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

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