A2 Economics: The Global Economy The economics of globalisation

Globalisation entails the processes that have resulted in the ever-closer links between the worlds economies e.g. trade, investment and production Globalisation manifests in two main different ways, global brands and global sourcing Global brands: Brands are increasing their penetration internationally. The quality of the product will be virtually identical but the price that you have to pay varies. Coca-Cola, McDonalds, and Snickers chocolate bars are available in all 5 continents Global sourcing: This refers to the ways in which MNCs now source their operations through worldwide production. Local domestic production has been replaced by manufacturing capacity on a global scale. This is a consequence of deindustrialisation. Toyota has set up manufacturing and assembly plants worldwide. These plants assemble vehicles from local as well as globally sourced parts International financial flows: These are becoming far greater. Countries such as China are financing a chunk of their fast economic growth from inward flows of international capital Cheap labour: For rich developed countries, goods are increasingly being manufactured abroad in developing countries such as India and China. This is because developing countries have a cost advantage in the form of cheap labour I.T and communications development: This has shrunk the time needed for economic agents to communicate with each other. Software programmers are effectively just as near as a clients office located in London or say India

Factors promoting globalisation Reduced protection in word economy: WTO has reduced the degree of protection in world trade. Tariffs and other trade-curbing factors are inconsistent with globalisation. The global economy is now has a number of regional trading blocs such as the EU, CARICOM which have established mutually beneficial links between one another Reduced capital movement restrictions: This is essential for business capital to move freely within the global economy. Exchange control has been gradually dismantled, allowing FDI to flow between developed economies and those that are emerging/developing Developments in IT: The technological change over the past generation has enabled firms to communicate via the Internet and has promoted global economic relations. Global supply chains that produce and sell their product can now be managed very effectively Liberalisation of domestic markets: In line with reduction in protection, many of the worlds economies, China especially, have

been more receptive to FDI from developed economies and in forming partnerships with MNCs enabling MNCs to directly purchase businesses in other parts of the world A fall in real transport costs: Unit transport costs particularly for sea transport have been falling increasing the viability for businesses to source on a global basis. Bulk distribution of products in containers by sea and to a much a lesser extent by air, has increased year on year. Economies of scale can be gained as vessels are aircraft have increased in size The impact of globalisation The world economy is now more integrated through the growth of trade and increasing dependency For developing economies globalisation has produced certain benefits: Higher living standards for more people Enjoyment of global brands Spreading best practice and technology faster Improved medical supplies that could increase life expectancy Increased liquidity of capital allowing investors in developing countries to invest in developed countries Increase flow of communications allow vital information to be shared by corporations across the globe Global mass media ties the world together Globalisation has its critics: Increased likelihood that an economic disruption in one nation will affect other nations due to increased dependency It is a new imperialism led that accentuates the gap between the poor and rich and leads to exploitation of works in developing countries Leads to environmental problems. A company may want to build factories abroad as environmental laws are weaker. Third world countries may cut down more trees to sell wood to richer countries

MNCs and FDI McDonalds and Coca-Cola are amongst the largest MNCs with manufacturing and retail outlets in many countries in the world MNCs provide FDI to the economies in which they operate This is investment that is necessary to produce or sell a good or service in a foreign country FDI involves capital flows between countries FDI should not be confused by portfolio investment which is the purchase of shares by foreign investors in businesses that are located in another country The activities of MNCs and the effects of FDI has been the subject of much debate and discussion by economist and politicians

Benefits and costs of FDI Many benefits are obtained by the receiving economy of investment: Injection into circular flow of income: leads to the multiplier effect for the economy, in particular creating more total expenditure and important employment creation. Longer term, the injection of FDI increases the economys potential output Effects of the balance of payments: FDI is a credit item on the financial account of the BofP. This could be a short-term inflow, or a sustained one once the business is established. For example, the investment of multinational hotel in the Caribbean islands generates further income through the increase increased flows of tourists and payments received by local carriers An increase in tax revenue: the MNC contributes to tax receipts and expenditure taxes on their purchases of their goods and services. Also, MNCs provide additional tax revenue through purchase of local services and corporation/profit taxes Improved productivity: This may result from pressure on local suppliers to improve their efficiency Technology transfer and the acquisition of specialist equipment: Developing economies receive the benefit of up-todate technology and products that have been developed by MNCs in their home market There are various disadvantages and risks associated from FDI inflows: The employment created may be only short term and could be less than expected: The reason for that is that MNCs have little affinity to the overseas economies in which they have invested. Companies may pull out of a country transferring production to another location. The MNCs may employ workers from their own country in the top management lobs resulting in employees from the host country filling lower paid positions MNCs may invest in labour-saving technology: This may not seem appropriate in a recipient country with high unemployment and large amount of surplus labour Net effects on the balance of payments being less than anticipated: The profits earned in a host economy being repatriated and count as a debit item in the invisible section of the current account of that country. Over time, the outflows of such profits may well exceed the initial capital injection Taxes received by the government may be less that expected: as a result of fewer than expected new jobs. Account should also be taken of any government subsidies that might have been given to the MNCs in order to encourage them to set up in the first instance Productivity gains and technology transfer effects could be very limited depending on the type of FDI Environmental costs associated with certain types of FDI, especially mineral extraction and natural gas production

FDI in some respects is a mixed blessing thus not all governments welcome MNCs with open arms

Other financial flows Hot money flows around the world to take advantage of changes and expected changes in interest and exchange rates These movements can be disruptive as the money may only stay in the country for a short time before it is move to a more profitable opportunity elsewhere Portfolio investments are longer term. There are a number of factors that attract people to purchase the shares and government bonds of another country- relative interest rates and anticipated profit levels These are influenced by a government policies and changes in the level of economic activity Other investment includes loans made to other countries at commercial rates. Firms in other countries may seek loans from abroad if the interest rate charged are more favourable than can be obtained at home Developing countries may receive foreign aid in the form of loans at favourable rate. Most cases, foreign aid has led to the net outflow of funds. More is paid in servicing and repaying past debt than is received in aid For some developing countries, more money is now coming from remittances, the pay sent home from people working abroad, than from foreign aid, FDI or from sales of exports Remittances tend to be least volatile source of foreign currency for developing countries

World Trade Organisation WTO: a global organisation that regulates world trade It is established to promote free trade and provides a forum for discussing trade issues, established agreed rules and even assesses if these rules are broken WTOs mission is to help trade flow smooth, freely, fairly and predictable This should produce a trading system wit the following characteristics Non-Discrimination 1. Most favoured nation treatment- countries cannot grant a special favour (lower rate of duty or duty access free) to one WTO member over another i.e. all countries treated equal basis 2. National treatment- treating foreigners and locals equally. Under this, imported and locally produced goods should be treated equally after they have reached the domestic market. This does not prohibit a country imposing tariffs on imported goods, but it does mean that the goods compete on same basis thereafter. Principle applies to services- foreign firms trying to set up operations elsewhere should be treated in exactly the

same way as domestic firms wishing to expand their operations Free Trade: This can be done by lowering trade barriers, tariff and non-tariff barriers. This will enable goods/services to flow more openly and fairly between members, providing benefits of gains from trade Predictability: The will help provide a stable business environment whereby firms will feel secure that trade barriers will not be raised at some future date. This will create a business environment where investment is encouraged, jobs are created and consumer welfare is increased. This is relevant for businesses moving to developing economies, where there are likely to be concerns over future political stability and economic prospects Promoting fair competition: The WTO system allows tariffs and, in some circumstances, other forms of protection. Once a restriction has been imposed by a member, WTO agreements mean thereafter should be free and fair competition in the market. This must not be distorted by further constraints on foreign items Special provision for developing countries: WTO has sought to assist the development of developing countries. WTO has sought to give such countries time and flexibility to implement various agreements. The agreements build upon the principles special assistance and trade concessions for developing countries WTO agreements The Uruguay Round agreements are the basis of the current WTO system The Uruguay Round covered three main areas: Tariff Cuts: Developed country members agreed a 40% in their tariffs on industrial products, to be phased over 5 year period from 1995. This reduced the average tariff from 6.3% to 3.8%. They agreed that fewer imported products should be charged at higher duty rates More binding tariffs: This is a commitment by a member not to raise tariffs above the listed rate. Developed countries increase the no. of bound line products to 99%, while developing countries increased it to 73%. These agreements provide more security for traders and investors Agriculture: Substantial progress was med to remove all nontariff restrictions on agricultural world trade. Most of these restrictions were converted to tariffs (tariffication). Tariffs applying to products from developing countries have been progressively reduced and commitments have been received from developed countries to reduce export subsidies for agricultural products. The Uruguay Round represents the first time that such an agreement has been reached in principle

The Doha Round

The current round of talks, the Doha Round was launched in 1999 and completed in 2006. It covered a variety of areas: In manufacturing, further reduction in tariff barriers were negotiated In services, access to the markets was a key issue. In many service markets non tariff barriers were key to restricting trade First world countries were particularly concerned to tighten up intellectual property rights in face of widespread piracy. Whilst, third world countries wanted their rights over plant derived compounds and folklore protected There was an agreement to tighten up the role of WTO in settling trade disputes

International Monetary Fund IMF is a global organisation that aims to promote international monetary cooperation and international trade Set up 1945 at Bretton Woods Conference Helps promote the health of the world economy following World War Two. Non-members: Cuba and North Korea. Members: 184 The IMFs purposes and responsibilities are: To promote international monetary co-operation To facilitate the expansion and balanced growth of international trade To provide exchange stability To assist in the setting up a multilateral system of payments To make resources available to members experiencing BofP difficulties, provided adequate safeguards are provided IMF has three main functions known as surveillance, technical assistance and lending The first two have the aim of promoting global growth and economic stability by encouraging countries to adopt sound economic policies The third function is used where member countries experience difficulty in financing their balance of payments Technical assistance and training are offered by IMF to help members to design and implement effective economic policies This assistance provides advice on monetary, fiscal and exchange rate policies especially. This has been widely taken up my emerging transition economies Many IMF members have severe balance of payment problems. In this case, the IMF lends money to such countries to ease their immediate positions It is important that recipients work closely with the IMF to avoid similar problems in the future Anti-globalisation supporters condemn the IMF for favouring military dictatorships that are friendly towards the US and EU MNCs

Some economists are concerned about the pro Keynesian approach for dealing with the BofP disequilibria. They believe supply side polices rather than devaluation are the best way of alleviating structural imbalance The IMF has also been blame for some serious economic problems In 2001 in Argentina, it is generally believed that IMF induced budget restrictions and the privatisation of important natural resources were responsible for the economic crises that ensued World Bank World Bank is a global organisation that provides developing funding. This includes financial support for internal investment projects such as improving infrastructure and constructing new heal facilities Rose out of the Bretton Woods agreements It is best described as the World Bank Group as it has five constituent agencies: International Bank for Reconstruction and Development (IBRD) International Finance Corporation (IFC) Multilateral Investment Guarantee Agency (MIGA) International Centre for Settlement of Investment Disputes (ICSID) IBRD and IDA provide low- or no interest loans and grants that do not have favourable access to international credit markets Loans cover areas such as: Health and education- to enhance human development in a country- for improving sanitation and combating aids Agriculture and rural development- for irrigation programmes and water supply projects Environmental protection- for reducing pollution and for ensuring that there is compliance with pollution regulations Infrastructure- roads, railways, electricity Governance for anticorruption reasons It has been accused of being a US/EU dominated agency for supporting their own political and economic interests Though its advocacy for free market reforms, its policies have been criticised as being harmful to some countries, especially where shock therapy has been introduced too quickly In spite of this, World Bank has had a considerable impact in assiting the worlds poorest economies

Macroeconomic performance
The recent macroeconomics performance of the UK economy The 4 key indicators build up the picture of macroeconomic performance

Economic growth in the short-run and the long-run Short-run economic growth: the actual output percentage increase in an economys output (actual economic growth) Long-run economic growth: the rate at which the economys potential output could growth as a result of changes in the economys capacity to produce goods and services (potential economic growth)

A shift of the PPC curve to the right shows long run economic growth as the economys maximum possible output has increased Movement from point A to B shows short run economic growth Short run economic growth occurs because more of the economys resources are being used- few people are unemployed, more machinery is being used to produce goods and services Total output moves closer to the PPC curve Long run economic growth occurs when there is an increase in quality of quantity of the nations resources of land, capital, entrepreneurship, labour This increase the potential output of the economy The difference between actual and potential output is called the output gap

In the short run, if actual output > potential output positive output gap This is likely to generate inflationary pressure If actual output < potential output, the economy has spare capacity The economy can expand its output without creating inflationary pressure. A negative output gap exists It is hard to measure the potential output accurately and the output gap can only be an estimate This reduce the reliability of the output gap as a measure in judging inflationary pressures Causes of economic growth in the short run Economic growth in the short run is more variable than in long run Trend rate of growth: the average rate of economic growth measured over a period of time, normally over the course of the economic cycle

Changes in AD An economy with spare capacity can experience economic growth as result of an increase in AD An increase in AD to AD1 results in real GDP rising from Y to Y1 There is positive economic growth. A reduction in AD would cause negative economic growth

AD = C + I + G + (X M) Changes in short run AS SRAS shows the level of production for the economy at a given price level, assuming labour costs and other factor input cost are unchanged Changes in the costs of production cause the SRAS to shift. An increase in costs of production, shift to the left. Decrease causes shift to right Changes in costs of production arise from changes in: Labour costs: lower wage rates reduce the costs of production for firms, allows them to reduce prices. SRAS shifts to the right, increasing real GDP to Y1 Other input prices: the price of raw materials and capital. If these prices fall, lowers costs of production. SRAS right, GDP increases Taxes and regulations: Changes in the taxation/regulation of a business will have an impact on business costs therefore shift the SRAS curve. Most regulation increase business costs, SRAS curve shift to the left and real GDP is reduced

The economic cycle Economic cycle: fluctuation in the level of economic activity measured in real GDP. 4 stages in this cycle- recession, recovery, boom, slowdown

Some economics argue that economic instability influence the rate at which the economy grows Long periods of unemployment can lead to hysteresis and consequent loss of human capital (knowledge and skills of the labour force) When the economy returns to a positive output gap, it does so at a slower rate of economic growth due to the loss of productivity and it becomes more difficult to raise output Thus, the economys trend rate of growth may be reduced Recovery- when economic growth becomes positive after recession Boom- when rate of economic growth excess rate of growth of potential GDP so the output gap is narrowed Slowdown- when the rate of economic growth begins to fall to zero Recession- when rate of economic growth becomes negative and real GDP falls The economic cycle is not as regular as above This is because each of the stages will vary in length and severity Some recessions are short lived, some are prolonged and deep There are three main causes of the business cycle: The multiplier and accelerator effects and their interaction The role of stocks (inventories) Monetary explanations of the economic cycle

The multiplier, the acceleration and their interaction Multiplier effect: the process by which any change in a component of AD causes a greater final change in GDP The size of the multiplier is determined by the size of the leakages (saving, taxation and expenditure on imports) from the circular flow of income Tracing expenditure follows that output and income will increase by the same amount in order to restore equilibrium between AD and AS The proportion of additional national income that goes to leakages is known as the marginal propensity to withdraw (MPW) and is made up of: Marginal propensity to save (MPS) Marginal propensity to tax (MPT)

Marginal propensity to import (MPM) The value can be calculated using the formula:

Since half of any increase in national income leaks out of the circular flow, the MPW is 0.5

The follows that any change in expenditure in the national economy wil cause national income to be multiplied This concepts goes some way to explain the upswings and downswings of the business cycle But what causes expenditure to change in the first places This is where the concept of the acceleration comes into play Accelerator: the theory of investment that states that the level of investment depends on the rate of change of national income Investment is needed for two reasons- to replace the capital stock that is wearing out and to provide new capital stock to give additional production capacity to meet rising demand The National Income Multiplier says that an initial increase in spending can cause further rounds of spending. Therefore, the final increase in National Income is greater than the initial spending (or injection of Money) Recession- there is no need for firms to undertake investment to raise productive capacity as demand for output is falling Hence there is likely to be little if any investment in the economy In times of rising national income firms will require additional capacity and thus investment will rise This increase may be larger in % terms than the increase in national income The key point is that investment depends on the rate of change of national income not on its level Thus investment is a volatile component of AD Investment can for example fall when the rate of growth of the economy slows down and this will tend to lower domestic demand The last point illustrate the way in which the multiplier and the acceleration may interact to generate periods in which real GDP rises more and more rapidly (the boom phase of the economic cycle) And the situation in which a slowdown in the economic growth becomes a period of falling real GDP (the recession phase of the economic cycle) Once actual output reaches potential output, the economy reaches its ceiling and economic growth must slow down

There must be a floor to economic activity as firms must invest a minimum amount to replace worn-out or obsolete capital and there is minimum level of consumption for households These ceilings and floors represent the turning points in the economic cycle- booms and recessions eventually come to an end The interaction between multiplier and the accelerator is a theoretical explanation of the determinants of the economic cycle The economic cycle is far from predictable and the fluctuations in economic activity not as regular as diagram would suggest The acceleration is not a description of economic reality. There are a number of limitations to the theory: If firms have spare capacity rising demand can be met without rising investment The theory of the acceleration ignores the crucial role that confidence and expectations play in investment decisions- firms will not respond immediately to rising demand by raising investment if they are uncertain about whether the rising demand will be sustained in the future Firms can exercise chose over investment to replace machinery that is wearing out and they may delay such investment Investment decisions are planned well in advance of changes in economic activity and can be difficult to halt or postpone The multiplier effect of changes in investment may be small it does not have a large impact on AD and thus economic growth External or random shocks to the economy can be just as important a cause of the economic cycle as the relationship between the accelerator and the multiplier Fiscal and monetary policy changes may help to smooth out the economic cycle and policy makers may be able to over-ride the accelerator and multiplier effects These limitations focus mainly on the size of the accelerator and multiplier effects and the extent to which they are predictable The interaction of the multiplier and the accelerator is not the only determinant of the economic cycle, however

Other explanations of the economic cycle Another explanation involves the behaviour of stocks With time lags in production, it is not always possible for firms to immediately increase output in order to meet higher demand Thus firms hold stocks of finished and semi-finished goods As with investment, the amount of stocks held by firms tends to fluctuate over the course of the economic cycle which contributes to the cycle itself When economy recovering from recession- confidence of firms is fragile. Firms will be reluctant to take on new workers or to increase their investment when they are unsure about whether demand will continue to rise in the future

As a result, they will tend to sell their stocks of finished goods instead of producing new output The recovery phase of the economic cycle will see a rise I output that is less than the rise in demand and the output growth will thus be slow But the stock of finished goods is limited As demand continues to rise, the confidence of firms will grow and they will start to build up there stock levels from current production This will boost output and create additional demand in the economy through the multiplier effect During this time the growth of output will exceed the growth of demand as firms re-stock Once stock levels have been rebuilt, output growth will slow down to match the growth in demand This slowdown in output will bring about the end of the growth phase of the economic cycle in line with the multiplier-accelerator theory above Stock levels will now start to increase as demand falls Eventually firms will cut back production to stop stock levels growing, the economy will enter the recession phase of the economic cycle and firms will run down their stocks of finished goods The cycle will start all again once firms cannot satisfy demand from their stocks Both theories of the economic cycle suggest that the pattern of rising and falling real GDP is inbuilt into the economic system The economic cycle occurs due to regular fluctuations of AD- this is the result of decisions of consumers and firms based on their expectations of the future

Causes of economic growth in the long run Changes in LRAS LRAS: the relationship between total supply and the price level in the long run. The LRAS curve represents the maximum possible output for the whole economy- its potential output Classical economists: economists who believe that the markets will clear in the long run, with prices and quantities adjusting to changes in the forces of supply and demand so that the economy produces its potential output in the long run. The economys LRAS curve is thus vertical Keynesian economists: economists who believe that market failures will results in price and quantity rigidities such that the economys equilibrium output in the long run may be less than its potential output Economic growth in the long run is caused by an increase in potential output of the economy. This is determined both by the quantity and quality of the factors of production An increase in both the quantity and quality of land, labour, capital will cause economic growth. In this case, the LRAS curve will shift to the right For example, if there is an expansion in the labour force it will be possible for the economy to produce a higher level of output

The quantity of the labour force Increasing the size of the labour force can be achieved in a no. of ways: Increases in the size of the population Increases in the labour force participation rate Immigration Labour force: all those people of working age who are in employment or actively seeking work Labour force participation rate: a measure of the proportion of the population able to work who are in employment of who are actively seeking work The biggest growth in labour force participation has come from an increase in the number of women entering the workforce Changes in tax and benefit system in the UK have also encouraged people to seek work by making more and more welfare benefits, such as Working Families Tax Credit, dependent on employment Raising the retirement age may be politically unpopular but it may be an economic necessity in Europe in the not too distant future Immigration increases the size of an economys labour force but also increases the size of the population Unless immigration contributes to productivity there might be little benefit in terms of GDP per capita Recent enlargements of the EU have increase the size of the labour force for those economies that have not restricted the free movement of labour from central and eastern Europe If immigrant workers stay on a temporary basis there may be no longterm increase in the productive capacity of the economies to which such workers migrate

The quality of the labour force The labour force can be made more productive through education and training This raises the workers human capital by equipping people with more skills and technical knowledge Human capital is important because it enables workers to cope with the demands of employment Of increasing importance is the ability of the labour force to be flexible in the tasks that they can do (functional flexibility) and being able to adapt

to changes in the labour market by acquiring skills for new jobs (occupational flexibility) The problem with policy makers is how to deliver this increased human capital The cost of education and training can be very high There is the issue of whether this should be provide by the government of by the market There is the question of what education and training should be provided UK compares favourably with Germany and France in terms of the % of the labour force with the highest qualifications Increasing the quality of labour force through investment in human capital is important for economic growth in the long run but it is not clear what should be provided. Time lags should also be considered Investment in human capital takes time to materialise

The quantity and quality of capital stock (Harrod-Domar model) An economys potential output is increase by an increase in the quantity/quality of the factors of production Increasing the quantity of capital stock will increase the economys productive capacity This requires investment in various types of capital It is not just the amount of investment that determines the potential output of the economy, it is also the quality of the investment The productivity of investment is measured by the economys capital output ratio This is the amount of capital needed to generate each unit of output Technological advance increase the productivity of investment because it require less capital being required to produce each unit of output

Consequences of economic growth If a governments are to pursue economic growth as a policy objective, they need to be aware of any conflicts it may have with other objectives

Growth and inflation The consequences of economic growth for inflation depend very much on the nature of economic growth Chinas economic growth has averaged around 9.6% over the last two decades, yet until 2007 its inflation rate remained below 3% Economic growth will cause higher rates of inflation, if growth is generated by increases in AD that are not matched by increases in AS At the simplest level, a rise in AD causes a movement up the LRAS causing price level to increase The closer the economy is to its maximum capacity, the more that the higher AD causes prices to rise

This is because the shortages of inputs push up production costs. This increases the no. of firms with little spare capacity to need the demand and labour shortages result in higher wage bills for firms As the gap between actual and potential output narrows inflationary pressure increases It is possible to avoid this by increasing the economys productive capacity. If the AS can be shifted to the right (LRAS1) AD can rise without inflationary pressures building up (a price level of P). Non inflationary economic growth is the goal of macroeconomic policy

In 2007, Chinas official rate of inflation more than trebled and many economists were expecting it to increase to over 6% in 2008

Growth, Employment and Unemployment The link between economic growth and employment is recognised by policy makers as central to improving macroeconomic performance In 2005, the EU relaunched its Lisbon Strategy as a growth and hobs strategy committing member states to raising investment in research and development and labour force participation rates By 2006 the number of people in employment in Ireland had increase by almost 60% since 1995, whereas over the same period employment in Belgium increased by only 11% The Irish economy grew by 7.3% per annum over the period, while average annual economic growth in Belgium was barely over 1% Since the demand for labour is derived demand, the number of people employed is closely related to output Increases in real GDP will ten to increase the demand for labour and so the level of employment will rise The relationship between output and jobs can be represented with an inverted employment curve on an AD/AS diagram

In the short run, increase in output (Y to Y1) increase the number of people employed (L to L1). In the long run,, raising labour force

participation rates through capital investment would shift the LRAS to the right and raise employment Increasing labour productivity may result in some reduction in employment in the short run, because firms may choose to produce the same output with fewer workers This can be represented by pivoting the employment curve to show less labour employed at each level of GDP In the long run, however, it is likely to generate more jobs as AD increase Higher employment might be expected to reduce employment but this is not always the case as the labour force itself is changing Increases in the working age population and in the no of people actively seeking work can mean that rising employment coincides with rising unemployment The consequences of economic for unemployment also depends upon the nature of growth and on the causes of unemployment Economic growth generated by increases in AD is likely to reduce cyclical unemployment, but may have little impact on unemployment arising from problems related to the supply of labour, such as structural/frictional unemployment

Growth and the balance of payments An increase in AD caused by rising consumption is likely to affect the BofP negatively This is because the demand for imports are likely to increase worsening the current account position The effect will be more pronounced if the demand for imports is income elastic On the other hand, if growth is export led, the current account is of the BofP will show an improvement Supply side improvements- increases in productivity, innovation and capital investment which contribute to long-run economic growth are less likely to worsen the balance of payments Increases in productivity will tend to increase international competitiveness by lowering unit labour costs and reducing the impact of growth on imports Higher capital investment will increase the productive potential of an economy resulting in a greater ability of domestic firms to meet higher levels of domestic demand Capital account: the section of the BofP that records the long-term flow of capital into and out of an economy. It records purchases and sales of assets and is split into two sections: long term capital flows and short term capital flows If growth causes the current account to worsen, this may be compensated by a capital account surplus Traditionally, the BofP has been viewed as a constraint on economic growth

Thirlwalls Law states that the rate of economic growth consistent with BofP equilibrium is equal to:

Growth and the governments fiscal position Governments fiscal position refers to the balance between government expenditure and revenue from tax receipts Public Sector Net Cash Requirement (PSNCR): the difference between government expenditure and revenue from tax receipts In a boom, tax receipts will tend to rise even without action by the government to raise tax rates or widen the tax base The higher level of economic activity will bring the government more tax revenue Higher employment results in more income tax revenue, higher expenditure by consumers results in more revenue from expenditure and higher levels of profit result in greater levels of corporation tax receipts Government spending will tend to fall during this period because there is likely to be lower unemployment in the boom phase of the economic cycle This reduces the about that has to be spent on JSA In a recession, taxes will fall and government spending will increases These changes are automatic and thus are called automatic stabilisers because they have the effect of dampening down a boom and cushioning the effect of a recession Automatic stabilisers: changes in government expenditure and taxation receipts that take place automatically in response to the economic cycle A budget surplus will tend to emerge during the boom phase of the economic cycle and a deficit to materialise in a recession. Governments will have to borrow to make up the shortfall during a recessions but they should be able to repay this borrowing during the boom years form the budget surplus The PSNCR therefore vary over the economic cycle The existence of this fiscal cycle reduces the size of the multiplier effect and dampens down the economic cycle , if the automatic stabilisers are allowed to work

Policy issues- growth, economic stability and international competitiveness Last ten years, economic stability has become an objective of macroeconomic policy Economic stability: the avoidance of volatility in economic growth rates, inflation, employment and unemployment and exchange rates, in order to reduce uncertainty and promote business and consumer confidence and investment

Economic stability has become a more prominent macroeconomic in recent years due the consequences of instability It is argued that instability in any of the key indicators leads to uncertainty which damages the countrys long term economic performance Uncertainty about demand and prices will undermine both consumer and business confidence A lack of consumer confidence discourages consumption which may cause the recession to prolong Business are likely to invest during times of uncertainty Macroeconomic policies to promote stability and growth have focused on: A prudent approach to the management of the economy Taking fiscal and monetary policy decisions on the basis of the long-term interests of the economy rather than the short term political interests Ensuring that fiscal monetary policies support each other Bringing openness and transparency to decision making through putting in place rules and targets Improving the supply side performance of the economy

Fiscal policy issues The governments budget will move into surplus in time of economic boom and into deficit in time of recession as a result of automatic stabilisers Governments must avoid the temptation to spend surpluses and to try to claw back deficits to balance the books- leads to more pronounced economic cycle If governments raise spending and cuts taxes because the budget is in surplus they run the risk of raising AD during the course of the boom phase of the economic cycle High levels of government borrowing can reduce the amount of finance available for private sector investment The private sector is then crowded out and private sector investment falls reducing the economys long term rate of economic growth High government borrowing will tend to push of interest rates The aim of UK fiscal policy is to balance the governments budget, but over the course of the economic cycle Short term political considerations are not supposed to drive decisions on government expenditure and taxation To promote economic growth, UK fiscal policy focuses on measures that will raise the productive capacity of the economy by shifting out the LRAS curve In times of recession, a government will have to borrow money to make up for the shortfall of tax receipts over government expenditure But they should not borrow more than this cyclical deficit to fund current expenditure

In other words, government borrowing is only justified if it arises automatically because of the economic cycle or is used for investmentthis is the golden rule of UK fiscal policy Cyclical deficit: a budget deficit that arises because of the operation of automatic stabilisers Different governments have different approaches to designing fiscal policy to promote economic stability and growth The broad principle are credibility, flexibility and legitimacy but there are different approaches to what rules and targets should be met Credibility: a credible fiscal policy framework is one where the government commitment to economic stability is trusted by the public, business and financial markets Flexibility: a flexible fiscal policy framework is one that has the flexibility to deal with macroeconomic shocks such as sudden changes in AD/AS Legitimacy: a legitimate fiscal policy framework is one that has widespread support and about which there is general agreement among the public, business and politicians The problem with the UKs approach is that it requires accurate estimation of productive capacity of the economy and the economys long term economic growth rate- difficult to estimate Governments would also have to be able to forecast the likely trend in actual economic growth to set spending and taxation for the years ahead The members of the Eurozone have abide the Stability and Growth Pact SGP: an agreement by members of the EU about the way in which fiscal policy should be conducted to support Europes single currency. It requires those countries adopting Europes single currency to abide by the following rules: A budget deficit of 3% of GDP or less A government debt of 60% of GDP or less Such rules are simpler to interpret and measure, but lack flexibility If an economy was in a recession, its government budget deficit will rise and may fall foul of the 3% limit SGP includes a financial penalty for economies that breach the rules- this would add to their credibility and legitimacy However, the penalties make it harder to an economy to bring a deficit down and because they lack flexibility might make the economic cycle more pronounced that it would otherwise if the automatic stabilisers of fiscal policy were allowed to operate Fiscal policy rules are no guarantee that governments will get these thing right or stick to their own rules Unless fiscal policy is run independently of government, there is always risk that politicians will take risks with fiscal policy and destabilise the economic cycle Politician are likely to be vote maximisers and favour fiscal expansion over fiscal prudent To be effective there must be penalties attached to the rules

Fiscal policy rules and targets may also encourage creative fiscal accounting whereby governments find ways around the rules by changing the way expenditure People may lose confidence in the government to stick to the rules or the rules themselves are worthless If this happens the whole credibility of government fiscal policy is eroded

Monetary policy issues Can promote economic stability in many ways Changes in interest rates have an impact on domestic demand through consumption and investment, and on net external demand through the exchange rate The way in which it does so is called the monetary transmission mechanism Monetary transmission mechanism: the way in which monetary policy affects the inflation rate through the impact it has on other macroeconomic variables Rapid economic growth and accelerating inflation can be dampened by increases in interest rates and an economic slowdown and falling inflation rates can be talked with reductions in interest rates Monetary policy can be used to manage the economic cycle and smooth out the fluctuations in short-run economic growth that bring with them in other key performance indication In short, monetary policy could be used to manage AD The primary objective of monetary policy is to promote price stability It is argue that low and stable rates of inflation provide a framework for economic stability Inflation erodes the purchasing power of money This damages the heart of any economic system- the exchange of money for goods and services If wage growth starts to increase to compensate for the value of money, there is a very real danger that inflation will get out of control Prices also serve a signalling function in a market economy Changes in prices should reflect changes in demand and supply and send out messages for resources to be allocated and reallocated to the goods and services that consumers most want Inflation is sometimes described as a noise that distorts the signalling function and thus the market system doesnt function so well Variation rates of inflation create economic uncertainty that discourages savings and investment, crucial for long term economic growth High relatives rates of inflation also damage international competitiveness in the long term, affecting output and jobs The role of monetary policy is therefore to deliver low and stable rates of inflation Central banks have been given responsibility to deliver price stability and have given operational independence from governments

This makes the monetary policy less susceptible to short-term political considerations and more likely to operate in the long-term interest of the economy The inflation target itself varies between countries Targets can be symmetric or asymmetric Symmetric inflation target: when deviations above and below the target are given equal weight in the inflation target Asymmetric inflation target: when deviations below the inflation target are seen to be less important than deviations above the target Inflation targeting has a number of benefits for growth and stability: Transparency and accountability- an inflation target makes the conduct of monetary policy clear. There is a firm commitment to price stability that is communicated to firms and households Expectations- an inflation target that is credible directly affects expectations of inflation. If people expect the inflation target to met, they will build this expectation into their behaviour and this will do much to bring about the inflation rate they expect. Firms will be confident in their investment plans if they expect future inflation to be low. This will raise productive capacity of the economy and reduce likelihood and demand-pull inflation Flexibility- the design of symmetric inflation targets gives as much weight to low inflation as it does to high inflation. This means that a degree of flexibility is built into the monetary policy, which can contribute to economic stability. For example, if inflation was predicted to fall below the bottom range of set, then the central bank is likely to reduce interest rate to raise AD. Without this symmetry, there might be a bias towards reducing inflation at the cost of slower economic growth and higher unemployment There are a no. of problems with inflation targeting Whether it promotes economic stability, growth and international competitiveness depends on the central bank bringing credibility to the target To be credible, the central banks has to build up a reputation for meeting its target This can lead to central banks trading of low economic growth for low inflation In order to be successful in hitting its target, central banks have to be good at forecasting inflation. Monetary policy works with time lags An increase in todays interest rate might have its full effect on inflation until up to two year later Even the best forecasts cannot anticipate unforeseen events. Until recently, the economies that have used inflation targeting have been remarkably stable The real test of inflation targeting is whether it can deliver economic stability and growth at a time when global economic conditions are themselves unstable

Supply-side policy issues Supply side policies aim to increase AS in order to increase the productive capacity, thereby helping to prevent inflation, reduce structural/frictional unemployment and improve the economys long run rate of economic growth and its trade position The shift in the LRAS increases real GDP to Y1 and allows future to increase in AD, raising real GDP still further to Y2 All this occurs without any increase in the price level- there is no trade-off between growth and inflation or price stability Some economies argue that the period of sustained, non-inflationary economic growth in the UK since 1992 has been the consequence of supply side improvements to the economy Some economist believe that supply side policies are not the panacea It is little use expanding the productive capacity of an economy if there is a deficiency of demand within the economy For example, if AD were at AD0, supply side improvements would have no effect on real GDP or the price level

Despite this, supply-side policies are increasingly seen as important to deliver improved macroeconomic performance in the long run and to improve international competitiveness International competitiveness: the ability of an economys firms to compete in international markets and thereby sustain increase in national output and income During the 1990s, Ireland attracted high level of investment from multinational companies, it economic growth exceeded the rest of Europe The Irish economy continued to grow rapidly, but this growth hid an emerging competitiveness problem from about 2000. This can be seen by Irelands growing current account deficit problem A countrys international competitiveness is determined by both the prices and the quality of its goods and services. These include The costs of production Productivity The exchange rate Relative unit labour costs can therefore change for three reasons A change in the cost of labour compared to other countries A change in productivity compared to other countries A change in the exchange rate Unit labour costs: the cost of labour per unit of output Relative unit labour costs: the cost of labour per unit of output of one country relative to its major trading partners

The problem with this measures of international competitiveness is that it takes no account of quality factors Quality factors that could affect international competitiveness might include: Design of products Delivery dates After-sales service Reliability Marketing In the case of Ireland, declining international competitiveness appears to boil down to problems related to poor growth in productivity, high growth in inflation and costs and a rising exchange rate At the top of the pyramid is sustainable growth in living standards- comes from past improvements in competitiveness Next in the pyramid are the factors that determine current competitiveness including business performance, productivity, prices and costs and labour supply. Last in the pyramid are the policy inputs There are three key things that the council believe determines future productivity: The business environment- this determines the cost and ease of doing business in Ireland and includes the impact of taxation, regulation, the degree of market competition, the extent of labour market regulations, the cost of raising finance on business Physical infrastructure- this determines productivity and costs and includes transport, energy and IT infrastructure that is affected by levels of investment by firms and government Knowledge infrastructure- education, training and research and development affects the quality of the labour force and of the products firms are able to produce Supply side policies might require higher government expenditure but some require fiscal and monetary policy to deliver the conditions for long-run economic growth and a stable macroeconomic environment These policies will not deliver immediate results