What is meant by financial sector stability?

Financial stability is considered to be a state in which the financial system i. e. the key financial markets and financial institutional system (banking) is resistant to economic shocks such as a global recession.

A stable financial system is capable of efficiently allocating resources, managing risks and arranging payments. When in financial stability, the system will absorb external and internal shocks using self-corrective mechanisms.

Financial stability is considered paramount for economic growth as most transactions in the modern economy are made through the financial system.

Financial instability leads to banks becoming unwilling to fund profitable projects and reluctant to distribute credit. This could lead to bank runs, hyperinflation or a stock market crash of the bank. Financial stability can also have a severe adverse impact on consumer and business confidence.

The recent banking crisis and 'credit crunch' that accompanied the 2008 global recession stimulated the creation of the Financial Policy  Committee (FPC) in the UK. The role of the FPC is to identify, monitor and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system.

What is Quantitative Easing?

Using money that has been electronically created, the Monetary Policy Committee purchases assets (usually government debt) from the private sector in order to inject money directly into the economy. This increases the demand, and therefore the price of government bonds and so encourages investors to instead purchase other assets such as corporate bonds and shares. This then encourages the issuance of new bonds to stimulate spending thus increasing aggregate demand within the economy. 

Since the policy was introduced in the UK in 2009, £375bn has been injected into the economy through quantitative easing. 

Market Failure (AS/A2 Macroeconomics)

Market failure refers to a situation in which a market fails to operate efficiently, hence the title ‘Market Failure’. There are two kinds of efficiency; allocative efficiency, which occurs when the market provides the desired quantity of the products in high demand, it is illustrated by when Price=Marginal cost, as shown on the diagram for perfect competition. Productive efficiency is the second type and this requires production to be at the lowest cost and is shown by production to be at the lowest point of the average cost curve. The result of market failure is a loss in economic and social welfare.

There are a number of examples of market failure that can be taken from AS principles, such as externalities. Products with negative externalities have a negative effect on a third party and cause the social cost to be higher than the private cost, in other words the price is lower than the cost of the implications consumption has. Negative externality markets demonstrate market failure as the wrong number of goods are supplied causing a loss in social welfare.

A situation where information failure is present is a second example of a failing market. When consumers are not fully aware of the benefits of merit goods they have a lower level of demand than what they would if there was perfect information and they were fully aware of the benefits they will receive through use or consumption of the good. The consequence of this is the loss in social welfare that consumers could potentially achieve if they had full information.

An example can also be taken from the A2 market typologies, this would be a market experiencing the dominance of a monopoly. This is because theory suggests that monopolies under produce, therefore purposely creating scarcity, to ensure high prices and as a result not providing allocative efficiency.  Also monopolies fail to achieve productive efficiency as they do not operate at the lowest point of the average cost curve. This is due to the lack of competition, monopolies don’t have to compete on price so will maximise profits with high profit margins through high prices rather than encouraging productivity to drive down costs.

The market of perfect competition is a market that provides both allocative and productive efficiency.  This is because there are so many buyers and sellers that competition is so intense that any firm operating above the most productive output will go out of business as there is only room for businesses making normal profits under perfect competition. Allocative efficiency is also seen to be achieved as price is equal to marginal cost, however, perfect competition is criticised for being idealistic as it is almost impossible to re-create in the real world. Therefore, for a market to be judged to be operating efficiently it can be compared with the characteristics of perfect competition as that is the most efficient market.

REER and NEER (A2 Macroeconomics)

REER and NEER

NEER

This refers to the nominal effective exchange rate, it is a measure of the percentage change in a currency’s value. It is known as the nominal exchange because it only calculates the numerical exchange value, it ignores the purchasing power of the currency (which is a theory that explains why people in India for example can live off the average wage of £3,850 a year, after exchanging Rupees to £’s). The nominal effective exchange rate of a currency is determined by the government under a fixed exchange policy and by the supply and demand of the currency for a floating exchange rate system. 

Extract 4 from the pre-release material for OCR Econ 4 includes a graph which illustrates a 50% fall in Iceland’s NEER, this is a steep depreciation. This means that the Icelandic Krona could only purchase half of the amount British pounds in 2011 that it could in 2007. This was caused by the drastic fall in demand for the Krona when the Icelandic banks collapsed during the world recession of 2008.

REER

The real effective exchange rate takes purchasing power into account and measures the change in prices that country’s demand for their exports. If a country’s real effective exchange rate falls it means that the price of their exports has fallen. 

In the same extract, it is highlighted that Latvia’s NEER was unchanged but experienced a 20% decrease of its REER, this was a result of the vigorous austerity policy Latvia implemented. Latvia carried out an internal devaluation by keeping wages low, the objective of this was to improve the international competitiveness of Latvia’s exports to soften the effect of the recession. 

The Law of Diminishing Returns (A2 Microeconomics)

This refers to the cost of production to firms in the short run, where short run is considered to be the period of time when at least one factor of production is fixed. 

The law of diminishing returns relies on the assumption that capital is a fixed factor. It states that as a firm increases the amount of inputs of a variable factor (such as labour), it will gradually derive less additional output per unit of labour for each further increase. This is a result of the fixed factor of production, which limits the capacity of cost efficient production. For example if a manufacturing firms owns 100 sewing machines, as the number of machine operators employed by the firm passes 100 and employees are required to share machines the output per worker will begin to fall.

As it becomes more expensive to produce each additional unit of output, marginal cost (MC) and average variable cost (AVC) will start to rise. 

Eventually, the rise in AVC will exceed the fall in average fixed cost (AFC) which generally occurs as fixed costs can be spread to a larger amount of units of output. When this happens, average total cost (AC) will also start to rise.

Source http://www.bized.co.uk/

Here, where MC is below AC, AC must be falling. This is because an additional unit of output that is cheaper than the average unit cost will pull down the average cost of production. Once the MC curve meets the AC curve, average costs begin to rise as they are exceeded by the marginal cost of output. If an additional unit of output is more expensive to produce that the average cost, the new average cost including this additional unit will be greater. 

This relationship results in the MC curve cutting the AC curve at its lowest point. This is where costs of production are at a minimum. Profit maximising firms will aim to produce at this point.

The Resource Curse (A2 Macroeconomics)

The Resource Curse

Over the past couple of decades we have seen the BRIC (Brazil, Russia, India and China) countries grow rapidly through various different methods. We already know that to achieve growth; there must be an increase in aggregate demand, which means there must be an improvement in at least one of the elements of aggregate demand.  However undeveloped countries will already have low consumerism due to limited disposable income, investment is minimal because they’re not attractive economies to trade in, consequently the government receive little in taxation revenue so do not have the finance to spur growth through fiscal policy. This leaves countries in the position where they must improve the balance of X-M, they can either increase exports which is known as an export led growth, or they can reduce imports by producing a high variety of goods to sell domestically. 

China is a great example of an economy exploiting export led growth as they specialised in cheap consumer goods to export to the Western economies. India is an example of an import based growth as they produced all the goods they needed and placed protectionist policies on foreign goods, this forces up the sales of domestic goods.

How does a country decide on their method?

One factor and often the deciding factor is the country’s access to resources, for example as mentioned in the ECON 4 extract many Sub Saharan African countries have found that they’re rich in natural resources such as oil and gas. This would encourage an economy to opt for an export led growth of primary commodity goods.

Finding masses of oil would therefore sound ideal for an undeveloped country as it will encourage firms to invest into the country, high sales for firms selling the commodities will increase aggregate demand. Therefore, the government will collect more in taxes so will have finance available to spend on education and health care which illustrates a multiplier effect on aggregate demand and will also improve the standard of life for the people.

So then why have the sub Saharan countries grown at a rate of 5% (much higher than EU economies) but according to the Human Development Index still have a standard of living that is significantly below the world average?

There are number of interconnected reasons for this, the most important and probably obvious one in my opinion is the high levels of corruption. Companies trading with foreign oil companies rarely trade as simplistically as business to business, the executives of the foreign firms often demand payments into private accounts to ensure the deal. This links to the second reason which is the inequality created as a result, the powerful few receive high payments from corporate deals the revenue of exports are kept in the hands of the elite rather than distributed to the many through higher wages. This is worsened as the process of extracting natural resources no longer requires heavy amounts of labour as modernisation and improvements in technology have caused the industry to become capital intensive. This may be more efficient for firms but will limit the effect on unemployment.

These reasons identify why the general population of resource rich countries do not benefit, but demand inflation can actually cause people to become worse off than they were before. As aggregate demand rises from the rise in exports it will shift up the supply curve and cause price level to rise, which is shown by an increase in the rate of inflation. This will make all the normal goods people buy more expensive, which will leave people with less money and therefore worse off than before the natural resources were found. This illustrates how although growth is required to fund development. Development is not always enjoyed from an increase in growth.