Been covering banking and the bond market with my A2 economics class and we talked about the collapse of Silicon Valley Bank. Below is a video from the WSJ on the whole SVB saga and the history behind bank regulation under Obama but deregulation under Trump. What is interesting is the fact that 94% of SVB’s deposits (see graph) were above the $250,000 which is insured by the Federal Deposit Insurance Corporation – government corporation supplying deposit insurance to depositors in US commercial and savings banks. However you do wonder why depositors kept so much money in a bank when you would want to spread your risk. Although you may need cash for day-to-day transactions, money could be put into a market fund and brought back into a bank account when needed.
WSJ talk about bonds and below are some notes on how bond yields work. This is part of the A2 syllabus Unit 9 – interest rate determination: loanable funds theory and Keynesian theory.
How do Bond Yields work? Say market interest rates are 10% and the government issue a bond and agree to pay 10% on a $1000 bond = annual return of $100. 100/1000 = 10% If the central bank increase interest rates to 12% the previous bond is bad value for money as it pays $100 as compared to $120 with the a new bond. The value of the new bond is effectively reduced to $833 as in order to give it annual payment of $100 a year the price would have to be $833 to it a market based return. 100/833 = 12%
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Being St Patrick’s Day I thought it appropriate to look at some humour.
“Why was the Irish economist afraid of swimming? He was conscious of the liquidity trap.”
“How do you confuse an Irishman when trying to maximise his utility when purchasing two products? Put two shovels against the wall and tell him to take his pick.”
“What do you call it when an Irish economist has an idea? Moral Hazard”
“An Irishman said he saw a ghost. The Irish economist said it was just the invisible hand.”
“What’s the difference between Iceland’s economy and Ireland’s? One letter and six months”
“We all know what pareto optimal allocation means… What about Irish optimal allocation — when all persons are equally well off, and one person really gets it bad, worse off, while all the rest are much better off…”
“An Irish economist walks into a pizzeria to order a pizza. When the pizza is done, he goes up to the counter get it. There a clerk asks him: “Should I cut it into six pieces or eight pieces?” The Irish economist replies: “I’m feeling rather hungry right now. You’d better cut it into eight pieces.” (see the “Father Ted” version above)
“Why would Father Jack not make a good economist? There would always be massive inflation as his only policy would be to increase liquidity.”
This year I am trying to get students to develop a deeper understanding of economic issues and to improve their evaluation skills for the written exam. The goal is that students will arrive at a collective meaning, rather than seek a “right” answer. Below is a plan of how you could structure the discussion.
Subject content – Economic schools of thought. Keynes v Hayek – this is part of Unit 9 of the CAIE A2 syllabus.
Content knowledge: Types of economies (left and right wing) covered at CAIE AS Level. The schools of thought are taught in class and questions (MCQ) and short answer are used to test student understanding of the characteristics of each. The two videos below are useful to consolidate knowledge.
Austrian economics and Keynesian economics explained in 1 minute. See below
Music (rap) video ‘Fear the boom and bust’ – Keynes v Hayek. See below
One of the challenges is to keep students on task and try and get contributions from all students. In order to overcome these issues I have developed a set of playing cards with certain statements on each. Students receive 8 playing cards with different assessment objectives/ skills/ elements of written work in economics – see photo. Students can only talk when they place a card on the table. Once a student has used up all their cards they can no longer contribute to the discussion. The link below has more detail on this method:
Students read a media extract on the topic. Extract selection is important – not too long and must be easy to relate to core knowledge. I have picked the article by Larry Elliott in the Guardian newspaper as this is media that is different to what students tend to be exposed to.
Number of students in a group is a determining factor – 8 to a group.
Tutorial/discussion over 2 periods
Opening question – essential that this is pitched at the level appropriate to the group as the intention is for the discussion to proceed through student interactions.
The new variant of capitalism should be the dominant policy option for governments.
If this is question doesn’t engage the students you could ask some of the following questions:
Start off with a simple question that is referenced from the text – ‘What aspects of Keynesian economics are evident in the extract?’
Allow each student to answer the opening question – 30 seconds. Other responses can spark conversation once everyone has replied.
Get students to continually reference the text so to keep the conversation relevant
Coaching – there may be the need to encourage deeper and more critical thinking. Need to avoid teaching by offering analysis and possible evaluations. Some questions to encourage critical thinking:
Why was the Keynesian variant relinquished in the 1970’s?
How did the 2008 GFC influence government policy?
Was austerity the answer to the issues caused by the GFC?
How did COVID-19 impact policy for left right and centre governments?
Should allow students to respond from their own perspective but must be related to the extract.
Student reflection – the hope is that students are able to develop a deeper understanding of the complexities of the subject content and read newspaper/magazine articles with a more holistic view of the how an economy works. The level of scaffolding for reflection will vary with each student but there is potential for all students to feel more confident in their knowledge and participation in future discussions.
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Over the last couple of decades property has been a significant driver of Chinese growth. The dependence on real estate is shown below and it is interesting to note that China was more dependent on housing construction than Ireland and Spain prior to the Global Financial Crisis.
Real estate related activities’ share of GDP by country, 1997-2017
Source: Rogoff and Yang
Real estate has impacted consumer spending, employment of workers, investment and demand for raw materials. Investment in property has increased by 5% of GDP in 1995 to 13% in 2019 – 70% of which was residential. As for household consumption 23% is spent on real estate. How do you work out the value of output for residential investment and is there a problem with double counting?
GDP andthe Output Approach
Gross domestic product (GDP) is defined as the value of output produced within the domestic boundaries of a country over a given period of time, usually a year. It includes the output of foreign owned firms that are located in that country, such as the majority of trading banks in the market. It does not include output of firms that are located abroad. There are three ways of calculating the value of GDP all of which should sum to the same amount since by identity:
NATIONAL OUTPUT = NATIONAL INCOME = NATIONAL EXPENDITURE
The output approach is the value of output produced by each of the productive sectors in the economy (primary, secondary and tertiary) using the concept of value added.
Value added is the increase in the value of a product at each successive stage of the production process. For example, if the raw materials and components used to make a car cost $16,000 and the final selling price of the car is $20,000, then the value added from the production process is $4,000. We use this approach to avoid the problems of double-counting the value of intermediate inputs. GDP will, therefore, be equal to the sum of each individual producer’s value added.
The Economist look at a simple example of calculating the output approach using a house. House is built and makes up the whole economy. It is made of steel which is made from iron ore.
House is sold – $1m Steel is sold – $600,000 Iron ore is sold – $500,00
How significant is the construction industry? As the builders add $400,000 to the value – 40% of GDP. But if the whole economy is the house is it 100% as the iron ore is an ingredient of the steel that is bought by the builder.
The Economist mention a paper by Kenneth Rogoff and Yuanchen Yang “Has China’s Housing Production Peaked?” in which they take a different view on calculating the value of property. They use the input-output total requirement matrix with the economy divided into 17 industries – manufacture of machinery, construction, transport etc. The coefficients indicate the production required directly and indirectly in each sector when the final demand for domestic production increases by one unit. By adding up the coefficients corresponding to the construction industry they found that 1 unit of increase in the construction sector requires 2.12 units of inputs from forward (other contractors) and backward (raw materials) industries. In breaking down the construction and installation as part of Chinese real estate, investment is RMB 7,630 bn. Thus 2.12 x 7,630 = RMB 16,176 which is the total value.
Therefore in the original option the Rogoff and Yang model would include the iron ore and not the value of the house or the $400,000 value added by the construction industry. Therefore:
Steel $600,000 + Iron ore $500,00 – $1.1m
There way of removing double counting is unusual as if you add the construction output $1m, steel output $600,000 and iron ore output $500,000 there is a double and triple counting:
x2 = Steel – counted twice – purchase of steel and when house is sold x3 = Iron ore – counted three times – purchased in raw material form, when used to produce steel and when house is sold.
The way that is normally talked about in textbooks is to only count the added value at each stage of production. Iron ore $500,000 + steel $100,000 + $400,000 construction costs – $1m = 100% of GDP in a one-house economy.
Sources: China & World Economy / 1–31, Vol. 29, No. 1, 2021. Has China’s Housing Production Peaked? Kenneth Rogoff, Yuanchen Yang
The Economist: Free Exchange – A universe of worry. November 27th 2021
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By trying to restrict investments in oil and gas ventures, is the ESG movement going to have the effect of reducing supply of oil as global demand increases? With this scenario the price of energy will increase and developing countries will find it even more difficult to provide its citizens with electricity, water etc which requires energy in the form of oil, gas and to some extent coal. Developing countries will need significant financial help from the developed world if they are going to grow in a sustainable and environmentally favourable way. The concern is the reliance on oil and gas and the ever increasing demand – see graph:
Environmental, social, and governance (ESG) investing is used to screen investments based on corporate policies and to encourage companies to act responsibly. There has been a lot of anti ESP feeling as a focus on environmental and social issues conflicts with the corporate duty of maximising the return for shareholders. Banks in particular have indicated that they may withdraw from corporate alliances that have promised to cut carbon emissions across entire industries – see video from the FT below. But as Gillian Tett points out:
The challenges around sustainability and business are not going to disappear. On the contrary, they’re becoming more urgent than ever.
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Below is a useful flow chart for anyone studying monetary policy. Both the NCEA Level 3 and CIE A2 courses cover this topic.
Negative – lower interest rates might depress spending by some retirees who rely on interest income. But these counterproductive channels are small compared to the Positive – lower interest rates = a lower propensity to save and a higher propensity to spend.
The side effects of monetary policy. Falling interest rates = accelerating house prices = social problems and political anxiety. If RBNZ kept interest rates at around 8% as in the 2000s to prevent the house price = New Zealand in deflationary spiral.
The economic and social consequences of deflation would be far worse than the (undeniable) problems with rising house prices. The low inflation / falling interest rate dynamic of the past two decades has been a global phenomenon, ultimately caused by a global change in the balance between savings and investment. The Reserve Bank of New Zealand could not have prevented this global trend from affecting New Zealand interest rates without causing severe damage to the economy. In New Zealand, the most important transmission channels are asset prices and the exchange rate. Falling interest rates tend to push asset prices up, which stimulates consumer spending. Falling interest rates also tend to reduce the exchange rate, which generates inflation via the prices of internationally-traded goods and services.
Source: Westpac Bank
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Wage Rate:- The price of labour as determined by market supply and demand. The demand for labour is said to be derived demand: – the demand for labour is dependent on the demand for the goods & services produced. Key factors that affect the quantity of labour supplied:-
age of population
non-wage factors
wages
Difficulty in acquiring qualifications – eg. doctors
social attitudes to employment
discrimination
Change in Demand for labour Change in Supply of labour
Wages A more realistic version of the market model measures the price of labour in real wages rather than in nominal or money wages. The difference is that nominal wages are the actual dollars that are paid for any job while real wages are a measure of the ability of those dollars (earnings) to buy goods and services. Therefore real wages consider the purchasing power of your income.
Sticky Wages Actual wages will rise much more easily than they will fall. Labour markets are extremely rigid when it comes to reducing wage levels. Several factors encourage wages to stick at higher levels and so prevent the market from clearing, as shown in ‘Supply and Demand Applications’ and below.
Equilibrium and Real Wages
A = Employed B = Involuntary Unemployment C = Voluntary Unemployment
Some of these factors occur through the natural operation of the labour market.
Strong trade unions can operate as ‘monopoly suppliers’ of labour. This keeps wages above the equilibrium equilibrium. Fewer workers are hired.
Hiring cheap labour may backfire on employers. This labour may not have the same level of skills as that of the firm’s existing workforce. This will increase costs for the firm if it has to provide too much training. Existing workers therefore hold the balance of power and can demand higher wages.
The idea that a job has a certain worth, an intrinsic value regardless of the action of demand and supply, can keep wages above equilibrium.
The influence of humanity values can be strong. It is easy to pay less for resources other than labour.
Some factors are imposed on the market by the government.
Legislated minimum wages prevent the market from clearing. Although these wages aim to protect the incomes of those in the lower paid jobs, the result is fewer jobs for those same workers.
Welfare benefits can be over-generous and this may discourage the unemployed from seeking jobs.
Price discrimination involves charging different prices to different sets of consumers for the same good or service. So when you are on your next flight there are going to be different fares for the same class of seat whether it be in economy, business class or first class. What variables at work to bring about price discrimination in airline routes?
What day of the week you fly – Monday and Friday are usually peak times for business so you should find that fares are expensive. Also because it is usually for business purposes it is assumed that firms will be paying for the flights and therefore are prepared to pay more.
Times of the day – morning and evening tend to be more expensive as this is peak time.
How competitive the route is – if there is a lot of competition fares will be cheaper to the extent that there maybe predatory pricing. There is a good piece in the video showing the fares for flights from Montreal to St Johns Newfoundland. Once low cost carriers entered the market Air Canada dropped their price below cost.
Reputation of each airline – better reputation = higher fare
The video below is a very good especially the fare structure on the New York to Los Angeles route.
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Below is a very good video from the Wall Street Journal on price elasticity of demand (PED). PED is key to understanding how companies price their products. Consumer spending has held up relatively well so far despite inflation, but experts say we’re approaching an inflection point. The WSJ explains the role ‘elasticity’ plays in a company’s decision on whether to raise prices. After the video I’ve included some notes about calculating PED and a mindmap.
Price Elasticity of Demand (PED) This measures the relative amount by which the quantity demanded will change in response to change in the price of a particular good. The equation is:
% change in Quantity ÷ Demanded % change in Price
How is PED calculated?
Consider the following demand schedule for buses in a city centre.
Price (average fare) Quantity of passengers per week 100c 1000 60c 1300 30c 2275
Suppose the current average fare was 100c, what is the PED if fares are cut to 60c?
The percentage change in QD is equal to: • The change in demand 300 (1300-1000) divided by the original level of demand 1000. To obtain a percentage this must be multiplied by 100. The full calculation is (300 ÷ 1000) x 100 = 30%
The percentage change in price is equal to: • The change in price 40c (100c – 60c) divided by the original price 100c. To obtain a percentage this must be multiplied by 100. The full calculation is (40 ÷ 100) x 100 = 40%
These two figures can then be inserted into the formula with 30% ÷ 40% = 0.75 Let us now consider the PED when the average fare is cut from 60c to 30c
The percentage change in QD is equal to: • The change in demand 975 (2275-1300) divided by the original level of demand 1300. To obtain a percentage this must be multiplied by 100. The full calculation is (975 ÷ 1300) x 100 = 75%
The percentage change in price is equal to: • The change in price 30c (60c – 30c) divided by the original price 60c. To obtain a percentage this must be multiplied by 100. The full calculation is (30 ÷ 60) x 100 = 50%
These two figures can then be inserted into the formula with 75% ÷ 50% = 1.5
Please note that the minus sign is often omitted in PED, as the price elasticity is always negative because demand curves slope downwards. The textbook displays figures as: PED = (-) 0.2
What price elasticity of demand figures tell us.
Determinants of Elasticity of Demand
The elasticity of a product is influenced by: • the number of substitutes available • whether it could be described as a luxury or a basic commodity • the proportion of the purchaser’s income it represents • the durability of the product.
Usefulness of Price Elasticity of Demand
The usefulness of price elasticity for producers. Firms can use price elasticity of demand (PED) estimates to predict:
1. The effect of a change in price on the total revenue & expenditure on a product.
The relationship between elasticity and total revenue.
Elastic Inelastic Unitary Price ↑ TR↓ TR↑ No Change Price ↓ TR↑ TR↓ No Change
2. The likely price volatility in a market following unexpected changes in supply.
3. The effect of a change in GST (indirect tax) on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.
4. Information on the price elasticity of demand can be used by a business as part of a policy of price discrimination – off-peak and peak travel in major cities. Before 9am – inelastic demand curve – after 9am elastic demand curve.
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Supply chain disruptions and large fiscal deficits have been part of the cause of the inflationary problems that have been prevalent in the global economy. Increased aggregate demand from government spending accompanied by supply constraints have seen prices soar. The IMF blog looked at how we should go back on history and look at how globalisation in the past has offered an antidote to inflationary spirals.
In the 1970’s technology improved global supply chains with the introduction of the shipping container which reduced transport costs of goods. Policymakers like the former US Fed Chairman Alan Greenspan see the relationship between globalisation and innovation a transition to low inflation. This idea has been embraced by current Fed Chairman Jerome Powell who talks of not only technology but demographic factors that bring about sustained disinflation. Trade liberalisation had a part of play here with the role of the General Agreement on Tariffs and Trade (GATT) – now know as the World Trade Organisation (WTO) – providing the rules for much of world trade and presided over periods that saw some of the highest growth rates in international commerce – see graph.
Modern inflation targeting by central banks (1-3% in New Zealand) also brought inflation under control as countries established a process that would allow them to attract capital flows or to globalise further. New technologies will produce better growth and increase the potential capacity of the economy (Production Possibility Curve shifts to the right) but requires a lot of cross-border co-operation. Some countries pursue costly ‘friendshoring’ strategies of steering trade to friendly nations and regimes while attempting to hobble rivals. In particular big economies look to protect strategic vital and strategic resources thereby preventing global economic growth. All of this may seem an easy solution to tame inflation but the reality is there are many variables that influence the inflation figure within countries.
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Below is a very good video from CNBC that covers the main causes of recessions – overheated economy, asset bubbles and black swan events. Good analysis of soft and hard landings as well as the wage price spiral effect.
“History teaches us that recessions are inevitable,” said David Wessel, a senior fellow in economic studies at The Brookings Institution. “I think there are things we can do with a policy that makes recessions less likely or when they occur, less severe. We’ve learned a lot, but we haven’t learned enough to say that we’re never going to have another recession.” As the nation’s authority on monetary policies, the Federal Reserve plays a critical role in managing recessions. The Fed is currently attempting to avoid a recession by engineering what’s known as a “soft landing,” in which incremental interest rate hikes are used to curb inflation without pushing the economy into recession.
Below is a link to an interview with RBNZ Governor Adrian Orr on National Radio’s Morning Report last week. For those new to economics he explains the concept of supply and demand in layman’s terms with regard to inflation. Notice that he doesn’t mention the word ‘recession’ although talks of a couple of quarters of negative activity. As was predicted the RBNZ increased the OCR by 50 basis points to 4.75%.
Remember in 2012 the focus for inflation was given to 2% which is the mid-point in the 1-3% band. Later in 2018 an additional policy objective was added to maintain a maximum sustained employment. Worth a listen. Also below is a mindmap on monetary policy which might be useful.
The impact of the recent Cyclone (Gabrielle) on the North Island of New Zealand have highlighted the problems of soil erosion and the damage from wood debris left behind after harvest (known as ‘slash’). Tonnes of woody debris, mixed in with silt and sediment, blanketed across landscapes, has destroyed critical infrastructure, farms, homes and polluted rivers and the marine coastal environment. Clear-fell harvesting of pine forests on steep erosion-prone land has been identified as a key source of this phenomenon.
Basically the forestry companies are internalising the benefit of forestry clearing but socialising the cost. This means that after they have taken what they want from the forestry plantation they leave unwanted wood – ’slash’. This ‘slash’ then causes huge damage when they is excessive rain in the area. In economic terms this is referred to negative externalities of production as the forestry company has failed to internalise the cost of the wood debris i.e. they have externalised the cost of the damage caused by slash. The New Zealand Government are to investigate the poor forestry harvesting and management and regulate practices in clearing of forestry land. This issue can be represented by a negative externalities of production graph which is part of the A2 and NCEA Level 3 syllabuses.
When there is a negative production externality, marginal social cost (MSC) exceeds marginal private cost (MPC), as in Figure 1.
Firms take decisions on the basis of MPC, so the market settles at Q1, rather than at Q*.
The shaded area represents the welfare loss for society in this position – i.e. the damage caused by ‘slash’.
This is where there is ‘slash’ caused by the forestry companies which imposes costs on households, farms, infrastructure etc that are not reflected in the costs faced by the forestry company.
Externalities – Key definitions
Private cost or benefit: a cost that is incurred (or a benefit that is enjoyed) by an individual (firm or household) as part of its economic activities
External cost: a cost that is associated with an individual firm or household’s production or other economic activities that is borne by a third party, and is not reflected in market prices
Social cost: private cost plus external costs
Marginal social cost: the cost to society of producing an extra unit of a good
External benefit: a benefit that is associated with an individual firm or household’s production or other economic activities that is received by a third party, and is not reflected in market prices
Social benefit: private benefit plus external benefits
Marginal social benefit: the benefit received by society from consuming an extra unit of a good
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Looking at the Deloitte analysis of “Annual Review of Football Finance 2022” the correlation between wage costs and league position is still very strong. Overall wage costs actually increased by 5% to £3.5 billion in 2020/21 eventhough clubs had agreed to wage cuts with the impact of COVID-19. However with revenue outstripping the growth in wages, the division’s wages/revenue ratio has reduced from 73% in 2019/20 to 71% in 2020/21.
Notable points from the graph are:
Big 6 clubs (Manchester City, Manchester Utd, Liverpool, Tottenham Hotspur, Arsenal and Chelsea) increased wages by 7%.
Manchester City has the biggest wage bill and revenue level.
Leicester were the biggest spenders outside the top 6
Fulham (relegated) and Crystal Palace had the highest wages/revenue ratio at 98% & 95%.
Sheffield Utd and Tottenham Hotspur had the lowest wages/revenue ratio at 49% & 57%
Both Sheffield Utd and West Bromwich Albion were relegated and spent the lowest on wages – £57m and £77m. Burnley was the next lowest at £86m but managed to avoid relegation by finishing 17th.
The big six accounted for 51% of EPL wage costs.
The wage gap between 6th place (Tottenham Hotspur) and 7th place (Leicester City) was £13m.
*Spearman’s correlation coefficient increased from 0.66 in 2019/20 to 0.87 in 2020/21 – means a stronger correlation between wages and league position.
*Spearman’s rank correlation measures the strength and direction of association between two ranked variables.
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I have blogged on this before but find it very useful in teaching Price Elasticity of Demand (see also mindmap at end of post) with my class. Tom Wainwright’s book “Narconomics: How to Run a Drug Cartel”is a useful source for discussion and he also wrote an article for the Wall Street Journal on “How economists would wage the war on drugs”. Essentially, the war on drugs is being lost. Badly. As Wainwright notes:
The number of people using cannabis and cocaine has risen by half since 1998, while the number taking heroin and other opiates has tripled. Illegal drugs are now a $300 billion world-wide business, and the diplomats of the U.N. aren’t any closer to finding a way to stamp them out.
This failure has a simple reason: Governments continue to treat the drug problem as a battle to be fought, not a market to be tamed. The cartels that run the narcotics business are monstrous, but they face the same dilemmas as ordinary firms-and have the same weaknesses.
El Salvador – a leader of one of the country’s two gangs has a human resource issue with high turnover of employees.
Mexico – the Zetas cartel franchises its brand like McDonalds which in turn has led to arguments over territory.
Rich countries – street corner dealers are struggle to compete on price and quality with the ‘dark web’. It is a similar scenario with Amazon.
To combat the drug trade governments have focused on restricting the supply. Each year acres of coca plants and manufacturing activities are destroyed but the price has remains around $150-$200 per pure gram for the past 20 years. How have the cartels managed to keep this price?
However, supply of drugs might not even be appreciably reduced when drug crops are targeted. Wainwright points out that:
Drug cartels are a monopsony – they are a single buyer of Andean coca leaves, so they have market power over the price of leaves (i.e. the cartels have the ability to strongly influence the market price of coca leaves). So if some crops are wiped out, the price is unlikely to rise because of the cartels’ market power.
The price of cocaine is so much higher than the crop input costs that even a large increase in crop prices would have little effect on the market price of cocaine (i.e. even a big increase in the price of coca leaves would lead to only a small shift in the supply curve for cocaine).
Also because of its addictive nature demand for drugs is relatively inelastic – the decrease in quantity demanded is less than the percentage increase in price. Therefore reduced supply and a higher price doesn’t change demand that much.
Demand-Side interventions seem to be a better option and they are also a lot cheaper. Weighing up reducing supply by destroying coca crops in remote areas against drug education in schools and you find the latter is a much more plausible option. Tom Wainwright’s explain this below in his talk to the Cato Institute below:
A dollar spent on drug education in U.S. schools cuts cocaine consumption by twice as much as spending that dollar on reducing supply in South America
Bigger loses have be inflicted on cartels with some US states making marijuana legal.
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Unit 9 of the new CAIE Economics course looks at national income and the 45 degree line graph. The graph below covers what you need to know and is one of the more complex graphs in the course. Aggregate expenditure shows the quantity of goods and services which households, firms and government are prepared to buy at different values of the general price level. The early classical economists believed that the size of the aggregate expenditure for output would be sufficient to employ everyone who wanted to work. John Maynard Keynes suggested that the achievement of a full and stable level of employment required the government to play an active part in determining the level of total expenditure. This policy known as demand management, was adopted by most governments in the post-war period. If a government is to manage aggregate demand effectively, it must be capable of influencing the components of aggregate demand i.e.. C+I+G+X-M. Government spending and taxation will be important instruments for this purpose, and by running budget deficits (spend more than they earn) or surpluses(spend less than they earn), the government can inject or withdraw purchasing power into or from the economy. Demand management policies were applied with considerable success in the two decades following the end of Second World War. Unemployment and inflation remained at very low levels throughout this period. However, these policies have proved to be much less successful since the mid-1960s.
The components of Aggregate Demand – AD = C + I + G + X – M
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Over the last 10 years a lot has been said about ‘Social Capital’ and its impact on the functioning of an economy. It has been argued that variations in social capital can account for differences in income levels, rates of economic growth, political involvement etc.
However, before going any further, what is social capital? There have been many explanations, nonetheless, the most widely used definition was first proposed in 1993 by Robert Putnam. It is as follows:
Social capital refers to ‘trust, norms and networks that shape the quality and quantity of a society’s social interactions’.
The majority of people would say that social capital is vital, as they would have a preference to live in a society where others can be trusted, where people are inclined to cooperate with each other, and where networks are all-embracing. Therefore, the trust variable impacts on the business investment and ultimately the country’s economy.
Recent research (Storonyanska et al. 2022) focuses on the area of trust and its positive effect on economic growth. Traditionally models (Robert Solow 1956) have focused on two ways in which to achieve higher GDP per capita growth – increased investment in business and improvements in productivity. Trust impacts these two processes (see mind map) – by boosting increasing long-term investment in fixed assets and productivity with reduced expenses, the economic value of a worker’s experience and skills and organisational improvement.
The lack of trust can make some investments too risky and countries with low trust levels usually invest in short-term projects. Investment in R&D requires a special trust as the future outcomes are sometimes very difficult to forecast. Therefore a lack of trust can direct investment into less ambitious projects, the implementation of which is easier to control. Instead, ambitious innovative projects generate increased demand for highly educated and productive employees and boost economic productivity in general. Trust can also add to productivity by decentralisation of decision making in organisations is among these mechanisms. Decentralised decision making allows using the capacity of employees that are “closer to the problem” to solve it faster.
Measuring trust The easiest way to measure social capital is to use the World Values Survey (http://www.worldvaluessurvey.org/ ) which addresses values and cultural changes in societies all over the world. The survey asks the question “Generally speaking, would you say that most people can be trusted or that you can’t be too careful in dealing with people?” This question seeks to capture ‘generalised trust’, which is whether two randomly selected individuals can trust each other in their own country.
The relationship between trust and economic development (see fig below) is indirect proof of the benefit of its benefits. The trust data is taken from the WVS (2017-2021) and the level of economic development in the country – 2019. High level of trust is unique to Scandinavian countries and Northern Europe with high living standards, social stability, and consistent economic growth. However Estonia and Lithuania have turned out to be even higher (34% and 31.7%, respectively) than in prosperous France (26.3%) or Italy (26.6%). Going against the trend are China and Belarus which have higher levels of trust than countries with similar GDP per capita. The same goes for Singapore and Macau with very high levels of GDP per capital but much lower levels of trust compared to the trend line.
Trust and Developing Economies The study by Zak (2003) also illustrated that if trust is suitably low (below 30% for the average country in figure 1), then the investment rate will be so low that income will languish or even decline. Economists call this a ‘poverty trap’, and the primary reason for a poverty trap is ineffective legal structures that result in low levels of generalised trust, and therefore little investment. Additionally, the threshold level of trust necessary for positive economic growth is increasing in per capita income; that is, the poorer a country currently is, the more trust is required to generate sufficient investment to raise living standards. This makes the low-trust poverty trap difficult to escape from. However, researchers have examined the effects of social capital (trust) on income differences across villages in developing countries. It was established that where villages have higher levels of social capital they also have higher levels of income per capita.
The social philosopher John Stuart Mill wrote in 1848 that:
‘The advantage to mankind of being able to trust one another penetrates into every crevice and cranny of human life: the economical is perhaps the smallest part of it, yet even this is incalculable.’
Sources: Iryna Storonyanska, Olena Ivashko, and Elena Mieszajkina. Trust as a Catalyst of Economic Growth: A National and Regional Breakdown. 2022 Christian Bjornskov. Happiness in the Nordic World. 2021 Zak.P. Trust – Journal of Financial Transformation Vol. 7 April 2003
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With the global economy experiencing supply chain pressures, inflationary problems, higher interest and geopolitical tensions are we seeing what the IMF call ‘slowbalisation’?
Part of this change has come about from the decoupling of the American, European and Japanese economies from China. This ultimately alters trade and investment flows around the global economy and will mean lower economic growth and less liquidity. For instance consider the restrictions on technology including complex microchips being placed by the US on China. Janet Yellen the US Treasury secretary referred to ‘friendshoring’ which means relocating production to countries that fall within the US economic sphere of influence. Apple’s announcement that it would begin sourcing sophisticated chips from North America is the signal that many global firms have been waiting for to begin reducing their exposure to China.
Furthermore as well as the impact of decoupling of trade with China, a shortage of labour will also add to production costs and will result in slower rates of growth. Labour force participation rates have dropped as less migrant workers coming into countries. This scarcity of labour will put further pressure on wages and ultimately inflation. To counteract the latter interest rates will continue to climb and this will lead to further problems:
The cost of financing economic expansion will become more expensive. Firms that have lived off 0% interest rates and negative real rates (nominal interest rate – inflation) will face increasing problems on their balance sheets
In the medium term interest rates are determined by inflationary expectations and rates tend to move lower in periods of disinflation and higher in periods of inflation. The risk for all central banks and policymakers is if the rate of inflation goes above that of expectations there can be a further tightening cycle. Although recently we have seen a reduction in inflation, central banks need to maintain a level of tightness – high interest rates – so that inflation levels are within a country’s target range.
Phases in the graph
Industrialisation was prevalent in Europe and the USA and the advances in transposition reduced the costs for firms and encouraged trade.
WW1 and WW2 saw a very protectionist environment with trade becoming regionalised with trade barriers and the breakdown of the gold standard into currency blocs.
The post-war recovery and trade liberalisation encouraged growth in Europe, Japan and developing countries. The war had also stimulated a hugely expansionary fiscal and monetary policy which rendered the gold standard unsustainable. Floating exchange rates took over from those that were pegged to the US dollar.
In 2001 China became a member of the World Trade Organization (WTO) and there was the emergence of more free market economies with relaxed capital controls between countries. This was helped by the fall of the Berlin Wall and the integration of the former Soviet bloc.
“Slowbalisation” followed the global financial crisis in 2008 and the rising geopolitical tensions with protectionist policies being imposed by many countries.
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Below is a useful graph from ANZ Bank which looks at the breakdown of components that make up GDP in New Zealand. The GDP of a country is made up of four things: C+I+G+(X-M).
C = Private Consumption
I = Business Investment
G = Government Consumption
(X-M) = Net Exports
Notice the movement in GDP over the years with the GFC in 2008 where exports revenue brought economic growth into positive territory. However up to 2020 it was private consumption that was the most prevalent with investment. COVID-19 saw a significant downturn with consumption and investment again helping GDP. Overall, domestic demand is set to get smaller, but the exports services such as education and tourism and less demand for imports should counterbalance the lack of domestic demand – see the graph. But the RBNZ has signaled that in order to get inflation down they need the domestic economy to experience a recession (two consecutive quarters of negative GDP) with private consumption falling significantly.
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Following on from my last post on the multiplier, below is a type of question which has been quite popular in the last couple of exam sessions. I have changed the data from the original CAIE question.
The table shows the values of selected macroeconomic variable over a two-year period.
What is the value of the multiplier?
A. 3 – B. 4 – C. 6 – D. 12
From the data both years are in equilibrium Year 1 NI = 3800 – Injections = 260+160+200 = 620 Withdrawals = 300+140+180 = 620 Year 2 NI = 4600 – Injections = 360+210+250 = 820 Withdrawals = 350+210+260 = 820
The increase in injections has been 200 but the increase in NI has been 800 (4600-3800) – therefore the multiplier is 4 – (4 x 200 = 800).
The Multiplier Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are ultimately purchased will experience an increase in their incomes. If they in turn, collectively spend about 3/5 of that additional income, then $180m will be added to the incomes of others. At this point, total income has grown by ($300m + (0.6 x $300m). The sum will continue to increase as the producers of the additional goods and services realise an increase in their incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be ($300m + (0.6 x $300m) + (0.6 x $180m). The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.
The value of the multiplier can be found by the equation 1 ÷ (1-MPC) You can also use the following formula which represents a four sector economy 1 ÷ MPS+MRT+MPM
Source: CIE A Level Revision Guide – Susan Grant
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ECONFIX 