Understanding Inflation Data

“Consumer Price Index (CPI) annual inflation – was 4.5% in October down from 5.2% in September”



Source: http://www.statistics.gov.uk/cci/nugget.asp?id=19

Inflation: Defined as sustain increase in general price level

Inflation standing at 4.5% in October means that prices of goods & services had increase 4.5% over the last 12 months. When it was announced earlier that the inflation rate have fallen from 5.2% to 4.5%, inflation wasn’t really falling. It is still increasing, but at a slower rate

This is a very common mistake by students in exam. Whenever they are given a data (with % axis) that shows a falling macroeconomic indicator, they will say “…..is falling” & thus lose 2/3 marks for that

The Myth Of Savings In UK

Source: http://www.statistics.gov.uk/

Savings ratio: Defined as proportion of disposable income that is saved rather than spent. For instance, if an individual has disposable income of £2000 & £500 is saved then we say the savings ratio is 25%.

But the figure here doesn’t reflect the true situation in UK & we never seen such high savings ratio. 12% is high enough & it was achieved in the earlier years.

Why savings ratio is high earlier?

(1) Economic growth. UK registered an average of 2.5% economic growth after the post-war period & this figure is much higher compared to other large EU economies such as France, Germany & Italy. The robust growth is accompanied by rising real income & living standards. People have more money for consumption & to set aside for savings

(2) High interest rates offered. When Lady Thatcher took over administration in 1979, it was a period of chaos. Inflation was as high as 27%. Being a monetarist, she believes that to control inflation she must control the money supply. As such interest rates were raised to as high as 14% & this act as a strong incentive to save rather than spend

(3) To repay debt. It all began towards the end of 1980s which coincide with the Lawson Boom. In that period, Nigel Lawson the Chancellor, took the populist step to slash income tax. Also in the same period, interest rates were so low that it actually encouraged more people to borrow & finance a property. Prices of property shooting up to 300% are common sight that time. Growth of 5% in 1988/89 was proven to be unsustainable. Rose in inflation, was followed by high interest rates & this is a painful experience for those who had take out loans. Recession followed suit after that. People became thrift to repay all the accumulated debts in earlier years

The good things about high savings ratio?

(1) Reduce reliance of consumption-led growth. UK economic growth is said to be fully driven by consumption. It stands at about 66% of GDP. This means if there is an overturn in consumer confidence, the public may start to reduce spending significantly & UK economy will therefore head towards a sharp downturn. Therefore UK needs some serious initiative to balance all the 4 components of AD (C, I, G & X-M) particularly investment spending & its export market. Having said that, this is no easy task. To reduce C, necessarily there must be low consumer confidence or high interest rates, but this will also pull downward the I. In other word C, I & X-M are somehow inter-related

(2) Financial backup. With high level of savings, one can prepare themselves for situations such as buying property, starting a family, retirement plan, sickness & other form of unforeseen circumstances. But it is worthwhile to take note that if the society is generally frugal it doesn’t serve well for the economy either. Japan has the largest saving in the world & the amount is remarkably larger than US GDP itself. Unfortunately its economy has remained stagnant throughout the 1990s

(3) More funds for investment. In theory as we learn in Unit 1 PPF, when the society choose to have high level of savings now, it means that there will be more monies available in the future for investment spending, thus leading to economic growth. Another way to look at this is people choose to sacrifice the present consumption in order to have higher standards of living in the future

(4) Banks can reduce lending from money markets. If all the years savings ratio in UK is high, banks, building societies & financial institutions could have avoid all the financial & economic mess that we have today. Low level of savings translates to lesser funds available for lending. Therefore in order to do business as usual, these banks will raise financing from the money market. If one of the large & influential institution such as Freddie Mac & Fannie Mae were to run into trouble, the whole financial system itself will collapse, when these banks suddenly loss the source of funding

Why savings ratio dropped in the recent years?

(1) Ease of credit. Before the sub-prime mortgage crisis, banks are superbly generous. Many people who were not qualify for loan under a traditional state may now even get a funding. Even some people with unstable job & income could easily get access to millions. Banks were willing to lend as they assume that the property market boom will ‘go on forever’. Therefore even poor paymaster will be able to repay their loan since the value of their property is rising. Various types of mortgages were issued such as 100%-mortgages, interest-only mortgages to induce people to borrow

(2) Low interest rates. On top of banks’ generosity, basic rate that time was very low, standing at about 3% in early 2000s before gradually increased to 5.75% in April 2007. This exacerbated the lending activities.

(3) Low real return from savings. Interest rates were very high in the early 1990s, at the rate of 12%. This partly explains why savings ratio persistently staying above 10% between year 1992 to 1997. In 2000s however, interest rates were very low & even staying close to inflation. From economic point of view, this reduces the incentive to save & therefore people would rather spend rather than earning a meagre return

Interestingly from the latest data, UK’s key interest rate is 2% while the inflation is standing at 4.5% & this actually gives negative real return of 2.5%. So one could begin to argue as to why people not starting to spend then? My answer is the problems of collapse in consumer confidence & job insecurity actually dominates the argument. After all in recession, having cash in hand is the safest thing one can do

Why this is bad?

(1) Risk of default. Low savings could only imply one thing & that is people have spent too much money into the economy & this aggravates demand-pull inflation. This is likely true from UK’s experience as 66% of its GDP is dictated by private consumption alone. When inflationary pressure build up, it is very normal for the MPC to increase interest rates to slowdown the heating economy. Also it’s part of meeting the inflationary target rate of CPI 2% +/- 1%. Interest rates rose to 5.75% last year & this mean more & more people will have repayment problem. This is also one of the key arguments as to how subprime mortgage crisis began

(2) Little financial backup. People with not much savings have very little margin for error. They could face difficulty in the current period of recession where retrenchment is common or even during the period of escalating inflation

(3) Large current account deficit. UK people generally have high marginal propensity to import. With any minor increase in disposable income, large bulk of it will be spent onto consumption of imported goods rather than saved. This explains why UK’s current account has remained almost permanently in deficit. Although there is an increase in trade in services over the years, but it is still insufficient to offset the large deficit in trade in goods. Large current account deficit greatly increase the chance of currency devaluation if the country is unable to attract sufficient inflow of capital or hot money which will create the demand for its currency. The collapse of Iceland kroner is due to this

(4) Financial & economic mess. If UK’s banks have large enough pool of savings, maybe everyone could have escaped this financial mess. The problem starts when the bank has insufficient deposits to create lending, as such raising it from the money markets. Northern Rock which had went into administration earlier this year was a good example, of how dangerous it could be by borrowing from other banks. Its collapse caused a temporary panic among Britons where people start queuing up to withdraw their money even from the bank that has sound balance sheet on fear that their money could vanished into the thin air. Luckily the British government acts fast enough to given assurance to depositors’ savings

But the damage onto British economy had been done. Credit crunch means difficult for bank to give lending, thus causing a fall in demand for housing. Prices of property suffer a freefall & there is negative wealth effect. Repossessions are everywhere. The last thing a borrower would like to see is his house being repossessed!

Some Techniques To Answer Unit 1: Markets & How They Work?

This will be a great revision tips & answering techniques for those of you taking the Unit 1: Markets & How They Work? (Edexcel) economics examination next month

Generally the paper consists of 2 parts. Part A has 8 multiple choice questions with options A to D. In part B, there will be 2 sets of data response questions where you have to choose 1. The weight carry by this paper is 90 & I always advise my students to attempt to score well in this paper since it’s the easiest among all

Time for the paper is 1 hour

Are those questions in Part A predictable? My answer is YES

Popular concepts being tested:

(1) Production possibility frontier. Standard of living in the present & future, PPF shifting inward & outward, concept of increasing opportunity costs from further producing one more unit of output

(2) Opportunity costs. The question will give a scenario e.g. 2 projects but the government only have such limited amount of funds. So in this case it has to choose & the project foregone is the opportunity costs

(3) Comparative advantage & absolute advantage. Students will be given 2 straight lines & asked to determine if trade is possible between the 2 countries & if it is, what good will be traded?

(4) Positive & normative statement. Students will be given 2 statements & asked to identify which is positive & which is normative

(5) Producer & consumer surplus. Question will normally give demand & supply curve intersecting one another. Students will be asked to determine area of consumer surplus/ producer surplus, what is the additional area/ fall in area of consumer surplus/ producer surplus when demand/ supply curve shifts

(6) Price elasticity of demand (PED). A table is given & students will be asked to determine if total revenue has increased/fallen given the demand for the product is elastic/ inelastic

(7) Cross elasticity of demand (XED). Identifying from options given, which pair of good is complement/ substitute, simple calculation of XED

(8) Income elasticity of demand (YED). Determining types of good whether it is inferior, luxury or necessities by calculation

(9) Price elasticity of supply (PES). Determining which option has inelastic supply in short run/ elastic supply in long run. Overall there will be normally 2 or 3 questions tested on the concept of elasticity itself

(10) Taxes & subsidies. Determining total subsidy payout by government/ tax collection by government, producers/ consumers portion of subsidy/ tax

(11) Demand & supply. This is the most popular question. Since establishment of the exam, without fail there will be a question on this. Student will be given 2 scenarios, where one will lead to movement of demand curve while another will give information about supply curve. Then students need to decide the new equilibrium

Techniques to score well in Part A

Rule no.1: Whenever you think that your answer can be supported by drawing a diagram please do so. Very applicable to questions involving PPF such as drawing out the PPF based on information given. The information here can be a scenario or data. Also very applicable to questions involving PED, XED, YED & PES

Rule no 2: If you are given a diagram, please do something onto it. Again if you are given a PPF, perhaps you can draw an inward or outward PPF. Or if you are given question on producer/ consumer surplus, please shade the area of the surplus. If there is question on taxation/ subsidy, please shade those areas

Rule no 3. If you are given data, please do interpretation or calculation. Very much applicable to PPF as sometimes you are given set of data or even PED/ PES/ XED/ YED

What to expect in Part B?

(1) Commodities. Very popularly tested in every single exam. They can be palladium, steel, uranium, bauxite, oil, aluminium etc. They could even give you some kind of plantations which share the same nature like commodities. You should feel very happy if you get commodities-based questions as nothing much they can test you on. Questions they will definitely ask, define PES, short run & long run PES of the mentioned commodity, impact onto producer from the increase in the price of that commodity & also what happen to the demand of the commodity if the price of substitutes change?

(2) Demand-supply diagram. This carry about 5m or 6m. Also the most popular question in Part B of each exam. I noticed that normally the intersection of both demand-supply curves will always lead to price increase

(3) Evaluation of price increase. Always mention, depends on the extent of shift in demand/ supply curve, the larger the shift the greater will be the price increase. Also can mention depends on PED/ PES, the more inelastic they are, the more will be the price increase

(4)Evaluation on substitute. Always mention depends on the level of substitubility between the 2 goods. If they are weak substitutes, increase in the price of one may not even affect the demand in another

I hope this helps you a lot in narrowing down the scope of your revision!

Learning Economics The Fun & Creative Way

Is economy that horror-ble? In the period of economic boom, all countries seems to have some kind of ego talking about their GDP figures, how does the stock market performs, rise in paycheck etc. But in the period of recession the only thing that haunts every economy is volatile stock market that wipes out billions in a day, rising unemployment, GDP sliding into red, pay cut & all other bad things

Well, it’s not wrong spelling. It is meant to be MATH rather than MASS. The plunge of US stock market is closely associated with those mathematically complicated investment that not any ordinary person on the street can understand. Maybe not even a Professor!

The ‘haunted’ White House represents series of problems that President-Elect Obama will inherit from its predecessor, George W. Bush. Among problems highlighted is the dying global economy led by the downfall of America, ballooning expenses on healthcare due to the rising amount of retirees & the large scale of unemployment in US economy

Margaret Thatcher's Contribution To UK Economy

As mentioned in the earlier post, due to Lady Thatcher’s strict view on less-government intervention, austerity measures such as budget cut on education, healthcare & housing was introduced. This was on top of higher interest rates proposed by her

During this time in 1981, UK went into a deep recession. As a result she reduced direct tax on income, but some 364 leading economists had written in to warn the possible consequences. This is followed by an increase in indirect taxes

She also contributed largely in reducing the power of trade unions. The largest single confrontation faced by her was the National Union Mineworkers (NUM) strike which lasted for a year from 1984-85. The strike was due to opposition against government’s decision to close down large number of mines & slashing down thousands of jobs. In 1985, the NUM conceded without a deal. In the same year 25 mines were closed & many more followed suit later. The remaining one were privatised

Privatisation is the process of transferring the ownership of business from the public sector to the private sector. Some large businesses are separated into several private entities. The aim is to prevent the abuse of private monopoly power, create more competition & allowing firms to operate more efficiently since now there are profit motives. Among firms are British Rail, British Petroleum, British Shipbuilders, British Coal, British Telecom etc

Owing to Thatcherism, UK economy had since then prospered. Macroeconomically, UK is faring better than France, Germany & Italy with an average annual growth of about 2.5%. Labour union has been tamed unlike those in France. Relatively UK also has lower unemployment if match against other large EU economies, thanks to the flexibility in labour market that she had brought in

Margaret Thatcher & UK's Recession in 1981

Margaret Thatcher became the very first lady Prime Minister in UK & yet the longest serving from 1979-1990. Her administration was one of the most interesting one in the history of UK economics as it led to many changes, some for the good & some bad. She is also known as the ‘Iron Lady’ due to her tough-talking rhetoric

When she came to power, UK at that time had:

(a) Powerful trade unions

(b) High inflation of 27% which is mainly caused by second world oil crisis provoked by the Iranian Revolution & also absurd wage demand by labour unions

(c) Unemployment which reach as high as 700, 000 people

(d) High government debt

Thatcher’s political & economic philosophy is reduced state intervention, encouraging the working of free markets & entrepreneurialism. Also she is a Monetarist. In other word she believes that the only way to stop spiralling inflation is to reduce money supply. Only when everyone has problem of getting access to money, there will be less spending into the economy thus reducing consumption (C), the biggest component of AD. When AD shifts leftward, price level will fall thus easing the easing inflationary pressure that built up in UK economy that time

But many economists felt that her extreme deflationary stance was far too much for the economy. Deflationary stance here means raising interest rates, raising taxes & reducing government expenditure (tight monetary & fiscal policy). Consistent with the AD-AS diagram that we learn, tightening stance here successfully remove the inflationary pressure in UK economy. However, it is done at the expense of worsening unemployment

Many social problems arise from here, such as riots in Britain in 1981 as people are being jobless for some time. Extreme austerity measures & high unemployment later fed into the whole economy & create a devastating force called negative multiplier effect. It means an initial fall in AD that is followed by a secondary larger fall in AD. This is proven when the unemployment in UK reached as high as 3 million in 1986

As in the case of higher interest rates, pound continued to appreciate against other currencies. This caused UK to lose competitiveness because buying goods & services from UK will be more expensive. That time sterling stood against dollar at £1 to $2.50 from $1.50. The problem is exacerbated when sterling became some kind of petro-currency owing to the fact that UK does produce its own oil from the North Sea. As countries buy oil from UK, demand for pound will increase even more, thus putting immense pressure onto the competitiveness of manufacturing sector

UK therefore tasted the worst effect of its recession in 1981

Of course there are more to say regarding Mrs. Thatcher contribution to British economic efficiency. That is mainly through the supply side policies she introduced. Also in the coming posting I will write about the notorious Lawson Boom during her tenure

Video Lesson by Richard Pettinger: Keynesian Economics

Video Lesson by Richard Pettinger: National Debt

Justifications Of Ever-Falling Mortgage Approvals In UK

It seems that the worst from property market woes in UK are far from over. In the latest data released by Bank of England, mortgage approvals have again fallen in October, standing at around 32, 000 which 1,000 lower than previous. Overall mortgage approvals have slumped 74% in just one year owing to the global credit crunch

What all this has to say?
Justifications:

(1) Banks more frugal in lending. The financial mess originated from US. High mortgage default rates there had caused the bank to seriously lose lots of money. Therefore this leads to liquidity problem. Banks are now more frugal to lend to each other, internally & externally. Unfortunately, British banks also raise money through money markets. Difficulty to extend cash caused them to cut mortgage lending. Homeowners in UK find it difficult to borrow money, & this automatically translates to fall in demand for housing. As such prices of house began to crash creating a negative wealth effect

(2) More banks will be nationalised. I argue that this problem is inflicted by the bank itself. It can’t be denied that initially banks do have serious balance sheet problems. But since the UK government is willing to pump in more money to increase liquidity, stabilise the financial system & slashed base rates to 3%, many banks remain stubborn in giving out mortgage financing. Some even increase the interest rate charge on credit cards. Part of the reason is that the bankers now would like to seize the opportunity to improve their financial standing.

But doing so will bring them more harm than good. Charging higher rates will further discourage spending in a dying economy. By not passing on the lower lending rates will witness more people to go defaults in environment where unemployment is increasing everyday. More will soon follow the footsteps of Northern Rock, Halifax, RBS & Bradford and Bingley

(3) UK economy will be in long recession. On average house prices had fallen between 10%-15%. Some other areas fell even more. With the current ongoing situation, there is no sign when the property market slump will be over. Since traditionally large proportion of Britons store their wealth in the property market, this translates to falling wealth which will negatively feed into the whole economy. As people feel poorer, they will spend lesser. Fall in consumption will cause a fall in AD. Real output will fall. This problem will be exacerbated by the negative multiplier effect

(4) Possibly another rate cut. The monetary authority will likely slash interest rates in the coming meeting in December (in fact they have. Now base rate is at 2%, the lowest in 57 years). Given the worsening UK economy outlook in 2009, the threat of inflation had been taken place by deflation. As such, MPC will have more flexibility to adjust the rate downward. Economic growth is the major concern now

(5) More fiscal stimulus. It is very normal to witness the government to spend more money into the economy during recession. Monies will be spent onto building motorways, construct schools, infrastructures etc that can potentially absorb several hundred thousands of redundant workers. The aim is to create consumption into the economy. But more often that not, national debt as % of GDP will increase. This is because government will need to borrow more to finance all those development projects, while at the same time GDP is shrinking. Do the math & you will understand

What Determines The Oil Price?

It is not that difficult to understand the commodities market, such as oil. It can be easily & effectively explained using simple demand-supply diagram analysis. The prices of oil will increase if there is strong demand or cutback in supply (or both). Its prices will fall, like now when the demand sets back & there is overproduction in the market

Demand factor

(1) Period. During the winter, demand for oil will increase for heating purposes. The same goes for summer holiday, where most people will be travelling around. These 2 drive the oil price up

(2) Economic growth. Oil price is strongly correlated with level of economic growth. In the period of boom, oil price will normally skyrocket as there is a strong demand for it to fuel the industrial activities. There will be more flights for meetings, more trucks delivering goods, more people doing sales thus more cars on the road & more factories operating. The rise in oil price is also exacerbated by the rapid economic expansion in China & India, which records an average 8-10% of annual economic growth in the last few years

(3) Decision to pile up. The extent of oil price increase will also depends on how much oil those large economies such as US, China & India decide set aside for their reserves. US had long established its own oil reserves, while China has come up with 4 strategic reserves centres at coastal areas of Zhenhai, Zhousan, Dalian & Huangdao. It will start operating this month. Meanwhile India is also in the midst of constructing its storage centre this year, with its first centre in Visakhapatnam. Its 2 upcoming oil reserves will be in Mangalore & Podur.

Countries want to have their own reserves as an insurance against war & other external shocks. In such period they can reduce their reliability on imported oil & release it from their own reserves. Also it may reduce the risk of cost-push inflation onto their economy

(4) Futures traders. The price of oil is actually set in the oil futures market. Futures is a binding contract that gives one the right to purchase oil at a predetermined price & predetermined date in the future. 2 popular traders of futures are speculators & hedgers. Speculators have no intention of buying the product, but merely guessing the direction of the price to profit from it. Unfortunately, these speculators are the major driver of oil prices in the market, driving the oil price to as high as $147 in July. Hedgers are like airline firms buying oil futures to safeguard against any rising prices that may jeopardise their operations

Financial institutions are also on the increasing extent treated oil contracts like investment in shares or currencies. They buy these oil contracts in the hope their value will go up before selling them. Alternatively, if they think that its price will fall, they will sell oil contracts they don’t own (short sell) & buy them later to profit from the difference

(5) Strength US dollar. All commodities such as oil, steel, gold, palladium, aluminium & tin are traded in the value of greenback. Therefore as value of dollar weakens against other currencies, it means relatively cheaper to buy oil. Demand for oil will increase & this will naturally push the oil price higher. Also the dollar may rebound later since there will be greater need for dollar to facilitate the transaction. Its value also depends on many other factors for e.g. level of interest rates in US

Supply factor

(1) OPEC’s role. OPEC (Organisation of Petroleum Exporting Countries) controls 55% of the world oil exports. If the world oil price is on the downward pressure it may jeopardise the revenue for some of its members such as Iran & Nigeria, which economies are less diversified. These 2 are also known as the price-hawk for their aggressive stance in lobbying for higher oil price. Therefore, to safeguard their interest, they have the tendency to cut production. As supply falls back, price will increase

(2) Non-OPEC’s role. Much attention were given to OPEC members, without realising that non-OPEC oil producers such as Russia, Oman, Norway & Mexico have the potential to influence the world oil price. Even if OPEC decided to cut back the supply of oil to raise its price, it will not be successful if on the other hand, these countries raise their production. For instance, in 2001 OPEC’s effort to push up oil price failed when Oman & Russia increased oil production heavily

(3) Weather. Unpredictable weather, such as Tropical Storm Gustav, hurricane Katrina & Rita had the potential of disrupting oil production. For instance it may damage the oil platforms, refining networks, pipelines etc. If it does, there will be a fall of supply in the market, thus driving the price up. As a matter of fact, much of this has to do with “self-fulfilling prophecy”. Oil traders “will want to believe” that this will happen, therefore driving the demand & therefore oil price

(4) Violence against producers. Lots of the world’s oil unfortunately comes from politically unstable countries such as Nigeria & Iraq. For instance, somewhere June this year, some militants had launched an attack at Bonga oil platform where Shell is operating, thus causing it to stop operating temporarily. As supply falls, oil price increased for that day

(5) Level of investment. Depending on the market price for oil. If the oil price is high, oil companies will generate greater supernormal profit which can be then reinvested onto their operations. These include R&D activities, exploration of new oil deposits, setting oil platforms, pipelines etc which actually costs billions of dollars. In the long run, once oil infrastructures were set up, producers will be able to be more responsive to market demand. Any shortage in demand can be met by increasing the supply of oil, thus stabilising the world oil price

The ultimate determinant of oil price will actually be the interaction between the demand & supply curve. Depends on which shifts more. For instance, the current world oil price lingering around $51 is said to be due to demand falling faster than the supply

Theories Of Development 3: Lewis Dual Sector Model

Proposed by Sir Arthur Lewis in 1954. The theory explains about the transition of labour between 2 sectors, from the agriculture to the industrial

The dual economies

(1) Agriculture. It was assumed that many LDCs (less developed countries) had dual economies, the traditional agriculture sector & modern industrial sector. The traditional farming is characterised by subsistence nature, that is most of the agriculture produce are meant for own consumption rather than traded. Also it is of low productivity, hence low output, low incomes, low savings & high unemployment. Migration of labours to urban is said to have negligible impact on agriculture output as MP = 0. (marginal product of farmer is zero). Think about this. How many farmers can be employed on a fixed number of lands?

Availability of food to remaining people will be higher since the same amount of food will be distributed amongst fewer people

(2) Industrial sector. The modern sectors will absorb surplus of labours from rural. As employment increase, there will be more output hence more income & profits. Additional income will increase demand for domestic goods & services while increase in profits will be reinvested. The rural-urban migration therefore offers self-generating growth

Evaluations

(1) MP = 0 is true in certain times. During the planting & harvesting period, definitely more workers will be needed

Shanty town in India

Shanty town in Mexico

Shanty town in South Africa

(2) Modern sectors may not want to hire more workers. With greater profits, modern sectors may invest in capital-intensive methods of production rather than labour-intensive. As a result, those newly arrived rural migrants which cannot be absorbed into formal economy will join the informal economy & live in shantytowns. (Have you watched Hulk at beginning of the scene in Rio De Janeiro? Those are shantytowns)

(3) Negligence of agriculture sector by government. Realising that it is industrial sector that drives the economy, government may soon neglect primary sector, yet most people live in rural areas where incomes are low. This will cause widening of income inequality

(4) Inability to absorb. The rural-urban migrations in LDCs in reality, has been much larger than the ability of industrial sectors to absorb. Urban unemployment will result & as such we say urban poverty has replaced rural poverty

Theories of Development 2: Harrod Domar Model

Harrod-Domar model is named after Sir Roy Harrod & Evsey Domar, who developed it in 1930s

This model suggests that economy’s growth rate depends on:

(1) Savings. The higher the level of savings, the greater will be the amount of funds available for investment purposes. Investment here include onto fixed capital & human capital

(2) Investment & the productivity of investment. Productivity of investment is also known as capital-output ratio. The lower the ratio the better. To illustrate, say £20 worth of capital equipment produces each £1 of annual output, then a capital-output ratio of 20 to 1 exist. A 10 to 1 capital-output ratio suggest that only £10 of capital is required to produce each £1 of output annually

Economic growth is often associated with amount of labour & capital. In LDCs (less developed countries), it is often the lack of physical capital that hinders economic growth. Meanwhile supply of labour is abundant. When there is economic growth, there will be higher income. As such this allow higher level of savings (cycle repeat itself)

Problems

(1) Economic growth vs. economic development. Both are not the same. Economic growth is necessary but not sufficient condition for development

(2) Difficult to enforce savings. In LDCs, incomes are generally low. Therefore it is difficult for people to save. The bulk of earnings will be spent on necessities

(3) Increased in savings, not necessary lead to economic growth. For a start, there must be people who are willing to take the risk to invest. Also it depends on whether they can access the funds at a reasonable interest rates

(4) Borrowing to finance growth. Borrowing from developed foreign countries, international organisations such as IMF & World Bank to finance investment, will only push the recipients to deeper poverty & having problems of debt repayment. This is because most of the aids are conditional & often the borrower will be forced to some austerity measures that will aggravate the cycle of poverty

(5) Law of diminishing return. This suggest that, as investment increases, the productivity of the physical capital will diminish, causing the capital to output ratio to increase. In other word, as more & more labour is being added to a production process, later these workers will get into each other’s way, causing a disruption e.g. waiting for turn to use an equipment. This will cause an increase in production costs

Video Lesson: National Debt By Richard Pettinger

Theories of Development 1: Fisher-Clark Theory Of Structural Change

This theory was introduced by 2 economists, Fisher & Clark. They proposed that every economy will go through 3 stages of production

(1) First stage is agriculture. Related to the activities of extracting raw materials through mining, forestry, fishing & agriculture. This is the main economic activity for low-income countries

(2) Second stage is industrial. Related to construction & manufacturing sectors. This is the main economy of middle-income countries. As economies develop, income will rise. Since agriculture goods have low YED, demand for them will increase but at less than proportionate of income. Compared to manufacturing goods, relatively it has higher YED. Therefore as income increases, demand for it will also increase at a higher rate. This will lead to rapid industrialisation, thus the shrinking size of agriculture sector

(3) Third stage is services. Related to provision of services such as education, health, international travel, banking etc. This is the core economic activity of high-income countries. Logically, as people feel even much richer, they will now demand for more services e.g. giving their child good education, greater concern for health & travelling internationally. Tertiary sector has very high YED (could be more than 1)

Argument of Fisher-Clark model:

Misleading theory. There are many LDCs (less developed countries) where its core economic activity is tourism, without actually having a properly developed secondary sector. We can get lots of good examples by referring to African countries such as Kenya

What could happen to these countries?

By specialisation,

(1) Volatile income. Countries such as Kenya & many others which are too dependent on tourism sector are very susceptible to global economic uncertainties. In the period of boom, the demand for tourism will increase tremendously & this will lead to increase in government’s revenue. In the period of economic slowdown such as now, obviously there will be much lesser people who want to travel

(2) Risk of collapse. Tourism has very high YED (more than 1). If the consuming nations such as US & Western Europeans face recession like now, a fall in income will generally lead to a greater than proportionate fall in demand for international travel. This negative spill over effects will spread into countries that rely on tourism sector. As a result, airline firms, hotel industry, local F&B will be affected. Falling profits will force them to cut employment. The negative multiplier effect will then spread into the whole system

(3) Rise in debt. Many of these economies are heavily indebted to IMF, World Bank & developed countries. Economy which is on the brink of collapse will push them to borrow more which is deemed by economists as not favourable. Most of those aids given are conditional or some are tied aid. For instance, World Bank & IMF will impose strict conditions such as cut in public spending to repay loan. But very often, these austerity measures cause the indebted countries to be in much poorer state as less development takes place. For developed foreign countries, they impose condition that the recipient countries must spent it onto the exports of donor country

Justification Of The Recent Fiscal Stimulus Announced By Labour

Chancellor Alistair Darling on Monday 24th Nov, had delivered his annual PBR (Pre Budget Report) speech & described many of the upcoming measures as “extraordinary response to extraordinary times”.

Among highlighted issues:

(a) VAT (Value Added Tax) reduced from 17.5% to 15% starting 1st December to end of 2009

(b) £3 billion worth of capital spending on public works projects brought forward from 2010/2011

(c) Further support £1.3 billion to help those who are unemployed to find work

(d) Tax relief for businesses making losses & deferral of rise in corporation tax rates for small businesses

(e) Tax rate for high income earner will rise from 40% to 45%

(f) Increase in NIC (National Insurance Contributions), something that small businesses claim as tax on jobs will increase 0.5% in 2011

(g) Increase in alcohol & tobacco duty

(h)) A 2p per litre increase in fuel duty

Judging the fiscal stimulus

(1) Preventing economic downturn. The increase in government spending & cut in tax is justified. By channeling £3 billion onto capital spending such as motorway building, council housing, schools & energy efficient projects, the Labour government will be able to create more employment. Also tax cut is an essential way to encourage people to spend into the economy, thereby avoiding a period of deflation. To be honest, deflation seems to be inevitable & yet it is an issue that is not thought off by many. Few months ago, people are worried about stagflation since oil price rose to $147 per barrel in July

(2) To earn more tax revenue. By engaging in ambitious borrowing, the government hopes to see UK economy to recover in a year or two. By then, tax revenue will increase & it can be used to patch the current fiscal deficit. On top of that, government may no longer need to spend so much on unemployment benefits in future. If the government does not start borrowing now, very likely recession will become worse. Unemployment will rise & more will be wasted for unemployment benefits payout. Therefore, government borrowing rise anyway

(3) Inevitable. National debt as % of GDP will rise, but this is expected in the period of recession. The logic is, as economy is slowing down, size of GDP shrinks but the level of debt increase. Do the math & you’ll get it

(4) Effective. Cut in VAT will relatively have a greater impact onto low income earners than those rich ones. As goods become cheaper, it means increase in the purchasing power, especially those poor consumers. Given that low income earners have higher marginal propensity to consume (mpc) & that is higher tendency to spend, this can give a good kickstart to economy. The rich has lower mpc as they have owned most of the goods. Therefore whenever there is an increase in income or purchasing power, they are likely to save huge portion of it

Meanwhile the loss of tax revenue can be recovered by increasing the income tax onto those high earners. For instance, from 2011 onwards those who earn £150, 000 will have to pay extra £3, 000 on tax while those with earnings of £200, 000 will pay extra £ 5,000. This is an increase of 40% to 45%

(5) The past is worse. Current UK’s national debt is just 43% of its GDP. We have seen worse one, 70% of GDP in 1970 & yet the government successfully brought it down

Problems

(1) Cutting VAT & other form of taxes may not work. Cutting these taxes may not even encourage people or firms to spend. Most of it could be saved to face future economic uncertainties. Some could be used to pay off debts. Also spending may not take place as the public knew that they will have to pay it back somehow in the future by the way of higher tax

(2) Chancellor Alistair Darling could be too optimistic. He often mentioned about UK economic recovery by end of 2009 or 2010. In my opinion, the economic recovery which may take place in a year or two, could be ‘postponed’. This is because as the economy is about to recover that time, workers & firms will be slammed with burdening tax, increase in NIC by 0.5% by 2011

(3) Worsening current account deficit. Cutting VAT may encourage people to begin spending on imported goods, thus worsening of the existing current account deficit. Also if imports outweigh exports, net exports (X-M) will fall, thus pulling AD down

(4) Fall in tax revenue. The top rate tax to 45% may actually cut government revenues rather than increasing it. This is because more rich people will have the incentive to evade tax. Although any increase in tax rates on incomes above £150, 000 affects only 1% of earners, this accounted for 25% of all income tax revenue.

So what do they do? For those very rich, they will move offshore & perhaps run their business from a tax haven. That is what many sports stars do

(5) The Japan case. The government has spent £80 billion this year, & yet it fails to lift the British economy out of recession. Therefore what is the justification that the bigger £118 billion next year will be successful? Japan is a good example. The government has tried spending itself out of depression & as a result their National Debt amounts to 194% of their GDP, yet the result is not there

Iran & The Myth Of Price Hawk

Logo of OPEC

All this while Iran is notoriously well known for its aggressive stance to deal with falling world oil price. Iran’s OPEC governor, Mohammad Ali Khatibi recently, has once again urged the other members to cut the production of oil between 1-1.5 million barrels per day & this will be confirmed when they meet in Cairo this 29th November

Last month the production of oil has actually been slashed by the same amount. The central of discussion is why Saudi Arabia & other major oil producers are passive while Iran is so active?

Price elasticity of demand (PED): Measures the responsiveness of quantity demanded for a good (oil) to the change in its price. It can also be written as:

PED = (% if change in quantity demanded) / (% change in price)

Application: To determine whether certain goods are price sensitive or not.

Types of PED

(1) Inelastic PED (PED less than 1). Even when there is a large increase in the price of a good, the quantity demanded will not fall by much. Say, if the price of an item increases by 30%, perhaps its quantity demanded will fall only by 15% (that is less than proportionate). Here its PED is 0.5 (when it comes to interpretation, we are only interested with the magnitude of changes, so the negative sign is abandoned). It works vice-versa. Goods like these are less price sensitive

For goods that are inelastic in demand, producer’s total revenue will increase if the price of that good increase. Examples are like oil, cigarettes, alcohol

(2) Elastic PED (PED > 1). This means even when there is a slight increase in the price of a good, its quantity demanded will suffer a large fall. Here the changes are larger than proportionate. Say price increases by 20%, its quantity demanded fall by 50%. Therefore the PED is 2.5. Such good is very price sensitive

For goods with elastic demand, the only way for producers to increase their total revenue is by reducing its price. Examples are like luxury goods & goods with many substitutes

There are other types of PED such as perfectly elastic demand (PED = ∞), perfectly inelastic demand (PED = 0) & unit elastic of demand (PED = 1), but they are less relevant here

The case for oil & Iran:

There is no close substitute for oil. Even if there is, we might not see them in the near future, such as the development of biofuel. Therefore we classify demand for oil as inelastic. That means even with the increase in world oil price, people will not reduce consumption of oil by much as they still need to travel to work, sending kids to colleges, leisure etc

With the inelastic nature, the best course for OPEC countries would of course be high world oil price as it will lead to higher total revenue (TR). But since its price has slumped from the high of $147 in July to approximately $49 on 20th November, no doubt OPEC members will suffer a huge fall in their TR

But one thing for sure, Iran (possibly Nigeria too) has the largest dependency on the export of oil. As much as 85% of Iran’s government source of revenue comes from oil alone. In other word, Iranian economy is too specialised & if there is fluctuation in oil price, it will largely affect their economy. Saudi Arabia, has began to diversify its economy to services sector such as tourism as a long term plan

Iran needs to negotiate with non-OPEC members

Many books & articles have given too much emphasis on OPEC countries, when the non-OPEC members are quite influential too. They are countries like Russia, Oman, Norway & Mexico

In order for world oil price to remain high, either demand must increase or the supply must be cut or both. In the current situation, definitely there will be no demand. Therefore the only option is to cut supply to boost its price. Therefore Iran needs to pursue talk with these non-OPEC members since they could potentially undermine the ability of OPEC to set high oil prices, by increasing production on their part

Why oil prices still fall despite October cut?

Simple. It does not take a genius to see this. Take a piece of paper & draw out a simple demand-supply curve. What happens when demand curve falls more than the supply curve?

For further reading: http://news.bbc.co.uk/2/hi/business/7731317.stm

The Rise of Campbell Soup

We have to see this from the point of income elasticity of demand (YED). YED measures the responsiveness of demand for a good to a change in income. It is given by the formula of:

YED = (% of change in quantity demanded) / (% change in income)

We have 3 situations:

(1) YED greater than 1 (luxury good e.g. international holiday, designers’ clothes). As income increases, quantity demanded for a good will increase by greater than proportionate. For instance say rise in income of 10% causes the quantity demanded for that good to increase by 20%. So YED = 2 (it works vice versa)

(2) YED between 0 & 1 (necessity e.g. vegetables, newspaper etc). As income increases, the quantity demanded for that good will increase, but LESS than proportionate. For instance, again rise in income of 10% will only cause the quantity demanded for that good to increase by 7%. Therefore YED = 0.7 (vice versa)

(3) YED is negative (inferior good e.g. bus travel, potato, crush grain). As income increases, there will be a fall in the quantity demanded for such good. Say, income goes up by 10%, the demand for it will fall 25%. Thereby the YED = -2.5 (vice versa)

The case for Campbell:

In US generally there is a decline in households’ income. However, the demand for Campbell Soup as a form of cheap meal in period where more people opt to eat at home surge dramatically. A top analyst in Bloomberg raised the valuation of its share price to $44.50 or 26% higher than the current $35.42

This is a strong evidence to claim Campbell Soup is an inferior good. But of course, its sales will drop in the period of economic recovery.

Should US Government Consider Bailing Out The 'Beg 3'?

The Big 3 has produced too much of those bulky cars with high fuel consumption & yet do not meet environmental standards

Arguments to bail

(1) Prevent worsening unemployment. Jobless rate in US had climbed to 6.5% in October, the highest rate last seen in 1994 (14 years high). In that month itself, total number of people being retrenched hit 240, 000. Overall, for the first 10 month 1.2 million Americans had lost their jobs. Here the ‘Big 3’ considering GM, Chrysler & Ford employ more than half million people.

If US Treasury decides to reject their begging bowl, very likely unemployment will be exacerbated in 2009 to a level of 10%. Don’t forget, there are many industries that are directly related to the auto industries particularly the supplier of car components. People working in that industry will be affected too. Soon the negative multiplier effect will feed into the whole economy

(2) Exacerbating recession. News of unemployment often serves as headlines these days & it creates trauma among working people. Yahoo had just decided to cut 10% of its workforce. HSBC that day had cut 450 employments. Citigroup will slash up to 75, 000 employment worldwide. Today (21st Nov) Rolls Royce just announced about its plan to slash 2000 jobs

As people loss confidence due to job insecurity, they will not be ready to make commitment by purchasing huge items on credit such as cars, properties, plasma TV etc. Also in such period, people expect price to continuously fall (period of deflation), causing them to defer spending. As private consumption falls, recession will be worsened. Great Depression in 1929 & Japan’s Depression in 1990s should be a good example

(3) Stock market panic. As Congress strongly rejects the proposed $25 billion bailout, investors grow panic. This result in heavy selling of shares across Wall Street sending Dow Jones below 8000 points, especially the shares of the Big 3. People no longer interested to hold stocks of companies that are on the verge of bankruptcy. The spillover effect is tremendous as it affects stock market across emerging economies too

(4) Bank tighten loans. With the fear of another credit crisis, now banks have been much frugal in lending. Number of loans approved dropped significantly. They refuse to extend loan even to people who are buying car. This causes the demand for car to fall & therefore a drop in the revenue of automakers. This even hurt more of its balance sheet. Also they refuse to give funds for Big 3 to finance their restructurings

(5) Equity. The US government had previously bailed ‘undeserving’ financial institutions which are largely accountable for all the mess today. So why not just bail the Big 3? Besides, it is not those blue collar workers in Detroit that contribute to the credit crunch

Arguments not to bail

(1) Free market argument. From the point of free market, the Big 3 should be left on their own. There should be no government intervention in whatever way. Furthermore economists argue that the period of difficulty is the best way to distinguish between the performers & the non-performers

(2) Moral hazard. If aid is given easily, very likely these car firms will not struggle to come out with something innovative e.g. competitive models compared to Japanese rivals or fuel efficient cars. Also they may not even have incentive to lower down production costs. Therefore the same problem will persist in near future. This is likely true since costs of production for automakers have been remaining stubbornly high all this while. The possible explanations are superb healthcare benefits given & ridiculous high salary to its workers

(3) Firms, shareholders & unions responsibility. There are many parties that we can put the blame on. The public condemns the poor management ability, for producing models of cars which are inferior compared to rivals, for producing cars which are not fuel efficient (big & bulky SUV) when oil prices are rising & lastly for signing expensive contracts with unions that it cannot afford. Also they have been bashed yesterday (21st Nov) as they flew to Washington with their begging bowl in a flight that costs $ 20, 000 when they can actually take $288 economy flight ticket.

Possibly, $25 billion given could be misused to sustain the lavish lifestyle of those top managements & paying themselves fat bonuses rather than pumping into business. Shareholdersought to be criticised for allowing the management to do so all this while. Unions must share the blame since they have made ridiculous demand for themselves, hence significantly increase the production costs of auto companies

(4) Problems even before bailing out. The car companies have been loss-making most of the time, even in the period of economic boom. For instance, GM’s operation in Europe has not been profitable for 4 years continuously, since 1999. In US, it had made losses amounting up to $12 billion in 2005 & 2006. As such by giving in the $ 25 billion, very likely it will not be sufficient to sustain their large overhead costs. In fact they have been given a $25 billion earlier this year

(5) Where is the line? There must be a limit, to which extent the US government can assist. If it decides to rescue the US auto industry, other industries which are loss making will think that the government is doing charity. As such they will not have the incentive to be more efficient, thereby turning to the government whenever they face difficulty

(6) Let the employment pattern change. It is argued that this transition, although is painful in the short run, but will not hurt the US economy in long run. For instance, UK once employed many people to work in manufacturing sector. But as Britain is losing her competitiveness due to appreciating pound, cheaper goods from emerging economies etc, more & more people leave this sector & join services sector. It does not take a genius to see that UK economy still prosper after that.

Also UK car industry is getting more insignificant nowadays compared to last time, but it does not spell an end to UK economy

(7) Pressure to other governments. While US is still weighing whether to assist the Big 3 or not, auto companies from the developed economies have already begin lobbying & pressuring their government to do the same in whatever way. If the bailout does materialise, these car makers will definitely argue as in why the US government is able to assist, but not their official? For instance, car manufacturers in EU are now lobbying for € 40 billion euros loan. Meanwhile, carmakers in Britain wanted more tax cuts which could potentially lead to worsening fiscal deficit

Similarities Between PM & A Lecturer

Hi fellow readers, I’m just trying to avoid the conventional postings. Let’s be casual at times. However, I’m neither directly nor indirectly comparing my role to the Prime Minister, not at all. His or her role is far more superior than mine. Interestingly, there could be some similarities

Managing classes is like managing an economy/ a country with different states. Depending on number of classes that I’m responsible for, generally the more classes that I have the greater is my responsibility

(1) PM’s blog vs. my blog. Believe it or not, some leaders do have their own blog to communicate with the people. Malaysia’s former premier, Tun. Dr Mahathir does that. He posts all issues that he disregards with e.g. poor current leadership, world economy, politics etc. I do the same thing too. I write about my opinion on financial issue in America, explaining why pound is falling & yet there is nothing to worry about, whether to bail or not to bail the Big 3 etc. My main intention here is to communicate my ideas to fellow students.

(2) Instill confidence among people vs. students. One of the roles undertaken by a PM is to ensure the existence of consumer confidence. This is utmost important, as it will be a catalyst of economic growth. When people have no confidence, they will not spend into the economy. Same as being a lecturer. I need to ensure my students are well prepared, continuously giving them inspiration (although sometimes pressuring them is more effective), teaching them the skills & techniques to answer papers etc. Without all these, they may not even have confidence to sit for exams. Worse, there are some which choose to skip the exams

(3) Paying tax vs. paying RM 20 for photocopy materials. Government will utilise the tax revenue which comes from income tax, corporation tax, VAT etc to spend into the economy. The same goes for me as well as other lecturers. We will collect RM 20 from each student for the purpose of photocopied materials. In other word the RM 20 is like a kind of ‘tax’. Then we use it for photocopying notes, case studies & exam papers. In real world the government could use that money to build schools, hospitals, upgrade infrastructures & other public works

(4) Mandate given vs. students’ can choose who they want. The public can choose who they want to be the country’s leader through election. The same goes for education industry. In some situation (although limited), students may opt to change lecturers

(5) Election vs. teacher’s evaluation. As there will be term election in the real world, there will be term evaluation for us teacher. If the outcome of the election is bad, we know that the people dislike the current leadership. The same goes for the class. We lecturers can tell if majority of the students like the teacher or not by reading the comments written on the evaluation form. Also the average score for each attribute like clarity in explanation, attitude in class, whether the teacher is helpful or not etc can be use as an indicator

(6) Unemployment vs. weak students. Governments often look into resolving issues regarding unemployment. These are the people that highly need assistance. Also this is to prevent the further widening of income inequality. Equally in class, I’m very concern (although I scold & cynically criticised them a lot) with those who are weak with Economics. I try to extend my help in whatever way I can for instance giving extra lessons, making my phone line available 24 hours a day etc. This is part of my effort to bridge the 'knowledge inequality' among students, especially between the strongest & the weakest

(7) PM late for events vs. me late for classes. I guess I don’t have to further explain on this

(8) PM needs to prepare speech vs. preparing lesson. Some may argue that PM’s speech is prepared by his or her PA (personal assistant). But in many cases, PM has to give speech independently especially in press conference. The speech & answering skills will become better over time. For me, at initial stage I need to prepare extensively for every lesson that I have. But once I’m familiar enough, there is not much preparation needed. Also over the time, I’m more able to address difficult questions asked by my students (although still need to improve). Here, students are like reporters

Is Falling Pound A Curse To British Economy?

Perhaps not,

(1) Fair valuation. IMF estimates that the fair value for pound is $1.50 to £1.The previous $2 to £1 shows that pound was overvalued against the dollar. Therefore the current devaluation is not more than a market correction (just like correction of share prices)

(2) Improve competitiveness. As pound falls against the dollar, Americans will find it cheap to buy more from UK. Export will increase. But for Britons, falling pound indicates falling purchasing power. Therefore they will import less. Depending on how long & how much pound devaluate, this may be able to revive UK manufacturing sector which is in deep recession. Also it may help to absorb some of those previously retrenched workers. Unemployment may be reduced

(3) Economic growth. Falling pound will cause demand for UK goods to increase. Therefore exports will increase. At same time, falling purchasing power means Britons will spend lesser on imported goods. Overall will be an increase in net exports (X-M). This will cause AD to increase, thus lifting the British economy

(4) Other countries are doing badly too. As UK is inevitably running into a recession, Monetary Policy Committee (MPC) will be forced to slash interest rates. People may begin to think that now it is no longer attractive to hold pound. But never forget, UK’s rival such as US is doing much worse. Japan had announced another recession recently. Germany is not spared too. In short all major economies are faring badly. Holding dollar or Euro or yen could be as good as holding pound. Interestingly, among these major economies, UK’s national debt as a % of GDP is among the lowest

Don't believe? Check this out http://en.wikipedia.org/wiki/List_of_public_debt . Although not the latest, but it's value hasn't changed much