Below is an essay I wrote at Haileybury College, UK as an 'A' Level Economics student which earned me the Brigadier H N Leveson-Gower Economics Prize at the College's Speech Day in 1997.
NOTE: This essay was written in Spring 1997 and hence the current economic turmoil in the far-east has not been taken into account
Question:On 15 February 1994, in an analysis of world-wide
recession, the 'Guardian' stated that 'those in charge of a country's
finances have to take into account what is happening in the rest of the
world'
Comment upon the significance of this principle for policy makers in
developed and developing economies.
To consider whether people in charge of a country's finances have to take into account of what is happening in the rest of the world, the degree to which a country is linked with others economically, politically and socially must be considered. Such linkages are virtually inevitable in today's world, given the sheer volume of international trade in the global economy in which practically all countries involve. It is worth noting that those three linkages are inter-related, and will be discussed in turn. However, the nature of such linkages may differ between developed and developing countries, and may affect the decision as to whether international affairs must be considered in the planning of national finance.
Those in charge of a country's finance have to set a healthy macroeconomic environment for the country. There must be high and sustainable economic growth (and living standards), low inflation, low unemployment and satisfactory and desirable balance of payments (BoP).
It is worth noting that BoP's effects on international exchange rate (XR) could affect other macroeconomic objectives, which may be in conflict with commitments to achieve satisfactory BoP. For instance, should an economy be in recession when the level of unemployment is likely to surge, as most countries were in the early 1990s, the normal level of national income (Ye) at which there is potentially full employment would drop as the withdrawals(W) and injections(J) moved to W2 and J2 respectively. The government could try to rectify this deflationary gap by expanding the aggregate demand (AD) in the economy. In doing so, however, not only would consumer demand on domestic goods and services expand, the demand for imports (M) will also increase, increasing the supply of domestic currency to S2, and destroying the external balance. On the other hand, a change in the demand for exports (X) by foreign countries would have a deflationary effect on domestic economy.
One major determinant of the demand for exports by a country's trading partner is their economic activities. X is part of J, and M is part of W in the circular flow of income and that at a deflationary gap, J would fall short of W and at an inflationary gap, W would fall short of J. Although each component of J and W do not have to match. In other words, X and M do not have to match in the current account BoP. However, it is likely that they would move in line with J and W respectively. As a result, a country's X performance is largely dependent upon what is happening in the rest of the world.
Another major determinant for a country's X and M is the country's XR. With a strong XR, M flourishes while X suffers, and vice versa for a weak currency. However, the strength of a currency is determined by the supply and demand of money, which in turn would be determined by X & M performances. Without intervention from central banks, a current account deficit, where M exceeds X, is characterised by an increase in money supply, which drives down the XR. This would help correcting the imbalances in the current account BoP. However, an XR is relative to other currencies. Therefore, a country's XR would in turn be partially determined by the trade performances of others. The XR is also dependant upon the rate of interests. Providing that investors have confidence in the countries concerned, they would increase their savings in a country which offers a higher interest rates, thus a higher yield.
The rate of interests, in turn, is often a monetary tool pursued by many governments to set a correct macroeconomic environment. They may attempt to increase the rate of interests, to increase domestic savings and reduce consumer expenditure when the economy becomes overheated at an inflationary gap. On the other hand, an economy could be stimulated with increased AD by a reduction in interest rates when income would be switched from savings to consumption. The XR of a currency, in turn could be used for macroeconomic management, should the Marshall-Lerner condition be fulfilled: the sum of the price elasticities of demand for M & X is greater than one, spare capacities to meet the Dx and that exporter must pass on full effects of XR adjustments. With an increase in the rate of interests, the XR of such currencies would increase relative to others, assuming that others do not alter their XR by the same amount. Assuming that the Marshall-
Lerner conditions are satisfied, such an increase in XR would lead to a reduction in the supply of M and an increase in the supply of X, due to the changes in the relative prices of M and X:
As a result of such movements, total expenditure on imports would increase, while that on exports would increase. As the price of imports of inputs decrease from such exchange rate movements, cost pressure in the final product markets is reduced. Together with the reduction in exports, which may also reduce the demand for wage increase from unions, such XR movements are deflationary. This reinforces the monetary policy of an increase in interest rates.
When an economy flourishes, GDP and hence output increases. As a result, the demand for labour would increases, reducing unemployment, given that the production probability frontier stays the same. However, it is likely that when a economy grows, there would be outward shifts in the production probability frontier, from improved technology due to increased research and development and the adoption of more capital intensive technologies. However, such increases in productivity which would reduce the demand of labour per unit of output may not cause an increase in unemployment should the overall level of economic activity is such that more labour is required even with an increased productivity. Furthermore, the increased productivity would increase the competitiveness in the final products market, further increasing the demand for X, ceteris paribus. Generally, such increase in output would drive economic growth.
Foreign investment is also an aspect for those in charge of a country's finance to take account of what is happening in the rest of the world. Just as the demand of goods and services would affect the current account BoP. Investment, which could take the form of foreign direct investments(FDI) or portfolio investments could also affect BoP, and thus the money supply. With FDI, profits which the investing firm make from investing in another country could be repatriated. Hence, in the long run, the country receiving FDI would have an increased profits outflow which will contribute towards a possible current account BoP deficit, whose effect are discussed. However, its effect could be outweighed by local multiplier effect, by the mere act of increased J. This gives rise to a higher level of national income as well as providing a source of employment, reducing unemployment. The increased national income may further increase AD, providing the thrust for economic growth. However, portfolio investments from abroad may just provide a source of finance for possible investments into actual production, involving paper transactions. Overall, it may be more desirable for a country to have a deficit in the capital account from FDI to balance a surplus in the current account, which would be reinforced by future increases in interest, profits and dividends (ipd) inflows.
Political and social linkages may also affect economic decisions, especially with investments. Political stability is crucial for investors' confidence for FDI and portfolio investments. Should investors believe, for instance, that the country in which they invest is politically unstable, which may affect future ipd repatriation, investments may be withdrawn. Also political instability in a country may also prevent future imports into that country. This could happen with the pursuit of Import Substituting Industrialisation by many developing countries, for example. To the extent that social tensions may affect political stability, social linkages may also affect economic linkages.
There are also various mechanisms in the global economy which make various countries obliged to react to changes in other countries. The European Union and its various mechanisms and policies are typical example. A good example of that would be the European Monetary System (EMS) and the Exchange Rate Mechanism(ERM). Countries opting to join the ERM maintain a fixed XR with other ERM currencies within a 15% band, except for Germany and the Netherlands which maintain a 2¼% band between their two currencies. Such maintenance require not only the central bank of a currency which is experiencing a depreciating or appreciating XR to intervene in the foreign XR market, but also central banks of other nations to proceed with supportive actions. For instance, if the Lira is rapidly depreciating, then not only would the Italian Central Bank be buying back Lira to reduce the money supply to maintain the XR. Other central banks are meant to, in theory, sell their only currencies to increase their money supply and to reduce the XR, such that the Lira could maintain the 15% band with other ERM currencies. Such supportive actions by other central banks have to be built into the mechanisms in which people plan a country's finance. When they are setting macroeconomic targets, such as the target inflation rate, they have to account for the possible needs to support other currencies, which may put up or down inflationary pressure domestically.
Not only do European countries adopt advanced integration policies, whereby countries have to take account of what is happening elsewhere in the European Union, other countries may also adopt pegged exchange rate systems, even after the break down of the Bretton Woods system in 1973, for various reasons. For instance, in Hong Kong, there had been an investors' confidence crisis in 1984, when the Sino-British Joint Declaration was announced, whereby China would regain sovereignty over Hong Kong from 1st July 1997. There were signs that investors started to pull investments out of the British colony. As a result, the Hong Kong government had decided to peg the Hong Kong dollar to the US dollar at a rate of HK$7.80=US$1, with an unstated band of ±1%, and investors' confidence was recaptured.
Developed and developing countries differ in their international linkages, however, due to their differences in economic, political and social development. For many developing countries (LDCs), primary commodities are still the emphasis in their exports market. For instance, 52% of Jamaican exports are on Bauxite and alumina. It is natural, hence, for those in charge of finance in those LDCs to look into the demand for such products. Many of these minerals/ores demand are suppressed when the industrialised world, their usual market is suffering from a recession, when their own demand for final products drop, and hence the demand for imports of any inputs for such final products are reduced. These lead to the phenomenon of a global recession, which spreads from the industrialised world to the LDCs.
When they see that the demand for their main exports in the world market are stagnant, they may have to step into the market to promote alternative production and exports. For instance, the governments may provide technical training and education for a new industry. Those who are against an 'interventionist state' may disagree with that, but even the Hong Kong government, which manages the most free economy in the world, as stated by the Washington based Heritage Foundation, do intervene selectively in parts of the economy. For instance, it has set up an Employees Retraining Board recently to retrain labour that had previously been employed in the manufacturing sector that is suffering frictional unemployment with the shifting of manufacturing activities from the British colony across the border to mainland China, where labour costs are significantly less. They had been retrained for the service sector. This could help Hong Kong to find a new market for her exports, as she is a regional and international financial centre.
On the trading front, one must not neglect the effects of oil price shocks on the world economy. The oil price shocks of 1973, 1979-80 have significant impact on the global economy. Their adverse effects on the LDCs' economy are particularly noticeable. The effects of the increase in oil prices worsened the LDC current account BoP deficit, which rose from 1.1% in 1973 to 4.3 % in 1975, and from 2.5% in 1978 to 5.1% in 1981. The effects of these increased bill from oil imports forced the oil importing countries, both developed countries and LDCs to find alternative sources of energy, besides examining ways to cope with the BoP problems, which are the main concerns for those in charge of a country's finance. Motor vehicles running on alcohol are extensively used in Brazil, while in the USA, a maximum speed limit of 55mph was imposed for motor vehicles in 1974, as it was found to be the most efficient speed of driving.
Other countries would also watch out for others' activities, at least for the economic reasons. For instance, the different quotas for imports to the USA or the import tariffs set by the EU are among the most sensitive issues in the LDCs. Those barriers to entry could significantly reduce their price competitiveness in the international market.
The developed countries have also got to be aware of what is happening in the rest of the world, as activities there may adversely affect their finance. For instance, the adoption of Import Substituting Industrialisation(ISI) strategies by some LDCs may reduce the market size of developed nations. However, such ISI strategies are carried out in stages, from the stage of consumer goods to capital goods. Developed countries may have to find loop holes into such market by continuing to export to these LDCs, with their capital or investment goods, or to continue supplying them with consumer goods by join venture projects or FDI with those countries concerned.
According to the Heckscher-Ohlin Theory of comparative advantage, countries have comparative advantages in the production that are intensive in the use of the factors of production with which they are abundantly endowed. All countries would benefit by specialising in the sector in which it has comparative advantage over others. However, such comparative advantages vary all the time has the countries develop at different paces. This is of particular importance to LDCs and Newly Industrialising Countries. Newly Industrialising Countries like Singapore and Taiwan face increased labour cost pressure, and that as the LDCs specialise in labour intensive industries, such countries find that their comparative advantage no longer lies in their abundant labour force, which is getting more expensive. With increased research and development and some FDI with technology transfer, they become significant international exporters of advanced exports like electronics equipment and pharmaceutical products. The developed countries, in turn, facing competition from these NICs, have to put up measures for that. Although trade barriers had been significantly reduced after the Uruguay Rounds, they still exist in many forms, as discussed.
To conclude, those in charge of finance in a country, in the developed or developing world have often got to take into account of what is happening in the rest of the world, on the economic, political and social front. Their mere act of management of macroeconomic objectives, such as the achievement of a satisfactory balance of payment or low inflation domestically have often forced them to react to changes elsewhere in the world, as the global economy is integrated economically, and that such linkages are often tied in with political and social developments internationally.