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UNIT 1: TRADE AND GLOBALISATION
An absolute advantage exists when one country can produce a good using fewer resources than
another country
...

A comparative advantage exists when a country can produce a good at a lower opportunity cost
than another country
...
This provides the basis for
specialisation and exchange between individuals and firms, and it is central to the explanation of
why countries trade and the process of globalisation
...

For example, two countries, New Zealand and UK can produce either cars or butter as shown below:
UK
New Zealand
Total

Cars
200
600
800

Butter (tonnes)
100
200
300

This table shows the number of cars and tonnes of butter that can be produced by each country
when they devote half of their resources to each commodity
...


UK
New Zealand

1 car
½ tonne of butter
3 tonnes of butter

1 tonne of butter
2 cars
1/3 a car

Here, we see that the UK has a comparative advantage in the production of cars because the
opportunity cost of producing one car is only half a tonne of butter whereas New Zealand will need
to give up 3 tonnes of butter to produce one car
...

According to the theory of comparative advantage, whichever country has the lower opportunity
cost of production should specialise in that product and then both countries should trade with each
other
...
The exchange rate is determined by the opportunity cost of production in each
country and would have to lie between the opportunity cost ratios of production for both countries
...
Therefore, the UK would expect to receive at least half a tonne of butter for each car given
to New Zealand
...
Therefore, New Zealand would expect to pay no more than 3 tonnes of
butter for each car receives from the UK
...

The same calculation would apply to butter to decide on a mutually beneficial exchange rate
...

Ø Transport costs reduce advantages of specialisation and trade particularly in the case of
low-price bulky goods, yet they are ignored
...
Some types of land can only be used
for specific purposes, some equipment might not be adaptable elsewhere and labour may
be occupationally or geographically immobile
...

Ø The assumption that full employment of all factors of production is unrealistic
...

Ø Constant returns to scale are assumed; however, some countries will enjoy economies of
scale that others won’t while some countries will suffer from diseconomies of scale that
others won’t
...

Ø The theory assumes perfectly free trade, but the presence of import restrictions reduces
specialisation
...

Ø If countries specialise in goods, there is a danger that demand for these goods will fall,
leading to mass unemployment
...
In the markets for these
non-homogenous products, consumer decisions are based not just on price but also on factors
like brand image, design, reliability, performance and availability
...

• There are also political and strategic motives for some trade
...

However,
• Some of the assumptions of the theory are only used to create a workable model; they do not
destroy its ability to illustrate an essential economic truth
...

• Comparative advantage is a dynamic concept as countries can gain or lose comparative
advantage over time
...
g
...

• The theory tends to provide a good explanation for the pattern of trade in basic homogenous
commodities and between more economically developed countries and less economically
developed countries, where different resource endowments and comparative costs of
production are the key factors
...


2

Benefits of Free Trade
For consumers:
• Enhancement of consumer choice: Consumers gain access to increased ranges of products with
free trade
...

• Consumers can access goods that could not otherwise be produced by domestic firms e
...

because of free trade within the EU, UK consumers have access to bananas which cannot be
grown in the UK because of the climate
...
Domestic producers are also incentivised to sell at relatively lower prices,
thus increasing consumer surplus
...

For producers:
• Access to a large market size: With free trade, producers can access the global market, opening
immense opportunities to increase revenue and profits
...
These lead to lower average costs of production and can be
passed on to consumers in the form of lower prices, increasing quantity demanded for their
goods
...

For employment:
• Larger market for producers will allow firms to expand, creating job opportunities
...

For inflation:
• There is a relatively low risk of cost-push inflation as firms will have access to cheaper raw
materials from abroad
...

For economic growth:
• Free trade encourages countries to specialise in products in which they have a cost advantage
...
GDP will most likely increase
...
This will increase net exports- X-M, in turn,
increasing Aggregate Demand and leading to economic growth
...
Free trade
can reduce the need for subsidies, allowing funds to be put to better use
...

3

Costs of Free Trade
For producers:
• Too much competition: Domestic producers may be unable to compete with producers in
foreign countries who have great cost advantages over them e
...
natural resources, climate
...

• Risk of theft of intellectual property: Many developing countries don't have laws to protect
patents, inventions and new processes and where there are, enforcement is poor
...

For employment:
• Reducing tariffs on imports allows companies to expand to other countries
...
This makes it difficult for domestic
producers in those same industries to compete, so they may reduce their workforce
...

These small family farms can't compete with subsidized agri-businesses in the developed
countries
...

For economic growth:
• If a country’s domestic firms cannot produce at costs low enough or the exchange rate is too
high, it’s exports will not be competitive abroad and this might run domestic firms out of
business as consumers demand more imports
...
It could also lead to a current account deficit as imports outweigh exports;
stumping economic growth
...

For the balance of payments:
• If foreign producers are too competitive for domestic producers to effectively compete, then
imports will far outweigh exports, leading to a current account deficit and a non-satisfactory
balance of payments
...
It currently has 164 members that are signed up to the mission statement
...
Non-discriminatory- Countries are not allowed to be informal or selective with free trade
...
Free from trade barriers- as few protectionism measures as possible
...
Predictable- enabling individual countries to foster economies where investment decisions can
take place, jobs can be created well, and businesses can flourish
...
Promoting fair competition- In some cases, this might mean protectionist measures to allow the
development of infant industries
...

5
...

Roles of the WTO (in relation to trade liberalisation):
• To set and enforce rules on international trade- countries that disobey rules can be punished
through fines or any other means
...


4

• To provide a forum for negotiating trade liberalisation- The WTO organizes large international
rounds of trade negotiations and creates an avenue for individual countries to discuss and agree
on trade policy
...

• To increase the transparency of the decision-making process- Countries know how rules are
negotiated and decided and can object to whatever they find unfair in the process
...

• To create regulation that helps developing countries fully benefit from global trade
...

Foreign Direct Investment (FDI)
Defined by the world bank as the net inflows of investment to acquire a lasting management
interest (10% or more of voting stock) in an enterprise operating in an economy other than that of
the investor
...

In simpler terms, it is the net international transfer of funds to purchase and acquire physical capital
like factories and machines, e
...
Nissan, a Japanese firm, building a car factory in the UK
...

• Capital inflows can help finance a current account deficit
...

• Investment from abroad could lead to higher wages and improved working conditions, especially
if the multinational companies are conscious of their public image regarding working conditions
in developing economies
...

• Introduces more competition, encouraging efficiency and lower prices for consumers i
...
higher
consumer surplus
...


Globalisation
This is the process through which national economies have become increasingly integrated and
inter-dependent
...
The lower costs of shipping products around the global economy help to bring
prices in the country of manufacture closer to prices in the export market, making international
markets more contestable
...

• Economies of scale- Economists believe that the minimum efficient scale (MES) has increased in
some industries, making a domestic market regarded as too small to satisfy the selling needs of
these industries
...

• Changing tax systems- Corporations desire lower taxes and other favourable cost situations
abroad, encouraging countries to attract their tax systems to attract FDI
...
Non-tariff protectionist measures like import licencing and foreign
exchange controls have gradually been dismantled, increasing trade between countries
...
E
...

Transatlantic trade and investment partnership (TTIP) between the EU and the USA
...

Advantages of Globalisation- same as free trade
Disadvantages of Globalisation
1
...

2
...
This is a
major issue in developing countries
...
Environmental costs- Governments place economic growth ahead of every other thing, causing
increased pollution
...

4
...
If this avenue of growth slows down, the growth potential from
exports is reduced and there is a risk of protectionism and trade wars
...
Greater risk of external shocks- As countries become integrated and inter-dependent, if one
country goes down, other countries are heavily affected e
...
the great financial crisis- a banking
crisis that started in the US and spread to the rest of the world
...

• Tariffs (Import duty/Customs duty): These are taxes placed on imports and could be ad
valorem (as a percentage of value) or specific (as an amount per unit)
...
They increase producer surplus and the welfare
of manufacturers and workers, reduce consumer surplus and the welfare of consumers and raise
revenue for the government
...

• Quotas: This is a quantitative restriction on imports of allowed into a country, so that even if
consumers wish to buy them, they cannot because of the physical limit in place
...
Quotas restrict total supply to
the domestic market, thereby increasing the price to consumers
...
However, prices of protected products will also be
increased
...

• Subsidies: These are payments made by the government to domestic producers, making it
profitable for them to increase their quantity of supply
...

• Exchange rate manipulation: To restrict imports, a government may restrict the availability of
foreign currencies that domestic residents can use to purchase foreign goods and services
...


6

• Regulation: This is protectionism in the form of excessive bureaucracy, unnecessarily strict
health and safety regulations and/or customs checks, and government procurement policies that
favour domestic producers
...
The EU is especially notorious for
setting very high standards for goods imported; especially food, to protect the trading bloc
...

For producers:
• Infant industries are nurtured and protected from international competition, so they have a
chance to develop
...

• The decline of dying industries such as the textile industry is cushioned, and jobs protected
...
These goods may be sold in the export market at prices lower than they would normally
be sold domestically, due to advantages like government subsidies
...
In such cases, protectionism aids the macroeconomic
objective of low levels of unemployment
...
Thus, consistently, tariffs will aid economic growth
as GDP increases
...

Costs of Protectionism
For consumers: As free trade provides consumers with cheaper prices, protectionism will reverse
this, leading to a reduction in consumer surplus and general economic welfare of consumers
...

For producers: Infant industries run the risk of becoming over-dependent on trade barriers and
never learning to become fully efficient
...

For economic growth: Protectionism could anger other countries, leading to retaliation that may
involve a refusal to import from that country
...

For the balance of payments: A fall in exports could also lead to a current account deficit, affecting
the balance of payments
...
It measures the value of the flow of trade and services into and out of a
country, usually in a calendar year
...

•
•
•

Current account- goods and services
...

Trade in services: banking, insurance
Primary income: From investments- interest, profits, dividends, migrant remittances
...

• Secondary income (Transfers)- payments to the EU, foreign aid
...
Capital account- Capital transfers e
...
debt forgiveness, transfer of capital assets because of
immigration and emigration
...
Financial account
• Portfolio investment- including transactions in equity securities, such as common stock, and
debt securities, such as banknotes, bonds, and debentures
...


Causes of Current Account Deficits
Demand side causes (cyclical): High incomes at home
Low incomes abroad
Strong exchange rate
Supply side causes (structural): Persistently high relative inflation
High unit labour costs- Low productivity
High minimum wages
Strong trade unions
Poor investment
Loss of comparative advantage
Resource depletion
Inadequate research, development and innovation

Consequences of Current Account Deficits
1
...
A negative trade balance usually means a current account deficit which means X-M (net
exports) is negative, causing AD to fall
...

2
...
As debt increases, confidence will be lost in the country’s abilities to pay the debt back
...
This will then cause supply of the pound to increase as more people move
their money out of the economy and sell the currency
...
This could lead to an overall economic crisis
...
The problem occurs when the current account deficit balloons out of
proportion and becomes a large percentage of the GDP
...
)
3
...
In theory, this could
potentially correct a current account deficit, as exports become cheaper and more attractive to
buyers around the world
...
In this case, cheaper exports do not guarantee an increase in demand
for exports
...
An
occurrence of stagflation would clash greatly with the macroeconomic objective of a 2% target
inflation rate and low unemployment rate
...
Unemployment- A current account deficit refers to when the volume of imports > volume of
exports
...
This will lead to unemployment rising due to lack of demand for domestic goods
...
Exchange rate changes: A currency devaluation is likely to increase exports and reduce imports if
a country as exports will be cheaper to foreigners and imports will be more expensive for
domestic buyers
...
(However, if the Marshall Lerner
condition doesn’t hold, this would worsen the current account deficit) In the short term, there
may be a deterioration in the current account because of the J curve effect, but the current
account should improve in the long run
...
Also, it will succeed if the resulting cost-push inflation is low
...
This policy, on a negative side,
could lead to retaliation by other countries, causing a currency war
...
Deflationary policies: Aimed at aggregate demand in the economy, e
...
by raising interest rates
or increasing taxes
...
Equally, firms will cut back on investment including purchases of imported capital
equipment
...
Deflationary policies will be more effective if the marginal
propensity to import is high
...

The higher the fall in imports for every £1 fall in income, the greater the improvement on the
current account will be
...
A fall in the rate of inflation relative to other countries will give exports
a competitive edge in the global market
...
Supply-side policies: Aimed at reducing unit labour costs, increasing investment, increasing the
skills in the labour force and improving the quality and design of products to increase exports
and reduce imports
...
Unlike currency
9

devaluation or deflating the economy that can affect the current account within a few years,
supply-side policies often take decades to improve the competitiveness of an economy
...

4
...
Tariffs and quotas can both have a significant impact in the short term
...
Also, protectionism isn’t much favoured by economists as the country is likely to
become less internationally competitive in the long run as domestic industries have no incentive
to improve their efficiency and protectionism in one country incites retaliation from its trading
partners, causing a loss of exports
...

5
...
Many countries today have currency controls including
Pakistan, Russia and Venezuela in 2015
...
In theory, tighter
currency controls will lead to a lower level of imports
...

6
...
This is only a short-term measure
and the deficit may appear again
...

• A fall in interest rates increases money supply, increases consumption and investment,
therefore, economic growth rises
...

• A fall in government spend and an increase in taxation reduces demand for imports, reduces
inflation, reduces the price of exports, fall in economic growth, rise in unemployment
...

Contractionary monetary policy- reducing the supply of money in the economy e
...
by raising
interest rates
...
g
...

However, there is a conflict of objectives
...

Also, consumer and business confidence could be so high that aggregate demand does not
significantly fall even when interest rates and tax rates go up
...

10

Expenditure-switching policies
• To change the relative prices of exports and imports
...
g
...

• Weaker exchange rate- lower interest rates, higher money supply, sell domestic currency
reserves
...

• Cause of the current account deficit- some causes require specific policies
...

• Time lags/monetary cost/ opportunity cost
...
Sometimes nations share a common currency e
...
the
Eurozone
...
The market in
which people or firms use one currency to purchase another currency is called the foreign exchange
market
...
g
...
50
...

Fixed exchange rates
A fixed exchange rate system is one where a currency has a fixed value against another currency or
commodity e
...
the gold standard which operated in the 19th and early 20th centuries
...
257 ounces of gold and holders of pounds could exchange them for gold at
that rate
...

• Interest Rates- Increasing domestic interest rates is likely to increase the value of the currency as
investment becomes more attractive
...
Hence the
demand for pounds will increase, shown by a shift to the right of the demand curve, whilst the
supply decreases, shown by a shift to the left of the supply curve
...

• Use of Gold and Foreign Currency Reserves- Central banks hold gold and foreign currency reserves
to alter the value of a currency
...
This would increase the
demand for pounds and hence raise its price
...


11

Advantages of Fixed Exchange Rates
1 Removes uncertainty associated with fluctuating prices - good for trade and investment
...
The country
cannot rely on a fall in exchange rate to regain competitiveness lost through inflation
...

Disadvantages of Fixed Exchange Rates
1 Countries must hold large supplies of their own currency, gold and foreign currencies to support
their currency
...
g
...
Governments must have a list of priorities for its spending plans
...
The
country may have to impose barriers to trade
...
This can be
costly and even futile
...

Floating Exchange Rates
A floating exchange rate system is one where the value of a currency is determined by the forces of
demand and supply on the foreign exchange markets and can fluctuate freely without any
government intervention
...

• People wishing to invest in the UK due to a high interest rate or confidence in the UK economy
...

• Foreign Direct Investors wishing to invest in the UK economy
...

• Foreign governments wishing to lower the value of their currencies
...

• People moving money out of the UK due to relatively low interest rates
...

• Foreign Direct Investors leaving the UK economy
• Governments wishing to replace £'s in their reserves with other assets
...

• Pessimism in the state of the economy- capital flight
...
In a free foreign exchange market, the balance of payments will automatically balance
...
For example, when
people abroad buy UK exports or assets, they will demand sterling to pay for them and when UK
residents buy foreign goods or assets, the imports of them will require foreign currency to pay
for them
...
It also ensures that the credits on the balance of payments are equal to the debits:
12

that the balance of payments balances
...

2
...
g
...

3
...
The pound may
be demanded for investment purposes due to a high rate of interest or stable economic
conditions
...
The value of the pound will remain stable
...
Uncertainty in international trading due to constantly changing prices has a negative impact on
trade and investment
...
External prices of home-produced goods change causing unstable demand
...
Increases speculation, which is a further cause of instability
...
The process of automatic correction of the Balance of Payments on current account is not
guaranteed as current account surpluses and deficits are not the only reasons why exchange
rates fluctuate and changes in the balance of payments will depend on the elasticities of demand
and supply for exports and imports
...

5
...
The initial advantage given by the cheaper pound
may be eroded by inflation over time
...
The government is less likely to tackle the problem of increasing inflation if exchange rates
automatically corrects deficit
...

Evaluation of disadvantages: Uncertainty with a floating exchange rate can be reduced by buying
currency on the forward market - buying currency for collection at a future date for an exchange rate
agreed at present
...

The Marshall Lerner Condition
The Marshall Lerner Condition shows the conditions under which a change in the exchange rate of a
country's currency leads to an improvement or worsening of a country's balance of payments
...

Therefore, if the condition does not hold and the demand for exports and imports are inelastic, then
a currency devaluation, which will lead to lower prices, will cause an overall reduction in total
revenue in the current account, worsening the current account deficit
...

In the short run, when a currency devaluation occurs, the Marshall Lerner condition doesn’t hold
...

This is because consumers/firms that tend to import take time to adapt to the new price of imports
so they continue buying imports at the same rate
...

13

Purchasing Power Parity (PPP)
This is an alternative method of equating currencies to using market exchange rates
...
Purchasing power is determined by the
relative cost of living and inflation rates in different countries
...

For example, if we convert GDP in Japan to US dollars using market exchange rates, relative
purchasing power is not considered, and the validity of the comparison is weakened
...

The Big Mac Index
This index, devised by The Economist, calculates how many units of a local currency are needed to
purchase a Big Mac
...

For example, if 200 Japanese yen (¥) are required to buy a Big Mac in Tokyo, and $2 are required in
New York, the 'value' of currencies are $1 = ¥100
...

Exchange rate and Balance of payments
The effect of exchange rate changes on the balance of payments will stem mainly from the current
account part of the balance of payments as movements in the exchange rate will have an impact on
the current account
...

Assuming demand for exports is relatively elastic, a depreciation will lead to an increase in the value
of exports and therefore improve the current account deficit
...

Similarly, a currency depreciation will also lead to an increase in the cost of buying imports
...

Therefore, in theory, a depreciation in the exchange rate should improve the current account
...


14

However,
1
...

2
...

3
...
However, a UK firm may decide
to keep the same foreign price and just make a bigger profit margin
...
Firms don’t adjust prices to consumers but have exchange rate movements absorbed
in their own margins
...

4
...
One reason was the sluggish global growth
...

5
...
When
consumer spending is growing, countries will be buying more imports
...
For example, in the
examples below from 1989-92, the current account improved – despite the Sterling index
remaining constant
...

The Influence of Demand and Supply on Foreign Currency Exchange Markets
Shifts of the demand and supply curves is caused by changes in things previously held constant
under the ceteris paribus assumption
...
g
...

An appreciation of the exchange rate occurs when there is a rise in the value of sterling due to
market forces
...
50 to £1=$2
...
In the diagram below an increase in the supply of sterling has caused its value to depreciate
from £1=$1
...
30
...
This
would increase the demand for the pound on the foreign exchange markets and lead to a reduction
in the supply of pounds as UK citizens decide to invest their money at home
...

However, if UK interest rates fall, UK rates would now be less competitive for savers and other
depositors
...
These movements would trigger a fall in the
value of the pound; a depreciation of the UK’s currency in the foreign exchange market
...

Supply curve will shift to the right, value of the pound will reduce in the foreign exchange market
...
Demand curve will shift to the right, value of the pound will increase in the forex
...
g
...
Therefore, demand for
the pound will fall, supply will rise as speculators sell more of the pound to buy other currencies
...

Relative investment prospects improving abroad: If investment prospects become brighter
abroad than in the UK, perhaps because of better incentives abroad, or because of worries about
impending recession in the UK again the demand for sterling will fall and the supply of sterling will
rise
...

Speculation that the exchange rate will fall: If businesses involved in importing and exporting, and
banks and other exchange rate dealers think that the exchange rate is about to fall they will sell
pounds before the rate does fall
...
People thinking of buying
pounds will wait until the rate does fall and hence, in the meantime the demand for sterling will fall
...

If speculators believe that the value of the pound is going to fall against the dollar, they will sell
pounds and buy dollars
...

Long term changes in international trading patterns: Over time, the pattern of imports and
exports is likely to change as consumer tastes change, the nature and quality of goods change and
the costs of production change
...
These shifts are gradual
and take place over many years
...
Additionally, there is a low
level of exports, therefore a low demand for pounds by overseas purchasers of British exports
...

Inflation: If the UK has a higher inflation rate than trading partners its exchange rate will fall
...
Import prices will be increasing more slowly and domestic demand for imports will
increase
...
This may cause a deficit on current
account and the exchange rate to fall
...
Expansionary
monetary policy will typically involve lower interest rates to make borrowing cheaper, encouraging
consumption and investment, and increasing the money supply, e
...
through quantitative easing –
creating money electronically
...
This is for two main reasons:
1
...

This is because with more currency chasing the same quantity of goods, firms will respond by
putting up prices
...
This domestic
inflation will make goods relatively less competitive in the global market and export demand will
fall
...

2
...
If money supply is increased through quantitative easing for example, then
this reduces interest rates
...
Lower interest rates will also tend to reduce the value of the currency
...
This will reduce the demand of the
pound as people sell pounds to buy other currency
...

However,
Economic history in the UK suggests that this might not be the case
...

This could have occurred for various reasons:
1
...
In the UK,
quantitative easing created £375bn of new money to buy assets
...
There were a few reasons for this
...
Banks didn’t lend the extra reserves they gained from
selling assets to the Bank of England
...

2
...
This could
occur because of low consumer confidence or the focus of individuals on cutting debt rather than
taking out new loans
...
In a liquidity trap, monetary policy can’t reduce interest rates because they are
already at the ‘Lower zero bound rate’
...

17

3
...
But UK inflation fell from mid-2011,
even though monetary policy remained expansionary
...

4
...
But, in the great recession, all currencies were
relatively weak
...

The Exchange Rate and Inflation
1
...
For example, an appreciation of the exchange rate usually reduces the price of imported
consumer goods and durables, raw materials and capital goods
...
Commodity prices: Many commodities are priced in dollars – so a change in the sterling-dollar
exchange rate has a direct impact on the UK price of commodities such as oil and foodstuffs
...

3
...
But the impact on inflation of a change in the exchange rate depends on what
else is going on in the economy
...
An exchange rate appreciation causes a slower growth of real GDP because of a fall in net
exports (reduced injection) and a rise in the demand for imports (an increased leakage in the
circular flow)
...
Changes in the growth of exports: A higher exchange rate makes it harder to sell overseas
because of a rise in relative prices
...

The Exchange Rate and Unemployment
A reduction in demand and output may cause job losses as businesses seek to control costs
...

Others are permanent if imports take up a permanently higher share of the domestic market
...


18

UNIT 3: THE EUROPEAN UNION
The EU is a customs union
...

• There are common external trade barriers (tariffs/quotas) on imports from non-member
countries, especially on agricultural products which are taxed very highly because the EU aims to
support the agricultural sectors of member nations
...

Ø The Common Agricultural Policy (CAP) aims to protect and support the farmers in EU
member countries by providing subsidies for them and establishing minimum prices for key
staple agricultural products like milk, cheese, wine and wheat
...

Ø Fisheries policy- quota on how much fish can be extracted from the sea by each fisherman
to maintain a given amount of fish in the sea and to ensure that there is not a depletion of
fish in the seas in the EU
...

Ø Environmental policies- EU has set policies on emission standards, allowed pollution levels
and tradeable permits
...
EU citizens can work or
live wherever they want to within the EU
...

• 17 out of the 28 members have adopted the Euro, so they are members of the Eurozone, a
monetary union
...
Free trade:
Free trade between members tends to lead to an improvement in the allocation of resources as it
creates a great incentive for nations to specialise and produce goods and services where they
have cost advantages
...
g
...
This is good for
consumers who can now access such markets and produces who can access raw materials from
markets that would’ve been closed to them without free trade
...
Firstly, greater international
competition will push domestic firms to become more efficient and reduce their prices to
compete
...
Thirdly, technological transfers become more real with free trade
...


3
...

5
...
This
will lead to greater efficiency, investment, and potentially, lower prices
...

Higher Foreign Direct Investment (FDI): Foreign businesses are attracted to member nations of
the EU because they are business gateways into other countries in the EU, and they are given
access to a large market because of the free trade
...
FDI also generates exports for the economies of
member nations
...
This will encourage competition and therefore, lower prices
...

Although large in absolute figures, contributions to the EU can be quite small as a percentage of
GDP
...
g
...

Free movement of labour and capital: Good for workers as they do not face geographical
obstacles to the mobility of their labour within the EU
...


Disadvantages of membership of the European Union (EU)
1
...

2
...
Although some member nations might not
benefit for all EU spending, they must contribute large sums of money that could otherwise
finance their health or education sectors
...
g
...

3
...
Countries outside the EU can develop trade agreements with individual
countries within the EU although they are not member nations
...
High levels of immigration: The free movement of labour creates a risk that uncontrolled
immigration could drain public resources, take advantage of benefit systems, avoid tax, etc
...

Since the EU is increasingly pursuing a political as well as an economic agenda, the incorporation of
more states especially those from Eastern Europe suits the aim of the EU becoming a world
superpower
...

1
...

This will lead to economic growth as economic activity increases
...
There will be an increase in employment due to economic growth and intensified competition in
the labour market leading to lower wage increases
...

3
...

4
...
This enhanced competition would
also place downward pressure on prices creating greater levels of consumer surplus
...
Labour from the poorer countries is likely to be cheap, potentially reducing production costs for
UK firms
...
The Centre for Economic Policy Research estimates that full enlargement will add £1
...

Disadvantages of the expansion of the EU on the UK economy
...
Many of the proposed new countries have a huge and inefficient agricultural sector
...
will
now be afforded to them
...
The inclusion of millions more
farmers will create budgetary and political problems
...
The new members, many of which have lived through decades of ruinous communist and
socialist rule, will be net recipients of the EU budget
...

3
...
The Commission reported that up to 335,000 workers could
move to the current 15 countries after enlargement
...

4
...

5
...

6
...

The European Monetary Union (Eurozone)
A group of countries who have adopted a single currency to achieve greater currency stability
between themselves and have a common central bank and monetary policy – an economic and
monetary union
...
These countries comprise the "eurozone",
338
...
Different currencies within Europe can be argued to be
a major obstacle to trade, in the same way as tariffs or quotas
...

Advantages of the Eurozone
1
...
The
elimination of such transactions costs is achieved within the Eurozone
...
Increased competition and efficiency: Despite free trade, large price differences remained
between member states
...

3
...
It has also
encouraged investment by firms that trade between these countries
...
Increased inward investment: Investment from the rest of the world is attracted to a eurozone of
some 326 million inhabitants where there is no fear of internal currency movements
...
From 1999 to 2003, the UK’s share of inward investment to EU
countries fell from 17
...
5%
...

5
...

The ECB being independent from short term political manipulation has resulted in a low average
inflation rate in the eurozone countries
...
The result is lower long-term interest rates
...

6
...

7
...

8
...
Inward investment is likely to be attracted by the reduced
uncertainty, reduced transactions cost and the large market size (population of EU is
approximately 370M)
...

9
...

The ECB cannot be manipulated by politicians seeking re-election; therefore, macroeconomic
policy is not driven by short term political considerations
...
Individual central banks will not be able to finance a budget deficit by printing money which
would lead to inflation
...

11
...

In general:
• Increased economic activity
• Lower unemployment
• Increased growth rates
• Higher standard of living
• Full realisation of competitive benefits of Single European Market
Disadvantages of the Eurozone
1
...

2
...

3
...
The trouble is that while one country might require a lower rate of
interest to ward of recession, another might require one to prevent inflation, creating the
problem of what country to aid
...
Transition costs e
...
vending machines, car park meters, loss of jobs in foreign exchange (‘one
off’ costs)
...
Customers had to get used to using the new money
...
Loss of flexibility of economic policy (Monetary & Fiscal)
6
...
Policies may
be in place which do not suit the domestic economic circumstances of some countries
7
...
(one size fits all)
22

8
...

9
...

10
...
g
...

11
...
Break-down of the eurozone would be expensive
...
There are fears that EMU will not survive a serious economic crisis e
...
as asymmetric shock
afflicts one part of the region more than another
...
A country will not be able to devalue its currency to restore competitiveness if its experiencing
balance of payments problems
...


23

UNIT 4: ECONOMIC DEVELOPMENT
Economic development is the process by which a country can satisfy the basic needs of its
inhabitants, raise their living standards and widen the range of economic and social choices open to
them
...

• To raise living standards including higher incomes, the provision of more jobs, better education,
and greater attention to cultural and human values, all of which will serve not only to enhance
material well-being but also to generate greater individual and national self-esteem
...

The emphasis placed on cultural and human values, self-esteem and freedom from ignorance show
that development is about more than advancing economic growth
...


Difficulties of measuring economic development
• What to include: People’s material standards of living are a given in measuring economic
development
...

• Measuring each of the items: It is possible to measure things like income per head, literacy
rates and mortality rates
...

• Arriving at a single measure of the level of development: Addition of measurements is only
meaningful if expressed in the same unit
...
g
...

• Deciding the importance of the distribution of the various components: For example, if the
average calorie intake increases but the poorest sections of the population have less to eat, has
development occurred? There is an interesting trade-off evident in some developing countries
between economic growth and freedom
...

The Usefulness of National Income in Measuring and Comparing Economic Development
National Income Statistics are the most commonly used means of comparing the economic growth
and living standards between different countries; real gross national income per capita has become
a main universal indicator of economic development
...

• Virtually all the goods and services produced in a country are considered and converted into a
single measure using market prices
...

• Virtually all countries compile GNY statistics, making them relatively easily accessible
...

24

• There is a correlation between the level of per capita GNY and other indicators such as mortality
rates, literacy rates, and calorific and protein intake
...
This is particularly a problem with rural societies that are largely
subsistence-based
...
GNY statistics are therefore likely to underestimate the
level of production in these societies
...
A larger proportion of consumption will
be of purchased items which are entered in GNY statistics
...

• As an economy becomes more urbanised, external costs of production and consumption such as
pollution and crime are likely to grow
...
Again, the growth of GNY is
likely to overstate the growth in human welfare
...
Markets are often highly fragmented,
and there is little competition to ensure that prices reflect undistorted marginal costs
...

• Exchange rates may not reflect local purchasing power
...
For international comparison, they are converted into a
common currency – usually the US dollar – at the current exchange rate but exchange rates
reflect demand and supply of traded goods and not non-traded goods
...
The level of GNY is therefore likely to understate the level of production in poorer
countries
...
It is much better to estimate GNY using
purchasing power parity exchange rates as they account for the fact that a dollar typically buys
more goods in a developing country than in a developed one
...

•

Simple GNY per head ignores the income distribution
...
However, with a
deepening of poverty, a growing inequality in the distribution of income and an increase in
unemployment, few would argue that this constitutes genuine development
...

• Even in nations with sophisticated accounting procedures GNP data is subject to revision for
some years after it is initially published due to the uncovering of errors
...


25

• Geographical area size is not considered: Countries with smaller geographical areas are likely to
have higher living standards as in larger countries, transportation costs take up more of the GNP
...
This is a health indicator
...
This is an educational indicator
...

The mathematical calculation of these three things generates a figure; the HDI
...
0-0
...
49-0
...
7-0
...
8 is very high development
...

Benefits of Economic Growth in Less Developed Countries (LDCs)
1
...
e
...
g
...
Economic growth during the Twentieth
Century was a major factor in reducing absolute levels of poverty and enabling a rise in life
expectancy
...

2
...
Thus, sustained growth stimulates jobs and contributes to
lower unemployment rates which is turn helps to reduce income inequality
...
Lower government borrowing: Economic growth will raise tax revenues and reduce government
spending on unemployment & poverty related welfare benefits Therefore, government
borrowing is reduced
...

4
...

5
...

6
...
This increases
the scope for future economic growth, creating a virtuous cycle of economic growth/investment
...
Increased research and development
...
Also, sustained economic growth
increases confidence and encourages firms to take risks and innovate
...

1
...

26

2
...
This is not good for any economy but especially for
LDCs, it is going back to square one and the economy may not be strong enough to come back
from that
...
Current account deficit: Increased economic growth tends to cause an increase in spending on
imports, therefore, causing a deterioration on the current account
...

4
...

This causes an increase in pollution
...
Economic growth also
means greater use of raw materials and can speed up depletion of non-renewable resources
...

5
...
For example, those with assets
and wealth will see a proportionally bigger rise in the market value of rents and their wealth
...
However, it depends upon
things such as tax rates and the nature of economic growth
...

6
...
For
example, with rising incomes, there are more goods to steal
...
Crime rates have risen since the 1930s
...

Polices to promote economic development in LDCs
There are several policy initiatives which could be implemented although they each create
problems both within the developed economies and for the developing nation
...
The aim of foreign aid is to fill
the savings gap in developing countries and promote economic development
...
Official aid comes directly form government sources
...
7% of each country’s total GNI
...
Multilateral aid is
aid diverted through an international organisation like the World Bank and the IMF
...


27

The forms of aid are the Official Development Assistance (ODA), the flow of capital from one
government to another and unofficial aid from NGOs e
...
Oxfam, who decide to spend money in
developing countries
...
Humanitarian aid- The main aim of this is to alleviate short-term suffering
...

Ø Food aid- the direct export of food to developing countries
Ø Medical aid- the direct export of medical services and supplies to developing countries
...

2
...

Ø Long-term loans- These often come with low interest rates, repaid over about 20 years
...

Ø Project aid- This is when money is given to developing countries for the funding of key
infrastructural projects e
...
building roads and bridges
...

Ø Commodity aid- Aid given to countries looking to improve productivity and regain
competitiveness
...

Benefits of Aid
• Evidence shows that aid packages do bring economic improvements to LDCs
...
Aid packages have also
contributed to vaccination programmes which have resulted in a decrease in infant mortality
...
In Africa, enrolment in primary
education has risen from 57% in 1999 to 70% in 2005
...
Foreign aid is needed to provide LEDCs with money for
investment needed to stimulate economic growth
...
For
example, a grant given for a road building project will not just benefit those using the roads
...

• Export revenues are often small
...
Foreign aid can be used to
purchase this equipment
...
Better education
and training leads to greater productivity
...
Better infrastructure will mean quicker delivery and communication times
thus reducing costs
...

Disadvantages of Foreign Aid
• Much of financial aid is often wasted through corruption, bad management, poorly thought-out
schemes or spent on arms deals
...

28

• Dependency on aid encourages laziness from domestic producers, reducing the incentive to
innovate and invest
...
This lack of a single, unified system has meant that the
money has not been systematically, rationally or efficiently allocated
...

• Developed countries could grow “aid-weary” and some would argue, justifiably so
...

• The tying of aid is not costless to the recipient country
...

Therefore, if aid is tied, third world countries could be worse off than if they had looked for a loan
at market rate of interest
...
A school building project may be half complete due to
insufficient funds or unavailability of workers
...
For instance, $2bn went into roads in Tanzania
but the network was no better afterwards because of poor maintenance
...
This means that the
money provided by aid displaces potential funds from private investors who could be
uncomfortable funding projects in countries that are aid dependent
...

Conclusion: ODA has successfully provided basic humanitarian needs in the many crises that
happen on a regular basis across the world
...

The IMF
The IMF is an organisation of 188 countries, working to foster global monetary cooperation, secure
financial stability, facilitate international trade, promote high employment and sustainable
economic growth, and reduce poverty around the world
...
IMF and Development
Several developing countries have sought IMF help in the last two decades as current account
deficits associated with the international debt problem have become too large to finance
...

The conditions imposed by the IMF have typically included the reduction in protectionist barriers,
devaluation of the official exchange rate, greater openness to foreign investment and tight
domestic fiscal and monetary policies
...
Possible
benefits include:
• A reduction in domestic inflation because of tightening monetary and fiscal policy
...

• More foreign investment will increase the economy’s capacity shifting its production possibility
frontier outwards
...

29

• A reduction in protectionist barriers forces a country’s domestic industries to become more
efficient if they are competing effectively in international markets
...
It is possible to argue that the conditions damage development as:
• Tightening of policy lowers aggregate demand, leading to higher unemployment and recession
is a distinct possibility
...

• Evidence suggests that the adjustment insisted on by the IMF hit poor families hardest
...

• Firms in developing countries are likely to struggle to compete in international markets when
protectionism is withdrawn
...
The
IBRD aims to reduce poverty in middle-income and creditworthy poorer countries, while the IDA
focuses exclusively on the world's poorest countries
...

The World Bank’s activities are focused on developing countries, in fields such as human
development (e
...
education, health), agriculture and rural development (e
...
irrigation, rural
services), environmental protection (e
...
pollution reduction, establishing and enforcing
regulations), infrastructure (e
...
roads, urban regeneration, electricity), and governance (e
...
anticorruption, legal institutions development)
...
Loans or grants for specific projects
are often linked to wider policy changes in the sector or the economy
...

Early efforts by the World Bank to finance large scale infrastructure investments in transport and
communications and utilities like water and electricity delivered relatively small benefits in terms of
increased GDP, perhaps because the economies of developing countries were not structured to take
advantage of them
...
For example, many of the projects which it finances
are designed to help developing countries make the most of trading opportunities open to them
...

Trade
For many developing countries, progression from low income to middle and upper middle-income
country status rests heavily on successful trade in regional and global markets
...

• Import substitution – where a country develops a domestic manufacturing capability and
capacity e
...
tomato growing businesses can grow into tomato processing factories
...

30

Many sub Saharan African countries and nations such as India and Sri Lanka have a trade ratio lower
than the world average
...

Successful trade provides developing/emerging countries with:
• A source of foreign currency to help the country’s balance of payments (countries with trade
surpluses build up US$ reserves)
...

• An injection of demand into the circular flow of income and spending, creating positive export
multiplier effects
...

• By opening markets to new competition, domestic producers are pushed to reduce prices,
thereby increasing the real incomes of consumers
...

• There are also risks that exports will be affected by geo-political uncertainty and cyclical shifts in
demand
...

Debt Relief
Many developing countries are burdened by extremely high levels of debt, with the result that funds
that could be used to reduce poverty must instead be diverted to making interest payments
...

The Heavily Indebted Poor Countries (HIPC) Initiative was launched in 1996 and provides debt relief
with the aim of either cancelling debt or reducing it to sustainable levels
...

Removing developing countries of part of their debt or cancelling it altogether is likely to carry
substantial benefits for their development
...

• It can be tied to conditions, and these conditions can be drawn up to encourage development,
e
...
evidence of low levels of corruption in government
...

• The breaking of ‘cycles of debt’: Many debts are serviced or repaid simply through further
borrowing and debt tends to increase over time
...

• The fostering of development through debt cancellation may be in the long-term interests of
developed nations
...
There is also a link between poverty, disease and
more controversially, terrorism, which can all impact on developed nations
...
Once debt burdens are lifted, countries might
be tempted to seek further loans, which might again be squandered
...

• The cancellation of debt comes at a cost to firms and governments in the developed world to
whom the money was owed
...

• Poverty exists to a greater or lesser extent in all nations
...
Some would argue that governments should tackle poverty in their own
countries before diverting resources to tackle poverty elsewhere
...

Over 40% of global tourism arrivals take place in the developing world and this proportion is on the
increase
...

Developing countries tourism exports grew by 154% between 1990 and 2000
...

Advantages of Tourism
• The biggest assets of developing countries are often their environment (including areas of
outstanding natural beauty) and their cultures
...

• Modern communication methods such as the internet have made it possible to promote tourist
destinations relatively cheaply
...

• Global prosperity is increasing, bringing with it higher income levels
...

• Air travel has become cheaper, further boosting demand for tourism
...

• Provision of tourist services is generally labour intensive
...
Economic theory suggests that developing countries may enjoy a comparative
advantage in labour intensive areas and tourism generates employment opportunities
...
These injections are likely to generate a multiple impact on domestic income as the
recipients of the initial expenditure spend their income and create jobs and incomes for others
...

• The infrastructure created to serve the tourist industry generates external benefits for third
parties involved in other sectors of the economy
...
For example, at times when prices of agricultural output are low, the
damage of this may be offset by income from tourism
...
Between 1990-2000 the increase in tourism expenditure in the EU was 49%, in
Developing Countries it was 133% and in the Least Developed Countries it was 154%
...

• Air and noise pollution from construction
...
A negative externality from tourism may be lower food
productivity as crops are inadequately watered
...
As well as directly affecting the lifestyles of
local citizens, there is a danger that this commercialism may ultimately reduce the attractiveness
of the area as a tourist destination
...

• Congestion on roads, especially in already busy cities
...
This,
clearly, is a global issue, but global warming is likely to lead to flooding, more extreme weather
conditions and increased difficulty in controlling disease in many developing countries
...
Much of the food and
drink consumed by tourists must be imported from abroad, while the profits generated by
multinational hotel chains are enjoyed by the owners of these companies and not by residents
...
g
...
Monetary policy- Setting the main monetary policy interest rate, quantitative easing or
exchange rate intervention to ensure stable prices and confidence in the currency
...
Acting as a banker to the Government- Government borrowing is financed by selling bonds on
the open market, and sometimes, the government fails to sell sufficient bonds
...
Central banks can intervene and buy government bonds to avoid
these ‘liquidity shortages’
...

Financial stability roles (these have become more crucial since the 2008 financial crisis):
3
...
If banks get into liquidity shortages, the Central Bank can lend them sufficient funds
...

4
...

Financial stability is crucial for high confidence in the financial system
...

However,
1
...
This will encourage more reckless risk taking as banks do not feel fully responsible
for the risks they take
...
Banks may not hold sufficient liquidity- Knowing that the central bank is available to provide
either short or long-term liquidity, banks may decide to hold inadequate short-term assets to
make more profit by giving out more long-term loans
...
Regulatory capture- This occurs when a body responsible for supervision of an industry loses its
focus on its duty to protect the public interest and represents the industry instead
...

4
...
They say
that banks should be allowed to fail if they are too illiquid
...
Setting key interest rates for the Eurozone to control the money supply
...
Managing the Eurozone’s foreign currency reserves and buying or selling currencies when
necessary to keep exchange rates in balance
...
Helping to ensure that financial markets and institutions are adequately supervised by national
authorities and that payment systems function smoothly
...
Authorising central banks in Eurozone countries to issue Euro banknotes
...
Monitoring price trends and assessing the risks they pose to price stability within the Eurozone
...
This information is then used to make a judgement on inflationary pressures over a
two-year forecast horizon
...
GDP growth and spare capacity (the rate of growth of GDP and the size of the output gap)
...

2
...

3
...

4
...

5
...

6
...

7
...
A strong exchange rate
might bring down inflation but risk causing a deeper economic slowdown via a fall in exports
...
International data including recent developments in the Eurozone, emerging economies, the US
and Japan
...
There are a variety of different interest rates that operate within
the external environment; for example, interest rates on savings in bank and other accounts,
borrowing interest rates, mortgage interest rates (housing loans), credit card interest rates and pay
day loans and interest rates on government and corporate bonds
...
The Bank of England Base Rate has been very low and stable for several years
...

• Decrease in the incentive to save as the rate of return on saving reduces
...

• Reduces real income of those with savings as they will get less of a return for their savings
...

• Exchange rates will fall because hot money will leave the economy when interest rates reduce
...

• It is the last resort to stimulate spending in an economy when other monetary policies fail to
work
...

• QE can work in several ways, but essentially it works by raising asset prices, starting with
government bonds, and then spreading out through the wider economy, giving a boost to bank
assets and current bank lending and creates a positive wealth effect for asset holders
...
This is done through an injection of electronic money
...

• The most immediate effect of the asset purchase is that prices of these existing assets (gilts) rise,
while yields - effectively, the interest on them - adjust downwards
...

• As new investment occurs, the new liquidity is re-directed towards sellers of bonds and shares
...

• The rise in the yields of other assets such as shares creates a wealth effect with holders of assets
experiencing an increase in their wealth, raising confidence and stimulating spending
...

The aim of this is that:
•
•
•
•

Bank lending starts to flow again, leading to increased household and corporate spending
...

Aggregate demand increases and the economy moves out of recession
...


Advantages of Monetary Policy
1
...
These
components of AD create an avenue for economic growth
...
A positive multiplier in the economy increases in economic growth, reducing unemployment in
the economy
...

3
...

Disadvantages of Monetary Policy
1
...

2
...
When interest rates change, it needs to go
through the transmission mechanism:
Ø Change in market interest rates- A change in policy interest rates has a positive relationship
with borrowing/saving rates
...
A higher money supply will increase spending and reduce saving, investment
and exports
...

Ø Effect on output, jobs and investment
...

Economists believe interest rate changes take 18 months to feed through to the macroeconomy
...
Reactions may not be as expected e
...
interest rate changes do not mean spending will change
...

36

The Fisher Equation of Exchange and Quantity Theory of Money
The quantity theory of money is a theory that directly links growth rates in the money supply to
growth rates in crises i
...
inflation
...
g
...

• V- Velocity of circulation- The number of times at which a given amount of money changes
hands in an economy in a year i
...
the number of transactions that take place with a given
amount of money
...
The velocity of circulation can decrease if there is a change from weekly to monthly
pay or an increased use of money substitutes e
...
credit cards
...

• P- Average price level- inflation rate
...

What is sold must be bought, therefore, MV=PQ, and any change in the price level is directly related
to a change in the money supply
...
This would suggest that there are three factors that
could influence inflation in the economy
...
They claim that although V will
decrease in a recession and increase in a boom, it will not change enough to affect P
...

This concludes at the fact that inflation can only occur if the money supply grows, as all other
components of the equation cannot impact price levels
...
The UK now adopts a tripartite system of regulation- there are 3 major
organizations that regulate the financial sector
...
e
...
There is only rationale for regulation if
public interest is at risk
...
The Financial Policy Committee (FPC): This is a macro-prudential regulation body, set up to
monitor the entire financial sector in identifying and preventing systemic risk, which is when
there is a great chance of a complete collapse of the financial sector
...
They advise the government on potential systemic risk
for the enactment of regulation to prevent such or of bank bailouts that may be necessary to
prevent against systemic risk
...
They also
provide emergency liquidity to banks through the Liquidity Assurance Scheme of the Bank of
England, to protect against systemic risk if banks suffer from liquidity crises
...
The Prudential Regulation Authority (PRA): This is a micro-prudential regulation body, so their
regulation is more targeted to maintain the stability of banks within the UK financial sector
...
They also specify
reserve requirements and ratios: the capital ratio, which measures the funds a bank has in
reserve against the riskier assets it holds that could be vulnerable in the event of a crisis; the
liquidity ratio which is the ratio of liquid assets held by a bank on their balance sheet, to their
overall assets and; the leverage ratio which is a simple indicator of a bank’s ability to absorb
losses
...
They are
also micro-prudential regulators, but their roles are different from the PRA’s
...
They do this in
four ways
...
g
...
Another is the promotion of competition so that
consumers can get better deals in terms of lower interest rates for borrowing and higher interest
rates for saving
...
Lastly, they ban or change misleading adverts for financial products e
...
adverts on loans
with inadequate information for consumers
...
Ban on market rigging with strong enforcement to reduce market rigging/collusion which harms
consumers, businesses and other financial institutions
...
Prevention of the sale of unsuitable products to consumers to protect them from products with
excessive risk, charges or limited benefits
...
Setting maximum interest rates to prevent consumer exploitation whilst preventing excessive
spending
...
Deregulation of the financial sector to allow more competition i
...
lower borrowing rates and
higher saving rates
...
Insuring deposits to protect consumer in case many bank customers withdraw their deposits
simultaneously due to concerns about the bank's solvency i
...
bank run
...
Ring fencing commercial banking from investment banking so that commercial banking funds
are not used to gamble in the investment banking sector
...

7
...
This lowers chances of bank failure and systemic risk
...
Liquidity assurance with conditions and punishments also lowers chances of bank failure and
systemic risk
...
Asymmetric information: This exists when one party has more information than the other and
uses that advantage for exploitation
...

However, banks could hide that information, making it difficult for regulators to decide and
impose the necessary regulation to protect against bank failure and systemic risk
...
Information failure: In cases of banning mis-selling of products and the sale of products that are
against consumer interest, regulators remain unaware of the next product being worked on by
financial institutions
...

3
...
This occurs
when parties are likely to take greater risks, knowing that a claim will be paid for by their cover
38

as they know more about their intended actions than the insurer
...
g
...
It is unlikely that moral hazard could ever be fully
eliminated from the financial services sector, but tighter supervision of firms may reduce that
risk
...
Regulatory capture: This occurs when a body responsible for supervision of an industry loses its
focus on its duty to protect the public interest and represents the industry instead
...
When the
costs of regulation are considered, government failure could occur as the costs in the case of
regulatory capture outweigh the benefits
...
Externalities: Deregulation could have unintended negative consequences
...
Over-regulation on the other
hand could force bankers to move to the shadow banking industry where regulation isn’t as
restrictive e
...
hedge funds and mutual funds where larger profits can be made
...
Inefficiency: In the case of maximum interest rates, an excess demand will occur in the market
...
It is also an incentive to bad borrowers to come into the market
...

3
...
If there
isn’t much to benefit from regulation, then the costs would outweigh the benefits meaning a
market/government failure has occurred
...

The money used to fund these organisations could be used in other sectors e
...
health and
education
...
If banks are
driven out of the industry by too much regulation, an oligopoly or monopoly situation could
occur
...
e
...

E
...
with maximum interest rates, efficiency will be harmed
...

• Benefits must outweigh the costs
...

The Role of the Financial Sector and its Impact on the Real Economy
The real economy is where goods and services are produced, and the financial sector involves
trading securities
...
Theoretically,
manufacturers could invest in new technology without sophisticated financial infrastructure, but
financial services make that simpler as fluctuations in production costs may be ironed out, making
future planning easier
...
The financial sector ensures stable consumption levels by
lending money, which otherwise would lead to a similar situation as the global recession of recent
years
...
In 2014, financial
services had accounted for at least 8% of the UK’s GVA
...
2 billion out of a total surplus on trade in services of
£78
...
The report also noted that there were more than one million people
(3
...


40

UNIT 6: FISCAL POLICY AND MACROECONOMIC POLICIES AND
OBJECTIVES IN A GLOBAL ECONOMY
A fiscal deficit is the situation in which, during a financial year, the government’s expenditure
exceeds its revenue
...
It has accumulated over time and
fluctuates depending on the will and ability of any government to pay parts of it off
...

(learn statistics for this at ending of March 18)
Factors that Influence the Size of Fiscal Deficits
• Cyclical reasons:
A recession or a sustained period of slow growth: In an economic downturn, revenue flows fall
from direct and indirect taxes whilst at the same time, the government is required to pay more
out in welfare benefits such as the means-tested income support, unemployment benefits and
other welfare handouts
...
The governments of most developed countries are prepared to
allow the automatic stabilisers to work through because, when their economy recovers, the
cyclical component of a fiscal deficit will diminish, indeed in an economic boom, the government
may run a budget surplus
...

Fiscal deficits seem an almost permanent feature in some economies; rarely is the government
able to find enough tax revenue to cover the annual spending budgets
...
g
...
The deliberate evasion of tax is illegal but countering
shadow markets where no tax is paid or in tracking down agents who are not paying taxes is
done better in some countries than others
...

Ø High levels of income and wealth inequality - Some economists argue that highly unequal
societies also end up with a worsening fiscal position for the government
...
At the bottom end of the labour market, if millions of people are in
low-paid, insecure work, many will not earn enough to pay much in tax and may remain
dependent on top-up welfare benefits, adding to the pressure on government spending
...
g
...

Ø Government inefficiency – Inefficiency in the public service sector will reduce value for money,
increasing the overall cost of providing services for the public
...
e
...

41

Ø High levels of government subsidy / financial support - over time, total government spending
can rise because of the many competing financial demands placed upon politicians and the
effects of lobbying by (often influential / powerful) pressure groups
...
The state might also get locked into providing financial
support for loss-making businesses and industries such as airlines
...

These reasons explain why many countries run a structural budget deficit
...

How do Governments Finance Fiscal Deficits?
Borrowing: In the case of a fiscal deficit, the government will have to borrow from the private
sector
...
The public-sector debt is the total amount of
debt owed by the government
...

However, this could cause lower spending which will shift AD to the left or lower investment
which will also reduce SRAS and a fall in economic growth
...
In a recession, tax rate increases could cause a significant drop in
spending
...
Could also be
a disincentive to workers, therefore, unemployment rises
...
As more money is taken from a business in the form of corporation tax, the less money it can
invest
...

2
...

3
...

• Reduction in government spending- This feeds into demand through supply- therefore, more
supply side policies e
...
privatisation, deregulation, welfare benefits being reduced
...
This solves
the structural issue of government inefficiency
...
Prices will also fall, increasing the disposable income of consumers and marginal
propensity to consume; increasing AD
...
This will
increase productive efficiency due to lower costs or give firms to increase salaries, generating
higher income and Marginal Propensity to Consume, which will increase AD
...

However, deregulation could end up reducing consumer welfare as firms have less incentive to
be fair in their dealings in terms of collusion and the prevention of monopolies
...
Above mentioned will work
but if the government reduces capital spending in areas like education, subsidies and healthcare,
the LRAS could also be affected (leftward shift), which means reduced productivity and cost
push inflation
...
Output gap- positive or negative?
2
...

Automatic Government Policy and Fiscal Deficits
This occurs when government spending and tax revenue change during different stages of the
economic cycle
...
Government spending on welfare
benefits will increase more than proportionately to the reduction of tax revenue
...

Discretionary Government Policy and Fiscal Deficits
This occurs when governments deliberately change relative revenues raised from taxes or
government spending as a percentage of GDP to change the level of Aggregate Demand
...

When the government reduces tax rates, then government revenue may fall, possibly below
government expenditure, causing or increasing a fiscal deficit
...

Possible reasons for the difference in relative performance of different economies:
• Productivity
• Inactivity i
...
voluntary unemployment
• Government policy and priorities
• Natural resources
• Black market and corruption
• Political stability
• Research and development
• Infrastructure
• Education
• Social mobility
• State of the budget
• Consumer and business confidence and activity
Problems facing policymakers when applying policies to achieve macroeconomic objectives:
Policymakers must consider numerous factors when tackling wide problems such as
unemployment, inflation and a country's current gross domestic product (GDP)

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