Depreciation of a currency isn't a cure all.

Many people like to see their currency get weaker in a floating or fixed exchange rate regime. this is because it causes export prices to fall and their country becomes more competitive. Few economists recommend depreciation as a policy for good reason, but politicians and manufacturers continue to call for it.

The UK has recently seen a 20% fall in their currency, the pound (GBP), against the dollar. Some now expect there to be a revival in British manufacturing and a rise in growth and jobs as a result. It is unlikely.

Of course a depreciation of a currency does make exports cheaper. There will be a rise in exports as a result, but there are many considerations before we can say this is unambiguously good.

Firstly the Current Account of the Balnance of Payments will only improve if the Marshall-Lerner conditions are met and the sum of the price elasticities of exports and imports sum to more than one. They will.

Mentioning imports is of course more than important. Import prices will rise with a depreciation and so will inflation. If firms rely on imported components then their costs will rise too. And let's not forget the humble holiday maker - it's not more expensive to holiday abroad. Those who champion UK manufacturing will say 'holiday in the UK', but how much rain and fish and chips can they really stand?

There is also the problem that depreciation only masks deeper problems, such as fundamentally low productivity, poor design and low quality. Temporary relief is at best provided by a depreciation which can easily be reversed. Further it isn't possible for all countries to depreciate their currency because exchange rates are a relative measure of value. A series of competitive devaluations will be at best inflationary and fruitless.

The most sensible thing ever said about depreciations is that 'there are just more questions' once they have occurred.

The article below examines the likely effect of the UK's recent depreciation.

The Guardian article is here

Primarily an example for IB students it raises very important questions about the pros and cons of floating exchange rates and the likely effects of exchange rate movements. Never forget the Marshall-Lerner conditions for HL candidates. VCE students will however recognise the effects of the changing value of the Australian dollar and the likely effects on the Australian economy and the macroeconomic goals.

Increasing industry concentration a concern

Economists have long understood that competition between firms brings the advantages of lower prices, improved quality and greater consumer choice. This is because firms deliver on these or they will be competed out of the market. 

The Australian Competition and Consumer Commission (ACCC) chairman has warned that market concentration (the percentage of market share held by the biggest firms) has risen to a level where consumers are possibly going to be worse off.

If a firm has monopoly power then they typically charge more and sell less, but earn higher profits. Over the last few decades mergers and takeovers have led to a very high proportion of Australian output being concentrated in the top 100 firms.

This provides a problem for the ACCC who regulate competition. The article below suggests that a change of rules whereby the firms that merge or want to takeover another have to prove the result will not harm competition. At present the ACCC have to prove it would harm competition.

An interesting point made by the ACCC is that if we want the benefits of economies of scale to work through to lower prices then we have to maintain a competitive environment. In other words a merger/takeover may improve productive efficiency but harm allocative efficiency.

The ABC cover the story here

This article deals directly with competition policy in Australia so is directly relevant to VCE economics. This is a part of IB economics also, and the harm that monopolies do to efficiency is often visited on Paper 1 of Higher Level in questions on the theory of the firm.

Headline inflation rise hides continued sluggishness

The Australian CPI figure released yesterday showed a significant jump in inflation, and for some this was great news s at least inflation headed back towards the target range of the Reserve Bank of Australia (RBA). This is almost certainly a false hope.

Looking at the figures it is clear that the massive rise in fruit and vegetable prices, largely due to massive flooding affecting supply, has made the CPI figure look more healthy than it really is. Take that out and the underlying rate of inflation actually fell.

Australia's headline and underlying inflation compared

The low inflation figures show that economic growth the Australian economy continues to slow down, and this is not good news. The end of the mining boom is severely affecting WA and the Northern Territory, but indicators don't show massive growth in the rest of Australia that will compensate.

Once again Greg Jericho in The Guardian provides excellent analysis and data of the inflation figures and considers the likely impact on monetary policy settings.

The Guardian article is here

VCE students are especially urged to understand the pressures in the economy at present - demand side pressures on policy settings. The article makes use of the Australian underlying inflation measures which are required knowledge.

IB students can use this as an example of inflation and monetary policy. The article is particularly strong at looking at how the various factors link together to give an overview of the health of the economy and the process and implementation of monetary policy.

Exploring Australia's unemployment rate a little more

Australia's unemployment rate is falling. That should be good news. However as pointed out a couple of posts ago this is not as straightforward as it seems.

The labour market is complex and what appears to be a substantial fall in unemployment masks a rise in part-time work, a fall in the participation rate and sharply different experiences of workers based on age and gender.

This article analyses the figures, using plenty of data in charts. The conclusion is that headline figures can appear good, but mask a serious problem.

As I made many relevant points before on Queensland I won't write much here. It is critical that you read the article to the end however.

The Guardian article is here

This is an article that provides vital information for VCE candidates on what is happening to unemployment in Australia.

IB candidates are also able to use this as an example and look at the key issues of measuring unemployment and should also consider how such unemployment can be cured. Note this article is not suitable for an IA as it is an analytical article - it does the job the IA should do, but there should be other articles out there on the latest unemployment figures (hint hint).

What is the best way to achieve equity?

Equity is a measure of fairness, and therefore a matter of opinion. The difference of opinion extends beyond what the best distribution of income is to how we should achieve it.

Some people believe that the way to achieve equity is through evening up in-work income. That can be done by raising minimum wages and taxing incomes progressively. Others believe that the best path is to pay benefits to those who require additional income. Both approaches will help reduce income inequality.

In Australia there is presently a debate between government and Trade Unions on the setting of the minimum wage. Australia has for many years had a very high minimum wage, but it has been falling in terms of the proportion of average wages this represents.

The Trade Unions want the minimum wage raised so that it is maintained at 60% of average incomes. The government does not want to commit to that because it fears that this may raise unemployment. (That would be cause real wage unemployment where the minimum wage in some industries is set above the market equilibrium.)

This is actually an argument of equity vs efficiency. There is no doubt that a high minimum wage promotes equity, the difference in take home pay will be made smaller. However it may harm efficiency.

Markets work through incentives. Earning  higher profit incentivises  firms to lower costs and improve quality in order to sell more products. It is a similar issue with workers, they are incentivised to work through wages. Higher wage rates attract more hours of work from workers.

If the minimum wage is too high there are two possible detrimental effects.
1. Firms cannot pay different rates of pay to different workers below the minimum wage
 A worker who is more productive should earn more than one who is less productive. However if both workers value to the firm is less than the minimum wage then both receive the same wage or, possibly, neither is employed.

2. The incentive to work harder and achieve improved skills and position is removed when there is equality in payment. The rational choice is to do the easier job yet get paid the same. Any move towards greater equity in income risks enhancing this effect and the economy suffers.

Overall this means that the economy is denied the competition it needs to achieve productive and allocative efficiency and as a result resources are misallocated.

There is no right answer to the question of the 'best' distribution of income. The trade-off between equity and equality is a real one though and must be considered in any policy proposal.

The Guardian covers the story here

This matter is of value to VCE students as the minimum wage is a key part of policy for the goal of equity. For IB students this has wider implications including the causes of unemployment and supply side policy.

Unemployment - the headline figures can disguise the truth

In Australia the rate of unemployment has generally been falling. This is usually good news, but there are other subtle points to consider, such as the situation in Queensland where the fall in unemployment might be hiding a more serious problem.

The unemployment rate is measured from a base figure of those people of working age who are looking for work or in work. This group are participating in the labour market, those who choose not to or cannot work are disregarded. The proportion of working age people active in the labour market is therefore called the participation rate.

The fact some people decide not to look for work can affect the unemployment figures and the article below gives an example of this. Unemployment in Queensland is falling, but some claim that this is because some people are so fed up with not finding a job they are simply giving up. If you are not seeking work you are no longer counted as unemployed and the unemployment rate appears to fall.

The discouraged workers as they are known are still without work. The participation rate has fallen and, in the case of Queensland, the number employed falls, but the unemployment rate also falls.

This could indicate a very serious problem with a number of people simply becoming detached from the labourforce, suffering all the personal costs of unemployment, but receiving none of the help the unemployed should receive. In addition the economy is loosing out on all the output those people could produce if they were in work.

Australia's participation rate, since 2011 there has been a downward trend

The ABC cover the story here

This story applies equally to IB and VCE students. The problems of unemployment and the difficulty measuring it is a core concept. There are also links to economic growth and supply-side economics as those not working represent a loss of output and those not seeking to work a serious restraint on aggregate supply.

Losing and gaining from inflation

Continuing the UK pound theme today I will look at a story on the effects of higher inflation in the UK.

Inflation has been subdued across the world in recent years despite very expansionary monetary policies being pursued by all central banks. In the UK inflation is well below the Bank of England target of 2% and in August was just 0.6% on the CPI measure. It has rocketed to 1% in September.

So far there is only anecdotal evidence that the fall in the value of the pound is responsible, but import prices will rise with the near 20% fall in the value of the pound since June. This would cause cost-push inflation and will compliment the demand-pull inflation that the Bank of England are encouraging by their recent reduction in interest rates to 0.25%.

The article, again from the BBC, looks at the effects higher inflation might have on households. It points out that when inflation reaches a rate higher than wages growth then real incomes start to fall, making people worse off. It also notes that those on benefits, many of which are frozen in value until 2020, also lose out.

One group that is protected are those who receive the old age pension (that is everybody in the UK who are old enough, it is not means tested). The old age pension goes up by at least 2.5% a year, or inflation on CPI or wages growth - whichever is higher. This protects the old against an important cost of inflation.

Note the link in the article to 'winners' from inflation.

The BBC article is here

The costs and benefits of inflation is relevant to everyone. This provides a very useful survey of the issue facing people today with low inflation and the impact of rising inflation. 

Exchange rates as a shock absorber

Economies are subject to 'shocks'. Classic ones include the jump in the price of oil in the 1970's, the rise in commodity prices in the 2000's and the Gulf wars. When they occur there is an unexpected 'shock' to Aggregate Supply or Aggregate Demand (AD). This can result in inflation, unemployment or both in the domestic economy.

The diagram below shows the effect of a shock to AD, say the shock of Brexit to the UK economy reducing consumer and business confidence. This would reduce Consumption and Investment expenditure, shifting AD to the left.

One of the benefits that an economy with a floating exchange rate has in this situation is that the currency can depreciate and act as a 'shock absorber'. The shock of Brexit has led many to believe that the UK economy will perform less well in the future and this, they reason, will mean the UK currency, the pound, will be worth less as a result.

This has led to a lower demand to buy pounds and increased selling as people seek to hold their wealth in other currencies that are less likely to loose value. The falling pound (see two posts ago for that) has an important benefit for the UK economy. 

The lower value of the pound means that UK exports now cost less in foreign currency and import prices in the UK will rise. As a  result there will be a rise in the volume of exports and fall in the volume of imports (the law of demand). As long as the Marshall-Lerner conditions hold (and they will) this will mean a rise in the value of Net Exports (X - M) which is a component of Aggregate Demand. This will, at least partially, offset the fall in AD - absorbing part of the shock.

Many argue that this is exactly why the UK was wise not to join the Euro.

The BBC cover this story here

This is very much an IB post, and touches on macroeconomics and international trade. It is particularly useful as an example of the argument around single currency areas where asymmetric shocks are likely.

Monetary Policy ineffective?

As IB students move to looking at macroeconomic policy I will provide some articles that highlight some recent issues and also help give context to the importance of understanding the theory of policy is important to understanding its use in reality.

The article below makes lots of points. It talks about how the Australian Treasurer (Finance Minister) believes that Monetary Policy has become ineffective in boosting economic activity at present. It also talks about how Fiscal and Supply-side policy must work together to achieve macroeconomic goals.

I am going to concentrate on monetary policy here. Morrison asserts that further interest rate cuts (Australian interest rates have fallen from 4.75% to 1.5% since 2012) will do nothing to stimulate the economy. This is suggesting that the transmission mechanism by which lower rates stimulate economic activity and raise the price level has stopped working.

The theory, which you will learn, suggests that lowering interest rates will raise Consumer and Investment spending and probably Net Exports, all components of Aggregate Demand. However when interest rates are very low many believe that the incentives to change behaviour cease to be significant. If coupled with lower consumer and business confidence even negative interest rates cannot help stimulate the economy on their own.

This is very much a current policy debate. Similar arguments are being had in Japan and Europe where the central banks not only set negative rates but are printing money to try to stimulate the economy.

Notice Morrison's use to the phrase 'pushing on a piece of string' - a classic term used to describe how lowering interest rates does nothing to solve a recession. The answer is more government spending and infrastructure investment. Of course that policy will be cheaper to finance when interest rates are low - so maybe low rates still have a role.

The Age covers the story here

Note that there is a lot of politics in this. Morrison, for example, refuses to acknowledge that more government spending is needed because the political priority is to cut spending to 'solve' the budget deficit. 

There are lots of articles on this argument - look for them for your IA.

The UK pound continues to fall

The exchange rates for the currencies of  most developed countries are 'free floating'. That is the value of the currency is determined by demand and supply in the foreign exchange market.

The foreign exchange market works to a great extent like any other market. The price of the currency rises when demand for the currency rises or supply falls. On the level of trade this means that when anyone wants to import, say British, goods they demand the pounds they need to pay British firms who supply them. There is then a market in pounds with those buying British goods and services demanding pounds and Britons selling pounds in order to gain the currency they need to import goods and services from other nations.

There is another aspect to currency markets however. The currency itself can be an asset and also a medium to invest in another country. Some people will want to invest their money in a country to get a higher return than they could elsewhere. Others will hold currency in order to make a capital gain, that is buy low and sell high.

This second reason to buy and sell currency makes the expectation of the future value of a currency very important. If you expect the value of a currency to fall you sell it before it does, this avoids a capital loss and prevents the advantage of getting a better interest rate being wiped out by the falling value of the currency.

Since Britain voted to leave the EU (in a travesty of a referendum) the pound has been falling in value.

The Pound against the US$ October 2015 to October 2016

The sharp fall on the day after the Brexit vote on June 23rd is clearly visible and so is the continued fall of the past two weeks.

The article linked below gives some reasons for this in particular. In summary these are:

*  Concerns that the UK economy will grow more slowly.

*  Concerns that the UK will not have free access to the EU single market after Brexit

*  That interest rates will not rise in the UK to prevent further domestic contraction (relative interest rates fall)

*  Concern that holding pounds will lead to a capital loss, due to the above reasons, so best to sell now.

Note the importance of expectations and risk in this system. It is crucial to behaviour.

The diagram below shows how the foreign exchange market for the pound might have behaved since June. Fewer buyers (who buys a currency with a way to fall leaving just 'trade' demand) D1 to D2 and more sellers (investors leaving for safer currencies) S1 to S2.

Note the links within the article that are worth exploring.

The BBC covers the story here

As this story is about the UK pound (GBP) this is most useful for IB students on how the floating exchange rate mechanism works. However VCE students should realise that the Australian dollar has the same floating system.

International Trade benefits the world, but not everybody in the world

Adam Smith and David Ricardo gave economics the theory of International Trade by 1817 (Smith 1776) and what they said remains the basis of the reason economists favour free trade over protection.

The theory says that countries should specialise according to their comparative advantage and as a result overall production will rise and these gains in output will be redistributed through trade (i.e. swapping of goods and services).

To achieve specialisation a country must grow some industries while others shrink (those in which other countries specialise). The result will be more jobs in some industries and less in others.

The loss of jobs is regrettable and is referred to as an 'adjustment cost.' Economists are fully aware of this cost and could explain to those who are now unemployed the overall benefit of the process. It will not be a popular message with the unemployed.

The World Bank is reported to have written a report confirming Smith and Ricardo's conclusions. The growth of free trade (Globalization) has led to overall more jobs, but some have lost out. They estimate 20% of job losses in some areas, like the USA, are due to free trade.

The problem is that there is no guarantee that a country will gain as many jobs through their specialization as they lose. Portugal is a good example. They have lost many jobs to lower cost manufacturing nations (such as Eastern Europe and China), but don't have the comparative advantage in high tech and knowledge based industries they need to replace those jobs.

So the World Bank report is basically saying Smith and Ricardo were right.

The BBC covers the story here

Road pricing in Melbourne - excellent idea

Infrastructure Victoria today issued a 200+ page interim report on future transport infrastructure planning in Melbourne. There is much in it that makes sense, including a cost-benefit analysis report showing which projects will yield more benefits than costs.

One of their proposals (and it is only an option) is to charge motorists $5 to enter the CBD. The aim is to reduce congestion by making people time their journeys differently and to move others on to public transport. The report suggests that 20% of journeys taking between 7am and 9am could be moved to other times.

This proposal is founded on the experience of many other cities. London, Singapore and Stockholm all have well developed charging schemes, although they are not all the same. London charges one amount between 7am and 6pm while Singapore varies the charge according to the time of day and level of congestion.

Road pricing schemes are highly effective when combined with other measures, such as improved public transport and subsidies of that system, park and ride schemes, car sharing schemes and high car parking charges for example. Without additional measures the price elasticity of demand is too inelastic for road pricing to make a significant difference, due to the essential nature of transport generally and the sheer convenience of driving your own vehicle.

Both major parties in Victoria rejected the proposed charges on the morning the report was published. So much for well considered long-term policy making. I have sent a letter!

The Age covers the story here

The ABC coverage is here

This article has some relevance to VCE as it deals with market failure (the negative externalities of using a car and congesting a road) and the price mechanism. IB students are much better equipped to investigate this topic using their knowledge of market failure and policy. (Good EE topic?)

Immigration is good for Australia

There have been calls for immigration to be halted, especially by the crazy right in Australia. However the consequences of halting migration would be dire, leaving Australians worse off.

The Age has written a piece describing the effect of halting migration. They point out that growth would slow, the workforce would age faster leading to a demographic imbalance and the government would face larger structural budget deficits. There are several other unpleasant consequences listed.

The article does miss one important point. Most Australian immigration is skilled migration. The immigrants go straight into the workforce without the need for expensive training and fill gaps that the economy would take years (decades) to fill itself. The result is that the supply-side of the economy is expanded (Long-run aggregate supply shifts to the right) and there is faster non-inflationary growth making everyone better off.

The unfortunate politics of immigration must be put to one side and the economic analysis of immigration considered more carefully to achieve a sensible solution. It is impossible to see a situation where Australia will not need at least 100,000 immigrants a year to avoid stagnating growth and an impossible pressure on the working population as the overall population ages.

The Age article is here

This article is directly relevant to VCE Unit 4 on Supply Side policy and to IB Macroeconomics (Paper 1). The impact of demographic changes is something that could easily put into an IB Internal Assessment piece using AD/AS analysis.