Theme 4 Macroeconomics Full textbook notes

Meaning of globalisation

Refers to a variety of ways in which countries are becoming more and more closely integrated, not just in the economic sense, but also culturally and politically.

Characteristics of globalisation (in the economic sense)

• An increase in trade as a proportion of world GDP

• Increased movements of financial capital and people between countries

• Increased international specialisation and division of labour

• The growing importance of global or transnational companies

• An increase in foreign direct investment

What factors have contributed to globalisation?

• Fall in transport costs

• Fall in communication costs

• Lowering of trade barriers since the Second World War

• Decline in communism and the opening up of China

• TNCs have taken advantage of the reduction of trade barriers to organise trade on a global scale

• Growth in the number and size of trading blocs

What is the law of comparative advantage?

When countries specialise in the goods in which they have comparative advantage (i.e. goods can be produced at lower opportunity cost) then world output and living standards will increase.

Impacts of globalisation on governments:

• Economic growth → higher incomes → higher tax revenues

• However, transfer pricing may result in lower tax revenue from corporation tax

  • When a global company manages its accounting of internal transactions within the company to show the highest profits in the country in which corporation tax is lowest

Benefits of globalisation for producers and consumer

Producers: Lower production costs as a result of offshoring and economies of scale

• The practice of moving business practices/operations to another country to benefit from lower labour costs, favourable regulations and access specialised skills

Consumers: A wider choice of goods and lower prices = increase in consumer surplus.

What assumptions underlie the theory of comparative advantage?

• No transport costs

• No trade barriers

• Constant returns to scale - averaage cost of production is constant

• Perfect mobility of resources between different uses

• Buyers/consumers have perfect knowledge

What are terms of trade and how are they measured

The relationship between the price of exports and the price of imports

Index of export prices

—————————— x 100 = TOT

Index of import prices

Limitations of the principle of comparative advantage:

• Transport costs might outweigh the benefits of comparative advantage

• Similarly, trade barriers might distort comparative advantage

• Increased specialisation and production might result in rising average costs caused by diseconomies of scale

Advantages of specialisation and trade

• Efficient resource allocation: specialisation and free trade based on comparative advantage result in an efficient allocation of resources

• Higher world output —> higher living standards

• Lower prices and more choice for consumers

• Incentive for domestic producers to become more efficient

• Larger markets for firms, enabling them to benefit from economies of scale

Disadvantages of specialisation and trade

• The law of comparative advantage is based on unrealistic assumptions

• For developing economies, specialisation in the production of primary products might prevent diversification into more productive manufacturing strategies

• A danger of overdependence on imports, especially those of strategic importance

• A country’s goods and services may be uncompetitive, resulting in a persistent trade deficit

What factors influence the pattern of world trade?

• Changes in comparative advantage

  • E.g. discovery of new natural resources, adoption of new technology, investment in infrastructure

• The growth of emerging and developing economies

• The growth since the Second W.W. in the number and size of trading blocs

• A long-term change in a country’s exchange rates against those of other countries will affect the relative competitiveness of that country’s goods and services

Factors influencing a country’s terms of trade

• Relative inflation rates

  • E.g. a higher inflation rate then export prices will be rising relative to import prices so a rise in the TOT

• Changes in raw material prices

  • A developed country that imports most of its raw materials, a rise in raw material prices would cause a fall in TOT

• Changes in exchange rates

  • Increase in exchange rate relative to other countries leads to export prices rising and import prices falling

• Tariffs

  • A tariff imposed on imported goods would cause an increase in import prices and so would lead to a fall in TOT

• Dependency on primary products (over long term)

Impact of changes in a country’s terms of trade

• Increase in TOT = Increase in living standards: A country has to export less to gain a given quantity of imports

• On the balance of payments on current account: Upward movement in a country’s terms of trade would decrease the competitiveness of its goods and services because its export prices would be rising relative to its import prices. So, BOP on CA likely to deteriorate

• Resource-rich developing countries: ownership of minerals and fuels causes an appreciation in the exchange rates of the currencies of these countries, so an increase in the TOT. However, this leads to a loss of competitiveness of their manufactured goods and services, leading to slower economic growth than may have otherwise happened

What are regional trade blocs?

Intergovernmental associations that manage and promote trade activities for specific regions of the world

What are Free Trade Areas

Trade barriers are removed betwen member countries, but individual members can still impose their own tariffs and quotas on countries outside the area.

Example: NAFTA

What are Customs Unions

When there is free trade between member states and a common external tariff on goods imported from outside the bloc

Example: EU

What are common markets

Customs unions, but with the addition that it is not only goods and services that can be moved freely within the area, but also factors of production (especially labour.)

Example: Mercosur, a south american customs union

What are monetary unions

Customs unions that adopt a common currency

Costs of regional trade agreements

• Trade diversion: trade may be diverted from low-cost producers outside the bloc to high-cost producers within the bloc

• Distortion of comparative advantage: Lead to less efficient allocation of resources, lowering global economic growth

• Loss of independent monetary policy: Countries would be unable to control their own interest rates and exchange rates

Benefits of regional trade agreements

• Trade creation and more specialisation between member countries

• Increase in FDI: Global companies may invest to be inside a trading bloc to avoid trade restrictions

————————————————— main ones

• Elimination of transaction costs: so no costs in changing currencies when goods imported or exported

• Price transparency makes it easier for consumers to compare prices across the whole bloc region

• Elimination of currency fluctuations between member countries may help to attract FDI

What are the two key functions of the WTO?

• Promote free trade among the 164 member countries through ‘rounds of talks’

• Settle trade disputes between members

What is protectionism

Measures designed to limit free trade

Arguments for protectionism / restrictions on free trade

• Protect infant industries - particularly for developing countries that are industrialising

• Protect geriatric industries - particularly for developed countries that are losing their comparative advantage: these industries gain time to restructure and rationalise production

• Employment protection by protecting industries

• Prevents ‘dumping’ - goods exported to another country at below the average cost of production, a form of predatory pricing

• Correct a balance of payments deficit on the current account

• Restrict imports from countries who have less stringent health and safety - e.g. america’s pink sludge chicken

• To raise tax revenue from tariffs for developing countries

• In retaliation because another country has restricted the imports of its goods

Types of restrictions on trade:

• Tariffs

• Quotas on how much can be imported

• Subsidies to domestic producers artificially lower domestic production costs = more competitive

• Non-tariff barriers: health regulations, labelling, environmental standards, documentation for goods

Impact of protectionist policy on consumers, producers, government, living standards, equality:

Consumers: Higher prices and less choice

Producers: Less incentive for domestic producers to become more efficient

Governments: Yay: Tax revenue from tariffs, Nay: Subsidies are a cost and once barriers are in place its hard to remove them bc they’ll have negative effects on domestic producers

Living standards: Less efficient world resource allocation bc distorted comparative advantage and less specialisation —> lower world output → lower living standards

Equality: trade barriers by developed countries onto developing countries could increase inequality between these countries

What is the balance of payments

A record of all financial transactions between one country and other countries

Causes of current account deficit

• Low productivity relative to other countries - not competitive internationally

• High inflation relative to other countries

• an overvalued exchange rate

• Dependence on highly priced imported raw materials

• Relocation of manufacturing industries to low-wage countries

• protectionism by other countries

Measures to reduce a country’s imbalance on the current account

• Supply side policies to increase productivity and competitiveness of countries exports

  • Market based: privatisation, deregulation

  • Interventionist: education to improve productivity, infrastructure investment

• Expenditure-reducing policy - e.g. deflationary fiscal policy = less imports

Define nominal exchange rate

The number of units of the domestic currency that can purchase a unit of a given foreign currency

Define real exchange rate

Calculated to measure the movements of the competitiveness of the country’s currency in relation to another country’s currency on the basis of inflation differential between the countries.

• The nominal exchange rate adjusted to reflect the different inflation rates inn the countries of the two currencies concerned

Define effective exchange rates

Measure the movements of a country’s currency value in a basket of currencies of trade-partner countries

Define trade-weighted exchange rate

The average exchange rate in a basket of currencies, weighted by the amount of trade with each country.

What are the 3 exchange rate systems?

• Floating exchange rates - market forces determine the value at which one currency exchanges for another

• Fixed exchange rates - the value at which one currency exchanges for another is fixed by the central bank or government against another currency or gold

• Managed exchange rates - market forces determine the value at which one currency exchanges for another but intervention by the central bank influences the exchange rate

Revaluation V.S. Appreciation of currency

Revaluation: Only occurs under a system of fixed exchange rates when gov decides to increase value of currency

Appreciation: Under a system of floating exchange rates due to market forces

Factors influencing floating exchange rates

• Relative inflation rates

• Relative interest rates - foreigners place money in UK banks w high interest, increasing demand for pound

• The state of the economy - if UK economy performing well, this will increase the confidence of speculators and foreign investors, increasing demand for pound

• Political instability causing fall in confidence in the currency - esp in developing countries

What is a country’s international competitiveness

The ability to sell its goods and services in domestic and international markets at a price and quality that is attractive in those markets

What are the two ways by which the exchange rate of a currency against other currencies may be influenced?

• Foreign currency transactions

• Interest rates

How can the central bank intervene in the foreign exchange market to influence the exchange rate?

For an appreciation:

• central bank buys it’s own currency on the foreign exchange market in exchange for foreign currency

• Increase in demand for domestic currency increases the value of its currency against foreign currency

How can the central bank use interest rates to appreciate the currency?

For appreciation:

• Raise interest rates

• Makes domestic currency more attractive to foreign people to put money in these banks, increasing demand for it

How did Pakistan’s central bank change interest rates?

May 2018: 6.5%

July 2019: 13.25%

What is a competitive devaluation?

Also known as a currency war when one country’s devaluation/depreciation results in other countries copying

When a country deliberately reduces the value of its currency in order to gain a competitive advantage and this results in other countries taking similar action

Effects of competitive devaluations/depreciations:

• Cause an increase in the rate of inflation because imports would become more expensive

• Decline in world trade because of uncertainty due to fluctuating exchange rate

How does a depreciation impact the current account on the BOP (next slide is eval)

• Makes goods and services more internationally competitive so SPICES = less imports more exports

• Improvement on current account

EVAL for depreciation’s impact on the current account on balance of payments - what is the Marshall learner condition

Depends on price elasticity of exports

Marshall-Lerner condition: the sum of the price elasticities of demand for imports and exports must be greater than 1 for there to be an improvement on the current account

What is the J-curve effect

There could be a time lag before the effects of the depreciation of currency work through the economy:

• The sum of the PEDs would be between 0 and 1 in the short run but above 1 in the long run

PED for imports price inelastic because of contracts for goods

PED for exports price inelastic because takes time for consumers to adjust to the price changes

Impact of depreciation on economic growth and employment

If there’s an increase in net exports, then AD will increase, so increase in RGDP. Therefore there should be an increase in employment

Impact of depreciation on the rate of inflation

• Inflation could rise due to AD shifting out (from rise in net exports)

• Rise in import prices (especially raw materials) likely to increase costs of production, causing AS to shift in and so an increase in the rate of inflation

Impact of depreciation on FDI flows

• May make the country more attractive for foreign investors because a unit of their own currency would buy more units of this country’s currency

• However, if depreciation is because of a lack of confidence in the country’s economy, FDI may decrease

What are some examples of non-price factors in international competitiveness?

• Quality

• Design

• Reliability

• Availability

What are 3 measures of international competitiveness

• Relative unit labour costs - the measurement of labour costs in one country relative to those in another country

• Relative export prices - might be affected by factors such as productivity e.g. labour productivity (output per worker per hours worked)

• The global competitiveness index - measured devised by the WEF based on factors such as infrastructure, macroeconomic stability, health, education, innovation

  • top 3 rankings for 2018: USA, Singapore, Germany

What are the two main factors influencing international competitiveness

• Real exchange rate - nominal exchange rate adjusted to reflect different inflation rates (nominal exchange rate x (domestic price level) / (foreign price level))

• Wage costs and non-wage costs

How do wage costs and non-wage costs influence international competitiveness

• Wage costs are the most important costs of production for many industries

  • relationship between labour productivity and wages is crucial in influencing unit labour costs

• Non wage costs are much higher in developed countries than in developing countries, so reduce the international competitiveness of goods from developed countries. They include:

  • National insurance paid by employers

  • Health and safety regulations

  • Environmental regulations

  • Employment protection and anti-discrimination laws

  • contributions to company pension schemes

What other factors can improve international competitiveness?

Governments can improve it through supply-side policies such as:

• Education and training schemes - increase occupational mobility of labour. This influences the level of human capital, which is the knowledge and skills of the workforce

• Public sector reform that removes red tape

• Privatisation

• Incentives for investment - e.g. tax breaks if companies use profits for investment

What are some benefits of being internationally competitive?

• Balance of trade surplus

• Export-led growth leading to increase in real incomes

• Low levels of unemployment

• Increase in FDI

What is absolute poverty?

When incomes fall below the minimum level to meet basic needs such as food, shelter, clothing, access to clean water etc.

What are three problems with the benchmark of relative poverty

• Subjective

• Subject to change over time

• Not comparable between countries

What is the distinction between wealth and income inequality

Wealth = Stock concept. Refers to inequality based on value of tangible assets e.g. property

Income = Flow concept. Refers to inequality based on incomes from wages and profit

What does the Lorenz Curve do?

Plots the cumulative percentage of the population against the cumulative percentage of total income

How is the Gini coefficient calculated?

G = A / (A+B)

Causes of income and wealth inequality between countries?

• Differences in natural resources like oil and gas

• Geography

• Differences in governance - command vs free economy

• Political instability; civil wars

• Natural disasters

• Population growth and structure

Name some measures of development

• The HDI

• The Multi-dimensional poverty index (MPI)

• Proportion of population with access to clean water / internet

• Proportion of male population engaged in agriculture

What’s the HDI?

A composite index of development, including 3 elements:

• Education (the mean years of schooling for a 25 year old)

• Health (life expectancy)

• Real GNI per capita

What’s the global MPI (multi-dimensional poverty index)

Composed of ten indicators corresponding to the same 3 components as the HDI, where GNI per capita → standard of living. Combines two aspects of poverty:

• Incidence - percentage of people who are poor

• Intensity - the average of the components above in which poor people are deprived

Name factors influencing growth and development:

• Primary product dependency

• Volatility in commodity markets

• Levels of savvings and investment

• Foreign exchange gap

• Capital flight

• Access to credit and banking

• Infrastructure

• Education

• Absence of property rights

• Corruption / poor governance / political instability

What are the problems with primary product dependency?

• Price fluctuations

• Fluctuations in tax revenues - fall in the price leads to fall in revenues leads to less tax

• Difficult of planning investment and output

• Natural disasters can cause severe disruption

• Protectionism by developed countries - e.g. US gives big subsidies to US cotton farmers so India can’t compete

• Low income elasticity of demand for primary products (Prebisch-Singer hypothesis)

• A country with loadss of a natural resource → appreciation of currency → makes other products less competitive

What’s the Prebisch-Singer hypothesis?

Suggests that countries that export commodities (raw materials / primary product) would be able to import less and less for a given quantity of exports - the TOT would decrease for primary commodity exporters.

Common explanation: the YED for manufactured goods is greater than that for primary products, so as global incomes rise, the demand for manufactured goods rises more rapidly than for primary products. → the prices of manufactured goods rise compared to primary products, causing a decline in the TOT for primary product dependent countries

What is a criticism of the Prebisch-singer hypothesis

• Some countries have developed on the basis of their primary products: e.g. diamonds account for 30% of Botswana’s GDP

Why is there such high volatility in commodity markets?

Demand and supply of commodities tend to be price inelastic

Demand inelastic because they’re required in the production of other low PED goods such as bread and steel

Supply inelastic because of the long growing period for soft commodities and long time to develop new mines for hard comoddities e.g. coal.

So, any demand- or supply-side shock will result in a significant price change

What is the Harod-Domar model:

Low incomes → Low savings → Low investment → Low capital accumulation → low incomes ….

What is the savings gap

The difference between the amount of domestic savings available and the amount of investment needed to meet a target rate of economic growth

Why do many developing countries face a shortage of foreign exchange?

• Dependence on export earnings from primary products

• Dependence on imports of capital goods and other manufactured goods

• Capital flight

• Debt

Why has debt become a particular problem for developing countries?

• Risky decisions to borrow money to finance major investment projects when the prices of goods which they were exporting were high

• An increase in oil prices → inflation → higher interest rates

• A fall in the value of the currencies of developing countries, increasing the burden of foreign debt

What is capital flight?

When individuals or companies decide to remove deposits in domestic banks and place them in foreign banks / buy shares or assets in foreign countries.

What are the problems with capital flight?

• Contributes to the savings gap and foreign currency gap

• Restricts economic growth

• Reduces the tax base - the country loses any tax payable on these assets

How does population growth impact development (Thomas Malthus)

Thomas Malthus preducted that famine was inevitable because population grows in geometric progression, whereas food production grows in the form of an arithmetic progression. This is believed to be relevant for some of the poorest developing countries.

Thomas Malthus’s theory in relation to Nigeria

Nigeria’s population increased from 42.8 million in 2000 ——→ 200 million in 2019

Population growth > GDP growth, so GDP per capita has been falling in Nigeria between 2014 and 2018

What is infrastructure?

The whole range of structures essential for an economy to operate smoothly, including: transport, telecommunications. energy supply, waste disposal

How does absence of property rights impact development?

Property/Land can act as collateral for a bank loan, and without this it can be too difficult to start a business

What are some non-economic factors that influence development/growth?

• Corruption (the use of power for personal gain) - inefficient allocation of resources

• Poor governance - inefficient allocation of resources

• Political instability = consumer/business uncertainty

• Geography - land-locked country like Niger is isolated from world markets

Name some market-orientated strategies promoting development:

• Trade liberalisation

• Promotion of FDI

• Removal of government subsidies

• Floating exchange rates

• Microfinance schemes

• Privatisation

What is trade liberalisation?

The lowering or complete removal of trade barriers such as tariffs, quotas, and non-tariff barriers

What are the benefits of trade liberalisation for consumers, companies, and the country?

• Consumers: lower prices so higher consumer surplus. Choice and quality of goods and services available will also increase

• Companies: diversifies risk, and enables firms to benefit from economies of scale → lower LRAC

• Country: promotes competition and usually leads to increased investment and productivity

The OECD has estimated that if G20 economies reduced trade barriers by 50% there would be up to a _ rise in real wages for lower and higher skilled workers

up to 8% rise in real wages

Some drawbacks of trade liberalisation:

• Some domestic industries unable to compete with competition from foreign suppliers → loss of jobs in these industries

• Adverse effects on the environment: more trade → more transport → more emissions

• Infant industries in developing and emerging economies may not be able to survive competition from companies in developed countries

How may governments promote FDI?

• Reduction in corporation tax (tax on profits)

• Increases in tax incentives and grants towards investment (e.g. ‘tax holiday’ for first few years or subsidising workers)

• Increasing ease of doing business in a country (less regulation, better infrastructure)

• Liberalisation of labour laws e.g. zero hour contracts

• Reducing trade barriers = easier to import components and export finished goods

What is microfinance

A means of providing extremely poor families with small loans (microcredit) to help them engage in productive activities / grow their tiny business.

Name some interventionist strategies influencing growth and development

• Development of human capital

• Protectionism

• Managed exchange rates

• Infrastructure development

• Promotion of joint structures

• Buffer stock schemes

What is the aim of protectionism?

Enable a country to diversify in a controlled way until it has built a strong domestic base. This approach will be most effective where a country’s domestic market is large enough to enable industries to benefit from economies of scale - then allowing them to cope with foreign competition.