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AS Economics – Hyperinflation causes and ends

Starting with a definition. In 1956 Phillip Cagan, an economist working at America’s National Bureau of Economic Research, published a seminal study of hyperinflation, which he defined as a period in which prices rise by more than 50% a month.

There seems to be common patterns when hyperinflation occurs in an economy. These include:

  1. Fiscal pressure – cost of funding a war, increased social welfare payments, corrupt officials taking money from the budget.
  2. Dependence of a particular resource – the resource curse. Some economies rely on exports of oil, iron ore or other resources to fund its spending. This has the effect of increasing the value of the currency and although this will make imports cheaper once the resource runs out or global prices start to drop the overvalued currency falls causing a large increase in imported prices. Furthermore governments come to depend on revenue from oil and a sudden drop in prices saw a massive drop in tax revenue – 90% of Venezuela’s revenue came from oil.
  3. Printing money – like Bolivia in the 1980’s, Venezuela overcame their shortfall in income by printing more money. The increase in the supply of money pushes up inflation. But what makes it worse is, as the inflation rate impacts the real value of government revenue, they continue to print money to finance the budget deficit which in turn exacerbates the problem – bigger budget deficit and further inflation.
  4. Exchange rate – at some stage the exchange rate will collapse as people lose confidence in the currency. Imports become ever increasingly expensive and feed into the inflation calculation.
  5. Inflationary expectations – In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue. This is evident in Venezuela as people become accustomed to higher prices and expect them to continue which makes inflation likely to continue.Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.

Hyperinflation tends to end in two ways.

  1. The paper currency becomes so utterly worthless that it is supplanted by a hard currency. This is what happened in Zimbabwe at the end of 2008, when the American dollar took over, in effect. Prices will stabilise, but other problems emerge. The country loses control of its banking system and its industry may lose competitiveness.
  2. The second, hyperinflation ends through a reform programme. This was very much the case in Bolivia in the 1980’s – Government spending was slashed. Price controls were scrapped. Import tariffs were cut. Government budgets were balanced. Therefore this typically involves a commitment to control the budget, a new issue of banknotes and a stabilisation of the exchange rate—ideally all backed with confidence-inspiring foreign loans. Without such reform, Venezuela’s leaders, though scornful of America, may find that its people are forced eventually to adopt its dollar anyway.

Sources:

  • The Economist “The half-life of a currency” September 15th 2018
  • The Economist “The roots of hyperinflation” February 12th 2018

New Zealand’s Terms of Trade – Milk Powder v Oil

The recent history of New Zealand’s terms of trade has been largely linked to dairy product export prices although in a longer-term context the price of imported oil has been paramount. Today we can see that the price of powdered milk (export) and the price of brent crude oil (import) are heading in the wrong directions. Powdered milk prices are falling and brent crude oil prices are rising which makes for an unfavourable terms of trade – see graph. This is not a good sign for the terms of trade which reached its peak in March this year.

What is the Terms of Trade.
The terms of trade index measures the value of a unit of exports in terms of the number of imports it can buy, or the purchasing power of our exports. This is similar to comparing the number of sheep exports that will buy a typical imported family car, from one time to another. The formula is:
Formula: Terms of Trade (TOT) =

Export Price Index (Px)           x   1000 (base year)
Import Price Index (Pm)

  • An increase in the TOT (e.g. from 1050 to 1200) is called “favourable”
  • A decrease in the TOT (e.g. from 1050 to 970) is called “unfavourable”

A “favourable” (increase) in the TOT may come about because the average:

– export price rose and import price stayed the same
– export prices rose faster than import prices
– export prices stayed the same and import prices fell
– export prices fell but import prices fell faster

The index number that results tells us whether merchandise export price movements have been favourable relative to import price movements. An increase in the terms of trade from 1000 to 1100 represents an increase in the purchasing power of our exports of 10% which means, other things being equal, we would be able to buy 10% more from overseas. As a country we would be wealthier. A decline in the terms of trade would result in the opposite situation.

Limitations of the Terms of Trade

Terms of trade calculations do not tell us about the volume of the countries’ exports, only relative changes between countries. To understand how a country’s social utility changes, it is necessary to consider changes in the volume of trade, changes in productivity and resource allocation, and changes in capital flows.

The price of exports from a country can be heavily influenced by the value of its currency, which can in turn be heavily influenced by the interest rate in that country. If the value of currency of a particular country is increased due to an increase in interest rate one can expect the terms of trade to improve. However this may not necessarily mean an improved standard of living for the country since an increase in the price of exports perceived by other nations will result in a lower volume of exports. As a result, exporters in the country may actually be struggling to sell their goods in the international market even though they are enjoying a (supposedly) high price. An example of this is the high export price suffered by New Zealand exporters since mid-2000 as a result of the historical mandate given to the Reserve Bank of New Zealand to control inflation.

In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant.

Evaluation

  • A decline in the terms of trade is not necessarily a bad thing. For example, a decline in the terms of trade may occur due to a devaluation in the exchange rate. This devaluation may enable a country to regain competitiveness and increase the quantity of exports.
  • The impact of a decline in the terms of trade will depend on the elasticity of demand. If demand is elastic, the lower price of exports will cause a bigger % increase in demand.
  • Some Less Developed Countries (LDCs) have seen an improvement in terms of trade because of rising price of commodities and food post 2008. It is not always LDCs who see a decline in the terms of trade.
  • It is important to distinguish between a short term decline in terms of trade and a long term decline. A long term decline is more serious for reflecting a fall in living standards.

Unemployment – a ‘luxury good’ in the developing world

Image result for unemployment in developing countriesFollowing from my last post about the welfare state, the lack of jobless benefits in developing countries has led to very low unemployment levels as workers simply cannot afford not to work. In order for them to survive they need to be prepared to do any sort of job. Even if unemployment benefits are available a lot of the time they are not worth the effort. In Thailand, for example, payments last six months and range from 1,650 baht per month ($52) to 15,000. To be eligible, a Thai worker must register with the social-security office. But only one in three does so.

Therefore if they have lost their job what do they do? A laid-off factory worker might lend a hand on the family farm, become a casual day labourer, or sell trinkets on the street. When Annan Chanthan left his job as a graphic designer in Bangkok five years ago, he thought about collecting unemployment benefits, but never bothered. He now earns more money selling lottery tickets next to Hua Lamphong railway station than he did in his former profession.

But the situation can be complicated in developing countries, with their large informal sectors, which offer a relatively easy way for unemployed people to pick up some income — undetected by the government — while they continue to receive jobless benefits. However the level of the unemployment benefit influence the duration of the period of unemployment, but it doesn’t really help workers find better jobs (such as those that pay a higher wage). However, the level of the benefit does seem to improve wages somewhat, although not the unemployment duration.

In poor countries, unemployment is paradoxically concentrated among the better off and better educated. They can afford to wait a bit for a job that matches their aspirations and qualifications. Their behaviour may also explain unemployment’s curious stability but when times are bad, they may settle for a worse job or stop looking, rather than wait longer, which would add to the rate of unemployment.

Source: The Economist June 9th 2018 – The luxury of unemployment

 

 

AS Revision – Income Elasticity of Demand graph

Currently taking CIE revision classes this holiday and was working through Unit 2 and income elasticity of demand. Quite a few of the class had never come across this graph which is popular in multiple-choice questions. It is important that you read the axis.

Usefulness of Income Elasticity of Demand

Knowledge of income elasticity of demand for different products helps firms predict the effect of a business cycle on sales. All countries experience a business cycle where actual GDP moves up and down in a regular pattern causing booms and slowdowns or perhaps a recession. The business cycle means incomes rise and fall.

Luxury products with high income elasticity see greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the economic cycle

The NZ economy has enjoyed a period of economic growth over the last few years. So average real incomes have increased, but because of differences in income elasticity of demand, consumer demand for products will have varied greatly over this period.

Over time we expect to see our real incomes rise. And as we become better off, we can afford to increase our spending on different goods and services. Clearly what is happening to the relative prices of these products will play a key role in shaping our consumption decisions. But the income elasticity of demand will also affect the pattern of demand over time. For normal luxury goods, whose income elasticity of demand exceeds +1, as incomes rise, the proportion of a consumer’s income spent on that product will go up. For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget on these products will fall. See table below for a summary of values.

A2 Revision – Economies of Scale Mind Map

With the A2 exam not far away here is something on Economies of Scale – also a mind map which I have edited from Susan Grant’s book.

When the average cost curve slopes downwards it means that average costs are decreasing as output increases. Whenever this happens the firm is experiencing economies of scale . If on the other hand the average costs are increasing as output increases the firm is experiencing diseconomies of scale . Why do firms experience economies of scale?

Technical Economies: large firms can take advantage of increased capacity machinery. For example, a double-decker bus can carry twice as many passengers as a single decker bus. But without the purchase costs and the running costs are not doubled.

Managerial Economies: In a small firm the manager may perform the role of cost accountant, foreman, salesman, personnel officer, stock controller etc. However, as a firm increases in size it can take advantage of specialisation of labour.

Commercial Economies: The large firm can buy it raw materials in bulk at favourable rates.

Financial Economies: the larger firm can negotiate loans from banks and related institutions     easily and at favourable rates.

Risk-Bearing Economies: All firms are subject to risk at sometime or other. However, the larger firm has distinct advantages in this area as small changes in supply and demand can often ruin a small company and larger firms can cover itself by producing a variety of products for a variety of markets.

Looks like inflation might hit 2% in New Zealand

The ASB Bank produce a very good Economic Report and below are some of the points they make with regard to inflationary pressures – useful for NCEA Level 2 and 3 as well as CIE AS and A2 level. The CPI will be on the rise with higher global commodity prices (see graph below) as well as the weakening NZ dollar which in turn makes imports more expensive.

  • Commodity-price related influences are expected to directly contribute around 1 percentage point to annual CPI inflation over 2018. The direct impact is expected to wane.
  • The period of retail deflation looks like it might be coming to an end. The lower NZD and pending increases in wage costs could see this component add to inflation. The extent to which prices will firm will depend on retail margins.
  • Administered price increases will add roughly half a percentage point to annual inflation despite the impact of the free tertiary fees policy. Higher prices for tobacco and local authority rates seem to be a fact of life: one driven by health objectives, the other by perennial infrastructure demand and a lack of competitive pressure.
  • The labour market is likely to become more of a source of price increases. We note that higher wages need not impact on consumer prices if they are offset by a corresponding increase in labour productivity/trimming in producer margins.
  • Price increases from the housing group are expected to subside. It is no longer a sellers’ market for existing dwellings. The balance of power for building work looks to be increasingly shifting towards the customer and away from the provider. Rental dwelling inflation is expected to remain moderate.

Breakdown of CPI Weighting

Source: ASB Bank – Economic Note – Inflation Watch 26 July 2018

Indifference Curves – Mindmap and Video

Been covering this topic with my A2 class and it is one of the more complex parts of the micro course. The video is particularly useful.


Income and Substitution Effects with Indifference Curves
Any price change can be conveniently analysed into 2 separate effects – the INCOME EFFECT and the SUBSTITUTION EFFECT.

Income effect of a price change: – when there is a fall in the price of a product, the consumer receives a real income effect and is able to buy more of this and other products in spite of the fact that nominal income is unchanged. If the consumer buys more of the good when the price falls it is a Normal good. If the consumer buys less of the good when the price falls it is seen as an Inferior good.

Substitution effect of a price change: – when there is a rise or fall in the price of a product, the consumer receives a decrease or an increase in the utility derived from each unit of money spent on the product and therefore rearranges demand to maximise utility. This is distinct from the income effect of a price change. For all products, the substitution effect is always positive such that a fall in price leads to an increase in demand as consumers realise an increase in the satisfaction they derive from each unit of money spent on the product.

Remember for normal goods, both the income and substitution effects are positive. But the income effect can be negative: if a negative income effect outweighs the positive substitution effect, this means that less is bought at a lower price and vice-versa. This good is therefore known as a Giffen good.

Giffen goods are generally regarded as goods of low quality which are important elements in the expenditure of those on low incomes. A good example is a basic food such as rice, which forms a significant part of the diet of the poor in many countries. The argument, not accepted by all economists, is that when the price of rice falls sufficiently individuals’ real income will rise to an extent that they will be able to afford more attractive substitutes such as fresh fruit or vegetables to makeup their diet and as a result they will actually purchase less rice even though its price has fallen.

New Zealand smokers affected most by inflation.

Smokers in New Zealand are particularly vulnerable to the inflation because the price of cigarettes has been increasing much more rapidly than earnings and the CPI. Māori households are worst affected as the New Zealand Health Survey showed that, in 2016/17, 35% of Māori adults were current smokers, while 15.7% of all adults smoked.

Cigarette and tobacco prices have been subject to annual increase in excise duties since 2010 as a measure to prevent smoking – see graph below. However the addictive nature of the habit – very inelastic demand – makes it very difficult to quit. The majority of smokers would like to stop smoking, and each year about half try to quit permanently.  Yet, only about 6 percent of smokers are able to quit in a given year.  Most smokers will need to make multiple attempts before they are able to quit permanently.

Rather than taxing the product a more realistic solution could be to prevent people from smoking i.e. focusing on the demand side rather than the supply side of taxing cigarettes. I blogged on this last year when discussing the war on drugs. War on drugs: Supply or Demand – that is the question

Demand-Side interventions seem to be a better option and they are also a lot cheaper. Weighing up reducing supply by destroying coca crops in remote areas against drug education in schools and you find the latter is a much more plausible option – see graph below. A dollar spent on drug education in U.S. schools cuts cocaine consumption by twice as much as spending that dollar on reducing supply in South America

Status Quo as the NZ Government makes too much money.
However the Government does make a lot of money from the excise tax – $1,710 million last year which was up $1,068 million from 2010: an increase of 60%. Only 61.7 million was spent on the national control programme in 2014/15 which equated to just 4.1% of the tobacco excise duty collected that year.

Source: BERL NZ