Chapter 6 Macroeconomic Problems.docx

Chapter 6 Macroeconomic Problems.docx

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Chapter6MacroeconomicProblems

Chapter6MacroeconomicProblems

Inflation

Whatisinflation?

•Definition–‘apersistent（sustained）increaseinthepricelevelsinaneconomy’

•Acomplexmacro-economicprinciple!

•Inflationhasbeenthemajor（oroneofthem）priorityformostgovernmentseconomicpolicy

•Neo-ClassicalandMonetaristeconomicpolicyfocusesonthecontrolofinflation

•Keynesianprioritiseunemployment

•Achangeinpriceforafewgoodsisnotinflation

•Therateisrecordedonanannualbasis

•Slowandsteadyinflationisnotbad!

Why?

•Competitive

•ConfidenceinMacroeconomy

•Predictable

•InflationinUK.

•BankofEngland

•Separateentitytothegovernment

•MonetaryPolicyCommittee

•2%TargetInflation

•Havetowritetotheprimeminister/ChancelloroftheExchequertoexplainanddifferencesof/-0.5%

•Atradeoffbetweeninflation,unemployment!

•HowisInflationcalculated?

•CPI–ConsumerPriceIndex（currentindexsince2003）

•InternationallyknownasHICP-coversentirepopulation

•RPI–Retailpriceindex–Headlineinflation

•Includesmortgagepayments–nobasisforinternationaluse

•Usedbygovernmenttocalculatepensionsandbenefits.Privatecontractsforcalculatinghouseholdrentandwagebargaining

•RPIX–excludesmortgagepayments–Underlyingrateofinflation

•RPIY–Excludesmortgagepaymentsindirecttaxes–theCorerateofinflation

Thecausesofinflation

1.MonetaryInflation

2.Cost-pushinflation

3.DemandPull

1.MonetaryInflation

MoneySupplyincreaseRateofInflationincrease

•Important–Onlyifthemoneysupplyisgrowingquickerthantheoutputintheeconomy!

•Demandformoney-whenthevalueofmoneyfallspeopleneedmoretobuythesameamountofgoodsandservices

•Thesupplycurveisvertical–perfectlyinelasticwhy?

•Quantitysuppliedfixedbycentralbank

•Printingmoremoneyeffectivelyshiftsthesupplycurve

•Valueofmoneyreduced–pricelevelincreased

•Quantitativeeasing–increasingthesupplyofmoneythroughtheissuanceofgov’tbondsviathecentralbank

•QuantityTheoryofMoney

•TheorydevelopedbyFriedmanandMonetaristschoolofeconomics

•MV=PT（Fisherequation）

•WhereMismoneysupply,Visthenumberoftimesmoneychangeshands,PisthepricelevelandTisoutputortransactionsintheeconomy

•Bothsidesoftheequationisequaltoexpenditureintheeconomy

•ByholdingVandTconstant（unaffectedbychangesinmoneysupply）itfollowsthatachangeinmoneysupplycausesanequal%changeinthepricelevel

•（selfstudy-researchfisherequation–relationshipbetweenInterestrateandinflation）

2.Cost-pushinflation

•Definition

•‘Asituationforinflationiscausedbyanincreaseinparticularpricesorwages’

•Itisindependentofaggregatedemand

•Higherpricesofrawmaterialssuchasmetal/oiletc.Commodities

•Increaseddemandforhigherwagestocovertheincreasedcostofliving

•Higherwagesthroughtradeunionpressure

•Depreciationontheexchangerateraisecostforimportedgoods

•Highinflationintradingpartnerseconomyifdemandfortheirgoodsisinelastic

•Increasedcorporatetax

•Supplyshocks–war,famineetc

•Tariffs?

Quotas?

3.DemandPullInflation

•Definition

•‘Whereinflationinaneconomyiscausedbyanincreaseinaggregatedemandsuchasanincreaseingovernmentspendingorareductionintheoverallleveloftaxationintheeconomy

•Pullspricesupiftheeconomyhasnosparecapacity

•Increasedconsumerspending

•Lowunemployment

•Lowinterestrates

•Confidenceineconomy

ConsequencesofInflation

•Itdependson:

•Rate

•Acceleratingorstable

•Anticipatedorshock

•Howitcomparestoothereconomies

•ShoeLeatherCosts

•Shoeswornout!

!

!

!

!

•Lookingforthebestinterestratestooffsetinflation（Firmsandindividuals）

•Walkingfrombanktobanketc.

•BeforeInternet/Telephone

•Consumersandfirmslookingforthelowestprices

•Lookingforjobs!

•MenuCosts

•Thecostsinvolvedinchangingprices

•Printingnewmenus

•Labourcostsofchanging1000’sofprices

•Newbrochures/advertisingetc.

•Changingwebsites

•WagePriceSpirals

•Amacroeconomicsituationinwhichrisingpricespushwageshigher;therisingwagesthenincreaseproductioncoststhatleadtofurtherpriceincreases–acontinuousspiral

•Theoutcome–recession-unemploymentetc

TheInflationRate

•LowstableinflationratescausedbyariseinADwillboostfirmsconfidence

•Inflationmaystimulateconsumption

•Nominalinterestratesmaybeloworevennegative

•Leadstodebtburdensfallingi.emortgageratesinREALtermsdecreasing

•RisesinhousepriceswillcreatemoreWEALTH

•Highinflationratesmakeitdifficulttoassesswhatishappeningtothepriceofgoodsandservices

•Confusepricesignals

•Inflationarynoise!

•Producersmayseetheriseinpriceofagoodasincreaseddemandwhenitmayjustbetheresultofinflation

•Leadstoamisallocationofresources

AcceleratingVSStableInflation

•Makesplanningdifficult

•Woulddiscourageinvestment

•Maymakewrongdecisionsbasedonexpectations

•i.e.agreewagerisesbasedoncurrentinflationrate

•AnticipatedInflation–whenthegeneralpricelevelrisesasexpected

•Firms,workers,consumersandgovernmentcanmakenecessaryadjustmentstomaintaina‘levelplayingfield’.Whatadjustmentscantheymake?

•NominalInterestratescanbeadjustedtomaintainrealinterestrates

•Consumerscanidentifyrealandrelativepricechanges

•Producerscansee‘pricesignaling’

•Governmentscanadjusttaxthresholds,pensions,benefitsandpublicsectorpay

•Uncertaintyaboutfutureinflationcausesfallinconsumptionandinvestment

•Borrowersgain/saversloseasinflationerodestherelativeinterestrate

•Incometransferredfromoldtoyoung（Oldpeoplesavemore）

•InternationalPricecompetitiveness

•Inflationwillmakeaneconomy'sexportsmoreexpensive（ifhigherthanthetradingpartners）

•Maydiscouragecapitalandfinancialinvestment

•Ina‘floating’exchangeratetheexchangeratewilldevaluethecurrency–canbeaviciouscircle

Balanceofpayments

•Abalanceofpaymentsmeansthatrevenuefromsellinggoodsandservicesabroadequalsexpenditureonimportsofgoodsandservices.

•Thebalanceofpaymentsisanofficialrecord–account-ofthesepayments.StatisticsonimportsandexportshavebeengatheredintheUKsince1687.

•Asanofficialrecord,thebalanceofpaymentsisbrokendownintotwoaccounts-thecurrentaccountandthecapitalandfinancialaccount.

Thecurrentaccount

•Thecurrentaccountismadeupofthefollowingpayments:

1.Tradeingoods（‘visibles’）-whichincludestheimportandexportof:

balanceoftrade

•Finishedgoods,suchascars,computers.

•Semi-finished,suchaspartsforassembly.

•Commodities,suchasoil,teaandcoffee.

2.Tradeinservices,suchasfinancialservices,tourismandconsultancy-balanceofinvisibles/invisiblebalance

3.Investmentincome,whichincludes:

•Overseasprofits,suchasthosefrombusinessactivitiesofsubsidiarieslocatedabroad.

•InterestreceivedfromUKfinancialinvestmentandloansabroad.

•Dividendsfromowningsharesinoverseasfirms.

4.Financialtransfers,suchasgifts,paymentshomefromimmigrantworkers,donationstocharityandoverseasaid.E.gpaymentfromUKtoEU

•Currentaccount（2009）

•TheCurrentAccountfor2009showedthattheUKhadadeficitof£18b.

Thecapitalandfinancialaccount

•Thisaccountmeasurestheflowsofcapitalandfinance,including:

•Realforeigndirectinvestment（FDI）-suchasaUKfirmsettingupamanufacturingplantinSouthAfrica.

•Portfolioinvestment-suchasUKcitizensbuyingsharesinanoverseasfirminanticipationofalongtermreturn.

•Short-termspeculativeflows,calledhotmoney-wherespeculatorsinvestabroadtoseekoutthehighestshort-termreturn.

•Officialfinancing-whichoccurswhenacentralbankbuysorsellscurrencies,securitiesandotherassetstocreateaninfloworoutflowintheaccounts.InanaccountingsensetheBankofEnglandmustensurethattheaccountbalances.

Officialfinancing

•Thebalancingitem

•Gatheringaccuratedataisahugechallenge,andisimpossiblewithoutadevicecalledthebalancingitem.

•Thereareinevitableerrorsindatacollectionaswellasomissions.Toallowforthese,governmentstatisticiansemploy‘thebalancingitem’,whichcanbedefinedasthedeviceusedtocompensateforerrorsandomissionsinthebalanceofpaymentsdata,andwhichbringsthefinalbalanceofpaymentsaccounttozero.

Currentaccountdeficits

•Adeficitisaproblemif:

1.Itispersistent.

2.ItformsalargeshareofGDP.

3.Therearenocompensatinginflows.

4.Theeconomyhaslowreserves.

5.Theeconomyhasapoorrecordofrepayingdebt.

•UKcurrentaccounthistory

•Thereisastrongconnectionbetweenagrowingeconomyandtradedeficits.

•Astheeconomycameoutofrecessionandintoaperiodofstronggrowthfrom1993thecurrentaccountdeficitbegantowidenrapidly.

•Thecurrentaccountdeficitfellquicklyfrom2008,whentheeconomyenteredadeeprecession.

•Economicgrowthandtradeperformance

•Thestronginverseconnectionbetweenagrowingeconomyandtradedeficitscanbeseeninthegraph.

•Economicgrowthabovetrendrateacceleratestheworseningofthetradebalance.

•Causesofcurrentaccountdeficits

•Thereareanumberofpossiblecausesofapersistentcurrentaccountdeficit,includingthefollowing:

1.Excessivegrowth

•Iftheeconomygrowstooquickly,andrisesabovethe‘trendrate’foraneconomy,whichinth