THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUEDâ€¦â€¦.):Growth-inflation

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Introduction to Economics ECO401

Lesson 11.7

THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS

(CONTINUED.......)

RELATIONSHIP BETWEEN THE "BIG FOUR"

Big Four In Case of Short Run:

In the short-term (up to about two years), the big four objectives of faster growth, lower

unemployment, lower inflation and the avoidance of balance of payments deficits are all

related.3 They all depend on aggregate demand, and all vary with the course of the trade (or

business) cycle.

In the expansionary phase of the trade cycle (i.e. just following a recession), AD grows rapidly,

the gap between actual and potential output narrows and unemployment (of the demand-

deficient sort) falls. However, rising demand puts pressure on prices (inflation), sucks in

imports and lowers competitiveness, moving the balance of payments towards a deficit. Thus

two of the problems get better, two worsen. The opposite happens in the contractionary phase

of the cycle (i.e. just following a boom).

Big Four In Case of Long Run:

In the long-run, and in a LIC context, however, the inter-relationships between the four

variables can get quite complex. We therefore take a more detailed look at the two way

relationships between pairs of issues.

a. Inflation-unemployment: This has already been covered extensively under the Philips

curve discussion (both under unemployment and inflation). Whether there is actually a

trade-off depends very much on which theory you subscribe to: monetarist or

Keynesian.

b. Growth-inflation: Economic growth is likely to put pressure on prices if there is no

slack in the economy and more production requires workers to work overtime,

machines to be used 24 hours a day etc. Depends also on whether growth is demand

led or supply led. If it is the former (as in the example above), then it is the AD curve

which is shifting right, given an upward sloping supply curve. If it is the latter, then we

are in the realm of AS shifts (due to technology improvements etc.) and given a

downward sloping demand curve, prices will fall. The reverse relationship between

inflation and growth is almost always negative. An exogenous rise in prices (as caused

by the oil price shocks of the 1970s) is equivalent to a leftward shift in the AS curve,

which causes equilibrium output to fall. Also, high inflation deters investment through

the uncertainty effect. Low investment reduces both the productive capacity of the

economy (AS shifts left), and decreases the investment component of aggregate

demand (AD shifts left). The combined effect on output is likely to be extremely

negative.

c. Growth-unemployment: Episodes of high economic growth will usually be

characterized by low unemployment, but this is not necessarily true. If growth reflects a

switch in production away from agricultural commodities and light manufactures

(labour-intensive) to capital intensive goods or to capital-intensive ways of producing

agricultural commodities or light manufactures, then unemployment can actually rise,

as labour is substituted by capital (machines). By the same logic, it might be that

We speak, of course, in the context of mature HICs, although an extension of this to LICs would not be

entirely misplaced.

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growth is moderate or zero, but a switch towards labour-intensive production causes

unemployment to fall considerably. The reverse relationship is obvious. Labour is a

resource and when unemployed implies the economy producing much below its

potential. Thus high growth is unlikely to be seen in the presence of high

unemployment. Also unemployment can affect growth through the former's effects on

social stability, crime, law and order. High unemployment is often associated with riots,

strikes and other disruptions (esp. if there are no so social safety nets like

unemployment benefit) and these seldom help the cause of productive activity or

growth, at least in the short-term.

d. Growth-BOPs: This depends on whether growth is of the import-substituting

industrialization (ISI) sort or export-oriented variety. ISI: If the country (e.g. India from

1947- to the 1980s) imports a lot of capital and machinery in order to set up industries

that can produce consumer goods for the home market that were earlier imported form

abroad, then this country can experience growth but a high current account deficit

initially (because the country produces not for the world market but for the home

market, so exports are low while imports of capital are high). Export-led: If a country's

growth is mainly attributable to its capture of a larger share of world markets through

exports, then that country is more likely to generate current account surpluses as it

grows. East Asian countries are prime examples. See also the relationship between

higher imports and growth/employment (below) .The reverse relationship is more

complicated. On the one hand, we see that a country with a fixed exchange rate will

experience a loss in reserves, a monetary contraction and thus a reduction in

aggregate demand (and hence growth) when faced with a BOPs deficit. On the other

hand, if the current account deficit (or capital account surplus) reflects an underlying

private sector resource gap and is financing productive private sector domestic

investment, then the long-term growth implications might be positive (due to higher

domestic private investment). In a related vein, if the private sector is importing a lot,

but the imports are knowledge-intensive and/or have a high technology/skill-content

that can further the learning and development of importing country producers then the

long-term growth implications might be even more positive.

e. BOPs-unemployment: The impact of BOPs deficits on unemployment (though

growth) is described above. Another channel could be as follows: If the BOPs deficit

largely reflects domestic consumers switching from local goods to imports, then a

BOP- could reduce domestic activity, growth and hence employment. The reverse

relationship would run as follows: High unemployment means low incomes in the

hands of consumers. Low incomes would imply low spending. The cut in spending

would also fall partly on imports, and therefore the BOPs would improve.

BOPs-inflation: Under a fixed exchange rate regime, a BOPs deficit reduces domestic

money supply which, as per the quantity theory of money, should reduce prices. With

floating exchange rates, a BOPs deficit will cause local currency depreciation, which

would make imports more expensive. Since imported goods are also included in the

basket of goods used in the consumer price index, inflation would be seen to increase

following the depreciation. The reverse relationship works through competitiveness and

real exchange rates. Higher domestic inflation (relative to the rest of the world, or our

trading partners, to be precise) will lower export competitiveness, causing the current

account to worsen. Since higher inflation also reduces the real interest rate (note: real

interest rate = nominal interest rate inflation) or real return on domestic financial

assets, the foreign demand for such assets falls, causing the capital account to go into

deficit as well. The combine effect on the BOPs can thus be quite negative.

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The Salter-Swan Diagram:

A framework which allows the relationships between the above macroeconomic problems to

be analyzed and appropriate policy prescriptions to be derived is the Salter-Swan diagram.

The diagram uses (real) exchange rateabsorption space, where the exchange rate is defined

as Rs. per $, and absorption is a term for aggregate demand-injection variables (like

government spending, money supply).

The Internal Balance and External Balance:

The internal balance (IB) line (combination of points where AD = AS in the economy) slopes

downward, explained as follows: Given fixed AS, he more appreciated the exchange rate (the

lower it is on the vertical axis), the lower the imports, the lower the AD, and therefore the

higher the required level of demand-injection (rightward movement on the horizontal axis) in

order to bring AD back up to the level of AS. Thus IB slopes downward. At any point to the

right of IB the exchange rate is more depreciated than is consistent with internal balance, and

therefore the economy is likely to be experiencing higher AD than AS, and thus inflation. At

any point to the left of IB, the economy faces unemployment.

The external balance (EB) line (combination of points where exports = imports), slopes

upward, explained as follows: As absorption increases, AD and imports increase, thus

requiring a more depreciated exchange rate to bring the current account back to balance

(through higher exports and lower imports). Thus EB slopes upward. At any point to the right

of EB, the exchange rate is more appreciated than is required for external balance (also called

overvalued exchange rate), and therefore the economy must be facing a current account

deficit. To the left of the EB, there is a current account surplus.

The intersection of IB and EB:

The intersection of IB and EB delivers the joint internal and external equilibrium for the

economy. The economy may in reality not be at this point but be on only one of the IB or EB

lines. In this case it will gradually move to equilibrium along the line it is on. The economy can

also be in any of the four quadrants: north (inflation, CA+), west (unemployment, CA+), east

(inflation, CA-), south (unemployment, CA-). LICs often find themselves in the east quadrant

where there is both inflation and unemployment. A combination of devaluation and lower

absorption (tight monetary and fiscal policies) can often do the trick.

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END OF UNIT 11 - EXERCISES

Assume that the government wishes to reduce unemployment in the economy.

Assume that every year from year 1 onwards the government is prepared to expand

aggregate demand by whatever it takes to do this. If this expansion of demand gives 7

per cent inflation p.a., fill in the table (below) for the first six years. Do you think that

after a couple of years people might begin to base their expectations differently?

Actual

Expected

Year

inflation

Inflation

14%

21%

14%

28%

21%

35%

28%

42%

35%

After a couple of years, people will realise that inflation is continuing to rise. They will therefore

expect this year's inflation to be higher than last year's, not the same.

Will targeting the exchange rate help to reduce inflation? Does it depend on the rate of

inflation in the countries to whose currencies the pound is fixed?

It will help to reduce inflation, if the rate of inflation is lower abroad than at home. The main

pressure will be on the export and import substitute sectors, which will have to reduce their rate

of cost increases in order to remain competitive.

If inflation is higher abroad, then targeting the exchange rate will not reduce domestic inflation:

instead, it will probably increase it. The balance of payments surpluses that will arise from the

initial lower inflation will have the effect of increasing money supply and hence fuelling inflation.

What is the best way to reduce unemployment when it is above the natural rate level;

when it is at the natural rate leve?

The government can use Keynesian type demand-management policies (raise government

spending above taxes, adopt expansionary monetary policy) to try to reduce unemployment

when the latter is above the natural rate level. However, when the economy is at the natural rate

level, the government should focus on supply-side policies to reduce the natural rate level.

Demand-increasing policies at this stage are more likely to feed into prices.

What will determine the speed at which inflation accelerates?

The amount by which unemployment is kept below the natural level (a process which is

determined by the level of excess demand). The more that unemployment is kept below the

natural level, the more will inflation accelerate.

Which electoral system would most favour a government being re-elected: the US fixed

term system with presidents being elected every four years, or the UK system where the

government can choose to hold an election any time within five years of the last one?

The UK system. This gives a government more flexibility to ensure that the economy is at the

politically best point of the business cycle at the time of the election.

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If V is constant, will (a) a £10 million rise in M give a £10 million rise in MV; (b) a 10 per

cent rise in M give a 10 per cent rise in MV ?

a. No (unless V = 1)

b. Yes

If both V and Q are constant, will (a) a £10 million rise in M lead to a £10 million rise in P;

(b) a 10 per cent rise in M lead to a 10 per cent rise in P?

a. No (unless V = Q: which it never would)

b. Yes

Can the government choose both the exchange rate and the money supply if it is

prepared to use the reserves to support the exchange rate?

Probably, but only for a short time. If the government reduces interest rates to avoid a

recession, but at the same time is unwilling to let the exchange rate depreciate, then it can

indeed use its reserves to support the currency. If speculators believe that the government can

succeed in supporting the exchange rate, then the government may well succeed. The

government will be helped in this, if it is supported by other central banks. Thus it was easier for

the UK to support a disequilibrium exchange rate when it was a member of the exchange rate

mechanism of the European Monetary System than it was before joining, because there was

joint support from the member countries to support currencies that were being pushed to the

floor of their agreed exchange rate band.

If, however, the government attempts to keep the exchange rate above its equilibrium level over

the long term, without correcting the underlying balance of payments problem, then it is likely

that the country could be forced to devalue: speculation will become too great. Thus, even

within the exchange rate mechanism (ERM), a country could be forced to devalue, despite

support from other countries. This was precisely what happened to the UK and Italy in

September 1992. Speculation against the pound and the lira became so great that their

exchange rates could not longer be maintained. The two countries left the ERM and their

exchange rates depreciated.

If importers and exporters believe that the exchange rate has `bottomed out', what will

they do?

Importers and exporters will stop speculating that the currency will fall. Importers will thus cease

`stocking up', and will cut back on imports, waiting for the exchange rate to rise. Exporters will

start selling more, to take advantage of the low exchange rate. The combined effect, therefore,

could be a substantial boost to aggregate demand.

What adverse internal effects may follow from (a) a depreciation of the exchange rate; (b)

an appreciation of the exchange rate?

a. It may fuel inflation by increasing the price of imported goods and reducing the need for

export industries to restrain cost increases.

b. It may damage export industries and domestic import-competing industries, which would

now find it more difficult remain competitive.

Describe the open market operations necessary to sterilise the monetary effects of a

balance of payments surplus. Would this in turn have any effect on the current or

financial accounts of the balance of payments?

The balance of payments surplus would lead to an increase in the money supply. To sterilise

this the authorities would have to sell securities on the open market. The resulting higher

interest rates would tend to lead to a continuing surplus on the financial and current accounts

and hence a continuing need to sterilise the resulting increase in the money supply.

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Under what circumstances would (a) contractionary and (b) expansionary policies cause

no conflict between internal and external objectives?

a. When there was an inflationary gap and a balance of payments deficit.

b. When there was a deflationary gap and a balance of payments surplus.

Making first new classical, and then Keynesian assumptions, trace through the effects

(under a fixed exchange rate) of (a) an increase in domestic saving; (b) a rise in the

demand for exports.

New classical:

a. A rise in saving will mean a lower level of aggregate demand. This will cause wage rates

and prices to fall, and thus cause imports to fall and exports to rise. There will be a

current account surplus. At the same time, the increased saving plus a lower

transactions demand for money will put downward pressure on interest rates. There will

be an outflow of finance and a capital account deficit. Given a high international mobility

of finance, the capital account deficit is likely to exceed the current account surplus. This

will lead to a contraction in the money supply and hence ease the downward pressure on

interest rates (or even allow them to rise again), thus reducing the size of the financial

account deficit, or at least allowing a growing current account surplus to `catch up' the

capital account deficit. Overall balance has been restored.

b. A rise in the demand for exports will cause the current account to move into surplus. At

the same time, the resulting rise in aggregate demand will increase the transactions

demand for money and put upward pressure on interest rates, causing an inflow of

finance and hence a capital surplus too. Money supply will thus rise. But this will then

put downward pressure on interest rates, thereby boosting aggregate demand and

hence the demand for imports, and also stemming the inflow of finance. The net effect

will be an erosion of the current and capital account surpluses until overall balance has

been restored. The current account will come back into balance because of flexible

prices and wage rates: prices and wage rates will go on rising until the current account

surplus has been eliminated.

Keynesian:

a. A rise in savings will cause a multiplied fall in national income and a reduction in the rate

of inflation. This will cause a fall in imports and a rise in exports and hence a surplus on

the current account. This will lead to a rise in the money supply as the Bank of England

sells pounds, but this will be more than offset by an endogenous fall in money supply

caused by the reduction in aggregate demand. This will allow the current account

surplus to persist. The reduction in money supply will prevent downward pressure on

interest rates. There will therefore be no capital account deficit to match the current

account surplus. Overall external imbalance will persist.

b. A rise in the demand for exports will cause the current account to move into surplus. The

rise in exports (being an injection) will also cause a multiplied rise in national income.

This will increase the demand for imports and will thus reduce the current account

surplus somewhat (but not completely, given that the rise in exports is partly matched by

a rise in other withdrawals too). The effect on the capital account will be relatively small.

The current account surplus will reduce the money supply but the rise in aggregate

demand will cause an endogenous rise in the money supply. The net effect on interest

rates, and hence the capital account, will depend on which of these two effects is the

greater.

Suppose that under a managed floating system the government is worried about high

inflation and wants to keep the exchange rate up in order to prevent import prices rising.

To tackle the problem of inflation it raises interest rates. What will happen to the current

and financial accounts of the balance of payments?

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The high interest rates will cause a surplus on the capital account. The higher exchange rate

will cause a deficit on the current account.

Imagine that there is an inflationary gap, but a balance of payments equilibrium.

Describe what will happen if the government raises interest rates in order to close the

inflationary gap. Assume first that there is a fixed exchange rate and then that there is a

floating exchange rate.

Fixed exchange rate: The higher interest rates will reduce aggregate demand and thus help to

close the inflationary gap. The higher interest rates, however, will lead to an increase in the

demand for and a decrease in the supply of sterling: the financial account will move into surplus,

and external balance will be destroyed. The reduction in inflation will also have the effect of

increasing exports and reducing imports, thereby also improving the current account. (As we

shall see in section 24.2 and Box 24.2, the effect does not end here. The balance of payments

surplus will increase the money supply, which will push interest rates back down again, thus

preventing internal balance from being achieved.)

Floating exchange rates: As under a fixed exchange rate, the higher interest rates will reduce

aggregate demand and thus help to close the inflationary gap. The higher interest rates will lead

to an increase in the demand for and a decrease in the supply of sterling: the financial account

will move into surplus, and external balance will be destroyed. The exchange rate will thus

appreciate, thereby restoring external balance. The effect of the appreciation will be also to

reduce the demand for exports (an injection) and increase the demand for imports (a

withdrawal). This will help to reinforce the effect of higher interest rates in dampening aggregate

demand and restoring internal equilibrium.

From the above it can be seen that monetary policy has a bigger effect on the domestic

economy under floating than under fixed exchange rates.

To what extent do Keynesians and new classicists agree about the role of fixed exchange

rates?

They are both critical. They both argue that monetary policy is relatively ineffective under fixed

exchange rates, and that overall imbalance on the balance of payments may persist.

What will be the effect of an expansionary fiscal policy on interest rates and national

income if there is a perfectly elastic supply of international finance (i.e. perfect capital

mobility)? See Lecture 44.

There will be no effect on interest rates. Instead, the money supply will expand fully (from an

inflow of finance) to match the rise in aggregate demand, thus giving the full effect on national

income with no crowding out.

Are exports likely to continue growing faster than GDP indefinitely? What will determine

the outcome?

Yes, so long as a growing proportion of countries' GDP comes from exports. If international

trade barriers continue to be eroded, if consumers continue to have a growing demand for

imports of goods and services (e.g. foreign holidays) and if firms continue to expand the

proportion of their purchases of capital, raw materials, components and semi-finished products

that they obtain from abroad, so the exports are likely to continue growing faster than GDP. The

growth may well level off over the years, however, as comparative advantage becomes more

fully exploited and as services (such as entertainment) account for a larger and larger proportion

of GDP.

Why could the world as a whole not experience a problem of a current account balance of

payments deficit?

Because every import to one country is an export from another, and every outflow of investment

income or transfer of money from one country is an inflow to another. Thus when all the current

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account deficits and current account surpluses of all the countries of the world are added up,

they must all cancel each other out.

What effect will there be on the four objectives of an initial excess of withdrawals over

injections?

If withdrawals exceed injections, national income will fall. Other things being equal, this will have

the following effects on the four objectives:

· Growth will be negative.

· Unemployment will rise.

· Inflation will fall.

· The current account of the balance of payments will tend to `improve'. The deficit will be

reduced, or eliminated, or be transformed into a surplus. If it was already in surplus, the

surplus will increase.

What effects, according to monetarists, would successful supply-side policies have on

the Phillips curve?

If the supply-side policies reduced the natural level of unemployment by improving the working

of the labour market (e.g. by improving information on jobs), then the (vertical) Phillips curve

would shift to the left. If, however, the supply-side policies merely affected output, the Phillips

curve would be unaffected.

Two economists disagree over the best way of tackling the problem of unemployment.

For what types of reasons might they disagree? Are these reasons positive or

normative?

They may disagree over what has caused unemployment. This could be either a disagreement

over facts or a disagreement over the way in which these factors operate on unemployment (i.e.

a disagreement over the correct model of unemployment). Alternatively they may disagree over

the effects on unemployment of particular policies. In each of these cases the disagreement is a

positive one.

On the other hand they may disagree over the degree of priority that should be given to tackling

unemployment, given that it might be at the expense of some other economic goal (like reducing

inflation). In such cases the disagreements are (at least in part) normative.

Make a list of the various inflows to and outflows from employment from and to outside

the workforce.

Inflows to employment:

· School/college leavers.

· Immigrants.

· Returners to the labour force: e.g. parents after raising children.

Outflows from employment:

· People who retire.

· People who are made redundant, who are sacked or who resign, and choose not to look

for a new job.

· People who temporarily leave their jobs: e.g. to raise a family, or to attend further or higher

education

· People who emigrate.

· People who die.

Why have the costs to the government of unemployment benefits not been included as a

cost to the economy?

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Because unemployment benefit is merely a transfer of money: from the taxpayer to the

unemployed. The monetary cost to the taxpayer is exactly offset by the benefit to the

unemployed.

If the higher consumer expenditure and higher wages subsequently led to higher prices,

what would happen to: (a) real wages; (b) unemployment (assuming no further response

from unions)?

a) Real wages would fall back again.

b) The lower real wages would cause consumer demand to fall (assuming that profit

earners spend a lower proportion their profits than do wage earners of their wages) and

thus shift AD curve back to the left again. But unemployment would fall, because firms

could afford to employ more workers at the now lower real wage.

How can a growth in labour supply can cause disequilibrium unemployment.

The AS curve will shift to the right. If wages are inflexible downwards, this will cause an excess

supply of labour at the given wage rate.

In what areas of the economy are jobs growing most rapidly in developed countries (and

in many fast-growing developing countries as well)? Is this due to a lack of technological

innovation in these areas?

In the service sector. It is partly due to a lack of displacement of labour by machines, but also

due to a rapid rate of growth in demand. (Note that in some parts of the service sector, there

has been a displacement of labour as a result of the information technology revolution.)

Do you personally gain or lose from inflation? Why?

You will have to answer this for yourself! Whether you gain or lose will depend on (a) whether

your income tends to go ahead of, or fall behind inflation; (b) whether you are a net borrower or

saver, and whether the rate of interest is above or below the rate of inflation (if it is below, then

the real rate of interest is negative and thus borrowers will gain and savers will lose); (c) just how

inconvenient you find it to update your information on prices so that you can decide whether

items are good value for money. If you are in receipt of a student grant, you are probably a

loser, given that grants have not risen to compensate for inflation.

Make a list of those who are most likely to gain and those who are most likely to lose

from inflation.

Gainers: powerful companies; members of powerful unions; property owners (if property is rising

in value more rapidly than prices generally).

Losers: those on incomes fixed in money terms (e.g. savers living on interest on their capital: the

real value of their capital will be being eroded by inflation); workers with no bargaining power;

people on state benefits, where these benefits do not rise in line with prices; students.

If consumer demand rises and firms respond by raising prices, is this necessarily an

example of demand-pull inflation? Could there be such a thing as demand-pull illusion?

(Clue: why might consumer demand have risen?)

If the rise in consumer demand were the result of higher wages resulting from trade union or

other wage-push pressure, then the rise in demand will be a symptom of these cost-push

pressures. To refer to the outcome as `demand-pull inflation' would be wrong. It would be a

case of demand-pull illusion. In practice, most inflationary episodes have both demand-pull and

cost-push elements.

How is the policy of targeting inflation likely to affect the expected rate of inflation?

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It is likely to make it approximately equal to the target rate, assuming that people believe that the

authorities (e.g. the Bank of England in the UK) will be successful in keeping inflation at

approximately its target level. The more successful the authorities are in keeping to the target,

the more will people's expectations help to guarantee that this success will continue. If,

however, people believe that the authorities will not be able to keep inflation down to the target

rate, then the expected rate will be above the target rate, making it more difficult for the

authorities to meet the target.

Why is the US current balance approximately a `mirror image' of the Japanese current

balance?

Because the USA and Japan have a high proportion of their trade with each other. Many US

imports are Japanese exports and many Japanese imports are US exports. Thus a Japanese

trade surplus is quite likely to correspond to a US trade deficit. Similarly, many of the income

flows into and out of each country are from the other. Thus Japanese investments in the US lead

to income flowing from the US (a debit on the US current account) to Japan (a credit on the

Japanese current account). Clearly, however, the current accounts are only an approximate

mirror image of each other, given each country's trade with other countries.

Where would interest payments on short-term foreign deposits in UK banks be entered

on the balance of payments account?

As a debit on the investment income part of the current account. Payments of interest, profits

and dividends are all elements in this part of the balance of payments account.

How did the British pound `fare' compared with the US dollar, the Italian lira and the

Japanese yen from 1980 to 2001? What conclusions can be drawn about the

relative movements of these three currencies?

Taking the period as a whole, the pound depreciated against the US dollar and substantially

against the Japanese yen, but appreciated against the Italian lira. There were, however,

fluctuations around this trend. There was, for example, an appreciation against the dollar

between 1993 and 1998 and against the yen between 1995 and 1998.

The movements mean that over the period as a whole there was a decrease in demand for the

pound relative to the dollar and yen, but an increase in demand for the pound relative to the lira.

This in turn would suggest, other things being equal, that the rate of inflation was higher in the

UK than in Japan and the USA but lower than in Italy.

Assume that an American firm wants to import cars from the UK. Describe how foreign

exchange dealers will respond.

The firm will want to purchase pounds with dollars. It will thus ask banks' foreign exchange

departments for a $/£ quote. The dealers will thus be put in competition with each other, trying

to offer the lowest $ price for pounds in order to obtain the business. But they must be careful

not to offer so low a $ price that they will be unable to buy the necessary pounds at an even

lower $ price from UK importers wanting dollars.

Go through each of the above reasons for shifts in the demand for and supply of rupees

and consider what would cause an appreciation of the rupee.

· A rise in Pakistan's interest rates relative to those abroad.

· A lower rate of inflation in Pakistan than abroad.

· A fall in Pakistan's incomes relative to those abroad.

· Better investment prospects in Pakistan than abroad.

· Speculators believe that the rate of exchange will appreciate.

· Pakistani goods become more competitive (in terms of quality, etc.) than imported goods.

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If the Malaysian ringgit is undervalued by 47 per cent in PPP terms against the US dollar,

and the Swiss franc overvalued by 53 per cent, what implications does this have for the

interpretation of Malaysian, Swiss and US GDP statistics?

The GDP figures understate the purchasing value of Malaysian national income by 47 per cent

relative to US national income, and overstate the purchasing value of Swiss national income by

53 per cent relative to US national income. In other words, at the exchange rates in question,

Malaysian national income seems 47 per cent lower relative US national income than it really is

in purchasing terms, and Swiss national income seems 53 per cent higher relative to US national

income than it really is in purchasing terms.

Can growth go on for ever, given that certain resources are finite in supply?

Yes, provided that technical progress continues to allow output be produced with declining

amounts of resources.

For what reasons might the productivity of land increase over time?

Because of the increase in quantity and quality of complementary factors. Thus a hectare of

land yields more agricultural output today than 100 years ago because of the increased

mechanisation of agriculture and the increased amount of chemicals used.

What would be the rate of economic growth if 20 per cent of national income were saved

and invested and the marginal efficiency of capital were 2/5?

Given the formula: g = i × MEC, the rate of economic growth will be:

20% × 2/5

= 8%

If there were a gradual increase in the saving rate over time, would this lead to sustained

economic growth?

Yes, but the rate of economic growth would gradually slow down, given that the Y curve gets

less and less steep. If, however, the extra saving were invested in research and development,

with the result that the Y curve shifted upwards, this would allow a higher output to result from

the extra saving and hence a faster rate of economic growth as saving increased over time.

If this is true, why do people not increase their rate of saving?

Because people generally have a preference for spending their money sooner rather than later.

Saving entails sacrificing present consumption for future consumption, and the cost of waiting

has to be offset against any increased consumption (from earning interest) in the future.

If there were a higher participation rate and GDP per capita rose, would output per worker

also have risen?

Not necessarily. GDP per capita will still rise if a greater proportion of the population work and

there is the same output per worker.

If people worked longer hours and, as a result, GDP per capita rose, how would you

assess whether the country was `better off'?

The country would be better off if the benefits from the extra consumption exceeded the costs of

working more. Calculating such costs and benefits is fraught with difficulties, however. For

example, just because people do work longer hours, it cannot be assumed that for them the

benefits outweigh the costs: the may have little choice over the number of hours worked, and

even if they did, they may not realise the full costs to them (in terms of lost leisure opportunities,

diminished family and social interactions and possibly poorer health). Also, some of the costs

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Introduction to Economics ECO401

and benefits are external to the people working the longer hours (e.g. costs and benefits to other

family members), and thus may well not be fully taken into account.

Identify some policies that a government could pursue to stimulate productivity growth

through each of the above means.

· Giving firms grants and/or tax relief for investment; reducing delays in hearing planning

applications.

· Putting more public money into education, training, R & D and infrastructure; better auditing

to ensure that such money is used efficiently.

· Reducing barriers to trade and outlawing various anti-competitive practices.

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