Nature and causes of fluctuation in Economic Activities,Economic Cycles,Trade Cycles,IGCSE,GCEO EXAM NOTES

Introduction

Britain has just suffered one of the deepest slumps in her post-1945 history; the Euro Area economies have struggled to climb out of recession amid unprecedented levels of financial turbulence and the crippling effects of high private and public sector debts

Many of the world’s richest countries have witnessed damaging contractions in activity since 2008. Few nations have escaped – although countries such as Australia, Poland, Norway and Canada seem to have emerged from the global financial crisis (GFC) in relatively good shape.

There are major doubts about the likely pace of growth for advanced nations. The new normal growth rate may be lower than in the last twenty years with important consequences for living standards and the ability of sovereign governments to extract them from the debt crisis.

We have had three recessions in the UK since the early 1980s, the most recent started in the spring of 2008 and real GDP fell by more than 4.5% in 2009 and - from peak to trough – the recession led to a 6% fall in national output.

In contrast, between 1993 and 2008 Britain enjoyed a period of sustained growth combined with low inflation and falling unemployment – an era once dubbed by the Governor of the Bank of England, Mervyn King as the ‘NICE’ decade, NICE standing for ‘non-inflationary continuous expansion’. This came to an abrupt halt in 2007 when global inflationary pressures soared and the world economy was shocked by thesub-prime crisis and the ensuing credit crunch and downturn.

What causes the economic cycle?

For A2 it is important to grasp the dynamic causes of different stages of the cycle. And to understand how macro developments in one country/region impact on other economies through trade, capital and other resource flows.  When looking at the causes of cyclical changes in production, incomes and jobs there are two main approaches:

• Endogenous models explain cyclical fluctuations in terms of internal events or policies i.e. changes which lie within the economic system
• Exogenous models argue that turning points in an economic cycle happen because of externaldemand-side or supply-side ‘shocks’ from beyond the economic system. These shocks create a disequilibrium for an economy and lead output and prices to deviate from a forecast path

Endogenous Models

The Stock Cycle

The stock cycle helps to explain changes in national output because all businesses hold stocks (inventories) of finished products or raw materials and components as a way of balancing changes in demand.

• When demand is strong and running ahead of supply, stocks fall and this is a signal either to raise prices and/or to expand production. Re-stocking can be a way out of a recession.
• Consider the car-scrappage scheme in the UK which was introduced as a way of boosting demand for new vehicles during the recession. This £2,000 cash incentive lead to a spike in demand some of which was met by selling vehicles stuck in vast car parks adjacent to the assembly plants.
• Some of the extra spending on new vehicles will have necessitated a rise in demand for components used in making a new car – there was a positive impact on supply-chain businesses and a rise in demand for stocks leading to an injection of extra incomes in the vehicle industry.

In the early stages of a recession, any slump in consumer demand will cause businesses to cut back on output so as to reduce the volume of stocks. We saw this effect at work in 2008-09 as the UK recession became a reality – consider the evidence from the chart below.

The chart shows “de-stocking”, in the 1st quarter of 2009, the reduction in the value of stocks amounted to more than £5bn. As British-based carmakers produced fewer cars and house-builders cut back on the number of new homes being built, so the derived demand for cement, bricks, glass, steel, rubber and other raw materials and component parts suffered. 

Key point: Changes in the stock cycle have important multiplier effects on supply-chain industries.
The use of ‘just-in-time’ (JIT) stock delivery systems in manufacturing has reduced the need for businesses to hold high stocks of intermediate products. It is now easier for supply to match changes in demand. For example, stocks tend to be less important in the service sector, which now accounts for more than 75 per cent of UK national output.

2. Fluctuations in one or more components of aggregate demand (AD)Movements in real GDP in the short term are mainly due to changes in the components of AD and shifts in short-run aggregate supply(SRAS).  

As with most of the advanced economies, UK household consumption is the largest element accounting for over 65% of spending on goods and services.

Here is a way of breaking down the aggregate demand calculation:

1. Domestic demand                           = C + I + G
2. External demand                             = X-M (also known as net trade)
3. GDP (Aggregate demand)            = C+I+G+X-M

For some countries domestic demand is a high % of total spending (e.g. the USA). In contrast in China, the economy has been driven forward by high trade and current account surpluses and domestic spending has been  lower – the Chinese government wishes to boost consumer spending and rely less on exports in order to sustain here fast rate of economic growth in the years ahead.

Recap on the main Stages of the Cycle

Boom

A boom happens when real GDP grows faster than the trend growth rateover a number of years. In a boom phase, AD is high and businesses expand output and employment and may also raise profit margins by increasing prices - causing cost-push and demand-pull inflation. The main characteristics of a boom are:

• A tightening of the labour market: Measured by the rate of unemployment or the number of unfilled job vacancies.
• High demand for imports: Demand increases due to a high marginal propensity to import.
• Public finances: An expansion provides a “fiscal dividend” to the government because tax revenues will be rising as people are earning and spending more. Business profits will be increasing and state spending on welfare tends to fall. A boom can lead to a ‘fiscal drag’ effect with tax revenues rising more quickly than the economy is growing.
• Strong company profits and investment: An upturn leads to higher profits & investment – this is known as the accelerator effect and you will have covered this at AS level.
• Cyclical boost to productivity: An expanding economy is good news for productivity because businesses are using labour resources more intensively. Productivity growth tends to be pro-cyclical.
• A risk of higher inflation: Demand-pull and cost-push inflation can occur if AD exceeds potential GDP over time leading an economy to operate with a positive output gap.

Slowdown

A slowdown occurs when real GDP expands but at a reduced pace – e.g. the UK economy in 2008

Recession

• The standard definition of a recession is ‘two consecutive quarters of negative GDP growth’ but a more inclusive definition is “a significant decline in activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators.”
• A depression is a persistent downturn in output and jobs with an economy operating well below its productive potential and where there can be powerful deflationary forces at work. As a rule of thumb, a depression occurs when there is a fall in real GDP of more than 10 per cent from the peak of the cycle to the trough.

Symptoms of a recession

There are many symptoms of a recession – here is a selection of key indicators:

1. A fall in purchases of components and raw materials from supply-chain businesses
2. Rising unemployment and fewer job vacancies for those looking for work
3. A rise in the number of business failures
4. A contraction in consumer spending & a rise in the percentage of income saved (savings ratio)
5. Falling private sector capital spending due to weak demand, deteriorating animal spirits, low profits and rising spare capacity
6. A drop in the value of exports and imports of goods and services especially for countries with many industries exposed to changing demand in the world economy
7. Price discounts offered by businesses and de-stocking as businesses look to cut unsold stocks
8. Government tax revenues fall and the budget (fiscal) deficit and government debt grows quickly

The UK recession of 2008-10 was a result of a mix of internal and external factors – among them:

• The end of the property boom – falling house prices hit wealth and led to a large contraction in new house building, many thousands of jobs were lost in the construction industry
• Reductions in real disposable incomes due to wages rising less quickly than prices
• The lagged effects of rising interest rates in 2007-08 (a tightening of monetary policy caused by rising food and energy prices and inflation above target)
• A sharp fall in consumer confidence – made worse by the rise in unemployment
• External events – such as recession in trading partners including the USA (which accounts for 15% of UK trade) and the Euro Area (55% of UK trade). Falling exports hit manufacturing industry hard
• Cut-backs in production led to a negative multiplier effect causing a decline in sales and profits for supply-chain businesses. This has contributed to rising unemployment.
• The credit crunch caused the supply of credit to dry up affecting many businesses and home-owners. And falling profits and weaker demand has caused a fall in capital investment – known as thenegative accelerator effect. There are few signs of a large recovery in bank lending especially to small and medium sized enterprises (SMEs)

The Output Gap

How much spare capacity does an economy have to meet a rise in demand? How close is an economy to operating at its productive potential? Has the recession had a permanent effect on our ability to supply goods and services? These sorts of questions link to an important concept – the output gap. 

The output gap is the difference between the actual level of national output and its potential level and is usually expressed as a percentage of the level of potential output.

Negative output gap – downward pressure on inflation

The actual level of real GDP is given by the intersection of AD & SRAS – the short run equilibrium. If actual GDP is less than potential GDP there is a negative output gap. Factor resources such as labour and capital machinery are under-utilised and the main problem is higher than average unemployment.
More people out of work indicate an excess supply of labour, which means there is downward pressure on real wages. In the next time period, a fall in real wage rates shifts SRAS downwards until actual and potential GDP are identical – assuming labour markets are flexible.

Positive output gap – upward pressure on inflation

If actual GDP is greater than potential GDP then there is a positive output gap. Some resources including labour are likely to be working beyond their normal capacity e.g. making extra use of shift work and overtime. The main problem is likely to be an acceleration of demand-pull and cost-push inflation. Shortages of labour put upward pressure on wage rates, and in the next time period, a rise in wage rates shifts SRAS upwards until actual and potential GDP are identical – assuming labour markets are flexible.

Recession and the output gap

• The UK will operate with a large negative output gap for some time.  But much depends on whether the recession will do long-term damage to our productive capacity.
• This might arise from a rise in business failures and people leaving the labour market if they suffer long periods out of work (long term structural unemployment). This is known as a hysteresis effect

When a business is operating at less than 100% capacity, it is said to have “spare capacity”.
Demand factors:

• Lower demand due to a decline in consumption or demand for raw materials
• Loss of market share due to poor marketing or competitors introducing better products
• Seasonal variations in demand - i.e. temporary spare capacity during off-peak times

Supply factors:

• Increase in capacity not yet matched by increased demand
• Because new technology has been introduced in anticipation of higher demand
• Improvements in productivity mean capacity increases for a given level of demand

Spare capacity allows businesses to respond to an unexpected increase in demand, when there isproductive slack, i.e. supply is price elastic. It also provides time for maintenance, repairs and employee training.

But it can also lead to inefficiency, which makes a business less competitive - and operating below capacity means higher unit costs because fixed costs are being spread over a reduced volume of output. This implies lower profitability than could be achieved.

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Theories of production

Theory of production means knowledge of what is permanent and normal in industrial production. Traditionally, this knowledge has been accumulated in tacit form in the professional skill of industrial managers and artesans, but today more and more of it is being documented in writing by researchers.
Most studies of production use either one of two alternative approaches, that is, they have either descriptive or normative purpose, as can be seen in the diagram on the right. The two resulting theory paradigms differ quite much from each other even when the object of study is the same.
Descriptive theory contains knowledge about past or present production but does not much help for modifying it to correspond better to latest requirements. Academic or historical studies are often of this type. They are sometimes categorized in two types: extensive studies of a large number of cases, and intensive studies of one or a few cases.
Normative theory of production contains generally applicable knowledge and tools that can be used in the management of production, especially for optimizing existing production and planning new production. Research for creating normative theory is usually extensive because it needs a large number of cases for its material.
Moreover, a third type of research can take place in connection of the "commission" marked in the diagram. It means simply studying and planning the execution of individual tasks, for example preparing for a new type of service, or removing problems in existing service. These case-specific or "intensive" studies seldom produce generally applicable new theory and they will not be discussed in the following.
Subdivisions of the theory of production. Theory is created by doing research, but the difficulty is that in order to be effective, research projects can only study a few limited questions at a time. The number of important questions that any field of industrial production has to deal with, is many times larger than an empirical research project could handle. If somebody thus wants to make a larger compilation - such as a "Handbook of the production of xx" - this has to be made not from empiria, but instead by studying numerous earlier published research reports. Indeed, suchproduct-specific compilations of theory have been made for many important fields of production. They will not be enumerated here, the main reason for it being that they are too numerous and besides they often soon lose their actuality because of the swift development of manufacturing technology.
The goal of manufacture is another possibility of categorizing theory of manufacture. There are only a few important types of goals of production that have attracted the interest of researchers, which means that by studying them it will be easier to get a good total view on the present theory of production than by perusing hundreds of handbooks of different products. These often used points of view in the current theory of production include:

• Technology of production
• Economy of production
• Quality of products
• Timing of production
• Logistics
• Ecology of production
• Occupational health and safety engineering
• Motivation and psychology of work
• Theory of autonomous groups

Technology of production

Almost all products today are made with special machinery, and each of these machines operates on the basis of a specific technology, i.e. on a base of knowledge about the specific productive operation. An overview of the various technologies related to a given type of products usually follows the typical process of manufacture. For example, clothing technology can be said to consist of the following sections, each of which describes a major phase in the process:

• The technology of fibres: the methods of collecting and cleaning natural fibres, of extruding synthetic fibres, of finishing fibres with the methods of mercerizing, easy-care or antishrink, and of blending fibres.
• The technology of yarns: spinning, assembling filament yarns, folding, cabling, and the fabrication of fancy or textured yarns.
• The technology of textile construction, such as weaving, knitting, braiding, stitch bonding, laminating, or nonwoven techniques.
• The technology of textile finishing: dyeing, printing, and mechanical finishing such as raising, pleating or shrinking.
• The technology of cutting, inclusive of pattern construction, grading and lay planning.
• The technology of sewing. There are special machines for lockstitch, chain stitch, blind stitch, flat seam, buttonholes etc.
• The technology of pressing and fusing.

Of course, for any given type of clothing the list of relevant technology can be shorter or longer than the general model given above.
The technological theory that exists for each productive operation consists, first of all, of data that define the role of the operation in the total production process. These data concern above all the capacity of each machine, its reliability, ease of use and other aspects of usability and, when relevant, the emission of chemicals. Besides, theory includes the instructions of using the machinery, written mostly by the constructors of these machines. Sometimes these instructions have been complemented by studies of occupational safety or methods engineering, carried out by the makers of the machinery or by the company that is using them.

Economy of production

The economic study of production aims at finding an optimum between benefits and expenditures of manufacture. For finding an optimum, several statistics are used, such as productivity and profitability, seeOptimizing Production. In economics most elements of production are measured as monetary variables, which makes it possible to construct an economical image or projection of the manufacturing process, as has been made in the lower half of the diagram below.

Instruments of economic management include budgeting the incomes and expenditures of production, setting objectives for the productivity of the most important operations; follow-up, measurement and reporting of all of these; and comparing the reported statistics to the agreed objectives.
Productivity Standards are a handy instrument when setting targets. They define the productivity of normal good pace of work, measured as work hours per manufactured unit, under various circumstances. These standards can then be used in work planning and possibly for defining work incentives or the wages for work contracts. The statistics to base the standard on can be obtained either from the factory's own files, or in co-operation between several or all the industries in a country, in a given branch of manufacturing.
Management by objectives is an arrangement where each employee agrees with his or her superior on the objectives for the next period's work in advance. The objectives are mostly economic. In this way the supervisor can clearly express which aspects in the activity are important from the company's point of view, and the employee gets more freedom in planning how the work is done. This arrangement persuades both parties to contemplate the purpose of the work and the means that are most effective to fulfil the agreed goals.
Management by objectives became very popular at the end of 20 century. Its weak point is that it is too easy to overlook quality of the products and other such goals of production that cannot easily be measured, which means that these goals should receive the special attention of any researcher that assists in developing a system of management by objectives.

Quality systems

Many large industries today have a quality system, a special arrangement for the task of defining and steering the quality of production. It usually consists of:

• A document on the policy of quality, as approved by the management
• A quality handbook (or the equivalent on a network)
• A certificate of the quality system, issued by an official body
• Quality objectives for each product
• Quality control
• routines to guarantee the right quality of the products
• quality inspection
• corrective actions.

Quality systems are described in the standard ISO 8402 and in the series of standards ISO 9000. Most countries also have a system of official certification of those companies where a standardized quality system is operative.
Regardless of what the company says in advertisements, the target of quality is in practice seldom set at highest possible, because attaining it in every finished product would perhaps cost too much. Instead, the company often wishes to define an optimal level of quality and marks out how it shall be obtained in production. These are defined by researchers, and the management of the company then approves the targets for production.
A much less complicated method for improving the quality of production is the quality circle, a Japanese method in which each ordinary work team at a plant discusses, perhaps weekly, the possibilities of improving the quality of the products and of minimizing the errors and losses in production. Available means for making these improvements consist mainly of rearranging the working routines of the team itself, though improvements elsewhere can be proposed, too, such as better raw material or less complicated details of the product.

Timing of production

The goal in time scheduling of manufacture is to integrate all the tasks in the chain of production so that no unnecessary waiting occurs and each task is given enough time but no more. Methods of scheduling include the standards of productivity and task programming techniques such as Gantt and PERT diagrams, like the diagram below, and the critical path method.

Explicit scheduling is indispensable especially in the case that the product consists of several parts that have to be made in different places. Besides, in many fields of production the company gets an advantage over competitors if it can deliver the product quickly. This goal can sometimes be achieved by concurrent engineering, i.e. overlapping some phases of the production, as in the Gantt diagram below.

Setting targets for timing is a powerful technique of management because it is easy to define exact timing targets and follow them up. Targets thus often are attained successfully, but there is the usual risk of management by objectives - forgetting those goals that cannot be measured.
Another trap to be avoided in programming is that in the initial enthusiasm of a project the objective for timing can become too tight, which can then spoil the possibilities for doing high-quality work. Especially the design phase of products often necessitates a period - the length of which may be impossible to foretell - of subconscious maturing of the proposal, and if it is not allowed an optimal design proposal is perhaps never found.

Logistics of production

The locality where a product is sold nearly always differs from the place of obtaining the raw material, which means that production entails much transportation of raw material and products in various stages of completion. The costs of transportation can be minimized by careful planning.
Storage is another type of secondary activity to manufacturing that brings about costs. Most products are made in several stages which are carried out in different places with various machines, the capacities of which per hour differ. It thus cannot be avoided to have some buffer storage between the different phases of production. It can also be invaluable when a machine must temporarily be halted, and besides you cannot count on that the sales always continue at a constant tempo.
The science of logistics can help in planning the production process and avoiding unnecessary cost of transportation and storage. Theoretical tools for this task are algorithms and computer programs.

Ecology of production

Ecology of production studies the flows of materials that result from making, using - and perhaps also discarding - various products and develops methods for minimizing the negative effects to the environment, such as the use of materials, pollution and production of waste. In manufacture there are many possibilities to diminish the use of raw materials and toxic processes. In doing so, you should also keep in mind the environmental effects during the product's use and final discarding, such as can be seen in the diagram below.

The ecological theory of manufacturing is also discussed on another page, under the title Ecology of Manufacture.

Occupational safety and health

In the study of ergonomics or "human factors engineering" the following straining and risk factors of work are discussed:

• mechanical dangers, such as sharp and mobile parts of machines and products
• physical factors, like heat, electricity, noise and shaking
• chemical factors, the risk of fires included
• biological hazards, e.g. bacteria
• physiological hazards, like lifting heavy objects
• psychological factors, e.g. loneliness and monotony of work, or, on the other hand, excessive noise.

The theory of occupational health and safety includes allowable limits for all the above-mentioned factors, as well as the methods for measuring them and their harmful effects. All industrial plants in developed countries are subject to periodical control of these topics.

Motivation and psychology of work

Many of the targets of production that have been enumerated above, are normally set by the management without discussing them neither with the employees nor with their delegates such as shop stewards. The result often is that many employees fail to understand why a target - which can be arduous to achieve - is important for the company, their motivation to work diminish, and they perhaps consider leaving their jobs. Lately several researchers have tried to find out what topics really are important for the employees.
Frederick Herzberg et al. found (1959) that human motivation factors fall into two groups: "dissatisfiers", and "satisfiers". These are not simply opposites, but rather like sensations in the same way as pain and pleasure. The strongest satisfying factors, or motivators, all had to do directly with the person's particular job:

• results, achievements
• recognition
• work itself, work as an interesting activity
• responsibility
• advancement.

Potentially negative factors in motivation are:

• company policy and administration
• supervision
• pay
• interpersonal relations
• working conditions

The manager should see to it that these do not annoy the worker, but even when they are arranged ideally they alone cannot motivate the worker. That is why Herzberg did not call them "motivators" butmaintenance factors or hygiene factors.
On the basis of the theory by Herzberg et al., hundreds of surveys have been conducted at various work places. M. Scott Myers interviewed 282 workers at a Texas Instruments plant, concluding that the classification proposed by Herzberg was valid there as well. On the right in the picture below, you will find the percentages of various motivation factors. It can be seen that some factors are almost exclusively positive, whereas others are negative, and some are both. It was also found that workers could to a certain extent be divided into two groups: those to whom it was more important to receive plenty of positive motivation, and others to whom avoiding negative motivation factors was more important (motivation seekers vs. maintenance seekers).

Research of motivation, or "human factors" of work has since continued until our day, and on the basis of its findings many improvements have been made in the conditions of work. Nevertheless, the satisfaction of employees has not generally increased. The reason perhaps is that the expectations of employees have ascended simultaneously.

Theory of autonomous groups

Many people have today great confidence on science, and when encountering a problem they often think that the best method is starting a project and hiring a competent researcher. However, there is still an alternative method, albeit ancient, where the existing team itself takes care of its working methods and updates them so that problems never spring up or, when they do, they are taken care of and removed. Such an autonomous team itself detects the sprouting problem, works out a remedy for it and modifies accordingly the working routines of the team. When the team belongs to a larger organization, great changes in its operation must first be accepted by the management and those other departments that are involved, of course.
Often cited advantages of autonomous activity are:

• Procedures of work that have been developed by the team itself are often better than those developed by outsiders, because it is the members of the group that know the problem and its alternative solutions the best. The risk of omitting important viewpoints diminishes.
• People today expect to have a right to deal with their own problems. When methods of work have to be modified, those changes found by the group itself will be accepted easily; the group will be willing to work for something on their own, and commit themselves to it.
• All the participants will profit in the form of mental growth. In the future, the group will also be able to recognize problems and deal with them on their own.

The theory and practice of autonomous groups was first developed by Kurt Lewin (1890-1947). They are especially useful in the case that a permanent team of an organization has encountered so difficult problems in their daily work that the team or its leader cannot solve them. A suitable method in this case is Action Research, the theory of which is explained in the paragraph Action Research and Theory.
Action research can be seen as medicine for an accidental illness of team work, but smaller doses of the same medicine can be used for preventing a future illness in the normal daily work of a team. This would mean regular joint discussions which guarantee that every member of the team really understands the collective purpose of the work and is willing, for its benefit, to modify his or her own activity when needed. Principles for such collective discussions can be found under the title "Democratic Debate".

Exchange Rates - Introduction & Overview

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Introduction

Currencies are traded in foreign exchange markets and the volume of money bought and sold is huge! Daily foreign exchange market turnover averaged $4 trillion in 2010, 20% higher than in 2007.

An exchange rate is the price of one currency in terms of another – in other words, the purchasing power of one currency against another.

Exchange rates are an important instrument of monetary policy

Measuring the exchange rate

Exchange rates are expressed in various ways:

Spot Exchange Rate - the spot rate is the rate for a currency at today’s market prices

Forward Exchange Rate - a forward rate involves the delivery of currency at a specified time in the future at an agreed rate. Companies wanting to reduce risks from exchange rate volatility can buy their currency ‘forward’ on the market

Bi-lateral Exchange Rate - the rate at which one currency can be traded against another. Examples include: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro

Effective Exchange Rate Index (EER) - a weighted index of sterling's value against a basket of currencies the weights are based on the importance of trade between the UK and each country.

Real Exchange Rate - this is the ratio of domestic price indices between two countries. A rise in the real exchange rate implies a worsening of competitiveness for a country.

Exchange rate systems

A country can decide the type of exchange rate system that they want to follow.

System	Main Characteristics	Recent UK History
Free Floating Exchange Rate	The value of a currency is determined purely by demand and supply of the currency Trade flows and capital flows affect the exchange rate under a floating system There is no target for the exchange rate and no intervention in the market by the central bank	Sterling has floated since the UK suspended membership of the ERM in September 1992 The Bank of England has not intervened to influence the pound’s value since it became independent
Managed Floating Exchange Rate	Value of the currency is determined by market demand for and supply of the currency Some currency market intervention might be considered as part of demand management (e.g. a desire for a lower currency to boost exports)	Governments normally engage in managed floating if not part of a fixed exchange rate system. Managed floating was a policy pursued in the UK from 1973-1990
Semi-Fixed Exchange Rates	Exchange rate is given a specific target. The currency can move between permitted bands of fluctuation on a day-to-day basis Interest rates are set at a level necessary to keep the exchange rate within target range – or direct intervention in the FOREX market Re-valuations are seen as a last resort	The UK operated a semi-fixed system from October 1990 - September 1992 when a member of the ERM. Sterling was eventually forced out of the ERM by a wave of speculative selling
Fully-Fixed Exchange Rates	The exchange rate is pegged and there are no fluctuations from the central rate A country can automatically improve its competitiveness by reducing its costs below that of other countries – knowing that the exchange rate will remain stable	Several countries operate with fixed exchange rates or currency pegs. The Ivory Coast Franc is pegged to the Euro, with the French Treasury guaranteeing convertibility. This facilitates exchange rate and price stability. The peg is not threatening international competitiveness given the low inflation rate in the Ivory Coast.

Countries with floating exchange rates

The Case for Floating Exchange Rates

The main arguments for adopting a floating exchange rate system are as follows:

1. Reduced need for currency reserves: There is no exchange rate target so there is little requirement for a central bank to hold foreign currency reserves to use during intervention
2. Useful instrument of economic adjustment: For example depreciation of the exchange rate can provide a boost to exports and stimulate growth during a recession and/or when there is a risk of deflation. A good example of this is Poland whose currency the Zloty depreciated against the Euro in 2009-10 which helped Poland to avoid recession during the global financial crisis. Indeed Poland was one of the few EU countries to avoid a slump during this difficult period.
3. Partial automatic correction for a trade deficit: Floating exchange rates can help when the balance of payments is in disequilibrium – i.e. a large current account deficit puts downward pressure on the exchange rate, which should help exports and make imports relatively more expensive. Much depends on the price elasticity of demand and supply of exports and the price elasticity of demand for imports – see the later section on the Marshall-Lerner condition and the J-curve effect
4. Less opportunity for currency speculation: The absence of an exchange rate target might reduce the risk of currency speculation. Speculators tend to attack weaker currencies where a government is trying to maintain a fixed exchange rate out of line with macro-economic fundamentals.
5. Freedom (autonomy) for domestic monetary policy: The absence of an exchange rate target allows policy interest rates to be set to meet domestic aims such as controlling inflation or stabilising the business cycle. Countries locked into a single currency system such as the Euro do not have the same freedom to manage interest rates to meet their key macroeconomic aims. This has become obvious as one of the limitations of being inside the Euro during the current crisis.

Floating exchange rates have their disadvantages – some of these are discussed next when we look at the advantages of fixed systems. One of the main disadvantages is that floating currencies can be volatile which makes doing businesses harder. An unexpected fall in the exchange rate can also be a cause of rising inflation.

Countries with managed floating exchange rates

The Case for Fixed Exchange Rates

The main arguments for adopting a fixed exchange rate system are as follows:

1. Trade and Investment: Currency stability can promote trade and capital investment because of less currency risk. Overseas investors will be more certain and confident that the returns from their investments will not be destroyed by sudden fluctuations in the value of a currency.
2. Some flexibility permitted: Some adjustment to the fixed currency parity is possible if the case becomes unstoppable (i.e. the occasional devaluation or revaluation of the currency if agreement can be reached with other countries). Some countries are tempted to engage in competitive devaluations and this threatens the outbreak of “currency wars”.
3. Reductions in the costs of currency hedging: Businesses have to spend less on currency hedging if they know that the currency will maintain a stable value in the foreign exchange markets.
4. Disciplines on domestic producers: A stable currency acts as a discipline on producers to keep costs and prices down and may encourage attempts to raise productivity and focus on research and innovation. In the long run, with a fixed exchange rate, one country’s inflation must fall into line with another (and thus put competitive pressures on prices and real wages)
5. Reinforcing gains in comparative advantage: If one country has a fixed exchange rate with another, then differences in relative unit labour costs will be reflected in the growth of exports and imports. Consider the example of China and the United States. For several years China pegged the Yuan against the dollar. Until July 2005 the exchange rate was fully fixed; since then the Chinese have allowed only a gradual depreciation of the dollar against the Yuan. Most estimates indicate that the Chinese currency is persistently undervalued against the dollar. This makes Chinese products cheaper and has led to numerous calls from US manufacturers for the Chinese to be persuaded to switch to a floating exchange rate or to adjust their currency by appreciating against the dollar.

Oligopoly & Game Theory,GCEO NOTES,IGCSE

Oligopoly & Game Theory

Game Theory

Game theory is mainly concerned with predicting the outcome of games of strategy in which the participants (for example two or more businesses competing in a market) have incomplete informationabout the others' intentions.

Game theory analysis has direct relevance to the study of the conduct  and behaviour of firms in oligopolistic markets – for example the decisions that firms must take over pricing and levels of production, and also how much money to invest in research and development spending.

Costly research projects represent a risk for any business – but if one firm invests in R&D, can a rival firm decide not to follow? They might lose the competitive edge in the market and suffer a long term decline in market share and profitability.

The dominant strategy for both firms is probably to go ahead with R&D spending. If they do not and the other firm does, then their profits fall and they lose market share. However, there are only a limited number of patents available to be won and if all of the leading firms in a market spend heavily on R&D, this may ultimately yield a lower total rate of return than if only one firm opts to proceed.

The Prisoners’ Dilemma

• The classic example of game theory is the Prisoners’ Dilemma, a situation where two prisoners are being questioned over their guilt or innocence of a crime.
• They have a simple choice, either to confess to the crime (thereby implicating their accomplice) and accept the consequences, or to deny all involvement and hope that their partner does likewise.

Confess or keep quiet? The Prisoner’s Dilemma is a classic example of basic game theory in action!

• The “pay-off” is measured in terms of years in prison arising from their choices and this is summarised in the table below.
• No communication is permitted between the two suspects – in other words, each must make an independent decision, but clearly they will take into account the likely behaviour of the other when under-interrogation.

Nash Equilibrium
A Nash Equilibrium is an idea in game theory – it describes any situation where all of the participants in a game are pursuing their best possible strategy given the strategies of all of the other participants.
In a Nash Equilibrium, the outcome of a game that occurs is when player A takes the best possible action given the action of player B, and player B takes the best possible action given the action of player A.

Two prisoners are held in a separate room and cannot communicate They are both suspected of a crime They can either confess or they can deny the crime Payoffs shown in the matrix are years in prison from their chosen course of action		Prisoner A
		Confess	Deny
Prisoner B	Confess	(3 years, 3 years)	(1 year, 10 years)
	Deny	(10 years, 1 year)	(2 years, 2 years)

• What is the best strategy for each prisoner? Equilibrium happens when each player takes decisions which maximise the outcome for them given the actions of the other player in the game.
• In our example of the Prisoners’ Dilemma, the dominant strategy for each player is to confess since this is a course of action likely to minimise the average number of years they might expect to remain in prison.
• But if both prisoners choose to confess, their “pay-off” i.e. 3 years each in prison is higher than if they both choose to deny any involvement in the crime.
• In following narrowly defined self-interest, both prisoners make themselves worse off
• That said, even if both prisoners chose to deny the crime (and indeed could communicate to agree this course of action), then each prisoner has an incentive to cheat on any agreement and confess, thereby reducing their own spell in custody.

The equilibrium in the Prisoners’ Dilemma occurs when each player takes the best possible action for themselves given the action of the other player. The dominant strategy is each prisoners’ unique best strategy regardless of the other players’ action Best strategy? Confess? A bad outcome! – Both prisoners could do better by both denying – but once collusion sets in, each prisoner has an incentive to cheat!		Prisoner A
		Confess	Deny
Prisoner B	Confess	(3 years, 3 years)	(1 year, 10 years)
	Deny	(10 years, 1 year)	(2 years, 2 years)

Applying the Prisoner’s Dilemma to business decisions

• Game theory examples revolve around the pay-offs that come from making different decisions.
• In the classic prisoner’s dilemma the reward to defecting is greater than mutual cooperation which itself brings a higher reward than mutual defection which itself is better than the sucker’s pay-off.
• Critically, the reward for two players cooperating with each other is higher than the average reward from defection and the sucker’s pay-off.

Consider this example of a simple pricing game: The values in the table refer to the profits that flow from making a particular decision.

		Firm B’s output
		High output	Low output
Firm A’s output	High output	£5m, £5m	£12m, £4m
	Low output	£4m, £12m	£10m, £10m

• Display of payoffs: row first, column second e.g. if Firm A chooses a high output and Firm B opts for a low output, Firm A wins £12m and Firm B wins £4m.
• In this game the reward to both firms choosing to limit supply and thereby keep the price relatively high is that they each earn £10m. But choosing to defect from this strategy and increase output can cause a rise in market supply, lower prices and lower profits - £5m each if both choose to do so.
• Example: Tesco fined for cartel pricing
  Tesco plc has been fined £10m as part of a wider £50m penalty slapped on supermarkets and milk companies by the Office of Fair Trading after it ruled there had been collusion over the price of cheese and milk. The scam - dating back to 2002 and 2003 - was said to have cost consumers around £270m. Tesco continues to deny it colluded with the other companies.
  News reports, summer 2011
  A dominant strategy is a strategy that is best irrespective of the other player’s choice. In this case the dominant strategy is competition between the firms.

• The Prisoners’ Dilemma can help to explain the breakdown of price-fixing agreements between producers which can lead to the out-break of price wars among suppliers, the break-down of otherjoint ventures between producers and also the collapse of free-trade agreements between countries when one or more countries decides that protectionist strategies are in their own best interest.
• The key point is that game theory provides an insight into the interdependent decision-making that lies at the heart of the interaction between businesses in a competitive market.

Prisoner's Dilemma and Climate Change Negotiations
Can repeated games of the prisoner’s dilemma help climate negotiations?
With 2012 signalling the expiry date of the Kyoto Protocol, there is an urgent need for a successor treaty to tackle the ever-increasing global emissions problem.
The main issue with tackling climate change is the cost to countries of implementing it. To be successful it will need profound transformation of energy and transport organisations, and changes in the behaviours of billions of consumers. The Stern Review admitted that it will likely cost 1% of GDP –even though it doesn’t seem much, it is double the amount currently spent on development aid worldwide.

• The USA sees a cap on emissions as a threat to competitiveness, and to its global supremacy;
• The developing world denounces any calls for a cap on emissions as an effort by former colonial powers to hold back development;
• Europe has been making encouraging though patchy progress towards targets, driven mainly by a one-off switch from coal to gas.

The issue here is how countries can expect to make cuts in emissions when their economic competitors refuse. This in turn leads to the Tragedy of the Commons which occurs when a group’s individual incentive lead them to take actions which, overall, lead to negative consequences for all group members. A country that refuses to act, whilst the other cooperates, will experience a free-rider benefit - enjoying the advantage of limited climate change without the cost. On the flip side, any country that imposes limits, when its competitors do not, incurs not just the cost of limiting its own emissions, but also a further cost in terms of reduced competitiveness

The dynamics of the prisoner’s dilemma do change if participants know that they will be playing the game more than once. 

In 1984 an American political scientist at the University of Michigan, Robert Axelrod, argued that if you play the game repeatedly you are likely to see emerging is cooperative rather than defective actions. 

He identified four elements to a successful strategy which is this case can be applied to climate negotiations:

1. Be Nice – sign up to unilateral cuts in emissions, as deep as your economy and financing capacity allows.
2. Be Retaliatory – single out countries that have not commenced action and, in collaboration, find ways of pressurising them until they do so.
3. Be Forgiving - when non-compliant countries come onboard give them generous applause; signal that good behaviour will be rewarded with even deeper cuts in your own emissions.
4. Be Clear - let everyone know in advance exactly how you are going to behave – that you will work with them if they take action on emissions, and that you will retaliate if they do not.

Repeated Prisoner’s Dilemma provides valuable insight into how countries should act away from the negotiating table and over the longer term. Ultimately, for the planet’s sake, one hopes that everyone will play the game

Source: Mark Johnston, EconoMax, December 2007

Demerit good

Introduction

Market failure with demerit goods
The free market may fail to take into account the negative externalities of consumption because the social cost exceeds the private cost. Consumers too may experience imperfect information about the long term costs to themselves of consuming products deemed to be de-merit goods
Obesity – a time bomb
There is a huge debate at the moment about the root causes of obesity and the social costs that arise fromincreasing levels of obesity. Obesity is also an international problem. Across the Atlantic in the USA, two out of every three Americans are overweight; one out of every three is obese. One in three is expected to have diabetes by 2050. Minorities have been even more profoundly affected.
What of harder drugs?
Should hard drugs be prohibited at all costs by the government in a bid to control demand by restricting supply? Regulation has been the route chosen by most governments in developed countries – but economists are divided on the issue. Some believe that legalisation and taxation of harder class drugs is a better policy to pursue, arguing that regulation is ineffective and costly. Another approach would be to divert resources away from regulation towards giving better information to drug users about the longer term health implications of their consumption decisions.
The case for a complete ban

The case for a complete ban on de-merit goods such as class A narcotics could be justified on the ground that the social marginal cost of consumption is always higher than the social marginal benefit. In the diagram above there is no output where the social benefit equals the social cost and welfare would be best protected by trying to enforce a total ban on the product.
Food additives – a de-merit good?

• The use of food additives has long been a subject of controversy.
• Examples include the preservatives used in products from soft drinks to barbecue sauce – designed to lengthen the shelf life of products available for sale in supermarkets.
• Research published in 2007 by the Food Standards Agency claimed a link between food additives and hyperactive behaviour in children leading to losses of concentration and a worsening in behaviour ands they want a number of food colourings to be banned.

Gambling – economic and social effects
From betting on the results of general elections, the Grand National, the number of corners that England win in one of their World Cup matches or the temperature in London on Christmas Day, we seem to have an almost insatiable desire for gambling on the outcomes of virtually every sporting, political, meteorological event.
Inevitably the rapid expansion of this industry raises important questions about the external costs and benefits of gambling. Some researchers point to the employment and tourism benefits that flow from the growth in demand for gambling services especially if businesses are established in some of the UK's poorest towns and cities. There is also a fiscal dividend from this booming industry with a predicted £3bn per year of extra tax revenues flowing into the Treasury's coffers.
But gambling also creates external costs. Over 350,000 people in the UK are thought to be addicted to betting and their problem gambling can contribute to crises including personal debt or bankruptcy, loss of employment and the breakdown of families. The dangers of addiction are greatest for the young and the vulnerable susceptible to advertising and marketing strategies.
The usual approach to de-merit goods is to tax consumption, so that the private cost of consumption is increased and demand contracts. But the government has actually got rid of betting & gaming duty (it was abolished in 2001) to be replaced with a tax on the profits of gaming companies. The Gambling Act of 2005 deregulates the industry and allows the creation of more casinos in the UK.
Three Examples:

Mephedrone ban – intervening to regulate a demerit good
The UK government has announced a ban on mephedrone. Behind the reason to classify this drug as a demerit good includes the informational failures that exist - “It is being taken by young people who have never taken drugs before in their lives because they think it is legal and it is safe. It is neither legal nor safe.” David Nutt, ex-head of Advisory Council on the Misuse of Drugs, discusses in this article in the Guardian why regulation rather than an outright ban should be implemented instead. (March 2010)

Credit card cheques as a demerit good
The government has announced a move to ban credit card cheques addressing the issue of the soaring value of UK consumer debt.  The move is part of a broader range of measures that attempts to partly bridge the informational failures (and resultant market failure) that lead to consumers inadvertently taking on debt that is beyond their means; and this recent measure highlights the government’s view on it as a demerit good. (July 2009)

External costs of alcohol abuse
The number of alcohol-related hospital admissions in England has topped one million for the first time. An NHS Information Centre report said admissions had increased by 12% between 2008-09 and 2009-10. That includes liver disease and mental disorders due to alcohol abuse as well as some cancers, accidents and injuries. The government is taking steps to address the problem including plans to stop supermarkets selling below cost alcohol and introducing tougher licensing regimes for pubs and clubs.

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