Government Macroeconomic

Intervention
Government Policy Objectives
Economic Policy

 Definition -> Attempt made by the Government to generate increases in

economic welfare

 After the Great Depression -> Recognition that the Government & Monetary

Authorities are responsible to advocate for economic welfare

 Methods -> Controlling Inflation, Unemployment and Economic Growth

 2 Main Types of Policies -> 1)Demand-Side Policies & 2)Supply-Side Policies

Demand-side Policies

 Definition -> Economic policies that influence the level of Aggregate Demand

 2 Main Types -> Fiscal Policy & Monetary Policy

Supply-side Policies

 Definition -> Economic policies that influence the level of Aggregate Supply

Macroeconomic Objectives

Objective Explanation
Must be Sustainable -> Does not exhaust natural
resources or cause too much pollution; Increase in
1)Economic Growth Living Standards; High Growth Rates -> May be very
good for developing countries; No Excessive
Structural/Environmental Difficulties
Lack of Rapid Inflation/Deflation; Does NOT Mean 0%
2)Price Stability -> Governments target steady levels of low-moderate
inflation; High Rates Must be Prevented -> Since it
 Objective Explanation
results in the following: reluctant investors, menu costs,
concerns those on fixed incomes
3)Full Employment - Target -> 0% Cyclical Employment; Natural Rate of
> Those willing and Unemployment -> Some seasonal, frictional and
able to have a job can structural unemployment are acceptable & inevitable in
get one the economy
In the Long-Run -> Value of Exports = Value of
4)Equilibrium in the Imports**; In Any Given Year ->** Country may run a
Balance of Payments deficit/surplus; not an issue unless it persists in the
long run
5)Income & Wealth
Inequality - Fair Distribution -> Subjective, not a matter of simply
> Addresses the deciding on a fixed number; If Small Group has Very
distribution of Large Proportion -> Could lead to social unrest and
income/wealth of a dissatisfaction with the Government
nation

Fiscal Policy
Government Budget

 Definition -> Annual financial statement showing the estimates of expected

revenue and spending during a fiscal year

 Budget Deficit -> Government Spending is greater than Tax Revenue

o Cyclical Deficit -> Due to slowdown/recession in the Economy

o Structural Deficit -> Consistently spending more than tax revenue;

fiscally irresponsible Government

 Budget Surplus -> Government Spending is smaller than Tax Revenue

National Debt

 Definition -> Amount of money Government owes both domestically and abroad,

which has accumulated over the years

 In Other Words -> The accumulation of a nation’s budget deficit over time
  Government ends up Needing to Raise Extra Finance -> Printing more

money, or by borrowing even more money

o Printing Money -> Reduces its actual value in the greater scheme/term,

leading to inflation

o Further Borrowing -> Either short or long term, and domestic or foreign

sources

o Main Takeaway -> Either method increases the National Debt

 Main Issue -> When large proportion is owed abroad, or it looks as if it can’t be

paid

 Domestic Debt -> Paid back to those with government bills through tax revenue

 National Debt is NOT the Same -> National debt is internal, while BOP is

external

Automatic Stabilisers

 Definition -> Mechanisms built into Government’s Budgets in order to stimulate

AD when economy requires a boost

 When AD’s Situation Improves -> These stabilisers automatically turn off

 Recession -> Ease financial stress by decreasing tax bills, or giving away State

benefits

o Without changes in the tax code or legislation

 Limit the Impact of Changes in the Economic Cycle -> Recession, Expansion

Reasons for Taxation

 Reason Explanation
1)Raise Revenue for Taxation is used along other methods
Government Spending simultaneously
Taxation is one of various methods to meet the
2)Manage Aggregate Demand
Government’s economic objectives
3)Alter Distribution of Income Income tax’s aim is to take money from the
& Wealth better off and give it to the poorer
4)Manage Market Failure or Taxation is one way in which market failures
Environmental Issues can be reduced/minimised
Main Types of Taxes

Type of
Definition Examples
Tax
Direct Tax levied directly on incomes & Income Tax, Corporation Tax,
Tax wealth, individuals or firms Inheritance Tax, etc
Indirect Levied when goods & services are Value Added Tax (VAT),
Tax bought, taxes on expenditure Goods & Services Tax (GST)
 Excise Duty // Specific Tax -> Amount charged, Ad Valorem Tax = % Rate of

the Basket

1)Progressive Tax

 Definition -> Proportion of income paid in tax increases as income increases

 Marginal Rate of Tax Increases

 Great Eg. -> Income Tax; richer people spend a greater proportion of their

income in income taxes

2)Regressive Tax

 Definition -> Proportion of income paid in tax falls as income increases

 Marginal Rate of Tax Decreases

 Great Eg. -> IVA, VAT, GST; poorer people spend a greater proportion of their

income in consumption taxes

3)Proportional Tax

 Definition -> Same proportion of income is paid in tax, independent of the level

of income

 Marginal Rate of Tax = Average Rate of Tax

 Average Rate of Tax -> Average percentage of total income that is paid in taxes

 Great Eg. -> Corporation Tax

**

**

Rates of Tax

 A)Average Rate of Tax

o Alias -> “Effective Rate of Tax” ; “Average Propensity to Pay Tax”

o Calculation -> ART = (Total Tax Due) / (Total Taxable Income)

 B)Marginal Rate of Tax

o Alias -> “Proportion of Increase in Income which is Taken in Tax”

o Calculation -> MRT = (Change in Tax Due) / (Total Taxable Income)

 MRT is Greater Than ART as Income Increases -> In progressive tax systems

Government Spending
  A)Capital Expenditure

o Definition -> Spending by the Government on goods & services intended

to create future benefits

o Alias -> Government Investment; Gross Capital Formation

o Infrastructure -> Roads, buildings, etc.

o Health & Education -> New hospitals, Schools or Sewage Systems

o Research/Innovation -> Defence, Space or Vaccinations

 B)Current Expenditure

o Definition -> Government Consumption spending on goods & services for

current use to directly satisfy the needs of members of the community

 Examples -> Wages of Public Sector’s Workforce, Road Maintenance, etc.

Reasons for Government Spending

Reason Explanation
Public goods (eg. Defence), Merit goods
1)Supply Goods & Services that
(eg. hospitals), and Transfer Payments (eg.
Private Sector Would Fail to Do
Benefits)
2)Achieve Supply-Side Spending on Education = Labour
Improvements in Macroeconomy Productivity
3)Reduce Negative Externalities
Eg. Pollution
Effects
4)Subsidise Industries in Need of
Eg. Agriculture
Financial Support
5)Redistribute Income Thus achieve more equity
6)Inject Extra Spending into Help increase Aggregate Demand and
Macroeconomy Economic Activity
Types of Fiscal Policies
  Definition -> Use of Government Revenue and expenditure to control the

economy, including Government borrowing

 Purpose -> Influence the level of AD within the economy

 Fall in Tax -> AD rises since consumers can spend more + firms have more

disposable (net) revenue to invest into business

 Government Expenditure -> Defence, Social Services, Infrastructure and

Education

o Financed through Taxes

 Important Note -> Fiscal Policies may be used as a means of Supply-Side

measures

 Discretionary Policy -> Actions taken in response of economic events

o Extreme Measures -> In order to offset the complex economic scenario

Feature Being Expansionary // Contractionary //

Assessed Reflationary Fiscal Policy Deflationary Fiscal Policy
Use of fiscal policy to enable Use of fiscal policy to reduce
Definition the economy to grow, the size of the economy,
increase the level of AD decrease in the level of AD
Cut in Taxes, Increase in Rise in Taxes, Decrease in
Government Spending; Main Government Spending; Main
Methods
Outcome -> C rises, I rises, Outcome -> C falls, I falls, G
G rises falls
Unemployment Falls Rises
Rises, since Price Level Fall, since Price Level
Inflation
increases decreases
Balance of
Possible Deficit N/A
Payments
Results in Surplus, as
National Budget Results in Deficit Generally Government Revenue is
increased
AD/AS Analysis of the Impact of Fiscal Policy

 A)Expansionary // Reflationary Fiscal Policy

o Long Run

o **

**

o Expansionary Causes

 Fall in Taxes

 Rise in Government Spending

o Expansionary Effects

 AD Rises -> AD -> AD1

  National Income Rises -> PL*Y -> PL1Y1

 Real GDP Rises -> Y* -> Y1

 Unemployment Falls -> Y* -> Y1

 Price Level Rises -> P* -> P1

o Short Run

o **

**

 B)Contractionary // Deflationary Fiscal Policy

o Long Run
o **

**

o Contractionary Causes

 Rise in Taxes

 Fall in Government Spending

o Contractionary Effects

 AD Falls -> AD -> AD1

 National Income Falls -> PL*Y -> PL1Y1

 Real GDP Falls -> Y* -> Y1

 Unemployment Rises -> Y* -> Y1

  Price Level Falls -> P* -> P1

o Short Run

o **

**

Monetary Policy
Monetary Policy

 Definition -> Central Bank’s use of interest rates, money supply and exchange

rates to control the economy

 Type of Demand-Side Policy

 Instruments // Methods
 1. Controlling Interest Rates

2. Targeting the Money Supply

3. Maintaining the Exchange Rate

 Central Bank

o Definition -> Public institution that manages the currency of a country (or

countries), controls the money supply and monetary policy

 Purpose -> Price Stability; some are required to enhance full employment

1)Interest Rates

 Definition -> Cost of borrowing money, and reward on lending/saving money

 Interest Rate Policy -> Use of interest rates to influence AD, through consumers

and businesses

 Other Banks -> Set their rates according the Central Bank’s base rate

o Purpose -> Ensure targeted inflation rate and liquidity in the economy

Type of Cost of
Interest Spending v/s
Interest Rate Borrowin Savings
Rates Saving
Policy g
Lower,
Lower
hence Discouraged
Rates; Main
people , since
Outcome: Spending greate
Expansionary can reward for
C rises, I r than Saving
borrow saving is
rises, AD
more lower
rises
money
Higher Higher,
Rates; Main hence Encouraged,
Spending
Contractionar Outcome: people since reward
is smaller
y C falls, I borrow for saving is
than Saving
falls, AD less higher
falls money
2)Money Supply
  Definition -> Total amount of money circulating in an economy at a given time

o Considers: Coins, Notes, Deposits, Current Accounts, etc.

 Controlling Supply -> Very complex, hence this method has been mostly

replaced by managing interest rates; yet it’s still relevant and applicable

 Quantitative Easing -> Central Bank prints money to buy paper assets in order

to increase money supply

Effect on Money to Consumption & AD

Interest Rates
Money Supply Lend Investment Curve
More Falls, since the
Increased
money to value of lending Both rise Rises
Money Supply
lend is lesser
Less Rises, since the
Decreased
money to value of lending Both fall Falls
Money Supply
lend is greater
Credit Regulations

 Definition -> Use of qualitative control measures by the Central Bank to regulate

the consumer credit on certain products

o Certain Products -> Mainly the ones affected by inflation or deflation

 Inflation -> Central Bank aims to make borrowing and spending harder

o Main Outcome -> Price Level Falls = Stability

 Deflation -> Central Bank aims to make borrowing and spending easier

o Main Outcome -> Price Level Rises = Stability

3)Exchange Rates

 Definition -> Cost of domestic currency in relation to other currencies

 Higher Interest Rates -> Domestic currency appreciates in value

 o AD Falls -> Net Exports fall, since exports become more expensive

abroad and imports become cheaper

 Attracts Foreign Depositors -> Increases the demand for the domestic

currency (hot money flows)

Type of Monetary Effect on AD

Net Exports
Policy Exchange Rates Curve
Appreciation of Fall, exports become less
Contractionary Falls
Currency competitive abroad
Depreciation of Rise, exports become
Expansionary Rises
Currency cheaper abroad
AD/AS Analytics of the Impact of Fiscal Policy

 A)Expansionary // Reflationary Monetary Policy:

o Definition -> Policy aimed at increasing the level of aggregate demand

within the economy

o Method -> Focuses to expand the money supply within the economy

1. Decreasing Interest Rates -> C and I rise

2. Increasing Money Supply -> C rises

3. Decreasing Exchange Rate -> X rises

o Acceptable Tradeoff -> Inflation rises

o Long Run
o ** **

o Expansionary Effects

 AD Rises -> AD -> AD1

 National Income Rises -> PL*Y -> PL1Y1

 Real GDP Rises -> Y* -> Y1

 Unemployment Falls -> Y* -> Y1

 Price Level Rises -> P* -> P1

o Short Run
 o **

**

 B)Contractionary // Deflationary Monetary Policy

o Definition -> Policy aimed at decreasing the level of aggregate demand

within the economy

o Method -> Focuses on decreasing the money supply within the economy

1. Increasing Interest Rates -> C and I fall

2. Decreasing Money Supply -> C falls

3. Increasing Exchange Rate -> X falls

o Purpose -> Cool off the economy and reduce inflationary pressures

o Long Run
o **

**

o Contractionary Effects

 AD Falls -> AD -> AD1

 National Income Falls -> PL*Y -> PL1Y1

 Real GDP Falls -> Y* -> Y1

 Unemployment Rises -> Y* -> Y1

 Price Level Falls -> P* -> P1

o Short Run
 o **

**

Supply-Side Policy
Supply-Side Policy

 Definition -> Policy that helps to improve a country’s productive potential of the

economy

 Purpose -> Shift the Long-Run Aggregate Supply Curve (LRAS) to the right

 Method -> Increasing the quantity or quality of the FOPS

  **

**

 Effects on Macroeconomy

1. Economic Growth -> Real GDP rises

2. Unemployment -> Falls

3. Price Level -> Falls

 Important Note -> There is a notable time-lag in the effect of Supply-Side

policies on LRAS

Objectives of Supply-Side Policy

 Purpose -> Improving productivity and productive capacity of the economy

  Microeconomic Measures -> That influence the Macroeconomy

 Productivity -> Quantity of goods & services produced per unit of input

o Increasing Productivity -> Real output can rise without an increase in

the price level

 Productive Capacity Increase -> Potential output of the economy has increased

o Shifting LRAS Outwards = PPC Outwards -> Supply-side policies’ effect

can be shown in either PPCs or LRAS graphs

 **

**

Tools of Supply-Side Policy

1. Labour Market Measures

2. Product-Market Measures

1)Labour Market Measures

 Definition -> Policies that involve increasing Government intervention in the

development of the FOPS

  Alias -> Interventionist Supply-Side Policy

 A)Pressuring Trade Unions -> Enhance working of the labour market

 B)Education & Training -> Improves worker’s human capital, productivity

improves

 C)Tax and Benefits -> Lower tax rates encourage people to work, so does

lowering unemployment benefits

o Lower Corporate Tax -> Encourages firms to try and be more efficient,

since they can keep more of their profits

2)Product-Market Measures

 Definition -> Policies that involve decreasing Government intervention or

involvement in markets

 Alias -> Market-led Supply-Side Policy

 A)Privatisation & Deregulation -> Introduce competition into market, thus

improving efficiency and productivity

 B)Investment in Technology -> Productivity and Efficiency would improve

o Financing -> Done through grants or through the tax system

o Main Outcome -> Encourages a more entrepreneurial culture

 C)Reduction in Red Tape -> Allows businesses to establish themselves, or to

make changes

Shifting the PPC Outwards

 Main Factors

o Immigration

o Deregulation
 o Labour Market Participation

o Innovation

o Investment

o Productivity Gains

o Education

 **

**

AD/AS Analysis of the Impact of Supply-Side Policy

 Determinants of the Outcome of Supply-Side Policy

1. Shape of the AS Curve

2. Whether other Policies are Considered

3. If AD is also Changing
  **

**

 Eg. Better Education

o AS Curve Rises -> AS -> AS1

o Equilibrium National Income -> Rises

o Real GDP Rises -> Y -> Y1

o Unemployment Falls -> Y -> Y1

o Price Level Falls -> P -> P1

Interaction Between Changes in AS & AS

  **

**

 Original Equilibrium -> PY, AD = AS

 If AD Rises to AD1 -> NNI, Real GDP and Employment all rise to Y1; Price

Level rises to P1

 AS Rises to AS 1 Simultaneously -> This further reinforces the rise in output

o Price Level -> Returns back to P (original stability)

Evaluating Supply-Side Policy

 Interventionist Policies -> May increase aggregate demand, due to an increase

in Government Expenditure

 Other Policies -> May have harmful effects on consumers, workers and the

environment

o Environmental Deregulation -> Leads to negative externalities to society

  Supply-Side Policies -> Usually effective at shifting LRAS

o Main Downside -> They may take years in order to show their results

International Economic Issues

Terms of Trade
Absolute v/s Comparative Advantage

 A)Absolute Advantage -> Ability to produce more of a product than another

country, with the same amount of resources

 B)Comparative Advantage -> Ability to produce a product at a lower opportunity

cost than another country (in comparison)

 International Trade -> Makes it possible for all countries to benefit from other

countries’ comparative advantages

o Even when one of the countries is more efficient at producing all products

Benefits of Specialization // Free Trade

 Example Scenario) Japan v/s Sweden

 Main Assumption -> Assume that only one person is available, and shares its

time equally between cars and toys


Cars Toys

Sweden 2 8
Japan 8 2
Analysis

 Terms of Trade -> 1:4 (Sweden) and 4:1 (Japan)

 Sweden -> AA in toys

  Japan -> AA in cars

 To Increase Total Output -> Both countries should specialise in their AA good

After Specialization

Cars Toys
Sweden 0 16
Japan 16 0
 Both Countries can Trade -> As long as they stay within their terms of trade

(1:4, 4:1)

 Possible Exchange Rate -> 1:1

o Sweden -> Gives up 6 toys

o Japan -> Gives up 6 cars

After Free Trade

Cars Toys
Sweden 6 10
Japan 10 6
 Overall Benefit

o Sweden -> Gained 2 toys, 4 cars

o Japan -> Gained 4 toys, 2 cars

 Main Outcome of Specialisation + Free Trade -> Both countries have more

from each good than previously

Terms of Trade

 Definition -> Ratio of a country’s export prices to import prices

 Exports -> Sale of goods & services abroad

 Imports -> Purchase of goods & services from abroad

  Calculation -> Terms of Trade = (Index of Export Prices) / (Index of Import

Prices) * 100

o Rise in Index = Improvement in the Terms of Trade -> More imports

can be purchased with the given amount of exports

o Fall in Index = Deterioration in the Terms of Trade -> Less imports can

be purchased with the given amount of exports

Free Trade Benefits

1)Lower Overall Price

2)Greater Choice of Goods for Consumers
3)Firms benefit from Economies of Scale
4)Increased Exports
5)Specialisation -> Countries gain an increase in economic welfare
Causes of Changes in Terms of Trade

Cause Explanation
Expansion of world trade in goods & services + capital flow,
1)Globalisation
leading to international interdependence
Increased demand for raw materials may push up prices,
2)Economic
improving the terms of trade of primarily exporting countries
Development
(eg. Canada or South Africa)
If Inelasticity of Exports is greater than Imports’ -> Terms
3)Price Elasticity
of trade will improve, since export prices can be increased
of Demand
further than import prices
Import Demand Increases -> Terms of trade
4)Economic worsen; Supply of Import Substitutes Increases -> Terms
Development of trade improve; More Goods for Exports -> Terms of
trade improve
Depreciation or Devaluation -> Terms of trade worsen;
5)Exchange Rate export prices have fallen, import prices have risen (relative to
the domestic currency)
 Cause Explanation
6)Protectionist Eg. Tariffs -> When these measures are taken, import prices
Measures are likely to fall, overall improvement in the terms of trade
7)Population More Goods are Demanded -> Therefore import demand
Growth rises, overall worsening in the terms of trade
Monopoly in a Good’s Production -> It can raise the
8)Competition good’s national price, overall improvement in the terms of
trade
**Competition Rises ->**Either lowers the prices of country’s
exports, or improves other country’s export availability \n
9)Globalisation
**Exporting Countries ->**Terms of Trade Worsen
\n Importing Countries -> Terms of Trade Improve
Impact of Changes in Terms of Trade

 Main Factor -> Depends on the PED of imports and exports

Effect Explanation
If Terms of Trade Improve, but both PEDs are Elastic -
> Overall worsening of trade balance + possible
unemployment, since total export income falls and total
1)Trade Balance import spending rises** \n **If Terms of Trade Improve,
but both PEDs are Inelastic -> Overall improvement of
trade balance, since total export income rises and total
import spending falls
**Usually Dependent on Raw Material Exports ->**Fall in
their export prices significantly deteriorate their terms of
2)Developing trade; ** \n Standard of Living Falls -> Earn less from same
Countries volume of exports, cannot afford to import as much \n
**Important Note -> The opposite holds true; improvement
in terms of trade is likely to improve its standards of living
If Terms of Trade Improve -> Export prices increase more
than import prices; fall in competitiveness and export
3)Price demand; damages the BOP** \n Export PED -
Competitiveness > Determines how much export demand falls \n **If Terms of
Trade Worsen -> Rise in competitiveness and export
demand; benefits the BOP

Protectionism
Protectionism
  Definition -> Action designed to reduce international trade

 Main Reason -> Countries fear that without trade barriers, domestic industries

may not be able to compete with foreign imports

 Opposite -> Free Trade

1)Tariff

 Definition -> Tax/Duty on a particular product as it is being imported

 Either Specific or Ad Valorem

 Purpose -> Shift good’s supply curve to the left

o Main Outcome -> Import’s Competitiveness falls, Price rises, Quantity

Demanded Falls

o Extent of Fall in Qd -> Depends on the Import’s PED

 Domestic Industry -> Sees its competitiveness increased, hence its own

production sales rise

 Main Drawback -> Consumer welfare is reduced

  **

**

2)Import Quota

 Definition -> Legal limit on the quantity of the good that can be imported to a

country

 Eg. USA -> Quota on sugar imports

 Licences -> Are given to firms allowing them to import up to a set limit

 Consumer Welfare Loss -> Greater loss than tariffs, since no tax revenue is

generated
  **

**

3)Export Subsidy

 Definition -> Money given to an exporter, so that the price of a good can be

reduced, thus more competitive internationally

 Increases Sales -> Output and Employment Increase

 Drawback -> May increase inefficient allocation of resources

o Government -> Could have used the money to focus on goods with

potential comparative advantage

 Main Effect -> Long-term economic growth may be reduced

4)Embargoes

 Definition -> Complete ban on products from a particular country

 Political Reasons -> Embargoes are usually the result of disputes between

nations or during times of war

  Placed on Dangerous/Harmful Products -> Eg. Drugs

 Longest Standing Embargo -> USA on foreign trade with Cuba

5)Excessive Administrative Burdens // Red Tape

 Definition -> Excessive “red tape” imposed on importers, in order to make

importing more difficult

 Purpose -> Limit the quantity of imports of particular products into a country

 Types of Red Tape -> Establishing Health/Production Standards, Detailed

Documentation, Scarce Set Entry Points, Multiple Procedures and Tedious

Documentation Processes

 Main Outcome -> Benefits domestic producers but consumer welfare is reduced

(due to sharper scarcity of imported available options)

Arguments for v/s Against Protectionism

1)Infant Industry
2)Unfair Competition
3)Unemployment
4)Sunset Industries
5)Dumping
1)Infant Industry

 Definition -> Industry expected to have a comparative advantage, yet small and

unable to compete with foreign established industries at the moment

 Protectionism -> Enables infant industry to establish its comparative advantage

and compete in its own right

o Short Run -> Higher Prices

o Long Run -> Lower Prices in the Future

  Issues -> Accurately identifying infant/sunrise industries is uncertain and

subjective, and deciding when they are able to compete without protection gives

rise to discussion

 Diversification -> High dependence in production of single good (1ry material)

leads to instability

o Protectionism Allows Development of New Industries -> This reduces

monoproduct dependence (especially of developing countries)

o Developing Countries -> Embrace this argument to justify their trade

barriers

 Sunrise Industry -> New industries rapidly growing that are believed to have

potential to be a market leader in the future

o Important Note -> The same arguments from Infant Industries apply to

Sunrise Industries

2)Unfair Competition

 Countries May Have Vast Supplies of Low Cost Labour -> Eg. China and

India can sell at prices with industrial countries can not compete with

 Compelling Argument for Protectionism -> If exploitation of labour can be

proved

 Not Justifiable -> Comparative Advantage theory explains how countries benefit

when opportunity costs differ

o Industrial Nation’s Should NOT Attempt to Compete -> Rather, they

should specialise in products they do have CA on

  Retaliation -> Country employs restrictions on trade in order to retaliate against

other country’s protectionist measures

o Not Justifiable -> As retaliation usually leads to a significant fall in world

trade and welfare globally

3)Unemployment

 Protecting Home Industries -> Increases competitiveness of national

industries, preserving the employment in the country

 Argument Used Alongside Infant/Sunrise Industry Arguments

 Major Flaw -> One must realise why home industries couldn’t compete in the 1st

place

 Higher Costs than Overseas = Lack of Comparative Advantage -> This

means nation should instead compete in markets where they do have CA

 Other Methods for Solving Unemployment -> Monetary, Fiscal and Supply-

Side Policies

4)Sunset Industries

 Definition -> Industries that have lost their comparative advantage; usually

industries that established themselves long ago and that demonstrate a decline

in productivity and fruition

 FOPS are Immobile -> This supposedly justifies that sunset industries can not

shift to expanding industries (thus why protectionism could theoretically be

justified)

 Temporary Protection -> Justified, to enable FOPS to migrate + prevent

structural unemployment
  Long-Term Protection -> Not justified, since it sharpens inefficiency + reduces

consumer welfare

5)Dumping

 Definition -> Sale of good in foreign market at a price below its marginal cost of

production

o Sold Below the Marginal Price -> Sold at a price that domestic

producers can not compete at marginally

 Persistent Dumping -> May continue indefinitely since exporting firm could be a

monopoly

 Difficult to Justify Protectionism -> Exporting country has CA in good’s

production

o Importing Country -> Receives lower prices + welfare gains

 Predatory Dumping -> Intention of destroying foreign competition, involving

predatory pricing

o Importing Country -> Experiences temporary benefits, but is later

affected; domestic industry is destroyed + loss of competition, overseas

monopoly may form

 Protectionism -> Only rationally justified in cases of predatory dumping

Balance of Payments
Current Account

 Definition -> Record of transactions in terms of trade in goods, services and

primary & secondary income

 Trade in Goods -> Export and import of goods

 o Alias -> Visible Trade

 Trade in Services -> Export and import of services

o Alias -> Invisible Trade

 Primary Income -> Income from interest, profits, dividends from foreign

investment + payments from people living overseas

 Secondary Income -> Transfer of money that is not an investment, without

receiving anything in return, Eg. Donations, overseas aid, military grants, etc.

 Surplus -> Payments received greater than payments made by the country

 Deficit -> Payments received smaller than payments made by country

 Balance of Trade -> Visible + Invisible Balance

Calculating the Balance of the Current Account

 Balance of the CA -> Difference between money flowing in and money flowing

out

o Components -> Trade in goods & services and 1ry and 2ry income

 Imbalance in the CA -> Either a deficit (negative figure) or a surplus (positive

figure)

 Example -> Trade in Goods = 373,149 credits + 504,029 debits = -130,880

deficit imbalance of trade in goods

 Balance of Trade in Goods & Services -> Trade in Goods Balance + Trade in

Services balance

UK Current Account Balance of Payments

Credits Debits Balance

Trade in Goods 373,149 504,029 -130,880
 Credits Debits Balance
Trade in Services 317,674 217,296 100,378
Balance of Trade 690,823 721,325 -30,502
Primary Income 207,497 244,810 -37,313
Secondary Income 18,040 45,535 -27,495
Total Current Account 916,360 1,011,670 -95,310
Financial Account

 Definition -> Record of the movement of money in the form of investments by

residents of a country and inward flow of investment

 Net Portfolio Investment -> Shares/stocks, Government/Corporate bonds and

derivatives

 Net Foreign Investment -> E.g. Huawei opens research facility in the UK

 Reserve Assets -> Holdings of foreign currencies

Capital Account

 Definition -> Capital transfers, including transfer of ownership of fixed assets or

non-financial assets

 Examples -> Cash grants, patents, copyrights

Balancing Item

 Definition -> Difference between the current account and the capital and

financial accounts

 Purpose -> Address errors and illustrate statistics

Causes of Imbalances in the Current Account

 Deficit Surplus
Excellent Reputation
Limited Domestic Production -> Country relies on in Production -
imports > Export demand
increases
Higher Standards of Living -> Demand for a broader
range of goods, imports rise
Unfavourable Terms of Trade -> Country believes they
must export more and more to maintain export
revenue, developing countries particularly
Lack of Competitiveness -> Overvalued currency
and/or greater rate of inflation, exports fall, imports rise
Economic Growth -> Requires import of capital goods
= persistent deficit, consumers become better off, thus
why they demand more imports
Inflation Faster than Competitors -> Exports become
less competitive than imports, results in trade deficit;
may lead to a depreciation to offset this
Lack of Confidence in an Economy -> Due to factors
such as persistent deficits or large rises in Government
deficit, investors may fear political change or lack of a
stable Government
Trading Partners with Negative Economic Growth -
> Buy less of its exports; the opposite happens when
there is rapid growth
Consequences of Imbalances in the Current Account

Effects on Domestic Economy Effects on External Economy

Need to Tighten Fiscal &
Monetary Policies → Reduce
Governments Under Pressure → To
domestic demand + introduce
introduce/increase protectionist measures
supply-side policies, improve
productive capability.
Devaluation of the Exchange Rate
Less Access to Imported → Higher import prices and lower export
Goods → As protectionist prices; Important Note → Effectiveness
policies are imposed depends on Marshall-Lerner and J-Curve,
may lead to further loss of confidence
 Effects on Domestic Economy Effects on External Economy
Fall in Foreign Investment
→ Sine confidence declines, less
economic growth + higher
unemployment

Exchange Rates
Exchange Rates

 Definition: Price of one currency expressed in terms of another currency or

against a basket of other currencies

 3 Types of Exchange Rate Systems: Floating, Fixed, and Managed-Float

 Appreciation: When a floating exchange rate increases in value compared to

another currency

 Depreciation: When a floating exchange rate decreases in value compared to

another currency

Floating Exchange Rate

  Definition: a country’s currency's value is determined solely by supply and

demand market forces.

Causes of Changes in a Floating Exchange Rate

Cause Explanation
**Countries with Deficit ->**End up supplying
more of their currency, leads to depreciation; **
Balance of Payments
\n **Eventually -> Foreign money will start to
Disequilibrium
leave to offset its loss in value, again
increasing the supply of currency
**Country with Rate Higher than Others -
High Inflation
>**Loss in confidence of its currency; ** \n
 Cause Explanation
**People Sell the Currency -> Its supply
increases on the market, leading to
depreciation
**International Money ->**Seeks the highest
return;** \n **If Country Raises its Interest Rate
->**Attracts inflows of money from foreign
Interest Rates
investors; \n **Appreciation -> Since foreign
investors will need to buy the currency to
deposit in domestic institutions
Speculation -> When one or
more people gamble on a
Aim to Make a Profit: By buying it back at a
currency rising (by buying) or
lower price or selling it at a higher price
falling (by selling), a floating
exchange rate increases in value
Impact of Changes in a Floating Exchange Rate

 Price Elasticity of Demand for Exports & Imports: Determine the impact of

exchange rates and Marshall Lerner’s condition

Effect Actual
AD Price Unemploy
Consider Net Exports Output
Curve Level ment
ed (GDP)
Fall: Imports rise Falls, sin
Falls, Falls,
Appreciat since cheaper, ce Net Rises, Y1 -
P1 -> Y1 ->
ion Exports fall since Exports > Y2
P2 Y2
more expensive decrease
Rise; Imports fall
Rises, si
since more Rises, Rises,
Depreciat nce Net Falls, Y2 ->
expensive, P2 -> Y2 ->
ion Exports Y1
Exports rise sinc P1 Y1
increase
e cheaper
Appreciation Impact on the Economy \n
Depreciation Impact on the Economy \n

Trade Weighted Exchange Rate

 Definition -> Weighted average of exchange rates of the domestic currency

against foreign currency

 Weight for Each Country -> Set by its proportion in trade with the domestic

country

E.g. Country X Trades with USA and Japan

 90% of Trade -> USA

 10% of Trade -> Japan

  Base Trade-Weighted Exchange Rate -> 100

 Country X’s Currency -> Rises 10% against USD$

 Country X’s Currency -> Also rises 50% against Yen

 Value of X’s Trade-Weighted Exchange Rate Index -> 114

o USD -> (100*0.9) * 1.1 = 99

o Japan -> (100*0.1) * 1.5 = 15

Trade-Weighted Exchange Rate -> 99 + 15 = 114

Fixed Exchange Rates

 Definition -> Government fixes the value of its currency to another currency, a

basket of currencies, or a commodity, e.g. Gold.

 Revaluation -> Government intervenes to increase the value of its currency

 Devaluation -> Government intervenes to decrease the value of its currency

Policies to Correct Imbalances in the Current Account of

the Balance of Payments
Government Policy Objective

 Stability of the Current Account

Ideal Situation

 CA in Equilibrium -> Inflows of Money = Outflows of Money

 In Reality -> Governments attempt to keep a steady level of imbalance

Persistent Deficit

 Main Issue -> Country could face severe economic problems

 Exchange Rate -> Depreciates with time, purchasing power of domestic

currency worsens abroad

  Inability to Pay International Debts -> May lead to extreme bankruptcy in some

circumstances

Persistent Surplus

 Main Issue -> Produces difficulties for trading partners

o Especially if it’s a Member of Monetary Union -> They are unable to

depreciate their exchange rate to offset the trade surplus

 Eg. Eurozone -> Faced this issue with Germany being in surplus, while Greece

was in debt (both at the same period of time)

Effect of Policies on the Current Account

Type of Policy Effects

Expansionary -> Current Account Improves: since net
1)Fiscal Policy exports rise Contractionary -> Current Account
Worsens: since net exports fall
Higher Interest Rates -> “Hot Money” may appreciate the
2)Monetary
currency; Current Account Improves ; Lower Interest Rates
Policy
-> Imports rise; Current Account Worsens
Promotion of Research & Development -> Intends to create
better/new products to gain competitive advantage; Current
3)Supply-Side Account Improves \n Improvement in Education & Training
Policy -> Improves skills of workforce, quality of graduates
improves; takes time, no guarantee that skills will benefit
the Current Account
Tariffs, Quotas, Etc. -> Domestic goods replace
4)Protectionist imports; Current Account Improves ; Excessive
Policy Administrative Burdens // Red Tape -> Imports more difficult
due to multiple barriers of entry; leads to Retaliation
o