Question - 01 Discuss whether a devaluation causes inflation

A devaluation leads to a decline in the value of a currency making exports more competitive and imports more expensive. Inflation occurs when there is an increase in the general price level. A devaluation could cause inflation for 3 reasons. Firstly, there is likely to be an increase in AD. AD = C+I+G+X-M, if exports are cheaper there will be more exports sold and the quantity of imports will fall. If the economy is close to full capacity then higher AD will cause inflation.

Diagram: Demand Pull inflation

However, increased AD may not cause inflation, it depends on various factors: a) If the economy is in recession and there is spare capacity a rise in AD will not cause inflation b) If other components of AD are not increasing (e.g. consumer spending is low) then there is unlikely to be demand pull inflation. (X-M is not the biggest component of AD) c) Also if exports are cheaper then the effect on AD depends upon the elasticity of demand. If demand is inelastic there will only be a small increase in Quantity and there could be a fall in the value of exports (Marshall Lerner condition states devaluation only increases AD if PEDx + PEDm >1) Secondly, if there is a devaluation then there will be an increase in the price of imported goods. Imports are quite a significant part of the RPI, therefore there will be cost push inflation. However, it is possible that retailers may not pass the price increases onto consumers but have lower profit margins. Thirdly, if there is a devaluation exports become less competitive without firms having to make much effort, therefore there is less incentive for them to cut costs and therefore in the long run costs will increase and therefore inflation will increase. However this may not occur if firms are well run and they keep incentives to cut costs. The UK devalued its currency quite significantly in 1992 when it left the ERM, however it didnt cause inflation. This was because the economy was in a recession and there was a lot of spare capacity. This shows there are many other factors affecting inflation. However, in the 1950 and 1960s inflation in the UK was often blamed upon the depreciating .

Question 2 Government Intervention in the Macro Economy

The government intervenes in the macro economy in various ways including demand and supply side policies. Macro Economics Objectives of the government include: 1. Low Unemployment 2. High but sustainable economic growth. 3. Low Inflation (inflation target in UK CPI = 2%) 4. Equilibrium on Balance of Payments (e.g. minimising current account deficit) 5. Reduce Government Deficit (in UK Chancellors Golden rule of Borrowing less than 3% of GDP) 6. Stable Exchange rates Non Economic Objectives 7. Environment - increasingly important 8. Issues of Equality. Types of Government Intervention 1. Supply Side Policies.

These are government policies which aim to increase productivity and efficiency in the economy. If they are successful, they will shift the LRAS to the right and potentially increase the long run trend rate of growth. An increase in productivity can also help to reduce inflation, especially cost push inflation. Improvements in productivity may make UK exports more competitive and, therefore, should help to improve the current account. Types of Supply Side policies 1. Interventionist. Government intervention to overcome market failure. For example, spending on education and training to reduce occupational immobilities. 2. Market Oriented supply side polices : This occurs when the government reduces regulations and enables market to work more freely. For example, reducing the power of trades unions and minimum wages can reduce labour market inflexibility's. Evaluation of Supply Side policies. They will take a long time, e.g. increasing education standards. May be subject to government failure. e.g. spending on education misplaced. Promoting free markets may increase inequality. E.g. removing trades unions may lead to worker exploitation.

Demand Side Policies Demand side polices to influence the level of AD. It may be to reduce the growth of AD, to prevent inflation. Alternatively, it could be to increase AD in time of a recession. Types of Demand Side Policies

1. Fiscal Policy - changing the level of government spending and taxation in the economy. It will effect the government's budget and fiscal position. 2. Monetary Policy - Influencing the supply and demand for money. In the UK monetary policy revolves around changing interest rates, which are set by the MPC (Bank of England). If there is inflation: The government could pursue deflationary fiscal policy. This involves increasing tax rate and / or cutting spending. The MPC could increase interest rates. This is known as a tightening of monetary policy. Note, in the UK the government no longer sets monetary policy, the Bof E is independent.

In a recession. Government can introduce Expansionary Fiscal Policy. This involves cutting taxes and / or increasing spending, AD should increase. The MPC can cut interest rates.

Evaluation It is difficult to control predict future economic trends, therefore, it can be difficult to know how much to change tax rates / interest rates. Time Lags, Interest rates can take upto 18 months to have an effects. Crowding out. Expansionary fiscal policy may increase government spending, but, reduce private sector spending. Depends on Confidence. For example, a cut in income tax may not increase AD, if confidence is low.

The aim of Demand side policies is to ensure sustainable growth. The aim is to avoid Boom and Bust economic cycles. In practise, this means that growth will be close to the long run trend rate of growth. This enables economic growth, without inflationary pressures

Question 3 The Difference Between Economists and Non Economists

Economists have a certain world view. Their economic training gives a different insight into issues that non economists might not appreciate or consider important. These are few examples of different approaches to economic issues. There are other examples of differences and perhaps these differences are not as significant as we might imagine; I would be interested in hearing the view of both economists and non economists (assuming of course a 'noneconomist' would read an economics blog..) Rational / Irrational Economic theory assumes people are rational and will make rational choices. Yet in the real world people often make decisions which can only be viewed as irrational from an economic perspective. E.g. Why would people choose to take out pay day loans at an interest of greater than 2,000% apr? Why would people pay more for a product that is identical to another cheaper product? This is perhaps a big difference, but also highlights a limitation of economics. This limitation is examined in behavioral economics

Opportunity Cost When watching a political debate or the views of voters, it always strikes me how little people consider the idea of opportunity cost. You can frequently here people say 'The government should save this hospital' 'The Government should provide more public transport' 'The government should reduce that tax'. However it is very rare that a pressure group or non economist will offer a way of funding the spending or tax cut; people often forget the opportunity cost of any economic decision. e.g. how often do you here voters of politicians argue 'The government should increase spending on public transport; and this can be funded by imposing a political unpopular tax on cars. Furthermore, this tax is likely to overcome external costs and improve social efficiency.' For an economist any decision on the governments budget imposes an unavoidable opportunity cost. Increase spending will lead to either higher tax or more borrowing. Non economists often forget the opportunity cost of economic choices. Statistics vs Personal recollections Non economists tend to put a greater emphasis on personal experiences and every day events. For example, many in the US feel the economy is already in recession because of the bad news on housing markets, subprime crisis and perhaps a personal experience of someone losing a job. An economist would be wary of giving importance to one off factors because they can give an inaccurate reflection of the overall picture. Exaggeration The media often seek to exaggerate the 'housing crisis' and 'rocketing' price levels. For example, in the UK, newspaper headlines have recently focused on 'The biggest house price fall for 15 months' This sounds more impressive than another headline, which is perhaps more accurate . 'Monthly house price figures show annual rate of House price inflation falls from 6.5% to 5.3%' Both headlines are correct in some way; but arguably the first headline emphasises a certain aspect of the statistics for greater 'shock value'. Of course, this is not to say economists can't use statistics for exaggerated effect; I'm sure readers could give numerous examples. But, perhaps non-economists are more likely to use misleading statistics, especially in the media and political world. Certainty vs Uncertainty The joke goes, put 10 economists in a room and you get 11 different answers. If you are wondering where the actual punch line is, don't worry - it's not that funny. But, the point here is that economists are trained to see both sides of the argument. For every statement a good economist will feel obligated to add numerous caveats and other potential outcomes. A recession might occur, but it depends on X,Y,Z. A non economist is more likely to see issues in black and white. The economy is messed up - We're heading for a recession. Externalities On the issue of imposing taxes on negative externalities, economists will justify tax and subsidies based on the issue of externalities. For example, an economist would say a congestion tax is justified because it internalises the external cost of driving into a city centre. Externality arguments can often be difficult to explain to non economists. If you mention a congestion charge to an average voter, there instinctive reaction would be 'not another tax on the motorist' 'this tax is unfair on low income groups'. This is not to say non economists cannot think in terms of externalities, but generally this is a low priority or doesn't immediately spring to mind

Question 4 How to Avoid a Recession

There are several things to try and avoid recession. Basically, the government and monetary authorities need to try and increase aggregate demand (consumer spending, investment, exports). There is no guarantee that they will work. It will depend on the policies and also the causes of the recession. For example, it is easier if the downturn affects just one country. In a global downturn, you are more subject to the fate of economies. If the recession is caused by very high interest rates, then cutting interest rates may help avoid a recession. But, if you have a large fall in asset prices / bank losses (often called balance sheet recession) it is more difficult because even if you cut interest rates, banks may still not lend.

Policies to avoid a Recession

1. Cutting Interest Rates. Cutting interest rates should help to boost aggregate demand. Amongst other things, lower interest rates reduce mortgage interest payments, giving consumers more disposable income. Lower interest rates also encourage firms and consumers to spend rather than save. (effect of lower interest rates) As well as cutting base rates, the monetary authorities could try and reduce other interest rates in the economy. e.g. the Central Bank could buy government bonds or mortgage securities. Buying these bonds causes lower interest rates and helps to boost spending in the economy. 2. Preventing Home repossessions. Home repossessions can cause bank losses and falls in consumer spending. The government may try to freeze mortgage rates to preventing house repossession. (e.g. Effects of Freezing subprime rates )Also, the Federal Reserve 3. Expansionary Fiscal Policy. Cutting taxes increases consumer disposable income. This can be a policy to increase consumer spending. However, it will cause higher government borrowing. This may not be practical for countries who are already seeing a rise in government bond yields (e.g. Euro members like Greece, Ireland and Italy, have little scope for expansionary fiscal policy) Also, there is no guarantee tax cuts will boost spending if confidence is very low. Can tax cuts avoid a recession?

As well as tax cuts, the government could try higher government spending on capital investment projects. This directly injects money into the economy, it may be more effective than tax cuts, if tax cuts are just saved. 3. Devaluation. A devaluation in the exchange rate can cause a boost in aggregate demand. A fall in the value of the dollar, makes exports cheaper and imports more expensive increasing domestic demand. (see: effects of devaluation) However, in a global recession, demand for exports may be quite inelastic. Also, in a global recession, countries may begin competitive devaluation. This is when several countries try to gain a competitive advantage by devaluing currency against others, but it proves self-defeating. 4. Quantitative Easing If interest rates are already zero, then the Central Bank may have to pursue unconventional monetary policies. This involves the Central Bank electronically creating money and using this money to buy long dated securities. This increases bank reserves and should help encourage bank lending. Also, it reduces interest rates on bonds which should help encourage spending and investment. See: Quantitative Easing explained 5. Higher Inflation Target. This is a conscious decision to target growth rather than inflation