Balanced Budget Fiscal Expansion (A2 Macroeconomics)

Balanced budget fiscal expansion is defined as: a policy to increase GDP through changing government spending and taxation levels, whilst leaving the overall fiscal budget position the same.

This method of fiscal expansion could be used in two ways. The first is that if you increase spending and taxes equally, through the multiplier effect, the expansionary government spending should have a bigger positive impact on economic growth than the negative impact of higher taxes. An example of this would be to temporarily increase income tax in order to finance capital investment.

The second is through a reallocation of government funding. In this case, cuts in spending on items such as public sector wages could be used to finance higher spending on items such a as infrastructure. Again, the multiplier effect should result in the benefits of increased spending on infrastructure being greater than the costs of cutting public sector wages. Another example of this would be to reduce spending on pensions and increase spending on capital investment.

Spending on pensions may be reduced by increasing the retirement age. As well as allowing more money to be spent on funding capital investment such as infrastructure projects, people will also be working longer causing the labour force to increase. This will therefore stimulate an increase in both aggregate demand and the economy's productive potential without increasing the government's budget deficit. 

The idea of a balanced budget fiscal expansion relies on the positive multiplier effect being greater than one. Generally, unless the economy is at or close to full capacity this is likely to be the case as a result of its reduction in unemployment.

For those currently studying at A2 through OCR, balanced budget fiscal expansion is mentioned in Extract 1 of the case study for The Global Economy module. The IMF recommended that the UK pursue a balanced budget fiscal expansion to increase growth. This form of fiscal expansion, if successful, would stimulate an increase in aggregate demand without compromising the government's Deficit Reduction Plan.

Should Latvia have joined the Euro?

Latvia is a reasonably new country as it only gained independence from Russia in 1991. With a population of 2 million, it has one of the smallest in the EU since joining the union in 2004. For Latvia to move to the next level of economic integration it had to meet the five regulations of the Maastricht Criteria which included restrictions on levels of inflation, debt and the ability to fix their currency to the Euro for two years. These are in place to ensure that economies sharing currency (in this case the euro) are similar and sync business cycles.

Probably the most obvious, but also potentially the most important benefit of joining the Euro for Latvia was that it will remove financial transaction costs of international trade. Although restrictions on trade such as tariff, quotas or regulations are already exempt to Latvia as they’re a member of the European Union, by joining the Euro the cost of exchanging currencies will be removed for Latvian firms. This will reduce Latvian firms costs as they will no longer have to ‘hedge’ their prices incase exchange rates change between the time an order is made and when it is paid for which can often be months down the line. This is especially beneficial for Latvia as it as an extremely open economy since they adopted a policy of internal devaluation, implementing austerity and a fiscal tightening, consequently making their exports cheaper which has since lead to a reliance on international trade for Latvia.

A second benefit to Latvian firms and also their people is that by joining the euro it guarantees that any debts to European countries will not increase due to fluctuating exchange rates. This may actually have a double positive effect for Latvia as this guarantee will ease the stress of debts for Latvians and could lead to an increase in domestic consumerism which would be more than welcomed by yet another economy recovering in an unbalanced manner from the deep recession of 2008.

However as with all economic decisions there are drawbacks or at least potential drawbacks! In the case of joining a single currency it places restriction on an economy, Latvia will no longer have control over their monetary policies, these will be controlled by European Central Bank in Frankfurt. It is unlikely that monetary policies will be consciously made in the interests of Latvia as they contribute little to the EU in comparison to economies such as Germany and France. An additional restriction is Latvia’s ability to undertake Keynesian policies of high government spending and low taxation. This is because even after joining the Eurozone Latvia must conform to the criteria concerning levels of Government debt.

Furthermore although joining the Euro does bring financial transaction benefits, it will intensify the competition on domestic Latvian firms from other countries within the Eurozone. Having a separate currency adds protection to domestic firms as Latvian consumers buying imports would have to pay for the transaction costs included in the price of goods, however now that these will be removed they will become more attractive. The extent of this effect will depend upon the elasticity of demand for the goods that Latvians import from within the EU, however they are likely to be elastic luxuries unavailable in Latvia, such as expensive German cars. This will reduce consumerism in Latvia on domestic goods, resulting in a fall in demand leading to a drop in investment from Latvian firms. This is a prime example of the negative multiplier effect within an economy. The significance of this is that Latvia’s reliance on exports will be greater.

Was it a good move?

We must remember that Latvia had no choice but to join the Euro at some point because they didn’t join the European Union until after the Euro was incorporated, however they could have delayed the transition like Poland who have done so for over 10 years and are still yet to show any interest in following suit. It is difficult to say whether it will be a success and we will not be able to judge this for some time, but although many of the effects of joining a single currency are economic, these may not have been the primary motive for Latvia. Only 25% of Latvia’s international trade is with other EU members which reduce the significance of the trade benefits already mentioned; however by furthering their integration with the union they will receive protection against any potential political confrontation with currently boisterous Russia. 

Submitted By Jack Murray

Is 'free' trade hindering the development of poor countries?

Trade is considered by many to be the engine of growth in a nation, acting as a spur for development. Neo-liberalists believe that free trade will lift people out of poverty, a view that is supported by the rapid development of the Newly Industrialised Countries (NICs), with the growth of China and India being particularly strong examples.

However, the view that free trade will lead the development of a nation is a highly controversial one. Strong arguments exist, stating that trade is often unfair to developing countries as stronger economies, firms and organisations control markets by following protectionist strategies such as tariffs and subsidisation and by controlling commodity prices.   

An example of this occurring is in the cocoa industry in Ghana where foreign commodity traders such as buyers for MNCs like Nestle and Cadbury trade in future markets (i.e. they buy supplies now to ensure delivery in 3 to 6 months). A downward pressure is put on cocoa prices due to competition from other exporting nations. Due to this, commodity prices are volatile which results in irregular income for workers and uncertain tax returns for governments of developing nations. 

The prices of commodities are also volatile as a result of their price inelastic demand and supply. A price inelastic demand is caused by most commodities being necessities rather than luxury goods and due to their lack of substitute goods. Commodities also have a price inelastic supply due to their relatively long period of time taken to excavate and the limit to their potential supply. This means that a small change in quantity demanded or supplied can radically affect their price and so make predicting revenue generated from their export difficult. 

In Ghana, as with many other developing nations, much of the nations income therefore depends on the actions of powerful MNCs from the developed world. Such as relationship is described as neo-colonial meaning that countries remain under control of overseas countries indirectly - despite them supposedly being independent. 

Further injustice: how 'free' is free trade?

This seems like a ridiculous question but, unfortunately, as developing countries are pressured into completely liberalising their markets the same is not being done to wealthier and more powerful nations.

In the EU free trade occurs internally. Externally, however, traders are faced with high import tariffs. Most of the processing and packaging of cocoa is completed in Europe as a result of the occurrence of tariff escalation. EU tariff imports are much higher for processed cocoa than for raw cocoa beans and as a result Ghana is forced to export the raw beans and lose out on the value added by processing them, meaning that workers have little opportunity to earn higher incomes. Through this process strong economies are able to maintain poorer countries in a state of under development and prevent large scale industrialisation. Instead high income countries purchase cheap commodities from the developing world and add value to them before exporting them back as high value, manufactured goods. Developing nations can become stuck in the primary sector, a constraint on development. This is known as the resource curse and is considered to be a curse because resources are exhaustible and currently depletion rates are unsustainable.

This supports A.G Frank's Dependency Theory which splits the world into an economically developed core and and underdeveloped periphery. The theory states that developed countries keep developing countries in a state of under development by exploiting its raw materials and selling it costly manufactured goods, technology and credit. Developing countries are exporting low value goods and importing high value goods. This results in a poor terms of trade. As the periphery remains underdeveloped, its most skilled workers move to the developed core creating a brain drain, further exacerbating the problem. 

The role of the World Trade Organisation (WTO)

The purpose of the WTO is to promote global free trade. Despite pressurising developing nations into completely liberalising trade, the WTO has not been successful in removing the EU Common Agricultural Policy (CAP) which discriminates against farmers in developing countries by undermining their natural price advantage and flooding their economies with heavily subsided imports. Critics of the WTO describe it as an organisation that favours the wealthy nations that were responsible for its creation by pressuring poorer nations into unfair trade agreements. 


Referring back to the example of Ghana, in 1995 Ghana joined the WTO in an attempt to increase its global trade. Instead the nation was faced with the joining condition that farms in Ghana should no longer be subsidised by the government (which until then had occurred to encourage farmers to continue supplying food for the country's growing cities). As a result, local farmers lost out to cheaper competition from EU imported goods that had been subsidised in their country of production. 


It cannot be denied that free trade between nations generates wealth, but is the benefit really being felt in the worlds poorer nations or is the liberalisation of markets in fact acting as a constraint to development?

Exchange Rates: Fixed vs Floating (A2 Macroeconomics)

The exchange rate is the price at which one currency is exchanged for another on the foreign exchange (FOREX) market. Two of the main types of exchange rate used by Governments are a free floating exchange rate and fixed exchange rate.

The Free Floating Exchange Rate

A free floating exchange rate is a system whereby the price of one currency expressed in terms of another is determined by the forces of demand and supply.

Advantages:

• A floating exchange rate means that a government can have a larger focus on achieving other macroeconomic objectives. For example, there is no need to set interest rates to achieve an exchange rate target so interest rates can be used to achieve price stability or encourage investment.
• Automatic adjustment should ensure a Balance of Payments equilibrium is achieved. For example, if a country has a balance of payments deficit then the currency should depreciate. This is because a deficit means that imports will be greater than exports. As a result, the supply of the nations currency will exceed its demand on the FOREX market which will cause the value of the currency to depreciate. This will make exports cheaper (and so raise demand) and imports more expensive (reducing demand), eliminating the B of P deficit. 
• It may be easier to adjust to external economic shocks such as a global recession. A global recession would reduce the demand for exports, causing reduced demand for currency on the FOREX markets and lead to a depreciation in the value of the currency, lowering the price of exports and making them more attractive.

Disadvantages:

• A changing value of a currency may result in consumer uncertainty. Exporters may be unsure of how much money they will receive when they sell abroad and importers may not know exactly how much it is going to cost to import a foreign good.
• The freedom to set domestic policy does not guarantee that price stability will be prioritised over other objectives. Automatic adjustment mechanisms may lead to governments pursuing short-term economic growth at the expense of higher inflation.
• The floating exchange rate can be inflationary by allowing import prices to rise as the exchange rate depreciates. This particularly an issue for countries who depend on imports for the provision of certain goods such as exotic foods.

The Fixed Exchange Rate

In a fixed exchange rate system, the government intervenes in the currency market so that the exchange rate stays close to an exchange rate target. 

Advantages:  

• A fixed exchange rate provides certainty for traders, investors and consumers by allowing the price of imports and exports to remain more stable. Some economists argue that this will result in higher levels of trade and investment.
• Fixed exchange rates can impose financial discipline on domestic firms to keep their costs under control in order to remain competitive in international markets. This helps the government maintain low inflation, which in the long run should reduce interest rates and stimulate trade and investment.
• A fixed exchange rate reduces the costs of international trade to firms by removing the need of hedging (limiting the risk that losses are made in changes in the price of currencies by buying currencies in future markets).

Disadvantages: 

• It may be difficult to work out the initial fixing of the rate of exchange. If it is fixed at a rate too high, exports will remain relatively expensive and imports cheap. This will result in a long term loss in international competitiveness by domestic firms and a poor position in the current account of the balance of payments. 
• In order to fix the exchange rate, the government will need to maintain a high level of foreign currency reserves in order to intervene on the FOREX market. This incurs an opportunity cost. In addition, whilst maintaining the exchange at a fixed rate, other macroeconomic policy objectives may be sacrificed. For example, governments may alter interest rates in order to influence the rate of exchange, conflicting with with the objective of maintaining price stability. 
• A fixing of the exchange rate could result in retaliation by other nations. Retaliation may take the form of protectionist measures such as trade barriers against imports from domestic firms. This will increase the price of exports, thus rendering the fixed rate ineffective in increasing trade.

Economic Growth: China vs. the UK (Eco4 and Buss4)

The logical place to begin this would be to ensure we’re aware of what growth actually is and how it comes about. Growth is illustrated by an increase in Gross Domestic Product, these figures are released on a quarterly basis but are likely to be re-examined and corrected as initial figures are often inaccurate. An increase in GDP is an example of short run economic growth as it shows a change in the output of an economy. This is caused by either an increase in Aggregate Demand or short run Aggregate Supply, therefore in theory an increase in any of the elements of Aggregate Demand will bring an economy growth. Okay so now that we’ve got the basic economic explanation sorted lets apply this to relevant reading for both Eco4 and Buss4.

To ordinary followers of the news the phrase ‘economic growth’ will be covered in positivity, however economists will be intrigued to understand what has caused this growth to then forecast the implications of the economic growth. In the UK growth brings scares of rising inflation, so how on earth have the Chinese managed to grow at an average rate of 9.5% over the past 10 years and only feel inflation levels of 3%? This is due to the nature of China’s growth, the Chinese have escaped the fear of inflation by ensuring that Aggregate Supply is increasing at a rate that matches that of aggregate demand. This can be achieved by increasing the quality of capital, China have tackled this by encouraging foreign investment through financial incentives such as tax allowances for foreign firms and improving infrastructure  with thousands of miles of new motorway and over 30 new airports subsequently making China a more efficient and therefore profitable country for a firm to operate in. This approach is shown by a shift to the right of the short run aggregate supply curve and therefore maintaining the current levels of inflation.

However this rapid rate of growth is finally appearing to begin to catch up on China, this is highlighted by the wage inflation that the economy is now experiencing. At first this seems strange considering the first attraction of expansion for Western firms to China was the appealingly low wage costs. However due to the one child policy the supply to the labour force has been restricted, which has left the economy nearing full capacity, this is shown by a movement of the aggregate demand curve up the vertical curve on the Keynesian aggregate supply curve.

Bringing things closer to home, as well documented in the news the UK economy is experiencing new found growth and climbing out of the deep recession of 2008. This is where the UK converse with China as our growth has been primarily powered by consumer spending and a recovery of the housing market. How does this happen though, why during a recession would we begin to start spending more money? Us as consumers have clearly taken the conscious decision to spend more and save less in other words increase our marginal propensity to spend. This decision derives from consumer confidence, we have been encouraged to feel more confident by policies introduced by Mark Carney. Such as forward guidance that gives us assurance that interest rates will not swiftly increase after loans are taken out and funding for lending which has made it easier to obtain house mortgages. Increasing the demand for houses has boosted the house markets recovery and caused prices to rise, consequently providing more confidence to consumers as we feel wealthier when we see our house increase in value. 

But there must be a catch, if recovering an economy was this simple then why would we ever worry? The consumer spending is worsening the Balance of Payments deficit because the level of imports is outweighing exports. The implications of this is that the government are forced to sell their bonds at a higher rate of interest thus making the economy more expensive to run. Secondly the issue with becoming reliant upon an improving housing market is that people will take out risky re-mortgages and cheaper loans due to the base rate of 0.5% is that if and when the housing market begins to decline then people may fall into negative equity on their property and this will cause consumer spending to come to a standstill as it is the ultimate killer of consumer confidence.  Ring any bells from 2008?

We are forever reminded of balanced diets and balanced lifestyles are the life to lead, well economies are the same, for them to operate healthily they must be balanced. Which is why China are not trying to encourage consumer spending, the current culture of China is to save almost a third of their income whereas UK consumers save as little as 5.7% of theirs. China have switched to this approach as it is seen as more sustainable method of growth. They’re promoting this policy by increasing their national minimum wage to leave people with more disposable income as consumption = disposable income X average propensity to consume. China have understood and accepted that growth will slow down with under this approach and have just released forecasted growth figures of 7.5%, but it may be in exchange for an economy that will continue to grow for years to come. Similarly the UK are also attempting this economy balancing act as Osbourne admits that an economic recovery based on debt fueled consumerism will not lead to a sustainable future. The plan is to boost and support investment end exporting business, as the UK are in the position where they can benefit from successful economies overseas and tap into their consumer market.  It poses the question of whether the UK and China could benefit assist each other with China’s newly proposed consumer market and the UK’s desire for exporting, the answer is quite possibly as Jaguar Land Rover demonstrate with their UK manufactured luxury cars receiving high demand from China. 

Submitted by Jack Murray

Economic Systems (AS Revision)

An economic system is the way in which production is organised in a country or group of countries. This includes what goods and services are produced, how theses goods and services are produced and who these goods and services should be received by. The three main economic systems that will be covered in this post are market economies, command economies and mixed economies.

The Market Economy

A market economy is defined as "an economic system whereby resources are allocated through the market forces of supply and demand". In a market economy the consumer is sovereign; the demand by consumers controls the output of produces and therefore the allocation of resources. This takes place through the price mechanism where firms respond to consumer choice through the free movement of price in response to demand and supply. The government will have little involvement in this process, with their main roles involving legislation and the protection of property rights. The USA may be considered the closest to a free market, however governments still play roles in providing some public services.

In a market economy the level of consumer choice will be dependent upon their income. The higher the income of the consumer, the greater their choice. This could lead to social inequality by excluding those on low incomes from various goods and services. However, a free market economy may be seen as beneficial to the consumer a competition between producers will be high. This will encourage allocative and productive efficiency in order to be price competitive as well as encouraging research and development by firms to compete on non-price factors such as quality. 

Command/ Centrally Planned Economies

A command economy is "an economic system where government, through a planning process, allocates resources in society". Examples of command economies include North Korea and Cuba. It is the governments that own the majority of resources and it is their role to allocate these resources. Both wages and prices of essential items are controlled by the state. Governments of command economy's set targets for production in long term plans that often aim for a high rate of growth in output.

Arguments against command economies include a lack of consumer choice. Not only are consumers exposed to a lack of variety of goods and services, but as workers they are also allocated jobs by the state.With equal choice and opportunity, workers have little incentive to improve. The lack of competition between producers removes the incentive to achieve economic efficiency, and also likely to result in a lower quality of goods and services that are provided.

The Mixed Economy

A mixed economy is defined as "an economic system in which resources are allocated though a mixture of the free market and direct public sector involvement". The UK is an example of a mixed economy, where a Private Sector and Public Sector exists. The private sector allocates resources through the market forces of supply and demand, but with government intervention in markets that would fail if left to the free market. The government allocates resources in the Public Sector, which includes services such as education, healthcare and the emergency services. 

If governments intervene effectively and to the correct extent, a mixed economy may considered to be the best of both worlds. However in some cases, government intervention in markets is unable to correct the existing the market failure and may even make the situation worse resulting in government failure.

Measuring Inflation - What you need to know at AS (Revision)

Inflation is defined as "a general increase in prices, and fall in the purchasing value of money overtime". 

How inflation works can be shown through a trip to the supermarket. I head to Sainsbury's and purchase a trolley full of a range of goods for £100. I then return to the supermarket a year later and purchase the same items, this time coming to a total of £105. I have experienced the effects of a 5% inflation rate. If I am to purchase these goods I will have to spend an extra £5 to what I did last year or I will need to remove an item from my trolley (shoplifting is against the law, no kleptomaniacs please). Inflation thus leads to higher prices and lower purchasing power. It tends to be a monetary phenomenon caused by a country printing more money than is justified by the country's wealth.

There are two main methods used to measure inflation in the UK. One being the Consumer Price Index (CPI) and the other being the Retail Price Index (RPI). The consumer price index (CPI) is a weighted index. The results from a Family Expenditure Survey are used to find out what people spend their money on. It measures a monthly change in the prices of over 600 different goods and services. These products have weights attached to them. The weight reflects the proportion spent on the different items. For example, if 15% of  consumer expenditure is on food then this will be given a weight of 15/100. 

The expenditure weights are held constant for a year. They are then reviewed and changed depending on a change in the households spending patterns. Then, throughout the year government employees visit a range of outlets throughout the country gathering price quotations for the 600 different goods and services. This is completed each month. Ultimately, the weights are multiplied by the new price index for each category in order to find a change in the total price level. 

The RPI uses the same basket of goods and services that the CPI uses but also includes housing costs (house prices and mortgage and council tax payments) that are excluded from the CPI. The RPI also uses the arithmetic mean between the old and new price whilst CPI uses the geometric mean. The end result of this is that the RPI always gives a larger figure for inflation than CPI. 

So what ones better? 

• CPI is regarded to be more accurate. It's maths is truer and reflects to the inflation that a lot more people experience.
• The RPI does not meet international standards. It doesn't match what other countries do.
• The CPI excludes all housing costs including mortgages, interest payments and council tax. It also excludes the road fund licence and TV licence.
• Both do not respond to changes in quality. Although the price of a good or service may rise, this may be accompanied by an improvement in quality. In this respect, both measures may over-estimate inflation. 
• Both do not take into account the prices of second hand goods. 

All in all, it is difficult to measure inflation within an economy. There are many factors that cannot be taken into account but may have a large effect on the rise or fall in levels of inflation. This therefore makes it hard to put a definitive value on the exact rate of inflation at a given time.

YOUR IDEAS:

At this point in time, the UK inflation rate is 1.9%. This is lower than the Bank of England's target of 2%. Is this good or bad for our economy? Tell us your thoughts!

Is mercantilism really a thing of the past?

So far while completing A level Economics, although I have learnt a relatively large amount that relates to mercantilism (monopolistic market structures and profit maximising firms), I have only come across the term through further reading. 

Put simply, mercantilism is the belief in the benefits of profitable trading. It involves maximising net inflow of foreign exchange (traditionally in the forms of gold and silver) by restraining imports and encouraging exports. It serves the interests of producers whose actions are protected and encouraged by the national government. Core to the support of of mercantilism is another new term - Bullionism. Bullionism is an economic theory that defines wealth by the amount of precious metals owned.

Mercantilism was most popular in the 16th to 18th centuries (know as the mercantile era). Mercantile firms would be protected against foreign and domestic competition through policies set by national government. Such policies included the provision of capital, the establishment of monopolies and the implement of tariffs and/or quotas to competing imported goods.


An example of extremity of mercantilism policy can be seen the Hudson's Bay Company, who traded beaver fur. In 1670 King Charles II granted the company a charter which gave Hudson's Bay Company a monopoly status in England and sole trade of the Hudson Straight territory. The charter also made the three founders of the company "the true and absolute lords and proprietors" of the Hudson's Bay area- an area which roughly took up 40% of Canada. The firm were the unofficial government of the area and had the power to pass laws, fight wars and issued its own currency. It has territorial control of the area for 200 years before being sold to the Dominion of Canada. The power given to the trading monopolies during the mercantile era, in my opinion, makes the power of modern day large MNCs seem slightly less threatening.

The end of the mercantile era is seen to be at around the time of the publishing of Adam Smith's The Wealth of Nations, which is considered to be at the base of the modern economic theory. The book argued that such a relationship between government and markets was a harm to the general population. Instead, Smith promoted policy based around free markets and the liberalisation of trade. He argued that mercantilism reduces competition and so acts as a drag on economic development.  By the middle of the 19th century, this opinion had caught on a Britain had embraced the idea of free trade.

More recently, mercantilism is seen as nothing more than a part of economic history. However, arguments for the mercantilism continuing to take place exist, particularly when looking at the case of China.

After China opened its doors to free trade in 2001, Chinese economic policy focused on encouraging FDI by MNCs through the promise of cheap labour a special export zones which contained lower tax rates. However, in 2006 China chose to move attraction of investment from foreign firms to investment into Chinese firms. It is the methods that China has taken to achieve this that are now being considered to be neo mercantilism. Policies have included actions to spur exports while reduce imports such as currency manipulation, high tariffs and tax incentives for exports. There are also arguments that China is now discriminating against foreign firms through policies such as land grants and tax incentives to Chinese firms, cash subsidies and controls on foreign purchases designed to force technology transfer into China.

The question is, is this really a new era of mercantilism in China or is the country simply showing justified levels of support to its growing domestic firms?


Suggested further reading: Enough is Enough: Confronting Chinese Innovation Mercantilism