Economics help blog – Page 154

What Determines Price Elasticity of Demand

11 May 201825 April 2015 by Tejvan Pettinger

Readers Question: What are the major determinants of price elasticity of demand? Elasticity of demand measures the responsiveness of demand to a change in price. Inelastic demand means a change in price causes a smaller % change in demand. It means people are unresponsive to changes in price. Inelastic demand will have some or all …

New Keynesianism

11 May 201823 April 2015 by Tejvan Pettinger

New Keynesianism refers to a branch of Keynesian economics which places greater stress on microeconomic foundations to explain macro-economic disequilibrium. A key element of new Keynesianism is the role of wage rigidities and price rigidities to explain the persistence of unemployment and macro economic disequilibrium.

New Keynesianism combines elements of traditional Keynesianism (sometimes referred to as old Keynesianism) with classical theory.

Elements of New Keynesianism

Many markets are imperfectly competitive (have a degree of monopoly power). Therefore firms have the ability to set prices, and firms may often be reluctant to cut prices – leading to price rigidity.
Many labour markets are imperfect. In particular, wages can be ‘sticky downwards’ e.g. both unions and firms both resist nominal wage cuts.
If there is a shock to the economy, such as a short-term fall in demand, markets don’t clear, and we end up with real wage unemployment.
Real interest rates may depart from the ‘natural interest rate’. The job of monetary authorities is to restore the correct interest rate to avoid macro-economic instability.

fall-dl-real-wage

This diagram shows how a fall in demand for labour causes unemployment – if there are wage rigidities which keep wages at W1 and not fall to W2.

New Keynesians believe there is a role for monetary and fiscal policy to play a role in stabilising the economy and reducing unemployment. However, they tend to favour monetary policy.
New Keynesians place a greater emphasis on development models from microeconomic behaviour to predict macro-economic outcomes. These models are known as Dynamic stochastic general equilibrium (DSGE).
A very simplified understanding of these models could be gained from the basic Taylor rule – The Taylor rule suggests the optimal interest rates given the rate of inflation and the output gap.
Some New Keynesian models, e.g. by Blanchard have stressed aiming at low inflation (e.g. optimal inflation target of 2%) These models state that targeting the optimal inflation rate also leads to an optimal rate of growth and unemployment. (This is sometimes known as the divine coincidence, though the breakdown of the great moderation has undermined the predominance of low inflation targetting.

An end to globalisation?

18 November 201721 April 2015 by Tejvan Pettinger

Readers Question: Why doesn’t WTO make into law that all manufactured goods should either be assembled or made in the continent where its been sold? There is so many reason why this should be put in place in our globalised world I don’t agree. The benefits of a globalised world are that we can benefit …

Different ideas of tight monetary policy

18 November 201719 April 2015 by Tejvan Pettinger

Readers Question: I only recently discovered your site, which is spectacular, and have been reading every article since then. However, I found that two of your articles are contradicting. In your article “Problems of Deflation” you state that the current monetary policy of the EU is tight due to 0.5% inflation and interest rates.

In your article about tight monetary policy though, you state that tight monetary policy could include open market operations and rising interest rates.

I was hoping that you would help me solve my misunderstanding.

It is a good question. Firstly tightening of monetary policy implies that the Central Bank is trying to reduce demand for money – and reduce the rate of economic growth. Tight monetary policy implies high real interest rates. Tightening of monetary policy usually involves higher real interest rates.

The most simple example of tight monetary policy would involve increasing interest rates.

Higher interest rates increase the cost of borrowing, increase the cost of mortgage payments and reduce disposable income – this leads to lower consumer spending and lower economic growth
Alternatively in theory, the Central Bank could try and reduce the money supply. For example, printing less money, or sell long dated government bonds to banking sector. This is very roughly the opposite of quantitative easing. Though open market operations haven’t been used in practise for quite a while.

How can you have tight monetary policy with low interest rates?

inflation-base-rates-since-03

A potential confusion is why do economists talk about tight monetary policy when interest rates are 0.5% or zero – like in the current climate?

If you have a quick glance of an economics textbook, zero interest rates imply loose monetary policy – low interest rates make borrowing cheap, mortgages cheap, and in theory should encourage spending and a higher rate of economic growth.

Benefits and Costs of Fixed Exchange Rates

16 February 202018 April 2015 by Tejvan Pettinger

Readers Question: Evaluate the advantages and disadvantages of both a floating exchange rate and a fixed exchange rate. Is there a “better” one to have? A fixed exchange rate occurs when a currency is kept at a certain level compared to other currencies. In practice, many of them are semi-fixed exchange rates like the Exchange …

Vertical Integration: Advantages and Disadvantages

15 January 201811 April 2015 by Tejvan Pettinger

Vertical integration occurs when two firms at different stages of production merge. It involves going up or going down the supply chain. Example of vertical integration. Brewery merging with chain of pubs Software supplier merging with Computer firm Coffer grower merging with a coffee retailer such as Nescafe Car firm Renault merging with a tyre …

Economic issues for the UK General Election

18 November 20175 April 2015 by Tejvan Pettinger

I’m off to New York on Wednesday, I’m tempted to stay until May 8th, so I can miss the UK General election campaigning, which so far has been quite depressing for the poor quality of economic debate.

This is just an outline of some issues for consideration. I may expand upon these in the coming weeks.

Whose fault was the 2008/09 economic crash? –

Essentially a global financial crisis, exacerbated by weak financial regulation. But, who was advocating much stricter regulation of the banks pre 2007?

See: who is to blame for great recession

Would the great recession have been worse?

Yes:

if UK had been in EURO.
If UK had not pursued expansionary fiscal policy in 2009
If Bank of England had not pursued expansionary monetary policy

Was the great depression caused by reckless government borrowing under Labour?

uk-national-debt

In 2007/08, UK public sector debt was close to the lowest level achieved since before the First World War in 1914.

Economic record of the coalition

1. Economic growth

real-gdp-growth-00-14-trend-line

Economic recovery – better than Europe.

Recovery came, but did period of austerity in 2011 unnecessarily delay the recovery? Should the recovery have been much stronger? Have we permanently lost output? Austerity pros and cons

Effects of Zero inflation on Aggregate Demand (AD)

18 November 20172 April 2015 by Tejvan Pettinger

Readers Question: I was really hoping you might be able to inform me of the effects that zero inflation (which the UK is currently experiencing) might have on aggregate demand in the economy?

Firstly, this post will help consider the impact of zero inflation on AD and economic growth – Is zero inflation a good thing?

To add a few things to this. Let us look at an AD curve

Aggregate Demand Curve AD-curve

If we look at an aggregate demand curve, we usually assume that a lower price level causes a movement along the AD curve (and higher AD).

Therefore, zero inflation should, in theory cause higher AD. The AD curve is sloped like this because:

A lower price level, ceteris paribus, gives consumers more disposable income. Assuming constant nominal wage growth a fall in the inflation rate, will give consumers more income, and so they will be more willing to spend.
A lower price level will, ceteris paribus, make UK goods more competitive and therefore encourage UK exports (X is a component of AD)
At a lower price level, interest rates usually fall, encouraging more spending (see effect of lower interest rates.)

However

This simple model of AD – plotting Price Level (PL) and National Income (Y) is an over-simplification. We talk about a lower price level, when often we mean just a fall in the inflation rate. I’m often uncomfortable with this model that slips in between price level / inflation rate. But, for A – Level economics at least, we don’t make the model more complicated.
The UK has seen a fall in the inflation rate to zero, but this fall in the inflation rate has occurred in many other European countries (some EU countries have experienced outright deflation), therefore the UK has not seen a big boost to competitiveness, and we would not expect a big rise in export demand as a result of zero inflation. Furthermore, the European economy is sluggish, there is weak export demand – even if we were more competitive.
Interest rates have been at 0.5% since March 2009, so with this fall in inflation to zero, monetary policy has effectively become tighter – real interest rates have increased.