Edexcel A-Level Economics (A)

THEME 4
A Global Perspective

STUDENT COMPANION

Author: Geoff Riley

Series Editor: Ruth Tarrant

EDITION DATE: SEPTEMBER 2020

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CONTENTS

4.1.1 Globalisation.................................................................................................................................................................................... 3
4.1.2 Specialisation and Trade.................................................................................................................................................................. 7
4.1.3 Pattern of trade............................................................................................................................................................................. 10
4.1.4 Terms of Trade............................................................................................................................................................................... 13
4.1.5 Trading blocs and the World Trade Organisation (WTO)...............................................................................................................14
4.1.6 Restrictions on Free Trade............................................................................................................................................................. 20
4.1.7 Balance of Payments...................................................................................................................................................................... 26
4.1.8 Exchange Rates.............................................................................................................................................................................. 34
4.1.9 International Competitiveness.......................................................................................................................................................40
4.2.1 Absolute and relative poverty........................................................................................................................................................44
4.3.1 Measures of development............................................................................................................................................................. 51
4.3.2 Factors influencing growth and development.................................................................................................................................54
4.3.3 Strategies influencing growth and development...........................................................................................................................66
4.4.1 Role of Financial Markets............................................................................................................................................................... 84
4.4.2 Market Failure in the Financial Sector...........................................................................................................................................90
4.4.3 Role of Central Banks..................................................................................................................................................................... 95
4.5.1 Public expenditure....................................................................................................................................................................... 102
4.5 2 Taxation....................................................................................................................................................................................... 105
4.5.3 Public sector finances.................................................................................................................................................................. 108
4.5.4 Macroeconomic policies in a global context................................................................................................................................113
Exam Support....................................................................................................................................................................................... 121

Coronavirus pandemic
The impact of the pandemic on the UK and world economy continued to emerge as this study companion was being
prepared. Some updates and special notes have been added to capture some of the macro effects, but students are
strongly encouraged to keep up to date with their background reading to have a really good awareness of the latest
trends in the data and the changing economic policy responses in different countries. (Geoff Riley, September 2020)

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4.1.1 Globalisation
Specification detail
• Characteristics of globalisation
• Factors contributing to globalisation in the last 50 years
• Impacts of globalisation and global companies on individual countries, governments, producers and consumers, workers
and the environment

What is globalisation?
Globalisation is a process by which economies and cultures have been drawn deeper together and have become more
inter-connected through global networks of trade, capital flows, and the rapid spread of technology and global media.
The share of global GDP accounted for by exports of goods and services has risen from 12% in 1960 to almost 30% now.

What is the key benefit of globalisation?

Globalisation allows businesses and countries to specialise in producing goods and services where they have a
comparative advantage. Specialisation and trade enable a gain in economic welfare, for example through lower prices
for consumers which increases their real incomes. They can then buy and consume more goods and services.

Share of World GDP by Region in 2018 (Per cent, adjusted for purchasing power, source IMF)
70.0%
59.24%
60.0%
Share in global GDP

50.0% 40.76%
40.0%

30.0% 16.29%
20.0% 7.49% 7.38% 6.48%
3.04%
10.0%

0.0%
Emerging market Advanced EU Latin America / Middle East, Middle East and Africa Sub-Sahara
and developing economies Caribbean North Africa, North Africa
economies Afghanistan, and
Pakistan

More than half of world output of goods and services now comes from emerging market / developing countries.
However, the entire sub-Saharan African region only accounts for three per cent of world output.
Characteristics of globalisation

Trade to GDP ratios are Expansion of financial capital Increasing foreign direct More global brands –
increasing for many countries flows across international investment and cross border including a rising number
borders acquisitions from emerging countries

Deeper specialization of Global supply chains & new Higher levels of cross-border Increasing connectivity of
labour e.g. in making specific trade and investment routes labour migration people and businesses
component parts through networks

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Factors contributing to globalisation in the last 50 years
What are some of the key factors that have contributed to the process of globalisation?

Technological
Containerisation Lower trade barriers Business demands advances

1. Containerisation – the real prices & costs of ocean and air shipping have come down due to widespread use
of standardised containers & the reaping of economies of scale in freight industries and huge container ports
built to serve them. This reduces the unit cost of transporting products across the world. Between 1996 and
2014, international trade costs declined by 15 per cent. Technological innovation has played an important role.
2. Technological advances – which cuts the cost of transmitting and communicating information – this is a key
factor behind trade in complex knowledge-intensive products using the latest digital technologies.
3. Differences in tax systems - Some nations have cut corporate taxes to low levels to help attract inflows of
foreign direct investment (FDI) as a deliberate strategy to drive growth.
4. Less protectionism – average import tariffs have fallen – but in recent years we have seen a rise in non-tariff
barriers such as import quotas, domestic subsidies and tougher laws & regulations hinting at a phase of de-
globalisation. The average global – or most favoured nation – import tariff was 5% in 2018 according to the
World Trade Organisation (WTO). In the 1990s and much of the 2000s it was above 8%.

Transnational Businesses (TNCs)

Transnational corporations (TNCs) base their manufacturing, assembly, research and retail operations in a number of
countries. Many TNCs have become synonymous with globalisation such as Nike, Facebook, Apple, Netflix, Uber,
Amazon, Google and Samsung. The biggest 500 TNCs together account for nearly 70% of the value of world trade.

TNCs are a key driver of globalisation because they have been re-locating manufacturing to countries with relatively
lower unit labour costs to increase profits and dividends for their shareholders. For example, Volkswagen, Toyota,
Nissan and General Motors all have plants in Mexico which has helped Mexico to build a comparative advantage in
assembling, manufacturing and then exporting vehicles to other countries including the United States and Canada.

A key recent feature of globalisation has been a surge in the number of transnational businesses from emerging market
/ fast-growing developing countries. For example, China Mobile is in the top ten consumer brands in the world and
Alibaba has expanded to be the biggest global online retailer. The Tata Group conglomerate from India has made
significant investments in Western economies e.g. buying Jaguar Land Rover. Infosys from India is one of the world’s
biggest information system businesses employing over 160,000 people worldwide. Chinese carmaker Geely bought
Swedish firm Volvo in 2010 for $1.8bn and took a 49.5% stake in Malaysian car-maker Proton (including the Lotus
brand) in 2017. China’s Huawei Technologies is a major global competitor to Samsung & Apple.

China Mobile Alibaba Tata Group Infosys Geely Auto Huawei

Impacts of globalisation and global companies on individual countries, governments, producers and consumers,
workers and the environment

Exam hint:
The impact of globalisation will be different in different countries depending on how well integrated they are in the world economy
and whether they have the factor resources that allow them to gain from globalisation. When evaluating the impacts of
globalisation, look at the effects on a case by case basis. Some nations are more open to trade and investment than others and are
at different stages of their economic development. The economic gains from globalisation are rarely equally distributed.

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Advantages from Globalisation
The transformation of emerging market economies in the last 30 years, and the resulting reduction in extreme poverty
have been built on globalisation. That process has helped cut prices in real terms and raised living standards in the
West. Here are some of the main advantages of globalisation:
1. Globalisation encourages both producers and consumers to reap benefits from the deeper division of labour
in global supply chains and harnessing economies of scale – leading to gains in economic welfare.
2. More competitive markets through trade reduces the level of monopoly supernormal profits and can
incentivize businesses to seek cost-reducing innovations.
3. Trade can help drive faster economic growth which leads to higher per capita incomes. This has reduced the
extent of extreme poverty in the world economy. Less than one person in ten lives on less than $1.90 a day.
4. There are advantages from the freer movement of labour between countries including relieving labour
shortages and promoting the sharing of ideas from diverse workforces.
5. Opening up of capital markets such as bond and stock markets increases the opportunities for developing
countries to borrow money to help overcome a domestic savings gap.
6. Globalisation has increased awareness among people around the world of the systemic challenges from
climate change and the effects of wealth/income inequality.
7. Competitive pressures of globalisation may prompt improved standards of government and better labour
protection through improved monitoring by international organisations. Many consumers are now focused on
the transparency of where the goods and services they buy come from.

Drawbacks from Globalisation

1. Rising inequality / relative poverty – the gains from globalisation will be unequal leading to growing political
and social tensions if inequality of income and wealth increases.
2. Threats to the global commons e.g. irreversible damage to ecosystems, land degradation, deforestation, loss
of biodiversity and severe water scarcity from a growing world economy.
3. Globalisation can lead to greater exploitation of the environment, e.g. increased production of raw materials,
and the impact of trading toxic waste (including plastic waste) to countries with weaker environmental laws.
4. Macroeconomic fragility – in an inter-connected world economy, external shocks in one region can rapidly
spread to other centres (this key aspect is known as systemic risk).
5. Trade imbalances: Increasing trade imbalances (both surpluses and deficits) lead to protectionist tensions,
wider use of tariffs and quotas and a move towards managed exchange rates.
6. Workers in may suffer structural unemployment as a direct result of the outsourcing of manufacturing to
lower-cost countries and a rise in the share of imports in a nation’s GDP.
7. Dominant global brands – businesses with dominant brands and superior technologies may squeeze out
smaller local producers leading to a reduction in choice for consumers and some job losses.

Exam hint: Globalisation raises important issues of equity as well as efficiency. Globalisation inevitably creates people who gain and
groups who lose out. The overall impact depends on the effectiveness of policies such as environmental interventions & labour
market policies designed to help compensate those affected in a harmful way and give people and communities the skills and
opportunities required to adjust to a fast-changing world economy.

Global growth in GDP and trade 2007-2020, percent, source: IMF, 2020 is a forecast
15.

10.

4.2 4.4
5. 3.3 2.5 2.7 2.9 2.9 2.6 3.3 3 2.4
2

0. GDP
Trade
-1.7
-5.
-5.2
-10.

-15.
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

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Coronavirus update: Impact on global trade
The pandemic has afflicted many countries and inevitably led to a contraction in the volume and value of trade crossing national
borders According to the IMF, world trade contracted by –3.5 percent in the first quarter of 2020, reflecting weak aggregate demand,
the collapse in cross-border tourism, and severe supply dislocations related to shutdowns / lockdowns designed to protect public
health. There are fears that a global trade recession in 2020 will be made worse if several countries revert to tariff and non-tariff
protectionist measures to support jobs in their domestic economies. World trade is forecast to contract by more than 10% in 2020.

Impact of globalisation on the UK economy

Has globalisation been of benefit to the UK? Here are some different aspects:
• Expanded choice and higher consumer surplus.
• Effects on retail prices and the rate of inflation.
• Impact of UK firms relocating their production of goods and services to lower-wage economies.
• Impact of net inward migration on real wages and on UK government spending / tax revenues.
• Impact of inward investment into UK on employment and growth.
• Impact on share prices and profits of UK companies.
External shocks in a globalised world

Global Financial Impact of Global Volatile World Growth slowdowns International &
Crisis 2007-2009 Pandemic in 2020 Commodity Prices in emerging nations Regional Trade &
Investment Deals

Currency volatility Extreme weather Geo-political

and policy changes events (drought, uncertainty & risks
e.g. devaluation flooding etc.) from terrorism

What are external shocks?

External shocks are events that come from outside a domestic economic system. The biggest external shock in recent
times was the Global Financial Crisis (GFC) from 2007 onwards, the consequences of which are still being felt today.
Latterly, the covid-19 pandemic has created one of the worst economic shocks to impact the whole world economy.
• Negative external shocks such as the financial crisis and the pandemic create much instability and can lead to
persistent periods of weaker economic growth, higher unemployment, falling real incomes and rising poverty.
• Positive external shocks might include the emergence of, and widespread adoption of technologies used by
businesses and households in many countries.

Coronavirus update: Globalised Singapore drops into deep downturn

No country is immune from the impact of the covid-19 pandemic. Widely regarded as one of the success stories in growth and
development in recent decades, data shows that the city-state Singaporean economy has contracted at a year-on-year rate of 12% in
the second quarter of 2020, representing its worst recession since independence from Malaysia in 1965. There are concerns that
Singapore is going to be one of the hardest hit economy in Asia.

Singapore is a high-income and low-unemployment, export-driven economy with a trade-to-GDP ratio in excess of 300%. The city
state is one of the most deeply integrated into the world economy and is therefore highly susceptible to a steep decline in the volume
of world trade which is expected to fall by 12% in 2020. Their construction sector relies heavily on migrant workers from Malaysia
and stringent border controls during lockdown has led to the virtual closing down of the construction sector. Tourism has been hit
affecting hotels, restaurants and transport. The world-renowned Singapore Airlines was prompted to raise Singapore $9bn via a
rights issue of equity (shares) and convertible bonds to counter the worst of the fallout of the pandemic.

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4.1.2 Specialisation and Trade
Key specification detail:
• Absolute and comparative advantage (numerical and diagrammatic analysis needed)
• Assumptions and limitations relating to the theory of comparative advantage
• Advantages and disadvantages of specialisation and trade in an international context

Absolute advantage
Absolute advantage occurs when a county can supply a product using fewer resources than another nation. If a
country using the same factors of production can produce more of a product, then we say that it has an absolute
advantage. Consider the following example of 2 people engaged in 2 tasks:

Output with both workers having 10 hours of time available

Bricks Laid Cakes Baked
Joe 80 20
Donald 40 50
Total (5 hours each) 60 (40 + 20) 35 (10 + 25)

In this example:
• With both people having the same factor resource (time) available
• Joe can lay more bricks than Donald (80 to 40)
• Donald can bake more cakes than Hilary (50 to 20)
• Joe therefore has the absolute advantage in bricklaying
• Donald therefore has the absolute advantage in baking cakes
• If they both specialise fully, then total output of bricks and cakes can increase

Output with both workers having 10 hours of time available

Bricks Laid Cakes Baked

Joe 80 0
Donald 0 50
Total (10 hours each) 80 (a gain of 20) 50 (a gain of 15)

In this example:
We are assuming there are constant returns from specialisation:
• Joe specializes in laying bricks by allocating all of her time to the task
• Donald specializes in baking cakes by allocating all of his time to the task
• Total output of both products increases from applying absolute advantage

Comparative advantage
David Ricardo was one of the founding fathers of classical economics. He developed the idea of comparative
advantage. Comparative advantage exists when:
• The relative opportunity cost of production for a good or service is lower in one nation than another country.
• A country is relatively more productively efficient than another.
• The basic rule is to specialise your scarce resources in the goods and services that you are relatively best at.
• This opens up gains from specialisation and trade which then leads to a more efficient allocation of resources.

Worked example of comparative advantage and potential gains from specialisation and trade

Output with ½ (half) of all available resources allocated to each industry in both countries
Beef Tobacco Opportunity Cost Ratio of beef & tobacco
Australia 250 200 5:4
Malawi 100 150 10:15
Total 350 350

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 • Australia has a comparative advantage in producing beef. This is because the opportunity cost of an extra unit
of beef is 4/5th unit of tobacco, whereas for Malawi the opportunity cost is 1.5 units of tobacco.
• Malawi has a comparative advantage in producing tobacco – the opportunity cost of an extra unit of tobacco is
2/3rd of beef whereas for Australia it is 5/4.

Output after specialisation has taken place

Beef Tobacco
Australia 400 (+150) 80 (-120)
Malawi 0 (-100) 300 (+150)
Total 400 (+50) 380 (+30)

If both countries specialise according to the law of comparative advantage, and assuming constant returns to scale,
then total output of both products (beef and tobacco) can rise.

Output after trade has taken place

Beef Tobacco
Australia 270 210
Malawi 130 170
Total 400 380

If both countries trade at a mutually beneficial terms of trade of 1 beef for 1 tobacco – they can both end up with
more of both products – this is a gain in economic welfare. As a result, Australia exports 130 units of beef and then
trades for 130 units of tobacco with Malawi, i.e. the terms of trade are set at 1:1.
Assumptions behind the theory of comparative advantage and trade
Key assumptions behind the theory are as follows:
1. Constant returns to scale – i.e. no economies of scale – which might in reality amplify the gains from trade.
2. Factor mobility between industries (e.g. high geographical + occupational labour mobility).
3. No trade barriers such as tariffs and quotas which artificially change the prices at which trade occurs.
4. Low transportation costs to get products to market – high logistics costs might erode comparative advantage.
5. No significant externalities from production and/or consumption of the products being traded.

Key exam point: Mutually beneficial terms of trade are not necessarily those that benefits both countries equally – the benefits from
exporting and importing goods and services may be unbalanced. Indeed, the perceived unfairness of trade is often used as one
justification for protectionist policies such as import tariffs and quotas and forms of hidden protectionism. Whenever you are
discussing the economics of trade, remember to comment on possible distributional effects as part of the evaluation.

Advantages of specialisation and trade

Gains from trade – an overview
1. Free trade allows for deeper specialisation and benefits from economies of scale.
2. Free trade increases market competition and choice which then drives up product quality for consumers.
3. Increased market contestability reduces prices for consumers leading to higher real incomes.
4. Trade can lead to a better use of scarce resources for example from global trade in sustainable technologies.

Gains from trade using supply and demand analysis

In this example we consider how consumers and producers might be affected by the ability to import coal into the EU
at an import-tariff free price which is lower than domestic suppliers can offer. Opening up a country to trade has
welfare effects for producers, consumers, employees, the government and other stakeholders.

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If coal can be imported at a lower price, consumer surplus increases but producer surplus for coal producers in the EU
falls because they can no longer sell their output at the previous high price.

Drawbacks of specialisation and trade

Most economists argue that trade in goods and services across national borders is an important driver of increased
competition, innovation and helpful in sustaining growth and improving living standards. However, it is important to be
aware of some of the possible risks and drawbacks if a country becomes highly open to international trade.

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 Transport costs e.g. Negative externalities Risk of rising structural Inequality – benefits
carbon emissions from from both production unemployment as trade from globalisation are
increased food miles and consumption patterns change unequally shared

Pressure on real wages Risks from global shocks

to fall in advanced and such as the Global
emerging countries Financial Crisis

Some of the main risks / drawbacks are summarised below:

1. Volatile global prices affecting export revenues and profits for producers and tax revenues for governments.
2. Risks that exports will be affected by geo-political uncertainties and cyclical fluctuations in demand.
3. Highly open countries have suffered from the negative external demand shock caused by the covid-19
pandemic. World trade is expected to decline by more than 10 percent in 2020.
4. Opening up to trade and investment may cause rising structural unemployment in some industries as the
pattern of demand, output and jobs changes. Poorer countries may opt instead for a strategy of
industrialisation via import substitution using import protectionism before they open up their markets.
5. Countries that specialise in only a few primary commodities may suffer from the natural resource trap (known
as the resource curse) which may make them poorer in the long-term than countries who are less dependent
on exporting primary commodities.

Trade and economic efficiency

It is important in your analysis to link some of the potential gains from trade to different types of economic efficiency.

Economic efficiency Possible impact of external trade on economic efficiency

Allocative efficiency Competition from lower-cost import sources drives market prices down closer to marginal cost and
then reduces the level of monopoly (supernormal) profits.
Productive efficiency Specializing and selling in larger markets encourages increasing returns to scale (economies of scale)
– i.e. a lower long run average cost of production.
Dynamic efficiency Economies open to trade may see more innovative businesses who invest more in research and
development and in the human capital of their workforce to help raise labour productivity.

X-inefficiency Intense competition in markets provides a discipline on businesses to keep their unit costs under
control to remain price competitive and profitable.

4.1.3 Pattern of trade

Key specification content:
• Factors influencing the pattern of trade between countries and changes in trade flows between countries:
o Comparative advantage
o Impact of emerging economies
o Growth of trading blocs and bilateral trading agreements
o Changes in relative exchange rates

What is the geographical pattern of trade?

• This is the countries with whom businesses and people trade
• Intra-regional trade is trade between countries in the same region (European Union, Africa, Asia)
• Countries tend to trade most with other nations in closest proximity – this is known as gravity theory

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Geographical pattern of trade for the UK
• The European Union is the UK’s largest trading partner and will remain so despite Brexit. In 2018, UK exports
to the EU were £289bn (46% of UK exports). UK imports from the EU were £345bn (54% of all UK imports).
• The EU’s share of UK exports has been falling in recent years: in 1999, the EU’s share was nearly 55%. The UK’s
biggest single national trade partner is the United States.
• China now accounts for over 7% of UK imports compared with 1.5% in 1999 and is the UK’s fourth largest
source of imports. China is the UK’s sixth largest export market.

Extension Idea: The Gravity Theory of Trade

Despite decades of globalisation, most trade happens between neighbouring countries. Trade flows within regions,
such as the European Union, are far greater than trade flows between regions or continents. The UK, for instance,
currently exports about 50% more to Ireland than it does to China.

Summary of factors behind the Gravity Theory of Trade:

• Businesses trade more in markets that are in close geographical proximity and with a big market size.
• Shared borders help facilitate high levels of trade and labour mobility especially in a single market.
• Shared language and a single currency cut the cost of agreeing trade contracts and market transactions.
• Similar consumer preferences encourage firms to compete on the basis of the strength of product brands.

What is the commodity pattern of trade?

• This is the type of products (i.e. goods and services) that are traded internationally.
• We can see the extent that a country has a dependence on primary v manufactured v service exports.
• Many less economically developed countries rely heavily on primary product exports.

Some lower-income countries have a high level of primary product dependence – here are some examples.
• Angola: 89% of exports is crude petroleum (oil), 8% is diamonds
• Ethiopia: 25% of exports is coffee
• Zambia: 80% of exports is raw copper, refined copper and cobalt
• Kenya: 23% of exports is tea and 14% cut flowers

The pattern of trade changes as countries move through stages of development. As a nation develops increasing
complexity and more capabilities, then they become capable of supplying and then exporting a broader range of
products within the global economy. A good example of this over the last forty years is South Korea.

Often the transition to a different pattern of trade comes from switching from growing and extracting to processing and
refining primary products through to final assembly and manufacturing. Patterns of trade adjust as countries develop a
new comparative advantage in industries such as financial services, transportation & tourism. The emergence of a
more diverse pattern of trade requires significant investment in human and physical capital.

Trade in goods:
Goods exported and imported include tangible manufactured products such as cars, components for aircraft, processed
food and drink, chemicals, pharmaceuticals, steel and computer equipment. Over 70 per cent of merchandise exports
(globally) are manufactured goods. The top three merchandise traders in 2017 were China, the USA and Germany.

Trade in services:
Heavily traded services include transportation (freight and passengers), tourism, health and education services,
financial services such as foreign exchange dealing and a huge range of business services such as accountancy,
consultancy, design and marketing. Services include computer and information services, royalties and license fees.
There has been a huge growth in international trade in services over the last thirty years. Many countries now export
creative services such as TV series, film rights, and other cultural events. In 2017, the United States, United Kingdom
and Germany were the top three commercial services exporters

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Factors affecting comparative advantage

Natural Resources Unit Wage Costs Infrastructure

Non-Price Factors Import Controls Exchange Rate

Comparative advantage is a dynamic concept it changes over time as a result of adjustments in:
1. The quantity and quality of natural resources available e.g. the discovery of new mineral reserves.
2. Demographics – factors such as an ageing population, migration, women’s participation in the labour force.
3. Rates of new capital investment including infrastructure spending.
4. Investment in research and development (R&D) which can drive business innovation.
5. Fluctuations in the exchange rate which then affect the relative prices of exports and imports.
6. Import controls such as tariffs, export subsidies and quotas used to create an artificial comparative advantage.
7. Non-price competitiveness – e.g. product design, innovation, product reliability, branding, technical standards.

Exam hint: The comparative advantage model is simplistic and may not reflect the real world (for example, only two countries are
taken into account). Most exports contain inputs from many different countries and products can travel across borders many times
before a finished good or service is made available for sale to consumers. Businesses rather than countries trade (as a general rule).
Most trade in services for example happens between people and businesses operating in cities rather than countries!

Impact of emerging economies on trade patterns

An emerging economy is one that can’t yet be classified as ‘developed’ and is investing heavily in its productive
capacity. The largest emerging economies (GDP at PPP) are still the BRICs, that is, Brazil, Russia, India and China. We
consider the CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa) and the MINT economies (Mexico,
Indonesia, Nigeria and Turkey). Emerging economies can impact on trade patterns in the following ways:

• Rising income means that they start to purchase more goods/services from elsewhere in the world, over and
above basic necessities e.g. demand for imported milk in China. This can include increasing imports of
commodities, which can push up prices of commodities for others.
• Attract MNC activity, as well as grow their own large companies which start to operate elsewhere in the world:
Examples include Huawei and China Construction Bank from China, Tata from India, Lukoil from Russia, and
Petrobras from Brazil
• Selling more medium to high value exports e.g. manufactured items and electronics, rather than commodities
or low-value-added items
• Currency volatility in emerging markets can have a large impact on commodity prices and raw material prices
in other countries
• Rising tension between developed economies e.g. US and emerging economies e.g. China, resulting in trade
wars / protectionist measures, as each country seeks a bigger slice of the world trading pie

Impact of trade blocs and bilateral trading agreements on trade patterns

• A trade bloc consists of a number of countries that agree to trade with each other with reduced or no trade
barriers (such as tariffs or quotas). There are varying degrees of integration and types of trade bloc:
• Preferential trade area – where there is reduced protectionism on a number of select goods/services amongst
the countries involved. This could just be between 2 countries i.e. bilateral trade agreement.

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 • Free trade area – there is completely free trade between the countries involved, but each country can set their
own trade restrictions on countries outside of the agreement. Examples include USMCA and EFTA.
• Customs Union – there is completely free trade between the countries involved and they all agree to impose
the same trade restrictions on other countries as each other. Examples include MERCOSUR (South America)
and Turkey’s relationship with the EU.

One key impact of the increase in the number and strength of trading blocs on global trading patterns is that they often
lead to more intra-regional trade (i.e. within the trade bloc itself) and less inter-regional trade (i.e. trade between
region / blocs). This may mean that countries do not always gain the benefits from specialising according to their
comparative advantage. There may be trade creation at the expense of trade diversion.

Data in focus
In August 2019, the US Treasury officially declared that China was a ‘currency manipulator’, after the Chinese currency dropped in
value against the US dollar unexpectedly, reaching its lowest value since 2007. At a time when tensions between the two countries in
relation to trade were already high, the movement of the Chinese currency was not welcomed by the US government, which claims
that slow growth in US export industries is due to ‘unfair tactics’ by China. China responded to the accusation by saying that its
currency was weakening because it was exporting fewer goods as a result of protectionist measures implemented by the US.

Exam hint: Remember that a currency can be weak against another, but strong against others – it is important to consider relative
exchange rates, or even the ‘Effective Exchange Rate’, which measures the value of a country’s currency against a basket of other
currencies.

4.1.4 Terms of Trade

Key specification content:
• Calculation of the terms of trade
• Factors influencing a country's terms of trade
• Impact of changes in a country's terms of trade

What are the terms of trade?

• The terms of trade (ToT) measures the relative prices of a country’s exports compared to the cost (prices) of
imported goods and services.

Formula for calculating the terms of trade:

Terms of Trade (ToT) index = (price index for exports) / (price index for imports)

• The terms of trade can be interpreted in words as the amount of imported goods and services an economy can
purchase per unit of exported goods and services.
• A rise in the price index for exports of goods and services improves the terms of trade and this means that a
country can buy more imports for any given level of exports.
• Terms of trade is one measure of a country's trade competitiveness – another is relative unit labour cost.

An improvement in the terms of trade mean that export prices are rising relative to import prices. This is sometimes
confusing for students, because more expensive exports suggest that demand for exports will decline, thus reducing
AD. But economists say that the ToT has improved when export prices rise because fewer goods have to be exported to
buy a certain amount of imports.
Factors influencing the terms of trade
• Global (world) prices for raw materials and components:
o Rising oil prices improve the terms of trade for oil exporters
o Rising gas prices worsen the terms of trade for energy importers
• The exchange rate:
o A stronger currency lowers import prices – leading to improved terms of trade for importers
o A weaker currency increases import prices – leading to reduced terms of trade for importers
• Import tariffs and other trade barriers such as quotas:
o An import tariff (tax) increases the price of imports, other factors remaining the same, this worsens
the terms of trade for an importing country e.g. the cost of imported food and energy goes up.

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Analysing and evaluating the effects of an improved terms of trade
Cause of improved Terms of Basic Analysis Evaluation Point
Trade

This gives a country the chance to import capital

Capital-intensive production e.g. using
A fall in the relative prices of goods more cheaply which will then help to
robotics may not necessarily create many
imported technology increase labour productivity & their long-run
new jobs & extra incomes.
competitiveness.

Rising export prices cause an increase in revenues There are risks of demand-pull inflation
A rise in the unit export prices from exports. This is an injection into the circular from a surge in export revenues. Inflation
of a country’s exports flow and improves the balance of payments on hits hardest lower income families i.e. it
current account. It increases the stock of foreign has a regressive effect on the distribution
exchange reserves. of income.

Coronavirus update: World commodity prices fall sharply during the first half of 2020 – impact on the terms of trade
As the table shows, there has been a substantial drop in the global price of many primary commodities during the first six months of
2020. Oil prices have more than halved with world oil demand forecast to slump by nearly 9 per cent, and coal and natural gas have
fallen by more than 25 per cent. For commodity exports, this will lead to a worsening (or deterioration) in their terms of trade.
Rubber- exporting nations for example will be getting a lower price per tonne of rubber and this is likely to lead to a worsening of
their balance of trade. If demand for a commodity is price inelastic, then a lower price will lead to a less than proportionate change in
demand leading to a drop in total revenue for suppliers.

Many low-income nations in Sub Saharan Africa for example are net primary commodity exporters and the steep decline in world
prices is an external shock will cause an inward shift of aggregate demand, weaker growth and worsening government finances.

Percentage change in world commodity prices: January 2020 to June 2020

Oil Coal Natural gas Natural rubber Platinum Base metals Silver Food Gold
Percent change -50.7 -27.4 -26.8 -21.9 -20 -14.4 -9.5 -9.1 9.9

4.1.5 Trading blocs and the World Trade Organisation (WTO)

Key specification content:
• Types of trading blocs (regional trade agreements and bilateral trade agreements):
o Free trade areas
o Customs unions
o Common markets
o Monetary unions: conditions necessary for their success with particular reference to the Eurozone
• Costs and benefits of regional trade agreements
• Role of the WTO in trade liberalisation
• Possible conflicts between regional trade agreements and the WTO

Regional Trade Blocs

ASEAN TPP European Union USMCA

African Continental
Free Trade Area

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The World Trade Organisation (WTO) permits trade blocs, provided that they result in lower import protection against
outside countries than existed before the creation of the trade bloc. Examples of regional trade blocs include:
1. USMCA - United States-Mexico-Canada agreement (USMCA replaced NAFTA in 2018).
2. Mercosur – Brazil, Argentina, Uruguay, Paraguay and Venezuela.
3. Association of Southeast Asian Nations Free Trade Area – known as ASEAN.
4. Common Market of Eastern and Southern Africa includes Zambia, Rwanda, Swaziland, Ethiopia and Kenya.
5. Trans-Pacific Partnership (TPP) – an agreement negotiated between Australia, Brunei, Chile, Canada, Malaysia,
Mexico, New Zealand, Peru, Singapore and Vietnam (the USA under Trump dropped out).
6. African Continental Free Trade Area – this agreement covers more than 1.2 billion people and includes more
than fifty African nations. It is the biggest free trade agreement established since the WTO launched in 1995.
Costs and benefits of regional trade agreements
One major benefit from regional trade agreements between countries that lower import tariffs and the abolition of
import quotas and other barriers to trade is that it can lead to trade creation effects.

Trade creation occurs when countries agree a trade deal that lowers tariffs between them (this may extend to a formal
customs union). As a result, consumers can now source imports from a lower cost country which leads to lower prices
and a rise in real incomes. Trade creation can be illustrated using a trade liberalisation diagram.

But the expanding number of regional trade agreements can be seen as a threat to globalisation. The WTO has noted a
trend towards regionalisation of trade for example within East Asia or the European Union. Some of the world’s
poorest countries might not be able to negotiate favourable tariff or quota free access to many of the markets of rich,
advanced countries. The WTO would prefer a global trade deal covering many goods and services rather than the
complex patchwork quilt of having over 4,000 separate free trade deals across the global economy in 2018.
Free Trade Areas
A free trade area (FTA) is where there are no import tariffs or quotas on products from one country entering another.
Current examples of free trade areas include:
• EFTA: European Free Trade Association consists of Norway, Iceland, Switzerland and Liechtenstein
• USMCA: A revised trade agreement between the USA, Mexico & Canada (formerly known as NAFTA)
• South Asian Free Trade Area (SAFTA) between Afghanistan, Bangladesh, Bhutan, India, Maldives, Nepal,
Pakistan and Sri Lanka
• African Continental Free Trade Area: New agreement with 55 nations participating
• Pacific Alliance: Chile, Colombia, Mexico and Peru

Bi-lateral trade agreement:

A bilateral trade is the exchange of goods between two nations promoting trade in goods and services and flows of
foreign investment. The two countries will reduce or eliminate import tariffs, import quotas, export restraints, and
other non-tariff trade barriers to encourage trade and investment. Examples of bilateral agreements include:
• EU-Japan Economic Partnership Agreement
• ASEAN – China Free Trade Area
• EU-South Korea Free Trade Deal
• China-Australia Free Trade Agreement

African Continental Free Trade Area

In 2018, over 50 African countries signed the African Continental Free Trade Area, which aims to accelerate economic
integration in Africa and increase trade within the continent. In 2016, intra-Africa trade grew to 16 per cent of Africa’s
trade. This is significantly higher than the 10 per cent share of intra-Africa trade in 2008 but overall, African countries
are less integrated in terms of trade and finance than other developing economies. The World Bank believes that the
African Continental Free Trade Area agreement has the potential to boost per capita incomes and lift 25 million people
out of extreme poverty.

Chain of reasoning: Examine how a free trade area might stimulate economic growth in Sub-Saharan Africa.

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Examine: Here are some possible evaluation approaches to the impact of the new African continental free trade area:
Theory focuses on
possible welfare gains: Lower prices for consumers
Economies of scale for suppliers
Increased competition in markets
Improved allocative efficiency - i.e. a gain in economic efficiency
Examine … critical
evaluation points Lost tariff revenues for national governments
Financing costs for building the necessary trade infrastructure
Regulatory reforms for common product standards will add costs for businesses
Local SME’s may suffer a loss of profit / jobs when facing stronger competition
Customs Unions
A customs union comprises a group of countries that agree to:
• Abolish tariffs and quotas between member nations to encourage free movement of goods and services.
• Adopt a common external tariff on imports from non-members countries. In the case of the EU, the tariff
imposed on, say, imports of South Korean TV screens will be the same in the UK as in any other EU country
• Preferential import tariff rates apply to trade agreements that the European Union has entered into with third
countries or groupings of third countries

The European Union is a customs union. The EU has customs union agreements with Turkey, Andorra and San Marino.
Another example of a customs union is the South African Customs Union involving Botswana, Lesotho, Namibia, South
Africa, Swaziland. Another is the Eurasian Customs Union involving Armenia, Belarus, Kazakhstan, Kyrgyzstan and
Russia.

How does a trading bloc differ from a customs union?

• A trading bloc is an agreement between countries to lower their import tariffs and perhaps extend this to
reducing the use of non-tariff barriers to trade. In a free trade area, each country continues to be able to set
their own distinct external tariff on goods imported from the rest of the world.
• A customs union is different from a free trade area. It adds on a common external tariff (CET) on all products
flowing from countries outside the customs union, unless specific trade deals have been established. Revenues
from import tariffs are combined for all member states. The countries in a customs union negotiate as a bloc
when discussing trade deals with countries outside the union. A good example is the recently introduced
bilateral trade deal between the European Union and Japan.

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Common (Single) Markets
A common market represents a deeper integration between participating countries.

Ways in which a Customs Union differs from a Single Market

• A single market is a stronger and deeper form of integration than a customs union.
• A single market involves the free movement of goods and services, capital and labour.
• In addition to a common external tariff, a single market tries to cut use of non-tariff barriers such as different
rules on product safety and environmental standards replacing them with a common set of rules governing
trade in goods and services within the common market.

Countries such as Norway and Switzerland are outside of the EU, but they are members of the EU single market, paying
into the EU budget to take advantage of some of the benefits of the free flow of capital, labour, goods and services.

Free movement of Free movement of

Free trade in goods Free trade in services
labour capital

The EU single market is built on four key freedoms:

1. Free Trade in Goods: Businesses can sell their products anywhere in EU member states and consumers can
buy where they want with no penalty.
2. Mobility of Labour: Citizens of EU states can live, study and work in any other EU country.
3. Free Movement of Capital: Financial capital can flow freely between member states and EU citizens can use
financial services such as insurance in any EU state.
4. Free Trade in Services: Services such as pensions, architectural services, telecoms and advertising can be
offered in any EU member state.

The most recent country to join the European Union was Croatia. The United Kingdom voted to leave the EU in a
referendum held in June 2016 which subsequently triggered the Brexit process after Article 50 was invoked. The UK’s
transition process out of the European Union is scheduled to come to an end in January 2021.

Potential economic benefits from countries joining the EU single market:

The EU Single Market has increased trade between members by 109% on average for goods & 58% for tradable services
since 1957. But not all countries have benefited to the same extent. The gains are significantly larger for small open
economies such as Ireland and Slovakia than larger EU states such as Spain and Italy.

Possible Advantage Comment

• Import-tariff free access to a single market of nearly Opportunity to exploit economies of scale – leading lower
500 million people of relatively high incomes long run unit costs and higher profits
• Easier to access foreign direct investment from Inward FDI can lift trend rates of economic growth and raise
inside/outside the EU factor productivity

• Access to EU structural funds – much of which is made Investment helps improve infrastructure and potential output
available to poorer EU nations (long run aggregate supply)
• Better access to EU capital markets EU companies can more easily raise extra investment funds
from bond and capital markets

• Discipline of intense competition from being inside Businesses must become more cost efficient + improve their
the EU single market dynamic efficiency to remain competitive.

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Monetary Union
• Monetary union is a deeper form of economic integration beyond participation in a single market.
• The single European currency was introduced in 1999 and came into common circulation in January 2002.
• No country has yet left the Euro Area despite problems, stresses and strains lasting many years
• As of August 2020, there are nineteen-member nations.
• Of 27 EU countries, 9 are not part of the single currency including Denmark, Sweden and Poland.
• As of August 2020, Bulgaria and Croatia have joined the Exchange Rate Mechanism II, a system for managing
exchange rate fluctuations and smoothing the path of entry into the single currency.

Possible advantages from joining the single currency:

Joining the single currency is a significant economic and political choice and one that a country will make only after
assessing the likely longer-term benefits and risks involved.

Currency risk Trade Investment Competition

Transa

Euro is more Euro enhances the Membership of Euro increases

stable than smaller gains from being in Euro is likely to price transparency
currencies the single market – stimulate inward and market
Reduced currency e.g. it encourages investment e.g. in competition which
risk makes is easier more cross border industries such as then helps A shared currency
for smaller trade in goods and tourism, financial consumers to find eliminates the
countries to services services, car- products at bettercostly conversion
making prices of money, it might
borrow money
improve labour
mobility within the
There are however risks and drawbacks from committing to joining a single currency: EU single market
• A country’s central bank loses the freedom to set monetary policy interest rates solely to meet key macro
objectives such as lowering inflation (higher interest rates) or preventing a recession (lower interest rates).
• Joining a common currency means that the option of a managed depreciation / devaluation of the exchange
rate to help improve price competitiveness in overseas markets is lost. Instead to become more price
competitive, a government may have to maintain deflationary fiscal policies to achieve an internal devaluation
of the price level.
• There are adjustment costs when switching currencies including menu costs and the risk that some retailers
will increase prices when the currency is switched to make extra profit in the short term.

Conditions necessary for the success of a monetary union

These conditions are associated with the concept of an optimal currency area (OCA). An Optimal Currency Area (OCA)
works best when:
• Countries are highly integrated i.e. a high percentage of trade is with fellow currency union nations. A good
example is Slovenia. Well over 80 percent of Slovenian trade is done with fellow members of the Euro Zone.
• Where each economy has a flexible labour market to cope with external shocks. Flexibility might include:
o Flexibility in real wages and salaries during an economic cycle.
o Workers with adaptable skills to reduce the risk of structural unemployment.
o High geographical mobility within & between countries.
o Flexible employment contracts including short-term job contracts.
• When the effects of interest rate changes or a movement in the exchange rate have a broadly similar effect on
businesses and households from country to country.
• When nations are willing to make fiscal transfers between each other & provide financial support during
difficult economic times.

The Euro Zone is a long way from being an optimal currency area. The nineteen-member nations have many differences
in their patterns of trade and in the structure of their economies. Consider for example contrasts between Germany
(one of the world’s biggest exporters of manufactured goods) with Spain (which is heavily reliant on construction,
finance and tourism). There are sizeable differences in per capita incomes throughout the Euro Area and big differences

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too in the structure of housing finance and in labour productivity. All of this has made it tricky for the European Central
Bank (ECB) to set a successful “one size fits all” interest rate that suits the economic interests of participating countries.

The crisis that engulfed Greece in recent years is a good example of the perils of joining a single currency when the
country was unused to low interest rates, too willing to increase their household and government debt and suffering
from a lack of price and non-price competitiveness with established (and richer) EU nations.

Costs and benefits of regional trade agreements

One major benefit from regional trade agreements between countries that lower tariffs and abolish quotas and other
barriers to trade is that it can lead to trade creation effects.

Trade creation occurs when countries agree a trade deal that lowers tariffs between them (this may extend to a formal
customs union). As a result of a reduced tariff, consumers in a participating nation can now source imports from a
lower cost country which leads to lower prices and a rise in real incomes. Trade creation can be illustrated using a trade
liberalisation diagram.

But the expanding number of regional trade agreements can be seen as a threat to globalisation. The WTO has noted a
trend towards regionalisation of trade for example within East Asia or the European Union. Some of the world’s poorest
countries might not be able to negotiate favourable tariff or quota free access to many of the markets of rich, advanced
countries. The WTO would prefer a global trade deal covering many goods and services rather than the complex
patchwork quilt of having over 4,000 separate free trade deals across the global economy in 2018.

Role of the WTO in trade liberalisation

The World Trade Organisation (WTO) was founded in 1995 but had its origins in the 1947 General Agreement on Trade
and Tariffs (GATT). A key principle of the WTO is that of multilateral trade. The WTO describes itself as having 4 roles:
conductor, tribunal, monitor and trainer. The WTO believes that:

“Global rules of trade provide assurance and stability. Consumers and producers know they can enjoy secure supplies and greater
choice of the finished products, components, raw materials and services they use. Producers and exporters know foreign markets
will remain open to them”

Conductor role:
Members of the WTO have come up with a set of rules that apply to international trade; the WTO ensures that these
rules are followed. The WTO organises ‘rounds’ of negotiations to be able to develop new rules (e.g. in response to the
rise of trade in services), but these can take well over a decade to be agreed upon, as there needs to be a consensus
amongst members. The latest round is known as the Doha round, and was launched in 2001. Any agreements reached
are then ratified by domestic parliaments.

Tribunal role:
This role involves settling disputes between members. Member are encouraged to sort out disputes by themselves, but
occasionally the WTO needs to convene a panel of experts.

Monitor role:
The WTO reviews the trade policies of its members to make sure that WTO rules are being applied fairly and
consistently.

Training role:
The WTO provides training to government officials in (mostly) developing countries, to help them engage in trade with
other WTO members

Conflicts between trade blocs and the WTO:

Trade blocs engage in free trade with their members (which is in line with WTO aims) but often put up trade restrictions
/ barriers against non-members (which is against WTO aims). All WTO members are currently members of at least one
regional trade agreement.

The WTO has said that regional trade agreements can, however, often support the WTO’s aims. Agreements on a local
or regional scale often go beyond what might have been possible in multilateral trade discussions and can pave the way

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for new policies to be rolled out to all WTO members. Agreements on intellectual property, environmental protection
and investment at regional level have informed WTO discussion on a multilateral level.

The WTO allows regional trade agreements provided that certain criteria are met. In particular, trade should flow more
freely within the RTA without barriers being raised on countries external to the RTA. Furthermore, developed countries
are allowed to give special trade treatment, in some circumstances, to developing countries. In the words of the WTO
“regional integration should complement the multilateral trading system and not threaten it”. If this principle is not
upheld, the WTO believes that RTA’s violate its key principle of the most-favoured nation (i.e. any special favour
granted to one country must be granted to all, to avoid discrimination).

Coronavirus update: Concentrated global trade in medical products and high import tariffs
Research from the World Trade Organisation (WTO) highlights the concentrated nature of export supplies of key medical products
such as pharmaceuticals, medical products and personal protective equipment (PPE) in the age of coronavirus. Data shows that
Germany, the United States, and Switzerland supply 35% of medical products and that China, Germany and the US export 40% of
personal protective products. And these essential supplies also attract relatively high import tariffs. For example, the average applied
tariff for hand soap is 17% and PPE supplies used in the fight against COVID-19 attract an average tariff of 11.5%.

More detail

Exports of medical products: Germany (14%), the United States (12%) and Switzerland (9%) held the leading share of world exports of
medical products in 2019. Singapore exported 18% of the world’s breathing apparatus, including respirators and ventilators.

Exports of protective products, including face masks, hand soap, sanitizer and protective spectacles: China leads the way with 17% of
world exports, followed by Germany (12%) and the United States (10%). China supplied 25% world exports of face masks in 2019.

Tariffs: Hong Kong, China; Iceland; Macao, China; and Singapore do not levy any import tariffs at all on medical products. European
Union members apply the EU common external tariff with an average of 1.5%. The global average applied tariff for hand soap is 17%.

4.1.6 Restrictions on Free Trade

Key specification detail:
• Reasons for restrictions on free trade
• Types of restrictions on trade:
o Import tariffs
o Import quotas
o Subsidies to domestic producers
o Other non-tariff barriers
• Analysing/evaluating impact of protectionist policies on consumers, producers, governments, living standards and equality

Key exam point: Most students in exam questions on protectionism focus their answers on import tariffs. The best students
recognise that there are many types of trade restriction and they make a clear distinction between tariff and non-tariff barriers.
There are many subtle forms of trade restriction, sometimes known as “hidden protectionism” and it is a good idea to have some
recent applied examples of these in your study notes ahead of the final exam.

Reasons for restrictions on free trade

Response to Response to a Employment Protect “fledgling” Raise tax revenues Response to the
allegations of export persistently large protection in key or infant sectors to help lower a impact of an
“dumping” trade deficit (M>X) (strategic) industries until they are budget (fiscal) economic recession
competitive deficit

What are the main reasons for protectionism?

What are some of the main arguments in favour of a government introducing protectionist trade policies? The key
justifications for protectionism include the following:
1. Infant industry argument – protecting emerging industries until they have achieved economies of scale.
2. Sunset industry argument – use tariffs to slow the decline of old sectors and limit structural unemployment.
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 3. Diversify an economy that is thought to be too dependent on one product (e.g. primary product dependence).
4. Raise tax revenues - this is important for many developing countries with a limited domestic tax base.
5. Improve the trade balance & preserve jobs in key “strategic” industries such as telecoms and energy sectors.
6. Prevention of unfair trade practices such as import dumping – where excess output is sold in another country
at a price below costs of production. Protectionism can be a retaliatory response to another country’s policies.
You might want to bring in some game theory into your answer when making this particular point.

Import Dumping
• Dumping happens when firms sell exports at below costs or below normal prices in the home market.
o The former implies predatory pricing – which is illegal.
o The latter implies a strategy of price discrimination – this is not illegal.
• A topical recent example has been the global steel industry. China’s steel industry is experiencing significant
excess capacity and China has been accused of dumping its steel products on the European Union, selling them
for less than they are worth. That makes it harder for EU steel producers to compete.
• In 2019, the European Commission imposed anti-dumping duties on e-bikes imported from China. European
producers had complained that Chinese manufacturers benefitted from unfair subsidies that allowed them to
flood the EU market.
• In 2020, China imposed 74 per cent anti-dumping and 7 per cent anti-subsidy duties on Australian barley from
saying that import dumping of the grains had “materially damaged local industry”. In 2020, China began an
investigation into claims that cut-price Australian wine imports were unfairly hurting its own producers.
• Anti-dumping duties (or tariffs) raise the price of an imported product to help protect local producers.

What are Anti-Dumping Tariffs?

• Anti-dumping tariffs are allowed under WTO rules when cases of dumping have been established.
• There are three main options when introducing an anti-dumping import duty:
1. An ad valorem duty – % of the net EU frontier price. This is the most common import duty.
2. A specific duty – a fixed value e.g. €100 per tonne of a product.
3. A variable duty – a minimum import price (MIP). Importers in the EU do not pay an anti-dumping duty if the
foreign exporter’s export price to the EU is higher than the MIP.
• The lesser-duty rule is that duties can’t exceed the level needed to repair the harm done to European industry
by the unfair dumping practices – currently between 9-13% for a range of steel products imported into the EU
from China.

Types of Trade Restriction

Import Tariffs Import Quotas Subsidies

Rules of Origin Migration Controls Managed Currencies

Protectionist policy Brief definition

Import quota A physical limit on the quantity of a good that can be imported into a country

Import tariff A tax on imports that may be ad valorem (%) or a specific tax (a set amount per unit imported)

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 Non-tariff barrier Trade barriers such as import quotas, environmental regulations, trade embargoes and export subsidies
Rules on the national source of a product e.g. a country might set a minimum percentage for locally
Rules of origin
sourced components
Payments by the government to suppliers that reduce their costs. The effect of a subsidy is to increase
Subsidy
supply and therefore reduce the market equilibrium price

Import Tariffs – Analysis and Evaluation of Impact

Import tariffs cause a switch of spending towards domestic producers. Import tariffs generate tax revenues for the
government and may – over time – lead to an improvement in a nation’s external trade balance.

Analysis: Summary of the likely impact of an import tariff

Impact of an import tariff Comment

Domestic output Expansion Higher price from the import tariff incentivizes expansion of output
Domestic demand Contraction Higher price reduces the real incomes of domestic consumers
Imports Fall in volume Tariff causes expenditure switching towards domestic production
Government tax revenues Increase Tariff revenue generates revenue for the government
Domestic producer revenue Increase A rise in producer surplus
Foreign producer revenue Falls They are selling fewer exports after the tariff – their revenue contracts
Consumer surplus Falls Consumers hit by higher prices
Overall economic welfare Falls There is a deadweight loss of welfare / loss of economic efficiency

Tariff analysis diagrams:

(1) Diagram before a tariff is applied to imported steel:

(2) Diagram after a tariff is applied to imported steel

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(3) Diagram showing the tariff tax revenue for the government

Look at the tariff diagrams above. Which area represents:

• The gain in domestic producer surplus?
• The loss of domestic consumer surplus?
• The increase in domestic production costs as a result of the tariff?
• The revenue earned by overseas producers

Exam tip: Keep up to date with news on trade wars / trade disputes between countries – for example the tit-for-tat tariffs
announced by the United States and China during 2018 and 2019. This will give you excellent awareness to use in the exams!

Import Quotas
• A quota is a limit on the total quantity of a product can be supplied to a market.
• An import quota therefore restricts supply of an imported product.
• By cutting market supply, the price of the imported product is likely to rise.
• Shadow markets may then develop with agents trading restricted products at higher unofficial prices.

Impact on Impact of an import quota Comment

A higher price makes it more profitable for domestic suppliers to
Domestic output Increases
enter the market
Domestic demand Contracts Because the quota reduces the quantity of imports available
Reduction in quantity depends on how severe (low) is the import
Import volumes Contracts
cap
Tax revenues No direct effect A quota is different from an import tariff

Domestic producer revenue Increases Selling increased output at higher price

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 Foreign producer revenue Falls Quota caps how much can be exported into the protected market

Consumer surplus Fall Higher prices reduce consumer welfare

Quota restricts free trade and leads to deadweight loss of
Overall economic welfare Falls
economic welfare

Impact of an import quota on different stakeholders

Impact on Analysis Evaluation

Quota is a barrier to trade, might encourage domestic

Domestic producers benefit from the cap on imports
Domestic firms to become less productively efficient
– this increases the market price and makes it more
producers Some producers hampered by scarce supply of higher
profitable for them to stay in / enter the market
quality overseas imports – hurts their competitiveness
Consumers likely to face a higher price in the market Consumers who work for domestic firms may benefit
because of limit on import products. Less from higher employment and wages
Consumers
competition in the market might affect the quality of Import cap might stimulate increased investment in
products available – impact on utility alternatives
Improved external balance from the reduction in
The No immediate tax revenues from an import quota - a
imports and an expansion of GDP from the increase
government contrast with an import tariff
in domestic production

Exam hint: Can you compare and contrast the impact of imposing a quota rather than an import tariff on the economy?

Domestic (and Export) Subsidies

What is a domestic subsidy?
• A domestic subsidy is any form of government financial help to domestic businesses.
• The subsidy helps firms to lower costs and thus become more competitive in home and overseas markets.
• Export subsidies are financial incentives to sell products in overseas markets at a profit.

Impact on Analysis Evaluation

Risk of a dependency culture emerging – i.e.
Domestic producers gain from the subsidy – they get
businesses relying on the subsidies rather than
the world price + a subsidy payment
taking their own steps to become more
Domestic producers Higher revenues will lift profits and might therefore
competitive by increasing productivity, eliminating
lead to a higher share price. Increased output creates
inefficiency and accelerating the pace of
the possibility of economies of scale
process/product innovation
Assuming that the subsidy is not large enough to
They may face higher taxes if expensive subsidies
Consumers change the world price, not direct effect on the
take up a high percentage of government spending
prices that consumers pay for their products
Unlike a tariff, a subsidy does not generate tax
Subsidy can be an effective non-tariff barrier to
revenues directly.
Government reduce the volume of imports by encouraging
Increased spending on subsidies may then cause a
domestic production
growing budget deficit

Non-tariff barriers (NTBs)

Tax relief for

Subsidies Embargoes and quotas Managed currencies
businesses

There are many different types of non-tariff barrier – some of the key ones are summarised below:
1. Intellectual property laws e.g. patents and copyright protection.

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 2. Technical barriers to trade including labelling rules and stringent sanitary standards at customs borders. These
rules and regulations increase product compliance expenses and act an extra friction cost for importers.
3. Preferential state procurement policies – where government favour local producers when finalizing contracts
for state spending.
4. Domestic subsidies – aid for domestic businesses facing financial problems e.g. subsidies for car
manufacturers or loss-making airlines.
5. Financial protectionism – e.g. when a government instructs banks to give priority when making loans to
domestic businesses.
6. Murky or hidden protectionism - e.g. state measures that indirectly discriminate against foreign workers,
investors and traders.
7. Managed exchange rates – government / central bank intervention in currency markets to affect relative
prices of imports and exports.

Examples of non-tariff barriers:

• Until recently China ruled that all avocados coming from countries such as Kenya had to be frozen to -30°C and
peeled before shipping!
• Trucks of fruit coming from North Macedonia to Serbia are subject to customs and sanitary checks, and long
wait times at the border. Fresh fruit deteriorates the longer trucks have to wait at the border!
• Within the African Continental Free Trade Area, businesses have to contend with 55 separate national
standards, 55 test certificates and 55 national inspection procedures. This slows the speed at which trade
takes place.

Evaluating the impact of protectionism

What are the main arguments against import protectionism?
The conventional view is that import tariffs nearly always lead to a deadweight loss of economic welfare mainly
through the effects of higher prices for consumers and the distorting effects of a tariff on market competition, prices
and the allocation of scarce resources.

Risk of Retaliation and a Higher prices for

Market Distortions
possible Trade War consumers

Regressive effect on Incentives to by-pass

Higher costs for exporters
income inequality controls in shadow markets

Main drawbacks:
1. Resource misallocation – leading to a loss of economic efficiency.
2. Dangers of retaliation – and risks of a persistent trade war as countries engage in “tit for tat” responses.
3. Potential for more corruption - tariffs are higher in less democratic countries, revenues can be appropriated.
4. Higher prices for domestic consumers – this have a regressive impact on poorer people / communities.
5. Increased input costs for home producers – this damages competitiveness for businesses that require key
imported component parts and raw materials that are subject to an import tariff or stringent quota.
6. Barriers to entry – protectionism reduces market contestability and thereby increases monopoly power.

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Exam context: Estimating the economic cost of a trade war
In 2018, the Trump Administration in the USA implemented tariffs on 12.7% of its imports, raising tariffs on targeted imports from an
average of 2.6% to 16.6%. As predicted in game theory, the US’s trade partners retaliated by targeting 8.2% of US exports, raising
import tariffs from an average of 7.3% to 20.4%. Research from US economists has attempted to estimate the impact of the trade
war on the US economy. Their main findings are that higher tariffs fed through directly and fully to increased import prices leading to
a $51 billion annual loss to US consumers and firms from higher import prices and a $7.2 billion annual aggregate loss when producer
gains and tariff revenue for the US government are factored in. (Source: VoxEU, November 2019)

Tariff analysis – using concepts of consumer and producer surplus:

Import tariffs tend to be good for domestic producers and the government but bad news for domestic consumers of a
product to which a tariff is applied. This is because tariffs increase the price for domestic consumers, and this leads to a
contraction in demand and then leads to lower consumer surplus.

When evaluating the impact of a protectionist policy such as import tariffs or import quotas, it is always a good idea to
consider the possible effects on different stakeholders – these might include:
• Domestic producers
• Foreign producers
• Consumers of goods and services
• The government

Impact on Analysis Evaluation

Domestic Producers benefit initially from an import tariff – Possible X-inefficiencies because of reduction in
producers they are protected from lower priced imports and intensity of market competition
can expect an increase in output at a higher price Other producers affected e.g. a tariff on steel raises
which increases their revenues and operating the cost of car and construction companies
profits.
Foreign (overseas) Import tariff is a barrier to trade and squeezes Producers may be able to shift production / exports
producers demand leading to lower revenues and profits to countries or regions where import tariffs are
lower.
Consumers Consumers face higher prices after the tariff – Impact on demand depends on the price elasticity of
leading to a fall in real incomes. May affect lower demand for the affected product. Tariffs on essential
income households more – regressive? items such as foodstuffs tend to have a lower price
Loss of consumer choice (lower utility) elasticity of demand.
The government Government tax revenues rise initially from having Adverse effects of possible retaliatory tariffs on
import tariffs – rising GDP and increasing other industries. Slower economic growth from
profitability of suppliers higher inflation.

Key exam point: Each country must consider the strength of the arguments for and against trade restrictions – often on a case-by-
case basis. A lot might depend for example on the economic circumstances prevailing at a given time and their longer-term trade
and development strategy.

4.1.7 rfBalance of Payments

Key specification content:
• Components of the balance of payments:
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 o The current account
o The capital and financial accounts
• Causes of deficits and surpluses on the current account
• Measures to reduce a country's imbalance on the current account
• Significance of global trade imbalances

Current account
The current account of a nation’s balance of payments is made up of four separate balances:
(1) Net balance of trade in goods
(2) Net balance of trade in services
(3) Net primary income (includes interest, profits, dividends and migrant remittances)
(4) Net secondary income (includes transfers i.e. contributions to EU, military aid, overseas aid)

• Trade Balance in Goods (X-M)

o Manufactured goods, components, raw materials
o Energy products, capital technology
• Trade Balance in Services (X-M)
o Banking, Insurance, Consultancy
o Tourism, Transport, Logistics
o Shipping, Education, Health,
o Research, Arts
• Net Primary Income from Overseas Assets
o Profits, interest and dividends from investments in other countries
o Net remittance flows from migrant workers living and working overseas
• Net Secondary Income
o Overseas aid / debt relief transfers
o Military grants
o UK net payments to the European Union budget (prior to the UK’s Brexit)

Balance of Trade in Goods and Services for the UK , percent of GDP

8
6
4
2
0
-2
-4
-6
-8
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
2018
Trade in services balance Trade in goods balance

The UK has run a deficit on trade in goods and services for 52 of the last 70 years and every year since 1998. The lion’s
share of the deficit is concentrated on trade with Germany, China, Spain, Belgium, the Netherlands and Norway. In
2016 the UK ran trade surplus with 67 countries, including the US, Ireland, Switzerland, the United Arab Emirates, Saudi
Arabia, Australia and Brazil.
Capital Account
The capital account of the balance of payments is a small element of it. The main items included are the following:
• Sale/transfer of patents, copyrights, franchises, leases and other transferable contracts (example would be
international buying and selling of land by businesses).
• Debt forgiveness/cancellation (forgiving debt is counted as a negative in this account).
• Capital transfers of ownership of fixed assets (i.e. international death duties).
Financial Account
The financial account includes transactions that result in a change of ownership of financial assets and liabilities
between UK residents and non-residents – this includes:

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 (1) Net balance of foreign direct inve stment flows (FDI).
(2) Net balance of portfolio investment flows (e.g. inflows/outflows of debt and equity).
(3) Balance of banking flows (e.g. hot money flowing in/out of banking system).
(4) Changes to the value of reserves of gold and foreign currency.

What is foreign direct investment?

• FDI is investment from one country into another (normally by companies rather than governments) that
involves establishing operations or acquiring tangible assets, including stakes in other businesses
• Foreign direct investment flows:
o Inward investment is a positive for the UK accounts
 E.g. an overseas business decides to build a manufacturing factory in the UK
 A foreign retail firm invests to open new stores in the UK
• Outward investment is a negative for the UK financial account of the balance of payments
o Investment made overseas by UK businesses

What are portfolio investment flows?

• Portfolio investment happens when people / businesses from one country buy shares or other securities such
as bonds in other nations.
• For example:
o A UK investor buys some shares in Google (this is a portfolio investment outflow for the UK accounts)
o A German investment bank might buy some of the sovereign debt issued by the UK government (this
counts as a portfolio investment inflow for the UK)

UK Balance of Payments for 2017 and 2018

Current account 2017 2018
Trade balance in goods -137035 -138093
Trade balance in services 113102 107124
Total trade balance (X-M) -23933 -30969
Total primary income -23571 -26650
Total secondary income -20861 -24025
Current balance -68365 -81644
Capital balance -1724 -2464
Financial account
Direct investment 12670 -10949
Portfolio investment -104752 -270760
Financial derivatives (net) 10342 13216
Other investment (net) -14923 185721
Reserve assets 6799 18566
Net financial transactions -89864 -64206
Net errors and omissions -19775 19902

Components of the UK Current Account (percent of GDP, annual data)

10
5
0
-5
-10
-15
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018

Secondary income balance Primary income balance Trade in services balance Trade in goods balance

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Causes of deficits on the current account
If a nation is running a current account deficit, this is known as an external deficit.
• It involves a net outflow of income from the economy’s circular flow.
• Deficit countries need to run a financial account surplus to achieve balance on their external accounts.
• This might be achieved for example by attracting inflows of financial capital (e.g. FDI) from other countries.
• Current account deficit nations are debtor countries.
Exam hint: It is important for student to understand that there is short term, medium-term and long-term causes of a current
account deficit. And, that not all of the causes of a deficit are necessarily the result of a poorly performing economy. It is a good idea
to make a distinction between cyclical and structural causes of a deficit.

Key Causes of a Current Account Deficit

• Poor price and non-price competitiveness which is perhaps the result of:
o Higher inflation than trading partners over a lengthy period of time.
o Low levels of capital investment and research and development spending.
o Weaknesses in design, branding and product performance – affecting non-price competitiveness.
• Strong exchange rate affecting demand for exports and imports:
o A high currency value increases the overseas prices of exports - leading to a fall in export demand.
o Appreciating currency makes imports cheaper – leading to rising import demand from consumers.
• Recession in one or more of a country’s major trade partner countries:
o Recession cuts value of exports to these countries – for example the UK might be adversely affected
by a recession in Germany which is the EU’s largest economy.
• Volatile global prices (e.g. soft and hard commodities):
o Exporters of primary commodities might be hit by a fall in global prices and a therefore direct fall in
the value of their export earnings.
o Importing nations could be hit by higher world prices for oil and gas, raw materials.
o If demand for imports is price inelastic (i.e. Ped<1), then increased world prices will cause higher
spending on imports.
• Strong domestic economic growth can be a cause of a widening current account deficit:
o Rising demand for imported raw materials and component parts used by domestic industries.
o Increased demand for and spending on imported capital equipment / new technologies.
o Rising demand for luxury imported goods (i.e. products with a positive income elasticity of demand).

Structural (supply-side) causes of a current account deficit focus on longer-term causes and include:
(1) Relatively low labour productivity / high unit labour costs.
(2) Insufficient investment in capital which limits a nation’s export capacity.
(3) Low levels of national saving.
(4) Long term declines in the real prices of a country’s major exports.

Examples of current account deficit countries in 2018 (Source IMF, the current account deficit is measured as a % of GDP)

Country Current Account Deficit (% of GDP)

Lebanon -25.6
Tonga -17.1
Cambodia -10.8
Malawi -9.3
Rwanda -8.9
Nepal -8.2
Uganda -6.9
Ethiopia -6.2

Consequences from a current account deficit

1. A loss of aggregate demand if there is a trade deficit (M>X) causes weaker real GDP growth and might then
lead to reduced living standards and rising unemployment.
2. Big current account deficits (in a floating currency system) will usually cause the external value of a nation’s
currency to depreciate, leading to higher cost-push inflation and a deterioration in the terms of trade.
3. Some countries running current account deficits may choose to borrow to achieve the required financial
account surplus, but this increase in external debt carries risks especially if interest rates rise since they will
find it harder to meet the interest repayments on overseas borrowing.

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 4. Unsustainable current account deficits can ultimately lead to a loss of investor consequence, leading to capital
flight and a possible currency / balance of payments crisis. The current account deficit may be a symptom of a
much deeper lack of supply-side international competitiveness.

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Causes of a current account surplus
What is a current account surplus?
A current account surplus means that there is a net injection of income into a country’s circular flow. Surplus nations
are known as creditor countries and – other things being the same – a surplus will lead to an accumulation of foreign
exchange including US $s e.g. from rising export sales or an increase in net primary and secondary income.

Examples of current account surplus countries in 2018 (Source IMF, the surplus is measured as a % of GDP)

Country Current Account Surplus

(% of GDP)
Macao SAR 35.9
Singapore 18.5
Taiwan Province of China 13.8
Switzerland 10.2
Netherlands 9.9
Thailand 9.1
Saudi Arabia 8.4
Germany 8.1
Norway 7.8
Denmark 7.7
Ireland 7.4
United Arab Emirates (UAE) 7.2

What are the main causes of a current account surplus?

A large, persistent current account surplus results from:
• A large and persistent surplus of savings (S) over investment (I) for households, firms and the government. In
these countries, consumption could be higher, and this would help to rebalance trade.
• A large positive gap between exports and imports, when net income balance and net transfers are small.
• An export surplus may be the result of high world prices for exports of commodities such as oil and gas.
• A surplus on the current account would allow a deficit to be run on the financial account.
o For example, surplus foreign currency can be used to fund investment in assets located overseas.
o For example, some current account surplus countries have large sovereign wealth funds.
• Current account surplus countries with floating currencies nearly always have a stronger exchange rate as a
result since high export sales leads to an increase in the demand for a nation’s currency.

Key exam point: A surplus is not necessarily the result of a country achieving a high level of price and non-price competitiveness. It
could simply be that a country is benefitting from strong world demand for and rising prices of their major exports.

Measures to reduce a country’s imbalance on the current account

Exam hint: When asked to analyse & evaluate policies to reduce a current account deficit, it is a good idea to make a distinction
between expenditure-switching measures and expenditure-reducing policies. It is important to match the policy to the cause!

• Expenditure Switching Policies

o These are policies designed to change the relative prices of exports and imports.
o For example - an exchange rate depreciation ought to improve the price competitiveness of exports
and make imports more expensive when priced in a domestic currency.
o Import tariffs are designed to create expenditure-switching effects by making imports more expensive.
• Expenditure Reducing Policies
o These are policies designed to lower real incomes and AD and thereby cut the demand for imports.
o E.g. higher direct taxes, cuts in government spending or an increase in monetary policy interest rates.

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 Expenditure Switching Policy How does the policy work in theory? Evaluative Comment

Depreciation of the exchange rate Reduces relative price of exports & makes Risk of cost-push inflation – which erodes
imports more expensive competitive boost + fall in real incomes

Import tariffs Increases the price of imports & makes Risk of retaliation from other countries if
domestic output more price competitive import tariffs are used as BoP policy

Low rate of inflation (perhaps deflation) Keeps general price level under control Risks from deflation as a way of
and makes exports more competitive achieving internal devaluation –
including lower investment

Expenditure Reducing Policy How does the policy work in theory? Evaluative Comment

Increase in income taxes Reduces real disposable incomes causing Cut in living standards and risk of
falling demand for imports damage to work incentives in labour
market
Cuts in real level of government spending Lowers aggregate demand, firms may Damage to short term economic growth,
look to export their spare capacity risks that austerity hits investment

Changes in the exchange rate and adjustment of a current account deficit

To what extent is a current account deficit corrected by changes in a country’s exchange rate?
• In theory, a large current account deficit leads to an outflow of currency from the circular flow which then
causes an exchange rate depreciation (within a floating currency system).
• And a weaker currency in theory helps bring about an adjustment of the trade balance as exports become
more competitive in overseas markets and imported goods and services appear more expensive in domestic
markets.
• In reality, the extent to which a current depreciation helps to improve the trade balance depends on a number
of factors. Students need to understand the J Curve effect and the associated Marshall-Lerner condition.
The J Curve Effect
• In the short term, a currency depreciation may not improve the current account of the Balance of Payments.
• This is because the price elasticities of demand for exports & imports are likely to be inelastic in the short term.
• Initially the quantity of imports bought will remain steady in part because contracts for imported goods are
already signed. Export demand will be inelastic in response to the exchange rate change as it takes time for
export businesses to increase their sales following a fall in prices.
• Earnings from selling more exports may be insufficient to compensate for higher total spending on imports.
• The balance of trade may therefore initially worsen. This is known as the ‘J-Curve’ effect.
• Providing that the price elasticity of demand for imports and exports are greater than one, then the trade
balance will improve over time.
• This is known as the Marshall-Lerner condition.

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The Marshall Lerner Condition
The Marshall Lerner condition states that a depreciation / devaluation of the exchange rate will lead to a net
improvement in the trade balance provided that the sum of the price elasticity of demand for exports and imports > 1.
Here are some numerical examples.

Sum of price Will a depreciation in

PED for exports PED for imports elasticity of demand currency improve the
for exports and trade balance?
imports
Country A 0.4 0.3 0.7 No
Country B 1.2 0.7 1.9 Yes
Country C 0.8 0.2 1.0 Leaves it unchanged

Exam tip: The J-curve effect and application of the Marshall-Lerner condition are effective ways to evaluate the impact of exchange
rate changes. However, the best students will always try to put these evaluative points in context. For example, they might consider
the goods/services typically traded by a particular country (e.g. the UK exports financial services & tourism, and imports food /
energy
/ raw materials) and make a judgement about the likelihood of the Marshall-Lerner or J-curve effects occurring.

Significance of global trade imbalances

What are global trade imbalances?
Imbalances refer to persistent current account surpluses for some countries contrasted with deficits in other nations.

Current account deficits and surpluses for major countries in 2018

(Source: IMF, October 2018, trade balance measured as a percentage of GDP)

Current Account Surplus Balance for 2018 Current Account Deficit Balance for 2018
Nations (% of GDP) Nations (% of GDP)
Singapore +18.5 Turkey -5.7
Switzerland +10.2 New Zealand -3.7
Netherlands +9.9 United Kingdom -3.5
Germany +8.1 India -3.0
Norway +7.8 Australia -2.8
South Korea +5.0 United States -2.5
Japan +3.6 Brazil -1.3
China +0.7 France -0.9

Why do they matter?

• Deficit countries:
o Run up large external debts and are increasingly reliant on foreign capital.
o May decide to switch towards using protectionist policies such as tariffs and quotas.
o Deficits can lead to a fall in relative living standards over time if economic growth slows down.
• Surplus countries:
o Are saving more than they spend, thereby depressing global demand and growth.
o May be adopting a policy to keep their currency deliberately under-valued against other countries.
o Might be under-consuming (thus affecting living standards) and allocating domestic scarce resources
to exporting overseas rather than allowing higher levels of domestic consumer spending.

Exam hint: One of the major issues with trade imbalances is that they strengthen those who want to move away from free trade in
goods and services. Significant trade imbalances have been a factor behind the rise of de-globalisation in recent years – i.e. they
create trade tensions that can lead to widespread use of tariff and non-tariff barriers.

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4.1.8 Exchange Rates
Key specification content:
• Exchange rate systems:
o Floating
o Fixed
o Managed
• Factors influencing floating exchange rates
• Government intervention in currency markets through foreign currency transactions and the use of interest rates
• Competitive devaluation/depreciation and its consequences
• Impact of changes in exchange rates on macroeconomic objectives

What is an exchange rate?

An exchange rate is the rate or price at which one country’s currency can be exchanged for other currencies in the
foreign exchange (FX) market. There is no such thing as “the” exchange rate – so if sterling (£) depreciates against the
United States $, it could still be appreciating against the Euro or the Japanese Yen.

Effective exchange rate: This is a weighted index of sterling's value against a basket of currencies where the weights
are based on the importance / share of trade between the UK and each country.
Exchange rate systems
What are the main exchange rate systems?
• A free-floating currency where the external value of a currency depends wholly on market forces of supply
and demand – there is no central bank intervention to influence a currency’s price.
• A managed-floating currency when the central bank may choose occasionally to intervene in the foreign
exchange markets to influence the value of a currency to meet specific macroeconomic objectives.
• A fixed exchange rate system e.g. a hard currency peg either as part of a currency board system or
membership of the ERM Mark II for those EU countries eventually intending to join the Euro. Currencies trade
at an officially announced level.

Describing changes in exchange rates carefully and accurately

Students should be aware that a depreciation and devaluation are different, even if they ultimately have the same
consequences:
• Depreciation is a fall in the value of a currency in a floating exchange rate system
• Devaluation is a fall in the value of a currency in a fixed exchange rate system
• Appreciation is a rise in the value of a currency in a floating exchange rate system
• Revaluation is a rise in the value of a currency in a fixed exchange rate system

Choice of currency system for selected countries

Exchange Rate System Exchange rate anchor currency (where relevant)

US Dollar ($) Euro Composite Currency or Other

Currency Peg
Fixed currency with no separate Ecuador Kosovo, San Marino
legal tender Zimbabwe
Currency Board System Hong Kong Bulgaria

Conventional exchange rate peg Qatar Denmark Kuwait

(fixed currency system) Saudi Arabia Senegal Nepal

Crawling exchange rate peg (semi- Jamaica Croatia China

fixed currency) Ethiopia

Managed floating currency Kenya, Brazil, Ukraine, South Korea, India, Zambia, South Africa, Thailand, Turkey, Sweden,
Mexico, Israel, Japan, Chile
Free floating exchange rate Australia, Canada, Norway, UK, USA, Euro Zone

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Free Floating Exchange Rates
British pound sterling (GBP) to Euro (EUR) monthly exchange rate from January 2007 to July 2020

Monthly exchange rate of British pound to Euro 2007-2020

1.6
1.5
1.4
1.3
1.2
1.1
1.
Nov '07
Apr '08

May '10
Oct '10

Nov '12
Apr '13

May '15
Oct '15

Nov '17
Apr '18

May '20
Jan '07
Jun '07

Sep '08
Feb '09
Jul '09
Dec '09

Mar '11
Aug '11
Jan '12
Jun '12

Sep '13
Feb '14
Jul '14
Dec '14

Mar '16
Aug '16
Jan '17
Jun '17

Sep '18
Feb '19
Jul '19
Dec '19
In a free-floating currency system (an example being the £ sterling against the Euro or the US dollar):
• The external value of the currency is set by market forces:
o The strength of currency supply and demand drives the external value of a currency in the markets.
o The currency can either appreciate (rise) or depreciate (fall).
• There is no intervention by the central bank:
o Central bank allows the currency to find its own market level.
o It does not alter interest rates or intervene directly by buying/selling currencies to influence the price.
• There is no target for the exchange rate:
o The external value of currency is not an intermediate target of monetary policy (i.e. interest rates are
not set at a level designed to influence the currency).

What factors cause changes in the currency in a floating system?

1. Trade/current account balances – countries that have strong trade and current account surpluses tend (other
factors remaining the same) to see their currencies appreciate as money flows into the circular flow from
exports of goods and services and from inflows of investment income.
2. Foreign direct investment (FDI) – an economy that attracts high net inflows of capital investment from
overseas will see an increase in currency demand and a rising exchange rate.
3. Portfolio investment – strong inflows of portfolio investment into equites and bonds from overseas can cause
a currency to appreciate.
4. Interest rate differentials - countries with relatively high interest rates can expect to see ‘hot money’ flowing
coming in and causing an appreciation of the exchange rate.

Chain of reasoning – the impact of higher interest rates on a floating exchange rate:

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Chain of reasoning – the effect of a fall in export demand on a floating exchange rate:

Managed Floating Exchange Rates

Brazilian Real Indian Rupee

With managed exchange rates:

• Currency is usually set day-to-day by market forces:
o Central bank normally gives a degree of freedom for market exchange rates on a daily basis.
• A central bank may intervene occasionally to influence the price:
o Buying to support a currency (i.e. selling some of their FX reserves).
o Selling to weaken a currency (i.e. adding to their FX reserves).
• Changes in policy interest rates to affect hot money flows i.e. increase rates to attract inflows of money into
the banking system looking for a favourable rate of return.
• In a managed floating system, the currency becomes a key target of a country’s monetary policy.
o Stronger exchange rate might be wanted to control demand-pull and cost-push inflationary pressures.
o A government might want to engineer a competitive devaluation to improve export competitiveness.

Policy Tools for Managing Floating Exchange Rates

• Changes in monetary policy interest rates:
o Changes in interest rates e.g. lower interest rates to depreciate the exchange rate.
o Causes movements of “hot money” banking flows into or out of a country.
• Quantitative easing (QE):
o Increase liquidity in the banking system arising from QE, usually causes an outflow of money leading
to depreciation of the exchange rate.
• Direct buying / selling in the currency market (intervention):
o Direct intervention in the currency market.
o Buying and selling of domestic / foreign currencies
• Taxation of overseas currency deposits and capital controls:
o Taxation of foreign deposits in banks cuts the profit from hot money inflows.
o A government might introduce controls on the free flow of capital into and out of a country perhaps
restricting how much currency a foreign investor can take out at a given time.

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Exam technique – Example of chain of reasoning: How can a central bank influence the value of a currency?

Competitive Devaluations / “Dirty Floating”

• Competitive devaluations occur when a country deliberately intervenes to drive down the value of their
currency to provide a competitive lift to aggregate demand, output and jobs in their export industries.
• They may try this when faced with a deflationary recession or perhaps to attract extra foreign investment.
• For nations with persistent trade deficits and rising unemployment, a competitive devaluation of the exchange
rate can become an attractive option - but there are some risks involved.
• Devaluing an exchange rate can be seen by other countries as a form of trade protectionism that invites some
form of retaliatory action such as an import tariff.
• Cutting the exchange rate makes it harder for other countries to export negatively affecting their growth rate
which in turn can damage the volume of trade that takes place between nations.
• Competitive devaluations of a currency go against the principles of trade based on comparative advantage.

Fixed Exchange Rates

Hong Kong Dollar – Bulgarian Lev – pegged

pegged to the US Dollar to the Euro

In a fixed exchange rate system:

• The government / central bank fixes the currency value:
o The external value is pegged to one or more currencies (known as the “anchor” currency).
o The central bank must hold sufficient foreign exchange reserves to intervene in currency markets to
maintain the agreed fixed exchange rate peg.
• Pegged exchange rate becomes official rate:
o Trade takes place at this official exchange rate.
o There might be unofficial trades in shadow currency markets.
• Adjustable peg system:
o Occasional realignments of a currency may be needed.
o E.g. a devaluation or revaluation depending on macroeconomic circumstances – the currency may
have drifted from the fundamental value and be a cause of a widening trade deficit and job losses.

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Impacts of changes in exchange rates
What Happens when the Exchange Rate Changes?
As an exchange rate changes, so does the value of amounts converted using the new exchange rate. Here is an example:

Currency Amount Exchange Rate Conversion

Sales € €100,000 £ = €1.25 £80,000
Sales € €100,000 £ = €1.10 £90,909
Sales € €100,000 £ = €1.50 £66,666
.
Ways Exchange Rates Impact Business Activity
1. Price of exports in international markets
2. Cost of goods bought from overseas
3. Revenues and profits earned overseas
4. Converting cash receipts from customers overseas

Example: Who Benefits or Loses from a Lower Exchange Rate?

Winners Losers

Businesses exporting into international markets Businesses importing goods and services
Businesses earning substantial profits in overseas currencies Overseas businesses trying to compete in the domestic market

To remember the opposite (higher exchange rate)

SPICED: Strong Pound Imports Cheaper Exports Dearer) – this is a frequently used mnemonic!
Impact of a currency depreciation
• A currency depreciation usually has a similar effect on the macro-economy as a cut in interest rates.
• A currency depreciation may help to provide a partial auto-correction of a large trade deficit.

Aggregate Demand
• Export prices fall • Imported raw
• Import prices rise materials & energy
• Net exports (X-M) • Costs of capital
• Investment equipment
• Real incomes
• Business confidence

Depreciation Aggregate Supply

Macro Objective Comment on the impact of a currency depreciation

Higher import prices feed into increased consumer prices – may help a country to avoid deflation and
Inflation it lowers real interest rates. But higher inflation threatens real living standards especially for groups
with weak bargaining power in the labour market who are unable to bid for higher wages.

A weaker currency is usually a stimulus to GDP growth e.g. from higher net exports but much depends
Economic growth on the price elasticity of demand for exports. Many exports require imported components which will
have become more expensive as a result of the depreciation.

A more competitive currency will help to increase domestic production and perhaps create a positive
Unemployment export multiplier effect which will further stimulate aggregate demand and jobs. There might be an
upturn in tourism / demand from overseas students to come to a country’s universities

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 Dependent on price elasticities of demand for X&M – possible J curve effect in the short run
Balance of trade
The impact on export sales depends in part on the strength of GDP growth in key export markets

Business Should help to improve profitability e.g. a fall in the external of the £ increases the overseas earnings
investment of UK plc in US dollars and Euros which will be now be worth more in £s.
Wider Depreciation is similar to a cut in interest rates i.e. an expansion of monetary policy) but there
macroeconomic are risks too – including higher costs of importing components, raw materials and prices of
effects important capital technologies.

Exam hint: When discussing the impact of exchange rate changes, remember to use aggregate demand and supply analysis from
Theme 2 to help support your arguments. E.g. you might show an outward shift in AD (rising exports) and an inward shift of AS
(higher import costs) resulting from a large depreciation in the external value of the exchange rate.

Exam technique: Chain of reasoning: How might a currency depreciation affect international competitiveness?

Evaluating Effects of a Currency Depreciation

In theory, a depreciation of the exchange rate provides stimulates aggregate demand, but this depends on:
1. The variable length of time lags as consumers and businesses respond.
2. The scale of any change in the exchange rate i.e. a 5%, 10%, 20%.
3. Whether the change in a currency is temporary or longer lasting?
4. The coefficients of price elasticity of demand for X&M (this relates this back to the Marshall-Lerner condition).
5. The size of any second-round multiplier and accelerator effects on incomes and investment.
6. When the currency movement takes place – i.e. Which stage of an economic cycle (recession, recovery etc).
7. The type of economy (e.g. the impact will be different for small developing nations v large advanced countries).
8. The degree of openness of the economy to international trade i.e. measured by the value of trade as a % of GDP.

Context: Brexit and Sterling’s Depreciation in 2016:

Research has found that the Brexit depreciation of sterling in June 2016 increased UK consumer prices by 2.9%, leading to an £870
per year rise in the cost of living for the average UK household, meaning people had to work 1.4 weeks longer to afford the same
goods & services. This suggests that a currency depreciation can increase inflation and reduce real incomes.

Evaluating Floating Exchange Rates

• Advantages of Floating Exchange Rates:
o Reduces the need for a central bank to hold large amounts of currency reserves.
o Freedom to set monetary policy interest rates to meet domestic objectives.
o May help to prevent imported inflation.
o Insulation for an economy after an external shock especially for export-dependent countries.
o Partial automatic correction for a current account / trade deficit.
o Less risk of a currency becoming significantly over/undervalued.
• Evaluation points:
o No guarantee that floating exchange rates will be stable.
o Volatility in a floating currency might be detrimental to attracting inward investment.

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 o A lower (more competitive) exchange rate does not necessarily correct a persistent current account
deficit - consider the J curve theory and the importance of non-price competitiveness.

Using AD-AS analysis

Consider the likely impact of an exchange rate appreciation:

Evaluating Exchange Rate Systems

Evaluating Fixed Exchange Rates
• Advantages of fixed exchange rates:
o Certainty of currency value gives confidence for inward investment from overseas businesses.
o Reduced need to engage in and costs of “currency hedging” for businesses such as airlines.
o Currency stability helps to control inflation – i.e. it is a discipline on businesses to keep labour costs low.
o A stable currency can lead to lower borrowing costs (i.e. lower yields on government bonds).
o Imposes responsibility on government macro policies e.g. to keep inflation under control.
o Less speculation in the currency market if the fixed exchange rate is regarded by traders as credible.
• Evaluation points:
o Reduced freedom to use interest rates for other macro objectives such as stimulating GDP growth.
o Many developing countries do not have sufficiently large foreign currency reserves to be able
maintain a fixed exchange rate over a period of time.
o Difficult for countries to use a competitive devaluation of their fixed exchange rate – this creates
political tensions and might lead to a protectionist response.
o Devaluation of a fixed exchange rate can lead to a surge in cost-push inflation – this is damaging for
competitiveness and has regressive effects on poorer families.

Floating versus Fixed Exchange Rates

• Fixed rates may be optimal for developing countries wanting to control inflation.
• Export-dependent economies may favour a managed floating rate e.g. to offset fluctuating world prices.
• Not every country has the scale of foreign currency reserves needed to influence the price of a currency.
• The choice of currency regime is hugely important for developing and emerging countries. Some countries
have opted to join a monetary union e.g. the nineteen members of the Euro Zone.

4.1.9 International Competitiveness

Key specification content:
• Measures of international competitiveness:
o Relative unit labour costs and relative export prices
• Factors influencing international competitiveness
• Significance of international competitiveness:
o Benefits of being internationally competitive
o Problems of being internationally uncompetitive

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What is competitiveness?
External competitiveness is the sustained ability of a country’s businesses to sell goods and services profitably at
competitive prices in overseas markets. The core measure of competitiveness is a nation’s relative unit labour costs
expressed in a common currency such as the US $ or the Euro.

What is the difference between price and non-price competitiveness?

Price (or cost) competitiveness:
• Key measure: Differences in relative unit labour costs (ULCs).
Non-price competitiveness:
• Key aspects are: Product quality, innovation, design, reliability and performance, choice, after-sales services,
marketing, branding, brand loyalty and the availability and cost of replacement parts.
Non-wage cost factors for businesses operating in international markets include:
1. Environmental taxes e.g. minimum prices on carbon emissions.
2. Employment protection laws & health and safety regulations.
3. Statutory requirements for employer pensions.
4. Employment taxes e.g. employers’ national insurance costs in the UK or payroll taxes in other countries.

Exam hint: Students must be aware that competitiveness can relate to price and non-price factors. Be aware that a range/mixture of
demand and supply-side policies might be needed in order for competitiveness to be improved over time.

Relative Unit Labour Costs

Unit labour costs are labour costs per unit of output. There is a simple formula for calculating unit labour costs:
Unit labour costs = total labour costs / total output

Unit labour costs are determined mainly by:

1. Average wages / salaries in a country’s labour market – one measure tracked is the hourly labour cost of
employing people in the labour market.
2. Labour productivity i.e. output per person employed or output per hour worked.

Key analysis point: Unit labour costs will tend to rise over time when wages are rising faster than productivity.

How to lower relative unit labour costs

• Relative unit labour costs will rise when:
o A country’s exchange rate appreciates.
o Wage costs rise relatively faster than other nations.
o Labour productivity growth is relatively slower.
• Options for reducing relative unit labour costs
o Monetary policy interventions aimed at a currency depreciation e.g. a managed floating exchange rate.
o Wage controls e.g. wage/pay freezes for people working in the public (state) sector.
o Supply-side measures designed to raise labour productivity / efficiency across many industries.

Context: The UK international productivity gap

In 2016, ranked on GDP per hour worked, the UK came fifth highest out of the G7 countries, with Germany top and Japan bottom.
UK productivity was 16% below the average of the rest of the G7 countries. (Source: UK Parliament Research Briefing)

Relative export prices

Relative export prices are one country's export prices in relation to other countries, usually expressed as an index.

Relative export prices will rise when:

1. There is an appreciation of the currency – causing export prices in overseas markets to rise.
2. There is a period of high relative inflation in one country compared to others – again this tends to make
exports appear more expensive when priced in an overseas currency.
3. When export businesses experience higher costs e.g. arising from environmental taxes, increased minimum
wages which leads them to raise price to protect their profit margins.
4. When exporters of goods and services are hit by import tariffs.

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Competitiveness Rankings
The annual Global Competitiveness Index published by the World Economic Forum (WEF) uses a range of indicators:

Indicator Brief comment on the indicator

Effectiveness of institutions Protection of property rights, rule of law, corruption

Quality of infrastructure Quality of transport, communications, energy etc.
Macroeconomic performance Inflation, fiscal balance, government debt, growth
Health and primary education Malaria incidence, prevalence of HIV, mortality rates
Higher education and training Quality of teaching and attainment e.g. in Maths
Efficiency of goods & labour markets Intensity of competition, tariffs, other barriers
Technological readiness Internet use, availability of latest technologies
Sophistication of business Supplier quality, business clusters,
Innovation Patent applications, research & development spend

UK’s Competitiveness Ranking for 2018

Competitiveness indicator 2018 Global Ranking for the UK Top ranked country in 2018
Overall competitiveness 8th USA
Institutions 7th New Zealand
Infrastructure 11th Singapore
Quality of roads: 26th Singapore
Efficiency of train services: 22nd Switzerland
ICT adoption 24th South Korea
Fibre Internet subscriptions: 75th South Korea
Innovation capability 7th Germany
Skills 12th Finland
Digital skills among population: 32nd Sweden
Internal labour mobility 48th (16th in 2017) Guinea
Diversity of the workforce 7th Canada
Market size 7th China
Financial system 8th United States
Soundness of banks: 40th Finland
Business dynamism 7th United States
Attitudes toward entrepreneurial risk: 5th Israel

Policies to improve competitiveness

These policies might include:
1. Competitive exchange rate – perhaps involving moving to a managed floating currency.
2. Competitive tax environment to attract inward investment and encourage new business to start up.
3. Investment in human capital to improve the quality of the workforce.
4. Increased research & development to drive a faster pace of innovation.
5. Stronger market competition to raise factor productivity and lower relative export prices.
6. Stable macroeconomic environment e.g. maintaining low inflation with steady economic growth to support
business confidence and investment.
7. Investment in critical infrastructure such as better road, air and rail links, improved ports, faster broadband
and fast fibre-optic internet connections.

Key point: Competitiveness is strongly affected by the pace of innovation in different markets and industries.

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 R&D Tax Credits Patent Box Initiative Public R&D and Highly skilled Nurturing an Increasing intensity
(used in Australia & – 10% corporation more Funding for migrants policy e.g. entrepreneurial of competition
South Korea) tax (a UK Policy) Higher Education skilled coders culture within markets

In short, innovation requires strong human capital, institutions and incentives.

Fiscal policy and international competitiveness

Fiscal policy can have an important part to play in driving competitiveness of countries:
1. Subsidies to lower the cost of research e.g. in pharmaceuticals, life sciences, robotics and artificial intelligence.
2. Tax incentives can encourage the commercialisation of ideas e.g. ideas coming out of universities.
3. Lower employment taxes to stimulate skilled migration from overseas.
4. Lower capital gains taxes encourage small businesses / start-ups.
5. Special economic zones (SEZ) to attract research-intensive businesses.

What matters for competitiveness in the long run?

• Macro competitiveness has important micro foundations:
o Competitive markets and innovative businesses.
o Skills, aptitudes and attitudes within a diverse workforce.
o Expanding opportunities for female entrepreneurs /refugees.
• Competitive advantage comes from having:
o Globally scaled businesses close to or at the technological frontier.
o A culture of innovative business start-ups / social entrepreneurs.
o A financial system that can provide appropriate and affordable credit for education, business research
and funding for business expansion.
• Reliance on currency depreciation / devaluation and wage cuts is not a sustainable competitiveness strategy:
o The most competitive countries tend to have the highest minimum wages.
o There is a continuous global battle for the most talented, highly skilled workers.
o “Races to the bottom” e.g. in tax rates and wages have a limited impact in the long run.
Internal and external devaluation
What is an internal devaluation?
• Internal devaluation happens when a country seeks to improve price competitiveness through lowering wage
costs and increasing productivity and not reducing the external value of their exchange rate.
• Good examples in recent years have applied to Latvia (a Baltic State) and Greece, in the wake of a severe
depression which followed the Global Financial Crisis. Ecuador is implementing internal devaluation.
• An internal devaluation requires several years of low relative inflation i.e. a country’s inflation rate lower than
price increases in other countries. With Greece, this involved price deflation i.e. a negative rate of inflation.
• Internal devaluation can be brought about by fiscal austerity (via higher taxes and cuts in government
spending) and/or a sharp rise in real interest rates – both impose deflationary pressure on output & prices.
• Internal devaluation is more likely to happen with a country that has a fixed exchange rate e.g. Ecuador has a
fixed rate against the US dollar. Greece is inside the Single European Currency zone and cannot devalue their
exchange rate unilaterally unless they opt to leave the single currency system and return to the drachma.
What is an external devaluation?
• An external devaluation happens when a country operating with a fixed or semi-fixed exchange rate system
decides to deliberately lower the external value of their currency against one or a range of other currencies.
• A devaluation of the currency means a domestic currency buys less of a foreign currency. One motivation is to
make exports more price competitive in overseas markets and to make imports relatively more expensive than
domestic supply.
• Linked aims might include reducing the size of a trade deficit and to cut the real value of sovereign. Debt owed
to international creditors. In theory, currency devaluation is a fast way of improving price competitiveness
than an internal devaluation.
• Examples of countries that have devalued in recent years include Egypt (a 16% fall v the US$ in 2016) and
Ghana whose currency was devalued by 17% against the US$ in 2019.

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Evaluation: Risks from an internal devaluation:
1. Severe loss of output and rising unemployment
2. Fall in nominal wages reduces living standards
3. Risks from sustained price deflation
4. Real value of debt increases
5. Danger of a country suffering a permanent loss of output (known as “hysteresis”)

Evaluation: Drawbacks from an external devaluation:

1. Increase in cost-push inflation from higher import prices
2. Reduces real incomes because of a rise in inflation
3. No guarantee that the trade deficit will improve (refer to the J Curve concept)
4. Foreign creditors will demand higher interest rates on new issues of government & corporate debt
5. Currency uncertainty makes country less attractive to inward FDI

Significance of International Competitiveness

To what extent do improvements in international competitiveness lead to higher standards of living?
• Benefits:
o Improved living standards e.g. measured by real GNI per capita (PPP).
o Stronger trade performance from an increase in export sales.
o Virtuous circle of economic growth.
o Employment creation.
o Higher government tax revenues as incomes and profits increase.
• Possible problems / drawbacks:
o Trade surpluses might invite a protectionist response.
o Possible risks of demand-pull inflation.
o Competitiveness might be achieved at the expense of growing inequality of income and wealth.
o Higher productivity might be achieved at expense of a worsening work-life balance and increased
incidence of mental health problems.
o Increased competitiveness might cause a country’s exchange rate to appreciate.

4.2.1 Absolute and relative poverty

Key specification content:
• Distinction between absolute poverty and relative poverty
• Measures of absolute poverty and relative poverty
• Causes of changes in absolute poverty and relative poverty

What is the difference between absolute and relative poverty?

• Absolute (extreme) poverty:

o When a household does not have sufficient income to sustain even a basic acceptable standard of living
/to meet people’s basic needs
o Absolute poverty thresholds will vary between developed and developing countries
o The World Bank now has two “extreme poverty lines”:
 (1) Percentage of population living below $1.90 a day (PPP)
 (2) Percentage of population living below $3.10 a day (PPP)
o Extreme poverty is multi-dimensional - about more than very low income per capita
• Relative poverty
o A level of household income considerably lower than the median level of income within a country
o The official UK relative poverty line is household disposable income of less than 60% of median income
o Median income is preferred by many development economists since the median per capita reveals
the progress of a ‘typical’ person in society and is not influenced to what happens at the tails of the
distribution for the lowest and highest income families.

Exam hint: It is important to make a clear distinction between absolute and relative poverty. It is possible for example for average
incomes per capita to be rising (helping to lower absolute poverty) whilst at the same time, relative poverty could be growing if the
gaps in income and wealth between rich and poorer households and communities get wider.

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Absolute (extreme) poverty
According to data from the World Bank, extreme poverty is declining but perhaps not quickly enough to meet one of
the sustainable development goals of lowering absolute poverty to less than 3% of the global population by 2030. The
percentage of people living in extreme poverty globally fell to a low of 8.6 percent in 2018 — down from 11 percent in
2013. The number of people living on less than $1.90 a day fell during this period by 68 million to 736 million.

• In 2018, about half of the world’s countries now have extreme poverty rates below 3 per cent.
• 41 per cent of people in Sub Saharan Africa live on a per capita income of less than $1.90 a day (PPP).
• The World Bank focuses on the concept of shared prosperity defined as when economic growth increases the
incomes and consumption of people in the poorest 40 per cent of the population.

Coronavirus update: Risk of sharp rise in extreme poverty

The World Bank has predicted that the COVID-19 pandemic could push up to 100 million people around the world into extreme
poverty and reverse almost a decade’s progress in cutting levels of absolute poverty in poorer nations. According to the United
Nations Development Report: “COVID-19 is the latest crisis to hit the globe, and climate change all but guarantees more will follow
soon. Each will affect the poor in multiple ways. We need to work on tackling poverty – and vulnerability to poverty - in all its forms.”

Main causes of absolute (extreme) poverty

1. Population growing faster than GDP in low income countries leading to lower per capita incomes.
2. A severe household savings gap – with many families unable to save and living on less than $1.90 per day.
3. Absence of basic government / public services such as education and universal health care.
4. Effects of endemic corruption in government and business.
5. High levels of debt and having to pay high interest rates on loans.
6. Damaging effects of civil wars and natural disasters leading to huge displacements of population.
7. Low rates of formal employment, many people in vulnerable/insecure jobs and earning poverty wages.
8. Absence of basic property rights which for example constrains ability to own land, claim welfare.

Low and unstable Absence of financial / Poor access to basic High unemployment /
household incomes welfare safety nets public & merit goods low employment

Exam hint: The causes of poverty are often complex and multi-causal. These causes will vary from country to country at different
stages of economic development. Become a mini expert on your chosen cluster of developing / emerging countries and find out
whether they are making significant progress in reducing extreme poverty and improving human development outcomes.

Relative Poverty
Relative poverty occurs because income and consumption are skewed across households, communities and regions.

Main causes of relative poverty include:

• Cuts in top rate income taxes in many countries increasing disposable incomes of richer households.
• Surging executive pay and high rewards for skilled workers compared to other employees.
• Regressive effects of higher food and energy prices on poorer households.
• Deep market failures in access to and affordability of good quality education, health & basic housing.
• Declining strength of trade unions in many countries and the rising monopsony power of some big employers.

Multi-Dimensional Poverty Index (MPI)

• The UN’s Multi-dimensional poverty index is an attempt to go deeper than the basic Human Development
Index to see if progress is being made - against sustainable development standards – to lower the vulnerability
of people in emerging and developing countries to severe deprivation.
• The MPI scrutinizes a person’s deprivations across 10 indicators in health, education and standard of living
• In 2019, 23% of people across 101 countries (1.3 billion people) were living in multi-dimensional poverty
o Two-thirds of these people live in middle-income countries, over half of them are aged under 18

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Metrics used to calculate the multi-dimensional poverty index

Dimension of Indicator Deprived if living in the household where… Weighting

poverty
Health Nutrition An adult under 70 years of age or a child is undernourished. 1/6
Child mortality Any child has died in the family in the five-year period preceding the survey. 1/6
Education Years of No household member aged 10 years or older has completed six years of 1/6
schooling schooling.
School Any school-aged child is not attending school up to the age at which he/she 1/6
attendance would complete class 8.
Standard of Cooking Fuel The household cooks with dung, wood, charcoal or coal. 1/18
living Sanitation The household’s sanitation facility is not improved, or it is improved but 1/18
shared with other households.
Drinking Water The household does not have access to improved drinking water or safe 1/18
drinking water is at least a 30-minute walk from home, round trip.
Electricity The household has no electricity. 1/18
Housing Housing materials for at least one of roof, walls and floor are inadequate 1/18
Assets The household does not own more than one of these assets: radio, TV, 1/18
telephone, computer, animal cart, bicycle, motorbike or refrigerator, and
does not own a car or truck.

Some recent data by country on multi-dimensional poverty

Country Gross national % of the population in % of the HDI Ranking (2019)

income (GNI) per severe multi-dimensional population living
capita poverty on less than $1.90
a day (PPP)
Niger $912 74.8 44.5 189
Ethiopia $1,782 61.5 27.3 173
Mozambique $1,154 49.1 62.4 180
Angola $5,555 32.5 30.1 149
Rwanda $1,959 22.2 55.5 157
Bangladesh $4,037 16.7 14.8 135
Cambodia $3,597 13.2 n/a 146
India $6,829 8.8 21.2 129
Mexico $17,628 1.0 2.5 76
Vietnam $6,220 0.7 2.0 118

Vietnam has a lower per capita income than India, yet their severe multi-dimensional poverty rate is less than one per
cent of the population and only two percent of inhabitants live on less than $1.90 a day (PPP). Vietnam’s relative
success in providing widely available basic health care and other infrastructure such as core sanitation facilities helps
explain this difference. The state has a crucial role to play in providing the public goods at scale necessary to reduce
multi-dimensional poverty.

Regions % of the population in severe % of the population living on less than

multidimensional poverty PPP $1.90 a day

Arab States 6.9 4.6

East Asia and the Pacific 1.0 2.1
Europe and Central Asia 0.1 0.6
Latin America and Caribbean 2.0 4.1

South Asia 11.3 17.5

Sub-Saharan Africa 35.1 44.7

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Measures of inequality
• Quintile ratio:
o This is the ratio of the average income of the richest 20% of the population to the average income of
the poorest 20% of the population.
• Palma ratio:
o This is the ratio of the richest 10% of the population's share of gross national income divided by the
poorest 40%'s share.
• Gini coefficient:
o A Gini index of 0 represents perfect equality, while an index of 100 implies perfect inequality.

Exam context: According to the 2019 Oxfam Report, Inequality is rising, and the middle class is shrinking. 26 people on Earth own the
same wealth as 3.8 billion people who make up the poorest half of humanity.

Exam hint: It is easy for students to get confused when interpreting the figures for the HDI and the Gini coefficient. For the HDI, a
value of 0 is low development and 1 is high development. For the Gini coefficient, we need to interpret the numbers in an almost
‘opposite’ way i.e. 0 is high equality and 1 is total inequality.

The Lorenz Curve

The Lorenz Curve gives a visual interpretation of income or wealth inequality. The diagonal line in the graphic below
shows a situation of perfect equality of income i.e. 50% of population has 50% of income.

Using the Lorenz Curve to measure the Gini Coefficient

• The Gini coefficient is between 0 and 1

• A value of 0 is zero inequality and 1 is total inequality

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The Gini coefficient here = area A / areas A + B

Countries with the highest income inequality in 2017

HDI rank Country HDI Value Quintile ratio Palma ratio Gini coefficient
113 South Africa 0.699 28.4 7.0 63.0
129 Namibia 0.647 20.1 5.8 61.0
101 Botswana 0.717 23.2 5.8 60.5
144 Zambia 0.588 21.1 5.0 57.1
188 Central African Republic 0.367 18.5 4.5 56.2
159 Lesotho 0.520 20.8 4.3 54.2
180 Mozambique 0.437 14.2 3.9 54.0
79 Brazil 0.759 15.6 3.5 51.3
90 Colombia 0.747 14.3 3.4 50.8

Countries with the lowest income inequality in 2017

HDI rank Country HDI Value Quintile ratio Palma ratio Gini coefficient

80 Azerbaijan 0.757 2.3 0.6 16.6

88 Ukraine 0.751 3.5 0.9 25.0
25 Slovenia 0.896 3.7 0.9 25.4
6 Iceland 0.935 3.6 0.9 25.6
27 Czechia 0.888 3.7 0.9 25.9
112 Moldova (Republic of) 0.700 3.7 0.9 26.3
38 Slovakia 0.855 4.1 0.9 26.5
122 Kyrgyzstan 0.672 3.7 1.0 26.8
58 Kazakhstan 0.800 3.7 1.0 26.9
53 Belarus 0.808 3.8 1.0 27.0
15 Finland 0.920 3.9 1.0 27.1
1 Norway 0.953 4.1 1.0 27.5

Exam hint: It is possible for median per capita incomes to be rising but for a country to see at the same time growth in the
proportion of the population living on less than half median income. World Bank data shows that in China and Ghana, growth in the
median has been accompanied with a rapid rise in the proportion of people living below half the median, meaning that the poorest
segments of society have been left behind.

Causes of income and wealth inequality within countries and between countries
Inequalities result from the outcomes of market activity and from the impact of inheritance and changes in taxes and
benefits. It is important to remember that wealth can generate income and income can generate wealth.

Main causes of inequality within countries:

1. Big differences in wages and earnings in different jobs/occupations.
2. Wage differentials are themselves caused by demand and supply-side factors in the labour market:
a. Minimum educational qualifications required (a barrier to entry to certain jobs).
b. Varying scale of trade union representation and collective bargaining power with employers.
c. Changing skill requirements of different jobs e.g. prompted by technological advances.
3. The effects of unemployment especially among the long-term unemployed and younger workers.
4. Damaging effects of poor health and nutrition on employment opportunities and productivity.
5. Changes in the taxation of income and wealth including the extent to which a tax system is progressive on
higher incomes and the wealth of the richest in a society.

Main causes of inequality between countries:

The gap in per capita incomes between countries has been closing over the last two decades, in part the result of
globalisation and the success that many developing / emerging nations have had in raising their economic growth rates
well above population growth so that per capita incomes improve. But there remain deep-rooted inequalities in income
between countries. Some of the causes are as follows:
1. Low life expectancy and fewer years of healthy life expectancy.
2. Low school enrolment rates as families cannot afford education - this widens the gender opportunity gap.

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 3. Low access to basic health care and poor nutrition which impairs brain development among the young.
4. Vulnerability to loan sharks for families mired in debt – having to pay very high interest rates.
5. Limited access to affordable technologies – creating a digital divide.
6. Much lower productivity which then leads to lower wages.
7. Low real spending power limits the size of domestic markets for goods and services.
8. Low prices for primary commodities – smallholder farmers have little or no bargaining power with
transnational corporations even when they form producer co-operatives.

Poorest countries in the world in 2017

HDI Ranking Country Human Life Expected Mean years Gross
Development expectancy years of of schooling national
Index (HDI) at birth schooling income
(years) (GNI) per
capita (2011
PPP $)
188 Central African Republic 0.367 52.9 7.2 4.3 663
181 Liberia 0.435 63.0 10.0 4.7 667
185 Burundi 0.417 57.9 11.7 3.0 702
176 Congo (Democratic Republic of the) 0.457 60.0 9.8 6.8 796
189 Niger 0.354 60.4 5.4 2.0 906
187 South Sudan 0.388 57.3 4.9 4.8 963
171 Malawi 0.477 63.7 10.8 4.5 1,064

Impact of economic change and development on inequality

Economic changes always have an impact on the pattern of employment and the earnings available in different jobs
and industries. For example, globalisation has led in many advanced countries to a “hollowing-out” effect meaning
there are more jobs in relatively unskilled work offering low rates of pay, fewer jobs in traditional full-time jobs in heavy
industry and more jobs in high-knowledge occupations that require qualifications which offer premium rates of pay.

The Kuznets Inequality Curve

The Kuznets Inequality Curve suggests that inequality often rises during a phase of rapid industrialisation and
urbanization but there may come a point when increased state welfare provision, progressive income and wealth taxes
and more balanced income growth across industries might lead to a fall in overall inequality at higher per capita
incomes.

Significance of capitalism for inequality

What are the main pillars of a free market capitalist economic system?
1. Private property – people can own tangible assets such as land and financial assets such as shares.
2. Self-interest – people widely assumed to act in their own rational self-interest.
3. Competition in markets – assisted by the entry / exit of firms from industries.
4. Operation of the price mechanism – where prices in markets act as rationing, signalling and allocation devices.
5. Freedom of choice – from what to buy, which job to have, where to live.
6. Limited role for government – e.g. to protect private property rights, maintain currency stability.

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To what extent is high income and consumption inequality an inevitable consequence of operating a capitalist system?

1. The profit motive: Commercial businesses are assumed to be driven by the profit motive when making
investment, output and employment decisions. Profits flow as dividends to shareholders and inequalities of
wealth can be widened as businesses list their shares on stock markets and investors can earn capital gains as
well as dividend income.
a. However – even within a capitalist system, there are many people motivated to run their businesses
as social enterprises, where profits made are reinvested for social / environmental purposes.
b. Co-operative businesses are owned by their members with profits shared out – the co-operative
model has become more popular in recent years especially after the global financial crisis.
c. The government can tax high profits and incomes through a progressive tax system so that the final
distribution of income in less unequal than original income.
d. Competition policy and intervention by industry regulators can help to control monopoly profits and
keep real prices down for consumers.
2. A capitalist labour market: In competitive labour markets, wages and earnings are influenced by the forces of
labour demand and supply. In theory there are few limits to the pay that can be achieved by the top earners
including those with scarce skills that the market values and executives who have the power to set their own
remuneration (including bonuses and share options). At the lower end of the pay scale, the majority of people
earning low wages are not represented by a trade union and have little bargaining power with an employer.
a. However – there are many possible interventions in labour markets that can alter the final distribution
of income and help to control inequality:
i. Minimum wage legislation setting pay floors that cannot be undercut.
ii. Legal caps on executive pay.
iii. Legal protections for employees especially in flexible jobs associated with the Gig Economy.
b. Government investment in human capital promoting skills and employability of vulnerable groups in
society can increase earnings potential.
The French economist Thomas Piketty wrote an influential book which argued that rising inequality was an almost
inevitable consequence of capitalism. The focus of Piketty’s work was the long-run evolution of the ratio of capital to
income. He claimed that this will rise even further as the 21st century unfolds. Wealth will become more concentrated
and inequality will rise. Piketty shows that there has been a sharp rise in the ratio of wealth to income in the early 21st
century, to around 5 or 6 compared to just 2 to 3 in the 1950s and 1960s.

Critics of Piketty counter that – over many decades - capitalism has helped make the world a more equal place. They
point to the impact of globalisation driven by increasing specialisation, trade and the diffusion of new technologies as
helping to reduce extreme poverty and reduce the gap in per capita incomes between countries. Paul Ormerod has
claimed that, in terms of differences in per capita income levels between countries, the world is now more equal than it
was in 1950, and probably at around the same level that it was in 1850.

Exam context: According to the World Bank, extreme poverty has increasingly become concentrated in Africa. In part, this is due to
the region's reliance on extractive industries, the prevalence of conflict, vulnerability to natural disasters and population growth.

Income and Wealth Inequality Concepts

Disposable income Income (after taxes & welfare benefits) available to you for saving or spending
Gini coefficient A measure of income inequality ranging from zero for complete equality, to one if a single person has
all the income.
Gross income Amount of money earned before direct taxes & other deductions
Household income Flow of weekly or monthly earnings from wages & salaries, interest, dividends and rental income.
Household wealth The value of a stock of assets such as property, shares, pension funds and other long-term savings
Mean household Average income per household
income
Median household Midpoint of all households ranked by income
income
Palma Ratio Ratio of the income share of the richest 10% of people to that of the poorest 40%
Real income Income adjusted for inflation
S80/S20 Ratio of income received by 20% of people with highest income to that received by the 20% with the
lowest income

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4.3.1 Measures of development
Key specification content:
• Three dimensions of the Human Development Index (HDI) (education, health and living standards) and how they are
measured and combined
• Advantages and limitations of using the HDI to compare levels of development between countries and over time
• Other indicators of development

What is development?
• Development means many things to many people. It is fundamentally about people development over time.
As of 2019, nearly 9 per cent of the world’s population still live on an income below $1.90 per day (PPP)
• The average per capita income in a high-income country is $43,000, versus $795 in a low-income country
• Nobel Economist Amartya Sen writing in “Development as Freedom”, sees development as concerned with
improving the freedoms and capabilities of the disadvantaged, thereby enhancing the overall quality of life
• Amartya Sen pursues the idea that human development provides an opportunity to people to free themselves
from persistent deep suffering caused by
o Early / premature mortality
o Persecution and intolerance
o Starvation / malnutrition
o Illiteracy

According to Professor Ian Goldin from Oxford University, development is about the ability to shape our own lives. It
requires information, literacy, participation and capabilities.

Michael Todaro specified three objectives of development:

1. Life sustaining goods and services: To increase the availability and widen the distribution of basic life-
sustaining goods such as food, shelter, health and protection services.
2. Higher incomes: To raise levels of living, including, in addition to higher incomes, the provision of more jobs,
better education, and greater attention to cultural and human values, all of which will serve not only to
enhance material well-being but to generate greater individual and national self-esteem.
3. Freedom to make economic and social choices: To expand the range of economic and social choices available
to individuals and nations by freeing them from servitude and dependence not only in relation to other people
and nation-states and to the forces of ignorance and human misery.

Context: Countries with the highest number of people living without household access to safe water in 2017 (million, source: UN)
India 163
Ethiopia 61
Nigeria 60
China 58
DR Congo 47
Tanzania 27
Uganda 24
Pakistan 22
Kenya 19

More than half of the people living in Ethiopia had no household access to safe water in 2017. In Eritrea, that figure was
82% and in Angola, 59% of people had no access to safe water.

Difference between Growth and Development

• Economic Growth:
o A sustained rise in a country’s productive capacity.
o An increase in real value of GDP / GNI per capita.
o Increases in the productivity of factors of production.
• Economic Development:
o Progress in expanding economic freedoms.
o Sustained improvement in economic and social opportunities.
o Growth in personal and national capabilities.

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Context: In sub Saharan Africa, 2/3rds of employment is in the informal sector, meaning growth figures are largely underestimated.

Context: The changing shape of the global economy

According to World Bank Development Data, the size of the world economy was $133 trillion in in 2019, compared to $120 trillion
current US dollars in 2017. Countries that increased their share of global GDP over the period include China, which increased its
share by over one percentage point to account for 17.7% of global GDP in 2019. India and Indonesia also saw relatively large
expansions taking their shares to 7.2% and 2.5% of the global economy respectively. Furthermore, Indonesia surpassed the United
Kingdom, Brazil and France since 2017 and is now the seventh largest economy in the world.

Coronavirus update: Sub Saharan Africa suffers first recession for 25 years and extreme poverty rises
COVID19 has caused massive economic losses for Africa. The region will go into recession for the first time in 25 years according to
World Bank economic forecasts. The region’s gross domestic product (GDP) per capita growth is forecast to be three to five
percentage points lower. We estimate that a decline in GDP per capita of 3% will increase the number of Africans living below the
international poverty line of $1.90 (2011 PPP) by 13 million people.

The Human Development Index (HDI)

• The HDI focuses on longevity, basic education and minimal income.
• It is a broad composite measure of improvements in people’s lives
1. Knowledge: The educational component is made up of two statistics – mean years of schooling and expected
years of schooling
2. Long and healthy life: A life expectancy component is calculated using a minimum value for life expectancy of
25 years and maximum value of 85 years
3. A decent standard of living: Using data for gross national income (GNI) per capita adjusted to purchasing
power parity standard (PPP)
• GNI (Gross National Income is used in part because of the growing size of remittances across countries)
• Log of income is used in the HDI calculation because income is instrumental to human development, but
higher incomes are assumed to have a declining extra contribution to human development

Coronavirus update: Human Development to decline for the first time since 1990
A new research report published by the UN in September 2020 concludes that globally, six years of progress in lifting human
development outcomes will be erased by the economic fallout from the pandemic. COVID-19has increased the number of people
living in extreme poverty from between 75-100 million and is having a direct negative impact on all three components of the HDI
namely health, education, and income. Per capita incomes are falling in many of the world’s lowest-income nations, health services
are stretched and about 9 in 10 children have been affected by school closures. The average impact on HDI hides huge inequalities
both within and between countries.

Countries with the lowest human development in 2017

HDI Ranking Country Human Life Expected Mean years of Gross national
Development expectancy at years of schooling income (GNI)
Index (HDI) birth schooling per capita
(2011 PPP $)
189 Niger 0.354 60.4 5.4 2.0 906
188 Central African Republic 0.367 52.9 7.2 4.3 663
187 South Sudan 0.388 57.3 4.9 4.8 963
186 Chad 0.404 53.2 8.0 2.3 1,750
185 Burundi 0.417 57.9 11.7 3.0 702
184 Sierra Leone 0.419 52.2 9.8 3.5 1,240
183 Burkina Faso 0.423 60.8 8.5 1.5 1,650
182 Mali 0.427 58.5 7.7 2.3 1,953
181 Liberia 0.435 63.0 10.0 4.7 667
180 Mozambique 0.437 58.9 9.7 3.5 1,093

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Countries with the highest human development in 2017

HDI Ranking Country Human Life Expected Mean years of Gross national
Development expectancy at years of schooling income (GNI)
Index (HDI) birth schooling per capita
(2011 PPP $)
1 Norway 0.953 82.3 17.9 12.6 68,012
2 Switzerland 0.944 83.5 16.2 13.4 57,625
3 Australia 0.939 83.1 22.9 12.9 43,560
4 Ireland 0.938 81.6 19.6 12.5 53,754
5 Germany 0.936 81.2 17.0 14.1 46,136
6 Iceland 0.935 82.9 19.3 12.4 45,810
7 Sweden 0.933 82.6 17.6 12.4 47,766
7 Hong Kong, China (SAR) 0.933 84.1 16.3 12.0 58,420
9 Singapore 0.932 83.2 16.2 11.5 82,503
10 Netherlands 0.931 82.0 18.0 12.2 47,900

Countries with a much higher GNI per capita ranking than their HDI ranking in 2017

HDI Ranking Country Human Life Expected Mean years Gross GNI per
Development expectancy years of of schooling national capita rank
Index (HDI) at birth schooling income minus HDI
(GNI) per rank
capita
(2011 PPP
$)
141 Equatorial Guinea 0.591 57.9 9.3 5.5 19,513 -80
120 Iraq 0.685 70.0 11.0 6.8 17,789 -53
56 Kuwait 0.803 74.8 13.6 7.3 70,524 -51
110 Gabon 0.702 66.5 12.8 8.2 16,431 -40
37 Qatar 0.856 78.3 13.4 9.8 116,818 -36

Countries with a much lower GNI per capita ranking than their HDI ranking in 2017

HDI Ranking Country Human Life Expected Mean Gross national GNI per
Development expectancy years of years of income (GNI) capita rank
Index (HDI) at birth schooling schooling per capita (2011 minus HDI
PPP $) rank
73 Cuba 0.777 79.9 14.0 11.8 7,524 43
98 Tonga 0.726 73.2 14.3 11.2 5,547 37
70 Georgia 0.780 73.4 15.0 12.8 9,186 35
106 Marshall Islands 0.708 73.6 13.0 10.9 5,125 33
122 Kyrgyzstan 0.672 71.1 13.4 10.9 3,255 32

Advantages and disadvantages of using the HDI

• The main HDI measure does not take account qualitative factors, such as cultural identity and political
freedoms (including human security, gender opportunities and human rights).
• The GNI per capita figure – and consequently the HDI figure – takes no account of income distribution.
• If income is unevenly distributed, GNI per capita will be an inaccurate measure of people’s well-being.
• Purchasing power parity (PPP) values used to adjust GNI data change quickly and can be inaccurate.

Gender Inequality and Human Development

• Gender Inequality HDI rankings includes indicators that reflect the extent of deep and persistent imbalances in
economic, social and political freedoms for women and girls in developed and developing countries.
• Rwanda has made significant progress in addressing gender inequalities – for example, in Rwanda, female
lawmakers make up 64 percent of parliament, outperforming a world average of one woman in five.

Difference between gender equality and gender equity

• Gender equality denotes women having the same opportunities in life as men, including the ability to
participate in the public sphere.

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 • Gender equity denotes the equivalence in life outcomes for women and men, recognizing their different needs
and interests.

Consider the data below which shows countries in the world (in 2017) with the lowest average years of schooling for girls.

Life expectancy at Expected years of Mean years of schooling Estimated gross

birth (years) schooling national income per
capita ($, PPP)
Country Female Male Female Male Female Male Female Male

Burkina Faso 61.4 60.0 8.3 8.8 1.0 2.0 1,289 2,014
Chad 54.5 52.0 6.4 9.5 1.2 3.4 1,412 2,088
Niger 61.5 59.4 4.7 6.0 1.5 2.6 691 1,119
Ethiopia 67.8 64.0 8.2 9.1 1.6 3.8 1,304 2,136
Yemen 66.6 63.7 7.6 10.3 1.9 4.2 149 2,308
Afghanistan 65.4 62.8 8.0 12.7 1.9 6.0 541 3,030

Coronavirus update: Pandemic threatens progress made in addressing gender economic inequalities
Research from the World Bank finds that the negative effects of the pandemic on women are disproportionately worse. Women in
lower-income countries are more likely to be engaged in vulnerable subsistence self-employment and domestic work and they are
overrepresented in industries with some of the largest disruptions, like hospitality, tourism and retail. Their care responsibilities have
been reinforced by existing social / cultural norms about who is expected to look after dependent relatives.

Other indicators of development

There are many ways of measuring the extent, durability and progress of improvements in human economic
development. Some of the key development metrics are summarised below:
• Changing structure of national output, trade and employment
• % of adult male and female labour in agriculture, % of arable land that is cultivated
• Access to clean water / improved sanitation facilities
• Energy consumption per capita / depth of hunger, incidence of malnutrition
• Fertility rates, natural rate of growth of population
• Prevalence of HIV, years of healthy life expectancy, child mortality
• Access to mobile cellular phone services, access to bank accounts, insurance
• Dependence of a country on foreign aid / levels of external debt
• High-technology exports (% of manufactured exports), patterns of exports
• Degree of primary export dependence
• Progress in achieving Sustainable Development Goals (MDGs)
Sustainable Development Goals (SDGs)
At present, there are seventeen published sustainable development goals:
1. Goal 1 End poverty in all its forms everywhere
2. Goal 2 End hunger, achieve food security and improved nutrition, promote sustainable agriculture
3. Goal 3 Ensure healthy lives and promote well-being for all at all ages
4. Goal 4 Ensure inclusive and equitable quality education and promote life-long learning opportunities for all
5. Goal 5 Achieve gender equality and empower all women and girls
6. Goal 6 Ensure availability and sustainable management of water and sanitation for all
7. Goal 7 Ensure access to affordable, reliable, sustainable, and modern energy for all
8. Goal 8 Promote sustained, inclusive and sustainable growth, full and productive employment and decent work for all
9. Goal 9 Build resilient infrastructure, promote inclusive & sustainable industrialization and foster innovation
10. Goal 10 Reduce inequality within and among countries
11. Goal 11 Make cities and human settlements inclusive, safe, resilient and sustainable
12. Goal 12 Ensure sustainable consumption and production patterns
13. Goal 13 Take urgent action to combat climate change and its impacts
14. Goal 14 Conserve and sustainably use the oceans, seas and marine resources for sustainable development
15. Goal 15 Protect, restore and promote sustainable use of terrestrial ecosystems, sustainably manage forests, combat
desertification, and halt and reverse land degradation and halt biodiversity loss and inclusive institutions at all levels
16. Goal 16 Promote peaceful and inclusive societies for sustainable development, provide access to justice for all
17. Goal 17 Strengthen the means of implementation and revitalize the global partnership for sustainable development

4.3.2 Factors influencing growth and development

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Key specification content:
• Impact of economic factors in different countries:
o Primary product dependency and volatility of commodity prices
o Savings gap: Harrod-Domar model
o Foreign currency gap
o Capital flight
o Demographic factors
o Debt
o Access to credit and banking o infrastructure
o Education/skills
o Absence of property rights
o Impact of non-economic factors in different countries

Exam hint: It is important that students recognise that different countries have varying reasons / explanations for their current level
of development. Clearly, if there are different causes then countries will need a range of diverse policies to raise development. It is a
good idea to choose three of four countries that are developing at present and become a mini expert on them for exams.

Primary Product Dependency

Typically, countries at an earlier stage of development tend to export a narrower range of products. Many developing
countries continue to have high dependence on extracting & exporting primary commodities. These economies are
vulnerable to volatile global prices. There are significant economic risks from over-specialisation especially when or if
the terms of trade from their main exports decline. Resource-rich (and factor input-driven) countries may suffer from
the natural resource curse. How can this happen? One reason is that extractive rents often fuel corruption, inequality
and wasteful consumption as natural resources are depleted. High commodity prices can cause currency appreciation –
and may lead to the Dutch Disease effect leading to premature de-industrialisation. Often resource revenues flowing
into government are not used productively to diversify the economy and improve HDI outcomes through investment in
basic education and health care. The end result is many developing countries rich in natural resources often have slow
rates of GDP growth and persistently poor human development scores.

The Prebisch-Singer Hypothesis

The Prebisch-Singer Hypothesis (PSH) suggests that, over the long run, prices of primary commodities such as coffee
and cocoa decline relative to prices of manufactured goods such as cars and washing machines. The core idea behind
the Prebisch-Singer hypothesis is as follows:
• There is likely to be a long-term decline in real commodity prices.
• In part this is because the income elasticity of demand for commodities is lower than for manufactured goods.
• Falling prices then worsens the terms of trade (ToT) for countries that are primary exporters over time.
• In this situation, countries might be better off focusing on import substitution policies which encourage rapid
industrialisation and improved export diversification designed to make a country more resilient to price
shocks.

In reality, for many countries, the pessimistic-projection of the Prebisch-Singer hypothesis has not happened:
• Labour intensive manufactured goods are now significantly cheaper because of globalisation, technological
improvements and the exploitation of numerous economies of scale.
• Rising global population and increasing per capita incomes have seen a hefty increase in the world prices of
many primary commodities. Consider for example the prices of rare earths used in manufacturing smart
phones.
• Many primary commodity exporters in developing countries have seen their terms of trade rise.

What is the Dutch Disease?

• Dutch Disease refers to the adverse impact of a sudden discovery of natural resources on the national
economy via the appreciation of the real exchange rate and the decline in export competitiveness.
• If natural resources are found and extracted and if the world price of them is rising, then export revenues will
increase and there will be increased investment into that sector.
• But the risk is that there is a corresponding loss of investment into other industries such as manufacturing
businesses. And the surge in export incomes can cause an appreciation of a country’s exchange rate which
then makes other sectors trying to export less competitive in overseas markets.
• A worst-case scenario is when manufacturing industries in developing countries start to shrink well before it
has reached middle-income status. This is known as premature de-industrialisation.

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Strategies for reducing Primary Product Dependency and Price Volatility

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 1. Better government – including more transparency & accountability to taxpayers so that it is clear how valuable
natural resource revenues are being spent.
2. Stabilisation Fund / Sovereign Wealth Fund – e.g. to fund human capital and infrastructure or to inject money
into an economy when aggregate demand dips.
3. Higher taxes of natural resource profits (i.e. extracting resource rents and then reinvesting in the domestic
economy to increase a country’s aggregate supply-side capacity).
4. Buffer stock schemes – these are designed in principle to reduce some of the effects of price volatility although
most less developed countries have limited ability to influence the world prices of their key exports.
5. Diversification – including shifting resources into processing, light manufacturing & tourism – giving higher
value added and making the economy less susceptible to external shocks.
Savings gaps and the Harrod-Domar Model

Poorer countries have

Low incomes limit
limited welfare / pensions
household savings
systems

What is the savings gap?

• Savings are needed to help finance capital investment such as new machinery and up-to-date technology.
• Many rich countries have excess savings, whereas in smaller low-income countries, extreme poverty make it
almost impossible to generate sufficient savings to fund much-needed capital investment projects.
• This increases reliance on foreign aid or borrowing from overseas (leading to higher external debt).
• This problem is known as the savings gap.
• In Sub Saharan Africa for example, savings rates of around 17 per cent of GDP compare to 31 per cent on
average for middle-income countries.
• Low savings rates and poorly developed or malfunctioning financial markets then make it more expensive for
African public and private sectors to get the funds needed for capital investment.

Harrod Domar Model of Growth

The Harrod-Domar model stresses the importance of savings and investment. The rate of growth depends on:
• Level of national saving (S)
• The productivity of capital investment (capital-output ratio)
• The capital-output ratio (COR)

For example, if £100 worth of capital equipment produces each £10 of annual output, a capital-output ratio of 10 to 1
exists. When the quality of capital resources is high and when an economy can better apply capital inputs and
appropriate technologies e.g. by using more advanced ideas, then the capital output ratio will be lower.

The rate of growth of GDP = savings ratio / capital output ratio.

Role of higher savings:

An increase in national savings leads to an Increase in investment – which leads to a larger capital stock – which leads to
an increase in real GNI – which leads to increased factor incomes – which in turn allows more households to save.

Importance of capital investment for developing countries

Investment is an important driver of growth for developing/emerging countries:
• Provides an injection of demand for capital goods industries and the construction industry.
• Creates positive multiplier effects.
• Increased capital stock can increase rural productivity and therefore per capita incomes and consumption and
savings in rural areas.
• Investment in new machinery and factories supports economies of scale especially in new / infant industries.
• It can help achieve export-led growth because of the increase in productive capacity.

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Some countries have a high investment-to-GDP ratio. The table below shows data on GNI, GNI per capita and
investment spending as a share of GDP for a selection of advanced and developing/emerging countries. The data on
income and income per capita is for 2017 and comes from the 2018 Human Development Report.

HDI rank in 2018 Country GNI (2011 PPP $ GNI Per Capita Investment (% of GDP)
billions) in 2017 (2011 PPP $) average of 2012-2017
in 2017
175 Guinea 26 2,081 75
86 China 21,224 15,309 42
173 Ethiopia 182 1,730 39
144 Zambia 63 3,689 36
149 Nepal 72 2,443 34
116 Indonesia 2,954 11,189 32
22 Korea (Republic of) 1,850 35,938 31
136 Bangladesh 580 3,524 30

An increase in capital investment does not guarantee faster economic growth. Much depends on the quality of
investment decisions and the ability of the labour force to then make productive use of appropriate technologies.

Context: Does technology hinder development?

According to development economist Dani Rodrik, although new technologies allow developing countries possibly to by-pass old
models of industrialisation, the main barrier is that in many countries, low-income countries are unable to take advantage of new
technologies due to a lack of skills and capabilities. New technology makes low-skilled labour more substitutable for capital. The
challenge is to invest sufficiently in human capital to improve capabilities so that new technology can be a blessing rather than a
barrier to development.

Foreign Currency Gaps

What is a foreign currency gap?
• Many developing countries face imbalance between inflows and outflows of currencies such as US $s and Euros.
• A foreign exchange gap happens when currency outflows exceed currency inflows This can occur when:
o A country is running a persistent current account deficit on their balance of payments
o There is an outflow of capital from investors in money & capital markets (this is known as capital flight).
o There is a fall in the value of inflows of remittances from nationals living and working overseas.

A key consequence of a foreign currency gap can be that a nation does not have enough foreign currency to pay for
essential imports such as medicines, foodstuffs and critical raw materials and replacement component parts for
machinery. In this way, a foreign currency shortage can severely hamper growth and hurt development outcomes.

Options for developing countries wanting to attract external finance

Developing economies can draw on a range of external sources of finance, including FDI, portfolio equity flows, long-
term and short-term loans (both private and public), overseas aid, and remittances from migrants living and working
overseas. Foreign direct investment remains the largest external source of finance for developing economies. It makes
up nearly 40 percent of total incoming finance in developing economies. Capital flows to developing countries have
fallen in the wake of the COVID19 pandemic.

Capital Flight
Capital flight is the uncertain and rapid movement of large sums of money out of a country. The UK’s Overseas
Development Institute (ODI) defines capital flight as "the outflow of resident capital which is motivated by economic
and political uncertainty.”

Foreign investors may

Capital flight can lead to
take their money out of
currency instability
a country

There could be several reasons for capital flight linked to a lack of investor confidence:

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 1. Political turmoil and unrest / risk of damaging civil conflict.
2. Fears that a government plans to take business assets / companies under state control.
3. Exchange rate uncertainty e.g. ahead of a possible devaluation of a currency.
4. Fears over the stability of a country’s financial system including their commercial banks.

Many billions of US$s each year are taken out of a country illegally especially in countries with persistently high levels of
corruption. Capital flight can undermine the stability of the financial system and lead to a weaker currency which in
turn then increases the prices of essential imported goods such as components and food and it makes it harder (more
expensive) for a country to finance their external debts. We tend to associate capital flight with countries where there
are deep-rooted economic and political difficulties such as Russia, Argentina, Pakistan, Nigeria and countries troubled
by civil war. One policy to limit capital flight is for a government to introduce capital controls which control how much
money people can take out of a country. However illegal capital outflows are much harder to stop.
Demographic factors
Demography is concerned with the size and composition of a population. Over time, demographic change can have a
powerful impact on the growth and development prospects of advanced and emerging / developing countries alike.

During the past half century, the world has experienced an unprecedented increase in its population size. In 1960,
roughly three billion people inhabited the planet; 50 years later, it was around seven billion – with almost one billion
people added in the decade between 2000 and 2010. The World Bank projects that in the next 35 years, another 2.5
billion people will be added to the planet; over 90% of this increase in population size will be in developing countries.
Between 2018 and 2030, the working age population will grow to 552 million in low- and middle-income countries. In
high income countries, the working-age population will decrease by 40 million people. The world population is
projected to reach nearly 10 billion by 2050.

Life expectancy is rising - globally, life expectancy has risen by seven years. In some countries, that rise has been as
much as 19 years, and that since 1990, life expectancy has improved in 96% of countries. Back then, people born in
eleven countries would not be expected to reach 50, yet this milestone was reached by every country in 2016.

Ageing populations and population decline

In a growing number of rich nations, population growth is slowing down, and, in some cases, there is negative natural
population growth not offset by inward migration. In Japan for example, an ageing population combined with low
female participation and low net inward migration is causing a contraction in the size of their active labour force. In
countries such as Latvia and Bulgaria, the resident population is declining by more than 1 percent each year.

According to the OECD, "the ageing of the population in OECD countries, which is expected to continue in the next
decades, may contribute to reduced innovation, reduced output growth and reduced real interest rates across OECD
economies.” Research published in 2017 suggested that an ageing population could lead to a slowdown in innovation.
Societies may become considerably more risk averse as their average age rises, which may have important
consequences such as reducing investment in the stock market or the extent of self-employment.

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The table below tracks a selection of high-income countries with a high median age and high age-dependency ratio.

Population Dependency ratio

Total Average annual growth Urban Median age (per 100 people ages
15–64)
HDI rank Country (millions) (%) (%) (years) Young Old age
age (0– (65 and
14) older)
2017 2030 2005/2010 2015/2020 2017 2015 2017 2017
19 Japan 127.5 121.6 0.0 -0.2 91.5 46.3 21.5 45.0
28 Italy 59.4 58.1 0.3 -0.1 70.1 45.9 21.3 36.3
15 Finland 5.5 5.7 0.4 0.4 85.3 42.5 26.3 34.0
41 Portugal 10.3 9.9 0.2 -0.4 64.7 43.9 21.0 33.2
5 Germany 82.1 82.2 -0.2 0.2 77.3 45.9 20.0 32.8

The UK has an ageing population: there are around 12.4 million people of pensionable age today. Population
projections predict that there will be 16.3 million people of pensionable age in the UK by 2041.

Possible microeconomic effects of an ageing population:

1. Changing patterns of consumer demand in markets / affecting profits of businesses in particular sectors
2. Impact on welfare spending and tax revenues e.g. health care for the elderly, treatment of chronic illness
3. Impact on housing market e.g. if people can live in their own homes for longer

Possible macroeconomic effects of an ageing population:

1. Impact on the rate of growth of productivity and long-term GDP growth - for example if there is an increase in
the age-dependency ratio
2. Impact on business competitiveness if the median age continues to rise rapidly
3. Increased demand for state-funded health care including social care and a possible reduction in tax revenues if
the active labour force contracts

Estimated fertility contribution to world population growth from 2015 to 2100, by regional development
More developed regions Less developed regions
2015 -17,367 87,846
2020 -32,715 167,803
2030 -57,646 315,645
2040 -82,698 491,309

Rapid population growth in developing countries

In many lower and middle-income countries, rising per capita incomes can actually cause an increase in population
growth. This is because higher incomes and consumption leads to improved access to health care and leads both to
higher fertility and to lower infant and child mortality. The table below shows countries with the fastest rate of growth
of population together with their HDI rankings – these are the countries in the world with the lowest median age.

Average annual growth Median age

HDI rank Country (percent) (years)

2005/2010 2015/2020 2015
189 Niger 3.7 3.8 14.9
162 Uganda 3.4 3.2 15.8
182 Mali 3.3 3.0 16.0
147 Angola 3.6 3.3 16.4
176 Congo (Democratic Republic of the) 3.3 3.2 16.8
174 Gambia 3.2 3.0 17.0
144 Zambia 2.8 3.0 17.1

Context: According to recent surveys in Ethiopia, Chad, and Zambia, less than 10% of children under 5 had their births registered.

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Opportunities from rapid population growth
1. A young median age and fast natural population growth contributes to an expanding population of working
age which can increase long-run aggregate supply (LRAS) causing an outward shift of the PPF.
2. Providing per capita incomes are rising, then population growth increases the size of domestic markets -
encouraging economies of scale and increased capital investment spending by businesses.
3. More people in work leads to a widening of the tax base to help government finances.
4. Population growth and urbanization tend to go together - population growth increases density and, alongside
rural-urban migration can lead to benefits from agglomeration economies. Urbanisation has been linked to
stronger innovation and it stimulates demand for new infrastructure which in turn creates jobs and creates
positive multiplier effects.
5. The challenge of feeding a growing population can be a catalyst for research and development and innovation
in farming designed to increase crop yields.

Risks and drawbacks from rapid population growth

1. A large number of young people entering the labour market creates challenges - not least in providing
sufficient jobs in the formal economy to prevent a large increase in youth unemployment.
2. Fast-growing population holds back the annual growth of per capita incomes. Income is spread more thinly
across large households which makes it harder to satisfy everyone’s basic needs and wants and can lead to
rising malnutrition.
3. Rapid population growth puts increasing pressure on the natural environment including demand for water and
energy and can threaten biodiversity.
4. High rates of rural-urban migration can lead to problems associated with urban density such as crime, the
spread of disease and increased inequalities of income and wealth.
Brain Drain Effects
Some countries experience a brain drain effect which describes the movement of highly skilled or professional people
from their own country to another country where they can earn more money. Brain drains can lead to de-population.
Examples of countries with negative population growth are shown in the table below. Consider the Baltic State of Latvia
as an example, their population is forecast to contract by 200,000 people between 2017 and 2030, a fall of over 10%.
The ageing Japanese population is forecast to shrink by nearly six million people over the same period and Ukraine may
see a 3 million decline in their total population.

Total Population Average annual growth

HDI rank Country (millions) (percent)
2017 2030 projected 2005/2010 2015/2020
41 Latvia 1.9 1.7 -1.2 -1.0
51 Bulgaria 7.1 6.4 -0.7 -0.7
46 Croatia 4.2 3.9 -0.2 -0.6
35 Lithuania 2.9 2.7 -1.4 -0.5
52 Romania 19.7 18.5 -0.9 -0.5
88 Ukraine 44.2 41.2 -0.5 -0.5
41 Portugal 10.3 9.9 0.2 -0.4
19 Japan 127.5 121.6 0.0 -0.2
31 Greece 11.2 10.8 0.3 -0.2
33 Poland 38.2 36.6 0.0 -0.2

Context: Conflict is a major cause of depopulation. Every minute in 2018, 25 people were forced to flee for their lives. The average
civil conflict now lasts more than nine years. According to the World Bank, the number of people in the world living in close
proximity to conflict has nearly doubled since 2007.

Disadvantages from a brain drain

1. Loss of human capital – this damages long-run supply-side potential and is a barrier to development.
2. Loss of enterprising younger workers who might have started up businesses at home.
3. Skills shortages affect HDI outcomes e.g. the emigration of skilled doctors, teachers & engineers.
4. Risk of a fall in aggregate demand because of a smaller population.
5. Depopulation and shrinking market size make the country less attractive to inflows of foreign investment.

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Possible advantages from a brain drain
1. Remittances from emigrants flow back to increase a nation’s gross national income (GNI).
2. People living overseas (the diaspora) may be able to help finance private sector capital projects in the future.
3. Acquisition of human capital by working & studying in other countries e.g. learning languages, earning degrees
– possibly leading to brain gains if they return to their country of origin.
4. May help to offset the risks from rapid natural growth of population such as higher inflation and pressure on
the built environment and natural resources.

Context: Remittances: In 2018, workers living abroad sent the most money home to their families living in these countries: India,
China, Mexico, Philippines and Egypt. Officially recorded remittances amounted to a record $529 billion in 2018 and were on track to
reach $550 billion in 2019. Remittances exceed 25% of GDP in five countries: Tonga, Kyrgyz Republic, Tajikistan, Haiti, and Nepal.

Coronavirus update: World Bank Predicts Sharpest Decline of Remittances in Recent History
Remittances – the money that migrants send back home and an important source of external development finance for many
countries – are projected to decline by 20% in 2020. There has been a sharp fall in employment and wages for migrant workers who
are exposed to economic recessions in countries where they have moved. Remittances are crucial in helping to bring down extreme
poverty not least because they help improve nutritional outcomes and are associated with higher spending on education and reduce
child labour in disadvantaged households. Remittances to low and middle-income countries are projected to fall by 20 percent to
$445 billion.

External Debt
Many developing countries accumulate a growing amount of external debt. External debt is owed to external
(overseas) creditors and examples of debt includes government bonds sold to foreign investors and private sector
credit borrowed from foreign banks. The scale of external debt is usually measured as a % of a country’s GNI.

External debt tends to rise when:

1. A government is running a budget deficit and finances this by selling government bonds to overseas creditors
2. A country is running a sizeable current account deficit which is partly funded by borrowing from overseas
institutions such as the IMF
3. Households and businesses borrow money in a foreign currency including mortgages and corporate bonds

Debt in itself is not necessarily a problem if the borrowing is being used to help fund capital investment projects which
will ultimately increase a nation’s productive potential and increase trend economic growth.

But there are risks with a developing country increasing the scale of external debt:
• Returns on investment might fall short of expectations especially if investment goes on projects not subject to
a proper cost-benefit analysis.
• If a country experiences a depreciation/devaluation of their exchange rate, the real value of the debt will
increase making it harder to repay. This is particularly the case with countries who borrow in US dollars.
• A recession can make it harder to meet the interest payments on debt since government tax revenues shrink.
• If overseas investors become nervous about the ability of a government to repay external debt, then a country
may suffer a credit-rating downgrade which will increase the interest rate needed to finance new loans.

High levels of external debt combined with high interest rates lead to the problem of a country’s interest payments
being a high percentage of GNI and an even bigger percentage of their export earnings each year. This has led to
pressure for debt relief policies involving some forms of debt forgiveness or debt rescheduling for the poorest
countries.
Access to credit and banking
Improving access to basic financial services, such as a bank account, credit, and insurance, is a crucial step in improving
people's lives. World Bank research finds that financial inclusion is on the rise globally, accelerated by mobile phones
and the internet, but gains have been uneven across countries. Globally, 1.7 billion adults remain unbanked, yet two-
thirds of them own a mobile phone that could help them access a range of basic financial services. Half of all the adults
in the world who lack bank accounts live in just seven countries.

The cost of finance and insurance in many of the least developed countries remains a structural problem: Many people
who have transaction accounts but whose incomes are low or irregular, rely on very expensive solutions, such as
payday lending, check-cashing services, or informal money-lenders to cover regular shortfalls in their income.

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 % of females that own a bank account

Singapore 96.1%
China 76.4%
South Africa 70.4%
Brazil 64.8%
Chile 59.2%
India 43.1%
Mexico 38.9%
Zambia 33.2%
Ethiopia 21.0%
Pakistan 4.8%
Afghanistan 3.8%
Yemen 1.7%
Turkmenistan 1.6%

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0%

Financial access connects people into the formal financial system, making day-to-day living easier and allowing them to
build assets, mitigate shocks related to emergencies, illness, or injury, and make productive investments. It makes it
easier for a government to measure economic activity and collect in tax revenues needed to pay for public services.

Millions of the world’s poorest people rely on informal loans often at high rates of interest. Millions find it tough to
secure loans for businesses or to fund education and health care because they will have no collateral.

Infrastructure

Off-grid renewables Transport Mobile money systems Drone technologies to

infrastructure improve health care

Improved irrigation in Border infrastructure Basic sanitation Waste disposal

farming systems

Infrastructure consists of a spectrum of public, semi-public, and private goods. Public goods include access to safe
drinking water and sanitation. Semi-public goods include networks providing electricity, roads, ports, and airports.

Infrastructure needs to be robust to cope with the effects of rapid urbanization and climate change. According to the
World Bank, over the next 35 years, urban populations are estimated to expand by an additional 2.5 billion people —
this is almost double the population of China. For the first time in history, more people now live in cities than in rural
areas. There is growing need for renewable energy infrastructure to build resilience to the effects of climate change.

Percentage (%) of population living in urban areas worldwide from 1950 to 2050, by country income groups. (Source: UN)

High-income Upper-middle- Lower-middle- Low-income World total

countries income countries income countries countries
1950 58.5 22.1 17.2 9.30 29.6
1970 68.7 32.2 22.6 15.7 36.6
1990 74.4 42.9 30.0 22.8 43.0

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 2015 80.9 64.1 39.2 30.9 53.9
2030 83.9 74.8 47.0 38.3 60.4
2050 88.4 82.6 59.0 50.2 68.4

How infrastructure gaps can limit economic growth and development:

Infrastructure gaps:
• Increase supply costs for businesses – this causes higher prices – therefore hitting real incomes for consumers.
• Reduces geographical mobility of labour causing higher structural unemployment (a labour market failure).
• Poor infrastructure hinders intra-regional trade: Intra-African trade is the lowest globally at 16%, compared to
40% in North America, 62% in European Union and 23% in the ASEAN economic area.
• It can make a country less attractive to FDI which might then slow economic growth.
• Makes an economy vulnerable to climate change / natural disasters such as flooding and earthquakes. By
2030, 700 million people could be displaced by intense water scarcity. Efficient water infrastructure is vital.
• Contributes to gender inequality.
• Have a direct impact on basic human development – e.g. having access to basic water and sanitation services.

Context: Nearly 50 million people in low income countries are now connected to mini grids. A mini grid is an electric power
generation and distribution system that provides electricity to a localized community. Despite progress, an estimated 650 million
people will not have electricity access in 2030 (World Bank).

Education and Skills – Gaps in Human Capital

What is human capital?
Human capital is the skill, knowledge, talent, experience and ability of workers. Human capital can be increased
through investment in education & training. The quality of education differs between and within countries. Globally,
more than 260 million children and youth are not in school and nearly 60 percent of primary school children in
developing countries fail to achieve minimum proficiency in learning.

Poor human capital hits labour productivity and ability to harness/adapt to new technologies. Low productivity keeps
wages down. Human capital deficiencies are closely linked to malnutrition. Better basic health care and nutrition helps
to unlock improved human capital by avoiding brain impairment and the effects of stunted growth.

Absence of property rights

Tragedy of the Rights to Own

Land Rights Intellectual Property
Commons Businesses

Why are property rights important for development?

1. Rights to own land and to establish businesses are seen as crucial for wealth creation e.g. private plots to farm.
2. Protection of property rights is a major barrier to corruption within government.
3. Community ownership / husbandry of natural resources can help overcome threats to eco-systems.
4. Laws on patents are important to secure investment in research industries.
5. Common rules encourage trade & investment between countries by reducing trade friction costs.

Context: The Invisible Billion

More than a billion people in the world lack formal identification and most of them live in Sub-Saharan Africa and South Asia. They're
typically members of the poorest and most vulnerable groups. 44% of women in low income countries – compared with 28% of men
– do not have a formal ID according to the World Bank.

Gender inequality as a barrier to growth and development

No society can achieve its potential without the full and equal participation of women and men. According to a recent
UN Human Development Report: “All too often, women and girls are discriminated against in health, education,
political representation, labour market, etc. — with negative repercussions for development of their capabilities and
their freedom of choice.”

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Aspects of gender inequality:
• In 2017 the global labour force participation rate was 49 percent for women, but 75 percent for men.
• 7% of women aged 15+ are employed as wage workers in low-income countries, compared to 18% of men
• Globally, only 1 in 3 small, medium, and large businesses are owned by women. This rate varies across and
within regions, from a low of 18% in South Asia to a high of 50% in Latin America & the Caribbean
• In Europe & Central Asia, men are 4% more likely to have a financial account than women. In Sub-Saharan
Africa and Middle East & North Africa, less than 40% of women have a basic bank (financial) account.
• 62 million girls are not in school. Pregnancy and early marriage are key reasons for girls dropping out of school.
• Worldwide, over one hundred economies have laws that keep women out of certain jobs.
• Across the globe women occupy, on average, 23% of parliamentary seats in 2016, up from 12% in 1997.
• Girls in conflict settings are 2.5 times more likely to be out of school than boys.
• While men are three times more likely to be in leadership roles worldwide, women are three times more likely
to do unpaid care work.
• In Bangladesh, child marriage has declined but remains high at 59%.
• Gender inequality has cost the world an estimated $160 trillion, according to a recent report.

Overview of gender inequalities according to HDI country grouping

Maternal Adolescent Share of Population with at Labour force participation rate

mortality birth rate seats in least some
ratio parliament secondary education
Development Group (deaths (births per (% held by (% ages 25 and older) (% ages 15 and older)
per 1,000 women) Female Male Female Male
100,000 women ages
live births) 15–19)
Very high human development 15 15.9 26.7 88.8 89.5 52.9 68.9
High human development 38 26.6 22.3 69.5 75.7 55.0 75.5
Medium human development 176 41.3 21.8 42.9 59.4 36.8 78.9
Low human development 554 98.4 21.7 18.5 30.7 59.3 74.7
Least developed countries 434 91.0 22.4 25.0 34.3 57.4 79.6
World 216 44.0 23.5 62.5 70.9 48.7 75.3

There are huge differences in gender development outcomes when we contrast high development countries and the
least developed nations. Maternal mortality is more than ten times higher; the adolescent birth rate is more than
three times higher in LDCs and only a quarter of females in the least developed countries have at least some secondary
education compared to nearly 90 per cent in countries ranked as reaching very high human development.

Corruption and conflict as a barrier to development

Most corrupt countries worldwide 2018, according to the Corruption Perception Index
0 2 4 6 8 10 12 14 16 18
Somalia 10
South Sudan 13
Syria 13
North Korea 14
Yemen 14
Afghanistan 16
Equatorial Guinea 16
Guinea Bissau 16
Sudan 16
Burundi 17

Corruption is due to a failure of governing institutions who lack transparency in where tax revenues are coming from
and how resources are spent. Corruption is defined broadly as the misuse of public power for private benefit. High
levels of corruption damages long term growth & development in a number of ways:

• Deters foreign direct investment by increasing the cost of doing business.

• Leads to allocative inefficiency / i.e. diverting public resources for private gain, there are numerous extreme
examples of extravagant wealth in economically less developed countries.
• Government decisions are often unduly influenced by lobbying.

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 • Contributes to income & wealth inequality and reduced progress in cutting the incidence of extreme poverty.
• Causes a loss of trust - i.e. a breakdown of social capital.
• Leads to poorer development outcomes because governments are not collecting sufficient tax revenues.

The most corrupt countries worldwide 2018 - according to the Corruption Perception Index – were Somalia, South
Sudan, Syria, North Korea and Yemen. Denmark, Norway, Sweden and Finland came top of the latest index.

Example Analysis and Evaluation Paragraphs:

Question: Examine the barriers that hold back the level of economic development.

Context: According to the IMF, “Corruption & weak governance are associated with lower economic growth, investment & tax
revenue collection, and with high inequality and social exclusion.” Their research has found that curbing corruption could generate
tax revenue of about $1 trillion annually across the world. This is revenue that can support economic growth and help to meet more
of the sustainable development goals.

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4.3.3 Strategies influencing growth and development
Key specification content:
• Market-orientated strategies:
o Trade liberalisation
o Promotion of FDI
o Removal of government subsidies
o Floating exchange rate systems
o Microfinance schemes
o Privatisation
• Interventionist strategies:
o Development of human capital
o Protectionism
o Managed exchange rates
o Infrastructure development
o Promoting joint ventures with global companies
o Buffer stock schemes
• Other strategies:
o Industrialisation: the Lewis model
o Development of tourism
o Fairtrade schemes
o Overseas aid
o Debt relief
• Awareness of the role of international institutions and non-government organisations (NGOs):
o World Bank
o International Monetary Fund (IMF)
o NGOs

Exam hint: This section on development policies mostly covers policies and ideas that you have already covered elsewhere in your A
level course – but you must now apply what you already know to the context of developing economies.

Market-oriented strategies

Estonia has followed a free

market approach Chile has adopted a free
market development agenda

Free-market approaches to growth and development favour giving a larger role to private sector enterprises using
liberalisation of markets, structural supply-side reforms to improve incentives for people and businesses and increased
transparency for government high on the policy agenda.

Examples of market-led policies:

1. Fiscal discipline – emphasising greater control of government spending, budget deficits and national debt.
2. Reallocating state spending away from subsidies (e.g. minimum prices to farmers) towards health care,
education & infrastructure.
3. Tax reforms – including widening the base of taxation and encouraging lower tax rates to raise enterprise and
work incentives as a means of creating wealth.
4. Liberalizing market interest rates – i.e. letting financial markets allocate capital among competing uses.
5. Floating rather than fixed exchange rates – which implies an absence of central bank intervention.
6. Trade liberalisation via reductions in import tariffs and fewer forms of protectionism such as import quotas
and other non-tariff barriers.
7. Privatisation – i.e. moving state enterprises from the government into the private sector.

Trade liberalisation
Trade liberalisation involves a country lowering import tariffs and relaxing import quotas and other forms of
protectionism. One of the aims of liberalisation is to make an economy more open to trade and investment so that it

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can then engage more directly in the regional and global economy. Supporters of free trade argue that developing
countries can specialise in the goods and services in which they have a comparative advantage.

Consider the diagram below which shows the effects of removing an import tariff on cars perhaps as part of a new
trade agreement between one or more countries:

Removing a tariff (ceteris paribus) leads to:

• A fall in market prices from P1 to P2
• An expansion of market demand from Q2 to Q4
• A rise in the volume of imported cars (no longer subject to a tariff) to a new level of Q1-Q3
• A contraction in domestic production as demand shifts to relatively cheaper imported products
• A gain in overall economic welfare including a rise in consumer surplus
• There is a fall in the producer surplus going to domestic manufacturers of these cars

Trade liberalisation can have micro and macroeconomic effects:

Micro effects of trade liberalisation:

• Lower prices for consumers / households which then increases their real incomes.
• Increased competition / lower barriers to entry attracts new firms.
• Improved efficiency – both allocative & productive.
• Might affect the real wages of workers in affected industries.

Macro effects of trade liberalisation:

• Multiplier effects from higher export sales.
• Lower inflation from cheaper imports – causing an outward shift of short run aggregate supply.
• Risk of some structural unemployment / occupational immobility.
• May lead initially to an increase in the size of a nation’s trade deficit.

Exam Technique: Chains of Analytical Reasoning on Potential Gains from Free Trade
Here is an example of how you might build a chain of reasoning to this question: Examine how a free trade area might
stimulate economic growth in Sub-Saharan Africa.

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The question asks students to examine and this is a command word that does require some evaluation:

Theory usually focuses on welfare gains:

• Lower prices
• Economies of scale
• Increased market competition
• Improved allocative efficiency
Examine … evaluation might focus on:
• Lost tariff revenues
• Financing costs for necessary infrastructure
• Regulatory reforms for common product standards
• Local businesses may suffer loss of profit / jobs when facing stronger competition

Promotion of Foreign Direct Investment

Many countries rely on inflows of foreign investment as a source of aggregate demand and as a driver of real growth.

Exam hint: Consider the possible effects of a rise in FDI on both aggregate demand and long run aggregate supply.

Main gains from attracting inflows of FDI:

1. Improved infrastructure especially in power and transport sectors.
2. Higher capital intensity / capital deepening i.e. more capital per worker which leads to higher productivity.
3. Better training for local workers leading to improved human capital and less risk of structural unemployment.
4. Investment grows a country’s export capacity (e.g. via firms attracted into special economic zones).
5. Technology & know-how transfer, promoting diversification and reducing primary dependence.
6. More competition in markets which then lowers prices for consumers and increases their real incomes.
7. Creates new jobs leading to higher per capita incomes and increased household savings.
8. FDI can promote a shift to higher productivity jobs and high value-added industries.

Exam hint: The impact (over-time) of foreign direct investment in a given country needs to be judged on a case-by-case basis.

What are the main risks from policies designed to attract investment into an emerging economy?
1. Multinationals wield power within host countries, and they can gain favourable laws & regulations.
2. Foreign multinationals take advantage of weak laws on environmental protection.
3. Multinationals have been criticised for poor working conditions in foreign factories.
4. Profits made in an LEDC are often repatriated to the host country.
5. Imports of components/capital goods initially have a negative effect on a country’s trade balance.
6. Multinationals may only employ local labour in lower skilled jobs.

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 Inequality – profits from FDI Many global corporations use Ethical standards from TNCs Volatile / footloose FDI flows – e.g.
are flow disproportionately to tax avoidance techniques to may be poor – especially in FDI is more volatile than
powerful elites increase their profits mining, farming and textiles remittance flows

Limited job creation effects / Monopsony power of TNCs

small spillover for local who are able to negotiate
content suppliers highly favourable prices

Policies designed to attract foreign direct investment

Attractive rates of Soft loans and tax reliefs / Trade and Investment Flexible labourforce +
corporation tax subsidies Agreements e.g. TPP skilled workers

Creation of Special High quality critical Open capital markets for Attraction of relatively
Economic Zones infrastructure remitted profits low unit labour costs

Coronavirus update: Pandemic leading to a steep drop in global FDI in 2020

Global foreign direct investment is projected to fall by as much as 40 percent in 2020. Developing economies appear more vulnerable
to this crisis because their economies are less diversified and highly dependent on primary commodities – many of whose prices have
fallen sharply in 2020. The pandemic appears to be accelerating a process of re-shoring or regionalization of production positing a
significant threat to globalisation and FDI into developing/emerging countries.

Removal of government subsidies

In many developing countries, a sizeable number of producers especially in farming and energy receive subsidies or
some other form of government financial support such as a guaranteed minimum price for farm produce. Economists
who support intervention to promote development argue that subsidies can play an important role in improving (for
example) farm incomes which then leads to higher capital investment and supports innovation and improved
productivity in the long run. Subsidies are a way of encouraging increased production to help overcome the challenges
of malnutrition among the poor and they help to generate surpluses of output for export.

However, free-market critics of government subsidies argue that:

1. Subsidies distort the working of the free-market price mechanism
2. Subsidies can stifle innovation because producers are less reliant on innovation as a way of making more profit
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 3. Producers / growers can become “subsidy-dependent” in the long run and there is the risk of corruption
syphoning off financial support to those who don’t need it leading to government failure
4. From an environmental point of view, subsidies can lower the incentive for producers to improve efficiency,
instead they are rewarded by increasing the intensification of farming which can lead to deforestation, a loss
of biodiversity and increased water scarcity. Farmers may overuse fertilisers or pesticides, which can then
result in soil degradation which reduces the maximum sustainable yield in the long run

Exam hint: Go back to your work in Theme 1 (microeconomics) to draw an analysis diagram showing what happens to price, output,
consumer and producer surplus if a subsidy is removed. Consider how businesses such as farmers affected by this might improve
their financial position if they can no longer rely on subsidies.

Free-market economists make the case for lowering / eliminating subsidies paid to consumers. For example, many
developing countries continue to use food-price subsidies or controls in a bid to improve nutrition. Whether this works
or not is open to question as households might substitute some of their limited budget towards foods with less
nutritional content because a subsidy effectively increases their real incomes.

Energy subsidies are widely adopted in developing countries - the IMF recently estimated that the value of energy
subsidies to consumers amounted to nearly 3% of global GDP. Economists concerned about environmental threats from
climate change would make the case for getting rid of these subsidies so that the price of energy accurately reflects the
externalities involved.

There is a case for cutting subsidies because of the high opportunity cost - perhaps government spending on subsidies
might be better allocated to education, health services and public infrastructure?

Context: The IMF has estimated that removing fossil fuel subsidies, which typically benefit the rich more than the poor, could gain up
to 4 percent of global GDP in additional money to spend on schools, hospitals, roads, and to invest in people’s human capital.

Floating exchange rate systems

The choice of exchange rate system is an important part of macroeconomic policy for developing countries. Over many
years, there has been a gradual shift among developing/emerging countries away from fixed (pegged) currency regimes
towards managed floating or free-floating systems. Managed floating remains the most common.

Some of the arguments for choosing a floating exchange rate are summarised below:
1. A floating exchange rate can be helpful for countries exposed to external economic shocks. For example,
Poland operates with a floating currency (the Zloty) inside the EU Single Market. When the global financial
crisis erupted in 2007-08 and the wider European economy went into recession, the Polish zloty depreciated
heavily against the Euro and the US dollar. This helped the Polish economy stabilise since their exports were
now more competitive. In contrast, Greece was locked into the single currency and could not rely on a
depreciation to restore some loss competitiveness.
2. Floating exchange rates mean that a country’s central bank does not have to intervene to change the
currency’s price. They do not have to maintain large reserves of gold and other foreign currencies.
3. Many developing countries have become more open to trade in goods and services and inflows and outflows
of investment. Maintaining a floating exchange rate implies that capital controls will not have to be used to
limit the inflow & outflow of currency and this may make a country more attractive to foreign investment.
4. Floating currencies are not necessarily volatile ones and allowing market forces to determine the price means
that a government/central bank is not using up foreign currency reserves to defend a fixed exchange rate that
the market has decided is not sustainable.

Exam hint: For the downsides of floating exchange rates and the case for managed intervention or perhaps a pegged currency
system, go back to the previous section (4.1.8) on exchange rate systems.

Evaluation:
• A floating currency might be more appropriate for a country with a low trade to GDP ratio since exchange rate
fluctuations would have less of an impact on the trade balance and the inflation rate.
• We have to consider whether a country has the size and reserves to be able to control their own currency.
Many smaller EU nations including the island countries of Cyprus and Malta have chosen to join the single
European Currency.
• An economy with one dominant trade partner might decide that the advantages of a pegged currency
outweigh come of the possible gains from currency flexibility.
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Microfinance schemes
The world's poor are exposed to irregular income flows, and their needs are irregular too – ranging from unforeseen
medical bills to having to pay more when food prices rise unexpectedly. Microfinance refers to a large number of
different financial products, including but not exclusive to
1. Micro-credit - the provision of small-scale loans to the poor for example by credit unions.
2. Micro-savings – for example, voluntary local savings clubs provided by charities.
3. Micro-insurance - especially for people and businesses not traditionally served by commercial insurance.
businesses - a safety net to prevent people from falling back into extreme poverty.
4. Remittance management – managing remittance payments sent from one country to another including for
example transfer payments made through mobile phone solutions.

The concept of microcredit was first introduced in Bangladesh by Muhammad Yunus who started the Grameen Bank
more than 30 years ago with the aim of reducing poverty by providing small loans to the country's rural poor.

A key feature of micro-finance has been the targeting of women on the grounds that compared to men, they perform
better as clients of micro finance institutions and that their participation has more desirable long-term development
outcomes. The Grameen Bank approach initially focused on small groups of 'lending circles' of largely female
entrepreneurs from the poorest level in the society. This became the widely accepted view of what micro finance is. In
reality there are thousands of commercial microfinance institutions (MFIs) including some large international operators.

Benefits of micro-credit
• Helps overcome the savings gap which limits entrepreneurship.
• Encourages entrepreneurship especially social enterprises.
• Targeted at women entrepreneurs.
• High rates of repayment because the system is built on social capital / trust.

Disadvantages of micro-credit
• High interest rates often well above 10-15%.
• Low success rate for new small businesses.
• Alleged forcible collection of debt in many villages – this is hard to monitor.
• Perhaps relatively ineffective compared to the impact of migrant remittances & foreign direct investment.

Privatisation
Privatisation is the transfer of a business, industry or service from public to private ownership.

Benefits of privatisation:
1. Private companies have a profit incentive to cut costs and be more productively efficient.
2. Government gains revenue from the sale of assets and no longer has to support a loss-making industry.
3. If a state monopoly is replaced by a number of firms this extra contestability in an industry will lead to lower
prices which helps to increase the real incomes of poorer households.
4. The competitiveness of the macro economy may improve especially if privatisation leads to increased
investment and benefits from economies of scale. Improved competitiveness will then drive higher exports
and long run GDP growth.

Drawbacks / disadvantages from privatisation

1. Social objectives are given less importance because privately-owned firms are driven by the profit motive.
2. Some activities are best run by the state operating in the public interest because they are strategic parts of the
economy e.g. water supply, steel and railways and have the characteristics of a natural monopoly.
3. Government loses out on dividends from any future profits.
4. Public sector assets are often sold cheaply, and the privatisation process may suffer from corruption.
5. Privatisation leads to job losses as firms increase their efficiency – this increases the risk of poverty for those
affected especially if they are structurally unemployed
6. Unless privatised corporations are regulated effectively, there is a risk of creating private monopolies who use
their market power to increase prices and profits, this can have a regressive effect on the distribution of
income.
Interventionist Strategies
Interventionist policies involve many different types of government intervention in markets designed to correct for
multiple market failures, influence patterns of trade and investment and address some of the root causes of extreme
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poverty and inequality. Supporters of interventionist strategies believe in the concept of a developmental state – where
the government can be an active and positive force in driving sustainable and inclusive growth and development.

Some of the key possible roles for the state (government) are summarised below:
• Basic (universal) and health care.
• Accessible & affordable education of good quality.
• Infrastructure especially in telecommunications, health and transport.
• Core public goods that the free market under-provides.
• Institutions of governance (including judiciary).
• Public-private partnerships in supporting urbanization.
• Smarter regulation e.g. building codes, regulation of monopoly power.
• Welfare provision to provide a basic social safety net and encourage saving.
• Progressive taxation and state spending to reduce inequality of income and wealth.

Context: In 2000, only 12% of the global population had mobile phone subscriptions, and about 60% had access to basic sanitation
whereas in 2015, phone subscriptions reached 97%, while about 70% had access to basic sanitation. (Source: World Bank, 2019)

Development of Human Capital

The World Bank defines human capital as "the knowledge, skills, and health that people accumulate over their lives,
enabling them to realize their potential as productive members of society.” Human capital is regarded as
complementary to investment in physical capital such as new buildings, plant and equipment and the latest technology.

Differences in productivity and per capita incomes are strongly linked to variations in the quality and quantity of human
capital available in a country. Research has found that between 10 and 30 percent of per capita GDP differences is
attributable to cross-country differences in human capital

According to the World Bank when they launched their new Human Capital Index in 2018, in poorer countries, almost a
quarter of children under five are malnourished, and 60 percent of primary school students fail to achieve even a
rudimentary education. Worldwide, more than 260 million children and youth are not in school.

Interventions to improve human capital might include:

1. Strategies to improve nutrition and reduce the extent of stunted growth among young people. An example is
the use of conditional cash transfers: Shombhob, a conditional cash transfer piloted in Bangladesh, has been
found to reduce wasting among children aged 10-22 months and improve mothers’ knowledge about the
benefits of breastfeeding.
2. Other health interventions can increase school attendance - a famous study in Kenya by economist Esther
Duflo found that deworming in childhood reduced school absences while raising wages in adulthood by as
much as 20 percent. A project in Nepal to improve basic sanitation led to a measured decline in anaemia
among the young.
3. Increased investment in primary and secondary schooling - including policies to improve the quality of
teaching and access to online education especially during the age of the co-vid19 pandemic.
4. Incentives to attract an inflow of skilled migrant workers and curb ‘brain drains’ of highly qualified people -
there are more Sudanese doctors working in London than Sudanese doctors working in Sudan.
5. Investment in training to re-skill people at risk of structural unemployment from the fast-changing pattern of
employment including robotics, automatic and artificial intelligence.
6. Cash transfer interventions can increase demand for education especially among the poorest families who
must make hugely difficult decisions about how to spend a meagre budget.

Building human capital may require behavioural interventions to address deeply rooted social and cultural norms that
often prevent young people from starting or completing different grades of education.

Eval – brain drain

Exam hints:
It is important to realise that interventions to build human capital can take several years to have a significant impact on productivity,
competitiveness, economic growth and poverty reduction. The impact of each intervention needs to be subjected to rigorous cost-
benefit analysis. Interventions in one country are not necessarily as effective in another as all developing countries are different.
Interventions are often hampered by inefficient bureaucracy which can lead to government failure.

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Protectionism
A reality of the global trading system is that average import tariffs are higher when imposed by developing / emerging
countries than those implemented by advanced, high-income nations. To what extent are protectionist policies such as
tariffs, quotas, domestic subsidies and other trade barriers effective in supporting growth and development for lower
and middle-income countries?

Trade-weighted average import tariff rate (2018) Source: World Economic Forum, Competitiveness Report, 2018
Iran 29%
Nepal 17%
India 15%
Ethiopia 14%
Brazil 12%
China 12%
Kenya 11%
South Korea 9%
Vietnam 8%
Mexico 5%

Main arguments/justifications for protectionism

1. Import substitution - erecting trade barriers are designed to protect fledgling domestic industries that have
not yet achieved sufficient economies of scale to become cost and price competitive in international markets.
The infant industry argument is often used as justification for tariffs that increase the prices of substitute
products in strategically important industries.
2. Need to raise tax revenues - import duty revenues can be a useful source of tax revenues for developing
countries especially when per capita incomes and formal employment is low which then limits the tax take
from the domestic economy.
3. Tariffs can be justified as a response to alleged dumping of products into a country i.e. selling at a price below
cost. Dumping can have a serious impact on the profits, investment and employment in those industries
affected.
4. Tariffs might be a retaliatory response to allegations that a country has used a competitive devaluation of
their currency to make their exports more price competitive.

However, there are risks for developing countries if they maintain high tariffs on imported goods and services:
1. Tariffs may protect jobs in some industries e.g. car making but have damaging effects elsewhere because they
increase the prices of key imported raw materials, components and capital technologies.
2. Revenues raised by tariffs might only be a small percentage of total government revenue and lost jobs in other
sectors will diminish the net effect on these revenues.
3. There is always the risk of retaliatory action by other countries - a good recent example has been the tit-for-tat
trade war developing between the United States and China.
4. Protectionist tariffs risk causing a loss of competition for domestic firms which eventually leads to lower
productivity, less innovation and weaker competitiveness.
5. Tariffs increase prices for consumers leading to higher inflation, reduced real incomes and an increased risk of
poverty for poorer households.
6. Protectionist subsidies for domestic firms can cost a government a lot of money leading to an increased
budget deficit and rising national debt.

Managed exchange rates

A managed-floating currency occurs when the central bank chooses to intervene in the foreign exchange markets to
affect the value of a currency to meet specific macroeconomic objectives. For example, the central bank might attempt
to bring about a depreciation to
• Improve the balance of trade in goods and services / improve the current account position
• Reduce the risk of a deflationary recession - a lower currency increases export demand and increases the
domestic price level by making imports more expensive
• Rebalance the economy away from domestic consumption towards exports and investment
• Sell foreign currencies to overseas investors as a way of reducing the size of government debt

Or to bring about an appreciation of the currency

• To curb demand-pull inflationary pressures
• To reduce the prices of imported capital and technology

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Overall, one key aim of managed floating currencies is to reduce the volatility of exchange rates. This is because big
fluctuations in the external value of a currency can increase investor risk and perhaps damage business confidence. If
the risk for example of overseas investor buying a government’s bonds rises, then they may demand a higher interest
rate (or yield) on those bonds as compensation.

Managed floating exchange rates might be used as a tool for a government to restore or improve the price
competitiveness of exporters in global markets or perhaps respond to an external economic shock

Latest IMF classification of countries using a managed floating system:

Albania, Argentina, Armenia, Brazil, Colombia, Georgia, Ghana, Guatemala, Hungary, Iceland, India, Indonesia, Israel, Kazakhstan,
Korea, Moldova, New Zealand, Paraguay, Peru, Philippines, Romania, South Africa, Thailand, Turkey, Uganda, Ukraine, Uruguay

IMF classification of countries using a free-floating currency:

Australia, Canada, Chile, Japan, Mexico, Norway, Poland, Russia, Sweden, United Kingdom, United States, European Union (Euro)

Exam hint:
To manage a floating currency, the central bank needs to have sufficient reserves of foreign currency available should it need to
intervene. There are risks involved in changing domestic interest rates to have an impact in currency markets. For example, higher
interest rates designed to attract hot money inflows and cause a currency appreciation might have the effect of reducing consumer
demand and cutting planned business investment which then has a negative effect on aggregate demand & growth.

Infrastructure development
Closing the infrastructure gap is now crucial in nearly all countries but especially emerging countries who want to make
progress towards meeting the SDGs, bring down extreme poverty, improve their export capacity and address numerous
environmental challenges. Infrastructure is critical for economic and social development the world over. Consider for
example two specific sustainable development goals:

• SDG 6: “Ensure availability and sustainable management of water and sanitation for all”
• SDG 7.1: “Ensure access to affordable, reliable, sustainable and modern energy for all”

We can see below how much needs to be done in many developing countries, many in sub Saharan Africa and East Asia.

Proportion of population with access to a piped on-premises water supply and improved sanitation, 2015
Egypt 95%
Ethiopia 12%
Rwanda 20%
Source: WHO/ UNICEF

Proportion of population with electricity access, 2014

Egypt 99%
Ethiopia 22%
Rwanda 9%
Source: World Bank World Development Indicators

For many countries there is insufficient investment in infrastructure. In part this is because of the enormous up-front
financial commitment and the many years before the full benefits of new projects show fruit. The savings gap in many
lower and middle-income nations makes financing big capital projects problematic and full of risk and the result can be
a lack of investment which ultimately hampers growth and affects people’s everyday lives. Attracting foreign direct
investment to help fund and build infrastructure has become a common feature for many developing countries. China’s
One Belt One Road initiative is an example of a hugely ambitious project stretching across many countries that could
have a transforming impact but there are risks involved in relying too heavily on overseas capital.

Joint ventures with global companies

A joint venture (JV) is a separate business entity created by two or more parties, involving shared ownership, returns
and risks. Joint ventures provide an opportunity for developing countries to acquire specific expertise in industries that
they are hoping will be a new source of comparative advantage in the years ahead. For global companies, a joint
venture can be a quicker way of securing access to new markets that were previously closed or subject to some form of
protectionist policy:

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Examples of recent joint ventures:
• (2017) Apple entered into a joint venture in China to open a new data centre to serve iCloud users there
• (2019) Renault injected €128m (£116m) into an electric vehicle joint venture with China’s Jiangling Motors
• (2019) Reliance Industries in India signed a joint venture with US jeweller Tiffany

Buffer Stock Schemes

One way to smooth out fluctuations in prices is to operate price support schemes e.g. through the use of buffer stocks.
Buffer stock schemes seek to stabilize the market price of agricultural products by
• Buying up supplies when harvests are plentiful to prevent a steep fall in market prices
• Selling stocks onto the market when supplies are low to prevent a large spike in market prices

In theory, buffer stock schemes will be profitable, since they buy up stocks of the product when the price is low and sell
them onto the market when the price is high. However, they do not work well in practice, many buffer stock schemes
have collapsed, and they can only work effectively for storable commodities.

Exam hint: Buffer stock schemes provide an opportunity to use the supply & demand analysis covered in Theme 1 microeconomics.

Buffer stock basic analysis:

The upper target price is designed to protect consumers from very high prices. The lower target price is designed to
support farmers/growers when the market price is heading lower.

In the diagram below, actual supply (S1) is greater than planned supply leading to a surplus. If there is a run of good
harvests, then stockpiles can build to high levels. Intervention purchases helps to drive the market price higher again.

Arguments for and against a Buffer Stock Scheme

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The success of a buffer stock scheme ultimately depends on the ability of those managing a scheme to correctly
estimate the average price of the product over a period of time.

Arguments for a buffer stock scheme:

1. Lower risk of extreme food poverty for poorest consumers.
2. More stable incomes and profits for farmers.
3. Helps macroeconomic stability / investment.
4. Buffer stock ought to be self-financing.

Arguments against using buffer stock schemes:

1. Buffer stock may not be large enough to change the market price.
2. Setting a high price for farmers often causes rising surpluses – i.e. a misallocation of resources.
3. High costs of storage and falling quality of product (which might then have to be sold at discounted prices).
4. Many buffer stock schemes fail because of poor administration/corruption.

Primary product dependence - alternatives to buffer stock schemes

• Strong evaluation involves considering alternative policies to stabilize prices and incomes for farmers
• In the long term, investment in capital goods such as irrigation and wider access to affordable insurance for
farmers/growers can be powerful
• So too are policies to reduce a country’s dependency on any one particular crop

Mobile technology to help Encourage processing / Improved basic storage Micro insurance policies for
farmers branding by farmers facilities + irrigation poorer farmers

Other Strategies

Lewis Model of Industrialisation

Arthur Lewis put forward a development model of a dual economy, consisting of contrasting rural agricultural and
urban manufacturing sectors. Initially, the majority of labour is employed upon the land, which is a fixed resource.
Labour is a variable resource and, as more labour is put to work on the land, diminishing marginal returns eventually
sets in there may be insufficient tasks for the marginal worker to undertake, resulting in reduced marginal product
(output produced by an additional worker) and underemployment. As people and countries grow richer, employment
in agriculture (mostly but not always) declines

Urban workers, engaged in manufacturing, tend to produce a higher value of output than their agricultural
counterparts. The resultant higher urban wages (Lewis stated that a 30% premium was required) might therefore tempt
surplus agricultural workers to migrate to cities and engage in manufacturing activity. High urban profits would
encourage firms to expand and hence result in further rural-urban migration. The Lewis model is a model of structural
change since it outlines the development from a traditional economy to an industrialized one.

Ethiopia: % Share of economic sectors in the gross domestic product (GDP) from 2007 to 2017

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 Agriculture Industry Services

100.0%
39.11% 37.9% 38.77% 41.76% 41.43% 38.58% 39.67% 39.89% 39.55% 36.48% 36.92%
80.0%
Share in GDP

60.0%
11.59% 10.21% 9.68% 22.1% 22.9%
9.44% 9.66% 9.48% 10.94% 13.47% 16.3%
40.0% 44.33%
42.27% 45.18% 45.88% 41.25% 41.24%
41.45% 38.52% 36.06% 34.84% 34.12%
20.0%

0.0%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Countries such as Bangladesh, Malaysia, Vietnam and Ethiopia have – in recent years - developed light manufacturing –
by building textiles and garment industries – to add momentum to the process of industrialisation but much of sub
Saharan Africa lags the rest of the world in terms of the contribution that manufacturing makes to national GDP. On
average, across the continent, manufacturing only represents about 10 percent of total GDP in Africa, lagging behind
other developing regions. Africa’s share of world manufacturing exports is less than 1%. Ethiopia, Rwanda and Tanzania
are three countries that have made sizeable progress in establishing scaled manufacturing sectors with growing export
capacity whereas Nigeria and South Africa have seen stagnating growth in their industrial sectors.

Bangladesh: % share of economic sectors in the gross domestic product (GDP) from 2007 to 2017
Agriculture Industry Services
2007 17.81 24.5 52.88
2017 13.41 27.75 53.48

Ivory Coast: Share of economic sectors in the gross domestic product (GDP) from 2007 to 2017
Agriculture Industry Services
2007 21.99 23.27 54.73
2017 21.58 24.69 44.87

Is rapid industrialisation always the right approach for sustaining growth and development?
1. Whilst much manufacturing remains labour-intensive, the rapid adoption of robots and other automated
processes can limit new job opportunities for people moving to urban areas where industries are concentrated
2. Successful manufacturing strategies often have close links back to farming and extractive sectors e.g.
developing processing capabilities for farmers who grow fruit. Kenya has established a cut-flower processing
industry that employs over 200,000 people and contributes more than $1 billion worth of exports each year
3. Light manufacturing does not always add a great deal of value added to production especially low-level
assembly tasks. Countries might do better in the long run if they invest in building human capital in industries
such as research, engineering and design.
4. There are drawbacks from rapid urbanisation especially if a country does not have the infrastructure to cope
with high rates of rural-urban migration. Many fast-growing cities suffer from problems of water stress, crime
and the risk of the spread of disease faced with under-developed health care systems.

Development of Tourism
In 2016, travel and tourism generated $7.6 trillion (10 percent of global gross domestic product) and an estimated 300
million jobs globally. There is a fierce debate about the long-term consequences of tourism - what role can tourism play
in growth and development? Can travel to less developed countries do more harm than good?

Countries with highest % of GDP linked to tourism

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 Share of total GDP
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Seychelles 21.2%
Cape Verde 16.2%
Malta 13.6%
Croatia 12.1%
Mauritius 11.3%
Barbados 10.9%
Cambodia 10.4%
Montenegro 9.8%
Thailand 9%
The Gambia 9%
Hong Kong SAR 8.9%
Morocco 8.6%
Jamaica 7.7%
Tunisia 7.3%
Malaysia 7.2%

Benefits of Tourism for Growth & Development

1. Employment creation - tourism is labour intensive industry.
2. Employs a significantly higher % of women helping to increase female labour market participation.
3. Export earnings - tourism is a service industry – it helps to generate foreign exchange.
4. It is an important source of diversification for many smaller countries – reducing primary dependency.
5. Tourism lifts aggregate demand – possibly creating local and regional income-multiplier effects.
6. Accelerator effects from investment in tourism infrastructure and services such as airlines and telecoms.

Critical Evaluation of Expanding Tourism

1. Exploitation of local labour by overseas TNCs, consider the rapid growth of sex industry in many countries
2. Many workers in tourism are migrants suffering from poor conditions such as low wages/long hours
3. Outflow of profits from foreign-owned tourist resorts, many resorts have few locally owned hotels.
4. Negative externalities from construction projects such as waste, pressure on the natural environment.
5. Rising property prices makes housing less affordable for local people.
6. Deepening pressures on local cultures from westernisation, the doubtful benefits of slum-tourism +
concerns with security and health.
7. Tourism can be a highly cyclical industry vulnerable to global economic and political shocks.

Tourism is becoming more significant for many of the world’s least developed countries (LDCs)

LDCs' Travel exports and international tourist arrivals

20 30

15
20
10
10
5

0 0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Travel exports US$ billion (LHS) International tourist arrivals (million, (RHS)

Context: “Countries that have diversified their economies into more complex sectors, like India and Vietnam, are those that will grow
the fastest in the coming decade.” Centre for International Development, Harvard (2019).

Coronavirus update: Tourist-dependent countries hit hard by the global pandemic

The coronavirus pandemic has shown how hard some countries have been hit by a collapse in overseas tourist travel. Mexico, Spain
and Italy are ranked as the three nations most exposed to this negative demand shock. Travel and tourism contributed 14.3 and 13.0
percent, respectively, to Spain’s and Italy’s GDP last year, including direct contributions from hotels, travel agents, airlines and
restaurants. That figure is even higher for Mexico with travel and tourism accounting for nearly 16 per cent of their GDP. The

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comparable figure for the UK is 9 per cent but in all of these countries, hundreds of thousands of jobs are at stake and these sectors
provide a hugely significant contribution to the current account of their balance of payments as well as an important source of
government tax revenues. Many developing / emerging countries are tourism dependent. In some South Asian nations, tourism
contributes (directly and indirectly) a significant share of national income. IMF research finds that Costa Rica, Greece, Morocco,
Portugal, and Thailand will be among the hardest hit with losses in tourism proceeds exceeding 3 percent of GDP.

Fairtrade Schemes
One of the driving forces behind the founders of Fair Trade was a desire to correct for multiple market failures in
industries for many primary sector commodities. These failures included the effects of monopsony power among
transnational food processors and food manufacturers which often led to farmers in some of the world's poorest
countries receiving an inequitably low and unsustainable price for their products.

The key aims of Fairtrade are to:

• Guarantee a higher / premium price to certified producers.
• Achieve greater price stability for growers.
• Improve production standards. A grower will be able to receive a Fairtrade licence if it can improve working
conditions, better pay and guarantees of environmental sustainability.

The Fairtrade movement has critics:

1. Impact on non-participating farmers: Some claim that by encouraging consumers to buy their products from
Fairtrade sources, this cuts demand for farmers in poorer nations not covered by the Fairtrade label thereby
worsening the risk of extreme poverty.
2. Who captures the gains from Fair-Trade coffee? There is some evidence that a large part of the premium price
goes to processors and distributors rather than the farmers themselves.
3. Others argue that the fundamental causes of poverty are not properly addressed by Fairtrade. Greater
investment needs to be made in raising farm productivity, reducing vulnerability to climate change, and
reaching multi-lateral trade agreements between countries to reduce import tariffs and improve access for
poor countries into the markets of rich advanced nations.
4. Other investment might be better targeted at encouraging farmers to establish producer co-operatives of their
own and create their own branded products selling direct to consumers.

Overseas Aid
Types of Overseas Development Assistance (Aid)
1. Bi-lateral aid: From one country to another.
2. Multi-lateral aid: Channelled through international bodies such as the United Nations.
3. Project aid: Direct financing of projects for a donor country.
4. Technical assistance: Funding of expertise of various types including engineering / medicine.
5. Humanitarian aid: Emergency disaster relief, food aid, refugee relief and disaster preparedness.
6. Soft loans: A loan made to a country on a concessionary basis that offers a lower rate of interest.
7. Tied aid: i.e. projects tied to suppliers in the donor country.
8. Debt relief: This can involve the cancellation, rescheduling, refinancing of a country’s external debts.

UK overseas aid commitments:

In cash terms, the UK gave £14 billion in aid in 2017 equivalent to 0.7% of the UK’s GNI. The UK aid strategy is to
allocate 50% of aid to fragile states and regions. The top five recipients of UK aid in 2016 were Pakistan, Ethiopia,
Nigeria, Syria and Turkey.

Exam hint: You should ensure that when discussing /evaluating aid that they consider the different types of aid i.e. not all aid is the
same! By considering different types of aid, you can compare and contrast their effectiveness, gaining valuable evaluation marks.

The table below shows the highest recipients of overseas aid in 2017 (Source: 2018 HDI Report)
Net official development assistance received

HDI rank Country (% of GNI) in 2016

187 South Sudan 64.5
181 Liberia 44.8
188 Central African Republic 28.4

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 185 Burundi 24.7
171 Malawi 23.5
184 Sierra Leone 21.9
168 Afghanistan 20.6

Benefits of overseas aid

1. Helps to overcome the savings gap + aid can help stabilize post-conflict environments and in disaster recovery.
2. Project aid can fast-forward investment in critical infrastructure – eventually leading to higher productivity.
3. Long-term aid for health and education projects – this builds human capital and stronger social institutions.
4. Targeted aid might add around 0.5% to the annual GDP growth rate of the poorest countries helping to lift
people out of extreme poverty - this can benefit donor countries too as trade in goods and services grows.

Risks / drawbacks from high levels of overseas aid

1. Poor governance - aid might leave the recipient country. It can finance corruption by ruling political elites.
2. Lack of transparency – hundreds of $m is spent on aid consultants and the costs of running developed country
non-governmental organisations.
3. Dependency culture – one aid paradox is that aid tends to be most effective where it is needed least – it may
harm an entrepreneurial culture.
4. Aid may lead to a distortion of market forces and a loss of economic efficiency and might cause higher
inflation.

The effectiveness of overseas aid needs to be monitored carefully so that each $ of aid is properly targeted to have a
favourable effect. Aid may work more when targeted at low income countries and perhaps when it is made partially
conditional on a government implementing some economic reforms. Aid does save lives – there is a measurable impact
for example of aid projects designed to reduce mortality from HIV & Aids.

Debt Relief
External debt is owed to external (overseas) creditors. Examples include government bonds sold to foreign investors
and private sector credit from foreign banks. The scale of external debt is usually measured as a % of a country’s GNI.

Data is for 2014 Total external debt Debt interest costs per year
% of GNI % of GNI
Mongolia 186.2 24.8
Ukraine 100.3 29.7
Sri Lanka 59.7 35.3
South Africa 42.3 14.8
Vietnam 40.6 21.7
Thailand 38.2 7.7
Mexico 34.7 18.9
Brazil 24.1 6.6
India 22.7 5.3
Bangladesh 18.8 11.1
China 9.3 0.8

External debt can be a severe constraint on growth and development – often, the interest payments on existing debt
takes up a large percentage of a nation’s export revenues or annual tax revenues. These debt repayments have an
opportunity cost; in other words, they might be better used in supporting development policies.

What is debt relief?

• Debt relief involves the cancellation, rescheduling, or refinancing of a nation’s external debts.
• Many of the world’s poorest countries have high levels of external debt owed to other governments,
institutions such as the IMF and foreign companies, banks and individuals.
• The Heavily Indebted Poor Countries Initiative (HIPCI) is an initiative to provide debt relief to heavily indebted
low-income countries.
• Debt relief agreements are often conditional on the host country introducing structural economic reforms.

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The case for offering debt relief
1. High debt and the interest payments on debt can further impoverish the most vulnerable people in poor
countries – debt relief is an appropriate form of aid for countries who lack access to global capital markets.
2. Poor countries highly dependent on exports of primary commodities are exposed to global economic shocks
which damage their export revenues and take them deeper into external debt. There is a moral argument for
helping the poorest countries and their inhabitants.
3. Debt relief can be made partially conditional on governments introducing economic and social reforms.

Arguments against extensive debt relief

1. Moral hazard argument – governments will spend and borrow more – perhaps recklessly – if they know/expect
that some of their debts will be written off in the future – this increases the risk of government failure.
2. If governments ran better macroeconomic policies e.g. to control inflation and state borrowing, then the
interest rates charged on new loans would fall making the repayment of debt less costly.

Exam Technique: Revision Essay Plan on Government Borrowing as a Development Policy

Question: With reference to examples of specific developing countries, evaluate the potential benefits of developing
countries borrowing to accelerate their growth and development.

Evaluation Paragraph 1
However, often the positive effects of debt-financed investment for developing countries are reduced because of the damaging
effects of corruption and the incomplete use of rigorous cost-benefit analysis before a project is undertaken. Both are examples of
government failure. For example, Mozambique borrowed US$850m for their national fishing industry but instead spent the money
on military boats and equipment. The result is that developing country governments are left with an increasing level of national debt
which then adds to the annual cost of servicing these loans. Kenya for example is among 18 sub-Saharan countries in 2019 where
government debt is above 50 per cent of GDP. The government debt of the lowest-income countries reached 55 percent of GDP, on
average, in 2019—a 19 percentage point rise since 2013. Some economists argue that rising sovereign borrowing and debt can
crowd-out the private sector either through higher market interest rates or an increase in business tax rates in the medium term
both of which might reduce private sector investment.

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Evaluation Paragraph 2
A counterargument is that borrowing carries risks including the fear that high rates of lending now from external creditors in might
lead to an external debt crisis in the future. Globalisation has allowed many economically less developed countries to raise finance in
the capital markets of developed nations. For example, in 2018, sub Saharan countries borrowed $17 billion in Eurobonds (including
oil exporters such as Angola and Nigeria). However this debt is often relatively expensive, contrasted for example with loans taken
out with the World Bank. When debt stocks are high and interest rates rise, the cost of servicing this borrowing can climb sharply. In
Kenya for example, external debt has grown to 36% of their GNI and interest payments on these loans account for 23% of the value
of their exports. One big risk is that a fall in world commodity prices and a subsequent depreciation of the exchange rate increases
the real value of debt expressed in a foreign currency leaving a government with less to spend on public services and welfare. This in
turn can damage their economic growth prospects.

The World Bank

The World Bank comprises two institutions managed by member countries: The International Bank for Reconstruction
and Development (IBRD) and the International Development Association (IDA). The IBRD aims to reduce poverty in
middle-income and credit-worthy poorer countries. The IDA focuses exclusively on the world’s poorest countries.

The World Bank:

• Provides grants and low interest loans.
• Offers policy advice and technical assistance to developing countries.
• Co-ordinates projects with governments.

Critics of the World Bank argue that the institution is risk averse, hugely over-staffed and overly sensitive to criticisms
of their flagship projects and with multi-million-dollar expense accounts in stark contrast to their original mission.

International Monetary Fund (IMF)

The International Monetary Fund (IMF) has played a prominent role in world financial affairs in the post-Second World
War period. In the 1950s and 1960s, its main purpose was to support the system of fixed exchange rates. Since then its
activities have evolved to embrace developing economies and both banking and sovereign debt crises.

Roles of the International Monetary Fund (IMF)

• IMF was founded at the Bretton Woods conference in 1944.
• The IMF works to foster global monetary cooperation, secure financial stability, facilitate global trade, promote
high employment and sustainable economic growth, and reduce poverty around the world.
• The IMF provides financing to its members when they are suffering economic difficulties.
• Financial assistance can come in the form of conditional loans or training.
• Emerging market countries argue the IMF requires reform given the changing balance of power in the world.
NGOs
An NGO is any not-for-profit voluntary group – it can operate on a local, regional, or international scale. NGOs (non-
governmental organisations) often operate on a small scale in developing countries. They frequently work in the areas

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of environmental improvement, community development, and human rights – there have been notable interventions
from NGOs in the areas of removal of landmines in previously war-torn countries (e.g. Cambodia), gender equality and
women’s rights, and raising awareness of “blood diamonds”. Choose two or three NGOs that operate in countries /
areas that you might be interested in and investigate their work!

Coronavirus update: Decades of development progress are at risk

The World Bank is forecasting that the covid-19 crisis will lead to a reduction in per capita incomes for 90 per cent of countries
around the world with emerging and developing nations being badly affected by this negative global economic shock. Decades of
development progress seem to be at risk.

According to the World Bank’s Global Economic Prospects (June 2020), “Emerging market and developing economies (EMDEs) are
expected to shrink by 2.5% in 2020, their first contraction as a group in at least 60 years. As a result, per capita incomes are expected
to decline by 3.6%, which will tip millions of people into extreme poverty this year.”
The fear is that more than 100 million people might be driven back into extreme poverty as a consequence of the crisis. Lower
income countries have under-developed and under-resourced health care systems and social welfare safety nets that offer far less
income protection than in advanced countries. Relatively poorer countries also have high levels of sovereign debt with debt service
costs significantly higher than the bond yields of high income, developed nations. Growth is at risk from a slump in demand in the
richest countries of the world which has negative consequences for demand for raw materials and components many of which flow
from supply-chains linked back to emerging countries.

The fall in world prices for many basic extractive commodities has led to a deterioration in the terms of trade for developing country
exporters and threatens to lead to slower economic growth as exports are a key source of aggregate demand. World trade is forecast
to contract by 13% in 2020 and there are renewed fears of a return to more tariff and non-tariff measures as some countries decide
to protect employment and incomes in their own domestic economies. Economists at the World Bank say that “Trade is typically
more volatile than output and tends to fall particularly sharply in times of crisis.”

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4.4.1 Role of Financial Markets
Key specification content:
• To facilitate saving
• To lend to businesses and individuals
• To facilitate the exchange of goods and services
• To provide forward markets in currencies and commodities
• To provide a market for equities

Exam hint: For the purposes of Edexcel A-level, you do not need to know about money markets and capital markets in detail
(although you need to understand foreign exchange markets), and you are unlikely to see questions on these areas – but it can be
invaluable in helping your wider understanding of financial markets if you have awareness of what they are and their roles.

Money, Capital and Foreign Exchange Markets

• The money market:
o This is a market for short term loan finance for businesses and households.
o Money is borrowed and lent normally for up to 12 months.
o Includes inter-bank lending i.e. the commercial banks providing liquidity for each other.
o Includes short term government borrowing e.g. 3-12 months Treasury Bills – to help fund the
government’s budget (fiscal) deficit.
• Capital market:
o Market for medium & longer-term loan finance.
o Capital markets are the markets where securities such as shares, and bonds are issued
o Includes raising of finance by the government through the issue of long-term government bonds for
example 10 year and 20-year bonds (loans).
o The bond market includes companies, governments and non-profits such as universities that raise
money by issuing bonds, essentially borrowing money at interest from investors.
• Foreign exchange market:
o A market where currencies (foreign exchange) are traded. There is no single currency market – it is
made up of the thousands of trading floors.
o Gains or losses are made from exchange rates – speculative activity in currency markets is often high.
o The spot exchange rate is the price of a currency to be delivered now, rather than in the future.
o The forward exchange rate is a fixed price given for buying a currency today & delivered in the future.

Role of financial markets in the wider economy

What is a financial market?
A financial market is any exchange that facilitates the trading of financial instruments, such as stocks, bonds, foreign
exchange, insurance or even commodities such as oil and gas. A financial market is a marketplace where financial
securities are traded on both a national and global level. Traders buy and sell those securities to gain potential profits
while trying to keep their risk limited.

Financial services in the UK economy

How important is the financial market to the UK economy and the prosperity of all of society? In 2017, the financial services sector
contributed £119 billion to the UK economy, 6.5% of GDP. The sector was largest in London, where 50% of the sector’s output was
generated. There were 1.1 million financial services jobs in the UK in 2017 (3.2% of all jobs.) The financial services industry ran a
trade surplus of £51 billion financial services trade of £51 billion and the sector contributed £27.3 billion in tax in the UK in 2016/17.
Source: UK Parliamentary Research Statistics, April 2018

What are the key roles of financial markets?

1. To facilitate saving by businesses and households: Offering a secure place to store money and earn interest.
2. To lend to businesses and individuals: Financial markets provide an intermediary between savers and borrowers.
3. To allocate funds to productive uses: Financial markets allocate capital to where the risk-adjusted rate of
return is highest.
4. To facilitate the final exchange of goods and services: They provide payments mechanisms e.g. contactless
payments.
5. To provide forward markets in currencies and commodities: Forward markets allow agents to insure against
price volatility.
6. To provide a market for equities: Allowing businesses to raise fresh equity to fund investment and growth.
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Examples of key financial markets

Characteristics of Money
• Durability i.e. it needs to last.
• Portable i.e. easy to carry around, convenient, easy to use.
• Divisible i.e. it can be broken down into smaller denominations.
• Hard to counterfeit - i.e. it can’t easily be faked or copied.
• Must be generally accepted by a population.
• Valuable – generally holds value over time.

Standard of
Medium of Store of Unit of
deferred
exchange value account
payment

Key Functions of Money

1. Medium of exchange: money allows goods and services to be traded without the need for a barter system.
Barter systems rely on there being a double coincidence of wants between two people involved in an exchange
2. Store of value: this can refer to any asset whose “value” can be used now or used in the future i.e. its value
can be retrieved at a later date. This means that people can save now to fund spending at a later date.
3. Unit of account: this refers to anything that allows the value of something to be expressed in an
understandable way that allows the value of items to be compared.
4. Standard of deferred payment: this refers to the expressing of the value of a debt i.e. if people borrow today,
then they can pay back their loan in the future in a way that is acceptable to the person who made the loan.

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Coronavirus update: Post pandemic, does cash have a future?

Monthly cash withdrawals from LINK ATM machines (£ million)

300
250
200
150
100
50
0
Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec.

2018 2019 2020

Has the coronavirus pandemic brought about the death of cash? Many people have barely used any cash since the introduction of
lockdown measures designed to protect public health. The Bank of England estimates that cash withdrawals through the LUK INK
ATM network dropped around 50% in late March 2020 and have increased only gradually since mid-April, remaining well below levels
seen prior to the pandemic shock. The maximum transaction allowed for contactless payments was increased to £45 during the crisis
which
accelerated the shift away from cash for many retail purchases.

What is the money supply?

The money supply is the stock of currency and other liquid financial instruments circulating in the economy of the
country at the particular point in time.
• Narrow Money
o The narrow money definition of the money supply is a measure of the value coins and notes in
circulation and other money equivalents that are easily convertible into cash such as short-term
deposits in the banking system.
o M1, called "narrow money", includes currency in circulation (banknotes and coins) and overnight
deposits. It depicts the value of the most liquid components of the money supply.
• Broad Money
o Broad money is a measure of the total money held by households and companies in the economy.
o Broad money is made up mainly of commercial bank deposits — which are essentially IOUs from
commercial banks to households and companies — and currency — mostly IOUs from the central
bank.

Total money supply in the United Kingdom from November 2016 to November 2018 (in £ billion)
M1 M4
Nov 2016 1,607.73 2261.2
Nov 2017 1,696.83 2370.21
Nov 2018 1,771.51 2398.48

Context: India’s De-monetisation

In 2016, India Prime Minister Narendra Modi announced that, to combat black market money, the two largest denomination notes –
the 500 rupee and 1,000-rupee notes – would cease to be legal tender, effective at midnight. Holders of these notes could deposit
them at banks but could not use them in transactions. This is a rare example of de-monetisation in a modern economy. Research
evidence finds that this policy was a negative shock for the Indian economy resulting in possibly a two percent reduction in GDP
growth. However, the announcement led to some unintended consequences one of which was the faster adoption of alternative
payments technologies such as e-wallets and point-of-service cards as Indians looked to work their way around the contraction in
cash in circulation. Source: Adapted from Vox Dev.

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Why do businesses need to raise extra finance from the financial system?

Facilitating Lending in the Financial System

It is good to be aware of the different length of loans available from the financial system. The interest rate may depend
on the length of the loan but the creditworthiness of the borrower including the risk of loan default.

Long-term loans Medium-term loans Short-term loans

Finances whole business over many years Finances major projects or assets with a Finances day-to-day trading of a business
long-life
Examples: Examples: Examples:
Share capital Bank loans Bank overdraft
Retained profits Leasing Trade creditors
Venture capital Hire purchase Short-term bank loans
Mortgages Government grants Factoring
Long-term bank loans

Debt Finance
Debt financing means borrowing money from an outside source with the promise of paying back the borrowed
amount, plus the agreed-upon interest, at a later date.

Bank Loan Bank Overdraft Credit Card Mortgage Peer to Peer Corporate Bond
Lending
Key Features of Bank Loans
1. Loan is provided over a fixed period (e.g. 5 years).
2. Rate of interest payable is either fixed or variable.
3. Timing and amount of loans repayments are set by the lender e.g. a commercial bank.
4. Non-performing loans (“bad debts”) occur when the borrower is unable to repay some or all of the debt.

Unsecured loans
• Money supported only by a borrower's creditworthiness, rather than by any type of collateral.
Secured loans
• Money you borrow that is secured against an asset you own, usually your home.

Equity Finance

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 Angel Investors Venture Capital Stock Market Crowd Funding
Listing
• Angel Investors - Individuals who inject capital for business start-ups.
• Venture Capital - Firms specializing in building high risk equity portfolios.
• Stock Market Listing - Offering shares to public & institutional investors e.g. via an initial public offering (IPO).
• Crowd Funding - Raising capital from a large number of individual investors via platforms such as Crowd Cube.

Coronavirus update: UK firms raise more finance during the covid-19 crisis
At times of economic and financial distress, and with revenues falling and losses mounting, many businesses have been forced to
raise more debt and equity finance during the crisis. According to the Bank of England, UK companies raised around £70 billion in the
four months to June 2020, more than triple the amount raised in 2019 as a whole. Some of this came by issuing new shares to the
stock market, other businesses raised money by issuing corporate bonds. Others borrowed directly from commercial banks including
taking advantage of government-backed loans targeting smaller businesses. However, some firms in vulnerable sectors, such as retail
and travel, have struggled to access finance with the risk that many will go out of business as their cash balances run out leading to
substantial job losses.

Commercial and Investment Banks

Commercial Banks Investment Banks Internet Banks Shadow Banks

What are the main functions of a commercial bank?

• Commercial banks provide retail banking services to household and business customers.
• Banks are licensed deposit-takers providing savings accounts.
• They are licensed to lend money and thereby create money e.g. via bank loans, overdrafts and mortgages.
• Commercial banks are nearly all profit-seeking businesses.
• A bank’s business model relies on charging a higher interest rate on loans than the rate paid on deposits.
• This spread on their assets and liabilities is used to pay the operating expenses of a bank and make a profit.

How banks create credit

Banks create credit by extending loans to businesses and households. They do not always need to attract deposits from
savers to do this. When a bank makes a loan, it credits their bank account with a bank deposit of the size of the
loan/mortgage. At that moment, new money is created in the financial system.

How commercial banks make a profit

• 1/ Interest-rate spreads – i.e. charging a higher interest rate on loans than the rate that is paid to savers.
• 2/ Service fees – this includes fees charged by a bank to borrowers when arranging loans.
• 3/ Brokerage percentages - many banks provide currency & share-dealing services and charge a brokerage fee
to customers for doing so.

How banks can fail

1. Run on the bank:
a. This happens when depositors panic and withdraw their savings fearing that the bank may collapse.
b. This creates a liquidity crisis for the bank, and they may need to find emergency sources of funding.
2. Credit crunch:
a. A bank may be unable to borrow money from other banks even on an overnight basis.
b. Heavy losses and collapsing capital threaten their commercial viability.
3. High losses from bad debts:
a. The loan default rate might rise e.g. in a recession as borrower struggle to make loan repayments

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 b. Then the credit rating of bank declines and their share price falls making it harder to raise new finance

Limits to credit creation by banks

• Market forces – these influence the number of profitable lending opportunities.
• Regulatory policies e.g. higher capital reserve requirements imposed by a central bank might limit lending
• Behaviour of consumers and businesses - e.g. decisions about how much of their debt to repay.
• Monetary policy – the level of monetary policy interest rates influences the demand for loans from
households and businesses including demand for business loans and mortgage loans in the housing market.

Liquidity risk for commercial banks

• Banks tend to attract short term deposits e.g. from savers.
• They often lend for longer periods of time e.g. a 20-year or 30-year property mortgage.
• As a result, a bank may not be able to repay all deposits if savers decide to withdraw their funds in one go.
• To reduce their risk, commercial banks will try to attract long term deposits but hold some liquid assets e.g.
cash as capital reserves.

Credit risk for commercial banks

• This is the risk to a bank of lending to borrowers who turn out to be unable to repay some or all of their loans.
• Credit risk can be controlled by research into the creditworthiness of borrowers and by banks having sufficient
capital in reserve. Minimum capital reserves may be imposed by the financial authorities.
• Most banks after the Global Financial Crisis have increased their capital reserves so that they can withstand an
increase in bad debts during an economic downturn.

Ratio of bank capital and reserves to total assets in the United Kingdom from 2008 to 2017

Ratio of bank capital and reserves to total assets in the United Kingdom (UK) from 2008 to 2017
8. 6.84 7.03 6.78
6.35
5.39 5.37 5.51 5.62
6. 5.1
4.41
4.

2.

0.
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Banks in the UK have increased their capital reserves in order to withstand a future economic recession / financial crisis.

Investment Banks

JPMorgan Chase Goldman Sachs Deutsche Bank Morgan Stanley UBS Barclays
Investment Bank

What are investment banks?

• An investment bank provides specialized services for companies and large investors:
o Underwriting and advising on securities issues and other forms of capital raising.
o Advice on mergers, acquisitions & corporate restructuring.
o Trading on capital markets (bonds and equities).
o Corporate research and private equity investments.
• An investment bank trades and invests on its own account.
• Commercial banks can provide investment banking services.

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Biggest investment banks worldwide 2018, by revenue (in million U.S. dollars)
JPMorgan 6,898
Goldman Sachs 6,196
Morgan Stanley 5,124
Bank of America Merrill Lynch 4,456
Citi 4,002
Credit Suisse 3,444
Barclays 3,318
Deutsche Bank 2,426
Jefferies LLC 1,789

4.4.2 Market Failure in the Financial Sector

Key specification content:
Consideration of:
• Asymmetric information
• Externalities
• Moral hazard
• Speculation and market bubbles
• Market rigging

Externalities Monopoly power Market rigging Speculative Moral hazard Asymmetric

from financial in financial bubbles / and attitudes to information and
instability markets irrational risk complexity
behaviour

Recap: What is meant by market failure?

Before looking at specific examples of financial market failure, it is a good idea to refresh your understanding of the
generic causes of market failure from Theme 1 microeconomics.

Asymmetric Information
• This type of market failure exists when one individual or party has more information than another individual
or party and then uses that advantage to exploit the other party for commercial advantage.
• Finance is a market in information – for example, often a potential borrower (such as a small business) has
better information on the likelihood that they will be able to repay a loan than the lender.

Externalities
• A negative externality exists when a market transaction has a negative consequence for a 3rd party.
• A positive externality exists when a market transaction has a positive consequence for a 3rd party.

Externalities in financial markets seem large – especially contagion effects – for example when there is a loss of trust
and confidence between lenders and between savers and financial institutions such as banks. A key concept is systemic
risk – which means that, when one or more financial organisations experience problems, this can lead to the risk of
wider damage to the economy which perhaps threaten the stability of the financial system. Millions of people can be
affected negatively as a result.

Consider this excerpt from recent Bank of England research on the externalities from financial market instability:

“In finance, the private sector left to its own devices will never fully price the consequences of its actions. Although externalities exist
in many markets and industries, those in finance seem especially large - contagion within the financial sector to other borrowers and
lenders from interconnections and panics and fire sales, and the aggregate demand externality from the responses of heavily
indebted households and businesses to shocks to income, interest rates or credit availability. Those externalities damage innocent
third parties in the form of unemployment and lost income when the financial sector can’t perform its normal intermediary functions
and credit dries up.”
Source: www.bankofengland.co.uk/-/media/boe/files/speech/2017/regulation-for-financial-stability-the-essentials.pdf

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The Bank of England estimates find that the Global Financial Crisis and recession that followed it left everyone in the
UK around £20,000 worse off than had the crisis not materialized. In part this is the result of lower real income, output
and employment across many industries. It comes from the fiscal costs of the bail-out of banks during the Global
Financial Crisis and ensuing period of fiscal austerity.

Examples of external costs (negative externalities) arising from financial crises:

1. Taxpayers (taxpayers bear the cost of bank bail-out costs and the impact of fiscal austerity).
2. Depositors (Risk of lost savings if a bank collapses).
3. Creditors (A rise in unpaid debts can create difficulties).
4. Shareholders (Lost equity from falling bank share prices).
5. Employees (Lost jobs in finance & the wider economy especially if a financial crisis turns into a recession).
6. Government (increased fiscal deficit and national debt and pressure to cut government spending).
7. Businesses (reduced demand for goods and services and higher borrowing costs for those needing loans).

Moral hazard
Moral hazard exists where an individual or organisation takes more risks because they know that they are covered by
insurance, or they expect that the government will protect them (i.e. bail them out) from any damage incurred as a
result of those risks. With moral hazard, agents behave differently in the knowledge that they are insulated from risk
i.e. someone else will cover potential future losses.

Bail-outs many encourage Sub-prime loans were

riskier behaviour repackaged to investors

Examples of moral hazard include:

• Individuals with large insurance policies to cover specific risks are more likely to claim against such policies.
• Government bailouts of commercial and investment banks encourages them to engage in riskier behaviour.
• Sub-prime mortgage lenders prior to 2007 were able to repackage loans into bundles bought by other
institutions.

House price bubble Share price bubble Bubble in crypto- Commodity price Credit bubbles Tulip Mania (1637)
currencies bubbles

Speculation and bubbles in financial markets

• A speculative bubble is a sharp & steep rise in asset prices such as shares, bonds, housing, commodities or
crypto currencies.
• The bubble is usually fuelled by high levels of speculative demand which takes market prices of financial assets
well above fundamental values.

What factors can cause a speculative bubble?

• Behavioural factors e.g. the herd behaviour of investors.
• Exaggerated expectations of future price rises (i.e. people expect property prices to carry on increasing).
• Irrational exuberance of investors – a term coined by Nobel-winning economist Robert Shiller.
• A period of very low monetary policy interest rates – which encourages risky investment by people and by
other agents in financial markets in search of higher yields.

Bitcoin price index from May 2012 to May 2019 (in U.S. dollars)

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 Bitcoin price index from May 2017 to May 2019 (in U.S. dollars)
16,000.
14,000.
12,000.
10,000.
8,000.
6,000.
4,000.
2,000.
0.
Apr 13

Apr 14

Apr 15

Apr 16

Apr 17

Apr 18

Apr 19
Oct 12

Oct 13

Oct 14

Oct 15

Oct 16

Oct 17

Oct 18
Jul 12

Jan 13

Jul 13

Jan 14

Jul 14

Jan 15

Jul 15

Jan 16

Jul 16

Jan 17

Jul 17

Jan 18

Jul 18

Jan 19
Market rigging (collusion)
• This market failure is effectively collusion or abuse of the power resulting from operating in a highly
concentrated market. Market rigging happens when some of the companies in a market act together in an
anti-competitive way, to stop a market working as it should in order to gain an unfair advantage.
• When there is a small number of firms in a market, they may choose to work together to increase their joint
profits and thereby exploit consumers.
• The Competition and Markets Authority report on UK banking in August 2016 said that “the older and larger
banks, which still account for the large majority of the retail banking market, do not have to work hard enough
to win and retain customers and it is difficult for new and smaller providers to attract customers.”
• Price rigging is illegal because it interferes with the natural market forces of supply and demand and harms
consumers by inhibiting competition.
• For example, it might lead to consumers having to pay higher interest rates on their loans.
• It might lead to savers earning lower rates of interest on their deposits than if the market was more competitive.

Monopoly power in financial markets

Market failure can arise when a market is not sufficiently competitive. The UK banking sector for example is dominated
by a few large banks, including the Lloyds Group, Barclays, the Royal Bank of Scotland (RBS), and HSBC. In term of
market shares for all categories of business, the market is clearly oligopolistic. There are significant barriers to entry
into the market which make life hard for new entrants as they seek to establish themselves and make a profit.

Market share of total assets for leading British-owned banks in the UK in 2017
Metro Bank**
0.21%
Tesco Bank 0.19%

The Co-operative Bank 0.31%

Virgin Money Bank 0.52%

TSB Bank 0.54% Other Banks 22.37%

CYBG: Clydesdale Bank, HSBC Bank plc 24.82%

Yorkshire Bank 0.55% Barclays Bank plc
Nationwide 14.37%
Building National Westminster
Society (NBS) Banks (Natwest) 3.35%
2.91% Santander UK 3.99% Lloyds
Bank
Standard Chartered Bank* 10.3%
6.22%

The Royal Bank of Scotland

(RBS) 9.36%

Leading UK banks from 2014 to 2017, by market share of gross lending

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 2014 2015 2016 2017

25.0%
Market share of gross lending

20.0%

15.0%

10.0%

5.0%

0.0%
Lloyds Banking Nationwide BS Royal Bank of Santander UK Barclays HSBC Bank Coventry BS Virgin Money
Group Scotland

Examples of barriers to entry into commercial banking

1. Regulatory barriers – i.e. the need to be given a banking licence by the central bank.
2. Natural or intrinsic barriers to entry – the costs of entering the market include marketing costs, building
reliable and secure IT and payments infrastructure
3. Strategic advantages of larger banks – including gains from vertical integration, a branch network and low
rates of customer switching – many people are reluctant to swap accounts & have strong default behaviour
4. First mover advantages - including strong brand loyalty for established banks

Brand loyalty leads to low rates of consumer switching. This ties in with behavioural theories since the default choice of
which bank to use is powerful in this market – leading to low rates of customer switching to other current accounts.
Main banks used for current accounts in UK (2018)

Which bank or financial services provider do you have your main current account with? (% of respondents)
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Barclays 15%
Santander 12%
Halifax 12%
Lloyds 12%
NatWest 11%
Nationwide 9%
HSBC 9%
TSB 5%
Royal Bank of Scotland 4%
The Co-operative 2%
Other 9%

However, although the commercial banking industry in the UK remains an oligopoly, there are signs that it is becoming
more contestable. The competitive threat from challenger banks, FinTech and new online market entrants is
increasing. Competitive threats are emerging from examples such as these:
• Established challengers: First Direct, Metro Bank, TSB, Virgin Money
• Online banks: Atom, Monzo, Zopa, Tandem
• Supermarket banks: Asda Money, M&S Bank, Sainsbury’s Bank
• Fin Tech companies offering banking services: Azimo, iZettle, Curve
• The Next Wave - digital platform companies such as Google and Apple Pay

Systemic risk in financial markets

What is systemic risk?
• Systemic risk is the possibility that an event at the micro level of an individual bank / insurance company could
then trigger instability or collapse an industry or economy.
• The Global Financial Crisis (GFC) illustrated how deeply inter-connected the financial world has become.

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 • Shocks in one location (e.g. the USA) or one asset class (e.g. sub-prime mortgages) can have a sizable impact
on the stability of institutions and markets around the world.
• Since the crisis, financial regulators have tried to make the banking system less vulnerable to economic shocks
and create firewalls to prevent damage from systemic risk.
• One approach has been to insist that commercial banks have higher capital reserves to help absorb losses.

Professor Joseph Stiglitz on the Financial Sector

“I have likened the financial sector to the brain of the economy: it is central to the management of risk and the allocation of capital.
It runs the economy’s payment mechanism. It intermediates between savers and investors, providing capital to new and growing
businesses. When it does its functions well, economies prosper, when it does its jobs poorly, economies and societies suffer.”

Key Terms in Financial Economics

AAA Highest credit rating for a bond or company.

Annuity Guarantees a regular income for the rest of your life, in return for paying over a sum from a pension fund
Assets Items owned by an individual such as property and investments
Base rate Interest rate set by Bank of England which is used as a benchmark by UK lenders
Bear Market Market where prices are falling against background of gloomy investors
Blue Chip Well established business regarded as relatively safe
Bond Lower to medium risk loans to the government or companies
Commodities Raw materials and foodstuffs traded in financial markets
Cyclicals Companies whose business prospects & share valuations are linked closely to the Economic Cycle
Default risk Possibility that issuer of a bond will be unable to make payments when they are due.
Deflation Fall in the general level of prices of goods and services in the economy
Derivatives Futures and options which are an arrangement to buy or sell an asset on a fixed future date at a price
agreed today
Diversification Spreading your investments to help reduce risk within your investment portfolio
Dividend Payment made by a company to its shareholders
Ethical funds These aim to make socially responsible investments
Junk bond High-risk bond of below investment grade
Leveraged loan Loan provided by a group of lenders
Liquidity How quickly an asset, such as equities, bonds or property, can be traded and turned into cash
Negative equity When the amount left to pay on a mortgage is greater than the value of the related property.
Risk Balance of potential loss and potential gain as perceived by the investor
Volatility Measure of how much an investment's price is likely to fluctuate during a set period of time
Yield A measure of the return on an investment compared to the price paid for it

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4.4.3 Role of Central Banks
Key specification content:
Key functions of central banks:
• Implementation of monetary policy
• Banker to the government
• Banker to the banks – lender of last resort
• Role in regulation of the banking industry

Exam hint:
Students must not assume that all central banks operate in the same way as the Bank of England – they are not all fully independent
of government; they do not all operate inflation targets and if they do, these inflation targets vary from country to country.

Examples of central banks

• Bank of England (UK)
• European Central Bank (ECB) for all member nations of the Euro Area
• United States Federal Reserve (The Fed)
• Bank of Japan (BOJ)
• Reserve Bank of Australia (AUD)
• Reserve Bank of New Zealand (NZD)

Setting interest rates Financial regulation Lender of last resort Debt management

What are the main functions of a central bank?

• Monetary policy function:
o Setting of the main monetary policy interest rate (sometimes called the base rate)
o Deciding on whether to use and the scale of quantitative easing (QE).
o Possible exchange rate intervention in a managed floating or fixed currency system.
• Financial stability & regulatory function:
o Supervision of the stability of the wider financial system.
o Prudential policies designed to maintain financial stability during times of crisis and high volatility.
• Policy operation functions:
o Lender of last resort to the banking system when commercial banks face a liquidity crisis.
o Managing liquidity in the commercial banking system so that they continue to lend to each other.
o Overseeing the payments systems used by banks / retailers / credit card companies.
• Debt management:
o Handling the issue and redemption of issues of government debt (bonds) of differing maturity.

Implementation of Monetary Policy

• Monetary policy involves changes in interest rates, the supply of money & credit and exchange rates to
influence the economy.
• Monetary policy is broader than simply changes in interest rates and it is important to be aware that there is
no such thing as “the” interest rate as there are thousands of different types of interest rate on savings and
loans at any one time.
• The impact of changes in interest rates was covered in Theme 2 macro so please refresh your understanding of
how movements in interest rates can affect different macroeconomic variables.

Monetary Policy in the UK

• The main aim of the Bank of England is to promote monetary and financial stability.
• Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the
Government's inflation target, which the Bank seeks to meet through the decisions taken by the Monetary
Policy Committee (MPC).
• The policy interest rate (base rate) is set each month by the Monetary Policy Committee. The 2% inflation
target is set by the UK government. Base interest rates in the UK have been below 1 percent since 2009.

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The Monetary Policy Committee (MPC)
• The Monetary Policy Committee does a thorough assessment of the UK economy several times a year.
• They look at a range of demand/supply-side indicators that might impact on inflationary pressures.
• The policy interest rate decision is taken after this.
• Key issue is the strength of inflationary pressures and the inflation forecast for the UK over the next two years.
• Inevitably there is a lot of uncertainty especially in a world of domestic and external economic shocks.
• Monetary policy affects both the demand and the supply-side of the economy. It does not operate in isolation.

Expansionary Monetary Policy Deflationary Monetary Policy

Reducing nominal and real interest rates Higher interest rates on both loans and savings

Steps to expand the supply of credit from the Tightening of credit supply (i.e. loans from banks
banking system e.g. via QE become harder to get)

Depreciation of the external value of the exchange Appreciation of the external value of the exchange
rate rate

Expansionary monetary policy

This is a monetary stimulus and involves changes in monetary policy designed to increase aggregate demand including
lower policy interest rates and measures to increase the supply of credit in the commercial banking system.

Contractionary monetary policy

This involves deflationary policies designed to lower the level / growth of aggregate demand to help control inflationary
pressure. This can involve a rise in interest rates, tighter controls on bank lending and perhaps attempts to cause an
exchange rate appreciation which would lower import prices.

Bank Base Interest Rate for the United Kingdom, percent

7

0
1/1/04
7/1/04
1/1/05
7/1/05
1/1/06
7/1/06
1/1/07
7/1/07
1/1/08
7/1/08
1/1/09
7/1/09
1/1/10
7/1/10
1/1/11
7/1/11
1/1/12
7/1/12
1/1/13
7/1/13
1/1/14
7/1/14
1/1/15
7/1/15
1/1/16
7/1/16
1/1/17
7/1/17
1/1/18
7/1/18
1/1/19
7/1/19

Evaluating a decade of very low interest rates

Central banks around the world cut interest rates sharply during the 2007-2009 global financial crisis. Interest rates
have remained at historic lows for many subsequent years close to or below 0% in most developed economies. In the
UK, the base interest rate has been below 1% since 2009. The European Central Bank (ECB) has their main interest rate
at 0.0%. The US Federal Reserve main rate is between 2.25% - 2.5% and has risen gently in recent years. In the UK, the
Bank of England cut the base policy interest rate to 0.1% in March 2020 in response to the economic damage and
uncertainty created by the coronavirus pandemic. They also expanded the scale of quantitative easing.

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Case for maintaining very low interest rates
1. Inflationary pressures in many advanced countries have remained weak giving little justification for raising
interest rates to control inflationary pressures.
2. Some economists argue that the Phillips Curve has flattened, i.e. the trade-off between unemployment and
inflation has weakened, this implies that an economy can operate at a higher level of aggregate demand and
employment without risking an acceleration of inflation.
3. Maintaining low interest rates help to stimulate capital investment which increases a country’s long-run
productive potential.
4. Low interest rates as part of an expansionary monetary policy have been helpful in supporting aggregate
demand and output during an era of fiscal austerity in many developed countries.
5. Keeping interest rates low may have helped to reduce the risks of price deflation and contributed to
maintaining a competitive currency which has helped export industries.

Counter-arguments – drawbacks from very low interest rates

In evaluation, a number of economists argue that advanced economies such as the UK would benefit from a period of
rising interest rates. Here are some of the arguments in support of this view:
1. A rise in monetary policy interest rates would help to control demand for credit, softens the growth of the
money supply and therefore helps to control demand-pull inflation especially when unemployment is low.
2. Increased mortgage rates may cause a slowdown in house price inflation and therefore help to make property
more affordable over time especially for hard-pressed young families who struggle to rent as well.
3. Higher interest rates will increase the return to saving – raising effective disposable incomes for retirees.
4. Higher interest rates reduce the risk of mal investment by business that only goes ahead because of the cheap
cost of capital.
5. Interest rates need to rise moderately now so that central banks can cut them in the event of a negative
external shock. They need to give themselves some leeway when the economy next experiences a recession.

Risks from raising interest rates

• High levels of unsecured debt – there is a risk of a significant slowdown in consumption if retail credit becomes
more expensive to service e.g. expensive credit cards. In the UK consumer credit is well above £200 billion.
• Higher interest rates might choke off business investment e.g. in new house-building and renewable energy
capacity.
• A rise in interest rates might cause the sterling exchange rate to appreciate thus making exports less
competitive, leading to an export slowdown and a worsening external deficit on the current account.
• Higher interest rates make government debt more expensive.
• Higher interest rates might lead to an economic slowdown which could hit share prices, pension fund assets
and dividend incomes.

Economics of a liquidity trap

A liquidity trap occurs when the nominal (or money) interest rate is close or equal to zero, and central banks find that
they have run out of room to stimulate aggregate demand during a slowdown or a recession.

Why might a liquidity trap happen?

• Risk averse banks
o Required to hold more capital
o Charging a risk premium on new loans especially to business customers
• Private sector businesses and consumers
o Low on confidence / animal spirits
o Focused on cutting their debt rather than taking out new loans

How to overcome a liquidity trap:

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 Fiscal policy may become more
important e.g. running a larger budget Central banks may supply the financial
deficit to lift aggregate demand through markets with extra liquidity e.g. via QE to
the circular flow and increase the money encourage them to lend to each other
supply. again and increase the flow of funds
available for borrowers

Central banks may opt to use negative Central banks and their governments
interest rates in a bid to reduce real may decide to switch to a managed
interest rates and encourage more floating exchange rate to seek a
borrowing and saving competitive depreciation

Coronavirus update: Will more countries move to negative interest rates to counter the global downturn?
The effective lower bound (ELB) is a term associated with the handling of monetary policy by a nation's central bank. ELB refers to
the point at which further cuts in the main monetary policy interest rate no longer provide stimulus to aggregate demand and GDP or
at which adverse effects, such as in the financial sector, can arise. The equilibrium interest rate is the interest rate at which
monetary policy is neither expansionary nor contractionary for a nation's economy. For many countries in recent years and especially
in the aftermath of the 2007-2010 Global Financial crisis, policy interest rates have been set well below the equilibrium interest rate
to provide support to demand, output and jobs and reduce the risks of deflation. Some central banks (including Denmark, Sweden
and Switzerland) have cut their policy interest rates below zero - i.e. they have moved to negative interest rates. The UK Bank of
England's latest analysis suggests that negative interest rates would not be an effective way of stimulating demand during a
downturn, so they prefer to keep their own monetary policy interest rate at a positive level (0.1%) but only just above zero.

Quantitative easing (QE)

What is quantitative easing?
• One of the main aims of quantitative easing is to increase the supply of money available for banks to lend.
• It is an alternative strategy to that of cutting interest rates.
• The Bank of England’s MPC’s quantitative easing programme, where the Bank creates new money to buy
financial assets totalled £445 billion of assets in August 2019 - £435 billions of which are government bonds
and £10 billions of commercial debt.

How does QE operate?

• QE involves the introduction of new money into the national supply by a central bank.
• In the UK the Bank of England creates new money (electronically) to buy assets (mainly bonds) from insurance
companies, pension funds and commercial banks.
• Increased demand for government bonds causes an increase in the market price of bonds and therefore
causes their price to rise.
• A higher bond price causes a fall in the yield on a bond (this is because there is an inverse relationship between
bond prices and yields).
• Those who have sold their bonds may use the extra funds/cash to buy assets with higher yields such as shares
of listed businesses and corporate bonds.
• Commercial banks receive cash, and this increases their liquidity. This may encourage them to lend out more
money.

As a result of quantitative easing, the assets on the balance sheet of the Bank of England have risen appreciably.

Coronavirus update: Bank of England expands their programme of quantitative easing (QE)
On 19th March, the Bank of England’s Monetary Policy Committee responded to the deepening recession brought about by the
pandemic by expanded its quantitative easing (QE) programme of bond purchases by £200 billion, taking the total value of assets it
can own to £645 billion. On 18 June, the MPC expanded QE by a further £100 billion, taking the total to £745 billion. Monetary policy
interest rates were cut in two stages from 0.75% to 0.1% - the lowest they have ever been.

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Total assets of the central bank in the United Kingdom from 2002 to 2017 (in billion U.S. dollars)

Total assets of the central bank in the United Kingdom (UK) from 2002 to 2017 (in billion U.S. dollars)
800.
700.
600.
500.
400.
300.
200.
100.
0.
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Summary of the main channels through which quantitative easing is supposed to work:
1. Wealth effect - lower yields (interest rates) lead to higher share and bond prices.
2. Borrowing cost effect - QE lowers the interest rate on long term debt such as bonds and mortgages.
3. Lending effect - QE increases the liquidity of banks and increased lending from banks lifts incomes and
spending in the economy.
4. Currency effect - lower interest rates has the side effect of causing the exchange rate to weaken (a
depreciation) which helps exports.

Exam hints:
Quantitative easing is a complex topic. Here are two key takeaway points:
1/ Buying government bonds raises their price and, in doing so, drives down the yield, or interest rate, they offer.
2/ Replacing government bonds with cash in the economy increases liquidity.

Arguments in favour of quantitative easing

• QE gives a central bank an extra tool of monetary policy besides changing interest rates.
• Increasing the size of the monetary base helps to lower the threat of price deflation. Without QE, the fall in
real GDP in the UK and other countries in 2009 would have been deeper & the rise in unemployment greater.
• Lower long-term interest rates have kept business confidence higher and given the commercial banking
system extra deposits to use for lending to those who need to borrow.
• QE can lead to a depreciation of a country’s exchange rate which then helps to improve the price/cost
competitiveness of export industries, adding to aggregate demand.

According to the UK Bank of England:

“Monetary easing (including lower interest rates and QE) led to lower unemployment and higher wages than would
have otherwise been the case, which particularly benefited younger age groups because they are more likely to work
than older groups and because their job prospects tend to be more pro-cyclical.”

Source: www.bankofengland.co.uk/-/media/boe/files/working-paper/2018/the-distributional-impact-of-monetary-policy-easing-in-the-uk-between-
2008-and-2014.pdf

Criticisms of quantitative easing (with specific reference to the UK economy)

1. Ultra-low interest rates can distort the allocation of capital and help keep alive zombie companies who might
not have survived with normal levels of interest rates (note: this is a key criticism of Hayekian/Austrian school).
2. QE has contributed to a surge in share prices and property values, the latter has worsened housing
affordability for millions of people and contributed to increase in rents which has worsened the geographical
immobility of labour.
3. QE has done little to cause an increase in bank lending to businesses, many commercial banks have become
more risk averse and charge higher interest rates to business customers.
4. QE has contributed to a decade of ultra-low interest rates which has been bad news for millions of people who
rely on interest from their savings. The real interest rate for many savers has been negative for over ten years.
5. Low interest rates and bond yields are a worry for pension fund investors because they worsen their deficits. If
companies must pay more into their employee pension schemes, they therefore have less money to spend on
investment which could harm productivity growth in the long run.

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Exam context: What are zombie firms?
Zombie firms are declining businesses deemed unable to cover the cost of paying existing interest payments on debt from their
current profits over an extended period. Some economists argue that zombie firms have become more numerous because of
persistently low interest rates in the financial system and the wide range of government subsidies and other financial support
(including bailouts) to firms designed to keep them going. Zombie firms are widely considered to be a drag on the economy.

Regulation of the Financial System

How are we to safeguard the financial system to ensure that another crisis does not arise in the future? Regulation of
financial markets attempts to overcome one or more market failures. Since the Global Financial Crisis, there has been
a significant increase in financial regulation although a number of commentators argue that there have been
insufficient structural reforms of the industry and that risks remain of another financial crisis in the years ahead linked
especially to high levels of private sector debt held by businesses and households.

Who are the main regulators of the UK financial system?

• Financial Policy Committee (FPC)
• Prudential Regulation Authority (PRA)
• Financial Conduct Authority (FCA)
• Competition and Markets Authority (CMA)

What are the main aims of financial market regulation?

1. Protect against the consequences of market failure:
a. Protect the interest of consumers.
b. Limit the monopoly power of commercial banks by encouraging increased competition.
c. Protect borrowers from excessively high interest rates on loans e.g. on unsecured credit.
d. Improved access to affordable and basic financial services – this is key for growth & development and
prevention of poverty in many countries.
e. Balance the interests of uninformed consumers with sophisticated sellers of financial services (i.e.
address problems arising from information asymmetry).
2. Encourage confidence in the economy & government:
a. Promote capital investment and sustainable long run growth.
b. Support trust in the banking system so that people and businesses are willing to save.
3. Allow the Central Bank (e.g. the Bank of England) to perform its other roles such as lender of last resort:
a. Prevent/mitigate systemic risk within financial markets that might damage the economy.

Financial Policy Committee of the Bank of England – “macro prudential regulation”

• The FPC’s main role is to identify, monitor, and take actions to remove or reduce risks that threaten the
resilience of the UK financial system as a whole.
• The FPC publishes a Financial Stability Report identifying key threats to the stability of the UK financial system.
• The FPC has the power to instruct commercial banks to change their capital reserve ratios.
• When the FPC decide that the risks to the financial system are growing, they may tell commercial banks and
other lenders to increase their capital buffers to help absorb unexpected losses on their assets (bad debts etc.)
• Capital buffers are part of “macro-prudential policy” - prudent means being careful at times of uncertainty.

UK Prudential Regulation Authority (PRA) – “micro prudential regulation”

• The PRA is part of the Bank of England and is responsible for the prudential regulation and supervision of
around 1,700 banks, building societies, credit unions, insurers and major investment firms.
• The PRA has a particular focus on the solvency of specific financial markets such as:
o Insurance providers
o Buy-to-let mortgage lenders
o Credit unions
o Other specialist lenders

Examples of regulation in financial markets

Liquidity ratios
• A liquidity ratio is the ratio of liquid assets held by a bank on their balance sheet to their overall assets.
• Commercial banks need to hold enough liquidity to cover expected demands from their depositors.

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 • In the wake of the Global Financial Crisis the Basel Agreement require commercial banks to keep enough liquid
assets, such as cash and bonds, to get through a 30-day market crisis.
• A liquidity ratio may refer to a reserve assets ratio for a bank which sets the minimum liquid reserves that a
bank must maintain in the event of a sudden increase in withdrawals.
• Liquid Asset Ratio = Cash & balances with central banks + government bonds / divided by a bank’s total assets.

Capital ratios
• A commercial bank's capital ratio measures the funds it has in reserve against the riskier assets it holds that
could be vulnerable in the event of a crisis.
• Banks must maintain sufficient capital which includes money raised from selling new shares to investors and
their retained earnings (i.e. non-distributed profits).

Counter-cyclical capital buffers for banks

Commercial banks are required to hold capital in the form of buffers which can be used to absorb losses during an
economic downturn, enabling them to continue lending to the economy. Without these buffers, banks are more likely
to cut back lending in the face of losses, making any downturn worse. The counter cyclical capital buffer rate for the UK
banking system is currently set at 1%. The FPC can raise this when financial risks are rising and relax it when financial
risks are easing. Counter-cyclical buffers can be summarised as following:
• Upswing in credit cycle – commercial banks are required to build up extra capital reserves.
• Downswing in credit cycle – commercial banks have more capital to help absorb losses.

Macro and micro prudential policies

Since the global financial crisis, regulators have placed increased emphasis on prudential regulation – i.e. putting in
place safeguards for the stability of the financial system

• Micro-prudential involves stronger regulation of individual financial firms such as commercial banks, payday
lenders and insurance companies. It seeks to protect individual depositors / borrowers.
• Macro-prudential regulation seeks to safeguard the financial system as a whole i.e. protect against systemic
risk. Macro-prudential seeks to make the system more resilient.

Regulation through leverage ratios

• The leverage ratio is an indicator of the ability of a bank or building society to absorb losses.
• Leverage ratio = Capital / Exposures
• The leverage ratio refers to the share of the total value of a firm’s assets and its other commitments (referred
to as ‘exposures’) that is funded with capital capable of absorbing losses while a firm is a ‘going concern’.
• The lower the leverage ratio, the more that a bank or building society relies on debt to fund their activities.
• In 2015, the FPC directed the Prudential Regulation Authority (PRA) to require each major UK commercial bank
and building society to meet a leverage ratio requirement and hold buffers over that requirement.
• The FPC have introduced a mortgage loan to income (LTI) cap which limits the number of mortgages extended
at LTI ratios of 4.5 or higher to 15% of a lender’s new mortgage lending. The proportion of high loan-to-income
mortgages that banks and building societies can underwrite is restricted to 15% of new mortgages.

Stress tests for commercial banks

Stress tests assess commercial banks’ ability not just to withstand severe shocks, but to maintain the supply of credit to
the real economy under severe pressure. Stress tests use tail-end risk events i.e. economic outcomes that lie well
outside the mainstream forecasts. A failure to adequately insure against tail-end risk was a major reason behind the
severity of the global financial crisis a decade ago.

The 2018 UK financial markets stress scenario was more severe than the global financial crisis. In the stress test, UK
GDP fell by 4.7%, the UK unemployment rate rose to 9.5%, UK residential property prices fell by 33% and UK
commercial real estate prices fell by 40%. The scenario included a sudden loss of overseas investor appetite for UK
assets, a 27% fall in the sterling exchange rate index and Bank Rate rising to 4%. (Source: FPC Report, July 2019)

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Key summary of financial market failures & examples of interventions in the UK

Financial market failure Current examples of interventions (including regulations) designed to address
the causes and consequences of market failure

Externalities arising from financial Depositor protection for families with savings
instability Increased capital requirements for commercial banks
Stress tests for commercial banks and other financial businesses
Limits to highly-leverage mortgage lending (LTV ratios)

Herd behaviour and speculative Financial Policy Committee created to oversee financial stability
bubbles in financial markets Monetary Policy Committee can raise interest rates to reduce the risk of an
unsustainable housing / asset price boom
Possible regulation of use of volatile crypto currencies
Market rigging / monopoly power of Tougher competition policy for anti-competitive behaviour
the banks Price cap on interest rates charged by pay-day lending companies
More licences to challenger banks to improve contestability

Asymmetric information and Penalties / compensation for miss-selling of PPI

complexity of financial products Improved financial literacy education in schools and colleges
Auto-enrolment in workplace pensions (mandated choice)

4.5.1 Public expenditure

Key specification content:
• Distinction between capital expenditure, current expenditure and transfer payments
• Reasons for the changing size and composition of public expenditure in a global context
• Significance of differing levels of public expenditure as a proportion of GDP on:
o Productivity and growth
o Living standards
o Crowding out
o Level of taxation
o Equality

Exam hint:
Students should remember that current and capital spending by the government will have different effects on the economy –
current spending is likely to affect AD alone whereas capital spending is likely to affect both AD and LRAS.

Government spending in the UK

Transfer Payments Recurring spending Investment Projects

Welfare Spending Public Services State Investment

The UK government expects to spend £813 billion in 2018-19. Social protection, health and education receive the
largest annual amounts. In 2017-18, social protection accounted for £268 billions of total government spending, health
£146 billion, and education £89 billion.

Current and capital spending

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Government spending is split into two categories based on whether the money is spent on an asset that lasts a number
of years (such as a new building or vehicle) or is spent on things that are used up (like salaries of civil servants or
teachers and nurses). The former is “capital” spending, and the latter as either “resource” or “current” spending.

Examples of current spending

Salaries of NHS Drugs used in health Road maintenance Army logistics supplies
employees care budget

Examples of capital spending

Construction of new New equipment in the Flood defence schemes Extra defence
motorways and bridges NHS equipment

Significance of government spending

• Government spending is a key component of aggregate demand.
• State spending can have a regional economic impact e.g. from spending on regional infrastructure projects.
• Important in providing public & merit goods to the wider population.
• Can help to achieve greater equity in society.

How government spending can affect household incomes:

• Welfare state transfers:
o Universal child benefits / unemployment benefit
o Public (state) pensions
o Targeted welfare payments - linked to income
• State-provided services (which offer “in-kind benefits” to people):
o Education – helps to reduce inequality of market incomes
o Health care – state provided health services
o Social housing e.g. Provided by local authorities
o Employment training

What are the Justifications for Government Spending?

1. To provide a socially efficient level of public goods and merit goods and overcome market failures:
a. Public goods and merit goods tend to be under-provided by the private sector
b. Improved and affordable access to education, health, housing and other public services can help
to improve human capital, raise productivity and generate gains for society as a whole
2. To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society –
this is part of the process of redistributing income and wealth. Government spending has an important
role to play in controlling / reducing the level of relative poverty.
3. To provide necessary infrastructure via capital spending on transport, education and health facilities – an
important component of a country’s long run aggregate supply.
4. Government spending can be used to manage the level and growth of AD to meet macroeconomic policy
objectives such as low inflation and higher levels of employment.
5. Government spending can be justified as a way of promoting equity.
6. Well-targeted and high value for money public spending is a catalyst for improving economic efficiency
and competitiveness e.g. from infrastructure projects.

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Free Market Agenda on the Size of Government
• Free market economists are sceptical of the impact of government spending in improving the supply-side
• They argue that lower taxation and tight control of government spending and borrowing is required to allow
the private sector of the economy to flourish (this is associated with the crowding-out theory)
• They believe in a smaller sized state sector so that in the long run, the overall burden of taxation can come
down and thus allow the private sector of the economy to grow and flourish.

Government spending and taxation in the UK over recent years

Revenue Spending

1000
Revenue / Spending in billion

900

800
pounds

700

600

500
2012 2013 2014 2015 2016 2017 2018* 2019* 2020* 2021* 2022*

The gap between total government spending and tax revenue shows the budget deficit if G>T or a surplus if G<T.

Crowding Out Theory

What is crowding-out?
The crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources
from the private sector to the public sector where productivity might be lower. It can lead to higher taxes and interest
rates which then squeezes profits, investment and employment in the private sector.

Increased government borrowing may lead to higher demand for loanable funds and therefore a rise in market interest
rates e.g. on bonds. This might then increase borrowing costs for private sector businesses.

Evaluating the Crowding Out Theory

1. The probability of 100% crowding-out is remote, especially if an economy is operating below its capacity and if
there is a plentiful supply of saving available to purchase newly issued state debt.
2. Keynesian economists are opposed to fiscal austerity and argue instead that fiscal deficits crowd-in private
sector demand and investment.
3. Well-targeted, timely and temporary increases in government spending can absorb under-utilized capacity and
provide a strong positive multiplier effect that eventually generates extra tax revenue.
4. Another criticism of the basic crowding-out theory is that the available supply of loanable funds is not limited
to domestic sources, external finance is available from other countries.

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What is crowding-in?
When an increase in government spending/investment leads to an expansion of economic activity (real GDP) which in
turn incentivizes private sector businesses to raise their own levels of capital investment and employment. Crowding-in
is a view supported by Keynesian economists.

Fiscal austerity – macro and micro effects of cuts in government spending

Micro impacts:
• Output, jobs and profits in construction, transport & defence sectors.
• Effects on real income and relative poverty of households.
• Effective demand for goods and services e.g. welfare caps might change the pattern of demand for goods and
services.
• Cuts in pension spending might lead some people to delay their retirement.

Macro impacts:
• Negative multiplier effects of cuts in public sector spending and employment.
• Lower fiscal deficit might help investor confidence / attract investment.
• Risks of deflationary pressures if cutting spending creates excess capacity (negative output gap).
• Bank of England more likely to keep interest rates at very low levels.

4.5 2 Taxation
Key specification content:
• Distinction between progressive, proportional and regressive taxes
• Economic effects of changes in direct and indirect tax rates on other variables:
o Incentives to work, tax revenues: the Laffer curve
o Income distribution
o Real output and employment, the price level (e.g. CPI)
o The trade balance (X-M) and FDI flows

Direct and Indirect Taxes

Direct taxes
• Direct taxation is levied on income, wealth and profit.
• Direct taxes include income tax, inheritance tax, national insurance contributions, capital gains tax, and
corporation tax (a tax on business profits).
• The burden of a direct tax cannot be passed on to someone else.

Indirect taxes
• Indirect taxes are usually taxes on spending.
• Examples of indirect taxes include excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on
many different goods and services together with the sugar tax.
• Producers may be able to pass on an indirect tax – depending on price elasticity of demand and supply.

Total tax revenues for the UK government (£ billion)

Tax revenues
700.
569.3 594.3
600.
515.3 533.7
500. 456.2 445.5 414.9 453.6 472.3 473.8 493.6
347.9 402.9 428.6
400. 375.8
315.6 321.7 324.7
300.
200.
100.
0.
2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2017/18*

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Exam Hint: Students often write incorrectly about progressive and regressive taxes. In both cases it is likely that the amount of
revenue generated from each type of tax by high earners will be higher. It is vital that students consider the proportion of income
spent in each category of tax.

Progressive Taxes
What are progressive taxes?
• With a progressive tax, the marginal rate of tax (MRT) rises as income rises.
• As people earn more, the rate of tax on each extra pound goes up. This increases the average rate of tax.
• Income tax in the UK is a progressive tax:
• Income tax on earned income is charged at three rates: the basic rate, the higher rate and the additional rate.
• For 2019-20 these rates are 20%, 40% and 45% respectively.
o Personal tax allowance (zero tax) up to £12,500
o Basic rate taxed on taxable income between £12,501 and £50,000
o Higher tax taxed on taxable income between £50,001 to £150,000
o Additional 45% marginal tax rate on any taxable income in excess of £150,000
(Note: Income tax rates are slightly different in Scotland)

The burden of income tax on households in different quintiles is shown in the table below:

Percentage of Gross Income taken by different taxes in the UK in 2014

Lowest 20% of 2nd Quintile 3rd Quintile 4th Quintile Highest 20% of All households
Income Income
Income Tax 2.5 4.4 8.2 11.2 16.9 11.8

Regressive Taxes
What are regressive taxes?
• With a regressive tax, the rate of tax paid falls as incomes rise – I.e. the average rate of tax is lower for people
on higher incomes. Examples include: Duties on tobacco and alcohol.
• A tax is said to be regressive when low income earners pay a higher proportion or percentage of their income
in tax than high income earners.

Consider data shown in the table which indicates that VAT is regressive as are indirect taxes when taken together.

Percentage of Gross Income taken by different taxes in the UK in 2014

Lowest 20% of Income 2nd Quintile 3rd Quintile 4th Quintile Highest 20% of Income All people
VAT 11.0 7.9 7.7 7.0 5.5 6.8
Duty on alcohol 1.5 1.0 1.0 0.9 0.7 0.9
Duty on tobacco 2.8 1.7 1.3 0.6 0.3 0.8
All indirect taxes 28.1 19.1 17.8 15.3 11.3 15.3

The Laffer Curve

What is the Laffer Curve?
• It is a (supposed) relationship between economic activity and the rate of taxation which suggests there is an
optimum tax rate which maximises total tax revenue.
• Why might total tax revenues fall if the tax rate increases?
o Increased rates of tax avoidance – higher taxes create a greater incentive to seek out tax relief, make
max use of tax allowances.
o Greater incentive to evade taxes (which is illegal) – i.e. non–declaration of income and wealth.
o Possible disincentive effects in the labour market – depending on which taxes have been increased.
o Possible “brain drain” effects – including the loss of highly skilled and high-income taxpayers.

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Evaluation of the Laffer Curve concept
1. Lower top rate taxes might increase income inequality.
2. Little evidence that high top rates of income tax is a barrier to inward migration of skilled labour.
3. Many people are on fixed hours / zero-hour contracts – so tax rates may have little impact on work incentives.
4. Are we actually more motivated to work if income tax falls? For some people, tax cuts will cause them to take
more leisure time instead of work – leading to a backward bending labour supply curve effect – especially at
higher wages/earnings.
5. There is a Keynesian explanation for some aspects of the Laffer Curve – cuts in direct and indirect taxes
increase real disposable income and therefore lead to higher consumer spending and aggregate demand.

Taxation and aggregate demand

• Changes in tax rates and tax allowances have direct and indirect effects on the level/growth of AD
• Changes in income tax and national insurance have a direct effect on people’s disposable incomes
• Changes in corporation tax affect the post-tax profit available for businesses to invest
• Changes in employers’ national insurance affect the cost of employing extra workers in the labour market
• A change in value added tax brings about changes in retail prices and affects the real incomes of consumers

Taxation and aggregate supply

• Changes in tax rates and tax allowances have a direct and indirect effect on SRAS and LRAS.
• Changes in VAT affect business costs e.g. the VAT applied when buying component parts / supplies.
• Changes in direct taxes can influence work incentives.
• Changes in business taxes might affect the level of foreign direct investment into a country.
• Taxes can affect the incentive to start a business or to spend money on research and development.

Chain of reasoning and evaluation – impact of cuts in corporation tax

Increase in post-tax
Businesses get to keep a
Government cuts the profitability may lead to
larger percentage of
rate of corporation tax a rise in planned
their operating profits
investment

Increased capital Creates a positive

Investment can be by
spending is an injection multiplier effect on
both domestic and
into the circular flow demand, output and
overseas businesses
model employment

Evaluation:
• Impact depends on the scale of the tax cut and whether it is long-lasting or considered to be a temporary
measure.

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 • Many factors affect capital investment e.g. the pace of technological change and strength of market
competition.
• Some extra investment may lead to a loss of jobs through capital-labour substitution effects.

Analysis of the possible impact of a rise in the standard rate of VAT from 20% to 25%

Macroeconomic Objective Comment on the effect of a rise in VAT

Inflation Higher in short run as business pass on tax
Economic growth Slower as real incomes and demand falls
Unemployment Higher if aggregate demand weakens
Balance of trade in goods & services Improved – falling incomes may cause demand for imports to contract
Spare capacity in the economy Rising spare capacity from weaker demand
Business investment Decline if businesses are hit by lower profits and weaker consumer spending
Government fiscal (budget) balance Short run improvement from higher taxes but risk of falling revenues in medium term

4.5.3 Public sector finances

Key specification content:
• Distinction between automatic stabilisers and discretionary fiscal policy
• Distinction between a fiscal deficit and the national debt
• Distinction between structural and cyclical deficits
• Factors influencing the size of fiscal deficits
• Factors influencing the size of national debts
• The significance of the size of fiscal deficits and national debts

Fiscal policy is an important instrument for a government wanting to manage the level of and rate of growth of
aggregate demand in order perhaps to reduce cyclical fluctuations in output and employment.

Automatic stabilisers and discretionary fiscal policy

• Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending – for
example, extra capital spending on roads or more resources into the NHS.
• Automatic stabilisers are changes in tax revenues and government spending that come about automatically as
an economy moves through the business cycle.

Explanations for automatic stabilisers:

1. Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which takes
money out of the circular flow of income and spending.
2. Welfare spending: A growing economy means that the government does not have to spend as much on
means-tested welfare benefits such as income support and unemployment benefits.
3. Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of money
from the circular flow. Conversely during a slowdown or a recession, the government normally ends up
running a larger budget deficit During a recession, revenue is likely to be lower due to less income earned,
less profits made and fewer goods being bought and at the same time government expenditure on
transfer payments e.g. income support and unemployment benefit.

Government Borrowing and Bond Interest Rates

When a government borrows it issues debt in the form of bonds. The yield on a bond is the interest rate paid on state
borrowing. Purchasers of British government bonds for example include pension funds, insurance companies and
overseas investors. The percentage yield on sovereign (government) debt has been low in recent years for countries
such as the UK and Germany but higher for nations such as Greece which has had several emergency bailouts in recent
times.

Distinction between fiscal deficit and the national debt

What is government borrowing?
Public sector borrowing is the amount the government must borrow each year to finance their spending.

What is national debt?

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Public sector debt is a measure of the accumulated national debt owed by the government sector.

Public sector debt

Public sector debt is owed by central and local government and by state-owned corporations.

A government runs a fiscal (budget) deficit when total government spending exceeds revenues from taxation over the
course of a year. The chart below tracks changes in government spending and tax revenues for the UK.

UK Government Spending and Taxation as a % of GDP

46.0
44.0
42.0
40.0
38.0
36.0
34.0
32.0
30.0

Taxation Government spending

The UK Fiscal Balance

It is normal for the UK government to run a budget deficit each year. Indeed, since 1970/71, the government has had a
surplus in only six years. The annual average budget deficit has been 3.3% of national income since 1970.

Budget (fiscal) balance in the United Kingdom as a % of GDP, 2020-21 forecasts are from the IMF
0.
-2.
-2.46 -2.22 -2.1
-4. -3.35
-6. -4.59
-5.53 -5.56
-8. -6.7
-7.51 -7.64
-10. -9.28
-10.08
-12.

-14. -12.7
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Distinction between structural and cyclical deficits

The size of the fiscal deficit is influenced by the current state of the economy:
• During an economic boom, when real GDP is expanding, and the economy is operating above its potential (i.e.
there is a positive output gap), then tax receipts are relatively high and spending on unemployment benefit is
low. This reduces the level of government borrowing
• The reverse happens in a recession when borrowing tends to be high. This is because a recession leads to rising
unemployment and falling real incomes which leads to an increase in state spending on welfare assistance

The structural fiscal deficit is that part of the deficit that is not related to the state of the economy. This part of the
deficit will not disappear when the economy recovers from a recession. It thus gives a better guide to the underlying
level of the deficit than the headline figure. The structural deficit cannot be directly measured so it has to be
estimated.

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Factors influencing the size of fiscal deficits
• Cyclical factors
o Rate of unemployment – higher unemployment reduces tax revenues.
o Consumer spending – strong consumer spending increases VAT revenue.
o Business profits – rising business profits increases revenue from corporation tax.
o Automatic stabilisers – in an economic downturn, the fiscal deficit rises as G increases and T falls.
• Long run factors
o Size of the welfare state – e.g. the scale and breadth of welfare assistance available.
o Relative level of welfare benefits e.g. compared to incomes.
o Demographic factors e.g. ageing population, the impact of net inward migration of labour.
o Size of the tax base and tax rates – i.e. is an economy moving towards a lower or higher tax burden.
o Efficiency of the public sector - e.g. the productivity of workers in the NHS and education in delivering
services.

Factors influencing the size of national debts

Government debt in the United Kingdom as a % share of GDP 1994-2019, 2020-21 forecast from the IMF
120
100
80
60
40
20
0

In August 2020, new data showed that public sector net debt in the UK exceeded £2 trillion for the first time and was
equivalent to 100.5% of GDP. A year ago, at the end of July 2019, the debt-to-GDP ratio was 80.1% of GDP. The debt-
to-GDP ratio for the UK last exceeded 100% in the financial year ending March 1963. (Source: ONS Statistics)

Scale of government spending

• Current spending on public services such as education and health care
• Investment spending e.g. on infrastructure in sectors such as transport, health, education & environment
• Spending on providing social welfare including universal credit and the state pension

Level of tax revenues

• Size of the tax base e.g. how many people in work and their incomes. How many businesses are profitable?
• Efficiency of tax collection, scale of tax avoidance & evasion.

Cost of servicing debt + state bailouts

• Yield on new and existing government bonds.
• Willingness of lenders to give the government new credit.
• Government rescue of businesses can add to public sector debt.

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Countries with the highest public (national) debt in 2019

Countries with the highest public debt 2019 (% of GDP)

United States 106.22

Bhutan 108.64
Mozambique 108.82
Singapore 114.1
Barbados 115.41
Portugal 117.55
Cabo Verde 123.47
Italy 133.15
Lebanon 155.13
Eritrea 165.11
Greece 176.64
Sudan 207
Japan 237.69
0. 50. 100. 150. 200. 250.

Countries with the lowest public (national) debt in 2019

Countries with the lowest national debt 2019 (% of GDP)

Russia 16.49
Kuwait 15.25
Democratic Republic of the Congo 13.49
Botswana 12.31
Solomon Islands 10.91
Estonia 8.2
Afghanistan 7.55
Brunei Darussalam 2.8
Macao SAR 0
Hong Kong SAR 0
0 2 4 6 8 10 12 14 16 18

Significance of the size of fiscal deficits and national debts

Is a High Level of Government Debt Dangerous?
“A high level of government borrowing will result in money having to be spent repaying that debt. This can lead to both a reduction
in investment and a requirement on future generations to continue paying off these debts, which could in turn have a negative
impact on national well-being” (Source: ONS)

Public debt is the total stock of debt issued by a government yet to be re-paid – it is known as the National Debt.

Arguments that rising national debt creates economic problems:

1. High fiscal deficits cause rising debt interest payments
2. This interest burden has an opportunity cost for less interest on debt could free up extra spending on health
and education. In 2018/19, gross debt interest payments for the UK were forecast to be £53 billion
3. An increase in the national debt is likely to cause higher taxes in the future. This will cut the disposable
incomes of taxpayers and reduce growth in the private sector
4. It might be unfair if the rising tax burden falls more heavily on future generations of taxpayers rather than
people who benefit from government spending now.

Counter arguments – the case for government borrowing:

Since 1970, the UK has run a budget surplus in only six years – it is normal for the government to borrow money.
1. A rise in borrowing to fund extra government spending can have powerful effects on AD, output and
employment when an economy is operating below full capacity output
2. There is an automatic rise in the budget deficit to cushion the fall in AD caused by an external economic shock.
A higher fiscal deficit is needed to lift AD back towards pre-recession levels and support an economic recovery

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 3. If a fiscal stimulus works, then the budget deficit will improve as a result of higher tax revenues and reductions
in welfare spending. A growing economy helps to shrink debt as a percentage of GDP
4. It makes sense for a government to borrow money if interest rates are low and if the deficit is being used for
investment to improve a nation’s infrastructure to aid competitiveness. Borrowing to invest can bring about
much needed improvements in public services such as education, health, transport and social housing. It can
lead to an increase in long run aggregate supply and therefore support long-run economic growth

Bond yields, fiscal deficit and financing the national debt

Government bonds are fixed interest securities. This means that a government bond pays a fixed annual interest – this
is known as the coupon. The coupon (paid in £s, $s, Euros etc.) is fixed but the yield on a bond will vary.

The yield is effectively the interest rate on a bond and the yield will vary inversely with the market price of a bond.
• When bond prices are rising, the yield will fall
• When bond prices are falling, the yield will rise

Here is an example:
• When a 10-year bond has a market price of £5,000 and pays a fixed annual interest (coupon) of £200
• Then the yield = (£200 / £5,000) x 100% = 4%
• Consider what happens when the market price of the bond falls e.g. because of speculative selling of bonds by
investors
• Assume the bond price falls to £4,300
• The interest (coupon) on the bond remains fixed at £200
• Therefore, the yield on the bond = (£200 / £4,300) x 100% = 4.65%
• There is an inverse relationship between the market price of a bond and the yield on a bond
• When bond prices fall, then the yield on the bond increases

Bond Yields on Ten-Year UK Government Debt

10 Year UK Government Bond Yield (Per Cent)

7
6
5
4
3
2
1
0
1/1/00
7/1/00
1/1/01
7/1/01
1/1/02
7/1/02
1/1/03
7/1/03
1/1/04
7/1/04
1/1/05
7/1/05
1/1/06
7/1/06
1/1/07
7/1/07
1/1/08
7/1/08
1/1/09
7/1/09
1/1/10
7/1/10
1/1/11
7/1/11
1/1/12
7/1/12
1/1/13
7/1/13
1/1/14
7/1/14
1/1/15
7/1/15
1/1/16
7/1/16
1/1/17
7/1/17
1/1/18
7/1/18

We can see from the chart that the yield on UK government bonds has been declining over the last 18-20 years. Indeed,
despite a high level of national debt and continuing budget deficits, the nominal yield on 10-year bonds has been below
2 per cent since 2016. In this sense, the UK government can borrow cheaply if it wants to increase investment spending.
There is a strong overseas and domestic demand for government bonds and yields have fallen due to the programme of
quantitative easing by the Bank of England. QE involves the BoE buying government debt which leads to the market
price of debt rising and the yield on bonds falling.

Bond yields have dropped in many other countries including Germany, Spain and Japan. The drop in ten-year bond
yields for Greece is perhaps a reflection of an improved macroeconomic situation for a country that has suffered badly
from the financial crisis, very high unemployment and price deflation.

Exam hint:
Essay questions on fiscal policy are common, perhaps asking students to evaluate the extent to which running a fiscal/budget deficit
is a problem for an economy, or whether high government debt is a problem, or whether government debt / fiscal deficits should be
reduced. These are worth practicing, especially under timed conditions.

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4.5.4 Macroeconomic policies in a global context
Key specification content:
• Use of fiscal policy, monetary policy, exchange rate policy, supply-side policies and direct controls in different countries,
with specific reference to the impact of:
o Measures to reduce fiscal deficits and national debts
o Measures to reduce poverty and inequality
o Changes in interest rates and the supply of money
o Measures to increase international competitiveness
• Use and impact of macroeconomic policies to respond to external shocks to the global economy
• Measures to control global companies' (transnationals') operations:
o Regulation of transfer pricing
o Limits to government ability to control global companies
• Problems facing policymakers when applying policies:
o Inaccurate information
o Risks and uncertainties
o Inability to control external shocks

Fiscal Austerity
Fiscal austerity is the term used to describe policies designed to reduce the size of a government fiscal deficit and
eventually control / lower the size of the outstanding national debt. In the UK, austerity policies have been in place
since 2010 in the aftermath of the Global Financial Crisis. Austerity has been imposed in countries such as Greece and
Italy as part of the bailouts of national governments by the European Union and the International Monetary Fund.

To what extent is fiscal austerity helpful or, in contrast, damaging to a country’s economic performance?

Overview of policies to reduce a fiscal deficit

This can be achieved in a number of ways:
Cuts in government spending
• Controlling public sector pay including wage freezes or limiting annual pay awards to 1%
• Limiting welfare entitlement
• Privatisation of state assets so that a government no longer has to cover losses
• Reductions in the size and scale of government subsidies
Higher taxes
• Higher indirect taxes such as VAT rising to 20%
• Cutting tax allowances or ending certain tax reliefs
• Bringing in new taxes e.g. new environmental taxes or taxes on digital businesses
Supply-side policies to encourage growth
• This approach focuses on the argument that a growing and a more competitive economy will be a more
effective way of cutting the deficit and the debt in the long-term
• Stronger GDP growth increases tax revenues because the tax base widens, and people/businesses are earning
higher incomes and profits
• In a progressive tax system, rising incomes and higher prices will lead to a faster growth of tax revenues
• Growth cuts a deficit as a % of GDP because the denominator (GDP) has increased

Prior to the coronavirus pandemic, the UK government’s current fiscal mandate (strategy) had three key objectives:
• Cutting the structural budget deficit to below 2% of GDP in 2020/21
• The public sector debt-to-GDP ratio to be falling in 2020/21
• Keeping total welfare spending below a cap set in the Autumn 2017 Budget

Arguments in favour of fiscal austerity:

1. Reducing the budget deficit and the national debt is in the long run interests of economy – for example it helps
to keep UK taxes lower and can avoid the problem of the state sector crowding-out investment and growth in
the private sector
2. Shrinking state encourages private sector growth in the long run
3. There is a high opportunity cost from over £50 billion spent each year on debt interest
4. Cutting the fiscal deficit can improve investor confidence and might attract more FDI into the UK

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 5. The upturn of the economic cycle is time for government to borrow less – ahead of another downturn or
recession – it makes sense to be running stronger budget finances before the economy enters a cyclical
slowdown or downturn

Arguments against fiscal austerity:

1. Austerity is self-defeating especially if it leads to price deflation and lower employment, because this depresses
employment and investment which are vital to sustain tax revenues in the future
2. Government bond yields are low – the yield on ten-year government bonds is less than 2 per cent – so this is
an opportune a time to invest more because infrastructure investment will increase both AD and LRAS
3. Wrong to cut state spending when economy is in a liquidity trap (i.e. unresponsive to low interest rates)
4. Economic growth is needed to pay back the debt and fiscal austerity makes this harder to achieve
5. There are damaging social consequences from fiscal austerity – it risks increasing inequalities of income and
can be a factor in more families having to use food banks and borrowing at very high interest rates from
payday lenders
6. Pay freezes in the public sector have harmed recruitment and led to growing shortages of key workers in
education and healthcare. This leads to longer waiting times and threatens the delivery of important merit goods

The Keynesian View

Keynesian economists tend to favour the active use of fiscal policy as the may way of managing demand and economic
activity. They argue that the fiscal multiplier effects of increased government spending can be high, and that fiscal
policy is a powerful device for helping to stabilise confidence, demand, output and jobs especially after severe external
economic shocks.

The Keynesian Fiscal Multiplier

Despite the extraordinary increase in UK government borrowing since the start of the Great Shutdown of the economy
in March and April of 2020, most economists believe that a further fiscal stimulus will be needed to prevent the UK
experiencing a depression and mass unemployment. In this case, the concept of the fiscal multiplier becomes an
important part of the debate.

The fiscal multiplier estimates the final change in real national income (GDP) that results from an initial (exogenous)
change in government spending and/or revenue plans. For example, if a £5 billion increase in government spending on
flood defence leads to a £12 billion final increase in real GDP, then the fiscal multiplier = £12 billion / £5 billion = +2.4.

If the fiscal multiplier is a high positive number, then a well-timed fiscal stimulus might be highly effective in helping to
lift aggregate demand, production, incomes and jobs as an economy tries to recover from a deep recession / downturn.

The size of the fiscal multiplier depends on:

1. How the fiscal stimulus is financed e.g. via increased borrowing
2. Extent to which a stimulus leads to higher interest rates / inflation
3. Degree to which an economy is open to imports (M is a leakage)
4. Impact on consumer & business expectations and confidence
5. Marginal propensity to consume and save of households affected

Which stimulus policy might work best?

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Consider three examples of a fiscal stimulus that might be introduced as a measure to grow the UK economy out of
recession in the wake of the corona virus pandemic:

Stimulus policy Argument in favour Drawback / limitation

Increased infrastructure Creates 000’s of jobs in construction and Bigger projects may suffer delays and cost-
spending supply-chain industries. Impacts on both AD over runs
and LRAS
Cutting value added tax Reduces prices and increases real incomes for Jobs rather than prices are the main driver
consumers. Could be used to help tourism & of spending. Cutting income tax for poorer
hospitality families might be a more effective policy
Reducing employers’ national Reduces payroll costs for firms and helps keep Very expensive for the government.
insurance unemployment down. Targeted fiscal stimulus might be better
strategy

Policies to reduce poverty and inequality

It is widely believed that persistent and deep relative poverty is a major barrier to growth and development. Hence the
importance attached by many countries to introducing effective poverty-reduction strategies. These policies will vary
from country to country and it is important to consider where a nation is in their economic development when
assessing what is possible and the likely impact.

According to a report on poverty in the UK published by the Joseph Rowntree Foundation in 2017, “Poverty wastes
people’s potential, depriving our society and economy of the skills and talents of those who have valuable contributions
to make. An estimated £78bn of public spending is linked to dealing with poverty and its consequences. This includes
spending on healthcare, education, justice, child and adult social services.” Poverty and inequality are multi-
dimensional and has huge consequences for economic well-being and the scale and depth of mental health issues in
the UK.

Policies designed to reduce inequality of income and wealth

Welfare systems
• Direct cash transfers to poorer households – conditional cash transfers link cash benefits to households
dependent on certain actions e.g. having their children immunised or attending school regularly
• Measures to introduce a basic pensions system – which in theory would allow households to save more of
their disposable income or increase spending on necessities such as education or better health care
• Government subsidies for transport and childcare to increase labour market participation
• School feeding programmes in low and middle-income countries (an example of “benefits in kind)) which
generally benefit the poorest children
Labour market policies
• Employment protection including legal protections for workers wanting to be represented by a trade union.
• Minimum wage laws - offering a guaranteed pay floor for lower-paid workers.
• Trials to introduce a universal basic income.
• Incentives to improve business training / productivity which ultimately will increase productivity. Productivity
is the biggest single driver of improved real wages and higher per capital incomes over time.
Tax reforms
• Progressive taxes on the income and wealth of the rich.
• Taxing profits of businesses to fund state spending including measures to curb tax avoidance by transnational
corporations.

In many countries, the problem of working poverty has become more acute particularly in the decade or more since
the Global Financial Crisis. In the UK, people in work are increasingly likely to be in relative poverty (i.e. not earning
enough to take household income above 60 per cent of median income). This has been linked to the rapid rise of the
Gig Economy and the increasing monopsony power of major employers.

Globally, the percentage of people living in working poverty – defined broadly as earning less than $3.10 a day (PPP
adjusted) varies widely by region as shown in the table below. Nearly two-thirds of people in work in sub Saharan Africa
earn below this threshold.

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 Working poor at PPP $3.10 a day

(% of total employment)

Regions
Arab States 24.7
East Asia and the Pacific 13.8
Europe and Central Asia 4.1
Latin America and the Caribbean 8.8
South Asia 42.7
Sub-Saharan Africa 61.6

Least developed countries 64.2

World 26.5

Economics of a universal basic income

Could a universal basic income be a radical but effective approach to reducing poverty, especially in the face of
technology-driven unemployment?

• A Universal Basic Income (UBI) is when all adults receive a no-strings-attached amount of money from the
state to cover the basic cost of living.
• With a basic UBI, the set amount is paid to everyone, regardless of their income or wealth.
• Countries such as Kenya, India and Finland have been experimenting with a form of universal basic income
with mixed results thus far.
• In Stockton, California (USA), a city with above-average unemployment, the Mayor has introduced an
experiment to give 100 people $500 per month.
• The Alaska Permanent Fund, built from the state’s oil revenues, pays all adults and children a dividend each
year – in 2018, it was $1,600 (£1,230).

Advantages of a universal basic income

1. UBI would be a direct way of reducing absolute poverty & lifting personal freedom and security – reducing
exposure to high interest debt and risks of needing emergency foodbank support.
2. UBI seen by supporters as a progressive policy designed to reduce relative poverty – which avoids the stigma
attached to many means-tested welfare benefits.
3. It allows a government to cut welfare spending and reduce the complexity of the tax and welfare system to
reduce disincentives.
4. UBI is seen as way of getting money into the hands of the working poor and reducing poverty where the future
of work seems increasingly insecure e.g. from robots and artificial intelligence.
5. Creativity in the workplace might be improved as people may have greater income stability and be more
inclined to take risks.

Risks and drawbacks from a universal basic income

1. Affordability – would people give up their income tax allowance or would higher rate taxes rise?
2. Work incentives – does a basic income diminish or enhance the incentive to search for paid work and be
entrepreneurial?
3. Effectiveness – the Finnish experiment found an increase in well-being but little noticeable impact on
employment
4. Universality – would it genuinely be a universal basic income for all, or would there be some conditions
attached?
5. Opportunity cost – money invested in cash transfers cannot be invested elsewhere unless public
borrowing/debt rises too
6. Alternatives – which works best? Cash transfers or free public services such as childcare and transport?

Context: According to Professor Maitreesh Ghatak from the LSE, when cash transfers were given to ultra-poor women, some
managed to escape poverty while others did not. In such interventions, the quantity of capital is key (sufficient to buy a cow, for
example) but complementary assets, such as a way to store milk and transport it to market, are needed to take advantage of the
transfer and rise above the critical threshold for escaping poverty. Sox: VoxDev, July 2019.

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Policies to increase international competitiveness
This is an extremely broad topic covered in more detail in section 4.1.9

Overview of policies to improve competitiveness

• Improving the functioning of labour markets

o Investment in all levels of education and training including early years education and
technical/vocational courses for school and college leavers.
o Encouraging inward migration of skilled workers – some nations have chosen a points-based system
of immigration targeting skilled occupations where there are labour shortages.
o Improvements in management quality.
• Critical (Core) Infrastructure Investment
o Better motorways, ports, hi-speed rail, new sewers – infrastructure gaps can severely hamper
businesses.
o Investment in clean energy networks to help support sustainable growth.
o Communications e.g. super-fast broadband, 4G and 5G networks.
• Supporting Enterprise / Entrepreneurship
o Improved access to business finance e.g. for start-ups and small & medium-sized enterprises.
o Incentives for business innovation including lower taxation on profits from patented products.
o Reductions in business red tape.
• Macroeconomic Stability
o Maintaining low inflation / price stability to help confidence.
o A sustainable and more competitive banking system to improve the flow of finance for investment.
o A competitive exchange rate versus major trading partners – for some countries this has involved
moving towards managed floating exchange rates and/or a competitive devaluation of a fixed
exchange rate.

Broadly, policies to increase competitiveness can be divided between economists who favour a free-market approach –
focusing for example on lower taxes, less regulation and trade liberalisation. Contrasted with schools of thought that
make the case for selected government intervention in markets designed to address the market failures that can
worsen competitiveness.

World Competitiveness Rankings for 2018

Source: World Economic Forum
High income Ranking East Asian and Ranking Sub Saharan Ranking Latin Ranking
countries Pacific African America and
countries the
Caribbean

USA 1st Singapore 2nd Mauritius 49th Chile 33rd

Singapore 2nd Japan 5th South Africa 67th Mexico 46th
Germany 3rd Hong Kong 7th Seychelles 74th Uruguay 53rd
Switzerland 4th Taiwan 13 th Botswana 90th Costa Rica 55th

Policies to respond to external shocks in the global economy

What are external shocks?
Shocks are unexpected changes in the economy that can affect variables such as inflation and the growth rate of GDP.
In an inter-connected global economy, events in one part of the world can quickly affect many other countries. For
example, the global financial crisis (GFC) brought about recession in many countries and financial distress in many
regions. It led to a fall in FDI flows into poorer countries and increased pressure on governments in rich nations to cut
overseas aid budgets.

One distinction to make is between demand and supply-side shocks. Analysis of both encourages you to use the AD-AS
analysis (including the diagrams!) you will have developed as part of Theme 2 in Year 12 economics.

Demand-side Shocks

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 • Economic downturn / recession in a major trading partner
• Unexpected tax increases or cuts to government spending programmes
• Financial crisis causing bank lending /credit to fall and which spreads to more than one country/region
• Unexpected changes in monetary policy interest rates
• Significant job losses announced in a major industry

Supply-side Shocks
• Steep rise/fall in oil and gas prices or other commodities traded in the world economy
• Political turmoil / strikes
• Natural disasters causing a sharp fall in production and damage to infrastructure
• Unexpected breakthroughs in production technologies which can lead to unexpected gains in productivity
• Significant changes in levels of labour migration into/out of a country

Exam hint: A change in oil prices will have a complicated effect on the economies of different countries. Try to understand a little
about the economic context facing each country. For example, is a country a net importer or an exporter of oil and gas? What scope
do policymakers to change variables such as interest rates and taxation in response to an external shock?

Shocks can be positive (i.e. helpful in driving economic growth) and negative (e.g. a deep financial crisis which reduces
confidence, spending and investment)

When analysing the impact(s) of an external shock, always remember to go back to the main macroeconomic
objectives. Consider the likely impact on:
• Real GDP growth
• Inflation (demand-pull and cost-push)
• Unemployment
• Competitiveness
• The Trade Balance
• Government finances
• Possible impact on inequality

Policies to absorb the effects of an economic shock

Not every country has the ability to respond quickly and effectively to external shocks. Much depends on how severely
they are affected by economic events.
1. Floating exchange rates (i.e. is there scope for a depreciation?)
2. Freedom to set / adjust monetary policy when conditions change - does the central bank have autonomy to
change interest rates or bring in unconventional policies such as QE?
3. Geographically and occupationally mobile / flexible labour force - a more flexible labour force helps an
economy adjust to shocks that change the pattern of exports
4. Strong non-price competitiveness of domestic businesses - this helps make demand and output more resilient
to fluctuations in the global economy
5. A diversified economy that is not over reliant on a few sectors
6. Strong fiscal position (stabilisation funds) - e.g. strong finances give a government the scope to run a fiscal
stimulus when aggregate demand falls

Keynesian approach to external economic shocks

• Keynesians believe that free markets are volatile and not self-correcting in the event of an external shock
• The free-market system is prone to lengthy periods of recession & depression
• Economies can remain stuck in an “underemployment” equilibrium
• In a world of stagnation or depression, direct state intervention may be essential to restore confidence and lift
demand.
• Keynes was one of the first economists to criticise the economics profession for adhering to unrealistic
assumptions

Measures to combat the power of transnational corporations (TNCs)

Multinationals or transnationals are large businesses that operate in a number of countries. They often separate their
production between various locations or have their different divisions – Head Office and Administration, Research and
Development, Production, Assembly, Sales – separated around a continent or the globe.

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Transnational corporations (TNCs) have become increasingly significant in the global economy. Indeed, research
produced in 2016 by the World Bank found that nearly 70 of the world’s top 100 economies are corporations with
Walmart, Apple and Shell richer than Russia, Belgium and Sweden. TNCs have the effect of ‘grouping’ nations together
systematically through both their production and supply chains and via the different markets they serve with products.
For example, the UK and Malaysia are linked together by the TNC Dyson. The famous bagless vacuum cleaners are
designed and sold in the UK but manufactured in Malaysia.

What is the scale of tax avoidance?

An increasing number of transnational corporations come from emerging countries in recent years, much of the
attention has been on issues such as tax avoidance strategies of corporations from advanced nations. US firms booked
more profits in Ireland than in China, Japan, Germany, France & Mexico combined according to a 2018 paper on tax
havens and multinational activity published by Professor Gabriel Zucman published in 2018. The standard corporate tax
rate on profits in Ireland is 12% but, considering tax reliefs and allowances, the effective corporate tax rate in Ireland is
estimated to be just 5.6%.

The OECD estimates that between 4% and 10% of global corporate tax revenues, or between $100 billon and $240
billion, is lost each year due to tax avoidance and much of this revenue would have accrued to governments in
developing and emerging countries. Multinationals avoid nearly £6 billion a year in the UK according to Treasury
estimates. In 2018, the FT reported that multinationals are paying significantly lower tax rates than before the 2008
global financial crisis.

A major trend in the last decade is that many countries have lowered their main corporation tax rates (some see this as
a “race to the bottom”) to help them attract foreign direct investment whilst at the same time, taxation on personal
income has risen. This is a key reason why opposition to TNC activities in the global economy has cemented.

What is transfer pricing?

• Transfer pricing is known as profit shifting and it happens when a TNC moves the profits they have made from
subsidiaries in a high tax country to other subsidiaries in a lower tax nation.
• Usually transfer pricing happens when a TNC sets up an internal trade - for example a royalty for using a
trademark or a charge for using component parts which then affects the costs of each subsidy and helps to
ensure that lower profits are booked in the higher-tax economy.

Summary – methods used by large businesses to avoid paying tax

1. Reinvested revenue to achieve faster growth (Amazon is a good example) which then means less profits to be
taxed
2. Much of a company’s operating profit might be earned in foreign countries – they may “book” this in nations
where corporate tax rates are low e.g. Ireland
3. They take advantage of tax credits / rebates for research and development including investment in renewable
energy projects
4. They take advantage of schemes such as employee-share ownership schemes – the cost of which might be
then offset against their tax liability

Context: Tax avoidance in the UK betting industry

According to recent research, the UK betting company Bet365 paid an effective corporate tax rate of 12.7% on profits of £1.4bn in
last 2 years. 4 of 5 of its UK gambling licences are registered with companies incorporated in Gibraltar (10%) and Malta (5%). Britain's
gambling firms have many offshoots in tax havens and often pay less than the 19% UK corporation tax rate.

Context: Starbucks and tax avoidance

Starbucks’ UK-based European business paid £18.3m in tax to the UK government in 2019, while paying their parent company in
Seattle £348m in dividends collected from licensing its brand.

Key exam point: Large companies tend to pay less taxes on their profit than smaller companies. The ability to ability to fund their
own accounting departments to find ways of becoming more tax efficient can be seen an internal economy of scale.

Corporate tax avoidance – policies to reform and reduce tax avoidance

1. Diverted profit tax: Known as the "Google Tax” - the 25% rate tax will apply to a company's profits diverted
from the UK through complex arrangements.
2. Stronger audit procedures: This is used in Germany which has collected over Euro 64bn in extra revenue from
large multinationals over the last five years

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 3. Criminal sanctions for TNCs and their executives: This targets people who engage in tax evasion – personal
liability for shareholders & directors for missing tax
4. International (multilateral) agreement on corporation tax: Some governments want to introduce a standard
minimum tax rate on corporate profits across all of the advanced (OECD) countries.
5. New digital services taxes: This is for businesses such as Amazon, Apple, Netflix, Facebook and Google

Potential Benefits of TNCs for Host Countries

The potential benefits of TNCs on the economic performance of host countries include:
1. Provision of significant employment and training to the labour force in the host country.
2. Transfer of skills and expertise, helping to develop the quality of the host labour force.
3. TNCs add to the host country GDP through their spending, for example with local suppliers and through capital
investment.
4. Competition from MNCs acts as an incentive to domestic firms in the host country to improve their
competitiveness, perhaps by raising quality and/or efficiency.
5. TNCs extend consumer and business choice in the host country.
6. Profitable MNCs are a source of significant tax revenues for the host economy (for example on profits earned
as well as payroll and sales-related taxes).

Potential Drawbacks of TNCs on Host Countries

The potential drawbacks of TNCs on host countries include:
1. Domestic businesses may not be able to compete with MNCs and some will fail.
2. TNCs may not feel that they need to meet the host country expectations for acting ethically and/or in a socially
responsible way.
3. TNCs may be accused of imposing their culture on the host country, perhaps at the expense of the richness of
local culture.
4. Profits earned by TNCs may be remitted back to the TNC's base country o low tax haven rather than reinvested
in the host economy.
5. TNCs may make use of transfer pricing and other tax avoidance measures to significantly reduce the profits on
which they pay tax to the government in the host country.

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Exam Support

Theme 4 Revision Checklist

Globalisation
□ Characteristics of globalisation
□ Factors contributing to globalisation in the last 50 years
□ Impacts of globalisation and global companies on individual countries, governments, producers and consumers, workers
and the environment
□ Specialisation and trade including absolute and comparative advantage
□ Patterns of trade (both geographical and commodity pattern of trade)
□ Trading blocs and the World Trade Organisation (WTO)
□ Terms of trade
□ Free Trade Areas
□ Customs Unions
□ Single Markets (including the EU)
□ Monetary Unions (including Euro Zone)
□ Restrictions on free trade including import tariffs, quotas and other non-tariff barriers
□ Impact of protectionist policies on consumers, producers, governments, living standards, equality

Balance of payments
□ Components of the balance of payments: current account, capital account, financial account
□ Causes of deficits and surpluses on the current account
□ Measures to reduce a country's imbalance on the current account
□ Significance of global trade imbalances

Exchange rates
□ Floating exchange rates
□ Fixed exchange rates
□ Managed exchange rates
□ Factors influencing floating exchange rates
□ Competitive devaluation/depreciation of the currency and its consequences

International competitiveness
□ Measures of international competitiveness: Including relative unit labour costs
□ Factors influencing international competitiveness
□ Policies to improve competitiveness

Poverty and Inequality

□ Distinction between absolute poverty and relative poverty
□ Measures of absolute poverty and relative poverty
□ Causes of changes in absolute poverty and relative poverty
□ Distinction between wealth and income inequality
□ Measurements of income inequality:
□ Causes of income and wealth inequality within countries and between countries
□ Impact of economic change and development on inequality
□ Significance of capitalism for inequality

Emerging and Developing Countries

□ Measures of development (HDI & others)
□ Factors influencing growth and development
□ Strategies influencing growth and development
□ Trade liberalisation
□ Foreign direct investment
□ Privatisation
□ Human Capital investment
□ Microfinance
□ Buffer stock schemes
□ Infrastructure investment
□ Overseas aid
□ Debt relief
□ Role of World Bank
□ Role of International Monetary Fund

The Financial Sector

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 □ Roles of financial markets (bond, currency, equity and money markets)
□ Causes of financial instability
□ Market failure in the financial sector
□ Speculative bubbles
□ Herd behaviour
□ Externalities from financial market failure
□ Market rigging in financial markets
□ Role of central banks in financial markets
□ Policies to support financial stability

Role of the state in the macroeconomy

□ Public (government) expenditure
□ Crowding out theory
□ Taxation - Direct and Indirect taxes
□ Distinction between progressive, proportional and regressive taxes
□ Economic effects of changes in direct and indirect tax rates on other variables:
□ Distinction between automatic stabilisers and discretionary fiscal policy
□ Distinction between a fiscal deficit and the national debt
□ Distinction between structural and cyclical fiscal deficits
□ Factors influencing size of fiscal deficits
□ Factors influencing size of national debts
□ The significance of size of fiscal deficits and national debts

Macroeconomic policies in a global context

□ Use and impact of policies to respond to external shocks to the global economy
□ Use and impact of policies to reduce inequality
□ Measures to control global companies' (transnationals') operation

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