MKT 3000: SOME BASIC ECONOMIC PRINCIPLES
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CONTENTS:
Comments,
questions and suggestions??
- What We Choose & the implications: - the
principle of trade, specialisation & comparative advantage.
- Microeconomics of Trade - how different
markets
for the
same goods interact.
- The Market System and the Circular Flow of Income.
- The case for 'free markets' and the
(economic) roles of Government
- Macroeconomic Basics - the Circular Flow
of Income
(CFoI),
with Government and Fiscal Policy
- Money, Interest and Discounting
- MacroEconomics & International Trade: The Forex
Market.
- What does this all mean? (New - October 2012)
1.
What do we choose & Implications: Is
there a simple logic which describes how we manage to have a life and
earn a living?
The whole economy, even for a small region, is a pretty complex
phenomenon. Yet it is bascially how we choose how to earn a living and
how to have a life. WE (or at least I) have to simplify
it.
Se, we are economical. We concentrate on a very simple
economy:
one with only two factors of production (land and labour),
which
is only interested in producing and consuming two goods (food
(+fibre); clothes (+ shelter)). These two goods, which
can
be thought of composites as indicated, comprise all the necessities of
life, and are all this simple economy produces, or, for the present,
wants
to produce. It is self contained and self-sufficient as a whole.
Our economy
is a self-contained collection of
producers and
consumers
- everyone is either one or both.
Notice - we are talking of an economy here - which
might
be a country, or a region, or a community or locality or village, or
whatever.
In the limit, such an economy could be as small as a self-sufficient,
single
and subsistence household. It doesn't matter how big or small it
is. All that matters - for the moment - is that it is
self-contained.
We will come to what can happen when two such economies meet and trade
with each other below. For the present, we just consider the
logic
of this single and simple economy as separate and self contained
entity.
What options does our economy have?
- to produce food (and fibre), or clothes, or (more likely) a
mixture of
the two.
- to consume (use) food and fibre or clothes, or almost certainly a
mixture
of the two.
What determines how much of each to produce and consume? More to
the point - if we know nothing about this wierd and wonderful 'economy'
what do we observe?
The diagram we will use relates production and consumption of one
good
(food (and fibre)) to the production and consumption of the other
(clothes
(and shelter)). So we measure (illustrate) quantities of
each
good on the two axes: quantity of clothes on the vertical axis
and
food on the horizontal axis - though it could just as easily be the
other
way round, it doesn't matter. Get a bit of paper and draw
this
diagram for yourselves now. Then read the following and trace the
argument (logic) out on your diagram as you follow it through.
Now - you have a right angled diagram, with quantity of clothes
on the vertical axis and quantity of food on the horizontal axis.
Presuming that we can measure these quantities, and add up the total
(production and use) of each by all the people we are looking at, we
can mark a point in the 'space' defined by the axes as the quantity mix
of clothes and food our economy is producing and consuming. Do
that.
What can we deduce from the choice of this bundle of goods which
our economy/society has chosen?
To answer that question, we need to consider what
options our economy has.
In the simplest terms, the options range between using all available
production factors
(land
and labour) to produce food; or to use all its factors to produce
clothes. In fact, and sensibly, it chooses to produce our observed
combination of the two goods. And, because
our citizens are sensible, they will organise themselves to produce as
much as possible of each good. What? How come we presume
they are sensible? Because (if you like) these are our ancestors,
and they were sufficiently capable to both survive and persist long
enough to reproduce - and we are the result. What about leisure and
living? Don't they take time and effort? Yes, so our
production
possibility set will represent the quantities of the two goods
our
citizens
are prepared to, are willing to produce, given that any
production
involves use of scarce (limited) time and effort, for which there are
competing
leisure (consumption) and recuperation (investment - see below) demands
So, following this logic, there is some upper limit to the
amount (quantity) of
each
good our citizens are prepared to produce in this economy. We can
mark these two upper limits (F* and C*) on each of the axes
of our diagram of the economy. Producing F* means that will not
produce
any C at all, so quantity of C is zero when Food production is at F*,
and
vice
versa. OK?
But neither of these extremes is likely to be a sensible choice for
our people - they are much more likely to choose a combination of the
two
goods, as we observe them doing. What are the production
possibilities for mixtures of the
two goods? Suppose we start with the economy producing all food
and
no clothes (at point F*), and now ask ourselves how much
clothing
this economy could produce if it diverted some of its resources from
food
to clothes production. How much food production would have to be
given up to produce the first few units of clothes? Probably not
very much, since some factors of production (land and labour) is not
very
good for food production and would be much better at producing
clothes.
Furthermore, some of our people would prefer to make clothes
than
produce food, so are likely to be better at producing clothes than
food.
So, to begin with, moving from F* upwards and to the left to produce
more clothes and less food, our economy could gain quite a lot of
clothes
without having to give up much food production. Eventually,
though,
as we progressively cut back on food production in order to produce
more
clothes, we will find that we are having to give up more and more food
for each extra unit of clothing production - as the extra
resources
we need to produce clothes are progressively better at producing food
than
clothes. Eventually, we would wind up producing all clothes and
no
food - at point C*.
So,
our
production possibility relationship will be curved between F* and
C*.
Make sure you follow this logic and the representation of it as the production
possibility frontier (PPF) on the diagram . This
should
be what you got on your own diagram as you followed the argument
through.
If you didn't, why not? Notice, it is frontier because
this
curve represents the maximum possible combinations of food and clothes
that our citizens are willing to produce, given the land, skills,
technologies
and work preferences they have.
Notice, too, what this PPF means. Suppose we start at point C*
and then ask how many clothes we have to give up to produce some
food.
Move along the PPF, and watch how much extra food we get as we
give
up limited quantities of clothes. (draw and imaginary triangle with the
hypoteneuse parallel to and touching the PPF - i.e. with the same slope as the PPF - the vertical
side of this triangle shows the amount of clothes we can exchange for the amount of food,
which is represented by the horizontal side of the triangle - see?).
At first, close to C*, we only have to give up a
little
clothes for a lot of food - the slope of the PPF is quite flat.
In
other words, the supply price (cost) of more food in terms of clothes
given
up (the opportunity cost, which here is the total cost
of
food production) is low.
But, as we progress down the PPF, the real cost of
food
(its cost relative to everything else in the economy, which in
our
case is clothes) increases - the slope of the PPF gets steeper.
The
cost of food production increases the more food we try and produce - the
real supply curve for food slopes upwards.
Repeat this argument (logic) for the price of clothes in terms of
food
- you will get the same answer - the real supply curve of clothes
also slopes upwards: the more we want to produce, the higher the cost
in
terms of foregone food production - the higher the real (relative) cost
of clothes.
PPF Conclusions:
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- The PPF shows the full employment capacity of the
economy: inside
it means unemployment; outside it is impossible (unless, that is,
we
add to the capacity of the economy - see below)
- So, it also shows the maximum real income our
economy
can generate,
in terms of food and clothes mixtures. Our producers are here
not producing these things just for fun, they are producing them
because
they and their neighbours want them - the products are their income,
their
return for the work they do.
- The slope of the PPF measures the real supply
price
(the
real cost) of producing each of the goods, in terms of the other.
- The supply curves for both products slope upwards
- greater
quantities supplied "cost" more per unit, in terms of the amount of the
other good which has to be given up.
How do we add to the capacity of the economy, and thus increase
incomes?
Any
and all of the following things will increase the capacity of our
economy,
and also increase incomes. Any and all these things will shift the
PPF
outwards (up and to the right).
- By "investing in human capital" - improving the skills and
productivity
of our people - the labour, (and the consumers), or simply having more
people.
- By investing in land to make it more productive (draining
it
etc.), or simply by taking over more land.
- By improving the effectiveness of our production systems -
getting more
out for the same level of land and labour input - improving
efficiency,
which means one or both of better management (ideally less
management,
since management by itself produces nothing), and better
technologies.
- By investing in capital (tools, plant and equipment)
which
labour
can use with the land to produce the goods.
- By combining these things so that work (production) becomes more
fun
and
more respectable, so that people are more willing to work than before
(a
point seldom, if ever recognised in the textbooks)
What does investment mean here? It means diverting
resources
from the production of food and clothes for current consumption to the
production of "capital" - a stock of new and better resources for
future
production or consumption. So, it is production and use of
another
good - capital. I can't draw three dimensional diagrams very
well,
and you can't read them very well either, I expect. So, for the
present,
we will ignore this complication, or, if you like, consider that part
of
both food and clothing production involves producing capital.
Each
must, actually, since food production requires seed and breeding
livestock
- capital, and clothes and shelter are produced in one period but
expected
to last for longer than one period, so are also capital goods, as
opposed to simply consumption goods. This simplification does not
materially affect the basic logic, the basic principles.
So, the PPF describes the
production
or supply side of our economy, and describes the consequences of
different choices about how much of each good to produce.
What about the consumption or demand side? Now we have
to think about how to represent consumer choices about how much of each
(food and clothes) they would like to have and enjoy. Go back to
your paper diagram. Start with some mix of the two which
represents
one
particular (and observable) choice (F1 of food
and C1 of clothes) -
a point (x) which will be in the middle of our diagram somewhere
- it doesn't really matter exactly where. But, if you are drawing this
on the diagram with the PPF on it (which you should now have labelled),
you
had better put your x somewhere on this frontier,
hadn't
you? Why?
Otherwise you will be trying to consume mixes of the two goods you
cannot
possibly produce (x lies outside the PPF).
Or
you will be wasting resources - x lies inside the PPF,
which means leaving people and land idle and unemployed when they could
be
working,
and working at something they would like to do, and earning a living,
and
producing something we want, and thus earning respect.
So, put your x on the PPF - anywhere else is daft,
(or,
as economists say, inefficient), so we would not expect people to
choose
it, unless they are so stupid as not to be human. This point x
represents
the mix of clothes and food that the people in our simple economy
choose for themselves - it is
the one we would observe them at, if we could find this simple economy
to look at, and measure properly without disturbing the people at all.
Now ask yourself how the consumers in the economy might judge other
combinations or mixes of the two goods that they might have chosen
instead
of x (F1 and C1)? How might they compare other possible points on
this diagram with x?
Within reason, more of each good would typically be considered
preferable
to less of each of the two goods, especially as we have included
capital
in each, - right? So we can identify the north east quadrant (all
points above and to the right
of point x) as a preferred
set or zone of possible consumption mixes or 'baskets' of goods.
Draw this zone on your diagram now.
And the south west quadrant
(all
points or good combinations consisting of less of both F1 food and C1
clothes)
will be considered inferior choices or combinations for our
consumer
population. Otherwise they would have chosen one of the points in
this zone, and they did not. Shade in this inferior zone in now.
So, somewhere in the top left (north west) and bottom right (south
east)
quadrants will lie a boundary which separates the preferred set
of consumption mixes from the inferior set, compared with our initial
combination
x.
There will be a separation between mixes which are preferred and mixes
of goods which are considered inferior - a separation zone or boundary
along which our citizens cannot make up their minds about which mix is
better and which worse - they are, in effect, indifferent between any
of
the mixes defined by this boundary or indifference zone.
This boundary will (has to) slope downwards and to the right,
passing through our reference point, x. And, furthermore,
it will have to lie everywhere outside (above and to the right of) the
PPF, and only touch the PPF at the observed mix (x). Why?
Because, if this society preferred any other possible mix (defined by
the PPF), other than x, they presumably would have worked out by now
how to choose this other mix. But they haven't and didn't, so the indifference boundary must lie outside the PPF -
see? In logic (and 'fact' in our mind experiment), any point, other than x, which is either on or inside the PPF
is revealed as necessarily
inferior to x by the very 'fact' of the observed choice of x
rather than any other possible mix. QED. So, draw such a
boundary
on your diagram.
You have just drawn what economists call an indifference curve
(or boundary) (let's label it I2) which indicates all those
combinations
of food and clothes which the consumers cannot judge to either worse or
better than the one they chose initially (x) - they are indifferent
between
any of the combinations which lie on this boundary or curve. So,
you can now extend the shading of both the preferred zone and the
inferior
zone up to this boundary. Got that? If not, go back and
re-read
the logic and re-draw your own diagram.
You should
have got
(most of) this diagram. But you didn't get three curves, you only
got I2. So what are the other curves? Well, what we are
drawing
here is a map of consumer preferences. The further north
east
we go this map, the more preferable the bundles of goods become -
bundles
to the north east of x have a higher value to the consumers than
bundles
to the south west. The indifference curve we have drawn is a
contour
line on this preference "hill" - a line joining together all those
points
(bundles of the two goods) which are considered of equal value by the
consumers,
the citizens of our economy. So there are as many other contour
lines
as we care to draw on this preference map. I have just drawn in
two
others, of lower value than I2, so I have labeled them I1 and Io
respectively.
Now go back to point x. Ask yourself how much food our
citizens would be willing to give up in exchange for a little more
clothes
- move upwards and to the left of point x along the
indifference
curve, I2. Why is it a curve, sloping downwards and to the right
('convex to the origin" (where the axes cross), in technical
language)? Think about it.
If you already have mix x, ask yourself how much F you woulod be
willing to give up (trade) in exchange for a bit more C? The more of F
you have, and therefore the less of C, the more likely it is that you
will be willing to offer more F for a little more C - down in the
right/bottom corner, you will be willing to give up a lot of F (long
horizontal 'bit' ) for a little more C (short vertical 'bit), so the slope of the indifference
curve here is likely to be shallow (flatter). As we get more C,
and thus less F, so the amount of F we are willing to trade for more C
will get greater - the slope of the indifference curve will get
steeper. Got that? If not, try the experiment again, and take
your time.
Why along the curve? Because, if we move upwards and to the
right
of this curve, we are assuming that our consumers consider themselves
to
have suddenly become richer. How come? Because they can get
to a preferred mix of both goods anywhere above and to the right of I2
- (I2 marks the boundary between the preferred set of goods and the set
considered inferior.) They choose x - because they could not get
any mix of goods above and to the right (outside) I2. If they
could
have, they would have, and x would be in a different place than we
supposed.
[This sort of analysis is known, in the textbooks as revealed
preference
theory for this reason - the
choices people actually make reveal
their
preferences for what they want, and about how much effort they
are
prepared
to put in (or goods they are prepared to give up) to get it]
Indifference Curve Conclusions:
An indifference curve also shows a constant real income level
for our economy, where income is now defined as command over
consumption
(and investment) mixes ("demand income"), rather than as the returns
from
production. Note, again, that this is not a distinction that the
textbooks identify. Why not? The answer takes us into some
even deeper conceptual water than we are already in, and I don't think
is necessary here.
So, if we want to know how much food our
consumers
will be prepared to give up (pay) for an additional quantity of
clothes,
we had better hold their demand incomes constant - otherwise we will
confuse
ourselves about why they are willing to pay more or less for more
clothes - mixing up the effect of having more income with the
consequences of a change in the terms of trade or
exchange - otherwise known as the price - actually the real (relative) price - as the rate at
which we can expect to exchange (barter) one unit of one good for a
unit of another.
So we move up the indifference curve I2. As we do so, what
do we
see? That our consumers are willing to give up progressively less
and less food for more and more clothes. The indifference curve
gets
steeper. The more clothes they want, the less food they are
prepared
to trade (pay) for them, the demand curve for clothes is downward
sloping.
Alternatively, move down the indifference curve from point x.
The consumers are willing to give up less and less clothes for more and
more food. The indifference curve gets flatter. The more
food
they want the lower the price in terms of clothes (the real price) they
are prepared to pay. The demand curve for food is downward
sloping.
The slope of the Indifference Curve shows the real
demand
prices (the prices people, as consumers or users, are willing to
pay) for the two goods.
These
are indeed real prices - each is priced relative to the other
(which
is all there is in this simple economy).
General (Market)
equilibrium: the PPF meets the Indifference
Curve. (or the lecturer meets the
class? Sorry, couldn't
resist
that). We have now isolated the fundamental dilemma for our
simple
economy: how can we reconcile the production value of goods, as
the things our people are prepared to do for others in return for
income
or payment, represented by the PPF, with the consumption value
of
goods, as the values people attach to consuming or having the goods for
themselves, represented by the indifference curve?
As the markets
(the
possible trade-offs) for each of the two goods settle down to their
equilibrium
positions, each will settle on a particular quantity and a particular
price
- at which the supply cost equals the demand price (where the supply
curve
and demand curve intersect). Where will this equilibrium quantity
mix (of food and clothes) be on our production possibility frontier
(PPF)
and consumer preference map (indifference curve map) diagram?
What
combinations (quantities) of the two goods would you expect this single
economy to choose? Think, before you read on.
Answer: first, it has to be a mix that our citizens are willing to
produce
- so the combination has to lie somewhere on the PPF. But where?
Where the consumers think they are getting the best value from their
consumption
- i.e. as high up the preference map as possible - on the highest
possible indifference contour or curve. Which is a single
unique
point (X) as a combination of C1 clothes and F1 food. This
economy,
or community, cannot do better than this on its own. Indeed, that is
exactly the way we constructed this mind experiment, or simple
description of the choices our simple society/economy make, which we
observed in this experiment.
We should expect a sensible, coherent and communicative, and
cooperative
community to come up with this, given time and no interference from
anywhere
else. This is how we would expect people to learn to behave, if
left
to themselves. What? No, you wouldn't expect this?
They
will fight and bicker? They will steal and thieve? They
will
behave like children, then? They won't grow up and be sensible
and
wise? Why not, if we leave them alone, wouldn't we expect them to
grow up and learn from their mistakes and work out how to do things
better?
Isn't this what humans do, if we leave them alone? If they don't,
they will wipe each other out. These people, in case you hadn't
noticed,
are our ancestors - so they didn't wipe themselves out.
OK,
so I
have altered the shape of the PPF here - the reason will become obvious
in a minute. For the present, just notice that this different
shape
reflects the capacity of the community, and its willingness to work at
these particular activities - this one is better at producing clothes
than
food compared to the previous one. Why? because it has more
labour and less land, perhaps, and clothing (and shelter) production is
more labour intensive and less land intensive than food and fibre
production. Or for a variety of other possible reasons, which you
should think about.
At this unique point, X, this single optimum (best
possible choice) combination of
food
and clothes, the indifference curve and the PPF will be tangential to
each
other - they will have the same slopes. In other words,
at
this point, the rate at which consumers are willing to give up one good
in terms of the other (the slope of the indifference curve), which is
the
consumer demand price for each good, will equal the rate at which it is
possible to supply one good in terms of the other - the supply cost of
each good - the slope of the PPF. At this point, and this point
alone,
the production value of the two goods will equal the consumption value.
What are these rates? They are the real (relative) prices of
each
good in terms of the other. The supply prices are equal to
the
demand prices at this general equilibrium in our two markets.
And the price ratio of one good in terms of the other is the slope of
the
tangent - the ratio of C0 to F0 in the diagram opposite - the
supply
price ratio of the slope of the PPF equals the demand price ratio of
the
indifference curve. So, this country's markets will settle down
at
a general equilibrium of producing and consuming at point X, =
C1
of clothes and F1 of food.
"General Equilibrium" Conclusion:
The social organisation of production and consumption - the choices
about what to produce and consume - how to have a life and earn a
living, can be seen, described and analysed as Markets - the balance
between supply and demand. In an ideal world, the relative prices
(exchange 'rates' or terms of trade) between goods and services will
indicate (and reflect) both the production possibilities, and the
consumer (or user) preferences for the goods and services.
Markets can
achieve the best of all possible worlds, in the real
world in which we live. This is a fact of logic not
just
an assertion or an assumption. It is true in principle.
And we, as humans, are uniquely capable of turning our principles into
practice (or vice versa -
deriving principles from the outcomes of our practiced practices) -
that is what we do that makes us different from the
animals.
If the real world does not live up to this principle in its practice,
then
we will work to understand why, and then work to fix it. This is
science and reason. Anything else is idle speculation or
fantasy.
Simple, isn't it? Tough, isn't it? Is this why people don't
like economics?
Implications:
The market system rewards the owners of the factors of production
- those who have the most land, the most capital and the labour skills
best fitted, most well matched to the wants of society (the consumer)
will
earn the most production income, and thus get to exercise the most
money
votes about what is produced. If you (land, labour,
capital,
or management) are useless, you won't get paid in this system, and you
won't get the chance to exercise your consumption income. To him that
hath
shall be given - from those who are most able, but not
(necessarily)
to those who are considered most deserving.
So we would also expect our sensible human community to show some
humanity
and seek to soften the harsh realities of natural selection (since that
is what this system really is). Our community will also develop governance
and redistribution (care) systems alongside its
market
systems. Why? Because, some form of government is an essential
complement
to this trading system - the long arm of the law is necessarily
attached
to Adam Smith's invisible hand of the market - to outlaw theft, enforce
contracts and protect property rights (whether these are common rights
or private rights). Once in place, such governments will also
become
responsible for managing the natural selection of the market -
including
acting as judge to redistribute losses and gains, and protect or
support
the less well off. The humane economy will naturally develop
gifts
from those who have to those who have not, which will be outside the
system
of exchange portrayed here. But not independent of it, since the
capacity
to give depends on the resources one can accumulate and incomes one can
generate.
We have not concentrated on either the sociology or the politics of
our economy, our community, here - because this is an economics
lesson.
But it is nonsense to pretend that these aspects of humanity do not
exist,
or that economics is fundamentally different and separated from
them.
They have to fit, and the way they fit is through the governance (or
management,
if you prefer) of what is, essentially, a market system.
Finally - the benefits of "Trade" - i.e.
exchanges of goods between different economies/societies.
Now, at last, we are in a position to look at the benefits from
trade.
Before we do, though, notice that all our analysis/experiment so far
has actually already been about trade and exchange within a single economy - the
benefits of specialisation and trade (doing what you do best, and
exchanging the products for the things you need) are implict in getting
the most/best out of what we've been lucky enough to have got - the
economy of life and living. You don't have to like it, any more than
you have to like gravity, but you can't live without it, and you can't,
in this world and this life, get away from it. It's called survival
(and prosperity) of the fittest. It may be a poor system, from where
you sit or stand, but it's better than all the rest - and we may be
sure that the rest have been tried by our ancestors, and they have
either been found wanting, or they have developed to what we have now.
Suppose, now, we have another community (or country, if you
prefer).
This second community - 2 - is different to community 1: it has
more land and less labour. The PPF for country 2 shows
that the country is better at food production and not so good at
clothing
production as country 1. But the preference maps are, for our
purposes, identical
for
the two countries. On its own, then, country 2 would choose to
produce
and consume C2 clothes and F2 food, at a real price ratio of C3/F3.

Now suppose you are a trader. You have an opportunity to do
business
between these two countries. What are you going to do? Buy
clothes where they are cheap and sell them where they are expensive,
and
the same thing for food. And where is food cheap? In
country
2 - you don't have to pay a much in clothes in country 2 as you do in
country
1. And clothes are cheap in country 1. So there is money to
be made shipping food from country 2 to 1 and clothes from 1 to 2 -
right?
Just think about the meaning of the slopes of the "price lines" in each
country - they show the price of one good in terms of the other.
And what happens when we start to
trade - exporting food from 2 to 1
and clothes from 1 to 2? The price of food will rise in country 2
(the food exporter), and
the price of clothes will fall in 2. Country 2's "price line" (C3
to F3) will get steeper. The opposite will happen in country 1 -
the line C0 - F0 will get flatter.
And what will limit this process of price changes as a consequence
of
trade between to two countries? Again, from the previous session
- the free trade or "world price" will be the same in each country -
the
slopes of the price lines will be the same, flatter than 1's and
steeper
than 2's. The trading price line will lie between the price lines
of the two countries, as in the figure below (Ce - Fe). I have omitted
the previous no-trade price lines from these diagrams, to make them
clearer.
But you should be able to re-draw these for yourselves.

So what? At this price ratio, country 1's optimum consumption
point
is now C1c of clothes and C1f of food. This is where the trade
price
line touches the highest possible indifference curve. A higher
indifference
curve than it can possibly get to without trade - a higher consumer or
demand income - so it is definitely better off with trade.
How does it manage to consume this amount of food (which is more
than
it could possibly produce itself in this diagram - C1f lies outside the
PPF)? Answer - it imports food, and pays for these
imports
with exports of clothes.
How much food and clothes would it pay country 1 to produce?
Where
the trade price line is the same slope as (lies tangential to) the PPF
- since the slope of the PPF shows the supply price ratio of the two
goods
- the price ratio which matches the opportunity costs of producing each
of the goods. So, country 1 produces P1c of clothes, and P1f of
food,
and trades (P1c - C1c) clothes for (C1f - P1f) food.
The exports [production minus consumption] of clothes pays for the
imports
(consumption minus production) of food, at the trading price ratio
between
the two products. And country 1 is clearly better off with trade
than without it, since it can now consume above (beyond) the limits of
its production possibilities. The same arguments apply to country
2. Follow them through for country 2 for yourselves.
Conclusions from Trade:
- Country 1 is said to have a comparative advantage in
clothing
production
- it can produce clothes relatively cheaply in terms of food,
whereas
country 2 has a comparative advantage in food production. Notice,
importantly, that one of these countries could be absolutely
better at producing both goods - able to produce both more food and
more clothes per person or per hectare. But this would make absolutely
no difference to its comparative advantage. Unless both
countries
are absolutely identical (in which case their real prices would also be
identical, and there would be no gain from trade, and thus no trade) ,
one must have a comparative advantage in one good and the other
must
have a comparative advantage in the other good - fact of logic;
mathematical
certainty; law of human nature - call it what you like.
- In particular - there is no way that one country can
possibly
have
a comparative advantage in the production of both goods.
Having a comparative advantage in one good automatically means
that
the country has comparative disadvantage in the other. This
result is perfectly general - it holds however many goods we might like
to consider - any country will have a comparative advantage in
something
- something which it is relatively good at compared with all the other
things it might be
able to do. Comparative advantage
relates your own abilities and capacity to produce one thing versus
another, NOT you advantage relative to other people in producing
either good.
- Trade allows these countries to exploit their
comparative advantages,
buying (importing) things which are relatively cheap from elsewhere and
paying for these imports with exports of things which are relatively
cheap
in this country, and thus relatively expensive elsewhere.
- It will pay countries to specialise in the things which
they
are
relatively good at - the things in which they have a comparative
advantage.
Country 1 here specialises in clothes - producing more than it is
willing
to consume, and country 2 specialises in food (& fibre) production.
- Trade prices equalise between countries as trade occurs,
which encourage
the appropriate supply and demand responses to exploit these
opportunities
for specialisation
- The results of this logical analysis are unambiguous
- trade
pays and is of benefit to everyone. There is no doubt
about this
- it is a fact of logic - it stands to reason. Not believing
this
is exactly equivalent to not believing that the earth is round and goes
round the sun - it is daft, nonsensical, illogical, without foundation.
- It is also, I argue, a fact of life as well as a fact of logic -
because
the principle of specialisation and trade according to comparative
advantage
is a basic principle of evolution and natural selection, and of life - how well off would you be if you tried to
be completely, 100%, self-sufficient? How well off would your local
community be? Your region be? Your country be? Rabbits
don't try to be wolves - they get better at being rabbits, and working
better with the resources and conditions in which they find themselves.
This is how natural ecosystems work, as well as how markets work.
But this is another story.
Why, then, is there apparently so much resistance to the idea of
economics,
markets and, especially, free trade? Well, what do you think? Stop
and
consider this question and your answers before we deal with this in
class.
Caveat: Although this
logic applies to the consequences
of choice in our economies, the logic does not necessarily indicate
anything very profound or useful about how we make these choices.
This is a topic to which we can return later in the course.
2.
Microeconomics of Trade -
how different
markets for the same
goods interact.
Trade happens when someone discovers that market prices for the same
goods
are different in different places - high prices in one place and low in
another. Common business sense then takes over - for example,
wheat
in North America versus wheat in Europe during the 19thC:
Remember - these diagrams are
drawn to respresent all other things
(incomes, tastes, preferences, technologies, demands supplies and
prices of all other goods etc.) all held CONSTANT - it is a PARTIAL
analysis, done under ceteris paribus
conditions. It is a mind-experiment. Think what happens
when, eg., population increases in Europe or costs of production fall
in America - through machines etc.
- Imports reduce the price of the good in the importing country (or
region
or locality) and increase the quantity which is purchased.
- Exports raise the price in the exporting region or location and
reduce
the quantity consumed (purchased)
So, where will the process of Trade reach equilibrium? Think,
before
you read on:
Trade will be in equilibrium when it no longer pays to buy cheap and
sell dear - in the limit, when the prices in the two markets are the
SAME
(apart from transport and marketing costs between the two
locations - see below).
The process of trade can be represented through:
- Excess Demand (XD): equivalent to the Demand for
Imports -
the difference between the quantity demanded and the quantity supplied
in the local market at each and
every price - which equals zero at the
local equilibrium price (Pe in the diagram above), and increases as
price
is reduced below Pe -
so XD is Downward
sloping.
- Excess Supply (XS): equivalent to the Supply of Exports
-
the difference
between the quantity supplied and the quantity demanded in the local
market at each and every price
-
which is zero at the local (autarchic - no
trade) equilibrium price
(Pu above), and increases
as price is increased
above this level - so XS is
Upward sloping.

With NO transport and marketing costs, the trading equilibrium will
be at the point of intersection of XD and XS - the same price in each
market,
with quantities exported equalling quantities imported. This is
sometimes
called the "Law of One Price"
- In practice, there are costs of moving goods between
different
markets
(especially over international borders), so prices of the same goods
are
not the same in different markets - they will generally be higher in
importing
markets and lower in exporting markets.
- The Importing price is often referred to in the statistics and
trade
press
as the "cif" price - meaning that the cost of the good, insurance
and freight charges are all included in the price.
- The Exporting price is often referred to as the "fob"
price -
meaning
the price of the good free on board the
exporting
ship, having been paid for, but not yet moved.
- The difference between these two prices therefore reflects the
costs of
moving the good (more generally, moving and marketing it)
- Although this illustration is in terms of international markets,
EXACTLY
THE SAME PRINCIPLES APPLY to separated regional or local markets.

Implications: Using this
elementary apparatus we can explain market developments and identify
many of the effects of market interventions and regulations (as will be
done in class)
For example - what about an export subsidy, to help cure domestic
unemployment? Who would gain, and who would lose, and by how much?

Which is why it has been fairly easy to get agreement that Export
Subsidies (dumping) are bad news and should be banned.
Back to Contents.
3.
The Market System
and the Circular Flow of Income.
<>
The Market system works through specialisation
and trade:
People, communities, regions and countries are better off specialising
in production and trading the products with neighbours than they would
be if they tried to be completely self-sufficient. If this were
not
the case, markets would not exist.
Specialisation and Trade relies on people and their businesses
exploiting
their comparative advantage - specialising their productive
activities
in those areas and products for which they are best able, relative
to all the other things which they
might do instead. The comparison
implicit in comparative is with your own alternatives, not with the performance of
actual or potential competitors. Your own
opportunity
costs (what you could earn doing something else) should be less than
the returns you earn doing your
present
things.
The general picture of interacting markets - the circular flow of
income:
- Households own the factors of production (land -
including
raw materials, labour, management and physical capital).
- Note - capital here means physical capital - plant,
equipment,
buildings
and machinery etc. (c.f. financial and money markets below)
- Households rent these factors to firms, in return for
income:
land rents; capital interest and dividend payments, and equity
appreciation
(capital gains); wages and salaries.
- Factor ownership provides income which fuels consumption and
demand in
the goods and services markets
- Firms rent the factors of production from households according to
their
demands for these factors, which is derived from the demands
for
the final goods and services
- Factor markets operate so as to encourage the owners of land,
labour,
manaement
and capital to rent out the services of the factors to the highest
bidder
- Firms add value to their own purchases of inputs and raw
materials.
They earn gross margins (total revenues minus cash input costs
[fuel,
power, packaging etc.] which is the value added to these inputs.
The Gross margin, or added value, or gross product
(each term means essentially the same thing for our purposes) is the
income
available to the fixed factors - land, labour, management and capital.
- In equilibrium, these returns will be normal profits - each firm
earning
sufficient to cover the opportunity costs of the factors of production
which they employ. If some firms or sectors are earning more than normal profits (those necessary to
persuade the participants to stay doing what they are already doing,
rather than doing something else), then more people and resources are
likely to come into this business, expanding supply, reducing prices
and profits.
[Note: profits in the everyday sense are, typically, just the
returns to capital - the earnings of the firms which are left after all
other legitimate costs (including labour and management costs) have
been
deducted. For self-employed family businesses, taxable profits
will
include the returns to the owners own labour and management, as well as
returns to the owners' land and capital, less allowable expenses in
servicing
mortgages, loans and debts. Economic profit is what is left after
further deducting the opportunity
costs of the owners' own capital, land, labour and management]
The UK food chain illustrates
the outcome of this circular flow of
income.
Agricultural and Food Chain, UK, 2000
(the date is now out of date, but the
principles are the same - the numbers are only illustrative) For
up-to-date data, see Defra's Agriculture
in the United Kingdom, 2010, Chapter 7 The Food Chain (xls
spreadsheet) Chart 7.2.
Farms produced £15.3 bn. of output, of
which
£8.7bn. was spent
on purchased inputs, leaving £6.6bn. as the gross product (gross
margin) or returns to the factors of production (land, labour,
management
and capital).
- The farm sector generates incomes to all those with a direct
interest
in
farming - the labour, owners of the capital (including the banks and
their
shareholders), the owners of the land, and the managers and farmers
themselves.
- Likewise, the input supply industries also process their own
inputs,
using
their own factors of production, producing their outputs (purchased by
the farm sector) and generating their own incomes to land (including
natural
resources), labour, management and capital.
- Farm Output, in turn, is further processed by the Processing,
Distribution
and Retailing (PDR) sectors to generate both incomes to their own
factors,
and also the final output purchased by the final consumers.
- Thus, the final consumption figure (£123 bn.)
represents
the
cumulative total of all values added throughout the food chain,
and hence represents the total cumulative income earned by all
those
engaged in this food chain.
- Note that imports generate incomes in other countries rather than
the
UK,
while exports generate incomes in the UK.
<>
Measurement Issues:
- Each of these flows (measured in £ bn.) represents a large
collection
of individual trades (prices times quantities): P
x Q
- Flows change through time because both prices and quantities
change: P1
x Q1 different from P2 x Q2
- Comparison between different years (periods) compares both price
and
quantity
changes
- Prices represent that rates at which quantities of one
good
or service
are exchanged for other goods and services - including the services of
factors of production (land, labour, management and capital), whose
prices
are rents, wages and salaries, and rates of return to capital.
- With prices set at some given, fixed level:
quantities
then
represent real income and real output of goods and
services
- the actual quantities of factor services which can be traded for the
purchase of actual quantities of goods and services - the purchasing
power
of each good or service in terms of all other goods and services.
- To measure these real quantities, prices (wages,
rents
etc.
as well as prices of goods and services) have to be fixed at some
given
level. - Pf. - constant prices
- Comparison of Pf x Q1 with Pf x Q2 then shows the changes in
'quantities'
between Q1 and Q2.
- Also, comparison between Pf x Q1 and P1 x Q1 shows the difference
in
prices
between the fixed, constant, prices and those ruling in period 1.
- Notice - simply fixing the price of ONE good (say for
fertiliser),
allows
the actual physical quantities of fertiliser used by farms between
years
to be measured, but does NOT allow the measurement of the purchasing
power
of this fertiliser - to measure the purchasing power, we need
to
fix all prices at some constant level (typically using some
general price deflator - a price index measuring
changes in all prices - the Consumer Price Index, or the Retail Price
Index, or the GDP deflator.
Back to Contents.
THE CASE FOR 'FREE MARKETS' AND THE ROLES
OF GOVERNMENT
4. Macroeconomic
Basics
- the Circular Flow of Income (CFoI) & GDP
Simplify the whole economy as an interaction between Consumers
(households),
Producers (firms), and Government. NOTE: This is a
circular
flow of INCOME (and spending) - although measured and identified in
money
terms, it is the livings (income and spending) - the real
purchasing
power of the money - which is important here. Always refer to the
flow as an INCOME flow and not a flow of money.
- Consumption (C) is spending on goods and
services for
final
use
(consumption) during this period.
- Investment (I) - an injection
into the
CFoI -
is the
purchase of actual physical capital (equipment etc.), or the
improvement
of peoples skills and expertise - final spending on things which are
intended
to increase income levels in future periods rather than this
one.
[Please Note: Firms are responsible for most of this investment,
not governments, though some government spending is investment for
future
periods rather than spending on current (this year's) goods and
services]
- Saving (S) is just and only income which is NOT
spent on
final goods
and services. (= Yd - C) - a withdrawal from the CFoI. [Please
Note: Investment spending is matched with Savings through the
financial
and money markets (see below), which are separate from this
Circular Flow of INCOME picture of the economy]
- Government Spending (G) is ONLY spending on final goods
and
services
(wages and salaries, paper, power, building maintenance and improvement
etc.) used up in this period or intended for use in future periods
(includes
any government investment) - an injection into the CFoI
- The other (major) part of total government expenditure is Transfer
Payments:
social security, unemployment benefit, public (national) pension
payments
etc. which simply add directly to the recipients incomes, and
which
are not paid in return for actual services.
- Taxes (T) are the government reciepts -
actually also raised
on
the
spending loop (VAT, excise duties), as well as on income streams
(income
and corporation taxes) - a withdrawal from the CFoI
- Exports (X) of goods and services provide
income for firms,
and
also
measure this part of total output of the economy - an injection
into the CFoI
- Imports (IM) of goods and
services leak income out of the
national (domestic)
flow of income - a withdrawal from the CFoI
- Total Expenditure equals
Output (C + I + G + X - IM) equals
Income
(called
Gross Domestic Product) (Y) which equals Disposable Income (Yd) plus
Taxes.
NOTE: Necessary Accounting equality (Total Expenditure =
Income)
over any one period (one year) does not necessarily imply equilibrium.
If Expenditure is growing, then so too will income - and both will be
larger
in the next period. If income is falling, then spending will also
fall, and both will be smaller next period.
Distinguish between
- trend growth (improvement in technology and productivity (outputs
per
unit
inputs)) typically about 2.5 - 3.5% per year
- cyclical growth (or decline) round the trend growth - booms
(strongly
positive
growth rates) and recessions (slower growth rates) or depressions
(negative
growth rates).
Equilibrium Process of the CFoI.
- Increasing Injections (G, I, X) and/or reductions
in Withdrawals (T, S, IM) will increase the CFoI
(increasing
income and output (expenditures) and vice versa.
- Multiplier process - increasing an injection (for
instance)
increases
income, which then leads to further increases in spending and resulting
income
- until income levels have risen sufficiently that new
levels
of withdrawals
equal the new level of injections (increasing incomes tend to lead to
increased
savings, taxes and imports). Y (GDP) will not be in
equilibrium until
resulting Withdrawals balance Injections
Fiscal Policy as a stabiliser of economic cycles:
- Government Fiscal Policy (the balance between G and T) can
influence
equilibrium
Income levels
- Increase G (or reduce T) to counteract a recession
- Reduce G (or increase T) to counteract an unsustainable boom
(income
growth
exceeding full capacity of the economy, which leads to inflation - see
below)
Capacity Limits:
- Total Capacity of the economy to generate output and income
depends on
the quantities of land, labour, management and capital plant and
equipment
available
- When all of these factors of production are fully employed, the
economy
is operating at full capacity. Otherwise, there is unemployment -
the economy could produce more income and output.
- Capacity can be increased by:
- investment in capital plant and
equipment - more
capital for production and output;
- increase in the labour force
participating in
the economy - more employment -> more output & income;
- improvement in technology - more
output &
income from the same amounts of labour and capital through
technological
improvement - better quality and more productive capital;
- improved productivity of labour -
better skilled
and better organised labour increasing the amounts that can be produced
and the income that can be earned;
- structural change- re-organisation
of
resources
among different firms with lower costs, improving management.
- Fiscal Policy (G and T) can affect these
capacity increasing
processes - so should be used with care and caution.
Money and CFoI (and Inflation) - the simple story.
- Nominal National Income (GDP) [or GDP
Current terms] = P x Y
(a
grand sum of millions of price times quantity trades,
measured on the Expenditure loop). If all prices increase, then no-one
is any better off, in spite of the fact that nominal (current) GDP has
increased. Hence:
- Y
is real income - in terms of purchasing power over all goods
and
services, and P is the general price level (an index of all
prices
in the economy) (and is reported in national statistics as the GDP deflator - ask if you want to
know how this is calculated!)
- Money (M) is the medium through which
these trades
take place (notes, coins, and current accounts with banks).
- Money is a STOCK which is exchanged between
different
people and businesses as trades happen
- The FLOW of money round the CFoI is given by
M
x V, where V is the Velocity of Circulation - the number of
times
any one £ changes hands in the course of 1 year.
- MV = PY (the Quantity
equation of
exchange)
always holds - it is the only way of defining and measuring V.
- If V is constant (which is it,
approximately), then PY (nominal or
current
GDP, national
income) can only increase if M increases.
- If Y is fixed by the Capacity Constraint -
at Yf
(full
employment national income), then any increase in MV will lead to an
increase
in P - inflation.
Note: a recent article in the Economist (Oct. 27, 2012) comments on the multiplier process
in the context of current austerity (shrinking budget deficits), which
you should be able to understand, at least in principle, from these
notes. A leader in the same issue also comments on the debates between
right and left (largely) about the sense of austerity in times of recession.
Back to Contents.
5. Money,
Interest
and Finance Markets
The Market for Money (Money market)
Money is used both as a medium of exchange for transactions (active
bank
balances) and also as a store of wealth (idle bank balances).

Demand
for and Supply of Money: The price of money is "the
interest
rate" (what we have to pay to get more of it!) in
quotes, becase 'the interest rate' is actually a proxy for a wide
constellation of interest rates, depending on the risks and
credit-worthyness of the borrower, and the judgements and resources
(including the willingness of the central banks and governments to back
up and underwrite 'bad' loans) of the lenders.
- Demand for money (current account bank balances) depends on:
- Income (especially for transactions or active balances)
- Price (the interest rate) especially for idle balances - the
higher the
interest rate, the greater the opportunity cost of holding wealth as
money
rather than as financial or physical assets.
- Money Supply is controlled by the Monetary Authority - the Bank
of
England
(BoE).
- Monetary Policy is decided by the Monetary Policy Committe of the
BoE,
with the objectve of controlling inflation
- either through controlling the Supply of Money directly (which
proves
to
be rather difficult)
- or by setting the base lending (interest) rate of the Bank of
England
to
the commercial banking system - the current system of Monetary policy.
(Setting the interest rate at a new level above r* will automatically
result
in a contraction of the supply of money to match the reduced demand -
since
the BoE, through its function as lender of last resort, implicitly sets
the
supply of money to match its ruling interest rate)
Capital Markets: Balance between Savings and Investment (new
plant
and equipment etc.)
The rate of interest also influences Savings and Investment - the
balance
in the capital market for loanable (investment) funds
Notice:
If the interest rate (set in the money market) results in I > S,
then there
will be a tendency for the level of National Income (Y) to grow -
increasing
savings (shifting this ceteris paribus Savings supply curve
shifts
to the right as incomes increase) to match the additional
investment.
However, increasing Y might also increase Imports and Taxes - so that
the
imbalance between savings and investment might persist - offset by
imbalances
between G and T, and between IM and X.
Financial and Asset Markets (The Stock Market) - who
owns what bits of existing
capital.
The Stock Market: where already existing shares are swapped
between
people who want more (buyers) and people who want to hold fewer shares
(the sellers). The total stock of shares is pretty well fixed (aside
from
occasional new issues).
The land market, as an illustration: The total stock of land is Qf. Whatever the price, this
total
stock cannot be changed (aside from minor changes like draining lakes
etc.)
The sellers are signalling a negative demand for the thing
(land
in this case) - the offer curve (Oc) - the higher the price, the
greater the quantity we might expect present owners to be willing to
sell.
By the same token, all present owners who are
not selling are exhibiting
a positive demand for their stock given present prices. This
positve
demand is labelled the reservation demand (RD) in the
above
figure, which is the mirror image of the offer curve (Oc). What
is not being offered for sale by present owners is being retained (held
onto) - that is, it is being demanded.
The excess demand curve (XD) shows how much more
land present owners and non owners want to own at each price -
more
is demanded over and above present holdings of land as the
price
falls.
The horizontal sum of the reservation demand (RD) and
the excess demand (XD) is the total demand (TD)
for
land, or stock. It is the intersection of this total demand (TD)with
the fixed supply (Sf) which determines the market price for land
(Pe).
The trades we observe in a stock market are those between people who
no longer want to own the stock, for whatever reason, shown by the
offer
curve (Oc) and those who want to own more than they presently
have
(which might be some or none at all) - shown by the demand for
additional
stock (excess demand) labelled XD
above. Offer and XD intersect
at the trading price (Pe) and Qt of land (or stocks and shares) change
hands between buyers and sellers.

When all these trades have been made, the present owners are
now
willing to go on owning land at the present price, and are not willing
to sell any.

Share Prices and Stock Market price movements.
So, what is a stock or share (or piece of land) worth? The simple
answer first - it is worth whatever someone else will pay for it.
The current market price of the share, or piece of land, or any other
physical
asset, is as good an estimate of what it is worth as you can get.
The current price reflects the total demand (reservation and excess
demand)
matched with the fixed available supply. The price will change,
as
in all markets,
only if demand shifts or supply shifts. For land
and stock markets, the shifts in total supply are usually pretty
trivial
compared with the total stock. So it is shifts in demand which
are
critical in determining prices in these stock markets.
What will shift the demand curve for land (or stocks and shares) and
hence change their prices?
- expectations of future annual returns - if these expectations
increase,
then demand for the asset will increase - shift to the right, pushing
up
the asset price
- expectations of future selling price (market price) for the asset
- it
is expected to become more valuable in the future than it is now -
which
also pushes up the current market price
The two values are related because the market price can be interpreted
as the market buyers expectations of future earnings or returns.
- The market price of an asset (P) is the present value of
its expected
future earnings stream or yield, say R/yr, as anticipated by the
people trading the
asset
in the stock market.
- This present value discounts future earnings because:
- we have to wait to get them, and could simply put our money in
a bank savings account (or buy a government bond) - the risk-free rate
or return or
discount
rate (r)
- we need to cover the expected inflation rate in the future (p)
- we need a premium to cover the uncertainty (risk) associated
with this
future stream (u)
- The discount rate (or interest rate) i can thus
be
thought
of as being made up of three components: the real risk-free rate of
return
(r), the expected inflation rate (p) and the risk premium (u).
- For any perpetual asset - whose returns are expected
to
continue
indefinitely at some fixed value (R) - the Present Value = R/i
The key relationships can be illustrated through this perpetual asset:
PV
= R/i = Market Price of the asset:
- If the return is fixed (assumed to be known and given) at R, then
an
increase
in the price of the asset implies a lower rate of return (as a % annual
payment) - as asset prices increase, their internal rates of return
fall (other things being equal)
- If returns are expected to increase, then we would expect the
price of
the asset to increase, given the discount rate as the opportunity cost
of capital - the rate of return we can earn on other alternative assets.
- If the interest rate in the economy increases, then the
opportunity
cost
of capital increases, and asset prices will fall.
So, if a particular company discovers a new recipe for making profits,
its annual returns (R) will be expected to increase, and its share
price
will increase until the internal rate of return falls back in line with
the market rate of interest - given the risk and inflation element of
the
company. Conversely, if the company falls on hard times, because
its market is shrinking or because it is being badly managed, its
returns
will fall and its share price will fall as well, until the internal
rate
of return is once more in line with the market rate.
Suppose we do not expect rents to remain constant in the
future.
What might they do? They might be expected to increase (or fall)
by some average and constant amount each year (say plus or minus £A
per year). In this case, the relevant sum for the present value
of
this stream of future rents (annual returns) becomes:
PV = R/i + A/i2 , where R is the basic rent
or annual return (expected this year) and A is the amount by which we
expect
this annual return to change each year in the future, and i is the
discount
rate (the opportunity cost of capital - what we could earn elsewhere,
investing
in something else). So, if we expect returns to fall, the present
value is reduced compared with the simple sum which assumes the return
stays constant. But, if we expect returns to increase, then the
present
value increases, too.
Or, we might expect a continual percentage change in the annual
return,
say plus or minus g% per year. In this case, the PV sum
becomes:
PV = R/(i - g), so that, if the expected growth rate (g) in
the returns on this asset are higher than the opportunity cost of
capital
(i), the present value for this asset goes to infinity: there
is
no price it is not worth paying for such an asset - which is an
explanation
of why share prices shoot upwards for companies expected to do very
well
in the future.
Depreciating assets - ones that wear out.
So, how do we account for the fact that physical plant and equipment
wears out and becomes obsolete? By making an allowance for the
depreciation
of the asset - the continual re-investment necessary to maintain it in
a non-depreciating state. Suppose that this depreciation rate is
d%.
The gross return we need to get from this asset needs to cover this
depreciation
rate, so the net return we need to get on any depreciating asset is the
gross return minus the estimated depreciation rate. So, the gross
return we expect to get should be i = r + p + u + d on these
assets.
Back to Contents.
6. Macroeconomics
&
International Trade: The FOREX market.
What, if anything, balances Imports with Exports in the
CFoI?
The Foreign Exchange (Forex) market - where people and
businesses
trade one currency for another.
- Demand for sterling (= supply of forex) depends on exports
of goods and services, and on inward flows of investment funds from
abroad
(capital inflows)
- Supply of sterling (= demand for forex) depends on imports
of goods and services, and on outward flows of investment funds from
the
UK to foreign countries (capital outflows)
- Balance of Payments (BoP) records all these transactions:
- Current Account (Exports vs. Imports)
- balance of visible trade
- balance of invisible trade (services, tourism travel etc.)
- Capital Account (flows of investment (financial) funds
into and
out of the country
- Official Financing - change in the Central Bank (BoE in the UK)
forex reserves.
e.g. 1996 UK situation:
Demand
: Ceteris paribus, exports and capital inflows will be
greater
the lower the exchange rate - demand curve slopes downwards.
Supply : ceteris paribus, will be greater the higher
is the exchange rate - the supply curve slopes upwards.
Equilibrium exchange rate balances exports plus capital inflows
with imports plus capital outflows.
Exchange rate managed by Central Bank (BoE) control of Forex
reserves, and
also through borrowing (repaying) loans from foreign banks.
Dforex and Sforex are also affected by Incomes (Y) and Interest rates
- Increasing Income shifts Sf right (increasing demand for imports)
->
e.r.
depreciation or BoP deficit (the typical UK condition prior to 1971 -
when under fixed exchange rates)
- Increasing Interest rates shift Sf left (discouraging capital
outflows),
and Df right (encouraging capital inflows -> e.r. appreciation or
BoP surplus (the typical German condition prior to 1971 under fixed
exchange rates)
Monetary Policy more powerful under floating exchange rates than
fixed:
Expansionary monetary policy:
- Increases Y
- Reduces r
- depreciates e.r -> more expensive imports, more competitive
exports
->
further expansionary effect.
- more likely to generate inflation
Under fixed exchange rates,
domestic expansion tends to increase imports faster than exports,
opening up a trade deficit. If this deficit is not counter-balanced by
a tight monetary policy (higher interest rates), then the BoP deficit
tends to get worse - and can only be financed by running down forex
reserves (or increased borrowing from abroad by the Central
Bank). The cure is then contraction of the domestic economy,
tight fiscal and monetary policy, or devluation - which will tend to
lead to inflation.
Purchasing Power Parity:
this theory is derived from the fact that, in the long run, we would
expect the exchange rate to adjust to actual trade flows, rather than
to capital flows, since the latter should ultimately reflect the
international competitiveness of the economy. If trade were all
one way (all imports, for instance, and no exports) then the exchange
rate would depreciate, since more people would be trying to sell
the currency than trying to buy it. On the other hand, if trade
were all exports and no imports, then the exchange rate would be
expected to appreciate. When in balance, imports will equal
exports, and the exchange rate will be stable. What this means is
that exchange rates will tend to adjust (in the long run) so that the
prices of tradable goods are the same in all countries in the trading
world - so there is no incentive to buy in one place and sell in
another. So long as there is no other intervention (taxes or subsidies
etc.) in the domestic markets, then prices will be the same
valued at the so-called purchasing power parity
rates. The Economist
regularly approximates these rates by calculating the exchange rates
which would have to hold if the price of a Big Mac hamburger were to be
same the world over (assuming that Big Mac hamburgers are essentially
tradable). See here
for the latest
version of this calculation, and the explanation.
NOTE:
the
capital account is typically much larger than the current (trade)
account. Capital inflows and outflows dominate export and import flows,
so the exchange rate is typically very sensitive to capital movements,
especially short term capital flows (unless these are
controlled). This can cause serious short term problems:
- Any currency which is viewed by the market as being vulnerable is
subject to considerable short term capital outflows, which makes the
currency even more vulnerable and liable to devaluation of fixed rate
or depreciation of a floating rate. Speculative bubbles (either bull or
bear) are frequent in the Forex market, especially but not only for the
lesser currencies (can even affect the major currencies - euro, $, yen,
£)
- rapid growth from Foreign Direct Investment (FDI) - direct,
because it refers to actual purchases of goods and services and
physical investment) tends to lead
to currency appreciation as a result of the capital inflows, as does an
increase in the price of raw materials and fuels, for net exporters of
these goods (sometimes
called the Dutch disease, after the experience of the Netherlands
when North Sea Oil was first discovered and exploited). This e.r
appreciation puts major pressure on the domestic economy - making
imports more competitive and exports more difficult to sell, tending to
contract the domestic economy. The domestic economy needs to be both
robust and flexible (sensible banks and stock markets) to cope with
this pressure.
What does this all mean - the place of Economics in the processes of Globalisation?
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