Economics of COVID-19 – mindmap

With the May/June exams looming here is some material on Covid-19 which could come up as part of a data response question or essay. The mindmap above looks at the three different shocks that were/are prevalent and the policies that were implemented by governments. Could be a useful way of introducing the topic.

Supply shock – will become more visible in the coming weeks as importers from China maybe unable to source adequate supply given widespread shutdowns across Chinese manufacturing.This loss of intermediate goods for production of final products cause a decline in revenue and consumer well-being. A good example of supply shocks were the oil crisis years of 1973 (oil prices up 400%) and 1979 (oil prices up 200%).

Demand shock – is already affecting consumer demand as travel slows, people avoid large gatherings, and consumers reduce discretionary spending. Already many sports fixtures have been cancelled which in turn hits revenue streams. With the uncertainty about job security demand in the consumer market will drop – cars, electronics, iPhones etc. Also tourism and airline industries are also exposed to the fall in demand.

Financial shock – although the supply and demand shocks will eventually subside, the global financial system is likely to have a longer-lasting impact. Long-term growth is the willingness of borrowers and lenders to invest and these decisions are influenced by: increased uncertainty regarding the global supply chain; a loss of confidence in the economy to withstand another attack; and a loss of confidence regarding the infrastructure for dealing with this and future crises.

Policy options

Monetary policy is limited to what it can do with interest rates so low. Even with lower interest rates this does not tackle the problem of coronavirus – cheaper access to money won’t suddenly improve the supply chain or mean that consumers will start to spend more of their income. The RBNZ (NZ Central Bank) could instruct trading banks to be more tolerant of economic conditions.

Fiscal policy will be a much more powerful weapon – the government can help households by expanding the social safety net – extending unemployment benefit. Also the guaranteeing of employment should layoffs occur. Tourism and airline industries are being hit particularly hard. Although more of a monetary phenomenon the ‘Helicopter Drop’ could a policy tool of the government. A lot of governments already have introduced ‘shock therapy’ and unleashed significant stimulus measures:

• Hong Kong – giving away cash to population – equivalent NZ$2,120.
• China – infrastructure projects and subsidising business to pay workers.
• Japan – trillions of Yen to subsidising workers. Small firms get 0% interest on loans.
• Italy – fiscal expansion and a debt moratorium including mortgages
• US – congress nearing stimulus package
• NZ – stimulus package industry based

Source: The Real Economy Blog

Japan’s monetary and fiscal policy are at odds with each other

The Bank of Japan (Japan’s central bank) and the Japanese government seem to be moving in opposite directions with regard to monetary and fiscal policy. On the one hand you have the Bank of Japan exiting its long-running experiment with ultra-loose monetary policy (low interest rates) with a depreciating currency (yen) rising bond yields and persistent inflation. Therefore the economy is preparing for positive interest rates which is normal for monetary policy. On the other hand you have the government implementing an expansionary fiscal policy.

Japan has a headline inflation rate above 2% for many months but there could be a delay in tightening as a lot of the pressure on prices is imported with local wages still not rising to match the inflation target over the long term. Also whilst inflation can be tackled with higher interest rates Japan has little chance to cut rates if prices undershoot. Consequently it makes sense to have a tighter monetary policy with the chance of higher inflation.

Adapted from CIE A Level Revision Book – Susan Grant

What is perplexing is the government’s expansionary fiscal policy which is estimated to be 3% of GDP. It consists of large tax cuts and rebates for households which appears to be more political than economic as an unpopular government is trying to please an unhappy electorate. Over the last 30 years Japan has required huge fiscal stimulus to achieve positive economic growth and avoid the risk of deflation. A positive inflation rate means that the business cycle could be managed by using interest rates and therefore less pressure on the government budget deficit to keep the economy going – injecting money in the circular flow of the economy.

Adapted from CIE A Level Revision Book – Susan Grant

Although it remains important for the central bank to avoid tightening monetary policy too early it seems irrational that the government should implement an expansionary fiscal policy. This makes the Bank of Japan’s job even harder and also uses up fiscal ammunition in the event of a global downturn.

Source: Japan’s fiscal and monetary policies are moving in opposite directions – FT November 10th 2023

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Argentina – an economy that never misses an opportunity to miss an opportunity

Below is a video from The Economist that looks at the problems facing the Argentinian economy. It is well documented that Argentina’s economic woes since the 1940’s have impacted the economy today. Some of the main teaching points from the video:

• There has been mismanagement of the Argentinian economy for decades
• Argentina’s inflation rate – above 100% for almost all of 2023 – see graph.
• Argentinians save in US$. Black market for currency as Argentinians can only legally buy US$200 per month at the offical exchange rate. Official rate – 360 pesos, Black market rate – 760 pesos.
• GDP US$650bn – one of the largest in South America but 1946 strong interventionist government through President Peron. Also protected industry from foreign competition.
• Country hasn’t embraced globalisation and Peronists have been in power for 16 of the last 20 years.

• Argentina has both huge reserves of lithium and copper but doesn’t use them to its advantage.
• Government overspending on price subsidies – electricity bill in EU $40/month. Argentina electricity bill is $5/month. Cost to Government – $12.5bn = 2% GDP
• Of the 13 million employed in Argentina over a third are employed by the state which there is a crowding out of investment money.
• Argentina has had a fiscal deficit for the last 13 years so therefore becomes dependent on the central bank printing money = more inflation.
• With Argentina regularly defaulting on its debt it has been the IMF that is prepared to lend to them. Argentina holds almost a third of all of the IMF’s total lending.
• Criticisms that most economists have of the IMF is that the conditions of the loans to Argentina were not strict enough. No requirement to stabilise the economy which was a missed opportunity,
• Loans are repaid in foreign currency – to access US$ they impose export taxes – 33% on soybeans. To stop farmers hoarding beans in silos waiting to a better exchange rate they introduced the Soybean dollar exchange rate (better than the official rate for farmers). For overseas bands coming into Argentina promoters have to pay the official dollar plus a tax – it is called Dollar Coldplay. Using your Argentinian credit card you pay an extra tax which they call Dollar Qatar.
• Solutions tend to result in the same outcome – more debt and higher inflation. Things need to get worse before they get better. Short-term pain for long-term gain but for this to happen there must be trust.

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How well do we understand inflationary expectations?

In looking at the causes of inflation, textbooks will cover demand-pull and cost-push but not go into much detail about inflationary expectations. If the consumer believes that prices of goods are going to increase this will have an impact on future price levels and the wage demands – a self-fulfilling prophecy.

Higher wages = Higher labour costs = Higher prices

Jerome Powell, US Fed Chairman, has made four 0.75 percentage point hikes in a row is an aggressive monetary policy to reduce inflation. Yesterday’s increase of 0.5% takes the bank’s benchmark lending rate to 4.25% – 4.5%, a range that is the highest since January 2008. He also alluded to inflationary expectations:

“We can’t allow a wage-price spiral to happen,” he said. “And we can’t allow inflation expectations to become unanchored. It’s just something that we can’t allow to happen.”

So how do you measure inflationary expectations? Policymakers use surveys at different times to monitor households’ and firms’ beliefs about prices. Furthermore, in order to try and shape consumer expectations central banks are very transparent as to their forecast of inflation and future interest rate changes.

How well do we understand households’ expectations? An article in the IMF Finance & Development (September 2022) looked at a deeper understanding of how consumers think about inflation. There seems to be a disagreement between consumers and policy makers with the former relying on the price change in a few products like coffee and petrol as an overall indicator of a country’s inflation rate. Past experiences —such as living through events such as the 1970’s oil crisis, the stagflation years of the late 1970’s, the Global Financial Crisis 2008, stock market crash of 1987 (Black Monday) etc, can influence peoples understanding of inflation for years to come. For instance if you lived through the stagflation years you are you more likely to be less optimistic about controlling inflation?

Andre et al (2022) recent research set out to see if economic policy (fiscal and monetary) and economic events result in the same expectations by laypeople and experts. They focused on unemployment and inflation and distributed surveys to 6,500 households and 1,500 experts. The survey asked respondents to consider four hypothetical shocks to the US economy:

• a sharp increase in crude oil prices
• a rise in income taxes,
• a federal government spending increase,
• a rise in the Federal Reserve’s target interest rate.

All respondents were given the current figures for inflation and unemployment and were asked to give their forecast of their movement over the following year after being given news about one of the four shocks. Interestingly laypeople believed that an increase in interest rates and income taxes would increase inflation which is contrary to what economics textbook models show – see Chart 1. The difference of opinion seems to stem from the interpretations of demand versus supply models see Chart 2. The experts used theoretical models and economic toolkits whilst the laypeople were more likely to rely on personal experiences, political views and a different interpretation – i.e. they look at supply-side issues:

higher interest rates = higher costs for firms = increase in prices to maintain profit margins = inflation↑

Experts take the view that it is a demand-side issue:

higher interest rates – higher cost of borrowing for consumers = less borrowing = inflation↓

Central Banks look to make communication more accessible

Central banks are now trying to, not only make communication accessible, but also much easier to understand. For example the European Central Bank (ECB) has built a presence around social media platforms using simpler language to explain the impact of interest rates on inflation.

Economic models depend on ‘rational expectations’ according to which households base their individual decisions—on how much to save, consume, and work—on expectations about the uncertain future state of the economy.

Source: Hall of Mirrors: How Consumers Think about Inflation by Carlo Pizzinelli
IMF F&D September 2022

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A2 Economics Revision: Keynes 45˚ line

With the CAIE A2 exam coming up here is a revision note on Keynes 45˚ line. A popular multi-choice question and usually in one part of an essay. Make sure that you are aware of the following;

Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:
2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X

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Why Fitch downgraded the US economy to AA?

Last week Fitch, one of the three major private credit-rating agencies, downgraded the US economy credit rating from AAA to AA. The main reasons for this:

• There is a major issue with US government spending and debt. Currently the US is now borrowing to pay its debt on interest on money it’s already borrowed (Ponzi scheme).
• Politically neither the Democrats nor the Republicans seem to have much interest in the country’s long-term fiscal trajectory. They walked away from debt-ceiling negotiations without doing much of anything
• Despite strong growth, the US government is running as large a deficit as it was during the worst of the Great Recession. And the debt now stands at $32 trillion.
• The US borrowing costs are up 35% a year as central banks hike interest rates to tackle inflation. The average interest rate on US government debt has risen from 1.6% as of 2021 to 2.1% today.
• Fitch is saying that the US government is not able to raise taxes or contain spending in a way that makes people confident that they can pay off its debt in the long-run.

What impact will this have?
The debt would increase the country’s borrowing costs, thus reducing investment relative to consumption. Larry Summers, the former Treasury secretary, stated that there maybe insufficient investment for venture capital, inadequately trained armed forces and maintain leadership in AI and biomedicine. There is also the risk of stagflation and of investors dumping American assets. The major concern is the government’s inability to do anything effective whilst the Republicans keep taking the debt ceiling hostage while running up huge deficits themselves. Below is a report from Al Jazeera which discusses the downgrade.

Who are the credit rating agencies?
There are three main rating agencies in the global economy – Standard & Poor’s, Moody’s and Fitch and they control more than 94% of outstanding credit ratings. They are basically an oligopoly influencing financial portfolio investments, the pricing of debt and the cost of capital. Their authority is also enhanced by the SEC (Security and Exchange Commission) who see them as the official CRA. See below for ratings.

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US debt ceiling and why it is important.

In 1917, the US Government passed a law that set a limit on the total amount of debt that the government can incur – initially set at $11.5bn. However Government debt has increased under every President and now stands at $31.4trn. In January this year debt hit this latest level which means that the Government cannot legally borrow anymore money. In order to increase the debt ceiling it must be voted through the House of Representatives which the Republicans have a majority. Although the ruling party is the Democrats, the Republican majority can pressure President Joe Biden to agree on cuts to the budget. In the past, under the same scenario, there have been hastily arranged agreements at the 11th hour to avoid a default. Below is a good video from the WSJ explaining the debt ceiling and the consequences of it not being raised.

New Zealand’s tight labour market but do all benefit?

Figures out yesterday show that unemployment in New Zealand remained at 3.4% which makes for a very tight labour market. One wonders if this figure is beyond the maximum sustainable levels with the RBNZ worried about the pressure on private sector wages feeding into inflation. The RBNZ would like labour market pressures to ease – i.e. they want unemployment – as this should bring down inflation. However on 18th May the government deliver the Budget and no doubt there will be some fiscal stimulus that the RBNZ will need to be aware of – Expansionary Fiscal Policy vs Contractionary Monetary Policy. It seems the Government want to put money into the circular flow especially as it is election year but the RBNZ want to keep inflation between 1-3%. Ultimately it is Politics vs Economics.

Full employment doesn’t mean all workers benefit
Full employment has normally been the concept that has been used to describe a situation where there is no cyclical or deficient-demand unemployment, but unemployment does exist as allowances must be made for frictional unemployment and seasonal factors – also referred to as the natural rate of unemployment or Non-Accelerating Inflation Rate of Unemployment (NAIRU). Full employment does suggest that the employee has a lot of bargaining power as the supply of labour is scarce relative to the demand. In theory a tight labour market should lead to higher wages and improved conditions of work as the employer has less labour to chose from. We have seen in the labour market incentives for employees in recommending potential candidates for vacancies in the company. Other incentives for potential employees include shorter working weeks, hiring bonuses and special leave days.

Michael Cameron’s article in The Conversation suggest that this doesn’t apply to all workers. A lot depends on the bargaining power of the worker and the elasticity of supply of labour. If the supply is very inelastic for a particular job (higher skilled) it is harder and most likely more expensive for the employer to find an alternative worker. This is evident when unemployment is low as the worker can easily look around at other job opportunities. On the contrary if the supply of labour is more elastic (lower skilled jobs) the worker has less bargaining power and the employer will have more potential workers to chose from. The graph below shows the elasticity of supply of labour – high skilled has a steeper curve (inelastic) whilst low skilled as a flatter curve (elastic)

Source: Economicshelp

ANZ New Zealand Labour Market Review | March 2023 Quarter
Michael Cameron writes in The Conversation

New Zealand tax report and the Laffer Curve

Just been covering the Laffer Curve with my Yr 13 class and it was very apt that the Inland Revenue Department (IRD) published a report that shows wealthy New Zealanders pay much lower tax rates than other earners. Based on the 311 of the wealthiest New Zealand citizens, the data shows that the average person in this group pays 8.9% tax on their income which includes capital gains on investments.

Robin Oliver an expert in tax economics was interviewed on Radio New Zealand’s “Morning Report” programme this morning and he is suggesting that changes are needed to income tax thresholds to make them fairer. Looking at the current tax rates and thresholds in New Zealnd (see table below) the jump in the tax rate from 17.5% to 30% when you hit the income bracket $48,001 to $70,000 is significant and the assumption is that this is a high level of income which it may well have been 20 years ago. However looking at the cost of living today this is well below what could be considered an income which should be taxed 30%. Click here to listen to the interview.

Laffer Curve

The laffer curve (named after American economist Arthur Laffer) indicates the relationship between the tax rate and the revenue gained by the government. If you charge a high tax rate it is unlikely that you will encourage people into work and therefore the tax revenue for the government is a lot lower if taxes had been lower. The curve suggests that, as taxes increase from low levels, tax revenue collected by the government also increases. It also shows that tax rates increasing after a certain point would cause people not to work as hard or not at all, thereby reducing tax revenue. Eventually, if tax rates reached 100% (the far right of the curve), then all people would choose not to work because everything they earned would go to the government.
Economists have long used the Laffer curve to justify tax cuts, including:

• Ronald Reagan in 1981 – resulted in lower revenues
• George W. Bush in 2001 – resulted in lower revenues.
• Donal Trump in 2017 – resulted in lower revenues

The Congressional Budget Office, a government watchdog, now reckons that US national debt will hit 95% of GDP by 2027, up from 89% two years ago before the tax cuts.

America (see graphic above) is not the only country that appears to be on the wrong side of Mr Laffer’s curve. A paper published in 2017 by Jacob Lundberg, estimates Laffer curves for 27 OECD countries. He found that only Austria, Belgium, Denmark, Finland and Sweden have top income-tax rates that exceed their revenue-maximising levels. However only Sweden could meaningfully boost revenue by cutting tax rates on high-income earners. Most countries, in other words, appear to have set their highest tax rates at or below the optimal rate suggested by the Laffer curve.

Source: The Economist – 19th June 2019 – Graphic detail

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New Zealand interest rate rises an over-correction?

On my way to work last week there was a very good interview on National Radio (NZ) with Robert MacCulloch an economics professor at the University of Auckland. This ended up to be my lesson plan with my A Level class for the last day of term. MacCulloch argued that the interest rate hike of 50 basis points was too great an increase and could lead to a hard landing and deeper recession that could be avoided. His main arguments were:

• Inflation has stabilised as quarterly inflation had dropped from 2.2% to 1.4% therefore no need for a 50 basis point rise.
• In other countries (USA) inflation is dropping and those central banks are holding off on interest rate increases.
• Stated that the RBNZ wants a hard landing and therefore a recession which can be damaging with higher unemployment.
• More gradualist approach should have been adopted.
• RBNZ stated that the post-covid inflation was a temporary blip and that stagflation was back in the early 1980’s – we live in a different world today.
• Would it be better to go hard early with higher increases and then be able to loosen monetary policy? This may mean recession where you hit mortgage holders and those that become unemployed.
• A lot of other central banks adopting a wait and see approach – couldn’t the RBNZ do the same?
• Okun’s Law – A slowdown in GDP growth typically coincides with rising unemployment. A hard landing will result in this.
• In NZ GDP shrank 2% compared to the UK 11%. NZ grew in 2021 so was there a need to have close to 0% interest rates and print $50bn?

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Loose monetary policy not solely to blame for present economic conditions.

Martin Wolf in the FT wrote an interesting piece in the FT yesterday talking about loose monetary policy and not to wholly blame the central banks for the economic environment today. Below are some of the main points that he makes:

• Deregulation of financial markets, free trade and China joining the WTO in 2001 lowered the global inflation rate.
• Huge savings were prevalent in the global economy – especially in China and Germany
• Balance global demand and supply = big investment in housing driven by financial liberalisation.
• COVID – money growth exploded with expansionary monetary and fiscal policy.
• Fiscal deficit of G7 countries jumped by 4.6%.
• Monetary – quantitative easing and stimulatory level of interest rates
• With supply chain issues, China’s lockdown and the Ukraine War, the dramatic increase in demand could not be met by a corresponding increase in supply. See graph
• Inflation = higher interest rates = shock to banking system
• Loose monetary not the blame for what has gone wrong in the global economy
• Mistake to think that there is a simple solution to the failing of the banking systems

Things would not be wonderful if central banks had stood idly by. We cannot abolish democratic politics. Economic policy must be adapted to our world, not to the 19th century. Martin Wolf

Source: IMF

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Globalisation to slowbalisation – IMF

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

1. Industrialisation was prevalent in Europe and the USA and the advances in transposition reduced the costs for firms and encouraged trade.
2. 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.
3. 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.
4. 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.
5. “Slowbalisation” followed the global financial crisis in 2008 and the rising geopolitical tensions with protectionist policies being imposed by many countries.

Source:

IMF Blog – Charting Globalisation’s Turn to Slowbalisation After Global Financial Crisis

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How do we know when a current account deficit is bad?

A current account deficit (CAD) allows residents to consume more products that it produces. However the country needs to finance the deficit by attracting investment into the country or by borrowing. This will involve an outlow of money in the future in the form of investment income. An increase in a CAD may also reduce AD, which may slow down economic growth and may cause unemployment.

A CAD could be indicative of a lack of competitiveness but it could also mean an excess of investment over savings which could mean a highly productive, growing economy. Although there is a deficit an important question is what the deficit is made up of? If a country is importing a significant amount of capital goods then these can add value to the economy by creating jobs and growth. For example if Air New Zealand buy planes from Airbus these are part of the service that they offer which employs people and generates income. But if a CAD reflects low savings rather than investment, it could be caused by an irresponsible expansionary fiscal/monetary policy like we have seen in New Zealand post-covid.

New Zealand’s annual current account deficit was $27.8 billion for the year ended in the June 2022 quarter, equivalent to 7.7 percent of GDP. The annual current account deficit rose by $16.3 billion during the year, driven by increases in the goods and services deficits. Sea transport costs (which is a services import cost) rose by $2.2 billion during the year, and was a driver behind a $5.0 billion deterioration in New Zealand’s services balance. However the record-breaking deficit shows we’ve been living beyond our means, becoming more dependent on foreign capital in the process. However CAD reflect underlying economic trends, which may be desirable or undesirable for a country at a particular point in time.

Causes of CAD

1. Overvalued exchange rate – If the currency is overvalued, imports will be cheaper, and therefore there will be a higher quantity of imports. Exports will become uncompetitive, and therefore there will be a fall in the quantity of exports.
2. Economic growth – If there is an increase in national income, people will tend to have more disposable income to consume goods. If domestic producers cannot meet the domestic demand, consumers will have to import goods from abroad. In New Zealand there is a high tendency to import manufactured goods as we don’t have a comparative advantage.
3. Drop in demand from trading partners – If there is a downturn in country A that normally buys another country B’s exports this will mean a loss of export revenue for country B. A current account deficit that results from the economic cycle is referred to as a cyclical deficit. Usually short-term and self-correcting
4. Growing domestic economy – when demand increases in the domestic economy it may mean that companies now have to import more capital goods and raw materials from overseas. As well as imports increasing, producers may switch their sales to the domestic market and not overseas (exports). However in the long-term firms output might increase so that they can sell both at home and abroad.
5. Higher inflation – if New Zealand’s inflation rises faster than our main competitors then it will make New Zealand exports less competitive and imports more competitive. This will lead to deterioration in the current account. However, inflation may also lead to a depreciation in the currency to offset this decline in competitiveness. 
6. Structural problems – a current account deficit that is persistent is concerning as it indicates that domestic firms are not internationally competitive and the country may have to borrow from overseas to fund the current account deficit. As well as an overvalued exchange rate (see above) the country might have low labour and capital productivity so finds it hard to compete internationally.

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Globalisation to regionalisation and its impact.

With the global economy experiencing supply chain pressures, inflationary problems, higher interest and geopolitical tensions are we seeing a move to more regionalisation rather than globalisation?

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 recent 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 there have been 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.

Response to shocks – GFC and COVID-19

The GFC and COVID-19 saw the primary policy response of an expansionary monetary policy (near 0% interest) due to insufficient aggregate demand. The result of this policy has changed the economic landscape. Today things are quite different:

• insufficient aggregate supply,
• persistent supply shocks,
• higher inflation,
• higher interest rates
• slow growth.

After years of loose fiscal, monetary, and credit policies and major negative supply shocks, stagflationary pressures are now putting the squeeze on a massive mountain of public- and private-sector debt. Recession (negative GDP for two consecutive quarters) seems on the cards.

Source: The Real Economy Blog

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Why has the US dollar got so strong and problems associated?

There has been a lot of talk about global currency’s depreciating against the US dollar but why has the dollar been so strong? In times of uncertainty people gravitate to the US dollar for safety – it is the global reserve currency and the vast majority of global trade is done in US dollars. The uncertainty in the global economy has been due to:

• The pandemic
• Expansionary fiscal and monetary policy
• Supply side problems not being able to keep up with demand
• Ukraine War which has increased energy and food prices.

From the above there has been strong inflationary pressure in the US especially and this needs contractionary monetary policy intervention – higher interest rates. The US Fed Reserve has increased interest rates ahead of other developed economies.

28th September 2022 – US dollar.

Problems with a strong US dollar
When the US dollar appreciated – see image above – it has a contractionary impact on the global economy. The dollar and US capital markets are far more globally important than the US economy itself – the currency is the world’s safe haven and its capital markets are those of the world. Therefore the exchange rate is crucial when money goes into and out of the US. Also countries worry about the exchange rate in particular when inflation is high – weak currency makes imports more expensive and can feed inflation. For those that owe money in US dollars a weak currency becomes very expensive as they have to convert more of their currency into US dollars – this is prevalent in the developing world. With Fed Chair Jerome Powell determined to bring US inflation down there is the risk of further interest rate hikes which could put economies into recession.

Source: Financial Times – Why does the strength of the US dollar matter? Martin Wolf

For more on Exchange Rates view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

UK Pound slumps as IMF advises against tax cuts

Below is a very good video from Al Jazeera that explains the Bank of England’s emergency intervention to calm the market after the UK’s government’s tax cut plans. Once these plans were announced the GB Pound slumped to it lowest level $1.035 against the US Dollar since 1985. The BoE announced it is buying up long-dated UK government bonds to bring stability to financial markets but even higher interest rates are still likely and that is worrying news for the country’s property market. Good coverage of this below from Al Jazeera.

Inflationary Expectations – Households v Economists

In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices.

At a recent press conference US Fed chair Jerome Powell expressed concern about expectations”
“We can’t allow a wage-price spiral to happen,” he said. “And we can’t allow inflation expectations to become unanchored. It’s just something that we can’t allow to happen.”

A recent IMF blog post by Carlo Pizzinelli looked at the inflationary expectations of consumers against those of policy makers. When monetary or fiscal policy are in the news how do consumer expectations for inflation change? Additionally how do economic events influence expectations? Can we say that consumers form the same expectations as those who deliver policy decisions? The researchers asked consumers to consider four speculative shocks and then make predictions about their impact on inflation and unemployment. The four were as follows:

• a sharp increase in crude oil prices as a result of falling world supply,
• a rise in income taxes,
• an increase in government spending,
• a rise in the US Federal Reserve’s interest rate.

It is an assumption that these shocks are generally understood by consumers. Researchers provided current figures for the rates of inflation and unemployment and asked them to give their forecasts for the two variables over the following year. They then provided news about one of the four speculative shocks and asked them to make new predictions for inflation and unemployment.

Results show that there are large differences in expectations from consumers and experts. Of note is consumers belief that an increase in income tax and interest rates would increase inflation which is contrary to what experts predict – see Chart 1.

In order to look into why there is a disagreement between two groups consumers were asked as to what they were thinking when they made their predictions – a focus was on demand side v supply side theory. Experts drew on their technical knowledge whilst consumers rely on personal experiences. Consumers believe that higher costs (interest rates up) for firms are then added to the price of the good or service. Experts predict a decline in prices as consumers spend less and save more – see Chart 2

It is important that central banks make their statements in a simple language so that there is clarity for the general public – e.g. when a central bank raises interest rates unexpectedly households are under the assumption that this action will lower inflation and their actions will ultimately lead to a reduction in inflation.

IB/A2 Economics – Macroeconomic policies essay

With the mid-year exams next week here are a couple of mindmaps I produced using OmniGraffle (Apple software). I found it a useful starting point for students to discuss the effectiveness of each policy and the conflicts within macro objectives. This is a very common essay question in CIE Paper 4. My question would be:

What policies has the government in your country implemented since Covid-19 and how successful have they been in meeting macro economic objectives? (25)

BBC Podcast – How do we stop high inflation?

This is a very good podcast on inflation and for anyone new to the subject it explains a lot concepts in very simple language. Concepts like fiscal policy, monetary policy, recession, stagflation etc. Click link below:

BBC – The Real Story – How do we stop high inflation?

The question that the economists try and answer is will the global economy go through a recession in order to get inflation down. Both central banks and governments cushioned the economic shock of the pandemic with low interest rates and spending respectively but this action has been blamed for increased inflation.

Larry Summers suggested that the US Fed had mistakenly seen the inflationary problem as transitory but there is a bit more stubbornness about price increases today. As he put it – some central banks need to go through their ‘full course of antibiotics’ (interest rate hikes) to control inflation as failure to do so means that inflation will return promptly and another course of antibiotics will need to be administered. The longer you leave it the more damaging the downturn/recession will be. He also states that every time the US economy has had an inflation rate greater than 4% and an unemployment rate below 4% the US economy has gone into a recession within two years. Those figures align with US inflation 8.5% and unemployment 3.6%.

Some great discussion and would be useful for a macro policy essay at CIE AS or A2 level. Good for revision of policies and their usefulness today.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Global Economic Outlook

Below is a look at economic conditions in leading global economies. Unemployment is surprising low and with the rise in the cost of living (see inflation figures) this should put pressure on wages. The unemployment rate within the OECD area fell to 5.2% in February, the first time it has fallen below the pre-pandemic unemployment rate (which was recorded in February 2020). The unemployment rate within the OCED had peaked at 8.8% in April 2020.

Inflation, Unemployment and Interest Rates
Annual inflation within the OECD area rose to 8.8% in March 2022, its highest annual increase since 1988. Energy prices have risen by over a third during the past year, while food prices have risen by ten percent within the OECD area. Most central banks have already commenced a tightening programme with the on-going threat of inflation. The Australian Reserve Bank commenced tightening their cash rate in early May, increasing the cash rate by 25 basis points to 0.35%. It is expected that the RBNZ will increase the OCR by 50 basis points next week.

Outlook
If you look at conditions in the major economies you find the following:

• China – limited growth potential with severe lockdowns
• USA – higher interest rates could lead to a bust scenario
• Euro Zone – cost of living crisis
• Emerging markets – food crisis / famines.

With the indicators looking at recessionary conditions the best news for the global economy would be a withdrawal from Ukraine by Russian troops and an end to a zero-Covid strategy in China. These actions should reduce food and energy prices and therefore save government spending on raising benefits and subsidising food and energy. Economists are fairly optimistic that we will avoid a recession in 2022 as they still have the tools to stimulate if things get worse. However with no end in sight for the Ukraine conflict and interest rates on the rise a recession is on the cards.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Inflation and Unemployment. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.