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Macroeconomics Notes
The National and International Economy
The Government’s four main macroeconomic objectives:
1
...

3
...


To achieve high economic growth
To keep inflation under control
To reduce unemployment
Avoid a current account deficit

1
...

Level of GDP: a measure of total output, income or expenditure in an economy at
any one time
...

Measuring output: GDP method: total output of all four factors of production in an
economy

Three Key ways of calculating output:
 Output Method: Value of produced output by industries
...

 Expenditure Method: Total amount spent in the economy
...

Real = Nominal X

𝑩𝒂𝒔𝒆 𝒚𝒓 𝒑𝒓𝒊𝒄𝒆 𝒊𝒏𝒅𝒆𝒙
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒓 𝒑𝒓𝒊𝒄𝒆 𝒊𝒏𝒅𝒆𝒙

Problems of Measuring Output:






Nominal mislead – use real
Double count resources- use value added
Not all output recorded- Hidden economy so compare expenditure with income
Different types of spending distort- e
...
spending on clearing up natural disaster
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

Real GDP per capita: 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 Believed people better off if this rises- does not show distribution of
income though
The PPC: shows the maximum combination of goods and services which an economy can produce
with existing resources and technology
...

Determined by the magnitude of leakages
...

Firms aim to match their output with demand, so a rapid rise in consumer expenditure should trigger
investment because firms believe that growth is going to continue, and now is the best time to
invest in capital in order to facilitate this rise in demand and AD
...


Limitations to the theories:








If firms have spare capacity, demand can be met without investment
Accelerator ignores confidence and expectation- firms may not respond immediately to
demand if uncertain
Firms may exercise choice over investment- may delay such investment
Investment decisions planned well in advance
Multiplier effect of changes in investment small- while volatile, not a large impact on AD
External/random shocks can be as important a cause of economic cycle as multiplier and
accelerator
Fiscal and monetary changes may help to smooth out economic cycle- override accelerator
and multiplier

Alternative explanation: Stocks

Stocks are the amount of finished goods that a firm holds in order to satisfy increases in demand
...
Largely depends on confidence
...


Output Gaps



+ve: when actual output, in the short-term, exceeds potential output
-ve: When actual output is below potential output
...

Benefits and Costs of Eco growth













Standard of living
Life expectancy
Unemployment should decrease
Government budget deficit should decrease
Profit for firms and better confidence
Current account may correct
May be more pollution (e
...
Kuznets Curve)- quality of life?
Inflation?
Current account may get worse
Opportunity cost with more capital goods
Externalities
Relative poverty (inequality)

Economic Growth Conclusions:




Short-run v long-run (short-run = inflation)
Sustainability- avoid boom-bust cycles
Rate comparison to foreign economies

The 72 Rule: if real GDP increase at 1% per year, it will take 72 years for GDP to double
...
Improvements in the quality and quantity of the four factors of production
...

Capital-Output Ratio: the amount of capital needed to produce each unit of output
...

Assumptions:




Savings (S) is a fixed proportion (s) of national income (Y)
Investment (I) is the rate of change in capital stock (ΔK)
No external trade and no government- national income equilibrium occurs when
withdrawals=injections

It follows that: sY= ΔK
Y=

ΔK
𝑠

If capital output ratio (k) is the amount of additional capital (ΔK) required to produce an
additional unit of output (ΔY) then it follows that:
ΔK

ΔY= 𝐾

So the rate of economic growth=

ΔY
𝑌

ΔY S
=
𝑌
𝐾
For many economies, particularly developing, low savings constraints growth- savings gap needs
plugging with FDI (allows more investment than savings would imply)

2
...




Hyperinflation: Very rapid rise in prices
...
Inflation, but at a lower rate
than previous
...




Measuring Inflation

Retail Price Index (RPI)



Traditional
700 goods issues to 6000 households

Consumer Price Index (CPI)



Most important
Used for setting inflation target since
2004



Items in basket of goods weighted
according to proportion of spending




Same as RPI, but excludes housing costs
Calculated similarly to other countries

Limitations:
 Regional price variations
 Hard to measure whole economy
 Needs updating
 Changes in trends
 Changes in quantity of products

Index:

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑜𝑛𝑒𝑦 𝑣𝑎𝑙𝑢𝑒
𝐵𝑎𝑠𝑒 𝑚𝑜𝑛𝑒𝑦 𝑣𝑎𝑙𝑢𝑒

𝑋 100

Comparison:
CPI


Often produces lower figure

Similarities
 Both calculate overall price
level
 Calculate overall cost of
representative basket of goods
 Both use base period for
comparisons
 Suffer weakness of assigning
fixed weights- not allow for
substitution effect
 Update weights regularly

RPI


Excludes pensioner households
and highest earners

Monetary Policy Committee: Part o B of E, set in 1997 by Gordon Brown (then Chancellor), sets
monetary policy, rates announced at noon on 1st Thursday of every month
...

Cost-Push Inflation: Firms experience a rise in production costs that are then passed onto consumer
in form of higher prices
...


Consequences of Inflation:




The Real Wage: decreases
Savings: depreciate in value
Current Account: deficit increases
...
g
...


Inflation Conclusions:





Stability
Type
Rate
Comparison to foreign economies

Deflation Dangers:




Decline in output; investors less willing
Decline in firms’ ability to invest
Deflationary expectations- consumers may delay purchases

3
...
Level= number,
rate= expressed as % of working pop
...

Economically Active: People of working age in work or looking for work
...

Full Employment: A situation where everyone of working age who wants a job at the current wage
rate can get one
...
e
...


Measuring Unemployment:
Methods:


Claimant Count: Number of people claiming unemployment related benefits, e
...
JSA
Pros: quick and easy
...
Carried out
4 times a year (61,000 households)
...

Pros: based on intl agreed concepts, compare with other countries and over time
Cons: More expensive + time consuming, representative sampling?

Why unemployed?
1
...
Cyclical/Demand Deficient: Recession, low AD and no requirement for labour
...
Structural: Mismatch between workers’ skills and jobs available
...

4
...

Solutions: cut benefits/make harder to obtain, increase job centre provision, spend more on
careers information
...
Phillips claimed the
relationship has been stable for over 100 years
...

This position is known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU)- a
level of unemployment below which inflation rises
...

As output increases, unemployment decreases from U1 to U1 as Ye increases to Y2
However, the short-run Phillips curve does not say how the economy will self-adjust- how
economy return to natural rate of unemployment (U1)
Eventually, due to increased inflation, workers will demand higher wages, increasing the cost
of production (SRAS1 to SRAS2)
...

The short-run Phillips curve shifts to the right to represent an increase in wages while
returning to Ye and Ue
...

The economy is in equilibrium but with a higher rate of inflation: adaptive expectations
hypothesis (people base their assumptions of what will happen in the future with what has
happened in the past)

4
...

Transactions crossing borders: sending wages, loans, exports and imports, government transfers,
FDI, obtaining foreign assets etc

Categories of the Balance of Payments:
1
...
Has been
in deficit every year since 1984
2
...
e
...
government borrowing
...
Balance of payments sums to zero
...
Capital account: Records capital transfers in assets and liabilities
...
g
...
Includes Foreign Direct Investment (FDI)
Current Account Deficit: Imports > exports
...
To balance this, the government must borrow from abroad, moving the financial account
into a surplus
...


Economic Growth and the Balance of Payments:
Thirlwall’s Law of the B of P: a country can only spend more on imports than they earn from exports
if their future earning potential is good
...


Exchange Rates
The exchange rate is the price of one currency in terms of another
...
g
...
35
Two main types:



Fixed: An exchange rate where the government or its central bank sets the exchange rate,
tying it to another currency
...
The exchange rate is free to move
...

Effective exchange rate: a weighted average value of a country’s currency relative to all major
currencies with the weights determined by the importance/volume of trade conducted in each
currency
...
Shows the competitiveness of a country
...
g
...
50
 £ overvalued, D for £ < S for £
 Exports fall, imports increase
 In freely-floating, pound would depreciate back to
equilibrium
 UK gov had to sell foreign currency reserves to
maintain value

Devaluation: process whereby a gov reduces price of its currency relative to an agreed rate in terms
of foreign currency
Revaluation: process whereby a government raises the price of its currency in terms of foreign
currency
The $ Standard created a stop-go phenomenon: pound overvalued in $ standard so British
government announced a devaluation- every time gov tried to stimulate eco growth imports
increased, meant interest rates had to rise to revalue the pound and sell foreign currency reserves
...

Hot money: capital which is frequently transferred between financial institutions in an attempt to
maximise interest or capital gain
...


Aggregate Demand
AD: the total spending in an economy: C + I + G + (X-M)



AD same as demand curve
Same movements

1
...


Change in factor other than
income could cause curve to shift up and
down e
...
interest rates

2
...


Investment Demand Function:

Change in a factor other than interest rates
e
...
corporation tax, will shift curve
...
Government Expenditure
Government spending (AD): the component including the money spent by the government on
public goods and services
...
g
...


4
...
Produced in this economy, sold in another
...
Produced in another economy, sold from abroad
...
g
...

Short-run: prices of resources are constant and at least one factor of production is fixed
Long-run: prices of resources are changing, as are the factors of production
...

 SRAS shift left or right if changes in firms’
costs, e
...
wage rates etc
 Sudden decrease is AS could arise from a
supply-side shock such as a natural disaster or
war

Only use SRAS to show cost-push inflation
...
Reflects the quality and quantity of the four
factors of production
...
New Classical (Monetarist School)

 Perfectly inelastic
 If AD shifts right, only P level changes
 Economy always running at full capacity
(long-run)

Theory:






In long-run, economy operate at maximum capacity
All resources fully employed in long-run
LRAS vertical as markets always clear
Economy always converge on an equilibrium level of unemployment (natural rate of
unemployment)
...


2
...

 When curve sloped upwards, supply bottlenecks,
causing increases in costs
...


Theory:





No guarantee of maximum output in long-run
Economy can operate below full employment
Markets don’t always clear, they fail
...
g
...
g
...

 Likely to occur in recovery or times when demand
rising rapidly
 Consumer spending increase
 One person’s spending = another’s income
 Investment may increase, shifting AD
N
...


𝟏

The Value of the Multiplier, K = 𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑷𝒓𝒐𝒑𝒆𝒏𝒔𝒊𝒕𝒚 𝒕𝒐 𝑾𝒊𝒕𝒉𝒅𝒓𝒂𝒘
MPW= MPS + MPT + MPI (i
...
Marginal Propensity to ‘Leak’)

Government Policies
Government policy is used to achieve the macroeconomic objectives
...

Monetary Policy: the manipulation of interest rates, the money supply and exchange rates to
influence AD in the economy
...
E
...

increase consumer spending
...

Economic Stability: the absence of volatility in unemployment, inflation, the current account and
economic growth in order to reduce uncertainty in the markets and promote consumer and business
confidence
...
g
...
g
...
Fiscal Policy





Demand side policy
Outlines by chancellor in annual budget
Budget deficit (government spending > taxation revenue), surplus, or balanced
The National Debt: the accumulation of all the annual budget deficits added together

The Fiscal Position
The fiscal position is the balance between
government spending and taxation
...

When +ve: Budget deficit
When -ve: Budget surplus

Government Spending:





Capital Expenditure: e
...
building schools, roads, hospitals etc
Current Spending: Running of public services
Transfer Payments: taxing rich, welfare to poor
Debt Interest Payments: paying interest to those who hold government debt

Taxation





Direct: a tax placed on the income of consumers and businesses
...
g
...
g
...
g
...
E
...

18%
...

Reflationary: aka expansionary: increase AD
Deflationary: aka Contractionary: decrease AD

PSNCR: the divergence between taxation and borrowing- represents the sum that the government
must borrow
...

N
...

Cyclical Budget Deficit: A deficit that changes in size in response to the economic cycle
...

The government getting it wrong:



E
...
in the run-up to an election: promise lots of spending and low taxes
Crowding out: when government spending fails to increase overall AD because higher
government spending causes an equivalent fall in private sector spending and investment
...
e
...

Increased interest rates leads to a reduction in private sector investment such that it
dampens the initial increase in total investment spending
...
This makes it harder for private individuals to borrow
...

Good Fiscal Policy:




Credibility: government’s commitment trusted
Flexibility: flexibility to deal with macroeconomic shocks
Legitimacy: widespread support and agreement that right thing to do



For euro members: Meet criteria of Stability and Growth Pact: agreement by members of
EU about the way in which fiscal policy should be conducted to support the single currencybudget deficit <3% of GDP, debt <60% of GDP

The Laffer Curve:
 T* max tax revenue
 Past T*- too much tax, low
spending, low output,
redundancies, disincentive to
work

Fiscal Policy: Pros v Cons
Pros





Can be targeted to specific areas
...
g
...

Has the potential to have a significant
impact
Multiplier effect? Value of K

Cons










Time lags
Can create disincentive effects
...
g
...

Can be inflexible with yearly budget
...
g
...

Can have unintended influences on
other objectives
...

Requires accurate estimations of:
multiplier, spare capacity, trend
economic growth rate
Can easily be influenced by politics
Needs government to maintain ‘goal
posts’ and not engage in “creative fiscal
accounting” e
...
changing way growth
is measured

Conclusions for Fiscal Policy:




Confidence levels in economy
Quality of information
How other policies being used (monetary must be reflationary if fiscal is)

2
...

In 1980s, government controlled money supply but not successful
...

Today, interest rates main short-term management of inflation
...

However, cheaper to borrow and may just buy more imports
...

A narrow definition of Money (M0) includes the stock of notes and coins in circulation and
commercial deposits at the B of E
A broader definition of Money (M4) is M0 + Sterling Wholesale: includes more than just the
physical money (such as currency and coins) but generally includes the deposits at
commercial banks and any money held in non-accessible accounts
...

Liquidity is the ease at which money can be spent
...

2
...

4
...


Gilts and the Money Supply



Gilts (Gilt-Edged Securities) are government bonds issued by the HM treasury on behalf of
the HM treasury on behalf of the British government
...







Nominal value: money paid back by government when the gilt matures
Face Value: the price at which the gilt is traded on the open market
Coupon: Return on the nominal value
Yield: interest rate on a gilt based on its buying price rather than its nominal value
𝑪𝒐𝒖𝒑𝒐𝒏

Yield = 𝑭𝒂𝒄𝒆 𝑽𝒂𝒍𝒖𝒆 𝑿 𝟏𝟎𝟎
Reduce Money Supply: Buy gilts, decreasing money supply for private banks to lend,
increase face value of gilts- decrease yield
Monetary Policy and the Exchange Rate


To manipulate the value of its currency, gov or central bank will need to influence D & S of
the currency
...
The primary goal is to achieve low, stable inflation by manipulating the
purchasing power of money
...
g
...
E
...
countries with high inflation- deviations below less important than above
...
Symmetry
allows for this, without symmetry may
be bias

Cons




Is it credible? B of E must have
reputation for meeting target
Must be good at forecasting inflation
Does not account for unforeseen
events

Interest Rates as a Monetary Policy Tool: Pros v Cons
Pros



Can be powerful at reducing inflation
Sig impact on 3 components of AD: C, I,
(X-M)

Cons






Conclusions for Interest Rates as a Monetary Policy Tool:


Other policies

Liquidity trap (use Quantitative Easing
to reverse)
Adverse side-effects
MPC restricted by foreign interest rates
Effects of interest rates not felt by
everyone
Estimated time lag of 18 months





Quality of info
Confidence levels
Spare capacity

Problems with Monetary Policy:






D side policy so can have conflicting effects on different objectives
Requires accurate estimations of the size of the multiplier, current inflation and future
inflation
...

Two main approaches:
1
...
Interventionist Approach: Favoured by Keynesians, increase productive potential through
gov intervention in markets to improve their performance
...

Based on international specialisation
Exchange market for currencies

Why Trade?





Cheaper prices
More choice
Quality
Export-led economic growth





Firms benefit from economies of scale
Greater political links between economies
Can create specialisation

Gains from Trade:


More choice, quality, prices, export led eco growth… (see above)

Weaknesses of International Trade:





Lower domestic output
Fall in domestic producer surplus
Rise in cyclical unemployment/structural if long term uncompetitive
Current account position may weaken

The Heckscher-Ohlin Theory:




The relative amounts of different factors of production within countries can explain the
difference in costs of production between countries, and therefore which goods they should
export
...
Trade takes place
where Domestic Demand = Domestic Supply
An open economy engages in international trade with foreign economies
...

 When economy open, world
supply floods the market with
cheaper prices
...

 Q2-Q3: Imports
 Tariff: an indirect and
regressive tax on imports
...

Domestic Demand falls, and domestic supply rises again
...

Methods:







Tariffs
Quotas
Exchange rate controls
Embargo
Set high-quality standards
Export subsidies

Protectionism: Pros (reasons) v Cons
Pros (Reasons)
 Reduce trade deficit
 Protect infant industries
 Prevent ‘dumping’ of products

Cons



Deadweight welfare loss
Retaliatory protectionist policies from
trading partners




Protect domestic jobs
Prevent negative externalities





Cost-push inflation
Inefficiency created/protected
Market failure (consumers directed
away from most efficient supplier)

Conclusions for Protectionism:





Severity of tariff/policy
Economies reliance on imports
What goods/services tariff/quota placed on
Economy using it (developing may be justified)

International Specialisation
International specialisation is where goods are produced in the countries that have the highest
quality products or can produce with the lowest cost
...

With international specialisation, global output should increase
...


Comparative Advantage
Comparative advantage refers to the ability of a country to produce a particular good at a lower
opportunity cost than another country
...

Tariffs on imports from all non-member states: common external tariff
...


Main EU policies:
1
...
Regional Fund: a fund to support weaker members
3
...
g
...



1995: agreed on name EURO
1998: European Central Bank (ECB) set up
1999: Exchange rate frozen
2002: notes and coins issued

Convergence Criteria:
1
...
Gov debt must not exceed 60% of GDP
3
...
5%
4
...
Stable exchange rate
UK Government’s Criteria for EURO:
1
...

3
...

5
...

Stages of Eco integration:
1
...
Trade Deflection: imports enter FTA through
border with lowest tariff and then re-exported around union
...
Customs Union
o FTA members remove tariffs and quotas between themselves
o Agree on a common external tariff: same tariff to non-members that applies across
borders of all countries
o Trade still not free
o May still be non-tariff barriers, e
...
product standards
3
...
g
...
Economic Union
o One official step-up from single market
o Same approach to fiscal policy: taxation rates unified
5
...
g
...
g
...
g
...

Liberalisation: reductions in the barriers to international trade in order to allow access to
the market for goods and services that traded intl
...

2/3 of world trade accounted for by world’s richest economies: suggests inequalities in the
distribution of the gains of trade identified by the theory of comparative advantage
Developing economies benefiting from rising share of intl trade over last 30yrs due to
exploitation of liberalisation of trade and comparative advantage

Economic Integration: Pros v Cons
Pros


Reduction in monopoly power: erodes
market power and increases choice

Cons



Trade diversion
‘Core-Periphery Problem’: investment
may flock to certain areas leaving
significant regional and structural




Greater innovation and R and D:
competition drives non-price
competition and dynamic efficiency
Larger marker= economies of scale:
firms can employ from wider skills
base, more sales
Over time intl specialisation may have
cost adv: specialist suppliers, skilled
labour concentration



unemployment- may be necessary to
have a common regional policy
Emergence of monopolies and
Oligopolies- global market power

International Specialisation
Intl specialisation: goods are produced in the countries that have the highest quality resources or
can produce with the lowest cost- best use of scarce resources
...
Unit cost advantage arises because it uses fewer resources to produce than other
countries
...


Comparative Advantage
Comparative Advantage: where one country produces a product with a lower relative opportunity
cost than another
...

Sources of Comparative Advantage:









Quality and quantity of natural resources
Demographics- ageing population, education, female participation
Rates of capital investment including infrastructure: reduce trade costs and increase supply
capacity
Increasing returns to scale and division of labour: increasing returns to scale is where output
grows more than proportionately to the inputs used
...
g
...
Can be
determined by geography, historical legacy, and economic and social development
Factor intensities: the balance between land, labour and capital required in the production
of a good or service
Labour intensive production: any production process that involves a large amount of labour
relative to other factors of prod
...
Intl trade can lead to changes in
behaviour over a period of time that can increase productive and allocative efficiency
...

Productive efficiency: if the costs of production have been minimised by economising in the
use of real resources
...

Economic efficiency: occurs when a production process is both productively and allocatively
efficient- pareto optimality achieved
...

Does economic integration play a more important role in who a country trades with?- world
divided into trading blocs
Does not explain why rich countries mainly trade with other rich countries- trade should
take place where relative opportunity costs are widest
With exception of transition economies- countries appear to trade within own group rather
than countries whose income level different
...

𝐼𝑛𝑑𝑒𝑥 𝑜𝑓 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑒𝑥𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒𝑠

Measured using the formula: 𝐼𝑛𝑑𝑒𝑥 𝑜𝑓 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑚𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒𝑠 𝑋 100%
If export prices rising faster than import- less exports to buy imports= improvement in terms of trade
(as opposed to a deterioration)
What do countries trade?




Primary commodities: goods produced in primary sector e
...
oil, wood
Secondary commodities: manufactured products
Tertiary commodities: service products e
...
financial services

The Prebisch-Singer Hypothesis: argument that countries exporting primary commodities will face
deteriorating terms of trade in the long-run which will trap them in a low level of development as
more and more exports will need to be sold to ‘pay for’ volume of imported secondary goods or
capital
...
It is a process by which a country
improves the economic, political and social well-being of its people
...
35 per day
Relative: income less than 50% of median income

Tackling Poverty: catch 22 situation
Growth for poverty or reduce poverty for growth

Measuring Development Success:
1
...
Human Development Index (HDI)
Developed by the United Nations Development Programme
Early attempt to produce a measure that combined some of the outcomes that might be values
when measuring development
Works by:



Three components- ranked in range 0-1 and averaged to give HDI figure

Components:




Life Expectancy at Birth: health and longevity of population
Adult Literacy Rate (2/3) and % of population enrolled in primary, secondary and tertiary
ducation (1/3)- indicator of knowledge and education
GDP per Capita: in $ at PPP as indicator of standard of living

Ranks:
More than 0
...
5-0
...
5

High development
Medium human development
Low human development

HDI: Pros v Cons
Pros


Successfully focuses on outcomes of
development rather than eco growth
Stimulated debate about policy
choices- countries may have similar
GDP but differing HDI
Allows judgements to be made over
time
Allows better allocation of intl help:
may not have low GDP but low HDI

Cons


Only focus on 3 aspects of
development- not complete picture
(but adding more may weaken value of

composite indicator)
 No economic/social justification of
three indicators/weights- different

weights=different figure

Opportunity cost: low HDI encourages

resource allocation to three
components, but what cost
 Not consider quality of two noneconomic measures of development
HDI is only an indicator: Must not be taken too literally or in isolation

3
...

The GINI Coefficient is a measure of the
degree of inequality in a country
𝑨

GINI Coeff=𝑨+𝑩
Lower is better

Issues with the measurement:


Absolute income per household misleading- use equivalence scales (judge against reference
household)- get true figure
Income may not be best indicator of inequality- people smooth consumption over time
...
Human Wellbeing (Happiness)
Does economic growth lead to happiness?
Yes

No







More income= more wants satisfied
Technological improvements- life easy
Greater wealth and disposable income
Better public services
Better infrastructure
Improved leisure time (e
...
abroad
holidays)







Work-life stress
Environmental degradation
Inequality
Congestion
Overconsumption of demerit goodsmarket fail

The Easterlin Paradox: happiness and income appear to be correlated, happiness not always
increase with income
Office of National Statistics publishes national well-being measures in spring and autumn every
year
...
Genuine Progress Indicator:
GPI is used to measure the economic growth of a country, as opposed to GDP
...
g
...
The Brundtland Commission “meet the needs of the current generation without
compromising the ability of future generations to meet own needs”
Future generations need stock of capital atleast as equal to capital used by this generation
Capital stock: includes man-made capital, natural capital and human capital
GPI better than GDP because:


GDP counts all expenditure as positive- including defensive expenditure

Defensive Expenditure: expenditure on offsetting costs, not increasing welfare- no net increase in
welfare
The Index of Sustainable Economic Welfare:









Total personal consumption (+ve)- value consumers place on consumed goods/services
Defensive expenditures (-ve): spending to maintain/restore wellbeing
Losses from Income inequality (-ve): assumed an increase in income equally beneficial to all
Environmental degradation (-ve): monetary costs of air and water pollution and global
warming
Depreciation of natural capital (-ve): loss of biological resources such as wetlands and
farmlands
Increases in man-made capital stock (+ve): spending on machinery/capital
Value of domestic labour (+ve): work done in households- valued at market rates
Non-defensive expenditure (+ve): state spending that not defensive

THE END RESULT: figure for GDP adjusted for a range of costs/benefits of production and
consumption not included in GDP
...

Limitations of GPI:




Lack of agreement on choice of adjustments that made to GDP- include crime rates etc?
Weighting cannot be determines objectively
Difficulties of placing monetary values on some of the components- shadow pricing

Characteristic of developing countries:







Low living standards
Low labour productivity
High population growth
Economy dominated by primary sector
High degree of market failure
Lack of economic power in intl markets

Constraints on Development










The resource curse: primary sector dominates because of factor endownments- low gain
enterprises
Trade and development trap: comparative adv in primary commodities (preb-sing)
Low savings: little funds for investment, Harrod Domar
Poor financial markets: savings are abroad (rich elites) or not channelled into secondary
sector
Market failures: poor infrastructure, financial markets etc – misallocation of resources
Inequality: wealth, land, income
Poor governments
Inability to access intl markets (regional trading blocs)
High levels of debt

Development Aid
Types of Aid:







Bilateral aid: one country to another
Multilateral: international organisations receive money from several countries give aid
Emergency/short-term aid: aka food aid or medical aid
Grants: no repayment required
Loans: repayment required- but to be aid must be ‘soft’ and not at market rates
Tied aid: given in return for purchase of donor country’s exports

Policies to promote development:







1
...
7% of GDP
Nations not meet targets and want to give to countries that use aid best- not always lowest GNI
If aid used for specific purpose, only useful if project useful
Must not damage incentives for locals
Must be careful not to cause Dutch disease






2
...
Export Promotion
Number of countries following ISI approach, number switched to export promotion: South
Korea, Singapore, Hong Kong, Taiwan (High Performing Asian Economies HPAE)
Focused on developing a comparative advantage in goods to export to developed world
Focused gov investment on strategic industries that always exposed to intl competition
Protectionism did play role, but quickly removed
Entrepreneurs adapted and dynamic efficiencies developed
At same time, heavy investment in education

Drawbacks:









Does not provide blueprint- many countries following same policies not grown
Success not due to single policy- some argue success due to macroeconomic climate, and
saving equally as important
Danger that HPAE become dependent on growth of developed nations
May encourage competitive devaluations in currency
HPAE losing comparative adv to countries like China and India

4
...
g
...
g
...
Washington Consensus
Given to developing economies by World Bank, IMF, US treasury department
Many developing countries had not option but to follow prescriptions
Policy prescription 1: Fiscal discipline





Keep balanced budget
Direct spending to healthcare, education, infrastructure
Widen tax base and lower marginal rates of tax
Market determined interest rates

Policy prescription 2: Market liberalisation and Privatisation




Privatise state owned
Deregulate markets and remove entry barriers to promote competition
Legally supported property rights

Policy prescription 3: Trade Liberalisation and Encourage FDI




Liberalise trade, remove tariffs and non-tariffs
Remove barriers to, and restrictions on, FDI
Competitive exchange rates

Arguments in Support
 Success in reducing inflation
 Promoted stable macroeconomic
climate
 Promoted FDI
 High rates of growth
 Jobs created by MNCs
 Reduction in debt

Criticisms
 Increased poverty as end price controls,
subsidies
 Malnutrition as liberalisation raised
prices
 Domestic food producers replaced with
imports from USA (agriculture heavily
subsidised)
 Rush to earn export revenue from ‘cash
crops’ dropped price- Prebisch singer
 Fiscal discipline achieved by cuts on
education, healthcare, infrastructure

Joseph Stiglitz: Washington Consensus focused on wrong problem
...
The World Bank
Created at the 1944 Bretton Woods conference
Mission:



Provide financial support for internal investment projects e
...
building roads
Official goal is reduction of poverty- promoted FDI and trade

Millennium Development Goals:









Eradicate extreme poverty and hunger
Achieve universal primary education
Promote gender equality
Reduce child mortality
Improve maternal health
Combat HIV/AIDS and other diseases
Ensure environmental sustainability
Develop global partnership for development

World bank has had considerable impact in assisting world’s poorest countries
Criticisms:




US/Western dominated- criticised for furthering own economic interests
Favours free-market reforms- policies can be harmful if implemented badly/too quickly
(Stiglitz)
Arguably promotes world inflation

2
...
Countries contribute funds to a pool
and can borrow if in need

IMF operates with a conditionality of loans: conditions/policies needed in exchange for loans
Criticisms:





Developed countries more dominant role
Favours military dictatorships who friendly towards west E
...
Castello Branco 1960s
Concerns over offering support to countries with poor human rights
Works on assumption all B of P disequilibria caused domestically- e
...
deteriorating terms of
trade

3
...
World Economic Forum
Founded in 1971
Non-profit organisation
Members: 1000 of world’s top organisations
Mission:



Improve state of world trade through pub and priv sector cooperation
Encourage sustainability

WEF’s Index of Competitiveness (attempts to measure quality of life, 144 countries measured
against 12 pillars):
1
...

3
...

5
...

7
...

9
...

11
...


Quality of institutions
Quality of infrastructure
Stable macro environment
Health and primary education
Higher education and training
Goods market efficiency
Labour market efficiency
Financial market development
Technological readiness
Market size
Business sophistication
Innovation

Globalisation
Globalisation is the processes that have resulted in ever-closer links between the world’s
economies, resulting in greater interconnectivity between nations
Countries become more interdependent
Globalisation is a 50yo phenomenon
Globalisation is indicated by:





A good can be produced anywhere
Raw materials can be sourced from anywhere
Products sold anywhere
Profits sent anywhere

Globalisation is manifest in:



Global brands- same brand with standardised products
Global Sourcing- global companies source operations through worldwide production

Factors promoting Globalisation:


Reduction in protection (WTO)- not system of multi-lateral trade now, regional trading blocs
dominate
Reduction in intl capital movements- lower exchange control, allow FDI flows
Development in IT and falling communication costs- global supply chains can now be
managed in a very effective way
Fall in real transport costs- e
...
sea- allows economies of scale and efficiency
Liberalisation of domestic markets- more positive and receptive to FDI and partnerships with
MNCs
...
Through activities, MNCs
provide FDI to economies in which they operate
...
g
...
Influenced by gov policy
Loans: to residents at commercial rates
Foreign aid: loans at favourable rates, grants (for many countries net outflow- interest)
Remittances: pay sent home to country from workers working abroad






Globalisation: Pros v Cons
Pros








Free trade- lower prices, trade creation,
cheap and best factors of production
Free movement of labour- firms can
find best labour/specialised labour,
workers can increase standard of living
and find employment
Economies of scale
Increase competition- efficiencies
Increased FDI in developing countries
Increase development (HDI)- FDI,
remittances etc

Cons






Free trade can harm developing
economies- premature exposure to
competition
Negative externalities
Labour drain- LRAS shift left
Tax avoidance and tax competitiongovernment compete with each other
to attract MNCs, gov fail to collect tax
Deindustrialisation- developed lose out
to cheap factors of production abroad

The Financial Sector
Bartering: swapping one commodity for another- double coincidence of wants needed
Functions of Money:



Medium of exchange
Store of value




Unit of account
Means of deferred payment

Features of Money:







Portability
Divisibility
Acceptability
Scarcity
Durability
Stability in value

Liquidity preference theory: suggests people desire to hold money as an asset
...
Monetary authorities must maintain
equilibrium, cannot set MS and ir independently

The Market for Loanable Funds

amount of saving determines amount of
loanable funds available for investment

as interest rate rises, savings rise and
loanable funds increase (demand for loanable
funds falls as well)

as interest rate fall, savings fall and loanable
funds fall

Quantity Theory of Money
The quantity theory of money is the hypothesis that: changes in prices correspond to changes in the
monetary supply
...

Money stock (m) is amount of notes and coins in circulation
Velocity of exchange (v) is rate at which money changes hands
V=

𝑉𝑜𝑙𝑢𝑚𝑒 𝑜𝑓 𝑡𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛𝑠
𝑚

=

𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 (𝑌) 𝑋 𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 (𝑃)
𝑚
𝑌𝑃

Fisher’s equation of exchange: V=

𝑚

Therefore, MV=PY
From a classical point of view, V would be stable in the LR, real output would tend towards natural
rate (Y)
...


Prices can only increase if the money stock increases
This may occur because of:





falling interest rates
more purchasing power
AD increases
P increases (as always on full capacity in LR)

The Financial Crises:
Great Depression:





1930s monetarist view dominant
Argued that gov should wait for labour market to adjust
But deflation occurred
Keynes’ general theory argued that depression would have ended sooner with adequate gov
spending

The Financial Crisis:







Deregulation- banking sector able to engage in hedge fund trading with derivatives
increasing demand for mortgages
...

Retail banks: banks that provide high-street services
Wholesale banks: banks that deal with companies and other banks on a large scale
Universal banks: banks that are both wholesale and retail
Liquidity ratio: ratio of liquid assets to total assets
...
Sell financial
assets to anther bank (or central bank) and agree to buy back at later date
...
Shareholders become part-owners of the firm and receive
dividends (share of profits)
Bonds: issues by governments in need of finance
...

Certificates of deposits (CDs): issues by banks to individuals/businesses for a fixed term
...
CDs can be sold on the open market between individuals
and firms
...
g
...
If this is
low, banks have leant large amounts of cash or engaged in risky securitisation,

The Financial Sector for Developing Economies
Rise in savings triggers eco growth (more money to lend to entrepreneurs)
However: banks might invest overseas, or interest rate too high for lending to individuals,

Short-term capital acquisitions: increase FDI and import capital
Foreign Exchange gap: lacking in foreign currency reserves
...

Microfinance:






Market failure in developing economies
Loans cannot be accessed
Property rights not secure so cannot act as collateral
People turn to informal markets- interest rate high and mitigates profit
Microfinance: exists in credit markets in developing economies
...
It provides small business loans in a manner
that is consistent with ethical lending practices
...
Every time period
add money to pool enabling one person to buy product each time period
...

Lottery is used to decide who gets to buy the product each time period
Everyone pays in until everyone has product- all pay same amount each time period and in
total
Prevents borrowing from exploitative informal lenders
Size of admin costs small, but may make scheme unprofitable
Relies on trust
Not as good as Grameen bank

The Central Bank
The central bank is the banker to the government of an economy
Objective: to achieve monetary and fiscal stability, to support gov’s policy vision

Type
Government Controlled

Pros



Cons
Work more closely with policy

Gov can focus banks obj on

macro obj




Independent




Likely to have short-term
view
Prefers low interest rates to
lower cost of government
borrowing
Influenced by political
ideology

Political separate- no
damaging influence
More stability in economy
Preferred by eco agents and
commercial banks

Roles of the central bank:







Monetary stability: stability in price level, inflation targeting
Financial stability: confidence in financial institutions and efficient flow of funds in eco
Issuing notes and coins: B of E prints for England and Wales exclusively
Manage exchange rate: B of E manages foreign currency reserves and gold- rare for
intervention as £ freely-floating
Banker to government- tax revenue, spending, borrowing handled by B of E (and Treasury)
...

Market maker of last resort: describes exceptional market intervention by a central bank
...


Lender of Last Resort: Pros v Cons (Should a central bank bail out a commercial bank)
Pros (yes)

Cons (no)











Prevents run on the banks: seeing one bank fail
may encourage this
...
Lasting banks
may become overcautious
...

May be handled by gov or NGO
Micro prudential regulation: a firm level oversight or financial regulation by regulators of financial
institutions, “ensuring the balance sheets of individual institutions are robust to shocks”
Macroprudential regulation: approach to financial regulation that aims to mitigate risk to financial
system as a whole (or systemic risk)
...
Financial Policy Committee (FPC)
Identifies, maintains and takes action to reduce systemic risks with view of protecting and enhancing
resilience of Uk financial system
...
Prudential Regulation Authority (PRA)
Regulates and supervises around 1500 banks, building societies, credit unions, insurers and major
investment firms
Goals:




Promote soundness and safety of firms it regulates
Contribute to seeking protection for insurance policyholders
Secondary obj to facilitate effective competition between firms

“Any firm that fails does so n a way that avoids significant disruption to critical financial services

---