Module 2881 Unit 6, The UK in the Global

Economy: “Globalisation and Protection”

6-1. AN INTRODUCTION TO GLOBALISATION AND PROTECTION

The gains from trade is the same concept as “why nations trade” and these gains lie
behind the trend towards increasing globalisation.

• Comparative advantage. To simplify greatly, it means that a country does what it

is best at! This is the main source of the gains from trade.

• A country will lack something that it cannot produce for itself, e.g., bananas in
Britain. So a country trades to get what it lacks but wants. This is a minor
reason.

• There is a gain in the variety of goods and services offered and wider consumer
choice if one can buy from abroad. The country pays for the imports by exporting
what it produces.

Generally, international trade increases incomes, fosters economic growth, improves the
standard of living, and allocates resources better, both within a nation and globally.

The globalisation process

Globalisation comes about by a reduction in protection, especially by the developed

countries, and the general freeing up of markets. Globalisation involves countries
specializing in what they are good at and exporting in exchange for goods or services
they are poorer at. It requires a reduction in protection in order to allow the increase in
trade which is necessary. It also needs the freer movement of capital and the ability to
invest in another country. A company in country “A” can then either set up a factory or
firm in a different country, “B”, or else buy an existing one there. As an example, the
British company Lever Brothers has operating companies and factories on every
continent in the world, has a research laboratory in China (among other places), and is a
genuine and long-established multinational company.

The motives for reducing protection are:

• To increase a country’s efficiency in production and hence improve the domestic

standard of living, resource allocation and growth.

Copyright © Kevin Bucknall

 • To reap the gains from trade (comparative advantage).

• To help the poor countries of the third world. This is not really an important
motive! The goods that the third world wishes to sell are often kept out of
developed countries by high levels of protection in order to assist their own
producers. Imports of agricultural produce in particular are often heavily
restricted for the sake of a relatively small number of farmers.

• Pressure from multi-national corporations on the various governments to allow

freer movement of goods and capital (in order to increase their own profits).

International Exchange

This really means why countries trade! If Britain can run an insurance service more
cheaply, say, than New Zealand, then it should do so, and sell it to the world (Lloyds of
London does this). In this example, we would buy back something, for instance mutton
and lamb. It is not necessary or even desirable to try to balance exports and imports with
a single country. We wish to balance multi-laterally, on a global basis.

The global trading pattern:

The developed world trades more with itself than with third world countries, which seems
surprising to some.

But this is reasonable really! Because:

• Income elasticities are high for services and fancy expensive manufactured
products, but low for raw materials (revise elasticities and what this means in
Unit 1 if you are a bit hazy). The developed world has high incomes, so it
imports such things as video cassette recorders and TV sets from Japan.
However, few poor developing countries produce such items. Instead they tend to
produce raw materials and agricultural products, such as bananas, coconuts, sugar,
sisal and hemp all of which have low income elasticities. Where poor countries
do export hi-tech goods, like TV sets from China, these are inevitably made in
joint-ventures, set up with foreign capital and know-how and owned in part by
foreign developed countries anyway. Many Japanese products are now made in
third world countries like China, as Japan has exported much of its manufacturing
capacity, a process known there as “hollowing out” the economy.

• Comparative advantage and wider consumer choice mean that, if we take motor
cars as an example, the Germans make Mercedes and BMW; the French make
Citroens and Peugeots; the Italians make Ferraris and Alfa Romeos …. and they
all sell motorcars to each other.
 • The demand for primary produce (often produced in third world countries) grows
only slowly, so trade with third world countries does not expand rapidly. At the
same time, technological improvements in the rich world often reduce the
quantity of raw material needed. As an example, Brazil produces much iron ore
but less of this goes into a typical motor car built in the UK now than it did fifty
years ago.

• An additional factor on the demand side is that most developed countries protect
their domestic agriculture, which severely limits the amounts that poor countries
can sell to them (remember?)

• The long-term price of many primary products does not increase much, in part for
the three reasons above which limit the growth in demand. A further reason lies
on the supply side: output of primary produce has increased over time. This is
partly through increases in yield but also because of the extra supply coming from
newly developing third world countries as they increase their exports. With
reasonably rapid growth in supply and little growth in demand, the long term
price must fall. At best it will increase but slowly.

Trade Protection and Trade Liberalisation

Trade protection means reducing or preventing imports from foreign countries by means
of measures like tariffs, quotas and non-tariff barrier (ntb’s).

• An import tariff is a tax, e.g., 20 per cent (being set as a percentage it is referred
to as an ad valorem levy) or £30 (as a set absolute amount it is called a specific
levy) which is placed on each item imported.
• A quota is a fixed quantity, such as 20 tons; only that amount in total can be
imported.
• Ntb’s, as they are usually called, are often rather subtle and clever ways of
reducing imports by the tricky use of laws or regulations. As an example, health
regulations may be used to reduce or prevent wheat imports; or peculiar safety
regulations, such as the minimum distance between brake pedal and clutch pedal
in a motor vehicle, may be invented and used to prevent the import of certain
vehicles.

Note that in order to reduce protection we:

• Reduce or eliminate tariffs (so importers pay less or nothing).

• But increase quotas (so a larger physical amount may be imported).
Reasons for protection

• The infant industry argument. This justifies the protection of a new industry
during its early years, in order to allow it to establish and grow behind tariff walls
and quota barriers. Once it is mature, then the protection can be withdrawn. This
is a respectable argument – but a common problem is that the infants rarely admit
to being grown up and protection may continue indefinitely! Eventually, the lack
of competition becomes a disadvantage rather than a help and the industry usually
continues to be permanently inefficient by international standards.

• Protection in order to level the playing field by keeping out cheap imports. This
is a poor argument usually

o it goes against the principle of comparative advantage;

o it reduces a nation’s flexibility in resource allocation (it freezes industries
as they are);
o it lowers the standard of living (people cannot buy from the cheapest
source so must pay more for the good which leaves less money to spend
on other things);
o it slows economic growth (if an industry becomes inefficient, it will hardly
grow fast); and
o it may also reduce exports (if the industry is poor, it is unlikely to be able
to sell to others).

• The danger of war. The case goes that we should protect our agriculture or basic
industries in case we are ever cut off by war. There is something in it as a
political slogan but it is not a very respectable economic argument – few wars in
the future will involve long years of submarine blockades of the UK! The nature
of war has changed with the huge technical advances in the military area since
World War Two.

• In order to help some special group, e.g., farmers. The sugar beet industry in the
European Union is heavily protected which keeps out much cane sugar from poor
countries and means that as consumers we all pay more for our sugar than we
need.

The movement to reduce protection since late 1970s – why did this occur?

• At that time many developed economies were not in the best of shapes because
various long-standing government and other restrictions had led to resource
misallocation, a lack of motivation, and slow economic growth, which held down
the lower standard of living. There were heavy restrictions in the labour markets,
the capital markets and sometimes the goods markets. The growth of
bureaucracy, the emergence of the “nanny state” to look after individuals
carefully, and many years of left-wing governments had led to this. The motives
 of the latter had been good, but there were several alleged and clearly undesirable
side-effects e.g., lack of competition, lack of personal incentives and some
erosion of the desire to succeed.

• There was a rise in economic theories promoting competition and free markets
(“the Chicago School” and Milton Friedman) and these eventually became widely
accepted. The data since suggest that they were right: lower tariffs do increase
per capita income as well as trade.

• Political – Prime Minister Margaret Thatcher and President Ronald Reagan came
to power and liked the idea of competition and freer markets. They felt that their
economies were stifled by over-restrictions and hence uncompetitive. They, or at
least their advisors, saw that this encouraged slow growth, resource misallocation
and lower standards of living. This was a “timing” factor perhaps and it just
might have happened anyway a little later?

• The collapse of the communist Soviet Union and Eastern Europe in and after
1989. This happened following many decades of central planning of the domestic
economy. Such countries cut themselves off from the international community
(known as autarky) which reduced competition and they had fallen well behind
international standards in many areas. After the collapse of the Berlin Wall in
1989 and the events that followed, most of these countries moved out into the
global area and adopted market mechanisms to try to restore and rejuvenate their
economies.

• China moved into the global arena after 1978 and slowly but steadily began to
adopt many market policies, although without ending communism or totally
dismantling central planning. As a result, China is now a weighty player in global
markets and its cheap exports keep the level of international inflation lower.

• The other “tiger economies” (Hong Kong, South Korea, Taiwan and Thailand
especially) grew rapidly on a policy of free trade and the use of market
mechanisms and people around the world noticed this – and began to copy the
policies.

• Technology changed. The rapid rise and spread of computers mean that global
markets, especially in finance, are feasible - and inevitable?

• Multi-national corporations rose, and they tend to think globally rather than on a
national basis.
Why protection hurts the people in the world

Less competition means a tendency for people, companies, and industries to rest on
their laurels and take it easy. This encourages a nation not to reduce or eliminate
slow-growth industries whose products are less in demand or are not competitive with
other nations.

As a result we may find:

• Resources become increasingly misallocated for what people wish to buy.

• A lower standard of living because consumers cannot buy products at the lowest
price.

• Growth becomes slower because companies do not strive hard to improve their
products, production methods, or technologies.

• Exports are lower than they might be, as the nation is not as good as some other
countries with which we cannot compete. This limit on exports hits third world
countries in particular. Much of the tariff reduction and quote increase that has
occurred so far has been primarily to assist the rich developed nations. Relatively
little has been done in areas that would help the poorer countries.

• There is less foreign trade in the world as a whole – so we have less comparative
advantage being followed. This means slower world growth, and a lower global
standard of living.

• The foreign exchange rate may be poorer, as the country is not exporting as well
as it might.
6-2. TRADING BLOCS AND THE WORLD TRADE ORGANISATION (WTO)

Trade blocs are of three kinds – these are listed in order, weakest to strongest:

1. Free trade areas: these have no internal tariffs or quotas on trade between the
members, but each country can set its own level of tariffs against the rest of
world. Recent examples are the North American Free Trade Association
(NAFTA) which joined together the USA, Canada and Mexico in 1994.

2. Customs unions: these also eliminate tariffs between members but in addition
they set a common external tariff against rest of world that each member country
must observe.

3. Common Markets: these cover much more than customs unions or tariffs and
quotas. They can, and usually do:

a. Include laws that free up labour and capital movement between the
members.
b. Harmonise taxes which means that one country cannot be too far out of
line with the others.
c. Adopt some common monetary measures, such as all using the same
currency. The Euro began in 2002 for most of the EU members but the
UK has so far chosen not adopt it.
d. Set up a fixed exchange-rate between the members.

Really the members of a common market are moving in the direction of being one
big economy, while retaining their own nationality.

Why set them up?

• To gain economies of scale.

• To compete with bigger nations, e.g., the EU against the USA.

• Political motivation (not our concern in this course).

There are two sorts of gains - static gain and dynamic gain

The static gain is the one-off benefit which a country usually obtains at the moment that
it joins.

• Trade creation versus trade diversion

Whenever any trading bloc is set up, or any country joins an existing bloc, there is
a trade creation effect. This allows the most efficient producer to expand and sell
its produce to the others, so all benefit to some degree. The producer gains a
larger market and can reap economies of scale. The consumers gain because the
price will be lower and the quality probably higher than they previously enjoyed.
This trade creation feature is always beneficial, and is often referred to as being a
positive effect.

There is also a trade diversion effect. This is what occurs when the country
joining ceases to buy from and sell to its traditional partners and starts to buy and
sell within the group. Unlike trade creation, trade diversion can be either positive
or negative. If a country previously imported from the best and cheapest producer
in the world, but after joining the organisation is now only allowed to buy within
the bloc, it has a harmful or negative effect.

So if a country joins a trading organisation it has to hope that both diversion and
creation are positive, or else that the gains on trade creation are bigger than any
losses on trade diversion! (Remember that these are all static gains).

The dynamic gain is the continuing benefit over time of more dynamism as a result of:

• the increased competition;

• the larger market allowing the economies of scale to run for ever;

• a more mobile and probably better motivated labour force;

• and increased capital flexibility.

• All of these lead to greater efficiency in production.

These dynamic gains are always positive, that is to say, continuing benefits will steadily
be achieved.
The World Trade Organisation (WTO)

The WTO replaced the General Agreement on Tariffs and Trade (GATT) as a result of
the Uruguay Round of negotiations (1986-94). You can see that it took eight years to
gain international agreement!

The aim of the WTO is to increase the amount of world trade by means such as
promoting tariff cuts, increasing and perhaps eliminating quotas, and minimizing, or
better yet solving, disputes between members. The WTO holds occasional meetings to
negotiate further reforms.

The WTO will not allow a nation in a recession to increase its tariffs or reduce the size of
the quotas it sets. In other words, it is not allowed to increase the level of its protection.
This rule is believed to have helped avoid the sort of harsh global economic slump that
we saw in the 1930s.

Present contentious and unresolved issues are:

• Agricultural trade is still restricted by the developed world (which hurts many poor
developing countries).

• Developing countries feel left out of the WTO progress and many believe that they
are discriminated against by the rich developed countries. It is often seen in the third
world as a sort of rich man’s club that has accepted poorer members but rather
ignores them.

• The concern in the West about working conditions and human rights in some poor
developing countries is a touchy issue. Poor countries usually want to get richer first,
then worry about things like working conditions later. They often resent being
lectured to by the rich club members and told that they should not do the things that
earlier made the rich rich!

The WTO is attacked by radicals – often physically - at international gatherings,

such as the one in Seattle in 1999.

The stated grounds for attack are that the WTO promotes globalisation and global
capitalism. The extreme radicals dislike these for both political and socio-economic
reasons:
The political views of the radicals (not economics but related to it)

• The radicals are strongly antagonistic towards capitalism as the preferred economic-
political system.

• The radicals are usually anti the USA, which is seen as the leader of the system.

• Some radicals are against the banks generally and international banking in particular.

• And some radicals seem to be pro communism; or pro anarchy; or pro nature and
going back to living in more primitive ways that are seen as natural rather than
artificial.

The socio-economic views of the radicals,

Many believe that the process of globalisation has led to the world’s poor people and
poor countries becoming even poorer, and therefore it is bad and must be resisted. They
often argue that the world’s income distribution has altered in favour of the rich.

Actually, in many cases people in the poorer countries are wealthier absolutely, but they
are poorer relatively to the rich. What often happens is that nearly everybody has got
richer but the rich have got richer faster and so the gap is widening. Those at the bottom
improve a bit but those at the top improve a lot more. It must be admitted that not
everybody gains: a tiny minority who happen to be unlucky, situated in the wrong place
in the country, or who are physically or mentally challenged always seem to lose. The
only way they can improve their lot is for their government to step in and help them.
Few governments in poor countries feel that they can afford to do this yet and it must
wait until the country is more developed.

Where the people are absolutely poorer – and this does happen - it is almost always
the result of one or two things (and sometimes both):

• Bad governments that have adopted poor economic policies (Zimbabwe, the
Sudan, Nigeria).
• Wars, rebellions, or coups (sadly common in much of Africa).

So it is often politics and people that cause it rather than capitalism or the rich nations.
The case that the weather causes the problems

Now and then the poverty and problems are the result of bad or changing weather
conditions, which lead to drought or floods that in turn cause famine and death. But such
severe results mostly occur in an area that is undergoing war, rebellion, or revolt.

More stable countries suffer from weather problems too but they can usually cope with
them without major and long running disaster. It rather looks as if the military or
political turmoil is the main factor involved where suffering is both intense and
prolonged.

It is common and understandable for bad governments to blame freak weather, or global
warming, or international capitalism, or indeed any thing they can think of to explain
away their own mistakes.

Be warned that the cause of such problems is a contentious issue which is much debated.
These views are mine, based on many years of living in third world countries, and
decades of studying the problems. But I might be wrong! You should consider the
evidence, think about it, and then make up your own mind.

Since I wrote the above paragraphs, the evidence of global warming has become
stronger and clearer. There is still dispute, but the majority of scientists working in
that area now appear to accept that global warming is a reality. Some dire warnings
have appeared. Currently, the worst worst situations still occur where war, civil war
or insurrection, or gross economic mismanagement raise their truly ugly heads.
6-3. THE BALANCE OF PAYMENTS

This was introduced in Unit 3but I repeat a bit here, then expand it to consider how we
can deal with problems in it.

• What is the balance of payments?

The balance of payments is a record of a country’s economic transactions with other

(foreign) countries. It includes the trade in goods and services, reveals how we pay for
this, or if did not pay it tells us what we still owe. It also includes other financial flows,
like foreign investment and company dividend payments.

We used to consider the balance of payments was divided into two: the
current account and the capital account. In 1998 a new method of presenting
our international situation was introduced which contains four categories
within the balance of payments.
1. The current account.

2. The capital account.

3. The financial account.

4. The international investment position.

THE CURRENT ACCOUNT

This course focuses heavily on the current account, which includes:

• Trade in goods.
• Trade in services.
• Income from working abroad, and from investments abroad.
• Current transfers: central government and private.
The UK Balance of Payments, 2003 in £ millions – The Current Account
(Simplified)

CREDITS DEBITS BALANCE

GOODS
Food, beverages & tobacco 10,827 21,099 - 10,272
Basic materials 3,325 6,125 -2,800
Oil and other fuels 16,478 11,128 5,350
Semi-manufactures 54,244 55,751 -1,507
Finished manufactures 101,961 138,255 -36,294
Other goods 868 1,594 -726
Total Goods 187,703 233,952 -46,249

SERVICES
Transportation 11,424 16,679 -5,255
Travel 13,673 29,443 -15,770
Financial services 13,244 3,277 9,967
Other services 49,965 25,060 24,905
Total services 88,306 74,459 13,847

INCOME
Employment from abroad 1,116 1,059 57
Income from investments 125,250 101,922 23,328
Total income 126,366 102,981 23,385

CURRENT TRANSFERS
Central government transfers 4,173 10,942 -6,769
Other sectors 8,886 11,860 -2,974
Total current transfers 13,059 22,802 -9,743

CURRENT ACCOUNT TOTAL 415,434 434,194 -18,760

The Ten Economic Goals and the Effects on the Balance of Payments

WHAT MIGHT OCCUR THE EFFECTS WE MAY EXPECT TO SEE

If we grow faster. The B of P worsens, as growth sucks in imports to
sustain production + higher incomes mean consumers
buy more foreign goods and services (these are generally
income elastic).
If the standard of living The B of P worsens as consumers buy more foreign
rises. goods/services.
If resource allocation The B of P probably improves, as the country is doing
improves. what it is best at.
If income distribution The B of P probably improves, as the rich reduce their
becomes more equal. purchases of foreign goods/services but other incomes
will not rise enough to suck in many more imports.
If inflation increases. The B of P worsens as our exports fall and imports rise.
If unemployment The B of P is probably a bit better as incomes are lower,
increases. which means consumers demand fewer imports.
Value of currency If the pound gets weaker it encourages our exports and
changes. discourages imports, so the B of P probably improves.
Note that the currency may be weak because the B of P
is already poor!

What can we do if the balance of payments gets into a “fundamental

disequilibrium” state?

A fundamental disequilibrium state means that:

• imports are considerably more than exports; and

• there is a persistent balance of payments deficit; and
• there is no likelihood that this situation will change.

The IMF will only allow major changes in exchange rates or special action to help the
balance of payments if the country can persuade the IMF officials that there actually is a
fundamental disequilibrium.

There are three possible ways of tackling this:

1. Via the exchange rate system – if the exchange rate is fixed (like China which
currently fixes the yuan against the US dollar) we might alter our exchange rate
 (although countries are bound by the IMF agreement as long as they are members.
This solution is not applicable to the UK as our exchange rate floats (see below).

2. Via demand side management of the domestic economy. Lowering the level of
aggregate demand would provide short term help by reducing imports and
possibly freeing up some goods and services for exports.

3. Via supply side management of the domestic economy. Pushing out the long run
supply curve would provide permanent help.

The first way of tackling a balance of payment problem: changing the foreign
exchange rate

The exchange rate methods that a country might have adopted

1. Floating.
2. Fixed.
3. Managed.

1. Floating rates:

These are normal for most countries these days; floating rates are currently in force for
the UK.

The supply of and demand for the pound determines its value.

1. The demand for pounds comes from foreigners who wish to buy British goods or
invest in Britain.

2. The supply of pounds comes from the British, as we buy goods or services from
abroad or we send money abroad to invest there.

This is the normal supply and demand curve situation: if we increase our imports, the
supply of pounds increases, so the value of the pound starts to fall.
 Price of pound
in dollars
D S1
S2

P1
P2

0 Q1 Q2 Quantity of pounds

When this happens, a second element might swing into action. Speculators might jump
in and sell pounds, hoping the fall will continue so that they will be able to buy them
back later at a lower rate. Should speculators sell in this way, it will drive the pound even
lower.

2. Fixed rates (the regime a country might have adopted):

The government sets the value of the currency in the foreign exchange market. It is
usually set well out of line with the foreign exchange rate that the market would
determine – there is no point otherwise because it can simply be left to the market This
method is not used much, except by a few communist countries.

Linking the rate to another country fixes it in a kind of way, but as the value of the other
country’s currency alters, so does yours! Malaysia currently links to the US$ which
helps it to stabilise its export and import prices for the USA and set them for other
countries in international contracts.

With our floating rate: if the balance of payments deteriorates, the foreign exchange rate
worsens automatically – thus making our exports cheaper and imports dearer, so it should
automatically correct the imbalance in time.

With a fixed FX rate: with “a fundamental disequilibrium” the country could devalue – if
the IMF will let it! Secret meetings would normally be held and the government would
try to persuade the IMF officials that there really is a “fundamental disequilibrium”.
A small digression: what can affect the balance of payments (and hence the value of
the currency)? (Note: you may need this for the exam).

1. Our demand for imports.

2. The demand of others for our exports.
3. Our inflation rate compared with that of others.
4. Our rate of interest compared with that of others.
5. Speculative capital flows.

Our demand for imports: if we import more, the balance of payments on current account
weakens and pounds flow abroad. This increase in the supply of the pound reduces its
value. The normal supply and demand curve analysis applies, as in the diagram above.

The demand of others for our exports: if foreign countries increase their demand for our
exports, our balance of payments improves and the value of the pound rises. The other
countries demand pounds in exchange for their currency, as they have to pay us in pounds
in the end.

Our inflation rate compared with that of others: if other countries inflate more slowly
than we do, our exports become relatively dear (so we can sell less), and our imports
become relatively cheap (so we import more), with the result that the balance of
payments deteriorates. This causes the pound to fall in value. You can see that when we
pay for the extra imports it puts more pounds on the market, while selling fewer exports
means we earn less foreign exchange.

Our rate of interest compared with that of others: if our interest rates rise (and no other
countries match it) then foreigners send more money to us to earn a higher rate of interest
and hence a bigger income. The influx of foreign capital then increases the value of the
pound and strengthens the balance of payments.

Speculative capital flows: “hot money” can race around the world seeking the highest
rate of interest commensurate with safety and risk. As the world gets wealthier and
multinational corporations increase, the size of the flow gets larger. If hot money races
into a country, it strengthens the balance of payments and increases the value of that
country’s currency. The real danger will come later when it races out again! The value
of the currency could then fall sharply and the balance of payments could weaken
rapidly. The total effect can be very destabilizing. The IMF will usually lend money to
help a country offset the sudden flood out.

3. Managed rates of exchange (the regime a country might have adopted):

This system is much like the floating one. The difference is that the value is not
completely free to move for ever. The government may step in (should it feel like it) to
shore up the foreign exchange rate if it starts to fall. It does this by buying pounds, using
the foreign exchange and gold reserves to do so. If the value of the pound begins to
increase, the government may judge it right to step and moderate the increase by selling
pounds on the international market. This would then increase the foreign exchange
reserves.

Although Britain has a floating exchange rate system, in the past the government has
been known to intervene to protect the value of the pound by buying and selling foreign
exchange. The rate of interest set by the Bank of England also affects the value of the
currency, as you will recall, because relatively high rates of interest attract foreign money
to be placed on deposit here. The government is influential in deciding on what rate will
be set. We know how the voting on the Committee went but the internal arguments are
normally secret.

The second way of tackling a balance of payments deterioration: demand side

management

Reducing the level of aggregate demand can have a short term effect and help the balance
of payments.

If we see the balance of payments weakening, perhaps because of high levels of domestic
consumption and imported consumer goods, the government can reduce the level of
aggregate demand, take the heat out of the economy, slow growth or even reverse it,
increase unemployment, and reduce inflation. This will help the balance of payments by
reducing imports and also by releasing goods for export that are no longer consumed
here.

Price Index
SAS1

110.0
100.0
AD1
90.0
AD2
Real GDP
0 GDP2 GDP1
Generally, this would be a short term response to a sudden crisis – the government
chooses to squeeze the economy because too much is going wrong within the ten goals.

The third way of tackling balance of payment problems: supply side management

Changes on the supply side tend to be a long term thing and it is not a tool that can
suddenly be wielded in a crisis to give quick results. It is a theoretical possibility but a
nation is usually well advised to keep trying to push out the supply curve anyway as part
of an ongoing process.

If we can increase the long run aggregate supply curve (the vertical part of the SAS
curve) it pushes down prices as well as increases output. This means our exports get
absolutely cheaper, so we are able to sell more, and hence the balance of payments will
improve. We also import less because our imports are relatively dearer now when
compared with home produce.

Price Index SAS1 SAS2

P1
P2

AD1
Real GDP
0 GDP1 GDP2

Here we see the SAS curve moving to the right (an increase in the underlaying rate of
economic growth) and gross domestic product increasing.

Other than the initial increase in growth and the improvement in the balance of payments,
we would see benefits for some other goals too: there would be an increase in the
standard of living (as prices fall and as incomes rise); and we can also expect an increase
in the number of people employed.
6-4. THE EUROPEAN MONETARY UNION (EMU).

When a member of the European Union (EU) joins the EMU its central bank loses some
power.

It gives up:

• The ability to determine monetary policy and fix interest rates; it accepts the one
set for all the members of EMU.

• The management of the exchange rate of its own currency. The country
henceforth uses Euros which are set to the national currency at a fixed rate.

The UK is not currently a member of EMU but it is a member of the EU.

The costs of joining EMU

• The UK would lose some sovereignty and power – we would be in the hands of
the decision makers for the EMU countries.

• If what is decided about the interest rate is good for most of the EU, but happens
to bad for us, we would lose. It might mean that if we were in a recession but the
other members were booming, interest rates might be set to curb the boom. This
would be inappropriate for our situation and it might force us to stay in recession
or even worsen it. Germany was like this in 2003 and still is. It is unlikely that
the average rate of interest set for all will be perfect for everyone: it will almost
certainly be set too high for some, and too low for others.

The benefits of joining

• We would have a fixed price of our exports to and imports from Europe. We
would not have to undertake currency exchange each time we import and export
involving other members. We would also not have to worry about the possibility
of future currency movements, as there would not be any.

• This means that there would be fewer shocks and fewer risks, as business people
would know what price they would get when they sell.

• This should lead to an increase in trade, lead to a reallocation of resources along

comparative advantage lines, help to increase the standard of living, speed up
economic growth, encourage more employment and help the balance of payments.
 • We would still be able to use fiscal policies to counteract undesirable changes in
our economy.

Fiscal policy for those in the EMU

Fiscal policy can be set independently by the members – but some suggest that in the
long term, tax rates will have to be roughly similar, if not identical (tax harmonization).

What would happen if a country’s tax rates were well out of line with the others?

• Labour or capital might flow from the high tax regime country to one where
taxation is lower.

• People might appeal to the EU or courts to obtain equal treatment under an EU-
wide piece of legislation and if successful could get a different tax rate applied.

It seems probable, however, that different countries would be able to retain their own tax
rates safely as long as they were not seriously out of line.

Opposition to joining the EMU

Many people are against joining the EMU, just as many are for it. The economic case
was presented above. Currently, the political opposition to joining is a worry to the
government, which has been going slow on the issue for some years.

Remember! This is an economics course and exam, not a political one. This means that
you can mention that there is both political support and opposition but you should not go
into much detail. For you own information here are a few points.

• Many people who have the vote fear that we would lose autonomy, which is true
(see above).

• The Conservative press is largely against joining.

• Prime Minister Tony Blair seems to be nervous about public reaction; the current
Chancellor of the Exchequer, Gordon Brown, might be in favour of joining, but
he has seems to have concerns that it would limit his power over the economy. In
addition, some allege there is a long-standing rivalry between these two
politicians for power and influence and internal Labor Party factionalism
complicates the issue.
 • Some people suffer from xenophobia and feel that we cannot trust foreigners in
general.

• Some believe that we cannot trust the bureaucrats in Brussels to do the right thing.

• Some believe we should only join when the conditions are right; this can be
meeting the Five Tests of Gordon Brown, or merely a way of ensuring that we
never join, by permanently claiming that conditions are still not right.

The five tests are concerned with:

• Convergence: is our economic cycle, as well as our rates of interest, in line with the other
countries in Europe?

• Trade and investment: would our firms get better access to capital and export markets in
Europe and would European and other investment increase in Britain?

• Flexibility: has the EU sufficient flexibility to cope with problems like inflation?

• Finance and the City of London: will the financial sector do well in the EU, especially
with the single currency?

• Economic growth and employment: will we do better if we join?

6-5. PUBLIC EXPENDITURE IN THE UK

What determines the size of public expenditure?

• Where the country is in the economic cycle – if we are in recession (around the
floor or trough in the diagram below) the government may choose to spend more
and increase the “G” component of aggregate demand (consumption + investment
+ government) thus pushing out the aggregate demand curve.

Gross
Domestic
Product Boom
Downswing GDP
Peak, or
Ceiling

Floor, or Slump
trough Upswing

0 Time in years

This is shown in the diagram below.

Price Index
SAS1

100.0
AD2
AD1
0 GDP1 GDP2
Real GDP

Conversely if we are in a boom, the government may choose to spend less, reduce the
“G” component of aggregate demand and pull back the aggregate demand curve, thus
reducing public expenditure. You can see the results in the diagram below. The level
of gross domestic product falls from GDP1 to GDP2 and the rate of inflation falls
from P1 to P2.
 Price Index SAS1

P1

P2
100.0
AD1
AD2
0 GDP2 GDP1
Real GDP

• If the government fears there is about to be an international recession or believes

there could be events that could lead to a downturn or downswing, they might
increase spending to offset it. There might, say, be a fear that investment or
consumption is about to fall.

• The government gets elected on its policies. If their manifesto stated they would
increase expenditure and solve certain problems, perhaps for instance to fix the
transport system, then they really should be spending if democracy is to mean
anything.

• The government’s general attitude, e.g., Old Labour taxes and spends more than
New Labour or than the Conservative Party.

The budget deficit or surplus

If the budget is in deficit, it means that public expenditure exceeds government revenue
which comes largely from taxation. The government may have to borrow to cover the
difference.

It is acceptable to run a budget deficit, if for instance, the government is deliberately

trying to increase the level of aggregate demand, expand the economy, and lead us into
an upswing. The policy of the current Chancellor of the Exchequer, Gordon Brown, is to
balance the deficits and surpluses over the whole economic cycle but he does not aim to
do so in any one year.
Public borrowing

The “public sector net cash requirement” (PSNCR) is what the government must borrow
in order to fill the deficit gap. The gap, if any, includes the total accounts of the central
government, local governments and the public corporations.

How is the PSNCR measured?

• The nominal PSNCR is the simple addition of the financial accounts of the above
three sectors.

• The seasonally adjusted PSNCR takes account of our place in the economic cycle
– the deficit and PSNCR increases naturally in a recession because the
government is paying out more to the unemployed and at the same time, tax
revenue is lower owing to the lessened economic activity.

• The PSNCR as a percentage of GDP is a useful measure;

o it helps us to judge how “large” it is in context;

o and also to compare our situation with that in other countries. We keep
our eye on the other EU countries in particular.

Does government borrowing matter?

There are both advantages and disadvantages in the government borrowing money. All
governments do it!

The advantages

• By borrowing and building things like roads, bridges, and docks (known as social
overhead capital) and providing better education or health for the people it can
speed up future economic growth. This will make it easier to pay back what is
being borrowed now, as well as what was borrowed in the past, because society
will be richer.

• The extra expenditure (“G”) might prevent a fall in national income and so the
government will not forgo the tax revenue it would otherwise have lost, or have to
spend more on the unemployed.

• Borrowing prevents the government from having to raise taxes now.

Governments that increase the rate of tax tend not to be popular and the
government wishes to be re-elected!
The disadvantages

• When the government borrows it tends to increase the rate of interest rate offered
and this might crowd-out private investment. Those who save might divert their
savings towards the government and away from industry or the banks (who lend it
to industry). A reduction in investment can harm future growth prospects.

• The sum borrowed has to be repaid (or else the level of national debt increases,
which is in itself not particularly bad). If the government raises taxes to do this,
not only will it be unpopular, it would reduce consumption and the standard of
living, and might reduce investment which could be detrimental to long term
growth.

• When the government repays its earlier borrowings, whatever sum it repays
cannot then be spent on what is deemed important at that time.

• To some extent, the disadvantages and advantages depend on what the

government decides to spend the borrowed money on and how effectively it
spends it.

Gordon Brown’s “Golden Rule”.

The Chancellor Gordon Brown decided that it is safe and desirable for the government to
borrow in order to spend on investment for the future, but not to borrow to cover current
consumption. He believes that the consumption component of government expenditure
must be financed by taxation.

He also tries to balance out borrowing and spending over the economic cycle, so the
government can borrow for a few years of recession but should then pay it back in times
of boom.

Public expenditure and income distribution

Generally, when a government wishes to redistribute income it prefers this to be towards

the poor rather than the rich, and it often does this via the social security system.

The problems with trying to redistribute income include:

• The really poor, sleeping in doorways etc, may not know about the benefits that
are available or even qualify for them (a fixed address may be required for
instance) so they do not benefit from the intended redistribution. The neediest
people can miss out.
• The sheer complexity of the rules mean that many who qualify do not apply for
state benefits – so the poor and aged do not get all they should. This is a widely
recognised problem that still awaits solution. Some other people, often the elderly
who were brought up to fear “accepting charity”, may refuse on principle to take a
handout from the state, even when desperately poor. The means test in order to
determine exactly how poor they are also deters some, perhaps many.

• The middle class tends to be good at getting its share because is educated and
vocal, when compared with those at the bottom end of society.

• The rich tend to be able to avoid a lot of income tax, and other taxes, in a variety
of ways. They are able to buy the advice of experts, set up trusts, live abroad for
part of the year and avoid tax, or simply conceal the income they obtain. The true
burden of taxation often seems to fall on the group in the middle rather than the
richer top end of society.

• A special problem is that governments have a tendency to subsidise groups which

are seen for some reason as desirable, whether the members are rich or poor.
Farmers are a particular example of this, where extremely poor hill farmers in
Wales receive a subsidy and so do the large, rich farms owned by millionaire
families who use managers rather than sweat themselves.

• Government may also change the tax system to favour a particular group e.g., to
increase or reduce the help for those paying mortgages. Such action alters income
distribution.

• Logic suggests that we should not subsidise groups at all, but should simply
identify the poor and those who need help - and then help them. Subsidising the
rich seems bizarre and wrong. Subsidising things rather than people seems
peculiar, e.g. council houses, but this is done and rarely questioned. The result is
an anomalous situation where many really poor are excluded from the benefits of
cheap public housing, and some recipients of it are now moderately wealthy but
are still subsidised.

• In the United States under President Bush, many rich people have received
substantial windfall income increases owing to changes in the tax system
apparently designed to benefit the wealthy. It is uncommon in Britain for
governments to alter the rules to favour the rich rather than the poor, although
Prime Minister Thatcher did this.

• It is perhaps more common for lethargy or inaction to allow the rich to be

favoured. As an example, the current Labour government has refused to increase
the rates of income tax on the rich. Further inaction has maintained the cut-off
points in the tax system, so that many quite ordinary people who might be
described as “comfortable” rather than rich have now moved up into the top rate
tax bracket.
• As a further example in the UK, governments for a long time have refused to
close certain legal loopholes that favour the rich, such as the current rules that
allow low rates of income tax for those living in the Channel Islands. Naturally,
the millionaire population of these islands is well above average, as large numbers
of rich people have moved to live there in order to preserver their wealth and
avoid paying taxes to help run the country.
6-6. INWARD FOREIGN INVESTMENT BY MULTINATIONAL
CORPORATIONS

These were introduced in Unit 2 – go back and revise if you have forgotten. It is now
time to increase our knowledge of how they operate.

The case for MNC’s investing in the UK and the rest of Europe

The EU likes MNC’s and the investment that they bring in:

• They bring in skills.

• They create jobs (this is usually well-publicised when a new factory is opened.)
• They add competition to a smaller economy.
• They help to increase output.
• This pushes out the long run aggregate supply curve and is a good source of
economic growth.
• They add to the capital available and the technology they bring is probably
modern and very advanced. (Recall that increased capital plus technical
advances are the main source of growth in most developed countries.)
• They generally add dynamism to the economy.

The case against MNC’s

There is a lot of myth and story-telling and the case against sometimes looks a bit
speculative rather than hard-fact based but here goes.

• They take their profits in the lowest tax regime country in which they operate. It
is easy to do, as they simply sell from one branch in high-tax country “A” at a low
price (so making little or no profit there) to a branch in a low-tax country “B”
which then makes high profits as a result – and of course pays little tax. This
process is called “transfer pricing”.

• They have often proved to be either corrupt or behaving in ways that border upon
corruption, in order to help themselves and improve their position and profits.
• They may favour their head-office home base country over the interests of the
local nations in which they operate.
• They will prevent cheap versions of their patented goods being made in poor third
world countries, even if the people are dying of aid. (This is not an economic
argument.)
• They successfully pressure national governments to water down environmental
and tax laws so as to favour their own profits.
6-7. EXTERNAL SHOCKS AND THE GLOBAL ECONOMY

All large shocks have an impact on the world level of economic activity, e.g., higher oil
prices; the war in Iraq in March 2003; or the Asian financial crisis of 1997.

All questions about external shocks can be tackled in the same general way:

1. The impact of the event on the ten major economic goals. (You will need to
think about them and apply them to your particular case. If you jot all ten
down, say in the margin of your exam question paper, you can ensure that you
do not miss any out).

2. The transmission of the event and its consequences around the world, which is
greater and faster than it used to be as a result of globalisation. Remember that
the exports of one country are the imports of another. The flows of liquid
capital might also be affected. Naturally, some countries will be affected more
than others.

3. You can almost always use the diagram of the determination of national
income by means of aggregate demand and supply to show the domestic effects
of any major external shock.

But clearly there will be differences in what will happen and not all events have exactly
the same results.

You might be asked about the effects on the UK specifically, or the question could be
more general and concerned with the effect on a wider area; always tailor your answer
to the question asked.

As an example, let us examine the effects of the current war in Iraq following the
invasion by British and American troops on our national economy.

• All wars increase the level of aggregate demand and tend to have an inflationary
effect.

War means increased demand for many things, e.g., steel, armaments, the defence
industry generally, and hospital and medical equipment. This means an instant
increase in the level of aggregate demand.
The effect of war on the macro economy: an increase in aggregate demand and inflation.

Price Index SAS1

110.0

103.0
100.0

AD2
AD1
0 Real GDP
GDP1 GDP2

The invasion and occupation mean an increase in aggregate demand in the UK, a boost in
output, with an associated increase in the level of employment, and extra inflationary
pressures, as in the diagram above. (The figures are assumed and the movement
exaggerated, in order to show the effects). The level of gross domestic product increases
from GDP1 to GDP2, and inflation rises from 3.0 percent to 10.0 per cent.

• It also pushes up the price of oil because of the extra demand for oil to use in the war.
In the case of the Iraq war, there is the additional fear that the war may drift on for a
long time and later could involve invasion into other countries in the Middle East.
This means an increase in the price of petrol, as you or your parents will probably be
well aware if you have a vehicle to run.

If the economy starts off in recession before the war:

The war can be helpful as it brings the economy out of the recession. This happened in
World War Two in 1939 when the British economy was stimulated, as was the American
economy. There is a strong school of thought that says the efforts in the USA to boost
their economy throughout the severe slump of the 1930s failed and only the advent of
war stimulated a recovery. The diagram below shows an economy such as in the USA in
the 1930s. An increase in demand would increase output and end the slump.
Starting a war in the middle of a recession

Price Index
AS1

110.0

100.0
90.0
AD2
AD1
Real GDP
0 GDP1 GDP2
Demand increases, output expands, which means more jobs become available to those
who are unemployed. Inflation does not increase as there is much spare capacity when
we start.

But if the economy starts off at full employment:

You will notice in the diagram below that no increase in output is possible, so the
increased demand because of the war all spills over into a higher rate of inflation.

It is arguable that Britain had a strong and buoyant economy on the eve of the invasion of
Iraq, and so the full employment diagram below is perhaps the more relevant one.

Starting a war when we already are close to full employment

Price Index SAS1

111.0

108.0

100.0 AD2
AD1
Real GDP
Real GDP GDP1 &
GDP2
The length of time involved

A short war can sometimes be helpful to an economy, especially when starting in a

recession or slump. The initial increase in demand is real and boosts national income but
being short the war is over quickly and the uncertainties vanish. On the other hand, the
war diverts resources to engage in war that could be allocated to areas such as health,
education, the private standard of living, pensions, or investment for future growth, so
there is a real cost to society.

A long war is generally harmful. If it is conducted in part on home territory there will be
much destruction of buildings and property. In these days of increased terrorism, there is
likely to be some damage wherever the war is fought. The war can breed new uncertainties,
divert investment towards the armaments industries away from consumer goods and
services, which reduces the standard of living, as well as add to inflationary pressures.

A long time ago, a major recession was common after the end of a major war.

This seems to have happened over all human history, including the First World War
(1914-18) Post-war there was a sudden fall in the level of aggregate demand. It was
difficult to reallocate resources quickly to the sort of goods and services demanded in
peace time and in addition the vast influx of discharged soldiers meant severe
unemployment.

There is now less of a danger of this happening: because of the work of Keynes we know
that government can increase the level of aggregate demand to offset the automatic fall
that peace brings. This is how we avoided the emergence of a slump after the Second
World War (1939-45) in the UK, the rest of Europe, and in the United States.

It is also now much quicker and easier to reallocate resources than it once was, which
will help us after any major conflict in the future. This is the result of the changes begun
by Prime Minister Margaret Thatcher after 1979 in the labour markets and financial
markets and perhaps to a lesser extent to the freedom given to the Bank of England to
reduce interest rates to stimulate investment and consumption.

To list the ten goals with possible effects from the invasion of Iraq war:

• Economic growth: is boosted in the short term; but probably slowed in the longer
term as resources go to waging war, rather than investing for the future.

• Allocation of resources: towards war goods and away from peace-time goods, such as
education or health.

• Inflation: the war worsens the inflationary pressures; this is particularly noticeable in
the price of petrol.
• Standard of living: reduces a bit; or at least not increases as much as it would
otherwise have done.

• Distribution of income: moves towards the suppliers of armaments, munitions,

uniforms and the like, as well as to the firms that reconstruct the Iraq economy when
the war is over.

• Balance of payments: possibly harmed a little, as we probably had to import a few

things with which to wage war; plus we probably lost a few exports as the goods or
services were diverted to Iraq. The net effect is probably small?

• Value of the pound: probably not affected much.

As another example of an external shock and how to tackle it, let us look at the
effects of a sustained rise in the price of crude oil.

Unlike the previous example which was focused on the demand side, a sustained rise in
the price of oil is a supply side problem. Such a price increase passes on through the
general economy quickly because of the immediate increase in the price of transport and
fuel. This increases the costs of virtually all producers and pushes up their micro supply
curves. In turn, this means an immediate shift upwards in the aggregate supply curve.

Note: the figures are all assumed in order to demonstrate the principle involved.

Price Index SAS2 SAS1

110.0
101.5
100.0

Real GDP
0 GDP2 GDP1

The results can be read off the diagram: we see inflation increasing from 1.5 per cent to
10.0 per cent and the level of national income falling from GDP1 to GDP2. There is little
a government can do under the circumstances. It is unable to increase the level of
aggregate demand to tackle the fall in output and the associated rise in unemployment,
because we are already close to full capacity working and all we would see after a
demand increase would be even more inflation. The only hope is to work on increasing
the general level of efficiency in the economy and stimulating people’s motivation to
work harder, i.e. to push the long run supply curve outward to the right. This by its
nature is a slow process. For those governments of countries that are oil producers, such
as the UK, it might make sense to promote the search for more oil beds, but this option is
not open to most countries, as they totally lack oil.

Higher oil prices affect the supply of some things more than others, for example they
have a disproportionate effect on the prices of petrol, bitumen and chemical fertilizer
production all of which use crude oil as a major raw material. Such products suffer a
substantial rise in price when the price of crude oil increases. The fear of a general world
recession is likely to emerge and then grow.

So the rise in the price of crude oil helps those countries that are oil producers, and harms
all oil importers. It can be particularly damaging to many third world countries as they
rely on imports of chemical fertilizer for their agricultural production which is a large
proportion of the economy. The agricultural output is used to feed the people and in
many cases to provide much-needed exports.

Notice that if you memorise and learn to manipulate the diagram for the determination of
national income via aggregate demand and supply how useful it is. You can use it when
tackling a great number of questions. And this is true not only in the exam room!

To list the ten goals with some possible effects from a substantial rise in the price of
oil:

• Economic growth: this is harmed, as fuel and transport cost increase, forcing the
short run aggregate supply curve upward.

• Allocation of resources: (not a lot to say here).

• Inflation: the oil price rise worsens any inflationary pressures.

• Standard of living: reduced a bit. To the extent that the tax on petrol is linked to
the price of crude oil, the retail price of oil tends to rise immediately.

• Distribution of income: moved away from users of motor vehicles as they pay
more for their petrol. The government also receives an increase in revenue from
the automatic tax increase.

• Balance of payments: possibly helped a little, as the UK enjoys net exports of

fuels.
• Value of the pound: probably not affected all that much? The adverse effect on
growth might be offset by a positive effect from the balance of payments.

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