Category Archives: Growth

Have Central Bankers’ got it wrong?

Below is very good video from the FT – here are the main points:

  • Central Banks – by lowering interest rates they could make savings less attractive and spending more attractive
  • After GFC low interest rate and asset purchases increased lending and avoided a global depression.
  • Now the world economy is not behaving as the central bankers’ said it would
  • Their theory was that with lose credit (lower interest rates) the economy would grow and inflation would rise.
  • Inflation is stagnant (unlike the 1960’s – see graph below) and this is worrying as a little inflation is required to lubricate the economy. It allows prices to fall in real terms.
  • The missing inflation may mean that the bankers’ theories are wrong.
  • Cheap money may have encouraged high asset prices and debt levels but it may undermine the economy without doing much for growth.

Inflation Unemployment.png

IMF’s global growth forecast

Below the FT’s Chris Giles talks to Maury Obstfeld, chief economist of IMF, on how the global economy is growing at its fastest rate in almost seven years. One chart (below) shows a falling unemployment rate with stagnant wage growth – Obstfeld talks of lower labour productivity as the reason for this. Well worth a look and very useful for the prospects of global growth – including developed and developing countries.

Unemp v Wages

Growth from cutting capacity – Chinese way

Economic growth is normally we associate growth with capital investment and a shifting out of the production possibility curve. The Chinese have implemented an alternative policy that entails cutting capacity of its steel and coal production by at least 10% over 5 years which will reduce global supply by 5%. The rationale behind this is that:

less supply = greater scarcity = higher prices = greater profits.

Supply curve leftAlthough there have been doubters over this policy it seems to have worked. Coal and steel prices increased as have the profits in those industries and this has led global markets to be more positive about China’s economy. The higher prices has also reduced the threat of deflation coming out of China. Furthermore the Yuan has appreciated and nominal growth has close to a five year high.

Problems with this policy:

  • The higher price caused by reduced supply raised concerns that supply would lead to surplus capacity.
  • The underlying problem was that cheap loans were forthcoming from Chinese banks for certain projects run by state-owned firms. This can lead to an uncomfortable scenario with the firms being reckless as if their investment runs into trouble they will be bailed out by the government.
  • The reducing of output of steel and coal means a loss of 1.8m jobs which will concern Chinese authorities as a top priority has been to keep unemployment as low as possible and thereby limiting possible unrest that may follow.

The Multiplier explained

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

IMF World Evaluation from the FT

Below is a very good video put together by the FT which summarises the recent IMF Report on the World Economy. Includes:

  • Better growth in China and the Euro zone makes up for slow US growth.
  • US infrastructure spending and tax reform still has to be approved by the senate.
  • Europe looking stronger than expected.
  • Emerging economies still face tough conditions.

Output Gap in Eastern European Countries

Output GapThe Economist had a very good graphic showing the difference between the actual and potential GDP in central and eastern European countries. In Romania a 16% rise in the minimum wage is likely to lift domestic demand and inflation whilst the Ukraine and Bosnia have problems with big negative output gaps where their GDP is well below their potential GDP.

Remember to mention the output gap when doing an essay that involves the business cycle. The output gap is the difference between demand and the economy’s capacity to supply. This is the difference between the ‘actual’ level of output (GDP) and the economy’s ‘potential’ level of output (potential GDP).

  • If the economy is running above capacity (GDP > potential GDP) the output gap is positive.
  • If the economy is running below its full capacity (GDP < potential GDP) the output gap will be negative.
  • There is a sweet spot which is where the level of output is consistent with stable inflation and full employment.

Remember that ‘potential’ output is not an upper limit on the level of output. Rather, think of potential GDP as the economy’s efficient level of output. Running the economy below potential GDP is inefficient because there are some resources that are not employed. Running the economy above potential GDP is also inefficient because resources are over-utilised (eg, machinery is being made to work too hard causing it to wear out too quickly).

While it is efficient to have the economy running at potential, quite often it does not. Resources can be over- or under-utilised, which will translate into inflationary or disinflationary pressure (over-utilisation will push future inflation up, while under-utilisation pushes future inflation down).

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Africa's Resource Curse

Below is a link to an excellent podcast from the BBC World Service. I have blogged on the resource curse before and the falls in commodity prices – oil and mining – over the last year have affected the sub-Saharan African countries that are dependent on their primary industries. There is also mention of GDP being a stupid model. Worth a listen – click on link below.

Africa: The Commodity Curse Returns

In the balance - Resource Curse

For most economies that have natural endowments like oil (Nigeria) or minerals, there is the risk of the economy experiencing the ‘resource curse’. This is when a natural resource begins to run out, or if there is a downturn in price, manufacturing industries that used to be competitive find it extremely difficult to return to an environment of profitability. According to Paul Collier, Nigeria has a resource curse of its own, the civil war trap in which 73% of the low income population have been affected by it, as well as a natural resource trap- where the so-called advantages of a commodity in monetary value did not eventuate – on average affecting only 30% of the low income population. It seems that in Nigeria there is a strong relationship between resource wealth and poor economic performance, poor governance and the prospect of civil conflicts. The comparative advantage of oil wealth in fact turns out to be a curse. governments and insurgent groups that determines the risk of conflict, not the ethnic or religious diversity. Others see oil as a “resource curse” due to the fact that it reduces the desire for democracy.

Click here for more on the Resource Curse from this blog

A2 Economics – The Laffer Curve

New to the A2 syllabus last year was the Laffer Curve. PBS Economics correspondent Paul Solman explores the question of just how high U.S. tax rates should or shouldn’t be and examines the relationship between economic activity and tax rates. There is a good explanation of the Laffer Curve which is the relationship between economic activity and tax rates.

In between, a smooth curve representing Laffer’s pretty simple idea: Somewhere above zero percent and below 100 percent, there is a tax rate where government will collect the most revenue in any given year. Now, the Laffer Curve applies to everyone, but the top so-called marginal rate is only relevant to the rich. It’s now 35 percent on all taxable income in excess of about $380,000 a year. Does that 35 percent rate maximize total tax revenue for the government?

Trump’s tax cuts likely to have limited impact on growth

Donald Trump has indicated that the US economy needs a big tax cut to stimulate some growth and aggregate demand –  C+I+G+(X-M). His rationale is that with consumers having greater income they will spend consume more (C) and businesses keeping more of their profits will invest more (I). He is even so confident that the tax cuts won’t put a dent in the overall tax revenue of the government. However economists are suggesting that the US economy is already growing as fast as it can and in order to improve its growth rate it needs to investment in productivity.

D Pull Inflation.jpegNevertheless, US tax cuts in the 1980’s under Ronald Reagan proved to be very effective in stimulating aggregate demand but the economic environment then was different to that of today. The 1980’s was an era of stagflation with the US experiencing 10% unemployment and inflation reaching 15%. Since the GFC in 2007 growth has been positive and unlike the 1980’s unemployment has been falling  – from 10% in Oct 2009 to 4.4% in April 20178. Tax cuts are all very well when you have high unemployment but with the rate falling to under 5% companies may find it difficult to respond to the greater demand for goods and services by taking on workers to increase supply. Tax cuts would then lead to an increase in inflationary pressure (see graph) which is turn would prompt the US Fed to increase interest rates.

ProductivityTrump’s plan would also increase the Federal deficit and borrowing from the government. This would put upward pressure on interest rates for the private sector which reduces the potential for further growth. As noted earlier the area that needs to be addressed is productivity, with a shift of the LRAS curve to the right – see graph.

The Doughnut Model of Economics

A recent book entitled “Doughnut Economics: Seven Ways to Think Like a 21st-Century Economist” by Kate Raworth of Oxford University’s Environmental Change Institute, offers an alternative to the all too familiar policy of economic growth to solve the issues of poverty, inequality, unemployment in the global economy. Simon Kuznets, who normalised the measurement of economic growth, stated that national income cannot be a accurate measure of total welfare in an economy as it only measures annual flows of money and not stocks of wealth and their distribution. Raworth states that the current model of endless economic growth using up the finite resources of the planet is not the way forward. Most textbooks refer to the circular flow as the model of the economic system – households, firms, banks, overseas markets and the government which bears little relationship to reality today. Instead Raworth goes beyond this simple circular flow model and includes social and environmental issues – energy, the environment, raw materials, water pollution etc.

The Doughnut
Raworth’s circular flow consists of two rings – see graphic below.

Doughnut Economics.jpeg

Inner Ring – this consists of the social foundation and those things we need for a good life – food, water, health, education, peace and justice etc. People living within this ring in the hole in the middle are in a state of deprivation.

Outer Ring – this consists of the earth environmental limits – climate change, ozone depletion, water pollution, loss of species etc.

The area between the two rings is the “ecologically safe and socially just space” in which humanity should strive to live. As stated in The Guardian review, the purpose of economics should be to help us enter that space and stay there. As the graphic shows we breach both rings as billions of people live below the poverty line and climate conditions, biodiversity loss, land conversion etc are at concerning levels. The video below is a useful explanation.