Piigs - F585


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Piigs - F585

  1. 1. OCR A2 - The Global Economy Unit F585
  2. 2. The examination for this unit is based on pre-released material In July 2011 the material concerns the problems of the PIIGS The exam lasts for 2 hours and there are 60 marks available This gives roughly 2 minutes per mark - don’t spend lots of time on low mark questions All questions are compulsory The mark allocation for the individual questions on the paper are as follows 1(a) 4 marks 1(b) 6 marks 1(c) 10 marks 2(a) 4 marks 2(b) 6 marks 2(c) 10 marks 3 20 marks
  3. 3. With most exam boards The following are required to achieve a particular grade: Grade A* - 90% = 72 marks Grade A - 80% = 64 marks Grade B - 70% = 56 marks Grade C - 60% = 48 marks Grade D - 50% = 40 marks Grade E - 40% = 32 marks
  4. 4. The pre-release material has 4 extracts: Extract 1: Recession in the euro area economies 2008 – 2009 Extract 2: Portugal, Italy, Ireland, Greece and Spain – the PIIGS Extract 3: The future of the Spanish economy Extract 4: International trade, international trade negotiations and developing economies A few general observations to assist examiners around my age Write clearly and use black ink – Economics examiners are elderly and myopic Never attempt to correct a diagram – clearly cross it out and draw it again Draw diagrams neatly and large (you are not paying for the paper) Always use a ruler/your debit card – it gives a better impression to the examiner Questions will be drawn from all areas and you must be prepared using your knowledge gained from the course to answer them
  5. 5. With essay type questions there are 5 levels The paper is synoptic: This means that you can be tested on anything you have done in economics Level 4 (a) 16-20 marks – requires excellent analysis, evaluation and includes a final paragraph giving a judgement on the question asked Level 4 (b) 11-15 marks - a balanced discussion of the question but without the level of evaluation & final judgement shown in 4(a) Level 3 5-10 marks – some analysis but is likely to be weak and one sided Level 2 3-4 marks – some application of knowledge and understanding of the question but lacking economic analysis Level 1 1-2 marks - For limited knowledge and understanding
  6. 6. The level achieved and the mark obtained within the level is determined by the quality of the answer as judged against 4 criteria Markers are required to identify these criteria as they occur in the response Criteria Knowledge and Understanding (K) – of concepts, appropriate economic terminology, definitions and theories relevant to the Q Application (Ap) –applying the data given in the texts to the economic theories, terminology, concepts relevant to the question Application (Ap) in the essay Qs involves making reference to the experience of the UK, EU or world economies Remember in the global paper you are supposed to have a knowledge of UK economic experience and performance over the past 10 years Analysis (An) – this is where you build up your argument, explaining and developing your theories and arguments and proving a logical chain of reasoning leading to your conclusion Diagrams and any formula constitute analysis
  7. 7. Judgement/Evaluation (E) – here, you will look at alternative points of view or consider occasions/circumstances in which there may be different outcomes In your evaluation you should make extensive use of words/phrases such as “as compared to”, “whereas”, “however”, “on the other hand” Make comparisons explicit not implicit – an evaluative statement E.g. “Whilst on the one hand UK membership of the Euro would reduce the risk to UK importers and exporters of exchange rate fluctuations it would mean that the UK would lose the valuable ability to control the domestic economy through adjustments to interest rates”
  8. 8. To score a high mark – Levels 4 and Answer the question set, not the question you wish had been set All 4 criteria must be addressed to some extent Good An and E applied to the Q and making use of the data provided is essential & you need to spend most time on questions that reward thi Failure to provide evaluation/judgement will reduce your marks Make extensive use of diagrams throughout – these will score high on An and enable you to present theories clearly and concisely If in doubt of the relevance of a diagram put it in – you will not lose anything Examiners use the phrase “evaluative tone” which applies to the overall presentation of an answer It is better to provide E throughout your response (using the key words and phrases), rather than attempt all your E at the end
  9. 9. <ul><li>To achieve the very highest marks the answer: </li></ul><ul><ul><li>Should establish the underpinning theoretical framework at the outset </li></ul></ul><ul><ul><li>i.e. If the question asks for the factors affecting the UK exchange rate do not leap straight into a list of factors ; instead point out that the ER is determined by the D for and S of £ and then explain how the factors you wish to discuss affect the value of the £, e.g. Exports will affect the demand for £ </li></ul></ul><ul><ul><li>Must be balanced; it must look at both sides of the argument </li></ul></ul><ul><ul><li>Whilst it will not be expected that each side will be addressed in equal depth and at equal length there should be significant discussion of both sides </li></ul></ul><ul><ul><li>Should come to a conclusion which briefly summarises the issues/arguments and comes to a final judgement, preferably with reference to the data provided in the extracts </li></ul></ul><ul><li>Don’t forget that your evaluation and judgement must be rooted in your analysis or it is only assertion and will not attract top marks </li></ul>
  10. 10. How to apply the criteria Assume the following question: The Extract (lines 35-36) argues that 'a more ambitious set of common macro-economic policies would help speed recovery in the Eurozone'. Using the data and your economic knowledge, assess the impact on the UK economy of recovery in the Eurozone as a whole. (25 marks) “ Macro economic policies are designed to...” (explain that they are designed to stabilise and increase GDP in the economy) (K) “ Recovery would mean closing the negative output gap..” (K) “ As Extract A indicates current macro policies have led to slower rates of growth” (Ap) (Analysis could take many forms, e.g)
  11. 11. The implications for economic growth The impact on employment/unemployment – possible diagram to cover 1 st two points The consequences for the balance of payments on current account The effects on the £/€ exchange rate The greater likelihood of avoiding a period of deflation The dangers of inflationary pressures building up The further development of the SEM in a period of recovery and increasing prosperity
  12. 12. Evaluation could come in the form of: The possible significance of a slow recovery – could mention PIIGS at this stage The possible supply problems if recovery is too rapid Whether the UK can take advantage of EU recovery Whether the advantage lies more with the rest of the EU in terms of exporting to the UK than for the UK exporting to the rest of the EU The significance of EU recovery for the UK relative to recovery taking place elsewhere in the world, i.e. in markets which have significance for the UK Whether or not recovery has implications for the movement of labour in and out of the UK and how this affects the UK labour market Now provide a final conclusion/judgement which could be along the lines of: Whether increased economic activity in the eurozone would or would not have A beneficial or negative effect
  13. 13. Let us consider certain aspects of the pre-release material
  14. 14. Recession in the Euro area economies Introduction Key terms: Recession – 2 quarters ( 6 months) of negative growth – a diagram opportunity is presented GDP 0 Time Trend Actual A Z X
  15. 15. Convergence in economic cycles The lack of convergence of economic cycles means that countries in the Euro Area were not at the same stages of their business cycle - Boom Slowdown Recession Recovery The problem faced by the European central bank – setting the Rate of interest (ROI) This lack of convergence really gets to the heart of the problem of the PIIGS GDP 0 Time Convergence Spain Germany Needs increasing ROI Needs falling ROI A
  16. 16. <ul><li>Can the ROI set by the ECB be too low – yes/no – be prepared to defend either view </li></ul><ul><li>ECB sets nominal policy interest rate for Euro area as a whole </li></ul><ul><li>Clear target for price stability – annual rate of consumer price inflation of 2% </li></ul><ul><li>Asymmetric nature of ECB inflation target – a good analytical/evaluatory point </li></ul><ul><li>Rate of inflation in anyone countries will depend on where it is in their business cycle </li></ul><ul><li>Demand-led boom with ↑ wage costs will have a higher rate of inflation than a country experiencing slower growth and where cost-push inflationary pressures are lower </li></ul><ul><li>If inflation > ROI then real ROI is negative </li></ul><ul><li>Consider what policies a government should follow under these conditions </li></ul><ul><li>Measuring economic convergence </li></ul><ul><li>Use of nominal – monetary- and structural – supply side indicators </li></ul><ul><li>Nominal convergence indicators : </li></ul><ul><li>Price inflation – the annual % change in the consumer price index </li></ul><ul><li>Short term ROI – e.g. policy interest rates set by a nation’s central bank </li></ul><ul><li>The size of the Budget deficit </li></ul><ul><li>The level of the national debt </li></ul><ul><li>Measures of exchange rate stability </li></ul>
  17. 17. Real convergence indicators: Trend growth rate of GDP Labour market - structural unemployment - NAIRU Growth of labour productivity – i.e. output per person employed Trade balances - share of GDP taken up by trade Capital investment as a share of GDP Housing market - rates of home ownership and the size of the rented property sector Cost/price competitiveness - index of relative unit labour costs in manufacturing industry and annual changes in output prices Importance of convergence Necessary to occur if the Eurozone is to be a optimal currency area (OCA) A key point to consider here in any judgement is could the PIIGS have created convergence by following deflationary policies or would it have been politically impossible? A case of government failure?
  18. 18. While not specifically mentioned in the specification the theory of an Optimal Currency Area provides and analytical frame work through which to view the PIIGS Remember you will not be penalised by examiners for having extra knowledge and understanding – just a lack of it What is a OCA? The following may help you to grasp the essentials: A geographical region in which it would maximize economic efficiency to have the entire region share a single currency - where the benefits of a single currency outweigh the disadvantages Assume Wales experiences an asymmetric shock (coal mines close down) Causes recession in Welsh economy - ↑ unemployment ↓ inflation As a separate entity Wales would ↓ ROI and depreciate its currency But in reality unemployed Welsh workers can move to Midlands or London
  19. 19. UK firms can invest in Wales to take advantage of lower labour costs and surplus labour There are not many geographical barriers to moving between areas within the UK. Now assume asymmetric shock in Greece: More difficult for Greek workers to move to Germany language barriers attachment to native country poor information regarding job availability etc German firms would have much more reluctance to invest in Greece due to language difficulties and poor perception of the Greek work ethic and inappropriate fiscal policies So there may be a difference between the UK and EU as a OCR as indicated below
  20. 20. <ul><li>↑ unemployment in Wales - UK parliament would ↑ subsidies to Wales </li></ul><ul><li>How willing would German tax payers be to buy Greek bonds and bailout Greece </li></ul><ul><li>A further example considers The North American Free trade area - NAFTA </li></ul><ul><li>If California went bankrupt it would be bailed out by US federal aid </li></ul><ul><li>The US would be very reluctant to bail out Mexico if it went bankrupt </li></ul><ul><li>The USA is an optimal currency area </li></ul><ul><li>Mexico, US, and Canada, the North American Free Trade area is not </li></ul><ul><li>Consider where the Ezone fits </li></ul><ul><li>The criteria for a successful currency union are: </li></ul><ul><li>Labour mobility across the region: </li></ul><ul><li>Physical ability to travel - visas, workers' rights, etc. </li></ul><ul><li>Lack of cultural barriers to free movement - such as different languages </li></ul><ul><li>Institutional arrangements - ability to have pension rights transferred </li></ul><ul><li>In Eurozone, capital is mobile, labour mobility is low, when compared to US. </li></ul>
  21. 21. 2. Openness Capital mobility and price and wage flexibility across the region Market forces automatically distribute money and goods to where they are needed Does not work perfectly as there is no true wage flexibility in the Eurozone 3. Automatic fiscal transfer mechanism To redistribute money to areas/sectors which have been adversely affected Usually takes the form of taxation redistribution Politically difficult to implement - better-off regions rarely give up their revenue easily Current EU arrangements ad-hoc and not built in
  22. 22. <ul><li>4. Similar business cycles </li></ul><ul><li>Allows the central bank to promote growth in downturns and to contain inflation in booms </li></ul><ul><li>If business cycles do not converge then optimal monetary policy may diverge </li></ul><ul><li>Union participants may be made worse off under a joint central bank </li></ul><ul><li>Europe scores well on some of the measures characterising an OCA </li></ul><ul><li>Countries highly integrated - high % trade with fellow currency union members but: </li></ul><ul><li>lower labour mobility than the United States </li></ul><ul><li>Cannot rely on fiscal federalism to smooth out regional economic disturbances </li></ul><ul><li>May be an optimal currency area in Benelux countries and France and Germany </li></ul><ul><li>Difficult when including members such as the profligate Greeks, Italians and Irish </li></ul><ul><li>Key issue is the degree of geographical mobility, government intervention and degree of economic convergence </li></ul><ul><li>Be prepared to use this theory in your answer to questions – it provides a framework for analysis and an area for evaluation </li></ul>
  23. 23. The OCR theory prompts the following question How far do you agree with the view that countries that are not economically convergent should not be allowed inside the single currency area? 20 marks Plan an answer A currency union works best with a small cluster of highly integrated and similar countries The reasons for keeping them out The PIIGS have not exercised the same budgetary controls During boom times they have run up huge fiscal deficits This has caused a loss of confidence among investors and speculators in international bond markets PIIGS have seen the interest rates they pay on their loans rise sharply Greece can no loner afford to borrow on the bond markets PIIGS are now forced to borrow form more fiscally prudent states & the IMF Why should they be allowed to join Met initial criteria Not totally their fault – German economy saves rather than spends – limited national trade multiplier effect European Commission should have exercised more oversight Given the right policies convergence could occur
  24. 24. Your evaluation could be along the lines of How far the problem caused by the PIIGS is likely to affect support for the Euro Whether exit from the zone would benefit the PIIGS or other members Whether given current conditions there currencies can converge These problems faced by the PIIGS have given rise to the concept of a 2 speed Euro area You need to be conversant with this idea
  25. 25. A two speed Euro area - Variation in the average growth rates achieved by countries inside the currency union Some suffering years of slower growth & high unemployment & ↓ living standards PIIGS likely to continue to experience difficulties in ↓ fiscal deficits & ↓ increase in government debt Why is this a problem for monetary union: ↓ standard of living in under-performing Euro Area countries High and rising unemployment Recession = ↓ tax revenues & huge ↑ budget deficits as a share of national income Sovereign debt crisis - emergency bail-outs from IMF & EU members Deflationary conditions attached to the emergency financial support
  26. 26. Brings about reductions in living standards for millions of people in these countries ↓ in public support for the Euro - threat to stability of the single currency system No discussion of recession is complete without a consideration of the shape that it may take The most outrageous example was probably given by the cartoonist in the mail who referred to “the dead cat bounce” I shall limit my discussion to the idea of the “double dip” The situation where an economy goes back into recession without achieving trend growth
  27. 27. AD ↑ from AD- to AD1 and rises to FE level at AD but falls back to AD1 With the aid of a diagram explain the possible causes of a double dip recession Price level 0 AS FE AD AD1 X AD- Z Real output
  28. 28. Possible causes of a double dip: Another external economic shock – collapse in major overseas export markets ↓ consumer confidence – so ↓ consumption – unemployment; ↑ debt; ↓ house prices ↓ business confidence – negative expectations - production cut-backs; ↓ investment ↑ exchange rate - ↓ international competitiveness – ↑ Euro against the US dollar Govt. policy - e.g. tightening of policy too soon - ↑ ROI or ↓ fiscal stimulus - Japan Inability to borrow – pressure from Bond markets forcing expenditure cut
  29. 29. At this stage of the proceedings it may be as well to remind ourselves of the stages of integration in an endeavour to decide whether monetary union is a step too far Knowledge of this area should assist with both analysis and evaluation It also contains a number of diagrams that are extremely relevant
  30. 30. <ul><li>Monetary union – common market with a single currency – a stage of integration </li></ul><ul><li>Economics Blocs – Stages of integration - you should be aware of these : </li></ul><ul><li>The degree of economic integration can be categorized into six stages: </li></ul><ul><li>Preferential trading area </li></ul><ul><li>Free Trade area </li></ul><ul><li>Customs union </li></ul><ul><li>Common Market </li></ul><ul><li>Economic and monetary union </li></ul><ul><li>Complete economic integration </li></ul><ul><li>1. Preferential trading area </li></ul><ul><li>Gives preferential access to partcipating countries </li></ul><ul><li>Done by reucing tariffs but not completely abolising them </li></ul><ul><li>First stage of economic integration </li></ul><ul><li>Line between PTA and free trade area blurred </li></ul><ul><li>2. Free Trade area – UK was a member of EFTA before it joined the EEC </li></ul><ul><li>All members abolish tariffs with other members </li></ul><ul><li>All members individually free to set external tariff with non-members </li></ul><ul><li>Aim of FTA is so that trade can grow – specialisation – comparative advantage </li></ul><ul><li>Leads to a problem known as trade deflection </li></ul>
  31. 31. <ul><li>Trade Deflection: </li></ul><ul><li>Free trade area leads trade deflection because of the differences in trade barriers </li></ul><ul><li>Diagram above right shows four counties A, B, C, D in a free trade area </li></ul><ul><li>All four trade with country E but all impose different tariffs </li></ul><ul><li>Lowest tariff imposed by A at 10% and the highest by D at 50% </li></ul><ul><li>All exports from E will be directed into the area through A - tariff is the lowest </li></ul><ul><li>Trade will be deflected to A - frustrates tariff policies of the other members </li></ul><ul><li>They may introduce rules of origin so that tariffs can be charged on goods traded inside the area that originate from non member countries. </li></ul>Trade deflection
  32. 32. <ul><li>3. Customs union </li></ul><ul><li>FTA with a common external tariff </li></ul><ul><li>Aim is to ↑ economic efficiency & closer political ties between the members </li></ul><ul><li>4. A common market </li></ul><ul><li>This is acustoms union with common policies on: </li></ul><ul><li>Product regulation </li></ul><ul><li>Freedom of movement of the factors of production – capital labour enterprise </li></ul><ul><li>May lead to a single market - efforts made to remove barriers in terms of: </li></ul><ul><li>Physical (borders) </li></ul><ul><li>Technical (standards) </li></ul><ul><li>Fiscal (taxes) </li></ul><ul><li>These barriers obstruct the freedom of movement of the four factors of production </li></ul><ul><li>Removal of barriers requires political will and common economic policies </li></ul>
  33. 33. <ul><li>Single market : </li></ul><ul><li>Full freedom of movement for all the factors of production ↑ efficientcy/ productivity </li></ul><ul><li>Very competitive environment, making the existence of monopolies more difficult </li></ul><ul><li>Inefficient companies will suffer a loss of market share and may have to close down </li></ul><ul><li>Efficient firms can benefit from economies of scale, ↑competitiveness and lower costs </li></ul><ul><li>Consumers benefit: </li></ul><ul><li>Competitive environment brings cheaper products </li></ul><ul><li>More efficient providers of products and also increased choice of products </li></ul><ul><li>Businesses in competition will innovate to create new products </li></ul><ul><li>However membership of a single market brings both gains and losses: </li></ul><ul><li>Trade creation – you need to be able to construct & explain this diagram: </li></ul><ul><li>When ↑ trade results from the ↓ trade barriers like tariffs and quotas </li></ul><ul><li>Country buying goods from a low cost rather than a high cost country </li></ul><ul><li>Consumers benefit because they are able to buy from a cheaper source </li></ul>
  34. 34. Trade Creation ↑ in trade due to ↓/elimination of tariffs and quotas 0 Price W1 Domestic demand Domestic supply W Price + tariff Price minus tariff E B A C Quantity W1 – price before joining – Demand OA supply OB W price after joining – Demand ↑ to OC supply ↓ to OE Trade creation EB + AC Before I go any further make sure you can explain the important areas on the diagram
  35. 35. <ul><li>As a result of membership there are certain losses – it is not all sweetness and light! </li></ul><ul><li>The problem of </li></ul><ul><li>Trade diversion: </li></ul><ul><li>Country has to buy from high cost rather than low cost producer </li></ul><ul><li>UK before it joined the EU bought food buy from low cost producers </li></ul><ul><li>After entry + common external tariff - cheaper to buy food from other EU countries </li></ul><ul><li>The higher the tariffs imposed before entry more likely that trade creation rather than trade diversion will take place </li></ul><ul><li>Net gains will tend to be larger, the greater the volume of trade between the countries in the common market </li></ul><ul><li>You need to be able to construct the diagram and fully explain it </li></ul>
  36. 36. Trade diversion ↑ in prices as producers in common market less efficient 0 Price Domestic demand Domestic supply E B A C Quantity EU price World price At world price demand OA and supply OB Price ↑ demand ↓ to OC supply ↑ to OE Explanation of the effects will complement the diagram and increase the marks
  37. 37. <ul><li>Other areas to consider as a result of joining a single market </li></ul><ul><li>Economies of scale: </li></ul><ul><li>Dynamic gains - occur over time - result from the economies of scale </li></ul><ul><li>Major reason for entry - size of the potential market - economies of scale </li></ul><ul><li>European Union has 430 million inhabitants compared to 57 million for the UK </li></ul><ul><li>Single market ↑cross border mergers to exploit the economies of scale </li></ul><ul><li>EU fairly homogenous and rich market - similar high income EOD products </li></ul><ul><li>Competition: </li></ul><ul><li>Domestic industries will face greater competition </li></ul><ul><li>↑ competition -> dynamic efficiencies - innovation, reduced costs, reduced prices </li></ul><ul><li>Gains in productive and allocative efficiency </li></ul><ul><li>Danger of oligopolistic control occurs through cross border mergers </li></ul><ul><li>Competition Commissioner has enforced competition policy </li></ul>
  38. 38. Transfers of resources: Contributions may be spent on an area that does not directly benefit the contributor e.g. the UK and the common agricultural policy Net transfer of resources = static losses and gains Dynamic economies - attract inflows of capital and labour making them more dynamic Customs unions - not as efficient as world wide free trade Single market - negative impact on some sectors due to ↑ international competition Your job in a question would be to decide whether the benefits outweigh the disadvantages
  39. 39. <ul><li>5. Economic and monetary union – a single market with a common currency </li></ul><ul><li>Given that you have seen the problems of EMU you might like to consider whether integration should have stopped with a single market </li></ul><ul><li>The final stage of integration </li></ul><ul><li>6. Complete economic integration </li></ul><ul><li>Integrated units have no control of economic policy: </li></ul><ul><li>Full monetary union </li></ul><ul><li>Fiscal policy harmonisation </li></ul><ul><li>Economic integration most common within countries - rather than within supranational institutions </li></ul><ul><li>So a question for you to plan is </li></ul><ul><li>Assess the view that Europe should have remained a free trade area rather than embracing monetary union </li></ul>
  40. 40. There are a number of areas that you can analyse and evaluate Free trade area: All members abolish tariffs with other members Trade between the members would flourish – benefits of EOS, MES, specialisation comparative advantage – trade creation diagram could be drawn All members individually free to set external tariff with non-members Countries could impose tariffs against external countries where trade diversion was taking place Possible danger of trade deflection but remedied by rules of origin No loss of monetary control Central bank free to set optimum ROI for the country Enables currency to float in accordance with market forces
  41. 41. Monetary union – a single market with a common currency Advantages Price transparency -make price comparison easier may lead to ↓ prices ↑ FDI due to ↑ currency stability & increased potential market size Potentially ↓ ROI, ↓ Govt interference, credible commitment to low inflation But : Loss of an independent monetary policy Inability to choose a different short term inflation/unemployment trade off Inability to react to country specific economic shocks 'Real' misalignment Asymmetric policy sensitivity
  42. 42. Evaluation PIIGS could have made it work using appropriate fiscal policies Given that its an un-optimal currency area – can it work? Deficit countries likely to struggle along with grudging help from surplus countries Would an independent monetary policy solve their problems Lets look at the PIIGS problems in more detail
  43. 43. The potential costs of a Single currency to the PIIGS Loss of an independent monetary policy Members pass control of monetary policy to the European Central Bank ECB would set ROI for area as whole rather than for any one country within the EMU This has several implications:
  44. 44. Effectively the ROI was too low leading to rapid increase in short run economic growth Fig 3 AD/AS and growth <ul><li>Trend growth = full employment (FE) </li></ul><ul><li>Growth below trend: </li></ul><ul><li>A negative output gap – AD1 </li></ul><ul><li>Economy is inside the PPB </li></ul><ul><li>↑ in C+I+G+(X-M) shift AD1 to AD </li></ul><ul><li>Growth above trend: </li></ul><ul><li>Positive output gap –AD2 </li></ul><ul><li>Inflation increasing </li></ul><ul><li>ECB ROI to low for PIIGS </li></ul>Price level Real output 0 AS FE AD AD1 AD2
  45. 45. Normally increased inflation would lead to a depreciation of the currency But in the Euro Area, a country with a relatively high rate of inflation cannot expect a depreciation of their exchange rate to restore lost competitiveness The PIIGS should have run a deflationary fiscal policy when AD was ↑ too rapidly They will have to achieve this in other ways such as a better supply-side of the economy or lower wages Part of their decline in competitiveness stems from these economies having a ‘fixed’ exchange rate against other members of the euro area. If the PIIGS had their own currency, they could let the value fall to a level that would make the country's tradable goods sectors competitive. Evaluate the view that PIIGS economic performance would improve by a currency devaluation and leaving the Euro Area (20) What issues could be considered and analysed in answer to this question Need to reduce wage costs to compete with Germany Rather than facing trade union anger over continuous wage deflation devaluation might be preferable
  46. 46. Price of $’s in Euros D & S of $’s Demand for $ Supply of $’s 1 D1 for $’s S1 of $’s 2 0 Equilibrium where $1 = €1 ↑ price of UK goods ->↓ US demand and ↓ supply of $’s – S-S1 PIIGS import more of the relatively cheaper US goods - demand for $’s ↑ - D-D1 ↓ supply of $’s and ↑ in demand ->↑ in the price of $s The overall effect of these changes is that the dollar has appreciated to $1 = €2. How inflation would depreciate the value of a currency
  47. 47. <ul><li>The effect of the inflation </li></ul><ul><li>Depreciation of the €, PIIGS exports have become cheaper and imports dearer </li></ul><ul><li>Less revenue is received from the sale of exports, as they have fallen in price </li></ul><ul><li>Terms of trade move against the PIIGS </li></ul><ul><li>Overall depreciation should benefits the PIIGS - Marshall-Lerner condition </li></ul><ul><li>BOP will benefit - the depreciation will lead to ↑ inflationary pressure in the PIIGS </li></ul><ul><li>Could lead to a rising inflationary spiral – could they control it </li></ul><ul><li>If prices are forced up the benefits of the initial depreciation will be lost </li></ul><ul><li>The need for spare capacity </li></ul><ul><li>Considerations to bear in mind when using devaluation as a policy weapon: </li></ul><ul><li>Cost push inflation - ↓ £ -> ↑ price of imports – food, raw materials, fuel </li></ul><ul><li>J-curve effect </li></ul>
  48. 48. Fig 12 - The J-Curve Following devaluation the account will get worse before it gets better Takes time for foreign buyers to realise PIIGS goods are cheaper and ↑ expenditure Long term contracts fix prices Short run - volume of exports remain the same and less will be spent on them More will be spent on imports until consumers find substitutes The short run demand for exports and imports will tend to be inelastic 0 BOP + BOP - Time J
  49. 49. 2. Other policy options by using supply side measures – outlined later Second part of question – leaving the Euro area Advantages Regain monetary independence Avoid years of grinding wage deflation to reduce unit labour costs Bring wage costs into line with workers productivity But: Euro took years to introduce PIIGS central banks would have to introduce new notes and coin FAST Bank runs as depositors shift money abroad to avoid losses – caps on withdrawal Cut off from foreign credit – banks would be reluctant to lend until currency stable Legal challenges – depositors with large losses might sue as in Argentina Foreign banks and pension funds would suffer effective default
  50. 50. Evaluation/judgement Will the depreciation set off inflationary pressures that PIIGS are unable or unwilling to contain or will there be a rising inflationary spiral given the power of trade unions Will the increased inflation wipe out the benefits of the initial depreciation Will the country be likely to increase welfare benefits as imported food prices increase Long run versus short run – how long will it take for the J curve effect to produce a surplus balance Are all the PIIGS able to benefit from increased international trade as opposed to the loss of intra community trade that they will suffer? Would costs of leaving Euro be greater than benefits
  51. 51. <ul><li>What unites these five economies is a loss in competitiveness compared to the rest of the euro area and to economies outside the euro area . </li></ul><ul><li>2 measures of competitiveness </li></ul><ul><li>↑ output prices feeds through to ↑ retail prices </li></ul><ul><li>↑ in relative unit labour costs </li></ul><ul><li>Both show a decline in the competitiveness of the PIIGS </li></ul><ul><li>Why </li></ul><ul><li>ECB unable to set a rate that controlled inflation throughout the zone </li></ul><ul><li>High relative rate of inflation can lead to a loss of competitiveness for a country: </li></ul><ul><li>Export sectors get priced out of market </li></ul><ul><li>Imported goods relatively cheaper taking a rising share of consumer demand </li></ul><ul><li>Causes of increases in producer prices </li></ul><ul><li>The exchange rate </li></ul><ul><li>Changes in indirect taxes </li></ul><ul><li>Changes in international commodity prices </li></ul><ul><li>Changes in wage costs </li></ul><ul><li>The strength of demand and the economic cycle </li></ul>
  52. 52. <ul><li>Unit labour costs - labour costs per unit of production </li></ul><ul><li>Two factors determine changes in this measure </li></ul><ul><li>The rate of increase in average wages / earnings in the labour market </li></ul><ul><li>2. The rate of increase in labour productivity (i.e. output per worker employed) </li></ul><ul><li>If wages rise by 5% & productivity ↑ 2% unit labour costs will rise by 3% </li></ul><ul><li>Relative unit labour costs - relative to those of another country </li></ul><ul><li>Depreciation of £ against € makes UK relative labour costs cheaper than they were </li></ul><ul><li>↑ relative unit labour costs - indicator of a ↓ cost competitiveness within Euro Area </li></ul><ul><li>The data in Fig 2.3 shows ↑ in relative costs led to ↑ in the size of their trade deficits in the years before the global financial crisis </li></ul><ul><li>How do these countries reduce their relative costs </li></ul><ul><li>↓ average wages - pay freeze or an actual cut in their wages and take home pay </li></ul><ul><li>↑ productivity – improve labour efficiency </li></ul><ul><li>Using a diagram analyse the likely effects of an increase in output prices and labour costs 6 marks – Don’t forget this is cost push inflation </li></ul>
  53. 53. ↑ labour costs and output prices are likely to create cost push inflation SRAS shifted left leading to a higher level of prices and a lower level of output Possibly shifting the economy to a negative output gap - ↑unemployment & ↓GDP Cost push inflation Supply side pressure Price level Real output P 0 AD P1 A B SRAS SRAS1
  54. 54. <ul><li>Extract 3 – The Spanish economy </li></ul><ul><li>Numerous problems </li></ul><ul><li>Collapse of construction bubble leading to </li></ul><ul><li>↑ unemployment - huge numbers of people directly & indirectly involved in construction </li></ul><ul><li>Banks exposed to property sector as they hold unsaleable property as collateral </li></ul><ul><li>Spanish government encouraging banking mergers </li></ul><ul><li>Negative accelerator effects </li></ul><ul><li>Negative multiplier effects – far reaching effects – migration </li></ul><ul><li>Unbalanced economy - Dependence on tourism/property = derived demand from rest of Europe </li></ul>
  55. 55. <ul><li>2. Very high level of welfare payments </li></ul><ul><li>60% of their previous wage for 18 months after losing their job </li></ul><ul><li>Guaranteed benefits of €420 per month for the long-term unemployed </li></ul><ul><li>Pensions far more generous than UK </li></ul><ul><li>Help to newly married €250 per month for 5 years </li></ul><ul><li>Welfare benefits and the rate of unemployment </li></ul><ul><li>Replacement ratio – % of Y replaced by benefits when unemployed </li></ul><ul><li>2/3rds wage for 18 months </li></ul><ul><li>Disincentive effect on working </li></ul>
  56. 56. Effect on incentives to actively search for work ↑ voluntary unemployment – make sure you know what this is ↑ frictional unemployment – don’t need to take first job to come along ↑ structural unemployment – no rush to retrain or move to where jobs are Social consequences of ↑ unemployment Estimated 40% of under 25’s 20% of working population ↑ relative poverty if no wage earner ↑ social unrest - loss of social cohesion damaging the fabric of society ↑ in unemployment-related crime ↑ stress related health problems and family breakdown ↑ social costs of rising level of debt – hits poor high rates Failure of labour market = ↑ negative externalities
  57. 57. <ul><li>3. Product market reforms urgently needed especially in utility industries </li></ul><ul><li>Lack of contestability allows high costs and prices </li></ul><ul><li>↑ costs of living for consumers and output costs for producers </li></ul><ul><li>Fiscal costs of recession </li></ul><ul><li>↓ tax receipts </li></ul><ul><li>2. ↑ benefit expenditure </li></ul><ul><li>3. Fiscal stimulus </li></ul><ul><li>1+2+3 = very large and growing budget deficit </li></ul>
  58. 58. Large budget deficits incurred by the PIIGS have increased their economic problems Evaluate the view that governments should always balance their budgets Explanation of term budget balance and the stance a government might take: Neutral fiscal stance is where the government runs a balanced budget Expansionary fiscal policy government uses a budget deficit (G>T) to ↑ AD Contractionary/deflationary fiscal policy - budget surplus (G<T) to ↓AD Influencing the level of AD in the economy is referred to as demand management Governments do this to smooth out fluctuations in the economic cycle Automatic stabilisers – the cyclical deficit
  59. 59. Auto stabilisers should balance out over the duration of the cycle Spain - large welfare state, big public sector as % total GDP automatic stabilisers have ↓ impact of the recession on her GDP GDP Time Trend Actual Govt,Y from tax increasing Govt. expenditure on benefits falling = Cyclical surplus Govt Y from tax decreasing Govt. expenditure on benefits increasing Cyclical deficit 0
  60. 60. <ul><li>In the past, governments attempted ‘fine-tuning: </li></ul><ul><li>∆ government spending/taxation, to make precise adjustments to the level of AD </li></ul><ul><li>Governments now accept that fiscal policy cannot be used so precisely </li></ul><ul><li>Automatic stabilisers adjust automatically to minimise fluctuations in the economic cycle - e.g. spending on unemployment benefits fall when economic activity is buoyant </li></ul>
  61. 61. <ul><li>Structural budget deficit </li></ul><ul><li>Structural budget deficit - changes in the structure of economic activity or govt. policy </li></ul><ul><li>↑ govt. expenditure due to lax policies when economy expanding </li></ul><ul><li>↑ numbers dependent on welfare benefits </li></ul><ul><li>↑ structural deficit implies ↑ taxes and/or reduce public spending </li></ul><ul><li>Public sector net cash requirement (PSNCR) - government spending > revenue </li></ul><ul><li>To finance the gap between revenue and spending government ↑borrowing </li></ul><ul><li>↑ Govt, structural deficit may mean less available for fiscal stimulus </li></ul>
  62. 62. Auto stabilisers take AD- to AD Fiscal stimulus required to get from AD to AD1 If government has a large structural deficit may not be able to afford the stimulus Govts. that ↑ the structural deficit in times of boom are risking problems when the economy contracts Price level Real output AS AD- AD FE AD1 0
  63. 63. <ul><li>Don’t forget that governments might not easily be able to reduce a cyclical deficit </li></ul><ul><li>A large Structural deficit and an ↑cyclical deficit may present them with the following problems: </li></ul><ul><li>1 Financing the deficit -substantial interest payments which will be a leakage - Oflow </li></ul><ul><li>2 government borrowing ↑ National Debt - spend more in debt interest payments </li></ul><ul><li>3 Fiscal ‘crowding-out </li></ul><ul><li>↑ budget deficit leads to higher interest rates and taxation </li></ul><ul><li>reduces private sector expenditure - consumption and investment spending ↓ </li></ul><ul><li>Contrast this with the benefits of a budget deficit </li></ul><ul><li>1 A stimulus to growth: </li></ul><ul><li>Crowding in </li></ul><ul><li>Additional capital spending, roads/schools ↑ LRAS </li></ul><ul><li>Can boost the long-run supply-side capacity of the economy </li></ul><ul><li>2 Demand management - ↑ aggregate demand, avoiding a large negative output gap. </li></ul>
  64. 64. Evaluation points: Will a cyclical deficits/surpluses balance over the period of the cycle Risk that governments will ↑ handouts in good times leading to ↑ structural deficits Re- election may be more important than sound economic policy – govt. failure Possible damage to supply side of the economy of increasing benefits Opportunity costs of increasing PSNCR Problems with Bond markets and increasing national debt Will deficit benefit the supply side or just increase AD Short run effects versus long run effects Perhaps a final judgement that the deficit has helped prevent a worse depression but has left PIIGS with huge deficits to manage
  65. 65. Spain has had to introduce a period of fiscal austerity to ↓ their budget deficit Retirement age has risen to 67 from 65 ↓ government spending - wage cuts for civil servants and frozen welfare payments make it easier to lay off employees and reduce redundancy packages. Spain urgently needs to increase its LRAS – its trend growth rate This means labour market reforms to improve efficiency of factor markets Product market reforms – where there is a lack of competition & contestability Aims of supply-side policies ↑ supply and efficiency of labour ↑ skills of the labour force – investment in human capital ↑ mobility of labour – geographical & occupational Remove barriers that stop wages reaching equilibrium levels – reduce TU powe Encourage flexible working practices What are the policies 1. Labour market measures: Lower rates of income tax - create incentives to work
  66. 66. <ul><li>Supply-side economists argue: </li></ul><ul><li>high income tax rates create disincentives to work </li></ul><ul><li>negative impacts on national income and the government’s total tax revenue </li></ul><ul><li>This effect is illustrated by the Laffer Curve </li></ul>Tax revenue is maximised at 35 % ↑ in the average tax rate has a negative effect on total tax revenue Government income from tax % of Y taken in tax 0 100 70 A 35 B
  67. 67. ↓ benefit payments to make voluntary unemployment less affordable Welfare benefits can also be made more difficult to claim Tax relief on Y from renting out accommodation - ↑geographical mobility Welfare to work strategy to ↑ levels of employment and participation National Minimum Wage to ↑ incentives to supply labour rather than live off benefits 2. Education and training To increasing the productivity of labour Should ↑ LRAS & ↓. unit labour cost per unit of output ↑ international competitiveness. 3. Trade union reforms TU’s –↑ the wages of their members by restricting the supply of workers ↑ labour costs ↓ efficiency & market flexibility ↓ international competitiveness 4. Reform employment laws ↓ govt. regulation of labour market to lower non-wage costs of employing workers Encourage short term contracts and part time labour Encourage profit related pay Encourage employee share ownership
  68. 68. <ul><li>5. Product market measures </li></ul><ul><li>Supply-side policies in product markets to ↑competition and efficiency </li></ul><ul><li>Private ownership of formerly public owned organisations: </li></ul><ul><li>Leads to greater productive efficiency </li></ul><ul><li>Reduced drain on the public purse </li></ul><ul><li>Deregulation: This is very important for Spain </li></ul><ul><li>removal of barriers to entry in an industry </li></ul><ul><li>Creates competitive markets where there had previously been a state monopoly </li></ul><ul><li>Contracting out the delivery of public services </li></ul><ul><li>Opening up of capital markets </li></ul><ul><li>Removal of barriers to the flow of capital </li></ul><ul><li>EU single market measures </li></ul><ul><li>Improving consumer information </li></ul><ul><li>Tougher competition policy </li></ul><ul><li>Forces firms to be more dynamically efficient </li></ul><ul><li>Reduces the ability of firms to abuse a dominant market position </li></ul>
  69. 69. 6. Measures to encourage entrepreneurship and capital spending: Loan guarantees for new start-ups Reducing rates of corporation tax for small businesses Allowing tax relief on profits used for investment purposes Regional policy assistance in depressed areas 7. Policies to encourage enterprise ↓ taxation & govt. spending ↓ corporation tax to increase investment Incentives to encourage FDI Encouraging business start ups
  70. 70. Consequences of policies Boost long term growth ↑ prosperity in long run Helps to achieve all macro-economic objectives simultaneously ↑ employment ↓ cost push inflation by increasing efficiency ↑ international competitiveness We can show the effects of these policies diagrammatically but remember they take time to have an effect
  71. 71. <ul><li>Supply-side growth and macroeconomic policy objectives </li></ul><ul><li>Supply-side growth offers the possibility of: </li></ul><ul><li>steady, non-inflationary, sustainable growth - improvement in the current account </li></ul><ul><li>inflation and current account problems under control even if AD rising </li></ul>LRAS – LRAS1 national income rises from OA to OB Govt can allow AD to ↑ without creating inflationary pressure Price level Real output LRAS AD 0 P1 LRAS1 P AD1 A B
  72. 72. An alternative diagram ↑ AD from AD to AD1 ↑ inflation PL to PL1 A supply side increase allows ↑ real output with lower prices PL- Price level Real output AS FE AD- AD AD1 AS1 PL PL1 PL- Fe1 0
  73. 73. In a rapidly-changing world there needs to be a high level of flexibility as patterns of demand change bringing about changes in the pattern of employment Analyse the determinants of a flexible labour market – 6 marks Labour market flexibility ↓ natural rate as labour moves from declining industries to growing industries Labour markets need to - adapt to change, respond to economic signals created by wage differentials Flexible labour market characterised by: Mobility of labour - adaptable, capable of learning new skill Training and retraining opportunities must be available Must be possible for employers to hire people with the skills they need Labour force must have good basic educational foundations Employers must be able to get rid of workers Employment protection laws but make employers less likely to hire in the first place Short term contracts - workers able and willing to adapt to employers requirements.
  74. 74. <ul><li>Labour market rigidities </li></ul><ul><li>UK labour markets more flexible than Europe </li></ul><ul><li>Less employment protection </li></ul><ul><li>Unemployment benefits last for only a short time so incentive to work greater </li></ul><ul><li>More inequality in the UK income distribution </li></ul><ul><li>Characteristics of inflexible labour markets :- </li></ul><ul><li>Employment protection legislation </li></ul><ul><li>Generous unemployment benefits - reduce the incentive to work </li></ul><ul><li>Relatively high minimum wages </li></ul><ul><li>Trade unions powerful </li></ul><ul><li>↑ wages above their free market equilibrium level </li></ul><ul><li>negotiate binding contracts, which may discourage employment </li></ul><ul><li>Structural unemployment caused by occupational and geographical immobility of labour </li></ul><ul><li>Workers in jobs for which they are not best suited </li></ul><ul><li>Disincentives to look for and take paid work – unemployment & poverty traps </li></ul>
  75. 75. <ul><li>Competition and contestability </li></ul><ul><li>Make sure you understand some of the features and characteristics of a contestable market: </li></ul><ul><li>Low entry barriers and exit costs which affects the ease of short-term “hit and run entry” </li></ul><ul><li>2. High levels of product differentiation between competing businesses and brands </li></ul><ul><li>3. The ability to price discriminate – charging different prices to different consumers for the same products </li></ul><ul><li>4. The cost structure of a market such that the minimum efficient scale is not a large percentage of market demand allowing many firms to enter and be competitive </li></ul><ul><li>5. There is interdependence between firms (similar to a competitive oligopoly) </li></ul><ul><li>Barriers to market contestability exist when there are sunk costs. These are costs that have been committed by a business cannot be recovered once a firm has entered the industry </li></ul>
  76. 76. Extract 4 – Pascal Lamy emphasises the importance of international trade Free Trade and Protection Free trade – absence of protection - based on Comparative Advantage Worlds’ resources used more efficiently when countries specialise in producing those goods and services in which they have a comparative advantage Comparative advantage – opportunity cost of producing the good in one country is less than elsewhere Benefits obtained by importing from countries where the opportunity cost is lower Concentrating on exporting something in which a country has a comparative advantage
  77. 77. Worldwide specialisation based on comparative advantage = efficient resource use Competition/economies of scale should lead to dynamic efficiencies Theory states that countries should specialise in the production of those goods where they have the greatest comparative advantage, or least comparative disadvantage Assume 2 areas Europe and Australia, both producing food and clothing. Australia Europe Product units per hour units per hour food 6 2 clothing 3 1.5 Australia produces more of both goods in less time - has an absolute advantage Benefits of Trade Australia Europe Product units per hour units per hour Food 6 3 Clothing 4.5 1.5
  78. 78. Case for trade - all countries taken together will gain in terms of increased production, economic efficiency, and welfare No guarantee gains equally distributed some countries may feel that it is their interest to restrict trade Arguments for protection The infant industry argument Cushion home employment Prevent dumping - anti dumping measure may be a technique of protection Improve Balance of payments Protect employment levels Avoid &quot;unfair&quot; competition – NIC’s exploit labour by paying low wages Arguments against protection . Retaliation - reduces world trade to the detriment of all Props up inefficient producers’ - do not face efficient competition Welfare loss to consumers
  79. 79. World price before tariff is OP domestic demand OC domestic supply OB Tariff ↑ price increases to P+T domestic demand ↓ to OA domestic output ↑ to OE Imports ↓ from BC to EA Total consumer welfare has fallen by P, P+T,F,G Domestic suppliers gain P,P+T,H,J at the expense of consumers HFKL represents the revenue from the tariff – the amount imported times the price Net loss - triangles JHL and FGK - tariff has reduced welfare as a whole Fig 5 Welfare loss Price Quantity Domestic demand Domestic supply World price 0 P P+T Tariff price C B E A J H L F K G
  80. 80. <ul><li>The rise of protectionism </li></ul><ul><li>Where govts to impose restrictions on trade in goods and services </li></ul><ul><li>Aim is to cushion domestic businesses and industries from overseas competition </li></ul><ul><li>Types. </li></ul><ul><li>Tariffs - a tax that ↑ price of imports </li></ul><ul><li>Quotas - quantitative limits on the level of imports allowed </li></ul><ul><li>Voluntary Export Restraint - two countries make an agreement to limit the volume of their exports to one another over an agreed period of time </li></ul><ul><li>Embargoes - a total ban on imported goods </li></ul><ul><li>Intellectual property laws (patents and copyrights) </li></ul><ul><li>Preferential state procurement policies –govt. favours local/domestic producers </li></ul><ul><li>Export subsidies - ↓costs of domestic producers – dumping </li></ul><ul><li>Domestic subsidies – to loss makers - car manufacturers or loss-making airlines </li></ul><ul><li>Import licensing - governments grants importers the license to import goods </li></ul>
  81. 81. <ul><li>Exchange controls - limiting foreign exchange that can move between countries. </li></ul><ul><li>Financial protectionism – credit crunch – banks prioritise loans to domestic business </li></ul><ul><li>Competitive devaluations - government intervenes to keep currency artificially low </li></ul>Be ready to make a judgement on the arguments for and against protection for any particular country
  82. 82. International Organisations The World Trade Organisation (WTO) WTO - global international organisation dealing with the rules of trade between nations WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments Aim is to ↓ tariffs and other types of protection through “rounds” where countries try to agree to reduce tariff levels To help producers of goods/services, exporters/importers conduct their business Multi-lateral agreements using the principle of “most favoured nation status” If a country agrees a tariff reduction with one country it has to accept the reduction with all others This can be contrasted with bi-lateral agreements where the country only agrees trading terms with another country and does not extend it to others
  83. 83. <ul><li>Main functions of the WTO are: </li></ul><ul><li>To oversee implementing and administering WTO agreements </li></ul><ul><li>To provide a forum for negotiations </li></ul><ul><li>To provide a dispute settlement mechanism </li></ul><ul><li>The goals behind these functions are: </li></ul><ul><li>Raising standards of living </li></ul><ul><li>Ensuring full employment </li></ul><ul><li>Ensuring large and steadily growing real incomes and demand </li></ul><ul><li>Expanding the production of and trade in goods and services </li></ul><ul><li>These objectives are to be achieved while allowing for the optimal use of the world's resources in accordance with the objective of sustainable development, and while seeking to protect and preserve the environment </li></ul><ul><li>The preamble also specifically mentions the need to assist developing countries, especially the least developed countries, secure a growing share of international trade </li></ul>
  84. 84. <ul><li>Multi-lateral agreements </li></ul><ul><li>Ensure consumers/producers security of supply </li></ul><ul><li>Exporters know that foreign markets will remain open to them </li></ul><ul><li>WTO decisions taken by consensus - ratified by members' parliaments </li></ul><ul><li>Agreements = legal ground-rules for international commerce - contracts, guaranteeing member countries important trade rights </li></ul><ul><li>Bind governments to keep their trade policies within agreed limits to everybody’s benefit </li></ul><ul><li>Trade friction is channelled into the WTO's dispute settlement process </li></ul><ul><li>Under certain circumstances countries may retaliate & resort to protection </li></ul>
  85. 85. <ul><li>Criticism of the WTO: </li></ul><ul><li>Protestors argue WTO is secretive and influenced by big MNC’s </li></ul><ul><li>TU’s - WTO rules enforce imports from countries with lower health/safety standards MNC’s- can move their capital leading to job loss in developed countries </li></ul><ul><li>Agricultural conglomerates are forcing small local based farmers out of business </li></ul><ul><li>Indigenous people too are being forced off their land </li></ul><ul><li>WTO - forced members to repeal laws that limit the free movement of capital </li></ul><ul><li>Developed countries hypocrisy: </li></ul><ul><li>WTO ↓ tariff and non-tariff barriers on manufactured goods – goods that the developing countries have absolute advantages in producing </li></ul><ul><li>Goods LDC’s mainly produce are heavily protected by tariffs and subsidies </li></ul><ul><li>WTO not reformed tariffs/subsidies that protect farmers in developed countries - CAP </li></ul><ul><li>MNC’s use WTO rules to close pirate operations in LDC’s - life saving drugs </li></ul>
  86. 86. More possible questions
  87. 87. <ul><li>Examine the view that the benefits of monetary union outweigh the disadvantages – 20 marks </li></ul><ul><li>Introduction </li></ul><ul><li>EMU - step on the road to a US of Europe - single currency - ECB </li></ul><ul><li>Number of elements to EMU: </li></ul><ul><li>1. Independent central bank - regulates the ROI and monetary policy </li></ul><ul><li>Lender of last resort for the European banking system </li></ul><ul><li>Criticised as over secretive - minutes of meetings are not published. </li></ul><ul><li>2. Euro, which is now the sole operational currency. </li></ul><ul><li>3. Growth and Stability Pact limited the budget deficit to 3% of GDP </li></ul><ul><li>Analysis </li></ul><ul><li>The potential benefits of a single currency: </li></ul><ul><li>Reduced transaction costs </li></ul><ul><li>Reduced exchange rate uncertainty </li></ul><ul><li>Increased intra-EMU competition – enlarged market </li></ul>
  88. 88. <ul><li>Increased volume of sales </li></ul><ul><li>Further economies of scale </li></ul><ul><li>Increased inward direct investment </li></ul><ul><li>Lower interest rates </li></ul><ul><li>Rise in competition & competitiveness </li></ul><ul><li>Lower costs </li></ul><ul><li>Higher productivity </li></ul><ul><li>Increased growth, employment & income </li></ul><ul><li>Improvement in the supply side </li></ul><ul><li>End to competitive devaluation </li></ul><ul><li>Greater price transparency </li></ul>
  89. 89. <ul><li>The potential costs of a Single currency </li></ul><ul><li>Loss of an independent monetary policy </li></ul><ul><li>Unable to devalue to maintain competitiveness </li></ul><ul><li>Pass control of monetary policy to the European Central Bank </li></ul><ul><li>Loss of power to choose a different short term inflation/unemployment trade off </li></ul><ul><li>Inability to react to country specific economic shocks – inflexible labour markets </li></ul><ul><li>Loss of exchange rate control </li></ul><ul><li>'Real' misalignment - economic development too low to maintain a single currency </li></ul><ul><li>Asymmetric policy sensitivity – UK and mortgages </li></ul><ul><li>Too deflationary – The ECB has adopted a target inflation rate of < 2% HICP </li></ul><ul><li>ECB is slower to react to falling growth rates than the BOE or the Federal Reserve </li></ul><ul><li>Lack of economic convergence – UK's economic cycle does not match Europe's </li></ul><ul><li>Stability and Growth Pact – difficult if the economy moves into a deep recession </li></ul>
  90. 90. The problem of mis-alignment Straight line shows desired economic convergence The trade cycles are shown as horizontally opposed UK in recession while Euroland in boom - different monetary policies are appropriate 0 GDP Euroland UK Time
  91. 91. Evaluation/judgement: Costs greater where: there is a lack of economic convergence Countries suffer differently from asymmetric shocks There is a lack of flexibility & mobility in factor markets Concern that the Euro area is not an optimal currency area
  92. 92. <ul><li>Comment on the extent to which “the positive impact of national stimulus packages is at best temporary” (Extract 4) (10) </li></ul><ul><li>Type of stimulus package is introduced – for example: </li></ul><ul><li>Temporary scrappage schemes - cars, boilers and other consumer durables </li></ul><ul><li>Temporary cuts in direct or indirect taxation for example a reduction in VAT </li></ul><ul><li>Temporary increases in state sector spending – labour subsidies – Germany </li></ul><ul><li>Whether government finances will allow continued stimulus </li></ul><ul><li>Whether the multiplier effect is strong – depending on: </li></ul><ul><li>Type of stimulus - Tax cuts or higher government spending? </li></ul><ul><li>Who benefits from tax reductions </li></ul><ul><li>What consumers do with income from tax cuts </li></ul><ul><li>Credit crunch – can firms borrow to take advantage of increasing national income </li></ul>
  93. 93. <ul><li>Will the budget deficit lead to a Balance of payments deficit where money flows out </li></ul><ul><li>If budget deficit increases will central bank increase the ROI </li></ul><ul><li>Is there spare capacity in the economy (size of the output gap) </li></ul><ul><li>Expectations on consumers and businesses </li></ul>
  94. 94. 6. Comment on the extent to which a reduction in global trade barriers in manufacturing and agricultural goods can help a developing country (10) Introduction Explanation of global trade barriers Reasons for global barriers Both developed and undeveloped countries use barriers Benefits of free international trade & their limitations Terms of trade Analysis Diagram of tariff barriers Numerical example of benefits of free trade Outline the problems that the country might incur - ↑ unemployment ↑ BoP deficit Evaluation Are advantages > costs May depend on individual circumstances of the country
  95. 95. <ul><li>Analyse the benefits of having a fixed rather than a floating exchange rate (6) </li></ul><ul><li>Advantages of fixed rates: </li></ul><ul><li>Business knows - price they will receive from exports and price of raw materials </li></ul><ul><li>Government has to follow economic policies that will maintain the fixed rate </li></ul><ul><li>Limit the fluctuations of the trade cycle - countries cant gain by depreciating </li></ul><ul><li>Disadvantages of fixed rates: </li></ul><ul><li>Need periodic revision - some countries need to devalue while others to revalue </li></ul><ul><li>Government might need to run a perpetual deflationary policy - ↓growth </li></ul><ul><li>Speculation - countries that have persistent BOP deficits </li></ul><ul><li>Advantages of floating rates: </li></ul><ul><li>Market system - the Forex market changes the rates automatically </li></ul><ul><li>Continuous adjustment - reflects purchasing power of one currency against another </li></ul><ul><li>Reduced speculative pressure, as countries cannot be forced to devalue </li></ul><ul><li>Disadvantages of floating rates : </li></ul><ul><li>No guarantee floating rate will solve Balance of Payments problems - PEOD </li></ul><ul><li>Effect on domestic inflation - when the currency depreciates </li></ul><ul><li>Currency appreciation - exports dearer - imports cheaper – deindustrialisation </li></ul><ul><li>Uncertainty - Since the removal of exchange controls massive capital flows can occur </li></ul>