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.

Sensible words

Gordon Brown as the UK Chancellor of the Exchequer (Treasurer or Finance Minister) had a 'Golden Rule'. Balance the budget of current expenditure over the economic cycle. That is he, like all sensible governments, separate the current and capital components of the government budget.

The article below says 'maybe this is a good idea?' Well while it is rather late this is a welcome contribution to the public debate.

It is not bad to borrow to invest!

The ABC article is here

Monetary policy in the Euro Area

Like many countries around the world the interest rate is at a record low. The European Central Bank (ECB) has kept its rate at 0% this month.

The Euro Area economy is growing slowly and inflation is so low that deflation is a real possibility. The response of the ECB has been to 'print' 1 trillion Euros of money and lower interest rates to encourage spending.

The ECB has been slower than most to act, partly because it has a 25 member committee that finds it difficult to agree. They may have acted far too late, or they may just feel that with rates so low and confidence so weak that monetary policy is ineffective.

There are lots of good stories like this around the world that will make good IA's.

The BBC cover the story here