Macroeconomic policy
Top-down policy by government and central banks, usually
intended to maximise growth while keeping down inflation and unemployment. The
main instruments of macroeconomic policy are changes in the rate of interest
and money supply, known as monetary policy, and changes in taxation and public
spending, known as fiscal policy. The fact that unemployment and inflation
often rise sharply, and that growth often slows or gdp falls, may be evidence
of poorly executed macroeconomic policy. However, business cycles may simply
be an unavoidable fact of economic life that macroeconomic policy, however well
conducted, can never be sure of conquering.
Macroeconomics
The big picture: analysing economy-wide phenomena such as
growth, inflation and unemployment. Contrast with microeconomics, the study of
the behaviour of individual markets, workers, households and firms. Although
economists generally separate themselves into distinct macro and micro camps,
macroeconomic phenomena are the product of all the microeconomic activity in an
economy. The precise relationship between macro and micro is not particularly
well understood, which has often made it difficult for a government to deliver
well-run macroeconomic policy.
Manufacturing
Making things like cars or frozen food has shrunk in importance
in most developed countries during the past half century as services have
grown. In the United States and the UK, the proportion of workers in manufacturing
has shrunk since 1900 from around 40% to barely 20%. More than two-thirds of
output in oecd countries, and up to four-fifths of employment, is now in the
services sector. At the same time, manufacturing has grown in importance in
developing countries.
Many people think that manufacturing somehow matters more than
any other economic activity and is in some way superior to surfing the internet
or cutting somebody's hair. This is probably nothing more than nostalgia for
times past when making things in factories was what real men did, just as 150
years ago growing things in fields was what real men did. Mostly, the shift
from manufacturing to services (as with the earlier shift from agriculture to
manufacturing) reflects progress into jobs that create more utility, this time
for real women as well as real men, which may explain why it is happening first
in richer countries.
Marginal
The difference made by one extra unit of something. Marginal
revenue is the extra revenue earned by selling one more unit of something. The
marginal price is how much extra a consumer must pay to buy one extra unit.
Marginal utility is how much extra utility a person gets from consuming (or
doing) an extra unit of something. The marginal product of labour is how much
extra output a firm would get by employing an extra worker, or by getting an
existing worker to put in an extra hour on the job. The marginal propensity to
consume (or to save) measures by how much a household's consumption (savings)
would increase if its income rose by, say, $1. The marginal tax rate measures
how much extra tax you would have to pay if you earned an extra dollar.
The marginal cost (or whatever) can be very different from the
average cost (or whatever), which simply divides total costs (or whatever) by
the total number of units produced (or whatever). A common finding in
microeconomics is that small incremental changes can matter enormously. In
general, thinking 'at the margin' often leads to better economic decision
making than thinking about the averages.
Alfred marshall, the father of neo-classical economics, based
many of his theories of economic behaviour on marginal rather than average
behaviour. For instance, given certain plausible assumptions, a
profit-maximising firm will increase production up to the point where marginal
revenue equals marginal cost. This is because if marginal revenue exceeded
marginal cost, the firm could increase its profit by producing an extra unit of
output. Alternatively, if marginal cost exceeded marginal revenue, the firm could
increase its profit by producing fewer units of output.
In all walks of life, a basic rule of rational economic decision
making is: do something only if the marginal utility you get from it exceeds
the marginal cost of doing it.
Market capitalisation
The market value of a company’s shares: the quoted share price
multiplied by the total number of shares that the company has issued.
Market failure
When a market left to itself does not allocate resources
efficiently. Interventionist politicians usually allege market failure to
justify their interventions. Economists have identified four main sorts or
causes of market failure.
The abuse of market power, which can occur whenever a single
buyer or seller can exert significant influence over prices or output.
Externalities - when the market does not take into account the
impact of an economic activity on outsiders. For example, the market may ignore
the costs imposed on outsiders by a firm polluting the environment.
Public goods, such as national defence. How much defence would
be provided if it were left to the market?
Where there is incomplete or asymmetric information or
uncertainty.
Abuse of market power is best tackled through antitrust policy.
Externalities can be reduced through regulation, a tax or subsidy, or by using
property rights to force the market to take into account the welfare of all who
are affected by an economic activity. The supply of public goods can be ensured
by compelling everybody to pay for them through the tax system.
Market forces
Shorthand for the pressures from buyers and sellers in a market,
rather than those coming from a government planner or from regulation.
Market power
When one buyer or seller in a market has the ability to exert
significant influence over the quantity of goods and services traded or the price
at which they are sold. Market power does not exist when there is perfect
competition, but it does when there is a monopoly, monopsony or oligopoly.
Marshall plan
Probably the most successful programme of international aid and
nation building in history. It was named after general george marshall, an
american secretary of state, who at the end of the second world war proposed
giving aid to western europe to rebuild its war-torn economies. North America
gave around 1% of its gdp in total between 1948 and 1952; most of it came from
the United States and the rest from Canada. The Americans left it to the Europeans
to work out the details on allocating aid, which may be why, according to most
economic analyses; it achieved more success than latter day aid programmes in
which most of the decisions on how the money is spent are made by the donors.
The main institution through which aid was administered was the organisation
for European economic co-operation (oeec), which in 1961 became the OECD.
Nowadays, whenever there is a proposal for the international community to
rebuild an economy damaged by war, such as iraq's in 2003, you are sure to hear
the phrase 'new marshall plan'.
Mean reversion
The tendency for subsequent observations of a random variable to
be closer to its mean than the current observation. For example, if the current
number is 7, the average is 5, and there is mean reversion, then the next
observation is likelier to be 6 than 8.
Medium term
Somewhere between short-termism, which is bad, and the long run,
lies the hallowed ground of the medium term – far enough away to discourage
myopic behaviour by decision makers but close enough to be meaningful. But not
many governments say exactly how long they think the medium term is.
Menu costs
How much it costs to change prices. Just as a restaurant has to
print a new menu when it changes the price of its food, so many other firms
face a substantial outlay each time they cut or raise what they charge. Such
menu costs mean that firms may be reluctant to change their prices every time
there is a shift in the balance of supply and demand, so there will be sticky
prices and the market for their output will be in disequilibrium. The internet
may sharply reduce menu costs as it allows prices to be changed at the click of
a mouse, which may improve efficiency by keeping markets more often in
equilibrium.
Mercantilism
The conventional economic wisdom of the 17th century that made a
partial come-back in recent years. Mercantilists feared that money would become
too scarce to sustain high levels of output and employment; their favoured
solution was cheap money (low interest rates). In a forerunner to the
20th-century debate between keynesians and monetarists, they were opposed by
advocates of classical economics, who argued that cheap and plentiful money
could result in inflation. The original mercantilists, such as john law, a
scots financier (and convicted murderer), believed that a country's economic
prosperity and political power came from its stocks of precious metals. To
maximise these stocks they argued against free trade, favouring protectionist
policies designed to minimise imports and maximise exports, creating a trade
surplus that could be used to acquire more precious metal. This was contested
for the classicists by adam smith and david hume, who argued that a country's
wealth came not from its stock of precious metals but rather from its stocks of
productive resources (land, labour, capital, and so on) and how efficiently
they are used. Free trade increased efficiency by allowing countries to
specialise in things in which they have a comparative advantage.
Mergers and acquisitions
When two businesses join together, either by merging or by one
company taking over the other. There are three sorts of mergers between firms:
horizontal integration, in which two similar firms tie the knot; vertical
integration, in which two firms at different stages in the supply chain get
together; and diversification, when two companies with nothing in common jump
into bed. These can be a voluntary marriage of equals; a voluntary takeover of
one firm by another; or a hostile takeover, in which the management of the
target firm resists the advances of the buyer but is eventually forced to
accept a deal by its current owners. For reasons that are not at all clear,
merger activity generally happens in waves. One possible explanation is that
when share prices are low, many firms have a market capitalisation that is low
relative to the value of their assets. This makes them attractive to buyers. In
theory, the different sorts of mergers have different sorts of potential
benefits. However, the damning lesson of merger waves stretching back over the
past 50 years is that, with one big ex ception - the spate of leveraged
buy-outs in the United States during the 1980s - they have often failed to
deliver benefits that justify the costs.
Microeconomics
The study of the individual pieces that together make an
economy. Contrast with macroeconomics, the study of economy-wide phenomena such
as growth, inflation and unemployment. Microeconomics considers issues such as
how households reach decisions about consumption and saving, how firms set a
price for their output, whether privatisation improves efficiency, whether a
particular market has enough competition in it and how the market for labour
works.
Minimum wage
A minimum rate of pay that firms are legally obliged to pay
their workers. Most industrial countries have a minimum wage, although certain
sorts of workers are often exempted, such as young people or part-timers. Most
economists reckon that a minimum wage, if it is doing what it is meant to do,
will lead to higher unemployment than there would be without it. The main
justification offered by politicians for having a minimum wage is that the wage
that would be decided by buyers and sellers in a free market would be so low
that it would be immoral for people to work for it. So the minimum wage should
be above the market-clearing wage, in which case fewer workers would be
demanded at that wage than would be hired at the market wage. How many fewer
will depend on how far the minimum wage is above the market wage?
Some economists have challenged this simple supply and demand
model. Several empirical studies have suggested that a minimum wage moderately
above the free-market wage would not harm employment much and could (in rare
circumstances) potentially raise it. These studies are not widely accepted
among economists. Whatever it does for those in work, a minimum wage cannot
help the majority of the very poorest people in most countries, who typically
have no job in which to earn a minimum wage.
Misery index
The sum of a country’s inflation and unemployment rates. The
higher the score, the greater is the economic misery.
Mixed economy
A market economy in which both private-sector firms and firms
owned by government take part in economic activity. The proportions of public
and private enterprise in the mix vary a great deal among countries. Since the
1980s, the public role in most mixed economies declined as nationalisation gave
way to privatisation.
Mobility
The easier it is for the factors of production to move to where
they are most valuable, the more efficient the allocation of the world's scarce
resources is likely to be and the faster gdp will grow. Apart from continental
drift, land is immobile. Capital has long been extremely mobile within
countries, and, with the rise of globalisation, it is now able to move easily
around the world. Enterprise is mobile, although to what extent depends on the
particular entrepreneur. Some members of the labour market zoom around the
world to work; others will not move to the next town.
Capital controls are the main obstacle to capital mobility, and
these have been mostly removed or reduced since 1980. The sources of labour
immobility are more numerous and complex, including immigration controls,
transport costs, language barriers and a reluctance to move away from family or
friends. Workers are far more mobile within the United States than they are
within the European Union or within individual eu countries. Some economists
reckon that the willingness of workers to move to where the work is helps to
explain the stronger economic performance and lower unemployment of the United
States.
Can you sometimes have too much mobility? Certainly, some
developing countries have suffered from hot money rushing into and then out of
their markets.
In general, the possibility that a factor of production may
suddenly move elsewhere can create serious economic problems. For instance, an
employer may think twice about investing in training an employee if it fears
that the employee may suddenly take a job with another firm. Similarly,
entrepreneurs are unlikely to take the risk of pursuing a new idea if they fear
that their capital may disappear at any moment, hence the importance of having
access to long-term capital, such as by issuing bonds and equities.
Modelling
When economists make a number of simplified assumptions about
how the economy, or some part of it, behaves, and then see what this implies in
various different scenarios. Milton Friedman argued that economic models should
not be judged on the basis of the validity of their assumptions, but on the
accuracy of their predictions. An expert billiards player, he said, may not
know the laws of physics, but acts as if he knows such laws. So his behaviour
could be predicted accurately with a model that assumes he knows the laws of
physics. Likewise, the behaviour of people making economic decisions may be
accurately predicted by a model that assumes their goal is, say, profit
maximisation, even if they are not actually conscious of this being their goal.
The more complex the thing being modelled, the harder it is to get right.
Economic forecasting has a poor overall track record. The more microeconomic
the thing being modelled, the more likely it is that a model can be designed
that will deliver accurate predictions.
Modern portfolio theory
One of the most important and influential economic theories
about finance and investment. Modern portfolio theory is based upon the simple
idea that diversification can produce the same total returns for less risk.
Combining many financial assets in a portfolio is less risky than putting all
your investment eggs in one basket. The theory has four basic premises.
Investors are risk averse.
Securities are traded in efficient markets.
Risk should be analysed in terms of an investor's overall
portfolio, rather than by looking at individual assets.
For every level of risk, there is an optimal portfolio of assets
that will have the highest expected returns.
All of this seems comparatively straightforward now, except
perhaps the bit about efficient markets. But it was shocking when it was put
forward in the early 1950s by harry Markowitz, who later won the Nobel Prize
for it. According to mr Markowitz, when he explained his theory to the high
priests of the chicago school, 'milton friedman argued that portfolio theory
was not economics'. It is now.
Monetarism
Control the money supply, and the rest of the economy will take
care of itself. A school of economic thought that developed in opposition to
post-1945 Keynesian policies of demand management, echoing earlier debates
between mercantilism and classical economics. Monetarism is based on the belief
that inflation has its roots in the government printing too much money. It is
closely associated with milton milton friedman, who argued, based on the
quantity theory of money, that government should keep the money supply fairly
steady, expanding it slightly each year mainly to allow for the natural growth
of the economy. If it did this, market forces would efficiently solve the
problems of inflation, unemployment and recession. Monetarism had its heyday in
the early 1980s, when economists, governments and investors pounced eagerly on
every new money-supply statistic, particularly in the United States and the UK.
Many central banks had set formal targets for money-supply
growth, so every wiggle in the data was scrutinised for clues to the next move
in the rate of interest. Since then, the notion that faster money-supply growth
automatically causes higher inflation has fallen out of favour. The money
supply is useful as a policy target only if the relationship between money and
nominal gdp, and hence inflation, is stable and predictable. The way the money
supply affects prices and output depends on how fast it circulates through the
economy. The trouble is that its velocity of circulation can suddenly change.
During the 1980s, the link between different measures of the money supply and
inflation proved to be less clear than monetarist theories had suggested, and
most central banks stopped setting binding monetary targets. Instead, many have
adopted explicit inflation targets.
Monetary neutrality
Changes in the money supply have no effect on real economic
variables such as output, real interest rates and unemployment. If the central
bank doubles the money supply, the price level will double too. Twice as many
dollars means half as much bang for the buck. This theory, a core belief of
classical economics, was first put forward in the 18th century by David Hume.
He set out the classical dichotomy that economic variables come in two
varieties, nominal and real, and that the things that influence nominal
variables do not necessarily affect the real economy. Today few economists
think that pure monetary neutrality exists in the real world, at least in the
short run. Inflation does affect the real economy because, for instance, there
may be sticky prices or money illusion.
Monetary policy
What a central bank does to control the money supply, and
thereby manage demand. Monetary policy involves open-market operations, reserve
requirements and changing the short-term rate of interest (the discount rate).
It is one of the two main tools of macroeconomic policy, the side-kick of
fiscal policy, and is easier said than done well.
Money
Makes the world go round and comes in many forms, from shells
and beads to gold coins to plastic or paper. It is better than barter in
enabling an economy's scarce resources to be allocated efficiently. Money has
three main qualities:
As a medium of exchange, buyers can give it to sellers to pay
for goods and services;
As a unit of account, it can be used to add up apples and
oranges in some common value;
As a store of value, it can be used to transfer purchasing power
into the future.
A farmer who exchanges fruit for money can spend that money in
the future; if he holds on to his fruit it might rot and no longer be useful
for paying for something. Inflation undermines the usefulness of money as a
store of value, in particular, and also as a unit of account for comparing
values at different points in time. Hyper-inflation may destroy confidence in a
particular form of money even as a medium of exchange. Measures of liquidity
describe how easily an asset can be exchanged for money.
Money illusion
When people are misled by inflation into thinking that they are
getting richer, when in fact the value of money is declining. Whether, and how
much, people are fooled by inflation is much debated by economists. Money
illusion, a phrase coined by Keynes, is used by some economists to argue that a
small amount of inflation may not be a bad thing and could even be beneficial,
helping to “grease the wheels” of the economy. Because of money illusion,
workers like to see their nominal wages rise, giving them the illusion that
their circumstances are improving, even though in real (inflation-adjusted)
terms they may be no better off. During periods of high inflation double-digit
pay rises (as well as, say, big increases in the value of their homes) can make
people feel richer even if they are not really better off. When inflation is low,
growth in real incomes may hardly register.
Money markets
Any market where money and other liquid assets (such as treasury
bills) can be lent and borrowed for between a few hours and a few months.
Contrast with capital markets, where longer-term capital changes hands.
Money supply
The amount of money available in an economy. In the heyday of
monetarism in the early 1980s, economists pounced upon the monthly (in some
countries, even weekly) money-supply numbers for clues about future inflation.
Central banks aim to manage demand by controlling the supply of money through
open-market operations, reserve requirements and changing the rate of interest
(to be exact, the discount rate).
One difficulty for policymakers lies in how to measure the
relevant money supply. There are several different methods, reflecting the
different liquidity of various sorts of money. Notes and coins are completely
liquid; some bank deposits cannot be withdrawn until after a waiting period. M3
(m4 in the uk) is known as broad money, and consists of cash, current account
deposits in banks and other financial institutions, savings deposits and
time-restricted deposits. M1 is known as narrow money, and consists mainly of
cash in circulation and current account deposits. M0 (in the UK) is the most
liquid measure, including only cash in circulation, cash in banks' tills and
banks' operational deposits held at the bank of England.
Although it is a poor predictor of inflation, monetary growth
can be a handy leading indicator of economic activity. In many countries, there
is a clear link between the growth of the real broad-money supply and that of
real gdp.
Monopolistic competition
Somewhere between perfect competition and monopoly, also known
as imperfect competition. It describes many real-world markets. Perfectly
competitive markets are extremely rare, and few firms enjoy a pure monopoly;
oligopoly is more common. In monopolistic competition, there are fewer firms
than in a perfectly competitive market and each can differentiate its products
from the rest somewhat, perhaps by advertising or through small differences in
design. These small differences form barriers to entry. As a result, firms can
earn some excess profits, although not as much as a pure monopoly, without a
new entrant being able to reduce prices through competition. Prices are higher
and output lower than under perfect competition.
Monopoly
When the production of a good or service with no close
substitutes is carried out by a single firm with the market power to decide the
price of its output. Contrast with perfect competition, in which no single firm
can affect the price of what it produces. Typically, a monopoly will produce
less, at a higher price, than would be the case for the entire market under
perfect competition. It decides its price by calculating the quantity of output
at which its marginal revenue would equal its marginal cost, and then sets
whatever price would enable it to sell exactly that quantity.
In practice, few monopolies are absolute, and their power to set
prices or limit supply is constrained by some actual or potential
near-competitors. An extreme case of this occurs when a single firm dominates a
market but has no pricing power because it is in a contestable market; that is
if it does not operate efficiently, a more efficient rival firm will take its
entire market away. Antitrust policy can curb monopoly power by encouraging
competition or, when there is a natural monopoly and thus competition would be
inefficient, through regulation of prices. Furthermore, the mere possibility of
antitrust action may encourage a monopoly to self-regulate its behaviour,
simply to avoid the trouble an investigation would bring.
Monopsony
A market dominated by a single buyer. A monopsonist has the
market power to set the price of whatever it is buying (from raw materials to
labour). Under perfect competition, by contrast, no individual buyer is big
enough to affect the market price of anything.
Moral hazard
One of two main sorts of market failure often associated with
the provision of insurance. The other is adverse selection. Moral hazard means
that people with insurance may take greater risks than they would do without it
because they know they are protected, so the insurer may get more claims than
it bargained for.
Most-favoured nation
Equal treatment, at least, in international trade. If country a
grants country b the status of most-favoured nation, it means that b's exports
will face tariff that are no higher (and also no lower) than those applied to
any other country that a calls a most-favoured nation. This will be the most
favourable tariff treatment available to imports.
Most-favoured nation treatment is one of the most important
building blocks of the international trading system. The world trade
organisation requires member countries to accord the most favourable tariff and
regulatory treatment given to the product of any one member to the 'like
products' of all other members. Before the general agreement on tariffs and
trade, there was often a most-favoured nation clause in bilateral trade
agreements, which helped the world move towards free trade. In the 1930s,
however, there was a backlash against this, and most-favoured nations were
treated less favourably. This shift pushed the world economy towards division
into regional trade areas. In the United States, most-favoured nation status
has to be re-ratified periodically by congress.
Multiplier
Shorthand for the way in which a change in spending produces an
even larger change in income. For instance, suppose a government loosens fiscal
policy, increasing net public spending by pumping an extra $10 billion into
education. This has an immediate effect by increasing the income of teachers
and of people who sell educational supplies or build or maintain schools. These
people will in turn spend some of their extra money, putting more cash into the
pockets of others, who spend some of it, and so on.
In theory, this process could continue indefinitely, in which
case the multiplier would have an infinite value. In practice, most people save
some of their extra income rather than spend it. How much they spend will
depend on their marginal propensity to consume. The value of the multiplier can
be calculated by this formula:
Multiplier = 1 / (1 - marginal propensity to consume)
If the marginal propensity to consume is 0.5 (50 cents of an
extra dollar), the multiplier is 2. In practice, it is often hard to measure
the multiplier effect, or to predict how it will respond to, say, changes in
monetary policy or fiscal policy.
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