Transcript IESL econ 22.09.2013 new

Economic Theory
Shashi Abeysinghe
B.Sc(eng), CIMA
Micro-economics
What’s the difference between
Microeconomics & Macroeconomics?
Microeconomics examines small economic
units, the components of the economy.
For example: individuals, households, firms,
industries
Macroeconomics looks at aggregates.
For example: national output, overall price level,
aggregate unemployment
What is a market?
The interaction of buyers & sellers of a
good or service
Questions relevant to all economies,
market-oriented or not
1. What goods & services should be
produced and how much?
2. How should the goods & services be
produced?
3. Who gets the goods & services?
4. How do changes in the production &
distribution mixes take place?
In a market economy, these questions are
handled by the market.
What & how much to produce:
determined by demand & supply conditions,
individual choices, & pursuit of profit.
How to produce:
determined by technology & resource costs.
Distribution:
based on ability & willingness to pay the price.
What if consumer wants or technology change?
Those changes alter demand & supply, which
changes prices, profits, & consequently output
levels & distribution.
The Circular Flow
Product Markets
money to pay for goods & services
goods & services
Households &
Resource Owners
Firms
labor & other resources
resource payments such as wages, rents, & interest
Resource or Factor Markets
The market is not the only way that the basic
questions of economics can be answered.
In some less developed nations, a
traditional economic system is used.
Custom & tradition determine the answers.
Social arrangements & culture dictate the
solutions.
Change occurs very gradually.
Historically the former Soviet Union had a
command economy.
Resources are government/publicly owned
and centralized control is used to
determine what is produced, how it is
produced, and how it is distributed.
No country in the world has
a purely market or purely command economy.
They have mixed economies with both
market and government sectors.
In this course, we will deal primarily with
the market system.
The Market:
Supply and Demand
What is the law of demand?
The lower the price of a good, the larger
the quantity consumers will buy.
So the demand curve slopes downward
from left to right.
What is the difference between
demand & quantity demanded?
Demand is the entire curve that shows the
relation between price & quantity
purchased.
Quantity demanded is one particular
quantity on the demand curve.
Example: Apple Market
Price of apples
(in dollars)
The demand for apples is the curve D.
The quantity demanded of apples when
the price is 25 cents is 6 thousand
bushels.
$ 0.25
D
6
Quantity of apples
(in thousands of bushels)
What factors change demand
(that is, shift the entire curve)?
1.
2.
3.
4.
Consumer income
Prices of substitutes and complements
Tastes
Consumer expectations
Example: Apple Market
Price of apples
(in dollars)
If income increases, people
will buy more apples at
every price & the entire
curve will shift to the right.
D2
D1
Quantity of apples
(in thousands of bushels)
What makes the quantity demanded of
apples change?
In other words, what causes a movement
along the demand curve for apples?
A change in the price of apples.
That’s it, only a change in the price of
apples.
Example: Apple Market
Price of apples
(in dollars)
Suppose the price of apples
falls from 25 cents to 20 cents.
Then the quantity demanded of
apples rises from 6 thousand
bushels to 8 thousand bushels.
$ 0.25
$ 0.20
D
6
8
Quantity of apples
(in thousands of bushels)
What is the law of supply?
The higher the price of a good, the larger the
quantity firms will be willing to produce and
sell.
So the supply curve slopes upward from left
to right.
What is the difference between
supply & quantity supplied?
Supply is the entire curve that shows the
relation between price & quantity provided.
Quantity supplied is one particular quantity
on the supply curve.
Example: Apple Market
Price of apples
(in dollars)
S
The supply of apples is
the curve S.
$ 0.22
The quantity supplied of
apples when the price is
22 cents is 7 thousand
bushels.
7
Quantity of apples
(in thousands of bushels)
What factors change supply
(that is, shift the entire curve)?
1. Technology
2. Prices of inputs (for example: land, labor,
machinery, raw materials)
3. Weather (in the case of agriculture)
Example: Apple Market
Price of apples
(in dollars)
S2
S1
If rainfall is low, the
supply of apples will be
reduced. At each price,
there will be fewer
apples provided.
Quantity of apples
(in thousands of bushels)
What makes the quantity supplied of
apples change?
What causes a movement along the supply
curve for apples?
Just a change in the price of apples.
Example: Apple Market
Price of apples
(in dollars)
S
$ 0.22
When the price of apples
falls from 22 cents to 20
cents, the amount provided
falls from 7 thousand
bushels to 6 thousand
bushels.
$ 0.20
6
7
Quantity of apples
(in thousands of bushels)
What is equilibrium?
It is a state of balance, where there is no
tendency for things to change.
P
QD
QS
condition
0.25
6
8
excess
supply
0.22
7
7
QD = QS
6
excess
demand
0.20
8
price
pressure
0
Equilibrium occurs where the quantity demanded equals
the quantity supplied, which is at the intersection of the
supply and demand curves.
Example: Apple Market
Price of apples
(in dollars)
S
Here the equilibrium
price is 22 cents & the
equilibrium quantity is
7 thousand bushels.
$ 0.22
D
7
Quantity of apples
(in thousands of bushels)
price
S
P2
P1
Suppose there is an increase in
the price of pears
(a substitute for apples).
Then the demand for apples
will increase.
Equilibrium price increases &
equilibrium quantity increases.
D2
D1
Q1 Q2
quantity
price
S2
P2
P1
S1
Suppose there is a long spell
of bad weather for apple
growing.
Then the supply of apples
will decrease.
Equilibrium price increases
& equilibrium quantity
decreases.
D
Q2 Q1
quantity
Example: cigarette market
Suppose that the surgeon general comes out with
stronger health warnings.
That will reduce the demand for cigarettes.
Simultaneously, there is a year of bad weather.
That decreases the supply of cigarettes.
price
S2
S1
P2 = P1
So S & D both decrease.
The equilibrium quantity
decreases. Equilibrium
price may increase,
decrease or stay the same.
In this example, the price
remained the same.
D1
D2
Q2
Q1
quantity
Resources are limited; wants are unlimited
Scarcity = not enough resources to produce the goods to satisfy
our wants.
Resources: Adam Smith in his Wealth of Nations (1776)
divided resources into land, labor and capital.
http://www.adamsmith.org/smith/won-intro.h
Adam Smith’s 3 resources: Land, Labor and Capital
1. LAND: used as shorthand for any natural resource,
not simply for agricultural land.
2. LABOR: manual power + skill ("human capital")
3. CAPITAL: produced means of production
for example, hammers, drill presses, computers ...
.
Although money is used to BUY all the above,
money is not itself a productive resource.
Capital grows through investment –.
Scarcity means that choices are
necessary.
When you can’t have all you want of
everything, you must make choices.
Microeconomics is the study of how to make
the best possible ( or the optimal) choice
under the constraint of limited resources.
Tradeoffs and the Production Possibility
Frontier
Economists would want to develop a more precise
model of the tradeoffs involved –
And that model can be represented graphically by
a “Production Possibility Frontier”, showing the
choices which are
-- possible (on or within the frontier)
-- efficient (exactly on the frontier)
-- inefficient (within the frontier)
-- impossible (beyond the frontier)
Cadillacs ... 1944 and 1946
Opportunity cost of tank = 10 passenger autos
M5 Tank
Cadillac Coupe
M5 tanks
The tank-auto trade-off:
an economist's view using the
Production Possibility Frontier
500
Autos
5,000
M5 tanks
The tank-auto PPF:
one POSSIBLE point is
(2000 autos, 300 tanks)
500
another POSSIBLE point
is
300
(4000 autos, 100 tanks)
Autos
2,000
5,000
M5 tanks
The tank-auto PPF:
an IMPOSSIBLE point is
(4000 autos, 300 tanks)
500
300
Autos
4,000
5,000
M5 tanks
500
200
an INEFFICIENT point is
(1000 autos, 200 tanks)
1,000
Autos
5,000
M5 tanks
500
The tank-auto equation:
TANKS = 500 – 0.1 AUTOS
Check out a few values:
AUTOS
TANKS
0
500
1000 400
2000 300
2001 299.9
Autos
5,000
M5 tanks
Equation in general form:
TANKS = a + b AUTOS
500
How to find the equation from the graph:
1. a = Y-INTERCEPT = 500
2. b = SLOPE = rise over run
= - 500 divided by 5000 = - 0.1
Autos
5,000
M5 tanks
What the intercept means:
TANKS = 500 – 0.1 AUTOS
500
IF we produced zero autos, we could produce up to
500 tanks, since
TANKS = 500 – 0.1 (0) = 500
Autos
5,000
M5 tanks
600
What happens when the intercept changes:
TANKS = 600 – 0.1 AUTOS
IF we produced zero autos, we could produce up to
600 tanks, since
TANKS = 600 – 0.1 (0) = 600
The PPF would shift OUT and parallel to itself.
500
This might be due to an increase
in the resources available for
production – for example, an
increase in the labor force, and a
new assembly line in the factory
Autos
5,000
6000
M5 tanks
500
What the slope means:
TANKS = 500 – 0.1 AUTOS
IF we were producing 2000 autos and 300 tanks
and if we decided to produce one more auto, we
would have to reduce tank production to 299.9
The OPPORTUNITY COST of an auto is
one-tenth of a tank.
Autos
5,000
M5 tanks
500
What happens when the slope changes:
TANKS = 500 – 0.05 AUTOS
If autos = 0, TANKS = 500
If autos = 5,000, TANKS = 250
If autos = 10,000, TANKS = 0
The possibility exists of producing more autos –
perhaps some way of producing auto
transmissions (but NOT tank transmissions) more
rapidly has been discovered.
Autos
5000
10,000
Introduction
to
Macroeconomics
Macroeconomics?
A Study of aggregate behavior of
Macroeconomic variables
- GDP
- Price level
- Employment
- Interest rate
- BOP
Let us look at the world economy
today
Some Statistics
Share of World GDP in 2005 (US$ billion)
Australia
2%
Rest of the World
21%
Brazil
2%
Canada
3%
China
5%
France
5%
Germany
6%
India
2%
Italy
4%
Japan
9%
United States
27%
UK
5%
Korea
2%
Mexico
2%
Spain
3%
Russian
Federation
2%
GDP growth rates in selected regions, 1995-2005
GDP growth rate (%)
10
8
6
4
2
0
1995
-2
1996
1997
1998
1999
2000
2001
2002
2003
-4
Year
Africa: Sub-Sahara
European Union
Newly industrialized Asian economies
World (All WEO countries)
2004
2005
The circular flow of
income
The interdependence of
goods markets
and
factor markets
The interdependence of goods and
factor markets
FIRMS
(suppliers of goods and services,
demanders of factor services)
HOUSEHOLDS
(demanders of goods and services,
suppliers of factor services)
(3)
Factor
demand
Rs
(2)
Producer
supply
Rs
Factor
services
P
Goods
P
S
S
PF2
P2
P1
PF1
D2
D2
D1
O
QF1QF2
Q
Factor
services
(4)
Factor
supply
Rs
D2
D1
O
Q1 Q 2
Q
Goods
Rs
(1)
Consumer
demand
The circular flow of
income
Consumption, injections, withdrawals and equilibrium
The circular flow of income
Firms
Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
Households
The circular flow of income
In an opened economy
INJECTIONS
Export
expenditure (X)
Investment (I)
Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
Government
expenditure (G)
BANKS, etc
Net
saving (S)
GOV.
ABROAD
Import
Net
expenditure (M)
taxes (T)
WITHDRAWALS
Macroeconomics policies
Microeconomic policies are intended to influence or control macroeconomics variables in
order to achieve macroeconomics relationships and outcomes
.
Fiscal policyThe government’s decision over taxation and public spending, which are incorporate in
the government’s budget, is referred to as fiscal policy.
Monetary policyCentral bank’s control over money supply affecting interest rate is known as monetary
policy.
Trade policyThe government’s actions influencing international trade constitute trade policy.
Eg: - Tariffs,
Quantitative restrictions on import trade,
Subsidies on export trade,
Controls over the payments of foreign exchange
Macroeconomics policies
cont..
Exchange Rate policyThe system of exchange rate maintained in the economy is the exchange rate policy.
This includes different systems such as fixed, floating or managed floating exchange
rate systems.
Redistributive policyThe governments usually design policy measures to redistribute income for the benefit of
low-income groups. Income distribution through taxation and welfare are important
components of the redistributive policy, included in the government budget.
Economic
Growth
Economic growth
- An increase in an economy's ability to produce goods
and services
- Sustainable increase in real output or real income of
an economy
Therefore increasing economic output, is possible
under two conditions:
•More resources are used in the economy.
•Existing resources are used more efficiently.
Measurement of Economic Growth
1. Current Real GDP
2. National Output
3. PPF
Current Real GDP
Rate of GDP growth in yeart =
[Real GDPt - Real GDPt-1]/Real GDPt-1
Calculate GDP Growth
Country
2002 2003
2003 2004
2004 2005
2005 2006
2006 2007
2007 2008
2008 2009
2009 2010
2010
Country 2002
GDP
in 62.70
62.7 73.70
73.7 80.58
80.58 86.07
86.07 95.55
95.55 82.02
82.02 91.87
91.87 96.74
96.74 106.5
106.5
GDP in
Sri
Sri Lanka
(billion)
Lanka
(billion)
Growth
18%
9%
7%
11% -14%
12%
5%
10%
Controversies in economic growth
GDP is not regarded as a good way of indicating the standard of living of individuals
and households in an economy.
•The current measure of GDP is not good at reflecting
the damage to the environment caused by much
economic activity.
• Ignores unpaid, voluntary work
•How has an economy developed?
•Which industries does it depend on?
• How sustainable are the routes that a country has
chosen to follow towards the goal of growth?
•How can we measure human happiness?
National Output
Relationship between total national outputs
(Y) to inputs:
Output = Level of technology in the
economy+ (productive services of capital +
Labour input + Natural resource input)
Y = A+ (K+L+R)
Output Grows due to:
-An increase in productive factors (K, L or R)
-An improvement in Technology (A)
Contribution to the economic Growth
1. Human Resources
- Increase in number of workers
Employment Rise
- Increase in working time
- Improvement in quality of work force
- Education, Training, Experience,
Positive working attitudes
Increase in
Contribution
- Use of technology
- Computers, automated equipments
- Improve working conditions
2. Natural resources
- Resources availability within the country
3. Capital Formation
- Machines, equipments, buildings and
inventories
- Depreciated when used in production
- Grows due to investment
4. Technology change and Innovation
R & D is an economic activity aimed at producing
technology
Invention – Discovery of New knowledge
Innovation – Incorporate new knowledge into production
techniques
New tools and machines
Training and Experience
New Management practices & new ways of organizing
activities
Sources of Growth - Where does it come from?
The sources of growth include:
•Natural resources
•Labour
•Capital
•Technology
The pace of technological change will depend on:
1.Scientific skills of the country
2.Quality of education
3.Amount of GDP devoted to research and
development
The four Wheels of Progress
Factor Income Growth
Human Resources
Natural Resources
Capital Formation
Examples
Size of the labour force
Quality of Labors (Education,
skills, discipline)
Oil and gas
Soils and climate
Equipment and factories
Social overhead capital
Technology change and Quality
of
scientific
Innovation
engineering knowledge
Managerial know-how
Rewards and innovation
and
Total Factor Productivity
Increase in output given the productive
factors
-Total Factor Productivity measured by change in
Technology
A = Y - (K+L+R)
-Labour Productivity output per unit of Labour input
Y/L
-Labour productivity can improve due to :
Technology improvements
Capital accumulation – Capital Labour ratio
(Actual and potential economic growth)
Economic Growth and the Production
Possibility Curve
Growth through making a fuller use of resources
x
Food
Production inside
the production
possibility curve
y
v
O
Clothing
Food
Growth in potential output
Now
O
Clothing
Growth in potential output
Food
5 years’ time
Now
O
Clothing
Cost of Economic Growth
Inequality of income
Pollution and other negative externalities
Loss of non-renewable resources
Lifestyle changes
Growth and the
business cycle
The business cycle
The business cycle
National output
Potential output
3
2
3
4
2
1
1
O
Time
4
Actual
output
The business cycle
Potential output
National output
Trend
output
Actual
output
O
Time
Growth and the
business cycle
The business cycle
in practice
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
Annual GDP growth rate (%)
Sri Lanka GDP Growth Rate
10
8
6
% 4
2
0
-2
Growth rates in selected industrial countries
10
UK
France
Annual growth rate (%)
9
8
Germany
USA
Japan
7
6
5
4
3
2
1
0
-1
-2
-3
1970
1975
1980
1985
1990
1995
2000
Causes to the booms and Recession
Random shocks
Policy-induced
Imported cycles
Expectations
Barriers to economic growth
•Insufficient or contaminated land
•Substandard labor supply
•Poor technical infrastructure
•Poor social infrastructure
•Poor industrial infrastructure
International Trade
Why international trade is essential ?
• Every Country lack some vital resources that it
can get only by trading with others
• Each country’s climate, labour force, & other
endowments make it a relatively efficient
producer of some goods & efficient producer of
other goods
• Specialization permits larger outputs & offer
economies of large-scale production
Modern Governments use three main
devices when seeking to control trade
• Tariff
Tax on imports
• Quota
Legal limit on amount of goods import
• Export Subsidy
Payment by the government to exporters to permit
them to reduce the selling price
Foreign Exchange Market
Foreign currencies are bought and sold for
local currencies
Exchange Rate
• The price of foreign currency that has to
be paid by the buyers of and, received by
the suppliers of foreign exchange
Participants in the Market
Bank customers
Commercial Banks
Central Bank
Balance of Payment
Statistical Records of foreign exchange
transactions of a country
Two main accounts
Inflow
outflow
The Balance of Payments Account
The current account
International Trade in goods and services
Net Factor income flows
Net transfers
Balance of payments: (Rs millions)
CURRENT ACCOUNT
1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods
2. Trade in services
a) Exports
b) Imports
Balance on trade in services
+191 211
224 259
33 048
+77 076
62 373
+11 114
Balance on trade in goods and services
21 345
3. Net income flows (wages and investment income)
+11 151
4. Net current transfers (government and private)
Current account balance
7 246
–17 440
Balance of payments: (Rs millions)
CURRENT ACCOUNT
1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods
2. Trade in services
a) Exports
b) Imports
Balance on trade in services
+191 211
224 259
33 048
+77 076
62 373
+11 114
Balance on trade in goods and services
21 345
3. Net income flows (wages and investment income)
+11 151
4. Net current transfers (government and private)
Current account balance
7 246
–17 440
Balance of payments: (Rs millions)
CURRENT ACCOUNT
1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods
2. Trade in services
a) Exports
b) Imports
Balance on trade in services
+191 211
224 259
33 048
+77 076
62 373
+11 114
Balance on trade in goods and services
21 345
3. Net income flows (wages and investment income)
+11 151
4. Net current transfers (government and private)
Current account balance
7 246
–17 440
Balance of payments: (Rs millions)
CURRENT ACCOUNT
1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods
2. Trade in services
a) Exports
b) Imports
Balance on trade in services
+191 211
224 259
33 048
+77 076
62 373
+11 114
Balance on trade in goods and services
21 345
3. Net income flows (wages and investment income)
+11 151
4. Net current transfers (government and private)
Current account balance
7 246
–17 440
Balance of payments: (Rs millions)
CURRENT ACCOUNT
1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods
2. Trade in services
a) Exports
b) Imports
Balance on trade in services
+191 211
224 259
33 048
+77 076
62 373
+11 114
Balance on trade in goods and services
21 345
3. Net income flows (wages and investment income)
+11 151
4. Net current transfers (government and private)
Current account balance
7 246
–17 440
Balance of payments: (Rs millions)
CURRENT ACCOUNT
1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods
2. Trade in services
a) Exports
b) Imports
Balance on trade in services
+191 211
224 259
33 048
+77 076
62 373
+11 114
Balance on trade in goods and services
21 345
3. Net income flows (wages and investment income)
-11 151
4. Net current transfers (government and private)
Current account balance
+7 246
–25 750
The Balance of Payments Account
The capital account
The financial account
investment
flows to and from reserves
Balance of payments (Rs millions)
CAPITAL ACCOUNT
5. Net capital transfers
+1 439
Capital account balance
FINANCIAL ACCOUNT
6. Investment (direct and portfolio)
a) Net investment in UK from abroad
b) Net UK investment abroad
Balance of direct and portfolio
7. Other financial flows (mainly short-term)
a) Net deposits in UK from abroad and
borrowing by UK residents
b) Net deposits abroad by UK residents and UK
lending to overseas residents
Balance of other financial flows
8. Reserves (drawing on +, adding to –)
Financial account balance
+1 439
+ 75 496
118 750
–41 254
+219 087
161 063
+58 024
+3 085
+19 855
Balance of payments: (Rs millions)
CAPITAL ACCOUNT
5. Net capital transfers
+1 439
Capital account balance
FINANCIAL ACCOUNT
6. Investment (direct and portfolio)
a) Net investment in SL from abroad
b) Net SL investment abroad
Balance of direct and portfolio
+1 439
+ 75 496
118 750
–41 254
Balance of payments: (Rs millions)
CAPITAL ACCOUNT
5. Net capital transfers
+1 439
+1 439
Capital account balance
FINANCIAL ACCOUNT
6. Investment (direct and portfolio)
a) Net investment in SL from abroad
b) Net SL investment abroad
Balance of direct and portfolio
7. Other financial flows (mainly short-term)
a) Net deposits in SL from abroad and
borrowing by SL residents
b) Net deposits abroad by SL residents and SL
lending to overseas residents
Balance of other financial flows
8. Reserves (drawing on +, adding to –)
+ 75 496
118 750
–41 254
+219 087
161 063
+58 024
+3 085
Balance of payments: (Rs millions)
CAPITAL ACCOUNT
5. Net capital transfers
+1 439
Capital account balance
FINANCIAL ACCOUNT
6. Investment (direct and portfolio)
a) Net investment in SL from abroad
b) Net SL investment abroad
Balance of direct and portfolio
7. Other financial flows (mainly short-term)
a) Net deposits in SL from abroad and
borrowing by SL residents
b) Net deposits abroad by SL residents and SL
lending to overseas residents
Balance of other financial flows
8. Reserves (drawing on +, adding to –)
+1 439
+ 75 496
118 750
–41 254
+219 087
161 063
+58 024
+3 085
Balance of payments: (Rs millions)
CAPITAL ACCOUNT
5. Net capital transfers
+1 439
Capital account balance
FINANCIAL ACCOUNT
6. Investment (direct and portfolio)
a) Net investment in SL from abroad
b) Net SL investment abroad
Balance of direct and portfolio
7. Other financial flows (mainly short-term)
a) Net deposits in SL from abroad and
borrowing by SL residents
b) Net deposits abroad by SL residents and SL
lending to overseas residents
Balance of other financial flows
8. Reserves (drawing on +, adding to –)
Financial account balance
+1 439
+ 75 496
118 750
–41 254
+219 087
161 063
+58 024
+3 085
+19 855
Balance of payments (Rs millions)
TOTAL CURRENT + CAPITAL + FINANCIAL ACCOUNTS
Total current account
–25 750
Total capital account
+1 439
Total financial account
+19 855
Total current + capital + financial accounts
9. Net errors and omissions
+3 854
–3 854
UK balance of payments: 2001 (£ millions)
TOTAL CURRENT + CAPITAL + FINANCIAL ACCOUNTS
Total current account
–25 750
Total capital account
+1 439
Total financial account
Total current + capital + financial accounts
9. Net errors and omissions
Overall balance of payments
+19 855
+3 854
–3 854
0
Exchange Rate
The domestic price of a foreign currency unit
or the foreign price of a domestic currency
unit
LKR 100=US$ 1
US$ 0.01=LKR 1
Spot Exchange Rate – Current exchange rate
quoted for immediate delivery
Forward Exchange Rate – Future exchange
rate quoted for today for delivery after a time
lag
Depreciation – Reduction the value of
domestic currency against foreign
currency
Appreciation – Increase in value in domestic
currency against foreign currency
Appreciation or depreciation occur in the
foreign exchange market due to BoP
imbalances
Exchange Rate System
Floating exchange rate System
ER is determined in the foreign exchange
Market demand for and supply of foreign
exchange
Fixed exchange system
Determined by the central Bank
Where do the Supply & Demand come of
Foreign Exchange?
International Trade in Good & Services
International trade in financial instruments
(Stocks & Bonds)
Purchase of physical assets
Determination of exchange rates
The equilibrium exchange rate
BoP equals zero
Demand – Inversely related to the ER
Supply – Positively related to ER
Determination of the rate of exchange
Price of £ in $/Exchange Rate
S by UK
D by USA
Q of £ /Foreign Exchange
Determination of the rate of exchange
S by USA
a
$ price of £
b
D by UK
QD
QS
Q of $
Determination of the rate of exchange
$ price of £
S by USA
d
c
D by UK
QS
QD
Q of £
Fixed versus Floating Exchange Rates
Advantages of fixed exchange rates
• certainty
• no speculation (if rate is absolutely fixed)
• prevents 'irresponsible' government policies
Disadvantages of fixed exchange rates
• conflicts with other macro objectives
• danger of competitive deflations
• problems of international liquidity
• difficulties in adjusting to shocks
• speculation
Fixed versus Floating Exchange Rates
Advantages of free-floating rates
• automatic correction
• no problem of international liquidity
• insulation from external events
• less constraint on domestic macro policy
Disadvantages of free-floating rates
• possibly unstable exchange rates
• speculation
• uncertainty for business
• but use of forward markets
• lack of discipline on economy
How to Boost Economic Growth - How
can we grow more
The policies to boost growth split into two
types:
Demand-side policies ( fiscal policy and
monetary policy)
Supply-side policies
Demand-side policies
To boost the level of aggregate demand and therefore
growth, the government needs to use deflationary
policies. These are policies that help to generate more
demand. They include:
•
•
•
•
•
Fiscal policy
Cutting tax rates to boost people's disposable income
Increasing the level of government expenditure
Monetary policy
Cutting interest rates to encourage more borrowing and
spending
Supply-side policies
These are policies that aim to boost the potential for the economy to
grow - in other words to supply more. They are policies that should
make the economy more productive and more responsive to
change. Examples include:
Cutting tax rates - this gives people the incentive to work harder and be more productive
Cutting benefits - this gives the unemployed a bigger incentive to find a job; a harsh
policy (but a fair one???).
Promoting education and training - this should make the workforce more skilled and
therefore more productive.
Promoting research and development (R & D) - spending on R & D will help find new
more efficient ways to produce and should lead to better and more varied products.
Promoting mobility - if the economy is to be as flexible as possible, people need to
retrain where necessary and they need to move to where the jobs are. The
government has to help encourage this.
The Causes of Economic Growth
Economic Growth is caused by improvements in the quantity and quality of
the factors of production that a country has available i.e. land, labour, capital
and enterprise. Conversely economic decline may occur if the quantity and
quality of any of the factors of production falls.
•
Improving the Quantity and Quality of Land Resources
•
Improving the Quantity and Quality of Human
Resources
•
Improving the Quantity and Quality of Capital
Resources
Thank you