Archive | readers questions

The Euro and deflation

A look at the effects of how an over-valuation of the exchange rate can cause deflation.

Readers Question: does an appreciation in the exchange rate cause deflation?

An appreciation does tend to reduce inflationary pressures. This is because after after an appreciation in the exchange rate:

  • Price of imports will fall, causing a fall in cost-push inflation.
  • Exports become less competitive, causing lower demand for exports. The rise in demand for imports and relatively lower exports will reduce domestic aggregate demand, helping to reduce demand-pull inflation.
  • The appreciation may increase incentive for manufacturers to cut costs to try and stay competitive.

If the country imports a lot of raw materials, such as oil, metals and good, then an appreciation will have a relatively significant effect on reducing inflationary pressures. It could cause deflation in exceptional circumstances.

But, will an appreciation cause deflation?

Deflation is quite rare in modern economies. Even heavily depressed economies often get just low inflation – inflation between 0 and 2%.

It depends on other factors in the economy. For example, if the appreciation is due to rising competitiveness and a strong economy, then there is likely to be normal economic activity and strong demand, despite the appreciation. Therefore, inflation can continue with an appreciation.

The impact on inflation will also depend on how much manufacturer’s pass the change in exchange rates onto consumers. After an appreciation, petrol prices may not fall as much as expected because petrol companies increase profit margins instead. Also, firms may engage in currency hedging so they smooth out currency fluctuations.

However, if the over-valuation in the exchange rate is accompanied by tight fiscal policy, tight monetary policy and a global economic downturn, then the deflationary impact of an over-valued exchange rate could well translate into actual deflation.

Long term over-valuation and deflation

eur-update_feb2014_deflation-blog-002

deflation in certain EU countries. Source: IMF

A slightly different scenario  to a temporary appreciation, is if a country is experiencing an exchange rate that is fundamentally overvalued for a long time.

This is relevant for several southern European economies who are in the Euro. Greece, Portugal, Italy and Ireland are all grappling with inflation of close to or less than 1%. Recently, prices have fallen in four countries, Greece, Cyprus, Portugal and Slovakia (Bloomberg)

In the Euro, these countries became uncompetitive, but there couldn’t be a devaluation because there is just one currency. To restore competitiveness, they are having to focus on reducing prices (a process known as internal devaluation). To some extent, this is causing deflation. Greece and Portugal lost so much competitiveness, that there is a need for a substantial fall in prices to restore competitiveness.

The over-valuation of the exchange rate is not the only cause of deflationary bias in the Eurozone. But, it is a significant one.

Therefore, being in a single currency (with no recourse to devaluation) can leave countries with significantly uncompetitive exports and an exchange rate which is unsuitable.  This can lead to deflationary pressures and even actual deflation, as Greece and Portugal are discovering at the moment.

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How is the economy affected by recovery of the underground economy?

Readers Question What if the black money parked in Swiss bank is recovered. Will it destabilize the current economy?

‘Black money’ I assume you mean money gained by illegal methods and money that will be frozen until someone can prove they legally own it.

Recovering frozen money

One scenario – If there is a large stock of illegal money currently frozen in Swiss bank accounts and this is recovered and put back in the economy and spent.

In theory, this injection of money into the economy could cause inflationary pressures. However, as a % of total money supply in the EU economy, it is likely to be a very small % and so wouldn’t really destabilise the economy.

What happens if you make the underground economy legal?

If all the ‘black money’ ‘underground economy’ was recovered and put back into the real economy, you would probably see an increase in real GDP. The ‘black’ economy or ‘underground’ economy refers to money and economic transaction not measured by government statistics and ignoring government regulations and laws.

If this activity switched from illegal to legal forms, it may just show up in higher GDP. I don’t think it would destabilise the economy because it isn’t really changing economic activity, just how it is measured.

For example, if you took a US state that has legalised Marijuana. Previously Marijuana sales were ‘underground’ and not recorded. Now it is legalised, sales will be registered by the government. The government will receive tax and it will show up in higher real GDP statistics. A little ironic perhaps, but legalising drugs is one way to increase real GDP statistics.  See also: Underground economy

 

 

Readers question: If yes what is the difference between FDI and black money.

A big difference. There is no real correlation

You could have ‘illegal, unrecorded foreign direct investment, e.g. a Mexican drugs cartel investing in drug distribution in the UK. This would increase the size of the underground economy in the UK. Though you might expect a percentage of the illegal profits to be repatriated to Mexico.

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UK Debt Held by Foreign Investors

One of the most common questions asked is, who owns UK National Debt?

Often  people assume that UK government debt is owned by foreign investors. However, foreign investors only hold about 25-30% of UK government debt. The rest is held by the UK private sector (pension funds, insurance companies e.t.c). Recently, the Bank of England has also been purchasing Gilts under the Asset Purchase Scheme.

In the past few years, the proportion of UK government debt held by overseas investors has been about 30%.

A different, but similar, concept is external debt. This is the total amount of UK debt (both private sector and public sector) held by overseas agents.

UK Debt Held By Overseas Investors 2005-09

Source: UK DMO

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Fiscal Spending and Crowding Out

A look at whether higher government (fiscal) spending causes crowding out?

Crowding out occurs when government spending leads to a corresponding fall in private sector spending, therefore the higher government spending has no overall increase in domestic demand.

Readers Question: Examine the way in which fiscal spending inflates prices and crowds out private spending.

Government spending is a component of AD. Therefore, if we have an increase in Government spending, we would get an increase in AD (AD=C+I+G+X-M)

If AD increased faster than Aggregate Supply, we are likely to get an increase in inflation. We can show this with a simple AD / AS diagram.

Diagram Showing Inflation 

 Note, if AS increased at same rate as AD, then prices may not rise. But, if the fiscal spending causes growth to be above the long run trend rate inflation is very likely.

 

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Readers Questions II

You are welcome to ask questions on Economics.

I will post the answer on this blog, for everyone to benefit from.

I shall try to answer the economics question and / or point to other resources but please bear in mind.

  1. The replies will be guidance and not for duplication. Your essays should always be your own work.
  2. My speciality is economics for British A Level standard. My university economics is rusty in parts, because generally I don’t use it in teaching A level economics.
  3. I can’t guarantee to always give full answers it also depends on my time schedule.
  4. The answers will not necessarily be complete. I know several of my essays on this site could be improved.
  5. I will answer as a new post. Check home page of blog for new post. With question and answers
  6. If you leave your email in the comments, I can try and let you know (email will not be published)

I studied PPE at Lady Margaret Hall college, Oxford University, and currently work as an Economics A Level teacher. I have also examined several different economic units for Edexcel AS and A2.

If you find the information useful, you are welcome to buy me a coffee.



 

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AD = C + I + G + X – M

Readers Question: what does AD stand for in economic terms??

AD = Aggregate Demand.

Aggregate Demand is composed of various factors C, I, G, X – M

C= Consumer spending

I = Investment (Gross fixed Capital Formation)

G= Government Spending

X= Exports

M= Imports

AD places a crucial role in determining the level of national output in an economy. Although Monetarists will argue it is AS which will determine the long run trend rate of growth.

Keynesian Approach to AD and Real GDP

Readers Question: What are the effects of a decrease in foreign incomes on UK exports, how will this effect the equilibrium level of income and the balance of trade?

Quite a few readers have asked this question. Unfortunately, A Level economics no longer uses the Keynesian 45 degree line approach to solving problems such as this. The last time I used this Keynesian model was quite a long time ago, so I am a bit reluctant to answer this kind of question. Nevertheless I will try offer some ideas.

Firstly, it is useful to understand what is happening from a simple perspective, then we can try to use the Keynesian model.

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Effects of Recession on Business

Readers Question: What will happened to the income of business sector if there is an economic decline in America?

An economic decline in the United States, is pretty much guaranteed to reduce the income of the business sector. The recent falls in the US stock markets are largely due to  expectations of a future downturn in the economy. Lower growth leads to lower profits, therefore dividends decline and shares become less attractive. If the US enters into recession, firms will experience a decline in profitability. This is because:

  1. Tendency for price wars to develop in a recession. Low sales encourage firms to cut prices
  2. Falling sales will lead to lower revenues.

Some firms will be affected more by the downturn. Firms producing luxury goods (Income elasticity of demand >1) will experience the biggest % fall in demand. This is likely to include manufacturers of luxury cars, 5 star hotels. Firms producing basic necessities will be more insulated from the effects of a recession.

AD and Circular Flow of Income

1. How can you show an AD shift left or right, using the circular flow? The conflict in my understanding is W MUST equal J because of identities etc. Yet AD can only move if W>J or J>W. I thought that if that happened, that is macroeconomic disequilibrium. Not a shift. is it disequilibrium (excess supply or demand), that leads to a shift? (like market forces and ordinary D&S diagrams?)

AD = C + I + G + X – M (total demand in the economy)

Keynesian Model

In the Keynesian model we refer to Aggregate Expenditure (E) A different term to the AD / AS model

AD = E = Cd + J

Here J(injections) equals investment (I), Government Spending (G) and Exports (X)

It is true that in Equilibrium J = W injections equal withdrawals.

If there is an increase in injections into the economy. There will be a rise in E (Total Expenditure = AD) causing a rise in National Income.

This means that there will be disequilibrium because J is now greater than W. However, as National Income rises there will also be a rise in withdrawals (W) people save more, pay more tax and spend more on imports

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UK House Price Crash?

Readers Question: Critically evaluate the argument for and against the likelihood of an imminent house price correction in UK ?

House prices in the UK have risen much faster than inflation; in the past 6 years average house prices in the UK have more than doubled. This has caused many to speculate that house prices are overvalued and are likely to fall, in the near future, to more realistic levels.

These are the arguments in favour of house prices falls.

House prices have risen faster than average incomes.

This has made it more difficult for first time buyers, especially the younger generation to get on the property ladder. With falling demand for new houses, it is only a matter of time before this is reflected in lower prices.

Rising Interest Rates.

Interest rates have increased 5 times in the past 18 months. This rise in interest rates increases the cost of mortgage payments. Therefore, more people will struggle to make mortgage payments and therefore make renting more attracting than buying. It is also worth noting interest rates have a delayed effect; this means it takes upto 18 months for interest rate increases to have an effect on the economy. Therefore, even if interest rates don’t increase anymore, there will be more people affected by interest rate rises (e.g. those negotiating new fixed rate deals, will see a big increase in cost)

Speculation.

If house price rises have been caused by the fundamentals of supply and demand, there is unlikely to be any correction. However, some experts believe the booming housing market has created a ‘bubble effect’; this means that speculators and foreign investors have been buying houses to try and make capital gains. If the market turns, then these speculators will seek to leave the market and cash in their capital gains. This could make a small correction much bigger. – Falling house prices lead to a fall in confidence and discourage many others from buying.

UK investors may also be alarmed by the experience of the US housing market which has already gone from boom to bust.

Prices overvalued

Evidence suggests that house prices are already starting to fall in some parts of the country. Demand is falling from many areas of the economy. Bovis, the new house builder predicted prices would fall by 3% this year. link – Times

A study by PwC suggested house prices are overvalued by 10% - link BBC. This follows reports from the International monetary Fund IMF, which also states UK house prices are fundamentally overvalued.

However, it is notoriously difficult to decide whether house prices are overvalued or not. For example, back in 2003, many commentators argued house prices were already overvalued. The UK housing market has often defied Market predictions

Credit Crisis

The run on Northern Rock, was due to problems in global credit markets. These problems will have an increasing effect on the UK Housing Market. Basically, US mortgage lenders were too willing to lend risky amounts to sub prime lenders. When the housing market faltered there was a rise in mortgage defaults as people couldn’t pay back their repayments. Therefore, many US mortgage companies went bankrupt. This has made other financial institutions much more wary of offering support for mortgage lending. To summarise it is increasingly difficult to get mortgages, especially risky unconventional mortgages. Therefore, this will make it more difficult for first time buyers to get a mortgage; demand will fall further.

However, UK mortgage lending is generally much stricter than US. At the moment, there is not a significant problem of mortgage defaults. With interest rates unlikely to rise in 2008, affordability is unlikely to deteriorate.

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