Governments analyze national economies {macroeconomics}|.
economic growth
For economic growth, developed nations need to keep interest rates high to encourage investment. They need high capital returns to pay high interest.
Developing nations have surplus labor and high underemployment. To grow as a transition economy, they need low population growth, increased capital, increased savings, and stable wages. They mix rural subsistence economies and urban money economies, with political conflicts. They have poor markets and poor distribution systems. They export only resources and unfinished goods. They need imports but have no cash to pay for them. They have low taxes, few schools, small wealthy class, no middle class, low investment rate, untrained business class, and poor agricultural techniques. They need capital goods and investment to change these problems.
economic growth: rate
If factor pricing is competitive and costs per factor unit are constant, output growth rate is sum of technology, labor, capital, and resource increase rates, each weighted by GNP percentage. Output per worker can increase through education, skill learning, management techniques, total economic organization, economies of scale, and inventions.
In countries, labor, money, goods, and services can move freely, to create producing and consuming systems {economy}|. Economies have variable labor, capital, natural resources, land, production methods, technologies, and income distributions, which affect societal and personal goods-and-services preferences.
Economy divisions {functional category} {situs} are manufacturing, commerce, education, law enforcement, finance, transportation, and government. Economy parts have equal status.
Market economies use supply and demand in open markets {invisible hand}| to regulate prices.
People have jobs {employment}|. Full employment is impossible. Need for unskilled labor always decreases over time. Automation displaces workers. People can be training or retraining. Business cycles change demand. Industries have different productivities. Unit-cost increase is greater near full capacity. Time lags delay reaching full capacity.
Job changing, automation, and retraining can cause unemployment {frictional unemployment}.
Everyone that wants to work can be working {full employment}. At full employment, increasing product-1 production causes decreasing product-2 production.
Economies {planned economy}| {command economy} can have central-government planning boards, which calculate and set production-unit prices, inputs, and outputs, based on value, desired distribution, and national goals. Bargaining sets output quotas. Consumers choose what to buy.
effects
Planned economies emphasize output, rather than cost. Planned economies often have poor-quality output, because they set price with little regard for cost, so managers must minimize costs.
incentives
In planned economies, incentives depend on goods produced {piece-rate}. Manual laborers and skilled workers have good pay. Service jobs pay less.
government
Government services and staple goods are free or cheap, such as housing, basic foods, medicine, and school.
National government can perform free-market business functions in one or more markets {state capitalism}|. Market economies can have state ownership of capital and investment.
Market economies can have state ownership of capital, resources, and businesses {state monopoly}|.
Economies {market economy}| can allow production units to decide what and how much to produce, and consumers to decide what and how much to consume, in open markets.
assumptions
People can buy or sell in all markets. People act in their self-interest to increase income and decrease cost. People know prices.
Market economies use supply and demand in open markets to regulate prices, by the invisible hand. All markets and prices interconnect. Demand for one product reduces demand for other products. Supply of one product reduces supply of other products. Price changes reflect everyone's self-interest and so bring about greatest common good {utility, market}.
regulation
Pure market economies do not necessarily result in full people or resource employment, economic growth, needed public services, or ideal income distribution, so government must regulate some markets. Government can create good markets, provide needed information, block monopolies, assess social costs, and control external effects.
competition
If free-market economies have many buyers and sellers, exchanges are insignificant percentage of total exchanges, and buyers and sellers do not cooperate, then sellers compete for buyers in pure competition.
Free-market economies can have no business regulations and allow all good and service exchanges {laissez-faire, market}|.
Workers can elect company leaders {worker-control capitalism}| or run company themselves {worker-control socialism}.
Workers can control capital {syndicalism}|.
Market economies can adjust markets through central planning and/or decentralized changes {socialism}| {market socialism}, to more equally distribute wealth and income based on need or effort.
Economies {state socialism}| {central-planning socialism} can have centralized economic planning.
Government can control a capitalist society {national socialism}|.
Economies {subsistence economy}| can depend on families or small communities, which produce and consume only their own products.
After feudalism, European countries tried to start colonies, acquire gold and silver, mine minerals, build commercial and military navies, and industrialize {mercantilism}|. Objective was positive trade balance.
Developing nations often have poor markets, poor distribution systems, and high underemployment; export resources but not finished goods; need imports but have no cash to pay for them; and have low taxes, few schools, small wealthy class, no middle class, low investment rate, untrained business class, and poor agricultural techniques. Developing countries need capital goods and investment to change these problems {transition economy}| and become developed countries.
Modern economic production depends on machines and large-scale output {industrialization}|. Industrialization makes cheaper goods and leads to higher population, and so causes more industrialization. Developing-society industrialization separates people into groups that work and groups that are traditional.
Meeting current economic needs responsibly {sustainable development}| can allow future generations to meet their economic needs. Wealth per capita can increase at optimum rate. Wealth is capital, natural resources, knowledge, skill, and organizations, but income includes only goods and services value.
Governments produce goods {community goods} and services {community services} that are not profitable or proper for businesses. For example, national government provides defense, prints money, and has retirement and disability programs. Local government provides education, fire services, housing, police services, and roads.
national treasury {exchequer}|.
Government can provide public goods that make better citizens, better consumers, or better-trained workers {external effect, government}, such as public education and health-and-safety publications.
States typically have laws {fair trade law} to protect small retailers against chain stores belonging to large corporations.
Nations can spend for popular job-creating programs that are run by state or led by cronies {macroeconomic populism}, by borrowing from other nations or printing money. This can cause inflation, bank failure, and currency devaluation. This also usually has high tariffs to protect jobs.
National governments can run businesses {nationalization}|, perhaps as benevolent monopolies. Nationalized firms can be inefficient and fail to meet customer needs.
Patents {patent, business}| allow inventors to make, sell, and use inventions as sole owners. Others must pay {licensing, patent} to use invention.
Government can guarantee good base prices {price support}|.
National government can spend money in industry sectors to raise demand {pump priming, economics}|.
Countries typically have funds {social security}| in which workers pay income percentage into fund, from which they or their spouses can retrieve money when they retire or become disabled.
Unemployment payments, accident or disability payments, illness payments, and old age payments {transfer payment, government}| provide money directly to people unable to work.
Anti-poverty programs, retraining grants and programs, aid to dependents, and aid to handicapped {welfare, government}| provide money indirectly to people unable to work.
Programs {workmen's compensation}| can receive percentage of worker income for use in case of death or disability.
People pay money to government in many forms {tax, types}. Taxes include capital-gains, excise, export, import, sales, turnover, and withholding taxes. Income tax can be on personal or business revenue. Estate tax can be on wealth at death. Property tax can be on real estate holdings. National taxes are income and value-added taxes. State taxes are income taxes, excise taxes, and sales taxes. Local taxes are property taxes. Taxes can be regressive or progressive.
Taxes {capital gains tax}| can be on capital gains over more than one year {long-term capital gains tax} or less than one year {short-term capital gains tax}.
Taxes {excise tax}| can be on each item or service.
Taxes {export tax}| can be on goods sent to foreign countries.
Taxes {import tax}| can be on goods purchased from foreign countries.
Taxes {sales tax}| can be a percentage, typically 3% to 8%, of retail purchase price, usually excluding food.
Taxes {turnover tax}| can be on buying and selling goods or services.
People typically must send income percentage {withholding tax}| to government to pay future taxes. Employers typically send paycheck percentage to government.
Taxes {progressive tax}|, such as income taxes, can assess at higher rates for higher incomes or wealth. They take lower percentage of income or wealth from lower-income people.
Fixed percentage taxes {regressive tax}|, such as sales and property taxes, take more value from lower-income people than from higher-income people. These taxes reduce consumption more than savings.
Governments can reach target GNP and control economic cycles by changing money price and availability {monetary policy}| {monetary theory}.
money supply: printing money
Governments can increase or decrease money in circulation {money supply} by printing or not printing money.
money supply: bonds
Governments can sell and buy bonds at fixed interest rates for different periods, such as three-month bonds and thirty-year bonds.
money supply: bank loans
Governments can raise or lower their bank-loan interest rate, the discount rate. If discount rate is lower, banks can charge customers lower loan interest rate, so people borrow more and money in circulation increases.
money supply: reserves
Governments can require banks to keep lower or higher percentages of money to cover loans, by the reserve ratio. If reserve ratio is lower, banks can loan more, people can borrow more, and circulating money increases.
interest rate
Printing money, decreasing discount rate, decreasing reserve ratio, and offering bonds increases money supply. When money supply increases, interest rates decrease, because money is less valuable. When interest rates decrease, money supply increases, because people save less.
Not printing money, increasing discount rate, increasing reserve ratio, and buying bonds decreases money supply. When money supply decreases, interest rates increase, because money is more valuable. When interest rates increase, money supply decreases, because people save more.
government
People receive income from working, spend for personal expenses, and have expectations about economy. Income changes slowly, but spending and expectations can change quickly. Government can affect people's spending and expectations. Government can raise and lower money supply, independently of taxes and spending, because it is the largest and most powerful institution and can incur or pay down debt. See Figure 1.
To stop expansion and inflation, governments increase interest rates and decrease money supply, to encourage saving and discourage borrowing. See Figure 2.
To stop recession, governments decrease interest rates and increase money supply, to encourage spending and encourage borrowing. See Figure 3.
Money passes from person to person {circulation, money}| {money circulation}.
Governments can vary interest rate {discount rate}| at which central bank lends money to commercial banks.
Money-supply and disposable-income increases result in larger increases in spending {multiplier effect, money}|, because increased money passes from person to person, by repeated spending. The multiplier process causes larger GNP increase than original income increase.
money supply
Government controls money supply. Government can change planned national expenditures or savings and so disposable income.
marginal propensities
People save some income and spend rest. Money-supply and disposable-income increases add extra income. People who receive extra income must decide how much to save {marginal propensity to save, multiplier} and how much to spend {marginal propensity to consume, multiplier}. Fraction that people decide to spend is money that goes into circulation. Average marginal propensity to spend is never 100%.
marginal propensities: change
Multiplier effect causes marginal-propensity-to-spend changes to multiply throughout economy.
circulation
Some money-supply or disposable-income increase goes to merchants. Merchants decide how much extra income to save or spend. Some money-supply or disposable-income increase goes to middlemen. Middlemen have marginal propensities to spend. Some money-supply or disposable-income increase goes to producers. Producers have marginal propensities to spend. Some money-supply or disposable-income increase goes to workers and investors. Workers and investors are the people that started the cascade. Some money-supply or disposable-income increase keeps cascading.
If average marginal propensity to spend is high, more people receive significant extra income. If average marginal propensity to spend is low, fewer people receive significant extra income. Typically, extra money is miniscule after ten transaction levels.
transaction velocity
Average marginal propensity to spend determines average number of times currency units change hands {transaction velocity, currency}. Transaction velocity can be ten.
multiplier
For example, people can spend 75% of increased money supply or disposable income for personal consumption, government, or exports and 3% for saving, 20% for taxes including Social Security and Medicare, and 2% for imports. Assume transaction velocity is 10. Income increase x multiplies through economy. Multiplier is sum, over transaction-velocity number, of the cascade of marginal propensities to spend. In this example, multiplier is 0.75 * x + 0.75 * (0.75 * x) + 0.75 * (0.75 * 0.75 * x) + 0.75 * (0.75 * 0.75 * 0.75 * x) + 0.75 * (0.75 * 0.75 * 0.75 * 0.75 * x) + 0.75 * (0.75 * 0.75 * 0.75 * 0.75 * 0.75 * x) + 0.75 * (0.75 * 0.75 * 0.75 * 0.75 * 0.75 * 0.75 * x) + 0.75 * (0.75 * 0.75 * 0.75 * 0.75 * 0.75 * 0.75 * 0.75 * x) + 0.75 * (0.75 * 0.75 * 0.75 * 0.75 * 0.75 * 0.75 * 0.75 * 0.75 * x) + 0.75 * (0.75 * 0.75 * 0.75 * 0.75 * 0.75 * 0.75 * 0.75 * 0.75 * 0.75 * x) = (0.75 + 0.54 + 0.41 + 0.30 + 0.23 + 0.17 + 0.13 + 0.09 + 0.06 + 0.04) * x = 2.8 * x. Number of terms is 10. Terms contribute successively lower values.
multiplier: example
Assume average marginal propensity to spend is 90% = 9/10. For every 10 extra dollars, average person spends 9 dollars and saves 1 dollar. See Figure 1. After 10 people receive remaining money, changes are insignificant, so transaction velocity is 10. Multiplier is approximately 9.
multiplier: USA
USA multiplier is 3 or 4.
multiplier: time
The multiplier process takes three to six months to complete. The multiplier effect makes economic planning difficult for more than two years.
Governments can change required minimum ratio {reserve ratio}| of bank reserves to demand deposits, because money available for loans is amount over minimum percentage of demand deposits {free reserves} {excess reserves}. If amount available for loans is more, interest rate is less, and people take out more loans for higher amounts.
Average number of times currency units change hands {money turnover} is money-supply use rate {transaction velocity, monetary policy}|. It measures economy expansion.
Of two moneys with same denomination, people hoard higher-valued one and circulate lower-valued one {Gresham's law} {Gresham law} (Thomas Gresham).
People spend a fraction of total disposable income {average propensity to consume} (APC) and save a fraction {average propensity to save} (APS). APC + APS equals one, because people must spend or save income.
People consume a fraction of disposable-income increases {marginal propensity to consume, income} (MPC) and save a fraction {marginal propensity to save, income} (MPS). For people, MPC + MPS equals one, because people must spend or save income.
Governments can adjust tax rates and government spending {fiscal policy}| {fiscal theory} to obtain target GNP and/or control economic cycles.
government revenue
People and businesses receive income from working, spend for personal expenses, and have expectations about economy. Income changes slowly, but spending and expectations can change quickly. Government can control spending using tax policies.
government spending
Government can spend more or less, independently of taxes, because it is the largest and most powerful institution and can increase or decrease debt. See Figure 1.
taxes
Tax decrease with no government-spending change increases demand, because people have more money. See Figure 2.
Tax increase with no government-spending change reduces demand, because people have less money. See Figure 3.
spending
Government-spending decrease with no taxation change decreases government demand. See Figure 4.
Government-spending increase with no taxation change increases government demand. See Figure 5.
spending and taxes
Government-spending decrease with equal tax decrease decreases overall demand somewhat, because government spends all, but tax decrease only fractionally increases private demand. See Figure 6.
Tax increase with government-spending decrease reduces overall demand greatly. See Figure 7.
Tax decrease with government-spending increase increases overall demand greatly. See Figure 8.
Government-spending increase with equal tax increase increases overall demand somewhat, because government spends all, but tax increase only fractionally decreases private demand. See Figure 9.
balanced budget
If government spending equals government revenue, GNP still tends to increase {balanced budget theorem}, because taxation only fractionally reduces private spending, but government spends all.
spending purposes
Government spending allocates resources to public functions, redistributes income, and stabilizes economic fluctuations.
tax effects
Taxation reduces private consumption and saving. Goods taxes keep price high but do not encourage production, because producers do not receive higher price. Fixed percentage taxes, such as sales, property, and other regressive taxes, take more value from lower-income people than from higher-income people. Regressive taxes reduce consumption more than savings. Taxes that assess at higher rates for higher incomes or wealth, such as income taxes and other progressive taxes, take lower percentage of income or wealth from lower-income people. Progressive taxes reduce savings more than consumption.
Economies tend to have periodic expansion and contraction {economic cycle}|.
multiplicative effects
Economies cannot expand at optimum moderate rate, because expansion tends to cause more expansion, and contraction tends to cause more contraction. See Figure 1.
multiplicative effects: contraction
If economy starts to contract, people become more pessimistic. They try to save money and spend less. Demand goes down, and economy contracts more. Economic cycle is on downward curve and goes toward recession.
However, lower demand makes prices lower. Lower demand for money makes interest rates lower and money cheaper. People have saved money. Eventually, lower prices make demand increase. Lower interest rate makes saving less attractive. People can no longer postpone buying things that have worn out. People start to save less and spend more. Recession ends. Economic cycle is at downward-curve bottom.
multiplicative effects: expansion
If economy starts to expand, people become more optimistic. They spend more money and save less. Demand goes up, and economy expands more. Economic cycle is on upward curve and goes toward expansion.
However, higher demand makes prices higher. Higher demand for money makes interest rates higher and money more expensive. People have little saved money. Eventually, higher prices make demand decrease. Higher interest rate makes saving more attractive. People already have everything they need and can postpone buying things. People start to spend less and save more. Expansion ends. Economic cycle is at upward-curve top.
cycle period
If expectation changes are rapid, economic-cycle period is short. See Figure 2.
cycle amplitude
If expectation changes are large, economic-cycle amplitude is high. See Figure 3.
efficiency
For maximum efficiency, economy can minimize economic fluctuations and maintain stable business conditions. Demand and supply can balance, so prices reflect real value, not expectations about the future. Efficient economic cycles have long periods and small amplitudes. See Figure 4.
National government can dampen economic-cycle amplitudes and lengthen economic-cycle periods. During expansion, government can tax more and spend less to decrease demand. During contraction, government can tax less and spend more to increase demand. Taxation and spending rates can depend on previous economic cycles.
equilibrium
Economy is in equilibrium {equilibrium, economy} if total spending equals total costs, because prices equal costs. Economy is in equilibrium if personal savings equal business investment, plus government purchases, minus taxes, plus exports, minus imports {national income identity, cycle}, because consumption equals output. Gross national product (GNP) is in equilibrium if planned expenditures equal present output, with no excess demand or supply. Economy can be at equilibrium, but not at full employment, when demand is unequal to output.
In economies or business sectors, small sales-rate changes typically result in large investment-and-inventory changes {acceleration principle}|.
up
GNP changes direction {turning point} and goes up in response to unused production factors, too-low investment, and too-low inventory levels. In recession, unused capacity and labor lead to lower costs and excess supply, both leading to lower prices and increased demand. In recession, low investment leads to low prices and increased demand. In recession, high inventory levels lead to excess supply, and lower prices and increased demand.
down
GNP changes direction and goes down in response to limited production factors, too-high investment, and too-high inventory levels. In expansion, production-factor limitations result in reduced supply and higher costs, both leading to higher prices and reduced demand. In expansion, high investment leads to higher prices and reduced demand. In expansion, low inventory levels lead to reduced supply, and higher prices and less demand.
House or stock prices can rise much beyond reasonable value {bubble, economics}.
If national planned expenditures are too low {deflationary gap}, businesses have unused resources and lower prices {deflation}|.
National economies can have severe recession {depression, economics}|.
In good times {expansion}, employment increases. Business inventories increase. Machinery and equipment expenditures increase. Consumer durable-good expenditures increase. Durable-good production increases. Business profits increase. Tax receipts increase. Interest rates increase.
Economies can have growth but growth is too slow and results in idle capacity and high unemployment {growth recession}.
Price increases {inflation, economics}| stop by reducing demand.
demand
Excess planned business investment, decreased planned saving, and government budget deficit cause excess demand.
government
Raising interest rates decreases planned business investment. Raising interest rates can increase planned savings. Government can tax more or spend less to reduce demand. Government can change price expectations through communication with public and businesses. Higher worker wage demands make higher prices from businesses {wage-price spiral}, but government can block them.
inflation
Government receives political pressure from people with fixed incomes, because inflation reduces money value. Inflation decreases long-term lending, because money value decreases over time, and people do not want repayment with lower-value currency.
Inflation and slower-than-normal growth {stagflation} can happen together. Money supply is high, and job-creation rate is low.
If people save too much and reduce planned expenditures, GNP decreases, resulting in lower savings {thrift paradox}| {paradox of thrift}, because savings rate is lower when GNP is lower.
Economic measurements {econometrics}| can build and verify economic theories, typically using regression analysis. Analysis can be about one variable over time {time-series analysis}, two variables at one time {cross-sectional analysis}, both variables on same sample {panel analysis}, or both variables on different samples {pooled cross-sectional analysis}. Econometrics requires classifying businesses and industries, such as by Standard Industrial Classification or North American Industry Classification System.
Economy is in equilibrium if personal savings equal business investment plus government purchases minus taxes plus exports minus imports {national income identity, measurement}, because consumption equals output.
Economies can reach state in which one consumer cannot become better off without making another worse off {static efficiency} {Pareto optimum, economics}, with same resources and technology.
conditions
Static efficiency results under the following conditions {pure market economy}. Plants operate at capacity and are at optimum scale. For all goods, marginal utility divided by price are equal. Price equals marginal cost. For all resources, marginal product divided by price are equal. For all factors, marginal revenue products are equal for all uses. Leisure marginal value equals labor marginal value. Marginal saving value equals marginal consumption value. Good marginal-utility ratios are equal for all consumers. Workers do what they like best and can do best. Workers can move freely among jobs.
Because employment increases in economic expansions, which inflation typically accompanies, unemployment level and price level inversely relate {Phillips curve}. Money and wage inflation relates to unemployment: (dw / dt) / w = h(U), where dw is wage change, dt is time change, w is wage, U is unemployment, and h(U) < 0. As unemployment increases, wages and prices decline.
Trade balance, services balance, and interest payments {current account balance} measures exports compared to imports.
Personal consumption plus personal savings {disposable income}| is an economy measure.
People can try to keep money rather than spend {effective demand}, so demand is less than optimum. People feel that their money is not enough for future needs. Printing more money can increase effective demand because money seems plentiful.
gross investment + government purchases + personal consumption + net exports {gross national product}| (GNP) is an economy measure.
In economies, people receive different incomes {income, economy} depending on skills, education, experience, responsibilities, and rank.
inequality measures
Governments measure income inequality {Lorenz curve} {Gisi coefficient}.
policies
Government policies can increase income equalization.
School loans and scholarships {education grant} improve worker incomes later.
Unemployment payments, disability payments, illness payments, and old-age payments {transfer payment, income} provide money directly to people unable to work. Anti-poverty programs, retraining grants and programs, aid to dependents, and aid to handicapped people {welfare, income} provide money indirectly to people unable to work.
Progressive taxation takes more money from higher-income people and less from poorer people. Taxes on wealth take money from rich people.
Laws against discrimination help people have equal opportunity to get income.
Savings bonds allow people to receive income later.
Wages and salaries {labor value}, set in labor market, determines income. Money value, set in money market, also determines people's income.
Income {imputed income} can be real but not monetary: farm production consumed by farm family, value of rent not paid to owner for house use, and housewife-work value.
Governments have debt {national debt}|, which they typically owe to citizens. Taxes pay this debt. Debt payments go back to people that pay taxes {tax friction}.
Total country output income {national income}| does not equal national product, because some production remains unsold, in inventory.
Countries can produce goods and services {national product}|.
Gross national product minus capital consumption {net national product} is an economy measure.
Personal consumption + personal taxes + personal savings {personal income}| is an economy measure.
Economies have personal consumption schedules, business investment schedules, government expenditure schedules, and net export schedules {planned expenditures}. Saving schedule and investment schedule must be equal for optimum GNP, because then demand and supply are equal.
Economists can use models, with equations about economic indicators, to predict business cycle {econometric forecasting}.
Economists can use estimated government spending, investment, exports, imports, and consumer spending to forecast GNP {analytical forecasting}.
Economists can use past indicator performance to predict business-cycle turning points {barometric forecasting}.
Indicators {indicator, economy} {economic indicator}| can predict GNP and business cycles. Some indicators do not relate to business cycle: price index, imports, exports, payment balance, and government activities.
Indicators that accompany business cycles {coincident series} are job openings, employment, production, sales, income, investment backlog, wholesale-price index, bank reserves, and interest rates.
Indicators that lag business cycle {lagging series} are long-term unemployment, investments, inventories, labor costs, debt, and loan rates.
Indicators that predict GNP and business cycles {leading series} are average work week, overtime, new unemployment-benefit claims, new investment intentions, business creation, inventory investment, commodity prices, stock prices, profits, margins, cash flows, money flows, credit flows, delinquencies, business failures, hiring, and layoffs.
Countries typically benefit from good, service, and money exchange {international trade} {trade, economics}|. Even if one country is always better than the other {comparative advantage, trade}, both can benefit, because each country can make what it does best. No trading has less market efficiency and higher cost. Immigration laws and visa requirements can restrict labor movements. Tariffs can restrict goods and services. Goods can have quotas. Foreign-investment restrictions can constrain money flow.
People can buy securities in one market at lower price and then sell them in another market at higher price {arbitrage}|.
Countries can have no international trade {autarky}|, because they have all resources they need.
Economies send currency to, and receive currency from, other countries {balance of payments}| {payments balance}.
demand
Currency demand increases with exports, foreign investment, foreign loan payments, and gold purchases.
supply
Currency supply increases with imports, overseas military operations, loans to other countries, and gold inflows.
exchange
Currency values vary relative to other currencies. National economies can use exchange-rate system {fixed exchange rate}. In open currency markets, currency exchange rates vary by demand and supply. Currency values depend on purchasing power, which relates to interest rates. Open currency markets can have wide exchange-rate fluctuations, making international trade more difficult.
institutions
Central banks try to keep currency-exchange rates within fixed ranges, by buying and selling currency to control market. International Monetary Fund (IMF) lends money to countries and regulates international financial and currency markets.
Between two countries, one country can produce goods or services cheaper than the other country, because one country has cheaper and usually more abundant production factors, including labor and capital, for those goods or services. One country typically produces some goods and services cheaper, and the other country produces other goods and services cheaper, because countries differ randomly in production factors. However, one country can produce all goods and services cheaper than the other country. For example, isolated islands can have high costs for everything.
importing
Countries try to get the cheapest and most abundant goods and services for their consumers. With free trade, countries can import needed goods and services that are cheaper than it can make domestically. Countries import goods and services that they make least efficiently and least cheaply, compared to other countries.
exporting
Countries try to expand markets for which they have the cheapest and most abundant goods and services, or higher value for quality, for their producers and for general prosperity. With free trade, countries can export goods and services that they make cheaper and/or that they do not need. They export goods and services that they produce most efficiently and cheapest, compared to other countries.
trade advantage
For two countries and two products, one country can typically produce one product cheaper {trade advantage}, and the other country can produce other product cheaper. Consumers in both countries have more value if they pay less. Producers in both countries have more value if they sell at lowest cost. With free trade, first country can send product in which it has advantage to second country, and second country can send product in which it has advantage to first country. Both countries now pay less for what they need than they pay with no international trade {absolute advantage}, and producers produce most cheaply. See Figure 1, Figure 2, and Figure 3.
production: factor
Countries have labor, capital, and natural-resource production factors, which they can use to produce goods and services. Production factors have production units. Full-time workers are labor production units. Machines are capital production units. Natural-resource production unit is one ton. At any time, countries have numbers of production factors.
Production units in different countries are the same in some ways and different in other ways. For example, natural resources can differ in purity, form, extraction ease, and cost. Machines can differ in quality, form, features, and cost. Average worker can differ in skill, knowledge, strength, and cost.
production: productivity
One production unit can help make many different goods or services. Production units have different efficiencies {productivity, unit} in making different things. For example, one worker can make two tables a day but only one rocking chair. One machine can weld two motorcycles in a day but only one car. One ton of iron can make several motorcycles but only one car.
When production units shift from making one good or service to making another, productivity ratio shows relative original product and new product amounts.
production: opportunity cost
If producer makes good or service, producer and country cannot make different good or service and has opportunity cost. Businesses must choose what to make with available production units. Businesses and countries make goods and services, based on demand. Available production units determine good and service cost and supply. Demand and cost determine prices, and prices affect demand, supply, and opportunity cost.
production: marginal cost
At any time, companies and countries try to use available production units most efficiently, to keep costs low and meet demand. Uses have optimum or lowest production marginal cost for the most recent good or service.
production: lowest marginal cost
Businesses try to make good and service optimum amounts at lowest marginal cost. Countries try to have good and service optimum amounts. At optimum, if any production unit shifts to another product, product cost rises, price rises, demand falls, and then supply and price decrease to where they were before. Other-product cost rises, price rises, demand falls, and supply and price decrease to where they were before. Everything returns to optimum. Other situations result in lower total production, because production optimizes already.
production: cost
Countries have fixed numbers of production units. Production units can make constant good and service numbers. People know relative productivities for producing goods and services in all countries. People know relative costs for producing goods and services in all countries, so people know relative product costs. In each country, goods and services have different costs.
production: product amount
If country has lowest product cost, for same total cost it can make more product than another country.
comparative advantage
Even if country has lower product cost for all products than other country, international trade can be advantageous for both countries {comparative advantage, international trade}|. The country that is better in everything exports the good or service that it makes the most cheaply compared to the other country and that has highest price difference. The country that is worse in everything exports the good or service that it makes almost as cheaply as the other country and that has lowest price difference. See Figure 4 and Figure 5.
For two countries and two products, each country can have higher cost for one product and not the other, or both countries can have higher cost for same product. In both cases, one country exports the product in which it has biggest difference. The other country exports the product in which it has least difference. See Figure 6 and Figure 7.
foreign exchange
For trade, country must sell something to another country to earn foreign currency to buy other country's exports. For only two countries, trade balance must be equal, so selling gets the money for buying. Trade must be reciprocal. Reciprocal trade requires trade advantage, or countries should not trade.
efficiency
International trade allows both countries to be as efficient as possible. Countries can employ all resources, receive the most money, and pay the least. Consumers get the most goods and services, at lowest prices. Workers get highest wages. Countries use resources most efficiently.
For example, each country has one worker each, who can perform 12 hours of work. Countries can make X or Y. See Figure 8.
Businesses maximize productivity. Different workers take different times to make different things. Different workers have different costs. Workers maximize productivity. Idle workers make nothing, so businesses make workers produce something. Workers must work at something, to gain money to buy domestic and/or imported goods, so the only question is: At what do workers work? Workers work where they can gain the most money.
With no trade, workers cannot specialize as much and so cannot get higher income. There is less opportunity and less productivity. With no trade, production must meet domestic needs only. Smaller markets have fewer economies of scale, scarcer resources, fewer workers, and less total money and demand. With trade, cheapest workers work to sell to higher-priced market and make more money.
In second country, workers pay lower prices than with no trade. Workers work to sell more higher-priced items in first country. They make more products than before and so make more money.
First country benefits from that item's increased supply and lower prices. For both countries, overall prices go down, and wages go up.
Trade tends to make production-factor prices more equal {factor price equalization theory}, because factor marginal returns are more equal.
Governments control international markets to make them voluntary, available, unrestricted, fair, safe, and viable {fair trade}|.
International trade can involve no tariffs or quotas {free trade}|.
International organizations {International Monetary Fund} (IMF) can lend money to countries and regulate international financial and currency markets.
In trade relations, countries reciprocate tariff reductions, to help both countries. Countries have reciprocal agreements {most favored nation status}| to give each other lowest tariffs.
USA, Canada, and Mexico have few tariffs and few trade restrictions {North American Free Trade Agreement} (NAFTA).
Extra output from trade depends on price ratio {terms of trade} {international trade terms} between two traded products. Higher price ratio makes more output.
National economies have difference {trade balance}| {balance of trade} between export values and import values.
Currencies have prices in terms of other currencies {exchange rate}| {monetary exchange}. Currency-value changes can restrict money flow.
World economies trade currencies in special markets {foreign exchange market} {foreign exchange}|.
Countries can try to keep exchange rates stable but can change rates if necessary {adjustable peg system}. Countries can maintain exchange rate and maintain certainty for businesses, but this does not allow monetary policy. Countries can let exchange rate float freely and independently use monetary policy, but this causes uncertainty for businesses.
Colony or state currency can be a multiple of another country's currency {currency board}. Colony or state must have enough other-country currency in reserve to cover all outstanding currency.
USA has money {Exchange Stabilization Fund}, to buy and sell in foreign-exchange markets.
Formerly, world economy transferred gold to back currencies {gold standard}|.
Countries can block another country's trade {embargo}|.
Import amounts can have restrictions {quota, trade}|.
Countries can tax imports {tariff}|, to protect national industries. Tariffs allow keeping prices high, but this hurts consumers.
Malysia "son of the soil" program {bumiputra} gave preferences to Malays.
Hedge funds can borrow cheaply in Japan and other low-interest countries and lend in high-interest countries {carry trade}.
Korean conglomerate {chaebol}.
Richer countries can send money and expertise {foreign aid}| to poorer countries. Aid can require loans or purchases. Foreign aid must be long-term to make exports increase. Foreign aid has little effect if receiving country has political trouble or management and work skills are low. Savings rates must be high, and capital yields must be great. Aid can help giver countries whose economy has contracted.
Major Japan banks have allied companies {keiretsu}, which own each other's stock. Banks supply money for investment and affect stock price or short-term profits. Ministry of Finance and Ministry of International Trade and Industry direct economy.
Mexico allows factories {maquiladora}, which make exports, near north border, to have financing from abroad to employ Mexican workers.
During Soviet-Union period, many countries {Third World} were non-aligned. After that, Third World refers to countries with poor, undeveloped economies that are agricultural and labor intensive.
Japanese gang {yakuza}.
In 1960's, economists found neoclassical aggregate-production function too simple {capital controversy} {Cambridge capital controversy} and now use multi-sectoral models, such as those of Leontief and Schraff. New classical economics uses aggregate-production functions.
Macroeconomic policy can maintain employment levels in free-market economies {neoclassical synthesis}.
A macroeconomics school {new Keynesian macroeconomics} combined microeconomic and macroeconomic models to modify Keynesian macroeconomics.
In 1970's, new macroeconomics school {new classical macroeconomics} (NCM) {new classical economics} built macroeconomic models from individual and company microeconomic behavior, in opposition to Keynesian macroeconomics.
history
Robert Lucas, Jr., Finn E. Kydland, and Edward C. Prescott developed New-Classical models {Real Business Cycles}, based on John Muth's ideas.
assumptions
NCM assumes that behavior maximizes utility and uses rational expectations and that markets can reach equilibrium through free exchange of prices and wages {market clearing}.
model
New classical economics can use representative-agent models. Agents, such as average consumer or producer, always optimize and have rational expectations. If productivity changes, business has cycles. Agent does not work if productivity and wages decline, waiting until they rise again, so government intervention does not work, since agents have full information.
Consumers or producers {representative agent} optimize. Agent optimizations determine economy demand or supply curves. Composition fallacy and Sonnenschein-Mantel-Debreu theorem of Kirman [1992] critically examine representative-agent models.
In monetary theory, money supply equals ratio, between money holdings and total income, times total income {Cambridge equation}. In this theory, money-supply increase increases prices. However, this theory is false.
In monetary theory, money supply times money transaction velocity equals physical output times average price index {Fisher equation} {quantity equation} {exchange equation}, because total spending equals total price. In this theory, money-supply increase increases prices, because demand increases. However, this theory is false.
In monetary theory, economy output increases faster than purchasing power increases, causes high inventories, and then causes recession and unemployment {Social Credit movement}, so government needs to add purchasing power early in cycle, to balance output and demand.
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Date Modified: 2022.0225