38.1: Introduction to Immigration Economics

38.1.1: Dimensionalizing Immigration: Numbers of Immigrants around the World

Learning Objective

Describe trends of global immigration

Key Points

• It is predicted that immigration rates will continue to increase over time. A 2012 Gallup survey determined that nearly 640 million adults would want to immigrate if they had the chance to.
• In 2005, the United Nations reported that there were nearly 191 million international immigrants worldwide; about 3% of the world population. In 2006, Europe, the United States, and Asia were found to host the largest number of immigrants at 70 million, 45 million, and 25 million, respectively.
• Regional factors contribute to immigrants selecting a specific host country. The prospects for employment, wage rate, standard of living, and immigration laws all contribute the immigrants’ decision of where to relocate.

Key Term

immigration

The act of coming into a country for the purpose of permanent residence.

Immigration

Immigration is defined as the movement of people from their home country or region to another country, of which they are not native, to live. There are specific economic factors that contribute to immigration, including the desire to obtain higher wage rates, improve the standard of living, have better job opportunities, and gain an education. Non-economic factors are also significant and include leaving a home country due to persecution, ethnic cleansing, genocide, war, natural disasters, and political control (for example, dictatorship). Throughout history, with improved transportation and technology, immigration has become increasingly common worldwide. Immigration numbers impact both the home country and the host country.

Immigration Statistics

In 2005, the United Nations reported that there were nearly 191 million international immigrants worldwide, which accounted for about 3% of the world population . This represented an increase in the number of immigrants by about 26 million since 1990. It is estimated that 60% of the immigrants moved to developed countries.

Country Immigrant Populations in 2005

The darker the color, the higher the percent immigrants in the population. The darkest blue indicates more than 50% of the population are immigrants. There is no data for countries in grey.

In 2006, the International Organization for Migration estimated the number of immigrants to be more than 200 million globally. Europe, the United States, and Asia were found to host the largest number of immigrants at 70 million, 45 million, and 25 million.

Moreover, it is predicted that immigration rates will continue to increase over time . A 2012 survey that was conducted by Gallup determined that nearly 640 million adults would want to immigrate if they had the chance. About one quarter of those surveyed (23%, or 150 million adults) stated that they would choose to immigrate to the United States. Seven percent (45 million adults) stated that they would choose to immigrate to the United Kingdom. Other top countries listed in the survey included Canada, France, Saudi Arabia, Australia, Germany, and Spain.

Net Immigration Rate

This graph shows the worldwide net immigration rate in 2011. The blue shows positive rates, the orange is negative, green is stable, and gray represents no data available. It is predicted that global immigration rates will continue to increase in the future.

Regional Factors for Immigration

Regional factors contribute to immigrants’ selection of a specific host country. The prospects for employment, wage rate, standard of living, and immigration laws all contribute to relocation decisions. Examples of immigration patterns in certain countries help to illustrate how specific factors influence immigration numbers worldwide.

• Europe: Immigrants helped to rebuild and repopulate Europe after World War II. In 2005 Europe experienced an overall net gain of 1.8 million people from immigration. This accounted for almost 85% of Europe’s total population growth that year. In 2010, according to Eurostat, there were 47.3 million immigrants living throughout Europe, which accounted for 9.4% of the total population; Germany, France, the United Kingdom, Spain, Italy, and the Netherlands experienced the highest immigration rates.
• Japan: Japan had strict immigration policies, but in the early 1990’s, issues such as low birth rates and an aging work force caused the country to reevaluate its laws. It is estimated that the number of foreign residents living in Japan in 2008 was more than 2.2 million. The largest groups of immigrants were from Korea, China, and Brazil.
• Mexico: Mexico does experience large numbers of immigrants crossing over the Guatemalan border, but many of these individuals enter illegally and get deported. There were an estimated 200,000 undocumented immigrants in Mexico in 2005 alone. Mexico is also the leading country for migrants moving to the United States. The tighter immigration laws have made immigrating to the U.S. from Mexico very challenging. Many Mexican immigrants enter and live in the U.S. illegally.
• United States: Factors that influence immigration to the U.S. include family reunification, employment opportunities, and humanitarian needs. When President Bill Clinton was in office, the U.S. Commission on Immigration Reform sought to limit legal immigration to about 550,000 people a year. Immigration has remained a heavily debated issue since then. U.S. borders have tightened in recent years to help control illegal immigration. It was documented in 2010 that 1 million immigrants obtained legal permanent resident status for that year.

38.1.2: Impact of Immigration on the Immigrant

Learning Objective

Assess the impact that immigration has on immigrants

Key Points

• Some reasons immigrants choose to leave their home countries include economic issues, political issues, family reunification, or natural disasters. Economic reasons include seeking higher wages, better employment opportunities, a higher standard of living, and educational opportunities.
• No matter the reasons behind an immigration decision, immigration provides the immigrant with a new start on life and more growth opportunities than were previously available.
• One of the initial challenges faced by immigrants is the cost of immigrating. However, the majority of challenges associated with immigration deal with assimilating into life in the host country.
• One of the initial challenges faced by immigrants is the cost of immigrating. It is not uncommon for immigrants to liquidate their assets, potentially at a substantial loss, to be able to afford to move.
• The majority of challenges associated with immigration deal with assimilating into life in the host country.

Key Term

immigrant

A person who comes to a country from another country in order to permanently settle in the new country.

Immigration

Immigration involves the movement of people from their home country to a host country or region, to which they are not native, to live. There are many reasons why immigrants choose to leave their home countries, including economic issues, political issues, family reunification, and natural disasters. In general, no matter what the reasoning is, immigrants move to another country to improve their life. Immigration presents both benefits and challenges for immigrants.

Benefits of Immigration

There are many benefits associated with immigration. Primarily, immigrants choose to leave their home country in order to improve their quality of life. Economic reasons for immigrating include seeking higher wage rates, better employment opportunities, a higher standard of living, and educational opportunities . It is also common for immigrants to leave their home country to escape from poverty, religious persecution, oppression, ethnic cleansing, genocide, wars, or a political structure (e.g. repressive dictatorship). No matter what the reasoning is behind immigration, it provides the immigrant with a new start on life and more growth opportunities than were previously available. Success in a new country is not guaranteed and often requires hard work and sacrifices, but many immigrants are willing to take risks for the possibility of a better future for themselves.

Immigration

This picture shows a group of North African immigrants on a boat near the island of Sicily. When most immigrants choose to leave their home country, the intent is to move in order to obtain a higher quality of life in the host country.

Challenges of Immigration

One of the initial challenges faced by immigrants is the cost of immigrating. Many immigrants are seeking better economic conditions in a new country, so the cost of moving can be substantial for them. It is not uncommon for immigrants to liquidate their assets, potentially at a substantial loss, to be able to afford to move. Also, during immigration many individuals are without work and must find work once they get settled.

The majority of challenges associated with immigration deal with assimilating into life in the host country. Many immigrants take low wage jobs until they can adjust to society, gain housing, and obtain an education. Immigrants must learn a new way of life and become familiar with the language and laws of the host country. While many immigrants leave their home country to escape persecution, it is possible that they could face discrimination or even racism in the host country. The process of immigrating is not easy, but for many individuals staying in their home country does not provide them with a promising future. Most immigrants are willing to take risks and work hard to build a solid future even though the process can be challenging.

38.1.3: Impact of Immigration on the Host and Home Country Economies

Learning Objective

Explain how immigration impacts the host country and the home country of immigrants

Key Points

• People immigrate for many reasons, some of which include economic or political reasons, family reunification, natural disasters, or the desire to change one’s surroundings.
• Immigration can represent an expansion of the supply of labor in the host country.
• Host countries are faced with a variety of challenges due to immigration including population surges, support services, employment, and national security.
• Reasons to immigrate can include the standard of living not being high enough, the value of wages being low, a slow job market, or a lack of educational opportunities.
• In the long run, large amounts of immigration will weaken the home country by decreasing the population, the level of production, and economic spending.

Key Terms

immigration

The act of coming into a country for the purpose of permanent residence.

assimilate

To absorb a group of people into a community.

Immigration

Immigration involves the movement of people from their home country to a host country, of which they are not native, to settle and live. People immigrate for many reasons; some of which include economic or political reasons, family reunification, natural disasters, or the desire to change one’s surroundings.

In 2006, the International Organization for Migration estimated the number of foreign migrants worldwide to be more than 200 million. Europe, North America, and Asia host the largest number of immigrants totaling 70 million, 45 million, and 25 million in 2005, respectively .

Immigration Rates

This map shows the migration rates worldwide in 2011. The blue countries experienced positive rates, orange indicates negative rates, green shows stable rates, and the gray shows where no data was available. Immigration involves individuals moving from their home country to live in a non-native country. In 2005, Europe, the United States, and Asia had the highest levels of immigration worldwide.

Impacts on the Host Country

A host country experiences both advantages and challenges as a result of immigration. At certain times throughout history, larger migrations have taken place which created huge population surges. The higher population numbers placed strain on the infrastructure and services within the host country. When immigrants move to a new country, they are faced with many unknowns, including finding employment and housing, as well as adjusting to new laws, cultural norms, and possibly a new language. It can be a challenge for a host country to assimilate immigrants into society and provide the necessary support.

Immigration does cause an increase in the labor force. This can impact great quantities of them if the immigrants are generally the same type of worker (e.g. low-skilled) and immigrate in large enough numbers so as to significantly expand the supply of labor.

Immigration is still a heavily debated topic in many host countries. Some believe that immigration brings many advantages to a country both for the economy and society as a whole. Others believe that high immigration numbers threaten national identity, increase dependence on welfare, and threaten national security (through illegal immigration or terrorism). Another argument is that high immigration rates cheapens labor. Empirically, research has shown this may be partially true. The Brookings Institute found that from 1980 to 2007, immigration only caused a 2.3% depression in the wages of the host country. The Center for Immigration Studies found a 3.7% depression in wages during 1980 to 2000.

Impacts on the Home Country

The home country also faces specific challenges in regards to immigration. In many cases, immigrants move to another country to provide positive changes for their future. Reasons to immigrate can include the standard of living not being high enough, the value of wages being too low, a slow job market, or a lack of educational opportunities. A home country must analyze immigration statistics to determine and address why citizens are moving to other countries. In the long-run, large amounts of immigration will weaken the home country by decreasing the population, the level of production, and economic spending. If a country is losing citizens due to economic reasons, the situation will not improve until economic changes are made.

At times, citizens of a country may leave because of non-economic reasons such as religious persecution, ethnic cleansing, genocide, war, or to escape the government (for example, a dictatorship). In these cases, it is not uncommon for the citizens to return to the home country at some point once the threat is no longer present. While a citizen is living in another country, if they receive an education and create a solid life, their individual success can also be beneficial to the home country, if they use their acquired skills to make a difference. Many individuals do not forget their home country and continue to support family members financially through the income from the country they migrate to.

37.1: Introduction to the Agriculture Economics

37.1.1: The Agricultural Market Landscape

Learning Objective

Outline the evolution of the agriculture market over time

Key Points

• The history of agriculture is complex, spanning back thousands of years across a wide variety of different geographic regions, climates, cultures, and technological approaches.
• The roots of agriculture are derived over 10,000 years ago, with tribes executing forest gardening alongside the domestication of animals in the Fertile Crescent region.
• As population expanded dramatically over time (see, so did the efficiency of agriculture economics. This began with agricultural improvements such as the hoe and is represented today with genetic engineering, robotics, irrigatiion, etc.
• This rapid expansion coupled with the essential role of food in our society has generated a field of economics solely dedicated to observing and predicting trends within the agriculture market landscape.
• Interesting trends in the agricultural market pertain to the decrease in cost for the actual farming aspects and an increase in costs for the distribution and sales system (particularly in the U.S.). This is largely a result of technological progress.

Key Term

Agricultural Economics

The study of the production, distribution, and consumption of goods and services related to food.

Agriculture, in many ways, has been the fundamental economic industry throughout history. The production and exchange of food laid the groundwork for all bartering, making it likely to be the oldest market in history. The production of food in modern times in developed nations is oddly taken for granted, as surpluses tend to define the market in pursuit of providing options.

Developing nations view agriculture quite differently, where famines and low yield years can dramatically affect the overall food supply in a given region. Due to the critical importance of food production, the agricultural market landscape is one of the most studied and evolved economic segments.

The History of Agriculture

The history of agriculture is complex, spanning back thousands of years across a wide variety of different geographic regions, climates, cultures, and technological approaches. Over 10,000 years ago, tribes began executing forest gardening. This evolved in the Fertile Crescent region into the domestication of animals (i.e. cattle, sheep, goats, pigs), growing of wheat and barley in Jordan Valley and the growth of cereal in Syria (all still about 10,000 years ago).

As population expanded dramatically over time (see ), so did the efficiency of agriculture economics. This began with agricultural improvements such as the hoe and the plow (2500 B.C.), irrigation via canals, and biological pest control as early as the bronze and iron ages. This evolved further in the middle ages with the advent of fertilizers, three field techniques, draft horses, and improved international exchange. Indeed, until the Industrial Revolution (18th and 19th centuries) the vast majority of the human population labored long hard days to generate enough food to feed the masses.

Human Population Growth

This chart illustrates the way in which human population growth evolved over time, underlining the difficulty in maintaining supplies to fill the needs of such a large population.

The modern era of farming is increasingly defined by selective breeding, crop rotation, economies of scale, electronic machinery, genetic modification, pesticides, and a host of other solutions that have rapidly expanded the overall potential capacity in farming.

Agricultural Economics

This rapid expansion coupled with the essential role of food in our society has generated a field of economics solely dedicated to observing and predicting trends within the agriculture market landscape. Basic macro and micro-economic principles apply to farming, as do the existence of externalities such as climate change and nutritional health. Agricultural economics is defined as the economic system that produces, distributes, and consumes agricultural products and services. This represents a large interconnected supply chain on a global scale.

Interesting trends in the agricultural market pertain to the decrease in cost for the actual farming aspects and an increase in costs for the distribution and sales system (particularly in the U.S.). This is largely a result of technological progress greatly reducing the need for human labor in the production of agricultural goods, weighting the costs more heavily on the human resources side of the equation.

The politics and economics of agriculture are also relevant issues on the global scale. US agricultural subsidies have had a large impact on international trade flows. The subsidies make US agricultural products artificially cheap, too cheap for developing nations to compete with. Developing nations, which may rely more heavily on agriculture in their economy than developed nations, argue that the US should reduce its agriculture subsidies. This tension is perhaps the biggest cause of the failure of the Doha Round, a World Trade Organization push for more open global trade, to make any progress since its initiation in 2001.

37.1.2: Subsidies and Income Supports

Learning Objective

Analyze the positive and negative affects of subsidies on agricultural economics.

Key Points

• Subsidized goods generally include wheat, corn, barley, oats, sorghum, milk, rice, peanuts, tobacco, soybean, cotton, lamb, beef, chicken and pork.
• Another, less direct, form of subsidy is in the taxing system for consumers. Consumers are not charged tax on food goods and clothes, which are considered necessities and thus should be provided at the lowest costs possible.
• In the context of international trade, government assistance in industry provides an unfair competitive advantage for those companies receiving the support.
• Overall, while subsidies are largely a good thing and enable individuals to buy the necessities, there are clear cut downsides to subsidies as well.
• Overall, while subsidies are largely a good thing and enable individuals to buy the necessities, there are clear cut downsides to subsidies as well. Politics must find a way to mitigate the negative externalities.

Key Terms

externalities

Impacts, positive or negative, on any party not involved in a given economic transaction or act.

subsidy

Government assistance to a business or economic sector.

When governments want to ensure their citizens have access to healthy foods at reasonable prices, a variety of governmental supports are provided to the industry to ensure it maintains low costs of production and high output. This is generally in the form of subsidy and income supports, which alleviate some competitive dynamics and operating expenses to maintain reasonable price points in the market economically.

Subsidies

An agricultural subsidy is defined as a government grant paid to farmers to supplement income and influence the overall cost and supply of certain commodities. In this industry, subsidized goods generally include wheat, corn, barley, oats, sorghum, milk, rice, peanuts, tobacco, soybean, cotton, lamb, beef, chicken and pork. illustrates the governmental priorities, based upon subsidies provided, for specific agricultural goods in the United States. These subsidies play a large role in enabling higher supply at lower price points, supporting the domestic agricultural industry.

Agriculture Subsidies in the U.S. (2005)

This chart illustrates the governmental priorities, based upon subsidies provided, for specific agriculture goods in the United States.

Another, less direct, form of subsidy is in the taxing system for consumers. Consumers are not charged tax on food goods and clothes, which are considered necessities and thus should be provided at the lowest costs possible. These consumer-based subsidies are another governmental attempt to enable citizens in the country to purchase basic food stuffs required to survive. Food stamps are a similar concept, used to empower low income individuals and ensure they have access to these basic foods as well (food stamps are often limited to milk, eggs, bread and other core foods).

Impacts of Subsidies

While these subsidies above are designed to have a positive effect on consumers looking to purchase foods, there are externalities to this process that can have a damaging affect on other groups:

• Global Effects: While domestic subsidies are good for driving up production domestically, it suppresses competition in the context of international trade. Government assistance in an industry is argued to provide an unfair competitive advantage for those companies, artificially lowering their costs of production, sometimes below the feasible level for countries (especially developing nations) not receiving these supports.
• Developing Nations: A complement to the above discussion is the effect on poverty and developing nations without the infrastructure to provide subsidies for their own farmers. The International Food Policy Research Institute has estimated a total loss of economic growth in developing nations at $24 billion in 2003, all of which translate to lost income for individuals who desperately need it.
• Nutrition: Another interesting side effect of subsidies and the artificially reduced price of food is obesity and overeating. Some argue that these low prices provide the incentive to buy more food than is necessary, and this over consumption has resulted in a highly unhealthy culture (particularly in the U.S.).
• Environmental Implications: As food prices reduce distribution increases, thus driving an environmental externality which already existed even further. The cost, environmentally, of transporting a high quantity of agricultural goods across the globe has resulted in high degrees of pollution and waste.

Overall, while subsidies are largely a good thing and enable individuals to buy the necessities, there are clear cut downsides to subsidies as well. Politics must find a way to mitigate the negative consequences while increasing the positive effects, allowing for balanced and healthy consumption across all demographics.

37.1.3: Price Supports

Learning Objective

Assess the way in which price controls affect supply, demand, and equilibrium pricing in agricultural economics.

Key Points

• Governments enact a variety of price controls on the agriculture business, both in the U.S. and abroad, to ensure desired supply and prices for specific necessities.
• Price supports are defined as subsidies or price controls that are leveraged by the government to artificially increase or decrease prices, and alter the supply consumed/quantity demanded by individuals within the system.
• The government may artificially increase prices through purchasing a portion of the consumer surplus or artificially increase quantity through offering subsidies to producers. This allows the government control over the established equilibrium in agriculture.
• The United States currently pays out around $20 billion annually to farmers and producers in agriculture in the form of subsidies via farm bills in order to artificially reduce prices and shift the supply curve.
• The subsidies provide a price floor (or a minimum price in which farmers can be reimbursed for certain products). This is a significant economic policy of price control to ensure farmers have proper incentive and revenues to continue to produce.

Key Terms

Price support

A subsidy or a price control with the intended effect of keeping the market price of a good higher or the quantity consumer higher within a market.

Subsidies

Financial support or assistance, such as a grant.

The agriculture industry is a critical component of any national economy because it represents both a substantial portion of gross domestic product and it is a core necessity for citizens within the system. Due to the fact that these goods are necessities, it is also important to keep in mind the way in which supply and demand would operate if there was a limited supply (required for survival, and thus potential demand upsides could be boundless). Due to these factors, governments enact a variety of price controls on the agriculture business, both in the U.S. and abroad.

Defining Price Supports

Price supports are defined as subsidies or price controls that are leveraged by the government to artificially increase or decrease prices, and thus alter the supply consumed/quantity demanded by individuals within the system. Understanding the effects of subsidies and price controls is critical in industries with a high degree of government involvement, and agriculture is one of the most affected industries.

is simply a supply and demand curve that demonstrates the consumer surplus and producer surplus opportunities in basic supply and demand chart. In this scenario, without external governmental intervention, the price equilibrium will remain in the center of the graph. However, the government may implement price supports that artificially consume some of the consumer surplus (in , this is 200 units). This drives the price upwards to $6 per unit despite the fact that the consumer is not gaining additional quantity (it is artificial quantity, as purchased by the government).

Consumer Surplus with Price Support

This graph is a complement to the first graph. It demonstrates the effect of implementing a price support on a basic supply and demand chart. The overall consumption will decrease as the government buys up consumer surplus. This demonstrates a price control on behalf of the government.

Consumer Surplus

This chart, in conjunction with the one below, illustrates the way in which price supports can alter supply and overall consumption. It demonstrates the consumer surplus and producer surplus opportunities on a basic supply and demand chart.

This can happen in reverse as well in the form of subsidies. Subsidies are the reduction of costs for producers, generally in the form of governmental grants provided to suppliers. In this scenario, prices are artificially reduced, allowing for an outward shift of the supply curve along the demand line, which creates a higher amount of consumption by consumers as a result of the reduced price. This is illustrated in , where the governmental subsidy allows for increased consumption power on behalf of the consumers in that market.

Subsidies and Supply

This chart shows how subsidies and price controls affect supply and demand. A subsidy, as illustrated here, will reduce the price and extend the overall supply demanded and consumed by individuals within the system. This is the most relevant chart to agricultural economics specifically.

Applying Price Supports to Agricultural Economics

The United States currently pays out around $20 billion annually to farmers and producers in agriculture in the form of subsidies via farm bills in order to artificially reduce prices and shift the supply curve outward to ensure the overall supply in the market is high enough to satisfy all prospective consumers. It is important to note how dramatically the recipients of farming subsidies have changed over time in the United States. In 1925, there were around 6,000,000 small farms of which 25% of the nation resided. By 1997, 72% of farm sales come from 157,000 large farms and only 2% of the U.S. population resides there. This is an interesting economic factor in farm subsidies, as these subsidies are largely going to corporations of substantial size, as opposed to small farmers.

The subsidies provide a price floor (or a minimum price in which farmers can be reimbursed for certain products). This is a significant economic policy of price control to ensure farmers have proper incentive and revenues to continue to produce at the level of goods desired by the U.S. government. Agricultural economics is a highly complicated market as a result of these price supports and controls, particularly from the perspective of subsidization and price control.

37.1.4: Supply Reduction

Learning Objective

Identify factors resulting in global reductions in agricultural supply levels.

Key Points

• Government policy has a large impact on the agriculture market, usually in the form of subsidies and price ceilings, by controlling the overall supply and demand equilibrium points in the market.
• Governments may reduce supply through utilizing quotas (limiting imports) or providing foreign aid (actively reducing domestic demand).
• Environmental concerns have also been widely cited as a reductive influence on the agriculture market. Global warming (increased average temperatures) has demonstrated a negative effect on overall plant yield for certain products.
• Other concerns reducing supply revolve around dramatic soil damage due to short-term yield increasing strategies, growing immunity to pesticides, loss of rural space for farming (due to urbanization), and availability of clean water for irrigation.

Key Terms

Dumping

Selling goods at less than their normal price, especially in the export market as a means of securing a monopoly.

Quotas

A restriction on the import of a good to a specific quantity.

Agricultural economics is largely bound by concepts of climate and overall world food producing capacity (i.e. farmlands and infrastructure), while simultaneously being enabled by government policy, technological advances, and the continued growth of developing nations. Understanding the reductions in aggregate supply in this industry, as a result of governmental policy or economic limits, is a critical component in understanding agricultural economics. We will look at both the governmental components and the climatic/aggregate demand components contributing to overall supply in this industry.

Governmental Policy

Government policy has a large impact on the agriculture market. Both subsidies and price ceilings are common and affect the overall supply and demand equilibrium points in the market. Governmental policy to reduce supply also exists and is executed often from a global trade perspective. One of the largest risks in this industry, due to the high degree of subsidization, is ‘dumping. ‘ Dumping is the process of selling undervalued goods in another market, upsetting price points and equilibrium. In this scenario, government policies may set quotas, or import limits, to reduce supply.

A second reduction in supply that is quite common in developed nations is utilizing surplus for foreign aid. Many developing nations lack the requisites to generate the appropriate supply of agriculture to feed the population. In this scenario, the leveraging of the surplus in one country can benefit the other country via aid, and in turn correct the supply/demand equilibrium in the donating country to the desired level.

Climate Change

Environmental concerns have also been widely cited as a reductive influence on the agriculture market. Global warming has been slowly increasing temperatures as the ozone layer erodes due to a variety of pollutants, altering the ecosystem averages outside of the evolutionary environment in which many agricultural products historically grew. Climate changes means a different growing environment for plants, which are not used to it. illustrates the reduction in yield as a result of altering climatic environments. Shifts in climate drastically reduce aggregate supply.

Climate Change Affecting Agriculture

This chart illustrates the reduction in yield as a result of altering climatic environments. Essentially, deviations outside of the normal temperature ranges drastically reduce aggregate supply.

Other concerns revolve around dramatic soil damage due to short-term yield increasing strategies, growing immunity to pesticides, loss of rural space for farming (due to urbanization), and availability of clean water for irrigation. All of these factors may reduce the aggregate supply and thus drive up prices. demonstrates rising food prices, perhaps from a number of the supply reduction factors discussed in this atom (or potentially unidentified factors). Controlling supply is a critical component of ensuring everyone has access to affordable food, and maintaining our ecosystem will clearly play a critical role in the years ahead.

Food Price Increases Over Time

Food prices over time, particularly in recent years, are demonstrating a trend upwards that may reflect a reduction in overall efficiency of agricultural production or reductions in supply.

37.1.5: Evaluating Policies

Learning Objective

Evaluate the economics of agriculture policies.

Key Points

• The political frame of the agriculture market is complex, with a wide range of critical concerns that need to be addressed both domestically and internationally.
• Concerns to keep in mind revolve around the international markets, bio-security, infrastructure, technology, water, and resource allocation to enable effective agricultural markets.
• Governments can use import quotas, subsidies, price floors, price ceilings, and aid to control their domestic market supply, demand, and equilibrium price point.
• Combining the issues above with tools provided, the agricultural business can change dramatically as a result of the concerns and activities of the respective government in a given economy.

Key Terms

infrastructure

The basic facilities, services, and installations needed for the functioning of a community or society.

Biosecurity

The protection of plants and animals against harm from disease or from human exploitation.

The political frame of the agriculture market is hugely complex, with a wide range of critical concerns that need to be addressed both domestically and internationally. Agricultural policy differs from nation to nation, but has a number of key questions and considerations that occur across the board. The purpose of this atom is to outline the various trends in agricultural economic policy, and how these governmental policies can be evaluated for efficacy in their respective markets.

Policy Concerns

Agriculture requires a vast support system and a great deal of oversight, as the consumption of grown foods poses a huge safety threat alongside a critical need for the health and survival of a civilization. Below is a list of core questions to keep in mind when evaluating agricultural policy:

• Biosecurity: The ability of a country to consistently provide enough food for its citizens is a major concern. Pests and diseases are a significant threat to yield rates and must be closely observed and regulated.
• International Trading Environment: Global agricultural trade is a complex issue, with quality control, pricing (dumping), and import/export tariffs. The dangers of biosecurity, or lack thereof, in particular are quite stringent.
• Infrastructure: Transporting goods, irrigation facilities, land utilization, and a variety of other logistics concerns are required by the government to enable effective economic trade (domestically and internationally).
• Technology: This is a critical driving force in increasing yield and lowering costs in the agriculture business. Enabling technological progress is a critical investment and something governments must provide incentives for.
• Water:Access to clean, potable water is a basic necessity to which not everyone has access.Effective sewage systems for irrigation and effective water treatment for sanitation are a required input, and must be provided via governmental centralized infrastructure.
• Resource Access: Ensuring access to land and biodiversity is another important component to a successful agricultural industry. Protection of environmental land and the overall ecosystem is an important policy consideration.

Policy Tools

With the above concerns in mind, it is also useful to understand some of the tools leveraged by governments to enable this industry:

• Subsidies: The government can utilize subsidies to reduce price points and increase the overall supply within a system . The use of subsidies in developed nations has been a major point of international contention, since they may force developing nations out of the global agriculture market.
• Price Floors/Ceilings: Price floors provide a minimum price point for a given product while price ceilings create a maximum price point. These are used to ensure appropriate pricing in a given industry (see ), and are often used in agriculture to control price points.
• Import Quotas: Policy makers often implement quotas in agriculture to retain more control over prices and protect domestic incumbents. Quotas, like other forms of trade protection, benefit the local industry.
• Aid: When aggregate supply is too high in a home country or there is a crisis in another, governments can provide their surplus to nations in need of food. This is both a way to provide utilitarian value while reducing aggregate supply.

Combining the issues above with tools provided, the agricultural business can change dramatically as a result of the concerns and activities of the respective government in a given economy. This is useful in controlling food prices, reducing waste, enabling efficiency and avoiding biosecurity issues.

36.1: Introduction to Natural Resource Economics

36.1.1: Types of Natural Resources

Learning Objective

Analyze natural resource economics and explain the types of natural resources that exist.

Key Points

• Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources.
• Every man-made product in an economy is composed of natural resources to some degree.
• Natural resources can be classified as potential, actual, reserve, or stock resources based on their stage of development.
• Natural resources are either renewable or non-renewable depending on whether or not they replenish naturally.
• Natural resource utilization is regulated through the use of taxes and permits. The government and individual states determine how resources must be used and they monitor the availability and status of the resources.

Key Terms

Renewable

Sustainable; able to be regrown or renewed; having an ongoing or continuous source of supply; not finite.

natural resource

Any source of wealth that occurs naturally, especially minerals, fossil fuels, timber, etc.

depletion

The consumption of a resource faster than it can be replenished.

Natural Resource Economics

Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources. It’s goal is to gain a better understanding of the role of natural resources in the economy. Learning about the role of natural resources allows for the development of more sustainable methods to manage resources and make sure that they are maintained for future generations.The goal of natural resource economics is to develop an efficient economy that is sustainable in the long-run .

Importance of the Environment

This diagram illustrates how society and the economy are subsets of the environment. It is not possible for societal and economic systems to exist independently from the environment. For this reason, natural resource economics focuses on understanding the role of natural resources in the economy in order to develop a sufficient and sustainable economy that protects natural resources.

Types of Natural Resources

Natural resources are derived from the environment. Some of the resources are essential to survival, while others merely satisfy societal wants. Every man-made product in an economy is composed of natural resources to some degree.

There are numerous ways to classify the types of natural resources, they include the source of origin, the state of development, and the renewability of the resources.

In terms of the source of origin, natural resources can be divided into the following types:

• Biotic: these resources come from living and organic material, such as forests and animals, and include the materials that can be obtained them. Biotic natural resources also include fossil fuels such as coal and petroleum which are formed from organic matter that has decayed.
• Abiotic: these resources come from non-living and non-organic material. Examples of these resources include land, fresh water, air, and heavy metals (gold, iron, copper, silver, etc.).

Natural resources can also be categorized based on their stage of development including:

• Potential resources: these are resources that exist in a region and may be used in the future. For example, if a country has petroleum in sedimentary rocks, it is a potential resource until it is actually drilled out of the rock and put to use.
• Actual resources: these are resources that have been surveyed, their quantity and quality has been determined, and they are currently being used. The development of actual resources is dependent on technology.
• Reserve resources: this is the part of an actual resource that can be developed profitably in the future.
• Stock resources: these are resources that have been surveyed, but cannot be used due a lack of technology. An example of a stock resource is hydrogen.

Natural resources are also classified based on their renewability:

• Renewable natural resources: these are resources that can be replenished. Examples of renewable resources include sunlight, air, and wind . They are available continuously and their quantity is not noticeably affected by human consumption. However, renewable resources do not have a rapid recovery rate and are susceptible to depletion if they are overused.
• Non-renewable natural resources: these resources form extremely slow and do not naturally form in the environment. A resource is considered to be non-renewable when their rate of consumption exceeds the rate of recovery. Examples of non-renewable natural resources are minerals and fossil fuels.

There is constant worldwide debate regarding the allocation of natural resources. The discussions are centered around the issues of increased scarcity (resource depletion) and the exportation of natural resources as a basis for many economies (especially developed nations). The vast majority of natural resources are exhaustible which means they are available in a limited quantity and can be used up if they are not managed correctly. Natural resource economics aims to study resources in order to prevent depletion.

Natural resource utilization is regulated through the use of taxes and permits. The government and individual states determine how resources must be used and they monitor the availability and status of the resources. An example of natural resource protection is the Clean Air Act. The act was designed in 1963 to control air pollution on a national level. Regulations were established to protect the public from airborne contaminants that are hazardous to human health. The act has been revised over the years to continue to protect the quality of the air and health of the public in the United States.

Wind

Wind is an example of a renewable natural resource. It occurs naturally in the environment and has the ability to replenish itself. It has also been used as a form of energy development through wind turbines.

36.1.2: Basic Economics of Natural Resources

Learning Objective

Explain basic natural resource economics

Key Points

• As a field of academic research, natural resource economics addresses the connections and interdependence between human economies and natural ecosystems.
• By studying natural resources, economists learn how to develop more sustainable methods of managing resources to ensure that they are maintained for future generations.
• Natural resource economics is studied on an academic level, and the findings are used to shape and direct policy-making for environmental issues. These issues include resource extraction, depletion, protection, and management.
• Natural resource economics findings impact policies for environmental work including issues such as extraction, depletion, protection, and management.

Key Terms

natural resource

Any source of wealth that occurs naturally, especially minerals, fossil fuels, timber, etc.

sustainable

Able to be sustained for an indefinite period without damaging the environment, or without depleting a resource.

Natural Resource Economics

Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources. The main objective of natural resource economics is to gain a better understanding of the role of natural resources in the economy. By studying natural resources, economists learn how to develop more sustainable methods of managing resources to ensure that they are maintained for future generations. Economists study how economic and natural systems interact in order to develop an efficient economy.

As a field of academic research, natural resource economics addresses the connections and interdependence between human economies and natural ecosystems. The focus is how to operate an economy within the ecological constraints of the earth’s natural resources .

Natural Resource Economics

This diagram illustrates that society and the economy are subsets of the environment. It is not possible for social and economic systems to exist independently from the environment. Natural resource economics focuses on the demand, supply, and allocation of natural resources to increase sustainability.

Areas of Study

Economists study the commercial and recreational use and exploitation of resources. Traditionally, natural resource economics focused on fishery, forestry, and mineral models. However, in recent years many more topics have become increasingly important, including air, water, and the global climate. Natural resource economics is studied on an academic level, and the findings are used to shape and direct policy-making for environmental issues.

Examples of areas of study in natural resource economics include:

• welfare theory
• pollution control
• resource exhaustibility
• environmental management
• resource extraction
• non-market valuation
• environmental policy

Additionally, research topics of natural resource economists can include topics such as the environmental impacts of agriculture, transportation and urbanization, land use in poor and industrialized countries, international trade and the environment, and climate change.

Impact of Natural Resource Economics

The findings of natural resource economists are used by governments and organizations to better understand how to efficiently use and sustain natural resources. The findings are used to gain insight into the following environmental areas:

• Extraction: the process of withdrawing resources from nature. Extractive industries are a basis for the primary sector of the economy. The extraction of natural resources substantially increases a country’s wealth. Economists study extraction rates to make sure that resources are not depleted. Also, if resources are extracted too quickly, the sudden inflow of money can cause inflation. Economists seek to maintain a sense of balance within extraction industries.
• Depletion: the using up of natural resources, which is considered to be a global sustainable development issue. Many governments and organizations have become increasingly involved in preserving natural resources. Economists provide data to determine how to balance the needs of societies now and preserve resources for the future.
• Protection: the preservation of natural resources for the future. The findings of economists help governments and organization develop measures of protection to sustain natural resources. Protection policies state the necessary actions internationally, nationally, and individually that must take place to control natural resource depletion that is a result of human activity.
• Management: the use of natural resources taking into account economic, environmental, and social concerns. This process deals with managing natural resources such as land, water, soil, plants, and animals. Particular focus is placed on how the preservation of natural resources impacts the quality of life now and for future generations.

36.1.3: Externalities and Impacts on Resource Allocation

Learning Objective

Examine externalities and how they the impact resource allocation of natural resources.

Key Points

• An externality is a cost or benefit that affects a party who did not choose to incur the cost or benefit.
• A negative externality, also called the external cost, imposes a negative effect on a third party.
• When external costs are present, the market equilibrium use of natural resources is inefficient because the social benefit is less than the social cost. In other words, society would have been better off if fewer natural resources had been used.
• Positive externalities, also referred to as external benefits, imposes a positive effect on a third party.
• Assuming that natural resources are used and also sustained, the external benefits of goods produced by natural resources impacts the majority of the public in a positive way.

Key Term

externality

An impact, positive or negative, on any party not involved in a given economic transaction or act.

Resource Allocation

Resource allocation is division of goods for the use of production within the economy. The needs and wants of society as well as industries impact what is produced. Suppliers focus on producing the varieties of goods and services that will yield the greatest satisfaction to consumers. In the long run, externalities directly impact resource allocation. It must be determined whether the production, as well as the process of production, creates more benefits that costs for the producers, consumers, and society as a whole.

Externalities

An externality is a cost or benefit that affects a party who did not choose to incur the cost or benefit. In regards to natural resources, production and use of resources can have a positive or negative effect on the allocation of the resources.

External Costs

A negative externality, also called the external cost, imposes a negative effect on a third party to an economic transaction. Many negative externalities impact natural resources negatively because of the environmental consequences of production and use. For example, air pollution from factories and vehicles can cause damage to crops . Likewise, water pollution has a negative impact of plants and animals.

Negative externality

Air pollution from vehicles is an example of a negative externality. It affects other than those who drive the vehicle and those who sell the gas.

In the case of negative externalities, the marginal private cost of consuming a good is less than the marginal social or public cost. The marginal social benefit should equal the marginal social cost (i.e. production should only be increased when the marginal social benefit exceeds the marginal social cost). When external costs are present, the use of natural resources is inefficient because the social benefit is less than the social cost. In other words, society and the natural resources involved would have been better off if the natural resources had not been used at all.

Developed countries use more natural resources and must enact sustainable development plan for the use of resources. Human needs must be met, but the environment and natural resources must be preserved. Examples of resource depletion include mining, petroleum extraction, fishing, forestry, and agriculture.

External Benefits

Positive externalities, also referred to as external benefits, impose a positive effect on a third party. An example of a positive externality is when crops are pollinated by bees from a neighboring bee farm. In order to achieve the socially optimal equilibrium, the marginal social benefit should equal the marginal social cost (i.e. production should be increased as long as the marginal social benefit exceeds the marginal social cost). Assuming that natural resources are used and also sustained, the external benefits of goods produced by natural resources impacts the majority of the public in a positive way.

35.1: Introducing Health Care Economics

35.1.1: Defining Health, Health Care, and Medical Care

Learning Objective

List the parties involved in the healthcare system in the United States

Key Points

• Kenneth Arrow, in 1963, differentiated health care economics from other economics due to the wide range of unique considerations involved (i.e. infinite demand, wide range of stakeholders, etc. ).
• Health care is a significant concern for patients, insurance companies, governments, businesses, health care providers, researchers, and non-profits. These parties determine the supply, demand, oversight, and externalities of the system.
• Currently, U.S. health care is largely privatized with the exception of medicaid and medicare, the former being for low income groups and the latter for retirees. This is unlike many developed nations, who have socialized support in place.
• The insurance company, the government (medicaid and medicare), or the individual (if they are not covered or if their particular procedure is not covered) is the direct client of the hospitals, pharmacies, and doctor’s offices.
• Overall, this system of health care in the U.S. is quite convoluted. There are many players involved and the stakes are extremely high.

Key Term

Health care

The prevention, treatment, and management of illness or the preservation of mental and physical well-being through the services offered by the medical, nursing, and allied health professions.

Health care economics is a segment of economic study pertaining to the value, effectiveness, and efficiency in medical care and health care services and issues. The study of health care, from an economic perspective, requires taking a broad lens on a complex system with a wide variety of stakeholders. In 1963, Kenneth Arrow differentiated health care economics from other economics due to the wide range of unique considerations involved. Health care, due to the severity of the need/demand, wide variety of externalities, government intervention, and role of doctors as third-parties (making critical purchasing decisions for other people), cannot be considered from the same perspective as other industries.

Defining Health Care

Health care is a significant concern for patients, insurance companies, governments, businesses, health care providers, researchers, and non-profits. It is a vast economic system with many internal players and externalities. Understanding the basic factors involved, both logistically and economically, will provide useful context in defining health care and the medical care services.

outlines who is involved, and in what fashion.

Health Care System Flow Chart

This flow chart does an excellent job of outlining the various stakeholders and influences in the broader health care system context.

• Health (Box B): Health metrics for health attributes from a value of life and overall utility-based perspective.
• Demand for Health Care (Box C): The overall health care demand, which is a complex array of inputs that can be summarized as health care seeking behaviors, and what factors influence them (i.e. externalities, price, time, perspectives, etc.).
• Supply of Health Care Costs (Box D):The supply of health care in most systems is quite complex, inclusive of direct inputs such as drugs, medical suppliers, and diagnostics to insurance companies (third parties) to health care professionals (doctors, nurses, etc.) to research.
• Evaluation of the Whole System (Box F): This is where the government factors in, particularly in countries with a more socialized system for health care, alongside the comparisons both internally and externally.

This process flow is what defines health care and the medical industry from an economic standpoint, and the relative influence of each of these components, and the interdependence between them, is worth studying to determine where higher degrees of efficiency and efficacy can be found.

Health Care System in the U.S.

With this in mind, it is useful to also outline the inputs and outputs of the U.S. health care system, particularly during this transitional time. At the time of this writing (2013), the Affordable Care Act (often referred to as ‘Obamacare’) will be coming into play shortly. While the details and implications of this are beyond the scope of this discussion, it is useful to understand what the basic construct that exists in the United States currently.

At the moment, health care is largely privatized with the exception of medicaid and medicare, the former being for low income groups and the latter for retirees. For most of us, health care insurance is generally purchased on a capital market by a policy-holder (who may be a company the beneficiary works for or the beneficiary themselves, depending upon the profession and contractual obligations of an employer). This health insurance plan offers a construct for what will be covered under an umbrella of monthly health care payments, and what is considered outside of the plan. There are many large health care insurance providers out there, offering this service to prospective beneficiaries.

Now, either the insurance company, the government (medicaid and medicare), or the individual (if they are not covered or if their particular procedure is not covered) is the direct client of the hospitals, pharmacies, and doctor’s offices. These institutions are also quite complicated, and require their own insurances against liability due to the high consequences in the field. Doctors and nurses provide a service, either actively performing a recommended approach (e.g. surgery) or recommending a treatment (e.g drugs). These medical professionals are largely overseen by the government from a quality control perspective (various standardized test and degree requirements), adding an additional line of complexity to the operation.

Overall, this system of healthcare in the U.S. is quite convoluted. There are many players involved and the stakes are extremely high. Picture a demand curve for a treatment for a deadly disease, what would the price point be? Considering the consequences, healthcare services often fall outside of standard macroeconomic concepts, defying supply and demand frameworks due to the nature of the business (i.e. life and death, the well-being of people). This underlines a social issue: how can we improve healthcare economics to maximize value and minimize costs?

35.1.2: Where a Dollar Spent on Health Care Goes: Introducing the Inputs to Health Care

Learning Objective

Discuss the factors that affect the cost of and access to healthcare

Key Points

• While a percentage breakdown of who procures the largest capital gains from health care is difficult to ascertain across such a complex system, it is safe to say that quite a few players contribute to the constantly rising price.
• In short, the dollar value of health care is largely provided by beneficiaries to insurance companies (or governments), and paid out to administrative systems who employ and pay health care providers.
• One of the most discussed topics in health care is accessibility. Governments and insurers provide economics means for this in developed nations.
• One of the larger issues in accessibility is nations without the infrastructure required to support health care industries. Developing nations often do not have access to the skills or suppliers required.

Key Terms

Medicaid

U.S. government system for providing medical assistance to persons unable to afford medical treatments.

Medicare

The system of government subsidies for health care for the elderly and disabled.

Beneficiary

One who benefits or receives an advantage.

Healthcare has many inputs and a wide variety of interested parties profiteering. Understanding what drives the need for health care (and what prevents it), what is included in the cost, and the overall accessibility of this essential service is critical to understanding economics issues in healthcare. A dollar spent on health care can find it’s way to insurance providers, medical service providers, pharmaceutical companies, governments, administrative bodies (managing these businesses), and laboratories. Understanding what individuals pay for and why, alongside what is available, is important data for navigating this market.

Where the Money Goes

While a percentage breakdown of who procures the largest capital gains from health care is difficult to ascertain across such a complex system, it is safe to say that quite a few players contribute to the constantly rising price of even simple procedures and doctor’s visits. A breakdown of the critical players illuminates this further:

• Health Care Providers: On the surface, this is who a beneficiary feels like they are paying. This is their doctors, nurses, psychologists, dietitians, technologists, chiropractors, surgeons, and a wide range of other hands on and customer facing roles. These individuals are further differentiated by the fact that they often act as references as opposed to direct suppliers, making them both a direct to consumer provider and a third party provider.
• Pharmaceutical Companies: Drugs are playing an increasingly large role in health care, and likely will continue to do so in the future. The constant development of new drugs, alongside the distribution of established medications, is an enormous part of the market.
• Insurance Providers: There is a divider between most medical service consumers and their providers, and this is the insurance company. For those who are covered by their full-time jobs (or dependents of these individuals), this is largely a matter of who their business purchases from. For others not covered, insurance issues are a complex and highly expensive issue, and getting coverage is quite difficult (this is being addressed in the U.S. by new legislation, and is not an issue in most other developed nations). The insurance companies command a huge profit and represent a substantial part of the medical price tag.
• Government: The role of government in health care is fiercely debated in the United States, but in most of the developed world the government is essentially the provider of health care plans (using social services models to consolidate tax revenues to be allocated for this service). In the U.S., this is only done for medicaid and medicare. The government also takes tax revenues from involved parties in this industry, driving prices up further.
• Administration: This is the hospital itself, or the doctors office, where the management team attempts to run a largely profitable business in the medical industry. Administration pays the health care providers and the government, taking income from direct consumers, the government, and the insurance companies to cover the cost of business (and often turn substantial profits).

With these group of incumbents in mind, it becomes quite clear why the costs are rising exponentially and are so unsustainable. The constant struggle between these large and powerful players coupled with an essentially infinite demand has left the consumer as an extremely weak player in the market. Indeed, with this in mind, the graph displays the trajectory of health care spending due to excess costs in the long term .

Health Care Costs

This graph illustrates the danger of continuing down path of using the excessively high cost-structure U.S. health care incumbents have dictated in the context of spending as a % of GDP.

Accessibility

One of the most discussed topics in health care is accessibility. Due to the fact that health care represents the ability for an individual to maintain a healthy and happy life, it seems intuitive that accessibility must as unlimited as possible. Of course, in a capitalistic system, this will not be the case. Economics dictates that price points will be determined based on supply and demand, and the demand in this industry is often essentially infinite. As a result, accessibility and profitability do not always align from an economic perspective. The U.S. employs medicaid and medicare to provide for low-income and elderly citizens that would otherwise be excluded from the market, while other countries have healthcare systems with more government intervention to address market failure.

One of the larger issues in accessibility is nations without the infrastructure required to support health care industries. Developing nations often do not have access to the skills or suppliers required to run modern hospitals and doctors offices, nor the ability to act preventatively (i.e. eating healthy, getting exercise, check ups, etc.). This creates enormous inefficiency in the system and reduces the economic viability of operating in these countries for insurance providers. Addressing this concern is one of the central issues for the United Nations (UN) and other nongovernmental organizations.

35.1.3: Different Health Care Systems Around the World

Learning Objective

Identify different types of healthcare systems

Key Points

• A health system consists of all organizations, people and actions whose primary intent is to promote, restore or maintain health. This includes efforts to influence determinants of health as well as more direct health-improving activities.
• The World Health Organization has been actively measuring a variety of performance indicators to determine an overall ranking system for health care on a global scale.
• The countries which perform the highest on these metrics are primarily located in Europe, where social systems are well designed at a governmental level to ensure prices remain accessible and care remain available.
• The U.S. has consistently ranked poorly and continues to perform substantially below European counterparts deemed developed at similar economic levels.
• Developing nations struggle to compete and compare apples to apples to developed nations, primarily due to the required infrastructure and capital requirements.

Key Terms

Universal healthcare

A system where every citizen is guaranteed access to a certain basic level of health services.

World Health Organization

The World Health Organization (WHO) is a specialized agency of the United Nations (UN) that is concerned with international public health.

Determinants

A determining factor; an element that determines the nature of something

Health care differs from nation to nation, sometimes substantially depending upon the level of economic development and the political system in place. Health care systems, on the global scale, is best defined via the World Health Organization’s definition: “A health system consists of all organizations, people and actions whose primary intent is to promote, restore or maintain health. This includes efforts to influence determinants of health as well as more direct health-improving activities. A health system is therefore more than the pyramid of publicly owned facilities that deliver personal health services. ” This definition is important when observing international health care systems, as it captures both developed and developing nations within this context.

Comparisons: Developed Nations

The World Health Organization has been actively measuring a variety of performance indicators to determine an overall ranking system for health care on a global scale. While this has seen some objections, primarily due to the selection of attributes which weigh into this ranking, it is designed to measure critical success factors which are easily comparably across borders (apples to apples). These measured attributes include health of the population, fair financial contributions, responsiveness of the system, preventable deaths, affordability and a range of other considerations.

The countries which perform the highest on these metrics are primarily located in Europe (generally northern Europe, see ), where social systems are well designed at a governmental level to ensure prices remain accessible and care remain available. Interestingly, the U.S. has consistently ranked poorly and continues to perform substantially below European counterparts deemed developed at similar economic levels. Two good examples are provided in the media relative to the overall capital costs and the subsequent returns on these costs, on being costs to hospital beds per capita and the other costs to physicians per capita . By these measures, European nations capture more value and efficiency within their systems. The most notable difference between these systems is that the US is that, of these countries, the US is the only country without universal healthcare.

Capital Costs and Physicians

Similar to the graph representing costs vs. beds, this chart illustrates the number of physicians available (relative to the population) in the context of capital expenditures. Once again the United States is a clear outlier, where the number of physicians is low and the cost quite high.

Capital Costs and Hospital Beds

This graph demonstrates the apparent correlation between beds (per 1000 people) and the costs involved in healthcare overall. This demonstrates that, on a per capita basis, the U.S. is spending a great deal without capturing much in return relative to available space for patients.

Economic Efficiency of Global Health Care Systems

Healthcare spending per capita is on the left y-axis and life expectancy is on the right. Country differences are apparent, especially when comparing the US to others.

Let us explore further through an example of health care in German (though not all European countries are the same). Germany has consistently demonstrated reductions in cost of health care per capita relative to GDP growth. German health care is regulated by the Federal Joint Commission, a public health organization which leverages governmental health reform bills to generate new regulations. This system also includes a total of 85% of the population on the government offered standardized health care plan, which covers a variety of health care needs across the board. The remaining 15% of the population has opted for private health insurance options, which provide unique niche benefits for specific groups. This system has been highly effective and affordable in providing health care to German citizens.

Developing Nations

With fewer resources, developing nations struggle to compete provide the same access to health care as do developed nations.

China is an interesting case study. China has a great deal of variance in quality and accessibility, with hospital wait times for the poor (depending on severity) taking many hours (sometimes days) compared to the rich, who are admitted immediately. Transitioning towards a system that provides care to the rich and the poor alike is the primary challenge in these developing regions.

35.1.4: Externalities in the Health Care Market

Learning Objective

Describe externalities in the healthcare market

Key Points

• An externality is any impact, be it positive or negative, on individuals or groups not involved in a given economic transaction.
• Negative externalities include tax costs, infectious disease, anti-biotic resistance and environmental degradation. The negative components impact others despite their participation in the system.
• Positive externalities include increases in wealth due to increased health, vaccinations to limit disease exposures and increases in technology and knowledge.
• Positive externalities include increases in wealth due to increased health, vaccinations to limit disease exposures and increases in technology and knowledge.

Key Terms

externality

An impact, positive or negative, on any party not involved in a given economic transaction or act.

Vaccinations

Inoculation with a vaccine in order to protect a particular disease or strain of disease

Defining Externalities

An externality is any impact, be it positive or negative, on individuals or groups not involved in a given economic transaction . That is to say, an externality is something that affects other people outside of the particular parties involved in an exchange.

Externalities

The basic premise of an externality is captured in this diagram, where external factors affect the internal economic system for a product or service.

A classic example of externalities is the automobile. Cars consistently produce air pollution whenever they are driven, slowly eroding the health of our ecosystem. This cost is shouldered not only by the driver of the vehicle, but also by every living thing on the planet. This is an example of parties not involved in the transaction (selling or buying the vehicle) being impacted, in this case negatively.

Health Care Externalities

In health care, the critical externality in most systems is the care provided to others. You benefit from others being healthy because it reduces the likelihood of you catching their illness (assuming it’s contagious). You benefit from a positive externality of others receiving health care.

Your health care costs are also affected by others choosing to purchase health care. The healthy pay more to the insurance company than they receive in treatment, while the opposite is true for the sick. Insurance fundamentally operates by taking the money from healthy people to pay for the procedures required by sick people.

Taxpayers should also be concerned with the state of the healthcare system not only because they pay for Medicare and Medicaid, but also because healthcare is a huge part of the US economy. In 2011, the US spent 17.2% of GDP on healthcare, more than any other country. Reducing the cost of health care can clearly increase the amount that the US can consume or invest.

Other negative externalities include:

• Infectious Disease: One of the largest reasons why health care is so critical is the fact that disease are infectious. Untreated disease will result higher population vulnerability to that disease due to increased exposure.
• Environmental Degradation:Health care produces a great deal of chemical waste, requires a great deal of emissions (ambulances, etc.) and alters the natural ecological environment of bacteria.
• Antibiotic Resistance: An interesting byproduct of the newer solutions to medical dilemmas is the slowly growing resistance of antibiotics in bacteria. Due to the way in which the health care industry has been operating, bacteria are dramatically altering to resist our solutions.

Positive externalities include:

• Health Affects Wealth: Healthy workers are absent from work less and are more productive workers. A health care market that effectively helps workers can lead to positive economic gains.
• Technology and Information: The study of health care, and the research involved in generating new solutions, has dramatically increased the knowledge and technological capacity of society in general. This has affected other industries, as research and development in health care affects the technological efficacy in other markets.
• Vaccinations: An interesting new development in health care is the advent of vaccines. Vaccination results in herd immunity, or essentially the fact that many individuals will become immune and thus reduce the likelihood that everyone in the population will contract certain diseases.

35.1.5: Current Issues in Health Care

Learning Objective

Explain the main parts of the Affordable Care Act and the current American healthcare system

Key Points

• U.S. citizens pay substantially more per capita for health care than do residents of other countries, and many people lack access to affordable health care.
• Patients have procedures performed by doctors, by the actual exchange of money occurs between the patient’s insurance provider and the doctor’s employer.
• The Affordable Care Act addresses issues like pre-existing conditions, anti-trust, unfair rates based on gender, universal standards and a range of other considerations.
• Many individuals believe that this new legislation will increase costs for small businesses, and will motivate ‘freeloaders’, or individuals who take government handouts.

Key Terms

Affordable Care Act

The ACA was enacted with the goals of increasing the quality and affordability of health insurance.

Pre-existing Conditions

A pre-existing condition is a risk with extant causes that is not readily compensated by standard, affordable insurance premiums.

Current issues in the U.S. health care system largely revolve around the significant policy changes imposed by the Affordable Care Act (ACA, or Obamacare), which attempts to provide health insurance coverage for all citizens. This legislation was designed to respond to many flaws in the current U.S. system of healthcare. It is also important to understand the criticisms of this change, as many voters in the U.S. disagree with proposed changes to the system.

U.S. House Votes for the Affordable Health Care Act

This map outlines the voting distribution in 2009 when the Affordable Health Care Act was brought to the floor.

U.S. Health Care Currently

The U.S., despite having some of the greatest technological advances and medical professionals, has consistently struggled to provide affordable, effective health care to everyone. The costs alone, on a per capita basis, underline the way in which the U.S. system has struggled to meet international standards in providing affordable care. illustrates the costs incurred by each individual in the system based on a country to country comparison. As it illustrates, consumers in the U.S. are faced with much higher (and growing) costs than international counterparts.

Health Costs Per Capita

This chart illustrates the costs incurred by each individual in the system based on a country to country comparison. As is demonstrated, consumers in the U.S. are faced with much higher costs (and consistently growing higher) than international counterparts.

Most Americans with private health insurance have it provided by their employers. There are also social welfare programs such as Medicaid and Medicare. The insurers negotiate rates with hospitals for different procedures. Patients then go into the hospital and get procedures recommended by doctors. The doctors are then paid by hospitals. This is a classic case of moral hazard: the two parties deciding for the transaction to occur- patients and doctors- are not the same two exchanging money.

Healthcare has a demand curve that fluctuates wildly based upon the extent of the issue – consumers who are facing serious health problems will likely demand healthcare at almost any price, allowing medical providers to take advantage of the inelastic demand. Further issues include the fact that doctors represent a third party (recommending drugs and procedures) and that insurance companies have the power to deny coverage to individuals who need it most.

The Affordable Health Care Act

In December of 2009, the Senate passing a bill called Patient Protection and Affordable Care Act. The Affordable Care Act is a complex piece of legislation, but a number of bullets from the bill are highly useful to understand:

• Pre-existing Conditions: Individuals with pre-existing conditions are much more likely to be expensive clients, and thus are not profitable to insure. This results in insurers refusing to insure these patients. The Affordable Care Act addresses this through legislation, saying providers cannot refuse coverage.
• Changing Insurance Rates: As a complement to the analysis above, insurance agencies also cannot alter rates based on pre-existing conditions or gender. This levels the playing field for the consumer, who historically had limited buyer power.
• Antitrust: Previously, insurance companies were immune to antitrust laws. This means they could generate monopolies geographically and exploit consumers. This immunity has been repealed.
• Standards: Obamacare also closes loopholes regarding to quality standards, ensuring that insurance providers do not reduce what is provided to clients in an effort to cut costs.
• Healthcare.gov: This is a way to enable consumers in finding health care insurers in a way that promotes capitalistic competition between providers. Previously, discussing pricing and plans with insurers was highly complex for many individuals (designed for businesses, not individual consumers).
• Medicaid and Medicare: Overall, medicare has been reduced while medicaid has been expanded. Medicare spending has been increasing dramatically. This has been cut by $400 billion, which is a source of discontent for many individuals. Medicaid has been expanded to 133% of the poverty level, covering more people.

Criticisms

The ACA will only work if both healthy and sick people alike buy insurance: if the healthy choose to pay the fine for not having insurance and only the sick buy insurance, then costs will increase. There is also a political critique of the ACA. Some feel that the government should not mandate that private citizens purchase insurance in the first place. They feel that the government is overstepping its bounds.

Many individuals also believe that this new legislation will increase costs for small businesses that are now required to buy insurance for their employees, and will motivate ‘freeloaders’, or individuals who take government handouts. Overall, while the goal is to enable more people to health care more affordably, many people believe this new approach will do not accomplish that.

34.1: Interest

34.1.1: Defining Capital

Learning Objective

Define and explain capital.

Key Points

• Fundamentally, capital is any product that is produced and has the ability to enhance the power of an individual to perform economically useful work.
• Capital is directly impacted by both interest and profit. Interest allows capital to be obtained, while profit is the accumulation of the capital.
• Features that determine whether a good is capital include: 1) the good can be used in the production of other goods (this makes it a factor of production), 2) the good is not used up immediately in the process of production, unlike intermediate goods or raw materials, and 3) the good was produced.
• Types of capital include: physical, financial, natural, social, instructional, and human.
• Types of capital include: physical, financial, natural, social, instructional, and human.

Key Terms

capital

Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).

depreciate

To reduce in value over time.

Capital

In economics, capital (also referred to as capital goods, real capital, or capital assets) references non-financial assets used in the production of goods and services. Capital is important because it is a significant factor in the creation of wealth.

Capital goods are used in the production process and may depreciated through accounting practice to incorporate utilization, though they are not consumed. It is possible for capital goods to be maintained or regenerated depending on the type of capital.

Classifications of Capital

In a broad sense, capital can be divided into two categories:

• Physical Capital: capital that must be produced by human labor before it can become a factor of production (also referred to as manufactured capital). Examples include machinery and buildings .
• Natural Capital: a factor of production that occurs naturally in the environment; for example, land or minerals.

Fundamentally, capital is any product that is produced and has the ability to enhance a person’s power to perform work that is economically useful. For example, roads are capital for individuals who live in a city.

Capital is directly impacted by both interest and profit. Interest is a fee that is paid by a borrower of assets. It is a form of compensation for the use of the assets. Commonly, it is the price that is paid for the use of borrowed money. Profit is the accumulation of capital, which is the driving force behind economic activity. Interest allows capital to be obtained, while profit is the accumulation of the capital.

Features of Capital

There are certain features that determine whether a good is considered capital. These features include:

1. the good can be used in the production of other goods (this makes it a factor of production),
2. the good is not used up immediately in the process of production, unlike intermediate goods or raw materials, and
3. the good was produced.

Modern Types of Capital

There are detailed classifications of capital which include the following types:

• Financial Capital is capital that is liquidated as money for trade, and owned by legal entities. It is a form of capital assets that is traded in financial markets. The value of financial capital is based on the market perception of expected revenues and risk.
• Natural Capital is capital that occurs naturally in the environment and is protected because it supports human life. Examples of natural capital include land and water .
• Social Capital is capital that is captured as goodwill or brand value. It is the general concept of inter-relationships between humans have money-like value that motivates actions.
• Instructional Capital is capital that is defines as the aspect of teaching knowledge and transferring knowledge that is not inherent in individual or social relationships.
• Human Capital is capital that includes social, instructional, and individual human talent combined together. As a term, it is used to define balanced growth where the goal is to improve human capital and economic capital equally.

34.1.2: Interest Rates and Economic Rationale

Learning Objective

Define and explain the relationship between interest rates and economic rationale.

Key Points

• The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money borrowed from a lender (creditor).
• The interest rate guides economic rationale because it is a vital tool of monetary policy.
• The interest rate directly impacts economic choices such as spending, investment, and consumption.
• When interest rates decrease, investment and spending increase. When interest rates increase, investments decrease which causes the national income to fall.

Key Terms

interest rate

The percentage of an amount of money charged for its use per some period of time (often a year).

monetary policy

The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

inflation

An increase in the general level of prices or in the cost of living.

Economic Rationale

Rationale is defined as an explanation of the basis or fundamental reasons for something. In economics, rationale are the reasons or thought processes that impact economic decisions. The interest rate is one of the primary influences on economic rationale.

Interest Rate

The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money borrowed from a lender (creditor). It is the percent of principal paid a certain amount of times per period.

Impact of the Interest Rate

The interest rate guides economic rationale because it is a vital tool of monetary policy. The interest rate is taken into account when dealing with economic variables such as investment, inflation, and unemployment. Central banks usually reduce the interest rate to increase investment and consumption in the country’s economy. The interest rate directly impacts economic choices such as spending, investment, and consumption .

Interest Rates

This graph shows the fluctuation in interest rates in Germany from 1967 to 2003. The interest rates reached 14% in 1969 and lowered to 2% by 2003. The interest rate in an economy directly impacts economic choices including spending, investment, and consumption.

Interest rates also influence inflationary expectations. People form an expectation of what will happen to inflation in the future. The current and projected interest rates are influential in these economic expectations. Investments are made based on the nominal interest rate and the degree of risk involved. Low interest rates are enticing, but can be problematic if an economic bubble forms. For example, low interest rates can lead to large amounts of investments poured into the real-estate market and stock market. When these bubbles pop, the investments fail, resulting in large unpaid debts and financial bankruptcy for individuals and banking institutions.

When interest rates increase, investments decrease, which causes the national income to fall. High interest rates do encourage more savings, which over time leads to more investment and higher levels of employment to meet production needs. Higher rates discourage economically unproductive lending such as consumer credit and mortgage lending.

The interest rate also directly impacts money and inflation because the government can affect the markets and alter the total of loans, bonds, and shares that are issued. When the interest rate is lower, it usually increases the broad supply of money. An increase in the money supply leads to inflation.

33.1: Fundamentals of Banking Crises

33.1.1: Causes of Banking Crises

Learning Objective

Describe some common causes of a banking crisis, Explain a bank run

Key Points

• A bank occurs when many people try to withdraw their deposits at the same time. As much of the capital in a bank is tied up in investments, the bank’s liquidity will sometimes fail to meet the consumer demand.
• Due to the mass interdependence of economies across the globe, a banking crisis in one nation is likely to dramatically affect other international economies.
• The Great Depression in 1929 resulted from a variety of complex inputs, but the turning point came in the form of a mass stock market crash (Black Tuesday) and subsequent bank runs.
• Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure to listen to economists predicting this over the past decade, caused the 2008 stock market crash and subsequent depression.
• Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure to listen to economists predicting this over the past decade, caused the 2008 stock market crash and subsequent depression.

Key Terms

Bank Run

A large number of customers withdraw their deposits from a financial institution at the same time due to a loss of confidence in the banks.

leverage

The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return, but usually at high risk.

In light of recent market and banking failures, the economic analysis of banking crises both historically and presently is a constant source of interest and speculation. Banking crises are when there are widespread bank runs: an abnormal number depositors try to withdraw their deposits because they don’t trust that the bank will have the deposits for withdrawal in the future.

Banking crises are not a new economic phenomenon, and similarly are not the only source of financial crises. Over the course of the past two centuries there have been a surprisingly large number of financial crises, as demonstrated in the attached figure . In understanding banking crises over time, it is useful to identify the causes in context with historic examples of banking collapses.

Financial Crises Globally since 1800

This chart is an interesting take on the relatively consistent frequency in which financial crises occur across the globe. It is interesting to note both the efficacy of Bretton Woods alongside the increasing risk of financial collapse in modern times.

Causes of Banking Crises

Banks can fail for several different reasons:

• Bank Run: A bank occurs when many people try to withdraw their deposits at the same time. As much of the capital in a bank is tied up in investments, the bank’s liquidity will sometimes fail to meet the consumer demand. This can quickly induce panic in the public, driving up withdrawals as everyone tries to get their money back from a system that they are increasingly skeptical of. This leads to a bank panic which can result in a systemic banking crisis, which simply means that all of the free capital in the banking system is withdrawn.
• Stock Market Positive Feedback Loops: One particularly interesting cause of banking disasters is a similar positive feedback loop effect in the stock markets, which was a much more dynamic factor in more recent banking crises (i.e. 2007-2009 sub-prime mortgage disaster). John Maynard Keynes once compared financial markets to a beauty contest, where investors are merely trying to pick what is attractive to other investors. There is a profound truth to this, creating an interdependent and potentially self-fulfilling investment thought process. This can create dramatic rises and falls (bubbles and crashes), which in turn can throw banks with poorly designed leverage into huge losses.
• Regulatory Failure: One of the simplest ways in which bank crises can occur is a lack of governmental oversight. As noted above, banks often leverage themselves to capture gains despite extremely high risks (such as over-dependence on derivatives).
• Contagion: Due to globalization and international interdependence, the failure of one economy can create something of a domino effect. In 2008, when the U.S. economy collapses, the reduced buying power and economic output from that economy dramatically damaged all economies dependent upon it (which includes most of the world). This is called contagion.

The Great Depression

The Great Depression highlights how bank runs caused a banking crisis, which ultimately became a global economic crisis.The Great Depression in 1929 resulted from a variety of complex inputs, but the turning point came in the form of a mass stock market crash (Black Tuesday) and subsequent bank runs. As fear began to grip consumers across the United States, people became protective of their assets (including their cash). This caused a large number of people to the banks to withdraw, which in turn motivated others to go to the banks and get their capital out also. Since banks lend out some of their deposits, they did not have enough cash on hand to meet the immediate withdrawal requests (they became illiquid) and therefore went bankrupt. Within a few weeks this resulted in a systemic banking crisis (see ).

1929 Stock Market Crash

As the market falls, investors create a positive feedback loop and self-fulfilling prophecy due to a lack of confidence that drives it down even further.

33.1.2: Consequences of Banking Crises

Learning Objective

Explain consequences of banking crises on the broader economy

Key Points

• Banks play a critical role in economic growth, primarily through investment and lending.
• After a banking crisis, investment suffers. When banks lack liquidity to invest, growing business depending upon loans struggle to raise the capital required to execute upon their operations.
• The fall in liquidity and investment, in turn, drives up unemployment, drives down governmental tax revenues and reduces investor and consumer confidence.
• Imports and exports play an increasingly large role in the health of most developed economies, and as a result, the relative well-being of trade partners plays an increasingly critical role in the success of domestic economies.

Key Terms

liquidity

The degree to which an asset can be easily converted into cash.

Economic crisis

A period of economic slowdown characterised by declining productivity and devaluing of financial institutions often due to reckless and unsustainable money lending.

Banking crises have a dramatic negative effect on the overall economy, often resulting in an eventual financial and economic crisis in a given economic system. Banking crises have a range of short-term and long-term repercussions, domestically and globally, that underline the severe repercussions of irresponsible banking practices, poor governmental regulation, and bank runs. The most useful way to frame the consequences of bank crises is by observing the critical role banks play in economic growth, primarily through investment and lending.

Domestic Consequences

Within a given system, banking failures create a range of negative repercussions from an economic perspective. Banks coordinate and economy’s savings and investment: the act of pooling money to capture higher returns for everyone while simultaneously funding business dependent upon leveraging debt and equity. With this in mind, a banking crises can have a variety of averse individual and economic consequences within the system.

First and foremost, investment suffers. When banks lack liquidity to invest, businesses that depend upon loans struggle to raise the capital required to execute upon their operations. When these businesses cannot produce the capital required to operate optimally, sales decline and prices rise. The overall economic performance of any debt-dependent industries becomes less dependable, driving down consumer and investor confidence while reduce overall economic output. Banks also perform more poorly, due to the fact that they have less capital to invest and returns to acquire.

This drives down the overall economic system, both in the short term and the long term, as companies struggle to succeed. The fall in liquidity and investment drives up unemployment, drives down governmental tax revenues and reduces investor and consumer confidence (damaging equity markets, which in turn limits businesses access to capital). There is a distinctive cyclical nature to these adverse effects, as each are interconnected in a way that creates a domino effect across the domestic economic system.

Global Consequences

While these domestic consequences are expected and, in many ways, intuitive, the global dependency upon foreign trade in modern markets has exacerbated these effects. Imports and exports play an increasingly large role in the health of most developed economies, and as a result the relative well-being of trade partners plays an increasingly critical role in the success of domestic economies.

A good example of this is to look at the way in which the U.S. (and to some extent, European) banking disasters in 2008 and 2009 led to a complete global financial meltdown, destroying economies not involved in the irresponsible investing practices executed by banks in these specific regions. identifies the critical importance of economic well-being in trading partners, as the U.S. banking and financial crises spread rapidly (within the course of just one year) across a substantial portion of the globe (though there are certainly other factors that contributed to the financial crisis and its consequences). The domestic reduction of capital for businesses, income for consumers and tax revenue for governments ultimately results in a reduction of trade and economic activity for other economies.

2009 GDP Growth Rates

This figure shows the growth in GDP for world economies in 2009. The slow and negative growth demonstrates all of the economic losses that resulted in part from the U.S. financial crisis, highlighting the dependency of global economies.

33.2: The 2007-2009 Crisis

33.2.1: Causes and Immediate Impacts of the Crisis

Banks, consumers, and the government all contributed to improper borrowing and lending, which in turn created a downward spiraling economy.

Learning Objective

Summarize the causes that led to the 2007 banking crisis

Key Points

• The recent financial crisis, commonly referred to as the sub-prime mortgage crisis of 2007-2008, began with the failure of a series of derivative-based consolidation of mortgage-backed securities that encapsulated extremely high risk loans to home-owners into a falsely ‘safe’ investment.
• Banks offered loans to debtors that couldn’t afford them, and then bundles these debt instruments and sold them.
• The banking crisis spread into a broader financial crisis as companies were negatively affected by the crisis in financial institutions to which they were connected.
• The government did not regulate the housing market at all, as a result of the elimination of two critical clauses: verification of income and a 20% down payment.
• The U.S. stock market, realizing the scale of errors of the banks, lost all investment confidence. This cut the NYSE in half, drastically reducing the value of the U.S. economy.

Key Terms

CDO

A type of asset-backed security and structured credit product constructed from a portfolio of fixed-income assets.

Sub-prime

Designating a loan (typically at a greater than usual rate of interest) offered to a borrower who is not qualified for other loans (e.g. because of poor credit history).

The recent financial crisis, commonly referred to as the sub-prime mortgage crisis of 2007-2008, was borne of the failure of a series of derivative-based consolidation of mortgage-backed securities that encapsulated extremely high risk loans to homeowners into a falsely ‘safe’ investment. To simplify this, banks pushed mortgages on prospective home owners who could not afford to repay them. Then they combined and packaged varying mortgage-backed securities based off of these loans and sold them as highly dependable and safe investments, either through a lack of due diligence (negligence) or lack of ethical consideration. This created an economic meltdown, starting with the United States, that spread across the global markets.

The inherent complexity of the causes and dramatic repercussions (most of which are still ongoing) require a great deal of context. It is a fiercely debated and widely discussed issue in the field of economics (and in mainstream media), providing a real-life case study for many of the critical concepts of economic theory.

How Did This Happen?

The inputs to the 2007-2008 economic collapse, briefly touched upon above, are complex and still evolving. That being said, there are a few key talking points from an economic perspective that should be discussed. A useful perspective to take is the various stakeholders and their contributions :

Inputs to the Mortgage Crisis

This graph outlines two of the three parties in the collapse (excludes government), as the banks and the buyers both took on ridiculous amounts of risk.

• Banks: Simply put, the banks made two critical errors. First, they lent money to people who could not pay it back (to buy homes). They pursued what is referred to as ‘predatory lending,’ or lending to individuals they knew could never pay it back. Secondly, banks knowingly grouped these loans into bundles called collateralized debt obligations (CDOs) and sold them as extremely safe derivative investments. They were not safe.
• Consumers: Consumers played their role as well, acting as easy prey for the banks predatory practices. Individuals bought homes they could not afford utilizing loans they could not pay back. This drove them into debt, to the extent at which they had to default. This meant that the capital banks expected to get back did not arrive, it simply was not there.
• Government: The government did not regulate the housing market, as a result of the elimination of two critical legal clauses that required the verification of income and a 20% down payment. In short, the U.S. government used to ensure that prospective home buyers could put down 20% of the their borrowing in addition to verify that their income could cover their mortgage payments. Without such verification, it became easier for people to get mortgages they could not afford.

Combining these factors, the problem largely revolved around irresponsible lending and borrowing which was then turned into derivatives that were labeled safe despite their massive risks. This resulted in an economic realization of loans that could not be repaid, which spread through the banking system and turned into large scale obligations that could not be met.

Economic Impact

What happened next is well captured in the . In short, the banks eventually failed due to their investments. In order to prevent the entire financial system from collapsing, some of the banks (and other financial institutions) were bailed out.

2008 Crisis Flow Chart

This chart embodies critical checkpoints in the economic decline reactions to poor mortgage management by the banks. Understanding the implications of each point on this diagram will greatly enhance the larger understanding of the short term effects of this economic collapse.

Of course the negative effects did not stop there. The U.S. stock market lost confidence in financial institutions and some of the companies connected to them and subsequently crashed. The NYSE fell by half, drastically reducing the value of the U.S. economy. This was then telegraphed into a loss of consumer confidence and business access to investment. Within a few months, there were job cuts, bankruptcies, and reduced spending, as the crisis spread throughout the economy (both domestically and globally).

33.2.2: Recovery

The objective of economic recovery when in crisis is to stabilize the economy and recapture the value lost using economic stimulus strategies.

Learning Objective

Discuss the characteristics of the recovery from the 2007 crisis

Key Points

• One of the key components to the crisis recovery in the United States is an act called the American Recovery and Reinvestment Act of 2009 (ARRA). It invests money in the economy to drive spending and recovery.
• ARRA is largely based on the Keynesian macro-environmental concept of driving spending through enabling spending, in turn driving up demand, creating jobs, and driving spending up further.
• The Troubled Asset Relief Program (TARP) was another recovery strategy, buying toxic assets off the banks to prevent them from failing.
• TARP was criticized for protecting banks who behaved unethically and with a lack of strategic intelligence as businesses, essentially implying that they should have failed.
• While the stock market has recovered and the banks are in better shape now than before the collapse, the average American is still less likely to have a job or to be underemployed.

Key Terms

Economic crises

A period of economic slowdown characterized by declining productivity and devaluing of financial institutions often due to reckless and unsustainable money lending.

stimulus

Anything that may have an impact or influence on a system. In 2009, it is the monetary investments in the economy to recover from the collapse.

The 2007-2009 economic crisis has had far-reaching and profound effects on both the domestic and global markets, primarily as a result of the sub-prime mortgage disaster originating in the United States. Addressing these economic ramifications to induce recovery has been the focal point of global governments and global agencies such as the International Monetary Fund (IMF). The objective of economic recovery when in crisis is to stabilize the economy, and from there recapture the value lost through economic stimulus strategies while addressing the factors which contributed to the collapse in the first place.

Stimulus Package

One of the key components to the crisis recover in the United States is an act called the American Recovery and Reinvestment Act of 2009 (ARRA), put into place by the Obama administration just as the first days of his term were beginning. This act has seen substantial debate, both positively and negatively, as to the efficacy and overall implementation of the program. Understanding the inputs, and expected outcomes, is critical to understanding the economics behind reacting to economic crises (particularly from a Keynesian perspective).

The stimulus package can be broken down via the attached figure in regards to monetary investment in specific places , totaling $831 billion (USD) between 2009 and 2019. The goal of investing or providing tax relief and subsidies for individuals and companies is to drive up purchasing behavior and offset the positive feedback loop attributed to economic crises. This is largely based on the Keynesian concept of driving spending through enabling spending, in turn driving up demand, creating jobs, and driving spending up further. President Obama’s administration was criticized by classical economists for employing this as well as Keynesian economists (such as Paul Krugman) for not employing it enough. That being said, the efficacy in the attached figure demonstrates that it was likely a strategic reaction to the economic crisis .

ARRA Efficacy Projections

This graph points out the economic opportunity cost of not utilizing the ARRA, which would likely have left the U.S. (and subsequently, the global) economy in significantly worse shape than it is now.

Stimulus Investments (U.S.) of ARRA

This graphic demonstrates the different silos receiving government aid within the domestic economy, as a direct result of the American Recover and Reinvestment Act (ARRA).

Troubled Asset Relief Program (TARP)

Perhaps more debatable still, is the reaction to the inevitable and deserved bankruptcy of the banks and insurers involved in the toxic mortgage-backed securities (i.e. CDO’s) that drove the economy into disaster were bailed out by the government. These companies, such as AIG, Bank of America, Citigroup, and other distributors of toxic investments were handed the required capital by the government to offset their massive losses due to undue risk and poor leveraging. This was in the form of the government utilizing tax money to purchase these securities, removing the toxic assets from the books of the companies involved (who were deemed ‘too big to fail’). This move saved the economic decline and restored consumer confidence through direct government intervention.

TARP was also largely criticized, with a high number of seemingly reasonable objections. The first, and most intuitive, is that these businesses deserved to go under. Bad business practice, poor investment, and grossly unethical behavior deserves bankruptcy. Instead, the government demonstrated that, as long as certain fiscal influence is achieved, these competitive rules are negligible. Secondly, and slightly more complex, is the implementation of the TARP act (which necessitated SIG-TARP, an oversight group ensuring that TARP money went out to those who it was intended for). It was noted on many occasions that TARP money was ill-used.

Outcomes

While the long-term outcomes of these practices cannot yet be predicted, the progress made so far is worth analyzing economically. First and foremost, job numbers have improved, although not as much as had been hoped or expected (see ). While this is positive, it does not capture the large number of people who are underemployed or the individuals who have abandoned the search for employment. GDP growth has inched along to positive numbers, as has the profitability of many businesses and industries. Interestingly enough, as of the end of 2013, the stock market has not only recovered but expanded beyond 2007 levels.

U.S. Job Gains and Losses

This graph demonstrates the negative affect that the collapse had on jobs as well as the pacing of economic recovery in the short-term.

33.2.3: Global Impacts

The 2007-2009 economic collapse was damaging not only to the U.S. but also global markets, driving the global economy into recession.

Learning Objective

Analyze the extent to which the 2007 crisis was global

Key Points

• Modern markets are dependent upon one another across national borders, where global trends in economic growth and well-being will have a dramatic impact on national economic well-being and vice versa.
• In December 2007, the U.S. officially fell into an 18-month long recessionary period of negative GDP growth, which This spread rapidly around the map to create a global recession in Q3 and Q4 in 2008 and Q1 of 2009.
• Another indirect global impact that occurred as a result of the economic collapse was political instability, primarily due to the inability of developed nations to pursue altruistic investments and global poverty reduction processes during recessionary times.
• On the upside, many global organizations and countries are actively employing policies to minimize the likelihood of a re-occurrence in the future.

Key Term

recession

A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, and industrial production.

Modern markets are dependent upon one another across national borders, where global trends in economic growth and well-being will have a dramatic impact on national economic well-being and vice versa. As a result, the 2007-2009 economic collapse had large effects not only at the origin (in the United States), but also on a global scale. The speed in which the market decline spread across the globe underlines just how far globalization and international interdependence has come, with GDP growth numbers in 2009 already demonstrating substantial losses across the map (see ).

2009 Global GDP Growth and Decline)

As this map illustrates, many international markets fell rapidly into decline as a direct result of the U.S. sub-prime mortgage disaster.

Recession: Domestic to Global

In December 2007, the U.S. officially fell into an 18-month long recessionary period of negative GDP growth (over two consecutive quarters). This recessionary period spread rapidly around the map, creating a global recession in Q3 and Q4 in 2008 and Q1 of 2009 (defined as a contraction in global GDP growth during that time) as is represented in this figure . To provide additional context to the global adverse effects of the sub-prime mortgage crisis, of 65 countries that record and report GDP only 11 escaped a recessionary period between 2006 and today.

World GDP Growth

It is quite clear in this graphic, the global GDP growth dropped dramatically following the U.S. crisis, pitching the entire global economy into a recession.

Even countries where double-digit economic growth had been a consistent trend going into 2008, such as China, began to experience growth reductions due to reduced consumer purchasing power on a global scale. China has seen reductions towards the 7%-8% economic GDP growth (year on year), from clear double-digits in previous years.

Political Instability

Another indirect global impact that occurred as a result of the economic collapse is political instability, primarily due to the inability of developed nations to pursue social welfare investments and global poverty reduction processes during recessionary times. Indeed, these instabilities are not only isolated to developing nations. Countries in the EU, such as Greece, Spain and Italy, have seen dramatic GDP decreases and unemployment numbers reaching or exceeding 20% in some cases. This instability has placed a great deal of pressure on government officials to solve these huge economic problems in the short-term. The United States has also seen an incredible reduction in governmental efficacy with the least effective house of representatives for nearly a century alongside dramatic polarization of public opinion towards left-wing and right-wing ideas.

Global Responses

Positively, many global organizations and countries are actively employing policies to minimize the likelihood of a re-occurrence in the future. Reducing interest rates to drive up borrowing and investment, providing tax benefits to the unemployed and underemployed, and subsidizing new business have created positive steps towards meaningful recovery globally.

There have also been a series of banking and financial regulatory changes across the world.These global safety nets and prevention policies are setting the tone for future strategies to avoid economic crises and minimize the prospective damage that occurs as a result of these unethical practices.

32.1: Capital Flows

32.1.1: The Balance of Payments

Learning Objective

Explain the components and importance of the balance of payments

Key Points

• Whenever a country receives funds from a foreign source, a credit is recorded on the balance of payments. Whenever a country has an outflow of funds, it is recorded as a debit on the balance of payments.
• When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit.
• BOP=Current Account+Financial Account+Capital Account+Balancing Item.
• The current account records the flow of income from one country to another.
• The financial account records the flow of assets from one country to another.
• The capital account is typically much smaller than the other two and includes miscellaneous transfers that do not affect national income.

Key Term

balance of payments

A record of all monetary transactions between a country and the rest of the world

The balance of payments (BOP) is a record of all monetary transactions between a country and the rest of the world. This includes payments for the country’s exports and imports, the sale and purchase of assets, and financial transfers. The BOP is given for a specific period of time (usually a year) and in terms of the domestic currency.

Whenever a country receives funds from a foreign source, a credit is recorded on the balance of payments. Sources of funds include exports, the receipt of loans or investment, and income from foreign assets. Whenever a country has an outflow of funds, such as when the country imports goods and services or when it invests in foreign assets, it is recorded as a debit on the balance of payments.

When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned from its foreign investments, by running down central bank reserves, or by receiving loans from other countries .

U.S. Current Account

The chart shows the current account deficit of the U.S., both in dollars and as a percent of GDP. Deficits in the current account must be offset by surpluses in the financial and capital accounts.

Components of the Balance of Payments

The BOP can be expressed as:

The current account records the flow of income from one country to another. It includes the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors), and cash transfers.

The financial account records the flow of assets from one country to another. It is composed of foreign direct investment, portfolio investment, other investment, and reserve account flows.

The capital account is typically much smaller than the other two and includes miscellaneous transfers that do not affect national income. Debt forgiveness would affect the capital account, as would the purchase of non-financial and non-produced assets such as the rights to natural resources or patents.

The balancing item is simply an amount that accounts for any statistical errors and ensures that the total balance of payments is zero.

32.1.2: The Current Account

Learning Objective

Calculate the current account

Key Points

• The balance of trade is the difference between a nation’s exports of goods and services and its imports of goods and services. A nation has a trade deficit if its imports exceeds its exports.
• The net factor income records a country’s inflow of income and outflow of payments. Income refers not only to the money received from investments made abroad but also to remittances.
• Cash transfers take place when a certain foreign country simply provides currency to another country with nothing received as a return.
• A country’s current account can by calculated by the following formula: CA = (X-M)+NY+NCT.

Key Terms

credit

An addition to certain accounts.

balance of trade

The difference between the monetary value of exports and imports in an economy over a certain period of time.

debit

A sum of money taken out of an account.

The current account represents the sum of the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors), and cash transfers. It is called the current account as it covers transactions in the “here and now” – those that don’t give rise to future claims.

The balance of trade is the difference between a nation’s exports of goods and services and its imports of goods and services. A nation has a trade deficit if its imports exceed its exports. Because the trade balance is typically the largest component of the current account, a current account surplus is usually associated with positive net exports. This, however, is not always the case. Secluded economies like Australia are more likely to feature income deficits larger than their trade surplus.

The net factor income records a country’s inflow of income and outflow of payments. Income refers not only to the money received from investments made abroad (note: the investments themselves are recorded in the capital account but income from investments is recorded in the current account) but also to the money sent by individuals working abroad, known as remittances, to their families back home. If the income account is negative, the country is paying more than it is taking in interest, dividends, etc.

Cash transfers take place when a certain foreign country simply provides currency to another country with nothing received as a return. Typically, such transfers are done in the form of donations, aids, or official assistance.

Calculating the Current Account

Normally, the current account is calculated by adding up the 4 components of current account: goods, services, income and cash transfers.

Goods are traded by countries all over the world. When ownership of a good is transferred from a local country to a foreign country, this is called an export. When a good’s ownership is transferred from a foreign country to a local country, this is called an import. In calculating the current account, exports are marked as a credit (inflow of money) and imports are marked as a debit (outflow of money).

Services can also be traded by countries. This happens frequently in the case of tourism. When a tourist from a local country visits a foreign country, the local country is consuming the foreign services and this is counted as an import. Likewise, when a foreign tourist comes and enjoys the services of a local country, this is counted as an export. Other services can also be transferred between countries, such as when a financial adviser in one country assists clients in another.

A credit of income happens when a domestic individual or company receives money from a foreign individual or company. This would typically take place when a domestic investor receives dividends from an investment made in a foreign country, or when a worker abroad sends remittances back to the local country. Likewise, a debit in the income account takes place when a foreign entity receives money from an investment in the local economy.

Finally, a credit in the cash transfers column would be a gift of aid from a foreign country to the domestic country. Similarly, a debit in the cash transfers column might be the provision of official assistance by the local economy to a foreign economy.

Thus, a country’s current account can by calculated by the following formula:

CA = (X-M)+NY+NCT

Where CA is the current account, X and M and the export and import of goods and services respectively, NY is net income from abroad, and NCT is the net current transfers. When the sum of these four components is positive, the current account has a surplus.

Global Current Accounts

The map shows the per capita current accounts surpluses and deficits of countries around the world from 1980 to 2008. Deeper red implies a higher per capita deficit, while deeper green implies a higher per capita surplus.

32.1.3: The Financial Account

Learning Objective

Calculate the financial account

Key Points

• A financial account surplus means that buyers in the rest of the world are purchasing more of a country’s assets than buyers in the domestic economy are spending on rest-of-world assets.
• The financial account has four components: foreign direct investment, portfolio investment, other investment, and reserve account flows.
• Foreign direct investment (FDI) refers to long term capital investment such as the purchase or construction of machinery, buildings, or even whole manufacturing plants.
• Portfolio investment refers to the purchase of shares and bonds.
• Other investment includes capital flows into bank accounts or provided as loans.
• The reserve account is operated by a nation’s central bank to buy and sell foreign currencies.

Key Terms

interest rate

The percentage of an amount of money charged for its use per some period of time (often a year).

central bank

The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.

The financial account (also known as the capital account under some balance of payments systems) measures the net change in ownership of national assets. When financial account has a positive balance, we say that there is a financial account surplus. A financial account surplus means that the net ownership of a country’s assets is flowing out of a country – that is, foreign buyers are purchasing more domestic assets than domestic buyers are purchasing of assets from the rest of the world. Likewise, we say that there is a financial account deficit when the financial account has a negative balance. This occurs when domestic buyers are purchasing more foreign assets than foreign buyers are purchasing of domestic assets. For example, a financial accounts deficit would exist when County A’s citizens buy $200 million worth of real estate overseas, while overseas investors purchase only $100 million worth of real estate within Country A.

Calculating the Financial Account

The financial account has four components: foreign direct investment, portfolio investment, other investment, and reserve account flows.

Foreign direct investment (FDI) refers to long term capital investment such as the purchase or construction of machinery, buildings, or even whole manufacturing plants. If foreigners are investing in a country, that is an inbound flow and counts as a surplus item on the financial account. If a nation’s citizens are investing in foreign countries, there is an outbound flow that will count as a deficit. After the initial investment, any yearly profits not re-invested will flow in the opposite direction, but will be recorded in the current account rather than the financial account .

FDI in Austria

Austria has experienced a surplus of foreign direct investment: more foreign investors invest in Austria than Austrian investors do in the rest of the world. This contributes to a financial account surplus.

Portfolio investment refers to the purchase of shares and bonds. It is sometimes grouped together with “other” as short term investment. As with FDI, the income derived from these assets is recorded in the current account; the financial account entry will just be for any buying or selling of the portfolio assets in the international financial markets.

Other investment includes capital flows into bank accounts or provided as loans. Large short term flows between accounts in different nations are commonly seen when the market is able to take advantage of fluctuations in interest rates and/or the exchange rate between currencies. Sometimes this category can include the reserve account.

The reserve account is operated by a nation’s central bank to buy and sell foreign currencies; it can be a source of large capital flows to counteract those originating from the market. Inbound capital flows (from sales of the account’s foreign currency), especially when combined with a current account surplus, can cause a rise in value (appreciation) of a nation’s currency, while outbound flows can cause a fall in value (depreciation). If a government (or, if authorized to operate independently in this area, the central bank itself) does not consider the market-driven change to its currency value to be in the nation’s best interests, it can intervene. Such intervention affects the financial account. Purchases of foreign currencies, for example, will increase the deficit and vis versa.

To calculate the total surplus or deficit in the financial account, sum the net change in FDI, portfolio investment, other investment, and the reserve account.

Interest Rates and the Financial Account

The outflow or inflow of assets in the financial account depends in large part on the domestic interest rate and how it compares to interest rates in other countries. A higher central bank interest rate will tend to increase the interest rate on all domestic financial assets, such as bonds, loans, and government securities. In general, if interest rates are higher in one country than another, an investor would prefer to purchase financial assets in the country with the higher interest rate.

An increase in the domestic interest rate will therefore cause foreign investors to purchase more domestic assets, creating a financial account surplus. Likewise, a fall in the domestic interest rate will cause domestic investors to purchase foreign assets in place of domestic assets, and will cause a financial account deficit.

32.1.4: The Capital Account

Learning Objective

Calculate the Capital Account

Key Points

• A deficit in the capital account means that money is flowing out of a country and the country is accumulating foreign assets.
• The capital account can be split into two categories: non-produced and non-financial assets, and capital transfers.
• Non-produced and non-financial assets include things like drilling rights, patents, and trademarks.
• Capital transfers include debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, and the transfer of ownership on fixed assets.

Key Term

debt forgiveness

The partial or total writing down of debt owed by individuals, corporations, or nations.

There are two common definitions of the capital account in economics. The first is a broad interpretation that reflects the net change in ownership of national assets. Under the International Monetary Fund (IMF) definition, however, most of these asset flows are captured in the financial account. Instead, the capital account acts as a sort of miscellaneous account, measuring non-produced and non-financial assets, as well as capital transfers. The capital account is normally much smaller than the financial and current accounts.

Like the financial account, a deficit in the capital account means that money is flowing out of a country and the country is accumulating foreign assets. Likewise, a surplus in the capital account means that a money is flowing into a country and the country is selling (or otherwise disposing of) non-produced, non-financial assets.

Calculating the Capital Account

The capital account can be split into two categories: non-produced and non-financial assets, and capital transfers. Non-produced and non-financial assets include things like drilling rights, patents, and trademarks. For example, if a domestic company acquires the rights to mineral resources in a foreign country, there is an outflow of money and the domestic country acquires an asset, creating a capital account deficit .

Natural Gas Rights

If a U.S. company sold its rights to drill for natural gas off the southern coast of the U.S., it would be recorded as a credit in the capital account.

Capital transfers include debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and uninsured damage to fixed asset. For example, if the domestic country forgives a loan made to a foreign country, this transfer creates a deficit in the capital account.

Thus, the balance of the capital account is calculated as the sum of the surpluses or deficits of net non-produced, non-financial assets, and net capital transfers.

32.1.5: Reason for a Zero Balance

Learning Objective

Discuss the long term equilibrium of a country’s balance of payments

Key Points

• Equilibrium in the foreign exchange market implies that the quantity of currency demanded = quantity of currency supplied .
• The quantity of a currency demanded is from two sources: exports and rest-of-world purchases of domestic assets. The quantity supplied of a currency is also from two sources: imports and domestic purchases of rest-of-world assets.
• Therefore, exports + (rest-of-world purchases of domestic assets) = imports + (domestic purchases or rest-of-world assets).
• Finally, this means that exports – imports = (domestic purchases of rest-of-world assets) – (rest-of-world purchases of domestic assets).
• In other words, the current account balances out the financial account and the balance of payments is zero.

Key Terms

foreign exchange

The changing of currency from one country for currency from another country.

net exports

The difference between the monetary value of exports and imports.

Capital Flows

Trade within a country differs in one important way from trade between countries: unless the two nations share a common currency, any trade requires that countries go through the foreign exchange market to trade currency, in addition to trading goods and services. For example, imagine that buyers in France purchase oranges produced in Chile. The French buyers use the euro in order to make the purchase but the Chilean orange producers must be paid with the Chilean peso. This exchange between France and Chile requires that the firms exchange euros for pesos.

In general, there are two reasons for demanding a country’s currency: to purchase assets within the country and to purchase a country’s exports – that is, the goods and services produced within that country. The country’s currency is supplied when it is used to purchase foreign currencies. This also happens for two reasons: to purchase assets in other countries and to import goods or services from other countries.

Imaging that we are analyzing Italy’s economy and its currency transactions with the rest of the world. If an American buyer wishes to purchase bonds issued by an Italian corporation, she becomes part of the world demand for euros to buy Italian assets. Adding the demand for exports to the demand for assets outside of a country, we get the total demand for a country’s currency.

Likewise, a country’s currency is supplied when it is used to purchase currencies in the rest of the world. Italian euros, for eample, are supplied when Italian consumers or firms import goods and services from the rest of the world. Italian euros are also supplied when Italian purchasers acquire assets from other countries.

Equilibrium and Zero Balance

When a country’s balance of payments is equal to zero, there is equilibrium in the market for that country’s currency. Equilibrium occurs when:

Quantity of currency demanded = quantity of currency supplied

We have already seen that the quantity of currency demanded is equal to the demand for exports and demand for domestic assets. The quantity of currency supplied is equal to the demand for imports and the domestic demand for foreign assets. Thus, we can rewrite the relationship:

Exports + (foreign purchases of domestic assets) = imports + (domestic purchases of foreign assets)

Finally, we can rearrange the above formula as:

Exports – imports = (domestic purchases of foreign assets) – (foreign purchases of domestic assets)

The left-hand term is net exports – the difference between the amount of goods and services a country exports and the amount that it imports. We refer to this difference as the current account. When a country exports more goods than it imports, this number is positive and we say that the country has a current accounts surplus. When a country imports more than it exports this number is negative and we say that the country has a current accounts deficit.

The right-hand term is the difference between the foreign assets that people within the country purchase and the domestic assets that are purchased by foreigners. This is called the financial account. These assets include the reserve account (the foreign exchange market operations of a nation’s central bank), along with loans and investments between the country and the rest of world (but not the future regular repayments/dividends that the loans and investments yield; those are earnings and will be recorded in the current account). The financial account is also sometimes used in a narrower sense that excludes the foreign exchange operation of the central bank. When a country buys more foreign assets that other countries buy of its assets, this balance is positive and there is a financial account surplus.

If the above equation holds true, then any current account surplus must be matched by a financial account deficit, and vice versa. This holds true when a country’s currency market is in equilibrium and there are no external currency controls.

Exchange Rates

Exchange rates are constantly fluctuating to ensure that the quantity of currency supplied equals the quantity demanded. Because of this, the inflows and outflows of money are equal, creating a balance of payments equal to zero.

32.2: Exchange Rates

32.2.1: Introducing Exchange Rates

In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another.

Learning Objective

Explain the concept of a foreign exchange market and an exchange rate

Key Points

• Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous.
• In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers.
• The foreign exchange rate is also regarded as the value of one country’s currency in terms of another currency.

Key Term

exchange rate

The amount of one currency that a person or institution defines as equivalent to another when either buying or selling it at any particular moment.

In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, or rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency . For example, an inter-bank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91.

Exchange Rates

In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers.

Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today, but for delivery and payment on a specific future date.

How the Foreign Exchange Market Works

In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer’s margin (or profit) in trading, or else the margin may be recovered in the form of a commission or in some other way.

Different rates may also be quoted for different kinds of exchanges, such as for cash (usually notes only), a documentary form (such as traveler’s checks), or electronic transfers (such as a credit card purchase). There is generally a higher exchange rate on documentary transactions (such as for traveler’s checks) due to the additional time and cost of clearing the document, while cash is available for resale immediately.

32.2.2: Finding an Equilibrium Exchange Rate

There are two methods to find the equilibrium exchange rate between currencies; the balance of payment method and the asset market model.

Learning Objective

Differentiate between the Balance of Payment and Asset Market Models

Key Points

• The balance of payment model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance.
• The balance of payments model focuses largely on tradeable goods and services, ignoring the increasing role of global capital flows.
• The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies. This includes financial assets.

Key Terms

depreciate

To reduce in value over time.

purchasing power parity

A theory of long-term equilibrium exchange rates based on relative price levels of two countries.

Countries have a vested interest in the exchange rate of their currency to their trading partner’s currency because it affects trade flows. When the domestic currency has a high value, its exports are expensive. This leads to a trade deficit, decreased production, and unemployment. If the currency’s value is low, imports can be too expensive though exports are expected to rise.

Purchasing Power Parity

Purchasing power parity is a way of determining the value of a product after adjusting for price differences and the exchange rate. Indeed, it does not make sense to say that a book costs $20 in the US and £15 in England: the comparison is not equivalent. If we know that the exchange rate is £2/$, the book in England is selling for $30, so the book is actually more expensive in England

If goods can be freely traded across borders with no transportation costs, the Law of One Price posits that exchange rates will adjust until the value of the goods are the same in both countries. Of course, not all products can be traded internationally (e.g. haircuts), and there are transportation costs so the law does not always hold.

The concept of purchasing power parity is important for understanding the two models of equilibrium exchange rates below.

Balance of Payments Model

The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers, or depreciates, the value of its currency. If a currency is undervalued, its nation’s exports become more affordable in the global market while making imports more expensive. After an intermediate period, imports will be forced down and exports will rise, thus stabilizing the trade balance and bringing the currency towards equilibrium.

Asset Market Model

Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the increasing role of global capital flows . In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. The flows from transactions involving financial assets go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.

Share of Stock

The key difference between the balance of payments and asset market models is that the former includes financial assets, such as stock, in its calculation.

The asset market model views currencies as an important element in finding the equilibrium exchange rate. Asset prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of the assets. The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies. These assets are not limited to consumables, such as groceries or cars. They include investments, such as shares of stock that is denominated in the currency, and debt denominated in the currency.

32.2.3: Real Versus Nominal Rates

Real exchange rates are nominal rates adjusted for differences in price levels.

Learning Objective

Calculate the nominal and real exchange rates for a set of currencies

Key Points

• The measure of the differences in price levels is Purchasing Power Parity. The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies.
• If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1.
• When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms.
• Changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.
• To calculate the nominal exchange rate, simply measure how much of one currency is necessary to acquire one unit of another. The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries.

Key Terms

nominal exchange rate

The amount of currency you can receive in exchange for another currency.

real exchange rate

The purchasing power of a currency relative to another at current exchange rates and prices.

Currency is complicated and its value can be measured in several different ways. For example, a currency can be measured in terms of other currencies, or it can be measured in terms of the goods and services it can buy. An exchange rate between two currencies is defined as the rate at which one currency will be exchanged for another. However, that rate can be interpreted through different perspectives. Below are descriptions of the two most common means of describing exchange rates.

Nominal Exchange Rate

A nominal value is an economic value expressed in monetary terms (that is, in units of a currency). It is not influenced by the change of price or value of the goods and services that currencies can buy. Therefore, changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.

When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms. The nominal rate is set on the open market and is based on how much of one currency another currency can buy.

Real Exchange Rate

The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country’s currency necessary to buy a market basket of goods in the other country, after acquiring the other country’s currency in the foreign exchange market, to the number of units of the given country’s currency that would be necessary to buy that market basket directly in the given country. The real exchange rate is the nominal rate adjusted for differences in price levels.

A measure of the differences in price levels is Purchasing Power Parity (PPP) . The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies. Using the PPP rate for hypothetical currency conversions, a given amount of one currency has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency.

Groceries

Purchasing Power Parity evaluates and compares the prices of goods in different countries, such as groceries. PPP is then used to help determine real exchange rates.

If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1. However, since these assumptions are almost never met in the real world, the real exchange rate will never equal 1.

Calculating Exchange Rates

Imagine there are two currencies, A and B. On the open market, 2 A’s can buy one B. The nominal exchange rate would be A/B 2, which means that 2 As would buy a B. This exchange rate can also be expressed as B/A 0.5.

The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries. So, in this example, say it take 10 A’s to buy a specific basket of goods and 15 Bs to buy that same basket. The real exchange rate would be the nominal rate of A/B (2) times the price of the basket of goods in B (15), and divide all that by the price of the basket of goods expressed in A (10). In this case, the real A/B exchange rate is 3.

32.2.4: Exchange Rate Policy Choices

A government should consider its economic standing, trade balance, and how it wants to use its policy tools when choosing an exchange rate regime.

Learning Objective

Explain the factors countries consider when choosing an exchange rate policy

Key Points

• A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies since most of their liabilities are denominated in other currencies.
• Floating exchange rates automatically adjust to trade imbalances while fixed rates do not.
• A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand. Because these tools are reserved for preserving the fixed rate, countries can’t use its monetary or fiscal policies to address other economic issues.

Key Terms

fixed exchange rate

A system where a currency’s value is tied to the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

floating exchange rate

A system where the value of currency in relation to others is allowed to freely fluctuate subject to market forces.

When a country decides on an exchange rate regime, it needs to take several important things in account. Unfortunately, there is no system that can achieve every possible beneficial outcome; there is a trade-off no matter what regime a nation picks. Below are a few considerations a country needs to make when choosing a regime.

Stage of Economic Development

A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies . Developing economies often have the majority of their liabilities denominated in other currencies instead of the local currency. Businesses and banks in these types of economies earn their revenue in the local currency but have to convert it to another currency to pay their debts. If there is an unexpected depreciation in the local currency’s value, businesses and banks will find it much more difficult to settle their debts. This puts the entire economy’s financial sector stability in danger.

Developing Countries

The developing countries, marked in light blue, may prefer a fixed or managed exchange rate to a floating exchange rate. This is because sudden depreciation in their currency value poses a significant threat to the stability of their economies.

Balance of Payments

Flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs in an economy with a floating exchange rate, there will be increased demand for the foreign (rather than domestic) currency which will increase the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and decreases the trade deficit. Under fixed exchange rates, this automatic re-balancing does not occur.

Monetary and Fiscal Policy

A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand. In general, fixed-rates are not established by law, but are instead maintained through government intervention in the market. The government does this through the buying and selling of its reserves, adjusting its interest rates, and altering its fiscal policies. Because the government must commit its monetary and fiscal tools to maintaining the fixed rate of exchange, it cannot use these tools to address other macroeconomics conditions such as price level, employment, and recessions resulting from the business cycle.

32.2.5: Exchange Rate Systems

The three major types of exchange rate systems are the float, the fixed rate, and the pegged float.

Learning Objective

Differentiate common exchange rate systems

Key Points

• A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency’s value is allowed to freely fluctuate according to the foreign exchange market.
• A fixed exchange-rate system (also known as pegged exchange rate system) is a currency system in which governments try to maintain their currency value constant against a specific currency or good.
• Pegged floating currencies are pegged to some band or value, either fixed or periodically adjusted. These are a hybrid of fixed and floating regimes.

Key Terms

pegged float exchange rate

A currency system that fixes an exchange rate around a certain value, but still allows fluctuations, usually within certain values, to occur.

fixed exchange rate

A system where a currency’s value is tied to the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

floating exchange rate

A system where the value of currency in relation to others is allowed to freely fluctuate subject to market forces.

exchange rate regime

The way in which an authority manages its currency in relation to other currencies and the foreign exchange market.

Example

• Examples of floating currencies include the US dollar, the European Union euro, the Japanese yen, and the British pound. Examples of fixed currencies include the Hong Kong dollar, the Danish krone, and the Bermudian dollar.

One of the key economic decisions a nation must make is how it will value its currency in comparison to other currencies. An exchange rate regime is how a nation manages its currency in the foreign exchange market. An exchange rate regime is closely related to that country’s monetary policy. There are three basic types of exchange regimes: floating exchange, fixed exchange, and pegged float exchange .

Foreign Exchange Regimes

The above map shows which countries have adopted which exchange rate regime. Dark green is for free float, neon green is for managed float, blue is for currency peg, and red is for countries that use another country’s currency.

The Floating Exchange Rate

A floating exchange rate, or fluctuating exchange rate, is a type of exchange rate regime wherein a currency’s value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. The dollar is an example of a floating currency.

Many economists believe floating exchange rates are the best possible exchange rate regime because these regimes automatically adjust to economic circumstances. These regimes enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, they also engender unpredictability as the result of their dynamism.

The Fixed Exchange Rate

A fixed exchange rate system, or pegged exchange rate system, is a currency system in which governments try to maintain a currency value that is constant against a specific currency or good. In a fixed exchange-rate system, a country’s government decides the worth of its currency in terms of either a fixed weight of an asset, another currency, or a basket of other currencies. The central bank of a country remains committed at all times to buy and sell its currency at a fixed price.

To ensure that a currency will maintain its “pegged” value, the country’s central bank maintain reserves of foreign currencies and gold. They can sell these reserves in order to intervene in the foreign exchange market to make up excess demand or take up excess supply of the country’s currency.

The most famous fixed rate system is the gold standard, where a unit of currency is pegged to a specific measure of gold. Regimes also peg to other currencies. These countries can either choose a single currency to peg to, or a “basket” consisting of the currencies of the country’s major trading partners.

The Pegged Float Exchange Rate

Pegged floating currencies are pegged to some band or value, which is either fixed or periodically adjusted. These are a hybrid of fixed and floating regimes. There are three types of pegged float regimes:

• Crawling bands: The market value of a national currency is permitted to fluctuate within a range specified by a band of fluctuation. This band is determined by international agreements or by unilateral decision by a central bank. The bands are adjusted periodically by the country’s central bank. Generally the bands are adjusted in response to economic circumstances and indicators.
• Crawling pegs:A crawling peg is an exchange rate regime, usually seen as a part of fixed exchange rate regimes, that allows gradual depreciation or appreciation in an exchange rate. The system is a method to fully utilize the peg under the fixed exchange regimes, as well as the flexibility under the floating exchange rate regime. The system is designed to peg at a certain value but, at the same time, to “glide” in response to external market uncertainties. In dealing with external pressure to appreciate or depreciate the exchange rate (such as interest rate differentials or changes in foreign exchange reserves), the system can meet frequent but moderate exchange rate changes to ensure that the economic dislocation is minimized.
• Pegged with horizontal bands:This system is similar to crawling bands, but the currency is allowed to fluctuate within a larger band of greater than one percent of the currency’s value.

32.2.6: Fixed Exchange Rates

A fixed exchange rate is a type of exchange rate regime where a currency’s value is fixed to a measure of value, such as gold or another currency.

Learning Objective

Explain the mechanisms by which a country maintains a fixed exchange rate

Key Points

• A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to.
• A fixed exchange rate regime should be viewed as a tool in capital control. As a result, a fixed exchange rate can be viewed as a means to regulate flows from capital markets into and out of the country’s capital account.
• Typically, a government maintains a fixed exchange rate by either buying or selling its own currency on the open market.
• Another method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate.

Key Term

fixed exchange rate

A system where a currency’s value is tied to the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency’s value is fixed against the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

Reasons for Fixed Exchange Rate Regimes

A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable and is especially useful for small economies in which external trade forms a large part of their GDP.

This belief that fixed rates lead to stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. Capital controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation’s government can use to regulate flows from capital markets into and out of the country’s capital account. A fixed exchange rate regime should be viewed as a tool in capital control.

How a Fixed Exchange Regime Works

Typically a government maintains a fixed exchange rate by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves.

Another, method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This method is rarely used because it is difficult to enforce and often leads to a black market in foreign currency. Some countries, such as China in the 1990s, are highly successful at using this method due to government monopolies over all money conversion. China used this method against the U.S. dollar .

PRC Flag

China is well-known for its fixed exchange rate. It was one of the few countries that could impose a fixed rate by making it illegal to trade its currency at any other rate.

32.2.7: Managed Float

Managed float regimes are where exchange rates fluctuate, but central banks attempt to influence the exchange rates by buying and selling currencies.

Learning Objective

Describe a managed float exchange rate and explain why countries choose managed floats

Key Points

• Generally the central bank will set a range which its currency’s value may freely float between. If the currency drops below the range’s floor or grows beyond the range’s ceiling, the central bank takes action to bring the currency’s value back within range.
• Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance.
• A managed float regime is a hybrid of fixed and floating regimes. A managed float captures the benefits of floating regimes while allowing central banks to intervene and minimize the risk of harmful effects due to radical currency fluctuations that are a characteristic of floating regimes.

Key Term

Managed Float Regime

A system where exchange rates are allowed fluctuate from day to day within a range before the central bank will intervene to adjust it.

Managed float regimes, otherwise known as dirty floats, are where exchange rates fluctuate from day to day and central banks attempt to influence their countries’ exchange rates by buying and selling currencies. Almost all currencies are managed since central banks or governments intervene to influence the value of their currencies. So when a country claims to have a floating currency, it most likely exists as a managed float.

How a Managed Float Exchange Rate Works

Generally, the central bank will set a range which its currency’s value may freely float between. If the currency drops below the range’s floor or grows beyond the range’s ceiling, the central bank takes action to bring the currency’s value back within range .

India

India has a managed float exchange regime. The rupee is allowed to fluctuate with the market within a set range before the central bank will intervene.

Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance. For example, if a currency is valued above its range, the central bank will sell some of its currency it has in reserve. By putting more of its currency in circulation, the central bank will decrease the currency’s value.

Why Do Countries Choose a Managed Float

Some economists believe that in most circumstances floating exchange rates are preferable to fixed exchange rates. Floating exchange rates automatically adjust to economic circumstances and allow a country to dampen the impact of shocks and foreign business cycles. This ultimately preempts the possibility of having a balance of payments crisis. A floating exchange rate also allows the country’s monetary policy to be freed up to pursue other goals, such as stabilizing the country’s employment or prices.

However, pure floating exchange rates pose some threats. A floating exchange rate is not as stable as a fixed exchange rate. If a currency floats, there could be rapid appreciation or depreciation of value. This could harm the country’s imports and exports. If the currency’s value increases too drastically, the country’s exports could become too costly which would harm the country’s employment rates. If the currency’s value decreases too drastically, the country may not be able to afford crucial imports.

This is why a managed float is so appealing. A country can obtain the benefits of a free floating system but still has the option to intervene and minimize the risks associated with a free floating currency. If a currency’s value increases or decreases too rapidly, the central bank can intervene and minimize any harmful effects that might result from the radical fluctuation.

32.3: Equilibrium

32.3.1: Open Economy Equilibrium

In an open economy, equilibrium is achieved when no external influences are present; the state of equilibrium between the variables will not change.

Learning Objective

Summarize the factors that determine the macroeconomic equilibrium state

Key Points

• In the case of market equilibrium in an open economy, equilibrium occurs when a market price is established through competition.
• The trade balance is a function of savings and investment. Since actors can save or invest domestically or internationally relative changes can have large effects on the trade balance and the health of the economy as a whole.
• There are three properties of equilibrium: the behavior of agents is consistent, no agent has an incentive to change its behavior, and equilibrium is the outcome of some dynamic process (stability).

Key Terms

output

Production; quantity produced, created, or completed.

equilibrium

The condition of a system in which competing influences are balanced, resulting in no net change.

trade

Buying and selling of goods and services on a market.

Open Economy

In an open economy there there is a flow of funds across borders due to the exchange of goods and services. An open economy can import and export without any barriers to trade, such as quotas and tariffs. Citizens in a country with an open economy typically have access to a larger variety of goods and services. They also have the ability to invest savings outside of the country.

An open economy allows a country to spend more or less than what it earns through the output of goods and services every year. When a country spends more than it make, it borrows money from abroad. If a country saves more money than it makes, it can lend the difference to foreigners.

The equation used to determine the economic output of a country is

The economy’s output (Y) equals the sum of the consumption of domestic goods (C_d), the investment in domestic goods and services (I_d), the government purchase of domestic goods and services (G_d), and the net exports of domestic goods and services (NX). The sum of C, I, and G provides the domestic spending of a country, while X provides the foreign sources of spending.

The amount that a country saves is total of investment and net exports:

NX can also be considered the trade balance of a country. Therefore

Consider, for example, what happens if domestic interest rates rise relative to foreign interest rates. Savings will increase and investment will drop as investors borrow and invest abroad instead. The balance of trade will increase, affecting the health of the economy. In an open economy, market actors can choose to save, spend, and invest either domestically or internationally, so relative changes affect not only the flow of capital, but also the health of the economy as a whole.

Economic Equilibrium

In an open economy, equilibrium is achieved when supply and demand are balanced . When no external influences are present, the state of equilibrium between the variables will not change. In the case of market equilibrium in an open economy, equilibrium occurs when a market price is established through competition. For example, when the amount of goods and services sought by buyers is equal to the amount of goods and services produced by sellers. When equilibrium is reached and the market price is established in an open economy, the price of the goods or service will remain the same unless the supply or demand changes.

Equilibrium

The graph shows that the point of equilibrium is where the supply and demand are equal. In an open economy, equilibrium is achieved when the amount demanded by consumers is equal to the amount of a goods or service provided by producers.

There are three properties of equilibrium:

1. The behavior of agents is consistent,
2. No agent has an incentive to change its behavior, and
3. Equilibrium is the outcome of some dynamic process (stability).

In an open economy, equilibrium is reached through the price mechanism. For example, if there is excess supply (market surplus), this would lead to prices cuts which would decrease the quantity supplied (reduces the incentive to produce and sell the product) and increase the quantity demanded (by offering bargains), which would eliminate the original excess of supply. The interest rates also adjust to reach equilibrium. Although consumption does not always equal production, the net capital outflow does equal the balance of trade. The capital flows, which depend on interest rates and savings rates, also adjust to reach equilibrium.

32.3.2: Impacts of Policies and Events on Equilibrium

Government policies and outside events may affect the macroeconomic equilibrium by shifting aggregate supply or aggregate demand.

Learning Objective

Analyze the effects that events and policies can have on economic equilibrium

Key Points

• One type of event that can shift the equilibrium is a supply shock – an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good.
• An increase in the price level can lower aggregate demand as a result of the wealth effect, the interest rate effect, and the exchange rate effect.
• By implementing protectionism policies such as tariffs and quotas, a government can make foreign goods relatively more expensive and domestic goods relatively cheaper, increasing net exports and therefore aggregate demand.
• Capital flight occurs when assets or money rapidly flow out of a country. This leads to an increase in the supply of the local currency and a drop in the exchange rate. Net exports rise as a component of aggregate demand.

Key Terms

protectionism

A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on imports.

nominal

Without adjustment to remove the effects of inflation (in contrast to real).

stagflation

Inflation accompanied by stagnant growth, unemployment, or recession.

The macroeconomic equilibrium is determined by aggregate supply and aggregate demand. Much of economics focuses on the determinants of aggregate supply and demand that are endogenous – that is, internal to the economic system. These include factors such as consumer preferences, the price of inputs, and the level of technology. However, there are many factors that affect the macroeconomic equilibrium that are exogenous to the economic system – that is, external to the economic model.

Supply Shock

One type of event that can shift the equilibrium is a supply shock. This is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good, which in turn affects the equilibrium price. A negative supply shock (sudden supply decrease) will raise prices and shift the aggregate supply curve to the left. A negative supply shock can cause stagflation due to a combination of raising prices and falling output . A positive supply shock (an increase in supply) will lower the price of said good by shifting the aggregate supply curve to the right. A positive supply shock could be an advance in technology (a technology shock) which makes production more efficient, thus increasing output.

Supply Shock and Equilibrium

A supply shock shifts the aggregate supply curve. In this case, a negative supply shock raises prices and lowers output in equilibrium.

One extreme case of a supply shock is the 1973 Oil Crisis. When the U.S. chose to support Israel during the Yom Kippur War, the Organization of Arab Petroleum Exporting Countries (OAPEC) responded with an oil embargo, which increased the market price of a barrel of oil by 400%. This supply shock in turn contributed to stagflation and persistent economic disarray.

Inflation

Inflation can result from increased aggregate demand, but can also be caused by expansionary monetary policy or supply shocks that cause large price changes. Changes in prices can shift aggregate demand, and therefore the macroeconomic equilibrium, as a result of three different effects:

• The wealth effect refers to the change in demand that results from changes in consumers’ perceived wealth. When individuals feel (or are) wealthier, they spend more and aggregate demand increases. Since inflation causes real wealth to shrink and deflation causes real wealth to increase, the wealth effect of inflation will cause lower demand and the wealth effect of deflation will cause higher demand.
• The interest rate effect refers to the way in which a change in the interest rate affects consumer spending. When prices rise, a nominal amount of money becomes a smaller real amount of money, which means that the real value of money in the economy falls and the interest rate (i.e. the price of money) rises. A higher interest rate means that fewer people borrow and consumer spending (aggregate demand) falls.
• Finally, the exchange rate effectrelates changes in the exchange rate to changes in aggregate demand. As above, inflation typically causes the interest rate to rise. When the domestic interest rate is high compared to that in other countries, capital flows into the country, the international supply of the domestic currency falls, and the price (i.e. exchange rate) of the domestic currency rises. An increase in the exchange rate has the effect of increasing imports and decreasing exports, since domestic goods are relatively more expensive. A decrease in net exports leads to a decrease in aggregate demand, since net exports is one of the components of aggregate demand.

Trade Policies

Trade policies can shift aggregate demand. Protectionism, for example, is a policy that interferes with the free workings of the international marketplace. By implementing protectionism policies such as tariffs and quotas, a government can make foreign goods relatively more expensive and domestic goods relatively cheaper, increasing net exports and therefore aggregate demand. Since the world demands more goods produced in the home country, the demand for the domestic currency increases and the exchange rate rises.

Capital Flight

Capital flight occurs when assets or money rapidly flow out of a country due to an event of economic consequence. Such events could be an increase in taxes on capital or capital holders, or the government of the country defaulting on its debt that disturbs investors and causes them to lower their valuation of the assets in that country, or otherwise to lose confidence in its economic strength.

This leads to an increase in the supply of the local currency and is usually accompanied by a sharp drop in the exchange rate of the affected country. This leads to dramatic decreases in the purchasing power of the country’s assets and makes it increasingly expensive to import goods. Net exports rise as a component of aggregate demand.

32.3.3: Effect of a Government Budget Deficit on Investment and Equilibrium

A budget deficit will typically increase the equilibrium output and prices, but this may be offset by crowding out.

Learning Objective

Evaluate the consequences of imbalances in the government budget

Key Points

• A government’s budget balance is the difference in government revenues (primarily from taxes) and spending. If spending is greater than revenue, there is a deficit. If revenue is greater than spending, there is a surplus.
• A government deficit can be thought of as consisting of two elements, structural and cyclical. At the lowest point in the business cycle, there is a high level of unemployment. This means that tax revenues are low and expenditures are high, leading naturally to a budget deficit.
• The additional borrowing required at the low point of the cycle is the cyclical deficit. The cyclical deficit will be entirely repaid by a cyclical surplus at the peak of the cycle. This type of deficit serves as an automatic stabilizer.
• The structural deficit is the deficit that remains across the business cycle because the general level of government spending exceeds prevailing tax levels. Structural deficits are the result of discretionary fiscal policy and can shift the aggregate demand curve to the right.
• Crowding out is a negative consequence of budget deficits in which higher interest rates lead to less private investment, higher exchange rates, and fewer exports.
• Crowding out is a negative consequence of budget deficits in which higher interest rates lead to less private investment, higher exchange rates, and fewer exports.

Key Terms

cyclical deficit

The deficit experienced at the low point of the business cycle when there are lower levels of business activity and higher levels of unemployment.

structural deficit

The portion of the public sector deficit which exists even when the economy is at potential; government spending beyond government revenues at times of normal, predictable economic activity.

business cycle

A fluctuation in economic activity between growth and recession.

aggregate demand

The the total demand for final goods and services in the economy at a given time and price level.

A government’s budget balance is determined by the difference in revenues (primarily taxes) and spending. A positive balance is a surplus, and a negative balance is a deficit. The consequences of a budget deficit depend on the type of deficit .

U.S. Budget Deficits

The graph shows the budget deficits and surpluses incurred by the U.S. government between 1901 and 2006. Although deficits may have an expansionary effect, this is not the primary purpose of running a deficit.

Cyclical Deficits

A cyclical deficit is a deficit incurred due to the ups and downs of a business cycle. At the lowest point in the business cycle, there is a high level of unemployment. This means that tax revenues are low and expenditures (e.g., on social security and unemployment benefits) are high, naturally leading to a budget deficit. Conversely, at the peak of the cycle, unemployment is low, increasing tax revenue and decreasing spending, which leads to a budget surplus. The additional borrowing required at the low point of the cycle is the cyclical deficit. By definition, the cyclical deficit will be entirely repaid by a cyclical surplus at the peak of the cycle.

This type of budget deficit serves as a stabilizer, insulating individuals from the effects of the business cycle without any specific legislation or other intervention. This is because budget deficits can have stimulative effects on the economy, increasing demand, spending, and investment. Higher spending on transfer payments puts more money into the economy, supporting demand and investment. Furthermore, lower revenues mean that more money is left in the hands of individuals and businesses, encouraging spending. As the economy grows more quickly, the budget deficit falls and the fiscal stimulus is slowly removed.

Structural Deficits

The structural deficit is the deficit that remains across the business cycle because the general level of government spending exceeds prevailing tax levels. Structural deficits are permanent, and occur when there is an underlying imbalance between revenues and expenses.

This is the budget gap still exists when the economy is at full employment and producing at full potential output levels. It can only be closed by increasing revenues or cutting spending. Unlike the cyclical budget deficit, a structural deficit is the result of discretionary, not automatic, fiscal policy. While automatic stabilizers don’t actually shift the aggregate demand curve (because transfer payments and taxes are already built into aggregate demand), discretionary fiscal policy can shift the aggregate demand curve. For example, if the government decides to implement a new program to build military aircraft without adjusting any sources of revenue, aggregate demand will shift to the right, raising prices and output.

Although both types of government budget deficits are typically expansionary during a recession, a structural deficit may not always be expansionary when the economy is at full employment. This is due to a phenomenon called crowding out. When an increase in government expenditure or a decrease in government revenue increases the budget deficit, the Treasury must issue more bonds. This reduces the price of bonds, raising the interest rate. The increase in the interest rate reduces the quantity of private investment demanded (crowding out private investment). The higher interest rate increases the demand for and reduces the supply of dollars in the foreign exchange market, raising the exchange rate. A higher exchange rate reduces net exports. All of these effects work to offset the increase in aggregate demand that would normally accompany an increase in the budget deficit.

31.1: Introduction to International Trade

31.1.1: Reasons for Trade

Learning Objective

Discuss the reasons that international trade may take place

Key Points

• International trade is the exchange of capital, goods, and services across international borders or territories.
• Each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations.
• Benefits of trade include lower prices and better products for consumers, improved political ties among nations, and efficiency gains for domestic producers.

Key Term

comparative advantage

The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.

International trade is the exchange of capital, goods, and services across international borders or territories. Trading-partners reap mutual gains when each nation specializes in goods for which it holds a comparative advantage and then engages in trade for other products. In other words, each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations .

International Trade

Countries benefit from producing goods in which they have comparative advantage and trading them for goods in which other countries have the comparative advantage.

In addition to comparative advantage, other reasons for trade include:

• Differences in factor endowments: Countries have different amounts of land, labor, and capital. Saudi Arabia may have a lot of oil, but perhaps not enough lumber. It will thus have to trade for lumber. Japan may be able to produce technological goods of superior quality, but it may lack many natural resources. It may trade with Indonesia for inputs.
• Gains from specialization: Countries may gain economies of scale from specialization, experiencing long run average cost declines as output increases.
• Political benefits: Countries can leverage trade to forge closer cultural and political bonds. International connections also help promote diplomatic (rather than military) solutions to international problems.
• Efficiency gains: Domestic firms will be forced to become more efficient in order to be competitive in the global market.
• Benefits of increased competition: A greater degree of competition leads to lower prices for consumers, greater responsiveness to consumer wants and needs, and a wider variety of products.

To summarize, international trade benefits mostly all incumbents and generates substantial value for the global economy.

31.1.2: Understanding Production Possibilities

Learning Objective

Explain the benefits of trade and exchange using the production possibilities frontier (PPF)

Key Points

• The production possibilities curve shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology.
• Points outside the production possibilities curve are unattainable with existing resources and technology if trade does not occur with an external producer.
• Without trade, each country consumes only what it produces. However, because of specialization and trade, the absolute quantity of goods available for consumption is higher than the quantity that would be available under national economic self-sufficiency.

Key Terms

Autarky

National economic self-sufficiency.

Production possibilities frontier

A graph that shows the combinations of two commodities that could be produced using the same total amount of each of the factors of production.

In economics, the production possibility frontier (PPF) is a graph that shows the combinations of two commodities that could be produced using the same total amount of the factors of production. It shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology.

PPFs are normally drawn as extending outward around the origin, but can also be represented as a straight line . An economy that is operating on the PPF is productively efficient, meaning that it would be impossible to produce more of one good without decreasing the production of the other good. For example, if an economy that produces only guns and butter is operating on the PPF, the production of guns would need to be sacrificed in order to produce more butter . If production is efficient, the economy can choose between combinations (i.e., points) on the PPF: B if guns are of interest, C if more butter is needed, or D if an equal mix of butter and guns is required.

Production Possibilities Frontier

If production is efficient, the economy can choose between combinations on the PPF. Point X, however, is unattaible with existing resources and technology if trade does not occur.

If the economy is operating below the curve, it is operating inefficiently, because resources could be reallocated in order to produce more of one or both goods without decreasing the quantity of either. Points outside the curve are unattainable with existing resources and technology if trade does not occur with an outside producer.

The PPF will shift outwards if more inputs (such as capital or labor) become available or if technological progress makes it possible to produce more output with the same level of inputs. An outward shift means that more of one or both outputs can be produced without sacrificing the output of either good. Conversely, the PPF will shift inward if the labor force shrinks, the supply of raw materials is depleted, or a natural disaster decreases the stock of physical capital.

Without trade, each country consumes only what it produces. In this instance, the production possibilities frontier is also the consumption possibilities frontier. Trade enables consumption outside the production possibility frontier. The world PPF is made up by combining countries’ PPFs. When countries’ autarkic productions are added (when there is no trade), the total quantity of each good produced and consumed is less than the world’s PPF under free trade (when nations specialize according to their comparative advantage). This shows that in a free trade system, the absolute quantity of goods available for consumption is higher than the quantity available under autarky.

31.1.3: Defining Absolute Advantage

Learning Objective

Relate absolute advantage, productivity, and marginal cost

Key Points

• A country that has an absolute advantage can produce a good at lower marginal cost.
• A country with an absolute advantage can sell the good for less than the country that does not have the absolute advantage.
• Absolute advantage differs from comparative advantage, which refers to the ability to produce specific goods at a lower opportunity cost.

Key Term

Absolute advantage

The capability to produce more of a given product using less of a given resource than a competing entity.

Absolute advantage refers to the ability of a country to produce a good more efficiently than other countries. In other words, a country that has an absolute advantage can produce a good with lower marginal cost (fewer materials, cheaper materials, in less time, with fewer workers, with cheaper workers, etc.). Absolute advantage differs from comparative advantage, which refers to the ability of a country to produce specific goods at a lower opportunity cost.

A country with an absolute advantage can sell the good for less than a country that does not have the absolute advantage. For example, the Canadian economy, which is rich in low cost land, has an absolute advantage in agricultural production relative to some other countries. China and other Asian economies export low-cost manufactured goods, which take advantage of their much lower unit labor costs .

China and Consumer Electronics

Many consumer electronics are manufactured in China. China can produce such goods more efficiently, which gives it an absolute advantage relative to many countries.

Imagine that Economy A can produce 5 widgets per hour with 3 workers. Economy B can produce 10 widgets per hour with 3 workers . Assuming that the workers of both economies are paid equally, Economy B has an absolute advantage over Economy A in producing widgets per hour. This is because Economy B can produce twice as many widgets as Economy B with the same number of workers.

Absolute Advantage

Party B has an absolute advantage in producing widgets. It can produce more widgets with the same amount of resources than Party A.

If there is no trade, then each country will consume what it produces. Adam Smith said that countries should specialize in the goods and services in which they have an absolute advantage. When countries specialize and trade, they can move beyond their production possibilities frontiers, and are thus able to consume more goods as a result.

31.1.4: Defining Comparative Advantage

Learning Objective

Analyze the relationship between opportunity cost and comparative advantage

Key Points

• Even if one country has an absolute advantage in the production of all goods, it can still benefit from trade.
• Countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.
• Specialization according to comparative advantage results in a more efficient allocation of world resources. A larger quantity of outputs becomes available to the trading nations.
• Competitive advantage is distinct from comparative advantage because it has to do with distinguishing attributes which are not necessarily related to a lower opportunity cost.

Key Terms

Opportunity cost

The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.

competitive advantage

Something that places a company or a person above the competition

comparative advantage

The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.

Comparative Advantage

In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. Even if one country is more efficient in the production of all goods (has an absolute advantage in all goods) than another, both countries will still gain by trading with each other. More specifically, countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.

Specialization according to comparative advantage results in a more efficient allocation of world resources. Larger outputs of both products become available to both nations. The outcome of international specialization and trade is equivalent to a nation having more and/or better resources or discovering improved production techniques.

Determining Comparative Advantage

Imagine that there are two nations, Chiplandia and Entertainia, that currently produce their own computer chips and CD players . Chiplandia uses less time to produce both products, while Entertainia uses more time to produce both products. Chiplandia enjoys and absolute advantage, an ability to produce an item with fewer resources. However, the accompanying table shows that Chiplandia has a comparative advantage in computer chip production, while Entertainia has a comparative advantage in the production of CD players. The nations can benefit from specialization and trade, which would make the allocation of resources more efficient across both countries.

Comparative Advantage

Chiplandia has a comparative advantage in producing computer chips, while Entertainia has a comparative advantage in producing CD players. Both nations can benefit from trade.

For another example, if the opportunity cost of producing one more unit of coffee in Brazil is 2/3 units of wheat, while the opportunity cost of producing one more unit of coffee in the United States is 1/3 wheat, then the U.S. should produce coffee, while Brazil should produce wheat (assuming Brazil has the lower opportunity cost of producing wheat).

Comparative vs Competitive Advantage

It is important to distinguish between comparative advantage and competitive advantage. Though they sound similar, they are different concepts. Unlike comparative advantage, competitive advantage refers to a distinguishing attribute of a company or a product. It may or may not have anything to do with opportunity cost or efficiency. For example, having good brand recognition or relationships with suppliers is a competitive advantage, but not a comparative advantage. In the context of international trade, we more often discuss comparative advantage.

31.1.5: Absolute Advantage Versus Comparative Advantage

Learning Objective

Differentiate between absolute advantage and comparative advantage

Key Points

• The producer that requires a smaller quantity inputs to produce a good is said to have an absolute advantage in producing that good.
• Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than another.
• The existence of a comparative advantage allows both parties to benefit from trading, because each party will receive a good at a price that is lower than its opportunity cost of producing that good.

Key Terms

Absolute advantage

The capability to produce more of a given product using less of a given resource than a competing entity.

comparative advantage

The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.

Absolute advantage compares the productivity of different producers or economies. The producer that requires a smaller quantity inputs to produce a good is said to have an absolute advantage in producing that good.

The accompanying figure shows the amount of output Country A and Country B can produce in a given period of time . Country A uses less time than Country B to make either food or clothing. Country A makes 6 units of food while Country B makes one unit, and Country A makes three units of clothing while Country B makes two. In other words, Country A has an absolute advantage in making both food and clothing.

Absolute Advantage

Country A has an absolute advantage in making both food and clothing, but a comparative advantage only in food.

Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than another. Even if one country has an absolute advantage in producing all goods, different countries could still have different comparative advantages. If one country has a comparative advantage over another, both parties can benefit from trading because each party will receive a good at a price that is lower than its own opportunity cost of producing that good. Comparative advantage drives countries to specialize in the production of the goods for which they have the lowest opportunity cost, which leads to increased productivity.

For example, consider again Country A and Country B in . The opportunity cost of producing 1 unit of clothing is 2 units of food in Country A, but only 0.5 units of food in Country B. Since the opportunity cost of producing clothing is lower in Country B than in Country A, Country B has a comparative advantage in clothing.

Thus, even though Country A has an absolute advantage in both food and clothes, it will specialize in food while Country B specializes clothing. The countries will then trade, and each will gain.

Absolute advantage is important, but comparative advantage is what determines what a country will specialize in.

31.1.6: Benefits of Specialization

Learning Objective

Discuss the effects of specialization on production

Key Points

• Whenever countries have different opportunity costs in production they can benefit from specialization and trade.
• Benefits of specialization include greater economic efficiency, consumer benefits, and opportunities for growth for competitive sectors.
• The disadvantages of specialization include threats to uncompetitive sectors, the risk of over-specialization, and strategic vulnerability.

Key Term

comparative advantage

The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.

Whenever a country has a comparative advantage in production it can benefit from specialization and trade. However, specialization can have both positive and negative effects on a nation’s economy. The effects of specialization (and trade) include:

• Greater efficiency: Countries specialize in areas that they are naturally good at and also benefit from increasing returns to scale for the production of these goods. They benefit from economies of scale, which means that the average cost of producing the good falls (to a certain point) because more goods are being produced . Similarly, countries can benefit from increased learning. They simply are more skilled at making the product because they have specialized in it. These effects both contribute to increased overall efficiency for countries. Countries become better at making the product they specialize in.
• Consumer benefits: Specialization means that the opportunity cost of production is lower, which means that globally more goods are produced and prices are lower. Consumers benefit from these lower prices and greater quantity of goods.
• Opportunities for competitive sectors: Firms gain access to the whole world market, which allows them to grow bigger and to benefit further from economies of scale.
• Gains from trade: Suppose that Britain and Portugal each produce wine and cloth. Britain has a comparative advantage in cloth and Portugal in wine . By specializing and then trading, Britain can get a unit of wine for only 100 units of labor by trading cloth for labor instead of taking 110 units of labor to produce the wine itself (assuming the price of Cloth to Wine is 1). Similarly, Portugal can specialize in wine and get a unit of cloth for only 80 units of labor by trading, instead of the 90 units of labor it would take to produce the cloth domestically. Each country will continue to trade until the price equals the opportunity cost, at which point it will decide to just produce the other good domestically instead of trading. Thus (in this example with no trade costs) both countries benefit from specializing and then trading.

Of course, there are also some potential downsides to specialization:

• Threats to uncompetitive sectors: Some parts of the economy may not be able to compete with cheaper or better imports. For example, firms in United States may see demand for their products fall due to cheaper imports from China. This may lead to structural unemployment.
• Risk of over-specialization: Global demand may shift, so that there is no longer demand for the good or service produced by a country . For example, the global demand for rubber has fallen due the the availability of synthetic substitutes. Countries may experience high levels of persistent structural unemployment and low GPD because demand for their products has fallen.
• Strategic vulnerability: Relying on another country for vital resources makes a country dependent on that country. Political or economic changes in the second country may impact the supply of goods or services available to the first.

As a whole, economists generally support specialization and trade between nations.

31.1.7: Relationship Between Specialization and Trade

Learning Objective

Discuss how countries determine which goods to produce and trade

Key Points

• Nations decide whether they should export or import goods based on comparative advantages.
• Generally, nations can consume more by specializing in a good and trading it for other goods.
• When countries decide which country will specialize in which product, the essential question becomes who could produce the product at a lower opportunity cost.

Key Term

Opportunity cost

The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.

Specialization refers to the tendency of countries to specialize in certain products which they trade for other goods, rather than producing all consumption goods on their own. Countries produce a surplus of the product in which they specialize and trade it for a different surplus good of another country. The traders decide on whether they should export or import goods depending on comparative advantages.

Imagine that there are two countries and both countries produce only two products. They can both choose to be self-sufficient, because they have the ability to produce both products. However, specializing in the product for which they have a comparative advantage and then trading would allow both countries to consume more than they would on their own.

One might assume that the country that is most efficient at the production of a good would choose to specialize in that good, but this isn’t always the case. Rather than absolute advantage, comparative advantage is the driving force of specialization. When countries decide what products to specialize in, the essential question becomes who could produce the product at a lower opportunity cost. Opportunity cost refers to what must be given up in order to obtain some item. It requires calculating what one could have gotten if one produced another product instead of one unit of the given product.

For example, the opportunity cost to Bob of 1 bottle of ketchup is 1/2 bottle of mustard . This means that in the same amount of time that Bob could produce one bottle of ketchup, he could have produced 1/2 bottle of mustard. Tom could have produced 1/3 bottle of mustard during the time that he was making one bottle of ketchup. Tom will have the comparative advantage in producing ketchup because he has to give up less mustard for the same amount of ketchup. In sum, the producer that has a smaller opportunity cost will have the comparative advantage. It follows that Bob will have a comparative advantage in the production of mustard.

Comparative Advantage

Tom has the comparative advantage in producing ketchup, while Bob has the comparative advantage in producing mustard.

There is one case in which countries are not better off trading: when both face the same opportunity costs of production. This doesn’t mean that both countries have the same production function – one could still be absolutely more productive than the other – but neither has a comparative advantage over the other. In this case, specialization and trade will result in exactly the same level of consumption as producing all goods domestically.

31.2: Gains from Trade

31.2.1: Exports: The Economic Impacts of Selling Goods to Other Countries

Exporting is a form of international trade which allows for specialization, but can be difficult depending on the transaction.

Learning Objective

Evaluate the effects of international trade on exporting countries

Key Points

• Export is defined as the act of shipping goods and services out of the port of a country.
• Legal restrictions and trade barriers are in place internationally to control trade, whether goods are being exported or imported.
• When legal restrictions and trade barriers are lessened or lifted the producer surplus increases and so does the amount of the goods and services that are exported from the country.
• Exporting allows a country’s producers to gain ownership advantages and develop low-cost and differentiated products.
• Due to an extra layer in the chain of distribution which squeezes the margins, exporters may have to offer lower prices to the importers than to domestic wholesalers in order to move their product and generate business.

Key Terms

export

Any good or commodity, transported from one country to another country in a legitimate fashion, typically for use in trade.

trade

Buying and selling of goods and services on a market.

Exports

Export is defined as the act of a country shipping goods and services out of the port of a country. In international trade, an export refers to the selling of goods and services produced in the home country to other markets (other countries) . The seller of the goods and services is referred to as the “exporter. “

Exports

The map shows the primary exporters for countries around the globe. The colors indicate the leading merchandise export destination for the indicated country (the United States main export destination is the European Union). Exporting is the act of shipping goods and services to other countries.

Protecting Exports

In order to protect exports, commercial goods are subject to customs authorities for both the exporting and importing countries. Legal restrictions and trade barriers are in place internationally to control trade, whether goods are being exported or imported. When legal restrictions and trade barriers are lessened or lifted the producer surplus increases and so does the amount of the goods and services that are exported to other countries.

Impact of Exports

Exporting goods and services has both advantages and disadvantages for countries involved in international trade.

Exporting allows a country’s producers to gain ownership advantages and develop low-cost and differentiated products. It is viewed as a low-risk mode of production and trade. Exporters also experience internationalization advantages which are the benefits of retaining a core competence within a company and threading it through the value chain instead of obtaining a license to outsource or sell the goods or services.

Disadvantages of exporting are mainly the result of manufacturers having to sell their goods to importers. In domestic sales, manufacturers sell directly to wholesalers or even directly to the retailer or customer. For exports, manufacturers face and extra layer in the chain of distribution which squeezes the margins. As a result, manufacturers may have to offer lower prices to the importers than to domestic wholesalers in order to move their product and generate business.

31.2.2: Imports: The Economics Impacts of Buying Goods from Other Countries

Imports are critical for many economies; they are the defining financial transactions of international trade and account for a large portion of the GDP.

Learning Objective

Evaluate the effects of international trade on an importing country

Key Points

• Imports are defined as purchases of good or services by a domestic economy from a foreign economy.
• Protectionism is the economic policy of restraining trade between countries through tariffs on imported goods, restrictive quotas, and government regulations.
• In most countries, international trade and importing goods represents a significant share of the gross domestic product (GDP).
• International trade is generally more expensive than domestic trade due to additionally imposed costs, taxes, and tariffs.
• On a business level, companies take part in direct-imports; a major retailer imports goods from an overseas manufacturer in order to save money.

Key Terms

protectionism

A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on imports.

trade

Buying and selling of goods and services on a market.

import

To bring (something) in from a foreign country, especially for sale or trade.

Imports

Imports are defined as purchases of good or services by a domestic economy from a foreign economy. The domestic purchaser of the good or service is called an importer. Imports and exports are critical for many economies and they are the defining financial transactions of international trade.

Protecting Imports

Due to the economic importance of imports, countries enact specific laws, barriers, and policies in order to regulate international trade. Protectionism is the economic policy of restraining trade between countries through tariffs on imported goods, restrictive quotas, and government regulations. When trade barriers and policies of protectionism are eliminated, consumer surplus increases. The price of a good or service will decrease while the quantity consumed will increase.

Impacts of Buying Imported Goods

On a national level, in most countries international trade and importing goods represents a significant share of the gross domestic product (GDP). International trade has a significant economic, social, and political importance in many countries. Imports provide countries with access to goods and services from other nations. Without imports, a country would be limited to the goods and services within its own borders .

Imports

The map shows the largest importers on an international scale. The color indicates the leading source of merchandise imports for the indicated country (the United States’ imports the largest percentage of its goods from China). Imports account for a significant share in the gross domestic product (GDP) of a country.

International trade is generally less expensive than domestic trade despite additionally imposed costs, taxes, and tariffs. However, the factors of production are usually more mobile domestically than internationally (capital and labor). It is common for countries to import goods rather than a factor of production. For example, the U.S. imports labor-intensive goods from China. Instead of importing Chinese labor, the U.S. imports goods that were produced in China by Chinese labor.

On a business level, companies take part in direct-imports, which occur when a major retailer imports goods that are designed locally from an overseas manufacturer. The direct-import program allows the retailer to bypass the local supplier and purchase the final product directly from the manufacturer. Direct imports save retailers money by eliminating the local supplier.

31.2.3: Costs of Trade

Free trade is a policy where governments do not discriminate against imports and exports; creates a large net gain for society.

Learning Objective

Identify the groups that benefit and the groups that are harmed by free trade policies

Key Points

• Free trade eliminates export tariffs, import quotas, and export quotas; all of which cause more losses than benefits for a country.
• With free trade in place the producers in exporting countries and the consumers in importing countries all benefit.
• One of the main disadvantages is the selective application of free trade. Economic inefficiency can be created through trade diversion.
• Trade restricts displaces workers, makes overcoming unemployment challenging, increases economic inequality, and can lower wages.
• When free trade is applied to only the high cost producer it can lead to trade diversion and a net economic loss.
• Another disadvantage is that by increasing returns to scale, can cause certain industries to settle in an geographically area where there is not comparative advantage.

Key Terms

welfare

Health, safety, happiness and prosperity; well-being in any respect.

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

free trade

International trade free from government interference, especially trade free from tariffs or duties on imports.

Free Trade

Free trade is a policy where governments do not discriminate against exports and imports. There are few or no restrictions on trade and markets are open to both foreign and domestic supply and demand.

Advantages

Free trade is beneficial to society because it eliminates import and export tariffs. Restricted trade affects the welfare of society because although producers experience increases in surplus and additional revenue, the loss faced by consumers is greater than any benefit obtained . When a country trades freely with the rest of the world, it should theoretically produce a net gain for society and increases social welfare. Free trade policies consist of eliminating export tariffs, import quotas, and export quotas; all of which cause more losses than benefits for a country. With free trade in place, the producers of the exported good in exporting countries and the consumers in importing countries all benefit.

Tariffs

This image shows what happens to societal welfare when free trade is not enacted. Tariffs cause the consumer surplus (green area) to decrease, while the producer surplus (yellow area) and government tax revenue (blue area) increase. The amount of societal loss (pink area) is larger than any benefits experienced by the producers and government. Free trade does not have tariffs and results in net gain for society.

Disadvantages

One of the main disadvantages is the selective application of free trade. Economic inefficiency can be created through trade diversion. It is economically efficient for a good to be produced in the country with the lowest production costs. However, this does not always occur if a high cost producer has a free trade agreement and the low cost producer does not. When free trade is applied to only the high cost producer it can lead to trade diversion to not the most efficient producer, but the one facing the lowest trade barriers, and a net economic loss. Free trade is highly effective and provides society with a net gain, but only if it is applied.

Due to industry specializations, many workers are displaced and do not receive retraining or assistance finding jobs in other sectors. The nature of industries and trade increases economic inequality. As a result of unskilled workers the wages within the various industries may decline.

Another disadvantage is that by increasing returns to scale, can cause certain industries to settle in an geographically area where there is not comparative advantage. Despite this disadvantage, the level of output that is generated by free trade for both the “winner” and the “loser” is increased substantially.

The Results of Free Trade

Economists have studied free trade extensively and although it creates winners and losers, the main consensus is that free trade generates a large net gain for society. In a 2006 survey of American economists, it was found that 85.7% believed that the U.S. should eliminate any remaining tariffs and trade barriers. Economists professor N. Gregory Mankiw explained that, “few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards. “

31.3: The United States in the Global Economy

31.3.1: The Importance of Trade

International trade is an integral part of the modern world economy.

Learning Objective

Discuss the reasons of the U.S. increase in international trade participation after World War II

Key Points

• The international market serves as an important place for the exchange of goods and services.
• Economic theory shows that there are gains from trade for both countries involved.
• Advances in transportation has dramatically reduced the costs of moving goods around the globe.
• Technological advances have made international production and trade easier to coordinate.
• Trade barriers between countries have fallen and are likely to continue to fall.

Key Terms

production possibilities curve

The various combinations of amounts of two commodities that could be produced using the same fixed total amount of each of the factors of production

comparative advantage

The ability of a party to produce a particular good or service at a lower margin and opportunity cost over another.

Economists generally support trade because it allows for increased overall utility for both countries . Gains from trade are commonly described as resulting from:

Silk Road Trade

Even in ancient times, people benefited from widespread international trade. The benefits from international trade have increased as costs decline and the international system becomes better integrated.

• specialization in production from division of labor (according to one’s comparative advantage), economies of scale, scope, and agglomeration and relative availability of factor resources in types of output by farms, businesses, location and economies
• a resulting increase in total output possibilities
• trade through markets from sale of one type of output for other, more highly valued goods.

The Rise of International Trade

International trade is important, and, over time, has become more important. There have been three primary reasons for this increase in importance.

First, there have been large reductions in the cost of transportation and communication. It is now much cheaper to not only operate internationally and trade with foreign partners, but also to exchange information between potential buys and sellers.

Second, technological advances have made international production and trade easier to coordinate. More efficient telecommunications, from the first transatlantic telephone cable in 1956 to the popularization of the internet in the 1980s and 1990s, have allowed companies to exchange goods more efficiently and lowered the costs of international integration. Technological advances, from the invention of the jet engine to the development of just-in-time manufacturing, have also contributed to the rise in international trade.

Third, trade barriers between countries have fallen and are likely to continue to fall. In particular, the Bretton Woods system of international monetary management has shaped the relationship between the world’s major industrial states and has resulted in a much more integrated system of international exchange. Established in 1946 to rebuild the international economic system after World War II, the Bretton Woods Conference set up regulations for production of their individual currencies to maintain fixed exchange rates between countries with the aim of more easily facilitating international trade.This was the foundation of the U.S. vision of postwar world free trade, which also involved lowering tariffs and, among other things, maintaining a balance of trade via fixed exchange rates that would be favorable to the capitalist system. Although the world eventually abolished the system of fixed exchange rates, the goal of more open economies and free international trade remained.

31.3.2: The Balance of Trade

The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period.

Learning Objective

Explain the relationship between the trade balance of a nation and its economic well-being

Key Points

• A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap.
• Factors that can affect the balance of trade include the currency exchange rate, cost of inputs, barriers to trade such as tariffs and regulations, and the prices of domestic goods.
• The twin deficits hypothesis contends that there is a strong positive relationship between a national economy’s current account balance and its government budget balance.

Key Terms

net capital outflow

The net flow of funds being invested abroad by a country during a certain period of time.

net exports

The difference between the monetary value of exports and imports.

The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period, measured in the currency of that economy. It is the relationship between a nation’s imports and exports. It is measured by finding the country’s net exports. A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap.

Factors that can affect the balance of trade include:

• The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy compared to those in the importing economy
• The cost and availability of raw materials, intermediate goods, and other inputs
• Currency exchange rate
• Multilateral, bilateral, and unilateral taxes or restrictions on trade
• Non-tariff barriers such as environmental, health, or safety standards
• The availability of adequate foreign exchange with which to pay for imports
• Prices of goods manufactured at home

In addition, the trade balance is likely to differ across the business cycle. In export-led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle.

Twin Deficits Hypothesis

The twin deficits hypothesis is a concept from macroeconomics that contends that there is a strong link between a national economy’s current account balance and its government budget balance. This link can be seen from considering the national accounting model of the economy:

Y=C+I+G+(NX

Y represents national income or GDP, C is consumption, I is investment, G is government spending, and NX stands for net exports (exports minus imports). This represents GDP because all the production in an economy (the left hand side of the equation) is used as consumption (C), investment (I), or government spending (G), and the leftover production is exported (NX).

Another equation defining GDP using alternative terms (which in theory results in the same value) is:

Y=C+S+T

Y is again GDP, C is consumption, S is savings, and T is taxes. This is because national income is also equal to output, and all individual income either goes to pay for consumption (C), to pay taxes (T), or becomes savings (S).

Since Y=C+I+G+NX, and Y-C-T=S, then S=G-T+NX+I, which simplifies to:

(S-I)+(T-G)=(NX)

If (T-G) is negative, we have a budget deficit. Assuming that the economy is at potential output (meaning Y is fixed), if the budget deficit increases and savings and investment remain the same, then net exports must fall, causing a trade deficit. Thus, budget deficits and trade deficits go hand-in-hand .

Twin Deficits in the US

In the U.S., net borrowing has tended to have a direct relationship with net imports. The red line represents net imports, which is equivalent to the negative balance of trade, and the black line represents net borrowing, which is equivalent to the government budget deficit. Although the two are not identical, a rise in one tends to accompany a rise in the other, and vice versa.

The twin deficits hypothesis implies that as the budget deficit grows, net capital outflow from a country falls. This is because the nation is financing its spending by selling assets to foreigners. The total rate of national savings falls, which may lead to an increase in the interest rate as lending to the country (i.e. buying bonds and other financial assets) becomes more risky.

31.4: Barriers to Trade

31.4.1: Tariffs

Tariffs are taxes levied on goods entering or exiting a country, and have consequences for both domestic consumers and producers.

Learning Objective

Discuss the consequences of a tariff for a domestic economy

Key Points

• Tariffs can be levied on goods being imported in a country (import tariff), or exported from a country (export tariff). They may be levied in order to protect domestic producers (protective tariff), or to raise revenue for the government (revenue tariff).
• Specific tariffs levy a fixed duty on a good. Ad valorem tariffs are based on a percentage of the good’s value. Compound tariffs are a combination of specific and ad valorem tariffs.
• Tariffs often increase domestic producer surplus and the quantity of a good supplied domestically, but hurt domestic consumer surplus.

Key Term

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

One barrier to international trade is a tariff. A tariff is a tax that is imposed by a government on imported or exported goods. They are also known as customs duties.

Types of Tariffs

Tariffs can be classified based on what is being taxed:

• Import tariffs: Taxes on goods that are imported into a country. They are more common than export tariffs.
• Export tariffs:Taxes on goods that are leaving a country. This may be done to raise tariff revenue or to restrict world supply of a good.

Tariffs may also be classified by their purpose:

• Protective tariffs: Tariffs levied in order to reduce foreign imports of a product and to protect domestic industries.
• Revenue tariffs: Tariffs levied in order to raise revenue for the government.

Tariffs can also be classified on how the duty amount is valued:

• Specific tariffs: Tariffs that levy a flat rate on each item that is imported. For example, a specific tariff would be a fixed $1,000 duty on every car that is imported into a country, regardless of how much the car costs.
• Ad valorem tariffs: Tariffs based on a percentage of the value of each item. For example, an ad valorem tariff would be a 20% tax on the value of every car imported into a country.
• Compound tariffs: Tariffs that are a combination of specific tariffs and ad valorem tariffs. For example, a compound tariff might consist of a fixed $100 duty plus 10% of the value of every imported car.

Consequences of Levying a Tariff

To see the effects of levying an import tariff, consider the example shown in . Assume that there is an import tax levied on a good in a domestic country, Home. The domestic supply of the good is represented by the diagonal supply curve, and world supply is perfectly elastic and represented by the horizontal line at P_w. Before a tariff is levied, the domestic price is at P_w, and the quantity demanded is at D (with quantity S provided domestically, and quantity D-S imported).

Effects of a Tariff

When a tariff is levied on imported goods, the domestic price of the good rises. This benefits domestic producers by increasing producer surplus, but domestic consumers see a small consumer surplus.

When the tariff is imposed, the domestic price of the good rises to P_t. Now, more of the good is provided domestically; instead of producing S, it now produces S*. Imports of the good fall, from the quantity D-S to the new quantity D*-S*. With the higher prices, domestic producers experience a gain in producer surplus (shown as area A). In contrast, because of the higher prices, domestic consumers experience a loss in consumer surplus; consumer surplus shrinks from the area above P_w to the area above P_t (it shrinks by the areas A, B, C, and D).

Because the tariff is a tax, the government gains some revenue. The government charges a tariff amount of P_t-P_w on every imported good. The amount of revenue is equal to the tariff amount times the number of imported goods, or (P_t-P_w)(D*-S*). This results in a governmental gain of area C.

In this example, domestic producers and the government both gain from the import tariff, and domestic consumers lose. However, if the world price is higher than the domestic price, a tariff will not change the price or quantity consumed of a good.

31.4.2: Quotas

Quotas are limitations on imported goods, come in an absolute or tariff-rate varieties, and affect supply in the domestic economy.

Learning Objective

Discuss the economic consequences of different kinds of quotas

Key Points

• There are two types of quotas: absolute and tariff-rate. Absolute quotas are quotas that limit the amount of a specific good that may enter a country. Tariff-rate quotas allow a quantity of a good to be imported under a lower duty rate; any amount above this is subject to a higher duty.
• Justifications for the use of quotas include protection for domestic employment and infant industries, protection against unfair foreign trade practices, and protection of national security.
• Quotas often hurt domestic consumers and benefit domestic producers. Quotas may also provide incentives for administrative corruption and smuggling.

Key Terms

quota

A restriction on the import of something to a specific quantity.

absolute quota

A limitation of the quantity of certain goods that may enter commerce during a specific period.

tariff-rate quota

Allows a specified quantity of imported goods to be entered at a reduced rate of duty during the quota period, with quantities entered in excess of the quota limit subject to a higher duty rate.

Barriers to trade exist in many forms. A tariff is a barrier to trade that taxes imports or exports, thus increasing the cost of a good. Another barrier to trade is an import quota, which places a limit on the amount of a good that may enter a country.

Types of Quotas

There are two main types of import quota: the absolute quota and the tariff-rate quota.

An absolute quota is a limit on the quantity of specific goods that may enter a country during a certain time period. Once the quota has been fulfilled, no other goods may be imported into the country. An absolute quota may be set globally, in which case goods may be imported from any country until the goal has been reached. An absolute quota may also be set selectively for certain countries. As an example, suppose an absolute, global quota for pens is set at 50 million. The government is setting a limit that, in total, only 50 million pens can be imported. If there were a selective, absolute quota, only 50 million pens would be able to be imported, but this total would be divided among exporting countries. Country A might only be able to export 10 million pens, Country B might be able to export 25 million pens, and Country C might be able to export 15 million pens. Collectively, the total imports equal 50 million pens, but the proportions of pens from each country are set.

A tariff-rate quota is a two-tier quota system that combines characteristics of tariffs and quotas. Under a tariff-rate quota system, an initial quota of a good is allowed to enter the country at a lower duty rate. Once the initial quota is surpassed, imports are not stopped; instead, more of the good may be imported, but at a higher tariff rate . For example, under a tariff-rate quota system, a country may allow 50 million pens to be imported at the low tariff rate of $1 each. Any pen that is imported after this first-tier quota has been reached would be charged a higher tariff, say $3 each.

Sugar: Tariff-Rate Barriers

In the US, the import of sugar is regulated by tariff-rate barriers. In 2012, the US allowed over 150,000 tons of raw cane sugar to be imported from Brazil at a reduced tariff rate.

Reasons to Implement Quotas

Quotas are often implemented for similar reasons as other trade barriers. Often, quotas are instituted to:

• Protect domestic industries and employment: By reducing the number of foreign imports, domestic suppliers must produce more to meet domestic demand. By producing more, the suppliers must hire more domestic workers, increasing employment. Additionally, setting quotas to reduce foreign competition allows domestic “infant industries,” or young, small industries, to grow and mature to a competitive level.
• Protect against unfair trade practices: Setting a quota helps protect a domestic economy from unfair trade practices such as dumping, the pricing of imports below production cost. By restricting imports, quotas minimize the impact of such activities.
• Protect national security: Import quotas discourage imports and encourage domestic production of goods that may be necessary to the security of the country. By protecting and encouraging the growth of these defense-related industries, a country will not have to be dependent on foreign imports in the event of a war.

Consequences of Quotas

Like other trade barriers, quotas restrict international trade, and thus, have consequences for the domestic market. In particular, quotas restrict competition for domestic commodities, which raises prices and reduces selection. This hurts the domestic consumer, who experiences a loss in consumer surplus. On the other hand, this very action benefits the domestic producer, who sees an increase in producer surplus. Often, the increase in producer surplus is not enough to offset the loss in consumer surplus, so the economy experiences a loss in total surplus.

Quotas may also foster negative economic activities. Import quotas may promote administrative corruption, especially in countries where import quotas are given to selected importers. There are incentives to give the quotas to importers who can provide the most favors or the largest bribes to officials. Quotas may also encourage smuggling. As quotas raise the price of domestic goods, it becomes profitable to try and circumvent the quota by bringing in goods illegally, or in excess of the quota.

31.4.3: Other Barriers

Barriers to trade include specific limitations to trade, customs procedures, governmental participation, and technical barriers to trade.

Learning Objective

Distinguish different barriers to trade

Key Points

• Specific limitations to trade barriers include local content requirements and embargoes. This category of barriers comes from trade regulations.
• Customs and administrative procedure barriers include bureaucratic red tape and anti-dumping practices. This category of barriers comes from government procedures.
• Governmental participation barriers include government procurement programs, export subsidies, and countervailing duties. This category of barriers involves the direct participation of government in trade.
• Technical barriers to trade include sanitary regulations, measurement and labeling standards, and ingredient standards. This category of barriers involves health, safety, and measurement standards.

Key Terms

countervailing duty

A tax levied on an imported article to offset the unfair price advantage it holds due to a subsidy paid to producers or exporters by the government of the exporting country if such imports cause or threaten injury to a domestic industry.

embargo

A ban on trade with another country.

Dumping

Selling goods at less than their normal price, especially in the export market.

In addition to tariffs and quotas, other barriers to trade exist. They can be divided into four separate categories: specific limitations to trade, customs and administrative procedures, government participation, and technical barriers to trade.

Specific Limitations to Trade

This category of trade barriers stems from regulations on international trade. Some examples include:

• Local content requirements, or domestic content requirements, are rules that mandate how much of a product must be produced domestically in order to qualify for lowered tariffs or other preferential treatment.
• Embargoes are prohibitions on trade ban imports or exports, and may apply to certain categories of products, or strictly to goods supplied by certain countries .

Customs and Administrative Procedures

This category of trade barriers refers to trade impediments that stem from governmental procedures and controls. Some examples include:

• Bureaucratic delays: Delays at ports or other country entrances caused by administrative or bureaucratic red-tape increase uncertainty and the cost of maintaining inventory.
• Anti-dumping duties: In international trade, dumping refers to a form of predatory pricing in which exported products are priced below the cost of production or below the price charged in the home market. Anti-dumping duties are usually extra taxes levied on the product to neutralize the predatory pricing and bring the price closer to the “normal value. “

Government Participation

This category of trade barriers represents direct governmental involvement in international trade. Some examples include:

• Government procurement programs: Public authorities, such as government agencies, are much like private interests in that they must also buy goods and services. Unlike private interests, governments are more likely to buy domestically produced goods and services, rather than the lowest-cost commodities. Because government procurement often represent a significant portion of a country’s GDP, foreign suppliers are at a disadvantage to domestic ones when it comes to these programs.
• Export subsidies: Export subsidies are production subsidies granted to exported products, usually by a government. With export subsidies, domestic producers can sell their commodities in foreign markets below cost, which makes them more competitive.
• Countervailing duties: Countervailing duties, or anti-subsidy duties, are extra duties levied on imports in order to neutralize an export subsidy. If a country discovers that a foreign country subsidizes its exports, and domestic producers are injured as a result, a countervailing duty can be imposed in order to reduce the export subsidy advantage. In that respect, countervailing duties are similar to anti-dumping duties in that they both bring a imported product’s value closer to the “normal value. “

Technical Barriers to Trade

Technical barriers to trade are non-tariff barriers to trade that refer to standards implemented by countries. Because these standards must be met before goods are allowed to enter or leave a country, they represent international trade barriers. Some examples include:

• Sanitary and phytosanitary measures: These are health standards for plants, animals, and other products, and are designed to protect humans, animals, and plants from pests or diseases.
• Rules for product weights, sizes, or packaging.
• Standards for labeling and testing products.
• Ingredient or identity standards.

31.5: Arguments for and Against Protectionist Policy

31.5.1: National Security Argument

National security protectionist arguments pertain to the risk of dependency upon other nations for economic sustainability.

Learning Objective

Evaluate the arguments in favor of the use of trade protectionism in the security industry

Key Points

• Economic interdependence and globalization has resulted in a unique capitalistic system, where each country is largely dependent upon other countries for economic sustainability.
• It has been noted, somewhat intuitively and empirically, that conflict reduces trade. This highlights the risk of conflict harming an economy.
• A more specific context for trade and conflict can be the way in which trade is complicated during wartime. Indeed, trade during wartime can be a substantial threat to a nation, as economic levers such as sanctions can be utilized.
• Iran and North Korea are strong modern examples as well as the recent history of the U.S.-Iraq war. All of these economies struggle(d) against harsh economic sanctions.
• Combining these ideas, it is clear that there is substantial national security value to trade protectionism.

Key Terms

Self-sufficiency

Able to provide for oneself independently of others.

sanction

A penalty, or some coercive measure, intended to ensure compliance; especially one adopted by several nations, or by an international body.

Economic interdependence and globalization has resulted in a system, where each country is largely dependent upon other countries for economic sustainability (though to varying degrees). This results in a substantial national security threat in the form of conflicting or offensive trade strategies between countries. Indeed, economics is often used directly as a weapon of war and conflict via trade sanctions. This highlights a critical protectionist argument pertaining to the very real risk of dependency upon other nations for economic sustainability.

Trade and Conflict

An interesting discussion in economics is the relationship between trade and conflict. It has been noted, somewhat intuitively and empirically, that conflict reduces trade. However, is it also the case that trade reduces conflict? This question is largely unanswered, although the stances are becoming more highly developed. It is hypothesized that trade does not necessarily reduce conflict, but instead changes the nature of the conflict. Economic levers are much more practical than military levers, and are often used for similar reasons. For this reason, it is difficult to separate trade and conflict completely because there is some critical overlap between the two. This is a fundamental foundation for the trade protectionism logic from a national security perspective.

Trade During Conflict

A more specific context for trade and conflict can be the way in which trade is complicated during wartime. Indeed, trade during wartime can be a substantial threat to a nation depending on the scale and scope of the conflict (most notably who is involved). For example, consider World War II. In this scenario Germany was largely isolated in the conflict, and therefore had extremely limited trade partners. Direct conflict will almost always result in a complete cease in trading not only between the country in which the war is occurring, but also any of that country’s allies (who may or may not be directly involved). However, some argue self-sufficiency (via protectionism) in war is not necessary, as friendly nations will still provide trade and economic support.

Sanctions also play a dramatic role as an offensive militaristic maneuver. Iran and North Korea are strong modern examples as well as the recent history of the U.S.-Iraq war. In all of these circumstances, either the U.S. alone or along with a number of allies (representing substantial consumption percentages) actively limited the ability for these countries to trade and generate economic value for their nations (and subsequently their people). While this looks purely economic, it has important social and humanitarian implications as well. The chart makes this case quite clearly, pointing out the death toll in wartime if economic levers are utilized.

Infant Mortality in Iraq During Sactions

This graphic underlines the indirect consequences of employing economic levers (i.e. sanctions) in a militaristic fashion during a conflict. While the justification for these figures is complex, including other war-related factors, the correlation is quite clear. Diminishing a country’s economic prospects will in turn result in loss of life, particularly in developing nations.

Protectionism

Combining these ideas, it is clear that there is substantial national security value to trade protectionism. However, the opportunity cost of leveraging the ever-growing global markets make this an unattractive prospect if taken to any extreme, as the benefits of global trade rapidly offset the risk of economic dependency upon hostile nations.

31.5.2: Infant Industry Argument

Economic markets are inherently competitive and newer economies are vulnerable to their more developed counterparts in other countries.

Learning Objective

Discuss the use of trade protectionism to promote new industries

Key Points

• Trade protectionism is national policies restricting international economic trade to alter the balance between imports and goods manufactured domestically through import quotas, tariffs, taxes, anti-dumping legislation, and other limitations.
• The primary advantage to countries with higher economic power and bigger corporations is simply economies of scale, which infant industries in developing countries often protect against.
• The United States was employing heavy tariffs to protect their fragile economic system as the economy began to achieve autonomy after British rule, which proved effective.
• From a broader and more far-reaching perspective, protectionism as a general principle has been heavily criticized (even in infant industry situations). The argument is that free markets add value on a global level, while protectionism confines economic value to the nation employing it.

Key Terms

Dumping

Selling goods at less than their normal price, especially in the export market as a means of securing a monopoly.

Nascent

Emerging; just coming into existence.

Trade protectionism is defined as national policy restricting international economic trade to alter the balance between imports and goods manufactured domestically, usually executed via policies and governmental regulations such as import quotas, tariffs, taxes, anti-dumping legislation, and other limitations.

Arguments for Protecting Infant Industry

The primary purpose for this system is as the name implies: protection. Economic markets are inherently competitive, and newer economies are highly vulnerable to their more developed counterparts in other countries for a variety of reasons. The infant industry argument is that new industries need protection until they have become efficient enough to compete in the world market.

Despite the standard argument from mainstream economists postulating that free trade and open markets is the ideal system to allow for capitalistic development, there are many economists who believe that some degree of protectionism is the only way to minimize income gaps and substantial inequity from economy to economy (see ). The primary advantage to countries with higher economic power and bigger corporations is simply economies of scale and economies of scope, in addition to being further along the experience curve.

Economies of Scale

The basic premise behind economies of scale is that higher production quantity reduces cost per unit, ultimately allowing for the derivation of economic advantage in the market. Infant industries generally do not have the capacity to do this.

GDP by Country

This map demonstrates the vast difference in overall economic power across the globe, underlining the inequities that need to be addressed in economic policy formulation.

History has proven the value of protection for the countries employing tariff-based international trade policies. Alexander Hamilton first pointed out the inequities of developing economies with young industry in 1790, which was later picked up and developed by Daniel Raymond and Friedrich List in the 19th century. Around this time frame, the United States was employing heavy tariffs to protect their fragile economic system as the economy began to achieve autonomy after British rule. Indeed, Britain employed similarly protectionist policies during this time frame, setting the tone for large economic expansion in the longer term.

Criticism

Of course, protective policy while industry develops domestically is not a cure all. In Brazil in the 1980’s there were heavy protective policies in place to defend Brazil’s nascent computer industry from highly evolved competitors internationally. While this seemed practical, what ended up happening was quite damaging for Brazil. Technology advanced rapidly, and without strategic alliances on a global scale, Brazil largely missed out on these advances. This protectionism seems to have damaged industry prospects on a global level for Brazil in this scenario.

From a broader and more far-reaching perspective, protectionism as a general principle has been heavily criticized (even in infant industry situations). The reason for this is quite simply the significant jump in prosperity as international trade expanded, and the huge capacity for specialization, economies of scale, technology sharing, and a host of other advantages that have been a direct result of free global markets. The problem still remains, however, that this prosperity is often unregulated and of the greatest benefit to the influential players in established economies, sometimes at the expense of exploitation of developing nations (cheaper labor, reduced governmental oversight, etc.). As a result of this, protecting infant industries can benefit the nation employing them, but generally with the opportunity cost of global value.

31.5.3: Unfair Competition Argument

One of the strongest arguments for trade protectionism is unfair competition emerging due to differences in policy and enforcement ability.

Learning Objective

Examine the use of protectionism as a way of addressing unfair competitive practices

Key Points

• Protectionist policies are a highly charged topic in economic debates, as economies work to attain the optimal balance of free trade and trade protectionism to capture the most value.
• A recent topic is anti-dumping policies directed at international players looking to undercut domestic business through selling at dramatically reduced prices.
• Another critical risk in the global market is intellectual property (IP) protection as patents are often ignored globally, particularly by countries which lack the infrastructure to enforce IP laws.
• Another unfair competition threat is the emergence of global monopolies. Some of the larger ones attain enough global power and geographic diversification to be difficult to break up via domestic anti-trust laws.

Key Terms

Subsidies

Financial support or assistance, such as a grant.

Reverse engineering

The process of analyzing the construction and operation of a product in order to manufacture a similar one.

Dumping

Selling goods at less than their normal price, especially in the export market as a means of securing a monopoly.

Protectionist policies are a highly charged topic in economic debates, as economies work to attain the optimal balance of free trade and trade protectionism to capture the most value. In many ways, the global markets are torn between pursuing what is best on the global level and what is best at the domestic level, and there is sometimes dissonance between the two. One of the strongest arguments for some degree of trade protectionism is the tendency for unfair competition to emerge, particularly in developing markets without the infrastructure to monitor their businesses and enforce penalties. This is called the unfair competition argument.

Dumping

A popular recent topic is anti-dumping policies directed at international players looking to undercut domestic business through selling at dramatically reduced prices. This can be a substantial threat, particularly from economies where labor laws are lax and workers are exploited to create extremely low cost goods. This is also a risk when governments get too involved in business, a criticism often pointed out in China. Governments can provide subsidies to reduce costs for domestic companies. This can also be a threat in infant industries, where larger and more established players can push out smaller players via undercutting prices, absorbing losses until the competition goes bankrupt.

Offsetting this threat has been an ongoing struggle, with the emergence of international trade agreements and organizations like the World Trade Organization (WTO) playing an increasingly large role. One of the struggles with international trade is the difficulty of enforcement between nations, and the WTO plays a critical role in identifying malpractice and addressing it.

Intellectual Property

Another critical risk in the global market is intellectual property (IP) protection. Patents, in a domestic system, protect the innovator to allow them to generate returns on the substantial time investment required to invent or innovate new products or technologies. On a global scale, however, it is quite common for developing nations to copy new technologies via reverse engineering. This results in copycats violating the patents in an environment where the infrastructure domestically will probably not take legal action. This reduces the desire for innovation and places large economic risks on countries dependent upon this for growth.

This is addressed through international patent laws and trade agreements as well, alongside political pressures such as raising tariffs and placing import quotas on countries suspected to be in violation of patents. The downside to this is that utilizing these measures creates political unrest, global factions, and strained business relationships.

Mergers, Acquisitions, and Market Dominance

Another unfair competition threat is the emergence of global monopolies. Some of the larger ones attain enough global power and geographic diversification to be difficult to break up via domestic antitrust laws. demonstrates the substantial threat of deadweight losses being incurred in economies where consolidation results in a lack of competitive forces to drive down price.

Economic Losses in a Monopoly

This chart highlights the very real risk of lost economic value in a monopolistic situation (deadweight loss in yellow).

On the domestic level monopolies are widely seen as being addressed (though this is hotly debated by many economists in light of the ‘too big to fail’ and ‘too big to jail’ banks). On a global scale it is even more difficult to regulate, as the size and scale of these companies often extends beyond the power of the governments where these companies are located. This is addressed through international standards and trade agreements, standardizing governmental policy on a global level to reduce the risk of monopoly and unfair consolidation towards market dominance.

31.5.4: Jobs Argument

Many policy makers who are proponents of trade protectionism argue that limiting imports will create or save more jobs at home.

Learning Objective

Analyze the use of trade restrictions for strategic purposes

Key Points

• This argument is predicated on the simply fact that buying more domestically will drive up national production, and that this increased production will in turn result in a healthier domestic job market.
• Local governments leverage subsidies, tariffs, import quotas, and anti-dumping policies to maximize strategic capacity domestically, thus creating jobs.
• A sentiment towards protectionism has developed in the U.S. due to the jobs argument in view of an imbalanced trade ratio, where more exports (production and jobs at home) is required to sustain the ongoing consumption of imports.
• Along similar lines, it is common practice for companies to identify strategic alliances abroad and send much of the production work to these locations (outsourcing), motivating governments to bring these jobs back home.
• Local governments leverage subsidies, tariffs, import quotas, and anti-dumping policies to maximize strategic capacity domestically, thus creating jobs.

Key Terms

Import Quota

A restriction on the import of something to a specific quantity.

Trade Balance

The difference between the monetary value of exports and imports in an economy over a certain period of time.

Many policy makers who are proponents of trade protectionism make the argument that limiting imports will create more jobs at home. This argument is predicated on the idea that buying more domestically will drive up national production, and that this increased production will in turn result in a healthier domestic job market. Domestic industries will not have to compete with foreign producers, and are therefore protected from losing marketshare to cheaper imports.

Trade Balance

It is useful to consider the concept of a trade balance, or net exports, in the context of the jobs argument. It is interesting to look at to assess the extremity to which some nations are ‘consumer nations’ and others are ‘producer nations’. The U.S. and China are a great example of opposite sides of the spectrum, where the trade balance is heavy on one side of the spectrum.

Trade Balances on a Global Scale

It is interesting to look at this graph and assess the extremity to which some nations are ‘consumer nations’ and others are ‘producer nations. ‘ The U.S. and China are a great example of opposite sides of the spectrum, where the trade balance is heavily on one side of the spectrum.

In the U.S. this has created a dramatic push for trade protectionism policies; something the United States has not actively pursued in quite some time. The disastrous 2008 economic collapse via the clear-cut abuses by the banks, and the resulting drop in employment rates, has created an incredibly tangible social and political agenda to bring production back to domestic jobs from overseas. This sentiment towards protectionism is a direct result of the jobs argument in view of an imbalanced trade ratio, where more exports (production and jobs at home) are required to sustain the ongoing consumption of imports.

Outsourcing

Along similar lines, it is common practice for companies to identify strategic alliances abroad and send much of the production work to these locations. This is often a result of cheaper labor and easier systems of governance in those regions. The obvious perspective, from a policy making context, is that these are jobs lost to overseas competitors. While this perspective is often criticized for being short-sighted and against the modern economic view of free markets, it has resulted in policy makers providing incentives to ‘bring jobs back home. ‘

This idea of limiting outsourcing in light of the protectionist jobs argument has resulted in governmental subsidies that work to offset the costs of manufacturing domestically (in the U.S. particularly). These subsidies are essentially grants or tax breaks for companies operating domestically and creating jobs, driving up employment rates via protectionist strategies.

Trade Restriction Strategies

Offsetting the threats of outsourcing and trade imbalances and driving domestic purchasing, and thus domestic production, is done through a variety of political vehicles. Most notable among them are:

• Import Quotas: This is the act of limiting the number of a certain good that can be purchasing from a given country, ensuring that domestic producers maintain a portion of the market share.
• Tariffs: Tariffs are fairly straight-forward, essentially taxes to bring goods into a given country. High tariffs will raise the cost for foreign producers to sell their goods in a domestic system, providing strategic advantages for local producers. One of the pitfalls of tariffs is the likelihood of retaliation, where the foreign government returns with similar tariffs. This will in turn damage global prospects for domestic suppliers.
• Anti-dumping:Anti-dumping legislation actively offsets the ability of low cost or highly subsidized producers in foreign countries to undercut prices in a domestic system. Dumping is the process of selling goods far below market value to drive out competition, often in pursuit of creating a monopoly.
• Subsidies: On the other end of the spectrum, and as noted above, governments can provide subsidies to domestic producers to lower their costs and drive up competitive ability. This can in turn create jobs.

31.5.5: A Summary of International Trade Agreements

International trade agreements are agreements across national borders that reduce or eliminate trade barriers to promote economic exchange.

Learning Objective

Identify at least three main international trade agreements

Key Points

• International trade encounters a variety of obstacles which reduce trade incentives. This is usually through tariffs, quotas, taxes, and other trade restrictions.
• The WTO is the largest international trade organization, replacing the General Agreement on Tariffs and Trade (GATT) in 1995, designed to enable international trade while reducing unfair practices.
• NAFTA is a trilateral agreement between the United States, Canada and Mexico designed to minimize any trade or investment barriers between any of these countries (primarily in the form of tariffs).
• The APEC forum is a cooperative discussion between 21 countries in the Pacific Rim region promoting free trade, with a focus on newly industrialized economies (NIE).

Key Terms

Foreign direct investment

Investment into production or business in a country by an individual or company of another country.

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

International trade agreements are trade agreements across national borders intended to reduce or eliminate trade barriers to promote economic exchange. International trade encounters a variety of obstacles, some of which pertain to the protectionism identified in other atoms, which reduce trade incentives. This is usually through tariffs, quotas, taxes, and other trade restrictions. It is also useful to create standards and norms across different countries, particularly for things like intellectual property law recognition, which enables businesses to operate across borders.

There are quite a few international trade agreements, some of which are more formal than others. The trade agreements below provide a fairly comprehensive overview of the current international trade environment:

World Trade Organization (WTO)

The WTO is the largest international trade organization, replacing the General Agreement on Tariffs and Trade (GATT) in 1995, designed to enable international trade while reducing unfair practices. In many ways, the WTO is more complex than other international trade agreements because it incorporates a variety of smaller agreements into a larger framework. The WTO includes upwards of 60 different agreements alongside 159 official members and 25 observers. underlines how effective and universal international trade agreements are becoming. The WTO performs several objective functions as well if trade disputes arise, acting as a framework for assessing appropriate international trade practices.

WTO Members

The World Trade Organization (WTO) is an organization designed to oversee and enable international trade. This map shows how successful this has been on a global scale.

The core of the WTO is the most-favored nation (MFN) rule, which states that each WTO member must be charged the lowest tariffs that an importer places on any country. For example, if the US charges Brazil a 5% tariff on imported clothes, and this is the lowest tariff it has placed on any country in the WTO, all other WTO members must also be charged a 5% tariff. Every WTO member gets charged the lowest tariff that an importer charges any other member.

North American Free Trade Agreement (NAFTA)

Unlike the WTO, which is an entirely global approach, most international agreements stem from geographic proximity. NAFTA is a trilateral agreement between the United States, Canada and Mexico designed to minimize any trade or investment barriers between any of these countries (primarily in the form of tariffs). Generally speaking, the United States demonstrates a trade deficit with these countries relative to goods and a surplus relative to services. The United States also demonstrates high and fast-growing foreign direct investment (FDI) in both regions.

NAFTA Participants

This map outlines each of the countries involved in the North American Free Trade Agreement, an international trade agreement focused on a geographic proximity.

There has been a great deal of controversy surrounding this trade agreement. Agriculture is not included in this agreement, and is often a tough point of discussion for the WTO as well. Mexico is also a point tension due to the fact that it is developing economically (compared to the U.S. and Canada who are considered already developed). Finally, Canadians have often objected to the NAFTA agreements due to the way in which the United States FDI employs hostile takeovers. These agreements demonstrate some of the validity behind trade protectionism and isolationism (as discussed in other atoms in this chapter).

Asia-Pacific Economic Cooperation (APEC)

The APEC forum is particularly interesting in the context of the above agreements, as it is slightly less formal than the above two (it is referred to as a ‘forum’). The APEC forum is a cooperative discussion between 21 countries in the Pacific Rim region promoting free trade, with a focus on newly industrialized economies (NIE). Developing nations gaining access to capital investment and export agreements is the central outcome of APEC, driving economic growth through controlled global expansion. This region represents over half of the world’s GDP and 40% of the overall world population, making this a critical region of the world economy.

APEC Participants

The Asia-Pacific Economic Cooperation (APEC) is a forum of 21 countries in the Pacific Rim region, focusing on free trade and economic cooperation.

30.1: Questions for Debate

30.1.1: Arguments For and Against Discretionary Monetary Policy

Learning Objective

Contrast discretionary and rules-based monetary policy.

Key Points

• A discretionary policy allows policymakers to respond quickly to events.
• A rule-based policy can be more credible because it is more transparent and easier to anticipate, unlike discretionary policy.
• A strict rules-based approach does not allow for flexibility and as a result may limit choices or be inapplicable in certain circumstances, creating a need for a compromise between discretionary and rules-based policy.

Key Term

discretionary policy

Actions taken in response to changes in the economy. These acts do not follow a strict set of rules, rather, they use subjective judgment to treat each situation in unique manner.

Discretionary policies refer to actions taken in response to changes in the economy, but they do not follow a strict set of rules; instead, they use subjective judgment to treat each situation in a unique manner. For much of the 20th century, governments adopted discretionary policies to correct the business cycle. These typically used fiscal and monetary policy to adjust inflation, output, and unemployment. However, following the stagflation of the 1970s, policymakers were attracted to policy rules.

Discretionary Policy

A discretionary policy is supported because it allows policymakers to respond quickly to events. However, discretionary policy can be subject to dynamic inconsistency: a government may say it intends to raise interest rates indefinitely to bring inflation under control, but then relax its stance later. This could make the policy noncredible and ultimately ineffective.

Rules-based Policy

A rule-based policy can be more credible, because it is more transparent and easier to anticipate, unlike discretionary policy. Policy is implemented based on indicator events in the economy and the policy is expected and carried out in a timely manner. Further, as commented by Milton Friedman who argued in favor of a rules-based approach, the dynamics of discretionary policy present a lag between observation and implementation. This can create compounding issues related to the discretionary policy enacted. However, a strict rules-based approach does not allow for flexibility and as a result may limit choices or be inapplicable in certain circumstances.

Milton Friedman

Milton Friedman was a Nobel Prize (1976) recipient in the field of Economics and was a supporter of rules-based monetary policy.

Compromise

A compromise between strict discretionary and strict rule-based policy is to grant discretionary power to an independent body. For instance, the Federal Reserve Bank, European Central Bank, Bank of England, and Reserve Bank of Australia all set interest rates without government interference, but do not adopt a strict rules-based policy stance. In this case the central banking authorities have autonomy and are able to use monetary policy to enable their mandate of economic growth and full employment. The policies they enact cannot be destabilized by government fiscal policy.

30.1.2: Arguments For and Against Fighting Recession with Expansionary Monetary Policy

Learning Objective

Assess the value of discretionary expansionary monetary policy and the associated shortcomings.

Key Points

• The success of monetary policy intervention rests on the credibility of the central bank on one hand and the understanding of central bank operations related to interest rates and money supply effects on the part of the public, in general.
• Without central bank credibility with respect to low interest rate targets, economic agents may assume that expansionary policy will lead to inflation and begin augmenting behavior to initiate the outcome expected, higher inflation.
• Announcements can be made credible in various ways. One method would be to establish an independent central bank with low inflation targets (but no output targets).

Key Terms

discretionary

Available at one’s discretion; able to be used as one chooses; left to or regulated by one’s own discretion or judgment.

expansionary monetary policy

Traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding.

Expansionary monetary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into investing, leading to overall economic growth. Monetary policy, to a great extent, is the management of expectations between interest rates, the price of the use of money, and the total supply of money. Monetary policy uses a variety of discretionary tools to control one or both of these to influence outcomes like economic growth, inflation, exchange rates with other currencies, and unemployment. When the central bank is in complete control of the money supply, the monetary authority has the ability to alter the money supply and influence the interest rate to achieve policy goals .

Money supply

The increase in the money supply is the primary conduit for expansionary monetary policy.

However, the success of monetary policy intervention rests on the credibility of the central bank on one hand and the understanding of central bank operations related to interest rates and money supply effects on the part of the public, in general. For example, if the central bank is implementing expansionary policy but is committed to keeping interest rates low, the central bank needs to convey this policy with credibility, otherwise economic agents may assume that expansionary policy will lead to inflation and begin augmenting behavior to initiate the outcome expected, higher inflation.

Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body.

30.1.3: Arguments For and Against Fighting Recession with Expansionary Fiscal Policy

Learning Objective

Evaluate the pros and cons of fiscal policy intervention during recession

Key Points

• Government can enact changes in fiscal policy by changing taxes and government spending levels in various sectors.
• Fiscal stimulus through the debt creation channel, may result in reducing the availability of loanable funds, increasing interest rate which may in turn cause a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.
• Fiscal stimulus is implemented with the view that tax relief through a reduction in tax rate and or direct government spending through investment will provide stimulus to increase economic growth by directly influencing consumption or the government expenditure component of GDP.

Key Terms

crowding out

A drop in private investment caused by increase in government investment.

fiscal stimulus

Involves government spending exceeding tax revenue, and is usually undertaken during recessions.

Fiscal policy is a broad term, describing the policies enacted around government revenue and expenditure in order to influence the economy. Governments can increase their revenue by increasing taxes, or increase their expenditure by spending money on programs.

Expansionary fiscal policies are usually implemented during recessions because they attempt to increase economic demand, and as a result, increase economic output which is reduced during a recession. Expansionary fiscal policies involve reducing taxes or increasing government expenditure.

Remember that government revenue is based on collected taxes. When taxes exceed government spending, the government is characterized as having a surplus. When taxes equal government expenditures, the government has a balanced budget. When the government spends more than the revenue it collects, it has a deficit. Increasing government spending, creating a budget deficit, and financing the shortfall through debt issuance are typical policy actions in an expansionary fiscal policy scenario.

Due to the funding process of expansionary policy, there is a lack of consensus among economists with respect to the merits of fiscal stimulus. The discord mostly centers on crowding out, defined as government borrowing leading to higher interest rates that in turn may offset the stimulative impact of government spending. When the government runs a budget deficit, funds will need to come from public or foreign borrowing. As a result, the government issues bonds. This raises interest rates across the economy because government borrowing increases demand for credit in the financial markets. This may in turn reduce aggregate demand for goods and services, which defeats the purpose of a fiscal stimulus.

Fiscal stimulus is implemented with the view that tax relief through a reduction in tax rate and or direct government spending through investment (infrastructure, repair, construction) will provide stimulus to increase economic growth by directly influencing consumption or the government expenditure component of GDP .

Fiscal policy: Taxes

Taxes have not only been a way to initiate fiscal policy intervention, but have also been used to solidify popular approval. In the picture above former President George W. Bush is signing into effect the Tax Relief Reconciliation Act of 2001.

30.1.4: Arguments For and Against Inflation Targeting Policy Interventions

Learning Objective

Argue that central banks should maintain inflation targets, Argue that central banks should not maintain inflation targets

Key Points

• Inflation targeting is an economic policy in which a central bank publicly determines a target inflation rate and then attempts to steer actual inflation towards the target.
• Inflation targeting has often been successful in keeping inflation levels low and avoiding many of its negative effects.
• Inflation targeting is a transparent way to explain interest rate policy and to anchor consumers’ expectations about future inflation.
• On the other hand, if the rule is implemented very strictly, an inflation target could severely limit the central bank’s flexibility in responding to changing economic conditions.
• Others argue that, since inflation isn’t necessarily coupled to any factor internal to a country’s economy, inflation isn’t the best variable to target.

Key Terms

inflation

An increase in the general level of prices or in the cost of living.

central bank

The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.

Inflation targeting is an economic policy in which a central bank publicly determines a target inflation rate and then attempts to steer actual inflation towards the target. For example, in the United States, the Federal Reserve implicitly maintains a target inflation range of 1.7%-2.0%. When inflation falls below this range, the Fed would lower interest rates and raising the money supply in order to push inflation up. Likewise, when inflation rises above the target range, the Fed would raise interest rates and decrease the money supply in order to suppress the high level of inflation . While the inflation rate and the interest rate generally have an inverse relationship, these tools are not always successful in affecting inflation – for example, in response to the 2008 financial crisis and ensuing recession, the Fed raised its target inflation level to 2% and lowered interest rates to nearly zero. This did not, however, succeed in raising inflation to 2%.

Inflation Targeting

The relationship between the money supply and the inflation rate is not exact, but it suggests that a central bank can often affect inflation by adjusting the money supply through higher or lower interest rates.

Argument in Favor of Inflation Targeting

Proponents of inflation targeting argue that a volatile inflation rate has negative effects for an economy. High levels of inflation eat away at savings, increase menu costs and shoe-leather costs, discourage lending, and may create an inflationary spiral that leads to hyperinflation. Inflation targeting has been successful in keeping inflation levels low and avoiding many of these negative effects.

Further, inflation targeting is a transparent way to explain interest rate policy and to anchor consumers’ expectations about future inflation. When the central bank announces an inflation target of 2%, the public knows that if inflation goes too far above or below that level, the central bank will take action. This certainty stimulates economic activity. Further, the public’s expectations about inflation tend to be a self-fulfilling prophecy. When consumers expect high inflation they spend their money immediately, attempting to avoid higher future prices. This increase in demand leads to higher prices, causing more inflation. Likewise, when consumers expect deflation they tend to save their money, delaying consumption until prices fall. This decrease in demand causes producers to sell their goods at lower prices, and the cycle continues. Inflation targeting sets consumers’ expectations, making a certain inflation level easier to maintain.

Arguments Against Inflation Targeting

On the other hand, some argue that the costs of inflation targeting exceed the benefits. If the rule is implemented very strictly, an inflation target could severely limit the central bank’s flexibility in responding to changing economic conditions. During a recession, for example, central banks shouldn’t raise the interest rate even if inflation is above the target level. Further, sometimes higher inflation is a good thing because it stimulates spending. A central bank with a strict inflation targeting rule, however, would not allow that higher inflation rate even if it were otherwise beneficial.

Others argue that, since inflation isn’t necessarily coupled to any factor internal to a country’s economy, inflation isn’t the best variable to target. Adherents of market monetarism, for example, argue that targeting a nominal national income (nominal GDP) would be more effective than targeting inflation. Others suggest targeting long-run inflation, which takes the exchange rate into account, rather than the short-term inflation rate.