Synopsis: The second in the series about the Minsky Moment and how it changed economics.

Click here to read the original article.

1. Click here to read the introduction post.
2. Click here to read the first post on asymmetric information.

Discussion:
 
Hyman Minsky
 
Hyman Minsky is best known for his work on what causes a financial crisis. His work remained unnoticed throughout his lifetime and for a long while after. This is, in large part, due to the fact that his work was not in conformity with mainstream economics. While the majority of economists believed that markets were efficient (explained under ‘Context’), Minsky argued that inefficiency is what causes financial crises, and called this hypothesis the “financial-instability hypothesis”.
 
The financial-instability hypothesis
 
This describes how “long stretches of prosperity sow the seeds of the next crisis”, according to The Economist.
 
First, Minsky defined investment as giving money in the present in return for getting money back in the future.  For example, an ice cream machine is an investment. An ice cream parlor gives money right now to buy an ice cream machine. Due to the ice creams the machine produces, the firm gets money back in the future.
 
Where does the ice cream parlor get the money to buy the machine? It can get it from two sources: its own funds or others’ funds (e.g. the bank). The balance between the two sources is key to explaining financial instability.
 
Next, Minsky describes three types of investments.
 

1. Hedge financing: All of a firm’s borrowing is repaid with its future cash flow (explained in ‘Key Terms’). In order for this to work, a firm must have little borrowing and lots of profits. This is the most stable type of investment.
2. Speculative financing: Cash flow covers interest payment but firms must roll over their debt to repay the principal (explained in ‘Context’). This is riskier than hedge financing.
3. Ponzi financing: Cash flow covers neither principal nor interest; thus, a firm is forced to rely on the value of the asset to cover its costs (explained in ‘Context’). If the value of the asset falls, either due to contractionary monetary policy or an external shock, the firm will have to default.

 
These three types of financing are illustrated in the diagram below.

​Thus, an economy with mostly hedge financing is the most stable. An economy dominated by Ponzi financing, on the other hand, would mean that all asset values are vulnerable to external shocks of any kind, which, in turn, would hurt the economy. An economy could restrict itself to hedge financing, but will not do so. During times of healthy economic growth, firms are increasingly tempted to invest in riskier projects, and banks are increasingly tempted to finance these projects through riskier means, i.e. speculative and Ponzi financing. This is because they believe that a firm can ultimately pay back its debt, given the good growth.
 
Thus, an economy dominated by hedge financing slowly becomes an economy dominated by Ponzi financing, and a drop in asset values leads to a financial crisis. In other words, economic stability breeds instability.
 
The point at which asset prices start plunging is called a “Minsky moment”, which is a term coined by PIMCO’s former chief economist Paul McCulley. A Minsky moment is now synonymous with a financial crisis. This is illustrated in the diagram below.

Neither The Economist nor Minsky himself provided an explanation for the trough in the business cycle, but an explanation can be extrapolated from the cause of a Minsky moment. The Minsky moment is the point at which asset values collapse through some external shock (e.g. monetary tightening), or, more importantly, banks stop lending due to faltering confidence. Thus, the trough might be when banks once again resume lending when confidence picks up and they believe that the investment projects are safe.
 
If we assume this to be the reason for a trough, then we can assume that even without any external shocks (such as government intervention or a war), the business cycle would occur.
 
Minsky today
 
At the time, Minsky’s work was disregarded. People believed that markets are efficient and stable. Now, behavioral economics has adopted the idea that markets are not efficient.
 
Minsky and the nature of economics
 
The financial-instability hypothesis explains a very specific situation in which a stable economy leads to an unstable economy due to increasingly risky investments and financing. This goes against the grain of economic theory, which aims to explain a general concept. Take, for example, the theory of demand, which states that for any normal good, the increase in the price results in a decrease in demand. Thus, the theory of demand explains a multitude of economic situations – the financial-instability hypothesis does not.
 
For this reason, mainstream economics ignored Minksy’s hypothesis. After his death, and after the financial crisis, his work gained popularity and relevance.
 
The implications of the hypothesis
 
The world is still shaken up by the Global Financial Crisis (GFC) and its aftermath. Investment is much less risky now than it was pre-GFC. But if we were to look at the future of the global economy using Minsky’s hypothesis, the conclusion is clear: economic actors will forget, or perhaps ignore, the warnings of the GFC in favor of riskier and riskier financing.
 
Looking further
 
Looking past The Economist article, there are some things worth mentioning.
 
The application of the Minsky moment can be seen in the financial world. Firms have to make two types of decisions: which investment projects are worth pursuing, and how to finance them (i.e., through their own funds or borrowed funds). As the economy picks up steam, firms start undertaking riskier projects and they also start financing them with more of borrowed funds. This eventually leads to a Minsky moment of instability.
 
The other interesting point about Minsky’s work is what generates business cycles, and why they are self-adjusting. Mainstream thinking follows Keynesian economics: peaks and troughs are determined by whether an economy is above or below full employment. Minsky provides an alternative explanation to why the business cycle is self-adjusting.

Key Terms:
 
Cash flow: The amount of money generated by a business.
 
Context:

1. What does “markets are efficient” mean?

This refers to a hypothesis called the efficient market hypothesis.
 
The efficient market hypothesis states that all the available information in a market is already reflected in the price. One of the implications is that it is impossible to “beat the market”.
 
For example, assume the price of Disney shares is $10 per share. Disney then releases the news that a new movie is coming out, and everyone reacts immediately by buying Disney shares in the hope that when the movie comes out, the value of the share will appreciate. The share now costs $11. When the movie actually comes around, the market would have already reacted to the news and the price of the share will stay at $11.
 
An individual might try to beat the market by investing in a share given new information, but ultimately, according to the efficient market hypothesis, he or she will not be able to.

2. What does it mean to roll over debt to repay principal?

A firm rolls over its debt by borrowing principal from another bank.
 
Suppose an ice cream firm borrows $100 to buy an ice cream machine from Bank 1. The interest rate at Bank 1 is 10% a year. Thus, after a year, the ice cream firm must pay $110 to Bank 1.
 
At the end of year 1, the ice cream firm has made $30. Thus, it still needs to get $80 from somewhere to pay back Bank 1. The firm goes to Bank 2 and borrows $80 at 10% a year. It can now pay back Bank 1.
 
At the end of year 2, the firm owes Bank 2 $88. If the firm has made $30 again during year 2, it must borrow again to repay the principal from Bank 2.
 
This is how a firm rolls over debt. In theory, as long as the profits exceed the interest rate, a firm will ultimately be able to pay back all its debt.

3. How would an asset cover a firm’s costs?
​
Selling off an asset would get a firm money, which it can then use to pay back the bank. If the value of the asset falls, then it may not be able to cover the principal or the interest rate it owes the bank.

Synopsis: The first in the series about economic theory is about information asymmetry.

Click here to read the original article, and click here to read the introduction post.

Discussion: This article discusses the importance of information availability, and the consequences of information asymmetry (explained in “Key Terms”).

Introduction

In 2007, the state of Washington banned firms from checking applicants’ credit scores (explained in ‘Key Terms’) in the hope that it would make the labor market fairer, as applicants with poor credit scores are more likely to be poor, black, young, or all three. However, studies showed that the ban left specifically those groups with fewer jobs. Why did this happen? The answer lies in the availability of information.

Before 1970, little research was done on the importance of information. At the time, economists did believe that information availability was of paramount importance, but they assumed that it was freely available. For example, in any standard textbook, it was assumed that firms knew the productivity and utility of their workers, and could thus allocate wages efficiently.

Evidence to the contrary was met with great resistance from the economic community. In 1970, economist George Akerlof, published a paper called “The Market for Lemons”, which illustrated the fact that information is not so readily available in markets. Perhaps it was because Akerlof was very young – he had finished his PhD at MIT in 1966 and had just become an assistant professor at the University of California, Berkeley – his paper and his ideas were rejected for a long time. Journal editors dismissed his findings on the grounds that “if this is correct, economics would be different”.

“The Market for Lemons”

The theory is simple but powerful. Consider the market for cars. There are two types of cars: peaches (good quality cars) and lemons (bad quality cars). Now, suppose consumers value peaches at $10,000 and lemons at $5,000.

If buyers can tell which cars are peaches and which cars are lemons, trade for both will flourish. However, producers can mask the problems with lemons, like painting over scratches, such that consumers cannot tell the difference between the two.

Now, hesitant consumers will be willing to pay some midpoint between the value of peaches and lemons, e.g. $7,500, as they do not know whether the car they are purchasing is a peach or a lemon. Sellers who know that the car is a peach will reject the offer as it is much below the value of the car, whereas if the car were a lemon, producers would happily sell it. This is a classic example of “adverse selection” (explained in ‘Key Terms’).

Because a midpoint price would be offered to sellers, sellers will always refuse to sell peaches, and only lemons would be sold. Smart buyers would deduce that only lemons would be sold, and only offer $5,000. Because of this, information asymmetry kills the market for peaches, despite the fact that there would be people willing to buy it for $10,000 if only they knew it was a peach.
This is the basis of Akerlof’s paper: information asymmetry can eradicate the market for good products in favor of bad products.

Skepticism and signaling

Akerlof went on to win the Nobel Prize in 2001, sharing the prize with economists Michael Spence and Joseph Stiglitz. Mr. Spence’s reaction was that of incredulity – how is it that a Nobel Prize could be won by stating that some people know more than other people in markets? His criticism was not unfounded; the analogy of peaches and lemons was not even accurate in the market for cars. Clearly, it was the case that peaches were sold and that the market for peaches was not completely eradicated.

However, mainstream economics found many uses for this analogy. Take, for example, Mr. Spence’s own paper called “Job Market Signaling”. Employers would struggle to differentiate between good and bad workers – information asymmetry – so good workers signaled their value by showing employers specific things, such as a degree. As degrees are not easy to get, it is only accessible to the best candidates. Thus, workers signaled their worth to get a job.

The implication of this specific example is that degrees are used only to signal to employers their value, rather than what mainstream economics believed was the purpose of a degree: to improve the productivity and knowledge of the workers. Thus, a degree only benefits an individual looking for a job, rather than the whole society, which would have benefited from skilled workers in their markets.

In fact, another example of signaling is a candidate’s credit score. It is very hard to fake, and those with a good credit score would make more reliable employees. When the state of Washington created information asymmetry where applicants knew their credit scores, but employers did not, employers relied on other signals, such as education and experience. Because education and experience are rarer among the more disadvantaged groups than a good credit score is, this ban hampered, and not helped, these groups.

Signaling as a solution to adverse selection

Today, people overcome the problem of adverse selection by using signaling. Take, for instance, an insurance company for cars. The insurance company will get two types of drivers – risky and careful drivers. Only the driver will know which category he falls into, i.e. adverse selection. An insurance firm cannot profitably cater to the two groups equally. How does the company deal with this without knowing which drivers are risky and which ones are careful? They offer two types of insurance packages.

1. Low premiums and high deductibles (explained in ‘Key Terms’). The high deductibles would detract risky drivers, and careful drivers would be attracted low premiums (explained in ‘Context’).

2. High premiums and low deductibles. The high premiums would detract careful drivers, and risky drivers would be attracted to low deductibles.

Still, this is not a perfect solution; after all, careful drivers are still stuck with high deductibles. Just like it costs good workers a university degree to get a good job, it costs good drivers a high deductible to get a reasonable insurance plan.

Moral hazard and the principal-agent problem

The consequence of adverse selection and signaling is that people who buy insurance are more likely to take risks, a term coined as “moral hazard” when Kenneth Arrow wrote about this in 1963. In other words, moral hazard is when incentives are abused.

How do you align the interests of two parties, such as an employer and a risk-taking individual, such as an employee who is prone to slacking off? This question is referred to as the “principal-agent” problem, in which the principal, e.g. the employer, wants to make sure that his interests are aligned with the agent, the employee. The simplest solution is to reward the agent with some type of profit, i.e. bus drivers would be charged based on the number of passengers he carries. This would ensure that he does not slack off all day.

What if an agent’s hard work is not recognized? For example, what if there just aren’t any passengers for a bus driver to pick up? Another option to this problem is to provide the agents with “efficiency wages” (explained in ‘Key Terms’). Efficiency wages would be set high enough that individuals work hard; being caught and losing their job now costs a lot more.

This explains why wages do not fall to meet rising unemployment sometimes – efficiency wages are needed in order to ensure that existing workers are productive (explained under ‘Context’).

Conclusion

Research about information asymmetry reveals that in competitive markets, price is not equal to marginal costs (explained in ‘Context’) if adverse selection exists, as “good behavior is driven by earning a surplus over what one could get elsewhere”, according to Joseph Stiglitz.

As one of the revolutionary findings in economics, this redefines incentives, information availability, and equilibrium, in any job market.

Key Terms:
​
1. Credit score: A number that represents the creditworthiness of a person, e.g. their loan repayment record.

2. Information asymmetry: where one party has more information than another in a market.

3. Adverse selection: when information asymmetry is used before a transaction to benefit a certain party, such as when a car dealer charges more for a car than it is actually worth. Moral hazard, on the other hand, is when the information asymmetry is used after a transaction, such as when a driver with insurance drives more recklessly.

4. Premiums and deductibles: An insurance premium is the amount of money an individual must pay to purchase a policy. A deductible, on the other hand, is the amount of money the individual must pay first before the insurance covers the rest, e.g. if a car crash costs $1,000, the driver might have to pay the first $200 before insurance covers the remaining $800.

5. Efficiency wages: Wages that are above the equilibrium wage rate.

Context:

1. Why do certain combinations of premiums and deductibles attract certain types of drivers?

Risky drivers are more prone to accidents; thus, they need a low deductible to ensure that the insurance will cover most of the cost of crashes. They would be willing to pay for a high premium as long as they get the low deductible.

Careful drivers are not likely to get into an accident, so they would not need low deductibles. They will choose the package with the low premium and high deductibles.

2. Why are efficiency wages needed to ensure that workers are productive?

If efficiency wages are high enough that a worker cannot find wages as good as that in another job, the employee will make sure to work hard to retain his or her job.

3. When does price equal marginal cost? Does this apply to the labor market?

Price equals marginal cost (written P=MC) determines the price at which goods are sold in a perfectly competitive market, and only in a competitive market. Rules for determining price in other types of markets, such as monopolies, are different.

A perfectly competitive market is a market structure that is defined by four rules:

a. All perfectly competitive markets have free barriers to entry and exit. This means that it does not cost any money to join the market. Take, for example, the market for corn. To get permission to grow corn costs nothing, unlike in a monopolistic market such as tap water – there are rules and tariffs that block new sellers from selling tap water.

b. There is a large number of sellers in the market.

c.  Sellers are price-takers, not price-makers. This leads on from the second rule. If someone wants to sell corn for $4 when the market price is $3, they will not sell anything. This is because consumers have a large number of alternatives – due to the large number of sellers in the market – that will sell corn for $3. In a monopoly, the firm can decide to a much larger extent what price they wish to sell the good at – consumers have no choice but to accept that price as they cannot go to another seller to buy the same product.

d. Products are indistinguishable. In the market for corn, consumers do not consider one producer’s corn superior to others as they all look, smell, and taste the same.

Now, the definition of marginal cost (MC) is the cost of producing one extra unit of a good or service. Let us take the market for corn again. Once a farmer has set up his cornfield – equipments, land and other fixed costs are paid for – he starts producing corn. Say it costs $1 to water the soil around a single corn cob and a further $2 for a worker to shuck a single corn. Then, every time a new cob is ready to be sold, it costs the farmer $3. This is what is called the marginal cost.

With this, we can look at the price determining rule, P=MC.

In the previous example, MC=3. Suppose a new supplier, Supplier 1, enters the market for corn, and wants to sell each cob for $4. Another supplier, Supplier 2, will see this and sell his cobs for $3.9, attracting all the consumers of corn. Supplier 1 will lower his cost to $3.8, and then Supplier 2 will bid it down to $3.7. The cost will keep decreasing until a supplier hits $3. The price will not go lower than that, as it means that they would be making a loss for each cob that is sold. For example, if a supplier were to set his price at $2.9, and producing one corn cob costs $3, then the supplier would be losing $0.1 for every corn cob sold.

Because the market is so large, the bidding down process will be instantaneous. Price will be as low as possible such that the producers do not make a loss. The lowest possible price is the MC. Thus, P=MC in a perfectly competitive market.

Now, consider the labor market. The suppliers of labors are potential employees, and the consumers of labor are employers. In theory, the labor market is perfectly competitive, as it fulfills all four expectations for a perfectly competitive market:

a. Free barriers to entry/exit: it costs nothing to participate in the labor force, i.e. it costs nothing to start looking for a job and stop looking for a job.

b. Large number of suppliers: lots of people participate in the labor force, either at a job or actively looking for a job.

c. Suppliers are price takers: suppliers of labor, i.e. employees, accept the market wage rate, because if they do not, another supplier will come along and work for a lower wage.

d. Indistinguishable products: because of asymmetric information, an employer might struggle to tell which candidate is better, because only the candidate knows things such as their credit score and inherent ability.

In theory, then, the P=MC rule applies in the job market. The price of labor, i.e. the wage rate, is equal to the marginal cost of labor. In a news firm, for example, the price, or wage rate, of a journalist might equal the cost of an extra article written.
​
This article argues against mainstream theory. Signaling, for example, makes the workers distinguishable. A university degree or a high credit score would mean that the candidate is better than another candidate who has no university degree and a low credit score. Thus, the market for labor is not perfectly competitive, and P no longer equals MC. A great journalist might be paid a high efficiency wage, much more than the cost of writing an extra article, to encourage him to stay with the firm and work efficiently.

Over the next six weeks, The Economist will be writing articles about revolutionary economic theories, from the Nash equilibrium to information asymmetry. The introduction to this series can be read here. I will be following the articles and writing posts about them. The first one can be found here.

The introductory article states that too often, economists are blamed for not being able to foresee major economic events, such as the Global Financial Crisis. However, the ability to predict such events is a poor barometer of the usefulness of economics, as the point in economic theory is to explain how the world works. Many theories that were created years ago explain current events. Keynes’ fiscal multiplier, for example, explains the struggles the euro-zone faces, such as the “self-defeating pursuit of austerity”.

However, there are many problems with economic models. For example, the body of economic theory is not complete, as there are still gaping holes in the understanding of financial markets, for example. The already existing theory, as well, is not in its final form. It is constantly being revised and rewritten.

As well, over-reliance on mathematical models makes economic theory less credible. According to the article, “models should be a means, not an end”. Thus, anyone treating models as the end would be disappointed by their inability to accurately predict economic events.

Economics is very slow to accept revolutionary models that go against the grain. As a result, the evolution of economic thinking is sluggish. Mr. Akerlof’s paper on information asymmetry, called “The Market for Lemons”, was met with great resistance by several journalists who stated that if his theory were correct, “economics would be different”.

Still, none of this diminishes the importance of economic theory. While it may not be able to foresee future events accurately, theory is needed in order to explain the world around us. This series will thus elucidate the importance of economic theory, and follow how these groundbreaking theories redefined economics entirely.

The order of the articles is:

1. Information asymmetry
2. Minsky’s financial cycle
3. The Sloper-Samuelson theorem
4. The Keynesian multiplier
5. The Nash equilibrium
6. The Mundell-Fleming trilemma

Synopsis: A quick summary on Brexit and an exploration of what the UK's future might hold.

Discussion:

The UK’s decision to leave the European Union (EU) surprised both Leave and Remain supporters alike - not to mention, the rest of the world. Whatever decisions the UK’s new prime minister will take, Britain will still be stepping into the unknown. With an unclear future ahead, everyone seems to be asking the question nobody has the answer to: what next?

A summary of Remain and Leave arguments

On trade and the economy:

1. Leave supporter Ian Duncan Smith promises £350 million per week contributed towards the EU budget would be redirected to the National Health Service should the UK leave. In fact, most of this £350 million is returned by the EU through various payments, and the Leave party has since reneged on its promise.
2. Leave cites an abundance of red tape due to the EU’s many product regulations as a barrier to trade.
3. Remain states that uncertainty and a reduction of trade if the UK leaves would result in decreased growth, if not a recession, a statement met with general agreement among economists.

On the free movement of labor:

1. Leave claims that EU members, especially the Poles, are taking away British jobs. Remain argues that it is free movement of labor that guarantees healthy competition and that only the more skilled workers get UK jobs.
2. Leave argues that without forced cultural assimilation, Britain will face more and more pockets of impenetrable cultural bubbles.

Voter demographics

The Financial Times highlights five key demographics.

1. Areas where more people had a degree voted to remain.
   
2. Areas with a small number of people in “professional occupations” voted to leave.
3. Areas where more people had passports voted to remain.
4. Lower income areas voted to leave.
5. Older people voted to leave.

Immediate reactions
After the shocking results of the EU referendum nearly a fortnight ago, it is no surprise that both UK and global financial markets reflected the sentiment of uncertainty. Most notably, the pound briefly dipped to a thirty-year low at $1.32 on June 27th, far below its pre-referendum high at $1.50. This drop is somewhat a relief as it dissuades imports and encourages exports in the UK. Equity markets, on the other hand, have bounced back above their pre-referendum levels. According to The Economist, this is due to the “oil and mining giants… [having] little to do with the British economy.”

Meanwhile, the Bank of England governor, Mark Carney, has tried to douse the sudden upsurge of uncertainty by announcing that the central bank will take “whatever action is needed to support growth”, most likely including some form of expansionary monetary policy. He warns that there is only so much the central bank can do. According to the Financial Times, two-year British government bond yields became negative for the first time following his statement.

Standard and Poor’s (S&P) downgraded Britain’s AAA rating to AA, and Fitch Ratings downgraded them from AA+ to AA. Moody’s has lowered its outlook for the UK from stable to negative.
S&P also lowered the EU’s credit rating from AA+ to AA.

What next?

Starting with the practical aspects, the BBC outlines the process for the UK to leave the EU.

Synopsis: The history, uses and problems with GDP.

Click here to read the original article.

Discussion: This article discusses the origins and the appeals of Gross Domestic Product (GDP), as well as its major flaws.

Introduction

GDP is the sum of total final production minus imports. Both the final products as well as the input materials are adjusted for inflation to give real GDP. With such large markets, it is extremely tricky to calculate GDP and the figures need to be revised often.

Apart from the difficulties in calculating GDP, however, there are many other problems with this measure.

Problems with GDP

1. GDP does not take innovation into account. While a light bulb costs much more than a candlestick, it will also provide more light. The increase in quality of production, however, is not accounted for in GDP.
2. Free products are not accounted for. Most of the Internet, including Google, Facebook and YouTube, is accessible to everyone at no cost, but is not counted as the GDP calculation requires the final market value.
3. GDP does not take into account negative externalities such as pollution or congestion. For example, building an incinerator adds to GDP, but the pollution it produces is of no consequence.

World War II and GDP

The modern definition of GDP includes government spending. During World War II, the American government requested Russian-born economist Simon Kuznets to calculate national income. While he wanted to make government spending a cost for the private sector, economist John Maynard Keynes noted that during wartime, if government spending was a cost to the private sector, GDP would shrink even as the economy grew. (More about this is explained in ‘Context’.)

It is important to note the modern definition of GDP was established during wartime, when the main function of GDP was to manage supply. Today’s problems with GDP, such as its dismissal of pollution as a cost, was pedantic compared to the daunting task of survival of an economy during a war and after the Great Depression.

GDP was therefore devised to calculate manufacturing, which, during the fifties, took up a third of Britain’s GDP. Now, manufacturing takes only a tenth of the economy. Nowadays, there is increasing backlash against GDP. Former French president Nicolas Sarkozy and economist Joseph Stiglitz called for an end to “GDP fetishism”.

GDP and free goods

The problem with measuring manufacturing for GDP is that the measurement results in a bias. GDP, by definition, only measures output that is bought and sold, because the value of the output can be easily determined by looking at its market value. The problem with this is that “home production”, such as stay-at-home mothers and caring for the elderly, are not considered when calculating GDP, even when these services have a large intrinsic value.

Still, government services, most of which are free, are included in GDP, proving that there is no steadfast rule when it comes to measuring free goods in an economy.

To try and place a value on free services, the Bureau of Economic Analysis in the United States equates the market value of cooking in a restaurant to the value of cooking at home. Erik Brynjolfsson and Joo Hee Oh of MIT follow this approach when it comes to free online services to calculate the welfare gain.

Other sections of GDP measurement are done very indirectly. For example, houses which are rented have a clear market value and can therefore be included in GDP calculation, but the value of self-occupied houses has to be imputed.

As well, there is little consensus on how to treat products that used to be paid for but are now free, such as listening to music online, or reading newspapers. Just because newspapers are not printed anymore, but are read online, does that mean that GDP has decreased as the actual act of printing a newspaper is dwindling?

Adjusting for inflation

Perhaps the biggest problem with GDP as a measure of welfare is that adjusting for inflation has its own complications. In terms of simply calculating it, it is very hard to calculate changes in quality. While a newer computer might cost more than an older one, it can do more. Simply looking at the price therefore overstates inflation by about 0.6%, suggests Michael Boskin of Stanford University. People correct this error by using hedonic estimation (explained in ‘Key Terms’). However, as hedonic estimation takes a long time, it is not used all that frequently. And when a product develops so much that it can practically be considered a completely different product, such as when mobile phones developed from large, bulky ones to Smartphones, hedonic estimation does little to help.

Measuring quality for inflation becomes even harder when considering services instead of goods. A restaurant’s value depends on more than just the cost of producing the meal: it depends on the ambiance, crowd and many other factors that do not have a market value.

Completely new products are especially hard to incorporate into the consumer price index (CPI). In microeconomic theory, the value of the product to a consumer is the consumer surplus (explained in ‘Context’). But calculating consumer surplus requires knowledge of the reservation price (explained in ‘Key Terms’). As this is extremely hard to calculate, new products usually go into the CPI without the adjustment for consumer surplus.

Is there something better than GDP?

Using GDP as a measure of national economic performance can thus be questionable. If GDP calculation methods vary from month to month with, for example, the inclusion of new goods, then comparing GDP from year to year is even less reliable.

The Economist does not suggest alternatives for GDP. If a new GDP measure would be created, it must account for the change in quality of goods as well as the incorporation of new goods. Some economies use alternative measures. For example, Bhutan uses Gross National Happiness (GNH) as a measure of economic performance in order to preserve its Buddhist values. The Genuine Progress Indicator (GPI) is often suggested as it tries to measure quality of life. GPI accounts for pollution, unpaid work and family work. Unfortunately, it does not measure human capital, nor does it correct the problem that the CPI struggles to incorporate new products.

Right now, there is no feasible alternative to GDP. For the moment, economies have to stick with GDP as a measure of economic growth, problems and all.

Key Terms:

1. Inflation: the sustained increase in the average price level of an economy.
2. Hedonic estimation: a method of estimating the intrinsic value of a certain product, using questions to estimate developments of its characteristics. For example, “how much would you pay for a different-colored shoe than last year’s shoe?”
3. Consumer price index (CPI): a basket of consumer goods and services that represents usual purchases by households. Change in the CPI represents change in the average price level of an economy, i.e. inflation.
4. Reservation price: the maximum price a consumer will pay for a product, or the minimum price a producer will sell the product for.

Context:

1. What is GDP and how is it calculated?GDP measures the market value of all the final goods and services in an economy, i.e. the price at which they are sold. GDP is comprised of four parts:

GDP = C + I + G + (X-M)

‘C’ stands for private consumption.

‘I’ stands for investment.

‘G’ stands for government spending minus government transfers (e.g. financial aid). Government transfers do not count, as nothing new is being created in the economy; money is just shifting hands.

(X-M) stands for net exports, where X is exports and M is imports.

2. What is real GDP and how is it calculated?

Real GDP is GDP adjusted for inflation. It is calculated by:

Real GDP = Nominal GDP – Inflation

3. Why did Kuznets consider government spending to be a cost to the private sector? Why would wartime imply higher government spending?

The theory that government spending is a cost to the private sector is called the “crowding-out effect”. The crowding-out effect is two things:
​
a. When the government significantly increases its borrowing in order to spend in the economy, demand for money increases, as does the price of money, i.e. the interest rate. This is illustrated in the diagram below. When this happens, it costs more for the private sector to invest in capital, as borrowing money costs more. Thus, the private sector cannot invest and produce as much, and they are crowded out by the government.

In the diagram above, Ms stands for money supplied and Md stands for money demanded. Ms is a straight line because the central bank can only produce a fixed amount of money at any point in time. Before the government borrowed money from the central bank, Md was at Md1, resulting in the interest rate being at i1. Once the government borrows more money from the central bank, Md increases to Md2, resulting in the interest rate shifting to i2.

Why doesn’t the central bank increase money supplied in order to decrease interest rates? A central bank can increase money supplied a limited number of times before inflation becomes uncontrollable.

b. When the government spends on roads and other such projects, it takes away the opportunity to build those projects from the private sector, thus crowding them out.

4. Consumer surplus

​Consumer surplus is the difference between the reservation price and the price paid for the good, i.e. the amount of benefit consumers get from buying the good. In the diagram below, consumer surplus for someone willing to spend $k is the difference between the reservation price, $k, and the market price, P*, illustrated by the red rectangle. Therefore, total consumer surplus is the area below the demand curve but above the market price, i.e. the green triangle.

Synopsis: How economics has shaped the evolution of politics.

Click here to read the original article. 

Discussion:

This article discusses the history of prevalent economic thought and its effects on politics. Throughout history, politicians have adopted only those economic policies that allow them to stay in power. In this way, a country’s economic issues can be viewed through the “prism of the political structure.”

19th Century:

Political scenario: Wealthy creditors with no real interest in the government were concerned with “maintaining the real value of their money”, as can be seen by the use of the gold standard (explained in Key Terms) and their one allowance of government intervention, through the use of the central bank, to ensure the success of the financial system.

Economic climate: Classical theory dominated economics. Classical theory concerned itself with the self-correcting nature of an economy (explained in Context), and thus reasoned that the government had little place in the free market.

1914 – 1929:

Political scenario: World War I (1914-1918) resulted in the sudden need for ammunition and manpower. The brief respite during the Roaring Twenties was overshadowed by the Great Depression, which began in 1929.

Economic climate: Government intervention, high inflation and debt during World War I destroyed classical theory. Any attempts to rebuild classical theory during the twenties were outweighed by the Great Depression: there was great reluctance by mass democracies to put the strain of the gold standard on the already suffering working class.
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1930s and 40s:

Political scenario: In the aftermath of the Great Depression, economies did not return to full employment. This was a great cause for concern among politicians, and the worry was carried into World War II.

Economic climate: Popular economist J.M. Keynes focused on government spending to boost demand, and thus, lower unemployment, through the use of fiscal policy (explained under Key Terms). This theory gained traction during World War II, where government intervention increased greatly and unemployment was wrestled down to a manageable level. Welfare states (explained in Key Terms) seemed like a small concession compared to the threat of communism (explained in Context).

1960s and 70s:

Political scenario: The rapid rise of inflation led politicians to believe that the government focus on unemployment was wrong. Middle-class voters, angry at high taxes, were quick to support an economic reform. Reagan and Thatcher adopted new policies quickly, with Europe following later, having been shaken by the scare of Eurosclerosis (explained under Key Terms).

Economic climate: The previously successful Phillips curve (explained under Context) was falling apart. Milton Friedman and his followers thus argued that governments should shift their focus away from controlling unemployment and towards managing inflation through controlling the money supply. Supply-side economics (explained in Key Terms) became popular quickly, as did monetary policy, which led to an active central bank.

1980s and 90s:

Political scenario: The fall of inflation resulted in a reputation boost for central bankers, despite the fact that inflation may have decreased due to China’s entry into the global economy (explained under Context). Reagan's and Thatcher’s reforms were well underway, which led to a rise in the debt-to-GDP ratio.

Economic climate: Reagan's and Thatcher’s reforms meant the recognition of the financial sector as a key player in any economy.

1987:

Political scenario: The riskiness of the system that ensued from the increasing debt-to-GDP ratio encourage central banks to cut interest rates during any period of uncertainty, as was seen on Black Monday.

Economic climate: Economic actors interpreted central banks’ nervous response to a wobbly economy as their “[underwriting of] asset prices”. Buying assets with borrowed money seemed to be the quick and easy way to make fortunes.

1990s:

Political scenario: The end of fixed exchange rates, and along with it, capital controls (explained in Context) made global finance very powerful, as money could easily enter and exit economies and sectors. At the same time, the wealth of the financial sector allowed its key players to fund and win favour of the political elite.

Economic climate: The loss of control over capital flows turned government focus towards dissuading capital flight, while the wealth of the financial sector meant that politics supported economic policy that favoured financial markets.

1980s to 2007:

Political scenario: The threat of communism fell along with the Soviet Union. Center-right politicians who had acquiesced to government regulation during the Great Depression gained political power, while center-left politicians supported more right-wing policies. At the same time, trade-union power fell, partially due to globalization, and partially due to the “relative decline in manufacturing”. Organizing protests became harder when many of its remaining members were dispersed across different jobs in different economies.

Economic climate: Right-wing economic policies such as the freedom for free markets to function with minimal intervention were established. The decline in trade-union power and blue-collar worker votes resulted in the larger economic actors having a greater say in shaping economic policy. It is no surprise that today we see the central banks and other large institutions as the most powerful actors in our economies.

During this time, mainstream economic theory became more micro-based as well as mathematical, despite the rise of behavioural economics.

2008 on:

The aftermath of the Great Financial Crisis has taught us that debt and the financial sector should be more central to macroeconomics and macroeconomic policy. Popular policy focus now is on attacking and trying to prevent the effects of globalization, such as the movement of jobs away from developed economies to countries that provide cheap labor. The problem is that globalization has already happened, and its effects are already underway. What will determine the success of globalization is how the Chinese economy will deal with its financial system and whether the Federal Reserve will withdraw its monetary stimulus effectively.

Just as politicians have always reacted to the economic climate, we may find that our future economic state may be a shift away from globalization and towards nationalism.

​Key terms:

1. Gold standard: A system in which the value of currency is fixed in terms of gold, and could be traded in for gold.

2. Fiscal policy: the process of government spending to stimulate demand (fiscal expansion) or government saving to decrease debt (austerity).

3. Welfare state: Where the state plays a pivotal role in protecting and promoting the economy and its citizens.

4. Eurosclerosis: A term coined in the 70s by Herbert Giersch to describe the state of stagnation in Europe that may have resulted from over-regulation by the government.

5. Supply-side economics: also known as “trickle-down economics” and “Reaganomics” – the latter due to Reagan’s active promotion of supply-side economics – argues that production is the most important determinant of economic growth. For this reason, investors and businessmen should face less barriers to production and investment through lower taxes.

Context:

​1. Classical theory: The self-correcting nature of markets was first alluded to by the father of Classical theory, Adam Smith. The idea is that prices adjust themselves and equilibrium is regained in the economy.

Suppose this is the market for a good X. Initially, the supply of X is denoted by S, and the demand denoted by D1. The resulting price P1 and quantity Q1 is shown by the intersection of D1 and S at equilibrium point A.

Now, demand for X increases to D2. At the original price P1, more of X is demanded, resulting in quantity demanded Q3. This is point B. Seeing the increase in demand, suppliers increase the price of X to increase their profits. Now, fewer people can afford the good, but enough people still want more of the good that suppliers feel like they can increase the price. Still fewer people can afford the good, but suppliers can still increase the price. This process, indicated by the red arrows, continues until the economy adjusts to a new equilibrium C, where all the demand is met by supply. Classical economists refer to this as the work of the invisible hand, guiding the economy from one equilibrium to another.

While the theory of the invisible hand is often attributed to Adam Smith, Smith used it as a term to
discuss international trade, and did not mean it to be the process described above. Still, Smith, along with other classical economists like David Ricardo and John Stuart Mill, believed the economy to be self-correcting.

2. Why would the presence of a welfare state result be a small price to pay in the face of the threat of communism? During the Great Depression, it is the democratic countries that suffered, while communist countries seemed to be fairing better. To ensure that communism does not dominate democratic countries, the government had to ameliorate the economic situation by being heavily involved in the economy.

3. To learn more about the Phillips curve and its failure in the U.S. economy, read my article here.

4. Why did China’s entry into the global economy decrease inflation? Not only were cheap goods and services provided by China, but so was cheap labor. For this reason, costs of goods, services and labor fell around the world, resulting in decreased inflation.

5. Why would the end of the fixed exchange rate system lead to the end of capital controls? Under a fixed exchange rate regime, high levels of reserves are needed to keep the exchange rate from fluctuating. For example, Hong Kong needs high levels of reserves for its currency to remain pegged to the U.S. dollar. If, for some reason, Hong Kong becomes less appealing to investors, the demand for the Hong Kong dollar will decrease, and the reserves will deplete. Capital controls are needed to make sure sudden capital influx or capital flight does not deplete the reserves, and thus, the exchange rate.

Synopsis: How should China deal with its economic problems?

This post combines two articles by The Economist. Click here and here to read them.

Discussion:

These two articles discuss the current problems China is facing, potential solutions and its consequences.

China has been showing cracks in its economic structure for the past six months, and with the stock markets crashing on January 4 2016 and an increased debt-to-GDP ratio of about 300%, the problems with the Chinese economy are now being closely watched by everyone. According to the article “Rocks and Hard Places” (RHP), however, it is the foreign exchange market that bears watching for those wishing to know about the state of China’s economy.

China’s pegged exchange rate is much higher than its exchange rate would be in a floating system, and many believe that devaluing the yuan and bridging the gap between the real exchange rate and the current one would ameliorate the economy.

Asian countries during the Asian financial crisis faced a similar predicament to the one China is facing – According to “Fight or Flight” (FF), investor outlook turned from bullish to bearish, resulting in a great outflow of capital. Thus, reserves dwindled and the governments could no longer maintain a pegged currency. The key difference between those Asian countries and China is that China has, and has had for a while, tight capital controls. According to FF, during China’s great boom in the 2000s, foreign direct investment (FDI) was permitted while hot money was tightly controlled.

These preventive measures did not stop the depletion of China’s reserves – now down to $700bn, “thanks to capital flight and sinking asset values” (FF). An increase in China’s outward FDI paired with a decrease in inward investment resulted in the lowest net flow of inward investment since 2000.
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While China wishes to impose tighter capital controls to prevent a dwindling of reserves and tightening of domestic credit (explained in ‘context’), there is “no painless way to do so” (FF).
In terms of exchange rates, the Chinese can either keep the exchange rate steady or devalue the exchange rate. Keeping the exchange rate steady is a feasible option as China has $3.3tn in reserves. Here are the consequences for either action:

In terms of strengthening capital controls to reduce leakages, the Chinese government is already cracking down on banks in Macau and Hong Kong to keep them from helping leak money from China. If leakages increased, the government could decrease the cap on foreign transfers. This, however, would deter foreign investors, which would undermine growth.

However, according to RHP, these trade-offs to rebalance the Chinese economy are only short-run. Strengthening capital controls by locking down the capital account in the long-run could be vastly beneficial: free from the pressures of the global markets (explained in ‘context’), the government could “clean up bad debts and push through structural reforms needed for long-run growth”. In fact, locking down the capital account would result in unfreezing those accounts during a time when the Fed is not raising interest rates, which would deter investors from moving their money to the U.S.

Chances are, however, that if capital accounts were locked, the government would do little to implement structural reforms but would instead use it as an excuse to “rollover bad debts and delay reform” (RHP), i.e. following the Japanese path (explained in ‘context’).

In fact, despite the fact that locked capital accounts would allow for more flexibility in China’s monetary policy, the government “would find itself cornered” (RHP): once interest rates and reserve ratios were near zero, QE would lead to a further imbalance in the economy. The government would have to respond with massive fiscal stimulus or depreciation to allow for further monetary policy, all of which are irreversible actions for a few generations to come.

Instead, China may have a slightly less bitter pill to swallow. Given its capacity for lots of fiscal stimulus (government debt is low; thus, the government has room to borrow and then spend), it could force banks to “recognize bad loans, close insolvent businesses, and use that capacity to ease the pain on creditors and shore up banks” (RHP). This, still, may result in a sharp slowdown of growth, and perhaps even a recession. However, these are pills that other countries have followed and survived through. The question is whether the Chinese government was built to cope with such drastic measures (explained in ‘context’).

At the current time China is not facing an imminent crisis. It has “ample reserves, capital controls, trade surplus and a determinedly interventionist state” (FF). Increased purchase of foreign securities may, in fact, decrease the effect of depreciation on debt (explained in ‘context’). However, it remains that should China ever come to face such a crisis, its results would be disastrous.

Key Terms:

1. Capital account: a sum of private and public investment flowing in and out of a country.

2. Reserve ratios: a ratio of all deposits into a bank that must be held by the central bank. China’s reserve ratio is currently at 7.5%.

3. Bullish vs. bearish: Bullish means upward trending while bearish means downward trending.
4. Hot money: money that can be liquidated immediately. This is unlike FDI, which can be liquidated after a set amount of time (usually a few years).

5. Hard currency is the name for dollars, euro, yen, i.e. the more important currencies.

Context:

​1. What is the relationship between reserves and a pegged (or fixed) exchange rate? An exchange rate is pegged by the central bank’s buying or selling the domestic currency.

Let the supply and demand for yuan be denoted by S and D respectively. This results in a quantity of yuan in the market Q and exchange rate E. A decrease in the demand of yuan from D to D’ would lower the exchange rate to E’, where the quantity of yuan in the market is Q’. For the PBOC to increase the exchange rate back to E, where it was earlier, it has to decrease the supply of yuan. To do so, it has to sell other currency that the PBOC keeps in its reserves in exchange for the yuan, leaving less yuan in the market at S’. The exchange rate is once again E.

Thus, if China wishes to maintain its exchange rate, it must keep selling off its reserves, i.e. a depletion of reserves.

2. Why is there capital flight in China? This is because of investors’ fear that China is slowing down and their subsequent wish to withdraw investments from China and invest elsewhere.

3. Why do tighter capital controls lead to a “tightening of credit”? The amount of bank deposits will decrease, so banks cannot make as many loans; thus, credit conditions tighten.

4. If a decrease in exchange rates would not increase exports, why did China do so well during its more prosperous periods? When China faced good growth, it wasn’t the devaluation of the yuan that made it so successful (the yuan held steady). At that stage, there was enough capacity for exports to grow, with enough demand. After the GFC, China could not export as much because of decreased demand. They turned to investment, which is now faltering.

5. Why does purchase of foreign securities “hedge firms with foreign-currency debts against depreciation”? If firms have foreign currency debts and the currency depreciates, the debts increases. If firms have foreign assets, then it would reduce the impact of the debt.

6. Why would locking down the capital account free China from the “pressure imposed by global markets”? Without the capital lockdown, at sight of a higher interest rate in the U.S., investors would take their money from China and invest in the U.S., but with the capital lockdown, whatever the global market decisions are, a certain amount of investment stays in China.

7. How would China follow the Japanese path should they fail to implement structural reforms? Before Japan’s deflationary spiral, Japanese banks had bad debt and didn’t have them written off, leading to deflation.
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8. Why would China not be built to deal with the drastic measures proposed by The Economist? The problem is that China is communist: they’ll give people jobs, security, etc. as long as they don’t question the government. A loss of jobs thus leads to a criticism of the Chinese government, a risk China may not be willing to face due to fear of political reform.

Synopsis: A look at Japan’s economy and a discussion about how best to improve it

​Click here to read the original article.

Discussion:

This article discusses the ways in which Japan could improve its economic situation, chiefly through fiscal and monetary policy.

Krugman highlights aspects of the Japanese economy that are encouraging: “Output per working-age adult has grown faster than in the United States since around 2000, and at this point the 25-year growth rates look similar”, and “… Japan is closer to potential output than we are”. Nevertheless, Japan is struggling to escape from deflation. Why has Abenomics not worked as well as people hoped?
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The main ideas in his article are best portrayed through a flow chart:

1. According to Krugman, the two biggest issues are Japan’s over-reliance on fiscal expansion (which leads to a high debt-to-GDP ratio) and its chronic deflation. Fiscal consolidation may be called for to balance the debt-to-GDP ratio and to reduce Japan’s reliance on fiscal expansion, but Japan has no way of offsetting the effects of fiscal consolidation through QE; after all, the interest rates are already as low as can be.

2. It follows that one of the only solutions is to raise inflation such that real interest rates fall. This way, QE can happen alongside fiscal retrenchment. Krugman adds as a side note that raising inflation would also reduce the value of debt.

Krugman describes how Japan may be facing a negative Wicksellian rate (explained under ‘key terms’) as a permanent condition. He points out that even if the Bank of Japan were to promise greater QE, it is ultimately consumer expectations of future inflation that will determine inflation (more about this will be explained under ‘context’).

Krugman’s solution is to combine monetary policy with a burst in fiscal stimulus. The fiscal stimulus will raise the inflation, and the increase in inflation leaves room for more QE. Only when more QE is enacted can fiscal consolidation occur, which would cut down the debt-to-GDP ratio.
The question, then, is how high should inflation be? While the answer does not have a certain numerical value currently (i.e. it has to be high enough to allow QE to occur), it is clear that Japan’s 2% inflation is not enough.

Krugman emphasizes the problem of fiscal consolidation alone: it may cause an economy slump, in which case Abenomics may be beyond redemption. He says that the only measure left is for Abe to engage in aggressive austerity and QE together to increase inflation.
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Key terms:

1. Wicksellian rate (a.k.a. natural rate of interest): Kurt Wicksell was a leading Swedish economist who was best known for his idea of the natural rate of interest. The theory suggests that there is a long-run natural rate of interest, and if the current rate of interest is higher than said natural rate, there will be deflation, and if the current rate is lower than the natural rate, there will be inflation. When the current interest rate equals the natural rate of interest, there is equilibrium in the commodity market and price levels are stable. To read more about this (and how it pertains to modern-day economics), click here.

Context:

1. To understand this article, it is important to understand what Abenomics is. Abenomics is a portmanteau of the words economics and Abe – Shinzo Abe being the Prime Minister of Japan. His plan is to fire three ‘arrows’ to stimulate economic recovery. The first arrow is expansionary monetary policy in the form of QE, the second is fiscal stimulus, and the third is structural reforms, mainly through strengthening the Japanese army.

While these three arrows seem like feasible ways to revive the economy, Japan is still faced with lacklustre inflation, and many attribute this to the fact that Abe is not aggressive and hawkish in any of his three tactics, or arrows. Paul Krugman discusses what Abenomics’ next steps are.

2. How does future inflation determine inflation today? Consider this situation: a consumer in an economy wants to buy a new phone. She believes that inflation will increase in the future, i.e. the price of the phone will be higher in the future than it is currently. For this reason, she buys the phone today. Many consumers in the economy also believe that future prices will be greater than current prices, and buy the goods and services today instead of waiting for the price to increase. The aggregate demand in an economy suddenly increases, and producers increase the price of the goods and services in an economy as a response. This increase in prices of goods and services is, in fact, inflation. Deflation works in a similar way. In this way, inflation (or the lack thereof) is a self-fulfilling prophecy.
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3. In my opinion, there are a few problems with Krugman’s proposed solution. The first is that despite years of fiscal expansion by the Bank of Japan (BoJ), deflation still persists. Even aggressive fiscal expansion, which is what Krugman suggests, has its problems. Firstly, there is no telling when the aggressive expansion will result in a sufficient level of inflation; it could take much longer than the BoJ can afford, and it will exacerbate the debt-to-GDP ratio greatly. Secondly, even when the BoJ deems the inflation level in Japan as healthy enough to allow fiscal retrenchment to happen, they have to be wary of consumer expectations. Either the BoJ will have to execute fiscal consolidation so slowly that it now faces high inflation and a high debt-to-GDP ratio, or it will have to carry out fiscal consolidation quickly enough to avoid inflation from becoming a worry. The problem with the latter is that consumer, investor and producer confidence in the market is shaky enough as it is; fiscal consolidation may scare them enough to revert the economy back into the original state of deflation where people are hesitant about consumption, production and investment.

Synopsis: What China’s recent devaluation has to say about the state of the Chinese economy.

Click here to read the original article.

Discussion:

This article discusses the recent devaluation of the Yuan by the People’s Bank of China (PBOC). The reason behind this could be twofold: either to move the Yuan towards the market rate, thus moving the economy towards reform, or to make exports more competitive, thus helping China’s poor growth recover. Both are equally plausible: China is facing a more pressing need to shift its economy from an export-led one to a domestic demand one. Moving the Yuan towards the market rate helps shift the economy. However, as China has been facing increasingly disappointing export rates, the devaluation may help pick it up. Future moves by the PBOC will tell which one China is more concerned with. Such moves may include how China reacts to a market rate appreciation or how it reacts to future problems that could be solved by currency manipulation.

This move causes major political repercussions. The Fed’s interest rate hike is likely to happen in September, but this devaluation may postpone this increase. Therefore, the subject is bound to occupy many presidential debates. Furthermore, China’s leadership has been hoping to become an official reserve currency, which is less likely at the face of the devaluation.

Context:

1. It is important to understand, firstly, how devaluation could help the export sector of the economy. A currency that has been recently devalued causes the prices of all domestic goods and services to be relatively cheaper in foreign countries, thus encouraging foreign countries to purchase more domestic goods and services, i.e. the domestic economy is now exporting more.

2. In the second paragraph, the article cites “many other efforts to boost the economy”. These efforts are mainly:
      1. Cutting interest rates 5 times in the last 12 months. The interest rate is currently 4.6%. Note that this is expansionary monetary policy.

      2. Cutting the bank reserve ratios. Reserve ratios are a legally mandated percentage of all deposits that must be held with the Central Bank. In other words, if I were to deposit some money into a local bank, a certain percentage of that deposit must be held with the Central Bank, while the rest can be given out as loans by the local bank. In China, this percentage is 18%. Reducing the reserve ratio means that more money can be lent out by the local bank, thus encouraging spending and boosting up GDP and growth.

3. This article also mentions China’s wish to be an “official reserve currency”. All countries hold reserve currencies in the form of GBP, USD, Yen, Euro and SDRs. SDRs, Special Drawing Rights, are a concept created by the IMF, and act as a currency that can be used in foreign markets. The IMF explains it here. China wishes to be an official reserve currency.


4. The Treasury Department, U.S. Congress and some American businesses all claim that the Yuan is artificially low – that it should be higher. It is important to understand that this has no economic backing, but is used as a political tool to gain support. According to the IMF and international markets, the Yuan is moving closer to the market rate by being devalued.

5. According to this article, China’s cabinet has been “[offering] tax breaks and other incentives to help the trade sector.” These tax breaks and other incentives fall under the umbrella of fiscal policy.