Friday, October 17, 2014

Macroeconomic Logic-What Textbook Doesn't Tell You (Important for CIE/ CAL AS Economics) (Part 2)

In my previous posting on Macroeconomic Logic, I had explained how all the main four main macroeconomic variables such as economic growth, unemployment, inflation and current account deficit interact with one another in the most logical way. What I didn’t mention was, there are in fact more macroeconomic variables, or to be more precise macroeconomic objectives than you think. Three other crucial ones are government finances, income inequality and environmental goals which I had purposely omitted. I will add them into our discussions one at a time, so as to minimise confusions

In this second posting, I will introduce another two. One is government finances and another is appreciation/ depreciation of exchange rate. To make things simple, I will consider pound sterling all the time
1. Currency depreciation vs. growth. When the value of pound decreases, British goods will become artificially cheap. This will most likely lead to an increase in the amount of exports. At the same time, weak currency implies that foreign goods will now become artificially more expensive. Imports will likely fall. The combination of these two, holding other factors constant, will lead to a rise in (X-M). Since this is one of the components of AD, that means AD will now shift to the right. Economic growth is achieved as more goods/ services are produced to cater for foreigners

2. Currency depreciation vs. unemployment. When the value of pound decreases, home-made goods will become artificially cheap. As such, value of exports will increase. At the same time, foreign goods will appear artificially more expensive to Britons. That leads to lower imports. Rise in factory orders both from the international and home market will help to rejuvenate the beleaguered manufacturing industry in the UK. Firms will now require more manpower to produce the output. Unemployment is expected to fall

3. Currency depreciation vs. current account deficit. In theory, the weakening of home currency will promote international price competitiveness. Foreigners will now perceive British goods as artificially cheap and so, this may lead to greater exports. In contrast, Britons will consider any imported goods and services to be artificially expensive with the fall in pound. This discourages the consumption of imports. Assuming other factors to be constant, a rise in inflows coupled with a decline in outflows will overall reduce the size of the UK’s current account deficit

4. Currency depreciation vs. inflation. The fall in the value of pound can generally lead to three types of inflation within the UK. First, as exports become artificially cheap while imports artificially expensive, value of (X-M) will increase. This will shift AD to the right thus contributing to demand-pull inflation. Second, a weak pound will indicate that imported final goods, raw materials, spare parts and semi-finished goods are now artificially more expensive. Businesses, facing higher production costs will normally pass this on in the form of higher price to ensure a healthy margin of profits. Cost-push inflation is resulted. Interestingly, if the imported goods become expensive due to relatively higher inflation in other countries or due to weaknesses of home currency, that will contribute to imported inflation, which is also a type of cost-push inflation

5. Currency depreciation vs. government finances. The weakening of pound will promote the international competitiveness of British goods. A rise in factory orders is expected to increase the margin for factories. At the same time, unemployment is likely to fall in this key area due to more manpower needed. If one was to consider carefully, this will probably contribute to greater tax revenue due to higher corporate tax and higher income tax collected. At the same time, the government is expected to pay less in terms of Job Seekers’ Allowance as well as subsidies to prevent bankruptcy

More to come in my next posting. I will introduce fiscal policy and monetary policy and how it works to reduce current account deficit. On top of that, I will also show you how they can actually create effects onto other macroeconomic variables. This is one of the most crucial areas that is not properly introduced in CIE

Macroeconomic Logic-What Textbook Doesn't Tell You (Important for CIE/ CAL AS Economics) (Part 1)

This section is even far more important than my previous posting. A lot of the exam questions, especially macroeconomic essays cannot be well-answered if candidates have poor understanding of how Chapter 5, 6 and 7 are inter-connected. It is a crucial exam skill but for the current CAL/ CIE Economics syllabus, I personally find that the Chapters/ sub-topics aren’t organised in such a way that give candidates the best understanding of macroeconomics and how all those issues are related. In that perspective, Edexcel is way better where macroeconomic variables are introduced one at a time and students are taught to connect them all. While CIE does teach most of the macroeconomic variables, it seems that they are all over the place. GDP/ economic growth is in fact the most fundamental macroeconomic concept, but the weirdest part is that they chose to include it in A2. Most of the time when we talk about lowering unemployment, fall in inflation and widening of current account deficit, we cannot isolate economic growth from our discussions

At the most fundamental level, there are four main macroeconomic variables and they are economic growth, inflation, unemployment and current account deficit
1. Economic growth. Technically, a country/ nation is said to experience an economic growth if there is an increase in the real GDP or potential GDP. Both types of growth can be easily illustrated using the AD/ AS analysis. The former is achieved when the AD curve shifts rightward and the latter is attained when the AS curve increases. They are both growth but not quite the same. In layman’s term, real GDP refers to how much output (quantity) produced in the present whereas potential GDP refers to how much output a nation as a whole can actually produce if there is an improvement in both quantity and quality of factors of production. Since no one, not even economists can actually gauge the true underlying ability of an economy, therefore the term ‘potential’ is being used. As for out discussion here, we will mainly relate growth to an increase in real GDP. If you feel more comfortable, just think of it this way; so long as there an increase in output/ goods and services produced, then economic growth is said to have taken place in a country. More output implies more foods and beverages served, more new furniture produced, higher number of clothes, shoes, air conditioners, cars, mobile phones, papers, tiles, bricks, glasses, concretes, financial products, haircuts and others all made within the border of a country

2. Unemployment: It is when a person who is within the working age, willing and able to work but unfortunately fails to land on a job at the going wage rate. Bear in mind that not everyone who is within the working age group can be classified as jobless. To be counted as one, that person must fulfill all the conditions stated earlier. For an instance, if a person gave job searching and is 30 years old, then he/ she cannot be counted as one since there is no willingness involved. Equally if someone who voluntarily quits his/ her day job to enter full time studying, then that cannot be counted as well

3. Inflation: It is when there is a sustained increase in the average price level. Bear in mind this, just because the price of one or two main items have gone up, it cannot be a basis for us to claim that inflation has taken place. For inflation to exist, there must be an ongoing/ continuous rise in general prices and also overall price increase must be greater than overall price decrease. It is also true that the inflation may not be representative to everyone since our basket of consumption may differ substantially

Current account deficit. It is when the overall outflows of money are greater than the inflows for trade in goods, trade in services, net investment income and net transfers. Usually, the case of current account deficit is due to the poor overall performance for both trade in goods and trade in services. For most of the economies, these two components under the current account are the largest determinant

Now, upon understanding of the basics, we shall step into the next section which is understanding how these four components eventually affect one another. Please do not attempt to rot-learn/ rote-memorise. Use as much logic as possible. That is what I call as ‘sustainable learning’:

1. Economic growth vs. inflation: When there is growth, it is normally followed by a period of rising income. Well how? As mentioned earlier, more output will be produced and to produce that much output, factors of production have to be paid. With more income, consumption into the economy will increase and this can be represented by a rightward shift of AD curve. Demand-pull inflation takes place

2. Economic growth vs. current account deficit. Again, when income rises, people will have more money to spend into the economy. However, it is worth noting that not everything that they spent on is manufactured locally. Some of them are imported goods and services e.g. purchase of imported cars and travelling abroad. This means more money flowing out of the country and hence the case of current account deficit

3. Economic growth and unemployment. When income rises, people will have money to spend into the economy. They will go shopping, travelling domestically, watching movies, fine dining and others. This means businesses will have to employ more people to cater/ accommodate for the rise in customer sales and so unemployment will fall

4. Unemployment vs. inflation. There is an interesting relationship between these two. They are naturally, inversely related. As unemployment rises, inflation will fall and if unemployment falls, inflation will rise. Why is that so? When more people are unemployed, the spending power into the economy will fall. This means a fall in AD curve and so less demand-pull inflation. Likewise, when unemployment rises, it will put a downward pressure on wages. This means a fall in cost-push inflation as well. On contrast, when unemployment is low, there will be greater spending into the economy allowing demand-pull inflation to take hold. Equally, if unemployment is low, skilled manpower can be scarce and in other to retain or attract the best talents to work for them, wages have to be increased. This is the basis for cost-push inflation

5. Unemployment vs. current account deficit. When many people are jobless, that implies weaker overall spending into the economy which may lead to lower consumption of imported goods and services. As less money is outflowing from the country, then size of current account deficit will shrink

6. Inflation vs. current account deficit. When the country experiences relatively higher inflation than its commercial partners, then its goods and services produced are likely to become less price competitive. This implies lesser exports as trading partners would probably substitute towards other countries that are more price competitive. Therefore, current account deficit worsens

Part 2 will come very soon

Forecast Essay Questions for CIE Economics AS Paper 2

What Will Most Likely Appear For Microeconomics?

Chapter 1: Basic Economic Ideas
1. Production possibility curve and economic concepts that can be related to it e.g. growth, unemployment of resources, opportunity cost, international trade, investment in technology and others

2. Why mixed economy is the most common economic system or the desirability of mixed economy as compared to pure capitalism and socialism

Chapter 2: The Price System and the Theory of the Firm
1. Price elasticity of demand and how it is being used to increase total revenue

Chapter 3: Government Intervention in the Price System
1. Comparison between the two types of market failure e.g. public goods vs. merit goods and demerit goods vs. merit goods. Careful in the way the question is being phrased. May confuse candidates with the terms like private, external and social benefits or private, external and social costs

2. Comparing two economic policies and their relative effectiveness in increasing the production/ consumption of merit goods or reducing the production/ consumption of demerit goods

What Will Most Likely Appear For Macroeconomics?
Chapter 4: International trade
1. Establishment of trading blocs, their merits and demerits

2. Advantages and disadvantages of imposing trade barriers

3. Principle of comparative advantage and its limitations

Chapter 5: Theory and Measurement in the Macroeconomy
1. Difference between the Claimant Count and Labour Force Survey (LFS) method of measuring unemployment. Also candidates must know their respective limitations

2. List of factors that can influence the size of a labour force and their productivity

3. The construction of CPI and what are some of the problems

Chapter 6: Macroeconomic Problems
1. Knowing the difference between demand-pull and cost-push inflation. Being aware that monetary inflation is actually a form of demand-pull inflation and imported inflation is a kind of cost-push inflation. Must also know factors that can influence all these inflations

2. Difference between anticipated and unanticipated inflation

3. Factors that can cause the exchange rate to fluctuate such as interest rate, inflation rate, speculative actions and others

4. Which is more desirable for a country? Currency appreciation or depreciation? Must know merits and demerits for both

5. Comparing between two macroeconomic issues and which matters more to the government e.g. high inflation or large current account deficit, appreciation or high inflation, depreciation or worsening terms of trade and others

Chapter 7: Macroeconomic Policies
1. Comparing between expenditure-dampening and expenditure-switching policies to fix the problem of large current account deficit. Candidates can propose any policies under both and must also know their general limitations

2. Comparing SPECIFICALLY two economic policies to fix the problem of current account deficit e.g. tariffs vs. quota or tariffs vs. currency devaluation etc