A2 Economics – Keynes 45˚ line

Just completed the Keynes 45˚ line (still in the CIE A2 syllabus) with my A2 class and find this graph useful to explain it. A popular multi-choice question and usually in one part of an essay. Make sure that you are aware of the following;

Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:
2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X

The Ancient Art of Economic Forecasting – 2019 Coronavirus?

I came across this piece from a colleague on economic forecasting. The article below appeared in the Sydney Metropolitan Press in the late 1920’s. Although economic cycles don’t run to an exact time period the graph below would indicate that this model is not too far out of kilter.

  • The top line = years in which panics have occurred and will happen again
  • The middle line = years of good times, high prices and the time to sell stocks
  • The bottom line = years of hard times, low prices and good times to buy stocks

The past panic century of dates are 1911, 1927, 1945, 1965, 1981, 1999, 2019. Except for 1981, these were all pretty good years to sell stocks – The Big Picture blog. 2016 suggests the top of the present cycle with 2019 being a year of panic.

“The Ancient Art of Economic Forecasting” – Sydney Metropolitan Press 1920’s

The graph below professes to forecast the future trend of Australian business conditions, was first brought under the notice of the public in 1872. It was prepared by a Mr Tritch, whose origin and activities are shrouded in mystery.

  • The top line shows years in which panics have occurred, and will occur again. Their cycles are 16, 18 and 20 years.
  • The centre line shows the years of good times and high prices; the cycles are 8, 9 and 10 years.
  • The bottom line shows the years of depressions and low prices; the cycles are 9, 7 and 11 years.

The panic which occurred in 1893 is shown in 1891. Nevertheless, that year witnessed the beginning of the depression. 1915, just after the war started was a year of depreciation, and 1919, the year following the cessation of hostilities, was a period charcterised by good times.

As this chart was published in 1872, it is interesting to note the forecast of the panic in 2019 – coronavirus? It will be seen that there has been a general upward trend since 1926 with the panic occurring in 1927 after the high is reached. The bottom of the depression is reached at the end of 1930 and the upward trend begins in 1931.”

Financial Times – Free access and teaching ideas for economics teachers / students.

You may have seen this before but the Financial Times is offering free access to schools.  As long as teachers and students have an email associated with your school internet address, you can also create your own personal FT account, download the app and use the service on mobile/from home. Click the link below for more information and to register:
https://enterprise.ft.com/en-gb/secondary-education/

You can also access recommended FT articles and tasks picked by teachers which have exam type questions which relate to the articles. Very similar to the data response questions found in most exam papers.

Coronavirus – impact on the NZ economy

Below is a link to a very good interview with Corin Dann and Don Brash this morning on National Radio’s ‘Morning Report’. Former Reserve Bank Governor Don Brash says that the major Central Banks need to act together and reduce interest rates to offset the impact of Covid-19. The Central Banks he refers to are: US Fed, Bank of England, Bank of Japan and the European Central Bank. Good discussion of the impact of the NZ dollar on trade and the fact that just the past month in New Zealand, the virus may have cost as much as $300 million in lost exports to China. Worth a listen

National Radio – Don Brash interview

What is ‘Value’ in an economy?

I was recently given a review (from Palladium Governance Futurism) of Mariana Mazzucato’s book ‘The Value of Everything : Making and Taking in the Global Economy’ in which she challenges the view of what ‘value’ is in an economy. She refers to ex Goldman Sachs CEO Lloyd Blankfein’s quote

The people of Goldman Sachs are among the most productive in the world.’

Goldman Sachs was one of the many investment banks that had to be bailed out after the GFC but how do we value their productivity?

Privatise reward and socialise risk
It seems that the investment banks were happy to privatise the reward but socialise the risk – when it all “turns to custard” they need to be bailed because they are too big to fail. The question that people are now asking is what is the vulnerable asset class? Mortgage-backed securities was the cause in 2008. For a lot of these companies a large payout is a sign of success in that they are too big to fail and leave the government no alternative. However where is the value generation from this?

Value – historical perspective

  • French physiocrats – value was produced from the land
  • Adam Smith – saw landlords as rentier class
  • Marx – labour is the source of value

Today economics is more focused on a subjective, utility-focused approach and therefore sidestepping the historic debate about value which is undermining the discipline of economics. This new approach, according to Mazzucato, has weakened neoliberal economies to innovate. Key to understanding the the value debate is what is considered production in our GDP. The informal economy is a part of all economies but is not included in the national accounts. As is someone building their own house. So what is considered to be real wealth/value? Rather than focusing on how wealth was created and what counted as wealth, economists began to ask how utility was satisfied on the margin. This allowed for the mathematical approaches to be used in modern economics.

Thomas Aquinas stressed the need for a ‘just price’. It was immoral for a supplier to raise his price when consumers are in great need of a specific good (inelastic demand). The price should cover the cost of production and the maintenance of the worker and his family. Today value is in the eye of the consumer and price, in turn, reflects utility gained by a consumer from an additional unit go goods or services.

Finance and productive value

Finance’s case is founded on the notion that it is a necessary part of production by allocating capital to businesses. However Banks direct their revenues into interest payments and the share price. This fuels speculative bubbles which are refinanced through the securitisation food chain and therefore inflating assets without investment.

Australian bank Macquarie acquired utility company Thames Water – increased its debt to US$10.05 bn over 6 years, therefore leveraging the privatised assets they had acquired into increasing debt. By doing this they saved their own revenues for interest payments and shareholder distributions – hard to make the case for privatising public assets. Mazzucato also points out that since the GFC the finance sector has focused on debt deflation and unemployment and wage reduction so corporate profits could be maintained at the expense of employee earnings. So the financial sector continues to make contributions to GDP in the money it generates but firms in the tech sector and natural resources can’t contribute to the money supply the way commercial banks can, and can’t easily hedge parts of the economy.

The book also gives examples of factors that contribute to GDP but they don’t actually produce anything.

  • Ford – 2000’s – they made more money from selling loans for cars than by selling cars themselves
  • General Electric – finance arm of the business made around 50% of the whole group’s earnings.

On a more positive side Welsh Water was a company with the lowest ratio of debt to equity and the highest credit rating. It is mutually owned and operated as a not-for-profit operation.

Two great myths – Innovation and Public Sector

She points out that the world’s biggest companies have built themselves on the legacy of state backed, publicly funded innovation. EG:

  • Nearly all major parts on smartphones were developed in university-based research facilities using public money.
  • Defence Advanced Research Projects Agency – developed the Internet and SIRI
  • US Navy – GPS system used by phones and computers.
  • National Science Foundation grant – created the algorithm behind Google.
  • Pharmaceutical drugs – 2/3 of the most innovative drugs trace their research to funding by the US National Institutes of Health.

Final thought

Keynes was seen as the last supporter of government investment. He recommended state intervention during downturns in order to stimulate growth and spending. This intervention is intended to shock the economy into greater output

According to Mazzucato the public sector is the true creator of economic value – value which could not just be created by private counterparts. Vital to this is the rebuilding of the public sector’s funding for innovation. Her clear goal is that economists and governments alike to cease viewing value as a purely subjective and individualistic measure.

Revision note – Investment and MEC

Investment is spending on capital goods by firms and government, which will allow increased production of consumer goods and services in future time periods. Be careful not to confuse the economists’ definition of investment with another interpretation – that investment involves putting funds into financial assets such as stocks and shares. Marginal Efficiency of Capital Theory – As investment increases, the return on the last unit of capital employed will be less and less as a result the Law if Diminishing Returns (i.e. The MEC falls). 

The theory states that it is profitable to invest so long as the MEC (the % return) is greater than the rate of interest (the cost of funds needed to finance the investment). The OPTIMUM level of Investment is where:

% MEC = the rate of interest

At this point, the last unit of investment is covering its costs, and all previous units are profitable.

Gross and Net Investment

An important distinction to make is between gross and net capital investment spending

Net investment is positive when gross investment is higher than depreciation or capital consumption. Then there will be an increase in the nation’s stock of capital.

  • Fixed Investment – is spending on new capital machinery and plant, construction, housing, vehicles, etc.
  • Working Capital – is spending on stocks/inventories of finished goods and raw materials. The accumulation of stocks by firms, whether voluntary or involuntary, is counted as investment.

Gross Domestic Fixed Capital Formation (GDFCF) – is expenditure on fixed assets (buildings, vehicles and plant) either for replacing or adding to the stock of fixed assets.

Gross Domestic Investment Spending + Stockbuilding = Total Gross Investment

Other factors that affect investment demand

1. Expectations – the key to understanding investment decisions
The central message of economic theory and the evidence from business surveys is that capital investment is determined by the relationship between the expected returns from investment and the expected cost of financing the investment.

2. Returns to an investment project

The expected returns from capital investment are determined by the demand for and the price of the output of goods or services generated by an investment and also by the costs of production. A rise in demand for the output that capital is purchased to supply will increase the potential revenue streams that a business can expect from a new project. Similarly, a change in the costs of purchasing the capital inputs the costs of training workers to use new capital and in maintaining the capital stock will also affect the expected rate of return.

3. The importance of business expectations and uncertainty

Expectations of demand, prices and costs over the lifetime of the investment are key determinants of expected returns. There is always uncertainty about the expected rate of return particularly when demand is volatile and sensitive to changes in interest rates, the exchange rate and incomes.

The rate of return from an investment is also influenced by the rate at which an investment project is assumed to depreciate over time.

The cost and availability of internal and external finance is important, as higher costs of finance (e.g. higher interest rates) require greater returns from the investment to ensure that it is profitable.

At this point, the last unit of investment is covering its costs, and all previous units are profitable.

  • If profit levels rise, firms will have more money to spend on investment and will have a greater incentive to do so.
  • Advances in technology may encourage firms to replace less productive capital equipment.
  • The government may also encourage investment by cutting corporation tax on firms’ profits and by giving investment subsidies.

Unemployment in Denmark – generous benefits with strict controls

With unemployment at 4.2% – less than 120,000 – in Denmark it has one of the lowest rates of unemployment in Europe. Those unemployed get 90% of their former salary but there are very strict controls on those receiving these benefits. Some of them are outlined below:

  • Check-in with the government website every 7 days
  • Apply for 3 jobs each week that you are unemployed – also have to prove their efforts
  • Within two weeks after you become unemployed, you must upload and activate a CV on the government website.
  • Each month they have to attend an interview with a government job centre
  • Financial benefits maybe cut if they don’t abide by the conditions.

The video compares the French system with that of Denmark.

The paradox of Norway – fossil fuel giant and leader in renewable energies

In 1969 the discovery of oil off the coast of Norway transformed its economy with it being one of the largest exporters of oil. A lot of countries in similar positions have succumbed to the ‘resource curse’ in which countries tend to focus on a natural resource like oil. The curse comes in two forms:

With high revenues from the sale of a resource, governments try and seek to control the assets and use the money to maintain a political monopoly. This is where you find that from the sale of your important natural resource there is greater demand for your currency which in turn pushes up its value. This makes other exports less competitive so that when the natural resource runs out the economy has no other good/service to fall back on.

However it is the fall in commodity prices that is now hitting these countries that have, in the past, been plagued by the resource curse. As a lot of commodities tend to be inelastic in demand so a drop in price means a fall in total revenue since the the proportionate drop in price is greater than the proportionate increase in quantity demanded.

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.

The Economist – Ecowarriors bankrolled by oil – 8-2-20

What are they doing?

  • 98% of electricity is from renewable energies and technologies
  • Heating with oil is to be banned this year
  • 50% of new cars are to be electric
  • Oslo has set a ceiling every year for its greenhouse gas emissions
  • Oslo removed nearly all parking spaces from the city centre – now bicycle docks / benches
  • Norway is hoped to be completely emission-free shipping fleet over the next couple of decades – this accounts for almost all of Norway’s oil consumption
  • Sovereign wealth fund will sell its shares in companies dedicated to oil and gas exploration

Norway and Liberia – Coarse Theorem

Coarse Theorem – Ronald Coarse argued that bargaining between parties could produce a mutually beneficial and efficient solution to problems like pollution.

An example of this was the a deal between Liberia and Norway. Norway will give $150m in aid in return for Liberia stopping the destruction of its forests. The stick approach of trying to force Liberia to stop cutting down its trees might give way to a more effective carrot approach by paying Liberia to do so. This makes both sides better off. Liberia still gets the aid and Norway gets to preserve biodiversity and take a small step against climate change.

Norway’s challenges

This being said there needs to be more emphasis on the service sector as an earner of GDP – this sector already accounts for 55% of GDP. According to The Economist Norway faces 4 challenges:

  • Reduce it focus on gas and oil
  • Increase its productivity through the use of technologies
  • Reduce carbon emissions to meet the Paris agreement goals on climate change
  • Create 25,000 jobs a year so that oil workers can find meaningful employment

Source: The Economist – Ecowarriors bankrolled by oil – 8-2-20