BoJ still buying bonds as other central banks reverse asset purchases.

Within the OECD are annual inflation has been rising at an average of 9.6% – its ranges from 2.5% in Japan to 73.5% in Turkey. The US and the UK has inflation of 9.1%, Australia 6.3% and NZ 7.3%. Most of the bigger economies target a 2% inflation rate and in response to these higher rates the US Fed increased its interest rates by 75 basis points to 1.5-1.75% with a potential 50 or 75 basis point rise in July. The Reserve Bank of Australia also lifted its interest rate by 50 basis points to 1.35% in July.
In order to tackle this inflationary pressure it is normal for central banks to sell bonds / assets back into the market which is turn reduces the money supply and raises interest rates. This should depress aggregate demand as there is now less money in the circular flow and the cost of borrowing goes up. However, the Bank of Japan (BoJ) is out of kilter with accelerating interest rates as it has committed to its policy of yield curve control intended to keep yields on 10-year bonds below 0.25% by buying as much public debt as is required – see graph below:

FT – Investors crank up bets on BoJ surrendering yield curve controls

How to 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%

Yield curve control
Yield curve control (YCC) involves the BOJ targeting a longer-term interest rate by buying as many bonds as necessary to hit that rate target. It has been buying Japanese Government Bonds (JGB) at a monthly rate of ¥20trn which is double its previous peak of bond buying in 2016. Although there is no theoretical limit on its buying ability it has impacted the currency which has fallen to a 24 year low against the US dollar. This will push up the price of imports and inflation although the BOJ is confident that the price rises in its economy are transitory. If inflation does start to consistently hit levels above the BOJ’s target of 2% will they reverse their bond purchasing policy and shift to a higher yield cap?

Shorting JGB’s
A lot of investment banks are looking to short JGB’s. In this situation the trader suspects that bond prices will fall, and wishes to take advantage of that bearish sentiment—for instance, if interest rates are expected to rise. This will likely happen if the Japanese relax their YCC with interest rates rising and bond prices falling – see image below for a simple explanation of shorting.

Source: Online Trading Academy

Sources:

  • The Economist: – BoJ v the markets. June 25th 2022.
  • Financial Times: Investors crank up bets on BoJ surrendering yield curve controls. June 23rd 2022

Sign up to elearneconomics for comprehensive key notes with coloured illustrations, flash cards, written answers and multiple-choice tests on Monetary Policy that provides for users with different learning styles working at their own pace (anywhere at any time).

Inflation and the Base Year Effect

A price index is a means of comparing a set of prices as they change over time. Index numbers allow for a comparison of prices with those in an arbitrary chosen reference (base year), a year that current values can be compared against. This base year is usually given a numerical value of 100 or 1000. The index number allows for percentage changes to be calculated between various time periods.

If we look at the last few years some of the current inflation increases has been exaggerated by what are known as base-year effects. What has happened is that annual inflation has been measured against a time during the COVID-19 pandemic when economies were locked down and prices slumped. Therefore the inflation figures around the world have been increasing quite rapidly but soon they will be measured against the current higher prices which should mean a lower inflation figure. Regions such as Europe that rely on imported energy may see a greater fall in inflation than others if the price of fuels like oil and gas were to quickly cool. But that doesn’t seem likely in the current climate especially with the war in the Ukraine and come October the northern hemisphere heads back into winter with greater energy use. The graph above is a little out-of-date in that inflation in the UK is now 9.1% and the Bank of England expect it to exceed 11% in October. The USA has an inflation rate of 8.6% and it is expected to reach 9%.

Central Bank rate increases in 2022
Below are the central bank rate hikes this year and the big question is have they got their timing and rate increases right.

  • With the threat of inflation should banks have increased their rates earlier?
  • If they tighten too quickly will that tip their economy into recession and a hard landing?
  • What is the right rate increase for the current inflation figure?
  • How long (pipeline effect) will it take for interest changes to impact the inflation figure?
  • These are the challenging questions that central bankers face in today’s environment.

For more on Inflation and Base 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.

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.

Is German Football like the German Economy?

In teaching economics I try and relate as much as I an to the interests of the students. I have found that sport is one way of engaging a class especially in the macro indicators of a country – growth, unemployment, inflation, trade, inequality etc. The German economy has been the backbone of the EU for a number of years but has this corresponded to the success/failure of the national football team? The performance at the 2004 Euros were the catalyst to an overhaul of the German coaching system – outlined brilliantly in Raphael Honigstein’s book – Das Reboot. This came to fruition in the 2014 World Cup final when German beat Argentina 1-0 in extra time.

However a year earlier in 2013 there was an all German final in the European Champions League with Bayern Munich defeating Borussia Dortmund 2-1 at Wembley Stadium in London. In order to get to the final both teams beat Spanish counterparts – Real Madrid and Barcelona. What is fitting is that in economic terms German is the powerhouse of the European economy whilst in contrast Spain has suffered greatly from the euro crisis and austerity measures that have been imposed on it. If you look at post-war Germany you can see some correlation between the success of the national side and state of the economy.

The Economist looked at this and made the point that German has opened up its borders to not just traditional labour but also football players. Of the two squads on show at the Champions League Final at Wembley in 2013, 17 were from outside Germany.

Most visibly, Germany opened up. Just as immigrants flock to German jobs (more than 1m net arrivals in 2012), so players join German clubs. Between them Bayern and Dortmund have four Brazilians, three Poles, a Peruvian-Italian, a Serb, a Croat, a Swiss of Kosovar extraction, an Austrian of Filipino/Nigerian stock, a Ukrainian and two Australians—and so on. Of the German players, several have dual citizenship or a “migration background”. If the choice is between a German Europe or a European Germany, as the novelist Thomas Mann once put it, football points to the second.

2014 onwards

The 2014 World Cup victory, almost 25 years since they last won it, was achieved largely through the restructuring of German coaching system. The style of play was transformed from a defensive minded ‘park the bus’ attitude to one of free flowing counter attacking style. However the economy was not as buoyant as in previous years with unemployment 6.6% and the spectre of deflation rising its head. Roll on the 2018 World Cup and the defending champions had a disastrous campaign with not even getting out of pool play. This coincided with weakest growth in Germany for five years. The Euro 2020 (played in 2021 because of covid) saw Germany going out to England in the last 16. With regard to the club scene Bayern Munich did win the Champions League in 2020 but no German team made it to the semi-finals in 2021 as both Bayern Munich and Borussia Dortmund were knocked out in the quarter finals.

As with most countries the German economy failed to return to its pre-covid growth rate as shortages of manufacturing inputs have hampered any recovery. However, there are plenty of orders on the books for German companies for a potential rebound when supply constraints ease. On the football side of things under new manager Hansi Flick, ex Bayern Munich, the national side breezed through qualifying for Qatar 2022 in what was a weak group, but are still ranked only 12th in the world which is an improvement on 16th in 2018.

Consumption Function Cake

Went through the consumption function this morning with my A2 class and I recalled the superb cake that A2 student Lara Hodgson made for the class a few years ago – here’s hoping for a similar cake this term. Remember that the standard Keynesian consumption function is written as follows:

C = a + c (Yd) – where:

  •   C = total consumer spending
  •    a = is autonomous spending
  •    c (Yd) = the propensity to spend out of disposable income

Autonomous spending (a) is consumption which does not depend on the level of income. For example people can fund some of their spending by using their savings or by borrowing money from banks and other lenders. A change in autonomous spending would in fact cause a shift in the consumption function leading to a change in consumer demand at all levels of income. The key to understanding how a rise in disposable income affects household spending is to understand the concept of the marginal propensity to consume (mpc). The marginal propensity to consume is the change in consumer spending arising from a change in disposable income. The higher the mpc the steeper the gradient of the consumption function line. As you can imagine the consumption of cake was fairly rapid.

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

A2 Economics – Multiplier

Just been looking at the multiplier with my A2 class and here are some notes and a mindmap. An initial change in AE can have a greater final impact on equilibrium national income. This is known as the multiplier effect and it comes about because injections of demand into the circular flow of income stimulate further rounds of spending.

Multiplier Process

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 realize 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

MPS = Marginal propensity to save

MRT = Marginal rate of tax

MPM = Marginal propensity to import

MPC = Marginal Propensity to Consume (of additional income how much of it spent)

e.g. $1m initial spending; MPC=.8

=> income generated = 1/(1-.8) = 1/.2 = 5

=   $5m

=> $4m extra spending ($1m initial, $4m extra spending, $5m total)

Use different equations depending on the information given.

e.g.: a) if the MPC is 0.5 – 50% of the income will be spent, 50% will be saved.

then MPS is 0.5 then the multiplier is 2 = 1/0.5 = 2

b) if the MPC is 0.8 – 80% of the income will be spent then MPS is 0.2 then the multiplier is 1/0.2 = 5

c) if the MPC is 0.9 – 90% of the income will be spent then MPS is 0.1 then the multiplier is 1/0.1 = 10

What is the effect of MPT – the marginal propensity to tax or t.

  • greater MPT would lead to less income being spent in the economy

Below is a very informative mind map that I copied from an old textbook.

Multiplier.png

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

OCR – LSAP – FLP = New Zealand’s Monetary Policy Toolkit

Below is a useful flow diagram from the ANZ bank which adds Large Scale Asset Purchases (LSAP) and Funding for Lending Programme (FLP) to the Official Cash Rate (OCR – Base Rate)

LSAP – this is the buying of up $100 billion of government bonds – quantitative easing
FLP – this gives banks cheap lending based on the Official Cash Rate – could be about $28 billion based on take up
OCR – wholesale interest rate currently at 0.75%. Commercial banks borrow at 0.5% above OCR and can save at the Reserve Bank of New Zealand (RBNZ) at 1% below OCR.

With FLP and more LSAP this will mean lower lending rates and deposit rates. This should provide more stimulus in the economy and allay fears of future funding constraints making banks more confident about lending. Add to this a third stimulus – an OCR of 0.75%. Although there is currently a tightening policy the rate is probably still stimulatory. The flow chart shows the impact that these three stimulus policies have on a variety of variables including – exchange rates – inflation -unemployment – consumer spending – investment – GDP. Very useful for a class discussion on the monetary policy mechanism.

For more on Monetary Policy 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.

New Zealand inflation hits 5.9%. Potential for wage price spiral?

Consumer prices in New Zealand rose 5.9% annually in the December quarter.
Core inflation measures rose to 5.4% annually. Core inflation excludes certain items that are known for their volatility — namely, food and energy. With this figures it seems that ‘transitory’ inflation is not as relevant and inflation does have some momentum. There is a lot inflation coming in from abroad with Tradable inflation at 6.9%.

Domestic inflation was also strong with non-tradable inflation at 5.3%. Some of the main movers in the CPI:

  • Construction costs up by 15.7%annually – major supply chain issues here
  • Petrol prices up by 30.5% annually – reflects rises in oil prices globally and a weak NZ dollar making imports more expensive.
  • Food – annual change in food prices was 4.1% although the quarterly change was -0.1%
  • 40% of CPI is made up of imports and with inflationary pressure prevalent in the global economy this has led to higher import prices.

Higher inflation in a tight labour market – wage price spiral.
With a tight labour market comes pressure on wages and if they increase and are not accompanied by an increase in output/worker, companies have two choices. Either they absorb the higher costs or they put their prices up. Then with higher prices there is pressure on wages again as employees try to maintain their purchasing power which in turn could lead to a wage-price spiral.

Theory behind the wage-price spiral

As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

Source: ANZ Research December 2021 Quarter CPI Review

Africa’s resource curse lingers on.

Africa may have enormous natural reserves of oil, but so far most Africans haven’t felt the benefit. In Nigeria, for instance, what’s seen as a failure to spread the country’s oil wealth to the country’s poorest people has led to violent unrest. However, this economic paradox known as the resource curse has been paramount in Africa’s inability to benefit from oil. This refers to the fact that once countries start to export oil their exchange rate – sometimes know as a petrocurrency – appreciates making other exports uncompetitive and imports cheaper. At the same time there is a gravitation towards the petroleum industry which drains other sectors of the economy, including agriculture and traditional industries, as well as increasing its reliance on imports. It is estimated that for every extra dollar in foreign currency earned from exporting resources reduces non-resource exports by $0.74 – Torfinn Harding of the NHH Norwegian School of Economics and Anthony Venables of Oxford University.

Economists also refer to this as the Dutch Disease which makes reference to Holland and the discovery of vast quantities of natural gas during the 1960s in that country’s portion of the North Sea. The subsequent years saw the Dutch manufacturing sector decline as the gas industry developed. The major problem with the reliance on oil is that if the natural resource begins to run out or if there is a downturn in prices, once competitive manufacturing industries find it extremely difficult to return to an environment of profitability.

According to the UN a country is dependent on commodities if they are more than 60% of its physical exports – in Africa that makes up 83% of countries. One of the major concerns for resource rich countries is the wild fluctuations in commodity prices which can lead to over investment – Sierra Leone created two new iron-ore mines in 2012 only for them to close in 2015 as prices collapsed. However the amount of jobs created in the mineral extraction industry is limited – across Sierra-Leone of 8m people, about 8,000 work in commercial mines. A major problem in these countries is that when there is money made from resources it tends to go on government salaries rather than investing in education. infrastructure and healthcare etc.

Norway – has a different approach.
In Norway hydrocarbons account for half of its exports and 19% of GDP and with further oil fields coming on tap Norway could earn an estimated $100bn over the next 50 years. Nevertheless there is a need to wean the economy off oil and avoid not only the resource curse that has plagued some countries – Venezuela is a good example as approximately 90% of government spending was dependent on oil revenue – but also the impact on climate change. Norwegians have been smart in that the revenue made from oil has been put into a sovereign wealth fund which is now worth $1.1trn – equates to $200,000 for every citizen. This ensures that they have the means to prepare for life after oil.

Source: The Economist – ‘When you are in a hole…’ January 8th 2022

US Economy – potential for wage-price spiral

In the past expansionary monetary policy (low interest rates) would have acted as a catalyst to the real danger of a wage price spiral in which rising wages and prices become self-reinforcing, pushing inflation up. This was very apparent in the winter of 1974 in the US when inflation reached 12% and 15% by 1980. Is there the threat of another wage price spiral? Current employment conditions are very much in the favour of the employee. According to The Economist some combination of the following needs to happen to avoid inflation:

  • Rather than raising their prices firms absorb higher wages and have lower profits thereby not raising inflation.
  • The increase in real wages is matched by productivity growth – more demand is matched by more supply.
  • Workers return to the labour market therefore increasing supply and reducing the pressure on wages

Below is a very detailed look at the threat of a wage-price spiral in rhe US. Good discussion of labour market data and the impact of COVID on inflation. Is this inflation period is transitory or a more permanent fixture? Well worth a look

Theory behind the wage-price spiral

As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

A2 Economics – National Income Equilibrium – Multiple Choice

In preparation for P3 on Thursday here are a couple of A2 multiple-choice questions that some students have struggled with.

Question 1

In a closed economy, where the full-employment level of income is $90 million, C = 2/3 Y and I = $(40-3r) million, where C = consumption, Y = income, I =investment and r = the rate of interest. If planned government expenditure is $20 million, what rate of interest would be required for there to be full employment?

A  10% per annum B 12% per annum C  14% per annum D  16% per annum

Answer: A

Y = C + I + G

90 = 2/3(90) + (40 – 3r) + 20

90 = 60 + 20 + 40 – 3r

3r = 30

r = 10%

Question 2

In a closed economy with no government sector, there is no autonomous consumption and the marginal propensity to consume is 0.7. At the beginning of a time period firms set production targets of goods worth $1000 m of which planned sales to consumers = $800 m and planned additions to stocks = $200m.

Which one of the following statements is correct?

A       The economy is in equilibrium, with planned savings and investment equal to $200m.

B       The economy is in disequilibrium, with planned investment greater than planned savings.

C       The economy is in disequilibrium, with planned aggregate demand of $800 in, and planned aggregate supply of $1000m.

D       There will be an unplanned increase in stocks in $100in.

Answer

D       NY = $1000m and MPC = 0.7, thus planned consumption is $1000 x 0.7 = $700m while planned sales by firms = $800. This will lead to an increase in unplanned stocks by $100m.

Inflation in the global economy – a concern?

Very good video from The Economist with a historical and present day look at the inflationary problems in the global economy. The main points are as follows:

  • Inflation least predictable for decades – is it a temporary blip?
  • Most Central Banks aim for 2% inflation per year
  • Inflation over 2% for a short period of time is not such a concern but if it continues for a long period of time it does become troublesome.
  • People wondering why inflation was so low considering the unemployment rate was very low also.
  • Since COVID-19 inflation much higher especially in the US.
  • Is the era of low inflation now over?
  • US – 5.1% inflation – Brazil 9.5%
  • Explains the Base Effect and inflation only transitionary
  • Supply chains problems and increased demand coming out of COVID-19 has increased prices.
  • Demand Pull with Cost Push as the same time.
  • Used car prices have increased by 45% over the last year
  • Food and Fuel are a big part of the expenditures of those in the poor world.
  • Central Banks in emerging markets have to be ‘other toes’ in controlling inflation – Brazil, Mexico and Peru all increased interest rates this year.
  • Inflationary expectations are another concern – self-fulfilling.

Evergrade and China’s dependency on building stuff.

Since the economic reforms initiated by Deng Xiaoping over 30 years ago the Chinese economy has relied on investment growth to drive its economy. The World Bank has estimated that China’s annual growth rate over the last ten years has averaged approximately 9.8% of which expenditure on investment accounts for 6-8%. For future growth China cannot be dependent on this model of investment growth as, not only is it unsustainable, but the carbon footprint will become increasingly intolerable.

Between 1995 and 2010 China’s average growth rate was 9.9% but total investment in infrastructure and real-estate projects rose on average by 20% each year accounting for approximately 42% of GDP. In 2018 as a % GDP (5.57%), China’s average infrastructure spending in 2018 was 10 times higher than that of the United States and significantly higher than anywhere else in the world. What also has been increasing China’s investment rate is the declining efficiency of investment capital which is reflected in its high incremental capita-output ratio – annual investment divided by annual output growth.

Too much supply
With the increased investment by companies too, there is an issue with overproduction in which producers tend to look to international markets as domestic demand has been exhausted. This assumes that the international market for goods and services is buoyant, but the impact of global financial crisis in 2008 resulted in surplus products, lower prices and falling profits. As with many developed countries, China has expanded credit in order to maintain demand, but this can lead to a repeat of what caused the crisis originally.

Evergrande
Corporate sector debt in 2011 was 108% of GDP but this increased to over 160% in 2020. Most of the debt been brought about by new development including housing. This sounded alarm bells as the return on this investment will take a lot longer than planned when you consider that the occupancy rate of apartments is approximately 25%.

But an even more important reason behind the continued insistence on superblock planning is the reliance of Chinese city governments on land lease revenue. Sincethe tax-sharing reform of 1994, cities have been obliged to fork over an enormous percentage of their tax revenue to the central government. In order to generate enough revenue to cover social services and other costs, cities have come to rely heavily on China’s land-lease mechanism that allows the city to rent parcels of land to private developers for a period of 70 years. Thoughts from the Frontline

Evergrande and similar building developments have maintained social order and geared the revenue that officials have wanted. Capitalism with Chinese characteristics?

Unfortunately this building boom has led to many Ghost Cities in China where apartments lay empty and have done so for many years. Below you can see what one developer did when he ran out of money in 2013 – the empty towers were imploded in Kunming this year.

Final thought

In a response to changes in both domestic and international economic developments, China will need to create a new growth model and ensure that development is based on improved quality and performance. An integral part of this development is to support and guide the private sector and ensure that it can enjoy an equal chance of success in competing against government-run organisations. By enlarging domestic demand and science and technological innovation there is more likelihood of acquiring a sustainable economic model that is not dependent on infrastructure development, housing and export markets.

Source: Thoughts from the Frontline – Xi’s Changing Plan. John Mauldin – 2-10-21

Stephanie Kelton – TED Talk

Recent TED talk by Stephanie Kelton on Modern Monetary Theory – MMT – in which she makes the case to stop looking at government spending as a path towards frightening piles of debt, but rather as a financial contribution to the things that matter — like health care, education, infrastructure and beyond. “We have the resources we need to begin repairing our broken systems,” Kelton says. “But we have to believe it’s possible.” The table below looks at the difference between mainstream monetary policy and modern monetary policy.

What determines the Neutral Rate of Interest?

Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.
The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.

OCR > Neutral Rate = Contractionary and slowing down the economy

OCR < Neutral Rate = Expansionary and speeding up the economy

This neutral rate dictates when the RBNZ end their tightening or loosening cycle. If the neutral rate is seen to be 3% it is the expectation that the RNBZ will increase the OCR to 3%. The graph below shows the difference between the estimated neutral rate and the OCR. Note that:

2008 – positive gap as RBNZ trying to bring inflation under control – contractionary level
2019 – the gap narrows and monetary policy becomes less stimulatory as the neutral of the OCR is likely lower.

What determines the neutral rate of interest in an economy?

Supply of loanable funds (people who save money) and Demand to borrow money – neutral rate generates a level of savings and borrowing that delivers the economy to maximum sustainable employment and inflation – 2% in NZ but with Policy Target Agreement of 1-3%.
Potential growth rate of an economy – if people expect more growth = higher incomes = higher borrowing = upward pressure on neutral rates. Economists tend to look at the production function and how much we can produce in the long-run therefore impacting aggregate supply. With higher potential growth rates investment spending is expected to increase and with it interest rates.
Population growth – strong population growth = larger labour force = larger national output which supports the neutral rate of interest.
Age and life expectancy – higher life expectancy increases the amount that people save during their working years. If consumers buy now rather than later = potentially either lower saving rates and/or higher borrowing = neutral rate of interest rises.
Superannuation / retirement age – burden of funding retirees fall on a smaller working age population. This could require higher taxes which leads to less spending putting downward pressure on interest rates.
Debt – with low mortgage rates, debt servicing have been at record lows. People have therefore borrowed a lot money and now have high level of indebtedness levels. Therefore higher mortgage rates mean that consumers disposable income will be reduced.
Government debt – COVID-19 has led to increased government spending and bigger budget deficits. New Zealand economy is probably as sensitive to higher interest rates and an increase in rates by the RBNZ will be very influential, limiting how far interest rates have to rise. And with households and the Government already loaded up on debt, future borrowing capacity is now reduced, which will put downwards pressure on interest rates too.
Overseas investment – as New Zealand comes a more attractive place to invest it increase the supply of loanable funds to New Zealanders. The investment will also strengthen the dollar which make exports less competitive but imports cheaper. Global capital flows mean that we can’t get too far out of sync with other advanced economies – as long as global neutral rates continue their relentless move south, so too will New Zealand’s.

Outlook
With the COVID-19 lockdown, increasing levels of debt amongst households and business and record low interest rates there is an expectation the RBNZ will increase the OCR. But with the OCR at such a low level already the RBNZ is running out ammunition if it wishes to stimulate the economy through conventional monetary policy.

Source: NZ Insight: Neutral interest rates – 20th August 2021 – ANZ Bank

A2 Economics – Wage Price Spiral and the Long Run Phillips Curve

Part of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve.During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

Inflation – causes and examples from the global economy.

Here is an excellent video from CNBC which includes news clips from the 1970’s and beyond. Below are some of the main points:

  • 1960 – pint of milk in the UK 3p. Today 50p
  • Cost Push Inflation – today: supply-chain bottlenecks, shipping costs rising, labour shortages
  • Demand Pull Inflation – usually associated with an economy operating near full capacity
  • Milton Friedman – inflation a monetary phenomenon and the domain central banks.
  • With the expansion of money why has there been little inflation recently? Velocity of circulation is not evident – i.e. number transactions.
  • CPI – Headline Inflation but Core Inflation is more valuables it takes out volatile components of the CPI which have no reflection on the strength of their economy – e.g. oil. Gives you a better idea of the inflation trend.
  • A little bit of inflation is good – ‘Goldilocks’ not too hot but not too cold.
  • Hyperinflation – Brazil – 1980-1995. Weimar Republic – issues 100 Trillion D Mark note.
  • !970’s – Stagflation – wage price spiral – higher interest rates 20% – trade-off was the higher unemployment rate.
  • Central Banks – focus on inflation but also avoid a deflationary environment.

The New Corporation – Documentary

Following on from the very successful documentary ‘The Corporation’ comes ‘The New Corporation’. The Corporation​ examined an institution within society. THE NEW CORPORATION reveals a society now fully remade in the corporation’s image, tracking devastating consequences and also inspiring movements for change. Click on the link below to view screening options – The New Corporation