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Section 1: Micro economics (August – March, IB1)

Introduction

 II – basic terms and concepts

o Factors of production – and why you need to
check out the people in the check-in queue at the
airport
 Capital; man-made FOP – but
is NOT ‘money’ or ‘buying
shares’
 Investment; increase in
physical capital stock
o Basic economic problem and three possible
solutions – one leads to poverty, one leads to
tyranny and one is “least-bad” (shades of Churchill
here)
o What is an economic good?
o How scarcity leads to choice and thus an
opportunity cost
o Illustrating opportunity costs via a PPF
 Assumptions of the model
 Within and outside the PPF – infinite
possible combinations where there is no
“best” option
 Shifting the PPF – more or better FoPs
 De facto (= actual) and potential growth
 Illustrating development using a PPF
o Positive and normative statements
o Utility and marginal utility
o Micro vs macro

 III – basic data skills

o Economists do it with models
o What are variables
o Correlation (X rises and Y rises...or X rises and Y
falls)
o Causality (X rises and causes a rise in Y…)
o The post hoc fallacy (“Post hoc ergo propter hoc”
– “After this so because of this”)
o Nonsense correlation (also known as “spurious
correlation”)
o The usefulness of using an index
 Comparing different variables over time
(growth and income)
 Comparing prices of different items (…in
the same diagram)
 Comparing the same variable in differenct
countries (income, unemployment, inflation)

 1.1 Supply and demand

o Definition of mkts
 2/21

o Law of D, causal issue of slope (income and subst

effect), law of demand, effective demand
o Individual D and mkt D
o Non-P variables of D, shifting D-curve
o Law of S, causal issue of upward slope (incentive
and MC effect)
o Non-P variables affecting S (P, Q, Qual, avail of
Fops + P of related goods, taxes and subsidies, mkt
entry/exit)
 Note: the slope of the S- curve
deals primarily with MC...e.g.
the cost of ‘the next unit
produced’
o Movement along vs shift of S-curve
o In-class examples:
 Wheat…rising D (and possible decrease in
S due to wheat rust)
 Cars and GST…decrease in S…(total inc
of tax)
 Fitbit…changing D due to increase in
substs
 Gold….D falling….sold in USD…and
there is high speculative D…(link to low
PED and low PES for oil…and P
fluctuations)
 Increase in PL in UK…
 Min wage…and how a min price
affects a mkt

 inc
o Market equilibrium (mkt clearing P and Q)
o ΔD → ΔP → ΔQs; ΔS → ΔP → ΔQd
 EVAL; do mkts clear…e.g. can XS remain
in LR
o P mechanism as signal → resource allocation (two
S nd D curves and one PPF)
o Consumer and producer surplus, all. efficiency,
DW loss

 1.2 Elasticities
o PED; def, calculation, values, range along D-curve,
determinants
 Def: measure of responsiveness of change in
Qd DUE TO a change in P
 % ∆Qd/% ∆P
 PED value always in absolute value
 Applications: TR, commodities, indirect taxes,
X rev and M exp
 Why is it so difficult to tax away the neg
ext’s of sugar consumption?
 Extreme/strange D-curves and PED
o PES; def, calculation, values according to S-curve
intercept, determinants
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o
 Applications; commodities and price
fluctuations
o CPED; def, calculation, values (+ and -)
 Applications: firms and changes in P of subst’s or
complements
o yED; def, calculation, values (+ and -),
determinants
 Applications: link to primary goods and LDCs
+ falling ToT

 1.3 Government intervention

o Indirect taxes, expenditure tax, unit tax, ad
valorem, shifting the S-curve
 EVAL: impact on govt, HHs, firms of indirect
taxes (DW loss, CS, PS and SS)
o HL: incidence of tax
o Subsidies; def, reasons, using diagrams
 EVAL: incidence of subsidies, effects on
HHs, govt, firms and foreign firms
o Pmax and Pmin; def, reasons, examples, diags,
outcomes, links to labour mkts
 EVAL: “…why…which goods…primary
outcomes…secondary outcomes…possible
additional govt responses…LR
possibilities…”

 1.4 Market failure

o Definition of market failure – refer to MSC, MSB,
MPC and MPB
o Five reasons for market failure (four diags)
 def/expl/exemplify/ill; neg/pos externalities
(pollution)
 Neg in prod; gold/coal and oil from tar
sands

 def/expl/exemplify/ill; under-/over-provision
(public/merit and demerit/bads)
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 Neg in cons; tobacco and alcohol

 EVAL: the extent to which govt can influence

S and D
 def/expl/exemplify/ill; public and merit goods,
govt involvement
 Merit good; “my use confers benefits on
others” – high pos exts…AND “my use
also benefits ME in the LR…” I under-
consume because I do not know the pos
exts OR the good it does me in the future!
(Time inconsistent behaviour – see
‘Bridget Jones’ Diary’)
 Public good;
o A) Non-excludable – once the good is
provided…
o B) Non-rivalrous – (gives the ‘free rider
problem’) my use does not diminish
your use

 mon/olig (imperfect competition) (HL)

 SL: use an inel D-curve
 HL: use the monopoly curve from ToF

 def/expl/exemplify/ill; common access

resources (tragedy of the commons) – links to
sustainability and LDCs (“…play now, pay
later…”)
 Tragedy of the commons…

 HL: def/expl/exemplify/ill; asymmetric

information; poss govt responses; (NPOS:
moral hazard and adverse selection)
 HL: info-asymmetry – a) when the seller has
info the buyer doesn’t…or; b) when a buyer
has info the seller doesn’t
 a) In favour of seller; used cars, shares, houses
 b) In favour of buyer; health and fire insurance
(leads to 1) adverse selection and; 2) moral
hazard. The latter led to the Great Recession of
2008!)

 1.5 Theory of the firm (HL) Week 1 - 7

o TP, AP and MP – show dim rets
o Clearly distinguish between accounting and
economic costs
o Define LR and SR using the concept of factors (e.g.
fixed and variable costs)
o SR costs and dim rets
o LR costs and dim returns to scale – note the
enveloping effect of SRAC
o TR, AR and MR (P will always be AR – both in
mon and PCM)
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o Profit: definition (include opp costs!); profitmax at

MC = MR; other goals of firms (e.g. revmax,
predatory pricing, profit satisificing)

o PCM (define, ill, exemplify)

 Firms are price-takers, cannot influence P or Q
on mkt
 SR abn profit and LR normal profit
o Scenarios:
o Firm adopts new techn
o All firms…adopt new tech
o Autarky
o
 Shutdown point (P = AVC) and breakeven P (P
= ATC)
 Firms’ S-curves are basically the MC above
ATC (in LR) or MC above AVC (in SR)
 EVAL: allocative eff (P = MC) and prod eff (P
= ACmin)

o Mon (define, ill, exemplify)

 D = AR, MR falls twice as fast, profitmax still
at MC = MR
 Types of BTE
 Illustrate profit, Q, P in both profitmax and
revmax conditions
 Profitmax monopolies operate along elastic
portion of D-curve
 Efficiency in mon
 Natural monopoly (this is a situation rather
than market type) and EoS
 Def and ill nat mon and 4 different outcomes
(profitmax, MC pricing, AC pricing, using price
discr to make up for a loss)
 EVAL:
 all eff and prod eff compared with PCM
 Difficulties in regulating monopolies
 Four ways mon might be “better” than
PCM: EoS, nat mon, existence of high
neg exts, abn profit for R&D

o Mon comp (define, ill, exemplify)

 Since firms have some P power we approximate
the outcome with mon diag
 SR abn profit possible but in LR (due to low
BTE and perf knowl/info) there is only normal
profit
 How mon competitive firms use non-P
competition (ads…marketing…branding…etc)
 EVAL:
 P, Q, eff and profits in SR and LR
 Poss that mon comp does in fact
create choice, innovation and the
drive for new products

o Olig (define, ill, exemplify – use the 4FCR!)

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 Two possible outcomes due to large degree of

interdependence
 Non-collusive – kinked D-curve
illustrate non-P competition and broad
P rigidity
 Collusion – prisoners’ dilemma,
cartels, OPEC…and why cartels
frequently break down (no honour
amongst thieves)
o Tacit and formal collusion
o Most markets are to be
found in the “overlap”
between mon comp and
olig

o Price discrimination (define, illustrate, exemplify)

 Pre-requisites for P-discr (firm must have a
degree of mkt power on a mkt that shows diff
PED for diff groups that are identifiable,
separable and profitable)
 Use a diag to illustrate the increase in total
profit due to (3rd degree) P-discr….and
 EVAL: possibility of perfect price
discrimination and where the firm will set
the price (at MC = D, AR!); what happens to
CS?!

 HL calculations in micro (Syllabus sections 1.1 to

1.4)
o Plot a linear D-function, e.g. Qd = a – bP
o Identify slope, Q-intercept and P-intercept
o Draw changes in D – slope and shift
o Plot a linear S-function, e.g. Qs = c + dP
o Shift and “c”; slope and “d”
o Calculate eq P and Q
o Plot S and D curves, calculate XS in S or D
o Calculate effects of indirect taxes and subsidies on
HHs, firms, govt – e.g. TR, price, Q, CS, PS, SS
and DW loss
o Calculate the effects of Pmax and Pmin (e.g.
ΔTR… Δexpenditure… Δgovt costs…etc)
o Calculate profit from data (ToF)

Section 2 – macro (6 Nov...

 2.1 Overall economic activity
o Main macro objectives (and trade-offs!)
o Def Y=E=O, circular flow; sum L = sum J
o GDP – GNI (NPYfA), Yr (Ynom/GDP defl);
weaknesses of the figures
 Real issues
 Pr = (Pnomtn/CPItn)
*100
 Yr = (Ynomtn/GDP
defl) * 100
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 (NPOS!) Wr =
(Wnomtn/CPItn) *100
 (NPOS!) Real r = rnom
– infl
o Business cycle (stages and links to AD, U, i and
LRAS)

 2.2 AD and AS
o AD: slope (Yr effect and int’l subst effect);
components; shifts
o Shifts: a) non-policy factors
(expectations…wealth/debt in HHs…foreign
issues) and b) policy factors (fiscal and mon pol)
o AS: upward slope (P of FoPs DOES NOT
CHANGE along the AS curve!); Keynesian
version (linked to SRPhC) showing an i-U trade-
off) and the mon/N-C version with SRAS and
LRAS (no trade-off in LR
o LRAS shifts due to any change in quality, quantity
and avail of FoPs – does NOT shift due to change
in P of FoPs (note links to S-side policies of govt)
o Equil Y in both models (note that defl/infl gaps are
best illustrated using the mon/N-C model)
o Keynesian model (“…markets are
imperfect…wages are downward sticky…govt
needs to intervene to correct mkts…”)
 At low Y there is XS capacity, high U and high
inventory levels; at FE there is no XS capacity
 Equil poss at low Y levels of high U
 D-side policies to increase Y and lower U
 Trade-off of i-U shows a “menu” for govt
policy choice
 HL: Keynesian multiplier (k = 1 / MPL) – e.g.
how large a change in final output due to an
increase in G
o Mon/N-C model (“…people are rational…do not
suffer from money illusion…act on rational
expectations…”)
 There is a NRU and any increase in AD beyond
this is inflationary in the LR – no LR trade-off
 It is poss to move beyond Yfe but in LR the
economy will revert to this level of output

 2.3 Macro objectives (Started Tue 23 Jan 2017)

o Main macro policy objectives (“Big five”)
 1) Growth (↑GDPr/t)
 Causes of growth
 Increase in efficiency, quality
and quantity of FoPs, new
production methods, increase
in physical and human capital
(link to LRAS)
 Use PPF; de facto and
potential growth
 8/21

 Consequences of growth
 Increased SoL, poss infl, Y
distr issues, environment,
exchange rate and BoP (e.g.
the main trade-offs)
 2) Unemployment (%-age of TLF not
holding a job)
 Difficulties in measuring U
 Hidden U, underemployment,
errors in accounting,
 Social and economic consequences of
unempl
 Loss of personal and national
income, de-skilling, fall in tax
receipts, increased Gini coeff
 Crime, alcoholism, drug use,
socially “cast out”,
 Types of U
 Equilibrium and
disequilibrium U
 Full empl – e.g. frictional,
seasonal and structural
 D-deficient (cyclical or
Keynesian)
 Real wage (or classical)
 Evaluation: govt
policies to decrease U

 3) Price stability (e.g. infl – ΔCPI/t)

 Defs of infl, defl, disinfl and reflation
 Creeping, hyper- and core infl
 Use of PPI to “see ahead” in terms of
future infl
 Effects of inflation
 Everyone has “their own
private rate of infl”
 Redistribution costs, shoe
leather costs, menu costs, lack
of PP, low/fixed income
earners get hit, borrowers win
at expense of savers, fall in
int’l competitiveness,
 Effects of deflation
 Generally far worse than infl
 Possibility of self-reinforcing
feedback loop (AD downward
spiral) based on neg
expectations
 Causes of inflation
 D-pull and cost-push
 Poss govt&CB policies to deal
with infl
 Causes of deflation
 Malign and benign
 Effects of deflation
 Generally far worse than infl
 9/21

 SR and LR Phillips curve

 U ↔ i trade-off in Sr
 Possible LRPhC – no trade-off
in LR according to mon/N-C
school
 Link to LRAS
 4) External balance (e.g. exchange rate and
BoP)
 Increase in AD → infl…and thus the Px
rise…etc
 Contractionary policies → lower infl
and poss ↓M

 5) Income distribution (measured by
Lorenz curve and Gini)
 Equity vs equality (horizontal and
vertical equity)
 Lorenz curve and Gini coefficient
 Absolute and relative poverty
 Ways to even-out Y distr
 Services in kind
 Transfer payments
 Taxes
 Progressive,
regressive and
proportional income
taxes
 Eval: effects on HHs
of ΔT, services and/or
transfer payments
 2.4 Fiscal policy
o Govt budget – revenue and spending
 Current (services), capital (roads) and
transfer payments (soc benefits)
 Deficits, surpluses and debt
o Fiscal policy
 Main purpose
 Big four and evening-out the business
cycle
 Methods: ΔG and ΔT
 AD and govt policies
o Infl and defl gaps in K and mon/N-C
models (better: positive and negative
output gaps)
o K version (trade-off)
o Mon/N-C version (no LR trade-off)
 Automatic stabilisers
 Poss impact of G on LR growth (see
interventionist S-side policies)
o Evaluation of fiscal policies (see
the Keynesian vs monetarist debate
further on)

 2.5 Monetary policy

o Role of mon pol (Big 5 and even-out business
cycle)
 10/21

o Role of central bank (CB)

 Conduct mon pol (adjust AD)
 Interest rates
 Δ Sm
 Exchange rate policy (managed
exchange rate or “dirty float”)
 Lender of last resort

o AD-AS; contractionary (tight) and expansionary
(loose) mon pol
o Inflation targeting (often 2% +/- 1%)
o Evaluation of monetary policies
 Impossible to see future infl
 Time lags
 Trade-offs
 Liquidity trap (see US during
2009!)

 2.6 S-side policies

o Description of S-side (shifting LRAS)
o Forms of S-side, e.g. labour mkt policies, tax
policies, competition policies
 Market orientated – help producers produce
and worker work via privatisation, lower
labour taxes, lower capital gains taxes,
increased labour mobility via ease of hire-
and-fire legislation, reducing union power,
lower minimum wages
 Interventionist – create fundamentals for
increase output via education, R&D,
infrastructure, regional policies, employment
offices…etc
 Eval:
 Evaluation of S-side:
o Takes time to take hold (up
to 10 years according to
some studies)
o High social costs in SR
(higher U…loss of income
for low income families…)
o Limited validity of “lower
tax increases SL” argument
(Laffer curve is “95%
speculation”)
o The effects of tax cuts on
govt budgets and thus the
“squeeze” of the public
sector…and resulting
damage to LRAS (Reagan
“starved” the public sector
of funds in the 1980s)
o difficulties for govt to
implement unpopular
legislation
 11/21

o Initial decrease in tax

revenue and higher U has
often been seen

 HL calculations in macro
o GDP, GNI, adjusting for pop and infl
o Calculate growth rates from data
o Re-base a time series for CPI or GDP deflator
o Calculate the multiplier (k = 1 / MPL) and the
change in final output
o Calculate U from data
o Construct a Wi index, calculate infl
o Marginal tax rates

I end the section on macro with a round-up of the core K-Mon arguments. Asterisks
show “degree of importance”.

1. Main Keynesian arguments

a. Keynesian view and D-side policies:
i. ***Markets inherently imperfect/unstable and
result in crises now and then, do not
necessarily clear in SR, govt has a duty to
correct mkts.
ii. *Empirically we know that D-side policies
work
iii. *Can be targeted (industries and regions)
iv. *Reasonably fast (yet note the lags)
v. ***Poss multipl effects (k = 1 / MPL)
vi. Can help even-out incomes
vii. **Social benefits of lower U

2. Main mon/N-C arguments and S-side policies

a. Critique of Keynesian D-side policies
i. **New-classical critique and assumption that people
are rational, act upon rational expectations, no
money illusion
ii. ***Empiricism (1970s and stagflation “proved” the
LRPhC)
iii. *D-side is inflationary
iv. **D-side leads to deficits and debt
v. **Time lags (decision-making -> implementation ->
taking effect) lead to boom-bust cycles or at the very
least exacerbate the business cycle
vi. *Value of k has decreased over time.
vii. ***No LR trade-off! (See LRPhC)
viii. ***Crowding out

Figure 57.7 Crowding out – Keynesian and new-classical view

 12/21

I: The market for loans II: The investment III: Affect on aggregate demand
schedule Price
level LRAS

Interest Interest
AD
S C
r1
P1
A P0 AD*
r0 C
D1 In-c A
D0 AD0,AD2
Q0 Q1 I2I0 YFE Y1 GDPreal/t
Loans (billions €) Investment (billions€)

1. Assume that the economy is operating at the full employment level of output, YFE in figure 57.7, diagram III, and that
government increases government spending by way of increasing its borrowing on the open market. The increase in
government spending increases aggregate demand from AD0 to AD*, but…

2. …the increase in demand for loanable funds (diagram I) caused by government borrowing will drive up the interest rate
from r0 to r1, which in turn decreases investment…

3. …shown in the two different investment schedules in diagram II. This has a contractionary effect on aggregate demand;
AD1 or AD2 in diagram III. The movement from A to B or A to C in diagrams II and III are two of a number of
possibilities.

Summing up in economic shorthand: ∆↑G  ∆↑Dloanable funds  ∆↑r  ∆↓I  ∆↓AD… the increase in government spending
drives up interest rates which “crowds out” investment. The question of crowding out is largely one of degree. Most economists
would agree that there is some crowding out when government borrows money to fund additional spending, but there is a great deal
of contention as to the extent to which investment funding is affected.

Five possiblemacroeconomic trade-offs emerge from the discussion above:

A. Growth  price stability
B. Unemployment  price stability
C. Unemployment  balanced budget
D. Growth  trade balance
E. Domestic monetary policy (interest rate) freedom  stable (or fixed) exchange rate

Section 3 – trade (August – November, IB2)

 3.1 International trade
o Benefits of trade – choice, competition and lower
prices + better quality, consuming outside the PPF
(!), better resource allocation, EoS due to
specialisation
o Absolute advantage – when a country can produce
more goods than another given the same amount of
factors
o Comparative advantage
 13/21

 When the opp costs of a good are lower than

another country
 Remember “1048” and build two PPFs
based on it
 Sources of comp adv – factor endowment,
history, technology, human capital…
 Assumptions of comp adv
 No BTT, no transport costs, all FoPs
are 100% mobile, Pareto opt in both
countries, 100% specialisation
 Limitations of comp adv
 BTT and transport costs do indeed
exist, 100% specialisation is virtually
impossible, goods are NOT
homogeneous, FoPs are not 100%
mobile, income distr issues are not
addressed

o Barriers to trade (BTT)

 Definition: any action taken by govt that
lowers the ratio of Px/Pm
 Types
 Tariffs (tax on imports)
 Quotas (physical or monetary limit on
imports)
 Subsidies (gift/grant of $ to domestic
suppliers

 Arguments for BTT

 Save jobs (seriously erroneous – builds
on the classic “lump-sum of labour
fallacy”)
 Health and safety (seriously mis-used)
 Infant industry argument (some
validity)
 Environmental concerns (could be
valid, often mis-used)
 Source of govt revenue (circa 20% of
govt revenue in LDCs comes from
tariffs)
 National security (absolute nonsense
mostly)
 Correct BoP disequilibrium (opening
eggs with sledgehammers)

 Arguments against BTT (use the standard

issue tariff diagr for support here!)
 Allocatively ineff
 Higher costs and prices and less
competition
 Erodes homec’s competitiveness
 Creates comfort zones – inefficiency,
monopolies, corruption and cronyism
 Loss of real income for domestic HHs
 14/21

 Reciprocal trade barriers (e.g. from

these “beggar thy neighbour” policies)
 Loss of consumer surplus
 Loss of choice for domestic consumers
 Lower Y for trade partners mean that
exports will in fact ultimately fall!

 3.2 Exchange rates

o Exchange rate as “…P of USD in terms of €…”
o Definition of floating (S and D…mkt forces) and
fixed (a currency pegged against another or basket
of other currencies)
o Factors affecting S and D in floating regime
(depreciation and appreciation)
 Derived D for goods and services (e.g.
linked to X and M
 D for FDI and portfolio investment
 Relative interest rates
 Relative Y, relative inflation
 Speculation
 LR influences on exchange rates:
 govt defs; “looks untrustworthy” – exp
of higher future taxes to pay for the
deficit…and thus defl policy which
dissuades foreign monies. Also, poss
that govt has to borrow more money to
cover def.
 debt; means…higher degree of
uncertainty in future…and foreigners
avoid such currencies
 PPP theory; S-side policies making an
economy more efficient; overall R&D
and infrastructure (can often be seen in
LDCs)

o Evaluation of depr/appr
 Appreciation:
 Positive – cheaper imports for HHs and
thus higher PP and choice, lower costs
for imported factors for firms; lower
foreign debt servicing for govt; possible
that this forces an economy to become
more efficient in order to compete in
int'l market;
 Negative – can decrease X and increase
M; higher unempl for exporting
economies; lower growth rates;
 Depreciation:
 Positive – lower P of exports can
benefit growth, BoP and employment
 Negative – might lead to X-driven
inflation; BoP disequilibrium; (take
heed to take into account the Marshal-
Lerner condition and the J-curve here!)
 15/21

o Fixed exchange rate

 P of one currency set against another (or
basket of currencies)
 Devaluation and revaluation when the CB
re-fixes the exchange rate
 Keeping the exchange rate fixed
 If the exchange rate is too high
o CB lowers interest rates (D for curr
falls)
o CB sells domestic curr (S increases
for domestic curr)
 If the exchange rate is too low
o CB increases interest rates (D rises
for the domestic curr)
o CB buys the domestic currency on
the Forex mkt (D rises for the
domestic curr)

o Managed exchange rate

 CB intervenes at times to correct the
exchange rate – also known as a “dirty float”

o Evaluation of exchange rates

 Advantages of fixed regimes
 Predictability and certainty – good for
trade and HH expenditure
 Encourages fiscal discipline – govt
cannot use D-side policies
indiscriminately since deficits, debt and
infl will put pressure on the exchange
rate
 Less risk of speculation (an argument
that does not really hold up in reality)
 Makes it easier to compare prices over
time

 Disadvantages of fixed regimes

 Loss of domestic monetary policy – CB
does not have free hands with the
interest rate to use in D-side
 Need of large foreign reserves – in case
there is speculation against the currency
 There will be LR limit to fiscal pol too
– since defs/debt must be kept low to
discourage downward pressure on the
¤∆
 Possibility of increased unempl – when
govt raises interest to protect the peg

 Advantages of floating regimes

 BoP automatically adjusts
 No need for large foreign reserves
 Freedom of domestic monetary policy
 Reduced speculation
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 Disadvantages of floating regimes

 Instability and lack of predictability
 Lack of fiscal and monetary discipline
 Poss decrease in productivity as the
economy relies on a lower exchange
rate

 3.3 Balance of payments

o Current
 Visible trade (X-M in goods)
 Invisible trade (services, tourism, repatriation
of profit/interest/dividends, int’l transfers,
remittances, aid…)
o Capital
 Transfer of capital due to govt debt
forgiveness, immigration, royalties
o Financial account
 FDI, portfolio, currency speculation,loans
o Curr acc minus capital and fin acc = zero

o Debit and credit
o Effect on exchange rate of
 Curr acc def or surplus
 EVAL: the inverse holds also, e.g. a change
in the exchange rate will affect BoP…and it
is VERY hard to see causality! It also turns
out that there is often little to no correlation
between the exchange rate and the current
account!
o Effects of persistent curr acc deficit
 Outflow of capital
 Foreign ownership of domestic assets
 Downward pressure on the exchange rate
 Foreign debt
 Possible higher interest rates to attract
foreign capital – negative effect on AD
 Speculative bubbles (SEA crisis 1997)
 EVAL: however, not certain that a curr
acc def is harmful…see USA and
Australia for past 30 years! It depends
on from where the money is coming
and to what it is going (C or I).
 Alleviating a curr acc def
 Expenditure switching policies – tariffs,
subsidies…
 Expenditure reducing policies –
contractionary D-side policies
 Managing the exchange rate
o HL: Marshall-Lerner condition
 If ΣPED + PED for X is greater than one, a
devaluation will improve curr acc
 Questions:
o An LDC exporting primary
goods sees an appreciation –
how might this affect current
account?
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o The MDC importing the

primary goods sees its currency
depreciate – how might this
affect current account?
o J-curve
 A deval/depreciation might not immediately
lead to an improvement in curr acc as HHs
take time to change spending patterns and
firms are locked into contracts – e.g. PED
for M might be low in SR.

 3.4 Economic integration

o Bilateral – between two countries
o Multilateral – many countries (WTO)
o PTAs – exempt from WTO rules, grants
preferential access to a country
o Trade blocs and integration
 FTA (NAFTA) – no common outer tariff
o Issues of re-exports
o More issues of local content (value-
added) rules
 Customs union (EU prior to 1995) –
common outer tariff towards non-members
 Common market (EU) – Four Freedoms
(goods, capital, services and labour)
 Further integration – monetary union
(EMU)…possible federation (US and
German)
 EVAL: problems of integration;
convergence of taxes and social
benefits, common laws, further political
cooperation, social policies…
 Benefits of common market – increased
labour mobility, EoS, freer trade and
more goods available, incentivises
trade, can lead to improved resource
allocation, more competition…
o Trade creation – trade moves to lower-cost
producers in the FTA (diag!)
o Trade diversion – trade is moved to higher cost
producers in the FTA (diag!)
o Monetary union – e.g. EMU in €-land (19 of 28
EU members)
 Advantages
 Price transparency
 Trade creation
 EoS due to more trade
 Lower transaction costs for firms
 More investment due to increased
predictability
 Disadvantages
 Fiscal and monetary straightjacket
(“…one size fits all…” – nope)
 Increase in regional unempl

 3.5 Terms of trade

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o ToT is basically Px / Pm (“…how many exported

tonnes of bananas for the imported VW car…”)
o Index of ToT: index of Px basket over index of Pm
basket x 100
o Deterioration does not always mean “bad” – nor
does improvement necessarily mean “good”
o SR ToT change due to
 Exchange rates
 Relative infl (e.g. relative prices)
o LR ToT change due to
 S-side policies
 Productivity, innovation, technology
 Permanent declines in demand for certain
goods

o Result of a change in ToT

 Income is redistributed
 Affects BoP (recall M-L and J-curve!)
 Affects SoL
o EVAL: ToT have moved against
LDCs for some 40 years now due to
 Low PED for primary X
 Low yED for primary goods
in MDCs
 Increased supply of primary
goods (there is an element of
monopsony power – see
coffee markets)
 Increased use of alternatives to
primary products (often made
from oil, sadly enough)

 HL calculations in trade
o Calculating cost ratios and opp costs from data
o Calculating all the areas in the tariff/quota/subsidy
diags
o Calculate exchange rates
o Plot linear S and D curves for a currency (using the
P of one currency in terms of another)
o Current account and capital/financial account
surplus or deficit
o ToT index over time

Section 4 – development (November – February, IB2)

 Section 4.1 – Development
o Definition of dev (HDI…wider dev)
o Sources of growth (phys/human cap, appr techn,
institution-building)
o EVAL: correlation between growth and dev and
tricky issue of causality
 19/21

o Characteristics of LDCS; poverty…low

GDP…poor Y distr…large agricultural
sector….high birth rates…
o The poverty trap (or positive and self-reinforcing
development loop)
o EVAL: how have countries “escaped” the loop?!
(Empir)
o Range of characteristics, e.g. resource
endowment…climate….colonial history…political
stability…
o MDG…

 4.2 – Measuring development

o GDP, GNI, per capita, PPP adjusted
o Types of indicators:
health…infrastructure…education
o Composite indicators: HDI, gender equality index

 4.3 – the role of domestic factors

o Education, fin insts, app techn, gender equality,
income distr
 Lack of fin insts; how to fund start-
ups…businesses
o Lack of (see H. De Soto) property
rights → lack of collateral → cannot
get funding
o Why lack of property rights? Poor
inst’s…lack of proper census and tax
roll.
 Appropriate techn; (?!)… NOT capital that
demands highly educated workers… lots of
secondary capital… lots of
upkeep/renovation…expensive high tech
components…etc.
 Financing; micro credit (Grameen bank)
o Small groups, mutually responsible for
each other, small loans…


 4.4 – int’l trade

o Diversification of industries – moving up and out
of a narrow range of exports
 EVAL: the difficulties of moving up/out
(lack of capital, lack of good govt/insts, lack
of market access to MDCs – say, tariff
escalation)

o Tot over time

 PED, PES and yED for prim goods, links to
ToT
 20/21

 Over-specialisation, narrow range of X

 Results:
 Price fluctuations….and LR ↓in Px →
very difficult to predict/rely on steady T
incomes!
 Serious dependency on foreign markets
 Huge increases in agric in order to fund
foreign debt
o Other problems with trade:
 Access to (rich) markets
 Tariff escalation

o Failure of Doha Round – e.g. that LDCs still face

BTT (subsidies) for agric and textiles
 Subsidies…reasons “…food security,
health/safety…EQUITY” – who gets

o Export promotion (“…strong govt

control/ incentives…focused on X
markets to ↑AD…and dev” - use
examples!)
 BTT are often lowered
 Capital markets are freed
 Exchange rates adapted to show
S and D rather than pegged
 Focus on comp adv
 Govt intervention/control
 EVAL:
 Small domestic
markets (relatively) –
but at ‘mercy’ of
global mkts
(Thailand)
 Strong/functioning
(centralised) govt –
yet often debt and
upholding weak banks
and industries (Japan)
 Strong bent on
nationalism and
homogeneity – yet
often with
protectionist results
(Japan)
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 Stark govt
involvement – never-
ending discussion of
govt
ownership/control


o Import substitution (example is India!)

 Inf ind BTT
 Large domestic markets
 Strong (often
politicised/ideological) govt
intervention
 EVAL:
 1. Govt suck at picking
winners – ind’s with
EoS and comp adv
 2. ‘temporary’ in inf ind
BTT tend to go
on…and on…
 3. We see govt
monopolies…and
 4. National
champions…and
 5. Regulatory
capture…and
 6. Cronyism and
nepotism!
 7. Enormous forward
linkage effects (see
‘domestic S of road
machines’)
 8. Shoddy goods,
hugely ineff ind’s

 4.5 – FDI and portfolio inv

o Def of FDI, reasons for FDI,
o EVAL of FDI:
 Good: AD and growth, stimulate EoS, X rev,
int’l competitiveness,
 Bad:
 poss dependency and that MNCs might
be empowered at the cost of LDC
recipient econs (see Matt’s ex of the
textile factory in Namibia), ‘one-off’ of
inv as profits are repatriated
 risk of int’l business cycles, race to the
bottom effects, environmental concerns,
Y distribution, tax avoidance (see
‘transfer pricing’)
 22/21

 MNCs; exploitation of lab (really?!)…

nat res’s…govt’s… ; killing off local
ind’s; avoid tax!; MNCs are powerful –
and can ‘be more powerful than govts’.

 4.6 & 4.7 – Aid and development assistance

o Reasons for aid…
o Types of aid – bi-/multi…humanitarian..dev
assist…tied aid…soft loans…grant aid…ODA…
o NGOs…eval of efficacy…does aid filter
down…(lord Peter Bauer)…upholding rotten
regimes…are NGOs in fact “democratic and open”
o Aid debate; Jeff Sachs vs Will Easterly, pro and
con…
 Pro: help AD and poverty cycle; G can
increase; help fill a S-I gap; transfer of
techn/cap/human cap; SR relief
 Contra: ineff; SR…often does not build-in LR
growth; dependency; lack of govt…rule of
law…infrastr…fin insts…plus corruption; kill
local markets; high overhead and thus transfer
leakages; debt!; underpins corruption
(especially pre-90);
o HIPC initiative: some 31 nations were given large-
scale debt write-offs in 1990s and early 2000s
o Aid vs trade: problem with trade is that MDCs are
still highly reluctant to lower subsidies…and thus
trade more with LDCs which often have a comp
adv in textiles and agric
o IMF: global lender of last resort – help nations
with BoP issues and/or currency issues
 SAPs; heavy “loaner strings” attached, e.g. that
the IMF will demand severe conditions for
loans
 Getting the exchange rate right
 Interest up…G down…T often up; reduce i and
balance the budget
 Lower BTT…barriers to FDI…allow transfers
of money
 Removing mkt distorting subsidies

 Critique of SAPs: hit the poor the

most…have serious effects on AD and
thus Y…
 World Bank: pre-eminent dev org’n in
the world, data/stats/studies, soft loans
(but; still conditionality!)…

o Debt crisis – background and results (1973…to

circa 2005)
 1973/74 oil crisis
 Huge amount of petro dollars
 This XS was lent to LDCs at
low r
 Then the USD appreciated
(Volcker in 1981)
 Debt burden increased
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o
o Debt damage: lack of G; poor use of resources for
the country in paying off debt (huge opp costs);
often seen together with poor P&M goods; more
debt…to pay off past debt…; increased debt on
future loans as many LDCs became listed as “bad
borrowers”!
o HIPC: a) heavy and unsustainable debt; b) must
qualify with WB; c) must be a “good borrower”; d)
must have a poverty reduction program

 4.8 – Markets vs intervention

o Market oriented policies
 Free markets…trade
liberalisation….FDI flows…
 Asian Tigers…China…India
 Evaluation
 Strong govt
involvement in Asian
Tigers and China
 Environment
 Income distribution

o Interventionist policies
 Govt focus on edu, health
care, infrastructure…etc
 Pre-requisite is of course good
governance, rule of law and
functioning institutions
 Evaluation:
 Corruption and
bureaucracy often a
problem
 State-run monopoly
issues
 Too often
protectionist