Category: Economics for Business: Ch 26

One of the key problems faced by all countries over the past three years has been a lack of consumer demand. Firms face demand from a number of sources and when the domestic economy is struggling and domestic demand is weak, a key source of demand will be from abroad. By this, we are of course referring to exports. However, it was not just one country that plunged into recession: the global economy was affected. So, when one country was suffering from a weak domestic market, it turned to its export market and hence to other countries for demand. However, with these economies also suffering from recession, the export market was unable to offer any significant help. In order to boost exports, governments have tried to make their export markets more competitive and one method is to cut the value of the currency. Japan, South Korea, Thailand, Columbia and Taiwan are just some of the countries using this strategy.

Following these interventions, the Brazilian finance minister has commented that a new trade war has begun. Speaking to a group of industrial leaders in Sao Paulo, Mr. Mantega said:

‘We’re in the midst of an international currency war. This threatens us because it takes away our competitiveness.’

As more and more governments intervene in the currency market in a bid to boost exports, those refraining from intervening will suffer. Furthermore, interest rates throughout the developed world have remained low, as central banks continue their attempts to boost economics. However, this has led vast amounts of money to be transferred into countries, such as Brazil, where there is a better supply of high-yield assets. This has worsened the state of affairs in Brazil, as the Brazilian currency is now thought to be the most heavily over-valued currency in the world. This adversely affects Brazil’s export market and its trade balance. The following articles look at the lastest developments in this new ‘war’.

Articles

Currencty ‘war’ warning from Brazil’s finance minister BBC News (28/9/10)
Brazil warns of world currency war Telegraph (28/9/10)
Brazil warns of world currency ‘war’ Associated Press (28/9/10)
Brazil defends exporters in global currency battle Reuters (15/9/10)
Kan defends Japan’s intervention in the currency markets Associated Press (25/9/10)
US and China are still playing currency Kabuki Business Insider, Dian L. Chu (21/9/10)
How to stop a currency war The Economist (14/10/10)
What’s the currency war about? BBC News, Laurence Knight (23/10/10)

Exchange rate data
Exchange rate X-rates.com
Statistical Interactive Database – interest and exchange rates data Bank of England
Currencies BBC News
Currency converter Yahoo Finance

Questions

  1. Demand for a firm’s products comes from many sources. What are they? Illustrate this on a diagram.
  2. Why is a weak currency good for the export market?
  3. How will a country’s trade balance be affected by the value of its currency?
  4. Explain the process by which investors putting money into high-yield assets in countries like Brazil leads to currency appreciation.
  5. What are the options open to a government if it wants to devalue its currency? What are the advantages and disadvantages of each method?

With the full impact of the fiscal austerity measures yet to come, the fall in unemployment revealed in the latest ONS labour market release is probably a lull before the storm. Nonetheless, in the three months to July unemployment fell by 8,000 to 2.467 million, while the rate of unemployment – the number of people unemployed expressed as a percentage of those economically active – fell from 7.9% from 7.8%. But, within the ONS release we again saw an increase in the number of people who are long-term unemployed.

The number of people aged 16 or over who have been unemployed for at least 12 months stood at 797,000 in the three months to July. This represents an increase of 15,000 over the previous 3 months. While the pace of increase appears to have slowed – the number had risen by 100,000 in the three months to April – the pool of people who can be described as long-term unemployed is undoubtedly of much concern. To put this number into perspective, it means that of the 2.467 million people unemployed 32.3% have been so for at least a year. In effect, one-third of the pool of unemployed can now be thought of as long-term unemployed.

Of the long-term unemployed, 547,000 or 69% are male. This is the highest number of males described as long-term unemployed since the three months to May 1997 – the month when the Labour government of Tony Blair came to power. But, the historical context for female long-term unemployment is even bleaker. A further increase of 4,000 over the 3 months to July means that the number of females who are long-term unemployed has risen to 250,000. The last time long-term female unemployment was higher than this was in the three months to September 1995.

An obvious concern with the expectation that the total unemployment figure will grow in the not too distant future is that the number of long-term unemployed people will carry on growing. Of course, this not only has unfortunate implications for these individuals but for society and the economy more generally. Consequently, it raises some important and very difficult economic and social policy questions. One important economic question, for instance, is how we tackle the erosion of human capital as more and more individuals are divorced for longer and longer from the labour market. An erosion of human capital affects individuals and society not only in the present, but in the future too.

Articles

UK unemployment falls by 0.1 pct to 7.8 pct Associated Press (16/9/10)
Wasteland: Europe stalked by spectre of mass unemployment Independent, Alistair Dawber (16/9/10)
Job fears despite employment rise Telegraph, Angela Monaghan (16/9/10)
Part-time jobs fuel record rise in employment Express, Macer Hall (16/9/10)
UK unemployment falls to 2.47 million BBC News (15/9/10)

Data

Latest on employment and unemployment Office for National Statistics (15/9/10)
Labour Market Statistics, September 2010 Office for National Statistics (15/9/10)
Labour market data Office for National Statistics
For macroeconomic data for EU countries and other OECD countries, such as the USA, Canada, Japan, Australia and Korea, see:
AMECO online European Commission

Questions

  1. If the overall number of unemployed people is falling why is the number of long-term unemployed rising?
  2. The current unemployment rate is 7.8%. But, what do we mean by the unemployment rate?
  3. Draw up a list of the problems that you think arise out of long-term unemployment.
  4. Use your list to draw up a series of potential policies to tackle these problems.
  5. Why do some economists think the current fall in unemployment is a ‘lull before the storm’? What impact might this have on the number of people long-term unemployed?

The prices of grains and other foodstuffs are rising rapidly. Wheat prices rose some 40 per cent in July and have continued to rise rapidly since. In June wheat futures were trading at around 450 US cents/bushel. By early September, they were trading at around 700 US cents/bushel. Global food prices generally rose by 5% over the two months July/August. And it’s not just food. Various other commodity prices, such as copper and oil, have also increased substantially.

At the beginning of September there were three days of food riots in Mozambique in protest against the 30% rise in the price of bread. Seven people were killed and 288 were injured. On 2 September Russia announced that it was extending a ban on wheat exports for another 12 months following a disastrous harvest. In Pakistan, the floods have destroyed a fifth of the country’s crops. Drought in Australia and floods in the Canadian prairies have reduced these countries’ grain production.

In response to the higher prices and fears of food riots spreading, the United Nations has called a special meeting on 24 September to bring food exporters and importers together to consider “appropriate reactions to the current market situation”. And yet, although global cereal production is down by some 5% on last year, it is still predicted to be the third largest harvest on record.

So what is causing the price rises? Is it simply a question of the balance of supply and demand and, if so, what has caused the relevant shifts in supply and/or demand? And what role does speculation play? The following articles look at the issues and at the outlook for commodity prices over the coming months.

Clearly changes in commodity prices affect the rate of inflation. The news item (Bank of England navigates choppy waters) amongst other issues looks at the outlook for inflation and the various factors influencing it.

Articles
Commodity prices soar as spectre of food inflation is back Guardian, Simon Bowers (6/8/10)
Food inflation is a rumble that won’t go away Telegraph, Garry White (8/8/10)
Global wheat supply forecast cut BBC News (12/8/10)
Commodity crisis sparks fear of food inflation on high street Independent, James Thompson and Sean O’Grady (10/8/10)
Should we be concerned about high wheat prices? BBC News, Will Smale (6/8/10)
Commodity prices: Wheat The Economist (12/8/10)
Interactive: What’s driving the wheat price spike? Financial Times, Akanksha Awal, Valentina Romei and Steven Bernard (20/8/10)
Wheat pushes world food prices up BBC News (1/9/10)
UN to hold crisis talks on food prices as riots hit Mozambique Guardian, David Smith (3/9/10)
Grain prices spark global supply fears CBC News, Kevin Sauvé (3/9/10)
GRAINS-US wheat firms after Russian ban extension Forex Yard (3/9/10)
Global food prices reach 20 year high BBC News, John Moylan (3/9/10)
Speculators ‘not to blame for higher food costs’ BBC Today Programme, David Hightower (4/9/10)
Q&A: Rising world food prices BBC News (3/9/10)
Don’t starve thy neighbour The Economist (9/9/10)

Data
Commodity prices Index Mundi
Commodity prices BBC market data
Energy prices U.S. Energy Information Administration

Questions

  1. Use a supply and demand diagram to illustrate (a) what has been happening to wheat prices (b) what is likely to happen to wheat prices over the coming months?
  2. How relevant is the price elasticity of demand and supply and the income elasticity of demand to your analysis?
  3. What factors have caused the shifts in demand and/or supply of wheat and copper?
  4. What has been the role of speculation in the price rises? Is this role likely to change over the coming months?
  5. What is likely to happen to food prices in the shops over the coming months? Would you expect bread prices to rise by the same percentage as wheat? If so, why; if not, why not?
  6. If commodity prices generally rose by 5 per cent over the coming year, would you expect inflation to be 5 per cent? Again, if so, why; if not, why not?

Letter writing has, in many walks of life, rather gone out of fashion. For instance, many of us of a slightly older disposition remember how putting pen to paper was an important part of courtship and the building of relationships. Well, one modern-day couple who are getting very used to an exchange of letters is the Governor of the Bank of England and the Chancellor of the Exchequer. The latest inflation numbers from the Office for National Statistics show that the annual rate of CPI inflation for July was 3.1%. While the inflation rate is down from the 3.2% recorded in June it remains more than 1 percentage point above the government’s central inflation rate target of 2%. Consequently, Mervyn King will again be writing to the Chancellor to explain why this is the case.

Since the turn of the year, the annual rate of CPI inflation has, with the exception of February, been consistently above 3%. Even February was a narrow escape for the Governor because inflation came in at exactly 3%! Another way of putting the recent inflation record into perspective is to note that over the first seven months of 2010 the average annual rate of CPI inflation has been 3.3%.

The slight fall in July’s annual inflation rate is attributed, in part, to falls during July in the prices of second-hand cars and petrol whereas these prices were rising a year ago. Furthermore, the average price of clothing and footwear fell by some 4.9% between June and July of this year as compared with a fall of 3.2% in the same period a year ago. The result is that the annual rate of price deflation for clothing and footwear went from 1.4% in June to 3.1% in July.

Of course, within the basket of consumer goods price patterns can vary significantly. One significant upward pressure on July’s overall annual inflation rate was the price of food and non-alcoholic beverages, especially vegetables. The average price of food and non-alcoholic beverages rose by 1% between June and July which has seen the annual rate of price inflation for food and non-alcoholic beverages rise from 1.9% in June to 3.4% in July.

The fact that July shows inflation running in excess of 3% will surprise very few. In the latest Inflation Report the Bank of England reports that the Monetary Policy Committee’s view is that ‘the forthcoming increase in VAT was expected to keep CPI inflation above the 2% target until the end of 2011’. The Committee then expects what it describes as a ‘persistent margin of spare capacity’ to force inflation to fall back. But, the Committee also feels that the prospects for inflation are ‘highly uncertain’. Therefore, it is difficult to gauge just how many more letters will be passing across London between the Governor and the Chancellor in the coming months. Nonetheless, it would be probably be advisable for the Governor to make sure that he has a sufficient supply of postage stamps at his disposal, just in case!

Articles

UK inflation rate slows again in July BBC News (17/8/10)
Bank of England’s King forced to write another letter to Osborne as prices stay high Telegraph (17/8/10)
Inflation falls to 3.1% in July Financial Times, Daniel Pimlott (17/8/10)
Dearer food keeps inflation high UK Press Association (17/8/10)
Bank ‘surprised’ at inflation strength Independent, Russell Lynch (17/8/10)

Letters
Letter from the Governor to the Chancellor and the Chancellor’s reply Bank of England (17/8/10)

Data

Latest on inflation Office for National Statistics (17/8/10)
Consumer Price Indices, Statistical Bulletin, July 2010 Office for National Statistics (17/8/10)
Consumer Price Indices, Time Series Data Office for National Statistics
For CPI (Harmonised Index of Consumer Prices) data for EU countries, see:
HICP European Central Bank

Questions

  1. What does the Bank of England mean by a ‘persistent margin of spare capacity’? By what economic term is this phenomenon more commonly known?
  2. Why do you think the current rate of inflation is above target despite the spare capacity in the economy?
  3. Since the annual rate of CPI inflation remains in ‘letter-writing territory’ would you expect the Monetary Policy Committee to be raising interest rates some time soon? Explain your answer.
  4. What impact might the persistence of above-target inflation have for the public’s expectations of inflation?
  5. What impact can we expect the increase in the standard rate of VAT next January to have on the annual rate of CPI inflation? Is such an effect on the rate of inflation a permanent one?

We have learnt a lot this week about the appetite of households for spending. And, it appears that they are not particularly hungry. On Monday, the Quarterly National Accounts for Q1 revealed that, in real terms, household sector spending fell by 0.1% in the quarter despite disposable income growing by 2.1%. Today, we have learnt that households have continued to increase the amount of equity in their homes. The Housing Equity Withdrawal (HEW) figures for Q1 show that households increased their stake in housing by some £3.2 billion.

Housing Equity Withdrawal occurs when lending secured on dwellings increases by more than the investment in the housing stock. Housing investment relates largely to the purchase of brand new homes and to major home improvements, but also includes housing moving costs such as legal fees. What the Bank of England does is to compare these levels of housing investment with the amount of additional secured lending. If the Bank of England finds that additional secured lending is equal to the amount of housing investment then HEW is zero. If it is positive, then additional secured lending is greater than the levels of housing investment. This would show that the household sector was extracting equity from the housing stock and using mortgage lending to fund consumption, to purchase financial assets or to pay off unsecured debts, like credit cards.

But, the point here is that HEW is actually negative and has been so since the second quarter of 2008. Negative HEW means that housing investment levels are greater than the levels of new secured borrowing. In other words, household are increasing their housing equity. But, there is a cost to this choice because by doing so households are using money that could otherwise be assigned for spending or purchasing financial assets. One way of measuring the potential extent of foregone consumption is to note that the Bank estimates that the level of equity injected into housing in Q1 was equivalent to 1.3% of disposable income. Since Q2 2008 households have injected equity into housing to the tune of £38.34 billion, which is equivalent to 1.97% of disposable income, some of which might have otherwise been used to fund spending.

The negativity of HEW is not that surprising. In difficult economic times many of us might be tempted, if we can, to reduce our exposure to debt. Low interest rates may also be inducing households to pay off debt either because the interest rates on saving products are low and unattractive or because the size of mortgage payments for those on now lower variable rate mortgages gives them income with which to pay debt off. The bottom line is that after many years happily spending, households appear to be dining off a different menu.

Articles

Homeowners raise stakes in homes, says Bank of England BBC News (15/7/10)
Mortgage debt drops £3.2 billion Independent, Nicky Burridge (15/7/10)
Drop in outstanding mortgage debt UK Press Association (15/7/10)
Equity withdrawal still negative Financial Times, Cara Waters (15/7/10)
Saving may cause a double-dip recession Telegraph, Harry Wallop (13/7/10)

Data

Housing equity withdrawal (HEW) statistical releases Bank of England
Quarterly National Accounts, 1st Quarter 2010 ONS

Questions

  1. What do you understand by the term ‘housing equity withdrawal’?
  2. Compare the possible implications for consumer spending of positive HEW and negative HEW.
  3. What factors do you think lie behind the eight consecutive quarters of negative HEW?
  4. Why might a low interest rate environment affect the incentive to withdrawal housing equity? What other variables might also affect levels of HEW?
  5. How does HEW affect the net worth of households?