Are economic recessions inevitable?A:
The popular sentiment of financial analysts and many economists is that recessions are the inevitable result of the business cycle in a capitalist economy. The empirical evidence, at least on the surface, appears to strongly back up this theory. Recessions are highly frequent in modern economies and, more specifically, they seem to follow periods of strong growth. Unfortunately, empirical consistency can never prove inevitability. The only way to logically prove the inevitability of a business cycle outcome is through logic and reasoning, not historical evidence.
Consider the following scenario: a six-sided die is rolled 24 times, never landing on the number four. Assuming away statistical probabilities, the empirical evidence would suggest it is not possible to end on the number four. Logically, though, there is nothing preventing the 25th roll from landing on four. That possible outcome is consistent with everything known about a six-sided die. In the same way, it does not make sense to say recessions are inevitable only because history is filled with previous recessions.
"Recession" is the title given to a an economic period marked by negative real growth, declining output, depressed prices and rising unemployment. These periods result from an unusual, simultaneous and large grouping of business errors, or malinvestments. Faced with financial loss and declining margins, businesses scale back production and reallocate resources from less valuable ends to toward more valuable ends.
Oftentimes, the malinvestments create an atmosphere of unhealthy speculation in the market. Overvalued assets attract more investors who are chasing unsustainable gains. Many assert that the tendency to speculate on unsustainable investments is the primary driving force behind recessions. They suggest these speculators are a necessary part of the capitalist market and, consequently, periodic recessions are inevitable. As John Maynard Keynes suggested, "human nature requires quick results, there is particular zest in making money quickly."
Logically, though, there are missing components to this explanation. What creates the initial malinvestment? Why do so many previously smart and successful entrepreneurs fall into the trap? And why are there periods of strong asset or sector growth that do not cause speculative bubbles?
Economics and Inevitability
There are very few certainties or axiomatic truths in economics. Economists assert that human beings interact with scarce resources to pursue purposeful ends. Economics can show that no voluntary trade takes place without both parties receiving an increase in value, subjective value, at least in the ex ante sense. Economics can even show that price controls lead to relative shortages or surpluses. However, economic logic does not show the inevitable result of aggregated individual trades leads to periods of declining real output.
Another way to look at this problem is to ask another question: "Is it possible to achieve eternal economic growth?" Conceptually, yes. It is possible, though unlikely, that technological or operational innovations occur at a rate consistent with continuous growth. It is also conceptually possible that economic actors consistently make correct entrepreneurial judgments, allocate resources effectively and maintain a level of constant or ever-increasing productivity. If it is conceptually possible to achieve permanent rates of growth, then it cannot be, by definition, inevitable for economic recessions to occur.
Are monopolies always bad?A:
Monopolies over a particular commodity, market or aspect of production are considered good or economically advisable in cases where free market competition would be economically inefficient, the price to consumers should be regulated, or high risk and high entry costs inhibit initial investment in a necessary sector. For example, a government may sanction or take partial ownership of a single supplier for a commodity in order to keep costs to consumers to a necessary minimum. Taking such actions is in the public interest if the good in question is relatively inelastic or necessary, that is, without substitutes. This is known as a legal monopoly or, a natural monopoly, where a single corporation can most efficiently carry the supply.Natural monopolies are often found in the market for public utilities, relatively high-cost sectors that deter capital investment. The government may then support the total market share of a single corporation in providing water, electricity or natural gas to its public. In doing so, both government regulation of the price of a necessary good and a continuous supply are guaranteed, with external competition curtailed by the formation of a monopoly.Two examples of government-sanctioned monopolies in the United States are the American Telephone and Telegraph Corporation (AT&T) and the United States Postal Service. Prior to its mandated breakup into six subsidiary corporations in 1982, AT&T was the sole supplier of U.S. telecommunications. Since 1970, the United States Postal Service has been the sole courier of standardized mail across the U.S.
Government-sanctioned monopolies need not always be for reasons of economic efficiency or consumer price protection, however. Nine of the 52 states of the union operate legal monopolies of hard-liquor sales.
Are perfect competition models in economics useful?A:
Perfect competition is the name used for a set of false assumptions of mainstream economists in models that, without those assumptions, could not be applied to real data. In effect, these models create the framework necessary to make economics a positive empirical science. Most assumptions are derived from generalizations about economic phenomena. The field of contemporary economics constantly revises and attempts to strengthen its models to better test economic hypotheses.
Professional economists obviously understand that these parameters are unrealistic and do not accurately represent real phenomena, but many contend that important observations can still be rendered from perfect competition models. Others argue that these models are too fundamentally flawed to produce useful information and are only capable of testing theories that reinforce the nature of the model in the first place.
Arguments in Favor of Perfect Competition Models
Perfect competition models are used in microeconomics to explain and predict the actions of individual actors. To isolate specific variables and quantify their impacts, certain other problematic realities must be assumed away. These include barriers to entry; sticky prices; the role of entrepreneurs; heterogeneous and substitute goods; and imperfect information. The proponents of macroeconomic modeling believe these parameters are acceptable as long as economic modeling produces meaningful results.
Milton Friedman, founder of the Monetarist school and strong advocate of methodological positivism, stated that "complete 'realism' is clearly unattainable" and models must "yield predictions that are good enough for the purpose in hand or that are better than predictions from alternative theories." In other words, economics never has perfect testability and economists should look for the most accurate theories.
Economic author Donald Stengel argued that perfect competition described a desirable end, one that public policymakers and business managers could use to make economic decisions. In a book titled "The Principles of Managerial Economics," Stengel described how perfect competition models could highlight possible surpluses and deadweight losses to improve efficiency.
Arguments Against Perfect Competition Models
Despite its current orthodox status, many economists have criticized the use of perfect competition models. Critics claim the assumptions remove crucial characteristics of real markets and when those assumptions are dropped, the models no longer yield meaningful results.
F.A. Hayek, who was not entirely opposed to the use of empirical models in economics, said the theory of pure, or perfect, competition had "no claim to be called 'competition'" because the normal devices of competition are incompatible with the model. These include advertising, undercutting, or offering different products and services.
Economist Walter Block argues that perfect competition produces unrealistic and otherwise impossible results that are nevertheless used to justify irresponsible government policy. He points to antitrust legislation, which uses perfect competition as the benchmark for identifying so-called "market failures."
Hayek also considered perfect competition to be tautological. As he stated in "Individualism and Economic Order," perfect competition "confines itself to defining conditions in which its conclusions are already implicitly contained and which may conceivably exist but of which it does not tell us how they can ever be brought about."
Are there any exceptions to the law of demand in economics?A:
There are different definitions of the law of demand in economics. The most common definition, which is adapted to fit macroeconomic models, shows an inverse correlation between the price and quantity demanded of a good. There are some real-world exceptions to the model-based definition, but these same exceptions do not apply to the more specific, logically deductive law of demand.
Exceptions to the Law of Demand Model
The basic supply and demand chart in microeconomics shows price on the vertical axis, quantity demanded on the horizontal axis and a downward sloping demand curve. The supply curve is upward sloping and intersects the demand curve at equilibrium. However, not all markets fit this model in reality. Some goods see demand rise and fall with the price in a positively correlated relationship. This normally occurs with goods that have no close substitutes. Economists call some of these Giffen goods and others Veblen goods.
Giffen goods imply an upward sloping demand curve in a model. Historically, economists have only been able to point to one or two instances of goods that behaved like Giffen goods, such as rice in certain provinces in China or potatoes in 19th-century Ireland. Even these are considered controversial.
Most colloquial examples of Giffen goods are actually Veblen goods, which result from changes in consumer taste. Veblen goods actually have downward-sloping demand curves; the demand curve shifts to the right. Not all economists define this as a violation of the law of demand, however.
Deductive Law of Demand
The more expansive version of the law of demand cannot be plotted on a microeconomics price chart. There are no exceptions to this law of demand; its rules follow from syllogisms, or deductive logic, based on human action. A simplified description of this law is: as the true cost of acquiring a good increases, consumers tend to purchase less of it than they would have otherwise purchased.
The true cost of acquiring a good includes the opportunity cost. Even if the demand of a good, such as gold, increases as cost increases, its relative opportunity cost actually decreases.
Are there critics of the human development index (HDI)?A:
The human development index (HDI) assigns numerical values to different countries as a measure of human prosperity. These values are derived using measures of health, education, standard of living and life expectancy. Countries with higher scores on the index are said to be better developed than those with lower scores. The system is designed to be used to help determine strategies for improving living conditions for people around the world. However, some critics argue that these measures are flawed and do not create an accurate picture of prosperity.
HDI assigns weight to certain factors that are more common in developed economies but may not indicate a higher level of success or human happiness. Some critics challenge the inclusion of education in the calculation. High levels of education, while valuable for many pursuits, may not be necessarily be a clear indicator of prosperity. Countries with high per-capita gross domestic product (GDP) and long life spans would not necessarily achieve high HDI index scores if their overall literacy rate and educational attainment were low. The index assigns equal weight to education, health and wealth when these measurements may not always be equally valuable. The HDI assigns a lesser weight to GDP, although a nation's overall production may have a substantial impact on prosperity for many people.
The index is designed to consider other factors besides wealth, allowing a multifaceted examination of global prosperity and emerging market nations. The weaknesses of this measurement lead some critics to challenge its practicality for use in establishing foreign policy. Other factors that influence prosperity may not be sufficiently captured by this measurement.
Can Internet companies be vertically integrated?A:
Internet companies can be vertically integrated, just as traditional businesses vertically integrate to consolidate costs and to expand corporate reach in the market.
Vertical integration occurs when a merchant or business begins to absorb the various levels above and below it in the distribution chain. The benefit for the business is a potential reduction in transactional costs and the ability to control production more directly.
For example, say a small clothing designer has vertically consolidated by purchasing a small boutique for selling his or her clothes. The designer then creates a website where he or she can immediately place clothes that go on sale. Additionally, the designer can market through his or her own website and social media accounts. In this way, overhead costs such as marketing or paying a Web designer to maintain a site are minimized.
Perhaps one of the best examples of emerging vertical integration on the Internet is retail giant Amazon. Amazon's competitors include online and traditional brick-and-mortar retailers. However, Amazon has managed to emerge as a dominant seller in many areas, such as video streaming and traditional retail items, such as clothing. Constantly seeking to integrate, Amazon has experimented with drones for delivering packages, which would eliminate reliance on delivery companies such as FedEx or UPS. This is particularly important for Amazon, which promises free two-day delivery for its Prime members.
Challenges for Internet Integration
In 2012, Nathan Wilson used gas stations as a case study on vertical integration in a paper for the Federal Trade Commission (FTC). While vertical integration offered benefits for a company, Wilson found that it ultimately also resulted in higher prices. One reason was an intentional effort by a company to increase demand for its product, according to Wilson.
Can state and local governments in the US run fiscal deficits?A:
There is nothing about the nature of state and local governments that prevents them from running deficits in the same manner as the U.S. federal government. A fiscal deficit is brought about whenever government revenue fails to meet government expenditures – an accounting reality that can strike any government. However, most state and local governments carry some form of legal requirement for balanced budgets.
Only one state (Vermont) does not carry a balanced budget requirement, but there are varying degrees about the severity of these laws. Per the U.S. Government Accountability Office (GAO), certain balanced budget requirements "are based on interpretations of state constitutions and statues rather than on explicit statements that the state must have a balanced budget." Some states have a judicial mandate for balanced budgets, but it is up to the legislature to create legal enforcement mechanisms to ensure enforcement.
According to the National Conference of State Legislatures, there are three types of balanced budget requirements:• A requirement that the governor's proposed budget must be balanced.• A requirement that the state legislature pass a balanced budget.• A requirement that the budget must actually be balanced at the end of any given fiscal year so that no fiscal deficit may be carried forward.
However, there are only two real constraints on state and local governments that do not balance their budgets according to constitutional or legislative statute. States cannot issue debt in the same way that the federal government can. Debt requires approval of the legislature or even the voting public. The last state government to borrow long-term funds was Connecticut in 1991. Non-federal government spending is capped by revenue. The second major constraint is the democratic process itself. Officials who run up government debt can be voted out of office if they fail to uphold their own laws.
State and local governments do not really have the economic ability to run fiscal deficits to encourage aggregate demand like the federal government. With this macroeconomic handicap, many state and local economies ask for federal aid during times of hardship.
Can the Efficient Market Hypothesis explain economic bubbles?A:
The efficient market hypothesis (EMH) cannot explain economic bubbles because, strictly speaking, the EMH would argue that economic bubbles don't really exist. The hypothesis's reliance on assumptions about information and pricing are fundamentally at odds with the mispricing that drives economic bubbles.
Economic bubbles occur when asset prices rise far above their true economic value and then fall rapidly. The EMH states that asset prices reflect true economic value because information is shared among market participants and rapidly incorporated into the stock price. Under the EMH, there are no other factors underlying price changes, such as irrationality or behavioral biases. In essence, then, the market price is an accurate reflection of value, and a bubble is simply a notable change in the fundamental expectations about an asset's returns.
For example, one of the pioneers of EMH, economist Eugene Fama, argued that the financial crisis, in which credit markets froze and asset prices dropped precipitously, was a result of the onset of a recession rather than the burst of a credit bubble. The change in asset prices reflected updated information about economic prospects.
Fama has said that for a bubble to exist, it would have to be predictable, which would mean that some market participants would have to see the mispricing ahead of time. He argues that there is no consistent way to predict bubbles. Because bubbles can only be identified in hindsight, they cannot be said to reflect anything more than rapid changes in expectations based on new market information.
Whether bubbles are predictable is subject to debate. Behavioral finance, a field that attempts to identify and examine financial decision making, has uncovered several biases in investment decision making, both on an individual and market level. Inattentiveness to certain kinds of information, confirmation bias and herding behavior are a few examples that might be related to economic bubbles. These biases have been shown to exist, but determining the incidence and level of a particular bias at a particular time is not so straightforward.
Of course, it should be noted that the EMH doesn't demand that all market participants are right all the time. However, one of the theory's core tenets revolves around the idea of market efficiency. Given that market participants share the same information, the consensus price should accurately reflect an asset's fair value because those who are wrong transact with those who are right. Behavioral finance, on the other hand, argues that the consensus can be wrong.
The definition of a bubble is that the right price is fundamentally different from the market price, meaning that the consensus price is wrong. Whether it is predictable or not, some have argued that the financial crisis represented a serious blow to the EMH because of the depth and magnitude of the mispricings that preceded it. However, Fama would likely disagree.
Consumer Confidence Vs. Consumer SentimentA:
Consumer confidence and consumer sentiment are very similar in that they both refer to the degree of confidence consumers feel about the overall economy and their personal financial state. Consumer confidence or sentiment helps predict the level of spending that consumers will engage in. A high level of consumer confidence means that consumers, generally feel good about their financial condition, especially their ability to obtain and keep jobs.
If consumer confidence is relatively high, then consumers are going to increase the amount of money that they spend. On the other hand, if consumer confidence is relatively low, then consumers are going to spend less. (See also: Consumer Confidence: A Killer Statistic.)
Consumer confidence is measured by two indexes: the Consumer Confidence Index (CCI) and the Michigan Consumer Sentiment Index (MCSI). The CCI is a survey conducted by a not-for-profit research organization for businesses called the Conference Board that distributes information about management and the marketplace. The Conference Board usually surveys 5,000 households from the country's nine census regions. The survey usually covers five major sections:
- Current business conditions
- Business conditions for the next six months
- Current employment conditions
- Employment conditions for the next six months
- Total family income for the next six months.
The MCSI is a telephone survey of 500 households conducted by the University of Michigan. The purpose of the survey is to collect information about consumer expectations regarding the overall economy. The MCSI also covers five sections:
- Personal financial situation now and a year ago
- Personal financial situation one year from now
- Overall financial condition of the business for the next 12 months
- Overall financial condition of the business for the next five years
- Current attitude toward buying major household items.
Although the surveys seek to provide a similar measurement of consumers' views on the economy, they often can and do diverge in the short term. This is due to a variety of factors:
- The surveys are not always conducted at the same time during the month, so one may miss a significant economic event, such as a rise in gas prices, which would affect consumer outlook.
- The two surveys query a dramatically different number of households. It stands to reason that the CCI, with 5,000 respondents, would be more sensitive.
- The scope of the survey differs, as well; the Michigan survey has significantly more questions and tends to yield more detailed information.
- In terms of impact, the Conference Board survey tends to better pick up on indicators related to the job market, which the Michigan survey is more sensitive to pocketbook issues like the price of gas.
This question was answered by Chizoba Morah.
- Current business conditions
Did the Federal Reserve's quantitative easing add to M1?A:
Quantitative easing (QE) is an unconventional monetary policy tool that the Federal Reserve, the U.S. central bank, engaged in from November 2008 to October 2014. During that time, the Fed used newly created money to purchase Treasuries, mortgage-backed securities and debt issued by Fannie Mae and Freddie Mac from its member banks. All told, the central bank increased its assets by $3.6 trillion to a total of $4.5 trillion. The Fed's member banks' assets increased accordingly, allowing them to lend more and having a similar effect to printing money.
While QE had a profound effect on the money supply, however, it did not directly increase M1, which measures the supply of coins and bills in circulation, checking account deposits and certain other instruments such as travelers' checks.
QE is analogous to printing money, but the newly created money the Fed used for its asset-buying program remained in a notional, electronic form. It did not take the form of bills and coins. Nor did it end up in bank customers' checking accounts. In fact, to prevent rapid growth in the money supply as a result of the Fed's asset purchases, the central bank asked the Treasury to sell securities and deposit the proceeds in the Supplemental Financing Account at the Fed. That pushed the latter's liabilities up by around half a trillion dollars in early 2009.
QE caused MB – the monetary base, which includes central bank money – to outstrip M1 immediately after the first phase of QE (QE1) began. It has continued to exceed M1 ever since, though the gap narrowed after the third and final phase (QE3) ended in 2014.
On the other hand, M1 growth clearly accelerated as QE got underway. This was not a direct, mechanical result of growth in MB, but it does have to do with the Fed's response to the financial crisis.
As the housing market began to tank, the central bank made several deep cuts to the federal funds rate, taking it from from 5.25% in mid-2007 to an unprecedented low of 0% to 0.25% in December 2008. It did not hike rates again for seven years, and then only by a quarter of a percentage point.
Ben Bernanke, the Fed chair at the time, wrote in July 2009, "as the economy recovers, banks should find more opportunities to lend out their reserves"; these reserves, the liabilities side of the Fed's balance sheet, increased dramatically under QE. "That would produce faster growth in broad money (for example, M1 or M2)." Low rates encourage banks to lend: since profit margins on loans become thinner, higher volumes are needed to generate the same earnings. From borrowers' perspective, demand for loans increases as the price of borrowing falls. At the same time, the incentive to stash savings in interest-bearing accounts falls, so checking account deposits rise. All of these effects push up M1.
Did the repeal of the Glass-Steagall Act contribute to the 2008 financial crisis?A:
The repeal of the Glass-Steagall Act was at most a minor contributor to the financial crisis. At the heart of the 2008 crisis was nearly $5 trillion worth of basically worthless mortgage loans, among other factors. Although the repeal allowed for much bigger banks, it can't be blamed for the crisis.
Since non-bank lenders originated the overwhelming majority of subprime mortgages, and the buyers of over half of them in the 10 years leading up to the 2008 crisis were not banks – commercial or investment – but Fannie Mae and Freddie Mac, pointing the finger at this particular banking regulation is not warranted.
Some argue that the repeal of the Glass-Steagall Act of 1933 caused the financial crisis because banks were no longer prevented from operating as both commercial and investment banks, and repeal allowed banks to become substantially larger, or "too big to fail." However, the crisis would likely have happened even without the Glass-Steagall repeal.
Glass-Steagall applied to banks, and although many of mortgage-backed derivatives were created and sold by banks, subprime mortgages — the underlying assets of the derivatives — were originally issued by non-bank lenders, and these initial loans would not have been prevented by Glass-Steagall. In addition, investment banks such as Lehman Brothers, Bear Stearns and Goldman Sachs — all major players in the subprime mortgage meltdown — never ventured into commercial banking. They were investment banks, just as they had been before Glass-Steagall was repealed.
The root cause of the financial crisis was the subprime mortgage meltdown. At the heart of that problem lies the Department of Housing and Urban Development (HUD), which required Fannie Mae and Freddie Mac to purchase more "affordable" mortgages to encourage lenders to make loans to low-income and minority borrowers. In order to meet HUD's goals, lenders began to institute policies such as foregoing any requirement for a down payment and accepting unemployment benefits as a qualifying source of income. (Again, the majority of these lenders were private mortgage lenders, not banks, so the Glass-Steagall Act didn't apply to them.) This lead to a lot of people getting mortgages they couldn't afford, making defaults inevitable.
There were a number of contributing factors to the financial crisis, and partial blame can be assigned to deregulation. The repeal of the Glass-Steagall Act, however, played at most a minor role in the crisis.
Do budget deficits "crowd out" the market?A:
Government deficits crowd out private investment, although the mechanism through which that occurs can be more or less direct. The crowding out is in a relative, not absolute sense. Like any other economic good, investment capital is scarce. Any government bonds issued to pay for a deficit are purchased with investment funds that might have otherwise gone toward private investment.
If the government decides to raise taxes to finance a deficit, those additional taxes will further discourage private investment. Should the government decide to monetize the debt, the cost-of-living increases will also eat at savings and investment.
Crowding out also occurs in the market for loanable funds in general. Government bonds are a form of debt that has less counterparty risk than even the safest government bonds. When new government bonds are introduced, risk-averse investors are pulled away from other forms of safe income securities. This also raises the rate of interest that competing bonds have to offer. As with total private investments, these changes are relative rather than absolute.
Crowding Out, Interest Rates and Small Businesses
One of the more controversial alleged effects of government deficit spending relates to small business lending. Critics of expansionary fiscal policy argue that the real interest rate (not the market interest rate) is artificially inflated by large deficits. This, they assert, disproportionately affects small business lenders. The superabundance of cheap loans makes it easy for the government to borrow, but hard for individuals and small companies to survive marginal increases in the real rate.
Many academics and policy analysts contend that deficits disproportionately affect small businesses. Others argue that it's theoretically possible for the real interest rate to push away some lenders, but that loose monetary policy can help make up for any negative impact.
Interest rates do not necessarily need to rise to present this type of opportunity cost from fiscal deficits. The new real rate of interest need only be higher than it otherwise would have been without the government crowding out effect.
The Fallacy of Crowding In
Some proponents of fiscal deficits counter that, while crowding out is possible in financial markets, there is an opposite effect as well. This theory, known as "crowding in," argues that government spending will create such an increase in aggregate demand that the private sector has to ramp up production. This added production requires that additional capital be invested.
This argument is an extension of the traditional multiplier effect, whereby a dollar spent from government creates more than a dollar's worth of growth in gross domestic product (GDP). Those who disagree with this argument see several statistical flaws in it. They argue that the most obvious is that businesses cannot conjure investment capital just because aggregate demand is stronger. Instead, they believe it is more likely that the cost of capital will rise and that certain businesses will profit at the expense of others.
Do CIF charges affect the customs duties?A:
The abbreviation CIF stands for "cost, freight and insurance." It is a term used in international trade in reference to transporting goods from one destination to another through maritime shipping. The term has changed to include inland and airline shipments.
When a buyer purchases goods and chooses to have them delivered using the CIF model, the seller does most of the work. The seller is therefore responsible for paying the transport to deliver goods to the nearest port, freight to deliver goods to a destination chosen by the buyer and insurance for the goods.
The responsibility of the seller ends once the goods reach the buyer’s port of choice. The buyer is then responsible for other charges that enable the goods to be cleared from the port. These charges include customs clearance fees, port security fees, docking charges and warehouse storage fees.
CIF charges do not affect customs charges. The buyer still has to pay customs duty whether shipping is done through CIF or the Free On Board model (FOB). The FOB model is better for a buyer in terms of profit, because the buyer is responsible for insuring the goods and paying freight when using FOB. In FOB, the goods are considered delivered once they cross the ship’s rail. The buyer can negotiate a better price for freight than the seller who might be looking to make extra profit. There is also better communication when the buyer uses his or her own forwarder rather than relying on one selected by the vendor who might charge extra to make a profit.
Do interest rates increase during a recession?A:
Interest rates rarely increase during a recession. Actually, the opposite tends to happen; as the economy contracts, interest rates fall in tandem.
The Federal Reserve has tools to control interest rates. During a recession, the Fed usually tries to coax rates downward to stimulate the economy. When a recession is on, people become skittish about borrowing money and are more apt to save what they have. Following the basic demand curve, low demand for credit pushes the price of credit—meaning interest rates—downward.
The Federal Reserve
The Federal Reserve exerts major influence on interest rates. It can push rates upward or downward by adjusting the federal funds rate, which is the interest rate at which banks lend money to each other to meet overnight reserve requirements, and by buying or selling Treasury bonds (T-bonds). When a recession hits, the Federal Reserve prefers rates to be low. The prevailing logic is low interest rates encourage borrowing and spending, which stimulates the economy.
Supply and Demand
In a bad economy, consumers tend to become more fastidious with household finances. They are more careful about borrowing and more motivated to save the money left over after meeting expenses. This supply and demand dynamic creates an environment for low interest rates to thrive. When everyone wants to borrow money, interest rates tend to rise; the high demand for credit means people are willing to pay more for it. During a recession, the opposite happens. No one wants credit, so the price of credit falls to entice borrowing activity.
(For related reading, see: How Banks Set Interest Rates on Your Loans.)
Does a stock split lead to the gapping up/down of the stock?A:
If a company splits its stock, there will be no gapping of the stock due to the split itself. A stock split does not materially affect a company's value and will not lead to the wide changes in value that are seen in gaps.
A stock split simply means that a company has increased the number of outstanding shares by the split factor. For example, if you hold 100 shares worth $1,000 in a company that undergoes a 2-for-1 stock split, you will hold 200 shares after the split. Before you get too excited about that possibility, keep in mind that the value of your position will remain the same. Instead of 100 shares at $10, you will have 200 shares at $5 after the split. This is where the confusion between a stock split and a gap comes in, since the price will fall from $10 to $5 at the time of the split and the change will be instant.
On the other hand, when a gap in a stock occurs, it means the stock's price has either increased or decreased sharply with no trading occurring in between. On a chart, this abrupt price movement will form an empty space or break between the prices. For example, let's say that the stock of XYZ has closed at $10 one day. After regular trading hours, the news comes out that the company might file for bankruptcy. At the start of the next trading day, XYZ's stock starts to trade at $5. This sharp decline means there is a large gap between the two days. In a 2-for-1 split, however, the price of the share declines by 50% but the value does not decline, so there is no real gap.
The reason gaps are not seen in stock charts after a stock split is because all of the past price data is adjusted to the current split. If you download the historical data of a stock, you will often see both the adjusted and the unadjusted share prices. In the event of splits, the unadjusted data will show gaps at each point the company split its shares. All the charts you see on financial websites should be adjusted for all past splits. Consider, for example, this chart of Apple Computers as it went through a stock split in Feb 2005.
The chart you will see on any financial site after a stock splits is represented by the red line. This represents the split-adjusted share price. The blue line represents the unadjusted share price of the stock after the split. The large drop in the blue line is the point at which the shares in the company split, causing what looks like a gap. The shares were trading at roughly $90 before the split and $45 after the split, cutting the price of the share in half. What the chart with the adjusted price does is divide all of the past prices by the split factor, making it look as though the split never happened. Note how at the start of the chart above, the blue line (unadjusted) is at roughly $30. The red line, which reflects all of the past prices on a split-adjusted basis, starts at roughly $15 (equivalent to $30 divided by the split factor of two).
The bottom line is that a stock split causes no change in the value of a company or in the value of an investor's shares, nor does it cause any gaps in a stock's chart, because past price movements are adjusted for the split.
(For more on stock splits, see Understanding Stock Splits.)
Does perfect competition exist in the real world?A:
First, let's review what economic factors must be present in an industry with perfect competition.
5 Requirements of Perfect Competition
- All firms sell an identical product.
- All firms are price-takers.
- All firms have a relatively small market share.
- Buyers know the nature of the product being sold and the prices charged by each firm.
- The industry is characterized by freedom of entry and exit.
Because these five requirements rarely exist together in any one industry, perfect competition is rarely (if ever) observed in the real world. For example, most products have some degree of differentiation. Even with a product as simple as bottled water, for example, producers vary in the method of purification, product size, brand identity, etc. Commodities such as raw agricultural products, although they can still differ in terms of quality, come closest to being identical, or having zero differentiation. When a product does come to have zero differentiation, its industry is usually concentrated into a small number of large firms, or an oligopoly.
Barriers to Entry Prohibit Perfect Competition
Many industries also have significant barriers to entry, such as high startup costs (as seen in the auto manufacturing industry) or strict government regulations (as seen in the utilities industry), which limit the ability of firms to enter and exit such industries. And although consumer awareness has increased with the information age, there are still few industries where the buyer remains aware of all available products and prices.
As you can see, there are significant obstacles preventing perfect competition from appearing in today's economy. The agricultural industry probably comes closest to exhibiting perfect competition because it is characterized by many small producers with virtually no ability to alter the selling price of their products. The commercial buyers of agricultural commodities are generally very well-informed and, although agricultural production involves some barriers to entry, it is not particularly difficult to enter the marketplace as a producer.
Economists' Thoughts on Perfect Competition
No economist believes perfect competition is representative of the real world. Very few believe perfect competition is ever achievable. The real debate among economists is whether perfect competition should be considered a theoretical benchmark for real markets. Neoclassical economists argue that perfect competition can be useful, and most of their analysis stems from its principles. Many other smaller schools of thought disagree.
Many economists are highly critical of the neoclassical reliance on perfect competition. These arguments can be broadly separated into two groups. The first group believes the assumptions built into the model are so unrealistic it cannot produce any meaningful insights. The second group argues that perfect competition is not even a desirable theoretical outcome.
Nobel laureate F.A. Hayek argued that perfect competition had no claim to be called "competition." He pointed out that the model removed all competitive activities and reduced all buyers and sellers to mindless price-takers.
Joseph Schumpeter noted that research, development and innovation are undertaken by firms that experience economic profits, rendering perfect competition less efficient than imperfect competition in the long run.
(For related reading, see: Economic Basics: Competition, Monopoly and Oligopoly.)
- All firms sell an identical product.
Does QVC accept debit cards?A:
QVC accepts debit card payments as one of its many payment options. The company, which is the world’s leading video and e-commerce retailer, had sales of $8.8 billion in 2014. Purchases of items from QVC can be made by both Visa and MasterCard debit cards.
QVC Payment Options
Other payment options for QVC purchases includes all major credit cards, PayPal Credit and the company’s own Qcard. Users can apply for a Qcard, the company’s credit card that makes purchases faster, and then store the payment information in their accounts. Checks are also accepted as a form of payment for most purchases, although items do not ship until the check is received.
Debit cards and credit cards can also be used to purchase QVC gift cards. Purchasers can choose a denomination ranging from $5 to $500 for each gift card. These cards can be mailed or emailed directly to the buyer or a gift recipient.
Another popular option for payments on QVC is Easy Pay. Debit cards are not listed as an option for this method. Customers can select Easy Pay to receive the item and then make monthly payments. The first payment is due at the time the item ships, with additional payments due every 30 days. Qcards and credit cards are accepted for QVC’s Easy Pay program. There are no additional fees to purchase items using this method.
QVC was founded in 1986. The company’s name stands for "Quality, Value, Convenience." In 2014, QVC shipped 173 million products worldwide. As of 2015, it is a publicly traded company under the name Liberty Interactive Corporation on the NASDAQ Global Market.
Does raising the minimum wage increase inflation?A:
There are conflicting views on whether raising the minimum wage increases inflation. Tied to this is the question of what effect a higher minimum wage has on employment because historically, high unemployment goes hand-in-hand with high inflation. While raising the minimum wage would help stimulate the economy due to the increased spending power of workers receiving higher wages, a former CEO of one of the biggest employers in the United States explained that too high of a government-mandated minimum wage would have a deadly effect on employment.
According to Ed Rensi, formerly of McDonald’s, a higher minimum wage would not only kill existing jobs but also result in closing a substantial number of small businesses, from 15% to 20%. In theory, raising the minimum wage forces business owners to raise the prices of their goods or services, thereby spurring inflation. In actual practice, however, it is not so simple since wages are only one part of the cost of a product or service paid for by consumers. A higher minimum wage can be offset by heightened productivity by workers or trimming down a company’s manpower.
In 2014, fast-food workers in the United States started asking for a minimum wage of $15 an hour, or almost double what they were earning. If their demand is granted, a typical burger flipper or order taker at McDonald’s would end up earning more than $30,000 per year.
Suffice it to say, raising the minimum wage to an excessively high rate would exert inflationary pressure on the economy, but increasing it to keep pace with inflation would only have a minimal effect. (For related reading, see: The Minimum Wage: Does It Matter?)
Does the federal government fund any NGOs? Which ones?A:
A non-governmental organization (NGO) is a non-profit, citizen-based group that functions independently of government. NGOs are organized on local, national and international levels to serve specific social or political purposes. Despite their independence from government, many NGOs receive significant funding from government entities.
While an NGO can be funded entirely or in part by government funding, it may keep its non-governmental status by prohibiting government representatives from membership. In the United States, about 1.5 million NGOs are in operation, representing a wide variety of causes. Many of those receive funding from local, state and federal government entities. The funding often comes as a result of a grant award. However, other forms of funding, such as product donations, can occur. Examples of NGOs that currently receive government funding, or that have received government funding in the past, include:
- American Association of Retired Persons (AARP)
- Doctors Without Borders
- World Vision United States
- World Wildlife Fund
Government funding of NGOs is sometimes viewed as controversial, because the funding may support certain political goals rather than a nation's development goals. As such, certain NGOs will not accept funding from the government or any intergovernmental association. For example, the environmental NGO Greenpeace does not take any funding from government , corporations or political parties. Greenpeace has this policy in order to maintain "absolute independence."
Economists' assuptions in their economic modelA:
When you look at an introductory textbook for microeconomics, it seems as though economists live in a world that barely resembles the real one. Their models are built on a series of assumptions, including that individual actors have perfect information about their choices or that subjective human values can be measured quantitatively. Some models even assume away competition, substitute goods and marketing.
Economists create these elaborate fantasies in order to apply testable theories onto an otherwise deductive social science. Without assumptions, quantitative economic models would not be able to produce any meaningful conclusions.
Science, Positivism and Deduction
In his 1953 essay titled "The Methodology of Positive Economics," Milton Friedman explained why economists need to make assumptions to provide useful predictions. Friedman understood economics couldn't use the scientific method as neatly as chemistry or physics, but he still saw the scientific method as the basis. Friedman stated economists would have to rely on "uncontrolled experience rather than on controlled experiment." He was promoting a method of logical positivism, which is a subset of epistemology.
The scientific method requires isolated variables and testing to prove causality. Economists can't possibly isolate individual variables in the real world, so they assume most of them away to create a model with some constancy. Errors are bound to happen, but most economists are OK with that as long as those errors are small enough.
Not all economists are methodological positivists. Some argue that standard models are too unrealistic to ever be relied on, and applying positivism to social sciences implies human choice is an illusion.
Economist Robert Murphy of the Institute for Energy Research, a not-for-profit organization that conducts research and analysis on the functions, operations, and government regulation of global energy markets, argues economics should be focused on logical deduction, not logical positivism. Logical deduction is the science used in philosophy, mathematics and computer science. Murphy, along with some other Austrian-school economists, contend certain economic tendencies and laws are only knowable through human reasoning. (For related reading, see: Is economics a science?)
Globalization and International InvestmentA:
Globalization has resulted in greater interconnectedness among markets around the world and increased communication and awareness of business opportunities in the far corners of the globe. More investors can access new investment opportunities and study new markets at a greater distance than before. Potential risks and profit opportunities are within easier reach thanks to improved communications technology.
Countries with positive relations between them are able to increasingly unify their economies through increased investment and trade. Products and services previously available within one country are made more readily available to new markets, resulting directly in improved economic opportunities for workers in those economies and leading to improved household incomes.
For investors, these opportunities present a wider range of investment options and new ways to profit. Investment in global markets is possible for the investing public through stock purchasing, as most brokerage firms are able to access international stock markets and provide their clients with the opportunity to purchase shares in companies around the world.
(For related reading, see: Getting Into International Investing.)
As a result, most businesses try to stay competitive with their counterparts in other parts of the world, broadening their competitive horizons past their local areas and home countries. Maintaining competitiveness often requires sourcing materials and outsourcing labor from other countries. Competitive companies have increasingly turned to global markets as a source not only of new customers but also of production locations and partners for new ventures. Globalization has facilitated this and made the transition to global markets easier.
Globalization Increases International Investing
Over time, these practices result in increased cultural similarities between countries and increasingly connected economies that have more mutual interests and challenges. Globalization and international investment are tied together and lead into one another as companies act internationally by increasing their international investment out of mutual interest and the need to stay internationally competitive. Companies benefit from pricing differences, or arbitrage, in different markets for labor and supplies. Globalization compels connected economies to continue to invest in each other to protect their economic health and acquire new profits. International investments have increased as a direct result of globalization and continue to do so. This is pulling more economies into globalization, further increasing international investment as this happens.
When countries seek collectively to pursue the opportunities provided by globalization, the demands of the new economic activity cause social change that develops these countries and prepares them to better pursue industrial activity. The society becomes a developed nation as its workforce begins to attract the investment activity of enough companies to cause the social and economic change necessary to produce a modern industrialized economy. This process is a result of the international investment that characterizes globalization. The competitive nature of globalization, in other words, ultimately has a social and economic impact that transforms economies in pursuit of investment and greater economic activity. This knits economies into each other and results in increased international investment. (For related reading, see: The 3 Biggest Risks Faced by International Investors.)
Halloween's Effect on the EconomyA:
Based on the Keynesian school of economic thought, major spending holidays can have significant short-term benefits for the economy by encouraging extra purchases that might not otherwise occur. According to the National Retail Federation, in 2017 Americans planned to spend a record $9.1 billion on Halloween, up from $8.4 billion in the previous year.
It could also be argued that the state of the economy affects the Halloween industry more than Halloween affects the economy. In a down economy, for instance, consumers may be less likely to spend on frivolous goods such as costumes, candy, pumpkins and home decorations, or attend parties. Conversely, booming economic times might serve as a boon to Halloween expenditures. Regardless of which way the relationship is considered more causally significant, many economists believe the increase in spending has a positive effect. Increased spending generally leads to higher gross domestic product (GDP), helping to jump-start economic activity and lead to potential job growth.
It is entirely possible, however, that the net positive effects of Halloween consumer spending are offset by net negative effects elsewhere. For example, some consumers might anticipate an increase in spending around late October and, to compensate, increase their savings during the preceding months. This tends to reduce gross spending during August and September. Others might curb their spending in November, both to compensate for increased spending for Halloween and also in expectation of Christmas spending. (For related reading, see: 8 Tips to Help You Control Holiday Spending.)
Employment and Commercial Activity
Halloween also has a seasonal impact on employment and commercial activity. The NRF report revealed consumers planned to spend on average $86.13 in 2017 and a large share of that would go for costumes and candy. Many retail stores open up only for Halloween and, when November arrives, these shops close up and wait until the next spooky season. Additionally, some industries expect and plan for large increases during the holiday, including producers of pumpkins and candy. Other economists argue spending on nearly useless consumer goods such as costumes and decorations only used for one day deviates resources from more productive activity. If saving is reduced as a result of holiday spending, the total capital investment stock is all the worse for it. The receipts of companies that employ people full-time year-round might drop because more dollars are chasing seasonal goods.
Others have argued Halloween is full of in-kind payments, such as costumes or candy, rather than lump-sum transfers, such as cash, because in-kind payments are more inefficient in satisfying consumer wants. After all, you can buy whatever you really value most with cash, whereas it is unlikely that your candy bar is your most valued good.
An economics writer, Jeffrey A. Tucker, argued in his 2009 article for Ludwig von Mises Institute that Halloween teaches valuable economic lessons that could have very long-term benefits: children should work for their rewards, bartering is an option and appearance matters. The most accurate answer is probably this: Halloween is a substantial industry and has an impact on the economy. However, it is very difficult to identify exactly what that impact is and whether it is a net positive. (For related reading, see: How Much Americans Spend on Halloween.)
How are aggregate demand and GDP related?A:
According to Keynesian macroeconomic theory, gross domestic product (GDP) is a way to measure a nation's production. Aggregate demand takes GDP and shows how it relates to price levels. Quantitatively, aggregate demand and GDP are exactly the same.
A Keynesian economist might point out that GDP only equals aggregate demand in long-run equilibrium. This is because short-run aggregate demand always measures total output for a given price level (not necessarily equilibrium). In most macroeconomic models, however, the price level is assumed to be equal to "one" for simplicity.
It must always be the case that an increase in aggregate demand will increase GDP since the two figures are one and the same.
Calculating Aggregate Demand and GDP
There are actually three methods for estimating GDP: total value of all goods and services sold to final users; sum of income payments and other production costs; or the sum of all value added at each production stage.
Conceptually, all of these measurements are tracking the exact same thing. Some differences can arise based on data sources, timing and mathematical techniques used.
In general macroeconomic terms, both GDP and aggregate demand share the same equation: total consumption spending + gross private investments + total government expenditures + net of exports minus imports.
You may also see the equation written this way: GDP or AD = C + I + G + NX
GDP and aggregate demand are often interpreted to mean that economic growth is driven by the consumption of wealth and not its production. In other words, it disguises the structure and relative efficiency of production underneath total expenditures.
Additionally, GDP does not take into consideration the nature of what, where and how goods are created. It does not distinguish, for example, producing $100,000 worth of toenail clippers versus $100,000 worth of computers. In this way, it's a somewhat unreliable gauge of real wealth or the standard of living.
How are capitalism and private property related?A:
Private property rights are central to a capitalist economy, its execution and its legal defenses. Capitalism is built on the free exchange of goods and services between different parties, and nobody can rightfully trade property they do not own. Conversely, property rights provide a legal framework for prosecuting aggression against nonvoluntary means of acquiring resources; there is no need for capitalist trade in a society where people could simply take from others what they want by force or the threat of force.
Private Property, Ownership and Homesteading
Contemporary notions of private property stem from John Locke's theory of homesteading. In this theory, human beings gain ownership of a natural resource through an act of original cultivation or appropriation; Locke used the expression "mixing of labor." For example, if a man discovered an unknown island and began to clear the land and build a shelter, he is considered the rightful owner of that land. Since most resources have already been claimed at some point in history, the modern acquisition of property takes place through voluntary trade, inheritance, gifts or as collateral on a loan or a gambling wager.
Private Property Promotes Economic Efficiency
Most political theorists and nearly all economists argue that capitalism is the most efficient and productive system of exchange. Private property promotes efficiency by giving the owner of resources an incentive to maximize its value. The more valuable a resource, the more trading power it provides the owner of the resource. This is because, in a capitalist system, someone who owns property is entitled to any value associated with the property.
When property is not privately owned, but rather shared by the public, a market failure emerges known as the Tragedy of the Commons. The fruit of any labor performed with a public asset does not belong to the laborer but is diffused among many people. There is a disconnect between labor and value, creating a disincentive to increase value or production. People are incentivized to wait for someone else to do the hard work and then swoop in to reap the benefits without much personal expense.
The owners of private property have the right to transfer ownership as they see fit. This naturally cultivates trade between those with different resources and different wants. Since most people want to maximize the value of their trade, competitive bids are accepted to receive the highest exchange value. Owners of a similar kind of resource compete with each other for exchange value. This system of competition creates supply and demand.
Consider this simplistic example: someone owns a goat and would rather have chickens. He decides to sell his goat to purchase chickens. All of the sellers of chickens compete for his money, which drives prices lower. He must similarly compete with all other goat sellers when trading his goat.
Private Property and Law
The reason humans are willing to compete with each other in voluntary trade is precisely because there are laws that protect private property. For a person to receive property he believes is valuable, he must provide a service that someone else believes is valuable. Everyone gains in the ex-ante sense.
How are earmarks and pork barrel spending related?Both earmarks and pork barrel spending involve spending money on certain projects or specific events. Projects paid for by earmarking are more likely to benefit a larger portion of the population. Pork barrel projects are more likely to benefit a smaller group, specifically because a group of individuals related to the benefited group provides the funds for the project.
An earmark project may consists of spending money from a bank, federal or state government to pay for a needed service in an area. One example of such a service is a better road. Anyone who uses the road in the city is likely to benefit. It may be a well-traveled road that provides a route for many on a regular basis. It benefits either the majority of the group or a large group. A road project paid for by pork barrel spending is work done on a road not used by the majority of people in an area. It may be located in a specific neighborhood and used mainly by those living or working in the neighborhood. It is paid for by people who live or work in the neighborhood or who have other associations with it. Because the project is specific and benefits a small group of people, it is labeled pork barrel.
It is found that pork barrel politics is more likely to draw criticism from taxpayers than earmark projects, since a few individuals reap the benefit from it. The fact that a project is paid for by the wealthy and benefits the wealthy may bring up questions of inequality.
How are industrial goods different from consumer goods?A:
Industrial goods are made up of machinery, manufacturing plants and materials, and any other good or component used by other industries or firms. Consumer goods are ready for the consumption and satisfaction of human wants, such as clothing or food. Consumer goods are not used in the production of other goods, while industrial goods are.
Industrial goods are based on the demand for the consumer goods they help to produce. Industrial goods are classified as either production goods or support goods. Production goods are used in the production of a final consumer good or product, while support goods help in the production process of consumer goods, such as machinery and equipment.
Consumer goods, on the other hand, are tangible commodities produced and purchased to satisfy the wants of a buyer. Consumer goods are classified as durable goods, non-durable goods or consumer services.
Durable goods have a significant lifespan of three years or more. The consumption of a durable good is spread out over the entire life of the good, which causes demand for maintenance and upkeep. Bicycles, furniture and cars are examples of durable goods.
Non-durable goods are goods that are purchased for immediate consumption or use, and they have a lifespan that is less than three years. Food, beverages and clothing are examples of non-durable goods.
Consumer services are intangible products or services that are produced and consumed at the same time. Haircuts and car washes are typical examples of consumer services. (For related reading, see: Which economic factors most affect the demand for consumer goods?)
How are investment banks regulated in the United States?A:
Investment banks in the United States are continuously reviewed and regulated by the Securities and Exchange Commission, or SEC. They are also intermittently regulated and investigated by Congress. Technically, investment banks exist because they were legally distinguished from commercial banks through prior acts of Congress.
Defining Investment Banks
Investment banks became an official legal designation following The Banking Act of 1933, commonly referred to as Glass-Steagall. The Banking Act was a response by Congress to the financial calamity of the Great Depression, where more than 10,000 banks closed their doors or suspended operations.
Proponents of Glass-Steagall argued that the financial sector would be less risky by reducing bank and customer conflicts of interest. Hearings were held by the Pecora-Glass Subcommittee to determine whether depositors faced undue risks from banks with security affiliates. No substantial evidence was ever presented, and it was determined that banking should be segregated but protected by the Federal Deposit Insurance Corporation, or FDIC.
This gave rise to investment-only banks. Congress defined them as banks in the business of underwriting and dealing in securities. By contrast, commercial banks became defined as those that took deposits and made loans.
The barriers between commercial and investment bank affiliation were removed in 1999 by the Financial Services Modernization Act, or Gramm-Leach-Bliley. A broader term was adopted for all types of money intermediaries: financial institutions.
Congress Regulating Investment Banks
Several other influential acts of Congress followed The Banking Act. The 1934 Securities Exchange Act provided new regulations for securities exchanges and broker-dealers; the SEC was created with this act. The Investment Company Act and the Investment Advisers Act were passed in 1940, creating regulations for advisers, money managers and others.
Following a stock market decline in 1969, concerns were raised that trading volumes were growing too large for investment banks to handle. Congress reacted by founding the Securities Investor Protection Corporation, or SIPC.
Investment bank capital requirements were updated in 1975 with the Uniform Net Capital Rule, or UNCR. The UNCR forced investment banks to maintain a certain level of liquid assets and detail them in quarterly Financial and Operational Combined Uniform Single, or FOCUS, reports.
Problems with different international capital standards led to the 1988 Basel Accord. Even though it was primarily designed for commercial banks, it was a seminal moment in creating supranational regulations for financial institutions.
Congress attempted to repeal the separation between investment and commercial banks in 1991 and 1995 before finally succeeding with Gramm-Leach-Bliley. That Act allowed for the creation of financial holding companies that could own both commercial banks, investment banks and insurance companies as affiliates.
The Sarbanes-Oxley Act was passed in 2002, which regulated executives and empowered auditors. After the financial crisis of 2008, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank brought an enormous amount of new regulations for all kinds of financial institutions.
SEC Regulating Investment Banks
The powers of the SEC are an extension of those enumerated in Congressional legislation. Nearly every aspect of investment banking is regulated by the SEC. This includes licensing, compensation, reporting, filing, accounting, advertising, product offerings and fiduciary responsibilities.
How can a change in fiscal policy have a multiplier effect on the economy?A:
A change in fiscal policy has a multiplier effect on the economy because fiscal policy affects spending, consumption and investment levels in the economy. The multiplier effect is the amount that additional government spending affects income levels in the country.
The two major mechanisms of fiscal policy are tax rates and government spending. Typically, fiscal policy is used when the government seeks to stimulate the economy. Governments borrow money to spend on projects or return money to taxpayers via lower tax rates or tax rebates. The overall effect on the economy is the same as when the government seeks to target and improve aggregate demand. Influencing economic outcomes via fiscal policy is considered Keynesian economics.
The multiplier effect determines the efficacy of expansionary fiscal policy. If people simply save the money because of poor economic conditions or a desire to repair household balance sheets, there is no effect on gross domestic product. This is a symptom of a deflationary environment. In this case, policymakers may choose monetary policy to stimulate the economy instead of fiscal policy. Outside of extreme circumstances, the multiplier effect is greater than 1.
If the multiplier effect is 3, it means that each $1 of stimulus will lead to $3 in income. This type of effect is due to increased demand that results in increased consumption and spending. This encourages businesses to invest, expand and hire additional workers, which has ameliorative effects on income and gross domestic product. In turn, increasing incomes and economic activity also leads to more spending and consumption. Thus, fiscal policy has a multiplier effect.
How can a country's debt crisis affect economies around the world?A:
A country's debt crisis affects the world through a loss of investor confidence and systemic financial instability. A country's debt crisis occurs when investors lose faith in the country's ability to make payments due to either economic or political troubles. It leads to high interest rates and inflation. It creates losses for investors in the debt and slows the global economy.
The effect on the world differs based on the size of the country. For large, currency-issuing countries, such as Japan, the European Union or the United States, a debt crisis could throw the entire global economy into a recession or depression. However, these countries are much less likely to have a debt crisis as they always have the ability to issue currency in order to pay back their own debt. The only way a debt crisis could happen is due to political issues.
Smaller countries have debt crises due to profligate governments, political instability, a poor economy or some combination of these factors. The rest of the world is affected as foreign investors of the debt lose money. Other countries in the same geographic area can see interest rates on their debt increase as investor confidence plunges and redemptions mount in funds that invest in foreign debt. Some funds with excessive leverage can even be wiped out.
Normally, the world's economy has the liquidity and means to absorb these shocks without massive effects. However, if the global economy is in a precarious state, this type of risk aversion has the potential to spark instability in financial markets. An example is the Asian financial crisis in 1997, which started in Thailand as the country had extensively borrowed in U.S. dollars.
A slowing economy and weakening currency made it impossible for Thailand to make payments. Investors in debt of foreign countries aggressively pared back bets, leading to weakening currencies and spiking interest rates in periphery countries, such as South Korea and Indonesia.
How can I use the rule of 70 to estimate a country's GDP growth?A:
You could use the rule of 70 to estimate a country's gross domestic product (GDP) growth by dividing 70 by the expected GDP growth rate. The economic growth rate could be used to determine the amount of years it would take a country's GDP to double.
The rule of 70 is used to estimate the number of years it would take for a certain variable to double. Divide 70 by the variable's growth rate to estimate the number of years it takes for the variable to double.
The economic growth rate could be used in the calculation using the rule of 72 to estimate a country's GDP growth. The economic growth rate is calculated by subtracting the GDP of year 1 from the GDP of year 2 and dividing the resulting value by the GDP of year 1.
For example, assume you want to compare the number of years it would take the U.S. GDP to double to the amount of years it would take China's GDP to double. The United States had a GDP of $15 billion for the current year and a GDP of $14.5 billion for the previous year. The economic growth rate is 3.45% (($15 billion - $14.5 billion)/($14.5 billion)).
On the other hand, assume China had a GDP of $10 billion for the current year and $8 billion for the previous year. China's economic growth rate is 25% (($10 billion - $8 billion)/$8 billion).
It would take approximately 20.29 (70/3.45) years for the U.S. GDP to double. On the other hand, it would take 2.8 years (70/25) for China's GDP to double.
How can industrialization affect the national economy of less developed countries (LDCs)?A:
Industrialization – the period of transformation from an agricultural economy to an urban, mass-producing economy – has accompanied every period of sustained per capita gross domestic product (GDP) growth in recorded history. Less than 20% of the world's population live in industrialized nations, yet they account for more than 70% of world output. The transition from agrarian to industrial society is not always smooth, but it is a necessary step to escape the abject poverty found in less-developed countries (LDCs).
The first period of industrialization took place in Great Britain between 1760 and 1860. Historians disagree about the exact nature and causes of this first Industrial Revolution, but it marked the first period of compounding economic growth in world history. Industrialization reached the United States in the early 19th century and eventually spread to most western European nations before the end of the century.
There are two widely accepted dimensions of industrialization: a change in the types of predominant labor activity (farming to manufacturing) and the productive level of economic output. This process includes a general tendency for populations to urbanize and for new industries to develop.
Effects of Industrialization
Economic and historical research has overwhelmingly showed that industrialization is linked to rising educations, longer life spans, growing individual and national income, and improved overall quality of life.
For example, when Britain was industrializing, total national income increased by more than 600% from 1801 to 1901. By 1850, workers in the U.S. and Great Britain earned an average of 11 times than workers in non-industrialized nations.
These effects have proven to be permanent and cumulative. By 2000, per capita income in fully industrialized countries was 52 times greater than in non-industrial countries. Industrialization disrupts and displaces traditional labor, encouraging workers towards more valuable and productive activity that is accompanied by better capital goods.
Hong Kong's Industrialization
Perhaps no industrialization was as rapid, unexpected and transformational as that which occurred in Hong Kong between 1950 and 2000. In less than two generations, the small Asian territory grew into one of the wealthiest populations in the world.
Hong Kong is only 1,000 square kilometers in size. It lacks the land and natural resources of major industrial powers such as the U.S. and Germany. Its period of industrialization began with textile exports. Foreign businesses became increasingly attracted to operating in Hong Kong, where taxation was low, no minimum wage laws existed, and there were no tariffs or subsidies for international trade.
In 1961, the British governor of Hong Kong, Sir John James Cowperthwaite, instituted a policy of positive noninterventionism in the former colony. Between 1961 and 1990, the average GDP growth rate in Hong Kong was between 9 and 10%. The lowest five-year growth rate, from 1966 to 1971, was still 7.6% per year.
Industrialization in Hong Kong was accompanied by a huge number of small and medium-sized companies. Despite no pro-industrialization policies by the Hong Kong government, investment venture capital flooded into Hong Kong from the outside – though not from China, which placed an embargo on trade with its neighbor. As of 2015, Hong Kong's average income was $33,534.28. In 1960, prior to industrialization, it was barely over $3,000 in 2015 dollars.
How Can Inflation Be Good for the Economy?A:
Inflation is and has been a highly debated phenomenon in economics. Even the use of the word "inflation" has different meanings in different contexts. Many economists, businessmen, and politicians maintain that moderate inflation levels are needed to drive consumption--operating under the larger, overarching assumption that higher levels of spending are crucial for economic growth. The Federal Reserve typically targets an annual rate of inflation for the United States, believing that a slowly increasing price level keeps businesses profitable and prevents consumers from waiting for lower prices before making purchases. There are some, in fact, who believe that the primary function of inflation is to prevent deflation.
Others, however, argue that inflation is less important and even a net drag on the economy. Rising prices make savings harder, driving individuals to engage in riskier investment strategies to increase or even maintain their wealth. Some claim that inflation benefits some businesses or individuals at the expense of most others.
You may hear the term "inflation" used to describe the impact of rising oil or food prices on the economy. For example, if the price of oil goes from $75 a barrel to $100 a barrel, input prices for businesses will increase and transportation costs for everyone will also increase. This may cause many other prices to rise in response. However, most economists describe a subtly different effect when they talk about inflation. Inflation is also a function of the supply and demand for money, meaning that producing relatively more dollars causes each dollar to become less valuable, making the general price level rise.
Possible Benefits of Inflation
When the economy is not running at capacity, meaning there is unused labor or resources, inflation theoretically helps increase production. More dollars translates to more spending, which equates to more aggregated demand. More demand, in turn, triggers more production to meet that demand.
Famous British economist John Maynard Keynes believed that some inflation was necessary to prevent the "Paradox of Thrift." If consumer prices are allowed to fall consistently because the country is becoming too productive, consumers learn to hold off their purchases to wait for a better deal. The net effect of this paradox is to reduce aggregate demand, leading to less production, layoffs and a faltering economy.
Inflation also makes it easier on debtors, who repay their loans with money that is less valuable than the money they borrowed. This encourages borrowing and lending, which again increases spending on all levels. Perhaps most important to the Federal Reserve is that the U.S. government is the largest debtor in the world, and inflation helps soften the blow of its massive debt.
Economists once believed in a real inverse relationship between inflation and unemployment, and that rising unemployment could be fought with increased inflation. This relationship was defined in the famous Phillips curve. The Phillips curve was largely discredited in the 1970s, however, when the U.S. experienced "stagflation," or high levels of inflation and rising unemployment at the same time; thought to be impossible at the time.
How can marginal utility explain the 'diamond/water paradox'?A:
One of the most disconcerting problems to Adam Smith, the father of modern economics, was he could not resolve the issue of valuation in human preferences. He described this problem in The Wealth of Nations by comparing the high value of a diamond, which is unessential to human life, to the low value of water, without which humans would die. He determined "value in use" was irrationally separated from "value in exchange." Smith's diamond/water paradox went unsolved until later economists combined two theories: subjective valuation and marginal utility.
Labor Theory of Value
Like nearly all economists of his age, Smith followed the labor theory of value. Labor theory stated the price of a good reflected the amount of labor and resources required to bring it to market. Smith believed diamonds were more expensive than water because they were more difficult to bring to market.
On the surface, this seems logical. Consider building a wooden chair. A lumberjack uses a saw to cut down a tree. The chair pieces are crafted by a carpenter. There is a cost for labor and tools. For this endeavor to be profitable, the chair must sell for more than these production costs. In other words, costs drive price.
But the labor theory suffers from many problems. The most pressing is it cannot explain prices of items with little or no labor. Suppose a perfectly clear diamond naturally developed in a perfect shape. It is then discovered by a man on a hike. Does it fetch a lower market price than an identical diamond arduously mined, cut and cleaned by human hands? Clearly not. A buyer does not care.
What economists discovered was costs do not drive price; it is exactly the opposite. Prices drive cost. This can be seen with a bottle of expensive French wine. The reason the wine is valuable is not because it comes from a valuable piece of land, is picked by high-paid workers or is chilled by an expensive machine. It is valuable because people really enjoy drinking good wine. People subjectively value the wine highly, which in turn makes the land it comes from valuable and makes it worthwhile to construct machines to chill the wine. Subjective prices drive costs.
Marginal Marginal Utility vs. Total Utility
Subjective value can show diamonds are more expensive than water because people subjectively value them more highly. However, it still cannot explain why diamonds should be valued more highly than an essential good such as water.
Three economists -- William Stanley Jevons, Carl Menger and Leon Walras -- discovered the answer almost simultaneously. They explained that economic decisions are made based on marginal benefit rather than total benefit.
In other words, consumers are not choosing between all of the diamonds in the world versus all of the water in the world. Clearly, water is more valuable. They are choosing between one additional diamond versus one additional unit of water. This principle is known as marginal utility.
A modern example of this dilemma is the pay gap between professional athletes and teachers. As a whole, all teachers are probably valued more highly than all athletes. Yet the marginal value of one extra NFL quarterback is much higher than the marginal value of one additional teacher. (For related reading, see: What does marginal utility tell us about consumer choice?)
How can the federal reserve increase aggregate demand?A:
The Federal Reserve can increase aggregate demand in indirect ways by lowering interest rates. Aggregate demand is a measure of the total consumption of goods and services over any time period. Aggregate demand is the most important ingredient that can be targeted by the government through fiscal or monetary policy.
Fiscal Vs. Monetary Policy
Fiscal policy is a much more direct way to affect aggregate demand as it can put money directly in the hands of consumers, especially those who have the greatest marginal propensity to spend. This increased spending leads to positive spillover effects such as businesses hiring more workers.
Some typical ways fiscal policy is used to increase aggregate demand include tax cuts, military spending, job programs and government rebates. In contrast, monetary policy uses interest rates as its mechanism to reach its goals. Ostensibly, the Federal Reserve's mandate is to balance competing goals of employment and price levels.
Targeting Aggregate Demand
However, aggregate demand is an important component in both of these measures. Therefore, the Federal Reserve is deeply concerned with it. When resources are constrained and there is an increase in aggregate demand, inflationary risks increase. If total consumption of goods and services in the economy decreases, then businesses have to let go of workers in response to the declining revenue.
The Federal Reserve's direct effect on aggregate demand is mild. When it lowers interest rates, asset prices climb. Higher asset prices for assets such as homes and stocks boost confidence among consumers, leading to purchases of larger items and greater overall spending levels. Higher stock prices lead to companies being able to raise more money at cheaper rates.
The Federal Reserve's largest effect in boosting aggregate demand is to create supportive financial conditions. It lacks the tools to generate aggregate demand in the way of fiscal policy, but it can create an environment in which low interest rates lead to lower borrowing costs and higher asset prices, which is supportive of increased spending and investing.Of course, spending and investing play a large role in determining economic activity in the short-term and the long-term. Therefore, in some ways, the Federal Reserve is like an accelerator for the economy. In certain circumstances, monetary policy can be quite ineffectual in increasing aggregate demand. One such time period was the recovery after the Great Recession. The financial crisis left serious scars on consumers and businesses. Fiscal policy was not aggressive enough to close the gap between the actual measure of aggregate demand and the ideal level of aggregate demand.The economy limped along, growing at an anemic pace; however, all sorts of financial assets were very strong.
Bond markets, stock markets and commodities hit all-time highs within five years of the bottom in asset prices of March 2009. Economic conditions slowly improved, but many people were left out of the recovery. This divergence highlights the limitations of monetary policy in such circumstances.
Gridlock in Congress led to a complete halt in any sort of discussion of fiscal policy. The Federal Reserve started buying billions of dollars worth of bonds to improve liquidity and financial conditions. Given the lackluster recovery, it failed to generate aggregate demand.
Critics of the Federal Reserve highlight this as evidence its policies are ineffective in helping the middle class. Additionally, they say the fruits of easy financial conditions flow to those who own assets. Easy financial conditions lead to asset bubbles, which can create wasteful investment, wealth destruction and harm to the economy.
Defenders of monetary policy argue that without monetary policy, the economy would be much worse. However, it is difficult to quantity. One comparison is the relative outperformance of the United States versus Europe or Japan. The Federal Reserve was much more aggressive than these central banks, and it resulted in higher growth rates.
How can the problem of asymmetric information be overcome?A:
Asymmetric information is inherent in most, if not all, markets. To take a basic example, a patient admitted to a hospital probably has less information about illness and recovery options than the doctor does. Markets compensate for this by developing agency relationships where both parties are incentivized to produce an efficient outcome.
In the hospital case, the doctor has an incentive to diagnose accurately and prescribe treatments correctly, or else he might be sued for malpractice or otherwise have his reputation suffer. Since it is likely that doctors and patients have repeat relationships, the law of repeat dealings also shows that both actors are better off in the long run if they deal fairly with one another.
Asymmetric Information and Adverse Selection
According to economic theory, asymmetric information is most problematic when it leads to adverse selection in a market. Consider life insurance: A customer might have information about his risk that the insurance company cannot easily obtain.
To compensate for a lack of information, the insurance company might increase all premiums to offset the risk of uncertainty. This means that the riskiest individuals (who ostensibly value insurance most highly) effectively price out some of the less risky individuals (who aren't willing to pay as much).
Adverse selection theoretically leads to a sub-optimal market even when both parties to an exchange are dealing rationally. This sub-optimality, once understood, provides an incentive for entrepreneurs to assume risk and promote a more efficient outcome.
Market Responses to Adverse Selection
There are a few broad methods of addressing the adverse selection problem. One very clear solution is for producers to provide warranties, guarantees and refunds. This is particularly notable in the used car market.
Another intuitive and natural response is for consumers and competitors to act as monitors for each other. Consumer Reports, Underwriters Laboratory, notaries public and online review services such as Yelp help bridge gaps in information.
The study of efficient market arrangements is known as mechanism design theory, which is a more flexible offshoot of game theory. Notable contributors include Leonid Hurwicz and David Friedman, son of Milton Friedman.
How Can You Calculate Correlation Using Excel?A:
Correlation measures the linear relationship of two variables. By measuring and relating the variance of each variable, correlation gives an indication of the strength of the relationship. Or to put it another way, correlation answers the question: How much does variable A (the independent variable) explain variable B (the dependent variable)?
The Formula for Correlation
Correlation combines several important and related statistical concepts, namely, variance and standard deviation. Variance is the dispersion of a variable around the mean, and standard deviation is the square root of variance.
The formula is:
Since correlation wants to assess the linear relationship of two variables, what's really required is to see what amount of covariance those two variables have, and to what extent that covariance is reflected by the standard deviations of each variable individually.
Common Mistakes with Correlation
The single most common mistake is assuming a correlation approaching +/- 1 is statistically significant. A reading approaching +/- 1 definitely increases the chances of actual statistical significance, but without further testing it's impossible to know. The statistical testing of a correlation can get complicated for a number of reasons; it's not at all straightforward. A critical assumption of correlation is that the variables are independent and that the relationship between them is linear. In theory, you would test these claims to determine if a correlation calculation is appropriate.
The second most common mistake is forgetting to normalize the data into a common unit. If calculating a correlation on two betas, then the units are already normalized: beta itself is the unit. However, if you want to correlate stocks, it's critical you normalize them into percent return, and not share price changes. This happens all too frequently, even among investment professionals.
For stock price correlation, you are essentially asking two questions: What is the return over a certain number of periods, and how does that return correlate to another security's return over the same period? This is also why correlating stock prices is difficult: Two securities might have a high correlation if the return is daily percent changes over the past 52 weeks, but a low correlation if the return is monthly changes over the past 52 weeks. Which one is "better"? There really is no perfect answer, and it depends on the purpose of the test.
Finding Correlation in Excel
There are several methods to calculating correlation in Excel.
The simplest way is to get two data sets and use the built-in correlation formula:
This is a convenient way to calculate a correlation between just two data sets. But what if you want to create a correlation matrix across a range of data sets? To do this, you need to use Excel's Data Analysis plugin. The plugin can be found in the Data tab, under Analyze.
Select the table of returns. In this case, our columns are titled, so we want to check the box "Labels in first row," so Excel knows to treat these as titles. Then you can choose to output on the same sheet or on a new sheet.
Once you hit enter, the data is automatically made. You can add some text and conditional formatting to clean up the result.
How can you find the demand function from the utility function?A:
A consumer's budget constraint is used with the utility function to derive the demand function. The utility function describes the amount of satisfaction a consumer gets from a particular bundle of goods. Say there are two goods a consumer can choose from, x and y. Assuming no borrowing or saving, a consumer's budget for x and y are equal to income. To maximize utility, the consumer wants to use the entire budget to buy the most x and y possible.
The first part of figuring out demand is to find the marginal utility each good provides and the rate of substitution between the two goods—that is, how many units of x the consumer is willing to give up so she can get more y.
The substitution rate is the slope of the consumer's indifference curve, which shows all of the combinations of x and y the consumer would be equally happy to accept. However, just because the consumer doesn't prefer one combination over another on a subjective level, she has to take into account what is affordable.
The point where the budget line meets the indifference curve is where the consumer's utility is maximized. This happens when the budget is fully spent on a combination of x and y with no money left over, which makes that combination the optimal one from the consumer's point of view.
The point of utility maximization is key to deriving the demand function. Because they are equal where utility is maximized, the marginal rate of substitution, which is the slope of the indifference curve, can be used to replace the slope of the budget curve. The slope of the budget curve is the ratio between the price of x and the price of y. Replacing it with the marginal rate of substitution simplifies the equation so only one price remains. This makes it possible to find out the demand for the product in terms of its price and the total income available.
In terms of this particular example, the demand function would thus formally express the amount of x the consumer is willing to buy, given her income and the price of x.
This demand function can then be inserted into the budget equation to derive the demand for y. The same principles apply: Instead of two price and product variables, the resulting equation could be simplified so it only includes the price of y, the consumer's income and the total quantity of y demanded, given both of those factors.
(For related reading, see: What is the utility function and how is it calculated?)
How did John Maynard Keynes influence business cycle theory?A:
John Maynard Keynes created the theoretical arguments for a new type of economic strategy: government intervention used to smooth out the business cycle. Keynes died in 1946, but his ideas created the Keynesian school of economics and led to the development of macroeconomics. Keynes' ideology dominated the economic paradigm from 1945 until the late 1970s. According to Keynes, free markets do not always contain self-balancing mechanisms; sometimes government intervention is necessary to minimize downturns and promote growth. He believed that without state assistance, the booms and busts in the business cycle could spiral out of control.
Macroeconomics and the Business Cycle
Keynes' specific interpretations were rarely new; most of his concepts were known to other thinkers at the time, but his overall proposal was radical. Keynes combined three principle tenets. The first was that aggregate demand could be predictably manipulated by several factors. The second was that prices are sticky and economic adjustments are not always efficient. It was the third tenet that was significant: in the short run, changes in aggregate demand impact real output and employment more than prices. In other words, governments could try to manipulate consumption and investment without price changes creating negative effects.
Keynes also believed that individual agents act correctly according to microeconomic incentives, but sometimes the aggregate of individual decisions leads to adverse aggregate outcomes. The dominant economists at the time were unable to refute Keynes' attacks. An entirely new study of economics, one that focused on the aggregate impacts, was developed.
Government Management of the Economy
Contemporary notions of monetary and fiscal policy stem from Keynes' concepts. A common Keynesian analogy compares the economy to a car. If the economy is going too fast, government policy can step on the brakes. Conversely, it can hit the gas when the economy is too slow.
Later economists such as F.A. Hayek, Milton Friedman, Murray Rothbard and Joseph Schumpeter challenged Keynes' notion of government management. Nevertheless, Keynes' policies remain very popular with the International Monetary Fund (IMF), the World Bank and most governments around the world.
Politicians loved Keynes' ideas. Not only did Keynes offer the first plausible explanation of the Great Depression, but his theories created a scientific justification for massive spending without raising taxes. During subsequent business cycles and recessions, politicians could offer a proposal different than "let the market sort it out."
It is worth noting that some governments arrived at counter-cyclical policy decisions before Keynes published "A General Theory" in 1936. Herbert Hoover launched the first anti-depression interventions in the United States in 1930. Keynes' theories did not really take hold until after WWII with the Bretton Woods Agreement.
Keynes was the most famous economist in the world by 1944. He led a British proposal to create supranational economic entities and a global plan for addressing macroeconomic issues. Not all of Keynes' plans were adopted; he faced considerable pushback from the U.S. in particular, but his general principles became dominant.
How did mass production affect the price of consumer goods?A:
Before the advent of mass production, goods were usually manufactured on a made-to-order basis. Once mass production was developed and perfected, consumer goods could be made for the broadest possible market. Anything consumers needed or desired could be made in larger quantities. Mass production resulted in lower prices of consumer goods. Eventually, the economies of scale result in the most affordable price of any product for the consumer without the manufacturer having to sacrifice profits.
A good case in point would be the automobile and its predecessor, the horse-drawn carriage. There was never any form of mass production of the horse-drawn carriage. A carriage was made only if there was a person, company or organization ordering it. Only then would the craftsmen who specialized in building carriages begin to create the vehicle.
Industrialization pioneer Henry Ford and his method of manufacturing motor cars changed everything. While Ford was not the inventor of the motor car, he is credited with developing mass production techniques, such as the assembly line, which have helped reduced production costs.
Instead of manufacturing a few units a month, Ford’s plants could complete hundreds of cars per day. While only the wealthy could afford the handmade carriages, cars became the ultimate consumer product due to affordability that gave greater mobility to the average American family of the early part of the 20th century.
This comparison still holds true today. Automobile brands such as Rolls Royce, Maserati or Lamborghini employ modern-day craftsmen to create vehicles, making them the equivalent of the handmade carriages of yesteryear. Meanwhile, Toyota, Ford and GM mass produces cars, making them more affordable to the average consumer.
While mass production is now the norm for consumer goods, there remains a demand for handmade products at higher prices, which may or may not be of superior quality. Their attraction is the fact that they are not intended for everyone. Handmade cigars are sold at a premium, with prices much higher than branded cigars from other sources, for example. Yet the average cigar smoker may not be able to tell the difference between hand-rolled cigars and mass-produced cigars when taking a blind test.
Other products that are handmade rather than mass-produced and fetch higher prices – sometimes out of the range of the average consumer – include designer gowns, jewellery and leather goods, such as shoes and bags. They have machine-made, mass-produced counterparts, and purists insist that it takes a trained eye to spot the difference.
About the only thing that cannot be mass-produced but is still in demand by collectors would be artwork, such as paintings and sculptures. While they can be reproduced and mass-produced, there can only be one original. There is, for example, only one Mona Lisa, but knock-offs can be created by any talented artist adept at copying the masterpiece.
How did mercantilism affect the colonies of Great Britain?A:
England is small and contains relatively few natural resources. During Great Britain's mercantilist period, the prevailing economic wisdom suggested that the empire's many colonies could supply raw materials and resources to the mother country and subsequently be used as export markets for the finished products. The resulting favorable balance of trade was thought to increase national wealth. Great Britain was not alone in this line of thinking. The French, Spanish and Portuguese competed with the British for colonies; it was thought, no great nation could exist and be self-sufficient without colonial resources.
Controlled Production and Trade
During this time, there were many clear aggressions and human rights violations that were committed by imperial European empires on their colonies in Africa, Asia and the Americas, though not all of these were directly rationalized by mercantilism. Mercantilism, did however, lead to the adoption of enormous trade restrictions, which stunted the growth and freedom of colonial business.
In the 1660s, for example, England passed the Navigation Acts, a series of laws designed to make American colonies more dependent on manufactured products from Great Britain. British authorities further enumerated a set of protected goods that could only be sold to British merchants, including sugar, tobacco, cotton, indigo, furs and iron.
Trade, at this time, became triangulated between the British Empire, its colonies and foreign markets. This fostered the development of the slave trade in many colonies, including America. The colonies provided rum, cotton and other products heavily demanded by imperialists in Africa. In turn, slaves were returned to America or the West Indies and traded for sugar and molasses.
Inflation and Taxation
The British government also demanded trade in gold and silver bullion, ever seeking a positive balance of trade. The colonies often had insufficient bullion left over to circulate in their own markets, so they took to issuing paper currency instead. Mismanagement of printed currency resulted in periods of inflation. Additionally, Great Britain was in a near-constant state of war. Taxation was needed to prop up the army and navy. The combination of taxes and inflation caused great colonial discontent.
How did moral hazard contribute to the 2008 financial crisis?A:
The financial crisis of 2008 was the result of numerous market inefficiencies, bad practices and a lack of transparency in the financial sector. Market participants were engaging in behavior that put the financial system on the brink of collapse. Historians will cite products such as CDOs or subprime mortgages as the root of the problem. However, it's one thing to create such a product, but to knowingly sell and trade these products requires moral hazard.
A moral hazard exists when a person or entity engages in risk-taking behavior based on a set of expected outcomes where another person or entity bears the costs in the event of an unfavorable outcome. A simple example of a moral hazard is drivers relying on auto insurance. It is rational to assume that fully insured drivers take more risks compared to those without insurance because, in the event of an accident, insured drivers only bear a small portion of the full cost of a collision. (See also: The Fall of the Market in the Fall of 2008)
Before the financial crisis, financial institutions' expected that regulating authorities would not allow them to fail due to the systemic risk that could spread to the rest of the economy. The institutions holding the loans that eventually contributed to the downfall were some of the largest and most important banks to businesses and consumers. There was the expectation that if a confluence of negative factors led to a crisis, the owners and management of the financial institution would receive special protection or support from the government. Otherwise known as moral hazard.
There was the presumption that some banks were so vital to the economy, they were considered "too big to fail." Given this assumption, stakeholders in the financial institutions were faced with a set of outcomes where they would not likely bear the full costs of the risks they were taking at the time. (See also: How "Too Big to Fail" Banks Will Get Even Bigger)
Another moral hazard that contributed to the financial crisis was the collateralization of questionable assets. In the years leading up the crisis, it was assumed lenders underwrote mortgages to borrowers using languid standards. Under normal circumstances, it was in the best interest of banks to lend money after thoughtful and rigorous analysis. However, given the liquidity provided by the collateralized debt market, lenders were able to relax their standards. Lenders made risky lending decisions under the assumption they would likely be able to avoid holding the debt through its entire maturity. Banks were offered the opportunity to offload a bad loan, bundled with good loans, in a secondary market through collateralized loans, thus passing on the risk of default to the buyer. Essentially, banks underwrote loans with the expectation that another party would likely bear the risk of default, creating a moral hazard and eventually contributing to the mortgage crisis.
The financial crisis of 2008 was, in part, due to unrealistic expectations of financial institutions. By accident or design - or a combination of the two - large institutions engaged in behavior where they assumed the outcome had no downside for them. By assuming the government would opt as a backstop, the banks actions were a good example of moral hazard and behavior of people and institutions who think they are given a free option.
Quasi-government agencies such as Fannie Mae and Freddie Mac offered implicit support to lenders underwriting real estate loans. These assurances influenced lenders to make risky decisions as they expected the quasi-government institutions to bear the costs of an unfavorable outcome in the event of default.
How did the Great Recession affect structural unemployment?A:
The collapse of the housing bubble in 2007 and 2008 caused a deep recession, which sent the unemployment rate to 10.0% in October 2009 – more than double is pre-crisis rate. As of September 2017, the unemployment rate has fallen to below its pre-crisis lows, indicating that the spike in unemployment was cyclical, in other words, that it was a response to the business cycle that reversed itself as the overall economy recovered. There is an argument to be made, however, that the Great Recession caused an increase in structural unemployment.
Unlike cyclical unemployment, structural unemployment is not directly correlated to the business cycle, but is a chronic response to broad economic shifts. If someone loses their job as a real estate agent because of a downturn in the housing market, then finds another job as the market picks up, they have experienced cyclical unemployment. If someone loses their job as an elevator operator because elevators have become automated, they are experiencing structural unemployment. (Both forms contrast to frictional unemployment, the unavoidable result of imperfect information in a healthy labor market.)
According to one line of thinking, the Great Recession caused such profound disruption in some areas of the country that local economies contracted permanently and local industries fizzled out or moved elsewhere. Structural unemployment increased as a result: people, particularly the low-skilled, were unable to find jobs without moving or entering a new industry, which often proved too difficult due to economic, educational or other barriers. The housing crisis – the immediate cause of the Great Recession – made matters worse by tying people to houses they could not sell without losing money.
Structural unemployment is difficult to measure, but there are hints in the data that the spike in unemployment following the crisis was not purely cyclical. While the headline unemployment rate (the one mentioned above, also known as U-3) has fully recovered, other measures have not. U-1, which measures the share of the labor force that has been unemployed for 15 weeks or longer, remains above it's pre-crisis low; this measure of chronic unemployment may provide a window into the level of structural unemployment. Similarly U-6, which includes those who have given up looking for a job or have reluctantly settled for part-time work, remains above its pre-crisis low.
A 2011 IMF working paper attempted to measure the Great Recession's effect on structural unemployment in the U.S, and concluded that it had risen by around 1.75 percentage points from a pre-crisis level of 5%. The paper also suggested that, as a result of the rise in structural unemployment, inflationary pressures would result from a fall in (U-3) unemployment to levels below around 7%. In 2017, inflation remains subdued with unemployment rates below 5%.
While it is possible that structural unemployment is higher today than it was before the housing bubble burst, it is difficult to parse the causes of the increase. In the decade since the financial crisis began, automation has accelerated, pushing people out of manufacturing jobs. Competition from foreign producers, particularly in China, has increased. Rents in big cities and the costs of higher education have increased rapidly, making it more difficult to enter the markets and industries where labor is in high demand. Some of these phenomena are themselves related to the crisis, arising in part from it or contributing to the direction it took.
Did the Great Recession raise structural unemployment? There probably is no simple answer.
How did the Soviet economic system affect consumer goods?A:
The now-defunct Soviet Union was not a good place for its citizens, who suffered from chronic shortages of consumer goods. What goods were available to them were generally inferior to what was available in the West.
During its nearly seven decades of existence from 1922 to 1991, the Union of Soviet Socialist Republics was one of the two major communist powers – the other being China – that followed the centralized planning model for its economy, a basic tenet of communism.
As such, the Soviet Union's ordinary citizens were generally not allowed access to imported consumer goods, especially those manufactured in the United States. Also known as "the Iron Curtain," the Soviet economic system called for self-sufficiency in all matters, from bread to clothes to cars to fighter aircraft.
The Soviet Union failed for a number of reasons. Political analysts say that the Soviet economic system was inferior to the free market economy espoused by the United States and most of the West.
The input-output analysis developed by Nobel Prize-winning economist Wassily Leiontief sees the economy as a network of interconnected industries; one industry’s output is used as an input by another.
Centralized planning, however, left little room for quick adjustments to errors in judgment or external factors beyond the state's control. When one industry failed, the other industries followed suit.
By the mid-1980s, the Soviet Union had 98 percent control of the retail trade. Private businesses were taboo. It was only the small family farms in rural areas that remained in the hands of private citizens.
In the meantime, the countries surrounding the Soviet Union in the post-World War II years had become economic powerhouses producing consumer goods that vastly improved the quality of life for citizens who could afford them. With German cars, French perfume, Italian wines and British-made appliances, Western Europeans were living the good life compared to their Soviet counterparts, who had gotten used to long queues whenever the farm-to-market supply chain was disrupted.
Worst of all, consumers in the Soviet Union had developed a taste for foreign products, such as U.S.-made Levi jeans, despite similar Soviet Union-made attire being available at lower prices. It did not matter if the jeans were smuggled and sold at atrocious prices. Soviet consumers had just enough exposure to the outside world to be familiar with what was available and to demand better-quality goods than the Soviet economic system could provide them.
Throughout its history, the Soviet Union tried to instill in its people the message that consumerism was an evil that belonged only in the decadent West. Soviet consumers believed otherwise, which is why they welcomed perestroika and the USSR collapse.
How did World War II impact European GDP?A:
World War II brought about untold changes in Europe and elsewhere. This period marked a cultural and economic shift for the entire globe, and the recovery from that shift echoes to this day. Economically, the period after the end of World War II was a time for moving from the industry of creation for the purpose of destruction and into the industry of creation for creation's sake, of exploring new technologies and business models previously unheard of. In Europe, this shift is most clearly illustrated by the change in the gross domestic product (GDP) in the years immediately following the war.
The GDP is a numerical metric that measures all the finished products and services produced by a particular population, usually a single nation or collection of nations, such as the European Union. The GDP is calculated by adding the sum of all consumer spending, government spending, business spending and total imports less total exports for the time period in question. This metric is used to assess many aspects of a nation's economic health, including general growth patterns and standard of living. In years when the GDP is at an increase, the economy is understood to be growing, unemployment tends to be down and exports tend to be up.
Even during war time, American output steadily grew, as the physical damage done to the country was relatively limited. This allowed Americans to buckle down and work on bolstering industry rather than having to focus on rebuilding what was lost. Conversely, many countries in Europe suffered extensive damage to buildings and infrastructure, so the end of the war was a time for intensive rehabilitation. However, the end of the war also marked the beginning of a period of expansive growth for Europe and other nations. For the second half of the 20th century the United States, Europe, and Japan experienced amazing gains. In fact, the European GDP tripled between the end of the war and the year 2000.
One of the theories behind what allowed such prolific growth in a region ravaged by war is that the end of World War II and the instability of the previous decades presented Europe the opportunity for catch-up growth. Since the years in between World War I and World War II were rife with global economic instability, Europe had not had time to implement many of the advancements pioneered in the U.S. and elsewhere. Where Americans were developing new technologies such as nylon and Teflon, and making important advancements in areas such as the automotive industry, many Europeans were still heating their homes with coal. Basically, the non-stop turmoil of the pre-war years left little time for advancement on the continent. However, once the war ended, all these new technologies and advancements in business and industry became available to economies newly able and ready to embrace them. People who worked in wartime as soldiers and nurses now needed jobs, and American advancement during the preceding years provided the perfect blueprint for how to use this newly available workforce. This and other factors contributed to an upswing in the GDP of Europe that persisted well into the 1970s.
How do "factor endowments" impact a country's comparative advantage?A:
Factor endowments impact a country's comparative advantage by affecting the opportunity cost of specializing in producing certain goods relative to others.
A comparative advantage exists when the opportunity cost of specialization is lower than that of other nations. The existence of a comparative advantage is, in turn, affected by the abundance, productivity and cost of labor, land and capital. Other factors also might influence a country's comparative advantage in practical terms, such as a highly developed financial system or economies of scale.
A simple example of a factor endowment with respect to land would be the presence of natural resources such as oil. Countries with abundant oil tend to export oil, focusing internal resources toward producing the factor they have in quantity. Angola is an extreme example of such specialization: oil accounts for 98% of its exports.
Labor is a key input in most products, from agriculture to cellphones, and its characteristics affect a country's comparative advantage. An abundant labor force means that a country has a lower opportunity cost of specializing in labor-intensive activities. A highly skilled labor force is more expensive and more productive than an unskilled labor force. For example, as China's labor force has grown more skilled, wages have risen and China has begun specializing in more complex manufactured goods.
Factor endowments are not static. With education, for example, the characteristics of the labor force can change. The same holds true for investments in capital and infrastructure. Over time, both can affect a country's sources of comparative advantage.
How do central banks impact interest rates in the economy?A:
The central bank for the United States – the Federal Reserve (the Fed) – is tasked with maintaining a certain level of stability within the country's financial system. Specific tools are afforded the Fed that allow for changes to broad monetary policies intended to implement the government's planned fiscal policy. These include the management and oversight of the production and distribution of the nation's currency, sharing of information and statistics with the public, and the promotion of economic and employment growth through the implementation of changes to the discount rate.
The most influential economics tool the central bank has under its control is the ability to increase or decrease the discount rate. Shifts in this crucial interest rate have a drastic effect on the building blocks of macroeconomics, such as consumer spending and borrowing.
What Is the Discount Rate?
For banks and depositories, the discount rate is the interest rate assessed on short-term loans acquired from regional central banks. Financing received through federal lending is most commonly used to shore up short-term liquidity needs for the borrowing financial institution; as such, loans are extended only for an overnight term. The discount rate can be interpreted as the cost of borrowing from the Fed.
Decrease to the Discount Rate
When the Fed makes a change to the discount rate, economic activity either increases or decreases depending on the intended outcome of the change. When the nation's economy is stagnant or slow, the Federal Reserve may enact its power to reduce the discount rate in an effort to make borrowing more affordable for member banks. (For related reading, see: How does the Federal Reserve determine the discount rate?)
When banks can borrow funds from the Fed at a less expensive rate, they are able to pass the savings to banking customers through lower interest rates charged on personal, auto or mortgage loans. This creates an economic environment that encourages consumer borrowing and ultimately leads to an increase in consumer spending while rates are low.
Although a reduction in the discount rate positively affects interest rates for consumers wishing to borrow from banks, consumers experience a reduction to interest rates on savings vehicles as well. This may discourage long-term savings in safe investment options such as certificates of deposit (CDs) or money market savings accounts.
Increase to the Discount Rate
When the economy is growing at a rate that may lead to hyperinflation, the Fed may increase the discount rate. When member banks cannot borrow from the central bank at an interest rate that is cost-effective, lending to the consuming public may be tightened until interest rates are reduced again. An increase to the discount rate has a direct impact on the interest rate charged to consumers for lending products, and consumer spending shrinks when this tactic is implemented. Although lending is not as attractive to banks or consumers when the discount rate is increased, consumers are more likely to receive more attractive interest rates on low-risk savings vehicles when this strategy is set in motion. (For related reading, see: How does a high discount rate affect the economy?)
How do changes in interest rates affect the spending habits in the economy?A:
Changes in interest rates can have different effects on consumer spending habits depending on a number of factors, including current rate levels, expected future rate changes, consumer confidence and the overall health of the economy.
It's possible for interest rate changes, either up or down, to have the effect of increasing consumer spending or decreasing spending and increasing saving. The ultimate determinant of the overall effect of interest rate changes primarily depends on the consensus attitude of consumers as to whether they are better off spending or saving in light of the change.
Keynesian economic theory refers to two conflicting economic forces that can be influenced by interest rate changes: the marginal propensity to consume (MPC) and the marginal propensity to save (MPS).These concepts basically refer to changes in how much disposable income consumers tend to spend or save.
Spend or Save?
An increase in interest rates may lead consumers to increase savings, since they can receive higher rates of return. An decrease in interest rates is often accompanied by a corresponding increase in inflation, so consumers may be influenced to spend less if they believe the purchasing power of their dollars will be eroded by inflation.
The current level of rates and expectations regarding future rate trends are factors in deciding which way consumers lean. If, for example, rates fall from 6% to 5% and further rate declines are expected, consumers may hold off on financing major purchases until lower rates are available. If rates are already at very low levels, however, consumers will usually be influenced to spend more to take advantage of good financing terms.
The overall health of the economy impacts consumer reaction to interest rate changes. Even with rates at attractively low levels, consumers may not be able to take advantage of financing in a depressed economy. Consumer confidence about the economy and future income prospects also affect how much consumers are willing to extend themselves in spending and in financing obligations.
(For related reading, see: What is the relationship between inflation and interest rates?)
How do companies use price discrimination?A:
Price discrimination is a strategy that companies use to charge different prices for the same goods or services to different customers. The three main types of price discrimination are first degree, second degree and third degree. Companies use these types of price discrimination to determine the prices to charge different consumers.
Companies use first degree price discrimination to sell a product for the maximum price a consumer will pay. For companies to use this strategy, they must know what their consumers are willing to pay for a good. For example, car dealers may exercise first degree price discrimination by looking at how a potential car buyer is dressed. A consumer who has the latest version of a phone and wears expensive clothes is more likely to be able to pay a premium for a new car.
Companies practice second degree price discrimination by charging different prices based on the quantity demanded. Companies generally offer special prices for consumers who buy in bulk. For example, communications companies may offer special bulk discounts for buying a variety of their products. Many communications companies offer a packaged deal for Internet, phone and TV services at a discount to what consumers would pay for all three services separately.
Companies can also engage in third degree price discrimination by offering different prices for different groups. Some companies may use age to discriminate consumers and charge different age groups different prices. For example, students and senior citizens may be given discounts because they exhibit high price sensitivity.
How do economies of scale work with globalization?A:
Globalization – the integration of factors of production and inclusion of consumer groups from different markets around the world – facilitates unprecedented achievements of economies of scale for producers. Access to increased numbers of laborers, investors, markets, resources, technologies and business models through globalization can theoretically maximize productive efficiency to a level consistent with the size of the world's population.
Economies of Scale
Economies of scale refers to the phenomenon of diminishing marginal costs associated with each additional unit of output. A company experiences economies of scale as it specializes and is able to produce extra goods with fewer and fewer input costs.
According to economic theory, economies of scale are the natural consequence of specialization and the division of labor. It is one of the chief drivers of economic growth. However, firms do not realize economies of scale in perpetuity; there is a maximum level of efficient output for any given inputs, and operations may sometimes extend too far and cause diseconomies of scale.
With access to new inputs and potentially more profitable markets, globalization can increase specialization and operational efficiency. The practical consequences of globalization include lower costs to consumers, access to capital for wealthy countries, access to jobs for poorer countries, increased competition and higher global productivity.
As globalization spreads the division of labor to a global scale, countries are able to export labor and production processes that they are relatively less profitable at and instead specialize in labor that is relatively more profitable. This result can be seen in factory jobs being driven out of the United States, which frees up capital for highly technical, highly productive fields such as IT. Companies are able to pursue higher degrees of efficiency and increase their economies of scale.
How do Economies of Scope and Economies of Scale Differ?A:
Economy of scope and economy of scale are two different concepts used to help cut a company's costs. Economies of scope focuses on the average total cost of production of a variety of goods, whereas economies of scale focuses on the cost advantage that arises when there is a higher level of production of one good.
Economies of Scope
The theory of an economy of scope states the average total cost of a company's production decreases when there is an increasing variety of goods produced. Economy of scope gives a cost advantage to a company when it produces a complementary range of products while focusing on its core competencies. Economy of scope is an easily misunderstood concept, especially since it appears to run counter to the concepts of specialization and scale economies. One simple way to think about economy of scope is to imagine that it's cheaper for two products to share the same resource inputs (if possible) than for each of them to have separate inputs.
An easy way to illustrate economy of scope is with rail transportation. A single train can carry both passengers and freight more cheaply than having separate trains, one for passengers and another for freight. In this case, joint production reduces total input costs. (In economic terminology, this means that one input factor's net marginal benefit increases after product diversification.)
For example, company ABC is the leading desktop computer producer in the industry. Company ABC wants to increase its product line and remodels its manufacturing building to produce a variety of electronic devices, such as laptops, tablets and phones. Since the cost of operating the manufacturing building is spread out across a variety of products, the average total cost of production decreases. The costs of producing each electronic device in another building would be greater than just using a single manufacturing building to produce multiple products.
Real-world examples of the economy of scope can be seen in mergers and acquisitions (M&A), newly discovered uses of resource byproducts (such as crude petroleum) and when two producers agree to share the same factors of production.
Economies of Scale
Conversely, an economy of scale is the cost advantage a company has with the increased output of a good or service. There is an inverse relationship between the volume of output of goods and services and the fixed costs per unit to a company.
For example, suppose company ABC, a seller of computer processors, is considering purchasing processors in bulk. The producer of the computer processors, company DEF, quotes a price of $10,000 for 100 processors. However, if company ABC buys 500 computer processors, the producer quotes a price of $37,500. If company ABC decides to purchase 100 processors from company DEF, ABC's per unit cost is $100. However, if ABC purchases 500 processors, its per unit cost is $75.
In this example, the producer is passing on the cost advantage of producing a larger number of computer processors onto company ABC. This cost advantage arises because the fixed cost of producing the processors has the same fixed cost whether it produces 100 or 500 processors. Generally, when the fixed costs are covered, the marginal cost of production for each additional computer processor decreases. At lower marginal costs, additional units represent increasing profit margins. It offers companies the ability to drop prices if need be, improving the competitiveness of their products. Large, warehouse-style retailers such as Costco and Sam's Club package and sell large items in bulk due in part to realized economy of scale.
Although an economy of scale may seem beneficial to a company, it has some limits. Marginal costs never decrease perpetually. At some point, operations become too large to keep experiencing economies of scale. This forces companies to innovate, improve their working capital or remain at their present optimal level of production. For example, if the company that produces the computer processors surpasses its optimal production point, the cost of each additional unit may begin to increase instead of continuing to decrease. (For related reading, see: What are some examples of economies of scale?)