Beyond the crisis: lessons for the future of the eurozone

Great lecture at the LSE on 7th September. A ticket must be requested on 31st August if you want to attend. Please consider going if you want to learn more about the Eurozone crisis. Lecture is conducted by Herman Van Rompuy, Prime Minister in Belgium from 2008 to 2009. More information found on the LSE website.

Hope to see you there!

The Economic Cycle

The Economic Cycle

Also known as the business cycle, it shows how the economy fluctuates above and below its trend rate of growth.

When the economy is performing above its trend rate of growth, there is a positive output gap. During a positive output gap, the economy is in a boom whereby growth is high and unemployment is low.

When the economy is producing below its trend rate of growth, there is a negative output gap. The economy is said to be in a recession where growth is very low or even negative, along with high unemployment.

Reasons for these fluctuations

There are many theories devised to help explain fluctuations in the economic cycle. In the exam, it is important to prioritise your arguments, thus I have ordered the following according to my opinion, of course you may think otherwise:

1. Outside shocks

Outside shocks can be classified by demand shocks and supply shocks. Demand shocks affect AD in the economy, and can lead to a recession or downturn. For example, e-coli in German cucumbers supposedly sourcing from Spain led to AD for Spanish (and other European grown) vegetables, see article, to fall (from Russia in particular). 

A supply side shock affects AS within the economy. Examples include conflict in the Middle East affecting oil supplies and the Japanese earthquake affecting supply chains of manufactured goods, see article. Other evidence for this is, if you take a look at this website, you will see that Japan is currently experiencing negative growth, due to the earthquake.

2. Speculative bubbles

Rapid growth of asset prices (gold, property, shares…) leads to a bubble because people will speculate that the price will continue to rise and buy the asset. When the price is above the real value of the asset, people will start to sell and the bubble bursts. Speculation can destroy business and consumer confidence. People will stop spending, leading to a recession. This contributed to the UK recession (2008) when house prices plummeted, see article.

3. Changes in technology on the supply side of the economy

Technical progress can increase the rate of growth of total factor productivity (TFP). A change in TFP measures the change in total output when all the factors of production are changed in the economic long run. Technical progress measures how much more productive the factors of production have become over a period of time. Technology has inevitably increased the rate of economic growth in some developing countries where it is much needed, e.g. mobile phones in Uganda, and it has also led to the growth of developed countries thus creating the world’s most powerful economies, e.g. Japan.

4. Changes in inventory

Firms invest in stocks of raw materials and finished goods to smooth production and cope with changes to demand. However sometimes firms can over-anticipate demand leading to unsold stock, which can lead to a cut in current production and a slow down in the economy. Recessions in the UK and USA are made worse due to changes in inventory.

5. Political business cycle theory

Governments tend to cut taxes or implement new policies to give people more money before elections as a way a ‘buy votes’. People have more money, thus increasing spending leading to a boom period. After the election, governments deflate aggregate demand to prevent the economy from over-heating.

6. The multiplier and the accelerator

An increase in investment increases AD and leads to an increase in national income. This is known as the multiplier. Higher income leads to more investment (increasing AS), known as the accelerator. The extent to which the multiplier increases AD is down to:

a)     The marginal tax rate

b)    Marginal propensity to import

c)     Savings

Therefore this isn’t top in my list because, for the UK, the multiplier is not large since all of the above are reasonably large (the multiplier is calculated by 1 divided by the above). If the values for all of the above are high, there will be lower investment.

7. Climatic factors

El Nino/La Nina and sun spots (or lack of) can create extreme conditions resulting in   changes to harvest, affecting the agriculture market. The price of the grain and the quality of food can be damaged, leading to a fall in output in the producer country. This can lead to a fall in business confidence and thus a recession. El Nino Southern Oscillation is an event that occurs every 2 to 7 years and last 1 to 2 years. Cold water is suppressed in the Pacific Ocean, causing warm, dry weather over Southern Asia (India, Philippines…) and Oceania (Australia, New Zealand…) and increased rainfall over the America’s. El Nino can also affect the fishing industry. Sun spots can increase surface temperatures, causing warmer and drier weather.

Word of the Day

Cartel

A collusive agreement made by firms (or countries in the case of OPEC) to fix prices and sometimes fix output. Firms will want to collude to decrease the amount of uncertainty faced in the market. Cartels are illegal, and the government regards them as anti-competitive. Cartels can increase inefficiency in the market because it protects inefficient firms, while the efficient firms enjoy supernormal profits (watch up to 4.18 on this video, disregard the market structure and understand that supernormal profits are depicted by the shaded area on the video).

Word of the Day

A positive statement

A statement that can be proven to be true or false. A positive statement does not contain any bias and is simply a fact or a false fact. For example, if I say that paper is not made from wood, this is a positive statement because one can test what paper is made from (the statement will inevitably be made untrue since paper is made from wood, however that doesn't mean the statement is not a positive one).

In economics, it is useful to identify a positive statement from a normative statement.

A normative statement

A statement that is based on opinion and cannot be proven true/untrue. For example, 'fiscal policy is more effective than monetary policy at increasing aggregate demand', is a normative statement because it contains one's view and cannot be tested (because fiscal and monetary policy are frequently used hand in hand).

Production Possibility Frontier and Long Run Aggregate Supply

The PPF shows the combination of capital and consumer goods that can be produced within the economy. The PPF shows what the economy can produce. If the economy is producing inside the PPF, point X, it is in a recession. Unemployment is high and the economy is not producing at it’s full productive capacity.

When the economy is producing on the PPF, point Y, it IS producing at its full productive capacity. It is also producing on the LRAS curve, point V on the supply/demand diagram. Real national output is YFE and the price level is P1. Full employment of resources has been achieved, which means that the labour force is fully employed, see Word of the Day. The only way to increase output is by increasing investment in capital goods (which increases consumer goods) thereby increasing LRAS. If this happens, economic growth is occurring in the long run. See Word of the Day. LRAS1 moves rightward to LRAS2 and thus SRAS1 shifts rightward to SRAS2. Real national output in the economy has increased from YFE to YFE2. Assuming AD remains unchanged, the price level falls from P1 to P2.

Word of the Day

Full Employment

According to Beveridge's definition, which is perfectly acceptable to use in the exam, full employment is when 3% or less of the labour force is unemployed.

According to the free market definition, full employment occurs when ASL = ADL

Full employment also occurs when the economy is producing on the LRAS curve, see PPF and LRAS. This is because when there is no spare capacity, all workers willing and able to work are working.

It does not mean that all members of the working population are in employment, frictional and structural unemployment is always occurring.

Stock Markets take a heavy dip

The FTSE 100 and Dow Jones dropped heavily yesterday (Friday) due to the uncertainty bought about by US economic growth and it's debt ceiling, and Spain and Italy's unmanageable public finances. There are fears that Italy and Spain may need bailouts as well, which is why investors sold these stocks.  Spain has the fourth largest economy in the EU, however its bond yields (interest rates on government bonds) remain high at 6.4% and in Italy, 6.3%. Greece, Ireland and Portugal had levels of above 7% when they desperately seeked bailouts by the IMF and European Union, highlighting the risk that Italy and Spain face. Have a look at this video to learn more.

The FTSE 100 fell by almost 3.5%, it's lowest fall since the collapse of Lehman Brothers in September 2008. The Dow Jones fell by 4.3%, Japan's Nikkei fell by 3.7% and Hong Kong's Hang Seng fell by 5%. 

Only time will tell what will happen, how investors react to markets will influence economies in the way they want because speculation is a powerful tool. If things continue the way they are, the EU may have to start preparing more bailout packages. As for the USA, someone once told me that when America sneezes, the whole world catches a cold.