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Fish
4
1
Coconut
8
6
Opportunity costs
Friday
Robinson
Fish
2 coconuts (8/4)
6 coconuts (6/1)
Coconut
1/2 fish (4/8)
1/6 fish (1/6)
Tariffs (price)
Quotas (volume) and voluntary export restraints
Subsidies on domestic products
The figure below shows the equilibrium of supply and demand of a country
without, and with tariffs.
Economic welfare = consumer surplus + producer surplus + government surplus
In the situation without tariffs:
Consumer surplus: Area 1 + 2 + 3 + 4 + 5 + 6
Producer surplus: Area 7
Imports:
Q2 Q1
In the situation with tariffs:
Consumer surplus: Area 1 + 2
Producer surplus: Area 3 + 7
Government surplus:
Area 5
Deadweight loss: Area 4 + 6 (nobody benefits from deadweight loss)
Imports:
Q4 Q3
As concluded, tariffs and quotas result in deadweight loss (area 4 & 6) in the
economy. Though, we still maintain these tariffs and quotas to protect our own
firms. This reduces globalization, which is the process of countries becoming
more open to foreign trade and investment. By the end of WWII the General
Agreement on Tariffs and Trade (1948) was established to reduce tariffs and
quotas (volume) to improve international trade. The GATT was later replaced by
the World Trade Organization. Reasons to oppose the WTO come from 3 sources:
WTO allows countries to determine that dumping has occurred when if a product
is exported for a lower price than it sells for on the home market. However, there
are good business reasons for firms to do so which makes it unclear why these
normal business practices should be unacceptable when used in international
trade.
Positive analysis: concerns what is (to possess)
Normative analysis: concerns what ought to be
Trading blocks:
Free trade area: no tariffs and quotas between themselves, but restrictions
(free to choose) to non-member countries.
Customs union: like free trade area but with common external tariffs and
quotas with non-member countries.
Common market: like customs union but also with futures of one single
market, like a tax system.
schuldbewijs voor een lening die door een overheid, een onderneming of een
instelling is aangegaan) from the public in the bond market. After the purchase,
the money is in the hands of the public.
Conversely, if the central bank decides to decrease the money supply, it can do
this by selling bonds from its portfolio to the public. After the sale, the currency it
receives for the bonds is out of the hands of the public.
One of the Ten Principles of Economics is that prices rise when too much money
is printed (because the value of money decreases). Another principle is that
society faces a short-run trade off between inflation and unemployment.
Monetary transmission mechanisms
Delta M can be limited by increasing the interest rate which will result in a lower
demand for credit less money creation.
Liabilities
Deposits: 100.00
Liabilities
Deposits: 100.00
The money supply (which equals currency plus demand deposits) equals
190.00, thus when banks hold only a fraction of deposits in reserve, banks
create money.
At the end of this process of money creation, the economy is more liquid in the
sense that there is more of the medium of exchange, but the economy is no
wealthier than before (wealth, as a concept, is a stock as opposed to a flow).
The Money Multiplier
The creation of money does not stop here. Suppose that the borrower from the
First Bank uses the 90.00 to buy something from someone who then deposits
the currency in the Second European Bank, which also has a reserve ratio of 10%.
Second European Bank
Assets
Reserves: 9.00
Loans: 81.00
Liabilities
Deposits: 90.00
The Second Bank keeps assets of 9.00 in reserve and makes 81.00 in loans,
creating an additional 81.00.
Eventually the 81.00 is deposited in the Third European Bank, which also has a
reserve ratio of 10% and keeps 8.10 in reserve and makes 72.90 in loans.
Third European Bank
Assets
Reserves: 8.10
Loans: 72.90
Liabilities
Deposits: 81.00
Each time money is deposited and a bank loan is made, more money is created.
Continuing this process, the total money supply shall be increased with a total of
1.000.00.
The amount of money the banking system generates with each euro of reserves
is called the money multiplier. In this economy, where the 100.00 reserves
generates 1.000.00 of money, the money multiplier is 10.
Although this money is not physically placed somewhere, the banking system is
such that we have trust that if we did wish to withdraw all that money in cash the
bank would have sufficient funds to be able to meet our demand.
The size of the money multiplier
The money multiplier is the reciprocal of the reserve ratio (R). If R is the reserve
ratio for all banks in the economy, then each euro of reserves generates 1/R
Euros of money. In the example above, R=1/10, so the money multiplier is 10.
If the reserve ratio would be only 5 per cent (R = 1/20), then the banking system
would have 20 times as much in deposits as in reserves, implying a money
multiplier of 20. Each euro of reserves would generate 20.00 of money.
If the reserve ratio would be 20 per cent (R = 1/5), deposits would be 5 times
reserves, the money multiplier would be 5 and each euro of reserves would
generate 5.00 of money.
Thus the higher the reserve ratio, the less of each deposit banks lend out, and
the smaller the money multiplier.
The Central Banks Tools of Monetary Control
When the Central Bank decides to change the money supply, it must consider
how its actions will work through the banking system. A Central Bank has three
main tools in its monetary toolbox: open market operations, refinancing rate and
reserve requirement.
Open-market Operations
schuldbewijs voor een lening die door een overheid, een onderneming of een
instelling is aangegaan) from the public in the bond market. After the purchase,
the money is in the hands of the public.
Conversely, if the central bank decides to decrease the money supply, it can do
this by selling bonds from its portfolio to the public. After the sale, the currency it
receives for the bonds is out of the hands of the public.
Reserve Requirement
The ECB sets minimum reserve requirements, but it applies them to the average
reserve ratio over a specified period rather than at a single point in time. It does
this to stop the amount of lending fluctuating wildly, in order to maintain stability
in the money market. Hence, the ECB uses reserve requirements in order to
maintain stability in the money market rather than as an instrument to increase
or decrease the money supply.
Problems in controlling the Money Supply
The central bank cannot perfectly control the Money Supply, because in a system
of fractional banking, the amount of money in the economy depends in part on
the behaviour of depositors and bankers. This causes the Central Bank to face
two problems:
1. The Central Bank does not control the amount of money that households
choose to hold as deposits in banks.
The more money households deposit the more reserves banks have, and
the more money the banking system can create.
The less money households deposit, the less reserves banks have, and the
less money the banking system can create.
2. The Central Bank does not control the amount that bankers choose to lend.
When money is deposited in a bank, it creates more money only when the
bank lends it out. Because banks can choose to hold excess reserves
instead, the central bank cannot be sure how much money the banking
system will create.
Transactions motive
Precautionary motive
Assets/speculative motive
The current account records payments for imports and exports of goods and
services, plus incomes flowing into and out of the country, plus net transfers of
money to and from abroad. A current account surplus is where credits exceed
debits and a current account deficit is where debits exceed credits. The current
account is usually divided into four subdivisions:
1. The trade in goods account: records imports and exports of physical
goods. This balance is also called the balance on trade in goods or balance
in visible goods or merchandise balance. A surplus is when exports
exceed imports. A deficit is when imports exceed exports.
2. The trade in services account: records imports and exports of services
(transport, tourism). The balance is called the services balance.
The balance of both the goods and services account is known as the
balance on trade in goods and services or simply the balance of
trade.
3. Income flows: wages, interest and profits flowing into and out of the
country.
4. Current transfers of money: government contributions to and receipts
from the EU and international organisations, and international transfers of
money by private individuals and firms. (for example: money sent from the
Netherlands to a Dutch student studying in the UK)
The capital account records the flows of funds (into the country (credits) and
out of the country (debits) )associated with the acquisition or disposal of fixed
assets, the transfer of funds by migrants, and the payment of grants, by the
government for overseas projects and the receipt of EU money for capital
projects.
The financial account records flows of money into and out of the country for the
purpose of investment or as deposits in banks and other financial institutions. It
records the holding of shares, property, bank deposits and loans, government
securities etc.
In other words, unlike the current account, which is concerned with money
incomes, the financial account is concerned with the purchase and sale of assets
(bezittingen).
Example:
Financial account: interest rates rise larger short-term inflows / smaller shortterm outflows more demand for sterling / less supply sterling financial
account will go into surplus the exchange rate will appreciate.
Current account: interest rates rise exchange rate appreciates imports
become cheaper / exports become expensive current account will go into
deficit
At this point, any financial account surplus is matched by an equal current (plus
capital) account deficit!
Purchasing Power Parity
Over the long-term, exchange rates should be such that you are able to buy the
same product for the same price anywhere in the world. Based on how over- or
undervalued a currency is, it is predictable to determine whether the exchange
rate rises or decreases.
BMI
The Big Mac is identical anywhere in the world. Therefore the Big Mac index is
created to determine how over- or undervalued a currency is, making it a
predictor of future exchange rates.
For example:
Switzerland:
1 Big Mac = 6.5 Swiss francs
1 Swiss franc = $1.16
USA:
1 Big Mac = $4.79
How over-valued is the Swiss franc?
Exchange rate (PPP) = 1 franc = 4.79 / 6.5 = $0.74
Actual exchange rate = 1 franc = $1.16
Thus: (n o) / o x 100 = (1.16 0.74) / 0.74 x100 = %56.7
The government or Central Bank may intervene in the foreign exchange market
to reduce day-to-day fluctuations in the exchange rates or prevent longer-term,
more fundamental shifts in the rate. There are several options:
Using reserves: the Central Bank can sell gold and foreign currencies from
the reserves to buy their own currency, causing the demand for this
currency back to the right (increase demand).
Borrowing from abroad: It can use foreign borrowed currencies to buy their
own currency and shifting the demand for this currency to the right
(increase demand).
Raising interest rates: demand for currency increases and supply
decreases.
The Bretton Woods system was a form of adjustable peg exchange rate,
where countries pegged (fixed) their exchange rates to the US dollar, but could
re-peg it at a lower or higher level if there was a persistent and substantial
balance of payments deficit or surplus.
This system was abandoned in 1971 as a result of the US inflation and increasing
trade deficit on the BoP. A period of managed floating occurred afterwards,
which is a system of flexible exchange rates, but where the government
intervenes to prevent excessive fluctuations or even to achieve an unofficial
target exchange rate.
The ERM (Exchange Rate Mechanism) was a semi-fixed system whereby
participating EU countries allow fluctuations against each others currencies only
within agreed bands. Collectively their currencies float freely against all other
currencies. The ERM came into existence in 1979 and was replaced by the single
currency in 1999.
Before countries could join the single currency, members were obliged to achieve
convergence of their economies. Each country had to meet five convergence
criteria:
Inflation: should be no more than 1.5% above average inflation rate of the
three countries in the EU with the lowest inflation.
Interest rates: the long term government bonds should be no more than
2% over the average of the three countries with the lowest inflation.
Budget deficit: no more than 3% of GDP.
National debt: no more than 60% of GDP.
Exchange rates: the currency should have been within the normal ERM
bands for at least two years with no realignments or excessive
intervention.
Opposition to EMU
GIIPS = NO