Unit 10 - Macroeconomic Strategies and Policies

International debt problems

A number of developing countries - severely indebted-low income countries or SILICs - have built up high levels of external debt as a result of borrowing to finance deficits on the current account of their balance of payments and to fund development projects. In 2011 in Guinea-Bissau, for example, debt was 259 per cent of GDP; in Burundi it was 202 per cent (International Monetary Fund figures). The high level of debt can act as a block to development as the countries have to spend large amounts servicing the debt (that is, paying the interest on the debt), which could have been spent on, say, education, training and the infrastructure. In some cases there is a net inflow of funds from developing countries to developed countries as a consequence of debt repayments. When doubts begin to be raised about a country's ability to pay interest on its debts, it becomes difficult for it to raise further finance. The uncertainty tends to discourage foreign direct investment and trade. - Infrastructure, education, property rights: There is a magical scene in Satyajit Ray's 1955 film Pather Panchali, which narrates with great sensitivity the life of a very poor family in rural India. One day the young son of the family walks a great distance from his home and sees a train for the first time. In his childhood life he has no means of travelling far beyond his village, and so no easy chance to escape the poverty of his upbringing. The lack of infrastructure not only means a difficulty in moving bulk-enhancing goods to a point from which they may be exported (a problem more telling in land-locked economies) to earn foreign currency, but it precludes individuals from moving to where income-earning opportunities may be found. This lack of infrastructure can deter FDI from multinational companies (MNCs), and indeed is not only an issue with LDCs. A few years ago a chief executive explained his firm's decision for not investing in the UK as 'their transport is like a third world country'. This and similar experiences may lie behind the present UK government's commitment to capital spending on the railway network. Without basic literacy and numeracy skills, only basic work can be done; as technology develops, even those opportunities may not be available. Recently a train-operating company in England advertised jobs for cleaning its train carriages, and insisted that applicants be literate, as safety notices had to be read and followed. Perhaps not a recruitment problem in England, but if such an opportunity had been advertised in Burkina Faso, 64% of the adults would have been excluded from applying. Education provision, even at primary level, is likely not to be widespread in some LICs, owing to lack of government funding, there is a dependency on international charities. Moreover, great distances may be involved, overwhelming for small children. There is also likely to be a lack of qualified staff (so, again, international charities have a major role). As mentioned earlier, in low-income families children are seen as a source of labour in self-subsistence economies: they are needed to work on the land, or to manufacture artefacts which have a sale value, and so cannot be spared to attend school. It was mentioned earlier that one hindrance to develop is an inability to acquire finance for investment. Lenders would like their loans to be secured by collateral, in developed countries, owned property often fills this role - and ownership can be proved through documentation. In England and Wales the Land Registry has detailed records of exactly who owns what. However such precise documentation may well not exist in developing countries. Even though a family may have lived on and worked a tract of land for generations, and so are assumed to own it, there may be no written proof of their property right; the land therefore cannot be offered as security for a loan.

The role of central banks

Areas which operate as discrete economies have a central bank: in the USA it is the Federal Reserve and in the eurozone of the EU it is the ECB, the European Central Bank. The Bank of England was founded in 1694, and until 1946 it was a private organisation; Clement Attlee's Labour government nationalised it in 1946. Tony Blair's Labour government granted it a degree of independence in 1998, particularly in terms of monetary policy, but it remains a public organisation. The Bank of England plays a number of significant roles in the operation of the UK economy, some of which are described in the following paragraphs as an example of the kinds of activities involved in central banks' operations. Different central banks will have varying degrees of independence and sets of responsibilities. For example, debt management is a function of some central banks, but not in the UK. - The implementation of monetary policy: The Bank of England is responsible for setting what is known as the 'interest rate' - the one that is discussed by firms, households, bankers and economists. This is actually the rate charged by the Bank of England to other banks which borrow from it; this will feed through to their own interest rates, so it is reasonable to assume that the base rate is a benchmark to some extent of all interest rates levied in the UK (although, as mentioned above, the LIBOR is also significant). The Bank of England refers to this as 'the bank rate'. Since the adoption by the Conservative government of the 1980s of a fundamental monetarist approach to economic policy, controlling inflation has been the prime target of UK macroeconomic policy. There have been recent discussions about moving away from this, possibly to some form of national output targeting, but so far nothing solid has emerged. The government sets a target for inflation (currently 2 per cent, on the CPI measure - this is actually the median of an allowable range of 1-3 per cent), and macroeconomic policy is directed toward maintaining this. If inflations is outside these limits, the governor of the Bank of England is required to write an open letter to the Chancellor of the Exchequer explaining why the Bank's responsibilities are seemingly not being fulfilled, which is an indication of the limited nature of the Bank's independence. A key variable in achieving this is the rate of interest. In simple terms, there is an inverse relationship between the rate of interest and the demand for money for consumption and investment. So, for example, a rise in the interest rate will reduce the aggregate demand in relation to aggregate supply, and the price level will fall. (Refer back to Units 4 and 5 if you need to refresh your memory about this.) Until 1998, the rate of interest was set by the government of the day. As stated above, this responsibility was then transferred to the Bank of England. The government continues to set the inflation target, but the decision about which interest rate is appropriate for achieving this is now out of government control. It was felt that it is better if economic professionals make this decision, rather than politicians; furthermore, it removes from government the risk of being criticised for monetary policy decisions which are political rather than economic - such as lowering rates to raise a government's standing in opinion polls, perhaps as an election approaches. The Monetary Policy Committee (MPC), a committee of nine economists, meets eight times a year (until September 2016 they met monthly). Having been provided with a substantial amount of detail about the current state of the economy, the committee discusses and then votes on whether to raise or lower the rate of interest, and by how much, or whether to keep it unchanged. Four of the nine members are appointed directly by the Chancellor of the Exchequer, which has led to discussion about the extent to which the decision is actually independent of politics. Commercial financial organisations are not obliged to follow any changes, but there is a general tendency for some changes. If the bank rate rises, the cost of loans will in many cases rise (although savings rates may not). When the bank rate falls, savings rates usually fall quite quickly but borrowing rates are often slower to respond. However the increasing use of fixed-rate mortgages diminishes the immediate effect of bank rate changes for many households. Since March 2009 the Bank of England has also been responsible for decisions about quantitative easing. This is often described as 'printing money' - which is what it is, effectively, although the process is electronic. With money created in this way, the Bank of England purchases financial assets, such as government bonds, from banks; this extra liquidity enables them to increase their lending, and so add activity to the circular flow of income. To date (November 2016) £425 billion has been created.

Facilitating the exchange of goods and services

Borrowing and lending, described above, depend on money as a store of wealth. Its primary function, however, is as a medium of exchange. Traditionally coinage was invented in the empire of Lydia in the seventh century BCE, as a much more efficient way of obtaining goods and services than a barter system. Despite the need for money to be easily portable, there has been for some time in the developed economies an increasing reluctance to use cash money as a medium of exchange, and it is certainly unusual for households and firms to keep their wealth in the form of cash stored somewhere accessible, whether in a safe, under a mattress or in a china pig. In the process of exchange, cheques have been in widespread use for some time. The oldest surviving English cheque dates from 1659, but there is a steady decline now in the share of financial transactions mediated by a cheque in favour of debit and credit cards, although a decision by the banks to phase out this medium of exchange by 2018 has been reversed. It is now predicted that electronic means of transaction will lead to the extinction of cash money. The financial sector is the provider of these alternatives to cash: cheques have to be cleared, credit arranged through plastic cards has to be recorded and monitored, and decisions have to be made about who can be eligible to use such means of payment. In developed economies these markets are in the private sector, and there is fierce competition. By this means the economic principle of consumer sovereignty should prevail - providing consumers with what they want, in a variety of forms, with efficient service and low prices. Whether or not this is achieved is a matter of some dispute, and regulatory structures exist to monitor these providers, in particular to compensate for market failure. A few readers may remember the heavy defeat of the Labour Party in the UK general election of 1983. One of the many reasons put forward to explain this defeat was the pledge in the party's manifesto to nationalise the banks. It is beyond the scope of the A level to consider the pros and cons of such a radical move, but the belief that consumer advantage arises from competition rather than monopoly, especially a state-owned monopoly, may have contributed to making the policy unappealing to the electorate. For those who wish to continue to use cash, the extensive network of cash machines (formally known as ATMs - automated teller machines) provided by the financial sector facilitates the acquisition of this traditional medium of exchange. Older readers may remember the time before such technology existed: cash could only be obtained from a desk at a bank, whose opening hours tended to be 10-3, Mondays to Fridays only. This usually meant giving up a lunch hour to queue to obtain one's money for the week. The response of the financial service providers to the need for households and firms to have easy and instant access to money has led to a state of convenience that could be taken as an excellent example of consumer sovereignty.

Effects of public expenditure

Changes in the total amount of public expenditure, or changes in individual sectors of the budget, will affect the performance of the economy in a range of ways. - Productivity and growth: You will recall that productivity is a ratio of output and input: it is generally expressed as output per worker in a given time period. Clearly an increase in productivity will mean that more output can be obtained from the same amount of resources, and so economic growth (which is an increase in output, measured by GDP) will rise. Public spending on improvements to the education system, on training, and on the establishment and funding of apprenticeships, should raise human capital and so lead to a higher rate of productivity, provided that such spending is targeted at skills currently needed in an internationally competitive postmodern economy. Productivity in the transport sector, which is related to the cost of delivering components and resources, and of finished products, as well as enabling labour to overcome geographical immobility, should rise if appropriate infrastructure projects are included in capital spending. Conversely, cutting - or, at least, not increasing - spending in this sector (so that existing infrastructure is not repaired or maintained satisfactorily) can lead to unreliability in the provision of transport and longer, more costly journeys. For example, there were recently several major failures of the overhead wiring system on the railways out of King's Cross. Thousands of people failed to get to work. These lines were electrified in the late 1970s under British Rail, a state-owned monopoly, which had regularly been underfunded. The cheapest option for electrification had been chosen and now, at almost four decades old, it is increasingly unreliable. As a spokesperson said on TV news at the time, the privatised railway industry had inherited poor-quality infrastructure. - Living standards: Living standards is a term of wide-ranging definition, but might be said to cover a household's ability to consume, and their access to benefits in kind, e.g. health and education services. Raising or lowering benefits in real terms will affect the living standards of those income deciles for whom they make up a significant proportion of income. Acute or chronic ill health reduces enjoyment of life's opportunities, not just for those directly affected but also for those who care for them, and limits or prevents access to employment income to enable acts of consumption. Poor-quality education will limit access to job opportunities and possibly perpetuate a low-income existence. Queues to access government services may be lengthened, or shortened, by changes in government spending. It was announced in November 2016 that HM Revenue and Customs (HMRC) is planning to reduce its spending on call centres; the feared outcome of this will be longer waiting times for people wishing to speak to tax and revenue advisers. - Crowding out: 'Crowding out' has a number of meanings in current economic thinking. Financial crowding out occurs if a government borrows large sum of money and so competes with the private sector for these funds. The resulting pressure of demand for money on the available supply will raise the cost of borrowing, and so some firms at least will not proceed with their investment decisions. So, government borrowing has 'crowded out' private sector economic activity. Real-resource crowding out refers to the need of the public sector for more of those resources and so it tends to push up prices of them. Crowding out also refers to the loss of opportunities for the private sector because of public provision, often at subsidised cost, or for free. For example, the expansion of sixth-form provision by the state sector in Cambridgeshire (new sixth forms in secondary schools and larger enrolments for sixth-form colleges) has had an effect on the numbers progressing to Year 12 in private schools. - Level of taxation: Government spending requires government income. This is mostly acquired in the form of taxation. In simple terms, then, higher spending requires higher taxation, and vice versa. There used to be a simplistic view that Conservative governments spent less and therefore taxed less, while Labour governments did the opposite. Whereas it is reasonable arithmetic to assume that levels of government spending will be linked to the amount of tax that must be collected, this ignores government borrowing to fill gaps between spending plans and expected revenue. In elective governments, the proportion of household income that is taken as tax needs to be considered in terms of re-election prospects, as well as in view of more fundamental economic factors: the lower disposable income is (e.g. because of higher taxation), the lower aggregate demand is likely to be. For firms, too high a tax reduces their ability both to pay reasonable wages and to invest. Conversely, the households that make up the electorate, and firms which choose to operate in the UK, expect certain standards of government provision. This expected or desired level of spending may require an income greater than that which can be viably acquired through taxation, so government may borrow to fill the gap; the link between spending and taxation then becomes less straightforward. - Equality: Some of the factors discussed above would also affect the country's Gini coefficient - the measure of how close or far from equality of income and/or wealth distribution an economy is. An increase or reduction of benefit levels may, as noted, have an impact on living standards, but in terms of equality what matters is where those increases or decreases are targeted. Removing child benefit from those households where one member has an income over £60 000 p.a. will, by reducing the final income of those in this decile, create a statistical increase in equality, all other things being equal. The various aspects of public spending which impact on job opportunities and wages may, in spreading opportunities more widely, reduce the number of low-income households and so move the economy toward equality. A reduction in government subsidies to train-operating companies will result in higher fares. At least some of those who commute to work by train are people who cannot afford to run a car. Making these necessary journeys to work more expensive on a daily basis may mean that some will give up their work, and consequently their income, bringing their households closer to poverty and increasing inequality. Improvements to, or neglect of, education and training provided by public spending will have an effect on both equality of opportunity and equality of access. The term 'postcode lottery' refers to the fact that there is substantial inequality in being able to enjoy good-quality education or healthcare, dependent on what part of the country you live in.

Development

Development occurs when a country's population experiences an increase in its welfare. In its Human Development Report, published each year, the United Nations takes a broad view of development. As the report title suggests, it discusses human development. It states that this involves the enrichment of the lives and freedoms of ordinary people, and occurs when people's choices are enlarged as a result of the expansion of their capabilities. It identifies three essential capabilities - the ability of people to: - lead a long and healthy life - be knowledgeable - have access to the resources needed for a decent standard of living. However, other areas of choice and freedoms are also considered important; these include the ability to vote, to choose an occupation and to decide where to live, and freedom from discrimination, fear, exploitation and injustice. All these contribute to an increase in welfare. So, development is concerned with increasing people's capabilities and enriching their choices by making not only economic but also social and political progress. Additionally, it is important that the progress is sustainable. - Development and economic growth: Read the sections on 'Developed and developing countries', 'Defining development' and 'Identifying the less developed countries' in Chapter 10 of your textbook. Economic growth normally brings with it development. This is because the rise in the output of goods and services usually means that people's standard of living rises. Economic growth may also mean that more resources can be devoted to healthcare and education, thereby increasing people's longevity and quality of life and the proportion of students entering further and higher education. (Note that development might also foster future economic growth, e.g. through the better physical and social infrastructure which comes with development, which in turn facilitates further growth.) However, economic growth can occur without development taking place. For example, if the rise in output is achieved by people working longer hours and more pollution being created, and is accompanied by a fall in the average life span or a reduction in human rights, it is unlikely that development has occurred. So while economic growth and development are closely connected, they are not the same thing. Development involves more than just increases in income. 'Development' is variously defined. Here are three definitions, by Dudley Sears (1920-83), Michael Todaro (b.1942) and Amartya Sen (b.1933), respectively. These are all economists who specialise in development economics. - The reduction and elimination of poverty, inequality and unemployment within a growing economy. - Widely distributed access to opportunities to improve the quality of life. - Development is concerned with improving the freedom and capabilities of the disadvantaged, thereby enhancing the overall quality of life. It should be about increasing political freedom, economic freedom, and social freedom, and not just about raising incomes. Sears' version is the most specific in terms of the economic variables involved. Todaro focuses on qualitative aspects, while Sen widens the scope of the term away from strict economics into social and political issues.

Constraints on policy implementation

Economists are often derided for their seeming inability to solve the many and varied problems that arise in a complex modern society. One common anti-economist jibe is to ask an economist 'Why don't your policies work?', to which the economist replies, 'Because people don't do what we tell them to do.' In truth, however, policy-makers face a number of situational difficulties. - Inaccurate information: The essence of economic policy-making is to analyse the state of the present and its causes in the past, and so devise, like a doctor, a treatment or cure. However, accurately to assess the economic nature of the present and past is no easy task. Information must be gathered (itself not a straightforward task) and then the question must be asked, How accurate is that information? It is not possible to ask all household and all firms - and those asked may not wish to disclose information they feel might help their competitors. For example, the living costs and food survey in the UK, on which the calculation of CPI inflation is based, obtains information from a sample of about 6000 households - but there are over 20 million households in the country. The quarterly GDP figure is calculated three times, in the hope that each successive figure, with more time for information to come in, will be more accurate. In less-developed countries the problem will be exacerbated by there perhaps not being a system in place to gather information to any helpful extent. It is often held against the economic profession that few professionals foresaw the coming of the financial crisis in the first decade of this century. Perhaps we could adapt for economics the famous statement from the US Secretary of Defense, Donald Rumsfeld, who in 2002 spoke of 'known knowns' (information we know we have),'known unknowns' (information we know we lack), and 'unknown unknowns' (what we don't realise we don't know). This last category might explain the general failure of economists to see the financial crisis coming. - Risks and uncertainties: A common cliché in movie dialogue is that, whenever a character is wavering over a decision that involves a risk, the trusty buddy says, 'You can't make an omelette without breaking eggs.' This also applies to economic policy-making. Despite the confident assertion of some theorists that human beings (reduced in the technical terminology to 'economic agents') will always act rationally, the truth is that behaviour is unpredictable. Economists can estimate how individuals, or households, or firms, or purchasers of domestic goods in other countries, may behave and these educated guesses may sometimes to be right - and sometimes not. The lowering of an interest rate to promote instant gratification at the expense of deferred gratification has a certain arithmetical logic, but savers may continue to save, perhaps because they are anxious about the security of their employment and so feel they need a secure nest egg. As all economic policies have side-effects, what may happen is an undesired side-effect, without the positive, hoped-for main effect. - External shocks: Another tired piece of dialogue is that grand let-out clause by which a character will qualify any future plans, '...unless I get run over by a bus'. Economies can be run over by buses, in the form of external shocks, discussed earlier in this topic. Contingency planning there may be, but not all shocks, which are by their nature unforeseen and unexplained, can be countered with success. A few readers may remember the long queues outside petrol stations, and then the issuing of ration coupons to every household, in the oil crisis of the early 1970s, as a result of turbulence in the Middle East. In the campaign for Scottish independence in 2014, a major argument for the economic viability of an independent Scotland was the ability of the new country to raise revenue from the North Sea oil industry. The growth of 'fracking' in the USA prompted Saudi Arabia to lean on OPEC to increase the supply of oil to the world, to lower its price and drive the American shale oil industry out of business. North Sea oil prices fell heavily - an event with an external source that would have seriously tested the economy of a new nation.

Externalities and moral hazard

It would be reasonable to describe the financial sector as an oligopoly, i.e. it is dominated by a small number of large firms. You may recall from Unit 7 Topic 4 that a significant feature of the oligopolistic market structure is interdependence. Recall also that an externality is an effect on an economic relationship of a third party not directly involved in that relationship. Banks and financial institutions monitor each other's performance, their marketing policies and innovations. Furthermore, this interdependence has an operational aspect, as banks lend to each other. If, as occurred noticeably in 2008, a large number of defaulting borrowers affects a bank's operational viability, other banks will be reluctant to lend to it. This reluctance can become widespread, so even banks that remain secure may find the acquisition of funds through inter-bank lending difficult. Thus, the difficulties of weaker banks may affect the trading relationship of all participants in the sector. A bank that seems to be in danger of failing, through what in hindsight looks like unwise or careless trading, damages public trust in all economic agents within the sector. Moreover, there is a tendency for the media to highlight such stories, exacerbating the anxieties of banks' customers. The former UK building society Northern Rock was one of several to transform itself into a bank. Its business plan involved securitisation and, when difficulties in this area challenged Northern Rock's liquidity, it sought help from the Bank of England. This became widely known quickly, and domestic customers of the bank began to fear for their deposits. A run on the bank began, aggravated by pictures of long queues outside branches on TV news programmes and in newspapers. A bank failure can have extreme externality effects, and the policy of the UK government was to prevent this. The bank was nationalised a few months later, but anxiety about the continuing stability of the financial sector remained. Indeed, not long afterwards, two other UK banks, LloydsTSB and the Royal Bank of Scotland, had to be partly nationalised. However, the bailing out of failing banks involves moral hazard. This is where one party takes risks knowing that any negative consequences of those risks will be borne not by itself but by another party. In a speech in October 2009 the then governor of the Bank of England described bank bail-outs as the 'biggest moral hazard in history'. A business plan fraught with risk may be tempting because of the potential for large profits, but a bank may be deterred from such operation if it is felt that its survival could also be threatened. However, if it knows that failure is impossible because it will be rescued by the government, the moral constraint of the risk is likely to be ignored. The bank will not have to face the downsides of its actions. Allowing a bank to fail so as not to encourage other banks to avail themselves of moral hazard creates severe externality effects. In September 2008 the large American investment bank Lehman Brothers (founded in 1850), which had been substantially involved with sub-prime mortgages, filed for bankruptcy. It was not bailed, and its collapse sent shock waves throughout the world's financial markets and was considered to be one of the major factors behind the global financial crisis of that time. Little attention was given at the time to the principle of moral hazard, and an observer might aver that the failure of the bank served as a lesson to other institutions that the failure of a risky policy would not result in salvation in the form of a government rescue package.

Public expenditure

The level of public expenditure, also called government spending, is influenced by a number of factors. One is the level of taxation that the government is able to raise. While at any one time a government may aim to spend more or less than it raises in tax revenue, in the long run a government will aim to balance approximately its spending and revenue. Governments in low-income countries are restricted in the amount of tax revenue they can raise and hence in the amount they can spend. Government spending is categorised in three ways: - capital expenditure - spending on infrastructure projects such as schools, hospitals, roads, railways (e.g. HS2) - current spending - money spent to provide government services: goods (e.g. syringes for the NHS), services (cleaning government buildings), wages for government employees - transfer payments - spending on social security benefits. You will recall that transfer payments, unlike capital and current spending, do not involve an exchange - output is not purchased and consumed - but funds are moved from one economic agent (in this case, the government) to another (households in receipt of benefit payments, who may then decide to spend or save this income). Any government, in the short run, may seek to operate a budget deficit or a budget surplus to influence the level of aggregate demand. - A budget deficit arises when government spending exceeds tax revenue. Such a deficit will raise aggregate demand and reduce any negative output gap. - In contrast, a budget surplus occurs when tax revenue is greater than government spending. A government may aim for a budget surplus in order to reduce demand-pull inflation (a rise in the price level caused by the inability of supply to meet demand). As well as government spending being used to influence the level of economic activity, changes in economic activity also influence government spending. A low level of economic activity, resulting in low income and high unemployment, will put upward pressure on unemployment benefit and other state benefits. Demographic trends can influence public expenditure. An ageing population, for instance, can increase government spending. The rise in the number of pensioners in the UK is increasing public expenditure on state pensions, healthcare and residential care. A significant proportion of state healthcare expenditure goes on the elderly. Changes in people's expectations of the quality of state-funded services can affect government spending, especially in democracies where governments are anxious to retain the support of voters. Advances in technology put upward pressure on public expenditure in countries where most education and healthcare is state funded. Schools and hospitals will seek more sophisticated computers and other equipment; more sophisticated equipment will enable hospitals to carry out more complicated operations which will be likely to involve extensive aftercare. Governments can spend money in a bid to improve human capital and reduce poverty. Raising educational standards and improving training should reduce structural unemployment and increase productivity. Higher productivity can lead to a virtuous circle of development (Topic 3). Global circumstances also affect both the level and type of government expenditure. Since the expansion of the EU, especially with the addition of eastern European countries formerly under Soviet influence, large numbers of immigrants have entered the UK: some of these have been entitled to benefits, for example child benefit and jobseeker's allowance. This increase in population, and the government spending associated with it, does not arise directly from a rise in the native birth rate. The need to remain internationally competitive may well have an effect on capital expenditure, It has been felt for a long time that airport capacity in SE England is inadequate in comparison with that of other competing European economies, so business activity may be lost to the UK. At the time of writing, considerable expenditure looks likely to occur as a result of adding a runway to Heathrow Airport. The proposed withdrawal from the EU will affect the nature of government spending: contributions to the EU (which are transfer payments) may cease in whole or part, depending on the nature of the new relationship. It is reasonable to think that some of this money will be used to replace current EU funding, such as to agriculture. In other words, what was transfer payment may become current expenditure. Other changes in international commitments may have their effects. For example, the UK has been criticised for not spending enough on defence, and so not meeting its NATO commitment - currently 2 per cent of GDP (Jan 2017).

Measure to control global companies

You will recall from Unit 9 Topic 1 the significant role played by MNCs - multinational corporations, also known as transnationals or global companies. Because these operate in a number of countries, they are able to spread their activities among their global plants and in doing so maximise their ability to obtain advantages from the differing regulatory environments in different countries. For example, an MNC may choose to locate a polluting manufacturing sector of its operation in a country with less strict pollution control. An issue that is currently occupying the attention of governments is transfer pricing - an internal accounting procedure by which the discrete branches of MNCs charge each other for the activities they undertake. What this means in practice is that tax due is made liable in a country with a low rate. For example, a few years ago (until 2012) Amazon UK used a subsidiary in Jersey, Indigo Starfish, to supply DVDs. Items under £18 exported from Jersey did not incur VAT, so Amazon UK was able to undercut other mainland suppliers, and HM Revenue and Customs did not receive the VAT it would have if the product were sold on the UK mainland. (The Channel Islands are only associate members of the EU.) The UK government acted to disallow this anomaly. More serious in terms of quantity of lost revenue is the currently legal practice of firms transferring the income from their activity to a branch in a lower-tax country. In this way firms do not pay the due amount of corporation tax on profits generated in a specific country. Amazon, Google, and Starbucks are among the firms recently highlighted for this practice. These companies have received hostile press coverage and become subject to petitions against them. At the time of writing (December 2016) the UK government is examining means by which these firms can be taxed on their activities in the country itself. In December 2016, McDonald's announced that its headquarters were to move to the UK, and that it would fully pay all tax due on its activities there. However, there is a limit on the extent to which MNCs can be controlled by individual governments, whose regulations cannot reach beyond their own borders. MNCs can, and do, respond to regulations which they regard as a threat to their profitability by moving out of the country whose regulatory environment they find chafing, and move to more amenable territories. With this attitude they have acquired the adjunct 'footloose'. MNCs provide employment; they are a significant part of FDI and, if their products are exported, they contribute towards the balance of trade. Thus the loss of an MNC may have serious repercussions for an economy, most notably in a local area. Consider the anxiety in the UK following the EU referendum about the possible loss of the Nissan plant in Sunderland, an area of high unemployment. Moreover, a country with a persistent current account deficit, such as the UK and the USA, needs FDI (which is in the financial account of the balance of payments) to counterbalance this. Developing countries in particular are vulnerable to the demands of MNCs. In addition to the advantages listed above, they also provide technology transfer. The relationship, for example, between Royal Dutch Shell and the Nigerian government has been troubling environmental NGOs.

Market failure in the financial sector

You will recall the concept of market failure in microeconomics (Unit 3 Topic 1). The market mechanism should ensure that equilibrium is achieved: this is normally interpreted as an equilibrium between supply and demand, with a price determined by that equilibrium quantity. However, markets do not always achieve this, either because of external distorting factors (such as a government regulation), or because, even if left to themselves, they may not be efficient. There are other equilibria which may be considered, such as allocative efficiency: AR = MC (Unit 7 Topic 1). This means that the resources forgone by the consumer (i.e. the price paid for a good) are equal to the resources used by the producer in making the good that is purchased - its marginal cost. Market failure is when the desired equilibrium is not achieved, and this occurs in financial markets, for the following reasons. - Asymmetric information: Asymmetric information - also commonly known as information failure - refers to the existence of an imbalance in the knowledge/information available to the two parties in a transaction, causing one of the parties to be at a disadvantage. This may occur among financial institutions themselves, of between the institutions and their customers - firms and households. Before the financial crisis of 2008, there was a noticeable avidity in the financial sector to trade in such assets, and hindsight has revealed that in a number of cases the assets purchased were not secure. At the onset of the crisis, 'sub-prime' mortgages in the USA were considered to be a leading culprit. These were mortgages for domestic property given to people whose incomes were variable or temporary; the lenders underplayed the risk of default, thinking perhaps that in a period of economic prosperity the risk was not actual. Packages of these mortgages were sold on to other institutions (securitisation), who then found that they had purchased an asset of low value, as in many cases the borrowers defaulted. The purchasers of these packages of assets may have been less well informed about their quality then a responsible purchaser should have been, or may have been given misleading information. Had there not been this asymmetry of information, trade in such asset packages may have been more secure. Domestic customers and small businesses may not be fully aware of the nature of the financial product they are buying. (One assumes that large firms can afford to employ, or hire, specialist advisers - an example of a managerial economy of scale.) Over the past decade, financial institutions have been required to pay substantial compensation to consumers for mis-selling products. A common example of such mis-selling is the endowment mortgage. In this form of mortgage the borrower pays only the interest on the loan, while simultaneously taking out an endowment policy: after a fixed number of years of regular payments, a sum is returned equal to (or greater than) the value of the mortgage, so that it can be redeemed on its expiry date. The ability of the endowment policy to generate the necessary funds depends on the return on the investment which the lender makes, over the period of the policy. In many cases it was not explained to borrowers that receiving a pay-out sufficient to redeem the mortgage capital depended on a number of unknowable variables over a long period, perhaps several decades. So in many cases, endowment policies are now failing to provide funds sufficient to redeem a mortgage. Without the appropriate information, purchasers were not in a position to make a decision about a product that would satisfy their utility. The financial sections of UK newspapers frequently contain stories about consumers who have purchased financial assets, or taken out loans, which turned out to be unsuitable because the purchaser did not read all the 'small print' - the often lengthy and linguistically bewildering terms and conditions. The seller could disclaim responsibility by arguing that no information asymmetry occurred, as the purchaser had access to all the required information. Whether or not possibly incomprehensible small print counts as valid information is an ethical issue beyond the scope of this specification and, arguably, beyond the scope of economics as a social science. Nevertheless, there is an argument that the provision of information in a form (perhaps deliberately) not congenial to the purchaser is an instance of asymmetry of information.

Factors influencing growth and development

-Reliance on primary production: A number of developing countries concentrate largely on producing and exporting primary products. Zimbabwe, for example, relies heavily on the production of tobacco, cotton, sugar and beef, and Brazil on the production of coffee, copper and oil. Reliance on primary products carries a number of risks as their demand and supply, and hence their prices, can be subject to significant shifts. Demand for commodities is heavily reliant on the performance of developed economies and, increasingly, on the performance of some emerging economies. For example, commodity prices fell during the decline in economic activity in a number of major economies as a result of the financial crisis which began in 2008. Demand can also fall significantly if alternatives are found. For instance, demand for tin was adversely affected by the development of aluminium. Demand for primary products also tends to rise slowly with increases in world incomes. The supply of agricultural products can be affected by weather conditions and diseases, and the supply of minerals is influenced by discoveries and the rate of depletion. The newly industrialised countries of East Asia, which rely more heavily on secondary production, have generally performed better than those countries that still rely on primary production. Both the demand and supply of primary products are often of a relatively low price elasticity - inelastic, in other words. Demand is necessary regardless of price, as changes in technology and therefore substitutability are unlikely to have a rapid effect on demand. Despite the use of fibre optic cable, copper is still needed as a conductor in wires; food is still sold in tins, made of aluminium. Coffee drinking as a habit is not in noticeable decline. Price elasticity of supply is of course affected by the nature of supplying primary products; harvests are not instantly expandable, nor are mines. The result of inelastic price elasticities of supply and demand means that small changes in demand or supply have significantly larger effects on price, leading to a kind of price volatility that makes it difficult for primary product dependent countries to forecast their income reliably. In Figure 1.1, a small rise in supply from S1 to S2 has resulted in a proportionately larger fall in price from P1 to P2. - The savings gap: A simple model, known as the poverty cycle, illustrates a fundamental problem for developing countries. A lack of employment opportunities means there is a low income for most. Low-income earners have no surplus income to save; without savings there are no funds for borrowing, and so no capital investment occurs, so employment opportunities do not increase, and so on as a vicious circle. The Harrod-Domar model - named after the British economist Roy Harrod and the American economist, Evsey Domar, who formed the model independently of each other in 1939 - demonstrates that savings are a key determinant of economic growth, as one of the factors leading to investment and technological progress. The model is sometimes expressed algebraically as the economic growth rate (DY/Y) equals the savings ratio(s) divided by the capital-output ratio (k). DY/Y = s/k The capital-output ratio shows how much capital is required to produce a unit of output. The lower the ratio, the higher is the level of capital productivity. The thinking behind the model is that the rate of economic growth will be increased by government policies that promote savings, investment and technological progress or that attract investment funds from abroad. For example, if initially the savings ratio is 6 per cent and the capital-output ratio is 3, then the economic growth rate will be 6 per cent ÷ 3 = 2 per cent. - If, by encouraging people to save more - for example, by launching tax-free government saving schemes - the savings ratio can be raised to 9 per cent, the model suggests that the economic growth rate will rise to 9 per cent ÷ 3 = 3 per cent. - If, by giving government grants to research and development centres, the capital-output ratio is reduced to 2, the economic growth rate would again rise to 3 per cent (6 per cent ÷ 2). One of the problems that many developing countries experience is raising the savings ratio, because of the low incomes in the country. This is why many developing countries seek to attract investment funds from other countries, either in the form of foreign direct investment (FDI), loans or financial aid. The model has been criticised on a number of grounds. For example, raising the savings ratio will not stimulate investment and economic growth if there is a lack of appropriate financial institutions to channel the funds from savers to investors or if there is a lack of viable investment projects.

Foreign currency gap and capital flight

Development requires a capital infrastructure, which low-income countries may not be able to create themselves; few developing countries, for example, have constructed their own railway systems. Initially, British investment and engineering were prominent in this field (as readers of Anthony Trollope's novel The Way We Live Now may recall); currently, China is the leading railway enabler in the developing world. Therefore, unless the capital is donated, it must be purchased with foreign currency. Inability to generate sufficient amounts of such currency is a hindrance to development; this is known as the foreign currency gap. Concentration on primary products, as described above, is a factor in this predicament. The Prebisch-Singer hypothesis suggests that the terms of trade move against developing countries, with the price of their exports of primary products falling relative to the price of their imports of manufactured products. While demand for manufactured products and for services is income elastic, demand for agricultural products is income inelastic. The price of primary products can also be driven down by improvements in technology that allow the development of synthetic substitutes, such as plastics replacing rubber, and that reduces the quantity of minerals required to make a given quantity of manufactured goods. Innovations in farming practices increase output with fewer inputs, i.e. productivity rises. Developing countries can also encounter problems in seeking to gain entry into the markets of developed economies because of trade barriers, including subsidies, that some countries impose. For example, Brazilian and Malaysian steel producers have complained about the difficulty they experience in trying to sell steel to the USA because of the subsidies the US government gives to its own producers. So, with these pressures impacting on LICs' ability to export and earn foreign currency, their capacity to purchase capital goods for the investment vital to development is restricted. It has been argued (in what is named the neo-colonial dependency model) that developed HICs deliberately kept down prices of primary products from their LIC colonies while extracting high prices from them for the capital they needed. This kept them in a low development state, so that they could continue to be exploited as sources of cheap food and raw materials, while being high paying customers for the HICs' manufactured capital goods. The failure to be able to afford significant improvements to infrastructure will mean that firms' production and transport costs will be relatively high; low productivity and poor infrastructure may also hinder economic growth by discouraging foreign direct investment. The theory of trickledown, introduced in Section 9, requires the wealth generated by entrepreneurs and owners of the means of production to be filtered throughout the population, both in terms of income-earning opportunities created, and by tax revenue being spent on merit goods. However, profit generated in LICs from ownership of capital may not be retained in the firm, to be used for capital improvement and job creation. It may be invested abroad, where returns may well be higher. This circumstance, known as capital flight, further reduces a developing country's ability to form the structures necessary for its improvement.

Direct taxes

Direct taxes provide a high yield and are relatively cheap to collect. Income tax raises more revenue than any other tax. Direct taxes are convenient, since most can be deducted at source at regular intervals, and are automatic stabilisers as the revenue from them changes automatically to offset inflationary or deflationary pressures. For instance, when demand is rising, people will move into higher income tax brackets and so more tax revenue will be raised and demand pressures will be reduced. Most direct taxes are progressive and so are equitable; those who are most able to pay bear the strongest burden. Recent changes to UK income tax have been aimed at increasing this move toward equality of income distribution. In 2010 the amount of income that could be earned tax-free was £6475; since April 2016 it is £11 000 - so a considerable number of low-paid workers now do not pay income tax. Formerly there were only two rates of income tax, the standard rate (20 per cent at the time of writing) and the higher rate (40 per cent). In 2010 a further rate was introduced, 50 per cent (to apply to income over £150 000 p.a.); this was reduced to 45 per cent two years later. However, some economists argue that direct taxes provide a disincentive to work, save and take risks. High direct taxes may discourage some people from working overtime or entering the labour force. What particularly matters here is the marginal rate of tax. This is the rate of tax paid on extra income, which is often higher than the percentage paid on total income. For example, some years ago the author of this section was teaching part-time in a university, and earning in total an amount just under the threshold for income tax, so the percentage of income paid as tax was zero. He was then offered some extra classes, but payment for these would have taken him over that threshold, so he would pay tax on the income from those classes. At the time that was 30 per cent (so that was the marginal rate - his extra income from the additional classes would incur a tax of 30 per cent). Considering the extra amount of time and preparation involved, he turned the offer down, as 70 per cent of the fee per class was not a sufficient incentive to take on the work. On the other hand, direct taxes may also encourage some people to work longer hours to maintain their standard of living. Similarly, high rates of tax on income from savings may increase or reduce savings, depending on how savers respond. The disincentive effect was taken into consideration by the UK government; since April 2016 savers now have a personal savings allowance, so £1000 of interest on savings is now free of tax. High rates of corporation tax may discourage firms from risk-taking, and they may also reduce investment because firms have less money available to plough back into their business and have less incentive to do so. There is a risk that tax rates may become so high that they result in a reduction in tax revenue. This view is illustrated in what is called a Laffer curve, named after the American economist Arthur Laffer (b.1940). Figure 4.2 shows that a cut from a high rate of z to a lower rate of y increases tax revenue. It also suggests that there is an optimum tax rate of x. This supports the argument that low rates of tax may strengthen Incentives, but may prevent the achievement of other tax objectives. Developing countries with low levels of school enrolments typically do not rely significantly on direct taxes because these require a relatively high level of literacy among the population.

Monetary policy

Remember that monetary policy covers government and central bank decisions on the exchange rate, interest rate and the money supply. At any one time, a government or central bank can control either the rate of interest or the money supply, but not both. Figure 5.1 shows that the monetary authority can in theory set the money supply at Q but would have to accept a rate of interest of R. Or it can aim for an interest rate of R but this would mean that the money supply would have to be Q. In practice, monetary authorities have found it hard to control the money supply. This is because it is difficult to measure the money supply accurately as the assets which act as money are developing all the time and because commercial banks have a vested interest in increasing their loans, which count as money. It has also been noticed that any measure of the money supply can change its nature if the monetary authorities try to control it. (This tendency is referred to as Goodhart's Law, after Charles Goodhart, who had been chief monetary adviser at the Bank of England.) In 2009, however, the Bank of England considered the economic situation so serious that it had to try to raise aggregate demand by increasing the money supply - a move it referred to as quantitative easing. (Consider what was said in the previous topic, that monetary and not fiscal policy is the preferred option for managing AD.) Nevertheless, until the arrival of the credit crunch (a sudden, sharp decrease in availability of money or credit from lenders in 2008-9), the monetary authorities relied more on interest rate changes rather than seeking to change the money supply. This is in part because they can target interest rates more directly by changing the bank rate. Such changes provide a clear signal to firms and households that the monetary authorities are taking action to improve macroeconomic performance. They can also be particularly effective in countries where there is a high level of household debt, and cuts in the rate of interest may not only increase aggregate demand in the short term but may also increase aggregate supply in the longer term by reducing the cost of investment. There is a time lag before interest rate changes take effect and they may not be effective if they run counter to consumer confidence and have a different impact on different groups. There are also a number of other limitations to interest rate changes. One is that it is possible that when a central bank changes its interest rate, not all commercial and investment banks will follow suit. Some firms may also choose to borrow from abroad and so may not be directly affected by interest rate changes in the domestic economy. In addition, there is a risk of a liquidity trap occurring, and a rise in the rate of interest may increase rather than reduce the inflation rate. A liquidity trap arises when the rate of interest is so low that any increase in the money supply will not be able to lower it further. At such a low rate of interest, there is the related problem that any further cut will have no impact on aggregate demand. For instance, if households and firms are not prepared to borrow when the rate of interest is 0.25 per cent, it is unlikely they would start borrowing at 0.1 per cent. A rise in the rate of interest may help to reduce demand-pull inflation but it would not be an appropriate measure to reduce cost-push inflation. This is because it would raise the costs of those firms which borrowed in the past. Governments in some developing economies may be reluctant to cut interest rates for fear that investors will lose confidence and will not buy government bonds. If they cannot sell government bonds, it becomes harder for them to influence economic activity by increasing government spending when there is a risk of a recession. In addition, they may be worried that frequent changes in the rate of interest may lead to exchange rate instability, which in turn may affect their international competitiveness. Globalisation is also affecting monetary authorities' ability to control inflation. It is, however, difficult to determine whether globalisation is reducing or increasing inflationary pressure. On the one hand, the increased availability of cheap imports from China and other emerging economies, and the competitive pressures these imports are putting on domestic producers, are tending to reduce inflation. On the other hand, the increased demand by the emerging economies for raw materials and food is tending to put upward pressure on prices. Until the recent collapse in oil prices, it was commonplace to explain the rising cost of petrol by referring to the rapid rise in China of a demand for cars. The extent to which interest rate changes affect those on low income is disputed. Economic textbooks tend to refer to the diminution of income of those who, not in employment, rely on income from savings. Whereas there have been letters in the press from savers making this point, in December 2016 the Bank of England governor Mark Carney attempted to refute this accusation by pointing out that statistics did not show any reduction in the incomes of the lower paid as a result of the Bank's monetary policy of low interest rates and quantitative easing. Low interest rates may also have an effect on international competitiveness, in that foreign investors may be attracted by the low cost of borrowing for capital projects.

Taxation

Taxation has a number of functions. - Taxation is a means of raising revenue to finance the provision of public and merit goods and to fund government administration. - Another function is to influence the level of aggregate demand. When there is cyclical unemployment, a government may lower taxes; when there is demand-pull inflation, it may raise them. Tax revenue also funds some supply-side policies. - Progressive taxes (see below) combined with state benefits may be used to reduce income inequality and poverty by redistributing income from the rich to the poor. - Regressive taxes will have the opposite effect. Taxation may also be used to protect domestic industries from foreign competition (tariffs) or to correct market failure by discouraging the consumption of demerit goods. - The desirable qualities of a tax: Adam Smith described four principles of taxation. These are that a tax should be equitable in the sense that the amount of tax people pay should be based on their ability to pay it. There should also be certainty, so that people know how much tax they have to pay. The other two qualities he identified are that a tax should be economical and convenient to collect. Two additional principles are that a tax should be flexible and efficient. A flexible tax is one that can be adjusted in order to meet changing economic conditions. An efficient tax is one which corrects market failure and so results in a more efficient allocation of resources. We can also consider efficiency in terms of incentives: tax cuts might help government revenue by enhancing incentives. (See also the Laffer Curve, later in this topic.) - Progressive, proportional and regressive taxes: Taxes can be categorised as progressive, proportional or regressive. - A progressive tax takes not only a larger amount in tax as income rises, but also a greater percentage of a person's income. Income tax is a progressive tax. A certain amount of a person's income is tax-free and then, as income rises above that threshold, the income is subject to higher tax bands. - A proportional tax takes a fixed percentage, which does not change as income rises. If a proportional tax is used, a rich person will pay a larger sum in tax than someone on a lower income, but both people will pay the same percentage of their income in tax. - A regressive tax is one that falls more heavily on the poor since it takes a larger percentage of the income of the poor than of the rich. This would be the case if a tax were a fixed amount for everyone, for it is the percentage of income taken, and not the amount, that determines whether a tax is progressive, proportional or regressive. For instance, if a tax takes £4000 from a man with an income of £12 000, and £80 000 from a woman with an income of £800 000, the rich woman loses a larger sum, but the tax is regressive since the poor man loses a larger percentage (33.33 per cent) than the rich woman (10 per cent). The TV licence can be regarded as a regressive tax, as people pay the same amount for it irrespective of their income. - Direct and indirect taxes: A direct tax is a tax on the income of individuals and firms. In the UK, examples include income tax and corporation tax. The latter is a tax on the profits of firms. The burden of a direct tax is borne by the individual or firm on which it is levied. An indirect tax is a tax on goods and services purchased. Indirect taxes can also be called outlay or expenditure taxes. VAT and excise duties are indirect taxes. The burden of an indirect tax can be passed on, in whole or part, to someone else. A trader is likely to pass on some of the burden of excise duty on wine, for example, to his customers in the form of higher prices. Recent decades have seen a move in many countries towards greater reliance on indirect taxes because of the belief that direct taxes have more of a disincentive effect than indirect taxes. There are actually a number of advantages and disadvantages to both types of tax.

Interventionist strategies

- Development of human capital: Human capital can be developed by raising the educational attainment of the population. By creating opportunities for people to acquire appropriate skills, higher value added output can be produced, earning higher income as exports. On the assumption that there is a link between skills levels and wages, income levels will rise - helping to break the poverty cycle of low Income, low saving, low investment. - Protectionism: Infant industries may, as suggested earlier in this topic, enjoy the assistance of protectionist measures (see Section 9): they may be able to obtain a viable share of the domestic market if competing imports are taxed (tariffs) or limited in quantity (quotas). As with subsidies, there is the problem of judging the appropriate time to remove this assistance, so that the industries can learn to be strong by facing competition directly. - Managed exchange rates: The self-check exercise at the end of Section 9 Topic 3 was about the Chinese government's manipulation of its currency, the renminbi, to keep the prices of its exports low and therefore maintain its international competitiveness. This is an example of managing an exchange rate to assist in development. If macroeconomic policy is focused on export-led growth, then the maintenance of competitive prices for the exports would assist in keeping those sectors active, providing output, income, and employment. - Infrastructure development: At the time of writing, November 2016, the UK government has announced a high level of spending on improving the country's roads. Major improvements to the railway network have been announced in addition to the intention to construct the HS2 railway. Economic growth is facilitated by being able to move goods from the site of production to their markets; by the inexpensive movement of raw materials and components necessary to produce those goods; and by lowering the barriers to geographical mobility, so that a labour force can find its way to the job opportunities, perhaps encouraging occupational mobility as well. Even though railways may be described as nineteenth-century technology, they still feature prominently when countries wish to develop areas of their economies. The (controversial) construction of a railway to Tibet, and the connection to the port of Darwin in the Northern Territory of Australia, are examples of very demanding and expensive infrastructural Improvements which were seen as having a long-term developmental function. - Promoting joint ventures with MNCs: You have seen already how the participation of MNCs in a country's economy can assist its development. However, there is a risk that, to borrow terminology from sociology, the MNC will cause only 'development in'. This is where local people are not employed and all profits are repatriated so no advantage accrues to the host country. 'Development of', where the presence of an MNC does benefit the host country, cannot be assured. However, there is an alternative approach, where the MNC forms a joint venture with a firm in the host country - a cooperative and collaborative alliance. Soon after the collapse of the Soviet Union in 1991, and the formation by its former republics of the Commonwealth of Independent States, these newly re-established economies announced their intention to operate on a market basis, and welcome participation from the capitalist economies which had previously been seen as the ideological enemy. Western firms were invited to form joint ventures with former Soviet industries. The emerging economies acquired funding and skills, while the investors gained access to an extensive market which had previously had only limited access to consumer goods. - Buffer stock schemes: You will recall that a problem faced by some developing countries is their dependence on agricultural and commodity exports for their earnings of foreign currency, especially because the prices of commodities can be very volatile owing to their price elasticity of demand. An attempted solution to this is the establishment of a buffer stock scheme. In this, countries producing a particular product agree to collaborate: they agree on a maximum (a 'ceiling') price and a minimum (a 'floor') price for the product, so that it will always be sold only within that range, thus giving their economies the predictability that the free market mechanism did not. If there is at any time surplus production - which may, if supply exceeds demand, drive the price below the floor - some is withdrawn from the market and stored. In times of shortage, which could drive the price above the ceiling, this stored product is added to the market. Buffer stock schemes are problematic; countries which choose not to join, or who, having joined, choose not to follow the agreements scrupulously, prevent the operation from running smoothly. Moreover, there is the cost of storage to consider. If the amount stored becomes unsustainable and is therefore brought on to the market, the ensuing glut will send the price below the floor, possibly ruining more vulnerable producers.

The role of the financial sector

- Facilitating saving and lending: Think back to the macroeconomic model called the circular flow of income, which you studied in Unit 5 Topic 1. You may recall that saving was one of the withdrawals (W) from the flow, while investment (that is, spending by firms on capital goods) was an injection (J). This model assumes a long-term equilibrium, in which withdrawals (savings (S) + taxation (T) + imports (M)) equal injections (investment (I) + government expenditure (G) + exports (X)). In algebraic terms W = J. The implication here is that saving by households provides funds for financial institutions to lend to firms for investment spending. So, without saving, there will be neither renewal nor expansion of physical capital. New technology will not be adopted, so productivity will fall, raising unit costs and so lowering the international competitiveness of an economy. Rising demand may not be met as additional capital resources may not be affordable if funding for lending is scarce. This relationship between saving and investment was also a prominent feature of the poverty cycle (Unit 9 Topic 5). Low incomes mean that little money is left over for saving, so investment cannot take place; without this investment, the economy cannot expand into the production of higher value-added goods, so wages remain low and the cycle repeats, endlessly. Both models, the circular flow and the poverty cycle, assume the existence of an intermediary, which attracts households to deposit their surplus income and then makes it available to firms needing loans. In other words, the transition from saving to investment, vital for the continuing health and growth of an economy, requires a financial services sector. In developed countries these are well established, although that does not mean that they function well. The financial crisis of 2008 revealed several flaws in the supposedly sophisticated financial systems of developed nations, and since then governments have been reviewing their overseeing and their regulation of these markets, to ensure that the vital process of saving and lending is secure and efficient. Financial markets are not free from market failure, which will be covered in detail later in this topic. In developing countries, however, the emergence of a functioning financial sector may still be rudimentary. Even if there is surplus household income, there may be nowhere to save it, and so saving and lending remain local, informal, and on a small scale. Saving plays another role in the economy - it enables deferred gratification. Individuals and households may think providently, aware that future income may not always be sufficient to provide future needs; having a store of wealth (savings) to access in the future - created, often incrementally, from current final income - will enable the maintenance or enhancement of a standard of living. However, a consumer will want a reward for this deferment of spending, which will not be gained by putting banknotes in a tin box under the bed. This reward for saving is the interest rate, which a saver will expect a bank to pay. The assumption is that the initial sum will have a higher real value when it is called upon in the future. The saver will also need to bear in mind that inflation will reduce the value of savings, so should look at the real interest rate (i.e. the nominal interest rate quoted by the institution minus the rate of inflation). However, consumers in developed economies are showing an increasing impatience, and a preference for instant gratification over deferred gratification. Consumer durable goods once considered luxuries, such as washing machines, colour televisions and cars, are now considered to be basic necessities, yet the increasing sophistication of these goods means that for many they are not affordable out of current income. Rather than save for these, as was often the only means available in earlier generations, today's consumers often borrow to make these purchases, either in the form of bank loans, or through the use of a credit card (2016 is the 50th anniversary of the credit card in the UK). However, such access to money is not free, and consumers pay for this ability to borrow by paying interest. A financial infrastructure is vital, to collect money from savers and distribute money to borrowers, and by means of interest rates they themselves find their economic motivation, i.e. profit. It is intuitively correct to assume that the ability and willingness of households to borrow will be closely linked to the affordability of the loan, i.e. the rate of interest payable; it is also empirically verifiable that the rate of interest influences the consumer's choice between instant and deferred gratification. The main reason for the very low official interest rate in the UK since 2009 has been the need to encourage consumption rather than saving. Indeed, in 2010 the economic journalist Anatole Kaletsky wrote that interest rates for households should be negative - that is, they should pay banks for holding their savings - since this would result in all income being spent, which in his view the UK economy needed at the time. Although this has not happened officially - at the time of writing the UK interest rate is 0.25 per cent - rates on some savings accounts are so low that there would seem to be little to gain from saving. However, the role of interest rates in firms' investment spending is more controversial. Economics textbooks, like the one attached to this course, emphasise the relationship between interest rates and investment decisions, even if the money is not being borrowed but is taken from retained earnings. In this case the opportunity cost of saving, i.e. the return on saving that is forgone if the money is spent on capital goods, is said to be a determining factor. The relevance of this model, sometimes known as the marginal efficiency of capital, is sometimes questioned. It is plausibly suggested instead that extrapolated future demand is more relevant: in other words, firms consider what capital they need to meet the demand they predict for the future, based on current patterns - and then borrow to finance it. Keynes put what he called 'animal spirits' into the process, highlighting the importance of the mood and feelings of those responsible for investment decisions. Ultimately, however, the financial sector makes all this possible, and now exists as a very sophisticated array of means and possibilities.

The impact of macroeconomic policies

- Fiscal policy: The use of fiscal policy - government spending and raising revenue through tax - has a number of adverse side-effects, such as inflexibility (fiscal decisions tend to be taken annually, so if they turn out to be unsuitable or mistaken, there may be a while before they can be amended), time lags and the possibility of crowding out. It can be difficult for a government to estimate the size of the change in government spending or the taxation needed to achieve a given level of GDP. This is because the government has to calculate the size of the multiplier. For example, if the multiplier is 3 (that is, any rise in extra spending will cause a final rise in GDP three times as great), a government could raise its spending by £20m if it wants GDP to rise by £60m. However, in practice it is difficult to calculate the multiplier accurately. This is because to do so it is necessary to estimate how much of any extra income will leak out of the circular flow in the form of saving, taxation and spending on imports. It is now the general consensus in developed economies that fiscal policy is the appropriate instrument for budget management, but not for demand management (i.e. instigating changes to AD). Decisions about levels of spending and rates of taxation are taken with deficit and debt reduction in mind. It is perhaps significant that one of the key issues of the UK autumn statement of 2016 was the abandonment of an earlier promise to balance the budget by 2020. Fiscal measures to reduce the deficit and the national debt may affect levels of output and employment if taxes rise and spending falls. Given the potential vulnerability of the UK economy owing to uncertainty following the EU referendum, it was felt that the risk of harming economic activity to achieve a reduction in deficit and debt would not be appropriate. At the time of writing, borrowing is set to rise, and some tax burdens are being reduced. There are also constraints on the use of fiscal policy. In some developing economies, the public sector is relatively small with low levels of tax revenue and low government spending. In such economies, the impact of discretionary fiscal policy is likely to be small. Globalisation has also made it more difficult for a government to operate higher tax rates than rival economies.Indeed, recent years have witnessed an increase in tax competition, with governments competing for FDI by cutting their direct taxes and competing for sales of consumer products by cutting indirect taxes. In 1994 Estonia was the first European country to introduce a flat tax system. It was soon followed by a number of other east European countries including Georgia, Latvia, Lithuania, Romania, Russia, Slovakia and the Ukraine. When most countries introduce flat taxes, they usually cut them. A pure flat tax would involve operating one tax rate for all forms of indirect and direct tax rates. The idea is that such a system would make it simpler and cheaper for households and firms to calculate and pay their taxes and for the government to collect. The reduction in firms' administrative costs can encourage FDI, and the fact that the tax rate does not rise with income can encourage workers to work longer hours and accept promotion, as well as encouraging more people to enter the labour force. A simpler tax system can also reduce the incentive and opportunity to evade paying tax. A criticism of the system is that it is regressive: it might hinder a move toward distributional equality. In practice, though, most of the systems introduced have not been pure flat tax systems; rather, they have set a uniform rate for direct tax above a threshold. This means that people are able to earn a given amount of income before they have to pay tax.

Demographic factors

- Rapid population growth: It is predicted that most of the future world population growth will occur in Asia and sub-Saharan Africa. In many countries in these continents, the birth rate and the dependency ratio are high. (The dependency ratio is a measure showing the number of dependents, aged zero to 14 and over the age of 65, in relation to the total population, aged 15 to 64.) Workers have to support a high number of dependent infants. The potential labour force is also reduced as mothers leave the labour force for a time to raise the children. If the birth rate is rising it means that output per worker has to rise in order to support them and to maintain income per head. To increase income per head will involve even greater increases in productivity. A high birth rate may also make it more difficult to achieve economic growth because resources that might have been used to increase the productive potential of the country by, for example, increasing physical investment and training workers, may have to be used to provide healthcare and schools for children. Rapid population growth can also threaten sustainable economic growth as it can put pressure on natural resources. For example, to feed a growing population, fish stocks may have to be depleted and land farmed over-intensively; fertile farmland and rainforests may have to be built on to house more people. An increase in population size can also add to pollution and overstretch water supplies. - Migration: While many developing countries in Africa and Asia are experiencing difficulties coping with rapid population growth and numbers of children relative to the labour force, many developed countries are experiencing the opposite problems of falling populations and high numbers of dependent elderly relatives. For example, Italy's population is predicted to fall by 16.2 million by 2050, Germany's by 8.8 million and the UK's by 2 million, and the proportion of the EU population over 65 is expected to rise from 15 to 22 per cent. These trends are increasing developed countries' demand for labour. The USA, Japan and many EU countries are now actively recruiting skilled and unskilled staff from developing countries. The loss of workers from developing countries increases their dependency ratios, reduces their productive potential and could discourage multinational companies setting up branches there. However, emigration can also bring some advantages to developing countries. The workers who emigrate may send income home to their relatives along with information on production methods and products produced abroad. Rapid rural to urban migration, sometimes referred to as urbanisation, is another factor of some developing countries. People move from the countryside into cities in search of higher living standards. For instance, in India life expectancy is seven years higher and adult literacy 215 points higher in cities than in rural areas. Urbanisation does, however, put pressure on infrastructure in cities and can result in the growth of slums and environmental damage. A number of governments are trying to reduce internal migration to limit growth. Others are building new cities to divert people away from their overcrowded capital cities. For example, Egypt is building 20 new cities in an attempt to divert people away from Cairo.

Market-oriented strategies

- Trade liberalisation: International trade produces opposing tensions. On the one hand, governments feel that they have a responsibility to ensure the continuing viability of their economies, in particular the employment of their labour force. Imported products from countries with a comparative advantage due to lower labour costs can threaten domestic markets and those employed in them by undercutting the price of domestic products. A response to this is protectionist measures, reducing the attractiveness of imports either by, for example, raising their price through tariffs, or by limiting their supply through quotas. However, developing countries need to finance their further development by earnings from their exports, so they need equable access to world markets. The international organisations GATT (General Agreement on Tariffs and Trade), from 1948, and its successor, the WTO (World Trade Organization), from 1995, have been working toward a liberalisation of trade in the form of increasing free access to markets. The economic consensus is that free trade, governed by the market mechanism and unimpeded by interventionist action to protect domestic markets, will raise global trade, global incomes and living standards, especially in the developing world. This is not, however, a political consensus, and the WTO still has a long way to go. The world's largest economy, the USA, may be moving into a more protectionist phase; on the other hand, the UK, when no longer a member of the EU, will not be obliged to impose that custom union's common external tariff, and may make trade deals beneficial to emerging markets. As is always the case in economics, one must wait and see. - Foreign direct investment: There are a number of reasons why multinational companies (MNCs) invest directly in developing countries, including: - to gain access to the markets of developing countries - to lower the amount of tax paid - to reduce the costs of production, labour costs especially. Producing within a country is a way of getting round any trade barriers that a country imposes. However, while this is a reason in some cases where the markets are significant or expected to be significant in the near future, such as China, it is not an important motive in many developing countries. Locating some of their production abroad may enable MNCs to reduce the amount of tax they pay. This is because if taxes on profits are low in a particular country, the MNCs can charge low prices to their branches in that country in order to keep those branches' costs low, making the profit levels there higher and the overall tax paid low. However, the particular attraction of developing countries as a destination for FDI is the relatively low costs of production that operate there. In a number of developing countries unit labour costs are significantly lower than in industrial countries. This is because wage rates are relatively low and productivity levels in countries such as India, where educational standards and IT training are increasing, are not that much lower than in industrial countries. Other cost savings may also be made as a result of the incentives provided by the developing countries' governments, such as factory and office rents, and fewer regulations on health and safety, working hours and environmental standards.

The significance of economic growth for development

The effect that economic growth has on development depends on how it is achieved, how the benefits are shared out, and the extent to which it is accompanied by costs. Growth is a necessary condition for development, and the process is ongoing: as mentioned in Topic 1,developmental improvements to an economy themselves can be stimuli to further growth. If economic growth has arisen from increases in investment in human capital, physical capital and technological progress, it is unlikely that the benefits will be confined just to increases in the quantity of the goods and services enjoyed. Investment in human capital, by raising people's knowledge and skills, will also be likely to increase their health, their range of interests, their expectations, their self-respect, their political involvement and their sense of social inclusion. The cohesion in society that may emerge from these last two factors, in particular, is sometimes discretely categorised as social capital. Investment in physical capital and technological progress can reduce the physical demands of work and thereby improve working conditions. Technological progress can also improve healthcare by, for example, increasing the number and complexity of operations that can be carried out. It can improve communication, so enabling people in remote areas to participate in education, and provide people with more information on which to base their choices. - The Lewis two-sector model: The Lewis two-sector model is named after the economist W Arthur Lewis (1915-51) who developed it. He was from the Caribbean island of St Lucia, so here is a model about development from an economist who grew up in a developing area. It stresses how moving resources from low-productivity agriculture into high-productivity manufacturing and service sectors will raise development. Lewis argued that in many developing economies there is a dual economy with a rural and urban sector. He suggested that the rural sector in developing countries is often based on subsistence farming and employs more workers than needed. Indeed, he argued that the marginal productivity of some of the workers, especially those working on family farms, is zero. (This is based on David Ricardo's law of diminishing marginal returns, which he exemplified in an agricultural context.) The other sector is the urban sector, where manufacturing and services use more up-to-date technology and enjoy a higher rate of productivity. Lewis argued that this second sector can afford to pay higher wages and that, if it does, workers will transfer to more productive use and economic growth will increase. This migration from rural to urban will continue until an equilibrium is achieved - full employment in the urban sector and sustainable productivity in the rural sector. There does appear to be a link between the growth of the manufacturing and service sectors and economic growth. However, it is not a simple link. The Lewis model also assumes that there are job vacancies in the urban sector and tends to overlook some of the problems, including overcrowding, that can occur when people move from rural to urban areas. There is another often-used model for growth and development, by the American economist Walt Rostow. This assumes that economies grow incrementally, in five clear stages, moving from agriculture to industry with the creation of a virtuous circle: saving enables investment, which increases productivity; this generates higher incomes, which in turn leads to more saving.

Topic 4 - The role of the state in the macroeconomy

To promote economic growth and development, governments use a range of macroeconomic policies. In this topic you will examine public expenditure, taxation and public sector finances in more depth. In the next topic you will consider macroeconomic policies in a global context.

Distinguish between automatic stabilisers and discretionary fiscal policy. (10 marks)

Automatic stabilisers cover changes in taxation and government expenditure that occur as a result of changes in GDP, whereas discretionary fiscal policy denotes deliberate changes in taxation and government expenditure. When GDP rises, tax revenue increases as more people are employed, people earn higher incomes and spending rises. At the same time that, say, income tax revenue, VAT and excise duty rise, government spending on social security is likely to fall as employment rises. This reduction in the government's net contribution to aggregate demand is likely to slow down the rise in economic activity. Automatic stabilisers also work to smooth out downward fluctuations. If GDP is falling, tax revenue will automatically fall, while government expenditure on social security will automatically rise. During a recession, a government may also implement an expansionary discretionary fiscal policy. In such cases, the government will deliberately reduce tax rates or increase government spending in order to boost aggregate demand and economic activity. Discretionary fiscal policy describes this deliberate manipulation of taxation and government expenditure to achieve a government policy objective.

Borrowing from foreign private sector sources

Developing countries may borrow from foreign commercial banks to finance development projects and programmes. If these succeed in raising output and foreign currency earnings, the developing countries may have little difficulty in meeting the interest charges and repaying the capital sums borrowed. In practice, this source of external finance can be problematical for developing countries. This is because the poorer developing countries can find it difficult to obtain loans from commercial banks and may experience problems in repaying the debts. The latter problem can occur if the projects and programmes are not successful, if the countries experience a recession, a fall in exports or natural disasters, or if interest rates rise.

Absolute and relative poverty

Most people in El Salvador are poor in relation to most people living in the Netherlands, and many people in Mali lack basic shelter and are malnourished. This illustrates the difference between relative and positive poverty discussed in Section 9 Topic 5. The UN assesses poverty in broad terms, taking into account not only lack of income but also lack of access to education and healthcare and lack of choice, for example on how to spend part of the day (a lack of leisure time).

Direct controls

Policies involve time lags (see Activity 1), and there is no guarantee that they will work well - or at all. Sometimes, to achieve an economic end, a direct control through regulation may be preferred. For example, firms with large market shares (i.e. they have a high concentration ratio, Section 7) might limit competition. This may allow firms to charge higher prices as there are fewer available close substitutes. High prices adversely affect people on a low income, and this is particularly the case if the product is essential - like the provision of electricity. This matter could be dealt with by, for example, imposing a regulation preventing firms from exceeding a particular percentage of market share; if they did, some kind of demerger would be necessary. The UK is not so draconian, but there is a regulation that any merger that creates a market share greater than 25 per cent has to be investigated - and action may then be taken. When two cinemas chains, Cineworld and Picture House, merged in 2012, the new company owned two of the three cinemas in Cambridge; this was felt to be anti-competitive, and it was required to sell one of them. Equality of access to university education is a supply-side policy, but encouragement and recommendation, and arranging access to finance, may not be enough. Children from lower-income households, almost all of whom are educated at state schools, are currently under-represented. This has a negative effect on social mobility and preserves income differentials. Currently UK universities have target percentages of state-educated pupils which they are expected to meet. It is not beyond imagination to think of a target becoming a quota. Perhaps the ultimate economic regulation is to be found in the science fiction novel Logan's Run (William Nolan and George Clayton Johnson, 1967). In order to maintain a high standard of living at a time when resources are scarce, the population is strictly limited by means of a maximum life span. One is officially terminated at 21 (30 in the movie).

Remittances

Remittances - that is, money sent home by migrant workers - now makes a significant contribution to the GDP of a number of developing economies. For instance, World Bank figures show that in 2015 remittances made up almost a quarter of the GDP of Haiti and almost a third of that of Liberia. Remittances have the advantage that they tend to be more consistent than private capital flows. These can fall dramatically if levels of economic activity decline or if financial investment opportunities increase in other countries.

What is the link between taxation policy and the balance of payments?

Tax in the form of import duties (tariff) may mean a reduced level of imports (by value) and possibly their substitution by domestic products. This will have a positive effect on the balance of trade in goods and services in the current account. Conversely, abolition of duty may have the opposite effect. In terms of the capital account, foreign direct investment flows may be influenced by the level of corporation tax: firms considering which countries to operate in consider, amongst many issues, how much tax they will have to pay on their profits.

As stated above, the MPC 'having been provided with a substantial amount of detail about the current state of the economy . . . discusses and then votes on whether to raise or lower the rate of interest'. Suggest some of the detailed information the MPC would need to consider in reaching its decision.

The Bank of England website states: 'The nine members of the Committee are made aware of all the latest data on the economy and hear explanations of recent trends and analysis of relevant issues. The Committee is also told about business conditions around the UK from the Bank's Agents. The Agents' role is to talk directly to business to gain intelligence and insight into current and future economic developments and prospects.' Among the data considered would be: - the current situation of manufacturing output - to predict If bottlenecks in production will have a future effect on supply and therefore prices - determinants of the costs of production - possible changes in the costs of raw materials and components - impact of wage changes - external circumstances which may affect the flow and cost of imported materials - information on wage trends and other sources of income - to predict future demand patterns. - trends in the housing market, as interest rates may have a serious effect on its operation since many house buyers fund their purchase through borrowing. Activity in the services sector, the largest in the UK economy, will help to provide a picture of how prices may change. What is likely to happen in the labour market? Is there evidence of any pressure, so that shortages could force up wages and therefore prices? Or is a surplus more likely, reducing the pressure on employment costs? What is likely to happen to the exchange rate, the state of which affects the price of imports? How about levels of confidence among households and firms? This affects, in the former case, the balance between saving and spending, and, in the latter case, between the balance between retaining profit and capital investment.

In practice, it can be difficult to categorise countries. In the past, economists defined countries as 'developed' if they were members of the Organisation for Economic Cooperation and Development (OECD). The OECD now includes Mexico but excludes Singapore, which has a much higher real GDP per head and a longer average life expectancy than Mexico. There is also debate about which countries to classify as emerging economies. The Economist, for instance, includes Poland as an emerging economy whereas the UN classifies it as a developed economy. The term 'emerging markets' was first coined by Antoine van Agtmael, who wanted to come up with a positive term to encourage people to invest in developing countries. Then, later in the 1980s, economists started to refer to the fast-growing economies of SE Asia as 'tiger economies'. In 2001, Jim O'Neill, chief economist of Goldman Sachs, separated out four of the emerging economies as BRICs. He forecasted that Brazil, Russia, India and China would grow to become larger economies than the G7 group by 2050. 1. In what sense are all economies 'developing economies'? 2. Under what circumstances might Mexico be classified as a developed economy in 2050? 3. Which of the BRICS has had the fastest growth rate in recent years?

1. All economies are developing economies in the sense that they are all trying to raise the living standards of their citizens, and the majority are seeking to expand their citizens' economic and social choices. 2. Mexico may be classified as a developed economy in 2050 if its real GDP and the economic welfare of its citizens increase by a significant amount. For example, both the rate of employment may have increased, and the quality of work, with a rise in median income for the population as a whole. 3. China has experienced the fastest growth rate, in some years in double digits. At the time of writing (2017) this has slowed to about 7 per cent, but that is still well above most other countries' growth rates.

Somalia was ranked the most corrupt country in the world, jointly with North Korea, in 2015 by Transparency International, an organisation which compiles a Corruption Perception Index based on surveys of business and expert opinion. The country has been experiencing a civil war since 1991. More than one-third of the population is dependent on food aid, and fewer than a quarter of its children go to school. It is thought that Somalia may be the most illiterate country in the world, and may have the highest maternal mortality rate in the world. However, it is difficult to be precise on the figures as the country is too dangerous for some experts to work in. 1. Explain the effect that being ranked as 'the most corrupt country in the world' is likely to have had on Somalia's ability to attract FDI. 2. What effect is a civil war likely to have on the quantity and quality of the country's labour force? 3. Explain why a high rate of illiteracy and a high maternal mortality rate are likely to be directly linked. 4. Why might one be uncertain about the validity of the statement that Somalia is 'the most corrupt country in the world' in 2015?

1. Being ranked 'the most corrupt country in the world' would have discouraged FDI. MNCs would not have wanted to set up branches or production facilities in a country that is regarded as being very corrupt. However, even if it had not been ranked 'the most corrupt in the world' it would have found it very difficult to attract FDI due to its civil war and low educational standards. 2. A civil war will reduce the quantity and quality of the country's labour force. Some workers, and future workers, will be killed and some will be so badly injured that they are unable to work in the future. A civil war may also encourage some of the workers to emigrate. The quality of the workforce will also be lowered. Some workers will be suffering mental and physical illnesses as a result of the war and so will be less productive. Productivity will also fall due to disruption to education and training, and the likely reduction in resources devoted to education and training that will result from the civil war. 3. A high rate of illiteracy may reduce the quality of medical care in the country. Nurses, doctors and midwives may be poorly trained. In addition, mothers may not be fully informed about the care they need to take of themselves when pregnant. 4. It cannot be claimed with certainty that Somalia was the most corrupt country in the world in 2015. This is because reliable data is not always available and because there are few experts in the country to carry out surveys to produce alternative measurements of development there. In creating statement about less developed countries one must always be aware of the scarcity, and unreliability, of data.

The Grameen Bank of Bangladesh, a not-for-profit organisation, bases its loans on several principles. These include: making loans only for business purposes and not for consumption purposes; charging a rate above that paid on savings, but not an excessive rate; and collecting that interest on a frequent basis, usually weekly. There have been criticisms made of the Grameen Bank and other providers of microfinance. Two such criticisms are that it is difficult to ensure that the loans do not just go to cover people's daily needs and that small loans cannot make much of a difference. 1. Explain one benefit of collecting interest on a frequent basis. 2. Discuss whether 'small loans cannot make much of a difference'.

1. Collecting interest on a frequent basis makes it less likely that borrowers will build up large debts that they might be unable to pay. 2. Whether small loans are able to make a difference or not will depend crucially on what they are used for. If they are used for consumption purposes or businesses that do not succeed, they may only improve living standards in the short term. If, however, they are used to finance businesses that grow and become successful, they will create employment and income. This extra income and employment will lead to more spending which, in turn, will lead to further income and employment.

Since 1990 the World Bank has lent more than $15bn for primary education projects in developing countries. These projects have increased the number of children going to primary school by in some cases abolishing fees and in others paying parents to send their children to school. While the World Bank projects have succeeded in increasing the quantity of education, they have not always achieved good-quality education. For instance, a World Bank project in Peru improved school buildings, provided free school textbooks and some teacher training. The standard of education, however, did not improve as the teachers lacked motivation largely due to low pay. Their poor pay also discouraged them from using the free textbooks as they preferred to collect commissions from commercial publishers for recommending their books. The teachers were also not supervised as there was a lack of school inspectors. 1. By promoting education, is the World Bank pursuing a fiscal, monetary or supply-side policy approach? 2. Explain why it may be necessary to pay parents to send their children to school. 3. Identify two measures the Peruvian government could introduce to improve the quality of the country's primary education.

1. It is a supply-side policy approach. It is designed to improve the skills of the country's labour force. It is also designed to improve the economic welfare of people by enabling them to be better informed and so more able to make choices. 2. It may be necessary to pay parents to send their children to school because such a decision may involve costs which poor parents may not be able to afford, for example transport and equipment. There may also be an opportunity cost in the form of lost earnings if the children were working or helping in the family business and with domestic chores. 3. The Peruvian government could seek to improve the quality of the country's primary education by raising the pay of teachers and employing more schools inspectors. Of course, such measures might be difficult for a Peruvian government to finance.

Table 1.3 A comparison of HDI values in 2000 and 2015 (United Nations) 1. Discuss the trends in the HDI index for the countries shown. 2. Explain why a country's HDI value could fall.

1. Over time, most countries' HDI values rise. This is true of only two countries in this list. Bolivia's rise is substantial; Bangladesh's less so. None of the falls is spectacular, the most noticeable being Vietnam and Haiti. 2. A country's HDI value could decline as a result of a decrease in its life expectancy, education, or GNI performance. As you know from your study of macroeconomics, GNI/GDP can be influenced by recessionary situations in trading partners; life expectancy can be affected by major health crises (such as ebola in Sierra Leone); school attendance will be influenced by general health levels, and by GNI, in terms of funding available to provide schooling.

Table 1.4 A comparison of the UK and Rwanda in 2015 1. The evidence provided in Table 1.4 strongly suggests that Rwanda has low economic development relative to the UK. In what ways could the Rwanda data be interpreted as indicating lower economic development? 2. Identify three other indicators of economic development.

1. Quality of life is a core feature of development, and life expectancy is considered a quality issue. High infant mortality suggests there is an inadequate health service and, in emotional terms, is also a quality of life matter. Low income per head limits consumption opportunities, and the consequent low demand provides no stimulus for supply and employment. Low internet access is an indicator of an underdeveloped infrastructure and limits opportunities for learning and the operation of commerce. 2. There are a number of other indicators of economic development, including doctors per 100 000 people, televisions per 1,000 people, savings as a percentage of GDP, daily per capita supply of calories, unemployment rate, recorded rapes per 100 000 women aged 15 and above, suicides per 100 000 people, and the female adult literacy rate.

China used to impose a special tariff on imported car parts to encourage multinational car companies based in China to buy from local suppliers and so reduce imports. The USA, Canada and the EU, however, complained to the WTO that the tariff was against WTO rules. In July 2008 the WTO ruled in their favour. The Chinese government then introduced a new 'green tax' which it claimed was designed to reduce fuel consumption and fight pollution. The tax was placed on so-called gas-guzzling cars - that is, cars with engine capacities larger than 4.1 litres. Most such cars are foreign-made whereas most cheaper cars, with smaller engine capacities and so exempt from the tax, are made in China. 1. Assess whether the imposition of a tariff on imported car parts would necessarily increase demand for car parts from local suppliers. 2. Is China's new 'green tax' direct or indirect? Is it progressive or regressive Explain your answer. 3. Discuss two advantages of China's new 'green tax'.

1. The imposition of a tariff on imported car parts may increase demand for car parts from local suppliers as it would be expected that it would raise the price of imported car parts. There are, however, three reasons why such a measure may not increase demand for the domestically produced car parts. One is that the foreign producers may absorb the tariff. They may decide to reduce their profits rather than pass on the tax in the form of higher prices. Another reason is that, even if the tariff is based on the imported car parts, they may still be cheaper than the domestically produced ones. The price gap may actually have been a significant one and, while the effect of the tariff may narrow it, it may not eliminate it. In addition, even if the tariff makes the imported car parts more expensive than those domestically produced, local suppliers may not experience an increase in demand if the quality of the parts they produce is noticeably lower than the imported ones. 2. The new 'green tax' is an indirect tax as it is a tax on the sale of a product rather than a tax on income. It also appears that the tax is effectively a progressive one as the tax is placed on large, expensive cars which tend to be bought by the rich. People who buy the smaller, cheaper tax-exempt cars tend to be those with lower incomes. 3. One advantage of China's new 'green tax' is that it is likely to reduce imports into the country. The tax is one way of protecting domestic suppliers which appears to get round the WTO rules. If demand for car parts from domestic producers increases, domestic output and employment may rise. There is a risk, however, that the tax may result in a misallocation of resources and may lead to retaliation. If this is the case the tax in the longer term will not raise output and employment. In addition, as time progresses, income will rise in China and so demand for cars with larger capacities may increase. The new 'green tax' may reduce pollution as cars with smaller engine capacities are cleaner. If successful in cutting pollution, the quality of people's lives in China will be increased. Again, however, demand for larger engine cars is more income elastic and so in the longer term other measures may need to be taken such as promoting greater use of cars powered by electricity and greater use of public transport.

Characteristics of developing countries

Developing countries are not all the same. For example, the newly industrialised countries, as their name suggests, have a relatively strong industrialised base and relatively high incomes. However, many of the developing countries, especially the least developed countries, have a number of characteristics in common including: - low income per head - low living standards with, for instance, low life expectancy, high rate of illiteracy and lack of access to healthcare - a high proportion of the population employed in the primary sector - low levels of investment in human capital - a heavy dependency on a narrow range of export products - low productivity - low savings ratio - poor financial infrastructure - high unemployment and underemployment (Underemployment is where jobs fail to use the potential of an employee, e.g. a job that does not utilise an employee's skills or qualifications.)

Tax and FDI flows

Empirically, rates of corporation tax (the tax paid by firms on their profit) are a strong determinant of levels of FDI (foreign direct investment). International competitiveness is relevant here: MNCs incorporate into their location decisions the varying rates of corporation tax in the countries they are considering. Current UK policy is to reduce this tax to 17 per cent by 2020, but that is still higher than the current level in its close neighbour (where English is also the first language), the Republic of Ireland (12.5 per cent).

Providing a market for equities

Equities is the common formal term nowadays for shares in public limited companies. As mentioned previously in this course, capitalism as a form of economic structure is so named from the fact that the means of production is financed by private funds - physical capital - in return for which an appropriate share of profit is allocated (the dividend). Funding for business activity has long been arranged among friends and family, involving a degree of trust and knowledge between entrepreneur and investor; this is still a common form of capitalisation, known as the private limited company, where ability to invest is limited by invitation. Some very large international firms - such as Mars, the confectionery company - have this structure. This type of structure, however, limits the range and number of potential investors, and is particularly unsuitable for firms in need of large amounts of capital for development and expansion. The ability to obtain finance from the public at large is an essential feature of modern business, but to ensure that this operates efficiently and with a high degree of security, professional organisation is needed. Just as production firms often use wholesalers to find outlets for them, as this is an activity for which they have neither time nor resources, so firms wishing to raise capital make use of stock exchanges to do this for them. These organisations provide a market for traders in equities to make their dealings, and set up regulatory systems to ensure that trading is fair and protected from information asymmetry. At the time of writing the deregulation of the London Stock Exchange has just passed its 30th anniversary (an event, in October 1986, known as the 'Big Bang'). One purpose of this major series of changes was to make share dealing easier and more widespread: to create, in the words of the government at the time, 'a share-owning democracy'. However, despite the expansion of shareholding among the nation's households, the major shareholders are pensions funds and insurance companies. Both receive income (the former as regular contributions by employers and employees, the latter as premium payments made by the holders of insurance policies) which needs to be retained for use at a later date, as pension payments or pay-outs for claims. Pension funds and insurance companies use this income to purchase shares, in the hope not only that the monetary value will increase to counteract the depreciation of inflation, but to contribute to the firms' profits. So in this sense, equities markets play a vital role in the provision of insurance and of pensions. In addition to stock exchanges (sometimes known as bourses) and firms of market traders, banks play a major role in this process, advising firms on their share issues and undertaking the organisation of 'going public' - when a firm, previously privately financed, wishes to obtain funding from the much wider net of public and corporate investors. Without the facilitation from these financial institutions, the financing of firms' activities would be slow, uncertain, and cumbersome.

The spread of HIV/AIDS

HIV/AIDS remains a very serious problem in a number of developing countries and particularly in sub-Saharan Africa, where 24.7 million people are infected (71 per cent of the world total of 34.8 million, 2015 figures). As well as the human misery and suffering caused, HIV/AIDS has also affected economic growth. It results in declining productivity, rising rates of absenteeism and the loss of some of the workforce. In South Africa, the country with the highest percentage of people in the world affected by HIV/AIDS, the worst-hit sectors of the economy are those with the most mobile workers. One of these sectors is mining, which relies heavily on migrant labour from rural areas within the country and other nearby countries, including Mozambique and Malawi. The miners, who live away from their families, have regular contact with the prostitutes who are attracted to the miners' settlements.

Topic 5 - Macroeconomic policies in a global context

In this concluding topic you will revisit the major economic policies of macroeconomics - fiscal, monetary (which includes exchange rates) and supply-side, as well as direct controls - and consider their effects, in the UK and in the economic world as a whole, on: - the management of fiscal deficits and national debts (which you studied in Topic 4) - poverty and Inequality - interest rates and the supply of money - international competitiveness. You will consider how economies respond to external shocks, and how they attempt to control the operations of multinational companies (also known as global or transnational firms). You will also study how economic policy-makers deal with the difficulties of inaccurate information, risks and uncertainty.

Privatisation

Privatisation was covered in detail in Unit 8 Topic 3. It is often stated that, in a capitalist economic system, the motivation to obtain and increase profit encourages investment and ensures that firms are run well: firms aim for productive efficiency to reduce costs and so enlarge profit margins, and ensure that new technology is adopted to keep the firm dynamically efficient in the face of competition. Privatisation, it is often claimed, increases efficiency because it increases competition. Industries in the private sector will go out of business if they do not produce products that consumers want to buy at a price they are prepared to pay. If they do well they will be able to take advantage of the profits earned and they will be freed from political control and interference. However, some economists claim that privatisation does not always result in greater competition and efficiency since the privatised industries may have or may gain considerable market power and may not take externalities into account when making their production decisions. Many developing countries are currently pursuing a policy of privatising many of their industries in a bid to increase efficiency and attract more FDI. These motivational elements are missing when firms are publicly owned. The American economist Milton Friedman once said, 'When everybody owns something, nobody owns it, and nobody has a direct interest in maintaining or improving its condition.' An often-heard slogan during the UK privatisation process of the Conservative government of the 1980s was 'leaner and fitter'.

Topic 1 - International growth and development

This topic concerns the nature and measurement of economic development and the limits to economic growth in developed and developing countries. You will examine indicators of development and explore a number of obstacles to economic growth and development, both internal and external. As it is important to appreciate the limitations of gross domestic product (GDP) as an indicator of development, it would be very useful to re-read the paragraphs comparing the GDP of different countries and examining other ways of measuring living standards in Unit 4 Topic 1.

Public sector finances

- Automatic stabilisers and discretionary fiscal policy: Automatic stabilisers are forms of government spending and taxation that change automatically to offset fluctuations in GDP. They occur without any deliberate changes in tax rates and government expenditure plans. For example, when the economy is growing rapidly, incomes and spending will rise. This will increase direct and indirect tax revenue. The higher level of economic activity will also reduce government spending on state benefits. The higher tax revenue and lower government spending will dampen down the rise in GDP and may stop the economy overheating. In terms of the AD formula, C + I + G + (X - M), G may fall, and the rise of C should be retarded. The opposite case is that when economic activity is falling, there is greater government spending, both on benefits (e.g. more people will be unemployed) and on policies to attempt to boost activity. This rise in G should offset the fall in C, and so the decline in economic activity should be retarded. Figure 4.3 shows how automatic stabilisers respond to changes in GDP. The figure also shows that at low levels of GDP, such as at Q, there will be a budget deficit with government expenditure exceeding tax revenue, whereas at high levels of GDP, for example at Q2, there is a budget surplus with tax revenue exceeding government expenditure. At Q1 the budget is in balance, with government expenditure equalling taxation. In contrast to automatic stabilisers, discretionary fiscal policy refers to the deliberate change in tax rates and government expenditure. - Contractionary or deflationary fiscal policy is designed to reduce aggregate demand by cutting government spending and/or increasing taxation. - Expansionary or reflationary fiscal policy involves increases in government spending and/or cuts in tax rates or tax coverage, designed to increase aggregate demand. The challenge for governments is to strike the right balance between allowing automatic stabilisers to work, and applying discretionary policy. If, for example, taxes are lowered and/or government spending is increased to boost the economy in addition to the automatic responses described above, an overheated economy may occur. - Fiscal deficit and the national debt: A need for the public sector to borrow arises when it spends more than it raises in revenue - in other words, when there is a fiscal deficit. It is important to distinguish between fiscal deficit - where government spending exceeds its revenue in a given time period - from the various deficits that apply in the balance of payments, such as a trade deficit or a current account deficit. The amount it may have to borrow (known officially as the PSNCR - public sector net cash requirement; this used to be called the public sector borrowing requirement or PSBR) is influenced by the budget position of local government and by the net trading surplus or loss of public corporations, but principally by the government's budget position. A government can finance its borrowing by borrowing from the central bank, from commercial banks and from the non-bank private sector. When it borrows, it sells government bonds. Some future tax revenue will have to be spent financing the interest that has to be paid on the government bonds. If government debt rises to high levels, it may become difficult to find willing buyers for its debt. High levels of borrowing may also discourage FDI as foreign MNCs may perceive the government as irresponsible; they may also feel that future levels and forms of taxation may be detrimental to their activities. Money that is borrowed because of a fiscal deficit is not usually repaid in full in any given fiscal year (fiscal years are not necessarily the same period as calendar years), so debt accumulates, The total debt owed by a country is its national debt, which is often expressed as a percentage of GDP. At the beginning of 2015, for example, the figure for the UK was £1.56 trillion, or 81.6 per cent of GDP.

Between 1960 and 2016 world population more than doubled from 3.1 billion to 7.4 billion. This rapid rise has led to concerns that such a large population will put unsustainable pressure on the environment and food supplies. The latter concern has revived interest in the Malthusian theory of population. In his book An Essay on the Principle of Population, published in six editions between 1798 and 1826, Malthus argued that population would have a tendency to grow faster than agricultural output. In mathematical language, population grows exponentially, but agricultural output growth is arithmetical. In practice, the farmers of the world produce a surplus of food in part due to advances in technology. The rate of increase in population has also slowed in both developed and developing countries. This decline has been largely caused by a fall in birth rates, although the birth rates in developing countries remain higher than those in developed countries. 1. If farmers produce a surplus of food, why do some people go hungry? 2. Explain two reasons why the rate of increase in population has 'slowed'. 3. Explain two reasons why birth rates are high in developing countries. 4. Describe one benefit of a fall in a developing country's birth rate.

1. Despite a surplus of food, some people still go hungry because of an uneven distribution of income and hence of food. There may also be a temptation, or even encouragement, to export as much as possible to help the balance of payments as a priority over feeding the population, possibly because much-needed hard currency can be earned in this way. 2. One reason why the rate of increase in population has slowed is that the education of women has increased. This has resulted in women marrying later and deciding to have fewer children, in part so that they can pursue careers and enjoy a better quality of life. Another reason is that improved healthcare has reduced infant mortality and improved awareness of birth control measures. Knowing that more of their children will survive, some families have decided to have fewer children. 3. Birth rates are high in developing countries for a number of reasons. One is high infant mortality: couples have a large number of children because they do not expect all of them to live. Other reasons are a lack of education about birth control methods and a lack of access to contraceptive methods. In addition, in many poor countries, children are seen as a source of income and support. They may be put to work when they are still relatively young and, particularly in countries without welfare systems, may support their parents in their old age. Women may also have little expectation of a career and so may not seek to limit the size of their families. 4. A fall in a developing country's birth rate will reduce its dependency ratio. With the same output, income per head will rise, and more resources could be devoted to investment in physical and human capital and infrastructure. The labour force may also increase if some women, having fewer children, enter or re-enter the labour force.

The UN has set developed countries a target of official foreign aid of 0.7 per cent of their GDP. Table 2.2 shows the official foreign aid a number of countries gave in 2015. In the wake of the financial crisis of 2008-9, many developed countries cut their foreign aid budgets. The USA was one of the countries that reduced the aid it gave, but remained a large donor in value terms. 1. Identify two countries which met the UN's target for foreign aid in 2015. 2. How might the statement that the USA was a large donor be qualified? 3. Why may developed economies reduce their foreign aid budgets? 4. Does foreign aid ensure that resources are transferred from developed to developing countries?

1. Sweden, Norway, UK. 2. The USA was a large donor in terms of the absolute amount of aid it gave. In terms of percentage of its GDP, however, the USA was well below the UN's target level and was lower than any of the other nine countries shown in the table. 3. Developed countries may reduce their foreign aid budgets if their own economic conditions and objectives lead them to cut public expenditure or if they become concerned about the effectiveness of foreign aid. If, for example, developed economies are experiencing a recession or their governments are concerned to reduce taxation, they may consider cutting government spending. Reducing spending on foreign aid tends to be less unpopular with the general electorate than reducing spending on pensions and healthcare. In addition, if developed economies believe that the foreign aid they are giving is not promoting development but is being used for unsuccessful projects or military purposes, or is being misappropriated by corrupt government officials, they are likely to reduce or stop the foreign aid they give. 4. The aim of foreign aid is to transfer resources from developed to developing countries. However, foreign aid will not be successful in this objective if the aid is exceeded by the interest and capital repayments made on past borrowing from developed countries. In this case, there will be an outflow of money, and hence claims on resources, from developing to developed countries.

Topic 2 - Strategies for growth and development

In this wide-ranging topic you will consider some of the strategies that governments and other organisations can employ to promote growth and development, including strategies that are market based and those that rely on direct government intervention. You will also explore a model of growth and development - the Lewis two-sector model - and examine the sources of finance that developing countries may draw on.

Supply-side policies

Supply-side policies have the potential to help a government achieve all of its macroeconomic objectives. However, there is no guarantee they will work: some may be inflationary in the short term and some may take time to work. Supply-side policies can also involve a relatively high opportunity cost. This applies particularly to education, training and healthcare programmes. Instead of, for instance, raising the school leaving age, a government could raise state pensions or lower income tax. While education, training and healthcare programmes would be expected to raise labour productivity and so aggregate supply, the impact will be influenced by the quality and appropriateness of the policies. If such policies do succeed, the benefits may be substantial: more people, in that they have a better skills set, will have the opportunity to earn higher wages, and so income distribution may become less unequal. Improvements in productivity leading to lower costs should boost international competitiveness. More profit for firms from higher sales and more efficient production should raise tax revenue, possibly giving a government more flexibility in terms of managing its debt. In addition, there is a risk that supply-side policies may reduce rather than increase macroeconomic performance. For example, if unemployment is of a cyclical nature, then cutting unemployment benefit will be likely to raise unemployment. While it may make the unemployed try harder to find a job, the jobs will not be there for them. With lower benefits, they will spend less, which will reduce aggregate demand, in turn causing more unemployment. Increasing aggregate supply by raising the quality and quantity of resources will not be effective if there is a lack of aggregate demand. Figure 5.2 shows that if there is initially a negative output gap, an increase in aggregate supply will not cause economic growth. It will just raise the size of the negative output gap - from a-b to a-c. The effectiveness of all macroeconomic policies depends on the accuracy of the information on which they are based and all are affected by economic shocks (see 'External shocks' below).

Topic 3 - The financial sector

'Money makes the world go around.' This is a line from a song in the musical Cabaret, but it is a fundamental economic truth: the essence of economic activity, exchange, almost universally now uses money as the medium of the process of exchange. To ensure that the money is available, financial markets exist, to transform surplus unused income (i.e. savings) into loans, and to ensure that a sufficient supply of money is available to an economy to enable it to function smoothly - i.e. that there is enough liquidity. Financial markets exist in a variety of forms, and their functioning involves problems and constraints

Structural and cyclical fiscal deficits

A fiscal deficit may be cyclical or structural. You will recall that economic activity seems to move in cycles: a boom period is followed, at some indeterminate time, by a recession, but economies recover and return to growth again. Much research has been undertaken in an attempt to discover a pattern - so that if a downturn can be predicted, action can be taken to forestall it - but no consensus has emerged. When an economy moves into recession, aggregate demand is falling (in diagrammatic terms, the AD curve shifts to the left). Automatic stabilisers come into effect, with, if thought necessary, the use of discretionary fiscal policy. There will be a gap between government spending (which will rise because of increased benefit payments and capital spending to boost the economy) and tax revenue, which falls as less economic activity is taking place. There is a fiscal deficit - spending exceeds revenue. However, this has been brought about by the nature of the economic cycle, rather than by deliberate government policy to spend beyond income. Such cyclical deficits are expected to disappear when the economy recovers: rising activity increases tax revenue, while the need to spend owing to recession diminishes. Accounting foresight would suggest that any surplus generated during a boom would be retained to pay off the debt created by a cyclical deficit; it is not a long-term problem, as the economy should always return to fiscal equilibrium. On the other hand, discretionary expansionary fiscal policy can lead to a fiscal deficit if governments increase spending, either through a change in benefit policy which raises levels, reaches more people, or enters new areas (e.g. providing free bus travel for those of pension age) or through capital spending (such as on a high-speed railway project). This may create a structural deficit. This is not linked directly to the economic cycle, and cannot be expected to disappear as an economy grows; it can persist at full employment.

Discuss the effects of an expansionary fiscal policy on GDP, employment and the trade in goods balance.

An expansionary fiscal policy will involve cutting taxes and/or raising government spending. For example, the government may reduce the basic rate of income tax and may raise spending on, say, road building. The fall in income tax would raise disposable income and this, combined with higher government spending, would increase aggregate demand (AD). If the economy is operating below full employment level, an increase in aggregate demand will raise GDP, as shown below in Fig 6.1. The cut in taxation and rise in government spending may increase GDP even if the economy is operating at full employment, provided that the fiscal policy measures also stimulate an increase in aggregate supply. This could occur if the cut in taxation stimulates more people to enter the labour force and extra government spending raises educational standards, training or investment levels. The graph below illustrates GDP increasing as a result of a rise in both aggregate demand and aggregate supply. Notice also the effect on the price level in the figure below. A higher level of GDP is likely to lead to higher employment as firms take on more workers to produce the extra output demanded. Government spending on education, training and job creation schemes may also increase employment by raising the skills of workers. Additionally, cuts in income tax may make work a more attractive option for some of those currently on benefits. However, some economists argue that government spending on benefits, while generating extra aggregate demand, may reduce the incentive to work. The effect of an expansionary fiscal policy on the trade in goods balance will depend in part on what any extra government spending goes on. By increasing aggregate demand, an expansionary fiscal policy may lead to a worsening of the trade in goods balance. This is because the higher level of aggregate demand may suck in more imports and divert products from the overseas to the home market. However, higher spending on, say, education, training, research and development and investment subsidies may result in a rise in productivity, and thereby lower firms' unit costs and the country's international price competitiveness. Cuts in corporation tax may also raise investment. So, both measures may increase a country's export revenue, reduce its import expenditure and improve its trade in goods position.

Factors influencing the size of national debts

As explained above, any borrowing not repaid in a fiscal year is added to the national debt. A government in a recession is unlikely to be able to repay its borrowing quickly, and so the debt will rise. Even if revenue exceeds income, governments may prefer to use the surplus for further spending (see the previous paragraph for possible reasons) rather than reduce the size of the debt. A fiscal surplus is technically known as PSDR (public sector debt repayment) but to use it as such is discretionary. Interest must be paid on the national debt (Activity 1), but the interest rate may have some effect on whether the debt is allowed to grow or is diminished. If interest rates are low - which is not uncommon for countries with a history of good economic management and trustworthiness - national debts may allowed to grow. Some countries, such as the USA, have debt limitation laws, and EU members are committed to the Stability and Growth Pact, one condition of which is that national debt does not exceed 60 per cent of GDP.

Speculation, market bubbles and market rigging

Consider the following two situations: - A few years ago the manufacturers of Branston Pickle announced that there may be shortages in supply, and almost immediately jars of the product went up for sale on eBay at prices greatly above expected market price. - About a decade ago, Warner Home Video discontinued production of the subtitled version of the DVD of the distinguished Japanese film trilogy Ningen no Joken. Not long afterwards, copies began to appear on Amazon Marketplace at up to 10 times their retail price. Imagine how these scenarios might develop. Those who cannot imagine their food without Branston will pay the high price, and hoard the commodity. Serious collectors of classic Japanese cinema will fork out the high sums required to ensure that this major item is in their collection. However, it may also occur that those who care not for Branston, and those with no interest in old Japanese movies, will buy these products at the higher price on the assumption that the price will go higher still, i.e. they are speculating that they will be able to sell them on at a profit. At some point, however, realisation will set in that the items are priced absurdly above their actual value, the utility they offer to their consumers. At dozens of pounds per bottle the opportunity cost of pickle on salad becomes too great, or, to borrow the phraseology of Karl Marx's value theory, the gap between the exchange value and the use value becomes too great. Those who have purchased the items speculatively will want to dispose of them; to do so, they lower the price and the market now becomes flooded with unwanted bottles of pickle and DVDs of Ningen no Joken. The operation of the market mechanism brings the price down, and anyone still holding on to the item will sell at an enormous loss. There is a crash - the bubble has burst. This is the kind of scenario which can distort the efficient operation of financial products. Shares, currencies, and financial instruments can become victims of this speculation. The effect of speculation on the oil price was mentioned above (under 'providing forward markets in commodities and currency'). Some readers may remember the 'dot com boom' of 1995-2001, when eager speculation in new internet companies developed rapidly, until it was realised that the enormous nominal value of the shares of these firms represented in some cases almost no capital value or indeed profit potential. Many companies came crashing down and the 'dot com boom' became the 'dot com bubble'. The best-known example of speculative disaster is, of course, the Great Crash of 1929, which led to a worldwide recession for much of the following decade. Those involved in financial dealing have, of course, access to specialist knowledge, and the temptation exists to use that knowledge to their advantage. Insider trading is a market distortion frequently reported in the news and in fiction (most popularly, perhaps, in Oliver Stone's movie Wall Street). Although such action is illegal, adherence to the so-called 'eleventh commandment' ('Thou shalt not get caught') ensures that it continues to occur. The possession of specialist knowledge can be called upon by market professionals to rig the market. A recent significant example has been the rigging of the London Interbank Offered Rate (LIBOR). This is the rate of interest which banks pay to borrow from each other. It is this, rather than the Bank of England base rate, which has the major influence on the rates at which households and firms borrow money. The way it is calculated makes it prone to dishonest manipulation. In this way the price of money globally (LIBOR also relates to dollars and yen) for households and firms becomes distorted.

Possible benefits from the presence of MNCs

Developing countries can receive a range of benefits from the presence of MNCs, including an inflow of foreign currency, an increase in employment, a rise in incomes, higher government revenue and an inflow of technology. The arrival of the MNCs leads to an inflow of capital funds and, once established, the MNCs are usually significant contributors to a developing country's exports. If the MNCs do sell some of their output in a developing country, that country's imports may also fall. The MNCs will also employ some local workers and, as long as they do not replace domestic firms, will increase overall employment levels. The rise in employment will raise income levels directly and indirectly. More people will be in employment and their spending will generate further employment and income. In turn, the higher income will lead to a rise in government tax revenue, which will increase its ability to finance development projects. Domestic firms may also be able to learn from the technology and management techniques used by the MNCs and may be able to employ some workers trained by the MNCs (technology transfer).

Financial inflow from other countries

Developing countries seek external finance, in the form of FDI, loans from foreign banks and foreign aid, to cover current account deficits and promote economic growth and development. The reason why the finance is sought from outside is because the low levels of income in developing countries do not generate sufficient savings to finance deficits and development projects.

Categories of country

Countries, in assessing their progress, can be grouped in a number of ways. One traditional way was to group them into 'First World', 'Second World' and 'Third World' countries. The First World comprised the developed economies of Western Europe, the USA, Canada, Australia, New Zealand and Japan; the Second World comprised the communist countries of Eastern Europe and Russia; and the Third World included most of the countries of sub-Saharan Africa, Asia and Latin America. Owing to the economic and political changes that have taken place, and are still taking place, in Eastern Europe and Russia and the emerging economies, this categorisation is now thought to be largely out of date, and economists rely mainly on other groupings. One main current categorisation is into developed, developing and less developed countries. These are not quantitatively specific but, broadly, developed countries are those with relatively high incomes and a high proportion of their labour force employed in the secondary and tertiary sectors. Among the countries in this category are the countries of Europe, including Eastern Europe, Russia and North America. The developing countries category includes a wide range of countries: - newly industrialised countries (NICs) including Singapore, South Korea, Thailand and Taiwan - emerging economies, including Brazil, China, India, Indonesia, Mexico and Turkey - middle-income countries of Latin America some very low-income countries of Asia and sub-Saharan Africa. Developing countries are countries that are building up their industrial base and moving away from reliance on primary products. These are broad categorisations and, within each category, there is a considerable degree of variety. The UK and its close neighbour, the Republic of Ireland, are both 'developed' countries, but agriculture, for example, plays a much greater economic role in the Republic of Ireland than in the UK. Finally, the term 'less developed country' (LDC) refers to countries that have some way to go to reach the level of development of the richest countries. As outlined in Unit 9 Topic 5, the World Bank divides countries into one of three bands according to annual per capita Gross National Income (GNI): - Low Income Countries (LICs): GNI of $1045 or less - Middle Income Countries (MICs): $1046-$12 735 - High Income Countries (HICs): $12 736 or over. These are 2016 figures - they are frequently adjusted. Some analysts also talk about the North-South divide. This refers to the geographical division between the richer countries, which are mainly in the northern hemisphere, and the poorer countries, which are mainly in the southern hemisphere, including countries in Africa, Asia and Latin America.

Exchange rate policy

Floating exchange rates, by their very nature, should not be subject to direct government policy, but they will be affected by other policy decisions. Low interest rates may lead to a net outflow of money, as saving is unattractive, and high rates will have the opposite effect. Low taxes may attract FDI inflows, and high taxes may see that FDI being redirected elsewhere. Whereas a low exchange rate should make exports cheaper and so easier to sell, it will raise the price of imports; if imports constitute a large proportion of the consumption of low-income groups, increasing inequality may occur. Some countries - China being the best known and most contentious example - choose not to have their exchange rates floating freely, so that this aspect too of monetary policy can be directly controlled.

Inexperience and vanity

Governments, especially of states newly independent after a period of colonisation, or democratically formed after the expulsion of a dictator, may take time to develop the experience necessary to ensure that merit goods are efficiently provided, that infrastructural improvements are set in motion, and that a tax and distribution system can work successfully to enable 'trickledown' to affect the population. In some states, development is hindered by the vanity of an absolute ruler, who diverts most of the country's GDP to himself and his vanity projects. Jean Bedel Bokassa, ruler of the Central African Republic from 1966 to 1979, declared himself an emperor in 1977 and held a coronation ceremony which cost $20 million, one twelfth of the country's GDP. Government was difficult under his reign - It was even rumoured that if a minister disagreed with him, Bokassa would cook and then dine on him.

Foreign aid

Foreign aid involves the transfer of resources from developed countries to developing countries. It can come from governments, international organisations such as the World Bank, the UN and the EU, and from non-governmental organisations (NGOs) such as Oxfam and Save the Children. Foreign aid can take a number of forms, including loans at reduced rates of interest or with long repayment periods, grants that do not require repayment, food aid, and the provision of financial, educational, technical and advisory services. - Bilateral aid is aid given directly from one country to another and most of it is tied. The term tied aid means that the donor stipulates what the aid is to be spent on or from which country - usually the donor country - the products must be purchased. Some of these products may be more expensive or of a lower quality than products that could be produced elsewhere. - Multilateral aid is given by a group of countries in the form of international organisations or NGOs. Most is untied, so the recipients can choose what and where to buy. As indicated above, untied aid is usually more effective than tied aid, as is aid that takes into account the resources and development needs of the recipient countries. Many economists also suggest that, to be effective, foreign aid should be combined with poverty reduction. So they argue that foreign aid should be given for programmes that concentrate on widening access to meet basic needs, such as education, healthcare and water, rather than large-scale, prestigious investment projects. One of the criticisms of foreign aid is that it is poorly targeted. This refers not only to the projects and programmes supported, but also to the distribution of foreign aid. Indeed, the poorest countries do not receive the most foreign aid. Some economists also claim that the level of foreign aid currently being given is insufficient. The UN has set a target for industrial countries' aid budgets of 0.7 per cent of their GDP (part of the UN's Millennium Project). Foreign aid is vulnerable when developed countries' own governments need to make reductions in public spending. Cuts in foreign aid tend to be less politically unpopular than, for example, cuts in domestic education and healthcare spending. Such cuts may be supported by those who argue that foreign aid has not made a significant contribution to development. They mention that foreign aid is not always spent by governments on appropriate projects, that some is misappropriated, and that it can reduce the incentive for developing countries to overcome their problems and so can make them dependent on receiving foreign aid. It is argued that trading with countries, rather than sending aid, is a more productive and longer-term form of assistance.

Immediately after the election of Donald Trump as US President in November 2016 many investors throughout the world who owned US government bonds sold them (a phenomenon named by journalists as the 'Trump Dump'). They feared that Trump's economic policies would have negative effects on performance. As is often said, a slowdown in the USA has a global effect. Trump also stated that he would cancel the Trans Pacific Partnership, a trade deal involving the USA and 11 other countries with Pacific coastlines. China, the world's second largest economy, was anxious about what seems to be President Trump's favourable approach to Taiwan, which China regards as a rogue province of its own. He is also known to favour protectionist trade policies, and has threatened to withdraw the USA from the North American Free Trade Area (NAFTA). What might be the global effects of US trade policy following the introduction of such policies? (If you are reading this later, you can compare your answer with what actually happened.)

If the bond dumpers are right and inflation rises in the US economy, causing a downturn in activity, US aggregate demand may fall. The USA is the world's largest economy. It consumes enormous quantities of raw materials, agricultural commodities and manufactured goods from the rest of the world, so all exporters to the USA may see a fall in the volume and value of their exports. As X is a component of AD, the economies of any country which substantially exports to the USA will suffer. Moreover, a downturn will affect the income of US employees, who may not be able to afford overseas holidays. Countries which attract large numbers of US tourists may experience difficulties in certain sectors. After the events commonly known as 9/11, there was a considerable drop in the numbers of US tourists coming to the UK. London theatres depend heavily on US tourists, so for a while they struggled to cover their costs. (West End productions are expensive to mount, and rents are high.) The 12 countries in the Trans Pacific Partnership (TPP) account for 40 per cent of the world's economic activity. Free and less restricted trade boosts world trade and the incomes of all countries involved. Should the TPP not come into being (all 12 countries must ratify it), these opportunities will be lost. This would be a significant blow, especially for the less developed economies in the partnership, such as Peru, Chile, Vietnam and Malaysia. Protectionist policies limit access to developed markets for emerging economies, with consequential effects on the employment levels of those countries and on their foreign currency inflows, so limiting their ability, through spending in the economy, to create trickledown effects.

Possible disadvantages from the presence of MNCs

It is possible that MNCs may lead to a net currency outflow. This will occur if the repatriation of profits made and wages earned by workers from the MNCs' countries and the purchase of imports from the MNCs exceeds the capital inflow and contribution to exports. In addition, the technology and methods employed by MNCs may be inappropriate for some developing countries. For example, MNCs may use capital-intensive methods whereas labour-intensive methods might be more suitable. However, the main concerns about the activities of MNCs focus on the adverse effects they can have on the labour force and the environment. As noted earlier, they may have been attracted to the developing countries in the first place by less strict labour and environmental regulations than in their home countries. Some MNCs have been accused of using child labour, depleting non-renewable resources and contributing to pollution. One of the most notorious examples of the harmful effects that an MNC can have on a developing country is the gas leak that occurred from Union Carbide's factory in Bhopal, India, in 1984. At the time, this killed thousands of local people and injured half a million. Years later, people in the area are still suffering the ill effects.

Indirect taxes

Indirect taxes also provide a high yield and are relatively cheap to collect. Some, such as VAT, also act as automatic stabilisers, since the yield from the tax varies with the level of economic activity. Some economists argue that indirect taxes do not discourage effort since the taxes are linked to spending rather than earning. However, high indirect taxes can discourage people from buying. If the disincentive to purchase products legally at the current rate of VAT becomes extensive, this may have an effect on output and consequently employment. It was perhaps with this anxiety in mind that VAT was temporarily (for 12 months) reduced by 2.5 per cent (from 17.5 to 15 per cent) in 2008, at the start of the financial crisis, with the expectation that this would boost economic activity by £20 billion. High indirect taxes may also encourage people to buy products from countries with lower tax rates or even from illegal importers. In 2000, Imperial Tobacco claimed that rising excise duty had encouraged UK smokers to buy a third of their cigarettes either overseas or from smugglers. Because VAT is usually passed on by producers to consumers, it is added on to the price; therefore changes in VAT affect the price level, and feed into the inflation calculation. Excise duty, an additional tax on certain products regarded as demerit goods (tobacco and alcohol products, and petrol/ diesel) can also significantly affect the prices of these goods. Fuel for vehicles takes up a considerable proportion of spending for some households and firms, and has a notable impact on inflation. Moreover, the raised cost of delivery affects all products, and so feeds through to the price level generally. A government can increase indirect taxes to discourage the consumption and production of certain goods, but if it has incorrect information about the effects of these products such a move may lead to the misallocation of resources - an example of government failure. Indirect taxes are regressive, so a rise in indirect taxation will hit the poor hardest. This is one of the main concerns voiced about indirect taxes.

Microfinance

Microfinance, which is also sometimes referred to as microcredit, involves providing loans and other financial services to low-income individuals and households, who often find it difficult to get loans. This gives them the opportunity to borrow small amounts to set up businesses and get out of poverty. Dr Muhammad Yunus, a Bangladeshi economist and winner of the Nobel Peace Prize in 2006, is credited with developing microfinance. In the 1970s his bank in Bangladesh, the Grameen Bank, started a system of small loans for business purposes. Now thousands of financial institutions across the world are providing such financial services, enabling the lower-income deciles (Unit 7 Topic 3) to save and to borrow to develop businesses, which will enable them and others to get out of poverty. Supporters of microfinance argue that it enables such sectors of the population to develop their entrepreneurial skills and to provide employment for others. They also claim that it can lead to poverty reduction without the need for charitable handouts. Critics argue that not all such people have entrepreneurial skills, that some microcreditors may be tempted to charge them more than they can afford, and that microfinance is likely to have only a small impact on poverty reduction.

Tax and the trade balance

Taxation, in terms of import duties (tariffs), may affect the balance of trade: if the tariff is passed on to the consumer as a higher price, and cheaper domestic products are available, the amount of money spent on imports will fall. This is not a simple issue, however, for other factors have a role in determining the choice between imported and domestic products. Being convinced, for example, that a BMW endows its owner with more status than a domestic brand of car may count for more than the price differential caused by a tariff.

Development of primary industries

The role of agriculture in development used to be somewhat overlooked. In the past some countries did seek to reduce their agricultural sectors as quickly as possible. However, it is now recognised that improving agricultural performance can play a significant role in development since developing countries have a cost advantage in producing certain crops because of their natural resources. The key elements of such a strategy are to raise productivity, to diversify into products that have both positive income elasticity of demand and income elastic demand, and to process more of the products produced. Raising productivity will release labour for the secondary and tertiary sectors, increase the availability of agricultural products and reduce their price to industry and households. It will also increase the price competitiveness of the products produced and so may increase export revenue. This could be used, for example, to pay for imported capital goods or to pay off international debt. Diversification will reduce a country's vulnerability to sudden shifts in demand and supply. It can also enable the country to move into producing crops that are in increasing world demand and thereby raise the country's exports. For example, in the 1980s and 1990s, Kenyan farmers diversified into the production of flowers and luxury vegetables, such as French beans, which are exported to Europe. This policy has significantly increased the country's export revenue and raised farmers' income - but it has not been without cost. The reduction in the production of food, including maize and potatoes, for the home market has raised its price, and tropical forests have been bulldozed to provide land on which to grow flowers. This suggests that any diversification has to be carefully managed. Moreover, the shift to growing crops for biofuel takes land out of use for growing food. In 2007 the then president of Cuba, Fidel Castro, in a speech widely reported, spoke out against this practice. The governments of developing countries are also becoming increasingly aware that they lose out by not adding value to their agricultural products by processing them. For example, while most of the world's tobacco and cocoa is grown in the developing world, most cigarettes and chocolates are produced in developed countries. This has led the governments of developing countries to consider how they can build up their secondary sectors.

Banker to the government

The services of the Bank of England are not available to individuals (except its employees) and firms - it is the bank of HM Government. The government is of course a great receiver of money - mostly in the form of tax revenues; it is also a great spender - the wages of its many employees, its benefit payments and its capital spending. These revenues and outgoings are managed by the Bank. The Bank also holds the responsibility for the design and issue of bank notes (and the collection and destruction of worn ones). Coins are the responsibility of the Royal Mint, a company wholly owned by the Treasury. Banks in Scotland and Norther Ireland are allowed to issue notes, but do so under the regulation of the Bank which, despite its name, is the central bank for the UK. As you will recall from your study of macroeconomics, there is a strong belief that a major cause of inflation is the supply of money, so the Bank must take great care to control the number of notes in circulation - the new replace the old rather than supplement them. Adding to the money supply is a separate issue, and as was outlined above (quantitative easing), is now done electronically. The obverse of a Bank of England note carries the legend 'I promise to pay the bearer on demand the sum of x pounds' and is signed by the Chief Cashier. What does this actually mean? Not much, in reality: when an officer of the Bank was asked what would happen if a member of the public entered the Bank with a ten pound note and exercised this demand, the answer was 'We'd give him two five pound notes in exchange.'

Government interventionist and free market approaches

There is some debate about how far governments and international organisations can influence development. Some economists argue that free market forces will not necessarily increase living standards in developing countries. They argue that low standards of education, low levels of investment and high levels of debt make it unlikely that significant development will occur without assistance from domestic governments and international organisations. In contrast, other economists argue that providing the framework in which free market forces can operate will increase development, with capital moving from developed countries to take advantage of appropriate opportunities. They suggest that politicians often make the wrong decisions and that government intervention can stifle incentives, so they support free market forces, including the removal of trade barriers. One of the key aims of opening up the country to free international trade is to build up the production of manufactured goods and to increase the importance of exports. Countries that are mainly exporters of manufactures tend to have the highest growth rates. This is largely because of the higher income elasticity of demand for, and greater ability to control the supply of, manufactures than primary products. The expectation is that domestic firms will respond to the increased competition by becoming more competitive and, as a result, the value of exports of manufactures will increase. Access to the world market provides the opportunity for domestic firms to specialise and grow, and so take advantage of economies of scale. Those in favour of a free market approach also support privatisation and encouraging foreign direct investment (FDI). We shall look at some market-oriented strategies and interventionist strategies in more detail.

Significance of the size of fiscal deficits and national debts

Whether or not large fiscal deficits and growing national debts are a serious problem depends on the nature of the economy in question, its previous history, and the degree of confidence placed in it by other countries. Countries which, for example, have recent history of defaulting on debts will find that they can no longer find lenders, or will have to pay very high interest rates, owing to the risks involved. However, even economies regarded as reliable and secure may experience difficulty if they continue to run large fiscal deficits and allow national debt to rise. It will be thought that the country is living beyond its means, that the activity of its economy is unable to maintain the level of spending required or desired. In such cases the country may find its international credit rating lowered (as has happened to the UK in the past). It may find it harder to borrow money, and will be faced with the difficulty of reducing the size of the debt to re-establish international confidence. This could mean substantial cuts to government spending and a possibly severe reduction in living standards. The recent fiscal history of Greece is a case in point.

Impact of non-economic factors

- Corruption: Corruption acts as an obstacle to development because it diverts tax revenue, loans and aid from, for example, investment in physical and human capital into the pockets of corrupt officials. It also discourages international trade. Studies have found that the more corruption there is, the less foreign trade there will be. It is thought that this relationship works both ways. High levels of corruption discourage foreign trade because foreigners would rather not deal with bribe-seeking customs officials and bureaucrats. On the other hand, a lack of foreign trade may also mean that the government has less incentive to crack down on corruption. While corruption is widespread throughout the world, it does appear to be particularly high in parts of sub-Saharan Africa. Corrupt governments may also result in overseas aid not reaching its intended recipients. In 2015 Oxfam drew attention to a survey which stated that 61 per cent of the UK public agreed with the statement, 'corruption in poor countries' governments makes it pointless donating money to help reduce poverty' - an increase in 17 percentage points since 2008. -War: By its very nature, war is destructive. It kills and injures people, destroys and damages buildings, and makes some land unusable because of landmines. It also disrupts education and training, and diverts resources from the production of capital and consumer goods into the construction of weapons. In addition, it discourages international trade and FDI. The destructive effects of war clearly have a detrimental effect on both economic growth and development. Developing countries are prone to civil war, sometimes of a tribal nature (such as the Hutu genocide campaign against the Tutsi in Rwanda in 1994), or to replace a dictator of one persuasion with another of a competing ideology. Sierra Leone, Angola, Liberia and Nigeria, for example, have all had their development impeded by internal conflict in the last half century.

Other strategies

- Industrialisation and the Lewis model: Manufactured products often have a higher value added than primary products. This means they can generate more income and, for those who make them, better wages. Moreover, for countries where a large percentage of the population is engaged in primary production, productivity may be low owing to the labour force being too large. Return to the Lewis two-sector model earlier in this topic for the economic thinking behind this strategy. - Development of tourism: A number of developing countries are seeking to build up their tourist industries. Tourism is seen as a key industry as it is labour-intensive, has income-elastic demand, can make use of the countries' natural resources, and brings in export revenue. It also has links with other industries. For example, the expansion of the tourist industry will increase demand for transport, and tourists will buy locally produced goods. The importance of tourism as a source of income was highlighted by Thailand, whose important tourist industry was understandably devastated by the tsunami of 2004. More recently, fear of terrorism has had an adverse impact on the economies of countries such as Egypt and Morocco. However, the benefits of tourism for developing countries are not always as great as they might appear. Much of the work created is seasonal and unskilled. In addition, some of the food and drink the tourists consume may be imported from their countries and the hotels they stay in may be run by foreign chains. The expansion of the tourist industry may also damage the environment. Holiday complexes may be built in areas of natural beauty; the large volumes of water used in hotels (including in their swimming pools) may add to water stress; and large numbers of visitors to beaches, historic sites and rainforests can create pollution and reduce the attractiveness of the sites. Tourism can also lead to a clash of culture if the tourists behave in a way which the indigenous population does not understand or finds disquieting. For example, the quality of life of some popular tourist resorts is adversely affected by the drunken behaviour of a minority of tourists visiting these resorts.

Table 4.1 Planned UK government spending in 2017 (£bn) as at December 2016 1. What proportion of total planned spending was the government planning to spend on social security and services? 2. Why might the amount actually spent on social security be different from that estimated? 3. The government was expecting to borrow more in 2017, so why was it forecasting a fall in spending on debt interest payments? 4. Explain possible reasons for the intended change in spending on health.

1. 34.31 per cent 2. The amount spent on social security and services may be different from that estimated if the level of unemployment is higher or lower than expected. If unemployment is higher, spending on welfare benefits will be greater and so social security and services spending would be above £269bn. Inward migration may also increase and some of these migrants may be entitled to certain benefits. 3. The government was forecasting lower spending on debt interest payments, despite borrowing more, because the interest rate had fallen. Per pound, significantly less interest was paid. 4. One reason why the government is planning to spend a little more on health may be because of a rise in the population - due to some extent to immigration, with more pregnancy and infant care required - and to the increasing need to provide care for an ageing population. The rise in cost of medical equipment, especially drugs, will also be relevant.

Table 2.1 Inflows and outflows of FDI $bn in selected countries The factors that influence the amount of FDI a country attracts include the size of its market, its expected growth, the productivity of its workers, the strength of its financial institutions, the viability of its government's policies and its overall political stability. 1. Identify three government policy measures that may attract more FDI. 2. According to Table 2.1: a) What happened to the amount of FDI between 2009 and 2014? b) What might be inferred to explain the situation in the three largest economies represented here (USA, UK, Germany) c) Compare the FDI positions of the USA and Mexico.

1. A cut in corporation tax, an increase in government investment subsidies and an increase in government spending on education. 2. Table 2.1 shows the following: a) For three of the world's largest economies (USA, UK, Germany), inflows fell but outflows rose, but in the two smaller European economies, and in Mexico, both inflows and outflows rose. b) More, and more attractive, FDI opportunities may be appearing in emerging economies, so inflows into highly developed economies fall as FDI is directed elsewhere, whereas these countries themselves are taking increased advantage of outward FDI opportunities. c) The USA experienced much larger inflows and outflows of FDI than Mexico in both years. Mexico had a net inflow in both years whereas the USA had a net outflow in both years.

Between 1996 and 2006 the Chinese economy grew at a very rapid annual rate of 10.5 per cent. Since that time, however, the country's average annual rate of growth has been lower. To increase the growth prospects of the economy, the Chinese government is seeking to improve the country's infrastructure. In 2008 it opened the world's largest airport in Beijing and the world's largest sea crossing bridge, which has halved the travel time between two of China's busiest ports, Ningbo and Shanghai. A number of high-speed railway lines have been opened or are under construction. 1. Explain what is meant by a fall in the economic growth rate. 2. Why is improved infrastructure important for economic growth?

1. A fall in the economic growth rate means that the country is continuing to produce more output but that the rise in output is slowing. 2. A good infrastructure is important for economic growth as it will reduce firms' costs of production. Good transport, communications systems, schools and hospitals enable firms to operate more efficiently and raise the productivity of the labour they employ (external economies of scale). The resulting lower costs of production will increase the country's international competitiveness and increase its net exports. Higher net exports, in turn, will lead to a rise in aggregate demand and, with more productive capacity, higher real GDP.

At the outset of the 2008-9 financial crisis a number of governments were seeking to avoid a recession by introducing fiscal stimulus packages. Some economists, however, are critical of governments using discretionary fiscal policy. They argue that counter-cyclical stimulus can do more harm than good. They think that politicians usually take too long to recognise the risk of a recession (a recognition lag) and then too long to implement fiscal policy measures (an implementation lag). As a result, by the time the expansionary fiscal policy causes a rise in aggregate demand, the recession will be over (the behavioural lag), and so the higher aggregate demand will just add to inflationary pressure. They also think that as governments are reluctant to tighten fiscal policy sufficiently during a boom, counter-cyclical fiscal policy leads to higher public sector debt. 1. How might a fiscal policy stimulus package avoid a recession? 2. Explain what a tightening of fiscal policy during a boom means. 3. Explain why counter-cyclical fiscal policy may lead to higher public sector debt.

1. A fiscal stimulus package might avoid a recession as it could replace falling private-sector demand by raising public-sector demand and have an overall economy-wide impact on AD. 2. Tightening fiscal policy during a boom would involve reducing government spending, or at least reducing the growth of government spending, and raising taxes. 3. A counter-cyclical policy may lead to higher public sector debt if the government operates a budget deficit during the downturn, but does not generate a matching budget surplus during an upturn.

In November 2008 the IMF agreed to lend Pakistan $7.6bn after the country had asked it for at least $9bn. Pakistan had previously received a considerable amount of aid from both international financial institutions and from individual governments. The USA, which had lent the country $10bn since 2001, was wary about giving further loans as it had estimated that 70 per cent of its previous loans had been misspent. In 2008 the Pakistani government was seeking aid to service foreign debt, pay for imports, particularly oil, and to tackle terrorism. The country's prospects had been weakened by an outflow of foreign private financial capital. The Pakistani government had estimated it would need at least $15bn over the next two years. As well as approaching the IMF, it was also planning to ask the World Bank and individual governments for assistance. Governments often ask for aid from the IMF with some reluctance. This is because the aid can come with conditions including the requirement that taxes are raised and government spending is cut. Other concerns include that the granting of a large aid package could push up the country's exchange rate and that the amount of aid could vary from the amount agreed. A rise in the exchange rate could reduce the country's international competitiveness. The unpredictability of aid flows can make it difficult for developing countries as they often find it hard to attract inflows of private financial capital to smooth fluctuations in aid. When less aid is received than expected, governments tend to find it easier to cut investment spending rather than consumption spending, which includes the payment of salaries to government employed workers. 1. Explain three reasons why a government, rather than an organisation such as the IMF, may be reluctant to give foreign aid. (3 marks) 2. Why might the IMF require a government to raise its taxes and cut government spending? (2 marks) 3. Assess whether a rise in a country's exchange rate will make it more difficult to service its international debt. (4 marks) 4. What effect may a cut in government investment have on economic development? (4 marks) 5. Assess whether foreign aid is effective. (7 marks)

1. A government may be reluctant to give foreign aid if it fears that the recipient government or governments are corrupt. In this case there will be concern that the aid will not benefit the poor and will not increase development. Similar concerns will arise if the government believes that any foreign aid it gives will go on military spending. A government may also consider that any development projects or programmes for which developing countries are seeking funds may not be worthwhile. In addition, a government may be concerned that any foreign aid it gives in the form of loans at concessionary rates will not be repaid. 2. The IMF may require a government to raise taxes and cut government spending if it believes that the government is building up debt by operating large budget deficits. In the short term, a cut in government spending and a rise in taxes will reduce the size of a budget deficit. Overall the IMF requires a country to live within its means. 3. It is debatable whether a rise in the exchange rate will make it easier or more difficult to service its international debt. If the debt is denominated in dollars, then a rise in the value of the country's currency against the dollar will reduce the payments in terms of that currency. There is a risk, however, that a rise in the exchange rate, which would make the country's exports increase in price, may reduce its export earnings and so make it more difficult to make its interest payments on its debt. 4. A cut in government investment is likely to reduce economic welfare, which is the essence of development, in a number of ways. If the government cuts its spending on education and healthcare, the quality of people's lives and their earning potential is likely to be reduced. Lower investment is also likely to reduce aggregate demand and aggregate supply and so may increase unemployment and reduce long-run economic growth. These effects again will reduce economic welfare. In addition, if the government was planning to invest in schemes to improve the environment, economic welfare will again be reduced. If the investment was inefficient and was leading to high taxes and debt repayment, a cut in investment could raise welfare. 5. Whether foreign aid is effective or not depends crucially on its form, how it is targeted and how it is used. Multilateral, untied aid is usually more useful than bilateral, tied aid as it is less restrictive and less likely to be motivated by commercial objectives on the part of donors. Grants are more likely to be beneficial to developing countries as they will not place a debt burden on the countries. Foreign aid needs to be negatively correlated with countries' income levels, with most going to the countries with the lowest GDP per head. Its effectiveness is also influenced by how it is used in the developing countries. It is generally thought to be more effective if it goes towards programmes that reduce poverty, raise educational standards and promote sustainable development. Such programmes would, for example, increase access to clean water, provide free education to both boys and girls, and make use of production methods that draw on the country's resources in a way that does not harm the environment. For foreign aid to work it is also important that it exceeds debt repayments to ensure that resources are moved from the rich to the poor countries.

The travel and tourism industry is a large and growing industry, and a significant part of that growth is coming from the emerging economies. These economies are becoming well established as places to visit and are also beginning to provide more visitors. The number of tourists going to, for example China, Vietnam and Thailand, is rising very significantly. Some potentially attractive tourist destinations, however, are not yet realising their full potential. Reasons may include the poor quality of - and bureaucratic delays at - some airports, a lack of good accommodation and, particularly, concern about terrorist attacks. 1. Explain one reason why more people from developing economies are taking holidays abroad. 2. Assess how employees in developing countries not directly employed in the travel and tourism industry could benefit from their governments seeking to attract more foreign tourists. 3. Identify one reason, other than those mentioned, why fewer UK citizens may want to holiday in developing economies in the future.

1. A major reason why more people from emerging economies are taking holidays abroad is that incomes in those countries are increasing. Demand for travel, especially foreign travel, has a positive income elasticity demand. 2. Those not directly employed in the travel and tourism industry may benefit from the government seeking to attract more foreign tourists in a number of ways. One is that they could take advantage of improvements the government might make to the country's airports when they themselves travel by air, whether internally or abroad. If the government provides assistance to hoteliers to improve their accommodation, a country's residents could enjoy more comfortable stays when they go on holiday in their own country. If government measures are successful and more tourists visit a country, its travel and tourism industry will earn more income. There will be a multiplier effect, raising income even more. With higher income, more jobs will be created and not just in the travel and tourism industry. Higher tax revenue will be generated which can be spent on education and healthcare. 3. Those not directly employed in the travel and tourism industry may benefit from the government seeking to attract more foreign tourists in a number of ways. One is that they could take advantage of improvements the government might make to the country's airports when they themselves travel by air, whether internally or abroad. If the government provides assistance to hoteliers to improve their accommodation, a country's residents could enjoy more comfortable stays when they go on holiday in their own country. If government measures are successful and more tourists visit a country, its travel and tourism industry will earn more income. There will be a multiplier effect, raising income even more. With higher income, more jobs will be created and not just in the travel and tourism industry. Higher tax revenue will be generated which can be spent on education and healthcare.

In the past few years some of the activities of the Bank of England have drawn considerable attention and, in some cases, sharp criticism. In 2013, the newly-appointed governor, Mark Carney, began a programme known as 'forward guidance'. The Bank's base rate, at 0.5 per cent, had not changed since 2009, and there was much speculation about when the rate would rise from this long-lasting and historic low. To offer some help to households and firms whose finances would be affected by a rise in interest rates, the Bank offered guidance about when in the future a rate rise might be expected. In one case, any future rise was linked to another variable: the unemployment rate. The interest rate would stay at 0.5 per cent until the unemployment rate fell to 7 per cent. This figure was reached rather more quickly than expected, and the interest rate did not rise. None of the forward guidance advice ever turned into truth, so the programme was abandoned, with some derision in the financial press. Quantitative easing was resumed after the referendum vote in the belief, widespread among economists and markets, that there would be a very quick negative reaction to the 'leave' result, so the economy would need some assistance, in this case with further added liquidity. Furthermore, the interest rate was lowered to 0.25 per cent. In a speech to the Conservative Party Conference in September 2016, the Prime Minister, Teresa May, made remarks that were considered to be a criticism of this policy - that the Bank of England's monetary policy actions assisted those who were secure in their income and wealth, but had a negative effect on those on low incomes. The governor of the Bank felt that such criticism was inappropriate: he felt that the Bank was being blamed for the state of the economy in which the policy was operating - and this was the responsibility of politicians, not the Bank of England. In November 2016, the governor expressed the opinion that after the completion of 'Brexit' negotiations, expected in 2019, there should be two further years of transition as this would give UK businesses a better opportunity to manage their affairs in the new situation of non-membership. The controversial element here was that such a view was felt to be outside the Bank's responsibilities. 1. What might be the possible reasons for the lack of success of the 'forward guidance' programme? (5 marks) 2. How might a fall in interest rates differently affect those with high, and with low, incomes? (7 marks) 3. What is quantitative easing and in what way does it create 'further added liquidity'? (5 marks)

1. A successful and respected Hollywood scriptwriter, William Goldman, said that the utter inability of movie producers successfully to predict the success or failure of their product was down to the fact that 'nobody knows anything', a remark which has acquired a reputation for simple wisdom in the industry. It could be argued that the same is true for economics. (A distinguished American economist, J K Galbraith, cracked the joke, 'Why do we have economists? To make astrologers look good!') In a complex and sophisticated postmodern society, so many factors impinge on economic variables that prediction is, at best, hopeful rather than accurate. Whereas, in the case quoted, the unemployment rate fell more quickly than expected, other circumstances, such as sluggish consumption and investment, had not moved to a position where an interest rate rise would be necessary or even beneficial. 2. Low interest rates benefit the many households with variable rate mortgages (where the mortgage rate reflects changes in the bank rate) and those with enough financial security to apply for a mortgage. It also benefits those who can afford loan repayments on big ticket items such as new cars. Those not in a position to take out loans do not enjoy any advantage from being able to borrow money at low rates. Furthermore, as many people on a low income rely on returns from savings to supplement their income, derisory rates (in some cases as low as 0.01 per cent) offer little such assistance. 3. Quantitative easing is, in effect, an electronic form of printing money - in other words, creating an increase in the money supply. At various times in the past, commercial banks have purchased government bonds, and these have a monetary value. In quantitative easing, the Bank of England buys these back, and instead of paying for them in paper money it does so by electronically raising the balance of the banks. This increase in the banks' funds enables them to lend more money, so this finds its way into the economy; there, it should, through the multiplier effect, stimulate further activity, particularly if lent to business for capital Investment that creates jobs and output.

The increased competition generated by China put downward pressure on inflation throughout the world at the start of the twenty-first century. It did this directly by supplying countries with low-priced manufactured goods. It also did it indirectly by restricting the ability of firms in other countries to raise their prices. As the twenty-first century has progressed, some economists have been questioning whether the impact of the growth of China was changing from reducing to increasing inflation. China is now the largest consumer of a wide range of commodities, including aluminium, copper, iron ore, steel, platinum, steel and zinc. As wages increase in the country, the population of China is also demanding more and better-quality food. In recent years, however, China's food production has grown faster than its consumption and it is now a net exporter of a range of food including wheat and rice. Over time, prices will increase in China and wages will rise but Chinese prices will remain below those in western countries for some years yet. Indeed, as China moves up the value chain, it can be expected that the country will be putting downward pressure on a range of products, including cars. 1. Explain why China's exports may reduce the profit margins of some UK firms yet increase the profit margins of other UK firms. 2. Do higher wages necessarily mean higher costs of production? 3. Why might competitive pressure from China increase aggregate demand in the UK?

1. China's exports may reduce the profit margins of UK firms which make products that compete with Chinese imports. If the UK firms experience a rise in costs, they may be reluctant to raise their prices because of the competition from Chinese firms. As a result, the UK firms will have to absorb the higher costs by reducing their profit margins. However, some UK firms may switch their purchase of raw materials from high-cost suppliers to cheaper, Chinese suppliers. Lower costs with the same prices will increase UK firms' profit margins. 2. Higher wages do not necessarily mean higher costs. This is because productivity may increase more rapidly than wages, which will reduce unit labour costs. 3. If competitive pressure from China keeps the UK rate of inflation low, then the Bank of England can set a relatively low interest rate. This, in turn, may stimulate a rise in both consumption and investment and so increase aggregate demand.

Sierra Leone is regarded as being one of the poorest countries in the world and regularly achieves the lowest position in the United Nations Development Programme's annual survey of human development. Two-thirds of women are illiterate and more than 70 per cent of Sierra Leoneans live on less than US$0.70 a day. Most children in the country do not go on to secondary school and only 5 per cent of these few progress to higher education. Ninety-three per cent of the country's exports are primary products. Despite its fertile agricultural land and diamond mines, the country has a high unemployment rate. It finds it difficult to attract FDI because of its poor infrastructure and relatively high levels of corruption. While a woman's chance of dying in childbirth is 1 in 48 000 in Ireland, it is 1 in 8 in Sierra Leone. Leonean women die from bleeding, infection, obstructed labour and pregnancy-induced high blood pressure. They give birth in ill-equipped and poorly staffed hospitals or at home, often in unhygienic conditions. In 2015, male life expectancy in Sierra Leone was 49 years, in comparison to 79.5 years in the UK. Its spending on education was 2.88 per cent of GDP in 2015 (5.5 per cent in the UK). 1. Explain what is meant by human development. (5 marks) 2. Identify three indicators from the passage which show that Sierra Leone is a developing country. (3 marks) 3. Explain two disadvantages of relying on primary products. (4 marks) 4. Compare Sierra Leone's government spending on education in 2015 with that of the UK. (3 marks) 5. Discuss whether an MNC would want to set up a branch in Sierra Leone. (5 marks)

1. Human development is the process of increasing people's choices by expanding their capabilities to carry out certain functions and achieve certain objectives. The three essential capabilities are for people to live a long and healthy life, to be knowledgeable, and to have access to the resources required for a decent standard of living. This is why the HDI indicator takes into account life expectancy at birth, educational attainment and GDP per head. However, human development goes further and includes the capability of people to participate in society, be free from discrimination, fear, exploitation and injustice, and for society to ensure that living standards can continue to rise for future generations. So human development occurs when people's lives are enriched, their freedoms are increased and the opportunities available to them are enhanced. 2. Three from lowest HDI value, high levels of female illiteracy, high rate of absolute poverty, low level of secondary school enrolment, low percentage of students entering higher education, poor infrastructure and high rate of maternal mortality. 3. One disadvantage of relying on primary products is that, in the case of agricultural products, supply can be adversely affected by bad weather conditions and disease. A drought in Sierra Leone, for instance, would reduce the country's production of maize. Another disadvantage of relying on primary products is that, in the case of minerals, demand may fall if there are discoveries elsewhere, if the minerals run out or if technological progress makes a mineral obsolete for many of its former uses. In Sierra Leone's case, the discovery of more gold or the running out of gold in its mines could reduce the country's earnings from gold sales. 4. Sierra Leone's government spending on education was half that of the UK's, as measured by percentage of GDP, in 2015. It would also have been a smaller amount as Sierra Leone's GDP was considerably below that of the UK's. 5. There is a possibility that an MNC might want to set up a branch in Sierra Leone. This is because the country has a ready supply of cheap labour. It might also want to exploit the country's fertile land and gold reserves. It is more probable, however, that an MNC would not want to set up a branch in Sierra Leone. This is because most of the labour force has a very low level of education which means that it is likely to have low levels of productivity. The passage also suggests that medical care is limited and much of what there is is not of a good standard. This may mean that workers will suffer from poor health and so have many days off work, which would increase costs of production. Of course, an MNC would consider a range of other factors before making its decision. These factors would include the country's transport infrastructure, the stability or otherwise of the government, whether income is increasing in the country, and the rate of taxation.

A poverty line marks the minimum a person needs for food, clothes and shelter. Anyone whose income falls below this line is considered to be experiencing absolute poverty. The UN used to draw the poverty line at $1 a day or, more precisely, in terms of what that amount could buy in the USA. This definition made its debut in the World Bank's 1990 World Development Report and was later adopted by the UN. It is regularly revised, so that by 2005 the figure was $1.25. In 2015, the World Bank's preferred measure was that people are poor if they cannot match the standard of living of someone living on $1.90 a day in the USA in 2015. According to the 2005 definition, 1.4bn were living in poverty in 2005; in 2015 757m were living in poverty by the standard set for that year. Table 1.1 compares the proportion of people living in poverty in 2005 and 2015 as measured by the respective World Bank definitions for 2005 and 2015. Table 1.1 People living on less than $1.25 (2005)/$1.90 (2015) a day (percentage of total population) 1. Why is it important to measure poverty? 2. Which area experienced the largest fall in poverty between 2005 and 2015? 3. Did poverty fall throughout the world between 2005 and 2015? Explain your answer.

1. It is important to measure poverty to assess the extent to which it is a problem, to formulate policies to combat it, and to assess the success or otherwise of these policies. 2. Sub-Saharan Africa and India both experienced falls of 16 percentage points over 2005-15. 3. Absolute poverty fell in all the regions surveyed.

Philo and Melinda are a young couple who have found a flat they think they can afford, and are now looking for a mortgage. There is a vast choice, but they think that a set-period fixed-rate deal would suit them initially. They did not study economics, and do not follow current affairs in detail. 1. How might information failure occur in this instance? 2. How would steps taken to avoid information failure be of benefit to the lender?

1. Philo and Melinda need to know that interest rates are variable over time - so that by the time the set term ends, they may be paying more interest than they need to be. They need to know what will happen to their repayments after the fixed period - for example, to be told about reversion to SVR (standard variable rate) and what that means. On their side, the lender needs enough information about the couple to be sure that they will be able to afford payments at a higher rate. 2. If the couple find themselves unable to afford their mortgage repayments because they have not been properly informed at the outset, the lender may face the organisational task of arranging repossession and resale of the property. Moreover, negative coverage of the couple's plight might find its way into the press. If a similar experience is endured by many homeowners, as is possible, lenders will find themselves with much to do that is not part of their primary service.

Malnutrition is the biggest contributor to child mortality, present in half of all cases. Those children who survive malnutrition grow up to experience worse health and lower educational achievements. The World Health Organization (WHO) believes that hunger is the greatest single threat to the world's public health. It argues that more foreign aid should be devoted to improving nutrition. In 2008, for example (at the time of writing, the latest year for which comparative figures were available), only $300m of aid went to improving basic nutrition, less than $2 for each child below two in the 20 worst affected countries. This was considerably less than that devoted to HIV/AIDS which causes fewer deaths than child malnutrition. Financial help to combat HIV/AIDS amounted to $2.2bn which worked out at $67 per person with HIV in all countries, including rich ones. 1. Why would reducing hunger be not only a humanitarian act but also benefit a country's economic performance? 2. Identify two reasons why a developed country may give more aid to combat HIV/AIDS in a developing economy than to reduce malnutrition.

1. Reducing hunger obviously has a humanitarian justification. The most basic of human needs is the need for food - it is essential for survival. There are also economic benefits from reducing hunger. If fewer people die from hunger and fewer people experience malnutrition, the labour supply will be higher and more productive. 2. A developed country may give more foreign aid to combat HIV/AIDS in a developing country because it has more direct experience of the illness than it has of malnutrition. It may also be concerned that HIV/AIDS in other countries may increase cases in its own country with the movement of people between countries.

South Africa attracted more than $10bn in FDI in 2008, but only $1.8bn in 2015. The South African government is well aware that FDI can fluctuate significantly. In the light of the risk that FDI might fall as well as rise, the South African government seeks to ensure a relatively high savings ratio. In many developing countries the savings ratio is low. This has consequences not only for increasing the capital stock but also for financing pensions and for the current account position. 1. Why are savings ratios low in many developing countries? 2. What may discourage foreign direct investment in South Africa? 3. Explain how a low savings ratio may affect the current account position of the balance of payments.

1. Savings ratios are low in many developing countries because incomes are low. When people are poor they have to use most, if not all, of their income to buy basic necessities. It is only when people's incomes rise that they can 'afford' to save. Indeed, as incomes rise, people save more in total and more as a percentage of their income. Savings may also be discouraged by a lack of appropriate financial institutions. For example, in many parts of rural Bangladesh people have no easy access to banks. 2. Foreign direct investment in South Africa may be discouraged by a number of factors. These include concerns about low productivity, concerns about the economic prospects of the country, concerns about political instability, high crime levels and the spread of HIV/AIDS. 3. A low savings ratio may reflect a current account deficit. This is because if consumer spending is high, some of that will be going on imports. Domestic firms may also concentrate more of their products on the home market, at the expense of exporting.

The farmers' cooperative Kuapa Kokoo in Ghana has been a fair trade success. It started in 1993 with 200 cocoa farmers. This figure had grown to 87,907 by 2013. In 2006 the cooperative bought nearly half of Divine, the fair trade chocolate company. The cooperative has benefited from stable prices and has made good use of the premium it has been paid for its cocoa beans. It has invested in bringing fresh water to the villages and in education and healthcare projects. 1. Explain how stable prices can benefit farmers. 2. How might investing in healthcare projects benefit a farming cooperative?

1. Stable prices allow farmers to plan ahead. They can plant their crops and rear their animals, knowing what they will receive in revenue per unit. In a situation of fluctuating prices, in contrast, they may find that they make a loss. This might cause them to reduce what they plant or the number of animals they rear in the next season. They may then find that demand was higher than they expected but they will not be able to meet the demand. 2. Investing in healthcare should improve the health of the farmers and their families. The higher quality of life these people will enjoy is an objective in itself. It will also reduce the number of days farmers are sick and unable to work. This, together with the farmers being physically fitter, will increase their productivity, raising both the quantity and quality of their output and so their earning potential.

In 2007 the Indian economy grew at approximately 9 per cent, which boosted the government's tax revenues. Nevertheless, the government had a budget deficit which was equivalent to 6.4 per cent of GDP. The Indian economy was also experiencing a rising inflation rate of 7 per cent. In the 2007 budget, Palaniappan Chidambaram, India's finance minister, announced an increase in spending on education of 34 per cent and an increase in spending on health and family welfare of 22 per cent. 1. Does the passage suggest that India's budget position was being affected by automatic stabilisers or by discretionary fiscal policy? Explain your answer. 2. In assessing a government's budgetary position, why is it more useful to consider it as a percentage of GDP than as an absolute figure? 3. What effect may an increase in government spending on education have on India's budget position in the short term, and in the long term?<

1. The passage suggests that India's budget position was being affected by automatic stabilisers. It mentions that economic growth had increased the government's tax revenue. However, it also suggests that India's budget position was being affected by discretionary fiscal policy. This is because there is reference to the government deliberately choosing to increase its spending on education and health and family welfare. 2. It is more useful to consider the deficit in percentage of GDP terms than in absolute terms as it gives a clearer indicator of the relative size of the deficit and the ability of the government to finance that deficit. For instance, in 2015 the USA had a budget deficit of $439bn whereas Egypt had a deficit of only $30.7bn. The USA's deficit, however, was only 2.5 per cent of the country's GDP, whereas Egypt's was 8.9 per cent. 3. An increase in government spending on education might increase India's budget deficit in the short term. This is because the gap between tax revenue and government spending would widen. In the longer term, though, more government spending on education could reduce India's budget deficit. If the spending raises the quality of education, Indian workers may become more productive. As a result, India's output and income will increase which will raise revenue from both direct and indirect taxes.

Spain's government has privatised virtually all its previously state-owned enterprises and has more than doubled its spending on research and development since 2000. Innovation, however, has taken time and on its own is not enough to raise efficiency. Spanish productivity growth is slow, often only reaching a third of that of France, Germany and Italy. Two of the reasons for this poor productivity performance are shortcomings in state education and the red tape that Spanish firms face. 1. Identify two motives for privatising a state-owned enterprise. 2. Why is innovation on its own not enough to raise efficiency? 3. Explain two supply-side policies that Spain could introduce to improve its macroeconomic performance.

1. Two motives for privatising a state-owned enterprise are to raise revenue and to increase efficiency. 2. Developing new methods of production and new capital equipment will not be effective in reducing costs if workers lack the skills to adopt the new methods and use the new machines. In addition, developing new products will not raise allocative efficiency if people do not want to buy the products. 3. Two supply-side policies that Spain could introduce to improve its macroeconomic performance are deregulation and education. The removal of some laws and restrictions may reduce firms' costs of production and may make them more responsive to changes in consumer demand. If, for instance, firms can dismiss workers with a shorter period of notice should demand fall, their labour costs may be reduced. As well as being able to respond more quickly to a reduction in demand, it may also mean that they will adapt more quickly and fully to a rise in demand, knowing that any extra workers they take on can easily be dismissed in the future should market conditions deteriorate. Improved education may result in workers becoming more mobile and more productive. Greater mobility and higher productivity should increase allocative and productive efficiency as more resources should move more smoothly to reflect changes in demand and costs of production should fall. Both deregulation and improved education have the potential to reduce inflationary pressure and increase international competitiveness. If the quality of domestically produced products rises and their relative cost falls, any current account deficit should be reduced and the higher demand should result in a rise in real GDP and a fall in unemployment.

It was announced in the autumn statement in November 2016 that National Savings and Investments (NSI), a government-owned savings bank backed by HM Treasury, is to offer next year a savings bond with an interest rate of 2.2 per cent; the current base rate from the Bank of England is 0.25 per cent. A maximum of £3000 of bonds may be purchased. It is hoped thereby that households may be encouraged to increase their savings. 1. Why would a government feel it necessary to encourage households to save? 2. Why do you think a maximum of £3000 was set - a figure regarded in the press as disappointingly low? 3. What effect might the availability of these bonds have on savings organisations in the private sector?

1. Without savings, financial institutions may face a shortage of funds available for lending. Fewer households may be able to afford 'big ticket' items, such as fridges, sofas, cars; small businesses may find it harder to get started, and firms in general may have difficulty raising finance for capital investment. All of these circumstances will contribute to a slowing down of the economy in the future - in economic terms, the circular flow of income will be retarded. 2. A rate of 2.2 per cent is well above the Bank of England's base rate, and so if there is a substantial take-up of these bonds the Treasury will find it costly to make the required interest payments. Moreover, saving, although necessary for reasons given above, is a withdrawal from the circular flow, in that income is not being spent on current output. The £3000 limit may be intended to ensure that not too much household income is withdrawn in this way. 3. At the time of writing it is very difficult to find a savings rate above 2 per cent in the commercial sector, even if a commitment is made to leave the sum untouched for a fixed period. Commercial banks and building societies may find that fewer households save with them, possibly affecting their liquidity (although such organisations do not depend solely on household savings for their liquidity). Those that need savers' funds may find they have to raise the interest rates they offer - and to maintain their profitability they may have to raise their loan rates too.

Distinguish between a cyclical and a structural deficit.

A cyclical deficit is caused by a slowdown in economic activity as a part of the economic cycle. As demand and employment fall, government revenue (e.g. from income tax, corporation tax and VAT) falls, but spending on benefits - especially jobseeker's allowance - rises, creating an expenditure greater than income. A structural deficit is not directly linked to variations in economic activity, but is caused by spending decisions made by government, perhaps to increase benefits, expand merit good provision, or embark on major infrastructural improvements. Such spending, if it exceeds current revenue, will create a deficit.

Population control

A number of developing countries have a high birth rate and a high dependency ratio which can place a considerable burden on resources and act as a block to development. Reducing population growth can increase the possibility of raising economic growth rates and can improve quality of life, particularly for women and children. There are a number of ways in which governments can seek to limit population growth. One is by imposing fines on couples who have more than a certain number of children. Another is by giving financial incentives to those who have only one or two children. However, both these 'stick' and 'carrot' approaches have drawbacks. Each requires the government to monitor the size of families, may encourage couples to be dishonest about the number of children they have and, if abortion is legal, may result in a gender imbalance with more boys being born than girls. Fining couples who exceed a set number of children can lead to the even more serious problems of infanticide and the trading of children. In 2015 China announced that it was cancelling its one-child policy, which had been in effect for 35 years; a substantial imbalance between male and female children had developed with the male/female ratio reaching 117/100. Another approach is to increase information about family planning methods and to subsidise contraceptives. Some countries, including India, have also provided financial incentives for people to be sterilised. However, such methods can meet opposition on the grounds of culture and religion. The development of a welfare system that provides care for the elderly and improvements in healthcare can reduce the incentive to have large numbers of children. One other method that appears to be particularly successful is raising the educational opportunities available to girls and women. Educated women tend to be more aware of family planning methods and, due to greater expectations of living standards and greater employment opportunities, are likely to have more incentive to limit their family size.

Debt relief

A number of developing countries have run into difficulties in repaying the loans they have taken out from commercial banks and from international financial institutions at concessionary rates. Some, including Mexico and Argentina, have even defaulted on their loans. Debt as a percentage of GDP was running at an average of 48 per cent for low-income countries in 2014. The high levels of debt experienced by some countries mean that in a number of cases there is a net outflow from developing countries to developed countries, with debt repayments exceeding aid payments. Concern about the ability of developing countries to continue to service their debt, and the adverse effect the interest and capital repayments are having on their development, has led to a number of initiatives to ease or cancel developing countries' debt. In 1996 the IMF and World Bank introduced an initiative to reduce the debt burden of the heavily indebted poor countries (HIPCs). In 2000 the UK government announced it would write off the debt owed to the UK from the poorest 41 countries. This decision was largely in response to pressure from Jubilee 2000 (a global coalition of NGOs and charities that campaigns for debt relief). However, the UN has warned that debt relief is not sufficient to help some of the poorest countries. It argues that more foreign aid and the opening of developed countries' markets to exports from poor countries is also needed. Those who do favour debt relief urge that conditions should be laid down to ensure that the funds are used for development purposes and not for military spending or prestigious public building projects. Critics of debt relief argue that those countries with high levels of corruption or which have mismanaged funds do not deserve to have their debts 'forgiven'. They also claim that eliminating debt payments will encourage developing countries to borrow higher levels of funds than they can afford to repay and will not make them use those funds efficiently.

Banker to the banks and regulatory role

A smooth flow of liquid assets is vital to the operation of the circular flow of income. If money is not available for the purchase of goods and services, production will falter, as there is no point in producing that which will not generate income. If production falters, employment falls, and so the income available to purchase disappears, and a vicious circle sets in. The Bank of England is ultimately responsible for ensuring that commercial banks and other financial institutions that participate in the supplying of liquidity (known as SMF, the Sterling Monetary Framework) can operate efficiently. All SMF members have accounts at the Bank, and the liquid reserves deposited there serve to provide the transfers between one bank and another. When, for example, an employer pays a salary to an employee, funds move from the employer's bank account to that of the employee. There needs to be enough liquidity for this to take place, so the Bank has a number of regulations and devices available to ensure that commercial banks have sufficient funds available to meet their transactional needs. Furthermore, as we have seen, the failure of a bank, in addition to the harm that causes to its depositors, has an externality effect in that a surge of fear may bring the vital processes of lending and spending to a halt. A responsibility of the bank of England is as lender of last resort (LOLR): any bank with liquidity problems can turn to the Bank for a loan to keep it afloat, as Northern Rock did in 2007. The interest rate for such borrowing is likely to be high. Remember that money is a commodity and so, from the point of view of economic analysis, it is subject to the interaction of supply and demand and the price mechanism. The extent to which markets should be left alone, or made subject to intervention, has long been a question of fundamental debate in economics. In the case of money, its vital role in the continuing function of the circular flow means that it should be at least monitored, if not indeed regulated. The Bank of England was for a long time the regulator of the financial markets, but this role was removed from it in 2001 when, at the instigation of the then Chancellor, Gordon Brown, the Financial Services Authority (now the Financial Conduct Authority) was established. It was widely felt that the banking difficulties that occurred from 2007 onward were partly due to a belief that regulation should be light-touch: the economic ideology of laissez-faire prevailed. Experience showed that this was not satisfactory, so in 2013 many regulatory responsibilities were returned to the Bank in the form of the Prudential Regulation Authority, an organisation wholly owned by the Bank of England which, in the Bank's words, 'is responsible for the prudential regulation and supervision of around 1700 banks, building societies, credit unions, insurers and major investment firms'.

Providing forward markets in commodities and currency

Consider these two situations: - A chocolate manufacturer knows that it needs a higher level of production in the run-up to Easter, with special products like eggs and bunnies. So, more cocoa beans will be needed, and the firm cannot, of course, order them just before they are needed - it needs to feel secure in its supply - so the deal for the cocoa beans will be made some time in advance. But how much should they pay - the price now or the price when they're delivered? You know from your study of microeconomics that the price of a commodity can vary greatly because of fluctuations in its supply, and this is especially the case with agricultural products that are subject to climatic variations. So, which will be the better price - now or later? - A firm knows that at a future date it will need a large amount of foreign currency, say, euros or dollars. As you know, the pound sterling has a floating exchange rate relationship with both of these currencies. When will the exchange rate be more advantageous? Now, or when the currency is needed? There are financial markets, known as futures markets, which aim to deal with these trading issues. If it thinks that the price of cocoa beans will be higher in the future, the chocolate firm can arrange a contract so that it pays the price that applies now for delivery at a specific future date, no matter what the future price is. If it is right in its prediction, then it profits from this deal - known as a future or forward contract. The opposite deal is also open to them - to buy at the future price, if the firm feels that that will be a lower price Similarly, the firm in need of dollars or euros may feel that the exchange rate will be less favourable later and so arranges to change the pounds into dollars or euros at a specific future date, but at the rate which obtains now - or the opposite, if that is felt to be the trend. Or, as a compromise, they may agree on a rate of exchange. These firms could be wrong in their predictions of course - and so they will lose, rather than gain. There is therefore an element of gambling involved. Some forward contracts are made solely for this reason and such purchasers are called speculators, who hope to exploit their knowledge of markets to make a profit from future trading. One of the reasons given for oil price rises is because of high demand from speculators. They do not need the oil themselves but, feeling confident that its price will continue to rise, they take out future contracts at today's prices, and then sell the contract on at a later date, when the price is higher.

Use of macroeconomic policy to respond to external shocks

Economists place great value on their predictive skills - if the future can be known, it can be dealt with. Leaving aside the question of how wise such an approach is (recall from Topic 2 the lack of success with forward guidance), events occur outside the control of any one economy; these, even if happening far away geographically, may impinge on a country's economic performance. Policy-makers need to be able to respond. Such events are known to economists as external shocks and these may be economic, natural or political. - The global financial crisis of recent years is considered to have had its roots in the sub-prime mortgage market in the USA (see Topic 2). This led to a global downturn in aggregate demand. The UK's policy responses to this included quantitative easing, a very low interest rate, and a temporary cut in VAT. - In 2011 in Japan, a tsunami (at Fukushima) and an earthquake (at Kyoto) affected the output of Japanese industry, and this affected availability of supply throughout the world, especially of car parts. The inability to complete a car in a European factory because of a shortage of components may cause temporary lay-offs, and a government may feel a requirement to respond. - There are a number of potential economic issues associated with the election of Donald Trump as US President (Activity 4).

Fair trade schemes

Fair trade schemes started on a small scale in the 1960s when the products were sold mainly through charity shops. The movement, however, reached a larger market in the late 1980s when supermarkets started to stock Fairtrade products. Now a range of Fairtrade products, including coffee, cotton, chocolate, sugar and tea, are sold in western supermarkets. Different countries have their own labelling schemes. In the UK it is the Fairtrade Foundation. The Fairtrade Labelling Organization (FLO) sets and reviews Fairtrade standards and helps producers gain Fairtrade status. Fair trade schemes aim to protect farmers in developing countries from the monopsony power of MNCs - that is, the tendency of large multinational firms to control suppliers on the basis of their being the only viable buyer - and from the volatility of market forces. They do this by paying a 'fair', stable and guaranteed price. This price is set above the cost of production and includes a premium to be used for reinvestment and community projects including healthcare, housing and sanitation. Critics of fair trade schemes argue that the schemes can be bureaucratic and their coverage is limited.

Summary for The role of the state in the macroeconomy

In this section you have: 1. looked at public expenditure: the reasons for changes in the size and nature of such spending, and the effects this may have on various aspects of an economy, such as economic growth and standards of living, taxation and equality 2. analysed taxation, its various forms and effects on: - motivating, or demotivating, participation in the labour market - the distribution of income - prices - the balance of trade and foreign direct investment 3. explored a diagrammatic analysis known as the Laffer curve 4. examined the meaning and significance of: - discretionary fiscal policy and automatic stabilisers - structural and cyclical deficits - the national debt.

Summary for Strategies for growth and development

In this topic you have examined possible strategies for promoting growth and development under three main headings: market-oriented strategies, interventionist strategies and other strategies such as promoting industrialisation and tourism, foreign aid, debt relief and fair trade schemes. There is a difference of opinion among economists as to whether development is best promoted by government interventionist or free market policies. The key points are as follows: - There are difficulties in raising aggregate demand in developing countries. - Three of the key ways in which governments and international organisations seek to raise economic growth are by increasing human capital, physical capital and technological progress. - Developing countries seek external finance because there are insufficient funds within their own countries to cover deficits on the current account of their balance of payments and to fund development projects. - Borrowing from commercial banks can cause problems if the projects financed prove to be unsuccessful, if interest rates rise, if exports fall, or if a natural disaster or a recession occurs. - Microfinance can enable small businesses to get started and, by creating jobs and raising incomes, these can promote development. - The presence of MNCs in developing countries may raise the country's income, employment, exports and technology. However, the net contribution of MNCs to the countries' balance of payments may not be very significant, they may use child labour, they may deplete non-renewable resources and they may contribute to environmental damage. - The key elements of improving agricultural performance are to raise productivity, diversify into products with high income elasticity of demand, and process more of the products produced. - The Lewis model suggests that development can increase by moving labour from the rural to the urban sector. - Fair trade schemes are designed to ensure that primary producers receive a fair price, to promote ethical labour standards and to promote development. - Debt relief can be beneficial if the funds released are used to promote sustainable development. - The IMF seeks to help countries with balance of payments difficulties, stabilise their exchange rates, and promote world trade. It lends to developing countries at concessionary rates to meet their debt repayments. - The World Bank seeks to aid development by lending money at low or no interest for projects in developing countries.

Summary for The financial sector

In this topic you have looked at various aspects of financial markets, in particular: 1. The functions of financial markets in ensuring the smooth and continuous operation of the circular flow of income: - by facilitating saving - by lending to firm and households - enabling the exchange of goods and services - creating a market for firms to obtain finance by means of selling shares to the public 2. how financial markets may become subject to market failure: - by not providing sufficient information to customers to enable a reasonable decision to be made - by creating negative effects on third parties - through the operation of moral hazard - through inflating prices by speculative buying, leading to unsustainable prices - by using undue influence to fix prices or rates to their advantage 3. the role and functions of a central bank, especially the Bank of England, in: - implementing monetary policy, especially through the setting of interest rates - acting as the government's bank - assisting the banking system as a whole - regulating the banking industry and the financial system

International institutions and NGOs

The International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (more commonly known as the World Bank) were set up at a conference at Bretton Woods in the USA in 1944. The IMF and the World Bank are sometimes referred to as 'International Financial Institutions'. - The IMF: The IMF seeks to help countries cope with deficits on the current account of the balance of payments, stabilise their exchange rates and, by removing trade restrictions, promote world trade. Since the early 1980s a high proportion of IMF loans at concessionary rates have gone to developing countries. These loans, assistance to renegotiate existing loans and, in some cases, debt relief are intended to help the recipient countries meet their trade and debt commitments and so avoid disruption to the world economy. This help is conditional on a recipient government agreeing to draw up a plan with the IMF to improve its public finances and macroeconomic performance by boosting its net exports, reducing any budget deficit and introducing supply-side policies to increase efficiency. Such a plan is referred to as a poverty reduction strategy. - The World Bank: The World Bank is actually a group of five linked institutions. It started by helping mainly European countries to recover from the effects of World War II. However, its main objective since 1949 has been to promote development in developing countries. It provides technical advice on infrastructure projects and lends funds for projects and programmes that would have difficulty attracting commercial loans. The International Development Association, part of the World Bank set up in 1960, provides 'soft' loans (grants not requiring repayment and loans at low rates of interest) to poor developing countries. The World Bank lends for projects that improve education, healthcare, communications and promote sustainable development. - NGOs: There are very many NGOs working throughout the world to improve the quality of life in all countries. Examples include: well-known charities focusing on poverty, such as Oxfam environmental groups like Greenpeace and the World Wide Fund for Nature (WWF) sectors of the UN - the World Health Organization (WHO) and UNESCO (scientific, educational, cultural), which is playing a role in restoring the devastation of ancient sites in the middle east very specific organisations such as the Mines Advisory Group (MAG), in which the late Princess Diana had a strong role.

Removal of government subsidies

The Lewis model, as well as that of Rostow, posits a process of industrialisation as a significant element in growth and development. However, funds for investment in developing countries may be hard to obtain and new industries may face severe competition from the long-standing and very experienced industries in countries which underwent the industrialisation process much earlier. To enable these infant or sunshine industries to get off the ground and maintain themselves viably, they may receive government subsidies. These may assist start-up costs and enable the firms to offer the products at a price that makes them internationally competitive. It may seem counterintuitive to suggest that the removal of such subsidies can have a positive impact, but consider this in metaphorical terms: you don't really learn to ride a bike until the stabilisers are taken off; similarly, the immune system does not develop fully if it is overprotected by drugs - it needs to meet infection and fight it. So, it is argued, the continuation of subsidies as firms grow protects them from challenges, so they do not learn to how meet and overcome them. Learning how to be competitive internationally is an indispensable part of a firm's development and survival in a globally interactive world, and cossetting by subsidies distorts that process. In terms of microeconomic theory, subsidies distort the operation of the market mechanism. The dominant ideology in world trade, promoted by the WTO, is for free market competition, and subsidies to industry are seen as an unfair advantage which dilutes competition; the EU, for example, has strict regulations against them. The same argument applies to the use of protectionist policies for imports; this will be revisited later in this topic.

Summary for Macroeconomic policies in a global context

The key points in this topic were: - how decisions about taxation and government spending affect (fiscal policy) the activity of households and firms - the effects that government decisions about interest rates, the amount of money available in an economy (the money supply) and interest rate (the cost of borrowing) may have on economic performance - how attention to factors of supply can improve the overall operation of an economy - government use of direct regulation to ensure particular desirable economic activity - the desire of countries, often constrained, to influence the operation of multinational companies in their economies - the effect on the formation and implementation of government policy, and on economic performance, of inaccurate information, unexpected side-effects of policy and unpredictable external events.

Indicators of development

The main indicator of development has traditionally been increases in income as measured by increases in real GDP per head. Care is necessary in interpreting increases in GDP per head as indicating improvements in living standards. It is important to compare changes in real GDP and, when making comparisons between countries, to convert currencies at purchasing power parities (PPP). (This was explained in Unit 4 Topic 1 so re-read that now if you need to.) In addition, it is important to take into account the composition of GDP, how it is distributed, and the hidden economy. Changes in GDP are also an indicator of only one aspect, albeit a significant aspect, of development. This is one of the reasons why the UN developed the Human Development Index (HDI). - The Human Development Index: The HDI is a composite indicator of development measured between 0 and 1. It takes into account the three basic areas of development: a long and healthy life, knowledge and a decent standard of living. It assesses these by considering: - life expectancy at birth - mean years of schooling for adults aged 25 years and more and expected years of schooling for children of school entering age - gross national income (GNI) per capita at purchasing power parity (PPP). The purpose in the choice of these variables is developmental: how much in terms of resources a country has to work with to improve itself; how skilled the population is to enable that improvement; and how much time, in terms of a working life span, is available to use those skills. Table 1.2 shows the top five and the bottom five countries by HDI ranking in 2015. Table 1.2 shows the contrasts between countries. For example, the average life span in Chad is not much over half that of Switzerland; the expected school years in Switzerland is about four times more than in Eritrea; and the income level per head in Norway is 111 times greater than that of the Central African Republic. The table also shows that countries with higher income levels can have lower HDI values. For example, Eritrea has a higher per capita income level than Burundi but a lower HDI value. This suggests that Eritrea has been less successful than Burundi in using its income to benefit its population, particularly in terms of education. Based on these values, countries are categorised into high human development (HDI 0.8 or more), medium human development (HDI 0.5-0.799) and low human development (HDI below 0.5). It also identifies the least developed countries, most of which are in Asia and sub-Saharan Africa. Development is further analysed in terms of gender differences, and the degree of the empowerment of women. For example, the gender-related development index (GDI) measures the same capabilities as the HDI but adjusts the indices used for gender; it gives a lower value the greater the degree of gender inequality. The GDI value is lower than the HDI value for each country, which indicates that gender inequality exists in every country. Gender inequality is more significant in developing countries than developed countries.

Factors influencing the size of fiscal deficits

The size of a deficit will be affected by how much is spent in relation to income. Spending may rise because of an electoral promise or policy commitment. If, for example, more people meet the official qualifications for jobseeker's allowance, spending on that benefit will rise. Spending may also rise because of distinct policy decisions, such as increasing public sector wages or upgrading the highways infrastructure. Some of these decisions may be taken because the maintenance of economic growth is seen to depend on them (such as the spending on a third runway at Heathrow), or because it is felt that, with an election approaching, a favourable impression will be created among voters. There may also be unavoidable rises in financial contributions to NGOs, such as payments to the EU. The size of a deficit may be controlled by raising tax, but as has already been mentioned, taxes act as a disincentive to work, consumption and investment, and may displease the electorate. So, the interaction of a need or desire to spend with the extent to which taxation can be augmented will determine the size of the deficit.

Summary for International growth and development

This topic has focused on the nature and measurement of development and limits on economic growth and development. It has also contrasted the experience of developed and developing countries. The key points are as follows: - Development occurs when people's lives are enriched and their capabilities and choices are increased. - Development is a wider concept than economic growth, and economic growth does not always result in development. - Countries can be categorised in terms of development in a number of ways including: developed and developing countries; high, medium and low income countries; and high, medium and low development. - GDP and GNI per capita are still widely used as an indicators of development but they measure only one component of development. - HDI is a wider measure of development and has become an excellent indicator of development. - Most of the least developed countries not only have low income per head, but also, for example, a high proportion of their labour force employed in the primary sector, low investment and low productivity. - A high birth rate increases the dependency ratio, can lower income per head and can divert resources from raising the productive potential of the country to catering for the needs of the children. - Emigration of workers from developing countries reduces the size of their labour force and increases their dependency ratios. - Relying on primary production has a number of disadvantages, including the income inelastic demand for many agricultural products and the risk that advances in technology will lead to alterations to some primary products. - Some economists think that the terms of trade have tended to move against developing countries. - Trade barriers make it difficult for developing countries to enter the markets of some industrial countries. - Lack of finance means that savings and investment levels are low in many developing countries. - The high levels of debt result in high costs of servicing the debt and difficulty in raising future finance. - Corruption, war and the spread of HIV/AIDS are acting as obstacles to economic growth and development in a number of developing countries.

Floating exchange rate systems

You looked at floating exchange rate systems in Section 9 Topic 3. A floating system is where the value of a country's currency relative to another finds its level through the unimpeded movement of the supply of, and demand for, that currency. This process acts as a form of discipline. A falling exchange rate will raise the cost of imports while making exports cheaper; this should encourage domestic producers to provide competitive import substitutes, and strive to sell more abroad. This stimulus to domestic industry should increase output both for domestic consumers (the C component of aggregate demand) and export markets, with a corresponding reduction in imports because they are more expensive, and so less attractive: so in the (X-M) component of AD, M falls and X rises. A rise in AD is an indispensable part of the development process.