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|Yates. [pic] Economics [pic] | |1-1 THREE [pic] ECONOMIC [pic] ISSUES | |Trying to understand what [pic] economics [pic] is about by studying definitions is| |like trying to learn to swim by reading an instruction manual. Formal analysis | |makes sense only once you have some practical experience. In this section we | |discuss three [pic] economic [pic] issues to show how society allocates scarce | |resources between competing uses. In each case we see the importance of the | |questions what, how, and for whom to produce. | |The Oil Price Shocks | |Oil is an important commodity in modern economies. Oil and its derivatives provide | |fuel for heating, transport, and machinery, and are basic inputs for the | |manufacture of industrial petrochemicals and many household products ranging from | |plastic utensils to polyester clothing. From the beginning of this century until | |1973 the use of oil increased steadily. Over much of this period the price of oil | |fell in comparison with the prices of other products. [pic] Economic [pic] activity| |was organized on the assumption of cheap and abundant oil. | |In 1973-74 there was an abrupt change. The main oil-producing nations, mostly | |located in the Middle East but including also Venezuela and Nigeria, belong to OPEC| |- the Organization of Petroleum Exporting Countries. Recognizing that together they| |produced most of the world's oil, OPEC decided in 1973 to raise the price for which| |this oil was sold. Although higher prices encourage consumers of oil to try to | |economize on its use, OPEC correctly forecast that cutbacks in the quantity | |demanded would be small since most other nations were very dependent on oil and had| |few commodities available as potential substitutes for oil. Thus OPEC correctly | |anticipated that a substantial price increase would lead to only a small reduction | |in sales It would be very profitable for OPEC members. | |Oil prices are traditionally quoted in US dollars per barrel Figure 1-1 shows the | |price of oil from 1970 to 1986 Between 1973 and 1974 the price of oil tripled, from| |$2 90 to $9 per barrel. After a more gradual rise between 1974 and 1978 there was | |another sharp increase between 1978 and 1980, from $12 to S30 per barrel. The | |dramatic price increases of 1973-74 and 1978-80 have become known as the OPEC oil | |price shocks, not only because they took the rest of the world by surprise but also| |because of the upheaval they inflicted on the world economy which had previously | |been organized on the assumption of cheap oil prices. | |Much of this book teaches you that people respond to prices. When the price of some| |commodity increases, consumers will try to use less of it but producers will want | |to sell more of it. These responses, guided by prices, are part of the process by | |which most Western societies determine what, how, and for whom to produce. | |Consider first how the economy produces goods and services When, as in the 1970s, | |the price of oil increases sixfold, every firm will try to reduce its use of oil | |based products. Chemical firms will develop artificial substitutes for petroleum | |inputs to their production processes, airlines will look for more fuel efficient | |aircraft, electricity will be produced from more coal fired generators In general, | |higher oil prices make the economy produce in a way that uses less oil. | |How does the oil price increase affect what is being produced? Firms and households| |reduce their use of oil intensive products which are now more expensive. Households| |switch to gas fired central heating and buy smaller cars. Commuters form car pools | |or move closer to the city. High prices not only choke off the demand for oil | |related commodities, they also encourage consumers to purchase substitute | |commodities. | |Higher demand for these commodities bids up their price and encourages their | |production Designers produce smaller cars, architects contemplate solar energy, and| |research laboratories develop alternatives to petroleum in chemical production. | |Throughout the economy, what is being produced reflects a shift away from expensive| |oil using products towards less oil intensive substitutes | |The for whom question in this example has a clear answer OPEC revenues from oil | |sales increased from S35 billion in 1973 to nearly $300 billion in 1980 Much of | |their increased revenue was spent on goods produced in the industrialized Western | |nations In contrast, oil importing nations had to give up more of their own | |production in exchange for the oil imports that they required In terms of goods as | |a whole, the rise in oil prices raised the buying power of OPEC and reduced the | |buying power of oil-importing countries such as Germany and Japan. The world | |economy was producing more for OPEC and less for Germany and Japan Although this is| |the most important single answer to the 'for whom' question, the economy is an | |intricate, interconnected system and a disturbance anywhere ripples throughout the | |entire economy In answering the 'what' and ‘how' questions, we have seen that some | |activities expanded and others contracted following the oil price shocks. Expanding| |industries may have to pay higher wages to attract the extra labor that they | |require. For example, in the British economy coal miners were able to use the | |renewed demand for coal to secure large wage increases. The opposite effects may be| |expected if the 1986 oil price slump persists. | |The OPEC oil price shocks example illustrates how society allocates scarce | |resources between competing uses. | |A scarce resource is one for which the demand at a 7ero price would exceed the | |available supply. | |We can think of oil as having become more scarce in [pic] economic [pic] terms when| |its price rose. | |The Role of Government | |Having mentioned the effect of government tax policy on the income distribution, we| |now examine in greater detail the role of the government in society. In every | |society governments provide such services as national defense, police, firefighting| |services, and the administration of justice In addition, governments make transfer | |payments to some members of society. | |Transfer payments arc payments made to individuals without requiring the provision | |of any service in return. | |Examples are social security, retirement pensions, unemployment benefits, and, in | |some countries, food stamps Government expenditure, whether on the provision of | |goods and services (defense, police) or on transfer payments, is chiefly financed | |by imposing taxes, although some (small) residual component may be financed by | |government borrowing | |Table 1 2 compares the role of the government in four countries In each case, we | |look at four measures of government spending as a percentage of national income | |spending on the direct provision of goods and services for the public, transfer | |payments, interest on the national debt, and total spending Italy is a 'big | |government' country Its government spending is large and it needs to raise | |correspondingly large tax revenues In contrast, Japan has a much smaller government| |sector and needs to raise correspondingly less tax revenue These differences in the| |scale of government activity relative to national income reflect differences in the| |way different countries allocate their resources among competing uses | |Governments spend part of their revenue on particular goods and services such as | |tanks, schools, and public safety They directly affect what is produced Japan's low| |share of government spending on goods and services in Table 1 2 reflects the very | |low level of Japanese spending on defense Governments affect for whom output is | |produced through their tax and transfer payments By taxing the rich and making | |transfers to the poor, the government ensures that the poor are allocated more of | |what is produced than would otherwise be the case, and the rich get correspondingly| |less | |The government also affects how goods are produced, for example through the | |regulations it imposes Managers of factories and mines must obey safety | |requirements even where these are costly to implement, firms are prevented from | |freely polluting the atmosphere and rivers, offices and factories arc banned in | |attractive residential parts of the city | |The scale of government activities in the modern economy is highly controversial In| |the UK the government takes nearly 40 per cent of national income in taxes Some | |governments take a larger share, others a smaller share Different shares will | |certainly affect the questions what, how, and for whom, but some people believe | |that a large government sector makes the economy inefficient, reducing the number | |of goods that can be produced and eventually allocated to consumers | |It is commonly asserted that high tax rates reduce the incentive to work If half of| |all we earn goes to the government, we might prefer to work fewer hours a week and | |spend more time in the garden or watching television That is one possibility, but | |there is another one if workers have in mind a target after tax income, for example| |to have at least sufficient to afford a foreign holiday every year, they will have | |to work more hours to meet this target when taxes are higher Whether on balance | |high taxes make people work more or less remains an open question Welfare payments | |and unemployment benefit are more likely to reduce incentives to work since they | |actually contribute to target income If large scale government activity leads to | |important disincentive effects, government activity will affect not only what, how,| |and for whom goods are produced, but also how much is produced by the economy as a | |whole | |This discussion of the role of the government is central to the process by which | |society allocates its scarce resources It also raises a question Is it inevitable | |that the government plays an important role in the process by which society decides| |how to allocate resources between competing demands'. This question lies at the | |heart of [pic] economics [pic], and we return to it shortly when we examine the | |role of markets in [pic] economic [pic] life | |First, however, we must refine our notion of scarce resources To do so, we | |introduce a useful tool of [pic] economic [pic] analysis, the production | |possibility frontier. | | | |THE PRODUCTION POSSIBILITY FRONTIER | |To see how this tool helps us to think about scarcity and the problem of what to | |produce, we consider a hypothetical economy in which there are two types of good, | |food and films. There are four workers in the economy. A worker can produce in | |either the food industry or the film industry. | |Table 13 shows how much of each good can be produced per week. The answer depends | |on how the workers are allocated between the two industries In each industry, the | |more workers there are, the greater is the total output of the good produced. We | |have assumed that production in each industry satisfies the law of diminishing | |returns. Each additional worker adds less to total industry output than the | |previous additional worker added For example, consider the film industry. Beginning| |from the position of no workers and no output, the first worker employed increases | |output by 9 units per week. Adding a second worker raises film output only by 8 | |units per week, taking total film output to 17 units per week. Adding a third | |worker increases output by only 7 units per week, and the addition of yet more | |workers leads to even smaller increases in film output. | |What lies behind the law of diminishing returns'. We have implicitly assumed that | |workers in the film industry have at their disposal a fixed total amount of | |cameras, studios, and other equipment. The first worker has sole use of all these | |facilities. When a second worker is added, the two workers must share these | |facilities. The addition of further workers reduces equipment per worker to even | |lower levels. Thus, output per worker in the film industry falls as employment in | |the film industry rises. One worker produces 9 units per week, two workers average | |only 8 units per week, and three workers average only 8 units per week. A similar | |story applies in the food industry. The fixed total supply of available land, | |water, and fertilizer must be shared between the total workforce. The first worker,| |using all these resources, produces 10 units of food per week, but output per | |person falls to 8,5 units per week when two workers share these resources, and is | |only 7,5 units per week when three workers share them. Both industries exhibit | |diminishing returns as additional workers are added. | |Table 1 3 shows the possible combinations of food and film output that can be | |produced in the hypothetical economy if all workers are employed. At one extreme, | |with all workers employed in food production, the economy can produce 25 units of | |food and 0 units of film. At the other extreme, with all workers employed in the | |film industry, the economy can produce 30 units of films but no food. By | |transferring workers from one industry to the other, the economy can produce more | |of one good, but only at the expense of producing less of the other good. We say | |that there is a trade off between food production and film production. In moving | |down the rows of Table 1 3, society is trading off food for films, giving up units | |of food production to obtain additional units of film output. | |To explain why the curve through the points A to E is called a 'frontier', let us | |think about the point G in Figure 1-2. Society is then producing 10 units of food | |and 17 units of films. This is a feasible combination From Table 1-3 it can be seen| |that this requires one person in the food industry and two in the film industry. | |But with only three people working, society has spare resources because the fourth | |person is not being employed G is not a point on the production possibility | |frontier because it is possible to produce more of one good without sacrificing | |output of the other good. Putting the extra person to work in the food industry | |would take us to the point C, yielding 7 extra units of food for the same film | |output. Putting the extra person to work in the film industry would rake us to the | |point D, with 7 extra units of films but no loss of food output. | |The production possibility frontier shows the points at which society is producing | |efficiently. More output of one good can be obtained only by sacrificing output of | |the other good. Points such as C, which lie inside the frontier, are inefficient | |because society is wasting resources. More output of one good would not require | |less output of the other In our hypothetical example, the waste or inefficiency | |arises because some members of the potential workforce are nor being used to | |produce goods. | |Points that he outside the production possibility frontier, such as the point H in | |Figure 1 2, are said to be unattainable It would be nice to have even more food and| |films but, given the amount of labor available, it is simply impossible to produce | |this output combination. Scarcity of resources, in this example the restriction | |that at most only four workers are available for producing goods, limits society to| |a choice of points that lie inside or on the production possibility frontier. | |Society has to accept that its resources are scarce and make choices about how to | |allocate these scarce resources between competing uses In this exam-pie, the | |competing uses are employment in the food industry and employment in the film | |industry. | |Given that people like food and films, society should want to produce efficiently. | |To select a point inside the production possibility frontier is to sacrifice output| |unnecessarily. Society's problem is therefore to make a choice between the | |different points that lie on the production possibility frontier In so doing, it | |decides what to produce It might select the point A, with no films but a lot of | |food, or the point C, with a more balanced mixture of food and films. Depending on | |society's preferences between food and films, it might choose any point on the | |production possibility frontier. However, in choosing a particular point, society | |will also be choosing how to produce It will then be necessary to refer back to | |Table 1-3 to determine how many workers must be allocated to each of the industries| |to produce the desired output combination. As yet, our example is too simple to | |show for whom society produces. To answer that question, we need more information | |than the position on the production possibility frontier | |FIGURE 1-2 THE PRODUCTION POSSIBILITY FRONTIER. The production possibility frontier| |shows the maximum combinations of output that the economy can produce using all | |available resources. The frontier represents a trade off more of one commodity | |implies less of the other. Points such as H lying above the frontier are | |unattainable. They require more resource inputs than the economy has available. | |Points such as G inside the frontier are inefficient. By fully utilizing available | |resource inputs the economy could expand output and produce on the frontier. | |1-3 THE ROLE OF THE MARKET | |Markets bring together buyers and sellers of goods and services In some cases, such| |as a local fruit stall, buyers and sellers meet physically In other cases, such as | |the stock market, business can be transacted over the telephone, almost by remote | |control. We need not go into these details Instead, we use a general definition of | |markets. | |A market is a shorthand expression for the process by which households' decisions | |about consumption of alternative goods, firms' decisions about what and how to | |produce, and workers' decisions about how much and for whom to work are all | |reconciled by adjustment of prices. Prices of goods and of resources, such as | |labor, machinery and land, adjust to ensure that scarce resources arc used to | |produce those goods and services that society demands | |Much of [pic] economics [pic] is devoted to the study of how markets and prices | |enable society to solve the problems of what, how, and for whom to produce. Suppose| |you buy a hamburger for your lunch. What does this have to do with markets and | |prices? You chose the cafe because it was fast, convenient and cheap. Given your | |desire to eat, and your limited resources, the low hamburger price told you that | |this was a good way to satisfy your appetite. You probably prefer steak but that is| |more expensive. The price of steak is high enough to ensure that society answers | |the 'for whom' question about lunchtime steaks in favor of someone else. | |Now think about the seller's viewpoint. The cafe owner is in the business because, | |given the price of hamburger meat, the rent and the wages that must be paid, it is | |still possible to sell hamburgers at a profit If rents were higher, it might be | |more profitable to sell hamburgers in a cheaper area or to switch to luxury lunches| |for rich executives on expense accounts. The student behind the counter is working | |there because it is a suitable part-time job which pays a bit of money If the wage | |were much lower it would hardly be worth working at all. Conversely, the job is | |unskilled and there are plenty of students looking for such work, so owners of | |cafes do not have to offer very high wages | |Prices are guiding your decision to buy a hamburger, the owner's decision to sell | |hamburgers, and the student's decision to take the job. Society is allocating | |resources - meat, buildings, and labor - into hamburger production through the | |price system If nobody liked hamburgers, the owner could not sell enough at a price| |that covered the cost of running the cafe and society would devote no resources to | |hamburger production. People's desire to eat hamburgers guides resources into | |hamburger production However, if cattle contracted a disease, thereby reducing the | |economy's ability to produce meat products, competition to purchase more scarce | |supplies of beef would bid up the price of beef, hamburger producers would be | |forced to raise prices, and consumers would buy more cheese sandwiches for lunch. | |Adjustments in prices would encourage society to reallocate resources to reflect | |the increased scarcity of cattle. | |There were several markets involved in your purchase of a hamburger. You and the | |cafe owner were part of the market for lunches. The student behind the counter was | |pan of the local labor market. The cafe owner was part of the local wholesale meat | |market and the local market for rented buildings. These descriptions of markets are| |not very precise. Were you part of the market for lunches, the market for prepared | |food, or the market for sandwiches to which you would have turned if hamburgers had| |been more expensive? That is why we have adopted a very general definition of | |markets which emphasizes that they are arrangements through which prices influence | |the allocation of scarce resources. | |1-4 POSITIVE AND NORMATIVE [pic] ECONOMICS [pic] | |In studying [pic] economics [pic] it is important to distinguish two branches of | |the subject. The first is known as 'positive economies', the second as 'normative | |economies'. | |Positive [pic] economics [pic] deals with objective or scientific explanations of | |the working of the economy. | |The aim of positive [pic] economics [pic] is to explain how society makes decisions| |about consumption, production, and exchange of goods. The purpose of this | |investigation is twofold: to satisfy our curiosity about why the economy works as | |it does, and to have some basis for predicting how the economy will respond to | |changes in circumstances. Normative [pic] | | economics [pic] is very different. | |Normative [pic] economics [pic] offers prescriptions or recommendations based on | |personal value judgments. | |In positive [pic] economics [pic], we hope to act as detached scientists. Whatever | |our political persuasion, whatever our view about what we would like to happen or | |what we would regard as 'a good thing', in the first instance we have to be | |concerned with how the world actually works. At this stage, there is no scope for | |personal value judgments. We are concerned with propositions of the form: if this | |is changed then that will happen. In this regard, positive [pic] economics [pic] is| |similar to the natural sciences such as physics, geology, or astronomy. | |Here are some examples of positive [pic] economics [pic] in action. Economists of | |widely differing political persuasions would agree that, when the government | |imposes a tax on a good, the price of that good will rise. The normative question | |of whether this price rise is desirable is entirely distinct. Similarly, there | |would be substantial agreement that the following proposition of positive | |[pic] economics [pic] is correct: favorable weather conditions will increase wheat | |output, reduce the price of wheat, and increase the consumption of wheat. Many | |propositions in positive [pic] economics [pic] would command widespread agreement | |among professional economists. | |Of course, as in any other science, there are unresolved questions where | |disagreement remains. These disagreements are at the frontiers of | |[pic] economics [pic]. Research in progress will resolve some of these issues but | |new issues will arise and provide scope for further research. | |Although competent and comprehensive research can in principle resolve many of the | |outstanding issues in positive [pic] economics [pic], no corresponding claim can be| |made about the resolution of disagreement in normative [pic] economics [pic]. | |Normative [pic] economics [pic] is based on subjective value judgments, not on the | |search for any objective truth. The following statement combines positive and | |normative [pic] economics [pic]: The elderly have very high medical expenses | |compared with the rest of the population, and the government should subsidize | |health bills of the aged.' The first part of the proposition - the claim that the | |aged have relatively high medical bills - is a statement in positive | |[pic] economics [pic]. It is a statement about how the world works, and we can | |imagine a research program that could determine whether or not it is correct. | |Broadly speaking, this assertion happens to be correct. The second part of the | |proposition - the recommendation about what the government should do - could never | |be 'proved' to be correct or false by any scientific research investigation. It is | |simply a subjective value judgment based on the feelings of the person making the | |statement. Many people might happen to share this subjective judgment, for example | |those people who believe that all citizens alive today should be able to purchase | |roughly equal amounts of luxury and recreational goods after paying for the | |necessities of life. But other people might reasonably disagree. You might believe | |that it is more important to devote society's scarce resources to improving the | |environment. | |There is no way that [pic] economics [pic] can be used to show that one of these | |normative judgments is correct and the other is wrong. It all depends on the | |preferences or priorities of the individual or the society that has to make this | |choice. But that does not mean that [pic] economics [pic] can throw no light on | |normative issues. We can use positive [pic] economics [pic] to spell out the | |detailed implications of making the choice one way or the other. For example, we | |might be able to show that failure to subsidize the medical bills of the elderly | |leads middle-aged people to seek a lot of unnecessary medical checkups in an | |attempt to detect diseases before their treatment becomes expensive. Society might | |have to devote a great deal of resources to providing check-up facilities, leaving | |less resources available than had been supposed to devote to improving the | |environment. Positive [pic] economics [pic] can be used to clarify the menu of | |options from which society must eventually make its normative choice. | |1-5 MICROECONOMICS AND MACROECONOMICS | |Many economists specialize in a particular branch of the subject. For example, | |there are labor economists, energy economists, monetary economists, and | |international economists. What distinguishes these economists is the segment of | |[pic] economic [pic] life in which they are interested. Labor [pic] economics [pic]| |deals with problems of the labor market as viewed by firms, workers, and society as| |a whole. Urban [pic] economics [pic] deals with city problems: land use, transport,| |congestion, and housing. However, we need not classify branches of | |[pic] economics [pic] according to the area of [pic] economic [pic] life in which | |we ask the standard questions what, how, and for whom. We can also classify | |branches of [pic] economics [pic] according to the approach or methodology that is | |used. The very broad division of approaches into microeconomic and | |macro-[pic] economic [pic] cuts across the large number of subject groupings cited | |above. | |Microeconomic analysis offers a detailed treatment of individual decisions about | |particular commodities. | |For example, we might study why individual households prefer cars to bicycles and | |how producers decide whether to produce cars or bicycles. We can then aggregate the| |behavior of all households and all firms to discuss total car purchases and total | |car production. Within a market economy we can discuss the market for cars. | |Comparing this with the market for bicycles, we may be able to explain the relative| |price of cars and bicycles and the relative output of these two goods. The | |sophisticated branch of microeconomics known as general equilibrium theory extends | |this approach to its logical conclusion It studies simultaneously every market for | |every commodity. From this it is hoped that we can understand the complete pattern | |of consumption, production, and exchange in the whole economy at a point in time. | |If you think this sounds very complicated you are correct. It is. For many | |purposes, the analysis becomes so complicated that we tend to lose track of the | |phenomena in which we were interested. The interesting task for | |[pic] economics [pic], a task that retains an element of an in [pic] economic [pic]| |science, is to devise judicious simplifications which keep the analysis manageable | |without distorting realm too much. It is here that microeconomists and | |macroeconomists proceed down different avenues. Microeconomists tend to offer a | |detailed treatment of one aspect of [pic] economic [pic] behavior but ignore | |interactions with the rest of the economy in order to preserve the simplicity of | |the analysis A microeconomic analysis of miners' wages would emphasize the | |characteristics of miners and the ability of mine owners to pay It would largely | |neglect the chain of indirect effects to which a rise in miners' wages might give | |rise For example, car workers might use the precedent of the miners' pay increase | |to secure higher wages in the car industry, thus being able to afford larger houses| |which burned more coal in heating systems. When microeconomic analysis ignores such| |indirectly induced effects it is said to be partial analysis. | |In some instances, indirect effects may not be too important and it will make sense| |for economists to devote their effort to very detailed analyses of particular | |industries or activities. In other circumstances, the indirect effects are too | |important to be swept under the carpet and an alternative simplification must be | |found. | |Macroeconomics emphasizes the interactions in the economy as a whole. It | |deliberately simplifies the individual building blocks of the analysis in order to | |retain a manageable analysis of the complete interaction of the economy. For | |example, macroeconomists typically do not worry about the breakdown of consumer | |goods into cars, bicycles, televisions, and calculators. They prefer to treat them | |all as a single bundle called 'consumer goods' because they are more interested in | |studying the interaction between households' purchases of consumer goods and firms'| |decisions about purchases of machinery and buildings. | |SUMMARY | |[pic] Economics [pic] analyses what, how, and for whom society produces. The | |central [pic] economic [pic] problem is to reconcile the conflict between people's | |virtually unlimited demands with society's limited ability to produce goods and | |services to fulfill these demands. | |The production possibility frontier shows the maximum amount of one good that can | |be produced for each given level of output of the other good. It depicts the | |trade-off or menu of choices that society must make in deciding what to produce. | |Resources are scarce and points outside the frontier are unattainable. It is | |inefficient to produce within the frontier. By moving on to the frontier, society | |could have more of some good without having less of any other good. | |Industrial Western countries rely extensively on markets to allocate resources. The| |market is the process by which production and consumption decisions are coordinated| |through adjustments in prices. The role of prices is central to this definition. | |In a command economy, decisions on what, how, and for whom are made in a central | |planning office. No economy relies entirely on command, but there is extensive | |planning in many Soviet bloc countries. | |A free market economy has no government intervention. Resources are allocated | |entirely through markets in which individuals pursue their own self-interest. | |Modern economies in the West are mixed, relying mainly on the market but with a | |large dose of government intervention. The optimal level of government intervention| |remains a subject of controversy. | |Positive [pic] economics [pic] studies how the economy actually behaves. Normative | |[pic] economics [pic] makes prescriptions about what should be done. The two should| |be kept separate as far as possible. Given sufficient research, economists should | |eventually agree on issues in positive [pic] economics [pic]. Normative | |[pic] economics [pic] involves subjective value judgments. There is no reason why | |economists should agree about normative statements. | |Microeconomics offers a detailed analysis of particular activities in the economy. | |For simplicity, it may neglect some interactions with the rest of the economy. | |Macroeconomics emphasizes these interactions at the cost of simplifying the | |individual building blocks. | |In previous chapters we have learned to use demand curves to represent consumer | |behavior. The properties of these demand curves may usefully be summarized by own | |price, cross price, and income elasticities of demand. In this chapter we go behind| |these measures of demand by building a model of consumer behavior. | |The model of consumer choice explains how buyers reconcile what they would like to | |do, as described by their tastes or preferences, and what the market will allow | |them to do, as described by their incomes and the prices of different goods. The | |model allows us to predict how consumers will respond to changes in market | |conditions. It helps to make sense of the price and income elasticities examined in| |Chapter 4. | |5-1 THE THEORY OF CONSUMER CHOICE | |The model has four elements, which describe both the consumer and the market | |environment: | |The given income that the consumer can spend | |The prices at which goods can be bought | |The consumer's tastes, which rank different combinations or bundles of goods | |according to the satisfaction they yield the consumer | |The behavioral assumption that consumers do the best they can for themselves. Of | |the possible consumption bundles that can be purchased out of a given income, the | |consumer picks the bundle that maximizes his or her own satisfaction. | |Each of these elements in the model requires detailed discussion. | |The Budget Constraint | |Together, elements (1) and (2) define the consumer's budget constraint. | |The budget constraint describes the different bundles that the consumer can afford.| | | |Which bundles are feasible, or can be afforded, depends on two factors: the | |consumer's income and the prices of different goods. | |Consider a student with a weekly budget (income, allowance, or grant) of ?50, which| |can be spent on meals or films. Each meal costs ?5 and each film ?10. What | |combination of meals and films can the student afford to buy: Completely going | |without films, the student can spend ?50 on 10 meals at ?5 | |each. Completely going without meals, the student can buy 5 cinema tickets at ?10 | |each. Between these two extremes lies a range of combinations of meals and films | |that together cost exactly ?50. These combinations are called the budget | |constraint. | |Thus, the budget constraint shows the maximum affordable quantity of one good given| |the quantity of the other good that is being purchased. Table 5-1 shows the budget | |constraint for the student in our example. Each row of the table shows an | |affordable consumption bundle. For example, row 4 shows that 6 meals (costing ?30) | |and 2 films (costing ?20) use up all available income. Other rows are calculated in| |the same way. | |Table 5-1 shows the trade-off the student must make between meals and films. Higher| |quantities of meals require lower quantities of films. For a given income, the | |budget constraint shows how much of one good must be sacrificed to obtain larger | |quantities of the other good. It is because there is a trade-off that the student | |must make a choice between meals and films. | |The Budget Line | |It is useful to depict the budget constraint of Table 5-1 as a budget line. | |Plotting the data of Table 5-1, the budget line in Figure 5-1 again shows the | |maximum combinations of meals and films that the student can purchase out of | |available income. The position and shape of the budget line are determined by its | |end points A and F, which have a simple [pic] economic [pic] interpretation. Point | |A shows the maximum quantity of films (5 that the budget will purchase if the | |student goes without meals. ?50 buys at most 5 tickets at ?10 each. Point F shows | |that ?50 buys at most 10 meals at ?5 each if the student goes without films The | |budget line joins up points A and F. Intermediate points on the line such as B and | |C show more balanced purchases of meals and films. The budget line is a convenient | |way to examine the trade-off between meals and films The slope of the budget line | |indicates how many meals must be sacrificed to get another film Moving from point F| |to point E reduces the quantity of meals from 10 to 8 but increases the quantity of| |films from 0 to 1 This trade-off between meals and films is constant along the | |budget line Giving up two meals at ?5 each always provides the extra ?10 to buy an | |additional cinema ticket. We now see the crucial role of prices It is because film | |tickets cost twice as much as meals that two meals must be sacrificed to purchase | |another film ticket If films cost three times as much as meals it would be | |necessary to sacrifice three meals to pay for one extra film The slope of the | |budget line depends only on the ratio of the prices of the two goods The slope of a| |line is the change in the vertical distance divided by the corresponding change in | |the horizontal distance In Figure 5-1 the slope of the budget line is — 0,5 A | |positive change of 1 film must be divided by the corresponding negative change of | |—2 meals. | |This example illustrates the general rule Slope of the budget line = — ph/pv | |where PH is the price of the good whose quantity is measured on the horizontal axis| |and Pv is the price of the good whose quantity is measured on the vertical axis In | |our example, the price of meals PH is ?5 and the price of films Pv is ?10 Formula | |(1) confirms that the slope of the budget line is — 0,5 and the minus sign reminds | |us that there is a trade-off We have to give up one good to get more of the other | |good. Thus, the two end-points of the budget line (here, A and F) show how much of | |each good the budget will buy if the other good is not purchased at all. The slope | |of the budget line joining these end-points, depends only on the relative prices of| |the two goods. | |Any point above the budget line (such as G in Figure 5-1) is unaffordable. The | |budget line shows the maximum quantity of one good that can be afforded, given the | |quantity purchased of the other good and given the budget available for spending. | |Given. n income of ?50, the point G is out of reach since it requires ?25 to buy 5 | |meals and ?50 to buy 5 cinema tickets. Points such as K, which he inside the budget| |line, leave some income unspent. The point K requires ?10 for meals and ?20 for | |films leaving ?20 unspent The student could use this ?20 to buy 4 extra meals | |(moving from K to D without sacrificing films) or to buy 2 extra film tickets | |(moving from K to B without sacrificing meals) Only on the budget line is there a | |trade off where the student must choose between films and meals. | |FIGURE 5-1 THE BUDGET LINE The budget line shows the maximum combinations of goods | |that the consumer can afford given income and the prevailing prices. Points such as| |B and C on the budget line AF use up the entire consumer budget Points such as G. | |above the budget line are unaffordable. Points such as K. inside the budget line | |would allow additional consumption of at least one good. | |[pic] | |We now introduce the concept of the marginal rate of substitution of meals for | |films. | |The marginal rate of substitution of meals for films is the quantity of films the | |consumer must sacrifice to increase the quantity of meals by one unit without | |changing total utility. | |Since consumers prefer more to less, an additional meal tends to increase utility. | |To hold utility constant, when one meal is added the consumer must simultaneously | |sacrifice some quantity of the other good (films). The marginal rate of | |substitution tells us how many films the consumer could exchange for an additional | |meal without changing total utility. The marginal rate of substitution must be a | |negative number: it is the ratio of a negative change in the quantity of films to | |the positive change in the quantity of meals when utility remains unaltered. | |Suppose the student begins with a bundle comprising 5 films and no meals. Having | |already seen 4 films that week, the student probably does not enjoy the fifth film | |very much. With no meals, the student is very hungry. The utility of this bundle is| |low: being so hungry, the student cannot really enjoy the films anyway. To obtain | |the same amount of utility the student could give up a lot of films in exchange for| |a little food. The marginal rate of substitution is a large negative number and we | |say that it is high. | |Suppose instead that the student is consuming a large number of meals but seeing | |few films. To obtain the same amount of utility, the student will be reluctant to | |sacrifice much cinema attendance to gain yet another meal. The marginal rate of | |substitution is a small negative number and we say that it is low. When the ratio | |of films to meals is already high the marginal rate of substitution of meals for | |films is high. It makes sense to sacrifice abundant films for scarce meals. | |Conversely, when the ratio of films to meals is already low the marginal rate of | |substitution of meals for films is low. It does not make sense to sacrifice scarce | |films for yet more meals. | |Economists believe that this common-sense reasoning about tastes or preferences is | |very robust. It will hold in a wide range of circumstances. Indeed, it is | |sufficiently plausible that it can become a general principle, the third assumption| |we need to make about consumer tastes. It is called the assumption of a diminishing| |marginal rate of substitution. | |Consumer tastes exhibit a diminishing marginal rate of substitution when, to hold | |utility constant, diminishing quantities of one good must be sacrificed to obtain | |successive equal increases in the quantity of the other good. | |For example, our student might be indifferent between, that is, be equally happy | |with, bundle X - (6 films, 0 meals), bundle Y = (3 films, 1 meal), and bundle Z = | |(2 films, 2 meals). Beginning from bundle X, a move to Y sacrifices 3 films for 1 | |meal, but a further move from Y to Z sacrifices only I film for 1 extra meal. Such | |tastes satisfy the assumption of a diminishing marginal rate of substitution. | |These three assumptions - that consumers prefer more to less, can rank alternative | |bundles according to the utility provided, and have tastes satisfying a diminishing| |marginal rate of substitution - are ail we shall require. It is now convenient to | |show how tastes can be represented as indifference curves. | |THE OVERALL PICTURE | |Macroeconomics is the study of the economy as a whole Macroeconomics is concerned | |not with the details - the price of cigarettes relative to the price of bread, or | |the output of cars relative to the output of steel - but with the overall picture | |In Part 4 we shall study issues such as the determination of the total output of | |the economy, the aggregate level of unemployment, and the rate of inflation or | |growth of prices of goods and services as a whole. | |The distinction between microeconomics and macroeconomics is more than the | |difference between [pic] economics [pic] in the small and [pic] economics [pic] in | |the large, which the Creek prefixes micro and macro suggest The purpose of the | |analysis is also different | |A model is a deliberate simplification to enable us to pick out the key elements of| |a problem and think about them clearly Although we could study the whole economy by| |piecing together our microeconomic analysis of each and every market, the resulting| |model would be so cumbersome that it would be hard to keep track of all the | |[pic] economic [pic] forces at work Microeconomics and macroeconomics take | |different approaches to keep the analysis manageable. | |Microeconomics places the emphasis on a detailed understanding of particular | |markets To achieve this amount of detail or magnification, many of the interactions| |with other markets arc suppressed In saying that a tax on cars reduces the | |equilibrium quantity of cars we ignore the question of what the government docs | |with the tax revenue If the government has to borrow less money, it is possible | |that interest rates and the exchange rate will fall and that improved international| |competitiveness of UK car producers will actually increase the equilibrium output | |of cars in the UK. | |Microeconomics is a bit like looking at a horse race through a pair of binoculars | |It is great for details, but sometimes we get a clearer picture of the whole race | |by using the naked eye Because macroeconomics is concerned primarily with the | |interaction of different parts of the economy, it relies on a different | |simplification to keep the analysis manageable Macroeconomics simplifies the | |building blocks in order to focus on how they fit together and influence one | |another. | |Macroeconomics is concerned with broad aggregates such as the total demand for | |goods by households or the total spending on machinery and buildings by firms As in| |watching the horse race through the naked eye our notion of the individual details | |is more blurred but we can give our full attention to the whole picture We are more| |likely to notice the horse sneaking up on the rails | |19-1 THE ISSUES | |We now introduce some of the main issues in macroeconomics. We pose a series of | |questions, which form the theme of the analysis in Part 4. | |Inflation. The annual inflation rate is the percentage increase per annum in the | |average price of goods and services In Chapter 2 we introduced the retail price | |index (RP1) a weighted average of the prices households pay for goods and services | |The percentage annual growth in the RP1 is the most commonly used measure of | |inflation in the UK. | |What causes inflation? The money supply? Trade Unions? Why do people mind so much | |about inflation? Does inflation cause unemployment? These are among the questions | |we shall seek to answer. | |Unemployment. Unemployment is a measure of the number of people registered as | |looking for work but without a job. The unemployment rate is the percentage of the | |labor force that is unemployed The labor force is the number of people working or | |looking for work It excludes all those from rich landowners to heroin addicts who | |are neither working nor looking for work Unemployment is now high Why has it in | |creased so much in the 1980s? Are workers pricing themselves out of jobs by greedy | |wage claims? Is high unemployment necessary to keep inflation under control or | |could the government create more jobs? Output and Growth Real gross national | |product (real GNP) measures the total income of the economy It tells us the | |quantity of goods and services the economy as a whole can afford to purchase It is | |closely related to the total output of the economy Increases in real GNP are called| |[pic] economic [pic] growth. What determines the level of real GNP? Does | |unemployment mean that real GNP is lower than it might be? Why do some countries | |grow faster than others? | |Macroeconomic Policy Almost every day the newspapers and television refer to the | |problems of inflation unemployment and slow growth. These issues are widely | |discussed they help determine the outcome of elections and make some people | |interested in learning more about macroeconomics. The government has a variety of | |policy measures through which it can try to affect the performance of the economy | |as a whole. It levies taxes, commissions spending influences the money supply | |interest rates and the exchange rate and it sets targets for the output and prices | |of nationalized industries. What the government can and should do is the subject of| |lively debate both within the field of [pic] economics [pic] and in the country at | |large. As usual it is important to distinguish between positive issues relating to | |how the economy works and normative issues relating to priorities or value | |judgments In the ensuing chapters we try to make clear which aspects of the policy | |debate refer to differing beliefs about how the economy works and which aspects | |refer to differences in priorities or value judgments. | |19-4 NATIONAL INCOME ACCOUNTING | |Measuring GDP | |Gross domestic product (GDP) measures the output produced by factors of production | |located in the domestic economy regardless of who owns these factors. | |GDP measures the value of output produced within the economy. Most of this output | |will be produced by domestic factors of production but there arc some exceptions. | |Suppose Datsun or Peugeot builds a car factory in the UK. They employ UK workers | |and use machines made in the UK Their output is part of GDP for the UK. However, | |the company's profits are owned by shareholders in Japan or France Hence the value | |of the factory's output cannot be expected to be the same as the value of incomes | |earned by UK households Initially we shall simply suppose that we are discussing a | |country with no links with the rest of the world. Shortly, we shall introduce the | |rest of the world and show that it is precisely the issue of how to treat payments | |of profits and other income to foreigners that explains why we have to distinguish | |GDP from the concept of GNP, which we introduced earlier. When an economy has no | |transactions with the rest of the world we say that it is a closed economy. | |We begin by considering how our simple circular flow diagram should be extended to | |recognize that transactions do not take plate exclusively between a single firm and| |a single household. Firms hire labor services from house holds, but they buy raw | |materials and machinery from other firms. If we include the value of the output of | |cars in GDP we do not want also to include the value of the steel sold to the car | |producer which is already in the value of the car. | |To avoid double counting, we use the concept of value added. | |Value added is the increase in the value of goods as a result of the production | |process Value added is calculated by deducting from the value of the firm's output | |the cost of the input goods that were used up in the act of producing that output. | |Closely related to the concept of value added is the distinction between final | |goods and intermediate goods. | |Final goods are goods purchased by the ultimate user. They are either consumer | |goods purchased by households or capital goods such as machinery which are | |purchased by firms. Intermediate goods are partly finished goods which form inputs | |to another firm's production process and are used up in that process. | |Thus, ice cream is a final good but steel is an intermediate good which some other | |firm uses as an input to its production process In classifying capital goods as | |final goods we suppose they are not used up in subsequent production In the | |language of Chapter 6, we suppose that they do not depreciate or wear out Shortly, | |we shall see how depreciation may be handled within this framework. | |The following example should help you son out these concepts and it is important | |that you should study it until you have mastered these ideas. We assume that there | |are four firms m the economy a steel producer, a producer of capital goods | |(machines) used m the car industry, a tyre producer, and a car producer who sells | |cars to the final consumers, the households. Table 19-6 shows how we may calculate | |GDP for this simple economy. | |The steel producer makes ?4000 worth of steel, one quarter of which is sold as an | |intermediate good to the firm that makes machines and three quarters of which is | |sold to the car producer to make cars. If the steel producer also mines the iron | |ore from which the steel is produced, then the entire ?4000 is value added or net | |output by the steel firm. This revenue is directly paid out in wages and rents or | |is residual profits which also accrue to households as income. Hence the first two | |rows of the last column also add up to ?4000. Although firms have spent ?4000 | |buying this steel output, this does not show up as expenditure on final goods since| |steel is entirely an intermediate good which will be used up in later stages of the| |production process | |The machine manufacturer spends ?1000 buying steel input which is then converted | |into a machine to be sold to the car producer for ?2000. The value added of the | |machine manufacturer is ?2000 less the ?1000 spent on steel inputs. And this net | |revenue of ?1000 accrues directly or indirectly to households as income or profit. | |Since the car firm intends to keep the machine, its full value of ?2000 is shown | |under Final expenditure. | |Like the steel producer the tyre manufacturer produces an intermediate output which| |does not show up under final expenditure If the tyre manufacturer also owns the | |rubber trees from which the tyres were made the entire output of ?500 is value | |added and will contribute directly or indirectly to household incomes. If the tyre | |company bought rubber from a domestic rubber producer we should have to subtract | |the input value of rubber from the tyre manufacturers output to obtain value added | |or net output, but we should have to add another row showing the value added of the| |company producing the rubber for sale to the tyre company. | |The car producer spends ?3000 on steel and ?500 on tyres. Since both are used up | |during the period in which cars are made we subtract ?3500 from the car output of | |?5000 to obtain the value added of the car producer. This net revenue pays | |households for factor services supplied or is paid to them as profits. | |Finally, the car producer sells the car for ?5000 to the final consumer households.| |Only now does the car become a final good and its full price of ?5000 is entered as| |final expenditure. | |Table 19 6 shows that the gross value of all the transactions that occurred is ?11 | |500 but this overstates the value of the goods the economy has actually produced | |For example the ?3000 that the steel producer earned by selling steel to the car | |producer is already included in the final value of car output It is simply double | |counting to count this ?3000 twice. | |Column (5) shows the value added at each stage in the production process. In total | |this comes to ?7000 and this is the correct measure of the net output of the | |economy. Since each producer pays out the corresponding net revenue to households | |either as direct factor payments or indirectly as profits household earnings also | |equal ?7000 in the last column of the table. If we simply counted up the payments | |made to households as income and profits we would get the same measure of the | |economy's output or GDP. | |Table 19 6 confirms that we also get the same answer if we measure spending on | |final goods and services In this case the final users are the households buying the| |cars and the car producer buying the (everlasting) machinery used to make cars. | |22-1 MONEY AND ITS FUNCTIONS | |Although the crucial feature of money is its acceptance as the means of payment or | |medium of exchange, money has three other functions. It serves as a unit of | |account, as a store of value, and as a standard of deferred payment. We discuss | |each of the four functions of money in turn. | |The Medium of Exchange | |Money, the medium of exchange, is used in one-half of almost all exchange. Workers | |exchange labor services for money. People buy or sell goods in exchange for money. | |We accept money not to consume it directly but because it can subsequently be used | |to buy things we do wish to consume. Money is the medium through which people | |exchange goods and services. To see that society benefits from a medium of | |exchange, imagine a barter economy. | |A barter economy has no medium of exchange. Goods are traded directly or swapped | |for other goods. | |In a barter economy, the seller and the buyer each must want something the other | |has to offer. Each person is simultaneously a seller and a buyer. In order to see a| |film, you must hand over in exchange a good or service that the cinema manager | |wants. | |There has to be a double coincidence of wants. You have to find a cinema where the | |manager wants what you have to offer in exchange. Trading is very expensive in a | |barter economy. People must spend a lot of time and effort finding others with whom| |they can make mutually satisfactory swaps. Since time and effort are scarce | |resources, a barter economy is wasteful. The use of money - any commodity generally| |accepted in payment for goods, services, and debts – makes the trading process | |simpler and more efficient. | |Other Functions of Money | |The unit of account is the unit in which prices are quoted and accounts are kept. | |In Britain prices are quoted in pounds sterling; in France, in French francs. It is| |usually convenient to use the units in which the medium of exchange is measured as | |the unit of account as well. However there are exceptions. During the rapid German | |inflation of 1922-23 when prices in marks were changing very quickly, German | |shopkeepers found it more convenient to use dollars as the unit of account. Prices | |were quoted in dollars even though payment was made in marks, the German medium of | |exchange. | |Money is a store of value because it can be used to make purchases in the future. | |To be accepted in exchange, money has to be a store of value. Nobody would accept | |money as payment for goods supplied today if the money was going to be worthless | |when they tried to buy goods with it tomorrow. But money is neither the only nor | |necessarily the best store, of value. Houses, stamp collections, and | |interest-bearing bank accounts all serve as stores of value. Since money pays no | |interest and its real purchasing power is eroded by inflation, there are almost | |certainly better ways to store value. | |Finally, money serves as a standard of deferred payment or a unit of account over | |time. When you borrow, the amount to be repaid next year is measured in pounds | |sterling. Although convenient, this is not an essential function of money. UK | |citizens can get bank loans specifying in dollars the amount that must be repaid | |next year. Thus the key feature of money is its use as a medium of exchange. For | |this, it must act as a store of value as well. And it is usually, though not | |invariably, convenient to make money the unit of account and standard of deferred | |payment as well. | |Different Kinds of Money In prisoner-of-war camps, cigarettes served as money. In | |the nineteenth century money was mainly gold and silver coins. These are examples | |of commodity money, ordinary goods with industrial uses (gold) and consumption uses| |(cigarettes), which also serve as a medium of exchange. To use commodity money, | |society must either cut back on other uses of that commodity or devote scarce | |resources to producing additional quantities of the commodity. But there are less | |expensive ways for society to produce money. | |A token money is a means of payment whose value or purchasing power as money | |greatly exceeds its cost of production or value in uses other than as money. A ?10 | |note is worth far more as money than as a 3x6 inch piece of high-quality paper. | |Similarly, the monetary value of most coins exceeds the amount you would get by | |melting them down and selling off the metals they contain. By collectively agreeing| |to use token money, society economizes on the scarce resources required to produce | |money as a medium of exchange. Since the manufacturing costs are tiny, why doesn't | |everyone make ?10 notes? | |The essential condition for the survival of token money is the restriction of the | |right to supply it. Private production is illegal. Society enforces the use of | |token money by making it legal tender. The law says it must be accepted as a means | |of payment. In modern economies, token money is supplemented by IOU money. An IOU | |money is a medium of exchange based on the debt of a private firm or individual. A | |bank deposit is IOU money because it is a debt of the bank. When you have a bank | |deposit the bank owes you money. You can write a cheque to yourself or a third | |party and the bank is obliged to pay whenever the cheque is presented. Bank | |deposits are a medium of exchange because they are generally accepted as payment. | |22-3 MODERN BANKING | |The goldsmith bankers were an early example of a financial intermediary. | |A financial intermediary is an institution that specializes in bringing lenders and| |borrowers together. | |A commercial bank borrows money from the public, crediting them with a deposit. The| |deposit is a liability of the bank. It is money owed to depositors. In turn the | |bank lends money to firms, households, or governments wishing to borrow. | |Banks are not the only financial intermediaries. Insurance companies, pension | |funds, and building societies also take in money in order to relend it. The crucial| |feature of banks is that some of their liabilities are used as a means of payment, | |and are therefore pan of the money stock. Commercial banks are financial | |intermediaries with a government license to make loans and issue deposits, | |including deposits against which cheques can be written. | |We begin by looking at the present-day UK banking system. Although the details vary| |from country to country, the general principle is much the same everywhere. | |In the UK, the commercial banking system comprises about 600 registered banks, the | |National Girobank operating through post offices, and about a dozen trustee savings| |banks. Much the most important single group is the London clearing banks. The | |clearing banks are so named because they have a central clearing house for handling| |payments by cheque. | |A clearing system is a set of arrangements in which debts between banks are settled| |by adding up all the transactions in a given period and paying only the net amounts| |needed to balance inter-bank accounts. Suppose you bank with Barclays but visit a | |supermarket that banks with Lloyds. To pay for your shopping you write a cheque | |against your deposit at Barclays. The supermarket pays this cheque into its account| |at Lloyds. In turn, Lloyds presents the cheque to Barclays which will credit | |Lloyds' account at Barclays and debit your account at Barclays by an equivalent | |amount. Because you purchased goods from a supermarket using a different bank, a | |transfer of funds between the two banks is required. Crediting or debiting one | |bank's account at another bank is the simplest way to achieve this. | |However on the same day someone else, call her Joan Groover, is probably writing a | |cheque on a Lloyd's deposit account to pay for some stereo equipment from a shop | |banking with Barclays. The stereo shop pays the cheque into its Barclays' account, | |increasing in deposit. Barclays then pay the cheque into its account at Lloyds | |where Ms Groover's account is simultaneously debited. Now the transfer flows from | |Lloyds to Barclays. | |Although in both cases the cheque writer's account is debited and the cheque | |recipient's account is credited, it does not make sense for the two banks to make | |two separate inter-bank transactions between themselves. The clearing system | |calculates the net flows between the member clearing banks and these are the | |settlements that they make between themselves. Thus the system of clearing cheques | |represents another way society reduces the costs of making transactions. | |The Balance Sheet of the London Clearing Banks | |Table 22-2 shows the balance sheet of the London clearing banks. Although more | |complex, it is not fundamentally different from the balance sheet of the | |goldsmith-banker shown in Table 22-1. We begin by discussing the asset side of the | |balance sheet. | |Cash assets are notes and coin in the banks' vaults just as the goldsmiths held | |gold in their vaults. However, modern banks' cash assets also include their cash | |reserves deposited with the Bank of England. The Bank of England (usually known as | |the Bank) is the central bank or banker to the commercial banks. | |Apart from cash, the other entries on the asset side of the balance sheet show | |money that has been lent out or used to purchase interest-earning assets. The | |second item, bills and market loans, shows short-term lending in liquid assets. | |Liquidity refers to the speed and the certainty with which an asset can be convened| |back into money, whenever the asset-holders desire. Money itself is thus the most | |liquid asset of all. | |The third item, advances, shows lending to households and firms. A firm that has | |borrowed to see it through a sticky period may not be able to repay whenever the | |bank demands. Thus, although advances represent the major share of clearing bank | |lending, they are not very liquid forms of bank lending. The fourth item, | |securities, shows bank purchases of interest-bearing long-term financial assets. | |These can be government bonds or industrial shares. Although these assets are | |traded daily on the stock exchange, so in principle these securities can be cashed | |in any time the bank wishes, their price fluctuates from day to day. Banks cannot | |be certain how much they will get when they sell out. Hence financial investment in| |securities is also illiquid. | |The final two items on the asset side of Table 22-2 show lending in foreign | |currencies and miscellaneous bank assets whose details need not concern us. Total | |assets of the London clearing banks in May 1986 were ?200.1 billion. We now examine| |how the equivalent liabilities were made up. | |Deposits are chiefly of two kinds: sight deposits and time deposits. Whereas sight | |deposits can be withdrawn on sight whenever the depositor wishes, a minimum period | |of notification must be given before time deposits can be withdrawn. Sight deposits| |are the bank accounts against which we write cheques, thereby running down our | |deposits without giving the bank any prior warning. Whereas most banks do not pay | |interest on sight deposits or chequing accounts, they can afford to pay interest on| |time deposits. Since they have notification of any withdrawals, they have plenty of| |time to sell off some of their high-interest investments or call in some of their | |high-interest loans in order to have the money to pay out depositors. | |Certificates of deposit (CDs) are an extreme form of time deposit where the bank | |borrows from the public for a specified time period and knows exactly when the loan| |must be repaid The final liability items in Table 22-2 show deposits in foreign | |currencies and miscellaneous liabilities such as cheques in the process of | |clearance. | |23-2 THE BANK AND THE MONEY SUPPLY | |In this section we study the ways in which a central bank can affect the supply of | |money in the economy The narrowest measure Ml of the money supply is currency in | |circulation outside the banking system plus the sight deposits of commercial banks | |against which the private sector can write cheques Thus the money supply is partly | |a liability of the Bank (currency in private circulation) and partly a liability of| |commercial banks (chequing accounts of the general public). | |In the last chapter we introduced the monetary base, the currency supplied by the | |Bank both to the commercial banks and to private circulation, and the money | |multiplier, the extent to which the money supply is a multiple of the monetary base| |We saw that the money multiplier was larger the smaller the cash reserve ratio of | |the commercial banks and the smaller the private sector's desired ratio of cash to | |bank deposits. | |We now describe the three most important instruments through which the Bank might | |seek to affect the money supply resent requirements, the discount rate, and open | |market operations. | |Reserve Requirements | |A required reserve ratio is a minimum ratio of cash reserves to deposits that the | |central bank requires commercial banks to hold If a reserve requirement is in | |force, commercial banks can hold more than the required cash reserves but they | |cannot hold less If their cash falls below the required amount, they must | |immediately borrow cash, usually from the central bank, to restore their required | |reserve ratio. | |Suppose the commercial banking system has ? l million in cash and for strictly | |commercial purposes would normally maintain cash reserves equal to 5 per cent of | |sight deposits. Since sight deposits will be 20 times cash reserves, the banking | |system will create ? 20 million of sight deposits against its ?l million cash | |reserves. Suppose the Bank now imposes a reserve requirement that banks must hold | |cash reserves of at least 10 per cent of sight deposits. Now banks can create only | |?10 million sight deposits against their cash reserves of ?1 million. | |Thus, when the central bank imposes a reserve requirement in excess of the reserve | |ratio that prudent banks would anyway have maintained, the effect is to reduce the | |creation of bank deposits; reduce the value of the money multiplier, and reduce the| |money supply for any given monetary base. Similarly, when a particular reserve | |requirement is already in force, any increase in the reserve requirement will | |reduce the money supply. | |When the central bank imposes a reserve requirement in excess of the reserves that | |banks would otherwise have wished to hold, the banks are creating fewer deposits | |and undertaking less lending than they would really like. Thus a reserve | |requirement acts like a tax on banks by forcing them to hold a higher fraction of | |their total assets as bank reserves and a lower fraction as loans earning high | |interest rates. Can the banks do anything about it? ' | |Although there are profitable lending opportunities, the banks can take advantage | |of them only if they can increase their cash reserves. In principle, they could try| |to borrow cash from the central bank. If the point of a reserve requirement is to | |reduce the money supply, the central bank will be reluctant to lend banks the cash | |they want to make additional loans, increase deposits, and expand the money supply.| |With lucrative lending opportunities around, the banks may be able to induce the | |private sector to exchange cash in circulation for bank deposits. Banks can offer | |more generous interest rates on time deposits or stay open later to encourage | |people to make greater use of chequing facilities. By attracting more cash from the| |general public, banks may then be able to restore former levels of deposit lending,| |though there is then the danger that the central bank will raise the reserve | |requirement still higher. | |One form of reserve requirement that has been especially popular in the UK is the | |use of special deposits. Commercial banks were required to deposit some of their | |cash reserves in a special deposit at the Bank, and this money could not be counted| |as part of the banks' cash reserves in meeting their reserve requirements. Varying | |the amount required as special deposits gave the Bank another lever for controlling| |deposit creation by the banking system and the size of the money multiplier. | |The Discount Rate | |The second instrument of monetary control available to the central bank is the | |discount rate. The discount rate is the interest rate that the Bank charges when | |the commercial banks want to borrow money. | |When the discount rate was an important pan of monetary control in the UK it used | |to be known as the Bank Rate, or Minimum Lending Rate (MLR). | |Suppose banks think the minimum safe ratio of cash to deposits is 10 per cent. For | |the purposes of this argument it does not matter whether this figure is a | |commercial judgment or a required ratio imposed by the Bank. On any particular day,| |banks are likely to have a bit of cash in hand. Say their cash reserves are 12 per | |cent of deposits. How far dare they let their cash reserves fall towards the | |minimum level of 10 per cent? | |Banks have to balance the interest rate they will get on extra lending with the | |dangers and costs involved if there is a sudden flood of withdrawals which push | |their cash reserves below the critical 10 per cent figure. This is where the | |discount rate comes in. Suppose market interest rates are 8 per cent and the | |central bank makes it known it is prepared to lend to commercial banks at 8 per | |cent. Commercial banks may as well lend up to the hilt and drive their cash | |reserves down to the minimum 10 per cent of deposits. The banks are lending at 8 | |per cent and, if the worst comes to the worst and they are short of cash, they can | |always borrow from the Bank at 8 per cent. Banks cannot lose by lending as much as | |possible. | |Suppose however that the Bank announces that, although market interest rates are 8 | |per cent, it will lend to commercial banks only at the penalty rate of 10 per cent.| |Now a bank with cash reserves of 12 per cent may conclude that it is not worth | |making the extra loans at 8 per cent interest that would drive us cash reserves | |down to the minimum of 10 per cent of deposits. There is too high a risk that | |sudden withdrawals will then force the bank to borrow from the Bank at 10 per cent | |interest. It will have lost money by making these extra loans. It makes more sense | |to hold some excess cash reserves against the possibility of a sudden withdrawal. | |Thus, by setting the discount rate at a penalty level in excess of the general | |level of interest rates, the Bank can induce commercial banks voluntarily to hold | |additional cash reserves. Since bank deposits now become a lower multiple of banks'| |cash reserves, the money multiplier is reduced and the money supply is lower for | |any given level of the monetary base. | |23-4 THE DEMAND FOR MONEY | |In 1965 the amount of money (M 1) in the UK was ?7.6 billion. By 1985 it was ?65 | |billion. Why were UK residents prepared to hold nine times as much money in 1985 as| |in 1965? Answering that question will introduce us to the factors that determine | |money demand, which in turn sets the stage for understanding how monetary policy | |affects the economy. | |We single out three key variables that determine money demand: interest rates, the | |price level or average price of goods and services, and real income. Before | |examining whether movements in these variables can explain the ninefold increase in| |money holdings between 1965 and 1985, we reconsider why people hold money at all. | |The Motives for Holding Money | |Money is a stock. It is the quantity of circulating currency and bank deposits held| |at any given time. Holding money is not the same as spending money when we buy a | |meal or go to the cinema. We hold money now in order to spend it later. | |The distinguishing feature of money is its use as a medium of exchange, for which | |it must also serve as a store of value. It is in these two functions of money that | |we must seek the reasons why people wish to hold it. | |People can hold their wealth in various forms -money, bills, bonds, equities, and | |property. For simplicity we assume that there are only two assets: money, the | |medium of exchange that pays no interest, and bonds, which we use to stand for all | |other interest-bearing assets that are not directly a means of payment. As people | |earn income, they add to their wealth As they spend, they deplete their wealth. How| |should people divide their wealth at any instant between money and bonds? There is | |an obvious cost in holding any money at all. | |The opportunity cost of holding money is the interest given up by holding money | |rather than bonds. | |People will hold money only if there is a benefit to offset this cost. We now | |consider what that benefit might be. | |The Transactions Motive In a monetary economy we use money to purchase goods and | |services and receive money in exchange for the goods and services we sell. Without | |money, making transactions by direct barter would be costly in time and effort. | |Holding money economizes on the time and effort involved in undertaking | |transactions. | |If all transactions were perfectly synchronized, we would earn revenue from sales | |of goods and income from sales of factor services at the same instant we made | |purchases of the goods and services we wish to consume. Except at that instant, we | |need hold no money at all. | |The transactions motive for holding money reflects the tact that payments and | |receipts are not perfectly synchronized. We need to hold money between receiving | |payments and making subsequent purchases. | |How much money we need to hold depends on two things, the value of the transactions| |we wish to make and the degree of synchronization of our payments and receipts | |Money is a nominal variable not a real variable We do not know how much ?100 will | |buy until we know the price of goods. If all prices double, both our receipts and | |our payments will double in nominal terms To make the same transactions as before | |we will need to hold twice as much money. Putting this differently: | |The demand for money is a demand for real money balances. | |We need a given amount of real money, nominal money deflated by the price level, to| |undertake a given quantity of total transactions. Hence when the price level | |doubles, other things equal we expect the demand for nominal money balances to | |double, leaving the demand for real money balances unaltered. People want money | |because of its purchasing power in terms of the goods it will buy. | |The second factor affecting the transactions motive for holding money is the degree| |of synchronization of payments and receipts. Suppose that, instead of spreading | |their shopping evenly throughout the week, households do all their shopping on the | |day they get a salary cheque from their employers. Over the week, national income | |and total transactions are unaltered, but people now hold less money over the week.| | | |A nation's habits for making payments change only slowly. In our simplified model | |we assume that the degree of synchronization remains constant over time. Thus we | |focus on real national income as the measure of the transactions motive for holding| |real money balances. | |The Precautionary Motive Thus far we have assumed that people know exactly when | |they will obtain receipts and make payments. But of course we live in an uncertain | |world. This uncertainty about the precise timing of receipts and payments gives | |rise to a precautionary motive for holding money. | |Suppose you decide to buy a lot of interest-earning bonds and try to get by with | |only a small amount of money holdings. You are walking down the street and spot a | |great bargain in a shop window. But you do not have enough money to take advantage | |immediately of this opportunity. By the time you have arranged for some of your | |interest-earning bonds to be sold off in exchange for money, the sale may be over. | |Someone else may have snapped up the video recorder on sale at half price. This is | |the precautionary motive for holding money. | |In an uncertain world, there is a precautionary motive to hold money. In advance, | |we decide to hold money to meet contingencies the exact nature of which we cannot | |yet foresee. | |If we had foreseen the contingency we would have had plenty of time to cash in | |interest-earning bonds to have money available. If we did not have to take | |advantage of the transactions opportunity immediately, it would not matter that it | |was unforeseen: we could still cash in our bonds at our leisure and buy the | |half-price video recorder. We forgo interest and carry money for precautionary | |reasons, because having ready money allows us to snap up unforeseen bargains, or | |stave off unforeseen crises by making immediate payments. Together, the | |transactions and precautionary motives provide the main reasons for holding the | |medium of exchange. They are the motives most "relevant to the benefits from | |holding the narrow definition of money M l.The Asset Motive Suppose we forget all | |about the need to transact. We think of a wealthy individual or a firm deciding in | |which assets to hold wealth. At some distant date there may be a prospect of | |finally spending some of that wealth, but in the short run the objective is to earn| |a good rate of return. | |Some assets, such as industrial shares, on average pay a high rate of return but | |are also quite risky. Some years their return is very high but in other years it is| |negative. When share prices fall, shareholders can make a capital loss, which | |swamps any dividend payment to which they are entitled. Other assets are much less | |risky, but their rate of return tends to be much lower than the average return on | |risky assets. | |How should people divide their portfolios of financial investments between safe and| |risky assets? We discussed this question in detail in Chapter 13 and you might like| |to reread Sections 13-4 and 13-5. We concluded that, since people dislike risk, | |they will not put all their eggs in one basket. As well as holding some risky | |assets, they will keep some of their wealth in safe assets. Although on average | |this portfolio will earn a lower rate of return, it will help avoid absolute | |disaster in bad years. | |The asset motive for holding money arises because people dislike risk. People are | |prepared to sacrifice a high average rate of return to obtain a portfolio with a | |lower but more predictable rate of return. The asset motive for holding money is | |important when we consider why people hold broad measures of money such as sterling| |M3. it is much less relevant when we consider why people hold the medium of | |exchange as measured by Ml. Why? Because if we are going to lend or invest money | |for any length of time, we can put it in a time deposit, which is safe but earns | |interest, rather than in a sight deposit or in cash which, though equally safe, | |earn no interest. Since time deposits are included in sterling M3 but not in Ml, | |the asset motive is of interest chiefly for wider measures of money. However, as | |more sight deposits start to bear interest, this distinction is breaking down. | [pic]