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IGCSE Economics Notes
Scarcity and Opportunity Costs
Needs: Things that people need to survive
...

• Humans have needs and unlimited wants
...

Factors of Production
1
...
ex
...

2
...

3
...

ex
...

4
...
Risk
takers who use their skills in order to make profit
...
business owners
...

Resources are the inputs, and goods and services are the outputs
...

Firm: organization that owns factories, offices, etc
...

Opportunity cost: the costs of sacrificing the best alternative forgone
...
What to produce?
2
...
For whom to produce?


Worker
producing
potato
chips
0
1
2
3
4
5

Market Economy:
• Factors of production are owned by individuals and private firms
...

• Individuals and firms produce what will generate the most amount of money
...

• Firms respond quickly to what consumers want
...

• There is almost no role for the government (no taxes)
...

• Only consumers who can pay will be able to receive goods/services
...

• Some consumers are unaware of the negative effects of the harmful goods
...

Plan Economy:
• State controls all factors of production
...

• 3 basic questions are determined by the state
...

Advantages:
• Government can ensure that all necessary goods are produced
...

• Government can prevent production of harmful goods
...

• Shortages of basic goods (food), and a surplus of unnecessary goods
...

• Government and private sector decide what is produced
...

2 factors of demand: price and quantity
{If the price goes down, the quantity produced goes up
...
}
Inverse Relationship: price and quantity demanded react oppositely to each other
...
The curve itself does not
change!
Demand Curve

What factors may cause a shift in the demand curve?
• Incomes
...

• Complementary goods: goods that complement each other
...

• Advertisement
...

• Weather
...

Example Demand Curves
The price of cars generally increases
...




If the price changes, the curve will stay the same
...

Non-Price factor (income):
Inferior Goods: goods that are bought when income is low but bought less as income rises
...
public
transportation
Normal Goods: goods that are bought more as income rises
...
designer brands
...

Positive Relationship: as the price rises, the quantity supplied rises
...

Extension of Supply: how supply increases with a rise in the price of a product
...

Change in supply (non-price factors):
• Cost of factors of production
...

• Technological advances
...

• Global factors
...

Market Equilibrium: when demand is equal to supply
...


Dutch supermarkets import cheaper eggs from Eastern Europe
...

Price elastic: when the quantity demanded of a good/service is very sensitive
...

Examples
• Demand for electricity is price-inelastic because electricity is a basic good and there aren't any
substitutions
...

• Demand for bread is price-inelastic because it is a basic good
...

• Demand for newspaper is price-elastic because they are not needed, and there are
substitutions
...
– old v
...


x 100

Elasticity Indicators:
• If PED is smaller than -1 it is ELASTIC
• If PED is between 0 and -1 it is INELASTIC
• If PED= -1 it is UNITARY ELASTIC
• If PED= 0 it is PERFECTLY INELASTIC
PED value is always negative
...

If demand is elastic, prices should decrease
...

Formula for revenue: Sales Price x Quantity Sold
ex
...
Total Revenue= 10 x $1= $10
...

Period of time: the longer the time period, the more sensitive the demand will be, so it will be an
elastic demand
...

Examples
• Education: Inelastic because education is required until a certain point, and it is needed in
order to get a good job
...
It is a
basic good, and there are no substitutes
...
The demand is affected by day, and also the substitutes like
Netflix
...


PES
Price elasticity of supply: how much the quantity supplied of a good changes after a change in the
price of the good itself
...

• If PES is between 0 and 1 it is INELASTIC
...

PES determinants:
• The availability of factors of production
...

Examples
• Seats at the cinema on a Saturday night are inelastic
...

• Train seats on a Monday morning at 11AM are elastic
...

• Production of paper is elastic
...

• Beef is inelastic
...

• Taxes increase production costs, hence reducing the supply
...

• Taxes can be used by the government to finance education, healthcare, and infrastructure
...




After the tax was placed on cigarettes, the price went up,
and supply went down
...
Less people will smoke the harmful good
...

• Subsidies reduce production costs hence the supply is increased
...

• It makes essential goods/services affordable for low income consumers
...

It is now more affordable for low income families to get
an education
...


Social Costs and Benefits
Private Benefits: the benefits enjoyed by the one undertaking the economic activity
...

Private Benefits + External Benefits = Social Benefits
Positive Externality: when an economic activity generates positive effects for others not involved in
the economic activity
...

Private Costs: costs paid by the one undertaking an economic activity
...

Private Costs + External Costs = Social Costs
Examples
Vaccinations: Social Benefits
Private: you don't get sick
...

Smoking: Social Costs
Private: lung cancer, health issues
...

Cleaning the house: Social Benefits
Private: healthier, liveable, better study space
...


Road construction: Social Costs
Private: raw materials, capital, labor, land
...

Studying/HW: Social Benefits and Costs
Private Benefits: good education, diploma
...

Private Costs: sleep deprivation, stress
...

Why do some companies continue to produce uneconomic goods?
PROFIT
...

Examples
• Taxes on harmful goods like tobacco and alcohol
...

• Regulations like non-smoking areas and age limits
...


Money
Specialization: each worker or firm specializes in different goods/services
...

• Better quality
...



Result: people have to trade to get other goods and services that they don't produce
themselves
...

5 characteristics of money:
1
...

2
...

3
...

4
...

5
...

Barter trade: swap goods/services in exchange for other goods/services
...
Trading options are limited
...
Medium of Exchange: used to swap goods/services in exchange for money
...
Unit of Account: used to account for the value of goods/services
...

3
...

• Wealth can be stored in valuables like gold, jewelry, property or money
...

4
...

Types of Money:
• Cash money
...

• Bank deposits
...

Demand for Money: individuals and organizations (firms/governments) who need money to finance
their expenditure
...

• Charging fees for provision of other financial services
...

Central Bank:
• Issuing notes and coins
...

• Managing national debt
...

• Lender of last resort
...

• Operating government’s monetary policy
...

• Borrow from bank
...

Firms can sell shares to others and receive money
...
If the firm makes profit, the firm owner must share the profit with the share holder
...

Stock Market: this is where stocks/shares are sold
...

• The shareholder may also decide to sell its stocks on the stock market
...


Occupations and Earnings
Wages: $ per week
...

Factors that influence supply of labor:
• Wages
...

o Voluntary
...

o Learn new skills
...

• Piece rate: per piece of output produced
...

• Performance related payments
...


Labor Market
Derived Demand: demand for labor depends on the demand for the output they produce
...

• More demand for houses; more demand for construction workers
...
However,
at a certain point wage has reached a point that workers are satisfied and choose to relax, even
though the wage rises (backward bending supply curve)
...

• Where supply of labor = demand for labor
...

Productivity
Price/productivity of
capital

Supply
Net advantage of an
occupation
Provision and equality
of education/training
Demographic
(population) changes

Non-wage
employment costs

Demand: firm
Supply: labor/workers

Example Curves
Population decreases due to mass emigration
...

The firms will raise the wages in order to get more workers
...

The demand for labor will decrease because it costs more to pay
for expensive materials and pay many workers

Trade Unions
Trade Union: organization that represents workers, negotiates wages on behalf of them and defends
worker’s rights
...

• Defending employee’s rights and jobs
...

• Improving pay and other benefits (pensions and sick pay)
...
If one organization negotiates, the workers have more chance in success of reaching their
objectives
...
one teacher asks for more wage versus all teachers asking for a higher wage
...

• Overtime ban
...

• Go slow
...

The strength of a trade union depends on:
• How many members they have
...

• How important their workers are, such as utility workers rather than restaurant staff
...

Reasons for spending:
• Survival/satisfy basic needs
...



In order to consume, people need money from income or they can borrow or use their savings
...

• Disposable income: income after taxes are paid
...

• Consumer confidence about the future
...

Low income families spend most of their income on basic needs
...

Saving: storing money to use in the future
...

• Gain interest over their savings
...

Borrowing: others lending money to them
...

• Price of desired good is too high to pay at once (house/car)
...

• Wealth
...

• Availability to borrow
...

Financial Crisis: too many borrowers unable to repay loans
...

• If you are unable to repay mortgage, the bank will take the house
...

• Sole traders don't sell stocks or shares
...

• Personal contact with staff and customers
...



•

Owner can keep all the profits
...

• Full responsibility of everything
...

Partnership: legal agreement between 2 or more persons to own, finance and run a firm together
...

Advantages:
• Easy to set up
...

• More money available
...

Disadvantages:
• Partners can disagree
...

• Financial capital is limited to what partners can contribute
...

Owners are shareholders
...
In exchange they
give up some ownership to those who buy the shares/stocks
...

Controlling interest: person who owns 50% or more of the shares will get the most power
...

• Chief executive manager and other managers are appointed: Board of Directors
...

Private Limited Company: can only sell shares to people known to existing shareholders
(family/friends/relatives)
...

Public Limited Company: can sell shares to anyone on the stock market
...

• Liability is limited to amount invested in shares
...

Disadvantages of limited companies:
• More expensive to set up (legal costs, minimum amount of financial capital must be reached to
be able to set up
...



Cooperatives: organization owned by a group of people (members)- not partners
...


Cost
Costs: the payment that the firm has to make to produce goods/services
...

Total Fixed Cost (TFC): costs that do not change when the output changes in the short run
...
rent or interest on a bank loan
...

ex
...


Break Even Quantity:
Total Fixed Costs
(price per unit – Average variable cost)

Measuring Productivity
Average product of labor: total output per period
number of employees
Average revenue product of labor:
total revenue per period
number of employees
Division of labor:
• Workers specialize in production processes
...

Objective: production becomes more efficient
How?
• Train workers
...

Factor substitution: process in which labor is replaced by capital (robots)
...


Production Stages
Industrial sectors: group of firms specializing in similar goods/services
...

• Extraction of raw materials (mining/drilling)
...

• Using raw materials to build something (construction)
...

• Selling goods and services (retail)
...


Size of Firms
Measuring size of firms:
1
...

• <50 employees: small firm: not always because small firms may produce large output if
they use machines
...
Organization (number of departments/branches)
...
Capital employed
...
Market share
...

How firms grow in size:
1
...

2
...

Types of Integration:
1
...
ex
...

2
...
ex
...

Forward Integration: firm taking over its customer
...
factory takes over shop
...
ex
...


Scale of Production
Economies of scale (EOS): a decrease in the average costs due to an increase in output produced
...



Internal EOS: decreasing unit costs due to a firm growing internally
...

Marketing Economies: advertisement costs are lower because its spread over large output
...
Coca-Cola produces thousands of bottles each day so their average marketing
costs are low
...

Technical Economies: large firms have more money to buy better equipment and hire
researchers
...
The researchers can develop new
technology which lowers costs as well
...
The
loss of one good can be compensated by profits on another good
...

Skilled workforce: if the industry grows more skilled, workforce will be available and it will be
cheaper to find skilled labor
...

Ancillary firms: if the industry grows, supplying firms will be attracted to grow as well
...
automobile industry and tire industry
...

Shared infrastructure: if industry grows, investment in infrastructure grows and other firms
benefit
...
Rotterdam port
...
The organization is
too large to work efficiently
...

Why does this happen?
• Management difficulties: large firm gets chaotic; difficult to coordinate
...
Productivity decreases
...
Their price goes up
hence production costs rise
...
ex
...

• Access to financial capital is limited
...

• Firm owner prefers to remain small
...

• Increase sales
...

Achieve product superiority
...

Maximize profits
...
Price competition
...

2
...

• Advertisement
...

• Product distribution
...
McDonalds and Coca-Cola / KFC and Pepsi
• Customer loyalty cards
...

• Firms cannot set their own price; it depends on the equilibrium price of the whole market
(decided by price-takers)
...

• No/low barriers to entry
...

• Huge power to determine price: price setter/maker
...

• Able to restrict supply and hence set a high price: abnormal profits
...

• Lower output and higher prices
...

Potential dangers of a monopoly:
• High prices
...

• Less incentive to innovate
...

Barriers to entry: obstacles for new firms to start a new business in a certain industry/market
...

• Historical reasons
...

• Exclusive dealing (McDonalds and Coca-Cola)
...


Macroeconomics


Economic objectives of every government:
• Low and stable inflation
...

• Economic growth
...

Economic Growth: a percentage increase of real output of an economy over a period of time
...
A country produces different
goods/services so to measure it we take the value of it
...

Gross Domestic Product (GDP): the monetary value of all output produced in a country in a certain
time period
...


3 methods to measure GDP
1
...

2
...

3
...

THE 3 METHODS TO MEASURE GDP WILL ALWAYS GIVE THE SAME VALUE!
Measuring Real Output
Assume a country produces 10 units that are $5 each
...
How much is the national income?
$50
...
The year after, each unit increased in price to $7 but the country still produces 10 units
...

3
...
Inflation occurred
...
The increase was due to an increase in prices (inflation)
...

Using GDP statistics
1
...

2
...

3
...



Standard of living: well-being of people in a country
...

• More workers are employed
...

BUT:
• May lead to more resources being used and in the long run their depletion
...

Causes of Economic Growth
1
...

2
...

3
...

4
...


Inflation
Inflation: sustained increase in the general price levels
...

• More money units needed than before to buy the same amount of goods/services
...

Causes of inflation:
• Monetary inflation: too much money supply from banks and government
...

• Demand-Pull inflation: too much total demand for all goods/services in country
...

• Rise in business taxes, wages or imported inflation
...
To maintain their profit level, firms increase their prices
...

Government wants low and stable inflation (macroeconomics objective)
...

• It means firms/households earn more in a reasonable way
...

Use of Price Index:
• As an economic indicator
...

• As an indicator for wage demands by labor
...



•

Composition of goods in the price index may change over time due to technological innovation,
population changes or change in preference/taste
...

• Unemployment rises
...

• Domestic goods become less competitive and imported goods become more popular
...

Deflation: sustained decrease in general price level
...

Negative consequences of Deflation:
• Lower prices mean that firms lose revenue and profit
...

• Economic growth falls
...

• Consumers notice falling prices, so they postpone spending because they are waiting for the
prices to fall even more, so firms lower the prices even further
...

Labor force: part of the population that is at the working age, willing and able to work, with or without
a job
...


Measuring Unemployment:
1
...

2
...

Difficulties in measuring:
• Fraud (secretly working but also receiving benefits)
...

• Surveys take a long time to conduct
...



Causes of Unemployment
Frictional Unemployment: temporarily unemployed
...

• Casual unemployment: those who quit or lost their job and are in search of a new job
...

Structural Unemployment:
• Industries and occupations that disappear: other countries taking over the industry,
substituted by other goods, labor replaced by capital
...

• Technological unemployment: employees redundant due to ICT (banking services on
the internet)
...
}
Possible Solutions for Frictional and Structural Unemployment:
• Education and training (retrain yourself)
...

Cyclical Unemployment: caused by a decrease in aggregate demand
...

• Firms produce less
...

• Firms will fire workers
...

• Increase government expenditure
...

Consequences of Unemployment:
• Easier to find new employees
...

An unemployment rate of 9% for only a few months is better than a 6% unemployment rate of more
than a year
...

• Losing self confidence
...

• Higher crime rates
...

• Education of kids in jeopardy
...


Effects on the economy:
• Not using resources effectively
...

• Government expenditure on benefits increases
...

• Money spent on benefits could have been spent on education or healthcare (opportunity
costs)
...

Expansionary Fiscal Policy: lower tax and higher government expenditure
...

• Consumers and firms spend more
...

Result:
• Economic growth
...

Contractionary Fiscal Policy: raise taxes and lower government expenditure
...

• Consumers and firms spend less
...

• Firms reduce prices to attract consumers
...

Result:
• Low and stable inflation
...

Objectives of Tax:
• Source of income for the government
...

• Reduce consumption of imported goods
...

Government expenditure paid for by taxes:
• Subsidies
...

• Salaries for government officials like police, judges and teachers
...


Tax Systems:
1
...

2
...

3
...


Note: In every tax system, high income households will
always pay more tax in total amount than the low income
households
...


Progressive Tax: tax system where the tax rate (% tax) increases as income increases
...

Income
Tax Rate
10,000
50%
40,000
25%
100,000
10%
Proportional Tax: tax system where each income group pays the same tax rate irrespective of their
income
...
ex
...

• They are unavoidable
...

Indirect Tax: taxes on expenditure on goods/services
...
ex
...

• Black markets may arise
...

• Tax goes via the seller to the government
...

Budget Deficit: Planned income < Planned expenditure
...

Balanced Budget: Planned income = Planned expenditure
...



•
•
•

Lower tax revenue due to economic crisis
...

Other Crisis such as war on natural disasters
...

• Lower public expenditure
...

• Sell government assets (public firms)
...

• Money printed by Central Bank goes to commercial banks
...

• The amount of money supply determines how much economic activity takes place
...
It is the reward for people who save their money and
for those who lend it out
...

Expansionary Monetary Policy: increased money supply
...

• More spending by firms and households
...

• More production by firms so they need more workers
...

Results:
• Lower unemployment
...

Expansionary Monetary Policy: reduce interest rates
...

• Consumption and investment goes up
...

• More output produced
...

Results:
• Economic growth
...

Contractionary Monetary Policy: decrease in money supply
...

• Spending by firms and households falls
...



•

Firms lower prices to attract consumers
...


Contractionary Monetary Policy: increase interest rates
...

• Consumptions and investment falls
...

• Output produced falls
...

Results:
• Demand-Pull inflation falls
...

Possible obstacles for firms to produce more and create economic growth and jobs:
• Lack of skilled labor
...

• High taxes
...

• Subsidies education
...

• Increase government expenditure on infrastructure
...

• Subsidize public transport to reduce car usage
...

• Remove laws that prevent firms to increase efficiency
...

• Allow firms to hire foreign workers easier
...


Economic Development
Economic growth: increase in the value of output produced by an economy over a period of time
...

• More jobs created
...

• Higher standard of living
...

Standard of living: the level of quality of life for a population
...

• Low level of economic development
...

• Poor infrastructure
...

• Poor healthcare system
...

ex
...

Reasons for low economic development:
• Large part of population working in the primary sector; low income for people
...

• Insufficient investment in education, healthcare and infrastructure; low skilled labor, high
death rate and it is difficult to trade goods
...

• Other factors including war and corruption
...

• Below the poverty line: less than $1 per day
...

Development Indicators:
• GDP per capita (total GDP divided by population)
...

• Life expectancy at birth
...

• Access to water and sanitation
...

• % of population working in the primary sector
...

3 Indicators:
1
...

2
...

3
...



4 levels:
1
...

2
...

3
...

4
...

Ranking in 2015:
1
...

2
...

3
...

4
...

5
...

Reducing Poverty:
• Improving education
...

• National minimum wage
...

• Providing more or higher social welfare benefits like unemployment benefits
...


Population
Population growth is a non-price determinant
...

Negative sides of population:
• Overpopulation: too many people with insufficient resources
...

• More crime/violence
...

Population consists of different groups:
• Elderly/retired/disabled
...

• Working population
...

• Working population must earn income and produce goods/services needed by the rest of the
population
...
R
...

• The higher the ratio, the more difficult it is for the working population to support the rest of the
population
...

• High dependency ratio means heavier burden on the country’s resources
...

• Students leaving school at an older age
...

• Workers retire earlier
...

• Less choice for consumers
...

• Lower GDP
...

• Higher unemployment
...

Countries trade goods/services:
• They don't produce by themselves
...

International Division of Labor: specialization of countries in production of particular goods/services
...

• Faster production
...

• Less resources/factors of production used
...

• Some countries specialize because they have an advantage
...

EXAMPLE
Germany and Japan: each country has 100 workers and splits them in 2 equal groups to produce 2
different goods
...
1 Japanese worker can produce 2 cars
...
1 Japanese worker can produce 8 TVs
...
For every car produced, 4 TVs are sacrificed
...
Every Japanese worker producing a car could have produced 4 TVs
...
The opportunity cost of a car is 4 TVs
...
1 German worker can produce 1
...

2
...
2 TVs
...
For every car produced, 2 TVs are sacrificed
...
For every German worker producing a car, they could have produced 3
...

5
...

160 TVs
= 1:2
80 Cars
Germany has the lowest opportunity cost for cars
...

Germany should produce cars, and Japan should produce TVs
...

Absolute Advantage: when more goods/services can be produced with the same resources
...
This means that they have insufficient
resources to satisfy all wants and needs
...

Export earns the country revenue, and the revenue can be used to pay for imports
...

Positive Effects:
• More output produced
...

• More jobs
...

• More choice for consumers
...

• Domestic jobs will be lost
...

• Economic development in developing countries disrupted because of cheap imports
...

Natural barriers that prevent trade:
• Distance
...



Advantages:
• Countries can specialize and trade freely
...
There is no need to be self-sufficient
...
Increased variety of goods/services
...

• Increased competition and efficiency
...

• Additional business opportunities
...
There will be more
consumers worldwide hence more profit
...
Able to obtain best resources and technology from other
countries
...

• Less risk for conflicts
...

Disadvantages:
• Losses of jobs
...
Firms unable to compete will shut down and fire
workers
...
Many raw materials
from developing countries bought by rich countries; no resources left over
...

• Exploitation of workers
...

• Widening gaps between rich and poor countries
...
Poor countries stay poor because all profit goes to the rich
countries
...

• Protect local/domestic producers
...

• Conflict between countries
...

Objective: reduce imports and increase exports
...




Tariff: indirect tax on imported goods/services
...
They'll likely switch to buying
domestically produced goods
...


Effect: Local firms have lower production costs and can supply more
at lower prices
...


Quotas: restriction on the amount of imported goods
...

Effect: Shortage of imported goods, so prices rise
...

Embargo: ban on import or export
...

• Prevents import of infectious diseases
...
Embargo for North Korea
...

• “Punishment” for producing nuclear weapons
...

ex
...

Effect: Making it almost impossible or very expensive to import
...



Reasons for protectionism:
• To protect local firms against foreign competition
...

o Sunset industries
...

o Against dumping
...

• Retaliation against other countries
...

• May help young firms to survive against stronger international firms until they are strong
enough
...
Developing country tries to set up their own tech industry, so they need to be protected from
Sony, Samsung and Microsoft
...
They are about to disappear, but they still employ a lot
of workers
...

• Industry needs protection against foreign competition
...

• Utility industry (gas/water/electricity)
...

• Weapons industry
...

Dumping: the practice of selling a good below production costs
...

• Once the local competitors are gone the foreign firm becomes a monopolist and raises prices
...

• Dumping made possible because firms receive subsidies
...
Chinese industries are often accused of dumping goods in the US and EU markets
...

• Country pays more for imports than receives for exports
...

Retaliation: taking revenge
...

• Political action during conflict
...

• Restrict expansion for local firms in international markets
...

• Protect inefficient firms
...



Protect inefficient firms: if local firms receive too much protection they will get complacent/lazy to
innovate
...

• Develop new products/services
...


Balance of Payments (BOP)
How does a country know how much it exports and imports?
• It records all transaction on a balance
...

Balance of Payments: record of all financial transactions between residents and organizations (firms)
of a country with the rest of the world
...

Export: country sells goods to foreigners and receives money
...

Credit: money flows into the country
...

• Foreigners pay for exports
...

Debit: money flows out of the country
...

• Local residents pay for imports
...

International Trade: exchange of goods/services across borders
...

• Trade of physical, visible objects
...

• Trade in nonvisible items
...

o There is a trade surplus
...

o There is a trade deficit
...

• Capital account
...

• Net errors and omissions
...
Visible Trade
...
Invisible Trade
...
Income
...

4
...

• Money flows from labor, pensions, gifts, donations, tax, and development aid
...

• Buying/selling non-financial assets like land or capital
...
Direct Investment
...

2
...

• Buying/selling of stocks and bonds
...
Other Investment
...

•
•
•

Financial Account includes gold and foreign currency reserves
...

Central Bank holds reserves of gold and foreign currencies
...

• Bought by the government as precaution
...

• Pay for imports
...

• Late payments received (bought on credit)
...

• Interest payments over loans paid later
...



BOP Deficit: credit < debit
Balanced BOP:
• In theory, a BOP is always balanced
...

• However, this generates income and surplus on the Current Account
...

• Money needed
...

• Must exchange currency first
...

Exchange Rate: price of a currency in terms of another currency
...

Buying a currency = Demand for currency
Selling a currency = Supply of a currency
• When a currency is bought, another currency is sold
...

• Dutch pay in £
...

• Demand for £ rises
...

• Supply of € rises
...

• £ became more
expensive for the Dutch
...

Money flowing into a country:
• Currency gets bought
...

• Exchange rate rises
...

• Supply of the currency rises
...

Factors affecting demand/supply for a currency:
• Tastes and preferences for a country’s goods/services
...



•
•
•

Economic growth
...

Interest rates (money flows from low to high)
...
ex
...

• Foreigners need to buy £
...

• Value of £ rises
...

• Supply of $ rises
...

Economic Growth: people have a higher income so more is spent on imported goods/services
...

• Supply of currency rises
...

• Demand for foreign currency rises
...

Expensive exchange rate means:
• Exports are expensive
...

Cheap exchange rate means:
• Exports are cheap
...

Effects on the economy depend on how much a country
depends on imports and exports:
Luxembourg: Expensive ER
...

Japan: Cheap ER
...

Exchange Rate Systems (ERS):
1
...

2
...

3
...

Free Floating ERS: exchange rate is determined by market forces (supply/demand)
...

• Appreciation: increase in value due to market forces
...




Advantages:
• Central Bank does not need to intervene to keep rate stable
...

Disadvantages:
• Exchange rate may be very volatile
...

Fixed ERS: exchange rate is fixed at a certain rate against
another currency (usually against $ or €)
...
$1 = €1
• If the exchange rate changes, the Central Bank
intervenes by using Forex (foreign currency)
Reserve
...
50), the US Central Bank must intervene
...

• They will do this until the exchange rate is back at $1=€1
...
50? They will buy the € and sell the $
...

• Creates certainty about export and import prices (good for trade)
...

• Central Bank must keep a large Forex Reserve
...

Central Bank intervening in Fixed ERS

Demand Shift: if the currency drops below the fixed
rate
...

• Demand for $ rises
...


What if the currency keeps on changing?
• Central Bank may run out of Forex Reserve
...



•

Government has to reset a new fixed rate
...

• Revaluation: resetting currency value to a higher rate
...

• Also known as a “Dirty Float ERS” because its not completely free floating but it is managed
...
Turkey (Lira)
Lira/$ may appreciate or depreciate between a certain band
width
...
30-3
...
30
...
The demand for Lira will rise, so Lira will
be back within band
...

• Government can decide to abandon Managed Floating ERS and change to Free Floating ERS
...

Advantages:
• Exchange rate is limited/less volatile
...

Disadvantages:
• Central Bank must keep a considerable Forex Reserve
...


Trade Imbalances
Trade imbalances create unstable exchange rates
...

• Currency depreciates/devaluates
...

Effects:


•
•

Country may have to borrow money
...

Result:
• Demand-pull inflation
...

• Currency appreciates/revaluates
...

Effects:
• Exports become less attractive
...

Result:
• Unemployment
...

Solutions to trade deficit:
• Let Free Floating ERS correct it (self correcting BOP)
...

o Protectionist measures
...

• Reduce demand for exports through:
o Expansionary policies
...






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