OCR F585 Global Economy June 2011 Toolkit

OCR A2 Economics Unit F585 -
The Global Economy

June 2011 Revision Toolkit

OCRF585ToolkitJune2011(tutor2u) Page2

TableofContents
Introduction ............................................................................................................................................ 3
Extract 1: Recession in the euro area economies 2008 2009 .............................................................. 5
Extract 2: Portugal, Italy, Ireland, Greece and Spain the PIIGS .......................................................... 20
Extract 3: The future of the Spanish economy ..................................................................................... 29
Extract 4: International trade, international trade negotiations and developing economies .............. 39
Suggested exam-style questions ........................................................................................................... 47
Glossary of Key Terms for F585 The Global Economy .......................................................................... 51


Introduction
This is the introductory section of the pre-release material we will look at some of the concepts
and issues flagged up by this introduction in the right-hand column below.
Recession in the Euro Area

The euro area economies all experienced
negative economic growth during 2008 2009
as the global economic crisis spread.

However, the reduction in GDP was not uniform.
Some euro area economies entered recession
earlier than others, some experienced more
severe recessions than others and not all
economies had emerged from recession by the
end of 2009.

The lack of convergence of the economic cycles
in the euro area raised questions about the
viability of the monetary union which was just
over 10 years old.

Comments on the introduction

Definition of a recession:
A marked slowdown in economic activity, more
strictly defined (in many countries) as at least two
consecutive quarters of declining real GDP

The economic / business cycles of the seventeen
countries inside the Euro Zone are not fully
convergent. The timing of recession and recovery has
been different as has the depth of the downturn and
the strength of the rebound in demand, output and
employment

In macroeconomics, convergence normally refers to
the process by which the per capita income of a
relatively poor country catches up with that of a
richer country. But it is also used in the context of
convergence of inflation rates, interest rates and real
measures such as economic growth, productivity and
trade patterns.

Shifting competitiveness

It was not just the lack of convergence of the
economic cycles which raised concerns about
the future of monetary union in the European
Union (EU). A number of economies appeared to
suffer from a lack of competitiveness both
inside and outside the euro area. Portugal,
Ireland, Italy, Greece and Spain (dubbed the
PIIGS) had grown increasingly uncompetitive
Lu
union.

Without implementing measures to tackle this
lack of competitiveness many thought that their
continued membership of the euro area was
unsustainable.

Competitiveness
Competitiveness is a broad term describing whether
or not a business or a country is competitive in
international trade against competitors. We often
make a distinction between price/cost
competitiveness and non-price competitiveness:

Cost competitiveness: Typically measured by the
level of relative unit labour costs of one country
against another. Competitiveness is affected (over
time) by relative rates of inflation. For example if
inflation in Spain is regularly higher than the Euro
Area average, then Spain will tend to lose
competitiveness in European markets

Non-price competitiveness: This focuses on factors
such as product quality, brand reputation, the ability
to get products to the market on time and the
performance characteristics of a product relative to
others.

Calls for further trade liberalisation

Whilst fiscal stimulus measures had had an
impact on economic growth in the short term,
the World Trade Organisation (WTO) called
upon developed and developing economies to
renew their efforts to further liberalise world
trade.

Pascal Lamy, the Director-General of the WTO,
stated his belief that, in the long term, trade
liberalisation was the key to promoting
economic growth for developed and developing
economies alike.

Such a view is strongly supported by economic
theory, yet trade liberalisation on its own is not
a guarantee of human development and
poverty reduction.

Trade liberalisation:

Liberalisation means deregulation and other
measures, including the lowering of trade
barriers, aimed at opening up a market or
industry to full competition. In the context of
world trade it is a process whereby countries
sign bilateral or multilateral trade agreements to
reduce import tariffs, quotas and other forms of
protectionism in a bid to stimulate greater trade
in goods and services.

The World Trade Organisation:
The WTO is an organisation that was formed in
1995 to control trade agreements between
countries and to set rules on international trade.
It replaced GATT (the General Agreement on
Tariffs and Trade). Their website is at
www.wto.org

Human development:
The Human Development Index (HDI) is an index
devised by the UN Development Programme to
assess comparative levels of development in
countries, quantified in terms of literacy, life
expectancy and purchasing power (i.e. real GDP
measured in US dollars and with a purchasing
power parity adjustment).

Is the Euro Area in crisis? This is the main focus on extracts 1, 2 and 3

Extract1:Recessionintheeuroareaeconomies20082009

The Euro Area in 2011 with Estonia the 17
th
country to join in 2011 (Source: ECB website)
The text for Extract 1 is below we have highlighted key terms in bold text and after each section
we pick out some of the detail to provide further background, evaluative comment and analysis.
Since its launch in 1999, and the issue of notes and coins in 2002, the euro has established
itself as a major international currency. Fears that the euro would be a have
not been /reserve currency and the
second most popular currency for international transactions. The euro area economy is the second
largest in the world, based on comparisons of GDP at purchasing power parity.
Background
The Euro Area is a group of seventeen countries that share the same currency the Euro. Aggregate
statistics on the Euro Area are summarised in the table below
Data is for 2009 Euro Area European Union United States
Population 330.5 500.3 307.5
GDP (PPP) Euros, trillion 9.0 12.6 11.3
GDP per capita (PPP), Euros, thousands 27.1 25.1 36.9
Exports of goods and services (% of GDP) 19.7 13.4 11.1
Labour productivity (PPP), Euro Area = 100 100.0 91.2 128.3
Source: European Central Bank Annual Report, 2010


Purchasing Power Parity (PPP)
Reference is made in the article to 'W
Purchasing Power Parity is a commonly used method of currency valuation based on the idea that
two identical goods in different countries should eventually cost the same. This is illustrated by the
L Big Mac index, which takes a Big Mac hamburger and compares its prices in different
countries in order to establish the relative value of their currencies. More here
The external value of the Euro

The external value of the Euro against the US Dollar (source: Timetric)
The Euro has become one of the most heavily traded currencies in the world. Partly this is the
natural consequence of the economic size of the currency bloc. This section makes reference to a
reserve currency:
Reserve currencies:
x A reserve currency is a currency that is traditionally held in countries' official reserves
because of its global importance as a medium of exchange and its inherent stability.
x A reserve currency is sometimes called an anchor currency and is a currency that national
governments and other institutions are happy to hold as a key part of their foreign exchange
reserves. It acts as a pricing currency for commodities such as gold, oil, wheat and copper.
For decades the reserve currency of choice has been the US dollar partly because the USA is the
gest economy. For the Americans one of the benefits of this is that the USA can borrow
from the rest of the world at a slightly lower interest rate because there has been a lengthy queue of
foreign investors willing to purchase $ denominated assets such as US Treasury bonds. China for
example has amassed a mountain of foreign exchange reserves arising from their trade surpluses.

In recent years there has been a shift in holdings of foreign exchange there are now more Euros in
circulation than dollars, an 8
the euro accounted for 27 per cent of official foreign reserves, up from 18 per cent soon after its
1 same period.
The two requirements for a currency to have reserve status is credibility of a government that it will
not default on its debt or by printing too much of it. Will the
economic difficulties facing several Euro Area countries including the PIIGS that dominate much of
the OCR F585 stimulus cause a loss of investor confidence in the Euro and threaten its reputation
as a reserve currency?

The external value of the Euro against UK sterling (source: Timetric) a rise in the chart shows that the Euro
has appreciated against sterling (e.g. during 2008)
The economies of the euro area were not immune from the effects of the global economic crisis of
2008 2009. Setting interest rates for the euro area as a whole is difficult when there is a lack of
convergence in economic cycles. The European Central Bank (ECB) must make a judgement based
on the performance of the euro area economy as a whole.
The global economic crisis
A2 students will be familiar with the phrase global economic crisis a period of time when the
world economy was subject to a number of severe external shocks including the world financial
crisis that followed the collapse of the sub-prime lending boom. And also the fall-out from a surge in
the prices of internationally traded foodstuffs, energy and metals. The financial crisis was a major
demand-side shock for advanced, highly developed nations including member countries of the Euro
Zone and such was the severity of the shock that a deep recession was inevitable in late 2008 and
through 2009 despite attempts by policy-makers in government and in central banks to launch
economic stabilisation / stimulus policies.


Convergence in economic cycles
Convergence means a coming together of one or more economic data series. The extract refers to a
meaning that countries in the Euro Area were not at the
same stages of their business cycle. Ensure that you understand what these stages are:
x Boom
x Slowdown
x Recession
x Recovery
The European Central Bank has the job of setting the nominal policy interest rate for the currency
bloc and it has a clear target for price stability defined as an annual rate of consumer price
inflation of 2%. The rate of inflation in anyone of the Euro countries will depend in part on where it is
in their business cycle because inflation is determined by a mix of demand and cost factors. For
example a country experiencing a demand-led boom with rising wage costs and other input costs
will have a higher rate of inflation than a country experiencing slower growth and where cost-push
inflationary pressures are lower.
Policy interest rates in the Euro Area
The OCR F585 stimulus document does not provide any data on the policy interest rates set by the
ECB so we have included it below for information:

Official nominal interest rates set by the European Central Bank (source: Timetric)
As the financial crisis enveloped the European Union, the European Central Bank started to cut
interest rates from 4.25% in late 2008 down to just 1% in the spring of 2009 they have stayed at
this historically low rate ever since.


Inflation in the Euro Area
The OCR F585 stimulus does not provide data on inflation in the Euro Area here it is

Consumer price inflation for the Euro Area the ECB targets price stability (inflation of 2%) source: Timetric
Fig. 1.1 shows the quarterly growth in real GDP for the euro area as a whole and for its individual
economies, except Malta. Despite euro area GDP falling in the second quarter of 2008, only five of
the 16 members had experienced negative economic growth. This number rose to nine by the third
quarter of 2008 and to 13 by the fourth quarter of the same year. It was not until the first quarter of
2009 that all euro area economies were experiencing falling GDP.
Similarly, the end of recession for the euro area economy as a whole came in the third quarter of
2009, yet three economies (Greece, Spain and Cyprus) remained in recession. They were joined by
Italy in the fourth quarter as the country looked set to enter a double-dip recession.
Not only was the timing and length of the recession different in the various national economies of the
euro area, so too was the severity of the recession. Ireland, Luxembourg, Slovenia, Slovakia and
Finland all experienced a reduction in GDP from peak to trough significantly above that of the
average for the euro area economy as a whole. The fall in GDP in Greece, France and Cyprus was
significantly below this average.

There is a lot in the preceding paragraph and in the table so let us take it piece by piece!
Fig 1.1 contains a huge amount of data on the quarterly change in the real (inflation-adjusted)
national income (real GDP) for the member nations of the Euro Area. The data deals with the
x Timing of the recession
x The duration of the downturn
x The severity of the contraction in national output from peak to trough assuming that the
trough of the cycle has been reached (perhaps not so in Italy, Spain and Greece up to the
end of the data provided)
Timing
According to Figure 1.1
1. Slovakia and Ireland were the first countries to see negative growth in Q1 2008
2. Ireland was the first to officially fall into recession using the conventional definition of a
period of two successive quarters of falling GDP

3. Five countries were contracting in the 2
nd
quarter of 2008, nine by the 3
rd
quarter and
thirteen by the 4
th
quarter
4. All fifteen were contracting in the 1
st
quarter of 2009 this fell to ten in the 2
nd
quarter and
only three in the 3
rd
quarter of 2009
5. Greece was the last Euro Area country into recession (the 4
th
quarter of 2008) this explains
in part the lower fall in GDP from peak to trough although data for the 4
th
quarter of 2009 is
not available and Fig 1.1 does not provide any data for the 1
st
half of 2010
Duration
Duration refers to the length of time over which real GDP was declining. According to Figure 1.1
1. Germany suffered four quarters of falling GDP (Q2 2008 through to Q1 2009)
2. Italy saw five quarters of negative growth
3. Spain saw six quarters of contracting GDP (Q3 208 through to Q4 2009) although the severity
of recession was not as steep as for Germany or Italy
4. Slovakia avoided a technical recession (output fell in the 1
st
quarter of 2008 and the same
period in 2009) but the country also saw the highest quarterly decline in real GDP with an
8.1% drop in the 1
st
quarter of 2009. This highlights the flaw in the official definition of

language!
Severity
The final column in figure 1.1 displays the % fall in real GDP from peak to trough. For the Euro Area
as a whole the decline was 5.1% - by way of contrast the fall in UK real GDP during the recession was
L C l output
(6.7%) but Germany has recovered strongly during 2010 and into the early months of 2011.
The absolute fall in real GDP is one way of measuring the severity of the downturn.
But there are other approaches not covered in the data one of which is the output gap. The
output gap shows the difference between actual and potential GDP.
During a recession real GDP declines and nearly always takes actual GDP well below the long run
potential level implying a negative output gap.
As a result of the recession, many Euro Area countries have a large amount of spare capacity
measured both by the output gap but also by the rate of unemployment.

Average output gap for the seventeen countries of the Euro Area
For the Euro Area as a whole in 2009 the level of output was 5% below estimated potential GDP. A
slow recovery in 2010 and another year of growth in 2011 are expected to shrink the output gap
but this will vary from one country to another. When the output gap is negative there is less risk of
demand-pull inflation in the single currency area. This will be a factor considered by the European
Central Bank when setting interest rates.

Unemployment as a % of the labour force average for the Euro Area
The rate of unemployment in the Euro Area climbed from 7.5% in 2008 to nearly 10% in 2010 the
chart above (taken from the OECD World Economic Outlook) shows that unemployment is forecast
to decline gradually but remain above 9% of the labour force. Much of the increase in
unemployment in n2008-2010 was cyclical, caused by a fall in aggregate demand and output.

Risks of a double-dip recession
Fig 1.1 makes reference to Italy as one of the countries that -dip
.
A double-dip recession happens when an economy goes into recession twice without having
undergone a full recovery in between. In other words there is a second downturn before the
negative output gas has closed and actual GDP has recovered to be in line with potential GDP.
No data is provided in Fig 1.1. about what happened in the first six months of 2010 and whether a
double-dip recession happened? A double dip can occur for a variety of reasons including:
x A fresh external economic shock: Industries involved in exporting goods and services are
affected by a downturn in one or more of their major overseas export markets
x Consumer confidence: There is a decline in consumer confidence which turns a fragile
economic recovery into another contraction. Confidence might decline for a variety of
reasons for example a persistent fall in property prices, declining real disposable incomes
or the effects of rising unemployment
x Business confidence: There is a fall in business confidence leading to a fresh burst of
production cut-backs and a fall in planned capital investment spending. One of the features
of the recent recession in Europe has been the sharp decline in business and investor
confidence k
x Higher exchange rate: Recovery might be halted by an appreciation of the exchange rate
for example an appreciation of the
Euro against the US dollar.
x Policy mistakes - e.g. tightening of policy too soon: The withdrawal of a monetary and/or
fiscal stimulus (e.g. higher interest rates, higher taxes and cuts in government spending) has
the effect of causing a contraction of demand and production in the circular flow.
You might use an AD-AS analysis diagram to show a double-dip recession illustrating for example
an inward shift of the AD curve or a leftward shift in the short run aggregate supply curve.

In the end the Italian economy has avoided a double dip recession although real GDP growth rates
remain low and the recovery is fragile. Real GDP in Italy increased by just over 1% in 2010 but is
forecast to be weaker in 2011 so the risk of a double dip is not over for Italy!

The economic cycle for Italy (source: Timetric)
^ed concerns that the national economies of the euro area had not
converged. Differences in their economic performance could be only partly explained by differences in
the fiscal response to the downturn. Much more important was that economic performance
appeared to be affected by differences in their openness to international trade, the structure of
their economies and in their competitiveness.
As it emerged from recession there were concerns that a - was developing,
seriously affecting the viability of the monetary union
Economic convergence
No discussion of the economics of the single currency is
complete without reference to the idea of convergence!
Convergence means that the economic variables of
different countries move closer together over time.
How might convergence be measured? As always in
macroeconomics we can take a number of indicators
some of which are said to be nominal (meaning they are
essentially monetary indicators) and others are real or
structural (meaning that they refer to the supply-side or
underlying structure of the economy).


Nominal convergence:
This refers to monetary indicators such as:
1. Consumer price inflation the annual % change in the consumer price index
2. Short term interest rates
3. The size of the annual Fiscal (Budget) deficit
4. The level of gross government debt
5. Measures of exchange rate stability
Real convergence
This is referred to in the previous section of the extract real indicators include:
1. The trend (underlying) growth of GDP (i.e. the sustainable long run average growth rate)
2. Labour market performance including the rate of structural unemployment and the non-
accelerating inflation rate of unemployment (NAIRU)
3. Growth of labour productivity i.e. output per person employed
4. Trade balances in goods and services and also differences in the geographical pattern of
trade and share of GDP taken up by trade
5. Capital investment as a share of GDP
6. Housing market structures including rates of home ownership and the size of the rented
property sector
7. Indicators of cost and price competitiveness such as an index of relative unit labour costs in
manufacturing industry and annual changes in output prices (referred to in Figure 2.2 on
page 8 of the F585 stimulus document).
Why does the apparent lack of real economic convergence matter and perhaps, as the extract
suggests, the viability of the Euro Area in the years to come?
Part of the answer lies in the concept of an optimal currency area (OCA) developed initially by the
work of the Canadian economist Robert Mundell.
Mundell explored the conditions required for a group of countries to establish and run a successful
single currency. An optimal currency area is a geographical region where it is thought a single
currency would help to maximise economic welfare and enhance macroeconomic performance over
a period of time.
Start from the idea that all participating nations share the same currency and have to live with the
policy interest rate set by the central bank. In our focus for June 2011 this is the policy rate set by
the European Central Bank (ECB).
Can the interest rate decision work for all members of a currency union? Or will structural
differences in their economies be exposed and perhaps made worse by having a monetary union
where there is no option for an exchange rate adjustment to restore lost competitiveness?

For Mundell an optimal currency area requires:
1. Countries within it are highly integrated with each other, i.e. a high percentage of trade in
goods and services is done with fellow currency union members
2. Where each economy has a sufficiently flexible labour market to cope with an external
shock such as rising oil prices or a major demand-side shock in the world economy. Labour
market flexibility might include:
a. Flexibility in real wages and salaries at different times during an economic cycle
b. Workers with flexible and adaptable skills to reduce structural unemployment
c. A high level of labour mobility within and between members of a currency union
d. Flexible employment contracts including lots of shorter term job contracts
3. An OCA is also likely to work well when the impact of interest rate changes have a broadly
similar effect on businesses and households from country to country.
4. When member nations are willing and able to make fiscal transfers between each other, for
example to help stabilise demand and provide financial support during difficult times
The economic, social and political difficulties in the Euro Area throughout the last few years have
thrown into the spotlight the reality that the Euro Area is not close to be an optimal currency zone.
A currency union works best with a small cluster of highly integrated and similar countries, for
example Germany, the Netherlands and Austria. It was never likely that launching a currency union
with twelve nations rising quickly to seventeen in 2011 would work well.
Crucially the countries joining the Euro have not exercised the same budgetary controls many
countries including the PIIGS referred to specifically in Extract 2 have run up huge fiscal deficits
which ultimately has caused a loss of confidence among investors and speculators in international
bond markets. Little wonder that many heavily indebted countries have seen the interest rates they
pay on their loans rise sharply. We return to this in the section on Extract 2.
Let us pick out three items mentioned on the convergence agenda:
1/ Openness to international trade
An open economy is one that is open to flows of trade in goods and services and inflows and
outflows of direct and portfolio capital investment. In other words, it is an economy where a
significant and rising share of national income is linked directly to trade and investment with other
countries.
As one might expect, countries within the Euro Area have different histories of openness to world
markets and also to the effects that changes in world trade have on their balance of payments and
economic growth.
2/ Structure of their economies
This refers to the structure of output and jobs from economy to economy. Some EU nations have a
relatively high dependence on high volume manufacturing industries such as textiles, footwear, car
manufacturing and household appliances. For others, the size of their construction and tourism

industries or the value-added from sectors such as business and financial services is particularly
important. These variations come into stronger focus in Extract C when we look at the problems
facing the Spanish economy.
Although Spanish manufacturing industry contributes a similar percentage of GDP as or Germany, a
sizeable percentage of Spanish GDP and employment also comes from the property and
construction industry, much of it linked to the fortunes of the tourism sector. Greece is a good
example of a country with a relatively smaller share of GDP from the industrial sector.
Country GDP Per
Capita Euros
2009
Industry as
share of GDP
(by valued
added) (%)
Unemployment
% of labour force
(Oct 2010)
Budget Balance 2009 %
of GDP
Germany 29.1 26.5 6.7 -3.0
Ireland 32.2 31.9 14.1 -14.4
Greece 23.4 17.9 11.5 -15.4
Spain 26.2 26.1 20.7 -11.1
France 27.0 18.8 9.8 -7.5
Italy 25.6 25.1 8.6 -5.3
Portugal 19.8 22.8 11.0 -9.3
UK 29.2 21.1 7.7 -11.4

The table above uses data from EuroStat to illustrate differences in the economic make-up of a
selection of Euro Area countries and also the UK (which of course has an opt-out from the Euro).
3/ Competitiveness
We mentioned competitiveness in the introduction to the toolkit. This is a term used to describe
whether an industry or an economy has a competitive advantage or an edge when trading in
international markets. A common measure of competitiveness is to look at relative unit labour costs
in manufacturing industry (i.e. the labour costs per unit of output relative to other countries).
We can also consider data on producer output prices (the prices of products as they leave the
factory gate). And also the actual figures for the value of exports and imports as part of the current
account of the balance of payments. Real world trade data can help to reveal whether or not an
economy has a comparative advantage in a particular good or service.
As it emerged from recession there were concerns that a - was developing,
seriously affecting the viability of the monetary union
t-
x A two-speed Euro area means that there is a variation in the average growth rates achieved
by countries inside the currency union.
x Some nations may have to suffer a number of years of slower growth and persistently high
unemployment and falling real and relative living standards.

x The governments in these countries are likely to continue to experience difficulties in cutting
their fiscal deficits and in limiting the rise in government debt.
Much attention has focused on the PIIGS group in this respect (more of that in our section on Extract
3) but keep in mind that there are seventeen member nations of the Euro and all countries are
vulnerable to difficult macroeconomic conditions and external shocks having a single currency
does not mean a consistent and similar growth rate!
Why might this threaten the viability of the monetary union?

Protests about government spending cuts and other economic reforms in Greece
There are stresses and tensions within the Euro Area and the events of the last two years have
thrust many of these onto the front pages of the newspapers and the TV news bulletins.
x A cluster of under-performing Euro Area countries have high and rising unemployment
much of which is long-term and employment prospects for the unemployed are bleak
x Slow growth and recession has cut the flow of tax revenues to many EU countries bringing
about a huge rise in budget deficits as a share of national income.
x In 2010 we saw a sovereign debt crisis engulf several Euro Area nations notably in Greece
and Ireland both of whom were eventually forced into accepting emergency bail-outs from
the International Monetary Fund and from fellow European Union members
x Part of the conditions attached to the emergency financial support is deep cuts in state
(government) spending and also higher taxes both of which bring about reductions in
living standards for millions of people in these countries.
x Little wonder that public support for the Euro has fallen and it is this which may be the
biggest threat for the future health and stability of the single currency system

Rising government debt

Gross government debt as a share of GDP (source: Timetric)
Our additional chart above tracks what has happened to gross government debt measured as a
share of GDP. The crucial point is that the recession has caused a surge in debt levels Italy has a
huge level of debt but Portugal, Ireland and Greece appear to have reached and perhaps breached
the tolerance levels of the international bond markets in terms of how much debt can be issued.
Now we turn in Extract 2 to the PIIGS countries finding life tough inside the single currency!
Spain is featured in Extract C but this chart is important context for what is to come. Spanish
government debt as a share of national income was falling consistently during the strong growth
years from 2002 onwards. Indeed in some years the Spanish government was running a budget
surplus causing debt to fall.
So Spain went into the recession when her housing bubble burst with a relatively low level of
national debt. This is one reason why long-term bond yields for Spain are fairly low in stark
contrast to Greece, Portugal and Ireland.
Overall
The global financial and economic crisis from 2007-2010 has exposed fault-lines in the currency bloc
and there remains a possibility albeit a remote one that some nations may opt to cut loose from
the Euro, devalue and partially default on their debts and return to their own currency.
Fundamentally the single currency system brought together seventeen countries that are different
from each other in their economic structure and performance and this has made it incredibly hard
to accommodate a single currency and a single official interest rate during times of global economic
distress. The Euro Area is not an optimal currency area and the crisis is prompting calls for further
economic reforms among the countries that have chosen to use the Euro as a medium of exchange.

Extract2:Portugal,Italy,Ireland,GreeceandSpainthePIIGS

Five countries in the euro area are now singled out as countries sharing common characteristics
likely to make their continued membership of the euro area challenging.
These economies Portugal, Italy, Ireland, Greece and Spain (the PIIGS) on the surface look an
unlikely grouping (see Fig. 2.1). Economic performance in Ireland, Greece and Spain was strong
before the recent recession. All three economies had experienced above average rates of economic
growth in the period 2000 to 2007. Over the whole period Greece and Spain had grown twice as
much as the average for the euro area as a whole, where real GDP had increased by 18.5%. In
Ireland, real GDP had grown by almost 56% over the same period. In comparison, economic growth
in Portugal and Italy over the period was about two thirds of the average for the euro area economy.
The PIIGS group of countries are selected for special treatment in this stimulus document partly
this is because they have all to one degree or another been involved in a debt crisis since the
recession hit Europe. And all are regarded as vulnerable within the Euro Area has their economic
performance worsened since joining the single currency?
What unites these five economies is a loss in competitiveness compared to the rest of the euro area
and to economies outside the euro area. The ECB produces two measures of competitiveness. One is
based on increases in output prices (see Fig. 2.2) and the other on increases in relative unit labour
costs (see Fig. 2.3). Both measure changes in the competitiveness of individual economies relative to
their main trading partners over time. Both indices show a decline in the competitiveness of the PIIGS
since 1999, the year of the launch of monetary union in the EU.
We look at the data at competitiveness in the following pages


Part of this lost competitiveness is due to the failure of ECB monetary policy to control inflation in
all parts of the euro area. Effectively, for Portugal, Italy,
Ireland, Greece and Spain. Short term economic growth has come at the cost of high inflation.
Part of their decline in competitiveness stems from these economies having a
against other members ,

With the risk of depreciation eliminated, FDI has poured into these fast-growing economies. But
these are short term influences on economic growth. The real problem for these economies is the
longer term influences on economic growth which come from a poor supply side performance.
Has the ECB failed to control inflation?
No. The European Central Bank sets policy interest rates with the aim of maintaining price stability
within the Euro Area as a whole rather than for any one particular country. The extract above is
misleading because it is ngle economy it could
never do that should not be used.
What does this phrase mean? Effectively, for Portugal, Italy,
Ireland, Greece and Spain
The extract is suggesting that higher inflation in the PIIGS group has been in part due to the ECB
setting policy interest rates too low for these economies 1
rates in countries such as Ireland and Spain were negative and that this contributed to a boom in
borrowing much of it linked to a booming housing market which created extra inflationary pressures
in these countries and caused them to be heavily exposed when the Global Financial Crisis took hold
from 2007 onwards.
Short term economic growth has come at the cost of high inflation
This line hints at a worsening trade-off between economic growth and price stability. Be prepared
to use an aggregate demand aggregate supply diagram to show how this might come about. The
risk of demand-pull inflation is greatest when an economy is operating with a positive output gap
i.e. there is a shrinking margin of spare capacity, unemployment is falling and there is pressure for
wages and other input costs to rise too.
No data is provided in the extracts on the rates of consumer price inflation for the PIIGS countries.
Instead we are given information on producer prices presumably because this is a proxy for
inflation at an earlier stage of the supply chain.

Consumer price inflation for the PIIGS and the Euro Area (Source: Timetric)
Our additional chart above provides some background on consumer price inflation in the PIIGS
economies. The histogram tracks the inflation rate for the Euro Area as a whole. We can see that for
the PIIGS between 2001 and 2008, in most years, their inflation rates were higher than the Euro Area
average in some cases by 2% or more in any given year.
Key point: Over time, a persistently high relative rate of inflation can lead to a loss of
competitiveness for a country because their export sectors may get priced out of markets. And
imported goods and services will begin to appear cheaper in domestic markets threatening to take a
rising share of consumer demand.
The PIIGS group did experience higher inflation but they did not lose control of inflation, indeed in
historical context their inflation rates were still below what they had experienced in the 1990s.
Price deflation in 2009-2010: The crucial change is what has happened to consumer price inflation
during the recession year of 2009 and into 2010. Notice in the chart above that Ireland, Portugal and
Spain all slipped into a period of price deflation. And persistent deflation can be as damaging to a

,
area
This phrase explains a possible connection between inflation and the value of the exchange rate.
Briefly eir exchange rate may start to depreciate in value
because of a worsening trade balance (growing imports and less competitive exports). Foreign
investors in a country may also take some of their money out (this is known as capital flight) if they
regard the economy as weak on controlling inflation and in the expectation of slower growth and
lower real returns on their investments.

Key point: Within the Euro Area, a country with a relatively high rate of inflation cannot expect a
depreciation of their exchange rate to restore lost competitiveness they will have to achieve this in
other ways such as a better supply-side of the economy or (more painfully) lower wages.
Figure 2.1: Annual GDP growth rates for the PIIGS and for the Euro Area

The chart shows the annual percentage change in real GDP for the PIIGS and Euro Area average.
x The data is not sourced properly one has to assume that the data comes from an official
source such as EuroStat and we are not told whether the GDP statistics for 2010 are a
forecast or not. The data for 2011 is clearly a forecast but this is not shown in the chart and
we are not told from where the forecast has come.

1. Speed of growth: Ireland had the fastest average growth for most of the years from 2000
through to 2007, followed by Greece and then Spain.
2. Over the same period Portugal and Italy were growing more slowly than the Euro Area
average and from 2001 they failed to achieve an increase in real GDP of more than 2%.
Portugal had a shallow recession in 2003, in the same year Italian growth was close to zero
3. Ireland saw the steepest decline in annual growth rates from 6.1% in 2007 down to -7.5%
in 2009 but the forecast for 2011 is that her economy will recover the strongest of those
shown although at a rate of around 3% which is much low2er than her average growth rate
during the 1990s and first seven years of the new century.
4. Greece was the last of the countries shown to fall into recession, had the smallest fall in real
GDP during 2009 and is forecast to have the weakest recovery in 2011

Figure 2.2: ECB Index of competitiveness based on output prices for Portugal, Ireland, Italy, Greece
and Spain 1999-2009 (1999 Q1 = 100)
This is the second of the three data charts in the stimulus material it focuses on producer prices

What data is the chart showing?
The data in Fig 2.2 is for producer output prices. This measures the prices of (typically
manufactured) goods when they leave producers. In the UK this is often referred to as
and what happens to producer prices is frequently shown through later on in
changing retail prices for consumers. Some producers supply direct to the final consumer. Others sell
to wholesalers and from there to retail chains.
What does the data tell us?
Over an eleven year period the index of producer prices for all selected countries shows an increase
but this ought not to surprise anyone! We would expect the prices charged by producers to have
increased over this period; indeed the firm conclusion is that the annual rate of producer price
inflation for all of these countries was low. In Spain there was a 20% rise from 1999-2009, in Ireland
a 15% increase. Greece saw producer prices move higher by 14% and Italy and Portugal saw the
slowest rate of factory gate inflation of 9% and 7% respectively. For all five countries, the average
annual change in producer price inflation over the ten year range was less than 2%.
x There was some evidence of producer price deflation from 1999 through to the end of 2000
and another phase of mild deflation or gently rising producer prices during the middle of the
decade from 2004 through to 2008.

x The steepest annual rise in producer prices came from the start of 2002 through to the end
of 2003. Does this provide some evidence about the impact of the introduction of the Euro
which came into common circulation in January 2002? Some critics of the single currency
claim that the switch to a new currency gives producers the opportunity to exploit confusion
about the value of a new currency by raising their prices and making higher profit margins.
The index of producer prices in Ireland for example climbed from 102 in the 1
st
quarter of
2002 to 116 at the same stage two years later.
x We could do with better data to come to a stronger view on this claim we are not provided
with comprehensive data on consumer / retail prices which would be a better guide to any
likely price gouging by retailers as a new currency the Euro came into circulation as a
means of exchange when buying goods and services.
What causes producer prices to change?
This chart provides an opportunity for some analysis of the possible causes of rises or falls in the
prices of manufactured goods.
Producer price inflation is affected for example by changes in:
1. The exchange rate e.g. depreciation in the exchange rate will cause an increase in the
prices of imported components and raw materials, leading to higher variable costs for
manufacturers who may then choose to pass on their higher costs to their own customers.
All five of the countries shown in the chart share the same currency
2. Changes in indirect taxes e.g. a change in value added tax or other excise duties which are
taxes on producers. Whether or not they are passed through in producer prices depends in
part on the price elasticity of demand and price elasticity of supply for their final output
3. Changes in international commodity prices e.g. a rise in the world price of oil or natural
gas and also foodstuffs used in the food processing industries.
4. Changes in wage costs e.g. producer prices may rise in industries where wages rise faster
than productivity (causing an increase in unit wage costs) and where labour costs are a

5. The strength of demand and the economic cycle producers find it easier to make higher
prices stick when demand in their markets is strong and rising. Spain and Ireland fit the bill
here as for most of the decade - until their economies were engulfed in the global financial
crisis they enjoyed above average real GDP growth with a fast-expanding aggregate
demand. In contrast during a recession when demand has fallen and producers find that
they have high levels of unsold output, there is pressure for price discounting. Notice in Fig
2.2 that during 2the later months of 2008 and into 2009 we see producer prices falling in
Spain and Ireland and they were fairly flat in other countries.
Be ready to use supply and demand analysis diagrams to explain why produce prices can rise or fall.
Overall Spain and Ireland are two countries where producer prices have risen most quickly but this
is not decisive evidence that they have become less competitive within the single currency area. The
gap with the other PIIGS countries is not huge. And we are not given any information on an index of
producer prices for the Euro Area as C L A

Figure 2.3: ECB Index of competitiveness based on relative unit labour costs for Ireland, Italy,
Greece and Spain 1999-2009 (1999 Q1 = 100)
Competitiveness figures prominently in the F585 stimulus material for the June 2011 paper and Fig
2.3 is an important part of this.

What data is the chart showing?
The data in Fig 2.3 shows an index of relative unit labour costs for Ireland, Italy, Greece and Spain
over a period from 1999 through to the end of 2009.
What are unit labour costs?
Unit labour costs are labour costs per unit of production. Two factors determine changes in this
measure
1. The rate of increase in average wages / earnings in the labour market
2. The rate of increase in labour productivity (i.e. output per worker employed)
Say for example that, in a given year, wages rise by 5% and there is also a 2% improvement in
productivity this implies that unit labour costs will rise by 3%.
What are relative unit labour costs?
These are labour costs relative to those of another country (e.g. comparing German labour costs
with those of Ireland) and they are usually expressed in a common currency. This means that
changes in the exchange rate can bring about a change in relative unit labour costs for example a

depreciation of the pound (sterling) against the Euro can lead to UK relative labour costs appearing
cheaper than they were.
Inside a single currency area the option of a depreciation / devaluation of the exchange rate are not
open to member nations. A rise in relative unit labour costs is taken as an indicator of a worsening of
cost competitiveness within the Euro Area.
What is the data showing?
The data covers four countries (Portugal not included although it was in Fig 2.2)
Over the eleven years since the launch of the Euro (1999-2009)
x Irish relative unit labour costs have increased by 27% - but significantly there was a 32% rise
from 2003 through to the middle of 2008 this was the period when the Irish economy
became notably less competitive (in purely cost terms)
x Spanish relative unit labour costs have grown by 13% - there was a 14% rise between 2002
and 2008
x Greece relative unit labour costs have risen by 15% but since the start of 2002 there has
been a 32% growth in this measure
x Italy relative unit labour costs have edged higher by 12%
Relative unit labour costs were falling for the first two L -2000. In
part this was because the external value of the Euro was depreciating against currencies such as the
US dollar and the pound (sterling).
Is this change in the data significant?
Yes! Fig 2.3 reveals an important change in relative costs within the single currency area. The four
countries chosen have seen their unit costs rise and assuming this has been translated into higher
prices this implies that they have lost some cost and price competitiveness. Depending in part on
the price elasticity of demand for different goods and services, a rise in the relative cost / price of
output will lead to a substitution effect away from producers in PIIGS economies and we might see
this in a change in the balance of trade in goods and services. Countries such as Spain and Greece
saw a sizeable increase in the size of their trade deficits in the years before the global financial crisis.
Limitations of the data given in the extract
We are not given any information on what has happened to relative unit labour costs for other
nations within the Euro Area. It would have been preferable to see the path of relative costs for the
leading economy Germany a country that has experienced supply-side reforms (notably in the
former East Germany) with the result that relative unit labour costs have actually fallen.
It would also be helpful to have some data on the trade balances for the PIIGS countries to see if
their above average growth, higher relative inflation and worsening competitiveness has shown
through in a widening of their trade or current account deficits on the balance of payments. I have
provided this data below for Spain and we can see from the next chart how the current account
deficit for Spain measured as a share of GDP grew from 4% in 2002 to more than 10% in 2008.

Spanish economy current account of the balance of payments (source: Timetric)
Has the recession affected relative unit labour costs?
The data in Fig 2.3 takes us up to the end of 2009 and we can see some of the effects of the
recession on unit labour costs. Relative unit labour costs have dipped for Spain and Ireland but not
for Greece whose data appears to show a continuing rise in relative costs the index based to the
start of 1999 actually overtakes Spain and Italy in the 2
nd
and 3
rd
quarter of 2009.
Relative unit labour costs will fall when:
1. There is a fall in average wages / earnings in the labour market. One feature of the
recession has been pressure for hundreds of thousands of workers to accept either a pay
freeze (meaning a real pay cut) or an actual cut in their wages and take home pay
2. An improvement in productivity businesses have been challenged by the recession to
streamline their production and find ways to improve labour efficiency


Extract3:ThefutureoftheSpanisheconomy

Extract 3 focuses on Spain Ls biggest economies (until recently it was the 9
th
largest
in the world but the recession has caused them to drop to 12
th
in the global league table). Spain
makes up 8.5% of the EU GDP so developments in Spain have a sizeable bearing on the economic
health of the Euro Area as a whole and also the UK the UK is the second largest foreign investor in
Spain and there are around 700 British companies based in the country. There are around 387,000
British people permanently residing in Spain.
Spain Macro Indicators 2007 2008 2009 2010 2011

Real GDP (% change) 3.6 0.9 -3.7 -0.2 0.9
Consumer spending (% change) 3.7 -0.6 -4.2 1.5 1.7
Capital investment (% change) 4.5 -4.8 -16.0 -6.8 -1.8
Exports (% change) 6.7 -1.1 -11.6 9.2 8.1
Imports (% change) 8.0 -5.3 -17.8 6.4 5.8
Unemployment rate (% of the labour force) 8.3 11.3 18.0 19.8 19.1
Fiscal balance (% of GDP) 1.9 -4.2 -11.1 -9.2 -6.3
Official policy interest rates (per cent) 4.3 4.6 1.2 0.8 1.1
Consumer price inflation (per cent) 2.8 4.1 -0.2 1.5 0.9
Balance of Payments Current Account (% of GDP) -10.0 -9.7 -5.5 -5.5 -5.2

The Future of the Spanish Economy
Up until the end of 2009, the ^'W (4.71% from peak to trough) was less than the
average of that in the euro area as a whole (see Fig. 1.1).
Yet RR de Acua & D^dependence on the
construction industry might mean that it would not recover from recession with the rest of the euro
area economies and that, peak to trough, the decline in GDP might be as much as 11%.

They suggested that an economic recovery ^
unemployment rate could rise to 25%.

The Spanish economic cycle (source: Timetric)

Unemployment in Spain, measured as a % of the labour force (source: Timetric)
Our supporting charts reinforce the extract in showing the recession in Spain and what appears to be
a shallow and fragile economic recovery. Unemployment rose from 8% of the labour force in 2008 to
peak (for now) at just over 20% - less than the 25% mentioned in the extract. But keep in mind that
official figures for unemployment nearly always understate the true level of unemployment.

A housing bubble in Spain increased construction from 7.5% to 10.8% of GDP (2000-2006), but the
Spanish building boom has come to a spectacular end - since the market's peak in April 2007, home
prices have tumbled 24 per cent and nearly 750,000 homes remain unsold or not completed.
The importance of Construction
The extract makes clear reference to the dependence of the Spanish economy of the construction
industry. The building industry takes up a large percentage of GDP and millions of jobs depend
directly or indirectly on it from construction firms, building supply industries, estate agents,
architects and other occupations connected to the property sector. On some estimates around 15%
of Spanish GDP is created from the construction industry and more than one worker in ten has a job
in the building industry.
There is no doubt that the Spanish property and construction sector has taken a big hit during the
recession. Many building projects remain half finished either because the supply of finance has
dried up or because property developers suffered a steep loss of confidence as buyer-demand
dropped away. Refinancing loans to finish construction projects became both difficult and expensive.
This section of the extract is an opportunity to bring in a discussion of negative accelerator and
negative multiplier effects:
x Negative accelerator effects: This is when there is a collapse in investment demand because
of a decline in final demand for a product in this case new housing (including off-plan
buildings)
x Negative multiplier effects: This happens when a fall in investment spending brings about a
multiplied final decrease in equilibrium national income and jobs. The multiplier effects of a
deep recession in the Spanish housing / construction industry have been large. The industry
is labour intensive and so the domestic labour market feels the effect of both of contraction
in employment and cuts in nominal and real wages.

Dependence on tourism and property highlights the risks of an unbalanced economy and Spain
provides a good example of this. There is much talk of trying to bring about a balanced recovery in
European countries. This is much talk about the need for a balanced recovery one where
consumers and the government sector spend proportionately less (as a share of GDP) and exports
and investment grow in their place.
Quite how Spain will achieve this is open to question! The extract does not say which policies the
Spanish socialist government under Prime Minister Jose Luis Rodriguez Zapatero has introduced (if
at all) to provide economic support for the struggling construction sector.
Spain has one of the most generous welfare systems in the euro area. Typically, a worker made
unemployed in Spain will receive up to 60% of their previous wage for 18 months after losing their
job. Fearing the social consequences of rising unemployment, the Spanish government introduced
for the long-term unemployed. This alone added 3% of GDP
budget deficit.
This next section is about the possible connection between the generosity of welfare benefits and
the rate of unemployment. The important concept to explain here is that of the replacement ratio
i.e. the ratio of income out of work to income when in a job. The extract mentions that workers can
receive close to two thirds of the wage from their previous job for an extended period (18 months).
x What might this do for the incentives to actively search for work?
x Does this mean that there is a higher level of voluntary unemployment in Spain?
x Does Spain therefore have higher frictional unemployment and a higher natural rate of
unemployment?
x What options does the Spanish government have to change this? Will sufficient people vote
for a government that plans (voluntarily) to change employment laws including reducing the
scale of out-of-work benefits?
Social consequences of rising unemployment
Unemployment in Spain is high perhaps the highest in the whole of the European Union and
much of it is long-term. Spain in particular has a high level of long-term youth employment where
people have been out of work for at least one year. It is difficult to achieve a sustained reduction in
long term unemployment rates think about why this is so:
The extract asks us to think about the social consequences of high jobless rates:
1. Unemployment increases relative poverty especially in regions and for families where there
is no one of working age in a job
2. It can lead to social unrest and a loss of social cohesion damaging the fabric of society
3. There is a possible rise in unemployment-related crime
4. Increased incidence of stress related health problems and family breakdown
5. The social costs of rising level of debt many of the poorest families with poor employment
prospects can fall into a spiral of debt, paying huge annual rates of interest on unsecured
loans

In other words persistently high unemployment is a failure of the labour market and creates
important and costly negative externalities.

The next section of the extract deals with the fiscal costs of the recession in Spain
Combined with a reduction in tax receipts, the budget deficit in Spain has required big cuts in
discretionary spending and has limited the ability of the Spanish government to continue to use
fiscal policy to prevent aggregate demand falling further.
Discretionary spending is that spending that is not determined by the stage of the economic cycle
and which a government has some degree of control. This is different from automatic changes in
government spending that arise as the economy moves from boom to slowdown to recession. In the
case of Spain, the relatively large welfare state and big public sector as a share of total GDP has
meant that the automatic stabilisers have helped to mitigate the impact of the recession on her
GDP. This links back to the top of Extract C which claims that the drop in Spanish GDP has been less
than for the Euro Area as a whole. This has been useful in preventing a depression but it has left
Spain (along with other PIIGS countries) with a huge fiscal deficit to contend with.


Real house prices i.e. nominal house prices adjusted for inflation (source: Timetric)
The Spanish government has had to introduce a period of fiscal austerity in a bid to reduce the size
of their budget deficit. The official retirement age has risen to 67 from 65 and the government has
cut government spending, including across-the-board public servant wage cuts and frozen welfare
payments from pensions to child support. It is also aiming to introduce labour market reforms that
make it easier to lay off employees and reduce redundancy packages.
Unlike the first decade of its membership of the euro area, Spain cannot expect the ECB interest rate
to boost economic growth. With high inflation for much of the last decade, real interest rates in
^^'W/
years, Spain must turn its attention to improving its long-run growth potential as emphasised not
only by research groups such as RR de Acua & Asociados but also by the IMF.
As part of its role, the IMF holds discussions with members every year. A team from the IMF visits the
country, collects economic and financial information,
economic developments and policies before preparing a report. Fig. 3.1 summarises key aspects of
the report published by the IMF on the Spanish economy in March 2009.
Key aspects of a report published by the IMF on the Spanish economy in March 2009
Despite the economic slowdown, wage and unit-labour costs are outpacing those in other euro area
countries and inflation remains structurally above the euro area average. This reflects a lack of
competition and contestability in output markets, inefficient labour markets, and relatively low
productivity. Spain must introduce policies to improve its international competitiveness. Plans for
product market reforms also need to be implemented.
Some of this extract repeats what has already been said namely that the Spanish economy enjoyed
a period of strong growth during the early years of their membership of the Euro (propelled in part
by strong inward investment and a period of low interest rates) but at a cost of relatively high
inflation and a boom in borrowing and credit that came unstuck in 2008-09.

This reflects a lack of competition and contestability in output markets, inefficient labour markets,
and relatively low productivity. Spain must introduce policies to improve its international
competitiveness. Plans for product market reforms also need to be implemented.
Competition and contestability
Make sure you understand some of the features and characteristics of a contestable market:
1. Low entry barriers and exit costs which affects the ease of short-
2. High levels of product differentiation between competing businesses and brands
3. The ability to price discriminate charging different prices to different consumers for the
same products
4. The cost structure of a market such that the minimum efficient scale is not a large
percentage of market demand allowing many firms to enter and be competitive
5. There is interdependence between firms (similar to a competitive oligopoly)
Barriers to market contestability exist when there are sunk costs. These are costs that have been
committed by a business cannot be recovered once a firm has entered the industry
Inefficient labour markets and relatively low productivity
What does this mean? In simple terms a labour
market that fails to match labour demand and
labour supply in ways that achieve desired
economic outcomes. The word inefficiency hints
strongly at a number of causes of labour market
failure some examples might include:
x Persistently high rates of structural
unemployment caused by occupational
and geographical immobility of labour.
This can show through for example in big
differences in regional unemployment
rates within a country.
x Workers in jobs for which they are not best suited for example a generation of graduate
students who find that many of the available jobs do not make use of their qualifications.
This is an example of allocative inefficiency in the labour market.
x Failures of the labour market to provide sufficient skills and training for people
x Disincentives to look for and take paid work a classic example of a labour market
inefficiency is the existence of the poverty trap or an unemployment trap where people feel
that there is little economic incentive to work extra hours or take a job

Employment rates in the Spanish economy (Source: Timetric)
An inefficient labour market finds it difficult to increase the percentage of the population of working
age into a full or a part-time job. Our chart above provides some data on employment rates for Spain
since the Euro was launched in 1999. Spain has made some progress in lifting employment both for
male and female workers but we can see the damage that the construction and tourism recession
has done to male employment rates a decade of increase has been wiped out in two years.
Note in the chart above that the employment rate among older workers has also started to decline
because of the recession.
The importance of labour market flexibility
We think a key word in this section of the extract is that of flexibility! In a rapidly-changing world
there needs to be a high level of adaptability as patterns of demand change bringing about changes
in the pattern of employment.
The IMF appears to be criticising inflexibilities and immobility in the Spanish labour market and
arguing for labour market reforms to boost the human capital of the workforce and the skills and
incentives of people joining the labour market for the first time.
Relatively low productivity
Productivity is a measure of how much is produced per unit of input. Labour productivity can be
calculated per worker, per hour worked, etc. The IMF claims that labour productivity is relatively low
in Spain. And we have provided some background on this below. Note how for a long time after
1999, the annual improvement in labour productivity in Spain has lagged the average increase
attained by the Euro Area as a whole. Indeed in a few years Spanish labour productivity actually fell!
There was a surge in output per worker employed in 2009 but this can be put down largely to the
savage job losses in construction and tourism which meant that the employed labour force fell by
more than output. There is some evidence here for Spain under-performing on labour productivity.
Consider which policies might raise labour efficiency in Spain in the years ahead.

Productivity growth in Spain and in the Euro Area (source: Timetric)
Spain must introduce policies to improve its international
There is a huge potential policy agenda here! Remember that competitiveness is partly a question of
price and cost but also (and perhaps more importantly in globalised markets), it is down to non-price
factors when battling for sales and market share in world trade.
Plans for product market reforms need to be implemented
Examples might include:

1. Reforms to competition policy i.e. tougher policies on cartels and collusion and
enforcement of competition policy rules
2. Liberalisation of markets to reduce monopoly power (e.g. in retailing and property) and
make markets more contestable
3. Reductions in red tape e.g. fewer rules and regulations for private sector businesses
4. Policies to improve incentives for business start-ups - new suppliers may have the
advantage of product innovation or a more competitive business model based on
different pricing strategies
5. Trade i.e. opening up the domestic market to greater international trade and inward
investment both to create more competition but also to raise productivity and
increase the productive capacity of the economy. Lower tariffs and quotas also have the
effect of reducing the cost of imported technology and other capital goods.
The IMF agenda
The prescription that the IMF is proposing for Spain is not unusual! The International Monetary Fund
has long preached increased competition allied to fiscal discipline as a recipe for economic reform.


Extract4:Internationaltrade,internationaltradenegotiationsand
developingeconomies

Trade, Economic Recovery and Development
Having spent the bulk of the stimulus material focusing on the recession in Europe, Extract 4 changes
the focus away from the macroeconomic difficulties facing the PIIGS group of countries towards the
broader issues of how best to sustain a recovery in world trade in goods and services.
The focus of the extract is an edit of a speech given by the Director General of the World Trade
Organisation a body given the task of policing trade around the world economy and promoting
liberalisation of trade between nations and regions. One would expect the Director General to be in
strong support of measures designed to reduce protectionist measures and stimulate trade flows.
This shows through clearly in his comments.
Background: Turbulence in the World Economy 2007-2010
Much of the important background to extract is key developments in the global economy during the
remarkable period from 2007 onwards.

2007 2008 2009 2010
Real GDP (% change)
World 3.6 1.3 -2.2 3.5
Emerging Economies 7.9 5.6 1.9 7.2
Latin America 5.0 3.4 -3.4 6.0
USA 1.9 0.0 -2.6 3.7

World Trade (% change) 8.4 3.7 -12.5 12.5

World Capital Investment Spending (% change) 7.1 3.6 -3.2 9.9
Developed (advanced nations) 1.5 -3.1 -14.0 1.9
Emerging Economies 19.5 16.1 13.8 19.5
Source: HSBC Global Economic Outlook

It is rare for global GDP to decline in real terms but it did so in 2009 by over 2 per cent. Crucial to
many of the issues raised in this case study is that world trade also shrank for the first time in nearly
twenty years and it did so spectacularly by over 12 per cent. There was also a collapse in
manufacturing production
capital investment spending among developed economies.
But many emerging economies continued to grow during the Global Financial Crisis and in its
aftermath. These countries are now the biggest drivers of demand growth in the world economy
leading to huge shifts in power and influence in the global economic and financial system.

Here is the main body of Extract 4 together with our commentary and analysis:
Concerns about the impact of the global economic recession are not confined to members of the
euro area. Pascal Lamy, Director-General of the World Trade Organisation (WTO), emphasised the
importance of international trade in his speech to the European Policy Centre in Brussels on 24
February 2010. The role of the WTO is to promote international trade and ensure that trade flows
smoothly, freely, fairly and predictably. Pascal Lamy concluded his speech by stating that there was
Doha Round of international trade negotiations.
Fig. 4.1 below reproduces excerpt from his speech.
Further background on the Doha Round can be found here:
http://en.wikipedia.org/wiki/Doha_Development_Round
Fig. 4.1
Excerpts from a speech by Pascal Lamy, European Policy Centre in Brussels on 24 February 2010
These are not easy times. We know that in 2009, growth of real world GDP was negative, estimated
at 2.2%. Furthermore, the global unemployment rate reached its highest level ever. The adverse
impact of the recent financial crisis on the world economy in terms of output and employment is
undeniable.
World trade has also been a casualty of this crisis, contracting in volume terms by around 12% in
2009 the sharpest decline since the end of the Second World War. The main explanation for this
freefall in trade has been the simultaneous reduction in aggregate demand across all major world
economies.
To a lesser degree, trade has been adversely affected by some instances of increased tariffs and
domestic subsidies, new non-tariff measures and more anti-dumping actions
This section concerns the sharp fall in the real value of world trade (i.e. in volume terms) in the wake
of the global financial crisis and the world recession in 2008-09. A contraction in global output of 2%
was accompanied by a 12% decline in the value of international trade. This is known as de-
globalisation. See the supporting data in the chart below.

The steep fall in the value of global trade is also shown below by the drop in the value of
merchandise trade measured as a percentage of global GDP. This was a sudden reversal of a long-
term increase in global exchange of goods and services growing from 20% of world GDP in 1970 to
over 50% in 2007.

Several factors have combined to cause the slump in trade:
a. A freezing of trade credit many export dependent businesses and countries found it
difficult to get the finance necessary to pay for making and then transporting products
to overseas markets
b. The dominance of manufactured products in global exchange: The percentage of world
trade now accounted for by manufactured durable products has grown over the years
but in the international downturn this is where cancelled orders were concentrated.

Exporting countries such as Germany and Japan suffered most from the collapse in
demand. There was also a slowdown in the growth of manufactured exports from China
c. Export quotas: Some food-producing countries took steps to limit food exports in the
aftermath of rising world foodstuff prices. They wanted to make sure that there was
sufficient to eat at affordable prices for their own population first.
d. The vertical disintegration of global production a slump in demand for consumer
durable products and capital goods (e.g. new machinery and technology) hit supply-
chain industries across the world causing a steep decline in intra-industry trade
e. The rise of protectionism - in 2009 the World Trade Organisation warned of a return to
open and hidden forms of import controls by many countries struggling to cope with the
recession. This is referred to by Pascal Lamy in his speech when he mentions new non-
tariff measures and more anti-dumping actions.
Recap on protectionist policies
Protectionism represents any attempt by a government to impose restrictions on trade in goods and
services. The aim is to cushion domestic businesses and industries from overseas competition.
x Tariffs - a tariff is a tax that raises the price of imported products and causes a contraction in
domestic demand and an expansion in domestic supply.
x Quotas - quantitative limits on the level of imports allowed.
x Voluntary Export Restraint Arrangements where two countries make an agreement to
limit the volume of their exports to one another over an agreed period of time.
x Embargoes - a total ban on imported goods.
x Intellectual property laws (patents and copyrights).
x Preferential state procurement policies where a government favours local/domestic
producers when finalising contracts for state spending e.g. infrastructure projects
x Export subsidies - a payment to encourage domestic production by lowering their costs.
Subsidies in the form of soft-loans can
in overseas markets. Well known subsidies include Common Agricultural Policy in the EU, or
cotton subsidies for US farmers.
x Domestic subsidies government financial help for domestic businesses facing financial
problems e.g. subsidies for car manufacturers or loss-making airlines
x Import licensing - governments grants importers the license to import goods.
x Exchange controls - limiting foreign exchange that can move between countries.
x Financial protectionism for example when a national government instructs its banks to
give priority when making loans to domestic businesses. This form of protectionism seems to
be on the rise in the aftermath of the credit crunch.
x Murky or hidden protectionism - e.g. state measures that indirectly discriminate against
foreign workers, investors and traders. A government subsidy that is paid only when
consumers buy locally produced goods and services would count as an example.
x Competitive devaluations: Where a government intervenes in currency markets to keep the
foreign exchange rate of their currency artificially low. This has become more prominent in
recent years with some countries (notably Brazil) claiming that their economy has suffered
because of currency wars. The WTO is currently investigating this.

In most developed economies, including the EU, stimulus packages have been instrumental in
preventing further deterioration in output, while preparing the path to recovery. But the positive
impact of national stimulus packages is at best temporary and worries are mounting over the huge
budget deficits created by many governments. Economies urgently need other sources of growth.
This section links in to the issue of fiscal stimulus policies and the arguments relating to the high size
of fiscal deficits in many countries. For the OCR exam understand well how fiscal stimulus policies
can work in stabilising demand, output and jobs. (Keynesian economists support the active use of
fiscal policy to actively manage demand during a recession). But be prepared to evaluate the
possible effects of high budget deficits and rising levels of government debt.
European countries with a high level of state debt may be constrained in using fiscal policy to
manage demand and activity in their economy during a recession. Some of the risks of a high level of
debt are:
x Interest rates on bonds may have to rise to persuade investors to fund further new
borrowing. This will increase the cost of servicing debts and put pressure on how much
money is available for other important areas of government spending such as education
x Rising debt today may lead to higher taxes in the future and may crowd out consumer
spending and business investment. It also means that future generations of taxpayers
may face the largest burden of repaying the debt even though they were not responsible
x Possible future balance of payments problems by selling debt to overseas investors the
interest on the loans will leave an economy adding to the current account deficit
x When debt levels reach high levels there is an incentive for a government to reduce the real

This can lead to capital flight from a country and a run on the currency.
That said there are many economists who are less worried about the size of government debt. If a
country has access to lines of credit from both domestic and foreign sources, what is wrong with
extra borrowing? Especially if this helps to restore & stabilise aggregate demand at a time of
macroeconomic weakness

An example of a fiscal stimulus would be a social housing investment project

Why might the impact of a fiscal stimulus be largely temporary?
Much depends on what type of stimulus package is introduced for example:
x Temporary scrappage schemes such as for cars, boilers and other consumer durables
x Temporary cuts in direct or indirect taxation for example a reduction in VAT
x Temporary increases in state sector spending / financial support for jobs including labour
subsidies (the German government used such a scheme during the recession)
The temporary nature of a stimulus may refer to the weakening of the fiscal multiplier effect arising
from a stimulus from the government. The fiscal multiplier measures the final change in national
income that results from a deliberate change in either government spending and/or taxation.
Several factors affect the likely size of the fiscal multiplier effect:
1. Choice of stimulus: Tax cuts or higher government spending?
2. Taxes: Who are the beneficiaries of tax reductions? Tax cuts seem to have a bigger effect on
demand when targeted on lower income families with a high propensity to spending
3. Expectations of taxation in the future consumers may save temporary tax cuts because
they fear or expect a reversal of taxes later on in the business cycle
4. Availability of credit for businesses affected by fiscal stimulus policies can they raise the
necessary finance to allow them to expand production and take on extra workers?
5. Openness of the economy and the level of the exchange rate to what extent will a fiscal
stimulus lead to a rise in import demand with money leaving the circular flow?
6. Monetary policy response to a large rise in government borrowing will policy interest
rates rise in response to a higher budget deficit?
7. Amount of spare capacity in the economy (size of the output gap)
8. General level of consumer & business confidence / uncertainty sometimes known as the
state of animal spirits.
This is where trade can be an important part of the story, both in the short to medium-term and in
the long run. We must, therefore, ensure that trade remains open. But we must also work to keep
opening trade through the conclusion of the Doha Round. A Doha deal would provide new market
opportunities for developing economies, in particular, through the reduction of tariff barriers and
domestic subsidies.

When analysing a tariff or a domestic subsidy try to consider the direct and indirect effects on
consumers and producers. And also use economic welfare concepts such as consumer and producer
surplus
Allegations of dumping have been the most frequent cause of trade disputes in recent years. 88 of
the 104 anti-dumping cases taken to the World Trade Organisation in the second half of 2009 were
brought by developing countries against subsidised imports.
The standard effects of a tariff can be shown in this diagram:

The Doha Round of international trade negotiations was started in 2001. The last talks in Geneva in
2008 collapsed as China, India, the USA and the EU could not agree on import rules. The main issue
surrounded agricultural trade and rules which allow countries to protect poor farmers through
tariffs in the event of falling prices.
The Doha Round of trade talks has tried to ensure that developing countries benefit more from freer
trade. But talks have repeatedly collapsed because of a failure of developed and developing countries
K
economies such as the USA and the EU want their producers to be able to gain greater access to fast-
growing markets such as China and India. On the other hand, developing countries want to be able to
gain greater access to markets for agricultural products in the USA and the EU. So far, agreement
between the developed and developing countries has been illusive
This section is about the perennial disputes between countries about unfair trade practices and in
particular barriers to access to consumer markets for developing countries wanting to use exports
as a growth and development strategy.
Price
Output (Q)
Domestic Demand
Domestic Supply
World Price
Qd Qs
Pw
Pw + Tariff
Qd2 Qs2
Revenue from Tariff
M
Pw + T
Deadweight loss of
economic welfare from
the tariff

Data from the World Bank Development Report on average tariffs on manufactured & primary products
Over the years average tariffs and other import controls have declined, with progress especially
marked in developing Asia and in Eastern Europe after the break-up of the Soviet Union. But the
recent breakdown of the Doha trade talks has dashed hopes of a globally based multi-lateral
reduction in import tariffs and other forms of protectionism. In its place there has been a flurry of bi-
lateral trade deals between countries and the emergence of regional trading blocs.
Trade and economic growth
Lamy is arguing for greater openness and continued efforts to broker trade agreements between
countries. Here are some of the arguments for increased trade and competition between nations
and the link with long-term economic growth:
a. Trade enhances the division of labour as countries specialise in areas of
comparative advantage.
b. Deeper relationships between markets across borders enable producers and
consumers to reap the full benefits of economies of scale.
c. Competitive markets reduce monopoly profit margins and provide incentives for
businesses to seek cost-reducing innovations and improvements in their products.
d. The combined effects of these gains in efficiency should be over time an
improvement in growth and higher per capita incomes. The OECD Growth Project
found that a 10 percentage-point increase in trade exposure was associated with a
4% rise in income per capita. But these gains represent an average we must also
consider the distributional consequences of rising incomes.


Suggestedexam-stylequestions

1. The exam paper last two hours and that there are sixty marks available.
2. You have approximately 2 minutes per mark but keep in mind that the higher marks are

3. You may also be eligible to receive extra time in the exam
4. All questions are compulsory
Here is the mark allocation for individual questions on the paper
x 1 (a) 4 marks
x 1 (b) 6 marks
x 1 (c) 10 marks
x 2 (a) 4 marks
x 2 (b) 6 marks
x 2 (c) 10 marks
x 3 20 marks
Suggested questions for 1 (a)
1. Describe was is meant by a reserve currency (4)
2. Describe what is meant by (4)
3. u loose monetary policy
4. Describe what is meant by a recession (4)
5. Describe what is meant by a - (4)
6. Describe what is meant by a contestable market (4)
7. Describe what is meant by a double-dip recession (4)
8. Describe what is meant by a fiscal stimulus (4)
9. Describe what is meant by a non-tariff barrier (4)
10. Describe what is meant by a soft currency (4)
11. Describe what is meant by an open economy (4)
12. Describe what is meant by convergent economic cycles (4)
13. Describe what is meant by domestic subsidies (4)
14. Describe what is meant by economic growth (4)
15. Describe what is meant by economic performance (4)
16. Describe what is meant by foreign direct investment (4)
17. Describe what is meant by free trade (4)
18. Describe what is meant by import tariff (4)
19. Describe what is meant by international competitiveness (4)
20. Describe what is meant by long-term unemployment (4)
21. Describe what is meant by monetary union (4)
22. Describe what is meant by purchasing power parity(4)
23. Describe what is meant by real interest rates (4)
24. Describe what is meant by the multiplier effect (4)

25. Describe what is meant by trade liberalisation (4)
26. Describe the consequences of a period of negative economic growth experienced by one of
the PIIGS countries in 2008-09 (4)
27. For two countries shown in Fig 1.1, describe changes in real GDP over the period shown
using your knowledge of the economic cycle (4)
28. Distinguish between an open and a closed economy (4)
29. Distinguish between the economic costs and the social costs of high unemployment (4)
30. Distinguish between a fixed and a floating exchange rate (4)
31. Distinguish between human development and poverty reduction (4)
32. Distinguish between a budget deficit and the national debt (4)
33. Distinguish between nominal and real interest rates (4)
34. Distinguish between monetary convergence and real convergence (4)
35. Distinguish between a contestable and a perfectly competitive market (4)
36. Distinguish between structural and cyclical unemployment (4)
37. Distinguish between an economic slowdown and an economic recession (4)
38. Distinguish between discretionary government spending and automatic stabilisers (4)
Suggested questions for 1 (b)
1. Analyse the multiplier effects that may occur when there is a fall in one or more of the
components of aggregate demand (6)
2. Analyse how a decision by the European Central Bank to lower interest rates can affect an
economy such as Ireland (6)
3. Analyse how relative unit labour costs may increase in one or more of the PIIGS countries (6)
4. Fig 1.1 shows that real GDP in Ireland and Slovenia has fallen by more than 10% from peak
to trough. Analyse how this fall in GDP will affect inflationary pressures in these countries (6)
5. Analyse how recession in Euro Area countries has led to a big rise in their budget deficits (6)
6. Analyse the policies that might increase potential economic growth in a country (6)
7. Analyse the methods by which Euro Area countries can bring government borrowing under
control (6)
8. 1 for this freefall in (global) trade has been the simultaneous reduction
A
aggregate demand has led to a 12% contraction in global trade (6)
9. l
st
quarter of 2009 that all Euro Area economies were experiencing
Cu A L A
as Spain (6 marks)
10. S A
such a high rate of unemployment (6)
11. L l - Analyse the
reasons for this forecast. (6)
12. Analyse the benefits of having a fixed rather than a floating exchange rate (6)
13. Analyse the impact on economies such as Portugal, Italy, Ireland, Greece and Spain of a
decision by the ECB to intervene to cause a depreciation in the external value of the Euro (6)
14. Analyse some of the benefits of free trade between nations (6)

Suggested questions for 1 (c)
1. C
L
2. C S
to a delayed economic recovery (10)
3. Comment on the extent to which a generous welfare system in Spain may affect the rate of
unemployment in this economy (10)
4. Comment on the effectiveness of fiscal stimulus policies in helping to reduce the depth of
the recession in Euro Area countries (10)
5. Comment on how a high rate of inflation affects competitiveness of a country inside a
currency union (10)
6. C l
creates macro-economic problems (10)
7. Comment on whether EU countries have made the right decision in choosing to break their
fiscal rules during this recession? (10)
8. Comment on the limitations of a policy of the European Central Bank maintaining a policy of
low interest rates as a way of helping the EU economy during a recession (10)
Suggested questions for 2 (a)
1. Explain the role of the International Monetary Fund (IMF) (4)
2. Explain the role of the European Central Bank (ECB) (4)
3. Explain the aims of the Doha Round of international trade negotiations (4)
4. Explain two different methods of protectionism (4)
5. Explain two supply-side policies to increase the labour supply (4)
6. Explain the aims of a fiscal stimulus (4)
Suggested questions for 2 (b)
1. Using a diagram, analyse the causes of a rise in producer prices in one of the Euro Area
countries (6)
2. L L l l C
S S u
diagram, analyse the causes of inflation mentioned in this passage (6)
3. l S -run growth
u
effects of successful policies to improve long-run growth (6)
4. Using a diagram, analyse the effects of the European Union lowering their import tariff on
food imports from developing countries (6)
5. Using a diagram, analyse the effect of a developed country introducing a domestic subsidy
to one of the producers (6)
6. Using a diagram, analyse some of the potential gains from international trade (6)
7. Using an aggregate demand and supply diagram, analyse the likely effects of successful
policies to increase economic growth (6)

Suggested questions for 2 (c)
1. Comment on the extent to which a fixed exchange rate rather than a floating exchange rate
is a stimulus to inflows of foreign direct investment (Extract 2) (10)
2. Comment on the effectiveness of a government cutting taxes as a fiscal stimulus to avoid or
reduce the effects of a recession (10)
3. Comment on the extent to which generous welfare systems are a cause of unemployment
(Extract C) (10)
4. Comment on the extent to which a depreciation or devaluation of an exchange rate is an
effective option for a country wishing to improve its international competitiveness (10)
5. Comment on the difficulties of the European Central Bank setting interest rates that are
optimal for any one country inside the single currency area? (10)
6. Comment on the extent to which a reduction in global trade barriers in manufacturing and
agricultural goods can help a developing country (10)
Suggested questions for 3
1. Discuss the extent to which international agreements to reduce trade barriers are a useful
way of stimulating economic growth in the short to medium-term and in the long-run (20)
2. Attempts to cut budget deficits and government debt in the early stages of a recovery may
damage a countr -run economic performance. Discuss (20)
3. S Assess the
policies that are likely to be effective in achieving this aim for the Spanish economy (20)
4. Discuss the extent to which the Euro Area is an optimal currency area and whether this
matters for the long-term viability of the currency union? (20)
5. To what extent is the European Central Bank right to continue to set interest rates to
maintain low inflation for the Euro Area as a whole? (20)
6. How far do you agree with the view that countries that are not economically convergent
should not be allowed inside the single currency area?
7. Despite the difficulties experienced by the PIIGS nations in recent years, the European single
currency area has been a success. Discuss (20)
8. If the UK had joined the euro, do you think the country would have fared better during the
recession? (20)
9. If Spain had its own currency, it could let the value of its currency fall to a level that would
make the country's tradable L S
economic performance would improve by a currency devaluation and leaving the Euro Area
(20)
10. 1 and other forms of protectionism risk a country sacrificing
medium-term growth opportunities for near- Do you agree? (20)

GlossaryofKeyTermsforF585TheGlobalEconomy
Here is a selection of terms that might be useful in preparing for this exam paper. Some are core to
the A2 macroeconomic syllabus and others are focused on the economics of the Euro in particular.
Term Description
AAA credit rating 1
bonds, effectively indicating that the risk of default is negligible
Beggar my Neighbour This is a policy that seeks to promote a country's economy at the expense
of another country. An obvious example is the use of tariff barriers. A
country may place tariff on imports to help promote local domestic
industry. This may help local unemployment, but, be at the expense of the
other country's export sector
Bond market The market in which longer-term debt securities are issued by companies
and governments and then traded
Brain drain The movement of highly skilled or professional people from their own
country to another country where they can earn more money
BRIC economies Brazil, Russia, India and China short hand for the rise of emerging markets
in the global economy. The BRICs have a bigger share of world trade than
the USA.
Bubble When the prices of securities or other assets rise so sharply and at such a
sustained rate that they exceed valuations justified by fundamentals,
making a collapse likely.
Budget deficit Occurs when government spending is greater than tax revenues
Capital flight The rapid movement of large sums of money out of a country per due to a
lack of confidence in a country's economy and/or its currency and political
turmoil
Catch-up effect When countries that start off poor grow more rapidly than countries that
start off rich. The result is convergence in per capita incomes
Clean float Exchange rate that varies (or floats) free from government intervention
Cohesion Fund Part of the budget of the European Union, given to relatively poorer
countries such as Spain and Greece and newer EU countries to help them
develop economically
Comparative
advantage
The relative advantage that one country has over another. Countries can
benefit from specializing in and exporting the product(s) with the lowest
opportunity cost of supply
Competitive
devaluation
When a country tries to devalue its currency to increase its
competitiveness. However, this often encourages other countries to also
devalue leading to only temporary increases in the competitiveness of
exports.
Currency union A group of countries (or regions) using a common currency for example
the 17 countries that have entered the single European currency
Current account
deficit
The amount by which money relating to trade, investment etc going out of
a country is more than the amount coming in. The current account is made
up of balances in trade in goods and services, net incomes from overseas
investments and net transfers. A current account deficit implies a net

Debt burden The amount of debt that a business or country has expressed as a % of GDP
Debt deflation High levels of debt leading to falling asset prices

Debt forgiveness The cancelling by a creditor of a debt to a country or a company
Deflation A persistent fall in the general price level of goods and services
Depression Used to describe a severe recession which may become a prolonged
downturn in the economy and where GDP falls by at least 10 per cent
Discouraged workers People often out of work for a long time who give up on job search
Discretionary fiscal
policy
Deliberate attempts to affect aggregate demand using changes in
government spending, direct and indirect taxation and borrowing.
Disequilibrium
unemployment
Disequilibrium unemployment comes about when the aggregate demand
for labour is less than the aggregate supply of labour at the current real
wage rate and market forces are failing to correct the problem
Double dip recession When an economy goes into recession twice without having undergone a
full recovery in between
Dumping When a producer in one country exports a product to another country at a
price which is either below the price it charges in its home market or is
below its costs of production
Economic nationalism The idea that a country's economy will perform best if its industries are
protected from competition, for example by taxes on imported goods
Economic shocks Unpredictable events such as volatile prices for oil, gas and foodstuffs.
Economic stability When the main indicators such as growth, prices and unemployment do not
change much from one year to another.
Economic structure The balance of output drawn from different economic sectors ranging
from primary (farming, fishing, mining etc) to secondary (manufacturing
and construction industries) to tertiary and quaternary sectors (tourism,
banking, software industries)
Emerging markets The financial markets of developing countries
ERM II ERM II is the exchange rate mechanism which provides the framework for
exchange rate policy cooperation between the euro area countries and the
non-euro area EU Member States. ERM II is a multilateral arrangement with
fixed, but adjustable, central rates and a standard fluctuation band of 15%.
Euro Single currency adopted by most member-countries of the European Union
European Central
Bank (ECB)
The central bank of the European Union based in Frankfurt, responsible for
setting interest rates, controlling the money supply etc of countries using
the Euro
European Economic
Area
An area in which goods and services can be traded freely, formed in 1993
by the countries of the European Union with Norway and Iceland.
Expansionary
monetary policy
A policy by monetary authorities to expand money supply and boost
economic activity, mainly by keeping interest rates low to encourage
borrowing by companies, individuals and banks
Expectations How we expect the future to unfold this can have powerful effects on the
spending decisions of households, businesses and the government
Fine-tuning Changes in monetary policy or fiscal policy designed to gradually manage
the level of aggregate demand and prices
Fiscal drag The tendency of income from taxation to rise when an economy is growing.
This helps to slow consumer spending and corporate activity, and thus acts

as a counterbalance to unrestrained growth
Fiscal stability Many governments seek to maintain a degree of balance between tax
revenues and public sector spending. The amount by which government
expenses exceed income is the fiscal deficit. If income exceeds spending,
the government has a budget or fiscal surplus. A balanced budget is one in
which spending equal revenue
Fiscal stimulus Government measures, normally involving increased public spending and
lower taxation, aimed at giving a positive jolt to economic activity
Fixed exchange rate An exchange rate that is fixed against other major currencies through action
by governments or central banks. Likely to involve periodic intervention in
the foreign exchange market by one or more central banks.
Floating exchange
rate
When a currency's exchange rate is allowed to move freely depending on
supply and demand in the foreign exchange market. There is no
intervention by a central bank in an attempt to manage or manipulate the
external value of one currency against another.
Foreign direct
investment
FDI is the acquisition of a controlling interest in productive operations
abroad by companies resident in the home economy. May involve the
creation of new productive capacity such as a new factory
Foreign exchange
reserves
The reserves of gold or foreign currencies (e.g. US dollars or Euros) typically
held by central banks on behalf of their national government
Free trade International trade unhampered by government-imposed constraints, such
as tariffs, quotas, restrictions on foreign ownership, and other barriers.
Full capacity output A level of national output where all available factor inputs are fully
employed this is a factor influencing the underlying growth rate
Full employment When there enough job vacancies for all the unemployed to take work
Globalisation The deepening of relationships between countries of the world reflected in
an increasing level of overseas trade and investment.
Government debt The amount of money a country owes to lenders. Governments usually
borrow by issuing government bonds which are bought by financial
institutions
Hard landing A full-scale recession shown by a decline in real national output
Hidden
unemployment
Unemployment which is known to exist but is not included in the official
government figures
Hot Money Money that flows freely and quickly around the world economy looking to
earn the best available rate of return. It might be invested in any asset
whose value is expected to rise (e.g. property or shares) or simply be placed
in an account offering the best real rate of interest.
Inflationary pressures This refers to the demand and supply-side pressures that can cause a rise in
the general price level. Demand-pull inflationary pressure is greatest when
actual GDP exceeds potential GDP causing a positive output gap. Cost-push
inflationary pressure can arise from increases in unit wage costs, rising
import prices and an increase in the prices of raw materials, fuel and
components used in production
Infrastructure The transport links, communications networks, sewage systems, energy
plants and other facilities essential for the efficient functioning of a country
and its economy
International The IMF is an organisation of 186 countries, promoting global monetary

Monetary Fund (IMF) cooperation, financial stability, international trade, employment and
sustainable economic growth.
Investment income Interest, profits and dividends from assets owned and located overseas.
J Curve Effect The effect of currency depreciation on the trade deficit depends on price
elasticity of demand for exports and imports. In the short term, demand is
often inelastic and the J Curve effect says a trade deficit can actually worsen
after depreciation, but get better in the medium term.
Job search The process by which workers find appropriate jobs given their tastes and
skills
Keynesian economics The economics of John Maynard Keynes. The belief that the state can
directly stimulate demand in a stagnating economy. For instance, by
borrowing money to spend on public works projects like roads, schools and
hospitals.
Labour shedding Cut backs in employment often seen in a slowdown or a recession
Lisbon Strategy A comprehensive agenda of structural reforms aimed at transforming the
EU into
-based economy in the
L L C
Macro stabilization
policies
A coordinated set or group of mostly restrictive fiscal and monetary policies
aimed at reducing inflation, cutting budget deficits, and improving the
balance of payments
Managed floating
currency
An exchange rate that is basically floating but subject to intervention from
time to time by the monetary authorities, in order to resist fluctuations that
they consider to be undesirable
Mercantilism The notion that the wealth of a nation was based on how much it could
export in excess of its imports, and thereby accumulate precious metals.
Applied in the modern context to countries accumulating huge trade
surpluses in goods or services and focusing on export-led growth
NAFTA North American Free Trade Agreement - a free trade area agreement
signed by the US, Canada and Mexico
NAIRU Non-accelerating inflation rate of unemployment: the number of people
without work that is necessary at a particular time in order to prevent
prices rising too fast.
National debt The total amount of debt that the government owes the private sector
Negative equity Negative equity occurs when the value of an asset falls below the
outstanding debt left to pay on that asset. Term is most commonly used in
connection with property prices and describes a situation where the market
value of a house is less than the existing mortgage debt.
Negative interest rate An interest rate that is below zero. For real interest rates, this can occur
when the inflation rate is higher than nominal interest rates.
Net investment Gross investment minus an estimate for capital depreciation
Net inward migration When the number of migrants coming into a country is greater than those
leaving in a given time period
Neutral interest rate A neutral interest rate is a rate of interest that neither deliberately seeks to

stimulate aggregate demand and growth, nor deliberately seeks to weaken
growth from its current level. In other words, a neutral rate of interest
would be that which is set at a level which encourages a rate of growth of
demand close to the estimated trend rate of growth of real GDP.
Non-inflationary
growth
Sustained growth of real national output whilst maintaining price stability
Open market
operations
Central bank intervention in money markets where it buys and sells
securities to control the money supply and the level of interest rates
Output gap The difference between actual and potential national output. A negative
output gap after a recession implies that an economy has a large margin of
spare productive capacity.
Overseas assets Assets such as businesses, shares, property which are owned in overseas
countries and which might generate a flow of investment income which is a
credit item on the current account of the balance of payments.
Paradox of thrift The basic concept is that if people save more in a recession, it will reduce
consumption and thus aggregate demand will fall, impeding economic
growth and, in fact, lowering the general level of savings
Phillips Curve A statistical relationship between unemployment and inflation
Policy asymmetry When a given change in interest rates affects different groups or different
countries to a lesser or greater degree
Potential output The economy's maximum productive capacity in a physical sense. The
largest output that could be produced, given the prevailing state of
technology, with all available labour, capital and land fully utilised.
Price stability Price stability occurs when there is low inflation and the price changes that
do occur have little impact on day-to-day decisions of people.
Productivity A measure of efficiency e.g. measured by output per person employed or
output per person-hour
Protectionism The use of tariff and non-tariff restrictions on imports to protect domestic
producers from foreign competition
Purchasing power
parity
Method of currency valuation based on the premise that two identical
goods in different countries should eventually cost the same.
Purchasing power
parity
Method of currency valuation based on the premise that two identical
goods in different countries should eventually cost the same. This is
illustrated by the Big Mac index.
Quantitative easing Central banks flood the economy with money by printing new notes, to
increase the supply of money. The idea is to add more money into the
system to avert deflation and encourage banks/people to borrow and
spend.
Quota A quota imposes a physical limit on the quantity of a good that can be
imported into a country in a given period of time.
Rational expectations Where decisions are based on current information and anticipated future
events
Real disposable Income after taxes and benefits, adjusted for the effects of inflation

income
Real interest rate The nominal rate of interest adjusted for inflation
Real wage The nominal wage adjusted for the effects of inflation
Regional Aid Money given by the EU to particular areas to help their economic
development e.g. money available from the European Regional
Development Fund
Relative deflation The
an inflation rate, which has not necessarily descended into negative
territory, but is markedly lower than comparable economies
Remittances Sending of money to people in another country for example migrant
workers sending some of their wages to their home country.
Reserve currency A foreign currency that is held in countries' official reserves because of its
global importance as a medium of exchange and its inherent stability
Ricardian equivalence The argument attributed to David Ricardo that government budget deficits
have no lasting effects on economic activity. Rational taxpayers are
supposed to anticipate that tax cuts today will mean tax increases in future,
and so save more when the government saves less.
Soft landing A slowdown in activity but which does not result in a recession
Sovereign wealth
fund (SWF)
A government or state run fund usually created by profits from natural
resources such as oil, gas or minerals. Highly secretive, their assets grew
dramatically when oil prices rose to record levels. Some of the largest SWFs
are in the oil-rich Middle East
Spare capacity When a business is not making full use of its available capacity there are
spare factors of production including land, labour and capital. When an
economy has plenty of spare capacity, short run aggregate supply tends to
be elastic.
Special drawing rights A unit of money created by the IMF. Each member country can borrow
SDRs at favourable interest rates from the IMF's reserves when they are
needed for reasons related to a country's balance of payments
Stability and growth
pact
EU's fiscal rule intended to maintain discipline in the public finances of Euro
Area member-states. The pact sets a limit for government budget deficits of
3 per cent of gross domestic product in normal times.
Structural funds EU funds (part of the Cohesion Budget) that aims to narrow economic
development disparities among EU regions and Member States
Tariff A tax on imported products which may be ad valorem (%) or a specific tax (a
set amount per unit imported).
Tight labour market When demand for labour is high and there are shortages of labour.
Businesses may have to offer higher wages to attract more workers
Time lags The time it takes for one change e.g. a change in interest rates to affect
other variables e.g. consumer confidence and spending
Toxic debt Loans that may not be repaid.
Trade-off Choices have to be made between different objectives of policy

Transmission
mechanism
How a change in interest rates affects sectors of the economy
Trend growth The long run average growth rate mainly determined by changes in the
stock of available factor inputs and also improvements in productivity
Under-employment When people want to work full time but find that they can only get part-
time work the result is a loss of hours that the economy can use
Unemployment trap When the prospect of the loss of unemployment benefits dissuades those
without work from taking a new job creates a disincentives problem
Unit wage costs Labour costs per unit of output
Unorthodox
monetary policy
Any policy undertaken, usually by central banks, that operates outside the
usual parameters for influencing either the price or the quantity of money
in an economy. this includes quantitative easing
Unsecured credit Credit not secured by another asset i.e. money borrowed on credit cards
Velocity of circulation The average number of times a unit of money changes hands in an
economy during a given period - normally measured by dividing the total
amount spent (GDP) by the amount of money available (money supply)
Wage price spiral A situation where workers bid for higher wages because they have seen
their real income eroded by rising prices. This can lead to a further burst of
cost-push inflation in an economy.
Wealth effect The supposed link between changes in wealth and household spending
World Bank Owned by 186 member countries, the World Bank is a source of financial
and technical assistance to developing countries. It normally targets public
works and other essential capital or social projects.
World Trade
Organisation
The WTO oversees trade agreements, negotiations and disputes between
member countries

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OCR F585 Global Economy June 2011 Toolkit

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OCR A2 Economics Unit F585 -

The Global Economy

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