Japan's negative interest rates

Monetary policy is a key tool of economic management. It is usually applied by Central Banks to control inflation. The main tool of monetary policy is the rate of interest, although since 2008 the creation of additional money to add to the money supply (known as quantitative easing) has become common.

When interest rates are changed they affect the decisions of firms and households so that consumption and investment may change. Interest rate movements can also affect exchange rates. Therefore the policy can influence Aggregate Demand (AD).

The Japanese economy has seen many years of slow growth or recession. The chart below shows that Japan's relatively poor economic performance dates back to the 1990's, but the GFC has affected them like every other major economy.

The Japanese government has used expansionary fiscal (budgetary) policy and expansionary monetary policy since the 1990's. This has had little success in stimulating the Japanese economy.

The latest move has been to set negative interest rates. This applies to commercial bank deposits with the Bank of Japan. It means it costs the commercial banks money to have cash in their accounts at the Bank of Japan. Therefore, reason the Bank of Japan, it is more profitable for the commercial banks to lend the money to their customers and so stimulate AD.

Will it work? That seems unlikely given the failure of earlier stimulus measures which include a large quantity of money creation. However the fact that the Bank has tried to do something extra has encouraged the stock market.

The BBC cover the story here 

Questions.

1. Note the fall in the value of the Yen described in the article. Can you explain why the Yen depreciated?
2. What factors might cause an expansionary monetary policy be ineffective in raising AD?

This article has great relevance to IB students study of macroeconomic policy and exchange rates. For VCE the process of how monetary policy works and its influence on AD through consumption, investment and net exports, via exchange rates, is equally relevant.

The tricky problem of the Budget

If you listen to Australia's politicians they will generally tell you that the Australian government spends too much and that is why the Federal government runs a Budget deficit. You shouldn't really listen to politicians.

The problems of Australia's Budget are actually due to both spending and revenue problems. From my point of view far more due to revenue than expenditure.

The article below reports the views of the Treasury Secretary, John Fraser. Mr Fraser is a civil servant and so not bound to give a political point of view. He points out that revenue has continuously been lower than forecast in recent years, and that is why the Federal Budget is further in deficit than various government announcements have predicted.

The article is essential reading for VCE students. It describes the issues facing the Federal Budget and the difficulties of forecasting revenues, which is pretty essential when setting out plans for four years in the future. No government can escape this problem completely.

For Australia the government failed to see the fall in commodity prices which have led to much lower export values and profit taxes. Also growth has slowed which means that taxes on incomes are not rising as fast as hoped. Worse the government failed to tax the resources sector properly during the mining boom.

For those interested in this issue Ross Garnault's book 'Dog Days' is available in all good bookshops and online.

The Age article is here

This article is essential reading for VCE students, but IB students will find it relevant to the issue of fiscal policy.

Will tax deal end transfer pricing?

Today many firms are multinationals and operate around the world. This has brought many benefits and the effect of globalization on living standards has been considerable.  (This is actually the continuation of specialisation and trade you learn about in the first weeks of any economics course).

One of the drawbacks of this globalisation has been that multinationals have developed ways to pay their tax in countries where the profit taxes (corporate taxes) are lowest. This is, of course, rational behaviour for after-tax profit maximizing firms.

Transfer pricing works like this. Say you are a publisher and sell a really excellent economics textbook in the UK. The profit tax in the UK is 30%. Schools in Malaysia want to buy the book. Rather than sell them the book from the UK at £33 the publisher sells the books to their subsidiary in Singapore for £6, just over the cost of production. The subsidiary then sells the books to the Malaysian schools making all the profit in Singapore where the profit tax rate is just 10%.

I'm not bitter, but that's what Simon and Schuster did with my textbook, paying royalties only on the £6 earned in the UK.

This is perfectly legal. Firms such as Starbucks have bought their coffee from their Swiss subsidiary for the whole of Europe at high prices so the profit is declared in low tax Switzerland. Google have paid just £130m tax in ten years in the UK.

Now the OECD (The Organization for Economic Cooperation and Development - the 'rich countries club') have signed a deal to make multinational firms pay tax where they really earn it. This means they should pay profit tax on all the operations in the country where their activities take place.

It will be difficult to police, and only 31 countries have signed. This means firms might just start declaring their profits in a country which has not signed. However the system they hope to implement should allow countries to demand tax on the amount of tax the firm would have made if declared correctly.

The BBC covers the story here

This issue has direct relevance to IB Paper 2 and for taxation policy. For VCE this is a topic that is relevant to trade and budgetary policy.

Australian inflation, good or bad news?

The latest inflation figures put Australian inflation at 1.7%. That's higher than economists predicted, but still quite low (the RBA target is 2 - 3%, on average, over the business cycle).

All VCE students need to be aware of the main economic data over the last four years and so it is important to follow the trends in inflation as well as unemployment, growth, the current account and government finances.

The ABC report the latest inflation figures in the article below. It notes that 'core' or 'underlying' inflation is at 2%. It is headline inflation which is at 1.7%. However like many people the ABC ignores the actual RBA target which is 2 -3% on average. It is quite possible that inflation is on target as this is a period of subdued growth during the 'downswing' of the business cycle.

Two things to note from the article.
1. Subdued growth and inflation around where you might expect in this stage of the business cycle means that interest rates are unlikely to move from their record low of 2%. There is no need to stimulate Aggregate Demand (AD), as inflation edging up suggests that AD is reasonably healthy. If it wasn't falling oil and communication prices would have caused the expected lower inflation rate.

2. Inflation can be caused by 'Demand pull' factors or 'Cost push' pressures. However it is measured by aggregating price changes over a range of different sectors. The article shows how some sectors of the economy have seen price rises, others price falls. The 'inflation' figure of 1.7% is a weighted average of the various actual price changes.

Look carefully at the data. Be prepared to follow changes in inflation and what causes it for the rest of the course.

The ABC report Australia's inflation figures here

 

Australia's core inflation rate since January 2013 

This article has direct relevance to the VCE course. However inflation is a key macroeconomic indicator which is controlled through monetary policy and so also part of the IB course.

The falling oil price

The plummeting oil price is one of the major economic events that will affect the world economy in 2016. For students of economics it is impossible to ignore. (Note for Australian students the parallel with commodity prices should be obvious.)

The chart, from Tradingeconomics.com, shows the oil price for the last five years. The fall from $110 to $30 a barrel will impact the economies of every nation because oil is fundamental to the worlds energy supply. However the impact on each country is going to be different.

This is a huge subject and so today I will concentrate on Russia as an example, a major oil exporter.

It is fair to say that in the last twenty years oil and gas exports have allowed the Russian economy to expand and the standard of living of Russians has been improved due to this. In terms of macroeconomics Russia's net exports (X - M) has boosted Aggregate Demand (AD) and taxes on oil and gas (collected in a variety of ways) have funded a large proportion of Russia's government spending (G).

The fall in the oil price is disastrous for Russia. As net exports fall so does AD. The government finds that its revenue is falling and they must cut government expenditure to cope with their budget deficit, and so reduce AD further.

But the story is the exact opposite if you are an oil importer. Next exports will rise, as the cost of imports fall, shifting AD to the right. Also energy costs are an important part of firms costs and so AS moves to the right too.

So the result for Russia and other exporters, such as Venezuela, is a budget crisis,  lower output, higher unemployment and possible deflation. Oil importers may see higher growth and employment.

There are other effects and considerations, not the least of which is the implication for exchange rates (see article).  For now we will leave it at the initial effects on the AD/AS model and a classic example of an 'asymmetric shock' - the same event affecting countries in opposite ways.

The BBC cover the effect on Russia here

Questions:
1. What are the implications for the macroeconomic goals of Russia of the oil price fall.
2. How should Russia's economic policy mix change as a result?
3. What are the implications for the macroeconomic goals of non-oil producers of the oil price fall.
4. How should non-oil producers economic policy mix change as a result?
5. How can exchange rates help 'soften the blow' of the oil price shock?

This story is very applicable to IB with many avenues for an IA on trade and exchange rates as well as macroeconomics. If falling oil prices are chosen for an IA then students would be well advised to focus on just one aspect.
For VCE there are clearly lessons that can be applied to falling commodity prices.

Tax reform is a current issue

The Australian government has a budget problem. It's not always the problem they claim it to be so quickly here are the key problems:

1. The government does not raise enough money.  All budgets are a balance between income and revenue. Presently there is a budget deficit because successive Australian governments cut taxes and allowed some groups to have tax concessions which are politically difficult to remove.

2. The population of Australia is ageing. This will lead to the need to higher government spending in the future on services such as health and on benefit payments, such as pensions. There is also the likelihood that the working population will shrink, meaning fewer workers are available to pay the tax needed to raise revenue.

3. Commodity prices are falling. Australia relies on commodity exports to maintain its standard of living. The collapse in iron ore and coal prices means both Australia income and government tax revenue is falling.

Therefore action must be taken to establish a guaranteed revenue stream for the government. Reforming Australia's appallingly complex tax system, which has many built is advantages for vested interest groups, is essential. Everyone agrees on this point!

Th problem for politicians is that they can loose support if they upset voters by asking them to pay more. Therefore they are reluctant to make the tough calls.

One suggestion is that GST is raised to 15%, making everyone pay more. There are pros and cons.

Pros: GST is difficult to avoid, you pay it as you spend. It is cheap to collect, firms do a lot of the work for you and raising the rate makes little difference to collection costs. People don't notice when they pay it, it's in the price, so you get fewer complaints.

Cons: The tax is regressive. That means that the burden falls more heavily on the lower paid (lower income quintiles/deciles of the population) and so works against the goal of equity. If placed on goods with external benefits (positive externalities) it makes market failure worse.

An additional point is that if not applied equally on all goods it changes relative prices. Therefore goods without GST become more attractive to consumers and more resources are allocated to them, with fewer resources going to taxed goods. (This is how taxes work!) However an inefficient allocation of resources can result while the government are trying to do the right thing.

The Treasurer, Scott Morrison, is struggling with all of this as he prepares his first Federal Budget. He is concerned, according to the article below, with the effect of GST on Education and Health. Both are 'Merit goods' and they have external benefits. We wish to encourage increased consumption of both, not reduce consumption through tax.

The ABC cover the story here.

How Australia deals with the 'Budget crisis' is going to be a vital topic for VCE economists and a case study for IB students.

Questions.

1. What is the effect of raising GST on the distribution of income? (Goal of equity)

2. How does putting GST on health differ from putting GST on education? (Hint. Only private education will attract GST.)

Do icecream makers actions mean market failure theory is wrong?

Both Unilever, who are the worlds major icecream brand, and Mars, one of the major chocolate makers are shrinking the size of their products to help consumers make 'healthier choices'.

This seems to contradict the standard economic theory which says in the presence of externalities a free market will fail to allocate resources efficiently.

First let's recap what a free market is. There is no government intervention and so firms produce an amount that maximises profit and consumers maximise the benefit (utility) they can derive from their income. Competition is the only force restraining the behaviour of firms and households.

Economic theory tells us that when there are externalities present the market will not allocate resources in an optimal way. With ice-cream and chocolate we find there are negative externalities of consumption. Consumers over-estimate the benefits of consuming the good because they do not consider all of the costs of consumption, such as the dangers of high sugar and fat consumption (I'm going to assume you know the details of this danger).

The standard market outcome is shown below, in this case for cigarettes.

The market provides no incentive for firms to reduce production (and so consumption) to 0Q*. The market fails when left to itself.

So why has Mars and Unilever decided to take action to effectively reduce their output from 0Q1?

There are a number of explanations. In no particular order:
1. Competition. Doing this first gains the firms market share. Those who feel they should act to improve their health are attracted to the new smaller products. Mars and Unilever increase profit.
Note that competition will make other firms follow if successful.

2. Higher profits. Smaller portions will not be matched with proportional price cuts.

These first two reasons means the free market is alive and well. It has just adjusted to the new market conditions.

3. Better information has changed household preferences. The problem of negative externalities in consumption is a 'lack of information'. Many years of better education has led to a better informed public and pressure for firms to behave ethically. Consumers want to make a better choice.

There are a number of ways to correct market failure, such as tax and legislation. However here we have an example of the market reacting to better information which is closing the gap between Marginal Social Benefit and Marginal Private Benefit (MPB has moved to the right).

For some the conclusion will be a victory of the free market. For others it will be seen as the victory of many years of publicly funded research and education.

The Guardian covers the story here.

This post is more suited to IB Economics, but Market Failure is part of VCE Unit 3 where the MSC/MSB analysis is not required, but the principle is.

If used for an IB Internal Assessment the theory can be closely applied and explanations of motive explored.

New Year, new start

It was a great regret that thos blog was not used at all last year. However for 2016 the blog is relaunched with a focus on both IB and VCE.

Readers are encouraged to comment on stories. This is especially important as the post commentaries on stories are usually deliberately one-sided to promote discussion.