effects of changes in interest rates
on the exchange rate and hence
on imports and exports
• effects of changes in I, M and X on
national income
80
9.6
MONETARY POLICY
Control of money supply over medium
and long term
• restricting size of PSNCR
• problem of financial crowding out
Short-term monetary control
• techniques to control money supply
– open-market operations
– other
• controlling interest rates
– role of Monetary Policy Committee
of Bank of England
– backing up MPC decisions in repo
market
• rationing credit
81
9.7
EFFECTIVENESS OF
MONETARY POLICY
Reducing the PSNCR
• the desire to cut taxes
• difficulty in cutting government
expenditure
Short-term monetary control
• problems with credit rationing
• the effectiveness of changes in
interest rates
– inelastic demand for loans
– unstable demand for money
• importance of confidence in policy
Using monetary policy
• using interest rate to target inflation
82
Chapter
10
Unemployment and Inflation
83
10.1
MONEY AND PRICES
The quantity theory of money
The equation of exchange
• M money supply
• V velocity of circulation
• P price level
• Q quantity of national output
• MV = PQ
The link between money and prices
Assumptions about the velocity of
circulation (V)
• the Keynesian view
– the monetary transmission
mechanism
– the money–interest rate link
– the interest rate–spending link
• the monetarist view
– the theory of portfolio balance
– the short-run variability of V
84
10.1 (cont.)
Assumptions about output and prices
• monetarist and new classical views
– the interdependence of
markets
– the flexibility of prices
• the Keynesian view
– the stickiness of wages and
prices
– the effects of investment on
aggregate supply
85
10.2
INFLATION AND UNEMPLOYMENT:
MONETARIST VIEWS
Incorporating expectations into the
analysis of the Phillips curve
• adaptive expectations
The accelerationist theory
• accelerating inflation when
unemployment is kept below the
‘natural’ level
• effects of deflationary policies
• the long-run Phillips curve
• Phillips loops
Policy implications
86
10.3
INFLATION AND UNEMPLOYMENT:
NEW CLASSICAL VIEWS
Assumption of flexible wages and
prices
Rational expectations
• meaning of rational expectations
• imperfect information
• implications for aggregate supply
and the Phillips curve
• policy implications
Real business cycles
• explanations in terms of fluctuations
in aggregate supply
• causes of changes in aggregate
supply
• policy implications
87
10.4
INFLATION & UNEMPLOYMENT:
KEYNESIAN VIEWS
Changes in equilibrium unemployment
• higher structural unemployment
• hysteresis
The persistence of demand-deficient
unemployment
• payment of efficiency wages
• insider power
Incorporation of expectations
• expansion of aggregate demand
• contraction of aggregate demand
Keynesian criticisms of non-
intervention
88
10.5
COMMON GROUND BETWEEN
ECONOMISTS?
Short-run effect of changes in AD
• major effect on output and
employment
• relatively small effect on prices
Long-run effect of changes in AD
• relatively small effect on output and
employment
• relatively large effect on prices
• some Keynesians disagree
– stress long-run effects of changes
in AD on investment
Incorporation of expectations
89
10.6
DEMAND-SIDE POLICY
Case against discretion
• time lags
• over-correction
• government may ignore long-term
consequences
Case for rules
• can reduce inflationary expectations
• create a stable environment for
investment and growth
Case against rules
• can cause severe fluctuations in
interest rates and can cause
greater instability
• which rule to choose?
• rules may conflict
• rules may become unsuitable
Case for discretion
• helped by better forecasting and
quick-acting policies
• allows government to respond to
changing circumstances
90
10.7
SUPPLY-SIDE POLICY
The use of supply-side policies
• to reduce unemployment
• to reduce inflation
• to increase economic growth
Market-orientated supply-side policies
• reducing government expenditure
• tax cuts
– effects on incentives
– effects on imports
– tax cuts for business
• reducing the power of labour
• reducing welfare
• policies to encourage competition
– privatisation
– deregulation
– introducing market relation-
ships into the public sector
– the Private Finance Initiative
– free trade & capital movements
91
10.7 (cont.)
Interventionist supply-side policy
• industrial policy
– rationalisation
– advice and persuasion
– information
– finance for research and
development
– assistance to small firms
• infrastructure development
• training and education
92
Chapter
11
International Trade
93
11.1
THE GAINS FROM TRADE
The law of comparative advantage
• specialisation as the basis for trade
• absolute advantage
• comparative advantage
• the gains from trade based on
comparative advantage
The limits to specialisation and trade
The terms of trade
• PX/PM
Other reasons for gains from trade
• decreasing costs
• differences in demand
• increased competition
• trade as an ‘engine of growth’
• non-economic advantages
94
11.2
ARGUMENTS FOR
RESTRICTING TRADE
Methods of restricting trade
• tariffs
• quotas
• administrative barriers
• other
Arguments for restricting trade
• infant industry argument
• changing comparative advantage
• to prevent dumping
• to prevent establishment of a
foreign-based monopoly
• to spread risks
• externalities
• pursuing national interests (but
against world interests)
– exploiting monopoly power
– protecting declining industries
• other economic arguments
• non-economic arguments
95
11.2 (cont)
Problems with protection
• protection as ‘second best’
• world multiplier effects
• retaliation
• cushions inefficiency
• bureaucracy
96
11.3
WORLD ATTITUDES TOWARDS
TRADE AND PROTECTION
History of protection
• pre-war growth in protection
• post-war reduction in protection and
the role of GATT
• re-emergence of protectionism in
the 1980s
– the use of non-tariff barriers
• The Uruguay Round
– aims of the Uruguay Round
negotiations
– problems in reaching agreement
– the agreement
The WTO
• dispute settlement
• conflicting interests in trade
disputes
97
11.4
TRADING BLOCS
Types of preferential trading
arrangement
• free trade areas
• customs unions
• common markets
Direct effects of a customs union
• trade creation
• trade diversion
Lonter-term effects of a customs union
• longer-term advantages
• longer-term disadvantages
Preferential trading in practice
• the EU
• NAFTA
• other examples
98
11.5
THE EUROPEAN UNION
Historical background
From customs union to common
market
• Common Agricultural Policy
• regional policy
• competition policy
• tax harmonisation
• social policy
The single market
• historical background
• the Single European Act
• completing the single market
• benefits of the single market
– trade creation
– reduction in the direct costs
of barriers
– economies of scale
– greater competition
99
11.5 (cont.)
• criticisms of the single market
– radical economic change is
costly
– adverse regional multiplier
effects
– development of monopoly /
oligopoly power
– trade diversion
• evidence
• the future of the EU
– effect of new members
100
11.6
TRADE AND DEVELOPING
COUNTRIES
Trade strategies
• primary outward looking
• secondary inward looking
– import-substituting
industrialisation (ISI)
• secondary outward looking
– possibly complemented by
primary inward looking
Approach 1: exporting primaries
• justification
– exploits comparative advantage
– a ‘vent for surplus’
– an ‘engine for growth’
101
11.6 (cont.)
Approach 1: exporting primaries (cont)
• problems with traditional trade
theory
– comparative costs change
– benefits may not flow to nationals
– may lead to greater inequality
– externalities
• long-term problems
– low income elasticity of demand
– protection in advanced countries
– technological developments
– rapid growth in imports
– adverse movements in terms of
trade
102
11.6 (cont.)
Approach 2: ISI
• justifications
– problems of primary exporting
– dynamic potential in manufacturing
• infant industries
• rapid technological advance
• patterns of protection
– selecting industries for protection
– tariff and quota escalation
– attracting multinational investment
103
11.6 (cont.)
Approach 2: ISI (cont.)
• adverse effects of ISI
– often counter to comparative
advantage
– tends to cushion inefficiency
• encourages establishment of
monopolies
– artificially low interest rates
• use of capital-intensive techniques
– encourages rural–urban migration
– adverse effects on rural sector
– leads to greater inequality
– environmental problems
– limit to home market
104
11.6 (cont.)
Approach 3: exporting manufactures
• transition to from inward-looking to
outward-looking industrialisation
– a neutral trade approach
– active promotion of exports
• gains from exporting manufactures
– conforms more closely with
comparative advantage
– increased competition
– increased investment
– more employment, greater equality
• drawbacks of exporting manufactures
– retaliation from advanced countries
• but attitudes of WTO
– competition from other developing
countries
– vulnerability to world fluctuations
• trade between developing countries
– trade blocs of developing countries
105
Chapter
12
Balance of Payments
and Exchange Rates
106
12.1
THE BALANCE OF PAYMENTS
ACCOUNT
Meaning of the balance of payments
The current account
• trade in goods
• trade in services
• balance of trade in goods & services
• income flows
• current transfers of money
• balance on current account
The capital account
The financial account
• investment
• short-term financial flows
• flows to and from reserves
• financial account balance
Assessing balance of
107
payments figures
108
12.2
EXCHANGE RATES
The rate of exchange
• individual rates of exchange
• exchange rate index
Determination of exchange rates
• the equilibrium exchange rate
• appreciation and depreciation
• shifts in currency demand & supply
– differences in interest rates
– differences in inflation rates
– relative investment prospects
– change in aggregate demand
– speculation
109
12.3
EXCHANGE RATES AND THE
BALANCE OF PAYMENTS
Exchange rates and the balance of
payments: no government
intervention
• a floating exchange rate
• automatic balancing of overall
balance of payments
• current, capital & financial accounts
may not separately balance
Exchange rates and the balance of
payments: government intervention
• reducing short-term fluctuations
– using reserves
– borrowing from abroad
– changes in interest rates
• maintaining a fixed rate of exchange
over the longer term
– deflation / reflation
– supply-side policies
110
– import controls
111
12.4
FIXED VERSUS FLOATING
EXCHANGE RATES
Advantages of fixed exchange rates
• certainty
• no speculation (if rate is absolutely
fixed)
• prevents 'irresponsible' government
policies
Disadvantages of fixed exchange rates
• conflicts with other macro
objectives
• danger of competitive deflations
• problems of international liquidity
• difficulties in adjusting to shocks
112
• speculation
113
12.4 (cont.)
Advantages of free-floating rates
• automatic correction
• non problem of international
liquidity and lack of reserves
• insulation from external events
• governments free to choose their
domestic policy
Disadvantages of free-floating rates
• possibly unstable exchange rates
• speculation
• uncertainty for business
– but use of forward market
• lack of discipline on economy
114
12.5
THE ORIGINS OF THE EURO
Post-war regulation of exchange rates
• the Bretton Woods system
• its collapse in the early 1970s
• dirty floating
The ERM
• features of the ERM
• the 1980s
• crisis in the ERM
– events of 1992
– events of 1993
• a return of calm
The Maastricht Treaty
• background
• Stage 1
• Stage 2
– the convergence criteria
• Stage 3: economic and monetary
union (EMU)
115
12.6
EM U
Birth of the euro
• meeting the convergence criteria
• role of the European Central Bank
Advantages of EMU
• eliminating conversion costs
• increased competition and efficiency
• elimination of exchange-rate
uncertainty between members
• increased inward investment
• lower inflation and interest rates
Disadvantages of EMU
• political arguments
• adjustment to shocks
– problem of asymmetric shocks
• EU12 may not be an
• regional problems
Recent developments
116
12.7
GLOBALISATION AND THE
PROBLEM OF INSTABILITY
The need for policy co-ordination
• the search for policy co-ordination
– G7 meetings: attempts at
harmonisation
– but lack of convergence
Difficulties in achieving harmonisation
• differences in budget deficits and
debts
• interest rate divergence
• elimination of exchange-rate
uncertainty between members
• different internal structures of
economies
• politicians more concerned with
domestic issues
117
12.8
DEBT AND DEVELOPING
COUNTRIES
Origins of the debt problem
• borrowing to finance development
• the 1973/4 oil shock
• the 1979/80 oil shock
– world recession: fall in export
earnings
– fall in commodity prices
– high interest rates: increased cost
of servicing debt
Rescheduling debt
• rescheduling official loans
• rescheduling commercial bank loans
118
12.8 (cont.)
Dealing with debt
• structural reforms
• IMF structural adjustment
programmes
– tight fiscal policies to reduce
budget deficits
– privatisation and liberalisation
– open trade policy
– hardship from IMF programmes
• debt forgiveness
– HIPC initiative
– pressure to cancel debts
– Jubilee 2000
119