Readers Question: What effect does expansionary fiscal policy have on the fishing sector?

If successful, expansionary fiscal policy will increase Aggregate demand and increase the rate of economic growth. In a recession, expansionary fiscal policy could play a significant role in increasing level of living standards and levels of consumption.

Expansionary fiscal policy involves changes to tax and spending to increase overall aggregate demand in the economy. E.g. lower income tax rates will increase disposable incomes of consumers. With an increase in disposable income they can afford to buy more fish. Therefore, in a recession, the fishing sector may benefit from expansionary fiscal policy.

However, I’m not sure of the income elasticity of demand for fish. In a recent post, we looked at how the demand for Champagne had been drastically reduced by the recession. Expansionary fiscal policy would certainly be good for Champagne growers.

However, a fish and chip supper is unlikely to be a luxury good. If incomes fall, it is possible some consumers will buy fish and chips rather than go to a more expensive restaurant. In a recession, I doubt the demand for fish falls too significantly.

Also, there is the wider question of whether fiscal policy can actually increase the rate of economic growth.

See: Limitations of fiscal policy.

Champagne is a very good example of a luxury good. (a change in income causes a bigger % change in demand) Furthermore, supply of Champagne is limited to certain regions of France. With this monopoly power over supply,  French wine producers have been able to set very high prices. Champagne can easily go for over £100 a bottle. But, several years of over supply combined with the current recession is causing wine merchants to consider selling Champagne at knockdown prices.

Exports of Champagne to Britain fell 45% in the first 6 months of this year. This is a classic example, of how in a recession, people avoid expensive luxury items and choose cheaper alternatives.

If we assume income fell by 4% this year, a 45% fall in demand gives an income elasticity of demand of approximately 10.

The problem for wine merchants is that they have a dilemma.

• They have so many unsold stocks, the law of supply and demand suggests they should reduce prices to perhaps £10.
• But, if they do reduce prices so much, Champagne may lose its lustre as being a special ‘luxury good’. It’s like being able to buy Levi Jeans in Tesco for £10.99. Levi would lose their brand image for being special. If Champagne is sold for £10, it will be harder to command those high prices when the economy recovers.

see: Times Article – Vintage Champagne could be £10

Readers Question: What is the difference between depression economy and underdeveloped economy?

A depression economy suggests the economy is experiencing a deep recession, characterised by falling output and rising unemployment. An economy experiencing a recession could have a high GDP per Capita or a low GDP per capita. E.g. UK and the US have  both experienced a recession in the past year.

There is a difference between the definition of a recession and depression, which you can view here: Depression and Recession definition. Basically, a depression is a much more severe recession.

In everyday use, people may interchange depression and recession. For example, people may refer to the current situation as a depression. Even though the current situation doesn’t really meet the guidelines of having a fall in GDP of more than 10%.

An underdeveloped economy is an economy characterised by

• Low GDP per capita. Perhaps less than $2,000 a year
• Low levels of infrastructure – education, transport and health care.
• Low levels of human development. E.g. low levels of Literacy, low life expectancy e.t.c

There are different ways of measuring underdeveloped economies. For example, the United Nations uses

Less Developed Countries (LDCs) and Least Developed Countries (LEDCs) – These are countries with very low levels of economic indicators

The Independent featured an interesting article on the Demise of the Dollar.

There are more reasons for the dollar’s economic weakness here

The weak dollar is causing the price of gold to rise and the Euro to appreciate.

In some respects, the US won’t mind a weak dollar at the moment. This is because:

• Weak dollar will help boost exports and limit imports. Overall domestic demand should be stronger
• It will help reduce their long term trade deficit.
• With inflation currently very low, they will not be worried about the inflationary impact of a depreciation.

The danger comes if the gradual depreciation becomes an a sharp fall because investors fear for the future of the US economy.

The Falling dollar is bad news for

• The Eurozone. With Eurozone in recession or growing very slowly. The appreciation of Euro against dollar will harm EU exports and make a sustained recovery difficult.
• Countries with Large Dollar Reserves. Since the US is the global reserve currency, most countries have exposure to the falling dollar and will see their dollar assets reduce in value. This may make it more difficult to attract foreign investors to buy US treasury bills to fund the US government deficit.

See also: Benefits and costs of a falling dollar

Readers Question: Why Do we Study Economics In School?

1. It’s Good to Study and improve the mind. At least, that is what I was told when I was learning ancient Greek and Latin.

Many Employers are not looking for a specific degree but, the ability to learn, write and understand relevant ideas. I guess the idea is that if you have an A level in Economics (or other subject), you would be able to understand a firm’s business plans and be a competent employer.

2. Understand Practical Mathematics

I often teach students doing further Maths (double A Level Maths) but can they calculate a percentage? No! – Only differentiation and calculus. At least in A Level economics you should learn how to calculate a percentage.

3. Understand What is Happening.

The current crisis has shown that it is hard to separate our daily lives from Economics. Many people get confused over interest rates, inflation and government borrowing. But, these are issues which affect our daily lives and own financial well being. Understanding economcis helps comprehend what is happening and why we have lost our job.

4. Understand Graphs.

Ask anyone what is happening to price level between Aug and Nov 2008, and the majority will say prices fell. But, a good A level student will understand the difference between absolute changes and rates of changes. Of course, the answer is prices are rising at a slower rate. I have seen TV newsreaders and newspaper columnists get confused over this issue.

5. Understand Two Sides of the Argument.

We live in a sound bite society, where the mass media often try to portray issues in black and white. – Medicare good / Medicare bad. In economics, you hopefully learn to appreciate there is more than one side of the argument and see issues from different perspectives. This gives a more balanced view of economic / social issues.

6. The Economic Perspective.

The standard of political debate can be depressing. Learning economics gives a different insight. e.g. understanding:

• the opportunity cost of spending more on health care / cutting taxes e.t.c
• The social benefit of taxing goods with negative externalities.
• The social benefit of subsidising goods with positive externalities.

See also: Top 10 Reasons for being an economist

Readers Question I am confused by the statement that is written in my O’level text book (Economics Author: Dan Moynihan & Brian Titley). It says that if the current account is in surplus the financial account will be in deficit. Is this true?

Yes, it is true

• Firstly, the current account on balance of payments measures trade in goods,  services, investment incomes and current transfers
• The financial account measures capital flows / short term and long term. For example, long term investment in building a factory or financial flows such as buying bonds or depositing money in bank accounts.

Current Account = (Financial + Capital Account)

Note: The (Financial + Capital Account) used to be just called the capital account

Why does Current Account and Financial account balance?

Basically, if we import goods and services, we need an inflow of capital (financial flows) to be able to pay for them.

If you take a simplistic model.

Suppose, we import £1m of clothes from China. We need to buy £1m of Chinese Yuan. To get this foreign currency, we need an inflow of foreign currency in the financial account.

For example, if the Chinese deposited £1m of Chinese Yuan in British Banks, the foreign currency comes into the UK and this is how we can afford the goods. This bank deposit would be counted as a short term capital flow and included in financial account as a credit item. This balances the debit on our trade in goods.

What would happen if we couldn’t attract capital flows from China?

Suppose we wanted to import goods from China, but, China wasn’t sending capital flows to the UK. This would mean more money is flowing out of the UK than coming in.

This would mean the supply of pounds is greater than the demand and the Pound would fall in value. This would make our exports cheaper and imports more expensive. This depreciation would reduce the current account deficit.

Since the Credit Crunch the UK has found it harder to attract capital flows. Because we have a current account deficit, we have seen the Pound fall in value. So a large current account deficit often causes a depreciation, especially, if the country struggles to attract a balancing item on the financial / capital account.

Liquidity trap: When monetary policy becomes ineffective because, despite zero / very low interest rates, people want to hold cash rather than spend or buy illiquid assets.

Example: Cut in interest rates in early 2009, failed to revive economy.

• Liquidity trap explained

Keynesians argue that a liquidity trap means fiscal policy becomes very important for getting an economy out of a recession. Since interest rates are zero but aggregate demand is still falling, governments need to intervene to ‘crowd in’ resources left idle.

The argument is that the rise in private sector saving needs to be offset by a rise in public borrowing. Thus government intervention can make use of the rise in private saving and inject spending into the economy. This government spending increases aggregate demand and leads to higher economic growth

Monetarists are more critical of fiscal policy. They argue that government borrowing merely shifts resources from private sector to public sector and doesn’t increase overall economic activity. They argue the increase in government borrowing will push up interest rates and crowds out private sector investment. They point to the experience of Japan in the 1990s where a liquidity trap was not solved by government borrowing and a ballooning public sector debt.

Keynesians respond by saying, government borrowing may well cause crowding out in normal circumstances. But, in a liquidity trap, the excess rise in savings means that government borrowing won’t crowd out the private sector because the private sector resources are not being invested, but just saved. Resources are effectively idle. By stimulating economic activity the government can encourage the private sector to start investing and spending again (hence the idea of ‘crowding in’)

Also, Keynesians say that as well as expansionary fiscal policy, it is essential that governments / monetary authorities make a commitment to inflation. If expansionary fiscal policy occurs during periods of deflation it is likely to fail to boost overall aggregate demand. It is only when people expect a period of moderate inflation that real interest rates fall and the fiscal policy will be effective in boosting spending.

The Bank of England has been buying gilts through the creation of money. One reason for increasing the money supply is to try and avoid deflation.

Japan is experiencing a serious bout of deflation. In Japan prices are currently falling at a record 2.4%. (BBC link) This fall in prices is also termed a negative inflation rate.

European countries are also experiencing deflation.

• Belgium – 1.2%
• Spain – 1.0%
• Germany – 0.3%
• UK RPI is -1.3% (though the governments preferred measure, CPI, is 1.6%)

Deflation can be damaging for an economy because:

Deflation creates expectations of further price falls, and therefore consumers reduce their spending because they expect goods to become spending in the future. This fall in spending creates further deflationary pressure in the economy.

Deflation increases the real value of debt. This makes it harder to meet repayments and companies are more at risk of going bankrupt. Because bankruptcies increase, banks become reluctant to lend. This leads to a further fall in spending and investment.

Real interest rates increase. Normally bank rates are stuck at 0%. Therefore, deflation of 2.6% means the real interest rate in Japan is quite high for the economic situation. This makes it attractive to save money and unattractive to borrow.

The European countries will be hoping the deflation just reflects the recent falls in oil prices, but, once deflation takes hold, it influences consumer expectations and economic behaviour making future deflation more likely. This is why we talk of a deflationary spiral. Deflation can be a difficult habit to break. Deflation was a prominent feature of the Great Depression.

Related

• Deflation vs Inflation
• Deflationary pressures explained
• Deflation explained

Note: Be Careful when talking about inflation and deflation.

• For example, recently the CPI measure of inflation fell from 1.7% to 1.6%. This means prices are rising at a slower rate.
• The RPI measure of inflation changed from – 1.4% to – 1.3%. This means that measure by RPI prices are now falling by 1.3% a year.

Watching Channel 4 news, the newsreader made a mistake saying RPI inflation fell to 1.3%. She missed out the negative sign and this changed its meaning.

Readers Question: What did Keynes mean by ‘In the Long Run we are all dead’ – From ‘In the Long Run we are all dead’

For Keynes, the short run was important and due to the instability of the macro economy government intervention may be necessary to kickstart the economy.

Classical economists tended to be more dismissive of short term falls in output. According to their models, falls in real output below the equilibrium would only be temporary and the economy would return to equilibrium of its own accord. In particular, classical economists argued that if the economy is below full employment, wages should fall and labour markets will clear solving the unemployment.

But, Keynes argued that this was a wrong approach. He stated that the economy may well return to full employment, but, without government intervention this could take a long time.

This is why he quipped in the long run we are all dead. Why wait 10 years for a reduction in unemployment when the reduction could be achieved much quicker?

He argued that what happened in the short run could influence the long run. High unemployment created a negative multiplier effect which reduces output even further. When resources are idle, it may be difficult to get them re-employed. He also highlighted the fact labour markets may not clear. For example, wages are sticky downwards (in other words trades unions resist nominal wage cuts). But, also even if wages did fall, this could be damaging because workers would have less income and so spending would continue to fall.

This analysis provided the justification for government intervention – increased government spending financed by borrowing to kick start the economy and make use of passing saving.

The recent depreciation in the Pound has had a significant impact on firms and individuals who trade and buy / sell from abroad.

Who Benefits from a Weak Pound?

• Firms selling goods abroad. A weak pound means UK exporters can sell their goods cheaper and / or increase their profit margins. Foreign buyers need less currency to buy the same quantity of UK goods.
• British Manufacturers. The depreciation in the Pound has given a boost to British Manufacturers.
• The UK current account deficit. A fall in the value of the Pound should help improve the UK’s trade balance as exports become relatively more attractive than imports.
• Kraft Trying to Buy Cadburys. Since Kraft gave its indicative offer on September 7, the Pound has fallen 2%, meaning the purchasing power of the US company has increased, putting it in a stronger position to offer more per share, if it wants to try a takeover of British Cadbury’s. (FT)
• Firms who can shift from selling to Foreign Market. If firms can switch sales from domestic to exports, they will benefit. This depends on their market and how flexible their business is.

Who Loses from a Weak Pound?

• British Consumers buying imported goods. Many imported items like food and electrical goods will become more expensive as the pound weakens. This will push up shop price inflation in the new year, especially as VAT will go back up to 17.5%
• British Tourists. That trip to New York or Paris will just be more expensive now the Pound is weak. (I was lucky to buy a new Macbook in New York in August before the recent depreciation)
• Firms importing raw materials. Firms who import raw materials from Europe are facing a large rise in costs.
• Inflexible firms who have no alternative but to import from abroad. Companies importing champagne or Spanish food items to sell to British consumers will be facing a tough time because the Euros strength has reduce their profit margins.

Related

• Weak sterling and effects on economy