Concepts Explained: Economics

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Have you ever shaken an invisible hand? Been flattened by a falling market? Or wondered what took the bend out of Phillips’ curve? The animated video below explains some of the great dilemmas faced by governments trying to run an economy – whether to save or spend, control inflation, regulate trade, fix exchange rates, or just leave everyone to get on with it and not intervene. You’ll learn why Adam Smith put such a high price on free markets, how Keynes found a bold new way to reduce unemployment, and what economists went on to discover about the impact of policy on people’s and businesses’ behaviour – which may not always be entirely rational… Transcripts are below each of the videos.

Sections

  1. The impossible trinity  Nations want it all – currency flows, low interest rates and stable exchange rates. Dream on, nations, you have got to choose.
  2. Comparative Advantage  Why do countries sign free trade agreements? it is not just because they get to keep the pens, but to try to take advantage of their comparative advantage.
  3. The Phillips Curve  Bob Phillips took some time out of crocodile hunting to have a stab at explaining how wages, prices and unemployment interplay.
  4. The Paradox Of Thrift  Is it better to save or to spend? According to Keynes, if you do not spend, you are going to make the economy even worse.
  5. The Invisible Hand  An economy is a tricky thing to control, and governments are always trying to figure out how to do it.
  6. Rational Choice Theory  People are pretty rational. But not quite rational enough for the good of the economy.

^ 1. The Impossible Trinity


Source: Open University (2011). 60 Second Adventures in Economics

Nations want it all – currency flows, low interest rates and stable exchange rates. Dream on, nations, you’ve got to choose. Most countries trade with one another – which is usually pretty good for all involved – but it does mean it is a bit harder for each to keep control of its own finances. There are three things that governments are particularly keen on. They like to keep the exchange rate stable so that import and export prices don’t suddenly jump around. They also like to control interest rates so they can keep borrowers happy without upsetting savers. And they like to let money flow in and out of their country without causing too much disruption. But there’s a problem when you try to do all of these at once. Say for example, the Eurozone tries to lower its interest rate to boost investment and reduce unemployment. Money flows out to earn higher interest rates elsewhere. Exchange rates drop, which causes inflation, so the Euro interest rate is forced back up again. You can either fix your exchange rate and let money flow freely across national borders – but have no control over your interest rates. Or control your interest and exchange rates – but then you cannot stop the capital flowing in and out. But, like an overzealous triathlete – you cannot do all three at once.

^ 2. The Principle Of Comparative Advantage


Source: Open University (2011). 60 Second Adventures in Economics

Why do countries sign free trade agreements? it is not just because they get to keep the pens, but to try to take advantage of their comparative advantage. Whether you think economies work best if they’re left alone or that governments need to do something to get them working, the one thing that cannot be controlled is the rest of the world. Fear of foreign competition once led countries to try and produce everything they needed, and impose heavy taxes to keep out foreign goods. However, economist David Ricardo showed that international trade could actually make everyone better off, bringing in one of the first great economic models. He pointed out that, even if a country can produce pretty much everything at the lowest possible cost, with what economists call an ‘absolute advantage, it is still better to focus on the products it can make most efficiently – that sacrifice the least amount of other goods – and let the rest of the world do the same. By specialising, they can then export these surpluses to each other and both end up better off. This is the principle of comparative advantage – and it has persuaded many countries to sign up to free-trade agreements, but unfortunately, it can take a long time for countries to trade their way to prosperity. And because it is now much easier to move to where the money is – it is increasingly not only goods that cross borders, but people – which has somewhat uprooted Ricardo’s theory.

^ 3. The Phillips Curve


Source: Open University (2011). 60 Second Adventures in Economics

Bill Phillips was a crocodile hunter and economist from New Zealand, who spotted that, when employment levels are high, wages rise faster – people have more money to spend, so prices go up and so does inflation. And likewise, when unemployment is high, the lack of money to spend means that inflation goes down. This became known as the Phillips Curve. Governments even set policy by the curve, tolerating the inflation when they spent extra money creating jobs. But they forgot that the workers could also see the effects of the curve. So, when unemployment went down, they expected inflation and demanded higher wages, causing unemployment to go back up, while inflation remained high. Which is what happened in the 1970s when both inflation and unemployment rose. Then in the 1990s unemployment dropped while inflation stayed low, which all rather took the bend out of Phillips’ curve. But at least part of Phillips’ troublesome trade-off lives on: when faster growth and full employment return, you can bet inflation will be along to spoil the party.

^ 4. The Paradox Of Thrift


Source: Open University (2011). 60 Second Adventures in Economics

Is it better to save or to spend? According to Keynes, if you don’t spend, you’re going to make the economy even worse. Much like a child getting his pocket money, one of the biggest economic questions is still whether it is better to save or spend. Free-marketeers like Hayek and Milton Friedman say that, even in difficult times, it is best to be thrifty and save. Banks then channel the savings into investment, in new plants, skills and techniques that let us produce more. And even if this new technology destroys jobs, wages will drop, and businesses hire more people – so unemployment falls again. Simple. At least in the long run… But then a “live-fast-die-young” kinda chap called John Maynard Keynes cheerfully pointed out that “in the long run we’re all dead”. So, to avoid the misery of unemployment, the government should instead spend money to create jobs. Whereas if the government tightens its belt when people and businesses are doing the same, less is spent, so unemployment gets even worse. That is the paradox of thrift. So instead they should spend now and tax later when everyone’s happy to pay – Though making people happy to pay tax was something even Keynes didn’t solve.

^ 5. The Invisible Hand


Source: Open University (2011). 60 Second Adventures in Economics

An economy is a tricky thing to control, and governments are always trying to figure out how to do it. Back in 1776 economist Adam Smith shocked everyone by saying that what governments should actually do is just leave people alone to buy and sell freely among themselves. He suggested that if they just leave self-interested traders to compete with one another, markets are guided to positive outcomes ‘as if by an invisible hand’. If someone charges less than you – customers will buy from them instead – so you have to lower the price or offer something better. Wherever enough people demand something, they will be supplied by the market – like spoilt children – only in this case, everyoneʼs happy. Later free-marketeers like Austrian economist Friedrich Hayek, argued that this ʻhands offʼ approach actually works better than any kind of central plan. But the problem is, economies can take a long time to reach their ʻequilibriumʼ, and may even stall along the way. And in the meantime people can get a little frustrated, which is why governments usually end up taking things into their own more visible hands instead.

^ 6. Rational Choice Theory


Source: Open University (2011). 60 Second Adventures in Economics

People are pretty rational. But not quite rational enough for the good of the economy. Of all the things to factor in when running an economy, the most troublesome is people. Now by and large – humans are a rational lot. When the price of something rises people will supply more of it – and buy less of it. If they expect inflation to go up – people will usually ask for higher wages – (though they might not get them) And if they can see interest or exchange rates falling in one country, people with lots of money there will try to move it out, faster than you can say ‘double dip’. And governments often decide their economic policies assuming such rational actions. Which would be great, if it weren’t for the fact that those pesky humans don’t always do what’s best for them. Sometimes they mistakenly think they know all the facts, or maybe the facts are just too complicated And sometimes people just decide to follow the crowd, relying on others to know what they’re doing. When too many cheap mortgages were being sold in 2007 – a lot of people didn’t know what was going on. And a lot of others just followed the crowd. Some lenders may have rationally believed that, when the crunch came, the scale of the problem would force governments to rescue them. Which was true for the banks. If not for all their customers.

 

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