Current Trends in Business Economics - Essay Example

BUSINESS ECONOMICS A1. The current account deficit depicts a measure of the extent to which Australia draws upon overseas resources in excess of its capacity to earn the same by way of exports and other similar credits (Kelly 1994, Pp. 198). It calculates the exchange of real goods and services and the transfer of payments in a given year. Real goods refer to market goods, while services refers to payment of interest on loans borrowed, royalties on intellectual property, income earned on international investments, etc. Transfer of payments on the other hand, refers to foreign remittances received by families from workers employed overseas, grants given to foreign countries, etc. There is an inverse relationship between a country’s current account and its foreign debt, all things remaining equal. This can be observed from the current account and foreign debt statistics of Australia, in the current year. In the year 2009 there is a deficit in Australia’s current account. This is because of a continued rise in its net foreign debt which results in a negative impact on a country’s current account. As shown in the figure below – the total current account deficit for the year 2009 amounts to $6346 million. Figure 1: Australia’s Balance of Payments: Key Figures (Australian Bureau of Statistics, 2009) Revenue gains received by a country help in increasing the balance in its current account while excessive expenditure leads to a deficit. Thus, if a country imports more goods and services than the goods and services it exports, it leads to a deficit in its current account and vice versa (Daly, 2004). The above figure shows an increase in Australia’s net foreign debt, over the years from $506,355 million in 2006- 07 to $616,650 million in 2008 – 09 (Australian Bureau of Statistics, 2009), thus indicating that its exports far exceeds its imports, and the savings are relatively lower as well. Thus, it can be said that there is an inverse relationship between current account deficit and foreign debt of a country, as the foreign debt increases, with savings remaining constant, there is a deficit in the current account while, a reduction in foreign debt, increase in exports, increase in savings, etc would lead to a surplus in the country’s current account. Another significant relationship between CAD (current account deficit) and foreign debt of a country is the fact that as the country experiences a CAD it leads to an increase in foreign borrowings, which is required to pay off the deficit, which ultimately leads to a further increase in foreign debt. As the foreign debt rises, the interest on it rises simultaneously, thereby further increasing the CAD, and this cycle continues. A2. According to Keynes, disproportionate saving, which far exceeds the planned investment, poses a grave threat to the economy, considerably raising the chances of recession or depression. Excessive savings may lead to various outcomes such as decline in consumer demand, excessive investments in previous years, cynical attitudes towards businesses etc. Hence, it is necessary to keep savings in check, to prevent the economy from deteriorating. The classical economists believed that excessive supply of loanable funds would lead to a decline in interest rates. In the figure below, if the investment (I) in capital goods falls from old I to new I then such a fall would lead to a simultaneous increase in savings, which would cause a decline in interest rates, to compensate the excessive supply. Hence the saving S would then be equal to the investment I. However, Keynes opposed such a theory and argued that the rate with which savings decrease, is not equal to the rate with which the interest rates decline, owing to the income and substitution effects. Also, investment in capital goods occurs through long term planning, and hence is a preplanned investment. Thus, it assumed that in the long term, the rate of decline in interest rates is relatively higher than rate of increase in spending. Thus, in the Keynesian model, savings S and investment I are depicted as inelastic and hence is shown as a steep slope. Assuming that both demand and supply are inelastic, a significant fall in interest rates would be required to bridge the gap between savings and investment, which in turn, requires a negative interest rate at equilibrium. This is the point where I intersects S. Keynes argues that such a negative rate of interest in unnecessary. The classical economists believed that the rate of interest can cause equilibrium between savings and investment. Keynes opposed this view on the grounds that saving is a function of income, while interest rates are a function of marginal efficiency of capital, hence interest rates cannot cause equilibrium between savings and investment. He further stated that excessive savings would lead to unemployment and ultimately a reduction in the total expenditure. The classical economists assumed that savings and investment are interest elastic which would result in excessive savings in case of a rise in interest rates. Thus, according to them, investment will be higher at lower interest rates. However, Keynes opposed this view. He argued that the demand for money would rise in case of reduced interest rates. Besides, investments are always made keeping in mind the long term benefits. Thus, if the interest rates are lower, the return on investment would be lower too; hence the investment would fall, in the event of lower interest rates (Arnold, 2008). A3. The Marginal Propensity to Consume (MPC) alternatively known as the slope of consumption function indicates the percentage of each additional unit of household income which is used for consumption. It is calculated as: MPC = Change in Consumption Change in Income It also forms the basis of determining the slope of aggregate expenditure and plays a crucial role in the multiplier process. MPC depicts the manner in which households spend their extra or additional income. For example, if the MPC of a household is 0.75, it suggests that the household spends 75 percent of its excess income on household consumption. The Slope of the Consumption Function The diagram below shows the slope of consumption function ‘C’ which is sloped positively on the graph, thus indicating that the higher level of income leads to higher expenditure on household consumption. The other line, depicting a 45 degree slope, indicative of the relative slope of consumption, meaning thereby, that this slope is relatively flatter indicating a slope of less than 1. The value of the slopes indicates that for each $1 change in household income, there is a simultaneous change in consumption expenditure equal to 0.75. The size of the multiplier The size of the multiplier is directly related to the slope of consumption function hence the bigger the size of the multiplier, the steeper will be the slope of consumption function (Beenhakker, 2001).It calculates the exaggerated change in aggregate production caused on account of a change in an independent variable such as investment expenditure. Such an exaggerated change occurs on account of change in production which leads to a change in income thereby stimulating higher consumption. This consumption in turn, is again an expenditure on production leading to a rise in income and hence further rise in consumption. This cycle ultimately causes an increased change in the aggregate production and hence in consumption. The MPC thus becomes an integral part of this process, since it ascertains the amount of consumption which is induced on account of such a change in production as well as income. Thus, if the MPC is higher than the multiplier process, then it leads to higher consumption with each progressive cycle. The relationship between MPC and the multiplier process can be calculated as: Expenditure Multiplier = 1 (1 – Marginal Propensity to Consume) This shows that rise in MPC leads to a fall in the value of the denominator (on the right hand side of the equation) which further leads to an overall increase in the fraction and hence, the size of the multiplier (Kroon, 2007). A4. The relationship between the supply curve and the marginal cost curve for the perfectly competitive firm can be explained with the help of the figure illustrated below: In the above diagram, the point P1 denotes the starting point of the firm’s supply curve, which is the price at which the firm is barely able to cover its average variable cost. As the prices increase from price P1 to P2 and from P2 to P3, there is a simultaneous increase in quantity produced, i.e., from Q1 to Q2 and from Q2 to Q3. The firm attains equilibrium at the points where its MC curve intersects the MR curve. Thus the equilibrium at Price P1 and Quantity Q1 is attained at point MR1 where the marginal cost curve intersects the marginal revenue curve. The short run supply curve of the firm is indicated at a point where its MC curve lies slightly above its AVC (Average Variable Cost) curve. Industry supply curve Assuming that there are x number of firms which exists in a perfectly competitive industry, at each price level P1, P2, P3; the industry supply curve is illustrated on the x axis which shows the quantities that each firm produces, as shown by the marginal cost curve, which lies just above the AVC curve. In the second diagram (b), the industry supply curve is calculated by taking into consideration the quantities of goods produced by each individual firm and multiplying it with ‘x’ (i.e. the total number of firms in the industry) and plotting the amount derived, against the relevant price. Thus at price P1, the AVC is higher than the average revenue, hence no quantity is produced at this point, meaning thereby the firm will not supply any goods below this price (Black et al, 2000, Pp. 95). A5. There is an inverse relationship between the quantity of money demanded and the interest rate. This is shown in the following diagram: Figure: Demand for Money The demand for money is depicted by the curve which shows the relationship between the quantity of money and the money interest rates. The inverse relationship between the two, denotes that with the increase in interest rates, the propensity to hold money reduces since holding money becomes relative more expensive as compared to other interest earning alternatives such as bonds, stocks etc. Thus, with every increase in interest rates, the households well as firms will reduce their money balances. There are various reasons for holding up money such as households hold money to pay for routine household expenditures such as buying groceries, maintaining cars, paying rent, spending for their children etc, while businesses hold money for buying supplies, or paying wages etc. People also hold money to account for unforeseen situations such as accidents or medical emergencies. However, higher interest rate makes it expensive for people to hold money. Thus if the interest rates increases, the cost of holding money increases hence the demand for money falls, and vise versa. Also the opportunity cost of holding money is directly related to the nominal interest rates. The curve shown in the diagram above indicates the relationship between interest rates and the quantity of money that individuals would want to hold, and since higher rates of interest increases the opportunity cost of holding money, quantity of money demanded is inversely related to the interest rates (Gwartney et al, 2008). A6. There are various forces which have led to globalization in markets and in production, however the two major forces are: technological advances - which have led to significant reduction in costs; and trade liberalization - which has led to reduced trade protection and more liberal world trading systems. Rapid technological developments has facilitated ease in transportation, enhanced communication and faster and reliable sharing and processing of information, which in turn has contributed significantly to the rise in global production levels as well as the development of global markets. Such changes have facilitated the global competition to increase thus enabling the firms across the globe to produce better quality products and services. This has further led to a significant increase in the number of alternatives / choices available to the consumers and has put a greater emphasis on the firms to deliver better and higher quality of goods and services at lower costs in order to sustain their competitive positioning in the industry. Such an expanded market place, at international level, has in turn put a greater emphasis on the firms across the globe, to restructure their business strategies and work in collaboration with consumers and suppliers in order to reduce their production costs and offer better quality of goods and services at reduced prices. Changes in technology has also led to the development of dynamic markets whereby consumers have a far greater control over the choice of goods and prices and new firms as well as products have easy entry into the markets at a faster rate (Mentzer, 2001). Trade liberalization on the other hand, has led to a significant expansion of the world market as trade barriers are lowered by countries and the international markets become more and more integrated. The removal of trade barriers have led to reallocation of factors of production such as land, labor and capital to economies having greater competitive advantage owing to which goods and services are now readily and freely available at significantly reduced prices. Post trade liberalization, the world trading systems are now redefined to include a highly concentrated system of trade relations which facilitates amalgamation of practically all economies through evolution of world markets for various goods and services. Such a shift towards a larger and better global marketplace, has led to significant transformations in the manner in which firms operate and most importantly the internationalization of production. As a result, national markets are increasingly merging within one another with an expansion of intra – industry trade, and a simultaneous rise in global competition which has now transcended beyond boundaries thereby significantly impacting and influencing local economies (Held, 1999). A7. The exchange rate of a country plays a vital role in facilitating adjustment of an economy to the terms of trade and other external setbacks, which a country faces. As the markets become increasingly established and profound, the exchange rate movements experienced by it become more and more pronounced. The term exchange rate refers to the price of an Australian dollar stated with regard to other currencies. With regard to Australian dollar, the exchange rate movement is measured on the basis of two most common elements: the US dollar (since the US dollar is the most leading international medium of exchange) and the TWI or the Trade Weighted Index. The Australian dollar is traded on the foreign exchange rate, mainly against the US dollar. The Trade Weighted Index on the other hand is not a single measure of currency, but in fact refers to a ‘basket’ of currencies, i.e. the currencies of various other countries against which the Australian dollar is traded. The TWI is often considered as a better method of evaluating the general trends in the exchange rate as compared to the evaluation of the same based on a single currency (i.e. US dollar alone). This is because, it gives an overall and accurate idea of the movement in Australian dollar as compared to global currencies, for instance if it is measured against US dollar alone, then ascertaining how it fares in comparison to other currencies would be difficult to predict. The theory of purchasing power parity alternatively known as the exchange rate theory is used to study the movements in exchange rates because it studies the differences between exchange rates of different countries by adjusting the unit of each currency to that of the other in a manner that causes the unit of all the currencies to have the same purchasing power, after the exchange rate is taken into consideration. Figure: Gold price in US Dollars, and the Exchange rate of AUS and USD The above figure depicts the movement of Australian dollar against the gold prices for the period from 2002 – 2008. It shows the changes in Australian dollar over the years against the gold prices in the same span. It can be observed that the dollar rate has various fluctuations between the given periods of time. This can be attributed to the higher or lower inflation rate as compared to its global trading partners. Thus, if the inflation rate of a country is continuously higher as compared to its global trading partners then the exchange rate of that country would tend devalue in order to avoid a persistent loss of competitiveness in the long run. Thus, if the inflation in one country keeps on pushing the prices higher, but remains constant in the other countries then the exchange rate would change to reflect the changes in the relative purchasing power of the currencies of the countries involved. A8. A fiscal policy is the policy adopted by the government with regard to taxation and public spending. The government implements various types of fiscal policies to control the economy these include the expansionary policy as well as the contractionary policy. The contractionary policy is implemented by the government, in case of severe inflation faced by the economy. The contractionary policy entails a drastic reduction in government spending or a significant increase in taxes or a combination of both (Apostolou et al, 2000). In summary a contractionary policy refers to the policy adopted by a government to reduce spending and increase taxes. The basic objective of a contractionary policy is supposed to control the inflation and stabilize the economy. Its impact is depicted in the figure below: Figure: Impact of implementation of Contractionary Policy Aggregate demand decreases and the price level is stabilized as a result of governments restrictive spending / increased tax rate. The fiscal policy is regarded as tight / contractionary when there is excessive fiscal balance i.e. the revenue is higher than the spending, and it continues to increase; or the deficit continues to rise, as compared to the previous years. Prior to implementing the fiscal policy, the government depends on various economic indicators (such as the type of inflation experienced by the economy – i.e. demand pull or cost push) as well as statistical figures with a view to assess their position in the business cycle. A common measure, however, of implementation of a contractionary policy is increasing taxes and reducing the government spending, since, rise in taxes leads to lesser disposable income at the hands of the households, thus reducing their spending; while reducing the government spending leads to a simultaneous reduction in the disposable income of those entities who are a part of the government spending. Thus the government, implements the contractionary policy by increasing taxes and reducing government expenditure and thereby successfully reducing the output, employment and inflation rate in the economy (Pailwar, 2000). References: Apostolou, N. G., Crumbley, D. L., (2000). 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