Ultimate Guide (IB) - Economics (HL)
Introduction to Economics
1.1 Key Concepts:
Definition
is a social science that studies the relationship between humans and the economy using past experiences and observations
studies how humans make decisions with the limited resources at their disposal to satisfy their unlimited needs and wants
Key concepts (WISE CHOICES)
9 interlinked central concepts of IB econ (WISE CHOICES (Well-being, Interdependence, Scarcity, Efficiency, CHOices, Intervention, Change, Equity, Sustainability))
Scarcity: limited availability of resources in relation to our unlimited wants,
- fundamental concept of opportunity cost (what you forego to gain something else) and choicesefficiency → input < output, optimal use of resources to minimize resource waste
equity → fair distribution of resources, rather than equal. Fair is normative (subjective)
Economic Well-Being → multidimensional concept relating to the prosperity level and quality of living standards of people (financial security, ability to meet basic needs, make economic choices for personal satisfaction, maintain adequate income levels)
Sustainability: using resources such that needs of future generations aren’t compromised
Change: The economic world is constantly changing (institutional, structural, technological, economic, and social level), and economists need to be wary of that in their models.
Interdependence: instead of being self-sufficient, economic actors interact with each other and thus are interdependent
Intervention: generally market powers organize economic activity but when they fail to meet social goals governments intervene to control choices
1.2 Central Economic Problem (Scarcity):
Definition
Friction between unlimited needs and limited resources
Exacerbated by mindless use of resources since these are diminishing
Depends upon product as well as location (affects availability of resource) and circumstances (poverty; higher scarcity)
Gives rise to need for choices on how to allocate the 4 factors of production
Associated Concepts (Wants/Needs, Resources)
Wants: desires vs Needs: goods and services
expressed as consumer demand in markets
Resources: factors of production used to create goods to satisfy these wants
Land → resources needed to produce goods/services
Labor → Skilled/unskilled human efforts
Capital → machinery/tools or money used to make profit
Entrepreneurship → combination of all factors; organise the planning and allocation
Resource Allocation
[Central Problem] → rise to Basic Economic Questions: What, how much, how and for whom to produce
What/How Much → consumer demands {well being, sustainability, equity → what demands are prioritized efficiency, sustainability→ how much to produce}
How → labor (labour intensive) or machines (capital intensive) {efficiency, sustainability}
For Whom → depends upon the economic system.
Pure market → for those who can buy
Intervention → whatever maximizes equity and well being
Allocation of Resources: process of dividing factors of production to produce goods and services in an economy to answer the basic economic questions
3 types of economies based on this:
Planned (govt intervention)
Market (invisible hand of market)
Mixed (PPPP → public private partnership projects)
Associated Questions: What extent governments should intervene in this allocation?
Opportunity Cost
arises from scarcity
what you are foregoing in order to obtain something
All economic goods have an opportunity cost
1.3 Production Possibilities Curve (PPC)
Modelling
Modeling: allows analysis of economic problems by narrowing down the focus to a few variables, keeping others constant (ceteris paribus)
diagrammatic or mathematical
PPC as a model
PPC: Graphical model of a two products that an economy can produce given that all the resources in the economy are being used efficiently; time period and technology remains fixed
illustrates scarcity, choice, opportunity cost and efficiency
concave curve from the origin
within curve → inefficient, on it → efficient, outside → unattainable (as resources are limited and tech is fixed)
Assumptions;
No Wastage: max output is attained when operating on the curve
Fixed Production Possibilities; all resources dedicated to only two goods
Resource Availability; fixed amount of resources
Constant Technology at a given instance (change →shifts PPC)
Conditions: (i.e. max efficiency)
Full Employment: assume all factors of production (incl. labor) completely used → full employment
Efficiency: all resources are being used optimally and there is no wastage, i.e max output
Actual Growth:
increase in actual output (amount of goods a country is producing ⇒ indicated by where a country is standing)
Rightward movement
Potential Growth = Curve Shifts
change in the amount of goods a country can produce
improvements in quantity or quantity of factors of production or tech can shift the ppc to the right
Downward Slope → need to forego a certain quantiy of one good for more of another good. This shows increasing opportunity cost, as the slope gets tangentially steep
Linear Slope: opportunity cost ratio =1 (constant)/the max possible value of A and B is same
1.4 Circular Flow Model of Income
Fundamental Ideas
graphical model to explain the flow of money in a closed economy
illustrates interactions b/w different sectors in an economy; thus showing interdependence
Fundamental principle: exchanges in an economy are voluntary and every actor benefits from them and market economies are not a zero-sum game ( ⇒ no win-lose situation)
2-Sector Model
simplified version with only firms and households
Assumptions:
Firms: produce all goods
Households: own all factors of production
Closed Economy (no foreign investment/govt/financial institutions)
Households:
1. Supply Factors of Production: gain income → buy products → generate revenue for firms
2. Supply to the Factor Market: demand from product market
Firms:
Household Productive resources (Labor) → produce output → sold in product market → revenue used for rent
Model Terminology
Wages: Income earned by households = rent paid by firms
Profit: Money earned by firms
Rent: expenses paid by firms
Expenditures: Consumption of households = income earned factor market → [supplies] → product market demands
Firm spending: Land, Labor, Rent, Wages
Money flowing in the model → Gross National Income
Rising: economy is growing
Falling: economy is in recession
Five-sector Model
includes government, foreign sector and financial sector
Injections and Leakages: in/out flow of money into the model/economy
Injections → increase income
government spending, financials sector incentivization (investments/loans) and foreign sector (exports bring revenue)
Leakages: withdrawal of money from the flow → taxes, savings, and/or imports
Microeconomics
Microeconomics is the branch of economics that deals with the behavior of individual economic agents, including consumers, firms, and workers.
Key Concepts in Microeconomics
1. Basic Principles of Microeconomics
Scarcity: The fundamental economic problem is scarcity—resources are limited, but human wants and needs are virtually limitless. This forces individuals and firms to make choices about how to allocate resources efficiently.
Opportunity Cost: The cost of forgoing the next best alternative when making a decision. For example, if you spend money on a concert ticket, the opportunity cost is what you could have spent the money on, such as books or a dinner.
Efficiency: Achieving the most output with the least amount of input, often referred to as productive efficiency. In microeconomics, this can also mean using resources in ways that maximize total benefit to society.
Utility: The satisfaction or pleasure derived from consuming goods and services. Consumers make decisions to maximize their utility given their limited resources.
2. Demand and Supply
At the heart of microeconomics is the interaction between demand and supply. The price of goods and services is determined by the balance between the quantity that consumers are willing to buy and the quantity that producers are willing to sell.
A. Law of Demand
The law of demand states that, all else being equal, as the price of a good or service increases, the quantity demanded decreases. Conversely, as the price decreases, the quantity demanded increases. This negative relationship is often depicted with a downward-sloping demand curve.
B. Law of Supply
The law of supply states that, all else being equal, as the price of a good or service increases, the quantity supplied increases. As the price decreases, the quantity supplied decreases. The relationship between price and quantity supplied is typically positive, depicted by an upward-sloping supply curve.
C. Equilibrium Price and Quantity
The equilibrium occurs where the quantity demanded equals the quantity supplied. At this point, the market-clearing price is established. If the price is too high, there will be excess supply (surplus), and if the price is too low, there will be excess demand (shortage). The market naturally adjusts to the equilibrium price.
3. Elasticity
Elasticity measures how responsive the quantity demanded or supplied of a good is to a change in price or other factors.
A. Price Elasticity of Demand (PED)
Price elasticity of demand refers to the responsiveness of the quantity demanded of a good to a change in its price.
Elastic Demand: When the price of a good increases, and the quantity demanded decreases significantly (PED > 1).
Inelastic Demand: When the price changes have little effect on the quantity demanded (PED < 1).
Unitary Elasticity: When a change in price leads to an equal proportional change in quantity demanded (PED = 1).
Factors affecting PED include the availability of substitutes, necessity versus luxury status, and the proportion of income spent on the good.
B. Price Elasticity of Supply (PES)
Price elasticity of supply measures the responsiveness of quantity supplied to changes in price.
Elastic Supply: When producers can increase production quickly in response to price increases (PES > 1).
Inelastic Supply: When production cannot be easily increased despite price increases (PES < 1).
Unitary Elastic Supply: When a price change results in an equal proportional change in the quantity supplied (PES = 1).
C. Income Elasticity of Demand (YED)
This measures how demand for goods changes as consumer income changes.
Normal Goods: Goods for which demand increases as income increases (YED > 0).
Inferior Goods: Goods for which demand decreases as income increases (YED < 0).
D. Cross-Price Elasticity of Demand (XED)
This measures the responsiveness of the demand for one good when the price of a related good changes.
Substitutes: If the price of one good rises, the demand for the other good increases (XED > 0).
Complements: If the price of one good rises, the demand for the other good decreases (XED < 0).
4. Consumer and Producer Surplus
Consumer Surplus: The difference between what consumers are willing to pay for a good and what they actually pay. It represents the benefit to consumers from participating in a market.
Producer Surplus: The difference between the price at which producers are willing to sell a good and the price they actually receive. It represents the benefit to producers from participating in a market.
Both surpluses are maximized at market equilibrium, and changes in price or quantity can lead to changes in total surplus.
5. Market Structures
Microeconomics also studies different market structures, each of which impacts pricing and competition differently.
A. Perfect Competition
In a perfectly competitive market:
There are many buyers and sellers.
All firms sell identical (homogeneous) products.
There is free entry and exit from the market.
Firms are price takers, meaning they accept the market price as given.
There is no long-term economic profit, as new firms can enter and drive profits to zero.
B. Monopoly
In a monopoly:
There is only one seller in the market.
The monopolist controls the entire supply of a product and can set prices.
Barriers to entry prevent other firms from entering the market.
Monopolists often produce less and charge higher prices than in competitive markets, leading to inefficiency.
C. Oligopoly
In an oligopoly:
A few large firms dominate the market.
Products may be homogeneous or differentiated.
Firms may engage in price competition, but also non-price competition like advertising.
There can be barriers to entry, and firms are interdependent—each firm's decisions affect the others (e.g., collusion, price leadership, or game theory).
D. Monopolistic Competition
In monopolistic competition:
There are many firms in the market.
Each firm produces a slightly differentiated product, allowing some degree of price-setting power.
There is free entry and exit in the market.
Firms compete on price, quality, and brand differentiation.
In the long run, firms earn normal profit (zero economic profit) due to free entry and exit.
6. Costs of Production
Understanding the costs faced by firms is critical for analyzing how firms decide on output and pricing.
A. Fixed and Variable Costs
Fixed Costs: Costs that do not change with the level of output (e.g., rent, salaries).
Variable Costs: Costs that change with the level of output (e.g., raw materials, labor costs).
B. Total, Average, and Marginal Costs
Total Cost (TC): The sum of fixed and variable costs.
Average Cost (AC): The cost per unit of output, calculated as total cost divided by the number of units produced (AC = TC/Q).
Marginal Cost (MC): The additional cost of producing one more unit of output. It is crucial for firms' decision-making regarding production levels.
C. Economies of Scale
As firms increase production, they often experience economies of scale, where average costs fall as production increases. This happens because fixed costs are spread over more units, and operational efficiencies improve.
7. Government Intervention
Governments intervene in markets for various reasons, such as correcting market failures, ensuring equity, or influencing economic outcomes.
A. Price Controls
Price Floors: A minimum price set by the government (e.g., minimum wage). A price floor above equilibrium creates a surplus (e.g., unemployment).
Price Ceilings: A maximum price set by the government (e.g., rent controls). A price ceiling below equilibrium creates a shortage (e.g., housing shortages).
B. Taxes and Subsidies
Taxes: Governments may impose taxes on goods and services to reduce consumption or generate revenue. Taxes shift the supply curve upwards, increasing the price consumers pay and reducing the quantity supplied.
Subsidies: Governments provide subsidies to encourage production or consumption of certain goods, which shifts the supply curve downwards, lowering prices for consumers.
C. Externalities
Externalities are the unintended side effects of economic activities that affect third parties. They can be either:
Positive Externalities: Benefits to others (e.g., education, public health).
Negative Externalities: Costs to others (e.g., pollution, traffic congestion). Governments may intervene to address these externalities through regulation or taxation.
Macroeconomics
Macroeconomics is the branch of economics that focuses on the behavior, performance, and structure of the entire economy, rather than individual markets.
I. Key Macroeconomic Objectives
Governments and policymakers generally pursue the following macroeconomic objectives:
A. Economic Growth
Economic growth refers to the increase in a country’s output of goods and services, typically measured by GDP. A growing economy generally leads to higher standards of living and increased employment opportunities.
B. Full Employment
Full employment occurs when all individuals who are willing and able to work at the prevailing wage rates are employed. It does not mean zero unemployment, as some natural unemployment (frictional and structural) always exists.
Types of Unemployment:
Frictional Unemployment: Short-term unemployment as people move between jobs.
Structural Unemployment: Unemployment due to changes in the structure of the economy (e.g., technological advances).
Cyclical Unemployment: Unemployment caused by a downturn in the business cycle.
C. Price Stability (Low Inflation)
Price stability refers to keeping inflation at a low and stable rate. High inflation can erode the purchasing power of money, while deflation (a decrease in prices) can lead to economic stagnation.
Measurement of Inflation: Inflation is typically measured by the Consumer Price Index (CPI) or the Producer Price Index (PPI).
Target Inflation Rate: Central banks often aim for an inflation target of around 2% to ensure economic stability.
D. Balance of Payments Stability
The balance of payments refers to the record of all economic transactions between a country and the rest of the world. A stable balance of payments means that a country’s imports and exports are balanced and that the country can service its external debts.
Current Account: Measures a country’s imports and exports of goods and services, as well as net income from abroad.
Capital Account: Tracks investment flows in and out of the country.
II. Key Macroeconomic Concepts
A. Aggregate Demand (AD)
Aggregate demand is the total quantity of goods and services demanded in an economy at different price levels. It is the sum of consumption, investment, government spending, and net exports (exports minus imports).
Formula:
Where:
C = Consumption
I = Investment
G = Government spending
X = Exports
M = Imports
Factors Affecting Aggregate Demand:
Consumer Confidence: If consumers are optimistic about the economy, they tend to spend more, increasing AD.
Interest Rates: Lower interest rates make borrowing cheaper, which can increase investment and consumption.
Government Policy: Increased government spending or tax cuts can boost aggregate demand.
B. Aggregate Supply (AS)
Aggregate supply refers to the total quantity of goods and services that producers in an economy are willing and able to supply at different price levels.
Short-Run Aggregate Supply (SRAS): In the short run, production can increase with higher prices, as firms can increase output by hiring more labor and using existing capital more efficiently.
Long-Run Aggregate Supply (LRAS): In the long run, the economy is at full capacity, and output is determined by the economy’s resources (labor, capital, and technology).
C. Economic Growth and the Business Cycle
Economic growth is the increase in the production of goods and services. The business cycle describes the fluctuations in economic activity that occur over time, typically including phases of expansion (growth) and contraction (recession).
Phases of the Business Cycle:
Expansion: Increasing economic activity and rising employment.
Peak: The point at which the economy is at its highest output level.
Recession: A period of declining economic activity, usually accompanied by rising unemployment.
Trough: The lowest point in the cycle, marking the end of a recession.
D. Inflation
Inflation is the rate at which the general price level of goods and services rises, leading to a decrease in the purchasing power of money.
Types of Inflation:
Demand-Pull Inflation: Occurs when aggregate demand exceeds aggregate supply, leading to upward pressure on prices.
Cost-Push Inflation: Happens when the cost of production increases (e.g., higher wages or raw material costs), causing producers to raise prices.
E. Unemployment
Unemployment is the condition in which individuals who are capable of working and actively seeking work are unable to find employment.
Types of Unemployment:
Frictional Unemployment: Short-term unemployment that occurs when individuals are transitioning between jobs.
Structural Unemployment: A longer-term form of unemployment caused by a mismatch between workers’ skills and the demands of the labor market.
Cyclical Unemployment: Unemployment caused by the decline in economic activity during a recession.
F. Fiscal Policy
Fiscal policy refers to the use of government spending and taxation to influence the economy. It is often used to stabilize the economy during fluctuations in the business cycle.
Expansionary Fiscal Policy: Involves increasing government spending or decreasing taxes to stimulate economic activity during a recession.
Contractionary Fiscal Policy: Involves reducing government spending or increasing taxes to cool down an overheating economy.
G. Monetary Policy
Monetary policy refers to the actions of a central bank to control the money supply and interest rates in an economy.
Expansionary Monetary Policy: Lowering interest rates or increasing the money supply to stimulate economic growth.
Contractionary Monetary Policy: Raising interest rates or decreasing the money supply to reduce inflation.
Tools of Monetary Policy:
Open Market Operations: Buying and selling government securities to influence the money supply.
Discount Rate: The interest rate charged to commercial banks for borrowing from the central bank.
Reserve Requirements: The percentage of deposits that banks must hold in reserve rather than lend out.
III. Macroeconomic Equilibrium
Macroeconomic equilibrium occurs when aggregate demand equals aggregate supply in the economy. At this point, there is no tendency for the overall level of output and prices to change.
Short-Run Equilibrium: Occurs when the quantity of goods and services demanded equals the quantity supplied at the current price level.
Long-Run Equilibrium: In the long run, the economy is at full employment, and the LRAS curve is vertical.
IV. Policy Conflicts and Trade-Offs
Governments and central banks often face trade-offs when trying to achieve macroeconomic objectives. For example:
Inflation vs. Unemployment: An economy may face a trade-off between lowering inflation and reducing unemployment. Expansionary policies may lower unemployment but increase inflation.
Economic Growth vs. Income Inequality: Economic growth may lead to higher incomes, but it can also exacerbate income inequality if the benefits are not distributed equally.
V. Conclusion
Macroeconomics plays a crucial role in understanding how economies function at large scales, influencing government policies, business strategies, and the lives of individuals.
The Global Economy
4.1 Benefits of International Trade
International trade is the exchange of goods, services, and capital across national borders. It plays a crucial role in the global economy, offering numerous benefits to participating countries.
Benefits of International Trade
Increased Consumer Choice
Lower Prices
Economies of Scale
Increased Efficiency and Productivity
Access to Resources
Economic Growth
Greater Innovation
Transfer of Technology and Knowledge
Improved International Relations
Absolute and Comparative Advantage
Absolute Advantage: A country has an absolute advantage in producing a good or service if it can produce it using fewer resources (or at a lower cost) than another country.
Comparative Advantage: Comparative advantage is a more nuanced concept than absolute advantage. A country has a comparative advantage in producing a good or service if it can produce it at a lower opportunity cost than another country. This is the foundation of the theory of specialization and trade.
Opportunity Costs: Opportunity cost is the value of the next best alternative for when making a choice. In the context of trade, it refers to the amount of one good that a country must sacrifice to produce one more unit of another good.
Sources of Comparative Advantage: Comparative advantage can arise from various factors:
Differences in Factor Endowments: Countries have different amounts of resources like land, labor, capital, and natural resources.
Differences in Technology: Some countries have 1 more advanced technology than others, leading to higher productivity and lower costs in certain industries.
Climate: Climate conditions can favor the production of certain goods in specific regions. For example, tropical climates are ideal for growing bananas and coffee.
Specialized Skills and Knowledge: A country may develop a comparative advantage in industries where it has accumulated specialized skills and knowledge over time, like the Philippines in Business Process Outsourcing (BPO).
Gains from Trade: The theory of comparative advantage suggests that countries can gain from trade by specializing in producing goods and services where they have a comparative advantage and trading for goods and services where they do not. Even if a country has an absolute advantage in producing everything, it can still benefit from specializing in what it is relatively more efficient at producing and trading with other countries. This specialization and trade lead to higher overall global output and consumption possibilities for all participating nations.
Limitations of the Theory of Comparative Advantage
Simplified Assumptions: The theory of comparative advantage is based on several simplifying assumptions that may not always hold true in the real world:
Perfect Competition
No Transport Costs
Constant Costs of Production
Two-Country, Two-Good Model
Full Employment
Free Trade
Factor Immobility: The theory assumes factors of production (labor, capital) are perfectly mobile within a country but immobile between countries. While labor mobility is limited, capital is becoming increasingly mobile internationally.
Changing Comparative Advantage: Comparative advantage is not static and can change over time due to technological advancements, changes in factor endowments, government policies, and other factors. Countries need to adapt to shifting global comparative advantages.
Terms of Trade: The gains from trade are not always evenly distributed and depend on the terms of trade (the ratio of export prices to import prices). Unfavorable terms of trade can reduce the benefits of trade for a country.
Development Concerns: Developing countries may face challenges in benefiting from trade if they specialize in primary commodities with volatile prices and low value-added, while developed countries specialize in higher value-added manufactured goods and services.
Externalities: The theory may not fully account for externalities, such as environmental costs associated with increased production and transportation due to trade.
Political and Social Factors: Trade policies are often influenced by political and social considerations, such as national security, protection of infant industries, and concerns about income distribution, which are not fully captured by the theory of comparative advantage.
4.2 Types of Trade Protection
Trade protection refers to government policies that restrict or limit international trade to protect domestic industries from foreign competition.
Tariffs, Quotas, and Subsidies
Tariffs: Tariffs are taxes imposed on imported goods or services.
Effects on Markets and Stakeholders:
Increased Price of Imports
Reduced Imports
Increased Domestic Production
Government Revenue
Consumer Surplus Loss
Producer Surplus Gain
Inefficiency
Quotas: Quotas are quantitative restrictions on the volume of imports allowed into a country during a specific period.
Effects on Markets and Stakeholders:
Limited Import Quantity: Quotas directly limit the amount of a good that can be imported, regardless of price.
Increased Price of Imports: By restricting supply, quotas typically lead to higher prices for imported goods.
Increased Domestic Production: Similar to tariffs, quotas protect domestic industries and allow them to increase production.
No Government Revenue: Unlike tariffs, quotas do not generate revenue for the government (unless import licenses are auctioned).
Consumer Surplus Loss: Consumers face higher prices and reduced availability of imported goods.
Producer Surplus Gain: Domestic producers benefit from reduced competition and higher prices.
Potential for Corruption: Quota allocation can be subject to corruption and rent-seeking behavior.
Subsidies: Subsidies are government payments to domestic producers. These can take various forms, such as direct cash payments, tax breaks, or low-interest loans.
Effects on Markets and Stakeholders:
Lower Production Costs for Domestic Firms: Subsidies reduce the production costs for domestic firms, making them more competitive.
Increased Domestic Production: Subsidies encourage domestic firms to increase production.
Increased Exports (Export Subsidies): Export subsidies can help domestic firms sell more goods in international markets.
Lower Prices for Domestic Consumers (Production Subsidies): Production subsidies may lead to lower prices for consumers if cost savings are passed on.
Government Expenditure: Subsidies involve government spending, which needs to be financed through taxes or other revenue sources.
Potential Inefficiency: Subsidies can keep inefficient domestic firms in business, leading to a misallocation of resources.
Trade Disputes: Subsidies can be challenged by other countries as unfair trade practices, potentially leading to trade disputes.
Administrative Barriers
Definition: Administrative barriers are non-tariff barriers to trade that take the form of regulations, procedures, and bureaucratic hurdles that make it more difficult and costly to import goods.
Types of Administrative Barriers:
Product Standards and Regulations
Customs Procedures
Bureaucratic Delays
Rules of Origin
Sanitary and Phytosanitary (SPS) Measures
Technical Barriers to Trade (TBT)
4.3 Arguments For and Against Trade Control/Protection
Trade control or protectionism refers to government policies that restrict international trade. t.
Arguments for Trade Protection / Advantages of Trade Protection
Governments and industries advocate for trade protection for various reasons, often citing benefits to the domestic economy and society.
Protection of Infant (Sunrise) Industries:
Rationale: New industries in a country, especially in developing economies, may be too weak to compete with established foreign firms. These "infant industries" need temporary protection to grow, mature, and become competitive globally.
Mechanism: Protectionist measures like tariffs or subsidies can shield these nascent industries from intense foreign competition, allowing them to gain market share, develop expertise, and achieve economies of scale.
Limitations: "Temporary" protection can become permanent, leading to inefficiencies and rent-seeking. It can be challenging to identify truly "infant" industries with long-term potential and to remove protection later.
National Security:
Rationale: Certain industries are considered vital for national security, such as defense, energy, food, and critical infrastructure. Dependence on foreign suppliers for these strategic sectors can be risky, especially during geopolitical instability or conflict.
Mechanism: Trade protection can ensure domestic production capacity in these sectors, reducing reliance on imports and enhancing self-sufficiency.
Limitations: This argument can be broadly applied to many industries, potentially leading to excessive protectionism. It can also be used as a pretext to protect inefficient industries that are not genuinely critical for national security.
Health and Safety:
Rationale: Governments may impose trade restrictions to protect consumers from harmful or unsafe imported products. This includes food safety standards, product safety regulations, and restrictions on hazardous materials.
Mechanism: Import bans, strict testing and certification requirements, and labeling regulations can prevent the entry of goods that do not meet domestic health and safety standards.
Limitations: These measures can be used as disguised protectionism if standards are set arbitrarily high or are discriminatory against foreign producers. It's important for standards to be based on scientific evidence and applied transparently.
Environmental Standards:
Rationale: Countries with strong environmental regulations may argue for trade protection to level the playing field with countries that have lax environmental standards. This aims to prevent "pollution havens" where industries relocate to countries with weaker rules to gain a cost advantage.
Mechanism: Tariffs or import restrictions can be imposed on goods produced in countries with lower environmental standards, encouraging them to adopt stricter regulations.
Limitations: Environmental protectionism can be controversial and may be seen as a barrier to trade, especially by developing countries that argue that environmental standards should be linked to development levels and financial assistance.
Anti-Dumping:
Rationale: "Dumping" occurs when foreign firms sell goods in an export market at prices below their cost of production or below prices in their domestic market. This is considered an unfair trade practice that can harm domestic industries.
Mechanism: Anti-dumping duties (tariffs) can be imposed on dumped imports to raise their prices to a "fair" level and protect domestic producers from predatory pricing.
Limitations: Defining "dumping" and proving injury to domestic industries can be complex and subject to political influence. Anti-dumping duties can be easily misused as protectionist measures.
Unfair Competition:
Rationale: This argument extends beyond dumping to encompass other perceived unfair practices by foreign competitors, such as government subsidies, lax labor standards, or intellectual property violations.
Mechanism: Trade protection is sought to counter these "unfair" advantages and create a level playing field for domestic firms. This can involve countervailing duties (to offset subsidies) or other trade restrictions.
Limitations: "Fairness" is a subjective concept, and what constitutes "unfair competition" can be debated. Protectionist measures based on this argument can easily escalate into trade disputes.
Balance of Payments Correction:
Rationale: A country facing a persistent balance of payments deficit (where imports exceed exports) may use trade protection to reduce imports and improve its trade balance.
Mechanism: Tariffs and quotas can reduce import demand, theoretically helping to decrease the trade deficit and improve the overall balance of payments.
Limitations: Trade protection is generally not an effective or sustainable solution for balance of payments problems. It can distort trade, invite retaliation, and may not address the underlying macroeconomic causes of the deficit. Better solutions often involve exchange rate adjustments or fiscal and monetary policies.
Government Revenue:
Rationale: Tariffs are a source of government revenue, particularly for developing countries where tax collection systems may be less efficient.
Mechanism: Tariffs on imports generate tax revenue for the government as a percentage of the import value.
Limitations: Relying on tariffs for revenue can be inefficient and distortive. As trade volumes decrease due to tariffs, revenue may also decline. Modern tax systems should ideally rely on more efficient and less distortionary revenue sources like income or consumption taxes.
Protection of Jobs:
Rationale: A common and politically appealing argument is that trade protection saves jobs in domestic industries that face competition from imports.
Mechanism: By limiting imports, trade protection can increase demand for domestically produced goods, theoretically preserving or creating jobs in those industries.
Limitations: While protection may save jobs in specific protected industries, it often comes at the cost of job losses in other sectors (e.g., export industries, retail, and industries that use protected goods as inputs). Protectionism also reduces overall economic efficiency and can lead to lower real incomes, ultimately harming job creation in the long run.
Economically Least Developed Country (ELDC) Diversification:
Rationale: ELDCs often rely heavily on exporting a narrow range of primary commodities. Trade protection can be used to encourage diversification into manufacturing and other higher value-added industries, reducing dependence on commodity exports and promoting economic development.
Mechanism: Temporary protection can help new manufacturing industries in ELDCs to establish themselves and diversify the economy away from primary commodity dependence.
Limitations: Similar to the infant industry argument, protection for diversification should be temporary and carefully targeted. It's crucial to create an environment that promotes efficiency and competitiveness rather than long-term dependence on protection.
Arguments Against Trade Protection / Disadvantages of Trade Protection
Economists generally argue against trade protection, highlighting its negative impacts on economic efficiency, consumer welfare, and global trade relations.
Misallocation of Resources:
Rationale: Trade protection distorts market signals and leads to a misallocation of resources. It encourages resources to flow into less efficient, protected industries, rather than into sectors where a country has a comparative advantage.
Mechanism: Protection raises prices in the domestic market, making it profitable for less efficient domestic firms to operate and expand. Resources are drawn away from more efficient export-oriented industries or sectors where the country is truly competitive.
Consequences: Lower overall productivity, reduced economic growth, and lower living standards compared to a free trade scenario.
Retaliation:
Rationale: When one country imposes trade barriers, other countries are likely to retaliate with their own protectionist measures. This can lead to trade wars, where multiple countries impose tariffs and restrictions on each other's exports, harming global trade and economic growth.
Mechanism: Country A imposes tariffs on imports from Country B. Country B retaliates by imposing tariffs on imports from Country A. This cycle can escalate, reducing trade volume and increasing trade costs for all involved.
Consequences: Reduced global trade, decreased export opportunities, increased uncertainty for businesses, and potential damage to international relations.
Increased Costs for Businesses:
Rationale: Trade protection, especially tariffs and quotas on imported inputs, increases costs for domestic businesses that rely on these imports for production. This can reduce their competitiveness, both domestically and internationally.
Mechanism: Tariffs raise the price of imported raw materials, components, or capital goods. Quotas limit the availability of these inputs. This increases production costs for domestic firms that use these imports.
Consequences: Reduced profitability for businesses, decreased competitiveness, potentially higher prices for final goods.
Higher Prices for Consumers:
Rationale: Trade protection leads to higher prices for consumers. Tariffs and quotas directly increase the prices of imported goods. Reduced competition from imports also allows domestic firms to charge higher prices than they would in a free trade environment.
Mechanism: Tariffs are taxes on imports, directly raising prices. Quotas restrict supply, also leading to higher prices. Reduced import competition allows domestic firms to face less price pressure.
Consequences: Reduced consumer purchasing power, lower living standards, and regressive impact on lower-income households who spend a larger proportion of their income on essential goods.
Less Choice for Consumers:
Rationale: Trade protection reduces the variety of goods and services available to consumers. Quotas directly limit the quantity of imports, and tariffs make imports more expensive, reducing their demand and availability.
Mechanism: Quotas limit import quantities. Tariffs reduce import demand, leading to fewer imported products being offered in the market.
Consequences: Reduced consumer satisfaction, less access to specialized or unique products, and potentially lower quality if domestic firms face less pressure to innovate and improve their offerings.
Domestic Firms Lack Incentive to Become More Efficient:
Rationale: Trade protection reduces competitive pressure on domestic firms. Shielded from foreign competition, they have less incentive to innovate, improve efficiency, and reduce costs. This can lead to complacency and stagnation in the long run.
Mechanism: Reduced import competition weakens the pressure on domestic firms to improve productivity, adopt new technologies, or streamline operations. Protected firms can survive and even thrive without being globally competitive.
Consequences: Lower productivity growth, reduced innovation, and a less dynamic domestic economy in the long run.
Reduced Export Competitiveness:
Rationale: Trade protection can harm a country's export competitiveness. By raising input costs (as mentioned above) and by inviting retaliation from trading partners, protectionist measures can make it more difficult for domestic firms to export their goods and services.
Mechanism: Higher input costs due to protection make exports more expensive. Retaliatory tariffs imposed by other countries directly reduce export demand.
Consequences: Reduced export earnings, slower export growth, and a less competitive position in the global economy.
Free Trade Versus Trade Protection
Free Trade: A system where goods and services can flow between countries without government-imposed barriers like tariffs, quotas, or subsidies.
Arguments for Free Trade: Leads to greater economic efficiency, lower prices, increased consumer choice, higher economic growth, and fosters international cooperation. Based on the theory of comparative advantage, it maximizes global output and consumption.
Arguments against Free Trade: Can lead to job losses in import-competing industries, potential exploitation of workers and the environment in developing countries, and may not be suitable for infant industries or strategic sectors.
Trade Protection: A system where governments actively intervene to restrict or regulate international trade, typically to protect domestic industries.
Arguments for Trade Protection: Can protect infant industries, safeguard national security, address unfair competition, generate government revenue, protect jobs, and promote diversification in ELDCs.
Arguments against Trade Protection: Leads to economic inefficiency, higher prices, reduced consumer choice, retaliation, reduced export competitiveness, and can hinder long-term economic growth and innovation.
The Debate: The debate between free trade and trade protection is ongoing and complex. Economists generally favor free trade due to its efficiency and welfare benefits, but recognize that there may be specific, limited cases where carefully targeted and temporary protectionist measures might be justified. However, the risks of protectionism outweigh the potential benefits in most situations. Finding the right balance between openness and targeted intervention is a key challenge for policymakers.
4.4 Economic Integration
Economic integration refers to the process where countries coordinate and merge their economic policies to reduce or eliminate trade barriers and increase economic interdependence.
Preferential Trade Agreements (PTAs)
Preferential trade agreements are the least integrated form of economic cooperation. They involve countries reducing tariffs and other trade barriers on certain goods or services traded among themselves, while maintaining independent trade policies with the rest of the world.
Bilateral Agreements: These are trade agreements between two countries. They are often focused on specific sectors or products and can be easier to negotiate than larger agreements.
Example: The Japan-Philippines Economic Partnership Agreement (JPEPA) is a bilateral agreement aimed at strengthening economic ties between Japan and the Philippines through reduced tariffs and improved trade rules.
Regional Agreements: These agreements involve three or more countries within a specific geographical region. They aim to promote trade and investment within the region.
Example: The ASEAN Free Trade Area (AFTA) is a regional agreement among the ten member states of the Association of Southeast Asian Nations (ASEAN), including the Philippines. AFTA aims to reduce tariffs and non-tariff barriers among ASEAN members, fostering regional trade and economic integration.
Multilateral Agreements: These are agreements involving many countries across the globe. The most prominent example is the World Trade Organization (WTO).
The World Trade Organization (WTO): The WTO is a global international organization dealing with the rules of trade between nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. The goal is to ensure that trade flows as smoothly, predictably and freely as possible.
Key Functions of the WTO:
Administering trade agreements
Acting as a forum for trade negotiations
Settling trade disputes
Providing technical assistance for developing countries
Monitoring national trade policies
Principles of the WTO:
Non-discrimination:
Most-Favoured-Nation (MFN): Treating all trading partners equally. If a country grants a special favor (such as a lower customs duty rate for one of their products) to one trading partner, they have to do the same for all other WTO members.
National Treatment: Treating foreigners and locals equally. Imported and locally-produced goods should be treated equally once the foreign goods have entered the market.
Freer trade: Gradually lowering trade barriers through negotiations.
Predictability: Foreign companies, investors and governments should be confident that trade barriers will not be raised arbitrarily.
Fair competition: Discouraging unfair practices such as export subsidies and dumping products at below-cost prices to gain market share.
Development and reform: Giving more time for developing countries to adjust, greater flexibility, and special privileges.
Trading Blocs
Trading blocs are a form of regional economic integration where a group of countries agree to reduce or eliminate trade barriers among themselves and may also adopt common external trade policies towards non-member countries. Trading blocs aim to promote trade liberalization and economic cooperation among member nations.
Free Trade Areas (FTAs) / Free Trade Agreements: In a free trade area, member countries eliminate tariffs and quotas on trade with each other, but each member maintains its own independent trade policies with non-member countries.
Example: NAFTA (now USMCA - United States-Mexico-Canada Agreement) is a free trade area. Member countries (USA, Mexico, and Canada) have eliminated tariffs on most goods traded between them, but each country has its own tariffs and trade policies when dealing with countries outside of the bloc.
Customs Unions: A customs union goes a step further than a free trade area. Member countries not only eliminate internal trade barriers but also adopt a common external trade policy. This means they apply the same tariffs and quotas to imports from non-member countries.
Example: Mercosur (Southern Common Market) in South America is a customs union. Member countries (Argentina, Brazil, Paraguay, Uruguay) have free trade among themselves and a common external tariff on imports from outside the bloc.
Common Markets: A common market builds upon a customs union by allowing for the free movement of factors of production – labor and capital – in addition to goods and services. This means that workers and businesses can move freely between member countries without restrictions.
Example: The European Economic Community (EEC), before it became the European Union, was a common market. It allowed free movement of goods, services, capital, and labor among member states.
Advantages and Disadvantages of Trading Blocs
Trading blocs offer several potential benefits and drawbacks to member countries and the global economy.
Advantages of Trading Blocs
Trade Creation
Greater Access to Markets and Potential for Economies of Scale
Greater Employment Opportunities with Freedom of Labour
Stronger Bargaining Power in Multilateral Negotiations
Greater Political Stability and Cooperation
Disadvantages of Trading Blocs
Trade Diversion
Loss of Sovereignty
Challenge to Multilateral Trading Negotiations
Advantages and Disadvantages of Monetary Union
A monetary union is a high level of economic integration where member countries adopt a single common currency and a unified monetary policy, typically managed by a common central bank.
Advantages of Monetary Union
Reduced Transaction Costs
Price Transparency
Elimination of Exchange Rate Uncertainty
Increased Trade and Investment
Greater Price Stability
Enhanced Policy Coordination
Disadvantages of Monetary Union
Loss of Independent Monetary Policy
Loss of Exchange Rate Adjustment Mechanism
One-Size-Fits-All Monetary Policy
Fiscal Policy Constraints
Initial Costs of Conversion
Potential for Asymmetric Shocks
4.5 Exchange Rates
An exchange rate is the price of one country's currency expressed in terms of another country's currency. It determines how much of one currency you can get for another.
Floating Exchange Rates
A floating exchange rate system is a regime where the exchange rate of a currency is determined by the free market forces of supply and demand. There is no official target level for the exchange rate, and the government or central bank generally does not intervene to manipulate its value.
Determination by Demand and Supply:
Demand for a Currency: The demand for a country's currency arises from foreign individuals, firms, or governments wanting to:
Import goods and services: To buy Philippine products, foreign buyers need to exchange their currency for Philippine Pesos (PHP).
Invest in Philippine assets: Foreign investors wanting to invest in Philippine businesses, stocks, bonds, or real estate need to purchase PHP.
Travel to the Philippines: Tourists visiting the Philippines need PHP to spend on goods and services.
Speculate on the PHP: Currency traders might buy PHP if they expect its value to rise in the future.
Supply of a Currency: The supply of a country's currency comes from domestic individuals, firms, or the government wanting to:
Import goods 1 and services: To buy foreign products, Philippine buyers need to exchange PHP for foreign currency (e.g., USD).
Invest in foreign assets: Philippine investors wanting to invest abroad need to sell PHP to buy foreign currency.
Travel abroad: Filipinos traveling to other countries need foreign currency for their expenses.
Speculate against the PHP: Currency traders might sell PHP if they expect its value to fall in the future.
Equilibrium Exchange Rate: The exchange rate is determined at the point where the demand for and supply of the currency are equal. This equilibrium point is constantly shifting as demand and supply factors change.
Changes in Demand and Supply for a Currency
Several factors can cause shifts in the demand and supply curves for a currency, leading to changes in the exchange rate.
Factors Affecting Demand for a Currency:
Changes in Demand for Exports: If global demand for Philippine exports (e.g., electronics, BPO services) increases, foreign buyers will need to buy more PHP to pay for these exports, increasing the demand for PHP and causing the PHP to appreciate (increase in value).
Changes in Interest Rates: If interest rates in the Philippines rise relative to other countries, it becomes more attractive for foreign investors to invest in Philippine assets to earn higher returns. This increases demand for PHP and leads to appreciation.
Changes in Speculation: If speculators believe the PHP will become stronger in the future (e.g., due to positive economic news), they will buy PHP now to profit later, increasing demand and causing appreciation.
Increased Tourism: A rise in tourism to the Philippines increases the demand for PHP as tourists need local currency for spending, leading to appreciation.
Foreign Direct Investment (FDI) Inflows: Increased FDI into the Philippines (e.g., foreign companies setting up factories) increases demand for PHP as foreign firms need to convert their currency to PHP for investment, causing appreciation.
Factors Affecting Supply of a Currency:
Changes in Demand for Imports: If Philippine demand for imports increases (e.g., due to rising consumer spending), Filipinos will need to sell more PHP to buy foreign currency to pay for imports, increasing the supply of PHP and causing the PHP to depreciate (decrease in value).
Changes in Interest Rates: If interest rates in the Philippines fall relative to other countries, it becomes less attractive for foreign investors to hold Philippine assets. Philippine investors may also seek higher returns abroad. This increases the supply of PHP and leads to depreciation.
Changes in Speculation: If speculators believe the PHP will become weaker in the future (e.g., due to negative economic news), they will sell PHP now to avoid losses, increasing supply and causing depreciation.
Increased Tourism Abroad by Filipinos: A rise in Filipinos traveling abroad increases the supply of PHP as they sell PHP to buy foreign currency for their trips, leading to depreciation.
Foreign Direct Investment (FDI) Outflows: Increased FDI outflows from the Philippines (e.g., Philippine companies investing abroad) increases supply of PHP as domestic firms sell PHP to buy foreign currency for overseas investment, causing depreciation.
Increased Remittances Outflows: If Filipinos working abroad send less money home (remittances), the supply of foreign currency to the Philippines decreases, which, conversely, could lead to PHP depreciation (less foreign currency inflow to demand PHP). However, typically, remittances are a demand factor for PHP, so a decrease in remittances would decrease demand for PHP and cause depreciation. Correction: Increased remittances outflows from the Philippines (Filipinos sending money out of the country) would increase the supply of PHP, causing depreciation. However, remittances are usually inflows to the Philippines.
Consequences of Changes in the Exchange Rate on Economic Indicators
Changes in exchange rates have significant consequences for various economic indicators:
Impact of Currency Depreciation (e.g., PHP weakens against USD):
Exports become cheaper: Philippine goods and services become cheaper for foreign buyers when priced in their own currency. This can increase exports.
Imports become more expensive: Foreign goods and services become more expensive for Philippine buyers. This can decrease imports.
Trade Balance Improvement: Increased exports and decreased imports can lead to an improvement in the trade balance (exports become closer to or exceed imports) or a reduction in a trade deficit.
Inflation may increase: Imported goods become more expensive, directly increasing import prices. Also, increased export demand can lead to higher domestic demand and potentially demand-pull inflation. Cost-push inflation can also occur if imported inputs for domestic production become more expensive.
Economic Growth: Increased exports can boost aggregate demand and contribute to economic growth. However, higher inflation can offset some of this positive impact.
Employment: Increased exports can lead to increased employment in export-oriented industries. However, higher import prices might negatively affect industries reliant on imported inputs.
Tourism: The Philippines becomes a cheaper tourist destination for foreigners, potentially increasing tourism.
Impact of Currency Appreciation (e.g., PHP strengthens against USD):
Exports become more expensive
Imports become cheaper
Trade Balance Deterioration
Inflation may decrease
Economic Growth
Employment
Tourism
Fixed Exchange Rates
A fixed exchange rate system (also known as a pegged exchange rate) is a regime where a country's central bank officially sets and maintains the exchange rate of its currency at a specific target level or within a narrow band.
Mechanism of Fixing:
Setting a Par Value: The government or central bank declares a specific exchange rate for its currency against another currency (or a basket of currencies or gold). For example, the Philippine Peso might be fixed at PHP 50 per 1 US Dollar.
Central Bank Intervention: To maintain the fixed rate, the central bank must be willing and able to buy or sell its own currency in the foreign exchange market in unlimited quantities whenever the market rate deviates from the fixed rate.
If demand for PHP increases, pushing for appreciation: The central bank must supply PHP (sell PHP and buy foreign currency reserves) to meet the increased demand and prevent appreciation beyond the fixed rate. This increases the supply of PHP in the market, pushing the exchange rate back down to the fixed level.
If supply of PHP increases, pushing for depreciation: The central bank must demand PHP (buy PHP using its foreign currency reserves) to absorb the excess supply and prevent depreciation below the fixed rate. This increases the demand for PHP in the market, pushing the exchange rate back up to the fixed level.
Foreign Currency Reserves: Maintaining a fixed exchange rate requires the central bank to hold substantial foreign currency reserves (e.g., USD, EUR) to intervene in the market.
Advantages of Fixed Exchange Rates:
Exchange Rate Stability
Lower Inflation
Credibility
Disadvantages of Fixed Exchange Rates:
Loss of Monetary Policy Independence
Need for Large Foreign Currency Reserves
Potential for Speculative Attacks
Difficulty in Choosing the Right Fixed Rate
Lack of Flexibility
Managed Exchange Rates
A managed exchange rate system (also known as a hybrid or dirty float) is a regime that combines elements of both floating and fixed exchange rate systems. In a managed float, the exchange rate is primarily determined by market forces, but the central bank intervenes occasionally to moderate exchange rate fluctuations, smooth out volatility, or guide the exchange rate in a desired direction.
Types of Managed Exchange Rate Systems:
Dirty Float: The most common type of managed float. The central bank intervenes in the foreign exchange market to smooth out short-term fluctuations and prevent excessive volatility, but there is no explicit target level for the exchange rate. The central bank may buy or sell currency to lean against the wind or calm disorderly markets.
Target Zone or Band: The central bank sets a target range or band for the exchange rate. The exchange rate is allowed to float freely within this band, but the central bank intervenes to keep it within the band if it approaches the upper or lower limits.
Crawling Peg: A system where the exchange rate is adjusted gradually and predictably over time, often to offset inflation differentials between countries. The exchange rate is pegged, but the peg is regularly adjusted in small increments.
Rationale for Managed Float:
To reduce excessive volatility: Floating exchange rates can be volatile, which can create uncertainty for businesses and investors. Managed float aims to reduce excessive short-term fluctuations.
To prevent disorderly markets: Central bank intervention can help to stabilize markets during periods of panic or excessive speculation.
To influence the exchange rate: Governments may want to influence the exchange rate to improve competitiveness, manage inflation, or achieve other macroeconomic objectives, even in a system that is primarily floating.
Challenges of Managed Exchange Rates:
Determining the appropriate level of intervention: It can be difficult for the central bank to decide when and how much to intervene. Excessive intervention can distort market signals and deplete reserves, while insufficient intervention may be ineffective.
Credibility and Transparency: Managed floats can lack transparency if the central bank's intervention policy is not clear. This can lead to uncertainty and speculation.
Conflict with Monetary Policy Goals: Similar to fixed exchange rates, managing the exchange rate can sometimes conflict with domestic monetary policy goals.
4.6 Balance of Payments (BOP)
The Balance of Payments (BOP) is a systematic record of all economic transactions between the residents of a country and the rest of the world over a specific period, usually a year. It summarizes all flows of money into and out of a country.
Balance of Payments
The BOP is essentially an accounting statement that tracks a nation's financial dealings with the rest of the world.
Credit and Debit Items: Every transaction in the BOP is classified as either a credit or a debit.
Credit Items (+): These are transactions that bring money into the country. They represent inflows of funds from abroad.
Examples:
Exports of goods and services
Inward investment by foreigners (foreigners investing in the Philippines)
Receipt of remittances from Filipinos working abroad
Foreign tourists spending money in the Philippines
Borrowing from abroad
Debit Items (-): These are transactions that send money out of the country. They represent outflows of funds to other countries.
Examples:
Imports of goods and services
Outward investment by residents (Filipinos investing abroad)
Remittances sent by foreigners working in the Philippines to their home countries
Filipino tourists spending money abroad
Lending to foreigners
Surplus or Deficit on an Account: For each component account of the BOP (explained below), there can be a surplus or a deficit.
Surplus: Occurs when credit items are greater than debit items in a particular account. This means more money is flowing into the country than out, for transactions recorded in that specific account.
Deficit: Occurs when debit items are greater than credit items in a particular account. This means more money is flowing out of the country than in, for transactions recorded in that specific account.
Components of the Balance of Payments
The BOP is divided into three main accounts:
Current Account: This account records transactions related to the flow of goods, services, income, and current transfers between a country and the rest of the world. It reflects a country's trade in goods and services and its earnings from investments and transfers.
Balance of Trade in Goods (Visible Trade): Records exports and imports of physical goods (merchandise).
Credit: Exports of goods (+)
Debit: Imports of goods (-)
Balance of Trade in Services (Invisible Trade): Records exports and imports of services.
Credit: Exports of services (e.g., tourism to the Philippines, BPO services exported by the Philippines, transportation services provided to foreigners) (+)
Debit: Imports of services (e.g., Filipinos travelling abroad, using foreign transportation services, importing foreign financial services) (-)
Net Income: Records income earned from abroad minus income paid abroad.
Credit: Income receipts from abroad (e.g., profits and dividends from Philippine investments abroad, wages and salaries earned by Filipinos working abroad) (+)
Debit: Income payments to abroad (e.g., profits and dividends paid to foreign investors in the Philippines, wages and salaries paid to foreigners working in the Philippines) (-)
Current Transfers: Records unilateral transfers (payments without any goods or services in return) between countries.
Credit: Current transfers received from abroad (e.g., foreign aid received by the Philippines, remittances from Filipinos working overseas) (+)
Debit: Current transfers paid to abroad (e.g., foreign aid given by the Philippines, remittances sent by foreigners working in the Philippines) (-)
Current Account Balance: The sum of the balance of trade in goods, balance of trade in services, net income, and net current transfers. It can be in surplus or deficit.
Capital Account: This account records transactions related to the transfer of ownership of fixed assets (capital goods) and non-produced, non-financial assets. It is relatively small and less significant than the current and financial accounts for most countries.
Capital Transfers: Records transfers of ownership of fixed assets (e.g., debt forgiveness, migrants' transfers of assets).
Credit: Capital transfers received from abroad (+)
Debit: Capital transfers paid to abroad (-)
Acquisition/Disposal of Non-produced, Non-financial Assets: Records transactions involving intangible assets like patents, trademarks, copyrights, and franchises.
Credit: Sale of patents/trademarks etc. to foreigners (+)
Debit: Purchase of patents/trademarks etc. from foreigners (-)
Capital Account Balance: The sum of capital transfers and acquisition/disposal of non-produced, non-financial assets.
Financial Account: This account records transactions that involve the change of ownership of financial assets and liabilities. It tracks the flow of financial capital into and out of a country.
Direct Investment: Long-term investment where the investor has a lasting management control or significant degree of influence over the enterprise.
Credit: Inward direct investment (foreigners investing in Philippine businesses and gaining control) (+)
Debit: Outward direct investment (Filipinos investing in businesses abroad and gaining control) (-)
Portfolio Investment: Investment in financial assets like stocks and bonds, without gaining managerial control.
Credit: Inward portfolio investment (foreigners buying Philippine stocks and bonds) (+)
Debit: Outward portfolio investment (Filipinos buying foreign stocks and bonds) (-)
Reserve Assets: Transactions by the central bank in its holdings of foreign currency reserves, gold, and SDRs (Special Drawing Rights). Used to manage the exchange rate and finance BOP imbalances.
Increase in reserve assets is usually treated as a debit (-) as it represents an outflow of funds (domestic currency is used to buy foreign assets).
Decrease in reserve assets is usually treated as a credit (+) as it represents an inflow of funds (foreign currency assets are sold to obtain domestic currency).
Other Investment: Includes other financial flows like loans, deposits, and trade credits.
Credit: Inflows of other investment (e.g., foreigners depositing money in Philippine banks, borrowing from abroad) (+)
Debit: Outflows of other investment (e.g., Filipinos depositing money in foreign banks, lending to foreigners) (-)
Financial Account Balance: The sum of direct investment, portfolio investment, reserve assets, and other investment.
The Marshall-Lerner Condition and the J-Curve Effect
These concepts are crucial for understanding the impact of exchange rate changes on the current account balance.
The Marshall-Lerner Condition
The Marshall-Lerner condition is a condition that must be satisfied for a currency devaluation or depreciation to lead to an improvement in a country's trade balance (and current account). It states that the sum of the price elasticities of demand for exports and imports must be greater than one.Price Elasticity of Demand for Exports (PedX): Measures the responsiveness of the quantity demanded of exports to a change in their price. If PedX is high (elastic demand), a fall in export prices (due to depreciation) will lead to a proportionally larger increase in export quantity.
Price Elasticity of Demand for Imports (PedM): Measures the responsiveness of the quantity demanded of imports to a change in their price. If PedM is high (elastic demand), a rise in import prices (due to depreciation) will lead to a proportionally larger decrease in import quantity.
Marshall-Lerner Condition Formula: For current account to improve, PedX + PedM > 1.
Intuition: If the combined demand for exports and imports is sufficiently price elastic, then the quantity effects of devaluation/depreciation (increased exports, decreased imports) will outweigh the price effect (exports become cheaper, imports become more expensive), resulting in a net improvement in the trade balance.
If Marshall-Lerner Condition is NOT met (PedX + PedM ≤ 1): Devaluation/depreciation may actually worsen the current account. This could happen if demand for exports and imports is price inelastic. In this case, the percentage change in quantities is smaller than the percentage change in prices, and the value of imports may rise more than the value of exports, leading to a deterioration of the trade balance.
The J-Curve Effect
The J-curve effect describes the short-run and long-run effects of currency devaluation or depreciation on the current account balance. It illustrates that in the short run, the current account may initially worsen before it starts to improve in the long run, tracing out a J-shaped curve over time.Reasons for the J-Curve Effect:
Time Lags in Quantity Adjustments: It takes time for consumers and businesses to adjust their consumption and production patterns in response to price changes caused by devaluation/depreciation.
Recognition Lag: Consumers and firms may not immediately recognize the change in relative prices.
Decision Lag: Even if they recognize the price changes, it takes time to make decisions to switch to cheaper exports or reduce imports.
Implementation Lag: Firms need time to adjust production, marketing, and distribution to take advantage of increased export competitiveness or to switch to domestic substitutes for imports.
Contracts: Existing import and export contracts are often in place and cannot be immediately changed in response to exchange rate movements.
Valuation Effect (Price Effect Dominates Initially): In the very short run, the immediate effect of devaluation/depreciation is to make imports more expensive in domestic currency terms. Even if import quantities do not fall immediately, the value of imports (in domestic currency) rises due to higher prices. Export prices in foreign currency fall, but export quantities may not increase immediately. Thus, initially, the value of imports may rise more than the value of exports, leading to a worsening of the trade balance.
Long-Run Quantity Adjustment (Quantity Effect Dominates Later): Over time, as consumers and businesses fully adjust to the new relative prices, the quantity effects start to dominate. Export volumes increase as foreign buyers respond to lower prices, and import volumes decrease as domestic buyers switch to relatively cheaper domestic goods. This leads to an improvement in the trade balance, and the current account starts to move towards surplus or reduced deficit.
Shape of the J-Curve:
Initial Deterioration: The current account initially worsens after devaluation, moving downwards on the graph, forming the downward sloping part of the "J".
Turning Point: After a period of time, the quantity effects begin to outweigh the price effect, and the current account starts to improve.
Improvement: The current account balance then starts to improve, moving upwards on the graph, forming the upward sloping part of the "J".
Long-Run Equilibrium: Eventually, the current account is expected to reach a new equilibrium level, hopefully improved compared to the pre-devaluation level.
Policy Implications: Policymakers need to be aware of the J-curve effect when using devaluation/depreciation to correct a current account deficit.
4.7 Sustainable Development
Meaning of Sustainable Development: Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.
Sustainable Development Goals (SDGs): The SDGs, also known as the Global Goals, are a universal call to action to end poverty, protect the planet, and ensure that by 2030 all people enjoy peace and prosperity. There are 17 SDGs, which address global challenges like poverty, inequality, climate change, environmental degradation, peace, and justice.
Relationship between Sustainability and Poverty: Poverty can hinder sustainability as people struggling to survive may deplete natural resources for immediate needs.
4.8 Measuring Development
Multidimensional Nature of Economic Development: Economic development is not just about economic growth (like increases in GDP). It's a multidimensional process that involves improvements in living standards, health, education, and reductions in inequality, alongside economic growth.
Single Indicators: These focus on one aspect of development.
GDP/GNI per person (per capita) at PPP:
GDP (Gross Domestic Product): The total value of goods and services produced within a country's borders.
GNI (Gross National Income): The total income earned by a country's residents and businesses, including income from abroad.
Per capita: Dividing total GDP or GNI by the population to get an average per person.
PPP (Purchasing Power Parity): An adjustment to exchange rates to make comparisons of income and prices across countries more accurate, reflecting the actual buying power of money in different countries.
These indicators provide a measure of average economic output or income per person, adjusted for differences in price levels.
Health and Education Indicators: Examples include:
Life expectancy: Average number of years a person is expected to live.
Infant mortality rate: Number of deaths of infants under one year old per 1,000 live births.
Literacy rate: Percentage of the population that can read and write.
School enrollment rates: Percentage of children enrolled in primary, secondary, or tertiary education.
These indicators reflect the social progress and human capital development in a country.
Economic/Social Inequality Indicators: Examples include:
Gini coefficient: Measures income inequality within a country (0 = perfect equality, 1 = perfect inequality).
Poverty rate: Percentage of the population living below a defined poverty line.
Wealth distribution: How assets are distributed across the population.
These indicators show how evenly distributed the benefits of development are within a society.
Energy Indicators: Examples include:
Energy consumption per capita: Total energy used by a country divided by its population.
Renewable energy share: Percentage of energy from renewable sources (solar, wind, hydro, etc.).
These indicators reflect a country's energy use patterns and sustainability in energy production and consumption.
Environmental Indicators: Examples include:
Carbon dioxide emissions per capita: Amount of CO2 released per person.
Air and water pollution levels: Measures of environmental quality.
Deforestation rates: Percentage of forest area lost over time.
These indicators reflect the environmental impact of development.
Composite Indicators: These combine multiple single indicators to provide a broader measure of development.
Human Development Index (HDI): A composite index combining:
Life expectancy at birth (health).
Mean years of schooling and expected years of schooling (education).
GNI per capita at PPP (standard of living).
The HDI provides a summary measure of average achievement in key dimensions of human development.
Gender Inequality Index (GII): Measures gender inequality in three dimensions:
Reproductive health (maternal mortality ratio and adolescent birth rate).
Empowerment (proportion of seats held by women in parliament and secondary and higher education attainment levels).
Economic status (labor force participation rate of women and men).
The GII shows the disadvantages facing women and girls and is calculated for as many countries as data allows. More information is available from the
Inequality-adjusted Human Development Index (IHDI): Adjusts the HDI for inequality in each of its dimensions. It reflects the actual level of human development experienced by people in a society, accounting for inequality. You can find details on the
Happy Planet Index (HPI): Focuses on sustainable well-being, measuring:
Well-being: Life satisfaction.
Life expectancy.
Inequality of outcomes.
Ecological footprint: Environmental impact per capita.
The HPI emphasizes both well-being and environmental sustainability.
Strengths and Limitations of Approaches to Measuring Economic Development:
Single indicators are easy to understand and calculate but provide a limited view of development.
Composite indicators offer a more comprehensive view but can be complex to calculate and may involve subjective choices in weighting and combining different indicators.
Possible Relationship between Economic Growth and Economic Development:
Economic growth (increase in GDP) can be a driver of economic development, providing resources for improvements in health, education, and infrastructure.
4.9 Barriers to Economic Growth and/or Economic Development
Poverty traps/poverty cycles:
Low income → Low savings → Low investment in education, health, infrastructure → Low productivity → Low income (and the cycle repeats).
Poor health → Low productivity → Low income → Poor nutrition → Poor health (and the cycle repeats).
Economic barriers:
Lack of Infrastructure
Low Levels of Education and Human Capital
Insufficient Access to Credit and Capital
Trade Barriers
High Levels of Debt
Dependence on Primary Commodities
Political and social barriers:
Political Instability and Corruption
Social Inequality and Discrimination
Conflict and Lack of Security
Weak Institutions
Lack of Property Rights
Social and Cultural Norms
Significance of different barriers to economic growth and/or economic development:
Interconnectedness: These barriers are often interconnected and mutually reinforcing. For example, poverty can lead to poor health and education, which in turn can perpetuate poverty.
Context-Specific: The significance of each barrier can vary greatly depending on the specific country or region. Some countries may be more heavily impacted by economic barriers like lack of infrastructure, while others may struggle more with political instability or social inequality.
Policy Implications: Understanding these barriers is crucial for designing effective development policies. Addressing these barriers requires a multifaceted approach that tackles economic, social, and political issues simultaneously.
4.10 Economic Growth and/or Economic Development Strategies
Strategies to promote economic growth and/or economic development:
Trade strategies:
Export promotion: Policies aimed at making a country's exports more competitive to increase export volumes and earnings.
Import substitution: Policies designed to reduce reliance on imports by promoting domestic industries that can produce goods previously imported.
Trade liberalization: Reducing trade barriers like tariffs and quotas to increase international trade.
Trade agreements: Bilateral or multilateral agreements to reduce trade barriers and promote trade between participating countries.
Diversification:
Economic diversification: Shifting an economy away from dependence on a narrow range of products or sectors (often primary commodities) towards a wider array of sectors, including manufacturing and services.
Product diversification: Expanding the variety of goods and services produced and exported.
Market diversification: Expanding the range of export markets to reduce vulnerability to economic shocks in specific regions.
Social enterprise:
Definition: Businesses that prioritize social or environmental objectives alongside profit. They reinvest profits to further their social mission.
Social enterprises can contribute to economic development by addressing social needs, creating jobs, and promoting inclusive and sustainable growth.
Market-based policies:
Free markets: Emphasizing minimal government intervention and reliance on market forces (supply and demand) to allocate resources.
Privatization: Transferring ownership of state-owned enterprises to the private sector to increase efficiency and competition.
Deregulation: Reducing government regulations to encourage business activity and innovation.
Flexible exchange rates: Allowing exchange rates to be determined by market forces to facilitate international trade and investment.
Interventionist policies:
Government intervention: Active role of the government in the economy to guide and direct economic development.
Industrial policy: Government policies to support specific industries deemed important for economic development, such as subsidies, tax incentives, and targeted investments.
Protectionism: Using tariffs, quotas, and other trade barriers to protect domestic industries from foreign competition.
Exchange rate controls: Government management of exchange rates to influence trade competitiveness.
Provision of merit goods:
Merit goods: Goods and services that the government believes are socially desirable and should be available to everyone, regardless of their ability to pay (e.g., education, healthcare).
Government provision or subsidies: Direct government provision of merit goods or subsidies to make them more affordable and accessible.
Inward foreign direct investment (FDI):
Definition: Investment made by a company or entity based in one country into a business or asset in another country, where the foreign investor has control or significant influence.
Benefits: FDI can bring capital, technology, expertise, and market access, contributing to economic growth, job creation, and technology transfer.
Attracting FDI: Governments may implement policies to attract FDI, such as tax incentives, special economic zones, and infrastructure development.
Foreign aid:
Official development assistance (ODA): Financial aid provided by governments and multilateral organizations to developing countries to promote economic development and welfare.
Types of aid: Grants, concessional loans, technical assistance, humanitarian aid.
Purposes of aid: Poverty reduction, infrastructure development, health and education improvements, humanitarian relief, and promoting good governance.
Multilateral development assistance:
Definition: Development assistance provided by international institutions composed of multiple countries as members (e.g., World Bank, International Monetary Fund, regional development banks, UN agencies).
Advantages: Pooling resources from multiple donors, leveraging expertise, and coordinating development efforts across countries.
Institutional change:
Definition: Reforms aimed at improving the quality and effectiveness of a country's institutions, including legal systems, property rights, governance structures, regulatory frameworks, and financial systems.
Importance: Strong institutions are crucial for establishing a stable and predictable environment for economic activity, protecting property rights, enforcing contracts, reducing corruption, and promoting good governance.
Strengths and limitations of strategies for promoting economic growth and economic development:
Each strategy has potential strengths and limitations, and their effectiveness can vary depending on the specific context of a country.
Trade strategies: Can boost growth and efficiency but may also lead to job losses in some sectors and vulnerability to global market fluctuations.
Diversification: Increases resilience but can be challenging to implement and may require significant investment and structural changes.
Social enterprise: Addresses social needs but may face challenges in scaling up and achieving financial sustainability.
Market-based policies: Can improve efficiency and attract investment but may exacerbate inequality and fail to address market failures.
Interventionist policies: Can correct market failures and promote strategic industries but may lead to inefficiencies, rent-seeking, and government overreach.
Provision of merit goods: Improves social welfare but can be costly and may lead to government budget deficits.
FDI: Brings capital and technology but may also lead to exploitation of resources and profits repatriation.
Foreign aid: Can provide crucial resources but may be ineffective if poorly managed or tied to conditions that undermine national ownership.
Institutional change: Fundamental for long-term development but can be politically challenging and take a long time to yield results.
Strengths and limitations of government intervention versus market-oriented approaches to achieving economic growth and economic development:
Government intervention:
Strengths: Can correct market failures, address inequality, promote strategic industries, and provide public goods and merit goods.
Limitations: Risk of inefficiency, corruption, rent-seeking, poor information, and crowding out private sector activity.
Market-oriented approaches:
Strengths: Promotes efficiency, innovation, consumer choice, and economic freedom.
Limitations: May fail to address market failures, can exacerbate inequality, may not prioritize social and environmental goals, and can lead to instability.
Optimal approach: Often involves a mix of both, with the government playing a regulatory and supportive role while allowing markets to function efficiently. The appropriate balance can vary depending on the specific context and development goals.
Progress toward meeting selected Sustainable Development Goals in the context of two or more countries:
SDGs as a framework: The SDGs provide a global framework for assessing development progress across a wide range of goals.
Country-specific progress: Progress towards SDGs varies significantly across countries, depending on their starting points, resources, policies, and specific challenges.
Measuring progress: Track progress using SDG indicators, which are specific metrics defined for each goal and target. Data is collected and reported at national and international levels.
Comparing countries: Analyze and compare the progress of two or more countries on selected SDGs, identifying successes, challenges, and lessons learned. This can involve looking at specific indicators, policies, and contextual factors that have influenced their performance.
Focus on selected SDGs: Given the breadth of the SDGs, it is often useful to focus on a few selected goals that are particularly relevant to the countries being compared or to the specific area of study (e.g., poverty reduction, education, health, environmental sustainability).