Reader Qu. Discuss the impact if an increase in domestic demand on the country's economy and the strategy that is used by your country in order to stabilize domestic demand?

• Effect of domestic demand on a country's economy

If there is an increase in domestic demand it will be likely to influence Monetary policy and, to a lesser extent, fiscal policy

In the UK, the main tool for stabilising domestic demand is Monetary Policy. Monetary policy is controlled by the MPC, which is part of the Bank of England. They have a target for inflation of CPI = 2% +/-1. Therefore, an increase in domestic demand is likely to impact on their decisions when setting interest rates.

Each month the MPC try to predict future inflationary pressure. If inflation is likely to increase above the target then they will need to increase interest rates to reduce demand. An increase in domestic demand is likely to increase the risk of inflationary pressure, unless the economy is below full capacity. Therefore, a rise in domestic demand will probably cause interest rates to rise.

The MPC look at over 30 statistics to try and get the best indication of inflationary pressures. Domestic demand is one of the most important.

If the increase in domestic demand is very significant, governments may also use fiscal policy. Fiscal policy can be used to deflate the economy through high taxes and lower spending.

Related:

• Fiscal Policy
• What determines effectiveness of monetary policy?
• UK Monetary Policy
  

Labels: economic growth

READER's QUESTION: Discuss the impact of an increase in domestic demand on the country's economy?

An increase in Aggregate Demand (domestic Demand) will have the effect of increasing economic growth and possibly inflation.



The higher output is likely to reduce unemployment. This is because as output increases, firms demand more workers to produce the extra goods.

If AD increases too much, the economy will get close to full capacity and therefore will cause inflation.

The increased domestic demand may also cause a deterioration on the current account balance of payments. This is because higher domestic demand would lead to an increase in imports.

The Effect of Increased Demand Depends on Many Factors.

1. What is the Long Run Trend Rate of Growth?

In China the economy can grow by 7-8% without causing inflation.
In the UK, the long run trend rate (average sustainable growth) is about 2.6%. Therefore, if domestic demand in the UK rose by 4-5% it would be likely to cause inflation and lead to a boom and bust economic cycle. This is because increasing AD by 5% is unsustainable. It would lead to a shortage of goods and therefore inflation would occur. This inflationary growth is unsustainable

2. How Much Spare Capacity is There?

If the economy is below full capacity, or if there is a recession, then an increase in AD will cause higher economic growth without causing inflation. However, if the economy is already close to full capacity then an increase in domestic demand will cause inflation.

3. Depends on Marginal Propensity to Import.

The MPM is the % of extra income that is spent on imports. If the MPM is high then the increase in domestic demand is likely to cause a big deficit on the current account balance of payments. The MPM is high if there is a shortage of goods produce in the country. The UK and US have a high MPM because they have had a reduction in their manufacturing sectors.

Labels: economic growth

In this post: I suggested several problems of relying on consumer led economic growth. However, there are some reasons Not to Be Concerned by Consumer / Service Sector Led Growth

1. Changing Comparative Advantage.

Due to lower labour costs in China and other parts of Asia, it is much cheaper to produce labour intensive manufactured goods in China and not the US. Therefore, there is no reason why the US should feel obliged to try and compete with low labour cost countries. Countries should specialise in goods where they have a comparative advantage. For the UK and US this is no longer in manufactured goods but in industries like finance, insurance and education.

2. Increased Export Revenue from the Service Sector.

It is a mistake to feel that manufacturing is the best source of export revenue. Increasingly the UK and US achieve net foreign income flows through foreigners coming to study at American and British universities. This counts as a positive item on the current account. Therefore, there is nothing intrinsically wrong with relying on a service sector based economy. It is just that in the US consumer spending grew too fast and was unsustainable.

3. Self Correcting Mechanisms

If a country experiences a growing current account deficit it is not necessarily a problem. Firstly for many years Asian investors were willing to balance the current account deficit by buying US securities - causing a surplus on financial account, Balance of Payments. Now that these funds are drying up, it is causing a devaluation in the dollar. A devaluation should help correct the imbalances. It makes imports more expensive so reduces demand for imports. Over time it should help reduce the current account deficit.

• Economic Growth essays and revision notes

Labels: economic growth

Should we be concerned about Consumer / Service Sector led Growth?

In the past 10 years the UK and US economy has experienced strong economic growth, but, the main determinant of economic growth has been from consumer spending rather than increased manufacturing output. It has been suggested that economic growth is unbalanced. Furthermore, both the UK and US economies have relied on a booming housing market to finance consumer spending. The results has been a fall in the savings ratio, a rise in debt and growing current account deficits. What the are the effects of relying on consumer led growth? Should governments do more to boost balanced growth?

Problems of Consumer Led Growth

Balance of Payments deficit.

As a result of consumer led growth, the US has experienced a large deficit on the current account. This is because the imports of goods and services is greater than the exports of goods. The US current account deficit has approached 7% of GDP and is a significant problem and reflection of the unbalanced nature of growth.

Devaluation

The devaluation in the dollar is partly related to this high level of consumer spending and current account deficit. Because American consumers are spending more on imports the supply of dollars is greater than the demand from other countries. With a net outflow of money, this causes a devaluation of the dollar. (There are other reasons behind the devaluation but, this is one factor)

Growth Dependent on Housing Market.

One reason why US consumer spending has been so strong is that it has been buoyed by rising house prices. Rising house prices have enabled people to remortgage; it has also increased consumer confidence. Therefore, the housing market has played a key role in the economic growth of the US and UK. However, now that the US housing market is in decline, it means that many people who took out risky mortgages are now in danger of defaulting. It is also causing a marked slowdown in growth.

However: There are also reasons not to be concerned about Economic Growth

More on:

• Economic Growth

• Should Government increase Economic Growth?

Labels: economic growth

CAN YOU PLEASE EXPLAIN THE CONCEPT OF PURCHASING POWER PARITY

Purchasing Power parity

A purchasing power parity exchange rate takes into account the different purchasing power of currencies in their home countries for a given basket of goods.

• For example, one dollar will buy more goods in China than in UK. This is because the cost of living is cheaper in China. Real exchange rates don't often take this into account.

PPP give a better comparison of living standards of two or more countries than using gross domestic products (GDP) using market exchange rates.

PPP is not straight forward because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.

Related Essay: TO what extent does GDP measure living standards

PPP has implications when comparing living standards for instance, GDP per capita in the People's Republic of China is about US$1,800, while on a PPP basis it is about US$7,204.

Labels: economic growth

• Examine the role of GDP figures as a measure of economic development. (15)
• GDP measures National Output, National Income and National Expenditure.
• GDP per capita gives a rough guide to average income per person in the country.
• GDP is a rough guide to living standards.

• Higher GDP enables more consumption of goods and services.
• Potential for Higher tax revenues, and therefore government spending on public services like health, education and transport.
• Higher GDP may create more employment opportunities.
• Generally countries with much higher GDP OECD countries have more economic development than low GDP

Limitations of GDP in measuring Economic Development

1. Depends on distribution of GDP.

For example, if 90% of GDP is owned by small oligarchy then the majority of economy may have low economic development. This is an issue for several sub saharan African economies, where high % of GDP is owned by small % of those in power.

2. GDP may underestimate economic development.

This is because official GDP statistics do not include black market; this is a significant part of subsistence economies. However, economic development often reduces the size of this "black market" or economic activity which is not recorded.

3. Difficult to Compare Living Standards through GDP.

This is because exchange rates do not reflect local purchasing power of a currency. For example, a Big Mac may cost $5 in Japan, but $1 in India. Therefore, comparisons need to take these into account.

4. Levels of Infrastructure important to economic development.

For example, GDP may not be used to improve infrastructure, communication and transport. These factors are very important for determining development. GDP does indicate how money is spent. GDP may be used to finance projects that do not help education development.

5. Standards of education important for long term economic development.

6. Some countries may get high GDP from primary products, but struggle to develop and diversify into manufacturing and service sector based economy.

See also:

• Does Economic Growth Bring Increased Happiness?

Labels: economic growth

"Examine the factors which might explain why 'strongly rising domestic demand has run ahead of overall economic growth" [60]


Basically, the question is asking "why is domestic demand increasing at say 4-5% per year, but economic growth is only increasing at say 2%"

These are some factors, which may explain the unbalanced growth the UK has seen in recent years:

1. Rising House Prices.

House prices have doubled in past 6 years. Rising house prices lead to an increase in consumer wealth. This increases consumer confidence, and also, homeowners can remortgage to get equity withdrawal. Therefore, rising house prices have led to higher consumer spending. This is a significant factor in increasing consumer spending because 75% of households own their house; housing is also the biggest form of wealth of UK. However, rising house prices do not increase the productive capacity of the economy. This has been a big factor in increasing domestic demand at a faster rate than economic growth.

2. Lower Real Interest Rates

Lower interest rates make it more attractive to borrow and therefore lead to an increase in consumer spending. Lower interest rates have also contributed to a fall in the savings ratio; this means savings are falling and consumer spending is rising as a % of net income. This explains why domestic demand is outstripping demand. A fall in the savings rate theoretically leads to less investment and therefore explains why economic growth is lower than consumer spending.

• However, over time you would expect lower interest rates to contribute to higher levels of investment; because it is cheaper to borrow for investment. This should benefit general economic growth and not just consumer spending.

3. Exchange Rate.

A strong exchange rate makes exports more expensive and less competitive. Therefore, there is a fall in demand for exports. This harms the manufacturing sector, which relies heavily on exports. Therefore, although consumer spending is rising, other aspects of economic growth like manufacturing output is in relative decline. This explains a lower growth rate. However, the manufacturing sector has been declining as a % of GDP. This makes the economy less dependent upon manufacturing than it used to be. The decline in competitiveness and changing comparative advantage is also exacerbating the decline in the manufacturing export sector.

4. Supply Side Factors.

Domestic demand is rising, but the Productive capacity of the economy may be lagging behind. Therefore, in the long run this will lead to inflation and a balance of payments deficit. Therefore, it is not sustainable for domestic demand to run ahead of economic growth in the long run.

Other factors to consider:

• Increased availability of credit
• Changing Comparative Advantage
• Cost Push factors like rising Oil prices
• Government spending as a component of AD
  

Labels: economic growth, essays

In this essay I looked at: Whether economic growth reduces relative poverty and inequality.

It is a controversial subject and there have been numerous studies examining this issue in both developed countries and developing countries.

Another controversial question is whether income inequality matters

Does it Matter if Economic Growth does not reduce Income Inequality?

Some economists argue that inequality is essential for creating suitable incentives for people to work, innovate and take risks. If economic growth was managed to reduce relative inequality, it may cause a situation of lower growth rates. They argue that as long as people’s real incomes are increasing, it shouldn’t matter if other people experience faster increases in income.

However, contrary to this position, other economists argue that reducing relative poverty should be a goal of the government.

1. Inequality can often be a cause of social problems such as alienation, leading to crime, vandalism and even rioting (as in the case of Paris 2006 and Brixton, UK 1981)
2. Inequality is often the result of inequalities of opportunities. For example, those on low incomes and unemployed often have a lack of education and skills. This kind of inequality should be reduced.
3. Economic Growth is a poor indicator of living standards and well being. Governments should consider other objectives as more important.

In addition to economic arguments, there are of course, many other arguments we could add to these 3 suggestions

Labels: economic growth, inequality

I recently wrote an essay does Economic growth increase Happiness?

"Increasing rates of economic growth has long been the holy grail of conventional economics and politics. To a large extent most developed economies have been highly successful in increasing economic output. But has such an impressive increase in national output actually improved people's standard of living?"

Costs and limitations of Economic Growth include factors such as:

1. Pollution
2. Diesease of affluence
3. Higher Crime
4. Longer working hours and more stress
5. Diminishing marginal utility of extra income.
6. Increased Inequality

Are we better off because of growth. Will future economic growth solve our problems or just magnify our existing ones?

What do you think? Feel free to leave a comment.

Labels: economic growth