Sunday, October 21, 2012
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Monday, October 8, 2012
Revision - Money
Money is medium of exchange which can clear past and present obligation. Money is anything that is generally accepted as payment for goods and services and repayment of debts.
Functions of money
Money is often defined in terms of the three functions or services that it provides. Money serves as a medium of exchange, as a store of value, and as a unit of account.
Medium of exchange:
Money’s most important function is as a medium of exchange to facilitate transactions. Without money, all transactions would have to be conducted by barter, which involves direct exchange of one good or service for another. The difficulty with a barter system is that in order to obtain a particular good or service from a supplier, one has to possess a good or service of equal value, which the supplier also desires. In other words, in a barter system, exchange can take place only if there is a double coincidence of wantsbetween two transacting parties. The likelihood of a double coincidence of wants, however, is small and makes the exchange of goods and services rather difficult. Money effectively eliminates the double coincidence of wants problem by serving as a medium of exchange that is accepted in all transactions, by all parties, regardless of whether they desire each others’ goods and services.
Store of value:
Money also functions as a unit of account, providing a common measure of the value of goods and services being exchanged. Knowing the value or price of a good, in terms of money, enables both the supplier and the purchaser of the good to make decisions about how much of the good to supply and how much of the good to purchase.
A standard of deferred payment
Money can be used to pay over time for commodities. Goods and services can be paid for in installments over a period of time e.g hire purchase. This was much more difficult and complicated in the barter system.
Characteristics
General acceptance
The essential quality of good money is that it should be acceptable to all, without any hesitation in the exchange for goods and services.
Portability
It is also an important quality of good money that is should be easily transferable from one place to another for doing business and making payment. The paper money is easier to carry because it has minimum possible wait than metallic money.
Storability
Money should be storable and it should not be depreciate with time. If the money used is perishable it will lose its value in few days. Paper money has this quality of storability.
Divisibility
Good money is that which could be divided into small units without losing any value.
Durability
Money should be durable. It should not lose its value with the passage of time. The gold and silver coins do not wear out quickly and quality of money remains the same.
Economy
It is important quality of good money that it should be made economically. If there is heavy cost on issuing more money that is not good money. Good money is that has low cost and more supply. Paper money has this quality of economy.
Revision - Does a Current Account Deficit Matter?
A current account deficit measures the balance of trade in:
The financial account comprises of 2 main features:
Some economists argue we need not worry about a current account deficit. This is because:
Reasons to Worry about a Current Account Deficit.
1. There could be problems financing the deficit in the long term. A short term deficit is not a problem, but if you have a deficit of over 6% of GDP then it is a problem if you rely on Capital flows. A significant part of the current account deficit in US is finance by Chinese investors buying US securities, at relatively low interest rates.
2. Most countries would not be able to borrow such large amounts at low interest rates. The US currently can because the US is seen as the World’s reserve currency. However if attitudes to the US economy change and investors lose their confidence in the US economy, they will stop buying US debt. This will cause 2 problems.
3. In the US the current account deficit is to a large extent caused by excess spending in the economy. It is partly caused by government borrowing which increases Aggregate Demand in the economy and hence growing demand for imports. A large current account deficit is often a sign of an unbalanced economy. It could be a sign of structural weakness and an uncompetitive manufacturing sector. This is particularly a problem in the Eurozone where the exchange rates are permanently fixed.
4. A deficit on the current account increases foreign liabilities. In the beginning a current account deficit could be just a deficit on buying goods. However over time the deficit will be increased by the interest payments on the capital surplus. Foreigners invest in the US. On these investments they receive interest payments or dividends. These dividends count as a debit on the current account. Therefore the longer the deficit goes on the higher the level of investment income debits will be accrued. This means that in the future the economy will need to attract capital flows just to pay off the investment income. As well as the deficit on goods and services.
Example of Iceland's Current Account Deficit
Iceland is an example of a country with a large current deficit which later imploded.
In the years leading up to 2008, there was a sharp inflow of capital to Icelandic banks. This enabled Iceland to run a record current account deficit. Iceland was spending more than they were earning. When capital flows dried up, banks lost money and there was a rapid deterioration in the current account.
In the Eurozone, current account deficits are a bigger cause for concern because countries have a permanently fixed exchange rate (common currency). Therefore they can't devalue to restore competitiveness. Therefore countries may have to pursue internal devaluation (deflation) to restore competitiveness.
It depends on the size of the current account as a % of GDP. Clearly in Iceland's case, over 20% of GDP was unsustainable. But, in US case 6% of GDP later shrank to a more manageable 3% of GDP.
A current account deficit is often a signal of another underlying problem. For example, a banking boom (in Iceland's case). A boom in domestic demand or a lack of competitiveness in Eurozone.
- goods
- services
- net investment incomes and transfers
The financial account comprises of 2 main features:
- a) Short Term Capital flows e.g. hot money flows and purchase of securities
- b) Long Term Capital flows e.g. investment in building new factories
Some economists argue we need not worry about a current account deficit. This is because:
- If a current account deficit is financed from long term capital inflows then this can be beneficial for the economy. Inward investment can increase the productive capacity of the economy.
- In an era of globalisation it is much easier to attract sufficient capital flows to finance the deficit.
- If the deficit gets too large it will cause a devaluation which helps to reduce the deficit. Also when there is a slowdown in consumer spending the deficit will fall.
- A current account deficit provides an outlet for domestic demand and prevents inflation.
Reasons to Worry about a Current Account Deficit.
1. There could be problems financing the deficit in the long term. A short term deficit is not a problem, but if you have a deficit of over 6% of GDP then it is a problem if you rely on Capital flows. A significant part of the current account deficit in US is finance by Chinese investors buying US securities, at relatively low interest rates.
2. Most countries would not be able to borrow such large amounts at low interest rates. The US currently can because the US is seen as the World’s reserve currency. However if attitudes to the US economy change and investors lose their confidence in the US economy, they will stop buying US debt. This will cause 2 problems.
- US interest rates will need to rise to attract enough people to buy the debt. These higher interest rates will reduce demand in the economy. Higher interest rates will particularly hurt American consumers who have large amounts of debt at the moment.
- If capital flows can’t be attracted then the dollar will continue to devalue further. This could cause inflationary pressures, interest rates may need to rise to stabilise the dollar.
3. In the US the current account deficit is to a large extent caused by excess spending in the economy. It is partly caused by government borrowing which increases Aggregate Demand in the economy and hence growing demand for imports. A large current account deficit is often a sign of an unbalanced economy. It could be a sign of structural weakness and an uncompetitive manufacturing sector. This is particularly a problem in the Eurozone where the exchange rates are permanently fixed.
4. A deficit on the current account increases foreign liabilities. In the beginning a current account deficit could be just a deficit on buying goods. However over time the deficit will be increased by the interest payments on the capital surplus. Foreigners invest in the US. On these investments they receive interest payments or dividends. These dividends count as a debit on the current account. Therefore the longer the deficit goes on the higher the level of investment income debits will be accrued. This means that in the future the economy will need to attract capital flows just to pay off the investment income. As well as the deficit on goods and services.
US current account deficit reached 6% of GDP in 2006. This reflected strong domestic demand and a decline in competitiveness. The credit crunch caused a reduction in US current account deficit.
Example of Iceland's Current Account Deficit
Iceland is an example of a country with a large current deficit which later imploded.
In the years leading up to 2008, there was a sharp inflow of capital to Icelandic banks. This enabled Iceland to run a record current account deficit. Iceland was spending more than they were earning. When capital flows dried up, banks lost money and there was a rapid deterioration in the current account.
Current Account Deficits in the Eurozone
Conclusion
It depends on the size of the current account as a % of GDP. Clearly in Iceland's case, over 20% of GDP was unsustainable. But, in US case 6% of GDP later shrank to a more manageable 3% of GDP.
A current account deficit is often a signal of another underlying problem. For example, a banking boom (in Iceland's case). A boom in domestic demand or a lack of competitiveness in Eurozone.
Revision - Factors that determine international competitiveness
A look at factors affecting international competitiveness. International competitiveness is a measure of the relative cost of goods / services from a country. Countries which can produce the same quality of goods at a lower cost are said to be more competitive.
1. Relative Inflation
If the inflation rate is relatively lower than other countries, then over time you become more competitive because your goods will be increasing at a slower rate. For example, in the post war period Japan and Germany had relatively lower inflation rates than major competitors, this helped them to become more competitive.
2. Productivity
Productivity is a measure of output per input. The most common measure would be labour productivity. For example, with improved technology and education, a country can enjoy higher labour productivity and therefore produce goods at a lower cost. Higher labour productivity is the key to increasing competitiveness and living standards at the same time.
German vs Italian labour productivity. During this period, Italian labour productivity growth has tended to lag behind Germany, leading to lower competitiveness of Italian exports.
3. Exchange Rate
Movements in the exchange rate will determine competitiveness. For example, a sharp depreciation will make exports cheaper and more competitive. An increase (appreciation) in the exchange rate, makes the foreign currency price more expensive.
Often movements in the exchange rate reflect relative costs. For example, if a country has lower inflation, this will lead to an appreciation in the exchange rate, making exports relatively more expensive. Thus a floating exchange rate, helps to maintain relative competitiveness levels.
However, sometimes economies can artificially maintain a lower value of the exchange rate to maintain competitiveness. For example, China has been accused of exchange rate manipulation. China buys large quantities of US securities, this causes an increase in the value of the dollar and helps to keep the Yuan undervalued. Therefore, this helps Chinese exports to be more competitive and explains the large Chinese current account surplus
Government has used supply side policies to increase productivity. E.g. education and training.
However, there is a limit to what the government can do to increase productivity. Increased productivity can be due to other factors.
Competitiveness in the Euro
In the Euro, countries have a permanently fixed exchange rate - they cannot devalue to restore competitiveness. Therefore divergences in labour costs and productivity will have a bigger impact on competitiveness than in a floating exchange rate. See: EU Competitiveness
4. Tax Rates
Tax rates on labour and corporations will be a factor in determining competitiveness. For example, higher labour taxes will increase the unit cost of labour faced by firms, leading to lower competitiveness.
5. Cost of Doing Business
It is argued that countries with more labour market regulations and regulations about doing business will have higher costs and lower competitiveness. For example, the difficulty in gaining planning regulations to expand a factory.
The World Bank produce a list of countries which are the 'easiest places to do business'. The criteria include factors such as flexibility of labour markets, degree of regulations, protection of private property.
Top 10 Ease of doing business
6. Infrastructure
A key factor in determining competitiveness is the cost of transport. For example, some argue the UK's competitiveness is undermined by bottlenecks in transport, such as limited airport capacity in London and traffic jams on major roads.
1. Relative Inflation
If the inflation rate is relatively lower than other countries, then over time you become more competitive because your goods will be increasing at a slower rate. For example, in the post war period Japan and Germany had relatively lower inflation rates than major competitors, this helped them to become more competitive.
This graph of relative inflation rates showed that during the period shown, inflation in Greece fell from close to 5% to below 2%. This suggests that Greece will have become slightly more competitive in this period.
2. Productivity
Productivity is a measure of output per input. The most common measure would be labour productivity. For example, with improved technology and education, a country can enjoy higher labour productivity and therefore produce goods at a lower cost. Higher labour productivity is the key to increasing competitiveness and living standards at the same time.
This shows labour productivity index for UK and Germany. Between 1990 and 2005, Germany labour productivity increased 25 base points. UK labour productivity increased by 35 base points. Showing that the UK had faster improvements in labour productivity during this period.
3. Exchange Rate
Movements in the exchange rate will determine competitiveness. For example, a sharp depreciation will make exports cheaper and more competitive. An increase (appreciation) in the exchange rate, makes the foreign currency price more expensive.
Often movements in the exchange rate reflect relative costs. For example, if a country has lower inflation, this will lead to an appreciation in the exchange rate, making exports relatively more expensive. Thus a floating exchange rate, helps to maintain relative competitiveness levels.
However, sometimes economies can artificially maintain a lower value of the exchange rate to maintain competitiveness. For example, China has been accused of exchange rate manipulation. China buys large quantities of US securities, this causes an increase in the value of the dollar and helps to keep the Yuan undervalued. Therefore, this helps Chinese exports to be more competitive and explains the large Chinese current account surplus
Government has used supply side policies to increase productivity. E.g. education and training.
However, there is a limit to what the government can do to increase productivity. Increased productivity can be due to other factors.
Competitiveness in the Euro
In the Euro, countries have a permanently fixed exchange rate - they cannot devalue to restore competitiveness. Therefore divergences in labour costs and productivity will have a bigger impact on competitiveness than in a floating exchange rate. See: EU Competitiveness
4. Tax Rates
Tax rates on labour and corporations will be a factor in determining competitiveness. For example, higher labour taxes will increase the unit cost of labour faced by firms, leading to lower competitiveness.
5. Cost of Doing Business
It is argued that countries with more labour market regulations and regulations about doing business will have higher costs and lower competitiveness. For example, the difficulty in gaining planning regulations to expand a factory.
The World Bank produce a list of countries which are the 'easiest places to do business'. The criteria include factors such as flexibility of labour markets, degree of regulations, protection of private property.
Top 10 Ease of doing business
- Singapore
- Hong Kong
- New Zealand
- United States
- Denmark
- Norway
- United Kingdom
- South Korea
- Iceland
- Ireland
6. Infrastructure
A key factor in determining competitiveness is the cost of transport. For example, some argue the UK's competitiveness is undermined by bottlenecks in transport, such as limited airport capacity in London and traffic jams on major roads.
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