Economics help blog – Page 246

To what extent is Bank of England responsible for low inflation?

10 March 202029 March 2008 by Tejvan Pettinger

Readers Question: What credit can the adoption of central bank independence take for the relative stability of the UK business cycle since 1997?

The MPC, Bank of England, are responsible for setting interest rates and determining UK monetary policy. They seek to keep inflation close to the government’s target of CPI 2% +/-1 %

Between 1997 and 2007, the UK enjoyed a period of unbroken economic growth and low inflation. It appears that the UK has been able to avoid the ‘boom and bust‘ economic cycles that characterised the boost way period – most notably the Lawson boom of the late 80s and following recession.

The statistics on inflation and economic growth were impressive, especially when put in historical context. It is a good question to ask how much we can credit the independence of the Bank of England?

Why the MPC has helped keep inflation on target

1. They are independent. They are not subject to political pressures. E.g. they are not tempted to cut interest rates just before an election. This used to be a problem for UK economy, with many experiences of boom and bust economic cycles.

2. Monetary Policy is pre-emptive. They try to prevent inflation before it occurs. They predict future inflation trends. If inflation looks to be increasing above the target of 2%+/-1 then they can increase interest rates to reduce consumer spending and keep inflation on track.

Housing Spending and Urban Development

27 March 2008 by Tejvan Pettinger

Readers Question: Will an extra $20 billion per year spent on housing have the same impact on the economy as an extra $20 billion spent on interstate highways?

It depends on the state of the economy.

At the moment, 2008, one of the biggest threats to the US economy is falling house prices. Data released for last month showed a record fall in house prices. Lower house prices are undermining consumer confidence and leading to lower consumer spending. This is one of the main causes of lower economic growth.

Falling house prices are being driven by two factors

Rise in mortgage defaults
Excess Supply.

Building more houses at this particular time would not help, it would exacerbate the glut in house prices and cause a further fall in prices. Therefore, this could cause further problems in the economy.

Economic Impact of Beijing Olympics

24 March 2008 by Tejvan Pettinger

Readers Question: Use the ideas and theories you have encountered in your study of the macroeconomic business environment to assess the possible impacts on China of holding the Olympic games in Beijing in 2008.

The Olympic Games will effect the Chinese economy in the following way.

Increase in Tourism. This is a short term effect but will help increase spending in the economy. It will come from the athletes, spectators and media who will travel to Beijin. It is argued the Olympics will also provide a long term boost in repeat tourism; this could be quite significant for China as the tourist industry is largely underdeveloped.

Increased Investment in Infrastructure. To prepare the economy for the Olympics, the Chinese authorities have attempted to improved infrastructure and transport links, these will have some effect in increasing the productive capacity.

Readers Questions on Exchange Rates UK

15 January 202024 March 2008 by Tejvan Pettinger

1) You say depreciation causes inflation for the three reasons you mention, but later, that in the long run, a higher rate of inflation will cause depreciation. So my first question is how are these two phenomena linked? Is ‘long run’ the key; i.e. it takes a prolonged high inflation to cause a devaluation, but devaluation causes inflation sooner? How long does it take for those three reasons to really kick in?

It depends, there is no straight answer. The two phenomena may occur simultaneously. Also it is complicated by the fact that many factors affect the exchange rate apart from just inflation. (e.g. short term interest rates)

2) My next question is that I’m aware that factors such as rising commodity prices can exert upward inflationary pressure, but are there any other factors that affect the devaluation of a currency – or is it purely down to inflation?

Many factors can affect exchange rates. These include:

Interest Rates – lower interest rates cause less hot money flows and depreciation.
Expectations – If investors expect a currency to devalue they will sell less. Confidence and market expectations are important in determining exchange rate
Current account deficit. A large current account deficit may put downward pressure on exchange rates
Read more

Long Term Interest Rates US

24 March 2008 by Tejvan Pettinger

Readers Question: If long term Interest rates in the US do not fall, how will this impact the US economy?

Short Term Interest rates are governed by the Fed’s Current monetary Policy. These have fallen sharply in recent months from 4.25% to 2.25%. This reflects the Feds desire to avoid an economic downturn. The sharp cut in rates is an attempt to reflate an economy reeling from falling house prices, financial insecurity and lower economic growth.

Long Term Interest Rates involve interest rates on securities such as 30 year bonds. With long term bonds, the interest rate tends to reflect the markets long term expectations of inflation. They tend to be less volatile than short term rates.

If markets expect inflation to rise, bonds become less attractive to hold and therefore investors require a higher interest rate to make it attractive to buy.

Difference between Short Term and Long term interest rates in the US.

To see the difference between short term and long term interest rates view this table at the US Treasury

Elasticity and temporary price rises

15 January 202022 March 2008 by Tejvan Pettinger

OK, I have a question for you. This was the example which popped to mind as I was reading your entry. (price elastic products)

Here in my Middle Eastern country, sheep are sold for meat. Each year, prior to the Festival of the Sacrifice (Muslim holiday where every family buys a sheep to butcher at home in the house), families go shopping for their sheep. In the weeks prior to the Festival, the price of sheep goes UP, UP, UP. Sometimes the prices seem to reach scandalous levels. Of course, after the Festival, the price falls back to normal.

It appears that according to your explanation, this would be a PRICE INELASTIC good. However, this is NOT a monopoly, as there are MANY, MANY sellers of sheep in the market-place. It looks more like a collusion of price-fixing among the many sellers, to me. What do you think about this?

Thanks for question, it is interesting. I feel that the increase in price is due to an exceptional increase in demand, but a relatively inelastic supply of sheep at this particular time.

What seems to happen at this particular point in time, is that demand for sheep may increase by, say 1000%. However, in this festival week, the supply cannot increase by 1000%? I assume that farmers will try and predict the increase in demand. However, it may be that they can only increase the supply of sheep on the market by say 500%. Therefore, despite an increase in the supply of sheep, the increase in demand for sheep is far greater and therefore prices rise.

Since buying a sheep, at this time, is seen as an essential purchase, demand is very inelastic for sheep during this week. Therefore, consumers are willing to pay the higher price (a price they wouldn’t pay at other times of the year when other types of meat would be seen as a substitute.)

Inelastic demand and monopoly

A good can still have an inelastic demand even if markets are competitive. Demand for sheep is inelastic because consumers don’t see any alternative to buying sheep. In the UK, demand for tobacco is inelastic because smokers don’t see any alternative to smoking

However, because there are many sellers, demand for individual farmers may be elastic. E.g. if one farmer sold cheaper sheep he would see an increase in demand. Similarly a particular brand of cigarettes may be elastic despite overall demand for cigarettes being inelastic.

Collusion and High Prices?

Perhaps the farmers could try harder to increase supply at this time, but, you can see the temptation to avoid doing this. This week offers a chance to make a very high profit. My feeling is that farmers are not actively colluding to set high prices. But, they don’t have much incentive to try and increase supply and avoid prices rising. In other words, it is easy for farmers to tacitly collude and allow prices to rise each year. Farmers have little to be gain from working out how to avoid the shortages which benefit them so much.

Price Elastic Products – Are there any benefits?

15 January 202020 March 2008 by Tejvan Pettinger

Readers Question: When would you want to own a business that sells price-elastic products? Why?

Price elastic products mean that if there is an increase in price, there will be a bigger % fall in demand. Therefore, with elastic goods, there is little incentive to increase the price because there will be a bigger % fall in demand. Elastic products suggest the good is in a competitive market and therefore it is more difficult to make profits. If demand was price inelastic a firm could put up prices and make profits, for example, a firm with monopoly power is likely to have inelastic demand.

When Price Elastic products are Beneficial

1. For a Sales Maximising Firm.

If a firm wishes to increase market share and increase its sales then price elastic means that cuts in price will beneficial in increasing sales.

However, it depends on how other firms react. If one firm cuts its price, demand may be elastic, but if all the other firms follow suit demand is likely to be inelastic and the price war only causes a small increase in sales (see Oligopoly Kinked demand curve)

Banking Collapse and the Withdrawal of money

15 January 202019 March 2008 by Tejvan Pettinger

Readers Question: What do you think would happen if all depositors of a bank requested their deposits?

The Banking would probably collapse – unless it could secure unlimited funding from a Central Bank or other banks.

If a bank has deposits of £10billion. The bank will keep perhaps 1% in liquid assets (i.e. cash that can quickly be given to customers who demand it. Therefore, out of £10 billion, the bank will have cash reserves of say £100million. We say it has a liquidity ratio of 1%. Therefore, if customers asked for £100 million to be withdrawn the bank could do it. However, once customers require more cash, it faces a problem – The bank doesn’t have the deposits in a liquid form.

What banks do is they lend out deposits to other people. This is how they make a profit. They pay you 2% a year to save money, then lend to someone else and charge 7%. They can do this because usually people don’t want to suddenly withdraw all their money and it is more profitable than simply keeping money behind the counter.