What Economics is about

Economics- The science of scarcity; the science of how individuals and societies deal
with the fact that wants are greater than the limited resources available to satisfy those
wants.

Topic Definitions
Opportunity Cost- The most highly valued opportunity or alternative forfeited when a
choice is made.
Scarcity - when wants exceed our ability to satisfy
Decisions at the Margin- Decision making characterized by weighing the additional
(marginal) benefits of a change against the additional (marginal) costs of a change with
respect to current conditions.
Efficiency- Exists when marginal benefits equal marginal costs
Equilibrium- Equilibrium means "at rest"; it is descriptive of a natural resting place
Ceteris Paribus- A Latin term meaning "all other things constant," or "nothing else
changes."

• Positive economics- focuses upon that which is

o What is" refers to economic study based upon observable and tested
phenomenon
o Cause and Effect
• Based upon collected data, we know sales will rise 10% if prices
are lowered 5%
o Emphasis on reality; not opinion or conjecture
• Normative economics - is concerned with what should be
o "what should be" refers to that study concerned with advancing ideals and
values
o More philosophical than empirical
• No one should pay more than 25% of their earnings in taxes
• "Why"
 Because any more than that goes against the idea of small
government and a dynamic free market.

Microeconomics vs. Macro

o Microeconomics- is concerned with the primary elements of an

economy; that is, an individual, a firm, a particular industry, or specific
market
o Macroeconomics- studies the economy as a whole, firms and
individuals reacting to scarcity in the collective sense.

Micro economics
• Individual (referred to as consumer) level economic activity
• Individual Firms Behavior
o "The Firm" is generic term for a single business unit
• Industry of similar firms
• Single markets, comprised of individuals or firms within a similar business sector
Macro economics
• The economy at large
o The nation's economy
o World economic growth
• An economic market not subdivided into industry groups
• Issues may involve exchange rates, capital investment, mass labor markets, or
trade.

GATT and the World Trade Organization (WTO), for which GATT is the foundation,
has included:
Promotion of free trade:
• elimination of tariffs; creation of free trade zones with small or no tariffs
• Reduced transportation costs, especially resulting from development of
containerization for ocean shipping.
• Reduction or elimination of capital controls
• Reduction, elimination, or harmonization of subsidies for local businesses
• Creation of subsidies for global corporations
• Harmonization of intellectual property laws across the majority of states,
with more restrictions
• Supranational recognition of intellectual property restrictions (e.g. patents
granted by China would be recognized in the United States)

Critics argue that:

Poorer countries suffering disadvantages: While it is true that globalization

encourages free trade among countries, there are also negative consequences because
some countries try to save their national markets. The main export of poorer countries is
usually agricultural goods. Larger countries often subsidise their farmers (like the EU
Common Agricultural Policy), which lowers the market price for the poor farmer's crops
compared to what it would be under free trade.

Exploitation of foreign impoverished workers: The deterioration of protections for

weaker nations by stronger industrialized powers has resulted in the exploitation of the
people in those nations to become cheap labor. Due to the lack of protections,
companies from powerful industrialized nations are able to offer workers enough salary
to entice them to endure extremely long hours and unsafe working conditions, though
economists question if consenting workers in a competitive employers' market can be
decried as "exploited". It is true that the workers are free to leave their jobs, but in many
poorer countries, this would mean starvation for the worker, and possible even his/her
family if their previous jobs were unavailable.
The shift to outsourcing: The low cost of offshore workers have enticed corporations to
buy goods and services from foreign countries. The laid off manufacturing sector
workers are forced into the service sector where wages and benefits are low, but
turnover is high. This has contributed to the deterioration of the middle class which is a
major factor in the increasing economic inequality in the United States. Families that
were once part of the middle class are forced into lower positions by massive layoffs and
outsourcing to another country. This also means that people in the lower class have a
much harder time climbing out of poverty because of the absence of the middle class as
a stepping stone.

Weak labor unions: The surplus in cheap labor coupled with an ever growing number of
companies in transition has caused a weakening of labor unions in the United States.
Unions lose their effectiveness when their membership begins to decline. As a result
unions hold less power over corporations that are able to easily replace workers, often
for lower wages, and have the option to not offer unionized jobs anymore.

Increase exploitation of child labor: for example, a country that experiencing

increases in labor demand because of globalization and an increase the demand for
goods produced by children, will experience greater a demand for child labor. This can
be "hazardous" or “exploitive”, e.g. quarrying, salvage, cash croping but also includes
the trafficking of children, children in bondage or forced labor, prostitution, pornography
and other illicit activities.

Some Trade Stats:

Developing Countries:
The World Bank classifies countries according to their Gross National Income (GNI) per
capita as either low income, middle income, or high income. Low income and middle
income economies are referred to as developing economies.
Balance of Trade:
The difference between a country’s total imports and exports, when exports exceed
imports, there is a trade surplus; the converse yields a trade deficit.

Customs Union:
Any group of nations that has agreed to eliminate tariffs on goods traded among
members, while imposing common external tariffs on goods entering from outside the
group. The European Union is the best-known example.
Dumping:
A company is said to be dumping a product when it exports the product at a price lower
than the price it charges in the home market. Dumping is problematic for businesses in
the importing country because they have to cope with a foreign competitor that sells
products very cheaply. Dumping is considered as an unfair business practice. With the
WTO anti-dumping agreements, governments can appeal to the WTO to impose
retaliation against countries where companies break dumping laws.
Firm
An independent unit which utilizes the factors of production to produce goods and
services
Free Trade Area
A cooperative arrangement among two or more countries to eliminate tariff barriers
among themselves while not applying a uniform external tariff on imports from non
participant countries
Goods and services:
A good is a tangible item that someone has made, mined, or grown. Goods include
naturally occurring substances (oil, iron ore), agricultural products (grains, livestock), and
manufactured or processed products (packaged foods, toys, timber, furniture,
computers, machine parts). A service is a form of work, assistance, or advice that
provides something of value to someone else but does not produce a tangible item. Air,
rail, or sea transportation are services. Communication by telephone or Internet is a
service. So is the work done by engineers, doctors, lawyers, architects, and
entertainers? Tourism is a service, too: The money spent by foreign visitors at Disney
World, the Grand Canyon, and other attractions inside the United States represents
earnings from the export of tourism services. The distinction between goods and
services can sometimes be blurry. When a musician plays a concert, for example, he or
she provides entertainment services to those who attend. But if the performance is
recorded and turned into a CD, the musician has also created a tangible good.

Industrial Country:
Those countries whose society shifted from agricultural based to modern industrial.

Industrial Revolution:
The Industrial Revolution refers to the social and economic changes that occurred in
Great Britain from the middle of the 18th to the middle of the 19th century. British society
shifted from a primarily agricultural society to a modern industrial society. Other
countries quickly followed the British transition.

Intellectual property:
Intellectual property refers to the creations of the mind, such as inventions, literary or
artistic works, and symbols, names, and designs used in commerce. Intellectual property
is divided into two categories: industrial property, which includes inventions and
trademarks, and copyrights, which include novels, plays, films, and paintings, among
many other things. Intellectual property can be a cause of trade disputes when
standards for protection of intellectual property differ in different countries. For instance,
it is in the interest of U.S. companies to have intellectual property such as music
copyrights respected in China, but the Chinese government does not regulate copyright
issues as much as the US government does.

Multilateral:
If something is multilateral, it means that more than two countries participate in it. A
multilateral agreement is an agreement that at least three countries have signed. A
multilateral institution is an organization in which at least three countries participate. If
just two countries reach an agreement between themselves, that agreement is said to be
bilateral. The United States, for example, has a bilateral free-trade agreement with
Israel. But NAFTA, a free trade agreement among three countries -- the United States,
Canada, and Mexico -- is a multilateral agreement. When people use the term
multilateral, however, they usually have in mind something involving more than three
countries. The post-World War II multilateral trade rounds, for example, have involved
dozens of countries.

Non-Tariff Barriers (NTB):

Import quotas, burdensome customs formalities, foreign exchange controls, or other
measure or policies (other than tariffs) which restrict or prevent trade.

Protectionism:
The establishment of barriers to the importation of goods and services from foreign
countries in order to protect domestic producers

Quotas:
Quotas are quantitative restrictions on the import of certain goods and services. Rather
than imposing tariffs, governments wishing to limit access to or raise the prices of certain
goods or services will sometimes specify in laws or regulations that total yearly imports
of a particular good or service may not exceed a certain quota, which may be expressed
as a quantity of exports or as a dollar value of exports. The United States maintains
import quotas on imported clothing, sugar, peanuts, and several other items. Under an
international agreement governing trade in clothing and fabrics, the United States
applies different import quotas to the clothing produced by different developing
countries.
Tariff:
A list of taxes or customs duties payable on imports or exports
Wholesalers:
A wholesaler is an agent that sells goods in large quantities to retailers, who then sell
those goods to the general public.

MALAYSIA'S ECONOMIC SYSTEM

By RHODA HABTEMICHAEL

General Characteristics of Agricultural, Industrial, and Information Age Economic

Systems

Agricultural Age Economic Systems: feudal economic systems and earlier ancient
empire economic systems based on slavery
Industrial Age Economic Systems: rise of capitalist economic systems and then socialist
economic systems ( as a critique of capitalism)
Information Age Economic Systems: both capitalist and socialist economic systems are
being greatly restructured as they become part of a global economy; no pure
systems hybrids instead, through also privatization trends world wide--including
in former socialist countries

Information/Data on Malaysia's Economic System, a mixture of private enterprise and

soundly managed public sector, has posted a remarkable record of 8%-9%
average growth in 1987-92. This growth has resulted in a substantial reduction in
poverty and a marked rise in real wages. Dspite sluggish growth in the major
world economies in 1992, demand for Malaysian goods remained strog and
foreign investors continued to commit large sums is the economy. The
government is aware of the inflationary potential of this rapid development and is
closely monitoring fiscal and monetary polices
Conclusions on Malaysia. Malaysia is in Agricultural and Industrial age. Its economic
growth has resulted in exporting rapidly the manufactured goods, and foreign
investors are making difference in the country's economy. Malaysia is the worlds
largest exported of natural rubber and palm oil

Economic system of Islamic

Islam is an entire way of life, and Allah's Guidance extends into all areas of our lives.
Islam has given detailed regulations for our economic life, which is balanced and fair.
Muslims are to recognize that wealth, earnings, and material goods are the property of
God, and we are merely His trustees. The principles of Islam aim at establishing a just
society wherein everyone will behave responsibly and honestly.
A Muslim should be responsible in spending money. Extravagance and waste are
strongly discouraged.

Economic system

Question 1
Economic system
• An economic system is comprised of the various processes of
organizing and motivating labor, producing, distributing, and circulating of the fruits of
human labor, including products and services, consumer goods, machines, tools,
and other technology used as inputs to future production, and the infrastructure
within and through which production, distribution, and circulation occurs. These
processes are over determined by the political, cultural, and environmental
conditions within which they come to exist. In comparative economic systems, these
economic systems are usually defined within determinate political boundaries.

• Thus, one would speak of a Chinese economic system, although

China may, in fact, be a complex conglomeration and interaction of economic
systems. Nevertheless, bounding economic systems in this way provides a way of
discussing how such systems are made possible and changed by the specific effects
of politico-institutional, cultural, and environmental differences. Thus, one might
discuss how the capitalist economic system of 1999 Germany is different from the
capitalist economic system of 1999 Britain, for example.
American Economic System

• This book also demonstrates that the American economic system

has been marked by almost continuous change. Its dynamism often has been
accompanied by some pain and dislocation -- from the consolidation of the
agricultural sector that pushed many farmers off the land to the massive restructuring
of the manufacturing sector that saw the number of traditional factory jobs fall sharply
in the 1970s and 1980s. As Americans see it, however, the pain also brings
substantial gains.

• Economist Joseph A. Schumpeter said capitalism reinvigorates

itself through "creative destruction." After restructuring, companies -- even entire
industries -- may be smaller or different, but Americans believe they will be stronger
and better equipped to endure the rigors of global competition. Jobs may be lost, but
they can be replaced by new ones in industries with greater potential.

• The decline in jobs in traditional manufacturing industries, for

instance, has been offset by rapidly rising employment in high-technology industries
such as computers and biotechnology and in rapidly expanding service industries
such as health care and computer software.

Socialism

• Socialism is the social system which institutionalizes envy and self-sacrifice:

It is the social system which uses compulsion and the organized violence of
the State to expropriate wealth from the producer class for its redistribution to
the parasitical class.
• Despite the intellectuals’ psychotic hatred of capitalism, it is the only moral and just
social system.
• Socialism is a political and economic system which advocates collective or
governmental ownership and the administration of the means of production and
distribution of goods. In a socialist society, there is no private property and, at least
theoretically, everyone cares for those less fortunate. In this form of government
everyone has generally the same amount of money, which means the rich person’s
money goes to the poor so that everyone can be middle class.

Capitalism

• Capitalism is the only moral system because it requires

human beings to deal with one another as traders--that is, as free moral agents
trading and selling goods and services on the basis of mutual consent.
• Capitalism is the only just system because the sole criterion that
determines the value of thing exchanged is the free, voluntary, universal judgment of
the consumer. Coercion and fraud are anathema to the free-market system.
• It is both moral and just because the degree to which man rises or
falls in society is determined by the degree to which he uses his mind. Capitalism is
 the only social system that rewards merit, ability and achievement, regardless of
one’s birth or station in life.
• Yes, there are winners and losers in capitalism. The winners
are those who are honest, industrious, thoughtful, prudent, frugal, responsible,
disciplined, and efficient. The losers are those who are shiftless, lazy, imprudent,
extravagant, negligent, impractical, and inefficient.
• Capitalism is the only social system that rewards virtue and
punishes vice. This applies to the business executive and the carpenter, the lawyer
and the factory worker.
• Basically, Capitalism advocates private property, and that society
does better when an individual can purchase and produce as they see fit. Socialism,
in essence, is the theory that property ownership should reside in the hands of the
government, and that the government can do more with the assets than individuals
can. The difference between Capitalism and Socialism can be summed up by their
definitions. They are based upon completely opposite philosophies.
• Capitalism is a political and economic system in which factories,
companies, land, etc. are owned privately in order to create profit for the owners.
Prices of goods and services fluctuate depending on the desire of the consumer and
the availability of the goods (the law of supply and demand). In a capitalist society,
there will be significant differences in wealth and power between those who have
capital (machines, factories, ships, land, etc.) and those who do not.
• Capitalism is the only politico-economic system based on the
doctrine of individual rights. This means that capitalism recognizes that each and
every person is the owner of his own life, and has the right to live his life in any
manner he chooses as long as he does not violate the rights of others.

If you divide Socialism by Capitalism you'll get a well balanced economic system.

Question 3

Question 4

Free Trade

The freedom to trade goods increases the supply and choice of produced goods. This
increase will potentially increase consumption. If someone is free to trade his goods with
someone else, they will both benefit from the trade.

That is the idea, anyway. Smith argued that "Perfect freedom of trade would even be the
most effectual expedient for supplying them [consumers], in due time, with all the
artificers, manufacturers and merchants, whom they wanted at home" (Smith, 1776:
670). He completely favors of the freedom of trade for the potential to supply the
demand of every consumer in the market.

Question 5

Oligopoly
An oligopoly can be defined as an industry in which few firms control the entire market.
In an oligopoly, there is a small number of firms that dominate the market.

The following are all good examples of industries that have an oligopolistic market
structure:

• Groceries - dominated in the UK by Asda/Wal Mart, Tesco, Sainsbury and

Safeway/Morrisons
• Chemicals/oils - wide definition of the term chemical but key players are Shell,
Exxon, GlaxoSmith Klein, ICI, Kodak, Astra-Zeneca, BP, DuPont, BASF and
Bayer
• Brewers - Interbrew, Scottish and Newcastle, Guinness, and Carlsberg Tetley
have a four firm concentration ratio of 85%!
• Fast food outlets - McDonalds, Burger King, KFC
• Bookstores - Amazon, Barnes & Noble, Borders, Blackwells, Waterstones
• Detergents - Unilever and Proctor and Gamble
• Music retailing - HMV, Virgin, Tower, Amazon, MVC
• Banks - NatWest, Barclays, HSBC, Lloyds TSB
• Entertainment - Time-Warner, BMG,
• Electrical retail - Dixons, Currys, Comet
• Electrical goods - Sony, Hitachi, Panasonic, Canon, Bush, Fuji
• Mobile phone networks - O2, Vodafone, Orange, T-Mobile
• Home DIY - B&Q, Focus, Homebase
• OPEC is an example of Oligopoly since few countries control the production of
oil, the steel and the automobile industry in United States of America is another
example.

The Key characteristics of an Oligopolistic Market are as follows: -

• It is a market dominated by a small number of participants who are able to

collectively exert control over supply and market prices.
• Few firms sell branded products which are close substitutes of each other.
• Entry barriers for the other firms are high; the barriers can be due to patents,
copyrights, government rules / regulations or ownership of scare resources.
• Firms are interdependent for decision making.
• Products can be homogenous (standardized) or heterogeneous (differentiated).
• The sellers are the price makers and not price takers, since the few sellers
mutually dominate the pricing decisions.
• The sellers can achieve supernormal profits in the long run.
• The sellers can achieve economies of scale; since for the large producers as the
level of production rises, the cost per unit of products decreases; thus ensuring
higher profits.
• There is high degree of market concentration, since the four-firm concentration
ratio is often used, where the market shares of four largest firms are measured
(as a percentage) since they form the major portion of the market share.

An Oligopolist faces a downward sloping demand curve; however; the price elasticity
depends on the rival¡¦s reaction to change its price, investment and output.
The firm uses Game Theory, in this method the firms takes into account the
decisions/strategies of the competitors before deciding their strategies. The different
forms of Oligopoly are: -

1. Duopoly: - A Duopoly, is a simple form of Oligopoly in which only two firms dominate
a market. e.g.:- Pepsi and Coke, Cadbury and Schweppes.

2. Oligopsony: - In Oligopsony, there are few buyers and large number of sellers. The
other characteristics are same as Oligopoly.

3. Bilateral Oligopoly: - A market with a few sellers (oligopoly) and a few buyers
(Oligopsony) is referred as Bilateral Oligopoly.

4. Cartel: - When there is a formal agreement among the Oligopolist for a collusion (to
increase prices and restrict production in the same way as a monopoly) with an objective
to reduce risk and foster joint profit it is termed as Cartel.

Monopolistic
– A monopolistically competitive market has three fundamental
characteristics
• Many buyers and sellers
• Sellers offer a differentiated product
• Sellers can easily enter or exit the market

Whereas monopolistic competition is a market structure that has a large number of

sellers, each of which is relatively small and posse a very small market share.

Extras

Political systems vs. democratic political

• Firstly, wages are lower in totalitarian political systems then in

democratic political systems simply due to the differences in political structure; in
stating the obvious, workers may be denied a say in how they are governed in a
totalitarian system to the benefit of governing individuals.

• This is in contrast to a democratic system where politicians must

garner voter support. Workers would then have the ability to exercise their collective
voting power and influence their wages through elected politicians that may garner
support with worker-favorable governmental policy such as an increase in the
minimum wage rate.

• Secondly, companies that operate in a totalitarian environment

would experience higher profits due to low wages. As Vernon (1966) has pointed out
with the PLC, if the major input into a production process is non-skilled labour, the
cost of that labour and wage differentials across national boundaries becomes a
major location decision factor thus it is fair to reason that companies faced with rising
wages would eventually seek out other lower wage locations regardless of the
political system.
 • When testing these assumptions within an Asian context, inter-
country comparisons are fraught with difficulties including among other things cultural
and psychographic differences that may have an 'apples and oranges' comparison
affect. In the hope of overcoming such difficulties, Indonesia has been selected as a
model for comparison as both company and labour force actors can be examined pre
and post political change.

Question 6

The objectives of the firm can be viewed as the motives of the entrepreneur/s who own
and run the firm. There a number of goals that firm can pursue in its day to day
operations - it may try to maximise profits, sales or growth, meeting shareholder
expectations, or increasing market share. Maximising profits - making the biggest
possible profit, or the smallest possible loss - is recognised as the main objective of most
firms. Profit is the difference between the firm's total revenue (output sold multiplied by
price) and its total cost of production. While it is generally recognised that profit
maximisation is the main objective of most businesses, we mustn't overlook the fact that
firms may have other objectives. .

What is produced is what people want. Firms will follow changes in household demand,
changing production as demand is influenced by tastes and preferences, and by
technology.

Firms in competitive markets usually attempt to find the least cost, greatest profit
method of production.

Economists assume that firms, operating in competitive markets, always try to maximize
their profits. This is done by increasing the quantity of goods or service you produce.
As we know, revenue equals the price per unit multiplied by the quantity sold. In
competitive markets, there is little likelihood of increasing your price without decreasing
the quantity you sell.

Firms will produce one more unit of a good, as long as the additional revenue gained is
greater than the additional cost of production. Economists say ''Production increases as
long as marginal revenue is greater than marginal cost''.

In a market economy, firms invest in research and development, and in new

technologies, in a continual attempt to lower their costs. Firms are always looking for
the least cost method of production.

At the same time, some firms may be focussing on sales maximisation, in an attempt
to gain a share in the market. A firm may sell at lower prices for a time, and reduce the
profits paid to it's owners, as result. The shareholders in this firm may be focussing on
the long term, 5 to 10 year period, rather than on the next two years. Proponents of this
management objective focus on market share as the key to profitability.

Alternative Aims and Objectives

Not all businesses seek profit or growth. Some organisations have alternative objectives.
Examples of other objectives:

Ethical and socially responsible objectives – organisations like the Co-op or the Body
Shop have objectives which are based on their beliefs on how one should treat the
environment and people who are less fortunate.

Public sector corporations are run to not only generate a profit but provide a service to
the public. This service will need to meet the needs of the less well off in society or help
improve the ability of the economy to function: e.g. cheap and accessible transport
service.

Public sector organisations that monitor or control private sector activities have
objectives that are to ensure that the business they are monitoring comply with the laws
laid down.

Health care and education establishments – their objectives are to provide a service
– most private schools for instance have charitable status. Their aim is the enhancement
of their pupils through education.

Charities and voluntary organisations – their aims and objectives are led by the
beliefs they stand for.

Changing Objectives

A business may change its objectives over time due to the following reasons:

A business may achieve an objective and will need to move onto another one (e.g.
survival in the first year may lead to an objective of increasing profit in the second year).

The competitive environment might change, with the launch of new products from
competitors.

Technology might change product designs, so sales and production targets might need
to change.

Question 7

Fiscal Policy

Fiscal policy is carried out by the legislative and/or the executive branches of
government. The two main instruments of fiscal policy are government expenditures
and taxes. The government collects taxes in order to finance expenditures on a number
of public goods and services—for example, highways and national defense.

Fiscal and monetary policy - comparison

Fiscal policy should not be seen is isolation from monetary policy.

For most of the last thirty years, the operation of fiscal and monetary policy was in the
hands of just one person – the Chancellor of the Exchequer. However the degree of
coordination the two policies often left a lot to be desired. Even though the BoE has
operational independence that allows it to set interest rates, the decisions of the
Monetary Policy Committee are taken in full knowledge of the Government’s fiscal policy
stance. Indeed the Treasury has a non-voting representative at MPC meetings. The
government lets the MPC know of fiscal policy decisions that will appear in the annual
budget.

Impact on the Composition of Output

Monetary policy is seen as something of a blunt policy instrument – affecting all sectors
of the economy although in different ways and with a variable impact

Fiscal policy changes can be targeted to affect certain groups (e.g. increases in means-
tested benefits for low income households, reductions in the rate of corporation tax for
small-medium sized enterprises, investment allowances for businesses in certain
regions)

Consider too the effects of using either monetary or fiscal policy to achieve a given
increase in national income because actual GDP lies below potential GDP (i.e. there is a
negative output gap)

Monetary policy expansion

Lower interest rates will lead to an increase in both consumer and fixed capital spending
both of which increases current equilibrium national income. Since investment spending
results in a larger capital stock, then incomes in the future will also be higher through the
impact on LRAS.

Fiscal policy expansion

An expansion in fiscal policy (i.e. an increase in government spending) adds directly to

AD but if financed by higher government borrowing, this may result in higher interest
rates and lower investment. The net result (by adjusting the increase in G) is the same
increase in current income. However, since investment spending is lower, the capital
stock is lower than it would have been, so that future incomes are lower.

Differences in the Effectiveness of Monetary and Fiscal Policies

When the economy is in a recession (when business and consumer confidence is very
low and perhaps where deflationary pressures are taking hold) monetary policy may be
ineffective in increasing current national spending and income. The problems
experienced by the Japanese in trying to stimulate their economy through a zero-interest
rate policy might be mentioned here. In this case, fiscal policy might be more effective in
stimulating demand. Other economists disagree – they argue that short term changes in
monetary policy do impact quite quickly and strongly on consumer and business
behaviour. Consider the way in which domestic demand in both the United States and
the UK has responded to the interest rate cuts introduced in the wake of the terror
attacks on the USA in the autumn of 2001
However, there may be factors which make fiscal policy ineffective aside from the usual
crowding out phenomena. Future-oriented consumption theories hold that individuals
undo government fiscal policy through changes in their own behaviour – for example, if
government spending and borrowing rises, people may expect an increase in the tax
burden in future years, and therefore increase their current savings in anticipation of this

Differences in the Lags of Monetary and Fiscal Policies

Monetary and fiscal policies differ in the speed with which each takes effect the time lags
are variable

Monetary policy in the UK is extremely flexible (rates can be changed each month) and
emergency rate changes can be made in between meetings of the MPC, whereas
changes in taxation take longer to organize and implement.

Because capital investment requires planning for the future, it may take some time
before decreases in interest rates are translated into increased investment spending.
Typically it takes six months – twelve months or more before the effects of changes in
UK monetary policy are felt.

The impact of increased government spending is felt as soon as the spending takes
place and cuts in direct and indirect taxation feed through into the economy pretty
quickly. However, considerable time may pass between the decision to adopt a
government spending programme and its implementation. In recent years, the
government has undershot on its planned spending, partly because of problems in
attracting sufficient extra staff into key public services such as transport, education and
health.

Evaluation: Problems with the use of active "demand-management" policies

(1) The measurement of output: Where are we in the cycle? Where are we going? How
fast? Will we know when we get there? Inaccuracies in estimating the possible trade-offs
in macroeconomic policy

(2) Time lags in the policy process: measurement, decision, execution and then
effectiveness of policy changes

(3) What kind of fiscal policy? Spending (on what?) or tax cuts (for whom?)

(4) Will spending (fiscal policy) ‘crowd-out’ other spending, either directly or indirectly?

(5) Will changes in fiscal or monetary policy affect other economic objectives - such as
the exchange rate, the trade balance and the provision of public services?

(6) Fiscal policy is weak (ineffective) when investment is very sensitive to interest rates
and when consumers pierce the veil and attempt to offset the actions of the government
(e.g. saving a tax cut, or increasing their saving when higher government spending leads
to expectations of higher taxes in the future)
(7) Monetary policy is weak (ineffective) when consumers are willing to hold large
quantities of money rather than spend them even when interest rates are very low

Budget deficits and surpluses. When government expenditures exceed government tax
revenues in a given year, the government is running a budget deficit for that year. The
budget deficit, which is the difference between government expenditures and tax
revenues, is financed by government borrowing; the government issues long-term,
interest-bearing bonds and uses the proceeds to finance the deficit. The total stock of
government bonds and interest payments outstanding, from both the present and the past,
is known as the national debt. Thus, when the government finances a deficit by
borrowing, it is adding to the national debt. When government expenditures are less than
tax revenues in a given year, the government is running a budget surplus for that year.
The budget surplus is the difference between tax revenues and government expenditures.
The revenues from the budget surplus are typically used to reduce any existing national
debt. In the case where government expenditures are exactly equal to tax revenues in a
given year, the government is running a balanced budget for that year.

Expansionary and contractionary fiscal policy. Expansionary fiscal policy is defined

as an increase in government expenditures and/or a decrease in taxes that causes the
government's budget deficit to increase or its budget surplus to decrease. Contractionary
fiscal policy is defined as a decrease in government expenditures and/or an increase in
taxes that causes the government's budget deficit to decrease or its budget surplus to
increase.

Classical and Keynesian views of fiscal policy. The belief that expansionary and
contractionary fiscal policies can be used to influence macroeconomic performance is
most closely associated with Keynes and his followers. The classical view of
expansionary or contractionary fiscal policies is that such policies are unnecessary
because there are market mechanisms—for example, the flexible adjustment of prices and
wages—which serve to keep the economy at or near the natural level of real GDP at all
times. Accordingly, classical economists believe that the government should run a
balanced budget each and every year.

Combating a recession using expansionary fiscal policy. Keynesian theories of output

and employment were developed in the midst of the Great Depression of the 1930s, when
unemployment rates in the U.S. and Europe exceeded 25% and the growth rate of real
GDP declined steadily for most of the decade. Keynes and his followers believed that the
way to combat the prevailing recessionary climate was not to wait for prices and wages to
adjust but to engage in expansionary fiscal policy instead. The Keynesians' argument in
favor of expansionary fiscal policy is illustrated in Figure 1 .
 Figure 1Combating a recession using expansionary fiscal policy

Assume that the economy is initially in a recession. The equilibrium level of real GDP,
Y1, lies below the natural level, Y2, implying that there is less than full employment of the
economy's resources. Classical economists believe that the presence of unemployed
resources causes wages to fall, reducing costs to suppliers and causing the SAS curve to
shift from SAS1 to SAS2, thereby restoring the economy to full employment. Keynesians,
however, argue that wages are sticky downward and will not adjust quickly enough to
reflect the reality of unemployed resources.

Consequently, the recessionary climate may persist for a long time. The way out of this
difficulty, according to the Keynesians, is to run a budget deficit by increasing
government expenditures in excess of current tax receipts. The increase in government
expenditures should be sufficient to cause the aggregate demand curve to shift to the right
from AD1 to AD2, restoring the economy to the natural level of real GDP. This increase in
government expenditures need not, of course, be equal to the difference between Y1 and
Y2. Recall that any increase in autonomous aggregate expenditures, including government
expenditures, has a multiplier effect on aggregate demand. Hence, the government needs
only to increase its expenditures by a small amount to cause aggregate demand to
increase by the amount necessary to achieve the natural level of real GDP.

Keynesians argue that expansionary fiscal policy provides a quick way out of a recession
and is to be preferred to waiting for wages and prices to adjust, which can take a long
time. As Keynes once said, “In the long run, we are all dead.”

Combating inflation using contractionary fiscal policy. Keynesians also argue that
fiscal policy can be used to combat expected increases in the rate of inflation. Suppose
that the economy is already at the natural level of real GDP and that aggregate demand is
projected to increase further, which will cause the AD curve in Figure 2 to shift from AD1
to AD2.
 Figure 2Combating inflation using contractionary fiscal policy

As real GDP rises above its natural level, prices also rise, prompting an increase in
wages and other resource prices and causing the SAS curve to shift from SAS1 to SAS2.
The end result is inflation of the price level from P1 to P3, with no change in real GDP.
The government can head off this inflation by engaging in a contractionary fiscal policy
designed to reduce aggregate demand by enough to prevent the AD curve from shifting
out to AD2. Again, the government needs only to decrease expenditures or increase
taxes by a small amount because of the multiplier effects that such actions will have.

Secondary effects of fiscal policy. Classical economists point out that the Keynesian
view of the effectiveness of fiscal policy tends to ignore the secondary effects that fiscal
policy can have on credit market conditions. When the government pursues an
expansionary fiscal policy, it finances its deficit spending by borrowing funds from the
nation's credit market. Assuming that the money supply remains constant, the
government's borrowing of funds in the credit market tends to reduce the amount of
funds available and thereby drives up interest rates. Higher interest rates, in turn, tend to
reduce or “crowd out” aggregate investment expenditures and consumer expenditures
that are sensitive to interest rates. Hence, the effectiveness of expansionary fiscal policy
in stimulating aggregate demand will be mitigated to some degree by this crowding-out
effect.

The same holds true for contractionary fiscal policies designed to combat expected
inflation. If the government reduces its expenditures and thereby reduces its borrowing,
the supply of available funds in the credit market increases, causing the interest rate to
fall. Aggregate demand increases as the private sector increases its investment and
interest-sensitive consumption expenditures. Hence, contractionary fiscal policy leads to
a crowding-in effect on the part of the private sector. This crowding-in effect mitigates
the effectiveness of the contractionary fiscal policy in counteracting rising aggregate
demand and inflationary pressures.

The goals of the Federal Reserve Board (the Fed) are to encourage economic growth,
control inflation, reduce unemployment to acceptable levels and stabilize the exchange
rate between the U.S. dollar and foreign currencies in the foreign exchange marketplace.
Monetary policy is one the two ways the government can impact the economy. By
regulating the cost of money, the Federal Reserve can affect the amount of money that
is spent by consumers and businesses. An example of the operation of monetary policy
involves decisions made by the Federal Open Market Committee to raise or lower
interest rates in an effort to reduce unemployment, control inflation but continue to
encourage a sustainable

Fiscal policy: The term fiscal policy refers to the expenditure a government undertakes to
provide goods and services. Fiscal policy also involves government financing of these
expenditures. These expenditures affect the economy in a number of ways including
having an affect on the inflation and unemployment rates. There are two methods of
financing: taxation and borrowing. If the government does not have the tax revenue to
fund expenditures, it can turn to the capital markets to borrow the necessary money.
Federal and state governments have the power to raise or lower taxes, or to modify the
way in wh

costs and effects of inflation

There is widespread agreement that high and volatile inflation can be damaging both
to individual businesses and consumers and also to the economy as a whole.

However, economists disagree about the relative seriousness of inflation. The revision
notes below cover some of the main economic and social costs associated with
persistent inflation in goods and services.

Effect on UK competitiveness - if the UK has higher inflation than the rest of the world
it will lose price competitiveness in international markets. This assumes a given
exchange rate. If the exchange rate depreciates, this may help to restore some of the
lost competitiveness. Consider the chart above which shows the annual average
increase in consumer prices for the UK, the United States and Euroland during the last
four decades. Inflation in Britain has been relatively higher than in other major competitor
countries - although the chart also indicates a movement towards inflation
convergence during the 1990s

Question 8

The cost of inflation: by M M Smal

Introduction

Inflation undermines the role of money as a unit of account and as a monetary standard.
This contrasts with most other activities where, once a standard is chosen, every effort is
made to ensure that it is maintained (Konieczny, 1994). Inflation creates confusion
because, while it is easy to recognise that one rand buys fewer goods and services, it is
much more difficult to determine what it is worth and what it will be worth. The former
problem deals with the role of money as a means of exchange, whereas the latter affects
the role of money as a store of value. It is not surprising that nowadays high inflation is
generally recognised internationally by monetary and fiscal authorities as undesirable
and bad for national economies. There is a growing appreciation worldwide that it is not
possible to achieve long-term growth and employment by tolerating, let alone fuelling,
high rates of inflation.

In South Africa, the De Kock Commission in its final report in 1985 states that "in the
long term the primary objective of monetary policy should be the maintenance of
reasonable stability of the domestic price level." This important objective of monetary
policy is also recognised in the South African Reserve Bank Act. In his first Governor’s
Address to the Bank’s shareholders in August 1989, Dr C. L. Stals stated that the Bank’s
primary mission is to protect the value of the rand, i.e. to combat inflation. Since August
1989 the Reserve Bank’s policy actions have placed a high priority on counteracting the
forces of inflation in the South African economy (Meijer, 1990: 31).

From time to time, policy makers, and particularly the monetary authorities, have been
accused of contributing to the sub-optimal performance of the South African economy
through their actions to reduce inflation. Although there is a price to be paid for reducing
inflation, policy makers have to face the question of whether that price would not be
lower than the price that would ultimately have to be paid for allowing high, and often
increasing, inflation.

The desire to reduce inflation reflects a judgment that inflation imposes significant costs
on the community. The first argument for the case of price stability would be to identify
the cost of inflation itself. Unfortunately, many of the social costs of inflation are difficult
to calculate accurately. Even the economic costs of inflation are not easy to quantify.
These costs are usually spread over an extended period and are not as evident as the
costs of price stabilisation policies, which are normally confined to a relatively short
period. Moreover, the costs of inflation constantly change over time as economic
behaviour adapts to inflation.

Given the diversity of the types of costs that have been identified as stemming from
inflation, no specific empirical research has comprehensively quantified all these costs.
However, the analysis of empirical evidence on the nature of the relations among
inflation, uncertainty, relative price variability and output growth has made substantial
progress in the 1990s. Although consensus cannot be said to exist, there are now firm
indications that the gross benefits of low inflation are larger than was thought at the
beginning of the 1990s (O’Reilly: vii).

It is not the purpose of this article to undertake an extensive empirical analysis to

calculate the exact cost of inflation in South Africa. Instead, a summary is provided of
some of the costs of inflation, illustrated with graphs and tables. The next section
describes the measurement and historical development of inflation in South Africa. Then
the main changes in attitudes to inflation are discussed, and the most important costs of
inflation dealt with. The article concludes that inflation creates uncertainty about the
future, that there are costs in having to cope with inflation and that 'living with inflation' is
no solution for sustainable higher economic growth or development. It highlights the
need to ensure that inflation does not become a permanent feature of the economy.

Question 10
Saturday March 27, 2010

Towards sustainable growth

By CECILIA KOK

SHAFRI Awang, 38, started drafting a new personal budget plan last week upon
receiving a letter from his employer telling him that his monthly salary would be revised
upwards by about 7% beginning next month.

“It’s good news for me and my family, as the higher disposable income will give us more
capacity to spend on things that we like,” says the father of two, who has been working
for a publication house in Petaling Jaya over the last 15 years.

Shafri has long wanted to buy the latest electrical goods and gadgets and to upgrade the
subscription of entertainment and telecommunications services for his family to “enhance
their lifestyle and catch up with the latest technology”. But the economic uncertainty and
the meagre pay rises over the last two years meant that these plans had to be put on hold
until recently.

In general, Shafri’s experience is similar to that of many other Malaysians whose salaries
will be or have been hiked this year. While not many could get the good pay bump that
Shafri has received, a Bank Negara survey showed that the average salary increment this
year would definitely be better than last year’s, as most companies would be unwinding
the freeze on salary increases this year.

In its recent annual report, the central bank stated that the average private sector salary
would likely grow 4.1% this year, compared with around 3.4% in 2009. In addition, more
jobs are expected to be created this year.

The survey indicated a growth of about 5% in employment, particularly in the

manufacturing, services and construction sectors, while the unemployment rate would
ease slightly to 3.6% in 2010 compared with 3.7% previously.

The improvement in the local labour market conditions is a result of Malaysia’s strong
economic rebound as seen in the last quarter of 2009. And with a sustained positive
consumer sentiment under a low-inflation environment, consumer spending will likely
pick up pace this year.

“The increase in consumer spending is a crucial factor to strengthen domestic demand

this year,” an economist with a local bank says.

Domestic demand, which encompasses consumption and investment by both the public
and private sectors, is expected to continue to be the main driver of the country’s
economic growth this year.
But with private investment likely to remain sluggish (expected to grow by a marginal
0.7% this year after a sharp decline of 21.8% last year) and public consumption taking a
back seat, growth in domestic demand will largely hinge on private consumption, the
economist explains.

Private consumption, which represented about 53.3% of the country’s gross domestic
product (GDP) last year, is projected to grow 3.8% this year, compared with a mere
growth of 0.8% in 2009. And that would be sufficient to help domestic demand grow at
3.2% in 2010, up from a contraction of 0.4% in 2009.

Since the onslaught of the global financial crisis, Malaysia and the rest of generally
export-driven Asian countries have been seeking a new direction to ensure sustainable
growth. Towards this end, many economists have argued that one of the key areas where
the region can find new sources of growth is domestic demand, especially consumer
spending and private investment.

“There is ample room for consumer spending in Malaysia to grow, and policymakers can
play a role in this area by actively looking at ways to help improve the purchasing power
of its people,” a foreign fund manager says.

“That itself could create a sustainable multiplier effect for other sectors to grow. As for
private investment, it is really about the Government creating a conducive environment
for businesses, both foreign and local, to operate – competitively and without any
discriminatory elements.”

In the week ahead, the Government will be unveiling the first phase of the highly
anticipated New Economic Model (NEM). The market has been expecting to see some
bold measures being introduced to restructure the country’s economy.

Prime Minister Datuk Seri Najib Tun Razak recently said the NEM would be looking at
boosting both domestic and foreign direct investments in high value add sectors that
could drive the creation of more high-paying jobs. He also emphasised there would be
some administrative reforms to support the implementation and ensure the success NEM.

“It’s a good thing … Asia really has to restrategise to remain dynamic, even as it is
leading the global economy out of the slump,” the foreign fund manager says.

Besides domestic demand, many economists have pointed out that Asia also has to look
at two other main areas for new sources of growth. These are the services sector and
regional economic integration.

A significant services sector is an important fundamental of any developed economy.

Last year, Malaysia’s services sector made up 57.5% of the country’s GDP. The sector is
expected to grow 4.9% this year, compared with 2.6% last year.
Undoubtedly, the significance of the services sector is growing in Malaysia. But
economists note that the country’s services sector, like many other emerging economies
in the region, is largely slanted towards export-driven industries.

For a more sustainable growth in the services sector, the initiatives should focus on areas
that are domestic-driven like wholesale and retail, accommodation, restaurant and
telecommunications, as well as tourism, and finance and insurance.

There is a consensus view that the advanced economies – which had been the traditional
trading partners of Malaysia as well as other countries in Asia – would see modest and
uneven growth this year. Hence, regional economic integration would create an
alternative market for Asia to trade.

“Some things cannot be changed … trade and an open economy is necessary for dynamic
growth, particularly for countries with a small domestic market like Malaysia,” an
economist says.

But with advanced economies expected to remain weak for some time, Malaysia has to
diversify its trade and focus on emerging markets in the region that are growing rapidly
such as China and India. Intra-regional trade has already been growing gradually over the
past year, and if this trend could be sustained, there would be further support for the
country’s exports growth.

Net exports’ contribution to Malaysia’s GDP this year is expected to contract by 2.7
percentage points as imports growth is expected to outpace exports growth. Last year, net
exports’ contribution to the country’s GDP rose 1.1 percentage points.

Based on the prevailing economic indicators, Bank Negara in its latest assessment predict
that Malaysia’s GDP this year would grow between 4.5% and 5.5%, recovering
significantly from a contraction of 1.7% in 2009.