Sunday, February 15, 2009

Why Economics Is Related To The Art Of Balancing?

There must be a sense of balance between macroeconomic variables. In other word, 'too high of something is bad' & 'too low is bad' either. Here are the reasons:

(1a) Inflation too high will cause:
(i) Erode the purchasing power of money
(ii) Cause workers to bargain for higher wages to sustain their current standard of living, which often aggravates inflation
(iii) Leather shoe costs
(iv) Menu costs
(v) Redistribution of income from lenders to borrowers & employees to government
(vi) An early warning that the economy may go bust soon

(1b) Severe deflation will cause
(i) Loss of confidence with the economy
(ii) Further contraction in real economy as everyone postpones spending in expectation of lower price in the future. It is a cycle
(iii) Inevitable depression, which is the worst case scenario
(iv) Massive unemployment
(v) Capital flight
(vi) Weakening of currency as in the period of deflation normally interest rates will be very low

(2a) Very high savings ratio means:
(i) Everyone is thrifty & not spending into the economy. May contract the economy unless is countered by increase in the components of injections (government spending, investment & exports)
(ii) House prices are likely to be low due to lack of demand
(iii) Inflation in the country is likely high & the central bank is controlling it via higher interest rates which attract savers

(2b) Very low savings ratio:
(i) Banks will not have enough money to generate lending & they often resort to borrowing from the money market. One of the main reasons for banking crises in UK
(ii) May face liquidity problem in case large number of depositors would like to withdraw their money

(3a) Widening current account deficit:
(i) Must be able to continuously attract the inflow of foreign capital. Otherwise home currency will depreciate
(ii) Unsustainable economic growth with high inflation
(iii) Exports are growing at a slower rate than imports
(iv) Means home country is fast losing competitiveness
(v) Currency could be too strong

(3b) Widening surplus in current account:
(i) The economy is probably export-driven. Therefore it is very susceptible to global economic climate
(ii) The standard of living could be low & as such the people consume lesser imported goods
(iii) Currency could be too weak & as such may dampen the purchasing power

(4a) Oil price too high:
(i) Unsustainable growth with high inflation
(ii) Probably the availability is getting lower
(iii) Unhealthy speculation in oil futures
(iv) May cause stagflation
(v) More firms making losses especially those which find difficulty in passing on price increase

(4b) Oil price too low
(i) Sign of global recession like now
(ii) Major exporters face severe declining export revenue. As such, they may restrict investment into operations. May lead to lesser discovery of oil fields in future

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