Government Debt and the Trade Deficit

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People often refer to the idea of a Twin Deficit, especially in the US. The twin deficit refers to Government borrowing – government spending greater than tax revenues. Government borrowing creates an annual budget deficit and increases national debt. Current account deficit (imports greater than exports) on Balance of Payments US current account deficit 5% …

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Airline price discrimination

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Price discrimination involves charging different prices to different sets of consumers for the same good. Firms can charge different prices depending on several criteria:

  • Quantity bought (e.g. lower unit price when higher quantity is bought)
  • Time of use (higher price at peak times)
  • Age profile (e.g. discounts for OAPs)
  • When unit is bought (e.g. discounts for buying early)

The main principle behind price discrimination is that a firm is trying to make use of different price elasticities of demand. If some people have a very inelastic demand, it means they are willing to pay a higher price. If the firm can set higher prices for these consumers it can increase its revenue and profits. Other consumers will be more sensitive to prices (elastic demand) and so will respond to special offers and price discounts. The firm can benefit if it can separate these consumers and therefore reduce their consumer surplus. See theory of price discrimination here

In the real world, price discrimination might involve charging a different price for a slightly different good.

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In this example, of price discrimination, students are given a cheaper price

How does an Airline practise price discrimination?

1. Time of buying a ticket.

There is no hard and fast rule, but if you buy a ticket several months in advance it tends to be cheaper. If demand for the particular flight is high, then the airline starts putting up the price of that flight. It means that the remaining tickets will only be bought by people willing to pay a higher price (inelastic demand). If a particular flight is not selling very well, the airline will do the opposite and reduce the price. This lower price attracts more people who are sensitive to prices and ensures that the flight will fill up.

Ideally, the airline would like to fill up the plane with passengers paying the most they are willing to pay. There is no point in selling very cheap tickets and having the flight sold out many weeks in advance.

Why does the price of an airline ticket change from hour to hour?

You may have had experience of looking for an airline ticket and seeing a flight for £200. The next day, you return to buy a ticket, but see it has gone up to £220. This is very annoying but is due to price discrimination. The airline will reserve a certain number of economy tickets at a low price (to attract early customers more sensitive to price. But, if the tickets for flight are selling well, it can afford to charge higher prices for the remaining few tickets. The airline is trying to capture as much consumer surplus as possible)

2. Unsocial hours cheaper

Because some flight times are less popular, these flights will tend to be cheaper. For example, if you take a weekend break. Most people would prefer to come back late on Sunday. These late Sunday flights tend to be more expensive than early morning Sunday flights.

3. Paying extra for seats with more leg room.

In economy class, Virgin offered a seat with 3 inches of extra legroom for £30. At 185cm, I jumped at the offer. To me, it is a good £30 investment. It was quite popular with nearly 40% of seats in economy class now being taken up with extra legroom seats. It is not quite price discrimination because it’s a slightly different product, but the airline is able to charge higher prices to those consumers with slightly more inelastic demand. In addition to the 3 inches of extra legroom, you could go to the other extreme and pay £15,000 for a first-class airfare.

Interestingly, you can only buy these extra legroom seats shortly before the flight. I wonder if this is to discourage people from avoiding business and just buying a cheap upgrade to economy class?

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Difference between microeconomics and macroeconomics

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Readers Question: Could you differentiate between micro economics and macro economics?

  • Microeconomics is the study of particular markets, and segments of the economy. It looks at issues such as consumer behaviour, individual labour markets, and the theory of firms.
  • Macro economics is the study of the whole economy. It looks at ‘aggregate’ variables, such as aggregate demand, national output and inflation.

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Micro economics involves

Macro economics involves

  • Monetary / fiscal policy. e.g. what effect does interest rates have on the whole economy?
  • Reasons for inflation and unemployment.
  • Economic growth
  • International trade and globalisation
  • Reasons for differences in living standards and economic growth between countries.
  • Government borrowing

Moving from micro to macro

If we look at a simple supply and demand diagram for motor cars. Microeconomics is concerned with issues such as the impact of an increase in demand for cars.

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This micro economic analysis shows that the increased demand leads to higher price and higher quantity.

Macro economic analysis

This looks at all goods and services produced in the economy.

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  • The macro diagram is looking at real GDP (which is the total amount of output produced in the economy) instead of quantity.
  • Instead of the price of a good, we are looking at the overall price level (PL) for the economy. Inflation measures the annual % change in the aggregate price level.
  • Instead of just looking at individual demand for cars, we are looking at aggregate demand (AD) – total demand in the economy.
  • Macro diagrams are based on the same principles as micro diagrams; we just look at Real GDP rather than quantity and Inflation rather than Price Level (PL)

The main differences between micro and macro economics

  1. Small segment of economy vs whole aggregate economy.
  2. Microeconomics works on the principle that markets soon create equilibrium. In macro economics, the economy may be in a state of disequilibrium (boom or recession) for a longer period.
  3. There is little debate about the basic principles of micro-economics. Macro economics is more contentious. There are different schools of macro economics offering different explanations (e.g. Keynesian, Monetarist, Austrian, Real Business cycle e.t.c).
  4. Macro economics places greater emphasis on empirical data and trying to explain it. Micro economics tends to work from theory first – though this is not always the case.

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Economies of scope

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Economies of scope occur when a firm can gain efficiencies from producing a wider variety of products. These efficiencies can involve lower average costs. It can also involve increased revenue from being able to increase sales in new, related markets. It is similar to concept of economies of scale – where higher output leads to …

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Does Government Debt Matter?

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Readers Question: Does Government debt matter? Do high fiscal deficits threaten economic stability?

Summary

Many worry that high levels of government debt could cause economic instability. In certain occasions, countries with high debt have seen investors lose confidence, leading to higher bond yields and putting pressure on the government to slash spending, for example, several countries in the Eurozone (2010-12). In rare cases, governments with high debt have responded by printing money – causing inflation to spiral out of control, for example, Germany in the 1920s. Another potential problem is when government debt is financed by overseas borrowing. If overseas investors lose confidence and sell their debt it can cause a loss of foreign exchange and a destabilising devaluation.

However, in many cases, high levels of government debt do not cause instability – but can actually prevent a deeper recession. The main argument for government borrowing is that in a recession, government borrowing and government spending can help prevent a collapse in demand and economic growth. In a recession, generally, people save more and so wish to buy government debt. This means governments can often borrow cheaply to finance public sector works.

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In the 1950s, national debt in the UK reached 200% of GDP, but it did not compromise economic growth or inflation. The UK was able to reduce this debt burden over several decades of economic growth.

Does debt matter?

  • It depends on how it is financed – e.g. does it rely on overseas borrowing which can be riskier?
  • What are the prospects for economic growth? – With economic growth, the debt to GDP ratio is likely to fall. If you are stuck in recession, the debt to GDP ratio will likely rise.
  • Are domestic investors willing to buy government bonds? Japan has very large public sector debt, but it has a large pool of domestic savings so the government has been able to borrow cheaply.
  • Is the debt cyclical or structural? Debt is a bigger problem if the government is borrowing heavily during a period of growth and there is a structural deficit.

More detail on question

Economic stability would involve.

  • Low inflation
  • Positive, sustainable economic growth (e.g. close to long-run trend rate of growth)
  • Stable bond yields (i.e. avoid rapidly rising bond yields which could create difficulty in dealing with debt.)
  • Stable exchange rates

High fiscal deficits mean the government is forced to borrow a large sum – Annual government spending is greater than tax revenues.

For example, in 2011/12 the UK government will have to borrow an estimated £125bn (just under 8% of GDP). Anything over 3% of GDP could be classed as a high fiscal deficit.

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Policies to solve deflation / low inflation

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Deflation means a fall in prices (a negative inflation rate).

Though policymakers should generally be concerned if there is an inflation rate less than the target of 2%.

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Source: World Bank. Low inflation in US and the EUro area in 2009 and 2014 – cause for concern.

 

For example, in the Eurozone Jan 2015, the headline inflation rate is -0.2%. Even if we strip away volatile prices like oil, core inflation is 0.8%. This is a very low rate of inflation.

There are many serious potential problems of low inflation/deflation

  • Higher real debt burdens,
  • Decline in spending,
  • Higher unemployment.

See costs of deflation for more detail.

What options are available to overcome deflation?

Monetary policy

The traditional tool of monetary policy is interest rates. If inflation is too low, the Central Bank can try to cut interest rates. In theory, this should boost spending and aggregate demand. For example, lower rates reduce the cost of mortgage payments, giving people more to spend.

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However, there are times when cutting interest rates are not sufficient. In a liquidity trap – zero interest rates may not encourage sufficient spending. For example, after the credit crunch – lower interest rates failed to boost demand sufficiently. Lower interest rates failed to solve low inflation for many reasons:

  • People preferred to save because of ongoing recession
  • People took opportunity to pay off debts
  • Banks didn’t want to lend, so firms couldn’t get loans despite low rates
  • Banks didn’t pass the full base rate cut onto consumers.

Unconventional monetary policy

With a failure of interest rates, the traditional tool of monetary policy, Central Banks needed to consider unconventional monetary policy. Some of these policies are relatively untried.

Helicopter drop – print money

In theory, creating inflation should be the easiest thing – just print money and according to the quantity theory of money – we should get inflation. A particular policy for printing money is termed the ‘helicopter drop’ – where the Central Bank gives newly created money to consumers directly. Central Banks have been reluctant to pursue this strategy, presumably because it goes against the mentality of serious Central Bankers and their inflation-fighting credentials. But, it would be a solution to deflation. The most challenging aspect would be knowing about much money to print, to get the right amount of inflation.

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How bad is government debt?

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One of the most popular topics on this blog is government debt. UK National debt and list of countries sovereign debt.

To many people the sums involved are so large, there seems something instinctively wrong, even dangerous, about allowing the government to borrow so much. As Mrs Thatcher said, she was brought up a grocer’s daughter and she learnt how to balance the books.  Why should the government be any different? Also, if a government has so much debt, is there not a cost to the future generation?

There are more points to be made, and some of the below are incomplete. This blog is more of a starting point for further discussion. For example, if you’re in the Eurozone and don’t have a Central Bank, government debt takes on a different complexion.

1. Mortgage Analogy

Firstly, there is the mortgage analogy. Most people could never afford to buy a house, so they get into large debt and take out a mortgage. This may take them 30 years plus to pay back.  In the case of your mortgage, your debt to income level could be 400%. Yet, despite the high ratio of debt to income, most people don’t feel it is irresponsible. Mrs Thatcher the grocer’s daughter might have wanted to balance the books, but she wouldn’t have felt bad about borrowing to expand her business.

You could argue that there is a big difference between a mortgage and government borrowing. With a mortgage, the debt is secured by an asset – the value of your house. The government borrow for welfare payment, national health care e.t.c. With government spending, it is harder to see the assets which act as collateral for the borrowing. Governments can have substantial assets. Though after years of privatisation, the UK’s assets have shrunk considerably. To underline the importance of assets, some studies have shown that the sustainability of government debt is related to the level of assets. Governments with more assets are generally in a better position to borrow more.

Also, it depends on why the government is borrowing. If the government is borrowing to finance investment in public investment, there could be a  return to higher growth and higher tax receipts. If the government is borrowing to shorten a recession, then there will also be a benefit of improved tax receipts. If the government borrows to increase spending on welfare payments for an ageing population, there is less future benefit of borrowing.

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Consumer Expectations

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consumer-expectations

Consumer expectations refer to the economic outlook of households. Expectations will have a significant bearing on current economic activity. If people expect an improvement in the economic outlook, they will be more willing to borrow and buy goods. But, with negative expectations, they will cut back on spending and be more risk-averse. Expectations may also influence …

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