Econometrics
Mathematics and sophisticated
computing applied to economics. Econometricians crunch data in search of
economic relationships that have statistical significance. Sometimes this is
done to test a theory; at other times the computers churn the numbers until they
come up with an interesting result. Some economists are fierce critics of
theory-free econometrics.
Economic
and monetary union
In january 1999, 11 of the 15
countries in the european union merged their national currencies into a single
european currency, the euro. This decision was motivated partly by politics and
partly by hoped-for economic benefits from the creation of a single, integrated
european economy. These benefits included currency stability and low inflation,
underwritten by an independent european central bank (a particular boon for
countries with poor inflation records, such as italy and spain, but less so for
traditionally low-inflation germany). Furthermore, european businesses and
individuals stood to save from handling one currency rather than many.
Comparing prices and wages across the euro zone became easier, increasing
competition by making it easier for companies to sell throughout the euro-zone
and for consumers to shop around.
Forming the single currency also
involved big risks, however. Euro members gave up both the right to set their
own interest rates and the option of moving exchange rates against each other.
They also agreed to limit their budget deficits under a stability and growth
pact. Some economists argued that this loss of flexibility could prove costly
if their economies did not behave as one and could not easily adjust in other
ways. How well the euro-zone functions will depend on how closely it resembles
what economists call an optimal currency area. When the euro economies are not
growing in unison, a common monetary policy risks being too loose for some and
too tight for others. If so, there may need to be large transfers of funds from
regions doing well to those doing badly. But if the effects of shocks persist,
fiscal transfers would merely delay the day of reckoning; ultimately, wages or
people (or both) would have to shift.
In its first few years,the euro
fell sharply against the dollar, though it recovered during late 2002. Sluggish
growth in some european economies led to intense pressure for interest rate
cuts, and to the stability and growth pact being breached, though not scrapped.
Even so, by 2003 12 countires had adopted the euro, with the expectation of
more to follow after the enlargement of the eu to 25 members in 2004.
Economic
indicator
A statistic used for judging the
health of an economy, such as gdp per head, the rate of unemployment or the
rate of inflation. Such statistics are often subject to huge revisions in the
months and years after they are first published, thus causing difficulties and
embarrassment for the economic policymakers who rely on them.
Economic
man
At the heart of economic theory
is homo economicus, the economist's model of human behaviour. In traditional
classical economics and in neo-classical economics it was assumed that people
acted in their own self-interest. Adam smith argued that society was made
better off by everybody pursuing their selfish interests through the workings
of the invisible hand. However, in recent years, mainstream economists have
tried to include a broader range of human motivations in their models. There
have been attempts to model altruism and charity. Behavioural economics has
drawn on psychological insights into human behaviour to explain economic phenomena.
Economic
sanctions
A way of punishing errant
countries, which is currently more acceptable than bombing or invading them.
One or more restrictions are imposed on international trade with the targeted
country in order to persuade the target's government to change a policy.
Possible sanctions include limiting export or import trade with the target;
constraining investment in the target; and preventing transfers of money
involving citizens or the government of the target. Sanctions can be
multilateral, with many countries acting together, perhaps under the auspices
of the united nations, or unilateral, when one country takes action on its own.
How effective sanctions are is
debatable. According to one study, between 1914 and 1990 there were 116
occasions on which various countries imposed economic sanctions. Two-thirds of
these failed to achieve their stated goals. The cost to the country imposing
sanctions can be large, particularly when it is acting unilaterally. It is
estimated that in 1995 imposing sanctions on other countries cost the american
economy over $15 billion in lost exports and 200,000 in lost jobs in export
industries.
Widely considered a notable
success was the use of economic sanctions against the apartheid regime in south
africa, although some economists question how big a part the sanctions actually
played. Clearly important was the fact that the sanctions were imposed
multilaterally by the international community, so there were comparatively few
breaches of the restrictions. But, arguably, the most crucial factor in
persuading the government in pretoria to cave in was that foreign companies
fearing that their share price would fall because their investments in south
africa would attract bad publicity voluntarily chose for commercial reasons to
disinvest.
Economics
The “dismal science”, according
to thomas carlyle, a 19th-century scottish writer. It has been described in
many ways, few of them flattering. The most concise, non-abusive, definition is
the study of how society uses its scarce resources.
Economies
of scale
Bigger is better. In many
industries, as output increases, the average cost of each unit produced falls.
One reason is that overheads and other fixed costs can be spread over more
units of output. However, getting bigger can also increase average costs
(diseconomies of scale) because it is more difficult to manage a big operation,
for instance.
Efficiency
Getting the most out of the
resources used. For a particular sort of efficiency often favoured by
economists, see pareto efficient.
Efficiency
wages
Wages that are set at above the
market clearing rate so as to encourage workers to increase their productivity.
Efficient
market hypothesis
You can't beat the market. The
efficient market hypothesis says that the price of a financial asset reflects
all the information available and responds only to unexpected news. Thus prices
can be regarded as optimal estimates of true investment value at all times. It
is impossible for investors to predict whether the price will move up or down
(future price movements are likely to follow a random walk), so on average an
investor is unlikely to beat the market. This belief underpins arbitrage
pricing theory, the capital asset pricing model and concepts such as beta.
The hypothesis had few critics
among financial economists during the 1960s and 1970s, but it has come under
increasing attack since then. The fact that financial prices were far more
volatile than appeared to be justified by new information, and that financial
bubbles sometimes formed, led economists to question the theory. Behavioural
economics has challenged one of the main sources of market efficiency, the idea
that all investors are fully rational homo economicus. Some economists have
noted the fact that information gathering is a costly process, so it is
unlikely that all available information will be reflected in prices. Others
have pointed to the fact that arbitrage can become more costly, and thus less
likely, the further away from fundamentals prices move. The efficient market
hypothesis is now one of the most controversial and well-studied propositions
in economics, although no consensus has been reached on which markets, if any,
are efficient. However, even if the ideal does not exist, the efficient market
hypothesis is useful in judging the relative efficiency of one market compared
with another.
Elasticity
A measure of the responsiveness
of one variable to changes in another. Economists have identified four main
types.
Price elasticity measures how
much the quantity of supply of a good, or demand for it, changes if its price
changes. If the percentage change in quantity is more than the percentage
change in price, the good is price elastic; if it is less, the good is
inelastic.
Income elasticity of demand
measures how the quantity demanded changes when income increases.
Cross-elasticity shows how the
demand for one good (say, coffee) changes when the price of another good (say,
tea) changes. If they are substitute goods (tea and coffee) the
cross-elasticity will be positive: an increase in the price of tea will
increase demand for coffee. If they are complementary goods (tea and teapots)
the cross-elasticity will be negative. If they are unrelated (tea and oil) the
cross-elasticity will be zero.
Elasticity of substitution
describes how easily one input in the production process, such as labour, can
be substituted for another, such as machinery.
Endogenous
Inside the economic model; the
opposite of exogenous).
Engel's
law
People generally spend a smaller
share of their budget on food as their income rises. Ernst engel, a russian
statistician, first made this observation in 1857. The reason is that food is a
necessity, which poor people have to buy. As people get richer they can afford
better-quality food, so their food spending may increase, but they can also
afford luxuries beyond the budgets of poor people. Hence the share of food in
total spending falls as incomes grow.
Enron
In a word, all that was wrong
with american capitalism at the start of the 21st century. Until late 2001,
enron, an energy company turned financial powerhouse based in houston, texas,
had been one of the most admired firms in the united states and the world. It
was praised for everything from pioneering energy trading via the internet to
its innovative corporatate culture and its system of employment evaluation by
peer review, which resulted in those that were not rated by their peers being
fired. However, revelations of accounting fraud by the firm led to its
bankruptcy, prompting what was widely described as a crisis of confidence in
american capitalism. This, as well as further scandals involving accounting
fraud (worldcom) and other dubious practices (many by wall street firms),
resulted in efforts to reform coporate governance, the legal liability of
company bosses, accounting, wall street research and regulation.
Enterprise
One of the factors of production,
along with land, labour and capital. The creative juices of capitalism; the
animal spirits of the entrepreneur.
Entrepreneur
The life and soul of the
capitalist party. Somebody who has the idea and enterprise to mix together the
other factors of production to produce something valuable. An entrepreneur must
be willing to take a risk in pursuit of a profit.
Environmental
economics
Some people think capitalism is
wholly bad for the environment as it is based on consuming scarce resources.
They want less consumption and greater reliance on renewable resources. They
oppose free trade because they favour self-sufficiency (autarky), or at least
so-called fair trade, and because they believe it encourages poorer countries
to destroy their natural resources in order to get rich quick. Although few
professional economists would share these views, in recent years many attempts
have been made to incorporate environmental concerns within mainstream
economics.
The traditional measure of gdp
incorporates only those things that are paid for; this may include things that
reduce the overall quality of life, including harming the environment. For
instance, cleaning up an oil spill will increase gdp if people are paid for the
clean-up. Attempts have been made to devise an alternative environmentally
friendly measure of national income, but so far progress has been limited. At
the very least, traditional economists increasingly agree that maximising gdp
growth does not necessarily equal maximising social welfare.
Much of the damage done to the environment
may be a result of externalities. An externality can arise when people engaged
in economic activity do not have to take into account the full costs of what
they are doing. For instance, car drivers do not have to bear the full cost of
making their contribution to global warming, even though their actions may one
day impose a huge financial burden on society. One way to reduce externalities
is to tax them, say, through a fuel tax. Another is prohibition, say, limiting
car drivers to one gallon of fuel per week. This could result in black markets,
however. Allowing trade in pollution rights may encourage 'efficient
pollution', with the pollution permits ending up in the hands of those for
which pollution has the greatest economic upside. As this would still allow
some environmental destruction, it might be unpopular with extreme greens.
There may be a case for
international eco markets. For instance, people in rich countries might pay
people in poor countries to stop doing activities that do environmental damage
outside the poor countries, or that rich people disapprove of, such as chopping
down the rain forests. Choices on environmental policy, notably on measures to
reduce the threat of global warming, involve costs today with benefits delayed
until the distant future. How are these choices to be made? Traditional
cost-benefit analysis does not help much. In measuring costs and benefits in
the far distant future, two main things seem to intervene and spoil the
conventional calculations. One is uncertainty. We know nothing about what the
state of the world will be in 2200. The other is how much people today are
willing to pay in order to raise the welfare of others who are so remote that
they can barely be imagined, yet who seem likely to be much better off
materially than people today. Some economists take the view that the welfare of
each future generation should be given the same weight in the analysis as the
welfare of today's. This implies that a much lower discount rate should be used
than the one appropriate for short-term projects. Another option is to use a
high discount rate for costs and benefits arising during the first 30 or so
years, then a lower rate or rates for more distant periods. Many studies by
economists and psychologists have found that people do in fact discount the
distant future at lower rates than they apply to the near future.
Equilibrium
When supply and demand are in
balance. At the equilibrium price, the quantity that buyers are willing to buy
exactly matches the quantity that sellers are willing to sell. So everybody is
satisfied, unlike when there is disequilibrium. In classical economics, it is
assumed that markets always tend towards equilibrium and return to it in the
event that something causes a temporary disequilibrium. General equilibrium is
when supply and demand are balanced simultaneously in all the markets in an
economy. Keynes questioned whether the economy always moved to equilibrium, for
instance, to ensure full employment.
Equity
There are two definitions in
economics.
1 the capital of a firm, after
deducting any liabilities to outsiders other than shareholders, who are
typically the legal owners of the firm's equity. This ownership right is the
reason shares are also known as equities.
2 fairness. Dividing up the
economic pie. Economists have been particularly interested in this with regard
to how systems of taxation work. They have examined whether taxes treat fairly
people with the same ability to pay (horizontal equity) and people with
different abilities to pay (vertical equity).
The fairness of other aspects of
how the gains from economic activity are distributed through society have also
been debated by economists, especially those interested in welfare economics.
Some economists start with the presumption that the free-market outcome is
inherently inequitable, and that equity (sharing out the pie) must be traded
off against efficiency (maximising the size of the pie). Others argue that it
is inequitable to take money away from someone who has created economic value
to give to people who have been less skilled or industrious.
Equity
risk premium
The extra reward investors get
for buying a share over what they get for holding a less risky asset, such as a
government bond. Modern financial theory assumes that the premium will be just
big enough on average to compensate the investor for the extra risk. However, studies
have found that the average equity premium over many years has been much larger
than appears to be justified by the average riskiness of shares. To solve this
so-called equity premium puzzle, some economists have suggested that investors
may have greater risk aversion towards shares than traditional theory assumes.
Some claim that the past equity premium was mismeasured, or reflected an
unrepresentative sample of share prices. Others suggest that the high premium
is evidence that the efficient market hypothesis does not apply to the
stockmarket. Some economists think that the premium fell to more easily
explained levels during the 1990s. Nobody really knows which, if any, of these
interpretations is right.
Euro
The main currency of the european
union, launched in january 1999 and in general circulation since 2002 .
Euro
zone
The economy comprising all the
countries that have adopted the euro. There is much debate among economists
about whether the euro zone is in fact an optimal currency area.
Eurodollar
A deposit in dollars held in a
bank outside the united states. Such deposits are often set up to avoid taxes
and currency exchange costs. They are frequently lent out and have become an
important method of credit creation.
European
central bank
The central bank of the european
union, responsible since january 1999 for setting the official short-term
interest rate in countries using the euro as their domestic currency. In this
role, the european central bank (ecb) replaced national central banks such as
germany's bundesbank, which became local branches of the ecb.
European
union
A club of european countries.
Initially a six-country trade area established by the 1957 treaty of rome and
known as the european economic community, it has become an increasingly
political union. In 1999 a single currency, the euro, was launched in 11 of the
then 15 member countries. Viewed as a single entity, the eu has a bigger
economy than the united states. In 2002, a further 10 countries were invited to
join the eu in 2004, increasing its membership to 25 countries, with more
countries likely to follow later.
Evolutionary
economics
A darwinian approach to
economics, sometimes called institutional economics. Following the tradition of
schumpeter, it views the economy as an evolving system and places a strong emphasis
on dynamics, changing structures (including technologies, institutions, beliefs
and behaviour) and disequilibrium processes (such as innovation, selection and
imitation).
Excess
returns
Getting more money from an
economic investment than you needed to justify investing. In perfect
competition, the factors of production earn only normal returns, that is, the
minimum amount of wages, profit, interest or rent needed to secure their use in
the economic activity in question, rather than in an alternative. Excess
returns can only be earned for more than a short period when there is market
failure, especially monopoly, because otherwise the existence of excess returns
would quickly attract competition, which would drive down returns until they
were normal.
Exchange
controls
Limits on the amount of foreign
currency that can be taken into a country, or of domestic currency that can be
taken abroad.
Exchange
rate
The price at which one currency
can be converted into another. Over the years, economists and politicians have
often changed their minds about whether it is a good idea to try to hold a
country's exchange rate steady, rather than let it be decided by market forces.
For two decades after the second world war, many of the major currencies were
fixed under the bretton woods agreement. During the following two decades, the
number of currencies allowed to float increased, although in the late 1990s a
number of european currencies were permanently fixed under economic and
monetary union and some other countries established a currency board.
When capital can flow easily
around the world, countries cannot fix their exchange rate and at the same time
maintain an independent monetary policy. They must choose between the
confidence and stability provided by a fixed exchange rate and the control over
interest rate policy offered by a floating exchange rate. On the face of it, in
a world of capital mobility a more flexible exchange rate seems the best bet. A
floating currency will force firms and investors to hedge against fluctuations,
not lull them into a false sense of stability. It should make foreign banks
more circumspect about lending. At the same time it gives policymakers the
option of devising their own monetary policy. But floating exchange rates have
a big drawback: when moving from one equilibrium to another, currencies can
overshoot and become highly unstable, especially if large amounts of capital
flow in or out of a country. This instability has real economic costs.
To get the best of both worlds,
many emerging economies have tried a hybrid approach, loosely tying their
exchange rate either to a single foreign currency, such as the dollar, or to a
basket of currencies. But the currency crises of the late 1990s, and the
failure of argentina's currency board, led many economists to conclude that, if
not a currency union such as the euro, the best policy may be to have a freely
floating exchange rate.
Exogenous
Outside the model. For instance,
in traditional neo-classical economics, models of growth rely on an exogenous
factor. To keep growing, an economy needs continual infusions of technological
progress. Yet this is a force that the neo-classical model makes no attempt to
explain. The rate of technological progress comes from outside the model; it is
simply assumed by the economic modellers. In other words, it is exogenous. New
growth theory tries to calculate the rate of technological progress inside the
economic model by mapping its relationship to factors such as human capital,
free markets, competition and government expenditure. Thus, in these models,
growth is endogenous.
Expectations
What people assume about the
future, especially when they make decisions. Economists debate whether poeple
have irrational or rational expectations, or adaptive expectations that change
to reflect learning from past mistakes.
Expected
returns
The capital gain plus income that
investors think they will earn by making an investment, at the time they
invest.
Expenditure
tax
A tax on what people spend,
rather than what they earn or their wealth. Economists often regard it as more
efficient than other taxes because it may discourage productive economic
activity less; it is not the creating of income and wealth that is taxed, but
the spending of it. It can be a form of indirect taxation, added to the price
of a good or service when it is sold, or direct taxation, levied on people's
income minus their savings over a year.
Export
credit
Loans to boost exports. In many
countries these are subsidised by a government keen to encourage exports.
Typically, the credit comes in two forms: loans to foreign buyers of domestic
produce; and guarantees on loans made by banks to domestic companies so they
can produce the exports that should pay off the loan. This effectively insures
producers against non-payment. When governments compete aggressively with
export credits to win business for domestic firms the sums involved can become
large. The economic benefit of export credits is unclear at the best of times.
This may be because they are largely motivated by political goals.
Exports
Sales abroad. Exports grew
steadily as a share of world output during the second half of the 20th century.
Yet by some measures this share was no higher than at the end of the 19th
century, before free trade fell victim to a political backlash.
Externality
An economic side-effect.
Externalities are costs or benefits arising from an economic activity that
affect somebody other than the people engaged in the economic activity and are
not reflected fully in prices. For instance, smoke pumped out by a factory may
impose clean-up costs on nearby residents; bees kept to produce honey may
pollinate plants belonging to a nearby farmer, thus boosting his crop. Because
these costs and benefits do not form part of the calculations of the people
deciding whether to go ahead with the economic activity they are a form of
market failure, since the amount of the activity carried out if left to the
free market will be an inefficient use of resources. If the externality is
beneficial, the market will provide too little; if it is a cost, the market
will supply too much.
One potential solution is
regulation: a ban, say. Another, when the externality is negative, is a tax on
the activity or, if the externality is positive, a subsidy. But the most
efficient solution to externalities is to require them to be included in the
costings of those engaged in the economic activity, so there is
self-regulation. For instance, the externality of pollution can be solved by
creating property rights over clean air, entitling their owner to a fee if they
are infringed by a factory pumping out smoke. According to the coase theorem
(named after a nobel prize-winning economist, ronald coase), it does not matter
who has ownership, so long as property rights are fully allocated and
completely free trade of all property rights is possible.
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