Contemporary Macroeconomics: New Global Disorder 9811995419, 9789811995415

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Springer Texts in Business and Economics

Vasilii Erokhin Gao Tianming Jean Vasile Andrei

Contemporary Macroeconomics New Global Disorder

Springer Texts in Business and Economics

Springer Texts in Business and Economics (STBE) delivers high-quality instructional content for undergraduates and graduates in all areas of Business/Management Science and Economics. The series is comprised of self-contained books with a broad and comprehensive coverage that are s­ uitable for class as well as for individual self-study. All texts are authored by established experts in their fields and offer a solid methodological background, often accompanied by problems and exercises.

Vasilii Erokhin · Gao Tianming · Jean Vasile Andrei

Contemporary Macroeconomics New Global Disorder

Vasilii Erokhin   School of Economics and Management Harbin Engineering University Harbin, Heilongjiang, China

Gao Tianming   School of Economics and Management Harbin Engineering University Harbin, Heilongjiang, China

Jean Vasile Andrei   Faculty of Economic Sciences Petroleum and Gas University of Ploieşti Ploiesti, Prahova, Romania National Institute for Economic Research “Costin C. Kiriţescu” Romanian Academy Bucharest, Romania

ISSN  2192-4333 ISSN  2192-4341  (electronic) Springer Texts in Business and Economics ISBN 978-981-19-9541-5 ISBN 978-981-19-9542-2  (eBook) https://doi.org/10.1007/978-981-19-9542-2 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Singapore Pte Ltd. The registered company address is: 152 Beach Road, #21-01/04 Gateway East, Singapore 189721, Singapore

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Foreword Regional and global markets, as well as international value chains, are becoming increasingly unstable due to unbalancing influences from both inside and outside. We live in a kind of new normal economic and geopolitical reality when the global economic slowdown entails an increase in volatility in all commodity and money markets, and governments are trying to compensate for the decline in policy performance by meddling in the markets and strengthening the administrative regulations in all spheres of life. As a rule, both conventional education and academic science fail to keep up with the rapid changes in the economic and development agenda. Studies that attempt to identify current trends in economic development in real time and interpret them from the point of view of the fundamental provisions of economic science are extremely rare and far more valuable. In their book entitled Contemporary Macroeconomics: New Global Disorder, Dr. Erokhin, Prof. Gao, and Prof. Andrei strive to bridge the gap between the conventional knowledge on macroeconomics and the real-life situations we are witnessing in economic, financial, political, and cultural relations between people and countries. The book provides the most comprehensive set of fundamental and emerging concepts in macroeconomics, including market equilibrium, economic development and growth, international trade, and globalization. It encourages learning macroeconomics by applying theories in real life to explain contemporary imbalances in markets and outline economic and social trends in the new normal economic reality. One of the things I definitely like about this book is that the authors enhance the relevance of the concepts by giving practical examples and dividing material into meaningful divisions (cases and boxes, questions and quizzes, definitions and highlights). Such an architecture makes the book easy to use in both learning and teaching. I highly recommend this book to undergraduate students of economic faculties and postgraduate business trainees, as well as for general audience interested in grasping macroeconomics. Elias G. Carayannis

Professor of Information Systems and Technology Management Co-founder and co-director of the Global and Entrepreneurial Finance Research Institute Director of research on Science, Technology, Innovation and Entrepreneurship at the European Union Research Center at the George Washington University School of Business Washington, D.C., USA

Preface The global economy is now under extremely severe pressure from a great variety of geopolitical, economic, social, environmental, and public health challenges. Over the past few years, the COVID-19 pandemic has been disrupting global production and supply chains and has been aggravating global economic development controversies. The recurrent problems of poverty and income inequality between and within countries, food insecurity and hunger, and unemployment and social disorders have resulted in the exacerbation of economic, trade, political, and even military tensions in many parts of the world. The flaring Russia-West rivalry over the reformatting of the “global influence” system and the reshaping of the markets, the ongoing China-USA trade and economic tensions, anti-lockdown riots and social unrest across Europe and North America—all these problems have particularly flared up recently. The increased volatility and instability of all kinds of previously established links between countries determine the nature of the new normal global development. The new normal reality involves the ever-deeper interlacing of all kinds of relations between people, communities, businesses, and markets. International exchange of goods and services has boomed over the past decades. ­ Capital crosses borders to be invested in multinational projects. People migrate b ­ etween countries in search of better jobs and living conditions. Technologies are exchanged between countries and transnational corporations. The use of ­versatile financial tools and mechanisms accelerates the redistribution of wealth from developing to developed countries and back. Despite their dissimilarity, individual national communities or social groups are forced to unite in order to resist common threats, such as pervasive globalization, internationalization of all kinds of regulations, standardization, unification, and loss of identity. The new regionalization manifested in the rise of all kinds of protectionism (trade protectionism, travel bans during the COVID-19 outbreak, cultural protectionism, political populism, etc.) is the response of countries (groups of influence within countries, political parties) and communities (economic and cultural elites and opinion leaders) to the rapid and unsustainable globalization of recent decades. The new highly volatile global environment calls for a comprehensive analysis of multidimensional contributing factors to be able to get the economy back on track for stable and sustainable development at the earliest. This book attempts to explore the theme of economic development in the era of instability by studying how the conventional concepts of macroeconomics could be adapted to the new normal and, in turn, how they should be reinterpreted under the influence of the current global processes. The publication covers a lot of ground in contemporary macroeconomics, from fundamental theories such as market structures and equilibrium to emerging concepts that reflect the most critical challenges of modern times, including economic slowdowns, the resilience of public health systems,

VII Preface



digitalization, environmental footprints, and many more. In view of the damaging consequences of the pandemic for the entire global economy, as well as the new normal market volatilities and uncertainties, the book examines how existing macroeconomic tools and policies could be adapted to the new normal to ensure sustainable post-pandemic development and growth. The book examines the determinants of real income, employment, and unemployment, the price level and inflation, and the conduct of macroeconomic policy. Readers will explore and interpret the behavior of economies and countries at both national and international levels. In particular, they will gain a greater understanding of the economic levers behind fiscal and monetary policies and how they are implemented to influence a country’s economic goals. This book introduces the building blocks of the macroeconomy and provides an overview of the performance of the economy in the long run. Topics focus on demand and supply, major macroeconomic indicators and economic growth, labor market and unemployment, inflation, international trade and trade policy, money and monetary policy, exchange rates and international capital flows, and fiscal policy and budgets. The publication addresses business cycles and how economies expand and contract in response to changes in the global markets. Through this exploration, readers will learn how to evaluate decisions on monetary and fiscal policy, aggregate supply and demand, markets, technology, global finance, and politics. They will also learn how to apply conceptual principles of macroeconomics in practical ways to everyday life. The content is organized into five parts that introduce a reader to the most comprehensive set of macroeconomic concepts and their real-life implications. Part I provides a thorough introduction to the foundations of macroeconomics and confronts a reader with various types of market structures and indicators that measure the macroeconomic performances of certain economic entities. Part II delves into the concept of economic equilibrium and contemporary manifestations of disequilibrium in markets, such as economic slowdowns, unemployment, and inflation. Part III looks at various forms of market failures, including disruptions of supply chains, rises in monopoly power, monetary and fiscal responses to the COVID-19 crisis, and emerging social problems. The new normal features of economic development and growth are further detailed in Part IV, which addresses the pandemic-related challenges and the longer-term perspectives of sustainable economic and social development. Part V offers insights into how globalization has impacted international trade and the competitiveness of various countries in the market. The authors discuss the measures that countries have taken and can take in the future to adapt to the exigencies of the new normal impacts on the global economy. The main text is interspersed with real-life illustrations and cases that demonstrate the practical implications of the concepts under study. This makes the reading relevant and active. Every chapter starts with learning objectives and ends with a series of questions and quizzes that enable easier reinforcement of the course content. This book is written mainly for students, but it would be much

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Preface

more useful to the broader public audience, including postgraduates, researchers, and business people who will be able to learn more about the peculiarities of the new normal development pathway. Dr. Vasilii Erokhin

Harbin, China Prof. Gao Tianming

Harbin, China Prof. Jean Vasile Andrei

Ploiesti, Romania

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Acknowledgments The study is supported by the Grant of Central Universities of the Ministry of Education of the People’s Republic of China (project no. 3072022WK0917). In addition to that, the development and the advent of the book would hardly be possible without the diligent support of Harbin Engineering University, Petroleum-Gas University of Ploiesti, National Institute for Economic Research ‘Costin C. Kiritescu’, Romanian Academy, and Research Network on Resources Economics and Bioeconomy Association. We thank all of these organizations and all the people involved for providing us with the necessary facilities and support, emphasizing that none of the grants or organizations above is responsible for the specific content and interpretations of this publication. Our appreciation goes to Prof. Elias G. Carayannis, the co-founder and co-director of the Global and Entrepreneurial Finance Research Institute and the director of research on Science, Technology, Innovation and Entrepreneurship at the European Union Research Center, George Washington University School of Business, who kindly supported the book with his outstanding foreword. We sincerely thank Ms. Emily Zhang, Senior Editor, Mr. Karthik Raj S ­ elvaraj, Project Coordinator, and the entire Springer Nature team for their continuing support throughout the development of the book. Last, but definitely not least, we are truly indebted to our families and friends, who shared their continuing support and encouragement throughout the preparation of the book.

XI

Contents I

Essentials of Macroeconomics

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Subject of Macroeconomics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4  Major Schools of Thought. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 1.2.1  Classical School. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 1.2.2  Keynesian School . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 1.2.3  Monetarism. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 1.3  Study of Macroeconomic Processes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 1.3.1  Aggregation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 1.3.2  Modelling. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 1.4  Basic Concepts and Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 1.5  National Economy and Reproduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 1.5.1  Macroeconomics and National Economy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 1.5.2  Economic Reproduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 1 1.1 1.2

2 2.1

Macroeconomic Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

Costs, Revenues, and Profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.1  Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.2  Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.3  Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2  Economies and Diseconomies of Scale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3  Gross Domestic and National Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4  National Income and Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5  Quality of Macroeconomic Measurements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 3.1 3.2

38

38 44 46 50 53 59 63

68

Market Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

 Market Structures and Concentration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  Competitive Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.1  Types of Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.2  Perfect Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.3  Monopolistic Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3  Monopoly and Oligopoly. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1  Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.2  Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4  Monopsony and Oligopsony . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.1  Monopsony . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.2  Oligopsony . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

70 77

77 78 80 83

84 86 92

92 94 97

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Contents

4 4.1 4.2 4.3

Major Actors in Contemporary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

II

Disequilibrium Macroeconomics

5 5.1

Demand and Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

6 6.1

Macroeconomic Equilibrium. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

 Governments and Macroeconomic Policies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100  Households. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104  Firms and Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 4.3.1  Firms and the Theory of the Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 4.3.2  Transnational Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 4.4  Countries and Alliances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 4.4.1  State as Economic Entity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 4.4.2  Integration of Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 4.5  International Organizations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 4.5.1  International Financial Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 4.5.2  International Trade Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 4.5.3  Other International Economic Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

 Demand, Supply, and Equilibrium in Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 5.1.1  Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 5.1.2  Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 5.1.3  Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 5.2  Aggregate Demand and Aggregate Supply. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 5.2.1  Aggregate Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 5.2.2  Aggregate Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 5.3  Shifts in Demand and Supply and Changes in Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . 160 5.3.1  Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 5.3.2  Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 5.3.3  Price Administration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 5.3.4  Public Procurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 5.3.5  Market Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 5.3.6  International Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166 5.3.7  Import Tariff and Import Quota . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 5.3.8  Export Tariff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 5.4  Price Determination and Price Elasticities of Demand and Supply. . . . . . . . . . . . . . . . . 170 5.4.1  Elasticity of Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170 5.4.2  Elasticity of Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

 Theory of Macroeconomic Equilibrium. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 6.1.1  Classical Theory of Macroeconomic Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183 6.1.2  Keynesian Theory of Macroeconomic Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184 6.1.3  Marxian Model of Macroeconomic Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186 6.1.4  Walrasian General Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187

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 National Economic Performance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187 6.2.1  Classical Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 6.2.2  Concept of Marginal Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 6.2.3  Neoclassical Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189 6.2.4  Institutional Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190 6.3  Consumption, Investment, and the Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190 6.3.1  Neoclassical Concept of Consumption and Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190 6.3.2  Keynesian Concept of Consumption and Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194 6.3.3  The Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 6.4  Commodity Market Equilibrium. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 6.4.1  Neoclassical Interpretation of Commodity Market Equilibrium . . . . . . . . . . . . . . . . . . . . . 204 6.4.2  Keynesian Interpretation of Commodity Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . 205 6.5  Equilibrium in Commodity and Money Markets: The IS-LM Model. . . . . . . . . . . . . . . . . 208 6.6  Equilibrium and the New Normal Approaches to Economic Policy . . . . . . . . . . . . . . . . 212 6.6.1  Interpreting the IS-LM Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212 6.6.2  Equilibrium and Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214 6.6.3  Equilibrium and Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216 6.6.4  The New Normal Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222 6.2

7 7.1

Economic Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223

 Theory of Economic Cycles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224 7.1.1  Marxian Interpretation of Economic Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 7.1.2  Neoclassical Interpretation of Economic Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228 7.1.3  Keynesian Interpretation of Economic Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 7.2  Types of Economic Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231 7.2.1  Kitchin Inventory Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232 7.2.2  Juglar Fixed-Investment Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234 7.2.3  Kuznets Infrastructural Investment Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236 7.2.4  Kondratiev Waves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238 7.3  Crises of the Modern Age: From the Great Depression to the COVID-19. . . . . . . . . . . 241 7.3.1  Structural Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241 7.3.2  Agrarian Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242 7.3.3  Financial Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243 7.3.4  Monetary Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244 7.3.5  Stock Market Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 7.3.6  Modern Crises of Economic Transformation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 7.4  Equilibrium Determinants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247 7.4.1  Approaches to Interpretation of the Equilibrium Determinants . . . . . . . . . . . . . . . . . . . . . 247 7.4.2  Self-sustaining Fluctuations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 7.5  Stabilization Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256 8 8.1 8.2

Disequilibrium and Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259  Labor Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260  Unemployment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266

XIV

Contents

8.2.1  Foundations of Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266 8.2.2  Theories of Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273 8.3  Effects of Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279 8.4  Labor Market Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293 9 9.1

Disequilibrium and Inflation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295

III

Market Failure

10 10.1

Government Interventions in Unbalanced Markets . . . . . . . . . . . . . . . . . . . . . . . . 335

11 11.1

Money. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371

 Foundations of Inflation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296 9.1.1  Meaning of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296 9.1.2  Types of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299 9.1.3  Theories of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303 9.2  Causes and Effects of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311 9.2.1  Causes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311 9.2.2  Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 9.3  Measuring Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322 9.4  Dealing with Inflation in the New Normal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331

 Failures and Imbalances in Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336 10.1.1  Market Failures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336 10.1.2  Government Failures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339 10.1.3  Government Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341 10.2  Rise in Monopoly Power and Antitrust Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345 10.3  Asymmetrical Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349 10.4  Market Externalities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351 10.4.1  Internalization of Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355 10.4.2  Corrective Taxes and Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355 10.4.3  Distribution of Property Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357 10.4.4  Direct Government Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359 10.5  Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360 10.6  Lockdowns and Disruptions to Supply Chains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369

 Fundamentals of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372 11.1.1  Role of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372 11.1.2  Theories of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375 11.2  Monetary System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383 11.2.1  Forms of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383 11.2.2  Money Circulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385 11.3  Money Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387

XV Contents

11.4 11.5

12 12.1 12.2 12.3 12.4

13 13.1 13.2 13.3 13.4 13.5



 Monetary Policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394  Monetary Approaches to the New Normal Equilibrium. . . . . . . . . . . . . . . . . . . . . . . . . . . . 398 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409

Credit and Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411  Fundamentals of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 412  Lending and Lending Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419  Central Banks and Credit System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423  Commercial Banks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 442

Public Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443  Fundamentals of Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444  Government Budget and Public Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449  Taxes and Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456  Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460  Fiscal Approaches to the New Normal Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477

14 14.1 14.2 14.3

Social Issues of Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479

IV

The New Normal Development and Growth

15 15.1

Foundations of Economic Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 529

 Social Policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480  Economic Growth and Social Justice. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485  Welfare and Wellbeing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491 14.3.1  The Concept of Social Welfare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491 14.3.2  The Pareto Criterion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493 14.3.3  The Utilitarian Concept . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497 14.3.4  Cardinal Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499 14.3.5  The Rawls Criterion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499 14.3.6  The Concept of Social Wellbeing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 14.4  Poverty. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503 14.5  Inequality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525

 Basic Economic Development Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530 15.1.1  Economic Development and Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531 15.1.2  Institutional Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533 15.1.3  Stable and Sustainable Economic Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533 15.2  Classical Theories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535 15.2.1  Smith’s Self-interested Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 536 15.2.2  Ricardo’s Specialization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537 15.2.3  Malthus’s Constant Productivity Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538

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Contents

 Marxism and Neo-Marxism. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 540 15.3.1  Marx’s Capital Accumulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 540 15.3.2  Rostow’s Linear Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543 15.3.3  Baran’s Economic Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546 15.3.4  The Neocolonial Dependence Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546 15.3.5  Warren’s Shift Toward Socialism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 548 15.4  Neoclassical Theories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549 15.4.1  The Harrod-Domar Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549 15.4.2  The Robinson Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551 15.4.3  The Solow-Swan Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 554 15.4.4  The Mankiw-Romer-Weil Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557 15.4.5  The Kaldor Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561 15.5  Developmentalist Theories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 562 15.5.1  Lewis’s Unlimited Supply of Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 562 15.5.2  Hirschman’s Unbalanced Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564 15.5.3  Nurkse’s Balanced Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 565 15.5.4  The Rosenstein-Rodan Big Push . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567 15.6  Contemporary Interpretations of Economic Development . . . . . . . . . . . . . . . . . . . . . . . . 569 15.6.1  Structuralism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 569 15.6.2  Institutionalism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571 15.6.3  International Dependence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 577 15.3

16 16.1

Technological Choice and Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 579

17 17.1 17.2

Human Capital and Economic Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 611

 Technologies and the New Normal Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580 16.1.1  Innovation-Driven Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580 16.1.2  Innovations and the New Normal Economic Development . . . . . . . . . . . . . . . . . . . . . . . . . 584 16.2  Technological Development Priorities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 588 16.2.1  International Development Agenda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 588 16.2.2  Technological Development Regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 589 16.2.3  The New Normal Technological Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 592 16.3  Production and Technological Possibilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 595 16.4  Innovation Pessimism. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 16.5  Creative Destruction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 604 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610

 Approaches to Understanding Human Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612  Theories of Economic Growth and Human Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617 17.2.1  Classical School, Marxism, and Neoclassics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617 17.2.2  Schultz’s Human Capital Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 618 17.2.3  Becker’s Neoclassical Human Capital Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 619 17.2.4  Modern Interpretations of Human Capital Development and Economic Growth . . . . . 623 17.3  Investing in Human Capital: Growth Effects and Returns . . . . . . . . . . . . . . . . . . . . . . . . . . 625 17.4  Inequalities in Human Capital Development. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630

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17.5 17.6

 Human Capital and Education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641  Human Capital and Health . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 642 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 653

18

Post-pandemic Sustainable Development: The Farer-Reaching Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 655

 Sustainable Development Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 656  Sustainable Economic Development. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 660 18.2.1  Understanding and Measuring Sustainable Economic Development . . . . . . . . . . . . . . . . 660 18.2.2  Green Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 664 18.2.3  Blue Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 667 18.3  Economics and Environment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 670 18.4  Environmental Footprints. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 675 18.4.1  The Ecological Footprint Concept . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 675 18.4.2  Air Pollution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 679 18.4.3  Climate Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 679 18.4.4  Water Pollution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681 18.4.5  Soil Pollution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 682 18.4.6  Biodiversity Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683 18.5  Pursuing Sustainable Development. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 693

18.1 18.2

V

Globalization and International Competitiveness

19 19.1

Theories of International Trade and Competitiveness . . . . . . . . . . . . . . . . . . . . . 697

 Classical Country-Based Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 698 19.1.1  Mercantilism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 698 19.1.2  Smith’s Absolute Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700 19.1.3  Ricardo’s Comparative Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 703 19.1.4  The Heckscher-Ohlin Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 706 19.2  Modern Firm-Based Theories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 709 19.2.1  Vernon’s Model of International Product Life Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 709 19.2.2  Linder’s Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 711 19.2.3  Posner’s Technological Gap Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 714 19.2.4  Hicks’ Theory of Technological Progress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 715 19.2.5  Krugman’s Economies of Scale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 718 19.3  Alternative Concepts of International Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720 19.3.1  Haberler’s Theory of Opportunity Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720 19.3.2  Minhas’ Theory of Factor Intensity Reversal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 722 19.3.3  The Samuelson-Jones Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 724 19.3.4  Balassa’s Theory of Intra-industry Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 726 19.4  Emerging Theories of International Trade. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 728 19.4.1  Melitz’s Model of Heterogeneous Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 728 19.4.2  Theory of Incomplete Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 731

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Contents

19.4.3  Porter’s Theory of Competitive Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19.4.4  The Gravity Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19.4.5  Spatial Economy and International Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

732 733 734 738

20 20.1

International Capital Flows and Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 741

21 21.1 21.2

International Migration of Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 781

22 22.1

Liberalization and Protectionism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 817

 International Capital Movement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 742 20.1.1  Foundations of Capital Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 743 20.1.2  Classical Theories of International Capital Movement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 745 20.1.3  The Keynesian Interpretation of International Capital Movement . . . . . . . . . . . . . . . . . . . 747 20.1.4  Theories of International Financing for Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 748 20.2  International Investment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 751 20.2.1  Direct Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 751 20.2.2  Portfolio Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 755 20.3  External Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 758 20.4  Exchange Rates and Currency Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 762 20.4.1  Currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 762 20.4.2  Exchange Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 767 20.5  Foreign Exchange Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 774 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 779

 Fundamentals of International Migration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 782  Theories of International Migration of Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 786 21.2.1  Ravenstein’s Migration Laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 786 21.2.2  Lee’s Push and Pull Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 790 21.2.3  Neoclassical Theory of Migration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 790 21.2.4  Piore’s Dual Labor Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 792 21.2.5  New Economics of Labor Migration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 793 21.2.6  Wallerstein’s World Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 794 21.2.7  Human Capital in the Context of Labor Migration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 796 21.3  Drivers and Effects of International Migration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 799 21.3.1  Drivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 799 21.3.2  Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 801 21.4  Governance of International Migration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 805 21.5  The New Normal Trends. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 808 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 816

 Free Trade and Protectionism. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 818 22.1.1  Free Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 818 22.1.2  Protectionism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 820 22.2  Foreign Trade Policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 824 22.2.1  Theories of Foreign Trade Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 824 22.2.2  Tariff Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 830 22.2.3  Non-tariff Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 835

XIX Contents

22.3 22.4

23 23.1 23.2 23.3 23.4 23.5



 Multilateral Regulation of International Trade. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 839  The New Rise in Protectionism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 845 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 851

Globalization and Regionalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 853  Globalization Through the Ages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 854  Measuring Globalization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 859  Effects and Controversies of Globalization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 870  The New Anti-globalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 880  Globalization and Social Policy in the New Normal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 883 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 889

Supplementary Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 891 Glossary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 892 Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 921 Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 929

XXI

About the Authors Vasilii Erokhin  is an Associate Professor, School of Economics and Management, Harbin Engineering University, China. Since 2017, Dr. Erokhin is a researcher at the Center for Russian and Ukrainian Studies (CRUS) and Arctic Blue Economy Research Center (ABERC), Harbin Engineering University, China. Dr. Erokhin is an author of over 200 publications in the areas of macroeconomics, global development, international trade, sustainable development, and food security issues with a focus on emerging markets, developing countries, and economies in transition. His major book titles include Shifting Patterns of Agricultural Trade: The Protectionism Outbreak and Food Security (2021), Handbook of Research on Globalized Agricultural Trade and New Challenges for Food Security (2020), and Handbook of Research on International Collaboration, Economic Development, and Sustainability in the Arctic (2019). Dr. Erokhin is a guest editor at MDPI Sustainability and MDPI Economies; an Associate Editor at Springer’s Journal of Knowledge Economy; an editorial board member at several international journals and publications. Dr. Erokhin is a holder of honorary awards from the Ministry of Agriculture of the Russian Federation and the Ministry of Education and Science of the Russian Federation.

Gao Tianming  is a Professor, School of Economics and Management, Harbin Engineering University, China. He obtained his Bachelor's degree in Industrial External Trade from Harbin Engineering University, Master's degree in Management from the Russian Presidential Academy of National Economy and Public Administration under the President of the Russian Federation, and a Ph.D. degree in International Economics from Moscow State Institute of International Relations under the Ministry of Foreign Affairs of the Russian Federation. He has over 15 years of professional experience as a general representative of Chinese transnational corporations in Russia and the CIS. He is a Director and Chief Expert of the Center for Russian and Ukrainian Studies (CRUS) and Arctic Blue Economy Research Center (ABERC) at Harbin Engineering University, Deputy Head of the Heilongjiang International Economic and Trade Association, leading consultant of governmental bodies and commercial

XXII

About the Authors

organizations in the sphere of economic collaboration between China, Russia, and South Korea. Professor Gao is the author of many publications in the areas of economic development, industrial policy, and investment. He is a member of the Scientific Board of the Research Network on Resources Economics and Bioeconomy (RebResNet), an editor at MDPI Sustainability special issues, and a regular member of the editorial boards in many international peer-reviewed journals.

Jean Vasile Andrei  is a Professor at the Petroleum-Gas University of Ploiesti, Department of Business Administration, and Managing Director at the Center for Renewable Energies and Energy Efficiency, National Institute for Economic Research ‘Costin C. Kiritescu’, Romanian Academy. He holds a Ph.D. in Economics from the National Institute of Economics Research—Romanian Academy of Sciences. Jean Andrei is an Editor-in-Chief at the International Journal of Sustainable Economies Management (USA), an Associate Editor at Economics of Agriculture Serbia, an Editor at MDPI Sustainability special issue “Sustainable Economic Development: Challenges, Policies, and Reforms”, and a scientific reviewer for International Business Information Management Association Conferences—IBIMA. He is also a founder of the Research Network on Resources Economics and Bioeconomy (RebResNet) and a member of the Balkan Scientific Association of Agrarian Economists. Particularly issues like business investment process, economic efficiency, and valuing economic and human potential are among his research and scientific interests, where he has published over 20 papers, four books, and conference presentations. Book editorial experience: Shifting Patterns of Agricultural Trade: The Protectionism Outbreak and Food Security (2021), Handbook of Research on Agricultural Policy, Rural Development, and Entrepreneurship in Contemporary Economies (2020), and Sustainable Entrepreneurship and Investment in the Green Economy (2017).

XXIII

Abbreviations AC Average Costs AD Aggregate Demand ADB Asian Development Bank AFC Average Fixed Costs AfCFTA African Continental Free Trade Area AI Artificial Intelligence APC Average Propensity to Consume APEF Association of Iron Ore Exporting Countries APVAX Asia Pacific Vaccine Access Facility AR Average Revenue/ Augmented Reality AS Aggregate Supply ASEAN Association of Southeast Asian Nations ATC Average Total Costs AVC Average Variable Costs BIS Bank for International Settlements CCI Consumer Confidence Index CG Consumer Goods CIPEC Intergovernmental Council of the Copper Exporting Countries COE Compensation of Employees COMESA Common Market of Eastern and Southern Africa CPI Consumer Price Index CSGR Centre for the Study of Globalization and Regionalization EB External Benefits EBRD European Bank for Reconstruction and Development

EC External Costs ECOSOC Economic and Social Council EEC European Economic Community ER Extended Reality EU European Union FAO Food and Agriculture Organization FC Fixed Costs FDI Foreign Direct Investment FMCG Fast Moving Consumer Goods FPI Foreign Portfolio Investment FRS Federal Reserve System FSB Financial Stability Board FTA Free Trade Area GATS General Agreement on Trade in Services GATT General Agreement on Tariffs and Trade GCI Global Competitiveness Index GDP Gross Domestic Product GFN Global Footprint Network GGGI Global Green-Growth Institute GHG Greenhouse Gas GII Global Innovation Index GMI Gross Mixed Income GNI Gross National Income GNP Gross National Product GOS Gross Operating Surplus HDI Human Development Index IBRD International Bank for Reconstruction and Development ICC International Chamber of Commerce

XXIV

Abbreviations

ICSID International Centre for Settlement of Investment Disputes IDA International Development Association IFC International Finance Corporation ILO International Labor Organization IMF International Monetary Fund IoT Internet of Things IPCC Intergovernmental Panel on Climate Change IS Investment-Savings Model ISID Inclusive and Sustainable Industrial Development KFP The A. T. Kearney/ Foreign Policy Globalization Index KOFGI KOF Globalization Index LM Liquidity Preference— Money Supply Model LRAS Long-Run Aggregate Supply MC Marginal Costs MCSI Michigan Consumer Sentiment Index MEI Marginal Efficiency of Investment MERCOSUR South American Common Market MGI The McKinsey Global Institute Connectedness Index MIGA Multilateral Investment Guarantee Agency MP Marginal Profit/Means of Production MPC Marginal Propensity to Consume MPI Marginal Propensity to Invest/Multidimensional Poverty Index

MPK Marginal Product of Capital MPL Marginal Product of Labor MPS Marginal Propensity to Save MR Marginal Revenue MRPL Marginal Revenue Product of Labor MRPT Marginal Rate of Product Transformation MSB Marginal Social Benefit MSC Marginal Social Cost MU Marginal Utility NAIRU Non-Accelerating Inflation Rate of Unemployment NBER National Bureau of Economic Research NDI National Disposable Income NEST Working Group of National Experts on Science and Technology Indicators NFI Net Foreign Investment NI Net Income NNP Net National Product NRA National Recovery Administration OCC Organic Composition of Capital OECD Organization for Economic Cooperation and Development OPEC Organization of the Petroleum Exporting Countries PB Private Benefits PC Private Costs PISA Program for International Student Assessment PPC Production Possibility Curve PPF Production Possibility Frontier

XXV Abbreviations

PPI Producer Price Index PPP Purchasing Power Parity PWA Public Works Administration RCEP Regional Comprehensive Economic Partnership ROA Return on Assets ROE Return on Equity RP Rate of Profit RSV Rate of Surplus Value SACU Southern African Customs Union SB Social Benefits SC Social Costs SCO Shanghai Cooperation Organization SDG Sustainable Development Goals SDR Special Drawing Rights SLL Short-Term Liquidity Line SRAS Short-Run Aggregate Supply TA Total Assets TC Total Costs TNC Transnational Corporation TR Total Revenue TRIMS Agreement on Trade-Related Investment Measures TRIPS Agreement on Trade-Related Aspects of Intellectual Property Rights TVC Total Variable Costs



UBI Universal Basic Income UN United Nations UNCITRAL United Nations Commission on International Trade Law UNCTAD United Nations Conference on Trade and Development UNDP United Nations Development Programme UNEP United Nations Environment Programme UNESCO United Nations Educational, Scientific and Cultural Organization UNIDO United Nations Organization on Industrial Development VAT Value Added Tax VC Variable Costs VR Virtual Reality WBG World Bank Group WCED World Commission on Environment and Development WCO World Customs Organization WHO World Health Organization WPI Wholesale Price Index WTO World Trade Organization WWF World Wildlife Fund

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Essentials of Macroeconomics

I

3

Introduction

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_1

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4

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Chapter 1 · Introduction

Learning Objectives: 5 Understand the subject of macroeconomics and major differences between macroeconomics and microeconomics 5 Get initiated to the foundations of macroeconomic thoughts 5 Study the contents of macroeconomic processes 5 Learn basic concepts and definitions macroeconomics deals with 5 Understand economic turnover and reproduction 1.1  Subject of Macroeconomics

Modern economic theory involves the study of problems related to the functioning of the economy as a whole. They largely affect everyone, since the problems of unemployment, inflation, exchange rates, among many other economic issues, influence people’s livelihoods. Being a part of economic theory, macroeconomics is closely interrelated with microeconomic phenomena. At the same time, being an independent branch of economic theory, macroeconomics has its own subject of research along with the range of issues under consideration. The ways of exploring the functioning of the economy also differ. This section defines the subject of macroeconomic research and the features of studying macroeconomic processes. Macroeconomics is a branch of economic theory (economics). Economics is a discipline that studies how to allocate and use scarce economic resources in order to maximize production and satisfy increasing needs of people to the fullest. Economic theory is a social science that considers the economic behavior of individuals and organizations during production, distribution, and consumption of goods and services. Economic theory consists of microeconomics and macroeconomics. Microeconomics analyzes individual components of the economy. It studies the economic behavior of individual economic actors (households, firms, etc.) in the markets of certain goods and services (foods, consumer goods, transport services, etc.) and the markets of economic resources (labor, capital, and land) in various types of market structures (competition, oligopoly, monopoly, etc.). Microeconomics considers how a firm (producer) or a household (consumer and/or owner of economic resources) makes economic decisions and operates with such variables as output, price, income of consumers, profit of firms, wages of workers, demand for and supply of a product or economic resource on the market. Macroeconomics studies the economic behavior of aggregate economic actors (sectors of the economy) in aggregated markets and considers economic issues that affect the entire economy (not individual industries) and society as a whole. Macroeconomics studies the behavior of the economy in both the short term (at different phases of the economic cycle) and the long term (long-term economic growth and changes in the production capabilities of the economy). At the same time, the laws of economic behavior are studied not only at the level of the national economy (closed economy), but also at the level of interaction of the country with other economies worldwide (open economy). Macroeconomics operates with aggregate values, such as gross domestic product, national income, aggregate

5 1.1 · Subject of Macroeconomics

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demand, aggregate supply, total price level, unemployment rate, interest rate level, and exchange rate, among others. It studies causes and effects of the long-term economic growth, cyclical fluctuations of the economy (business cycles), unemployment, inflation, government budget, balance of payments, etc. At the same time, macroeconomic theory tries not only to study and explain economic phenomena, but also to elaborate a macroeconomic policy to ensure stable growth of aggregate output, full employment of resources, and a stable price level in both closed and open economies. Thus, the main difference between macroeconomics and microeconomics is the level of analysis of economic processes. Microeconomics studies the mechanism of price setting on particular markets, consumer behavior, and producers’ motivation for making decision about the volume of output. In macroeconomics, two main markets are considered: the market of goods and services and the money market. However, unlike microeconomic research, macroeconomics tries to establish the mechanism of equilibrium in the economy through the general equilibrium in the commodity and money markets and through their interaction. Similar to that in microeconomics, macroeconomic equilibrium is abstract and ideal. The appearance of unemployment, inflation, public debt, and fluctuations in the volume of national production are all imbalances. Macroeconomics largely studies the consequences of disequilibrium, assess them, and suggests ways to reduce their negative effects. At the same time, macroeconomics and microeconomics are closely interrelated, since both study economic behavior and use similar methodology for analyzing economic processes. On the one hand, macroeconomic events stem from the interaction of people seeking to maximize their own wellbeing. General economic trends arise from millions of individual decisions. Therefore, when studying macroeconomics, the foundations of microeconomics should be taken into account. Most contemporary macroeconomic concepts have a microeconomic justification, i.e., they are based on the aggregation of the behavior of individual economic actors. On the other hand, all decisions of individual actors are made on the basis of analysis and consideration of the macroeconomic situation. However, despite the fact that both disciplines use the same variables, macroeconomic variables are not a simple sum of variables that reflect individual decisions. For example, in macroeconomics, aggregate supply is not a kind of supply studied by microeconomics, while a sum of product prices does not result in the total price level in the economy. Not every statement that is true for an individual is always true for the economy as a whole. Thus, microeconomics and macroeconomics have specific research subjects and are based on specific approaches and theories. Case box The Savings Paradox. In microeconomics, higher savings make a person richer. In macroeconomics, however, if a society saves more by buying fewer goods and services, it can become poorer, not richer. A decrease in aggregate demand pulls down aggregate output and aggregate income.

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Chapter 1 · Introduction

Macroeconomics and microeconomics operate with the same subjects: firms, households, and the state. Many of their actions and the consequences of making common decisions affect economic activities of an individual entity, but also the entire economy. Case box In the context of a general decline in production, incentives for investment decrease. For a firm, this means finding a new point of profit maximization in a smaller volume of production. For the economy, this means a further decline in domestic production. Households’ incomes go lower. For the economy, this means that part of the goods produced remain unsold.

Macroeconomics deals with vital problems. The macroeconomic situation affects the living conditions of everyone, the economic activity of every company, public policy, and the wellbeing of the entire society. The importance of macroeconomics is that it: 5 identifies patterns of macroeconomic processes and phenomena, i.e., causeand-effect relationships in the economy; it helps to understand and explain macroeconomic interdependencies; 5 serves as a basis for the development of principles and instruments of economic policy that can prevent or mitigate macroeconomic problems; 5 allows one to make forecasts of economic development and anticipate future economic problems. By adjusting various macroeconomic parameters, governments attempt to influence the economy so as to improve its economic performance. Different economies perform in different ways, but macroeconomic objectives typically i­nclude economic growth, combating poverty, inequality, and unemployment, controlling inflation, and balancing the current account on the balance of payments. Governments also have objectives in relation to the environment and various social issues. Macroeconomic objectives are detailed in 7 Chap. 4 (see 7 Sect.  4.1. “Governments and Macroeconomic Policies”). The knowledge of macroeconomics is important for the economic health of every nation and every economic agent as a basis for making economic decisions and evaluating proposals put forward by politicians that can have far-reaching consequences for the national and global economies. In addition, an understanding of macroeconomic theory allows reducing diverse individual parameters of economic life to several of the most important macroeconomic indicators amenable to regulation. In general, the following main areas of research can be distinguished in macroeconomics: 5 The theory of consumption identifies main determinants of consumer spending. 5 The theory of investment decision-making explores the motivation of private firms when making decisions about changing the volume of investment demand in the economy.

7 1.2 · Major Schools of Thought

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5 The theory of money explains the determinants of the demand for money and the role of money in the economy. 5 The employment theory examines the effective level of unemployment, the causes of forced unemployment, and the impact of unemployment on the dynamics of GDP. 5 The theory of economic growth determines the optimal rates of economic growth, along with its sources and consequences. Due to the developing character of any economy, macroeconomics should identify the conditions for the transition of the economy to a new qualitative level, i.e., the conditions for economic growth. 5 The theory of economic cycles examines the phases of development, their parameters, and the causes of economic downturns. 5 The theory of economic policy. Macroeconomics addresses fundamental issues, such as state regulation of the economy, its principles, methods, and boundaries of government intervention into the economy. 5 The theory of international economics. Research on the problems of globalization has become particularly important. 5 The theory of the transition economy. The development of this sphere of macroeconomics is associated with the emergence of the market economy in the former socialist countries. The structure of the national economy is very diverse. Economic development is not only growth, as any economy goes through periods of ups and downs. The task of macroeconomics is to determine the conditions of general equilibrium that can occur in the economy. To do this, it is necessary to identify the r­elationships between consumption, investment, government intervention, unemployment, percentage rate, changes in the price level, etc. As a result, a single mechanism for the operation of the economy should be created. In macroeconomics, it appears in the form of a concept. Such a concept should provide a solution to several ­issues: the cost assessment of the national product, achieving the optimal level of employment, inflation, economic growth, economic cycle, and the directions and effectiveness of the government policy. 1.2  Major Schools of Thought

The macroeconomics agenda is associated with the construction of a holistic concept of the market economy based on the theoretical views of representatives of various schools. For most of economic parameters, there are alternative, even radically diverse views on the same issues. The ideas about the functioning of the economy, its challenges and their solutions are formed in various schools. The most significant theoretical concepts are classical, Keynesian, monetarist, and institutional schools. It is among these schools that ideas on determining the prerequisites for research, functioning of the economy, identifying the patterns of interaction of individual markets and the nature of the relationship between them, the implementation and priorities of economic policy differ significantly.

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Chapter 1 · Introduction

1.2.1  Classical School

The classical school dominated economic theory until the 1930s. Before the XX century, macroeconomics had not developed into the integral science. Therefore, it is difficult to outline the single outstanding representative of the classical concepts. Research and interpretation of individual issues and macroeconomic ­problems can be found in the works of Adam Smith, David Ricardo, Karl Marx, and Leon Walras, among others. In general, the school represents the orthodox classics. This concept is presented in the most systematic form in Alfred Marshall’s book “Principles of Economic Theory”,1 as well as in the works of Robert Solow, Thomas Sargent, Robert Lucas, Neil Wallace, and other scholars who continue the traditions of the classical school in the form of neoclassic economics. Major provisions of their concepts are addressed in detail in the following chapters in this book. In general, the ideas of the classic school could be summarized as follows: 5 There are two independent sectors in the economy: real and monetary. Changes in the monetary sector do not affect the real sector, but only result in the deviation of nominal variables from real variables. This means that all prices are relative. The “neutrality of money” principle applies. The two sectors exist in parallel, which means that the behaviors of nominal and real variables do not coincide. This is the “classical dichotomy” principle. There is no money market in the classical model, while the real sector consists of labor market, capital market, and commodity market. 5 Perfect competition operates in all markets in the real sector, which corresponded to the economic situation of the late XVIII century and the entire XIX century. Therefore, economic agents are the so-called price-takers. They cannot influence market prices. 5 In the conditions of perfect competition, all prices (nominal variables) are flexible. They adapt to the changes in the supply-demand ratio and provide automatic balancing of the disturbed equilibrium in all markets. This applies to the price of labor (wages), the price of borrowed funds (interest rate), and the prices of goods. In the economy, there operates the Smith’s “invisible hand” principle of markets’ self-balancing and market clearing. 5 No external force should interfere in the regulatory process, much less in the functioning of the economy. This is how the basic principle of state non-interference in the economy is justified (“laissez faire, laissez passer”). 5 The main problem of the economy is the scarcity of resources. Therefore, they must be distributed and used efficiently. The total output is always at the potential (or natural) level, which corresponds to the level of output at full employment of economic resources. 5 The scarcity of resources brings to the fore the problem of production. The classical model is the one that studies the behavior of the economy from the aggregate supply side (the supply-side model). Aggregate demand always

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Marshall (1890).

9 1.2 · Major Schools of Thought

1

corresponds to aggregate supply. The Say’s law states that supply generates adequate demand, since each economic agent is both a seller and a buyer, and their expenses are always equal to income. 5 The scarcity issue is being solved slowly. Technological progress that allows for the increase in the production capabilities of the economy is a long process. The mutual balancing of markets and the adaptation of prices to changes in the supply-demand ratio also occur over a long period of time. Therefore, the classical model describes the behavior of the economy in the long-run (the long-run model). Three events were of fundamental importance for the development of macroeconomics and the transformation of the classical school. First, the collection and systematization of aggregated data started during the World War I. That provided an empirical basis for macroeconomic research. In the 1920s, a group of economists from the National Bureau of Economic Research (NBER) led by Simon Kuznets and Richard Stone created a system of national accounts in the USA. Second, in the 1920s, Wesley Clair Mitchel, an American economist, justified business cycles (the cycles of economic activity) to be a recurring economic phenomenon. Third, the Great Depression in 1929–1933 contradicted the postulates of classical economists about a self-regulating economy. 1.2.2  Keynesian School

The founder of macroeconomics as an independent branch of economic theory is John Maynard Keynes, an English economist, who analyzed the causes and first consequences of the Great Depression in his book “The General Theory of Employment, Interest and Money”.2 He showed that macroeconomics had its own subject and some specific methods of analysis. Keynes’ contribution to economic theory was so outstanding that his ideas have been addressed as the Keynesian Revolution. Keynes considered macroeconomics as an integral system and completely rejected all the postulates of the classical school. According to Keynesians, the classic school considered economy as an ideal, abstract model that did not reflect real economic processes. The main provisions of the Keynesian concept (further detailed in the chapters below) could be summarized as follows: 5 The real sector is closely related to the money sector. The “money neutrality” principle is replaced by the “money matters” principle. This means that money has an impact on real variables. The money market becomes a macroeconomic market, a segment of the financial market. Therefore, the equilibrium interest rate is set on the money market, not the debt market (the capital market or long-term assets). 5 There is imperfect competition in the markets, so prices (nominal variables) are rigid, or, in Keynes’ terminology, sticky. They “stick” at a certain level and

2

Keynes (1936).

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Chapter 1 · Introduction

do not change for a certain period of time. The rigidity of prices leads to the fact that the equilibrium in the markets is established, but not at the level of full employment of economic resources. 5 In a situation of underemployment of resources, aggregate demand, not aggregate supply, becomes the main economic problem. Firms are ready to produce as many goods as consumers are ready to buy from them. Therefore, the Keynesian model is a model that studies the behavior of the economy from the side of aggregate demand (the demand-side model). 5 The expenditures of the private sector (households and firms) can not provide the amount of aggregate demand required to achieve the potential level of aggregate supply. Therefore, state intervention and state regulation of the economy are necessary. 5 The government’s stabilization policy, which is primarily a policy to regulate aggregate demand, affects the economy in the short term. Price rigidity exists for a relatively short time, so the Keynesian model describes the behavior of the economy in the short run (the short-run model). The central message of Keynes’ theory was that the market economy does not guarantee economic stability. Therefore, in order to counteract economic crises and high unemployment, it is necessary for the government to ­implement a stabilization policy. For about three decades after the World War II—a period when most countries experienced rapid economic growth—there was an increasing belief that the state was able to prevent economic downturns by ­actively implementing fiscal and monetary policies to influence aggregate demand. However, in the 1970s, many developed countries found themselves in a situation of stagflation—a combination of inflation and stagnation, i.e., low or even negative economic growth rates and high unemployment combined with high i­nflation. It appeared that such situation had emerged as a result of the stabilization policy. This is how the Keynesian Revolution was replaced by the neoclassical counter-revolution. 1.2.3  Monetarism

Just as the Keynesians in the 1930s became the leading school in the wake of criticism of the classics, the monetarists took their place in the 1970s, criticizing main postulates of the Keynesian school. Monetarism is one of the most demonstrative trends in modern economic theory. The monetarist theory is based on the idea of permanent income and the theory of monetary demand. According to the monetarist concept: 5 Economic entities act in accordance with the theory of adaptive expectations. 5 Households plan their income based on permanent income, not current one. 5 State intervention in the market contradicts the nature of the economy, but it has to be tolerated. Through issuing money, the state has long been present in

11 1.2 · Major Schools of Thought

1

the money market. Therefore, it should primarily deal with the regulation of the monetary sector to adjust the dynamics of money supply growth. 5 State intervention in the real sector of the economy is undesirable. First, public investments are less effective than private ones. This is because the state aims to solve social and general economic problems rather than making profit. Thus, the motivation of the state’s investment decisions poorly complies with the market economy principles. Second, an increase in public procurement of goods and services is possible due to an increase in state revenues. Taxes is the core source of state income. To increase them, the state increases taxes on businesses. This results in a decrease in incentives for businesses to invest. In such situation, private business could be gradually replaced by the public sector. But, as the historical experience of development has shown, the expansion of the public sector in the economy leads to a decrease in the efficiency of the economy as a whole. 5 The goal of the state is to ensure the stability of the economy while preserving the foundations of the market mechanism. 5 The state should not seek to employ all citizens. There is always a certain level of unemployment in the economy (the so-called “natural unemployment”). The desire to keep unemployment below the natural level may result in inflation. 5 In order to change the situation in the economy, it is necessary to regulate the aggregate supply. 5 Money is not just wealth, but a kind of assets. 5 The money market interacts with the real sector not only through indirect mechanisms, but directly through the optimization of the asset portfolio. In the long term, money is neutral. In the short term, the change in money supply is primary related to changes in the real sector of the economy. The difference between the main provisions of the classic, Keynesian, and monetarist schools is visualized in . Table 1.1. Along with monetarism, there are several alternatives to the Keynesian school: 5 New classical macroeconomics. The central idea of the school is the concept of rational expectations. It says that if the expectations of economic actors are rational, then the economy is always at the level of full employment. Therefore, in this situation, the economic policy of the government is ineffective. Major representatives of the school are Robert Lucas, Thomas Sargent, and Neil Wallace. 5 Real business cycle theory. It suggests the source of economic fluctuations to be technological shocks, not economic policy. The theory is developed by Finn Kydland and Edward Prescott. 5 Supply-side economics. The theory was proposed in the early 1980s by Arthur Laffer to overcome stagflation in the USA. Nowadays, it is used to explain the possible impact of fiscal policy on long-term economic growth.

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Chapter 1 · Introduction

. Table 1.1  Comparative analysis of postulates of major schools Parameters

Classic (neoclassic) school

Keynesian school

Monetarism

Motivation of economic actors

Rational expectation to get more income

Subjective motivation. Institutional and psychological factors particularly matter

Adaptive expectations

Money

Money is a counting unit with no independent value

Money is wealth

Money is asset

Market interaction

Markets are not interrelated

Markets are interrelated

Markets are neutral in the long term. The change in the money market is primary in the short term

Prices

Flexible

Inflexible (influence of institutional factors)

Flexible

Economy

Perfect competition

No self-regulation

Should be close to the ideal market

Factors of production

Interchangeable

Non-interchangeable

Interchangeable

Government policy

The state only issues money and collects taxes

Fiscal and monetary policy to stimulate aggregate demand

Monetary policy (priority) to stimulate aggregate supply

Employment

Full employment

Underemployment, involuntary unemployment

Natural unemployment

Macroeconomic equilibrium

All real sector markets are constantly in equilibrium

The balance is instantaneous, it is rather an exception

Balance is achieved with full employment. Imbalance is caused by the actions of the state

Stabilizers

Prices, wages, interest rates

Government polity (public procurement of goods and services, taxes)

Money supply

Source Authors’ development based on Zhuravleva (2014)

Macroeconomics as a science is constantly developing. The changes concern both the essence of the issues under study and the content of the proposed answers. These changes occur under the influence of two groups of factors. First, new theories and approaches are emerging to explain economic processes. Second, the world economy itself is developing, putting forward new questions and demanding new answers.

13 1.3 · Study of Macroeconomic Processes

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1.3  Study of Macroeconomic Processes

The study of macroeconomic processes is characterized by the use of general research methods. However, the emphasis is made on identifying specific tailored research methods. Both microeconomics and macroeconomics are based on the following general principles of research: 5 The “all other things being equal” principle is used in the construction and theoretical study of economic processes. 5 Macroeconomics employs abstract indicators and parameters which concentrate the most essential and significant features of an economic issue or process. 5 Macroeconomics combines the inductive and deductive approaches to research, as well as positive and normative economic theory. 5 Graphs, formulas, and calculations are widely used in both macroeconomics and microeconomics. The research methods in macroeconomics are featured in aggregation and modeling. 1.3.1  Aggregation

Macroeconomics employs its own specific approach to the use of the main indicators, values, markets, or economic actors. Since macroeconomics studies economy as a whole, not particular industries or economic entities, it uses aggregated parameters, such as gross domestic or national product (GDP and GNP, respectively), unemployment rate, price level, inflation rate, interest rate, etc. All entities represent a set of real actors in the economy: firms, households, government, and the foreign sector, or global economy. They reflect a generalized version of the entities of respective type with the most typical features inherited in them. There are differences in the representation of the economic actors’ behavior in macroeconomics and microeconomics. The general economic theory analyzes the general principles of the functioning of economic institutions, both private and public. Macroeconomics determines the role of these entities in the establishment of the macroeconomic equilibrium. Case box Households receive personal income (after taxes) and use it for consumption and saving. Businesses aim to maximize their profit to increase performance and expand activities. In microeconomics, household income is one of the determinants of individual consumption, while the profit maximization efforts influence the profitability of individual business. In macroeconomics, these effects are aggregated (living standards instead of household income, consumers’ behavior instead of individual consumption, overall performance of the economy instead of the individual profitability, etc.).

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Chapter 1 · Introduction

Macroeconomics studies aggregated markets of commodities, services, money, and labor. They differ from each other in terms of objects of purchase and sale, types of prices, and features of establishing the equilibrium price. On the commodity market, industry-specific features disappear. It is an aggregated market of final goods and services delivered to consumers. Part of this market is the capital market. The real capital market is represented by the market of investment goods. The market of real goods and real capital establish the market of real assets. The labor market is also devoid of industry specifics. It sells labor as such, without any professional or industry features. The labor market and the real asset market establish the real sector of the economy. It is assumed that only national currency is traded in the money market. Due to the fact that the securities market has a great influence on economic processes, it is studied as a separate financial market. Various securities are traded on this market: stocks, bonds, promissory notes, checks, etc., but macroeconomics ­studies government bonds as an aggregated security. The money market and the securities market are integral parts of the financial market. Macroeconomic models employ a variety of indicators. A special feature of macroeconomic analysis is the division of macroeconomic indicators into three groups: flows, assets (stocks, reserves), and the parameters of the economic situation. Flows reflect the transfer of values by economic actors to each other in the process of economic activity. They are economic parameters measured per unit of time (usually, year or quarter). The flow values include gross national product (GNP), net national product (NNP), national income, disposable income, consumer spending, public procurement, savings, investments, and budget deficit. Assets are economic parameters, the value of which is determined at the moment. The most important indicators of assets used in macroeconomics include property (real capital, financial assets, intellectual property rights), national wealth (total assets owned by firms, households, and the state). Assets also can include real cash balances (the stock of payment means in the form of cash). Flows and assets can be interconnected. The households’ budgets reflect all income and expenditure flows, as well as related changes in the composition of assets. Parameters of the economic situation include interest rate, price level, inflation, unemployment rate, and the return on capital and other assets. All indicators used in macroeconomics are averaged parameters of individual markets, economic sectors, and various economic entities. For most of the macroeconomic parameters, nominal and real values are used. The price level P is considered to convert nominal indicators into real ones, particularly, in the calculation of GDP, interest rates, or wage rates. To sum up, it should be stated that macroeconomics is characterized by the facts that it studies aggregated markets, operates with aggregated economic entities, and uses aggregated indicators to assess economic processes.

15 1.3 · Study of Macroeconomic Processes

1

1.3.2  Modelling

Macroeconomic modeling also has distinctive features. It aims to analyze interactions between all economic entities in all sectors of the economy, as well as to assess the consequences of behavior and decisions made by economic actors. The most commonly used approach is the formalization of economic phenomena and processes in order to identify the main relationships between them. Such models are generalized in nature. Case box Some examples of macroeconomic models are the circular flow model, the AD-AS model (aggregate demand – aggregate supply), the Keynesian cross, the IS-LM model (investment-savings and liquidity preference – money supply), the Phillips curve, the Laffer curve, and the Sollow-Swan model, among others. They are detailed in the following chapters of the book.

The specifics of all macroeconomic models can be summarized in the four points: 5 models are abstract; 5 they use assumptions or simplifications; 5 they represent the most general tools of macroeconomic analysis; 5 they have no national specifics. At the same time, the macroeconomic analysis is based on the “other things being equal” principle. It assumes that the dynamics of the parameter under study depends on the change of one factor only, provided that all other factors are constant. For example, aggregate demand changes only under the influence of the price level, provided that personal disposable income and tax payments are constant. Therefore, macroeconomic models use endogenous and exogenous variables. Endogenous (Internal) Variables. Their value is determined as a result of the study. They include, for example, the level of employment, inflation, unemployment, and planned expenditures. Exogenous (External) Variables. Their value is set in advance. Some examples of exogenous parameters used in the macroeconomic analysis are government spending, tax rates, and money supply. The effects of exogenous parameters are estimated as either a certain constant or a random, probabilistic value. Case box The division of variables into endogenous and exogenous is conditional. It very much depends on the theoretical approaches of particular economic schools. Thus, income is an exogenous variable in the Keynesian model of money demand and an endogenous variable in the neoclassical approach.

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Chapter 1 · Introduction

The research objectives in macroeconomics determine the use of various types of models. The methodology of economic modeling can be built on the basis of the following criteria: 5 Presentation of research subject: logical, graphical, and economic models. 5 Period of analysis: short-term and long-term models. 5 Number of involved entities: two-sector (households and firms), three-sector (households, firms, and state), and four-sector (households, firms, state, and foreign sector) models. 5 Openness: closed (national economy only) and open (influence of international economic processes and the foreign sector on domestic market) models. 5 Time reflection: static, comparative statistics, and dynamic models. Three types of interactions are commonly considered: behavioral (motivations and preferences of economic actors); technological (organizational, production, and logistical links between economic actors); institutional (dependencies arising from the norms, traditions, and rules established in the society). Modern macroeconomic modeling particularly takes into account the economic motivation of various stakeholders. Economic entities act in the market and make their decisions under the influence of expectations and preferences. All actors make decisions about current activities in view of some expectations of the future. They can expect an increase in prices and wages or a change in taxes or interest rates. For example, if the interest is expected to get higher, then households and firms will be more willing to save most of their income in a bank rather than spend it on current consumption. Expectations are formed based on an assessment of the results of events that have occurred or forecasts about expected events. Also, macroeconomic models usually consider the concepts of economic expectations manifested by certain schools of economic thought. Expectations differ by the nature of their development. Ex post expectations are estimates given by an economic actor after the completion of the process. They are used for the empirical verification of the recommendations, theoretical concepts, as well as for the calculation of economic development indicators. Ex ante expectations are intentions of an economic actor that determine the decisions the actor makes. Ex ante expectations can be static, adaptive, and rational. Static (Naive) Expectations: economic actors take into account unchanged parameters of the current economy when making their decisions about future activities. For example, the next year prices can be expected at the current level (Eq. 1.1):

Pt+1 = Pt where: current price; Pt Pt+1  expected price in the future.

(1.1)

1

17 1.3 · Study of Macroeconomic Processes

Adaptive expectations arise when an economic actor builds their behavior based on past experience and corrects these expectations taking into account changes in the market situation. For example, the expectation of price changes will take the following form (Eq. 1.2):

Pt+1 = Pt + b(Pt − Pt1 )

(1.2)

where: b adaptation coefficient, 0 < b < 1; error value, or the difference between the expected price and the real (Pt − Pt1 )  price. Case box Households and, to some extent, firms tend to have adaptive expectations due to the fact that they do not have exact vision of the economic situation in the future. Adaptive expectations mechanism was actively employed by monetarists, as it illustrated the simple truth that people learn from the mistakes of the past in order to avoid them in the future. The disadvantage of this method is that in the dynamic economic environment, the past experience is not always applicable to future events. When expectations are formed based on the mistakes of the past only, many of future threats are not interpreted properly.

Rational Expectations assume that economic entities build their plans based on the information available to them. That means that they are guided by probable future events when making their decisions. The most widely used interpretation of the rational expectations concept is the Lucas’ model, in which the value of the expected parameter depends on several factors. For example, some economic entities are concerned about the future price level, while the latter depends on the economic situation and the actions of other entities. As a result, the model displays the result of the interaction between stakeholders. In this case, the future price example takes the following shape (Eq. 1.3).

Pt+1 = Pt (Xi )

(1.3)

where: Xi  pricing factors. Since economic entities commonly rely on the lessons of the past when making decisions, so it is possible to take into account the mistakes of the past in rational expectations. All entities act fairly accurately, without making systematic mistakes. Information is important for making a decision, so an economic actor must constantly monitor the economic situation. Errors in forecasts in this model are only random.

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Chapter 1 · Introduction

1.4  Basic Concepts and Definitions

As demonstrated earlier, macroeconomic analysis operates with aggregated entities (households, firms, state, and foreign sector) and aggregated processes (aggregate supply and demand, consumption, inflation, unemployment, etc.). The former act as sellers and buyers in the aggregated markets of goods, services, resources, as well as the financial market. By doing so, they receive income and use it for certain purposes. Households receive income Y in the form of wages, rent, interest, or dividends. From the received income, they must pay taxes T . The remaining part represents disposable income Yd (Eq. 1.4):

Yd = Y − T

(1.4)

where: Yd  disposable income; Y income; T taxes. Some households receive public welfare payments and pensions as additional income. These are transfers Tr. They are taken into account when determining the amount of disposable income (Eq. 1.5):

Yd = Y − T + T r

(1.5)

where: Tr  transfers. Part of the disposable income can be spent on the purchase of goods and services, i.e., consumer spending C. Consumer spending includes the cost of the so-called fast-moving consumer goods (FMCG) purchased on a daily basis. Another part of household income can be saved (S). The purpose of savings is to generate additional income for households. Household income from savings is called interest, and the return on savings is measured by the interest rate r. It represents the ratio of the income received to the amount of savings multiplied by 100%. The interest rate can be real (r rate cleared from inflation) and nominal (current interest rate i). The relationship between the nominal and real interest rates is described as follows (Eq. 1.6):

r =i−p

(1.6)

where: r real interest rate; p  price growth rate; i nominal interest rate. Households either keep their savings in a bank (then a bank pays them interest (income) for storing money), or they buy securities. So, the household income is divided into consumer spending and savings (Eq. 1.7).

Yd = C + S

(1.7)

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19 1.4 · Basic Concepts and Definitions

where: Yd  disposable income; C consumer spending; S savings. Firms also receive income from the sale of goods and services. Their revenues consist of costs and profits. The received profits are used for either the resumption of production on the same scale or its expansion. All expenses of firms aimed at resuming the production process in order to make a profit are called investments, or investment expenses I . In economic theory, investments include expenses for the purchase of fixed assets and raw materials, construction and changes in reserves. To carry out their activities, firms can use their own funds or borrow from outside. The basis of borrowed funds are household savings stored in banks, so the total amount of investment should be equal to the total amount of savings (I = S). The state also receives income, the main part of which is established by taxes T mandatorily paid by firms and households. In fact, the state redistributes part of the income of economic entities in its favor to address economic, social, or political issues. But these received tax revenues are again redistributed between economic entities to solve the same tasks. Case box In such redistribution, a taxpayer is not necessary a recipient of public funds. For example, income tax is paid by all employees, while only some employees receive child allowances.

Macroeconomics divides state expenditures into public procurement of goods and services G and transfers Tr. Public Procurement is the expenses of the state for the maintenance of public administration bodies, the carrying out of state orders for the industry, the production of public goods. In fact, they aim at production rather than making profit for the state. Transfers are non-reciprocal irrevocable payments made by the state to address economic, social, or other issues. Examples of transfers are unemployment welfare, child allowance, pensions, and scholarships. The main recipients of transfers are households. In economic theory, transfers also include grants and subsidies provided by the state to businesses free of charge. All expenses and revenues of the state are recorded in the state budget. If income exceeds expenses, the state has a surplus. If the state does not have enough income to cover expenses, then it lacks money and experiences deficit. Ideally, the amount of taxes received should be equal to the amount of public procurement and transfers paid (Eq. 1.8):

T = G + Tr

(1.8)

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Chapter 1 · Introduction

where: T – taxes; G – public procurement; Tr – transfers. The foreign sector is taken into account when modeling an open economy. Some of the goods produced in the national economy are exported abroad, while at the same time, a certain part of foreign goods ends up on the domestic market, i.e., goods are imported and exported. Export Ex is the income from the export of goods, import Im is the expenses (withdrawals) of the national economy for the purchase of goods from abroad. The difference between exports and imports is called net exports NX (Eq. 1.9).

NX = Ex − Im

(1.9)

where: NX   net export; Ex export; Im import. Ideally, an equilibrium should be established, when all the income received in the economy should be used, i.e., income should be equal to expenses. Approaches to understanding the macroeconomic equilibrium are addressed in detail in the following chapters of this book. In the simple two-sector model of the economy (households and firms), the equilibrium is described by Eq. 1.10):

Y =C+I

(1.10)

In more complex models that take into account the influence of the state and the foreign sector, the equilibrium is modified. Equation 1.11 depicts what is called the Basic Macroeconomic Identity for an Open Economy.

Y = C + I + G + NX

(1.11)

In macroeconomics, all economic entities one way or another operate in the commodity (services) market. However, since these markets are devoid of sectoral differences, they can be considered as one large national market. It is characterized by such parameters as demand, supply, and price. All these features are, however, aggregated, as macroeconomic analysis applies. Aggregate Demand ( AD) is determined by the monetary expenditures of economic entities at a certain price level. The number of aggregate demand variables depends on the type of a model. In case of the two-sector model, aggregate demand consists of consumer and investment spending (Eq. 1.12):

AD = C + I

(1.12)

In the three-sector model, aggregate demand also includes public procurement of goods and services. The open model takes into account net exports (Eq. 1.13):

AD = C + I + NX

(1.13)

21 1.4 · Basic Concepts and Definitions

1

. Fig. 1.1  Interaction between aggregate supply and aggregate demand. Source Authors’ development

Aggregate Supply ( AS) is the total supply of goods and services produced within an economy at a given overall price in a given period. The amount of aggregate supply is determined by the quantity and quality of economic resources (labor, capital, land, and entrepreneurial abilities) and the level of existing technology. The desire of firms to produce goods and services depends on the prices and productivity of economic resources (factors of production), which determine the production costs of firms, as well as on the prices of goods and services, which determine the revenue of firms. The AD-AS ratio allows determining the equilibrium level of aggregate output Y and the equilibrium price level P (. Fig. 1.1). The absolute values of prices used in the general market model in microeconomics are replaced by the price level P, a relative value, in macroeconomic analysis. Part of the income of economic entities flows into the financial market, which includes three sectors: money market, stock market, and foreign exchange market. In the money market, all economic entities exhibit demand for cash. Money supply is carried out by the state only, a monopoly issuer of cash. The price of money is the interest rate. There are always intermediaries in this market, such as commercial banks. Stocks and other securities are traded on the stock market. The demand for them is also exhibited by all types of economic entities, who aim to receive additional income. Macroeconomics assumes households to be the main buyers in the stock market. Companies issue shares and bonds in order to obtain additional investment resources. The state issues debt obligations in order to finance the budget deficit or additional expenses. The price is also the interest rate (the difference between dividends and interest is not taken into account). On the foreign exchange market, the demand for the national currency is exhibited by foreign companies that purchase goods and services from this economy or securities issued by national bodies. Domestic producers and households also demand for foreign currency to buy goods and services from abroad. As on the money market, the supply is provided by the national central banks. The price in this market is the exchange rate. In the labor market, the supply is provided by households, while the demand for labor is exhibited by businesses and the state. The price of labor is the wage rate. The labor market is sometimes referred to as the market of economic resources. . Table 1.2 presents the features of the main market parameters in macroeconomics.

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Chapter 1 · Introduction

. Table 1.2  Major parameters of various markets in macroeconomics Market

Supply

Demand

Price

Commodities and services

Firms

Households, firms, state, foreign sector

Price level in the economy

Money market

State

Households, firms

Interest rate

Stock market

State, firms

Households, firms

Interest rate

Foreign exchange market

State

Foreign sector

Exchange rate

Labor market

Households

Firms

Wage rate

Source Authors’ development

The macroeconomic analysis is based on the expenses-income turnover model (. Fig. 1.2). Relationships and interactions between economic entities determine the patterns of the entire national economy. The model reflects the cash flows that connect all stakeholders in the processes of production, distribution, and consumption of goods and services. The analysis of the turnover model starts with households. They own all the factors of production (resources) and offer them to the corresponding market in order to obtain factor income from the sale (rent) of these factors. In this market, they meet with buyers—firms that demand resources for the production of goods and services. Market prices are established as a result of the supply-demand interaction in the market of factors of production. It is assumed that the market prices facilitate the purchase of all the supplied factors of production. At these prices, households receive their income, while firms obtain factors of production to fulfill their functional role—the production of final consumer goods and services. They supply products to the appropriate market, where they are demanded by households. It is assumed that households spend all the factor income on consumption. Thus, consumer spending by households results in the monetary income (total revenue) of firms. Households receive products at their disposal and in such a way they fulfill their functional role—consumption.

. Fig. 1.2  Turnover of expenses and income. Note G = goods and services; I = income; E = expenses; F = factors of production. Source Authors’ development

23 1.4 · Basic Concepts and Definitions

1

The level of analysis in the model depends on the number of actors. If two economic entities are considered, then the incomes of households are the expenses of firms, and vice versa. Businesses’ expenses include the flows of wages, rents, and dividends. Consumer spending flows forms the income of firms from the sale of finished products. The “income-expenses” flow (. Fig. 1.2) goes in the opposite direction to the “resources-goods and services” flow). As a result, total sales made by firms should be equal to the sum of the household income. However, the simple two-sector model is far from reality, since it is based on the assumptions of a closed economy with no involvement of the state. All the income received by households is spent on the purchase of goods and services. If these assumptions are rejected, the model transforms as follows: 5 households do not spend all their income on consumption, they also save; 5 a part of household income is used to pay taxes to the state; 5 households buy products not only from domestic firms, but also from abroad. All of the above is a “leak” from the income-expenses flow. Leakage (withdrawal) is any non-consumption use of factor income, such as personal savings S, net taxes (taxes minus transfers) T , and imports Im. Leakages reduce the money available throughout the rest of the economy. On the other hand, any economy produces not only consumer goods and services, but also the means of production—investment goods. The demand for these goods is exhibited by firms. Firms can receive funds for investment expenses (purchases of investment goods) only in the financial market, where household savings go to. In addition, the state also imposes a demand for goods and services of domestic firms through public expenditures of goods and services. Finally, the foreign sector demands domestic products, thereby spending on exports (. Fig. 1.3).

. Fig. 1.3  The leakages-injections model. Note C = consumption; Y = factor incomes; Ex = exports; G = government procurement; I = investment; Im = imports; T = taxes; S = savings. Source Authors’ development

24

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Chapter 1 · Introduction

Each leakage corresponds to an Injection, which is a non-consumption expenditure on aggregate production. Injections include investment expenditures, government purchases, and exports. These are termed injections because they are injected into the core circular flow of consumption, production, and income. This injected revenue into the product markets is then used for factor payments and becomes household income. Case box The Leakages-Injection Model could be visualized in the form of a graph (. Fig. 1.4). The horizontal green line is the injections line. It includes investment expenditures I , government procurement G, and exports Ex. The positively-sloped red line is the leakages line. It includes saving S, taxes T , and imports Im. The intersection of the two lines is the equilibrium level of aggregate production, which matches the equilibrium level of aggregate production generated by the Keynesian Cross (see Chap. 6 for the Keynesian model of macroeconomic equilibrium).

The combination of the two-sector model (. Fig. 1.2) and the leakages-injections model (. Fig. 1.3) results in a more realistic form of the economic turnover model for an open economy with the involvement of the state, the one the macroeconomic analysis is based on (. Fig. 1.5). Public sector: 5 purchases goods and services G required for the maintenance of the public sector of the economy, production of public goods, economic and social regulations, and governance. Public procurement includes the purchase of goods for the army and wages of civil servants and military personnel. 5 obliges economic entities and households to pay taxes T , which are the main source of budget revenues and a means of redistribution of national income. There are direct and indirect taxes. The former are imposed on income and property, while the latter are included in the prices of goods and services (for example, value added tax (VAT), sales tax, excise taxes, etc.). 5 pays transfers Tr to households, such as pensions, scholarships, unemployment welfare, poverty reliefs, disability allowances, and subsidies Sb to firms. Transfers and subsidies are non-consumption payments that households and firms receive from the government. Government purchases of goods and services, transfers, and subsidies are government expenditures. Taxes are the main source of government revenue that allows the government to pay for its expenses. To simplify the analysis, subsidies are usually not considered separately in macroeconomic models. This is due to the fact that in developed countries, subsidies are usually paid directly only to agricultural producers and only during periods of serious downturns. Firms receive assistance from the government in an indirect form through tax benefits (for example, through an investment tax credit).

25 1.4 · Basic Concepts and Definitions

1

. Fig. 1.4  Visualization of the leakages-injections model. Source Authors’ development

. Fig. 1.5  The three-sector turnover model for an open economy with the involvement of the public sector. Note C = consumption; Y = factor incomes; G = government procurement; I = investment; T = taxes; S = savings; Sb = subsidies; Tr = transfers; B = borrowing; P = payments (wages, rent, interest, profit). Source Authors’ development

The inclusion of the foreign sector in the analysis establishes a four-sector model of the open economy. The model takes into account linkages between the national economy and the global market (. Fig. 1.6). In the case of a trade surplus, a country receives more money from the foreign sector for the sale of its goods and services than it pays for the purchase of foreign goods and services—the country’s income from international trade exceeds its expenses. This means that the country acts as a saver (lender). In order to get the missing funds to pay for goods and services purchased from a given country, the foreign sector takes a loan, selling financial assets (securities) to this country (Kout, or capital outflow in . Fig. 1.6). Capital outflow is money flowing out

26

Chapter 1 · Introduction

1

. Fig. 1.6  The four-sector turnover model for an open economy with the involvement of the public sector and the foreign sector. Note C = consumption; Y = factor incomes; G = government procurement; I = investment; T = taxes; S = savings; Sb = subsidies; Tr = transfers; B = borrowing; P = payments (wages, rent, interest, profit); Ex = export; Im = import; Kin = capital inflow (in case of trade balance surplus); Kout = capital outflow (in case of trade balance deficit). Source Authors’ development

of the domestic financial market in the form of payments for the purchase of foreign financial assets and loans to foreign borrowers. In the case of a trade deficit, a country acts as a borrower. Since the country’s expenses for the purchase of foreign goods (import costs) exceed the income received from the sale of its products to the foreign sector (export income), it borrows from the foreign sector by selling its financial assets and receiving cash to pay for them (Kin, or capital inflow in . Fig. 1.6). Capital inflow is the inflow of funds into the domestic market as a result of the sale of national financial assets to foreign buyers and/or loans from foreign financial intermediaries. This means that the savings of the foreign sector flow into the economy. The difference between the value of foreign assets purchased by domestic economic agents and the value of assets purchased by foreigners in a given country is called net foreign investment (NFI). It corresponds to net capital outflow (the difference between capital outflow and capital inflow). There are direct and portfolio foreign investment. Foreign Direct Investment (FDI): an economic entity of one country buys and controls capital in another country (creates a subsidiary, opens

27 1.5 · National Economy and Reproduction

1

a branch of a company, or buys a foreign company). Foreign Portfolio Investment (FPI): an economic entity of one country buys shares of a foreign company, but does not have direct control over this company. Commonly, macroeconomic analysis considers portfolio investments—the movement of financial assets between countries. Capital flows are considered as payment for financial assets purchased by countries from each other (private and public). Net foreign investment (NFI) always equals to net exports NX . When NX > 0 , the income received by a country from the sale of its products to other countries exceeds its expenses for the purchase of goods and services from other countries (Ex > Im). Therefore, a country acts as a saver (lender), while the foreign sector acts as a borrower (the savings of the foreign sector SF < 0). Capital outflow is granting loans to other countries. In such a case, NFI > 0, which means that investments made by domestic economic entities into foreign countries exceed those made by foreigners into the domestic market. When NX < 0, a country purchases more goods and services from abroad than it receives from other countries in exchange of its products (Im > Ex). In this case, SF > 0, which means that the foreign sector acts as a saver (lender). A country borrows from abroad to pay for imports. As such, capital flows into the economy, and the net foreign investments are negative (NFI < 0). 1.5  National Economy and Reproduction 1.5.1  Macroeconomics and National Economy

The system approach to the study of the national economy provides for the consideration of the national economy as an open economic system. This implies the existence of three main elements: a territory in which the economic system operates and develops, a set of industries as the basis of economic activity, and the population living in this territory. The system is considered as an interconnected integrity of internal components: economic, environmental, social, and demographic subsystems. Across these subsystems, main goals of the macroeconomic analysis on the national level could be summarized in the following four points: 5 determination of the conditions (historical preconditions, contemporary trends) favorable for the economic development of a particular country; 5 description of the internal structure of the national economy and identification of factors that make it possible to effectively address national specifics of the scarcity issue; 5 specification of historical, social, economic, political, and environmental conditions and selection of the most suitable form of economic order for a given country; 5 evaluation of the effectiveness of economic regulations and decisions made by various economic actors, including strategic and tactical decisions made by the government.

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Chapter 1 · Introduction

. Table 1.3  Country-level methods of macroeconomic analysis Methods

Study subjects

System approach

Economy as a system; types of economic systems; major economic goals; national economy in the global market

Macroeconomic approach

Macroeconomic indicators and trends, theories and models; markets of capital, labor, goods, services, and money

Mesoeconomic approach

National economy as a set of industries; interindustry inflows and outflows; input-output balance

Regional studies

Comparative advantages of regions; allocation of resources and production forces

Institutional method

Interests, motivation, and behavior of economic actors; trade associations and other organizations; laws, customs, and informal rules

Historical method

The specifics of the previous stages of the economic and historical development of a country, the national community; the parameters of the current stage of historical development; resources and possible scenarios of historical development in the future

Source Authors’ development

There are six methods of macroeconomic analysis commonly employed at the country level (. Table 1.3). The term “national” should be perceived as a synonym for “country-wide”, where the national economy is the economy of the entire country, not of industries, territories, or ethnic entities. Here, “nation” refers to the population of a country. As a branch of science, national economics studies the specific historical preconditions and contemporary development trends of a particular country from the position of how the country-specific features of macroeconomic processes manifest themselves in certain conditions. It is advisable to start studying such implications of macroeconomic processes by considering economic reproduction as the basis for the development of the national economy. The reproduction-based approach allows considering the national economy as a self-reproducing system, rather than a set of enterprises, households, industries, etc. This means that the interaction and interrelations between the elements of this system create conditions for the continuation, resumption, and repetition of economic processes. 1.5.2  Economic Reproduction

Economic Reproduction refers to recurrent (or cyclical) processes in the sphere of production. Society cannot stop consuming and producing. Every process of production, considered in a continuous flow of its renewal, is a process of reproduction conditioned by the circulation of goods and money in the market economy. The market cannot exist without reproducing all the elements of the economy. In

29 1.5 · National Economy and Reproduction

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other words, in order for the economic system to function, it must reproduce raw materials, means of production, labor force, and other resources—not only as elements of production, but also as economic relations. Moreover, the subjects of these relations are not individual economic agents, but aggregated groups of economic actors. In the market economy system based on the division of labor, reproduction is possible provided that all goods are sold and all means of production and consumer goods are reimbursed. This condition implies compliance with certain proportions in the economy. For the first time, the idea was articulated by Francois Quesnay (1694–1774), who is considered to be the farther of macroeconomic analysis. The Quesnay’s model of reproduction is closely related to his theory of classes, which he distinguished depending on their contribution into the creation and appropriation of a pure product. According to Quesnay, the nation consists of the productive classes of the proprietors and cultivators of land and the unproductive class composed of manufacturers and merchants. He demonstrated the way in which the products of agriculture, which is the only source of wealth, would in a state of perfect liberty be distributed among the classes of the community. Farmers create a pure product, proprietors (king, lords, church) appropriate this product, while the unproductive class transform the agricultural product into another form. He did not distinguish between capitalist farmers and land-owners, combining them into one productive class. Quesnay presented the process of reproduction not only as the reproduction of material goods, but also as the reproduction of classes, i.e., industrial relations. For the first time, he raised the question of basic and derivative incomes. Quesnay analyzed only simple reproduction, abstracting from foreign trade and price variability. He demonstrated that the repetition of the production process is possible under the condition of proportionality, which is achieved on the basis of competition and free play of prices, i.e., on the basis of the natural order. State intervention violates this order. The concept of natural order mistakenly transferred the eternity of the laws of nature to economic laws. Case box The simple account of the Quesnay’s reproduction process given by Bilginsoy (1994) runs as follows: initially, farmers and artisans hold annual advances of two billion livres’ worth of agricultural product, respectively. Farmers also hold two billion livres’ of money, which, in turn is paid to the landowners as the rent. Farmers and artisans use their annual advances to produce five billion livres’ worth of agricultural and two billion livres’ worth of industrial product, respectively. Next, landowners buy one billion livres worth of agricultural and one billion livres worth of industrial product for consumption purposes. Farmers spend one billion on industrial good to replenish their original advances. Artisans spend one billion of their advances on subsistence food consumption and the other one billion to purchase raw materials from the agricultural sector. Thus, when the circle is completed, the economy is once again ready to reproduce itself: farmers are left with two billion livres worth of agricultural goods and two billion livres; artisans hold annual advances of one billion in the form of raw materials.

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Chapter 1 · Introduction

Later, Karl Marx approached to the Quesnay’s theory of reproduction through the lens of society and developed the theory of reproduction and circulation of social capital, which included the abstract theory of implementation, the theory of national income, and the theory of economic crises. Marx viewed reproduction as the process by which society re-created itself, both materially and socially. He distinguished between “simple reproduction” and “expanded (or enlarged) reproduction”.3 In the former case, no economic growth occurs, while in the latter case, more is produced than is needed to maintain the economy at the given level, making economic growth possible. The Marx’s theory is detailed in the following chapters in this book (see 7 Chap. 15, 7 Sect.  15.3 for the Marxist vision of economic development). Here, the main provisions of the reproduction approach could be summarized as follows: 5 The production of material goods in any society is a continuously repeating process, or reproduction. 5 The reproduction of social capital involves its transformation in the spheres of production and circulation. The result of this movement is expressed in the gross social product, while social capital itself is a set of individual capitals interconnected through the market mechanism. 5 The process of reproduction is the unity of three processes: the reproduction of the gross social product, productive forces, and production relations. These processes can be separated only theoretically. In reality, they are carried out in unity and interaction. The gross social product is the material basis for the continuous renewal and development of production. The reproduction of productive forces includes the reproduction of labor and means of production. The reproduction of natural resources, or natural conditions for economic growth, is pivotal. As society develops, reproduction becomes increasingly economic and environmental in its nature. 5 Reproduction covers all four phases of social production – production—creation of material goods required for the existence and development of society; – distribution—determination of the contribution of each member of society to the production (input, quality, proportion of participation); – exchange—movement of goods and services from one entity to another, a form of social communication between producers and consumers that mediates the social exchange of values; – consumption—use of produced goods and services to meet certain needs. 5 Expanded reproduction based on mechanization is the core factor of economic and social development. Added value is the source of expansion (accumulation) of social capital. 5 The continuity of social production is provided by the establishment and availability of material and public reserves in the amount of the one-year volume of production.

3

Marx (1867).

31 1.5 · National Economy and Reproduction

1

5 Reproduction implies a relationship between the structure of production and the structure of social needs, i.e., a certain proportionality. 5 Social production is divided into the production of means of production and production of consumer goods. There are a variety of relations between economic entities. Enterprises produce and sell; households consume and accumulate; state bodies collect taxes and meet collective needs. In order to simplify all the complicated processes in the national economy, the continuous repetition of production and consumption processes can be represented as a model of economic turnover (previously addressed in 7 Sect.  1.4). At the same time, alike economic units are combined (aggregated) into sectors (economic entities), while alike economic operations are combined into flows (goods and services, money, etc.). Enterprises and firms that produce goods and services consumed in domestic market by households and other economic actors are the main creative links in the economic turnover chain. Enterprises operate in a close connection with customers (demand for their products), as well as between themselves (supply of resources). Through purchase and sale, these relationships are carried out in the consumer market, where goods and services are sold, and in the resource market, where factors of production are purchased. The constant renewal, repetition, and continuation of these relationships is the criterion of economic reproduction. All goods in economic circulation are dual in their nature (tangible and monetary). Households are the starting point in economic turnover. To meet their needs for food, clothing, and other goods, they offer land, labor, capital, and entrepreneurial abilities as factors of production. On the other hand, households represent both the final product of economic turnover and its ultimate goal. Production functions to facilitate consumption. Thus, consumption is ensured by the sale of resources, their productive consumption, production, and sale of tangible goods and services. Households pay direct taxes to the state (income, wages, land, etc.) and receive wages, allowances, and other transfer payments from the state (pensions, scholarships, subsidies, etc.). Enterprises pay indirect (turnover tax, excise tax) and direct taxes (profit tax, social insurance contributions) to the state and receive transfer payments from the state in the form of subsidies, tax benefits, bonuses, preferential loans, and payment of current expenses of public bodies. This model represents the economic turnover in a closed national economy. As demonstrated in 7 Sect. 1.4, in an open economy, the foreign sector is added to the economic turnover scheme. The continuing repetition of these circular processes constitutes economic reproduction. There are different types of economic reproduction. Commonly, two criteria are used to distinguish between the quantity of reproduced product and the quality of the reproduction process in economic terms (. Table 1.4). The way of usage of revenue, additional product, and other forms of a surplus value allows giving a quantitative characteristic of reproduction, i.e., whether the total output in the economy increases, contracts, or remain stagnant. However, any society is also developing qualitatively, which means that economic and social

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Chapter 1 · Introduction

. Table 1.4  Types of economic reproduction Criteria

Type of reproduction

Definition

Use of surplus value

Simple

Repetition of the production process on the same scale. No economic growth occurs, because all the new surplus value created by wage-labor is spent by the employer on personal (final) consumption

Expanded

Repetition of the production process on an increased scale. Economic growth is possible, because a part of the new surplus value is reinvested in production (more is produced than is needed to maintain the economy at the given level)

Contracted

Repetition of the production process on a smaller scale due to the lack of income or the inexpediency of the development of this type of production. Business operating at a loss outnumbers growing business. This causes investment, employment, and output in the economy to fall, so that the GDP and national income decline

Extensive

Increase in the scale of production due to additional labor and material resources (factors of production) on the same technical basis and at the same level of qualification of employees

Intensive

Increase in the scale of production due to the qualitative change in the factors of production, the transition of production to a new technical and technological levels

Mixed

Increase in the scale of production due to the mix of extensive and intensive approaches to the use of resources

Qualitative parameters of production factors

Source Authors’ development

phenomena are never reproduced in their original form even in case of the simple reproduction. As a rule, expanded reproduction occurs, when production is resumed on an ever-larger scale and in qualitatively new forms. Extensive reproduction is one of the forms of reproduction of an expanded type, which means an increase in the scale of production due to additional labor and other resources on the same technical basis and at the same level of qualification of employees. The resulting increase in output is achieved by an increase in all involved resources.

33 1.5 · National Economy and Reproduction

1

Commonly, extensive growth includes an increase in the number of employees, working hours, lands, extracted raw materials and energy, etc. It is widely accepted that the extensive type of reproduction restricts opportunities for economic growth in the long-run, because it encounters scarce resources, therefore, it itself gets restricted. In contrast to extensive reproduction, the intensive one is characterized by a qualitative change in the factors of production and the transition of production to a new technical or technological level. Intensive and extensive factors are always in a certain combination, mutually complementing each other. The boundaries between them are relative and flexible. In history, there has been a constant mutual transition from one type of reproduction to the other. Therefore, in various mixed combinations, in various periods of time, extensive approaches prevail over intensive one, and vice versa. That is why when studying intensification of economic growth, one should distinguish between intensification as an increase in labor intensity and as a transfer of the economy to a predominantly intensive path of development, when much of the total output (its increase) is obtained due to intensive factors. The intensive type of economic reproduction goes through two stages in its development. The first stage is a partial intensification associated with the mass displacement of manual labor and its replacement with machine labor. At this stage, the intensification is carried out mainly due to labor force. The second stage is the increase in labor productivity due to the saving of all factors of production, an absolute reduction in costs per unit of effect. This type is characterized by a simultaneous increase in the intensity of all factors of production. An intensive type of economic reproduction means the expansion of production due to a better, more complete use of various resources based on the achievements of science and technology and their qualitative changes. The intensification is possible through the update of equipment and modernization of production process, better use of all resources, progressive shifts in the industrial structure of production, saving of resources, professional development of employees, strengthening of labor discipline and motivation to work, environment protection, better management, optimization of foreign economic relations, etc. Since intensification unites the improvement of the material and individual factors of production and the achievement of the greatest performance, the intensification parameters can be divided into two groups. The first group includes factors that reflect the improvement of production and characterize the technical and economic level of production in a certain period of time: 5 age composition of the equipment, its suitability or depreciation, and the share of obsolete equipment in the total assets (for example, the coefficient of renewal of production facilities); 5 capital-labor ratio (average annual cost of funds divided by the average number of employees); the energy-labor ratio; 5 degree of mechanization and automation of production (coefficient of mechanization, i.e., the volume of output produced by machines divided by the total output as a percentage);

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Chapter 1 · Introduction

5 technical and economic level of output, the correspondence of manufactured products to international standards of quality, competitiveness of domestic production; 5 level of organization of production (the degree of division of labor, introduction of advanced approaches); due to the mobilization of these factors, it is possible to significantly increase the growth rate of labor productivity; 5 quality of labor force; 5 structure and rational use of investments, their role in improving the quality and expanding the assortment of production. The second group of indicators of intensive expanded reproduction characterizes the efficiency of economic production or the entire economy. To summarize, it should be said that the single economic space establishes the basis of economic reproduction and ensures its integrity as a system. The economic space is a set of material and technical conditions of production, branches of the infrastructure of public production (transport, telecommunications, and energy systems), and institutions created by the state. Chapter Questions: 5 What is macroeconomics? How does it differ from microeconomics? 5 State the main likely macroeconomic objectives for an economy. 5 What is meant by a leakage from the income-expenses flow? Provide examples of leakages. 5 How could a certain leakage be addressed by an injection? Establish leakages-injections pairs and explain relationships between variables within them. 5 What components does the economic turnover include? Subject Vocabulary: Aggregate Demand: the total amount of demand for all finished goods and services produced in an economy at any given price level in a given period. Aggregate Supply: the total supply of goods and services produced within an economy at a given overall price in a given period. Asset: a resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit. Economic Reproduction: recurrent (or cyclical) processes by which the initial conditions necessary for economic activity to occur are constantly re-created. Flow: a transfer of values by economic actors to each other in the process of economic activity; the creation, transformation, exchange, transfer, or extinction of economic value that involve changes in the volume, composition, or value of assets and liabilities. Macroeconomics: a branch of economics that studies the economic behavior of aggregate economic actors (sectors of the economy) in aggregated markets and considers economic issues that affect the entire economy (not individual industries) and society as a whole.

35 References

1

Microeconomics: a branch of economics that studies the implications of economic behavior of individual economic actors in the markets of certain goods, services, and factors of production in various types of market structures. Public Procurement: an expense of the state for the maintenance of public administration bodies, the carrying out of state orders for the industry, the production of public goods. Transfer: a non-reciprocal irrevocable payment made by the state to address economic, social, or other issues.

References Bilginsoy, C. (1994). Quesnay’s tableau economique: Analytics and policy implications. Oxford Economic Papers, 46, 519–533. Keynes, J. M. (1936). The general theory of employment, interest and money. Macmillan. Marshall, A. (1890). Principles of economics: An introductory volume. Macmillan. Marx, K. (1867). Capital: A critique of political economy. 7 https://www.marxists.org/archive/marx/ works/1867-c1/. Zhuravleva, G. (Ed.). (2014). Economic theory. Macroeconomics-1, 2. metaeconomics. Economics of transformation. Dashkov & Co.

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Macroeconomic Indicators

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_2

2

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Chapter 2 · Macroeconomic Indicators

Learning Objectives: 5 Learn how to calculate costs, revenue, and profit and understand the relationship between various types of these parameters 5 Understand the concept of the economies of scale 5 Differentiate between gross domestic and national products, income, and wealth 5 Master macroeconomic analysis skills using various approaches to the calculation of major indicators 5 Summarize major threats to and limitations of macroeconomic measurements 2.1  Costs, Revenues, and Profit

As is well known from economic theory, the purpose of economics is to satisfy human needs. The means of achieving this goal is production, in the process of which both tangible economic goods and intangible services are created. Society cannot stop producing, because it cannot stop consuming. Therefore, the main goal of macroeconomics is to ensure economic growth and development through the expansion of production. Macroeconomic measures of growth and development are based on such fundamental concepts of microeconomics as costs, revenues, and profit. It is their interrelation that allows producers to make decisions about the production of goods and services at the micro-level. Individual decisions are aggregated and transformed into general macroeconomic trends. 2.1.1  Costs

Every company strives to get the maximum profit from its production and commercial activities. There are two ways to achieve this goal: by increasing prices and by reducing the cost of resources used for the production and sale of products. Costs are the expenses incurred in a production process, the cost of resources and factors of production in a monetary form. Costs are usually associated with certain losses that must be incurred to obtain results. Therefore, costs are all material, natural, energy, information, labor, and other costs expressed in monetary form. Sales price largely depends on the amount of costs, since it is based on the cost of resources. Costs were first studied by representatives of the classic school of economic thought. Smith introduced the concept of absolute costs, while Ricardo developed the idea of comparative costs. By costs, they understood the average social costs incurred in the production of a unit of goods at an enterprise. According to Marx, the cost of production is what the commodity costs a capitalist, i.e., the aggregate costs of acquiring the means of production and labor (constant capital C and variable capital V ). In the market economy, all costs of a firm are considered as opportunity costs. They arise due to limited resources. Opportunity costs are the costs estimated

39 2.1 · Costs, Revenues, and Profit

2

in terms of benefits in the production of various goods and services, or it is the amount of one product that needs to be sacrificed to increase the production of another. Thus, Opportunity Costs represent the potential benefits an individual or business misses out on when choosing one alternative over another. Case box The company sold its product A for $200. The total expenses of the company amounted to $175. From this, profit equalled $25 (200 − 175). Based on the forecast data, in that same year, the company had an opportunity to reorient itself to the production of product B. The expected annual sales volume for product B was $220, the expected total costs—$196. Therefore, the profit from reorienting on product B could be $24. In this case, $24 is the opportunity cost of choosing product A over product B. Since the actual profit minus alternative cost is greater than 0 (25 − 24), the chosen alternative for the production of product A is considered optimal.

Costs can be defined as fixed costs (FC), variable costs (VC), total (gross) costs (TC), marginal costs (MC), and average costs (AC). Fixed Costs are costs that remain unchanged regardless of the amount of goods or services produced or sold. They are expenses that have to be paid by a company, regardless of any specific business activities. Examples of fixed costs are depreciation of equipment, rent, salaries of administrative staff, interest paid on loans, travel expenses, etc. These costs also exist when a company does not produce anything. Case box The company spends $300 a month on salaries, $100 on renting retail space, $55 on depreciation expenses, $34 on property taxes, and $40 on advertising. As a result, fixed costs reach $529 per month. This amount must be multiplied by 12 to get the amount of fixed costs for the year. Total fixed costs remain unchanged. But in the simple two-factor economic model, the growth of output increases revenues, which means that the average fixed costs could go down. The average fixed costs are calculated by dividing total fixed costs by the amount of goods or services produced.

Variable Costs are costs that change in proportion to how much a company produces or sells, i.e., they rise as output increases and fall as output goes down. Examples of variable costs include expenses for the purchase of raw materials, fuel, direct labor costs, shipping expenses, etc. The higher the amount of goods or services produced and sold, the greater the amount of variable costs, and vice versa. When production starts, variable costs grow quickly, then somewhat slower, then after a certain point E, they again increase faster than the rate of increase in production does (. Fig. 2.1). This indicates that the law of diminishing returns or productivity of costs (factors) of production comes into effect.

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Chapter 2 · Macroeconomic Indicators

2

. Fig. 2.1  Fixed, variable, and total costs. Source Authors’ development

Total (Gross) Costs are costs of a company for the production and sale of products, including entrepreneurial profit as a reward for entrepreneurial risk. With the start of production, they grow faster than output increases, then after reaching a certain level, their growth slows down. At some point, total costs overtake the growth of output. This is the diminishing returns principle, which says that each company has its own optimal size, beyond which costs grow faster than production (economies and diseconomies of scale are further detailed in 7 Sect.  2.2). Total costs represent a sum of fixed and variable costs (Eq. 2.1):

TC = FC + VC

(2.1)

Case box The company produces 2,000 shoes a year. It incurs the following costs: rent payments ($25,000), interest payment ($11,000), labor costs per one pair of shoes ($20), and raw materials per one pair of shoes ($12). Rent and interest payments are fixed costs. Since fixed costs do not change their value when output changes, they equal $36,000 ($25,000 + $11,000). The cost of production of one pair of shoes is variable costs ($20  +   $12   =   $32). With total annual amount of sale, variable costs reach $64,000 ($32 X $2,000). Total costs are calculated as the sum of fixed and variable costs: $36,000 + $64,000 = $100,000.

Marginal Costs are additional costs required for the production of an additional unit of goods or services. In other words, it is the change in total production cost that comes from making or producing one additional unit. Marginal costs are calculated by dividing the change in production costs by the change in quantity (Eq. 2.2):

MC =

TC Q

(2.2)

41 2.1 · Costs, Revenues, and Profit

2

. Fig. 2.2  Marginal productivity of factors of production. Source Authors’ development

A firm increases output if an additional unit of production costs is lower than its selling price until the marginal costs equal the price of the product. Marginal costs show how much it will cost a company to increase the volume of production by one unit. In the beginning, the marginal costs can be reduced to the point of marginal productivity in the production of an additional unit of goods or services (point E in . Fig. 2.2). Gradually, MC increases and reaches variable costs at point O. Therefore, at a certain level of production, the benefit of producing one additional unit and generating revenue from that item will bring the overall cost of producing the product line down. The key to optimizing manufacturing costs is to find that point or level as quickly as possible. Average Costs are the costs of producing a unit of production. AC is defined as the ratio of the total (gross) costs TC to the amount of goods or services produced Q (Eq. 2.3):

AC =

TC Q

(2.3)

. Figure 2.3 demonstrates the reversed arc-shaped AC curve. When production starts, average costs are high at C1, since fixed costs are distributed over a small amount of goods Q1. With an increase in the output to Q2, AC falls to C2. When the output reaches Q0, AC results in its minimum point M . After passing the point, AC is increasingly influenced by variable costs (purchase of raw materials, materials, etc.), thereby, the average costs increase to C3 and continue rising as the output volume expands. The arcing of the AC curve is caused by positive and negative economies of scale further explained in 7 Sect. 2.2.

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Chapter 2 · Macroeconomic Indicators

2

. Fig. 2.3  Average costs and the economy of scale. Source Authors’ development

Case box The economy of scale is the return caused by the increase in output. It is manifested in the positive, constant, or negative reduction of average costs per unit of production. For example, when the increase in the use of resources by two times results in the increase in output by three times, the effect is positive. This could be achieved by introducing innovations or specialization in the production of certain goods. A neutral effect implies a constant scale of production, i.e., when an increase in the amount of resources by two times results in a symmetrical increase in output by two times. With an increase in output, the neutral effect disappears. The negative effect provides for an increase in production by less than two times with an increase in resources by two times. This can happen when the company’s activities do not correspond to the scale of production, problems in management, etc.

Average costs are divided into average fixed costs (AFC), average variable costs (AVC), and average total (gross) costs (ATC). Average Fixed Costs are determined by dividing the total fixed costs TFC by the amount of goods or services produced Q (Eq. 2.4):

AFC =

TFC Q

(2.4)

With an increase in the amount of products, average fixed costs will decrease. Consequently, fixed costs per unit of output tend to a minimum. Conversely, with a decrease in the amount of goods or services produced, higher fixed costs are accounted for each unit of output. As a result, average fixed costs increase (. Fig. 2.4).

43 2.1 · Costs, Revenues, and Profit

2

. Fig. 2.4  Average fixed costs. Source Authors’ development

Average Variable Costs are calculated by dividing the total variable costs TVC by the amount of goods or services produced Q. With an increase in output, average variable costs fall and reach their minimum value. After passing the minimum, they begin to rise under the influence of diminishing cost productivity law. Average Total Costs are determined in two ways: by dividing the total costs TC by the volume of production Q (Eq. 2.5) and by summing the average fixed costs AFC and average variable costs AVC (Eq. 2.6).

TC Q

(2.5)

ATC = AFC + AVC

(2.6)

ATC =

In the long run, the average costs curve TAC can be drawn as a tangent to the set of short-term curves of average costs ATC n (. Fig. 2.5). These curves rise in

. Fig. 2.5  Average costs curves. Source Authors’ development

44

2

Chapter 2 · Macroeconomic Indicators

accordance with the law of diminishing returns. This means that an increase in production volume will sooner or later bring losses. If outdated equipment is replaced with a modern one, then the costs for each new technology will be different ( ATC 1, ATC 2, ATC 3, etc.). In the long run, the total average costs curve TAC shows changes in the company’s costs in the longterm period with different technological changes (processes). In the conditions of perfect competition in the long term, a firm maximizes profit provided that the price of the good is equal to the average costs, marginal income, and marginal costs. 2.1.2  Revenues

Similar to costs, revenues can be analyzed by using total, average, and marginal values, i.e., the parameters of total revenue (TR), average revenue (AR), and marginal revenue (MR). Total Revenue is the total amount of money that a company earns by selling all products or services at market prices during a period of time. This is the result of the work of a firm or an individual in monetary terms. Revenue for the owners of the factors of production becomes costs for the buyers of these factors. Thus, for a worker, who is the owner of labor, wages are income (payment for labor), while for an enterprise, labor is one of the production costs. Total revenue is calculated as the product of the market price P of a good or a service by the amount of goods or services sold Q (Eq. 2.7).

TR = P × Q

(2.7)

A firm operating in a market of perfect competition (where each economic entity accounts for an insignificant share of the market) cannot influence the price. Therefore, for such a firm, the price of its goods or services is a given value. Therefore, the total revenue depends only on the volume of output. The situation is different in the market of imperfect competition, where a firm can influence the price. In order to sell more products, it reduces the price. In this case, the total revenue of a company depends on both the price and the volume of production. Average Revenue is the revenue received from the sale of a unit of output. It is defined as the ratio of total revenue TR to the amount of goods or services sold Q (Eq. 2.8). In terms of its value, average income equals market price.

AR =

TR Q

(2.8)

Marginal Revenue is the increase in revenue from sales growth per additional unit of output. It is calculated by dividing the increase in total revenue TR by the increase in the amount of goods or services Q (Eq. 2.9). This is the receipt of additional revenue from the sale of an additional unit. It shows the degree of performance of a company. In perfect competition, the marginal revenue of a competitive firm coincides with the market price of products.

2

45 2.1 · Costs, Revenues, and Profit

MR =

TR Q

(2.9)

Case box The company sells 10 packages of milk for $9 each, which gives a total revenue of $90. To sell 11 packages, the company needs to reduce the price to $8.50, resulting in the total revenue of $93.50 (8.50 × 11). This means that the marginal revenue of 11 packages is $3.50 ($93.50 − $90). Most likely, in this situation, the company will decide to increase sales at a lower price.

Case box The company sells 200 cans of orange drink for $2 each. The total revenue is $400. If the price is reduced from $2 to $1.95, the company will be able to sell an additional unit of orange drink. The total revenue from the sale of 201 cans at $1.95 is $391.95. Thus, the marginal revenue equals to $400 − $391.95 = (−$8.05). This means that if the price decreases and an additional unit is sold, the company incurs losses. Most likely, in this situation, the company will abandon plans to reduce the price.

Taking into account the participation of factors of production in the formation of income, there is a distinction between factor and disposable income. Factor Income is the flow of income that is derived from the factors of production, i.e., the general inputs required to produce goods and services. Factor income is primary income. It is formed from the use or sale of capital, labor, and land. Factor income is most commonly used in macroeconomic analysis, helping governments to determine the difference between GDP and GNP (further detailed in 7 Sect. 2.3). Factor income comes in the following forms: wages as income generated from labor, rent as income on the use of land, interest as income generated from capital, and profit is an assessment of the work of an entrepreneur. Disposable Income is the final (net) income or factor income after paying direct taxes, social insurance contributions (pensions, benefits, scholarships, etc.). It is used by an individual or a household at their own discretion. At the macro level, disposable personal income is closely monitored as one of the key economic indicators used to gauge the overall state of the economy. Income is subject to distribution between different categories of employees. The wellbeing of people largely depends on the level of income received. Therefore, a fair distribution of income depending on the use of factors of production (wages for labor, rent for land, and interest for capital) is very important. At the same time, these incomes represent the prices of the factors of production, i.e., the incomes are used to purchase capital, land, labor, etc. As a result, it turns out that a distribution of monetary income is also carried out through the prices of factors of production.

46

Chapter 2 · Macroeconomic Indicators

2.1.3  Profit

2

Profit is the main parameter of production efficiency, the goal of a firm, and the driver of the market economy. Mercantilists were among the first who developed and studied the concept of profit. They believed profit to arise in the sphere of circulation, in foreign trade, as a result of selling domestic products on the international market at a higher price. Physiocrats argued that profit is created only in agriculture. Smith and Ricardo justified the idea of creating surplus value in material production. They defined profit as a deduction from the product of the worker’s labor in favor of a capitalist. Developing this approach, Marx called profit a converted form of surplus value, i.e., the surplus value which turns into profit after the sale of a good or service. The source of profit is the unpaid labor of hired workers, or surplus labor. Neoclassicists do not recognize the labor theory of value and consider surplus over costs to be profit. According to the neoclassical vision, profit is established as a reward for skillful actions and knowledge applied by an entrepreneur, introduction of technical and technological innovations, payment to an entrepreneur for the risk and uncertainty, the establishment of high (monopoly) prices, and due to a shortage of goods or services on the market. Summing up these components of profit, one receives a total profit. One part of it is an entrepreneurial profit, and an entrepreneur receives it in the form of salary. This part is included in the production costs as a normal profit. The other part of the total profit is the excess profit or excess over the costs. It is not included in the production costs. It is the result of technical innovations, monopoly prices, deficit in the market, etc. Profit is the difference between the total revenue TR from the sale of goods or services and the total costs TC of the production and sale of goods or services (Eq. 2.10). In monetary terms, profit can be described as a financial benefit realized when the revenue generated from a business activity exceeds expenses, costs, and taxes involved in sustaining this activity.

P = TR − TC

(2.10)

Although profit is a microeconomic concept, it performs the following functions in macroeconomics: 5 Distribution. Profit establishes funds that ensure the effective operation of firms, industries, and the entire economy. 5 Incentive. Profit is a driver of the market economy. It helps to reduce production costs. An increase in profit is a signal for the development of production. 5 Budgeting. At the expense of profit, budget revenues at various levels are established. The greater the profit of businesses, the bigger the budgets of administrative entities and the national budget. The following types of profit are distinguished: 5 Total (gross) profit is a deduction of total costs TC from the total revenue TR; it looks at profitability after direct expenses. 5 Operating profit is calculated by deducting operating expenses from gross profit; therefore, it looks at profitability after operating expenses.

47 2.1 · Costs, Revenues, and Profit

2

5 Net profit is the income left over after all expenses, including taxes and interest, have been paid. It is calculated by deducting both of these from operating profit. A company uses net profit to solve its production, economic, and social tasks. From the net profit, a businessman receives entrepreneurial income in the form of wages. The degree of increase in profit is shown by the profit rate—the ratio of profit P to the funds spent C, expressed as a percentage. 5 Accounting (financial) profit is net income earned after subtracting all monetary costs from total revenue. It shows the amount of money a firm has left over after deducting the explicit costs of running the business (wages, inventory needed for production, raw materials, and production, transportation, sales, and marketing costs). 5 Economic profit is a profit an entity earns after accounting for both explicit and implicit costs. It is different from accounting profit because it also includes implicit costs, which are various opportunity costs a company incurs when allocating resources elsewhere (company-owned buildings, equipment, self-employment resources). 5 Normal profit occurs when the difference between a company’s total revenue and combined explicit and implicit costs are equal to zero, or alternatively when revenues equal explicit and implicit costs. Profit maximization is one of the main goals of any company. It is achieved through the interaction of external and internal factors of the company’s activities. The main requirement for maximizing profit is the profitability of each unit of output. If the marginal revenue MR is greater than the marginal costs MC, the profit increases, and its maximum is not reached. As soon as MC exceed MR, the growth of total profit stops. Consequently, profit reaches its maximum, when MR = MC. Case box . Table 2.1 presents data on output, revenue, costs, and profits at the Smith’s dairy farm. If the farm produces 1 L of milk, its profit is $1, with 2 L it increases to $4, etc. It is obvious that Smith will produce as much milk as possible to get the maximum possible revenue, that is, he will strive to maximize it. In this example, profit maximization is achieved with 4 or 5 L of milk with a profit of $7. The decision on the output can be considered from the other side by comparing the marginal revenue and the marginal cost of producing every additional unit of milk. The marginal revenue of the first litre of milk produced is $6, the marginal costs are $2, that is, by producing the first unit, Smith will ensure a profit increase of $4. As long as the marginal revenue exceeds the marginal costs, Smith should continue increasing the production of milk, since this will increase profits. The situation changes when the volume reaches 5 L. The marginal revenue from the production of the 6th liter will be $6, and the marginal costs will be $7, which means a loss of $1 of profit. Therefore, Smith should produce no more than 5 L of milk.

Chapter 2 · Macroeconomic Indicators

48

. Table 2.1  Profit maximization case: Smith’s dairy farm

2

Output (Q)

Total revenue (TR)

Total costs (TC)

Profit (P)

Marginal revenue (MR)

Marginal costs (MC)

0

0

3

−3

1

6

5

2

12

8

1

6

2

4

6

3

3

18

12

6

6

4

4 5

24

17

7

6

5

30

23

7

6

6

6

36

30

6

6

7

7

42

38

4

6

8

8

48

47

1

6

9

Source Authors’ development

In conditions of perfect competition, price P is a given value for a company. Any amount of goods and services are sold at the same price. The average revenue AR will also be constant and equal to the marginal revenue MR, since each subsequent unit of output will be sold at the same price as the previous one. In this case, P = AR = MR. Combining all the curves on one graph (. Fig. 2.6), a firm maximizes profit at the intersection point of the MR curve and the MC curve. The intersection of the marginal revenue MR with the marginal cost MC occurs at points M and K (. Fig. 2.7). At point M , marginal costs decrease, therefore, profit increases. A company increases its output to point K , which implies profit maximization. The maximum profit attracts new firms to the industry, which leads to an increase in supply and a decrease in the price of goods, thereby

. Fig. 2.6  Profit maximization at the intersection point. Source Authors’ development

49 2.1 · Costs, Revenues, and Profit

2

. Fig. 2.7  Intersection of marginal revenue with the marginal costs curve. Source Authors’ development

. Fig. 2.8  Profit maximization in the monopolistic market. Source Authors’ development

reducing the profits of firms. The influx of new firms into the industry stops when the price covers only average costs: P = AC. In a pure monopoly, a price is no longer a set value. The more products a company produces, the lower the selling price is. The demand D and average revenue AR curve has a negative slope, and MR stay below AR. A monopolist maximizes its profit at MR = MC, but MR < P (. Fig. 2.8). With the amount of goods and services produced Q1, a monopolist receives the maximum profit. The MR and MC curves intersect at point M , which corresponds to the output Q1. In its turn, volume Q1 corresponds to point O on the demand curve and price P1. If a firm that maximizes profit in the conditions of perfect competition can only control the volume of output, then a firm that maximizes profit in the conditions of pure monopoly determines the volume of output and price. A monopolist firm can produce fewer products and sell them at a higher price. Also, it can significantly reduce costs by increasing the output.

50

Chapter 2 · Macroeconomic Indicators

2.2  Economies and Diseconomies of Scale

2

Firms differ by their production capacity. Along with fairly large firms with tens of thousands of employees, there are medium and small enterprises, family companies, individual entrepreneurs, etc. Regardless of the size, firms strive to produce goods in such a volume when the average costs are minimal. But in a short period, a company is restricted by its production capacity, primarily, the amount of its capital. Meanwhile, at enterprises of different production capacities operating within the same industry, the volumes of product output at which average costs are minimized are different, i.e., each firm has its own average costs curve. Therefore, it can plan its optimal output within its average costs curve. Experiencing restrictions in its production capacity in the short run, any firm still plans its activities for the future. This means that it proceeds from the fact that it will be able to change its production capacity in the long run. When planning its activities, a company models the AC curves for various variants of production capacity. This allows it to set a volume of production at which the average costs are minimal, and, therefore, choose a variant of production capacity that minimizes average costs. It is believed that the larger the enterprise, the lower AC it enjoys. Larger companies can produce more by spreading the cost of production over a larger amount of goods. This effect is called the Economies of Scale—a reduction of production costs that is a result of making and selling goods in large quantities, for example, the ability to buy large amounts of materials at reduced prices. Economies of scale are cost advantages reaped by companies when production becomes efficient. However, the advantage is not always the case. As demonstrated in 7 Sect. 2.1, the effects of the economies of scale can be positive, negative, or neutral. In some cases, the growth of total costs lags behind the growth of product output. As a result, there is a positive effect of the economies of scale—a reduction of average costs with an increase in output. If the growth of total costs outstrips the growth of output, then there is a negative effect of the economies of scale—an increase in average costs with an increase in output. If the increase in total costs is equal to the increase in output, then there is a neutral effect of the economies of scale—average costs do not change with a change in output. Case box Suppose that when a firm increases its capital from 120 to 150 units and labor from 500 to 625 units, its output increases from 200 to 220 units. What is the effect of the economies of scale in this case? Capital increased by 1.25 times (150/120), labor increased by the same 1.25 times (625/500), while output increased by only 1.1 times (220/200), which is less than 1.25. Consequently, there is a decreasing return on scale (negative effect).

51 2.2 · Economies and Diseconomies of Scale

2

The type of the effect determines the minimum effective size of an enterprise, at which the volume of production allows minimizing average costs. Minimum effective sizes of enterprises are different for different sectors. In some industries, companies have quite significant volumes of output (for example, heavy industry, such as metallurgy and mechanical engineering). These industries have developed an oligopolistic structure (further discussed in 7 Chap. 3), when the supply is provided by several large enterprises. It is impossible to imagine a competitive small enterprise in such oligopolistic markets. But along with such industries, there are those in which the minimum effective size of a typical enterprise is small (service industries, retail trade, etc.). They are dominated by small businesses, which are often more viable than large firms. Among the determinants of the positive effect of the economies of scale, the following factors can be distinguished: 5 Specialization, which allows individual production operations to be performed on various types of specialized equipment, often in specialized departments, or by workers who have achieved a high degree of professionalism in their narrow areas. The specialization of management personnel also plays an important role. For example, in small firms, an entrepreneur by themselves develops the strategy, examines costs, carries out current operational planning, etc. Larger firms hire employees to perform these functions. Costs associated with the maintenance of managerial personnel in large firms are usually recouped by increasing the efficiency of production and the competitiveness of products. 5 Use of high-performance and expensive equipment, which is effectively employed only when fully loaded and when advanced technologies are applied. In this case, the costs associated with the operation of the equipment are reduced, since the price of high-performance equipment, as a rule, is lower per unit of production than that of low-performance equipment. 5 Large firms enjoy significant advantages in the market. The purchase of raw materials and the sale of products in large batches are usually associated with lower average costs than small batches. Large firms also significantly expand the boundaries of the market for their products. Commonly, they operate in both domestic and global markets. 5 Large firms are commonly considered as more reliable borrowers compared to smaller firms, therefore, they enjoy advantages in obtaining bank loans. Case box An example of a positive effect of the economies of scale is a livestock breeding enterprise for fattening cattle. Such a large agricultural complex is more profitable than small livestock farms. It has relatively lower production costs, the possibility of indepth specialization of production resources, and the use of high-performance advanced machinery and equipment.

52

2

Chapter 2 · Macroeconomic Indicators

At the same time, with a certain size of output, the positive effect of the economies of scale transforms into a negative one. If a firm continues to expand beyond a certain point, average costs eventually rise. This is because a firm suffers from diseconomies of scale. Average costs start to rise because production becomes inefficient. The possible reasons why diseconomies of scale might happen are as follows: 5 The complexity of managing a large company. The structure of management in large companies is excessively complicated. As a result, the management system becomes too bureaucratized. The information coming from one unit to another is distorted (the so-called “information noise”). There are too many layers between top managers and low-level staff. As a result, managers are late in making decisions, sometimes they even do not have a reliable understanding of the company’s work. 5 In a large firm, the incentives for employees to demonstrate initiative are weakened. There is no clear connection between the performance of an individual employee and a company as a whole. When an employee works in a small company, they personally knows all workmates. There is a clear understanding of to what extent the success of such a company depends on an individual employee. In a large company, employees miss this feeling. They often feel like a part of a smaller group (division, department, shop), and their group-related interests prevail over those of a company. Most countries have multilevel economies, where firms of different sizes coexist. At the same time, in many developed countries, such multilevel systems are based on small businesses. Globally, the share of small businesses (enterprises with up to 250 people) in the total number of firms accounts for 95%. In the global output, their portion exceeds 50%. Small firms make up the fabric of the economy, often filling and complementing the niches that large companies do not go into. The competitiveness of small firms is conditioned by the fact that they operate in sectors, where the effective size of a typical enterprise is small. For small firms, storage costs are close to zero (in the service sector, they are absent). They adapt flexibly to the changing market situation. They can take into account the individual characteristics of a customer. Small business plays an important role in the development of many important areas of scientific and technological progress. In the USA, small businesses account for about half of all scientific and technical developments. Small firms commonly cooperate with large ones, for example, they supply components to automobile factories or packaging companies for the assembling of complex equipment. Cooperation between large and small businesses (franchising), which has become widespread in developed countries, gives a particularly significant economic effect. It is most often found in trade and the service sector. In this system, a large parent company provides a small company with the exclusive right to use its trademark, allocates loans on preferential terms, and provides consulting and advertising services. Also, in some cases, the size of the market niche is so tiny that only small firms can meet the specific demand. For example, in small settlements, the needs of the local market are met by

53 2.3 · Gross Domestic and National Products

2

local small enterprises or individual entrepreneurs. In such areas, small firms play a significant role in the implementation of employment policy. They concentrate a significant part of the economically active population. 2.3  Gross Domestic and National Products

The main indicator that characterizes the level of economic development of a country through the value of its output is the gross domestic product (GDP). In macroeconomic analysis, it is employed in parallel with the gross national product (GNP) to capture the specifics of allocation of factors of production between national markets. Gross Domestic Product is an aggregate economic indicator that expresses in market prices the total value of goods and services produced within a country, and only using the factors of production of a given country. The Organization for Economic Cooperation and Development (OECD)1 defines GDP as “an aggregate measure of production equal to the sum of the gross values added of all resident institutional units engaged in production (plus any taxes, and minus any subsidies, on products not included in the value of their outputs); the sum of the final uses of goods and services (all uses except intermediate consumption) measured in purchasers’ prices, less the value of imports of goods and services, or the sum of primary incomes distributed by resident producer units”. According to the International Monetary Fund,2 GDP is “the monetary value of final goods and services—that is, those that are bought by the final user—produced in a country in a given period of time”. An alternative concept, gross national product, or GNP, counts all the output of the residents of a country. Thus, Gross National Product is defined as the market value of goods and services intended for final consumption, produced during a year with the help of production factors belonging to a given country. Therefore, any output produced by foreign residents within the country’s borders is excluded in calculations of GNP, while any output produced by the country's residents outside of its borders is counted. GNP starts with GDP, adds residents’ investment income from overseas investments, and subtracts foreign residents’ investment income earned within a country. GNP is calculated by subtracting from GDP the amount of values created on the territory of a given country by using foreign capital, and adding the amount of values produced abroad by using resources belonging to citizens of a given country. In a closed economy, GNP is always equal to GDP. In an open economy, the difference between the two parameters arises due to the difference in the level of

1 2

Organization for Economic Cooperation and Development (2002). Callen (2020).

54

2

Chapter 2 · Macroeconomic Indicators

development of foreign firms on the territory of a country (branches, joint ventures, the use of foreign workers, etc.) and, accordingly, the participation of national resources in various forms of production activities abroad, external loans, etc. GNP is greater than GDP when the income of owners of factors of production used abroad is greater than the income of owners of foreign capital used in the national economy. GDP, as well as GNP, can be estimated through expenditures, income, and production. The amounts obtained by using different methods should not differ. This is due to the fact that in a market economy, the expenses of some business entities are simultaneously revenues for others. According to the expenditures method, GDP consists of goods and services purchased by individuals, businesses, and the government. This also includes investments in fixed assets and the unsold output. In fact, this is the total monetary value of all flows of goods consumed in the economy (Eq. 2.11):

GDP = C + I + G + (Ex − Im)

(2.11)

where: C consumption; I investment; G government spending; Ex  exports; Im  imports. Consumption (C) includes the current consumption of all goods and services: all short-term (or one-time) and long-term use goods and services. The purchase of housing is not included in durable goods; they relate to investments. Investment (I ) is the sum of the expenses of enterprises for the purchase of buildings, equipment, raw materials, energy, etc., as well as the expenses of individual citizens for the purchase of housing. GDP reflects gross investment, but if depreciation deductions are excluded, they do not turn into net investments. Net investments show invested capital at the beginning and the end of a year. Public procurement of goods and services (G) includes not only what is purchased by the central government, but also by local authorities. This includes all expenses from the purchase of weapons to the construction of roads and housing, equipment for hospitals and schools, etc. However, GDP does not include interest payments on public debt and transfer payments. Thus, consumption, investment, and public procurement characterize the costs of purchasing goods and services within a country. But in an open economy, some of the goods produced are sold outside a country. At the same time, part of the money inside a country is spent on the purchase of goods imported from other countries. Exports (Ex) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore, exports are added.

55 2.3 · Gross Domestic and National Products

2

Imports (Im) represents gross imports. Imports are subtracted since ­imported goods are included in the terms G, I , or C, and must be deducted to avoid counting foreign supply as domestic. The difference between exports and imports is net exports NX , the amount of which is included in GDP. The second way to estimate GDP is through income. The income approach measures GDP as the sum of the factor incomes generated to a economy. The income part consists of the income of the population from labor (wages) and property income (profit, interest, rent) (Eq. 2.12):

GDP = COE + GOS + GMI + T − S

(2.12)

where: COE  compensation of employees; GOS  gross operating surplus; GMI   gross mixed income; T taxes on production and imports; subsidies on production and imports. S Compensation of employees (COE) measures the total remuneration to employees for work done. It includes salaries, as well as employer contributions to social security and other such programs. Gross operating surplus (GOS) is the surplus due to owners of incorporated businesses. It may be referred to as profits, although only a subset of total costs is subtracted from gross output to calculate GOS. Gross mixed income (GMI) is the same measure as GOS, but for unincorporated businesses. This often includes most small businesses. The sum of COE, GOS, and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices. The difference between basic prices and final prices (those used in the expenditure calculation) is the total taxes and subsidies that the government has levied or paid on that production. So adding taxes less subsidies on production and imports converts GDP at factor cost to gross domestic income. There are components of GDP that do not take the form of income, such as depreciation and indirect taxes. The latter include general sales tax, excise taxes, property taxes, royalties, etc. The third way to calculate GDP is through production. This method determines the contribution of all producers to the gross product. In this case, the value added is determined, i.e., what each enterprise adds to the value of the gross product. The production approach is the most direct of the three as it simply sums the outputs of every class of enterprise to arrive at the total. First, it estimates the gross value of domestic output out of the many various economic activities. Then, it determines the intermediate consumption, i.e., the cost of material, supplies, and services used to produce final goods or services. Third, it deducts intermediate consumption from the gross value to obtain the gross value added. Value added is defined as the difference between the revenue from the sale of products and

56

2

Chapter 2 · Macroeconomic Indicators

the costs of material factors of production. In fact, in this case, the entire newly created value is determined, to which depreciation is added. Not all transactions carried out by economic entities during a year are included in the GDP and GNP calculations. First, these are transactions with financial instruments, such as the purchase and sale of securities (shares, bonds, etc.). Financial transactions are not directly related to changes in current real production. Second, the sale and purchase of second-hand goods that were in use: their value was taken into account earlier. Third, private transfers (for example, gifts): in this case, it is the redistribution of funds between entities. Fourth, government transfers. The gross output should be distinguished from the gross national product. Gross Output is the value of all goods and services produced in the economy over a certain period of time. According to the Bureau of Economic Analysis,3 gross output is a measure of an industry’s sales or receipts, which can include sales to final users in an economy (GDP) or sales to other industries (intermediate inputs). Gross output can also be measured as the sum of an industry’s value added and intermediate inputs. It is the measure of total economic activity, all new goods and services produced, not limited to final output (including those intended for the production of other goods and services). The latter constitute intermediate consumption, as opposed to final consumption. GDP and GNP, unlike gross output, are cleared of intermediate consumption. The level of gross output in a situation of full employment in an economy is called the level of natural output. Both GDP and GNP include components created in previous periods, not current accounting periods, but embodied in the value transferred from the means of production to the created goods and services. This is depreciation. If we subtract it from GNP, we get a net national product (NNP). Net National Product is the monetary value of finished goods and services produced by a country's citizens, overseas and domestically, in a given period, minus the amount of GNP required to purchase new goods to maintain existing stock (depreciation). Case box The USA remain the largest economy in the world with GDP (nominal) of over $17.7 trillion in 2020. It represents a quarter share of the global economy. China follows, with $11.8 trillion, or 16.3% of the world economy. Sixteen countries have economies above $1 trillion. The top 20 economies add up to over 80% (. Fig. 2.9).

As a macroeconomic parameter, NNP has a significant drawback: it ­carries distortions that the state introduces into the structure of market prices. ­Without the intervention of the state, the sum of the market prices of all goods is

3

Gross Output (2021).

57 2.3 · Gross Domestic and National Products

2

. Fig. 2.9  GDP by countries in 2020. Source Roser (2021)

decomposed into the factor incomes of households. However, the state, by introducing indirect taxes, on the one hand, and providing subsidies to firms, on the other, contributes to either an increase in market prices (the former case with taxes) or a decrease in them (the latter case with subsidies). When using macroeconomic parameters for analyzing the level of economic development, the per capita values are employed. They allow for international comparisons and classifications that divide countries into developed, developing, and least developed economies. In the nominal method, market exchange rates are used for conversion. Nominal GDP estimates are commonly used to determine the economic performance of a whole country or region, and to make international comparisons. Case box With 18.3% of the world economy, China is the world’s largest economy in 2020, on a PPP basis. The total economy of China is estimated at over $24 trillion. The USA follows China with $20.9 trillion (. Fig. 2.10). Twenty-seven economies have GDP (PPP) greater than $1 trillion. In 2020, Argentina and the Philippines fell below $1 trillion marks. Ninety have above $100 billion and 158 have above $10 billion. The top five economies constitute about half of the global GDP; the top ten make up 61%, top 20 economies add up to over 75%. Eighty smallest economies only contribute 1%, and 150 lowest ranked constitute only 10% of the total.

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2

. Fig. 2.10  GDP (PPP) by countries in 2020. Source Statistics Times (2021)

Nominal GDP is useful for large-scope GDP comparison, either for a country or region or on an international scale. However, nominal GDP does not account for the living standards in a country—it focuses only on economic growth and performance. Also, generally speaking, nominal GDP can differ significantly from year to year depending on variations in the exchange rate. Nominal GDP per capita does not reflect differences in the cost of living and the inflation rates; therefore, using a GDP PPP (purchasing power parity) per capita basis is arguably more useful when comparing differences in living standards between nations. To obtain the true values (real GNP and GDP), it is necessary to clear the nominal parameters from the influence of inflation, i.e., apply price indices (measuring inflation is further detailed in 7 Chap. 9, 7 Sect. 9.3). Purchasing power parity exchange rate is the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country. PPP GDP is used to measure both the economic growth and living standards in a country, making it a useful tool in global comparisons. The PPP approach uses exchange rates to convert one country’s currency into the other. Then, using a consistent amount of money, the quantity of goods and services that may be purchased in the countries is compared. PPP GDP stays relatively stable from year to year and is not significantly impacted by shifts in the exchange rate. But this measure does not incorporate discrepancies in quality between goods and services in different countries. In general, it is less exact than nominal GDP and often hinges on estimates rather than calculations. As such, the nominal GDP is typically used to measure and compare the size of national economies.

59 2.4 · National Income and Wealth

2

2.4  National Income and Wealth

National income is one of the main aggregate macroeconomic indicators used in the system of national accounts. Gross National Income (GNI) is the total amount of money earned by a nation’s people and businesses, including investment income, regardless of where it was earned, and money received from abroad such as foreign investment and economic development aid. To determine the amount of national income, it is necessary to deduct indirect taxes from the net national product and add subsidies. Indirect Taxes are taxes on goods and services levied by setting an extra charge to the price or tariff. Unlike direct taxes, indirect taxes are not directly related to the income or property of a taxpayer, i.e., an individual or a legal person who is legally obliged to pay a tax. Such a person is usually a manufacturer or seller of goods and services. Here, the tax burden through the price mechanism can be shifted to another person, usually a buyer of goods and services. There are three main types of indirect taxes: excise taxes, fiscal monopoly taxes, and customs duties. Excise taxes are divided into individual or selective, which are levied on certain types of goods and services, and universal. The latter include turnover tax and value added tax. Types of taxes and their role in an economy are detailed in 7 Chap. 13, which discusses public finance and fiscal policy instruments employed by governments. National income can also be determined by calculating the gross national product by the income approach, excluding two types of payments—depreciation and indirect taxes on business. In this sense, the total income of a nation can be defined as earned revenue. Therefore, it excludes indirect taxes, since no resources have been invested by the state in generating this type of revenue. Based on the national income parameter, the value of final goods and services produced in a country is estimated at factor costs, not the market value, which is overestimated in comparison with factor costs by the amount of indirect taxes. Thus, it represents the net earned income. This determines the value of national income as a macroeconomic parameter and its wide application in theoretical analysis. The macroeconomic analysis distinguishes between produced and used national income. Produced NI is the entire volume of the newly created value of goods and services. Used NI is calculated as the difference between the produced NI and losses from natural disasters, damage during storage, and the foreign trade balance. The system of national accounts commonly uses the parameter of National Disposable Income (NDI), which is the total amount of income received and transferred to economic units as a result of production activities, income from property, and income redistribution. The United Nations’ System of National Accounts4 defines NDI as “gross or net national disposable income may be derived from gross or net national income by adding all current transfers in cash or

4

United Nations. (2009).

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in kind receivable by resident institutional units from non-resident units and subtracting all current transfers in cash or in kind payable by resident institutional units to non-resident units”. As a macroeconomic indicator, NDI aggregates the following components: 5 wages as remuneration to employees paid in cash and in kind; 5 social insurance contributions that do not depend on the quantity and quality of labor and are made by enterprises; 5 indirect taxes on business and other government charges; 5 subsidies are not contained in market prices used by major statistical indicators, therefore, they are deducted from the total income; 5 benefits as transfer payments to households in cash and in kind made by public or private non-profit organizations; 5 international aid as non-refundable payments made by one state or international organization to another, including contributions to international organizations; 5 retained profits as the net profit that remains with corporations after deducting labor costs, depreciation, taxes, interest, and dividends from the value added produced. 5 income from property (dividends, rent, and interest); 5 income from individual activities (small non-corporate enterprises, free-lancers); 5 income from insurance as the balance of annual payments of insurance benefits and insurance contributions; 5 income from foreign operations as the balance of transactions with the world. The level of output when an economy is at its full capacity (all factors of production are used efficiently) is called the full employment level of national income. At this level of income, there is no shortage of demand in an economy and therefore there is no cyclical unemployment (see 7 Chap. 8 for learning how imbalances of major macroeconomic parameters, including national income, cause unemployment). In addition to income received in the market, a significant number of people in any country receive additional income from the state in the forms of pensions, allowances, and other cash and in-kind payments. Sometimes, certain firms also receive help. All payments made by the state to individuals or firms that increase their purchasing power or competitiveness in the market are called transfer payments. Adding transfer payments to the national income after taxes and payments results in the gross personal income. Personal income is intended for use by individuals, including paying all individual taxes from it. Case box The World Bank’s5 classification of countries by income splits all economies in the world into one of four categories determined by the country’s GNI per capita: low-income, lower-middle-income, upper-middle-income, and high-income economies (. Fig. 2.11). The GNI thresholds between income groups have changed through time based on the World Bank definitions. Currently, 27 low-income economies have GNI below $1,045; 55

5

World Bank (2021).

61 2.4 · National Income and Wealth

2

. Fig. 2.11  World Bank’s income groups. Source Our World in Data (2021)

lower-middle-income economies—GNI between $1,046 and $4,095; 55 upper-middle-income economies—GNI between $4,096 and $12,695; 80 high-income economies—GNI above $12,696.

National Wealth is the total value of all of the money, investments, goods, and property held in a country at a particular time. The System of National Accounts6 defines national wealth as “the sum, for the economy as a whole, of non-financial assets and net claims on the rest of the world”, i.e., it includes, in addition to material resources, financial assets, non-productive material assets (copyrights, licenses, etc.), but financial liabilities are deducted. National wealth in a broad sense is everything that a nation possesses in one way or another. In this sense, the national wealth includes not only material goods, but also all natural resources, climate, works of art, and much more. National wealth in a broad sense should be understood as a set of economic benefits accumulated in a c­ ountry in the form of material, natural, and human capital reproduced by people, representing the result of labor and natural forces, providing a constant, continuous, and stable process of expanded economic reproduction. However, all this wealth is very difficult to calculate and express in money terms. Therefore, the macroeconomic analysis uses the parameter of national wealth in a narrower sense defined above. National wealth refers to everything that is somehow mediated by human labor and can be reproduced. In other words, the national wealth of a country is a set of material and cultural goods accumulated by this country during its history. This is the result of the work of many generations of people.

6

United Nations (1993).

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Thus, national wealth is directly related to economic reproduction previously addressed in 7 Chap. 1 of this book. National wealth increases primarily due to the excess of the produced goods, services, and other values over the current consumption in a given year. Consequently, the source of national wealth is the output reproduced on an expanded basis. There is, however, a reverse link. The growth of output itself, its rates, and the absolute size of the increase depend on the volume and the composition of the national wealth. The latter consists of a number of basic elements. The “three-factor concept” of wealth includes assets and natural and human resources, in other words, land, labor, and capital as the core factors of production. The material capital reproduced by individuals is represented by a combination of fixed and working capital and consumer durable goods. The national wealth also includes reserves, which are finished products in the sphere of circulation, material reserves at enterprises and in the retail, reserves of the state, and public insurance funds. Reserves serve as a stabilizer of the economy amid volatilities and other disturbances. They ensure the stability and continuity of production in the situation of economic turbulence, market failure, or natural disaster. The experience of many developed economies shows that reserves should be large enough and make up at least 25% of the production potential. National wealth includes natural resources involved in economic turnover or those that have been explored and may be involved in economic turnover in the near future. The value of natural capital as an element of national wealth can be calculated as follows (Eq. 2.13):

  1 NW = Q × R × 1 + r

(2.13)

where: NW natural wealth (capital); quantity of available natural resources; Q R  rent (the difference between the price of a good or a service produced with the use of natural resources, their costs, and profits of the enterprise); r capitalization rate determined by the reproduction cycle or the depletion of resources. An important element of material wealth is the public housing fund and social and cultural institutions. This division is somewhat conditional due to the inclusion of housing. By its nature, housing should belong to the category of household property. In most countries, it is accounted as a separate constituent of the national wealth. In addition to housing, the household property includes consumer durable goods (for example, furniture, household appliances, etc.). Human capital is a source of accumulation of national wealth, a necessary condition for expanded reproduction. From an economic point of view, it includes the accumulated stock of knowledge, professional skills, experience, health, abilities, and motivations for productive work. As an element of national

63 2.5 · Quality of Macroeconomic Measurements

2

. Fig. 2.12  Total wealth by asset group in the world in 2014. Source Tzvetkova and Hepburn (2018)

wealth, human capital is inseparable from its bearer, opposed to other factors of production. Case box

. Figure 2.12 demonstrates that human capital held the largest share of global wealth at 65% of all wealth in 2014. This figure fell from 69% in 1995—a development which the World Bank attributes to the steep decline after 2000 in the shares of human capital in high and upper-middle-income countries. This decline is in turn a result of rapidly aging labor forces and slumping real wages (especially in high-income OECD countries). Still, according to the World Bank, human capital is the largest component of wealth in all but low-income countries, where the value of natural capital exceeds that of human capital.

2.5  Quality of Macroeconomic Measurements

Although GDP is a common measure of economic growth, it does have some limitations. First is inflation, because price increases affect the interpretation of economic growth rates. An increase in money GDP is matched by an increase in prices. This problem can be overcome by using real GDP to measure growth. Real GDP is a macroeconomic statistic that measures the value of the goods and services produced by an economy in a specific period, adjusted for inflation. Essentially, it measures a country's total economic output, adjusted for price changes. Population growth must be taken into account when analyzing growth patterns. An increase in population can offset the growth in GDP. Therefore, it is difficult to make accurate calculations of GDP. To overcome this problem, changes

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in GDP per capita should be calculated by dividing GDP by the size of the population. At its most basic interpretation, per capita GDP shows how much economic production value can be attributed to each citizen. Alternatively, this translates to a measure of national wealth since GDP market value per person also readily serves as a prosperity measure. Small countries, rich countries, and more developed industrial countries tend to have the highest per capita GDP. Statistical errors can affect the interpretation of GDP. To calculate GDP, the government collects data from businesses and people. Errors are commonly made because the information is entered inaccurately or left out. Therefore, the reported value of GDP can differ from its true value. The lack of reliable information when deciding on the field of macroeconomic regulation leads to a certain distortion of the expected balance between inflation, increase in bank credit rates, and outflow of capital from the real sector to the sphere of speculative circulation. Case box For some goods and services, economic activity is not recorded because these goods and services are not traded. For instance, home gardening. In many least developed countries, people heavily rely on their own domestic production to live. If such activities are not recorded, the value of GDP can be incorrect and underreported. There could be a different story when a good is produced and traded, but this economic activity goes unrecorded. Such transaction becomes a part of the hidden or informal economy. It is the economic sector consisting of transactions that are (illegally) not declared for tax purposes, and which are therefore not taken into account in official statistics.

As a macroeconomic parameter, GDP can be used to assess living standards in society. However, an increase in GDP does not automatically mean that living standards have also increased. A standard of living refers to the amount and quality of material goods and services available to a given population. The standard of living includes basic material factors such as income, GDP, life expectancy, and economic opportunity. The standard of living is closely related to the quality of life, which can also include factors such as economic and political stability, environmental quality, climate, and safety. The measures of quality of life often include non-material characteristics, such as relationships, freedom, and satisfaction. For an unbiased evaluation of net economic wellbeing, it is necessary to take into account the stratification of the population by income level. GDP fails to reflect income inequality in society. Instead, the Gini coefficient is used to show the nature of the distribution of the entire amount of income of the population between its individual groups. With an even distribution of income in society, the Gini coefficient is equal to 0. The higher the degree of polarization of society by income level, the closer the coefficient to 1. GDP does not take into account external costs, for instance, environmental costs. With increased output and consumption, the costs imposed on the

65 2.5 · Quality of Macroeconomic Measurements

2

. Fig. 2.13  Income inequality in the world in 2019, Gini index. Source Roser and Ortiz-Ospina (2021)

environment will likely rise. The environmental impact of economic growth includes the increased consumption of non-renewable resources, higher levels of pollution, global warming, and the potential loss of environmental habitats. GDP fails to track the depletion or degradation of natural, human, built, and social capital on which all economic activity ultimately depends. There are two essential features of a macroeconomic indicator to replace GDP: it should measure genuine economic welfare, not just economic activity, and it should indicate the sustainability of that welfare over time. Sustainable development is defined as balancing the protection of the natural environment with the fulfillment of human needs so that these needs can be met not only in the present, but in the indefinite future. The term has prompted a global recognition of the close linkage between environmental health and economic development, as well as the need to alter social and economic policies to minimize the human impact on the planet. Economic activities that deplete natural capital are unsustainable and therefore should not be credited as a measure of sustainable economic welfare since they limit the next generation’s prospects. See 7 Chap. 18 for a discussion of the sustainable development concepts, goals, and the vision of sustainable economic growth in the world. Case box Both the southern part of Africa and Latin America stand out as regions of the world with very high inequality. Southeast Asia and most of developed countries in Europe and North America, on the other hand, have relatively low levels of inequality (. Fig. 2.13). The income inequality issues along with the Gini coefficient are detailed in 7 Chap. 14.

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The reliability of macroeconomic assessments is undermined by the shadow economic activities, the scale of which is extremely difficult to assess in both individual countries and the world as a whole. When economists calculate macroeconomic indicators of a country, such as GDP, GNP, or GNI, they do not include what goes on in the shadow economy. This means that every c­ ountry across the world is probably considerably wealthier than macroeconomic estimations suggest. The shadow economy directly determines the level of economic wellbeing, although this is not reflected quantitatively in the GDP or GNP figures. The Shadow Economy refers to all work activity and business transactions that are undeclared and for which taxes that should be paid are not. In this regard, it can be defined as the movement of goods, values, and services that are not controlled by society, i.e., social and economic relations between citizens and social groups that are hidden from authorities, including the following: 5 criminal economy—economic crime built into the legal economic activities (embezzlement and theft of public funds, drug trafficking, crimes against personal property of citizens as a form of non-economic redistribution of income, such as robberies or racketeering); 5 false economy—legal economic activities with fictitious results that are reflected in the reporting system as real (for example, overreporting or falsification of accounting figures); 5 informal economy—a system of informal interactions of economic entities based on personal relationships and direct contacts between them (it supplements or replaces the officially established procedure for performing economic activities); 5 illegal second economy—activities hidden from control, either prohibited by law or not registered in accordance with the established procedure. Case box In developed countries, the shadow sector accounts for between 10 and 25% of total income, while in some developing and least developed economies, it represents a significant portion of GDP (. Fig.2.14).

The economy is influenced by the political situation in a country, the specifics of fiscal and monetary policies, as well as other government regulations, that altogether affect the allocation of financial and economic resources for investment, consumption, and saving. The difficulties in obtaining objective cost estimates are supplemented by the problems of accounting for production in kind. Nevertheless, despite all the challenges to the accuracy and reliability of macroeconomic indicators, they remain informative and useful parameters of the economic situation in a country. They are also pivotal for predicting the economic development of a country and making the right economic decisions.

67 2.5 · Quality of Macroeconomic Measurements

2

. Fig. 2.14  Shadow economy estimates. Source Market business news7

Chapter Questions: 5 What is meant by opportunity costs? Give examples. 5 What is the difference between GDP and GNP? 5 How to calculate GDP by sources of income, expenditures, and production? 5 Explain the effects of the economies of scale. 5 What happens to average cost when a firm benefits from economies of scale? 5 How does national income differ from national wealth? 5 Name major challenges to the quality of macroeconomic measurements. Subject Vocabulary: Cost: expenses incurred in a production process, the cost of resources and factors of production in a monetary form. Economies of Scale: a reduction of production costs that is a result of making and selling goods in large quantities. Gross Domestic Product: an aggregate economic indicator that expresses in market prices the total value of goods and services produced within a country, and only using the factors of production of a given country. Gross National Income: the total amount of money earned by a nation’s people and businesses, including investment income, regardless of where it was earned, and money received from abroad such as foreign investment and economic development aid.

7

Market Business News (n.d.).

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Gross National Product: a market value of goods and services intended for final consumption, produced during a year with the help of production factors belonging to a given country. National Wealth: the total value of all of the money, investments, goods, and property held in a country at a particular time. Profit: the difference between the total revenue from the sale of goods or services and the total costs of the production and sale of goods or services. Revenue: the amount of money that a company earns by selling products or services at market prices during a period of time.

References Callen, T. (2020). Gross domestic product: An economy’s all. 7 https://www.imf.org/external/pubs/ft/ fandd/basics/gdp.htm. Gross Output. (2021). What is gross output? 7 https://grossoutput.com/gross-output/. Market Business News. (n.d.). Shadow economy—Definition and meaning. 7 https://marketbusinessnews.com/financial-glossary/shadow-economy-definition-meaning/. Organization for Economic Cooperation and Development. (2002). Glossary of statistical terms. 7 https://stats.oecd.org/glossary/detail.asp?ID=1163. Our World in Data. (2021). World bank’s income groups, 2016. 7 https://ourworldindata.org/grapher/ world-banks-income-groups. Roser, M., & Ortiz-Ospina, E. (2021). Income inequality. 7 https://ourworldindata.org/income-inequality. Roser, M. (2021). Economic growth. 7 https://ourworldindata.org/economic-growth. Statistics Times. (2021). List of countries by GDP (PPP). 7 https://statisticstimes.com/economy/countries-by-gdp-ppp.php. Tzvetkova, S., & Hepburn, C. (2018). The missing economic measure: Wealth. 7 https://ourworldindata.org/the-missing-economic-measure-wealth. United Nations. (1993). System of national accounts 1993. United Nations. United Nations. (2009). System of national accounts 2008. United Nations. World Bank. (2021). World bank country and lending groups. 7 https://datahelpdesk.worldbank.org/ knowledgebase/articles/906519-world-bank-country-and-lending-groups.

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Market Structures

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_3

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Learning Objectives: 5 Understand the concepts of market, market structure, and market concentration 5 Differentiate between the forms of perfect and imperfect competition 5 Understand the main features, advantages, and disadvantages of monopoly and oligopoly 5 Find out the similarities and differences between monopolistic and monopsonistic markets 3.1  Market Structures and Concentration

Market as an economic mechanism that replaced natural economy has been establishing for centuries, during which the content of the concept itself has been undergoing transformations. Contemporary neoclassic economic literature uses the definition of market given by Antoine Cournot (1838)1 as “not any particular market place in which things are bought and sold but the whole of any region in which buyer and sellers-are in such free intercourse with one another that the prices of the same goods tend to equality easily and quickly”. According to this definition, a market covers a region from which buyers and sellers are drawn, and not any particular place where they assemble. There exists commercial intercourse among buyers and sellers, so that they are aware of the prices offered or accepted by them. Therefore, the same price must rule for the same thing at the same time.2 However, the same price obtains only in a perfect market. In real life, markets are imperfect. The following elaboration was added to Cournot’s definition by Alfred Marshall (1890)3: “the more nearly perfect a market is, the stronger is the tendency for the same price to be paid for the same thing at the same time in all parts of the market”. Modern definitions of market consider the existence of multiple markets of multiple commodities, i.e., a separate market for a separate commodity, service, or any kind of value that is exchanged. In these markets, buyers and sellers get in touch with one another through various means of communication, either directly or through middlemen. There is competition among buyers and competition among sellers, whether perfect or imperfect, so that through such competition, the price of a commodity is influenced. Therefore, a Market can be defined as a system of economic interactions between economic entities, directly or through middlemen, which is based on the exchange of goods and services. This definition avoids simplistic and inherently incorrect interpretations. The modern market should be understood neither as a place where trading operations are carried out nor trade as a type of activity associated with the purchase and sale of goods. The market is the whole set of

1 2 3

Cournot (1838). Seth (2021). Marshall (1890).

71 3.1 · Market Structures and Concentration

3

economic interactions between economic entities on the principle of payment for the goods and services provided. Initially, a simple market appeared, where everyday goods were exchanged (food, clothing, shoes, etc.). With the emergence of capitalism, the market sphere has expanded and included not only consumer goods, but also means of production, labor, securities, scientific developments, etc. The modern market, while remaining a mechanism of interaction between buyers and sellers, has turned into a system of regulation of the economy, as well as social interactions between people. The existence of a market implies the need for economic entities that act in the market. They include the following: 5 Households are economic units composed of one or more people. They are both owners and suppliers of resources (capital, land, and labor). Their main goal is to satisfy their needs at the maximum possible level. 5 Businesses are enterprises, entrepreneurs, commercial banks, and other business entities that employ resources to produce goods and services and then supply them to the market to maximize their profit. 5 Government (state) is represented by public institutions and organizations that exercise legal and political power in order to implement public regulation of the economy to generate economic growth and ensure multidimensional security and protection of the population. Economic entities should be independent in making transactions on the purchase and sale of goods and services, as well as in the disposal of their income. There should be a variety of forms of property and management, competition, reliable information about market processes. Economic entities should have the right to set the prices of their goods and services independently and enter or leave the market freely. The market has a huge impact on all aspects of economic life, performing a number of economic functions: 5 It sets prices in accordance with the costs of socially necessary labor and the law of supply and demand (further detailed in 7 Chap. 5). 5 It provides information about the quantity, quality, and assortment of goods and services. This allows manufacturers to constantly adjust their production with changing market conditions. 5 It allows producers to exchange the results of their activities. Consumers have the opportunity to choose sellers they prefer (any parameters meaningful to consumers might apply). Vice versa, sellers can target the most suitable buyers for their products. 5 The regulatory function of the market is pivotal. The market determines what goods and services should be produced, how, and for whom. This function is performed by competition, which is the main regulatory force in the market. 5 The market forces producers to reduce costs, which becomes possible with the introduction of innovations and technological achievements, i.e., market stimulate technical and technological development. This leads to the emergence of new goods and services to meet the needs of people.

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. Table 3.1  Types of markets

3

Criteria

Types

Economic purpose

Markets of goods, services, means of production, technologies, securities, labor

Geographic (territorial) location

Intraregional, regional, national, and international markets. Alternatively, domestic and global markets

Maturity

Developed and emerging markets, monopoly and oligopoly

Legality

Legal and illegal markets (shadow economy)

Industry (sector)

Markets of manufactured and consumer products, food and agricultural products, etc.

Sales

Wholesale and retail markets

Source Authors’ development

5 It removes underperforming and uncompetitive economic entities from the market and, conversely, encourages the growth of efficient enterprises and promising start-ups. The market mechanism frees the economy from the shortage of goods and services, which contradicts the economic interests of market participants. Discrepancies between the appearance of a need and its satisfaction are possible, but they are temporary. As a result, the average level of stability of the entire economy increases. The concept of market structure is intended to determine the degree of competitiveness, economic freedom, or, on the contrary, the prevalence of control and planning in a particular market. Commonly, the “level of competition” parameter along with its derivatives are used to characterize market features. Market Structure is a set of interrelated qualitative and quantitative interactions between separate market elements, which characterizes stable certainty of the market and ensures its operation. These include the internal location, the order of individual market elements, and their portion in the total market volume. In different types of markets, different combinations of market elements might apply (. Table 3.1). Market Segmentation is the division of consumers of a given product into separate groups that have different requirements for the product. Market Segment is a part of the market, a group of consumers of products or enterprises that are formed based on certain common characteristics or criteria (. Table 3.2). Different market structures can apply to different sectors of the market (branches). The parameters include the number of sellers and buyers in a particular sector, the entry-exit barriers, product differentiation, elasticity of demand and supply, technologies applied in the production of certain goods or services, vertical and horizontal integration, and product diversification, among others. The branch structure determines the opportunities for choosing a strategy for the

3

73 3.1 · Market Structures and Concentration

. Table 3.2  Market segments Criteria

Segments

Geographic

By territories or administrative division (provinces, states, districts, municipalities, etc.), by population density (urban, suburban, and rural areas, by climate conditions (continental, subtropical, etc.)

Demographic

Grouping of the population by age, gender, income level, education level, confession, nationality, etc.

Psychographic

Grouping of the population by lifestyle and individual qualities

Behavioral

Random or planned purchases, emotional attitude to certain products, etc.

Source Authors’ development

behavior of the enterprise, which is expressed in its price, product, advertising, and investment policies. Strategic goals are established by the enterprise, such as the improvement of the public welfare, efficient allocation of resources, scientific and technological progress, or achievement of social equity. Various parameters of the size of economic entities (firms) can be used, including the share of a firm in the total volume of sales, the share of employees of a firm in the number of employees involved in the production of a certain product, the share of the firm’s assets in the total value of the assets in the market, and the share of value added in the company in the aggregate added values of all producers. The role of certain companies and their individual shares of the total production in a particular market is called Market Concentration. It is a key metric to measure the intensity of competition within a market. Two approaches to the calculation of market concentration are the Lerner index and the Herfindahl– Hirschman index. Lerner Index (Li) is a measure of monopoly power that equals the markup over marginal cost as a percentage of the price (Eq. 3.1).

Li =

P − MC P

(3.1)

where: P price of a good set by a firm; MC  marginal costs. The index measures the percentage markup that a firm can charge over its marginal cost. The index ranges from 0 (low) to 1 (high). The higher the Li, the more a firm can charge over its marginal cost, hence the greater its monopoly power.4

4

Bondarenko (2017).

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When calculating the Li, the main problem is to properly estimate the marginal costs from the position of a producer, not only from a point of view of an external observer. Therefore, marginal costs are commonly replaced by average costs AC. The following assumptions are made when doing this. First, a company operates in the long term. Second, a company has a constant return on scale, that is, the output does not change much over time. In this form, the Lerner index is equal to the share of profit in revenue (Eq. 3.2). The larger it is, the higher the degree of monopolization.

Li =

Pr (P − AC) × Q = P×Q TR

(3.2)

where: Q quantity of goods or services produced; Pr  profit; TR  total revenue. Three factors affect the Li value: 5 elasticity of demand for goods produced by a company—the smaller the fluctuations in demand under the influence of prices, the lower the elasticity and the greater the value of the index; 5 interaction with competitors—the more competitors in the market and the greater their size, the less the company’s ability to maximize profit and the smaller the value of the index; 5 degree of regulation—the more active the antimonopoly regulation, the smaller the value of the index. Case box Let us assume an average supermarket and a convenience store operating in the same area. The price margin in supermarkets is usually 15–20%, while that in convenience stores is 25–30%. The difference is due to the fact that supermarkets operate in a more competitive environment. Other retail outlets that are also open during the day attract a significant number of customers. That is why supermarkets offer lower prices to compete. Convenience stores work 24 h a day, so they can charge a higher price compared with supermarkets because some of their customers fall at a time when other shops are closed. Also, it may happen that during the day, it makes no sense for a customer who lives nearby to look for alternative options for the sake of an insignificant purchase. The number of customers in such stores depends less on prices than it does at supermarkets (less elastic demand). According to the Lerner index, small stores get more monopoly power, since they enjoy a higher margin with the same product. But at the same time, due to a smaller amount of sales and higher average costs, such stores receive less profit than supermarkets do.

The higher the price elasticity of demand of a firm’s product, the lower its Li value. It is because a high elasticity of demand means that any increase in the price of the product will cause customers to switch to substitute goods. This reduces the

3

75 3.1 · Market Structures and Concentration

. Table 3.3  Classification of commodity markets based on the parameters of interchangeability of goods and the interdependence of enterprises Market types

Interchangeability

Market entry barriers

Products

Producers

Perfect competition

Full (ED → ∞)

Non-detectable (ED → 0)

Insignificant (L → ∞)

Monopolistic competition

Partial (0 < E D < ∞)

Homogeneous oligopoly

Full (ED → ∞)

Detectable − ( ∞ < E D < 0)

Significant (L > 0)

Heterogeneous oligopoly

Partial (0 < E D < ∞)

Monopoly

Non-detectable (ED → 0)

Entry blocked

Source Authors’ development

monopolist’s ability to sell its products at a higher markup. There is an inverse relationship between the Lerner index and the elasticity of demand (Eq. 3.3).

Li =

1 ED

(3.3)

where: ED  elasticity of demand. It is assumed that in perfect competition, P = MC, that results in Li = 0. By itself, monopoly power does not guarantee a high profit, since profit depends on the ratio of average costs to the price. A firm may have more monopoly power than other firms, but at the same time, receive less profit. The values of L and E can be used to characterize the types of market concentration from pure competition to monopoly (. Table 3.3). Case box The company produces 1,000 units of goods Q and receives $1.2 million as profits Pr. The price P that maximizes profit is $4,000. Let us calculate the Lerner index. First, we find the total costs TC as a difference between the total revenues TR and profits Pr assuming that TR = P × Q. From that, TC = P × Q − Pr = $4, 000 × 1, 000 units −$1, 200, 000 = $2, 800, 000. Se$2,800,000 = $2,800. cond, we calculate the average total costs AC as AC = TC Q = 1,000 With a constant effect of scale, an increase in all the resources by t times leads to an increase in the volume of output by t times. In this case, the average costs coincide with the marginal costs AC = MC = $2,800. Finally, we calculate the Lerner mo$4,000−$2,800 nopoly power index as Li = P−MC = 0.3. MC = $4,000

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Herfindahl–Hirschman Index (HH i) is an alternative metric that is employed to gauge monopoly power using real industry data. The Herfindahl–Hirschman index is a measure of the competitiveness of an industry in terms of the market concentration of its participants.5 The HH index is a general indicator of market concentration often used to determine market competitiveness before and after mergers and acquisitions. At the same time, the index is a measure of market concentration—the higher the market concentration, the fewer competitors in the market and, accordingly, the closer the market to a monopoly. By and large, it acts as a measure of competition between companies and related industries. At the same time, it is used to diversify the portfolio, in particular, to determine the number of positions in the portfolio. The HH index is one of the indicators that allows for distinguishing markets by the degree of competition (perfect and monopolistic competition, oligopoly, and monopoly). The index shows the number of companies represented within a particular market segment, as well as the share of their products in the total output in this segment (Eq. 3.4).

HHI = s12 + s22 + · · · + sn2

(3.4)

where: n  number of firms in the market; sn  market share of the n firm. The HH i value ranges between 1 and 10,000, where 10,000 indicates the complete monopolization of the market sector by one firm. Ideally, in the conditions of market competition, the value of the HH index should tend to 1. In this case, the market is divided equally between all producers. It is commonly accepted that HH i < 1,000 indicates good competition, 0 < HH i < 1,800 depicts a moderate concentration on the market, while HH i > 1,800 means a high degree of market concentration. Thus, the HH i value allows for distinguishing between low-concentrated, moderately concentrated, and high-concentrated markets. Case box Let us assume there are twenty companies in the market segment. Of these, nineteen firms have a market share of 2.71%, and one company accounts for 48.59% of the total market. In this case, the HH i value is 2,500, which is a high degree of market concentration. If one company out of twenty has a market share of 35.82%, and the remaining nineteen companies have 3.38% of the market each, then the HH i value goes down to 1,500, which indicates a moderate level of competition in the market.

5

Bondarenko (2019).

77 3.2 · Competitive Markets

3

The simplicity of the HH index carries some inherent disadvantages, primarily, in terms of the failure to adequately assess competition in specific situations. For example, consider a situation in which the HH index is used to evaluate the segment with ten active companies in it each having about 10% of the market. According to the HH approach, this segment seems highly competitive. However, many specific factors may characterize certain market segments, for example, geography. These ten companies in the “high-competitive” market could operate only in certain territories of a country, so that each firm, in fact, has a monopoly on the market in which it operate. In order to use the HH index correctly, markets must be clearly defined and many factors must be taken into consideration. 3.2  Competitive Markets 3.2.1  Types of Competition

Competition is an economic rivalry in the market between producers for the right to get the maximum profit, as well as between buyers for a greater benefit. It allows for the efficient use of scarce resources, that are distributed by industries and types of production in such a way that the products obtained from these resources generate profit. Thus, competition is a regulatory force in market conditions, one of the manifestations of Smith’s “invisible hand” concept. In terms of the market concentration discussed in 7 Sect. 3.1, markets can be classified based on the numbers of producers (sellers) and consumers (buyers) operating in these segments (. Table 3.4). . Table 3.4 does not include such types of markets as perfect competition and monopolistic competition (further explained in 7 Sects. 3.2.2 and 3.2.3, respectively). This is due to the fact that the number of buyers and sellers can not serve as the only criterion for the classification of markets. Both markets are Bilateral Polypolies—markets of a large number of relatively small buyers and sellers, none

. Table 3.4  Stackelberg’s classification of markets by the number of sellers and buyers Buyers

Sellers One

Several

Many

One

Bilateral monopoly

Monopsony, constrained by oligopoly

Monopsony

Several

Monopoly, constrained by oligopsony

Oligopoly, constrained by oligopsony (bilateral oligopoly)

Oligopsony

Many

Monopoly

Oligopoly

Bilateral polypoly

Source Authors’ development

78

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of whom can influence the price of commodities. In one case, however, goods traded in the market are homogeneous (each of its units has the same characteristics), while in the second case, they are close substitutes. Therefore, the interchangeability of commodities should also be employed as the classification criteria. This criterion can be estimated using the indicator of price cross-elasticity. Competition plays an important role in the market mechanism as it coordinates and manages the economy. The economic role of competition is that it avoids the potential chaos that could be generated by the freedom of entrepreneurship and choice. The competition encourages firms and owners of factors of production to respond appropriately, satisfying the desires and needs of society. Competition forces firms to use the most efficient production technologies. In a competitive market, a producer who is unable to apply the most effective technology (ensuring the production of a given amount of goods at the lowest cost) will be displaced by more efficient firms. This is how competition “sanitize” the market. Due to the competition in a competitive market system, the identity and unity of public and private interests are achieved. Firms and suppliers of resources acting exclusively in their own interests (related to maximizing either production profits or income from factors of production) in a highly competitive struggle ensure that the interests of society are satisfied. Thus, competition manages private interests so that they automatically and involuntarily ensure the achievement of public interests. This is the essence of the Invisible Hand concept, according to which economic entities are guided by the unseen forces of the free market economy to achieving a common goal in the best interest of society, the goal that they not aimed at individually. By pursuing their individual economic interests, members of society often serve the interests of society more effectively than when they consciously seek to serve it. The constant interplay of individual pressures on market supply and demand causes the natural movement of prices and the flow of trade. 3.2.2  Perfect Competition

Perfect Competition is a type of market structure where there is an extensive number of producers and consumers competing with one another, who all have full and symmetric information about the market. It is a theoretical market structure in which the following criteria are met: 5 Products in the market are homogeneous, so that consumers do not care which producer to buy from. All products are perfect substitutes, and the price cross-elasticity of demand for any pair of producers tends to infinity. 5 There is no non-price competition. This means that any increase in price by one producer above the market average leads to a reduction in demand for its products to zero. Thus, the difference in prices is the only reason for preferring one producer over another. 5 The number of economic entities in the market is infinitely large, while their individual shares in the market total are so small, that decisions of separate producers (buyers) about changing the volume of their sales (purchases) do

79 3.2 · Competitive Markets

3

. Fig. 3.1  Price and quantity of output in perfect competition. Source Authors’ development

not affect the price. At the same time, it is assumed that there is no collusion between sellers or buyers to obtain monopoly power in the market. The market price is the result of interactions between all buyers and sellers. 5 Free entrance and exit. There are no barriers—no patents or licenses that restrict activities in a certain market, no significant initial investments are required, a positive effect of scale is insignificant and does not prevent new firms from entering the market, no state intervention in supply or demand (subsidies, tax incentives, quotas, social programs, etc.). The freedom of entry and exit presupposes absolute mobility of all resources from one type of activity to another, as well as between territories within a country or globally. 5 Complete or perfect knowledge about products being sold and prices charged by each firm. All decisions are made in certainty. This means that all firms are aware of their revenues and costs, the prices of all resources and all possible technologies, while all consumers have complete information about the prices of all firms. It is assumed that the information is freely distributed on a constant basis. In perfect competition, the output and its price are determined by the intersection of the demand and supply curves, where the supply curve is the curve of public marginal costs (S = MC in . Fig. 3.1). Producers agree to offer each next unit of production to the market only if its price at least covers the costs of its production (marginal costs). Thus, in perfect competition, the market price P∗ exactly coincides with the marginal cost of producing the last unit of output Q∗. The maximum price that consumers agree to pay for a given unit of production (the price of demand) is a measure of the public value of this unit of goods for buyers. All demand prices determine the demand curve. On the other hand, the marginal costs of producers are the essence of the public value of the resources spent in the production of each additional unit of goods. Thus, as long

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as the price of demand exceeds the marginal costs, society acquires more than it spends by producing an additional unit of output. Public welfare, thereby, increases. The company’s gain from the production of an additional unit of output is equal to the difference between its demand price and marginal costs.

3

Case box Let us assume that a consumer agrees to pay $100 for a given unit of production. The producer’s costs are $80. If a product is sold at the maximum price of demand ($100), then the producer’s welfare grows, while that of a consumer remains unchanged. If the actual price of a product is only $80, then a buyer gets all the benefits in welfare, while a producer receives the minimum acceptable amount of money and thus loses nothing. If the price is set in the range between $80 and $100, then both sides benefit.

Thus, an additional output allows either to increase the welfare of a consumer without reducing that of a producer, or to increase the welfare of a producer without reducing that of a consumer, or, finally, to increase the welfare of both counterparts. Accordingly, the public welfare from the selling of all units of goods becomes maximum when the price of demand equals marginal costs. The output at which this balance is achieved (Q∗ in . Fig. 3.1) is the effective level of public output. Perfect competition is the condition for achieving effective output. On the one hand, it leads to balancing the equilibrium market price and the marginal costs of producers. On the other hand, the equilibrium price coincides with the maximum price at which consumers agree to purchase the last unit of output. As a result, the price of demand equals the marginal costs. 3.2.3  Monopolistic Competition

Monopolistic Competition is a market structure in which the features of perfect competition coexist with certain elements of a pure monopoly. There are many firms operating in the market (fewer than in perfect competition) that offer goods or services that are similar, but not perfect substitutes. The model of monopolistic competition was elaborated by Edward Chamberlin (1933)6 in the “Theory of Monopolistic Competition”, the book that has become a milestone in the development of the general equilibrium concept, welfare economics, and international trade theory.7 The four features of a monopolistic competitive market are differentiated products, many producers and sellers, relatively low entry and exit barriers, and non-price competition.

6 7

Chamberlin (1933). Rothschild (1987).

81 3.2 · Competitive Markets

3

Product differentiation is a key feature of a monopolistic competitive market. It assumes that there are economic entities in the market who produce similar, but not homogeneous products, i.e., not perfect substitutes. Products can be differentiated due to their physical characteristics (size, weight, color, taste, etc.), location (for example, adjustments made for selling similar products in developed and developing countries), and image or marketing features (package, trademark, company image, advertising). Vertical differentiation assumes distinguishing products by quality or any other criterion, which allows grading from good to bad. The horizontal one assumes that when comparing two products with similar “numerical” features, a buyer chooses a product according to their taste. Case box When creating its own version of a product, each company acquires a kind of limited monopoly. For example, Apple is the only supplier of iPhones in the global market. Nevertheless, it still faces competition from companies that offer substitute products, i.e., Apple operates in the monopolistic competition environment.

Similar to perfect competition, there are many firms in monopolistic competition, so that an individual firm occupies a small portion of the market. A large number of sellers, on the one hand, excludes the possibility of collusion and coordinated actions between firms in order to control total output and increase market prices. On the other hand, it does give a certain company control over prices. Compared with perfect competition, where any increase in price could ruin demand for firms’ products in the market, product differentiation in monopolistic competition gives producers more space when setting their prices. This is because many consumers remain committed to a particular brand or company even when the price is higher. However, this effect is relatively small due to the similarity of the products supplied by competitors. The cross-elasticity of demand between products in monopolistic competition is quite high. Since the possibility space for price competition is not that large, firms in monopolistic competitive markets commonly practice non-price methods. To influence sales, firms may either improve the differentiation of their products or reconsider promotion strategies. Due to the high product differentiation and the commitment of consumers to certain brands, entering the market is more difficult than in perfect competition. A new firm should not only produce competitive products, but also win over the consumers. This may require additional costs for advertising, sales promotion, and strengthening the differentiation of products, i.e., providing them with such qualities that would distinguish them from those already available on the market. The weak effect of scale in production, small initial investments, and the small average size of firms make entry to the market relatively easy. Because there is freedom of entry, supernormal profits encourage more firms to enter the market in the short run leading to normal profits in the long term. In the short run, a firm maximizes profit where marginal revenues MR equal marginal costs MC (MR = MC), thus receiving supernormal profit at output Q1 and price P1

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3

. Fig. 3.2  Short-run equilibrium under monopolistic competition. Source Authors’ development

(. Fig. 3.2). The price is determined at a point where the imaginary line from the equilibrium output passes through the point of intersection of the MR and MC curves and meets the average revenue AR curve, which is also the demand curve (D = AR). The supernormal profit is determined by the equilibrium output multiplied by the difference between AR and the average total cost ATC.8 Supernormal profit encourages new firms to enter the market. Both existing firms and newcomers in monopolistic competition produce at a level where marginal cost (MC L) and marginal revenue (MRL) are equal. As the number of firms in the market grows, the demand curve (DL) shifts to the left as a result of reduced demand for an individual company’s products due to increased competition (. Fig. 3.3). Such action reduces supernormal economic profits to the normal level, depending on the magnitude of the entry of new players. Individual companies are no longer able to sell their products at above-average costs. Companies in monopolistic competition earn zero economic profit in the long run. At this stage, there is no incentive for new entrants in the industry. Advantages of the monopolistic competition market can be summarized as follows: 5 product differentiation expands choice for consumers; 5 competition keeps prices close to the level of marginal costs, which are at the lowest possible level for differentiated products (although slightly higher than in perfect competition); 5 market power of an individual firm is relatively small, so firms, for the most part, are price setters, rather than price takers; 5 this type of market is the most advantageous for buyers. Commonly, firms in the monopolistic competition market are rather small (in size and in share in the market total). Their size is limited by the negative effect

8

Corporate Finance Institute (2021).

83 3.3 · Monopoly and Oligopoly

3

. Fig. 3.3  Long-run equilibrium under monopolistic competition. Source Authors’ development

of scale of production. If existing firms use all the opportunities of the economies of scale, then the supply in the market will grow due to the entry of new firms, and not the expansion of the activities of existing ones. The small size of firms determines the main disadvantage of monopolistic competition as a market structure such as the uncertainty of small businesses due to the instability of market conditions. The situation of weak market demand can lead to financial losses, bankruptcy, and exit from the market. If market demand is strong, this increases the influx of new firms into the market and thus lowers the profit ceiling for existing ones. The small size of firms and the uncertainty of the market situation limit the financial opportunities for research and innovations. 3.3  Monopoly and Oligopoly

A market in which at least one of the assumptions of perfect competition is not met is called Imperfect Competition. The following types of such a market are distinguished: 5 Pure (absolute) monopoly. In this market, goods or services are produced and supplied by one company. Unique products can not be substituted. Control over prices is high, i.e., prices are set by a monopoly. Consumers are forced to buy at high prices. The entry of other producers into the industry is closed. 5 Duopoly. Two firms produce and supply a product and control market prices. 5 Oligopoly. Several firms (commonly, up to five) produce and supply either homogeneous or differentiated products to many buyers. 5 Bilateral monopoly. This is the market with one supplier and one consumer. 5 Monopsony. In this market, many producers compete for one large buyer, who dictates the price. 5 Oligopsony. There are many producers and sellers and several buyers in the market.

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Chapter 3 · Market Structures

In an imperfect competition environment, companies sell different products and services, set their own individual prices, compete for market share, and are often protected by barriers to entry and exit, making it harder for new companies to challenge them.9 While perfect competition is a hypothetical model, imperfect competitive markets are widespread.

3

3.3.1  Monopoly

Monopoly is a situation in the market when a single company controls the whole supply in a certain market with its product offerings that have no substitutes. Monopolies tend to share four features, such as high barriers of entry, the dominance of single seller, control over prices, and the economies of scale. In many cases, monopolies are of natural origin (Natural Monopoly), when they are established due to natural causes. Such monopolies can arise in industries that require unique raw materials or technology. Case box In many sectors, monopolization is hardly avoidable. Examples of natural monopolies are railways, airports, water supply, heating, sewage, etc. It is impossible to have two gas pipelines from two competing companies in an apartment, as well as to receive heat and water from two stations. Many public service sectors are natural monopolies.

Monopolies can take various legal forms. The mainstream types of business organizations are cartels, syndicates, trusts, and concerns. Cartel is a union of otherwise independent enterprises of the same industry, in which all participants retain their ownership of the factors of production and products and sell goods in the market independently, but act together and thus can control prices for the goods they produce, without competition. They agree on quotas (shares of each firm in the total output or sales), prices, and territories where they operate. Syndicate is a temporary alliance of a number of enterprises that produce heterogeneous products and join together to manage a large transaction, which would be difficult, or impossible, to effect individually. Members of a syndicate retain their factors of production individually, but consider produced goods or services as their common property which is distributed through a single channel. Trust is an association of legal entities in which joint ownership for the means of production and finished products is established. Concern is a union of formally independent enterprises from different industries within which a parent company establishes financial (monetary) control over other participants. Concerns are particularly widespread in the market.

9

Liberto (2021).

85 3.3 · Monopoly and Oligopoly

3

. Fig. 3.4  Equilibrium under monopoly. Source Authors’ development

A monopoly should never be confused with Monopoly Power, which is the ability of a firm to influence prices and profits by manipulating its output and sales. In general, monopoly power refers to a firm’s ability to charge a price higher than its marginal cost. Using its monopoly power, a firm can increase its profit by setting higher prices, while producing and supplying fewer products than the market needs (below public effective level). Profit maximization in a monopoly market occurs where MR = MC. As demonstrated previously in 7 Sect. 3.2.3, supernormal profit attracts new firms to enter the market. However, compared to a competitive market (even the case of monopolistic competition demonstrated in . Fig. 3.2), there are barriers in a monopolistic market that actually enable a monopoly to keep supernormal profits by increasing price and reducing output. . Figure 3.4 shows how a monopoly is able to make supernormal profits because the price AR is greater than ATC. In a competitive market, the equilibrium is established at point C. Under monopoly, it is point M with output Qm (lower than Qc under competition) and price Pm (higher than Pc under competition). Supernormal profit is defined as (AR − ATC) × Q. Deadweight welfare loss in a monopolistic market is a combined loss of producer and consumer surplus compared to a competitive market. Along with the overall public welfare loss, monopolies are believed to allocate resources less effectively compared to firms in a competitive market. Under monopoly, price P is greater than MC (Pm > Pc). In a competitive market, more consumers would benefit with price at Pc. A monopoly itself is less efficient compared to a firm in a competitive market, because it is not the lowest point on the ATC curve. It has less incentive to cut costs because it does not face competition from other firms. Therefore, the ATC curve is higher than it should be. Theoretically, monopolies enjoy higher economies of scale, which enables them to benefit from lower average costs in the long run. In real life, however, it is possible that if a monopoly gets too big, it may experience diseconomies of scale failing to coordinate efficiently its bloated assets and staff.

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There are, however, arguments in favor of a monopoly. Higher public and economic costs resulting from the existence of a monopolistic market can be viewed from an alternative point. It is the monopoly power that stimulates technical, organizational, and marketing improvements, since it guarantees that the results obtained are not immediately replicated by competitors, but they increase the profit of a company. Monopolies also conduct research in order to protect the markets they control from the potential invasion of competitors, ensuring cost advantages for themselves. It is also important that monopolies have greater opportunities in comparison with firms in competitive markets for conducting costly research at the expense of their supernormal profits. Case box Google, Amazon, Apple, and some other tech giants can be considered monopolies in their segments of the market. They have not explored the unique advantages as natural monopolies, but have gained their monopoly power due to the effective implementation of innovations, technological advancements, management and business practices, etc. Therefore, monopoly does not always lead to inefficiency.

The very desire of a firm to maximize economic profit from increasing its market power stimulates technological progress. Antitrust regulations are applied by many governments worldwide to prevent market failures and reduce public welfare loss (see 7 Chap. 10, 7 Sect. 10.2), but at the same time, governments in most countries grant inventors the rights to temporary monopolies as they carry out patent protection of inventions, know-how, and innovations. Thus, in some situations, monopolistic markets facilitate the emergence of brand new advanced products and technologies, as well as the reduction in marginal and average total costs, which contributes to the growth of public welfare. 3.3.2  Oligopoly

Oligopoly is a market in which a relatively small number of sellers serve many buyers. Either explicitly or tacitly, these firms collude to restrict output and affect prices to achieve above normal market returns. Oligopolies often emerge as competitive companies grow and capture markets, gradually displacing or absorbing competitors. Over time, the number of companies offering certain products and services decreases to several large corporations. Customers, in turn, tend to trust famous and reputable brands when choosing products. In the developed oligopoly, the dominant companies can completely control pricing. The distinctive feature of an oligopoly is the complete or partial absence of price competition among firms. This substantially restricts the entrance of new firms to the oligopolistic market. They are not allowed to pass the existing legal restrictions or too high initial costs. Thus, the following features of an oligopoly can be distinguished:

87 3.3 · Monopoly and Oligopoly

3

5 Few firms and many buyers. The market supply is provided by several large firms that sell their product to many small buyers. 5 Differentiated (heterogeneous) or standardized (homogeneous) products. 5 Oligopolists’ decisions regarding output volumes and prices are interdependent. If one firm reduces prices, others do the same to retain their customers. However, if one firm raises prices, then others may not follow his example, as they risk losing their market share. 5 Due to a high dependency of firms on each other’s actions, no individual firm enjoys decisive control over prices. 5 High market entry barriers. Case box Examples of oligopolistic markets are the markets of smartphones (Apple and Samsung), laptops (Lenovo, HP, and Dell), aircraft (Boeing and Airbus), and soft drinks (Coca-Cola and Pepsi).

There are several forms of oligopoly: 5 Dominant oligopoly—several firms with one of them occupying over 60% of the market. 5 Homogeneous oligopoly (pure or undifferentiated)—the market is divided between several firms that produce or sell homogeneous products or varieties of the same product. 5 Heterogeneous oligopoly (differentiated)—firms trade in heterogeneous products or services that substantially differ in varieties and features. 5 Collective oligopoly—firms cooperate with each other in determining the price or volume of output. Such a structure carries signs of collusion and monopolization of the market. The variety of forms of behavior in oligopolistic markets and the peculiarities of relationships between forms in specific market situations determine the existence of various models of oligopoly. Oligopolistic markets are divided into two types depending on how firms interact with each other: cooperative oligopolies (the Price Leadership model) and non-cooperative oligopolies (the Cournot model and the Kinked Demand Curve model). If firms in an oligopolistic market prefer cooperation over aggressive competition, but they can not establish a cartel because it contradicts the antitrust legislation, they can coordinate their activities as if an agreement between them existed. One of the forms of such conscious coordination is Price Leadership, when one of the firms in the market receives the status of a price leader recognized by others and regulates market prices (the price setter). Other firms act as price takers thus establishing a competitive environment for the price leader. The latter assumes the risk of being the first to start adjusting the price to the market situation, assuming that others will follow. If this does not happen (other firms do not agree with the

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Chapter 3 · Market Structures

3

. Fig. 3.5  The price leadership model. Source Authors’ development

price change), the price leader bears losses until it returns to the initial price level. A significant risk of making the first decision causes the relative rigidity of prices in oligopolistic markets. A price leader assigns its price as the current market price, and allows competitors to trade freely at this price. Price takers determine the optimal volume of their output as MC = MR, where MR is equal to the price of the dominant firm (. Fig. 3.5). Let us suppose that the price leader estimates the market demand curve as D, and the supply of competitive firms as Sf (found by adding individual marginal cost curves above the average variable costs of each firm). Knowing the share of demand that firms can satisfy, the dominant firm estimates the demand curve Dd for its products (the residual demand curve). At price P1 and above, competitors are able to satisfy all market demand, i.e., the residual demand of the dominant firm is zero. At price P2, the total market demand is equal to the P2 C segment, the share of oligopolistic firms accounts for P2 B, and the residual demand of the dominant firm is BC. If we set point A on the P2 C segment so that BC = P2 A, we get a point on the Dd curve of the dominant firm. The entire Dd curve is built in the same way. At price below P3 (the minimum average variable costs of price takers), the dominant firm covers all market demand, since for other firms it makes no economic sense to produce. Thus, the full demand curve of the dominant firm is the Dd curve plus the FD segment. At MCd = MRd, the output and price are optimal for the dominant firm at the intersection of Qd with Dd curve. At price Pd, the total market demand is Qt, from which the dominant firm accounts for Qd units, while other firms account for the remaining Qt − Qd. Case box Pizza Hut is an example of a dominant firm in the price leadership model. IBM used to be the price leader in the computer market, Coca-Cola in the soft drinks market, General Motors in the automotive industry, but the growth of other firms (price takers, according to the price leadership model) has weakened the dominant positions of price leaders.

89 3.3 · Monopoly and Oligopoly

3

. Fig. 3.6  The Cournot model. Source Authors’ development

Barometric Price Leadership assumes the existence of several approximately equivalent enterprises in the market, so no firm dominates others and no firm needs to be the leader. Under these conditions, one of the firms acts as a price leader not because it has the largest market share or the lowest costs, but because of its special ability to track changes in the market situation (the upcoming rise or fall in prices for resources used by firms in the industry, changes in prices for complementary or substitute goods). Such a firm declares the change in prices at first and assumes that other organizations would accept it. Other firms perceive the actions of this company as an indicator, or a barometer of the future situation in the market. The Cournot Model is an oligopoly model of equilibrium, in which the behavior of firms is based on a comparison of independent forecasts about ­market changes. Each firm anticipates the moves of its competitors and chooses such output and price that would stabilize its position in the market. If the initial calculations are incorrect, the company corrects the parameters. After a certain period of time, the shares of each company in the market are balanced and do not change in the future. Antoine Cournot (1838)10 illustrated his model with the example of a duopoly, in which two duopolists have identical products and identical costs. In . Fig. 3.6, the R1 (Q2 ) curve is the reaction curve of duopolist 1 to the amount of output change made by duopolist 2, and, accordingly, the R2 (Q1 ) curve is the reaction curve of duopolist 2 to the amount of output change made by duopolist 1. The intersection of the two best-response curves of the two rivals in oligopoly is the Cournot Equilibrium, the point of output level at which firms have no incentive to change their output. At the equilibrium point, duopolist 1 chooses the optimal output Q1∗, assuming its competitor’s output to be Q2∗. In turn, duopolist 2 simultaneously and independently from duopolist 1 chooses the optimal output Q2∗, assuming the output of its competitor to be Q1∗. Thus,

10 Cournot (1838).

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each firm decides its own output so as to maximize profit and no firm wants to change its choice unilaterally acting on the assumption that its competitors do not change theirs. Despite its advantages in depicting the patterns of the oligopolistic market, the Cournot model has been receiving criticism due to using too simple initial assumptions. In the model, oligopolists do not assume the possibility of changing the output of their competitors. Also, the behavior of firms in the market is symmetrical. Meanwhile, in real life, oligopolists adhere to various types of behavior, as well as the oligopolistic market itself is far more complex than the duopoly model can picture it. The Kinked Demand Curve Model developed by Paul Sweezy (1939)11 aims to explain the rigidity of prices in the non-cooperated oligopoly. The model suggests that prices in an oligopolistic market are fairly stable and there is little incentive for firms to change them. That is, if a firm increases the price, it loses its competitive advantage and risks facing a fall in demand and revenue. Therefore, demand is price elastic for a higher price. However, if a firm decreases the price, it would potentially expand its share in the market at the expense of its rivals. Competitors, who do not want to lose their markets, would cut prices too. Therefore, for a price cut, demand is price inelastic. In the situation when all firms in the market reduce prices almost simultaneously, there is no gain in market share for anyone. Therefore, firms prefer non-price competition, while the prices remain relatively stable. Suppose that three oligopolists A, B, and C produce homogeneous products and each owns 1/3 of the market. If firm A reduces its price below the market average P∗, then firms B and C are likely to follow its example, so as not to lose their customers and prevent the strengthening of firm A at their expense. However, if firm A raises its price above P∗, then firms B and C would hardly do the same expecting to expand their shares in the market at the expense of some of the customers of firm A. It can be assumed that if competitors ignore the price increase in an oligopolistic market, but react accordingly to the price decrease, then the demand curve of firm A will have different slopes above and below the level of the prevailing price. The kink of the demand curve D at the prevailing price point breaks the marginal revenue curve MR in the BC section (. Fig. 3.7). Suppose that the marginal costs curve MC passes through this gap in the BC section. Then, the optimal output volume is Q∗ at the optimal price P∗. Any increase in costs ′ shifts the MC curve to the right (MC ) within the BC segment, but neither the optimal output nor the optimal price changes. Similarly, we can consider the situation when the market demand changes (. Fig. 3.8). An increase in the market demand (the shift of the demand curve ′ D upwards right to D ) along with a corresponding shift in the marginal revenue ′ curve MR to MR results in the increase in the optimal volume of production from ′ Q∗ to Q , but the market price P∗ remains unchanged.

11 Sweezy (1939).

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. Fig. 3.7  The kinked demand curve model (rising costs). Source Authors’ development

. Fig. 3.8  The kinked demand curve model (rising demand). Source Authors’ development

Therefore, the kinked demand curve model suggests that changes in either costs or demand still lead to the same price. If competitors expect an adequate reaction to their actions, they try to refrain from unilateral price increases or decreases. An exception may be a situation where oligopolists’ costs differ significantly from each other, and a firm with the lowest costs can set a lower price to benefit from this advantage. Moreover, since buyers can easily change between sellers by choosing the one with lower prices, competition forces oligopolists to sell their products at the same or almost the same prices. The exception is a differentiated oligopoly. If a company has developed a high commitment to its brand among buyers, then they agree to pay a higher price for a higher-quality product. Also, firms may not seek to maximize profits, but prefer to increase market share and so be willing to cut prices, even with inelastic demand.12

12 Pettinger (2019).

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Case box

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In a pure or poorly differentiated oligopoly (for example, the markets of aluminum, cement, or steel), there is a tendency to prices equalization. In highly differentiated industries, oligopolists tend to charge comparable prices. However, the assumption about the possible reaction of competitors is not always true for certain markets. Lowering the price by one of the oligopolists can be regarded as a sign of the low quality of the product or problems with distribution, rather than a method of price competition. Accordingly, the reactions of competitors depend on their perceptions and their vision of the situation in the market.

The main advantage of an oligopoly is that competition among large firms improves the quality of products, accelerates scientific and technological progress, and thus affects all segments of the economy. However, oligopoly restricts access of new (potentially, more effective) firms to the market. In many ways, an oligopoly is similar to a monopolistic market, which means it bears similar drawbacks for the economy. Oligopolists may conspire to get out of the control of the law, imitating a competitive environment, while simply pursuing their individual benefits at the expense of buyers. As a result, there can be a decline in the profitability of resource use and an increase in the number of dissatisfied customers. Despite the concentration of financial reserves among oligopolists, many of innovative products are developed by small and medium-sized businesses, who commonly lack financial or labor resources to scale up their inventions. This is what corporations use, independently implementing the developments of small businesses that are not able to provide capital for their innovations. 3.4  Monopsony and Oligopsony 3.4.1  Monopsony

Monopsony is a situation in a market in which there is only one buyer and many sellers. If in a monopoly with only one seller in the market, prices are controlled by a monopolist, then in a monopsony, prices are controlled by a buyer. Case box A common example of a monopsony is the labor market in a small town, where there is only one large employer and many potential employees (a coal mine in a remote area or a giant plant, the sole employer in a single-industry town). Such employers often offer less unfavorable working conditions compared with bigger and more diversified cities, lower wages, to which people agree in the absence of other jobs. In such territories, a monopsonist company is the only opportunity for the local population to get at least some work in

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. Fig. 3.9  Supply curve in a monopsonistic market. Source Authors’ development

the immediate vicinity of their home, without leaving their locality. The prerequisite for monopsony in the labor market is low mobility of labor, when workers are not ready to resettle or retrain.

In a monopsonistic market, the supply curve reflects not only the supply of one individual firm, but the entire industry as a whole. This is because the entire market is unrolled to a monopsonist, and many producers compete for a monopsonist’s desire to purchase a product. In the market with one buyer and many sellers, competition between the latter pushes the price down. Thus, a monopsonist dictates prices and sets them at a lower level compared to a perfectly competitive market. From the monopsonist’s point of view, the market price of supply reflects the dynamics of the average costs AC of the entire industry. The total supply in such a market is depicted by a curve that reflects the aggregation of the average costs of different firms in this market (. Fig. 3.9). Points on the AC curve correspond to certain supply prices (P1−3) a monopsonist buyer offers when purchasing a quantity of goods Q1−5. For a monopsonist, the supply price can be either descending (rare case) or ascending (commonly). Thus, the supply price in the market controlled by a monopsonist can either rise or fall. Consequently, the marginal costs of purchasing a product from a monopsonist buyer are not constant (as in perfect competition). They can decrease or increase as the AC curve reflects the dynamics of average costs. Let us consider the most common situation when the monopsonist’s demand D crosses the supply-costs curve AC with an increasing supply price (. Fig. 3.10). Amid rising supply price, a monopsonist buyer will face increasing marginal costs of purchasing goods or services in the market (the MC curve is above the ascending branch of the AC curve). The AC curve shows average costs in the market (for a monopsonist, this is also the supply curve). The MC curve shows marginal costs in the market (for a monopsonist, this is the curve of marginal costs of purchasing products). The demand curve D demonstrates marginal utility MU or marginal revenue MR (for a monopsonist, D = MU = MR).

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. Fig. 3.10  Equilibrium under monopsony. Source Authors’ development

Under monopsony, the equilibrium is established at the intersection of marginal costs and marginal revenues (point E). Point E1 determines the price P1 at which a monopsonist purchases products in a monopsonistic market. This price is below the one that would have been established under perfect competition between buyers (P1 < P0). Purchase volume Q1 is also below Q0. Thus, a monopsonist determines the quantity of purchased goods by comparing its MC and MR and finding the intersection. The E − E0 − E1 triangle is a deadweight welfare loss, which is a loss of earnings that are not captured by a monopsonist. The light blue area shows the transfer of income from sellers to buyers. When a monopsony exists in a labor market (see case box above), the transfer of income from workers to a monopsonist employer increases income inequality in society. The effects of deadweight loss and transfer of income under monopsony are similar to those under monopoly. In both situations, prices deviate from the state of equilibrium that would otherwise have been established under perfect competition. The only difference is that a monopolist sets prices above the level of perfect competition to gain supernormal profit, while a monopsonist sets prices below the level of perfect competition to benefit from a transfer of income (compare . Figs. 3.4 and 3.10). Case box Many of the local markets for primary raw agricultural products are monopsonies. For example, small dairies are often forced to hand over milk to the only processing plant in the district at a low price, because milk is a perishable product. Small farmers who grow vegetables and fruits commonly sell their products to a local cannery below the market price to save on storage and transport.

3.4.2  Oligopsony

Situation in the market when there is one buyer is called Pure Monopsony. In real life, however, there are various combinations of buyers and sellers in various

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markets. A market for a product or service which is dominated by a few large buyers is called Oligopsony (the opposite of an oligopoly). Buyers have a ­significant influence on sellers. If they lower prices, suppliers have no choice but to comply. Each of the buyers is relatively large compared to the total size of the market. This provides significant control over the entire market. The degree of control depends on the number and size of buyers. Entry barriers are widely used to establish control over the market. The most common practices include patents, resource ownership, government franchises, high entrance costs and investments, and brand awareness. These barriers make the entrance to the market extremely difficult for new firms. Oligopsony occurs due to the fact that sellers offer homogeneous products in the market and thus they have few alternative sources of revenues. Although there may be alternative buyers, they are less desirable for particular sellers in particular territories. That is why few buyers influence the market price, which is a situation of imperfect competition. Under perfect competition, a seller is free to choose between many buyers. The competition between buyers results in the establishment of an equilibrium price acceptable to both a buyer and a seller. In an oligopsonistic market, a seller can only sell to a small number of companies, so a seller must accept the price at which a buyer purchases, since there is no alternative buyer in the market. Case box The fast-food industry is one of the distinct examples of an oligopsonistic market. In the USA, several giant buyers (McDonald's, KFC, Burger King, Wendy's, etc.) control the entire market of meat and poultry. Such control allows them to impose on farmers the price they pay for meat, in addition to influencing animal breeding conditions and labor standards. The cocoa market is another example of an oligopsony. Three companies (Cargill, Archer Daniels Midland, and Barry Callebaut) consume the majority of the world’s cocoa bean production, mainly from small farmers in developing countries.

The advantages of an oligopsony as a market structure include the control of the market by buyers and the determination of prices. Buyers have considerable power and control over business transactions. They can use this factor to their advantage and dictate prices, output volume, and other conditions, knowing that sellers have few alternatives to sell. Under imperfect competition, buyers can get the desired amount of goods at the current price without having to exert any influence on the already set price. The higher the elasticity of supply for a given product, the less it can affect the price. Among the disadvantages of an oligopsony is the fact that suppliers are not allowed to apply any conditions to their products. Services or goods must be adapted to the demand of customers in terms of both quantity and price. This is a problem for sellers, as they may have to compromise with their prices in order to sell their products. This may bring significant losses to sellers and thus it may adversely affect the entire economy.

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Chapter Questions:

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5 Reveal the essence of the market as an economic category. What are the causes and preconditions of market development? 5 Who are the principal economic entities in the market? What functions does a market perform? 5 What is meant by the term “competition”? What types of competition do you know? 5 Assess the advantages and disadvantages of monopoly in comparison with perfect competition. 5 How is monopsony different from monopoly? Give examples and discuss major features of monopsonistic markets. 5 Explain the effects of supernormal profit, deadweight welfare loss, and transfer income in monopolistic and monopsonistic markets. Subject Vocabulary: Competition: an economic rivalry in the market between producers for the right to get the maximum profit, as well between buyers for a greater benefit. Imperfect Competition: a market in which at least one of the assumptions of perfect competition is not met. Market: a system of economic interactions between economic entities, directly or through middlemen, which is based on the exchange of goods and services. Market Concentration: a role of certain companies and their individual shares of the total production in a particular market. Market Segment: a part of the market, a group of consumers of products or enterprises that are formed on the basis of certain common characteristics or criteria. Market Structure: a set of interrelated qualitative and quantitative interactions between separate market elements, which characterizes stable certainty of the market and ensures its operation. Monopolistic Competition: a market structure in which the features of perfect competition coexist with certain elements of a pure monopoly. Monopoly: a situation in the market when a single company controls the whole supply in a certain market with its product offerings that have no substitutes. Monopoly Power: an ability of a firm to influence prices and profits by manipulating its output and sales. Monopsony: a situation in a market in which there is only one buyer and many sellers. Oligopoly: a market in which a relatively small number of sellers serve many buyers. Oligopsony: a market for a product or service which is dominated by a few large buyers. Perfect Competition: a type of market structure where there is an extensive number of producers and consumers competing with one another, who all have full and symmetric information about the market.

97 References

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References Bondarenko, P. (2017). Lerner Index. Available at 7 https://www.britannica.com/topic/Lerner-index. Bondarenko, P. (2019). Herfindahl-Hirschman Index. Available at 7 https://www.britannica.com/topic/ Herfindahl-Hirschman-index. Chamberlin, E. (1933). Theory of monopolistic competition. Harvard University Press. Corporate Finance Institute. (2021). What is Monopolistic Competition? Available at 7 https://corporatefinanceinstitute.com/resources/knowledge/economics/monopolistic-competition-2/. Cournot, A. (1838). Researches into the mathematical principles of the theory of wealth. New York, NY: The Macmillan Company. Liberto, D. (2021). Imperfect competition. Available at 7 https://www.investopedia.com/terms/i/imperfect_competition.asp. Marshall, A. (1890). Principles of economics: An introductory volume. Macmillan. Pettinger, T. (2019). Oligopoly. Available at 7 https://www.economicshelp.org/microessays/markets/oligopoly/. Rothschild, R. (1987). The theory of monopolistic competition: E.H. Chamberlin’s influence on industrial organisation theory over sixty years. Journal of Economic Studies, 14(1), 34–54. Seth, A. (2021). Markets: Definition, classification, condition and extent of the market. Available at 7 https://www.economicsdiscussion.net/articles/markets-definition-classification-condition-andextent-of-the-market/1682. Sweezy, P. (1939). Demand under conditions of oligopoly. Journal of Political Economy, 47, 568–573.

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© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_4

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Learning Objectives: 5 Understand the fundamentals of macroeconomic policies and the role of the state in the market 5 Study major features of the key macroeconomic entities, such as households, firms, state, and the foreign sector 5 Discuss the role of transnational corporations in contemporary globalizing markets 5 See how various forms of economic integration influence the economic and trade policies of individual states 5 Learn about major international economic, trade, and financial organizations acting in the global economy 4.1  Governments and Macroeconomic Policies

As shown in 7 Chap. 2, the macroeconomic analysis uses aggregate values that characterize the development of the economy as a whole: gross national and domestic products, price level, interest rate, inflation, employment, and others. The most important outcome of macroeconomic analysis is the elaboration of macroeconomic policy. Macroeconomic Policy is the regulation of the behavior of macroeconomic agents in the market to ensure and maintain stable macroeconomic equilibrium and growth of the national economy. These two goals of macroeconomic policy contradict each other since economic growth is impossible without a violation of the existing proportions and equilibrium in the markets. Breaking the balance, the economy moves forward, develops, achieves balance again, in order to break it afterwards—this is the dialectic of economic development. Without this contradiction, neither society nor economy would have been able to develop. The main thing is to ensure that market fluctuations are mild enough to prevent shocks in the economy and society. In view of this approach, the macroeconomic policy could be either market-determined or structural. Market-Determined (Stabilization) Macroeconomic Policy is a policy aimed at smoothing cyclical fluctuations in the economy and ensuring full employment of resources. The market-determined macroeconomic policy includes: 5 monetary policy (money and credit) (further detailed in 7 Chap. 11); 5 fiscal policy (taxation and budgeting) (further detailed in 7 Chap. 13); 5 income policy (see 7 Chap. 14 for income-related issues of economic growth); 5 foreign economic policy (various dimensions of foreign exchange, trade, and labor policies are addressed in Part V). Structural Macroeconomic Policy is a policy aimed at ensuring and maintaining sustainable economic growth. It includes all measures aimed at stimulating economic development. In contemporary globalized markets, the goal of economic growth of an individual country is not only to increase the welfare of the

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population in this country, but also to displace competitors to win the competition in domestic and foreign markets of goods, services, and financial and economic resources. According to the level of policy, its direction, planning horizon, and other criteria, different types of macroeconomic policy are distinguished (. Table 4.1). In addition, there are two other important spheres of macroeconomic policy that unite all the types presented in . Table 4.1. These are anti-inflationary policy (detailed in 7 Chap. 9) and anti-monopoly policy (see 7 Chap. 10, 7 Sect. 10.2). The former is aimed at curbing inflation and is connected with all areas of financial policy. The latter includes price, insurance, production, trade, and resource policies, since monopolies may arise in any of these areas. The main entity that conducts macroeconomic policy is the state, represented by the public authorities (legislative, executive, and judicial), commonly referred to as “the government”. The macroeconomic policy is aimed at macroeconomic entities (households, firms, state itself, and the foreign sector) and markets (goods and services, financial market, the market of economic resources, etc.). Thus, the state acts both as the main subject conducting macroeconomic policy and as the object of this policy, since public authorities are controlled by society.1 The state regulates the behavior of macroeconomic entities and the equilibrium in markets to achieve certain goals and objectives. The main goals of the macroeconomic policy are closely related to its functions: eliminating market failures (further detailed in 7 Chap. 10) and ensuring the social and economic wellbeing of the people (social welfare) (social issues of economic growth are discussed in 7 Chap. 14). The objectives of macroeconomic policy are determined by the development requirements that are set by the changing reality in a given period of time. Therefore, depending on the state of economic development, not only the tasks of macroeconomic policy change, but also its types (counter-cyclical, anti-inflationary, economic growth, stabilization, etc.). Commonly, the macroeconomic policy is aimed at achieving the following objectives: 5 ensuring sustainable economic growth that allows achieving higher quality and standard of living of the population; 5 ensuring high employment (a negligible forced unemployment may occur), which provides an opportunity for all individuals to realize their abilities and earn income depending on the quality and quantity of labor spent; 5 ensuring social security that guarantees a decent existence for the unemployed, disabled, and elderly people, as well as children; 5 ensuring economic freedom, which allows economic entities to choose the sphere of activity and the model of economic behavior; 5 ensuring overall economic security; 5 achieving an optimal balance of payments, ensuring the establishment of equilibrium in international markets, and stabilizing the exchange rate of the national currency.

1

Alexandrov (2020).

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. Table 4.1  Types of macroeconomic policy

4

Criteria

Types

Level

External (foreign) policy—a public policy aimed at regulating the relations of the domestic market with the foreign sector Internal (national, regional, local) policy—regulation of the relationship of macroeconomic entities within the domestic sector of the economy

Direction

Social policy—a public policy aimed at ensuring the growth of the welfare of citizens Economic policy—measures aimed at the growth and development of the national economy and the maintenance of macroeconomic equilibrium in the domestic market

Planning horizon

Long-term policy—a policy of economic growth in order to ensure long-term conditions for the maximum possible growth and development of the economy Short-term policy—a policy of stimulating or restraining economic growth, that is, smoothing economic development cycles

The way the state affects the economy

Incentive policy—a policy carried out during a downturn in order to revive and grow the economy Stabilization policy—a policy carried out to preserve the current situation in the economy Deterrent policy—a policy used during the boom period, when the economy is overheated; it is aimed at reducing (cooling) business activity in the economy

The use of macroeconomic tools

Discretionary policy—a legislative, official change by the government of the value of regulated parameters or instruments of macroeconomic policy in order to stabilize the economy. In the case of fiscal policy, this is the amount of public procurement, taxes, and transfers. These changes are reflected in the laws and legislative acts, for example, in the state budget Automatic policy—employment of built-in (automatic) stabilizers, which are tools whose value does not change, but the very presence of which (their embeddedness in the economic system) automatically stabilizes the economy, stimulating business activity during a recession or cooling the economy during overheating

Source Authors’ development

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When conducting macroeconomic policy, comprehensive use of legislative, economic, indirect, and administrative methods is carried out. By employing these tools, the government affects the economy. Legislative tools include: 5 development of laws, norms, and regulations that establish uniform rules for all economic entities; 5 protection of property rights; 5 encouragement of competition and establishment of a competitive market environment; 5 curbing the influence of monopolies; 5 incentivizing various forms of entrepreneurship; 5 creation of a favorable investment climate. Economic methods include the functioning of the public sector of the economy, targeted financing of state programs and projects, as well as public procurement. Administrative tools include: 5 antimonopoly regulation (prevention of monopoly collusion, regulation of the activities of major entities in the market, compulsory separation of large corporations, etc.); 5 establishment of mandatory standards and quotas (social, sanitary, environmental); 5 establishment of living and wellbeing standards (mandatory minimum wage, unemployment benefits, administrative restrictions to people and businesses, etc.). The key indirect methods are monetary and fiscal policies, foreign economic regulations (lending and promotion of export transactions, attraction or restriction of foreign investment), and accelerated depreciation of assets. Previously in 7 Chap. 1, 7 Sect. 1.4, we discussed interactions between various economic entities in the market. In macroeconomics, there are four entities: households (7 Sect. 4.2), firms (7 Sect. 4.3), the state (7 Sect. 4.4), and the foreign sector (7 Sect. 4.5). Each of these entities has specific features and carries out different activities. However, in the macroeconomic modeling of the behavior of economic entities, only those features that have a significant impact on economic development are taken into account. They are reflected in the dynamics of the key macroeconomic indicators, such as GDP, GNP, national income, inflation, and unemployment. On the one hand, economic entities are considered as a set of real economic entities included in the respective group. On the other hand, they are approached as typical representatives of economic entities of a particular type. For example, when analyzing the economic behavior of households in the market, an individual household is assessed as a typical representative of households. The same applies to domestic firms and foreign enterprises.

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4.2  Households

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At its simplest, a household is one person living alone or a group of people who live together or share living arrangements in a house or a flat. In macroeconomics, Households (the household sector) are a cumulative macroeconomic entity, which includes all private economic units within a country, whose activities are aimed at meeting their own needs. All factors of production are owned by households. They receive income due to selling or leasing these resources and distribute this income between current consumption and savings. Consequently, households demonstrate three types of economic activity: they offer factors of production in the market, consume part of the income received, and save the remaining part of it by opening savings accounts in banks or purchasing securities and real estate. The households sector unites all employees, owners of large and small capital, land, securities, who are either employed or not employed in public production. Historically, households have been involved in all processes in the economy. The difficult economic and financial situation of the majority of the population is believed to be the main reason for an economic crisis. A household can sometimes be interpreted from a different point of view. It is often considered a synonym for a family, but not all households are families. One person can represent a household. A household is an accounting and statistical parameter used to analyze the state of society. Gross and monetary incomes are allocated as part of household finances. Gross Income includes monetary income, the cost of in-kind receipts of food products and benefits, subsidies, and gifts provided by the state and organizations in kind (excluding accumulated savings). Gross income has been taking a dominant position throughout the developing world, where savings have always been at a low level due to the relatively low level of income. The composition of gross household income is dominated by Cash Income, which is the amount of money that a household possesses to support its expenses. Cash income can be classified according to several criteria: 5 sources of income—wages and an additional payment of employment, income from doing business, income from securities, rent for leased property, insurance compensation, income from the sale of property, payment of state funds (budgets, extra-budgetary funds), etc.; 5 regularity of receiving—regular income (salaries, rents, etc.), periodic income (royalties, income securities, etc.), occasional or one-time income (gifts, income from the sale of property); 5 stability of income—guaranteed income (pensions, income from state loans); conditionally guaranteed income (wages), and non-guaranteed income (fees, commission). The expenses formed as part of household finances play an important role in the entire economic system of a country. Their significance lies in the fact that using its income, a household ensures the formation and development of the market of goods and services, and also increases the demand for securities, thereby

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expanding the stock market. Moreover, households are pivotal suppliers of labor and entrepreneurial activity in the market. Satisfaction of the needs of household members can be carried out by supplying labor in the market and further use of income for the purchase of goods and services. The expenses of a household represent the actual costs of acquiring material and spiritual values to ensure the life support and existence of a household and its members. These costs include consumer expenses and expenses not directly related to consumption. Monetary expenses of a household are classified according to the three following criteria: 5 regularity—permanent expenses (food, utilities), regular expenses (clothing, transport, utility payments), and one-time expenses (medical care, durable goods, real estate purchase); 5 necessity—high-priority or necessary expenses (food, clothing, medical care), desirable expenses (education, insurance premiums), and other; 5 usage—consumer funds for the purchase of goods and payment for services, mandatory payments and contributions, savings in deposits and securities, purchase of foreign currency, cash money, etc. The aggregate of actual income and expenses establishes the household budget. One of the most important features of households is savings. Household Savings is a part of the money released as a result of the economic activity of households and saved by them. There can be various reasons for saving, such as relatively large incomes (conversely, a lack of money that forces households to save), uncertainty in the economy, or savings for investment. The savings activity of the population has a direct impact on the current and future demand and thus affects the dynamics of major macroeconomic indicators. Saved funds are withdrawn from circulation (at the same time, they commonly change their form), which leads to a change in the structure of the money supply, slows down money circulation, and reduces inflation. The saving behavior of households determines which part of saved income can be transformed into investment and consumer loans. Accumulated savings are an important element of the household budget that allows households to make substantial purchases, covering unforeseen expenses, and maintaining the current level of consumption during periods of income decline. 4.3  Firms and Corporations 4.3.1  Firms and the Theory of the Firm

Firms (the business sector) are a macroeconomic entity, which represents the aggregation of all firms and enterprises operating within a country. They purchase factors of production, sell manufactured products, render services, and maintain and develop production. Thus, firms carry out three types of economic activity: demand for factors of production, supply of goods, and investment of capital. The functions of firms and enterprises depend on the profile of their activities

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. Table 4.2  Types of firms and enterprises Criteria

Types

Ownership

Public (state) enterprises Municipal enterprises Private enterprises Non-governmental property

4

Other forms of ownership (mixed ownership, foreign ownership) Purpose

Production of goods Execution of works Rendering of services

Industry

Industrial enterprises Agricultural enterprises Enterprises in the spheres of transport, communication, construction, etc.

Size

Micro enterprises Small enterprises Medium enterprises Large enterprises

Goal

Commercial enterprises Non-commercial enterprises

Source Authors’ development

(production of goods, performance of works, provision of services, etc.). Their functions are specified depending on the industry affiliation. Performing their functions, firms solve a number of tasks, including the following: 5 making profit, increasing the market value, providing income to owners; 5 providing consumers with goods, works, and services of appropriate quality in accordance with demand and available production capabilities; 5 providing staff with wages, adequate working conditions, and opportunities for professional growth; 5 rational use of economic resources; 5 introduction of new and advanced practices, know-how, and innovations in production, organization of labor, and management; 5 ensuring the competitiveness of products and a firm as a whole. Firms can be classified according to various criteria (. Table 4.2). The main characteristics of a firm as the primary independent organizational unit of entrepreneurship undertaking include the following: 5 legal independence—a firm is a legal entity registered with the relevant public authorities;

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5 production independence—a firm independently decides what, where, and how to produce and sell; 5 financial independence—a firm independently distributes the revenues it receives; 5 organizational independence—a firm independently chooses the type of its organization and internal structure. In general, a firm (company, enterprise) can be defined as an independent territory-separated and resource-separated complex that carries out the production and reproduction of resources. A firm as an economic entity can consist of one or more enterprises. The term “enterprise” is used to refer to the primary technological unit (plant or factory). However, in practice, the terms “firm” and “enterprise” are often used as synonyms. A firm carries out an exchange with other economic entities in the market with a corresponding transformation: exchange of money for resources—combining and aggregating resources in production—manufacturing goods—exchanging these goods for an amount of money that exceeds the amount originally spent. The complexity of technological, organizational, and economic relationships within a firm, as well as the versatility of the interaction of a firm with other economic entities, determine the need to take into account the specifics of the internal and external business environment. In general, the External Environment of a firm can be characterized as the whole set of factors affecting its activities, namely: consumers, competitors, suppliers, intermediaries, economic, social, and political situation in a country, as well as the level of science and culture. The external environment is the aggregation of conditions and factors that arise independently of a firm and that have a significant impact on a firm. External factors can have either a direct (micro-environment) and indirect (macro-environment) impact on a firm. The former directly affect the production and economic activities of a firm (consumers, suppliers, competitors, and intermediaries). The latter include: 5 scientific and technical factors (the level of research and development in a country, technology, equipment); 5 economic factors (the state of the country’s economy as a whole, inflation, balance of payments, employment, interest rates); 5 political factors (political situation in a country, stability of domestic and foreign policy, social stability); 5 natural factors (availability of natural resources and the state of the environment); 5 social and demographic factors (the level of culture, traditions, values accepted in a given society, demographic changes). The Internal Environment of a firm is the environment that determines the technical and organizational conditions of a firm and that is the result of management decisions. The internal environment includes resources (material, financial, labor), organizational and management structure of a firm, technologies, and information.

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. Table 4.3  Theories of the firm Theories

Representatives

Concept

Neoclassical theory

Alfred Marshall, John Clark

A firm appears as a transformative enterprise that minimizes production costs as its social functions and strives to maximize profit. Therefore, a firm exists and makes decisions to maximize profits

Institutional theory

Ronald Coase, Oliver Williamson

A firm is an integral self-reproducing complex, an aggregate of specific resources that allow extracting a synergistic effect from their connection

Behavioral theory

Richard Cyert, James March, Herbert Simon

A firm is a living system, i.e., a system that has a highly unique inner spirit, philosophy, and corporate culture, that gives a firm purposefulness, a desire for harmonious development, an attitude towards partners and competitors based on business ethics

4

Source Authors’ development

The following factors influence the specifics of the internal environment: 5 the sector of the economy and the sphere of production; 5 the organizational structure of a firm; 5 goods, works, and services produced, executed, and rendered by a firm; 5 duration of the production cycle; 5 equipment and technologies used in the production; 5 nomenclature and quality of resources, materials, and semi-finished products used in the production; 5 number of employees and the overall level of their qualification; 5 level and qualification of management. In contemporary macroeconomics, the interpretations of the nature of a firm can be divided into three groups: neoclassical (mainstream economics today), institutional, and behavioral (. Table 4.3). Neoclassical Theory of the Firm (late XIX century—early XX century) treats a firm as a pure production (technological) unit. The main conceptual provisions of the neoclassical theory are as follows: 5 A firm is a category of production. Its appearance is associated exclusively with production as a result of the development of the division of labor and cooperation based on machine production.

109 4.3 · Firms and Corporations

4

5 A firm is an integral part of the market. It operates irrespectively of the will of a economic entity. Therefore, there is no differentiation between a firm as an economic entity and the market. 5 The behavior of a firm is completely similar to that of other economic entities (for example, households). Therefore, a firm as an economic entity possesses no distinctive features. 5 A firm is interpreted as a closed monolithic entity. Its internal organization is not explored. Therefore, it degenerates into a kind of formal structure, a black box, whose activity is described by a production function (input—completely interchangeable and complementary resources, output—products). 5 The activities of a firm are predetermined and stable (perfect information, complete rationality of the behavior of economic entities), so the market is cost-free and all transactions are instantaneous; 5 A firm aims to maximize its profit, i.e., increase the difference between revenues and expenses. Neoclassical economics dominates mainstream economics today, so the theory of the firm (and other theories associated with neoclassicism) influences decision-making in a variety of areas, including resource allocation, production techniques, pricing adjustments, and the volume of production.2 Institutional Theory of the Firm grew out of the neoclassical paradigm in the 1930s. Initially, the institutional approach existed not as an independent theory, but as a variant of neoclassical interpretation that attempted to eliminate some of its shortcomings. The fundamental difference between the neoclassical and institutional approaches is that the latter compares revenues with transaction costs, rather than overall production costs. The following provisions were justified: 5 A firm is opposed to the market as an internal hierarchical structure is opposed to an external spontaneous one. 5 As a category of production and exchange, a firm has a contractual nature. Unlike the market, where relationships are mediated by relatively short-term contracts, a firm is a set of long-term contracts of owners of specific resources. 5 The main reason for the existence of firms is the presence and value of transaction costs associated with the uncertainty of the external market ­ environment and imperfect information. Therefore, a firm aims to minimize transaction costs. In contemporary macroeconomics, alternative theories of the firm have been emerging. They are not related to the development of the neoclassical direction itself. Instead, they are trying to use new analysis tools. These include the Behavioral Theory of the Firm and its variants (the theory of satisfaction and the evolutionist concept, among others). According to the behavioral approach, a focus is made on the inner motives and direction of firms, using a range of models and different

2

Murphy (2020).

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assumptions about those who work in a firm. Due to such an approach, the proponents of the behavioral theory criticize the desire to maximize profit as the purpose of the firm’s activity. An important contribution to the criticism of this provision was made by Herbert Simon, the 1978 Nobel Prize laureate in economics. Simon is the author of the theory of satisfaction. According to Simon (1947),3 the firm’s principal objective is satisficing or satisfactory profits. The firm’s goal is not maximizing profits but attaining a certain level or rate of profit, holding a certain share of the market or a certain level of sales. The key arguments of the behavioral theory are: 5 It is not clear which profit (long-term or short-term) should be maximized; 5 An entrepreneur often does not seek to maximize profit at all. They is satisfied with the level of profit that they considers acceptable, often focusing on a certain “mental income”, which could be the satisfaction from their activities, thirst for success, etc. 5 As a rule, a firm is managed by employees who are not interested in maximizing profit—a value that is difficult for the owner to grasp (and, accordingly, evaluate the performance of managers). They are interested in increasing the total revenue, the growth of the company and the shareholders’ dividends, i.e., the parameters that directly affect the remuneration of managers. Managers can pursue their own goals of personal enrichment to the detriment of a company. The most important feature of the behavioral theory is the revision of the tradition of studying a firm as an organization with strictly defined boundaries. Here, a firm is considered as an open system in the unity of factors of the external and internal environment. It is an active public entity that not only adapts to the market environment, but also changes it. In a certain sense, a firm becomes the fundamental category of macroeconomic analysis, while the market becomes a derivative. The clients of a firm are also part of it, because they provide direct information flows in the form of proposals, complaints, requests, or threats to cross over to competitors. In practice, employees communicate with customers even more often than with their colleagues within a firm. The goal of a firm in the conditions of complex corporate entities with several centers of power (shareholders, managers, employees, creditors, investors, competitors, suppliers, consumers, the state) is the desire for satisfaction, due to the need to find a balance of interests of the parties. It is the desire for satisfaction and optimization that is a sign of rational behavior, because a firm permanently faces a conflict of goals. Rational Behavior refers to a decision-making process that is based on making choices that result in the optimal level of benefit or utility for an individual.4 According to Simon (1947),5 decision-making is about achieving outcomes that are good enough for a firm based on limited information and balancing the interests of others.

3 4 5

Simon (1947). Hayes (2020). Simon (1947).

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4

Case box Most companies formulate their missions—a kind of super-task, the foundation for setting the goals of the entire organization. This is a message to customers and society that reflects the ideology, socially significant intentions of a firm, gives a clear idea of the activities, the concept and the meaning of the existence of a firm. During the COVID-19 pandemic, consumers have become more emotional and sensitive to brand communications. Many global leading companies, such as Coca-Cola, Nike, or McDonald’s turned to universal themes, appealing to family values, friendship, and love. Such a more intimate communication with consumers has helped businesses to survive difficult times. Advertising campaigns dedicated to the fight against the virus became role models for many. LVMH (Christian Dior, Givenchy, and Loro Piano brands) has launched the production of disinfectants at its perfume factories in France. Several tons of antiseptics were given free of charge to hospitals and city authorities. To combat the virus in Italy, Prada, the world’s famous fashion brand, launched the production of medical masks and wear.

4.3.2  Transnational Corporations

A significant part of the goods and services in the world are produced by enterprises that are controlled by foreign (international) capital. Companies that have organized cross-border value chains with the use of foreign direct investment, produce goods or render services internationally, and carry out income and asset management in more than one country are called Transnational Corporations (TNCs). The following key characteristics of TNCs are distinguished: 5 Distribution: TNCs sell a significant portion of their products abroad, thereby having a noticeable impact on the global market. 5 Location of production facilities: some subsidiaries and branches are located in foreign countries. 5 Ownership: TNCs are owned by residents of different countries (capital originates from different multinational sources). At least one of these features is enough for a company to be considered a transnational corporation. The world’s largest companies have all three features at the same time. In the modern world, it is difficult to distinguish a transnational company from an ordinary one due to the higher internationalization of sales markets, production, capital, and property. Case box Since 2003, Forbes’ Global 2000 list has measured the world’s largest public companies in terms of four equally weighted metrics: assets, market value, sales, and profits. The 2021 edition offered a glimpse into the early economic implications of the COVID-19 pandemic. The largest corporations (market value criteria) are Apple, Microsoft, and Amazon (USA), Aramco (Saudi Arabia), and Tencent (China) (. Table 4.4).

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112

. Table 4.4  The world’s largest corporations in 2021, $ billion

4

Rank

Company

Country

Market value

Sales

Profit

Assets

1

Apple

USA

2,252.3

294.0

63.9

354.1

2

Microsoft

USA

1,966.6

153.3

51.3

304.1

3

Saudi Aramco

Saudi Arabia

1,897.2

229.7

49.3

510.3

4

Amazon

USA

1,711.8

386.1

21.3

321.2

5

Alphabet

USA

1,538.9

182.4

40.3

319.6

6

Facebook

USA

870.5

86.0

29.1

159.3

7

Tencent Holdings

China

773.8

70.0

23.3

203.9

8

Alibaba Group

China

657.5

93.8

23.3

250.1

9

Berkshire Hathaway

USA

624.4

245.5

42.5

873.7

10

Samsung Electronics

South Korea

510.5

200.7

22.1

348.2

Source Authors’ development based on Forbes Global

20006

The reasons for the emergence of multinational corporations are very diverse, but all of them are more or less related to the advantages of planning in comparison with a pure market. Since large companies can complement spontaneous self-development in a free market with intra-company planning, TNCs turn out to be a kind of planned economy that consciously uses the advantages of the international division of labor. Transnational corporations have several advantages over domestic firms: 5 opportunities to increase efficiency and strengthen competitiveness, which is common to all large industrial firms that integrate supply, production, research, distribution, and sales enterprises; 5 mobilization of intangible assets related to the economic culture (production experience, management skills), which TNCs can both use domestically and transfer to other countries; 5 additional opportunities to increase efficiency and strengthen competitiveness by accessing resources worldwide (cheaper or more qualified labor, raw materials, research potential, production capabilities, and financial resources of the host country); 5 proximity of foreign branches to local consumers and the ability to obtain information about the market and competitors in the host country. Branches of transnational corporations gain important advantages over local firms through using the scientific, technical, and managerial potential of a parent company; 5 opportunity to take advantage of the country-specific regulations, such as fiscal policies in different countries, differences in exchange rates or interest rates and labor regulations. 6

Forbes (2021).

113 4.3 · Firms and Corporations

4

5 extension of life cycles of technologies and products by transferring them to foreign branches as they become obsolete in certain markets while focusing the efforts and resources in the parent country on the development of more advanced technologies and products; 5 greater ability to overcome protectionist barriers in particular countries by replacing export of goods with that of capital (i.e., by launching production in other countries); 5 greater ability of a large firm to reduce economic risks by locating its production facilities in different countries worldwide. TNCs are becoming a determining factor for deciding the role of a ­country in the global market, as well as for the development of the global economy. Host countries benefit from the inflow of investments in many aspects. The widespread attraction of foreign capital contributes to the reduction of unemployment in a host country, as well as the growth of budget revenues. With the launch of domestic production of those goods that were previously imported, there is no need for a host country to spend resources on importing them. Export-oriented companies that produce competitive products contribute to strengthening the positions of a country in the global market. In addition to quantitative contributions, there are also qualitative advantages brought by TNCs to host countries. The activities of TNCs force local companies to make adjustments to the technological process, the established practice of industrial relations, a­llocate more funds for training and retraining of their employees, pay more attention to the quality of their products, their design, and consumer properties. Most often, foreign investments are based on the introduction of new technologies, the production of new types of goods, and the introduction of advanced management and business practices. Case box Realizing the benefits host countries could get by attracting TNCs, international organizations recommend developing countries to invite TNCs to assist with technical modernization or improvement of business processes. Many developing and least developed countries compete for attracting TNCs. For example, when General Motors was choosing the location for its large plant for the production of cars and spare parts, its management considered the Philippines and Thailand. Experts recommended Thailand due to its more developed car market. However, General Motors selected the Philippines, where the government offered the company a series of benefits, including tax and customs reliefs.

TNCs promote economic integration by establishing economic ties between countries. In such a way, corporations facilitate the gradual dissolution of national and regional markets in a single global market (. Table 4.5).

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. Table 4.5  Effects of TNCs’ activities

Positive effects

4

For host countries

For capital-exporting countries

For the global economy

Obtaining additional resources (capital, technologies, managerial experience, qualified labor)

Unification of rules and regulations (import of institutions and global practices)

Increase in production and employment

Greater influence on other countries

Promotion of globalization, the convergence of markets, and closer ties between countries and corporations in the global market

Promotion of competition in the domestic market

Increase in revenues

Global planning and the establishment of preconditions for the more collaborative, predictable, and safer global order

Lower government control over the activities of national corporations abroad

Emergence of new centers of economic power acting in private interests that may not coincide with interests of individual countries or society as a whole

Additional tax revenues in the budget Negative effects

External control over the choice of a country’s specialization in the global market Displacement of local businesses from the most profitable and promising spheres Increase in instability of the national economy

Tax evasion of the largest corporations Source Authors’ development

Along with the positive aspects of TNCs in the world economy, there are also negative impacts on the economy of both host and home countries. The following negative effects of transnational corporations could pose a threat to the national security of host countries: 5 displacement of local companies from the market, their concentration in less profitable sectors of the economy; 5 turning host countries into dumping grounds for outdated and environmentally hazardous technologies; 5 seizure by foreign firms of the most developed and promising segments of industrial production and research facilities of the host country; 5 increasing risks in the development of investment and production processes; 5 reduction of budget revenues due to the use of internal (transfer) prices within TNCs or between their branches in different countries.

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4

The transnationalization of activities reduces economic risks for corporations, but increases them for host countries. The fact is that multinational corporations can quite easily move their capital between countries, leaving a country that experiences economic difficulties and switching to a more prosperous one. When this happens, the situation in the country from which TNCs withdraw their capital could become even more difficult, since disinvestment (mass withdrawal of capital) leads to a rise in unemployment and other negative effects. The most common misconception about the consequences of the activities of transnational corporations is the opinion that some countries necessarily benefit, while others suffer losses from the activities of TNCs. In real life, both sides may win or lose simultaneously. The balance of benefits and losses largely depends on the control over the activities of TNCs by governments, the public, and international organizations. 4.4  Countries and Alliances 4.4.1  State as Economic Entity

The state is not only the most important component of the political system of society, but also an indispensable subject and a regulator of its economic life. As historical experience shows, the state has always played a pivotal role in economic development. Due to the growing scale and complexity of relationships in the global economy and the emergence of global problems, the XX century was marked by an increasing role of the state in the economy of all countries worldwide. With the development of the global economy, the forms, methods, and intensity of government regulations have been becoming integral parts of the economy, market, production, and reproduction. The state as a subject of economic relations is included in the system of market relations in two following forms: 5 A “chief entrepreneur”. Being an entrepreneur, the state carries out activities that involve the commercial use of public-owned assets. Entrepreneurial activity is carried out by state-owned enterprises of various types (unitary enterprises, state corporations). However, making a profit is not the main criterion for the performance of state entrepreneurship. The state is responsible for the operation of the economy as a whole, not only the public sector. The government solves a wide range of social and economic issues that do not generate profit directly for state-owned enterprises (acceleration of scientific and technological development, financial support for small businesses, support of underperforming territories, new jobs for people, economic security, etc.). 5 A large consumer, a participant in transactions for the purchase of ­various products and services. These include government purchases of goods (industrial, agricultural), services (educational, medical, research), and military products. The state may place orders for the production of certain

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Chapter 4 · Major Actors in Contemporary Markets

nomenclature of goods. For enterprises, state orders guarantee sales, reduce the risk of non-payments, increase the ability to use industrial and research equipment provided by the state, and provide other benefits (subsidized loans, tax reliefs, etc.). Case box

4

During the COVID-19 pandemic, the role of the state as a consumer has increased radically. In most countries of the world, governments have made significant purchases of personal protective equipment, as well as of such medical devices as artificial lung ventilation and infrared thermometers. For example, in the first months of the COVID-19 outbreak in 2020 in the USA, states spent over $7 billion on the purchase of necessary medical supplies. While many enterprises in various sectors of the economy went bankrupt during the pandemic, the largest suppliers of personal protective equipment made a good profit.

As a macroeconomic entity, the state uses its administrative power to connect the interests of various social groups and individuals. It encourages them to act to achieve certain public goals together. In any society, individuals are divided on many grounds: physical, psychological, cultural, social, professional, ethnic, religious, etc. The same applies to businesses, as they are different and they pursue different goals. Sometimes, individuals and businesses are guided by polar opposite interests. The state, as a form of social organization, embodies and expresses common interests of society, which are ensuring social security and preserving the integrity, independence, and cultural and historical individuality of society. Society has no other institutions that would express and protect the interests of various strata and social groups as the state does. In the free market, the state ensures that public interests are not infringed upon by the aspirations and interests of certain social groups, industries, monopolies, corporations, or individuals. The state is a subject and a carrier of universal interest, as well as its defender and guarantor. In the market economy, the state performs the following functions: 5 Legislation—regulation of entrepreneurial, production, financial, and other activities in the market, monitoring the compliance of regulations by all economic entities. 5 Protection—creation of favorable conditions for the development of the national economy or individual sectors and industries of the national economy. 5 Stabilization—maintaining high employment, low inflation, and the implementation of anti-crisis measures. 5 Economic function—possession, disposal, use of public property, and the adjustment of the market mechanism (production of public goods, distribution of resources, etc.). 5 Redistribution—adjusting financial flows through taxes, duties, subsidies, subventions, and other tools of state intervention. 5 Social function—ensuring the maintenance of social welfare at a certain level.

117 4.4 · Countries and Alliances

4

Case box The aggravation of social and economic problems during the Great Depression in the USA and the world economic crisis in the 1920-1930s resulted in the revision of the role of the state in the economy. The state acted as a stabilizer of market failures (see 7 Chap. 10 for government interventions in unbalanced markets and the tools used by the state to address market failures). Since then, the state is associated with the solution of macroeconomic tasks: stimulating economic growth, ensuring progressive shifts in the sectoral and territorial allocation of production, countering inflation and unemployment. This understanding of the role of the state establishes the foundation of the Keynesian economics—the concept that says that economic downturns could be prevented and optimal economic performance could be achieved by influencing aggregate demand through active stabilization and economic intervention policies by the government (the Keynesian model of macroeconomic equilibrium is further detailed in 7 Chap. 6). To pull the global economy out of the Great Depression, John Keynes recommended increased government expenditures and lower taxes to stimulate demand. Contemporary macroeconomics sees new areas where the state could participate, such as the regulation of social consequences of cyclical changes in production (for example, structural unemployment, as explained in 7 Chap. 8), active measures to smooth out the imbalances in the development of certain territories, or the investment of state capital in advanced, knowledge-intensive industries that require significant initial costs and do not provide a quick return on investment.

Case box During the COVID-19 pandemic, the redistributive function of the state has been aimed at contributing to the stability of the national economy and ensuring economic growth. The scope of redistribution has expanded by the inclusion of reproduction of fixed capital, support of small businesses, support of industries hurt by lockdowns and other pandemic-related restrictions, support of territories, etc. Through redistribution, governments in many countries prioritized low-income segments of the population.

In macroeconomics, the role of the state in the market is commonly distinguished between regulatory and positive. The regulatory role determines what the state should do to smooth out the imperfection of the market, prevent its failures, and ensure economic development and growth. The positive role of the state in the economy characterizes what the state actually does to improve the welfare of society. Ideally, the intended and actual roles of the state should coincide. In reality, there is always a gap between the regulatory and positive roles, sometimes quite a significant gap. This could happen due to the following reasons: 5 divergence of interests of those who manage (the government) and those who are managed (businesses, people); 5 mistakes and misconceptions on the part of politicians; 5 misunderstanding of the techniques and methods of economic policy; 5 consequences of previous decisions.

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Therefore, along with market failures, there are also the failures of the state, such as: 5 multiple centers of political decision-making, each of which is guided by its own understanding of public interests; 5 self-interest of state officials and corruption; 5 lack of clear performance criteria of public bodies’ activities; 5 economic or social events or macroeconomic parameters different from those expected by the government. Both the market and the state have a certain degree of imperfection. The retrospective analysis of macroeconomic processes has demonstrated that there should be no alternative choice between the market and the state. Today, almost all economies in the world, including the most advanced and developed countries, are mixed economic systems. A Mixed Economy is one that protects private property and allows a certain level of economic freedom in the use of capital, but also allows for governments to interfere in economic activities in order to achieve social aims. In mixed economies, the state is built into the market mechanism as its integral part. Therefore, the state acts as an optimizing factor of economic development. A country-individual combination of free-market principles and government regulations established the unique national economic model. The National Economic Model is a model that describes the economic mechanism of a country using a variety of indicators. Special attention is paid to the parameters that characterize the basics of the economic mechanism in a given country—the ratio of private and public ownership in the economy and the degree of independence of macroeconomic entities in the domestic market. Each country is characterized by its national model of economic organization, as countries differ in the level of economic development and social and national conditions. William Baumol, Robert Litan, and Carl Schramm (2007)7 elaborated the model that differentiated four types of the market economy (or “capitalism”): 5 Entrepreneurial capitalism is based on the activities of innovative firms, commonly small and medium businesses. 5 Capitalism of large firms that prevail in the production of mass products. 5 State capitalism with a significant role of the state in making key economic decisions. 5 Oligarchic capitalism, in which economic power is concentrated in the hands of several individuals or families. In every market economy, these forms of ownership coexist simultaneously in different combinations. These combinations change over time, but at any given moment, one or two forms may prevail. This unique combination forms the specifics of the national economic model from the point of view of ownership.8

7 8

Baumol et al. (2007). Bulatov (2019).

119 4.4 · Countries and Alliances

4

Case box In the USA, there is a combination of entrepreneurial capitalism (it introduces innovations into economic life) with the capitalism of large firms (based on these innovations, it carries out mass production of new goods). Previously, the US economic model was characterized by the prevalence of large firms. Japan’s national economic model is founded on the capitalism of large firms combined with state capitalism, although Japan is gradually moving to the US-type capitalism. In addition to the ratio of ownership, the USA and Japan differ in the levels of freedom of entrepreneurship. This difference could be seen in such parameters as the ease of starting a business, access to loans, and the tax burden on business. The Global Competitiveness Report, which considers these parameters of doing business, ranks the USA above Japan.

4.4.2  Integration of Countries

The national economy interacts with the foreign sector through Foreign ­Economic Relations, that is, the exchange of goods, services, national currency, and ­information. The Foreign Sector is the totality of all economic entities that have a permanent location outside a country. The foreign sector should be ­understood as a macroeconomic entity through which the economic communication of all countries is carried out. Economic relations between countries are regulated by their laws and the interests of individual economies. The foreign sector is composed of the following four markets: 5 Market of goods and services, where countries exchange various products, commodities, tangible goods and assets, and intangible services and assets. 5 Financial market, where financial assets are exchanged (money, securities, shares). 5 Market of resources, where labor is exchanged. 5 Foreign exchange market, where banks sell loans and cash deposits. Most countries of the world participate in integration organizations, which are becoming increasingly important entities in the world economy in the context of growing globalization. Globalization is turning a significant part of the world economy into a single market for goods, services, knowledge, and capital (further detailed in 7 Chap. 23). At the same time, individual countries tend to develop external economic relations with neighboring countries within certain regions. Such an orientation of the country's foreign economic relations to neighbors, or institutional arrangements designed to facilitate the free flow of goods and services and to coordinate foreign economic policies between countries in the same geographic region is called Economic Regionalism. The economic basis of regionalism is savings on transaction costs, which are commonly lower when connecting with neighboring countries, which are closer to domestic firms in terms of distance (lower transport costs), but also more familiar in terms of culture, traditions, business practices, behavior, and other features.

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Economic regionalization is the basis for International Economic Integration, which is a process of merging (convergence) of national economies (commonly, neighboring countries) into a single economic complex based on deep and stable economic, trade, financial, and other ties. Typically, economic integration involves the reduction or elimination of trade barriers and the coordination of monetary and fiscal policies to reduce costs for both consumers and producers and to increase trade between the countries involved in the agreement.9 An Integration Organization is an economic grouping created to regulate integration processes between its member countries. There are dozens of integration associations in the world, of which the most advanced are the European Union (EU), the South American Common Market (MERCOSUR), and the Association of Southeast Asian Nations (ASEAN) (see case boxes below). On the one hand, the advancement of integration organizations (the level of their convergence) means the convergence of the key parameters of development in member countries. On the other hand, their development involves the unification of the economic, financial, trade, and social policies of member states. In the first case, convergence is measured by such parameters as the ratio of mutual trade within the alliance to the total foreign trade turnover or GDP, the dynamics of convergence of domestic prices for similar goods or interest rates on loans, and other macroeconomic measurements. According to JanTinbergen (1954),10 economic integration can be either positive or negative. The latter implies the elimination of economic and trade barriers between countries, while the former includes the creation of additional incentives for integration (expansion of transport infrastructure for mutual trade, harmonization of taxes, coordination of economic policy, etc.). Bela Balassa (1961)11 proposed a classification of stages of economic integration according to the degree of advancement of integration organization (. Table 4.6). The free trade area (FTA) is the simplest and most widely spread form of integration. As stated in . Table 4.6, the FTA regime assumes abolishing trade barriers (mainly, customs duties) between the participating countries. Concerning third countries, each member state has the right to pursue its own policy, including introducing its own customs tariffs and other restrictions. Sometimes, different FTAs complement each other, when member countries participate in more than one free trade agreement, or when there is an agreement between two or more FTAs. Free trade agreements allow for cascading connections. If a country enters a free trade agreement with countries united by another free trade agreement, the new FTA includes the old FTA plus this new country (or countries). Countries establish FTAs to reduce barriers to the exchange of goods or services, so that trade can grow as a result of specialization and the division of labor (i.e., through comparative advantages). According to the theory of comparative advantage

9 Kenton (2021). 10 Tinbergen (1954). 11 Balassa (1961).

121 4.4 · Countries and Alliances

4

. Table 4.6  Stages of economic integration #

Stage

Definition

1

Free trade area

A type of integration bloc, within which member countries cancel customs duties, taxes, and fees, as well as quantitative restrictions in mutual trade, while goods may be landed, handled, manufactured or reconfigured, and re-exported under specific customs regulation (generally, not subject to customs duty)

2

Customs union

A type of international integration involving the coordinated abolition of national customs tariffs by the member countries of the organization and the introduction of a common customs tariff and a unified system of non-tariff regulation of trade in relation to third countries

3

Common market

A type of international integration when member countries adopt a common external tariff (like in customs union) and agree on the free movement of goods and services (like in free trade area), as well as capital and labor across national borders among the members of the bloc

4

Economic union

An interstate agreement between two or more countries that allow the free circulation of capital, labor, goods, and services (like in common market), as well as the harmonization and unification of economic, fiscal, monetary, and social policies

5

Political union

Complete political and economic integration of two or more countries, allowing these countries to act as a single entity, pursue a common foreign policy, in particular in the field of security, and develop common approaches within the framework of domestic legislation (civil and criminal)

Source Authors’ development

(see 7 Sect. 19.1.3), in an unlimited market (in equilibrium), an economic entity specializes in the activity where it has a comparative (not absolute) advantage. Within an FTA, such a specialization results in an increase in income and, ultimately, wealth and wellbeing for all member states. But the theory refers to the aggregate wealth, not its distribution. In fact, there may be significant losses, in particular, in industries that used to be protected or supported by the national government, but that have found themselves competing with foreign counterparts within the FTA market. In principle, the overall benefits of trade can be used to compensate for the consequences of reducing trade barriers in the relevant sectors of the economy. Case box An example of the free trade area is the Association of Southeast Asian Nations (ASEAN) established in 1967 in Bangkok, Thailand. Initially, it included Indonesia, Malaysia, Singapore, Thailand, and the Philippines. Later, Brunei Darussalam in 1984, Vietnam in 1995, Laos and Myanmar in 1997, and Cambodia in 1999 joined

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the organization. Papua New Guinea and East Timor have special observer status. Currently, with a population of 649.07 million people, a total GDP of $2.99 trillion, and a foreign trade turnover of $2.816 trillion, ASEAN is one of the largest regional organizations. Despite the COVID-19 outbreak, the economy of the bloc grew by 2.7% in 2020 (by 4.6% in 2019). ASEAN aims at strengthening economic growth and social and cultural development of the region, promoting regional peace and stability, expanding mutually beneficial cooperation in trade, economy, finance, education, and culture.

Customs union is a more complex form of economic integration compared with free trade area. In addition to reducing trade barriers between member countries like in FTA, customs union assumes the establishment of a Common Customs ­Tariff for third countries, i.e., the customs regime when the same customs duties, import quotas, preferences, or other non-tariff barriers to trade apply to all goods entering the customs union, regardless of which particular country within the customs union they enter. The agreement on the establishment of the customs union stipulates the following points. 5 removal of internal customs borders between member states; 5 transfer of customs control to the external perimeter of the union (common tariff); 5 elimination of customs procedures in mutual trade in goods of domestic origin; 5 unification of forms and methods of collecting foreign trade statistics; 5 coordination of forms and methods of granting benefits to economic entities that participate in foreign economic and trade activities; 5 introduction of a unified system of tariff and non-tariff regulation for trade with third countries for all member states of the customs union; 5 creation of a unified system of trade preferences. Member countries agree on the establishment of interstate bodies that coordinate the implementation of a coordinated foreign trade policy. Commonly, such interstate regulation takes the form of periodic meetings of ministers or heads of relevant departments (trade, customs, economic), which rely on a permanent interstate secretariat in their work. Case box The world’s oldest customs union is the Southern African Customs Union (SACU). It includes Botswana, Eswatini (formerly Swaziland), Lesotho, Namibia, and South Africa. The main goal of the SACU is the liberalization of trade relations between member countries, the removal of trade barriers, and the introduction of a single currency, the Afro. South Africa is the leading economy of the bloc (such dominant economies are called “anchor states”). It exerts a great influence on setting the level of customs duties and excise taxes and distributing revenues depending on the shares of member

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countries in the total volume of trade. Goods produced in one country are freely exchanged between member states without any quantitative restrictions, but mutual trade between Namibia, Botswana, Lesotho, and Swaziland is underdeveloped. This is due to the low level of diversification of foreign trade in these countries (no incentive to exchange homogeneous goods). The SACU agreement is not limited to customs regulations. Member countries aim to deepen economic integration by unifying policies in the spheres of industrial development, agriculture, competition, and unfair trade practices.

A more complex form is the common market. Along with free mutual trade and a common customs tariff, the common market provides member countries with freedom of movement of labor and capital, as well as coordination of economic policy. A common market establishes a single economic space between member states. Quotas and tariffs for the import of goods are removed. However, non-tariff restrictions on trade between countries may remain. Among them are phytosanitary requirements, national administrative procedures, and many other things that differ in countries that establish a common market. This creates barriers to trade between them. Not all firms are ready to adapt to the requirements of other countries within a common market, that is why non-tariff barriers between member states are removed gradually (a transition period applies). Free exchange of factors of production allows for more efficient use of scarce resources, which ultimately leads to an increase in productivity. The common market creates a more competitive environment and thus restricts monopolies. It also means that inefficient companies incur losses and are forced out of the ­market. To increase competitiveness, they have to reorganize their production and i­mprove quality and performance. Through higher competition, consumers benefit by ­getting a wider assortment of more qualitative goods and services at lower prices. However, some of the local producers may lose out on competition and end up bankrupting without support from their national government. Another disadvantage of creating a common market is labor migration from less developed countries to more advanced states. Case box An example of a common market is MERCOSUR established between Argentina, Brazil, Paraguay, and Uruguay in 1991. Starting from 1995, the integration has deepened and the organization has advanced from a free trade area to a customs union and then to a common market. At the moment, most of the countries in Latin America (Chile, Colombia, Ecuador, Peru, Guyana, Suriname) are associate members of MERCOSUR. Mexico and New Zealand are observers to this organization. With a population of almost 300 million people and an area of about fifteen million square kilometers, MERCOSUR is known for its rich natural resources and agricultural potential. It is a large exporter of soybeans (63% of the world’s soybean production), beef, chicken, corn, coffee, steel, and mechanical engineering products. In April 2020,

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MERCOSUR countries agreed on an initiative to allocate an additional budget of $16 million to combat the COVID-19 outbreak. The funds belonged to the MERCOSUR Structural Convergence Fund and were intended for the provision of medical supplies and personal protective equipment.

4

The economic union is the most advanced stage of economic integration. It combines three previous stages and complements them with the implementation of a common economic and monetary policy. This stage requires participating countries to establish supranational bodies for coordination of actions and monitoring the economic development of member states, as well as for making operational decisions on behalf of the group as a whole (see 7 Sect. 4.5.1 for the definition of supranational organizations). Governments concede part of national sovereignty in favor of these bodies, which are entitled to make decisions on issues related to the integration organization without the consent of the governments of member countries. Supranational regulation involves interference in the spheres of exchange and production, for example, through a common fiscal policy, subsidies to individual industries or territories from the budget of the bloc, or common economic development programs. Nevertheless, even in the economic union, national states retain such an important economic function as the redistribution of national income through the national budget. The concentration of a fairly significant part of the created product in a particular state (anchor state, as referred to earlier in this section) is one of the essential forms of economic isolation of individual countries within the union. It may cause misbalances and contradictions between member states. Case box So far, the only example of a functioning economic and monetary union is the European Union (EU). It was established after the World War II. The main idea was that countries with close trade and economic relations could cooperate without the threat of a military conflict. The EU was not always as big as it is today. When European countries started to cooperate economically in 1951, only Belgium, Germany, France, Italy, Luxembourg, and the Netherlands participated. Over time, more and more countries decided to join. The EU currently consists of 27 countries. The United Kingdom withdrew from the EU on 31 January 2020. With just 6.9% of the world's population, EU trade with the rest of the world accounts for some 15.6% of global imports and exports. Together with the USA and China, the EU is one of the three largest global players in international trade. The COVID-19 pandemic has become a test of the management system in the EU. There have been disputes over financial and economic programs. Many experts suggest that the pandemic has triggered the transformation of the EU. It has cast a long shadow over the Schengen area, the Eurozone, and other common EU policies.

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The highest form of integration is a political union (the stage of total economic integration, according to Balassa (1961)12), in which the integrating countries are united into a federation or a confederation. However, Balassa’s vision of economic integration in the 1960s could not have envisaged the variety of forms of alliances between countries as we now know it. Balassa’s stages have since been expanded and now include up to eight steps (depending on classification): regional autarky, free trade area, customs union, common market, economic union, monetary union, fiscal union, and political union. Monetary union (single currency plus single central bank) and fiscal union (harmonization of taxes plus fiscal sovereignty) are actually interchangeable, as, for example, Molle (2006),13 Robson (1998),14 and Crowley (2006)15 place these two levels of integration in different orders. 4.5  International Organizations

By integrating national markets into a single world market, globalization exacerbates the contradictions between them. International competition for access to economic resources is growing. The balance of power in the global economy is changing, generating new contradictions (see 7 Sect. 23.3 for emerging contradictions of globalization) and exacerbating many long-standing conflicts during crises like the global financial and economic crisis of 2007–2008 or the COVID-19 pandemic (see 7 Sect. 23.4 for the discussion of the anti-globalization manifestations of the pandemic). Meanwhile, globalization increases the economic interdependence of the countries in the global market and thus strengthens the trend towards cooperation. Global economic regulation acts as a compromise between these two trends of globalization. International Economic Organizations are organizations created on the basis of an international agreement or by the decision of an existing international organization for the purpose of analyzing, discussing, and resolving various issues of the international economic, trade, financial, or social agenda. There are two categories of international economic organizations: 5 international governmental (interstate) economic organizations that are created on the basis of intergovernmental agreements and are subjects of international law; 5 international non-governmental economic organizations, which are associations of legal entities or individuals from different countries that are not subjects of international law.

12 13 14 15

Balassa (1961). Molle (2006). Robson (1998). Crowley (2006).

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The regulation of the world economy is carried out primarily by interstate economic organizations, although the importance of non-governmental economic organizations is increasing. The regulatory role of international economic organizations in the world economy is manifested in the fact that they: 5 develop norms of behavior of states and economic entities in the global market and monitor their implementation (these norms take the form of international treaties and conventions and become binding for its participants); 5 develop recommendations that, although not legally binding, serve as a guide for the majority of countries in the world; 5 act as centers for the study of global economic problems and analytics; 5 act as coordinators of multilateral cooperation on a wide range of problems of industrial development, agriculture, international trade, capital flows, and knowledge exchange; 5 create conditions for the development of a multi-party and bilateral negotiation process on economic and social issues. Case box During the COVID-19 pandemic, the role of international economic organizations as channels for implementing international assistance programs has dramatically increased. For example, through the COVID-Solidarity Response Fund,16 the World Health Organization (WHO) led and coordinated global efforts on supporting countries to prevent, detect, and respond to the pandemic. WHO launched an appeal for $1.96 billion to support the response in countries towards suppressing transmission, reducing exposure, countering misinformation and disinformation, protecting the vulnerable, reducing mortality and morbidity rates, and increasing equitable access to diagnostics and vaccines for all.

Classification of international economic organizations can be carried out on various grounds. The most common approaches involve affiliation with the United Nations and the spheres in which organizations operate (. Table 4.7). 4.5.1  International Financial Organizations

International financial organizations have been playing an increasingly important role in the economy amid progressing globalization. An International Financial Organization is an organization established on the basis of intergovernmental (international) agreements in the sphere of international finance with the participation of either states or non-governmental institutions. The activities of international financial organizations greatly contribute to the strengthening of international economic relations and the activation of the participation of countries in international

16 World Health Organization (2021).

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. Table 4.7  Classification of international economic organizations By affiliation

By sphere

Groups

Organizations

Groups

Organizations

Organizations within the United Nations or affiliated with the United Nations

• United Nations Conference on Trade and Development • Economic and Social Council • International Labor Organization • Food and Agriculture Organization • World Trade Organization • World Bank Group

Development aid and collaboration in the spheres of economy and social support

• Organizations within the United Nations framework or affiliated with the United Nations • Organization for Economic Cooperation and Development • International Atomic Energy Agency

Organizations not affiliated with the United Nations

• Organization for Economic Cooperation and Development • Development Assistance Committee • International Energy Agency • Nuclear Energy Agency • Centre for Educational Research and Innovation

International financial organizations

• International Monetary Fund • World Bank Group • Bank for International Settlement • Financial Stability Board

International trade organizations

• World Trade Organization • United Nations Con­ference on Trade and Development • World Customs Organization

Other international economic organizations

• United Nations Organization on Industrial Development • Food and Agriculture Organization • International Labor Organization • European Bank for Reconstruction and Development • Asian Development Bank

Regional economic organizations

• Asian Development Bank • African Development Bank Group • Inter-American Development Bank

Source Authors’ development

monetary and credit relations. Financial organizations are a key element of the institutional framework of the international financial system. Having a significant amount of financial resources, they influence economic development and business environment in individual countries, as well as worldwide.

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International financial organizations are created by combining the capital of member countries to solve various tasks. The main of those include: 5 stabilizing and regulating global currency and stock markets; 5 maintaining and stimulating international trade; 5 managing the balance of payments deficit; 5 lending to state programs of sectoral and regional development and assistance to small and medium-sized businesses; 5 investing in large international projects in various spheres; 5 financing of international aid, scientific research, environmental protection, and other international initiatives. International financial organizations (as well as other international economic organizations) are Supranational Organizations, which means that member countries cede authority and sovereignty on at least some internal matters to the group, whose decisions are binding on its members. They are subjects of international law and they conclude agreements with states and other international organizations. To achieve their goals, international financial organizations use a wide range of methods of financial analysis and risk management and employ leading consulting, audit, and insurance companies, research centers, and investment banks. 4.5.1.1  International Monetary Fund

The International Monetary Fund (IMF)17 promotes international financial stability and monetary cooperation. It also facilitates international trade, promotes employment and sustainable economic growth, and helps to reduce global poverty. The IMF is governed by and accountable to its 190 member countries. The IMF was conceived in July 1944 at the United Nations Bretton Woods Conference in New Hampshire, USA. To maintain stability and prevent crises in the international monetary system, the IMF monitors member country policies as well as national, regional, and global economic and financial developments through a formal system known as surveillance. The IMF provides advice to member countries and promotes policies designed to foster economic stability, reduce vulnerability to economic and financial crises, and raise living standards. Providing loans to member countries that are experiencing actual or potential balance-of-payments problems is a core responsibility of the IMF. Individual country adjustment programs are designed in close cooperation with the IMF and are supported by IMF financing, and ongoing financial support is dependent on the effective implementation of these adjustments. In response to the COVID-19 pandemic, the IMF temporarily increased the access limits under emergency financing instruments and the annual limit on overall access under non-concessional resources. The IMF also established the Short-term Liquidity Line (SLL) to

17 International Monetary Fund (2022).

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provide a backstop to members with very strong policies and fundamentals. Annual access limits for the Poverty Reduction and Growth Trust were temporarily increased in response to the COVID-19 pandemic. The IMF issues an international reserve asset known as Special Drawing Rights (SDRs) that can supplement the official reserves of member countries participating in the SDR Department (currently all members of the IMF). A general allocation of SDRs must be consistent with the objective of meeting the longterm global need for reserve assets and requires Board of Governors approval by an 85% majority of the total voting power. Once agreed, the allocation is distributed to member countries in proportion to their quota shares at the Fund. Total global allocations are currently about SDR 204.2 billion ($293 billion). 4.5.1.2  World Bank Group

The World Bank Group18 is a global partnership of 189 member countries working for sustainable solutions that reduce poverty and build shared prosperity in developing countries. Its mission includes: 5 combating extreme poverty by reducing the share of the global population that lives in extreme poverty to 3% by 2030; 5 promoting shared prosperity by increasing the incomes of the poorest 40% of people in every country. The World Bank Group consists of five organizations19: 5 International Bank for Reconstruction and Development (IBRD)—lends to governments of middle-income and creditworthy low-income countries. 5 International Development Association (IDA)—provides interest-free loans (credits) and grants to governments of the poorest countries. Together, IBRD and IDA make up the World Bank. 5 International Finance Corporation (IFC)—focuses exclusively on the private sector and helps developing countries achieve sustainable growth by financing investment, mobilizing capital in international financial markets, and providing advisory services to businesses and governments. 5 Multilateral Investment Guarantee Agency (MIGA)—promotes foreign direct investment into developing countries to support economic growth, reduce poverty, and improve people’s lives, offers political risk insurance (guarantees) to investors and lenders. 5 International Centre for Settlement of Investment Disputes (ICSID)—provides international facilities for conciliation and arbitration of investment disputes. Since the start of the COVID-19 crisis, the World Bank Group has committed over $157 billion to fight the impacts of the pandemic. Provided from April 2020 to June 2021, it included over $50 billion of IDA resources on grant and highly

18 World Bank (2022a, 2022b). 19 World Bank (2022a, 2022b).

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concessional terms. The support was tailored to the health, economic, and social shocks that countries are facing. The World Bank made $20 billion available to help developing countries finance the purchase and distribution of COVID-19 vaccines. In addition, it partnered with COVAX on a new financing mechanism that let COVAX make advance purchases to help speed up the vaccine supply.20 4.5.1.3  Bank for International Settlements

4

Bank for International Settlements (BIS) was established in 1930 in order to coordinate the activities of central banks and develop international cooperation in the financial sphere. Currently, the BIS is owned by 63 central banks, representing countries from around the world that together account for about 95% of world GDP. BIS aims to support central banks’ pursuit of monetary and financial stability through international cooperation, and to act as a bank for central banks. To pursue this mission, BIS provides central banks with a forum for dialogue and broad international cooperation, a platform for responsible innovation and knowledge-sharing, in-depth analysis and insights on core policy issues, and sound and competitive financial services.21 The regulatory role of BIS in the global financial system is determined primarily by the fact that it elaborates banking standards. An example is Basel III which is an internationally agreed set of measures developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2007–2009.22 The measures aim to strengthen the regulation, supervision, and risk management of banks. These are minimum requirements that apply to internationally active banks. 4.5.1.4  Financial Stability Board

The Financial Stability Board (FSB) is an international body that monitors and makes recommendations about the global financial system. The FSB promotes international financial stability; it does so by coordinating national financial authorities and international standard-setting bodies as they work toward developing strong regulatory, supervisory, and other financial sector policies. It fosters a level playing field by encouraging the coherent implementation of these policies across sectors and jurisdictions.23 The FSB was established to: 5 Assess vulnerabilities affecting the global financial system as well as identify and review the regulatory, supervisory, and related actions needed to address these vulnerabilities. 5 Promote coordination and information exchange among authorities responsible for financial stability.

20 21 22 23

World Bank (2021). Bank for International Settlement (2022a, 2022b). Bank for International Settlement (2022a, 2022b). Financial Stability Board (2022).

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5 Monitor and advise on market developments and their implications for policies. 5 Monitor and advise on best practices in meeting regulatory standards. 5 Undertake joint strategic reviews of the international standard-setting bodies and coordinate their respective policy development work to ensure this work is timely, coordinated, focused on priorities, and addresses gaps. 5 Set guidelines for establishing and supporting supervisory colleges. 5 Support contingency planning for cross-border crisis management, particularly with regard to systemically important firms. 5 Promote member jurisdictions’ implementation of agreed commitments, standards, and policy recommendations, through monitoring of implementation, peer review, and disclosure. The FSB consists of representatives of national financial institutions (ministries of finance or central banks) of 23 countries, as well as representatives of international economic organizations that develop standards and regulate and supervise the financial sector. The FSB’s decisions are not legally binding on its members—instead, the organization operates by moral suasion and peer pressure, in order to set internationally agreed policies and minimum standards that its members commit to implementing at the national level. 4.5.2  International Trade Organizations

International trade and economic organizations and agreements, in which almost all countries of the world participate, are of particular importance for the development of international trade. The main ones are the World Trade Organization (WTO), the United Nations Conference on Trade and Development (UNCTAD), and the World Customs Organization (WCO). 4.5.2.1  World Trade Organization

The World Trade Organization (WTO) came into being in 1995. One of the youngest of the international organizations, the WTO is the successor to the General Agreement on Tariffs and Trade (GATT) established in the wake of the World War II. The WTO provides a forum for negotiating agreements aimed at reducing barriers to international trade and ensuring a level playing field for all, thus contributing to economic growth and development. The WTO also provides legal and institutional frameworks for the implementation and monitoring of these agreements, as well as for settling disputes arising from their interpretation and application. The current body of trade agreements comprising the WTO consists of sixteen different multilateral agreements (to which all WTO members are parties) and two different plurilateral agreements (to which only some WTO members are parties).24 24 World Trade Organization (2022a, 2022b).

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The main activities of the WTO are: 5 negotiating the reduction or elimination of obstacles to trade (import tariffs, other barriers to trade) and agreeing on rules governing the conduct of international trade; 5 administering and monitoring the application of the WTO’s agreed rules for trade in goods, trade in services, and trade-related intellectual property rights; 5 monitoring and reviewing the trade policies of our members, as well as ensuring transparency of regional and bilateral trade agreements; 5 settling disputes among countries regarding the application of the agreements; 5 building capacity of government officials in international trade matters; 5 assisting the accession of countries who are not yet members of the WTO; 5 conducting economic research and collecting and disseminating trade data; 5 explaining to and educating the public about the WTO, its mission, and its activities. The following five WTO principles establish the pillars of the contemporary multilateral trading system25: 5 Trade without discrimination. Under the WTO agreements, countries cannot normally discriminate between their trading partners. Grant someone a special favor (such as a lower customs duty rate for one of their products) and you have to do the same for all other WTO members. This principle is known as the most-favored-nation treatment. Imported and locally-produced goods should be treated equally—at least after the foreign goods have entered the market. The same should apply to foreign and domestic services, foreign and local trademarks, copyrights, and patents. This principle is known as the national treatment. 5 Freer trade: gradually, through negotiation. Trade barriers include customs duties (or tariffs) and measures such as import bans or quotas that restrict quantities selectively. Lowering trade barriers is one of the most obvious means of encouraging trade. The WTO agreements allow countries to introduce changes gradually, through progressive liberalization. 5 Predictability: through binding and transparency. When countries agree to open their markets for goods or services, they bind their commitments. A country can change its bindings, but only after negotiating with its trading partners, which could mean compensating them for loss of trade. The binding and transparency improve the predictability and stability of international trade. 5 Promoting fair competition. Many of the other WTO agreements aim to support fair competition. The rules on non-discrimination (most-favored-nation and national treatment) are designed to secure fair conditions of trade. 5 Encouraging development and economic reform. Over three-quarters of WTO members are developing countries and countries in transition to market economies. The WTO gives them transition periods to adjust to the more unfamiliar and difficult provisions, particularly so for the least-developed countries.

25 World Trade Organization (2022a, 2022b).

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During the COVID-19 pandemic, the WTO is addressing the crisis through timely and accurate information. The dedicated page was created on the WTO website to provide up-to-the-minute trade-related information including relevant notifications by WTO members, the impact the pandemic has had on exports and imports, and how WTO activities have been affected by the pandemic.26 The WTO has developed a set of indicators to provide “real-time” information on trends in world trade: the Goods Trade Barometer and the Services Trade Barometer.27 Both barometers highlight turning points in world trade and are intended to complement conventional trade statistics and forecasts. 4.5.2.2  United Nations Conference on Trade and Development

United Nations Conference on Trade and Development (UNCTAD) is a permanent intergovernmental body established by the United Nations General Assembly in 1964.28 UNCTAD supports developing countries to access the benefits of a globalized economy more fairly and effectively. It provides analysis, facilitates consensus-building, and offers technical assistance to developing countries. This helps these economies to use trade, investment, finance, and technology as vehicles for inclusive and sustainable development. Working at the national, regional, and global levels, UNCTAD helps countries to comprehend options to address macro-level development challenges; achieve beneficial integration into the international trading system; diversify economies to make them less dependent on commodities; limit their exposure to financial volatility and debt; attract investment and make it more development-friendly; increase access to digital technologies; promote entrepreneurship and innovation; help local firms move up value chains; speed up the flow of goods across borders; adapt to climate change and use natural resources more effectively. The development efforts of UNCTAD in the time of the COVID-19 pandemic include mobilization of financial resources for development, the global initiative towards the post-COVID-19 resurgence of micro, small, and medium enterprises, and transport and trade connectivity. UNCTAD provides a range of technical cooperation products that can help countries put in place the policies, regulations, and institutional frameworks as well as mobilize the resources needed to mitigate or recover from the impacts of COVID-19.29 UNCTAD also supports countries in identifying the set of measures and actions most appropriate to address key economic sectors affected by COVID-19, including through market studies and competition impact assessments of incentives and exemptions. It assists countries to strengthen consumer protection through coordinated enforcement and information exchange mechanisms, improved awareness-raising campaigns, and complaint tools and measures addressing the needs of vulnerable and disadvantaged consumers.

26 27 28 29

World Trade Organization (2021a, 2021b). World Trade Organization (2021a, 2021b). United Nations Conference on Trade and Development (2022). United Nations Conference on Trade and Development (2021).

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4.5.2.3  World Customs Organization

4

World Customs Organization (WCO) was established in 1952 as an independent intergovernmental body whose mission was to enhance the effectiveness and efficiency of customs administrations. Today, WCO represents 183 customs administrations across the globe that collectively process approximately 98% of world trade. As the global center of customs expertise, WCO is the only international organization with competence in customs matters and can rightly call itself the voice of the international Customs community.30 WCO develops international standards, fosters cooperation, and builds capacity to facilitate legitimate trade, secure a fair revenue collection, and protect society, providing leadership, guidance, and support to customs administrations. WCO 183 members, three-quarters of which are developing countries, are responsible for managing more than 98% of world trade. 4.5.3  Other International Economic Organizations

In recent decades, the role of other international organizations (according to classification by the sphere of activity in . Table 4.7), especially specialized and regional international economic organizations, has significantly increased. O ­ rganizations affiliated with the United Nations (United Nations Organization on Industrial Development, Food and Agriculture Organization, among others) develop norms and standards in the form of conventions and recommendations and provide technical assistance to member countries in order to ensure the application of international norms reflected in the adopted conventions and recommendations. Regional development banks represent another large group among other international e­conomic organizations. They play an important role in regulating the international financial system, especially in less developed regions of the world. Developed countries from outside the respective regions also participate in regional banks and often play a major role in determining their policies. 4.5.3.1  United Nations Organization on Industrial Development

United Nations Organization on Industrial Development (UNIDO) is the specialized agency of the United Nations that promotes industrial development for poverty reduction, inclusive globalization, and environmental sustainability. The mission of the UNIDO is to promote and accelerate inclusive and sustainable industrial development (ISID) in member states. The relevance of ISID as an integrated approach to all three pillars of sustainable development is recognized by the 2030 Agenda for Sustainable Development (see 7 Chap. 18 for Sustainable Development Goals), which calls to build resilient infrastructure, promote inclusive and sustainable industrialization, and foster innovation.31

30 World Customs Organization (2022). 31 United Nations Organization on Industrial Development (2022).

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The main areas of UNIDO’s activities include the following. First, UNIDO serves as an international center for collecting and analyzing information on industrial development problems, organizes discussions of these problems, and promotes interaction between member countries in order to solve them. Second, UNIDO acts both as a financing entity and an executive agency in the system of international technical assistance. At the same time, UNIDO’s activities are currently concentrated in three thematic areas: 5 combating poverty through industrial development; 5 expanding the trade potential of less developed countries through the promotion of industrial development; 5 development of green energy projects. In carrying out the core requirements of its mission, UNIDO has considerably increased its technical services over the past ten years. At the same time, it also substantially increased its mobilization of financial resources during the COVID-19 pandemic, testifying to the growing international recognition of the organization as an effective provider of catalytic industrial development services. 4.5.3.2  Food and Agriculture Organization

Food and Agriculture Organization of the United Nations (FAO) is a specialized agency of the United Nations that leads international efforts to combat hunger. FAO’s goal is to achieve food security for all and make sure that people have regular access to enough high-quality food to lead active and healthy lives. With over 194 member states, FAO works in over 130 countries worldwide.32 FAO focuses on improving the nutrition and living standards of the population of the member countries, the efficiency of agricultural production, and the living conditions of the population in rural areas. FAO’s activities include: 5 collection, analysis, and dissemination of information on agricultural development; 5 monitoring of global food security; 5 development of recommendations and advice on agricultural and food policy issues and promotion of international cooperation in agriculture; 5 providing technical assistance to member countries to ensure the development of their agriculture and food production. To respond to the challenges of the COVID-19 pandemic, FAO implemented an array of tools to support policy analyses and assess the impact of COVID-19 on food and agriculture, value chains, food prices, and food security across the globe. Specifically, FAO is reorganizing its humanitarian and resilience programming to ensure continued delivery of assistance where there are already high levels of need while meeting new needs emerging from the direct and indirect effects of COVID-19. These include providing smallholder farmers and herders with

32 Food and Agriculture Organization of the United Nations (2022).

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seeds, tools, livestock feed, and other agricultural inputs; distributing seeds and home gardening kits, food storage systems, and poultry and other small stock to improve household nutrition and diversify incomes in communities where undernutrition and poverty are prevalent.33 FAO is playing a role in assessing and responding to its potential impacts on people’s lives and livelihoods, global food trade, markets, food supply chains, and livestock. FAO believes this will allow countries to anticipate and mitigate possible disruptions the pandemic may trigger for people’s food security and livelihoods, avoiding panic-driven reactions that can aggravate disruptions and deteriorate the food and nutrition security of the most vulnerable communities. 4.5.3.3  International Labor Organization

International Labor Organization (ILO) is the only tripartite agency in the United Nations. Since 1919, it has been bringing together governments, employers, and workers of 187 member states to set labor standards, develop policies, and devise programmes promoting decent work for all people.34 The main aims of the ILO are: 5 to promote full employment and improve living standards in member countries; 5 to promote economic and social reforms; 5 to respect fundamental human rights, human life, and health; 5 to promote cooperation between entrepreneurs and workers. 5 to encourage decent employment opportunities and enhance social protection 5 to strengthen dialogue between member countries on work-related issues. The pivotal activity is policy-making, which manifests itself in the development of international conventions and recommendations on social and labor relations. The ILO conventions are binding agreements for member countries. In addition to standard-setting activities, ILO provides technical assistance to member countries. The sources of financial resources are contributions from member countries. The ILO’s technical assistance is financed from the organization’s budget. 4.5.3.4  European Bank for Reconstruction and Development

European Bank for Reconstruction and Development (EBRD) was founded in 1991 to create a new post-Cold War era in Central and Eastern Europe.35 The EBRD is owned by 69 countries, as well as the European Union and the European Investment Bank. Each shareholder is represented on the Board of Governors, which has overall authority over the bank. The objectives of the EBRD include the following: 5 assistance in the implementation of structural and sectoral market reforms; 5 promotion of competition, privatization and private entrepreneurship, strengthening of financial institutions and their legal framework;

33 Food and Agriculture Organization of the United Nations (2021). 34 International Labor Organization (2022). 35 European Bank for Reconstruction and Development (2022).

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5 promotion of the development of infrastructure necessary for the development of the private sector; 5 promotion of the development of effective management of private enterprises. In order to achieve these goals, the EBRD acts as a direct investor, assists in attracting foreign investment and in mobilizing financial resources in the domestic markets of the member countries, as well as provides technical assistance to the member states. The EBRD’s emergency COVID-19 financing package for 2020–2021 is worth €21 billion. The Resilience Framework provides finance to meet the short-term liquidity and working capital needs of existing clients. Financing is expanded under the Trade Facilitation Programme. The bank also offers fast track restructuring for distressed clients. It has enhanced established frameworks that can reach out to small and medium enterprises and corporates that are not yet clients of the bank. The EBRD’s Vital Infrastructure Support Programme finances working capital, stabilization, and essential public investment during the pandemic.36 4.5.3.5  Asian Development Bank

Asian Development Bank (ADB) was established in 1966 to support the social and economic development of countries in Asia and the Pacific. It envisions a prosperous, inclusive, resilient, and sustainable Asia and the Pacific, while sustaining its efforts to eradicate extreme poverty in the region. ADB assists its members, and partners, by providing loans, technical assistance, grants, and equity investments to promote social and economic development. ADB maximizes the development impact of its assistance by facilitating policy dialogues, providing advisory services, and mobilizing financial resources through co-financing operations that tap official, commercial, and export credit sources.37 ADB is supporting its developing members in responding to the COVID-19 pandemic through finance, knowledge, and partnerships. ADB’s COVID-19 response consists of a $20 billion package and the $9 billion Asia Pacific Vaccine Access Facility (APVAX). The former supports developing member countries in countering the severe macroeconomic and health impacts caused by COVID-19, including $2.5 billion in concessional and grant resources, as well as $2 billion earmarked for the private sector (non-sovereign). The latter offers rapid and equitable support to developing member countries as they procure and deliver effective and safe COVID-19 vaccines.38 Chapter Questions: 5 Name major objectives of the macroeconomic policy. Are they similar to all states?

36 European Bank for Reconstruction and Development (2021). 37 Asian Development Bank (2022). 38 Asian Development Bank (2021).

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5 What is the difference between discretionary and automatic macroeconomic policy? Illustrate these two types of policy with examples. 5 Explain the roles of households and firms in the market by using the parameters of supply (i.e., what they offer in the market), demand (i.e., what they consume), and saving (i.e., how they save). 5 Which of the three theories of the firm says that a firm exists to maximize profits? 5 How is a free trade area different from a customs union? 5 Give examples of international financial and international trade organizations. How do they affect the global economy? 5 Discuss the role of transnational corporations in shaping the contemporary markets and balancing (or disturbing) global supply chains. Do you think TNCs are good or evil for stable economic development? Subject Vocabulary: External Environment: a set of exogenous factors that affect activities of an economic entity (consumers, competitors, suppliers, intermediaries, economic, social, and political situation in the country, the level of science and culture). Firm: a macroeconomic entity, which represents the aggregation of all firms and enterprises operating within a country or in the global market. Foreign Sector: the totality of all economic entities that have a permanent location outside a country; a macroeconomic entity through which the economic communication between countries is carried out. Household: one person living alone or a group of people who live together or share living arrangements in a house or a flat; a typical individual macroeconomic entity, whose activities are aimed at meeting their own needs. Integration Organization: an economic grouping created to regulate integration processes between its members. Internal Environment: an environment that determines technical and organizational conditions of an economic entity and that is the result of management decisions (resources, organizational and management structure of a firm, technologies, information). International Economic Integration: a process of merging national economies into a single economic complex based on deep and stable economic, trade, financial, and other ties. International Economic Organization: an organization created on the basis of an international agreement or by the decision of an existing international organization for the purpose of analyzing, discussing, and resolving various issues of the international economic, trade, financial, or social agenda. Macroeconomic Policy: a regulation of the behavior of macroeconomic agents in the market to ensure and maintain stable macroeconomic equilibrium and growth of the national economy. Rational Behavior: a decision-making process that is based on making choices that result in the optimal level of benefit or utility for an economic entity.

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State: a macroeconomic entity that acts simultaneously as an entrepreneur through managing public-owned assets, as a consumer through placing orders and public procurements in the market, and as a regulator through establishing the rules and carrying out economic, trade, monetary, fiscal, and social policies. Supranational Organization: an organization, in which member countries cede authority and sovereignty on at least some internal matters to the group, whose decisions are binding on its members. Transnational Corporation: a company that organizes cross-border value chains with the use of foreign direct investment, produces goods or renders services internationally, and carries out income and asset management in more than one country.

References Alexandrov, D. (2020). Macroeconomic policy of the state: Criteria and classification in modern conditions. Innovations and Investments, 8, 27–33. Asian Development Bank. (2021). COVID-19 (Coronavirus): ADB’s Response. Available at 7 https:// www.adb.org/what-we-do/covid19-coronavirus. Asian Development Bank. (2022). Who We Are. Available at 7 https://www.adb.org/who-we-are/ about. Balassa, B. (1961). The theory of economic integration. G. Allen & Unwin Ltd. Bank for International Settlement. (2022a). About BIS—Overview. Available at 7 https://www.bis.org/ about/index.htm?m=1%7C1. Bank for International Settlement. (2022b). Basel III: International Regulatory Framework for Banks. Available at 7 https://www.bis.org/bcbs/basel3.htm. Baumol, W., Litan, R., & Schramm, C. (2007). Good capitalism, bad capitalism, and the economics of growth and prosperity. Yale University Press. Bulatov, A. (Ed.). (2019). International economics and international economic relations. Complete Course. KNORUS. Crowley, P. (2006). Is there a logical integration sequence after EMU? Journal of Economic Integration, 21(1), 1–20. European Bank for Reconstruction and Development. (2021). The EBRD and the Coronavirus Pandemic. Available at 7 https://www.ebrd.com/what-we-do/coronavirus. European Bank for Reconstruction and Development. (2022). Who We Are. Available at 7 https:// www.ebrd.com/who-we-are.html. Financial Stability Board. (2022). About the FSB. Available at 7 https://www.fsb.org/about/. Food and Agriculture Organization of the United Nations. (2021). Novel Coronavirus (COVID-19). Available at 7 http://www.fao.org/2019-ncov/en/. Food and Agriculture Organization of the United Nations. (2022). About FAO. Available at 7 http:// www.fao.org/about/en/. Forbes. (2021). Global 2000. How the World’s Biggest Public Companies Endured the Pandemic. Available at 7 https://www.forbes.com/lists/global2000/#200e78fc5ac0. Hayes, A. (2020). Rational Behavior Definition. Available at 7 https://www.investopedia.com/terms/r/ rational-behavior.asp. International Labor Organization. (2022). About the ILO. Available at 7 https://www.ilo.org/global/ about-the-ilo/lang--en/index.htm. International Monetary Fund. (2022). The IMF at a Glance. Available at 7 https://www.imf.org/en/ About/Factsheets/IMF-at-a-Glance. Kenton, W. (2021). Economic Integration. Available at 7 https://www.investopedia.com/terms/e/economic-integration.asp. Molle, W. (2006). The economics of European integration: Theory, practice, policy. Routledge.

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Murphy, C. (2020). Theory of the Firm. Available at 7 https://www.investopedia.com/terms/t/theory-firm.asp. Robson, P. (1998). The economics of international integration. Routledge. Simon, H. (1947). Administrative behavior. New York, NY: The Macmillan Company. Tinbergen, J. (1954). International economic integration. Elsevier Publishing Company. United Nations Conference on Trade and Development. (2021). COVID-19 Response. Available at 7 https://unctad.org/programme/covid-19-response. United Nations Conference on Trade and Development. (2022). About UNCTAD. Available at 7 https://unctad.org/about. United Nations Organization on Industrial Development. (2022). UNIDO in Brief. Available at 7 https://www.unido.org/who-we-are/unido-brief. World Bank. (2021). How the World Bank Group Is Helping Countries Address COVID-19 (Coronavirus). Available at 7 https://www.worldbank.org/en/news/factsheet/2020/02/11/how-the-worldbank-group-is-helping-countries-with-covid-19-coronavirus. World Bank. (2022a). About the World Bank. Available at 7 https://www.worldbank.org/en/about. World Bank. (2022b). Who We Are. Available at 7 https://www.worldbank.org/en/who-we-are. World Customs Organization. (2022). Discover the WCO. Available at 7 http://www.wcoomd.org/en/ about-us/what-is-the-wco/discover-the-wco.aspx. World Health Organization. (2021). COVID-19 Solidarity Response Fund. Available at 7 https://www. who.int/emergencies/diseases/novel-coronavirus-2019/donate. World Trade Organization. (2021a). COVID-19 and World Trade. Available at 7 https://www.wto.org/ english/tratop_e/covid19_e/covid19_e.htm. World Trade Organization. (2021b). WTO Trade Barometers. Available at 7 https://www.wto.org/english/res_e/statis_e/wtoi_e.htm. World Trade Organization. (2022a). Principles of the Trading System. Available at 7 https://www.wto. org/english/thewto_e/whatis_e/tif_e/fact2_e.htm. World Trade Organization. (2022b). The WTO. Available at 7 https://www.wto.org/english/thewto_e/ thewto_e.htm.

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Learning Objectives: 5 Learn about the concepts of demand and supply 5 Understand how the interaction between demand and supply results in establishing equilibrium in the market 5 Reveal differences between individual demand and supply and aggregate quantities demanded and supplied in macroeconomic markets 5 Discover major determinants of shifts in market equilibrium 5 Study elasticity and its manifestations in prices and income

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5.1  Demand, Supply, and Equilibrium in Markets

Supply and demand are the fundamental concepts of macroeconomics. The entire idea of the market economy is based on the relationship between demand and supply. Demand is the quantity of goods and services that buyers want to purchase at a certain moment. The volume of demand is determined by the quantity of goods and services consumers are willing to buy at a certain price. The relationship between the volume of demand and the price is the demand ratio. Supply, in turn, is the quantity of goods and services available in the market at a certain moment. The volume of supply is determined by the amount of goods and services that producers are ready to sell in the market at a certain price. The correlation between the price and the volume of supply is the supply ratio. The price, therefore, reflects both the level of demand and the level of supply. The supply-demand ratio is the main force of resource allocation. In theory, it is believed that in the market economy, the interaction of supply and demand contributes to the most efficient allocation of resources. 5.1.1  Demand

Economics distinguishes between the concepts of need and demand. A Need is a necessity that takes a specific form depending on the level of development of society and an individual. Human needs are limitless; they are growing constantly. Demand is a form of expression of a need measured by the amount of money that consumers are willing to pay for goods or services they need. The willingness to purchase should be supported by money. Therefore, needs turn into demand when an individual becomes a consumer by expressing the desire to pay a certain price for a certain product. For a product, the Quantity Demanded is the total quantity of a product that buyers want and can purchase under certain conditions, such as tastes and preferences of consumers, the amount of their monetary income and savings, prices of the product and other goods in the market, and many more. The Demand Price is the maximum price that people agree to pay for a certain amount of a given product or service. Expressed mathematically, the quantity demanded is a function of the factors that determine demand (price, income, consumer preferences, etc.) (Eq. 5.1).

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. Fig. 5.1  Demand curve. Source Authors’ development

Qd = f (P, I, Psub , Pcom , . . . ) where: Qd P I Psub Pcom  

(5.1)

quantity demanded; price of a product; income of a consumer; price of a substitute product; price of a complementary product.

When analyzing demand or supply, macroeconomists use the “all other things being equal” premise to say that all variables, except those currently being studied, are considered constant. From here, the simplest way to calculate demand is to use the demand-price function Qd = f (P). In a form of a demand curve, it depicts the dependence of the quantity demanded for a certain product on its price (. Fig. 5.1). The Y-axis is the price P that a seller receives for a certain quantity of goods offered and that a buyer agrees to pay for this quantity of goods. The X-axis shows the total required and offered quantity of goods Q in a given time. The demand curve runs down right, because consumers commonly agree to buy more units of a good or service if the price of this good or service decreases. A lower price allows them to buy more. Moreover, lower price attracts other consumers who previously could not afford to pay a higher price for this good or service. Thus, the Law of Demand says that if the price of a certain good or service increases, then the demand for this good or service decreases (all other factors remaining unchanged). In other words, the higher the price, the smaller the quantity demanded. If the price of a particular good increases, then the number of buyers of this good decreases, since the opportunity cost of this good increases along with the price. As a result, consumers buy less of a more expensive product, because, in order to acquire it, they have to give up more of other goods or services valuable to them.

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Case box Under certain conditions in the market, there appear goods for which the relationship between price and quantity demanded contradicts the fundamental law of demand. They are known as Giffen goods—products for which demand increases as the price rises, and vice versa. Commonly, they are low-income goods for which there are few substitutes in the market. Examples are rice, wheat, and other dietary staples essential in low-income countries. When the price for staples rises, low-income consumers tend to increase consumption of these staples in order to stock up (often by reducing demand for more expensive products, such as meat or dairy). Although the Giffen paradox is rarely observed in developed economies, the introduction of the COVID-19 lockdowns in February–March 2020 triggered a substantial increase in both prices of and demand for foods, medicines, drinking water, and other supplies across the world.1, 2

5

Case box Another deviation from the fundamental law of demand is the Veblen effect which says that for goods exclusive in nature demand increases as the price increases. Alike Giffen goods, Veblen goods are symbols of status, that demonstrate the success of their holders. Common examples are pricey jewelry, watches, cars, or gadgets. Different social or income groups have different Veblen goods. An iPhone or a MacBook could easily be considered Veblen goods in low-income communities. The main feature of a Veblen good is that it could not be purchased by a majority of the members of a particular community.

In . Fig. 5.1, the demand curve D divides the space between the axes P and Q into two areas. The points situated below the curve reflect such price-demand ratios, at which competition between consumers for a product puts pressure on the market. If the quantity of goods in the market remains unchanged, then perfect competition of buyers pushes the price up until only those buyers who are ready to buy at the D curve price remain in the market. If the price does not change, at least for a short time, then the competition of buyers leads to increased searches for goods at this price. The demand curve separates the zone of competition of buyers and those combinations of prices and demand that can never happen in practice. Thus, the demand curve is a locus of points that correspond to the highest price that buyers are willing to pay for a certain quantity of goods over a standard period of time. When a price goes up, the quantity demanded decreases for two reasons. First is the substitution effect: buyers try to substitute more expensive goods with less

1 2

Erokhin and Gao (2020). Yuen et al. (2020).

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expensive ones of similar quality or other characteristics. Second is the income effect: when prices increase, consumers feel themselves poorer than they were before. The law of demand reflects the relationship between prices and the quantity demanded that exists at a certain price. According to the law, there is an inverse relationship between prices and quantity demanded. Putting it most simply, lowering prices allows producers to sell more goods in the market, while price rises depress demand (all other things being equal). Case box If the price of beef rises, households reduce the consumption of more expensive beef and switch to less expensive poultry—this is an illustration of the substitution effect. If the price of beef doubles, households’ real income decreases. As a result, households decrease consumption of not only beef, but also other goods—this is an illustration of the income effect. Price is the most important, but not the only determinant of demand. Non-price determinants of demand are tastes, expectations, consumer preferences, advertising, fashion, as well as many other factors that affect demand (see 7 Sect. 5.3 for various determinants of shifts in demand).

The macroeconomic analysis distinguishes between individual demand, market demand, and aggregate demand: 5 Individual demand is the need of an individual for a particular product, expressed in money. 5 Market demand is the total quantity demanded across all individual buyers in a market for a given period. 5 Aggregate demand is the total demand for all goods and services in an economy that all economic entities are ready to buy at a certain price (see 7 Sect. 5.2). Individual demand curves for the same product are different for different consumers, reflecting the peculiarities of their consumer preferences, needs, willingness to pay the price, money constraints, and many other factors. . Figure 5.2 demonstrates how the market demand can be calculated. Based on the individual demand curves, none of the consumers would want to buy a product at price P1. For consumer 1, any sets at a given price are unattainable. For consumers 2 and 3, the equilibrium at price P1 is reached at point A , where the quantity demanded is zero. Accordingly, the market demand is zero. At price P2, the quality demanded at point B for consumer 1 is also zero, while for consumers 2 and 3, equilibriums are established at points C and D, respectively. The market demand at price P2 is 0 + QC + QD. Similarly, at price P3, the equilibrium for consumer 1 is reached at point E, for consumer 2—at point F , and for consumer 3—at point G. Consequently, the market demand at price P3 is the sum of individual demands of consumers 1, 2, and 3, i.e., QE + QF + QG. The resulting market demand curve is produced by connecting the individual equilibrium points at different prices.

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5 . Fig. 5.2  Building the market demand curve based on individual demand curves (horizontal method). Source Authors’ development

5.1.2  Supply

The law of supply, like the law of demand, demonstrates the relationship between the price and the quantity of goods—in the case of supply, goods that producers are willing to sell. Supply is the amount of goods or services that a producer (seller) offers in the market or can supply in the market, depending on the prices of these goods or services and other factors. The Quantity Supplied is the amount of goods that an individual seller or a group of sellers wants and is able to sell in the market under certain conditions. The Supply Price is the minimum price at which the seller agrees to sell a certain amount of a given product or service. Supply is depicted as the dependence of the quantity supplied on the factors that determine it (Eq. 5.2).

Qs = f (P, Pres , t, K, Pc , . . . )

(5.2)

where: Qs quantity supplied; Pres   price of resources; t taxes and donations; K level of technology used in production; Pc price of competing products (those that can be produced with the use of the same amount of resources or the level of technology). If all the factors that determine the quantity supplied (except for the price of the product), remain unchanged or are recognized as such, then one can move from the general function of supply to the function of price Q = f (P). This function reflects the dependence of the quantity supplied on the price. Graphically, this function is represented as a supply curve (. Fig. 5.3).

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. Fig. 5.3  Supply curve. Source Authors’ development

The supply curve runs upward right, because the higher the price, the more firms want and are able to produce and sell products. Its ascending slope shows that the quantity supplied increases along with the price. Thus, the curve reflects the relationship between the quantity of goods in the market and the prices of these goods. The ascending curve expresses the essence of the Law of Supply, which says that the higher the price for a good, the greater the quantity of these goods offered by producers in the market. The concavity of the supply curve is explained as follows: with an increase in the price of a good, an increasing number of firms enter the market by producing and supplying this good, thereby causing a significant increase in the quantity supplied. At some price level, the market becomes saturated and the expansion of production and supply slows down. As a result, output stabilizes regardless of the price level. If the price continues to rise, the supply curve transforms into an upward running vertical line. The supply curve S divides the space between the axes P and Q into two areas. The points situated above the curve reflect such price-supply ratios, at which competition between sellers pushes the price down until only those entities who are ready to sell at the S curve price remain in the market. If the price does not change, at least for a short time, then the competition of buyers leads to increased searches for goods at this price. The demand curve separates the zone of competition of buyers and those combinations of prices and demand that can never happen in practice. Thus, the demand curve is a locus of points that correspond to the highest price that buyers are willing to pay for a certain quantity of goods over a standard period of time. The main components that establish the supply curve and that affect its shape are: 5 production costs primarily determined by prices for resources (factors of production) and the level of technology; 5 production technology—the use of more advanced technology reduces average production costs, more goods are produced, which increases the quantity supplied; 5 prices for resources—for example, a reduction in the wages of the company's workers reduces production costs and increases the supply;

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5 prices of related goods, especially those that can easily substitute each other in the production (an increase in the price of one good results in the increase in the price of another); 5 producers—the more producers in the market, the greater the quantity supplied; 5 buyers—the more buyers in the market, the greater quantity supplied they can buy; 5 taxes and subsidies—an increase in taxes reduces output, while an increase in subsidies causes an expansion of production; 5 government policy—quotas and customs tariffs affect the amount and prices of goods supplied in the market; 5 industry-specific factors—for example, climate factors in agriculture or tourism. Higher price covers the production costs and brings income. As the price increases, the producer increases output to get a higher profit. At a price that brings more profit than in other industries, production increases due to the overflow of capital into this industry from others. This is how an increase in price finances the expansion of production. An increase in prices and an increase in profits makes the expansion of production not only desirable, but possible. Producers self-finance their activities to increase output. When prices go up, the supply increases due to the entry of producers with higher individual costs into the market. Case box According to the law of supply, the need for a higher price in the market is explained by the law of diminishing returns. In the short term, at least one of the factors of production is constant, while the rest are variables. As the variable factor of production increases, the return from each additional unit tends to decrease. This is the essence of the Turgot’s law of diminishing returns. As a result, an increase in output in the short term causes a rapid increase in costs. Average costs (costs per unit of product) go up. If people want to consume more of a certain good or service, they must pay the costs of producers by buying this good or service at a higher price.

5.1.3  Equilibrium

In the market economy, the interaction of supply and demand balances the price and thus generates Market Equilibrium—the state in which supply and demand balance each other and market supply of goods or services matches the demand for these goods or services. The resulting Market Price is the price that satisfies both a seller and a buyer. It reflects a situation when the plans of buyers and sellers in the market completely coincide, and the volume of goods that buyers intend to buy is equal to the volume of goods that producers intend to supply. As

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a result, there is an Equilibrium Price, i.e., the price at which the supply of goods and services matches the demand for them. In market equilibrium, no factors affect raising or lowering the price as long as all other conditions remain equal. Point A in . Fig. 5.4 is the point of market equilibrium. The position at which the price is above the equilibrium point is called a surplus. In the market, s­ urplus means overstocking. If the price is below this value, the market experiences excessive demand, which results in a deficit. At price PE, the equilibrium QS = QD is reached. This is a balance at which the quantity of goods offered for sale is equal to the quantity of goods that buyers intend to purchase. When price P2 exceeds the equilibrium price, overstocking happens (QS2 − QD2 ). Price P1 below the equilibrium results in the deficit QD1 − QS1. An increase in demand drives up both the equilibrium price and the equilibrium quantity of a product. There is a direct relationship between changes in demand and changes in the equilibrium price and the equilibrium quantity (. Fig. 5.5).

. Fig. 5.4  Market equilibrium. Source Authors’ development

. Fig. 5.5  Increase in equilibrium price and equilibrium quantity due to increase in demand in the short run. Source Authors’ development

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. Fig. 5.6  Decrease in equilibrium price and equilibrium quantity due to increase in supply in the short run. Source Authors’ development

An increase in supply reduces the equilibrium price and increases the equilibrium quantity of a product. There is a direct relationship between the change in supply and the change in the equilibrium quantity of a product, and an inverse relationship between the change in supply and the change in the equilibrium price (. Fig. 5.6). Shifts in the supply and demand curves (further detailed in 7 Sect. 5.3) affect prices and quantity of goods and services in the market in the four following ways: 5 An increase in demand causes a shift in the demand curve to the right, as a result of which both the equilibrium price and the equilibrium quantity increase. 5 A decrease in demand shifts the demand curve to the left, as a result of which both the equilibrium price and the equilibrium quantity decrease. 5 An increase in supply shifts the supply curve to the right, as a result of which the equilibrium price decreases and the equilibrium quantity increases. 5 A decrease in supply shifts the supply curve to the left, as a result of which the equilibrium price increases and the equilibrium quantity decreases. Using these four options, it is possible to determine the equilibrium point for any fluctuations in supply and demand in the market. However, sometimes the two curves shift simultaneously, which significantly complicates the analysis of the market situation. In the long term, a simultaneous increase in supply and demand may, first, lead to an increase in the equilibrium quantity of goods or services in the market, second, cause a slight response in any direction (increase or decrease), or, third, not affect the equilibrium price (. Fig. 5.7). In the long term, the supply curve is represented by the SL curve. When there is a shortage in a competitive market, prices rise. This encourages sellers to increase output. Gradually, the market gets saturated, and supply matches the demand at the equilibrium point. In case of overstocking, prices go down. Producers respond to this situation by reducing production. As a result, the market returns to equilibrium.

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. Fig. 5.7  Increase in equilibrium quantity due to simultaneous increase in supply and demand and the supply curve in the long run. Source Authors’ development

. Fig. 5.8  Walras’s market equilibrium. Source Authors’ development

The macroeconomic analysis employs several alternative interpretations of market equilibrium. Walras’s Law (Walras’s General Equilibrium Model) states that the existence of excess supply in one market must be matched by excess demand in another market so that both factors are balanced out.3 This model illustrates the simultaneous interaction of supply and demand for a certain product. Walras emphasizes the ratio of the quantity of demand and the quantity of supply in establishing the equilibrium (. Fig. 5.8). According to Walras, the price of a good or service in one market is not determined independently of the prices of other goods and services in other ­markets. Instead, prices of all goods and factors are determined simultaneously in all

3

Kenton (2021).

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5 . Fig. 5.9  Marshall’s market equilibrium. Source Authors’ development

markets. Since they balance each other, a particular market reaches equilibrium if all other markets do so. The equilibrium price is established due to the following two reasons: 5 influence of excess supply over demand (when the market price exceeds the equilibrium price)—excess supply drives the price down through the competition of sellers, and market price decreases; 5 influence of excess demand over supply (when the market price is below the equilibrium)—excess demand rises the price through the competition of buyers, and market price increases. English economist Alfred Marshall focused on the ratio of the demand price and the supply price in establishing the equilibrium. Marshall’s Partial Equilibrium Model explains the price determination of goods and services, keeping the prices of other goods and services constant and also assuming that various goods and services in various markets are not interdependent. According to Marshall, the equilibrium price is established under one of the following conditions (. Fig. 5.9): 5 excess of the demand price over the supply price (when the quantity supplied is below the equilibrium level)—producers respond by increasing supply; 5 excess of the supply price over the demand price (when the quantity supplied is above the equilibrium level)—producers respond by decreasing supply. Both models show the natural ability of the market to get self-adjusted by continuously searching for establishing a balance between supply and demand. Thus, the market adjusts prices taking into account the economic interests of sellers and buyers, bringing them closer to the equilibrium state (through either prices or quantities). The market mechanism becomes a way of economic development. This is what Adam Smith meant by the invisible hand of the market, which regulates markets, establishes order, balance, and proportionality, and thus facilitates economic and social development.

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5.2  Aggregate Demand and Aggregate Supply

In a similar way to understanding market demand, aggregate demand in macroeconomics is defined as the dependence of quantity demanded on price and other parameters. However, there is no price as such in the aggregate market. There is a price level measured in percentage, not monetary units. The quantity demanded in the aggregate market cannot be measured in physical terms. All goods and services that can be purchased on the domestic market are expressed in terms of gross domestic product and can only be measured in monetary units. But when it comes to demand, it is necessary to find out who is willing to buy certain goods or services at a certain overall price level. 5.2.1  Aggregate Demand

Aggregate Demand is the sum of all individual demands for individual goods and services supplied on the market, or the total amount of goods and services that consumers are ready to buy at a given overall price level at a given time. Unlike individual demand, aggregate demand is a more complex category. It depends on the level of income and the price level. The lower the price level, the greater portion of gross output can be purchased by consumers. Conversely, the higher the price level, the smaller portion of gross output they would be willing to buy. Such an inversely proportional relationship between the price level and the aggregate demand is constant. Graphically, the aggregate demand model can be represented as the AD curve in . Fig. 5.10. As previously shown in 7 Sect. 5.1, for individual demand, the descending slope of the curve could be explained by either the income effect or the substitution effect (or both effects acting simultaneously). The former is associated with a drop in the price of a certain product, which contributes to an increase in the purchasing power of income, i.e., the ability of a buyer to increase purchasing. The latter also involves a drop in the price, due to which a buyer

. Fig. 5.10  Aggregate demand curve. Source Authors’ development

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. Fig. 5.11  Effects of price determinants on aggregate demand. Source Authors’ development

seeks to purchase a larger amount of a certain product instead of more expensive goods. However, as discussed above, the essence of aggregate demand can not be explained by individual prices and the shifts in the physical quantity of goods purchased by individual consumers. Instead of shifts in individual prices and quantity demanded, the downward path of the AD curve should be explained by the quantitative theory of money, i.e., the amount of money in the economy (Eq. 5.3). According to this theory, aggregate demand directly depends on the money supply and the velocity of money and it inversely depends on the overall price level.

M × V = P × Q, or, Q =

MV MV , or AD = P P

(5.3)

where P overall price level in the economy; M   money quantity (money in circulation); V velocity of money circulation; Q quantity demanded (portion of gross output demanded in the economy). The aggregate demand is influenced by price and non-price factors. Price determinants cause a change in the volume of aggregate demand in the form of shifting [P; Q] points along the curve from one point to another up or down (. Fig. 5.11, sections BA and BC). Price-related determinants of aggregate demand include interest rates, wealth (material values), and imports. 5 The effect of interest rate (the Keynesian effect)—a higher price level increases the demand for money, thereby raising the interest rate, thereby causing a reduction in aggregate demand for goods and services (BA section), and vice versa, when the interest rate is reduced (BC section), aggregate demand increases. 5 The effect of wealth (the Pigou effect)—an increase in the price level reduces real purchasing power of accumulated financial assets with a fixed value

157 5.2 · Aggregate Demand and Aggregate Supply

5

. Fig. 5.12  Effects of non-price determinants on aggregate demand. Source Authors’ development

(bonds, time deposit accounts), which makes their owners poorer and causes a reduction in aggregate demand. 5 The effect of import purchases (the exchange rate effect)—a reduction in prices of foreign goods and services increases imports and thus decreases aggregate demand for domestic goods and services. Conversely, a decrease in the overall price level on the domestic market contributes to a reduction in imports and an increase in exports. Non-price determinants of aggregate demand shift the AD curve to the left (downward) or to the right (upward) (. Fig. 5.12). Major non-price determinants of aggregate demand include the following: 5 Consumer welfare. The higher the level of wellbeing, i.e., the amount of wealth (the change in which in this case should not be caused by a change in the overall price level), the greater the consumer spending and the greater the aggregate demand—the AD curve shifts to the right to AD1. In a reverse situation, it shifts to the left to AD2. 5 Consumer expectations, which include expectations of changes in income and changes in the price level in the future. For example, if an individual expects an increase in income tomorrow, this individual may increase consumption already today. This results in an increase in aggregate demand ( AD shifts to AD1 ). The second option, if an individual expects an increase in the price level tomorrow, this individual increases consumption today by purchasing as much as possible at a still lower price (the inflationary psychology), which also leads to an increase in aggregate demand. 5 Consumer debt. A high level of debt can force an individual to cut current expenses. This decreases aggregate demand and shifts the AD curve downward to AD2. Conversely, debt relief could trigger consumption and shift the aggregate demand curve upward to AD1. 5 Taxes. Cutting taxes entails an increase in income and the quantity demanded at a given price level, i.e., aggregate demand increases. Consequently, the AD

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curve shifts to the right to AD1. If the government raises taxes, aggregate demand falls as a result of lowering the disposable income of households and businesses ( AD curve shifts to the left to AD2). 5 Interest rates. If interest rates go up, decreasing consumption forces the aggregate demand down ( AD curve shifts to AD2). Conversely, lower interest rates disincentivize saving, stimulate consumption, and thus push the AD curve up to AD1. 5.2.2  Aggregate Supply

5

Aggregate Supply is the total amount of all goods and services produced within an economy and supplied on the market, or the total output produced in a country at a given overall price at a given time. Being calculated as the total output, aggregate supply is equal to either GNP or GDP, depending on the approach to measuring it. Graphically, the aggregate supply is depicted as the AS curve (. Fig. 5.13). The aggregate supply curve shows that the higher the price level P, the higher the aggregate supply and the higher the output volume Q. This implies a relationship between the price level and the volume of output within an economy (territory, country, region, or world). This dependence is direct and positive, i.e., with the increase in the overall price level in the economy, aggregate supply increases proportionally. Contemporary macroeconomics understands the aggregate supply curve as an aggregation of three segments: horizontal (Keynesian) segment (underemployment of resources and factors of production), intermediate (ascending) segment (convergence to full employment), and vertical (classical) segment (full employment of factors of production) (. Fig. 5.14). The horizontal (Keynesian) segment shows how production expands at a constant overall price level. The increase in output is achieved by employing unused resources. As soon as all previously unused factors of production are employed, the horizontal AS curve starts ascending. Further on, the increase in output requires the involvement of scarce resources (redistribution of factors of production previously employed in other spheres). This forces up the overall price level in the economy. Producers increasingly invest in

. Fig. 5.13  Aggregate supply curve. Source Authors’ development

159 5.2 · Aggregate Demand and Aggregate Supply

5

. Fig. 5.14  Contemporary interpretation of the aggregate supply curve. Source Authors’ development

. Fig. 5.15  Effects of price determinants on aggregate supply. Source Authors’ development

research and adopt new technologies and other advancements. At some point, the economy reaches full employment of all factors of production, i.e., the limit of production capacity at the current level of economic, social, and technological development (see 7 Chap. 16 for resource and technological limitations to economic development, particularly, 7 Sect. 16.3 for the concept of production possibility frontier). At this point, further expansion of production is impossible. An increase in the overall price level does not result in the growth of supply. From a theoretical point of view, the situation of full employment of resources is normal for an open market, where factors of production can freely flow from one sphere to another. Therefore, the vertical section of the AS curve is called the classic segment. Price-related determinants of aggregate supply show the movement of [P; Q] points along the AS curve from point B upward to point A or downward to point C (. Fig. 5.15). A higher overall price level in the economy stimulates the increase in the production of goods and services, thereby pushing the aggregate supply upward. Lower prices, on the contrary, depress output and, accordingly, force the aggregate supply down.

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5 . Fig. 5.16  Effects of non-price determinants on aggregate supply. Source Authors’ development

Non-price determinants, such as changes in prices of domestic and imported resources (factors of production), labor productivity, or changes in legislation or government policies, could shift the AS curve either downward right or upward left (. Fig. 5.16). An increase in prices of resources (land, labor, capital) boosts production expenditures, therefore reducing output along with the aggregate supply. In such a situation, the AS curve shifts upward left to AS 1. Vice versa, a decrease in prices causes a reverse reaction. Lower costs allow producers to increase output and supply more goods and services in the market (the AS curve shifts downward right to AS 2). The same applies to foreign factors of production—lower prices push the AS curve down to AS 2, while more expensive imported labor, capital, or other resources shift the AS curve upward to AS 1. The growth of labor productivity increases the volume of production, thereby increasing the aggregate supply from AS to AS 2, while lower productivity depresses the performance of individual producers and the entire economy ( AS falls to AS 1). With an increase in taxes, production costs go up, thereby reducing output. The AS curve shifts to the left to AS 1. Conversely, the government may incentivize economic activity by cutting taxes. This increases output and shifts the AS curve to AS 2. So, a shift of the aggregate supply curve to the right indicates lower costs per unit of production and an increase in aggregate supply. Conversely, a shift to the left assumes the economy experiences higher production expenditures per unit, which results in a decrease in the aggregate supply. 5.3  Shifts in Demand and Supply and Changes in Equilibrium

Implementing its economic policies and regulations, the government in one way or another influences either aggregate supply or aggregate demand (or both) thereby transforming the market equilibrium. The balance could be affected

161 5.3 · Shifts in Demand and Supply and Changes in Equilibrium

5

through collecting taxes from households and businesses, providing subsidies, setting maximum or minimum prices, making public procurements or interventions in markets, and regulating foreign trade. 5.3.1  Taxation

The introduction of a tax on producers in the amount of T monetary units for each unit of output pushes the S curve upward left by T value (. Fig. 5.17). Previously, producers supplied Q0 amount of goods at price P0. As the tax increases production costs, now producers are willing to supply the same Q0 amount of goods at higher price (P0 + T ). Most likely, consumers refuse buying at this price and cut consumption. Producers attempt to compensate increased costs by a simultaneous decrease in output and reasonable increase in price. As a result, the equilibrium shifts from E to E1 with lower quantity supplied Q1 and higher price P1. In a reverse situation, a tax relief program by the government could stimulate the growth in output by reducing production costs per unit. The increase in output would force the S curve downward right, and the new equilibrium in the market would be established at some point along the D curve with higher quantity supplied and lower price. In theory, such a kind of shift would be similar to the effect of subsidies (see 7 Sect. 5.3.2, . Fig. 5.18). Due to the introduction of the tax, consumers’ loss equals the area of the P1 E1 EP0 quadrangle. Similarly, producers lose the equivalent of the P0 EE2 P2 quadrangle. The amount of new tax collected by the government is measured by the area of the P1 E1 E2 P2 rectangle. Thus, the combined losses of producers and consumers exceed the amount of tax collected by the government by the area of the EE 1 E2 triangle. This amount represents the non-recoverable losses of the economy (deadweight losses) as a result of the introduction of the T tax.

. Fig. 5.17  Effect of taxes on market equilibrium. Source Authors’ development

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5 . Fig. 5.18  Effect of subsidies on market equilibrium. Source Authors’ development

5.3.2  Subsidies

A subsidy is a kind of payment made by the state to producers. Commonly, it is associated with the production or sale of each unit of output. Suppose that a subsidy is given to producers in the amount of A monetary units for each unit of output sold on the market. Then, the quantity supplied increases, i.e., the S curve moves downward right by A units to S1 (. Fig. 5.18). As a result, the equilibrium shifts from point E to point E1 with greater quantity supplied Q1 and lower equilibrium price P1. In a reverse situation, if the government calls the previously given subsidy back, such action increases production costs per unit and depresses the output. The decrease in output would shift the S curve upward left (see illustration of the taxes effect in . Fig. 5.17), and the new equilibrium in the market would be established at some point along the D curve with lower quantity supplied and higher price. Consumers would gain from the introduction of a subsidy in the amount equivalent to the area of the P1 E1 EP0 quadrangle. Producers’ gain equals the area of the P0 EE2 P2 quadrangle. To subsidize producers, the government allocates funds in the amount of the P1 E1 E2 P2 rectangle. Thus, the combined gain of producers and consumers do not cover the amount of funds spent by the government by the area of the EE1 E2 triangle. Similar to previously demonstrated deadweight loss in the case of taxes, the amount EE1 E2 represents a non-recoverable loss of the economy as a result of the introduction of the A subsidy. 5.3.3  Price Administration

Prices in the market could be administrated by the government by establishing maximum price (price ceiling) or minimum price (price floor).

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5

. Fig. 5.19  Effect of establishing the price ceiling on market equilibrium. Source Authors’ development

5.3.3.1  Price Ceiling

Price Ceiling is the mandated maximum price Pmax a seller is allowed to charge for a good or service. The maximum price is set below the equilibrium price P0 to help consumers purchase certain staples, such as food and agricultural products, or pay for essential services, such as utility fees, that they would not be able to buy or pay for at equilibrium prices. As a result of establishing a price ceiling, the output reduces from Q0 to Q1 (. Fig. 5.19). Simultaneously, the quantity demanded increases from Q0 to Q2. The occurrence of excess demand in the market results in the deficit E1 E2—the difference between the quantity demanded Q2 and the quantity supplied Q1. By setting Pmax below the equilibrium price P0, the government attempts to improve the purchasing power of households and businesses, who are now able to buy certain goods and services at prices between P0 and Pmax. Since the quantity supplied decreases from Q0 to Q1 = Qs (Pmax ) (equilibrium point E1) and the quantity demanded rises from Q0 to Q2 = Qd (Pmax ) (equilibrium point E2), some buyers are forced out of the market and, thus, lose their surplus (gain from the purchase). Those consumers who stay in the market now pay less for more affordable goods and services, and their consumer surplus increases. . Figure 5.19 illustrates one of the scenarios when the quantity demanded Q1 is purchased by consumers with the greatest willingness to pay. In this case, the resulting surplus of consumers is the largest. The net change in the total consumer surplus equals the difference between A and B. . Therefore, the exact effect (positive or negative) depends on the sizes of A and B, which in turn depend on the configuration of the supply and demand curves. Thus, while consumers could either gain or lose from setting the price ceiling, producers definitely lose. Price reduction decreases the total surplus of producers by the amount A + C. Since A is lost by producers in favor of consumers, this does not affect the public welfare. The total change in the aggregate surplus of consumers and producers is calculated as (A − B) + (−A − C) = −B − C. This is the amount lost in the economy due to the introduction of the price ceiling (because of the distortion of the market equilibrium and the loss of efficiency). In case the quantity supplied Q1 is totally bought out by only those consumers

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the government targeted (for whom the equilibrium price P0 is unaffordable), the overall surplus of all consumers in the economy will be the smallest, while the overall loss of public welfare will be the greatest. Therefore, such price administration practice could be reasonable if the gain received by low-income households overweighs (in either political or social terms) all the economic losses that arise. Deficits and supply shortages could lead to social tensions, queues at shops, the emergence of the shadow economy, and many other misbalances in the market. In the longer term, price administration compromises both the quality and assortment of goods and services in the market.

5

5.3.3.2  Price Floor

Price Floor is the minimum price Pmin set by the government that can be charged for a good or service in the market. It is set above the equilibrium price P0 in a situation when the free market fails to provide a sufficient level of income to certain groups of producers or suppliers of factors of production. As a result of such regulation, the quantity demanded falls from Q0 to Q1 (. Fig. 5.20). Higher price incentivizes producers to increase supply from Q0 to Q2. Excess supply in the market results in establishing the E1 E2 surplus—the difference between the quantity supplied Q2 and the quantity demanded Q1. . Figure 5.20 illustrates one of the scenarios when the quantity demanded Q1 is satisfied by producers with the lowest production costs. In this case, the total surplus of producers is the greatest. The change in producers’ surplus (positive or negative) depends on the ratio of the A rectangle and the C triangle, where C designates loss and A designates gain. The change in the consumer surplus is calculated as −(A + B). The non-recoverable losses are equivalent to the areas of triangles B and C. However, overall non-recoverable losses could rise if those producers who experience higher production costs enter the market attracted by a minimum guaranteed price. This happens because low-cost producers would lose their surplus, while the surplus of high-cost producers would be the lowest possible.

. Fig. 5.20  Effect of establishing the price floor on market equilibrium. Source Authors’ development

165 5.3 · Shifts in Demand and Supply and Changes in Equilibrium

5

. Fig. 5.21  Effect of public procurement on market equilibrium. Source Authors’ development

5.3.4  Public Procurement

In many countries, price support aims at increasing prices of certain goods or services in the market in order to ensure a certain level of revenue for producers of these goods or services. One of the ways to achieve this goal is to set a certain price P1 and then buy some quantity of products out the market to keep the market equilibrium price at this established level. The demand from the government in general or individual public entities can be represented as perfectly inelastic (the concept of elasticity is further explained in 7 Sect. 5.4) (. Fig. 5.21). Government buys out the surplus in the amount of QG = Q2 − Q1. In . Fig. 5.21b, the total market demand increases by the amount of QG. As a result, market equilibrium is established at a price P1. Since the price rises (P1 > P0 ), consumers’ surplus decreases by the amount of A + B, while producers’ surplus increases by the amount of A + B + C. In addition, there occurs the surplus of the state as a buyer in the amount equal to the area of the G rectangle. Public welfare grows by the amount of C + G. Thus, the appearance of new buyers in the market leads to an improvement in the position of sellers and the redistribution of surplus for buyers, while the overall public welfare improves. 5.3.5  Market Intervention

In the event of a shortage in the market, the government can act as a seller of goods and services in short supply. Similar to demand in a form of public procurement, supply from the government in a form of market intervention is perfectly inelastic (. Fig. 5.22). The government sells products in the market in the amount of the shortage QG = Q2 − Q1. In . Fig. 5.21b, the total quantity supplied increases by the

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5 . Fig. 5.22  Effect of market intervention on market equilibrium. Source Authors’ development

amount of QG. The new market equilibrium is established at a price P1. Since the price goes down (P0 > P1 ), consumers’ surplus increases by the amount of A + B + C, while producers’ surplus decreases by the amount of A + B. There occurs the surplus of the state as a seller in the amount equal to the area of the G rectangle. Public welfare increases by the value of C + G. Thus, the entrance of new sellers into the market results in the improvement in the position of buyers and the redistribution of surplus for sellers, while the overall public welfare improves. 5.3.6  International Trade

In the absence of international exchange, market equilibria are achieved at price P1 in country 1 and price P2 in country 2. Under free trade, countries exchange goods, services, resources, and factors of production with each other. Economies become open and the market equilibrium is achieved at price P∗ (. Fig. 5.23). In country 1, at price P∗, economic entities are willing to produce goods or render services in the amount of Q11, while consumers are willing to purchase these goods and services in the amount of Q21. The deficit equals the amount of imports Q21 − Q11. As a result, producers’ surplus in country 1 decreases by the area of quadrangle B and consumers’ surplus increases by the amount of A + B . Public welfare rises by the size of the A triangle. In country 2, at price P∗, producers are willing to supply goods and services in the amount of Q22, while consumers are willing to purchase them in the amount of Q12. There occurs surplus in the amount of exports Q22 − Q12. As a result, producers’ surplus in country 2 grows by C + F, and consumers’ surplus decreases by the size of the F quadrangle. The total surplus of consumers and producers in country 2 rises by the size of the C triangle.

167 5.3 · Shifts in Demand and Supply and Changes in Equilibrium

5

. Fig. 5.23  Equilibria in global market and countries 1 and 2. Source Authors’ development

Thus, the transition to an open exchange is beneficial for both countries. Quantitatively, the total gain in monetary terms can be estimated as the aggregation A + C. 5.3.7  Import Tariff and Import Quota

The government may impose tariffs, quotas, and other restrictions and regulations to curtail the import of certain goods and protect or support domestic producers. If price PW on the world market is lower than price P0 on the domestic market of a country, then under free trade, there occurs a flow of goods (import) into this country from the world market, i.e., domestic goods are displaced from the domestic market by imports. Let us assume that price PW does not depend on the quantity of goods or services supplied and demanded in a given country. Then, supply from the world market SW for a given country is perfectly elastic (see 7 Sect. 5.4 for price elasticities of demand and supply). It can be illustrated by a horizontal line (. Fig. 5.24). At price PW , domestic producers are willing to supply goods in the amount of QS and consumers are willing to purchase goods in the amount of QD. As a result, imports equals QD − QS. The introduction of an import tariff in the amount of t reduces the supply from the world market—the SW curve shifts upward by the amount of the tax to SW 1. This results in the increase in price up to P1 = PW + t. Therefore, the introduction of the tariff t leads to the increase in quantity supplied by domestic producers from QS to Q1, the decrease in quantity demanded from QD to Q2 , and the cut in imports equal to Q2 − Q1. As a result, producers’ surplus rises by the area of the A quadrangle, consumers’ surplus reduces by the area of the A + B + C + F quadrangle, and the amount of tax T = t × (Q2 − Q1 ) collected by the government is represented by the F rectangle. Thus, the introduction of an import tariff eventually results in the overall loss of consumers, producers, and the state (B + C).

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5 . Fig. 5.24  Introduction of import tariff. Source Authors’ development

Instead of applying a tariff, the government may introduce a quota, i.e., a restriction on the quantity of a particular good that may be imported into a country. If the quota is equal to Q2 − Q1, then the supply coming into a country from the world market could be illustrated by the SW 2 curve (. Fig. 5.25a). The total supply S made up of the domestic supply S and the supply of the global market SW 2 intersects the demand curve at price P1 and the quantity demanded Q2 (. Fig. 5.25b). For both producers and consumers, the consequences of introducing an import quota are similar to those of introducing an import tariff (compare . Figs. 5.24 and 5.25b): producers’ surplus increases by the area of the A quadrangle and consumers’ surplus decreases by the area of the A + B + C + F quadrangle. The only different effect is that in the case of an import quota, the government does not collect taxes and the area F is gained by

. Fig. 5.25  Introduction of import quota. Source Authors’ development

169 5.3 · Shifts in Demand and Supply and Changes in Equilibrium

5

foreign producers. Therefore, the total loss of a given country from the introduction of an import quota amounts to the area of the B + C + F quadrangle. 5.3.8  Export Tariff

If the price of a certain product on the world market PW is higher than that on the domestic market P0, then under free trade, producers could gain from exporting a given product outside the country. Let us assume that the world price PW is not affected by the quantities supplied and demanded in a given country. Then the demand DW on the world market would be perfectly elastic (the horizontal line in . Fig. 5.26). At this price, domestic producers are willing to supply goods in the amount of QS and consumers are willing to purchase them in the amount of QD. As a result, exports equals QS − QD (. Fig. 5.26a). Suppose the government imposes an export tariff in the amount of t for each unit of exported goods. Ultimately, this tax (tariff) is paid by foreign consumers through buying more expensive goods supplied by domestic producers in the global market. Due to the tax, the quantity demanded DW decreases by the value t down to DW 1 (. Fig. 5.26b). The equilibrium price falls from PW to P1 = PW − t. At this new price P1, producers are willing to supply in the amount of Q2, domestic consumers are willing to purchase in the amount of Q1, and exports decline down to Q2 − Q1. As a result, the surplus of domestic consumers increases by the area of the A quadrangle and that of producers decreases by the area of the A + B + C + F quadrangle. The amount of tax T = t × (Q2 − Q1 ) equals to the area of the F rectangle. Similar to the use of import tariff, the introduction of export tariff again results in the loss B + C.

. Fig. 5.26  Introduction of export tariff. Source Authors’ development

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5.4  Price Determination and Price Elasticities of Demand

and Supply

5

When carrying out macroeconomic analysis, it is essential to understand how quantities demanded and supplied are affected by changes in prices of products, resources, and substitute goods, as well as how consumer income transforms into consumer spending in response to fluctuations of prices of certain goods and services on the market. Elasticity is a measure of how sensitive a quantity supplied or a quantity demanded is to the change in price or income, or the degree of response of supply and demand to changes in income and price. Elasticity is measured by the Coefficient of Elasticity calculated as the change in the volume of supply or demand Q when price P changes by 1% (Eq. 5.4).

E=

Q P

(5.4)

When E > 1, the variable (either supply or demand) is said to be more than proportionally affected by the change in market factors (either price or income). A value E < 1 suggests that the dependent variable is relatively insensitive to changes in price or income (supply or demand are said to be inelastic). Perfect inelasticity is a situation when E = 0, which means that a quantity supplied or a quantity demanded does not respond to any changes in prices or income. 5.4.1  Elasticity of Demand

Elasticity of Demand is a measure of the sensitivity of quantity demanded relative to a change in price or income. Income Elasticity of Demand is a measure of how a quantity demanded changes depending on the change in real income of consumers. Assuming all other factors remain constant, an increase in the overall level of income in the economy drives up consumer spending. Consequently, the quantity demanded rises. Those goods or services the demand for which increases with the growth of income are said to be positively elastic to income. For instance, higher-income societies demonstrate higher demand for luxuries. Goods or services the demand for which decreases with the growth of income are said to be negatively elastic to income. An example is low-quality food products—with the growth in income, people tend to switch to more qualitative foods, and demand for cheaper staples declines. Price Elasticity of Demand illustrates the responsiveness of the quantity demanded to a change in the market price of certain good or service. Essential goods are commonly less elastic to either income or price, because people would still need to buy them irrespective of price changes or the level of income (staple foods, medicines, housing and public utility services, etc.).

171 5.4 · Price Determination and Price Elasticities of Demand and Supply

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Case box If a 10% cut in the price of product A causes a rise in the quantity demanded of  then the price elasticity of demand for product A equals 3  product A by 30%,

E=

Q P

=

30 10

= 3 . Such a product is said to be elastic to price. If the same 10%

cut in price forces  up the quantity demanded  by 5%, then the price elasticity of deQ 5 mand would be 0.5 E = P = 10 = 0.5 . In this case, product A is said to be inelastic to price. If the quantity  A remains unchanged, product A is  demanded of product

0 perfectly inelastic to price E = Q P = 10 = 0 .

From the example above, we can see that demand can be elastic, inelastic, perfectly inelastic, or perfectly elastic to price or income. With elastic demand, a certain percentage change in price or income leads to a larger percentage change in quantity demanded. The coefficient of elasticity is greater than one (E > 1) (. Fig. 5.27). This means that the quantity demanded of a certain product is more than proportionally affected by the change in the price of this product. The more substitutes a product has on the market, the higher its elasticity, because consumers can replace more expensive products with cheaper ones (or vice versa, when the price falls or income rises). With inelastic demand (E < 1), a percentage change in either price or income is not associated with a substantial change in the quantity demanded (. Fig. 5.28). The demand for a good or service is less than proportionally affected by the change in price for this good or service or by the change in the overall level of income in the economy. Those goods for which there are few substitutes on the market are commonly inelastic (people would need to continue buying them despite any changes in the market). When E = 1, the elasticity of demand is considered as unitary. In such a case, an X percent change in either price or income causes an X percent change in quantity demanded (. Fig. 5.29). The demand for a good or service is exactly proportionally affected by the change in price for this good or service or by the change in the overall level of income in the economy.

. Fig. 5.27  Elastic demand. Source Authors’ development

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5

. Fig. 5.28  Inelastic demand. Source Authors’ development

. Fig. 5.29  Unitary elastic demand. Source Authors’ development

With perfect inelastic demand (E = 0), the quantity demanded remains unchanged with any change in either price or income (. Fig. 5.30). Perfectly inelastic goods or services are absolutely unique on the market, no substitutes exist, which means that producers may charge any price and people would still buy these products. A reverse situation is a variety of substitute products on the market, between which consumers may easily switch without compromising quality or any other characteristics. This is a situation of perfectly elastic demand (E = ∞), where a tiny change in the price of a good or service or a change in income in the economy could trigger a dramatic increase in quantity demanded (alternatively, a complete rejection of buying a given product) (. Fig. 5.31).

173 5.4 · Price Determination and Price Elasticities of Demand and Supply

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. Fig. 5.30  Perfectly inelastic demand. Source Authors’ development

. Fig. 5.31  Perfectly elastic demand. Source Authors’ development

The Cross Elasticity of Demand is the dependence of the change in the quantity demanded of one good on the change in the price of another good. The coefficient of cross elasticity is calculated by dividing the percentage change in the quantity demanded of one good and by the percentage change in the price of the other good.4 Cross elasticity occurs between either complementary or substitute goods. For the latter, cross elasticity is positive, i.e., the higher the coefficient of cross-elasticity, the greater the interchangeability of goods. For complementary goods, cross elasticity is negative. With an increase in the price of one good, the quantity demanded of a complementary good falls. Products that are neutral in relation to each other have zero cross elasticity.

4

Hayes (2021).

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Case box Oranges and tangerines are substitute products with positive cross elasticity—an increase in the price of oranges forces up the demand for less expensive tangerines. Examples of complementary products with negative cross elasticity are cars and gasoline. When gasoline price rises, the demand for “gas-guzzlers” falls, and consumers switch to smaller cars or even electric vehicles. At the same time, oranges and cars are goods neutral to each other. Their cross elasticity is zero because no change in the price of oranges affects the demand for cars.

5

The elasticity of demand changes under the influence of the following factors: 5 availability of substitutes on the market—elasticity increases with a growth in the assortment of substitute goods with similar qualities; 5 usability of a product—the higher the adaptability of a product in various spheres, the higher its elasticity; 5 portion of income spent by consumers—the higher the portion of average consumer income spent on buying a product, the higher the elasticity of this product; 5 necessity of a product—the more people need a certain product, the lower its elasticity; 5 scarcity of a product—the scarcer the product, the lower its elasticity; 5 time—for everyday products, elasticity is higher in the long term (for a consumer, it takes time to reconsider everyday purchases and react to changes in price or income). For durable goods, the elasticity of demand is higher in the short term. For example, when price increases, people may postpone buying and use stocks they have. For a producer, understanding the elasticity of demand is critical for doing business. Producers with high elasticity operate in a more competitive environment, therefore, they have to compete on price and simultaneously ensure a sufficient volume of sales. Those businesses that are less elastic commonly operate in less competitive markets (oligopolies or monopolies discussed previously in 7 Chap. 3). They can set higher prices without fearing for being forced out of their market niches by more elastic competitors. 5.4.2  Elasticity of Supply

The elasticity patterns previously addressed in relation to demand pertain equally to supply. Elasticity of Supply is a measure of the sensitivity of quantity supplied relative to a change in price or income. It is calculated as a change in the quantity supplied Q to a change in price P or income I , i.e., it shows the responsiveness of the quantity supplied of a good or service to a change in the market price of this good or service or to a change in the level of income in the economy.

175 5.4 · Price Determination and Price Elasticities of Demand and Supply

5

With elastic supply (E > 1), an increase in the price (income) causes a more than proportional increase in the quantity supplied (. Fig. 5.32). The higher the elasticity (E → ∞), the faster producers’ gain diminishes (consumers switch to less expensive substitutes). The lower the elasticity (E → 1), the longer producers stay in the break-even zone (in the absence of alternatives, consumers continue buying at increasing prices). With inelastic supply (E < 1), a price (income) increase causes a less proportional change in the quantity supplied (. Fig. 5.33). When E = 0, supply is considered as perfectly inelastic. In this situation, any significant change in either price or income does not lead to a change in the quantity supplied (. Fig. 5.34). Producers are not able to increase their output, no matter how high the price (income) rises. In a reverse situation, when E = ∞, supply is considered perfectly elastic (. Fig. 5.35). Here, any change in the price of a good or service or a change in income in the economy causes radical changes in the quantity supplied (up to a

. Fig. 5.32  Elastic supply.. Source Authors’ development

. Fig. 5.33  Inelastic supply. Source Authors’ development

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5 . Fig. 5.34  Perfectly inelastic supply. Source Authors’ development

. Fig. 5.35  Perfectly elastic supply. Source Authors’ development

complete shutdown or freeze of production). In a perfectly elastic market, producers are willing to supply any amount of goods or render services at price P0. The elasticity of supply is influenced by factors similar to those that affect the elasticity of demand, including the specifics of the production process, quantity and quality of goods, and time. If a producer is able to expand production amid growing prices or switch to the production of other products amid falling prices, then the supply of a given product is considered elastic. If goods cannot be stored for a long time, then the elasticity is low. If a producer fails to adapt to price changes in the short term, this supply is referred to as perfectly inelastic. Chapter Questions: 5 Explain how individual demand and individual supply differ from macroeconomic parameters of aggregate demand and aggregate supply, respectively. 5 Describe Veblen goods and Giffen goods using the following parameters: price-demand relationship, scarcity, substitute goods, and level of income of typical consumers.

177 References

5

5 Give examples of price-related and non-price determinants of aggregate demand. 5 A price set by the government above the equilibrium price to support domestic producers—is it a price ceiling or a price floor? 5 Using the supply and demand curves and domestic and world prices, illustrate adverse effects of foreign trade regulations on public welfare. 5 How is a perfectly elastic demand different from a perfectly inelastic demand? Illustrate the price-quantity ratios for both cases. Subject Vocabulary: Aggregate Demand: the total amount of goods and services that consumers are ready to buy at a given overall price level at a given time. Aggregate Supply: the total amount of all goods and services produced within an economy and supplied on the market at a given overall price at a given time. Demand: a form of expression of a need measured by the amount of money that consumers are willing to pay for the goods and services they need. Demand Price: the maximum price that consumers agree to pay for a certain quantity of a given product or service. Elasticity: a measure of how sensitive a quantity supplied or a quantity demanded is to the change in price or income. Market Equilibrium: a situation in the market when supply and demand balance each other and market supply of goods or services matches the demand for these goods or services. Market Price (Equilibrium Price): a price that satisfies both producers and consumers, when the quantity of goods or services consumers intend to buy is equal to that producers intend to supply. Quantity Demanded: the total quantity of goods or services that consumers want and can purchase on the market at a given price at a given time. Quantity Supplied: the total quantity of goods or services that producers or sellers want and can sell on the market at a given price at a given time. Supply: the amount of goods or services that a producer (seller) offers on the market or can supply on the market, depending on the prices of these goods or services and other factors. Supply Price: the minimum price at which a producer agrees to sell a certain quantity of a given product or service.

References Erokhin, V., & Gao, T. (2020). Impacts of COVID-19 on trade and economic aspects of food security: Evidence from 45 developing countries. International Journal of Environmental Research and Public Health, 17(16), 5775. Hayes, A. (2021). Elasticity. Available at 7 https://www.investopedia.com/terms/e/elasticity.asp. Kenton, W. (2021). Walras’s Law. Available at 7 https://www.investopedia.com/terms/w/walras-law.asp. Yuen, K. F., Wang, X., Ma, F., & Li, K. X. (2020). The psychological causes of panic buying following a health crisis. International Journal of Environmental Research and Public Health, 17, 3513.

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© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_6

6

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Learning Objectives: 5 Understand the concept of macroeconomic equilibrium 5 Discover the approaches to interpreting macroeconomic equilibrium 5 See how the concept of efficiency applies to establishing equilibrium 5 Reveal differences between major economic schools in defining consumption, investment, and the multiplier 5 Discover determinants of equilibrium in the commodity and money markets and understand the relationship between these two types of equilibrium 5 Study the equilibrium-related effects of monetary and fiscal policies 5 Discuss potential approaches to establishing macroeconomic equilibrium in the new normal economic reality

6

6.1  Theory of Macroeconomic Equilibrium

Macroeconomics is commonly considered as a kind of macro-market where aggregate supply interacts with aggregate demand. As previously demonstrated in 7 Chap. 5 (7 Sect. 5.2), in efficient markets, aggregate supply matches aggregate demand. This means that under this condition, all consumers can find and purchase goods they need, while all producers can sell goods they have produced. A mismatch means either inefficient use of resources (when aggregate supply exceeds aggregate demand, a part of the output is not demanded), or failure to meet the needs due to insufficient demand (when aggregate demand exceeds aggregate supply, there is a deficit in the market). Therefore, the fundamental goal of the macroeconomic policy is to establish the Macroeconomic Equilibrium, a state of the economy when both the use of scarce resources and their distribution among economic actors (producers, consumers, government) are balanced, i.e., the balance between the following parameters is achieved: 5 available resources and the use of resources; 5 factors of production and the production performance; 5 production and consumption; 5 supply and demand; 5 commodity and financial flows. Achieving full equilibrium is an economic ideal. In real life, there happen economic downturns, inefficient use of resources, or other distortions in the market. The construction of the general equilibrium models is a kind of theoretical exercise. Since any economy acts as an evolving system of expanded reproduction, the establishment of a dynamic (not static) equilibrium must be considered in terms of reaching certain proportions between the core elements of the economic system: 5 factors of production (volume and allocation of inputs required for the production of a certain amount of material goods); 5 saving (share of income accumulated to maintain a certain level of output); 5 distribution of income between the owners of factors of production;

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6

. Fig. 6.1  Types of macroeconomic equilibrium. Source Authors’ development

5 exchange (the supply-demand relationship in terms of volume and structure of output and consumption and prices); 5 the commodity-money ratio in the market. Commonly, eight types of macroeconomic equilibrium are clustered in four criteria, which are the level of the equilibrium, time, degree of implementation of interests of various economic actors, and stability of the balance (. Fig. 6.1). Partial Equilibrium occurs in a single market of finished products, factors of production, or services. This is a theoretical construction that focuses on a few economic variables to study the equilibrium problem in a separate market (­microeconomic approach), while leaving out diverse exogenous factors. In reality, the markets of all goods and services and all factors of production are interconnected. Each of the markets adapts to the economic situation and strives to get the maximum income. Thus, when modeling macroeconomic equilibrium, it is necessary to take into account the economic interrelationships of all prices and decisions, that is, to consider the situation of general equilibrium. General Equilibrium means the economy has achieved balance in all markets simultaneously when a change in supply or demand in one market affects the equilibrium prices and sales volumes in all markets. The general equilibrium concept can be traced back to the classical economics, although neither Adam Smith nor David Ricardo operated with macroeconomic parameters. And yet Smith expressed the idea that the free interaction of producers and consumers in competitive market results in the establishment of a general equilibrium beneficial to all economic actors. Short-Run Equilibrium is achieved when aggregate demand AD equals shortrun aggregate supply SRAS. The AD-SRAS intersection occurs when the equilibrium price PE matches the equilibrium output QE at point E (. Fig. 6.2). When at least one of the two curves shifts, the equilibrium point moves correspondingly,

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. Fig. 6.2  Short-run and long-run macroeconomic equilibrium. Note AD = aggregate demand; SRAS = short-run aggregate supply; LRAS = long-run aggregate supply.Source Authors’ development

establishing new equilibrium parameters in the market. Thus, the AD-AS model allows one to forecast changes in prices and output caused by changes in aggregate demand or aggregate supply. Long-Run Equilibrium occurs when the aggregate demand curve intersects the short-run aggregate supply and the long-run aggregate supply LRAS curves at the same point (. Fig. 6.2). In the long run, the AD-AS model shows what happens to prices and output at full employment of all resources. The location of the LRAS curve matters. If it is located to the right of the E equilibrium point, resources are inefficiently utilized (the economy is in a recession). If the real equilibrium exceeds the potential (the LRAS curve is to the left of the E equilibrium point), the economy is overheated, because the resources are overused. Case box There is a paradox whereby an increase in aggregate demand causes the price of goods to rise, while a reduction in aggregate demand does not necessarily push prices down, especially in the short term. Such a situation when prices do not respond to a decrease in aggregate demand is called The Ratchet Effect. The term comes from the name of a device, which prevents a wheel from turning in the opposite direction. It first came up in the book entitled “The Growth of Public Expenditure in the United Kingdom”.1 It was further explored in the 1980s by Robert Higgs,2 who demonstrated how economic crises result in the strengthening and expansion of government agencies and regulatory bodies. The economic meaning of the effect is that price rises occur more easily than price drops. The reasons for the effect may be monopolism, the actions of trade unions that prevent the reduction of nominal wages, or state policy of price regulation amid inflation. Many scholars evidence the emergence of the ratchet effect amid the

1 2

Peacock and Wiseman (1961). Higgs (1987).

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COVID-19 pandemic: temporary anti-pandemic government controls and regulations will likely be retained long after the crisis abates thus turning into permanent features of the new normal economic reality.

Ideal Equilibrium is observed in the economic behavior of individuals with the full optimal realization of their interests in all sectors of the economy. A ­ chieving such a balance presupposes the observance of the following conditions of reproduction: all individuals are able to find consumer goods in the market; all ­entrepreneurs are able to find the factors of production they need; the entire output of the previous year is sold out. In reality, these targets are rarely met simultaneously. Real Equilibrium is an equilibrium established in the market in conditions of imperfect competition under the influence of external factors in the market. Stable Equilibrium occurs if the market is back to the initial equilibrium after the deviation. In the case of Unstable Equilibrium, the market can not itself return to the assigned condition. Several major approaches to defining macroeconomic equilibrium are commonly distinguished in the literature, such as the classical theory (7 Sect. 6.1.1), the Keynesian theory (7 Sect. 6.1.2), the Marxian model (7 Sect. 6.1.3), and the Walrasian general equilibrium (7 Sect. 6.1.4). 6.1.1  Classical Theory of Macroeconomic Equilibrium

The classical theory of macroeconomic equilibrium, which prevailed in economic literature until the 1890s, is based on the assumption that the level of expenditure is always sufficient to buy out output created at full employment. This assumption is based on the Say’s Law arguing that the very process of production generates income exactly equal to the value of output, i.e., supply generates its own demand (further reading: “A Treatise on Political Economy, or the Production, Distribution and Consumption of Wealth”3 by Jean-Baptiste Say). Based on this reasoning, one can assume that the classical approach does not take into account the situation where a portion of income can be saved. Saving complicates achieving macroeconomic equilibrium. However, classical economists believed that saving did not lead to insufficient demand, since every saved value would be invested (see 7 Sect. 6.3 for a detailed explanation of effects of consumption and investment on equilibrium). According to the classical school, the AS curve is vertical line (. Fig. 6.3). The classical vision proceeds from the premise that the economy is operating at full capacity and with full employment of resources. Under such conditions, it is impossible to increase output in the short run, even if the increase is prompted by

3

Say (1821).

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. Fig. 6.3  The classical interpretation of macroeconomic equilibrium. Source Authors’ development

a substantial rise in aggregate demand. Individual firms may try to expand their output by offering higher prices for resources. However, in doing so, they reduce the output of other firms in the market. Competition leads to higher prices and fuels inflation. Thus, in the short run, a change in aggregate demand can only affect prices, not aggregate supply and employment. The proponents of the classical school argue that the government should not intervene in the market. They consider the latter a self-adjusting structure. The market economy is thus immune to recessions, as self-regulation mechanisms constantly bring output to a level of full employment. The instruments of self-regulation are prices, wages, and interest rates. Their fluctuations in the competitive environment equalize supply and demand in all markets (commodities, labor, money, etc.) and ensure full and rational use of resources. Thus, the classical model of macroeconomic equilibrium is applicable to perfect competition markets, when the fundamental macroeconomic proportions are regulated automatically, and there is no need for any interventions. With the complication of the market relations, imperfect competition, and the growth of oligopolies and monopolies in the early 1900s, there emerged a need to update the approach to understanding the macroeconomic equilibrium. 6.1.2  Keynesian Theory of Macroeconomic Equilibrium

The interpretation of macroeconomic equilibrium was revised by John Maynard Keynes in 1936 in “The General Theory of Employment, Interest and Money”.4 Criticizing the classical theory, Keynes argued that imbalances are inherent to the market economy. The latter fails to guarantee full employment of resources. Therefore, there are no intrinsic automatic self-regulation mechanisms in the market economy. 4

Keynes (1936). 

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Case box The Keynesian approach to criticizing the classical vision of equilibrium concerns two main points. The first relates to the relationship between investment, savings, and interest rates. There is a discrepancy between investment and savings plans, since they are carried out by different economic agents, for different reasons, and they are determined by different factors. Therefore, the interest rate is not the only factor that is taken into account when planning investments. According to the Keynesian m ­ odel, it is not the interest but the disposable income of households that determines the dynamics of consumption and savings. In addition, savings are not the only source of investment. Credit institutions are an alternative source of investment not considered by the classical school. The second argument concerns the mobility and flexibility of prices in the market economy. The emergence of monopolies and strong trade unions in the early 1900s reduced the elasticity of prices and wages. Due to volatile aggregate demand and inelastic prices, unemployment persists for a long period of time. To balance the market, the government should intervene by adjusting aggregate demand.

According to the Keynesian interpretation of aggregate supply, the AS curve is either a horizontal or ascending line (. Fig. 6.4). The horizontal segment of the AS curve depicts the situation of recession and underutilization of labor and other inputs. An expansion of production (higher utilization of inputs) results in an increase in output and employment without affecting prices. The intermediate segment of the AS curve reflects a situation when an increase in output is accompanied by a slight increase in prices (the gap could happen due to the uneven development of individual industries, the use of outdated equipment, or employment of less-skilled workers compared to other sectors). As a result, rising costs per unit fuel prices for final goods and services. However, in contrast to the classical interpretation of aggregate supply, the real volume of output increases (see a detailed discussion of the contemporary interpretation of the AS curve in 7 Chap. 5.2.2, 7 Sect. 5).

. Fig. 6.4  Keynesian interpretation of macroeconomic equilibrium. Source Authors’ development

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According to Keynes, output and, accordingly, the level of employment directly depend on the level of aggregate expenditure (aggregate demand). The main component of the latter is consumption. After-tax income is equal to consumption plus savings, so the factors that determine consumption affect savings. Disposable income is the fundamental factor determining the amount of consumption. Another component of aggregate demand is investment. The amount of investment is determined by the expected rate of net profit and the real rate of interest (see 7 Sect. 6.3 for a detailed discussion of consumption and investment). Since consumption and investment expenditures are determined by a number of other factors, aggregate demand is generally volatile. The instability of the latter causes imbalances in the economy. To achieve macroeconomic equilibrium, aggregate demand must be effective. According to Keynes, effective demand consists of consumption and investment costs. Keynes proposes to maintain effective demand with the help of a multiplier (see further in 7 Sect. 6.3.3), which associates an increase in effective demand with an increase in investment (see 7 Sect. 6.3.2 for the Keynesian model of consumption and investment). 6.1.3  Marxian Model of Macroeconomic Equilibrium

The Marxian interpretation of macroeconomic equilibrium is based on the theory of the movement of the aggregate social product and capital. At the macro level, social capital is a set of individual capitals in their interrelation and interdependence in circulation. The connection between the cycles and turnovers of individual capital stipulates the circulation of social capital. The latter results in the establishment of the aggregate social product in either a monetary or natural form. From a monetary point of view, the aggregate social product consists of constant (fixed) capital (means of production), circulating (fluid) capital (labor), and surplus value. From a natural point of view, the social product includes production of means of production (used in the production process as capital) and production of commodities (elements of consumption and income). Capital must exceed consumption by the value of the accumulated means of production required for the expansion of production (further reading: “Capital. A Critique of Political Economy”, 7 Chap. 8 “Fixed Capital and Circulating Capital”5). The Marxian model of social reproduction characterizes the conditions of macroeconomic equilibrium. The Marxian concept is further detailed in 7 Chap. 15. However, in reality, these conditions are not necessarily implemented, since the proportions between the constituent of the social product are established under competition in the market. In modern conditions, when the international division of labor and trade has developed, analyzing the reproduction of the social product and equilibrium should not abstract from foreign trade and the role of the state, which acts as both a consumer of finished products and a regulator of macroeconomic proportions and processes.

5

Marx (1885).

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6.1.4  Walrasian General Equilibrium

The Walrasian Equilibrium (also called competitive equilibrium) is a closed mathematical model in which economic actors are divided into owners of factors of production (land, labor, capital) and entrepreneurs. Each actor strives to achieve the maximum use of the factors possessed. Firms act as buyers in the market of factors and sellers in the market of consumer goods. Households (owners of factors of production) conversely act as sellers in the market of factors and buyers in the market of consumer goods. In this model, the roles of sellers and buyers are constantly changing. All expenditures of producers are converted into incomes of households, while all expenditures of households are converted into incomes of producers. General equilibrium presupposes the establishment of equilibrium in exchange and production. Equilibrium in exchange means that the effective (actual) demand is equal to the effective supply. Equilibrium in production means that the price of a product is equal to the production cost, which includes normal profit as a reward for capital. Such an equilibrium in production and exchange is a theoretical assumption. The selling price is rarely equal to the cost of production, just as there is no exact correspondence of effective demand to effective supply. But such a state could be considered normal in the sense that under perfect competition, any market tends to reach equilibrium. If the price of a product exceeds the cost of its manufacture, firms receive profit and expand production. If the price is lower than the cost, firms incur losses and reduce output. As a result, the prices of final goods change and a general equilibrium is established (further reading: “Elements of Pure Economics”6). 6.2  National Economic Performance

In its wide range of applications, the general equilibrium theory could be used to analyze the efficiency of the economy. Efficiency is the relationship between the costs of scarce resources and the output of goods and services. This ratio can be measured in physical (technological efficiency) or monetary (economic efficiency) terms. Efficiency can be viewed from two perspectives: reproduction and production. The former involves determining the efficiency of the entire reproduction process, including production, distribution, exchange, and consumption. Therefore, overall economic efficiency should reflect all these stages and should be considered as an aggregated performance of individual stages. The second aspect is that the efficiency of production is commonly considered from the point of view of the use of inputs (labor, resources fixed capital). When analyzing efficiency, it is important that social production can expand in extensive or intensive ways or a combination thereof. The extensive path involves quantitative changes in the factors of production. In this case, the growth is based on a simple increase in means

6

Walras (1954). 

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of production and other inputs. In the intensive mode, the increase in output is achieved by a qualitative improvement of the use of means of production and available resources. The challenge is to identify the point at which the efficiency is the highest. Major schools have developed different approaches to finding the efficiency optimum. 6.2.1  Classical Economics

6

Based on the labor theory of value, the classical theory argues that the efficiency increases due to either an increase in the amount of labor applied in production, or an increase in labor productivity. The interpretation of Adam Smith’s concept of efficiency could be summarized as the increase in output due to the expansion of the market and the division of labor. The efficiency of the economic system is characterized by the degree of satisfaction of needs, which is directly proportional to the physical volume of output produced by a country. Hence, economic efficiency is equated with macroeconomic categories such as GDP and national wealth. The volume of national wealth depends on the amount of labor employed in production, which is regulated by the accumulation of capital and the growth of the population. According to Smith, the increase in wealth is the achievement of the economic optimum. David Ricardo argued that amid decreasing profitability, efficiency and national wealth should be measured by net product rather than gross one. Population growth stimulated by the accumulation of capital causes the transition to the cultivation of lower-quality agricultural lands, which require higher costs for the production of a unit of wealth. The price of products increases. This causes the rent received by the owners of relatively better agricultural land to go up and the real wages of workers to decline. Still, it cannot fall below the subsistence minimum, so nominal money wages must rise, which, in turn, lowers the rate of profit. As a result, the marginal product of labor reaches a level that leaves no surplus to producers in the form of profit after the payment of wages and rents. There are no incentives at this frontier for capital accumulation and expansion of production, and these processes are suspended. Therefore, the goal of economic policy is to increase net product, not expand the output. The expansion of production is effective as long as it results in an increase in the net product. According to Ricardo, the optimum of efficiency is achieved at the equilibrium point, where accumulation ceases and the net product achieves its maximum. 6.2.2  Concept of Marginal Efficiency

Instead of the classical premise of the proportionality of satisfaction to the physical volume of output, the proponents of the marginalist theory introduced the concept of diminishing marginal utility and emphasized the principle of rarity. The marginalist concept of economic efficiency evolved from the theory of general equilibrium. It captures the Efficiency of Exchange, a consequence of the

189 6.2 · National Economic Performance

6

equilibrium of supply and demand in the market of consumer goods, and the Efficiency of Production (distribution) of resources, a consequence of the equilibrium in the market of factors of production. According to the marginalist theory, the efficiency of exchange is calculated as a relation of marginal utility to fixed money income (Eq. 6.1).



 Ui i =  Mi

(6.1)

where  i sum of marginal efficiency of all economic actors (i = 1, 2, . . . , n);  Ui sum of marginal utility of all economic actors (i = 1, 2, . . . , n);  Mi   sum of fixed money income of all economic actors (i = 1, 2, . . . , n).

The method above is fraught with difficulties in measuring individual utility and the impossibility of summing up individual utilities or effects. Vilfredo Pareto formulated the optimum of the efficiency of exchange as a state of equilibrium in which no individual economic actor can improve their position in the market without worsening the situation of other firms (see 7 Chap. 16, 7 Sect. 16.3 for the discussion of the Pareto Production Possibility Frontier). The marginalists’ contribution to finding the optimum of production efficiency consists in the development of the theory of marginal productivity. The latter explains the income from all inputs by the marginal product of these inputs. Also, marginalists established the dependence of the demand for inputs on the demand for consumer goods. Based on these premises, the marginalists theory of general equilibrium approaches to interpreting production efficiency as a situation, when the increase in output of one product is not possible without reducing the output of any other product. The profit maximization and cost minimization concepts are applied to determine the equilibrium point. 6.2.3  Neoclassical Economics

The novelty of the neoclassical interpretation of efficiency consists in the study of specific deviations from equilibrium. The nature of the neoclassical theory is manifested in its formulation of the concept of economic efficiency. Similar to marginalists, neoclassical economists consider efficiency through the prism of satisfaction of needs, but they focus on material needs that can be assessed in monetary terms. According to Alfred Marshall, long-term economic equilibrium is determined by both needs (the demand side) and production costs (the supply side). Marshall approached to interpreting efficiency from a point of view of continuing evolution and transformation of needs due to the development of production itself. Marshall contributed to the theory of efficiency by adding the term Consumer Surplus, the difference between the price that a buyer would be willing to pay rather than going without the thing and the price that a buyer actually pays. Being the economic

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measure of surplus satisfaction, consumer surplus increases the effect. In macroeconomic terms, this effect is not Ricardo’s net product, but the net aggregate surplus calculated as the difference between the level of satisfaction of needs and the efforts required to achieve this level. Thus, as argued above, the neoclassical school in general and Marshall in particular focus on studying deviations from the general equilibrium. At the same time, the consumer surplus receives more attention compared to the producer surplus. Society is made up of consumers, who prevail in the market. Therefore, it is their interests that must be taken into account when assessing economic efficiency. It is commonly believed that the neoclassical school culminated in the works of Arthur Pigou. However, in his understanding of equilibrium, Pigou deviated from the neoclassical interpretation. Pigou’s concept of equilibrium is significantly adjusted in comparison with the concept of optimum. He abandons considering individual deviations from equilibrium along with Marshalls’ categories of consumer and producer surpluses. Instead, he tries to bring all individual deviations into a system consisting of discrepancies between tenants and landowners, private and individual interests, and public and individual products. The Pigou’s Economic Optimum determines the state of the economy, in which the marginal social products of the factors of production are equal across all sectors and markets. The optimal condition can be achieved by equating the individual and public products of each sector on the basis of appropriate taxation policies and subsidies. 6.2.4  Institutional Economics

Based on the provision that the main function of institutions in the economy is to reduce transaction costs, representatives of the institutional school see the effectiveness of institutions in minimizing these costs. Due to the fact that institutions are fundamental elements of the economy, the concept of institutional equilibrium considers the efficiency of the economy at three levels: institutional, microeconomic (classical and neoclassical schools), and macroeconomic (Keynesian and neo-Keynesian schools). The neoclassical general economic equilibrium of full employment, as well as the Keynesian equilibrium of underemployment, are special cases of institutional equilibrium. Together, they provide the optimum of economic efficiency. The economic efficiency of the institutional system depends on the supply and demand initiated by institutions, awareness of economic entities and their adaptation to new institutions, as well as the functioning of informal institutions in the economy. 6.3  Consumption, Investment, and the Multiplier 6.3.1  Neoclassical Concept of Consumption and Investment

Consumption (C) is the individual and shared use of goods and services to meet people’s material and spiritual needs. In monetary terms, consumption is the

191 6.3 · Consumption, Investment, and the Multiplier

6

amount of money spent by people on the purchase of goods and services. Analysis of consumer behavior establishes certain consumption patterns that must be taken into account when studying macroeconomic equilibrium. Irving Fisher’s dynamic model of consumption assumes two periods. In period 1, an economic entity receives income and distributes it to consumption and saving (Eq. 6.2).

Y1 = C1 + S1 ; S1 = Y1 − C1

(6.2)

where Y1 income in period 1; C1   consumption in period 1; S1 saving in period 1. In period 2, an economic entity receives income from labor Y2 and income from property (savings made earlier). The income is spent on consumption. Then, consumption in period 2 depends on the accumulated savings of period 1 (S1 (1 + r)) and income of period 2 Y2 (Eq. 6.3).

C2 = Y2 + S1 (1 + r) = Y2 + (Y1 − C1 )(1 + r); C2 + C1 (1 + r) = Y2 + Y1 (1 + r)

(6.3)

where Y2 income in period 2; C2   consumption in period 2; S2 saving in period 2. Thus, the volume of consumption in the two periods depends on income and interest rate. Graphically, consumption in periods 1 and 2 could be displayed as a line showing the combinations of consumption volumes depending on income in the two periods (straight red KL line in . Fig. 6.5). Households tend to prefer

. Fig. 6.5  The optimal choice of consumption. Note C1∗ = optimal consumption in period 1; C2∗ = optimal consumption in period 2; K = Y1; L = Y1 + Y2 (1 + r). Source Authors’ development

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future consumption to current consumption depending on the interest rate. The higher it is, the more willingly households save. The lower it is the higher the current consumption. Saving is an increasing function of the interest rate, while consumption is a decreasing function. The indifference curves (blue curves in . Fig. 6.5) show different consumption options in periods 1 and 2 that provide the same level of welfare. R ­ educing consumption in period 1 allows an economic entity to increase consumption in period 2, and vice versa. At point A, future consumption is preferable to current consumption. At point C, on the contrary, preference is given to current consumption to the detriment of future consumption. At point B, preferences are equal. The higher the curve is located, the more important preferences in determining the consumption-saving behavior of an economic entity. Consumption is limited by income. When knowing the dynamics of preferences, the optimal choice between the volumes of consumption in periods 1 and 2 is made based on the combination of the income restrictions and preferences (point B is the optimal choice point). Equation 6.4 expresses the neoclassical approach to understanding consumption: (6.4)

C = Ca + bv V − br Y where V assets value;   bv marginal propensity to consume/assets dC dV ;

br marginal propensity to consume/interest rate

Ca   autonomous consumption.



dC dr

 ;

The Marginal Propensity to Consume (MPC) on the interest rate is a parameter that measures the proportion of an aggregate raise in consumption caused by a change in the interest rate by one unit. Similarly, the MPC on the profitability of property shows the proportion of an aggregate raise in consumption caused by a change in the profitability by one percentage point. The consumption function depends on the current income level and the discounted income in the future (Eq. 6.5).

C = Y1 +

Y2 1+r

(6.5)

Proceeding from such an interpretation of consumption, interest rate establishes the basis for making consumer decisions. Neoclassical theory suggests that consumption is limited by the household budget (Y − T = C + S, where Y = income, T = income tax). The neoclassical school places great emphasis on Savings, which are interpreted as deferred (future) consumption. Let us consider how neoclassical economists determine the optimal amount of savings (the value of the optimal capital reserve), as well as how an economic entity seeks to achieve this value. To do this, it is necessary to determine the marginal product of capital, real costs, and marginal profit.

193 6.3 · Consumption, Investment, and the Multiplier

6

. Fig. 6.6  Capital market: neoclassical interpretation. Note P = overall price level on the market; Pc = book value of a unit of capital; PPc = actual price of a unit of capital. Source Authors’ development

Marginal Product of Capital (MPK) refers to the change in output Q when an additional unit of capital C is employed while the other factors of production are constant (Eq. 6.6):

MPK =

∂Q ∂C

(6.6)

The real equilibrium price of capital is established as a result of the interaction of supply and demand, where the latter equals marginal productivity (. Fig. 6.6). The D = MPK equivalence exists due to the fact that at high prices for capital, an economic entity can receive a sufficient return from buying a few units of capital. As price decreases, a firm faces diminishing marginal returns while acquiring more and more units of capital. As previously discussed in 7 Sect. 6.1.1, the supply curve in neoclassical interpretation is a vertical line (. Fig. 6.3). The Sc curve in . Fig. 6.6 also takes the shape of a vertical line, since at any given time, the supply of scarce capital is limited. In the competitive market, the price of capital fluctuates. When it decreases, a firm can sell an earlier purchased unit of capital at a lower price. To recover the outgoing capital, a firm makes annual contributions to the depreciation fund d. Inflation should be taken into account in the form of interest rate r. Therefore, Real Costs of a firm depend on the relative cost of capital PPc , real interest rate r, and the depreciation rate d (Eq. 6.7):

TC Pc = (1 + r + d) P P

(6.7)

Given that MPK reflects the firm’s benefit from the use of a certain amount of capital, the Marginal Profit (MP) could be calculated as a difference between the marginal product of capital and real costs (Eq. 6.8):

MP = MPK −

Pc (1 + r + d) P

(6.8)

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. Fig. 6.7  Demand for investment: neoclassical interpretation. Source Authors’ development

Based on the three-factor neoclassical interpretation of the dependence of the amount of capital acquired on the interest rate, depreciation, and marginal product, the demand curve for investment Id could be constructed (. Fig. 6.7). A higher interest rate increases real costs and reduces the amount of money purchased. At the current rate r ∗, a firm makes investment in the amount of I1. A change in all other factors, except for the interest rate, results in a shift in the demand for investment. For example, the increase in the performance of capital caused by the introduction of new technologies increases the demand for investment (Id1 shifts to Id2). The new equilibrium point of investments is I2. Depending on the ratio of the marginal product of capital and the real costs of its application, a firm increases or decreases the stock of capital. This process continues until marginal product balances against costs (the condition for determining the optimal capital reserve) (Eq. 6.9):

MPK =

Pc (1 + r + d) P

(6.9)

The rate at which a firm accumulates the optimal reserve of capital depends on the ability to adapt to changes in the macroeconomic environment. It also depends on how quickly the newly acquired capital is introduced in the production (new facilities built, new equipment installed and put into operation, etc.). 6.3.2  Keynesian Concept of Consumption and Investment

The Keynesian approach to interpreting consumption is different from that used in neoclassical economics. First, income is considered to be an endogenous parameter. Second, consumption depends on disposable income. Third, the distribution of income for consumption and saving directly depends on the level of income. Any government aims to satisfy people’s needs. The degree of satisfaction is determined by the level of disposable income, while the latter depends on the economic situation in a country. Hence, consumption is a function of income (Eq. 6.10):

C = f (DI)

(6.10)

195 6.3 · Consumption, Investment, and the Multiplier

6

. Fig. 6.8  Consumption: Keynesian interpretation. Source Authors’ development

In . Fig. 6.8, line A (bisector) shows that all income is used for consumption (no saving). In real life, however, only a fraction of income is consumed. This situation is depicted by the C curve, which crosses the ordinate axis above zero point in point Ca. The [0; Ca ] section represents the value of Autonomous ­Consumption. It is not directly related to the level of disposable income. Therefore, even if an economic entity receives no income during some period of time, it continues consuming, as it spends reserves (savings for future use). Keynes believed that as income rises, consumption growth slows. People tend to increase their consumption with income growth, but not proportionally to the extent the income actually rises. If consumption C and income A intersect, then at E0 equilibrium point, the entire amount of income is used for consumption (no saving). Beyond E0, the growth of consumption lags behind the growth of saving. Productive Consumption is the use of factors of production, goods, and services by producers, state, and other economic entities in the process of production and social activities. The higher the disposable income, the greater the level of productive consumption. Individual Consumption refers to the goods and services consumed by households. The amount of goods and services consumed along with other parameters (composition of consumption by types of goods, sectors, etc.) form consumer behavior. Case box Consumer behavior is one of the proxy indicators of the overall health of the economy as determined by consumer opinion. People and businesses tend to increase consumption amid economic growth, while in times of recession, consumer expectations worsen. Consumer behavior is commonly measured by the Consumer Confidence Index (CCI) and the Michigan Consumer Sentiment Index (MCSI). Since the beginning of

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the COVID-19 pandemic in 2020, both indexes have dropped substantially, as consumers have become particularly uncertain about the future. Consumption-related indexes could be used as predictors of deviations from macroeconomic equilibrium: gloomy consumer expectations result in weaker demand for goods and services in the market, impacting the overall economic situation in a country or around the globe.

6

In the Keynesian theory, consumption depends not just on income, but also on the propensity to consume. Average Propensity to Consume (APC) is the ratio of the part of disposable income spent on consumption C to the total disposable income DI (Eq. 6.11). With the growth of disposable income, the average propensity to consume decreases.

APC =

C DI

(6.11)

Marginal Propensity to Consume (MPC) is the ratio of the increase in disposable income that goes to consumption to the increase in that income. Similar to APC, MPC declines as disposable income grows. Case box Economic downturns affect the consumption and spending behavior of people. The COVID-19 outbreak has demonstrated how consumption patterns and people’s propensity to consume could be radically transformed in a short period of time. The Bundesbank survey7 demonstrated that people in Europe reduced overall spending and reoriented consumption from durables and leisure activities on staple foods and other essential goods and services amid the coronavirus-induced income losses and higher inflation expectations. Standard economic theory says that people tend to spend more on durables to protect income from the increase in inflation. However, as the COVID-19 economic crises combined both inflation, unfavorable economic expectations, and physical restrictions in the supply of goods and services, people reacted by cutting the overall spending in an attempt to save reserves for the uncertain future. In the USA, J.P. Morgan8 evidenced similar shifts in the propensity to consume along with some downgrading behavior as more and more consumers settled for more affordable options amid the pandemic outbreak.

Savings (S) are a portion of disposable income that has not been used for consumption. It is an increase in wealth. Since disposable income Yd can either be consumed or saved, the savings function S can be obtained by subtracting autonomous consumption Ca from disposable income (Eq. 6.12):

S = sY d − Ca 7 8

Bundesbank (2020). Morgan (2020).

(6.12)

197 6.3 · Consumption, Investment, and the Multiplier

6

. Fig. 6.9  Saving: Keynesian interpretation. Source Authors’ development

where s – marginal propensity to save. In . Fig. 6.9, line S demonstrates the amount of savings at different levels of national income Y . At Y0, all income is consumed, i.e., savings are zero. If income increases, so do savings. Thus, for income Y2, the value of savings is positive. It equals the distance between the S line (bisector) and the consumption line (similar to the situation depicted in . Fig. 6.8). If the amount of national income is small (Y1 ), then savings become negative, i.e., the country spends reserves. In the most unfavorable case, when the national income is zero, a country is forced to borrow an amount equal to the value of autonomous consumption. The Keynesian interpretation of saving is different from the ­ neoclassical one in terms of analyzing investment demand. Main difference is the ­approach to determining the marginal product of capital (in the neoclassical theory) and the marginal efficiency of capital (in the Keynesian theory). As shown in 7 Sect. 6.3.1, in the neoclassical theory, MPK is derived from the production function, i.e., based on the technology used and, more broadly, on research and development. In the Keynesian theory, marginal efficiency depends primarily on expectations about future profits, inflation, and interest rates. Thus, it is a subjective category that particularly depends on the expectations of people and businesses, i.e., behavior. Marginal Efficiency of Investment (MEI) is the interest rate at which the estimated value of income from investment (the expected rate of return) is equal to the current value of investment. The Keynesian approach takes into account the time factor. The acquisition of capital goods today allows a firm to receive income from using these goods over a long period of time. Discounting must be used to estimate the current value of the expected return on investment (Eq. 6.13).

198

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. Fig. 6.10  Demand for investment: Keynesian interpretation. Source Authors’ development

R=

n  i=1

Ri (1 + r)i

(6.13)

where R expected return; Ri   income received minus current production costs in year i ; r rate of discount; n number of years. The two theories differ in approaches to understanding interest rate. According to the neoclassical school, interest rate is found at the intersection of savings and investment curves. Hence, neoclassical economists derived the equality of investment and savings. According to Keynes, interest rate determines the amount of investment, not determined by it. A firm makes investments as long as MEI stays above interest rate. In . Fig. 6.10, investment I1 is made at the nominal interest rate r . In the Keynesian interpretation, interest rate is a monetary phenomenon that develops in the money market as a result of the interaction of demand and circulation. Its value depends on psychological factors (see previously discussed expectations and behavior drivers). Market volatilities increase the propensity to liquidity, so a higher interest rate is required to overcome the increased propensity. Stability, on the contrary, lowers the liquidity preference along with the interest rate. Expectations of changes in the interest rate cause shifts of the demand curve for investment. Thus, the expectation of a decrease in the interest rate shifts the Id curve to the left. This happens due to the fact that goods produced with the use of this equipment will have to compete in the future with goods produced with the use of new equipment that pays off at a lower return.

199 6.3 · Consumption, Investment, and the Multiplier

6

. Fig. 6.11  The Keynesian model of income-expenditure equilibrium (the Keynesian cross) Note E = C + I + G + Xn (aggregate expenditure); C = c + MPC(Y − T ) (consumption); S = s + MPS(Y − T ) (saving); I = i = const (investment); G = g = const (government expenditure). Source Authors’ development

The interest rate determines the lower threshold of profitability of future investments: the lower the rate the higher the circulation. Marginal Propensity to Invest (MPI ) is a measure of change in investment depending on the change in the difference between MEI and interest rate. The greater the difference, the greater, other things being equal, the amount of investment. MEI is particularly sensitive to pessimistic moods and panic in the market. A sudden drop of the marginal efficiency down to the interest rate can cause economic crises. Keynes noted that changes in expectations cause fluctuations in the marginal efficiency of investment and, consequently, investment costs of firms. In the Keynesian model, equilibrium is achieved when expenditures (aggregate demand) equalize real output (aggregate supply). This income-expenditure equilibrium model is called The Keynesian Cross (. Fig. 6.11). For the sake of simplicity, suppose that net exports are zero, and the c, s, i , and g variables are autonomous (exogenous) values that do not depend on the total income. The bisector line serves as the starting point for the construction of the model. At any point in this line, aggregate income Y is equal to aggregate expenditure E. The intersection of the bisector line with the function of aggregate expenditure C + I + G + Xn at point E3 shows the value of aggregate income Y3 at which macroeconomic equilibrium is established. The slope of the expenditure line reflects the marginal propensity to consume, i.e., the change in consumption compared to the change in income. If the output is below the equilibrium (to the left of E3 point), aggregate demand exceeds aggregate supply. Firms start reducing inventories and increasing output, i.e., income and planned expenditures are leveled off. Conversely, if the output exceeds equilibrium (to the right of E3 point), firms are forced to reduce production to reduce aggregate supply down to aggregate demand. For producers, such fluctuations mean that actual expenditures include both planned and unplanned investment, when the latter performs the function of the supply-demand equalizer. The conclusion that follows from

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this model is that expenditures determine output. The model illustrates the idea that the greater the demand, the higher the equilibrium volume of income. 6.3.3  The Multiplier

Any change in the expenditures that make up aggregate demand (consumer, investment, public) activates the so-called Multiplication expressed in the excess of the increment of total income over the increment of autonomous demand (Eq. 6.14):

DY = Mp × DE

6

(6.14)

where DY increment in national income (product); Mp numerical coefficient (multiplier); DE   increment in aggregate expenditure. The Multiplier is an economic factor that shows how the increase or change in aggregate demand affects the equilibrium income. In the economic turnover, any additional expenditure turns into income of those economic entities who sell goods or services. Thus, at the next turn of the economic cycle, this income can again turn into expenditure, thereby increasing the aggregate demand for goods and services. However, in each cycle, part of the additional income is saved and thus does not go back into circulation. This relationship between the multiplier and consumer behavior (propensities to consume and save discussed above) could be reflected as follows (Eq. 6.15).

Mp =

1 1 = 1 − MPC MPS

(6.15)

where Mp multiplier; MPC   marginal propensity to consume; MPS marginal propensity to save. What follows from Eq. 6.15 is that the greater the additional expenditure on consumption (lower savings), the greater, other things being equal, the multiplier. The increase in the proportion of savings in income causes a decline in the multiplier value. Under normal conditions in the market, consumption and savings are relatively stable. They adapt to changes in income. Therefore, the multiplier effect is of particular importance in cases where changes occur in investment or government spending. This is because the two types of expenditures can be used as direct tools to adjust the equilibrium by affecting either aggregate demand or aggregate supply.

6

201 6.3 · Consumption, Investment, and the Multiplier

Case box Suppose that over a period of time, investment increased by $100. With MPS = 1/2, Mp = 2. Then the domestic product increases by $200. However, the multiplier applies to any change in aggregate expenditure, including cuts in investment. A $100 reduction in investment at Mp = 2 reduces GDP by $200.

The multiplier effect relates to the Acceleration effect. The latter establishes a connection between an increase in demand for goods and an even greater increase in investment required to produce these goods. In other words, a change in demand for investment is a function of change in income, with investment increasing to a greater extent than income gains (Eq. 6.16):

I = h × DY

(6.16)

where I induced investment; h acceleration coefficient; DY   increment in national income (product). The Accelerator Effect means that a change in sales of finished goods leads to a change in demand for inputs that are used in the production of those goods. Investment Accelerator is a coefficient that shows the dependence of changes in investment on changes in income. There are differences between the multiplier and the accelerator. The multiplier explains a one-time direct impact on income (output) in the current year, while the accelerator depicts the relationship between investments made today and the expansion of output in the future. Autonomous investment produces the multiplier effect, which contributes to the growth of income. The subsequent increase in demand and sales leads to the emergence of induced investment (the accelerator effect). One of the main aims of the government is to develop built-in economic stabilizers, which would put the multiplication effect under control by adjusting the MPC value. This challenge becomes more complex in the context of induced investments. In each subsequent production cycle, increased aggregate income induces not only higher consumer expenditures, but also growing investment (The Supermultiplier Effect). Another important task of the equilibrium analysis is to compare the ratio of equilibrium output and potential output at full employment and investment opportunities. In addition to the situation where the equilibrium and potential volumes are equal, two types of gaps could emerge. Recessionary Gap is a situation when aggregate expenditure is insufficient to achieve output at full employment Y ∗. The equilibrium is set at point Y0 below potential level (. Fig. 6.12). A further decline in expenditures results in a decline in output (the multiplier effect speeds up the drop). In such a situation, expenditures (particularly, investment expenditures) must be incentivized to move the equilibrium point up to the full employment level.

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. Fig. 6.12  Recessionary gap. Source Authors’ development

6

. Fig. 6.13  Inflationary gap. Source Authors’ development

Inflationary Gap is a situation in which the equilibrium volume of output is above the potential level, i.e., the amount by which aggregate expenditure must be reduced in order to reduce equilibrium GDP to a non-inflationary level of full employment (. Fig. 6.13). Under an inflationary gap, the demand for goods exceeds the output the economy can supply. A subsequent rise in prices results in an increase in business revenues (in the short run). However, rising costs (including higher wages) whip up the “wages-prices” inflationary spiral. To avoid negative consequences for the economy, it is necessary to curb the factors that fuel excess demand. If the gap is caused by the excess of money in the economy, then a tighter monetary policy should apply (see 7 Sect. 6.6.2 for the overview of monetary approaches to establishing the equilibrium, as well as 7 Chap. 11, 7 Sect. 11.4 for a detailed discussion of the monetary instruments). Both the recessionary and the inflationary gaps could be illustrated by the AD-AS model. In the Keynesian Cross model, prices are fixed, i.e., the model does not allow tracking price changes. The AD-AS model can be useful for ­studying price dynamics. . Figure 6.14a illustrates the deflationary gap, i.e., the value of aggregate expenditures (point A) is below the full employment. Here, the

203 6.4 · Commodity Market Equilibrium

6

. Fig. 6.14  Deflationary gap. Source Authors’ development

government should stimulate demand to lift point A to the right closer to the AD2 curve. . Figure 6.14b shows that an increase in demand from AD1 to AD2 causes an increase in prices from P1 to P2, i.e., the nominal volume of ­expenditure changes with no change in real output. To narrow the inflationary gap, the government should cut aggregate expenditures, i.e., should push the AD curve downward left back to the AD1 position. Thus, according to the Keynesian concept, the equilibrium in the market depends on the amount of aggregate expenditure. Changes in aggregate expenditure (consumption, investment, government spending) cause a multiplier effect on aggregate income (output). Investments are particularly important, since they directly affect the equilibrium, while consumption adapts to changes in the overall level of income. 6.4  Commodity Market Equilibrium

Equilibrium in the commodity market can be defined as the balance between aggregate demand AD and aggregate supply AD at any price in the market. The conditions of equilibrium follow from the Basic Macroeconomic Identity, which postulates that output equals the sum of all planned expenditures (Eq. 6.17):

Y AS = C + I + G + (Ex − Im) where Y AS   gross output (aggregate supply); consumer spending; C I business investment; government spending; G Ex exports; Im imports.

(6.17)

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This equality is established if outflows and inflows in the commodity market are balanced. If in a simple model, the equilibrium is established when savings equal investments, then in the full model, the equilibrium can be expressed as follows (Eq. 6.18):

S + T + Im = I + G + Ex

(6.18)

where S saving; T   taxes.

6

This condition follows from the economic cycle concept, when all the goods produced go into current consumption, since the entire volume of supply consists of consumer goods. The equilibrium is reached when households direct all the factor income received to consumption, i.e., CAS = CAD. The equilibrium is disturbed if a part of disposable income is saved. Due to the diversion of a portion of the factor income from the commodity market, aggregate demand falls below aggregate supply. To restore the equilibrium, either the supply should be reduced or additional demand should be added. The latter could be stimulated through the investment demand I (savings derived from the capital market). Such a transformation changes the composition of both the supply and the entire equilibrium (Eq. 6.19):

C+S =C+I

(6.19)

The state creates the outflow from the commodity market in the form of taxes T . To restore the equilibrium through adding a compensatory inflow, the government could make public procurements G in the market (additional demand). International trade will take part of the income away in the form of payment for imported goods and services Im. In that case, the outflow is compensated by inflowing revenues from exports Ex (Eq. 6.20).

C + S + T + Im = C + I + G + Ex

(6.20)

If the equilibrium is reached in the commodity market as a whole, then individual markets for final goods and factors of production are balanced too. To ensure the stability of the equilibrium, prices of goods and services should be balanced with the prices of factors of production in a certain way. The former must provide sufficient income to recover costs and generate profits for producers. The latter must be high enough to generate sufficient returns to owners of capital, land, labor, and other resources. However, the issue is bigger than determining the conditions of the equilibrium. Approaches to achieving the equilibrium also matter. 6.4.1  Neoclassical Interpretation of Commodity Market

Equilibrium

As shown in 7 Sect. 6.1.1, the classical school proceeds from the assumption that in the long run, the market ensures the full employment of all resources available.

205 6.4 · Commodity Market Equilibrium

6

Self-regulation allows the market to eliminate imbalances and return to the full employment equilibrium point. One of the postulates of the classical approach is based on the Say’s Law of Markets, which states that supply creates its own demand (further reading: 7 Chap. 15 in “A Treatise on Political Economy”9). In other words, real aggregate demand (income generated by past production and sales in the economy) is always sufficient to consume the aggregate output produced in the economy with the use of available factors of production. Consequently, there is always the AD = AS equilibrium in the market, and there is no reason to expect any crises of overproduction (AD < AS) or deficit (AD > AS) in the economy. The question is what happens to the equilibrium if part of the income received is then saved? The neoclassical model postulates that if money can bring interest, then economic entities would turn money into investment in expectation of returns. If investment I is equal to savings S, then one of the fundamental conditions of macroeconomic equilibrium is observed (I = S). In this case, the AD = AS equilibrium is not disturbed. Neoclassical economists accepted that decisions on saving and investing are made by different economic entities whose goals and actions may not coincide. However, fluctuations of the interest rate in the money market balance interests of economic actors. The I = S equality is established due to the interest rate getting into the equilibrium. According to the neoclassical model, price fluctuations that affect the equilibrium occur not only in the commodity market, but also in the labor market. Lower prices in commodity markets lead to lower wages or unemployment if wages do not grow. In the latter case, the supply of labor exceeds the demand for labor. Amid spreading unemployment, workers are forced to accept lower wages. Wages continue falling until hiring those who agree to work at lowering wages brings profit to producers. In other words, market forces ensure the achieving the equilibrium in the labor market at full employment of labor (yet at lower wages). Another issue is the influence of money. Since the overall price level rises or falls in parallel with the quantity of money in circulation, an increase in the quantity of money results in an increase in aggregate demand. Therefore, maintaining equilibrium requires controlling the supply of money as the stability condition of both process and aggregate demand. Neoclassical economics belittles the role of the state. If the market obtains natural regulators capable of ensuring the full use of available resources, then government intervention is unnecessary. The classical theory postulates the principle of neutrality of the state. The government should refrain from influencing economic entities operating in a competitive environment. 6.4.2  Keynesian Interpretation of Commodity Market

Equilibrium

As shown in 7 Sect. 6.1.2, proponents of the Keynesian approach express doubts about the ability of the market mechanism to automatically bring the economy 9

Say (1821).

206

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to the full employment equilibrium. Neoclassical economists consider prices mobile and flexible, while the Keynesian model proceeds from the fact that prices and wages are reluctant to changes, especially in the short run. As previously demonstrated in . Fig. 6.4, output falls when the AD curve shifts to the left. In the neoclassical interpretation, the fall in prices could have supported the output. No change in prices (the Keynesian interpretation) further depresses the output. Such a situation could result in a fairly long decline in production. The model illustrates the Keynesian postulate saying that supply (the real volume of output producers maintain) is determined by demand (just the opposite of the Say’s Law). Therefore, a decrease in aggregate demand (from AD1 to AD2 in . Fig. 6.4) leads to a decrease in output (from Q1 to Q2 in . Fig. 6.4). In this situation, the AD = AS equity is still achieved, but at a level below potential volume (Q∗ > Q1 > Q2 ), i.e., resources are underemployed. Thus, the Keynesian theory rejects the neoclassical assumption that supply creates its own demand. Instead, it suggests that aggregate demand creates its own supply. The Keynesian school assumes there is an inverse causal relationship between supply and demand, where aggregate demand creates supply. If aggregate demand is low, then output is below the full employment potential. With inflexible prices, low demand in the market could push the economy into a long-term depression with high unemployment. Market forces could not change the situation. Therefore, the government should intervene with macroeconomic tools aimed at stimulating aggregate demand. For example, the state can act as an i­nvestor, replenishing the lack of investment demand with an increase in government expenditures. Case box In the XX century, the Keynesian concept became the theoretical substantiation of a new approach to the role of the state in the economy. In today’s novel reality of deeply intertwined markets, country-specific disequilibrium easily emerges into global economic recessions (the COVID-19 pandemic being the demonstrative example). In such situations, the Keynesian approach to ensuring the macroeconomic equilibrium becomes particularly relevant. The contemporary anti-crisis policies of most countries are based on the Keynesian postulate that the state should intervene in the markets by pursuing an expansionist financial and monetary policy. In times of crisis, Keynes recommended not only expanding public spending, but also stimulating private sector investment through tax cuts, lower interest rates, and providing support to businesses and people through government subsidies, employment, and financial support. The use of those tools was evidenced in 2020–2021 during the pandemic.

However, even with the significant involvement of the state in establishing the macroeconomic equilibrium, the market economy still experiences numerous imbalances, such as inflation, unemployment, recession, and many more. The Keynesian approach allows governments to mitigate imbalances through implementing active monetary and fiscal policy, but not to eliminate disbalances

207 6.4 · Commodity Market Equilibrium

6

completely. The Keynesian policy combats either inflation or unemployment. However, stagflation (a combination of high unemployment and high inflation evidenced today in many countries worldwide) does not fit into the Keynesian model. Moreover, the Keynesian stimulation of aggregate demand can itself provoke stagflation. Case box The expansion policy pursued to stimulate demand (for example, payments to people widely practiced in 2020–2021 to support the population during lockdowns) leads to an increase in nominal, rather than real aggregate demand. It stimulates production for a short time, while in the long run, the government-induced new demand leads to inflation, a reduction in production, and an increase in unemployment. Suppose the government employs expansion policy in the pre-equilibrium situation (point A in . Fig. 6.15). An immediate reaction of the market to a rapid increase in cash incomes is to push output up (the equilibrium point moves from A to B). Taking the nominal monetary increase in demand for the real improvement of the purchasing power of the population, producers simultaneously increase output (from Y1 to Y2) and prices (inflation rises from I1 to I2). Thus, the increase in demand from AD1 to AD2 drives up both employment and inflation. Amid growing prices, inflation expectations emerge among consumers, workers, and producers. Rising costs push the supply curve upward left from AS 1 to AS 2. As a result, when businesses and ­employees adapt to inflation and start making the same production and consumption decisions they used to make before the inflation, the economy finds itself at a new level of employment and production. However, now inflation is higher at point C. Output returns to its initial level, but the growth of monetary income has already entered wages and overall production costs. Therefore, the equilibrium does not return to point A, but moves to point C, at which the initial output Y1 is produced at a much higher price I3. In this example, the newly established [Y1 ; I3 ] equilibrium denotes stagflation. In the long run, output remained unchanged, responding to each circle of expansion by the inflationary growth from A to C.

. Fig. 6.15  The government intervention paradox at times of inflation. Source Authors’ development

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Fundamental differences between the demand-side economics (described by the Keynesian model) and the supply-side economics (described by the neoclassical model) can be summarized in two arguments. First, while in the neoclassical model, supply creates its own demand, in the Keynesian model, demand creates its own supply. Second, in the neoclassical model, demand adapts to supply due to changes in price-related factors (interest rate and prices of factors of production and final goods). In the Keynesian model, supply adjusts to demand due to changing volume of output. 6.5  Equilibrium in Commodity and Money Markets: The IS-LM

Model

6

Money Market is a part of the financial market, a market of short-term highly liquid assets, in which the demand for and supply of money determine the level of interest rate (further detailed in 7 Chap. 11, 7 Sect. 11.3). Equilibrium in the money market is achieved when the amount of money supplied is demanded by economic entities and backed up by reserves of these entities in the forms of cash money or bank deposits. In the short term, suppose that the supply is controlled by the central bank (or any other government body, depending on the country) at the constant level M . If the price level is also stable, the AS curve is a vertical line, while the AD curve is a downward sloping line. The equilibrium established at the intersection of the AS and the AD curves determines the equilibrium rate of interest. The inclusion of the money market equilibrium in the analysis of the general macroeconomic equilibrium could be done by using the IS-LM model, which allows for studying the interaction between the commodity market and the money market. The model is based on the Keynesian interpretation of the equilibrium. It first appeared in John Hicks’s paper “Mr. Keynes and the “Classics”: A Suggested Interpretation”10 in 1937 and then it was further elaborated by Alvin Hansen in his book “Monetary Theory and Fiscal Policy”11 in 1949. The IS-LM model is also called the Hicks-Hansen model. In the commodity market, equilibrium is established when investment I equals saving S. The equality is reflected by the IS curve. In the money market, the equilibrium assumes that the demand for money (or liquidity L) equals the supply of money M (the LM curve). The commodity and the money markets are linked by the interest rate r. The Interest Rate is the cost of obtaining loans to finance investment projects, i.e., r value largely determines whether a particular investment project is profitable to an investor. Hence, investments can be considered a function of the interest rate (I = f (r)). The higher the interest rate, other things being equal, the lower the level of investment spending, and vice versa. The IS curve is downward sloping illustrating the fact

10 Hicks (1937). 11 Hansen (1949).

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. Fig. 6.16 The IS curve: change in aggregate output upon changing interest rate. Source Authors’ development

. Fig. 6.17 The LM curve: change in aggregate output upon changing interest rate. Source Authors’ development

that an increase in the interest rate from r1 to r2 and further to r3 results in a decrease in the investment and a consecutive fall in output from Y1 to Y2 and then to Y3 (. Fig. 6.16). Since the equilibrium is established at I = S, the IS curve shows various combinations of interest rate and income in which savings equal investment, i.e., the combinations of the equilibrium positions (E points) in the commodity market. For all points beyond the IS curve, planned expenditures are lower than income, i.e., there is an overproduction of goods and services. For all points below the IS curve, there is a deficit (underproduction) in the commodity market. The LM curve illustrates the relationship between the interest rate and income at the equilibrium points in the money market (. Fig. 6.17). The curve is upward sloping illustrating that the equilibrium in the money market is established when an increase in the interest rate corresponds to an increase in real income.

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. Fig. 6.18  The IS-LM model: equilibrium in commodity and money markets. Source Authors’ development

The equilibrium is maintained if the increase in income from Y1 to Y2 and further to Y3 is facilitated by a rising interest rate (r1 to r2 and then to r3, respectively). Points beyond and below the LM curve show deviations from the equilibrium. In all points beyond the curve, the supply of money exceeds demand for money (M > L). Below the curve, demand for money is greater than supply (M < L). The equilibrium point E in . Fig. 6.18 at which the two curves intersect fixes such a [rE ; YE ] ratio when the equilibrium is achieved in both the commodity and the monetary markets. At this interest-income ratio, there is neither surplus nor deficit in both markets. The aggregate demand in this situation is called effective demand. In points outside E, there is either the equilibrium in the money market (points A and C) at no equilibrium in the commodity market, or the equilibrium in the commodity market (points B and D) at no equilibrium in the money market. For example, at point A, a low interest rate encourages excess investment, while a high rate at point B discourages investment expenditures. The deviations from the equilibrium are considered unfavorable by economic entities. Their disbalance-induced activities in the market contribute to the restoration of the equilibrium. Shifts in the IS and the LM curves reflect the effects of the economic policy. Fiscal measures, i.e., changes in public spending and taxes, affect changes in the location of the IS curve. For example, a rise in government expenditure (not related to a change in the interest rate) shifts the IS curve upwards from IS 1 to IS 2 (. Fig. 6.19). The upward shift of the IS curve causes a simultaneous increase in income (from Y1 to Y2) and interest rate (from r1 to r2). Notably, the increase in income (�Y = Y2 − Y1 ) is much smaller than it would be in the absence of the influence of the money market. If the LM curve is a horizontal line (the demand for money is determined by the supply of money rather than the interest rate), the potential increase in income is YP = A − E1. Under the influence of the interest rate, �Y < �YP. Thus, the money market suppresses the multiplier effect that would

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. Fig. 6.19  The IS-LM model: change in equilibrium due to the increase in autonomous expenditure. Source Authors’ development

. Fig. 6.20  The IS-LM model: change in equilibrium due to the increase in money supply. Source Authors’ development

otherwise boost autonomous expenditures (the [E1 ; A] segment is a multiplied increase in expenditures). The increase in autonomous expenditure initially causes a multiplicative increase in national income, but at the same time, the demand for money soars, dragging up the interest rate (money supply being fixed). In turn, the rising interest rate discourages investment and incentivizes savings, thereby slowing down the increase in income. The LM curve shifts due to changes in monetary policy. Suppose amid no changes in real national income, the supply of money has increased due to money emission. In this case, the LM curve would shift downward right (. Fig. 6.20). Such a shift drives income up from Y1 to Y2, but pushes interest rate down from r1 to r2. The fall in interest rate (�r = r2 − r1 ) is smaller than it would be in the absence of the influence of the commodity market. If the IS curve is a ­vertical line (both investment and savings do not depend on the interest rate), the potential decrease in the interest rate is rP = A − E1. The commodity market

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slows down the fall in the interest rate. An increase in the money supply leads to a fall in the interest rate. A lower rate stimulates investment and consumption and thus increases demand for money pushing the interest rate up again. The IS-LM model is a Keynesian model that captures the interaction of various processes occurring in the commodity and the money markets. Since its inception in the 1930-1940s, it has become the fundamental model for the analysis of the effects of economic policies on markets. 6.6  Equilibrium and the New Normal Approaches to Economic

Policy

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6.6.1  Interpreting the IS-LM Model

The sections above have demonstrated that different economic schools interpret the factors of equilibrium and the effects of the economic policy aimed at establishing the equilibrium in different ways. Proceeding with the discussion of the IS-LM model and applying this model to the substantiation of various economic policy tools the government employs to get the economy back on track, we further consider the neoclassical and the Keynesian approaches to balancing unstable markets. The key difference between the neoclassical and the Keynesian interpretations is the elasticity of the commodity and the money markets and the combination of elasticities of the IS and the LM curves (see 7 Chap. 5, 7 Sect. 5.4 for the concept of elasticity and elasticities of demand and supply). According to the neoclassical school, the IS curve is elastic, while the LM curve is inelastic (. Fig. 6.21a). As previously shown in 7 Sect. 6.3.1, neoclassical theory considers interest rate to be the decisive factor that affects the volume of investment and balances investment I and savings S in the market. Thus, the

. Fig. 6.21  The IS-LM Model: neoclassical interpretation. Source Authors’ development

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. Fig. 6.22  The IS-LM Model: Keynesian interpretation. Source Authors’ development

demand curve for investment is elastic, and therefore, the IS curve is elastic too. The LM curve is considered inelastic due to the adherence of neoclassical economists to the quantitative theory of money. According to the neoclassical concept, the demand for money is largely a transactions demand. It underreacts to changes in the interest rate. Thus, the demand curve for money is inelastic, and therefore, the LM curve is inelastic too. The extremum is a perfectly inelastic LM curve (. Fig. 6.21b), when the demand for money does not respond to any changes in the interest rate. According to the Keynesian school, as opposed to the neoclassical concept, the IS curve is inelastic, while the LM curve is elastic (. Fig. 6.22a). As demonstrated in 7 Sect. 6.3.2, in the Keynesian interpretation, the demand for investment is essentially independent of the interest rate, as the volume of investment is affected by other contributing factors such as expectations, propensities, level of technology, taxes, etc. The less sensitive I is to changes in r, the less elastic the IS curve. The demand for money consists of transactions and speculative demand, the latter reacting strongly to changes in the interest rate. The greater the sensitivity of the demand for money to changes in the interest rate, the more elastic the LM curve. The extremum is a perfectly elastic LM curve (. Fig. 6.22b), when the demand for money is determined by the volume of supply. Perfectly elastic LM curve illustrates the Liquidity Trap situation, which occurs when the interest rate is so low that any increase in the supply of money ends up in speculative transactions without affecting either the interest rate or national income. A low interest rate is complemented by low inflation and slow economic growth or even recession in the economy. During a liquidity trap, economic entities tend to hold cash rather than make deposits in banks, spend money, or buy illiquid assets. Summing up, we can say that in the neoclassical interpretation, the IS curve is elastic and the LM curve is inelastic, whereas in the Keynesian interpretation, the IS curve is inelastic and the LM curve is elastic. This difference in understanding the elasticity situation in the IS-LM model preconditions discrepancies in assessing the effects of stabilization policies employed by the government.

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6.6.2  Equilibrium and Monetary Policy

6

Monetary Policy affects the supply of money, interest rates, and the availability of credit resources to businesses and people (see a comprehensive discussion of monetary policy in 7 Chap. 11). If the government aims to spur economic growth and stimulate business activity, it pursues expansionary monetary policy by increasing the supply of money, lowering interest rates, and making money more accessible. If the government aims to curb inflation, it practices contractionary monetary policy by reducing the supply of money, increasing interest rates, and making money more expensive and less accessible. The use of expansionary monetary tools shifts the LM curve downward right (. Fig. 6.23). In the neoclassical interpretation, the increase in the supply of money results in significant growth of income (from Y1 to Y2) amid a moderate decline in the interest rate (from r1 to r2) (. Fig. 6.23a). However, as demonstrated in 7 Sect. 6.1.1, in the neoclassical interpretation, the aggregate supply curve is a vertical line (. Fig. 6.3), which means that an increase in aggregate demand does not change the level of output, but stimulates inflation. Thus, an increase in the supply of money as a result of the expansionary monetary policy depresses the interest rate and pushes up aggregate expenditures. The Y1 → Y2 shift in . Fig. 6.23a is interpreted as an increase in aggregate demand, not output. Since �r < �Y , a lower cut of interest rate is absorbed by greater inflation of demand. Consequently, in the neoclassical interpretation, expansionary monetary policy is inefficient, because it fuels inflation due to an increase in the supply of money and aggregate expenditures. According to the Keynesian model, the effect of the expansionary monetary policy on economic growth is insignificant (Y = Y2 − Y1 . Fig. 6.23b) due to the low sensitivity of investment and savings to fluctuations of the interest rate (�r > �Y ). Due to a strong decline in the interest rate from r1 to r2, the econ-

. Fig. 6.23  Effects of expansionary monetary policy in a neoclassical and b Keynesian interpretations. Source Authors’ development

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. Fig. 6.24  Effects of contractionary monetary policy in a neoclassical and b Keynesian interpretations. Source Authors’ development

omy may fall into a liquidity trap (see above in 7 Sect. 6.6.1). Perfectly inelastic IS curve (a vertical line in the Keynesian interpretation) just illustrates the liquidity trap: no economic growth amid the collapsing money market (at low interest rates, transactions with securities bring no profit). In this regard, the Keynesian school considers expansionary monetary policy ineffective. Still, it could be employed as a short-term measure, when the interest rate is too high and the economy suffers from a shortage of money supply. The use of contractionary monetary tools shifts the LM curve upward left (. Fig. 6.24). Neoclassical economists believe the contractionary monetary policy to be one of the most efficient tools the government could use to manipulate the aggregate demand. The reduction in the supply of money compresses aggregate expenditures from Y1 to Y2, thereby restraining the inflation of demand (. Fig. 6.24a). The interest rate increases insignificantly compared to a fall in expenditures (|�r| < |�Y |). The overall loss for the economy is also insignificant, because output stays stable in the long run due to the inelasticity of the LM curve. In the Keynesian interpretation, contractionary monetary policy could be employed when markets need rapid balancing in the short run. It results in a significant rise in interest rate from r1 to r2 amid a much lower fall in income from Y1 to Y2 (|�r| > |�Y |). However, over the long-term horizon, shrinking demand will inevitably depress output and deepen the gap between the supply of money and the volume of domestic output. Case box The Keynesian attitude to the contractionary monetary policy is demonstratively illustrated today by the anti-crisis and anti-inflationary measures employed in many countries across the world. The rise in base rates (the key interest rate set by monetary authorities

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for lending money from the central bank to commercial banks) as a reaction to soaring inflation in the USA and Europe in 2021 against the backdrop of the COVID-19 crisis correlates with the economic slowdown and even decline. In particular, a radical increase in the base rate in Russia from 4.25% in 2020 (before the pandemic) up to 7.50% in October 2021 is accompanied by a decline in Russia’s GDP in 2020 and projected slow recovery in 2021.

6

Thus, in the Keynesian interpretation, the use of contractionary monetary tools results in a slight decrease in aggregate expenditure, i.e., a slight weakening of inflation of demand. The expansionary measures insignificantly affect domestic output. A more detailed discussion of the effects of various types and instruments of monetary policy on the macroeconomic equilibrium and certain economic parameters can be found in 7 Chap. 11, 7 Sect. 11.4. To sum up, we could say that expansionary monetary policy could either fuel inflation by stimulating expenditures amid relatively insignificant economic growth (the neoclassical interpretation) or generate a modest increase in output in the short run while potentially dragging the economy into the liquidity trap (the Keynesian interpretation). Contractionary monetary policy could efficiently help the government to stabilize prices (the neoclassical interpretation), but it should be employed as the short-term anti-inflationary measure (the Keynesian interpretation). 6.6.3  Equilibrium and Fiscal Policy

Fiscal Policy involves the use of government spending and tax policies to establish the macroeconomic equilibrium (see 7 Chap. 13 for a detailed discussion of fiscal policy). If the government aims to spur economic growth and stimulate business activity, it pursues expansionary fiscal policy by increasing government spending and lowering taxes. If the government aims to curb inflation, it practices contractionary fiscal policy by cutting government spending and raising taxes. The use of expansionary fiscal tools shifts the IS curve upward right (. Fig. 6.25). According to the neoclassical theory, the efficiency of the expansionary fiscal policy is low due to the poor sensitivity of the demand for money to the ­interest rate. At the same time, demand for money is sensitive to income, while ­investment is sensitive to interest rate (as previously discussed in 7 Sects. 6.1.1 and 6.2.1). The potential gain in income in the neoclassical interpretation (Y = Y2 − Y1 in . Fig. 6.25a) is significantly lower than that in the Keynesian version of the model (. Fig. 6.25b). Thus, in the neoclassical theory, expansionary fiscal policy has a weaker effect on leveraging national income than in the Keynesian model. According to the neoclassical concept, the rising interest rate (from r1 to r2 in . Fig. 6.25a) erodes the positive effect of expansionary fiscal policy (�r > �Y )

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. Fig. 6.25  Effects of expansionary fiscal policy in a neoclassical and b Keynesian interpretations. Source Authors’ development

and depresses investment expenditures. Rising government spending drives down or even eliminates investment expenditures and private sector spending. In macroeconomics, this effect is called the Crowding Out Effect. The greater the increase in the interest rate as a result of expansionary government spending, the greater the reduction in investment (the stronger the crowding out effect). Comparing . Fig. 6.25a, b, we can see that neoclassical economists expect the crowding out effect to be higher (�ra > �rb ). The strength of the effect directly depends on the elasticity of the LM curve. Case box Against the backdrop of economic recession during the COVID-19 pandemic, most governments worldwide have been attempting to support business activity and stimulate aggregate demand by increasing government spending and lowering taxes on businesses and people (even imposing a moratorium on a number of taxes and payments). Such approach to the anti-crisis policy is consistent with the Keynesian understanding of the effectiveness of expansionary fiscal policy as a tool to spur national income and output.

The use of contractionary fiscal tools shifts the IS curve downward left (. Fig. 6.26). According to the neoclassical theory (. Fig. 6.26a), contractionary fiscal policy could be effective in the short term (a significant drop in interest rate from r1 to r2 amid a tiny decline in income from Y1 to Y2 at �r > �Y ). In the long run, however, the use of contractionary fiscal instruments presents itself as problematic due to substantial time lags and resistance from the public and business.

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6 . Fig. 6.26  Effects of contractionary fiscal policy in a neoclassical and b Keynesian interpretations. Source Authors’ development

Case box As illustrated in the case boxes above, in 2021, monetary authorities in many countries reacted to mounting inflation by raising base rates in an attempt to dampen aggregate demand brought on by the expansionary policies at the early stages of the COVID-19 pandemic. According to the neoclassical interpretation of achieving equilibrium, such a sharp cut of money inflows (contractionary fiscal policy) allows the government to quickly cool down the market and curb inflation. In this case, proponents of both the neoclassical and the Keynesian schools agree that contractionary fiscal policy could be applied as an instrumental stabilization measure in times of high inflation, but in the long run, it hinders economic growth.

According to the Keynesian vision (. Fig. 6.26b), even a tiny reduction in inflationary pressure (a decline in interest rate from r1 to r2) by means of contracting aggregate demand would cost a dramatic drop in national income from Y1 to Y2 (�Y > �r). Here, the government must calculate and decide whether curbing inflation is worth such a loss. Thus, in the Keynesian model, any shrink in aggregate demand ultimately results in a reduction in aggregate income. Therefore, a contraction does not eliminate the root problem of inflation. Consequently, constraining fiscal policy could be employed as a short-term measure only. To sum up, we say that expansionary fiscal policy could result in a substantial gain in income (the Keynesian interpretation), but it potentially leads to the emergence of the crowding out effect in the market (the neoclassical ­assumption). Contractionary fiscal policy is an effective short-term measure to curb inflation (the two theories), but in the long run, it depresses economic development by taking out a significant portion of income from circulation (the Keynesian interpretation).

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6.6.4  The New Normal Equilibrium

As the discussion of the divergent effects of monetary and fiscal policies shows, it is important to understand how to combine policy tools to achieve the desired result not only in different situations in the market, but also in light of different theoretical interpretations of macroeconomic equilibrium. The contemporary new normal operation of global markets amid high uncertainty and extremely dynamic variability necessitates the elaboration of a certain combination of the neoclassical and the Keynesian approaches to monetary and fiscal regulation. The genius of the new normal situation is that any fiscal measure introduced in the commodity market affects the money market, and, conversely, any monetary regulation aimed to curb inflation is then reflected in the parameters of the commodity market. Over decades of economic turbulences (the most recent downturns being the COVID-19 outbreak, the oil prices rollercoaster in the late 2010s, and the 2008 financial crisis), economists have evidenced that neither fiscal nor monetary policies entirely deliver on expectations. Using the IS-LM model, it is possible to model the results of simultaneous application of fiscal and monetary measures. Clearly, during an economic recession like the one experienced by the world during the COVID-19 pandemic, the main goal of all governments is to stimulate economic growth and business activity. The macroeconomic theory says that to achieve such a goal, the government must use expansionary measures in both commodity and money markets. In other words, the government simultaneously increases spending (or lowers taxes) (expansionary fiscal policy) and raises the supply of money on the market (expansionary monetary policy) (. Fig. 6.27). If the increase in government spending (IS 1 shifts to IS 2) is accompanied by the increase in the supply of money (LM 1 shifts to LM 2), aggregate income rises substantially from Y1 to Y2 at no change in interest rate r1. Thus, a simultaneous application of expansionary monetary and fiscal policy measures shifts the equilibrium point from E1 to the right (E2 ) with a significant gain in national income and output (�Y = Y2 − Y1 ) and no additional inflationary pressure on the economy.

. Fig. 6.27  Simultaneous use of expansionary monetary and fiscal measures to stimulate economic growth amid recession. Source Authors’ development

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Case box

6

Simultaneous application of the two types of expansionary measures could increase the pressure of government spending on the overall price level in the economy and a corresponding decline in real supply of money (LM 1 shifts upward left to LM 3). In such a situation, the interest rate jumps up from r1 to r3 with no change in national income (Y1). The equilibrium point moves up from E1 to E3 thereby illustrating the crowding out effect. In an attempt to remedy the situation, the government increases the real supply of money from LM3 to LM2 (�LM(LM2 − LM3 ) > �LM(LM2 − LM1 )), or at least to LM 1 to get back to the initial equilibrium. This escalates inflation. In 2021, many countries experienced a similar effect as a result of several waves of money supply expansions at the early stages of the COVID-19 outbreak (welfare payments to people, subsidies to businesses, tax cuts, and other expansionary measures). Therefore, in the new normal reality, periods of expansion should alternate with periods of contraction to balance markets and keep the economic development trajectory within the corridor set by the government.

The effects of simultaneous application of contractionary monetary and fiscal policies in an effort to stabilize prices and interest rates are illustrated in . Fig. 6.28. The shift of the IS curve from IS 1 downward left to IS 2 reflects a decrease in government spending (for example, the termination or significant reduction of support programs for businesses and people in 2021) coupled with an increase in taxes (the end of the moratorium on tax payments introduced in many countries in 2020). Such measures are accompanied by a cut in the supply of money (LM 1 shifts to LM 2). Then, the interest rate stabilizes at r1. However, the cost of this stability is a substantial loss of income (�Y = Y1 − Y2 ).

. Fig. 6.28  Simultaneous use of contractionary monetary and fiscal measures to sustain post-recession economic growth. Source Authors’ development

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Thus, the IS-LM model illustrates the difficulty of achieving two goals (economic growth amid low inflation) at a time, even though the combination of fiscal and monetary instruments produces a certain effect. In times of misbalances in markets, it is important to pick the trajectory and consistently employ either expansionary or contractionary measures or a predefined combination of the two, avoiding short-term fluctuations. Chapter Questions: 5 What is macroeconomic equilibrium? Name fundamental proportions which condition the equilibrium and explain the relationships within and between them. 5 How is general equilibrium different from partial equilibrium? 5 Explain the sense of the basic macroeconomic identity from a point of view of establishing macroeconomic equilibrium. Discuss the roles of the identity elements. 5 Summarize differences between the neoclassical and the Keynesian interpretations of consumption and investment. 5 Give examples of how anti-crisis policies during the COVID-19 downturn induced the crowding out effect. 5 What is liquidity trap? According to the neoclassical interpretation, could any composition of the IS-LM model result in a liquidity trap? 5 The Keynesian school values contractionary fiscal policy as an effective tool to curb inflation. True or false? Explain your reasoning. 5 Illustrate negative and positive effects of expansionary monetary policy for spurring economic growth and stimulating business activity in the midst of an economic recession. Subject Vocabulary: Accelerator Effect: a change in sales of finished goods leads to a change in demand for inputs that are used in the production of those goods. Autonomous Consumption: the expenditures that consumers must make when they receive no disposable income. Average Propensity to Consume: the ratio of the part of disposable income spent on consumption to the total disposable income. Basic Macroeconomic Identity: the equality between output and the sum of all planned expenditures, including consumer spending, business investment, government spending, and net exports. Crowding Out Effect: a situation in the economy when rising government spending drives down or even eliminates investment expenditures and private sector spending. Inflationary Gap: a situation in which the equilibrium volume of output is above the potential level. Keynesian Cross: the model where the equilibrium is achieved when expenditures (aggregate demand) equalize real output (aggregate supply).

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Liquidity Trap: a situation, which occurs when the interest rate is so low that any increase in the supply of money ends up in speculative transactions without affecting either the interest rate or national income. Macroeconomic Equilibrium: a state of the economy when both the use of scarce resources and their distribution among economic actors are balanced. Marginal Efficiency of Investment: the interest rate at which the estimated value of income from investment (the expected rate of return) is equal to the current value of the investment. Marginal Propensity to Consume: the ratio of the increase in disposable income that goes to consumption to the increase in that income. Marginal Propensity to Invest: a measure of change in investment depending on the change in the difference between marginal efficiency of investment and interest rate. Multiplier: an economic factor that shows how the increase or change in aggregate demand affects the equilibrium income. Ratchet Effect: a situation when prices do not respond to a decrease in aggregate demand. Recessionary Gap: a situation when aggregate expenditure is insufficient to achieve output at full employment. Say’s Law: the law that says that production generates income exactly equal to the value of output, i.e., supply generates its own demand.

References Deutsche Bundesbank. (2020). How are households’ consumption plans affected by the COVID-19 Pandemic? Available at 7 https://www.bundesbank.de/en/publications/research/research-brief/2020-35-covid-19-pandemic-consumption-849870. Hansen, A. H. (1949). Monetary theory and fiscal policy. McGraw Hill. Hicks, J.R. (1937). Mr. Keynes and the “Classics”: A suggested interpretation. Econometrica, 5(2), 147–159. Higgs, R. (1987). Crisis and leviathan: Critical episodes in the growth of American Government. Oakland, CA: Independent Institute. Keynes, J. M. (1936). The general theory of employment, interest and money. Macmillan. Marx (1885). Capital. A Critique of Political Economy. Volume II. Available at 7 https://www.marxists. org/archive/marx/works/1885-c2/index.htm. Morgan, J. P. (2020). How COVID-19 has transformed consumer spending habits. Available at 7 https:// www.jpmorgan.com/solutions/cib/research/covid-spending-habits. Peacock, A., & Wiseman, J. (1961). The growth of public expenditure in the United Kingdom. Princeton University Press. Say, J.-B. (1821). A treatise on political economy, or the production, distribution and consumption of wealth. Philadelphia, PA: Claxton, Remsen & Haffelfinger. Walras, L. (1954). Elements of pure economics, or the theory of social wealth. Translated by Jaffe, W. London: Allen and Unwin.

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Economic Cycles

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_7

7

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Learning Objectives: 5 Understand the concepts of cyclicity and economic cycle 5 Reveal differences between major approaches to understanding economic cycles 5 Study four types of economic cycles 5 Go over the contemporary history of crises 5 Discover the approaches to interpreting equilibrium determinants 5 Summarize stabilization policy measures aimed at smoothing market fluctuations 7.1  Theory of Economic Cycles

7

Markets permanently balance between equilibrium and disequilibrium, as shown in 7 Chap. 6. An equilibrium is commonly achieved in the short run only. Combinations of various factors (demand, supply, expectations, macroeconomic policy, etc.) exert constant pressure on the equilibrium, seeking to shift the equilibrium point. The resulting imbalance (a consequence of the more substantial impact of one factor or a combination of factors) then gets equalized under the combined influence of other factors. Thus, the market consistently alternates between infinitely many equilibriums passing from one state to another and then looping back. Such cycling of market positions is a way of self-regulation of the economy. Cyclicity is a form of economic development when the latter transitions from one macroeconomic equilibrium to another. In economics, cyclicity is the upward (or downward) spiral movement rather than a simple rotary movement. This feature reflects the progressive nature of the economic development (or a regressive one, in case of downward spiraling). Economic Cycle is the transition of the economy from one state of macroeconomic equilibrium to another. During the cycle, a new structure of the economy develops due to regrouping resources and factors of production between markets, upgrading production facilities, shifting consumption patterns, introducing new technologies, and many other factors. Fluctuations in business activity are not easily predictable. Therefore, the concept of the economic cycle is conditional. Detecting the economic cycle can be difficult. Markets experience regular, irregular, or random fluctuations caused by seasonal, natural, or anthropogenic factors. In macroeconomic analysis, economists face the need to understand the determinants of disbalances, distinguish regular changes from irregular ones, and elaborate methods to eliminate or at least dampen the fluctuations. The very term “cycle” implies the recognition of a regular and predictable nature of macroeconomic volatility. Moreover, it implies that fluctuations are driven by endogenous factors. Some economists argue that economic cycles are irregular deviations as they are caused by exogenous factors (which makes cycles unpredictable) (see 7 Sect. 7.4). In the broadest strokes, an economic cycle can be illustrated as a two-phase change of expansion and contraction, alternately passing through peaks and troughs (. Fig. 7.1). The economy develops and grows not linearly, but through deviations from the long-term trend (Y ∗ ). The trend line Y ∗ designates the potential GDP, while line Y represents the current GDP at any given time t1−n. The

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. Fig. 7.1  Economic cycle: stages. Source Authors’ development

trend line is built so that it smooths out the fluctuations in current real GDP over a long period of time. Thus, macroeconomic analysis distinguishes long-term trends from short-term changes in business activity. Extremes b and f designate peaks, where the current GDP reaches its maximum, while points d and h are troughs, where GDP collapses to its minimum. The  distance between two peaks ( b; f segment) or two troughs ([d; h] segment) indicates cycle period (the time it takes for GDP to move from one peak (trough) to another). The distance between the extremes and the trend line Y ∗ is the   oscillab; b′ segtion amplitude. It shows the extent to which current GDP goes beyond (   ment) or below ( d; d ′ segment) the long-run trend.   The cycle is composed of contractions ([b; d] segment) and expansions ( d; f segment). During contraction, the output gap grows until current GDP drops below the potential GDP (Y < Y ∗). Commonly, this happens due to a sharp contraction in aggregate demand (there are other reasons as well, see 7 Sect. 7.4 for a detailed discussion). All factors of production are underutilized. Cyclical unemployment grows. Prices remain unchanged, but if contraction turns into a depression, prices fall. The economic function of a crisis is to reestablish proportions between core macroeconomic parameters, such as production and consumption, supply and demand, output and circulation (remember the fundamental proportions of the macroeconomic equilibrium discussed previously in 7 Chap. 6, 7 Sect. 6.1). Crisis recovers the economy through the price mechanism and creates conditions for economic development in the future. Overproduction and underproduction are the two types of crises. Overproduction is most common in the market economy. Too many goods in the market mean a portion of output remains unsold. Stocks of unsold products grow along with costs for storage, profits fall, and producers go bankrupt. The demand for money (bank loans) increases while the supply of money drops. Interest rates go up, but banks still collapse, and prices of shares and other securities fall. Unemployment rises, and the entire economy suffers.

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Case box The first industrial crisis broke out in the UK in 1825. In 1836, the USA experienced one of the first economic depressions. In 1847–1848, the first global industrial crisis hit both the USA and several European countries. The first cyclical crisis emerged in 1857. The deepest global downturn in the XIX century happened in 1873. In the XX century, crises followed swiftly on one another (1920–1921, 1929–1933, 1937–1938) (see 7 Sect. 7.3 for structural, agrarian, and financial cries of the modern age). In the USA, the Great Depression (1929–1933) caused a 40–50% fall in output amid a rise in unemployment up to 25% (further detailed in 7 Sect. 7.3.5).

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At the lowest point of a cycle (trough), GDP stops falling (unemployment stops rising) due to the bottoming-out of aggregate demand. Due to freezing production, excessive commodity stocks are gradually absorbed in the market. Stocks are eliminated or sold out at reduced prices. The withdrawal of obsolete equipment and other facilities from current assets suspends the fall in prices. Gradually, investment demand and aggregate demand revive. GDP starts expanding, and unemployment decreases. Case box During the 1929–1933 crisis in the USA, farmers destroyed cotton crops in over ten million hectares. The price fell so low that burning the crops became cheaper than harvesting. In Brazil, farmers burned about five million pigs and ten million bags of coffee.

The recovery begins with the growth of real GDP and the reduction of unemployment due to the growth of aggregate demand, primarily investment demand. The decisive factor in the transition from depression to recovery is the renewal of fixed assets. This stimulates the renewal of production capital. Demand starts rising. Firms employ labor and increase demand for new equipment, resources, and factors of production. Amid restoring demand, prices go up (early inflation). Once the current GDP Y reaches the potential long-term trend Y ∗, the cycle peaks. At the peak, the rapid growth of aggregate demand causes a rapid increase in the price level (the demand-pull inflation). GDP rises above the potential level Y ∗, while unemployment tends to zero. Production operates at full capacity with maximum employment of all resources. However, at some point, production growth surpasses the growth of effective demand, and the economy starts cooling down. As a result, aggregate demand shrinks, GDP falls, and unemployment rises. The economic cycle restarts and repeats.

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. Fig. 7.2  Marxian four-stage model of an economic cycle. Source Authors’ development

7.1.1  Marxian Interpretation of Economic Cycle

The simplified interpretation of the economic cycle presented above is essentially a two-phase model of revolving contractions and expansions. Troughs and peaks act as turning points between the two phases. The more comprehensive and commonly used classical model of the economic cycle includes four stages: expansion, peak, contraction, and trough (extremes considered as longer-lasting phases, rather than short-living rotating points). Cyclicity as a statistical regularity was first revealed by Clement Juglar in the 1860s (see 7 Sect. 7.3.2 for a detailed discussion of Juglar cycles) and then elaborated by Karl Marx. In . Fig. 7.2, point a1 represents the maximum level of economic activity achieved in the previous cycle. As demonstrated previously in . Fig. 7.1, line Y ∗ is the long-term development trend. Crises commonly emerge due to a disequilibrium between aggregate supply and aggregate demand. As a result, prices and profits fall, dragging output and employment with them. The Marxian theory explains crises (consequently, economic cycles) by the influence of endogenous factors inherent in the capitalist economy, i.e., the contradiction between production (social form) and appropriation of its results (private form). The social character of production means the universal interconnection and interdependence of macroeconomic processes. The private form of appropriation of production results is manifested in the fact that firms seeking to maximize profits make decisions and act autonomously, i.e., independently of each other. Unilateral actions of individual economic actors violate macroeconomic equilibrium. Disturbances of the equilibrium are explosive as they aggravate the contradictions accumulated in the economy in previous periods (earlier cycles to the left of point a1): 5 between production and consumption (overproduction crises); 5 between labor and capital (rises in unemployment); 5 other macroeconomic proportions (see the macroeconomic equilibrium conditions in 7 Chap. 6, 7 Sect. 6.1, particularly, a sharper increase in savings compared to investment demand, primarily due to the growth of a depreciation fund).

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Thus, according to Marx, an economic crisis (contraction) is a return to macroeconomic equilibrium by restoring partial and general equilibrium. This return opens the way to a new cyclical economic recovery, then a new contraction, and so on indefinitely. Marx proved that cyclicity is a form of economic development inherent in capitalism. Marx believed that the periodicity of crises (i.e., a cycle) is based on the periodic mass renewal of fixed capital. The crisis time itself corresponds to the average lifetime of industrial equipment, the active part of fixed capital. 7.1.2  Neoclassical Interpretation of Economic Cycle

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Neither the classical school nor neoclassical economists have specifically analyzed cyclic oscillations. The classical macroeconomic analysis is a long-term analysis that approaches macroeconomic processes from the point of view of economic growth (the Y ∗ trend in . Fig. 7.1). As previously discussed in 7 Sect. 6.1.1, in the neoclassical interpretation of the equilibrium, supply generates its own demand (Say’s Law). That means the economy always operates at the highest possible potential level of employment. In this interpretation, potential GDP Y ∗ equals the potential level of real GDP Y . It is the maximum possible output volume with the full and effective use of all available resources in the economy. Hence, it follows that the real value of aggregate supply entirely determines the real value of aggregate demand at full employment (i.e., the potential GDP). The nominal value of aggregate demand changes under the influence of either supply of money or the velocity of money circulation. If supply shrinks (or circulation slows down), aggregate demand in nominal terms decreases (in . Fig. 7.3, the AD1 curve shifts downward left to AD2). The shift causes a temporary fall in real GDP from Y1 to Y2. The equilibrium point moves from E1 to E2, at which Y2 < Y1 (higher unemployment). However, automatic market mechanisms (flexible prices, wages, and interest rates) restore the equilibrium at the initial level of potential GDP Y1. The new equilibrium is established at point E3 at constant AS (full employment of resources), a new level of AD2, but lower price level (P2 < P1 ).

. Fig. 7.3  Neoclassical interpretation of economic contraction. Source Authors’ development

229 7.1 · Theory of Economic Cycles

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Thus, neoclassical economists interpreted contraction as a temporary deviation from the equilibrium at full employment. Therefore, according to the neoclassical school, during contraction, the economy faces disequilibrium unemployment, while cyclical unemployment is impossible due to the recovery action of market mechanisms (Adam Smith’s idea of the “invisible hand” of the market). Summarizing the neoclassical interpretation of an economic cycle, let us note the fundamentals. Macroeconomic fluctuations are caused by exogenous factors (disbalances in the monetary market). Contraction is a temporary deviation from macroeconomic equilibrium. Unemployment during contraction is voluntary unemployment, not forced one. Market mechanisms automatically restore the disturbed equilibrium of full employment, so the government should not intervene in the economy to stabilize it. Until recently, neoclassical economists denied the recurrence of crises, explaining ups and downs by impacts of external shocks. The essence of a cycle is reduced to the violation of the stock-flow proportion, i.e., a balance between invested capital and annual output. In the neoclassical interpretation, profit is the primary factor of capital accumulation. The theory does not emphasize the gap between the optimal level of capital in the economy and its actual volume. In such a scheme, capital accumulation would go evenly if the volume of profit received by producers was constant or grew steadily. But this does not happen because of changes in the level of employment and wages. An increase in capital volume would require an increase in employment and, therefore, would curb unemployment. In turn, a decrease in unemployment followed by a rise in wages lowers profits. Amid lower profits, producers cut investments. This leads to a relative decrease in the amount of capital employed and a decrease in employment, leading to a fall in wages and increased profits. Thus, capital accumulation restores, and the economic cycle repeats. 7.1.3  Keynesian Interpretation of Economic Cycle

The Keynesian school agrees with the neoclassical interpretation of the economic cycle as an adaption of capital supplies peculiarities in reproduction. A kind of equilibrium proportion is assumed to exist between the value reproduced over a period of time and the stock of capital accumulated by the end of that period. As long as this balance remains undisturbed, there are no cyclical fluctuations in the economy. Any deviation in the value-stocks ratio from the equilibrium could give rise to cyclical fluctuations of both capital and domestic product. Adjusting the size of capital stock pursues an elusive goal, such as re-establishing the balance between capital and the value of annual reproduction. The Keynesian interpretation of the economic cycle differs from the neoclassical vision in understanding the driving force that causes fluctuations. The Keynesian school hypothesizes that producers always seek to equalize the actual capital stock with its equilibrium level. This is the very force that activates cyclical volatility. The equilibrium value of capital is the optimal level. It gravitates the actual value and determines the size of stocks. According to Keynes, the main reason

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for an economic cycle is the dependence of the marginal efficiency of capital on changes in expectations. This dependence determines the susceptibility of the marginal efficiency of capital to fluctuations that trigger an economic cycle. Cyclicity is caused by fluctuations in effective demand (primarily investment demand) due to changes in real GDP, employment, and other macroeconomic parameters. Thus, in the Keynesian interpretation, an economic cycle is affected by endogenous factors. Unlike the neoclassical model, Keynesian analysis is a short-term analysis. It focuses on the current dynamics of variables, not the longterm trend. Since the Keynesian school proceeds from price level being constant, the actual GDP Y is analyzed as an objective indicator. At the peak, investments reach a level where the marginal efficiency of capital starts falling. Commonly, there are few investment projects with the highest marginal efficiency of capital in any economy. Other projects are less profitable. Consequently, an increase in excessive capital not employed in the highest-efficient projects causes a decline in the overall marginal efficiency. Combined with a rising interest rate (due to the growing demand for money), falling marginal efficiency depresses investment demand. A fall in aggregate demand pushes down effective demand, employment, and domestic output (income). This is how the contraction stage of an economic cycle starts. At the lowest point of a cycle, the demand for money falls due to falling employment and income. This cuts interest rates down. A lower rate can restore investment demand if the marginal efficiency of capital increases. In turn, a drop in investment can give rise to the marginal efficiency of capital, since many projects in the economy lack capital. Thus, reaching the through can change expectations. A more optimistic investors’ vision of future growth contributes to the rise in the marginal efficiency of capital. Following investment demand, effective demand, income, and employment keep growing. The economy enters the expansion stage (recovery and growth). While witnessing reviving effective demand, investors continue expressing optimistic expectations and marginal efficiency continues growing. Investment demand goes up despite the increase in interest rate due to the growth in demand for money under the influence of income growth. Upon reaching the full employment, the peak begins. Soon, under the pressure of rising inflation, the cycle turns down. The Keynesian interpretation of an economic cycle is close to the Marxian vision. In both theories, the existence of a cycle is associated with peculiarities in investment. According to Keynes, investment is the most volatile part of aggregate demand. If investment demand falls, so does aggregate demand (in . Fig. 7.4, the AD1 curve shifts downward left to AD2). The fall in aggregate demand results in a drop in current (real) GDP by Y = Y1 − Y2. This loss is not a temporary deviation from equilibrium (compare with the neoclassical interpretation of contraction illustrated in . Fig. 7.3). In the Keynesian interpretation (price P1 remaining constant), the shift in equilibrium from E1 to E2 causes cyclical (forced) unemployment. Amid underemployment and stable prices, the return to the initial equilibrium E1 could take long. The market operates at the underemployment equilibrium E2 until investors’ expectations change.

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. Fig. 7.4  Keynesian interpretation of economic contraction. Source Authors’ development

The state must intervene in the market through increased government expenditures and/or tax cuts to accelerate recovery. Such an intervention spurs effective demand and shifts the equilibrium closer to the point of full employment (ideally, the market returns to E1 or even goes beyond the initial equilibrium). According to Keynes, the most significant effect is brought by government investment in fixed capital, which compensates for the fall in private investment. Summarizing the Keynesian interpretation of an economic cycle, let us note the fundamentals. The level of actual GDP Y is determined by effective demand (the interaction of aggregate demand and potential GDP Y ∗). Therefore, macroeconomic fluctuations (deviations of Y from Y ∗) are caused by endogenous factors (disbalances in aggregate demand, primarily investment demand). Since market mechanisms fail to ensure full employment of resources, the government should stabilize the equilibrium by keeping effective demand at the level of full employment (see 7 Sect. 7.5 for the stabilization policy). The marginal efficiency of capital, marginal propensity to consume, and interest rate serve as starting points to explain cyclical fluctuations in the economy. 7.2  Types of Economic Cycles

As shown in 7 Sect. 7.1, both the essence of an economic cycle and the factors that determine market fluctuations are subjects to conflicting interpretations. However, it is possible to identify some general trends in economic development both in the short term and over the extremely long-term horizon. The longer the cycle time, the more debatable its very existence. In particular, as demonstrated in 7 Sect. 7.2.4 below, many economists question the existence of Kondratiev waves (45–60 years), not to mention extremely long Forrester waves and Toffler civilization shifts (. Fig. 7.5). Therefore, this section focuses on discussing the four most commonly accepted types of economic cycles, such as Kitchin cycles (7 Sect. 7.2.1), Juglar cycles (7 Sect. 7.2.2), Kuznets cycles (7 Sect. 7.2.3), and Kondratiev cycles (7 Sect. 7.2.4).

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. Fig. 7.5  Types of economic cycles. Source Authors’ development

7.2.1  Kitchin Inventory Cycles

The Kitchin cycle is named after its discoverer, British entrepreneur and statistician Joseph Kitchin. He identified short-term fluctuations in markets in the process of studying business activity data in the USA and the UK in the late XIX and early XX centuries (further reading: “Cycles and Trends in Economic Factors”1). A distinctive feature of Kitchin fluctuations is the short cycle time, which ranges from one year to a maximum of five years (commonly in the literature—2–4 years). The macroeconomic theory assumes the Kitchin cycle to be an integral component of longer waves, such as Juglar cycles, Kuznets cycles, and Kondratiev cycles (see below in 7 Sect. 7.2). Kitchin himself explained the existence of short-term cycles by fluctuations in world reserves of gold. In the modern interpretation of the Kitchin theory, the emergence of cycles is associated with delays in receiving feedback from the market (time lags) that affect the decision-making and behavior of producers. That is, producers start responding when

1

Kitchin (1923).

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. Fig. 7.6  Kitchin inventory cycles. Source Authors’ development

the strength of the contributing factor is already fading. Due to the time lag, the most significant impact of such reactionary measures is observed when the market no longer experiences the action of the initial contributing factor (. Fig. 7.6). For instance, producers react to the rise in aggregate demand by increasing the employment of resources and utilization of capacities. The resulting greater supply floods the market with goods. As the market fails to absorb the excess supply, producers increase stocks. The decision to cut output is made with an unavoidable delay due to the time lag in the exchange of information between producers and consumers (checking the information and making the decision also take time). In addition, there is an inevitable delay between making the decision and the actual changes in production (in some industries, adjustments in production take rather long). Also, there is a time lag between the reduction of output and the actual absorption of stocks by the market. Case box Kitchin cycles are commonly interpreted as those peculiar to individual markets and industries. One of the examples is animal husbandry. Rising demand for meat due to the increase in the purchasing power of the population causes a deficit on the market. Prices go up. There emerges an imbalance between growing demand and stable supply. Evidencing higher prices, farmers respond to a rise in demand by expanding production capacities (building new stalls for animals, increasing livestock population, purchasing animal feeding stuff and medicines, hiring staff, etc.). However, in animal husbandry, it is impossible to increase output in a short time. Raising animals takes several months (pigs) or even years (cattle). Gradually, the market gets saturated, and prices fall, but farmers cannot scale back production in a short time. As a result, when the livestock population is reduced, the demand for meat may rise again on the market—a cycle repeats. The livestock sector is one of the most demonstrative examples, but lags in producers’ reaction to information received from the market happen in many industries.

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The short-term cyclicity happens due to market asymmetries and lack of relevant information about market conditions (see 7 Chap. 10, 7 Sect. 10.3 for asymmetrical information as a type of market failure). Producers fail to know for sure what factors prevail in the market at a certain point in time. This information reaches them with a delay. Producers adjust the output in accordance with the information received, but at that particular time, the market situation may change again. Thus, short cycles occur due to the inability to obtain up-to-date information in a timely manner. 7.2.2  Juglar Fixed-Investment Cycles

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The Juglar cycle is twice as long as the Kitchin cycle (7–12 years). The cycle was discovered in the 1860s by Clement Juglar when studying fluctuations in industrial production in France, the UK, and the USA based on the fundamental analysis of changes in interest rates and prices. The fluctuations coincided with investment cycles, which in turn caused changes in GNP, inflation, and employment (further reading: “Des crises commerciales”2). Case box An illustration of Juglar cycles is global crises in the period between the two world wars in the first half of the XX century, such as alternating economic, industrial, and financial crises of 1920–1921, 1929–1933, and 1937–1938 (see below in 7 Sect. 7.3). In 1939, Joseph Schumpeter identified eleven Juglar cycles for the period from 1787 to 1932 (further reading: “Business Cycles”3).

In essence, the Juglar cycle is the same Kitchin cycle, but with the addition of fluctuations in investment. Unlike the Kitchin cycle, the Juglar cycle considers fluctuations in the volume of investment in fixed assets, not only changes in capacity utilization and stocks. Investments in fixed assets do not occur instantly but require a particular time to make an investment decision, establish new production facilities, and put them into operation. That means that in addition to time lags inherent in the Kitchin cycle, Juglar introduces time lags associated with making investment decisions and implementing investment projects. This increases the cycle time. The complete Juglar cycle consists of four stages with two phases in each stage (. Fig. 7.7). The output starts growing at the recovery stage ([A; B] segment in . Fig. 7.7). This stage is conditionally divided into two phases: start (the initial impetus caused by making a decision to expand production) and acceleration (further growth in output amid first injections of investments).

2 3

Juglar (1862). Schumpeter (1939).

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. Fig. 7.7  Juglar fixed-investment cycles. Source Authors’ development

At the upswing (prosperity) stage ([B; C] segment), investments gain full strength, and output growth continues. In the growth phase, output increases to the extent that it meets the existing demand (before the intersection of the supply and demand curves). In the overheating phase, the growth in both output and investment goes on, but demand stagnates. As a result, producers are forced to increase stocks in warehouses. At the recession stage ([C; D] segment), investments are no longer needed. Demand falls. In the collapse phase, production costs surpass revenues received from selling goods. In the recession phase, producers radically cut both investments and production capacity. At the depression (stagnation) phase ([D; E] segment), producers do not invest. Output continues falling while producers spend stocks. In the stabilization phase, demand is fully satisfied with the current level of supply and available stocks. Stocks are almost spent in the transition phase, while supply is still too low to meet future demand. This potential gap between low supply and reviving demand establishes the basis for new investments in production, and a cycle restarts with the new recovery ([E; F] segment). Case box About twelve years have passed between the previous global economic recession in 2008–2009 and the economic crisis of 2020–2021. On the one hand, this timing fits perfectly the Juglar cycles chronology. On the other hand, the 2020–2021 crisis is caused by the COVID-19 pandemic rather than endogenous economic factors. However, some parameters of the global economy in the pre-pandemic period reflected possible onset of economic recession in Juglar’s interpretation—imbalances of supply and demand in a number of markets, a decrease in the return on investment, an increase in inventories, and a slowdown in the growth rates of the world’s leading economies. So, it is likely that an economic recession would have come even in the absence of the pandemic. Nevertheless, the pandemic has dramatically exacerbated the existing problems and dramatically turned the emerging recession into a deep crisis.

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Juglar’s theory explains both the cyclicity and frequency of crises in the global economy, as well as it helps governments and businesses prepare for them. All economic cycles are interconnected (shorter cycles are integral elements of longer cycles, while the latter are part of super long economic waves). The Juglar cycle is no exception. It includes short-term Kitchin cycles, and at the same time, it is incorporated in longer Kuznets cycles and Kondratiev waves. 7.2.3  Kuznets Infrastructural Investment Cycles

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The Kuznets cycle lasts about 15–25 years. The cycle is named after Simon Kuznets, an American economist and the 1971 Nobel Memorial Prize winner, who first presented his interpretation of economic cycles in 1930 (further reading: “Secular Movements in Production and Prices”4). Kuznets associated economic waves with demographic processes, particularly the influx of immigrants and related changes in the construction industry. He called the waves “demographic” or “construction” cycles. In the Kuznets interpretation of an economic cycle, four stages are more or less similar to those composing both Juglar and Kitchin cycles. However, the following features distinguish the Kuznets’ interpretation of expansion, peak, contraction, and trough: 5 At the expansion stage, demand for labor grows, unemployment declines, and consumer demand rises. An increasing expansion of output characterizes steady growth. Gross domestic product increases. 5 The peak is the highest point of economic recovery, at which employment, GDP, and other vital macroeconomic parameters reach their maximum values. At the peak point, output growth freezes. 5 The contraction stage follows the peak with a decrease in the values of the key macroeconomic parameters. The drop accelerates as contraction deepens. 5 At the trough stage, similar to the peak stage, output growth freezes, but amid high unemployment, low demand for goods, and bankruptcies of businesses. At this stage, the economy adapts to new conditions. The recovery relaunches a next spiral of an economic cycle. Kuznets applied the concept of an economic cycle to studying national income (further reading: “Economic Growth and Income Inequality”5). In the pre-industrial era (point A in . Fig. 7.8), inequality in the economy increases with economic growth. Initial industrial modernization ([A; B] segment) results in a sharp rise in inequality in income distribution. In mature industrial economies ([B; C] segment), inequality tends to decrease until it balances at some steady longterm level. This pattern is true not only for developed countries, but also for

4 5

Kuznets (1930). Kuznets (1955).

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. Fig. 7.8  Kuznets infrastructural investment cycles. Source Authors’ development

developing countries and traditional societies embarking on the path of industrial growth and modernization (see 7 Chap. 16 for a detailed discussion of the role of modernization in economic growth). Case box Countries differ in the degree of income differentiation (see 7 Chap. 14, 7 Sect. 14.5 for a comprehensive discussion of inequality). In industrialized economies, inequality reached its maximum at the beginning of the XX century. During the 1920–1950s, in most of developed countries, income inequality gradually smoothed. Some economists argue that differences between countries in terms of income distribution depend primarily on peculiarities of economic development over a long period of time (history, traditions, the evolution of policies, etc.). Thus, during the capitalist modernization in the 1960–1970s, income differentiation became higher in Latin America than in Southeast Asia, where rapid economic growth coincided with decreasing inequality in income distribution.

Kuznets also paid much attention to studying economic growth. He highlighted six characteristics of economic growth peculiar to highly developed economies: 5 High growth of per capita income. Income growth in developed economies exceeds the rate of population growth. 5 High growth of performance of factors of production, that affects the growth of per capita income. Achieving high efficiency is impossible without the introduction of technological innovations into production. It radically improves the employment of labor and other factors of production. 5 Structural transformation of the economy. This primarily concerns the migration of labor from agriculture to the industrial sector. The current trend is the migration of labor from the industrial sector to the service sector. Urbanization substantially changes the economic environment.

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5 Political, social, and ideological transformation. 5 Internationalization of economic recovery due to the expansion of markets by developed countries and the use of cheaper resources and labor in developing economies. 5 Limited dissemination of the results of economic recovery. Until now, the distribution of income across the world remains highly unequal. The gap in the living standards between countries and population groups within countries is quite large (see further in 7 Chap. 14, 7 Sect. 14.5). Today, Kuznets cycles are considered technological (infrastructural) cycles distinguished by the massive renewal of essential technologies. In this interpretation, they are assumed to be constituent elements of long Kondratiev waves.

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7.2.4  Kondratiev Waves

Kondratiev cycles last about 45–60 years. The theory was developed in the 1920s by Nikolai Kondratiev, a Russian economist, who studied long-term cycles in Western developed economies. He drew attention to cyclical fluctuations in the long-term dynamics of some economic parameters (further reading: “The World Economy and Its Conjuncture during and after the War”6). The following four patterns determine the existence of long waves in the economy: 5 Expansion is preconditioned by cardinal and fundamental changes that affect the economic environment and production patterns. For example, they can be caused by introducing inventions and innovations into production, the rise of new global leaders (countries, companies) in the market, or changes in money circulation and supply of money. 5 Expansion intervals of long waves are accompanied by dramatic turning points, such as wars or revolutions. 5 Contraction intervals of long waves are accompanied by a protracted depression in the agricultural sector. 5 The dynamic sequence of long waves is similar to that in the medium-term and short-term fluctuations occurring in the economy. That is, Kondratiev waves pass through the same stages of expansion (improvement), peak (prosperity), contraction (recession), and trough (depression). Key macroeconomic indicators, such as GDP, are used to identify cyclicity. Economists commonly associate long Kondratiev waves with changes in technological paradigm. Inventions of new technologies and breakthrough approaches to production transform industries and the entire structure of the economy (. Fig. 7.9).

6

Kondratiev (1922).

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. Fig. 7.9  Kondratiev waves. Source Authors’ development

At the expansion stage ([A; B] segment), inventions and innovations developed at the previous stage are introduced into production. Prices grow along with interest rates. Peak B is the highest point of the cycle. Kondratiev argued that many wars and cataclysms of the past occurred at the peak stage. They were associated with increases in government procurements and military spending, i.e., rises in the domestic product. At the early phase of contraction ([B; C] segment), output could continue growing due to the prolonged effect of investments made at the peak, but the growth rate slows down. The economy is overheated, while the market is saturated with excessive supply. Interest rates fall, and prices stop growing (deflation could occur). Trough D is the lowest point of the cycle called depression. At this stage, GDP stagnates or even falls. Extremely low interest rates do not stimulate demand for money. Inflation is also low, but consumer demand does not grow. Depression is the hardest time of the cycle. However, during this period, the economy recovers, adapts to new conditions, and prepares for another breakthrough. Many of innovative approaches and new solutions invented during crisis years then brought the economy back on track. Case box The six-wave periodization of Kondratiev waves presented in . Fig. 7.9 is debatable. There is no consensus on the starting point of stage VI. However, such extremely long cycles can hardly have a clearly defined beginning or end. It is evident that the fifth wave of the information community is gradually being replaced by the dominance of biotechnologies, nanotechnologies, the development of artificial intelligence technologies, and other groundbreaking innovations. The healthcare industry is making significant progress. The COVID-19 pandemic has only increased the attention of researchers and the community to innovations in medicine and healthcare.

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Stages defined by Kondratiev and further integrated with alternating technology patterns by other economists could be summarized as follows: 5 Stage I (1780–1830)—the invention of a steam engine, use of coal, industrial production of cotton and textiles. 5 Stage II (1830–1880)—coal mining, industrial production of steel and other metals, construction of railways. 5 Stage III (1880–1930)—electricity, development of heavy engineering and electric power industries, discoveries in inorganic chemistry, production of steel and electric engines. 5 Stage IV (1930–1970)—oil and gas, automobiles, internal combustion engines, growth of oil refining companies, further development of the chemical industry, establishment of mass production. 5 Stage V (1970–2010)—information technologies, electronics and microelectronics, robots, computers, lasers, telecommunications. 5 Stage VI (2010—present time)—biotechnologies, nanotechnologies, medicine, cognitive technologies, artificial intelligence. Case box The very existence of Kondratiev waves is highly controversial to many economists. Indeed, is it worth assuming that the technology patterns identified in the XIX century are still relevant today? Technological progress is accelerating. In the XXI century, the transition to a new technological stage of development takes years, not decades. Kondratiev cycles shorten and will continue shortening in the future. Some economists predict that cycle time will soon reduce to only 10–15 years. The onset of the so-called technological singularity will transform the entire relationship between technologies and economic development. The technological progress will affect economic growth not in stages (from one breakthrough invention to another), but permanently on the basis of convergence of nanotechnologies, biotechnologies, information, and cognitive technologies. If this hypothesis is true, then Kondratiev cycles may end in the 2040–2050s.

Despite the importance of the cyclical development of society revealed by Kondratiev, the model only studies the system’s behavior with fixed parameters in a closed environment. Such theoretical constructions may fail to answer questions related to the nature and behavior of the system under study. Macroeconomic analysis should also capture aspects associated with the genesis of the system and its components. Such a comprehensive approach allows economists to reveal the causes of a particular type of system’s behavior depending, for example, on the external environment. In view of the new normal economic reality, this approach is crucial for understanding the nature of crises and translating past experiences onto ongoing economic and social turbulences.

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7.3  Crises of the Modern Age: From the Great Depression to the

COVID-19

From the discussion of different approaches to understanding fluctuations, one can see that economic cycles are not truly cyclical in the sense that interpretations of cycle length vary. For instance, as argued in 7 Sect. 7.2.4, one of the novel interpretations of Kondratiev long waves suggests the shortening of the oscillation period over time. Nevertheless, against the background of various interpretations of cycles, certain trends can be distinguished in the cyclical change of periods of growth and recession of the world economy. Crises have been accompanying people since long ago. In the XVIII century, there were crises of underproduction in agriculture. In the XIX century, first industrial crises were caused by disbalances between industrial production and demand. Before the XX century, economic crises hit individual countries, but since the early 1900s, they have been spreading globally. The international community of countries has elaborated mechanisms to prevent global crises, such as government regulation of markets, international financial and trade organizations, continuing monitoring of economic and social processes, and many more. However, predicting and avoiding crises is still hardly possible. In modern times, Europe, the Americas, Asia, and the world have faced dozens of crises, and they continue facing them. Due to the extremely tight interconnectedness of markets and countries in the world economy, crises are caused by a combination of many exogenous and endogenous factors. They easily spill over to interrelated industries and economies worldwide. Nevertheless, some common features allow economists to distinguish structural crises (7 Sect. 7.3.1), agrarian crises (7 Sect. 7.3.2), financial crises (7 Sect. 7.3.3), monetary crises (7 Sect. 7.3.4), and stock market crises (7 Sect. 7.3.5). 7.3.1  Structural Crises

Structural Crisis is a long-term non-cyclical phenomenon expressed in the decline of individual industries or groups of industries (sectors) of the economy that violates the key macroeconomic proportions. Structural crises are generated by deep disproportions between the development of individual spheres and sectors of the economy. Structural downturns can last for so long that they cover several consecutive economic cycles. They involve fundamental shifts in markets and deep transformations of production (for instance, on the basis of new technologies) and consumption (change in living standards or consumer behavior) patterns. Structural crises manifest themselves in either underproduction or overproduction (or a combination of both in different markets). Structural crisis can be in sync with the economic cycle or run counter to it. Structural crises first showed up in developed countries in the 1970s. One of the worst structural crises occurred in 1973–1975, when the Organization of the Petroleum Exporting Countries (OPEC) raised oil prices and thus aggravated the economic downturn that began in 1974 with a structural crisis in the global oil

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market. In the USA, industrial production dropped by 13% (Germany—22%, Japan—20%, Italy—14%, France—13%, the UK—10%), stock prices plummeted by 33% (the UK—56%, France—33%, Italy—28%, Japan—17%, Germany—10%), and the number of bankruptcies increased by 6% (the UK—47%, Japan—42%, Germany—40%, France—27%). In 1975, the number of unemployed people across developed countries reached fifteen million people. Over ten million people were transferred to part-time jobs or temporarily dismissed. Disposable income decreased substantially. The crisis broke out amid the Arab–Israeli conflict when several OPEC member states imposed the oil embargo against countries that supported Israel. Oil output fell sharply. On October 16, 1973, oil price skyrocketed by 67% from $3 to $5 per barrel in just one day. During 1974, oil prices rose from $3 to $12 per barrel. The oil crisis hit the USA the hardest. For the first time, the country faced a shortage of oil. US President Richard Nixon called on fellow citizens to avoid using cars when possible. Government agencies were advised to save energy and reduce the fleet of vehicles, while airlines were ordered to reduce the number of flights. The energy crisis seriously affected Japan. The country increased the import of coal and liquefied natural gas and accelerated the national nuclear program. 7.3.2  Agrarian Crises

Agrarian Crisis relates to the relative overproduction of agricultural products and the accumulation of substantial unsold stocks. As a result, the indebtedness of farmers grows, many of small- and medium-size producers turn bankrupt. Agrarian crises are commonly caused by a combination of natural factors, disbalances in the labor market and organization of labor in the agricultural sector, technical and technological backwardness of agricultural producers, irregularities in land use and land tenure, and other factors related to agricultural production. Agrarian crises inhered the world economy for about a century from the 1870s to the 1970s. The first agrarian crisis erupted in 1873 and lasted until the mid-1890s. It struck Western Europe, Russia, and the USA. The reduction of transportation costs due to the development of maritime transport and the expansion of the railway network in Europe lowered prices of grain supplied to European countries from the USA, Russia, and India. In the USA, production costs in crop farming were substantially lower than in Europe due to the large acreage of free fertile land available for cultivation in central and western parts of the country. Russia and India, large agricultural producers, also increased their exports to Europe. Landlords and farmers in Europe could not withstand the competition due to higher costs and higher rents inflated by large landowners. After the World War I, an acute agrarian crisis broke out in 1920 amid a radical reduction in purchasing power and living standards in Europe. It struck Europe and spilled over to the USA, Canada, Argentina, and Australia. The market had not yet recovered from the first crisis when the new one emerged in 1928 in Canada, the USA, Brazil, and Australia. It

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engulfed leading capitalist economies and the largest exporters of agricultural raw materials and food. The crisis concurred with the industrial crisis of 1929–1933 (see 7 Sect. 7.3.5) and lasted until the beginning of the World War II. The third agrarian crisis began after the World War II. In the mid-1950s, it spread globally and hit almost all countries worldwide. The following main reasons explain the protracted nature of agrarian crises in the first half of the XX century. First, the monopoly of private land ownership forced tenants to continue paying land rent during the crises. When prices of agricultural commodities fall, land rent is paid by further lowering the wages of farmworkers and profits. Due to such burdening fixed costs, it is difficult to get out of a crisis by introducing improved technology and reducing production costs. Second, until the mid-1950s, agriculture was less developed compared to industrial production. As previously argued in 7 Sect. 7.2, peculiarities of cyclicity are mainly determined by investments in fixed capital. In agriculture, fixed capital played a relatively modest role compared to the industrial sector. Thirdly, during crises, small producers seek to maintain their output and even produce more to not lose crops as their only source of income. This further aggravates the overproduction problem. By the early 1970s, the crisis of overproduction had changed into the underproduction of agricultural products in many countries, particularly across the developing part of the world. Today, food shortages, hunger, and malnutrition are recognized among the most pressing global problems. Addressing the hunger problem and ensuring food security for all countries and people worldwide is emphasized as one of the United Nations Sustainable Development Goals to be achieved by 2030 (see 7 Chap. 18 for the UN Sustainable Development Goals). 7.3.3  Financial Crises

Financial Crisis is a sharp decline in the value of financial instruments. Monetary crises and stock market falls are varieties of financial crises (further discussed in 7 Sects. 7.3.4 and 7.3.5, respectively). A typical financial crisis is characterized by a sharp increase in interest rate, a rise in a portion of troubled banks and nonbank financial institutions, as well as problem debts, a cut in lending, and an increase in bankruptcies. In addition, there happen large-scale drops in prices of securities and delays in payments. The first financial crisis that synchronously hit the USA, the UK, Germany, and France dates back to 1857. It started in the USA with mass bankruptcies of railway companies that resulted in the stock market crash. The latter provoked the crisis of the banking system. That same year, the crisis spilled over to the UK and then entire Europe. Finally, the wave of stock market fluctuations swept across Latin America and other parts of the world. In 1873, the financial crisis broke out in Austria and Germany. It was preconditioned by the expansion of the lending market in Latin America fueled by capital inflows received from the UK. The speculative upturn in the real estate

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market in Germany and Austria also played its role. The market rally in Austria and Germany ended with the stock market crash in Austria that caused crashes across financial centers in Europe (Zurich, Amsterdam). German banks refused to roll over credits previously provided to US banks, and thus the crisis spread to the USA and other countries. The 1914 financial crisis was triggered by massive sold-out of foreign securities by the USA, the UK, France, and Germany, who needed money to increase their military expenditures amid heating up World War I. Unlike other downturns that tend to spread from a few ignition sources, the 1914 crisis broke out almost simultaneously in several countries after the warring parties started liquidating their foreign assets. That led to a collapse in both commodity markets and money markets. At that time, the panic in the banking sector in the USA and the UK was brought under control by substantial money interventions made by central banks. However, after the war, the downturn resumed in 1920–1922 amid simultaneous post-war deflation and recession in European countries (the UK, Italy, the Netherlands, Finland, Norway, Denmark) and the USA. 7.3.4  Monetary Crises

Monetary (Banking) Crisis is a situation when banks face a sudden ­withdrawal of deposits by depositors. Since banks use most of the funds received as ­deposits for lending, it is not easy to repay deposits immediately. Therefore, a mass ­withdrawal of deposits can turn into a bankruptcy of a bank, resulting in ­customers losing their deposits in an amount not covered by insurance. Banking ­crises could be either cyclical or non-cyclical. The latter are commonly caused by exogenous non-economic events rather than endogenous economic factors (for instance, chronic budget deficits, crop failures, wars, violations in the monetary system caused by the insolvency of credit legislation, etc.). Examples of mass withdrawals from banks are the 1931 banking crisis in the USA and the withdrawal of deposits from Northern Rock Bank in 2007. In 1997–1999, many countries, primarily the fast-growing economies of Asia, faced the Asian financial crisis. It was accompanied by a rapid collapse of national currencies and stock indices. It took major Asian economies several years to recover from that fall. Banking crises are commonly associated with periods of risky lending as they result in the non-payment of loans. In 2008–2009, real estate bubbles in the mortgage market in the USA triggered the global financial crisis and economic recession throughout the world. Some experts believe that the world economy has not entirely recovered from the 2008–2009 crisis. At that time, disbalances in monetary systems were smoothed by significant injections of money, whereas structural imbalances remained. For instance, the 2010–2013 debt crisis that spread across EU member states originated in Greece’s bond market in 2009. The downturn was accompanied by a decrease in the credit ratings of European countries and the inability to obtain new loans. The 2020 crisis unraveled many of those structural problems of the past (see below in 7 Sect. 7.3.6).

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7.3.5  Stock Market Crises

Stock Market Crisis is a sharp drop in securities prices due to an excessive supply of securities. One of the worst stock market crises in modern history was the Great Depression that started in the USA in 1929 and then emerged into a fullscale global financial crisis, industrial decline, and mass unemployment in many countries, including Canada, the UK, France, and Germany. Certain crisis phenomena in the US economy were observed long before the stock market crash of 1929. In the 1920s, the country was developing rapidly (national income rose from $32.0 billion in 1913 to $89.7 billion in 1927). Despite the fact that the economic cycle had reached the contractionary stage, the speculative bubble was emerging. Stock value tripled in seven years. About 30 million people (25% of the population) were involved in stock exchange dealings. The supply of money in the market increased by over 60%. The boom in consumer spending coincided with the expansion of consumer lending and installment sales. At the same time, sales of essential consumer products had been falling since 1926. Production of automobiles decreased. The construction sector shrank. To stimulate economic growth, the Federal Reserve System gradually reduced the interest rate from 6.5% in 1921 to 4.0% in 1926 and then 3.5% in 1927. The injection of money into the economy was reduced shortly before the crisis broke out. At the same time, the growth of the unsecured supply of money continued due to the issuance of bills of exchange, promissory notes, and depository receipts. On October 24, 1929, most of the banks changed the rules for granting loans to brokers. The loan term was reduced to one day until the closing of a trading session. Therefore, traders were forced to sell securities at any price at the end of the session to repay their loans. On October 29, 1929 (Black Tuesday), brokers sold 16.4 million securities. During one trading session, the market capitalization fell by $10 billion (about one-eighth of the domestic product at that time). The crash spilled over to other markets. Prices of wheat, cotton, and many other agricultural products and consumer goods dropped dramatically. In three weeks, the loss grew to about $30 billion, or one-third of GDP. Loans backed up by securities and real estate turned into bad debts. Banks clamped down on loans, which caused a flurry of bankruptcies across the country. There began the mass closure of banks and financial institutions unable to pay off their depositors. The economy plunged into a recession with deflation and unemployment. Prices fell by 23% in 1929–1932 and then by another 4% in 1933. Over four million people lost their jobs in 1930. By 1932, unemployment had risen to 10% and then to almost 20% by 1933. People suffered from malnutrition, while some studies reported up to five million people to die of starvation. To stimulate investment in industrial production, the government launched programs of emergency public and construction works, loans, and assistance to farmers. The established National Recovery Administration (NRA) regulated prices, wages, working hours, conditions for providing bank loans, producing essential products, and other economic parameters. The export of gold was banned. During 1933–1937, a total of $12 billion was appropriated to the Public Works

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Administration (PWA) to spur consumer demand by providing state-funded employment opportunities for people (construction of highways, dams, bridges, public buildings, etc.). Some signs of recovery appeared only in 1937. GDP almost reached the level of 1929, and unemployment declined. The contraction stage plateaued and turned into stagnation, which lasted for several more years. The proponents of the Keynesian theory argue that the Great Depression was preconditioned by a shortage of money supply. At that time, currencies, including the dollar, were pegged to gold. The rapid growth of mass production in the 1920s was not sufficiently supported by limited gold reserves, i.e., not backed up by means of exchange. The New Deal economic policy instituted by Franklin Roosevelt was based on the Keynesian approach to stimulating aggregate demand through public works projects, payments to people, government intervention in the market, and strict regulation of markets. Contrary to Keynesian economists, the Neoclassical school blamed the Federal Reserve System for mismanaging the monetary market. The money supply should have increased with the growth of production and decreased with its decline, while in the late 1920s, the Federal Reserve was adopting a diametrically opposite policy. The Great Depression left an indelible mark on the future of the global economy. The consequences for the USA and the world were so severe that the interpretation of the role of the government in the economy has changed. The Keynesian school has gained prominence. Since then, the use of monetary, fiscal, and other policy instruments has emerged as an approach to smoothing out economic cyclicity, mitigating the effects of economic contraction, and counteracting overheating in markets (see 7 Sect. 7.5 in this chapter for stabilization policies, as well as 7 Chaps. 10, 11, and 13 for various instruments of government regulation of unbalanced markets). 7.3.6  Modern Crises of Economic Transformation

In the 1980–1990s, many countries worldwide experienced economic decline amid market transformations (the so-called transition economies of Eastern Europe, the former Soviet Union, and Asia). Those crises were non-cyclical. Still, they were triggered by endogenous factors, such as the transition from the centrally planned economy to the market economy and the competition-based exchange and distribution of resources. In the era of globalization, the synchronization of cyclical fluctuations across developed, developing, and transition economies is particularly manifested. It is facilitated by the internationalization of markets and production, the increased dependence of all countries on foreign trade, the emergence of transnational corporations as major drivers of internationalization, the reduction of tariffs and other customs barriers in trade within and between various integration associations, and the decrease in quantitative restrictions on imports of a variety of consumer and industrial goods and food and agricultural products (although in recent years, including amid the COVID-19 outbreak, trade tensions have arisen globally) (see 7 Chap. 22 for the discussion of liberalization and protectionism, particularly, 7 Sect. 22.4 for the rise in trade

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protectionism during the COVID-19 crisis). Due to the growth of interconnectedness of markets and countries, cyclical economic crises intertwine with equally damaging structural disbalances in individual markets (oil, food, energy, raw materials), as well as disproportions the international division of labor, inequality between countries, and environmental problems. Such tighter interconnectivity has expressed itself during the economic downturn that started in 2020 due to the COVID-19 outbreak. In some markets, as well as in the financial sphere, foreboding precursors had been observed in 2018–2019, well before the pandemic ruined production chains and transboundary exchanges in 2020. For all countries, the pandemic-induced decline has become one of the most severe challenges they faced in recent decades. In this regard, many experts acknowledge the emergence of the new normal reality to which all sectors of the economy and all spheres of social relations must adapt. The 2020–2021 pandemic crisis can be referred to as a new form of transformational crisis. There have been radical transformations in the economy, finances, healthcare, and labor market, but not only these areas. The COVID-19 pandemic has already transformed the habits and behavior of people, businesses, and governments worldwide. Value chains, logistics, consumption patterns, consumer preferences, marketing and production strategies of transnational companies, and risk management practices are all being actively transformed and optimized for new normal conditions (see 7 Chap. 18 for the discussion of the new normal challenges of economic development related to the COVID-19 pandemic, 7 Chap. 21, 7 Sect. 21.5 for the new normal trends in international migration of labor, 7 Chap. 22, 7 Sect. 22.4 for the new rise in protectionism, and 7 Chap. 23 for the new normal globalization and regionalization). 7.4  Equilibrium Determinants 7.4.1  Approaches to Interpretation of the Equilibrium

Determinants

Previously in this chapter, we have repeatedly referred to endogenous and exogenous factors that could disturb fundamental macroeconomic proportions and trigger market fluctuations. The following three approaches to interpreting the determinants of macroeconomic disequilibrium have emerged so far: 5 Exogenous factors. From this point of view, an economic cycle is a result of fluctuations (or rather a one-time effect) of external factors: military conflicts, civil tensions, migration, scientific discoveries and inventions, changes in oil prices, discoveries of large deposits of natural resources, natural disasters, etc. 5 Endogenous factors. A cycle is considered a phenomenon inherent in the economic system. Over time, the same factors can lead to both a downturn and a rise in business activity. Cyclical renewal of fixed capital is one of the decisive determinants of alternating fluctuations in the economy.

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. Table 7.1  Interpretations of determinants of macroeconomic equilibrium and economic cycles

7

Theories

Cyclicity determinants

Monetarism

Disbalances in the money market

Rational expectations theory

Unexpected changes in money circulation

Real business cycle theory

Shocks in the economy, in particular, shock changes in production efficiency

Political business cycle theory

Monetary and fiscal policy of the government

Theory of overaccumulation of capital

Disproportions in production, such as overproduction of capital

Theory of underconsumption

Decrease in consumption as a consequence of falling income

Psychological theory

Sentiments of economic agents and expectations of changes in the market

Source Authors’ development

5 Interaction of exogenous and endogenous factors. Changes in exogenous factors trigger fluctuations of endogenous parameters (for example, government policy aimed to smooth cyclical fluctuations). At large, equilibrium (cyclicity) determinants include such factors as periodic depletion of autonomous investments, strengthening and weakening of the multiplier effect, fluctuations in the supply of money, and the renewal of capital goods. However, different economic schools and individual theories emphasize different causes of cyclical fluctuations (. Table 7.1). According to the Monetary Theory, an economic cycle is determined by monetary factors only. When demand for goods expressed in money increases, trade revives, production expands, and prices rise. When demand decreases, trade weakens, production declines, and prices fall. Non-monetary exogenous factors such as natural disasters, military conflicts, or social events can result in the decline in living standards and depress certain industries, but they can not cause the overall economic recession. In its interpretation of cyclicity determinants, the Rational Expectations Theory is close to monetarism. It states that macroeconomic fluctuations are caused by monetary shocks, but only unexpected ones. For example, if economic agents foresee an increase in the supply of money, such an expectation only leads to an increase in prices, not real domestic product. Thus, the theory of rational expectations nearly denies the regularity of macroeconomic fluctuations. The interpretation of the role of economic policy coincides with that accepted in monetarism: the macroeconomic stabilization policy of the government cannot affect the economy (real GDP) in the long term, since economic agents foresee the results of the policy. Their natural reactions in the market blunt the effectiveness of government interventions.

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The Real Business Cycle Theory assumes real shocks in the economy to be the sources of macroeconomic fluctuations. The most influential are shocks in productivity that shift the aggregate supply curve (as previously discussed in 7 Chap. 5, 7 Sect. 5.2.2). Fluctuations in aggregate supply are caused by technological shifts, changes in fashion and tastes, climate change, government regulations, including changes in fiscal and monetary policy. They all affect productivity in either direct or indirect ways. If changes and shocks are permanent, they affect the long-term economic development trend Y ∗. If they are temporary, they cause cyclical fluctuations in the economy. The Political Business Cycle Theory assumes the government triggers macroeconomic fluctuations by implementing certain monetary and/or fiscal measures. The government is expected to have complete control of these two macroeconomic policy instruments. The actions of politicians are aimed at winning votes, because politicians want to be re-elected. Thus, the government tends to pursue tighter and less popular monetary and fiscal policies in post-election periods rather than just before elections. In case a downturn happens in a pre-election period, softer macroeconomic policies are applied. Thus, the cyclicity coincides with the frequency and duration of election periods (about five years). The Theory of Overaccumulation of Capital states that economic development goes faster in sectors that produce industrial products than those that manufacture consumer goods. At the same time, the former are much more exposed to the cyclicity impacts than the latter. At the expansion phase of the economic cycle, the output of industrial products grows faster than the production of consumer goods, while during contraction, industrial sectors fall deeper compared to more flexible consumer markets. Such a disproportion between the sectors within the economy can disbalance the course of economic development. Industries that produce capital-intensive goods develop faster. It is the real imbalance in the structure of production, and not just the lack of money supply that causes crises. According to the Theory of Underconsumption, cycles are triggered by disbalances between production and consumption due to different propensities to save and propensities to consume (previously discussed in 7 Chap. 6, 7 Sect. 6.3) inherent to individuals and businesses at a particular time. There have been suggested various interpretations of underconsumption. The most common version of the theory approaches understanding underconsumption as excessive saving. Economic declines occur when too much of current income is saved and too little is spent in the market. It is the high propensity to save that disturbs the balance between production and consumption. The reason for excessive savings is the uneven distribution of income. Those who receive higher income tend to save, i.e., the majority of savings accrue to the largest companies and wealthiest individuals. If wages could be raised along with the simultaneous equal redistribution of national income, the share of saving in total income would be moderate. To achieve this, income must be distributed evenly, which is hardly attainable in reality. The Psychological Theory outlines the role of expectations of economic agents (motives, behaviors, etc.) in the occurrence of cyclical fluctuations in the economy. The spontaneously arisen optimistic mood quickly spreads among all economic agents through various market and social channels. This contributes to

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speculative inflating of demand, widespread use of bank credit, and unjustified increase in production. The economy deviates from equilibrium. Crises broke out amid mass panic in the market due to rising interest rates, falling prices, and chain reactions of sold-outs and bankruptcies. Contraction can be combated by the emergence of the new wave of optimism in the economy and expectations of economic growth in the near future. 7.4.2  Self-sustaining Fluctuations

7

Since recently, equilibrium-related studies have focused on investigating the permanently non-equilibrium economic systems. Many scholars, including Paul Samuelson, Alvin Hansen, John Hicks, and Roy Harrod, investigated the mechanism of self-sustaining cyclical fluctuations of the economic system. Samuelson demonstrated that under certain circumstances, the interaction of the multiplier and accelerator effects could generate continuous self-sustaining cyclical fluctuations (see 7 Chap. 6, 7 Sect. 6.3.3 for the concepts of multiplication and acceleration). Hansen studied the combined effects of multiplier and accelerator on national income propagation and discovered that increased aggregate income simultaneously stimulates consumer expenditures and investment (the super-multiplier effect). Explorations in this area of macroeconomic analysis have resulted in the proposal of the Multiplier-Accelerator Model, or the Hansen-Samuelson Model (further readings: “Interactions between the Multiplier Analysis and the Principle of Acceleration”7 by Paul Samuelson and “Full Recovery or Stagnation?”8 by Alvin Hansen). The principle of the multiplier-accelerator effect could be explained as follows. An increase in investment by one unit can trigger a more significant rise in the domestic product (national income) (the multiplier effect). In turn, in the future (certain time lag applies), the increased income will cause a faster growth of investments (the accelerator effect). Being a constituent element of aggregate demand, these newly induced more considerable investments will trigger another multiplier spiral. The income will increase again, thereby encouraging producers to expand their investments. As argued previously in 7 Chap. 6, 7 Sect. 6.3.3, both the multiplier and the accelerator can work back. That means the multiplier-accelerator effect can cause a much deeper fall in investment than a decrease in national income or real domestic product. The multiplier-accelerator effect is expressed through the relationship between income, consumption, and investment. To sum consumption C and investment (savings) I is the simplest way to represent income Y (previously demonstrated in 7 Chap. 6, 7 Sect. 6.3). At any period of time t , the value of consumption Ct is expressed as the sum of autonomous consumption Ca and the share of income

7 8

Samuelson (1939). Hansen (1938).

7

251 7.4 · Equilibrium Determinants

allocated to current consumption adjusted to the marginal propensity to consume (MPC) (Eq. 7.1).

Ct = Ca + MPC × Yt1

(7.1)

Accelerator v is the ratio of investment in period t (It ) to the change in national income in previous years (Yt1 − Yt2 ). Then It can be expressed as the sum of autonomous investments Ia and the change in national income adjusted to the accelerator (Eq. 7.2).

It = Ia + v × (Yt1 − Yt2 )

(7.2)

Proceeding from Eqs. 7.1 and 7.2, the multiplier-accelerator model could be expressed as follows (Eq. 7.3):

Yt = Ca + Ia + MPC × Yt1 + v × (Yt1 − Yt2 )

(7.3)

Case box The combination of multiplier and accelerator effects explains the mechanism of medium-term cycles. For example, some exogenous factors (discovery of new lands, technical innovations, etc.) can stimulate the rise in autonomous investments. Increased investments push up domestic product Y . This happens due to the multiplier effect, which depends on the marginal propensity to consume (MPC). In turn, the growth of Y produces new investments, which grow further due to the accelerator effect.

One of the parameters of the economic cycle is its movement (dynamics), i.e., the frequency of fluctuations in the level of income and the cycle trend. Cycle dynamics D can be determined by calculating a discriminant (Eq. 7.4).

D = (MPC + v)2 − 4v

(7.4)

At D > 0, national income Y changes monotonically, while at D < 0, national income Y oscillates. There could be damped oscillations, explosive oscillations, and constant amplitude oscillations depending on different combinations of MPC and v (. Fig. 7.10). At MPC × v < 1, the economy encounters damped oscillations. After experiencing the initial external shock, the oscillations of the real value of national income Y gradually sink down to the equilibrium value Y ∗ (. Fig. 7.10a). At MPC × v > 1 , the economy encounters explosive oscillations (. Fig. 7.10b). At v = 1, the system exhibits constant amplitude oscillations at any MPC values. The amplitude is limited from two sides. Commonly, even explosive oscillations do not go beyond the ceiling represented by potential product Y ∗. This is the supply-side limitation on the amplitude. On the other hand, the fall in national income is limited by negative net investment equal to the value of depreciation. This is the demand-side limitation on the amplitude, since investment is an element of aggregate demand. When hitting the aggregate supply ceiling, the Y curve starts declining and continues falling until it hits the aggregate demand floor. The growth resumes, and the cycle repeats.

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. Fig. 7.10  Economic cycle with different multiplier-accelerator values Note a damped oscillations; b explosive oscillations; c constant amplitude oscillations. Source Authors’ development

Non-equilibrium systems of explosive type (. Fig. 7.10b) are open ­systems with complex interactions with the outside world (exogenous factors) and internal elements and processes (endogenous factors). In explosive systems, equilibrium is natively unstable. Consequently, such systems are predisposed to transition to chaotic fluctuations. For the explosive-like disbalances, the ­stabilization of the floor-ceiling corridor by adjusting the influence of exogenous and endogenous factors is essential, since the responsiveness of the entire system to disturbances depends on the policies implemented by the government and the width of the band the economy is allowed to fluctuate within. 7.5  Stabilization Policies

Stabilization Policy of the government is a set of macroeconomic policy measures aimed at stabilizing the economy at the level of full employment of all factors of production, i.e., the level of potential output. Stabilization economic policy is applied to eliminate the following disparities in the market:

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5 unevenness and cyclicity of economic development; 5 failure of the market mechanism to eliminate emerging disbalances; 5 instability in the economy and society that incurs economic losses to a country; 5 deviation of key parameters from the development trajectory set by the government. The government can intervene in the economy in many ways. The rule is that the government should pursue an expansionary macroeconomic policy to stimulate growth during recessions and a contractionary macroeconomic policy to avoid overheating during recoveries. In other words, stabilization policy seeks to smooth out the amplitude of fluctuations in real GDP Y around the trend line Y ∗ (remember . Fig. 7.1 in 7 Sect. 7.1). To curb inflation and avoid too fast overheating of the economy at the expansion stage of a cycle, the government restrains the increase in aggregate demand by: 5 raising interest rate and selling government securities in the open market; 5 decreasing government expenditures and raising taxes; 5 lowering wages; 5 cutting government investment and public-funded construction. To incentivize business activity and economic growth at the contraction stage of a cycle, the government stimulated aggregate demand by: 5 lowering the interest rate and purchasing securities in the open market; 5 increasing government expenditures and lowering taxes; 5 raising wages; 5 launching new investment projects and programs, increasing government investment, and creating new jobs. Thus, stabilization policy is a set of countermeasures to current business activity: cooling down during booms and heating up during recessions. The government modifies an economic cycle and reduces disbalances in each of the stages. Approaches to stabilizing economic cycles are discussed in detail in the following chapters of the book (see, for instance, 7 Chap. 10 for government interventions in unbalanced markets, 7 Chap. 11 for monetary policy, 7 Chap. 13 for fiscal policy, 7 Chap. 14 for social policy, and 7 Chap. 18 for ensuring sustainable economic development). Therefore, this section outlines the overall vision of the goals and techniques of stabilization policy. As shown in 7 Chap. 6, the neoclassical school and the Keynesian school are the two dominant but fundamentally different approaches to interpreting the role of the state in the economy. Proponents of the Neoclassical school center their reasoning around supply. They believe a market to be a self-regulating system that is able to automatically balance major macroeconomic proportions and ensure economic development. Therefore, the government should stay away when a crisis washes out weaker producers from the market, thus establishing a new spiral of development. Still, monetary instruments could be applied. ­Contractionary

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monetary policy (expensive money, high base rate, high interest rates in commercial banks, etc.) aims to clear the market of less competitive economic entities. Fiscal policy could be employed as an auxiliary tool. It aims at reducing tax rates. Lowering taxes incentivizes business activity, contributes to expanding production and investment, spurs aggregate supply, and decreases unemployment. At the same time, a stabilization program involves a decrease in the supply of money. Emphasizing the role of disparities in aggregate demand in causing disbalances in the market, the Keynesian school advocates for the active use of fiscal instruments by the government. They can be employed to either reduce or increase spending. To stimulate demand, Keynesian economists recommend governments increase procurements. Such interventions improve the expectations of businesses and people. Monetary policy also plays an important role. In economic downturns, the government should lower interest rates to stimulate investment with cheaper credit money and make money more affordable and less expensive. However, contemporary macroeconomic policy disfavors extremes. In most of the countries worldwide, a standard set of stabilization tools integrates Keynesian and neoclassical methods. They are applied in various combinations depending on particular disproportions the government addresses. Thus, stabilization programs operate with the following instruments: 5 control over the growth of the supply of money in the economy by restricting lending to the government and businesses by a central bank and other financial institutions; 5 managed devaluation of the national currency within a corridor as a means of curbing inflation expectations; 5 reduction or complete refusal of the government to interfere in pricing (for instance, lower subsidies for private consumption and individual industries, such as agriculture); 5 financial stabilization and competition between banks in setting interest rates; 5 reduction of institutional barriers to the movement of goods and capital, including cross border exchange and international trade; 5 reduction of real wages in the economy in order to curb inflation and stimulate saving among wealthier segments in society (the most dangerous measure of all that make up a standard stabilization package, because contraction of domestic demand can raise cost inflation and increase business risks, which, in turn, can result in the outflow of capital from a country, not saving). In order to apply the above set of stabilization tools properly, the government needs to identify a current stage of the cycle correctly. The following groups of indicators can be employed: 5 Procyclical Variables rise during expansion and fall during contraction: GDP, employment rate, output volume, prices, revenues, volume of money supply, velocity of money circulation, short-term interest rates. 5 Countercyclical Variables fall during expansion and rise during contraction: inventories of finished products, stocks of factors of production, unemployment rate, bankruptcy rate.

255 7.5 · Stabilization Policies

7

5 Acyclical Variables are indifferent to the phases of a cycle: some types of government spending (for example, fundamental research programs, national defense), exports to or imports from particular countries (for instance, intergovernmental long-term contracts or trade in essential staples or energy). It is crucial to constantly monitor macroeconomic parameters that may s­ ignal an imbalance in the market or the approach of the downturn phase of an economic cycle: 5 Leading Variables reach their highest (lowest) levels before the economy reaches the peak (trough, respectively) of a cycle. They precede the turning points of a cycle and signal the onset of the next phase. For example, the level of industrial capacity utilization or stock prices begins declining before a crisis breaks out, as well as it starts recovering before the economy enters the ­expansion stage of a cycle. 5 Lagging Variables reach their highest (lowest) levels after the economy has reached the cycle’s peak (trough, respectively). Examples are investment and interest rates in commercial banks. The unemployment rate reaches its maximum somewhat later than the economy has entered the trough stage of a cycle. 5 Coincident Variables change simultaneously and in accordance with changes in economic activity (real GDP, industrial production, level of income, etc.) They determine phases of an economic cycle. The application of stabilization programs has its price measured by the fall in GDP. This price (i.e., a portion of GDP lost due to the government’s intervention in the market) is greater, the less diversified the economy and the less developed the market institutions in a country. Under certain circumstances, the employment of stabilization tools may harm the economy and even destabilize it. During such radical crises as the COVID-19 pandemic, there increases the role of the government in stabilizing markets and keeping the economy from falling into depression. The contemporary new normal interpretation of state intervention in economic cycles necessitates setting the limits within which the government is allowed to pursue active stabilization policy. Chapter Questions: 5 Define an economic cycle. How does a cycle differ from macroeconomic disequilibrium discussed in 7 Chap. 6? 5 Name four stages of an economic cycle in the Marxian model. Show what happens to major macroeconomic parameters (GDP, employment, inflation, interest rate) at each stage. 5 Distinguish the neoclassical interpretation of an economic cycle from the Keynesian approach. What factors cause cyclicality? 5 Explain the critical difference between the Kitchin cycle and the Juglar cycle. 5 How do demographic processes in the economy affect cyclicity? 5 Do you think the Kondratiev waves adequately explain the long-term parading of economic development?

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Chapter 7 · Economic Cycles

5 Characterize structural and financial crises. Can a financial turmoil turn into a structural depression? 5 What is the distinct feature of transformational crises? How would you categorize the pandemic-induced economic decline of the early 2020s: structural, financial, public health, or transformational crisis? Can it turn into a cycle? 5 Compare the interpretations of equilibrium determinants. Which of them better explains the COVID-19 economic downturn? How did the government in your country attempt to stabilize the economy during that crisis? Subject Vocabulary:

7

Agrarian Crisis: a situation of overproduction of agricultural products and the accumulation of substantial unsold stocks. Cyclicity: a form of economic development when the market transitions from one macroeconomic equilibrium to another. Economic Cycle: a transition of the economy from one state of macroeconomic equilibrium to another. Financial Crisis: a sharp decline in the value of financial instruments. Juglar Fixed-Investment Cycle: a medium-term economic cycle (7–12 years) caused by changes in capacity utilization coincided with fluctuations in investment in fixed assets. Kitchin Inventory Cycle: a short-term economic cycle (2–4 years) caused by time lags in the movement of information that affect the decision-making of economic agents. Kondratiev Cycle: a long-term economic wave (45–60 years) caused by technology life cycles and radical shifts in technology paradigm. Kuznets Infrastructural Investment Cycle: a long-term economic cycle (15– 20 years) caused by demographic processes and changes in mobility of labor. Monetary (Banking) Crisis: a situation when banks face a sudden withdrawal of deposits by depositors. Stabilization Policy: a set of macroeconomic policy measures aimed at stabilizing the economy at the level of full employment of all factors of production, i.e., the level of potential output. Stock Market Crisis: a sharp drop in securities prices due to the excessive supply of securities. Structural Crisis: a long-term non-cyclical phenomenon expressed in the decline of individual industries or groups of industries (sectors) of the economy that violates the key macroeconomic proportions.

References Hansen, A. H. (1938). Full recovery or stagnation? Norton. Juglar, C. (1862). Des crises commerciales: Et de leur retour periodique en France, en Angleterre et aux Etats-Unis. Guillaumin et C-ie, Libraires-Editeurs. Kitchin, J. (1923). Cycles and trends in economic factors. Review of Economic Statistics, 5, 10–16.

257 References

7

Kuznets, S. (1930). Secular movements in production and prices. Their nature and their bearing upon cyclical fluctuations. Houghton Mifflin. Kuznets, S. (1955). Economic growth and income inequality. American Economic Review, 45(1), 1–28. Kondratiev, N. (1922). The world economy and its conjuncture during and after the war. Volodga: Institute of Conjuncture of Petrovskaya-Rozumovskaya Agricultural Academy. Samuelson, P. A. (1939). Interactions between the multiplier analysis and the principle of acceleration. Review of Economics and Statistics, 21, 75–78. Schumpeter, J. (1939). Business cycles. New York, NY: McGraw-Hill Co.

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Disequilibrium and Unemployment

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_8

8

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Chapter 8 · Disequilibrium and Unemployment

Learning Objectives: 5 Explore the specifics of demand for labor and supply of labor 5 Understand the effects of shifts in the labor market equilibrium 5 Learn the fundamentals of unemployment 5 Explore theoretical interpretations of unemployment (classical school, Marxian school, Keynesian school, monetarism, institutional and sociological school, contract theory of employment, theory of flexible labor market) 5 Reveal the effects of unemployment on the economy and society 5 Study active and passive approaches to labor market regulation 8.1  Labor Market

8

Labor Market is a system of economic mechanisms, institutions, and regulations that facilitate the use and reproduction of labor. It connects demand for labor and supply of labor in various combinations from a pure monopoly to perfect competition. The latter is characterized by a large number of firms competing with each other for hiring the best (most proper) workers and establishing the pool of required skills and qualifications of labor. Economic entities exercise demand for labor. Since labor is one of the fundamental factors of production, firms hire workers so that they contribute to producing goods or rendering services, i.e., creating value. In general, the demand for labor primarily depends on the value generated per employee. To derive the exact function of demand for labor in perfect competition, let us consider how an individual firm decides on the number of employees hired. The condition for maximizing profits in a perfectly competitive market is the equality of marginal revenue to marginal costs. In the labor market, this condition means that the revenue (income) that a firm receives from hiring an additional employee (an additional unit of labor) must be equal to the nominal (monetary) wage paid to this last hired employee. The revenue generated by an additional employee is the income that a firm receives from selling goods produced by this employee. The revenue depends on the price of goods produced by an additional unit of labor P and the marginal productivity of this additional unit expressed by the marginal product of labor MPL (Eq. 8.1). The cost of the last employed unit of labor is the nominal wage W . Thus, a profit-maximizing firm hires additional units of labor until the revenue generated by the last unit hired MRPL is equal to the nominal wage paid to an additional worker. A firm maximizes its profit if the following condition is met:

MRPL = W = P × MPL; MPL = where MRPL   MPL W P

W P

marginal revenue product of labor; marginal product of labor; nominal wage; price of produced good.

(8.1)

261 8.1 · Labor Market

8

. Fig. 8.1  Demand for labor. Source Authors’ development

Thus, assuming a fixed stock of capital and unchanged technology, a firm hires additional units of labor until the real wage paid to the last employee hired is equal to the marginal product of that worker’s labor. One of the essential properties of the production function is that an increase in the quantity of one factor of production pushes total output up (provided that other factors of production and technology do not change), but decreases the marginal product of this factor. In the labor market, the law of decreasing marginal productivity means that the marginal product of labor MPL falls with introducing each additional unit of labor L. Since MPL = W P , the demand for labor DL is a decreasing function of real wage WR (DL = DL (WR )) (. Fig. 8.1). The higher the real wage WR, the fewer workers L firms hire. Consequently, the real wage is inversely proportional to the demand for labor. A decrease in real wage from WR1 to WR3 increases the number of units of labor hired from L1 to L3. The demand for labor shifts from point A to point C (. Fig. 8.1). If the real wage rises (for example, from WR2 to WR1), the demand for labor shrinks from point B to point A, and the number of workers employed falls from L2 to L1 (. Fig. 8.2). The equilibrium point moves along the curve from A to B or C due to changes in the wages-labor combination with the constant marginal product of labor. Changes in other factors of production (capital stock, quantity of natural resources) or the level of technological or human capital development shift the entire DL curve either upward right (advancement) or downward left (degradation). These are factors that affect labor productivity and therefore cause firms to change the demand for labor while keeping real wages unchanged. If the marginal product of labor improves, then the demand curve shifts from DL1 to DL2 (. Fig. 8.3). At any level of real wage, firms hire more workers as workers become more productive. From the initial point A1, the market equilibrium shifts to A2 with no change in real wage WRA, but with an increase in the number of workers employed from LA1 to LA2. Conversely, if the marginal product of labor declines (labor productivity falls), the demand curve shifts downward left, and firms hire fewer workers.

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Chapter 8 · Disequilibrium and Unemployment

. Fig. 8.2  Demand for labor: shifts along the demand curve. Source Authors’ development

8

. Fig. 8.3  Demand for labor: shift of the demand curve. Source Authors’ development

The supply of labor is exercised by households. When deciding whether to offer their labor in the market or not, households maximize the utility of their labor force by making a choice between being employed (work) and being unemployed (leisure). In order for a household to give up leisure and choose work, the compensation for this sacrifice is to be high enough. The compensation is the income received for the labor contributed, i.e., real wage WR. The function of the supply of labor can be obtained by maximizing the utility by households. The higher the real wage, the higher the opportunity cost of leisure, the stronger the desire of households to work, and the greater the number of people who offer their labor L in the market. Therefore, all other things being equal, the supply of labor SL is an increasing function of real wage. In . Fig. 8.4, an increase in real wage from WR1 to WR3 causes a rise in the supply of labor from point A to point C (an increase in the amount of labor units supplied in the market from L1 to L3).

263 8.1 · Labor Market

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. Fig. 8.4  Supply of labor. Source Authors’ development

. Fig. 8.5  Supply of labor: shifts along the supply curve. Source Authors’ development

The positive slope of the SL curve reflects the direct relationship between real wages and people’s desire to work. The higher the compensation for non-leisure activities (WR3 > WR2 ), the more households supply their labor (L3 > L2 ), and the equilibrium point moves along the curve from B to C (. Fig. 8.5). Conversely, the lower the reward (WR1 < WR2 ), the fewer households supply their labor (L1 < L2 ), and the equilibrium point moves along the curve from B to A. Therefore, a change in real wage due to a change in nominal wage W or a change in the price WR either   level P WR = W affects the supply of labor SL by shifting the equilibrium point P along the supply curve upward (rise in WR) or downward (decline in WR). Changes in the employable population, the labor force participation rate, the employment-to-population ratio, migration of labor, the level of wellbeing and national

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Chapter 8 · Disequilibrium and Unemployment

wealth, or the expected change in real wages in the future shift the entire SL curve either to the right (improvement) or to the left (decrease). With no change in the real wage, households offer more labor in the market. From the initial point A1, the market equilibrium shifts to A2 with no change in real wage WRA, but with an increase in the number of workers employed from LA1 to LA2 (. Fig. 8.6). Households may also reduce the supply of labor. In such a case, the curve shifts to the left. The intersection of the supply and demand curves at point E establishes the equilibrium real wage WRE which corresponds to the optimal number of employed labor LE (. Fig. 8.7). With real wage WR1 below the equilibrium, demand for labor (point B) exceeds the supply of labor (point A). The economy faces a deficit of labor. In order to attract workers, employers increase wages. Responding to a rising wage, more people seek to get a job (movement from point A toward point E along the SL curve). However, at the same time, higher wages force employers to manage rising costs by hiring fewer workers (movement from point

8

. Fig. 8.6  Supply of labor: shift of the supply curve. Source Authors’ development

. Fig. 8.7  Labor market equilibrium Source Authors’ development

265 8.1 · Labor Market

8

D toward point E along the DL curve). With real wage WR2 above the equilibrium, the supply of labor (point C) surpasses the demand for labor (point D). Employers try to cut costs by offering lower wages. The number of people willing to supply their labor at a lower rate decreases (movement from point C toward point E along the SL curve). As wages decline, firms exercise higher demand for less expensive labor (movement from point B toward point E along the DL curve). Market forces balance wages at point E, at which all firms fill their vacant positions with proper employees at an adequate price, and everyone who wants to supply their labor receives an adequate reward. The equilibrium in the labor market is a result of a change in either the demand for labor or the supply of labor. In both cases, equilibrium is restored by adjusting real wage, which then results in adjusting the equilibrium amount of labor. As noted above, the demand curve shifts in response to changes in the marginal product of labor. That means that when the firm’s marginal revenue from hiring an additional worker increases, the demand for labor grows (the D curve shifts upward right to D2) (. Fig. 8.8). A rise in real wage from WE to WE2 drives supply of labor up from LE to LE2. The new equilibrium in the labor market is established at point E2 with higher wages and a greater number of employed people. Conversely, when the marginal revenue declines, firms hire fewer workers (the D curve shifts downward left to D1). A fall of real wage from WE to WE1 depresses the supply of labor. The new equilibrium is reached at point E1 with lower supply (LE1 < LE ) of less rewarded labor (WE1 < WE ). Changes in the supply of labor are illustrated by shifts of the supply curve S either to the right to S2 (increase) or to the left to S1 (decrease) (. Fig. 8.9). Excessive supply of labor (LE2 > LE ) increases the competition between workers for available jobs in the market. Employers cut costs by offering lower wage (WE2 < WE ) and demanding more labor at a reduced price. The equilibrium point slides along the D curve from point E to point E2. Therefore, the new equilibrium is established at a lower wage and higher employment. A decline in the supply of labor from S to S1 increases competition between employers for fewer workers who remain in the

. Fig. 8.8  Changes in the demand for labor. Source Authors’ development

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Chapter 8 · Disequilibrium and Unemployment

. Fig. 8.9  Changes in the supply of labor. Source Authors’ development

8

market (LE1 < LE ). Employers attract workers by raising wages from WE to WE1 , but such a rise depresses the overall demand for labor. The new equilibrium is reached at point E1 with a higher wage and a lower number of workers employed. Analysis of supply and demand in the labor market demonstrates how the average wage rate is determined. A competitive labor market brings together firms that demand for certain quantitative and qualitative parameters of labor and workers of different qualifications capable of working for these firms. The demand for labor in a given economy, territory, or sector is determined by the aggregate demand of all firms. In response to the aggregate demand, there is the aggregate supply of labor exercised by households and individuals in active working age. However, both the aggregate supply of labor and the aggregate demand for labor are segmented. Differences in professional occupations, qualifications, competencies, levels of education, and many other parameters of supply and demand divide people (supply) and firms (demand) into segments. Due to diverse parameters, these groups do not compete with each other. Wages differ depending on the quality of the labor force and the specifics of particular jobs. Differences in the quality of labor are objectively determined not only by the abilities of workers, but also by the costs of acquiring the specific knowledge to perform the specific work. The labor force itself takes the form of human capital, which includes innate abilities and talents, as well as education, acquired qualifications, and experience (further discussed in 7 Chap. 17). 8.2  Unemployment 8.2.1  Foundations of Unemployment

Imbalances between supply and demand in the labor market induce unemployment. Unemployment is a social and economic phenomenon consisting in the fact that a certain part of the population in active working age does not have a job

267 8.2 · Unemployment

8

and, accordingly, income (those who want to work cannot find work at an adequate wage rate). The economically active population is divided into those included (L) and not included (NL) in the labor force. The former category comprises people who either have a job or remain unemployed, but want to work and look for a job. The total labor force is divided into two parts: 5 Employed people (E) are people who have full-time or part-time jobs. An individual is also considered employed when he does not work during vacation or sick leave or due to bad weather, natural disasters, or other emergencies. People employed unofficially (shadow sectors, illegal activities) do not fall into the E category. 5 Unemployed people (U) are people of working age who are unemployed at the moment, but who actively look for jobs. They make purposeful efforts to find a job. They are ready to start working immediately or they wait for starting a work from a certain date. An active search for a job is the main criterion that distinguishes the unemployed from people not included in the labor force. The NL category includes people not engaged in public production who seek no employment. The category comprises the institutional population (­ people maintained by public institutions such as prisons or asylums and therefore temporarily excluded from the employable population due to various natural or administrative restrictions) and people who could work, but prefer remaining unemployed (full-time students, retirees, housewives, etc.). The key ­ indicator of unemployment is the unemployment rate. Rate of Unemployment is the ­ratio of the number of unemployed people to the total labor force, expressed as a ­percentage (Eq. 8.2). The total labor force is equal to the total number of employed and unemployed people (E + U).

RU =

U × 100% E+U

(8.2)

where RU   rate of unemployment; U number of unemployed people; E number of employed people. Market failures and disbalances deviate the labor market from equilibrium. However, one should distinguish equilibrium previously discussed in 7 Sect. 8.1 from full employment. Full Employment is a situation when the number of jobs available in the economy corresponds to the number of people looking for work. With full employment, the number of employed does not change in response to the expansion of effective demand, i.e., no unemployment exists. Most macroeconomists, however, acknowledge a certain level of natural unemployment to be an essential feature of a mobile and flexible labor market. Natural Unemployment is the equilibrium in the labor market established under the combined influence of factors raising and lowering wages, demand for labor, and supply of labor. If the actual unemployment rate exceeds its natural level, the country loses part of its gross product.

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Chapter 8 · Disequilibrium and Unemployment

Case box The optimal level of natural unemployment in developed economies is 4–6%. However, the optimum varies substantially depending on the specific features of particular markets. For example, in Central Europe, unemployment around 5% is still considered natural, while Sweden and Norway aim at keeping the natural equilibrium unemployment rate below 2%. The USA tolerates rather high unemployment up to 7–8%, while Japan keeps it down to 1.5–2.0%.

8

Natural unemployment in an equilibrium labor market is established under a combined influence of frictional and structural unemployment. Frictional Unemployment is a predominantly short-term voluntary unemployment that arises due to discrepancies between the number of employees and vacant jobs, when the information about available jobs is incomplete, unreliable, or not freely accessible to all people in the market. Examples of frictional unemployment are changes in professional occupations and voluntary movements of workers between sectors or enterprises. Commonly, it takes up to three months to find a new job. Voluntary frictional unemployment includes those who are temporarily unemployed or voluntarily quit their jobs, as well as those looking for jobs and waiting for starting work in the near future. Being part of the natural unemployment, frictional unemployment is an immanent feature of the labor market. A certain level of frictional unemployment even benefits the economy by optimizing the use of the labor force. Seeking better and higher-paid jobs, people are incentivized to develop their skills and qualifications, select jobs these qualifications fit the best, and thus improve the overall productivity and performance of the economy. Case box One of the illustrations of frictional unemployment is a graduation of students. After graduating from colleges or universities, they join the labor force and remain unemployed until they find jobs. Another example is women who return to work after having maternity leave. When people start looking for work, they are considered frictionally unemployed. Frictional unemployment can be reduced by improving information about available vacancies and ensuring adequate access to this information for all. Online job searching services such as Simply Hired, Monster, and CareerBuilder have gained prominence during the COVID-19 pandemic. Many job seekers look for jobs through employment-oriented networks like LinkedIn and even general social media resources like Facebook and Twitter.

Structural Unemployment occurs when a surplus of labor in one sector coexists with a shortage of labor in another. Structural unemployment includes people who lose their jobs or fail to find a job due to the introduction of new e­ quipment

269 8.2 · Unemployment

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and technologies or closure of conventional lower-performing enterprises or entire industries. Commonly, retraining is needed to upgrade qualifications that do not match the new requirements or develop entirely new skills demanded in the new sectors. Structural changes accompany economic development (see, for example, 7 Chap. 6 for innovations-driven economic cycles and 7 Chap. 16 for the role of technologies in the new normal economic development). New technologies give rise to new sectors and new goods that displace the old ones. Innovations shift the supply-demand patterns not only in the labor market, but across the entire global economy. Fundamental transformations in the demand or certain skills and qualifications trigger the cross-sectoral redistribution of labor. In contrast to short-term frictional unemployment, workers who lose jobs due to structural shifts cannot easily find jobs in other sectors or territories. ­Structural unemployment lasts longer than frictional unemployment. It primarily hits lowskilled labor in conventional industries, as well as people in economically backward areas or monotowns established around large industrial enterprises. Case box In the new normal economic patterns, structural unemployment paradoxically grows along with the rise in demand for labor. The thing is that those firms that open vacancies for high-qualified specialists in new sectors, such as information and digital technologies, big data, artificial intelligence, etc., may fail to find competencies they need in the market. There are open vacancies, but no people to fill these positions. Technological progress makes qualifications increasingly outdated. Without continuing upgrading of skills and competencies, a significant part of qualified labor remains unemployed. In the 1980s, structural unemployment increased sharply in developed economies amid the steady economic growth. The number of people employed in labor-extensive industrial production decreased, while the new labor-intensive sectors boomed. Therefore, economic growth is not always associated with the rise in employment. On the contrary, as competitive growing sectors require less labor per unit of value they create, economic development may give rise to unemployment (see the hysteresis effect in 7 Sect. 8.3, . Fig. 8.16).

Along with frictional and structural unemployment, seasonal and cyclical unemployment are distinguished. Seasonal Unemployment is a type of unemployment caused by seasonal fluctuations in demand for labor in certain industries (agriculture, construction, fisheries, tourism, etc.). Seasonal fluctuations in employment can be predicted and taken into account when elaborating labor market regulations and employment policies in particular sectors or territories. Cyclical Unemployment implies repeated deviations of the actual unemployment rate from the natural one (see 7 Chap. 7 for economic cycles). Cyclical unemployment goes up in times of economic downturn, when the overall demand for labor falls, and declines in times of economic recovery.

Chapter 8 · Disequilibrium and Unemployment

270

Case box During the 2008 financial crisis, the construction sector experienced cyclical unemployment. As more and more borrowers defaulted on the debt obligations associated with their houses and new loan requirements became more stringent, demand for new construction declined. Due to the increase in the total number of unemployed and the increase in the number of borrowers unable to make payments on their houses, the construction sector fell deep. About two million construction workers lost their jobs. As the economy recovered in the early 2010s, banks resumed granting loans to people and businesses. People started buying and renovating houses, and real estate prices went up. Construction firms exercised higher demand for new workers to meet that renewed demand in the housing sector, and cyclical unemployment declined.

8

Cyclical unemployment indicates the underutilization of labor in the economy. The difference between the potential gross product at full employment (or natural equilibrium unemployment rate) and the actual gross product at cyclical unemployment is the Unemployment Gap. Depending on the size of the gap, five possible states of the labor market are distinguished at full employment (positions 1 and 2 in . Table 8.1) and cyclical unemployment (positions 3–5, respectively). The Beveridge model allows one to distinguish between natural and cyclical unemployment. The model comprises the number of unemployed U and the number of job vacancies V . The bisector of the angle 0 is a set of equilibrium points, at each of which U = V (. Fig. 8.10). Point B and all points above the bisector reflect undersupply of labor (V > U), while point D and all points below the bisector reflect oversupply of labor (U > V ). All bisector points correspond to full employment. Natural unemployment includes only frictional and structural

. Table 8.1  States of the labor market depending on the size of the unemployment gap #

Labor market

Unemployment

Number of employed people

GDP

Production capacity

1

Full employment

Below natural

Above equilibrium

Raises to a maximum

2

Natural employment

Natural

Equilibrium

Natural equilibrium

Grows due to net investment

3

Underemployment

Above natural

Below equilibrium

Grows due to the increase in the capital-labor ratio

Declines due to depreciation

4

Recession

Declines

Underutilized

5

Recovery

Grows

Source Authors’ development

271 8.2 · Unemployment

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. Fig. 8.10  The Beveridge model. Source Authors’ development

unemployment. The model shows that natural unemployment may exist even at full employment. The size of such “unemployment at full employment” (UF ) increases with distance from the origin. Full employment at point A corresponds to unemployment UF2 = UL2 . However, it is unclear which contributing factors predominate. Short-term factors trigger frictional unemployment, while long-term ones cause structural unemployment. It can only be accepted that unemployment UF2 is determined by a certain combination of structural and frictional elements. Beveridge curves BC1 and BC2 go through the full employment points A and B, respectively. For each given state of the labor market (see . Table 8.1 above), the Beveridge curve shows how the demand for labor (number of jobs) and unemployment change over an economic cycle. At the economic recovery stage, the market shifts from the full employment point A to point B, at which demand for labor exceeds supply (V3 > U1 ). Unemployment U1 is below the natural equilibrium level U2. On the contrary, in the recession phase (point D), demand for labor falls below the supply (V1 < U3 ). The number of unemployed people exceeds the number of job vacancies, and the actual unemployment U3 surpasses the natural unemployment U2. The unemployment gap (U3 − U2) demonstrates the cyclical unemployment. A further downward movement along the BC1 curve below point D would widen the gap. That would mean an increase in cyclical unemployment, i.e., a rise in the number of unemployed U amid the decline in the number of job vacancies V . An increase in any of the two constituent parts of unemployment (structural or frictional factors) moves the labor market from full employment equilibrium A to point C. The BC1 curve shifts to BC2. The number of unemployed still corresponds to the number of job vacancies at full employment, but potential contributions of either structural or frictional factors to natural unemployment UF3 are greater (U3 > U2 ). In addition to the causes of occurrence (frictional, structural, cyclical, and seasonal unemployment), other criteria for classifying unemployment also apply

272

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Chapter 8 · Disequilibrium and Unemployment

. Fig. 8.11  Types of unemployment. Source Authors’ development

(. Fig. 8.11). Real unemployment comprises people who have both the ability and desire to work, but who can not find jobs in the labor market due to various reasons. Registered unemployment is a somewhat formal parameter. A part of the unemployed does not report their status to the officials. These people may find a job within a short period of time (frictional unemployment) or enter the shadow sector (unreported employment). The longevity of unemployment is measured by the time between becoming employed and finding a new job. According to this criteria, short-term unemployment corresponds to frictional unemployment, while stagnant unemployment reflects long-term structural disbalances in the labor market. Sector-specific and territory-specific unemployment arise due to the supply-demand imbalances in a particular industry or territory. They are triggered by the uneven economic development of territories, as well as demographic, historical, cultural, and other specific factors. The unemployment focals emerge in monotowns and remote areas, where both occupational and geographical mobility of labor is limited by the narrow labor market, underdeveloped transport infrastructure, or monopolization of demand for labor by few large employers or government bodies. When imbalances spread from one industry to the entire economy or from a particular territory to the whole country, sector-specific or territory-specific unemployment turns into mass unemployment. Mass unemployment is one of the most acute social and economic problems (previously discussed in 7 Chap. 7, 7 Sect. 7.3.5 in the case of the Great Depression in the USA).

273 8.2 · Unemployment

8

8.2.2  Theories of Unemployment

The theory of employment encompasses a variety of conceptual approaches to interpreting the nature and contributing factors of employment and unemployment. This section summarizes the views of major economic schools, such as the classical (neoclassical) school, the Marxian approach, the Keynesian model of the labor market, the monetarist school, and contemporary theories of labor and employment. The Classical (neoclassical) school is based on the provisions of Smith’s classical theory previously discussed in 7 Chap. 1, 7 Sect. 1.2.1 (fundamental approaches) and 7 Chap. 6, 7 Sect. 6.1.1 (theory of macroeconomic equilibrium). The school considers the labor market as an internally heterogeneous and dynamic system of economic and social relations regulated by market forces. The price of labor (wages) affects the supply of labor and demand for labor and balances them. The price of labor quickly and flexibly reacts to changes in the market environment by rising or falling depending on the current situation. Wages affect the demand-supply equilibrium in the labor market. If unemployment arises as a result of the oversupply of labor, then it depresses prices and, consequently, wages until the new equilibrium at a lower wage rate is reached. Conversely, excessive demand for labor drives wages up to a certain level at which additional supply balances increasing needs for labor in the economy. Therefore, classical and neoclassical models of unemployment all adhere to the fundamental principle of self-adjusting market elaborated by Adam Smith (further reading: “An Inquiry into the Nature and Causes of the Wealth of Nations”1). In its most consistent form, the neoclassical concept of unemployment was formulated by Arthur Pigou in the 1930s (further reading: “The Theory of Unemployment”2). A characteristic feature of the neoclassical analysis of the labor market is the extension of the microeconomic approach to macroeconomics. Similar to the market equilibrium models illustrated in 7 Sect. 8.1, the neoclassical ­equilibrium in the perfectly competitive labor market is established at the intersection of demand for labor DL (the equilibrium real wage WRE) and supply of labor SL (the equilibrium number of employed people LE) (. Fig. 8.12). The labor market equilibrium is achieved at full employment LE. This postulate follows from the theory of general equilibrium, which states that since individual perfect competitive markets ensure the efficient utilization of resources, then the totality of perfectly competitive markets ensures full employment (see 7 Chap. 6, 7 Sect. 6.1.1 for the classical theory of macroeconomic equilibrium). According to the classical interpretation, full employment is the situation in the labor market when jobs are available for all those who want to get employed at the equilibrium wage rate WRE established in a perfectly competitive market. The output (income) at full employment (potential GDP) is such a level of real GDP

1 2

Smith (1776). Pigou (1933).

274

Chapter 8 · Disequilibrium and Unemployment

. Fig. 8.12  The classical model of labor market Source Authors’ development

8

at which full employment of labor is achieved in a perfectly competitive market with a certain amount of capital and level of technology. Suppose the supply of money in the economy declines and the real wage rises from WRE to WR1. Since the new real wage exceeds the equilibrium wage (WR1 > WRE ), the disequilibrium in the labor market induces unemployment. In this new situation, the supply of labor L2 (point B) exceeds the demand for labor L1 (point A), and the unemployment gap equals (L2 − L1 ). According to the classical model, any disequilibrium is just a temporary deviation from market equilibrium E. The unemployment (L2 − L1 ) of temporary disequilibrium between points A and B is voluntary unemployment (or frictional unemployment discussed in 7 Sect. 8.1). Many people would want to work for WR1 above the equilibrium wage, but few employers agree to bear increased labor costs. The disequilibrium itself triggers the mechanism for achieving equilibrium. Part of the newly unemployed (L2 − L1 ) would agree to get back to work at a lower rate WR (WRE < WR < WR1 ) . Over time, the number of unemployed gradually moves from L2 toward LE, while the real wage falls from WR1 to WRE. The market self-adjusts the supply-demand ratio, and the equilibrium reestablishes. Nevertheless, modern neoclassical economists acknowledge that certain factors may hamper self-adjustment and lengthen the unemployment disequilibrium. For example, trade unions may oppose the reduction of wage rates to protect the workers, or the government may set the minimum wage to guarantee a certain level of income in the economy. If the disequilibrium in the labor market persists, then the economy fails to reach its potential level of GDP (income), and the recession continues. While in the classical interpretation, workers voluntarily quit jobs in response to inadequate wages, the Marxian theory attributes unemployment to the objective laws of capital accumulation. Karl Marx investigated the linkages between the accumulation of capital and the demand for labor and emphasized the

275 8.2 · Unemployment

8

involuntary nature of unemployment in capitalist markets (further reading: “Capital: A Critique of Political Economy”3). As discussed in 7 Chap. 16, technological progress increases the productivity of inputs and thus reduces demand for labor. In industrialized economies, most competitive sectors intensively consume capital and technologies rather than labor. The demand for labor concentrates in niches (high-qualified workers, certain narrow qualifications, unique skills, etc.), leaving many people unemployed. According to the Marxian interpretation, unemployment follows from the capitalist form of industrialization and technical progress. As capital strives to reproduce and multiply itself, it reduces demand for labor as it increases. Workers do not voluntarily choose unemployment, as the classical school postulates. Instead, they are driven out of the labor market. Therefore, unemployment is inherent to capitalist markets. Moreover, the unemployment problem aggravates as capitalist economies develop. Capital accumulates and transforms the share of variable capital directed for the purchase of labor decreases, while the share of permanent capital spent on the purchase of means of production goes up. Such structural changes affect the demand for labor. If capital’s structure did not change, then the demand for labor would increase in proportion to the accumulation of capital. However, as the structure of accumulated capital changes, the growth of demand for labor fails to keep pace with the capital accumulation rate. Indeed, the accumulation of capital creates jobs and attracts new labor to various sectors across the economy, but the growth of capital outpaces that of employment. Less and less labor is required per unit of capital, and the demand for labor falls in relation to the size of capital. In addition to the less intensive attraction of labor into production, the accumulation of capital facilitates modernization and reorganization of traditional labor-extensive industries and thus pushes workers from production. Marx was the first to substantiate the unemployment patterns in capitalist economies. He rejected the classical postulate that the optimal use of productive capacity simultaneously ensures the full use of labor. Instead, Mark demonstrated that unemployment permanently exists in all markets and countries even in times of economic growth. Disbalances between labor and capital trigger economic crises (see 7 Chap. 7, 7 Sect. 7.1.1) and stipulate the stage-by-stage evolution of economic systems (the Marxian approach to understanding the essence of economic development is further detailed in 7 Chap. 15, 7 Sect. 15.3). The Keynesian school treats the labor market as an inert system where the price of labor is fixed (further reading: “The General Theory of Employment, Interest and Money”4). The main parameters of employment (demand for labor, rates of employment and unemployment, etc.) are determined outside the labor market by the effective demand in the market of consumer and investment goods and services. The labor market sets wages and thus affects the supply of

3 4

Marx (1867). Keynes (1936).

276

8

Chapter 8 · Disequilibrium and Unemployment

labor which directly depends on the average wage level. However, the supply of labor plays no meaningful role in establishing actual employment. It only shows the maximum possible employment at a given wage. The demand for labor is affected by aggregate demand, investment, and output. The lack of aggregate effective demand produces involuntary unemployment, which can be eliminated by expansionary monetary and fiscal policies (see 7 Chap. 11, 7 Sect. 11.4 and 7 Chap. 13, 7 Sect. 13.4, respectively). The government-driven increase in aggregate demand fuels the demand for labor, which, in turn, stimulates employment. According to the Keynesian concept, employment is affected not only by aggregate demand, but also by the structure of aggregate demand, i.e., the distribution of demand between industries and sectors. Public investment is believed to be an effective means of supporting employment. As previously outlined in 7 Chap. 1, 7 Sect. 1.2.2, the Keynesian model rests on the principle of government intervention in adjusting macroeconomic processes and behavior patterns of market actors (see 7 Chap. 6, 7 Sect. 6.3.2 for the Keynesian concepts of propensity to consume, propensity to save, motivation to invest, etc.). Summarizing the above, it is fair to say that, unlike the classical theory, the Keynesian understanding of unemployment is based on the following postulates: 5 labor market equilibrium is primarily affected by the effective demand for labor (real aggregate demand at the equilibrium point); 5 nominal wages are largely determined by the interaction of workers and employers (employment contracts), rather than the interaction of supply and demand in the market; 5 trade unions prevent nominal wages from declining even amid unemployment; 5 minimum (nominal) wage applies; 5 since the labor market is not perfectly competitive, wages commonly exceed the marginal disutility of labor. A fundamental premise of the Keynesian analysis is the price level stability. Keynes accepted the classical interpretation of the demand curve for labor, which states that the demand for labor DL is a function of real wage WR (illustrated above in . Fig. 8.1). However, Keynes rejected the classical understanding of the supply curve of labor. As households look to nominal wages, not real wages, the supply of labor SL is a function of nominal wage WN (SL = f (WN )). Therefore, labor flows to those markets where nominal wages are higher, but labor does not leave the market if real wages fall at once for all households (for example, due to inflation across all sectors). Keynes disagreed that nominal wages could be lowered to restore full employment, as workers supported by trade unions would resist wage cuts (remember the fundamental Keynesian proposition of no perfect competition in labor markets). Real wages can be reduced without lowering the nominal wage by raising the overall price level, but such an action may not result in achieving full employment. Since Keynes attributed the labor market equilibriums to the state of the commodity market, suppose the latter balances at point E1 (. Fig. 8.13a). At this point, full employment corresponds to the potential GDP YE1. At the level of

277 8.2 · Unemployment

8

. Fig. 8.13  Keynesian model of labor market. Source Authors’ development

prices PE in the economy, the labor market achieves the full employment equilibrium at real wage WRE (WRE = WN ) and the number of employed people LE1 (point EL1 in . Fig. 8.13b). The labor market and the commodity market are interlinked. That means that a change in the aggregate demand in the commodity market affects the aggregate demand for labor. Suppose the aggregate demand for commodities falls from AD1 to AD2 (. Fig. 8.13a). The derivative demand for labor responds to such fall by declining from DL1 to DL2 (. Fig. 8.13b). Since trade unions do not allow nominal wages to be reduced, real wages remain unchanged at WRE (providing that the price level PE remains constant). In the labor market, the equilibrium point EL1 shifts to EL2, and there arises unemployment equal to (LE1 − LE2 ) . According to the classical theory, this is the unemployment of disequilibrium, since point EL2 deviates from the market equilibrium (compare illustrations of unemployment segments in . Figs. 8.12 and 8.13). According to the Keynesian model, point EL2 does not deviate from the equilibrium, but establishes the new equilibrium of cyclical unemployment. The supply curve SL changes its shape to match this new equilibrium. Its lower section no longer coincides with the marginal disutility of labor. Point EL3 (actual employment) lifts to point EL2, so that the SL curve transforms into the WRE EL2 EL1 SL curve. Therefore, the wage rate WRE stays above the marginal disutility of labor that corresponds to actual employment LE2. Lowering the real wage rate does not change the situation. No matter how deep wages fall, firms would not increase demand for labor until the effective aggregate demand grows ( AD2 shifts back toward AD1). That means that the demand for labor remains at LE2 with any change in real wages (for example, see point EL3 with same LE2 at the substantially lower wage WR1). Cyclical unemployment (LE1 − LE2 ) persists due to low effective demand in the economy, not the individual labor market. Thus, the Keynesian school states that at full employment, aggregate employment is inelastic, that is, it does not respond to an increase in effective demand. Full employment occurs only when effective demand reaches a

278

8

Chapter 8 · Disequilibrium and Unemployment

potential level of real GDP. Equilibrium in the labor market is not necessarily established at full employment. As the labor market is affected by the aggregate demand in the economy, disequilibriums in the commodity market may cause longterm involuntary cyclical unemployment. Self-adjustment may take long, that is why the government must step in with stabilization policies aimed at spurring effective demand. Sharing a classical vision of the labor market as a self-adjusting system, the Monetarist school states that the rational level of employment is determined by the price of labor. Government intervention disrupts market self-regulation. Stimulating the aggregate demand in the labor market by injecting money into the economy may spur inflations. Markets tolerate a certain level of unemployment that coexists with the equilibrium. This natural rate of unemployment reflects the actual structural patterns of labor markets and commodity markets, including market imperfections, stochastic fluctuations in demand and supply, the cost of information on vacant jobs and available labor, the costs of labor mobility, and other parameters. Temporary deviations of employment from its natural level are self-restored in a relatively short time. If actual employment exceeds the natural equilibrium level, inflation accelerates. Conversely, deflation occurs if actual employment remains below the natural rate. The government designs and implements employment stabilization policies to combat deviations in the unemployment rate from its natural equilibrium, as well as dampen fluctuations in output and employment. Monetarists advocate using expansionary and contractionary monetary policies to balance the labor market (see 7 Chap. 11, 7 Sect. 11.4 for the variety of monetary instruments). The proponents of the Institutional and sociological school assume that the unemployment-related issues should be addressed by various kinds of institutional reforms. The school departs from pure macroeconomic analysis and captures a variety of non-economic factors to explain the discrepancies in the labor market, including social, occupational, sectoral, ethnic, gender, age, and other differences in the composition of the labor force and the corresponding levels of wages (institutionalism as one of the theories of economic development is discussed in 7 Chap. 15, 7 Sect. 15.6.2). The Contract theory of employment synthesizes neoclassical ideas with Keynesian interpretations of unemployment (further reading: “Wages and Unemployment under Uncertain Demand”5 and “Implicit Contracts and Underemployment Equilibria”6). On the one hand, it accepts the Keynesian thesis about the rigidity of monetary wages and states that the labor market can be adjusted by changes in output and employment, not prices. On the other hand, this rigidity itself is derived from the optimizing behavior of individuals pursuing their economic interests. The theory proposes that employers and employees enter into

5 6

Baily (1974). Azariadis (1975).

279 8.3 · Effects of Unemployment

8

long-term contractual relations with each other. The parties honor the implicit contract between them because it is mutually beneficial, not because it is legally binding. During the economic decline, firms try to keep wages. During the economic recovery, they do not rapidly increase the wages of qualified workers. Therefore, smooth adjustments of wages throughout the economic cycle do not trigger harsh volatilities in the labor market. The Theory of flexible labor market emerged in the late 1970s to reflect structural economic and social transformations across developed countries (further reading: “Global Labor Flexibility”7). It assumes the need for deregulation of labor markets, the transition to more flexible, functionally individualized, and non-standard forms of employment (part-time, short-term contracts, etc.). This approach is particularly relevant in today’s new normal economic reality as it allows governments to make labor markets more flexible and responsive to volatilities and uncertainties. The theory assumes promoting flexibility in hiring, regulating working hours, establishing flexible modes of work, managing wages, protecting workers’ rights, as well as adapting the volume, structure, quality, and price of labor to fluctuations in supply and demand in the labor market. In general, the theory of flexible labor market involves the adaptation of diverse forms of relations between employers and employees. It aims at rationalizing total costs, increasing profitability, and maintaining dynamic labor markets. 8.3  Effects of Unemployment

Most theories of the labor force and employment agree that the market economy produces unemployment. Competition ruins firms and entire industries leaving workers temporarily or permanently unemployed. The accumulation of capital spurs technical progress and modernization thus depressing demand for labor in capital-intensive sectors. Market failures, economic cycles, and other volatilities inherent to the market economy disbalance labor markets. Moreover, employees themselves compete with each other for better jobs. The effects of unemployment (both negative and positive) vary for the economy as a whole and for individuals (. Table 8.2). Adverse economic factors of unemployment include expenditures incurred by the public budget on welfare payments to the unemployed (registered unemployment, according to . Fig. 8.11). The budget loses from the underpayment of taxes by the unemployed. Other negative consequences include a decrease in production and consumption of goods, a decline in the standards of living of the population, and a depreciation of knowledge and competencies across the unemployed labor force. At the same time, being immanent to any market economy, moderate unemployment may generate positive effects. The stand-by labor force currently unemployed in the economy can be used to advance structural

7

Standing (1999).

280

Chapter 8 · Disequilibrium and Unemployment

. Table 8.2  Economic and social effects of unemployment Category

Losses

Gains

Economy

Increase in public expenditures (welfare payments to the unemployed, retraining programs)

Incentive to improve performance through competition

Decrease in domestic output

Reserve of the labor force to be used in large-scale projects

Underpayment of corporate and income taxes

Retraining and professional development of temporarily unemployed labor

Loss of income, deterioration of the standards of living

Increase in social value and status of labor

Aggravation of income inequality and related social tensions

Retraining, education, professional reorientation

Increased crime

More free time

People

8

Source Authors’ development

transformations of the economy (retrained and employed in new sectors, attracted to new territories, utilized in implementing large-scale infrastructure or construction projects, etc.). A fear to lose a job stimulates employees to work harder, perform better, and develop skills and competencies. Temporarily unemployed people may devote more time to personal development and growth, education, and retraining. Unemployment exerts a negative impact on society by widening gaps between not only income groups (the rich and the poor), but also within these groups (for example, employed and unemployed people within the low-income segment). Social tensions arise between and within social groups. Some of those who have lost income may start committing crimes (robberies, frauds, etc.), join the shadow sector, or suffer physical and mental illness caused by stress from losing their jobs. Social apathy due to a long futile search for a new job degrades labor potential and depresses the willingness to get back to work in the future. Nevertheless, there are also gains, including a change in the employee’s opinion about the social value and status of being employed and an opportunity to devote more time to personal development and education. Case box In the new normal economic reality, the effects of unemployment on the economy and society are ambiguous (as shown above in . Table 8.2), but losses are exacerbated (consequently, gains are offset) against the background of high volatility and instability of domestic and global markets, as well as the uncertainty of the post-pandemic recovery of the world economy. Due to the COVID-19 pandemic, the number of unemployed in the world in 2020 rose sharply to 224 million people (from 5.4% in 2019

8

281 8.3 · Effects of Unemployment

to 6.6% in 2020 worldwide) (. Table 8.2). Global unemployment is expected to remain above the pre-pandemic level until at least 2023 (. Table 8.3). The economic downturn induced by the pandemic has affected different groups of workers and countries unequally, deepening inequalities within and between countries and weakening the economic, financial, and labor capacities of all. Since mid-2021, higher-income countries have demonstrated faster recovery of the labor market compared to lower-income and middle-income economies. Employment in Europe and North America is recovering faster than in Southeast Asia, Latin America, and the Caribbean. The crisis has particularly hit women’s employment across service sectors. The disruption of education and training (closure or online formats) will have increasing long-term consequences for young people. The structure of demand for labor and the movement of labor between countries is changing (see 7 Chap. 21, 7 Sect. 21.5). There grows demand not only for doctors, but also for IT and communication specialists, business analysts, and experts in online education and marketing of online services.

An estimation of unemployment is complicated by the following impediments: 5 Part-time employment. Commonly, statistics does not distinguish between full-time and part-time employees and thus underestimates the unemployment rate. 5 Unemployed who have lost hope for returning to work. They may be reported as temporarily unemployed, but in reality, they face long-term stagnant unemployment. 5 Unreliable information. Unemployed people may claim that they continue looking for jobs, receive welfare payments from the government, but work in the shadow sectors. As noted above, unemployment is both a macroeconomic and an individual problem. In addition to the economic and social effects of unemployment for the economy and society summarized in . Table 8.2, another side economic and non-economic consequences of unemployment can be distinguished. The non-economic sphere comprises social, psychological, and political consequences of job loss. At the individual level, a failure to get a job for a long period of time breeds inferiority, stress, illness, and loss of friends. The loss of income or part of the income today potentially decreases future standards of living due to the loss of qualification (lower chance of finding a high-rewarding job in the future). At the macroeconomic level, unemployment reduces output. The unemployment gap (see 7 Sect. 8.2.1) increases the deviation (lag) of actual GDP from potential GDP (full employment). There arises the GDP Gap calculated as the ratio of the difference between actual GDP (Y ) and potential GDP (Y ∗ ) to potential GDP (Eq. 8.3):

YG =

Y − Y∗ × 100% Y∗

(8.3)

8

3,407

3,471

3,532

3,578

2020

2021

2022

2023

253

263

273

283

2020

2021

2022

2023

611

616

618

622

2020

2021

2022

2023

60.4

60.3

60.3

60.2

61.0

66.4

66.2

65.7

65.4

67.3

59.4

59.3

59.0

58.6

60.5

Labor force participation rate, %

592

588

581

572

587

267

257

248

239

240

3,375

3,325

3,257

3,183

3,287

Employment, millions

57.5

57.4

56.9

56.3

58.1

62.6

62.2

61.9

61.7

64.0

56.0

55.8

55.4

54.8

57.3

Employment-topopulation ratio, %

8 International Labor Organization (2022).

Source Authors’ development based on International Labor Organization (2022)8

617

2019

High-income countries

253

2019

Low-income countries

3,473

Labor force, millions

2019

World

Country groups / years

. Table 8.3  Labor force and unemployment in 2019–2023, world and country income groups

29

31

35

40

29

16

16

15

14

12

203

207

214

224

186

Unemployment, millions

4.7

4.9

5.6

6.5

4.8

5.7

6.0

5.9

5.6

4.9

5.7

5.9

6.2

6.6

5.4

Unemployment rate, %

282 Chapter 8 · Disequilibrium and Unemployment

283 8.3 · Effects of Unemployment

8

where YG   GDP gap; Y actual GDP; Y ∗ potential GDP. Okun’s Law named after Arthur Okun who first proposed it in 1962 establishes the relationship between the GDP lag and the level of cyclical unemployment (further reading: “Potential GNP: Its Measurement and Significance”8). Okun’s coefficient (β > 1) measures the deviation of real output from its potential level caused by an increase in the real unemployment rate by one percentage point (Eq. 8.4).

  Y − Y∗ × 100% = −β × u − u∗ Y∗

where β u u∗ (u − u∗ )  

(8.4)

Okun’s coefficient; real unemployment; natural unemployment; cyclical unemployment.

The law says that if real unemployment exceeds natural unemployment by one percentage point, then the GDP lag equals to β percentage points. Actual GDP is inversely proportional to cyclical unemployment: the higher the unemployment rate, the lower the actual GDP compared to the potential GDP at full employment. It is accepted that if real unemployment remains unchanged in the reporting period compared to the previous year, then real GDP grows by 3% (Eq. 8.5):

Yt − Yt−1 × 100% = 3% − 2 × (ut − ut−1 ) Yt−1

(8.5)

where real unemployment (current period); ut ut−1   real unemployment (previous period). In Eq. 8.5, 3% is an average annual growth rate of potential GDP in developed economies due to the yearly increase in employed resources (labor and capital) and technological progress. Coefficient 2 shows by how many percentage points actual GDP decreases when the unemployment rate rises by one percentage point in the absence of economic growth. This coefficient reflects the sensitivity of changes in GDP to changes in the real unemployment rate. This means that in the absence of economic growth, an increase in unemployment by one percentage point reduces real GDP by 2%. Equation 8.5 allows one to find not only

9

Okun (1962).

284

Chapter 8 · Disequilibrium and Unemployment

. Fig. 8.14  Okun’s output-unemployment curve. Source Authors’ development

8

the deviation of GDP caused by the growth of unemployment, but, conversely, an increase in real unemployment due to the economic decline. According to Okun’s law, unemployment rises in times of economic downturn and decreases in times of economic revival (. Fig. 8.14). In the former case, a decline in the gross output from Y2 to Y1 pushes the unemployment up from U2 to U3. Conversely, a growing economy (output shifts from Y2 to Y3) demands more labor, and the unemployment falls from U2 to U1. Case box The coefficient was calculated by Arthur Okun for the USA, so it may differ for other countries. According to Okun’s calculations, in the 1960s, the β parameter for the USA was 3 with a natural unemployment rate of 4%. That means that every percentage of market unemployment reduced actual GNP by 3% compared to GNP at full employment. Okun attributed the gap to the fact that not all those laid off are registered as unemployed in times of cyclical unemployment. Part of employed labor shifts to part-time work. The average labor productivity decreases due to the hidden unemployment in production. Thus, Okun’s coefficient demonstrates that output is determined not only by the level of technology, but also by the change in the behavior of economic stakeholders when the economic situation changes.

In the long term, the output can be increased by attracting additional capital and labor and introducing technical and technological innovations. In the short run, when firms reactively respond to changes in aggregate demand by adjusting their output, the only factor of production which cost can be changed is labor. When demand rises, such long-term inflexible factors as capital accumulation and technological advances make a rather modest contribution to increasing output. When demand falls, firms start cutting their costs by adjusting the most

285 8.3 · Effects of Unemployment

8

flexible element—labor costs (part-time schedules, no hiring new employees, or staff cuts). To manage labor costs, firms can reduce or extend working hours, or the number of workers employed, or both parameters. Therefore, being the most flexible factor of production, labor is the first to face the effects of market disequilibriums and volatilities. Rates of unemployment differ substantially between developed and developing countries. One of the essential features of the new normal economic reality is the increase in natural unemployment in developed markets. Natural unemployment has actually absorbed frictional and structural unemployment. Today, the natural unemployment rate depends on the minimum wage rate (the higher the wage in developed countries, the higher the natural unemployment), unemployment benefits (substantial welfare payments in developed countries compared to developing economies fuel natural unemployment), and trade unions (powerful trade unions protect workers’ rights in developed countries). As noted above in 7 Sect. 8.2.1, natural unemployment is inherent to market economies. It is the long-term equilibrium in the labor market at which expectations (aggregate demand, demand for labor, economic growth, inflation, etc.) match the current macroeconomic parameters of the market. This interpretation of the natural level of unemployment lies at the heart of the dynamic model of a stable level of unemployment elaborated by Milton Friedman (. Fig. 8.15). The model assumes that a part of the employed E loses their jobs and becomes unemployed U . Then a part of the unemployed finds new jobs. The equilibrium (natural unemployment) balances the numbers of newly unemployed and newly employed workers. The number of employed who lost their jobs and became unemployed (SU × E, where SU is the share of employed who lost their jobs of the total number of employed) is equal to the number of unemployed who found work and became employed (SE × U , where SE is the share of unemployed who found jobs of the total number of unemployed) (SU × E = SE × U). The natural unemployment hypothesis suggests that fluctuations in aggregate demand only affect current output and employment. In the long run, the market remains in the classical equilibrium (the natural unemployment rate and the potential output), on which short-term fluctuations in aggregate demand exert no effect. However, the natural unemployment concept can be challenged, since, in the long term, both the GDP and the unemployment rate are affected by fluctuations in aggregate demand. An economic downturn can damage the economy in the long term by affecting the natural unemployment rate. One of the effects of this kind is hysteresis. The term describes the long-lasting impacts of past events

. Fig. 8.15  The dynamic model of labor. Source Authors’ development

286

Chapter 8 · Disequilibrium and Unemployment

. Fig. 8.16  Economic hysteresis. Source Authors’ development

8

on natural unemployment. Economic Hysteresis is unemployment caused by past disruptions in the labor market, which tends to persist even after these disruptions have been eliminated. An economic downturn depresses nominal macroeconomic parameters of output and employment, but does not change real ones. But hysteresis reduces aggregate supply ( AS1 curve shifts leftward to AS2) (. Fig. 8.16). Output falls from Y1 to Y2, and natural unemployment in the economy rises. Persisting unemployment at lower output reduces aggregate demand in the economy ( AD1 falls to AD2), and the economy shrinks to point C with a substantially worse supply-demand ratio. Case box The hysteresis effect can explain the rise in unemployment in Europe after the two oil crises in the mid-1970s and early 1980s. A substantial decrease in the aggregate demand for labor drove up unemployment across Europe. Trade unions responded to flaring unemployment by demanding higher wages. Employment opportunities deteriorated sharply—no firm wanted to employ new labor amid falling aggregate demand and rising wages. As a result, the unemployment crisis outlasted oil shocks that had triggered it. In the USA and Japan, where trade unions pursued less stringent policies, unemployment peaked during the oil crises, but then returned to the pre-crises level in the 1980s (no hysteresis observed).

Economic and social turbulences aggravate psychological pressure on people and affect the personal qualities of the unemployed. The degradation of valuable skills changes attitude towards work and depresses the willingness to get a job. The share of long-term structural unemployment in natural employment rises, while that of flexible frictional unemployment declines. Economic

287 8.3 · Effects of Unemployment

8

. Fig. 8.17  Phillips curve. Source Authors’ development

downturns also affect wage systems, since the unemployed lose influence on the wage determination process. Therefore, hysteresis is deemed to be a menace to the long-term stability of the labor market and the entire economy. That is why the overarching goal of the government’s employment policy is to shift the supply curve to the right (further detailed in 7 Sect. 8.4), in particular, by cooling inflation expectations. The correlation between the unemployment rate and the change in monetary wages was derived by Alban Phillips (further reading: “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957”9). The Phillips Curve illustrates the inverse relationship between inflation I and unemployment U (. Fig. 8.17). The initial equilibrium between inflation I1 (prices and wages) and unemployment U1 establishes at point A on the original short-term Phillips curve PC1. The increase in the money supply pushes prices and wages up. The influx of money triggers consumption. In the short-term, higher aggregate demand (the equilibrium slides along the PC1 curve from point A to point B) fuels inflation (from I1 to I2). Consequently, amid booming demand and intensive use of all resources above the natural level, unemployment declines from U1 to U2. Competition for attracting scarce resources to expand output and supply drives up all kinds of production costs, including wages. The increase in total costs, in turn, erodes the shortterm effect of increasing demand as a factor of output growth. In the long run, unemployment U2 returns to its natural level U1, but at a higher level of prices and wages I2. The new equilibrium establishes at point C. The long-term Phillips curve

10 Phillips (1958).

288

Chapter 8 · Disequilibrium and Unemployment

takes the form of a vertical straight line NAIRU (non-accelerating inflation rate of unemployment) that corresponds to the natural unemployment rate at any level of prices and wages I (Eq. 8.6):

I = I2 − b × (u2 − u1 ) + υ

(8.6)

where I inflation; I2 expected inflation; (u − u∗ )  deviation from natural unemployment (cyclical unemployment) (see Eq. 8.4); b coefficient (b > 0); υ supply shocks.

8

A new attempt to reduce unemployment in the short term will again require an injection of money into the economy. This will temporarily shift the equilibrium upward along the new short-term Phillips curve PC2. Both prices and wages will go up, and the inflation-unemployment cycle will repeat with the acceleration in inflation above I2 and the return of unemployment to its normal NAIRU = U1 in the long run. Case box The rationale behind the Phillips curve is that during economic downturns, high unemployment keeps the labor supply abundant. There is no need for businesses to raise wages. Therefore, total labor costs remain relatively low. Amid economic recovery, businesses compete for labor by offering higher wages and thus fueling inflation. Until the late 1970s, many developed countries practiced balancing between inflation and unemployment. The economic policy allowed an increase in unemployment to combat inflation. Conversely, employment was stimulated by the weakening of control over inflation. However, in the long term, unemployment returns to its natural level regardless of the rate of inflation.

The Keynesian school acknowledges different short-term and long-term shapes and configurations of the Phillips curve. Monetarists recognize only the short-term Keynesian Phillips Curve. According to the theory of rational expectations, the market swiftly adapts to changes in aggregate demand. It states that the minimum possible unemployment rate always corresponds to its natural level, and, therefore, the Phillips curve always takes the form of a vertical straight line. Along with managing the inflation expectations, various economic policy measures are applied to reduce the natural unemployment rate by shifting the AS curve to the right, i.e., by increasing the economic potential Y as illustrated in . Fig. 8.16. However, these shifts mainly address those unemployed who are ready to get back to work right away (short-term frictional ­ unemployment).

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Long-term structural unemployment can be addressed by introducing v­ ocational retraining programs and other initiatives aimed at improving cross-sectoral occupational mobility of labor as part of government policy. 8.4  Labor Market Regulation

Unemployment (particularly, structural unemployment) is one of the starkest examples of market failure (failures and imbalances in markets are further discussed in 7 Chap. 10). Disregarding the classical concept of self-adjusting labor markets, a responsible government should aim at avoiding deep structural unemployment and smoothing the consequences of frictional unemployment. Preventing adverse social and economic effects of unemployment on economic development condones certain distortions the government intervention may bring to the classical equilibrium in the labor market. To a greater or lesser extent, governments around the world pursue targeted labor policies and establish comprehensive regulations (hiring and dismissal procedures, wage and hour laws, labor safety, days-offs and vacations, resolution of labor conflicts, workers’ rights, etc.). The two central aims of labor market regulation include the following: 5 Preventing cyclical unemployment while maintaining the natural level of unemployment as a combination of frictional and structural forms of unemployment. Within natural unemployment, the government should decrease the share of the structural element (longer-term forced unemployment) by means of increasing the share of the frictional element (shorter-term voluntary unemployment). 5 Creation of a flexible labor market capable of quickly adapting to changes in endogenous and exogenous parameters while maintaining resilience to economic, social, and political shocks. In the now normal environment, flexibility implies using part-time workers and temporary employment, easy switching between offline and online formats, in-office and remote work, education, and retraining (see 7 Chap. 21, 7 Sect. 21.5 for the new normal transformations of contemporary labor markets). In such a flexible market, everyone who wants to work should be able to find a job that meets their needs. Public regulation in the labor market is implemented in active and passive forms. Active Public Policy is a set of legal, organizational, and economic ­measures carried out by the government in order to reduce unemployment in a country. Examples of legal measures are setting the retirement age, working hours, compensation for off-hour work, minimum wage, labor safety standards, etc. Organizational measures include vocational education and training, creation of new jobs, professional development of the unemployed, and employment counseling and support. Economic measures are incentives for firms who create jobs and expand hiring people, such as preferential credits and loans, subsidies, or tax incentives. The most commonly used active measures include the following: 5 stimulation of investment in the economy, which is the main condition for expanding production and creating new jobs;

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5 organization of training and retraining of the unemployed (particularly, in the case of structural unemployment); 5 development of employment services, job centers, bureaus, and other intermediary bodies to distribute reliable and relevant information on vacant jobs, employment opportunities, and support programs; 5 promotion of small and family entrepreneurship and other forms of smallscale employment and self-employment; 5 support for jobs to certain target groups, such as young people, university graduates, people with disabilities and special needs; 5 facilitating a change of residence in order to obtain a job; 5 international cooperation in addressing employment-related challenges, including international migration of labor; 5 providing jobs in the public sector (education, health care, utilities, construction, public works, etc.).

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Active labor policies aim at increasing the economic and social efficiency of employment by changing its structure and forms, creating conditions for the development of human capital, and improving economic foundations of employment (competition between employers for attracting best labor, competition between workers for best jobs, market-based wages, etc.). Passive Public Policy implies support for the unemployed in the form of unemployment benefits, material assistance, and other social payments, as well as free medical care. Contemporary labor market policies combine active and passive approaches: 5 maximum activation of non-investment factors of economic growth in order to generate new jobs; 5 development of an effective mechanism for financing active and passive programs; 5 improving the efficiency of employment services; 5 reorienting the unemployed to an active independent job search, 5 shifting the emphasis from passive services for the unemployed to active professional consultations, career guidance, and psychological assistance; 5 targeted regional policy in the labor market (special programs to combat unemployment and diversify employment opportunities in certain territories); 5 dual passive policy (assistance to the unemployed plus the insurance of the employed against unemployment). According to the neoclassical approach, the regulation of unemployment should combine lowering wages and explaining to trade unions that rising wages during economic decline spurs unemployment. The government should employ low-income people to moderate social unrest. The Keynesian school also advocates the use of public works (construction of roads, infrastructure, public buildings, etc.) along with measures aimed at reviving competition, investment, and, as a result, consumer demand (public procurement and other forms of government spending). When unemployment rises against the background of inflation (see

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the Phillips curve case illustrated in . Fig. 8.17), monetarists propose removing all burdens on the public budget to reduce inflation. Curbing inflation strengthens the currency and establishes a healthy market environment. A self-regulating market cleanses itself of inefficient businesses through bankruptcy and attracts new competitive producers able to expand the supply and contribute to reducing unemployment. To rejuvenate the economy, monetarists suggest rising the refinancing rate to the level not accessible to weak enterprises. This curbs inflation by cutting money supply and leaves underperforming enterprises without access to funding at the same time. Case box During the COVID-19 pandemic, almost all countries in one way or another tried to curb rising unemployment and related social unrest through support measures for both businesses and citizens. In the USA, immediate measures to support the labor market and the population include an expanded unemployment benefit of $300 per week and the extension of support programs for firms and long-term unemployed people. The government allocated about $284 billion for affordable loans to small businesses. The support package complemented the law on the financing of the federal government in the amount of $1.4 trillion until October 2021. The EU SURE program provides for directing €100 billion of preferential loan funds to keep European firms from dismissing at least part of their employees. The UK allocated $5.7 billion to fight unemployment, out of which $3.9 billion contributed to the Restart program designed to help over one million unemployed people return to the labor market. Another $1.9 billion was directed to additional funding of the employments services.

Approaches to combating unemployment differ depending on the individual concept of labor policy particular country (or particular government) adheres to. Several national-specific models of labor market regulation can be distinguished: the competition-based American model (relatively free labor market, moderate government interventions in times of severe disequilibriums), the society-oriented Scandinavian model (achieving maximum possible employment, public sector jobs, support of the unemployed, mitigating income inequalities), and the job-forlife Japanese model (tenure contracts, wages depend on work experience and age). In general, the unemployment rate is directly proportional to the level of unemployment benefits, but inversely proportional to the number of employment programs and retraining opportunities offered in a country. Chapter Questions: 5 Illustrate and interpret moves of the equilibrium point along the demand and supply curves and the shifts of the demand and supply curves in the labor market. 5 Explain the essence of natural unemployment as a combination of frictional and structural unemployment. 5 What is the unemployment gap and how does it differ from the GDP gap?

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5 What is the main difference between full employment and natural employment? Can full employment coexist with natural employment in the labor market? 5 Formulate the classical vision of unemployment. From the classical point of view, how should unemployment be addressed? 5 How would you define the principal difference between the Marxian and the Keynesian interpretations of unemployment? 5 Distinguish between economic and social effects of unemployment for the economy, society, and individuals. Which of the effects dominate in the new normal economic reality? 5 How does the Okun’s law explain the relationship between the GDP lag and the level of cyclical unemployment? Do you think this relationship adequately describes the GDP-employment linkage? 5 Define economic hysteresis and explain its operation in the labor market. 5 Why does inflation inversely relate to unemployment? 5 Discuss the applicability of conventional active and passive policies in regulating labor markets in the new normal economic reality. Are there any modifications to contemporary labor policies which you may suggest to better address the new normal trends? Subject Vocabulary: Active Public Policy: a set of legal, organizational, and economic measures carried out by the government in order to reduce unemployment in a country. Cyclical Unemployment: a type of unemployment that implies repeated deviations of the actual unemployment rate from the natural one. Economic Hysteresis: a situation in the labor market when unemployment caused by past disruptions tends to persist even after these disruptions have been eliminated. Full Employment: a situation in the labor market when the number of jobs available in the economy corresponds to the number of people looking for work. Frictional Unemployment: a predominantly short-term voluntary unemployment that arises due to discrepancies between the number of employees and vacant jobs. GDP Gap: the ratio of the difference between actual GDP and potential GDP to potential GDP. Labor Market: a system of economic mechanisms, institutions, and regulations that facilitate the use and reproduction of labor. Natural Unemployment: an equilibrium in the labor market established under the combined influence of factors raising and lowering wages, demand for labor, and supply of labor. Okun’s Law: the law that establishes the relationship between the GDP lag and the level of cyclical unemployment (unemployment rises in times of economic downturn and decreases in times of economic revival). Passive Public Policy: a support for the unemployed in the form of unemployment benefits, material assistance, and other social payments.

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Phillips Curve: the inverse relationship between inflation and unemployment. Rate of Unemployment: the ratio of the number of unemployed people to the total labor force expressed as a percentage. Seasonal Unemployment: a type of unemployment caused by seasonal fluctuations in demand for labor in certain industries. Structural Unemployment: a type of unemployment that occurs when a surplus of labor in one sector coexists with a shortage of labor in another. Unemployment: a social and economic phenomenon consisting in the fact that a certain part of the population in active working age does not have a job and, accordingly, income (those who want to work cannot find work at an adequate wage rate). Unemployment Gap: the difference between the potential gross product at full employment (or natural equilibrium unemployment rate) and the actual gross product at cyclical unemployment.

References Azariadis, C. (1975). Implicit contracts and underemployment equilibria. Journal of Political Economy, 83(6), 1183–1202. Baily, M. N. (1974). Wages and unemployment under uncertain demand. The Review of Economic Studies, 41(1), 37–50. International Labor Organization. (2022). World Employment and Social Outlook: Trends 2022. International Labor Organization. Keynes, J. M. (1936). The general theory of employment, interest and money. Macmillan. Marx, K. (1867). Capital: A critique of political economy. Available at 7 https://www.marxists.org/archive/marx/works/1867-c1/. Okun, A. (1962). Potential GNP: Its measurement and significance. In Proceedings of the Business and Economic Statistics Section of the American Statistical Association (pp. 89–104). Alexandria, VA: American Statistical Association. Phillips, A. W. (1958). The relation between unemployment and the rate of change of money wage rates in the United Kingdom, 1861–1957. Economica, 25(100), 283–299. Pigou, A. C. (1933). The theory of unemployment, Vol. 8 of A. C. Pigou: Collected Economic Writings. Basingstoke: Macmillan. Smith, A. (1776). An inquiry into the nature and causes of the wealth of nations. London: W. Strahan. Standing, G. (1999). Global labor flexibility: Seeking distributive justice. Palgrave Macmillan.

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© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_9

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Learning Objectives: 5 Learn the meaning and types of inflation 5 Explore major theories of inflation (theory of cost-push inflation, theory of demand-pull inflation, Keynesian theory of inflation, monetarist theory of inflation) 5 Reveal root causes of inflation 5 Summarize monetary and non-monetary effects of inflation 5 Discover approaches to measuring inflation 5 Discuss distinctive features of anti-inflationary regulation in the new normal 9.1  Foundations of Inflation 9.1.1  Meaning of Inflation

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Along with unemployment (a disequilibrium in the labor market), macroeconomic imbalances manifest themselves in inflation as a result of macroeconomic instability, when aggregate demand exceeds aggregate supply. Inflation is the excessive growth of money supply (aggregate demand) in comparison with the supply of goods and services (aggregate supply), which results in the depreciation of money (loss of purchasing power) and a general long-term increase in commodity prices. Initially, the economic meaning of inflation was associated with the depreciation of money due to the excessive supply of capital. The term “inflation” arose in connection with the massive transition of national monetary systems to the circulation of non-exchangeable paper money. Case box Although inflation can be traced far back in ancient history, the term “inflation” itself was first used in North America during the civil war of 1861–1865 to refer to the rapid increase in paper money circulation. A century earlier, the first attempt to introduce paper money into circulation resulted in catastrophic inflation in France (although not called “inflation” at that time). In the 1720s, France decided to start exchanging paper money for gold and silver coins. However, the excessive emission of paper money unbacked by gold and silver ruined the market.

The reverse process, when money becomes too scarce (reduction in aggregate demand) in comparison with the supply of goods and services (aggregate supply either remains stable or decreases at a slower rate compared to the fall in aggregate demand), causes a decrease in prices, or deflation. Deflation is an increase in the purchasing power of a currency manifested in a reduction of prices due to the rising value of money or undersupply of money in circulation. Therefore, deflation implies a cut in the cost of goods and services amid an increase in the cost of

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money. Although price cutting may seem to be a positive phenomenon, ­deflation rather indicates a recession in the economy, a reduction in gross output, and rising unemployment. Lowering prices mean lowering returns. Economic agents put expenditures and investments on hold with the expectation of gaining higher returns on capital in the future when prices resume rising. This behavior further depresses aggregate demand and pushes prices down. Stagnating output (no new investment for expanded reproduction) stunts economic growth and sends the economy into recession. However, pure deflation has become rather rare. It is now limited to short-term seasonal declines in prices in individual markets (for example, agricultural products). Case box One of the most demonstrative examples of a long-lasting deflation is Japan’s “economic miracle”. Economic reforms in the second half of the XX century substantially improved the level of income across the nation. When demand for necessities was generally satisfied, the government started stimulating savings. Free capital was absorbed by the rapidly growing securities market. Higher returns in the stock market diverted capital from the production sector and encouraged speculative trading. It turned out more profitable for companies to gain from shorter-term financial operations than from investing in longer-term real sector projects. The government tried to limit the speculative market by increasing the base rate. However, that further shrank investment in the construction sector and the real estate market and squeezed the money supply in the country. The slowdown in the two key markets depressed the already sluggish consumer behavior, and a recession spilled over to other sectors. Prolonged deflation has markedly hampered economic growth—over the past decade, Japan’s annual GDP growth rate has not exceeded 1.5%.

In the new normal reality of the diversity of markets, inflation in one market may coexist with deflation in another. This combination is called Biflation—a simultaneous occurrence of inflation and deflation in the economy, i.e., an increase in prices for one category of goods (one sector or industry) and a decrease in prices for another category (sector, industry) within the economy (country, region, or the entire world market). Examples of biflation are appreciating essential goods and depreciating luxury goods, or inflation in the market of consumer goods amid a fall in prices of goods purchased on credit. The biflation mechanism works as follows: in times of economic downturn, people first cut consumption of luxury goods (higher elasticity to income), but continue consuming essential goods (lower elasticity to price). The central bank emits money to stimulate economic activity. Emission bolsters the money supply and drives up prices for essential goods (since the aggregate demand for these goods is relatively stable). An increase in unemployment and a decrease in the purchasing power of the population cut demand for luxury goods, not essential goods. Prices of luxury goods fall (deflation), while those of essential goods rise (inflation).

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Case box The fundamental principle of biflation (sector-specific inflation and deflation within an economy) can be applied to the world economy as a whole. One of the characteristic features of the new normal economic reality is the imbalance of individual domestic markets in relation to the world market. The world economy is the economy of biflation, as some countries face inflation, while others experience deflation. Biflation occurs in a country, when prices of foreign goods rise (inflation in the world market), but domestic prices fall (deflation in the domestic market). For example, China experienced biflation in the 2000s due to rising commodity prices and falling prices of final products.

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A fall in output (aggregate supply) may be accompanied by an increase in prices (aggregate demand). This situation is called stagflation. Stagflation is a situation when production stagnates or falls amid rising unemployment and a continuous increase in prices. Being peculiar to the new normal economic reality, stagflation is associated with new conditions for the reproduction of capital in the cyclical development of individual economies. Stagflation is commonly driven by exogenous factors, such as the global economic slowdown due to the COVID-19 pandemic. Other exogenous triggers of stagflation include irrational developmental policies (to spur post-pandemic economic revival, governments widely use expansionary policies that fuel inflation), the profit-driven behavior of monopolies and transnational corporations (they respond to declining effective demand by raising prices for their goods and services), as well as natural and man-made disasters that disrupt supply against the background of stable or growing demand. Stagflation is the worst kind of imbalance associated with inflation because it combines inflationary demand and costs. Case box Today, the risk of stagflation in the global economy is greater than ever in the past few decades. In developed economies, stagflation was last observed in the 1970s. Then, a 2% drop in the GDP in the USA was combined with inflation above 9% and unemployment of about 8%. Expansionary monetary policy, excessive growth of money supply across developed and developing countries, disrupted supply chains (both domestic and international), rising world prices for energy, food, and factors of production, the risk of the spread of new variants of COVID-19 and new lockdowns—all these factors accelerate inflation and slow down the recovery growth of the world economy.

A slowdown in the average rate of price growth compared to the previous period is called Disinflation. Unlike inflation and deflation, which both refer to the change in prices, disinflation refers to the change in the rate of inflation. If a central bank decides to employ a tighter monetary policy, and the government starts selling off some of its securities, it could reduce the money supply, causing

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a disinflationary effect. Similarly, a shortened business cycle or recession can also cause disinflation. For example, if businesses decide to keep prices unchanged to increase market share, the economy may experience disinflation. Disinflation is considered the opposite of reflation, which occurs when the government stimulates the economy by increasing the money supply. Reflation is a fiscal or monetary policy aimed at expanding output, stimulating spending, and containing the effects of deflation (further discussed in 7 Chap. 11, 7 Sect. 11.4 for monetary policy and in 7 Chap. 13, 7 Sect. 13.4 for fiscal policy). 9.1.2  Types of Inflation

The interpretations of the causes and effects of inflation have evolved with the development of economic relations. Nevertheless, at all times, inflation was understood as a long-term process of growth in the price level, which had a certain impact on a variety of economic, political, and social aspects of life. Due to such a multifaceted interpretation of inflation, several types of inflation are commonly distinguished (. Fig. 9.1).

. Fig. 9.1  Types of inflation. Source Authors’ development

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Similar to natural unemployment (see 7 Chap. 8, 7 Sect. 8.2.1), Mild Inflation is the market equilibrium established under the combined influence of aggregate demand and aggregate supply that results in a moderate increase in the price level (up to 5%). Mild inflation is common in most economies, particularly developed economies. In many developing countries, inflation rates exceed 5%. Creeping Inflation is an increase in the price level of no more than 10%. In general, a one-digit rate of inflation (either mild or creeping inflation) is positive for the economy, since it stimulates economic reproduction, incentivizes firms to renew the assortment, and adjusts prices based on the alternating supply and demand. Such inflation can be addressed and managed by conventional inflationary instruments (see 7 Sect. 9.4) and monetary and fiscal measures (7 Chap. 11, 7 Sect. 11.4 and 7 Chap. 13, 7 Sect. 13.4, respectively). Galloping Inflation implies the rise in prices from 10–20% up to 100–200% per year. With galloping inflation, economic entities account for price changes in contracts, while people seek to save money by investing in goods and other material values. Such inflation is difficult to manage through the simple application of standard monetary and fiscal measures. It requires structural economic, social, and even political reforms. Hyperinflation occurs when the overall price level rises by more than 50% per month or more than 200% per year. It is challenging to make a firm distinction between hyperinflation and galloping inflation. Formally, the beginning of hyperinflation is considered to be the month in which the price increase for the first time exceeds 50%, and the end is the month preceding the one in which the price increase falls below this threshold and stays below it for at least a year. Case box Galloping inflation is more common than hyperinflation. Nevertheless, some countries faced severe hyperinflation, especially after the World War II. The Pengo in post-war Hungary is the currency that experienced the world’s highest hyperinflation ever. In the period from August 1945 to July  1946, the maximum inflation per month reached 40 quadrillion percent 40 × 1015 . At the peak of inflation, prices rose by 150,000% per day. The largest banknote ever circulated on the planet was equal to sex  denomination tillion Pengo 1021 . The countries of Central and Eastern Europe, as well as Russia and other post-Soviet states, experienced galloping inflation and, in some cases, hyperinflation after the collapse of the Soviet Union in the early 1990s. A striking example is that the breakup of Yugoslavia in 1992 was accompanied by hyperinflation, which reached its peak in 1994 (116,546 million percent per year, or 314 million percent per month). Although the occurrence of galloping inflation in the world has declined sharply since 2000, some countries periodically face this problem. For example, in the bottom year of the economic crisis in Venezuela in 2018, average annual inflation skyrocketed to 1,370 thousand percent (686% in 2021).

Inflation can originate both within the economy and outside it. Depending on the nature of inflationary impulses in relation to the economy, imported inflation should be distinguished from exported inflation. If a country maintains a fixed

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exchange rate, an increase in the prices of imported goods brings inflation to the country. Imported Inflation is a type of inflation that emerges due to the increase in prices of imported goods or a significant inflow of foreign currency into a country. Imported inflation manifests itself in two cases. First, obtaining loans in foreign currency and exchanging foreign currency for the national one increases the supply of money in the domestic market. Second, inflation can be imported when countries with an active balance of payments practice emission of the national currency to purchase foreign currency. Exported Inflation implies the spillover of inflation from one country to another as a result of conducting trade and financial operations in different currencies in international economic relations. Exported inflation is common for those countries whose currency is used as a reserve currency (for example, the US Dollar or the Euro) or whose goods shape a significant share in the imports of other countries. Depending on the correlation of price increases for different commodity groups, inflation can be balanced or unbalanced. Balanced Inflation is a type of inflation when prices of different commodity groups remain unchanged relative to each other. Both businesses and people tolerate mild or even creeping balanced inflation. The former adjust prices periodically, while the government commonly supports the purchasing power of the latter by periodic indexations of minimum wages and welfare payments. Unbalanced Inflation is characterized by a constant change in the prices of various goods in relation to each other in different proportions. Such dissimilar volatility of prices damages businesses (hard to make pricing and investment decisions) and people (hard to choose a less painful strategy of consumption and saving). Amid both balanced and unbalanced inflation, economic actors (people, businesses, and governments) seek to anticipate changes in the key macroeconomic parameters. In accordance with the criterion of expectation, inflation can be distinguished between anticipated inflation and unanticipated inflation. Anticipated Inflation is the rate of inflation expected by economic actors and reflected in their respective economic behavior (including irrational expectations and panic behavior). Expectations are associated with a vision of the prospects for the development of the country’s economy or an anticipated increase in prices due to economic, social, political, or force majeure events (for example, lockdowns during the COVID-19 pandemic and fears of a shortage of certain goods). A typical behavior pattern is to reduce savings and increase current consumption (to win from purchasing today at a lower price). The supply outmatches the emerging demand, and a rise in current demand as a result of inflation expectations provokes a further increase in prices. Expected inflation is associated with the reallocation of income (redirection of part of savings into consumption), a reduction in money reserves, and more frequent changes in price tags. Money lenders seek to receive their money from borrowers with increased interest, i.e., adjusted for expected inflation. Unanticipated Inflation is associated with a spontaneous spike in prices. Its consequences are more adverse than those of anticipated inflation, as it triggers the speculative redistribution of wealth among people. Those whose incomes are fixed (wages, pension, benefits, etc.) suffer from unanticipated inflation the most. A sudden change in prices gives no time to adjust the consumption-saving

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strategy. It takes time for nominal monetary incomes to change, and people with fixed incomes lose due to the gap between the spike in prices and the indexation of nominal income. Because of the gap, the nominal monetary income in the current period (MNt) remains equal to the nominal monetary income in the pre-inflation period (MNt−1). However, since the rate of inflation i rises, real income falls (Eq. 9.1):

MRt =

MRt−1 i+1

(9.1)

where real monetary income in the current year t ; MRt MRt−1   real monetary income in the pre-inflation period (t − 1). Since the return on capital depends on the interest rate, the real interest rate r is determined on the basis of nominal interest rate R and inflation rate i . If an economic actor expects a certain inflation rate, the expected inflation rate ie is used as a variable (Eq. 9.2).

r=

9

R − ie ie + 1

(9.2)

where r real interest rate; R   nominal interest rate; ie   expected inflation rate. If an individual (any economic actor) keeps the money for a certain period of time (no change in the nominal amount of money in possession), then the real i amount of money decreases by inflation i+1 . That means that if nominal incomes of a large number of people in a country remain unchanged during the period of inflation, their real incomes fall. Those economic actors who are able to adjust their incomes may win. They are banks that set an interest rate on deposits below the inflation rate. Another winning party is the government, which emits money and receives a Seigniorage, an income from money emission calculated as the difference between the cost of producing a currency unit and the real denomination of this unit. Commonly, seigniorage does not exceed 1% of GNP, but it rises substantially during periods of inflation (the denomination growth outpaces that of emission costs). The loss of real incomes of the population as a result of inflation is called an Inflation Tax. An inflation tax is essentially a consumption tax. Thus, rising inflation during the period of economic recovery absorbs part of a rise in real incomes through inflation tax, reduces consumption, and thus prevents the economy from overheating. Depending on what forms the inflationary imbalance takes, open (explicit) and hidden (suppressed) inflation are distinguished. Open Inflation is an explicit excess of aggregate demand over aggregate supply, i.e., the amount of money exceeds the volume of goods and services sold. Open inflation is manifested in a

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prolonged increase in prices. It includes demand-pull inflation and cost-push inflation (further addressed in 7 Sect. 9.2.1), price cap inflation, and tax inflation. Tax inflation is when high rates of income taxes slow down the growth of output. With high taxes, producers have no incentives to invest in the development of production. They can earn more by depositing money in a bank and receiving income in the form of interest. When the government raises tax rates, firms simply increase prices by the size of the tax rate. Anticipating the introduction of new taxes and other payments, producers raise prices in advance in an attempt to compensate for future losses. Such preventive increase in prices triggers price cap inflation. Hidden Inflation occurs when the government restrains or bans price increases by freezing prices and incomes, setting upper limits for the growth of prices and incomes, and establishing proportions between wage growth and labor productivity. Administration of prices commonly results in a deficit of goods in the market. Therefore, hidden inflation is more harmful to the economy than open inflation, as it disables the supply-demand mechanism of pricing and paralyzes the market. Most countries refuse employing direct administration of prices. Depending on the ability of the state to manage inflation, the latter is divided into manageable inflation and unmanageable inflation. In the first case, the government can slow down or accelerate the growth rate of prices in the medium term. In the case of unmanageable inflation, the rate of inflation can not be effectively got under control in the short term (further discussed in 7 Sect. 9.4). 9.1.3  Theories of Inflation

Theories of inflation explore the causes of long-term growth of prices and elaborate approaches to managing inflation. In the broadest strokes, a multitude of theories of inflation is divided into theories of cost-push inflation and theories of demand-pull inflation. The latter is based on the quantitative concept of money reflected differently in the Keynesian theory of inflation and the monetarist quantitative concept of inflation. Theory of Cost-Push Inflation attributes inflation to permanently rising production costs, such as wages, prices for imported resources (raw materials, energy resources), and profits. One of the branches of the cost-push theory associates price increases with the growth of wages (labor costs). First attempts to demonstrate the influence of wages on prices were made in the XIX century (further reading: “A History of Prices”1) and then elaborated in the first half of the XX century (further reading: “Interest and Prices”2 and “Gold and Prices”3). The idea was that the growth of wages during periods of cyclical declines in output boosts overall production costs and, consequently, pushes up prices. Trade unions strive

1 2 3

Tooke, T. (1838).  Wicksell (1936). Laughlin (1909).

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for wage increases during an economic downturn to protect workers. Employers compensate for rising labor costs by charging higher prices for marketed goods and services. Inflation reduces real wages, trade unions again claim higher wages, and inflation rises again (further reading: “The New Inflation”4). This cause-andeffects link between wages and inflation is called the Wage-Price Spiral. The inflation problem is attributed to the concentration of economic power in the hands of large companies and trade unions. Monopolies are not subject to the laws of competition in setting wages and prices. They pull wages down below the equilibrium, while trade unions push them up beyond it. Trade unions may win in the short-run (companies agree to raise wages), but they ultimately fail in the long run, as companies simply shift extra labor costs to consumers (finally, the workers themselves). However, this interpretation of the causes of inflation does not take into account the influence of monopolies’ desire to receive super-profits on the overall dynamics of prices. The theory postulates that price increases are dictated solely by an increase in costs. It turns out that monopolies do not strive to achieve the highest possible rate of profit, which is doubtful. The key element of the wage-price spiral is labor productivity. The improvement in the performance of labor alleviates the pressure of rising wages on prices. With modest growth in labor productivity, not to mention the stagnation or decline of performance, the pressure of rising wages on inflation increases substantially. The second branch of the cost-push theory linked inflation with rising prices for imported goods. This factor of cost inflation plays an important role due to changes in prices for energy resources and raw materials in the world market and fluctuations in the exchange rate of the national currency in relation to major reserve currencies (see imported inflation in 7 Sect. 9.1.2). A depreciation of the national currency pushes up the prices of imports and thus fuels domestic inflation (further detailed in 7 Chap. 20, 7 Sect. 20.4). Inflation is the higher the heavier a given country depends on imports. The effect explicitly manifests itself in the market of final goods. Implicitly, it spreads over the economy as various types of imported resources and intermediate goods increase costs in domestic value chains and thus cumulatively scale up the inflationary effect. Conversely, when the national currency appreciates, imports become cheaper, and domestic prices go down. An increase in profits can also affect price changes. The so-called administered inflation is a rise in prices caused by companies in an attempt to fatten their profits. An important condition for administered inflation is the market oligopolistic power of the largest companies (previously discussed in 7 Chap. 3 in relation to market concentrations and oligopolies). In the 1960–1970s, the structuralist school revised the classical theory of costpush inflation (the structuralist approach to economic development and growth is further discussed in 7 Chap. 15, 7 Sect. 15.6.1). The key idea was to explain inflation by country-specific structural factors, such as the ratio of industrial

4

Thorp and Quandt (1959).

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production (the progressive sector) to agriculture (the conventional sector). Conventional sectors respond to monetary shocks or aggregate demand shocks with a lag, during which the rise of output and employment in the industrial sector outpaces that in the agricultural sector. A delayed rise of prices for agricultural products then stimulates the expansion of the industrial sector and thus triggers a new round of inflation. Aggregate supply always fails to keep pace with aggregate demand due to the rigidity of the structure of individual industries and sectors. The first generation of structuralist models addressed inflation in Latin America. According to this branch of the structuralist cost-push theory, inflation is a dynamic process caused by disproportions between industries and sectors of the economy, inelasticity of supply in relation to demand, low mobility of ­factors of production, and weak flexibility of prices (further reading: “Macroeconomics of Unbalanced Growth”5). Early structuralism attributes the emergence of inflation to the structure of demand, or transformation of demand. Thus, in developing countries, industrialization transforms demand (living standards improve, incomes rise, consumption patterns evolve from basic products toward more complex industrial goods). Transformation, in turn, stimulates changes in output and consumption, drives up prices, and increases the amount of money in circulation. Along with domestic factors, such structural inflation implies exogenous influences, for example, frequent devaluations of the national currency, sharp changes in export income, shortages of foreign currency, or rapid increases in imports. According to the structuralism, inflation is to be curbed by structural reforms aimed at stimulating balanced economic growth, eliminating imbalances, and increasing the elasticity of supply and mobility of factors of production. Conventional monetary, financial, and price regulations cannot cope with inflation. Moreover, restrictive measures without appropriate structural adjustments can give rise to a structural economic crisis. In the 1970s, the second generation of structuralist models postulated three premises of the so-called Scandinavian model of inflation: the division of the economy into export-oriented and domestic sectors, delays in wage changes, and fixed exchange rates. A characteristic feature of the Scandinavian model of inflation is the specific pricing of labor that has developed in Norway and Sweden (further reading: “A Model of the Price and Income Distribution Mechanism of an Open Economy”,6 “Wages, Growth and the Distribution of Income”,7 and “The Scandinavian Model of Inflation”8). The high degree of government control over wage contracts and agreements between employers and trade unions stipulated an almost synchronous and equal increase in wages across all sectors. For instance, in Sweden, wage agreements were first concluded for a period of one year. In the 1980s, agreements were signed by unions of workers of certain industries, on the one hand, and associations of entrepreneurs, on the other. By the 2000s,

5 6 7 8

Baumol (1967). Aukrust (1970). Edgren et al. (1969). Frisch (1977).

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the agreement period had expanded to three years. Agreements were signed by representatives of the union of municipal employees, the association of regional authorities, and the federation of administrative councils of Sweden. The agreements aimed at determining the procedure for calculating wages and stabilizing the labor market. Theory of Demand-Pull Inflation attributes inflation to the excess of effective demand for goods and services over the aggregate supply. The roots of the theory stretch back into the early years of the monetary theory (XIX century), which laid down the foundations of the link between the amount of money in circulation and the level of commodity prices. This relationship was clearly demonstrated by Irving Fisher in 1911 (further reading: “The Purchasing Power of Money”9). Alfred Marshall and Arthur Pigou amplified the quantitative theory of money by capturing the demand of economic agents for means of payment both as a means of circulation and as an insurance fund (further reading: “Money, Credit, and Commerce”10 and “The Economics of Welfare”11). Being based on the quantitative theory of money, the demand-pull concept of inflation explained the mechanism of inflation intrinsic to the XIX century and the first decades of the XX century. In the vast majority of cases, inflation of that time represented an upward reaction of prices to an increase in the supply of fiat banknotes unbacked by precious metals (commonly, during wars or post-war economic collapses—see, for example, “Types of War Inflation”12). Hence the methods recommended by quantitative theory to combat inflation included, first of all, reducing the volume of paper money and restoring their connection (exchange) with gold. At that time, such measures were sufficient to restore money circulation and pricing. In the XX century, the theory of demand-pull inflation split into the Keynesian and the monetarist branches. The Keynesian school radically transformed the early monetarist approaches to interpreting inflation. The Keynesian Theory of Inflation is founded on the two assumptions. The first is that under certain conditions, the self-regulation market mechanisms may fail to steer the economy out of crisis (previously discussed in 7 Chap. 1, 7 Sect. 1.2.2). This drawback of the market justifies the need for government interventions into regulating the economy by correcting imbalances. The second provision is that the government must adjust and stimulate the so-called effective demand by increasing government expenditures (see, for example, 7 Chap. 6, 7 Sect. 6.1.2 for the Keynesian theory of macroeconomic equilibrium) and employing liberal monetary policy (further discussed in 7 Chap. 11, 7 Sect. 11.4). It was the second provision on which a new interpretation of inflation and a new practical approach to dealing with inflation were substantiated. The novelty that the Keynesian school has contributed to the understanding of inflation is the rejection of rigid laws earlier postulated by the quantitative theory of money (particularly, in Fisher’s interpretation). The

9 10 11 12

Fisher (1911). Marshall (1923). Pigou (1920). Pigou (1941).

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Keynesian theory accepted the dynamic nature of both the velocity of money circulation and the volume of commodity transactions. Consequently, it recognized the effects of money circulation and the supply of goods on inflation. The theory also captured interest rates and unequal liquidity of various means of payment and securities as variables employed in the analysis of quantitative patterns of inflation (further reading: “The General Theory of Employment, Interest and Money”13). A rigid proportion in the interaction of the money supply and prices was challenged. Keynesian economists suggest that under certain conditions, a moderate increase in the money supply (effective demand in general) exerts a stronger effect on the rise in output and employment (through a decrease in the interest rate and, accordingly, through the growth of investment), but a weaker effect on the growth of prices. In other words, the Keynesian school not only rejected the thesis of the quantitative theory of money about proportionality in the change in the money supply and the price level, but it also put forward the thesis that low creeping inflation (defined above in 7 Sect. 9.1.2) could stimulate production and business activity in general. Quite opposite, the classical quantitative theory of money has a net negative attitude toward the fall in the purchasing power of money. It was Keynesian ideas that changed attitudes toward inflation in developed countries. Mild or creeping one-digit inflation was recognized as an intrinsic feature of the normal development of a market economy and a driver of output, gross product, and economic activity. The increase in the money supply amid structural unemployment can help boost investment and output and thus revive the economy. Nevertheless, it is expressly understood that higher galloping inflation and hyperinflation damage markets and pose substantial risks to the economic, social, and even political stability of countries. Galloping inflation occurs in conditions of full employment, when the increase in the money supply translates into the growth of prices. Galloping inflation and hyperinflation disorder money circulation and depress economic growth. Summarizing the provisions of the Keynesian theory of inflation, it should be stated that the Keynesian school emphasizes the following three factors of inflation: 5 monetary and credit expansion (see the Keynesian attitudes toward expansionary and contractionary monetary policies in 7 Chap. 6, 7 Sect. 6.6.2); 5 rising costs (increase in prices of raw materials and factors of production, outpacing the growth of wages compared to workforce productivity gains); 5 monopoly power of certain producers. In the Keynesian scheme of inflation, an increase in the supply of money boosts aggregate demand and thus triggers demand-pull inflation. An increase in prices of factors of production pushes up production costs and thus stimulates cost-push inflation. Monopolies seek to maximize their profits by raising prices beyond the supply-demand equilibrium (. Fig. 9.2).

13 Keynes (1936).

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9 . Fig. 9.2  The Keynesian model of inflation. Source Authors’ development

According to the Keynesian school, inflation should be addressed by an active government policy, i.e., a combination of monetary instruments, public expenditures, redistribution of public revenues, and protectionism. The fundamental element of the anti-inflation regulation is a fiscal policy aimed at equalizing the distribution of national income and stimulating effective demand. Expansionary fiscal policy boosts income. Effective demand can also be stimulated by increasing budget expenditures and employing liberal monetary policy. The contractionary fiscal policy allows the government to curb inflation in the short run, but in the long run, it may depress economic growth by taking out a significant portion of income from circulation (previously demonstrated in 7 Chap. 6, 7 Sect. 6.6.3). Case box After the World War II and until the late 1970s, many of developed countries adhered to the Keynesian vision of the decisive role of the government in economic regulation. The employment of Keynesian measures to stimulate production, primarily deficit budget financing, boosted economic growth in the post-war period, but simultaneously fueled inflation. The latter emerged in the mid-1960s and especially in the 1970s. Some countries even faced galloping inflation. High inflation was recogni-

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zed as a severe economic threat to stable economic growth. Conventional Keynesian measures were no more effective in overcoming permanent galloping inflation. Since the late 1970s, most countries have retreated from adhering to pure Keynesian-type administration of economic development and have shifted to a more balanced use of indirect monetary and fiscal instruments (further explored in 7 Chaps. 11 and 13, respectively).

Monetarist Theory of Inflation attributes inflation to the excess money supply. The theory gained relevance in the 1970s, as more and more countries drifted away from the Keynesian vision of dealing with inflation. The new monetarism emphasized the role and importance of the classical quantitative theory of money, albeit in a more comprehensive interpretation. Monetarists led by M ­ ilton Friedman explain market imbalances by the excessive economic intervention of the state, including its failure to manage money emissions. Therefore, the decisive role of the state in regulating the economy should be reduced to managing the amount of money in circulation, which itself facilitates the healthy and stable development of a market economy (further reading: “The Optimum Quantity of Money”14). According to monetarists, curbing inflation involves measures aimed at reducing the amount of money in circulation and effective demand. In fact, these are the postulates of a deflationary policy (see further in 7 Sect. 9.4), including Targeting, which implies restraining the growth of the amount of money (monetary aggregates) within predetermined limits. Particular importance is attached to the complete elimination of deficit budget financing (monetization of deficits) and the maintenance of a tight restrictive monetary policy (demonetization of surpluses) (further reading: “A Monetary and Fiscal Framework for Economic Stability”15). Measures aimed at addressing cost-push inflation are considered inefficient. Instead, monetarists recommend concentrating on developing and supporting the competitive market environment on the domestic market and practicing a floating exchange rate in foreign economic relations. In general, the monetarist approach aimed at regulating demand-pull inflation is based on the following assumptions: 5 money supply exerts a decisive influence on economic development; 5 stability of money circulation is to be ensured by monetary authorities; 5 inflation disrupts money circulation, and thus it should be kept to a minimum; 5 principles of healthy finance include balancing budget revenues and expenditures, avoiding a budget deficit, and reducing public debt; 5 reducing the tax burden stimulates business activity and economic development; 5 tax cuts reduce public revenues, therefore, the government should proportionally cut public expenditures (primarily, the social component);

14 Friedman (1958). 15 Friedman (1948).

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. Fig. 9.3  The monetarist model of inflation. Source Authors’ development

5 cutting social expenditures incentivizes economic activity and employment (people work to earn income); 5 public investments are reduced and carried out in accordance with the principle of intensification, i.e., the focus on the development of science, high-tech industries, ensuring innovation-driven economic development; 5 volume and structure of the money supply, exchange rate, interest rates, and customs tariffs are major tools of the government economic policy.

9

In view of the monetarist school, inflation is driven by the growth in the supply of money, which results in blowing up aggregate demand. Monetarists also stress the role of inflation expectations of economic actors in hyping or retarding inflation (. Fig. 9.3). To regulate inflation, Friedman proposed a monetary policy rule (The Friedman’s Rule), according to which the annual growth rate of the money supply should be targeted within the 3–5% corridor (further reading: “A Program for Monetary Stability”16). The rule says that the opportunity cost of holding money faced by economic agents should equal the social cost of creating additional fiat money. The bottom boundary is set at the annual growth rate of GDP. The ceiling determines the growth rate of the money supply, which causes no inflation. Finding the most appropriate monetary policy rule has been one of the central elements of the quantitative theory of money since the 1930s (the Chicago school). An alternative rule was formulated by Henry Simons (The Simons’ Rule), who suggested that changes in the money supply would act as an intermediate variable with the aim of keeping an index of commodity prices stable. Therefore, a constant price level should be targeted in the short-run (further reading: “Rules versus Authorities in Monetary Policy”17). The contemporary interpretation of the monetarist rule (The Taylor’s Rule) elaborated by John Taylor in the 1990s states that the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates, and of deviations of actual GDP from potential GDP (further reading: “Discretion versus Policy Rules in Practice”18). A comprehensive discussion of the evolution of monetary rules can be found in “Friedman, Chicago, and Monetary Rules”.19

16 17 18 19

Friedman (1960). Simons (1936). Taylor (1993). Dellas and Tavlas (2016).

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Summarizing the fundamental differences between the Keynesian and the monetarist interpretations of inflation, let us note the following. The Keynesian school proceeds from the assumption that the level of employment is determined by the volume of output. Aggregate demand does not necessarily correspond to the volume of means of payment, since part of the funds is set aside in the form of savings. Both output and capital investment are determined by business expectations of the effective demand in the future. With the equality between interest rates and the interest return on investment, investing and saving do not depend on each other. Monetarists stress the importance of regulation of the money supply by adjusting the exchange rate of the national currency, interest rates, and customs tariffs. The monetary rule (any of the modifications noted above) postulates that the amount of money in circulation should increase annually at a rate equal to the potential growth rate of real GDP. For developed economies, this rate should not exceed 3–5% per year (see mild inflation in 7 Sect. 9.1.2). The Keynesian and the monetarist theories laid down the fundamentals of the two directions of anti-inflationary regulation, such as the deflationary policy and the income policy (further discussed in 7 Sect. 9.4). 9.2  Causes and Effects of Inflation 9.2.1  Causes

As demonstrated above, an increase in the growth rate of the money supply is an indispensable condition for the emergence or acceleration of inflation. With an exogenous increase in the growth rate of the money supply, inflation is driven by monetary factors. If the supply of money is affected by changes in the real sector of the economy (rising production costs, structural shifts in demand, etc.), then inflation is caused by non-monetary determinants. In this regard, inflation generated by monetary factors is considered to be demand-pull inflation, while that triggered by non-monetary factors is cost-push inflation. As previously noted in 7 Sect. 9.1.3, Demand-Pull Inflation is generated by excessive growth of aggregate demand compared to aggregate supply. This type of inflation is directly affected by consumers, that is why it is also called consumption-driven inflation. Demand-pull inflation can be caused by an increase in the money supply (monetary impulse), government expenditures, private investment, as well as inflation expectations that speed up money circulation. Commonly, the following four causes give rise to demand-pull inflation: 5 Budget deficit and the growth of public debt. Inflation emerges when the deficit is covered by the emission of banknotes or public securities. 5 Militarization of the economy and growth of military spending. During military conflicts, governments often resort to excessive emissions of unbacked paper money to rapidly mobilize funds. The growth of unproductive consumption of a part of the national income due to military spending multiplies the budget deficit and bumps up public debt.

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5 Credit expansion. It is carried out by issuing banks when lending to governments and when saturating the money supply with foreign currency exchanged for the national currency. Commercial banks cover unproductive government spending by lending to economic entities in excess of real needs. In such a way, they blow up the amount of money in circulation. 5 Imported inflation. As previously noted in 7 Sect. 9.1.2, obtaining loans in foreign currency and exchanging foreign currency for the national one increases the supply of money in the domestic market. Buying foreign currency at the price of excessive emission of national currency also fuels inflation.

9

Growing aggregate demand pushes up prices and thus increases the profits of producers. Higher gains allow the latter to expand output and attract additional labor and other economic resources. The increase in the monetary incomes of resource owners further escalates the growth of aggregate demand and prices. Therefore, the model of demand-pull inflation rests on the basic interaction ­between aggregate demand and aggregate supply (see 7 Chap. 5, 7 Sect. 5.2 for aggregate demand and aggregate supply and 7 Chap. 6, 7 Sect. 6.1 for the shortrun and long-run macroeconomic equilibrium in the AD-AS model). In other words, the demand-pull inflation results from the growth of aggregate demand upon reaching the potential level of real GDP. In addition to the growth in the supply of money, aggregate demand may go up due to changes in other non-price variables. As demonstrated in 7 Chap. 6 (see 7 Sect. 6.4 for the basic macroeconomic identity), these include the factors that determine the amount of expected spending by each of the four macroeconomic actors: consumer spending C, business investment I , government expenditures G, and net exports (Xn = Ex − Im). However, no demand-pull inflation occurs if all the four factors, including the growth in the supply of money, cause aggregate demand to rise within the potential GDP threshold. At the initial stage of demand-pull inflation, prices go up slowly. As a rule, prices lag behind the growth rate of the money supply. This is due to the fact that at the early stage, an increase in demand is accompanied by an increase in national income and employment (as long as there are idle factors of production in the economy, such as labor, raw materials, and means of production). In addition, an increase in income enforces the propensity to save. Economic actors consider inflation as a temporary phenomenon (the so-called money illusion) and tend to hold their money. Such an economic behavior pegs down the velocity of circulation of money. As a result, the aggregate demand AD shifts along the Keynesian (horizontal) segment of the aggregate supply curve AS from AD1 to AD2 (. Fig. 9.4). The level of prices remains unchanged (P1 ), but the new equilibrium reestablishes at point E2. The increase in real GDP from Y1 to Y2 at constant price P1 narrows down the gap between real output and potential output Y3 ((Y3 − Y2 ) < (Y3 − Y1 )). Consequently, the use of previously idle factors of production intensifies, unemployment declines, and the economy comes out of the recession stage.

313 9.2 · Causes and Effects of Inflation

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. Fig. 9.4  Early stage of the demand-pull inflation. Source Authors’ development

. Fig. 9.5  Second stage of the demand-pull inflation. Source Authors’ development

At the second stage, the ongoing growth of the money supply speeds up the circulation of money and accelerates inflation. The fall in the purchasing power of money encourages its owners to turn money into goods at all costs. As a result, inflation increasingly reproduces itself. Aggregate demand moves further to AD3 (. Fig. 9.5). The equilibrium point goes beyond the Keynesian segment of the aggregate supply curve AS from E2 to E3. Consequently, the heretofore unchanged price P1 jumps to P3. In the Keynesian interpretation, the price hike up to P3 reflects premature inflation, not pure demand-pull inflation (mild or creeping one-digit inflation, as noted in 7 Sect. 9.1.3). At this stage, the economy grows and inflation is accompanied by an increase in domestic product and national income. Real GDP reaches the potential level Y3 (full use of all factors of production, full employment of labor, or natural level of unemployment).

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As soon as the aggregate demand exceeds AD3, it becomes excessive. Further increase in aggregate demand to AD4 can no longer be responded by an increase in aggregate supply beyond the production possibility frontier Y3 (the concept of production possibility frontier is further detailed in 7 Chap. 16, 7 Sect. 16.3). The true demand-pull inflation is attributed to the vertical segment of the aggregate supply curve AS (. Fig. 9.6). The shift in the market equilibrium from E3 to E4 drives prices from P3 up to P4 with no change in potential output Y3. On the horizontal segment of the AS curve, nominal and real GDPs grow at the same rate, since there is no inflation at constant price P1, and changes in nominal GDP reflect only changes in real GDP. At the second stage, nominal GDP grows faster than real GDP, since the growth of nominal GDP reflects increases in both real GDP and prices (mild inflation from P1 to P3). On the vertical segment, the growth of nominal GDP reflects only an increase in the price level (demand-pull inflation from P3 to P4), while real GDP remains unchanged. Soaring prices require more and more money to be injected into the economy to support the minimum living standards of the population. At some critical point of inflation, the rate of depreciation of money outpaces the rate of increase in the money supply. That means that the growth rate of production lags behind the rate of circulation of money. Critical points of inflation are different for different social groups. For retired people, students, and other recipients of fixed welfare payments, the critical point of inflation is the lowest. Commonly, any indexation of fixed payments, first, lags behind inflation, and, second, fails to adequately compensate for the loss of income due to inflation. For the rich individuals and the largest companies, the critical point of inflation is the highest, as they can afford to lose a tiny part of their substantial income by paying higher prices. There is a critical point for the state. Rising prices increasingly erode the returns on each new emission of money and the value of collected taxes depreciates. Over time, the economy reaches full employment, beyond which further expansion of domestic product is no longer possible (point Y3 in . Fig. 9.6). Income remains unchanged,

. Fig. 9.6  Third stage of the demand-pull inflation. Source Authors’ development

315 9.2 · Causes and Effects of Inflation

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and excess demand further ignites the inflationary spiral. Facing permanent inflation, consumers and businesses increase current consumption to the detriment of savings and thereby further provoke inflation. A reduction in savings means no new investment. Hence, the production possibility frontier Y3 can not be expanded, and the aggregate supply lags behind the aggregate demand. As demonstrated in 7 Sect. 9.1.3, inflation may also be caused by a rise in costs of production, distribution, service, circulation of money, or any other types of costs in the economy. Supply-Push Inflation implies an increase in prices provoked by a rise in production costs in the conditions of underutilization of factors of production. An economic downturn is commonly accompanied by the reduction of the aggregate supply in the economy due to the increase in prices for factors of production. The escalation of costs is shifted to the prices of goods. If these goods are used as intermediate products in value chains, production costs rise along the entire chain and thus multiply inflation by affecting many producers. If a good is high elastic to price, a producer can not compensate for rising costs by hiking prices. In this case, the producer’s profit decreases. Due to a falling return, part of the capital leaves production and goes into savings. The cost-push inflation can also be caused by tax hikes, increases in interest rates on business capital, and rises in prices in individual foreign markets or the world market. In the latter case, appreciation of imported raw materials, components, and intermediate goods fuel inflation in the domestic market (see imported inflation defined above in 7 Sect. 9.1.2). As such, a rise in prices for imports not only triggers imported inflation, but also reduces the equilibrium volume of domestic output. This situation does not contradict the statement that the economy operates at full employment of all resources, since full employment involves the use of all factors of production offered at a given price. Thus, cost-push inflation is driven by the following factors: 5 Labor performance slowdown and a drop in output. Structural shifts in the economy, such as performance degradation, push up production costs per unit of output, depress profits, cut domestic product, and drive up prices. 5 Expansion of the service sector. The gain in productivity in the service sector is lower compared to that in manufacturing or agriculture. Meanwhile, a significant portion of production costs in the service is established by wages. Therefore, higher expenditures on lower-performing labor result in faster growth of prices for services compared to prices for goods. In large cities, the service sector contributes substantially to driving inflation. 5 Wage-push inflation. The share of wages in the total volume of production costs rises as trade unions and the government force employers to keep wages up to compensate for inflation. Ultimately, producers transfer additional costs to prices or reduce investment and output. 5 Non-price competition. Improvements in production are commonly associated with additional costs (higher quality of products, wider assortment, advertising, faster delivery, etc.). They all add up to costs and, accordingly, prices.

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. Fig. 9.7  Cost-push inflation. Source Authors’ development

9

Since a rise in costs of production deteriorates output, the aggregate supply curve shifts upward left from AS 1 to AS 2 (. Fig. 9.7). Accordingly, prices go up from P1 to P2, while real GDP falls from Y1.2 to Y2.2. The new equilibrium reestablishes at point E2 at a higher price level and a lower output. The potential level of GDP (production possibility frontier) shrinks from Y1 to Y2. That means that with the same amount of factors of production, the economy is now able to produce less at a higher price. Such an economy experiences stagflation, when an economic downturn and rising unemployment are accompanied by inflation (previously defined in 7 Sect. 9.1.1). The change in the price level equal to (P2 − P1 ) is the cost-push inflation. In reality, a distinction between cost-push inflation and demand-pull inflation is challenging. Nevertheless, it is commonly accepted that demand-pull inflation persists as long as there is excess aggregate demand. Cost-push inflation, according to the neoclassical school, wears itself out by depressing the demand for resources and gradually disappears (however, the issue of restoring output and employment remains). Demand-pull inflation manifests itself in the long run only, while in the short run, the growing demand is accompanied not only by an increase in prices, but also by an expansion of output. With cost-push inflation, rising prices are always accompanied by a drop in production and a reduction in revenues. Either the demand-pull inflation or the cost-push inflation (or a combination of the two) may give rise to the inflationary spiral. Inflationary Spiral is a process of interdependent growth in prices and wages, in which an increase in prices calls forth a compensatory rise in wages, and the latter triggers a new rise in prices. The spiral results from a combination of unanticipated demand-pull inflation and cost-push inflation. It works as follows. An unexpected increase in the supply of money on the side of the government (central bank or other monetary authority) stimulates aggregate demand and, therefore, generates demand-pull inflation. As wages remain unchanged due to a lag between price hikes and indexation of wages (see the wage-price spiral

317 9.2 · Causes and Effects of Inflation

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. Fig. 9.8  Inflationary spiral in demand-pull inflation. Source Authors’ development

discussed above in 7 Sect. 9.1.3), real incomes fall. Workers request their wages to be increased in proportion to inflation. Such a rise in wages increases business expenditures, depresses economic activity, and ultimately cuts aggregate supply, generating cost-push inflation and pushing prices even higher. Real incomes fall again, and workers request another pay boost. An increase in the nominal wage is first perceived as a rise in real income. People translate it into consumption, thereby speeding up the demand-pull inflation. The latter is accompanied by costpush inflation due to rising nominal wages. The two types of inflation complement each other and skyrocket prices. Suppose the full employment equilibrium between the aggregate demand AD1 and the aggregate supply AS 1 is established at point E1 (. Fig. 9.8). Any increase in the supply of money boosts the aggregate demand and shifts the aggregate demand curve from AD1 upward right to AD2. A new equilibrium is set at point E1 at higher price P2 and the national income beyond the full employment level Y1. The stability of the new equilibrium depends on the inflation expectations of the owners of factors of production. Higher prices of factors of production (remember, all factors are employed, no idle inputs available) drag the aggregate supply curve from AS 1 to AS 2 back to the full employment level Y1. The equilibrium reestablishes at point E3 at the initial level of the national income Y1, but a substantially higher price P3. If the initial shift in the aggregate demand from AD1 to AD2 is caused by a one-time change in the investment or consumer demand, then the price may remain at P2 and even get back to P1 after the one-time effect gets exhausted. However, if the rise in the aggregate demand is driven by the expansionist policy of the government, then the rise in prices takes the shape of an inflationary spiral. Cost-push inflation can also produce an inflationary spiral. The fundamental difference from the demand-driven inflationary spiral is that with the cost-push inflation, the growth of the aggregate supply exerts a downward effect on real GDP. Aggregate supply shifts from AS 1 upward left to AS 2, and the equilibrium

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. Fig. 9.9  Inflationary spiral in cost-push inflation. Source Authors’ development

9

reestablishes at point E2 at higher price P2 below the potential national income at full employment Y1 (. Fig. 9.9). A rise in production costs not compensated by a change in aggregate demand reduces profits and amass inventories. Producers are forced to revise their production programs by cutting costs, i.e., by curtailing output. Overcoming the recession is possible by stimulating aggregate demand (pushing the aggregate demand curve upward right from AD1 to AD2). However, the transition to the new equilibrium point E3 means that the owners of factors of production have achieved only an increase in prices from P2 to P3, and the new rise in production costs may restart the inflationary spiral. The Keynesian cross model (previously addressed in 7 Chap. 6, 7 Sect. 6.3.2) considers the mechanisms of inflationary and deflationary processes as ways to achieve the equilibrium volume of output. In case of the inflationary deviation from the macroeconomic equilibrium E, the actual volume of output Y1 (aggregate supply) lags behind the potential volume of goods and services Y2 that domestic and foreign economic actors would like to receive (aggregate demand) (. Fig. 9.10). The gap between the potential amount of demand (planned expenditures) and the amount of demand that can be met at the moment (real expenditures) is called Inflationary Gap (previously illustrated in 7 Chap. 6, . Fig. 6.3.9). In . Fig. 9.10, the inflationary gap is represented by the difference between aggregate expenditures AE at point B and aggregate revenues AR at point A at the current volume of output Y1. Failing to scale up production to match the demand, producers reduce stocks of goods in warehouses ( ABE triangle), hire additional workers, attract other resources, and subsequently increase prices. In the case of the deflationary deviation from the macroeconomic equilibrium E, the actual volume of output Y3 exceeds the demanded volume of goods and services Y2. Aggregate supply surpasses aggregate demand. The gap between the real amount of demand and the amount expected by producers is called the Deflationary Gap (similar to the recessionary previously illustrated in 7 Chap. 6, . Fig. 6.3.8). In . Fig. 9.10, the deflationary gap is represented by the difference

319 9.2 · Causes and Effects of Inflation

9

. Fig. 9.10  Inflationary and deflationary gaps. Source Authors’ development

between aggregate revenues AR at point C and aggregate expenditures AE at point D at the current volume of output Y3. Failing to sell all goods they have manufactured, producers increase stocks of goods in warehouses (ECD triangle), release excessive labor and other factors of production, and cut prices. This causes deflation and increases unemployment. Thus, deviations from the equilibrium compromise the ability of a market economy to rationally allocate resources and ensure a fair distribution of income. Broadly speaking, inflation-driven disequilibriums degrade the economic potential of a country. 9.2.2  Effects

Like any multifactorial macroeconomic process, inflation has a number of consequences, both positive and negative. The positive ones include the following: 5 Inflation stimulates trade, as inflation expectations spur current consumption and discourage saving. Similarly, it speeds up the turnover of all kinds of assets, as businesses strive to squeeze as much performance out of the factors of production as possible before they depreciate. 5 Inflation facilitates competition and natural selection, as underperforming enterprises fail. Also, inflation can support the competitiveness of domestic goods in comparison to expensive imports. 5 Moderate inflation degrades real incomes gradually, which encourages economic actors continuously improve performance and productivity to sustain a certain level of income. 5 Inflation redistributes income between lenders and borrowers, with borrowers benefiting from the depreciation of the loan currency. Having received a longterm loan at a fixed interest rate, a borrower ultimately returns only part of the loan, since the real purchasing power of money decreases due to inflation.

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When prices stagnate, wages and other returns on factors of production also remain stagnant for a long time. Low inflation discourages entrepreneurs from increasing the turnover of their assets. Propensity to save preponderates over propensity to consume, and falling current consumption depresses aggregate supply (see 7 Chap. 6 for the concepts of propensity to save and propensity to consume). High inflation, on the contrary, hits the propensity to save. Consumption accelerates and drives up prices. Inflation expectations and panic buying ruin the national currency and send the economy into galloping inflation or hyperinflation. In general, the effects of inflation are negative, rather than positive. It affects economic growth and development, society, and various aspects of public life. The following deteriorating effects of inflation could be emphasized: 5 gross domestic product declines, as price fluctuations make production programs and the entire prospects for economic development uncertain; 5 capital flows from the production sphere to trade and intermediary operations, where faster turnover and are higher potential returns help capital holders to compensate for rising inflation; 5 sharp price changes give rise to speculative activities (unwarranted rise in prices of certain products, deficits, etc.); 5 increasing cost of credit depresses lending and loans; 5 financial resources and other reserves of the state depreciate; 5 inflation compromises the living standards of the population and fuels social tension. Along with eroding the propensity to save, high inflation discourages investment and pushes the capital out of a country to less volatile markets. Capital that remains in the domestic market flows from long-term investment projects to short-term endeavors. Exports decline due to the overall fall in domestic output, imports increase, and the balance of payments gap widens. One of the inevitable consequences of inflation is the redistribution of income. Inflation hits the poor because their nominal income grows slower compared to that of the wealthy. Prices of essential goods that prevail in the consumption basket of the poor rise faster than for non-essential and luxury goods. As noted above, inflation primarily affects social groups with fixed incomes. Thus, inflation devalues real incomes and savings of the bulk of the population, thereby aggravating income inequality. The same applies to the world economy, when inflation in the world market or price hikes in certain segments of the world market hit the most vulnerable developing and least developed countries. Individual manifestations of inflation depend on the causes of inflation. Generally speaking, inflation can be driven by internal and external factors. As shown in 7 Sect. 9.1.1, in the past, inflation commonly originated from excessive emissions of unbacked money, by which governments attempted to finance budget deficits. By and large, depreciation of the national currency due to an increase in the money supply is a feature of the past. Today, it rarely happens in developed countries, but it still may occur in developing economies, where immature market institutions may fail to cope with structural imbalances in the economy. To address problems that require rapid solutions (budget deficit, balance of

321 9.2 · Causes and Effects of Inflation

9

payments gap, or social protests), the government may opt for emissions. Underdeveloped channels of money circulation get overwhelmed and fail to absorb surplus money by directing it to production and value-adding sectors. Therefore, one of the deepest causes of inflation in emerging market economies is the low level of development and inefficient structure of the economy. This is manifested in high production costs and the low competitiveness of domestic producers. In developed countries, an increase in the money supply plays an important, but not decisive role. There, money depreciates under the influence of other monetary factors, such as the growth of public debt, an acceleration of money circulation, an increase in the share of non-cash payments, or an expansion of credit. Under the new normal economic reality, the growing interdependence of countries mainstreams external causes and effects of inflation. In both the domestic and world markets, inflation can be generated by individual economic actors, such as transnational corporations and banks. One of the key factors of inflation is monopolistic pricing. Today, monopolies rule most of the sectors, including communal services, energy supply, communications, or housing. One of the examples of international monopolistic pricing is the Organization of Petroleum Producing Countries (OPEC). Although the OPEC is not a pure monopoly, its member countries control a substantial share of the global production and distribution of oil. By agreeing on gross output and distributing quotas between the members, the OPEC affects global oil prices. By adjusting the volume of production, monopolies seek to restrain the overproduction of goods in order to support prices. The excessive credit expansion of banks, especially not accompanied by an adequate expansion of material production, can also trigger inflation. Today, budget deficits are predominantly covered not by an additional emission of money, but through government borrowing (issuance of debt obligations by the state). In times of severe deficit, the state may adsorb a lion’s share of credit resources available in the domestic market, thus taking them away from producers and then flooding the market with money unbacked by material assets. One of the important causes of inflation is the rise in the prices of imports (imported inflation) and exports (exported inflation). With regard to imports, rising prices for foreign supplies (resources, intermediate products, final goods) increase the production costs of domestic producers and push up the consumer price index (a consumer basket). The impact of rising prices of exports on domestic inflation is indirect. For example, higher price abroad compared to the domestic price incentivizes producers to export goods rather than marketing them domestically. The outflow of certain categories of goods from the domestic prices creates a deficit and raises prices. The inflow of foreign currency due to the active trade balance also contributes to inflating domestic prices. An active trade balance means that a country exchanges material goods for foreign currency. To absorb foreign currency from the domestic market, the central bank buys it out by issuing the national currency into circulation. A significant factor in inflation is currency devaluation. In fact, devaluation results from deep inflationary processes in the economy, which depress the value of the national currency against foreign currencies and international monetary units (further detailed in 7 Chap. 20, 7 Sect. 20.4). Depreciation of the national currency pushes up prices for imports and gives rise to imported inflation.

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9.3  Measuring Inflation

9

As shown in 7 Sect. 9.1.1, inflation commonly implies disproportionate increases in prices for different goods in different sectors. The overall price level grows, while individual commodity groups experience individual price dynamics (especially in the case of unbalanced inflation). Therefore, an adequate measuring of inflation requires employing price indexes instead of absolute measures. Price Index is the ratio of the price in the current year to the price in the base year multiplied by 100%. The following main types of price indices are commonly used: consumer price index, producer price index, export and import price index. The most commonly used indicator of the price level is the Consumer Price Index (CPI)—a measure that examines the weighted average of prices of a basket of consumer goods and services. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. When calculating it, not all final goods and services are taken into account, but only those that make up the consumer basket purchased by a typical household. This includes basic food products, a set of non-food products (clothing, shoes, household goods), and basic services (medical, transport services, communications, recreation, culture, personal hygiene). The consumer price index is also called the cost-of-living index. It allows one to assess the change in real incomes of the population over time. Nominal income is income expressed in monetary units, while real income is the amount of goods that can be purchased with nominal income (see 7 Chap. 2, 7 Sect. 2.3 for the nominal GDP and the concept of purchasing power parity). Therefore, the consumer price index is best suited to measure the cost of living of the population. However, the component of the consumer basket must be carefully selected to represent the diverse consumption patterns of different social groups and ensure the comparability of estimations over time (as consumption patterns may transform dramatically over the course of several years, let alone decades). The price index calculated for a constant set of goods is called the Laspeyres Index (Eq. 9.3). The Laspeyres Index weighs base period prices and final period prices with base period quantities. It divides expenses on a specific basket in the current period by how much the same basket would cost in the base period. The numerator calculates the nominal expenditure required to consume base period quantity at final period prices. This means that when IL = 1, an individual can afford the same basket of goods in the current period as they did in the base period.

 Pt Qb  IL = Pb Qb

where: IL Laspeyres index; Pt price, current period; Pb price, base period; Qb   quality of products, base period.

(9.3)

323 9.3 · Measuring Inflation

9

The index is easy to calculate and cheap to construct because quantities for future years do not need to be calculated, only base year quantities (weightings) are used. Thus, it presents a meaningful comparison, as changes in the index are attributable to the changes in price. The main disadvantages of the index are that it is upward-biased and tends to overstate price increases (compared to other price indices). Therefore, it tends to overestimate price levels and inflation. The Laspeyres index takes into account the prices of imported goods but overlooks the possibility of replacing more expensive goods with cheaper ones, i.e., there is an underestimation of the possible change in the commodity structure. The Paasche Index is calculated for a changing set, i.e., it takes into account the possibility of mutual substitution of goods (Eq. 9.4). It weighs base period prices and final period prices with final period quantities. The numerator calculates nominal GDP in the final period, while the denominator calculates nominal expenditure required to consume final period quantities at base period prices. This means that when IP = 1, a consumer could have afforded the same bundle of goods in the base period as they can now.

 Pt Qt IP =  Pb Qt

(9.4)

where: Qt – quality of products, current period. The advantage of the Paasche index is that it can be employed for a small array of products, as well as for a wide assortment of goods. It allows for a high degree of aggregation, i.e., it captures an extensive assortment of commodity groups. The calculation is carried out on the basis of data on the volume of output in the current year, current prices, and prices of the base year. The ratio of the obtained calculations makes it possible to find out the influence of the price factor on price, i.e., to measure the dynamics of price growth or inflation. Sometimes this index is called the Producer Price Index (PPI), where the number of goods and services produced in the current year is taken as price weights. The PPI is different from the CPI in that it measures costs from the viewpoint of industries that make the products, whereas the CPI measures prices from the perspective of consumers. The Wholesale Price Index (WPI) is a typical set of goods purchased by firms and is calculated as the ratio of the price of a set of goods by firms in the current year to its price in the base year. It measures and tracks the changes in the price of goods in the stages before the retail level. This refers to goods that are sold in bulk and traded between entities or businesses (instead of between consumers). The Paasche index does not reflect the decline in the level of wellbeing that occurs at the same time. Fischer’s formula eliminates the disadvantages of both indices (Eq. 9.5). The Fischer Index is the geometric mean of the Laspeyres and the Paasche indices.  IL IP If = (9.5)

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Chapter 9 · Disequilibrium and Inflation

The ratio of nominal GDP to real GDP shows an increase in the GDP due to price increases. This measure of the level of prices of all new, domestically produced, final goods and services in an economy in a year is called the GDP Deflator. The GDP deflator measures the intensity of inflation or deflation. If the value of the price index is greater than 1, then there is a deflation of GDP. If the price index is less than 1, then there is inflation. The GDP deflator takes into account the prices of all goods and services produced in the country, but not those of imported goods. It allows for changes in the set of goods and services in accordance with the change in the composition of GDP. The consumer price index is calculated for a constant set of goods. Therefore, it does not take into account changes in the structure of the output. Instead, the GDP deflator is calculated for a dynamic set of goods. It allows one to capture this change, but fails to reflect a decrease in the standard of living. In addition to indices, measuring inflation employs calculating the rate of inflation (Eq. 9.6).

RI =

9

It − Ib × 100% Ib

(9.6)

where: RI rate of inflation; It price index, current period; Ib   price index, base period. The rate of inflation makes it possible to determine the ratio between the nominal interest rate i and the real interest rate r as a function of the rate of inflation. When RI ≤ 10%, the real rate is equal to the difference between the nominal i−RI rate and the rate of inflation (r = i − RI ). When RI > 10%, then r = 1+R . I While recognizing the efficiency of indices in reflecting inflation, we should not forget about certain flaws and distortions associated with the use of these measures. First, indices capture all kinds of price hikes, including those related to the improvement of the quality and technical parameters of final goods. For example, a new flagman model of a smartphone is more expensive compared to the previous generation models, but such an increase in price has nothing to do with inflation. Therefore, inflation indices may contain a non-inflationary component, which may distort the true picture of inflation. Another flaw relates to the degree of aggregation of a particular measure. The GDP deflator covers the e­ ntire range of goods produced in a country (highest aggregation). However, if substantial structural transformations occur in a relatively short period of time, the deflator would fail to reflect them adequately. That happened in 2020, when aggregate macroeconomic parameters lagged behind the rapid changes in the macroeconomic environment due to the outbreak of COVID-19. On the one hand, aggregated measures such as GDP deflator allow capturing multiple parameters and producing comprehensive assessments in the long-term retrospective, but on the other hand, they may be inaccurate in the short run. Finally, price indices and the GDP deflator can only be applied when assessing open inflation, while hidden inflation is non-quantifiable.

325 9.4 · Dealing with Inflation in the New Normal

9

9.4  Dealing with Inflation in the New Normal

Inflation is a permanent companion of a market economy It cannot and should not be eliminated once and for all. Nevertheless, the adverse, damaging, and destroying effects of inflation addressed above call for certain regulations. With the help of a variety of anti-inflationary measures, undesirable economic and social consequences of inflation can be prevented, dampened, or mitigated. Anti-Inflationary Policy (deflationary policy) is a set of tools for managing effective demand by adjusting money supply through monetary and fiscal measures. The individual selection of anti-inflationary mechanisms (government expenditures, interest rates, taxes, etc.) depends on the economic situation in a country and the development priorities for a particular period of time. There are no exclusive anti-inflationary mechanisms. Instead, the government put together various macroeconomic approaches and tools that produce desired anti-inflationary effects (. Fig. 9.11). As demonstrated above in 7 Sect. 9.2.1, inflation results from a disequilibrium between aggregate demand and aggregate supply when the former outpaces the latter. Imbalances can be caused by both monetary and non-monetary factors. Regardless of what factors actually have pushed prices up, the resulting inflation can be addressed by either a decrease in the rate of the money supply through a soft adaptation policy (adaptation of the economy to inflation by adjusting the base rate and implementing a soft price and income policy) or a stringent anti-inflationary policy (administrative regulation of effective demand and money supply with parallel control of prices and wages). Irrespective of differences in interpretations of inflation discussed in 7 Sect. 9.1.3, the relationship between the rate of inflation and the growth rate of the money supply is commonly accepted. Therefore, in most countries worldwide, anti-inflationary regulations are primarily based on monetary and fiscal policies.

. Fig. 9.11  Approaches to dealing with inflation. Source Authors’ development

326

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Chapter 9 · Disequilibrium and Inflation

The use of monetary and credit instruments aims at regulating the volume and composition of the money supply along with the circulation of money in the economy (further detailed in 7 Chap. 11). They include monetary policy, credit policy, and foreign exchange policy. The mainstream monetary methods include restricting the growth of the money supply and loans, increasing interest rates (base rate), increasing the rate of required reserves, and selling public securities in the open market. Currency policy regulates the exchange rate of the national currency, while credit policy deals with adjusting aggregate supply by granting loans and credits to domestic producers. The financial component of anti-inflationary regulation implies the use of budgetary, fiscal, and pricing instruments. The fiscal policy provides for balancing incomes and expenditures or keeping the budget deficit at its lowest. It aims at, first, direct support of producers in the form of reducing the tax burden, and second, indirect stimulation of savings (both corporate and individual) (further detailed in 7 Chap. 13). Most commonly used fiscal methods include reducing public spending, boosting tax revenues (increasing direct and indirect taxes, abolishing tax benefits), as well as tightening the depreciation regulations. Pricing policy suggests the direct and indirect intervention of the government in regulating prices and wages. In particular, income policy implies the establishment of parallel control over prices and wages by freezing them or setting limits on growth. The government may compensate people and businesses for losses from inflation through indexation of wages (in the public sector) and welfare payments. The government periodically indexes pensions, scholarships, and other payments. However, indexation commonly lags behind inflation in both time and volume. Therefore, it compensates for part of the loss only, and thus it insignificantly improves the standard of living. Foreign trade policy as a constituent element of structural anti-inflationary regulation rests on the use of tariff and non-tariff methods of regulating imports and prices of foreign goods. Structural policy is aimed at optimizing the sector of stateowned enterprises (privatization, deregulation), the preferential development of enterprises focused on the consumer sector, high-tech industries, mechanical engineering, and technical and managerial innovations that improve the production potential of the economy. By practicing the antimonopoly policy, the government exercises control over the costs and prices of monopolies (see 7 Chap. 10, 7 Sect. 10.2). The anti-inflationary policy combines a future-oriented anti-inflationary strategy and short-term reactionary anti-inflationary tactics. The long-term anti-inflationary strategy is designed to moderate inflation expectations, support current demand, control the budget deficit by raising taxes and reducing government spending, reform the money circulation, and mitigate the influence of exogenous inflationary drivers. The strategy involves two approaches: 5 Reduction of the budget deficit and curbing emission of money. To do this, the government employs targeting aimed at regulating the growth rate of GNP by increasing taxes and cutting government expenditures. 5 Maintaining full employment and price stability, regulating prices and incomes in order to link wage increases with changes in prices (indexation of incomes proportionally to changes in the price index).

327 9.4 · Dealing with Inflation in the New Normal

9

Moderating inflation expectations in the long term suggests comprehensive development and strengthening of market institutions (price liberalization, anti-trust regulation, promotion of production and sales, encouragement of small business, easing of customs restrictions, etc.). The overriding goal is to eradicate unmanageable inflation. Today, governments widely use exchange rate regulation as an external tool for bringing domestic inflation under control. The appreciation of the national currency decreases prices for imports and pushes down the overall price level in a country. However, appreciation of the national currency drives up production costs and deteriorates the competitiveness of domestic goods in the world market, so the use of the exchange rate as an anti-inflation tool is limited. The short-term anti-inflationary tactics are aimed at quick cooling the inflationary pressure on the economy by narrowing down the gap between aggregate supply (increase) and aggregate demand (reduction). It does not eliminate the causes of inflation, but takes current inflation under control by implementing the following measures: 5 state support of the economy through preferential taxation of enterprises; 5 targeted programs for the employment of certain groups of population; 5 support for the development of new sectors; 5 increase in interest rates on deposits; 5 appreciation of the national currency; 5 nullification—an introduction of a new currency instead of depreciated one; 5 revalorization—a forced return to the pre-inflation (or any other) value of the national currency by withdrawing excess money from circulation; 5 devaluation—a decline in the official exchange rate of the national currency in relation to other currencies or a decrease of the gold content of the national currency. In terms of time, the government may implement anti-inflationary regulations gradually or introduce them abruptly (the so-called shock therapy). There is no answer to the question of which type of policy is more efficient. It depends on the size of an economy, the economic and social situation in a country, the degree of integration into the world market, the current rate of inflation, and many other parameters. Generally speaking, the higher the inflation rate, the prompter the actions. Shock measures are commonly applied to cool down hyperinflation, while creeping inflation and even galloping inflation could be addressed by longer-term structural anti-inflationary regulations. Shock therapy may be extremely efficient at the moment, but its longer-term consequences can be damaging to society (falling living standards, rising unemployment). Gradual regulations bear lower social costs in the short term, but they generate the Inflation Inertia, a situation where economic entities get used to the permanent increase in prices, expect them in the future based on their past experience, take inflation into account when planning economic activities (consumption, saving, investment), and thereby maintain inflation. In the new normal economic environment, increasingly frequent disconnections and gaps in the global production and supply chains, investment lags, and inequalities between countries restrict production possibilities. Collapses most

Chapter 9 · Disequilibrium and Inflation

328

. Table 9.1  Inflation rate in major economies, average consumer prices

9

Country

2019, %

2022, %

2019–2022*

2025, %

2022–2025*

2019–2025a

USA

1.5

3.5

+2.0

2.5

−1.0

+1.0

China

2.9

1.8

−1.1

2.0

+0.2

−0.9

Japan

0.5

0.5

–

1.0

+0.5

+0.5

Germany

1.4

1.5

+0.1

1.8

+0.3

+0.4

UK

1.8

2.6

+0.8

2.0

−0.6

+0.2

India

4.8

4.9

+0.1

4.0

−0.9

−0.8

France

1.3

1.6

+0.3

1.2

−0.4

−0.1

Italy

0.6

1.8

+1.2

1.3

−0.5

+0.7

Canada

1.9

2.6

+0.7

2.1

−0.5

+0.2

South Korea

0.4

1.6

+1.2

2.0

+0.4

+1.6

Russia

4.5

4.8

+0.3

4.0

−0.8

−0.5

Brazil

3.7

5.3

+1.6

3.1

−2.2

−0.6

Australia

1.6

2.1

+0.5

2.4

+0.3

+0.8

Spain

0.7

1.6

+0.9

1.7

+0.1

+1.0

Mexico

3.6

3.8

+0.2

3.0

−0.8

−0.6

Note aExpected change in the current year compared to the base year, percentage points Source Authors’ development

of the production chains experienced in 2020 amid the COVID-19 outbreak have fueled inflation globally on the supply side. On the demand side, largescale programs aimed at supporting people and businesses during the pandemic (direct payments and preferential lending, deferral of taxes and payments, etc.) have pushed up aggregate demand. Global inflation has been rising since 2020, and countries import inflation from the world market. According to the International Monetary Fund,20 the effect of the pandemic-induced imbalance of supply and demand will persist for at least several years (. Table 9.1). In 2022, the average inflation in developed and developing markets reached 3.9% and 5.9%, respectively. Gradually, the inflation rate declined due to the normalization of the work of international production and supply chains, tightening monetary policy, as well as the reorientation of demand from goods (panic buying d ­ uring lockdowns and unsatisfied pent-up demand after the lifting of lockdowns) to services (pre-pandemic consumption patterns). By 2025, inflation is projected to return to the level of 2019, but in some developed countries (USA, Japan, Germany, UK), it will still stay above the pre-pandemic level.

20 International Monetary Fund (2022).

329 9.4 · Dealing with Inflation in the New Normal

9

. Fig. 9.12  Consumer price inflation, annual % change in 2020–2021. Source Authors’ development

In addition to breaking production chains and expanding demand, global inflation is largely spurred by rising fuel and food prices. The growth is expected to sustain in the coming years, but at more moderate rates compared to the period of 2020–2021. In 2022, prices of natural gas and oil increased by 58% and 12%, respectively. This is a significant increase, but nevertheless, it is lower compared to the skyrocketing price hikes observed in the global energy market in 2021 against the background of a sharp post-pandemic recovery of the world economy. For example, in the USA and Italy, energy prices rose by more than 29% in 2020–2021, in the UK—by 24.5%, in Canada—by 21.2% (. Fig. 9.12). Food prices rise due to labor shortages in the agricultural sector (anti-pandemic restrictions on seasonal migration of labor), a rise in aggregate demand (demand-pull inflation), and an increase in prices of fertilizers, seeds, animal feed, and other inputs (cost-push inflation). Food inflation is much lower than energy inflation, but it particularly affects developing countries, aggravating the food insecurity problem. The imbalances and drawbacks of the new normal version of the global economy that have emerged during the pandemic will undoubtedly change the nature of global economic development in the years to come. However, it is unlikely that the long-term new normal trajectory will change. The general trend toward increased globalization will continue, although many countries are now stepping away from it (further discussed in 7 Chap. 22 in relation to the new rise of protectionism and in 7 Chap. 23 in relation to regionalization). Imbalances will gradually be resolved through tighter monetary policy and a reduction in bond purchases, which will moderate inflation. As vaccination rates rise around the world, many of the restrictions on the transborder movement of labor are lifted. Reviving service sectors absorb part of excessive aggregate demand by diverting it from commodity markets. To stimulate aggregate supply, it is necessary to support small businesses and

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Chapter 9 · Disequilibrium and Inflation

entrepreneurship, promote the free flow of capital across sectors within and between production and supply chains, and prevent the emergence of oligopolies (as many small businesses have gone bankrupt during the pandemic). As economic activities revive, less direct support in a form of welfare payments would be needed. Cutting mass support programs allows governments to restrict further growth of the money supply and curb inflation. Moderating inflation expectations changes the consumption-saving ratio in favor of the propensity to save. It is crucial to reduce budget deficits by cutting the enormous expenditures many countries faced in 2020– 2021. However, a sharp reduction in public spending after massive payments during the pandemic may provoke a deepening of social tensions and add up to anti-vaccination, anti-lockdown, anti-QR-code, and other protests of recent times. Therefore, it is necessary to gradually reduce direct support by strengthening indirect mechanisms that stimulate the economic activity of both businesses and the population. Chapter Questions:

9

5 Explain the principal difference between inflation and stagflation. 5 Which type of inflation do you consider most damaging for the economy in the short run? What about the longer-term perspective? 5 What is the current rate of inflation in your country? How would you classify it? 5 How does the wage-price spiral work? 5 Distinguish the fundamental disagreements between the Keynesian and the monetarist interpretations of inflation. 5 Summarize the propositions of the demand-pull and the cost-push concepts of inflation. 5 Can inflation be positive for the economy? If yes, explain how and for whom. 5 How does a deflationary gap arise? How is it different from the inflationary gap? 5 Formulate the monetary policy rule. 5 What are the advantages of the GDP deflator as a measure of inflation? Are there any drawbacks or limitations? 5 Explain how the consumer price index differs from the producer price index. 5 Discuss characteristic approaches to the new normal regulation of inflation. Subject Vocabulary: Anti-Inflationary Policy: a set of tools for managing effective demand by adjusting money supply through monetary and fiscal measures. Biflation: a simultaneous occurrence of inflation and deflation in the economy. Consumer Price Index: a weighted average of prices of a basket of consumer goods and services. Deflation: an increase in the purchasing power of a currency manifested in a reduction of prices due to the rising value of money or undersupply of money in circulation.

331 References

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Deflationary Gap: a gap between the current amount of demand and the amount of demand expected by producers. Demand-Pull Inflation: a type of inflation generated by excessive growth of aggregate demand compared to aggregate supply. GDP Deflator: a measure of the level of prices of all new, domestically produced, final goods and services in an economy in a year. Inflation: an excessive growth of money supply (aggregate demand) in comparison with the aggregate supply of goods and services, which results in the depreciation of money and a long-term increase in commodity prices. Inflation Inertia: a situation where economic entities get used to the permanent increase in prices and expect them in the future based on their past experience. Inflationary Gap: a gap between the potential amount of demand and the amount of demand that can be met at a certain point in time. Inflationary Spiral: a process of interdependent growth in prices and wages, in which an increase in prices calls forth a compensatory rise in wages, and the latter triggers a new rise in prices. Price Index: a ratio of price in the current year to price in the base year. Producer Price Index: a measure that takes the number of goods and services produced in the current year as price weights. Stagflation: a situation in the economy when production stagnates or falls amid rising unemployment and a continuous increase in prices. Supply-Push Inflation: a type of inflation driven by a rise in production costs in the conditions of underutilization of factors of production. Targeting: an approach to anti-inflation regulation which implies restraining the growth of money supply within a predetermined threshold. Wholesale Price Index: a ratio of the price of a set of goods produced in the current year to its price in the base year.

References Aukrust, O. (1970). PRIM I: A model of the price and income distribution mechanism of an open economy. Review of Income and Wealth, 16, 51–78. Baumol, W. (1967). Macroeconomics of unbalanced growth: The anatomy of urban crisis. The American Economic Review, 57(3), 415–426. Dellas, H., & Tavlas, G. (2016). Friedman, chicago, and monetary rules. The University of Chicago. Edgren, G., Faxen, K.-O., & Odhner, C.-E. (1969). Wages, growth and the distribution of income. The Swedish Journal of Economics, 71(3), 133–160. Fisher, I. (1911). The purchasing power of money. New York, NY: Kelley and Millman. Friedman, M. (1948). A monetary and fiscal framework for economic stability. American Economic Review, 38(3), 245–264. Friedman, M. (1958). The optimum quantity of money. Aldine Publishing Company. Friedman, M. (1960). A program for monetary stability. Fordham University Press. Frisch, H. (1977). The scandinavian model of inflation: A generalization and empirical evidence. Atlantic Economic Journal, 5, 1–14. International Monetary Fund. (2022). World economic outlook update: Rising caseloads, a disrupted recovery, and higher inflation. Washington, DC: International Monetary Fund.

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Keynes, J. M. (1936). The general theory of employment, interest and money. Macmillan. Laughlin, L. (1909). Gold and Prices, 1890–1907. Journal of Political Economy, 17, 257–271. Marshall, A. (1923). Money, credit, and commerce. Macmillan. Pigou, A. C. (1920). The economics of welfare. Macmillan. Pigou, A. C. (1941). Types of war inflation. The Economic Journal, 51(204), 439–448. Simons, H. (1936). Rules versus authorities in monetary policy. Journal of Political Economy, 44(1), 1–30. Taylor, J. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39(1), 195–214. Thorp, W., & Quandt, R. (1959). The new inflation. McGraw-Hill. Tooke, T. (1838). A History of Prices, and of the State of the Circulation, from 1793 to 1837. London: Printed by A. Spottiswoode, New-Street- Square. Wicksell, K. (1936). Interest and prices. Macmillan.

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Learning Objectives: 5 Understand what market failures mean and how they occur 5 Distinguish government failure from market failure 5 Overview forms, methods, and tools of government regulations 5 Study four types of market failure, including the rise in monopoly power, asymmetrical information, market externalities, and public goods 5 Discuss transformations of market and government failures in the new normal economic reality 10.1  Failures and Imbalances in Markets 10.1.1  Market Failures

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According to the classical viewpoint, the market automatically reestablishes the equilibrium after any disturbance. As argued in 7 Chap. 6, 7 Sect. 6.1.1, the neoclassical theory of macroeconomic equilibrium postulates that the market mechanism can efficiently regulate the economy by balancing output, prices, wages, and interest rates (remember the Say’s Law saying that supply generates its own demand). However, the classical approach to considering the market a self-regulating system is rather a theoretical idea than a real-life situation (especially given the increasing complexity of relationships between economic agents and the internationalization of markets). Painful cyclical and structural crises of the past (see 7 Chap. 7) have intensified the need for government interventions in market mechanisms when the latter fail. Markets may fail in many cases. For instance, the market mechanism may fail to ensure efficient use of resources and the supply of a sufficient amount of goods. Market Failure is a situation when the market mechanism fails to arrange and coordinate economic processes in such a way as to ensure the efficient use of all available resources at the level of full employment. The market failure risk is one of the focal points for the Keynesian theory. According to the Keynesian interpretation of macroeconomic equilibrium (see 7 Chap. 6, 7 Sect. 6.1.2), the economy cannot get out of recession with no outside help, since the volume of supply in the market is determined by effective demand. To support demand, the government creates new jobs (discussed in 7 Chap. 8), stimulates consumption, and applies a set of stabilization and development measures (see 7 Chap. 7, 7 Sect. 7.5 for stabilization policies and following 7 Chaps. 11–14 for monetary, fiscal, investment, and social regulations). The main goal of government intervention is to establish the macroeconomic equilibrium as an optimal combination of economic entities’ freedom in doing business and the regulatory government’s influence on their behavior. The balance involves the preservation of the dynamism and efficiency of free entrepreneurial activity while preventing potential failures due to mismanagement. Thus, the intervention is driven by shortcomings and negative phenomena that could spontaneously emerge in the market economy:

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5 First, as previously demonstrated in 7 Chap. 3, perfect competition could result in the rise of monopolies. In turn, monopolism destroys competition and thus undermines the economic system’s ability for self-regulation. Monopolies can only be restricted and governed by the state. 5 Second, under spontaneous market relations, aggregate demand could mismatch aggregate supply. Assuming demand to generate its own supply, self-balancing could take long. Recessions and overproduction crises could last for years. The state is able to exert a stimulating effect on aggregate demand and restore the macroeconomic equilibrium. 5 Third, no market mechanism aims at achieving public interests, only individual interests of economic actors. Nevertheless, the economy and the society need public goods, clean environment, social protection, equality, etc. Therefore, the government intervenes in market relations to correct social and economic anomalies and ensure the supply of public goods and benefits (see 7 Sect. 10.4 for the correction of market externalities and 7 Sect. 10.5 for the delivery of public goods). 5 Fourth, accelerating technological progress poses a number of challenges to a society that only the state can address. These include fundamental scientific research, training and retraining of employees, urbanization, food security, etc. Solutions to such problems require substantial funding provided by the state. The above definition of market failure implies disturbances of macroeconomic equilibrium and inefficient allocation of factors of production that could occur for various reasons. To understand why a market fails, we need to understand how it should operate. The economic theory (both neoclassical and Keynesian interpretations of macroeconomic equilibrium) says that markets coordinate producers and consumers by establishing an equilibrium price. If the market mechanism works appropriately, the price reflects the balance between supply and demand. In the case of market disbalances, higher or lower prices cause overproduction crises or deficits. Disbalances could trigger failures due to many reasons. Commonly cited market failures discussed in this chapter include market power and monopolization (see further in 7 Sect. 10.2), information asymmetries and gaps (7 Sect. 10.3), positive and negative externalities (7 Sect. 10.4), and under-provision of public goods (7 Sect. 10.5). Monopoly is one of the most common causes of failure. Monopolies in sectoral and regional markets can be detrimental to public welfare (previously shown in 7 Chap. 3, 7 Sect. 3.3). If one economic entity acquires all the factors of production in the market, it sets prices at its discretion. With no competition in the market, self-regulation mechanisms fail. Monopolies tend to set prices above the equilibrium because no company can compete with them. Therefore, they maximize their profits at the expense of overall public welfare. Another source of market failure is asymmetric information. It occurs when there is not enough information to guide buyers and sellers in the market. Because the sides are poorly informed, they can make wrong decisions. Prices do not reflect the actual value of goods, i.e., they unpredictably deviate from the equilibrium point.

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Externalities occur when consumption or production affects a third party not involved in these processes. For example, when the government overspends money, it may trigger negative externalities, as taxpayers end up paying more money to someone. The examples of externalities are environmental pollution, the environmental damage caused by certain economic entities to society, businesses, and people. Market failures may be caused by the under-provision of certain goods or services of vital necessity to people. These public goods may be supplied in insufficient quantities or at extremely high prices. Examples are defense, education, health care, police services, or street lighting. Most of these goods and services do not generate profit. Thus, if left to free-market forces, such public goods could be underprovided in the economy. Along with the four sources listed above, failures may occur for other less common reasons: 5 incomplete markets, where only some of the necessary conditions for market formation exist (for example, the market of insurance services, medical services, or public pension systems); 5 unemployment, inflation, and other kinds of macroeconomic, especially sharply manifested in times of crisis and economic depression; 5 excessively uneven income distribution (in case the government does not employ compensation programs to reduce inequality, income gaps between the groups of people may jeopardize social stability and endanger the overall macroeconomic stability in a country); 5 imbalance between supply and demand (when resources are allocated inefficiently, some people live off the taxpayers’ money while those in need struggle to meet their basic needs). Case box The so-called absent market used to be a typical example of market failure in the past. In colonies in the XVIII–XIX centuries, colonizers forced farmers to overproduce cash crops such as cotton and coffee. That resulted in a lack of land and resources to produce staples such as rice, wheat, and sugar. People in colonies across Africa and Latin America suffered from hunger because there was no adequate market for staple food. After gaining independence in the XX century, many of former colonies restructured their economies to provide themselves with food crops.

Disbalances and failures are eliminated not only through state intervention, but also through agreements between businesses and people, education, and information. Market actors with similar interests may unite to ensure the implementation of agreements between all members of the group. They do this because they see collective benefits in enforcing these agreements. Following agreements benefits all. Information asymmetry can be eliminated by informing producers, consumers, and other market actors. Information gaps can be narrowed by explaining the actual value and cost of what producers and consumers bear and pay in the market. Consumer forums, blogs, rating agencies, media, and social networks all work to reduce information asymmetry (further detailed in 7 Sect. 10.3).

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10.1.2  Government Failures

The need to compensate for market failures and correct the market mechanism determines the establishment of government regulations to increase public welfare and improve the allocation of resources (detailed in 7 Sect. 10.1.3). Still, similar to the market, the state is not an ideal mechanism. In practice, its intervention in economic activity can lead to losses in efficiency. Government Failure is a situation where the state cannot ensure the efficient allocation and use of public resources. If failed, state intervention in the economy has negative consequences due to the distortion of pricing mechanisms and reduced efficiency of factors of production. Potentially, government failures occur in those areas where market mechanisms combat disbalances better than the direct intervention of the state. Sources of government failures include the following (. Fig. 10.1): 5 political failures caused by the imperfection of the political process; 5 administrative failures due to the peculiarities of the system of public authorities; 5 economic failures associated with the specifics of non-market activities of the state and the degree of government intervention in the economy; 5 information failures due to the degree of development of the communication system between the state and economic and social institutions. One of the sources of government failure is the political nature of public power: its universality, bureaucracy, economic power, a set of regulation measures

. Fig. 10.1  Types of government failures. Source Authors’ development

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(coercive, permissive, and prohibitive) in the government’s direct jurisdiction. However, the exercise of these powers is carried out by certain people. Therefore, any government measure can be taken by individual officials either lawfully and rationally or voluntary and irrationally. The abuse of authority (the use of the powers entrusted to an official for profiteering) and the pursuit of egoistic purposes (personal enrichment, misappropriation of public funds, etc.) undermine the efficacy of government regulations. Another source of government failure is the specifics of the economic activities of the state. State-owned enterprises and institutions are heavily involved in producing specific non-market goods to make up for the lack of a market in particular sectors. These include business regulation services, supply of pure public goods (see 7 Sect. 10.5), social protection, welfare transfers, and other non-profit activities. The inefficiency of the state as a supplier of non-market goods and services arises due to the distortion of the interaction of non-market demand and non-market supply. In such a situation, market mechanisms produce wrong signals, leading to a loss of efficiency. Distortion of non-market demand occurs due to the imbalance between costs and benefits, i.e., the mismatch between those who benefit from the government intervention (a certain group of the population) and those who pay for these benefits (taxpayers). This gap results in allocative inefficiency (social costs overrun benefits) and dynamic inefficiency (deterioration of conditions for long-term economic growth due to the suppression of incentives of businesses and people to invest and innovate). The non-market supply can cause the following types of government failures: 5 Difficulty in defining and measuring output. It is challenging to determine the essential characteristics of non-market goods and services, as well as to measure the quantity of public goods needed in the economy and assess the compliance of these goods with quality standards. 5 State monopoly. Non-market goods and services are commonly supplied (consumed) by a single entity authorized by the government. The government protects the exclusive monopoly of this entity in a particular area. Therefore, there are incentives for such state-backed enterprises to reduce costs and improve the quality of goods and services. 5 Lack of an effective regulator. In the non-market sector, there is no natural regulator similar to the market mechanism of free competition. State-owned suppliers of non-market goods and services do not actually face the risk of bankruptcy, since the state covers their losses. They are excluded from the market environment. They do not compete in the free market for clients or resources. Therefore, failing to receive signals from the market may result in inefficient allocation of resources. The above features of non-market production cause weak organizational motivation, as a result of which the vast majority of state enterprises experience significant X-inefficiency—a situation when a firm lacks the incentive to control costs due to a lack of competitive pressure. This causes the factors of production to be allocated inefficiently and the average cost of production to be above the market average.

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A significant source of government failure is the asymmetries of information required for making decisions, monitoring, and controlling their implementation. Information gaps, i.e., incompleteness, unreliability, and incorrectness of information consumed by the government, negatively affect the quality and effectiveness of government regulations. In general, the information failure problem in the sphere of public economic management is due to four groups of reasons: 5 technical failures—difficulties in collection and processing of large amounts of information (the big data issue); 5 formal logical failures—objective incompleteness of information about the future and imperfection of economic forecasts; 5 anthropogenic effects—deliberate distortion of information and misleading public authorities in order to exploit them for personal advantage; 5 information asymmetries between government bodies and certain groups of businesses or people lobbying for sectoral, regional, and other interests and seeking to mislead public authorities and encourage the adoption of decisions beneficial to these groups. The occurrence and growth of information asymmetry push up administrative costs associated with measuring the performance of certain departments, monitoring and resolving disputes between them, as well as receiving, verifying, and analyzing information. Administrative failures are caused by excessive bureaucracy seeking political rent. Bureaucracy as a form of public authority is one of the most striking manifestations of government failure due to the threat of transforming public interests into group advantages and personal benefits. Corruption and other administrative failures are common to many developing economies and least developed countries, as well as for developed states. 10.1.3  Government Regulations

Despite the risk of failure when interfering in natural market processes, the need for government regulation of market imbalances is in little doubt among economists. In a modern market economy, no government is too anxious to directly set up and regulate the supply of goods and the distribution of resources. It creates conditions for the free operation of the market mechanism, i.e., the “invisible hand” of the market is supplemented by the “visible hand” of the state. Since recently, however, the role of the state in the economy has been gaining importance. The state has been involved in the market economy in order to maintain social and economic stability (for example, see 7 Chap. 7 for the role of the state in smoothing out cyclical recessions and crises), restore macroeconomic equilibrium (7 Chaps. 8 and 9 for labor market regulations and anti-inflation policies, respectively), and control monopolies (see 7 Sect. 10.2). In general, the government is actively involved in adjusting macroeconomic processes. Government Regulation of the Economy is a purposeful impact of the government on the economy in order to increase the efficiency of certain market processes. It is a system of legislative, executive, and control measures implemented

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by the state to stabilize markets and adapt the economy to changes in domestic and/or external circumstances. The approaches to regulation are outlined in the public economic policy aimed at improving the wellbeing of people. Case box Comprehensive mechanisms of government regulation of the economy have evolved in a number of rapidly developing and developed countries in Asia (primarily China and Japan) and Latin America (Chile), as well as some countries in Western Europe (Austria, Germany, Spain, the Netherlands, France). In transition economies (Russia, Central Asia, Eastern Europe), the state sector’s share in the market remains high. The state plays a minor role in regulating market processes in the USA, Canada, and Australia.

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Through implementing regulation measures, the government aims to correct imbalances and imperfections of the market mechanism. The following functions are fulfilled: 5 supporting competition through establishing equal conditions for all market actors; 5 providing a legal framework for the market system; 5 limiting the market power of monopolies through the anti-trust regulation; 5 protecting the environment; 5 building the public infrastructure; 5 developing fundamental science and financing research and development; 5 combating inflation and unemployment; 5 stimulating economic growth; 5 emitting money into circulation; 5 stabilizing economic fluctuations and cycles; 5 redistributing incomes and resources; 5 ensuring social protection and social guarantees for certain segments of society. State regulation of the economy covers mainly legal, financial, and social areas. Legal regulation of the economy is a system of public acts, which regulate the operation of market structures (stock exchanges, banks, joint-stock companies, etc.), protect rights of market actors, restrict monopolies, punish shadow and illegal activities, etc. Financial regulation applies to taxes, investments, subsidies, and prices. Social regulation includes guaranteeing the minimum wage, ensuring employment, and indexation of fixed incomes. Public regulation involves various methods and techniques of intervention (. Table 10.1). The principal aim for the state is to ensure equal conditions for all economic entities in the market, develop the competition, increase the volume of production and consumption of goods and services, and improve the quality and standard of living of the population. The variety of methods and policies used by the government to prevent market failures, regulate markets, and decrease negative consequences of market imbalances are discussed in the following chapters in this book (for example, see 7 Chap. 7 for stabilization policies and regulation of economic cycles, 7 Chap. 8

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. Table 10.1  Forms and methods of government regulation of market failures Forms

Methods

Administrative regulation

Licenses, quotas, control over quality and prices

Legislative regulation

Legislative and regulatory measures (laws, rules, instructions, etc.)

Indirect economic policies

Subsidies, grants, allowances, preferential lending, tax benefits

Direct economic measures

Monetary, fiscal, and customs regulations

Source Authors’ development

. Fig. 10.2  Government regulation tools. Source Authors’ development

for labor market regulations, 7 Chap. 9 for anti-inflation policies, 7 Chap. 11 for monetary policy, 7 Chap. 13 for fiscal policy, and 7 Chap. 14 for social policy). Thus, the government uses a set of means, methods, and measures that establish a system of regulation tools (. Fig. 10.2). Direct Regulation is manifested in public documents containing explicit instructions, decisions, laws, and amendments. These measures require strict implementation and entail punishment in case of partial or complete nonimplementation. Administrative methods are based on the power of government authority. They include measures of authorization and prohibition (for instance, the issuance or revocation of licenses) and coercive measures (the requirement to comply with various standards and norms). Direct administrative regulation is commonly employed in the following areas: 5 direct control over monopolistic markets by establishing fixed prices; 5 determination and maintenance of the minimum standard of living; 5 public health control (quality standards, emissions control; 5 targeted economic programs aimed at mitigating macroeconomic imbalances; 5 protection of national interests in international relations through licensing of exports and state control over imports of goods and capital and migration of labor.

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Indirect Regulation is a proposal from the state to economic entities to implement certain economic decisions. Indirect methods provide market actors the possibility of free choice within certain limits. These are methods of economic and financial regulation, not administrative prescriptions. As such, they are complemented by a system of economic incentives for those market actors who obey regulations. The distinction between indirect economic and direct administrative methods is conditional to a certain extent. To use economic methods, it is necessary to have an executive decision of the relevant authorities. Vice versa, administrative regulations incentivize or disincentivize certain reactions in the market, similar to how economic methods act. However, the distinction is important from the point of view of the nature of the market. Economic methods are considered market-oriented. They do not distort the market environment, but adjust the natural flow of market processes. Administrative methods directly affect market processes, sometimes in a non-market way. They allow the government to redirect economic processes promptly, but they distort the market environment. As such, they may further aggravate disbalances and cause failures. Institutional Regulation combines legal, ethical, psychological, and organizational norms, customs, and traditions. They include the organization of international meetings on economic issues, chambers of commerce and industry, economic councils and unions, and other economic, financial, and market institutions. The advanced form of government regulation is economic programming or indicative (recommendatory) planning, which provides for the integrated use of all elements of regulation. Indicative Planning is the process of developing a system of interrelated macroeconomic parameters, as well as determining measures of government influence on economic and social processes in order to achieve these performance targets. These include parameters of economic dynamics, such as the GDP, economic growth, money circulation, employment, living standards, and inflation, among others. An indicative plan should be balanced in terms of the use of material, labor, and financial resources. The lack of resources today implies their possible acquisition in the future. Therefore, indicative plans are similar to forecast calculations. They determine the structure of the economy (GDP) by industries and types of economic activity (for instance, industrial production, agricultural sector, services, etc.), the structure of exports and imports, mainstream directions of research and development, growth of various kinds of production and distribution infrastructure, and other parameters of the economic and institutional policy of the government. Case box In general, indicative planning relies on the coherence and harmony of the public interest. Therefore, amid an economic recession, a decline in production, and increased unemployment, the confidence in the far-reaching indicative plans and indirect methods may be undermined. When this happens, the economy enters a period of uncertainty and distrust in balanced performance indicators established by the government.

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Despite the shortcomings, indicative plans make it possible to develop reasonable goals, objectives, and methods for implementing public social and economic policy, as well as to maintain the interaction between the segments of the governance system (for instance, between the federal center and provinces). The indicative plan combines in a single conceptual document the current economic policy, forecasts and performance targets of government programs, the system of direct and indirect measures applied by the state, the volume of government expenditures, and the possibility of influencing the dynamics of microeconomic parameters. Under favorable economic conditions, economic and administrative regulations stipulated by an indicative plan stimulate economic growth. The use of an indicative plan makes it possible to implement large-scale programs, such as the relocation of labor resources, development of territories, or protection of the environment. Economic programming targets at industries, territories, the social sphere, scientific and technological progress, employment, economic growth, and foreign trade in the short-term (current programming), medium-term (current and future programming), and long-term (prospective programming). Case box In current conditions, medium-term programming is evolving. It is typical for some countries in Europe (Austria, Finland, France, Germany, Spain, Sweden) and Asia (India, Japan, South Korea). The USA uses targeted and emergency programs instead of nationwide programming. These include housing, energy, scientific, agricultural, and other programs. Targeted programs are not exclusive to the USA. Other countries also implement them. Emergency programs address mass unemployment, galloping inflation, and other market failures that require a rapid reaction. Examples of emergency programs are support programs implemented in many countries during the COVID-19 pandemic in 2020–2021—direct payments to people, tax benefits for business, government procurements in the health care sphere, and food aid to the poor.

In its regulation efforts, the government combines various instruments and mechanisms to support economic growth, the wellbeing of people, and the efficient allocation of resources. Economic programming is a system of comprehensive measures of the government’s influence on the economic and social development of the country. The elaboration of nationwide development programs aims to prevent the emergence of macroeconomic imbalances that could cause market failures and then escalate into an economic crisis. 10.2  Rise in Monopoly Power and Antitrust Regulation

One of the most common sources of failure is drifting away from perfect competition and the subsequent emergence of monopolies. The concept of monopoly was previously discussed in 7 Chap. 3, 7 Sect. 3.3. Therefore, this section outlines the scope of government interventions in monopolistic markets. In such markets,

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a firm chooses the most beneficial combination of price and output rather than adapts to spontaneously forming prices. As a result, society as a whole suffers losses. It is customary to distinguish between situational, natural, and legal monopolies. They all imply restrictions on entry into the market. Under situational monopoly, the restriction is the inaccessibility of specific conditions for competitors due to the concentration of property by one firm. A natural monopoly implies the potential underperformance of any competitors in the market due to the unique advantages of one firm (market entry could not be restricted). In a legal monopolistic market, the restrictions are imposed by the state. Most commonly, monopolization is attributed to the rise of natural monopolies due to the restrictions on access to natural resources. These can be artificial restrictions (quotas, licenses, direct bans, etc.) or natural barriers (geographical location, climate, size of the market, connection to other markets, etc.). A Natural Monopoly is a market situation in which a minimum of average production costs is achieved when only one firm supplies a given product or service. Monopoly arises in markets where there are no alternatives or close substitutes to products or services supplied by one firm. Thus, to a certain extent, such an offer is unique in the market. Any increase in the number of firms in the market causes an increase in average costs. A natural monopoly is based on economies of scale, where only one firm is able to supply certain goods or services in a certain territory efficiently. This means that entering competitors would be less effective than a monopolist.

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Case box Examples of natural monopolies are oil companies, electric power companies, railways, and telecommunication companies in remote areas. Natural monopolies frequently arise in the service sector. Services can be rendered only to those customers who are in direct contact with the supplier (for instance, public utilities, post, underground railway). The capacity of the market also facilitates the rise of natural monopolies. For example, a supermarket in a small settlement remote from big cities may be considered a monopolist in the local market.

Under economic globalization, classical resource-extraction natural monopolies are being replaced by situational monopolies that spread beyond the resource sectors. A Situational Monopoly is based on exclusive access to resources or facilities critical to producing certain goods, for which a firm establishes a monopoly. Thus, market power can be secured by property rights to unique mineral deposits, specific production facilities, or critical elements of infrastructure. A situational monopolist may not possess unique technologies, brands, or tangible assets. But it owns the situation that creates a monopoly. Today, globalization opens up vast markets and creates a multitude of competitors. It ensures the dissemination of skills, practices, and technologies worldwide, allowing competitors to copy and reproduce any product (at least the design and major functional features). In such an unstable environment, conventional monopolies that own assets lose their

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competitive advantages. It takes time to build a brand, develop a new product, or enter the market with new technology. During this time, the situation in the industry, the competitive environment, and consumer preferences may change. Therefore, capturing a flexible situational advantage might be more beneficial for a firm than holding a rigid monopolistic power. Case box An extremely dynamic post-industrial economy based on the rapid progress of information technologies and the growth of the service sector contributes to the emergence of situational monopolies. The largest IT companies of our time are essentially situational monopolies. Most of them have grown from small businesses that once found unique niches in emerging markets (Google—Internet business, Facebook (now Meta)—communication, Amazon—buying and delivery, etc.). Sometime in the future, situational monopolies may completely supplant conventional natural monopolies. The search for potential monopoly opportunities in the narrowest market niches, as well as in new markets opening up due to the development of advanced technologies (information, communication, biotechnology, medicine, artificial intelligence, genetics, etc.) will acquire the same (or even greater) importance as the development of new technologies and products, the creation of strong brands, and cost reduction. This fundamental shift characterizes the new normal economic reality.

Along with natural and situational monopolies, there are cases when the state purposefully promotes the establishment of a monopoly. A Legal Monopoly is a situation in the market when the state empowers certain companies or individuals to serve as exclusive producers, suppliers, or buyers of certain goods or services. A legal monopoly could occur due to any of the three types of exclusive rights: 5 Patent system. A patent is a certificate issued by the government of a country to a company or an individual for the right of exclusive use of the invention made. A patent is also a document giving the right to engage in a certain type of economic activity, such as trade, transportation, fishing, etc. 5 Copyright, according to which intellectual property rights holders have the exclusive right to sell or reproduce their works for a lifetime or a certain period of time. 5 Trademarks are special drawings, names, or symbols that allow their owners to distinguish their products, services, or companies. Competitors are forbidden to use registered trademarks of other companies. Having faced a monopoly-induced market failure, the government may either accept the efficiency loss or forcibly prevent some of the resource allocation options achievable through voluntary interaction between market actors. The latter option can also bring losses, but anti-trust regulation potentially allows for reducing the market failure effect. There are four ways to address market failure through anti-trust regulation:

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1. When dealing with monopolized markets, including natural monopolies, the government commonly resorts to regulatory measures, particularly price regulation. Prices can be set at two levels: 5 Socially optimal price, i.e., P = MC. In this case, a monopolist could face either profit or loss. Therefore, if a monopolist suffers losses, the state subsidies it so the production of essential goods (primarily public goods) continues. 5 A price that ensures a fair profit, i.e., P = AC. In this case, a monopolist either gains profit or breaks even. However, a monopolist may inflate its costs to generate more significant profit. Along with price regulation, the government may forcibly adjust market access conditions. This is the cornerstone of anti-trust regulation. Access adjustment can include a forceful easing of the access (to prevent the emergence of natural or situational monopolies), as well as its limitation (to incentivize legal monopolies). The adjustment is carried out by implementing the following three measures. 2. Regulation of the exploitation of resources to increase the efficiency of their use. This approach to anti-trust regulation is particularly prevalent in the case of natural monopolies in extractive industries. 3. Establishing the time limits. This measure is commonly applied to legal monopolies. Through the regulation of the use of intellectual property rights, the government sets certain thresholds (for example, patents for the production of certain goods or the provision of services, territories in which a monopolist is allowed to operate, limited licenses, etc.). 4. Creating competition at the entrance. In many cases, monopolistic markets can not be demonopolized in a short time. In this situation, the government should at least try to improve the performance of companies operating in the market. For this purpose, a competitive selection of the most efficient entities can be established (auctions, competition-based issuance of licenses for activities and property rights, etc.). Thus, not being able to overcome the natural monopoly without losing efficiency, the state has to choose one of the two approaches: to use regulatory measures to affect certain aspects of the monopolist’s activities directly or to gradually fill the market with enterprises, organizations, and public sector entities through setting price limits or imposing various kinds of obligations on monopolists. Anti-trust Regulation is a system of legislative and regulatory legal acts aimed at developing fair competition and overcoming the negative consequences of the monopoly power of any particular firm in the market of goods, services, or factors of production. Case box In 1998, the United States Department of Justice filed a lawsuit against Microsoft, which at that time controlled 90% of the market of software for personal computers and desktops. According to the authorities, Microsoft used its monopoly power to

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impose the Internet Explorer browser on users of Windows and, in such a way, destroy Netscape, one of the competitors. Microsoft forced manufacturers of personal computers to preinstall Internet Explorer as the default browser, referring to the Windows licensing conditions and threatening to raise prices. Fines and strict restrictions were imposed on Microsoft, for example, not to force producers to use Microsoft products and provide third-party developers with an application programming interface for creating Windows applications. The trial contributed to the resignation of Bill Gates as Microsoft CEO in 2000. Microsoft itself lost part of the Internet market, including advertising and search, and also lost out to Apple and Google in the global market of smartphones.

Anti-trust regulation is pivotal for an open marketplace as it potentially gives consumers lower prices, higher-quality products and services, more choices, and greater innovation. However, there are many opponents to government interventions in the market in the form of anti-trust regulation who argue that ­allowing businesses to compete freely, even if such competition results in more power for some firms, would ultimately give consumers the best prices and benefit the economy. 10.3  Asymmetrical Information

Market mechanism fails when it cannot provide access to complete and reliable information about goods and services traded in the market, producers and consumers, and other market features to all market actors. These are market failures induced by information asymmetries. Asymmetrical Information is a market situation that occurs when one party to a market transaction possesses greater knowledge about the situation in the market or particular qualities of goods, services, firms, etc., than the other party. In a situation of asymmetry, a buyer can not control a seller, since a buyer chooses a seller before goods are received or services are rendered. The quality assessment is then based on assumptions or previous experience. Case box The uncertainty issue in a situation of asymmetrical information was investigated by Akerlof (1970)1 on the example of the second-hand car market. Car dealers call “lemons” those flawed cars that look good at first view. Cars of good quality without hidden flaws are called “peaches”. Let us assume that sellers of “peaches” want to get at least $800 for their cars, and buyers are ready to pay no more than $1,000. Sellers of flawed “lemons” want to get at least $200 for their cars, and buyers are

1

Akerlof (1970).

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ready to pay no more than $400. By appearance, “lemons” and “peaches” look similar, so it is difficult for a buyer to tell one from the other without implicit inspection. A buyer can only see the externals and cannot know how reliable the engine is. Sellers, however, are aware of the quality of cars they offer, while buyers are not. It can also be assumed that if the amount of “peaches” available in the market is close to that of “lemons”, then the average price of $700 is established (lower than for “peaches”, but much higher than for “lemons”). Then buyers who wanted to buy a “peach” for $800, but received a “lemon” for $700 (because there are no “peaches” at this price on the market) would be very disappointed. Potential buyers of “lemons” would wait until the price drops. On the other hand, sellers would hold back “peaches” because the equilibrium price is lower than the real value of their good cars. As a result, the market will fail, or only “lemons” will stay in the market.

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The performance of the entire market depends on how adequately prices reflect the market situation, i.e., costs, expectations, needs, effective demand, etc. Incomplete information affects the allocation and use of resources by distorting behavior patterns of producers and consumers and making market actors avoid hardly predictable long-term relations. These are manifestations of market failure. Perfect and reliable information does not guarantee success in the market. Still, it greatly facilitates its achievement by contributing to more effective communication between economic entities and better allocation of scarce resources. The incompleteness of information leads to the incompleteness of the market, a situation where individual needs remain unmet, since potential producers are uncertain of the actual needs of consumers. Governments commonly contribute to improving the information and communication infrastructure in domestic markets and internationally. This activity produces positive externalities (see further in 7 Sect. 10.4). Case box Asymmetries often occur due to the difference in qualifications of market actors, i.e., the ability to interpret the available information. Such asymmetries are intrinsic to education, science, consulting, and healthcare. For example, the COVID-19 pandemic has provided vivid examples of asymmetries that occur between doctors and patients regarding diagnosis and treatment, as well as between individuals and public health authorities regarding vaccination. Prodigious anti-vaccination movements have emerged in some countries, such as Russia, while pseudoscientific versions of the virus’s origin, its symptoms, and treatment have been spreading on the Internet. Due to appropriate qualifications for scientific interpretation of the information, healthcare professionals find themselves in a preferential position in relation to ordinary people (if we consider this situation as the interaction of two types of economic entities in the market). Here, the information asymmetry causes market failure (in this example, a thriving anti-vaccination campaign).

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Using role models can contribute to solving the information asymmetry problem. Considering the case above, respected and reputable professionals in medicine and science can act as educators in virology, microbiology, and vaccination and thereby influence public opinion. The same role can be performed by social media influencers and other key opinion leaders not directly related to medicine, but respected by the gross of the people. However, government intervention is necessary in hard situations and life-critical circumstances (in particular, mandatory vaccination and anti-pandemic safety measures). 10.4  Market Externalities

The third type of market failure is the occurrence of externalities (side effects) in the market exchange mechanism. Externalities are costs of individuals or society that are not reflected in prices (negative externalities) or benefits enjoyed by economic entities not involved in the transaction (positive externalities); costs or benefits of a third party. The market will not lead to social efficiency if the actions of producers or consumers affect the wellbeing of other people. Case box Let us assume in the future, COVID-19 vaccinations will be offered to people seasonally as commercial medical services. In this case, not only consumers of this service will benefit (those who got vaccinated), but also many other people, because the total number of people infected will go down. This is how consumption by some leads to an increase in utility for many.

Externalities stem from either consumption, production (technology), or monetary sources: 5 Consumption externality is an external effect that arises due to the existence of two types of dependencies not separated from each other: a direct functional dependence of utility on the amount of consumed good for one person and an inverse direct functional dependence for another person. That means consuming a good causes a positive externality for one person and a negative externality for the other. 5 Technological externality is an external effect that arises when the output ­volume of one producer technologically depends on the output volume of another economic entity. 5 Monetary externality is an external effect that arises when the income or costs of one economic entity are influenced by the output volumes, pricing policy, advertising, and other activities of another economic entity. Externalities can also be categorized into positive and negative. Positive externalities occur when the consumption or production of a good causes a benefit to a third party (see the vaccination case above). They generate external

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benefits EB and result in a discrepancy between private benefits PB and social benefits SB, where SB = PB + EB. Negative externalities mean harmful effects to a third party. They result in an increase of external costs EC to a third party and a discrepancy between private costs PC and social costs SC, where SC = PC + EC. In the absence of externalities, PB = SB and PC = SC. Also, the following four types of externalities can be distinguished depending on the combination of production and consumption elements of external sources: 5 Production-production. Negative externality: factory A releases waste into a river. This activity harms the production process at downstream factory B. Positive externality: factory A produces chemicals used by factory B in making water filters. The latter are consumed by factory A to treat water. 5 Production-consumption. Negative externality: people living nearby factory A and consuming water from the river suffer from harmful emissions. Positive externality: local residents use the infrastructure developed by factory A (roads, electricity, public utilities, kindergartens, shopping malls, etc.). 5 Consumption-production. Negative externality: people speak up against chemical production, which builds up pressure on factory A and increases its costs on water treatment. Positive externality: the fence around factory A needs no surveillance if it fronts a crowded street. Any violators of the territory would not pass unnoticed. 5 Consumption-consumption. Negative externality: individual performance decreases if a person experiences a negative influence from neighbors (for instance, noise at night, no sleep, etc.). Positive externality: strong networks of colleagues and friends improve the psychological atmosphere in a team and increase the overall performance of a firm. Thus, economic entities pursue their goals and simultaneously harm or benefit other entities. In terms of establishing the macroeconomic equilibrium, the core problem with externalities is that prices in a competitive market reflect only private costs (or private benefits) while not reflecting social costs (social benefits, respectively). In a free market, negative externalities may induce overproduction compared to the socially efficient output volume. Positive externalities, on the contrary, may result in the underproduction of goods and services. The socially efficient output volume is achieved when marginal social benefit MSB equals marginal social costs MSC. At negative externalities, MPC < MSC. Suppose factory A discharges waste into a river. If the discharge volume is proportional to the output volume, then the environmental pollution increases along with the output. Since factory A does not practice wastewater treatment, then MPC < MSC (no private costs on water treatment). Output volume exceeds the socially efficient level. With no wastewater treatment facilities, the output equals Y1 at price P1 (. Fig. 10.3). The equilibrium is set at point E1 (MPC = MSB). As shown above, MSC = MPC + MEC. Consequently, turning external costs into private costs of factory A would cut the effective output down to Y2 and push the price up to P2. At the new equilibrium point E2, MSB = MSC. At positive externalities, MPB < MSB. For example, each member of society benefits when fellow citizens receive a good education. However, when

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. Fig. 10.3  Negative externality. Source Authors’ development

. Fig. 10.4  Positive externality. Source Authors’ development

deciding on pursuing a university degree, we think about a personal benefit, not a public one. A rational consumer compares the price of a good education and the benefits that can be potentially obtained in the future. Investment in human capital may fall short of the public optimum. The equilibrium is established at point E1 at the intersection of marginal private benefit and marginal social costs (. Fig. 10.4). Marginal social benefit is greater than marginal private benefit by the amount of marginal external benefit, i.e., MSB = MPB + MEB. Therefore, the socially efficient equilibrium can be achieved at the intersection of marginal social benefit and marginal social costs (point E2). Thus, positive externalities are commonly associated with underproduction, as the optimal output volume is not attained. Summarizing the impact of positive and negative effects on the degree of market failure, five areas of influence should be distinguished (. Table 10.2).

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. Table 10.2  Effects of positive and negative externalities Parameter

Positive effect

Negative effect

Beneficiaries

A third party appropriates part of the overall utility of a good

Part of the costs is imposed on a third party

Price composition

Social benefit is not included in price

Social costs are not included in price

Price level

Prices are below the socially efficient level

Prices are below the socially efficient level

Output volume

Output falls short of the socially efficient level

Output exceeds the socially efficient level

Resource utilization

Poor attraction and use of resources

Excessive attraction and use of resources

Source Authors’ development

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The main ways to increase positive external effects include the following: 5 state subsidies to firms that produce goods or render services that generate positive external effects (goods for children, textbooks, medicines); 5 state transfers and tax benefits for individuals who consume products that generate positive externalities (tax deductions for education); 5 indirect payments to employees that stimulate the consumption of “useful” goods (payment for purchasing books, gym membership, anti-smoking campaigns); 5 social advertising; 5 production of some major products or rendering social services by the state. The following methods and practices are employed to regulate negative external effects: 5 a ban or restriction on the production, distribution, and consumption of certain products (a ban on smoking in public places); 5 excise taxes on “harmful” goods (alcoholic beverages, tobacco, drugs); 5 social anti-advertising (warning labels on cigarette packs). The state can also sell or somehow distribute the rights to produce negative external effects. This measure is much tougher than introducing an excise tax, but somewhat milder than a complete ban. It is usually used in cases where the magnitude of negative external effects should not exceed a certain critical value. In general, four types of interventions can be used by the state to reduce the overproduction of goods with negative externalities and to make up for the underproduction of goods with positive externalities: internalization of externalities, special taxation, distribution of property rights, and direct government control.

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10.4.1  Internalization of Externalities

Internalization of Externalities means that a firm acknowledges negative external effects it generates and considers previously disregarded social costs when determining the optimal output volume. Externalities are internalized when prices are adjusted so that they reflect the total social costs (negative externalities) or full social benefit (positive externalities). Internalization refers to the transformation of externalities into internal effects. One of the internalization solutions is to merge economic entities connected by an externality into a single entity. Case box Consider the “production-production” externality discussed above. Water pollution by factory A negatively affects the quality of goods produced by downstream factory B (negative externality). If factories A and B merge into one concern, the external effect will disappear. Since both factories are now parts of one entity, the externality turns into the internal effects within the system. Water treatment costs previously faced by factory B now become the costs of the entire group, i.e., the costs of factory A. Plant A is then incentivized to control emissions and thereby minimize the negative externality. Market failure diminishes.

However, internalization is not always possible or desirable. In some cases, merging production facilities can threaten the performance of merging firms due to the negative economies of scale. Then, for society as a whole, the potential elimination of one market failure through internalization may result in the emergence of side failures, such as a decrease in the competitiveness, a reduction in the number of jobs, a decrease in tax payments, and, ultimately, a bankruptcy of merged enterprises. 10.4.2  Corrective Taxes and Subsidies

Another way to encourage a firm to curb externalities it generates is to make it pay for them. Facing extra costs, such a firm would try to optimize its cost–benefit ratio. The government can mitigate this market failure by imposing corrective taxes or granting corrective subsidies. Corrective Tax is a tax on the output meant to equalize the marginal private costs and marginal social costs. It forces a firm to treat external costs as internal ones, thus narrowing the gap between MPC and MSC by an amount equal to marginal external costs (MEC = MSC − MPC). A tax T equal to marginal external costs MEC could bring the market equilibrium point closer to the optimum, at which MSB = MSC (. Fig. 10.5). A firm considers T an additional cost, so the MPC curve shifts upward left by T points toward the MSC curve. With no

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. Fig. 10.5  Corrective tax. Source Authors’ development

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. Fig. 10.6  Corrective subsidy. Source Authors’ development

corrective tax, the equilibrium is established at point A, at which MPC < MSC. The introduction of the tax balances private and social costs, but depresses ­output (in a perfectly competitive market). The amount of the tax levy equals the area of the CBFD rectangle. The new equilibrium established at point B is ­effective, since MPC + MEC = MSC = MSB. The reduction in social costs (hence, the efficiency gain) equals the area of the BAF triangle. So, introducing a tax on production that generates a negative externality reduces the output volume and increases the market price. The market price now reflects not only private costs of producers, but also external costs. Corrective Subsidy is a subsidy meant to bring marginal private benefits closer to marginal social benefits. It is granted to producers or consumers of goods that generate positive externalities. Thus, a subsidy narrows the gap between MPB and MSB up to the MPB = MSB optimum. With no corrective subsidy, the equilibrium is established at point A, at which MPB < MSB (. Fig. 10.6). Granting a

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corrective subsidy S equal to marginal external benefits MEB (marginal external benefits being permanent) could trigger the demand for the subsidized good. Rising demand spurs supply (Y1 shifts to Y2) and prices. At the new equilibrium point B, the output volume Y2 is socially efficient, since MEB + MPB = MSB = MSC. The volume of the corrective subsidy equals the area of the CBFD rectangle. However, the use of corrective taxes and subsidies encounters certain obstacles. The imposition of corrective tax on output furnishes the desired result under the stipulation that there is only possible technology for producing targeted goods or services. Thus, the externality is directly and unambiguously connected with the output volume. If the degree of externality fluctuates with no change in the output, then a corrective tax imposed on output would not encourage a firm to employ a socially efficient technology. In such a case, the government may use taxes (fines) on the externality itself, not output. Imposing a fine in the amount of MEC per unit of external effect equalizes private and social costs, i.e., MPC + MEC = MSC. This encourages a firm to both produce at a socially optimal level and use socially efficient technology. An adequate calculation of marginal social costs when setting a tax or a fine is challenging. The introduction of penalties for generating an externality is also fraught with certain technical difficulties, since measuring externalities may require specific equipment or technology, i.e., additional costs. If an ­externality relates to the performance of employees, mental conditions of people, perceptions, teamwork environment, and other intangible parameters of that sort, such an externality is non-quantifiable. Therefore, government measures (­corrective taxes, fines, subsidies, etc.) cannot be applied in relation to many of ­intangible externalities due to the unavailability of adequate quantitative estimates of marginal external costs and benefits. Also, the same firm may produce several externalities simultaneously, each of which must be measured. Corrective taxes are then imposed separately depending on marginal external costs generated by particular externalities. The penalty should play the role of the resource price, but unlike the latter, its value is calculated, not established in the competitive market. Thus, corrective taxes and subsidies cannot deal exhaustively with the externalities problem. First, it is difficult to calculate marginal costs and benefits. Second, corrective taxes paid by producers of goods or services associated with negative externalities do not necessarily achieve their goal. 10.4.3  Distribution of Property Rights

In the section above, we assumed the government to moderate the externalityrelated clashes in the market by imposing a fee for the right to generate an external effect. But suppose the state is unable or unwilling to intervene. Conventional approaches to addressing the externality problem (internalization and corrective taxes and subsidies) had dominated until 1960 when Ronald Coase suggested the existence of double-edged external effects (further reading: “The Problem of

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Social Cost”2). Negative externalities arise from competition between different resource uses if property rights in each of these options are not vested. Their explicit allocation diminishes or reduces externalities. In this case, government intervention in the economy is efficient only if the costs of such intervention are lower than the losses associated with market failures. In turn, the redistribution of property rights is efficient when the related costs are lower than the increase in value resulting from the redistribution. The Coase Theorem states that when bargaining costs are negligible, externalities can be internalized by establishing the government ownership of resources and allowing those rights to be freely exchanged in the market. Suppose the rights are properly vested and secured and can be traded. In that case, the market mechanism can lead the parties to a Pareto efficient agreement regardless of the initial allocation of property (supposing transaction costs to be sufficiently low). For example, if a firm is entitled to pollute the environment (a license or any other government regulation), those who suffer pollution can pay this firm to compensate for emissions reduction. Alternatively, if residents of a particular territory are entitled to access to clean surroundings, a company that builds a plant nearby can buy from them permission for pollution. The Coase theorem can be illustrated by the example of factories A and B we have used above. Factory A pollutes a river. Factory B has to use polluted water. The pollution volume varies directly as the output volume of factory A. The latter maximizes its own profit and ignores the losses incurred by factory B. The costs of factory B directly depend on the emissions volume generated by factory A, since the former incurs additional costs due to water treatment. Therefore, factory B would prefer to compensate factory A for reducing the emissions volume, since that would keep costs of factory B down. But that would also decrease the profit of factory A due to an output cut. If factory B’s gain exceeds factory A’s loss, trade in the externality is possible. Suppose that factory A’s profit is a function of the pollution volume, or marginal private benefit (the MPB curve in . Fig. 10.7). For factory B, the loss is also the function of the pollution volume, but the function of marginal private cost (the MPC curve). Then, the compromise emission volume acceptable both to factory A and factory B is X ∗. At this point, the marginal benefit of factory A equals the marginal costs of factory B. Under the permissive legislative regime, factory A has the right to emit. In this case, its emission volume would equal X1 (MPB = 0). The pollution level is inefficiently high (here, social efficiency is considered, i.e., the efficiency for the system of two factories) because factory A’s harmful influence on factory B is ignored. Factory B would benefit from reducing the pollution volume from X1 to X0. To convince factory A to cut emissions, factory B compensates factory A for the loss of profit in the amount equal to the area of the EX0 X1 triangle. Doing

2

Coase (1960).

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. Fig. 10.7  Illustration of the Coase theorem. Source Authors’ development

that, factory B reduces its costs by the EXo X1 C area, while gaining the EX1 C triangle as a net cost save. As a result, the resources get allocated efficiently (for this particular A-B system of two entities), and the aggregated profit of factories A and B peaks. Under the prohibitive legislative regime, environmental pollution is disallowed. Factory B is thus entitled to prohibit any emissions generated by factory A. In this case, factory B would likely advocate zero pollution at point X2 with no marginal costs on eliminating harmful consequences of factory A’s emissions. However, zero pollution is inefficient for society, because at this point, factory A ceases production and receives no profit. Factory A would benefit from compensating factory B for the permission to increase the pollution volume from X2 to X0. The compensation would equal the area of the EX0 X2 triangle. Having paid for the permission, factory A increases its revenue by the EX0 X2 P1 area, from which it gains the EX2 P1 triangle as a net profit. The resources are allocated in a socially efficient manner, as MPB = MPC. 10.4.4  Direct Government Control

Coase’s idea of self-regulation of externalities by achieving socially efficient distribution of resources among economic entities does not necessarily provide a working solution to the market failure problem. This theoretical construction holds true for bilateral transactions in the absence of information asymmetry and at zero transaction costs. Therefore, in some cases, the government must directly intervene to resolve disagreements between economic entities and establish uniform rules for all by introducing prohibitive or restrictive regulations. For example, in many cities in Europe, local authorities prohibit or restrict automobiles from entering a city center to combat traffic jams or reduce air pollution.

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State authorities also impose quantitative restrictions on the emission of certain substances into the atmosphere or water or prohibit the use of heavy-polluting machinery and technologies. These are examples of direct government control in addressing the externality problem. 10.5  Public Goods

Most of the goods traded on the market are economic goods. Their prices are established based on the interaction of supply and demand in the competitive market. Also, there are goods and services needed by people, but not supplied by private firms due to their high cost, non-excludability from consumption, and non-rivalry in consumption. The government must ensure the supply of these public goods. Public Goods are such goods that are non-excludable from consumption (consumers who do not want to pay for such goods cannot be deprived of the possibility of consuming them) and that do not reduce the amount available for others when consumed (non-rivalry characteristic). Case box

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The consumption of certain public goods is commonly limited to a certain territory. In fact, government regulation starts by identifying the community that consumes particular public goods. The boundaries of this community may not coincide with those of the society that pays for the production and actually produces the good. From the point of view of differentiating the boundaries of consumption and production, there can be distinguished international, national, and local public goods. International public goods are either available to all people worldwide (climate change mitigation, international security, etc.) or supplied within a certain macro-region (food aid across Africa). National public goods include national defense, the maintenance of the general rule of law, and the federal executive, legislative, and judicial powers. Local public goods are those supplied locally within a city or other territory (public transport, street lighting, local police, local environmental programs, etc.).

Non-rivalry means that consumption of a public good by one person does not diminish the ability of others to get the same amount of the same good. An increase in the number of consumers does not entail a decrease in the utility of a good for every new consumer. Non-rivalry is the extreme form of a positive externality. Many people jointly and simultaneously benefit from having access to public protection (police service, fire protection, national defense). None of the many benefits a larger portion of the external effect. Marginal private benefits are the same for all consumers. Moreover, the number of users may grow due to the stable production and supply of public goods. Non-rivalry creates situations unusual for a market economy. For instance, if there is an individual who wants to use a public good without paying for it, the optimal use of resources implies the provision of such a good for free (see the explanation of the Free-Rider Problem below).

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Non-excludability means that no one can be forbidden from consuming a public good, even if one refuses to pay for it. Restricting consumer access to the public good is almost impossible. Producers have no real choice whether to supply a good only to those who pay for it, or to all people. It is impossible to prevent the consumption of a public good by those who do not comply with the supplier’s requirements. Sanctions against nonpayers would be detrimental to all users, including those who pay. Therefore, the social efficiency of a public good would decrease. In some cases, public goods are material objects, but more often, they are intangible goods different from other goods in the market. Nevertheless, these are still real economic products, since, on the one hand, they have utility for consumers. On the other hand, their creation requires resources that could be otherwise employed in the production of other goods. Public goods include the establishment of the rule of law (constitutional order and other regulations) and property rights, which is a prerequisite for the normal operation of the market mechanism. Case box Such public goods as national defense, meteorological service, street lighting, national parks, and forestry have the properties of non-rivalry and non-excludability in consumption. They are undoubtedly necessary for society, so they are produced by state-owned companies or private ones, but at the expense of the state budget.

Depending on the combinations and degrees of rivalry/non-rivalry and excludability/non-excludability, goods and services are distinguished between pure public and private goods, excludable goods, and collective goods. Pure public goods are characterized by non-rivalry in consumption due to their indivisibility and non-excludability from consumption due to external effects. Only for a few public goods, the number of beneficiaries can increase almost infinitely at no additional cost. The exclusion of such goods from consumption affects the entire society (police service, defense). Such goods are not divisible into elements that could be supplied as separate goods. However, public goods and services vary considerably in the degree of rivalry and excludability. Therefore, the supply is dominated by mixed public goods, i.e., those with other than extreme combinations of non-rivalry and non-excludability features. For example, many consumers can use scientific knowledge (non-rivalry). However, patents, copyrights, or subscriptions may restrict access to certain knowledge. If so, knowledge is a mixed public good (non-rival, but excludable). The restriction of access (exclusion from consumption) breaks a public good into several independently traded goods that may compete against each other in the market (high rivalry). Between absolute non-rivalry and non-excludability on one side and high rivalry and excludability on the other, there is a range of intermediate combinations, i.e., the types of public goods and services (. Fig. 10.8). Mixed public goods can be traded. Due to the fact that public goods and services differ greatly from each other in the degree of excludability and rivalry, only

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. Fig. 10.8  Categorization of public goods by degrees of rivalry and excludability. Source Authors’ development

two categories of mixed goods are commonly distinguished. These are overloaded goods (non-rival in consumption only up to a certain point) and excludable goods (the non-excludability condition is not met).

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Case box Typical examples of overloaded public goods are roads and other transport routes and facilities (bridges, tunnels, etc.). Up to a certain level, the utility of these goods remains unchanged. In the ordinary course of events, no marginal utility arises, i.e., new consumers (drivers) do not degrade the utility for others. However, in the rush hour, every additional car on a road worsens the traffic situation, decreases speed for all, increases risks of accidents, and causes other inconveniences for all. Starting from the moment of overload (in this example, the rush hour), marginal social costs grow by the amount of marginal externalities. In contrast, the supply of pure public goods to additional consumers incurs no marginal public cost. Examples of excluded public goods are TV programs (paid subscription), public transport (fare and tickets), and municipal parks (entrance fees).

So, for many public goods suitable for collective consumption within broad but finite limits, there arises a problem of choice. 5 offer goods and services for free to all people as pure public goods; 5 charge moderate prices, thus excluding some goods from free consumption and keeping the load below the optimal level; 5 increase transaction costs, bringing prices for public goods closer to the market equilibrium price determined by freely fluctuating demand and non-rival supply.

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All three options are associated with efficiency loss. The one that ensures the best allocation of resources in specific circumstances must be chosen. If a good allows for collective consumption and the actual number of consumers is far from the maximum possible, such a good should be supplied for free. Charging a fee not only prevents the expansion of consumption at zero marginal costs, but must itself be supported with resources. Therefore, it increases the average cost. It is also necessary to estimate demand for a particular public good. Since public goods are not economic goods, the common supply-demand interaction in the free market may not apply here. Therefore, other forms of demand should be considered. The demand for public goods reflects the consumer’s perception of their utility compared to other goods (the volume or value of other goods given up to obtain an additional unit of public good). Such demand implies a price that a consumer would potentially be willing to pay for a unit of a public good. The demand for any good is aggregated by summing up individual demands. The horizontal method of building aggregate demand curve was addressed in 7 Chap. 5, 7 Sect. 5.1.1. Economic goods are purchased in different quantities at one equilibrium price (see, for instance, . Fig. 5.9). Public goods cannot be purchased in different amounts due to their indivisibility, but the fee for the same amount of indivisible goods could differ for different consumers. Free access to a p ­ ublic good implies that society as a whole pays for the production and supply of that good. The cost is distributed among all citizens of a country, all members of a particular society. Therefore, in relation to public goods, vertical aggregation is employed (constant supply at different prices). Suppose that a public good is produced in the amount of Y ∗ and consumed by three individuals (. Fig. 10.9). The optimal distribution of the overall cost would be one when consumer 1 pays price P1 and consumer 2 pays price P2. Consumer 3, whose demand for this particular public good is negative (the D3 curve), receives compensation P3 for the inconvenience he endures by participating in covering costs of a good with negative utility. For any of individual consumers, there is no need to pay the full price at which a good is supplied to society. Consumers make different contributions to the overall price due to their individual willingness to pay. The optimum is achieved when the sum of contributions equals the opportunity cost of the resources needed to obtain a unit of a public good. Even if all consumers are willing to pay, they pay different prices (consumers 1 and 2 in . Fig. 10.9). Therefore, those consumers whose marginal willingness to pay is lower (consumer 3) gain the most. Since consumers benefit from a pure public good regardless of whether they pay for it or not, some individuals may try to avoid unnecessary costs by receiving the utility for nothing. Therefore, there is no incentive for either firms or individuals to pay for the good because they can consume it without paying for it. An example is a situation when an entrepreneur, having benefited from the division of labor, having received access to scarce resources belonging to society and public services, and having gained a profit, refuses to pay a certain amount of tax determined by the law. This is one of the examples of a market failure known as a Free-Rider Problem—a situation when people benefit from a public good/service without paying for it.

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. Fig. 10.9  Aggregate demand for public goods (vertical method). Source Authors’ development

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The production of public goods requires collective actions, i.e., the sum of individual contributions of labor, money, etc. A potential individual need for the results of such actions does not guarantee an individual’s participation in the production. The expected effect can be achieved with different combinations of individual costs and efforts. A common economic entity seeks to maximize benefit while minimizing costs (reducing the individual share of the total collective costs). Consequently, an interest in public goods is compatible with avoiding participation in the collective actions required to obtain benefits from using that good. The free-rider problem is one of the central issues to the collective action theory. Such a type of economic behavior wields a major influence on the public sector. There are two possible reactions: rely on voluntary participation (everyone wants to be a free-rider for a particular public good) or entrust the supply of this good to the state (the latter uses its power to coerce). Regarding mixed public goods, the cost of coercive involvement in collective actions may exceed the cost of overcoming non-excludability (i.e., introducing access restrictions and making all people pay for the public good they consume). The free-rider problem is more likely to occur in larger communities, where obtaining adequate information about all payers and non-payers is more challenging than in smaller groups. The problem undermines the social efficiency of the supply of pure public goods. Addressing the free-rider problem, the government may launch the production of public goods in state-owned enterprises or attract private companies through the public procurement system. In any of those two alternatives (or most usually a combination of the two), the government must first collect taxes from people and businesses. Thus, the production of public goods in the market economy results in the emergence of state entrepreneurship and the development of the public procurement system. Summarizing the consideration of the role of the state in eliminating market failures, it should be said that the state seeks to solve two interrelated tasks: to ensure the regular operation of the market and to solve (or at least mitigate) acute social and economic problems. Nevertheless, government regulation of the economy and market interventions must be carried out within certain limits. First of

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all, state interventions that could destroy the market mechanism and replace it with direct regulation are unacceptable. Indirect tools (taxes, subsidies, etc.) are much more effective, especially those integrated into the market economy. Moreover, when applying a whole set of economic measures, the government should consider that many of them are contradictory. Therefore, it is necessary to identify the potential negative effects of government intervention in a timely manner and take measures to eliminate them. From time to time, it is essential to take steps to denationalize the economy. The methods include promoting competition and the liberalization of markets, the reduction of entry barriers, and an active anti-trust policy. Stimulating mixed entrepreneurship can also be an effective measure. Finally, an effective measure of indirect state intervention is the denationalization of public property and the development of privatization. 10.6  Lockdowns and Disruptions to Supply Chains

A relatively new type of a market failure is the disruption of global supply chains due to the introduction of anti-pandemic measures amid the spread of the COVID-19 virus. Various kinds of barriers to the cross-border movement of cargoes, goods, labor, and tourists (up to temporary lockdowns of entire industries and sectors) were introduced both at the international level (World Health Organization) and in individual countries. Contemporary supply chains are much more complex and globalized than decades ago (see, for example, 7 Chap. 7, 7 Sect. 7.3 for the consequences of most striking crises in the XX century). Regarding supply chain disruptions, transformation shifts induced by crises in the past were not as injurious as today. Those crises damaged certain companies or sectors for a relatively short time. The COVID-19 pandemic, first, triggers deep structural changes and, second, produces longer-lasting residual effects. The pandemic affects both supply and demand, so the risk of a global structural economic recession is much more severe now than ever before. The COVID-19 outbreak has already hit the global economy, while its final economic outcome can hardly be predicted. Restrictions on cross-border trade, transport and other mobility, and businesses distinctively affect countries deeper integrated into global production and supply chains. 7 Chapter 18 below details the pandemic-related challenges of economic development. In this section, we outline market failures that have resulted from the anti-pandemic government regulation. One of the critical problems is the dramatic drop in cargo and passenger traffic due to the closure of national borders, mass bankruptcies in many sectors (especially tourism, restaurant and hotel business, transport), volatility of foreign exchange and financial resources, lockdowns for businesses and people, decline in demand and purchasing power, as well as uncertainty among all market actors. China became the first country to introduce lockdowns at the local and then national levels as early as January–February 2020. All types of transportation were affected. Regular multimodal schemes were destroyed. Logistics companies urgently looked for alternatives to the broken links (for example, compensated

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for the closure of automobile roads between cities and provinces by increasing railway traffic). Railroad transport has become the largest carrier of China’s internal cargo and external supplies during the pandemic. It has helped factories and trading companies resume production and supply of their goods in a timely manner. To ensure fast economic recovery, China has fully used one of its major competitive advantages—the capacious domestic market. Already before the pandemic in 2019, about 58% of China’s GDP was generated by domestic consumption. The foreign trade sector, extremely significant in the past, provided only 11% of the GDP. A significant increase in various welfare programs (by 11.5% in January-March 2020 and then by almost 13% quarterly until the end of 2020) allowed the government to support domestic demand. China’s focus on the domestic market as a source of national economic development was emphasized well before 2020. Current economic policy is based on the “six stabilities” (employment, financial operations, foreign trade, foreign investment, domestic investment, expectations) and “six guarantees” (security in jobs, basic living needs, operations of market entities, food and energy security, stable industrial and supply chains, normal functioning of primary-level governments) (further reading: “The Coronavirus Will Not Change the Long-Term Upward Trend of China’s Economic Development”3). Much attention is paid to attracting foreign investments and developing investment opportunities domestically. The customs authorities have been working hard and efficiently. Customs clearance and processing time for priority cargoes have been reduced significantly. There were opened green corridors for medical supplies and health care items, as well as for raw materials, resources, and spare parts required to support economic activity and restore operations after the lockdown. Overall, freight traffic between China, Europe, and the Americas has declined, but major supply chains have been safeguarded or modified. Markets in Europe, the USA, and worldwide have also been experiencing the consequences of quarantine measures and government anti-crisis regulations. The cross-border freight traffic has not been closed, but certain restrictions applied. Transport companies have lost clients, and the volume of intra-EU, intra-US, and international traffic has decreased. Most countries imposed restrictions on both the transborder and domestic movement of people in 2020 to prevent the spread of the virus. In one form or another, constraints are likely to remain in the coming years. Falling demand due to lockdowns combined with health and safety concerns has induced the closure of many businesses across various sectors, negatively affecting entire global supply chains. In this new normal economic reality, producers face twofold negative consequences. On the one hand, they close up or suspend their operations (diminishing supply). On the other hand, demand for their products and services falls. This situation scales up the risk of individual market failures to grow into a global economic recession. The ongoing transformation of international supply chains may further degrade supplier diversification in the global economy and deteriorate opportunities for developing countries to benefit from integration into

3

Zhang (2020).

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international markets, human capital flows, and technology exchanges. These events would cause significant damage to industrialization across the developing world and hinder the economic and social progress that developing countries have achieved in recent years. Government involvement in mitigating the negative consequences of multiple market failures seems both unavoidable and helpful. In most countries, the public transport sector (railways, airline companies) has received substantial support from the government. Other sectors receive support in the forms of tax holidays, utility fees exemptions, subsidies, and direct financial aid. It is also essential to avoid government failures and not entirely rely on state interventions as the only way to overcome the crisis. The new market landscape is being established, to which governments, businesses, and people would have to adapt. As global risks are evolving, economic agents (including government as both regulators of and participants in economic relations) will seek to adjust their interactions with suppliers and supply chains. Effective management of these networks would demonstrate the company’s ability to withstand the novel challenges. Ensuring employees’ safety and sustaining supply chains would be of primary concern to businesses. Disruption of global supply chains due to the COVID-19 outbreak could last long. The pandemic calls for intensified efforts to strengthen multilateral approaches to achieving inclusive and sustainable economic development (see Part IV for a more comprehensive discussion of the new normal economic development and growth, particularly, 7 Chap. 18 for the discussion of the long-term perspective of the post-pandemic sustainable development). Chapter Questions: 5 How would you distinguish market failure from government failure? Do they occur independently? 5 What sources of market failure do you know? Which of them is the most influential and which is the most damaging? 5 Give examples of direct and indirect regulations. What is the primary difference between these two types of government regulation? 5 Explain the essence of indicative planning. Does it refer to direct regulation? 5 Distinguish the approaches to anti-trust regulation of natural, situational, and legal monopolies. Which of the forms of monopoly power most likely induces a market failure? 5 Why do information gaps occur in the market? 5 What is externality? Explain how consumption, technological, and monetary externalities differ. 5 Give examples of positive and negative externalities. How can the government address them? 5 No one can be forbidden from consuming a public good—is it a non-rivalry or a non-excludability principle? 5 Discuss the free-rider problem concerning the anti-crisis government regulation during the COVID-19 pandemic. Are there any manifestations of this problem?

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Subject Vocabulary:

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Asymmetrical Information: a market situation that occurs when one party to a market transaction possesses greater knowledge about the situation in the market or particular qualities of goods, services, firms, etc., than the other party. Coase Theorem: when bargaining costs are negligible, externalities can be internalized by establishing the government ownership of resources and allowing those rights to be freely exchanged in the market. Corrective Subsidy: a subsidy granted to economic entities that generate positive externalities to bring marginal private benefits closer to marginal social benefits. Corrective Tax: a tax on the output of goods that generate negative externalities imposed to equalize the marginal private costs and marginal social costs. Externality: a cost of individuals or society not reflected in price (negative externality) or a benefit enjoyed by economic entities not involved in the transaction (positive externality). Free-Rider Problem: a situation when people benefit from a public good/service without paying for it. Government Failure: a situation where the state cannot ensure the efficient allocation and use of public resources. Government Regulation of the Economy: a purposeful impact of the government on the economy through a system of legislative, executive, and control measures in order to increase the efficiency of certain market processes. Legal Monopoly: a situation in the market when the state empowers certain companies or individuals to serve as exclusive producers, suppliers, or buyers of certain goods or services. Market Failure: a situation when the market mechanism fails to arrange and coordinate economic processes in such a way as to ensure the efficient use of all available resources at the level of full employment. Natural Monopoly: a market situation where a minimum of average production costs is achieved when only one firm supplies a given product or service. Non-Excludability: a feature of public goods that means no one can be forbidden from consuming a public good, even if one refuses to pay for it. Non-Rivalry: a feature of public goods that means that consumption of a public good by one person does not diminish the ability of others to get the same amount of the same good. Public Good: a good that is non-excludable from consumption (consumers who do not want to pay for such goods cannot be deprived of the possibility of consuming them) and does not reduce the amount available for others when consumed (non-rivalry characteristic). Situational Monopoly: a market situation in which a firm obtains exclusive access to resources or facilities critical to producing certain goods, for which this firm establishes a monopoly.

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References Akerlof, G. (1970). The market for “Lemons”: Quality uncertainty and the market mechanism. The Quarterly Journal of Economics, 84(3), 488–500. Coase, R. H. (1960). The problem of social cost. Journal of Law and Economics, 3, 1–44. Zhang, X. (2020). The coronavirus will not change the long-term upward trend of China’s economic development. Finance: Theory and Practice, 24(5), 15–23.

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© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_11

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Learning Objectives: 5 Explore the essence of money and its role in the economy 5 Master fundamental theories of money (metallistic theory, nominalistic theory, Keynesian theory, Marxian theory, quantitative theory) 5 Overview forms of money and money aggregates 5 Elucidate the specific features of money market equilibrium 5 Distinguish between expansionary and contractionary monetary policy 5 Discuss monetary approaches to establishing macroeconomic equilibrium in the new normal economic environment 11.1  Fundamentals of Money 11.1.1  Role of Money

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We are so accustomed to the existence of money that we take money and commodity-money exchange for granted. Money is the blood of an economic organism. However, in its modern form, money appeared relatively recently. Today, we broadly define Money as a commodity used as a universal equivalent of the value of all other goods. In a subsistence economy, money did not exist because it was not needed for exchanging products. Economic actors satisfied their needs with the products of their own labor. Money appeared with the emergence of production for exchange to facilitate sales and purchases. The rationalist concept attributes the origin of money to the agreement between people to introduce special tools needed to facilitate commodity exchange. According to the evolutionary concept, money appeared beyond the will of people as a result of the long development of exchange, when one commodity stood out to play the role of money. In general, four forms of exchange have developed: 5 At an early stage of exchange between communities, there existed a simple, or random form of value (one commodity randomly expressed its value in another commodity). This form of exchange involves two poles of expression of value. On the one side, there is a commodity that expresses its value, that is, a commodity that plays an active role (a relative form of value). On the other side, another commodity expresses the value of the active commodity in a passive form (an equivalent form of value). The use value of an equivalent commodity serves as an expression of the value of goods. Concrete labor contained in an equivalent commodity manifests its opposite, abstract labor. Private labor spent on the production of an equivalent commodity expresses social labor. 5 The separation of pastoralist and agricultural tribes (early forms of the division of labor) substantially increased the number of equivalent commodities in exchange and thus gave rise to the full, or expanded form of value. Active commodities in the relative form of value then faced a multitude of equivalent goods. Due to a variety of equivalent goods, active commodities were not enough to adequately express the value of each commodity in the process of exchange.

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5 Further development of production and exchange called for the separation of specific goods that played the role of means of exchange in local markets. However, there was no one means of value, and the universal form of value was alternately performed by various commodities. 5 The monetary form of value is characterized by the emergence of one commodity as a universal equivalent. The separation of crafts from agriculture along with the emergence of cities and industries expanded the market for goods and services and necessitated the development of a monetary form of exchange. The role of money is fixed in one commodity, which possesses such properties as qualitative homogeneity, quantitative divisibility, persistence, and portability. Case box Historically, various materials have acted as money, including bronze, copper, iron, and precious metals. Silver and gold have appeared to be the most suitable for fulfilling the role of money due to their natural qualities: uniformity, divisibility, persistence, ductility, softness, portability, and liquidity. The high price of gold and silver was associated with their rarity and labor intensity (a small amount of precious metal contains a substantial amount of labor). Silver and gold were both accepted as money in many countries until the end of the XIX century. Since then, gold had dominated the money exchange sphere.

The advent of money made it possible to overcome the narrow patterns of mutual exchange of individual producers and create conditions for the emergence of market exchange participated by many. This, in turn, has contributed to the further specialization of production. The use of money allowed economic actors to divide the one-time process of mutual exchange of commodities (C → C) into two separate processes: the exchange of one commodity for money (C → M) and the acquisition of another commodity at another time in another place (M → C). The use of money has no longer been reduced to the mean of exchange. The money exchange has gained independence from commodity exchange. Producers can keep the money received from the sale of their goods until the moment of purchase of the desired goods. There has arisen saving, which could be used both to purchase goods and to lend money and pay off debts. Certain forms of money have outgrown local and even national markets and have become universally accepted worldwide. Therefore, it is fair to say that modern money performs the following functions: 5 Measure of value. Money as a measure of value is used to compare and measure the values of various goods and services. Many schools of economic thought accept that it is not money that makes goods commensurate, but the amount of labor spent on the production of goods. However, comparing amounts of labor embodied in particular goods is challenging. Therefore, there is a technical need to establish a universally accepted unit of measure to

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compare heterogeneous goods with each other. Countries establish their domestic measures of value, or Standard of Prices, a means of measuring prices of all goods and services in an economy in universally accepted monetary units. Under the metallic currency circulation, the standard of prices was the fixed weight amount of metal taken as a unit (see, for example, the gold standard further discussed in 7 Sect. 11.2.1). Today, money acts as a means of evaluating transactions, i.e., in the form of a price as an assessment of the utility and value of goods. 5 Means of circulation. Money as a means of circulation serves retail turnover, the services market, and the debts market. As noted above, the process of commodity circulation implies the sale of one commodity for money and the purchase of another commodity for money (C → M → C). Therefore, money serves as both the starting point and ending point of circulation. Unlike goods that leave the market after the sale, money is constantly in circulation. It acts as an intermediary in the exchange. Money as a means of circulation reduces the costs of circulation since money exchange requires much less effort and time than the direct exchange of goods. 5 Means of payment. This function involves the sale of goods on credit. The form (C → M → C) is transformed with the introduction of the debt obligation D into the circulation process in the following way: (D → C) → (C → M) → (M → D). This means that there is no simultaneous counter movement of goods and money. The end point of the exchange process is the repayment of the debt. The costs of circulation decline by reducing the effort and time to make a purchase and sale. Credit money (debt obligations, including bills, banknotes, checks, bank cards, electronic money) serves as a universally accepted means of payment. However, the time gap that arises in the process of commodity circulation can create a risk of non-payment by a debtor. Massive debtor insolvency could destabilize the entire monetary system. 5 Store of value. After the sale of goods and services, money is temporarily withdrawn from circulation to be used to make purchases in the future. The accumulation of money is crucial for the development and growth of commodity production, since the acquisition of means of production and consumer goods is based on the accumulation of money by producers and consumers. In the past, when precious metals acted as money, money performed the function of accumulating treasures. Today, paper money cannot perform this function due to inflation. Money cannot be saved and accumulated without losing its value, unless it is invested in some assets during storage. Therefore, money acts as a special asset that provides its holders with purchasing power in the future. Being the most liquid commodity, money acts as the most convenient form of the store of value and wealth. 5 World money. This function is manifested in the relationship between countries or legal entities and individuals located in different countries in the form of foreign trade relations, international loans, the provision of services to foreign counterparts (universal means of payment and universal materialization of social wealth) (further discussed in 7 Chap. 20, 7 Sect. 20.4).

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Case box In the gold standard era before the outbreak of the World War I, silver and gold (then gold alone) performed the function of world money. They were used in international settlements as a general purchasing medium in the form of cash money, as a store of value to establish a reserve fund, as the final means of payment in cases of the passive balance of payments, as well as a currency to replenish currency reserves for current international settlements. Today, gold has ceased to perform the functions of world money. It acts as one among many commodities. After the abolition of the convertibility of the US Dollar into gold in 1971–1973, the currencies of developed countries act as world money. The IMF uses international accounting units (Special Drawing Rights), which are artificially created international reserve funds designed to regulate the balance of payments of IMF member states, replenish official reserves of member states, and serve settlements of member countries with the fund.

The withdrawal of gold from circulation and the cessation of the functions of money is called Demonetization. The latter was primarily triggered by inflation due to the excessive emission of paper money unbacked by gold. The conversion of paper money into gold reduces the country’s gold reserves. Therefore, gold-related standards were abandoned globally in the early 1970s. Nowadays, the value of banknotes is determined only by the trust of their holders. Banknotes and coins act as money only because the government claims that they are money and people should accept them as such. The commodity and gold nature of money is a thing of the past. Today’s money is entirely credit money. Gold reserves are used to maintain the value of the national currency. Exchange rates of national currencies are based on economic, financial, trade, and political actions of governments, as well as international agreements (exchange rates and currency trading are detailed in 7 Chap. 20, 7 Sect. 20.4). 11.1.2  Theories of Money

Interpretations of the essence of money, its role in the economy, its quantity in the market, as well as approaches to the implementation of monetary policy differ in major theories of money, such as the metallistic theory, the nominalistic theory, the Keynesian theory, the Marxian theory, and the quantitative theory of money. The metallistic theory of money attributes the wealth of society to precious metals, which perform all functions of money. Having emerged in the XVI– XVII centuries, the early version of the metallistic theory reflected the paradigm of mercantilism, the then-prevailing economic and trade concept which justified every possible inflow of precious metals into a country (further detailed in 7 Chap. 19, 7 Sect. 19.1.1). During the transition from mercantilism to classical political economy in the XVIII century, the metallistic theory gradually lost its position, since it did not imply the need for replacing full-fledged metal money

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with paper money. However, in the 1870s, Karl Knies modernized monetarist views by pushing the provisions of the metallistic theory closer to the new conditions of money circulation (further reading: “Geld und Credit”1). According to Knies, the money supply includes not only metal money, but also banknotes emitted by the central bank. By that time, a significant role of credit in the economy had called for a massive issuance of paper banknotes. However, recognizing banknotes, Knies opposed unbaked paper money not exchanged for metals. After the World War I, proponents of the metallistic theory advocated the preservation of the gold standard in the forms of gold bullion and gold exchange standards (further explained in 7 Sect. 11.2.1). After the World War II, representatives of the theory suggested restoring the gold standard in domestic monetary circulation. However, with the complete abolition of the gold content of all world currencies by the early 1970s, the metallistic theory of money tailed off. Case box One of the last manifestations of the metallistic theory of money can be attributed to the mid-1960s, when, in an economic and financial confrontation with the USA, France declared its commitment to the gold standard and submitted most of the dollars in the national reserve to the USA for exchange for gold. Following France, other countries also claimed to exchange paper dollars for gold. As a result of a sharp decline in gold reserves, the USA announced the abolition of the gold backing of the US Dollar in 1971. During the 1970s, the Bretton Woods monetary system based on the gold exchange standard was eliminated. The world economy switched to floating exchange rates with no gold content in currencies.

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The nominalistic theory of money states that since money is created by the state, the value of money is determined by the state in accordance with its nominal value. James Steuart proposed the concept of the ideal monetary unit, according to which money performs only the function of a price scale (further reading: “An Inquiry into the Principles of Political Economy”2). George Berkeley considered money as a ratio of abstract value, ordinary signs of value with no material content not related to goods. The nominalistic theory of money flourished in the late XIX century and the early XX century. Georg Knapp considered money as a creation of law and order and considered it as a means of payment (further reading: “The State Theory of Money”3). According to Knapp, paper money not denominated in gold can perform all the typical functions of full-fledged metal money. Banknotes are accepted as a means of payment regardless of their metal content. Having no connection with gold or silver, they represent conditional

1 2 3

Knies (1873). Steuart (1767). Knapp (1924).

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signs of value, to which the state provides certain solvency. In the early XX century, the evolution of the nominalistic theory was manifested in the fact that Knapp based his concept of money on paper money rather than full-fledged coins. At the same time, analyzing the money supply, Knapp only considered state treasury notes and fractional coins. Credit money (bills of exchange, banknotes, checks) was excluded from the nominalistic vision of money circulation, which actually made the theory inconsistent as credit money spread. A number of followers of the theory used it to criticize the gold standard system. Rejecting the metal concept of the theory of labor value, the nominalistic theory detached paper money not only from gold, but also from the value of commodities, since paper banknotes themselves were endowed with value and purchasing power only on the basis of state power. Case box An important consequence of the nominalistic theory of money is the rationale that inflation is caused by shifts in wage and income levels, not an increase in the amount of money in circulation. The nominalistic approach to monetary policy was practiced in Germany, where the government widely used money emissions to accommodate the budget deficit during the World War I. However, hyperinflation in Germany in the 1920s put an end to the dominance of the nominalistic theory of money.

The Keynesian theory of money further modified the nominalistic approach to interpreting the essence of money during the Great Depression. It called for the abolition of the gold standard and advocated the need for public regulation of money supply and money exchange. According to Keynes, the advent of paper money is a progress in the development of society, since it is more elastic than gold and is able to ensure the prosperity of society (further reading: “A Treatise on Money”4). The advantage of paper money is that its quantity in circulation can be regulated by the central bank. Therefore, the state can adjust commodity prices, wages, and the entire market. In general, public regulation of the economy is a cornerstone of the Keynesian school (see, for example, 7 Chap. 1, 7 Sect. 1.2.2 for fundamental ideas of the school, 7 Chap. 6, 7 Sect. 6.1.2 for the Keynesian theory of macroeconomic equilibrium, and 7 Chap. 7, 7 Sect. 7.1.3 for the Keynesian interpretation of economic cycle). The Keynesian approach to interpreting the demand for money is further detailed in 7 Sect. 11.3. The practical goal of the Keynesian nominalistic idea of money was the theoretical justification for the abolition of the gold standard, the transition to the circulation of paper money, and the regulation of the economy through adjusting prices and inflation (the Keynesian theory of inflation is discussed in 7 Chap. 9, 7 Sect. 9.1.3).

4

Keynes (1930).

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Case box According to Keynes, the utility of money is based on its exchange value, that is, the utility of those goods that can be bought with it. The amount of paper money held by people is determined by the purchasing power required by the population. In turn, the purchasing power depends on wealth and habits. Wealth increases slowly, while habits change fast. These changes are affected by many factors, including the frequency of receiving income and preferences in the ways of using and saving money (see the Keynesian concepts of marginal propensities to save and consume in 7 Chap. 6, 7 Sect. 6.3.2). Thus, the Keynesian theory of money is closely intertwined with macroeconomic theory as a whole. It is hardly possible to distinguish between monetary and non-monetary issues, that is, the role of studying the interaction of monetary and non-monetary factors of reproduction has increased significantly in the years since Keynes.

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The Marxian theory of money considers money as a commodity. According to Karl Marx, gold had long been used as money only because it retained features of a commodity and it could be used for personal and social needs (further reading: “Capital”, volume I, 7 Chap. 3 “Money, or the Circulation of Commodities”5). Like any commodity, gold has its value determined by the amount of labor required to extract gold, process it, and produce coins. Gold creates a special consumer value, which allows coins to function as a universal equivalent. That is, the prices of goods correlate with the value of money. The labor expended to create money is an abstract form of money. In the Marxian theory, money is a form of expression of exchange value. The origin of wealth is associated with the costs of labor, that is why a commodity created with the use of labor may act as money. Thus, in order to express the value of a commodity, money must itself represent a certain value determined by the cost of labor. Therefore, the optimal form of money is a gold coin, as it has social value accepted universally by all economic actors. According to Marx, the amount of money in circulation changes in direct proportion to the sum of the prices of goods sold (minus the sum of the prices of goods sold on credit) and the amount of future payments (minus repayable obligations) and inversely proportional to the velocity of money circulation (Eq. 11.1). With the development of commodity production and the emergence of the function of money as a means of payment, the total amount of money should decrease, since the development of credit and non-cash payments have the opposite effect on the amount of money.

M=

5

CD − CC + PF − PO V

Marx (1867).

(11.1)

379 11.1 · Fundamentals of Money

11

where M money quantity; V money velocity; CD sum of the prices of goods and services sold; CC  sum of the prices of goods and services sold on credit (not due to be paid for). PE sum of future payments (debt payments); PO sum of offsetting payments (repayable obligations). In metallic monetary systems, money quantity was regulated spontaneously, as money acted as a store of value (rather, a means of treasure). Excess money flew out of circulation to treasure if the need for money declined, and vice versa. With the advent of paper credit money not exchangeable for gold, the circulation of cash is carried out in accordance with the above law of money circulation. With the abolition of the gold content of national currencies, this law is reflected in the fact that banknotes issued for circulation must be provided with bank assets, such as inventories, gold and other precious metals, freely convertible currency, securities, and debt obligations. Unreasonable emission of money violates the law by overflowing the market with excessive money and depreciating its value. Case box The Marxian theory emphasizes that the evolving exchange gives rise to new forms of money that serve the new needs of the economy and society. New functions of money shape value as a separate phenomenon. Any token can act as money. Therefore, money has two key features. On the one hand, it is a commodity, and on the other hand, it is an expression of value. According to Marxism, money created the conditions for international exchange. Being a universally accepted measure of value, money also serves as a means of accumulation and wealth. It allows for international settlements and facilitates the exchange of goods and services.

The quantitative theory of money postulates that the value of money is determined by its quantity in circulation. The free market equalizes the supply of money and commodities with demand for them and thus establishes prices and determines the value of money. Having originated in the XVI–XVII centuries in the works of Jean Bodin (further reading: “The Response of Jean Bodin to the Paradoxes of Malestroit”6), the theory was elucidated in the XVIII–XIX centuries by David Hume (further reading: “Political Discourses”, discourse III “Of Money”7), James Mill (further reading: “Thomas Smith on Money and Exchange”8),

6 7 8

Bodin (1568). Hume (1752). Mill (1808).

380

Chapter 11 · Money

and Charles Montesquieu (further reading: “The Spirit of the Laws”,9 books XIII and XX to XXIII). The modern quantitative theory of money is based on the use of credit money and paper money circulation. It includes the transactional school, the Cambridge school, and the monetary school. The transactional direction of the quantitative theory of money proceeds from the purchasing power of money. Irving Fisher identified six determinants of purchasing power: money quantity, money velocity, average weighted price index, commodity supply, bank deposits, and the velocity of deposit-check circulation (further reading: “The Purchasing Power of Money”10). Assuming that the amount of money paid for goods is equal to the quantity of goods multiplied by commodity prices, Fisher built the equation of exchange (The Fisher Equation) (Eq. 11.2):

M ×V =P×Q

(11.2)

where P – average weighted price level; Q – real output.

11

Based on the fundamental functional dependence of the equation (left part equals right part), Fisher concludes that prices P are directly proportional to the amount of money in circulation M (money velocity V is taken as a constant value) and inversely proportional to the amount of goods in the market Q. The latter variable is almost constant. Thus, the overall price level in the economy fluctuates in parallel with the amount of money in circulation. Case box Fisher assumed V and Q to be constant in the long run, thus building the functional link in the equation of exchange on the relationship between the two dependent variables P and M . In fact, due to the cyclical nature of economic development previously discussed in 7 Chap. 7, neither money velocity nor gross output can be taken unchanged. Even within relatively short periods of time (stages of economic cycles), their rises and falls dramatically affect the macroeconomic environment. Moreover, commodity prices are influenced by a number of non-economic factors (discussed in 7 Chap. 9), not directly related to the money supply.

The Cambridge quantitative school of money attaches special importance to the role of money as a store of value (in contrast to the transactional school which distinguishes the functions of money as a means of circulation and a means of payment). The Cambridge branch of the monetary theory is associated

9 Montesquieu (1748). 10 Fisher (1911).

11

381 11.1 · Fundamentals of Money

with the names of Alfred Marshall and Arthur Pigou (further reading: “Money, Credit, and Commerce”11 and “The Economics of Welfare”12). The Cambridge school expresses the money quantity through the final product using the liquidity parameter (The Pigou Equation) (Eq. 11.3).

M =P×R×K

(11.3)

where R  total output in physical terms per unit of time t ; K   portion of the final product (P × R) kept in liquid form. The two equations of exchange differ from each other in a way that the Fisher equation uses the money velocity variable V , while the Pigou equation employs the coefficient K = V1 . One can derive Eqs. 11.2 from 11.3 by replacing K with V1 . Both Fisher and the Cambridge school take output and money velocity as constant variables in the long-term perspective. Therefore, they both attributed fluctuation of the price level P to changes in the money supply M . At the same time, the transactional school and the Cambridge school ignore the function of money as a measure of value along with its role as a universal equivalent of value. The difference between the branches of the quantitative theory is that the transactional school proceeds from the analysis of the supply of money, while the Cambridge school focuses on the demand for money and the demand for goods and services. Although the approach of Pigou and Marshal differs from that of Fisher, it establishes a direct relationship between money and prices. Thus, the two directions remain within the quantitative theory narrative. Case box One of the key practical features of the Cambridge interpretation of the quantitative theory of money is the recognition of the special demand for money, due to which economic actors withdrew money from circulation in the form of cash balances. That is why the Cambridge branch is also called the concept of cash balances. Pigou focused on private assets and the behavior of businesses and consumers, i.e., on the relative price of money for individual holders rather than the absolute price of money in the economy. According to Pigou, cash balances include cash and balances on current accounts. That means that the money quantity is the amount of cash money held by the population and businesses.

Modern monetarism previously discussed in 7 Chap. 9, 7 Sect. 9.1.3 represents the neoclassical branch of the quantitative theory of money. The monetarist school proceeds from the assumption that due to the intrinsic mechanisms

11 Marshall (1923). 12 Pigou (1920).

382

Chapter 11 · Money

of competition and pricing, markets always return to equilibrium. Therefore, the government should not interfere in economic processes. Based on the models of macroeconomic equilibrium (see 7 Chap. 6, 7 Sect. 6.1), monetarists suggest that the equilibrium is achieved automatically by changing relative prices, or prices of individual goods. The transition from one state of equilibrium to another is associated with changes in absolute prices, i.e., the overall price level. The latter is affected by changes in the money supply. The amount of money in circulation also affects the dynamics of national income. The contemporary monetarist version of the quantitative theory of money abandons the assertion that money supply and price dynamics are proportionally related, but accepts a one-way causal relationship between the variables. Monetarists recognize the need to capture changes in the money velocity, but attach little importance to this factor. Fisher’s assumption of the constant output in the long run has been revised, but the money quantity still plays a decisive role in explaining fluctuations in output and other macroeconomic parameters. Monetary policy is recognized to be the most effective tool for regulating economic development (further discussed in 7 Sect. 11.4). Case box

11

The monetarist approach to public regulation of markets was widely practiced in the past in the USA and European countries to drag economies out of stagflation and structural crises (see 7 Chap. 7, 7 Sect. 7.3 for the most damaging economic and financial crises of the modern age). Since the 1920s, various monetarist measures have been employed across the world to adjust money markets and spur economic activities. One of the most demonstrative examples is Reaganomics, the set of economic policies of U.S. President Ronald Reagan in the 1980s, which allowed the United States to weaken inflation and strengthen the dollar.

An important element of the monetarist concept is the exogenous nature of changes in the money supply. That is, the money supply affects macroeconomic parameters, not the other way around. The theory distinguishes between short and long periods of manifestation of the effect of monetary policy, the consequences of which differ depending on the time period. In the short run, macroeconomic variables such as output and employment highly depend on changes in the money supply. This happens because of the low flexibility of prices in the short term. Prices lag behind the change in the money quantity, and the latter affects employment and output. Over a long period, both prices and nominal income get adjusted to the new level of the money supply. In the long term, real variables of employment and output are primarily influenced by the size of capital reserves, the quality of labor, and the level of technology, rather than shorter-term monetary factors. The market itself can not trigger economic turmoil, as it is a self-regulating system. It is disturbed from the outside by exogenous processes and interventions into the self-regulation mechanism. Nevertheless, state intervention in the economy is inevitable—not to adjust market mechanisms, but to incentivize market forces by applying monetary policy. The long-term mone-

383 11.2 · Monetary System

11

tary policy should aim at stabilizing and controlling inflation. From the standpoint of monetarism, such a future-oriented economic policy best contributes to maintaining optimal rates of economic growth. 11.2  Monetary System 11.2.1  Forms of Money

According to the features of the universal equivalent, all forms of money can be distinguished between full-fledged money (good money) and token money (bad money). Full-Fledged Money is money made from a material that has the same value both in circulation in a form of money and in accumulation in a form of wealth. In other words, it is money, the nominal value of which corresponds to the value of the metal contained in it. The purchasing power of full-fledged money (its ability to exchange for a certain amount of goods and services) depends on the value of precious metals or other materials contained in the monetary unit. Currently, full-fledged money does not participate in money circulation. Token Money is a form of money whose intrinsic value does not exceed its face value (denomination) set by the issuing body or accepted by people. Token money includes all forms of post-gold money, such as paper money, credit money, deposited funds, and fractional coins. Token money loses its commodity nature, as it has no intrinsic value. The cost of producing a unit of token money is negligible compared to its face value. Having no intrinsic value, token money acquires a representative value accepted by all economic actors (the value it represents because of legal enactment or a custom). The representative value determines the purchasing power of token money. The representative value of a token unit is the portion of the gross product represented by one monetary unit. It is determined by the ratio of the need for money and the amount of money in circulation. Thus, both the representative value and the purchasing power of token money depend on the amount of money in circulation. Monetary System is a set of all forms and methods of money emission, money circulation, and money exchange historically emerged in a country and legally established by the government. Depending on the form of money that prevails in circulation, monetary systems can be distinguished between commodity monetary system, metallic currency system, and credit money system. As noted above in 7 Sect. 11.1.1, early commodity monetary systems accepted various commodities as equivalents to facilitate exchange. A distinctive feature of commodity money is that its value as money equals its value as a commodity. Commodity money has an intrinsic value, i.e., an important set of consumer properties. With the evolution of the division of labor and the development of industrialization and urbanization, commodity monetary systems gave way to metallic currency systems. The latter assume circulation of full-fledged gold and silver money in parallel with credit money freely convertible into bullions and coins. The metallic system exists in a form of either bimetallism or monometallism (. Fig. 11.1).

384

Chapter 11 · Money

. Fig. 11.1  Types of metallic currency systems. Source Authors’ development

Bimetallism is a monetary system in which two metals (silver and gold) coact as universal equivalents of value. Bimetallic systems include parallel currency systems (the ratio between gold and silver coins establishes in the free market), dual currency systems (the government sets the ratio between the metals), and limping currency systems (one of the metals dominates over another). Case box

11

The emergence of limping currency systems largely contributed to the failure of bimetallism and facilitated the transition to monometallism. Gold coins (intrinsic value above the face value) were driven out the circulation by silver coins (intrinsic value equal to or below the face value). People preferred to store more expensive gold coins and pay with cheaper silver coins. This is known as Gresham’s law: bad money drives good money out of circulation.

Monometallism is a monetary system founded on one monetary commodity (gold, silver, or another metal). Monometallism evolved from the gold coin standard in the XVIII century (gold performed all the functions of money) to the gold bullion standard that existed until the 1940s (no circulation of gold coins, limited exchange of banknotes for gold on the gold market), and then to the gold exchange standard until the 1970s (banknotes are exchanged for certain currencies, which are then exclusively converted into gold). With the displacement of gold from circulation, there emerged a system of paper and credit money. Paper Money is banknotes of certain face value issued by the state to cover public expenditures. The stability of paper money is ensured primarily by observing a certain proportion between the money quantity and the supply of goods and services. Compliance with this proportion implies a deficit-free public budget. Covering deficits by increasing domestic debt and emitting extra money in circulation may provoke inflation. The expansion of commercial and bank credit has resulted in the emergence of credit money. To a certain extent, it has eliminated some of the shortcomings of paper money. Credit Money is a form of money that implies an exchange on credit. The monetary system has

385 11.2 · Monetary System

11

changed radically with the advent of banks, or rather, bank deposits and loans, and the introduction of bills of exchange and checks. Banknotes, bills of exchange, and bank checks are now combined into the credit money category. Yet, they differ from paper money as they act as measures of value and credit documents that facilitate relationships between lenders and borrowers (further discussed in 7 Chap. 12). 11.2.2  Money Circulation

Regardless of the specific forms of money and types of monetary systems, the economy functions on the basis of money circulation. Money Circulation is the movement of money in cash and non-cash forms when serving the exchange of goods and services and other settlements in the economy. Cash circulation is served by banknotes, fractional coins, and treasury notes, i.e., money in its physical form. Non-cash circulation is the turnover of money in the form of transfers to accounts in banks and other credit organizations and offsets of mutual claims. It is served by bills of exchange, transfer orders, bank checks, and bank cards. As a rule, a high share of cash in total money circulation indicates a low level of development of the monetary system. Today, amid the progressing dematerialization of money and the emergence of electronic means of payment cash turnover hampers economic development by reducing money velocity and pushing up costs associated with money circulation between people, businesses, banks, and the state. The variety of forms of money challenges measuring the money supply and determining its optimal size. Money Quantity is the sum of all funds in cash and non-cash forms in the economy. The active part of the money quantity includes money that directly serves the economic turnover. The passive part consists of savings and cash balances that can potentially be involved in circulation. New money comes from banks and other credit organizations (further detailed in 7 Chap. 12). Issue of Money is the injection of money into circulation in the form of the transfer of certain amounts of money in cash and non-cash forms from banks to economic actors, such as public organizations, businesses, and people. The issue of money, which results in an overall increase in the money quantity is called Emission. The issue of money may not increase the amount of money in circulation. Non-cash money enters the market when commercial banks grant loans to their customers, while cash is channeled through operating cash desks. In parallel, there is a reverse process of depositing cash in the cash desks of banks and non-cash repayment of previously granted loans. Therefore, money rotates between lenders and borrowers. Moreover, commercial banks do not themselves multiply money quantity as they operate with secondary money having been emitted by the central bank. The analysis of quantitative changes in money circulation and the regulation of money quantity in the economy require the use of money aggregates. Monetary Aggregate is an element of a certain group of liquid assets that refers to the particular volume and structure of the money supply. The aggregates establish a

386

Chapter 11 · Money

. Fig. 11.2  Money aggregates hierarchy. Source Authors’ development

11

hierarchical system, where each subsequent aggregate absorbs previous ones, and each of the aggregates characterizes the money quantity depending on the liquidity of a particular aggregate (. Fig. 11.2). Liquidity is the ability of material assets to turn into money and perform the functions of money. Monetary aggregates differ from each other in the degree of liquidity, i.e., the ability to quickly turn into cash with minimum losses. The composition of monetary aggregates differs in different countries. In its most complete form, it includes four levels of the money supply, as tracked by the Federal Reserve System: 5 M0—the sum of the dollar amounts of currency in circulation, including paper money and coin currency; 5 M1—all M0 aggregates, plus non-bank travelers’ checks and checkable deposits; 5 M2—all M1 aggregates, plus money market shares, overnight repurchase agreements, and general-purpose, fund balances of broke money market, and saving deposits; 5 M3—all M2 aggregates, plus large deposits of over $100,000, agreements, balance in money market funds, and Eurodollar deposits. One of the key quantitative parameters of money circulation is Money Velocity, a number of transactions that money serves during a certain period of time.

387 11.3 · Money Market

11

It is calculated as the ratio of the GDP to the money quantity. A high velocity indicates high market activity associated with a fast turnover of funds. The faster the money rotates, the better it serves the exchange, and the lower the need for additional emission. However, a fast turnover can be a sign of a lack of trust in the national currency (economic actors avoid keeping money and rush to exchange it for assets as soon as possible). Low velocity indicates a slowdown in economic turnover. The circulation can be decelerated by a desire of economic actors to accumulate money and store it in long-term deposits. The velocity depends on a variety of factors, including the overall macroeconomic environment (stage of an economic cycle, economic growth rates, inflation), monetary parameters (share of non-cash funds in the composition of money circulation, development of credit; use of electronic money), and social and economic situation in a country (consumer demand, economic expectations). Case box In most countries, central banks do not monitor aggregates above M2, considering this parameter sufficient for the purposes of the monetary policy. For instance, the Federal Reserve System no longer tracks M3 since 2006. In the USA, M1 aggregate is dominated by other liquid deposits, that consist of negotiable order of withdrawal and automatic transfer service balances at depository institutions, share draft accounts at credit unions, demand deposits at thrift institutions, and savings deposits, including money market deposit accounts. Retail money market funds prevail among the unique components of M2 aggregate (. Table 11.1).

11.3  Money Market

Money for the economy is like blood for a living organism. Therefore, the state of the monetary system is one of the critical health metrics of the economy. As previously noted in 7 Chap. 6, 7 Sect. 6.5, Money Market is a market in which an equilibrium value of the money quantity and an equilibrium interest rate are established as a result of the interaction of demand for money and money supply. Money is not traded like other commodities in the market. The price of money is reflected by the interest rate. From the standpoint of the money theory, Interest Rate is the price of money as a means of saving reflected by the relative value of interest payments on loan capital over a certain period of time. Being the price of money, interest rate r determines the demand for money Md in the same way that the price of a commodity P affects the demand for this commodity Q (see the most basic illustration of the demand curve given in 7 Chap. 5, . Fig. 5.1.1). Demand for Money is the need for cash and non-cash funds to facilitate economic activities. It follows from the function of money as a means of circulation and a store of value (accumulation of wealth and saving), as well as the absolute liquidity of money. Aggregate demand for money consists of the demand for money to serve exchange and the demand for money as a store of value.

11

1,997.2

2,014.3

2,028.2

2,057.2

2,063.5

2,070.2

2,076.7

2,084.9

2,092.8

2,104.2

2,118.2

2,133.2

2,144.3

February 2021

March 2021

April 2021

May 2021

June 2021

July 2021

August 2021

September 2021

October 2021

November 2021

December 2021

January 2022

4,800.0

4,696.7

4,676.8

4,595.1

4,502.9

4,489.6

4,374.1

4,247.8

4,010.4

3,744.1

3,739.4

3,595.1

3,392.6

13,641.3

13,600.8

13,484.8

13,364.3

13,303.3

13,172.1

13,046.6

13,001.7

13,185.6

13,126.1

12,873.9

12,758.5

12,717.4

20,585.6

20,430.7

20,279.8

20,063.6

19,899.0

19,746.6

19,497.4

19,319.7

19,259.5

18,927.4

18,641.5

18,367.9

18,107.1

Total M1

77.2

87.8

98.6

107.4

117.3

128.9

141.5

152.0

161.3

175.4

194.9

213.8

233.8

Small denomination time deposits

Other liquid deposits

Currency

Demand deposits

Non-M1 M2

M1

January 2021

Period

987.0

971.6

971.0

973.0

976.2

977.9

981.8

988.6

997.8

1,007.8

1,055.6

1,068.2

1,063.0

Retail money market funds

. Table 11.1  Seasonally adjusted components of M1 and M2 in the federal reserve system in 2021–2022, $ billion

1,064.2

1,059.4

1,069.6

1,080.4

1,093.5

1,106.8

1,123.3

1,140.6

1,159.1

1,183.2

1,250.5

1,282.0

1,296.8

Total non-M1 M2

(continued)

21,649.8

21,490.1

21,349.4

21,144.0

20,992.5

20,853.4

20,620.7

20,460.3

20,418.6

20,110.6

19,892.0

19,649.9

19,403.9

Total M2

388 Chapter 11 · Money

Total M1

2,174.9

2,178.3

2,174.2

2,172.6

2,172.3

2,178,5

March 2022

April 2022

May 2022

June 2022

July 2022

August 2022

5,231.3

4,951.2

4,924.6

4,908.0

4,731.9

4,768.3

4,772.4

13,043.0

13,392.5

13,447.9

13,538.6

13,705.2

13,755.9

13,730.5

20,452.8

20,516.0

20,545.1

20,620.8

20,615.4

20,699.1

20,661.3

162.2

112.9

81.0

55.1

43.7

46.8

59.1

1,096.3

1,080.7

1,041.3

1,008.7

996.5

993.8

988.2

Retail money market funds

1,258.5

1,193.6

1,122.3

1,063.8

1,040.2

1,040.6

1,047.3

Total non-M1 M2

21,711.3

21,709.6

21,667.4

21,684.6

21,655.6

21,739.7

21,708.6

Total M2

389

14 Board of Governors of the Federal Reserve System (2022).

Source Authors’ development based on the Board of Governors of the Federal Reserve System (2022)14

2,158.4

Small denomination time deposits

Other liquid deposits

Currency

Demand deposits

Non-M1 M2

M1

February 2022

Period

. Table 11.1  (continued)

11.3 · Money Market

11

390

Chapter 11 · Money

The demand for money can be interpreted from the standpoints of the monetarist school (the classical quantitative theory of money discussed in 7 Sect. 11.1.2) and the Keynesian school. The classical theory attributes the demand for money to income. The demand for money curve Md shows how much money economic actors need to serve all transactions at a given interest rate. The quantity theory assumes the money velocity to remain constant, because it is associated with a relatively rigid structure of transactions in the market (see the Fisher’s equation of exchange in 7 Sect. 11.1.2). Nevertheless, it may change over time, for example, due to the introduction of new processing facilities in banks that speed up transaction time. Provided that V remains constant, a change in the amount of money in circulation M should cause a proportional change in nominal domestic product. The classical theory suggests that the real output Q changes slowly only under the influence of the factors of production and technology. Therefore, fluctuations in nominal product reflect changes in the price level. Thus, the change in the amount of money in circulation affects no real output, but a nominal product. This effect is called money neutrality. Irving Fisher made a significant contribution to the modernization of the quantitative theory of money (see the fundamentals of the theory of demand-pull inflation in 7 Chap. 9, 7 Sect. 9.1.3). By transforming Eq. 11.2, Fisher demonstrated the relationship between the money quantity M , gross output Q, and prices P (Eq. 11.4):

M=

11

P×Q V

(11.4)

The classical theory and Fisher’s equation characterize the relationship between the money supply and the interest rate: the increase in the money supply triggers inflation, and the latter pushes up the interest rate. This relationship between inflation and interest rates is called the Fisher effect. It tells that the demand for money depends on the three factors: 5 absolute price level (other things being equal, the higher the price level, the higher the demand for money, and vice versa); 5 real output (as output expands, real incomes grow, which means that people increase demand for money to serve rising transactions); 5 money velocity (all determinants of the velocity affect the demand for money). As previously noted in 7 Sect. 11.1.2, the Keynesian approach rests on the recognition of money as one of the forms of wealth. In the Keynesian interpretation, the demand for money is a liquidity preference. It depends on how much of their assets economic actors prefer to keep in liquid form. Being called the liquidity preference theory, the Keynesian theory of demand for money postulates that a portion of assets that economic actors keep in the form of money depends on liquidity, i.e., the time and costs associated with turning assets into cash. Paper money and coins are the most liquid assets. Therefore, economic actors prefer to keep the money rather than turn it into financial assets (invest). According to the

391 11.3 · Money Market

11

Keynesian theory of liquidity preference, there are three incentives for economic agents to keep part of their wealth in the form of money: 5 transactions motive (money is readily available to serve as a means of payment or a means of circulation); 5 precautionary motive (part of the wealth is kept in the form of money in order to serve sudden needs in the future); 5 speculative motive (investing of wealth in the form of money, shares, and securities may allow money holder to avoid losses due to price changes; money is used to multiply income by reselling securities). Thus, according to the Keynesian school, the aggregate demand for money consists of the operating demand, which takes into account the transactions motive and the precautionary motive, and speculative demand affected by the interest rate. It is the speculative motive that establishes the relationship between the demand for money and the interest rate. It follows that the classical school and the Keynesian school agree that money affects economic reproduction. The difference is that the classical school attributes this influence to prices, while the Keynesian school emphasizes the interest rate. The latter, according to Keynes, is the principal determinant of investment, while the investment is the critical factor of economic development and growth. The modern theory of demand for money brings into question the division of demand determinants into transactional, precautionary, and speculative motives. The interest rate manifests itself as a demand for money, but only because the former is the opportunity cost of storing money. Wealth is seen as a major trigger of the demand for money. The latter is influenced by inflation and expectations of businesses and consumers (optimistic expectations spur the demand for money, while pessimistic ones depress it). The demand for money for the purchase of financial assets is determined by the desire to generate income in the form of dividends or prices. The inverse ratio of demand to the interest rate r is illustrated by the demand curves for money (. Fig. 11.3). To simplify the model, we may

. Fig. 11.3  Demand curves for money. Source Authors’ development

392

Chapter 11 · Money

. Fig. 11.4  Supply curves of money. Source Authors’ development

11

say that the demand for money as a means of circulation (business, operational, or demand for money to serve transactions) does not depend on the interest rate. It can be illustrated by the vertical demand curve for money Mdc. Conversely, the demand for money as a store of value (speculative motive) is primarily affected by the interest rate. In this case, the demand curve for money Mdv takes a conventional shape of a downsloping demand curve. The money supply MS is set exogenously by a central bank. Money Supply is the amount of money in circulation in the economy determined by the respective monetary aggregates. If a central bank aims to keep the interest rate unchanged at r1 regardless of the amount of money in circulation, then it employs a flexible monetary policy. This case is illustrated by the horizontal supply curve of money MS1 (. Fig. 11.4). At the same time, ensuring the stability of the interest rate involves abandoning strict benchmarks for the growth of the money supply. For example, if the interest rate goes up, a central bank pushes it down by injecting money into circulation. Otherwise, an increase in the interest rate above the threshold would shrink the money supply. If a central bank prioritizes maintaining the stability of the money supply at M1, it cares less about the interest rate. Then, the supply of money is illustrated by the vertical line MS2. In this case, an increase in demand for money drives up the cost of credit. Vice versa, falling demand for money amid constant supply reduces the interest rate. Finally, if a central bank tolerates an interrelated change in both r and M , then the supply curve of money takes the conventional shape of an upward-sloping supply curve MS3. The money supply increases in parallel with the cost of credit, and the inclinations of the curve reflect the degree of influence of the interest rate on the money supply. Equilibrium in the money market is a balance between the money quantity supplied by a central bank and the demand for money expressed by economic actors. The neoclassical theory suggests that the equilibrium is achieved when

393 11.3 · Money Market

11

. Fig. 11.5  Money market equilibrium upon changing money supply. Source Authors’ development

prices are set at a certain level at the [AD; AS] intersection point (taking into account the transactions demand for money). If prices drop, an excess supply of money occurs. When this happens, a continuing depreciation of money eventually results in a new increase in prices. Thus, prices get back to the initial level, and the equilibrium in the money market is restored automatically. In the Keynesian interpretation, the equilibrium is also established when supply equals demand, but forces that lead to reaching the equilibrium point differ from those emphasized by neoclassical economists. Keynes also believed that a central bank had complete control over the money supply, so the money supply line runs vertically. Suppose the interest rate is lower than the equilibrium rate. Then it is more profitable for economic entities to use cash. The depreciation of securities is accompanied by an increase in the interest rate. As the interest rate rises, the demand for money declines until the money market returns to equilibrium. If the interest rate goes up, then the demand for bonds increases. This then causes a decrease in the interest rate and consequentially leads to an increase in the demand for money and the reestablishment of the equilibrium. If a central bank decides to increase the supply of money by purchasing securities in the market, this will contribute to the growth of excess reserves in the banking system. To reshape their balance sheets, banks will try to sell their excess reserves to convert them into income. The fastest way to do that is to lend reserves. However, such an excessive lending could pull down interest rates. Falling rates reduce the opportunity cost of holding money and increase the propensity to use cash. Thus, when an influx of bank reserves into the market shifts the supply curve to the right (from MS1 to MS2 in . Fig. 11.5), falling interest rate (from r1 to r3) causes economic entities to change their behavior. The change results in a downward movement along the Md curve from the equilibrium point E1 to the new equilibrium E3 at a higher supply of money (MS2 > MS1 ) and a lower interest rate (r3 < r1 ). If the money supply reduces from MS1 to MS2, then banks face a lack of reserves to meet their demands. In such a situation, they tend to sell securities or make payments to repay previously granted loans, as well as they refrain from

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. Fig. 11.6  Money market equilibrium upon changing demand for money. Source Authors’ development

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granting new loans to restore their reserves. In this situation, competition among borrowers raises interest rate from r1 to r2. With higher interest rate, economic entities reduce the amount of money they keep in favor of depositing the money in banks. The new equilibrium E2 is established at a lower money supply (MS2 < MS1 ) and a higher interest rate (r2 > r1 ). Another situation is a change in the nominal income with a fixed supply of money. Suppose the equilibrium is established at point E1 (. Fig. 11.6). An increase in the nominal income fuels the demand for money (the Md1 curve shifts upward to Md2). At the current rate, the demand for money exceeds the supply. Since the supply has not changed, additional funds could be generated by selling securities. Consequently, when the money supply is fixed, an increase in the demand for money leads to an increase in the equilibrium rate (from r1 to r2 in . Fig. 11.6). The new equilibrium is established at point E2 at a higher interest rate (r2 > r1 ) and no change in supply (MS ). With a decrease in the demand for money (a shift from Md1 to Md3), the interest rate falls from r1 to r3, and the equilibrium is established at point E3 at a lower interest rate (r3 < r1 ). Thus, changes in the interest rate restore equilibrium in the money market. 11.4  Monetary Policy

Equilibrium in the money market provides for the equality of the amount of money that economic agents want to have in their assets portfolio to the amount of money supplied by the banking system in the conditions of the current monetary policy of the government. Monetary Policy is a set of public measures aimed at regulating the monetary system and the loan market in order to achieve certain macroeconomic goals, such as tightening inflation, stabilization of the national currency, ensuring full employment, spurring economic growth, softening cyclical fluctuations of the economy, or securing the stability of the balance of payments.

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. Fig. 11.7  Types of monetary policy. Source Authors’ development

Case box Central banks develop long-term monetary strategies, which entail the analysis of the current situation, forecasts and scenarios, future-oriented directions of the monetary policy, and its goals and tools. For example, in August 2020, the Federal Reserve System approved the Statement on Longer-Run Goals and Monetary Policy Strategy14 to be revised every five years. Commonly, such documents set the inflation ceiling the central banks aim to keep by employing the monetary instruments. Initially set at 2% in the USA and the UK, the figure was increased during the COVID-19 pandemic (previously noted in 7 Chap. 9, 7 Sect. 9.4).

Monetary regulation of the economy is carried out on the basis of the principle of compensatory regulation, which involves a combination of contractionary monetary policy (tight money policy) and expansionary monetary policy (cheap money policy) (. Fig. 11.7). Expansionary Monetary Policy is a type of monetary policy aimed at boosting money supply by stimulating credit, relaxing bank reserve requirements, decreasing interest rates, liberalizing foreign exchange control, and accelerating money velocity. However, by spurring economic growth, the expansionary policy may trigger inflation and create bubbles in the money market. To cool the economy, the government resorts to the contractionary policy.

14 Board of Governors of the Federal Reserve System (2020).

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Contractionary monetary policy restricts money supply by limiting credit, toughening bank reserve requirements, increasing interest rates, tightening foreign exchange control, and decelerating money velocity. Contractionary measures oppose expansionary tools. Ultimately, they aim at reducing the money supply by increasing the cost of money in the economy. Contractionary regulations allow the government to curb inflation and improve the balance of payments, but they dampen economic growth. In the new normal economic environment, a growing number of countries move away from a pure expansionary policy or a pure contractionary policy. Most commonly, contemporary combined monetary policy implies ultra-low base rates, quantitative easing (central banks buy securities from the private sector), zero bank reserve requirements, assistance to banks and financial organizations in refinancing loans, and money injections into the economy. This is the policy pursued by many developed countries to address the pandemic-induced economic slowdown, particularly in the early months of the COVID-19 pandemic in 2020. Case box

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With the onset of the COVID-19 pandemic, the US Federal Reserve System reduced the base rate and the bank reserve requirements to 0–0.25% and zero, respectively. Several amendments have been adopted to the documents on the strategic objectives of the monetary policy, such as a provision that target inflation should be kept below 2% over a medium-term period, not at a certain point in time. A program of mass purchase of securities was launched. As a result, the Federal Reserve’s balance grew by about $3 trillion in 2020. In Europe, the European Central Bank practiced similar monetary measures. It conserved the zero base rate and the negative deposit rate (−0.5%), launched the purchase of assets, and granted massive assistance in refinancing loans. Similar measures (refinancing, ultra-low interest rates, massive purchase of securities from the market) were taken by the Bank of Japan and the People’s Bank of China. However, most of the central banks emphasize that quantitative easing, ultra-low rates, and other instruments of unconventional combined monetary policy will not operate permanently. Against the backdrop of rising inflation (previously discussed in 7 Chap. 9, 7 Sect. 9.4), central banks of many developed and developing countries have been tightening monetary ­policy since 2021.

The development and implementation of monetary policy is the key function of central banks. By employing a certain type of monetary policy, central banks adjust the money supply in the economy. In such a way, they indirectly regulate output, employment, and other macroeconomic parameters. Major monetary instruments include the following: 5 Bank reserve requirements. It is one of the most powerful means of influencing the money supply. Bank reserves are mandatory cash balances with central banks, i.e., the portion of assets a commercial bank is obliged to keep with a central bank. It largely determines the ability of a commercial bank to grant loans. Lending is possible if a bank has enough funds in excess of the reserve.

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Thus, by increasing or decreasing reserve requirements, a central bank regulates credit activities of banks and, accordingly, influences the money supply in the economy (the higher the bank reserve requirement, the lower the money supply, and vice versa). 5 Open market operations. Central banks act as economic entities in the market by selling or buying government and private securities. By doing that, central banks influence the amount of liquid funds of commercial banks by offering attractive interest rates. By buying securities in the open market, a bank increases the reserves of commercial banks, thereby improving their lending capacity and, accordingly, boosting the money supply. Conversely, central banks absorb money from the banking system by selling securities in the market. 5 Base rate. Central bank grants loans to commercial banks at a certain base rate (also called refinancing rate or policy rate). Adjusting the base rate, central banks either improve or degrade the ability of commercial banks to borrow money and, consequently, to rechannel the money to the open market. A bank may set one or several interest rates on various types of transactions or conduct an interest rate policy without fixing the interest rate. The base rate serves as an indicator of economic and inflationary expectations. For ­example, by increasing the rate, a bank may demonstrate its determination to fight against rising inflation or support the falling national currency, thus averting panic in the financial market. 5 Foreign exchange control. On the one hand, central banks ensure law enforcement in the sphere of foreign exchange and monitor foreign exchange operations. On the other hand, they manage the exchange rate of the national currency in relation to other currencies, preventing violent fluctuations. Under the floating exchange regime, the exchange rate can be affected by foreign exchange interventions (selling or buying foreign or national currencies in the market by a central bank to influence the exchange rate and the supply of and demand for a targeted currency) (see 7 Chap. 20 for a more detailed discussion of currency regulations and exchange market). 5 Quantitative restrictions. Central banks may limit the refinancing of banks or certain banking operations by credit institutions. Such direct administrative regulations are rather rare. They may be introduced for a short period of time to address some emergency in the market, for example, a rapid fall of the national currency. 5 Money aggregates. The bank may set targets for the growth of certain money aggregates based on the strategic directions of the national monetary policy, such as the control over the money supply, inflation targeting, or economic growth rate. Both the choice of monetary policy tools and the assessment of the monetary policy performance varies depending on which parameter of the equation of exchange the monetary policy targets at a certain period of time—money quantity, money velocity, output, or prices. Nevertheless, regardless of a particular combination of contractionary and expansionary tools, monetary policy measures succeed in the long run only if they counter the economic cycle. Time lags hamper

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countercyclical monetary policy. These include the recognition lag between the emergence of a need for regulation and the recognition of the need, the implementation lag between the recognition of a need and the implementation of monetary policies, and the effect lag between applying a measure and its effect on the economy. The problem can be partially tackled by reducing the lags. This implies coordination of the monetary policy with other policies, such as fiscal policy and foreign exchange policy (further discussed in 7 Chaps. 13 and 20, respectively). 11.5  Monetary Approaches to the New Normal Equilibrium

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In the new normal economic environment of increasingly interdependent markets, monetary policy must not only manage inflation and facilitate the turnover of money and commodities in the economy. It must also maintain a balanced system of external payments. Current account disbalance, prolonged balance of payments deficits, and external debt all destabilize the macroeconomic environment and depress economic growth. In the context of the growing interdependence of national economies, local disbalances spread throughout the entire system of international economic relations and exchange. Therefore, contemporary monetary policy should mean to simultaneously achieve both internal equilibrium and external equilibrium. As discussed previously in 7 Chap. 6, an internal equilibrium is a state of full employment, or a balance between the aggregate demand and aggregate supply at the level of potential output, with the lowest possible level of inflation. External equilibrium implies maintaining a balance of payments for official settlements, a zero (or set target value) current account balance, and a certain volume of foreign exchange reserves. In today’s increasingly globalizing world economy (on the one hand) and counter-global regionalization of markets (further discussed in 7 Chap. 23), the relationships between macroeconomic variables that characterize the internal equilibrium become much more complicated. They are all mediated by exogenous processes. At the same time, external factors have become increasingly sensitive to fluctuations in internal parameters. These new normal features complicate and challenge the use of conventional monetary tools. Robert Mundell and Marcus Fleming were among the first to model the simultaneous achievement of internal equilibrium (total output at the level of full employment) and external equilibrium (zero official settlements balance) at a fixed exchange rate in the conditions of international capital mobility (further reading: “The Appropriate Use of Monetary and Fiscal Policy under Fixed Exchange Rates”15 and “Domestic Financial Policies under Fixed and under Floating Exchange Rates”16). The Mundell-Fleming model assumes the joint use of monetary and fiscal policy instruments, such as government expenditures G and interest rate r. With external balance, an increase in government expenditures from G1 to G2 pushes up income (. Fig. 11.8). Higher income increases consumption, in-

15 Mundell (1962). 16 Fleming (1962).

399 11.5 · Monetary Approaches to the New Normal Equilibrium

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. Fig. 11.8  External balance. Source Authors’ development

cluding imports, and deteriorates the current account. The balance point moves from A to B to the area below the EB curve, the area of balance of payments deficit. To improve the balance of payments, the government affects the capital account by implementing a contractionary monetary policy. As noted previously in 7 Sect. 11.4, one of the key instruments of contractionary policy is the increase in the interest rate. A central bank rises the rate from r1 to r2, the inflow of capital neutralizes the deteriorating current account balance, and the balance of payments returns to equilibrium at point C. Therefore, an increase in the government expenditures (�G = G2 − G1 ) must be compensated by an increase in the interest rate (�r = r2 − r1 ) to keep external balance. With internal balance, an increase in government expenditures from G1 to G2 generates excess inflationary demand at point B (. Fig. 11.9). To curb it, monetary authorities raise r in an attempt to cut investment demand. The slope of the EB curve depends on capital mobility, that is, the inter-country movement of capital in response to changes in domestic interest rates. However, with any capital mobility, the EB curve’s trajectory is more flattened compared to that of the internal balance curve IB. The joint use of contractionary monetary instruments and expansionary fiscal tools keeps the economy at the level of full employment. At point D, the balance of payments is positive. The current account balance remains unchanged due to the constant government spending G2 at both point C (external balance) and point D (internal balance). However, the internal balance interest rate r3 exceeds the external balance interest rate r2. This gap attracts capital to the economy. There are four areas of macroeconomic disequilibrium in . Fig. 11.9: underemployment and balance of payments deficit in Zone I, inflationary demand and balance of payments deficit in Zone II, inflationary demand and balance of payments surplus in Zone III, and underemployment and balance of payments sur-

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. Fig. 11.9  Internal balance. Source Authors’ development

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plus in Zone IV. The internal and external balances are simultaneously established only at the intersection of the two curves. To move the economy to the joint balance condition from any other point, the government uses a combination of monetary and fiscal policy measures. For example, reestablishing macroeconomic equilibrium in Zone II (inflationary demand and balance of payments deficit) requires implementing contractionary monetary and fiscal policies. While the former is carried out by central banks (discussed above in 7 Sect. 11.4), the latter is shaped by the government (see further in 7 Chap. 13). They act independently, but the distribution of responsibilities between a central bank and the government is crucial for establishing the equilibrium. When dragging the economy from Zone II, a central bank is responsible for maintaining external balance, while the government aims at reestablishing internal balance. It is expected that their independent actions could bring the economy closer to the equilibrium point at the intersection of the EB and the IB curves. As illustrated in . Fig. 11.10a, in case of the optimal distribution of roles, the economy may travel from disequilibrium (point A) to external balance (point B with high government expenditures G3 and high interest rate r4) and then to internal balance (point C with an unchanged interest rate r4, but lower government expenditures G2). Finally, the new equilibrium reestablishes at point D, at which both the expenditures and the interest rate are close to the optimum levels G1 and r2, respectively. In case of wrong distribution of regulatory roles (a central bank is responsible for the internal balance, while the government manages external balance), the economy moves away from the equilibrium point E, and the overall imbalance widens (. Fig. 11.10b). For each individual combination of G and r, there is an individual optimal distribution of regulatory roles. In the Mundell-Fleming model, regulatory roles are distributed based on the principle of comparative advantage. The achievement of a macroeconomic ob-

401 11.5 · Monetary Approaches to the New Normal Equilibrium

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. Fig. 11.10  Distribution of regulatory roles under internal and external balances Note a optimal distribution; b non-optimal distribution. Source Authors’ development

jective is entrusted to the regulator whose economic policy instruments have a relatively greater impact on that particular goal. Monetary instruments are efficient in establishing external balance under a fixed exchange rate regime, since changes in r affect the balance of payments in two ways. First, an increase in r depresses investment and total output and thus improves the current account balance. Second, it attracts capital to the economy (banking system) and thus improves the capital account. In this regard, the balance of payments is more sensitive to changes in r compared to the gross output. Consequently, according to the distribution rule, a central bank deals with external balance by employing monetary instruments, while the government is responsible for keeping internal balance with fiscal policy tools. In the new normal reality, achieving internal and external equilibrium by means of monetary policy is complicated by a number of obstacles: 5 In 7 Sect. 11.4, we referred to recognition, implementation, and effect lags that hamper countercyclical monetary policy. Responses of consumers, businesses, and investors to changes in the interest rate are not only slow, but also unpredictable. Delay in the effects of monetary policy measures can exacerbate market volatilities and trigger unintended consequences. 5 The solution of the role distribution task very much depends on the adequate identification of the point at which the economy is located at a particular moment (the four zones in . Fig. 11.9) and the mutual disposition and slopes of the IB and the EB curves. In the case of incorrect location of the starting point or the relative slope of the curves, policy measures may harm the economy and drive it away from the equilibrium point. The location of the starting point is challenged by the behavior-related parameters, such as the marginal propensities to save, consume, or import. 5 It is difficult to predict possible changes in the demand for money, the behavior of investors and consumers, and the demand from foreign entities for domestic goods and services.

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5 The effectiveness and expediency of using certain monetary policy measures depend on such subjective perceptions as the public confidence in the government or expectations of future policies. When trust in the government is low, an increase in the interest rate may fail to cause a proportional inflow of foreign capital into the country. In such a case, a contractionary monetary policy of high interest rates would be ineffective. If increased interest rates carry a high risk for investors, the sensitivity of capital inflows to changes in the interest rate will be low. Consequently, the EB curve’s slope will approximate that of the IB curve, which will complicate the implementation of monetary policy. 5 A model may fail to adequately illustrate achieving macroeconomic equilibrium in a particular macroeconomic situation. For example, the mobility of capital may become extremely high or absolute (an infinitesimal deviation of the domestic interest rate from the world rate causes an infinitely large change in the mobility of capital). In this case, the EB curve is fixed at the level of the world interest rate and becomes horizontal. With such a location of the curve, using monetary instruments to achieve external equilibrium produces no effect. The tiniest reduction in the domestic interest rate would cause a radical outflow of capital to the world market and exhaust the foreign exchange reserves of a country. Similarly, any increase in the domestic interest rate will cause an unlimited inflow of capital, that is, an overflow of monetary resources above the threshold established by a central bank.

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The growing internationalization of economic life, deepening of integration processes, and increasingly close interconnection and interdependence of national economies are the key features of global economic development. In this new environment, domestic monetary policy can no longer remain purely domestic. It captures such elements of the external balance as the state of the balance of payments and the level of the exchange rate. In the contemporary open economy, the choice of monetary policy instruments and their performance largely depend on the regime and dynamics of the exchange rate. As discussed further in 7 Chap. 20, international capital flows and exchange increasingly affect domestic markets and domestic macroeconomic policies. The experiences of the recent global financial crises detailed in 7 Chap. 7, 7 Sect. 7.3 demonstrate how large global flows of hot money rapidly destabilize domestic money markets and undermine the effects of any domestic monetary regulations. The money market equilibrium addressed above in 7 Sect. 11.3 is usually illustrated by employing the IS-LM macroeconomic equilibrium model. The model makes it possible to find such combinations of the interest rate and income, at which equilibrium is simultaneously achieved in the commodity and money markets (previously explained in 7 Chap. 6, 7 Sect. 6.5). In order to make the model applicable to capturing the impact of monetary policy on both internal and external balances in an open economy, let us extend the standard IS-LM by introducing the balance of payments curve BP. The latter describes the relationship between income Y and interest rate r at external balance, that is, when the balance of official calculations is zero (. Fig. 11.11). In terms of its architecture, the

403 11.5 · Monetary Approaches to the New Normal Equilibrium

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. Fig. 11.11  Balance of payments curve. Source Authors’ development

BP curve is identical to the EB curve illustrated in . Fig. 11.8. An increase in income from Y1 to Y2 pushes up imports and, other things being equal, increases the current account deficit NX . The balance of payments reestablishes when NX + CA = 0, that is, an increase in Y must be compensated by a substantial capital account surplus CA. Therefore, at the level of income Y2, a central bank has to increase the domestic interest rate from r1 to r2 to attract foreign capital to be able to cover the current account deficit. A change in the exchange rate or any other exogenous parameter of net exports NX , as well as shifts in capital flows under the influence of factors not related to the change in the interest rate r, shift the BP curve either downward right or upward left. With low capital mobility and a fixed exchange rate, an increase in the money supply (expansionary monetary policy) shifts the liquidity-money curve LM 1 rightward to LM 2 (. Fig. 11.12). The interest rate declines from rA to rB, stimulating the expansion of investment and thus increasing the income from YA to YB. New internal balance establishes at point B. As noted above, higher income pushes up imports and deteriorates the current account deficit. In parallel, capital flows out of a country due to the reduction in the interest rate. Since the capital account changes in the same direction as the current account, the balance of payments deficit emerges (new internal balance point B is located to the right of the BP curve). If a country faces a balance of payments deficit and at the same time seeks to maintain a fixed exchange rate, it depletes its foreign exchange reserves by intervening in the foreign exchange market. A internal and external central bank c­ annot afford to maintain the money supply at the LM 2 level for a long time. To ­maintain a fixed exchange rate, the bank sells foreign currency and thus curbs the supply of national currency. Over time, the LM 2 curve shifts back to its original position LM 1 . As the money supply shrinks, the interest rate rises. This hinders investment and

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. Fig. 11.12  Monetary policy effects at low capital mobility and fixed exchange rate. Source Authors’ development

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depresses income. As income shrinks and the interest rate rises, the balance of payments improves. This process continues so long as the balance of payments remains negative. After a while, the economy finds itself in the initial position A. All the increase in the money supply that has been produced by the expansionary monetary policy is absorbed by the balance of payments, without affecting income. Thus, monetary policy at a fixed exchange rate turns out to be ineffectual, since the interventions in the foreign exchange market wipe out changes in the money supply. The solution could be either a Money Sterilization Policy (a form of monetary policy through which a central bank offsets a rise in net foreign assets by reducing net domestic equity, thereby keeping the money supply within an economy constant), or a change in the exchange rate of the national currency through its devaluation or revaluation. The BP curve’s slope depends on the degree of international capital mobility (negative association) and the marginal propensity to import (positive association). In the case of low capital mobility, the BP curve is relatively steep (steeper than the LM curve). The weaker the international capital mobility, the higher the domestic interest rate should be to ensure a sufficient inflow of foreign capital to restore external balance. When capital mobility is high, the BP curve is relatively flat (more flat than the LM curve). In this case, a tiny increase in the interest rate could trigger a substantial inflow of foreign capital. With high capital mobility, expansionary monetary policy boosts the money supply, thereby shifting the LM 1 curve to the right to LM 2 (. Fig. 11.13). Income rises from YA to YB, while the interest rate falls from rA to rB. Higher income drives up imports and generates a trade deficit. Similar to the above case of low capital mobility (. Fig. 11.12), capital outflows due to falling interest rates, but the outflow is greater. Because the capital account changes in parallel with the current account, a significant balance of payments deficit emerges.

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. Fig. 11.13  Monetary policy effects at high capital mobility and fixed exchange rate. Source Authors’ development

Under the balance of payments deficit, the demand for the national currency falls, and the interest rate should go down. To maintain a fixed exchange rate, a central bank intervenes in the foreign exchange market by selling foreign currency and buying national currency. The money supply shrinks along with income, the interest rate rises, and the balance of payments improves. The LM 2 curve shifts to the left until the balance of payments deficit is eliminated, i.e., to its original position LM 1. Thus, in the case of high capital mobility, expansionary monetary policy produces similar effects to those in the case of low capital mobility. The increase in the money supply is neutralized by interventions in the foreign exchange market. At the same time, since the outflow of capital with the same difference in domestic and world interest rates is now greater, the balance of payments deficit is bigger. The scale of interventions in the foreign exchange market and the rate of decline in foreign exchange reserves are higher, and the economy much faster returns to long-term equilibrium. Macroeconomic regulations aimed at achieving internal balance under a fixed exchange rate regime tend to produce either surpluses or deficits in the balance of payments. Such imbalances are to be corrected. In the case of a deficit, a central bank supports the exchange rate of the national currency by selling foreign currency and buying up the national currency. Such a policy exhausts foreign exchange reserves. Ultimately, the bank is forced to reduce the money supply. Alternatively, the bank may refuse to maintain a fixed exchange rate. Without interfering in the foreign exchange market, a central bank allows the exchange rate of the national currency (consequently, net exports NX ) to change until the balance of payments deficit (surplus) is eliminated. If capital mobility under a floating exchange rate regime of low, then an increase in the money supply boosts aggregate demand, and the LM 1 curve shifts to the right to LM 2 (. Fig. 11.14). The increase in the money supply drives income up from YA to YB and cuts the interest rate from rA to rB. The balance reestablishes at point B. Higher income stimulates imports and thus gives rise to a trade deficit. At the same time, capital flows out

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. Fig. 11.14  Monetary policy effects at low capital mobility and floating exchange rate. Source Authors’ development

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of the country in response to a decrease in the interest rate. The capital account balance also turns negative. As both the current account and the capital account change in the same direction, the balance of payments deficit emerges. To eliminate the deficit, a central bank allows the national currency to depreciate. Under the floating exchange rate regime, it no longer intervenes in the foreign exchange market and allows the exchange rate to fluctuate. The depreciation of the national currency stimulates an increase in net exports, and consequently, restores both aggregate demand and income. The balance of payments curve BP and the investment-saving curve IS shift to the right until they intersect with the LM 2 curve at point C. Therefore, with a floating exchange rate, monetary policy impacts income, while international capital mobility adds to this effect. In addition to the fact that an increase in the money supply contributes to the growth of investment and other components of domestic demand sensitive to lower interest rates, expansionary monetary policy also encourages external demand for the domestic product by depreciating the national currency. Currency depreciation is exacerbated by lower interest rates, capital outflow, and rising balance of payments deficit, creating conditions for growth in net exports and gross income. Similarly to the above case of low capital mobility, when capital mobility is high, the use of expansionary monetary tools pushes up aggregate demand (the LM 1 curve shifts to the right to LM 2), lowers the interest rate from rA to rB, and thereby contributes to the growth of income from YA to YB (. Fig. 11.15). However, due to its higher mobility, capital outflows faster in response to the same interest rate cut (r = rB − rA). Consequently, a country faces a larger balance of payments deficit. At the new point of internal equilibrium B, the depreciation of

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. Fig. 11.15  Monetary policy effects at high capital mobility and floating exchange rate. Source Authors’ development

the national currency and the incentives to increase net exports are greater than in the case of low capital mobility. The BP and the IS curves shift to the right to a greater extent, and internal and external balance is restored at point C. Thus, the high mobility of capital that has been acting as one of the fundamentals of the contemporary version of economic globalization, contributes substantially to the performance of monetary policy instruments. Amid rising money supply and net exports, income increases significantly due to the depreciation of the national currency. In this case, the increase in the money supply particularly stimulates external demand, which boosts international exchange and further promotes the internationalization of production and supply chains. . Figures 11.12–11.15 illustrate the effects of expansionary monetary policy with various combinations of capital mobility and exchange rate regime. Similarly, the model can be used to illustrate the effects of contractionary monetary policy. The money supply shrinkages, the interest rate rises, and other contractionary regulations (see . Fig. 11.15) drive the money market processes in the opposite direction. The main thing that follows from the above discussion is that in today’s open economy, the efficiency of domestic monetary policy largely depends on the exogenous parameters, such as the exchange rate regime and the international mobility of capital. When choosing the exchange rate regime and setting the degree of liberalization of capital flows, the government simultaneously determines the means of implementing domestic macroeconomic regulation. Knowingly or unknowingly, this choice for a country is predetermined. Conversely, when setting the priority goals of domestic economic policy, it must be remembered that the effects of domestic policy instruments could be distorted by external factors. This manifestation of the new normal economic reality in the sphere of macroeconomic policies is further discussed in 7 Chap. 13 (particularly, in 7 Sect. 13.4 in relation to fiscal policy, the counterpart of the twin monetary policy).

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Chapter Questions: 5 Define money from a rationalist point of view. How does this definition differ from the evolutionary interpretation of money? In your sight, which of the concepts most adequately discloses the nature of money? 5 Explain the difference between the measure of value and the store of value as functions of money. 5 What is the fundamental difference between the metallistic and the nominalistic interpretations of money? 5 Summarize the Marxian approach to understanding money. Discuss its similarities and dissimilarities with the Keynesian theory of money. 5 What is the key postulate that unites the family of quantitative approaches to interpreting money? Identify the nuances that distinguish the three quantitative branches from each other. 5 Give examples of bimetallism, monometallism, paper money, and credit money. 5 Describe the money aggregates hierarchy used in your country of residence. 5 Provide insight into major monetary tools. How does the use of the same tools differ depending on the type of monetary policy? 5 Why does capturing exogenous factors matter in planning domestic monetary policies in the new normal economic reality? 5 Illustrate effects of contractionary monetary policy on income and interest rate in various combinations of money velocity and foreign exchange rate. Subject Vocabulary:

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Bimetallism: a monetary system in which two or more metals or other materials coact as universal equivalents of value. Contractionary Monetary Policy: a type of monetary policy aimed at restricting money supply by limiting credit, toughening bank reserve requirements, increasing interest rates, tightening foreign exchange control, and decelerating money velocity. Credit Money: a form of money that implies exchange on credit. Demonetization: a withdrawal of gold from circulation and the cessation of the functions of money. Emission: the issue of money, which results in an overall increase in the money quantity. Expansionary Monetary Policy: a type of monetary policy aimed at boosting money supply by stimulating credit, relaxing bank reserve requirements, decreasing interest rates, liberalizing foreign exchange control, and accelerating money velocity. Full-Fledged Money: a money made from a material that has the same value both in circulation in a form of money and in accumulation in a form of wealth. Interest Rate: a price of money as a means of saving reflected by the relative value of interest payments on loan capital over a certain period of time. Issue of Money: an injection of money into circulation in the form of the transfer of certain amounts of money in cash and non-cash forms from banks to economic entities.

409 References

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Liquidity: the ability of material assets to turn into money and perform the functions of money. Monetary Aggregate: an element of a certain group of liquid assets that refers to the particular volume and structure of the money supply. Monetary Policy: a set of public measures aimed at regulating the monetary system and the loan market in order to achieve certain macroeconomic goals. Monetary System: a set of all forms and methods of money emission, money circulation, and money exchange historically emerged in a country and legally established by the government. Money: a commodity used as a universal equivalent of the value of all other goods. Money Circulation: the movement of money in cash and non-cash forms in the process of serving the exchange of goods and services and other settlements in the economy. Money Market: a market in which an equilibrium value of the money quantity and an equilibrium interest rate are established as a result of the interaction of demand for money and money supply. Money Quantity: a sum of all funds in cash and non-cash forms in the economy. Money Sterilization Policy: a type of monetary policy through which a central bank offsets a rise in net foreign assets by reducing net domestic equity, thereby keeping the money supply within an economy constant. Money Velocity: a number of transactions that money serves during a period of time. Monometallism: a monetary system founded on one monetary commodity. Paper Money: banknotes of certain face value issued by the state to cover public expenditures. Token Money: a form of money whose intrinsic value does not exceed its face value set by the issuing body or accepted by people.

References Board of Governors of the Federal Reserve System. (2020). Statement on Longer-Run Goals and Monetary Policy Strategy. Available at 7 https://www.federalreserve.gov/newsevents/pressreleases/monetary20200827a.htm. Board of Governors of the Federal Reserve System. (2022). Money Stock Revisions. Available at 7 https://www.federalreserve.gov/releases/h6/current/default.htm. Bodin, J. (1568). La response de Jean Bodin à M. de Malestroit. Paris: A. Colin (English version: “The Response of Jean Bodin to the Paradoxes of Malestroit, and the Paradoxes”, translated and with an introduction by G.A. Moore. Washington, D.C.: Country Dollar Press). Fisher, I. (1911). The purchasing power of money. New York, NY: Kelley and Millman. Fleming, M. (1962). Domestic financial policies under fixed and under floating exchange rates. International Monetary Fund. Hume, D. (1752). Political discourses. Edinburgh: printed by R. Fleming, for A. Kincaid and A. Donaldson. Keynes, J. M. (1930). A treatise on money. Macmillan & Company Ltd.

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Knapp, G. (1924). The state theory of money, abridged and translated by H. M. Lucas and J. Bonar. London: Macmillan & Company Ltd. Knies, K. (1873). Geld und credit. Weidmann. Marshall, A. (1923). Money, credit, and commerce. Macmillan. Marx, K. (1867). Capital: A critique of political economy. Available at 7 https://www.marxists.org/archive/marx/works/1867-c1/. Mill, J. (1808). Thomas smith on money and exchange. Edinburgh Review, 25, 35. Montesquieu, C. (1748). De L’Esprit Des Lois. Paris (English version: “The Spirit of the Laws”, translated and edited by A.M. Cohler, B.C. Miller, & H.S. Stone. Cambridge: Cambridge University Press). Mundell, R. (1962). The appropriate use of monetary and fiscal policy under fixed exchange rates. International Monetary Fund. Pigou, A. C. (1920). The economics of welfare. Macmillan. Steuart, J. (1767). An inquiry into the principles of political economy: Being an essay on the science of domestic policy in free nations. London: Printed for A. Millar and T. Cadell in the Strand.

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© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_12

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Learning Objectives: 5 Learn the fundamentals of credit 5 Explore the variety of bank, commercial, and consumer credits 5 Reveal lending rate determinants 5 Understand the architecture of a credit system 5 Summarize the roles and functions of a central bank in managing a banking system 5 Go over major functions and operations of commercial banks 5 Discuss the new normal tendencies in developing credit and banking sectors 12.1  Fundamentals of Credit

12

In today’s economy, the functioning of money described in 7 Chap. 11 is impossible without credit. It maintains the continuity of the money circulation and services the extended reproduction. The need for credit is due to the very nature of capital and the laws of its circulation and turnover in reproduction. Economic actors attract borrowed funds and pour them from one sector to another to cope with time gaps that arise between investing resources and receiving returns on these investments at various stages of production cycles. Moreover, there is an objective need to minimize production and circulation costs due to the optimal combination of own and borrowed funds. In many sectors, the need for money fluctuates considerably during a year (for example, agriculture, tourism, and other season-sensitive sectors). Large development or reconstruction projects require substantial one-time investments, and investors borrow funds to increase their capacity. Therefore, the need for a permanent redistribution of funds in the economy is clear. However, capital accumulated in the form of means of production cannot physically flow from one sector to another. It is for this reason that the capital exchange between sectors is carried out in monetary form through credit. Credit impacts the volume and structure of the money supply, payment transactions, and the velocity of money circulation. It accelerates the capitalization of profits and turning them into production assets. Credit stimulates the development of productive forces by accelerating the establishment of capital for the expansion of production. It serves creating, distributing, and using income. Servicing the circulation of funds through the credit system (see below in 7 Sect. 12.3), credit participates in distributing the gross product. To s­ ummarize the introductory part, let us say that redistribution in the economy is hardly possible without credit. Credit is a system of economic relations arising from the mobilization of temporarily available funds and lending them on conditions of maturity, repayment, serviceability, security, and purposefulness. Fundamental principles of lending include the following: 5 Maturity means that the credit must be repaid within the agreed period of time and in the agreed manner. Failure to comply with the terms of loan repayment might implicate fines and other penalties.

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5 Credit is naturally a loaned value. Repayment means the loaned value is to be returned to the lender after its use. At the macroeconomic level, repayment provides the economy with monetary resources, contributing to its qualitative and quantitative growth (see 7 Sect. 12.4 to learn how the banking multiplier works). 5 Being commercial entities, banks strive to make a profit. Bank’s product is money. Therefore, bank loans are products, which price is the interest rate. The serviceability (interest payment) of a loan expresses the economic status of a bank as one of the many economic entities in the market. 5 Security of a loan means that its repayment by a borrower must be guaranteed by the availability of material values, the guarantee of third parties, or any other types of guarantee. Compliance with the security principle reduces the lender’s risk of loss. 5 Purposefulness means that lending is carried out in accordance with the types and objects of the loan agreed by a bank. The purpose of a loan is fixed in the loan agreement. It remains subject to the bank’s control upon the expiry or termination of a loan contract. 5 Differentiated approach to lending means different conditions for issuing a loan. Loans should be granted to those economic entities who would be able to repay them in a timely manner. Compliance with this principle makes it possible to take into account both the national interests and the interests of lenders and borrowers. As mentioned above, the core function of credit is the distribution of value. It can occur on territorial and sectoral grounds. Interterritorial redistribution of value means that credit relations may involve any economic entities and individuals regardless of their location. Intersectoral redistribution through credit occurs when value is transferred from a lender in one sector to a borrower in another sector. The redistribution may affect not only the amount of material goods, means of production, and consumer goods produced during a year (gross product), but also the means of production and consumer goods created in preceding periods. Therefore, the redistributive function of credit applies not only to the gross domestic or national products, but to all material goods and the national wealth of a country. Nevertheless, the redistributive function of credit covers temporarily released value, not the entire wealth. Another function of credit is the replacement of valid money with credit operations. In the modern credit economy, all the necessary conditions for such substitution have been created. Transfer of money from one account to another associated with non-cash payments for goods and services, offsetting mutual debt, and transferring the balance of mutual settlements make it possible to reduce cash payments and improve the structure of money turnover. Also, the functions of credit include the accumulation and mobilization of monetary capital, cost savings due to the replacement of cash in circulation with credit money, the acceleration of the concentration and centralization of capital, and macroeconomic regulations.

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Case box As previously discussed in 7 Chap. 11, the modern economy implies no real money circulation, since banknotes in circulation are credit money. This feature of money may make one think that the function of credit as a substitute for credit money has exhausted itself and ceased to exist. However, it must be noted that the entry of the loaned value into the economic turnover does not act as a universal substitution of money. It temporarily replaces money in the economic turnover. The loaned value received by a borrower and included in the economic turnover thus performs the function inherent in money.

Short-term (up to a year), medium-term (one-three years), and longterm (over three years) credits are distinguished by the maturity parameter (. Fig. 12.1). Short-term ones are provided to compensate for the temporary lack of the borrower’s own working capital. The interest rate on these loans is inversely proportional to the maturity of a loan. Short-term credit in the form of interbank lending serves the circulation sphere, particularly, stock markets, trade, and the services sector. Medium-term loans are granted for various production

12

. Fig. 12.1  Types of credit. Source Authors’ development

415 12.1 · Fundamentals of Credit

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and commercial purposes in the industrial sector and agriculture, when the need for required funds is moderate. Long-term loans are used for investment purposes in reconstruction, modernization, or new construction across a variety of industries. They serve the movement of substantial amounts of fixed assets. According to the repayment mode, there are credits repayable in a lump sum and credits repaid in installments. The former mode is commonly applied to short-term loans, as it requires no differentiated interest rates. In the case of loans repaid in installments during the entire term of the loan agreement, their repayment conditions are determined by the contract. Typically, this mode is used in long-term credit agreements. Similarly, depending on the collection method, there are loans, the interest on which is paid at the maturity date, and loans, the interest on which is paid in equated installments during the term of the loan agreement. Compensatory financing facilities and paid loans are distinguished d ­ epending on the type of credit arrangement. Compensatory loans are forwarded to the borrowers’ current accounts to compensate the latter for their own expenses, including advance ones. Paid loans are used to pay for settlements and m ­ onetary documents presented to a borrower for repayment. According to periodicity, there are one-time loans and tranches. One-time loans are those provided on time and for the amount agreed in the contract. Tranches (credit lines) are legally formalized obligations of a bank to a borrower to grant funds within the agreed limit during a certain period of time. Fixed, floating, and stepped interest rates apply. Fixed rate remains unrevised throughout the entire period of a loan agreement. In this case, a borrower undertakes to pay interest at an agreed rate regardless of any changes in the market. Due to the high volatility of financial markets, fixed interest rates apply to shortterm lending. Longer-term credit agreements employ floating interest rates. They adjust to the current situation in the credit and financial markets. Stepped rates imply scheduled revisions in certain circumstances, for example, in times of high inflation. Depending on the loaned value, commodity, monetary, and mixed forms of credit are distinguished. A commodity form of credit precedes the monetary one. Loaned goods act as collateral at the same time, i.e., they simultaneously guarantee repayment. Goods are used in economic turnover, while loans are commonly repaid with money. Therefore, goods pass into the ownership of a borrower only after repayment of the loan and payment of interest. Lending money is a mainstream form of credit used by most of economic entities and individuals both within a country and in foreign economic turnover. However, it largely depends on the situation in the domestic and world markets, inflation, unemployment, exchange rates, and other macroeconomic parameters. A mixed (commodity-monetary) form of credit involves granting loans in one form of value and receiving repayments in another. Commonly, commodities are exchanged for money. In the new normal economic reality, the prevailing form of credit is a bank credit provided by commercial banks. Bank Credit is a credit provided by banks and other licensed credit and financial institutions to economic entities in the form of money and other monetary values. It is granted exclusively by credit

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and financial institutions licensed by a central bank to carry out such operations. Banks perform intermediary functions in credit and payments. To carry out these intermediary operations, banks accumulate funds temporarily available in the capital market and direct them to those sectors and enterprises that want to attract resources. Banks make a profit in the form of a loan or bank interest (see below in 7 Sect. 12.2). When granting loans, banks commonly operate not so much with their own capital as with attracted resources. Therefore, they lend money as idle capital. Case box A characteristic feature of lending in the new normal economic environment is the close intertwining of various types of bank and commercial credit. It is manifested not only in lending to enterprises, but also in offering a variety of credit products to individuals (consumer lending, mortgage lending, student loans, etc.). Bank loans do double service by boosting the means of payment of borrowers and increasing their capital. In the former case, loans in the form of money are used to fulfill debt obligations. In the latter one, loans in the form of capital magnify the capital stock. Thus, bank lending contributes to maintaining the uninterrupted circulation of capital and facilitates expanding and improving production.

12

Commercial Credit is a type of credit granted by enterprises to each other in the form of deferral of payment for supplied goods, services, or other values. The core purpose of commercial credit is to accelerate the merchandise turnover and speed up the turnover of added value contained in commodities. Commercial credit merges loan capital with industrial capital, as a result of which the size of commercial credit is limited by the amount of free capital available to industrial and trading companies. Commercial credit is inherently different from bank credit due to three reasons. First, the object of commercial credit is commodity capital, while that of bank credit is monetary capital. Economic entities grant commercial credits to each other to serve the production and distribution of goods and services. Here, loan capital is merged with industrial (commercial) capital, because enterprises literally lend capital in commodity form. In the case of bank credit, loan capital is separated from industrial and commercial capital. Second, a commercial credit differs from a bank credit by parties of credit transactions. In the former case, both a lender and a borrower are entrepreneurs. With a bank loan, only one of the parties (a borrower) acts as an entrepreneur, while the other (a lender) acts as a capital owner, since the capital granted by a lender does not operate in a lender’s enterprise. Third, commercial and bank credits have different dynamics. As for commercial credit, its movement parallels the movement of industrial capital: with the growth of industrial production and commodity turnover, both the supply of commercial credit and the demand for it increase. As regards bank credit, the situation is different. The growth in the supply of loan capital transferred through bank credit does not always reflect the growth of production. Thus, during economic downturns, the supply of loan capital tends to

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increase because shrinking production cannot absorb as much capital as it used to demand during the boom. In turn, rising demand for loan capital does not necessarily reflect the expansion of production. During crises, the demand for loan capital to cover widening gaps increases amid falling production. Case box Despite the pivotal role and widespread use of commercial credit, it cannot fully meet the needs of contemporary production due to its commodity nature and certain limitations. Commercial credit is granted in the amount corresponding to the commodity capital of a borrower, despite the fact that in the new normal reality, the need for capital could be much higher. Commercial credits are predominantly granted for relatively short periods of time, whereas global development programs of transnational corporations require stable long-term lending. There are discrepancies between the size of available funds and the borrower’s needs, as well as between the terms for which a loan can be granted by a lender and the terms required by a borrower. In the modern conditions of large-scale mass commodity production, credit should be massive, regular, affordable in terms of price and terms of lending, and sufficient in volume.

Consumer Credit is a type of credit used by specialized credit organizations or other economic entities to finance individuals. The main distinguishing feature of consumer credit is its purposefulness. In a monetary form, it is granted as bank credit to an individual for covering certain types of expenditures. In a commodity form, consumer credit can be granted by an economic entity to an individual in the form of goods for retail trade on installment terms. In other words, consumer credit acts as commercial credit in the case of the sale of goods or services with deferred payment through retail stores. Alternatively, it acts as a bank credit when providing a bank loan for consumer purposes. Case box Before the COVID-19 pandemic, the consumerist society model was largely based on the promotion of consumer lending and the transformation of consumer credit into a cheap, affordable, and conventional tool for stimulating consumer demand. However, since the COVID-19 outbreak in 2020, banks have revised the risk assessment criteria. The requirements for the credit history and the borrower’s debt burden have been raised so that potential clients could service their debts without compromising their financial situation. When making decisions on approving a loan, the number of additional checks on the borrower’s solvency, confirmation of employment, and, in general, the stability of income has increased. Affiliation of a borrower with certain sectors, for example, tourism, hospitality services, or other low-performing ­industries, has become one of the reasons for loan rejection. A characteristic feature of the new normal reality is the revision of consumer habits and patterns. Against the background of increased instability of income, people tend to switch to conscious

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consumption while trying to save money to establish reserves to cope with future crises. Among other trends is the emergence of individual credit offers for segmented groups of customers, as well as the expansion of the client base through the development of online credit channels.

Mortgage Credit is a long-term credit secured by real estate granted by banks or specialized financial and credit institutions for the purchase or construction of housing or the purchase of land. Mortgage lending is also used to renew fixed assets secured by land in agriculture, which contributes to the concentration of capital in the agricultural sector. The popularity of mortgage lending can be explained by the fact that it allows one to obtain material benefits in advance, while paying for these benefits in the future. This mechanism is particularly attractive for young people. Along with consumer credit, mortgage lending provides for expanding the effective demand by economic methods. This helps to stabilize market prices, as well as maintain the production and supply of basic consumer goods. Case box

12

The real estate market has turned out to be one of the least affected by the pandemic-induced economic downturn. Due to the unprecedented quantitative easing and other expansionary monetary regulations in the early months of the pandemic (previously discussed in 7 Chap. 11, 7 Sect. 11.5), mortgage lending demonstrated record growth. It was particularly stimulated by the support measures taken by governments, such as the preferential mortgage programs. In the USA, the easing policy of the Federal Reserve System and record low rates on long-term treasury bonds pushed mortgage rates down. The rate on 30-year loans for the purchase of housing fell below 3% in 2020. In the second half of 2020, pent-up consumer demand further pressed down mortgage rates. In an attempt to save money, people were investing in real estate. At the peak of the pandemic in the second quarter of 2020, American banks granted a record-high $1.1 trillion as mortgage loans. In the UK, the volume of housing sales in July 2020 increased by 38% compared to July 2019 and reached a ten-year ­maximum of $48 billion. However, the low rates era did last long. Since 2021, government assistance programs have been gradually squeezing, and banks have been raising interest rates.

Interbank Credit is a type of credit provided by banks to each other when some banks have surplus funds, while others lack them. Individual terms can vary radically from one interbank credit agreement to another, but amounts of credits are commonly quite substantial, unlike other loans provided by commercial banks. International Credit is a set of credit relations in which a state acts as a borrower or a lender, or one country lends to or borrows from another country.

419 12.2 · Lending and Lending Rate

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Non-governmental economic entities, such as banks, corporations, and the population, can also enter into international credit relations. A distinctive feature of international credit is that the parties belong to different countries. Government Credit is a credit in which a government acts as one of the parties in the person of executive authorities at the central, territorial, or municipal levels. Represented by a central bank, the central government can lend to certain territories, industries, or enterprises. Credit can be provided both on an auction basis and by direct forwarding funds to a designated borrower. The state can act as a borrower by emitting government securities or placing government debt (see 7 Chap. 13, 7 Sect. 13.2 for public debt). Credit as a relationship between a lender and a borrower rests on the movement of the loaned value, its spatial transition from one entity to another, and its temporary functioning in the circulation of the borrower’s funds. Movement is the most important characteristic of establishing a value. There is no credit without the circulation of value. In this regard, the fundamental laws of credit manifest themselves in the laws of its movement. The law of repayment of credit (in contrast to own or budgetary resources) reflects the return of the loaned value to a lender, to its starting point. It is the loaned value that was previously transferred for temporary use from a lender to a borrower that moves back to a lender in the process of repayment. What is crucial is that the loaned value not only returns to a lender. It also generates income for both a lender (interest rate) and a borrower (returns on borrowed funds) (the multiplier function of credit is further addressed in 7 Sect. 12.4). According to the law of conservation of loaned value, when returning to a lender, funds do not lose their consumer properties and value. Upon returning from a borrower, the loaned value takes its original form and enters into a new turnover. The law regulating the dependence of credit on the sources of its formation is defined as the law of equilibrium between the resources released and resources redistributed due to repayment. Time is essential for credit as an integral characteristic of the movement of value. The credit term depends on a number of factors, including the time of the release of resources. The movement of the loaned value in individual economic transactions is limited. This time limit stipulates the temporary nature of a lender and a borrower within a transaction. As a result, from one of the attributes of the relations of individual parties, the temporary nature of credit turns into the law of credit as a whole. This law reproduces the dependence of credit on the duration of the release of the loaned value and its use in the circulation of funds. The law of credit, which reflects such dependence, supposes the satisfaction of only the temporary needs of economic entities in the use of borrowed value. 12.2  Lending and Lending Rate

Since borrowers take advantage of capital that does not belong to them, they must pay for the right to use these resources. As mentioned above in 7 Sect. 12.1, credit is a bank’s product, which price is an interest rate, i.e., that part of the revenue that a borrower pays to a lender. Lending Rate is a payment received by a

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lender from a borrower as a result of the transfer of loaned funds for temporary use. The rate acts as an equivalent of the use value of the credit, which generates the movement of funds in the capital market. In monetary relations, the lending rate performs the following three functions: 5 redistribution—the transfer of part of the surplus value (profit) of economic entities and income of the population to a creditor for the use of borrowed funds, which are equivalent to the use value of a credit; 5 stimulation—loan interest is the key incentive for the effective use of borrowed funds and their timely repayment; its impact on a borrower’s performance depends on the interest rate, loan repayment mode, type of credit, and other credit-related variables that affect the return on borrowed funds; 5 regulation—lending rate generates the movement of funds in the capital market, creating conditions for the accumulation of idle resources of economic entities and the population, turning them into loan capital, and its rational placement within and between countries, industries, and the population. The quantitative expression of the price of credit resources is determined by the interest rate, the value of which reflects the ratio of supply of funds and demand for funds in the loan capital market. Interest Rate is the ratio of the annual income received on the loan capital to the amount of the loan provided, expressed as a percentage. Interest rates are influenced by both internal variables (loan terms, loan amounts, inflation, public economic policy, etc.) and external factors, such as the situation in foreign markets (. Fig. 12.2). Other things being equal, the longer the loan term, the higher the interest rate. Longer loan terms entail higher risks of non-repayment and other failures on a

12

. Fig. 12.2  Lending rate determinants. Source Authors’ development

421 12.2 · Lending and Lending Rate

12

borrower’s part due to changes in the economic environment. Similarly, the larger the loan amount, the higher the rate, since a lender risks facing higher losses in the case of a borrower’s insolvency. As inflation rises, the lender’s risk increases, so the interest rate tends to rise. However, it cannot grow on a par with inflation, since borrowers would not be able to pay such high interest. As a rule, the interest rate remains below the inflation index. The increase in the volume of idle resources in the economy (savings of legal entities and individuals who establish the loan capital) boosts the supply of loans in the market. Accordingly, interest rates go down. Conversely, a reduction in savings depresses the supply and pushes interest rates up. Rates commonly go down in times of economic recovery and rise amid economic downturns. Exogenous factors are particularly associated with fluctuations in exchange rates, movements of capital caused by the appreciation of loans to individual countries, instability of balances of payments, and other volatilities in the world capital market. As demonstrated in 7 Chap. 11, government regulation of interest rates is carried out by a central bank by managing the base rate, requires reserve ratios, open market operations, and other regulations that allow maintaining interest rates at a certain level. Expansionary economic policy cuts the rate, while contractionary measures drive it up. Reflecting the ratio of the amount of interest on a loan to the total amount of loan capital, the interest rate reflects the profitability of a monetary loan transaction. The rate depends on the supply-demand ratio in the loan capital market. Therefore, it is a dynamic variable, which value is determined by the economic situation. When setting the interest rate, commercial banks take into account the base interest rate (the interest rate applied in lending to highly creditworthy customers on secured loans) and the risk premium (spread). The base interest rate is calculated on the basis of the estimated cost of credit investments and the expected profitability of loan operations (Eq. 12.1).

RB = PR + BE +

CE LP

(12.1)

where RB   base interest rate; PR   average real price of attracted resources (weighted average price of a particular type of resource and its share in the total amount of paid and free funds mobilized by a bank); CE   expected costs of a bank to facilitate its operations; LP   expected amount of productively placed funds; BE   expected breakeven of bank’s loan operations. The risk premium is a fixed value. It is differentiated by transactions depending on the creditworthiness of a borrower, the availability and nature of the collateral for a loan, loan term, client’s relationship with a bank, and client’s credit history. The bottom loan price is determined by the bank’s costs of raising funds and ensuring its operation, while the price ceiling depends on the market conditions. The interest rate is the tool that economic actors (state, businesses, individuals, and

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society as a whole) use when choosing various investment options. The higher the rate, the higher the expected return on investment should be to make an investment decision. Gradually, as the intensive accumulation of capital in the preceding period initiates the law of diminishing returns, interest rates decline. As rates go down, lower-return investment opportunities become attractive. The deviations of interest rates from the average rate of return occur under the influence of general and specific factors. General ones include the ratio of supply of available funds and demand for borrowing, the economic policy of a government and a central bank, and inflation, among others. Specific factors are determined by the operations of commercial banks and individual conditions of loan agreements between banks and borrowers (loan amount, loan maturity, type of collateral, cost of the bank’s loan capital, creditworthiness of a borrower, etc.). Simple and compound interest approaches are used to calculate interest for the use of the loaned value. Accrual of simple interest is made on a permanent basis (the initial amount of the loaned value) (Eq. 12.2). This method is commonly used in short-term lending.

DA = DI × (1 + n × i)

(12.2)

where DA   accreted amount of debt; DI initial debt; n loan term in years or the ratio of the loan term in months (weeks, days) to the applicable assessment basis; i interest rate.

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Compound interest accrual is used in long-term lending, when a new accrual of interest is made on the accrued amount after the expiration of the accrual period (Eq. 12.3).

DA = DI × (1 + i)n

(12.3)

Pricing in the financial market is fundamentally different from conventional pricing in the commodity market, where final prices substantially depend on overall production costs or socially necessary labor costs. The price of credit reflects the general supply-demand ratio in the loan capital market. That means the price very much depends on non-cost factors, including rapid fluctuations in economic expectations, panic buying or selling, behavioral preferences, and other changes in short-term market parameters. Banking practices of different countries adopt different methods of interest accrual. They depend on measuring the number of days within a loan term and the accepted length of a year in days. British practice involves the calculation of exact interest with the actual number of days that compose the loan period. A year is taken to be 365 or 366 days, and the exact number of loan days is used for calculation. This method produces the most accurate results. In French practice, a simple interest rate is calculated based on the exact number of loan days (360 days per year). The loan term is measured by the exact number of days. This

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method gives the largest amount of accrued interest compared to others. German practice uses simple interest with an approximate number of loan days. A year is taken to be equal to 360 days (thirty days in a month). This calculation commonly produces the smallest amount of accrued interest. 12.3  Central Banks and Credit System

All types of credit relations between lenders, borrowers, government, and society are facilitated by the credit system. From an institutional point of view, Credit System is a network of credit and financial institutions serving the entire sphere of credit relations. It consists of the banking system and a set of non-bank credit and financial institutions capable of accumulating temporarily idle funds and directing them to economic turnover in the forms of credits and loans (. Fig. 12.3). Non-bank credit and financial institutions are represented by investment, financial, and insurance companies, pension funds, credit unions, savings banks and associations, and credit cooperatives. These non-bank institutions perform many banking operations and compete with banks in the loan capital market. However, despite the gradual blurring of distinctions between banks and non-bank financial institutions, the banking system remains the core of the credit infrastructure. Banks are financial and credit organizations that have the exclusive right to attract funds, place them on their own behalf and for their account on conditions of maturity, repayment, serviceability, and purposefulness, as well as to open and

. Fig. 12.3  Credit system. Source Authors’ development

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maintain bank accounts of legal entities and individuals. The core functions of banks include intermediation in granting loans and making payments (financial intermediation), accumulation and mobilization of temporarily available funds of businesses and the population and their transformation into operating capital, and regulation of money turnover by issuing credit instruments some of which perform the functions of money (bills of exchange, promissory notes, banknotes, bank cards, and other credit documents). All the banks in the economy establish the banking system of a country. Commonly, the banking system is founded on a central bank or a group of banking institutions that perform the functions of a central bank, for example, the Federal Reserve System. A central bank is legally assigned a monopoly on the emission of money and a number of special functions in the sphere of monetary policy. The second level is formed by commercial banks. They concentrate the bulk of credit resources and carry out a wide range of banking operations and financial services for legal entities and individuals. State-backed central banks are the core elements of the banking system and the most important tools for macroeconomic regulation (particularly, monetary policies discussed in 7 Chap. 11). A central bank monopolizes the emission of credit money (see 7 Chap. 11, 7 Sect. 11.2.1 for credit money), accumulates and stores official gold and foreign exchange reserves of a country and cash reserves of commercial banks and credit institutions, lends to commercial banks, credits and performs settlement operations for a government, and monitors ­operations of other credit institutions. The roles may vary depending on the specifics of national banking systems, but the most common functions of a central bank include the following: 5 Emission center. As noted above, central banks are the only financial institutions that have a monopoly right to issue credit money. This monopoly provides central banks with perfect liquidity. Exercising the right, a central bank independently makes decisions on the issue of new banknotes into circulation and on the withdrawal of old ones and approves the designs and denominations of new banknotes. The exclusive competence of a central bank includes all technical issues of money circulation, such as the production, transportation, and storage of banknotes and coins, rules for cash logistics and cash collection, procedures for conducting cash transactions, parameters of banknotes, and other technical functions. Over the last decades, the portion of banknotes in the money aggregate has been decreasing. Nowadays, the role of a central bank as an emission center for an economy is merely technical. The monopoly on the emission of money is needed primarily to prevent malpractices and offenses against the law in the spheres of money circulation and retail trade, as well as to ensure the liquidity of the country’s credit system. The higher the share of cash circulation in the market, the more important the central bank’s role as a national currency issuer. As for the organization and regulation of non-cash payments, the exclusive competence of a central bank includes the establishment of rules, standards, forms, and deadlines for noncash payments, as well as licensing of settlement systems, including clearing.

425 12.3 · Central Banks and Credit System

12

5 Government’s banker. A central bank serves the government’s financial transactions, mediates treasury payments, and lends to a government. A treasury stores funds in a central bank in the form of deposits. In turn, a central bank forwards a treasury all its profits above a certain predetermined threshold. Public debt management involves the central bank’s operations to regulate and repay government loans and conduct conversions and consolidations of public debt (further detailed in 7 Chap. 13, 7 Sect. 13.2). Central banks in various ways increase the attractiveness of government obligations, promote, buy, and sell them, and change the terms of sale, thus affecting their market value and yields. 5 Bank of banks and interbank clearing center. Commercial banks are clients of a central bank. The latter holds the required reserves of commercial banks, which allows it to monitor and coordinate their domestic and foreign activities (commercial bank accounts are liabilities, i.e., liabilities of a central bank and assets of commercial banks). Central banks act as lenders of last resort to commercial banks by granting loans by means of issuing money or selling securities. Moreover, central banks accumulate resources of all commercial banks in a country and carry out all settlements between them, i.e., they perform the role of a single settlement center for the banking system. However, with the advent of electronic payment systems, the central bank’s role as a settlement center has been declining. 5 Holder of gold and foreign exchange reserves. Central banks serve international financial transactions of their countries, control the balances of payments, act as buyers and sellers in the foreign exchange markets, and participate in the operations in the world markets of loan capital, gold, and other m ­ onetary values. The c­ entral banks’ competencies also include the regulation of gold and foreign exchange reserves which are used to carry out international settlements, cover the deficit of the balance of payments, and maintain the exchange rate of the national currency within a certain corridor (see 7 Chap. 20, 7 Sect. 20.4 for exchange rates and currency trading). 5 Supervisory authority. A central bank is the body of state regulation and supervision of the activities of credit institutions. The supervision aims at protecting the interests of creditors and depositors, as well as ensuring the stability of the banking system, while not directly interfering in the operations of commercial banks and financial and credit institutions. The need for banking supervision and regulation of banks and non-bank institutions is due to the pivotal role played by the credit system in the economy. It acts as a kind of shock absorber and a source of financial resources during economic downturns. A central bank is obliged to ensure the stable and effective operation of the country’s credit system in any macroeconomic situation. Therefore, one of the main tasks of banking supervision is to reveal potential disbalances in order to take preventive measures. 5 Regulator of the monetary policy. Lending to commercial banks and a government, a central bank thereby creates credit instruments of circulation. When carrying out operations with government securities, it affects lending rates and in-

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terest rates in the market. The central bank’s monetary regulations are designed to stabilize major macroeconomic parameters, such as inflation, unemployment, and exchange rates. As demonstrated in 7 Chap. 11, monetary policy can be aimed at stimulating monetary emission, i.e., the expansion of the total amount of money in circulation (credit expansion). In such a case, central banks contribute to reviving the economy amid decline. Conversely, it can also be aimed at restricting monetary emission, i.e., at reducing the amount of money in circulation. Central banks commonly use monetary and credit restrictions to cool down markets during too fast economic booms. When ­implementing monetary regulations, there arises a contradiction between combating inflation and stimulating economic growth. Therefore, as noted in 7 Chap. 11, 7 Sect. 11.5, the new normal monetary approaches to establishing macroeconomic equilibrium should involve linking the central bank’s monetary regulations with the government’s investment, financial and fiscal policies.

12

The fundamental principle of building a credit system is the separation of the functions of a central bank (any other financial authority that performs the functions of a central bank in a country) and all other banks that make up the country’s banking system. Central banks control and regulate activities of lower-level commercial banks and financial institutions, supply means of payment, maintain the purchasing power of the national currency in the domestic market and the stability of the exchange rate in the external market, and perform monetary regulations. Intermediary activities of lower-level banks (lending, payments, and other services) are designed to reduce risk and uncertainty throughout the banking system and the entire economy. The central bank’s activities should be aimed exclusively at achieving national-level goals. Its policies and actions are determined by the priorities of the national economic policy. Hence, central banks are not allowed to perform bank-to-business and bank-to-customer commercial operations and compete with commercial banks and other for-profit financial and credit institutions in the money market. Case box Depending on the organization, central banks can be divided into government-owned banks, joint-stock banks, and mixed banks. In the case of government-owned banks, capital is fully owned by the state (People’s Bank of China, Bank of England, Bank of Russia). In the case of joint-stock banks, capital is owned by shareholders. For example, the capital of the Federal Reserve System is owned by bank members of the Federal Reserve. Banks and insurance companies jointly own the Bank of Italy. Under a mixed regime, the bank’s capital is shared between the state and shareholders in various proportions. In Switzerland, 57% of the central bank’s capital is owned by cantons, and the remaining 43% is held by the business sector.

Regardless of the form of ownership, central banks are independent legal entities. Commonly, they are accountable to a legislature. Accordingly, the central

427 12.3 · Central Banks and Credit System

12

bank’s functions differ by country and form of ownership. In general, the functions can be classified into five groups based on the specifics of the target orientation and purpose of a central bank: banking operations, monetary regulation, information and analytics, regulatory affairs, and oversight and compliance monitoring (. Fig. 12.4). Within monetary regulation, central banks elaborate and implement uniform monetary and credit policies for the development and stabilization of the money market, monopolize the issue of paper money, regulate the emission of non-cash financial instruments, organize money circulation in the economy, and also act as lenders of last resort for commercial banks. Central banks are regulators of monetary circulation, emission centers, and institutions aimed at supporting the liquidity of commercial banks.

. Fig. 12.4  Functions of a central bank. Source Authors’ development

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Regulatory affairs imply the development of rules for conducting banking operations, the definition of the procedure and rules for accounting and reporting for the banking system, the elaboration of rules for maintaining settlements in the domestic and foreign markets, including with international organizations, foreign countries, and domestic and foreign legal entities and individuals. The bank’s activity in creating normative acts (regulations, instructions, orders) to regulate banking operations and accounting and reporting of commercial banks allows a central bank to streamline and develop the work of credit institutions and create a common methodological base and uniform standards for all actors in the money and credit markets. In accordance with the banking operations function, a central bank carries out all types of banking operations and other transactions, manages its gold and foreign exchange reserves, and maintains budget accounts at all levels of the country’s budget system through settlements on behalf of authorized executive bodies and state non-budgetary funds. The powers determined by the banking operations function allow a central bank to serve the diverse needs of economic entities and act as an authorized agent of the state for the settlement of financial transactions. Within the information and analytics sphere, a central bank monitors, analyzes, and forecasts a broad range of macroeconomic parameters, primarily in the spheres of money, finance, credit, foreign exchange, and prices. Relevant materials and statistics are published periodically. Central banks also participate in targeting the balance of payments of a country and establish and publish the official exchange rates of the national currency in relation to foreign currencies. Without performing the information and analytical function, central banks may fail in regulating the money turnover based on material and financial flows. Analysis and forecasting of the country’s economic development establish the database that allows a central bank to understand and predict the dynamics and structure of monetary relations. Comprehensive and relevant information on the development trends of the economy, individual sectors, the dynamics of the balance of payments, exchange rates, and banking indicators enables economic entities, including the banking community, to adjust their activities. Exercising oversight and compliance monitoring, a central bank supervises the activities of banks and banking groups and regulates, controls, and supervises the activities of non-credit financial institutions. Central banks conduct public registration of banks, issue licenses to perform banking operations, suspend their operations, and revoke them. In addition to these functions, central banks make decisions on the registration of non-governmental pension funds, register emissions of bank securities, and carry out foreign exchange regulations and control. These powers allow a central bank to comply with the targets for the development and strengthening of the country’s banking sector. By supervising the activities of commercial banks through permanent monitoring and checks for their compliance with the established rules and regulations, central banks protect the interests of depositors and creditors and ensure the stability of credit and financial institutions.

429 12.3 · Central Banks and Credit System

12

Commercial banks establish the second level of the banking system. They are credit institutions that perform credit, stock, and intermediary operations and settlements and serve money circulation in the economy (further discussed in 7 Sect. 12.4). The third element of the banking system is specialized credit and financial institutions engaged in lending to certain sectors and industries. They dominate in relatively narrow sectors of the loan capital market by offering specialized services to a small circle of clients. Some of the specialized credit and financial institutions include the following: 5 Investment banks. They issue and place securities and raise capital by selling their own shares or obtaining loans from commercial banks. 5 Savings institutions. Mutual savings banks, savings and loan associations, and credit unions accumulate savings and invest them in various areas (commonly, in commercial and residential construction). 5 Insurance companies. Offering a wide range of insurance products (life, property, liability, and commercial insurance), insurance companies have emerged into one of the key channels for accumulating savings and redirecting them to long-term investments in both the financial sector and the largest industrial, retail, and service corporations. 5 Pension funds. Similar to insurance companies, pension funds accumulate financial resources and contribute to establishing the gross insurance fund of the economy. In the financial market, they act like commercial investors by purchasing government securities and shares of private companies. 5 Investment companies. They act as intermediaries between individual money capitals and corporations operating in the non-financial sphere. Investment companies differ depending on fluctuations in securities exchange rates. They primarily invest in establishing portfolios of securities, liabilities, and shares of corporations and private companies. An increase in the prices of shares owned by an investment company drives up the price of its own shares. Case box Most of the developed countries adopt a three-tier credit system (central bank at the top, commercial banks in the middle, and specialized non-bank credit and financial institutions at the bottom). The American model of a credit system is a typical open market model with specialized financial and credit institutions. Being independent of each other, banks and corporations are free to choose clients and counterparts. The system is distinguished by the even development of all its segments and a wide network of credit institutions of all kinds. The Japanese model is a credit system that implies a close relationship between commercial banks and manufacturing and trading corporations. The role of corporate regulation is substantial. The largest corporations run their own banks or are served by particular banks. In Europe, the banking system is based on commercial, savings, and mortgage banks. Universal banks dominate the credit market as they are actively engaged in both banking operations and the placement of corporate securities.

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In the new normal economic reality, specialized credit and financial institutions have taken the lead in the loan capital market by turning into a large pool of long-term investment capital. However, the fall in the share of commercial banks in the total assets of credit and financial institutions does not mean that their role in the credit system has decreased. They continue to carry out such key functions as facilitating commercial credit and short-term and long-term financing. Thus, among the new normal trends, one should emphasize an increase in the number of insurance companies, pension funds, and investment, financial, and other nonbank organizations and the growth of their share in the gross credit and financial assets. Other features of the new normal credit market include the intensification of competition amid the concentration and centralization of capital in the hands of the largest transnational banks and credit institutions. Financial and credit institutions merge with the largest trade, industrial, and transport corporations, and the number of financial and industrial groups and transnational corporations grows. There occurs an ever deeper internationalization of activities of international associations and financial and credit institutions within the world credit system. In the volatile new normal markets, large conglomerations of financial and industrial capital can expect to remain capable of ensuring stability and carrying out financing large industrial, infrastructure, and other long-term and large-scale investment projects. Banks, as well as non-bank specialized financial and credit institutions, act as financial intermediaries in the capital market. They differ from the financial market operators, such as brokers and dealers, in that they sell their own debt instruments (deposits, bonds, insurance certificates, etc.) and use revenues to acquire debt liabilities of other financial entities. Unlike financial intermediaries, financial market operators do not issue debt instruments. The role of bank financial intermediaries in the loan capital market is that they manage the risks of deposit holders by diversifying their own investments. By doing that, intermediaries decrease real interest rates and the cost of capital, since, with a low risk of investment, clients tolerate low interest on invested capital. 12.4  Commercial Banks

The middle level of the banking system is made up of Commercial Banks, which are credit organizations that attract and accumulate temporarily idle financial resources and grant loans for profit. As demonstrated in . Fig. 12.3, there are universal and specialized commercial banks. Banks can specialize by activity (investment, innovation, mortgage), industry (industrial production, energy, construction, agriculture, foreign trade), or clients (servicing only corporations or only individuals). The main purpose of a bank is to intermediate in the movement of funds from lenders to borrowers and from sellers to buyers. Within the framework of such intermediation, banks perform the following five functions: 5 Accumulation of temporarily idle financial resources. Commercial banks attract funds from all economic actors, including the state, businesses, and ­people, and turn them into a capital in order to make a profit. By mobilizing

431 12.4 · Commercial Banks

12

temporarily idle financial resources, commercial banks accumulate income and savings in the form of deposits. They pay interest to depositors for the use of their financial resources and use these resources to credit business entities or invest in business projects. By further lending previously accumulated capital, banks generate effective demand, as borrowers invest the funds received in expanding output, employing factors of production, attracting resources, or purchasing goods and services. Therefore, lending helps to cope with overproduction by regulating the money supply (credit expansion or credit contraction). Central banks indirectly influence commercial banks or directly prescribe them to implement expansionary or contractionary monetary and credit measures. 5 Mediation in credit. A commercial bank acts as an intermediary between economic entities that offer financial resources in the market and those that demand them. This is how lending to the state, the business sector, and the population works. The main criterion for the redistribution of resources is the return received by borrowers. In principle, the redistribution requires no mediation, but without a mediator who facilitates a transaction and bears the risks, the transaction and associated costs of lending would be higher. Due to a wide diversification of their assets, commercial banks mitigate potential risks of market fluctuations for depositors. They redistribute funds from lenders to borrowers on the terms of maturity, repayment, and other conditions of loans addressed in 7 Sect. 12.1. The fee for mediation in lending is agreed upon based on the supply-demand ratio in the loan capital market. As a result, commercial banks mediate a free flow of financial resources in the economy, which facilitates the optimal use of factors of production. 5 Mediation in payments. By transferring funds from depositors to borrowers and back, commercial banks facilitate the operation of the payment system. Centralization of payments in banks reduces the costs of money circulation. In the new normal realities of the banking system, the diversity of settlements increases the risks accepted by commercial banks. It also increases their responsibility to customers for the timely and accurate execution of payments and other transactions. 5 Mediation in issuing and placing securities. Commercial banks mediate issuing and placing securities of their clients, in particular shares and bonds. On behalf of economic entities in need of resources, banks undertake to determine the volume, conditions, types of securities, and other conditions of the emission. Banks guarantee purchasing of issued securities. They purchase and sell them at their own expense or by organizing bank syndicates or granting loans to third parties willing to buy securities. Where a bank acts as an investment fund, it places its resources in securities on its own behalf. Then all risks, revenues, and losses from operations with purchased securities are attributed to the account of the bank’s shareholders. Acting as an investment consultant, a bank offers its clients consulting services in the sphere of securities management. Performing the information and analytics function discussed above in relation to central banks, commercial banks are able to provide clients with advice on a wide range of issues (investment, modernization, and

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r­econstruction of enterprises, mergers and acquisitions of firms, preparation of annual reports, audit, etc.). The role of commercial banks in providing customers with economic and financial information and consulting services has been increasing over the past decades. A contemporary commercial bank is not just a safe place to keep money, but an investment hub that equips its clients with all kinds of tools and data to manage their resources and generate profits on top of the interest rate. 5 Creation of means of payment. Commercial banks create non-cash credit money (deposit money). Also, they issue credit instruments, such as checks, bills, and bank cards. This function is carried out within the framework of the monetary policy pursued by a central bank through the network of commercial banks.

12

Commercial banks perform passive operations (raising funds) and active operations (placing funds) and conduct settlements in cash and non-cash forms (opening and serving current accounts, deposits, and currency accounts). In addition, they can engage in intermediary and trust operations (property and securities management). Special types of operations include purchasing government securities at their own expense, leasing (placing movable and immovable property purchased for renting it out), factoring (purchasing requirements for commodity supplies), consulting to commercial enterprises, and accounting audit operations. Passive Operations are operations for establishing bank resources (liabilities). They play a primary role in relation to active operations (discussed below), since before placing funds, a commercial bank needs to accumulate and mobilize them. Passive operations are divided into operations for the formation of own funds (equity capital) and operations for raising funds (liabilities) (. Fig. 12.5). The former include establishment of own resources that belong to a bank and must not be repaid in the future. The latter are those related to attracting side resources on a temporary basis. For these resources, a bank establishes liabilities to depositors, creditor banks, and holders of securities. The bank’s equity capital is a set of own funds and retained earnings of a bank. It includes authorized capital formed upon the establishment of a commercial bank. The second component of equity capital is the reserve fund (reserve capital) designed to cover possible losses of a bank on operations. ­Similar to other funds of a bank, the reserve fund is replenished with ­deductions from revenues. The third component of the bank’s equity capital is retained profit. The bank’s profit is the financial result of its activities, i.e., the excess of the bank’s receipts over its expenses. Despite its relatively modest share in the gross capital, the bank’s own funds play a pivotal role in the activities of a commercial bank by performing the following functions: 5 operation—own funds establish a foundation for developing bank’s operations, because without opening capital, no commercial bank can begin carrying out its activities. 5 protection—maintaining the stability of a bank and guaranteeing its liabilities to depositors and creditors;

433 12.4 · Commercial Banks

12

. Fig. 12.5  Operations of a commercial bank. Source Authors’ development

5 regulation—central banks regulate the activities of commercial banks by managing their own funds (particularly, the reserve ratio). The lion’s share of the bank’s liabilities is made up of deposits. In banking, a deposit is a value deposited in a bank by its owner under certain conditions fixed in the bank deposit agreement. Also, deposit refers to entries in the accounting record confirming the requirements of a deposit holder to a bank. Operations related to the raising of funds for deposits are called deposit operations. Commercial banks diversify deposits by various parameters, such as source (household and corporate funds) or maturity (demand deposits, time deposits, and savings deposits). Demand deposits may be withdrawn or transferred to another person or entity at any time without prior notice to a bank. As a rule, interest rates on such deposits are quite low. Examples of demand deposits are transaction accounts and current accounts. The former serve non-cash transactions of legal entities. The latter include check accounts and card accounts. Debiting funds from current accounts occurs by issuing a check or using a bank card. Overdraft accounts allow a negative balance.

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Time deposits are those accepted for a certain period, usually at least a month. The funds cannot be withdrawn before the maturity date. Withdrawal supposes the payment of interest on the demand deposit or the payment of a fine. A bank should be notified about the withdrawal of funds in advance. The movement of money on time deposits is not allowed. That means an account holder can neither put money nor withdraw it in parts. Commonly, time deposits offer higher interest rates compared to demand deposits, but that very much depends on the deposit term. Savings deposits are deposits used to accumulate capital and magnify its gains. Such deposits can be replenished with any amount of money at any time, but withdrawal is restricted. The interest rate depends on the term and amount of a deposit. There is a minimum amount of initial deposit. Non-deposit sources of raising funds include interbank loans and issued debentures. The former can be granted by a central bank or other commercial banks. Commonly, they are short-term loans that help a bank to maintain its solvency and liquidity. The latter are debt securities, such as promissory notes, bonds, and deposit and savings certificates. Active operations are operations for placing previously accumulated resources. They are secondary to passive banking operations, which means their parameters directly depend on those of passive operations. A commercial bank can place only those resources that it has attracted as deposits or other liabilities. As they are all borrowed funds, a bank must plan its active operations in such a way that the terms of return of money to a bank correspond to the terms of its return to customers. If active and passive activities match, such a reliable and solvent bank would be liable for its debts and would be able to generate profit and attract new customers. Credit and loan operations are operations to grant financial resources to a borrower for a certain period at a certain charge. Credit operations are the mainstream active banking operations that generate the bulk of the bank’s interest revenue. They are the most profitable, but also the riskiest. A bank elaborates its individual credit and lending policy, which determines the tasks and priorities of the bank’s lending activities, the means and methods of their implementation, as well as the principles and procedures for organizing lending. The policy creates the basis for the bank’s credit operations in accordance with the overall strategy of its activities. Investment and stock exchange operations are operations to invest bank funds in shares and securities of non-bank institutions to gain revenues from their economic, financial, and commercial activities, as well as the placement of funds in the form of time deposits in other credit institutions. A distinctive feature of investment operations in comparison with credit ones is that the former are initiated by a bank, not a client. They are independent investment activities of a bank itself. Stock exchange operations include operations for the purchase and sale of securities in order to make a profit due to the price gap. In addition to investment operations, stock exchange operations with securities include operations with promissory notes (accounting and re-accounting, protesting bills, collecting checks and bills, accepting and endorsing promissory notes, issuing and storing

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12

promissory notes, selling promissory notes at auction, etc.) and operations with securities listed on a stock exchange. In addition, banks can also perform operations in the stock market as professional parties in the role of brokers, dealers, or depositories. To act as professional market parties, banks must obtain separate licenses for respective activities. Foreign exchange operations are all banking operations denominated in foreign currency, including loans, deposits, and securities. In a narrow sense, foreign exchange operations refer to purchasing and selling foreign currency and carrying out foreign exchange transactions. Currency-related operations are associated with specific risks due to exchange rate volatilities and effects of exogenous factors. That is why central banks elaborate specific regulations in the sphere of foreign exchange that commercial banks must comply with (for example, compliance with net foreign exchange position). Commission and intermediation operations are intermediary operations performed by commercial banks on behalf of their clients for a fee (commission). These operations are banking services. There are settlement services related to the implementation of domestic and international settlements, trust services for the purchase and sale of securities, foreign currency, and precious metals by a bank on behalf of customers, mediation in the placement of shares and bonds, accounting and consulting services for clients, etc. Some of the commission operations include the following: 5 collection of receivables (a receipt of money on behalf of customers); 5 transfer operations and clearing; 5 trade mediation (purchase and sale of securities and precious metals for clients, factoring, leasing, and other trade operations); 5 trust operations (fiduciary banking); 5 consulting and legal assistance. Of particular importance among the commission banking services are clearing, treasury operations, and settlements. Settlements are operations for crediting and debiting funds from clients’ accounts, including paying for their obligations to counterparts. Commercial banks make settlements according to the rules and standards established by a central bank or a relevant financial authority. When conducting international settlements, banks also follow the rules adopted in international banking practice. Treasury operations are operations for receiving and issuing cash. More broadly, they can be defined as operations related to the movement of cash, as well as to the formation, placement, and use of funds in ­various active accounts of commercial banks and the accounts of customers of ­commercial banks. All of the above passive, active, and intermediary operations of commercial banks are based on the four principles: 5 Commercial banks work with clients within the real reserves of resources. This means that a bank carries out all operations within the balance of funds on its correspondent accounts. Performing specific banking operations (mortgage, investment, etc.) is strictly determined by the structure of the bank’s liabilities. Therefore, a bank must analyze the sources of its funds. Operating within the

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limits of actually available resources means that a commercial bank is obliged to ensure not only a quantitative correspondence between its resources and credit investments, but also to ensure that assets correspond to mobilized resources (above all, in terms of the maturities of its own capital and liabilities). However, when complying with the established standards and regulations, a bank is free to conduct its active operations. That means that the volume of active banking operations cannot be directly restricted by administrative regulations on the sides of a central bank or a government. 5 Being subjects of indirect economic regulation, commercial banks enjoy economic independence, but accept full responsibility for their activities. Compliance with this principle allows a bank to operate within the limits of actually attracted resources, while maintaining liquidity. Economic independence implies freedom of disposal of the bank’s funds and attracted resources, independent choice of customers and depositors, and independent disposal of after-tax profit. 5 Commercial banks shall be liable for their obligations with all funds and property belonging to them, which may be subject to recovery in accordance with the legislation in force. Banks assume all risks from their operations. The economic liability of commercial banks is not limited to current revenues, but extends to their gross capital. Since a commercial bank assumes all the risk from its operations, so it meets all the funds and property belonging to it, which can be subject to recovery in accordance with the current legislation (depending on the country). 5 As noted above in 7 Sect. 12.1, banks in their nature are commercial enterprises. That is why their relations with customers are based on the criteria of profitability, risk, liquidity, and other market parameters. The bulk of a commercial bank’s income is the difference between interest on loans and interest on deposits. There are alternative sources of income, such as commission fees for the provision of various types of trust, transfer, consulting, and other services summarized above. Bank’s expenditures deductible from revenues include operation costs, wages of bank employees, rental payments, and all other costs associated with maintaining banking activities and performing banking operations. The remaining amount is the bank’s profit. It is subject to accruing dividends to the bank’s shareholders. A certain part of the profit can be used to expand banking activities. In other words, common business principles fully apply to banking activities. The performance of banking activities is reflected by profitability as a r­ elative expression of profit. The total return on equity of a bank is calculated as the ratio of net income received within a certain period (usually a year) to the equity capital (authorized and reserve capital and retained earnings of previous years) (Eq. 12.4). The return on equity demonstrates the efficiency of the use of shareholder capital. Its value depends on the ratio of equity and borrowed funds in the total balance of a commercial bank. The greater the share of equity capital (accordingly, the more reliable and more stable a bank), the more challenging it is to maintain the high profitability of its capital.

437 12.4 · Commercial Banks

ROE =

NI E

12 (12.4)

where ROE   return on equity; NI net income; E average shareholder’s equity. Return on assets reflects the ratio of net profit and interest payments paid before income tax and all bank assets, including the equity capital of shareholders and borrowed funds (Eq. 12.5). The increase in return on assets reflects an increase in the efficiency of using bank’s assets.

ROA =

NI TA

(12.5)

where ROA   return on assets; TA total assets. The required reserve ratio is a percentage of the total amount of deposits that commercial banks are not authorized to lend to and that they keep with a central bank in the form of interest-free deposits (Eq. 12.6). With a full reserve banking, rR = 1, while with a fractional reserve banking, 0 < rR < 1.

RR = D × rR

(12.6)

where RR   reserve ratio; D deposits; rR bank reserve requirement. Bank’s credit capacity CC, i.e., the amount of funds that a bank can lend, is the difference between the total amount of deposits D and the amount of reserve ratio RR (Eq. 12.7).

CC = D − RR = D − D × rR = D × (1 − rR )

(12.7)

If a bank lends all of the funds, it makes full use of its credit capacity. However, it may keep part of the funds in the form of bank reserves. These funds would be excess reserves RE. Actual reserves RA is the sum of required reserves and excess reserves (RA = RR + RE). If a bank holds excess reserves above required reserves, then its reserve requirement is equal to the ratio of actual reserves to deposits (RDA ). In this case, a commercial bank underutilizes its credit capability, i.e., the amount of funds lent CA is below the bank’s credit capacity CC.

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438

Case box The economic consequences of the COVID-19 pandemic have turned out to be severe in most sectors of the world economy and most markets. Nevertheless, the banking sector has suffered smaller losses compared to other service industries. In 2020, the number of banks with assets above $1 trillion increased from 29 to 39. The country with the world’s largest banking capital is China. Almost one-fifth of the world’s 100 largest banks are located in China, while nineteen Chinese banks out of the world’s top 100 banks collectively hold assets worth $30.5 trillion. The so-called “Big Four” (Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China, and Bank of China) account for more than half of this total value (about $17.3 trillion in 2021, up 16.9% from the 2020 ranking) (. Table 12.1). The USA is in second place in the world among the countries with the largest bank capital. Of the top 100 banks, twelve American banks have combined assets of $15.5 trillion. The largest of them is JPMorgan Chase. In 2021, it succeeded to increase assets by 26.0% compared to 2020. Japanese Mitsubishi UFJ Financial Group held assets at $3.4 trillion, up 17.8% in 2021 from the year before, but its position in the rating remained unchanged.

. Table 12.1  Ranking the world’s twenty largest banks in 2021

12

2021 rank

2020 rank

Bank/company

Headquarters

Total assets, $ billion

1

1

Industrial and Commercial Bank of China

China

5,107.54

2

2

China Construction Bank

China

4,309.08

3

3

Agricultural Bank of China

China

4,167.06

4

4

Bank of China

China

3,737.81

5

5

Mitsubishi UFJ Financial Group

Japan

3,407.80

6

7

JPMorgan Chase

USA

3,386.07

7

9

BNP Paribas SA

France

3,080.55

8

6

HSBC Holdings PLC

UK

2,984.16

9

8

Bank of America

USA

2,819.63

10

10

Credit Agricole Group

France

2,741.77

11

13

Citigroup

USA

2,260.09

12

12

Sumitomo Mitsui Financial Group

Japan

2,257.65

13

11

Japan Post Bank

Japan

2,171.43 (continued)

439 12.4 · Commercial Banks

12

. Table 12.1  (continued) 14

15

Mizuho Financial Group

Japan

2,111.31

15

14

Wells Fargo & Co.

USA

1,955.16

16

16

Banco Santander

Spain

1,844.95

17

18

Barclays PLC

UK

1,842.49

18

17

Societe Generale

France

1,788.32

19

19

Groupe BPCE

France

1,768.51

20

20

Postal Savings Bank of China

China

1,739.00

Source Authors’ development based on S&P Global (2022)1

By granting loans and credits, banks create money. The process of creating money by commercial banks is called credit expansion (credit multiplication). It occurs if money enters the banking sector and the deposits of a commercial bank increase, i.e., if cash money turns into non-cash funds. If the amount of deposits decreases (for example, clients withdraw money from their accounts), then credit contraction takes place. Commercial banks can only create money under a fractional reserve banking regime, when 0 < rR < 1. If a bank hands out no loans, the money supply remains unchanged, since the amount of money received on deposit is equal to the amount of the bank’s reserves. There is only a redistribution between money outside the banking sector and money within the banking system within the same amount of money supply. Expansion begins from the moment of granting a loan. The maximum increase in the money supply is achieved when commercial banks do not keep excess reserves and make full use of their credit capacities. Once entering the banking sector, the money does not leave. Being loaned, the money does not settle with borrowers in the form of cash, but returns to the banking system (credited to accounts). Banking Multiplier is a mechanism for increasing (multiplying) money on deposit accounts of commercial banks during their movement between the clients’ accounts. As a rule, a single commercial bank cannot multiply money by itself. Funds are multiplied within a network of commercial banks. A banking multiplier is associated with an available gross reserve, which is an aggregation of resources of all commercial banks within the banking system that can be engaged in active banking operations at a time. Part of these funds is issued in the form of loans to borrowers. The remaining part establishes liquidity reserves. Its minimum amount is established by the central bank’s requirement as a percentage of bank liabilities (customer deposits). The loans granted go to the borrowers’ accounts in one or another bank. Minus the amount sent to reserve, these funds can

1 S&P Global (2022).

440

Chapter 12 · Credit and Banking

again be used for lending. Thus, the total amount of loans may be many times higher than the amount of funds received on the account of the first depositor. As a result, there is the sum of a decreasing geometric progression with a denominator (1 − rR ), , that is, a value less than 1 (Eq. 12.8).

M =D×

1 1 =D× 1 − (1 − rR ) rR

(12.8)

where M   money quantity.

12

Banking multiplier r1R shows the total amount of deposits that a banking system can create from each monetary unit held in an account in a commercial bank. The banking multiplier mechanism operates on the basis of providing centralized loans from the issuing bank. It can also be carried out when a central bank buys securities and foreign currency from commercial banks. The multiplier acts in both directions. The money supply increases if money enters the banking system (the amount of deposits increases) and decreases if money leaves the banking system (withdrawn from accounts). Since money is simultaneously put in banks and withdrawn from accounts, the gross money supply in the economy changes insignificantly. A more substantial change can occur only if a central bank changes the required reserves ratio. It affects the credit capabilities of commercial banks and the value of a banking multiplier. As previously demonstrated in 7 Chap. 11, changing the rate is one of the monetary tools a central bank can employ to adjust the money supply. Thus, if deposits of commercial banks go up, the money supply boosts to a greater extent due to the multiplier effect. Therefore, the exact effect on the money supply depends on the size of reserves of commercial banks and the banking multiplier. By affecting one or both of these variables, a central bank either boosts or squeezes the money supply depending on the current macroeconomic situation. Chapter Questions: 5 Name and explain the fundamental principles of lending. 5 What is the core function of credit? 5 Credits differ depending on repayment and collection methods. Is there a difference between credits repayable in installments and those, the interest on which is paid in equated installments during the term of the credit agreement? 5 Granting a commercial credit involves monetary capital—true or false? 5 Both mortgage credits and consumer credits serve consumption purposes by improving the purchasing capacity of borrowers. Why do these types of credit differ? 5 How do world markets affect lending rates in the domestic market? 5 Illustrate the architecture of the credit system in your country of residence. 5 Which of the functions of a central bank do you consider the most important in the new normal economic reality?

441 12.4 · Commercial Banks

12

5 Explain the difference between passive and active banking operations. How do these operations reflect the business nature of commercial banks? 5 Define the banking multiplier and illustrate its operation. 5 Summarize the new normal trends in developing credit and banking sectors. What are the reasons for the expansion of the accumulated banking capital during the pandemic? Subject Vocabulary: Active Operations: banking operations for placing previously accumulated financial resources. Bank: a financial and credit organization that has the exclusive right to attract funds, place them on its own behalf and for its account on conditions of maturity, repayment, serviceability, and purposefulness, and open and maintain bank accounts of legal entities and individuals. Bank Credit: a credit provided by banks and other licensed credit and financial institutions to economic entities in the form of money and other monetary values. Banking Multiplier: a mechanism for increasing money on deposit accounts of commercial banks during their movement between the clients’ accounts. Commercial Bank: a credit organization that attracts and accumulates temporarily idle financial resources and grants loans for profit. Commercial Credit: a type of credit granted by enterprises to each other in the form of deferral of payment for supplied goods, services, or other values. Consumer Credit: a type of credit used by specialized credit organizations or other economic entities to finance individuals. Credit: a system of economic relations arising from the mobilization of temporarily available funds and lending them on conditions of maturity, repayment, serviceability, security, and purposefulness. Credit System: a network of credit and financial institutions serving the entire sphere of credit relations. Government Credit: a credit in which the government acts as one of the parties in the person of executive authorities at the central, territorial, or municipal levels. Interbank Credit: a type of credit provided by banks to each other when some banks have surplus funds, while others lack them. Interest Rate: a ratio of the annual income received on the loan capital to the amount of the loan provided, expressed as a percentage. International Credit: a set of credit relations in which the state acts as a borrower or a lender, or one country lends to or borrows from another country. Lending Rate: a payment received by a lender from a borrower as a result of the transfer of loaned funds for temporary use.

442

Chapter 12 · Credit and Banking

Mortgage Credit: a long-term credit secured by real estate granted by banks or specialized financial and credit institutions for the purchase or construction of housing or the purchase of land. Passive Operations: banking operations for establishing bank liabilities.

Reference S&P Global. (2022). The World’s 100 Largest Banks, 2021. Available at 7 https://www.spglobal.com/ marketintelligence/en/news-insights/research/the-worlds-100-largest-banks-2021.

12

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Public Finance

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_13

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Learning Objectives: 5 Learn the fundamentals of finance and the financial system 5 Summarize approaches to interpreting finance (classical theory of finance, Keynesian theory of finance, neoclassical theory of finance) 5 Provide insight into government budget, budget deficit, and debt 5 Study specific features of internal and foreign public debts 5 Discover the foundations of taxation and taxes 5 Understand financial, budget, and fiscal policies 5 Distinguish between expansionary, contractionary, discretional, and automatic fiscal policies 5 Discuss fiscal approaches to establishing macroeconomic equilibrium in the new normal economic environment 13.1  Fundamentals of Finance

13

7 Chapters 11 and 12 discussed options for affecting macroeconomic equilibrium and reproduction through the regulation of the money supply with the use of monetary and credit instruments. No less important in macroeconomic regulation are financial, budgetary, and fiscal tools. They are all the more important in the new normal environment, as they allow governments to directly and indirectly redistribute wealth and address structural imbalances, disequilibriums, and gaps (social aspects of wealth redistribution in the new normal are further discussed in 7 Chap. 14). Finance is a system of economic relations arising in the process of formation, distribution, and use of financial resources in order to ensure economic reproduction and meet the needs of society. In the broad sense of the term, finance is the movement of value in economic turnover. Narrowly, finance is the unilateral monetary obligations of one economic agent to another. Modern finance is a monetary relationship (the difference between monetary and commodity exchange is demonstrated in 7 Chap. 11, 7 Sect. 11.1.1), in which the distribution of national income (no equivalent exchange) occurs through real money funds rather than through a price mechanism. Thus, by its origin, finance is a monetary relationship. Monetary relations become financial relations when monetary incomes are formed and used in the process of production and distribution of goods, i.e., when the movement of money gains a certain degree of independence. At this level of independence, money (finance) performs the following functions: 5 maintaining and servicing capital turnover as a condition for stability, dynamism, proportionality, and balance of expanded reproduction; 5 implementation of the target settings of the public economic policy to ensure full employment of factors of production, price stability, and sustainable economic growth (monetary policy in 7 Chap. 11, 7 Sect. 11.4 and fiscal policy in 7 Sect. 13.4); 5 distribution and redistribution of gross domestic product and national income between sectors, territories, economic actors, and people (eliminating inequalities is further discussed in 7 Chaps. 14, 16, and 17);

445 13.1 · Fundamentals of Finance

13

5 control over the production, distribution, and circulation of the economic product between sectors and economic entities; 5 provision of certain public services and public goods, such as ensuring internal and external security, public transport, infrastructure, and social security system (see 7 Chap. 10, 7 Sect. 10.5 for public goods). Case box Financial relations arise between various business entities on a variety of occasions. They may include payments to budgets of different levels and payments from budgets to legal entities and individuals, mutual settlements and loans between legal entities, central and local authorities, as well as states. However, the financial sector does include cash turnover that serves personal consumption and exchange, in particular, retail turnover, payments for services, as well as transactions between individuals.

The concept of finance has evolved in parallel with the concept of money (previously summarized in 7 Chap. 11, 7 Sect. 11.1.2). From the point of view of the functions of finance listed above, there exist three approaches to the definition of finance as an economic category. The reproduction interpretation encompasses all four stages of economic reproduction (production, distribution, exchange, and consumption). The distributive concept implies only a part of economic (financial) relations associated with the distribution and redistribution of GDP between economic entities. The exchange concept considers the exchange of goods and services to be a priority area for the emergence and functioning of finance. The theory of finance arose in tandem with political economy in the XV century in northern Italy. Trade capitalism gave rise to mercantilism not only in trade (further detailed in 7 Chap. 19, 7 Sect. 19.1.1), but also in the sphere of finance and financial management. Diomede Caraffa, Niccolo Machiavelli, and Giovanni Botero justified the need for the active intervention of the state in the economy and society (further reading: “The Prince”1 and “The Reason of State”2). Jean Bodin was among the first to systematize sources of funds, such as state lands, war trophies, gifts, tribute money, trade, import and export duties, and taxes (further reading: “The Response of Jean Bodin to the Paradoxes of Malestroit”3). The understanding that the public economic and financial sectors should obey uniform economic laws had evolved by the XVII-XVIII centuries due to the development and complication of treasury reimbursement methods. Mercantilism gave way to the classical theory of finance. Joseph Sonnenfels and Johann Justi considered financial science as part of cameralism, that is, the management of the state’s

1 2 3

Machiavelli (1513). Botero (1589). Bodin (1568).

446

Chapter 13 · Public Finance

finances in a highly centralized economy for the benefit of the state. Essentially, the two theorists laid the foundations of financial management, justifying ways to make profits for government needs. Justi proposed rules for the establishment and development of a tax system, according to which taxes should be uniform, fair, and scientifically justified. They should make no harm to the industries and human freedoms. Government expenditures need competent financial planning and budget forecasting (further reading: “The Beginnings of Political Economy”4). Sonnenfels interpreted financial theory as a set of rules for collecting money for the state by applying the most efficient methods. He emphasized the need for a moderate collection of taxes from economic entities to not degrade the taxable base (further reading: “The Principles of Police, Action and Finance”5). Adam Smith elaborated the classical theory of finance by detailing the analysis of government revenues, expenditures, and debts (further reading: “An Inquiry into the Nature and Causes of the Wealth of Nations”6), while David Ricardo developed the theory of value, taxes, and taxation (further reading: “On the Principles of Political Economy and Taxation”7). In the XIX century, Karl Rau formulated six fundamental principles of taxation: fairness, universality and uniformity, progressiveness, income base, untaxed minimum, and the principle of tax transfer (further reading: “Lehrbuch der politischen Oekonomie”8). In general, the classical theory of finance established by the XIX century had two features. First, finance was seen as funds belonging to the state (or public entities—municipalities, communities, lands, etc.). Second, finance was regarded beyond cash. It included all resources of the state regardless of their form (money, services, or materials). Case box The evolution of the classical theory of finance conditioned the gradual detachment of heads of state (monarchs) from direct disposal of public finances. A series of social revolutions and political reforms in Europe have resulted in the establishment of professional financial management embodied in governments accountable to parliaments. Budgeting became systemic, and financial relations acquired the appropriate legal status. The development and improvement of commodity-money relations have prioritized taxes in monetary form.

13

Amid the emergence of state-monopoly capitalism (1920–1960), the monetary and financial policies of most of the developed countries were dominated by the Keynesian concepts (see 7 Chap. 11, 7 Sect. 11.1.2 for the Keynesian theory of money and 7 Chap. 9, 7 Sect. 9.1.3 for the Keynesian theory of inflation). The

4 5 6 7 8

Justi (1755). Sonnenfels (1765). Smith (1776). Ricardo (1817). Rau (1837).

447 13.1 · Fundamentals of Finance

13

Keynesian theory of finance proceeds from the fundamental postulate of the entire Keynesian doctrine—market self-regulation mechanisms should be complemented by the government regulation (further reading: “The General Theory of Employment, Interest and Money”9). According to John Keynes, overproduction crises occur because of insufficient demand. Therefore, fiscal and financial instruments should be used to support expanded economic reproduction by stimulating demand for goods and factors of production. Public spending is the main tool for stimulating effective demand. By creating such demand, the government revives economic activities, which, in turn, boosts national income and employment. Fiscal policy affects personal demand and investment consumption as major components of spending. The Keynesian school postulates the need to increase government spending financed by loans. According to the Keynesian principle of deficit financing, governments may borrow money and tolerate budget deficits to finance public investment and current expenditures. Government investment improves the propensity to invest, while current expenditures increase the propensity to consume (see 7 Chap. 6, 7 Sect. 6.3.2 for the Keynesian concept of consumption and investment). Therefore, the Keynesian school abolishes the classical principle of mandatory equality between budget expenditures and budget revenues to establish the balance. The loan capital market becomes one of the tools for stimulating effective demand, and the budget deficit turns into one of the tools of public regulation of the financial sector (further discussed in 7 Sect. 13.2). Case box The Keynesian approach to the implementation of public financial policy used to be widely adopted by many developed countries. In the 1940-1960s, the extensive type of economic development corresponded to the Keynesian postulate on the need for public spending. Some countries in Western Europe introduced social forms of public economic regulation, such as government expenditures on education, health care, and social security. However, after the 1970s, the intensification of economic growth and the internationalization of markets have gradually neglected the Keynesian model of public finance.

The increasingly central role of finance in foreign economic relations amid more frequent disequilibriums in the world market has put forward the neoclassical theory of finance, or the theory of underemployment equilibrium. It is founded on the following four postulates: 5 economic performance and financial stability of a country largely depend on the economic power of the private sector and large enterprises and corporations as its core components; 5 government minimizes its interference in the private sector;

9

Keynes (1936).

448

Chapter 13 · Public Finance

5 capital markets and profits are the key sources of finance that determine the development parameters of large corporations; 5 internationalization of capital markets determines the integration of domestic commodity markets and entire economies.

13

In general, neoclassical theory is defined as a set of knowledge about the organization and rational management of financial resources, markets, and relationships. It provides for the government regulation with the use of such monetary policy instruments as the interest rate and operations on the open market (previously detailed in 7 Chap. 11, 7 Sect. 11.4). Government spending is considered from the angle of the ratio of factors of production. Neoclassical economists advocate reducing the total volume of public investment and changing its structure by increasing the share of costs associated with education, science, technologies, innovations, and investment in human capital. Paul Samuelson developed the concept of public goods, which are goods and services provided to society by the state (further reading: “The Pure Theory of Public Expenditure”10 and “Pure Theory of Public Expenditure and Taxation”11). Being provided by the state, universally accessible public goods can not be divided among individual consumers (members of society) (see 7 Chap. 10, 7 Sect. 10.5). This public goods concept raises the question of the distribution of resources between the public and private sectors. The former is entrusted with the financing of economic and social infrastructure, which ultimately maximizes profits. According to Samuelson, financial policy should aim at providing regulatory measures for the supply of public goods. The ultimate goal of government intervention in the market is to optimize government spending and redistribute resources between the state, businesses, and individuals. Therefore, in the neoclassical interpretation, financial and fiscal policies should establish savings that determine the size of capital investments and, ultimately, supply (output). Fiscal policy should be neutral for the development of an economy, i.e., it should give room for the market forces. Case box Since the late 1970s, the financial policy of the UK, the USA, Germany, and some other developed states has been based on the neoconservative strategy, a branch of the neoclassical theory of finance. It manifests itself in the theory of supply, one of the core provisions of which is economic deregulation, especially in the social sphere. Deregulation measures include the privatization of public property, the strengthening of the market competition mechanisms, and the emphasis on increasing profitability and stimulating the output. The government may intervene in the economy only in the interests of an individual producer.

10 Samuelson (1954). 11 Samuelson (1969).

449 13.2 · Government Budget and Public Debt

13

Thus, having originated as a science of treasuries of monarchs, the theory of finance has grown into an integral component of the modern economic theory (monetary policy, financial economics, fiscal policy). On the other hand, it has become one of the main tools for investment, financial management, and business administration. An emerging direction is financial engineering, which implies the design, development, and implementation of innovative financial instruments and processes and the creative setting of new financial tasks. Such new functions of finance define the modern Financial System as a set of financial relations on the formation, distribution, and use of centralized and decentralized funds (financial resources). Decentralized finance includes the financial resources of commercial companies, non-profit enterprises, and public organizations. Nevertheless, the central role in financial policy is played by centralized public financial funds, the main of which is the government budget. 13.2  Government Budget and Public Debt

Public finance is a system of economic relations associated with the concentration and subsequent target use of significant financial resources. Government Budget is an annual plan of public expenditures and sources of financial resources to cover these expenditures. As an economic category, a budget represents monetary relations arising between the state and economic entities (legal entities and individuals) regarding the redistribution of national income in connection with the formation and use of budget funds. From a monetary point of view, a budget is a centralized monetary fund accumulated mainly through taxes and used by the government. As an integral element of the financial system, a budget performs functions similar to those of finance: 5 distribution of funds through the formation and use of centralized pools of financial resources at the central and local levels (the government directs budget funds to support certain industries and territories). 5 affecting economic behavior of economic actors (by regulating financial and economic relations, the government boosts or restrains output, accelerates or weakens the growth of capital and private savings, and adjusts the composition of demand and consumption); 5 accumulation of funds and their mobilization for the implementation of nonprofit social programs and provision of public goods (healthcare, education, culture, support for the poor, public services, security, etc.). 5 government control over the receipt and use of budget funds. In unitary countries, these functions are implemented at two levels (central and local). In federal states, the budget system consists of three levels (central, regional, and local). Budgeting principles remain the same for all types of budget systems: unity, reliability of data, completeness of information, efficient collection and rational spending of funds, unified accounting approach, and the priority of public expenditures.

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Case box A budget is formed either automatically by simply updating the past year’s ­budget items or statistically by correcting the past year’s items on the basis of the average percentage of increase or decrease in income and expenditure for several previous years. The most advanced approach to budgeting is the direct estimates method. According to this method, budget items are established based on studying the dynamics of macroeconomic parameters. Its employment is possible only if a country has a developed system of reliable economic information, advanced computing technologies, and successful experience in long-term macroeconomic forecasting.

Any budget consists of the expenditure and revenue parts, the ratio of which determines the structure of a budget. Budget revenues are formed by taxes and non-tax revenues. The former are detailed below in 7 Sect. 13.3. The latter include income from the use of property in public and municipal ownership (income from investing temporarily available budget funds; interest received from granting budget loans; income from leasing public property; income from transferring part of the profit of public enterprises; income from the disposal of intellectual property rights, etc.), income from selling tangible and intangible public assets, payments and fees for performing of certain administrative functions, fines, sanctions, compensation for damage, and income from foreign economic activity. Budget expenditures include expenditures on public services, economic needs, national defense and security, foreign economic activity, public administration and management, and servicing public debt. Based on the economic content, budget expenditures are divided into current spending (the functioning of government bodies and budgetary institutions and the provision of financial support to various sectors) and capital expenditures aimed at ensuring innovative activities.

13

Case box In most countries, main expenditure items include public goods, social spending such as healthcare, education, and social security, and subsidies to farmers, infrastructure construction, and other domestic sectors. Some countries allocate substantial portions of their budgets to national security (Russia, the USA, China). The predominance of certain expenditure items in the overall composition of government spending depends on the level of state power and the functions assigned to it. At the national level, these are the social security expenditures, public administration, security, defense, and research, at the regional level—education, social security, health care, and at the local level—utilities and infrastructure.

Depending on the ratio of revenues and expenditures, a budget can exist in states of balance (revenues are equal to expenditures), surplus (revenues exceed expenditures), and deficit (expenditures exceed revenues). Deficits can occur for many reasons discussed in this book, such as cyclical recessions which depress budget

451 13.2 · Government Budget and Public Debt

13

revenues (7 Chap. 7), expansionary monetary and fiscal policy (7 Chap. 11 and 7 Sect. 13.4, respectively), market failures in the sphere of taxation (7 Chap. 10), public social policy under the influence of rising poverty, inequality, and demographic factors (7 Chap. 14). According to its nature, there are distinguished full, primary, structural, and cyclical deficits: 5 Full deficit is the difference between gross revenues and expenditures. 5 Primary deficit is the difference between revenues and expenditure, excluding payments for the repayment and servicing of public debt. Commonly, foreign creditors and international financial organizations impose a planned surplus of the borrower’s budget as a condition for restructuring public debt (providing a new loan to repay the existing one). A primary surplus demonstrates that a state is able to direct part of the budget revenues to repay its debt or service it by paying the interest. 5 Structural deficit is a deviation of the full employment budget from its target value, i.e., the difference between current government expenditures and those revenues that would have entered the budget at a natural level of unemployment under the current fiscal system. 5 Cyclical deficit is the difference between full and structural deficits. In times of economic downturn, the cyclical budget deficit increases as tax revenues decline, and the need for social transfers and other public expenditures increases. During the economic recovery, growing tax revenues and decreasing need for transfers reduce the deficit. Case box A deficit is usually seen as a negative phenomenon, but this is not always true. If the government seeks to adopt a deficit-free balanced budget at all costs, without taking into account the current economic situation, such a budget policy may generate or intensify an economic crisis due to cuts in vital expenditures and excessive tax raisings. A deficit of up to 5% of GDP is considered acceptable. The higher the deficit, the greater the risks of structural crisis and inflation. Typically, with a budget deficit above 10% of GDP, the economy breaks into an inflationary spiral as the government pumps the money supply and uses other monetary tools to cover the deficit. Another negative consequence of a high budget deficit is the diversion of money from investment to the financial market. When a government seeks to obtain money through the issuance of state bonds and raising interest rates, emerging bubbles in the financial market deprive the real sector of the capital required for development and growth.

Depending on the type of economic policy, the budget deficit can be active (the government consciously increases expenditures to finance strategic development projects) or passive (budget revenues go down due to an economic recession, and the government needs to raise wages and social security payments to stabilize the social sphere). Measuring the deficit requires using relative indicators, such as the share of deficit in expenditures (failure to cover expenditures) and the share of deficit in the GDP. Budget deficit risk forces the government to

452

13

Chapter 13 · Public Finance

seek additional financial sources to cover it. To increase revenues, the government may provide for an increase in direct and indirect taxes and other fees, sell out a public property, or use foreign exchange reserves. If conventional measures turn out to be insufficient, then the government may activate the mechanism of deficit financing through the emission of money (previously discussed in 7 Chap. 11, 7 Sect. 11.2.2) or the formation of public debt through borrowing from commercial banks, population, or foreign financial institutions or countries. The sum of the budget deficits accumulated by the government for a certain period of time is called Public Debt. In fact, by allowing the emergence of public debt, the government implements two fundamental functions of budget regulation, such as mobilizing funds to fulfill government obligations and stabilizing or stimulating macroeconomic processes (reduction of unemployment, stabilization of the foreign trade balance, saturation of the domestic market with goods, etc.). Public debt consists of internal (domestic) and external (foreign) debt. The formation and build-up of these two parts of debt have different macroeconomic effects. Internal Public Debt is the debt of the government to the economic entities and residents of a country established due to borrowing money in the domestic market to cover the budget deficit. There are the following negative consequences of the increase in internal public debt: 5 Public debt is the financing of current consumption (in a broad sense of the term, including investment) at the expense of future generations. Therefore, the build-up of public debt undermines the very foundations of sustainable economic development, which calls for meeting the current needs of the present generation without compromising the ability of future generations to meet their own needs (see 7 Chap. 18, 7 Sect. 18.2 for the concept of sustainable economic development). 5 Rising public debt forces the government to increase the tax burden. In the household sector, raising taxes depresses consumption and savings. In the business sector, it hinders investment growth and degrades the overall propensity to invest in the economy. 5 Increasing the credit issue in favor of the government reduces the ability of a central bank to refinance the banking system, contributes to raising the interest rate, and makes investing less attractive. 5 Paying interest on public debt means redistributing GDP to the holders of government receipts. Therefore, excessive public debt acts as a factor of social differentiation and income inequality. Also, it stimulates demand inflation. Foreign Public Debt is the debt of the government to foreign countries, foreign banks, and international organizations. The establishment of a foreign debt obligation is conditioned by an appropriate bilateral agreement between parties or an adoption by the government of a special decision on obtaining an external loan from international financial organizations, such as the International Monetary Fund or the International Bank for Reconstruction and Development.

453 13.2 · Government Budget and Public Debt

13

Foreign public debt does not include accounts payable, for example, those of resident firms to foreign counterparts (delivery of goods with deferred payment, short-term cash loans, bank loans), as well as the debt of domestic banks to non-residents. Such categories of debt are included in the total external debt of a country. Due to its denomination in foreign currencies, foreign debt is more difficult to manage compared to the internal one. To cover the latter, a central bank may increase the supply of money in national currency through the redemption of government bonds. In the case of external debt, such an instrument is available only to a few countries which issue world currencies. For example, the USA may serve its foreign debt by emitting its national currency, since the bulk of debts is denominated in the US Dollar. For the rest of the world, a failure to service foreign debt would mean default. In addition to default as an extreme consequence of foreign indebtedness, the adverse effects of foreign public debt include the following: 5 to serve or restructure its foreign debt, the government may be forced to sell public property to non-residents or grant certain concessions to foreign capital; 5 servicing of debt in the absence of foreign exchange reserves provokes a deterioration of domestic consumption and degradation of the standard of living of the population; 5 growth of debt to the outside world aggravates the economic and political dependence of a country, reduces its credit rating, and increases the cost of future credit resources. Case box In the new normal economic reality, increasing public debt poses a growing threat to the macroeconomic stability of individual countries and the entire global system of exchange. During the COVID-19 pandemic, governments, corporations, and individuals significantly increased borrowing to cover rising expenditures (social security payments and other government expenditures, production and business costs, consumer spending) (. Table 13.1). Since 2020, decelerating economy and falling revenues have been increasing budget deficits at all levels. Further accumulation of debt is becoming increasingly risky, but without blowing up borrowing, maintaining a relatively stable economy and macroeconomic equilibrium is challenging. Internal debt turns out to become unsustainable, because initially low interest rates set to stimulate consumption in the early days of the pandemic, are being revised to curb inflation (the ongoing shift to contractionary monetary policy by raising interest rates is discussed previously in 7 Chap. 9, 7 Sect. 9.4). Rising interest rates increase the cost of debt service for domestic borrowers. Foreign debt is even less stable. Currency depreciation can hit debts denominated in foreign currency and trigger a wave of bankruptcies both in the domestic market and abroad. Some developing countries are already experiencing external debt problems and are facing the risk of default.

Chapter 13 · Public Finance

454

. Table 13.1  General government fiscal balances and debt in major developed economies in 2016–2026, % of GDP Country/parameter

2016

2017

2018

2019

2020

2021

2022*

2026*

Net lending/ borrowing

−4.3

−4.6

−5.4

−5.7

−14.9

−10.8

−6.9

−5.3

Net debt

81.9

81.6

82.1

83.0

98.7

101.9

100.8

108.9

106.9

106.0

107.1

108.5

133.9

133.3

130.7

133.5

Net lending/ borrowing

−1.5

−0.9

−0.5

−0.6

−7.2

−7.7

−3.4

−1.6

Net debt

74.6

72.4

70.6

69.3

80.7

82.8

80.9

78.4

Gross debt

90.1

87.7

85.7

83.7

97.5

98.9

96.3

92.2

−3.8

−3.3

−2.7

−3.1

−10.3

−9.0

−3.9

−2.2

USA

Gross debt Euro area

Japan Net lending/ borrowing Net debt

149.6

148.1

151.2

150.8

167.0

171.5

169.2

169.4

Gross debt

232.5

231.4

232.5

235.4

254.1

256.9

252.3

251.9

−3.3

−2.4

−2.2

−2.3

−12.5

−11.9

−5.6

−2.9

UK Net lending/ borrowing Net debt

77.8

76.8

75.9

75.3

91.8

97.2

95.2

99.9

Gross debt

86.8

86.3

85.8

85.2

104.5

108.5

107.1

111.6

Net lending/ borrowing

−0.5

−0.1

0.3

0.5

−10.9

−7.5

−2.2

0.4

Net debt

28.7

26.0

25.6

23.4

34.7

34.9

32.5

22.2

Gross debt

91.7

88.8

88.8

86.8

117.5

109.9

103.9

89.7

Canada

13

Note * projection Source Authors’ development based on the International Monetary Fund (2021)12

In view of a number of negative effects of debt on the stability of the economy, the size and structure of debt must be managed. Public Debt Management is a set of government activities aimed at preventing the incurring of debt, reducing its volume, or stabilizing it at a certain level. Some of the activities may include the study of the situation in the capital market, issuance of new loans, revision of issuance

12 International Monetary Fund (2021).

455 13.2 · Government Budget and Public Debt

13

terms, payment of interest on previously issued loans, conversion and consolidation of loans, setting interest rates on government credit, and the repayment of previously issued loans that have expired. Commonly employed debt management practices include the following: 5 conversion—a change in the return on existing loans (usually, a decrease in the interest on loans to reduce the cost of their servicing); 5 consolidation—an extension of the maturity of earlier issued obligations to postpone the debt payment date; 5 unification—a consolidation of loans that were issued earlier (commonly, they are exchanged for new bonds); 5 refinancing—an issue of new bonds to repay the old ones; 5 default—a radical measure used by a state that renounces its previous obligations. Debt management is complicated by its close relationship to the budget deficit. In case the latter is structural or cyclical, the stabilization of debt is only possible by means of structural transformations in the economy. A budget deficit increases the demand for money and pushes the interest rate upwards, which increases the cost of debt servicing and, in turn, gives new rise to the deficit. This process is called self-reproduction of debt. The gap between the primary and secondary budget deficits associated with the need to service the growing public debt increases budget tensions, since even with a primary surplus, it requires attracting funds to the budget sector and increasing debt (. Fig. 13.1). The reason for the increase in borrowing can be not only the primary budget deficit, but also the very need to service the growing debt. When this happens, self-reproduction of debt accelerates (if the government fails to rapidly stabilize the budget deficit expansion). In the new normal economy, substantial budget deficits and the public debt generated by them aggravate risks of instability for the world economy. Therefore, the new normal macroeconomic policy implies a gradual departure from deficit financing (quantitative easing at the expense of the budget deficit) to the stabilization of budget revenue, output growth, and surge in investments. One of the most forceful tools of the new normal policy is taxation.

. Fig. 13.1  Self-reproduction of debt. Source Authors’ development

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Chapter 13 · Public Finance

13.3  Taxes and Taxation

Exercising its legal right of coercion, a state obtains significant financial resources collected in the form of taxes. Taxes are used to regulate the behavior of economic agents by inducing (reducing taxes) or hindering (raising taxes) certain activities. Tax is a mandatory fee or payment levied by a state from legal entities and individuals in the amounts determined by the law and within the established period of time. From an institutional angle, a tax is the only legal form of alienation of private or corporate property on the basis of obligation, gratuitousness, and irrevocability. It is secured by public enforcement, but has no character of punishment or indemnity. The concept of tax reflects the objective need to socialize the economic resources of society in order to serve its economic, social, and political needs. As society develops, this concept acquires an institutional form by performing fiscal and economic functions. The fiscal function implies the establishment of public revenues. The volume and composition of tax collection are determined by the need to implement national programs, public spending, law enforcement, and other administrative functions of the government. Therefore, the fiscal function of taxes is associated with ensuring a stable revenue base of budgets of all levels. It defines the basic level of taxes. By influencing economic reproduction, taxes perform the economic function. By adjusting tax rates and other parameters of taxes, the government stimulates or decelerates reproduction as a whole, as well as affects individual industries and sectors. Case box

13

Tax functions are interrelated. By establishing budget revenues, the fiscal function facilities the performance of the economic function. The latter contributes to the implementation of the fiscal function and strengthens it. Indirectly, taxes also perform a distributive function, since the use of various scales of taxation (see below in this section) makes it possible to smooth out economic and social inequalities by changing the ratio between the incomes of individual territories or social groups.

The performance of certain functions of taxes depends on what set of economic instruments the government employs. Taken together, tax instruments build a tax mechanism through which the state implements national fiscal policy. The classical postulates of taxation formulated by Justi and augmented by Smith (see 7 Sect. 13.1) have evolved into modern principles of taxation: 5 universality and fairness—the universality of taxation and the even distribution of the tax burden between economic entities and citizens in proportion to their income; 5 certainty—both the taxpayers and society as a whole must be aware of tax rates, due dates for certain taxes, and other parameters of taxation; 5 convenience—a tax should be collected at such time and in such a manner that are most convenient for a taxpayer;

457 13.3 · Taxes and Taxation

13

5 efficiency—all kinds of tangible and intangible costs associated with the collection of taxes should be minimized; 5 neutrality—all other things being equal, the amount of tax does not depend on the type of taxable activity, unless it is prohibited by law. The above principles apply equally to all stakeholders at all levels within the national fiscal system. Fiscal System is a set of principles, forms, and methods of establishing, changing, collecting, and abolishing taxes in accordance with the national legislation. The subjects and objects of taxation, the tax base, the tax period, and the tax rate are the integral elements of the system. Taxpayer (subject of taxation) is a legal entity or an individual who is legally obliged to pay certain taxes. In certain cases, a tax may be shifted from a formal payer (subject) to another person who becomes a final taxpayer. For example, value added tax is formally paid by legal entities that sell goods and services. Actually, this tax falls on all legal entities and individuals buying these goods and services. If a tax is non-transferrable, then a subject and a bearer of such a tax coincide (for example, corporate income tax). Taxable Item (object of taxation) is income or property from which a tax is charged (wages, profits, securities, real estate, goods, etc.). A taxable item must have value, quantitative, or physical characteristics which condition the obligation to pay a tax. Tax Base is a value, physical, or other characteristic of a taxable item. Tax Period is a calendar year or other period of time, at the end of which the tax base and the amount of tax payable are determined. Tax Rate is the amount of tax per unit of taxation (monetary unit of income, unit of land area, unit of measurement of goods, etc.). Different taxes have different effects on certain categories of taxpayers and other economic actors. In addition, they are levied and collected differently. Several classifications of types of taxes commonly apply (. Fig. 13.2). According to the type of a taxable item, direct and indirect taxes are distinguished. Direct taxes are taxes levied directly on individuals and legal entities, as well as on their income. In turn, direct taxes include real taxes (land, real estate, securities, etc.) and personal taxes (income tax, corporate tax, mineral extraction tax, capital income tax, inheritance tax, etc.). Indirect taxes are taxes on goods and services paid in the price of goods or included in the tariff. They include excise taxes (individual excise taxes on certain categories of goods, universal excise taxes on turnover, value added tax, etc.), monopoly taxes on goods whose production and distribution are monopolized by the state, and customs duties (further detailed in 7 Chap. 22, 7 Sect. 22.2.2). Direct taxes mainly perform a regulatory function by affecting economic reproduction (propensities to consume, save, and invest, effective demand, and other macroeconomic parameters), while indirect taxes accomplish a fiscal function by building-up budget revenues. The regulatory effect of direct taxes is manifested in the differentiation of tax rates and granting benefits. Through taxes, the government balances corporate and national interests, incentivizes the development of certain sectors, and stimulates employment, investment, and innovations.

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. Fig. 13.2  Types of taxes. Source Authors’ development

13

Depending on the body that collects taxes and manages respective budget revenues, there are central and local taxes. Central taxes are collected by the central government on the basis of national legislation. They are directed to the state budget. These include income tax, corporate income tax, and customs duties, among others. Local taxes are collected by local authorities within a territory. Examples are individual excise taxes and property tax. They contribute to local budgets. According to the intended use, taxes are divided into general taxes (labeled) and target taxes (unlabeled). Labeling involves linking a tax to a specific expenditure. Target tax must be used for financing its intended purpose only (for example, payments to pension or health insurance funds or the road use tax). All other unlabeled taxes are considered general taxes, i.e., taxes consolidated in the government budget. The advantage of general taxes is that they provide flexibility in fiscal policy, because they can be directed to any sphere or sector the government considers necessary. Depending on the tax base, there are taxes on production costs (land tax, tax on road users, tax on vehicle owners, fees for the use of natural resources), taxes on revenues (value added tax, excise duties, export tariffs), taxes on financial results (income tax, corporate property tax, advertising, target fees for maintenance, improvement, or cleaning of a territory, housing, or social facilities), and taxes on profits remaining at the disposal of economic entities (primarily, local taxes, such as license fee for trade permits, tax on the construction in resort areas, etc.).

459 13.3 · Taxes and Taxation

13

. Fig. 13.3  The Laffer curve. Source Authors’ development

Taxation scales can be proportional, progressive, regressive, and flat. Proportional tax is a tax whose rate remains unchanged for all taxable amounts (average and marginal tax rates remain constant when the tax base changes). Progressive tax is a tax whose average rate rises as the tax base increases. Conversely, regressive tax is a tax whose average rate declines as the tax base increases. Regressive taxes mean that their share is higher in the income of the lower-income segments of the population. The regressive nature of a tax is manifested if this tax is set at a fixed amount per unit of goods. Then the share of tax in income is higher for the lower-income buyer. Flat rate taxes are set in absolute amounts per unit of taxation, regardless of the tax base. Identifying the optimal taxation scale and optimal rates within the chosen scale is the key to the success of taxation. Generally speaking, setting tax rates too low, the government risks losing budget revenues, while setting them too high, it may trigger a number of negative effects, such as market and production distortions, underemployment of factors of production, the emergence of the shadow sector. Ultimately, budget revenues go down anyway. Arthur Laffer demonstrated that starting from a certain point, any rising in tax rate decreases the amount of tax revenues (further reading: “The Laffer Curve: Past, Present and Future”13). Graphically, the Laffer effect is illustrated by a curve that shows the dependence of the amount of tax revenue T collected by the government on the tax rate r (. Fig. 13.3). There are two extremums on the Laffer curve. At point A, tax rate rA is zero, and the government receives no tax revenue. At point E, tax rate rE is 100%. Again, there is no tax revenue, since no business continues working in the legal field, all economic entities move to the shadow sector to escape from the

13 Laffer (2004).

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Chapter 13 · Public Finance

extremely high tax rate. With all other values of r, taxpayers pay taxes, and the government receives revenues. Setting relatively low tax rate rB, the government can not expect collecting taxes above TB. Raising the rate, it increases the tax revenue. At point C, tax revenue reaches its maximum TC. Therefore, tax rate rC is the optimal rate. Further increase in tax rate from rC to rD pushes revenues down from TC to TD. The Laffer effect tells that if the current tax rate is above the optimal, then a decrease in the level of taxation to the optimal cuts budget revenues in the short run (the immediate effect of the rate cut), but increases them in the long run (an optimal rate favors full employment of all resources and incentivizes economic entities to come out of the shadows). Thus, both tax rises up to a certain level and tax cuts down to a certain level boost domestic output and gross income and increase budget revenues by expanding the tax base. The Laffer curve can be used to determine the total tax burden in the economy. At the country level, this parameter is calculated as the share of taxes and fees in the GDP. That is, this indicator reflects the share of GDP that the government appropriates through the mechanism of tax redistribution. As a rule, the richer the country, the greater portion of GDP is withdrawn through the tax system. The expansion of the government functions creates a prerequisite for increasing the tax burden and, in general, using taxation as an effective tool of macroeconomic regulation. 13.4  Fiscal Policy

13

Government measures aimed at mobilizing, distributing, and using financial resources on the basis of the financial legislation of a country establish a national Financial Policy. The specific features of the financial policy depend on the macroeconomic situation and economic, social, and other tasks being solved by the government in the short-term and long-term perspectives. The financial policy covers a set of tools that allow for effective public regulation of the economy. It consists of two interrelated areas, which are budget policy in the sphere of budget-related regulation and fiscal policy in the field of taxation and regulation of public expenditures. Both types of financial policy are intended to adjust certain macroeconomic parameters and influence the macroeconomic equilibrium. In accordance with the fundamentals of budgeting revealed in 7 Sect. 13.2, Budget Policy can be defined as a set of government regulations aimed at managing budget revenues, government expenditures, and the budget deficit. One of the concepts of budget policy postulates the need for the government budget to be balanced annually. However, such an approach to budgeting may degrade the efficiency of the fiscal policy by aggravating structural disbalances. Thus, during an economic downturn, budget revenues fall due to a decrease in output and incomes (shrinking tax base). The government should react to such a situation by raising tax rates, cutting public spending, or implementing a combination of the two methods. A resulting decrease in aggregate demand further deteriorates the macroeconomic situation. Balancing the budget by financing its deficit through

461 13.4 · Fiscal Policy

13

the money emission only leads to a nominal increase in fiscal and other budget revenues. They are eroded by inflationary price increases. The real incomes of the state continue falling, and the macroeconomic disbalance worsens. The second concept of budget policy implies balancing budget deficits within an economic cycle. This means that the government implements counter-cyclical measures and at the same time seeks to balance the budget. In order to counter the economic downfall, the government reduces taxes and increases public spending, i.e., it deliberately provokes a temporary budget deficit. At the revival stage of a cycle, the government balances the budget by raising taxes and cutting spending. The resulting budget surplus is used to cover the deficit that arose during the recession. Thus, the government pursues both a counter-cyclical policy and balances the budget in the medium-term perspective, not annually. This approach has its drawbacks, since the duration and intensity of ups and downs rarely coincide. Variations in the dynamics of macroeconomic parameters within an economic cycle challenge the coordination between fiscal policies and anti-crisis regulations. In the third version of financial policy, its role is to balance the economy as a whole, not just the budget. Macroeconomic stability can line up with different approaches to budgeting, that is, it can belong to both a budget-deficit economy and a budget-surplus one. Budget stability is a second-level parameter of the macroeconomic environment. This interpretation proceeds from the fact that macroeconomic stability maintains sustainable economic growth accompanied by ever-increasing tax revenues. As a result, a budget deficit eliminates. Thus, a deficit can be managed by raising taxes or attracting loans. However, in this case, the public debt grows. But in the conditions of accelerated accumulation of credit resources for financing the budget, macroeconomic stability maintains. Fiscal Policy is a set of government regulations aimed at establishing the rules for the withdrawal of taxes and spending of public funds. In the new normal reality, the type of economic and financial policy of a state depends on a variety of not only domestic parameters, but also exogenous factors. As shown in 7 Chap. 11, 7 Sect. 11.4 on the example of monetary policy, by influencing at least one of the components of aggregate demand (consumer spending, investment, public procurement, and net exports) from inside a country or experiencing the influence from outside, the government can either boost or depress the aggregate demand and the aggregate supply in the domestic market. Similar to its twin monetary policy, fiscal policy can be either expansionary or contractionary (. Fig. 13.4), or a combination of the two approaches. Both types of the policy are based primarily on Keynesian interpretations of the underemployment of factors of production. Therefore, they involve the use of taxes and government spending to regulate the aggregate demand. The neoclassical version of financial policy advocates maintaining a balance between fiscal revenues and government expenditures to keep macroeconomic stability. Expansionary Fiscal Policy is a type of fiscal policy aimed at boosting the money supply by increasing government spending G or cutting tax revenues T . This type of policy commonly applies during economic downturns. For example, in order to lift the economy out of recession, the government inflates the

462

Chapter 13 · Public Finance

. Fig. 13.4  Types of fiscal policy. Source Authors’ development

13

. Fig. 13.5  Effect of government expenditures on the gross product. Source Authors’ development

aggregate demand (especially, its investment component) by increasing expenditures from G to G1 (. Fig. 13.5). Exerting a significant impact on the pace and proportion of the aggregate demand and GDP, public expenditures stimulate both consumer spending C and investment I . The (C + I + G) curve moves upwards to (C + I + G1 ), and the equilibrium reestablishes at point E2 at higher aggregate expenditures AE 2 and greater gross product Y2. The impact of increased government spending on the growth of the aggregate demand and GDP is accompanied by a multiplier effect (see 7 Chap. 6, 7 Sect. 6.3.3 for the concept of multiplier). Experiencing the influence of the aggregate expenditures, the domestic product expands to a greater extent than the initial increase in public spending and the aggregate demand. Government Multiplier is the ratio of GDP growth to the increase in government spending. In . Fig. 13.5, the increase in government spending G pushes the aggregate demand

13

463 13.4 · Fiscal Policy

up from AE 1 to AE 2 and boosts the domestic product from Y1 to Y2. Therefore, the −Y1 Y = AEY22 −AE government multiplier MG can be calculated as MG = AE . The mul1 tiplier is inversely proportional to the marginal propensity to save (see 7 Chap. 6, 7 Sect. 6.3.3, Eq. 6.15). Taking into account the investment expenditures, the government multiplier formula can be expressed as Eq. 13.1:

MG = where: MG MPS MPC  MPI

1 1 = MPS 1 − MPC − MPI

(13.1)

government multiplier; marginal propensity to save; marginal propensity to consume; marginal propensity to invest.

With an increase in government spending, the increase in income is equal to Y = G × MG. Government spending adds to the total spending in the economy and, in accordance with the multiplier effect, gives rise to the domestic product from Y1 to Y2. The multiplier effect is bidirectional. That is, cutting government expenditures depresses the aggregate demand in the economy and reduces the domestic product by an amount greater than of initial reduction in government expenditures. For a deficit budget, MG > 1. In case of a budget surplus, MG < 1. If the government balances the budget, then MG = 0. The latter is explained by the fact that the amount of funds withdrawn from the aggregate demand is equal to the amount of funds that increase it. Therefore, the net change in the aggregate demand due to changes in public spending is zero. Case box In the 1980s, expansionary tax policies in the USA (known as Reaganomics) exerted a strong effect on the structural adjustment and growth rate of the economy. The maximum income tax rate was reduced from 46 to 34%. A similar expansionary policy was pursued in the UK by Thatcher’s government (cutting the maximum income tax rate from 52% in the early 1980s to 33% by the 1990s). In France, the income tax rate was reduced from 50% in 1986 to 34% in 1994. Tax cuts and other expansionary fiscal measures have allowed many countries to curb inflation and support economic growth. During the most recent economic downturn induced by the COVID-19 pandemic, most countries also lowered tax rates and increased government spending to stimulate economic activity and support businesses and people.

Contractionary Fiscal Policy restricts money supply by cutting government expenditures, raising tax rates, and introducing new taxes. Most commonly, contractionary instruments apply during times of rapid economic growth to cool down the economy and control inflation. Suppose that the government introduces

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Chapter 13 · Public Finance

. Fig. 13.6  Effect of taxes on the gross product. Source Authors’ development

a one-time tax, the amount of which does not depend on the GDP. The introduction of the tax degrades the disposable income of taxpayers. Therefore, consumer spending declines from C to C1 and drags down the aggregate expenditures (taking investment I and government expenditures G unchanged) (. Fig. 13.6). The equilibrium reestablishes at point E2 at lower aggregate expenditures AE 2 and lower gross product Y2. A change in disposable income by the amount of tax T depresses not only consumer spending, but also savings. This effect depends on the marginal propensity to consume. Therefore, to find the ultimate drop in consumption, the increase in tax rate should be multiplied by the marginal propensity to consume. Taxes also exert a multiplier effect on the domestic product. To illustrate it, the simple multiplier model captures the tax factor (Eq. 13.2).

13

MT =

1 1 = 1 − MPC × (1 − t) 1 − (MPC + MPI) × (1 −

�T �Y )

(13.2)

where: MT   tax multiplier; t marginal tax rate. The tax multiplier is always smaller than the government multiplier, since tax cuts indirectly affect consumption, while each additional unit of government spending has a direct impact on the aggregate demand, and, consequently, the domestic product and income. Government spending G is an integral component of aggregate expenditures, while taxes indirectly affect consumption C. The tax multiplier is equal to the government multiplier multiplied by the marginal propensity to consume.

465 13.4 · Fiscal Policy

13

Case box Most of the post-Soviet countries practiced contractionary fiscal policy in the early 1990s in an attempt to curb galloping inflation and reduce budget deficits that emerged after the collapse of the Soviet Union. In 1991, the budget deficit in Russia skyrocketed to 31% of GDP. The government raised the VAT and the income tax rates to 28% and 32%, respectively. Radical contractionary measures allowed the government to reduce the budget deficit by the mid-1990s. By contrast, in the USA, contractionary fiscal measures contributed to deepening the economic downturn during the Great Depression (previously discussed in 7 Chap. 7, 7 Sect. 7.3). In the 1930s, the Federal Reserve System reduced the money supply in order to support the price of gold (a condition for maintaining the gold standard) (see 7 Chap. 11, 7 Sect. 11.2.1 for the gold standard). That measure triggered money deflation, which turned into a depression under the influence of fiscal shocks. Raising tariff rates (Smoot-Hawley tariff) decreased imports and exports by 30% and 40%, respectively. In an effort to reduce the budget deficit, the government increased income tax rates (Revenue Act of 1932). As a result, unemployment rose by 24.9%, while GDP at current prices and real GDP collapsed by 57% and 22%, respectively.

Discretionary Fiscal Policy is the targeted regulation of public expenditures and taxation in order to affect the macroeconomic equilibrium. As noted above, a declining economy requires expansionary policy, while too fast economic growth should be contracted. When the economy is on the rise, the government restricts access to money. This makes credit resources more expensive and less accessible to economic entities. Both financial speculations and investment decline, and the economy cools down. During an economic downturn, the government decreases the price of money and makes credits more affordable. As shown in 7 Chap. 11, 7 Sect. 11.4 in relation to monetary policy, a central bank manipulates the price of money in reaction to the macroeconomic situation or in an attempt to change this situation. For the same purpose, the government manipulates taxes by raising tax rates during economic take-off and cutting them during a recession. The growth of taxes decelerates economic growth by forcing producers to reduce investments and degrading purchasing power of the population. Conversely, lowering taxes boosts economic recovery. Budget expenditures are also used as discretionary fiscal instruments. During crises, the government increases spending on purchasing goods and services, financing social programs, creating new jobs, and developing infrastructure. During the upswing, public spending is reduced. The government carries out discretionary measures purposefully. It identifies needs for certain measures, models required changes, forecasts the consequences, and makes amendments to legislation. Due to the time gaps and feedback failures that may occur during the multi-stage process of elaborating discretionary policies, such responses to the rapidly changing macroeconomic situation may turn out to be inefficient in the short run.

466

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Chapter 13 · Public Finance

Automatic Fiscal Policy is an automatic change in government spending and taxes in accordance with the changes taking place in the economy. There is no need for the government to periodically adjust tax rates and the amount of government spending. They are regulated automatically by the so-called built-in stabilizers, such as progressive taxation, unemployment benefits, or indexation of wages. Built-in Stabilizer is any measure that increases the public budget deficit during a recession and reduces it during a recovery automatically, without any special actions on the part of the government. The tax system provides for the exemption of such a tax, which varies in proportion to the GDP. Therefore, tax revenues increase in parallel with GDP growth. In particular, implementing a progressive scale of personal income tax ensures an automatic increase in tax revenues in times of economic growth. As GDP and consumption go up, a contribution from corporate income tax increases. Similarly, payroll taxes rise as new jobs are created. Conversely, when GDP falls, tax revenues from all these sources decline. Another built-in stabilizer is unemployment benefits and welfare payments. Target taxes that establish social security funds increase when employment is high. In such a way, the government automatically builds up reserves during the boom years. When employment is low, the reserve fund is used to support the unemployed in order to maintain consumption and smooth the downturn. The core idea of built-in stabilizers is to use operational measures to exert an active influence on the macroeconomic environment, mitigate cyclical fluctuations, and maintain the long-term economic development trend. Nevertheless, no built-in stabilizer is able to eliminate inflation and prevent economic downturns. Automatic policies aim at reducing macroeconomic disbalances, not eliminating them. Therefore, in order to maintain economic stability in the long run, a government should complement built-in stabilizers with discretionary fiscal measures, i.e., purposeful changes in the national fiscal system and public spending. The potential of fiscal policy should be supplemented by institutional, organizational, and economic measures. However, governments have limited room for maneuver, as they must fulfill certain economic and social obligations. That means, they can not raise taxes too high or reduce expenditures too low, as they are responsible for maintaining social stability and peace. 13.5  Fiscal Approaches to the New Normal Equilibrium

Both discretionary and automatic fiscal policy play an important role in maintaining macroeconomic equilibrium and social stability, but neither is a panacea for all economic problems. As for automatic policy, its inherent built-in stabilizers can only mitigate fluctuations in the economic cycle, not eliminate them. Conducting discretionary fiscal policy is even more challenging. These include time lags between making a decision and feeling the effect of this decision on the economy, administrative and bureaucratic delays, or politically charged economic actions (for instance, raising taxes may be required to stabilize the economic situation, but politicians ban it in fear of electoral losses). Nevertheless, a reasonable applica-

467 13.5 · Fiscal Approaches to the New Normal Equilibrium

13

. Fig. 13.7  Internal balance. Source Authors’ development

tion of both automatic and discretionary policy tools can significantly affect output, employment, inflation, and other macroeconomic parameters. As shown in 7 Chap. 11, 7 Sect. 11.5 on the example of monetary policy, in the new normal economic reality, government interventions in the self-regulating market mechanisms are aimed at ensuring that the economy simultaneously achieves internal and external balance. Wishing to restore external balance, that is, to eliminate the current account deficit, the government may apply two categories of tools. First is fiscal policy measures aimed at reducing government spending and, consequently, depressing output and increasing net exports. Second is a set of measures meant to switch consumption from imports to domestic goods and services. In the short term, such a switch to domestic output may be forced by devaluating the national currency or introducing taxes or quantitative restrictions on foreign trade. However, restricting foreign trade depresses trade turnover and decreases revenues from foreign trade. Therefore, devaluation is seen as a more forceful means of improving the current account balance. The same macroeconomic instruments can be used to restore internal balance. As argued in 7 Chap. 11, 7 Sect. 11.5, in the new normal environment, the government pursues two independent goals. The first is to achieve internal balance, i.e., the total output at full employment of factors of production or potential output with no inflation. The second goal is to establish external balance (net exports NX = 0). All other things being equal, an increase in government expenditures G or a reduction in tax revenues T pushes up income Y , but at the same time boosts imports IM . The depreciation of the national currency (an increase in the real exchange rate R) supports net exports NX and increases income Y . Achieving both internal and external balances assumes coordinating fiscal and foreign exchange policies. Suppose the initial equilibrium establishes at point A, which corresponds to the full employment of all available factors of production (. Fig. 13.7). Below the internal balance curve IB is the underemployment area. Any combination of exchange rate R ≥ R1 and government expenditures G ≥ G1 (the two con-

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. Fig. 13.8  External balance. Source Authors’ development

13

ditions simultaneously) sends the economy beyond the internal balance threshold to the overemployment area of inflationary demand. Thus, an increase in government expenditures from G1 to G2 boosts output and gives rise to overemployment. The exchange rate being constant, the economy moves from point A to the right to point B. In order for the internal balance to be restored, a government should revalue the national currency. A real appreciation of the national currency (a decrease in the exchange rate from R1 to R2) drives the economy out of the overemployment area. New equilibrium reestablishes at point C at full employment with a lower exchange rate R2 and higher government expenditures G2. In the case of external balance, equilibrium establishes at point A, which is a borderline position between net exports and net imports (. Fig. 13.8). Similar to the above situation, an increase in government expenditures from G1 to G2 boosts income and increases employment beyond the full employment level. The exchange rate R1 remaining constant, the economy moves from point A to point B to the net imports area below the external balance curve EB. Therefore, the rise in expenditures increases income, stimulates economic entities to increase consumption of foreign goods and services, and thus deteriorates the current account balance. To restore external balance, the government devalues the national currency. Real depreciation of the national currency (an increase in the exchange rate from R1 to R2) eliminates the current account balance deficit. New equilibrium reestablishes at point C at zero current account balance with a higher exchange rate R2 and higher government expenditures G2. Superimposing the IB and the EB curves (. Fig. 13.9) produces the Swan diagram developed by Trevor Swan in the 1950s (further reading: “Longer-Run Problems of the Balance of Payments”14). The four zones reflect the four possible combinations

14 Swan (1963).

469 13.5 · Fiscal Approaches to the New Normal Equilibrium

13

. Fig. 13.9  The Swan diagram. Source Authors’ development

of current account balance and employment: current account deficit and underemployment in Zone I, current account deficit and overemployment in Zone II, current account surplus and overemployment in Zone III, and current account surplus and underemployment in Zone IV. As achieving the equilibrium is only possible at one point E at the intersection of the two curves, the government should use both public spending G and real exchange rate R to balance the economy, i.e., to get it from a random disequilibrium point (for example, point A) to point E. The issue is which of the official bodies (a central bank that manages the exchange rate R or the government that manages public spending G) should be responsible for achieving which type of balance. This role distribution issue is addressed in relation to monetary policy in 7 Chap. 11, 7 Sect. 11.5. The roles shall be distributed based on the relative slopes of the IB and the EB curves. One of the straightforward distributions is that a central bank influences the exchange rate in order to achieve external balance, while the government (a ministry of finance or an equivalent body) maintains internal balance by managing government expenditures. However, this rule only works when the output is relatively sensitive to government expenditures, that is, the IB curve is steeper than the EB curve (. Fig. 13.10a). The less open the economy to the outside world, the more sensitive the output to public spending G. In this case, a significant increase in output due to the increase in government spending is accompanied by a relatively tiny drop in net exports (because in a relatively closed economy, the marginal propensity to import is small). Departing from a disequilibrium point A with high spending G3 and low exchange rate R1, the economy gravitates toward an equilibrium through a series of external and internal balances. At point D, both expenditures G1 and exchange rate R2 are closer to the optimal values of G2 and R3, respectively, than they were at point A ((G2 − G1 ) < (G3 − G2 ); (R3 − R2 ) < (R3 − R1 )). Therefore, the centripetal motion of the economy reduces gaps between current and optimal

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. Fig. 13.10  Distribution of roles in fiscal policy (output is sensitive to public spending). Source Authors’ development

13

levels of expenditures and exchange rate. Conversely, if, with this relative slope of the two curves, a central bank is responsible for maintaining internal balance and the government establishes external balance, then the centrifugal force would push the economy farther from equilibrium (. Fig. 13.10b). The gaps between current and optimal levels of expenditures and exchange rate would grow ((G2 − G1 ) > (G3 − G2 ); (R3 − R2 ) > (R2 − R1 )). Another variant of distribution is that a central bank influences the exchange rate in order to achieve internal balance, while the government manages expenditures to maintain external balance. Such a combination of regulatory roles applies when the output is relatively insensitive to government expenditures, that is, the IB curve is more shallow than the EB curve (. Fig. 13.11a). The more open the economy to the world market, the less sensitive the output is to changes in government expenditures G, since with a high marginal propensity to import, net exports decline significantly. Through a series of alternating external and internal balances, the economy tends to the equilibrium point E. Each new transition reduces gaps between current and optimal values of government expenditures and exchange rate ((G3 − G2 ) < (G4 − G2 ); (R3 − R2 ) < (R3 − R1 )). If at a given relative slope of the internal and external balance curves, a central bank is responsible for managing the exchange rate in order to achieve external balance, and the government adjusts public spending to maintain internal balance, then the economy would move away from the equilibrium point E (. Fig. 13.11b). Thus, the transition from the disequilibrium point A to external balance at point B and then internal balance at point C only widens gaps between current and optimal levels of expenditures and exchange rate. The Swan diagram shows how internal and external balances can be achieved under a fixed exchange rate system, the exchange rate acting as one of the macroeconomic tools. The economy is assumed to operate in conditions of limited mobility of capital (currency and capital controls, restrictions on currency con-

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. Fig. 13.11  Distribution of roles in fiscal policy (output is insensitive to public spending). Source Authors’ development

. Fig. 13.12  Fiscal policy effects at low capital mobility and fixed exchange rate. Source Authors’ development

vertibility, etc.). However, as demonstrated in 7 Chap. 11, 7 Sect. 11.5 in relation to monetary policy, the new normal reality implies that the effects of domestic macroeconomic policies are increasingly distorted by the international mobility of capital. Moreover, the effects could differ depending on the degree of mobility. For example, let us consider the new normal features of expansionary fiscal policy when capital mobility is low. In such a case, an increase in government expenditures boosts the aggregate demand and pushes the investment-savings curve IS 1 rightward to IS 2 (. Fig. 13.12). As a result, income rises from YA to YB. The increase in income drives up the demand for money, and the interest rate rises from rA to rB. Consequently, internal balance reestablishes at point B with higher income and higher interest rate.

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Implementing expansionary fiscal instruments exerts a twofold effect on external balance: a deficit in the current account coincides with a surplus in the capital account. The strengths of the resulting effects of expenditures and interest rates on the balance of payments BP depend on the mobility of capital. Low mobility means that capital flows are relatively insensitive to changes in interest rate. In this case, improvements in the capital account are negligible, and the overall balance of payments deficit generated by the large trade deficit persists. A location of the new point of internal balance B below the BP curve (to the right of the curve) indicates the balance of payments deficit. That is, either income YB (therefore, imports) is too high or interest rate rB (therefore, capital inflows) is too low. Thus, when capital mobility is low, implementing expansionary fiscal instruments produces a balance of payments deficit, although capital inflows partially compensate for the current account deficit. When planning domestic fiscal policy in the new normal conditions, it is necessary to take into account the exchange rate regime. With the balance of payments deficit, the exchange rate of the national currency tends to decline. The need to maintain a fixed exchange rate requires a central bank to intervene in the foreign exchange market by selling foreign currency and buying out national currency. These actions shrink the money supply in the domestic market. As a result, the liquidity-money curve LM 1 shifts to the left to LM 2, and the interest rate rises from rB to rC. As money becomes more expensive, consumption and investment fall. Lower spending depresses imports, and the current account deficit reduces. This process continues until the economy arrives at a zero balance of payments at point C. Macroeconomic equilibrium (internal and external balances and the balance of payments) reestablishes at interest rate rC and income YC. Thus, under a fixed exchange rate regime, the effects of expansionary fiscal policy are largely offset by a reduction in the money supply. Ultimately, income increases slightly from YA to YC. Although the new income at point C is higher than it used to be before the increase in government spending (YC > YA ), the total balance of payments is zero. A higher interest rate (rC > rA ) attracts capital, which facilitates increasing consumption and imports caused by rising income. In the case of high capital mobility, expansionary fiscal regulations also shift the IS 1 curve to the right to IS 2 (. Fig. 13.13). Boosts in income and interest rate are similar to those addressed above in the low capital mobility case. Rising income increases imports, while rising interest rate stimulates capital inflows. The current account and the capital account change in opposite directions. However, under high capital mobility, the balance of payments is primarily affected by changes in the interest rate. It stimulates large-scale capital inflows. The economy experiences a balance of payments surplus (new IS 2 curve and old LM 1 curve intersect at point B above the BP curve), and the exchange rate of the national currency tends to increase. To maintain the fixed exchange rate, a central bank has to intervene by selling national currency and buying out foreign currency, thus increasing its foreign exchange reserves. The money supply in the domestic market grows, and the liquidity-money curve LM 1 shifts to the right to LM 2. Consequently, the interest rate falls from rB to rC. As money becomes less expensive, consumption and investment rise along with imports, and the balance of

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. Fig. 13.13  Fiscal policy effects at high capital mobility and fixed exchange rate. Source Authors’ development

. Fig. 13.14  Fiscal policy effects at low capital mobility and floating exchange rate. Source Authors’ development

payments surplus reduces until it balances at point C. Macroeconomic e­ quilibrium (internal and external balances and the balance of payments) reestablishes at interest rate rC and income YC, both above their initial values before the implementation of expansionary fiscal measures (rC > rA ; YC > YA ). Under a floating exchange rate regime and low capital mobility, the expansionary increase in aggregate demand shifts the IS 1 curve to the right to IS 2 and raises income from YA to YB (. Fig. 13.14). Rising income stimulates imports and gives rise to the trade balance deficit. Although higher interest rate (rB > rA ) attracts capital into the country, but slow-moving remains relatively inelastic to changes in interest rate. Therefore, the balance of payments is primarily affected by a change in the current account. The location of the new balance point B be-

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low the BP1 curve (to the right of the curve) indicates the balance of payments deficit. With a floating exchange rate, the emergence of the balance of payments deficit causes the national currency to depreciate. Currency depreciation boosts net exports, which, in turn, further increases the aggregate demand. The IS 2 curve shifts further rightward to IS 3. Depreciating national currency reduces the balance of payments deficit. The exchange rate declines as long as there is a negative balance of payments. This means that the BP1 curve shifts to the right as long as the internal balance point locates below it (to the right of the curve). Since with an exogenous change in net exports, the balance of payments curve shifts to a greater extent than the investment-savings curve, the BP1 curve ultimately catches up with the intersection of the IS 3 and the LM curves. Macroeconomic equilibrium (internal and external balances and the balance of payments) reestablishes at point C with higher income (YC > YA ) and higher interest rate (rC > rA ). At point C, the balance of payments is zero, which is as it should be under a floating exchange rate regime. When taking into account the new normal international mobility of capital, fiscal policy makers have to accept that a rise in the interest rate attracts capital from abroad. Capital account improves, which partially compensates for the deterioration of the trade balance. However, under low capital mobility, the balance of payments deficit persists. Nevertheless, even a small inflow of capital means that the balance of payments deficit resulting from implementing expansionary fiscal tools turns out to be moderate. That means that a moderate depreciation of the national currency should be enough to restore the balance of payments equilibrium. In general, with a floating exchange rate regime, the performance of expansionary fiscal tools is enhanced by the depreciation of the national currency, which leads to a greater increase in income compared to a fixed exchange rate regime. In an economy with high mobility of capital, a floating exchange rate weakens the efficiency of the fiscal policy pursued by the government. Boosting the aggregate demand (the IS 1 curve shifts to IS 2) and income (from YA to YB), expansionary fiscal policies simultaneously push up the interest rate from rA to rB (. Fig. 13.15). Since capital is mobile, capital inflows and, consequently, the size of the capital account surplus are more than sufficient to compensate for the negative trade balance resulting from the increase in income. The balance of payments remains positive (the new internal balance point B lies above the BP1 curve). With a floating exchange rate, the national currency appreciates to equalize the balance of payments. As a result, net exports shrink, and the IS 2 and the BP1 curves shift leftward as far as there is the balance of payments surplus, that is, until the BP1 curve catches up with the intersection of the IS 3 and the LM curves. Internal and external balances restore at point C, where income and interest rate values slightly exceed their original values (YC > YA ; rC > rA ). The increase in income resulting from rising government expenditures is largely offset by the subsequent decline in net exports, and the effect of fiscal policy is moderate. To summarize, let us admit that employing fiscal instruments affects the aggregate income at both fixed and floating exchange rate regimes. However, their effi-

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. Fig. 13.15  Fiscal policy effects at high capital mobility and floating exchange rate. Source Authors’ development

ciency highly depends on the mobility of capital. With a fixed exchange rate, the performance of fiscal policy improves as capital mobility increases, while with a floating exchange rate, it degrades with a rise in the international mobility of capital. This is because expansionary fiscal policy increases interest rates and, consequently, incentivizes the inflow of capital. The latter is the greater the higher the mobility of capital. Under the fixed exchange rate regime, the balance of payments surplus forces the government to increase foreign exchange interventions and inflate the money supply. These actions enhance the overall effect of fiscal policy on the macroeconomic equilibrium. On the contrary, with a floating exchange rate, the balance of payments surplus appreciates the national currency and thus depresses the aggregate demand. Therefore, in the new normal economic reality with increasingly mobile international capital and increasingly intertwined international exchange regulations, the effects of domestic fiscal policies could be rather moderate. Applying fiscal instruments should be complemented by implementing relevant monetary tools (7 Chap. 11), financial and banking regulations (7 Chap. 12), and foreign exchange and foreign trade policies (7 Chaps. 20 and 22, respectively). Chapter Questions: 5 What functions does finance perform? Do they differ from the functions of money discussed in 7 Chap. 11? 5 Summarize the neoclassical approach to interpreting finance. Discuss its similarities and dissimilarities with the Keynesian theory of finance. 5 Which type of budget deficit threatens the macroeconomic equilibrium the most? 5 Most of the developed and developing countries had been amassing a substantial amount of public debt long before the COVID-19 pandemic broke out in 2020. Do you think public debt has turned into a new threat to macroeconomic stability in the new normal?

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5 Describe the fiscal system in your country of residence. Give examples of major direct and indirect taxes. Does a government use a proportional, progressive, or regressive scale? 5 Illustrate effects of contractionary fiscal policy on income and interest rate in various combinations of capital mobility and foreign exchange rate. 5 Why does taking into account the international mobility of capital matter in planning domestic fiscal policies? 5 In your opinion, which fiscal tools a government should prioritize in the new normal economic environment? Subject Vocabulary:

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Automatic Fiscal Policy: an automatic change in government spending and taxes in accordance with the changes taking place in the economy. Budget Policy: a set of government regulations aimed at managing budget revenues, government expenditures, and the budget deficit. Built-in Stabilizer: a measure that increases the public budget deficit during a recession and reduces it during a recovery automatically, without any special actions on the part of the government. Contractionary Fiscal Policy: a type of fiscal policy aimed at restricting money supply by cutting government expenditures, raising tax rates, and introducing new taxes. Discretionary Fiscal Policy: a targeted regulation of public expenditures and taxation in order to affect the macroeconomic equilibrium. Expansionary Fiscal Policy: a type of fiscal policy aimed at boosting money supply by increasing government expenditures or cutting tax revenues. Finance: a system of economic relations arising in the process of formation, distribution, and use of financial resources in order to ensure economic reproduction and meet the needs of society. Financial Policy: a set of government policies aimed at mobilizing, distributing, and using financial resources on the basis of the financial legislation of a country. Financial System: a set of financial relations on the formation, distribution, and use of centralized and decentralized financial resources. Fiscal Policy: a set of government regulations aimed at establishing the rules for the withdrawal of taxes and spending of public funds. Fiscal System: a set of principles, forms, and methods of establishing, changing, collecting, and abolishing taxes in accordance with the national legislation. Foreign Public Debt: a debt of a government to foreign countries, foreign banks, and international organizations. Government Budget: an annual plan of public expenditures and sources of financial resources to cover these expenditures. Government Multiplier: the ratio of GDP growth to the increase in government spending.

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Internal Public Debt: a debt of the government to the economic entities and residents of a country established due to borrowing money in the domestic market to cover the budget deficit. Public Debt: a sum of the budget deficits accumulated by the government during a certain period of time. Tax: a mandatory fee or payment levied by the state from legal entities and individuals in the amounts determined by the law and within the established period of time.

References Bodin, J. (1568). La response de Jean Bodin à M. de Malestroit. Paris: A. Colin (English version: “The Response of Jean Bodin to the Paradoxes of Malestroit, and the Paradoxes”, translated and with an introduction by G.A. Moore. Washington, D.C.: Country Dollar Press). Botero, G. (1589). Della Ragion di Stato (English version: “The Reason of State”, translated by P. J. and D. P. Waley; with an introduction by D. P. Waley. London: Routledge and K. Paul). International Monetary Fund. (2021). World economic outlook: Recovery during a pandemic. International Monetary Fund. Justi, J. (1755). Staatswirthschaft. Erster Band. Leipzig: Breitkopf (English version: “The Beginnings of Political Economy”). Keynes, J. M. (1936). The General Theory of Employment, Interest and Money. Macmillan. Laffer, A. (2004). The laffer curve: Past, present and future. The Heritage Foundation. Machiavelli, N. (1513). Il Principe (English version: “The Prince”, translated with an introduction by H. Mansfield. Chicago, IL: The University of Chicago Press). Rau, K. (1837). Lehrbuch der politischen Oekonomie. Universitätsbuchhandlung von C.F. Winter. Ricardo, D. (1817). On the principles of political economy and taxation. John Murray, Albemarle-Street. Samuelson, P. (1954). The pure theory of public expenditure. The Review of Economics and Statistics, 36(4), 387–389. Samuelson, P. (1969). Pure theory of public expenditure and taxation. In J. Margolis & H. Guitton (Eds.), Public Economics: An Analysis of Public Production and Consumption and their Relations to the Private Sectors (pp. 98–123). Macmillan. Smith, A. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations. London: W. Strahan. Sonnenfels, J. (1765). Grundsätze der Polizei Handlungs- und Finanzwissenschaft. Wien (English version: “The Principles of Police, Action and Finance”). Swan, T. (1963). Longer-run problems of the balance of payments. In H. W. Arndt & W. M. Corden (Eds.), The Australian Economy (pp. 384–395). Melbourne: Cheshire Press.

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© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_14

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Learning Objectives: 5 Explore the fundamentals of social policy 5 Discuss the contradictions between economic growth and social justice 5 Learn the concept of social welfare and approaches to measuring welfare 5 Distinguish between welfare and wellbeing 5 Study types of poverty and poverty indicators 5 Summarize major concepts and measures of economic inequality 5 Discuss the new normal manifestations of inequality and poverty 14.1  Social Policy

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Along with the imbalances in various markets (discussed in the above chapters in Part III), which shape the new normal economic reality, inequality (in its diverse manifestations) is a major setback to ensuring sustainable economic development. Inequalities in income and living standards between and within countries, inequalities in employment opportunities (7 Chap. 8), and inequalities in human capital development (7 Chap. 17) and technological development (7 Chap. 16) make it necessary for the state to intervene in the redistribution of both economic benefits and social opportunities. The specific organization of income redistribution in a particular country is determined by the level of economic development, political situation, consumer behavior parameters, and cultural and historical conditions. However, regardless of specific country-level features, the main task of redistribution is to level all kinds of gaps while ensuring the maximum possible economic growth and the level of economic and social development. Social Policy is the activity of the state in managing social processes, ensuring material and cultural needs, regulating social and economic differentiation, and allowing each member of society to realize their social and economic rights vital for the optimal reproduction and development (both social and individual). The essence of social policy is to regulate relations between members of society, aimed at supporting vulnerable communities, combating poverty, and achieving an acceptable level of wellbeing for all people. Social policy is carried out through the elaboration and implementation of social programs backed by the government budget, as well as through the redistribution of income and regulation of employment. The need for social policy is due not only to the natural inequality in the primary distribution of income as a result of the factor-by-factor distribution, but also to the formation of household budgets. The latter are affected by per capita incomes, the size and structure of families, and the ratio of dependents and persons obtaining independent income in particular households. As a result, inequality in distribution is compounded by inequality in consumption. In addition, as society develops, the requirements for the level of education and the workforce qualification increase. Scientific and technological progress emphasizes the role of creative work and the innovative potential of employees in economic and social development. Therefore, education, health care, and other types of human capital development (see 7 Chap. 17) are among those that society prioritizes and puts under its control.

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Case box Depending on the level of economic and social development and historical and cultural features of certain countries, several models of social policy can be distinguished. Thus, governments in Western and Central European countries redistribute a significant part of GDP through the budget (about 50%), set up employer-sponsored insurance funds, develop social partnership networks, and strive to maintain the highest possible employment. The Scandinavian model (Sweden, Denmark, Norway, Finland) proclaims achieving economic development goals through implementing proactive social policy (redistribution of national wealth through the budget (50–60% of GDP) and the ideas of social solidarity). In the USA, Canada, and the UK, the volume of redistribution of GDP through the budget is much lower than in Europe. The public employment policy is negligible (or passive), while private companies and organizations play a significant role in the provision of social services. In developing countries, scattered social policy systems mainly target vulnerable segments of society.

Amid the COVID-19 pandemic and the extremely high volatility across all spheres, social policy turned into a short-term stabilization tool the governments employed to smooth social unrest. However, the range of social policy goals and tasks is much wider (. Fig. 14.1). Major tasks of the social policy include the stabilization of the living standards and prevention of mass poverty; regulation of social and labor relations (wages, incomes, prices, working conditions, and reproduction of labor); maintaining a stable level of real income through anti-inflationary measures and indexation of income; establishing economic incentives for participation in public production; social protection of people and their basic social and economic rights; and development of public infrastructure (housing and utilities, transport, education,

. Fig. 14.1  Fundamental social policy goals. Source Authors’ development

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healthcare, and other means of living and development). The implementation of social policy tools is based on the following principles: 5 equality of all members of society before the law; 5 social solidarity—the commonality of the core interests and goals of people in a given country; 5 social justice—ensuring economic symmetry and equivalence in the life of people due to the conformity of rights and obligations, freedom and responsibility, contribution to national production, and the current social and economic situation of every individual. Case box Traditionally, the main directions of the social policy include the mobilization of social factors of economic growth, the establishment of a social protection system, as well as government support for basic social sectors (education, science, healthcare, housing, communal services, etc.). During the COVID-19 outbreak, social policy has become a significant factor in maintaining aggregate demand and income levels amid lockdowns and a freeze in business activity in many sectors. However, today, when most restrictions have been lifted and massive government aid programs have been curtailed, there arises an issue of incentivizing people and businesses to resume economic activities. Naturally, many employees would enjoy receiving benefits from the government rather than getting back to work. Therefore, in the new normal economic reality, social policy should move from direct support of people (only the most vulnerable communities should continue receiving minimal support) to indirect support of businesses and employment through increased investment in science, education, and healthcare and leveling emerging economic and social gaps.

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Social policy practices have developed in various directions and have captured various elements (. Fig. 14.2). Policy-related issues of education and health care are detailed in 7 Chap. 17, 7 Sects. 17.5 and 17.6, respectively. In this section, we focus on social insurance, social protection, social security, wage policy, public regulations of the labor market, and housing policy.

. Fig. 14.2  Major elements of social policy. Source Authors’ development

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Social Insurance is a system of cash benefits organized based on mandatory special contributions, which ensure the establishment and redistribution of trust funds to protect the property interests of individuals and legal entities and compensate them for damage in case of adverse events. Social insurance can be considered as a system of relations concerning the method of redistribution of income, where those not contributing to public production still receive maintenance from special public funds. On the one hand, the social insurance system restores and maintains people’s ability to work. On the other hand, it guarantees support and provision for those unable to work due to various reasons. Insurance payments include unemployment benefits, allowances for temporary disability and pregnancy, old-age pensions, disability payments, survivor’s benefits, etc. There are compulsory, voluntary, and private types of insurance. Compulsory social insurance is a type of public guarantee provided through targeted extra-budgetary funds (government budget or public funds). It applies to the social protection of both employed and unemployed people from possible changes in their material or social status due to various reasons. Commonly, compulsory social insurance includes medical insurance, pension insurance, travel insurance, and professional insurance in harmful or hazardous working environments. Voluntary social insurance is a type of insurance that is based on the principle of collective solidarity and mutual assistance in the absence of insurance support from the state. A kind of voluntary personal insurance is private insurance. It is carried out at the expense of contributions from individuals and legal entities, private insurance companies, and pension funds. Most commonly, private insurance is carried out by commercial insurance companies. Case box These days, voluntary social insurance funds are commonly considered a complement to compulsory insurance. This is due to the insufficient level of guarantees from the state in the compulsory social insurance system and the high level of income of policyholders. Such complementarity of funds allows the disadvantages of one type of insurance to be compensated by the advantages of another.

Social Protection is a system of measures aimed at preventing, reducing, or eliminating the consequences of social risks by ensuring a decent standard and quality of life. Typical social risk events include illness, job loss, and disability. The social protection system can be considered in the following aspects: 5 system of social guarantees and related measures aimed at maintaining a decent quality of life and standard of living; 5 commonality of subject and object mutual relations of social protection to reduce negative consequences of social risks by ensuring a decent quality of life and standard of living; 5 system of public bodies, institutions, and enterprises that maintain social protection and provide social services to people.

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Generally, there are two models of social protection. The social-democratic model stresses the role of the state in the socialization of income and emphasizes the importance of social management mechanisms at a national level. The neoliberal model prioritizes market self-regulation mechanisms and, therefore, opposes excessive government interventions in social and economic processes. Accordingly, there is a distinction between public and private social protection. The former is based on the public support for vulnerable communities and the social charity principle, which provides for an individual approach to determining disadvantageous groups and providing them with social assistance on preferential terms. The latter is based on the principle of personal responsibility for one’s own life and the lives of the dependents (close relatives, extended family, friends, etc.) by spending personal earnings and savings. This system focuses on private social insurance. Case box Many scholars associate social protection with maintaining a certain standard of living. From this angle, social protection is a set of public measures aimed at ensuring a decent standard and quality of life. In the new normal economic reality, however, an income-centered approach to establishing social security (a specific organizational and legal form of social protection carried out directly by the state) has been replaced by the broader term “social protection”. Although such large-scale social and economic downturns as the COVID-19 pandemic prove that the role of the state in providing social protection is still high, a truly sustainable social protection system should incorporate alternative forms of targeted social support for the most vulnerable communities. The government backs up by providing mass support, while non-governmental funds make the system flexible so it may react to economic and social volatilities.

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Public regulation of employment and wages is discussed above in 7 Chap. 8, 7 Sect. 8.4. With regard to the social dimension of labor-related regulations, the state’s primary role is to adjust the demand for labor by monitoring and providing information to all stakeholders, encouraging or disincentivizing the use of foreign labor in a country, or easing or reducing the access of certain categories of workers to the labor market (for example, by setting the retirement age). In addition, the government significantly influences the labor market by taking over the organization and financing the retraining system in an attempt to react to structural shifts in the economy or initiate transformations (further discussed in 7 Chap. 17, 7 Sect. 17.3). Public regulation of wages implies establishing the minimum wage or, in certain cases, the maximum wage (very similar to price floors and price ceilings discussed in 7 Chap. 5, 7 Sect. 5.3.3). The government may also restrict the growth rate of wages. These measures are used to prevent inflation and maintain the balance of payments. The housing policy is carried out by allocating funds from the budget to assist employees who rent housing. The government also provides land, preferential loans, or special tax treatment to construction companies. Usually, the state controls the amount of housing payments

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by setting a limit on the amount of income of owners for rented housing, or buys land from private ownership and uses it for public housing construction. The new normal economic reality transforms not only value chains and markets, but the entire social patterns. Contradictions between social groups are becoming more acute not only on economic issues (the issues of poverty and inequality are discussed below in this chapter), but also on racial, political, and ideological grounds. Therefore, the new normal social policy aims at ensuring steady social development, creating economic incentives for people and businesses, strengthening awareness of the social responsibility of every individual for their own fate and the fate of the country, preserving for each member of society a range of minimum needs that must be met in a non-market way, as well as neutralizing the adverse social consequences of the post-pandemic economic recovery by supporting socially vulnerable communities. Promising measures of the new social policy are the development of collective social protection, social insurance, and social assistance systems, as well as the provision of minimum social guarantees to all citizens, and not only target segments. The immensity of modern global economic and social crises shows that social policies should shift from individual social protection measures to the improvement of collective immunity to destabilizing external and internal influences. Collective social protection is a system of measures to ensure a stable normal (accepted in a particular society) material and social status of all citizens, not just the most vulnerable groups. The economic downturn triggered by the COVID-19 outbreak has hit not only low-income people, but also the middle class, entrepreneurs, and highly qualified specialists across many sectors. Due to the emerging globalization, volatility in some markets causes social upheavals in all segments of society. Therefore, conventional support for the poor should be complemented by comprehensive programs of social, legal, and informational assistance to all. Higher instability of the markets determines the expediency of the development of social insurance systems for the provision of the broader community in the event of social risks. Insurance contributions of the insured employees and their employers, as well as government subsidies, should establish designated social insurance funds. In most of the developed countries, social support programs were exceptionally substantial during the early months of the COVID-19 outbreak. In extreme situations, such an approach is justified, but the everyday practice requires developing targeted social assistance programs to provide targeted support to people in need of assistance due to the deterioration of their financial situation, marital status, age, or health. Unlike social insurance, which applies to all, social assistance allows a government to build more flexible support schemes and adjust them to a dynamic macroeconomic situation. 14.2  Economic Growth and Social Justice

The essential challenge the new normal economic reality poses is how to converge economic growth with social development goals. Social development itself is revealed through the maintenance of standards of living, confidence in the fu-

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ture, continuous improvement of wellbeing, and public peace. The ability of society to maintain its stable social position at an acceptable level is social stability. It is reflected in the dynamics of macroeconomic parameters, such as aggregate demand and aggregate supply, prices, interest rates, and the propensities to consume and save (see 7 Chap. 5, 7 Sects. 5.2 and 5.3 and 7 Chap. 6, 7 Sect. 6.3). Social stability is a variation of macroeconomic equilibrium. It allows society to make the optimal use of social factors of economic growth. Social stability is ensured through low unemployment, low inflation, and stable access of each member of society to tangible and intangible values. This, in turn, supposes the achievement of high rates of economic growth and development. Social Stability is the situation when society maintains stable standards of living, fundamental rights of people, and uninterrupted access to major goods, services, and other tangible and intangible values. It also assumes people to be responsible for their financial situation and to make economic decisions independently. The state ensures a unified approach to the social protection system and maintains the following parameters of social justice: 5 material wellbeing of each member of society and their social status should correspond to the individual contribution to the national wealth and be determined based on the volume of labor, capital, and other factors of production; 5 each individual should be guaranteed a certain minimum of subsistence, i.e., society should demonstrate respect for human dignity; 5 everyone should have the opportunity to improve their social status by improving personal qualities and upgrading human capital; 5 wealthier communities should make greater contributions to social development programs.

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As noted above in 7 Sect.  14.1 and further detailed in 7 Chap. 15, 7 Sect. 15.1.1, economic growth evolves into economic development when it implies a certain measure of income leveling and the creation of social guarantees and equal starting conditions for all people. Most of the developed markets demonstrate the convergence of economic efficiency and a certain degree of social justice. The expensive labor encourages the economy to increase performance and improve quality due to scientific and technological progress and the use of resource-saving and labor-saving technologies. From an economic perspective, Social Justice is the correspondence of economic relations (i.e., the distribution of wealth and income in a country) to the needs and interests of a given society. The social orientation of the economy implies the subordination of the economy to the tasks of human development. The need to form a socially oriented economy is due to the need to combat poverty and inequality by boosting scientific and technological progress and creative work, as well as the need to maintain adequate standards of living for all people. The social justice pathway involves the following four features: 5 optimization of compensations and benefits schemes, combating labor discrimination, increase in the standard of living, and higher labor productivity; 5 merging production management and ownership of the means of production;

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5 stimulating human capital development and cultivating the respect for knowledge and education; 5 development of social partnerships and co-management and self-management formats across all segments of the economy and society. The main tool for ensuring social justice is the redistribution of income. There are two contradictory concepts of the fair income distribution. The egalitarian one stands for the equitable distribution of income which, according to the proponents of the concept, best ensures social stability. The market concept advocates for unequal distribution of income based on the differences in performance of factors of production under free competition. In any society and any economy, income is distributed unevenly due to differences in abilities, levels of education, experiences, performances, and many other features of people. From the angle of the market distribution of income, social justice lies in the fact that the incomes of all owners of factors of production depend on the supply-demand ratio in the free market, and the marginal productivity of factors. Accepting this point of view, we should admit that the lower income of lower-skilled workers is fair, because, first, it produces a lower return on the unit of labor, and second, the effective demand for such labor is lower. The income premium of skilled labor or an entrepreneur who has managed to efficiently combine the factors of production is also fair. However, the market mechanism in no way provides a guaranteed level of wellbeing for all. It fails to ensure social justice in the sense that the market and competition do generate inequality (further discussed in 7 Sect. 14.5). Market failures (see 7 Chap. 10) distort the market environment and stir up income inequality. One of the social functions of the state is to level these gaps while simultaneously supporting market competition, the engine of economic development. Since maintaining a balance between economic growth and social justice is crucial, the government must restrain its income policies within clear boundaries. The minimal boundary is set by quantitative parameters of an adequate level of income, such as the subsistence minimum, the minimum wage, and the consumer basket. Subsistence Minimum is a physiological minimum of consumption, i.e., a minimum set of benefits that guarantees the satisfaction of basic needs. The subsistence minimum is set both per capita and for individual social groups. Generally, it grows along with the level of economic development of a country. The subsistence minimum is meant to ensure the minimum acceptable standard of living and personal development common for a particular country or community. Minimum Wage is a statutory minimum wage, which, as a rule, must correspond to the subsistence minimum. Countries and territories substantially differ in setting their minimum wage levels. Some countries set no minimum wage thresholds at all. In federal states, minimum wage levels may differ across administrative units (for example, by states in the USA or by cantons in Switzerland). In some countries, the minimum wage is exempt from income tax (Nigeria, Philippines), in others, the difference between before-tax and after-tax wages can be significant (Norway, Sweden, Denmark).

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Case box In many countries, the minimum wage has changed due to the economic and social consequences of the COVID-19 pandemic. In most of the developed economies and many developing countries, support to people and businesses in 2020–2021 included not only direct payments, but also an increase in wage rates and tax reforms. Montenegro demonstrated the highest increase in the minimum wage. In addition to raising the minimum wage, the country took on tax reform. As a result, the minimum wage in Montenegro raised by 102.7% in 2022. Minimum wage raced up in Argentina, Turkey, and Kazakhstan. Nevertheless, the inequality between developed and developing countries in terms of wages has not only persisted, but increased in recent years (. Table 14.1).

Consumer Basket (minimum consumer budget) is a set of basic consumer goods and services common for certain communities, territories, or countries. Such a set acts as a guideline for the social and economic development of a country in the long run. A consumer basket can also be defined as a minimum set of goods, services, and other values that allows an individual to maintain the minimum acceptable standard of living. However, such an interpretation of the consumer basket serves the statistical monitoring of consumption rather than provides an adequate measure of welfare. Depending on the specific features of a certain target group (age, gender, residence, level of income, level of education, and many other parameters), alternative consumer baskets may apply. The economic estimate of the consumer basket is the minimum consumer budget. In macroeconomic analysis, it is commonly matched with the average wage by category of employees or with the av-

. Table 14.1  Minimum wage in selected countries in 2022

14

Top ten countries

Minimum wage per month, $

Bottom ten countries

Minimum wage per month, $

Luxembourg

2,482.93

Papua New Guinea

43.00

Australia

2,389.90

Tajikistan

42.40

Ireland

2,073.00

Uganda

35.64

Monaco

2,057.00

Malawi

34.02

Netherlands

2,006.00

Kyrgyzstan

25.11

Belgium

1,934.00

Bangladesh

19.00

San Marino

1,920.00

Cuba

16.68

New Zealand

1,868.30

Sudan

9.42

France

1,868.00

Georgia

8.36

UK

1,829.02

Venezuela

2.48

Source Authors’ development

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erage pension (for retired people). The closer the minimum consumer budget to a model minimum set of goods and services, the higher the average wage and average pension compared to the corresponding minimum consumer budget, and the higher the standard of living. Along with the parameters of the subsistence minimum, minimum wage, and minimum consumer basket, the lower boundary of government intervention in the distribution of income can be determined by applying poverty indicators (detailed below in 7 Sect. 14.4). The human development index acts as an integral indicator of the general living conditions of people in a country and the social and economic pattern of current consumption and future development (further discussed in 7 Chap. 17, 7 Sect. 17.4). Case box The lower boundary of government intervention in income distribution is rather flexible. It may vary significantly for countries and even territories within a country due to differences in consumer stereotypes. People get used to certain standards of living standards and consumption. For example, what are a basic life need and an ordinary boon for people in Northern Europe, where the role of the state in income equalization is high, can be considered a luxury and surfeit for people in developing countries in Asia or Latin America, and even more so the least developed countries in Africa. Obviously, the standards of social justice and the minimum required government intervention in ensuring social justice may differ substantially across countries. Being content with little, people in developing countries can consider low standards of wellbeing a decent life and do not qualify for support from the budget. The specific content of social programs, therefore, depends on the economic and demographic situation in a particular country and other circumstances, including customary consumption patterns and habits.

Determining the upper boundary of the state’s participation in the distribution of income is much more controversial. To determine the optimal degree of administrative distribution of income, the latter should be distinguished between functional and individual income distribution. The functional one forms primary or so-called factor income, such as wage, profit, interest, rent, and entrepreneurial income. Individual income distribution is affected by various variables, both economic and non-economic ones, and therefore it is subject to regulatory influence from the state. . Figure 14.3 visualizes the interaction between the functional and individual distribution of generated income. Social inequality in the distribution of individual income aggravates under the influence of the following three factors: 5 an increase in demand for skilled (more expensive) from certain hi-tech sectors, which drives up returns on human capital as a factor of production, but only for certain categories of employees (or even narrower—certain categories of employees in certain territories);

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. Fig. 14.3  Interaction between the functional and individual distribution of income. Source Authors’ development

5 structural shifts in the economy due to technological progress and advances, which displace lower-skilled labor and increase the proportion of higher-paid labor in the total workforce; 5 increasing investments in human capital and improving the overall level of education and professional training in a country.

14

Universal economic and social laws of development that apply to all economies regardless of their national specifics produce more or less similar income distribution patterns across the world—the Pareto Principle. It says there is an inverse relationship between the cumulative income level and the specific weight of households. Thus, 80% of income is aggregated by 20% of the population, while the remaining 20% falls on 80% of the population. Too deep income inequality undermines the stability of society (see below in 7 Sect. 14.5), while too intensive income equalization depresses incentives to work and entrepreneurship (in other words, economic efficiency). Hence it follows that equality has its price. For greater equality, society pays with a deeper fall in efficiency. Facing the poverty problem, all countries in one way or another support the most vulnerable communities. However, everything that goes to the poor should be taken away from the rich. This is the main reason for the resistance to the widespread introduction of redistributive taxation (for instance, progressive taxes explored in 7 Chap. 13, 7 Sect. 13.3). Income redistribution measures, such as a progressive income tax, reduce real output by depressing incentives to increase performance (work harder—pay more taxes) and save (a substantial portion of income is taken away). Therefore, when the government maps the income distribution policy, it should compare the benefits of greater equality with the cost of losing part of national income (the economic costs of redistribution). For example, at point A, or the point before the introduction of the redistribution program, there are no taxes or transfer payments, so people live on their market incomes (. Fig. 14.4). Under free competition, point A designates the optimum equilibrium, as, at this point, no redistributive policy is required to maximize the total national income. However, at point A, upper economic brackets receive a substantially higher portion of the total national income than lower ones (IRA > IPA ). The government may

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. Fig. 14.4  Income distribution curve. Source Authors’ development

seek to narrow the income gap by introducing fiscal measures and public support programs, so that the income distribution equilibrium gets closer to point E, where IRE = IPE. If such measures make no harm to national output, the economy moves in a straight line from point A to point E. The slope of the EA line is 45°. This reflects the theoretical assumption that every unit taken from the upper-income segment increases the income in lower economic brackets by exactly one unit. Along the EA line, the total national income remains constant, which means that it is not affected by redistributive programs. If the state redistributes income by imposing high taxes on the richest, their savings and labor costs may decrease or migrate to alternative less efficient uses, which will reduce the total amount of real national income. That means that not the entire unit, but only part of a unit taken from the rich in the form of a tax actually reaches the poor, while the rest is wasted. The equilibrium deviates from the optimal 45° line and shifts along the alternative ABC line. The fundamental contradiction between social justice and economic efficiency is one of the features of the new normal economic reality. The desire for greater equality turns into losses in economic efficiency. The latter aims at ensuring the maximum return on efforts and resources spent. In principle, it contradicts social justice in the redistribution of resources in favor of the vulnerable communities, maintaining employment for all, addressing environmental problems, and other issues that produce no economic effect or lower returns on inputs. In general, the contradiction between economic efficiency and social justice reflects the contradiction between production and consumption, which affects the overall level of wellbeing in society. 14.3  Welfare and Wellbeing 14.3.1  The Concept of Social Welfare

The new normal justice-efficiency context discussed above substantiates the need for broadening the concept of social and economic efficiency to capture social costs (for example, environmental pollution) and social benefits (healthcare, ed-

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ucation, scientific potential). Such an extension provides for reaching social consensus or at least mitigating social contradictions, without which the economy can not develop and grow. Economic efficiency aimed at increasing public wellbeing is best achieved in the market economy with a predominance of private property and a certain degree of regulatory intervention of the state. Without the latter, the market fuels social differentiation, since the distribution is based on the productivity of inputs, including labor efforts and individual features of employees, and competition between the factors of production. Social justice is implemented mainly through the government-driven redistribution of income, which smooths down market externalities. However, the understanding of the essence of social justice and the quantitative assessment of its parameters vary for different people and social groups. Consumer values of homogeneous goods and services may diverge substantially depending on consumer habits and preferences, as well as cultural contexts in different countries. Having received income, an individual evaluates what benefits and in what amount can be consumed and compares it with the income level of other people. Based on the estimates made, one can find ways and means to level up income, and hence consumption. Therefore, an individual assesses the economic and social situation against individual preferences and the potential income that can be obtained in this situation. In terms of macroeconomic analysis, however, there is a need to subdue diverse assessments and quantify the parameters of welfare and wellbeing. Welfare is a social and economic category that reflects the overall level of an individual’s capabilities used to implement a life strategy and meet the full range of needs. Social welfare characterizes such parameters as stability (economic, social, political), prosperity (income or GDP per capita), and the availability of goods, services, and other consumer values (not only material consumption, but also benefits for the social, intellectual, and cultural development of an individual). Public welfare reflects the quality of a person's life. At the same time, the quality itself can be described by both economic and non-economic parameters. Together, they determine the degree of implementation of an individual's life attitudes and the level of satisfaction of personal needs.

14 Case box The subjectivity of perceiving welfare has manifested itself during the COVID-19 pandemic, when such welfare criteria as the quality of the healthcare system and its readiness to respond to peak load emerged. Amid knockdowns, welfare parameters included unrestricted communication, freedom of movement and visiting familiar places, and other seemingly insignificant life pleasures. The new normal interpretation of welfare has thus shifted somewhat from expanding consumption and obtaining more of new values to stabilizing and preserving existing ones. Among the fundamental parameters of welfare, the quality of the environment and ecology has remained unchanged, while other characteristics have undergone transformations (working conditions, availability of medical care, education and leisure, active social lifestyle, living conditions, etc.).

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. Table 14.2  Components and parameters of the quality of life Components

Parameters

Vital needs

Basic consumption, food, housing, health

Working conditions

Labor protection, injuries and occupational diseases, hygiene and sanitary conditions

Human development conditions

Human rights, income level and expenditure structure, social development, rest and leisure, birth rate

Environmental safety

Environmental parameters and environmental protection costs

Source Authors’ development

Quality of Life is a set of characteristics reflecting material, physical, social, and cultural wellbeing. Due to subjective perceptions of welfare discussed above, quality of life can hardly be assessed by a universal quantitative measure. Still, certain parameters common to most people can be defined. They are the level of satisfaction with basic material, social, and cultural needs, health, life expectancy, personal safety, social security, environmental conditions, and variations of freedom, among others. The quality of life is always perceived in the context of traditions and habits (history, national features, religion, lifestyle patterns, etc.). It is customary to distinguish four components of the standard of living: vital needs (housing, food), working conditions, human development conditions, and environmental safety (. Table 14.2). Both economic aspects and social, cultural, and environmental parameters matter in assessing the level of welfare and wellbeing. They all contribute to the overall standard of living, which can be expressed through the level of consumption of goods and services that meet people’s needs. The cost of living corresponds to a certain level of consumption, but the availability of material values is only one of the components of quality. The quality of life also depends on the accessibility of good education, career development, social protection, and a variety of available cultural benefits. Together, these parameters form public welfare, which can be measured in different ways. 14.3.2  The Pareto Criterion

One of the most widely accepted approaches to measuring welfare is the Pareto criterion. According to Vilfredo Pareto, effective distribution of benefits increases the welfare of one individual while decreasing the welfare of another. This principle is known as the Pareto optimality, which is the equilibrium at which resources are optimized in a way that the utility of any resource cannot improve without worsening the utility of the other. . Figure 14.5 shows the welfare (utilities) of parties A and B (individuals, businesses, sectors, countries, i.e., any two compet-

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. Fig. 14.5  Welfare possibility curve. Source Authors’ development

14

ing units)—UA and UB, respectively. The area within the UA UB welfare possibility curve represents the variety of combinations of utilities of two subjects (similar to the production possibility frontier explained in 7 Chap. 16, 7 Sect. 16.3). The configuration of the welfare possibility curve is determined by the finite resources of the two-subject system and the levels of knowledge and technology used. As in the case of the production possibility curve, an increase in resources or an improvement of technology shifts the border upward right (welfare increases), while a decline in inputs or a degradation of technology shifts it downward left (a range of utilities shrinks). Each point on the curve (points K and E) or within the curve (points L and M ) represents a certain combination of utilities that compose the welfare of two parties. The [UAF ; UBF ] combination is unattainable, since point F lies beyond the welfare possibility curve. One equilibrium can be preferred to another. The Pareto preference is a combination of the two utilities, at which the welfare of at least one party is higher, and all the others are not lower than in the alternative combination. So, points K , E, and M are preferred with respect to point L. At point K , with no decline in the welfare of party A (UAL), the welfare of party B is higher (UBK > UBL ). Similarly, at point M, party A enjoys higher welfare (UAM > UAL ) without compromising the welfare of party B (UBL ). At point E, the welfare of both parties improves (UAE > UAL , UBE > UBL ). On the other hand, point K is not Pareto-preferred with respect to point M, since, at point K , the welfare of party B is higher and the welfare of party A is lower than at point M (UBK > UBL and UAL < UAM, respectively). Accordingly, point M is not Pareto-preferred with respect to point K , since the welfare of party A is higher (UAM > UAL ) and that of party B is lower (UBL < UBK ) than at point K . Such equilibriums are called Pareto-incomparable. Consequently, the concept of Pareto-preference does not apply to every pair of points characterizing different combinations of utility. To reveal the optimum combination out of the

495 14.3 · Welfare and Wellbeing

14

variety of Pareto-preference and Pareto-incomparable points, one should find the Pareto Optimality, an equilibrium point at which an increase in the welfare of one party is impossible without reducing the welfare of another party. The Pareto optimal points lie at the welfare possibility curve (points K and E). The transition from one point to another is necessarily associated with an increase in the welfare of one party and a decrease in the welfare of another. The concepts of optimality, preference, and incomparability illustrate the thesis we have advanced above—when measuring welfare, one must consider the divergence of interests of economic entities. What seems preferable for one may turn out to be disadvantageous for another. It is obvious that party A would prefer the non-optimal equilibrium at point M to the Pareto optimal equilibriums at points K or E. Similarly, party B would prefer the economy remaining at point K . Their interests could be balanced at point E, at which compromising a certain portion of individual welfare from both sides improves the equality of welfare distribution in the economy. Speaking generally, if one economic system brings the economy to the Pareto optimal point E, and the other drags it away from the welfare possibility frontier to point L, then the first system is more efficient. Therefore, it is natural to demand such an organization of the economy that would bring it as close to the Pareto optimality as possible. The efficiency of Pareto distribution implies the maximization of public utility, although it is a socially neutral criterion. Therefore, a fair (by no means equal) distribution achieved in the market economy (the greatest total utility) is adjusted by a government through the redistributive system. But how can the government achieve the economic optimum when balancing the relationship between economic efficiency and distributive justice? One of the approaches to studying welfare maximization is the Edgeworth Box, a model that combines the utilities of two counterparties and identifies the conditions for achieving an optimal distribution of economic benefits. The box consists of two diagrams with indifference curves (one curve per party). They are located at the intersection of four coordinate axes, each pair of which corresponds to one party (. Fig. 14.6). The origin points A and B

. Fig. 14.6  Edgeworth box with two indifference curves. Source Authors’ development

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. Fig. 14.7  Edgeworth box with the Pareto area. Source Authors’ development

14

located opposite each other are extremums at which one of the parties concentrates all the utilities, while the other has nothing. For example, at point B, party A accumulates the maximum possible amount of goods A and B, and party B possesses no utilities at all. The space within the four axes represents all possible distributions of goods A and B between two parties. Indifference curves express combinations of goods that have equal value for an economic entity. They represent the preferences of both parties. The farther the curve is from the A and B extremums, the greater utility is received by an economic entity when having one or another combination of both goods. For any initial distribution of utilities, there are two indifference curves intersecting at point E1. They reflect the individual degrees of utility for parties A and B. If the curves do not intersect, both economic entities can improve their position through the exchange. In this case, the indifference curves form an area in the Edgeworth box, any point within which brings higher utility to each of the parties (the Pareto area in . Fig. 14.7). This new situation is a Pareto improvement in relation to the initial distribution of benefits. If the indifference curves intersect within the Pareto area (point E2 in . Fig. 14.6), then any other allocation of resources degrades the welfare for at least one of the parties, that is, there is no more mutually beneficial exchange in this case. These points are Pareto optimums. The set of optimums establishes a contract curve C (. Fig. 14.7). If the initial allocation of resources is inefficient (that is, the equilibrium point lies outside the contract curve), then a voluntary exchange of utilities continues until the resulting distribution becomes Pareto-efficient. In the exchange-based system, the Pareto-efficient equilibrium is the one the deviation from which incurs losses to both parties. The set of equilibria forms a negotiation subset of the contract curve. If we assume the system consists of two parties A and B, who each consume two goods the total amount of which is fixed, then the indifference curves can be combined into an Edgeworth box. Horizontal and vertical axes reflect the amounts of goods 1 and 2, respectively. As a rule, the initial distribution point n corresponds to the intersection of indifference curves U0A and U0B.

497 14.3 · Welfare and Wellbeing

14

At the intersection of the indifference curves at point E ∗, both parties win compared to the initial distribution situation at point n. Since the curves intersect, the utility of party A cannot be increased without reducing the utility of party B, and vice versa. That means thatthe distribution of utilities at point E ∗ is Pareto  A A B B efficient ( x1 ; x2 for party A and x1 ; x2 for party B). The contract curve C is a set of Pareto-efficient combinations of utilities for which the marginal rates of substitution of good 1 for good 2 are equal for both parties. The negotiation set is a section of the contract curve C, i.e., the set of intersections of indifference curves within the Pareto area. Within this set, bargaining is advantageous for both parties. For example, in . Fig. 14.7, party A benefits from selling good 1 and buying good 2, while party B benefits by doing the opposite. Thus, an effective Pareto equilibrium is a situation that can not be improved for one party without compromising the welfare of another party. The following conditions must be met to make the Pareto attainable: 5 efficiency in exchange (achieving optimal distribution of benefits between parties); 5 efficiency in production (technological efficiency); 5 optimal structure of the output (simultaneously achieved efficiency in exchange and production). Among the disadvantages of the Pareto criterion is its non-universality. It does not allow us to assess the situation when, as a result of changes in the distribution of benefits, the utility of one of the parties increases, and that of another party decreases (for example, the transition from a combination of utilities at point L to a new combination at point M in . Fig. 14.5). 14.3.3  The Utilitarian Concept

The second approach to assessing public welfare is the utilitarian criterion. Utilitarian philosopher Jeremy Bentham considered welfare to be the greatest happiness of the greatest number of people (further reading: “An Introduction to the Principles of Morals and Legislation”1). Utilitarianism is based on the evaluation of things in terms of their utility and ability to meet certain needs. According to Bentham, an individual is first a consumer aimed at meeting current needs. He cares less about production, as well as about the satisfaction of abstract needs in the future. Wealth is a variation of pleasure. Therefore, all economic and non-economic activities are reduced to multiplying it. This interpretation of wealth is close to the concept of wellbeing (see 7 Sect. 14.3.6 below), since it assumes an interpersonal comparison of happiness and related parameters.

1

Bentham (1789).

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498

. Fig. 14.8  Bentham’s public welfare function. Source Authors’ development

In utilitarianism, public welfare w is the sum of individual utilities u within a community (Eq. 14.1).

w(u1 , . . . , un ) =

n 

ui

(14.1)

i=1

14

n According to the utilitarian criterion, �w > 0 if i=1 (�u1 ) > 0. Let us assume, however, that this requirement is fulfilled even though the welfare of k people has increased, while the welfare of remaining (n − k) members of the community has decreased. The gain of the former turns out to be greater (in absolute value) than the loss of the latter (Eq. 14.2).   n k      (�ui ) (�ui ) >  (14.2)   i=1

i=k+1

Thus, the Bentham criterion implicitly assumes that the welfare of k members of the community is more significant for this community than the welfare of the remaining (n − k) members. Ultimately, a community as an economic unit cares not about the change in the distribution of welfare between individuals. What matters is the final output. The lost utility of one individual is negligible for the total welfare of society, as long as the loss turns into a gain for another individual. This phenomenon can be illustrated by moving along the welfare line W (. Fig. 14.8). The transition to another line is possible only with a simultaneous decrease or increase in the public welfare of both individuals (transitions to lines W0 and W1, respectively). The disadvantage of the utilitarian criterion is that it is inapplicable for comparing situations in which the greatest welfare does not coincide with the greatest number of people. So, if in a three-entity system, U1 = 6x, U2 = 2x, and

499 14.3 · Welfare and Wellbeing

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U3 = 1x, then the total welfare is Wi = 9x. In an alternative combination, U1 = 3x, U2 = 2x, and U3 = 2x making Wj = 7x. In the latter case, the total welfare is lower Wj < Wi , but the distribution of utility is more even. 14.3.4  Cardinal Utility

In contrast to the utilitarian approach, which allows for measuring utility and the additivity of individual utilities, the cardinal approach is based on assessing the decreasing marginal utility of monetary income. Its meaning is that an economic entity A whose income is higher than the income of economic entity B (for example, IA = 2IB) can acquire twice as many benefits as entity B. However, the additional utility gained by entity A from the consumption of additional goods is less than twice as large as that of entity B. According to the law of diminishing utility, the growth of individual monetary income increases its utility, but a lesser  to  extent. When the total monetary income or total output I is limited I = ni=1 Ii , the cardinal criterion for the fair distribution of income I can be represented as follows (Eq. 14.3):

w=

n 

(14.3)

ui (Ii )

i=1

  dui As income grows, its utility increases , but the gain per each addi> 0  dIi  2 d ui tional unit of income declines dI 2 > 0 . The efficiency of a particular variant of i

income distribution depends on individual features of utility functions of income

ui (Ii ). If we assume that people do not differ much by their ability to extract utility from income when exchanging (u1 (I1 ) = u2 (I2 ) = · · · = un (In )),  it for real goods  then given the assumptions ui′ > 0; ui′′ < 0 , we admit that the criterion w favors income equalization. When wealth is redistributed in favor of lower-income communities, their gain in utility exceeds the loss of upper economic brackets. However, by accepting   that people differ in their ability to extract   utility from income ( ui′ (Ii ) > uj′ Ij at Ii = Ij), we shall agree that ui′ (Ii ) = uj′ Ij only if Ii < Ij. Thus, depending on the assumption of the equal or unequal ability of people to extract utility from income, the cardinal criterion demonstrates both equal and unequal distribution of income. 14.3.5  The Rawls Criterion

In the early 1970s, John Rawls proposed an approach to explaining the distribution of income in conditions of uncertainty (further reading: “A Theory of Justice”2). At some initial point, society chooses a system of income distribution that it considers to be fair and beneficial for future growth and development. For 2

Rawls (1971).

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Chapter 14 · Social Issues of Economic Growth

. Fig. 14.9  Rawls welfare criterion. Source Authors’ development

14

each member of society, this future is hidden by the veil of ignorance. That means that no one knows for sure what income level or social status may be attained in the future. Thus, in Rawls’ concept, the veil of ignorance eliminates the influence of the current status of each individual on his perception of value and utility. Since most people are risk-averse, they naturally try to insure themselves against low incomes or low social status in the future by choosing the maximin criterion (w = min(u1 , u2 , . . . , un )) as a measure of fair distribution. The criterion assumes that public welfare depends only on the utility (welfare) of lower-income communities. The Rawls criterion is a maximin criterion, because it requires maximizing the utility of that segment of society whose welfare is minimal. Ultimately, public welfare is determined by the welfare of the least well-off members of society (. Fig. 14.9). If in the initial position (point E) individuals have equal welfare, then the growth of personal welfare of individual 1 from U1E to U1A (movement from point E to point A) with no change in the welfare of individual 2 (U2E ) contributes nothing to the increase in the total public welfare. Similarly, the increase in utility of individual 2 from U2E to U2B (shift from point E to point B) has no effect on the total welfare: the welfare curve W remains at the same position. Therefore, an ­increase in the welfare of the upper economic brackets does not increase the total public welfare. The total welfare curve shifts upwards from W to W1 only due to the simultaneous increase in the welfare of both individual 1 and individual 2 (upperincome and lower-income segments of society). 14.3.6  The Concept of Social Wellbeing

In the broadest strokes, the variety of approaches to measuring public welfare can be reduced to the most effective use of all types of tangible and intangible resources within a community. Such an interpretation of public welfare expands the

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. Table 14.3  Parameters of social wellbeing Criteria

Indicators

Material wellbeing

Income level, housing conditions

Physical wellbeing

Health conditions, personal safety

Individual social wellbeing

Interpersonal relationships, participation in social life, satisfaction with social status and social roles

Emotional wellbeing

Positive personality functioning, personal growth, social respect and status, mental health, stress, beliefs

Professional wellbeing

Professional competencies, labor productivity, human development opportunities and capabilities, career development, growth, promotion

Source Authors’ development

very concept of welfare to the concept of wellbeing. Social Wellbeing is an overall performance parameter of the social sphere, which aggregates the measures of public welfare, quality of life, and social security. It is a complex social phenomenon determined by the features of the everyday economic and social environment and people’s needs and expectations. Social wellbeing includes such elements as the standard of living reflected by average per capita income and the subsistence minimum and the quality of life determined by the parameters of health and sanitary wellbeing and the access of all people to adequate medical care. It also includes security-related issues, such as life safety, food security, and environmental security. An integral component of wellbeing is social security ensured by social tools that aim at helping a person get support in case of losing subsistence due to various reasons. The social wellbeing of an individual is largely based on the overall welfare of the entire society, but it is not reduced to it. As discussed above, an individual perception of wellbeing matters (even more than the perception of welfare which can be reflected by economic variables). Commonly, satisfaction is not directly related to prosperity (material wellbeing), but also implies physical, professional, and emotional wellbeing (. Table 14.3). Achieving wellbeing in one area does not mean achieving social wellbeing in general, since in certain situations, the specific weight of certain parameters may change significantly. For example, during lockdowns in 2020, many people prized emotional wellbeing over material one. In the context of globalization of economic and social development it is also necessary to consider the indicators of quality of life such as access to educational services, health care, sports and cultural facilities, level of subsistence, legal protection, safe environmental situation, and many others. In the global aspect, measuring social wellbeing should not only focus on the external environment, but also indicate that people can change the environment in accordance with their own needs and aspirations. One of the models of social wellbeing is a conservative-inertial (paternalistic) model. It is based on traditional ideas about life success, waiting for help from outside, weak adaptive mechanisms, and passivity. The

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alternative approach is the activity-dynamic (anti-paternalistic) model. It prioritizes active development of the environment, high adaptive abilities, and social activity. Social institutions play an important role in the formation of subjective wellbeing. They contribute to the socialization and adaptation of a person at different levels and in different circumstances. As noted above, social wellbeing is the sum of subjective assessments and established social practices that maintain social security. The latter is one of the core components of social wellbeing. It results from the activities of national, regional, and local authorities and other social institutions. They allow an individual to choose a way of interaction with the state and society. Thus, the responsibility for establishing and maintaining an adequate level of social wellbeing and social security is shared by an individual, society, and the state. In the new normal economic and social reality, threats to social security emerge. Specific local issues are aggravated by exogenous (i.e., less predictable and less manageable) global influences. Despite all the pandemic-related restrictions and the rise in protectionist policies, national borders are no longer insurmountable barriers that hold back new threats. Global problems are universal difficulties and contradictions in the relationship between nature and people, society, the state, and the world community. Many of them were partially implicit in the past, but they have emerged today amid the clash between progressing globalization and the new regionalism and anti-globalization (further discussed in 7 Chap. 23). In fact, contemporary development challenges are not just the consequences of globalization, but the self-expression of this complex phenomenon, which certainly has a social wellbeing dimension (. Table 14.4).

. Table 14.4  Contemporary global challenges to social wellbeing

14

Challenges

Manifestations

Social challenges

Demographic imperative with its many components, problems of inter-ethnic confrontation, religious intolerance, education, health care, organized crime

Social and biological challenges

New diseases of a global scale, genetic safety, drug addiction

Social and political challenges

Rising conflicts and tensions, including military conflicts, weapons of mass destruction, information security, cyberterrorism

Social and economic challenges

Increasing economic, financial, and market volatilities, depletion of non-renewable resources, energy, poverty, employment, food shortage

Spiritual and moral issues

Decrease in the general level of culture, violence and intolerance, inter-generation conflicts

Source Authors’ development

503 14.4 · Poverty

14

The very essence of the welfare state is now reconsidered. It is not just a savior or a supporter, but also a driving force that contributes to leveling social and economic development opportunities and fair usage of social and individual potentials. The combination of economic and social goals and development values has always been spotlighted by society. Economic development should benefit social equalization. In turn, social justice and social equalization can benefit economic development. The understanding of the concept and practice of social policy is being transformed. Its goal is to create an active, fair, and socially cohesive society. The most important attributes of social cohesion should include the availability of financial mechanisms for the redistribution of income in favor of the least well-off. However, in such a comprehensive redistribution of benefits (not only income, but a wide range of tangible and intangible benefits, values, and utilities), social policy actors must operate with many parameters. These are indicators reflecting the level of disposable income and consumption, life expectancy, health and healthcare, housing, and all dimensions of security addressed above. Priorities for the use of certain parameters of social welfare and wellbeing are determined depending on the specifics of a particular country or community. For example, developed countries may prioritize the individual, professional, and even emotional wellbeing of their citizens, while governments in developing countries are mainly concerned about securing material and physical wellbeing, ensuring food security, and fighting unemployment, inflation, and poverty. 14.4  Poverty

The interpretations of welfare and wellbeing discussed in 7 Sect. 14.3 agree that both income-centered welfare and the broader concept of wellbeing are states of opportunities. In the former case, these are the economic possibilities of consuming the desired goods, services, and other values. In the latter one, these are the possibilities of building the desired life strategy by choosing alternatives and establishing individual combinations of material, social, cultural, and other utilities. However, the variety of choices is restricted by numerous factors, one of the most forceful of which is the level of income. The inability of a household to meet basic needs for food, clothing, and housing from its current income is characterized as poverty. Poverty is both a macroeconomic and a humanitarian problem that has gone beyond national boundaries and has become global. It is exacerbated during recessions and economic crises, which makes poverty one of the deadliest threats to sustainable economic development. In its most general form, Poverty can be defined as a lack of opportunities and choices to meet vital human needs. However, in the light of the concepts of welfare and wellbeing discussed above, the essence of poverty should not be reduced to the amount of goods and services that a particular household can afford. Poverty is the socially induced inability of people to get access to the goods, services, and utilities they require (material, social, and cultural). It is the inability to comply with the standards of living and consumption common to most people in society.

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Chapter 14 · Social Issues of Economic Growth

. Table 14.5  Concepts of poverty Concepts

Essence

Absolute poverty

The concept is based on setting a threshold that allows a government to categorize certain segments of society as poor. The categorization is tied to a poverty line measured in monetary terms (for example, the international poverty line used in international comparisons)

Relative poverty

The concept is based on the identification of categories of people with lower income (other kinds of utilities) compared to the majority of the population. Relative poverty is measured by poverty lines set as a percentage of the average or median income in a country. The poverty threshold is thus linked to the median income and fluctuates in parallel with it. This approach allows a government to track the relationship between poverty and the degree of income inequality in a country

Subjective poverty

The concept prioritizes monitoring public opinion and assessing people’s perceptions of the social and economic environment in terms of opportunities to meet their needs and ensure a decent standard of living. It focuses on understanding the motivational attitudes and behavioral patterns of people that affect the economic potential of society

Deprivation

Within the framework of the concept, the poor are those whose consumption does not meet generally accepted standards and those who have no access to a certain set of goods and services. This approach allows a government to measure the depth of social and economic problems, since it explores the insufficiency of consumption (and/or non-consumption) of essential goods and services

Source Authors’ development

14

Studying poverty requires implementing a systematic approach, since poverty has many dimensions (not only economic, but also social, political, cultural, and even psychological). Economic manifestations of poverty are merely effects of internal and external economic environment to a greater or lesser extent distorted by public policies. Different countries approach to dealing with poverty in different ways. In general, however, several commonly accepted methods of measuring poverty can be distinguished. They are absolute poverty (earning less than the established absolute minimum), relative poverty (earning less than the rest), subjective poverty (feeling that the amount of utilities is scarce and insufficient), deprivation approach, as well as integral approach, which brings together a number of measures that reflect multinational nature of poverty (. Table 14.5). Absolute Poverty is a condition where individuals’ or households’ income level is below the poverty line expressed through the cost of a minimum consumer basket corresponding to the minimum standard of living in a particular country. Absolute poverty is understood as the inability of individuals (households) to meet their vital needs (food, clothing, housing). The generally accepted measure of absolute poverty is the international poverty line set by the World Bank at $1.90 a day at 2011 international prices. It is a threshold established on the average of the national poverty lines of fifteen of the poorest countries. Another criterion of ab-

505 14.4 · Poverty

14

solute poverty is the subsistence minimum (see above in 7 Sect. 14.2). Two approaches to establishing the subsistence minimum apply: 5 Statistical method measures specific weights of certain food products in the average consumer basket. The cost is first estimated for each subgroup of the food set at which a required nutritional standard is achieved (for example, the minimum dietary intake level recommended by the World Health Organization). Then the result is divided by the share of food products in the total expenditures of social groups presumably attributed to the poor (for example, the poorest 10%). Indeed, food is an ultimate priority compared to other needs. If the portion of food expenditures in a household’s budget is above a certain threshold, such a household is categorized as poor. Nevertheless, for certain segments of society applying the statistical method may produce misleading results. For example, in rural areas, the share of food expenditures in households’ budgets is usually lower than that in large cities, because rural people consume vegetables, fruit, meat, dairy, and other food products they grow themselves. Still, in most countries, the income per capita in rural areas falls a rather long way short of the income level in cities. 5 Normative method directly assesses whether consumption patterns in particular social groups keep in line with the established norms (for example, adequate nutrition). Based on the physiological needs associated with maintaining human health, a minimum set of food products is established to achieve the recommended amount of nutrient intake. Food consumption is usually estimated in terms of the calorie intake per capita per day. Then the current intakes per income brackets are compared with physiological standards of healthy and adequate nutrition. The minimum required set of non-food products and services is also established. One of the most controversial issues is which non-food products and services should be considered vital to be included in the subsistence minimum. Often, at least two absolute poverty lines are established—one to identify the poor and the other to categorize households in extreme poverty. The poverty line can be established based on the current goals of the social policy or specific circumstances. For example, the poverty bar may be lifted to cover wider segments of society by welfare programs or lowered to reduce social support expenditures of the state. That means that when determining the category of the poor, the government commonly proceeds from the current capabilities of the government budget to render required support to the poor. Case box According to the World Bank, before the COVID-19 outbreak, an estimated 9.2% of the global population lived below the international poverty line of $1.90 a day (further reading: “Poverty and Shared Prosperity 2020”3). This amounted to 689 million ext-

3

World Bank (2020).

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Chapter 14 · Social Issues of Economic Growth

. Table 14.6  Proportion of the population below the $1.90 poverty line in selected countries Bottom ten countries

Share of population below the poverty line, % 2000

2005

2010

2015

2019

South Sudan

–

–

42.46

70.53

80.71

Burundi

84.36

80.35

75.57

75.46

79.53

Madagascar

66.34

71.72

78.18

78.63

76.55

Democratic Republic of Congo

94.76

94.09

85.81

72.46

70.99

Central African Republic

76.19

71.24

61.60

74.61

70.76

Somalia

–

–

–

67.82

68.66

Malawi

57.59

72.52

71.13

68.90

67.55

Guinea-Bissau

53.75

61.07

68.39

67.40

62.65

Mozambique

81.14

76.90

68.33

62.84

62.29

Zambia

48.40

59.07

65.82

58.75

58.52

Source Authors’ development

14

remely poor, 52 million fewer than in 2015. In the developed countries of North America, Europe, and Asia, absolute poverty is negligible (1.00% in the USA, 0.30% in the UK, and 0.73% in Japan), while in the least developed countries of Africa, over 60–70% of the population fall below the poverty line (. Table 14.6). Since 2020, the COVID-19 outbreak has formed a new reality of poverty and inequality. The global trend towards poverty reduction observed in recent decades has reversed. For the first time in many years, in 2021–2022, global poverty resumed growth. According to the World Bank, up to 95 million people around the world fell below the poverty line in 2022. Of course, it is not the pandemic itself that is to blame, but the accompanying economic and social phenomena, such as the loss of sources of income due to lockdowns and shutdowns of businesses and the entire sectors, bankruptcies, supply chain disruptions, inflation, and many others. Not so much the formal parameter of absolute poverty is affected (the international poverty line), but the reduction of income, narrowing opportunities, and overall degradation of the quality of life in previously relatively well-off segments of society. Absolute poverty rises, but governments have been facing this phenomenon for a long time. The approaches to countering absolute poverty are well known and widely practiced. The new reality is the expansion of relative poverty up the social ladder into middle-income and even upper-middle-income communities.

Relative Poverty is a condition where individuals’ or households’ income level is below the poverty threshold that corresponds to a fixed share of average income. This approach makes no use of the subsistence minimum. Relative poverty is not about the lack of basic necessities (although, extreme poverty is comprised

507 14.4 · Poverty

14

in relative poverty), but the relative level of income (below the national average or community average). Relatively poor households receive incomes below average regardless of whether they have sufficient funds to meet their basic needs. According to this approach, poverty is considered a condition where a household fail to match the consumption pattern common to a certain community (the established standards of living and consumption). The relative poverty line is based on the prevailing ratios in the distribution of income among various segments of society. It shows to what extent an individual or a household is poor relative to a certain standard of living. In contrast to the concept of absolute poverty, the concept of relative poverty acknowledges the inevitability of poverty as a social phenomenon. Theoretically, according to the absolute approach, poverty can be combated by pursuing an appropriate anti-poverty policy. The relative concept says that poverty never ceases, since the poverty measure is linked to the average income, not the absolute poverty line. As a social and economic phenomenon, poverty results from inequality in access to tangible and intangible benefits and utilities. This means that, first, poverty can not be combated (but its manifestations can change), and second, poverty is relative in time and space. Case box Along with the absolute criterion of extreme poverty, the World Bank monitors higher poverty thresholds. They can be used as measures of relative poverty (. Table 14.7). The dynamics of these parameters demonstrate the overall growth of income in the world over the past two decades not only across developed countries, but also in the developing world. In China, the proportion of the population with daily incomes above $10 increased from 3.13% in 2000 to 56.17% in 2019. Indeed, China’s unprecedented economic growth since the early 2000s is an exceptional example. In general, however, the share of the population with average and above-average incomes increased in leading developing countries, such as Mexico, Argentina, Brazil, and Indonesia. Poverty is not an exclusive domain of the developing world. Although on a small scale (within 0.5% of the total population), poverty persists in the most developed economies. In the USA, Canada, and Australia, the proportion of the population with incomes below $3.2 per day is 0.25%, in Germany—0.24%, in Japan—0.22%, and in Italy—0.43%.

Subjective Poverty is the financial situation of individuals and households according to their own estimates. This approach to measuring poverty is based on studying individual perceptions of low or insufficient income. There is a link between the subjective perceptions of respondents about a sufficient minimum income and the level of real income the household obtains. People themselves indicate the level of income that would allow them to ensure an acceptable standard of living. The subjective concept allows for self-identification. Respondents identify their income status and assess the level of their welfare and wellbeing by themselves. The performance of the subjective policy approach depends on the objectives of the poverty assessment. Obviously, it is less efficient than the absolute or relative approaches if one needs to determine the exact number of people in need. But it is

14

0.34

0.24

42.36

0.50

Indonesia

Italy

0.25

3.51

0.18

9.96

18.61

0.26

8.48

0.26

–

Russia

South Africa

South Korea

Turkey

UK

USA

Source Authors’ development

0.25

0.25

19.40

0.67

8.12

0.50

12.01

Japan

Mexico

31.74

39.09

0.23

35.31

0.04

17.34

–

6.19

Germany

0.24

France

3.17

0.33

India

0.25

27.77

Canada

12.30

Brazil

China

7.37

0.32

Argentina

3.14

0.25

0.16

1.82

–

18.82

0.30

4.83

0.22

0.43

17.62

33.83

0.24

0.00

1.86

0.25

4.51

0.25

14.64

0.50

0.24

20.43

1.25

16.71

24.82

22.82

0.77

1.25

17.81

15.36

–

–

21.72

0.24

18.46

0.34

0.50

0.34

10.93

0.74

20.43

4.80

20.68

0.24

0.88

30.51

21.59

–

0.15

24.85

0.24

14.30

–

8.30

2010

2000

2019

2000

2010

$3.20–$5.50 a day

$1.90–$3.20 a day

Australia

G20 countries

0.50

0.40

8.02

0.51

19.36

2.94

16.39

0.27

1.24

32.34

33.56

0.26

0.08

11.92

0.25

10.50

–

8.76

2019

1.75

1.75

32.35

5.50

13.72

33.72

26.75

4.23

4.22

4.08

4.58

0.51

1.00

11.04

1.51

22.79

1.96

20.21

2000

1.75

1.50

26.60

3.26

16.42

21.57

30.65

0.75

2.68

18.28

7.51

0.49

0.61

26.19

0.75

23.36

1.00

18.34

2010

$5.50–$10.00 a day

. Table 14.7  Proportion of the population below the World Bank poverty lines in selected G20 countries

1.00

1.28

20.28

1.76

15.80

19.14

32.81

1.28

2.56

30.47

14.92

0.74

0.30

28.98

0.75

20.05

0.73

19.65

2019

97.00

97.51

37.16

92.50

15.86

28.40

29.43

94.02

92.79

0.86

1.22

99.26

98.75

3.13

97.75

34.34

96.69

40.87

2000

96.50

97.83

58.19

95.25

27.58

72.87

36.03

98.77

94.84

6.18

2.33

99.27

99.11

20.27

98.76

51.20

98.32

59.73

2010

Above $10.00 a day

97.23

97.86

69.52

97.40

26.35

77.56

44.23

97.51

95.32

16.69

5.10

98.80

99.31

56.17

98.47

60.34

98.52

59.09

2019

508 Chapter 14 · Social Issues of Economic Growth

509 14.4 · Poverty

14

useful in a political sense in determining the degree of social satisfaction of the population and the dynamics of its change. People may consider themselves to be poor, but a government may not recognize them as poor according to the absolute criterion of the subsistence minimum, and vice versa. Deprivation is a social process of reduction and/or deprivation of opportunities to meet the basic needs of an individual. Within the framework of social analysis, deprivation is defined as inequality of access to social benefits. Deprivation encompasses poverty and other forms of social disadvantage. In the 1960s, Peter Townsend identified major deprivations across various spheres that compose the overall wellbeing of an individual (further reading: “The Meaning of Poverty”4). The presence of any deprivation from the expert list means that a household has insufficient resource potential for optimal inclusion in the life of the society to which it belongs. To measure deprivation, statistical services in many countries use the deprivation method based on comparing the financial situation of a particular household with certain standards. These standards depend on the economic and social situation in a country and national and territorial specific and are therefore relative criteria. Some of the criteria include the availability of food, the availability of clothing appropriate to climatic conditions, the availability of health and education services, the quality of housing conditions, the safety of life and property, employment and working conditions, and the availability of means of communication, among others. Those who lack any of these utilities are considered poor. Combining different poverty parameters makes it possible to significantly clarify the poor population, since the status of poor is given to families or individuals who simultaneously meet several poverty criteria. On the one hand, the combined approach to measuring poverty denies the status of the poor to families that do not experience deprivation or do not consider themselves poor at a low level of current wellbeing. It confirms the thesis of concealment and instability of income received. On the other hand, it also denies the status of poor to a significant proportion of families recognized as poor only by deprivation or subjective concepts, but with a level of wellbeing that provides them with minimal means of subsistence. Thus, the multi-criteria poverty line eliminates the errors in identifying the poor that are unavoidable when using the methods separately. Thus, poverty studies are based on the use of a variety of statistical indicators which should be reliable, comparable in time and space, and available for measurement. The main indicators include the following: 5 proportion of the poor population (index of the number of poor); 5 income differentiation coefficient; 5 poverty gap; 5 poverty severity (mean-square poverty gap). The proportion of the poor population (index of the number of poor) (Eq. 14.4) is the proportion of the population whose income or consumption is

4

Townsend, P. (1962).

510

Chapter 14 · Social Issues of Economic Growth

below the poverty line, i.e., the proportion of the population that cannot afford to buy goods from the minimum consumer basket.

H=

q n

(14.4)

where: H   proportion of the poor population; n total population of a country; q number of people recognized as poor. The rate of poverty depends not only on the average per capita income, but also on the distribution of the income by population group. To estimate the distribution, the income differentiation coefficient is used. It is the ratio of income of the wealthiest 10% of the population and the poorest 10% of the population. A parameter of the poverty gap (Eq. 14.5) shows how far below the poverty line a household is. The poverty gap determines the poverty deficit of the entire population. The poverty deficit concept refers to the amount of resources needed to get the poor out of poverty. The poverty gap directly reflects the average deficit in total income or consumption for the entire population relative to the poverty line. This indicator is obtained by adding up all the deficits of the poor and dividing the result by the population. In other words, this indicator measures the total amount of resources needed to raise all the poor to the poverty line (divided by the population). This parameter can also be used for non-monetary indicators, provided that the distance indicator can be interpreted. For example, the poverty gap in education can be defined as the number of years of education required to reach a certain threshold. It should also be borne in mind that the poverty gap can be used as a parameter for the minimum amount of resources needed to eradicate poverty, i.e., the number of subsidies, donations, etc. to lift all the poor out of poverty, when all beneficiaries are identified (i.e., that each poor person receives exactly the amount of assistance that they need to get out of poverty.

14

 q  1  z − yi PG = n z

(14.5)

i=1

where: y  level of income or consumption in household i ; z  poverty line of household i . Poverty severity (mean-square poverty gap) considers not only the distance to the poverty line (poverty gap), but also inequality among the poor. Households that are further below the poverty line are heavily affected. The income deficit coefficient is commonly used to determine poverty severity and demonstrate the distribution of income among the poor (Eqs. 14.6–14.8).

P = H[I + k(1 − I)G]

(14.6)

511 14.4 · Poverty

I =1− k=

µ2 z

q q+1

14 (14.7) (14.8)

where: I income deficit coefficient; µ2  income of the poor; z poverty line; k coefficient that tends to 1 for large values of q; G Gini index for the poor. These indicators can be calculated on a household basis, i.e., by determining the proportion of households below the poverty line. Also, they can be determined at the level of individual residents by taking into account the number of people in each household. The poverty gap and poverty severity indicators are important additional parameters that illustrate the distribution of poverty. It is possible that certain groups have a high incidence but low poverty gap (if many group members are only slightly below the poverty line), while in other groups, there could be a low proportion of the poor, but a high poverty gap for those who are poor (when most members of the group are above the poverty line, but the level of consumption and income is still low). Poverty can also be measured by the ability to achieve certain benefits. The deprivation index for any of the basic human capabilities is calculated as the proportion of the population that does not have a standard level of meeting the needs of the total number of potential consumers of such goods. Five indexes could be applied: 5 Educational disability index can be calculated as the ratio of the number of children aged 3–17 who do not attend kindergarten or school to the total number of children in the corresponding age group. 5 Limited employment index is calculated as the ratio of the number of unemployed who suffer from a persistent form of unemployment or who work parttime (not on their own, but while on forced unpaid leave) to the number of employed. The index can also be calculated as the ratio of the number of people who work without education or qualifications to the number of the economically active population. 5 Healthy lifestyle index is determined by the ratio of the number of people who live in polluted territories, as well as in territories that are characterized by excessive content of harmful substances in drinking water and atmospheric air, to the total population. 5 Housing index is determined by the ratio of the number of families that live in conditions that do not meet sanitary and social standards, to the total number of households.

512

Chapter 14 · Social Issues of Economic Growth

5 Medical services index is calculated as the ratio of the population that is geographically remote from the first aid station, served by a medical institution that is insufficiently provided with specialists or is not equipped with the necessary medical equipment, to the total population.

14

Based on the five indexes of limited access to basic features, an integral index is calculated. It combines the values defined for each of the five individual indexes. Such integral parameters can become an effective tool for social policy. When determining the right of a household to receive targeted social assistance, the calculation of the integrated poverty index could reflect specific features of poverty in the region and thus correct the coefficient. With an integrated approach to measuring poverty, the poverty index aggregates monetary (GDP per capita) and non-monetary indicators of employment, health, and education. The global Multidimensional Poverty Index (MPI) is an international measure of acute multidimensional poverty complementing traditional monetary poverty measures by capturing the acute deprivations in health, education, and living standards that a person faces simultaneously. While certain aspects of wellbeing do depend on income, many others do not. As we have defined above, poverty can not be reduced to low income. It is the lack of basic opportunities to maintain a minimum acceptable quality of life in society. In order to maintain an acceptable standard of living and not become impoverished due to lack of income, one needs to be healthy and well educated. In other words, individual features that allow one to earn income matter. MPI measures poverty across three dimensions (living standards, health, and education) and ten parameters. Living standards indicators of poverty include assets, cooking fuel, drinking water, electricity, housing, and sanitation. The parameters of nutrition and child mortality establish the health dimension of poverty, while the education dimension captures years of schooling and school attendance. The MPI ranges from 0 to 1, and higher values imply higher multidimensional poverty. According to the most recent MPI 2021, 1.3 billion people (21.7% of the world’s total population) across 109 developing and least developed countries (mainly in Sub-Saharan Africa and South Asia) live in acute multidimensional poverty (. Table 14.8). The COVID-19 pandemic has transformed contemporary poverty tendencies and increased the number of the poor not only across the developing world, but also in developed countries. However, factors other than the pandemic have also been shaping the new normal poverty patterns. Deeper social, economic, political, and even civilizational processes affect the new normal poverty and its impacts on the economic and social development of countries and the entire global economy. Although a significant proportion of the new poor will be concentrated in the least developed countries, which suffered from the poverty-related issues well before the pandemic, middle-income countries will also be significantly affected by the consequences of both the pandemic itself and economic and social anti-pandemic measures (inflation, closure of businesses and industries, unemployment, disrupted value chains, and others). Up to 95 million of the new poor will be concentrated in middle-income countries (more than three-quarters of the to-

MPI

0.517

0.461

0.409

0.384

0.376

0.373

0.368

0.367

0.341

0.331

0.293

0.284

0.282

0.281

0.272

0.263

Countries

Chad

Central African Republic

Burundi

Madagascar

Mali

Guinea

Benin

Ethiopia

Guinea-Bissau

Democratic Republic of the Congo

Sierra Leone

Tanzania

Angola

Uganda

Afghanistan

Papua New Guinea

25.8

24.9

25.7

32.5

27.5

28.0

36.8

35.9

41.9

40.9

43.5

44.7

45.5

46.1

55.8

64.6

Population in severe multidimensional poverty, %

25.3

18.1

23.6

15.5

23.4

21.3

17.4

20.0

18.4

14.7

16.4

15.3

14.3

15.8

12.9

10.7

Population vulnerable to multidimensional poverty, %

. Table 14.8  MPI dimensions and indicators: bottom twenty countries in 2021

65.3

45.0

54.5

46.8

55.2

53.0

57.0

45.8

54.5

42.9

40.3

39.3

51.5

49.0

52.0

44.3

Living standards

4.6

10.0

24.0

21.2

22.5

23.0

23.1

19.1

14.0

20.8

21.4

19.6

15.5

23.8

20.2

19.1

Health

(continued)

30.1

45.0

21.6

32.1

22.3

24.1

19.9

35.0

31.5

36.3

38.4

41.2

33.1

27.2

27.8

36.6

Education

Contribution of deprivation in dimension to overall multidimensional poverty, %

14.4 · Poverty 513

14

5

0.263

0.261

0.259

0.259

Senegal

Mauritania

Liberia

Rwanda

22.2

24.9

26.3

27.7

Population in severe multidimensional poverty, %

25.8

23.3

18.6

18.2

United Nations Development Programme (2021).

(2021)5

Population vulnerable to multidimensional poverty, %

Source Authors’ development based onUnited Nations Development Programme

MPI

14

Countries

. Table 14.8  (continued)

55.9

51.7

46.6

30.9

Living standards

13.6

19.7

20.2

20.7

Health

30.5

28.6

33.1

48.4

Education

Contribution of deprivation in dimension to overall multidimensional poverty, %

514 Chapter 14 · Social Issues of Economic Growth

515 14.5 · Inequality

14

tal increase). Four out of every five people below the international poverty line live in rural areas, although the rural population accounts for only 48% of the world’s population. Many of the new poor are likely to be employed in informal services, construction, and manufacturing, i.e., those sectors in which economic activity has been most affected by various kinds of anti-pandemic restrictions. Before the COVID-19 outbreak, about half of the poor were children under fifteen, although that age group accounted for only a quarter of the world’s population. Children and youth (15–24 years) make up two-thirds of the global poor. The new normal feature of poverty is poverty among the economically active working population. The new poor over the age of fifteen will be predominantly employed in the non-agricultural sector (manufacturing, services, and trade). A significant proportion of the poor is women. While women’s poverty rates are low in Europe, North America, and most Latin American countries, gender-related poverty issues are rather common in Southeast Asia and Africa. Another new normal feature is poverty among the relatively educated strata of society. Globally, 35% of poor adults above fifteen have never received any education. A lower level of education is more common in rural areas compared to urban ones. 14.5  Inequality

Poverty is immanent to all types of economic systems. At all times, poverty slowed down the economic, social, technological, and political development of society. Nevertheless, poverty itself is not as damaging to the stability of economic development and growth as inequality. It is inequality that creates structural imbalances in the economy and society that compromise the stability of the entire system, reduce the performance of factors of production and resources, and trigger social and economic turbulences. Like poverty, inequality is not a new phenomenon, but in today’s economic reality, it creates new challenges for the entire world economy as an intertwined set of markets and communities. The new normal manifestations of inequality in the global market are addressed in 7 Chaps. 21–23 in relation to labor markets, trade, and global economic development. In this section, we summarize the fundamentals of economic and social inequality. Economic Inequality is the difference between individuals and social groups in the level of income, wealth, and standard of living. The multidimensional concept of economic inequality contains various aspects (see the components of welfare and wellbeing discussed above). Still, income inequality is the fundamental one. Inequality, or income differentiation, is the result of the income distribution. It expresses the degree of unevenness in the distribution of utilities and benefits. Inequality is manifested in unequal proportions of income received by different segments of society. The main causes of inequality include wage differentiation, the difference in inherited and acquired wealth, uneven distribution of property, unequal starting conditions for individual labor activity and entrepreneurship, differences in the level of education and physical, mental, and entrepreneurial abilities, and demographic factors (age, gender, marital status).

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An economic inequality could be defined through the concepts of income, wages, and wealth. Income is not only money received from wages, but also all money received from work (salaries, bonuses, bonuses), investments (interest on savings accounts and dividends from shares), savings, government benefits, pensions, and rent. Wages differ from income. It can be hourly, monthly, or yearly. It is usually paid weekly or monthly and includes bonuses. It can be within one company or the entire salary received in a country. Wealth refers to the total assets of an individual or household. It may include financial assets such as bonds and shares, property rights, and private pension rights. Wealth inequality refers to the unequal distribution of assets in a group of people. Therefore, inequality is a multidimensional phenomenon that affects all areas of society, but there is no universal methodology for measuring it. In the context of ensuring sustainable development, there is a need for a comprehensive assessment of the level of economic inequality and poverty in order to further substantiate the mechanism for coordinating development activities and government policies. In general, economic inequality refers to the differentiation of income received by different groups of the population. Measuring economic inequality is about determining the extent of stratification of the population by income level and identifying the main factors that affect such stratification. The study of economic inequality is carried out using three kinds of variation series of income distribution: 5 Distribution of households by per capita monetary income grouped by fixedsized intervals. This distribution is carried out by different types of households, for instance, urban and rural, with and without children, etc. 5 Distribution of the total monetary income of the population by 20% and 10% segments. It allows calculating the quintile and decile coefficients of differentiation and estimating income concentration. 5 Distribution into groups proportional to the size of the subsistence minimum. It allows for assessing the social structure of the population (poor, low-income, middle-class, rich, etc.) and its dynamics.

14

Statistical indicators such as the decile dispersion ratio and the Gini concentration coefficient are most often used for monetary assessment of economic inequality. The decile dispersion ratio shows differences in the income level of the richest 10% and the poorest 10% of the population (Eq. 14.9).

D=

W P

(14.9)

where K decile dispersion ratio; W   the wealthiest 10% of the population; P the poorest 10% of the population. The disadvantage of the decile method is that it measures income in diametrically opposite groups of the population, while the information about incomes in

517 14.5 · Inequality

14

. Fig. 14.10  Lorenz curve. Source Authors’ development

the middle of the income distribution is ignored. This is why alternative methods of measuring economic inequality are used widely in both national studies and international comparisons. Vilfredo Pareto found an inverse relationship between the level of income and the number of recipients (further reading: “Manual of Political Economy”6). Later, based on the Pareto principle, Max Lorenz offered a graphical representation of income inequality or wealth inequality in the form of a curve (further reading: “Methods of Measuring the Concentration of Wealth”7). Lorenz Curve is a graph showing the degree of inequality in the distribution of income in society or sector, as well as the degree of inequality in the distribution of wealth (. Fig. 14.10). The Lorentz curve LC represents the cumulative distribution of the population P and the corresponding income I . It shows the ratio of percentages of all income to percentages of all recipients. If income were distributed evenly, i.e., 10% of recipients would have 10% of the income, 50%—a half, and so on, then this distribution would look like a diagonal square with sides from 0 to 100%. In . Fig. 14.10, the EC line represents the fictional line called the line of equality, i.e., the ideal graph when income or wealth is equally distributed amongst the population. In reality, the distribution is different from the ideal model. For example, PA % of the population receives IA % of all income, PB % − IB %, etc. The LC curve visualizes the actual distribution of wealth between economic brackets. The bend of the LC curve reflects unevenness of income distribution: the farther the curve away from the EC line, the greater the inequality.

6

Pareto (2014).

7

Lorenz (1905).

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The Lorenz curve can be used to compare the distribution of income over time, in different countries, or between different population groups, taking into account pre- and post-tax income and transfer payments. For example, there could be found the share of a certain population group in the total amount of income, or what part of the population obtains a given share of total income. Such problem setting allows analyzing the degree of income concentration among different groups of the population and quantifying the unevenness of their distribution. While the Lorenz curve is most often used to represent economic inequality, it can also demonstrate unequal distribution in any system. Because the curve visually displays the distribution across each percentile, it can show precisely at which income percentiles the observed distribution varies from the line of equality and by how much. However, because constructing the Lorenz curve involves fitting a continuous function to some incomplete set of data, there is no guarantee that the values along a Lorenz curve actually correspond to the true distributions of income. Most of the points along the curve are just guesses based on the shape of the curve that best fits the observed data points. So, the shape of the Lorenz curve can be sensitive to the quality and sample size of the data and to the mathematical assumptions and judgments as to what constitutes the best fit curve. These may represent sources of substantial error between the Lorenz curve and the actual distribution. Hence, we can say that the Lorenz curve is the graphical method of studying dispersion. By its bend, the Lorenz curve presents the degree of income inequality in the economy. To quantify this degree, Italian statistician Corrado Gini proposed the Gini coefficient (further reading: “Variability and Mutability”8). The Gini Coefficient is the ratio of the area between the line of absolute equality EC and the Lorenz curve LC to the area between the line of absolute equality EC and the line of absolute inequality PE E. It is often used as a gauge of economic inequality, measuring income distribution or, less commonly, wealth distribution. The Gini coefficient ranges from 0 (perfect equality) to 1 (complete inequality). The closer the value is to 0, the smaller the bend in the Lorenz curve, and the income is distributed more evenly. The closer the Gini is to 1, the greater the bend in the Lorenz curve, and the more unequal the distribution. The Gini coefficient has important advantages over other indicators, as well as it has several limitations. First advantage is that it can be easily visualized. Second, as with any aggregate measure, it allows for general conclusions regarding inequality trends. At the same time, it does not identify whether rises or falls in inequality are triggered by changes at the bottom, middle, or top of the distribution. The coefficient is more responsive to changes in the middle of the distribution than other indices and less responsive to changes at the very bottom and at the very top.

8

Gini (1912).

14

519 14.5 · Inequality

. Table 14.9  Gini coefficient in selected countries in 2000–2019 Top ten countries

2000

2010

2019

Bottom ten countries

2000

2010

2019

Slovenia

24.04

24.93

24.63

Botswana

54.21

54.21

53.33

Slovakia

26.28

27.32

24.97

Brazil

58.99

53.69

53.43

Czech Republic

25.80

26.62

24.99

Mozambique

53.56

53.56

54.00

Belarus

31.17

28.57

25.28

Eswatini

60.45

60.45

54.58

Moldova

36.43

32.05

25.66

Central African Republic

61.33

56.24

56.24

United Arab Emirates

32.51

32.51

25.97

Sao Tome and Principe

32.13

30.82

56.32

Iceland

26.84

26.17

26.13

Zambia

49.13

55.62

57.14

Azerbaijan

34.65

26.55

26.55

Suriname

57.61

57.61

57.61

Ukraine

28.96

24.82

26.62

Namibia

63.32

63.32

59.07

Belgium

33.14

28.38

27.21

South Africa

60.69

63.38

63.03

Source Authors’ development

Case box The Gini coefficient is an important tool for analyzing income or wealth distribution within a country or region, but it should not be mistaken for the absolute measurement of income or wealth. A high-income country and a low-income one can have the same Gini coefficient, as long as incomes are distributed similarly within each. Some of the world’s poorest countries have some of the world’s highest Gini coefficients (about 60), while many of the wealthiest have some of the lowest (below 30) (. Table 14.9). Yet the relationship between income inequality and GDP per capita is not one of perfect negative correlation, and the relationship has varied over time. According to the World Inequality Lab, the global concentration of wealth is extremely high. The richest 10% of the world’s population currently account for 52% of the global wealth, compared to 8% of wealth for the poorest 50%. On average, a representative of the top 10% bracket earned $122,100 a year in 2021, while an individual from the poorest 50% earned only $3,920 a year, or 30 times less (further reading: “World Inequality Report 2022”9).

Inequality in income distribution can be reduced by levying income tax on higher-income segments of society (progressive taxation and other fiscal policy instruments are discussed in 7 Chap. 13) and redirecting transfers to the poor. Transfers are non-reciprocal payments to the unemployed, the retired, and other

9

World Inequality Lab (2021).

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Chapter 14 · Social Issues of Economic Growth

. Fig. 14.11  The shift of the Lorentz curve due to the collection of income taxes and the payment of transfers. Source Authors’ development

14

categories of people in need of social protection. A more even distribution of income contributes to strengthening stability in society and allows for maintaining balance in commodity markets. Therefore, income equality is considered an important economic goal. To achieve it, governments apply various social and economic policy measures, such as income tax rates differentiated depending on the level of income (progressive taxation), high inheritance taxes, minimum wage, transfers to vulnerable groups, social programs to incentivize human ­development and occupational mobility of labor, and many more. Both tax instruments and social support measures serve the same purpose—to reduce the bend of the Lorenz curve LC and bring it closer to the ideal even distribution EC. If taxes operate in the upper-income bracket (people with the highest incomes), then transfers push the LC curve upward to LC1 by reducing the proportion of people with low incomes (. Fig. 14.11). Any statistical indicator has its flaws. Just as the GDP indicator cannot be used to judge the level of economic wellbeing, the Gini coefficient (and other indicators of inequality) cannot give a fully objective picture of the degree of income inequality in the economy. This happens for several reasons: 5 First, the level of income of individuals is not constant. Sometimes, it changes dramatically over time. The income of young university graduates is usually low, but it grows as they gain experience and develop their professional capacities. The income tends to peak between the ages of 40 and 50, and then declines sharply when an individual retires. But an individual can compensate for the difference in income at different stages of the life cycle through various financial activities, for instance, taking loans or making savings. Younger people who are at the beginning of their life cycle are more inclined to take loans for education or business. People who are closer to the end of the economic

521 14.5 · Inequality

14

life cycle tend to make savings. The Lorenz curve and the Gini coefficient do not take into account the life cycle, which means they could be inaccurate in the estimation of the degree of income inequality. 5 Second, income is affected by the economic mobility of people. The US economy is an example of an opportunity economy, where anyone could become successful and rich due to a combination of diligence, talent, and luck. But there are also cases of loss of large fortunes or even complete bankruptcies of quite wealthy entrepreneurs. Due to high economic mobility, an individual or a household can experience various statuses of income distribution during their lifetime. The Lorenz curve and the Gini coefficient do not take the effect of economic mobility into account. 5 Third, individuals may receive transfers that are not reflected in the Lorenz curve, although they do affect the distribution of individual income. These could be various forms of assistance to the poorest segments of the population with food and clothing. They could also be provided in the form of numerous benefits (free travel on public transport, free trips to health resorts, etc.). With such transfers, the income status of poor people improves, but such improvement is not referred to by the Lorenz curve and the Gini coefficient. Therefore, the Lorenz curve and the Gini coefficient might not always be rigorously true for a finite level of population, which means that the equality measure shown may be misleading. When two Lorenz curves are being compared and such two curves intersect, it is not possible to ascertain which distribution represented by the curves displays more inequality. Also, the variation of income over the lifecycle of an individual is ignored by the Lorenz curve while determining inequality. The complexity of such a phenomenon as economic inequality gives rise to the existence of other indicators of its measurement. Among the most widely used are the Theil indexes and the mean log deviation measure. Both belong to the family of generalized entropy inequality measures. The values of generalized entropy measures vary between 0 and infinity, with 0 representing an equal distribution and higher values representing higher levels of inequality. Another method is Atkinson’s Inequality Measure. It allows one to measure shifts in the distribution of income among segments with different incomes. The construction of the Atkinson index is based on two assumptions. Firstly, the utility of the income of each of the n members of society is expressed by the following function (Eq. 14.10). For e = 1, utility is described by the function U(Yi ) = lnYi. These functions are characterized by decreasing marginal utility. Functions of this type are also used in models of consumer behavior in risk-associated situations. The elasticity of marginal utility by income is constant (equal to (−e)).

ui = U(Yi ) =

(Yi )1−e 1−e

where: ui  utility of income of an individual i ; Yi  income of an individual i ; e constant (e ≥ 0).

(14.10)

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Chapter 14 · Social Issues of Economic Growth

The second assumption is that the public welfare function W is the sum of individual utilities (Eq. 14.11).

W (u1 , u2 , . . . , un ) =

n 

U(Yi ) =

i=1

n  (Yi )1−e

(14.11)

1−e

i=1

The equivalent level of income Ye is income I , which under even distribution allows society to achieve the same level of wellbeing as with the current distribution of income (W (U(Ye ), . . . , U(Ye )) = W (U(Y1 ), . . . , U(Yn ))). Proceeding from such interpretation of Ye and considering Eqs. 14.10 and 14.11 for   1−e 1−e e) i) = ni=1 (Y1−e n × (Y1−e , n × ln Ye = ni=1 ln Yi. This implies that for e = 1,  1   1 n 1−e n , and for e = 1, Ye = Ye = n1 ni=1 (Yi )1−e i=1 Yi . The Atkinson index is defined as follows (Eq. 14.12):

IA = 1 −

Ye Y

where: IA  Atkinson index;  Y   arithmetical mean of income Y =

14

(14.12)

1 n

n

i=1 Yi

 .

From a statistical point of view, the equivalent income is a power mean of degree 1 − e (geometric mean at e = 1). For e = 0, the power mean coincides with the arithmetic mean. The general feature of power means (provided that the individual values of the averaged value are not the same) is that the smaller the exponent, the smaller the average. But if the individual values are the same, then any average value is the same as the individual one, and therefore, all averages are equal to each other. Thus, if income is evenly distributed, then Ye = Y . But due to individual differences, the equivalent income is less than the arithmetic mean. Equivalent income characterizes the minimum level of average income (and, consequently, the total income of all members of society), which would allow achieving the same level of wellbeing that is achieved with the existing average income and the existing inequality. The gap between Y and Ye the greater, first, the greater the income differentiation, and second, the greater the parameter e, which is a measure of society's inequality aversion. With e → ∞, the equivalent income tends to the minimum attainable level in a given society in a certain social, economic, political, and cultural environment (the lowest possible or absolute inequality aversion). The Atkinson Index is thus a relative (in terms of total income) expression of the price that society pays for the existing level of social inequality. To summarize, we must say that inequality and poverty are global social and economic problems that not only burden the lives of millions of people around the world, but also compromise the entire way the global economy is developing. The new normal features of poverty and inequality involve social, economic, political, cultural, and environmental dimensions. Inequality is a social problem,

523 14.5 · Inequality

14

since social stratification and income differentiation degrade the quality of education and human development, depress occupational and social mobility, affect health and life expectancy in certain social groups, and reduce motivation to improve the quality of labor. Due to the lack of resources and opportunities, it is difficult for poor people to adapt to the modern dynamic environment and promote to upper economic brackets. Inequality is also an economic problem, because it fuels imbalances in the market. Due to income stratification, producers cannot optimally adjust the supply to the needs of the larger segment of society and are forced to focus on narrow target groups in which demand is limited. This decreases the performance of factors of production. Rising inequality multiplies the number of low-income consumers. Their effective demand degrades both in terms of volume and assortment. Low-income households, first, try to spend less, second, the volume of their spending is insignificant, and third, their demand is extremely limited in terms of assortment (low value-added food staples and basic necessities). Inequality and poverty gear down environmental and climate change mitigation efforts, since poorer countries and communities cannot afford to implement advanced pollution control or recycling technologies. The cultural and political aspects of poverty and inequality are manifested in rising segregation and separation of upper-income and lower-income segments of society from each other. Their lifestyles, values, and behavior patterns diverge substantially. The new normal inequality is a paradoxical phenomenon that comprises two oppositely directed trends. Global inequality between countries has been declining in recent decades. The impressive economic advancement of certain developing countries (mainly, in Asia) has been reducing the overall global gap between the developed and developing worlds. If the COVID-19 pandemic has not reversed this convergence process, it has undoubtedly slowed it down. During the first waves of the outbreak in 2020–2021, the wealth of the world’s billionaires grew by $3.7 trillion, which is almost equivalent to the total annual public health budgets of all governments worldwide before 2020. During the same period, an additional 100 million people worldwide found themselves in extreme poverty due to the economic and social consequences of the COVID-19 pandemic and anti-pandemic measures. Still, the overall inequality between countries is much lower today than it was in the XX century. The closing-in of cross-country income gaps is to continue despite temporary setbacks due to relatively short-term crises. Another phenomenon is the growth of inequality within countries. Paradoxically, global inequality is decreasing amid rising inequality at the national level. Such decomposition of global inequality highlights the social and political consequences of the interaction of globalization (global convergence) and regionalization (national stratification) (further discussed in 7 Chap. 23). Chapter Questions: 5 What is the core goal of social policy? Have the social policy priorities and goals transformed since 2020 under the influence of the COVID-19 pandemic? 5 Characterize the social protection model implemented in your country of residence.

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Chapter 14 · Social Issues of Economic Growth

5 Explain the essence of social stability and social justice. Can socially stable economic development be unfair in terms of wealth distribution? 5 How would you distinguish subsistence minimum from minimum wage? Should minimum wage be always equal to the subsistence minimum? 5 Discuss potential effects of too deep income inequality, on the one side, and too intensive income equalization, on the other. 5 In your opinion, what is the fundamental difference between welfare and wellbeing? Which parameters of welfare and wellbeing would you prioritize? 5 Describe the operating principle of the Edgeworth box within the framework of the Pareto optimality analysis. 5 Illustrate the role of the international poverty line as a universal measure of absolute and relative poverty. 5 Applying the subjective poverty approach, how would you self-identify your economic situation? Has it changed in recent years? 5 Make a search on the Internet for the Lorenz curve parameters and Gini coefficient in your country of residence. Which measures does the government implement to mitigate inequality? 5 Summarize the distinctive features of the new normal poverty and inequality. Subject Vocabulary:

14

Absolute Poverty: a condition where individuals’ or households’ income level is below the poverty line expressed through the cost of a minimum consumer basket corresponding to the minimum standard of living in a particular country. Consumer Basket: a set of basic consumer goods and services common for certain communities, territories, or countries. Deprivation: a social process of reduction and/or deprivation of opportunities to meet the basic needs of an individual. Economic Inequality: a difference between individuals and social groups in the level of income, wealth, and standard of living. Minimum Wage: a statutory minimum wage, which commonly corresponds to the subsistence minimum. Pareto Optimality: an equilibrium point at which an increase in welfare of one party is impossible without reducing the welfare of another party. Poverty: a socially induced inability to get access to goods, services, and utilities people require (material, social, and cultural) and the inability to comply with certain standards of living and consumption patterns. Quality of Life: a set of characteristics reflecting the material, physical, social, and cultural wellbeing. Relative Poverty: a condition where individuals’ or households’ income level is below the poverty threshold that corresponds to a fixed share of average income. Social Insurance: a system of cash benefits organized on the basis of mandatory special contributions, which ensure the establishment and redistribution of trust funds to protect the property interests of individuals and legal entities and compensate them for damage in case of adverse events.

525 References

14

Social Justice: a correspondence of economic relations (i.e., distribution of wealth and income in a country) to the needs and interests of a given society. Social Policy: an activity of the state in managing social processes, ensuring material and cultural needs, regulating social and economic differentiation, and allowing each member of society to realize their social and economic rights vital for the optimal reproduction and development. Social Protection: a system of measures aimed at preventing, reducing, or eliminating the consequences of social risks by ensuring a decent standard and quality of life. Social Stability: a situation when society maintains stable standards of living, fundamental rights of people, and uninterrupted access to major goods, services, and other tangible and intangible values. Subjective Poverty: a financial situation of individuals and households according to their own estimates. Subsistence Minimum: a physiological minimum of consumption, i.e., a minimum set of benefits that guarantees the satisfaction of basic needs. Welfare: a social and economic category that reflects the overall level of an individual’s capabilities used to implement a life strategy and meet the full range of needs. Wellbeing: an overall performance parameter of the social sphere, which aggregates the measures of public welfare, quality of life, and social security.

References Bentham, J. (1789). An introduction to the principles of morals and legislation. Printed for T. Payne, and Son, at the Mews Gate. Gini, C. (1912). Variabilità e mutabilità: Contributo allo studio delle distribuzioni e delle relazioni statistiche. Tipografia di Paolo Cuppini. Lorenz, M. (1905). Methods of measuring the concentration of wealth. Journal of the American Statistical Association, 70, 209–217. Pareto, V. (2014). Manual of political economy: A variorum translation and critical edition. Oxford University Press. Rawls, J. (1971). A theory of justice. Belknap Press of Harvard University Press. Townsend, P. (1962). The meaning of poverty. British Journal of Sociology, 13(3), 210–227. United Nations Development Programme. (2021). Global multidimensional poverty index 2021. Unmasking disparities by ethnicity, caste and gender. United Nations Development Programme and Oxford Poverty and Human Development Initiative. World Bank. (2020). Poverty and shared prosperity 2020. Reversals of fortune. International Bank for Reconstruction and Development & World Bank. World Inequality Lab. (2021). World inequality report 2022. Paris School of Economics.

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Foundations of Economic Development

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_15

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Learning Objectives: 5 Learn the fundamentals of economic development 5 Distinguish between development and growth 5 Discover the roots of economic development studies 5 Examine the evolution of economic development concept in Marxism 5 Study major neoclassical models of economic development (Harrod-Domar growth model, Robinson growth model, Solow-Swan growth model, Mankiw-Romer-Weil model, and Kaldor growth model) 5 Learn developmentalist interpretations of economic growth (Lewis’s unlimited supply of labor, Hirschman’s unbalanced growth, Nurkse’s balanced growth, and Rosenstein-Rodan big push) 5 Discuss contemporary approaches to interpreting economic development, including structuralism, institutionalism, and international dependence 15.1  Basic Economic Development Concepts

15

The entire macroeconomic stability of the state depends on the parameters of its economic development (type, drivers, growth rate, etc.). Economic development encompasses many interrelated processes and systems. Economic development models in different countries have standard features despite specific individual differences. Economic Development is the transition of the economy to the qualitatively new form due to structural and institutional shifts. Development involves improving some aspects of economic and social relations and the fundamental change in qualitative parameters of the entire economy. Development is a multidimensional process of deep modernization and reorientation of a country’s economic and social system. Along with the growth of wealth and domestic product, economic development envisages radical changes in institutional, social, and administrative spheres. As previously discussed in 7 Chaps. 6 and 7, markets evolve through deviations from equilibriums. At each development stage, an equilibrium is characterized by a particular combination of relations of production and means of production. One way or another, a typical economic system passes three stages of development: 5 Pre-industrial Society—subsistence agriculture as a primary source of income, high dependence on climate and other natural factors, no social division of labor, closed production cycle, reliance on domestic resources, and low technological development. 5 Industrial Society—establishment of manufactures and large-scale factory production, mass production of goods, rapid industrialization and urbanization, scientific discoveries and technical resolutions, commodity trade and exchange, money and credit relations. 5 Post-industrial Society—ongoing scientific and technological progress, information and innovations as new productive forces, prevalence of the service sector and new digital and knowledge economy over the conventional manufacturing sector, replacement of manual labor with hi-tech jobs.

531 15.1 · Basic Economic Development Concepts

15

A variety of macroeconomic indicators (some of which are addressed previously in 7 Chap. 2) is used to assess the level of economic development of a country: 5 real GDP/GNP (total value, growth rate, rate of increase)—indications of the overall economic potential of a country, the size of the economy; 5 GDP/GNP per capita—measures of the level of economic development, a basis for inter-country comparisons; 5 structure of the economy—shares of industrial production, agriculture, and the service sector in GDP, a contribution of high-tech sectors to GDP, a growth rate of the knowledge economy; 5 output of essential goods and services per capita; 5 parameters of quality of life and living standards—life expectancy, quality and accessibility of education, medical care, and social services, social security, the quality of the environment, employment and career development opportunities, and the Human Development Index (the latter aggregate parameter is detailed in 7 Chap. 17, 7 Sect. 17.4); 5 economic efficiency parameters—profitability, productivity, and labor and capital intensity (see 7 Chap. 6, 7 Sect. 6.2 for interpretations of economic efficiency). Economic development is a contradictory and hard-to-measure process. It goes through periods of growth and recession (see 7 Chap. 7 for economic cycles) and involves qualitative transformations of relations of production and quantitative changes in means of production. The economic development theory acknowledges the economy to be an open and self-evolving system operating in the condition of chronic disequilibrium, where development occurs through a series of transitions from one fleeting equilibrium to another (previously discussed in 7 Chaps. 6 and 7). In order to employ efficient development policies, it is crucial to understand why economic development is inherently uneven. To do so, economic development should be considered in several dimensions: quantitative (economic growth—see 7 Sect. 15.1.1), qualitative (institutional development—see 7 Sect. 15.1.2), and environmental (sustainable development—see 7 Sect. 15.1.3). These measurements are united by the time factor, reflecting the duration, irreversibility, and unevenness of macroeconomic fluctuations. 15.1.1  Economic Development and Economic Growth

Due to the difficulties of measuring economic development, macroeconomists most commonly operate with economic growth as one of the criteria for economic development. Economic Growth is an increase in the total and/or per capita value of real GDP/GNP. In quantitative terms, economic growth is measured as the growth of GDP, GNP, or national income to assess the dynamics of a country’s economic growth. In qualitative terms, economic growth is determined by the growth rate of GDP, GNP, or national income per capita to compare the quality of life in different countries. Economic growth aims to improve the population’s living standards and ensure the country’s economic security. In practice, the

532

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economic growth rate is essential for any country. The higher the rate, the faster the country achieves its development goals (assuming the government declares the improvement of the population’s wellbeing as the development goal). The fundamental prerequisite for economic growth is the contradiction between social needs and production capacities, i.e., between aggregate demand and aggregate supply (see 7 Chap. 5 for shifts in aggregate demand and aggregate supply and changes in their elasticities). Another force is the law of increasing needs reflected in either growth of population (for example, in ­developing countries) or growth of needs (due to the increase in income or the development of mass production), or both. For economic growth to happen, increasing needs must be met by a continuous increase in supply and overall wealth (see 7 Sect. 15.2.3 below for Malthus’s idea of population-related constraints to economic growth). Constraints include scarce resources, the level of technology, qualification of labor, and other economic or social costs associated with output growth. In light of this vision, two types of drivers and constraints of economic growth are distinguished: the increase in inputs (direct quantitative growth factors) and the application of new and improved production methods (indirect qualitative growth factors). In this regard, there are three types of economic growth: 5 Extensive Growth implies an increase in GDP due to the attraction of additional factors of production and resources (labor, land, raw materials, energy, fuel, equipment, means of production) while not changing technologies. This is the easiest and fastest way to spur economic development in the short run (rather, the economic growth rate). Disadvantages are technical and technological stagnation and a slow increase in productivity. 5 Intensive Growth implies an increase in GDP due to the use of more efficient and qualitatively advanced factors of production (introduction of new equipment, use of advanced technologies and scientific achievements, resource-saving solutions, training programs, and management practices). Intensive use of scarce resources allows firms to improve productivity per unit of inputs and increase the quality of goods and services. Being a progressive type of economic growth, intensification contributes to the continuous scientific and technical progress of the entire economy. 5 Mixed Growth. In reality, there is no pure extensive or pure intensive economic growth. There is always a combination of the two. For example, qualitative advancements on the basis of innovations require additional investments in the means of production and labor. In turn, an extensive increase in labor and means of production is accompanied by a change in their qualitative parameters. Therefore, economic growth can be predominantly extensive or predominantly intensive, depending on the prevalence of certain factors of economic growth in certain situations. Thus, if the portion of real GDP obtained due to intensive factors exceeds 50%, economic growth is considered predominantly intensive.

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15.1.2  Institutional Development

The evolution of the economic development narrative is associated with the emergence and subsequent intensive use of the concept of structures. The latter allows macroeconomists to move beyond aggregate indicators, such as GDP or GNP. Economic studies increasingly address relationships between microstructures and mesostructures on one side and macroeconomic parameters on the other. Economic development results in changes in such structures and people’s behavior, reduces inequality, eliminates poverty, improves education and various social and medical services. In other words, modernization, progress, and growth associated with economic development bring about qualitative changes in the economy and society. All of the above systems and subsystems are abstract institutions. Acceptance of abstract institutions can be based on some kind of agreement or a shared understanding of institutions by society. Abstract institutions are factors that affect the economic and social environment in a country. Changes in abstract institutions are made through the activities of real institutions—formal entities recognized by society (governments, courts, public organizations). The link between economic growth and structural changes in institutions, i.e., the institutional component of economic development, is now widely accepted. Institutional Development is the creation or strengthening of a network of real institutions to generate, distribute, and use labor, material, and financial resources in order to affect abstract institutions. Some economic development theories recognize institutions as integral elements and drivers of economic development (see 7 Sect. 15.6.2 for institutionalism as one of the contemporary interpretations of economic development). 15.1.3  Stable and Sustainable Economic Development

The interpretation of economic development as an ongoing transformation of systems and their elements is key to understanding the essence of development. As previously discussed in 7 Chap. 6, development occurs only in those systems that deviate from the equilibrium. Deviation and the subsequent self-organization of the system to return to a new state of equilibrium with a qualitatively or quantitatively new combination of resources enable development processes in any economy and any market (see 7 Chap. 7 for stages of economic growth and economic cycles). The task of the government (extensively, all institutions) is to make deviations smooth and manageable to avoid sharp declines and deep crises. Steady-State Growth is an even and proportional growth of the economy when certain conditions are maintained unchanged, for example, the capital-labor ratio, the ratio of output to fixed capital, or other macroeconomic parameters. Thus, steady economic growth implies stable proportions between inputs and output, no changes in the composition of factors of production in the economy, and, therefore, stable proportions between industries. That means economic

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growth without changing the structure of the economy. Consequently, the idea of proportional growth contradicts the concept of development. Balanced Growth is a type of economic growth when growth rates of factors of production, technology, technical progress, and domestic product remain steady. Inputs and output increase by the same proportional amount. Both steady-state and balanced types of economic growth are quantitative increases rather than qualitative transitions to a new development stage. Case box The inconsistency of maintaining either steady-state or balanced proportional growth has become evident today. Amid ongoing radical structural adjustment (a transition from the conventional mass production economy to the economy based on knowledge, information, and innovation) and more frequent disequilibriums and crises, keeping inputs-output proportions unchanged is no longer possible. Rigid structures break, while flexible ones survive and evolve.

15

Apart from steady-state and balanced growth, macroeconomics operates with the concept of Sustainable Growth, an economic growth aimed at the complete satisfaction of the growing needs of the present generation without compromising the needs of future generations. Sustainable growth implies an increase in the domestic product without depleting the economic potential of a country. It is primarily based on balancing various factors of economic growth. Short-term growth can be achieved through the intensive exploitation of one or several factors of production (not all available resources at the same time). A resulting imbalance can trigger a crisis (see 7 Chap. 7). Sustainable growth involves the rational use of all available resources simultaneously to achieve the optimum in the long term. Sustainable growth is closely linked to the concept of sustainable development. In 1987, the UN Bruntland Commission defined Sustainable Development as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs”.1 Sustainable development concepts and approaches to establishing sustainable development are detailed in 7 Chap. 18. This section briefly outlines approaches to the interchangeability of resources (labor, equipment, capital, natural resources, etc.) as a precondition of sustainability. Weak sustainability determines the continuing level of social welfare as equitable from the point of view of the present and future generations. A fair growth implies that future generations should live at least as well as previous ones. The aggregate stock of all types of capital should not decline, but it can be modified (for instance, natural resources can be converted into physical or human capital). Thus, the concept of sustainable growth is similar to optimal growth in a way it implies a long-term positive increase in growth rates.

1

United Nations General Assembly (1987).

535 15.2 · Classical Theories

15

Strong sustainability suggests that intergenerational equity can only be true when the increase in consumption of resources does not harm the quality of the environment. According to this concept, there is no possibility of substituting physical and natural capital, while technological progress is insignificant. Strong sustainability considers natural resources non-renewable. It also emphasizes the uncertainty of both the future consequences of today’s actions and the needs and preferences of future generations. A potential compromise between weak and strong types of sustainability suggests a convergence of the minimum level of wellbeing (weak sustainability) with a minimum volume of natural capital that remains unused (strong sustainability). Therefore, sustainable economic growth is sustainable in both economic and environmental terms. Economic sustainability implies the long-term growth of consumption per capita. In contrast, environmental sustainability implies the longterm maintenance of a minimum required supply of natural resources (minimum environment quality). Summarizing approaches to interpreting economic development and proceeding to the discussion of economic development theories, we conclude that macroeconomic theory distinguishes development from growth (see below in this chapter). Development is associated with an ever-growing increase in satisfaction of all people’s needs, but this does not mean economic growth. On the other hand, economic growth that does not improve people’s lives (the majority of citizens) can not be considered development, because it leaves aside the vast majority of the population. A shift from the growth theory to the development theory represents a change in the priorities of macroeconomic analysis from growth to development, where growth is a consequence of internal transformations, i.e., the development. 15.2  Classical Theories

The classical school of economic thought emerged in the XVIII–XIX centuries in Britain, where the initial accumulation of capital had happened faster than in other countries. There were established manufacturing production and new industries, such as weaving, shipbuilding, mining, and cloth production. The classical school proclaimed that wealth is created in production. The source of wealth is labor spent on producing goods and services. In the previous chapters, we have already discussed classical interpretations of causes, factors, and effects of various macroeconomic phenomena (see, for example, 7 Chap. 1 for the overview of the core classical concepts, 7 Chap. 2 for the interpretation of fundamental macroeconomic indicators, 7 Chap. 6 for the classical theory of macroeconomic equilibrium, and 7 Chap. 7 for the nature of economic cycles). In this section, we study the approaches of the most prominent representatives of the classical school to understanding economic development and economic growth.

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15.2.1  Smith’s Self-interested Competition

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The classical school is coupled with the name of Adam Smith. His book “An Inquiry into the Nature and Causes of the Wealth of Nations”2 focuses on studying the sources of wealth and economic development of countries. Smith proceeded from the assumption that people pursue their individual gains when rendering services to each other and exchanging labor and its products. Nevertheless, while pursuing personal gains, an individual (an economic entity) contributes to the overall growth of productive forces in a country. This individual-public system of interests is based on the division of labor. According to Smith, division of labor stimulates productivity by improving workers’ skills, saving time when switching between production activities, and incentivizing the discovery and production of machines and equipment to ease labor and enhance performance. In his concept of the division of labor, Smith reflected the expansion of machine production. He postulated that both production and consumption are determined by the proportion of the population engaged in productive labor and the level of labor productivity. Smith sought to find out what types of labor contribute to the growth of wealth. This issue remains relevant to this day. To solve it, Smith divided labor into productive and unproductive. Productive labor creates surplus value. Smith used an example of a factory worker, whose labor increases the cost of materials he processes by worker’s wages and entrepreneur’s profit. Unproductive labor is paid out of income. For example, servant’s labor creates no surplus value; it is paid out of the household’s income. Smith also suggests that productive labor produces tangible goods, while unproductive one results in intangible services. Such an interpretation of labor allows Smith to hypothesize that wealth grows along with the portion of productive labor in the domestic product. Smith’s economic system was based on the assumption that capital represents reserves intended for future production. Working capital creates profit, which constantly leaves the owner in one form and returns to him in another. It consists of money that facilitates the circulation of the remaining three parts; food stocks other than those at the personal disposal of consumers; raw materials or semi-finished products in processing; and finished goods not yet sold in the market. Fixed capital generates profit without changing the owner. It comprises machinery and equipment, buildings intended for commercial and industrial purposes, land, and individual abilities of people (now called “entrepreneurial activity”). According to Smith, fixed capital can function and make a profit only with the help of working capital. The accumulation of capital allows an entrepreneur to expand production (fixed capital), give work to more workers (working capital), and ultimately contribute to economic growth.

2

Smith (1776).

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15.2.2  Ricardo’s Specialization

David Ricardo further developed Smith’s approach to understanding the foundations of economic development and growth. Proceeding from Smith’s types of labor and capital, Ricardo attempted to find an optimal distribution of factors of production. In his book “On the Principles of Political Economy and Taxation”,3 Ricardo acknowledges labor as the primary source of value. He thus sets out the one-factor labor theory of value. The latter postulates that the value of a good is directly proportional to the cost of labor spent on producing this good. Three drivers of economic growth are a division of labor, profit from trade, and capital accumulation. Productive investment and reinvestment of profits maintain continuous economic growth. Therefore, the change in the rate of return is the starting point for analyzing the long-term evolution of the economy. As a representative of the classical school, Ricardo argued that pursuing individual gains under free competition would benefit society as a whole. This idea shaped the promotion of free trade and doing business on the principles of respect for private property and freedom of enterprise. Conflicting economic interests can be resolved by competitive market forces and the restricted actions of a responsible government. Ricardo extended Smith’s theory to demonstrate how trade could lead to economic prosperity beyond the benefits of specialization and division of labor. He developed the comparative advantage concept as the basis for the specialization of industries within a country, as well as countries in international trade. According to Ricardo, countries can benefit by specializing in producing goods in which they enjoy the lowest opportunity costs and then exchanging surplus products (the same applies to individuals and firms in the domestic market) (see 7 Chap. 19, 7 Sect. 19.1 for Ricardo’s comparative advantage in international trade). The benefit of international exchange is based on the assumption of different wages in different countries, in contrast to domestic trade. Therefore, in addition to diversities in productivity, Ricardo’s comparative advantage takes into account diversities in wages. For example, even if country A has an absolute advantage over country B in producing goods 1 and 2, then mutually beneficial trade between these countries is still possible if the nominal wage in country A exceeds that in country B. Thus, international exchange is determined by the difference in wages. Making this conclusion, Ricardo actually says that if country A keeps higher wages due to the higher efficiency of its production, then country A obtains an advantage in the global market. Moreover, even lower efficiency in country A does not prevent it from competing with foreign producers. There is always such an exchange ratio with foreign currencies, when country A may benefit from exporting the goods with lower comparative lag and importing those with greater lag. Thus, Ricardo’s comparative advantage entrenched the two pillars of Smith’s economic growth theory, i.e., the specialization and the division of labor.

3

Ricardo (1817).

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Interpreting the foundations of reproduction, Ricardo recognized the Say’s law of markets, that is, his statement about the equilibrium state of the economy at full employment (see 7 Chap. 6, 7 Sect. 6.1.1 for Say’s Law in the classical interpretation of macroeconomic equilibrium). Ricardo abandoned Smith’s concept of value aggregated from various types of income. On the contrary, value breaks down into incomes. Nevertheless, following Smith, Ricardo omitted fixed capital in the analysis of reproduction. Instead, he associated the value of the social product with the sum of incomes. According to this approach, the social product can be fully distributed. Ricardo proceeded from the unity of purchase and sale, arguing that purchase follows sale. This idea was adopted from Say’s hypothesis about the impossibility of overproduction in the economy. Case box Ricardo allowed partial overproduction in the market economy, that is, a certain commodity to be produced in excess quantities, but no general overproduction. All economic entities in the market economy aim at the fullest satisfaction of consumers. Therefore, there is no ceiling for the growth of output and the expansion of demand except for the rate of profit. In the early XIX century, Ricardo failed to foresee the inevitability of periodic overproduction crises in the free market economy. As evidenced in 7 Chap. 7, 7 Sect. 7.3, the first overproduction crises erupted in the agricultural sector in Europe and the USA in the 1870s, five decades after Ricardo passed away.

Ricardo’s ideas have essentially influenced the development of the economic theory (some of the many neoclassical interpretations of Ricardo’s economic growth theory are addressed below in 7 Sect. 15.4). The development dimension of the comparative advantage theory has become the cornerstone of theories of international trade and competitiveness (see further 7 Chap. 19, 7 Sect. 19.1). The labor theory of value has been employed by economists (for instance, Karl Marx and his followers—see 7 Sect. 15.3) to explain the redistribution of wealth.

15

15.2.3  Malthus’s Constant Productivity Constraints

A different viewpoint on the factors of economic development and growth from those of Smith and Ricardo was outlined by Thomas Malthus in his book “An Essay on the Principle of Population”4 first published in 1798. Malthus’s concept is based on the hypothesis that exponential growth of population outstrips the arithmetical growth of productive forces in agriculture. The theory postulates that: 5 society remains in equilibrium only when the quantity of consumer goods corresponds to the size of the population;

4

Malthus (1798).

539 15.2 · Classical Theories

15

5 the supply-demand ratio determines prices for all goods; 5 population growth outstrips the increase in supply; 5 both economy and society need balancing—the level of real wages must be brought in balance with the subsistence minimum. Based on such a vision of the relationship between population growth (consumption) and output growth (supply), Malthus explained underdevelopment by the discrepancy between these two key macroeconomic parameters. The growing shortage of supply per capita aggravates poverty and lags some countries behind the others in the level of economic development. Scarcity of resources and factors of production is considered the principal reason for market self-regulation. The population growth must be associated with the increase in the amount of available resources to keep the per-capita provision (i.e., material wellbeing) stable. Case box Malthus’s idea of overpopulation as a factor in the economic backwardness of certain countries has remained one of the most controversial theories to this day. By 2050, the world population will exceed 9 billion people. The population growth is taking place against the deteriorating food security. According to the estimations made by the Food and Agriculture Organization,5 even today, more than 1.3 billion people do not have regular access to nutritious and sufficient food, while over 690 million people suffer from hunger. The food insecurity problem is inextricably linked with poverty. Both problems are particularly acute in Africa, as well as in some densely populated Asian countries (India, Bangladesh, Pakistan). China has been demonstrating impressive success in combating poverty and providing the population with a sufficient food supply, but the two threats remain valid. Thus, Malthus’s theory is relevant today as a vision of the modern global problem of non-renewable resources and the need for their rational and sustainable use to ensure the wellbeing of future generations.

Despite the provocativeness of some of Malthus’s ideas (in particular, controlling the size of the world’s population to balance aggregate supply and demand and maintain an acceptable standard of living), Malthus for the first time considered long-term prospects for economic growth from the point of view of global resource constraints. He predicted the demographic consequences of economic development by improving technologies and intensifying resource use. He also forecasted the inevitable impact of population growth on both the rate and type of economic growth. At the same time, Malthus stressed the relationship between overpopulation and such global problems as hunger, poverty, depletion of

5 Food and Agriculture Organization of the United Nations, International Fund for Agricultural Development, United Nations Children’s Fund, World Food Programme, and World Health Organization (2020).

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non-renewable resources—in fact, all those issues designated as global problems of mankind in the United Nations Sustainable Development Goals (see 7 Chap. 18). Today, the spread of neo-Malthusian ideas in different interpretations is spurred by the population growth across developing countries, which aggravates inequalities between and within countries (previously discussed in 7 Chap. 14, 7 Sect. 14.5). 15.3  Marxism and Neo-Marxism 15.3.1  Marx’s Capital Accumulation

A qualitatively new interpretation of classical views on the nature of economic development was proposed by Karl Marx. Previously in the book, we addressed the Marxian interpretations of reproduction and circulation of social capital (7 Chap. 1), macroeconomic equilibrium (7 Chap. 6), and economic cycles (7 Chap. 7). Regarding the economic development theory, Marx made a precious contribution to understanding the nature of economic growth with his idea of expanded reproduction (further reading: “Capital: A Critique of Political Economy”6). Marx approaches studying the capitalist mode of production by defining a commodity as a product of labor intended for exchange (general sale) in the market. Two types of commodity value are distinguished: 5 Use value expresses the utility of a commodity, i.e., the ability to satisfy needs as an object of consumption or a means of production. This property depends on the specific features of a commodity and the needs of society in these features. Thus, the use value of a commodity does not depend on the amount of labor required to produce this commodity. The use value changes along with changes in the market and society. 5 Exchange value is the ability of a commodity to be exchanged in certain proportions for other commodities. It is expressed in the ratio in which commodities are exchanged, i.e., something common to them all.

15

According to Marx, such a common thing embodied in any commodity is human labor. Therefore, the value of a commodity is measured by the amount of socially necessary working time (labor power) embodied in this commodity. Marx defines it as the labor-time required for producing goods with an average level of skill and intensity of labor and average technical equipment. Marx’s labor theory of value defines value as a production relation, social labor embodied in a commodity, socially necessary time. The value is determined not by actual production costs, but by the weighted average costs required for manufacturing a given product with an average level of skill and intensity of labor in society. As stated by Marx in Capital (volume I, 7 Chap. 1), “The greater the productiveness of 6

Marx (1867).

541 15.3 · Marxism and Neo-Marxism

15

labor, the less is the labor-time required for the production of an article, the less is the amount of labor crystallized in that article, and the less is its value; and vice versa, the less the productiveness of labor, the greater is the labor-time required for the production of an article, and the greater is its value. Therefore, the value of a commodity varies directly as the quantity, and inversely as the productiveness, of the labor incorporated in it”.7 In the production process, the labor of each individual producer is private. Still, the social nature of labor (the connection of people in the process of social production) does not disappear. It takes the form of abstract labor and thus acts as the value of a commodity, that is, the recognition by society of expenditures of human labor incurred. Labor also has use value. In contrast to the classical school, which interpreted labor as a commodity, Marx reveals that under the capitalistic system, workers supply no labor, but the ability to it, i.e., their labor power. The cost of labor power is determined by the sum of vital goods and services required for the preservation and development of the vital forces of a particular employee and his family members. The price of labor is wages. The use value of labor is expressed in its ability to generate greater value than that advanced by a capitalist—the surplus value, i.e., the difference between total value added in the production process and the cost of labor power (wages). Surplus value is the cornerstone for the existence of the capitalist mode of production, because capitalists have an interest in hiring only that labor that can add surplus value M to the cost of raw materials and other inputs C and cover wages V at the same time (Eq. 15.1):

W =C+V +M

(15.1)

where W value of a commodity; C fixed capital (operating expenditures); V variable capital (labor); M   surplus value. Having determined the fundamental difference between fixed and variable capital as elements of value, Marx developed the theory of exploitation (the appropriation of surplus value by a capitalist). The degree of exploitation is determined by the rate of surplus value RSV , i.e., the ratio of incomes of capitalists and workers M V . Marx also introduces the parameters of the rate of profit RP (Eq. 15.2) and organic composition of capital OCC (Eq. 15.3):

RP =

RSV C

(15.2)

C V

(15.3)

OCC =

7

Marx (1867).

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Industries where OCC is lower produce greater surplus value. The latter can only be created by labor. That is why RP in these industries is also higher. RP is equalized through intersectoral competition and intersectoral capital flow. Therefore, regardless of OCC in any particular sector, an equal amount of capital generates an equal amount of profit. Proceeding from this assumption, Marx concludes that the economy tends to generate an average profit under the capitalist mode of production. Prices are determined based on production costs and average profits. The production process is continuous. It includes simple reproduction (steady production with no qualitative or quantitative changes) and expanded reproduction (permanent increase in the quantity and quality of goods). Marx distinguished production of capital goods (means of production, or MP) and commodities (consumer goods, or CG). The total product generated by the two types of production during a year is the annual social product. Marx formulated social product proportions for simple reproduction (Eqs. 15.4–15.6) and expanded reproduction (Eqs. 15.7–15.9). Under simple reproduction, the output of capital goods must be sufficient to replenish consumer goods and means of production used in the preceding period (Eq. 15.4). The new value obtained in the production of capital goods must be equal to the need of commodities in the means of production (Eq. 15.5). The total value of commodities created in the production of consumer goods must balance the total need of means of production and consumer goods in commodities (Eq. 15.6).

15

MP(C + V + M) = C + CG(C)

(15.4)

MP(V + M) = CG(C)

(15.5)

CG(C + V + M) = MP(V + M) + CG(V + M)

(15.6)

Expanded reproduction requires the output of means of production to be greater than necessary to replenish an aggregated amount of capital and consumer goods (Eq. 15.7). The new value obtained in the production of capital goods must exceed the need of commodities for the means of production (Eq. 15.8). The value of commodities produced in the economy must be lower than the newly created value of consumer and capital goods combined (Eq. 15.9), since part of the surplus is spent on purchasing new means of production.

MP(C + V + M) > MP(C) + CG(C)

(15.7)

MP(V + M) > CG(C)

(15.8)

CG(C + V + M) < MP(V + M) + CG(V + M)

(15.9)

Output growth occurs primarily due to the increase in the production of capital goods. The contribution of the consumer goods sector to economic growth is less significant. According to Marx, capitalist reproduction inevitably results in disproportions in production, mismatches between production and consumption, and overproduction crises. Based on the dialectical evolution of productive forces and

543 15.3 · Marxism and Neo-Marxism

15

industrial relations, Marx distinguished stages of economic development (socioeconomic formations). The classical school considered these relations to be natural and did not tie them to the evolution of production and the change of development stages. Having used a historical approach, Marx discovered the fact that societies evolve by passing from one socioeconomic formation to another. He categorized economic evolution into slavery, feudalism, capitalism, socialism, and communism. Transitions are triggered by sharpening contradictions between productive forces and industrial relations (the former develop faster than the latter). 15.3.2  Rostow’s Linear Growth Model

Marx’s stages theory of development was reinterpreted in the 1950s by Walt Rostow from the point of view of the accelerated accumulation of capital through the utilization of both domestic and international savings. The latter was considered to be a means of spurring investment, i.e., the primary means of promoting economic growth and development. Rostow’s linear growth model distinguishes five consecutive stages of development that all countries must go through during the development process, namely, traditional society, preconditions for take-off, take-off, drive to maturity, and high mass-consumption (. Table 15.1). Stages differ by technical and economic parameters, such as the development of technologies, the sectoral structure of the economy, the structure of consumption, etc. (further reading: “The Stages of Economic Growth: A Non-Communist Manifesto”8). Traditional society. At this stage, over 75% of the total labor is engaged in agricultural production. National income is used unproductively (almost no investment in reproduction). The society is structured hierarchically, with political power belonging to local landlords or the central government. Preconditions for take-off. Transformations occur in agriculture, transport, and foreign trade. In modern industrialized countries, the transition from pre-industrial to industrial type of economic growth had happened by the 1850s. It started in Britain in the XVIII century, then spread to the USA and across Europe. Largescale machine production was established in the course of industrialization. The emergence of factories and plants gave impetus to urbanization and the growth of cities and large industrial centers. Take-off. This stage covers a relatively short period of time, up to three decades. Capital investment and output per capita go up amid the introduction of new technologies into the industrial and agricultural sectors. Growth starts in several central (most advanced) industries and then spreads to all sectors of the economy. For growth to become self-sustaining, the following three conditions must be met: 5 sharp increase in the share of productive investment in national income (from 5% to at least 10%);

8

Rostow (1960).

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. Table 15.1  Summary of Rostow’s stages of economic growth Stages

Economic growth

Traditional society

Society

Polity

Innovations

Industry

Investment

Traditional community values

Small hierarchical governing elite

Limited technology

Mainly agricultural (subsistence farming)

Very low if any (barter economy)

Pre-take off

Low (focus on export of agriculture)

Aspirational citizenry (eager to follow the success of neighbor)

Increasing elite legitimacy problems

Increasing commercialization. Low level of entrepreneurship

Enhanced agricultural productivity. Low-level manufacturing (focus on the extractive industries)

Surplus from agricultural exports used (funding expansion of domestic markets)

Take off

High (and sophisticated)

High level of social change (urbanized and educated society). Growth of wealthy social elite

Increasing demands for democracy (led by dominant intellectual leaders)

New productive methods induced. High level of entrepreneurship

Industrialization (helped by new infrastructure, manufacturing growth, and social change)

Domestic spending and aid from abroad (on new infrastructure)

Maturity

High (spread throughout society)

Strong urbanized society (fueling social discontent)

Political revolutions and then modern political institutions

High (extract efficiency from existing technology, high degree of professionalism)

High level of import substitution (natural endowments strong). Growth of new industries

High level of domestic spending and foreign investors

Mass consumption

Low to high

A bureaucratic society driven by consumer durables

Competitive democracy

High

Mainly services (the Third Wave of industrial growth)

Domestic spending and foreign investors

15

Source Authors’ development

545 15.3 · Marxism and Neo-Marxism

15

5 rapid development of one or more industrial sectors; 5 support of economic modernization in society. Drive to maturity. This is the technological progress stage (wide-spreading innovations, greater urbanization, more skilled labor, new management practices). In modern industrialized countries, this stage took place in the first half of the XX century. During that period, the increase in the share of savings in GDP from 5 to 15% spurred production. GDP growth rates significantly exceeded population growth rates. In most industrialized countries, economies reoriented on capital-intensive heavy engineering (mechanical engineering, metallurgy, automotive industry, aircraft engineering, chemical industry). High mass-consumption. At this stage, the economy shifts from supply to demand (from production to consumption). Consumer goods and services dominate the market. Scientific and technological progress gives birth to new industries, such as the computer industry and related digital services, information, Internet, robots, production of automatic systems, aerospace industry, biotechnologies, medicine, and bioengineering. Case study Asian countries, in particular Singapore and South Korea, are typical examples of countries whose economic development since the 1960s has been correlating with Rostow’s stages. In the absence of significant natural competitive advantages for economic growth, these small countries relied on accelerated industrialization and modernization of all industries. Openness to investment attracted foreign technologies, while international trade integrated local firms into global production and supply chains. Rapid urbanization (especially in Singapore) facilitated the growth of the service sector and mass consumption.

Rostow did not distinguish between economic development and high growth rates. The investment-growth ratio comes to the fore, while social and institutional changes stay in the background. In his later works (for example, see “Politics and the Stages of Growth”9), Rostow expanded the five-stage linear growth model by adding the “search for quality” stage. By so doing, he attempted to outline the prospect of contemporary socioeconomic development of modern societies. However, social aspects of development receive much less attention than the economic ones. Rostow overemphasizes modernization (the pre-conditions for take-off and the take-off stages). Other qualitative transformations, notably the transition to post-industrial society in the course of the scientific and technological revolution, are underscored.

9

Rostow (1971).

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Chapter 15 · Foundations of Economic Development

15.3.3  Baran’s Economic Surplus

The laws of capital accumulation under monopoly capitalism were described by Paul Baran in the 1950s (see “On the Political Economy of Backwardness”10). Baran’s most significant contribution to the economic development theory is the critical application of the economic benefit concept. The real benefit is the difference between the social product and actual constant consumption. A potential benefit is a difference between the current social product and potential output, provided the social system is improved. Baran admits that potential benefit is a speculative concept, since it depends on a yet non-existent model of social order. Baran used the benefit parameter to study developing economies. He introduced the concept of economic surplus—the mass of resources that a society could have at its disposal to facilitate economic growth. It is the amount that might be reinvested in productive ways to increase the future level of social output. According to Baran, the way the surplus is used in capitalistic countries (or misused to luxury consumption by the rich) demonstrates a slowdown of both industrial development and technological progress. The extraction of surplus by metropolitan countries and monopolies explains the dependence of developing economies and former colonies on developed states and their capitals. Undoubtedly, Baran managed to identify and explain changes in post-war capitalism. However, he overestimated the degree of monopolization and investment decline. Had those tendencies been dominating capitalistic countries in the 1950s, then there would have been no rapid post-war economic growth in Western Europe, no technological innovations, no increase in labor productivity, no new industries. It is also noteworthy that Baran underestimates other economic phenomena except monopolization. When advocating government intervention in the market economy, he emphasizes antitrust regulation but ignores such pillars of the Keynesian policy as government procurements or money emission. Monopolization does not entirely destroy competition. In the global market, corporations struggle with foreign competitors. In the domestic market, this struggle is commonly complemented by competition from new industries.

15

15.3.4  The Neocolonial Dependence Model

In the second half of the XX century, economic growth studies focused on the external dependencies of growth rates from institutional, economic, and political factors and the relationships between developing and developed countries. In continuation of the Marxist interpretation of economic growth, the Neocolonial Dependence Model emerged in the 1960–1970s. It linked the backwardness of the Third World countries with the historical inequality of developed and developing economies in the capitalist system. The model postulates that the center

10 Baran (1952).

547 15.3 · Marxism and Neo-Marxism

15

(developed countries) one way or another exploits the periphery (developing and least developed economies) and neglects its interests, which deteriorate development opportunities for the latter. Within a peripheral country, there are few but influential strata (landowners, biggest entrepreneurs, government and military officials, trade union leaders) who are interested in preserving the unequal capitalist system that is beneficial to them personally. Directly or indirectly, they serve (and are rewarded for doing so) the interests of various forces in the international arena, including transnational corporations and foreign aid institutions (such as the World Bank and the IMF), which are financially and otherwise associated with developed countries. The ideology and activities of local elites in the periphery countries often hinder reforms that can improve the living conditions of large population segments. The deterioration of these conditions results in permanent underdevelopment. The neo-Marxist theory of neocolonialism explains poverty in developing and, primarily, least developed countries by the very existence of industrialized development countries of the Global North and the small but influential comprador groups associated with them within developing countries. Therefore, economic backwardness in the neocolonial dependence model is considered an externally imposed phenomenon (in contrast to Rostow’s development stages or Warren’s structural shifts (see 7 Sect. 15.3.5 below), where internal factors such as a lack of savings or qualified labor affect development prospects the most). Case study The neocolonial model precisely conforms to the Marxist paradigm. However, many neo-Keynesian and neoliberal economists argue that underdevelopment is not a pre-capitalism development stage. Rather, it is a form of capitalist development, which can be called dependent capitalism. Some countries, having superiority in technology, trade competitiveness, and capital, can exert pressure on other countries dependent on them. In this relationship framework, the dominant developed countries exploit dependent developing and least developed economies and the appropriate part of the surplus product of the latter. Dependence ultimately stems from the international division of labor itself, which stimulates industrial development in some countries and restricts it in others.

Neocolonialism as a socioeconomic system is a set of elements connected by social, economic, and political relations between developed and developing countries (not necessarily former metropolitan states and former colonies). In other words, neocolonialism is an integral socioeconomic structure established by a multitude of “neo-colonies” (peripheral countries) and “neo-metropolies” (developed capitalist countries), united by relations in the spheres of production, distribution, exchange, and consumption of economic goods in the economic interests of neo-metropolies. Economic expansion combines the increase in dependence of underdeveloped states on capitalist economies and their corporations and the fight against potential competitors in the global market through various types of

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customs, investment, and business legislation (protective and incentive duties, tax regulations, quantitative restrictions, trade bans, government subsidies and export lending, regulation of international capital flows, exchange rates, dumping, etc.). Many of contemporary manifestations and arguments of the neocolonial dependence model have been discussed in previous chapters (for example, poverty and social inequality in 7 Chap. 14 and unemployment in 7 Chap. 8). Modern interpretations of related dependency concepts, such as the false-paradigm model and the dualistic-development thesis, are addressed in 7 Sect. 15.6.3. 15.3.5  Warren’s Shift Toward Socialism

Bill Warren in his book “Imperialism: Pioneer of Capitalism”11 called the dependence theories “mythology” and stated that previously underdeveloped countries had advanced substantially due to the influence of Western capitalism. He rejected the argument of Leninist imperialism, the highest stage of capitalism, that capitalist development outside Europe was no longer possible. Warren believed he was restoring the original view of Marx (especially concerning the results of Britain’s rule in India) that imperialism played a progressive role in promoting the spread of capitalism throughout the world, which was a prerequisite for socialism. After the World War II, most of the then colonies of developed countries in Africa and Asia gained independence. According to Warren, such independence is enough to establish the basis for economic growth, build its own social and economic institutions, and move away from the influence of former metropolitan countries (or, in the modern interpretation, transnational corporations or multilateral institutions). The spread of capitalist methods of production will gradually replace outdated institutions and structures. It will allow developing and less developed countries to enter a new stage of development through industrialization and technological progress. The industrialization of developing countries will lead to the growth of the working class, which in turn will contribute to the promotion of socialist ideas. Eventually, developing countries will transit to socialism, but necessarily through the stage of developed capitalist society.

15

Case study Warren’s theory was primarily formed amid the first successes of the newly independent countries in the 1960s, when most of the former colonies in Africa and Asia were demonstrating explosive growth after gaining independence. However, such an impressive growth rate was mainly due to the low base effect. In former colonies, any market-oriented reforms gave a quick result, and investments stimulated output growth. Over time, the growth rate has slowed. Most countries in Africa have never become the new leaders of the developing world. Certain success has been achieved in Asia,

11 Warren (1980).

15

549 15.4 · Neoclassical Theories

but it hardly entirely correlates with gaining independence and the transition to capitalist principles of the market economy. For instance, China and Vietnam, not entirely market-based economies, have been demonstrating high growth rates since the 1990s. Thus, progress can hardly be called inevitable, as Warren believed. Rather, it depends on specific policies implemented by governments, as well as the adequacy and consistency of such policies.

According to Warren, many of the economic and social problems of his days resulted from population growth in developing countries (as we see today, most of those problems have aggravated since then, such as growing inequality between and within countries (see 7 Chap. 14), unemployment (7 Chap. 8), poverty, and food insecurity (7 Chap. 14). However, population growth itself is not only a problem. It establishes prerequisites for developing local production, industrialization, and economic growth based on improving the labor force, technological progress, and the spread of capitalism. 15.4  Neoclassical Theories 15.4.1  The Harrod-Domar Growth Model

Since the 1940s, growth models of different types have been formulated based on the Keynesian saving-investment analysis (see 7 Chap. 6, 7 Sect. 6.3.2 for the Keynesian concept of consumption and investment). One of the first projections of the short-run Keynesian analysis into the long-run was developed independently by Roy Forbes Harrod and Evsey Domar. The Harrod-Domar growth model extended the Keynesian analysis of income and employment to the longrun setting and therefore considered both the income and capacity effects of investment (further reading: “Towards a Dynamic Economics”12). The model is based on the assumption that economic growth is directly proportional to the share of savings in GDP and inversely proportional to the capital-labor ratio (Eq. 15.10).

G=

S C

where G  economic growth rate; S share of savings in GDP; C capital-labor ratio.

12 Harrod (1948).

(15.10)

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Chapter 15 · Foundations of Economic Development

Warranted growth is a type of growth that guarantees the full use of existing capacities (capital). At any time t , investments I depend on the expected increase in output (income) Y (Eq. 15.11).

It = a × Yt∗

(15.11)

where It investment at time t ; Yt∗  expected output (income); a incremental capital-output ratio. Equation 15.11 actually illustrates the accelerator mechanism (see 7 Chap. 6, 7 Sect. 6.3.3 for the accelerator effect). At time t , savings are taken to be equal to investment (Eq. 15.12). When St = It, S × Yt = a × Yt∗.

St = S×Y t

(15.12)

where St – savings at time t ; Yt – actual output (income) at time t ; S   share of savings in GDP. Under warranted growth, all expectations of entrepreneurs are fully met. Therefore, there is no incentive to increase or cut output or anyhow modify operations. In this case, the expected increase in income equals actual growth (Yt∗ = Yt). Then Eq. 15.13 is derived from Eq. 15.12:

Yt S = Yt ar

(15.13)

where Yt Yt – output (income) growth rate, at which entrepreneurs’ expectations are fully met; ar incremental capital-output ratio required to ensure warranted growth.

15

At any given moment, ar is fixed, i.e., there is no replacement of labor with capital (vice versa, capital with labor). This premise is derived from the supposed rigidity of prices of labor (wages) and capital (rate of profit), not from technology constancy. The flexibility of labor prices is restricted by the minimum wage set by the government, while that of prices of capital—by the minimum acceptable interest rate. Therefore, stable warranted growth GW equals aSr . Its value is uniquely determined at each moment of time. Actual growth G does not necessarily equal warranted growth, although every firm strives to ensure its plans to be as accurate as possible. The divergence of actual and warranted values tends to increase, resulting in the system’s instability. Thus, if G > Gw, then the capital-output ratio is lower than required (a < ar ). This triggers the accelerator effect—demand for capital goods goes up. In turn, the investment multiplier spurs a further increase in production. If the actual growth rate falls below

15

551 15.4 · Neoclassical Theories

the warranted threshold (producers’ expectations are unfulfilled) (G < GW ), then factors of production are underutilized. The accelerator-multiplier effect further depresses output. Warranted growth is intended to guarantee the full utilization of production capacities. To ensure full employment of labor, the Harrod-Domar model introduces the concept of natural growth. It is determined by the growth rate of the supply of labor and the growth rate of its productivity. Under the assumption of exponential growth in labor supply and labor productivity, the natural growth rate is equal to the sum of growth rates of the two parameters (Eq. 15.14).

Gn = n + g

(15.14)

where Gn  natural growth rate (highest possible average value of G in the long run); n growth rate of labor supply; g growth rate of labor productivity. For labor and capital to be fully utilized, warranted growth must be equal to natural growth (Gw = Gn ). In reality, such equality is unattainable since the two types of growth rates are determined independently by different factors. They can only coincide by chance. Suppose Gw < Gn. If G > Gw, there occurs self-sustaining boom. Provided that Gw < Gn, then Gw < G < Gn. There seems to be no limit to the boom in the long run. Structural unemployment exists (the Gn level is not reached), but it is decreasing. However, inflation may rise due to the permanent overutilization of production capacities. The Gw > Gn situation is much worse. In this case, actual growth G never exceeds Gw (G < Gn < Gw ), because Gn acts as a physical barrier. The economy simultaneously faces unemployment (G < Gn ) and underutilization of factors of production (Gn < Gw ), i.e., an economic depression over an indefinitely long period of time. Thus, if the divergence of actual and warranted growth creates cyclical fluctuations, the divergence of warranted and natural growth results in chronic unemployment. Consequently, the HarrodDomar model illustrates the cyclical and long-term instability of the capitalist economy. 15.4.2  The Robinson Growth Model

The Harrod-Domar model has been redefined by Joan Robinson, who related investment with the rate of profit which in turn depended upon the distribution of income between wages and profits on the one hand and labor productivity and capital intensity on the other (. Table 15.2). Robinson’s theory of economic growth attempts to develop a cause-and-effect model of a capitalist economy operating in a historically defined time. The model emphasizes the role of entrepreneurial behavior in economic growth. According to the post-Keynesian approach, profit is both the source and the result of an investment. Consequently, profit is the motive of the investment activity of

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. Table 15.2  Major differences between the Harrod-Domar model and the Robinson model Parameter

Harrod-Domar

Robinson

Factor of capital accumulation

Saving income ratio and capital productivity

Profit wage relation and labor productivity

Primary driver of capital accumulation

Capital

Labor

Growth factor

Trade cycles

The explanation of trade cycles is neglected

Relevance

Capital-abundant developed economies

Capital-poor developing economies

Source Authors’ development

15

entrepreneurs. The rate of return is determined by the investment rate and the entrepreneurs’ propensity to save. In a state of equilibrium, a growing economy fully utilizes capital and labor if entrepreneurs’ expectations are met. However, expectations may be wrong, since they are simple projections of the current situation into the future (further reading: “Aspects of Development and Underdevelopment”13). Robinson distinguishes seven groups of economic growth factors: 1. Technical determinants. Robinson assumes no shortage of natural resources. The size and the quality of the workforce, the awareness of modern technologies, and the pace of technological progress are all given conditions. All enterprises form the elements of a fully integrated structure: they supply everything that is required to manufacture the elements of the final product. Labor costs are therefore the only item of variable costs. 2. Investment policy. According to Robinson, a reliable investment function can hardly be constructed. For any firm, the saving rate results from its desire to survive in the market. Expansion and development are lower-profile challenges. The target saving rate is positively related to profit at a given intensity of survival and development motives. 3. Conditions for savings. The model postulates that two types of income (profit and wages) demonstrate different propensities to save (higher for the former and lower for the latter). 4. Competition determines the way prices are established and the ability of prices to respond to changes in market demand. Prices are set by adding a profit-generating “mark up” to a unit of direct costs. The size of the mark up depends on the degree of monopolization in a particular sector (concentration of the market and barriers to the penetration of new capital into the industry). With short-term fluctuations in demand, the ratio of prices and direct costs is assumed to be more or less stable. Then the price equation for the consumer goods sector may be written as follows (Eq. 15.15):

13 Robinson (1978).

553 15.4 · Neoclassical Theories

P=

(1 + µ) × w a

15 (15.15)

where P  price; w  wage rate; a average output per unit of direct labor costs in the sector; µ average mark up. In a low-monopolized market, competition makes the average mark up a variable parameter. The output volume and employment are then determined by the existing production capacities of firms in the consumer goods sector. 5. Wage rates. It is assumed that the wage rate remains constant during each specific short period of time. One exception is a situation when labor is excessively demanded. Another exception is a such rise in investment or production costs that the real wage rate falls below the level workers are willing to accept. In the latter case, an increase in wages triggers inflation (the so-called inflation barrier). Wages should grow at about the same rate as labor productivity. Faster growth of wages compared to productivity causes inflationary pressure on the economy and the curtailment of investment plans. 6. Financial conditions. Robinson distinguishes two aspects of this issue. First is the relationship between the firms’ propensity to save and their borrowing power. This ratio determines the propensity to save in the economy. Second is the level of interest rates. According to Robinson, monetary policy (an adjustment of interest rates) can not ensure efficient regulation of investments. Thus, apart from a situation of high inflation, when a sharp increase in interest rates restrains investment, the role of monetary policy in influencing the level of investment in the economy is negligible. 7. Initial stock of capital goods and technical factors and labor characteristics determine the level of production capacity in the economy. An economy is unlikely to sustain equilibrium for any long period of time. It is challenging to attain sustainable economic growth due to time lags associated with implementing investment decisions, the consequences of wrong investments made in the past, or incorrect expectations projected into the future. To describe steady growth, Robinson uses the term Golden Age—a situation of full employment, when wages grow proportionally to productivity, profit remains stable, the government does not interfere the market, and expectations and the propensity to save both correspond to the growth in output. At the equilibrium, labor N is fully employed. Capital K is fully utilized when the capital-labor ratio v remains constant. In case of change, there is N = K v . Dividing both sides by N , we find the rate of change of labor compatible with the rate of change of capital (Eq. 15.16):

N = N

K v K v

=

v K K × = v K K

(15.16)

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Chapter 15 · Foundations of Economic Development

. Fig. 15.1  Golden equilibrium. Source Authors’ development

where N   number of workers employed; K   amount of capital utilized; v   capital-labor ratio.

15

Section OW in . Fig. 15.1 is the minimum wage rate, section ON is the growth K = OK , while of labor force, and the Y ∗ curve is the expansion path. At point C, N ∗ section ON designates the growth rate of labor. With wages OW , the rate of surplus (profits) equals HC. Such a profit absorbs the growth of labor—the golden age condition. �N �K �K The disequilibrium occurs when either �N N > K or N < K . In the former case, the population grows faster than capital stock. This brings about an increase in unemployment and a decrease in wages. As Robinson’s model assumes prices to be fixed, real wages fall and profits rise. As such, capital accumulation goes up until it catches up with the population growth rate. The golden age equilibrium is reestablished. In the latter case, population growth falls short of capital growth. Wages rise amid falling unemployment. Higher labor costs depress profits, and the rate of capital accumulation growth slows down. 15.4.3  The Solow-Swan Growth Model

Robert Solow and Trevor Swan further reinterpreted the Harrod-Domar model by linking output to inputs of capital and labor (see Solow’s paper “A Contribution to the Theory of Economic Growth”14). The Solow-Swan model postulates that the main reason for economic instability in the Harrod-Domar model is the fixed value of capital intensity a, which reflects the rigid ratio between capital and

14 Solow (1956).

555 15.4 · Neoclassical Theories

15

labor. In this case, one of the factors remains underloaded. In accordance with the neoclassical theory, the proportions between capital and labor should be variable. They are determined by cost-minimizing producers depending on the prices of these factors of production. That is why Solow used a linear homogeneous K production function Y = F(K, L) instead of a fixed L ratio. Dividing all parame Y ters by L and denoting income per employee L through y and capital intensity KL through k, we get Eq. 15.17.

y = LF(k, 1) = Lf (k)

(15.17)

Similar to the Harrod-Domar model, the Solow-Swan model assumes that the population grows at a constant rate n, while investments make up a constant share of income determined by the savings rate s (I = sY ). The growth rate k can be written as follows (Eq. 15.18):

dK dL sY L dk = − = − n = s − f (k) − n k K L K K

(15.18)

where dK   differential growth of capital K ; dL  differential growth of labor L. From Eq. 15.18, Solow derives his “fundamental equation”: the increase in the capital-labor ratio of one worker is what remains of the specific investments (savings) after all additional workers are provided with capital goods (Eq. 15.19):

dk ′ = sf (k) − nk

(15.19)

If sf (k) = nk, then, with a constant capital-labor ratio (dk = 0), the economic growth incurs no structural changes in factors of production (balanced growth). In the Solow-Swan model, as opposed to the Harrod-Domar model, the balanced growth trajectory is stable (. Fig. 15.2). The nk line shows how much each

. Fig. 15.2  Illustration of the Solow-Swan model. Source Authors’ development

556

Chapter 15 · Foundations of Economic Development

. Fig. 15.3  The Solow-Swan golden rule of capital accumulation. Source Authors’ development

15

employee must save and invest from their income in order to provide future workers with capital goods. The Sf (k) curve depicts the actual savings of employees depending on the capital-labor ratio. The growth of investment (savings) slows down with the increase in capital intensity k. According to the Solow-Swan fundamental equation, the distance between the Sf (k) curve and the nk line denotes the differential change in the capital-labor ratio dk. At point B (k ∗ ), there is no gap between the lines (balanced growth). At all points to the left of k ∗, the capital-labor ratio goes up (point A (k1 )). At all points to the right of k ∗, it falls (point C (k2 )). So, the economy constantly tends to point B, which means the balanced growth trajectory remains stable. In the Solow-Swan model, savings rate s matters only before the economy enters a steady development trajectory: the greater the s value, the higher the sk curve and, accordingly, the greater the k ∗ capital intensity. But once growth has balanced, its further pace depends only on population growth and technological progress. Therefore, the Solow-Swan model says the greater the saving rate, the higher the capital-labor ratio under balanced growth. Consequently, the higher the rate of balanced growth. However, as previously discussed in 7 Sect. 15.1.1, growth is not an end in itself. It is essential to determine conditions for optimal economic growth that ensures development. In a capital-abundant economy, an increase in output spurs growth. However, an increasing portion of income goes to saving, not consumption. In a capital-scarce economy, consumption exceeds saving, but the production sector lacks resources to increase supply and support economic growth. Somewhere in the middle between these two extremes is the optimal point, at which both consumption and output reach their maximums. This equilibrium is called the Golden Rule of Capital Accumulation (. Fig. 15.3). By adding the per capita output curve f (k) to . Fig. 15.2, the Solow-Swan model aims to maximize the distance between the per capita output and the per capita investment (f (k) − Sf (k) = f (k) − nk) (in the case of balanced growth). The distance is maximum at point B where the inclination n of the tangent line to the f (k) curve is equal to the inclination of the nk line. At this point, the capital-labor ratio is

557 15.4 · Neoclassical Theories

15

optimal (kopt). Therefore, it is necessary to identify such a rate of consumption/ac cumulation at which the Sf (k) curve crosses the nk line at point A kopt . The golden rule of capital accumulation allows for outlining economic development policies. If the economy accumulates greater capital stocks than it could have under the golden rule, then the government should reduce the saving rate. This would stimulate consumption, depress investment and, consequently, reduce capital stock. If capital stocks in the economy are below the golden rule threshold, the government should incentivize savings. Such a policy would cut consumption and increase investment. Consumption would resume as output grows due to higher investment. Population growth in the Solow-Swan model is interpreted as an increase in the working-age population (more effective labor units). The availability of an employable population can be improved by increasing the birth rate or immigration (or both factors). Faster population growth accelerates economic growth but reduces the per capita output. An increase in savings rate results in higher per capita income and spurs the capital-labor ratio, but it does not affect the economic growth rate. Therefore, technological progress (higher productivity of all inputs) is the only factor that boosts economic growth and pushes up per capita income. 15.4.4  The Mankiw-Romer-Weil Model

Gregory Mankiw, David Romer, and David Weil performed an empirical evaluation of the Solow-Swan model and created a human capital augmented version of the model to identify determinants of interregional differences in output levels and growth (further reading: “A Contribution to the Empirics of Economic Growth”15). The Mankiw-Romer-Weil model is an exogenous model of economic growth with a decreasing return on physical and human capital and an exogenous rate of technology growth. The model has three principal features: 5 Introducing such a category as human capital aims to improve the SolowSwan model, which explains economic growth through savings and population growth. The human capital parameter allowed for improving regression analysis results based on cross-country comparisons. 5 Human capital is limited to secondary school education. Its level is assessed through direct government expenditures. The authors are aware of the shortcomings of such an assessment associated with the non-accounting of indirect costs in the form of lost wages during schooling and the cost of education. Medicine, the second potential component of human capital development, is omitted due to technical difficulties. Concerning science as a possible component of human capital, the authors indicate that the rate of technological pro-

15 Mankiw et al. (1992).

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gress reflects the development of scientific knowledge. It is assumed that this rate does not differ significantly between countries. Therefore, it is taken as a constant value. 5 The model focuses on common rather than distinctive features of human and physical capital. The same substitution rate is provided for both types of capital, which is reflected in the assumption of transforming a unit of consumption into a unit of either physical or human capital. The same rate of depreciation for physical and human capital is also accepted. Human capital is introduced into the production function as a separate resource along with physical capital (Eq. 15.20):

Y (t) = K(t)α × H(t)β × (A(t) × L(t))1−α−β

(15.20)

where Y    output; K    reproducible physical capital; H   reproducible human capital; A   technological knowledge; L   raw labor; α   output elasticity with respect to physical capital; output elasticity with respect to human capital. β   The model assumes that α + β ≤ 1, therefore, the return on production resources declines. A fixed α value can correspond to a large number of β values. Therefore, the contribution of human capital to the domestic product may vary while ensuring the stability of output y∗. The latter is derived in the same way as in the Solow-Swan model (Eq. 15.21): β α  α  β  1−β  β 1−α 1−α−β SK1−α−β × SH1−α−β SK × SH 1−α−β SKα × SH ∗ (15.21) y = × = α+β n+g+σ n+g+σ (n + g + σ ) 1−α−β

15

Having distinguished the propensity to save by physical capital (SK is the share of income invested in physical capital) and human capital (SH is the share of income invested in human capital), let us construct accumulation equations for physical capital (Eq. 15.22) and human capital (Eq. 15.23): (15.22)

�k = SK × y − (n + g + a) × k

(15.23)

�h = SH × y − (n + g + a) × h where y =

Y A×L ,

k=

K A×L ,

h=

H A×L ,

y=

kα

× hβ.

A special case of the Mankiw-Romer-Weil model is the Romer model—an endogenous model of economic growth with a constant return on human and physical capital and no technological progress. It also includes human capital

559 15.4 · Neoclassical Theories

15

to explain economic growth by extending the Solow-Swan model. It is assumed that along with technological advancement, propensity to save, and population growth, economic growth is affected by directing resources to the accumulation of human capital. A clear distinction is made between abstract and concrete knowledge: when interpreting human capital, only productivity-changing knowledge is considered. The Romer model distinguishes the following four characteristics of human capital: 5 human capital is manifested in the acquired professional qualities, skills, competencies, and specific knowledge of employees; 5 accumulation of human capital by an employee (the assimilation of new knowledge and skills) increases on the basis of the already acquired stock of skills and knowledge; 5 human capital includes unskilled (raw) labor (for instance, an ability to physical labor inherited by an employee) and skills and knowledge (acquired competencies); 5 quality of human capital changes with time (years of study). The last two provisions define the way in which the value of human capital is determined (Eq. 15.24):

H(t) = L(t) × G(E)

(15.24)

where L(t) total number of workers used to measure unskilled raw labor; G(E)  function of skilled labor depending on the training time of an average employee; E average training time per employee. The model is based on the production function (Eq. 15.25):

Y (t) = K(t)α × [A(t) × H(t)]l−α

(15.25)

where labor efficiency coefficient; A(t)   H(t)  human capital, or the total volume of production services performed by skilled employees. Proceeding from the production function (15.25), output per unit of effective labor with an account of human capital is calculated as follows (Eq. 15.26):

y=

Y Y = A × G(E) × L A×H

(15.26)

Then output per employee is determined as follows (Eq. 15.27):

Y = A × G(E) × y L

(15.27)

Chapter 15 · Foundations of Economic Development

560

where A × G(E)  number of units of effective labor per employee; output per unit of effective labor. y Assessing human capital through training time expands the Solow-Swan model in another direction. To simplify the theoretical construction, the SolowSwan model ignores the distinction between an employable population and a country’s total population. Since human resources development is associated with studying, the accumulation of human capital involves a change in the ratio between the number of students and the size of the working population in favor of the former group. The proportion of employees L in the total population N is calculated as follows (Eq. 15.28):

e−nE − e−nT L(t) = N(t) 1 − e−nT where N L T E T − E  n

(15.28)

total population; share of employees in the total population; life time; training time; working time; rate of change in the population size.

Taking into account the portion of employable workers in the population, the output per employee is calculated as follows (Eq. 15.29):

15

e−nE − e−nT Y (15.29) = A × G(E) × y × N 1 − e−nT Equation 15.29 shows that an increase in training time has both a positive (due to the growth of G(E)) and a negative (due to a decrease in the proportion of −nE −nT workers in the population e 1−e−e −nT ) impact on output. Therefore, the model formulates the golden rule of the optimal training time (by analogy with the SolowSwan golden rule of capital accumulation). The contribution of human capital to growth is determined by taking the logarithm and decomposing of the production function (15.25) (Eq. 15.30): ln

α K H Y = × ln + ln + lnA L 1−α Y L

(15.30)

Evaluating the results of empirical verification of the model, Romer emphasizes two shortcomings. First, the model does not consider externalities associated with human capital. Therefore, differences between countries in the level of Y L are interpreted as the result of changes in A, while they could be associated with changes in human capital. Second, the model ignores differences between coun-

561 15.4 · Neoclassical Theories

15

tries in the quality of education, non-formal accumulation of knowledge, and other types of learning. 15.4.5  The Kaldor Growth Model

The classical theory of saving suggests that per capita consumption reaches its maximum if all capital gains are invested and all wage income is consumed. In this case, the classical condition of saving is fulfilled: the economy-wide saving rate corresponds to the rate of profit, and the interest on capital is equal to the rate of population growth. Nicholas Kaldor in a paper entitled “A Model of Economic Growth”16 suggested savings to be volatile. They can go up to a level when the actual growth rate drops to a guaranteed threshold. The Kaldor growth model formulates the so-called class-specific savings hypothesis based on the idea that the rate of savings from labor income (wages) is lower than the rate of income from profits. Aggregate savings are presented as follows (Eq. 15.31):

S = sp × rK + sw × wL 0 ≤ Sw < Sp ≤ 1

(15.31)

In this case, the aggregate savings quota s = YS is an exogenous and constant value. It is represented as a function of the rate of profit π (Eq. 15.32). Wage is defined as wL = Y − rK , since it is further distributed through the national income Y .

s(π) = (sp − sw) × π + Sw

(15.32)

The aggregate saving rate goes up with an increase in the rate of profit, if the most part of national income falls on the owner of income from profits. In contrast, the class-specific saving rate may hypothetically be higher. Hence the condition of equilibrium growth is formulated as follows (Eq. 15.33):

s(π) =n+δ a

(15.33)

δ  economy-wide depreciation rate (δ > 0); n  labor productivity. Labor productivity and the depreciation rate are exogenous and constant parameters of the model. Data can be inserted into the equilibrium growth equation based on the disequilibrium situation if the aggregate saving rate adapts to equilibrium. When the aggregate saving rate is low (s1 in . Fig. 15.4), fixed assets grow slowly compared to labor productivity. In the case of linear limited production technology, fixed assets depress economic growth. Excessive supply of labor reduces wages and, accordingly, the labor income factor. Excessive demand for capital pushes up the interest rate, and the rate of profit declines. 16 Kaldor (1957).

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. Fig. 15.4  Equilibrium rate of profit in the Kaldor growth model. Source Authors’ development

With a constant ratio of input factors, labor and capital are redistributed. The increase in the rate of profit lifts the saving rate. The process lasts as long as the economy stays in equilibrium, in which the growth rates of the two factors coincide. The aggregate saving rate reaches its equilibrium at point B. In a situation of too high saving rate (s3 ), the redistribution is also required to achieve equilibrium. 15.5  Developmentalist Theories 15.5.1  Lewis’s Unlimited Supply of Labor

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The Lewis model is a neoclassical model of development of a dualistic economy (two sectors) with an oversupply of labor proposed by William Arthur Lewis in 1954 (further reading: “Economic Development with Unlimited Supplies of Labour”17). The model postulates that labor surplus in one sector establishes the basis for growth in another sector and the economy as a whole. Lewis explains the growth of developing countries in the context of the flow of labor from the traditional subsistence sector to modern industrial production. After the World War II, developing countries strived to increase their growth rates and national income level, but faced low saving rates and insufficient investments. At that time, most experts believed that capital received from exports and other sources should be invested in the industrial sector to support economic growth through the expansion of industrial production. Lewis argued that the economy includes conventional sectors, such as agriculture, and modern sectors, such as industrial production. The former employs a large number of low-skilled workers and outdated equipment, while the latter expands by using new machinery

17 Lewis (1954).

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. Fig. 15.5  Lewis’s labor supply in a agriculture and b industry. Source Authors’ development

and attracting high-skilled labor. According to Lewis, modernization requires redistribution of resources from conventional to new sectors. Two central problems need to be solved to facilitate the redistribution: capital accumulation (mobilization of savings and turning them into investments) and employment (relocating labor from labor-abundant sectors to labor-scarce industries). Therefore, Lewis interprets modernization as redistribution of material and labor resources and exchange between sectors by contracting less productive industries and incentivizing more productive ones. . Figure 15.5 illustrates labor supply in agriculture and industry and the exchange between the two sectors. Since the agricultural sector experiences oversupply of labor, the marginal product of labor (MPL ) in agriculture would be zero. In theory, workers who generate no marginal product should receive no remuneration for their work. However, LA agricultural workers do receive wA wages equal to the APL average product they produce. Such a paradoxical situation develops exactly in traditional sectors, where the aggregated product is generated by an extended community of workers and their family members. Historically, agriculture has been a way of life rather than a branch of the economy as such. Work is often done collectively, so using the marginal product as a measure of labor productivity of a particular worker makes no economic sense. All employees participate in creating a domestic product regardless of the contribution of an individual. Labor productivity in the industrial sector is a more individualized indicator compared to traditional agriculture. Higher wages in industry (wI > wA ) attract some of agricultural workers to the sector. In an effort to maximize marginal product (MPLI curve), firms hire workers up to LI1 and raise wages up to wI . The total industrial output is then equal to area 0M1 ALI1 of which workers earn 0wI ALI1 as wages and entrepreneurs gain wI M1 A as profit. Reinvestment of this profit allows entrepreneurs to expand production by installing more equipment and hiring more workers. The marginal product curve shifts from MPI1 upward right to MPI2. Given the labor surplus still flowing from the agriculture to the industry, firms can now hire up to LI2 while maintaining wages at wI (wages in the industry are still higher than in the agriculture). Total output climbs to 0M2 BLI2, workers’ remuneration to 0wI BLI2, and entrepreneurs’ profit to wI M2 B. Thus,

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employment in a more productive industrial sector grows by means of reducing employment in less productive agriculture. Domestic product grows due to better utilization of factors of production. 15.5.2  Hirschman’s Unbalanced Growth

As previously discussed in this chapter, as well as in 7 Chaps. 6 and 7, one of the key features of economic development is stability. Most of the economic development concepts consider both balanced and unbalanced growth. The fundamental hypothesis of the unbalanced growth theories is that investments should go to strategically significant industries only, not all sectors of the economy simultaneously. Non-priority sectors automatically catch up due to such selective investment. Albert Hirschman was one of the first to formulate the concept of unbalanced growth (further reading: “The Strategy of Economic Development”18). According to Hirschman, creating imbalances through selective investment in the most promising industries is the best strategy for growth. Facing a lack of resources and suffering underdevelopment, a country should ensure the most efficient utilization of scarce factors of production. Accordingly, the development of strategically important sectors (those that are able to create or strengthen competitive advantages) should be prioritized. Unbalanced growth results in positive externalities (see 7 Chap. 10, 7 Sect. 10.4 for the concept of externalities). For example, sector A emerges and thus stimulates growth in sectors B and C. Thus, strategic sectors are economic growth engines for the entire economy. The complementarity of demand also leads to positive externalities. For instance, the increase in sales in sector A may spur demand for goods supplied by sectors B and C or reduce marginal costs in these sectors. In 7 Chaps. 6 and 7, we attributed economic growth to a continuous evolution of the economic system from one state of equilibrium to another through disbalances. Competition between sectors incentives imbalances that could potentially bring higher returns in the future. Larger disbalances could generate greater growth.

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Case box The theory of unbalanced growth particularly applies to developing and least developed countries. A balanced investment policy requires capital, a scarce resource in most of developing countries. Therefore, concentrating available resources on investing in one most competitive sector initially disturbs the equilibrium, but then attracts new investments, including from abroad. New investments correct the imbalance but cause new disequilibriums in other industries and the economy as a whole (thus contributing to further growth). However, the model idealizes the real situation assuming

18 Hirschman (1958).

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the market mechanism quickly responds to emerging deficits and the slightest changes in government policy. In developing markets, however, such communication systems are poorly developed. Therefore, new disbalances only aggravate old ones, thus making unbalanced systems rigid and inflexible.

Hirschman distinguishes two types of investment: 5 Investments in social infrastructure. Roads, energy transmission systems, transport, and communications establish the basis for any economic activity. Social investments generate a series of positive externalities. 5 Direct investments in the production of final goods and services. This is a kind of “fading” investment, as their externalities weaken as investments grow. Due to the lack of resources, these two types of investments should not be carried out simultaneously. Many scholars agree that the commitment to the unbalanced growth idea could benefit developing countries. Investments can be concentrated in innovative industries and related sectors. The government incentivizes other sectors to catch up by giving a push to one industry (see the big push theory in 7 Sect. 15.5.4). To maximize the effect, the government should develop social infrastructure, improve the quality of education, reveal hidden unemployment, and retrain labor. 15.5.3  Nurkse’s Balanced Growth

Investing is a necessary condition of economic development. Investments improve the production potential of a country on a new scientific and technical basis and determine the competitive advantages of firms and entire nations in the global market. For most of capital-scarce developing countries, attracting foreign capital in the form of direct and indirect investments and other assets is vital for ensuring economic growth. Almost all schools of economic thought have studied the interdependence of investment activity and economic growth. Keynes revealed the functional impact of investments on growth. He found that an increase in investment results in an increase in the national income by the amount greater than the initial increase in investment (see 7 Chap. 6, 7 Sect. 6.3.3 for the Keynesian interpretation of the multiplier effect). To launch such a self-sustaining multiplying growth, Ragnar Nurkse proposed implementing a balanced set of investments to get out of the vicious circle of capital deficit (further reading: “Problems of Capital Formation in Underdeveloped Countries”19). Similar to unbalanced growth models, Nurkse’s balanced growth theory advocates the industrialization of individual sectors to stimulate related industries. At the same time, the government should develop infrastructure, communications, and market institutions.

19 Nurkse (1953).

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It is necessary to invest heavily in various sectors in underdeveloped economies to create wide-scale inducements to productivity improvement and incentivize further investment. At the same time, it is essential to balance the development of the industrial and agricultural sectors to facilitate the exchange of resources and factors of production between them. The incentive to invest depends on the size of the market. According to Nurkse, developing countries suffer from low purchasing power. If cash incomes were low, the problem could be addressed by expanding the money supply. However, since real income matters, the expansion of the money supply increases inflationary pressure. Neither actual output nor investment grows. Low purchasing power depletes demand for consumer goods and services and capital. The market size determines the incentive to invest because entrepreneurs make their investment and production decisions taking into account potential demand for their products. The higher the demand in the market, the more attractive a country to invest in. That is why receptive developed markets attract more investment compared to developing economies. Case box A large population does not mean a large market. Although developing countries concentrate a large part of the world population, their productivity is lower compared to developed states. Lower productivity results in lower real per capita income and, consequently, lower consumption expenditures and savings. Developed countries are generally smaller in terms of population size than many of developing states. Still, higher productivity allows them to generate greater real per capita incomes, i.e., higher consumption expenditures and savings per capita. The physical size of a country has little to do with the size of its market. Smaller countries may consume more than bigger states. Conversely, big countries may have small markets. For example, Japan’s market is much bigger than Russia’s market, while Japan is forty-five times smaller than Russia.

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Low labor productivity retards economic growth. Productivity gains increase the flow of goods and services in the economy and push consumption. Consequently, developing countries should strive to increase productivity in all sectors. Since the economic growth prospects of a country are always limited by the size of its market, an increase in productivity can create the prerequisites for growth. Thus, economic growth can be launched by implementing large-scale investment programs in all sectors simultaneously. An increase in demand in one sector drives an increase in another. As Say’s Law states, supply creates its own demand (see 7 Chap. 6, 7 Sect. 6.1.1 for the classical interpretations of the Say’s Law). However, according to Nurkse, a country should rely on its own capital and resources as much as possible. The use of foreign capital may cause certain problems. For example, foreign investors may waste or inappropriately use resources or harm the environment in the host country. This, in turn, deteriorates the ability of this economy to diversify.

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15.5.4  The Rosenstein-Rodan Big Push

Both Hirschman’s theory of unbalanced growth and Nurkse’s theory of balanced growth agree that economic development and growth can be triggered by modernization through investment. In this sense, theories of unbalanced and balanced growth originated the general idea of a big push first proposed by Paul Narcyz Rosenstein-Rodan. This concept supposes integrated development of several industries within an economy, each of which could stimulate demand for the products of the remaining industries in the group. The increased demand then triggers the overall growth, even in poorer performing sectors (further reading: “The Theory of the ‘Big Push’”20). The big push theory is contrasted with the classical interpretations of macroeconomic equilibrium in the three following aspects: 5 The theory is based on more realistic assumptions about a certain indivisibility and inconsistency of production functions. In turn, this suggests higher revenues and more pronounced technological externalities. 5 The theory implies a movement towards the equilibrium where investment is zero. 5 In addition to the high risks and imperfections of the concept of investment, the market system in developing economies is commonly less efficient than in developed countries. Therefore, market signals in such systems can be delayed or misinterpreted. Case box The big push idea was undoubtedly influenced by the European Recovery Program (or the Marshall Plan) enacted in 1948 to help rebuilding Western Europe after the World War II. At that time, Keynesian critical attitude to the regulatory power of the market dominated in the USA and Europe. The market was considered a static system not able to lead developing economies out of the “vicious circle of poverty”. Therefore, most of the proponents of the big push theory took advantage of the popularity of the Keynesian idea of government regulation. The big push theory was well accepted in developing countries since it explained economic, social, and technological backwardness by the lack of capital. Also, large corporations from developed countries were interested in promoting such a theory when investing in new emerging markets.

The theory emphasizes four important factors that affect the efficiency of investment: 5 Hidden unemployment. When implementing large-scale investment programs in critical sectors, failure to consider hidden unemployment can cause social tensions. Hidden unemployment of about 3–5% is intrinsic to many emerging economies. It increases in times of economic or social uncertainty and declines

20 Rosenstein-Rodan (1976).

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when the economy grows. For the success of the big push policy, the government must identify sectors with high hidden unemployment and retrain workers so they can be reemployed in new emerging industries. 5 Material externalities. The firm’s income grows due to the complementarity and indivisibility of demand, that is, the interdependence of various investment decisions. Investments in low-competitive sectors carry significant risks, since supply meets no adequate demand in the market. But in the case of large-scale investment programs, sales losses in one sector are compensated by gains in another (complementarity of demand as a positive externality). Reducing these interdependent risks incentivizes investments. At the same time, low-elasticity demand in low-income countries makes troubles balancing supply and demand. This may be due to higher risks in a small market than in a large and growing market. The risk-reduction effect of the complementarity of demand is insignificant due to tiny investments. To overcome this insignificance, it is necessary to exceed the minimum level of investment, at which the complementarity of demand manifests itself. This discreteness of demand is called the indivisibility of demand. To exceed the minimum threshold and take advantage of the complementary demand, an initial influx of capital is needed to spur the production of goods and services on which new labor will then spend its additional income. 5 Investment in social infrastructure. One of the most demonstrative examples of the indivisibility issue and insufficient externalities is the investment in social infrastructure. Despite a long payback in this sphere, providing social facilities creates investment opportunities for other industries. For the economy as a whole, securing these overhead expenditures on social infrastructure requires a substantial amount of investment in each infrastructure project. This investment is a prerequisite for future higher returns. According to the big push theory, the lack of social infrastructure is one of the stumbling blocks to economic development. 5 Technological externalities. One of the reasons for the emergence of positive technological externalities is the training and development of human resources. The market self-regulation may fail in this case, because an entrepreneur may not want to invest in the development of an employee who then flies to a competitor or opens their own business. Nevertheless, human resource development is one of the most promising types of investment for a country, although it may cause losses for an individual firm. Therefore, the government should support and incentivize training opportunities to improve positive technological externalities. Both Rosenstein-Rodan and other proponents of balanced and unbalanced growth suggest the neo-Keynesian interpretation of economic growth factors. They accent the role of autonomous, government-driven investments in establishing economic growth. Launching self-sustaining growth in developing countries requires a substantial infusion of capital (about 12–15% of the national income). The market can not mobilize such a huge amount of investment. Therefore, it must be secured by the government.

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15.6  Contemporary Interpretations of Economic

Development

15.6.1  Structuralism

The development of global markets on the basis of the intertwining of national economies and progressing globalization necessitated a rethinking of economic growth and development concepts. The contribution of international trade to the economic development of individual countries has become particularly prominent. The evolution of theories of international trade is discussed in 7 Chap. 19. In this section, we address links between trade and development. Both classical political economy and neoclassical mainstream schools have considered international trade as an interaction of systems with different sets of parameters (different provision of countries with natural resources and population, varying levels of prices and technology development, etc.). Even the mercantilist theory of absolute advantage allows the production of the same goods and services at different costs in different countries, so that prices of imported and exported goods are not directly related to their production costs. Ricardo postulated that a country has a comparative advantage in producing a good if it is able to produce it cheaper than other countries. Therefore, international exchange is beneficial when prices differ. These differences persist due to the relative inelasticity of the movement of natural resources, labor, and capital between countries. The specialization in producing those goods for which countries enjoy comparative advantages makes it possible to enhance productivity and, accordingly, increase domestic product and income. However, the backwardness of a number of developing countries in the 1930– 1950s, particularly in Latin America, called forth the reconsideration of the classical principle of comparative advantage. In its pure form, the latter implies that in some countries, international trade promotes the development of new technologies, science, and education, while in the others, it stimulates the specialization in the extraction and primary processing of natural resources. Neoclassical theories assume factors of production to be relatively homogeneous, which allows aggregations into labor and capital. Raul Prebisch disaggregated these factors and hypothesized that as international trade increases, prices of resources decline, while prices of manufactured goods expressed in units of these resources rise. In fact, this means a deterioration in the advantage of those countries that specialize in trade in resources. The newly emerged Structuralist School focused on studying global economic structures, barriers to development, and market imbalances. Structuralism distinguishes the center of world trade from the periphery (the center-periphery model). The center is formed by industrialized countries, which have a relatively homogeneous economic structure and supply a diverse range of goods and services. The periphery has a heterogeneous economic structure (including dualism, high unemployment) and can only supply certain primary goods. According to Prebisch, the periphery is at a disadvantage in the international division of labor, as developing countries mainly specialize in exporting

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natural resources and low-processed goods. In support of his hypothesis, Prebisch put forward additional arguments related to the elasticity of supply and demand. In particular, he assumed that the production and supply of agricultural products are relatively inelastic, in contrast to the production and supply of industrial goods. The inelasticity in agriculture is due to the competition of small producers, while large industrial firms and the state more efficiently control industrial output and thus ensure higher elasticity of industrial products (further reading: “The Economic Development of Latin America and Its Principal Problems”21). Case box Prebisch founded his reasoning on Latin America’s trade in the 1920–1930s. But since the 1960s, prices of resources and raw materials have been increasing gradually. In fact, at that time, Prebisch’s hypothesis was not proved empirically. Nevertheless, modern studies22 confirm that in the long term, prices of natural resources decline compared to prices of industrial goods. Since the XVII century, the terms of trade in raw materials have been deteriorating. New technologies and innovations allow firms to cut costs. Synthetic analogs of many types of raw materials have been invented. Long-term cycles of prices have been discovered: prices of one kind of resources have been following prices of other kinds of raw materials for over 350 years. Thus, Prebisch’s hypothesis is now confirmed empirically.

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There are three fundamental differences between Prebisch’s structuralist theory and classical, neoclassical, and developmentalist theories considered in 7 Sects. 15.2, 15.4, and 15.5, respectively: 5 In the neoclassical interpretation (for example, the Heckscher-Ohlin model further detailed in 7 Chap. 19, 7 Sect. 19.1.4), countries in international exchange are economically independent of each other and relatively self-sufficient. They have approximately the same level of income and GDP per capita. According to Prebisch, peripheral economies depend on the center. The latter are richer, more developed, industrialized, and advanced. Peripheral economies depend on the center in various spheres, such as trade, technologies, and investment. The dependence allows central states to employ economic and trade sanctions against peripheral countries to affect their behavior. Neoclassical models do not rule out sanctions, but postulate that sanctions harm all parties, including developed countries who initiated them. 5 Prebisch distinguishes between raw materials and industrial goods. They differ in terms of production and trade. Production of raw materials is relatively inelastic, while production costs rise or at least remain unaffected. Production of industrial goods can rise or fall sharply depending on demand, while costs

21 Prebisch (1950). 22 Arezki et al. (2013).

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per unit decline when output grows. As a result of these immanent features, terms of trade deteriorate for the suppliers of raw materials and improve for those countries specializing in industrial production. The neoclassical school operates with the concepts of labor-intensive and capital-intensive goods. Import reduces returns of relatively scarce factors, while export increases rewards of relatively abundant factors. Ongoing deterioration in terms of trade in any good is irrelevant. 5 Both Ricardo’s theory of comparative advantage and Prebisch’s structuralist theory demonstrate that the absence of a direct relationship between costs and price in international exchange makes such an exchange unequal exchange. According to Ricardo, inequality affects both sides, i.e., no country always benefits more from international trade than the others. Prebisch says that the central countries receive part of the additional “intellectual rent”, withdrawing it from the peripheral economies. Since the unequal exchange between the periphery and the center can be interpreted as exploitation of developing countries by developed states, structuralism is often perceived as one of the novel interpretations of Marxism. However, in structuralism, economic development is triggered by the growth of wages above the average level, not capital accumulation or industrial revolutions as in Marxism. Lagging countries “pay” for the progress of developed economies. The wellbeing of the center rests on the backwardness of the periphery (see the inequality problem in 7 Chap. 14 and the discussion of various aspects of rising inequality between countries under the new normal in 7 Chaps. 16–17 and 20–23). Thus, in structuralism, wage differences produce development gaps, while the exploitation of countries arises out of these gaps. 15.6.2  Institutionalism

Economic science dominated in studying developing countries in the 1940–1950s. The progress of social sciences during the 1960–1970s predetermined the emergence of Institutionalism, the school that studies economic reactions of individuals on the evolution of social and economic institutions, including behavioral patterns, perceptions, habits, traditions, and ethical norms (further reading: “Economic Development: An Institutionalist Perspective”23). Success stories of developed and some of the rapidly emerging economies encourage developing countries to copy their development models and project them onto local context. However, the application of foreign models rarely yields the desired outcome due to differences in the institutional environment and cultural, historical, and political background between countries. Rostow’s linear growth model (7 Sect. 15.3.2) and the Harrod-Domar growth model (7 Sect. 15.4.1) assume developing countries to have certain initial conditions. These models may

23 Ayres (1991).

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work unpredictably in a different institutional environment, resulting in crises or disbalances in various spheres of economy and society. Some market economy principles effective in developed countries may produce deteriorating effects being simply imported into developing and transition economies. According to institutionalism, the development agenda cannot be narrowed down to economic transformations in developing countries and economies in transition. Using the examples of countries of South and Southeast Asia, Gunnar Myrdal argues that economic development is always accompanied by changes in social institutions, people’s behavior, and ideology. Examples include urbanization and the complex of institutional and spiritual changes commonly referred to as modernization (further reading: “Economic Theory and Underdeveloped Regions”24 and “Asian Drama: An Inquiry into the Poverty of Nations”25). Myrdal distinguishes the following four principles of modernization: 5 Rationalism: new approaches to conventional methods of production, distribution, and consumption in all spheres of economy and society. The search for rationality implies that the choice of economic development strategy should be based on knowledge and information. 5 Economic planning: search for a rational set of economic measures and policies aimed at accelerating development. 5 Equality: ensuring economic, social, and legal equality and higher income and standards of living for all. 5 Development of public institutions and society. These are changes aimed at increasing labor productivity, encouraging competition and entrepreneurial initiative, ensuring equal opportunities for all, improving living standards, and stimulating development. Examples of institutional changes are land reforms, anti-trust regulations, education, and government reforms. Social changes include the spread of such ideals as efficiency, diligence, honesty, rationality, self-reliance, and openness to changes. Case box

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Myrdal accepted these principles to be idealistic. When studying developing economies in Asia, he demonstrated that many of the modernization principles could never be attained in real life. Myrdal called it a drama: most of the development expectations have not been fulfilled, while new structural problems and challenges have emerged. The population explosion has been accompanied by a drop in living standards in a number of developing countries across Asia. It coincided with a crisis of hopes for a rapid transformation of traditional society and disenchantment with neo-Keynesian and neoclassical economic development theories.

24 Myrdal (1957). 25 Myrdal (1968).

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Myrdal examines the difficulties faced by modernization in developing countries. He draws attention to the role of traditional values, which is overlooked by most Western studies. In many cases, traditional values conflict with the ideals of modernization. In traditional societies, people have a strong sense of conservatism. Their culture is based on traditions and conventional practices and favors no experiments. In many societies, religion justifies the traditional social and economic stratification. Thus, the very way of life hampers modernization from both inside through local transformations and outside by introducing foreign experiences and technologies. The government can fuel development by launching nationwide modernization programs, but many developing countries lack qualified managers capable of planning and running wide-scale development projects. Myrdal examined economic and social planning across Asia. He found that some of the Asian countries adopted the economic planning approach in an attempt to combat poverty amid the booming growth of the population. According to Myrdal, economic progress in Asia could not have started without broad redistributive reforms. Many scholars outlined the underutilization of abundant labor among the causes of underdevelopment in Asia. Developmentalist school advocated the simple creation of new jobs in the industrial sector as a way to employ labor surplus and give rise to economic growth (particularly, the Lewis’s model of labor supply discussed in 7 Sect. 15.5.1). Myrdal doubts the workability of such an approach in Asia. Among the causes of labor underutilization, he emphasized labor market imperfections, weak institutional development of the economy and society, low standards of living, inadequate nutrition, and bad health of the poor. Elimination of labor shortage in the industrial sector by incentivizing the flow of labor surplus from agriculture is impossible due to the low qualifications and poor physical condition of workers exhausted by hard work and poverty. Thus, neither the Keynesian approach (economic growth through the attraction of the unemployed in government development programs) nor the developmentalist approach (transfer of surplus labor from traditional sectors to emerging ones) is applicable to developing countries. Consequently, according to Myrdal’s institutional theory, the main reason for underdevelopment is not the lack of capital (as many development models assume), but the underutilization of labor. Economic growth in developing countries can be spurred by bridging the gap between the rich and the poor, training human resources, and lifting people out of poverty. People must be adequately supplied with various economic and social goods and services to stimulate labor productivity. According to Myrdal, growth not accompanied by the improvement in the living conditions of the population is only quantitative growth without development, since it leaves aside the overwhelming majority of the population and is achieved at the expense of the population (see the discussion of development-growth relationships in 7 Sect. 15.1.1). The multidimensional institutional approach allows for a more comprehensive assessment of the development of a particular country. Most importantly, it illuminates the need for human resource development as the core long-term development goal.

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15.6.3  International Dependence

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According to institutionalism, the integrity within industrialized economies has been improved substantially due to the development of formal and informal institutions and the government regulation of the economy and society. However, global economic integration is still weak. Moreover, integration in developed countries has aggravated international disintegration (see, for instance, the growing economic inequality between industrialized and underdeveloped countries). Structuralism, institutionalism, and neo-Marxism (the neocolonial dependence model previously addressed in 7 Sect. 15.3.4) all note the increasing economic dependence of developing countries on developed states. Though, the interpretation of the causes of such dependence varies. In particular, the False-Paradigm Model explains the backwardness of developing and least developed countries by following the erroneous advice of foreign consultants (international organizations, aid funds, individual experts from developed countries) who are not familiar with local specifics. Many of the complex concepts, theoretical constructions, and econometric models they ­develop fail or work improperly in the local context (see divergences of formal and informal institutional structures in industrialized and traditional societies previously discussed in 7 Sects. 15.3.4 and 15.6.2). Many of local economic advisers to governments, scientists, politicians, and other officials and experts got education or training in western universities. They advocate for capital accumulation, productivity improvements, or high GDP growth while missing the need for fundamental institutional and structural reforms. Without establishing the institutional basis and implementing broad structural reforms, any smart improvements may be useless. The concept of dual societies (wealthier and less prosperous nations, inequality within countries) implicitly presents in the structuralist and institutionalist models and explicitly dominates the dependence theories. Economic development theories widely use the Dualistic-Development Thesis. It refers to reproducing and widening the gap between rich and poor (developed and developing, Global North and Global South, advanced and underdeveloped, industrialized and traditions, etc.) at all levels. The dualistic-development concept is based on the following four propositions: 5 A set of specific conditions when “higher” and “subordinate” subsystems appear within one system. Examples are the industrial and agricultural sectors in the Lewis’s model (7 Sect. 15.5.1), the center and the periphery in structuralism (7 Sect. 15.6.1), economic and social gaps between developed, developing, and least developed countries, and various kinds of income and legal inequalities within countries (previously discussed in 7 Chap. 14). 5 Dual structures are reproduced constantly. Contrasts between higher and subordinate subsystems persist. Implicitly, such a premise is contained in Marx’s stages of development (7 Sect. 15.3.1), Rostow’s linear growth model (7 Sect. 15.3.2), and models of structural transformation (7 Sect. 15.6.1).

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5 The gap between higher and lower subsystems not only persists, but it grows. Least developed countries have been increasingly falling behind developing economies, while the latter have been lagging behind developed states in labor productivity, industrialization, innovations, digitalization, and other parameters. 5 Higher subsystems do little to promote the development of the lower ones. In reality, they can even push them down, thus aggravating and multiplying underdevelopment. In general, dependency theories call into question the relevance of industrialization-related models (in particular, Lewis’s unlimited supply of labor for the industrial sector), pointing to the controversial nature of their provisions and the recent history of developing countries in Asia, Latin America, and Africa. The international dependence approach also rejects the assumption that developing economies have much in common. No universal solutions exist, and success stories can not be reproduced. Increasing imbalances in the international arena between developing and developed states call for fundamental economic, political, and institutional reforms both within countries and in a global context (further discussed, for example, in 7 Chap. 16 in terms of technological aspects of development and 7 Chap. 17 in light of human resources and social dimension of economic development). Chapter Questions: 5 What is the main difference between development and growth? Can they exist apart from each other? 5 How would you distinguish between steady, balanced, and sustainable growth? 5 Explain the essence of the classical interpretation of economic development. How does Smith’s concept of self-interested competition differ from Ricardo’s specialization? 5 Do you think Malthus’s theory of productivity constraints is still relevant today? 5 Summarize Marx’s visions of value and reproduction. How are these two concepts integrated into the theory of stages of economic development? 5 Name and characterize Rostow’s five stages of economic growth. Would you suggest any updates to this classification? 5 Define Baran’s economic surplus. Is it analogous to Marx’s surplus value? 5 How are warranted and natural growth alike and how do they differ? 5 According to Robinson, what factors determine economic growth? 5 Explain the difference between Robinson’s golden equilibrium and the SolowSwan golden rule of capital accumulation. 5 What are the principal features of the Mankiw-Romer-Weil model? 5 How do labor productivity and depreciation rate balance each other in the Kaldor growth model? 5 Which of the developmentalist theories interpreted modernization as redistribution of labor resources and exchange between sectors by contracting less productive industries and incentivizing more productive ones?

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5 Theories of balanced and unbalanced growth are variants of the big push theory. What are the principal distinctions of these three approaches to economic development? 5 Discuss the center-periphery concept and its contemporary interpretations in structuralism, institutionalism, and three theories of international dependence. Do you agree with any of these approaches to explaining the essence of international economic relations? Subject Vocabulary:

15

Balanced Growth: a type of economic growth when growth rates of factors of production, technology, technical progress, and domestic product remain steady and inputs and output increase by the same proportional amount. Economic Development: a transition of the economy from one state to another qualitatively new state due to structural and institutional shifts. Economic Growth: an increase in the total and/or per capita value of real GDP/GNP. Economic Surplus: a mass of resources that society could have at its disposal to facilitate economic growth. Exchange Value: an ability of a commodity to be exchanged in certain proportions for other commodities. Expanded Reproduction: a permanent increase in the quantity and quality of goods. Extensive Growth: an increase in GDP due to the attraction of additional factors of production and resources while not changing technologies. Golden Age: a situation of full employment, when wages grow proportionally to productivity, profit remains stable, the government does not interfere the market, and expectations and the propensity to save both correspond to the growth in output. Golden Rule of Capital Accumulation: an equilibrium at which both consumption and output reach their maximums. Institutional Development: a creation or strengthening of a network of real institutions to generate, distribute, and use labor, material, and financial resources in order to affect abstract institutions. Institutionalism: the school of economic thought that studies the economic reactions of individuals on the evolution of social and economic institutions, including behavioral patterns, perceptions, habits, traditions, and ethical norms. Intensive Growth: an increase in GDP due to the use of more efficient and qualitatively advanced factors of production. Natural Growth: a type of economic growth when the growth rate is equal to the sum of growth rates of labor supply and labor productivity. Neocolonialism: a socioeconomic system of elements connected by social, economic, and political relations between developed and developing countries. Simple Reproduction: a steady production with no qualitative or quantitative changes. Steady-State Growth: an even and proportional economic growth when major macroeconomic parameters remain unchanged.

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Structuralism: the school of economic thought that studies global economic structures, barriers to development, and market imbalances. Surplus Value: a difference between total value added in the production process and the cost of labor. Sustainable Development: a development that meets the needs of the present without compromising the ability of future generations to meet their own needs. Sustainable Growth: an economic growth aimed at full satisfaction of the growing needs of the present generation without compromising the needs of future generations. Use Value: a value that expresses the utility of a commodity, i.e., the ability to satisfy needs as an object of consumption or a means of production. Warranted Growth: a type of growth that guarantees the full use of existing production capacities (capital).

References Arezki, R., Hadri, K., Loungani, P., & Rao, Y. (2013). Testing the Prebisch-Singer hypothesis since 1650: Evidence from panel techniques that allow for multiple breaks. International Monetary Fund. Ayres, C. (1991). Economic development: An institutionalist perspective. In J. Dietz (Ed.), Latin America’s economic development (pp. 89–97). Lynne Rienner Publishers. Baran, P. (1952). On the political economy of backwardness. The Manchester School of Economics and Social Studies, 20(1), 66–84. Food and Agriculture Organization of the United Nations, International Fund for Agricultural Development, United Nations Children’s Fund, World Food Programme, & World Health Organization. (2020). The state of food security and nutrition in the world 2020. Transforming food systems for affordable healthy diets. FAO. Harrod, R. F. (1948). Towards a dynamic economics. Macmillan. Hirschman, A. (1958). The strategy of economic development. Yale University Press. Kaldor, N. (1957). A model of economic growth. The Economic Journal, 67, 591–624. Lewis, W. A. (1954). Economic development with unlimited supplies of labour. Manchester School of Economic and Social Studies, 22, 139–191. Malthus, T. (1798). An essay on the principle of population. Printed for J. Johnson, in St. Paul’s Church-Yard. Mankiw, G., Romer, D., & Weil, D. (1992). A contribution to the empirics of economic growth. Quarterly Journal of Economics, 107, 407–437. Marx, K. (1867). Capital: A critique of political economy. 7 https://www.marxists.org/archive/marx/ works/1867-c1/ Myrdal, G. (1957). Economic theory and underdeveloped regions. Duckworth. Myrdal, G. (1968). Asian Drama: An inquiry into the poverty of nations. Pantheon Books. Nurkse, R. (1953). Problems of capital formation in underdeveloped countries. Oxford University Press. Prebisch, R. (1950). The economic development of Latin America and its principal problems. United Nations. Ricardo, D. (1817). On the principles of political economy and taxation. John Murray, Albemarle-Street. Robinson, J. (1978). Aspects of development and underdevelopment. Cambridge University Press. Rosenstein-Rodan, P. (1976). The theory of the “Big Push.” In G. Meier (Ed.), Leading issues in economic development (pp. 632–636). Oxford University Press. Rostow, W. (1960). The stages of economic growth: A non-communist Manifesto. Cambridge University Press. Rostow, W. (1971). Politics and the stages of growth. Cambridge University Press.

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Smith, A. (1776). An inquiry into the nature and causes of the wealth of nations. W. Strahan. Solow, R. (1956). A contribution to the theory of economic growth. Quarterly Journal of Economics, 70, 65–94. United Nations General Assembly. (1987). Report of the world commission on environment and development: Our common future. United Nations General Assembly, Development and International Co-operation: Environment. Warren, B. (1980). Imperialism: Pioneer of capitalism. Verso.

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Technological Choice and Development

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_16

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Learning Objectives: 5 Learn the fundamentals of innovation-driven development 5 Identify features of innovation-driven development in the new normal economy 5 Summarize the international development agenda and the new normal technological trends 5 Characterize technological development regimes 5 Provide insight into the production possibility concept 5 Distinguish between innovation pessimism and innovation optimism 5 Discuss creative destruction ideas 16.1  Technologies and the New Normal Economy 16.1.1  Innovation-Driven Development

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Economic development is directly related to the ability of an economic actor to produce competitive products. That is the takeaway message of most of the economic development theories, from the classical ideas of absolute and comparative advantages (previously discussed in 7 Chap. 15, 7 Sect. 15.2) to modern interpretations of emerging concepts in international trade (7 Chap. 19) and global development (7 Chap. 23). In the pre-industrial era, economic growth was mainly facilitated by the expansion of the production base, i.e., the involvement of new resources and factors of production in the turnover (see 7 Chap. 15, 7 Sect. 15.1.1 for extensive growth). Since the progressing industrialization brought intensification to the fore, economic growth and development have been associated with various types of technical and organizational improvements and innovations. Innovation-Driven Economic Growth is an increase in the gross domestic output and wealth through the continuing introduction of innovations in all spheres of economic activity (production, sales, management, etc.). An essential prerequisite for innovative growth is an increase in competition in national and global markets—one of the consequences of economic globalization. Innovation-driven and intensive types of economic growth are related terms, since they both imply qualitative improvements and efficiency gains. Still, by contrast with periodic intensifications, innovative-driven economic growth is based on the permanent creation and implementation of various innovative solutions due to ever-increasing competition. With this type of growth, the innovative component in the final cost of production increases significantly. Human capital is the main factor of innovative growth. Both the state and commercial companies allocate significant resources to build up high-skilled and high-innovative labor. Another key feature of innovative growth is a keen perception of changing consumer needs and flexible adaptation of supply to these changes. The innovative type of development is based on the introduction of Innovations—final results of innovative activity embodied in the form of a new or improved product in the market, a new or enhanced technological process or equipment, or a new approach to rendering services. Unlike the related concepts

581 16.1 · Technologies and the New Normal Economy

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of invention, improvement, or new ideas, innovation must be introduced into production and generate profit. Thus, feasibility, compliance with producers’ requirements and consumers’ demand, and the ability to generate income are immanent features of innovations. Being a specific type of market product, innovation is characterized by a high degree of uncertainty in obtaining scientific, technical, and commercial results, uncertain demand, and substantial time gaps between incurring costs and gaining benefits (very probably, losses). Four functions of innovations include the following: 5 reorganization: the application of theoretical knowledge to obtain a socially valuable product; 5 motivation: innovations facilitate economic growth through increasing potential benefits of both producers and consumers; 5 renewal: new approaches to more intensive use of factors of production improve country’s competitiveness in the global market and leverage its macroeconomic parameters; 5 social function: higher comfort and quality of life, better use of natural resources, environmental protection. Innovations are highly diverse. Therefore, any unambiguous classification and distinguishing similar features are somewhat challenging. . Table 16.1 summarizes the most commonly used criteria for classifying innovations. Depending on technological parameters, innovations are divided into product and process innovations. The former includes using new materials, new semi-finished products, and components and the production of brand new products. The latter is associated with new methods of production (new technologies) or management (new organizational structures within a firm). Case box Technological parameters particularly separate the Western (American and European) and Eastern (Japanese, Korean) innovation systems. Thus, over two-thirds of innovations in the Western system are product innovations. In contrast, many of the most successful process innovations originate in the Eastern system (for example, the lean production method derived from Toyota’s management model in Japan). China is an exception to the Eastern system. Similar to the Western system, product innovations in China grow faster than process improvements.

In terms of depth of changes, innovations can be fundamental and incremental (or a combination of the two). Fundamental innovations are major inventions that facilitate new generations and spheres of technology. Incremental innovations are improvements of an existing product, such as more efficient use of components and materials or modifications in one or several technical subsystems (in the case of a complex product). Incremental innovations induce dissemination and improvement of equipment and technologies, create new types of machines and materials, and improve various parameters of goods, services, and technologies.

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. Table 16.1  Classification of innovations Criteria

Types of innovations

Technological parameters

Product innovations Process innovations

Depth of changes

Fundamental innovations Incremental innovations Combinatorial innovations

Type of novelty

Material innovations (including technical and technological innovations) Economic innovations Social innovations Organizational and managerial innovations

Continuity

Displacing innovations (instead of old technologies or approaches) Canceling innovations (abolishing old approaches or equipment) Recurrent innovations (return to previous approaches) Opening innovations (brand new approaches)

Market share coverage

Local innovations (improvements to specific equipment or processes) System innovations (technical, organizational) Strategic innovations (management principles)

Goal

Production performance Management performance Labor performance (including improvement of working conditions)

Dispersion

Sporadic innovations (one object) Diffuse innovations (many objects)

Orientation

Intra-organizational innovations Inter-organizational innovations

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Scale

Global-wide innovations Country-wide innovations Company-wide innovations

Source

Independent invention Order, contract (government, business)

Location in the production process

Entrance (changes in resources, equipment) Exit (products, services, technologies, information) Entire system (management, production, distribution)

Source Authors’ development

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Case box The introduction of a new product is defined as a fundamental product innovation if it radically improves the product’s characteristics. Such innovations are aimed at mastering new generations of machines and materials. They are based on fundamentally new technologies or a breakthrough combination of existing technologies. An example of a fundamental innovation is the transition from a steam engine to an internal combustion engine. The subsequent gradual increase in the efficiency of the latter is incremental innovation.

To assess returns on the introduction of new ideas, one should consider benefits received by both producers (subjects of innovation activity) and consumers (final recipients). Innovation is deemed to be successful when all of the four following conditions are met: 5 Value: consumers should value the outcomes of innovation. 5 Exclusiveness: these outcomes should clearly differentiate a new product from existing substitutes already available in the market. 5 Endurance: the resulting advantages should endure, i.e., a product remains competitive for a long time. 5 Liquidity: costs associated with the introduction of innovations should correspond to available resources of a producer. A product should be considered a profitable purchase for a consumer in terms of both quality and price. Any performance evaluation compares the amount of resources spent and the achievements obtained. An assessment of diverse innovative activities must capture numerous factors and coefficients. An idea passes through certain development stages, such as the conception of invention, improvement, and subsequent application. When studying these processes, one should adhere to a certain structured flow of stages or a logical chain from the appearance of an idea to gaining results of its implementation. Innovation Process is the transformation of scientific knowledge into innovation, i.e., a sequential chain of events during which an innovation matures from an idea to a product, technology, or service and spreads through its practical use. This six-stage process is aimed at creating the products, technologies, or services required by the market: 5 Fundamental research aims to obtain new scientific knowledge and study objective laws of development in various fields of science. The goal is to reveal new connections between phenomena and learn the laws of development of nature and society regardless of their specific use. Fundamental research includes theoretical studies and exploratory investigations. Theoretical studies result in scientific discoveries, the substantiation of new concepts and ideas, and the creation of new theories. Exploratory investigations mean to discover new principles of creating products and technologies, new properties of materials and their compounds, and methods of analysis and synthesis. Such studies confirm or reject theoretical assumptions and ideas. 5 Applied research aims at studying the practical application of earlier discovered phenomena and processes. It solves technical problems, clarifies unclear theoretical issues, and obtains specific scientific results, then used as a scientific

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and technical foundation in research and development work at stage 3. Applied research is always associated with a high probability of obtaining negative results. Therefore, there is a risk of loss when investing in applied research. 5 Development work uses applied research results to create (or modernize, improve) samples of new equipment, materials, or technologies. Development works include designing engineering objects or technical systems (design work), developing variants and options for a new object (industrial, infrastructural, etc.), and combining physical, chemical, technological, and other processes with labor into an integral production system (technological work). Thus, development work aims at creating (modernizing) samples of new products that can be transferred to mass production or directly to consumers. 5 Mastering the industrial production of new products includes testing new (improved) products and technical and technological preparation of production. At this stage, experimental work is carried out in order to manufacture and test prototypes of new products and technological processes. Experimental works aim to produce, repair, and maintain non-standard equipment, devices, installations, stands, and models. 5 The production stage involves manufacturing materialized achievements of scientific and technical developments (stages 1–4) in the amount determined by consumer demand. In the course of technological progress, the innovation process accelerates. Commonly, an innovative entity (research institute, enterprise, etc.) performs research and development works under contracts with industrial enterprises. Customers and contractors are mutually interested in R&D outcomes to be implemented and bring income as soon as possible. 5 The marketing stage involves bringing new products to consumers. Two processes coincide: the use of material and cultural goods produced on the basis of scientific and technical achievements and the maintenance of new products during their service life.

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Innovation processes are cyclical due to the chronological emergence, implementation, and withdrawal of innovations in various fields of science and technology. The Life Cycle of Innovation is a period that starts with the implementation of fundamental and applied research and includes the subsequent development and application of a new scientific and technical idea, the improvement of technical and economic parameters of the equipment, its repair and other maintenance, and ends with replacing equipment or technology by qualitatively new, more efficient innovative solutions. 16.1.2  Innovations and the New Normal

Economic Development

The main reasons for the emergence of innovations are consumer demand, the desire to claim leadership in an industry (country, world), improvement of a firm's internal processes, and competition. The latter reduces the time for creating ideas and forces producers to pay more attention to the quality of inventions

16

585 16.1 · Technologies and the New Normal Economy

and their dissemination. To remain competitive, producers put more effort into studying the consumer market. Analysis of innovation activities of competitors becomes an integral part of the business development strategy and radically affects new ideas. Literally, new technologies and improvements appear every day, replacing aging innovations that dominated the market as recently as yesterday. Through a combination of economic, social, organizational, and other factors (. Table 16.2), competition pushes economic actors to further improve all spheres of resource use, production, and management.

. Table 16.2  Determinants of innovation processes Factors

Drivers

Barriers

Economy and technology

Reserve of financial and material resources, technical capacities, and progressive technologies

Lack of funds to finance capital-demanding innovative projects

Availability of required economic, scientific, and technical infrastructure

Outdated material, scientific, technical, and technological base and a lack of reserve capacities

Material encouragement and reward for innovative activity

Dominance of current production interests over development prospects

Policy measures and incentives to encourage innovations

Restrictions imposed by antitrust regulations and tax, patent, and licensing legislation

Policy and legislation

Government support of innovation-related activities Organization and management

Flexibility of the organizational structure, democratic management style, predominance of horizontal information flows, self-planning, and favoring adjustments

Established rigid organizational structure, excessive centralization, authoritarian management, and predominance of vertical information flow Departmental isolation and barriers to intersectoral and inter-organizational interactions Rigid planning programs and approaches

Decentralization, autonomy, and establishment of targeted problem groups

Orientation on existing markets Orientation on short-term payback Difficulties in matching interests of all stakeholders involved in innovation processes (continied)

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. Table 16.2  (continued) Factors

Drivers

Barriers

Society, behavior, preferences, and culture

Moral encouragement and public recognition

Resistance to changes that can cause job loss, transform established way of life and activity, or violate behavior stereotypes and traditions

Self-realization and creative work

Fear of uncertainty and punishment for failure

Good psychological atmosphere among fellow employees

Resistance to everything new that comes from outside a company or country

Source Authors’ development

The spread of innovations depends on five aspects. 5 profitability (benefits derived from implementing innovations affect the popularity of innovation-related products); 5 accessibility (an easy-to-use innovation that requires few resources and fits a wide range of production programs attracts consumers); 5 compliance with demand (unskilled users may not accept sophisticated technologies); 5 availability of innovation-products and technologies for testing; 5 visibility of results (a noticeable improvement in the quality of life due to using new technologies increases demand for innovations).

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Since the XVIII century, the diffusion and adoption of innovations have accelerated. The new normal economic development is inseparable from the growth of a post-industrial information society. Both structurally and institutionally, the new post-industrial economy coexists with the conventional industrial economy and intertwines and interacts with it, thus forming integrated transitional forms. Generally, the new economy includes the production of computer and communication equipment, software, as well as the entire system of generation, storage, and use of information primarily built on the Internet. Nevertheless, such an interpretation of the new economy is relatively narrow. Undoubtedly, the new economy relies on the information and communication component. Progress in the sphere of information technologies triggers the interconnectedness of people, firms, and countries and thus promotes economic globalization. Case box In recent years, innovations most rapidly progress in medicine, telecommunications, and energy (see Sect. 16.2.3 below for the new normal technological trends). Amid the COVID-19 pandemic and the threat of multiple pandemics in the future, efficient health care technologies and practices are vital for humanity. The development and

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implementation of advanced medical innovations can significantly improve the quality and safety of life. Apart from fighting COVID-19, medicine is now focused on combating genetic and oncological diseases, digitalizing medicine, and improving public health systems (rapid deployment of large-scale healthcare capacities in critical conditions). Telecommunication technologies transform interactions with information (smartphones and gadgets, satellite and broadband Internet, etc.) and affect demand by setting higher technical requirements to goods and services in the market. Global processes of climate change, environmental degradation, and unsustainable use of natural resources amid growing needs of the industry and society in energy and resources facilitate the development of energy-related innovations, including renewable energy (see further 7 Chap. 18).

However, the new economy narrative should not be narrowed down to the information and communication component. The new postindustrial economy also rests upon biotechnologies, nanotechnologies, energy-saving technologies, new materials, and environmental and climate studies. The new economy is the knowledge economy of intellectual services. It is based on educational and research structures that aggregate and process information and transform it into knowledge, innovations, and new technologies. This processing of raw information into an intellectual product establishes the basis of new economic growth and facilities productivity improvements in the new economy. Knowledge Economy is an economy where the intellectual component outweighs conventional material factors of production and resources. Knowledge intensity is a distinctive feature of the most competitive and demanded goods in today’s global market. It turns into the new economic basis of innovations. Innovativeness of the new economy affects the contemporary business environment so that permanent changes (new inventions, etc.) and high risk (failure of research programs, costs-returns gaps, competition) become the new basis of economic growth and development. The productive forces of the new economy include integral components built on management and marketing technologies. The latter fuel up the new economy engine by revealing the productivity and efficiency potentials of both traditional (resources, labor, etc.) and new factors of production (intangible assets, knowledge, skills, reputation, brands, consumer loyalty). Being global due to the growing exchange of information, knowledge, and technologies, the new economy still remains fragmented in terms of both markets (in many countries, domestic markets are still poorly integrated into the global economy) and economic entities (domestic producers, consumers, and governments). On the one hand, the new economy converges production, finances, investments, trade, labor, and even cultures. On the one hand, there increases the number of international and national regulations required to control and manage these intertwined spheres of economic and social activities. Therefore, economic globalization is not a one-way highway to homogeneous markets, but a network of pathways of alternate convergences and detachments of national economies (globalization and regionalization are further discussed in 7 Chap. 23).

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16.2  Technological Development Priorities 16.2.1  International Development Agenda

16

Determining the priorities of technological development in the conditions of the new normal economic reality is primarily aimed at ensuring long-term sustainable development of the economy and society. At the same time, the nature of a country’s technological development should meet not only national development goals, but also global sustainable development goals and the solution of global problems. At the international level, priorities determine the most important areas of scientific and technological development common to many countries and the tasks that need to be addressed jointly. Contemporary tendencies in global development are characterized by a sharp increase in the influence of science and technologies due to the intensification of the processes of creating and distributing knowledge and the promotion of innovation-related activities. Under these conditions, the efficiency of public policy largely depends on how well the government formulates national scientific, technological, and innovative development priorities and what tools it uses to accomplish these priorities. Many countries use technological development priorities to shape their scientific, technical, and innovation policies. The main focus is made on solving strategic problems of social and economic development and ensuring the efficient use of national competitive advantages. These priorities arise from a multi-sided assessment of the possible contribution of their implementation to ensuring sustainable economic development and strengthening the competitive positions of a country in the global market. In this regard, the definition of common scientific and technical priorities for individual countries is particularly relevant for the convergence of development and cooperation plans. In many developed countries, the selection of technological development priorities substantiates policy-making in the spheres of science and technology. The attention is focused on solving strategic economic development tasks and implementing innovations that strengthen competitive advantages. The Working Group of National Experts on Science and Technology Indicators (NEST) was established in 1957 to monitor scientific, technological, and other innovations. NEST is a group of experts who monitor the performance of various technological areas. They developed recommendations for implementing innovation-related activities, which were then recognized by world standards. The so-called Oslo Manual1 contains information for analyzing innovative prospects (product, managerial, and research innovations) among a number of countries in Europe, Asia, Africa, and the Americas. The OECD’s Frascati Manual2 describes fundamental, applied, and experimental standards for collecting and reporting

1 2

Organization for Economic Cooperation and Development. (2005). Organization for Economic Cooperation and Development (2015).

589 16.2 · Technological Development Priorities

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data. UNESCO also periodically gathers information, analyses innovation-related activities, and publishes reports in the field of research and development. It collects data to support developing countries in acquiring relevant information about fundamental global trends in the spheres of production, technologies, and innovations. In 2008, Eurostat initiated innovation surveys3 οthe innovativeness of sectors by business type, types of innovation across Europe, and various aspects of innovation-driven development. Major international innovation assessment indices are INSEAD’s Global Innovation Index (GII)4 (132 countries, 60 parameters) and WEF’s Global Competitiveness Index (GCI)5 (141 countries, 103 parameters). The development of innovations in a particular country very much depends on the government’s attitude to new ideas. With appropriate legislation, low constraints, competent regulation of innovations, and incentives, innovations develop rapidly. In the absence of proper support, the introduction of innovations is challenging. Therefore, development lags behind. In the new normal economy, the efficient fulfillment of government tasks is impossible without implementing innovations and advanced technologies. There are priority areas in every sector (agriculture, finance and banking, industrial production, etc.). Their innovation-driven development and growth benefit the overall evolution of a country. Thematic priorities (. Fig. 16.1) aggregate principal directions and areas of research and development (for example, information and communication technologies, space systems, etc.). Investing in these areas can bring significant social and/or economic benefits in the medium or long term (spur economic growth, improve competitiveness, and address other key economic, scientific, and technical challenges). Functional priorities involve tasks related to the functioning of the research and innovation system, for example, accelerated development of human and labor resources, commercialization of research and development outcomes, etc. The selected priorities are focused on solving strategic social and economic development issues. All stakeholders, including the government, businesses, and scientific community, consider these issues when prioritizing specific development venues. 16.2.2  Technological Development Regimes

Determining scientific and technological priorities starts with studying global development trends at the macro-level (domestic and foreign economic and social policy, production, and dissemination and use of information). The second step is to formulate the country’s goals in terms of development parameters, foreign policy, and economic tasks. The third stage is the compilation of scenarios for struc-

3 4 5

Community Innovation Survey (CIS). Available at 7 https://ec.europa.eu/eurostat/web/microdata/ community-innovation-survey. Global Innovation Index. Available at 7 https://www.globalinnovationindex.org/home. Global Competitiveness Index. Available at 7 https://www.weforum.org/reports/the-global-competitiveness-report-2020.

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. Fig. 16.1  Technological development priorities. Source Authors’ development

16

tural policy and the selection of scientific and technological priorities. Further assessments of available financial, labor, and other types of resources are carried out for particular scenarios. Approaches to developing and improving certain technologies are formed on the basis of these assessments. Technology is a set or system of algorithmically or procedurally organized influences on an object or resource in order to obtain desired (expected) result. This definition includes technologies in various spheres, such as production, engineering, management, information, organization, finances, monitoring, and even politics. The technology nucleus consists of elementary operations and influencings on an object. They are strict and consistent. Any disruptions of the sequence of actions or parameters of influencings eliminate the technology (to be more accurate, transform the technology and results). Thus, there is a fairly rigid set of internal elements mandatory for those who employ the technology. These core elements determine the specifics of the production process and operation of companies that use the technology. Supporting elements beyond the technology nucleus establish the technology periphery. These elements facilitate the preparation of resources or objects for processing and correction and elimination of errors made

591 16.2 · Technological Development Priorities

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. Fig. 16.2  General scheme of technological development regimes. Source Authors’ development

during the core processes (quality improvement, adjusting, waste utilization, pollution control, etc.). The general scheme of technological development implies several transformations. Raw resources Rn processed with the use of technologies Tn turn into products Pn demanded by consumers Cn (. Fig. 16.2). Accordingly, improvements I in the process of technological development can be designated as evolutionary transitions from one stage to another: from resource to technology (IRT ), from technology to product (ITP), and from product to consumption (IPC). The development of technology is not only a change in its nucleus or periphery due to the expansion of functions and additional operations. It is also an improvement in the efficiency of the technology (resource, labor, or energy intensity) and its profitability (higher return on investment or an increase in output). Three types of resources can be used differently in different technologies (. Fig. 16.2). Technology T1 may consume resource R1 only, while technology T3 may require resources R2 and R3. Concurrently, technology T2 does not imply the use of raw materials, but depends on processed substances coming from other industries. In turn, technology T2 (as well as technologies T1 and T3) can break down into several related processes, each of which results in different products Pn and, consequently, different consumption options Cn. For each type of combinatorial technological development, there may be different combinations of resources, technologies, and resulting products. These combinations depend on the specifics of technologies, their conjugation, and the functions of new technologies. Ultimately, they depend on the multiplication parameters for individual phases of the technology development chain (IRT , ITP, and IPC), each of which is measured by the number of possible combinations of core and peripheral elements in a given phase. One can build an individual development scheme for any technology: input—technology nucleus—output. Two parameters characterize relationships between elements at different stages of the development process. Coefficient k1 is the ratio of the technology-product transition to the resource-technology transition TP (k1 = IIRT ). It characterizes the amount of resources embodied in the product. Coefficient k2 demonstrates the technology intensity of final products in the market (k2 = IIPC ). Based on the comparison of these two parameters, five technological TP development regimes are distinguished (. Table 16.3).

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. Table 16.3  Technological development regimes Regimes

Parameters

Features

k1

k2

Proportional

k1 = 1

k2 = 1

Equal diversity in different technological development stages

Expanding

k1 > 1

k2 > 1

The process evolves as the number of technological combinations grows

Contracting

k1 < 1

k2 < 1

Resource combinations outnumber combinations in processing and emerging technologies, while the latter outnumber the combinations of possible consumer choices

Locking

k1 > 1

k2 < 1

Technology combinations outnumber resource combinations and a variety of consumer choices

Exhaustive

k1 < 1

k2 > 1

The diversity of technological capabilities is poorer compared to the resource diversity and consumer choices

Source Authors’ development

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With proportional technological development, the diversity in the different phases of technological change is equal. This regime rarely occurs in real life. The expansion of technological development assumes that the amount of technological combinations increases. According to the combinatorial principle, the growth results in even greater consumption options and further technological changes. Contracting technological development is observed when resource combinations exceed combinations in processing stages and emerging technologies, which also surpass combinations of possible consumer choices. Contracting technology exists if there is no replacement in a narrow consumer segment that heavily depends on that technology. Contracting development is most susceptible to shrinking when alternative technological options appear. With locking technological development, technology combinations exceed resource combinations and a variety of consumer choices. In this case, existing technological capacities should be complemented by some alternative technologies in order to change k2 value and shift to an expanding development regime. With exhaustive technological development, the diversity of technological capabilities is sharply inferior to the resource diversity and consumer options that arise on the basis of the use of the technology. In this case, the technology becomes monopolistic, especially if the market strongly depends on this technology. 16.2.3  The New Normal Technological Trends

Technological Trend is a relevant and potentially promising direction for the development of technology in any field (either a unique development venue within the traditional sector or a completely new technology that creates its own sector).

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Innovation is the key to growth. Most companies strive to implement promising improvements to remain competitive and investment-attractive. It is crucial for investors to monitor and follow technological development trends, since investing in new directions and technological start-ups may potentially bring substantial benefits in new markets. However, the new normal economic reality has become extremely volatile. Radical restructuring of both business processes and consumption trends challenges any forecasts. Recent years have been full of unexpected technological advances as the entire world has changed to match the new normal patterns. It is hard to say whether the innovations that have emerged today are a temporary phenomenon of the COVID-19 pandemic or the long-term trends of the new normal reality. Evidently, the pandemic triggered the development of medicine-related technologies. Diagnosis, prevention, monitoring, and treatment—these spheres require continually improving medical technologies. The latter also includes digital healthcare solutions (tools and services that use information and communication technologies) and in vitro diagnostics (medical tests conducted on biological samples). Another trend is the widespread shift to remote work regimes. In advanced companies, virtual offices may soon prevail over conventional workplaces. Since the beginning of the pandemic in 2020, collaboration software and technologies have been greatly demanded. The global video conferencing market reached $7.87 billion—more than twice as much as in 2019. Many tech giants, including Twitter and Meta (former Facebook), have already announced increasing remote workplaces even after the COVID-19 pandemic ends. It is worth noting the growth prospects of videoconferencing services and platforms (Zoom, Cisco, Microsoft), collaboration software (Atlassian, Asana, Smartsheet), electronic documenting (DocuSign), as well as cloud computing services. Employers would need cloud technologies to set up digital workplaces and virtual offices. They have been available previously, but now they are emerging rapidly due to 5G Internet networks and the need for easier and more convenient computing and communication solutions. Clouds allow storing not only files, but large resource-intensive programs and entire operating systems. In 2021, Microsoft, which has long been developing its Azure cloud platform, launched Windows 365, a virtual cloud-based personal computer on Windows 10 or Windows 11. All information is stored in a cloud, not on a device. Some of Microsoft’s competitors in cloud computing are Snowflake, Dropbox, and Twilio. A few years ago, 3G and 4G technologies made it possible to access the Internet, use various services, manage data, and increase transmitting capacity for video and music streaming (YouTube, Twitch, Spotify). 5G technology is expected to revolutionize the communication sector by providing brand new services based on augmented reality and virtual reality (for instance, metaverse announced by Meta), as well as cloud gaming services such as Google Stadia or NVidia GeForce Now. Over time, 5G networks will get into all sectors of the economy. Almost all telecommunications companies such as Verizon, T-mobile, Apple, Nokia Corp, Qualcomm, and others are now working on developing 5G applications.

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5G technologies pave the way for developing virtual reality (VR), augmented reality (AR), and extended reality (ER). Virtual reality places a user in a virtual environment, while augmented reality complements it. Until recently, these technologies have been mainly used in games. Now, they are also employed in training and modeling. Wearable devices, such as augmented reality glasses from Apple and Google, evolve and become cheaper and more accessible (Oculus VR from Facebook, HTC Vive, Valve, Microsoft, and other hi-tech companies). Companies increasingly implement artificial intelligence (AI) to analyze user-product interactions, assess demand trends, and detect changing consumer behavior patterns by analyzing big data. In the future, AI technologies will allow managers to make better decisions and use resources more efficiently. Such technologies have already been partially implemented by tech giants, such as Apple, Meta, Amazon, Microsoft, and Netflix. Machine learning is a part of AI that is also implemented across industries to increase productivity. Comprehensive machine learning models help companies efficiently plan production programs, detect anomalies, make predictions and decisions, and generate analytics. Both technologies are essential success factors for businesses. Salesforce, Oracle, Adobe, and Accenture, among others, not only implement AI and machine learning solutions, but develop them and supply them in the market. Robotics is inextricably linked to AI. Since 2020, robot engineering technologies have been introduced into many sectors, primarily due to restrictions on the use of labor amid the COVID-19 lockdowns. Robotics has already opened up new employment opportunities (maintaining robots, software and hardware development), contributed to economic growth (higher-performing robots in various industries), and solved some of the social problems (remote services and deliveries during the pandemic). Another promising technological trend is the Internet of Things (IoT). This technology is already built into many devices, including household appliances, trains, cars, and various kinds of industrial and public infrastructure. Projections suggest that by 2030, there will be about 50 billion IoT devices in the world, a huge network of interconnected devices from smartphones to kitchen appliances. With innovations such as cloud computing and data storage, IoT devices, 5G networks, and artificial intelligence, big data has become more prevalent for organizations that want to improve their operational capabilities and better understand their customers. New techniques and architectures continue to emerge to collect, process, manage, and analyze a wealth of data in an organization. Almost all leading technology companies (Microsoft, Amazon, Google) express interest in collecting, analyzing, managing, and processing large data arrays. Companies such as Oracle, Salesforce, Accenture, and Splunk are directly engaged in developing big data technologies. Global environmental problems and the emerging food insecurity problem necessitate the transition from conventional foods to organic and even artificial food products. Promising technologies include farming of high-protein insects (Protix, AgriProtein, Ynsect, Essento), growing of algae, mushrooms, and hypoallergenic nuts (Terramino Foods), production of plant-based meat substitutes (Beyond Meat, Fry Family, Impossible Foods), and the artificial generation of meat from stem cells in laboratories (Mosa Meat, Upside Foods, Aleph Farms, BlueNalu, Finless Foods).

595 16.3 · Production and Technological Possibilities

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Contemporary environmental agenda also determines the rapid development of energy-related technologies, including renewable energy. In addition to the already common solar, wind, and hydropower, there emerge production of biodiesel (Renewable Energy Group), generation of geothermal energy (Ormat Technologies), and the use of silicon (Daqo New Energy). Alternative fuel engines are built, including biodiesel engines, gas fuel cells (FuelCell Energy), hydrogen cells (Plug Power), and proton-exchange fuel cells (Ballard Power Systems). Increased production of electric vehicles (Tesla and others) boosts demand for accumulators (Albemarle, QuantumScape, LG Chem) and charging stations (ChargePoint, Blink Charging, Contemporary Amperex Technology). The space industry has a potential of 10% growth annually. By 2030, its capitalization is projected to exceed $1.5 trillion. Private companies and start-ups (SpaceX, Virgin Galactic, Blue Origin, Rocket Lab, Astra Space, Spire Global, Momentus Space) successfully compete with state-backed space agencies and programs. Major breakthrough areas include orbital technologies (rockets, satellites, orbital stations) and space tourism. 16.3  Production and Technological Possibilities

The possibility of developing certain technologies depends on what resources a particular company, country, or world community is ready to spend on the technology. Unlike needs, resources are scarce. The coexistence of unlimited wants of rapid technological growth and a limited amount of available resources stipulates the need for an economic choice between alternative uses of factors of production. Each economic agent (company, industry, country) maintains an individual set of resources and uses them as efficiently as possible to gain the greatest possible reward. The maximum possible output under full and best use of a fixed amount of resources with unchanged technology is demonstrated by the production possibility frontier. Production Possibility Frontier is a curve (PPC) that shows maximum quantities of two economic goods that an economic entity (the economy as a whole) is able to produce with full and efficient use of all available resources and the current level of technology. The PPC model is founded on the following seven premises: 5 two goods (better demonstrativeness and simplicity of the model); 5 fixed amount of resources and factors of production; 5 fixed qualities (productivity) of resources and factors of production; 5 fixed technology (no technical and technological improvements); 5 full use of all resources and factors of production (no known unemployed inputs); 5 perfect interchangeability of resources and factors of production (all inputs used in the production of one good can be used in the production of another good with no efficiency loss); 5 efficient use of resources (reallocation of resources increases the output of one good and reduces the output of another).

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. Fig. 16.3  Production possibility curve. Source Authors’ development

. Fig. 16.4  Production possibility areas and points. Source Authors’ development

16

If available resources are directed to the production of good X , then the total output equals Xmax (Y = 0) (. Fig. 16.3). If all resources are redirected from good X to good Y , then the total output equals Ymax (X = 0). Beyond these two extremums, there are alternative distributions of resources between goods X and Y represented by a set of points on the PPC curve (for instance, points A and B). Point D and other points beyond the frontier are unattainable with available resources and technology. Points within a frontier (point C) describe a situation where resources are used inefficiently. Points A and B cannot be located to the top right of point C (area 1 in . Fig. 16.4), because all resources are used and allocated efficiently. Also, these points cannot be located to the left down of point C in area 2, because that would mean inefficient use and/or underutilization of resources. Thus, considering the seven PPC premises, we may see that points A and B can only be located along the curve, neither beyond nor within the frontier. Since such conditions are valid for any point laying on the curve, the PPC curve slopes downward. That is, the production of each additional unit of good X re-

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quires sacrificing a certain amount of good Y , and vice versa. It is impossible to increase the output of one good without reducing the output of another. To increase the output of good X from XA to XB (X = XB − XA), an economic entity reduces the output of good Y from YA to YB (Y = YA − YB) (. Fig. 16.3). The production possibility frontier can be interpreted as a product transformation curve. Expressed explicitly (Y = f (X)) or implicitly (F(X, Y ) = 0), the PPC equation shows how good X transforms into good Y by switching inputs from the production of one good to the production of another. The parameter called the marginal rate of product transformation (MRPT) is used to describe the transformation at point A (Eq. 16.1):

MRPT XY = −

dY = dX

∂F ∂x ∂F ∂y

= tanα

(16.1)

where α  slope of the tangent line to PPC at point A in relation to X-axis. At point A, the opportunity cost of X equals Y (OCX = Y ) (. Fig. 16.3). Roughly describing the PPC near point A by a straight line segment connecting points A and B, we assume opportunity cost of one unit of X Y to be roughly equal to X units of good Y at point A. If point B tends to point A Y (X → 0), then the X ratio tends to tanα. As a result, OC1X ≈ tanα = MRPT XY of units Y . Thus, the marginal rate of product transformation MRPT XY shows the loss of output of good Y when the output of good X increases by one unit. As the output of good X rises, the opportunity cost of each additional unit of good X expressed in units of good Y goes up. This is the essence of the increasing opportunity cost principle. The Law of Increasing Opportunity Cost says that with an increase in the output of one good, production of each additional unit of this good requires the rejection of more and more units of another good (that is, the opportunity cost of producing each additional unit increases). With the transition from point A to point B (. Fig. 16.5), the opportunity cost of producing good X increases (XB > XA). Therefore, tanαB > tanαA. Similarly, the opportunity cost of producing good Y decreases (YB < YA, therefore, tanβB < tanβA). One of the reasons for the increase in opportunity cost is that in order to produce more of good X , a firm diverts resources from producing good Y . Although the theoretical PPC model assumes perfect interchangeability of resources, in reality, factors of production can hardly be totally replaced without losing productivity. A country’s production capacity may change over time. Commonly, the production possibility frontier shifts due to changes in the quantity and quality of resources, as well as the development or degradation of production technologies. With the improvement of the technology in sector X , there become available new combinations of inputs and outputs not attainable previously. Using the same amount of resources, a country can now produce more of good X . PPC curve shifts along the X-axis to the right (PPC X curve in . Fig. 16.6). Since nothing has changed in Y technology, a country can not simultaneously increase the pro-

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. Fig. 16.5  Illustration of the law of increasing opportunity cost. Source Authors’ development

. Fig. 16.6  Shifts in the production possibility frontier due to advancing technologies or increasing inputs. Source Authors’ development

16

duction of good Y . Therefore, the production possibility frontier stretches along the X-axis only. Conversely, with technological development in sector Y (no improvements in sector X ), the output of good Y rises with no change in the output of good X . PPC curve then shifts along the Y-axis (PPC Y curve). With simultaneous technological advancement in the two sectors or with an improvement in the quality and/or quantity of inputs, the production possibility frontier expands along both the X-axis and the Y-axis (not necessarily by the same distance) from PPC 1 to PPC 2. Production capacity reduces due to underperformance of factors of production, deterioration in the quality of inputs, or a decrease in the amount of available resources. The production possibility frontier then shifts to the left down

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along one of the axes (PPC X and PPC Y curves in . Fig. 16.7) or the two axes concurrently (from PPC 1 to PPC 2), depending on which sector is affected by changes. With incomplete or inefficient (or both incomplete and inefficient) use of available resources, the production possibility frontier remains at PPC 1. That means that the potential for producing both goods remains unchanged. The economy moves to a point within the frontier (see point C in . Fig. 16.3 or area 2 in . Fig. 16.4) and produces fewer goods. Domestic product declines with no decline in resources or technologies. The two goods premise is perceived as theoretical. However, if goods X and Y are replaced with aggregated macroeconomic groups of investment and consumer goods, then the PPC model may reflect the production possibility frontier for a country or the entire global economy. The transition from a low frontier to a higher frontier of production capabilities is possible in the case of technical discoveries, improvement and creation of technologies, development of new mineral deposits, and other scientific breakthroughs. As available resources (technology improvements) increase, the curve expands upward right (. Fig. 16.8). If the amount of resources decreases (technologies degrade), then the production possibility frontier shrinks leftward down. With scientific and technological progress and advancement of all kinds of technologies, intensive economic growth due to the use of more efficient and qualitatively advanced factors of production expands the production possibility frontier (see 7 Chap. 15, 7 Sect. 15.1.1 for intensive economic growth). Growth occurs due to an increase in inputs’ productivity with no changes in the amount of available factors of production. It is possible that the performance improves in one of the sectors. In this case, the frontier still expands. The increase in productivity in sector X allows an economy to move from point A to point B. The output of both good X and good Y increases, because technological progress in sector X frees up resources previously used in producing good X . The market economy

. Fig. 16.7  Shifts in the production possibility frontier due to degrading technologies or decreasing inputs. Source Authors’ development

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. Fig. 16.8  Economic development (decline) due to changing production possibility frontier. Source Authors’ development

then reallocates these resources to sector Y . Expanding production capabilities is possible due to specialization and division of labor. The frontier extends when economic entities specialize in producing goods in which they enjoy competitive or comparative advantages and then exchange these goods. Trade creates wealth because voluntary exchange based on specialization and the best possible use of resources minimizes costs and maximizes rewards for all participants (the economy operates as close to its production possibility frontier as possible). 16.4  Innovation Pessimism

16

Permanent expansion of production capabilities through technological advancement is one of the interpretations of technological progress and economic development. This view is primarily based on the pace of industrialization in the XIX and XX centuries and the rapid computerization and digitalization we have been witnessing since the early 2000s. However, many studies report the slowdown in economic growth despite introducing new technologies and innovations. For example, the invention of the steam engine or the generation and use of electricity once revolutionized the industry and the economy. Today’s innovations do not lead to such dramatic upheavals. There are detailed improvements to existing technologies. Individually, their impact on economic growth is no longer as significant as it used to be in the past (further reading: “The Rise and Fall of American Growth”6). One of the extreme views on the role of technologies in economic and social development is Innovative Pessimism, a denial of the pivotal role of tech-

6

Gordon (2016).

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16

nologies in economic development and the interpretation of technology as the cause of depersonalization and the decline in the role of individuals in ensuring economic growth. The key to the description of economic evolution is the model of adoption of innovation (investment) decisions. The starting point of the analysis in this model is the subjective mechanism for making decisions about the feasibility of implementing an existing innovation, regardless of its type and nature. New products (services), new technologies (production and management), and new institutions (rules of interaction) can be considered innovations. Nevertheless, the mechanism for implementing these innovations is universal. It can be studied from a common methodological point of view. When an economic entity decides between implementing innovation and rejecting it, the decision-making process can be formalized easily. Implementing an innovation allows a firm to evolve from one production or management system to another. Similar to any economic activity, implementing innovations is associated with certain expenditures, such as old and new variable costs (CO and CN , respectively) and capital costs CC. Often, innovations do not reduce costs, but increase revenues. Both cases are depicted by Eq. 16.2.

ˆtn

[CO (t) − CN (t)]dt = (1 + r)CC

(16.2)

t1

where CO  variable costs in the old production system; CN   variable costs in the new production system; CC  capital costs; tn payback period (return on innovation-related investment); r efficiency of investment in innovation for the entire period tn. When implemented to technological innovations, Eq. 16.2 is interpreted as a condition of technological equilibrium. Then, CO and CN are variable production costs before and after implementing an innovation, respectively, and the price of innovation CC is capital expenditures (investment). In the case of institutional innovations, Eq. 16.2 is a condition of institutional equilibrium. Variables CO and CN are transaction costs before and after implementing an innovation, respectively, and the innovation price CC is transformation costs. Accordingly, an innovation is worth implementing when the rate of profit of the transformation exceeds a certain threshold r ∗ or at least breakeven (r > r ∗ or r > 0). Otherwise, innovation is rejected. Equation 16.2 employs integral because variable costs of a firm belong to permanent (current) costs and the price of innovation belongs to nonrecurring expenditures. Therefore, these values can only be measured over a certain time interval tn. From Eq. 16.2, an important conclusion follows: the larger planning horizon tn a firm uses, the more likely this firm implements an innovation. . Figure 16.9 visualizes the relationship between variable and capital costs when making an

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. Fig. 16.9  Geometric interpretation of the innovation launch mechanism. Source Authors’ development

innovation decision. Geometrically, the innovation launching rule says that the aggregated area of the dghf rectangle and the cdfe rectangle must be greater than the aggregated area of abdc (CC), cdfe (CO), and eft2 t1 (CN ) rectangles. Therefore, the longer the tn period, the greater the area of the dghf rectangle. That means the greater innovation-associated costs a firm may afford. Equation 16.2 could be transformed by including total revenue and the proportions of revenue directed to variable production expenditures in the case of implementing old and new production systems (Eq. 16.3).

(cO − cN )

ˆtn

x(t)dt = (1 + r)CC

(16.3)

t1

where x(t)  total revenue of a firm; cN proportion of revenue directed to variable costs in the new production system; cO proportion of revenue directed to variable costs in the old production system. Let us assume that the revenue constantly grows over time. Growth rate  t equals to 1x × dx dt . Then, x(t) = x0 e , where x0 is the value of x at the beginning of a period tn. In this case, Eq. 16.3 could be transformed to Eq. 16.4:

16

(cO − cN )

ˆtn

x0 et dt = (1 + r)CC

(16.4)

t0

Integrating Eq. 16.4 and introducing the parameter of the relative cost of innovations ν = x0 (cCOC−cN ) into Eq. 16.4, we receive Eq. 16.5:

eτ − 1 = v(1 + r)

(16.5)

Equation 16.5 depicts a geometric model of the innovation launch mechanism (. Fig. 16.10). If the exponential (left) part of Eq. 16.5 is greater than its linear

603 16.4 · Innovation Pessimism

16

. Fig. 16.10  Dependence of the innovation launch on the rate of economic growth. Source Authors’ development

(right) part, then innovation is worth implementing. Otherwise, the implementation is irrational and inefficient. An essential feature of this scheme is a critical value of the economic growth rate ∗. It serves as the boundary of the innovation profitability: in the rejection zone below the boundary, implementing an innovation incurs losses, while in the implementation zone above the ∗ threshold, an innovation brings gains. Consequently, the growth rate of a company (economy) is an independent factor in the innovation process. A similar effect is observed for the planning horizon: innovation is launched when a certain critical value of the planning horizon is reached (r > r ∗). Growth rate  is one of the pivotal factors of an innovative susceptibility of an economy manifested in the ability to transit from underperforming to a more efficient system. Therefore, active economic growth creates prerequisites for economic development, which could be considered efficiency growth. From an evolutionary point of view, an increase in efficiency leads to a more complex system, increased independence from the environment, and more rational use of resources. However, as previously discussed in 7 Chap. 15, growth alone cannot automatically result in development. One of the principal factors of economic development is the planning horizon. The latter depends on a variety of factors, including individual perception-related characteristics of an economic entity: confidence in the macroeconomic environment, expectations, fears, and the emotional mood (optimism or pessimism). At the same time, such a feature as optimism (pessimism) is not innate. It is determined by the environment in which an economic entity exists and operates. For an optimist, the planning horizon opt pes opt pes tn tends to be greater than that of a pessimist tn (tn > tn ). Consequently, the

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area of the dghf rectangle (. Fig. 16.9) would be greater for an optimist compared to a pessimist. As stated earlier, the greater the dghf area, the more substantial investments in innovations and technological development a firm may afopt pes opt pes ford (CN > CN and CC > CC ). Thus, an economy consisting of optimistic actors has a greater innovation sensitivity than that consisting mainly of pessimists. The second effect is that an optimist is usually less sensitive to mistakes in expectations. Equation 16.2 takes into account the expected values of future costs (revenues), whereas, in practice, they may be different. The mismatch β(t) between the expected value of profit (left part of Eq. 16.2) and its actual value is different for optimists and pessimists. Commonly, optimists tolerate greater risk of mistake compared to pessimists (β opt > β pes). Moreover, an optimist’s mistake tends to positive values, because an optimist usually overestimates future economic effects, while a pessimist underestimates potential gain. The third type of effect is related to the fact that the occurrence of a positive mistake leads to a revision of plans and, consequently, a change in the planning horizon. It is reasonable to assume that an optimist and a pessimist react differently to mistakes in their forecasts. In case of a mistake β(t) > 0, an optimist either does �t n ≥ 0). Accordingly, a pessimist not revise the planning horizon, or increases it (β(t)

16

�t n < 0). This means that systematic positive rigidly reduces the planning horizon (β(t) mistakes in forecasts lead to the fact that in subsequent projects, a pessimist adheres to a more modest planning horizon. Such behavior reduces both his own innovative susceptibility and the innovativeness of the entire economy. For an optimist, mistakes do not automatically result in rejecting innovation. An optimist continues to hope for the best, while maintaining a large planning horizon. Thus, the optimism (pessimism) phenomenon is a pivotal element of the innovation process. Optimism is a systematic overestimation of the future success (profitability) of a project with its accompanying risk tolerance. An optimist prefers profit over risk, while a pessimist prefers the opposite. If an optimist maximizes the benefit with a high risk tolerance, a pessimist minimizes the risk with some guaranteed benefit. These two types of economic behavior balance each other. Thus, optimism gives rise to new ventures and thereby increases the innovativeness of the economy. Without optimism, the economy would slide to stagnation with a lack of innovation. However, pessimism stabilizes the economy by making its operation more meaningful and predictable. Without pessimism, there would be a general searchlight with a huge number of bankruptcies, ruin, and business failures. Depending on the proportions between optimists and pessimists (a very flexible ratio that depends on the macroeconomic environment), the economy either develops or stagnates.

16.5  Creative Destruction

It should seem that in the new normal economic environment of high uncertainty and dynamic external transformations, pessimists prevail over optimists. Still, the ability of an economy to revive and maintain continuous innovative development is a defining competitive advantage in times of uncertainty. Both economic cycles theories (see, for example, Kondratiev waves in 7 Chap. 7, 7 Sect. 7.2.4) and

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economic development theories (primarily, Marxism and neo-Marxism—see 7 Chap. 15, 7 Sect. 15.3) proclaim that the economy develops due to the destruction of old companies, approaches, and ideas, which are replaced by new, more productive, and efficient innovations. This process is called Creative Destruction—a permanent improvement of the economy through the introduction of new technologies, due to which obsolete and unprofitable companies or entire industries are displaced from the market and resources are redistributed in favor of more efficient new companies and industries. Karl Marx was one of the first economists who set forth creative destruction in The Communist Manifesto. According to Marx, “the bourgeoisie cannot exist without constantly revolutionizing the instruments of production, and thereby the relations of production, and with them the whole relations of society”.7 In the XX century, Marx’s ideas were developed by Joseph Schumpeter, who also believed creative destruction to be a symptom of capitalism. However, according to Schumpeter, the destruction does not mean that a company or industry definitely breaks up. This only indicates that the economic feasibility of the economic entity under creative destruction has been exhausted or is close to exhausting (further reading: “Capitalism, Socialism and Democracy”8). Schumpeter stressed that in the long run, any system that is operating effectively at a given period of time risks losing competition to other systems that function differently. Therefore, the behavior of an economic entity should be evaluated only against the background of the overall development process in the context of a dynamically developing world. In this perspective, creative destruction can be associated with the economic cycles concepts (in particular, Kondratiev waves). Previously in 7 Chap. 7, 7 Sect. 7.2.4, we demonstrated that Kondratiev waves reflect cyclical processes of economic development determined by the renewal of inventories, investments in fixed assets and infrastructure development, and shifts in technological, social, and political development. Schumpeter described long cycles as a sequence of two phases: revolutionary changes in technology ([A; B] segment in . Fig. 16.11) and assimilation of revolution’s advancements ([B; C] segment)—very similar to Kondratiev’s expansion and contraction stages (see 7 Chap. 7, 7 Sect. 7.2.4, . Fig. 7.2.5). Defining economic cycles, Kondratiev used such parameters as the output of cast iron and lead, mining and consumption of coal, the average level of commodity prices, interest on capital, wages, and foreign trade turnover. On the other hand, Schumpeter believed cycle stages are determined by significant achievements of science and industrial production. Despite some differences in approaches, Kondratiev and Schumpeter's waves originate and end within almost the same periods. The length of fluctuations of both types of waves decreases over time. Thus, the technological process accelerates. Such a connection of approaches is important in the context of analyzing changes in the technological pattern and predicting future shifts. Moreover, it is important to take into account that technological progress is always based on previous achievements. New technological breakthroughs engender during previous

7 8

Marx (1848). Schumpeter (1976).

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. Fig. 16.11  Schumpeter’s long wave: stages. Source Authors’ development

. Fig. 16.12  Schumpeter’s long waves in the context of milestone economic and technological breakthroughs. Source Authors’ development

16

waves. The opposite is also true: outdated technological regimes may remain influential until new ones strengthen (. Fig. 16.12). The trend line rises despite ups and downs in individual waves, since the technological development is accompanied by an exponential increase in technical and economic efficiency. Thus, with every new technological breakthrough, the innovation wave then declines, whirling away obsolete development. The relationship between economic cycles and creative destruction can be described by the costs-results S-shaped graph . Fig. 16.13). It reflects the classical evolution model with modest growth at the beginning, followed by rapid progress and slowing down as it approaches the asymptote or its limit. The S-curve is half of the product development life cycle. Since economic waves rise and then decline, it is crucial to introduce innovations that boost new positive dynamics and push the curve upward.

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. Fig. 16.13 S-curve. Source Authors’ development

The S-curve concept assumes that over time, the amount of improvement in the technical features of a product changes as technologies develop and mature. In the early stages of technology development, the quality of products improves moderately. With technological progress, quality characteristics grow. However, at the maturity stage, old technology can no longer boost productivity growth as much as it did previously. Further improvements require increasing intellectual and time expenditures. As maturity is reached, the discrete nature of development can lead to changes in the set of competitive advantages in a specific industry or the entire economy. Since economic development is discrete, the emergence of new technology is no longer a continuation of old processes, but the beginning of a new wave. Innovations improve and outgrow their predecessors. As such, a new technology dominates until the next technological revolution occurs. . Figure 16.14 shows the evolution of technologies within one sector. When new technologies gain strength, they displace previous ones. This is how creative destruction works at the product level. The same applies to industries and the economy as a whole. . Figure 16.15 shows how the S-curve concept relates to value chains. A typical graph with intersecting S-curves illustrates supportive technological change within a single value chain, with the Y-axis reflecting a single measure of product quality. Disruptive or fundamental innovative technologies (see 7 Sect. 16.1.1 and . Table 16.1 for classification) bring a fundamentally new offer to the market. At the beginning, it is still of poorer quality than the established technology, but it has new properties and is addressed to different market segments. Disruptive technologies commonly originate in emerging value chains before invading established ones. The S-curve of disruptive technology creates a new market for itself. This confirms the thesis that technological progress is impossible without developments achieved at earlier stages. Supportive or incremental innovations contribute to the improvement of the product. Such technologies may be new, but they do not result in creating brand new products. They intend to improve the quality features of existing products demanded by mainstream consumers in existing markets.

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. Fig. 16.14  Discreteness of technology development. Source Authors’ development

. Fig. 16.15  Evolution and convergence of technologies in different markets. Source Authors’ development

Case box

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Smartphones have become a disruptive technology to traditional push-button mobile phones and thus have given rise to a completely different culture of consumption. Major hi-tech companies created a new market, which then opened an even greater number of mini-markets tied to the new platform—mobile applications, accessories for smartphones, gadgets, recharging devices, and many more.

Creative destruction is one of the features of imperfect competition. Schumpeter was one of the first to show that competition takes place in a dynamic world, rather than in static theoretical models. Changes such as the introduction

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of new products, discoveries of new technologies, the creation of new sources of materials, or the development of new types of organizations determine the new normal market today. According to Schumpeter, competition may be deadly dangerous for old firms as it brings no slight reductions in profits and output, but the threat of a complete failure in new markets. Today, economists use the term “innovative monopoly”, which is similar in meaning to the new competition described by Schumpeter or the very mechanism of creative destruction, however, in a more idealistic sense. Competition implies that no economic entity, even a monopolist, dominates the market forever. Any time, an innovation may turn the market upside down—old monopolists go bankrupt, and small start-ups triumph. Chapter Questions: 5 Define the essence of innovation-driven development. How would you distinguish it from innovation-driven growth? 5 Explain the difference between innovation and invention, discovery, and new ideas. 5 Major inventions facilitating new generations and spheres of technology—are these fundamental or incremental innovations? 5 What are the four conditions of successful innovation? 5 Summarize your vision of the role of innovations and technological development in the new normal economic environment. Which of the technologies that are booming today would endure over the longer term? 5 Name and characterize five technological development regimes. 5 What are the premises of the production possibility frontier concept? 5 Explain the reasons and effects of sliding the economy along the production possibility curve, expanding beyond the frontier, and falling within it. 5 How do you understand the opportunity cost concept? Formulate and illustrate the law of increasing opportunity cost. 5 Distinguish between optimistic and pessimistic economic behaviors in terms of the propensity to innovate. How does the latter depend on the planning horizon and the economic growth? 5 Discuss Schumpeter’s approach to defining technological development stages in light of Kondratiev waves. 5 Do you think technological development is discrete? Back up your answer with a critical discussion of the creative destruction concept. Subject Vocabulary: Creative Destruction: a permanent improvement of the economy through the introduction of new technologies, due to which obsolete and unprofitable companies or entire industries are displaced from the market and resources are redistributed in favor of more efficient new companies and industries. Innovation: an outcome of innovative activity embodied in the form of a new or improved product in the market, a new or enhanced technological process or equipment, or a new approach to rendering services.

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Innovation-Driven Economic Growth: an increase in the gross domestic output and wealth through the continuing introduction of innovations in all spheres of economic activity. Innovation Process: a sequential chain of events during which an innovation matures from an idea to a product, technology, or service and spreads through its practical use. Innovative Pessimism: a denial of the pivotal role of technologies in economic development and the interpretation of technology as the cause of depersonalization and the decline in the role of individuals in ensuring economic growth. Knowledge Economy: an economy where the intellectual component outweighs conventional material factors of production and resources. Law of Increasing Opportunity Cost: with an increase in the output of one good, the production of each additional unit of this good requires the rejection of more and more units of another good (that is, the opportunity cost of producing each additional unit increases). Life Cycle of Innovation: a period that starts with the implementation of fundamental and applied research and ends with replacing equipment or technology by qualitatively new, more efficient innovative solutions. Production Possibility Frontier: a maximum amount of goods and services an economic entity (the economy as a whole) is able to produce with full and efficient use of all available resources and the current level of technology. Technological Trend: a relevant and potentially promising direction for the development of technology in any field (either a unique development venue within the traditional sector or a completely new technology that creates its own sector). Technology: a set or a system of algorithmically or procedurally organized influences on an object or resource in order to obtain desired (expected) result.

References

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Gordon, R. (2016). The rise and fall of American growth: The U.S. standard of living since the civil war. Princeton University Press. Marx, K. (1848). The Communist Manifesto. 7 https://activistmanifesto.org/assets/original-communist-manifesto.pdf Organization for Economic Cooperation and Development. (2005). Oslo manual. Guidelines for collecting and interpreting innovation data. OECD. Organization for Economic Cooperation and Development. (2015). Frascati manual. Guidelines for collecting and reporting data on research and experimental development. OECD. Schumpeter, J. (1976). Capitalism, socialism and democracy. George Allen & Unwin.

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© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_17

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Learning Objectives: 5 Define human capital and distinguish it from labor 5 Study approaches to interpreting human capital and its role in economic development 5 Learn to estimate returns on investment in human capital development. 5 Discuss inequalities in human capital development 5 Explore Human Development Index 5 Review major human development trends across developed and developing economies 5 Summarize the new normal specifics of investing in education and health 17.1  Approaches to Understanding Human Capital

The post-industrial economy is characterized by large-scale implementation of intellectual activity outcomes (scientific and technical creativity and innovation) in public production. One of the main concerns of the government policy is human capital, while the principal economic tasks are to increase the volume of human capital and improve its quality. As demonstrated in 7 Chap. 16, economic growth could be explained as an outcome determined by technological change, accumulation of individual skills, and existing incentives under which economic decisions are being taken, including decisions to acquire physical and human capital. The first industrial revolution marked a breakthrough in economic development based on the rapid growth of productive forces. The appearance of machines, new technologies, and equipment determined the further development of human capital and its main components—culture, education, knowledge, economics, and social relations. Innovations accumulated by previous generations and increased market competition preconditioned the industrial revolution. Qualitative changes in society in the XIX century included: 5 implementation of accumulated human capital and knowledge in the industry; 5 transition from manual to machine labor, from manufacture to industrialization; 5 emergence of competition in all spheres of people’s lives and the establishment of civil society institutions; 5 improve in the living standards, education, science, and culture; 5 human capital development due to improving professional education, specialization of research, growth of research organizations, and increase in life expectancy.

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The second industrial revolution (from the 1850s till the 1900s) took place on the basis of a new round of growth in the level and quality of accumulated human capital. It formed the economy’s second, third, and fourth technological structures, created a developed industrial society, generated mass innovation in production, and contributed to a continuous increase in labor productivity. The third scientific and technological revolution started in the 1950s, allowing devel-

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. Fig. 17.1  Human capital levels. Source Authors’ development

oped countries to transition to the post-industrial economy and then to the innovative economy, or knowledge economy. Thus, each technological revolution and change in the technological structure of the economy were associated with a corresponding stage of human capital development. Today, human capital is a big draw in innovative development. Human capital affects economic growth and promotes development by expanding the knowledge and skills of people. Human Capital is a set of knowledge, skills, competencies, and abilities used to meet the diverse needs of an individual and society as a whole while making a profit and ensuring economic reproduction. The term was first used by Theodore Schultz in the 1960s and then elaborated by Gary Becker. They studied investments in human capital and formulated an economic approach to understanding human behavior (see 7 Sect. 17.2 for theories of economic growth and human capital). Broadly defined, human capital is an intensive factor of production and economic and social development. It involves an educated labor force, knowledge, intellectual and managerial labor tools, and labor environment, ensuring the efficient and rational use of human capital as a productive development factor. Contemporary classification of human capital consists of three levels: individual human capital at the microlevel, corporate human capital at the mesolevel, and national human capital at the macrolevel (. Fig. 17.1). Microlevel characterizes professional resources of individual employees. It also reflects individual entrepreneurial abilities, ethical qualities, character, discipline, and responsibility. This level is a platform for establishing the meso and macro levels. At the same time, the elements that make up the microlevel are independent and unaffected by each other. 5 capital of satisfaction (affecting and managing employees through incentives); 5 entrepreneurial capital (expenditures on developing entrepreneurial skills);

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5 cultural capital (managing expenditures associated with developing cultural, ethical, and moral qualities of individual employees); 5 health capital (monitoring physical wellbeing and health parameters of individual employees, maintenance of high health status); 5 intellectual capital (knowledge audit and efficient management of innovative activities of individual employees). Corporate human capital at the mesolevel is formed based on the microlevel, so its elements directly depend on individual human capital. To trace the relationship between intangible sources of human capital, one should pay attention to the sources of origin of various types of human capital. Labor resources of a company (staff) are formed as means of intellectual and health capital. At the same time, intangible capital needs managerial capital, that is, a force that directs its labor activity. In turn, managerial capital is affected by entrepreneurial capital and political capital at the corporate level. Political capital is formed based on the cultural and moral capital of individuals. Thus, mesolevel includes four types of human capital: 5 managerial capital (making managerial, economic, and technological decisions); 5 intangible capital (knowledge, relations within an organization); 5 patent capital (affecting human capital through patents, know-how, and licenses); 5 political capital (developing corporate vision and mission).

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Macrolevel constituting elements are formed on the basis of mesolevel elements. Being independent, they do not influence the behavior of other macrolevel parts. Thus, the development of social capital and public health capital is affected by the intangible capital of a firm, as well as the intellectual capital and health capital of an individual. Capital of national competitive advantage is formed by means of managerial capital of companies and entrepreneurial capital of individuals. Political capital features are influenced by political capital at the corporate level and the cultural and moral capital of individual employees. Four types of capital establish the macrolevel: 5 public health capital (improving the quality of medical services, organizing health-related sport and recreational events, ecological and environmental monitoring); 5 capital of national competitive advantage (professional training and retraining of managers and other employees at the country level); 5 social capital (impacting human capital through public institutions and legislation); 5 political capital at the national level (affecting social patterns at the national level). Human capital is similar to physical capital, but it has apparent differences (long-term benefits but a limited lifespan). Exhaustion may occur due to the loss

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of professional skills. Amid rapid technological progress and fundamental shifts in the labor market, some employees may fail to update and improve their professional skills and competencies. Human capital becomes obsolete faster than physical capital does. Its value rises and falls depending on changes in the supply of complementary factors of production (for instance, investment in education), as well as shifts in demand for their products (for example, innovations). Commonly cited types of capital include: 5 general capital: all knowledge and skills regardless of origin and implementation; 5 specific capital: special knowledge and skills that have practical value; 5 positive capital: human capital that provides a positive return on investment; 5 negative capital: human capital that provides no positive return on investment; 5 physiological capital: health, ability to work and efficiency, longevity; 5 intellectual capital: qualification, knowledge, and professional skills; 5 organizational capital: employees’ capabilities, qualifications, and competencies. Human capital development takes various forms and passes through different human life cycle stages. In the long term, the institutional environment required for an innovative socially-oriented type of development is formed due to improvements in education (see 7 Sect. 17.5) and health care (see 7 Sect. 17.6). Human capital development is a continuous process during which an individual reaches their highest potential and strives to optimize the combination of opportunities, such as education, job search, employment, and professional and personal growth. Thus, human capital development is associated with an investment in an individual and their development as a creative and productive economic resource. Seven factor groupings can be emphasized in terms of the growth-related effects of human capital development (. Fig. 17.2). Human capital management is based on the following fundamental principles: 5 human capital is considered an asset that requires investment, rather than a liability associated with expenditures; 5 business development models must coincide with human development strategies; 5 human capital management involves the implementation of advanced methods, approaches, and technologies; 5 balanced approach to motivating and stimulating the workforce; 5 targeting of investments in the formation of human capital; 5 regularity of quantitative and qualitative assessment of human capital; 5 scientific validity of human development activities. The level of human capital development in a given country depends mainly on the government’s efforts. The most common measures used by the government to influence the improvement of human resources include, for example, ensurance of housing affordability (favorable conditions for mortgage lending, as well as creating conditions for the development of the real estate market), education availa-

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. Fig. 17.2  Factors of human capital development. Source Authors’ development

17

ble to all (primary, secondary, and higher), wellbeing policies (creating a sufficient number of jobs), ensurance a sense of personal security by developing affordable insurance programs, increase in the longevity of the people through the development of the medical system and occupational safety, and development of new forms of pension insurance. The innovative approach to human capital development implies such measures as establishing links between educational institutions and business, developing new educational services and appropriate methodological support, introducing modern technologies and software into education, and international exchange of innovative methods.

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17.2  Theories of Economic Growth and Human Capital 17.2.1  Classical School, Marxism, and Neoclassics

The foundations of the human capital concept were laid in the classical works of William Petty, Adam Smith, and David Ricardo. They were the first to consider the workforce, human abilities, and education as key determinants of wealth and development. Living acting labor force was introduced and investigated by Petty. He considered it in the context of national wealth, the most important factor in the growth of the country’s wealth, on the one hand, and an integral part of it, on the other. Smith emphasized the predominant role of human abilities in relation to the material factor of production. According to Smith, the increase in productivity of useful labor depends on workers’ skills and the improvement of machines and tools they use. Ricardo noted the need and role of education in the economic growth of a country (see 7 Chap. 15, 7 Sect. 15.2 for classical theories of economic development and growth). Classical labor-related concepts of economic and social development were later elaborated by Karl Marx. Accepting the classical importance of labor in the economy, Marx interpreted labor as the totality of physical and spiritual abilities of workers used in the production process. Marx further substantiated the necessity of significant investments in developing the labor force (Marx’s labor theory of value was previously addressed in 7 Chap. 15, 7 Sect. 15.3.1). In the industrial era, Marx called workers the principal capital and development determinant. In the post-industrial society, the human capital concept has been revised. The very articulation of the human capital theory dates back to the 1950s when economic development gaps between industrialized and developing countries widened. Since the beginning of the XX century, economists have attempted to quantify the efficiency of human capital in the economy. They extensively used economic, mathematical, and statistical tools in studying such issues as human capital value, the impact of the education system on the country’s economic growth, the cost to the family of increasing economic value of an individual, and public expenditures on the upbringing and education of people. The formalization of the contemporary approach to the interpretation of human capital was facilitated by the specific social and economic conditions developed by the 1950s. 5 Transition to innovative production due to scientific and technological progress. It resulted in the increase in the role of complex work and special narrower qualifications of employees. The part and place of the labor force in the production process were revised. 5 Due to fundamental changes in the production processes, the share of intellectual, highly professional labor in the final cost increased. The material intensity of production gave way to intellectual and professional intensity. The latter was manifested in the growth of labor intensity, entrepreneurial income, and public funds.

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5 Widespread humanization (particularly in the most developed countries) resulted in the common acceptance of the human value idea at all levels of economic management and various kinds of social and economic relations. 5 The accumulated theoretical and methodological potential of the human capital concept made it possible to critically assess the state of scientific thought in the human capital area and develop the human capital theory. Two American economists, Theodore Schultz and Gary Becker (the Nobel Prize winners in 1979 and 1992, respectively), are acknowledged as the founders of the modern human capital theory (see 7 Sects. 17.2.2 and 17.2.3 for the essence of their human capital theories). 17.2.2  Schultz’s Human Capital Theory

An essential prerequisite for elaborating the human capital theory was the expansion of the traditionally narrow concept of capital. The starting point was that all elements of social wealth accumulated and used in production to generate profit are considered capital. In 1961, Theodore Schultz postulated that the concept of capital was premised on material assets that allowed one to manufacture goods or render services that had value. Understanding capital as something that provides future services allowed Schultz to distinguish between human and non-human capital (further reading: “Investment in Human Capital”1). Case box In the course of the scientific and technological revolution in the first half of the XX century, a shortage of highly qualified labor occurred. In the 1950s, labor-related studies refocused from using the existing labor force to developing qualitatively new human resources. Since that time, the level of education has increased significantly across both developed and developing countries. Noticeable progress has been evidenced in the development of intellectual productive forces, the accumulation of intangible wealth (competencies, skills, etc.), and the emergence of innovations in all spheres.

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Schultz’s human capital theory can be summarized in the following six premises: 5 human capital is an additional source of income created by an individual’s knowledge, skills, and abilities; 5 education is a form of capital, a pivotal factor that ensures economic growth, and at the same time a separate source of growth apart from institutions and other subjects of the institutional environment;

1

Schultz (1961).

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5 education capital is human capital because it is inseparable from an individual; 5 education capital is a source of future satisfaction and benefits; 5 human capital quality can be improved by investing in education; 5 investing in education is one of the forms of investments in factors of production that create a surplus product and surplus value. A broad understanding of human capital as a set of the most valuable and useful qualities inherent in an individual suggests that human capital cannot be considered just one of the determinants of productivity and economic growth. Since the value of individual attributes intrinsic to a worker is defined subjectively, human capital is a normative economy concept that essentially embodies a subjective component. Schultz discusses the nature of value and utility of human qualities. From the point of view of a complex system of diverse economic interests in diverse social and economic processes, one and the same quality of a worker may be valuable for one employer and useless for another. According to Schultz, all human abilities are either innate or acquired. An individual is born with an individual complex of genes that determine natural abilities. Human capital is a set of valuable qualities acquired by an individual that can be strengthened by appropriate investments. In the sphere of education, financial capital turns into human capital. That is, education costs turn into rewards for both an individual and the entire society (see 7 Sect. 17.3 for growth effects and returns of investment in human capital development and 7 Sect. 17.5 for human capital and education). Schultz distinguished the types of human capital according to the kinds of investments made in this capital. He pointed out that abilities and ­competencies developed through certain activities are attributable to the investment. Such investment activities include school education, on-the-job training, health protection, and the accumulation of information. Through these activities, certain groups of human abilities are formed. They can receive a capital assessment and be applied as human capital. Investments are costs because investors sacrifice part of the income today to obtain a higher gain tomorrow. 17.2.3  Becker’s Neoclassical Human Capital Theory

Gary Becker further elaborated the human capital theory and made the most outstanding contribution to this scientific direction. Therefore, he is recognized as a founder of the scientific school of human capital development. In 1962, Becker postulated that human capital is established by means of investment in people, such as education, training, health care, migration, and search for information on prices and incomes (further reading: “Investment in Human Capital: A Theoretical Analysis”2). These expenditures contribute to developing the productive force and intellectual and cultural potential of an individual. The book entitled “Human

2

Becker (1962).

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Capital: A Theoretical and Empirical Analysis, with Special Reference to Education”,3 published in 1964, laid the basis for fundamental research in the sphere of human capital development. Becker and his followers demonstrated that a high-quality educational system could be profitable for a country in the long term. This finding conditioned the approval and implementation of public investment policies in the spheres of secondary and higher education across the world. Becker identifies distinctive features of the economic approach to human behavior. He was convinced that it is the approach, not the subject of economic studies, that distinguishes economics from other disciplines. This approach can integrate different forms of human behavior. Becker proceeded from the fact that the behavior of all individuals is subject to the same fundamental principles: maximization of benefit, establishment of market equilibrium, and permanency of tastes and preferences. The economic approach involves maximizing behavior in a more explicit form and a wider range than other approaches. Households, firms, and government agencies all strive to maximize utility or wealth. ­Moreover, the economic approach assumes the existence of markets with varying degrees of efficiency. They coordinate the actions of different stakeholders (individuals, firms, industries, nations) so that their behavior becomes mutually consistent. It is also assumed that preferences do not change significantly over time and do not differ too much between the rich and the poor, or even among people from different societies and cultures. Market equilibrium is achieved because prices and other market instruments regulate the distribution of scarce resources in society, thereby limiting the desires and needs of market actors and coordinating their actions. Permanency of preferences is assumed concerning the fundamental objects of choice that each household produces using market goods, its own time, and other resources. The assumptions about maximizing behavior, market equilibrium, and permanency of preferences establish the basis of Becker’s approach to interpreting human capital. Therefore, according to Becker, human capital is a stock of an individual’s knowledge, skills, and motivations. Similar to physical capital, the accumulation of human capital requires significant costs due to a complex investment process. Although human capital is distinguished from physical capital, the two forms have similar properties. They are used in the long-term, incur repair and maintenance costs, and become obsolete before physical wearing. The return on human capital can be both individual (return on investment from the point of view of individual investors) and social (efficiency for society). Rates of return facilitate the allocation of investments between different types and levels of education, as well as between the education system and the rest of the economy. High rates of return suggest underinvestment, while low ones indicate overinvestment. An average return on investment in an individual is higher than that on investment in material capital. However, in the case of human capital, return decreases with an increase in the volume of investments, while in

3

Becker (1964).

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the case of other assets, it remains stable or declines slightly. Therefore, rational households should first invest in children’s human capital to obtain a higher return. Then, when the return on investment in children decreases with that on other assets, they should switch to investing in assets in order to subsequently pass them on to children as a gift or inheritance. One of the important features of investing in human capital is the diminishing marginal utility due to the embodiment of capital in the investor himself. This embodiment is the main reason why marginal benefits of human capital diminish as capital accumulates. Since memory, strength, and other mental and physical parameters of any individual are limited, the production of additional human capital sooner or later incurs increasing marginal costs and yields decreasing profitability. The role of investors’ own time in human capital development is closely related to the embodiment of human capital. The importance of time is so great that the increase in investment in human capital directly corresponds to the increase in time spent for development (see, for instance, 7 Sect. 17.3, . Fig. 17.4 for inter-temporal changes in expenditures and returns on investment in human capital development). A commonly accepted measure of the amount of education and training received by an individual is the number of years of study, i.e., an estimate based entirely on the length of time spent on developing human capital. This means that the accumulation of human capital inevitably stretches over a long period of time (the investment period). Lengthening the investment period due to the importance of own time may dampen the diminishing effect as capital increases but not eliminate it. In a finite lifespan, later investments can not generate income during the same period of time as early ones, and so the overall gain from later investment is smaller. Due to the delay in receiving, the return on later investments is lower due to the lower discounted net benefit. Investing in training complicates the relationship between present and future costs and revenues. The equilibrium condition for a firm investing in training in a competitive market can be expressed as follows (Eq. 17.1):

MP0 + G = W0 + C

(17.1)

where MP0  opportunity marginal product of trainees; return on training; G market wages of trainees; W0 opportunity and direct cost of training. C Initially, the marginal product equals wages (MP0 = W0) only if the return on training equals expenditures (G = C). Two premises must be considered. First, in the initial period, Eq. 17.1 is valid for an opportunity marginal product, not an actual one. Wages exceed actual marginal productivity if a portion of a potential product is sacrificed for the sake of training. Second, even if wages were initially equal to the marginal product, they would decline in the future (W0 < MP0) by the amount that makes up the return on training. Training affects the earnings-age relationship. Individuals undergoing training face lower earnings dur-

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ing the training period (a part of earning is spent on investing in education) and higher earnings in the future (additional income received due to better training) (see 7 Sect. 17.3 for returns on human capital investments). Becker’s human capital theory has also contributed to studying economic inequality (see 7 Sect. 17.4 for inequalities in human capital development). In Becker’s income distribution model, net earnings of an individual at age t are approximately equal to the earnings that this individual would have at this age with no investment in human capital plus total income from previously made investments and minus amount of investment (Eq. 17.2):

Et = Xt + kt − Ct

(17.2)

where Et net earnings; Xt  earnings with no investment in human capital; kt total income from previously made investments; Ct investment; t period of time.

Case box In developed economies, where large-scale investments are made in education, training, non-formal education, and public health, earnings not related to investments in human capital development make up a tiny fraction of an individual’s total income. In this case, Xt can be omitted when building the income distribution model. The lower the level of economic development of a country, the lower the contribution of highly skilled labor in GDP. Accordingly, the higher the share of earnings with no investment in human capital development in individual’s total income (country’s total wealth).

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The total return on investment in human capital depends on the volume of investments made and their rates of return. If earnings received from any investment remained unchanged in any age throughout the entire period of an individual’s labor activity, then the total income would be equal to the sum of products of investments on their rates of return adjusted for the finiteness of the working life. Differences in the total amount of investment made by different people are related to differences in their individual rates of return. To illustrate individual investments within the universal income distribution model, Becker used the supply and demand curves of investments in human capital. The unequal arrangement of demand curves for human capital investment reflects inequalities in trainees’ natural abilities. In contrast, the unequal arrangement of supply curves reflects inequalities in their access to financial resources. The wider the gap between individual curves, the more uneven the distribution of human capital (consequently, earnings).

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17.2.4  Modern Interpretations of Human Capital

Development and Economic Growth

Since the 1960s, the human capital theory has evolved and captured new areas of knowledge, including institutional approaches to development (economic returns on human capital in the context of the development of public institutions and transformation of the institutional environment), foreign economic activities (non-economic determinants of quantitative and qualitative parameters of human capital as comparative advantages), and intercountry comparisons (international labor and human development statistics). Since the early 2000s, human-related studies have been focusing on investigating the impact of investments in education on specific forms of human capital at the corporate level. Human capital research has expanded to sociology, cultural studies, and computer science. The following five provisions could describe the modern human capital theory: 5 over the course of life, an individual acquires and accumulates knowledge and skills and applies them in different areas; 5 interest in further development of human capital is spurred by a possibility to obtain higher income and improve wellbeing; 5 appropriate use of human knowledge and skills is required to improve productivity and economic efficiency of labor; 5 rejection of current needs in favor of the development of labor potential leads to an increase in wellbeing in the future; 5 motivation and stimulation are necessary conditions for acquiring and accumulating knowledge, skills, and abilities. Several criteria and types of studies can be used to characterize modern interpretations of the influence of human capital on economic growth (. Table 17.1).

. Table 17.1  Models of human capital influence on economic growth Criterion

Types of studies

Subtypes of studies

Analytical approach

Theoretical

Mathematical models Non-technical analysis

Empirical

Measurement of human capital Growth accounting Econometric models

Mechanism of influence of human capital on growth

Source Authors’ development

Direct impact of human capital

Neoclassical models

Indirect impact of human capital

Endogenous models

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As part of theoretical studies in an analytical approach to modeling human capital’s influence on economic growth, mathematical models define a functional relationship between human capital and growth. They estimate the impact of human capital on economic growth and development through several parameters. These mathematical models are the starting point in empirical studies of the influence of human capital on growth using world or regional economic data. The second part of theoretical studies, non-technical analysis, includes an evidence-based substantiation and a discussion of policies and the effects of policies of governments and international organizations with respect to fostering economic growth through the enhancement of human capital in target countries or regions. The empirical studies compare the theoretical base with real-life observations on the world economy or individual countries, as well as numerical assessment of the direct and indirect influence of human capital on economic growth. Some of these studies are focused on measuring human capital. They lay the quantitative foundation of empirical estimates of human capital influence on growth. They compile panel data on human capital and construct indices to measure human capital. The second component of empirical studies, growth accounting, is a simplified approach to calculating the contribution of factors of production to economic growth. It is based on the extended Solow-Swan growth model (see 7 Chap. 15, 7 Sect. 15.4.3) that reflects the dynamics of the human capital stock. This approach includes relatively simplified calculations and results in a quantitative assessment of the contribution of human capital to economic growth. The third component of empirical studies, econometric models, makes a quantitative assessment of the influence of human capital on economic growth on the basis of cross-sectional, time-series, and panel data regressions. Econometric models differ by specification, data they use, countries they capture, and human capital measurement. Neoclassical and endogenous models are distinguished depending on the assumptions made with respect to the technology production factor. Although technology is considered a pivotal determinant of economic growth, early neoclassical models considered its dynamics an exogenous influence on e­ conomic systems. Modern growth theories link technological change with consumers’ and producers’ behavior (endogenous elements). This approach acknowledges human capital as one of the drivers of economic growth and technological development. Therefore, it is also called the technological progress approach. This group of models studies the linkage between total factor productivity (taken to represent technological development in a given economy) and the average level of human capital development. Modern theory has departed from interpreting human capital just as a set of an individual’s innate qualities. Those who do not achieve their capacities and inherent abilities also obtain human capital. At the same time, the possession of human capital is not an intrinsic property. Inherent natural aptitudes and abilities are considered determinants of human capital accumulation and development. Innate, acquired, and enhanced qualities can be used by an individual in many areas other than business, i.e., profit-making activities. The modern theory

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thus considers the ratio of valuable attributes of an individual to human capital. According to the classical school, capital is a value that generates surplus value by exploiting factors of production. The contemporary interpretation of human capital emphasizes that human capital can acquire an irrational form under certain conditions. In other words, it may not generate profit but still be considered valuable and efficient (for instance, higher forms of creative activity in science, culture, art, charity, upbringing of children, or public administration). The modern theory distinguishes between the concepts of the labor force and human capital. According to the legislation of different countries worldwide, the labor force has a clearly defined statistical framework based on the gender and age composition of the population, social status of individuals, and many other parameters. Unlike the labor force, human capital is a broader concept that considers intellectual, creative, and innovative dimensions. Human capital is the unity of human resources and human potential, such as competencies, experience, intelligence, and continuous improvement and development. In the economic aspect, human resources are often interpreted as the total raw labor determined by the size of the population in a territory (labor resources) and the level of human capital development in this population. The following three features distinguish human capital from labor resources: 5 intellectual component in human capital; 5 persistent ability and willingness of individuals to systematically improve and develop their competencies and skills; 5 conscious choice of the appropriate type of activity and development trajectory. The need for qualitative transformation of labor resources into human capital follows from the features of the post-industrial stage of social and economic development characterized by accelerating technological progress, digitalization, innovations, and structural changes in the labor market (see previously discussed technology-related challenges of the new normal economy in 7 Chap. 16). 17.3  Investing in Human Capital: Growth Effects and Returns

Human capital is a long-term economic resource. Its profitability increases over time with the accumulation of knowledge and experience. For both an individual and the entire country, investing in education generates higher profit than investing in fixed assets (in the long run). Higher profitability stimulates an increase in both public and private investment in developing new qualities of human capital (intellectual potential, creative activity), as well as incentivizes people to spend more on obtaining education, advancing skills, and improving health. Investments in Human Capital are investments in education, training and developing individual skills and competencies, and maintaining health. Several features distinguish investments in human capital from other types of investments:

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5 Return on investment in human capital increases during the active working period of an individual and then decreases sharply. That is, the return depends directly on the length of an individual’s working period. The earlier investments are made, the faster they start generating gains. Long-term and continuous investments provide a more significant and long-lasting effect. Later investments generate returns for a shorter period of time (active working period limitation). 5 Human capital is subject to physical depreciation and obsolesce, but it can be accumulated, improved, and multiplied. The depreciation of human capital is determined by the natural aging of a human body, obsolescence of knowledge, or a change in the value of education received by an individual. Human capital is updated by retraining employees, gaining working experience, and maintaining health. If these processes are carried out continuously, then human capital improves and increases its qualitative and quantitative characteristics in its use. Education increases the efficiency of an individual not only as an employee but also as a student because previous education accelerates and facilitates the further accumulation of knowledge and skills. However, as an individual’s abilities are limited by natural factors, acquiring new knowledge takes more and more effort over time. 5 Investments in human capital must be economically feasible, morally justified, and reasonable from the point of view of the interests of a civilized law-governed society. Any other investment in developing an individual can not be considered an investment in human capital development. 5 Not all investments in human capital can be valued in monetary terms. In addition to monetary income, an employee can also receive moral satisfaction from work. Historical, national, and cultural patterns and traditions determine the nature and types of investments in human capital in individual countries, territories, or communities. Investing in human capital can have social, psychological, and other externalities that increase returns, but their quantification and measurement are somewhat challenging. 5 Riskiness of investing in human capital increases with an increase in investment volume. In contrast to an owner of material capital, an individual cannot distribute or diversify their risk. 5 Compared to investments in other forms of capital, investments in human capital are the most profitable from the point of view of both an individual and the entire society.

17

There are three main types of investment in human capital: 5 Investment in all kinds of education (primary, secondary, vocational, higher, formal and informal training, etc.), improvement of an individual’s knowledge, skills, and abilities, and on-the-job training. Education and training enrich a person with knowledge and skills and thus increase the amount of human capital (further detailed in 7 Sect. 17.5). 5 Investment in public and individual health involves spending on disease prevention, medical care, dietary nutrition, and improved living conditions. They

627 17.3 · Investing in Human Capital: Growth Effects and Returns

17

aim to lengthen life expectancy (i.e., prolonging the active working period of human capital as a factor of production) and thus increase workers’ efficiency and productivity (further detailed in 7 Sect. 17.6). 5 Investment in labor mobility, i.e., expenditures associated with migration from venues (territories, industries, sectors, jobs) with relatively low productivity to higher productive venues. The spending on migration and the search for information on prices and wages across countries or industries contribute to the reallocation of labor as a factor of production (see 7 Chap. 21 for international migration of labor). Investments in human capital are divided into tangible (material) and intangible (immaterial) investments. The former includes all the costs associated with the physical development of an individual (birth and upbringing of children), while the latter comprises expenditures on education, health care (partly), and human capital mobility (. Fig. 17.3). Sources of investment in human capital include individuals, households, firms, government, and international organizations. Governments spend public funds on education because using a well-educated labor force accelerates a country’s development. Employers invest in upgrading and advancing the skills of their employees in pursuance of higher profits due to improved productivity and innovativeness of labor. People themselves are willing to spend not only time but also money to

. Fig. 17.3  Types of investments in human capital development. Source Authors’ development

Chapter 17 · Human Capital and Economic Development

628

. Fig. 17.4  Expenditures and returns on investment in human capital development. Source Authors’ development

17

receive education, since more educated and skilled workers commonly earn more. The return on investment in human capital can be assessed by comparing employees’ wages with different levels of education. Expenditures on investing in education are divided into direct costs (tuition fees, textbooks, etc.) and opportunity costs (potential wage a student could earn by preferring working to training). When deciding whether to continue studying or drop out, students compare the benefits and costs. That is, they compare the expected marginal rate of return on investment in education with the return on alternative investments. Individual benefits of investing in an extra year of education (t1 + 1) yield earning gains for an individual’s remaining working life tr (. Fig. 17.4). Direct individual costs (DC area) include any fees or direct costs that an individual pays for receiving education during [t1 ; t2 ] period of time. Opportunity costs (OC area) reflect potential benefits lost due to spending time on education rather than working. The loss is calculated as a difference between wage Yne that undereducated employee starts receiving right after entering the labor market at time t1 and wage Yed that educated employee receives only after finishing education at time t2. Over time, Yed exceeds Yne, and loss turns into surplus. Starting from te time till the end of active working age period tr, an educated employee gains wage surplus ( X area). Active working period ends with a higher income Yed at point A for an educated employee in comparison to income Yne at point B for an undereducated employee. Another approach to assess the return of investment in education is to calculate the internal rate of return and compare it with the income from alternative investments. The internal rate of return is derived from the equality of the current value of future income and investment in education (Eq. 17.3). n  t=0

n

 Ct Bt t = (1 + r) (1 + r)t t=0

(17.3)

17

629 17.3 · Investing in Human Capital: Growth Effects and Returns

where Bt  revenue received due to education; Ct  education costs; r internal rate of return; t period of time. A distinction is made between the individual rate of return on human capital (the revenues-costs ratio for an individual) and the social rate of return (the revenues-costs ratio for the entire society). Ideally, social benefits include non-monetary or external effects of education, such as overall cultural effervescence, tolerance, and improved sanitation and healthcare. Given the scant empirical evidence on the externalities of education, social rates of returns are generally estimated based on directly observable monetary costs and benefits of education. Public expenditures on education are much higher than those of individuals or households, since the state covers the lion’s share of education costs at a primary, secondary, and higher level, including buildings, assets, and teachers’ wages. Therefore, the social rate of return tends to be lower than the individual one. The difference between individual and social rates of return reflects the role of the state in subsidizing the education system. Case box Gary Becker (see 7 Sect. 17.2.3 above) was one of the first to calculate the economic efficiency of education. He deducted the income of individuals with secondary education from the lifetime earnings of college graduates to determine the higher education surplus. Education costs substantially increase by the value of opportunity costs, i.e., the income students lose during their studies. According to Becker, the return on investment in an individual is higher than that on investment in material capital. With an increase in investment in human capital, the return declines, while in the case of other assets (for example, bank deposits, real estate), it generally remains unchanged. Therefore, many families prioritize investments in children due to their greater initial return. Only when the return declines to the rate of return on other assets, households start investing in these assets to pass them on to children in the future.

Equation 17.3 can be extended by capturing the dependence of wages on the level of education. This can be done by introducing the number of years after graduation, a variable that reflects the experience gained at the workplace. Knowledge and skills can be obtained in educational institutions or directly during work. Consequently, wages may increase with time in employment. Work experience is taken in quadratic form (Eq. 17.4) to capture the nonlinear nature of its accumulation. The bulk of applied knowledge and skills are accumulated during the early years of employment. As time passes, this process slows down. Also, as an individual approaches retirement age, human capital depreciates due to health impairment and declining incentives to acquire new knowledge and skills.

ln W = β0 + β1 × SCH + β2 × EXP + β3 × EXP2 + β4 × X + ε

(17.4)

630

Chapter 17 · Human Capital and Economic Development

where W SCH EXP X β0

wages within a given period of time; years of schooling; working experience or time in employment; control variables affecting the level of wages; average wages of workers with no education and no work experience employed in jobs that require no qualifications; rate of return on investment in education for one additional year of study; β1 [β2 ; β4 ]  rates of return on working experience. Summing up the effects of investments in human capital development, we should say that in some cases, such investments end up with no return. Low culture of gaining knowledge, lack of work ethics, or underdevelopment of entrepreneurship may produce negative outcomes. Risks of investing in human capital are associated with the inefficient investment in gaining knowledge that a trainee fails to use due to individual ability to assimilate information, low motivation, or other personal reasons. Positive effects of investment imply a return on the development of individuals and society as a whole. Investing in human capital development establishes a basis for economic growth, technological progress, increase in welfare, and improvement of health of the entire nation. 17.4  Inequalities in Human Capital Development

17

Human capital theories and approaches to assessing labor productivity discussed in 7 Sects. 17.2 and 17.3 define return on human capital as a bonus for the higher qualification obtained as a result of education and training over the course of life. Thus, inequality in the productivity of human capital accumulated due to various educational practices translates into income inequality. The new normal economic reality has substantially aggravated social and economic inequality issues all over the world. The economic freedom and competition principles conflict with achieving equality. Undoubtedly, the new normal pattern retains inequality as an inherent feature of economic development. However, the foundations of social differentiation and social stratification determined by inequality may change. As previously demonstrated in 7 Chap. 14 (7 Sect. 14.5), social and economic inequalities can be determined by environmental factors unrelated to employees’ cognitive characteristics and productivity. Such factors may include the climate and demographic differences, informal but relatively stable social barriers in the education and labor markets (for example, age or gender), and restrictions on social and occupational mobility. Also, income differences can be caused by random circumstances (for example, due to imperfect competition). The desire of individual workers to reduce inequality is manifested in an increase in the intensity of social, occupational, and territorial mobility of the economically active population and a decrease in the relative costs of such mobility (see 7 Chap. 21 for labor m ­ obility

631 17.4 · Inequalities in Human Capital Development

17

and migration). On the one hand, the new normal transformation of economic relations results in changes in the social hierarchy. On the other hand, the importance of understanding social inequality determinants in the new normal society increases along with the relevance of studying processes of social integration and disintegration. This necessitates elaborating a new vision of social differences and social differentiation criteria. Since human capital is a set of interacting needs and abilities of an individual, objective inherent and acquired differences in these needs and abilities differentiate individuals on the quality of human capital. Proponents of the human development concept qualify inequalities as obstacles to more complete disclosure of social development potential. Among other problems, the new normal economic reality faces increased social tensions and the resulting negative political and economic consequences. The latter covers a wide range of phenomena related to the economic costs of crime, socio-political conflicts, as well as frequent changes in legislation and law enforcement practices that deteriorate the investment climate. Common inequality measures in the sphere of human development include income level, life expectancy, and education. Income inequalities between and within countries have been addressed previously in 7 Chap. 14, 7 Sect. 14.5. Inequality in the achieved human potential is particularly manifested in the disparity in remuneration for work of different qualifications, as well as for the same work, depending on national and gender reasons. This issue is particularly relevant for developing countries, as well as some developed economies. Life expectancy directly characterizes the most important quantitative aspect of human capital. Many studies demonstrate the positive impact of life expectancy and the negative impact of differentiation of the educational level on human capital accumulation. Educational inequalities generally manifest themselves in the form of limited access to high-quality education. Commercialization of the education sphere reduces economic access to education. Inequality arises at the primary school level and then aggravates at the secondary and university levels. The same applies to the access to vocational training, especially higher professional education perceived as one of the main forms of occupational development. Improving the accessibility of education includes offering scholarships to students from various territories, communities, and social groups, incentivizing competition for students between educational institutions, increasing the number of institutions and programs, and promoting free educational platforms and resources. Case box The breakdown by education level shows that there will be more and more educated people in the world. The number of people with no education will be decreasing continuously. By the end of the XXI century, virtually all people in the world will have received some level of education. By 2050, only several least developed countries in Africa will likely have a rate of no education above 20%. Most of the cross-country gaps in literacy will be closed by 2050.

632

Chapter 17 · Human Capital and Economic Development

Capturing three dimensions of human development (decent standard of living, a long and healthy life, and access to knowledge) has resulted in establishing the international measure of human capital development called the Human Development Index (HDI). It is a composite indicator of human development in countries and regions of the world produced by the United Nations Development Programme (UNDP).4 HDI utilizes four key metrics: 5 life expectancy at birth (a parameter of long and healthy life); 5 expected years of schooling (access to knowledge of the younger generation); 5 average years of schooling (access to knowledge of the older generation); 5 gross national income (GNI) per capita (a parameter of standard of living). With the actual value for a given country and the global maximum and minimum, indices for each of the four metrics are calculated as follows (Eq. 17.5). Di = 1 if a country achieves the maximum value (0 for the minimum).

Di =

Vact − Vmin Vmax − Vmin

(17.5)

where dimension index; Di Vact actual value; Vmin minimum value; Vmax  maximum value. The second approach to calculating HDI is aggregating the four metrics to produce the resulting index. HDI is calculated as the geometric mean (equally-weighted) of life expectancy, education, and GNI per capita (Eq. 17.6). The education dimension is the arithmetic mean of the two education indices (mean years of schooling and expected years of schooling). 1

HDI = (IH × IE × II ) 3

(17.6)

where IH   health index; IE education index; II income index.

17

HDI also takes into account political, economic, and social issues faced by developing and developed countries worldwide, such as human rights and civil liberties, social security, territorial and social mobility of people, cultural development, access to information, public health, unemployment, crime, environmental

4

United Nations Development Programme (2019).

633 17.4 · Inequalities in Human Capital Development

17

protection, and many others. Based on the overall HDI value, human development level is rated as very high (HDI ≥ 0.80), high (0.80 > HDI ≥ 0.70), medium (0.70 > HDI ≥ 0.55), and low (HDI < 0.55). One of the challenges is obtaining reliable and comparable cross-country empirical data due to substantial differences in national reporting systems between countries. Worse yet, some governments deliberately embellish the situation in their countries. Currently, HDI covers UN member states, as well as several territories with special status. Due to the lack of reliable statistical data, certain HDI values for certain entities may be missing. Countries unwilling or unable to provide statistics on HDI components are not included in the rating but are considered separately. UNDP’s reports are usually one to two years late, as they require international comparison after national statistical services publish the data. The differences in the HDI parameters across the world are substantial, ranging from the highest values in North America, Europe, Japan, and Oceania to the lowest in Central Africa. In . Table 17.2, the most recent HDI values are summarized by human development groups, regions of the world, and the level of economic development of countries. Among countries, the highest HDI values in 2019 were registered in Norway (0.957), Ireland (0.955), and Switzerland (0.955), while Chad (0.398), Central African Republic (0.397), and Niger (0.394) demonstrated the lowest scores (. Table 17.3). Although average annual HDI growth rates have been higher across developing countries since the 1990s, most of developing states still lag far behind developed economies in all three human capital dimensions (standard of living, a long and healthy life, and access to knowledge). As witnessed in 7 Chap. 14, economic and social inequality is deemed to be one of the deadliest threats to economic growth and sustainable economic development. Inequality-adjusted HDI still demonstrates wide gaps between developed, developing, and least developed states, but for some of “very high” and “high” developed economies, drops in HDI scores due to inequalities in three basic dimensions of human development are significant (. Table 17.4). According to the UNDP methodology, inequality in life expectancy LE I is measured as inequality in the distribution of expected length of life based on data from life tables estimated using the Atkinson inequality index (see 7 Chap. 14, 7 Sect. 14.5). Among the top ten countries and territories, inequality in life expectancy is lowest in Iceland (2.4%) and Hong Kong SAR, China (2.5%). The highest inequality in life expectancy is evidenced in Chad (40.9%) and Central African Republic (40.1%) (. Table 17.5). The Atkinson inequality index is also used to estimate inequalities in education EI and income II as inequality in the distribution of years of schooling and income distribution, respectively. These estimations are based on data from household surveys. Switzerland’s education system is recognized as the most equal (1.8%), while Sierra Leone suffers the worst inequality in education (46.9%). Regarding inequalities in income, the gaps between developed and developing states are not that impressive. Thus, for OECD countries II = 22.2%, while for developing states, II = 24.6%. Across OECD countries, the richest 1% possess 15.1% of wealth. In some developed states, the income inequality level is even

634

Chapter 17 · Human Capital and Economic Development

. Table 17.2  HDI 2019: country groupings Group

Categories

HDI, value

Life expectancy at birth, years

Expected years of schooling, years

Mean years of schooling, years

GNI per capita, 2017 PPP $

Human development groups

Very high human development

0.898

79.6

16.3

12.2

44,566

High human development

0.753

75.3

14.0

8.4

14,255

Medium human development

0.631

69.3

11.5

6.3

6,153

Low human development

0.513

61.4

9.4

4.9

2,745

Regions

Level of economic development

World

17

Arab states

0.705

72.1

12.1

7.3

14,869

East Asia and the Pacific

0.747

75.4

13.6

8.1

14,710

Europe and Central Asia

0.791

74.4

14.7

10.4

17,939

Latin America and the Caribbean

0.766

75.4

14.6

8.7

14,812

South Asia

0.641

69.9

11.7

6.5

6,532

Sub-Saharan Africa

0.547

61.5

10.1

5.8

3,686

OECD countries

0.900

80.4

16.3

12.0

44,967

Developing countries

0.689

71.3

12.2

7.5

10,583

Least developed countries

0.538

65.3

9.9

4.9

2,935

Small island developing states

0.728

72.0

12.3

8.7

16,825

0.737

72.8

12.7

8.5

15,745

Source Authors’ development based on UNDP (2020)5

5

United Nations Development Programme (2020).

Norway

Ireland

Switzerland

Hong Kong SAR, China

Iceland

Germany

Sweden

Australia

Netherlands

Denmark

1

2

3

4

5

6

7

8

9

10

Eritrea

Mozambique

180

181

…

Countries and territories

2019 rank

0.456

0.459

0.940

0.944

0.944

0.945

0.947

0.949

0.949

0.955

0.955

0.957

60.9

66.3

80.9

82.3

83.4

82.8

81.3

83.0

84.9

83.8

82.3

82.4

10.0

5.0

18.9

18.5

22.0

19.5

17.0

19.1

16.9

16.3

18.7

18.1

3.5

3.9

12.6

12.4

12.7

12.5

14.2

12.8

12.3

13.4

12.7

12.9

Mean years of schooling, years

GNI per capita, 2017 PPP $

1,250

2,793

58,662

57,707

48,085

54,508

55,314

54,682

62,985

69,394

68,371

66,494

3.07

–

0.77

0.54

0.36

0.96

0.81

0.72

0.57

0.67

1.15

0.75

2.71

–

0.53

0.39

0.30

0.09

0.57

0.35

0.86

0.47

0.39

0.27

2000– 2010

1990–2000

Expected years of schooling, years

HDI, value

Life expectancy at birth, years

Average annual HDI growth, %

2019

. Table 17.3  HDI trends for selected countries and territories in 1990–2019

1.44

0.57

0.28

0.32

0.17

0.41

0.24

0.62

0.54

0.16

0.65

0.20

2010– 2019

635

(continued)

2.43

–

0.53

0.42

0.28

0.49

0.55

0.56

0.66

0.44

0.73

0.41

1990– 2019

17.4 · Inequalities in Human Capital Development

17

6

17

Burkina Faso

Sierra Leone

Mali

Burundi

South Sudan

Chad

Central African Republic

Niger

182

183

184

185

186

187

188

189

Mean years of schooling, years

GNI per capita, 2017 PPP $

0.394

0.397

0.398

0.433

0.433

0.434

0.452

0.452

62.4

53.3

54.2

57.9

61.6

59.3

54.7

61.6

6.5

7.6

7.3

5.3

11.1

7.5

10.2

9.3

2.1

4.3

2.5

4.8

3.3

2.4

3.7

1.6

United Nations Development Programme (2020).

1,201

993

1,555

2,003

754

2,269

1,668

2,133

2.37

1.17

1.76

2.33

−0.27

–

3.20

2.72

3.07

2.74

–

–

0.03

2.92

0.28

–

2000– 2010

1990–2000

Expected years of schooling, years

HDI, value

Life expectancy at birth, years

Average annual HDI growth, %

2019

Source Authors’ development based on UNDP (2020)6

Countries and territories

2019 rank

. Table 17.3  (continued)

1.95

0.94

0.84

0.61

0.58

0.69

1.40

1.83

2010– 2019

2.03

0.60

–

–

1.29

2.15

1.58

–

1990– 2019

636 Chapter 17 · Human Capital and Economic Development

0.747

0.791

0.766

0.641

0.547

East Asia and the Pacific

Europe and Central Asia

Latin America and the Caribbean

South Asia

Sub-Saharan Africa

0.513

Low human development

0.705

0.631

Medium human development

Arab states

0.753

High human development

Regions

0.898

Very high human development

Human development groups

HDI, value

Categories

Group

0.380

0.475

0.596

0.697

0.621

0.531

0.352

0.465

0.618

0.800

IHDI, value

30.5

25.4

21.5

11.7

16.5

24.3

31.3

25.9

17.6

10.7

KI

. Table 17.4  Inequality-adjusted HDI 2019: country groupings

29.7

20.2

11.6

9.7

9.9

15.0

30.8

20.8

10.1

5.2

LE I , %

34.1

37.5

18.0

8.2

13.4

32.5

37.9

37.1

14.5

6.4

EI , %

27.6

18.5

34.9

17.2

26.2

25.4

25.1

19.7

28.0

20.4

II , %

15.4

19.2

12.9

19.7

17.3

20.7

16.7

18.8

16.6

18.3

Poorest 40%

33.9

30.9

37.8

27.2

29.5

26.6

31.9

31.0

31.3

27.7

Richest 10%

Income shares by, %

637

(continued)

16.4

–

–

–

–

15.3

16.0

–

–

15.6

Richest 1%

17.4 · Inequalities in Human Capital Development

17

7

17

0.538

0.728

Least developed countries

Small island developing states 0.587

0.549

0.384

0.535

0.791

IHDI, value

20.2

24.2

28.4

22.3

11.8

KI

14.7

16.7

26.4

16.7

5.5

LE I , %

22.1

22.0

36.0

25.5

7.6

EI , %

23.8

34.0

22.9

24.6

22.2

II , %

17.6

–

17.9

17.4

17.9

Poorest 40%

30.6

–

30.8

31.3

28.7

Richest 10%

Income shares by, %

17.1

–

16.3

17.7

15.1

Richest 1%

United Nations Development Programme (2020).

Note IHDI = inequality-adjusted HDI; KI = coefficient of human inequality; LE I = inequality in life expectancy; EI = inequality in education; II = inequality in income Source Authors’ development based on UNDP (2020)7

0.737

0.689

Developing countries

World

0.900

OECD countries

Level of economic development

HDI, value

Categories

Group

. Table 17.4  (continued)

638 Chapter 17 · Human Capital and Economic Development

Norway

Ireland

Switzerland

Hong Kong SAR, China

Iceland

Germany

Sweden

Australia

Netherlands

Denmark

1

2

3

4

5

6

7

8

9

10

Eritrea

Mozambique

Burkina Faso

Sierra Leone

Mali

Burundi

180

181

182

183

184

185

…

Countries and territories

2019 rank

0.433

0.434

0.452

0.452

0.456

0.459

0.940

0.944

0.944

0.945

0.947

0.949

0.949

0.955

0.955

0.957

HDI, value

0.303

0.289

0.291

0.316

0.316

–

0.883

0.878

0.867

0.882

0.869

0.894

0.824

0.889

0.885

0.899

IHDI, value

29.6

32.4

34.5

29.5

30.7

–

6.0

6.9

7.9

6.5

7.9

5.6

12.6

6.8

7.2

6.0

KI

. Table 17.5  Inequality-adjusted HDI 2019: countries and territories

28.5

36.7

39.0

32.0

29.8

21.4

3.6

3.1

3.7

2.9

3.8

2.4

2.5

3.5

3.4

3.0

LE I , %

39.5

43.9

46.9

39.2

33.8

–

2.9

5.4

2.7

3.7

2.3

2.8

9.8

1.8

3.3

2.3

EI , %

20.9

16.6

17.7

17.3

28.4

–

11.4

12.2

17.3

13.0

17.7

11.7

25.6

14.9

15.0

12.6

II , %

17.9

20.1

19.6

20.0

11.8

–

22.8

22.6

19.6

22.2

20.4

23.7

–

20.2

20.5

23.2

Poorest 40%

31.0

25.7

29.4

29.6

45.5

–

24.0

23.3

27.0

22.3

24.6

22.5

–

25.5

25.9

21.6

Richest 10%

Income shares by, %

639

(continued)

14.6

9.5

10.5

14.3

30.9

14.3

10.7

6.2

9.1

9.0

12.5

7.6

–

10.6

11.3

9.4

Richest 1%

17.4 · Inequalities in Human Capital Development

17

8

17

South Sudan

Chad

Central African Republic

Niger

186

187

188

189

0.394

0.397

0.398

0.433

HDI, value

0.284

0.232

0.248

0.276

IHDI, value

27.4

41.3

37.4

36.0

KI

30.9

40.1

40.9

36.2

LE I , %

35.0

34.5

43.0

39.6

EI , %

16.4

49.2

28.4

32.3

II , %

19.6

10.3

14.6

12.5

Poorest 40%

27.0

46.2

32.4

33.2

Richest 10%

Income shares by, %

11.4

30.9

15.6

14.1

Richest 1%

United Nations Development Programme (2020).

Note IHDI = inequality-adjusted HDI; KI = coefficient of human inequality; LE I = inequality in life expectancy; EI = inequality in education; II = inequality in income Source Authors’ development based on UNDP (2020)8

Countries and territories

2019 rank

. Table 17.5  (continued)

640 Chapter 17 · Human Capital and Economic Development

641 17.5 · Human Capital and Education

17

higher than in least developed economies (for instance, compare Germany and Niger in . Table 17.5). Even though inequality gaps are generally lower across the developed world compared to developing economies and emerging markets, the COVID-19 pandemic and related economic declines have aggravated inequality issues worldwide. Rising inequality tends to become the gravest social challenge the governments will be facing in the new normal economic reality in the years to come. 17.5  Human Capital and Education

Many studies evidence a direct relationship between GDP and other key macroeconomic parameters on one side and the level of education on the other. The higher the education rate, the wealthier the country. Education contributes to improving the quality of life of people and makes life richer by developing cognitive and social skills and informing people about their abilities, opportunities, rights, and responsibilities in society. Government expenditures on education facilitate an increase in GDP in the future. New knowledge drives new technologies and innovations (see 7 Chap. 16 for technological development). Intellectualization of material production increases the need for highly qualified labor able to ensure the maximum possible productivity and creativity. Well-educated people obtain higher skills and perform more efficiently compared to undereducated employees. They possess a more comprehensive set of tools to solve problems and overcome difficulties. They are also better suited to perform more complex jobs, which often involve higher wages and greater economic benefits. Public education is one of the most important means of developing human capital among low-income disadvantaged populations. In most countries worldwide, governments invest in establishing and supporting public schools and improving vocational education and training to help all people upbringing and advancing their human capital. Building human capital through education and training promotes investment, enhances the development and deployment of new technologies, and increases returns per worker (productivity, return on investment, longer active working age, etc.). Case box Linkages between education, inequality, human capital development, and economic growth are complex and unique to a country’s circumstances. The growing importance of education is manifested in the willingness of employers to invest in developing the human capital of their employees and training specific skills they require at certain jobs. For developed countries, the trend of increasing educational qualifications is becoming increasingly obvious, indicating that most of the GDP is formed by a more educated part of human capital. Thus, one-third of GDP in the USA is produced by educated labor (over fourteen years of schooling).

642

Chapter 17 · Human Capital and Economic Development

The world went through a great expansion in education over the past two centuries. Global literacy rates have been climbing over the course of the last two centuries, mainly through increasing rates of enrollment in primary education. Secondary and tertiary education has also seen growth, with global average years of schooling being much higher now than a hundred years ago. Despite progress in the long run, however, significant inequalities remain. The most vulnerable groups of people are representatives of low-income segments of the population, namely: 5 rural residents and residents of small towns remote from university centers; 5 low-income households, including disabled, unemployed, and unskilled workers; 5 children from families with low educational potential of their parents; 5 children of migrants; 5 children with poor health; 5 graduates of primary vocational education institutions.

17

Many least developed and developing countries still face tremendous education-related challenges. Data on literacy rates by age groups shows wide generational gaps across the developing world: younger generations are progressively better educated than older ones. This indicates an increase in the overall literacy rate. However, for some countries, the share of the population with no formal education is projected to remain high in the next few decades (. Table 17.6). UNDP metrics of quality of education demonstrate substantially higher provision of developed economies with schools and teachers compared to developing countries and least developed states (. Table 17.7). HDI index includes such parameters as the pupil-teacher ratio at the primary school level (an average number of pupils per teacher in primary education) and the percentage of primary school teachers trained to teach (a percentage of primary school teachers who have received the minimum organized teacher training required for teaching at the primary level). In countries with a very high and high level of human capital development, the education system is more oriented on individual approach to children compared to medium and low HDI economies. The pupil-teacher ratio is lowest in Europe and Central Asia and highest in Sub-Saharan Africa. Such human capital development metrics as access to the Internet and international standards of education quality assessment are reported by UNDP for individual countries and territories (. Table 17.8). Schools with access to the Internet is a percentage of schools at the primary or secondary level with access to the Internet for educational purposes. Program for International Student Assessment (PISA) score is obtained in testing of skills and knowledge of ­fifteen-year-old students in reading, mathematics, and science. 17.6  Human Capital and Health

When assessing human capital, it is difficult to separate knowledge and skills embodied in an individual from health parameters that also determine labor productivity. Public health policy is the key to the effective development of human capital.

643 17.6 · Human Capital and Health

17

. Table 17.6  Share of the population with no formal education, 1970 to 2050, selected countries Countrya

Share of the population with no formal education, %

Absolute change, percentage points

Relative change, %

1970

2050

Ethiopia

95.53

40.17

−55.36

−58

Niger

97.61

35.70

−61.91

−63

Mali

93.40

33.73

−59.67

−64

Burkina Faso

94.62

31.61

−63.01

−67

Guinea

93.25

28.51

−64.74

−69

Chad

90.28

19.97

−70.31

−78

Cote d’Ivoire

87.54

18.68

−68.86

−79

Benin

82.98

17.17

−65.82

−79

Pakistan

77.14

17.00

−60.14

−78

Mauritania

88.15

15.93

−72.22

−82

a

Note Countries are ranked in descending order of the projected share of the population with no formal education in 2050 Source Authors’ development based on Lutz et al. (2014)9 and Roser and Ortiz-Ospina (2016)10

Adequate access to health care and proper nutrition increases life expectancy and helps people become more efficient at work. As the overall life expectancy increases across the world, society benefits from longer and more productive use of experience and skill of people and higher return on investments in human capital during longer active working period (previously demonstrated in 7 Sect. 17.3). Health Capital is an investment in an individual made in order to maintain and improve health and performance. Health capital is the basis for human capital in general. Investments in health contribute to reducing diseases and mortality and prolonging active working life (consequently, the period of productive use of an individual as a factor of production). Health status is an inherent natural capital of an individual. The other part is acquired as a result of the costs of the person himself and society (see 7 Sect. 17.2 for Schultz’s, Becker’s, and modern interpretations of inherent and acquired human capital). Human capital wears out ­during a lifetime. Investing in health care can slow down depreciation. However, not all investments in public health can be recognized as investments in human capital, but only those that are socially reasonable and economically feasible (similar to investments in education).

9

Lutz et al. (2014).

10 Roser and Ortiz-Ospina (2016).

644

Chapter 17 · Human Capital and Economic Development

. Table 17.7  Quality of education, country groupings, 2010–2019 Group

Categories

Pupil-teacher ratio, primary school, pupils per teacher

Primary school teachers trained to teach, %

Human development groups

Very high human development

14

–

High human development

19

–

Medium human development

32

73

Low human development

42

78

Arab states

22

90

East Asia and the Pacific

18

–

Europe and Central Asia

17

–

Latin America and the Caribbean

21

–

South Asia

33

71

Sub-Saharan Africa

40

79

Regions

Level of economic development

World

OECD countries

15

–

Developing countries

25

–

Least developed countries

38

77

Small island developing states

19

93

24

–

Source Authors’ development based on UNDP (2020)11

17

Similar to overall human capital, health capital includes primary and acquired capital. The former is determined by the inherent physiological properties of an individual. They are primarily predetermined, although genetic engineering ­allows for certain adjustments. Acquired capital is developed by using and advancing physiological properties during a lifetime. Different jobs value acquiring different health-related properties, such as physical strength, endurance, keen sight, or quick reaction.

11 United Nations Development Programme (2020).

Norway

Ireland

Switzerland

Hong Kong SAR, China

Iceland

Germany

Sweden

Australia

Netherlands

Denmark

1

2

3

4

5

6

7

8

9

10

Eritrea

Mozambique

Burkina Faso

Sierra Leone

Mali

Burundi

180

181

182

183

184

185

…

Countries and territories

2019 rank

43

38

28

40

55

39

11

12

–

12

12

10

13

10

16

9

Pupil-teacher ratio, primary school, pupils per teacher

100

52

61

88

97

84

–

–

–

–

–

–

97

–

–

–

Primary school teachers trained to teach, %

. Table 17.8  Quality of education, countries and territories, 2010–2019

–

–

1

0

–

–

100

100

100

–

–

–

99

100

–

100

Primary schools with access to the internet, %

1

–

4

2

–

–

100

100

100

–

–

–

95

100

–

100

Secondary schools with access to the Internet, %

–

–

–

–

–

–

501

485

503

506

498

474

524

484

518

499

Reading

–

–

–

–

–

–

509

519

491

502

500

495

551

515

500

501

Mathematics

Program for International Student Assessment score

645

(continued)

–

–

–

–

–

–

493

503

503

499

503

475

517

495

496

490

Science

17.6 · Human Capital and Health

17

17

South Sudan

Chad

Central African Republic

Niger

186

187

188

189

36

83

57

47

Pupil-teacher ratio, primary school, pupils per teacher

62

–

65

44

Primary school teachers trained to teach, %

12 United Nations Development Programme (2020).

Source Authors’ development based on UNDP (2020)12

Countries and territories

2019 rank

. Table 17.8  (continued)

–

–

–

–

Primary schools with access to the internet, %

–

–

–

–

Secondary schools with access to the Internet, %

–

–

–

–

Reading

–

–

–

–

Mathematics

Program for International Student Assessment score

–

–

–

–

Science

646 Chapter 17 · Human Capital and Economic Development

647 17.6 · Human Capital and Health

17

The parameters of health rating and health potential are commonly used to estimate the health status of human capital. Health rating is a degree of approximation of the current health status to its normative value from 0 (lowest) to 1 (highest). Health potential is an individual’s ability to achieve the best possible health status with allowances made for individual psychosomatic qualities, physiological properties, lifestyle, and investment in health. Unlike the life expectancy parameter, health potential captures the quality of life. Health potential HPt = 1 corresponds to maximum health rating HRt = 1 at age t (Eq. 17.7). t

HP =

1  HRa × LE t t

LE a

×

HRt × LE a × Pt HRa

(17.7)

where HPt health potential at age t ; average health rating calculated for statistical life expectancy with consideHRa  ration of gender and age; HRt health rating at age t ; LE a average life expectance for current health potential; LE t life expectancy of an individual at age t ; P t probability of survival during LE t years of an individual at age t. The health capital cycle includes three periods: a gradual increase in health potential from birth to 25 years, relative stability of health potential value from 26 to 35 years, and a subsequent decrease in health potential. Health potential is classified as follows. 5 good health—people who have not been sick within six months (1 ≥ HR ≥ 0.50) or suffered from mild sickness for up to a week (0.50 > HR ≥ 0.45); 5 average health—people who have been sick within the past six months with mild disease (for instance, seasonal cold) for more than a week (0.45 > HR ≥ 0.40) and well-controlled patients with chronic diseases (0.40 > HR ≥ 0.35); 5 lower average health—people suffering from acute illnesses and/or exacerbations of chronic diseases for several years (0.35 > HR ≥ 0.30); 5 poor health—people suffering from acute and frequent exacerbations of chronic diseases for a long time (0.30 > HR ≥ 0.20); 5 very poor health—people suffering from long-term chronic diseases resulting in disability (0.20 > HR ≥ 0.10). UNDP uses five metrics to assess the quality of health and living conditions (. Table 17.9). Lost health expectancy is a relative difference between life expectancy and healthy life expectancy, expressed as a percentage of life expectancy at birth. The state of the public health system is assessed by the number of physicians and the

648

Chapter 17 · Human Capital and Economic Development

. Table 17.9  Quality of health and living, country groupings Group

Categories

Lost health expectancy in 2019, %

Number of physicians per 10,000 people, 2010–2018

Number of hospital beds per 10,000 people, 2010–2019

Population using safely managed drinkingwater services in 2017, %

Population using safely managed sanitation services in 2017, %

Human development groups

Very high human development

14.2

31.2

52

95

87

High human development

12.3

17.0

31

–

–

Medium human development

13.9

7.9

7

–

–

Low human development

12.8

1.9

5

–

–

Arab states

12.9

10.4

14

–

53

East Asia and the Pacific

11.9

15.8

36

–

–

Europe and Central Asia

12.5

26.9

48

79

–

Latin America and the Caribbean

13.4

22.7

18

–

–

South Asia

14.2

8.7

6

–

–

Sub-Saharan Africa

12.8

2.3

9

–

–

Regions

17

(continued)

17

649 17.6 · Human Capital and Health

. Table 17.9  (continued) Group

Categories

Lost health expectancy in 2019, %

Number of physicians per 10,000 people, 2010–2018

Number of hospital beds per 10,000 people, 2010–2019

Population using safely managed drinkingwater services in 2017, %

Population using safely managed sanitation services in 2017, %

Level of economic development

OECD countries

14.5

29.2

47

92

84

Developing countries

12.9

12.2

21

–

–

Least developed countries

12.9

2.7

7

–

–

Small island developing states

12.7

23.1

25

–

–

13.2

15.5

27

–

–

World

Source Authors’ development based on UNDP (2020)13

number of hospital beds available per 10,000 people. Population using safely managed drinking-water services is calculated as a percentage of the population using drinking water from improved sources (piped water, protected dug wells and springs, etc.) that are accessible on premises, available when needed, and free from fecal and priority chemical contamination. Population using safely managed sanitation services is a percentage of the population using improved sanitation facilities (flush/pour flush toilets connected to piped sewer systems, septic tanks or pit latrines, etc.) that are not shared with other households and where excreta are safely disposed of in situ or treated off site. In general, developed countries across Europe and North America have established more advanced and endowed public health systems compared to developing and least developed states in Asia and Africa. Among developed states, Germany and Switzerland have reached the highest density of physicians and hospital beds per 10,000 people (. Table 17.10). Substantially all people in top HDI countries enjoy adequate access to safely managed drinking water and sanitation services. In contrast, many developing and most of least developed states suffer from the backwardness of local health care systems and extreme lack of medical staff.

13 United Nations Development Programme (2020).

17

Norway

Ireland

Switzerland

Hong Kong SAR, China

Iceland

Germany

Sweden

Australia

Netherlands

Denmark

1

2

3

4

5

6

7

8

9

10

Eritrea

Mozambique

Burkina Faso

Sierra Leone

Mali

Burundi

180

181

182

183

184

185

…

Countries and territories

2019 rank

13.0

12.2

12.5

12.2

13.0

12.4

13.8

13.6

15.2

13.8

14.1

14.0

–

14.2

14.2

14.6

Lost health expectancy in 2019, %

1.0

1.3

0.3

0.8

0.8

0.6

40.1

36.1

36.8

39.8

42.5

40.8

–

43.0

33.1

29.2

Number of physicians per 10,000 people, 2010– 2018

. Table 17.10  Quality of health and living, countries and territories

8

1

–

4

7

7

26

32

38

21

80

28

–

46

30

35

Number of hospital beds per 10,000 people, 2010–2019

–

–

10

–

–

–

97

100

–

100

100

100

–

95

97

98

Population using safely managed drinking-water services in 2017, %

–

19

10

–

–

–

95

97

76

93

97

82

–

100

82

76

(continued)

Population using safely managed sanitation services in 2017, %

650 Chapter 17 · Human Capital and Economic Development

South Sudan

Chad

Central African Republic

Niger

186

187

188

189

11.9

12.7

12.5

14.3

Lost health expectancy in 2019, %

0.4

0.7

0.4

–

Number of physicians per 10,000 people, 2010– 2018

4

10

–

–

Number of hospital beds per 10,000 people, 2010–2019

–

–

–

–

Population using safely managed drinking-water services in 2017, %

10

–

–

–

Population using safely managed sanitation services in 2017, %

651

14 United Nations Development Programme (2020).

Source Authors’ development based on UNDP (2020)14

Countries and territories

2019 rank

. Table 17.10  (continued)

17.6 · Human Capital and Health

17

652

Chapter 17 · Human Capital and Economic Development

Healthcare contributes to improving the quality of life, promoting economic growth, and supporting and developing the labor potential of society. Therefore, investment in health capital is one of the key elements of economic reproduction. Four groups of stakeholders invest in developing health capital: 5 People who are vitally concerned in maintaining their health as a determinant of their wellbeing. Investments at the individual level include purchasing medicines and commercial medical services, such as diagnostics, examination, and treatment. 5 Employers that are interested in employing healthy labor as a prerequisite of high productivity and competitiveness. Investments at the corporate level include expenditures on occupational health and safety, sanitary and environmental measures, medical surveillance of employees at the workplace, and recreational programs and offerings for workers. 5 Health insurance funds that guarantee medical care under various insurance programs. Variants of voluntary medical insurance include diagnosis of illness, injuries at the workplace, loss of income due to illness, payments during staying in hospital, and surgical and other treatment-related expenses. 5 Public expenditures on medical care and improving the health status of people. Health promotion policies combine different but complementary approaches, including legislation, fiscal measures, and organizational and structural reforming and adjusting the public health system.

17

In the new normal economic reality, health protection cannot be separated from other human capital development goals. In this chapter, we do not specifically address contemporary health-related concerns of the COVID-19 pandemic (see 7 Chap. 18 for the discussion of the post-pandemic economic development and 7 Chaps. 21–23 for the new normal trends in the cross-border of people, goods, and information). Still, the pandemic shock has demonstrated that inextricable links between people and the environment we live in determine the character of economic development. Therefore, establishing a comprehensive and sustainable approach to developing economic, social, and ecological dimensions of the public health systems is vitally important. The main guiding principle is the need to stimulate mutual support in turbulent times, i.e., take care of each other, our society, and the environment. The new role of the health sector should change towards health promotion, thus going beyond mere medical care and assistance. Public health services need to have greater powers that fully consider and respect people’s social and cultural needs. These powers should be aimed at meeting the needs of individuals and society in a healthy life and closer interaction between the health sector and diverse social, political, and economic elements of the new normal reality. Chapter Questions: 5 Give a definition of human capital. Do you consider human capital a factor of production? How would you distinguish human capital from labor? 5 Characterize human capital elements at different levels.

653 References

17

5 Differentiate social and economic factors of human capital development from social and demographic factors, social and mental factors, and production factors. 5 Summarize the neoclassical vision of human capital and its role in economic development. 5 Are there similarities and differences in Schmitz’s and Becker’s approaches to interpreting human capital? 5 What is the marginal product of human capital? How does it relate to employees’ wages and returns on investment in human capital? 5 Explain an interaction between expenditures and returns on investment in human capital development for educated and undereducated employees. 5 Human capital development drives social and economic inequalities worldwide. Do you agree with this statement? Debate and consider pros and cons. 5 How should education and health care policies transform to comply with contemporary challenges of the new normal economic reality? Subject Vocabulary: Expected Years of Schooling: a number of years of schooling that a child of school entrance age can expect to receive if prevailing patterns of age-specific enrolment rates persist throughout the child’s life. Health Capital: an investment in an individual made in order to maintain and improve health and performance. Health Potential: an individual’s ability to achieve the best possible health status with allowances made for individual psychosomatic qualities, physiological properties, lifestyle, and investment in health. Human Capital: a set of knowledge, skills, competencies, and abilities used to meet the diverse needs of an individual and society as a whole while making a profit and ensuring economic reproduction. Human Development Index: a combined indicator of human development built on four human capital metrics, such as life expectancy at birth, expected years of schooling, average years of schooling, and GNI per capita. Inequality-Adjusted Human Development Index: a human development index value adjusted for inequalities in three dimensions of human development, such as decent standard of living, a long and healthy life, and access to knowledge. Investments in Human Capital: investments in education, training and developing individual skills and competencies, and maintaining health. Life Expectancy at Birth: a number of years a newborn infant could expect to live if prevailing patterns of age-specific mortality rates at the time of birth stay the same throughout the infant’s life.

References Becker, G. S. (1962). Investment in human capital: A theoretical analysis. Journal of Political Economy, 70, 9–49. Becker, G. (1964). Human capital: A theoretical and empirical analysis, with special reference to education. Columbia University Press.

654

Chapter 17 · Human Capital and Economic Development

Lutz, W., Butz, W., & Samir, K. (2014). World population and human capital in the twenty-first century. Oxford University Press. Roser, M., & Ortiz-Ospina, E. (2016). Global education. 7 https://ourworldindata.org/global-education#citation Schultz, T. (1961). Investment in human capital. The American Economic Review, 51(1), 1–17. United Nations Development Programme. (2019). Human development report 2019. Beyond Income, Beyond Averages, Beyond Today: Inequalities in Human Development in the 21st Century. UNDP. United Nations Development Programme. (2020). Human development report 2020. The Next Frontier: Human Development and the Anthropocene. UNDP.

17

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18

Post-pandemic Sustainable Development: The Farer-Reaching Perspective

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_18

656

Chapter 18 · Post-pandemic Sustainable Development: The Farer-Reaching Perspective

Learning Objectives: 5 Explore the sustainable development concepts, premises, and pillars 5 Reveal features and metrics of sustainable economic development 5 Distinguish between the green economy and the blue economy 5 Discuss the economy-environment relationship 5 Summarize major ecological footprints of economic development 5 Review the Sustainable Development Goals 5 Outline the new normal challenges to sustainable development 18.1  Sustainable Development Concepts

18

Economic development aimed exclusively at maximizing profits and minimizing costs has hit the environment and society hard. Ecological decay, climate change, and social and gender inequality are only some manifestations of systemic crises that we all have faced since the late XX century. These global challenges have forced both scientists and governments worldwide to reconsider the essence of economic development and acknowledge the precedence of sustainable development over stable economic growth and preventing market failures and disequilibriums. First interpretations of the idea of limited natural resources and the need to restrain the uncontrolled growth of consumption are addressed above in 7 Chap. 15 (see 7 Sect.  15.2.3 for Malthus’s constant productivity constraints). In the late XVIII century, Thomas Malthus hypothesized that the exponential growth of populations did not match the increase in available natural resources and food. Over time, the gap widened and manifested itself in various forms of economic and social tensions and environmental disasters. However, it took more than 170 years since the publication of Malthus’s first works before his ideas about the discrepancy between economic growth rates and resource endowment came into the international agenda. In 1972, The Club of Rome released its first report on mathematical modeling of the exhaustion of natural resources due to population growth (further reading: “The Limits to Growth”1). The model contained twelve scenarios, five of which described a catastrophic decline in the population to 1–3 billion people due to excessive consumption growth. Seven more favorable scenarios were based on improving humankind’s environmental, demographic, and social awareness. Also in 1972, the establishment of the United Nations Environment Programme (UNEP) initiated a discussion of environmental issues at the global level. Due to the extreme complexity of problems (the interconnection of many environmental, economic, social, technological, and political factors), a unified approach to the definition of sustainable development has not been elaborated. The term “sustainable development” first appeared in international reports in

1

Meadows et al. (1972).

657 18.1 · Sustainable Development Concepts

18

the mid-1980s. It is believed that for the first time, sustainability as an approach to economic development was defined in 1987 by the World Commission on Environment and Development (WCED) in its Report of the World Commission on Environment and Development: Our Common Future2 (the so-called Brundtland Report). According to WCED, new global environmental challenges have emerged and worsened as a result of the exceptionally large gap between poverty and underdevelopment in the Global South (developing and least developed countries in Asia, Africa, and Latin America) and unsustainable overconsumption and overproduction in the Global North (developed economies of Europe, North America, Japan, and Australia). WCED advocated the need for a single global development strategy to narrow the gaps between the developed and developing poles in order to minimize adverse environmental consequences of unbalanced economic growth. The report emphasized the general dependence of all humankind on the state of the environment, i.e., the dependence of developed countries on the environmental status of developing parts of the planet and vice versa. Ecological problems have no national boundaries. That is why their consequences must be considered by the entire international community. Accordingly, all countries must jointly elaborate on responses to common threats such as transboundary air and water pollution, climate change, and unbalanced use of natural resources. Sustainable Development is a set of measures aimed at meeting the current needs of the present generation while preserving the environment and natural resources to ensure the ability of future generations to meet their own needs. Sustainable development aims at satisfying human needs and aspirations. It requires meeting the vital needs of all people and enabling all to meet their aspirations for a better life. Case box A fundamental characteristic of sustainable development is merging the concepts of needs and constraints. Needs are not any desires of society. As demonstrated above in 7 Chap. 14 (7 Sect.  14.5) and 7 Chap. 17 (7 Sect.  17.4), the world community is becoming increasingly divided due to economic and social inequalities between and within countries. That aggravates inequality in opportunities rather than just incomes. Therefore, the level of needs of people in different countries and within countries varies significantly. In such a new normal economic reality, needs are interpreted as priority needs to sustain and improve the poorest communities’ wellbeing to eliminate global inequalities. Constraints emerge due to the gaps in technological development (see 7 Chap. 16) and human capital development (see 7 Chap. 17). Constraints are superimposed on the ability of the environment to serve the present and future needs of humankind.

2

World Commission on Environment and Development (1987).

658

Chapter 18 · Post-pandemic Sustainable Development: The Farer-Reaching Perspective

. Table 18.1  Sustainable development pillars Pillars

Content

Criteria

Economic sustainability

Market allocation of resources, sustained levels of growth and consumption, an assumption that natural resources are unlimited

Growth, development, productivity

Environmental sustainability

It requires natural capital to be maintained as a source of economic inputs

Ecosystem integrity, carrying capacity, biodiversity

Social sustainability

It encompasses the ideas of equity, empowerment, accessibility, participation, sharing, cultural identity, and institutional stability

Equity, participation, empowerment, cultural identity

Source Authors’ development

The sustainable development concept rests on five premises: 5 Humanity is capable of making development sustainable and long-term, so that it meets the needs of the people living today, without depriving future generations of the opportunity to meet their needs. 5 The existing restrictions on the exploitation of natural resources are relative. They are related to the current state of technology and social organization, as well as the ability of the biosphere to cope with the consequences of human activity. 5 It is necessary to meet the basic needs of all people and allow everyone to make their dreams come true for a better life. Without this, sustainable and long-term development is impossible. One of the leading causes of environmental and other disasters is poverty, a common phenomenon in today’s world. 5 It is necessary to align the lifestyle of those who have considerable resources (monetary and material) with the ecological capabilities of the planet, in particular with regard to energy consumption. 5 The size and rate of population growth must be consistent with the changing productive potential of the global ecosystem.

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According to the United Nations Division for Sustainable Development3, the sustainable development agenda captures agriculture, biodiversity, biotechnology, climate change, demographics, disaster reduction and management, energy, health, land management, oceans and seas, poverty, trade and environment, transport, and waste, among others. All these areas could be grouped into three sustainable development pillars (. Table 18.1). 3

United Nations Division for Sustainable Development (2005).

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From an economic point of view, the sustainable development concept is based on determining the level of income that allows an economic entity to consume the amount of goods necessary today and not become poorer after a certain period of time. Therefore, the sustainable development concept postulates the principle of economically optimal use of limited natural resources. In other words, the income received today cannot be considered income if the same income cannot be received tomorrow due to the depletion of the resource of this income. Currently, different approaches to assessing the value of natural resources are employed. However, interpretation collisions may arise in addressing productive, natural, and human capital interchangeably and appraising natural resources. The economic approach is central to understanding sustainable development, but the latter has transformed the very concept of economic efficiency. Longer-term and more expensive economic projects that consider environmental footprints ultimately appear to be more cost-effective than a shorter-term investment that ignores environmental consequences. Economic aspects of sustainable development are further discussed in 7 Sect.  18.2. From an environmental point of view, sustainable development should ensure the stability of biological and physical systems. The viability of local ecosystems is particularly essential, since they affect the overall stability of the entire biosphere. Natural systems and habitats can also include man-made environments, such as cities or agricultural lands. Sustainable development focuses on preserving the ability of such systems to change, rather than keeping them in a “well-to-do” static condition. Environmental degradation, depletion of natural resources, pollution, and biodiversity loss reduce the ability of ecological systems to regenerate (see 7 Sect.  18.4 for environmental footprints). Sustainable development does not mean constraining economic development. Downshifting, return to nature, biological and cultural diversity, simple production practices, rejection of scientific and technological progress—all these actions could undoubtedly improve the quality of the environment, but at the same time reduce the living standards of society. This type of development (rather, economic and technological regression) is unacceptable. At the same time, living standards substantially differ across countries. It is hardly possible to ensure equally high living standards for all without damaging the environment. Therefore, sustainable development does not exclusively aim at preserving the biosphere. It aims at ensuring the survival of people as a biological species. At the same time, more and more people realize that the progressing degradation of natural habitats threatens the very existence of humankind. Nobody exactly knows where the no return point is (further discussed in 7 Sect.  18.3). In the new normal economic reality, the importance of the social dimension of sustainability increases considerably. The sustainable development concept is inherently socially oriented. It aims at preserving social stability by reducing the number of destructive conflicts and inequality gaps. Sustainable development is impossible without equitable distribution of resources and opportunities among all people. An adequate standard of living is an inalienable right of any individual. Conversely, overconsumption and waste of resources are not only reprehensible, but also harmful to establishing overall sustainable development.

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Reverting to the discussion of the development-growth relationship (see 7 Chap. 15, 7 Sect.  15.1.1), we must stress that the key parameter of sustainability is not just economic growth rate, but an increasingly equal distribution of income (resources, factors of production, other values) due to economic and social development. Material abundance brings with it problems to the same, if not greater, extent as poverty does. The development of the social component of the sustainable development concept has become the fundamental idea of respecting the rights of future generations. Superabundance is no less detrimental to sustainable development than poverty. The sustainability concept rests on the fundamental idea of respecting the rights of future generations. The planet’s natural resources are the common heritage of humankind, including present and future generations. Establishing sustainable development requires this permanent asset to be passed down through the generations as less polluted and damaged as possible. All three elements of the sustainable development model must be considered in a balanced manner. The interaction of economic and social elements facilitates achieving equity (for example, in terms of the income distribution) and targeting assistance to the poor. The interaction of economic and environmental elements leads to the need to evaluate and internalize environmental costs (internalization of externalities is addressed above in 7 Chap. 10, 7 Sect.  10.4.1) and cover pollution costs. The link between social and environmental elements calls for ensuring the rights of future generations to an adequate natural environment and participating of all people in its preservation. The Sustainable Development Model is a type of the civilization development model based on the synchronous ensurance of economic efficiency and economic security, social justice and social security, and environmental security and co-evolutionary development. 18.2  Sustainable Economic Development 18.2.1  Understanding and Measuring Sustainable Economic

Development

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As stated in the section above, sustainable development does not slow down economic growth by containing the employment of factors of production, but rationalizes the use of inputs. However, with increasing competition in all markets worldwide, the rationalization task becomes more challenging. The spread of information and digital technologies has dematerialized many conventional spheres of economic activity. In this new reality, sustainable economic development is primarily constrained by the lack of material resources and asymmetries of information and knowledge (see 7 Chap. 10, Sect.  10.3 for the idea of asymmetrical information). Sustainable Economic Development is a type of economic development that provides balanced forward-oriented solutions to present economic and social problems and ensures the preservation of the country’s environmental and natu-

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ral resource potential in order to meet the vital needs of present and future generations. Sustainable economic development is based on the following four criteria: 5 For renewable natural resources (land, forest, etc.), their quantity or ability to produce biomass (land productivity, for example) must at least stay stable over time (the simple reproduction regime, no decline in volume or productivity). 5 For non-renewable natural resources (mineral deposits, fossil fuels, etc.), the depletion of their reserves must be slowed down as much as possible. Over time, they must be replaced with renewables. Resource-abundant countries dependent on non-renewables (for example, oil and gas exporters) are to reinvest profit gained from exploiting natural resources to ensure progress in the renewables-related sectors. 5 Waste must be minimized by the introduction of low-waste and resource-saving technologies. 5 Environmental pollution in the future must not exceed its current level. Pollution must be reduced to an adequate level accepted by both society and the economy. When adjusting the sustainable development approach to specific local conditions, these criteria should be considered. Effective sustainable development metrics include a decrease in the environmental intensity of the economy and a decline in the share of products and investments in resource-exploiting spheres of economic activity. Nevertheless, measuring sustainable economic development is a challenging task. In general, sustainability is intangible, but some parameters can be quantified. A number of the metrics could fall into more than one category (. Table 18.2). In adapting them, policy-makers may use those applicable to local conditions and organize them to best reflect their community’s priorities and needs. Since any type of economic activity affects nature, people, and markets, there arise externalities, i.e., external consequences of economic actors’ activities that positively or negatively influence other parties (see 7 Chap. 10, 7 Sect.  10.4 for the concept of externalities). As previously demonstrated in 7 Chap. 10, externalities can be either negative or positive. In terms of economic impacts on the environment, the overwhelming number of externalities are negative, such as pollution, waste, land degradation, biodiversity loss, etc. Thus, externalities can be interpreted as detrimental environmental and economic consequences of economic activity not taken into account by economic actors. Externalities do not directly affect the economic performance of polluters themselves. Polluters are primarily interested in minimizing their costs. They ignore externalities as problems that incur additional costs. In a broad context, the following five types of external effects can be distinguished (depending on the type of influences, time, sector, or region): 5 Temporal (intergenerational) externalities. This type of externality is closely related to the sustainable development concept. The present generation should meet its own needs without compromising the living standards of future generations. Detonating degradation of ecosystems, exhausting non-renewable resources, and polluting the environment today, the present generation initiates severe environmental, economic, and social problems for descendants, reducing their ability to meet their own needs.

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. Table 18.2  Sustainable economic development metrics Metrics

Parameters

Local economic growth

Unemployment rate; labor force participation rate; domestic product growth; tax revenue; targeted industry development; sector diversity

Development of small business

Net new business establishment; firm age; farmers market; local and sustainable procurement; community banks; small business loans/ technical assistance

Greening real estate and the built environment

Green certification; renewable energy; land use mix; brownfield remediation; historic preservation; blight elimination; commercial vacancy and absorption rates; employers per acre; sprawl; walk score

Sustainable workforce

Population; educational attainment; qualified workers for target sectors; workforce training programs; laborshed

Equitable growth

Poverty; median household income; proximity of jobs to low-income neighborhoods; living wages; housing and transportation affordability; food security; broadband Internet access; benefit corporations

Transportation

Public transit readership; transit access; commuting time; vehicle miles traveled; commuting patterns

Quality of life

Cost of living; air quality; water quality, quantity, and price; access to parks and green spaces

Green economy

Green jobs; cleantech; recycling; green business patents; green business venture capital

Source Authors’ development

Case box

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In the near future, the depletion of oil reserves along with the degradation of agricultural land may aggravate energy supply and food security problems. Their solution will require a sharp increase in costs to meet the vital needs of people throughout the world. These are negative temporary externalities. Positive temporary externalities are also possible. Technological breakthroughs, scientific discoveries, and innovations aim at reducing environmental costs and increasing productivity in the future. For example, cheaper energy generation technologies (solar, wind, other renewables) may bring substantial economic and environmental benefits in the future.

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5 Global (inter-country) externalities. This type of externalities has already manifested itself in transboundary air and water pollution. Emissions of harmful substances into the atmosphere, pollution of rivers and seas, and other environmental impacts in one country create significant environmental and economic problems in other countries. International conventions, agreements, and bilateral treaties aim at reducing global externalities by combating transboundary pollution. 5 Intersectoral externalities. The growth of particular sectors, especially resource-extensive industries, causes significant environmental damage to other spheres of the economy. Positive cross-sectoral externalities also exist when technological progress in one sector initiates restructuring and reforms in other sectors. 5 Interregional externalities (transboundary environmental effects that occur between territories within a country). 5 Local externalities (environmental effects caused by individual enterprises that influence local communities). Arthur Pigou was one of the first to study individual and social costs associated with externalities (further reading: “The Economics of Welfare”4). According to Pigou, environmental pollution increases external costs. Any entrepreneur obviously aims to minimize individual costs to increase profits. One of the ways to do so is to save on environmental costs. Neither pollution nor waste costs are taken into account as production costs. Therefore, society is forced to allocate public funds to eliminate the environmental damage produced by an individual firm. Thus, the total social and production costs include the firm’s individual costs and the society’s external costs estimated in value form. Estimating external costs is one of the most challenging economic tasks. It is closely related to environmental impact assessment. The existence of externalities raises the question of the real social cost of goods produced by high-polluting industries. The undercounting of external costs’ portion in price along with market inefficiencies undercuts prices by the amount of actual social costs. Market failures (previously discussed in 7 Chap. 10, 7 Sect.  10.1), underestimation or free use of natural resources and services (check 7 Chap. 10, 7 Sect.  10.5 for the free-rider problem), and the complexity of economic assessment of environmental damage challenge adequate estimation of external costs under certain economic conditions. In most countries, environmental regulations force or incentivize polluters to pay environmental costs and include them in the price of their products. Therefore, the “polluter pays” principle is one of the premises of environmental economics. Such turning of external environmental costs into individual internal costs is called the Internalization of Expenditures (see 7 Chap. 10, 7 Sect.  10.4.1 for the internalization of externalities). One of the approaches to considering the

4

Pigou (1920).

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public interest is imposing a special tax on polluters in the amount equivalent to external costs. A Pigouvian Tax is an output tax that raises individual costs of businesses engaged in creating negative externalities to the maximum permissible level of social costs. The internalization of external costs is the principal task of direct and indirect economic regulation in the sphere of environmental protection. 18.2.2  Green Economy

Negative externalities can be reduced by greening the production and economic activities, i.e., the transitioning from a conventional resource-extensive economy to the green economy. Due to diverging interests of individual countries, lack of competencies in the new sphere, and inequality in allocation of natural resources and other factors of production, no single definition of the green economy concept has been elaborated (as well as the methodology, principles, and methods). Moreover, other related terms (green growth, environmentally oriented growth, low-carbon development, environmental economics) are interchangeably used as synonyms for the green economy. Nevertheless, major international organizations have reached a kind of consensus in understanding the green economy as a welfare-oriented economy focused on preserving natural ecosystems. Green Economy is an economy inseparably linked with the environment that aims at preserving the wellbeing of society through the efficient use of natural resources and the return of end-use products to the production cycle. The green economy theory rests on the following three premises: 5 impossibility of infinite expansion of economic activities (production, market power, etc.) in a limited space; 5 inability to meet ever-increasing demands in resource-limited environments; 5 all processes and activities are interconnected.

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The green economy aims at improving the wellbeing of society while reducing the burden on the ecosystem. The search for a balance between social policy, economy, and ecology is carried out on the basis of four principles: 5 The principle of sustainability. Society must recognize that natural resources are limited. Therefore, they need to be saved, used effectively, and recycled. The economy should stay within the environmental framework and promote development simultaneously. All should share the sustainability-oriented vision by saving water and electricity, reducing waste, separating garbage, consuming adequately, and reusing things. 5 The principle of justice and dignity. Nature should be protected across the world irrespective of a particular country’s level of economic development. People should join efforts to preserve the quality of the environment for future generations. Anyone must have access to a clean environment, water, and energy. 5 The principle of control and flexibility. The transparent global economy implies the shared responsibility of all countries for the pollution they produce

665 18.2 · Sustainable Economic Development

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and environmental protection measures they implement. Emission mitigation efforts may be adjusted to national economic, social, and cultural specifics, but still comply with common environmental standards. 5 The healthy planet principle. People (governments, businesses) should invest in nature, restore it, and protect and restore degraded areas. The protection of ecosystems and biodiversity is a priority of social and economic development. The contemporary green economy is developing in several directions: 5 Promotion of renewable energy sources. More than half of all fossil fuels must remain unexplored to ensure sustainable green development and mitigate climate change. Decarbonization through the use of renewables is the future of the energy sector. 5 Improvement of the waste management system. Developed countries generate up to 3 kg of solid waste per capita per day. Advanced waste treatment and waste reduction practices must be implemented. 5 Improvement of the water resources management system. Every sixth person on the planet suffers a shortage of fresh drinking water. 5 Development of green transport (electric vehicles, scooters, bicycles, etc.). Switching to carbon–neutral transport reduces the amount of harmful emissions, while switching from cars to bicycles improves the environment and eases traffic in cities. 5 Organic farming involves the reduction or complete elimination of herbicides, pesticides, and inorganic fertilizers. Organic products do not contain genetically modified organisms. They are preservative-free products stored and distributed separately from chemical and other unnatural substances. 5 Energy efficiency in housing and communal services. Low-performing heat-insulating materials and inefficient heat supply systems entail significant heat losses, i.e., they waste natural resources and increase emissions per unit of input. 5 Conservation and effective management of ecosystems. Most of the economic activities disturb ecosystems and may give rise to environmental degradation, biodiversity loss, and other harmful consequences. Case box European countries, the USA, and China champion the green economy agenda. Green sources generate over 40% of electric power in Germany (primarily wind energy). By the 2040s, Germany expects to abandon coal imports completely. More than 55% of electricity consumption in Switzerland is covered by hydropower. By 2050, the country plans to reduce the consumption of natural resources to the renewability threshold and radically reduce the ecological footprint. In Sweden, 50% of all waste is burned to produce bioenergy. To increase power generation, Sweden imports about 1.5 million tons of waste from neighboring countries. The country aims to phase out oil, coal, gas, and nuclear power. The USA launched the Green New Deal program in the 2000s. The country plans to switch to electric vehicles by the 2030s and completely abandon

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. Table 18.3  OECD’s indicators of green growth Areas

Indicators

Environmental and resource productivity

Output generated per unit of CO2 emitted or total primary energy supplied; output generated per unit of natural resources or materials used; multifactor productivity adjusted for the use of natural resources and environmental services

Natural asset base

Availability and quality of renewable natural resource stocks; availability and accessibility of non-renewable natural resource stocks; biological diversity and ecosystems

Environmental dimension of quality of life

Human exposure to pollution and environmental risks, public access to environmental services and amenities

Economic opportunities and policy responses

Technology and innovation that are important drivers of green growth; investment and financing that facilitate the uptake and dissemination of technology and knowledge; production of environmental goods and services that reflect economic opportunities that arise in a greener economy; prices, taxes, and transfers that provide signals to producers and consumers

Source OECD (2022)5

hydrocarbons in the 2050s. In China, more than 20% of electricity comes from renewable sources. Public investment in the renewable sector substantially exceeds that in the USA and the EU. China is the world’s largest supplier of solar panels and wind turbines (40% and 20% of the global market, respectively).

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The green economy concept supports resources conservation and reduces negative externalities. The growth of the living standards coexists with the growth of natural capital. This process is called Green Growth—a growth that stimulates economic development, while ensuring the preservation of natural assets and sustainable use of resources and ecosystem services. According to OECD, progress towards green growth is centered on the economy’s production and consumption. It describes the interactions between the economy, the natural asset base, and policy actions. The measurement framework identifies 26 indicators to capture the main features of green growth and monitor progress in four main areas (. Table 18.3).

5

Organization for Economic Cooperation and Development (2022).

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Global Green Growth Institute (GGGI) provides an alternative measurement of green growth, which is based on more than 35 indicators that represent several sectors, including energy, transport, cities, industry, water and land use, as well as green growth dimensions, including resource efficiency, optimal use of natural resources, socioeconomic resilience, green economic opportunities and social inclusion (. Table 18.4). Proponents of the green economy concept believe that the failures of the current economic system result in both economic and environmental crises. The economy wastes available resources. Although the overall standard of living in the world as a whole has increased significantly in recent decades, the negative consequences of unsustainable exploitation of resources are significant: environmental problems, depletion of all kinds of natural resources, lack of fresh water, food, and energy, and poverty and income inequality. All these problems pose severe threats to future generations. Today, the total economic consumption of resources exceeds the physical capabilities of the Earth by almost 20%. Tracing the change in the dependence of the ecological footprint on GDP per capita in different countries demonstrates a positive linear correlation between the two parameters—the higher the GDP, the greater ecological footprint the country generates (further discussed in 7 Sect.  18.4). 18.2.3  Blue Economy

In recent years, a narrower blue economy concept has emerged from the umbrella idea of the green economy. Blue Economy is a set of economic sectors and related activities that ensure sustainable use of all kinds of water resources and contribute to economic growth and social development, while improving the environmental sustainability of oceans, seas, inland waterways and resources, and coastal areas. The range of services and benefits produced by marine and coastal ecosystems is wide. They include habitats of marine organisms, resources for aquaculture, protection of coastal areas and offshore facilities from weather events, tourism and recreation, and water-associated living and non-living resources for global supply chains and local industries. Unsustainable use of one habitat inevitably leads to the loss of other services and valuable resources. Understanding and tracking the interlinkages between ecosystems, economic activity, anthropogenic impacts, and climate change are critical to ensuring the sustainable use of coastal and marine resources. The blue economy concept supposes a transition from the traditional sectoral management approach to the ecosystem approach relying on integrated coastal zone management, marine spatial planning, and the establishment of protected marine areas. Case box The role of oceans and seas in economic development cannot be overestimated. Over three billion people live off the ocean resources (mainly in developing countries). Oceans and seas feed about 10–12% of the world’s population. More than

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. Table 18.4  GGGI’s measurement framework of green growth Sectors

Indicators

Definition

Efficient and sustainable resource use

Efficient and sustainable energy

Delivering more services or products per unit of energy used

Efficient and sustainable water use

Delivering more services or products per unit of water used

Sustainable land use

Delivering more services or products for a fixed amount of land used

Materials efficiency

Delivering more services or products per unit of raw material used

Environmental quality

Properties and characteristics of the environment which may affect the health of human beings and other organisms

Greenhouse gas (GHG) emission reduction

Reduction and removal of CO2 and non-CO2 emissions from the air

Biodiversity and ecosystem protection

Protection of species, habitats, and ecosystems

Cultural and social value

Societal value given to natural capital

Green investment

Public and private investment that promotes sustainable resource use

Green trade

Competitiveness to produce and export environmental goods

Green employment

Employment created and sustained by economic activities that are more environmentally sustainable

Green innovation

Product, process, and service innovations

Access to basic services

General availability of services

Gender balance

Equality based on gender in terms of rights, resources, and opportunities

Social equity

Fair and equitable public and social policy

Social protection

Programs designed to provide benefits to ensure income security and access to social services

Natural capital protection

Green economic opportunities

Social inclusion

18 Source GGGI (2022)6

6

Global Green Growth Institute (2022).

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half of the world’s population lives either in coastal areas or less than 100 km from a coast. 90% of the total trade in goods is carried out by sea. About a third of the world’s total oil and gas is produced on a shelf. The value added created by maritime sectors exceeds $2 trillion ($3 trillion by 2030).

The blue economy includes sectors related to oceans, seas, and coastal areas regardless of whether they are located offshore (shipping, aquaculture, energy production) or onshore (ports, shipyards, algae production). The World Bank distinguishes five types of blue economic activity: 5 catching and trade in living marine resources (catching seafood and fish, using marine living resources for the production of pharmaceuticals, fertilizers, and chemical additives); 5 extraction and use of non-living non-renewable marine resources (extraction of minerals, energy resources, production of fresh water); 5 use of inexhaustible renewable resources (renewable energy on the continental shelf—solar, wind, waves, tidal); 5 maritime commerce and trade (shipping, coastal tourism and recreation, development of coastal zones and communities); 5 activities that contribute to environmental protection (carbon sequestration, coastal area protection, waste management in water areas and coastal territories). The OECD uses a more complex classification of eleven primary blue economy sectors and six emerging industries. Primary sectors include traditional maritime industries such as fishing, seafood processing, shipping, port infrastructure, shipbuilding and ship repair, offshore gas and oil production, marine engineering and construction, marine and coastal tourism, maritime business services, marine research and education, and dredging. Emerging industries include offshore wind power, ocean renewable energy, marine biotechnology, high-tech marine products and services, deep-sea drilling and mining, and marine aquaculture. New technologies in emerging blue economy sectors are expected to turn into a big profit by the 2030s. The World Bank suggests that 10% of the world’s food could come from seaweed. Sea water is a virtually unlimited source of lithium (about 230 billion tons). Antiviral drugs derived from marine organisms are already being tested. Innovative blue economy companies are working to reduce the cost of ocean energy solutions. The development of floating offshore wind farms substantially increases added value in the renewable energy sector ($230 billion by 2030). Floating solar power plants can cover up to 40% of the world’s energy needs. Such farms are installed mainly in freshwater inland reservoirs, but marine solar power technologies are also advancing. Onshore aquaculture reduces pollution of the seas and oceans and allows reducing fishing. The blue economy concept offers many solutions to develop the ocean economy and reduce costs while decreasing the burden on ecosystems: innovations and blue technologies, new types of eco-friendly services, goods, and food products, and more efficient and sustainable use of marine resources in traditional sectors.

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18.3  Economics and Environment

Central to understanding sustainable development is assessing the long-term environmental impact of today’s economic decisions. As discussed above, sustainable development involves minimizing negative environmental consequences and externalities for future generations. Therefore, the environmental constraints problem and the compromise between present and future consumption are the two cornerstones of the sustainable economic and social development of any country. Environmental economics studies the economic uses of natural systems (atmosphere, land, forests, rivers) and the biosphere as a whole. Ecological approaches are applied to contemporary processes of industrialization and urbanization to find solutions to such problems as climate change, resource depletion, and various kinds of inequalities. Industrial and urban ecology aims to establish smart and resource-saving artificial habitats in interaction with the environment and achieve the ecological balance between and within these systems. Applied ecology studies specific issues of rational environmental management, determines permissible loads on the environment, and develops methods for managing natural systems and ways of ecological modernization of various human activities. In general, all spheres of the environmental economics focus on achieving the following goals: 5 reduction of all types of emissions; 5 recycling and reuse of materials and resources; 5 improving the quality of air in cities, industrial sites, and buildings; 5 reduction of energy consumption by improving energy technologies; 5 improving the efficiency of water consumption; 5 integrated spatial development and efficient allocation and use of resources; 5 rational consumption; 5 restoration of the natural balance of flora and fauna.

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Ecological balance indicators include clean air, clean water, clean cities, natural state of the climate, soil, and forests, organic matter in the mass consumption of food, goods, and services. All these parameters establish the Natural Capital—a natural resources pool, including minerals, water, land, air, flora and fauna, and all living matter and ecosystems. Nature is a holistic system that interconnects all elements by the flow of matter and energy. This system is capable of self-healing, self-regulation, and adaptation. These abilities also establish natural capital. People consume minerals, coal, oil, wood, harvests, animals, and other living organisms, thus transforming natural capital into economic assets (industrial production, residential and infrastructure construction, transport, goods and services, etc.). Natural systems are destroyed and polluted. If the damage exceeds the ability of ecosystems to recover, people overspend natural capital. In other words, the present generation borrows capital from nature against future generations who will also need a certain amount of natural capital to support their living in the future. The increased intensity and scale of economic activities today disturb the ecological balance and stack up significant environmental debt to be paid by future generations.

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The most adverse environmental impact is caused by extractive industries (direct disturbance of landscapes), chemical and energy industries (air pollution through the combustion of fossil fuels and emission of harmful substances), pulp and paper production (deforestation), agriculture (degradation of soils and land and water pollution through implementing mineral fertilizers), and transport (air pollution). Generally, economic growth manifested in the increase in GDP is associated with the increased consumption of non-renewable resources and, consequently, more harmful environmental impact. 7 Section 18.2.2 suggested that more industrialized countries produce more remarkable ecological footprints. Indeed, the degree of the anthropogenic impact on the environment largely depends on the economy’s production capacity (see 7 Chap. 16, 7 Sect.  16.3 for the idea of the production possibility frontier). However, it also depends on the allocation of resources that contribute to establishing the country’s GDP. The government may set certain development trajectories by choosing between various combinations of non-renewable resources and consumer goods in the economy. An increase in consumption from YB to YA (. Fig. 18.1) increases employment of resources and reduced natural capital from XB to XA (all other things being equal). For example, the pace of global economic growth in the past decades has led to a decline in the availability of natural resources such as forests, as well as to a decline in sources of fossil fuels and various natural resources, loss of biodiversity, etc. Negative impacts of economic growth on the environment commonly include: 5 Pollution. Increased consumption of fossil fuels directly degrades air quality by emitting more soot and other harmful substances. The effects of increased CO2 emissions are less immediately visible. Nevertheless, it is recognized that CO2 accumulation contributes to the greenhouse effect, climate change, and more volatile weather. Therefore, economic growth increases long-term environmental costs (assuming that the economy operates at its production possibility frontier and no change in technology occurs—. Fig. 18.1).

. Fig. 18.1  The trade-off between economic growth and environmental resources. Source Authors’ development

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5 Climate change manifests itself in rising sea levels, more volatile weather, extreme heat, droughts, hurricanes, and snowfalls that all cause substantial economic costs. 5 Damage to nature. Increased pollution causes health problems and can damage the productivity of land and seas. 5 Soil erosion. Deforestation resulting from economic development damages soil and makes lands more prone to droughts. 5 Biodiversity loss. As demonstrated in . Fig. 18.1, economic growth at the production possibility frontier level causes extensive use of resources, including biodiversity loss. 5 Long-term toxins. Economic growth creates long-term waste and toxins, which may have unknown consequences (for example, increased use of plastic). Various indicators can measure the impact of economic growth on the environment: 5 level of pollution of natural components (atmosphere, water, and land resources); 5 total amount of harmful substances generated be various types of economic activity; 5 quantitative and qualitative composition of harmful emissions; 5 timely and correct reporting of harmful emissions by enterprises; 5 capital investment to environmental protection projects and activities; 5 elements of the environment that are most affected by the negative impact of anthropogenic activities; 5 interconnection and interdependence between the elements of the environment; 5 anthropogenic influence on changes in the quality of the environment and classification of its elements; 5 critical and conflict situations (the degree of degradation of natural components); 5 damage caused by environmental pollution.

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There are many theories of economic growth and the environment. The one is that up to a certain point, economic growth negatively affects the environment due to extensive exploitation of natural resources. Such a resource-extensive growth is typical for pre-industrial and industrial economies. Post-industrial economies more intensively use all types of resources. Moreover, post-industrial economic growth is primarily driven by new sectors, such as information technologies and services, that less depend on using natural resources. 7 Chapter 7, 7 Sect.  7.2.3 previously explained the Kuznets curve in relation to economic cycles. The same approach can be used to visualize the trade-off between economic growth and environmental resources (. Fig. 18.2). In pre-industrial economies ([A; B] segment), environmental degradation rises with an increase in GDP per capita (economic development equivalent). In industrial economies ([B; D] segment), the negative impact of economic growth on the environment slows down

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. Fig. 18.2  Kuznets curve for economic growth and the environment. Source Authors’ development

and reaches its peak at a turning point C. After passing the turning point, it goes down as the industrial economy evolves into the post-industrial economy ([D; E] segment). With an increase in living standards, a country employs more advanced cleaner technologies to control and curb all kinds of pollution. However, the curve does not reflect changes in natural capital. Also, it dogmatizes the environmental burden to decline with economic development in all post-industrial societies without considering country-specific side effects of consumption patterns. Moreover, economic globalization has tightly linked countries in one network. Reducing pollution in one or several post-industrial economies may result in relocating dirtier industries to less developed pre-industrial or industrial countries. Alternative models attempt to specify the growth-environment relationship (. Fig. 18.3). According to the Limits Theory, economic growth damages the environment, until the level where accumulated damage itself starts limiting further economic growth by raising both environmental and economic costs. If resources are exhausted, the price of available resources rises. The higher cost of traditional inputs incentivizes entrepreneurs to look for alternatives or develop resource-saving technologies (further reading: “A Synopsis: Limits to Growth. The 30-Year Update”7 and “Does an Environmental Kuznets Curve Exist for Biodiversity?”8). According to the New Toxics Theory, economic growth is associated with a permanent increase in environmental degradation. Some environmental problems may be addressed and even solved, but new more pressing threats arise as the economy grows. Free-market fails to stimulate producers to invest in environmental protection and tolerate individual costs today rather than turning them into ephemeral social costs sometime in the future (further reading: “Economic

7

Meadows et al. (2004).

8

Dietz (2000).

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Chapter 18 · Post-pandemic Sustainable Development: The Farer-Reaching Perspective

. Fig. 18.3  Economic growth models and the environmental damage relationship. Source Authors’ development

Growth and the Environment: Alternatives to the Limits Paradigm”9 and “The Rise and Fall of the Environmental Kuznets Curve”10). The Race to the Bottom Model suggests that in the early stages of economic development, pre-industrial and even industrial countries hardly care much about the environment. Moreover, some countries may intentionally lower their environmental standards and ease regulations to gain a competitive advantage in attracting investments or relocating entire industries from developed states. Over time, the worsening environmental situation forces governments (already industrialized countries) to tighten regulations and get progressing environmental degradation under control. Such action slows down the loss of natural capital, but fails to reverse the trend. Alternative interpretations of trade-offs between economic growth and environmental resources demonstrate the complexity of the relationship between these two categories. While there may be no conclusive evidence on the shape of the economy-environment relationship, the above models provide a starting point for revealing the effects that drive this relationship. The scale effect, the composition effect, and the technical effect are commonly distinguished (. Fig. 18.4). The scale effect means that economic growth negatively affects the environment, where an increase in the domestic product (or consumption) spurs environmental damage. According to the composition effect, the domestic product composition changes as the economy evolves. Economic growth at the pre-industrial stage promotes industrialization (more resource-extensive industrial products in GDP), but at the post-industrial stage, the balance shifts from industrial

18 9 Davidson (2000). 10 Stern (2004).

675 18.4 · Environmental Footprints

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. Fig. 18.4  Relationship between economic growth and environmental damage. Source Authors’ development

production to the service sector (more resource-intensive goods and resource-saving services in GDP). The technical effect means that technological developments allow producers to intensify the use of inputs and thus reduce the burden on the environment. Therefore, economic growth does not necessarily damage the environment. At least, development effects on natural capital differ depending on the type of growth and the type of economy. With rising real incomes, economic actors have a more remarkable ability to devote resources to protecting the environment and mitigating pollution’s harmful effects. Also, economic growth caused by improved technology can enable higher output with less pollution. 18.4  Environmental Footprints 18.4.1  The Ecological Footprint Concept

Economic development based on the desire to indefinitely increase the production of goods and services facilitates the anthropogenic degradation of ecosystems through negative impacts on biodiversity, ecosystem integrity, climate change, and ecosystem services. A range of methods has been developed to diagnose sustainability issues. They approach measuring sustainability from different angles at different scales, from the local level (households or communities) to the global level. Regardless of the level, the methods focus on studying the dynamic interactions between society and nature. One of the mainstream integrated assessment methods is the ecological footprint approach first proposed by Mathis Wackernagel and William Rees in the 1990s (further reading: “Ecological Footprints and Appropriated Carrying Capa-

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city”11 and “Our Ecological Footprint”12). Ecological Footprint is the biologically productive area (land and water area) required to produce and restore the resources consumed by people and absorb waste produced by people. According to Wackernagel and Rees, biologically productive territories include arable land for crop production; pastures and arable land for livestock production and livestock feed; water resources for seafood production and fishing; forests for timber and other forest products and waste capture; built-up land plots for housing and other urban infrastructure. The primary type of waste is carbon dioxide emitted as part of the combustion of fossil fuels. The ecological footprint value is expressed in universal standardized units of measurement—global hectares. Global Hectare is a conventional unit denoting a hectare of biologically productive territory or water area with a world’s average level of biological productivity for a given year. The biological capacity metric is used to compare the natural capital and the anthropogenic impact on the environment. The Biocapacity of a territory is biologically productive areas and water areas located in this territory that can provide ecosystem services to people. These services include the provision of biological resources (such as food or timber), the placement of infrastructure facilities, and the sequestration of waste, in particular carbon dioxide, from the combustion of fossil fuels. Biological capacity is related to the carrying capacity of a territory determined for the maximum population of a particular species that a given region can maintain without irreversible damage to its ecological productivity. If the ecological footprint in a territory exceeds the biocapacity, then the territory faces an ecological deficit. The latter indicates that the present consumption of resources exceeds the ability of the territory to maintain this level of consumption (unsustainable development). Conversely, if the biocapacity of a territory is greater than the ecological footprint, then the territory enjoys an ecological surplus indicating sustainable economic development. The ecological footprint is permanently monitored by the Global Footprint Network (GFN), an international research institute operating in North America, Europe, and Asia. In a number of countries, GFN assesses footprint in collaboration with the World Wildlife Fund (WWF). The set of methods developed by the GFN allows countries (as well as territories, cities, and individual households) to measure their level of consumption of natural capital and compare it with the amount of renewable resources available in a respective territory (. Table 18.5). Over the past five decades, the overall ecological footprint has increased by almost 190%, indicating a growing imbalance in the relationship between people and the environment, combined with fundamental environmental and social changes. More than 80% of the world’s population lives in countries suffering from an ecological deficit, consuming more resources than local ecosystems can restore. The ecological footprint value depends on the level of development and industrialization of countries. The average per capita footprint in developed econ-

11 Rees (1992). 12 Wackernagel and Rees (1996).

386.0

Germany

195.0

190.0

179.0

315.0

Saudi Arabia

South Africa

South Korea

339.0

Mexico

788.0

593.0

Japan

Nigeria

262.0

Italy

Russia

439.0

Indonesia

1,600.0

299.0

France

India

296.0

5,350.0

Canada

588.0

Brazil

China

146.0

178.0

Argentina

Total ecological footprint, million global hectares

Australia

Countries

33.1

58.4

13.7

1,000.0

120.0

147.0

75.5

52.0

322.0

577.0

127.0

164.0

1,330.0

549.0

1,800.0

309.0

291.0

Total biocapacity, global hectares

. Table 18.5  Ecological footprint parameters in major economies in 2021

2.6 1.0

−131 −63

6.2

4.7

−685

−852

4.4

−404

3.2

1.7

−36

−207

1.2

−177

5.8

4.7

−204

−1,290

4.6

−82

5.5

3.7

+27

8.1

+85

2.8

7.3

3.3

Ecological footprint per person, global hectares per capita

−302

+206

+74

+99

Ecological deficit/ reserve, % that ecological footprint deviates from biocapacity

0.6

1.0

0.4

7.0

0.6

1.1

0.6

0.9

1.2

0.4

1.5

2.5

0.9

15.0

8.6

12.6

6.6

(continued)

Biocapacity per person, global hectares per capita

18.4 · Environmental Footprints 677

18

18

278.0

2,610.0

UK

USA

1,120.0

71.8

113.0

13 Global Footprint Network (2022).

(2022)13

Total biocapacity, global hectares

Source Authors’ development based on Global Footprint Network

283.0

Total ecological footprint, million global hectares

Turkey

Countries

. Table 18.5  (continued)

3.5 4.2 8.0

−287 −133

Ecological footprint per person, global hectares per capita

−150

Ecological deficit/ reserve, % that ecological footprint deviates from biocapacity

3.4

1.1

1.4

Biocapacity per person, global hectares per capita

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679 18.4 · Environmental Footprints

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omies is four times higher than that in developing and least developed countries. Thus, the highest ecological footprints are reported for the most developed economies (USA, China, Japan), while least developed countries in Asia and Africa (Eritrea, Burundi, Afghanistan, Rwanda) demonstrate the world’s lowest footprint values. In general, wealthier countries face a high level of ecological footprint per capita, with a significant portion of their footprint coming from imported goods. International trade plays an essential role in sharing consequences of environmental load, because it allows the higher-footprint countries to use resources outside their territory, thus exporting a part of their ecological deficit. Therefore, global supply chains facilitate the relocation and sharing of environmental consequences of economic activities between developed and developing countries. 18.4.2  Air Pollution

Because of increased industrial production, many areas in the world are prone to heavy air pollution. The gaseous air pollutants of primary concern in urban settings include sulfur dioxide, nitrogen dioxide, and carbon monoxide (. Table 18.6). They are emitted directly into the air from fossil fuels such as fuel oil, gasoline, and natural gas burned in power plants, automobiles, and other combustion sources. Lead fumes are particularly toxic and essential pollutants of many diesel fuels. Airborne suspensions of microscopic solid or liquid particles called “particulates” or particles (e.g., soot, dust, smokes, fumes, mists) are significant air pollutants because of their very harmful effects on human health. They are emitted by various industrial processes, coal- or oil-burning power plants, residential heating systems, and automobiles. Air pollution in developing countries, especially in Asia and some African countries, is generally higher than in developed post-industrial economies. In North Africa, the concentration of particulate matter and pollutants in the air is exceptionally high due to the dry climate and significant sources of sand and dust. Globally, the level of air pollution substantially exceeds the norms of healthy existence established by WHO. More than 95% of the world’s population, not only in low- and middle-income countries, but also in most developed economies in Europe and North America, are exposed to the harmful effects of polluted air. Atmospheric pollution aggravates climate change (7 Sect.  18.4.3), water pollution (7 Sect.  18.4.4), soil pollution (7 Sect.  18.4.5), and biodiversity loss (7 Sect.  18.4.6). 18.4.3  Climate Change

Industrial enterprises emit huge amounts of carbon dioxide, methane, and heavy metal compounds into the atmosphere. Substances concentrate and form a kind of coating that lets in hot solar radiation, but retains heat rising from the Earth’s

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. Table 18.6  Major air pollutants Pollutant

Common source

Environmental risks

Carbon monoxide (CO)

Automobile emissions, fires, industrial processes

Contributes to smog formation

Nitrogen oxides (NO and NO2)

Automobile emissions, electricity generation, industrial processes

Damage to foliage; contributes to smog formation

Sulfur dioxide (SO2)

Electricity generation, fossil-fuel combustion, industrial processes, automobile emissions

Major cause of haze; contributes to acid rain formation, which subsequently damages foliage, buildings, and monuments; reacts to form particulate matter

Ozone (O3)

Nitrogen oxides (NOx) and volatile organic compounds (VOCs) from industrial and automobile emissions, gasoline vapors, chemical solvents, and electrical utilities

Interferes with the ability of certain plants to respire, leading to increased susceptibility to other environmental stressors

Particulate matter

Fires, smokestacks, construction sites, and unpaved roads; reactions between gaseous chemicals emitted by power plants and automobiles

Contributes to the formation of haze as well as acid rain, which changes the pH balance of waterways and damages foliage, buildings, and monuments

Lead (Pb)

Metal processing, waste incineration, fossil-fuel combustion

Loss of biodiversity, decreased reproduction, neurological problems in vertebrates

Source Authors’ development

18

surface. Such a warmup triggers the greenhouse effect, one of the most severe environmental problems humankind faces today. The increasing average annual temperature of the planet and the world ocean result in progressing climate change and more volatile weather. Frosts are interspersed with thaws. The number of abnormally hot or cold days, hurricanes, and floods has increased substantially. Extreme weather events are complemented by the ongoing melting of ice caps and permafrost in the Arctic and Antarctic and rising sea levels. According to the Intergovernmental Panel on Climate Change,14 by 2100, global sea-level rise would be 10 cm higher with global warming of 2.0 °C compared to 1.5 °C. With global warming of 2.0 °C, the Arctic Ocean would be free of sea ice in the summer once a decade (once a century with 1.5 °C). Coral reefs would be lost with warming by 2.0 °C (a decrease by 70–90% with 1.5 °C). 14 Intergovernmental Panel on Climate Change (2021).

681 18.4 · Environmental Footprints

18

One of the most radical consequences of climate change is a potential shift in climatic zones. Weather volatilities are expected to become sharper. Seasonality (mild transitions seasons, spring and autumns) may disappear. The frequency and strength of abnormal weather phenomena will increase. Due to rising humidity and average air temperature, some territories may become unhospitable and even uninhabitable by 2100. The Middle East (Qatar, Saudi Arabia, Bahrain, the UAE) is among the climate risk areas. Climate change will detriment the stability of agricultural production and threaten crop yields, especially across food-insecure countries in Africa, Asia, and Latin America. By 2080, the number of people suffering from hunger and experiencing acute malnutrition could rise by 600 million. Another severe consequence of climate change is the shortage of drinking water. In arid climate zones (Central Asia, the Mediterranean, South Africa, Australia), the water shortage problem could be further aggravated by lowering precipitation. Hunger, water scarcity, and changes in climatic zones could trigger transboundary migration of insects and the spread of diseases (for example, malaria or fever from tropical zones in Africa northward to Europe). Climate change triggers the melting of glaciers and sea ice. Sea level rise can reach 1 m by the 2100s (compared to only 0.1–0.2 m in the XX century). If it happens, lowlands and small islands may be flooded. Coastal areas in Western and Northern Europe, Russia, North America, and Southeast Asia are at risk. Limiting global warming to 1.5 °C (the internationally agreed maximum allowable limit) requires rapid and far-reaching measures and approaches in the spheres of industrial production, energy, transport, agriculture, and land and water use. Global human-induced carbon dioxide emissions need to be reduced by almost 45% by 2030 compared to the 2010 level. Carbon neutrality can be reached by the 2050s (at least in major economies). This means that all remaining emissions must be balanced by removing (sequestrating) CO2 from the air. 18.4.4  Water Pollution

Since the XIX century, the acidity of surface ocean waters has increased by about 30% due to higher CO2 emission into the atmosphere. The amount of CO2 absorbed by the upper layer of the oceans is increasing by about two billion tons per year. With the current rates of pollution and climate change remaining constant, the increased pressure on ecosystems from chemical pollution could be estimated (. Table 18.7). A significant deterioration in the quality of water resources occurs due to the introduction of chemical waste into water and the growth of pathogenic microorganisms. This results from improper environmental protection and disinfection of fresh water. Chemical contamination is often indistinguishable compared to immediately noticeable oil spills, untreated domestic and industrial effluents, or foamy detergents. The volume of natural harmful substances in water is negligible compared to anthropogenic pollutants, but it also contributes to deteriorating the overall quality of water resources. For instance, flooding washes chemical compounds out of the soil and carries them into rivers, poisoning fish and other living

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Chapter 18 · Post-pandemic Sustainable Development: The Farer-Reaching Perspective

. Table 18.7  Environmental threats to marine ecosystems due to climate change until 2050 Environmental threat

Impacts on ecosystems and potential economic losses

Sea level rise as a result of climate change and ice melting

Flooding of low-lying coastal areas and wetlands, erosion of coastal areas, increased flooding in other areas, increased salinity of rivers, bays, and aquifers

Increase in temperature and freshening of surface waters due to glaciers melting

Significant changes in the lower/middle trophic chains and fluctuations of the quantity and quality of food resources at higher trophic levels

Increase in primary productivity of the Arctic Ocean and the North Atlantic

Reduced proportion of stocks of valuable commercial species in the structure of biodiversity, significant modification of technologies for extraction of biological resources

Invasion of alien species Loss of marine biodiversity

Currently, 550 species of fish are endangered. The rate of biodiversity loss will continue to increase

Marine pollution

Marine ecosystems are under pressure from more than 300 chemicals that cause changes in the physical, chemical, and biological characteristics of marine and coastal zones

Acidification of the world’s ocean waters

The increase in CO2 emissions and climate warming causes an increase in the acidity of ocean waters, an increase in the concentration of inorganic carbon, a decrease in the pH of waters, and their saturation with calcium carbonate

Source Authors’ development

organisms. Discharge of untreated wastewater infects water with microbes. The inadequate quality of water causes a considerable number of diseases worldwide. 18.4.5  Soil Pollution

18

Along with water pollution, soil pollution is a severe environmental problem. Sources of soil pollution are chemicals and microorganisms. They change physical, chemical, and biological properties of soil, making soils less productive and fertile. Soil degradation is also caused by gases and dust emitted by industrial enterprises (chemical, petrochemical, cement, power plants, etc.), solid and liquid industrial and urban waste, chemicals used in agriculture (inorganic fertilizers, chemical plant protection products), as well as transport emissions. Soils are also destroyed by natural phenomena, such as earthquakes, erosion, drought, or fires. Soil erosion is the process of leaching or dissolving the surface layer of the soil. It involves moving, sorting, and deposition of soil particles caused by the leaching of the surface layer by rain, river, or other water flow (water erosion) or blow-

683 18.4 · Environmental Footprints

18

ing away by the wind (wind erosion). Erosion can also be caused by anthropogenic activities, such as improper land reclamation, deforestation and burning of forests, intensive crop production and animal husbandry, and excessive exploitation of water resources. Chemical pollution has the greatest impact on disrupting the biological balance of soils. Industrial enterprises emit dust containing heavy metals (e.g., lead, mercury) and gases (e.g., sulphur, nitrogen, chlorine compounds). Crude oil and oil derivatives, radioactive substances, and industrial waste are direct sources of soil contamination. Agriculture also significantly contributes to the contamination of soils through the use of chemicals. Farmers worldwide apply pesticides and toxic components as plant protection agents, fertilizers, and plant growth additives. Pesticides are life-threatening fertilizers used to control pests. Accumulating in plants, pesticides pose a threat to the health of people and domestic and wild animals. The production and application of pesticide-based fertilizers are expanding, and new types of pesticides are created. The application of pesticides boosts productivity and supports crops in the short run, but poses a negative long-term effect on the quality of the fertile layer of soils. Pesticides are also used after harvest to protect crops during storage and transportation. Mineral fertilizers are applied extensively. They include substances of inorganic origin, such as potassium, phosphorus, nitrogen, and others. The bulk of such fertilizers is safely removed from the soil with surface runoff and further evaporation of harmful components. The most dangerous chemical components are contained in nitrogen fertilizers, such as nitrates, ammonia, and calurea. High concentrated nitrogen fertilizers may contaminate groundwater and crops, causing food poisoning. Phosphate fertilizers accumulate in topsoil, delay soil self-purification, and pollute groundwater. The main effects of soil pollution include salinization (alkalization or acidification accompanied by leaching of nutrients, especially potassium); deterioration of soil structure (overdrying or siltation); fertility reduction due to changes in physical, chemical, and microbiological properties; negative impact of soil pollution on the development of plants and organisms at higher levels of the food chain (animals and humans). Chemical soil pollutants can penetrate crops and then enter the organisms of animals and humans. They can also directly impact surface and groundwater pollution by leaching harmful substances from soils. Technical and chemical pollution destroys the ecological and aesthetic value of vegetation cover. Chemical exposure to the soil changes its pH, causing acidification. The latter inhibits the growth of microorganisms and disrupts the decomposition of organic substances, which results in releasing toxic substances into the soil. 18.4.6  Biodiversity Loss

Establishing the ecological balance involves all ecosystems’ elements, including biogeocenosis, species diversity, and genetic fund. Even minor violations in this chain lead to disastrous results. A decrease in the number of species triggers genetic abnormalities that in turn cause irreparable changes and irretrievable loss of

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Chapter 18 · Post-pandemic Sustainable Development: The Farer-Reaching Perspective

unique biological qualities. Over the past century, biodiversity has declined dramatically. Many species have gone extinct. Extinction is a natural process. Some species go extinct, and new species evolve. Yet the anthropogenic activity has altered the natural processes of extinction and evolution. Today, species die out substantially faster than that could be due to natural evolutionary processes. The leading cause of biodiversity loss is the destruction of natural habitats. Industrial, infrastructural, and residential construction and other economic activities disturb forests, fields, wetlands, and water areas. People clear land to plant crops, graze animals, cut down forests to produce timber, and build plants, roads, and houses. As habitats shrink, they can support fewer living organisms. Surviving creatures have fewer partners to reproduce, so genetic diversity decreases. It is not just direct interference in the environment in the form of construction or industrial use of resources that contributes to the biodiversity loss. Market failures, the inefficiency of public policy, and institutional inefficiency should also be highlighted among the economic and institutional factors of the loss. By subsidizing factories and farmers, the government increases benefits derived from industrial and agricultural production in comparison with the conservation of biodiversity, which itself brings no economic gains. Together with market failures, such ineffective policies result in decisions that contribute to the depletion of biological resources. For example, when choosing between the economic use of a land plot (deforestation, farming, or construction) and the ecological conservation of this plot, an economic use is commonly preferred over conservation. Since the economic performance is assessed by macroeconomic indicators that do not reflect the state of the environment and biodiversity, public policy is often unsustainable. However, both national and international approaches to biodiversity conservation and sustainable development in general develop gradually. 18.5  Pursuing Sustainable Development

The implementation of the sustainable development concept receives increasing attention worldwide. In 2015, member countries of the United Nations adopted seventeen Sustainable Development Goals (SDGs) as part of the 2030 Agenda for Sustainable Development.15 The SDGs are a universal call to action to end poverty, protect the planet, and improve the lives and prospects of everyone, everywhere. Each goal has specific targets to be achieved over the fifteen years, by 2030. The SDG list opens with the fundamental problems and challenges of present days: every possible reduction of poverty worldwide (priority is given to the least developed and developing countries, but poverty has not been eradicated in developed countries), combating extreme manifestations of food insecurity and

18 15 United Nations (2015).

685 18.5 · Pursuing Sustainable Development

18

. Fig. 18.5  SGDs 1–4: targets and indicators. Source Authors’ development

ensuring access to adequate and healthy nutrition for all, reducing threats to public health and strengthening health care systems, and improving the level of education (. Fig. 18.5). From the point of view of ensuring sustainable economic development, it is essential to increase labor productivity through human capital development and the introduction of innovations and advancements in all sectors of the economy. All SDGs somehow recognize the environmental components of economic growth, such as increasing the efficiency of energy and other natural resources, the availability of energy, and the stability of energy supply, including from renewable energy sources, and reducing water pollution (. Fig. 18.6). In addition to achieving the overall balance between the level of development and the rate of economic growth, sustainable economic development benchmarks include improvement of all types of industrial, transport, communication, and innovation infrastructure and sustainable development of cities and territories.

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Chapter 18 · Post-pandemic Sustainable Development: The Farer-Reaching Perspective

. Fig. 18.6  SGDs 5–8: targets and indicators. Source Authors’ development

18

Particular attention is paid to the comprehensive reduction of all types of inequalities both between and within countries. Inequalities create gaps, imbalances, disequilibriums, and crises that hinder the smooth development process (as potholes on a bad road offset smooth and fast driving). Narrowing gaps balances supply and demand across countries and markets, thereby eliminating overconsumption and underconsumption (. Fig. 18.7). Responses to contemporary environmental challenges to the existence and development of humankind must involve combining the efforts of all countries to reduce the negative effects of environmental pollution, mitigate climate change, and preserve marine and other natural resources (. Fig. 18.8). The achievement of environmental goals requires mobilizing all resources of all countries and establishing a responsible environmental management shared by all people. Many countries implement their own sustainable development programs. It is essential to move from a global understanding of the importance of sustainable development to specific practices at the level of individual states and territories. The main directions of the sustainable development transition at the country level include:

687 18.5 · Pursuing Sustainable Development

18

. Fig. 18.7  SGDs 9–12: targets and indicators. Source Authors’ development

5 creation of a legal framework for the transition to sustainable development, including the improvement of legislation to set up economic mechanisms for the regulation of natural resources use and environmental protection; 5 stimulating economic activity and establishing limits of responsibility for its environmental effects (the biosphere is perceived as the mainstay of civilization and living base, not only a supplier of resources); 5 assessment of the economic and biological capacity of local ecosystems and determination of the permissible anthropogenic impact (ecological footprint); 5 mainstreaming the sustainable development narrative and education and training in the sphere of sustainable development. The COVID-19 pandemic has tested the ability of the existing infrastructure to head on to sustainable development and respond quickly and effectively to emerging global crises. COVID-19 has hit many areas of life and exacerbated sustainability issues. The lack of medical facilities, water, food, electricity, and other supplies to combat the pandemic is acute not only across the developing world, but also in developed countries. However, the new normal reality makes the de-

688

Chapter 18 · Post-pandemic Sustainable Development: The Farer-Reaching Perspective

. Fig. 18.8  SGDs 13–17: targets and indicators. Source Authors’ development

18

veloped-developing division irrelevant. Achieving sustainable development in a single country (even the most developed one) is impossible. One of the key takeaways of the pandemic is rethinking the very essence of sustainability as resilience for all. In a globalized world, instability in one country or market undermines the resilience of the entire system. The pandemic crisis has significantly adjusted the green development plans in many countries. Nevertheless, we should not expect any radical about-face in the

689 18.5 · Pursuing Sustainable Development

18

global greening and decarbonization policy. In many ways, the pandemic and related restrictions have only exacerbated the environmental problems. On the one hand, we have witnessed how governments can coordinate and quickly shut down economies or certain industries (thus indirectly decreasing industrial and transport pollution and greenhouse gas emissions). For example, bans on air travel and movement within cities and countries, temporary shutdowns of businesses, and remote work regime have resulted in a temporary reduction in energy consumption and greenhouse gas emissions. On the other hand, almost all countries faced a sharp increase in waste, including disposable packaging and medical waste. Third, the pandemic has spotlighted environmental risks and threats, including adverse effects of climate change and pollution on biodiversity loss and biological hazards. Fourth, the post-pandemic restart requires new solutions, in which the green and blue components should play their significant roles. Some countries (including the EU) have already confirmed strengthening their post-pandemic recovery programs’ environmental and climate components. Another new normal trend is the expansion of the environmental and green agenda. In addition to the energy-related issues, an increasingly more significant attention is paid to industrial and residential construction (both in terms of resource and energy efficiency and the use of new construction materials and technologies), transport, and agriculture. Environmental and social aspects of food production are spotlighted due to the increasing depletion of agricultural land and pressure on non-agricultural ecosystems. Restructuring the global food production and distribution system requires reducing pressures on ecosystems, increasing energy and water efficiency, diversifying crops to cope with more volatile weather, promoting local foods to make supply chains more resistant to disruptions, and implementing biodiversity support programs to reduce the risk of epizootic outbreaks. The social dimension of sustainability must also be taken into account by avoiding food prices volatilities, ensuring a stable supply of food and agricultural products, and fairly remunerating farmers for the product they supply. In response to transforming environmental, economic, and social challenges, new sustainable investment mechanisms have emerged, such as transitional, green, blue, and sustainable bonds. They incentivize investors to gain profit by channeling capital into previously low-profitable environmental and social projects. Sustainable Development Bonds are any type of debt instrument used exclusively to finance or refinance, either in part or in whole, new or existing sustainable development programs, social projects, or a combination of environmental and economic projects in the green or blue economy or related sectors. Sustainable development bonds must comply with the following four principles: 5 use of funds—all projects aim at generating environmental or social benefits; 5 project evaluation and selection—objectives, compliance with sustainable development goals, and selection criteria must be clearly indicated; 5 management of funds—proceeds from the placement of sustainable development bonds must be accounted for separately (separate account, separate portfolio, etc.); 5 reporting—up-to-date information on the use of funds must be provided.

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Chapter 18 · Post-pandemic Sustainable Development: The Farer-Reaching Perspective

One of the most pressing topics is the reduction of greenhouse gas emissions and the achievement of the Paris Agreement goals. In this regard, transition bonds have emerged as a way to intensify the decarbonization efforts. Blue bonds have been gaining popularity since recently. They aim at implementing projects to protect the oceans and coastal areas and support the blue economy. Case box The total emission of green bonds in 2020 exceeded $1 trillion for the first time since their launch in 2007. The largest issuers are the USA, China, and the EU countries. International issuers include International Bank for Reconstruction and Development, International Finance Corporation, European Bank for Reconstruction and Development, African Development Bank, and Asian Development Bank. In 2018, the Seychelles Islands issued its first sovereign blue bonds, raising $15 million to preserve islands and coral reefs. Nordic Investment Bank raised SEK 2 billion for water projects related to adaptation to climate change and prevention of water pollution. In 2019, the World Bank also issued blue bonds to draw attention to the ocean plastic pollution problem. In 2020, the Bank of China became the first issuer of blue bonds in Asia, raising over $940 million for offshore projects in the spheres of renewable energy and sustainable management of water resources and wastewater. In 2021, the Bank of China’s Hong Kong branch issued the transition bonds (RMB 5 billion) to meet China’s decarbonization goals and the Paris Agreement obligation.

18

In 2020, the first $74.9 billion worth of COVID-19 thematic bonds were issued to mitigate the economic and social effects of the pandemic and facilitate the post-pandemic economic recovery. The first pandemic-related bonds in China raised $143 billion to support businesses and provide assistance to people. China accounts for 90% of the world’s total emission of thematic bonds during the pandemic. The remaining 10% was issued by international and interregional development banks, as well as national banks in Spain, South Korea, and Sweden. Therefore, new sustainable development mechanisms are emerging in the financial market in response to new challenges. Along with the growth of the sustainable financing market, especially green and other thematic bonds, new standards for disclosing non-financial information are being developed. Companies are being evaluated for compliance with sustainable development principles. However, achieving sustainable development goals is hardly possible without joining the efforts of the government, businesses, and the financial sector. Another post-pandemic trend is localization. Countries not only fenced off each other with sanitary barriers, but also reoriented on their own forces and domestic markets. Yet, sustainable development transition supposes establishing an effective spatial structure of the economy while maintaining a balance of interests of all countries and territories. The transition predetermines the need to adjust and implement sustainable development programs for individual territories and further integrate these programs into the national sustainable development agenda. Economic and social development processes are significantly influenced

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by regional differences in natural and climatic conditions and the uneven spatial allocation of natural resources, factors of production, and people. The use of natural resources, environmental protection measures, and other development activities are always related to a certain territory. The territory-specific approaches must be consistent with national sustainable development objectives, but local specificities must be considered. The biosphere is a global environment we all live in. Therefore, international cooperation is a must for the effective transition to sustainable development. An essential manifestation of the new normal is the combination of the two challenges—climate change and biodiversity loss. In view of such a double threat to sustainability, nature-based solutions are seen as one of the principal ways to combat the climate crisis. Disturbed ecosystems need to be restored so that they can perform their ecological functions. At the same time, it is necessary to create new ecosystems and develop existing protected areas. In the coming years, we may expect a more systematic and balanced approach to solving both problems and increasing the transparency of environmental programs. The carbon neutrality and pollution reduction measures are already included in the national development plans and strategies in many countries. It is essential to promote the international partnership to be able to jointly solve the sustainable development tasks, participate in research projects on the reduction of anthropogenic impact on the biosphere, ensure parity between countries in resolving issues of transboundary transport of harmful substances, and ensure the environmental interests of each country in foreign economic activities. The hottest issues in the international environmental agenda include biodiversity conservation, protection of the ozone layer, mitigation of anthropogenic climate change, forest protection and reforestation, combating desertification, development of specially protected natural areas, destruction of chemical and nuclear weapons, and responsible use of oceans, land, and mineral and biological resources of the planet. Chapter Questions: 5 Formulate your understanding of sustainable development. Compare sustainable development with stable development and smooth economic growth. 5 What criteria must be met to make development sustainable? 5 How does the internalization of expenditures in the Pigouvian interpretation differ from the internalization of externalities in the market failure theory? 5 Explain the concepts of green economy and blue economy. Summarize differences and similarities. 5 What is natural capital? How can it be distributed in the economy operating at the production possibility frontier? What about the economy that underutilizes resources within the frontier? 5 Discuss possible relationships between economic growth and environmental damage. What models could be applied, and what effects could they produce? 5 Explain the essence of the ecological footprint metrics. Do you think the ecological footprint comprehensively measures sustainable development across the world?

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5 What ecological footprints of economic development are specific to the country or territory you live in? 5 The United Nations’ Sustainable Development Goals aim to comprehensively cover critical dimensions of sustainable development and contemporary challenges to the environment, economy, and society. In light of the new normal trends, can you suggest any metric that has been missed? Subject Vocabulary:

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Biocapacity: biologically productive areas and water areas located in a particular territory that can fully provide ecosystem services to people within this territory. Blue Economy: a set of economic sectors and related activities that ensure sustainable use of all kinds of water resources and contribute to economic growth and social development, while improving the environmental sustainability of oceans, seas, inland waterways and resources, and coastal areas. Ecological Footprint: a biologically productive land and water area required to produce and restore the resources consumed by people and absorb waste produced by people. Global Hectare: a conventional unit denoting a hectare of biologically productive territory or water area with a world’s average level of biological productivity for a given year. Green Growth: a growth that stimulates economic development, while ensuring the preservation of natural assets and sustainable use of resources and ecosystem services. Internalization of Expenditures: a turning of external environmental costs into individual internal costs. Natural Capital: a natural resources pool, including minerals, water, land, air, flora and fauna, and all living matter and ecosystems. Pigouvian Tax: an output tax that raises individual costs of businesses engaged in creating negative externalities to the maximum permissible level of social costs. Sustainable Development: a set of measures aimed at meeting the current needs of the present generation while preserving the environment and natural resources to ensure the ability of future generations to meet their own needs. Sustainable development aims at satisfying human needs and aspirations. Sustainable Development Bond: a debt instrument used exclusively to finance or refinance sustainable development programs, social projects, or a combination of environmental and economic projects in the green or blue economy or related sectors. Sustainable Development Goals: a universal United Nations’ call to action to end poverty, protect the planet, and improve the lives and prospects of everyone, everywhere. Sustainable Development Model: a type of the civilization development model based on the synchronous ensurance of economic efficiency and economic security, social justice and social security, and environmental security and co-evolutionary development.

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Sustainable Economic Development: a type of economic development that provides balanced forward-oriented solutions to present economic and social problems and ensures the preservation of the country’s environmental and natural resource potential in order to meet the vital needs of present and future generations.

References Davidson, C. (2000). Economic growth and the environment: Alternatives to the limits paradigm. BioScience, 50, 433–440. Dietz, S. (2000). Does an environmental Kuznets curve exist for biodiversity? Eidgenössische Technische Hochschule Zürich. Global Green Growth Institute. (2022). Tools and indicators. 7 https://gggi.org/global-program/ tools-and-indicators/ Global Footprint Network. (2022). Ecological footprint explorer open data platform. 7 https://data. footprintnetwork.org/?_ga=2.77639506.774838382.1643072800-1521078068.1643072800/ Intergovernmental Panel on Climate Change. (2021). Climate change 2021: The physical science basis. Cambridge University Press. Meadows, D., Meadows, D., Randers, J., & Behrens, W. (1972). The limits to growth. A report for the club of Rome’s project on the predicament of Mankind. Universe Books. Meadows, D., Randers, J., & Meadows, D. (2004). A synopsis: Limits to growth. The 30-year update. Chelsea Green Publishing. Organization for Economic Cooperation and Development. (2022). Green growth indicators. 7 https:// www.oecd.org/greengrowth/green-growth-indicators/ Pigou, A. (1920). The economics of welfare. Macmillan and Co. Rees, W. E. (1992). Ecological footprints and appropriated carrying capacity: What urban economics leaves out. Environment and Urbanization, 4(2), 121–130. Stern, D. (2004). The rise and fall of the environmental Kuznets curve. World Development, 32(8), 1419–1439. United Nations. (2015). Transforming our world: The 2030 agenda for sustainable development. 7 https://sustainabledevelopment.un.org/post2015/transformingourworld United Nations Division for Sustainable Development. (2005). Sustainable development issues. United Nations. Wackernagel, M., & Rees, W. E. (1996). Our ecological footprint: Reducing human impact on the earth. New Society Publishers. World Commission on Environment and Development. (1987). Report of the world commission on environment and development: Our common future. 7 https://sustainabledevelopment.un.org/content/ documents/5987our-common-future.pdf

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Learning Objectives: 5 Discover classical approaches to interpreting international trade (mercantilism, absolute and comparative advantages, and the relative factor endowment) 5 Study modern firm-based theories of international trade (Vernon’s model of international product life cycle, Linder’s theory of overlapping demand, Posner’s technological gap theory, Hicks’ theory of technological progress, and Krugman’s economies of scale) 5 Explore alternative concepts of international trade (Haberler’s theory of opportunity costs, Minhas’ theory of factor intensity reversal, the Samuelson-Jones theorem, and Balassa’s theory of intra-industry trade) 5 Discuss emerging theories of international trade in light of the new normal global economic development (Melitz’s model of heterogeneous firms, theory of incomplete contracts, Porter’s theory of competitive advantage, the gravity model, and spatial theory of international trade) 19.1  Classical Country-Based Theories

The economic knowledge in the sphere of international trade goes back centuries and covers almost all schools of economic thought. The classical interpretations of various macroeconomic concepts have been discussed above in relation to the general principles of macroeconomics (7 Chap. 1, 7 Sect. 1.2.1), macroeconomic equilibrium and economic performance (7 Chap. 6, Sects. 6.1.1 and 6.2.1), and economic development (7 Chap. 15, 7 Sect. 15.1). This section examines the approaches of the classical school to understanding the essence of international trade and its benefits and losses for individual countries. Country-based theories focus on studying imports and exports of standardized and undifferentiated goods and services for a country or a group of countries. Major country-based approaches to interpreting international trade include mercantilism (7 Sect. 19.1.1), theories of absolute advantage (7 Sect. 19.1.2) and comparative advantage (7 Sect. 19.1.3), and the Heckscher-Ohlin theorem (7 Sect. 19.1.4). 19.1.1  Mercantilism

It is commonly accepted that the ground for establishing the general theory of international trade was set by mercantilists in the XVI–XVIII centuries (further reading: “Traité de l'économie politique”1 by Antoine de Montchrestien, “England’s Treasure by Foreign Trade”2 by Thomas Mun, and “An Inquiry into the Principles of Political Economy”3 by James Steuart). Recognizing export as the

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1 2 3

Montchrestien (1615). Mun (1628). Steuart (1767).

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source of income and import as the cause of money outflow, mercantilists declared trade a source of wealth for a country. They recommended governments promote exports and restrict imports to ensure the inflow and accumulation of income. State support of domestic production and export, protectionism against importers, and a ban on foreign investment were recognized main factors of economic prosperity. Mercantilism is the international trade pattern in which a country seeks to become wealthier by increasing exports and restricting imports (by imposing a tariff on imports). This system is founded on the following principles: 5 regulation of foreign trade aimed to stimulate the inflow of wealth (gold and silver) and keep foreign trade balance positive; 5 support of domestic producers by importing cheap raw materials and subsidizing the export of value-added goods; 5 protection against the foreign competition (import tariffs and quotas, bans on import goods and foreign firms in domestic market); 5 population growth to maintain low wages. In the early mercantilism age (XV–XVI centuries), there prevailed the idea of minimizing the export of capital and maximizing the physical inflow of wealth in the form of gold and silver. Early mercantilists advocated a complete ban on capital outflow (payments for imports or foreign direct investment) to save and increase national wealth. Economic entities were obliged to spend all revenues received from foreign trade to pay for domestic factors of production and purchasing domestic goods. The money primarily served as a store of value. Therefore, early mercantilists shared the following basic principles: 5 all possible restriction of imports; 5 prohibition on the flight and any transfer of wealth abroad (up to imprisonment and the death penalty); 5 artificial increase in prices of imported goods (prohibitive tariffs and duties); 5 positive foreign trade balance and the balance of payments; 5 spending of export revenues in the domestic market. In late mercantilism (XVII–XVIII centuries), the focus shifted from keeping a positive balance of payments to achieving an active foreign trade balance by exporting value-added manufactured goods. Import of lower-value raw materials was allowed if imported inputs were used in generating added value for domestic producers in the foreign market. The ban on the export of money was lifted. Late mercantilists interpreted wealth as surplus (production, trade) that turns into money in the sphere of international trade (not physical wealth stored in a country). Thus, money was also considered a medium of exchange, not only a store of value. The following fundamentals laid the foundation for late mercantilism: 5 lifting of restrictions on the import of goods and the export of money; 5 active trade balance; 5 protectionism as the comprehensive economic policy of a state; 5 the “buy cheap—sell better” principle in international trade.

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At both the early and the late stages, mercantilism proclaimed protectionism in the domestic market and foreign trade. Protectionism is a type of government policy that implies establishing trade barriers (tariffs and quotas) to protect domestic producers from foreign competition. In a broad sense, protectionism includes supporting domestic firms and consumers and stimulating export (see 7 Chap. 22, 7 Sect. 22.1 for protectionism in international trade). However, mercantilism is a more comprehensive concept that also involves the political idea of building a powerful economy by amassing wealth, developing its domestic market using its own resources, and fencing itself off from neighbors, but still affecting those neighbors due to its size and all kinds of economic, trade, and political power. Some economies pursue these ideas today without referring to mercantilism, but implementing the mercantilist narrative in practice. Case box By the end of the XVII century, mercantilism was adopted as the economic doctrine across Europe. In the UK, mercantilism (protectionism) was introduced in the 1690 s. Some of its elements had been practiced till the 1850s. Austria, Sweden, and Russia followed the mercantilism doctrine in the XVII–XVIII centuries. At that time, the concepts of mercantilism and protectionism were almost identical. The mercantilist (protectionist) policy was believed to improve trade balance and contribute to economic development and the increase in living standards. The very improvement in the trade balance was associated with the growth of welfare and employment.

Mercantilism is one of the earliest trade-related economic doctrines distinguished by the integrity of its principles and concepts. Having emerged in the early capitalism era, it encapsulated the ideas of capital accumulation and enrichment as the integral elements of the national economic policy. Money determined the prosperity of the nation. However, the excess money supply in the economy pushes up prices, degrades purchasing power of the national currency, and results in the overheating of the economy. A real increase in welfare is inseparable from active unrestricted trade. Thus, the key assumptions of mercantilism (such as the accumulation of material wealth in the form of gold) reflected the nature of the pre-industrial development stage (previously discussed in 7 Chap. 15). Mercantilism did not stipulate that capital accumulation could fuel inflation, increase production costs, and make domestic products less competitive internationally. A consecutive decline in exports could result in a negative trade balance and thus trigger the outflow of money from the country. 19.1.2  Smith’s Absolute Advantage

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The critique of mercantilism became the starting point for emerging new trade theories in the XVIII–XIX centuries, the theory of absolute advantage being one of the earliest. It states that a country benefits from exporting those goods which

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it produces at a lower cost than other countries (the absolute advantage of an exporting country) and importing those goods whose production costs are higher (the absolute advantage of an importing country). Based on a combination of absolute advantages and disadvantages in producing various goods, the exchange between countries can be mutually beneficial. The benefit size is determined by the difference in production costs in different countries. To gain the benefit in international trade, governments should not interfere in allocating advantages driven by free-market competition and the division of labor. Absolute Advantage is the country’s capacity to produce certain goods at the lowest cost compared to other countries. Prominent representatives of the absolute advantages theory are Dudley North (further reading: “Discourses Upon Trade”4) and David Hume (further reading: “Political Discourses”5). In public opinion, the theory is mainly associated with Adam Smith (further reading: “An Inquiry into the Nature and Causes of the Wealth of Nations”6). According to Smith, countries are interested in the liberalization and development of international trade, since it is pointless to waste domestic resources on producing goods that can be imported at a lower cost. Trade between countries is mutually beneficial if the goods exchanged are produced in each of the countries at a lower cost. Therefore, the international exchange is facilitated by the difference in the absolute costs of producing goods in different countries. The theory of absolute advantage is based on the following four premises: 5 value of goods is determined based on the relative amount of labor required for manufacturing these goods; 5 labor is mobile within a country, not between countries 5 trade model involves two countries and two goods; 5 trade between the two countries occurs if each of the two countries produces one of the goods at a lower cost than the other country. Absolute advantages are conditioned by natural factors, such as climate, landscape, geographical location, quality of lands, or the availability of minerals and other natural resources. Natural advantages are particularly essential in developing agricultural production and extractive industries. Natural advantages can be improved (or new advantages can be acquired) due to the advancement of technologies, human capital, or management practices. In the absence of foreign trade, each country consumes only those goods it produces (and only in the amount it is able to produce). Prices on the domestic market are determined by the relative costs of manufacturing domestic products. Prices for identical goods produced in different countries are different. If the difference exceeds transporta-

4 5 6

North (1691). Hume (1752). Smith (1776).

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. Fig. 19.1  The absolute advantage illustration. Source Authors’ development

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tion costs, then exporting (importing) such a good makes a profit. For trade to be mutually beneficial, prices in the foreign market are to be higher than in the exporting country and lower than in the importing country. Assume countries A and B produce goods X and Y (. Fig. 19.1). Per unit of cost, country A can produce XA1 units of good X or YA1 units of good Y , or any combination of the two goods. Country’ B can produce XB1 and YB1 units, respectively. The maximum volumes of production are set by production possibility curves PPF A and PPF B (see 7 Chap. 16, 7 Sect. 16.3 for the concept of production possibility frontier). Country A enjoys an absolute advantage in producing good Y (YA1 > YB1), while country B possesses an absolute advantage in producing good X (XB1 > XA1). According to the theory of absolute advantage, exchange between countries occurs due to the difference in the relative costs of producing good Y expressed in the production costs of good X (or vice versa). The relative cost of one unit A1 B1 < XYB1 of good Y in country A is lower than that in country B (XYA1 ), which means country A enjoys an advantage. For good X , country B possesses an absolute ad< XYA1 vantage in relative costs (XYB1 ). Consequently, in this two-countries trade B1 A1 system, country A benefits from exporting good Y and importing good X , while country B benefits from exporting good X and importing good Y . International trade increases consumption due to more effective allocation of resources (specialization of production and cost cuts) and changes in consumption patterns (more affordable products in the domestic market improve purchasing power and living standards). In the absence of trade, the production possibility frontier (determined primarily by the structure of demand) remains unchanged (points AP and BP in countries A and B, respectively). By selling a part of goods in which a country has an absolute advantage, it receives more goods in exchange. By changing the structure of consumption, the country increases its total volume, going beyond the initial production possibility frontier. An even greater gain is received from specializing in producing goods in which a country has an absolute advantage (trade possibility frontiers TPF A and TPF B for countries A and B, respectively). In this case, both countries can increase consumption (point AT for country A and point BT for country B).

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Case box Chinese and Italian producers are deeply integrated into the international supply chains. China produces textiles at a lower price than any other country. Due to its vast vineyards and favorable climate, Italy produces wine at a lower price than any other country. Both countries enjoy absolute advantages in producing certain goods. Each country seeks to export goods it produces at the lowest cost and import those goods in which it faces a disadvantage. Clearly, China exports textiles and imports wine, while Italy exports wine and import textiles. Companies and other economic entities operate similarly to countries. They produce and sell goods in which they possess advantages and buy ones in which they experience disadvantages.

In practice, countries do not always specialize in producing and exporting goods competitive in the foreign market in terms of price. This commonly happens in the case of specializing in one product (for example, hydrocarbons in Russia or raw materials in Africa) and exploiting specific natural advantages (for example, production of tea in China or coffee in Brazil) or cheap labor (Asian countries). Further advancing Smith’s idea of absolute advantage, we can come to a paradoxical conclusion: if a country can get all the goods it needs from abroad at a lower price than producing these goods domestically, then it is in its interest to import those goods. Will such a country have anything to produce and sell? How will it pay for purchasing goods from abroad? The reason for the discrepancies observed in real life is the strict assumptions of the theory of absolute advantages (elastic demand for goods and services, labor as the only factor of production, full employment, zero transport costs, no foreign trade barriers). These assumptions make the theory of absolute advantage a largely abstract construct (still allowing us to understand the fundamental determinants of international trade). 19.1.3  Ricardo’s Comparative Advantage

In the early XIX century, David Ricardo attempted to answer why countries trade without having an absolute advantage (further reading: “On the Principles of Political Economy and Taxation”7). His comparative advantage principle postulates that exports and imports can be profitable for a country even in the absence of absolute advantages. If a country possesses an absolute advantage in producing several goods, then it should specialize in exporting a good in which it has the most significant absolute advantage. If a country has no absolute advantage in any of the goods, then it should specialize in exporting a good it can produce cheaper. As a consequence, import can be profitable for a country even when imported goods can be produced domestically at a lower cost than abroad. Therefore, international trade is a win for all countries and economic entities.

7

Ricardo (1817).

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Comparative Advantage is the country’s capacity to produce certain goods at lower opportunity costs compared to its trading partners (not the lowest cost as in the theory of absolute advantage). The theory of comparative advantage is founded on the following provisions: 5 participating in international trade can be beneficial for a country that has no absolute advantage in producing any goods; 5 countries specialize in producing goods for which they have relatively lower costs; 5 countries specialize in producing and exporting goods for which the ratio of production costs to production costs of other domestic goods (opportunity cost) is lower than the similar ratio in other countries; 5 difference in opportunity costs incentivizes countries to trade; 5 unlike absolute natural advantages, comparative advantages are temporary. The four premises of the theory can be formulated as follows: 5 countries benefit from trade due to changes in consumption patterns and specialization of production; 5 countries change the structure of consumption by exporting that part of the output for which they possess advantages; 5 by exporting part of their output, countries increase the total volume of consumption, going beyond their production possibility frontiers; 5 specialization in producing and exporting goods in which countries have a comparative advantage brings the maximum benefit from participating in international trade.

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Resting on the same assumptions as the theory of absolute advantages, the theory of comparative advantage introduces the concept of opportunity costs. Opportunity Cost is a simple comparison of prices of two goods in the domestic market expressed in the amount of labor spent on their production (see 7 Chap. 2, 7 Sect. 2.1 for the concept of opportunity costs and 7 Chap. 15, 7 Sect. 15.2.2 for Ricardo’s interpretation of opportunity costs). An opportunity cost is the amount of labor (working time) required to produce a good expressed through the amount of labor required to produce another good. According to the theory of comparative advantage, countries specialize in producing goods with lower opportunity costs compared to other countries. In this case, trade is mutually beneficial regardless of whether production in one country is more cost-efficient than in the other. Prices of imported goods are expressed through prices of goods that need to be exported to pay for imports. Therefore, the equilibrium price of a good in trade between two countries (the ratio of prices) is determined by domestic demands for this good in each trading country. As long as differences in the domestic ratios persist, each country possesses a comparative advantage, i.e., it has a good which production is more profitable at the current cost ratio than the production of other goods. Total output is the greatest when a country produces each good with lower opportunity costs. Consequently, the theory of comparative advantage says that the directions of export and import flows are determined by the relation of opportunity costs between countries (economic entities).

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. Fig. 19.2  The comparative advantage illustration. Source Authors’ development

Suppose country A is capable of producing XA1 units of good X and YA1 units of good Y , or any combination of the two goods within its production possibility frontier PPF A (. Fig. 19.2). Country B simultaneously enjoys absolute advantages in producing both goods (XB1 > XA1 and YB1 > YA1). According to Smith’s absolute advantage principle, country B dominates the market by exporting both good X and good Y to country A, while the disadvantaged country A has nothing to do but import them. However, the opportunity cost of producing a unit of good Y expresses in units of good Y in country A is lower than in country B A1 B1 < XYB1 (XYA1 ). That means that country A has a comparative advantage in good Y and can export it to country B in exchange for good X . In turn, country B may benefit more from specializing in producing good X and importing good Y than from exploiting both of its absolute advantages. If a country specializes in improving its comparative advantage, it allows it to expand consumption and go beyond the production possibility frontier to the trade possibility frontier (TPF A and TPF B for countries A and B, respectively). Thus, country A increases the domestic supply of good X for which it has no comparative advantage by importing it from country B (XA1 shifts to XA2, and the entire market grows beyond the production possibility frontier from PPF A to TPF A). The similar increase in the market size occurs in country B due to importing good Y (domestic supply of good Y grows from YB1 to YB2 and the production possibility frontier shifts from PPF B to TPF B). Such increases of domestic markets in the two trading countries result in aggregate output growth across the global economy. The total gain is the greatest when each good in the market is produced with lower opportunity costs. A comparison of the absolute advantage the comparative advantage principles demonstrates that in both cases, the gain from trade stems from the difference in cost ratios in the absence of trade (PPF slopes in the two countries). It follows that the directions of trade are determined by relative (opportunity) costs, regardless of whether a country has an absolute advantage or not. Similar to the theory of absolute advantages, Ricardo’s comparative advantage model is based on certain assumptions: equal cost of labor in trading countries, unrestricted trade, zero transport costs, full employment, and immobile fac-

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tors of production. The theory of comparative advantage ignores the impact of foreign trade on the distribution of income within a country, any fluctuations in prices and wages, inflation, and the transboundary mobility of capital. Only one factor of production (labor) is assumed to exist, while other essential trade-related factors are not taken into account, such as differences in the endowment of countries with natural resources and factors of production. Also, the theory proceeds from the premise of full employment, i.e., leaving the less efficient industry, workers immediately find jobs in a more efficient one. In general, such limitations do not allow one to explain trade between countries with relatively equal comparative advantages, none of which has a substantial advantage over the other. 19.1.4  The Heckscher-Ohlin Theorem

Various extensions have been made to the theory of comparative advantage to eliminate the effects of its assumptions. Eli Heckscher and Bertil Ohlin attributed the existence of comparative advantages to the relative availability of factors of production, especially labor and capital (further reading: “The Effect of Foreign Trade on the Distribution of Income”8 and “Interregional and International Trade”9). The Heckscher-Ohlin Theorem states that the relative factor endowment is determined by the degree of availability in comparison to other factors of production, not the physical amount of available factors of production. The price of any input directly depends on the scarcity of this input. Industries that utilize relatively abundant factors of production incur lower production costs than those utilizing relatively scarce inputs. Consequently, countries export goods produced with the use of abundant factors of production (abundant in a particular country) and import goods for which they face worse factor endowment. According to Heckscher and Ohlin, the inter-country differences in relative costs result from various combinations of factors employed in producing various goods. Factor endowments differ across countries. The law of proportionality of factors says that in an open economy, each country seeks to specialize in producing and exporting goods that require more factors a country is relatively better endowed with. International trade is the exchange of abundant factors for rare ones. The mobility of goods thus replaces the mobility of factors of production (some of which are immobile like land or low-mobile like labor). In a hidden form, countries export abundant factors and import scarce factors, i.e., in the global market, the movement of goods between countries compensates for the lower mobility of factors of production. The Heckscher-Ohlin theorem is based on the following assumptions: 5 Countries tend to export goods that require the use of relatively abundant production factors and import those that require relatively scarce factors.

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Heckscher (1919). Ohlin (1933).

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However, the factor endowment is not constant. Increasing its output, a country faces a gradual decrease in the marginal utility of factors added to production. Marginal utility means that the increase in the amount of input by one unit produces a smaller amount of additional output (see 7 Chap. 2 for the concepts of marginal cost and marginal revenue). 5 International trade equalizes prices of factors across countries. The theorem stipulates identical consumption patterns in trading countries, such as the commodity composition of consumption, consumer preferences, and other demand-related parameters. Similarly, producers face identical business patterns, such as equal production capabilities, tariffs, transportation costs, and other supply-related parameters. 5 The movement of factors of production can replace the export of goods. Any country (producer or importer) is capable of increasing the output of goods that require relatively abundant factors. In a producing country, growing demand for abundant factors would raise prices for such inputs (amid decreasing marginal utility of employing each additional unit). In importing countries, prices of factors would go down, since the need for scarce factors would be compensated by importing corresponding goods from factor-abundant countries. According to the theory of relative factor endowment, a country can not benefit from specializing in producing just one good. The two principal assumptions of the Heckscher-Ohlin theorem include factor intensity and factor abundance: Factor intensity implies the division of goods into capital-intensive and labor-intensive. If the capital-labor ratio for good A is greater than that of good B, then good A is considered relatively capital-intensive (respectively, good B is relatively labor-intensive). Factor abundance determines the difference between countries in the abundance of factors of production (capital and labor). The relative supply of a country with factors of production is expressed through either relative prices of factors or their amount. The Heckscher-Ohlin theorem has inspired numerous improvements and extensions that have resulted in establishing the umbrella theory of relative factor endowment: 5 The Stolper-Samuelson Theorem: an increase in the price of a good due to international trade results in an increase in return on the factor most intensively used in producing this good (further reading: “Protection and Real Wages”10). Since the increase in the relative costs of producing a labor-intensive good is accompanied by a growth of the ratio of wages to rent for the use of capital, the price of labor goes up relative to prices of both labor-intensive and capital-intensive goods, while the price of capital relatively decreases. Thus, the real return on labor increases and that on capital falls, regardless of in what exact configuration labor-generated and capital-generated revenues are used in purchasing labor-intensive and capital-intensive goods. Having made this con-

10 Stolper and Samuelson (1941).

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clusion, Wolfgang Stolper and Paul Samuelson revealed a fundamental relationship between trade and the distribution of income within a country (not possible based on earlier models that considered factors specific to individual sectors of the economy). 5 The Heckscher-Ohlin-Samuelson Theorem: the international exchange of goods and services bridges the differences in prices not only for traded goods, but also for factors of production (further reading: “International Trade and the Equalization of Factor Prices”11). If diversities in factor endowments between countries are minor, then free trade in goods completely replaces the movement of factors of production. When prices of factors are balanced between countries, the transboundary exchange generates no benefit. 5 The Rybczynski Theorem: an increase in the supply of an input results in an increase in output and export in industries that most intensively use this input and a simultaneous decrease in output and export in industries that least intensively use this input (further reading: “Factor Endowment and Relative Commodity Prices”12). If the capital-labor ratio in the economy goes up, then the capital-intensive industry expands production, while the labor-intensive one curbs it down. Such relationships between factor endowments and output make it possible to track a link between trade and economic growth. One of the most illustrious manifestations of the Rybczynski theorem is the so-called Dutch Disease. The discovery of natural gas in Groningen (Netherlands) in 1959 triggered a skyrocketing growth in the gas industry, withdrew resources from other sectors, and caused a substantial decline in higher-value-added manufacturing. 5 The Johnson’s Theorem: a change in external factors (exogenous variables) leads to a disproportionate increase in internal factors (endogenous variables) (further reading: “Economic Expansion and International Trade”13). A rise in the export price of a good may cause a more significant increase in the price of the main factor of production. An increase in the amount of input can cause a more remarkable rise in the output of goods that use this input. The theory of relative factor endowment eliminated some of the drawbacks of the theory of comparative advantages. The extensions allowed finding out how comparative advantages emerge and going beyond the one-factor Ricardian trade model. Nevertheless, a number of limitations remained: the mobility of factors of production within countries and immobility between countries, no account for trade barriers and government regulations, no transaction costs, and perfect competition. As a result, the theory of relative factor endowment can be applied under specific conditions. Most deviations fall under the phenomenon known as the Leontief paradox. In the 1950s, Wassily Leontief discovered that in the USA

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11 Samuelson (1948). 12 Rybczynski (1955). 13 Johnson (1955).

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(capital-intensive economy), the share of capital-intensive goods in exports decreased (despite the relative abundance of affordable capital), while the share of labor-intensive goods in exports grew (despite the high cost of labor in the country) (further reading: “Domestic Production and Foreign Trade”14). 19.2  Modern Firm-Based Theories

The fundamental transformation of the global economic and trade environment after the World War II gave rise to a shift from classical country-based trade theories to modern firm-based theories. The emergence of the latter was particularly fueled by progressing globalization, unification and liberalization of trade regimes between countries, and the rapid growth of transnational corporations. The country-based theories failed to adequately address the expansion of alternative economic actors in the global market and specific processes associated with the development of intra-industry trade and other forms of international exchange. Unlike the country-based theories that addressed capital and labor, firm-based theories attempt to capture other parameters that facilitate international trade, such as technologies, quality of goods and services, purchasing power and preferences of customers in domestic markets, brand and corporate loyalty, and many more. Major firm-based approaches to interpreting international trade include product life cycle theory (7 Sect. 19.2.1), country similarity theory (7 Sect. 19.2.2), the technology-related theories (7 Sects. 19.2.3 and 19.2.4), and the economy of scale (7 Sect. 19.2.5). 19.2.1  Vernon’s Model of International Product Life Cycle

One of the first firm-based theories of international trade was put forward in the1960s by Raymond Vernon (further reading: “International Investment and International Trade in the Product Cycle”15). The International Product Life Cycle Theory associates the development of international trade in finished goods with the stages of the product life cycle (see 7 Chap. 7, 7 Sect. 7.1 for the theory of economic cycles and 7 Chap. 15, 7 Sect. 15.3 for the stages of economic growth). The country’s specialization in producing particular goods changes as these goods go through life-cycle phases. Countries that previously exported certain goods may refuse to produce them in the future and switch to importing them (. Fig. 19.3). The New Product Stage. At this stage, production is located in the innovating country (commonly, developed economy, the upper section in . Fig. 19.3), since the bulk of the sales is made in the domestic market. Initially, the demand for new products and their marketability are uncertain. In such an uncertain en-

14 Leontief (1953). 15 Vernon (1966).

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. Fig. 19.3  The product life cycle illustration. Source Authors’ development

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vironment, producers particularly value the proximity to final customers, which provides effective feedback and improves the flexibility of production. Export opportunities gradually open up with gaining popularity and demand in the domestic market. However, producers still strive to be as close as possible to final consumers to receive information about the product and make necessary adjustments to adapt it to the foreign market. Therefore, foreign supply chains are relatively short and undiversified. During the initial phase of a life cycle, demand is price-inelastic due to low competition (see 7 Chap. 5, 7 Sect. 5.4 for the concept of price elasticity of demand and supply). Patent laws protect innovations from being copied by competitors. This means that the higher costs associated with locating production in the domestic market can be passed on to consumers. At this stage, the innovating country monopolizes the new market segment with its new product. The Mature Product Stage. By the time the product reaches the maturity stage, the competition in both the domestic and foreign markets increases. The initial patent protection expires, and producers worldwide start imitating the product (technology, know-how, etc.). The price elasticity of demand goes up with the increased competition, i.e., the innovating firm (country) faces the need to optimize production and reduce costs. An ever-greater portion of the gross output is exported to foreign markets, primarily to developing markets that have not yet established the production of analogous products or substitutions (see the consumption-production gap for developing economies in the bottom section in . Fig. 19.3). To cut costs and gain a competitive advantage, an innovating firm (country) relocates part of production facilities abroad to supply foreign markets directly, eliminate transport costs, and overcome tariff and non-tariff barriers established by the importing country. As a result, the export of goods from the innovating country declines along with domestic output.

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The Standardized Product Stage. Over time, the price elasticity of demand reaches its maximum as international competition grows and many producers worldwide supply similar products. Those who place production in the most competitive environments with the lowest costs win. As a result, output in the innovating country shrinks (higher labor costs, higher taxes, stricter regulations, etc.). The country which initially invented the product and introduced it into the market ceases producing it domestically and starts importing cheaper equivalent goods manufactured abroad until it turns into a net importer of this product. Developing economies emerge into net exporters of standardized products. Technology diffusion, standardization, and lower costs of producing abroad complete the life cycle of a product. The innovating country focuses on developing and launching a new product on the market, and the cycle repeats. Case box According to Vernon, the vast majority of product innovation originates in developed industrialized economies. Evidencing the post-war global economic environment in the 1960s, Vernon put forward the United States with its great industrial, financial, and labor potential not destroyed during the World War II. Developing countries were considered imitators of technologies and innovative products and consumers of standardized goods. However, we may see that many of developing countries act as sources of innovations adopted across the developed world (the most striking examples are China, South Korea, and Southeast Asian economies). In particular, in China, a capacious domestic market and high demand for new products create an innovation-friendly environment. Skilled and relatively cheap labor and scientific and technical potential of the country (in accordance with Vernon’s theory, initially created at the new product stage by imitating best western solutions) spur innovations in China and facilitate their transfer to developing and developed countries.

The product life cycle model emphasizes standardization. Developed countries are expected to export non-standardized goods technology-intensive and capital-intensive goods and import resource-intensive and labor-intensive products. As new technology becomes widespread and the goods enter the standardization stage, production relocates to lower-cost countries. The invention and initial development of technology commonly entail high start-up costs, staff training, and other expenses too high for capital-scarce developing countries. Once the technology becomes standardized, there is no need to use expensive equipment, highly skilled labor, or unique production processes. Therefore, production costs gradually fall. At the standardization stage, technology transfer to lower-cost developing countries becomes relatively easy. 19.2.2  Linder’s Hypothesis

Like many theories of international trade, the product life cycle model addresses international trade from the supply angle: lower production costs allow a country to increase exports and benefit from exploiting its comparative advantage in trade.

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. Fig. 19.4  Overlapping demand. Source Authors’ development

Meanwhile, the international trade agenda can also be approached from the demand side. The Theory of Overlapping Demand, elaborated by Staffan Linder in the early 1960s, says that a good can be exported only when the domestic market is saturated (further reading: “An Essay on Trade and Transformation”16). Linder argued that while factor endowment plays a vital role in determining the transboundary exchange of standardized products, trade in differentiated manufactured goods is way more affected by consumer preferences and tastes influenced by various noncost factors. Putting forward his hypothesis, Linder proceeded from the empirical evidence that trade in industrial goods is primarily concentrated in countries with approximately similar factor endowments. Linder attempted to demonstrate that it is demand, not factor endowment, that determines the composition, volume, and directions of international trade flows. Demand itself depends primarily on the per capita income in a country. The higher the income, the greater the demand for higher-quality and more diversified manufactured goods. Conversely, customers in lower-income countries tend to consume lower-quality standardized goods. The relationship between the level of income and the quality of goods demanded in a country can be illustrated by the line in . Fig. 19.4. Assume that in country A, the level of income varies from X1 (minimum income) to X3 (maximum income). Within this income pattern, people in country A can afford consuming goods whose quality varies from Y1 (the lowest quality threshold for country A) to Y3 (the highest quality threshold for country A). In country B, the level of income is higher than that in country A ([X2 ; X4 ] segment). Consequently, the overall demand pattern in county B captures higher-quality [Y2 ; Y4 ] segment. According to Linder, countries A and B would trade in goods whose quality varies between Y2 and Y3—the interval where demand patterns overlap due to overlapping income patterns. Thus, contrary to the factor endowment model, the closer the countries are to each other in terms of the level of development and income and the structure of demand, the more intensively they

19 16 Linder (1961).

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trade. Since the structure of demand is a function of per capita income, trade between countries with similar levels of per capita income is particularly intense. Domestic producers commonly possess an advantage in the domestic market, as they incur no transport costs and trade tariffs. They strive to maximize these advantages by producing goods most demanded in the domestic market. Thus, assuming fundamental business motivations to be identical in all countries, firms worldwide produce primarily to meet local demand. The prevailing orientation to the domestic market is also facilitated by the lack of information on foreign demand and the producers’ desire to maintain close communication with consumers, swiftly adapting their supply to changing preferences. When the domestic demand is met, producers start looking for new markets. They first explore markets with a similar structure of demand and consumer preferences (easier adaptation of products to local specifics, familiar demand patterns, more reliable information, etc.), i.e., countries with about the same level of per capita income as their country. This effect is illustrated by Linder’s concept of Overlapping Demand— the total demand for products of a certain quality or degree of complexity in all countries involved in international trade. Another essential feature of Linder’s hypothesis is that it emphasizes the tastes and preferences of consumers in determining the directions and structure of trade. Albeit implicitly, Linder demonstrated that permanently changing consumer preferences cause fundamental shifts in international trade. The so-called demonstration effect is that since the 1960s, developing countries have adopted many goods, technologies, and practices from developed economies. Case box Linder’s findings comprehensively and precisely describe the current nature of international trade. Linder’s model applies to trade in differentiated manufactured goods. It explains trade in lower-value-added raw materials and agricultural goods from the standpoint of the Heckscher-Ohlin model. Most of the trade in manufactured goods occurs between industrialized countries with similar inputs and similar levels of per capita income. Stores and markets are flooded with identical products and substitutes hardly distinguishable from each other—they are still traded between countries due to variations in consumer preferences.

Linder also underlined other factors that may affect trade. For instance, he assumed that cultural values and traditions could facilitate consumer preferences. Therefore, trade between countries with the similar cultural background may grow fast. Since distances increase transportation costs, it can be assumed that neighboring countries trade with each other more readily (this assumption was further elaborated by Jan Tinbergen—see 7 Sect. 19.4.4 for the gravity model). Cutting transport costs and introducing new communication technologies reduces geographical remoteness and disconnection of countries and stimulates international trade.

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19.2.3  Posner’s Technological Gap Theory

Changes in consumer preferences commonly reflect technological progress. In this sphere, Linder’s hypothesis intersects with technology-related theories of trade, which argue that the advancement of technologies entails the appearance of new goods along with the emergence of demand for them. Michael Posner suggested that a scientific discovery in one country may result in creating a fundamentally new technology or a new product demanded in other countries. Trade in such novel products grows regardless of factor endowments in individual countries. The technological leadership of an innovating country turns into the technological gap which drives international exchange. Gradually, other countries master innovations, and the gap decreases. All countries benefit from technological diversities. Those who export innovative products profit, and those who import them acquire new goods and technologies. As the innovation spreads, an innovating country loses its advantage and tries to establish a new one (further reading: “International Trade and Technical Change”17). An innovating firm that invents new products or technologies receives a quasi-monopoly profit due to the difference between the market price (high price for a highly demanded product) and production cost (new technology reduces costs and improves productivity). The profit (or advantage in producing a good) is gained until competitors in the domestic and foreign markets imitate the new product (technology). Imitation requires time, over which technology spreads to other countries. Posner distinguished two types of time lags: 5 Demand-side lag—time period required for foreign consumers to demonstrate demand for a new product. The faster they react, the sooner the export grows, and the more producers in other countries get involved in the competition generated by this innovation. 5 Imitation lag—time period required for foreign producers to start imitating new products or technologies. Its length depends on how well the innovation is protected by national or international patent law. Initially, a country A can be a net importer of a good, although produce a certain amount of this good domestically ([0; t1 ] time interval in . Fig. 19.5). A technological breakthrough allows country A increase domestic output Y and reduce imports M ([t1 ; t2 ] interval). Eventually, the country becomes a net exporter of the good (t2 and beyond). The time lag in demand or consumer reaction determines how quickly exports expand within the [t2 ; t3 ] time interval, when country A’s innovation is copied by other countries. As imitating expands, domestic output in country A reaches its peak and starts falling along with exports (t3 and beyond). Country A may even cease domestic production and again turn into a net importer. On the other hand, producers in country A may introduce new advancements, restore their technological leadership, and give rise to a new trade cycle based on the technological gap. At the later stages of the product life cycle ([t2 ; t3 ]

19 17 Posner (1961).

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. Fig. 19.5  Technological gaps in international trade. Source Authors’ development

and beyond), production commonly moves to countries where production costs are lower. Relocating production of mature goods, firms aim to reduce costs and thus extend the product life cycle by boosting the product’s competitiveness. Many developing economies used to build their economic development and industrialization strategies on copying mature products and technologies and improving them. The low cost of factors of production made mature goods competitive in price in developing markets. At the same time, lower effective demand (compared to developed economies) was efficiently satisfied at [0; t1 ] and [t1 ; t2 ] stages by more affordable mature products rather than expensive high-tech novelties. Posner’s technology gap theory is an elaboration of the concept of comparative advantages a country possesses and develops to gain profit from ­participating in international trade. As opposed to the Heckscher-Ohlin theory, which attributes comparative advantages to capital and labor endowments and their use in producing export and import goods, Posner emphasizes the role of acquired advantages in facilitating international exchange (such as the technological progress, research and development, attraction of labor and intellectual property from abroad, etc.). Temporary comparative advantages in possession of knowledge embodied in production allow countries to reduce costs and thus compete in foreign markets. 19.2.4  Hicks’ Theory of Technological Progress

Emphasizing technology as an independent factor of production and the international competitiveness determinant has significantly influenced the international trade narrative. Depending on the interpretation of technology, its exchange can be considered both a trade (albeit in a specific product) and a transboundary

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. Fig. 19.6  Neutral technological progress. Source Authors’ development

movement of the factor of production (the resource used in producing goods and rendering services). Along with labor, technology can be perceived as a labor-related resource that alone or in combination with land and capital is used to produce goods. However, technologies are much more mobile compared to other factors of production. Its development is fueled by the ever-accelerating technological progress that drives trade. Such a vision of the role of technological progress in the development of international trade was proposed by John Hicks (further reading: “The Theory of Wages”18). Hicks’ Theory of Technological Progress postulates that all goods are produced with the use of labor L and capital K . Their relative price (wr, or the wage-return ratio) remains constant. Based on possible combinations of labor and capital as factors of production, Hicks distinguished neutral, labor-saving, and capital-saving types of technological progress. Neutral Technological Progress is based on a technology that simultaneously increases the productivity of both labor and capital. In the course of neutral technological progress, the amount of labor and capital spent on producing a certain amount of goods reduces. At the same time, the relative amount of capital expressed in labor (KL ) and the relative amount of labor expressed in capital (KL ) remain unchanged. Suppose the production of a certain quantity of good X requires four units of labor and four units of capital (point A1 in . Fig. 19.6). Neutral technological progress (KL = 1) allows a firm to reduce the required amounts of K and L by two units each. Producing the same quantity of good X now requires only two units of capital and two units of labor (point A2). With a constant wage-return ratio, the improvement in productivity from A1 to A2 does 8L 4L = 4K = 1 and affect the relative amount of capital expressed in labor (wr = 8K K 4K 2K = = = 1 ). L 4L 2L

19 18 Hicks (1932).

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. Fig. 19.7  Labor-saving technological progress. Source Authors’ development

Labor-Saving Technological Progress is based on a technology that increases the productivity of labor relatively more than the productivity of capital. As a result, the relative amount of capital used in producing a certain quantity of good X increases, while the relative amount of labor decreases at the constant relative price of capital. Capital replaces labor in the inputs portfolio. The total amount of labor and capital spent on producing good X declines, but the relative contribution of capital rises. Labor-saving technological progress saves both labor and capital, but makes an industry in which it occurs relatively capital-abundant (in . Fig. 19.7, three units of capital per one unit of labor (KL = 3) instead of the one-to-one ratio (KL = 1) in the case of neutral progress). As a result, producing of the same quantity of good X requires only one unit of labor and three units of capital (point A3). Capital-Saving Technological Progress is based on a technology that increases the productivity of capital relatively more than the productivity labor. The relative amount of L used in producing a certain quantity of good X increases, while the relative amount of K decreases at the constant relative price of labor. Labor replaces capital in the inputs portfolio. The total amount of L and K spent on producing good X declines, but the relative contribution of labor rises. Capital-saving technological progress saves both labor and capital, but makes a industry in which it occurs relatively labor-abundant (in . Fig. 19.8, three units of labor per one unit of capital (KL = 31) instead of the one-to-one ratio (KL = 1) in the case of neutral progress). As a result, producing of the same quantity of good X requires only one unit of K and three units of L (point A3). In the absence of trade, any technological progress drives up the wellbeing of a country where it occurs, since it boosts productivity (the per capita domestic output). The impact of technological change on international trade depends on how it affects supply and demand. An output growth due to technological change can have a neutral, positive, and negative impact on the foreign trade of a country. The neutral one occurs when trade increases at the same rate as production. The positive impact of technological progress on trade occurs if trade growth outpaces that

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. Fig. 19.8  Capital-saving technological progress. Source Authors’ development

of production. It commonly happens when export-oriented industries grow faster than import substitution (at constant relative prices). The effect is recognized as negative when trade growth lags behind the output growth (domestic supply increases faster than exports). Similarly, consumption growth resulting from technological change can exert a neutral, positive, or negative impact on trade. When trade increases at the same rate as consumption, the impact is neutral. The positive impact of technological progress on trade manifests itself in outstripping the growth of trade compared to consumption (for example, demand for foreign goods increases faster than demand for domestic goods). The impact is negative if the trade fails to keep pace with the demand in the domestic market. Thus, the influence of technological progress on trade varies depending on whether supply and demand strengthen or neutralize each other. If both production and consumption exert a neutral effect on international trade, it increases at the same rate as production. If both production and consumption have a positive impact on trade, it increases at a faster rate than output. If the combined influence is negative, trade falls behind the production. Therefore, the impact depends on which factor has a stronger influence on international trade. 19.2.5  Krugman’s Economies of Scale

The four firm-based theories discussed above are variations of technological theories of international trade that emphasize the role of scientific and technological progress in shaping global trade patterns. A similar idea related to a transfer of production to other countries lies at the core of the theory of economies of scale formulated by Paul Krugman in the early 1980s (further reading: “Increasing Returns, Monopolistic Competition, and International Trade”19). According to Krug-

19 19 Krugman (1979).

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man, after satisfying domestic demand, countries (firms) start expanding their market space by entering foreign markets, which may turn into oligopolistic markets due to the consolidation and transnationalization of producers. The Economies of Scale Theory is a theory of international trade that postulates that countries with similar factor endowment benefit from foreign trade when specializing in those industries in which economies of scale occur (cost per unit of output declines as output increases). The theory demonstrates mutual benefit from trade between countries equally endowed with factors of production, provided that they specialize in different industries and reduce costs by developing mass production. Krugman’s theory is based on the concepts of economies of scale and monopolistic competition. The essence of Economies of Scale is that the appropriate level of technology and organization of production implies a reduction in long-term average costs as output increases (economies due to mass production). Specialization makes it possible to expand production, cut costs, and thus receive an advantage in the market. Krugman distinguishes external and internal economies of scale. The external effect is a reduction in production costs due to the growth in the scale of production in the industry. External economies of scale are manifested in the increase in the number of firms specializing in producing similar goods or services. The increase in the number of firms in the industry reinforces competition between them. With a pure external effect (no growth in the size of competing firms), perfect competition prevents producers (exporters) from raising their prices. Krugman abandoned the assumption of technology with constant returns and replaced it with the idea of internal economies of scale. The term “internal” emphasizes that it is the scale of production of an individual firm that determines unit costs (compared to the external economies of scale, when the size of the industry, not of a single firm, affects costs of a firm). Internal economies of scale are manifested in reducing production costs due to the scaling of production of an individual firm. The distinction between external and internal effects is fundamental, as it determines the nature of competition in the industry. Internal economies of scale occur with no change in the output of a good, but with a decline in the number of firms producing that good. This effect contributes to the monopolization of markets. With a pure internal effect, producers can change their prices assertively in an imperfectly competitive environment. The free market in the industry results in the concentration of all available resources in one firm that minimizes its unit costs. Thus, the economies of scale disrupt perfect competition and result in the concentration of production and the consolidation of firms (see 7 Chap. 3, 7 Sect. 3.2.3 for the concept of monopolistic competition). Since the 1980s, international trade has increasingly concentrated in giant transnational corporations. Such a concentration has resulted in the increase in intra-firm trade facilitated by strategic goals of a firm rather than the comparative advantage principle or factor endowment. In monopolistic competition, each firm produces its own kind of product (monopolizes its own brand). Brands compete for a consumer who may prefer one brand over another (despite the fact the products may be identical).

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Krugman demonstrates that with economies of scale and monopolistic competition, an increase in market size (an expansion to foreign markets) results in an increase in a variety of goods and competition between brands (biggest companies) and a simultaneous decrease in firms’ costs and prices for consumers. Therefore, economies of scale and monopolistic competition scale up the market. Krugman’s theory explains many of contemporary development in international trade and maps out trends, such as changes in the spatial allocation of production facilities between developed and developing countries, the distribution of commodity flows, fluctuations of resource prices, and the mobility of labor and capital. 19.3  Alternative Concepts of International Trade 19.3.1  Haberler’s Theory of Opportunity Costs

In the 1930s, the classical interpretations of the theory of comparative costs were revised with consideration for the realities of the general equilibrium theory of that time (rather, disequilibrium and the increasing economic imbalances that turned into global crises—see 7 Chap. 7, 7 Sect. 7.3 for the economic crises of the modern age). An essential contribution to the reinterpretation of the concept of comparative costs was made by Gottfried Haberler (further reading: “The Theory of International Trade with its Applications to Commercial Policy”20). Haberler’s Theory of Opportunity Costs transformed the classical Ricardian labor-based concept of costs by postulating that the cost of good X is measured in lost units of the output of good Y , not in units of labor spent on producing good X . The theory is based on the following premises: 5 each country has its own production possibility frontier that shows the ratio in which a country can produce two goods using all available resources, factors of production, and the best technology (see 7 Chap. 16, 7 Sect. 16.3 for the concepts of production possibility frontier and increasing opportunity costs); 5 countries export goods in which they possess the best production possibilities (Haberler particularly emphasized technologies) compared to other countries; 5 spread of advanced technologies around the world bridges technological gaps between countries and triggers changes in the commodity composition and directions of international trade. In accordance with the labor theory of value, cost is determined by the time (labor) spent on producing that good. Similarly, comparative advantages of countries in international trade are determined based on the labor-output ratio (see Ricardo’s interpretations of comparative advantage and opportunity costs in 7 Sect. 19.1.3). According to Haberler, Opportunity Cost is the value of one

19 20 Haberler (1936).

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good, expressed in the value of another good, the production of which must be reduced in order to free up resources required to produce one more unit of the first good. With limited resources, opportunity costs are always positive. Any economic entity aims to minimize these costs. A country obtains a comparative advantage in producing a good compared to another country if it can produce this good with a lower opportunity cost. Production possibility frontiers (see the comparative advantage illustration in . Fig. 19.2) demonstrate all of the combinations of goods that can be produced with full employment of all available factors of production. In the absence of trade, no country can go beyond its frontier. However, in the long run, the attraction of new resources, productivity growth, and technological advancements shift the production possibility frontier upward right. The difference in the relative prices of goods between countries (in slopes of their production possibility curves or opportunity costs of goods) reflects comparative advantages of these countries and lays the foundation for specialization and mutually beneficial trade. The convergence of production possibility curves with consumer indifference curves makes it possible to establish supply-demand equilibrium points. This method clearly demonstrates the benefits of international trade to all involved countries. In line with Ricardo, Haberler states that international exchange optimizes the use of the productive potential of participating countries. Case box Haberler’s model can be illustrated on the example of countries A and B and goods X and Y . Suppose country A spends two units of labor to produce one unit of good X and four units of labor to produce one unit of good Y . In country B, producing goods X and Y requires five units of labor each. According to the absolute advantage principle, country A enjoys absolute advantages in producing both goods as it spends fewer units of labor. However, what matters in international trade is the difference in opportunity costs. In country B, opportunity costs of producing goods X and Y are equal. That means that to increase the output of good X by one unit, country B drags five additional units of labor from producing good Y , i.e., cuts output of good Y by one unit. In country A, an increase in the output of good X by one unit costs 0.5 units of good Y (24 units of labor), but the reversal increase in the output of good Y requires abandoning two units of good X (24 units of labor). Thus, in terms of opportunity cost, good X is cheaper in country A, while good Y is cheaper in country B. Lower opportunity cost facilitates comparative advantage. Country B benefits from concentrating its resources on producing good Y , exporting it to country A, and receiving higher gain due to a higher exchange ratio. Similarly, country A benefits from specializing in good X . In the absence of international exchange, country A would sell two units of good X to get one unit of good Y in the domestic market (2X = 1Y ). Trading with country B, country A saves 0.5 units of good X per unit of good Y (1.5X = 1Y ).

In the global market, the comparative advantages balance is distorted by various interferences (monopolies and oligopolies, exogenous economic influences on

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domestic markets, information asymmetries, and many more). Each of these distortions can either depress or favor comparative advantages by affecting opportunity costs in trading countries. One of the shortcomings of Haberler’s theory is that it does not reveal the determinants of differences in production efficiency or advantages in technology. Nor does it answer the question of why certain countries retain leadership in the global markets for decades, although they should have lost it according to the theory of technological gap. 19.3.2  Minhas’ Theory of Factor Intensity Reversal

In the second half of the XX century, the theory of relative factor endowment underwent substantial revisions aimed at weakening rather strict Heckscher-Ohlin assumptions (see above in 7 Sect. 19.1.4). The Leontief paradox demonstrated that in some cases, the Heckscher-Ohlin fails to explain why labor-abundant countries export capital-intensive products, while capital-abundant ones specialize in supplying labor-intensive goods. One of the possible explanations is the reversal of factors of production: the same good can be labor-intensive in a labor-abundant country and capital-intensive in a capital-abundant country. The reversal occurs due to the high elasticity and interchangeability of factors of production. According to the theory of relative factor endowment, if good X is labor-intensive in labor-abundant country A and the same good X is capital-intensive in capital-abundant country B, then both country A and country B should specialize in producing and exporting good X . However, the fundamental assumption of the two-countries trading system, in which each country exports good X , disables any trade, because no consumer wants to import good X . As a result, the Heckscher-Ohlin theorem turns out to be not applicable universally. The factor reversal phenomenon was first explained by Bagicha Minhas in the early 1960s. Factor-Intensity Reversal is a situation in which the same good can be capital-intensive in a capital-abundant country and labor-intensive in a labor-abundant country. Minhas’ theory describes a situation in which international trade develops due to differences in the inputs’ productivity between labor-abundant and capital-abundant countries (further reading: “The Homohypallagic Production Function, Factor-Intensity Reversals, and the Heckscher-Ohlin Theorem”21). Case box One of the most striking examples of Minhas’ idea of factor reversal is agricultural production in developed and developing countries. In developed countries of Europe and North America, the agricultural sector tends to be more capital-intensive and higher-equipped with advanced machinery and equipment compared to developing economies in Asia, Latin America, and Africa. Rice cultivated in capital-abundant Europe

19 21 Minhas (1962).

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. Fig. 19.9  Substitution of factors of production between two countries. Source Authors’ development

is a capital-intensive commodity because its production involves a substantial amount of mechanization and advanced technology. Rice farmed in labor-abundant Asia is a labor-intensive commodity due to scarce capital and a substantial amount of labor employed in the agricultural sector. Despite the fact that both European and Asian countries farm rice, trade in rice between continents occurs due to a different combination of inputs used in rice production.

Suppose countries A and B produce goods X and Y (. Fig. 19.9). In country A, producing a unit of good X costs seven units of capital and two units of labor (point A) (KL = 27). At the same relative price of labor, producing a unit of good Y requires less capital, but more labor (KL = 35 at point B). Since 27 > 53, good X is a relatively capital-intensive product compared to good Y . In country B, producing a unit of good X costs two units of capital and seven units of labor (point D) (KL = 27). At the same relative price of labor, producing a unit of good Y requires less labor, but more capital (KL = 53 at point C). Since 27 < 53, good X is a relatively labor-intensive product compared to good Y . Therefore, the same good X is at the same time a capital-intensive good in country A and a labor-intensive good in country B. The difference in intensiveness is determined by the degree of curvature of the good X and good Y curves (the capital elasticity of labor, and vice versa). Elasticity of Substitution is a coefficient that shows how difficult it is to replace one factor with another in producing a specific good. It is calculated as the ratio of the percentage change in the capital-labor ratio to the percentage change in the relative price of factors of production. The theory of factor intensity reversal addresses trade determinants from the supply side. The theory of demand reversal provides an alternative explanation of the Leontief paradox from the demand side. Classical theories assumed consumer preferences to be identical across trading nations, but they are definitely not. Suppose that domestic consumers demand those products in which their country enjoys sufficient factor endowment. Demand Reversal is a situation in which a country imports those goods in which it possesses comparative advantage

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(relatively better factors endowment compared to its trading partners). Empirical studies evidence such a phenomenon, but its role in shaping international trade patterns is negligible. 19.3.3  The Samuelson-Jones Theorem

An alternative interpretation of the relative factor endowment was proposed by Paul Samuelson and Ronald Jones (further reading: “Ohlin Was Right”22 and “A Three-Factor Model in Theory, Trade and History”23). According to the specific factors model (Samuelson-Jones Theorem), international exchange is facilitated by differences in production costs due to different factor endowments of trading countries. Trade results in the growth of return on those factors of production that are specifically employed in export-oriented industries. As previously demonstrated in 7 Sect. 19.1.3, the Ricardian comparative advantage model laid the groundwork for many theories of international trade. International division of labor and exchange trigger international specialization. Countries direct their resources to the industries where they can be used comparatively more efficiently. Ricardo postulated that trade benefits not only countries but all people, but he ignored the impact of trade on income distribution. However, trade obviously affects income, and the effects vary both between and within countries. Exchanging labor between industries due to changes in demand for labor requires time and money. Changes in products portfolio exert different effects on the demand for different factors of production. As a result, international trade is not as equally beneficial to all people as the Ricardian model suggests. It benefits the nation, but can be detrimental to certain people or industries. Similar to the Ricardian model, the Samuelson-Jones model considered a production system with two kinds of goods produced and resources distributed between the two sectors. However, unlike Ricardo, Samuelson and Jones captured other factors of production than labor. They accepted labor to be a mobile factor of production, i.e., employable in different industries. Other inputs were called specific factors (used in producing certain types of goods). The model explores two sectors (industrial production and agriculture) and three factors of production (labor, capital, and land). Manufacturing uses labor and capital (no land), while agriculture utilizes land and labor (no capital). Thus, labor is considered a mobile factor (used across sectors). Capital and land are specific factors used only in one sector. Since labor is mobile, it can move freely from one sector to another. That means that labor would most probably flee from a lower-wage sector to a higher-wage one until wages in both sectors equalize. In the case of proportional changes in demand and prices across sectors, the distribution of labor between

19

22 Samuelson (1971). 23 Jones (1971).

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sectors and the intersectoral output ratio remains unchanged. However, the intrasectoral change in either prices or demand triggers changes in relative prices and other economic proportions across the economy. Thus, an increase in the price of manufactured goods drives up demand for labor in the industrial sector. Wages w go up, but to a lesser extent than prices of manufactured goods Pm. Labor moves from agriculture to the industrial sector. As a result, industrial output rises, while food production declines. At the same time, relative prices also change. This explains why wages do not increase to the same extent as the price of manufactured goods changes. Real wages of industrial workers expressed in price of manufactured goods Pwm declines, i.e., manufactured goods become relatively more expensive for workers. Real wages expressed in the price of agricultural products Pwa go up, i.e., food products become relatively cheaper. Amid rising output and falling real wages, producers’ income increases. As Pwm declines, the income of capital owners per unit of output grows in greater proportion than price. In the agricultural sector, the income of landowners goes down due to an increase in prices for manufactured products and the consecutive increase in real wages relative to the cost of food. Agricultural products become relatively cheaper in the market, and farmers lose. Countries differ in relative prices of manufactured and agricultural products. International trade results from the differences in the relative supply of goods. As discussed previously with regard to other theories of international trade, differences in relative supply are commonly related to factor endowments, level of technological development, and other factors. Most likely, a capital-abundant country with scarce natural resources would seek to specialize in manufacturing, while a resource-abundant country with scarce capital would be forced to specialize in agricultural production. Trade between the two countries establishes an integrated economy in which the total output equals the aggregated industrial and agricultural product of the two economies. Consequently, the relative world price of manufactured goods PPma balances between prices that existed in trading countries before trade started. As a result, trade increases the relative price of manufactured goods in a capital-abundant country and decreases that price in a resource-abundant country. In a capital-abundant country, an increase in the relative price of manufactured goods boosts food consumption and decreases relative agricultural output. In a resource-abundant country, international trade causes a decrease in the relative price of manufactured products, increases relative consumption in the industrial sector, and decreases relative industrial output. As a result, a resource-abundant economy becomes a net importer of manufactured goods and a net exporter of agricultural products. Therefore, trade differently affects income across the population. Samuelson and Jones base the assessment of this impact on changes in relative prices. In a capital-abundant country, changes in relative prices increase the income of capital owners and decrease the income of landowners. In a resource-abundant country, by contrast, the income of landowners rises, and the income of capital owners falls as relative prices of manufactured goods decline. Thus, Samuelson and Jones conclude that international trade benefits owners of abundant specific fac-

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tors of production employed in export-oriented industries. Owners of factors specifically used in import-oriented sectors lose. 19.3.4  Balassa’s Theory of Intra-industry Trade

One of the alternative interpretations of international trade as an intra-industry process was put forward by Bela Balassa and Herbert Grubel (further reading: “Tariff Reductions and Trade in Manufactures among the Industrial Countries”24 and “Intra-Industry Specialization and the Patters of Trade”25). They interpreted international trade as a composite of intra-industry and inter-industry trade. The latter is the international exchange of goods and services between industries. As discussed above regarding the classical country-based theories, this type of trade is facilitated by comparative advantages of trading countries. Intra-Industry Trade is the international exchange of goods and services within one industry. It can be facilitated by: 5 reduction of transportation costs between countries (for example, it is cheaper for a firm to import resources or goods than buy them domestically); 5 consumer preferences (consumers prefer foreign goods over domestic analogs); 5 seasonal differences (the same goods may be exported at one time of a year and imported in the other, for example, agricultural products); 5 economies of scale (specialization of firms in different countries on producing and exporting the same product with slightly different features—see Krugman’s theory of the economies of scale in 7 Sect. 19.2.5). Intra-industry trade is common to manufacturing industries in countries with a comparable level of technological development (trade in finished products between developed countries). Inter-industry trade occurs between developed and developing economies (for example, developing countries export resources and import finished products). Commonly, intra-industry trade does not trigger substantial migration of labor between industries, but within sectors, workers may acquire new specializations to adapt to changes in demand for highly differentiated products. Specializing in a particular industry, a small country can scale up its market by reaching foreign consumers and competing with larger economies in certain niche markets. Returns to all factors of production (regardless of whether they are relatively abundant or relatively scarce in particular countries) grow due to the economies of scale (. Table 19.1). Suppose D is the demand curve for differentiated products supplied by a firm in the monopolistic competitive market with several sellers of very similar goods (. Fig. 19.10). To increase sales in the monopolistic competitive environment, a firm must cut down price P (see 7 Chap. 3, 7 Sect. 3.2.3 for the monopolistic

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24 Balassa (1966). 25 Grubel (1967).

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. Table 19.1  Differences between intra-industry and inter-industry trade Parameters

Inter-industry trade

Intra-industry trade

Background

Theory of relative factor endowment

Theory of the economies of scale

Determinant

Comparative advantages in producing goods

Product differentiation

Factor endowment

Different relative factor endowment in trading countries

Similar or close relative factor endowment in trading countries

Countries

Predominantly developed and developing countries and economies of different sizes

Predominantly developed countries and same-size economies

Industries

Predominantly between major industries, e.g., industry and agriculture

Predominantly within industrial sectors

Goods

All types of homogenous goods and finished products

Product components and differentiated products

Economic effects

An increase in return on relatively abundant factors of production and a reduction in return on relatively scarce factors

An increase in return on all factors of production

Social effects

Significant social effect due to cross-sectoral shifts of labor

Negligible social effects

Source Authors’ development

. Fig. 19.10  Intra-industry trade in differentiated goods. Source Authors’ development

competition). Therefore, the MR marginal revenue curve is located below the D curve. The latter shows that a firm can sell Q1 units of a good for P1 each and get the Q1 × P1 revenue (point A) or sell Q2 units of a good for P2 each and get the Q2 × P2 revenue (point B). The change in the marginal revenue is less than the price of the additional unit of a good sold. But a firm experiences the econ-

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omies of scale, as in the intra-industry trade, it specializes in producing a specific good for the domestic and foreign markets. The AC average cost curve shows a reduction in costs as output increases (the economies of scale effect). As a result, the MC marginal cost curve is located below the AC curve, which can only be cut down to the MC level. The optimal output volume for a firm would be Q2 (point C at the intersection of the MR and the MC curves). If output exceeds Q2, then MR < MC, that is, the firm spends more than it gains (output should be reduced). If a firm produces less than Q2 units of its good, then MR > MC, that is, revenues exceed production costs (output can be expanded). With an optimal level of output Q2, a firm can charge P2 per unit (point B at the D curve). But since competitors enter the market with their highly diversified products, the AU curve also passes through point B, showing that a firm receives only an average return on its investment. Therefore, the firm’s profit from intra-industry trade is [C; B], the interval between its marginal revenue and the average cost at the optimal output. The degree of development of intra-industry trade is measured by the GrubelLloyd index (Eq. 19.1):

GL = 1 −

|X − M| X +M

(19.1)

where GL  the Grubel-Lloyd index; X exports; M imports. If GL = 0 (minimum value), then no intra-industry trade exists (only possible when either export or import is zero). If GL = 1 (maximum value), then intra-industry trade is at its peak (only possible when exports equal imports). One of the limitations of the index is that its value highly depends on how the industry or product group is defined. The broader the definition, the more likely it is that countries trade in a wide range of differentiated goods within a commodity group. The narrower the product group, the lower the GL value. 19.4  Emerging Theories of International Trade 19.4.1  Melitz’s Model of Heterogeneous Firms

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Since the 1990s, the development of information technologies and international databases on production, investments, and trade has allowed economists to reveal that only a tiny part of firms in different countries are involved in international trade. Across developed countries, less than 20% of companies exported or imported any goods or services. At the same time, such companies differed from those operating in domestic markets only by adopting more advanced production technologies and management practices, hiring more skilled labor, and offering higher

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. Fig. 19.11  Heterogeneity as a determinant of international trade. Source Authors’ development

wages. In the early 2000s, Marc Melitz summarized these diversities in the form of a mathematical Model of Heterogeneous Firms (further reading: “The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity”26). Melitz hypothesizes that the development of international trade is the cumulative effect of individual decisions of individual firms different in size, productivity, and many other parameters. Firms themselves decide whether they focus on the domestic market or export their goods, make foreign investments or not, import resources and other inputs or purchase them domestically, etc. According to Melitz’s model, only the most competitive, productive, and profitable firms can withstand high sunk and fixed costs associated with doing business internationally. Sunk Costs are expenses that cannot be recovered and that do not depend on decisions made today (for example, expenditures on creating an export product). Fixed Costs are expenses that do not depend on output and the economies of scale (for example, the overall cost of anchoring in the market of any foreign country: representative offices, marketing and distribution networks, service centers, etc.). These costs are higher the greater the number of countries in which a firm operates. High costs associated with entering foreign markets result in the fact that only the most competitive firms can expect to receive benefits from participating in international trade (put it another way, all the benefits concentrate in the hands of the largest companies that can bear higher expenditures). Entering the global market spurs the growth of most competitive firms and breaks the least competitive ones. Such qualitative changes lead to an increase in the average productivity in economies deeper integrated into the global market. Melitz distinguishes three categories of firms: non-exporting (operating in the domestic market only), exporting (those that either export or import goods and services), and multinational (firms that make foreign direct investments and set up production and distribution facilities abroad) (. Fig. 19.11).

26 Melitz (2003).

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Domestic Market. In a simplified form, profit is the difference between revenue and fixed costs. In the domestic market, the former depends on the demand for the firm’s products and the productivity of this firm. At a productivity level below Xdom, a firm goes bankrupt because its profit does not cover its fixed costs (−Y dom). Higher performing firms (X > Xdom) survive. Those who survive then face a choice to continue operating in the domestic market or try foreign markets. Export. At the same price elasticity of demand for a given product in domestic and foreign markets, demand in the foreign market could differ. Transportation costs, insurance, importduties, and other expenditures increase firm’s total costs from (−Y dom ) to −Y exp . To be able to cover the increased costs associated with entering the foreign market and make a profit, the exporting firm should increase its productivity compared to the non-exporting one ( Xexp compared to Xdom, respectively). Therefore, only firms whose productivity exceeds Xexp can compete in the foreign market. Those with productivity Xdam < X < Xexp are competitive in the domestic market only. Foreign Direct Investments. Suppose now that a firm has made direct investments abroad and built a factory in a foreign country to supply goods directly to foreign  customers. Such as investment would substantially increase fixed costs −Y exp from to (−Y inv ). However, having added to fixed costs, a firm saves on its variable costs (no transboundary transportation costs, customs clearance, etc.). Due to the reduction of variable costs, the cut-off productivity threshold Xinv corresponds to the intersection of the export and the investment curves, not the intersection of the investment curve with the productivity axis. Therefore, only the most productive firms (X > Xinv) can afford making foreign direct investments, although they can simultaneously export their goods and supply them domestically. Lower-performing firms (Xexp < X < Xinv) do not make investments, but still sell their goods in both foreign and domestic markets. Those with productivity Xdom < X < Xexp operate in the domestic market only, while the worst-performing firms (X < Xdom) fail. Melitz’s model of heterogeneous firms formalizes the following three statements: 5 Firms that produce differentiated products differ in their productivity. 5 Of all the firms in the domestic market, only the most competitive and profitable ones can become exporters, since entering the foreign market is associated with substantial additional costs. Accordingly, only the most successful of exporters can invest in setting up their production and distribution facilities abroad. 5 Before making a decision on entering the foreign market, the company’s management should model fixed and variable costs.

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Melitz integrated these provisions into a simple and empirically ascertainable model that allows one to find out which firms export and what products, which firms invest abroad and how much they can invest, and which firms supply exclusively to the domestic market. The model shows that international trade improves the wellbeing of the economic entities involved. However, due to the high costs associated with entering the foreign market, the most productive and profitable

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firms receive most of the benefits, further increasing their market share and profits. Lower-productive firms lose market share and part of profits. The attempt of a lower-performing firm to improve its market position by doing business internationally may ruin the business. Therefore, international trade facilitates business evolution—most competitive actors survive and develop, while the least productive ones become extinct. By removing inefficient economic entities from the market, international trade increaseы the overall performance of the global economy. 19.4.2  Theory of Incomplete Contracts

Another direction of the economic analysis of international trade that evolved in the early 2000s is the Theory of Incomplete Contracts, elaborated by Oliver Hart, Sanford Grossman, and John Moore. The application of the theory to explaining the international exchange of goods and services has drawn attention to the fact that most contracts cover product components specifically used in producing certain goods. Trade in such intermediate products always depends on the production of and demand for final goods (further reading: “The Costs and Benefits of Ownership”,27 “Property Rights and the Nature of the Firm”,28 and “Firms, Contracts, and Financial Structure”29). Incomplete contracts include outsourcing (the use of independent suppliers) and insourcing (the use of associated suppliers or in-house agencies). The development of international trade is determined by firms’ decisions on attracting foreign suppliers. With outsourcing, trade occurs between two independent firms. With insourcing, trade is facilitated by direct foreign investments in establishing divisions abroad (domestic and foreign divisions of one firm trade with each other). Thus, the theory of incomplete contracts postulates that international trade is a consequence of the firm’s decision to purchase intermediate products abroad from either its subsidiaries or independent foreign suppliers. Factors that motivate firms to prefer international outsourcing over domestic one include lower costs for manufacturing components abroad, technological progress in international communications, and complementarity in the factor endowment. The choice between international outsourcing and international insourcing is conditioned by higher direct investment costs in case of insourcing, transferring part of the costs to an intermediate supplier in case of outsourcing, and the cost of capital as a factor of production in relation to prices of products and factors of production. Incomplete contracts tie manufacturers of components to producers of finished goods, since the former can not sell their intermediate products separately from final goods. As added value of components is lower compared to the added value of final goods, intermediate suppliers strive to increase their part in final

27 Grossman and Hart (1986). 28 Hart and Moore (1990). 29 Hart (1995).

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profit by cutting production costs on their side, optimizing supplies, and introducing innovations that ultimately affect both the price and the quality of a final product. 19.4.3  Porter’s Theory of Competitive Advantage

The most well-known manifestation of the theory of incomplete contracts is global value chains. The concept of value chains was developed by Michael Porter, who divided economic activities of a firm into segments, such as logistics, production, marketing, sales, service, and others. Costs a firm incurs at each stage aggregate in the final cost of a product. Global Value Chains start up when producing and distributing a good involves segments represented by different companies (independent firms or subsidiaries in different countries) (further reading: “Competitive Advantage: Creating and Sustaining Superior Performance”30). By elaborating the Theory of Competitive Advantages, Porter hypothesized that the involvement of countries and individual firms in global value chains (i.e., the role in the global economy) is determined by four factors: the quantity and quality of factors of production, demand in the domestic market, the availability of related and supported industries, and the firm’s strategy and competition. 5 Following the neoclassical interpretation of comparative advantages in trade, Porter recognized factors of production to be the primary determinant of competitive advantage. Factor endowment is essential, but natural advantages must be continuously improved to ensure the permanent development of acquired advantages. 5 Demand in the domestic market results from both factor endowment and the level of development of acquired advantages. A competitive country continuously improves its supply by implementing advanced technologies and other product and process innovations, thus creating and supporting demand for its products in the domestic market and abroad. 5 Related and Supporting Industries incentivize and facilitate product improvements. Contemporary global value chains involve dozens of development companies, suppliers of raw materials and equipment, manufacturers, distributors, transport companies, marketers, and other supporting companies who jointly create a single competitive product and share the added value created within a chain. 5 Competition in the domestic and international markets forces firms to elaborate comprehensive development strategies and update them to be able to maintain their competitive advantages. Any company is focused on gaining a strong position in the market, so it must constantly look for new ways to reduce production costs, improve the quality and other features of its goods, and attract new consumers.

19 30 Porter (1985).

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Porter emphasizes that countries perform the best in those industries where all four determinants of competitive advantage support and amplify each other (the so-called Porter’s Diamond). The government is “a catalyst and a challenger” of these intra-diamond relationships. By pursuing certain economic policy, governments affect the parameters of competitive advantages by affecting the supply of factors of production, stimulating demands, and setting competition patterns. Exploiting their competitive advantages in the global market, countries benefit from participating in international trade in the following ways: 5 overcoming domestic factor endowment and resource constraints; 5 scaling up the domestic market and linking it with the world market by building domestic firms into global value chains; 5 earning additional income due to the difference between domestic and global average production costs; 5 developing country’s specialization, which contributes to increasing the productivity of resources and output gains; 5 boosting employment by expanding export-oriented production; 5 accelerating progressive structural shifts in the economy; 5 improving the organizational and technical base of production and enhancing the quality of goods and services, which results in an increase in labor productivity and overall efficiency of the economy. In addition to these country-level benefits, international trade contributes to establishing the new normal patterns of global economic development and growth: An increase in exchange between countries synchronizes economic cycles globally. On the one hand, such a close interdependence of individual economies fosters the spread of local disbalances (see 7 Chap. 7, 7 Sect. 7.3 for crises of the modern age). On the other hand, it allows countries to agree on a united approach to combating global problems and addressing global challenges. The overall sustainability of the system improves. International trade accommodates and coordinates all forms of exchange and other links between countries, such as capital, labor, and currency exchange, balances of payments, production cooperation, collaboration in science and research, and others. Trade depends on interregional and interstate relations, which is an essential prerequisite for developing international economic integration. Finally, international trade contributes to the further deepening of the international division of labor and the internationalization of economic relations between countries. 19.4.4  The Gravity Model

The growing interconnectedness of national economies has inspired a renewed interest to spatial models of international trade, notably the Gravity Model, first formulated by Jan Tinbergen in the 1960s (further reading: “Shaping the World Economy”31). Tinbergen implemented Newton’s law of gravity to analyze trade

31 Tinbergen (1962).

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exchange and hypothesized that the volume of trade between countries is directly proportional to their size (GDP) and inversely proportional to the distance between economic centers of trading countries (Eq. 19.2).

Ex ij = A ×

GDPi × GDPj Dij

(19.2)

where Ex ij f oreign trade turnover of countries i and j, i.e., total exports from country i to country j and total imports to country i from country j; GDPi  gross domestic product in country i ; GDPj  gross domestic product in country j; Dij distance between economic centers of countries i and j; A gravity constant. The gravity model is essentially based on the assumption that, other things being equal in a country’s foreign trade, foreign trade turnover is proportional to gross domestic product. It is assumed that with an increase in domestic product, more goods are exported and imported. The higher the domestic income, the more goods and services a country can import. The more a country produces, the more it can export. Domestic products of the two trading countries thus translate into the supply and demand in these countries in relation to each other. The increase in distance between economic centers of trading countries adversely affects their mutual foreign trade turnover due to higher transportation and transaction costs. Later modifications of the gravity model have specified its fundamental assumptions. In particular, trade turnover between two countries depends not only on the distance between them, but also on the distances to third countries. Most exporting firms in one country supply their goods to a small number of biggest importers in the biggest neighboring countries. Cheaper goods are supplied over shorter distances compared to more expensive products. Additional variables were introduced into the model, such as trade barriers between countries, domestic prices, and income level. The size of the economy is alternatively expressed through the population size, territory size, and GDP per capita. The determinants of trade costs include customs tariffs, transportation costs, membership in currency and trade unions, exchange rate volatility, political alliances, military blocs, language and cultural barriers, former colonial ties, and various location-related parameters (island state or landlocked country). 19.4.5  Spatial Economy and International Trade

19

In recent decades, the formulation of the general theory of international trade has become increasingly relevant. One of the variants is the Spatial Economy or the New Economic Geography, the fundamental provisions of which were elaborated by Paul Krugman (further reading: “Increasing Returns and Economic

735 19.4 · Emerging Theories of International Trade

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Geography”32). Analyzing the nature of centripetal and centrifugal economic and trade forces (the application of the gravitation principle in trade), which either localize various types of economic activity within a particular territory or result in their dispersion across countries and continents, the new economic geography explains the emergence of economic spaces and relations. International trade is one of the elements of the new economic geography, but not the core one. The spatial economy covers a wide range of economic, production, trade, social, and developmental issues that affect the uneven spatial development of the global economy as a whole. In the early 2000s, Esteban Rossi-Hansberg specified the Spatial Theory of Trade by hypothesizing that international trade arises when regions specializing in producing intermediate goods and those manufacturing finished products are located in different countries. Distance and other barriers to trade also matter (further reading: “A Spatial Theory of Trade”33). In particular, if a country specializing in assembling finished goods introduces import duties on intermediate products from countries specializing in supplying components, then under the protection of the tariff, some firms in this country may switch to producing intermediate products. Trade turnover between the two countries would go down, as firms would be able to get some part of components in the domestic market. According to the spatial interpretation of the international exchange, the shorter the distance between countries, the more intensively they trade with each other. The lower the transportation costs, the higher the specialization of a territory on producing goods in which it possesses a comparative advantage. The introduction of trade tariffs, quotas, and other barriers depresses interregional trade, but boosts intraregional trade within the customs area. The volume and structure of trade between countries are determined, among other things, by the initial structure of production, the history of relations between countries, and the trade policy of national governments. Chapter Questions: 5 Explain the difference between absolute advantage and comparative advantage. Why is the Ricardian model recognized as a breakthrough in the evolution of the international trade narrative? 5 Some of the long worn-out ideas of mercantilism are getting a second wind in the new normal economic reality. Would you agree with this statement? Support an answer with examples, if applicable. 5 The rigor of assumptions that underlie the Heckscher-Ohlin theorem has given rise to numerous revisions and reinterpretations of the fundamental relative factor endowment principle. What are these assumptions? 5 How do differences between new, mature, and standardized products affect trade in them? Reveal gaps between exports and imports in developed and developing countries at each stage. 32 Krugman (1991). 33 Rossi-Hansberg (2005).

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5 What is overlapping demand? Can supply overlap? 5 Summarize Posner’s vision of technological gaps and distinguish between demand-side lags and imitation lags. 5 What effects can a technological change have on output growth? Discuss possible effects on the use of capital and labor, production, and consumption. 5 What is the difference between external and internal economies of scale? 5 Do you see any dissimilarity of Haberler’s concept of opportunity costs from that of Ricardo? Compare them and reveal distinctions, if any. 5 Explain the essence of factor-intensity reversal in contrast to demand reversal. 5 The specific factors model states that an increase in the price of a good due to international trade results in an increase in return on the factor most intensively used in producing this good. True or false? 5 Discuss major differences between intra-industry and inter-industry trade. 5 How do you understand the concepts of sunk and fixed costs associated with entering the foreign market? Give examples. Can a firm experience both types of costs simultaneously? 5 In your opinion, does Porter’s concept of competitive advantage capture the essence of the new normal processes in the global market? 5 Do you agree with a statement that spatial theories of international trade, including the gravity model, adequately explain the volumes and directions of trade between countries? Subject Vocabulary:

19

Absolute Advantage: a country’s capacity to produce certain goods at the lowest cost compared to other countries. Comparative Advantage: a country’s capacity to produce certain goods at lower opportunity costs compared to its trading partners. Country-Based Theories: theories of international trade that focus on studying imports and exports of standardized and undifferentiated goods for a country or a group of countries. Economies of Scale Theory: countries with similar factor endowment benefit from foreign trade when specializing in those industries in which economies of scale occur. Factor-Intensity Reversal: a situation in which the same good can be capital-intensive in a capital-abundant country and labor-intensive in a labor-abundant country. Firm-Based Theories: theories of international trade that capture firm-level determinants of international exchange. Gravity Model: the volume of trade between countries is directly proportional to their size and inversely proportional to the distance between economic centers of trading countries. Heckscher-Ohlin Theorem: the relative factor endowment is determined by the degree of availability in comparison to other factors of production, not the physical amount of available factors of production.

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Heckscher-Ohlin-Samuelson Theorem: the international exchange of goods and services bridges the differences in prices not only for traded goods, but also for factors of production. International Product Life Cycle Theory: the development of international trade in finished goods is associated with the stages of the product life cycle: new product, mature product, and standardized product. Intra-Industry Trade: the international exchange of goods and services within one industry. Johnson’s Theorem: a change in external factors of trade leads to a disproportionate increase in internal factors of trade. Leontief Paradox: capital-intensive economies export labor-intensive goods and import capital-intensive ones. Mercantilism: an international trade pattern in which a country seeks to become wealthier by increasing exports and restricting imports. Model of Heterogeneous Firms: the development of international trade is the cumulative effect of individual decisions of individual firms different in size and productivity. Opportunity Cost: the value of one good, expressed in the value of another good, the production of which must be reduced in order to free up resources required to produce one more unit of the first good. Protectionism: a government policy that implies establishing trade barriers to protect domestic producers from foreign competition. Rybczynski Theorem: an increase in the supply of an input results in an increase in output and export in industries that most intensively use this input and a simultaneous decrease in output and export in industries that least intensively use this input. Samuelson-Jones Theorem: differences in production costs due to different factor endowments of trading countries result in the growth of return on those factors that are specifically employed in export-oriented industries. Spatial Theory of Trade: international trade arises when regions specializing in producing intermediate goods and those manufacturing finished products are located in different countries. Stolper-Samuelson Theorem: an increase in the price of a good due to international trade results in an increase in return on the factor most intensively used in producing this good. Technological Gap Theory: trade in novel products grows regardless of factor endowments in individual countries due to technological gaps between countries. Theory of Competitive Advantage: the involvement of countries and individual firms in global value chains is determined by the quantity and quality of factors of production, demand in the domestic market, the availability of related and supported industries, and the firm’s strategy and competition. Theory of Incomplete Contracts: trade in intermediate products depends on the production of and demand for final goods. Theory of Overlapping Demand: a good can be exported only when demand for this in the domestic market is fully met.

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Theory of Technological Progress: international trade is facilitated by different combinations of labor and capital as factors of production through neutral, labor-saving, and capital-saving types of technological progress.

References

19

Balassa, B. (1966). Tariff reductions and trade in manufactures among the industrial countries. American Economic Review, 56(3), 466–473. Grossman, S. J., & Hart, O. D. (1986). The costs and benefits of ownership: A theory of vertical and lateral integration. Journal of Political Economy, 94(4), 691–719. Grubel, H. (1967). Intra-industry specialization and the pattern of trade. The Canadian Journal of Economics and Political Science, 33(3), 374–388. Haberler, G. (1936). The theory of international trade with its applications to commercial policy. William Hodge & Co. Hart, O. D. (1995). Firms, contracts, and financial structure. Oxford University Press. Hart, O. D., & Moore, J. (1990). Property rights and the nature of the firm. Journal of Political Economy, 98(6), 1119–1158. Heckscher, E. (1919). The effect of foreign trade on the distribution of income. Ekonomisk Tidskrift, 21, 497–512. Hicks, J. R. (1932). The theory of wages. Macmillan. Hume, D. (1752). Political discourses. Printed by R. Fleming, for A. Kincaid and A. Donaldson. Johnson, H. (1955). Economic expansion and international trade. The Manchester School, 23(2), 95– 112. Jones, R. (1971). A three-factor model in theory, trade and history. In J. Bhagwati, R. Jones, R. Mundell, & J. Vanek (Eds.), Trade, balance of payments and growth (pp. 3–21). North Holland Publishing Co. Krugman, P. (1979). Increasing returns, monopolistic competition, and international trade. Journal of International Economics, 9(4), 469–479. Krugman, P. (1991). Increasing returns and economic geography. Journal of Political Economy, 99(3), 483–499. Leontief, W. (1953). Domestic production and foreign trade: The American capital position re-examined. Proceeding of the American Philosophical Society, 97, 332–349. Linder, A. (1961). An essay on trade and transformation. Almqvist & Wiksells. Melitz, M. (2003). The impact of trade on intra-industry reallocations and aggregate industry productivity. Econometrica, 71(6), 1695–1725. Minhas, B. (1962). The homohypallagic production function, factor-intensity reversals, and the Heckscher-Ohlin theorem. Journal of Political Economy, 70(2), 138–156. Montchrestien, A. (1615). Traité de l'économie politique. Rouen. Mun, T. (1628). England’s treasure by foreign trade or the balance of our foreign trade is the rule of our treasure. Printed by J.G. for Thomas Clark. North, D. (1691). Discourses upon trade; principally directed to the cases of the interest, coynage, clipping, increase of money. Printed for Tho. Basset, at the George in Fleet Street. Ohlin, B. (1933). Interregional and international trade. Harvard University Press. Porter, M. (1985). Competitive advantage: Creating and sustaining superior performance. Free Press. Posner, M. (1961). International trade and technical change. Oxford Economic Papers, 13(3), 323–341. Ricardo, D. (1817). On the principles of political economy and taxation. John Murray, Albemarle-Street. Rossi-Hansberg, E. (2005). A spatial theory of trade. American Economic Review, 95(5), 1464–1491. Rybczynski, T. (1955). Factor endowment and relative commodity prices. Economica, New Series, 22(88), 336–241. Samuelson, P. (1948). International trade and the equalization of factor prices. The Economic Journal, 58(230), 163–184.

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Samuelson, P. (1971). Ohlin was right. The Swedish Journal of Economics, 73(4), 365–384. Smith, A. (1776). An inquiry into the nature and causes of the wealth of nations. W. Strahan. Steuart, J. (1767). An inquiry into the principles of political economy: Being an essay on the science of domestic policy in free nations. Printed for A. Millar and T. Cadell in the Strand. Stolper, W., & Samuelson, P. (1941). Protection and real wages. The Review of Economic Studies, 9(1), 58–73. Tinbergen, J. (1962). Shaping the world economy. The Twentieth Century Fund. Vernon, R. (1966). International investment and international trade in the product cycle. Quarterly Journal of Economics, 80, 190–207.

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International Capital Flows and Exchange

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_20

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Learning Objectives: 5 Learn the fundamentals of international capital movement and exchange 5 Explore classical and Keynesian theories of international capital movement and approaches to international financing for development 5 Distinguish between direct and portfolio foreign investment 5 Discuss international borrowing and lending and the external debt problem 5 Go over a variety of currency types and exchange rate regimes 5 Study the new normal manifestations of domestic and external economic, trade, and political effects on exchange rates 5 Look into the specifics of contemporary foreign exchange 20.1  International Capital Movement

As it follows from the theories of international trade discussed in 7 Chap. 19, trade is not only the purchase and sale of goods and services between countries. In a broader sense, international trade should be interpreted as an international exchange of various kinds of goods, resources, factors of production, and intangibles. Classical theories of international trade postulated that only goods and services could be exchanged internationally, while factors of production could move between industries within a country but not between countries. The new normal economic reality involves the exchange of any goods and factors of production in the global market. Capital is invested abroad and attracted from abroad to implement joint international projects. People migrate between countries in search of better jobs and living conditions. Technologies are exchanged between countries and transnational corporations. The use of versatile financial tools and mechanisms accelerates the redistribution of wealth from developing to developed countries and back. Financial globalization contributes to the polarization of income distribution between and within countries, as scaling international investments multiplies the wealth of developed countries and widens the income gap between the rich and the poor. Contemporary financial globalization transforms currency, money, and financial markets into global markets dominated by the largest supranational financial organizations, transnational corporations, and transnational banks. A unified financial and economic space (standardized activities and regulations) facilitates the centralization and concentration of capital. These tendencies result in the emergence of a fundamentally new phenomenon of global financial capital, which expresses the economic power of individual countries and social groups at the global level. International trade and international movement of factors of production are interlinked. They complement each other. For instance, a labor-abundant country may import capital-intensive goods and export labor-intensive ones. Alternatively, it may attract foreign capital and develop a capital-intensive production domestically. At the same time, surplus labor may migrate to labor-scarce countries, where wages are higher. The principles of comparative advantage and factor endowment are equally applicable to trade in goods and capital and

20

743 20.1 · International Capital Movement

20

labor exchange. This chapter discusses the features of international capital flows and currency change. 20.1.1  Foundations of Capital Exchange

As noted above, international movement of factors of production is inextricably linked to international trade. It either substitutes international trade or supplements it. 5 Substitution. The international movement of factors of production substitutes international trade in goods if the latter is caused by a difference in the factor endowment. Suppose capital-abundant country A exports a capital-intensive good X . Meanwhile, it also exports capital to countries where the interest rate is higher than in the domestic market. An increase in the output of an export-oriented good X increases the need for capital. The price of capital in a capital-abundant country A rises. The increase in the interest rate hinders the export of capital, since the price of capital in country A goes up to the world’s average price. Thus, export of goods impedes capital movement (export). 5 Supplement. International movement of factors of production supplements international trade in goods if the latter is facilitated by other determinants than factor endowment (comparative advantages, economies of scale, technological gaps, etc.). Consider the case above. At some point in time, the price of capital in a capital-abundant country A would eventually exceed the world price (if a rise in output of good X continues). That would attract capital from abroad. Trade in goods triggers a change in the price of capital, which stimulates its movement between countries. Thus, the export of goods contributes to the capital movement (import). 5 Substitution and supplement. The international movement of factors of production substitutes inter-industry trade and supplements intra-industry trade when countries considerably differ in their factor endowments (see 7 Chap. 19, 7 Sect. 19.3.4 for the concepts of inter-industry and intra-industry trade). When factor endowment of the two countries varies widely, countries A and B specialize in producing unique goods X and Y , respectively. There is no international movement of factors of production, only inter-industry trade between the countries. With the exchange of factors of production, country A can start producing good Y and country B—good X . That triggers intra-industry trade. The gain in the world output due to international movement of factors of production exceeds that obtained due to international trade, as it is not goods but factors of production that move to the locations where they can be used most efficiently. In most cases, international mobility of factors of production is a more influential driver of economic growth than international trade. However, the movement of capital is significantly different from the movement of goods. Foreign trade is the exchange of goods as use-values. The export of capital involved withdrawing part of the capital from the domestic circulation and

744

Chapter 20 · International Capital Flows and Exchange

. Fig. 20.1  Types of capital in the global market. Source Authors’ development

adding it to the production and circulation in a foreign country. International Capital Flows are the movement of value in monetary and/or commodity form from one country to generate higher profits in a recipient country, or the counter-movement of capital between countries. The following factors facilitate capital flows: 5 uneven development of national economies: capital leaves stagnant/volatile markets and migrates to higher-profit and/or more stable economies; 5 current balance sheet imbalances trigger capital migration from surplus countries to deficit countries; 5 capital migration between countries is stimulated by the liberalization of national capital markets, i.e., the removal of restrictions on the import, operation, and export of capital; 5 development and expansion of international credit and currency and stock markets contribute to a large-scale increase in the international movement of capital; 5 capital migration is facilitated by transnational corporations and banks, internationalization of non-banking and non-financial organizations, and an increase in the number and resources of institutional and individual investors; 5 economic and financial policy of recipient countries, which aim to attract foreign capital, promote domestic investment, and service external and internal debts. International exchange of capital grows due to the ever-increasing interconnection of national economies and international industrial and technological cooperation. By attracting foreign capital, both developed and developing countries seek to give impetus to their economic development. International financial institutions, such as the International Monetary Fund (IMF), International Bank for Reconstruction and Development (IBRD), and other transnational banks and funds, accumulate, redirect, and regulate capital flows. Capital in the world market can be classified according to its form, period of circulation, source of funds, and intended usage (. Fig. 20.1).

20

745 20.1 · International Capital Movement

20

The movement of capital can be carried out in monetary and commodity forms. The former is represented by direct and portfolio investments (see 7 Sect. 20.2), loans, and foreign aid (see 7 Sect. 20.3). The commodity form includes export credits and contributions to the authorized capital of a company in the form of equipment, buildings, or vehicles. In terms of circulation (maturity), capital is distinguished between short-term investments (up to one year) and long-term investments (over a year). The former includes short-term trade loans, bank deposits, funds deposited in the accounts of financial organizations, short-term commercial papers, and other forms of capital. The latter involves long-term investments of entrepreneurial capital and loans of commercial banks, foreign countries, and international organizations. According to the source of funds, capital is divided into public and private. Public capital is funds received from the central government, local authorities, and other public institutions, including intergovernmental financial establishments such as the IMF. Private capital is funds obtained from non-governmental sources, i.e., the own or borrowed funds of private firms, banks, and funds. In least developed countries, the borrowing portfolio is dominated by public funds (for example, development and aid programs under the aegis of the UN or the IMF). Developed economies and most of developing countries attract capital from private sources. Loan capital is repayable funds loaned for a certain period of time in order to obtain interest on deposits, loans, and credits. Loan capital includes bank deposits, funds deposited in the accounts of financial organizations, and short-term and long-term loans. Governments attract loan capital from public and private sources to replenish foreign exchange reserves, cover budget deficits, implement macroeconomic stabilization policies, or service external and internal debts (see 7 Sect. 20.3 for foreign debt). Business (entrepreneurial) capital is funds invested directly or indirectly in producing goods or services or business in general to generate profit. Transnational corporations dominate the international flow of business capital. Funds of public institutions and international organizations can also be used as business capital. Major forms of business capital are direct and portfolio investments (see 7 Sect. 20.2). 20.1.2  Classical Theories of International Capital Movement

In 7 Chap. 19, 7 Sect. 19.1, we discussed classical country-based approaches to interpreting the essence and determinants of international trade that also address the fundamentals of capital exchange. According to Adam Smith, restrictions on the export of monetary capital depress the national currency’s exchange rate. Prices rise because the money supply exceeds the actual demand for money in the domestic market. Capital gets around government restrictions and outflows until the domestic and foreign prices of capital balance. Thus, Smith established a link between the amount of money in a country, its price (interest rate), commodity prices, and the flight of capital to countries where the purchasing power of money is higher (further read-

746

Chapter 20 · International Capital Flows and Exchange

ing: “An Inquiry into the Nature and Causes of the Wealth of Nations”1). David Ricardo explored the migration of entrepreneurial capital and labor based on the comparative advantages principle. Capital flows to markets where production costs are lower and return rates are higher (further reading: “On the Principles of Political Economy and Taxation”2). John Stuart Mill argued that the export of capital contributes to the expansion of trade and the most rational specialization of countries. It allows countries to get raw materials and food in the foreign market cheaper than in the domestic market. Countries can invest more capital in producing industrial goods that can be used in payment for raw products. Mill believed that an additional motive was needed for the export of capital. Such a motive is the decline of the rate of profit in the exporting country. Thus, according to Mill, capital exports stimulate the expansion of foreign trade and prevent the rate of profit from falling (further reading: “Principles of Political Economy”3). In the 1930–1950s, Eli Heckscher, Bertil Olin, Ragnar Nurkse, and Carl Iversen elaborated the neoclassical theory of capital movement. According to Eli Heckscher, an international equilibrium of prices for factors of production can be attained through international trade (see 7 Chap. 19, 7 Sect. 19.1.4 for the Heckscher-Ohlin’s relative factor endowment) or movement of factors of production, whose price and volume vary from country to country. Bertil Ohlin argued that the main incentive for international capital flows is the interest rate or marginal productivity of capital. Capital moves from sectors (territories) where its marginal productivity is low to higher-productive destinations. Ohlin also emphasized additional incentives that can affect capital flows, such as political situation, diversification of investment on the global market, tariff restrictions that impede commodity exports and stimulate the export of capital, and differences in profit margins. The movement of capital is based on the supply of capital in domestic markets, the amount of which depends on new savings and income from earlier investments. According to Ohlin, when exporting capital in loan form, an exporter seeks to secure a guaranteed sales market in the host country. By exporting capital in an entrepreneurial form, an exporter seeks to establish production in the importing country (see capital types in . Fig. 20.1). Thus, commodity exchange and capital export are interrelated, as the competition of goods is substituted or supplemented by competition of capital (further reading: “Interregional and International Trade”4). According to Ragnar Nurkse, international capital flows are facilitated by differences in interest rates affected by the supply of and demand for capital (previously addressed in 7 Chap. 15, 7 Sect. 15.5.3). Nurkse proposed several capital movement models. A capital exchange between the two countries producing consumer goods starts only if one of the countries significantly increases output due to the introduction of new technologies. If the production is capital-intensive, a

20

1 2 3 4

Smith (1776). Ricardo (1817). Mill (1848). Ohlin (1933).

747 20.1 · International Capital Movement

20

country starts importing capital. If it is labor-intensive, less demanded capital migrates to other countries (further reading: “Problems of Capital Formation in Underdeveloped Countries”5). Carl Iversen put forward the concept of marginal international mobility of capital. Different types of capital have different mobility, which explains the fact that the same country can simultaneously export and import capital to and from different countries. For example, before the World War I, the USA imported capital from Europe and exported it to Latin America. Iversen studied the relationship between capital exports and world prices of goods and raw materials. Restrictions on the inflow of foreign capital encourage importers to increase commodity exports and reduce commodity imports to maintain an active trade balance. A higher supply of goods depresses commodity prices, e­ specially prices of raw materials. A fall in prices decreases profit margins and reduces capital inflows (further reading: “Aspects of the Theory of International Capital Movements”6). 20.1.3  The Keynesian Interpretation of International Capital

Movement

In the XX century, the Keynesian school prevailed over classical and neoclassical ideas in most areas of economic science, including the theory of capital flow. John Maynard Keynes believed that a country could only become an exporter of capital when its exports of goods exceeded imports. The growth of foreign investment should be supported by the trade surplus of the exporting country. In this regard, it is necessary to redistribute the factors of production in favor of export-oriented industries. According to Keynes, such a redistribution reduces the cost of exports and improves the efficiency of capital use in export industries. It also reduces the demand for imported goods. Capital exports should be regulated in such a way that the outflow of capital corresponds to a gain in merchandise exports (further reading: “The General Theory of Employment, Interest and Money”7). Fritz Machlup believed trade surplus (a parameter of the accumulation of foreign means of payment) to be the immediate reason for stimulating capital export. The impact of importing capital is determined by the forms of its attraction. The most beneficial is the inflow of direct investment that establishes no debt. The demand of foreigners for domestic securities raises the prices of shares and bonds. It allows governments and firms to increase the issue of new securities for real investments, which entails an increase in consumption and income (further reading: “International Payments, Debts and Gold”8).

5 6 7 8

Nurkse (1953). Iversen (1935). Keynes (1936). Machlup (1964).

748

Chapter 20 · International Capital Flows and Exchange

According to Roy Harrod, trade surplus stimulates the growth of capital assets. The latter reduces the interest rate on short-term deposits and then on longterm ones. Countries with a low propensity to save and a high propensity to import should import capital to promote economic growth. Surplus capital appears in the form of excess savings, i.e., excess of savings over investment. The amount of savings is associated with the propensity to save. The real savings volume is determined by the product of the growth rate by the capital (technological) coefficient. Exporting capital for international development means sharing excessive funds globally. Capital-abundant exporters earn higher interest as a risk premium for directing capital to capital-scarce markets (further reading: “Towards a Dynamic Economics”9). Since the 1950s, capital migration between developed countries has emerged. To explain the migration of capital between the USA and Western Europe, Charles Kindleberger developed the concept of liquidity preference (further reading: “International Capital Movements”10). In the USA, long-term lending and short-term borrowing prevailed. That combination resulted in the low interest rate on long-term capital and the high interest rate on short-term capital. In Western European markets, short-term lending coexisted with long-term borrowing. The mutual movement of capital is determined by the desire of each country to meet its demand for capital according to the level of liquidity preference. American lenders buy long-term securities from Europe, while European ones get short-term liabilities from the USA. According to Kindleberger, the mutual movement of capital between two developed countries takes place even when savings are equal to investments in both countries, but the liquidity preferences are different. Since the 1980s, the capital movement has been carried out mainly through transnational corporations. Therefore, new aspects of the capital exchange are captured in modern concepts of TNCs, including some elements of firms’ theory. The concept of capital outflow by transnational corporations is based on the assumption that international expansion through capital export establishes additional advantages over local competitors in foreign markets (see 7 Chap. 4, 7 Sect. 4.3.2 for transnational corporations). 20.1.4  Theories of International Financing for Development

The current global challenges of economic inequality between developed and developing countries, as well as disparities within countries (see 7 Chap. 14, 7 Sect. 14.5 for the new normal inequalities between and within countries) necessitate international efforts to overcome gaps in order to achieve sustainable economic development (see 7 Chap. 18, 7 Sect. 18.2). International financing for de-

20

9 Harrod (1948). 10 Kindleberger (1988).

749 20.1 · International Capital Movement

20

velopment is based on providing funds to developing and least developed states. Through international development assistance programs, countries and international organizations provide part of these funds on preferential terms. The starting point for substantiating the need for financial support of developing countries was the conclusions about the peculiarities of capital accumulation in underdeveloped markets made by Simon Kuznets and Kenneth Kurihara (further reading: “Economic Growth and Income Inequality”11 and “Monetary Theory and P ­ ublic Policy”12). According to Kuznets, in the process of capital accumulation, an underdeveloped country faces the following challenges: 5 lack of savings due to low propensity to save; 5 low propensity to invest funds used in producing consumer goods into the expansion of industrial capacities; 5 shortage of foreign currency for attracting resources from abroad due to the balance of payments deficit. One of the solutions to these problems is to attract foreign capital. The inflow of foreign capital gives foreign currency and makes up for the lack of savings. In this regard, two types of development assistance approaches can be applied: filling the gap in savings and investment and replenishing foreign currency reserves. The filling the gap approach was first elaborated by Paul Narcyz Rosenstein-Rodan in the 1960s (the Rosenstein-Rodan Big Push model is discussed above in 7 Chap. 15, 7 Sect. 15.5.4). The primary purpose of capital inflow to underdeveloped markets under the assistance program is triggering the transition from stagnation to self-sustaining growth. Assistance includes public funds that do not aim to make a profit. Assistance is provided to raise savings that would then spur investment and support growth. Once public capital pushes initial investments, private capital would flow into the reviving economy (further reading: “The Theory of the ‘Big Push’”13). In the mid-1960s, Hollis Chenery and Alan Strout proposed the three-phase growth model of an underdeveloped economy (further reading: “Foreign Assistance and Economic Development”14). The period of time during which a country needs intensive attraction of foreign funds is separated into three phases. At each stage, the model highlights the main impediment to economic development. At stage one, investment is hindered by the lack of qualified labor in production and management. At stage two, low domestic savings fail to support economic development. The difference between investments that meet the needs of self-sustaining development and domestic savings determined by a country’s propensity to save should be equalized by attracting external resources. When the propensity to save reaches the required investment rate, the inflow of foreign capital stops. At stage three, growth is limited by the export–import gap. Domestic production

11 12 13 14

Kuznets (1955). Kurihara (1951). Rosenstein-Rodan (1976). Chenery and Strout (1966).

750

Chapter 20 · International Capital Flows and Exchange

fails to replace imports and supply competitive products on the global market. Structural transformation of the economy through the redistribution of investments is needed to bridge the gap. The government should aim at depressing the marginal propensity to import and advancing the growth rate of exports over that of imports. The shrinking current account deficit is covered by the inflow of foreign currency. The alternative to development assistance is the idea of partnership that emerged in the 1960s in the wake of the direct foreign aid crisis after the World War II. Partnership assumes the establishment of joint companies as a form of foreign investment with the participation of local capital. A joint company is supposed to ensure compatibility between foreign private capital, local government, and local business. It provides for the implementation of local investors’ goals, alignment of activities with the national development trajectory, attraction of foreign capital, development of local production, labor, and infrastructure, and the establishment of competitive import-substituting industries. A foreign investor in the partnership seeks to gain higher profit than in developed markets due to lower production costs and tax benefits offered by the government. However, a foreign investor needs guarantees of free export of income on capital and protection against the transfer of knowledge and technologies to domestic rivals. In the 1970–1980s, the theory of investment in underdeveloped markets was substantially extended by Kiyoshi Kojima. His ideas of pro-trade foreign direct investment and industrial development aimed to explain the rapid economic catch-up of new industrial economies in Asia, that capitalized initially on inward investments and then turned into net exporters of capital (further reading: “Theory of Foreign Direct Investment”15). Foreign direct investment is trade-oriented if it deepens the involvement in the international division of labor and contributes to the development of foreign trade of capital-exporting and capital-importing countries. This happens when sectors that have no comparative advantage on the domestic market start exporting direct investments. They employ scarce and expensive factors of production and invest in those industries where a host country possesses a comparative advantage. Direct investment in such sectors in developing economies contributes to expanding host countries’ exports to capital-exporting markets (a form of development assistance). Therefore, the global development efforts should include development assistance and the liberalization of imports from developing countries. At the first stage, assistance is provided through direct investment in primary industries. It is then channeled into production infrastructure. At later stages, development assistance should involve loans and transfers of technologies and management competencies.

20

15 Kiyoshi (1977).

751 20.2 · International Investment

20

20.2  International Investment

International investment is the dominant form of international capital flows. Broadly speaking, investments are funds invested in economic objects and projects intended to provide the economy with financial and other resources in the future. In macroeconomics, Investment is the profit-oriented injection of capital or other resources or property in the creation of new value or the replacement of worn-out production facilities or factors of production in the domestic market or abroad. Depending on the type of asset being purchased, injections are distinguished between direct investment (7 Sect. 20.2.1) and portfolio investment (7 Sect. 20.2.2). They pursue different goals and therefore differ in the degree of risk and profitability. A direct investor places resources in a specific asset in order to gain control over it. Assets include real estate, production facilities, or a share in the authorized capital, which allows a direct investor to influence decision-making within a firm. Therefore, a direct investor focuses on the prospective return on investments, which he can influence. A direct investor participates in managing firms and distributing profits. Direct investment is usually long-term. A portfolio investor seeks to receive passive income from investing, not to increase the influence or management power. To minimize risks, an investor distributes resources between several assets (a portfolio). Portfolio assets include shares, bonds, foreign currency, and short-term securities. A portfolio investor aims at receiving a stable return on invested funds in the form of dividends, bond coupons, or exchange rate differences on purchase and sale transactions. 20.2.1  Direct Investment

Foreign Direct Investment is the acquisition of a long-term interest by a resident of one country (direct investor) in a resident asset of another country (an enterprise with direct investments). The foreign direct investment includes both the investor’s initial acquisition of property abroad and all subsequent transactions between the investor and the enterprise in which the capital is invested. Direct investments include: 5 investment of equity capital abroad (foreign branches and subsidiary and associate companies); 5 profit reinvestment (the share of a direct investor in the income of a foreign-invested venture not distributed as dividends and not transferred to a direct investor); 5 intra-corporate capital transfers in the form of credits and loans between a direct investor and subsidiaries, associates, and affiliates. The reasons for exporting and importing foreign direct investment are diverse. The main ones are the desire to place capital in a country (sector) where it generates the maximum profit, avoid taxes, or diversify risks. The specific determinants of export and import overlap, but their roles differ:

752

Chapter 20 · International Capital Flows and Exchange

5 Technological leadership. The higher the share of R&D expenditure in a firm’s sales, the greater the exports (imports) of direct investments. By exporting direct investment, a firm seeks to maintain control over a critical technology that gives it a competitive advantage. The direct relationship between the level of R&D and the volume of capital exports is confirmed for most of developed countries. In terms of imports, direct investment is usually associated with acquiring advanced foreign technologies, over which a direct investor seeks to maintain its control. 5 Labor force quality. The higher the remuneration rate in a firm, the greater the export (import) of direct investment. 5 Advantages in advertising, which reflects the accumulated competencies in international marketing. The higher the share of advertising costs in a firm’s sales, the greater the exports (imports) of direct investments. 5 Economies of scale. The larger the share of the domestic supply in a firm’s overall output, the greater the direct investment exports. Before investing abroad, most businesses prefer to fully exploit the economies of scale in the domestic market. On the contrary, the smaller part of the firm’s supply goes to the domestic market, the greater its direct investment imports. 5 Company size. The bigger the size of a firm, the greater the exports (imports) of direct investment. 5 Concentration of production. The higher the concentration of production of a certain product within a firm, the greater its direct investment exports. On the contrary, the lower the concentration, the greater the direct investment imports. 5 Access to natural resources. The higher the firm’s demand for a certain resource, the greater its direct investment exports to the country that possesses it. 5 Need for capital. The higher the firm’s need for capital, the greater its direct investment imports. 5 Number of domestic branches. The more branches (other divisions) a firm establishes in a country, the greater its direct investment imports. 5 Production costs. The lower the production costs in the host country, the greater the direct investment imports. 5 Protectionism. Since capital imports can supplement and substitute imports of goods (see 7 Sect. 20.1.1 above for capital exchange fundamentals), the higher the level of customs and other protection of the domestic market, the greater the direct investment imports. 5 Market size. The larger the country’s domestic market, the greater the direct investment imports.

20

Thus, the determinants of export and import of direct investment largely coincide, which results in cross-investment. Advantages in the development of research, workforce qualification, advertising practices, and size of businesses affect both export and import of direct investment. Economies of scale, the concentration of production, and the need for natural resources trigger direct investment exports, but depress the import of direct investment. The need for capital, a significant number of domestic branches, lower production costs, higher protection of the domestic market, and market size affect foreign direct investment imports.

20

753 20.2 · International Investment

Case box Developed economies (Europe and North America) are the world’s largest investors. Foreign direct investment is diversified geographically, but developing countries (mainly Asian countries) attract the bulk of capital imports. They increased both imports and exports of direct investment even amid the pandemic-induced economic downturn, when other regions curbed investment activities (. Table 20.1). In terms of the accumulated FDI stock, the USA, the UK, and the Netherlands have been holding leadership since the 2000s (. Table 20.2). Among developing countries, only China joins the ranks of the world’s biggest investment powers.

. Table 20.1  FDI flows, by country groupings and regions, 2000–2020, $ billion Country groupings/ regions

FDI inflows

Developed economies

1,122.47

Europea

2000

FDI outflows 2010

2020

2000

2010

2020

751.81

328.54

1,073.70

1,026.81

353.94

710.78

482.67

88.91

North America

380.87

226.68

Other developed economiesb

30.82

42.47

234.18

848.02

629.56

80.52

180.26

187.32

312.47

141.81

59.37

38.37

84.78

131.62

641.92

670.35

88.79

365.37

385.94

10.38

47.24

39.78

1.55

10.36

159.18

437.93

578.13

Latin America and the Caribbean

79.79

160.53

87.57

8.21

54.91

–

Oceania

Developing economies Africa Asia

113.90

364.24

1.59 509.23

15.65

38.68

24.24

3.49

20.65

10.27

Transition economies

5.07

52.85

23.24

3.16

49.64

5.54

South-East Europec

0.56

4.60

6.11

0.32

0.31

Commonwealth of independent states

4.51

48.25

17.13

3.16

49.32

5.23

Least developed economies

4.60

23.21

233.61

0.79

4.33

2.80

1,356.65

1,393.73

998.89

1,162.49

World, total

–

1,392.18

739.87

Note a excluding South-East Europe; b Australia, Israel, Japan, and New Zealand; c Albania, Bosnia and Herzegovina, Montenegro, North Macedonia, and Serbia Source Authors’ development based on UNCTAD (2022)16

16 United Nations Conference on Trade and Development (2022).

940.20

278.44

483.95

442.62

379.29

365.87

232.20

7,408.90

UK

Japan

Germany

Canada

China, Hong Kong SAR

France

Switzerland

World, total

20,468.14

1,043.20

1,172.99

943.94

983.89

1,364.57

831.08

1,686.26

317.21

968.11

4,809.59

2010

Source Authors’ development based on UNCTAD (2022)17

27.77

305.46

2,694.01

China

Netherlands

USA

2000

FDI outward stock

39,246.20

1,628.86

1,721.80

1,953.92

1,964.43

1,977.24

1,982.13

2,055.41

2,351.80

3,797.60

8,128.49

2020

17 United Nations Conference on Trade and Development. (2022).

20

Top investors

. Table 20.2  FDI stock, by major investors and recipients, 2000–2020, $ billion

World, total

Germany

Canada

Ireland

Switzerland

Singapore

China, Hong Kong SAR

China

UK

Netherlands

USA

Top recipients

7,377.35

470.94

325.02

127.09

101.64

110.57

435.42

193.35

439.46

243.73

2,783.24

2000

FDI inward stock

19,898.88

955.88

983.89

285.58

648.09

633.35

1,067.52

586.88

1,068.19

588.08

3,422.29

2010

41,354.25

1,059.33

1,099.89

1,350.06

1,536.25

1,855.37

1,884.88

1,918.83

2,206.20

2,890.58

10,802.65

2020

754 Chapter 20 · International Capital Flows and Exchange

755 20.2 · International Investment

20

The economic effects of foreign direct investment are not fundamentally different from those of international trade. A simple two-countries model can be employed to analyze them (similar to those used in most of the classical and neoclassical models of international trade previously discussed in 7 Chap. 19). The international movement of capital boosts the global output due to a more efficient distribution of capital as one of the factors of production. At the same time, capital migration between countries redistributes the income of owners of factors of production. In capital-exporting countries, capital owners gain due to more efficient use of their assets, while returns on other factors of production decline compared to those on capital. In the capital-importing countries, capital owners lose due to lower returns on capital. 20.2.2  Portfolio Investment

As noted above, portfolio investments are capital investments in foreign securities that do not give an investor real control over the foreign asset. Foreign Portfolio Investment is an investment in the form of a group of assets (portfolio), including operations with equity securities (common stocks) and debt securities (banknotes, bonds, debt warrants, etc.). Although governments (central banks) also acquire foreign securities, portfolio investments are predominantly based on private entrepreneurial capital. International macroeconomics studies international portfolio investments, that is, investments in foreign securities. Therefore, portfolio investments are classified as they are listed in the balance of payments: 5 equity securities—a financial document which certifies the property right of its holder in relation to its issuer (shares, stocks); 5 debt securities—a financial document that certifies its holder’s debt in respect to its issuer. There are three commonly used types of debt securities: 5 bond, debenture, or note—monetary instruments that give their holder an unconditional right to a guaranteed fixed monetary income or a contractually agreed variable monetary income; 5 money market instrument—monetary instruments that give their holder an unconditional right to a guaranteed fixed monetary income on a certain date. These instruments are sold on the market at a discount, the amount of which depends on the size of the interest rate and the maturity date. They include treasury bills, certificates of deposit, and bankers’ acceptances; 5 financial derivatives—monetary instruments that certify the holder’s right to sell or buy primary securities. Examples are options, futures, warrants, and swaps (see 7 Sect.  20.5 for various financial instruments used in the forex exchange market). Portfolio investment is determined by similar reasons as foreign direct investment, adjusted for the fact that an investor acquires no right to control the asset it invests in. However, the liquidity of portfolio investments (the ability to quickly

756

Chapter 20 · International Capital Flows and Exchange

turn securities into cash currency) is significantly higher than that of direct investments. The main reason for portfolio investments is the desire to place capital in such securities in which it would generate the maximum profit. In a sense, portfolio investments are seen as a means of protecting money from inflation and generating speculative income. At the same time, neither the sector nor the types of securities mean if they generate the desired income. An investor can place its capital in any country, industry, or security, where it provides an acceptable return at an acceptable level of risk. Case box As in the case of direct investment, over 90% of foreign portfolio capital migrates between developed countries. Portfolio outward investment by developing countries is volatile. In recent years, there has even been a net outflow of portfolio investment from developing countries. However, major developing economies, such as China and India, are among the top ten portfolio investment destinations (. Table 20.3). . Table 20.3  Net portfolio equity flows, by investors and recipients, 2000–2020, $ billion Net exporters

Net portfolio investment outflows

Net importers

2000

2010

2020

Netherlands

–

–

100.07

Japan

1.29

–

Switzerland

–

7.17

Germany

27.95

South Korea

–

Russia

Net portfolio investment inflows 2000

2010

2020

Luxembourg

–

218.68

241.65

80.07

China

6.91

31.36

64.14

18.58

India

2.48

30.44

24.85

–

17.51

France

49.97

–

15.52

–

15.80

Spain

20.66

–

12.43

–

4.89

14.79

Australia

–

13.15

11.94

Canada

–

–

9.64

Belgium

–

–

8.20

Thailand

–

–

8.02

Finland

10.11

–

7.46

Brazil

–

–

5.93

Sweden

18.05

5.14

7.37

Malaysia

–

–

5.64

Kuwait

–

–

6.01

Source Authors’ development based on The Global Economy (2022)18

20

18 The Global Economy (2022a).

757 20.2 · International Investment

20

The new normal economic reality (frequent supply-demand imbalances, volatile markets, and inequality gaps between countries) brings about fundamentally new conditions for the accumulation and movement of portfolio investments. The three imbalances challenge the stability of the contemporary global financial system. Savings-consumption (investment) imbalance lies in the emergence of two poles: countries with a stable current account surplus (Germany, China, the Netherlands, and exporters of resources, primarily fossil fuels) and countries with a stable current account deficit (leading developed economies and emerging markets, such the USA, the UK, India, Brazil, South Africa, and Mexico). Current account surplus increases national savings, while deficit necessitates the need for attracting capital (inward direct and portfolio investment). If the capital generated by the current account surplus is not used domestically as national savings, then it is exported to capital-deficient markets (lent to other countries). The current savings-consumption imbalance is that the excessive level of consumption in countries with persistent current-account deficits is financed by the excess savings of countries with current-account surpluses. Thus, there is a global movement of capital mainly in the form of international portfolio investment from over-saving countries to over-consuming economies. As a result, the savings pole (surplus countries) finances the liabilities of the consumption pole (deficit countries). The problem is that under uncertainty or market failure, the flow of capital runs low or even dries out, which damages capital-importing economies and destabilizes the entire global financial system. External funding imbalance. Over the decades, both developed and developing economies have attracted significant direct and portfolio investment stocks (see case boxes above). By analogy with the saving and consumption poles, there have emerged the net creditors’ pole and the net debtors’ pole. On the one hand, the global external financing imbalance favors international portfolio investment, as a substantial amount of debt securities enter the market. On the other hand, the increase in the debt burden on the public and corporate sectors threatens the stability of the credit system and aggravates default-related risks. National regulation of the global financial market. The imbalance is manifested in the advent of low-transparent national regulations that attempt to capture individual interests of countries, but often contradict the global nature of the financial market. The establishment of new supranational framework regulations (for example, in the European Union) drives up transaction costs for financial market entities. Regulation adjustments and innovations are necessary to make the global financial market as transparent and safe as possible. Nevertheless, excessive regulations may lower interest rates, weaken economic activity, and reduce portfolio investment in the domestic market. The COVID-19 pandemic has shocked financial markets around the world. International investment has reduced radically, both portfolio and direct investment (still, to a lesser degree in developing Asia compared to developed Europe and North America). All developed countries and the vast majority of developing economies have implemented wide fiscal and monetary support programs. Across the developed world, assistance to business and the population incommensurably

758

Chapter 20 · International Capital Flows and Exchange

exceeded that across developing markets. As a result, despite a rather modest improvement in real economic parameters, the equity and debt markets in developed countries almost recouped the fall by the mid-2020. Shares of some hightech companies and sovereign debt obligations of reserve currency issuers (USA, UK, EU countries) exceeded pre-crisis levels (see 7 Sect. 20.4 for the concept of reserve currency). Meanwhile, stock and bond indices of developing countries have been growing much more slowly after the drop. In terms of portfolio investment, economic volatility has allowed reserve currency issuers to strengthen their leadership positions. That happened primarily due to the fiscal and monetary measures taken by wealthier developed countries (far beyond the means of underdeveloped economies). The fundamental imbalances have thus deepened, and the asymmetry of international portfolio investment has become more pronounced. 20.3  External Debt

Direct investment and portfolio investment in equity establish non-borrowed capital (the recipient country is not indebted to investors). Credit forms of capital raising (loans, credits, debt securities) form external debt. Depending on the balance of capital inflows and outflows, countries are divided into net importers and net exporters of capital. The external debt balance is determined based on the relationship between international assets and liabilities, i.e., the accumulated foreign capital (liabilities) and national capital abroad (assets). According to the classical theories of international trade, imports are financed exports. That is, in order to purchase a foreign good, a country must first supply its good or service abroad. However, trade is just one of the options. An alternative source of financing imports and the country’s budget as a whole is the inflow of capital from abroad. Any country can obtain and grant international loans or accept and invest entrepreneurial capital. According to the Walras’s Law, country’s imports are equal to the sum of its exports, net foreign sales of assets, and net interest on these assets (Eq. 20.1) (further reading: “Elements of Pure Economics”19 by Leon Walras).

M = X + NA + NI

(20.1)

where M imports; X exports; NA  net assets; NI net interest. Sales of assets in any form (property rights, securities, precious metals, etc.) generate capital inflow into a country. Interest payments are payments for the use of capital received in the past. The greater the sale of assets today, the higher the

20

19 Walras (1954).

759 20.3 · External Debt

20

future interest payments on raised capital. Consequently, the higher the NA today, the lower the NI expected in the future. Converting Eq. 20.1, we get Eq. 20.2, the right side of which is the current balance (the balance of goods and services plus net interest payments on capital considered as trade in capital services), and the left side is the balance of capital flows.

NA = M − X − NI

(20.2)

According to the Walras’s Law, the balance of trade in goods and services should be equal in magnitude but opposite in sign to the balance of capital flows. The excess of assets over liabilities characterizes a country as a net creditor (excess of liabilities over assetsa net debtor). Debtor countries can either timely fulfilling their debt obligations to foreign creditors or violate them and accumulate overdue payments. According to the IMF, non-paying countries or those with difficulties in servicing debt include states that have had overdue debts over the past five years and/or whose debts have been restructured (re-issued). External Debt is a part of the total debt of economic entities in a country attributable to foreign creditors (international organizations, countries, or private capital). Governments and firms may borrow abroad for a number of reasons. First, a narrow local debt market may fail to meet the borrowing needs of large corporations or the government, especially in developing countries. Second, foreign lenders may offer more attractive borrowing terms. Third, borrowing from international organizations such as the World Bank is an essential option for low-income countries that otherwise would face higher rates and less flexible repayment schedules when borrowing from private lenders. External debt comes up as a result of the country’s involvement in International Borrowing and Lending—the issuance and receipt of funds to/from foreign lenders with interest payment for the use of these funds for an agreed period of time. Until recently, the international capital stock has been dominated by public funds or the capital of international credit and financial organizations. Before the pandemic hit the world economy in 2020, international lending from private sources had been on the rise, but it shrinks now compared to enormous government anti-crisis and support programs and international aid initiatives. International borrowing and lending are generally mutually beneficial, as both the borrower and creditor countries benefit from it. However, businesses and people within countries benefit unequally. In a recipient country, borrowers win by attracting scarce capital, while domestic lenders incur losses due to rising competition in the domestic credit market. In a creditor country, capital lenders receive higher interest on capital invested abroad, while domestic borrowers face higher price for capital. The international credit features (repayment, maturity, interest payment, coverage, and purpose) facilitate the migration of credit capital between countries by: 5 redistributing capital to meet the needs of expanded reproduction; 5 saving circulation costs by supplementing current assets with credit funds, developing and accelerating non-cash payments, and replacing cash currency turnover with international credit operations; 5 promoting the concentration and centralization of capital.

760

Chapter 20 · International Capital Flows and Exchange

International credit accelerates reproduction by stimulating country’s foreign economic activities. It serves as a means of increasing the competitiveness of the creditor country and its firms. International credit creates favorable conditions for attracting foreign private investment, as it is commonly associated with benefits to investors. Finally, credit facilitates international settlement and foreign exchange operations. International borrowing and lending is a form of Intertemporal International Trade—an exchange of goods and services today for those in the future. Intertemporal trade stimulates current consumption by reducing consumption in the future (borrowing) or depresses current consumption in favor of future consumption growth (lending). That is, a borrower increases current consumption by reducing consumption in the future, when it will have to repay the loan (interest paid to a lender). A lender gives up part of its current consumption in expectation of a higher return on capital in the future (interest paid by a borrower). Some countries want to consume more than they produce and therefore borrow money from abroad. Other countries limit current consumption in favor of multiplying wealth in the future and therefore grant loans. International borrowing and lending depend on the price of future consumption expressed through the current consumption (an equivalent of opportunity costs in trade—see 7 Chap. 2, 7 Sect. 2.1 for the concept of opportunity costs and 7 Chap. 19, Sects. 19.1.3 and 19.3.1 for the interpretations of opportunity costs in international trade). This price can be represented by the real interest rate r. The amount of goods to be paid in the future is equal to the current consumption C multiplied by (1 + r). The relative price of future consump1 tion is then equal to 1+r . Suppose country A consumes more than it produces, while country B produces more than it consumes (. Fig. 20.2). Then the current demand of country A rises as the interest rate decreases, and the current supply of country B increases as the interest rate goes up. With no capital exchange between countries, the interest rate in country A is Y1, whereas in country B, it is Y2. This means that country A possesses a relative advantage over country B in terms of future consumption (Y1 > Y2). Once capital exchange occurs, country A borrows from country B, as the former needs to finance its current consumption. Country B grants a loan to country A to gain from a higher interest rate. Country B thus replaces its current consump-

20

. Fig. 20.2  Intertemporal trade. Source Authors’ development

761 20.3 · External Debt

20

tion by lending. Capital exchange equalizes interest rates in the two countries at YE . In both countries, current demand balances current supply at equilibrium point E. The balance means that country A obtains a loan from country B in the amount of CE. The amount country A will pay in the future in exchange for increased current consumption equals CE × YE. Since with no trade, interest rate Y1 in country A is higher than interest rate Y2 in country B, country A is more attractive for international investors than country B. To exploit this gap, investors redirect capitals to country A and reduce investing in country B. As a result of the inter-country capital flow, the interest rate in country A goes down until it meets rising interest rate in country B at some equilibrium level YE. As the interest rate in country A falls from Y1 to YE, current consumption rises as investors’ interest in saving falls and interest in current consumption rises. As the interest rate in country B rises from Y2 to YE, current consumption declines as investors become interested in saving for the future. Therefore, the interest rate is determined by the ratio of supply of and demand for consumption in the future. Intertemporal trade is triggered by intertemporal comparative advantages and the corresponding difference in real interest rates between countries. Countries that borrow abroad have good investment opportunities relative to current production opportunities, while creditor countries do not possess such advantages. Case box The bulk of the international movement of credit capital accrues to developed economies, which act as both lenders and borrowers. Among developing countries, the largest creditors are oil-exporting countries, which invest their substantial revenues worldwide. In many developing countries, the ratio of external debt to gross national income exceeds 60% (the global average in 2020), while in some countries, it dramatically outweighs it (. Table 20.4).

A well-functioning system of international borrowing and lending enables its participants to increase national and world output. In practice, however, recurring debt crises in individual countries or regions show that the system is far from perfect. Such crises are commonly combusted by declarations by a group of countries or individual states that they suspend paying or servicing their external debts. This could happen because of a substantial rise in the total debt beyond a certain threshold, deterioration of trade terms, difficulties in regulating the balance of payments, a significant and prolonged overall decline in p ­ roduction, capital flight from a country due to the deteriorating economic and political situation, or reduced inflow of long-term capital and increased attraction of short-term loans at higher interest rates. Heavy external debt degrades countries’ ability to invest in expanding production or improving competitive advantages as debt servicing distracts substantial resources from development programs. Poor debt management amid external shocks such as a drop in prices or an economic downturn can also trigger a debt crisis. External debt is usually expressed in the currency of the lender’s country rather than that of a borrower. That means

Chapter 20 · International Capital Flows and Exchange

762

. Table 20.4  External debt, percent of GNI, by countries, 2000–2020, % #

Country

2000, %

#

Country

2010, %

#

Country

2020, %

1

Liberia

367.11

1

Panama

180.18

1

Mongolia

275.75

2

GuineaBissau

265.38

2

GuineaBissau

129.60

2

Lebanon

222.11

3

Guyana

205.54

3

Lebanon

126.05

3

Panama

208.13

4

Republic of Congo

205.01

4

Jamaica

111.53

4

Montenegro

200.64

5

Sierra Leone

202.62

5

Montenegro

109.91

5

Zambia

170.70

6

Zambia

168.71

6

Belize

105.26

6

Mauritius

155.66

7

Serbia

168.32

7

Bulgaria

102.16

7

Mozambique

154.41

8

Malawi

159.10

8

Laos

98.11

8

Jamaica

135.01

9

Laos

152.43

9

Kazakhstan

92.60

9

Georgia

132.97

10

Kyrgyzstan

150.49

10

Sao Tome and Principe

91.81

10

Bhutan

132.05

Source Authors’ development based on The Global Economy (2022)20

that if the borrower’s currency weakens, the debt servicing cost rises. Debt-related imbalances have contributed to some of the gravest economic crises (see 7 Chap. 7, 7 Sect. 7.3 for major financial and monetary crises of the modern age). In the context of the growing interconnectedness of financial markets, local debt crises (regardless of the level of economic development of a country) would trigger imbalances across the globe. The increased vulnerability of the financial market is one of the hallmarks of the new normal economic reality. 20.4  Exchange Rates and Currency Trading 20.4.1  Currency

The international movement of capital is mediated by currency circulation, that is, the exchange of the national currency of one country for the national currency of another country in a certain ratio. However, currency is not a type of money but

20

20 The Global Economy (2022b).

763 20.4 · Exchange Rates and Currency Trading

20

. Table 20.5  Currencies: classification criteria and types Criteria

Currency types

Currency range

National (internal) currency, foreign (external) currency, regional currency, global (supranational) currency

Relation to foreign exchange reserves

Base currency, reserve currency, other currencies

Convertibility

Fully convertible currency, partially convertible currency (external convertibility, internal convertibility), non-convertible currency

Operation

Currency of price, currency of payment, currency of credit

Relation to other currencies

Hard currency, soft currency

Currency form

Cash currency, cashless currency

Currency construction

One-component currency, basket currency

Source Authors’ development

a way of using money in international transactions that serve trade, investment, capital exchange, and other foreign economic activities. Currency is a way national monetary units operate to mediate international trade, economic, and financial activities through exchanging monetary units of different countries in established proportions. Various criteria can be used to classify currencies (. Table 20.5). The classification of currency by range or status distinguishes national and foreign currencies. National Currency is a monetary unit of a country, a legal tender for all operations within this country. Foreign Currency is a legal tender of other countries legally or illegally used within a country. Global Currency is one that is accepted for trade and other international transactions throughout the world. One of the variations of global currency is regional currency. It was first introduced in 1999 when the European Union launched the Euro. It simultaneously acts as the national currency in most EU countries, regional currency within the EU, and global currency for the rest of the world. In relation to the country’s foreign exchange reserves, currencies are distinguished between base currency, reserve currency, and other currencies. Base Currency serves as a basis for quoting other currencies in a country. Commonly, national currency of a country acts as a basis currency, in which prices of foreign currencies are expressed (see 7 Sect. 20.4.2 for exchange rates). Reserve Currency is the currency of a country most widely used for serving foreign operations and therefore accepted as a reserve of international means of payment. Central banks accumulate and store reserves in reserve currencies of other countries to diversify the currency portfolio. The reserve currency is used as an international means of payment and reserve and serves as the basis for determining currency parity and exchange rate for non-reserve currencies. It is also used in money market interventions to regulate exchange rates or cover balance of payments deficits. Reserve

764

Chapter 20 · International Capital Flows and Exchange

currencies include global currencies, such as the US Dollar and the Euro, as well as national currencies of the strongest economies, such as the Chinese Yuan and the Japanese Yen. To service foreign trade and economic operations, countries (economic entities) exchange national currencies for foreign ones (currencies of their trading counterparts, reserve currencies, or global currencies). Such an exchange is possible if a national currency is convertible to other currencies. The convertibility depends on the level of economic development of a country, its foreign economic activity and involvement in global supply chains, the situation in domestic capital and commodity markets, and the stability of money circulation. Fully Convertible Currency is a currency exchanged without restrictions for other national currencies, widely used for payments on international transactions, and traded in the main foreign exchange markets. Full convertibility implies no restrictions on import, export, and exchange of national currency to other currencies at any time. Partially Convertible Currency is a currency, which usage in servicing international transactions is somehow restricted by territory, type of currency transactions, or currency holders. Depending on the residence and foreign economic activities of a currency owner, either external or internal restrictions could apply. Under external convertibility, only foreigners (non-residents) are allowed to exchange national currency for foreign currencies freely. The transition of a country to convertibility commonly starts with external convertibility, i.e., imposing restrictions on residents and domestic firms, while liberalizing foreign exchange for non-residents. External convertibility stimulates foreign economic activities and attracts foreign investors by facilitating the international movement of capital and integrating a country into the global market. To expand business on local markets, non-residents increase demand for national currencies, which improves exchange rates and strengthens national currencies’ positions globally. Under internal convertibility, only residents have the right to exchange national currency for foreign currencies. Restrictions imposed on non-residents substantially degrade the international convertibility of national currency. Non-Convertible Currency is a national currency that cannot be exchanged for foreign currencies. These are the currencies of countries, where foreign exchange is highly restricted due to the lack of foreign exchange reserves, balance of payments deficit, or heavy external debt. Case box Defining exact parameters of freely convertible currencies varies depending on international financial organizations and agencies that develop such classifications. Most commonly, the freely convertible currencies pool includes Australian Dollar (AUD), Canadian Dollar (CAD), Danish Krone (DKK), Euro (EUR), Israeli Shekel (ILS), Japanese Yen (JPY), Mexican Peso (MXN), New Zealand Dollar (NZD), Norwegian Krone (NOK), Singapore Dollar (SGD), South African Rand (ZAR), South Korean Won (KRW), Swedish Krone (SEK), Swiss Franc (CHF), Pound Sterling (GBP), and United States Dollar (USD).

20

765 20.4 · Exchange Rates and Currency Trading

20

Types of currency transactions include currency of price, currency of payment, and currency of credit. Currency of Price is a currency that expresses prices of goods or services in contracts. When concluding a contract, the choice of a particular currency of price is determined by the specifics of trade in certain goods or services on the international market, supply and demand on a particular market, intergovernmental agreements, national regulations, and relations between counterparts. Currency of Payment is a currency in which the payment of goods in foreign trade operations or the repayment of an international loan is made. If it is different from the currency of price, the contractually agreed conversion rate applies. Currency of Credit is a currency in which a lender grants commercial, banking, or international loans. The use of certain currency of credit is determined by business practices established between countries, banks, and economic entities. The choice of a particular currency of credit affects the interest on a granted loan. Commonly, lenders set higher interest rates for volatile (“softer”) currencies to mitigate currency risks, while more stable (“harder”) currencies imply lower rates. Hard Currency is a currency that remains relatively stable in relation to its nominal value and exchange rates of other currencies over the long term. Most of freely convertible, reserve, and global currencies are hard currencies. Soft Currency is a volatile currency whose exchange rate fluctuates significantly due to various economic or political factors. When a national currency weakens and remains volatile for a long period of time, a parallel circulation of two or more currencies may arise. To mitigate exchange risks, domestic economic entities may refuse to use soft national currency as a means of circulation or saving and substitute it with a harder foreign currency (currency substitution). Currencies are divided into cash and cashless currencies in terms of currency form. Cash Currency is banknotes and coins denominated in a certain currency that facilitate cash circulation within a country and abroad. Cash currency operations are mainly carried out by authorized banks and organizations, as well as individuals. Cashless Currency is an accounting entry used in facilitating non-cash settlements between authorized banks, legal entities, and individuals. Case box In recent years, cryptocurrencies have been emerging as an alternative form of currency. Cryptocurrency is an electronic means of payment that has no physical expression (like cash currency) and no entry in accounts in banks or any other financial organization (like cashless currency). Still, crypto “coins” can be used similar to conventional money as a means of saving or payment. A key feature of cryptocurrencies is the decentralization of issuance and exchange, i.e., no internal or external administrator (like a central bank in the cases of both cash and cashless money). Therefore, neither public authorities nor banks have yet developed efficient mechanisms to influence and regulate transactions of crypto assets. So far, cryptocurrencies remain a highly volatile financial instrument, but some countries are making attempts to use cryptocurrencies as legal tender. Thus, in 2022, El Salvador issued bitcoin bonds in the amount of $500 million.

766

Chapter 20 · International Capital Flows and Exchange

According to the construction principle, currencies are distinguished between one-component currencies and basket currencies. Most of the currencies based on national monetary units are one-component ones. Basket Currency is an interstate monetary unit whose exchange rate is defined as a weighted average of market values of several national currencies. Basket currencies are commonly cashless, unlike one-component currencies used in cash and cashless forms in everyday transactions. Case box An example of a basket currency is the Special Drawing Rights (SDR), an international reserve asset used by the IMF to supplement official reserves of its member states. The weighted average value of SDR is determined based on exchange rates of the Chinese Yuan, the Euro, the Japanese Yen, the Pound Sterling, and the United States Dollar. During the COVID-19 pandemic, substantial amounts of SDRs have been distributed between IMF member countries to meet the long-term global need for reserves, increase confidence in financial and monetary systems, strengthen the resilience and stability of the global economy, and support liquidity-deficit countries.

20

The new normal economic reality has transformed the global currencies pool. The pound sterling, which dominated in the XIX century, and the US dollar, which has been dominating since the 1950s, are now facing increased competition on the part of the Euro, the Japanese Yen, and, most recently, the Chinese Yuan. The global currency status is determined by leading positions of a country on the global market, deep involvement of domestic firms in transcontinental production and supply chains, substantial foreign exchange reserves, developed network of credit and banking institutions abroad, capacious financial market, liberalization of foreign exchange operations, and currency convertibility. The internationalization of the national currency can be driven by subjective factors, such as the active monetary and credit policy of a country during a certain period of time or a tradition of using certain currency as world money (for example, the Pound Sterling before the World War II). From the institutional point of view, the global currency status is conditioned by the penetration of certain national currencies into international circulation through banks and international financial organizations. The global currency status gives advantages to the issuing country, including covering the balance of payments deficit with the national currency or minimizing currency risks in international transactions. At the same time, this status imposes certain obligations on the issuing country, such as maintaining the relative stability of its national currency or avoiding exchange and trade restrictions. The use of national monetary units initially intended for servicing the domestic economy as an international measure of value, means of payment, and means of saving stirs discords. Relying on one currency to serve world economic relations potentially threatens the stability of the entire international payments system. The slightest disbalance in the issuing country could spread like wildfire across financial markets worldwide.

767 20.4 · Exchange Rates and Currency Trading

20

20.4.2  Exchange Rate

International economic transactions are mostly associated with exchanging one currency for another. In particular, such a need arises in foreign trade, long- or short-term investments abroad, and other transborder capital movements. So there is a need to establish a certain exchange ratio between currencies. Exchange Rate is the price of a country’s monetary unit expressed in monetary units of other countries. It is a specific monetary category that reflects the interaction of domestic and international markets through comparing domestic and world prices. The former is affected by domestic macroeconomic parameters such as cost, utility, demand, and others. When offering their goods globally, suppliers “reset” domestic effects and consider international pricing factors. The exchange rate serves as an internationally accepted measure of domestic prices. Directly, it facilitates international exchange by unifying monetary units of different countries. What is more important, it indirectly compares economic, financial, social, and political processes taking place in these countries and expresses them through relative prices of national currencies in the world market. This role enables the international exchange as such by providing a criterion of overall economic “rating” of a particular country (economic stability, quality and transparency of economic and financial policy, competitiveness of goods, and many other macroeconomic parameters). Depending on the approach to regulation, either fixed or floating exchange rates apply. Fixed Rate is an administered rate established based on the determined foreign exchange parities. In a fixed exchange rate system, the central bank (or other regulatory bodies) fixes the relative price of domestic and foreign currencies, or Currency Parity, in one of the following three ways: 5 Single-currency peg is pegging the exchange rate of a country’s national currency to the exchange rate of a foreign currency. For example, currencies of some small island states in the Caribbean are pegged to the US Dollar. In Africa, many currencies used to be pegged to the French Franc in the XX century (now some of them are pegged to the Euro). 5 Basket-currency peg is pegging the exchange rate of a country’s national currency to the basket of several currencies. It is less transparent than a single-currency peg, but some small countries deeply involved in international trade practice this exchange rate regime in an attempt to diversify risks and protect their monetary system from fluctuations of a single currency. The currency basket commonly includes currencies of major trading partners. 5 Currency committee peg is the most rigid form of administered pegging to a determined exchange rate set by the government (central bank). It allows no market-driven adjustments of the real exchange rate in response to either expansion or contraction of the money supply or any other changes in macroeconomic parameters. A more common alternative to a fixed exchange rate is a Floating Exchange Rate, which changes under the influence of supply of and demand for national

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and foreign currencies on the market. As long as a central bank does not interfere in the currency exchange by purchasing or selling foreign currency, a national currency remains in the free float regime. If it influences the exchange rate through foreign exchange transactions (selling national currency to depress its exchange rate or buying it to push the rate up), the managed float regime applies. Variants of managed float are crawling peg (central bank interventions in the foreign exchange market to achieve a specific desired exchange rate) and currency corridor (keeping the exchange rate between certain minimum and maximum values). The administered appreciation of the exchange rate by a central bank under a fixed exchange rate regime is called Revaluation. Conversely, Devaluation is an administered depreciation of the exchange rate by a central bank under a fixed exchange rate regime. The decline in the exchange rate under the floating regime is called Depreciation. Currency depreciation makes national goods cheaper and thus favors export and capital inflow, since non-residents can receive more money (national currency) in exchange for their currency. If a country experiences a balance of payments surplus, that means that domestic goods and financial assets are in greater demand than foreign goods and financial assets abroad. This increases the demand for the national currency and appreciates its exchange rate. Appreciation is the growth of the exchange rate under the floating exchange regime. The increase in the exchange rate makes non-residents spend more of their currency to get a unit of the national currency. This boosts prices of domestic goods, reduces exports, and stimulates imports of less expensive (in terms of appreciating national currency) foreign analogs. Too high exchange rate cools down as a result of a market-driven interaction between demand and supply, and the balance of payments equilibrium is restored without government intervention (. Table 20.6).

. Table 20.6  Effects of fixed and floating exchange rates Exchange rate/ currency

National currency appreciation

National currency depreciation

Rise in exchange rate

Drop in exchange rate

Fixed exchange rate National currency

Revaluation

Devaluation

Devaluation

Revaluation

Foreign currency

Devaluation

Revaluation

Revaluation

Devaluation

Floating exchange rate

20

National currency

Appreciation

Devaluation

Devaluation

Appreciation

Foreign currency

Devaluation

Appreciation

Appreciation

Devaluation

Source Authors’ development

769 20.4 · Exchange Rates and Currency Trading

20

As noted above, an exchange rate is not only a value of one currency expressed through another, but also a reference that allows comparisons between the economies of different countries. As such, proper assessment and analysis of economic development trends through comparing exchange rates of national currencies requires distinguishing between the nominal and real exchange rates. Nominal Exchange Rate is a direct expression of one currency’s price through the price of another currency (Eq. 20.3):

En =

Cf Cd

(20.3)

where En  nominal exchange rate; Cf   foreign currency; Cd  domestic currency. Real Exchange Rate is a ratio in which domestic goods can be exchanged for foreign goods calculated based on the correlation of the nominal exchange rate and the change in the price levels in the trading countries (Eq. 20.4).

Er = En ×

Pd Pf

(20.4)

where Er  real exchange rate; Pf   foreign price index; Pd  domestic price index. If the real exchange rate is high, foreign goods are relatively cheap, while domestic ones are relatively expensive. Domestic consumers purchase more foreign goods, while foreigners buy fewer domestic ones. Exports decline, and imports grow until a country turns into a net importer (extreme case). Conversely, if the real exchange rate is low, foreign goods are relatively expensive and less demanded, while domestic goods are relatively cheap and more demanded on the domestic market. A country reduces imports and increases exports of price-competitive domestic goods. Such a country is likely to become a net exporter. Like any market price, the exchange rate (the flexible exchange rate and its crawling peg and currency corridor variations) is a product of the supply-demand interaction (see 7 Chap. 5, 7 Sect. 5.1.3 for the concept of market equilibrium). Balancing supply and demand on the foreign exchange market results in establishing an equilibrium market exchange rate (. Fig. 20.3). The demand for foreign currency D is determined by the country’s needs in imports, the demand of economic entities (for example, traders and investors) for foreign financial assets, the demand of individuals (for example, tourists) for foreign currency, and many other foreign-related expenditures. The higher the exchange rate R, the lower the demand for foreign currency and the lower the amount of foreign currency Q on the domestic market. The supply of foreign currency S is determined by the de-

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. Fig. 20.3  Exchange rate equilibrium. Source Authors’ development

20

mand of non-residents for the national currency. The lower the national currency’s exchange rate in relation to the foreign one, the greater the number of domestic entities willing to purchase foreign currency. On the currency market, the supply-demand ratio is influenced by various factors, not exclusively economic ones. The multifactoriality of the exchange rate reflects its relationship with non-currency economic categories, such as costs, prices, money, interest rates, and balance of payments. The roles of individual factors in establishing the exchange rate change depending on the economic and political situation in a country and the world. Structural factors include competitiveness of domestic goods on the world market, the country’s balance of payments position, the purchasing power of national monetary units and inflation rates, difference in interest rates in different countries, government regulation of the exchange rate, and openness of the economy for international trade and investment. Market factors characterize the business environment in a country as well as the political situation, forecasts, and expectations. The fundamental exchange rate determinant is inflation, which affects the exchange rate by changing the purchasing power parities ratio. Purchasing Power Parity is the exchange rate that equalizes purchasing powers of national and foreign currencies. The purchasing power parity (PPP) concept assumes that over a long period of time, free trade equalizes prices of identical goods (basket of goods) across the countries (minus transaction costs). International competition balances domestic and foreign prices for goods and services traded in the global market. The higher the inflation rate in a country, the lower the exchange rate of its currency (all other conditions being equal). Inflationary depreciation of money on the domestic market depresses purchasing power of the national currency and thus declines its exchange rate against the currencies of lower-inflation countries. Suppose demand in country A for goods from country B declines due to higher inflation in country B. Consequently, country A reduces demand for the currency of country B, and the D1 curve shifts downward left to D2 (. Fig. 20.4). An inflationary rise in domestic prices in country B boosts the import of cheaper goods from country A. An increase in demand of country B for foreign currency

771 20.4 · Exchange Rates and Currency Trading

20

. Fig. 20.4  Effect of inflation on exchange rate. Source Authors’ development

. Fig. 20.5  Effect of a balance of payments on exchange rate. Source Authors’ development

of country A shifts the supply curve of the national currency of country B downward right from S1 to S2. As a result, the exchange rate of currency A against currency B grows from R1 (equilibrium point E1) to R2 (equilibrium point E2). That means that at the new equilibrium point E2, the same unit of currency B costs fewer units of currency A (R2 < R1). The exchange rate is affected by the balance of payments. The balance of payments surplus contributes to the currency appreciation, because foreign importers and debtors increase the demand for national currency. The balance of payments deficit depreciates national currency, as debtors exchange it for foreign currency to service or repay their external obligations. The higher the real exchange rate, the more expensive the domestic goods compared to foreign goods. That means a lower net demand for exports and a smaller current account surplus of the balance of payments. Therefore, net export NX is a function of the real exchange rate R (. Fig. 20.5). The current account balances the capital account (the excess of domestic investment over domestic savings is equal to the amount of domestic capital accumulation financed by foreign loans). That means that the current account balance is equal to the difference between savings S and investment I . Neither savings

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nor investments depend on the real exchange rate, so the (S − I) curve is a straight line. The intersection point E determines the equilibrium exchange rate R1. At this point, the amount of monetary units generated by capital account transactions is equal to the amount of monetary units required to cover the current account balance. Another exchange rate determinant is the change in interest rates. All other things being equal, changes in interest rates in the domestic market affect the foreign movement of capital, particularly short-term capital. An increase in the interest rate stimulates the inflow of foreign capital, while its cut encourages the outflow of capital, including domestic capital. Also, interest rates affect financial and banking operations. Banks gain profit from exploiting the difference in interest rates between the domestic and global financial markets. They borrow cheaper loans from a market where rates are lower and invest borrowed currency in a market where interest rates are higher. Thus, on the one hand, a nominal increase in interest rates on the domestic market decreases demand for a national currency, as loans become more expensive. The use of more expensive loans translates into higher production costs and, consequently, higher prices for domestic goods. As purchasing power parity declines, a national currency depreciates against foreign currencies. On the other hand, an increase in real interest rates (i.e., nominal interest rates adjusted for inflation) makes investments more profitable for foreigners (all other things being equal). Markets where interest rates are higher attract capital (see the illustration of intertemporal trade in . Fig. 20.2). Therefore, the demand for national currency in such markets goes up, and the exchange rate R of a national currency rises against foreign currencies (R1 shifts to R2 in . Fig. 20.6). Exchange rates are affected by both market and administrative regulations widely used today across developed and developing economies. In the new normal economic reality, the high interconnectedness of national markets increases the volatility of exchange rates against each other, which in turn aggravates disequilibrium in foreign exchange markets. Therefore, pure floating exchange rates are rather a theoretical concept. To a greater or lesser extent and by direct administrative measures or indirect market methods, monetary authorities in most countries intervene

20

. Fig. 20.6  Effect of interest rate on exchange rate. Source Authors’ development

773 20.4 · Exchange Rates and Currency Trading

20

in their national foreign exchange markets and manage exchange rates to avoid sharp fluctuations. The domestic economic policy also matters. Thus, if the government pursues an expansionary economic policy to stimulate growth (see 7 Chap. 11, 7 Sect. 11.4 and 7 Chap. 13, 7 Sect. 13.4 for expansionary monetary and fiscal policy), then the cut in savings shifts the (S1 − I) curve to the left to (S2 − I) (. Fig. 20.7). Accordingly, the fall of net exports from NX 1 to NX 2 contributes to establishing a current account deficit. A decline in supply boosts the real exchange rate from R1 to R2, i.e., the price of a national currency rises. Domestic goods become more expensive compared to foreign goods, which stimulates imports. If foreign governments pursue expansionary policy, it reduces global savings and raises the global interest rate from r1 to r2 (. Fig. 20.8). Such an increase pushes (S − I(r1 )) up to (S − I(r2 )), because domestic capital moves to foreign markets where the interest rate is higher (thus generating new supply). The consecutive increase in net exports from NX 1 to NX 2 contributes to establishing a current account surplus. The equilibrium real exchange rate declines from R1 to R2. National currency depreciates, and domestic goods become less expensive than foreign ones.

. Fig. 20.7  Effect of domestic policy on exchange rate. Source Authors’ development

. Fig. 20.8  Effect of foreign country’s policy on the exchange rate. Source Authors’ development

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The exchange rate is also affected by other factors, in particular, speculative currency transactions. If the national currency rate tends to decrease, then economic entities exchange it for more stable currencies, which further depresses the national currency rate. Currency markets react quickly to changes in the economic and political environments and related fluctuations in exchange rates. Amid financial and economic downturns, currency speculation and the spontaneous migration of hot money between markets intensify. The use of a particular currency on the global financial market and international settlements also matters. For example, the fact that the vast majority of international payments are made in US dollars fuels the demand for that currency. The international payments timing also affects exchange rates. Anticipating the depreciation of a national currency, importers seek to speed up payments in foreign currency in order to avoid losses due to the exchange rate rise. Exporters delay the repatriation of foreign exchange earnings to benefit from the rise. When a national currency appreciates, importers gain from delaying payments in foreign currency, while exporters accelerate the transfer of foreign exchange earnings to the domestic market. In the context of the new normal permanent instability in both global markets and relations between countries, exchange rates are increasingly affected by political factors and expectations rather than the economic situation. In such circumstances, the confidence in a country’s policy and its government is worth more for the exchange rate than macroeconomic parameters of that country. Often, the exchange rate is affected by an expectation of some data on trade and payments balances, the results of presidential or parliamentary elections, or international sanctions or other measures against certain countries. 20.5  Foreign Exchange Market

20

Interaction between the demand for currencies and their supply occurs on the foreign exchange market. Foreign Exchange Market is the sphere of economic relations that accommodates the purchase and sale of currencies and investment of foreign exchange capital. The market facilitates international settlements, insurance against currency risks, diversification of foreign exchange reserves, and currency interventions. It includes authorized banks (central banks and other monetary authorities), investment companies, currency exchanges, brokerage offices, economic entities involved in international trade, and individuals engaged in foreign exchange operations. From an organizational and technical point of view, the foreign exchange market is a set of communication systems that connect banks into a global network. Central banks, large commercial banks, and financial companies are active market makers. They set exchange rates or affect them by selling or purchasing national and foreign currencies in the global, regional, and domestic markets. Medium and small commercial banks and other economic entities and individuals are passive market users. Their influence on exchange rates is negligible. Foreign exchange markets are divided into the global exchange market and domestic currency markets of individual countries (. Fig. 20.9). Global foreign

775 20.5 · Foreign Exchange Market

20

. Fig. 20.9  Types of foreign exchange markets. Source Authors’ development

exchange market captures all national foreign exchange markets interconnected by communication systems. Capital flows between them depending on the data on individual currencies and expectations of currency traders. Domestic foreign exchange market is the foreign exchange market of a country, which can be divided into regional currency markets if several currency exchanges operate within a country’s territory. In relation to currency exchange restrictions and regulations, the foreign exchange market can be either restricted or unrestricted. Currency Restrictions are a set of public regulations of foreign exchange (administrative, economic, organizational) introduced at both national (government, central bank, other national monetary authorities) and international levels (IMF and other international financial and monetary organizations and agencies). Depending on currency pegs used in floating and fixed exchange regimes, foreign exchange markets are distinguished between single-mode and dual-mode markets. Single-mode market is a foreign exchange market that applies a floating exchange rate set during currency trading based on the interaction between the supply of and demand for national and foreign currencies. Dual-mode market is a market that simultaneously applies fixed and floating exchange regimes. The dual exchange rate regime is used by monetary authorities as a measure to regulate the movement of capital between the domestic and global capital markets. The parallel use of two modes mitigates the potential adverse impact of the global capital market on the economy. In addition, it allows the government to adjust exchange rates depending on the macroeconomic situation. According to the type of organization, currency markets are divided into stock exchange markets and non-exchange markets. Stock exchange market is a market operating in the form of a stock exchange, where commercial banks and authorized brokers and dealers conduct currency transactions. Non-exchange market is an interbank market, where banks, brokerage companies, legal entities,

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and individuals carry out currency transactions through commercial banks on a contractual basis. An example of an interbank market is the FOREX market, where market actors settle transactions by phone or electronic networks. In decentralized FOREX trading, the exchange is less restricted compared to the stock exchange or futures markets. Foreign currencies are purchased and sold in anticipation of making a profit from changes in the exchange rates in the domestic and international markets. Changes taking place in the foreign exchange markets are tracked through Conversion Transactions—immediate and fixed-term deals between foreign exchange market participants on purchasing and selling foreign currencies based on the agreed exchange rate and the date of completion. Contracts on immediate delivery terms are conversion operations with a value date of no more than two days from the contract date. The value date is the currency delivery date, i.e., the date when the contracted amount of currency is actually placed at the disposal of the transaction parties. One of the most common immediate transactions is Spot—a conversion operation with a value date no later than the second business day after the contract date. Spot transactions are used not only for immediate receipt of currency, but also for currency risk insurance and speculative operations. Whether free-floating or fixed, the spot rate reflects the current value of a national currency on the global market. Fixed-term currency transactions are transactions for the exchange of currencies at a pre-agreed exchange rate concluded today, but with a value date postponed for a certain period in the future. A time gap between the contract date and the delivery date (currency exchange date) is applied to hedge currency risks (gain from changing rates in the future compared to the contract date). Four types of fixed-term currency transactions are most commonly practiced: 5 Foreign exchange swap is an agreement on the simultaneous purchase and sale of approximately equal amounts of currency, provided that they are settled on different dates. Purchase and sale of two currencies take place on the terms of immediate delivery with simultaneous counter-deal for a certain period with the same currencies. 5 Forward a contract for the exchange of currency (a valid delivery of currency) at a certain date in the future at a predetermined rate. Traded currencies, their amounts, exchange rates, and the payment date are fixed at the time of contracting. A forward operation is often an element of a swap transaction. 5 Currency futures is a contract for the purchase and sale of currency in the future, in which a seller commits to sell and a buyer commits to buy a certain amount of currency at a set exchange rate within a specified period of time. Unlike customized and privately agreed and traded forwards, futures are standardized contracts traded publicly on stock exchanges. 5 Option is a bilateral contract for the right to buy or sell a certain asset (securities, currency, precious metals, etc.) at a fixed rate on a predetermined date or within an agreed period of time.

20

Irrespective of the particular exchange instrument used, currency exchange parties are exposed to greater or lower currency risks. Floating exchange rates,

777 20.5 · Foreign Exchange Market

20

unstable balances of payments, currency speculations, and debt crises make currency fluctuations more volatile and less predictable (see 7 Chap. 7, 7 Sect. 7.3 for major monetary and stock market crises). Currency Risk is the risk associated with changes in the exchange rate in the period between the contract date and the delivery (payment) date. The longer the period between the two dates, the higher the currency risk. Currency risk can be both a risk of loss and a risk of lost profits depending on the contracting party and the change in the exchange rate. On the contemporary market, the situation can change within hours or even minutes, so even the shortest spot transactions with immediate delivery are still exposed to currency risk. Therefore, with the increase in borrowing in international capital markets, large companies have been paying more attention to the state of foreign exchange assets and liabilities, resorting to ever-increasing volumes of bank insurance (hedging). For an exporter, the risk of loss is associated with reducing the export contract value in the exporter’s currency due to the foreign currency depreciation. An importer risks losing from the increase in the value of the import contract as a result of the increase in the foreign exchange rate. For a lender, a loss could occur due to the fall of the cost of a loan when the currency of credit appreciates in relation to the currency of payment. A debtor faces a loss when the cost of the loan rises with an increase in the currency of payment in relation to the currency of credit. Changes in exchange rates also affect the performance of transnational companies, which invest worldwide in different currencies. Given that transnational companies and transnational banks are now the largest foreign exchange actors, most of the currency risks that arise turn into international (or translational) risks. Translational risk arises when company’s assets and profits are converted into the national currency on a certain date. With the devaluation of foreign currency, the amount of capital investments expressed in foreign currency may be lower than that expressed in national currency and even turn into a loss. In this regard, transnational companies, banks, and other foreign exchange market actors diversify their foreign exchange assets, thus stimulating demand for the currencies of developed economies and the most stable and predictable developing countries (global, reserve, and fully convertible hard currencies). Chapter Questions: 5 How can capital movement supplement or substitute trade? 5 What is the fundamental difference between the classical and the Keynesian interpretations of international capital movement? 5 Do you agree that international financing for development does promote economic growth and development? Weigh key advantages and critical disadvantages. 5 Differentiate direct foreign investment from portfolio foreign investment. Discuss principal features of the two types of foreign investment in terms of start-up capital, control, returns, and liquidity. 5 Do you think external debt is a problem for a borrowing country? Most of developed economies are the world’s largest borrowers, but they still perform well. Debate this issue from the standpoints of lenders and borrowers and developed and developing economies.

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5 How do you understand the concept of reserve currency? Does a reserve currency need to be a global currency or a fully convertible currency? 5 How would you characterize the exchange rate regime practiced in your country? Apart from government regulations (if any), what other factors affect the exchange rate in your country? Subject Vocabulary:

20

Appreciation: a market-driven growth of the currency exchange rate under the floating exchange rate regime. Currency: a way national monetary units operate to mediate international trade, economic, and financial activities through exchanging monetary units of different countries in established proportions. Currency Restrictions: a set of administrative, economic, and organizational regulations of foreign exchange introduced at the national and international levels. Currency Risk: a risk associated with changes in the exchange rate in the period between the contract date and the delivery (payment) date. Depreciation: a market-driven decline of the currency exchange rate under the floating exchange rate regime. Devaluation: an administered depreciation of the currency exchange rate by a central bank under a fixed exchange rate regime. Exchange Rate: a price of a country’s monetary unit expressed in monetary units of other countries. External Debt: a part of the total debt of economic entities in a country attributable to foreign creditors (international organizations, countries, or private capital). Foreign Direct Investment: an acquisition of a long-term interest by a resident of one country (direct investor) in a resident asset of another country (an enterprise with direct investments). Foreign Exchange Market: the sphere of economic relations that accommodates purchasing and selling of currencies and investment of foreign exchange capital. Foreign Portfolio Investment: an investment in the form of a group of assets (portfolio), including operations with equity and debt securities. International Borrowing and Lending: the issuance and receipt of funds to/ from foreign lenders with interest payment for the use of these funds for an agreed period of time. International Capital Flows: the movement of value in monetary and/or commodity form from one country to generate higher profits in a recipient country, or the counter-movement of capital between countries. Intertemporal International Trade: an exchange of goods and services today for those in the future. Investment: a profit-oriented injection of capital or other resources or property in the creation of new value or the replacement of worn-out production facilities or factors of production on the domestic market or abroad.

779 References

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Nominal Exchange Rate: a direct expression of one currency’s price through the price of another currency. Purchasing Power Parity: an exchange rate that equalizes purchasing powers of national and foreign currencies. Real Exchange Rate: a ratio in which domestic goods can be exchanged for foreign goods calculated based on the correlation of the nominal exchange rate and the change in the price levels in the trading countries. Revaluation: an administered appreciation of the currency exchange rate by a central bank under a fixed exchange rate regime.

References Chenery, H., & Strout, A. (1966). Foreign assistance and economic development. American Economic Review, 56(3), 679–733. Harrod, R. F. (1948). Towards a dynamic economics. Macmillan. Iversen, C. (1935). Aspects of the theory of international capital movements. Levin & Munksgaard. Oxford University Press. Keynes, J. M. (1936). The general theory of employment, interest and money. Macmillan. Kindleberger, C. P. (1988). International capital movements. Cambridge University Press. Kiyoshi, K. (1977). Theory of foreign direct investment. Diamond. Kurihara, K. (1951). Monetary theory and public policy. Allen & Unwin. Kuznets, S. (1955). Economic growth and income inequality. American Economic Review, 45(1), 1–28. Machlup, F. (1964). International payments, debts and gold. Scribner. Mill, J. S. (1848). Principles of political economy. John W. Parker, West Strand. Nurkse, R. (1953). Problems of capital formation in underdeveloped countries. Oxford University Press. Ohlin, B. (1933). Interregional and international trade. Harvard University Press. Ricardo, D. (1817). On the principles of political economy and taxation. John Murray, Albemarle-Street. Rosenstein-Rodan, P. (1976). The theory of the “Big Push.” In G. Meier (Ed.), Leading issues in economic development (pp. 632–636). Oxford University Press. Smith, A. (1776). An inquiry into the nature and causes of the wealth of nations. W. Strahan The Global Economy. (2022a). Portfolio investment inflows, equities – country rankings. 7 https://www. theglobaleconomy.com/rankings/Portfolio_investment_inflows/ The Global Economy. (2022b). External debt – country rankings. 7 https://www.theglobaleconomy. com/rankings/External_debt/ United Nations Conference on Trade and Development. (2022). Data center. 7 https://unctadstat.unctad.org/EN/Index.html Walras, L. (1954). Elements of pure economics, or the theory of social wealth (Trans. by Jaffe, W). Allen and Unwin.

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International Migration of Labor

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_21

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Chapter 21 · International Migration of Labor

Learning Objectives: 5 Learn the fundamentals of international migration of labor 5 Explore major theories of international migration of labor (the migration laws, the push and pull factors theory, the neoclassical theory of migration, the dual labor market theory, the new economics of labor migration, the world systems theory of migration, and the human capital approach to migration) 5 Summarize economic and non-economic drivers and effects of international migration for donor and recipient countries 5 Examine contemporary approaches to the governance of immigration and reemigration 5 Discuss the new normal trends of international migration and the global exchange of labor 21.1  Fundamentals of International Migration

The international division of labor implies substantial disparities between countries in the availability of labor resources in terms of their size and qualities (see, for example, 7 Chap. 17, 7 Sect. 17.4 for inequalities in human capital development). A broad interpretation of the international division of labor as a specialization of countries in exploiting their advantages does not necessarily imply subsequent cooperation of results. However, if the latter occurs, it takes the forms of the exchange of goods and services produced based on the division of labor (international trade) or the exchange of labor itself (international migration). International Migration of Labor is the resettlement of the employable population from one country (territory) to another for an extended period of time (over a year) due to economic or non-economic reasons. In the past, migration was associated with people’s movements to new places of residence. In the context of globalization, such movements have become more intense and more diverse. Today’s huge global migration flows occur between continents, cover many states, and impose significant impacts on the economic, social, and technological development of cities and countries. According to the above definition, migration can be triggered by various factors (detailed in 7 Sect. 21.3 below). The essential one is the inter-country wage differentials. The search for higher wages forces people to abandon their accustomed places and experience significant economic, social, and psychological expenditures. International migration flows react to changes in the economic situation in certain countries or regions (the new normal migration trends are discussed in 7 Sect. 21.5), but migrants have always tended to prefer higher-return markets over lower-return ones. International migration can be classified according to various criteria (. Fig. 21.1). Thus, in terms of the direction of movement, there are emigration (outflow of people from a country), immigration (inflow of people into a country), reemigration (return of emigrants to their home country), and repatriation (return of immigrants to the country of origin).

783 21.1 · Fundamentals of International Migration

21

. Fig. 21.1  Types of international migration. Source Authors’ development

The second criterion refers to the nature of a location or dimension of a migration flow. Migration can occur within a country or a territory (internal migration), between countries (international migration), or between member countries that establish any kind of an integration association that allows trans-border movement of people (integration migration). According to the permanence (duration), migration is divided into permanent migration, temporary migration, seasonal migration, and commuting migration. Permanent migration is the departure of people abroad for permanent residence. Such migration is irreversible, i.e., emigrants pursue the goal of staying in a new country for a long time with the expectation of obtaining a permanent residence permit or citizenship. Temporary migration is the migration of people of active working age to get a job in another country for a certain period of time. Commonly, temporary migrants plan to earn and save capital abroad in a few years and then return to their home countries to start businesses or invest the money. Temporary migration can serve as a step to permanent migration. Temporary mi-

784

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grants who have succeeded abroad (a certain level of income, career development, social status, etc.) commonly prefer assimilating in a host country over returning home. Seasonal migration is the migration to a foreign country in a certain period of a year and for a certain period of time. One of the illustrative examples of seasonal migration is agricultural employment abroad during the harvesting season. However, seasonal production does not necessarily require seasonal labor. For example, agro-industrial integration in agriculture, intersectoral cooperation in the use of labor, and the introduction of new technologies and innovations reduce the need for seasonal migration. Commuting migration is the daily or weekly cross-border movements of people from places of residence to places of work. Commuting flows commonly occur between cross-border cities or cross-border rural areas and cities. In some countries, where large urban agglomerations are located close to the border, daily circular migrations between the two neighbor points across the border may exceed the total temporary migration flows between the countries. According to the degree of freedom, migration is classified into voluntary migration (non-forced resettlement of people), forced migration (removal or deportation of people from a country based on a decision of the judiciary, police, or other authorities), organized migration (migration carried out by authorized firms or organizations in accordance with national or international legislation, for example, organized recruitment of workers to work on a construction site abroad or recruitment of employees to work at foreign offices of a transnational corporation), and irregular migration (illegal or unreported movement of people between countries). As noted above, motives for making a migration decision are highly diverse (further detailed in 7 Sect. 21.3). The bulk of international migration is labor migration, which is the movement of people between countries in search of employment, higher remuneration for their labor, or career development. Labor migrants move due to economic reasons. From the point of view of ­economic theory, labor migration is the relocation of the factor of production (labor) from factor-surplus markets to factor-scarce markets invoked by the supplydemand interaction. Business migration is closely related to labor migration. Business migration is the migration of entrepreneurs in order to find better conditions for doing business (higher economic stability, more promising markets for doing business, business freedoms, and other parameters). Other types of migration in this classification (ethnic, family, etc.) are predominantly affected by social and other non-economic factors. The sixth classification refers to migrants who establish migration flows. According to the International Labor Organization (ILO), they include permanent resettlers (people moving to another country for permanent residence), contract workers (people employed temporarily, mainly seasonal workers and low-skilled labor engaged in heavy and unhealthy work with poor professional growth opportunities), high-qualified workers (employees with substantial work experience and qualification, including top specialists, managers, teachers, and students), irregular migrants (people entering and staying in a host country illegally, including foreigners with expired visas or those working with no work

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permit), and refugees (people forced to emigrate from their countries due to threats to their lives and activities, such as wars, violence, violations of human rights, natural disasters, environmental disasters, etc.). Case box Massive migration flows have always been associated with economic, social, or political disasters. During and after the World War I and World War II, flows of forced migrants substantially affected the demographic structure of the population in Europe and across the world. For example, in the late 1940s, several million Germans staying outside the new border of Germany were resettled in the territories of the Federal Republic of Germany and the German Democratic Republic (then again united in 1990). Substantial flows were caused by the breakup of the Soviet Union and rather hard economic and political transformations across Eastern Europe, Russia, South Caucasus, and Central Asia. Since the mid-2010s, civil and military tensions in the Middle East have sparked refugee crises in the EU and neighboring countries.

Migration occurs both between and within groups of developed and developing countries: 5 Migration from developing to developed countries. For the latter, foreign labor from developing countries means supplying domestic industries with labor (see 7 Sect. 21.3 to learn how migration affects host countries). Today, certain sectors in developed countries can hardly operate without attracting foreign labor (for example, public utility services). 5 Migration from developed to developing countries. The developed-developing migration flows are substantially smaller compared to reverse emigration to the Global North countries. Nevertheless, people still migrate to the Global South (mainly temporarily), being attracted by high wages that developing countries offer to qualified specialists for the purpose of adopting advanced foreign experience and competencies in specific sectors (for example, professors at universities, top managers, coaches, etc.). 5 Migration within developed countries (mainly due to non-economic motives rather than purely economic factors). 5 Migration within developing countries. Several new centers of attraction have emerged in the Global South, such as the newly industrialized countries in Southeast Asia or the oil-exporting Persian Gulf countries. They attract migrants from other developing and least developed economies. Case box Migration from developing to developed countries still dominates the world’s total migration. It is consistent with the theories of economic development that ­explain the exchange of factors of production between the periphery and center countries (see 7 Chap. 15, 7 Sects. 15.3.4 and 15.6.3 for the international dependence models and 7 Sect. 15.6.1 for the center-periphery structuralist model of economic development).

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However, it is not only the low-skilled labor that is migrating. Many developing countries face the brain drain problem—the outflow of skilled workers that degrades domestic labor’s overall quality and potential. Attracting intellectual immigration is part of the government policy in a number of developed countries. The USA, Canada, Australia, and other countries offer special immigration programs for qualified workers. In the USA, about half of the increase in the number of specialists in mathematics and information technologies is provided by the import of foreign labor (see 7 Sect. 21.3 below for the controversies of the brain drain issue).

International migration of labor affects markets and the overall economic situation in both recipient and contributing countries. Therefore, monitoring and governing these changes at domestic and global levels have become relevant for many states and international organizations. International migration plays a vital role in the demographic development of individual countries and regions of the world (for example, the level of human capital development previously discussed in 7 Chap. 17 or gender and age composition of the population). It can also either aggravate or bridge spatial disparities in the quality and composition of labor, as well as affect other essential parameters of a country’s economy. 21.2  Theories of International Migration of Labor

No unified theory of international migration of labor has been developed. Nevertheless, various classical, neoclassical, and modern theories probe into explaining the causes and effects of migration. This section explores prevailing concepts of labor migration, including Ravenstein’s migration laws (7 Sect. 21.2.1), push and pull factors (7 Sect. 21.2.2), macroeconomic and microeconomic dimensions of the neoclassical theory of migration (7 Sect. 21.2.3), dual labor market theory (7 Sect. 21.2.4), new economics of labor migration (7 Sect. 21.2.5), world systems theory of migration (7 Sect. 21.2.6), and human capital in the context of international migration of labor (7 Sect. 21.2.7). 21.2.1  Ravenstein’s Migration Laws

The general patterns of development of migration processes called the laws of migration were identified by Ernest Ravenstein in the late 1880s (further reading: “The Laws of Migration”1 and “The Laws of Migration: Second Paper”2). Although Ravenstein primarily focused on studying internal migration, many of these laws perfectly explain the essence and background of contemporary transcontinental movements of people: 1 2

Ravenstein (1885). Ravenstein (1889).

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5 Most migrants travel only a short distance. In the XIX century, the level of development of transport and related technologies could only facilitate massive relocations of people over relatively short distances. Few migrants moved over long distances, including between continents. International migration was not massive. Still, the law well applies to today’s closely interconnected world. Traveling short distances comes at a lower cost (economic, social, cultural, and other). Therefore, if there is a need to migrate, most people prefer shorter distances, such as a neighboring city or a neighboring country. As the distance increases, all kinds of economic and non-economic expenditures rise. It is potentially more challenging to adapt to completely unfamiliar conditions. Therefore, the number of migrants declines with an increase in the required distance of migration. 5 Migrants typically move to major cities. This hypothesis was affected by the rapid growth of cities as industrial and commercial centers across Europe and North America in the XIX century. In the modern interpretation of the law, it can be stated that it is urban areas that attract the overwhelming majority of migrants due to a broader choice of employment opportunities and better infrastructure (housing, transport, education, healthcare, entertainment, etc.). 5 Major urban centers generally have migrants from neighboring rural areas, and more distant migrants move to those rural areas. Since migrants prefer to travel relatively short distances and choose cities as their destinations, the bulk of migration accrues to the rural-to-urban flow. In most countries across the world, people abandon rural areas and rural way of life and fly to cities. The latter absorb people from the surrounding areas, that is why this process is called absorption. However, since no market niches can remain undersupplied for a long time, suburban rural areas attract people from remote rural areas, where employment opportunities are poorer, and the standard of living is lower. The law also applies to international migration. Thus, higher wages in the developed countries of Western Europe attract migrants from Eastern Europe. In turn, the vacant niches in the labor market in Eastern Europe are occupied by migrants from developing countries, where the standard of living is lower than in Eastern Europe. 5 When people from rural areas move to more distant areas, those from urban areas then move to fill the gaps in rural areas. Such a reverse movement of people from ecologically disadvantaged cities to ecologically clean rural areas was observed as far back as the XIX century. The urban-to-rural migration is called dispersion. Ravenstein suggested that such a movement of labor from cities to the countryside could fill the vacant niches in the labor market in rural areas and thus balance the supply of and demand for labor. However, dispersion is much smaller in terms of the number of migrants than absorption. Therefore, outgoing labor can not be quantitatively replaced by immigration from cities. Second, relatively well-to-do and skilled people who migrate from cities would not work in the fields or on a livestock farm. Moreover, many of them do not even plan to get employed in rural areas, as they receive income from business, property, or capital in a city.

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5 Each migration flow produces a counterflow. Since both absorption and dispersion create free niches in the labor market, they are filled by attracting labor from other territories within a country or from abroad. Consequently, each outflow of labor from one area generates an influx of labor into that area. However, since it is impossible to fully replace the outflowing labor in terms of either quantity or quality, imbalances may persist. Conversely, an influx of labor to an area generates oversupply and, accordingly, the outflow of surplus to other territories. 5 Rural people are more likely to migrate than urban people. The law is based on the assumption that the bulk of migration is made up of relatively poor people who move in search of work and income both within and between countries. In the XIX century, Ravenstein considered rural population poorer and, accordingly, more mobile than the urban population. Today, however, this assumption can be transferred to income inequalities of different groups of population irrespective of their place of residence. Since migration is driven by the search for better living conditions, it is fair to assume that poorer people migrate more frequently and more intensively, while wealthier people seek to maintain a level of income or social status they have achieved in their place of residence. However, many studies show the opposite. The poor is the least mobile group of the population. Moving to a new location involves costs that may be too high. Getting a better job requires a certain level of education and qualification, which many poor people can not reach. As a result, primarily middle-income people migrate. They have sufficient resources along with a sufficient level of education, skills, and work experience. 5 Long-distance migrants typically move to larger cities. The longer the distance between the place of departure and the destination point, the lower the reliability and completeness of information about various parameters of that destination point (employment opportunities, living conditions, price level, cultural specifics, etc.). As a rule, adequate information is available only about the largest cities of a country or territory. Moreover, major cities are easier to reach (for example, direct flights to international airports). Therefore, when choosing a specific destination, migrants tend to focus on capital cities or the largest economic centers of other countries. 5 Women are more likely to migrate shorter distances than men, while men more frequently venture international migration. Ravenstein argues that women are more likely to stay in the family’s place of residence because they take care of children and the home, while men are more likely to migrate in search of employment and income to provide for their families. 5 People whose families have lived in an area for more extended periods of time are less likely to move than those who have more recently moved to an area. Over time, it becomes more difficult to change the traditional place of residence, established way of life, accustomed working conditions, or social circle. Therefore, the longer a family stays in a place, the less likely it leaves it search-

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ing for a better option. However, some types of work and professions are associated with frequent relocations of workers. For example, a multinational corporation hires a group of managers to start a branch or a factory in a foreign country. When a new facility is launched, the team can be transferred to another country for another project. 5 The primary cause of migration is economic. As noted above and detailed in 7 Sect. 21.3 below, people migrate mainly due to economic reasons. Motivation can be both positive (increased income, greater opportunities, career development) and negative (escape from poverty, hunger, or unbearable working and living conditions). 5 Most long-distant migrants are adult individuals instead of families with children. Obviously, moving long distances is the more expensive and difficult for a family, the more members of this family migrate. Therefore, large families and families with children tend to be less mobile than small families or individuals. The greater the distance, the less likely a large family makes a migration decision. If relocation is necessary, a large family is more likely to choose a closer option (a neighboring city or region). Nevertheless, many families practice the so-called creeping migration. It is when only one family member migrates, finds a job, and arranges life in another country, and then remaining family members follow. 5 Migration increases as industries and commerce develop and transport improves. The development of all types of infrastructure (transport, telecommunications, banking and insurance services, consulting firms), as well as the increasingly close interconnection of countries through trade and other types of economic, financial, social, and cultural ties, make the world smaller and greatly facilitate migration. The higher the degree of globalization and the interconnection of labor markets, the easier it is to exchange labor between these markets. 5 Migration occurs in stages. In many cases, migration directly to the desired country or desired city is difficult due to high costs, lack of education or qualifications, or insufficient language proficiency. Many workers migrate in stages (for example, from a countryside to the nearest city, then to the capital city, then to the neighboring country, and only then to the desired destination). At each stage, a migrant accumulates work experience, the experience of living in a multicultural environment, and other characteristics that eventually lead to achieving the goal. Ravenstein’s laws of migration established the foundation for elaborating a range of theories of international migration of labor in the XX century. The laws of migration have had a huge impact on subsequent studies on the modeling and conceptualization of migration processes. Based on extensive empirical material, Ravenstein managed to comprehensively canvass the basic features of international migration.

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21.2.2  Lee’s Push and Pull Factors

Along with Ravenstein’s laws of migration, classical theories of migration also include the push and pull factors econometric model developed by Everett Lee in the 1960s (further reading: “Theory of Migration”3). According to Lee, there are variations of migration factors operating in particular territories. These factors may retain people within a territory, pull them, or push them out, thus facilitating inflows and outflows of labor. Push factors include economic motives (unemployment, low income, high taxes), social factors (poverty, inequality), political concerns (discrimination, restrictions of various freedoms, military tensions), and unfavorable natural and climatic conditions. Pull factors are those that attract people to a particular territory, such as a high level of economic development, high level of income, security, or easy labor market entry (including in the informal sector, which is essential for irregular migrants). In parallel with various combinations of push and pull factors, migration is affected by intervening factors (transportation costs, administrative regulation of migration, availability of reliable information about the intended destination, and others). The longer the distance between the place of origin and the destination point, the stronger the intervening influences and the weaker the pull effects (push factors exist locally and do not depend much on the desired destination). According to Lee, migration is a selective process. That means that the same factors can affect different people in different ways. Pull factors have a more significant impact on higher-educated people. Commonly, a qualified worker has a certain social status and an acceptable level of income in the place of origin, but he can still receive a better offer elsewhere. High mobility is characteristic of highly qualified specialists. For them, migration means moving up the career ladder and improving the income level. For lower-skilled workers, push factors are of greater relevance. An individual is an active agent who can independently make a decision to migrate or stay. A migration decision depends on the combination of push and pull factors. The mixture must be strong enough to justify the difficulties that potential migrants could experience during relocation. An essential feature that influences the propensity to migrate is a life cycle stage. Thus, those who enter the labor market or marry tend to leave the parental home and migrate out of a country, while people who divorce or leave the labor market (for example, retiring) can return home. 21.2.3  Neoclassical Theory of Migration

The neoclassical theory of migration is based on the assumptions of free competition and a perfect market of factors of production. The theory addresses migration at both the macro and micro levels. International migration at the macro

3

Lee (1966).

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level is driven by geographical differences in labor supply and demand (further reading: “Economic Development with Unlimited Supplies of Labor”4 and “Theories of International Migration: Review and Appraisal”5). In countries where labor is abundant in relation to capital, wages are low. Conversely, in capital-abundant markets, wages are high. Due to wage differentials, labor from low-wage economies moves to high-wage markets. In labor-abundant countries, the supply of labor decreases and wages rise, while in labor-deficit countries, the supply of labor increases and wages go down. The basic concepts in the neoclassical theory of migration at the macro level include the following: 5 international migration is the result of wage differentials in different countries; 5 eliminating wage differentials ceases labor exchange and migration; 5 international human capital flows, in particular highly skilled labor, respond to returns on human capital, which may differ from the average wages (migration may exist even between balanced markets due to different returns); 5 international labor exchange is facilitated by the labor market, while other markets impose insignificant impact on international migration; 5 governments can manage migration flows by influencing labor markets in the countries of origin and destination. Alongside the macroeconomic model of migration, there is also a microeconomic model of individual choice (further reading: “Illegal Migration and US Immigration Reform”6). It postulates that a potential migrant moves to a place where the expected net profit from migration is the greatest. The microeconomic provisions slightly differ from the macroeconomic ones above: 5 international migration of labor is driven by inter-country differences in returns on labor and employment levels; 5 individual characteristics of human capital that potentially increase the likely level of wages or the likelihood of employment in the destination country (education, experience, language proficiency, etc.) make migration likelier, all other things being equal; 5 factors that reduce the costs of migration increase the expected return on migration and therefore enhance the likelihood of international migration 5 individuals make migration decisions based on individual cost and profit estimates; 5 migration occurs until the expected return (the result of wages and employment levels) exceeds expenditures associated with relocation; 5 the greater the return-cost gap, the greater the number of migrants. In the microeconomic variant of the neoclassical theory, rational individuals make their migration decisions based on assessing the costs and profits associated

4 5 6

Lewis (1954). Massey et al. (1993). Todaro and Maruszko (1987).

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with moving to certain foreign destinations. International migration is thus conceptualized as a form of investment in human capital. Before claiming a higher salary in a foreign country, a migrant must take on certain costs, such as transportation and relocation, finding a job, learning a foreign language and culture, adapting to the new labor market, breaking old ties and establishing new ones, and other economic, social, and psychological expenditures. 21.2.4  Piore’s Dual Labor Market

In the late 1970s, Michael Piore transformed the classical approach to the interpretation of migration as a result of individual decisions of migrants. According to the dual labor market theory, international migration results from the structural needs of labor markets in modern industrialized economies. The theory ignores decision-making processes at the micro-level, focusing on macro-level factors. According to Piore, international migration is caused by the demand for foreign labor intrinsic to the type of economic development and growth of industrialized economies. The outflow of labor from developing markets is caused by low wages and high unemployment (further reading: “Birds of Passage. Migrant Labor and Industrial Societies”7). Piore associated the demand for foreign labor with four fundamental features of modern industrial society: 5 Structural Inflation. Wages not only express the supply-demand equilibrium in the labor market, but they also reflect the social status and certain qualities of employees. Any change in wages in one sector must be proportionately translated across the hierarchy of jobs in the economy in order to keep wages in line with social expectations. This issue is called structural inflation. Employing local workers by raising wages during labor shortages means keeping wages at that level in the future, even in times of labor oversupply on the market. The solution to the structural inflation problem is attracting foreign labor. Immigrants accept lower wages. Their wages can be cut when the labor market balances. Such a cut would not affect wages in other sectors and would not undermine social expectations of domestic workers. 5 Motivation Issues more often arise among lower-qualified workers than highskilled employees. The former have fewer opportunities for professional growth and career development. Employers are looking for workers who consider lower-level jobs a means of making money without any implications for status or prestige. For various reasons, immigrants’ expectations are more moderate compared to domestic workers, even underskilled ones. Even low wages abroad are considered sufficient compared to those of home country, even though migrants are aware of their lower social and economic status abroad.

7

Piore (1979).

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5 Economic Dualism. Capital is a fixed factor of production, while labor is a variable one—this is the inherent dualism between labor and capital segments of labor markets. Low wages, adverse working conditions, and poor career development prospects in labor-intensive sectors push domestic workers to capital-intensive industries, where wages are higher, and jobs are safer. Due to the low demand for jobs in labor-intensive sectors from local workers, employers attract immigrants. 5 Labor Force Demography. Structural inflation, low motivation, and economic dualism create demand for workers willing to work under adverse conditions, with low wages, instability, and little chance for professional growth. Therefore, the demand for foreign labor sustains. The implications of the dual labor market theory differ from those of neoclassical microeconomic models: 5 international migration is driven by the demand for labor in developed countries; 5 since the demand for foreign labor is facilitated by the structural needs of developed economies, the level of wages is not a condition for labor migration, so employers can attract workers without raising wages; 5 wages in recipient countries do not increase in response to a decline in immigration; 5 wages in recipient countries may drop in response to an increase in immigration; 5 governments can not substantially influence international migration flows, since changes in the demand for foreign labor are attributed to structural shifts in the economy. One of the shortcomings of the dual labor market theory is that it overemphasizes pull factors and overlooks push factors associated with demographic transformations in developing countries. Also, Piore underestimates the role of individual decisions in establishing international migration flows. 21.2.5  New Economics of Labor Migration

On the wave of rapid development of globalization and economic interconnectedness of markets since the 1980s, neoclassical theories failed to adequately address novel tendencies on the global labor market. There emerged the theory of new economics of labor migration which attributed migration to the decisions of families and households, not individuals (like the neoclassical theory) or employers in developed countries (like the dual labor market theory). In addition, the decisions are influenced by various domestic factors (further reading: “The New Economics of Labor Migration”8). The new economics of labor migration captures conditions in different markets, not just labor markets. It interprets migra-

8

Stark and Bloom (1985).

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tion as a process of household decision-making to minimize risks to family income. That is, migrants’ decisions are based not only on maximizing the expected return on their labor, but also on minimizing the risks associated with various market failures (see 7 Chap. 10, 7 Sect. 10.1 for failures and imbalances in markets). Unlike individuals, households can control risks that threaten their wellbeing by diversifying the allocation of household resources, such as family labor. While some family members may continue working in their home country, others may go abroad. In the event that returns on either domestic or foreign labor fall due to the deterioration of the economic situation on the domestic market or abroad, a family can count on remittances from abroad, or migrants can return home. In developed countries, household income risks can be mitigated by participating in private insurance schemes or receiving support through government programs. In more volatile developing markets, risks are higher, while many of risk management institutions are either underdeveloped or inaccessible to low-income families. The banking system and credit markets in developed economies stimulate saving and promote private investing. In capital-scarce developing countries, credits are more expensive to people and businesses. In the absence of accessible public or private insurance and credit programs, households tend to diversify sources of income. The diversification strategy works best when a household earns income from different sectors in different countries. That helps to minimize macroeconomic risks of downturns in particular sectors or countries. Migration (family members or the entire family) makes a household more flexible and adaptable to market volatilities and thus more competitive compared to non-migrating households. Along with the diversification of sources of income, migration can contribute to improving the social status of a household. Moving to another country can promote a family within a certain social group or even change a social group. Even lower income (compared to home country) can be tolerated if such a level of income does not prevent achieving a higher social status. Thus, a household makes a migration decision based on dissatisfaction with the current economic or social status. The degree of dissatisfaction can be measured by comparing own income with the average level of income within the social group. The permanent desire to improve social status makes migration a cyclical process that affects not only the country of origin, but also recipient markets. It is fair to say that migrants instinctively exploit such new normal feature as inequality between countries. Inequality benefits people who relocate to wealthier countries from economies with lower income-to-social status ratio. Since a long-term balance between countries through exchanging labor is unattainable, the new normal instability would fuel international flows of migrants. 21.2.6  Wallerstein’s World Systems

The migration-related challenges of globalization are emphasized by the world systems theory of migration developed by Immanuel Wallerstein in the 1970s

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(further reading: “The Modern World System”9). The world systems theory focuses on macro-level factors. It postulates that the migration of labor is facilitated by the political and economic structure of the expanding global market, i.e., economic and political globalization. Therefore, migration is an inevitable outcome of the growing interconnectedness of national markets. Wallerstein considers the world economy as a multicultural territorial division of labor, where the exchange of goods and factors of production ensures the daily life of all people in all countries. The division of labor is based on the specific features of production and exchange in the three zones of the world economy—the center, the semi-periphery, and the periphery (very similar to the international dependence models and the center-periphery structuralist model of economic development previously discussed in 7 Chap. 15, 7 Sects. 15.3.4, 15.6.1, and 15.6.3). The zones differ in geographical and cultural characteristics, but the primary criteria are the endowment of countries with labor resources and the quality of these resources. The abundance of low-quality labor in the periphery countries determines the specialization in producing labor-intensive goods. The center countries are less endowed with labor, but its quality is higher. Such a combination provides for the development of capital-intensive industries. The semi-periphery countries have no distinct advantages or disadvantages and combine labor-intensive and capital-intensive types of production in various industries. According to the structuralism (7 Chap. 15, 7 Sect. 15.6.1) and the international dependence model (7 Chap. 15, 7 Sect. 15.6.3), a stronger center exploits a weaker periphery. Wallerstein suggested that as the periphery countries get involved in the “world systems” through trade, capital movement, and global supply chains, the periphery population becomes more mobile and disposed to migration. The theory is founded on the following tenets: 5 Capitalists seek to replace labor with capital (machinery, technologies, etc.) to increase productivity and maximize profit. Mechanization of production in industrial centers and consolidation of lands in rural areas reduce the need for labor across the economy. Oversupply of labor on the domestic market pushes workers to the global labor market. 5 Extracting industries (the economic pillars of most of developing countries) demand more labor as periphery economies integrate into global supply chains and exports of resources grow. The effective demand from local producers and foreign companies creates a labor market based on a new concept of individualism and personal gain. Social and economic transformations in the labor market contribute to the geographical mobility of labor in the periphery and semi-periphery countries. 5 The internal geographical mobility of labor results in rapid urbanization of developing countries. People start moving abroad because globalization strengthens economic and cultural ties between the labor-abundant periphery and the capital-abundant center. Cities across the world grow and demand more and more labor.

9

Wallerstein (1974).

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5 Investment and globalization are accompanied by the development of transport and communication infrastructure. The periphery-to-center movement of labor generally corresponds to the reverse center-to-periphery movement of goods and capital. 5 Economic globalization strengthens non-economic social and cultural ties between the center and the periphery. 5 Global economic and social trends are affected by a few largest cities, which tend to concentrate banking, finance, management, and professional services, high-tech manufacturing, and qualified labor. The economic and social structure of the periphery countries is changing in the course of globalization. The latter accelerates migration from the Global South to developed countries, particularly to a few cities such as New York, London, Paris, Tokyo, Shanghai, and Sydney, that express an increasing demand for labor, including underskilled labor (cleaners, waiters, etc.). At the same time, the relocation of heavy industrial production abroad, the growth of advanced manufacturing in electronics and telecommunications, and the expansion of hi-tech service sectors segment the labor market (high demand for skilled and underskilled labor, but relatively low demand for labor in conventional sectors in the middle). Underskilled domestic workers are reluctant to take low-paying jobs in the “lower” sectors, thus triggering demand for immigrants. Meanwhile, well-educated domestic employees and skilled immigrants apply for high-paying jobs in the “upper” sectors only, again fueling demand for attracting foreign labor to fill the “lower” niches. Other workers accept jobs in the “middle” sectors, migrate within their countries or between global cities and countries, or rely on social insurance programs and government support. The world systems theory states that international migration reflects the political and economic patterns of an expanding global market. However, the provisions of the theory (the very division of the world into three zones) draw criticism, especially from anti-globalists (see 7 Chap. 23, 7 Sect. 23.3 for the controversies of globalization). In particular, many scholars challenge the postulate that the type of development of peripheral zones does not allow them to get out of their subordinate position. Nevertheless, the expansion of the center countries’ economic influence brings improvements and innovations to the periphery and thus improves productivity and reduces the amount of labor needed. The release of labor resources due to increased productivity and mechanization gives rise to a mobile workforce ready to move to other regions of the world. Thus, Wallerstein’s concept assumes that migration is driven not just by differences in wages between developing and developed countries, but also the general economic and social inequality. 21.2.7  Human Capital in the Context of Labor Migration

The human capital model also reflects social issues of inequality in the quantity and quality of labor. 7 Chapter 17 examined approaches to interpreting the essence of economic development and growth through human capital diversities.

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The theory states that migration is driven by such differences in the quality of human capital between countries (further reading: “The Costs and Returns of Human Migration”10 and “The Effect of Americanization on the Earnings of Foreign-born Men”11). Migration can be considered an investment in human capital development (compare with expenditures and returns on investment in human capital development discussed in 7 Chap. 17, 7 Sect. 17.3). At the first stage, a potential migrant incurs costs that could be recouped in the future by higher income (or an increase in the standard of living) (similar to the expenditures on education illustrated in . Fig. 17.4). Consequently, when making a migration decision, an individual estimates the net present value of benefits that could be received from moving to another country (Eq. 21.1):

PVNBj =

TR  IjT − IiT − Cij (1 + r)T T

(21.1)

ij

where: PVNBj  Tij TR IiT IjT r Cij

present value of net benefit from moving to country j; time an individual migrates from country i to country j; time an individual retires; income in country i in time T ; income in country j in time T ; individual discount rate; direct cost of relocation from country i to country j.

If PVNBj < 0, then migration makes no economic sense (current costs exceed potential benefits). If PVNBj > 0, then potential benefits of migration in the future will cover the current costs of relocation. Thus, making a migration decision at time T1, an individual compares the losses associated with the move, change of job, lifestyle, etc. ( ABE area in . Fig. 21.2) and the potential benefits (ECD area) (similar to the expenditures-returns ratio in the context of investment in human capital development illustrated in . Fig. 17.4). The Y0 D curve is a worker’s net income in the home country. The Y0 ABC graph is a compositional curve that reflects a net income of a worker who migrated to country j at time T1. With no migration, a worker’s net income at time T1 equals Y1 (point A). Due to various expenditures associated with relocation, a worker’s net income (now a migrant’s net income) drops from Y1 to Y0 (point B). However, after some time T2, the potential benefit from migration exceeds current income in country i (Y > Y2) until it reaches Y3 by the time a worker retires (point C). Ultimately, the net income in country j exceeds that a worker could have received in home country i (points C

10 Sjaastad (1962). 11 Chiswick (1978).

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Chapter 21 · International Migration of Labor

21

. Fig. 21.2  Expenditures and returns on international migration. Source Authors’ development

and D, respectively). When comparing potential destinations, a rational individual would choose a country where the maximum individual benefit could be attained (Y0 ABC − ABE). Equation 21.1 shows that the migration decision is affected by three factors: the level of income of an individual in a home country and potential country of destination (I ), an individual’s age or time a migration decision is made (T ), and relocation costs (C). The level of income I is represented by wages. Initially, migrants’ wages can be significantly lower than those of local residents (Y0 < Y1) (even profession, age, work experience, and other things being equal). Subsequently, the growth rate of migrants’ wages in a recipient country exceeds the growth rate of wages in a home country. Age T is a critical limitation for all potential migrants. It limits the period during which a migrant would be able to benefit from migration ([T1 ; T3 ] segment). Costs C associated with migration are divided into monetary and non-monetary. The former equal the sum of the direct costs associated with relocation and the indirect costs expressed by the decrease in income (depth of fall of point B in relation to point A) at time T1. Non-monetary costs are not directly quantifiable, but are often more important for a potential migrant. They include costs provoked by finding a new job, getting used to new living conditions, learning the language, or separation from family and accustomed social network. The human capital model of migration assumes migrants to be relatively young people, because returns are bigger the longer a migrant can work abroad (the greater the (T3 − T1 ) value). Migration is more profitable the larger the expected difference in income between points C and D. This explains why migrants from low-income countries move to higher-income markets (the bigger the income gap, the more attractive the destination). However, disposable ­income depends not only on labor efforts (wages), but also on the tax level, tax exemptions, and social security transfers. As a result, it turns out that a higher qualified (higher paid) specialist could benefit from leaving a home coun-

799 21.3 · Drivers and Effects of International Migration

21

try where income distribution is even due to high taxes and migrating to a country where income inequality is higher. Conversely, a low-skilled worker may benefit from moving to a developed country where equal income distribution is ensured by the minimum wage, labor legislation, and trade unions. The decision to migrate depends on the direct costs of relocation. Therefore, all other things being equal, potential migrants choose the destination that is closer to their home country (this assumption echoes one of Ravenstein’s laws of migration—see 7 Sect. 21.2.1). The theory of human capital explains many empirical facts and contemporary tendencies we are observing today in the global labor market. However, diverse drivers and effects of international migration of labor can not be exclusively attributed to the costs and potential benefits. Often, migrants’ behavior is driven by a complexity of economic and non-economic factors and hard-to-identify variables. 21.3  Drivers and Effects of International Migration 21.3.1  Drivers

Revealing major factors and causes of migration helps to understand the motives for the transborder movement of people. Depending on the possibility of regulation and adjustment, factors of migration can be divided into three groups: 5 living conditions that can not be changed or can be slightly adjusted during a long time (natural conditions, geographical location); 5 factors that can be changed gradually over a couple of decades (spatial development, infrastructure, industrial construction); 5 factors of operational regulation that may change over several years or even months (government regulations and programs, economic reforms, wages, social welfare). The impact of long-term and short-term factors on migration can be both negative and positive (see the push and pull factors discussed above in 7 Sect. 21.2.2). It is challenging to unambiguously identify which of them determines a particular migration decision. Their combinations form various drivers (or breaks) of migration (economic, cultural, environmental, political, and others). Most of the theories of migration agree that people move due to economic reasons, some of which include: 5 uneven development of countries (different phases of an economic cycle); 5 income inequalities between countries; 5 significant differences in unemployment rates between countries; 5 human capital and labor markets in developing countries (overpopulation, unemployment, low labor productivity); 5 lower price of labor in developing countries compared to developed markets.

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Economic drivers can be both individual (the economic situation in a country is stable, but people still decide to relocate due to the above reasons) and collective (massive migration in times of economic downturns). In addition to differences in the level of economic development and employment, economic motives include the export of capital and activities of transnational corporations. The latter integrate labor with capital by either moving labor from labor-abundant countries to capital-surplus markets or moving capital to labor-surplus regions. Case box Economic factors can be divided into two groups. The first is the exploration and development of new territories and lands (for example, mass migration to North America from Europe in the XVI–XIX centuries due to a series of geographical discoveries). Another example is the migration boom in Europe in the XIX century, when people massively moved to North America, Australia, and South Africa. The second group of economic factors includes the migration of skilled labor. An example is a migration from developing to developed countries in order to get a better job and develop a career (including brain drain).

Social motives closely relate to economic ones. They have been particularly pronounced in internal migration (for example, rural-to-urban flows), but globalization has emphasized social aspects of international migration. Large cities, including those in other countries, offer jobs that are lacking in rural areas. In addition to better employment opportunities and higher wages, workers in cities get access to all kinds of urban infrastructure (education for children, healthcare, social security, public services, entertainment, etc.). Social factors also include marriage, family reunion, education, professional development, and other non-economic motives that incentivize people to change their place of residence. Case box The rural-to-urban flight is only one social dimension of migration. Recently, in many developed countries (and among the wealthy segments of population in developing countries), there has emerged a reverse downshifting move from cities to rural areas. People are attracted by a better quality of the environment, lower density of population, lower burden on social and transport infrastructure, and a more regular and calmer way of life.

An increasingly significant factor in global migration is the development of transport, primarily air connections between countries, which has made it possible for people to move quickly over long distances. Information has become an inseparable element of migration in the era of globalization. Learning about life in other countries, people compare economic, employment, and social opportunities and change their own living conditions by moving to places they consider

801 21.3 · Drivers and Effects of International Migration

21

better (regardless of what particular parameters they use to assess and compare their current places of residence with other locations). Migration can also be driven by cultural motives, such as returning to the historical homeland, restoring lost ethnic ties, and joining cultural heritage and traditions. Unfortunately, in the context of the new normal global instability, migration is increasingly caused by political factors. Those who disagree with political discourses in their countries become either emigrants or, in the worst case, refugees. Political conflicts that result in open hostilities and military tensions trigger massive migration. In each case, many factors co-affect the migration decision. Economic drivers (the level of economic development, economic stability, standards of living, unemployment, etc.) are influenced by non-economic motives, psychological factors, age, physical wellbeing, and many other determinants. The diversity of factors gives rise to different effects of migration, which vary for migrants themselves, countries of origin, and recipient markets. 21.3.2  Effects

The economic effects of labor migration are extremely diverse. Still, they can be classified into impacts on labor markets in donor and recipient countries, impacts on public finances, and the side effects of migration. International migration of labor imposes significant and controversial economic and social effects on both contributing countries (donor markets from which people emigrate) and host countries (recipient markets to which people immigrate). As noted above in previous sections, an individual who decides to try migration takes a significant risk in the form of material expenditures (the cost of moving and settling in a new place of residence) and psychological pressure (separation from the accustomed way of life, friends and relatives, the need to learn foreign language and adapt to foreign culture and traditions). These risks can be accepted in the expectation of a gain in the future (see . Fig. 21.2 for current expenditures and future returns on international migration). However, many of these gains are intangible as migration is driven by a complexity of economic and non-economic motives. For example, an immigrant may seek to gain security or political freedom, none of which can be measured quantitatively. Therefore, quantitative estimates of the economic effects of migration proceed from the assumption that migration is primarily driven by disparities in real wages. This parameter demonstrates the purely economic impact of migration on labor markets in donor and recipient countries. The relative factor endowment theories of international trade discussed above in 7 Chap. 19 postulate that international trade equalizes prices for goods and factors of production in trading countries (see 7 Chap. 19, 7 Sect. 19.1.4 for the Heckscher-Ohlin theorem and its extensions, including the Stolper-Samuelson theorem and the Heckscher-Ohlin-Samuelson theorem). In reality, however, prices never balance due to market failures and countervailing factors (imperfect competition, government interventions, etc.). These gaps in wages (level of income, other economic parameters) trigger the relocation of labor between markets. Sup-

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Chapter 21 · International Migration of Labor

21

. Fig. 21.3  Migration of labor between countries. Source Authors’ development

pose workers migrate from country A to country B (. Fig. 21.3). The reduction in the supply of labor in donor country A (SA1 shifts upwards left to SA2) results in the decline of the number of employed people from LA1 to LA2. In recipient country B, immigration boosts the supply of labor in the domestic market from SB1 to SB2 and increases the number of employed people from LB1 to LB2. This movement of labor changes the balance of demand and supply in both markets, rises the average wages in country A from WA1 to WA2 and depresses the average wages in country B from WB1 to WB2. Workers in country A benefit from moving to country B as their income increases by (F − C). In country B, both employers (D + E) and the economy as a whole benefits as output grows by (F + E). Accordingly, country A loses as its domestic product contacts by (B + C) and employers’ income falls by (A + B). In country A, wages of the remaining workers go up ( A rectangle) due to the outflow of excess labor, while in country B, wages of local workers go down (D rectangle) due to the influx of foreign labor. Thus, as in the case of international trade, free international migration of labor divides society into winners and losers. The overall impact of migration on output is positive ((F + E) > (B + C)). Consequently, the redistribution of labor resources between countries contributes to the more efficient use of labor as a global factor of production and equalizes the prices of labor in domestic markets. Case box Immigration does not necessarily reduce the wages of domestic workers in recipient countries, as well as emigration may not raise wages in donor markets. That depends on the level of economic development of donor and recipient countries. As a rule, immigrants fill the niche in the labor market left by the locals due to various reasons (low pay, sweatshop labor, non-prestigious jobs). As such, immigrants do not directly compete with skilled local labor for jobs, which means immigration insignificantly affects the equalization of wages between sectors. Moreover, many developed countries

803 21.3 · Drivers and Effects of International Migration

21

today are focused on using foreign labor in the sectors that attract no local residents. Migration also acts as a buffer between local labor and unemployment. With the growing demand for labor in a country, new niches can quickly be filled by immigrants. When demand falls, migrants leave a country. Thus, both the level of employment and the level of wages change insignificantly for local residents. Such effects, however, are true when lower-qualified (or less demanding) immigrants do not compete for the same jobs with domestic workers. Once they begin taking up higher-paid jobs, the market equalizes wages (. Fig. 21.3).

As with employment and wages, the implications of international migration of labor are controversial for public finances. For migrants themselves, moving from one country to another is associated with changes in taxation. They stop paying taxes in their home country, but start paying them in the new host country. Therefore, the change in the wellbeing of foreign workers largely depends on whether the tax burden has increased or decreased with migration. In addition, in both donor and recipient countries, individuals have access to such public goods as public order, street lighting, or environmental protection, which significantly affects the overall level of wellbeing. However, the set and quality of public goods vary from country to country. Migration also changes the amount of transfer payments such as pensions, unemployment benefits, and social security payments. Due to the complexity of economic and non-economic variables, the assessment of moving from one public finance system to another is challenging. Migrants from developing countries face substantially higher taxes in developed countries, but at the same time, they receive access to a wide range of public goods and a developed system of social protection. For public finances in a donor country, the outflow of labor means reducing tax revenues. On the other hand, the country saves on reducing transfer payments and social expenditures. As for public goods, their costs weakly correlate with the number of consumers. Therefore, emigration hardly reduces public expenditures. Children, students, and retired people are mainly consumers of public funds. People of active working age, on the contrary, contribute to establishing public funds by paying taxes. Emigrants are people who have received education and acquired qualifications in their home country (often at the expense of public funds), but pay taxes in another country. In this regard, a donor country likely incurs net losses in terms of its public finances. Another outcome of emigration for a donor country is remittances. This cash flow is not directly included in public finances, but remittances increase the level of income of the domestic population and improve the country’s balance of payments. As for a host country, foreign workers create an additional burden on public finances due to the growth of transfer payments, the cost of maintaining public order, and certain social expenditures (especially if immigrants come with families). On the other hand, a recipient country receives a workforce without incurring the costs of education and vocational training. New workers ­contribute to the budget by paying taxes. In some way, a recipient country benefits even from

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. Table 21.1  Effects of migration for donor and recipient countries Country

Advantages

Disadvantages

Donor country

Lower unemployment and higher wages in the domestic market

Outflow of the most active part of the workforce

Lower social security payments and related expenditures (unemployment benefits, expenditures on education and healthcare)

Reduction of budget revenues (no taxes from emigrants)

Higher level of income and effective demand due to remittances inflow

Risk of inflation due to rising remittances inflow

Possibility of returning qualified workers who have gained experience and education abroad

Outflow of high-skilled workers and a risk of technological backwardness of a donor country

Increase in labor resources in the economy and growth of output and demand

Higher competition in the labor market, lower wages, the risk of unemployment for domestic workers

Elimination of structural imbalances and cyclical unemployment in the labor market

Increase in social security expenditures in case of permanent migration

Inflow of people in active working age and mitigating the aging problem

Capital outflow in the form of remittances

Increase in the competitiveness of domestic products by reducing the price of labor

Disinterest in developing labor-saving technologies due to the low price of labor (potential decrease in productivity)

Saving on pensions and social payments in case of temporary migration

Growth of social tension and interethnic conflicts

Saving on education costs in case of attracting qualified labor

Risk of illegal immigration

Recipient country

Source Authors’ development

accepting illegal immigrants who still pay indirect taxes such as excise taxes and sales taxes. Therefore, the financial result of immigration for a host country is likely to be positive. Thus, the effects of migration should be divided into advantages and disadvantages and considered separately in relation to donor and recipient countries (. Table 21.1). In addition to the economic and financial consequences of migration, its side effects include the reduction of unemployment in donor countries and higher risk

805 21.4 · Governance of International Migration

21

of unemployment in recipient markets, the contribution of knowledge and experience by foreign workers, the improvement of their skills while working abroad, and the subsequent use of their experience when returning to their homeland. One of the essential side effects is a brain drain from developing countries that has emerged in the late XX century. It degrades the scientific, technological, and intellectual potential of donor countries and, at the same time, provides significant benefits to recipient economies, which concentrate the most talented and qualified scientists and specialists. Case box Brain drain is a controversial issue. It is neither an explicit loss for developing donor countries nor a definite gain for developed recipient economies. In the new normal reality, intertwined domestic markets establish a global network that blurs national borders. Professionals who have left a developing country and gained a world-class education and work experience abroad may return to their home countries, claim ­better jobs, and benefit their economies. Thus, local human capital develops at the expense of other countries (foreign education), and donor countries benefit from their citizens going abroad. In this scheme, recipient countries lose as they spend their resources on developing foreign workers, who then return to their home countries. However, such a return drain of qualified labor from developed countries to developing economies may work provided that the latter grow and develop. Otherwise, highly skilled migrants have no economic incentive to return to their home countries.

Immigration also produces significant negative externalities for host countries. Entire areas of compact residence of foreign workers arise in cities or close to large enterprises that employ foreign labor. Due to the low level of income, low social status, and multiethnic composition, such districts often become zones of interethnic conflicts and crime. The influx of foreign people rarely evokes positive emotions among the local population. It is not just about taking up jobs from domestic workers, increasing competition in the labor market, and lowering wages for the locals. Even those people whose economic interests are not directly affected by immigration can be wary of foreigners. The specific causes of tensions between local populations and foreign workers can be very different, but commonly they occur due to various kinds of ethnic or religious intolerance. 21.4  Governance of International Migration

Due to such a variety of both positive and negative economic, social, and other effects, migration cannot but be an object of a fairly strict public regulation. While most countries move towards liberalizing their foreign trade and other economic and financial activities, almost all of them restrict and govern international migration. A striking example is the almost complete cessation of cross-border

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movements during the COVID-19 pandemic. Indeed, that was a force majeure. However, it is fair to expect that many of the barriers to migration will remain as the new normal features for years to come (further discussed in 7 Sect. 21.5). The need to regulate migration has resulted in establishing a comprehensive system of national and international regulation. Governments started interfering in the international movement of labor well before introducing first international trade policies. In the XVIII century, England prohibited industrial workers from emigrating. In the XIX century, many European countries restricted immigration. Since that time, countries have been elaborating numerous policies and regulations to control and govern migration flows. Governance of migration mainly relates to the governance of immigration. Very few countries apply any restrictions on emigration of their citizens (for example, North Korea), but the vast majority of them regulate immigration. A clear distinction is made between immigrants (people entering a country for permanent residence) and non-immigrants (temporary employment, business, or other purposes without obtaining permanent residence). Although non-immigrants can stay and work in a host country for an extended period of time, the regulation of permanent immigration is prioritized. In most countries, the governance of immigration is challenged by the increasing complexity of immigration, which has emerged from episodic movements to massive permanent flows, the high cost of adaptation and integration of immigrants to life and culture of host countries, as well as the search for long-term solutions to mitigate the pressure of demographic factors on economic development through immigration. At the national level, common aims of immigration policy include the following: 5 protection of national interests in the context of globalization of migration; 5 regulation of migration flows and protection against an undesirable influx of immigrants, both in number of immigrants and qualitative parameters of incoming labor; 5 countering illegal and unregulated migration; 5 meeting the needs of the economy in labor and modernization and development of major industries; 5 flexible regulation of the number of the foreign labor force with due account of maintaining the supply-demand balance in the labor market; 5 improvement of the demographic situation and a stabilization of and an increase in the resident population; 5 implementation of humanitarian and international obligations related to migration (for example, admission of refugees). 5 promoting the adaptation and integration of immigrants and interaction between immigrants and the local population. Most recipient countries employ a selective approach to regulating immigration. That means that the government incentivizes immigration of those categories of workers who are needed in a given country, while restricting the entry of non-prioritized immigrants. Such restrictions vary from country to country depending on the objectives of immigration policy:

807 21.4 · Governance of International Migration

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5 Professional qualifications. Most countries establish strict requirements for the level of education and work experience of immigrants. Commonly, priority is given to high-qualified specialists, but countries can also target attracting certain narrowly specialized workers and even low-skilled workforce depending on the demand for labor in certain sectors. 5 Individual characteristics (physical wellbeing of immigrants, age, social and marital status, no criminal record); 5 Quantitative quotas. The maximum share of foreign labor in the total labor in the market can be established at the national level or the level of individual industries or companies. Also, the government may limit the total number of immigrants entering a country within a certain period of time. 5 Economic regulation involves stimulating or restricting the hiring of foreign labor in certain industries. Businesses can either receive subsidies for attracting foreigners or pay higher taxes for preferring foreign labor over domestic workers. 5 Time constraints. Most countries set maximum periods of stay for foreign workers in their territory, after which they must either leave a host country or obtain permission to extend their stay. 5 Geographic priorities. Quantitative quotas may restrict or encourage the entry of immigrants from certain countries or territories. 5 Prohibitions. In certain industries, the employment of foreign labor may be explicitly or implicitly prohibited (for example, national security, defense, aeronautics). Explicit regulations directly prohibit foreigners from working in certain industries or enterprises, while implicit ones encourage the hiring of local labor. Case box Developed countries differ in types of immigration policies. The USA, Canada, Australia, and New Zealand encourage permanent immigration. Such a policy involves the selection of immigrants based on certain criteria along with clear planning of the required volume and qualifications of incoming labor. In Europe, immigration regulations are stricter. The preference is given to residents of former colonies (for example, India and Great Britain, some African countries and France). Most developed countries use scoring systems to attract highly qualified specialists to certain industries.

In addition to regulating and restricting immigration, many developed countries encourage reemigration, that is, the return of immigrants to their home countries. The following three types of programs apply: 5 Reemigration incentives programs. They include a range of activities from forced repatriation of illegal immigrants to assisting immigrants wishing to return to their countries. 5 Immigrant training programs. It is assumed that having received a good education in a recipient country, immigrants can get a higher-paid and prestigious job at home, which could encourage them to reemigrate to their countries.

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5 Economic assistance to countries of mass emigration. Developed countries conclude agreements with labor-exporting countries to invest part of the remittances and public funds in creating new enterprises and businesses in developing countries that could employ reemigrants. Despite the efforts of recipient countries, most of the reemigration programs have fallen short of their goals. Initially, the implementation of the programs allowed many emigrants to relocate back to their home countries. But as funding reduced, interest in reemigration options faded. As long as significant income disparities between donor and recipient countries persist, many people strive to migrate and gain a foothold in higher-income countries. 21.5  The New Normal Trends

Over the last few decades, international migration of labor has emerged in size, diversified in directions and composition of migrants’ flows, and thus generated unprecedented new challenges to individual countries and the entire world community. Today’s features of international migration are facilitated by qualitative changes that have been taking place in the world economy in the context of the new normal reality. Economic globalization that accelerated after the World War II affected all spheres and sectors of the world economy, including the migration of labor. Three stages of globalization can be distinguished in terms of the structural transformation of international migration (. Table 21.2). In the first decades after the World War II, globalization was driven by scientific, technical, and technological progress. It provided for the integration of industries and firms in different countries (especially within Europe and between Europe and North America), the transnationalization of the global economy, and international and regional economic, trade, and financial integration (establishment of the United Nations, International Monetary Fund, General Agreement on Tariffs and Trade, European Economic Community). On the one hand, developed countries used technical and technological advancements to expand industrial production and construction, thus demanding more labor. On the other hand, widening inequality gaps between countries pushed labor out of developing economies to higher-income markets. Immigration to developed countries substantially increased when former colonies in Africa and Asia gained independence. Both intercontinental and intracontinental movements of people emerged in North Africa, Southeast Asia, and Latin America. The increase in intracontinental migration particularly affected Western and Northern Europe. France, Belgium, the UK, and the Netherlands attracted labor from relatively labor-abundant Italy, Spain, Greece, and other countries of Southern Europe. At the second stage, globalization developed under the influence of the ongoing progress in information and communication technologies, transformational changes in Russia and Eastern Europe, and market reforms in China. However, technological progress has not eliminated inequalities between developed and developing

21

809 21.5 · The New Normal Trends

. Table 21.2  Economic globalization in the context of international migration of labor Stages

Years

Number of international migrants, million people

Scope

Drivers

Effects

Stage I

1950–1970

60–80

Developed countries

Technical and technological advancement. Dissolution of the colonial system. New independent states in Africa and Asia

Deepening of interstate and intersectoral economic and trade ties. Establishment of international and regional economic associations

Stage II

1970–1990

80–150

Developed and developing market economies

Progress in information and communication technologies. Market reforms in China. Dissolution of the Soviet Union and the socialist bloc of countries. New independent states in Europe and Central Asia

Strengthening and expansion of transnational corporations. Formation of global production and supply chains

Stage III

1990–present

150–280

Entire world

Ever-increasing acceleration of technological progress

Formation of global markets for goods, capital, technologies, and labor

Source Authors’ development

countries, if not aggravated them (see 7 Chap. 15, 7 Sect. 15.6 for contemporary interpretations of economic development, including the center-periphery model and the international dependence concept). Time lags in access to innovations and technological advancements for certain countries and regions (see 7 Chap. 19,

810

Chapter 21 · International Migration of Labor

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. Fig. 21.4  International migrants, total (left axis) and a percentage of the world’s population (right axis), 1990–2020. Source Authors’ development based on IOM (2021)12 and Global Migration Data Portal (2022)13

7 Sects. 19.2.3 and 19.2.3 for technology-related theories of trade and development) have widened gaps and triggered massive migration from the Global South to the Global North (including the brain drain). At the third stage, the world economy becomes global. Globalization means the growing economic interdependence of countries around the world as a result of the increasing volume and diversity of international trade, flows of capital and labor, and the increasing role of supranational institutions in governing global markets. Like all economic processes, migration has also become global and has involved all countries and regions of the world. Over the past three decades, international migration has almost doubled from 153 million people in 1990 to 280 million people in 2020 (. Fig. 21.4). North America has recorded a rapid increase in the absolute number of international migrants. The continent has received more than 30 million people (the world’s highest average annual growth rate of 2.8%). The position of Western Europe as one of the destination centers has strengthened. In the early 1990s, there were about 50 million international migrants in Europe. In 2020, that number reached 86.7 million people. The nature of migration to the Global North has changed. Labor migrants move not only to conventional destinations (developed countries of Europe, North America, and Oceania), but also those developing regions and countries that are undergoing rapid economic transformations due to

12 International Organization for Migration (2021). 13 Global Migration Data Portal (2022).

811 21.5 · The New Normal Trends

21

. Fig. 21.5  International migrants, by region of residence, 1990–2020, million people. Source Authors’ development based on IOM (2021)14 and Global Migration Data Portal (2022 )15

the integration into global trade, production, supply, and information networks. Labor also flows in the reverse direction from the Global North to developing countries, which had not been the case in the XX century. Rapidly growing economies such as China and regions such as Southeast Asia attract immigrants to make up for the shortage of high-qualified professionals in certain sectors as well as lower-paid underskilled workers. The number of immigrants in Asia exceeded 85 million people in 2020 (. Fig. 21.5). Arguably, the migration from developed countries to the Global South is fueled by transnational corporations, which have integrated the markets of goods, capital, technologies, and labor. However, the impact of transnational corporations on the current labor migration trends is ambiguous. On the one hand, they create jobs across the world, including in developing and even less developed countries, which deters emigration. On the other hand, by contributing to the modernization of the economy and social relations, improving the professional skills of domestic workers, establishing closer ties between the countries where they operate, transnational corporations favor mobility of labor resources. The role of big corporations in the circulation of highly qualified specialists and the brain drain from developing countries is particularly essential. In general, transnational corporations use labor in all countries and attract labor from all over the world similar to other factors of production to reduce their costs and maximize their profits.

14 International Organization for Migration (2021). 15 Global Migration Data Portal (2022).

Chapter 21 · International Migration of Labor

812

21

. Table 21.3  Top destinations and origins of international migrants in 1990–2020, million people Top destinations

1990

2000

2010

2020

Top origins

1990

2000

2010

2020

USA

23.3

34.8

44.2

50.6

India

6.6

7.9

13.2

17.9

Germany

5.9

9.0

9.8

15.8

Mexico

4.4

9.6

12.4

11.2

Saudi Arabia

5.0

5.3

8.4

13.5

Russia

12.7

10.7

10.1

10.8

Russia

11.5

11.9

11.2

11.6

China

4.2

5.9

8.7

10.5

UK

3.7

4.7

7.1

9.4

Syrian Arab Republic

0.6

0.7

1.1

8.5

UAE

1.3

2.4

7.3

8.7

Bangladesh

5.5

5.4

6.3

7.4

France

5.9

6.3

7.3

8.5

Pakistan

3.3

3.4

4.8

6.3

Canada

4.3

5.5

6.8

8.0

Ukraine

5.5

5.6

5.4

6.1

Australia

4.0

4.4

5.9

7.7

Philippines

2.0

3.1

4.7

6.1

Spain

0.8

1.7

6.3

6.8

Afghanistan

7.7

4.8

5.3

5.9

Source Authors’ development based on IOM (2022)17

(2021)16

and Global Migration Data Portal

Regional economic integration has contributed to transforming the international migration flows. Migration acts as a natural consequence of the broader processes of social, political, and economic integration that step over national borders. The very fact of establishing an integration association makes interlinks participating countries by easing the exchange of goods and factors of production, including labor. Removing borders between states promotes internal migration within a single integration space as part of international migration. In addition, such a bigger market becomes more attractive for immigration from outside. The EU market and traditional destinations (USA, Australia, Canada) attract tens of millions of people. Germany, France, Spain, and the UK are all among the world’s top destinations of international migrants (. Table 21.3). One of the new normal signatures is the increased volatility of all global markets, including the labor market, and all global processes, including migration. The COVID-19 pandemic has both increased instability and uncertainty and dramatically affected the movement of people not only between countries, but even within national borders. On the one hand, the pandemic can be rightfully considered a global scale force majeure, but a one-time phenomenon like a natural disaster that emerges today and disappears tomorrow, returning all the things to

16 International Organization for Migration (2021). 17 Global Migration Data Portal (2022).

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normal. On the other hand, when imposed on the underlying economic or social trends, any tiniest force majeure can produce far-reaching consequences. Therefore, it is crucial to consider the pandemic’s effects on international migration not just as temporary restrictions on the movement of people, but as radical system transformations of the world labor market and, in general, the exchange of labor resources between countries. It is fair to distinguish four new normal trends in the sphere of migration: economic, technological, sustainable development (including public health and the environment), and geopolitical. As has been pointed out above, the cross-border movement of factors of production in general and labor in particular is primarily determined by economic motives (the difference in wages and income levels between donor and r­ecipient countries). Obviously, this difference will continue determining the volumes and directions of migration flows. However, there has occurred a global shift in the centers of attraction of labor. The pandemic has only exacerbated this shift, as developed and developing countries undergo this endurance test with different results. Most countries in the world, including developed economies of North America and Europe, have been suffering significant economic and human losses, while some countries have relatively quickly restored business activities while minimizing the number of deaths from the pandemic (for example, China). As labor flows into higher-income markets, new centers of attraction have emerged across the developing world. East and Southeast Asia, primarily China and the newly industrialized countries, are becoming increasingly attractive for the migration of highly skilled labor. China severely restricted transborder movements ­during the pandemic, but the attraction of skilled labor remains one of the core priorities of national migration policy for the years to come. Oil-producing countries of the Middle East (the United Arab Emirates, Qatar, Kuwait) are ­attracting more and more immigrants to serve their growing economies as global oil and gas prices rebound. Emerging markets, such as Brazil, South Africa, India, and Turkey, gravitate labor from lower-developed and lower-income neighboring countries. However, illegal and irregular migration is still a problem for many countries in Asia, Africa, Latin America, and the Middle East. However, even the new normal economic patterns are also undergoing a constant transformation under the influence of unprecedentedly accelerated technological progress. Information becomes decentralized. Anyone can generate their own content and compete for consumers of that content in the global market with conventional media tycoons and government outlets. Therefore, potential migrants can receive comprehensive and relevant information on all issues related to living and employment in potential foreign destinations. Digital technologies make it easier for people to cooperate at all stages of relocation, from collecting visa documents to settling at a new place and building a new social network abroad. Networking and information sharing greatly facilitate migration. On the other hand, the development of digitalization during the pandemic has demonstrated that entering the labor market of another country does not have to be associated with a physical relocation to this country. Such technologies as remote work, virtual office, augmented reality, and the metaverse have radically changed the very approach to organizing work. Obviously, they will determine the

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labor market trends for the coming decades. For international companies, there is no longer a need to hire local workers in foreign countries, send their managers to foreign branches, or resettle teams of workers from one country to another. Instead, virtual teams can be quickly and cheaply established, easily transformed depending on current business goals, and then easily disbanded upon completion of works. Artificial intelligence can perform certain operations better than humans. For employees themselves, digitalization opens access to the global labor market without incurring economic and non-economic costs associated with changing their places of residence. Thus, it is fair to say that the new normal is the replacement of the physical movement of people with a virtual exchange of labor as a factor of production, which narrows the capacity gap between developed and developing economies. Amid increased volatility and uncertainty, achieving relative stability is a cornerstone of economic development. 7 Chapter 18 details the new normal dimensions of stability and sustainability. In terms of the restriction of international mobility of people, the reduction of emissions from air transport, and the temporary closure of many businesses, the COVID-19 pandemic has made some contribution to the environmental recovery. However, it is clearly just a brief respite. The new normal reality assumes an increasingly close link between migration and various aspects of sustainability in the broad sense of the word. As mentioned above, people tend to move to more developed areas, thereby increasing the already high burden on ecosystems in large cities or industrial centers. On the other hand, environmental degradation, climate change, or natural disasters force people to move from less environmentally sustainable regions to more environmentally sustainable ones, thereby spreading anthropogenic influence throughout the planet and scaling up threats to ecosystems. Urbanization, increasingly overcrowded dwelling in cities, and at the same time increasingly active transcontinental migration significantly raise the risk of emergence and rapid spread of diseases. The COVID-19 pandemic has shown that in today’s world, the localization of any public health threat is hardly impossible, since localization paralyzes the entire international economy built on interconnection and exchange between local markets. Developed countries can combat global threats to the health of their citizens on their territory, but they cannot ban immigration from developing countries for a long time, since it is vital for ensuring the operation of certain sectors of the economy. Amid a pandemic, immigrants from less developed countries (i.e., less secure countries in terms of the quality and capacity of public health systems) impose a potential threat to the health of local residents. A balance between the potential risks and potential losses is needed. One of the ways to find it is to eliminate gaps between developed and developing countries in the quality of healthcare, the quality of the environment and, in general, the quality of life. Unfortunately, more and more countries and territories are not only not approaching such a balance, but are moving away from it. The intensification of international tensions, new flaring conflicts, and trouble spots generate new flows of forced migrants and refugees (Syria, Afghanistan, Ukraine, Russia, civil conflicts and coups in Africa, Southeast Asia, and Latin America, the geopolitical

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confrontations between the USA and Russia, and the Russia-Ukraine war). International cooperation in the sphere of migration is undermined by the sole actions of individual countries and governments. A new world disorder establishes under the banner of eliminating disparities and developing a new multipolar world. Paradoxically, the new normal reality is characterized by the erosion of global values and global regulatory institutions amid the ever-growing global interdependence of countries. Chapter Questions: 5 What is international migration, and how does it differ from the migration of labor? 5 Do you think forced migration should be considered a variant of organized migration? 5 According to Ravenstein, long-distance migrants predominantly move to large cities. Put forward arguments for and against this statement. 5 Use the example of your country of residence to illustrate the push and pull factors theory. What factors could pull immigrants to your country, and what motives could push out emigrants? 5 Explain the concept of economic dualism. 5 How do current costs of relocation and potential gains from migration influence the migration decision? Illustrate your answer. 5 What are the major economic effects of migration? How do they differentiate for donor and recipient countries? 5 Does your country of residence benefit or lose from participating in international migration of labor? Distinguish between economic and non-economic gains and losses. 5 Describe the migration policy of your country of residence. Does it target attracting immigrants or restricting migration? What tools does the government practice to incentivize or disincentivize migration? 5 Discuss the new novel trends in the global labor market. Are there any other trends not captured in the chapter which you consider essential? Subject Vocabulary: Business Migration: a migration of entrepreneurs in order to find better conditions for doing business. Commuting Migration: a daily or weekly cross-border movements of people from places of residence to places of work. Emigration: an outflow of people from a country. Forced Migration: a removal or deportation of people from a country based on a decision of the judiciary, police, or other authorities. Immigration: an inflow of people into a country. Integration Migration: a migration between member countries that establish an integration association that allows trans-border movement of people. Internal Migration: a migration that occurs within a country or a territory. International Migration: a migration that occurs between countries.

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International Migration of Labor: a resettlement of the employable population from one country (territory) to another for an extended period of time (over a year) due to economic or non-economic reasons. Irregular Migration: an illegal or unreported movement of people between countries. Labor Migration: a movement of people between countries in search of employment, higher remuneration for their labor, or career development. Organized Migration: a migration carried out by authorized firms or organizations in accordance with national or international legislation. Permanent Migration: a departure of people abroad for permanent residence. Reemigration: a return of emigrants to their home countries. Refugees: people forced to emigrate from their countries due to threats to their lives, activities, freedoms, and rights. Repatriation: a return of immigrants to their countries of origin. Seasonal Migration: a migration to a foreign country in a certain period of a year and for a certain period of time. Temporary Migration: a migration of people of active working age to get a job in another country for a certain period of time. Voluntary Migration: a non-forced resettlement of people.

References Chiswick, B. (1978). The effect of americanization on the earnings of foreign-born men. Journal of Political Economy, 86(5), 897–921. Global Migration Data Portal. (2022). Data. Migration Statistics. 7 https://www.migrationdataportal. org/international-data?i=stock_abs_&t=2020 International Organization for Migration. (2021). World Migration Report. IOM. Lee, E. (1966). A Theory of Migration. Demography, 3(1), 47–57. Lewis, W. (1954). Economic development with unlimited supplies of labor. The Manchester School of Economic and Social Studies, 22, 139–191. Massey, D., Arango, J., Hugo, G., Kouaouci, A., Pellegrino, A., & Taylor, J. (1993). Theories of international migration: Review and Appraisal. Population and Development Review, 19(3), 431–466. Piore, M. (1979). Birds of passage. Migrant labor and industrial societies. Cambridge University Press. Ravenstein, E. (1885). The laws of migration. Journal of the Statistical Society, 48, 167–235. Ravenstein, E. (1889). The laws of migration: Second paper. Journal of the Royal Statistical Society, 52, 241–305. Sjaastad, L. (1962). The costs and returns of human migration. Journal of Political Economy, 70(5), 80–93. Stark, O., & Bloom, D. (1985). The new economics of labor migration. The American Economic Review, 75, 173–178. Todaro, M., & Maruszko, L. (1987). Illegal migration and US immigration reform: A conceptual framework. Population and Development Review, 19, 101–114. Wallerstein, I. (1974). The modern world system I: Capitalist agriculture and the origins of the European world economy in the sixteenth century. Academic Press.

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© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_22

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Learning Objectives: 5 Study conceptual approaches to interpreting free trade and protectionism 5 Explore theories of internal and external effects of foreign trade policy (infant-industry theory, Metzler’s paradox, optimum welfare-maximizing tariff theory, theory of distortions, theory of domestic divergences, theory of customs unions, theory of second best) 5 Discuss political-economic hypotheses of foreign trade regulation 5 Understand the effects of tariff and non-tariff regulations on output, consumption, and public wealth 5 Provide an in-depth look at the evolution and recent progress of the multilateral regulation of international trade 5 Reveal and discuss essential features of the new normal protectionism 22.1  Free Trade and Protectionism

Each country establishes a balance between the economic development goals, interests of domestic producers, and global development trends by pursuing certain foreign trade policies. The implementation of comparative and competitive advantages of countries and companies largely depends on their participation in international economic, financial, and trade interactions. In turn, the interests of domestic businesses significantly affect trade policies and regulations at the national level. Depending on the government intervention in regulating foreign trade activities, a distinction is made between free trade (7 Sect.  22.1.1) and protectionism (7 Sect.  22.1.2). 22.1.1  Free Trade

Free Trade is a type of foreign trade policy that assumes reducing or eliminating trade barriers, such as export and import duties, quotas, subsidies, and other tariff and non-tariff regulations. Being based on the comparative costs principle, free trade promotes the most efficient allocation of scarce resources and factors of production. Countries differ in the availability of resources, combinations of factors of production, and levels of technological development. Consequently, they produce similar goods at different costs. As previously discussed in 7 Chap. 19, international trade is about producing goods at relatively lower costs compared to other countries and then exchanging them for those goods whose production costs in a country are higher. If every country does so, the world economy can take full advantage of specialization and cooperation as the two integral elements of the international division of labor. In other words, free trade allows a country to gain more from the use of the limited amount of resources at its disposal. If a country cannot trade freely, it shifts resources from more efficient (lower cost) to less efficient (higher cost) uses to meet diverse needs of its domestic market by means of domestic production rather than trade. A side

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benefit of free trade is that it stimulates competition and moderates monopoly. Free competition on the part of foreign companies forces local producers to reduce costs, increase the quality of their products, introduce innovations and advancements, and thus promote economic development and growth. Consumers benefit from a better choice of a wider range of domestic and foreign products in the local market. Case box The Netherlands is one of the most demonstrative examples of economic development due to free trade. In the XVI–XVII centuries, the country emerged as one of the world’s largest trade and financial centers. The immigration of artisans and merchants from neighboring European states brought skills and know-how to the country and spurred the development of Dutch industries. The government encouraged trade and stimulated the growth of the merchant fleet and the expansion of Dutch trade all over the world. However, despite its commitment to the principles of free trade in general, the Dutch government protected domestic agriculture with import duties and supported domestic businesses by implementing various quality control regulations and protecting the interests of Dutch merchants abroad.

As noted above, the arguments in favor of free trade are based on the assumption that specialization increases the productivity of labor and other resources (in accordance with the law of comparative advantage). More efficient use of all kinds of inputs boosts output and improves living standards at both national and international levels. The free trader model assumes that the market (no regulatory body) balances demand, supply, costs, wages, and other macroeconomic parameters between exporting and importing countries and export-oriented and import-dependent sectors. On a free trade market, goods are exchanged at prices based on international average production costs and the comparative advantage principle. Free trade integrates national economies into the world economy and ensures the use of scientific and technological achievements for the most effective development of the national economy. Case box Rapid development of the newly industrialized countries of Asia at the end of the XX century is one of the most recent evidences of the effectiveness of the free trade policy. Equal conditions for importers and exporters, the reduction of restrictions on foreign trade, and the use of the market mechanisms instead of government regulations redistributed resources in favor of more efficient sectors and thus spurred GDP growth. The latter depends both on the very nature of the reforms and the scale of resources redistribution. In Asia, the average annual GDP growth rose to 5–6% amid trade liberalization reforms in the late 1990s and early 2000s, while the growth of foreign trade reached 9–10%.

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However, despite the many potential benefits, in reality, free trade policies can have a negative impact on the economic development of a country. Smaller domestic producers lose the competition to bigger transnational companies, go bankrupt, and leave the market. In critical cases, the mass exodus of domestic companies destroys entire industries. Employment may go down in the short term due to the downturn in industries not directly involved in foreign trade, but those still affected by the liberalization. Even a sharp increase in employment in the export-oriented sectors can not immediately compensate for the decline in other sectors. Export-oriented industries may not be able to absorb the labor force released from other sectors because of various market failures, delays in investments, time gaps needed for retraining workers, or restricted intersectoral or territorial mobility of labor. 22.1.2  Protectionism

Protecting the market through the imposition of customs duties on imported goods and services fundamentally changes the nature of free trade and results in the emergence of trade protection, or protectionism. Protectionism is a type of foreign trade policy aimed at supporting domestic production of goods and services and restricting foreign competition and imports by introducing import duties and quotas, trade embargoes, protection of intellectual property, administrative approvals, customs procedures, technical barriers, subsidies for ­exporters, restrictions on exchange operations, and capital transfer control. Protectionism encourages the development of domestic production capable of replacing imported goods. However, protectionism is associated with higher domestic prices for products protected by tariffs and duties (higher compared to the global price). Incentives for introducing technological advancements in industries shielded from foreign competition weaken. Some importers may try to save on tradeassociated expenditures by illegally bypassing customs controls. In response to protection measures against their products, foreign countries may introduce even higher trade barriers that impede trade and eliminate any gain from protection (see 7 Sect.  22.4 below for trade tensions and the new rise in protectionism). In a developing economy, protectionist measures may give rise to new industries, but harm other sectors. Nevertheless, protectionism is widely used by both developing and developed countries to protect domestic producers against the ever-growing competition in the global market. Case box An example of purposeful protectionism is England in the XVII-XIX centuries. Customs protection of domestic industry was first applied in the 1690s, when import duties of 20% were introduced on about 2/3 of all English imports. The level of duties gradually increased and peaked in the late XVIII century–early XIX century, when protection duties for certain goods reached 50%, while the import of some products was banned. The world’s first industrial revolution that occurred in England at that

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time was spurred by technological innovations introduced in textile, metallurgic, and a number of other industries. Industrial growth increased national wealth, drove up wages, eliminated unemployment, and restructured the domestic product from a traditional agriculture-oriented economy to innovation-driven industrial production.

In developed countries, protectionism is proactive. It primarily aims at supporting large national and transnational corporations and expanding their markets and operations worldwide by practicing a comprehensive system of foreign trade regulations at both national and international levels. Developing countries, on the contrary, tend to reactively protect their domestic markets from foreign competition and nourish their local industries and companies. Differences in the approaches of developed and developing countries to the protection of their markets are expressed in the use of different types of protectionism: 5 selective protectionism—protection of the domestic market from certain types of goods or services or certain countries or companies; 5 sectoral protectionism—protection of individual industries or sectors; 5 hidden protectionism—indirect non-customs measures and regulations; 5 collective protectionism—measures and regulations agreed and applied collectively by a group of countries (members of customs unions and other types of integration establishments). Case box Globalization and economic and trade integration of countries have resulted in the emergence of collective protectionism in various parts of the planet. It is carried out through concerted actions of groups of countries united by various kinds of trade or economic agreements. The most demonstrative example is the European Union. Countries tend to integrate to unite their powers, strengthen their competitive advantages, ease the flow of goods, capital, and labor between their domestic markets, and thus expand their economies of scale. The major regional associations (trading blocs) that apply collective protectionism include the Regional Comprehensive Economic Partnership (RCEP), trade agreement between the USA, Mexico, and Canada (USMCA), Southern Common Market (MERCOSUR), Association of Southeast Asian Nations (ASEAN), Common Market of Eastern and Southern Africa (COMESA), African Continental Free Trade Area (AfCFTA), and others.

The most commonly cited benefits of the protectionist policy for the economic development of a country and domestic producers include the following: 5 Support for new (infant) industries. Start-ups need assistance and support in their infancy to get established. Also, the perspective industries in which a country enjoys comparative advantages could be supported by the government to achieve economies of scale. However, wide-scale protection of all

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sectors is impractical since each and all domestic industries are never able to become equally competitive on the global market. 5 Increase in the national welfare. Trade restrictions can increase the ratio of export to import prices (which means better terms of trade). Import tariffs reduce the demand for imports from a given country, thereby reducing imports. However, such an effect is true only for major economies whose demand is substantial enough to affect the world price. 5 Increase in employment. The decline in imports due to trade restrictions stimulates the growth of domestic production. Consequently, the number of jobs goes up, but primarily in those industries which compete with imports. In export-oriented sectors, unemployment may rise. Restricting imports in country A reduces exports of its trading partner, country B. To respond, country B may introduce a retaliatory tariff on imports from country A. That would restrict exports from country A and degrade jobs in its export-oriented industries. Another reason is that a reduction in exports of country B reduces national income and, consequently, the purchasing power of that country. As country B can not import the same amount of goods from country A, the number of jobs in export-oriented industries in country A declines. Therefore, introducing import duties spurs employment in import-substituting sectors, but aggravates unemployment in export-oriented industries. 5 Eliminating dumping. Dumping is the sale of goods abroad below the domestic price (or world price). However, from the standpoint of economic efficiency, not all dumping requires anti-dumping measures. Predatory dumping occurs when a firm temporarily lowers prices to drive competitors out of the market and then raises prices to enjoy the monopoly profit. In the case of a temporary surplus of goods for export, foreign firms may practice temporary (sporadic) dumping. It hurts local producers in the short run, but when the export surplus is sold out, prices get back to the pre-dumping level. Permanent dumping occurs when large transnational corporations use price discrimination between markets to maximize overall profits. More elastic demand in the domestic market compared to foreign markets facilitates permanent dumping. Thus, it is caused by objective disparities between prices in domestic and foreign markets. Therefore, from the standpoint of economic efficiency, anti-dumping protectionist measures should be applied to short-term situational predatory and temporary dumping, but not to permanent differences in prices. 5 Compensation of subsidies of a foreign country to its producers. The government may impose a tariff on imports to compensate for the price difference between domestic goods and subsidized imports. 5 National security and defense. Selective protectionism allows the government to support strategic industries and fence them off from foreign companies and technologies. 5 Improving the trade balance. Imposing a tariff on imports reduce imports and improves trade balance (providing that exports remain unchanged). However, as noted above, trading partners may introduce retaliatory barriers to exports. Also, imports may grow despite the introduction of import duties due to the appreciation of the national currency. 5 Import duties are a substantial source of fiscal revenue for countries.

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Along with the arguments for protectionism, there are those against it. Although, the latter largely contradict the theory of comparative advantage. Countries benefit from trade due to specialization. To maximize their benefits, they should abandon certain industries and concentrate resources in sectors in which they possess comparatively distinct advantages. Export-oriented industries and proper fiscal and monetary policies can maintain overall employment, so that a country can focus on increasing real income by specializing in certain areas in accordance with the principle of comparative advantage. There are five principal drawbacks of protectionism: 5 Protectionism distorts the market environment, favors the emergence of domestic monopolies in trade, production, and finances, and thus depresses competition. 5 Protectionism slows down economic growth. The shrinkage of international trade due to tariffs and non-tariff restrictions negatively affects individual countries and the entire world economy. With free trade, countries identify and develop the most competitive industries by efficiently utilizing their advantages. Pursuing the protectionist policy, governments divert part of resources from better-performing sectors to support less efficient ones. 5 Protectionism, in particular the unilateral imposition of tariffs, often leads to trade wars and other distortions in international trade (see 7 Sect. 22.4 for trade tensions between major economies as a hallmark of the new normal protectionism). A country that unilaterally sets up tariff or non-tariff barriers to protect domestic producers from foreign competition risks being retaliated by its trading partners and facing tariffs on its main exports. 5 Protectionism fuels prices. Imports become more expensive due to tariffs. Since protectionism depresses competition, domestic producers are not incentivized to reduce costs and lower prices. Also, as noted above, protectionism favors monopolies, which benefit from raising prices. 5 Protectionism indirectly undermines exports. As emphasized previously, by reducing other countries’ income while protecting the domestic market from foreign competition, a country reduces the ability of its trading partners to purchase its export goods. Within global production and supply chains, final export goods are commonly composed of imported components. Therefore, import tariffs increase overall production costs along the entire chain and degrade the competitiveness of final goods. Both protectionism and free trade reflect the reaction of countries to transformations in the international division of labor and international economic relations. Modern economic history shows that since the XIX century, international trade patterns have been alternating between liberalism and protectionism. Nowadays, most countries seek to pursue a flexible foreign economic policy based on a combination of protectionism and free trade.

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22.2  Foreign Trade Policy

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Foreign Trade Policy is one of the elements of public economic policy aimed at regulating the export and import of goods and services by using customs duties and tariffs, non-tariff regulations, and financial transactions related to foreign trade. The combinations of foreign trade policy tools and their uses are determined based on the situation on domestic and global markets and foreign trade policy goals of individual countries. Theoretical approaches to establishing foreign trade policy can be divided into theories of internal effects of foreign trade policy, theories of external effects of foreign trade policy, and political-economic hypotheses of foreign trade policy (7 Sect.  22.2.1). 22.2.1  Theories of Foreign Trade Policy

Theories of Internal Effects of Foreign Trade Policy attempt to explain the consequences of public macroeconomic policies of individual states in foreign trade. The following five theories should be emphasized: 1. Infant-industry Theory is the classical theory of public industrial policy developed by Alexander Hamilton in the late XVIII century (further reading: “Report on the Subject of Manufacturers”1) and further advanced by Robert Baldwin and Pranab Bardhan in the XX century (further reading: “The Case against Infant Industry Protection”2 and “On Optimum Subsidy to a Learning Industry”3). The key message is that protection from foreign competitors allows infant industries to grow up faster, achieve economies of scale, and become competitive in foreign markets. Per unit production expenditures in infant industries are usually quite high (no economies of scale). In the early stages of development, they lose the competition to more mature foreign rivals. At the same time, start-ups are commonly associated with new knowledge and advanced technologies. Supporting infant industries through R&D subsidies, staff training, protection of intellectual property rights, and other measures attracts and secures investment. Both developing and developed countries have been practicing direct or indirect protection of infant industries since the times Hamilton first formulated his theory in the 1790s. Examples are the textile industry in England in the XVIII century, chemical industry in Germany in the late XIX century, aircraft and space industries in the USA and the EU, automotive industry in France, and shipbuilding in Japan in the XX century. 2. Metzler’s Paradox is the contradiction to the basic logic of protectionism, which says that an introduction of an import tariff can force foreign producers to reduce prices by a greater amount than the tariff rate to stay in the im-

1 2 3

Hamilton (1791). Baldwin (1969). Bardhan (1971).

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porter’s market (further reading: “Tariffs, the Terms of Trade, and the Distribution of National Income”4). On the one hand, barriers to imports push up domestic prices for imported goods and thus protect domestic producers. On the other hand, import tariffs cause the decline in world prices for imported goods of a country, which can compensate for the initial increase in domestic prices for imported goods. One of the examples of the paradox is the USAChina trade tension which caused a decrease in world prices for raw materials and metals in 2018–2019. It also slowed down the growth of the USA’s GDP by 0.3%, consumption by 0.3%, private investment by 1.3%, real household income by 1.0%, exports by 1.7%, and imports by 2.6%. 3. Optimum Welfare-Maximizing Tariff Theory formulated by Harry Johnson aims at finding the optimum import tariff on goods and services (further reading: “Optimum Tariffs and Retaliation”5). According to Johnson, a tariff that maximizes national income is equal to the product of the elasticity of demand for imports in the domestic market and the elasticity of demand for exports in the foreign market reduced by one. The lower the price elasticity of imports (price fluctuations negligibly affect imports), the higher the optimum tariff rate, and vice versa. In general, a tariff that maximizes wealth is either equal to or lower than the tariff that maximizes foreign trade revenue. For example, demand for oil is characterized by low price elasticity. Consequently, import tariffs on oil may be higher compared to those on higher-elastic goods, such as agricultural products. 4. Theory of Distortions developed by Jagdish Bhagwati states that the reduction of tariff and non-tariff restrictions (distortions) in foreign trade increases trading countries’ gain from trade (further reading: “The Generalized Theory of Distortions and Welfare”6). According to Bhagwati, welfare grows when there is only one barrier to trade that decreases. In the case of many distortions, the removal of one barrier insignificantly affects trade between countries and mutual gain from trade. The introduction of tariffs inevitably depresses wealth compared to the optimal strategy of free trade. The most efficient tool for correcting distortions is fiscal policy. Despite convincing theoretical arguments in favor of reducing barriers to the international exchange of goods and services, most countries pursue protectionist policies (to varying degrees). Multilateral regulations of international trade within the WTO and b ­ ilateral trade agreements between countries are pivotal for eliminating or at least managing distortions in contemporary global trade (see 7 Sect.  22.3 for multilateral regulation of international trade). 5. Theory of Domestic Divergences elaborated by Max Corden suggests that discrepancies between private and public economic interests within a country (divergences) should be corrected by internal measures. Applying foreign economic tools to adjusting internal processes produces distortions (further

4 5 6

Metzler (1949). Johnson (1953). Bhagwati (1969).

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reading: “Trade Policy and Economic Welfare”7). For example, trade-related measures are commonly used as a means of environmental protection or the climate change response even though trade itself hardly causes environmental problems. The latter are rather fueled by negative externalities of production (exploitation of natural resources, land use, etc.) or consumption (automobiles, plastics, etc.) within a country or by the transboundary spread of harmful effects (transboundary transfer of air and water pollution). Internal effects should be addressed by internal macroeconomic instruments, such as taxes, while external (transboundary) ones may require foreign trade regulations, such as import tariffs and international standards and safety regulations.

22

To summarize, the following postulates of the theories of internal effects of foreign trade policy should be emphasized: 5 protectionism ambiguously affects foreign trade and produces contradicting results; 5 foreign trade policy that maximizes budget revenues from foreign trade differs from that maximizing national welfare (GDP); 5 eliminating trade barriers increases national welfare (other things being equal); 5 foreign trade policy instruments are effective in addressing external processes, while their use to solve domestic issues gives rise to market distortions. Theories of External Effects of Foreign Trade Policy cover theories that seek to explain the consequences of macroeconomic decisions of trading partners for each other. The two most prominent theories in this group are the theory of customs unions by Jacob Viner and James Meade and the theory of second best by Richard Lipsey and Kelvin Lancaster. Theory of Customs Unions states that the coordination of foreign trade policy between countries in the form of trade agreements on the elimination of tariffs in mutual trade (customs unions and other forms of trade integration) produces two effects. The first effect is trade creation, i.e., the reorientation of ­consumers from domestic suppliers to external ones within the customs union. The s­econd effect is trade diversion, i.e., the reorientation of consumers from suppliers outside a union to those within a union (further reading: “The Customs Union Issue”8 and “The Theory of Customs Unions”9). The end result of a trade agreement depends on which effect prevails. The theory formulates the conditions under which positive effects of creating a customs union outweigh negative ones: the bigger the economic size of a union the better; the lower the average level of tariffs on imports outside a union the better; and the higher the competitiveness of member countries in protected industries before the establishment of a union the better.

7 8 9

Corden (1974). Viner (1950). Meade (1955).

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The above three conditions formulated by Viner and Meade are now commonly applied to assess the viability of potential international trade agreements. Empirical tests of the theory of customs unions have confirmed that the change in welfare due to the conclusion of trade agreements may differ for participating countries. For instance, Bela Balassa compared the elasticity of import demand of the European Economic Community (EEC) countries in 1953–1959 (before the establishment of the community) with the same indicator in 1959–1970 for several industries (Balassa’s theory of intra-industry trade is detailed in 7 Chap. 19, 7 Sect.  19.3.4). Balassa revealed no trade diversion effect within the EEC as a whole (with the exception of food and chemical products), while the trade creation effect (the increase in the elasticity of import demand from all countries) amounted to 10% (particularly in the oil industry, mechanical engineering, and automotive sector). In most cases, the trade diversion effect is offset by the trade creation effect, as a result of which the establishment of a customs union boosts member countries’ welfare. However, it is impossible to draw an unequivocal conclusion about whether the welfare of a particular country will increase or decrease after joining a customs union. Some countries may lose from participating in international trade agreements. In the 1960–1980s, the theory was extended. Jan Tinbergen showed that an increase in the size of a customs union increases the likelihood of a positive impact on the wellbeing of member countries (further reading: “Customs Unions”10). According to Richard Lipsey, the increase in a country’s wealth when joining a customs union depends on the share of local products in its domestic consumption. The higher this share, the greater the likelihood of a gain in welfare (further reading: “The Theory of Customs Unions”11). Jaroslav Vanek suggested that member countries could benefit from concluding a trade agreement if tariffs in relation to third countries were lower than the previously existing tariffs between member states (further reading: “General Equilibrium of International Discriminations”12). Murray Kemp and Henry Wan revealed that any group of countries could establish a customs union that would improve the global welfare, provided that capital flows within a union were not restricted and a common external tariff affected no world prices (further reading: “Elementary Proposition Concerning the Formation of Customs Unions”13). Finally, according to Paul Wonnacott and Ronald Wonnacott, the higher the tariffs in participating countries before joining a customs union, the more these countries gain from eliminating the tariffs (further reading: “Is Unilateral Tariff Reduction Preferable to a Customs Union?”14). Theory of Second Best is a kind of synthesis of the Keynesian and the classical economic theories regarding the prerequisites for the balance of internal and

10 11 12 13 14

Tinbergen (1957). Lipsey (1960). Vanek (1965). Kemp and Wan (1976). Wonnacott and Wonnacott (1981).

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foreign trade equilibrium. James Meade identified the conditions under which interference in international trade contributed to the wellbeing of both individual countries and groups of countries and, accordingly, to the growth of the world’s total output (further reading: “Theory of International Economic Policy”15). These conditions facilitate the concept of second best: apart from a free-trade policy, there is no other trade policy whose impact on the overall wealth would be unequivocally positive. This idea was then adopted by Richard Lipsey and Kelvin Lancaster to formulate the general theory of second best (further reading: “The General Theory of Second Best”16). The theory postulates that if one of the conditions of the Pareto optimum cannot be fulfilled (the optimal distribution of goods between consumers, the optimal distribution of resources between producers, the optimal volume of output), the second best optimum is achieved only through a deviation from all other conditions of the Pareto optimum. In contemporary markets, many factors may impede the achievement of Pareto optimums, such as the imperfect competition or the government’s macroeconomic policies that miss the market failure targets. Externalities, such as protectionist measures on the part of foreign countries, changes in world prices, or non-economic political, social, and technological transformations, can also produce deviations from Pareto optimums. Therefore, multiway distortions force governments to abandon optimal decisions and switch to the second best options. For example, the establishment of a customs union can be considered the second best option after the optimal free trade. The key propositions of the theories of external effects of foreign trade policy could be formulated as follows: 5 although establishing a union is neither the best foreign trade policy option for individual countries nor a clearly positive development for the world economy, positive effects that arise from such coordination commonly outweigh negative ones; 5 impact of trade integration on participating countries and foreign trading partners depends on the number of participants, size of their economies, level of their economic development, volume of mutual trade, and competitiveness of domestic companies in the global market; 5 the more countries coordinate foreign trade policies with each other, the larger the size of their economies, the higher the level of economic development; 5 the greater the volume of trade before coordination and the higher the competition, the higher the gains of participating countries from trade integration; 5 impact of trade integration on participating countries and foreign trading partners depends on changes in tariffs: if common customs tariffs are significantly lower than before integration, the effect of trade integration on participating countries would be positive; 5 trade integration expands the market and promotes economies of scale, which allows participating countries to increase output and reduce costs.

15 Meade (1955). 16 Lipsey and Lancaster (1956).

829 22.2 · Foreign Trade Policy

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Political-Economic Hypotheses of Foreign Trade Policy are extensions of economic theories and models through the use of concepts, categories, and assumptions of political science and economic analysis of political processes (primarily the public choice theory). The first political economic justifications for international trade were undertaken in the late 1960s–early 1970s. Correlation analysis was employed to reveal linkages between theoretical postulates and empirical parameters, including output, employment, exports, and imports. Studies focused on foreign trade policy as a tool for reducing income inequalities between and within countries, the role of sectoral lobbying in foreign trade policy, and protectionism as a status quo factor in the global economy. Early political-economic models of foreign trade policy narrowly focused on explaining trade policies of individual countries in a specific historical context. The subsequent development of the political economy of international trade has widened the conceptual framework by capturing formal models of foreign trade. According to the latter, trade policies of individual countries are determined by lobbying for the part of various pressure groups, such as the largest companies or banks. Being adjusted for the satisfaction of citizens with economic policies, lobbying configures the government’s foreign trade policy (further reading: “The Political Economy of Protection”17 and “Endogenous Lobby Formation and Endogenous Protection”18). Pressure groups represent various sectors and industries, and citizens’ satisfaction is expressed in political support for the government. The challenge is to determine the impact of various forms of trade policy (variations and degrees of protectionism and free trade) on a wide range of stakeholders in both global (foreign trading partners, transnational companies) and domestic (local producers and consumers) markets. Further integration of the finding that trade agreements could be beneficial into political-economic models promoted a multi-level theoretical approach to interpreting international trade as a consequence of the interaction between governments and owners of factors of production. The latter put pressure on governments to introduce trade policy measures they (owners) want, while governments seek to maximize the public benefit. Consequently, the foreign trade policy of a country is sprout in negotiating the level of trade barriers, which depends on the political and economic potential of each of the negotiators, as well as the willingness of governments to favor pressure groups and consider the interests of domestic consumers (further reading: “A Political-Economy Theory of Trade Agreements”19). The contemporary political economy of international trade comprises several hypotheses, including the hypothesis of pressure groups, the hypothesis of votes, the hypothesis of maintaining the status quo, the hypothesis of maximizing budget revenues, the hypothesis of foreign trade negotiations and retaliatory measures, and the hypothesis of ideological preferences. All contemporary political-economic hypotheses simultaneously capture political and economic prereq17 Hillman (1989). 18 Mitra (1999). 19 Maggi and Rodrigues-Clare (2007).

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uisites and factors that influence decisions made by major stakeholders, such as governments, pressure groups, and companies. For political economy, international trade is the result of reconciling economic interests in a political market in which foreign trade decisions are exchanged for intangible (political support) or material (budget revenues) resources. It is a product of interaction between stakeholders in domestic and international political processes. Aiming at maximizing their own benefits, stakeholders affect foreign trade policy at the national, regional, or international levels. From a practical point of view, the use of political-economic tools makes it possible to solve the paradoxes that arise in the monodisciplinary analysis of international trade. One of the paradoxes is that despite the theoretical axiom that free trade increases national and overall wealth, all countries establish barriers to foreign goods and competition. The assumption that the regulation of economic processes is based on the desire to maximize the public welfare (the interests of the m ­ ajority of the country’s citizens) does not allow explaining the paradoxes of c­ ontemporary foreign trade regulations. The latter precisely demonstrate the gap between the theory of international trade and real-life policy-making practices. Recently, there has been a significant increase in the use of non-tariff measures, which even more distort international trade compared to tariffs (see 7 Sects. 22.2.2 and 22.2.3 for the effects of tariff and non-tariff regulations of international trade). However, approaching these tendencies from a political-economic angle, we could say that maximizing the wealth of people and businesses is not the only goal of the government’s foreign trade policy, while the range of stakeholders involved in the elaboration of trade policies is not limited to governments. As a consequence, the economic efficiency of foreign trade policy may reflect individual interests of pressure groups, largest corporations, or other stakeholders rather than the wellbeing of the nation. Politicians may be interested in adjusting trade and economic policies in such a way as to win the next elections. Corporations, banks, and other influencers seek to maximize the economic, political, social, or other rent they receive. For consumers, foreign trade regulations affect the choice, quality, and prices of goods on the domestic market. Interests of consumers, pressure groups, and the government may differ, so do foreign trade policies. The interests of consumers are best served by free trade policies that maximize their welfare by reducing prices and diversifying the choice of domestic and imported goods. Pressure groups are usually interested in redistributive policies in their favor, when they can benefit at the expense of other economic actors. It is the activities of pressure groups that become the main reason for deviations from the general welfare-maximizing policy of free trade. 22.2.2  Tariff Regulation

The main instrument of foreign trade policy is customs tariffs. Customs Tariff is a systematized list of customs duty rates, i.e., taxes on import or export of goods at the time they cross the customs border of a country or a customs union. Tariffs are classified according to several criteria (. Fig. 22.1). Import duties are most widely used to protect domestic producers, regulate domestic prices, and collect

831 22.2 · Foreign Trade Policy

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. Fig. 22.1  Types of customs tariffs. Source Authors’ development

fiscal revenues. Export duties are less common. They prevent the outflow of domestic goods to foreign markets in cases of a shortage of particular products in the domestic market. Export duties also generate fiscal revenues for the budget. Transit duties are applied for goods transported through a customs territory. Ad valorem duties are set as a percentage of the price of goods. Specific ones are established in absolute terms from the unit of measurement. Combined duties mix the two approaches (for example, an ad valorem duty up to a certain value and a specific duty above this value). In terms of their application, customs tariffs include seasonal duties, antidumping duties, and countervailing duties. Seasonal duties are used for the operational regulation of international trade in seasonal goods, primarily agricultural and food products. Antidumping duties aim at preventing the import of goods at price below the global level, if such import is detrimental to domestic producers of similar goods. Countervailing duties are imposed on goods directly or indirectly subsidized by exporting countries, if such subsidies degrade the competitiveness of similar domestic products on the domestic market. Depending on the economic goals and results, fiscal, fiscal, protective, and expansionary duties are distinguished. From a fiscal point of view, all customs duties are just taxes that generate budget revenues. An example of a fiscal duty is a customs tariff on the import of goods not produced in a country. A country may need such goods and favor their imports, but it still imposes a duty to generate tax revenues. Fiscal duties are commonly rather low. Protective duties serve to protect domestic producers from foreign competition (for example, protection of start-ups at the early stages). High import duties can be expansionary in nature, as they stimulate capital exports.

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. Fig. 22.2  Effects of import duties on output and consumption. Source Authors’ development

Most of the customs duties are set permanently. They are fixed duties that cannot be changed depending on the circumstances. Flexible duties are customs tariffs whose rate may vary in certain cases. Nominal duties are tariff rates specified in a customs tariff. Effective duties reflect the real level of customs duties on final goods calculated by taking into account the level of duties imposed on imported resources, intermediate goods, and parts of final goods. Import duties protect domestic producers, but at the same time reduce domestic consumption by appreciating imports. Suppose that country A produces and consumes good X . An equilibrium in the domestic market is established at point E at the intersection of demand D and supply S (. Fig. 22.2). At equilibrium price PE, output (consumption) equals QE. Such a situation is specific to autarky. In its purest form, autarkic policy assumes that imports are fully replaced by domestic goods. Suppose that country A abandons protectionism and opens its customs borders. Since the world price is lower than the domestic price (PW < PE), prices on the domestic market under free trade fall down to PW , output shrinks from QE to QWS, and consumption rises from QE to QWD. Since domestic supply at point A does not match domestic demand at point D, the gap is covered by imports (QWD − QWS). Protecting domestic producers from foreign competition, country A introduces import duty T . If country A is too small to affect the world price, PW remains unchanged. The new domestic price goes up to PT (T = PT − PW ). The domestic output then increases from QWS to QTS. This growth is driven by rising prices for imports due to the establishment of import duty T . Domestic producers supply identical products (similar assortment and parameters), so they follow the market and raise prices for their products. Consequently, those producers who considered production unprofitable at price PW now expand output at a higher price PT . Due to rising prices, consumption in country A declines from QWD to QTD. More expensive imports shrink from (QWD − QWS ) to (QTD − QTS ), because the gap between domestic supply at point B and domestic demand at point C narrows. The share of domestic supply in total consumption increases amid falling demand.

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. Fig. 22.3  Effects of import duties on the public wealth. Source Authors’ development

Let us now consider the impact of import duties on consumers, producers, the government, and the country as a whole, i.e., on the public wealth. As demonstrated in . Fig. 22.2, import duty T pushes up the domestic price from PW to PT . Consumers’ loss from introducing the duty equals (a + b + c + d) (. Fig. 22.3a). However, higher price PT favors domestic producers who receive an additional benefit (area a above the supply curve S between prices PW and PT ). The government also wins from introducing the duty. Its gain is equal to the product of the duty rate (PT − PW ) on the value of imports after the introduction of the duty (QTD − QTS ), i.e., area c. The public wealth increases, since the government does not spend the entire amount received on the maintenance of customs service, but redistributes a certain part of the gain within the economy. Thus, in macroeconomic terms, consumers’ loss (a + b + c + d) is partially compensated by the gains of producers and the government (a + c). The loss (b + d) is not compensated—this is the deadweight cost of the import duty for the economy. Area b is the production-related deadweight cost of protectionism, i.e., the cost of the resources that have been spent on increasing domestic output from QWS to QTS instead of using them more efficiently in other sectors under the free trade regime. Area d is the consumption-related deadweight cost of protectionism, i.e., consumers’ loss due to shift of demand to less desirable, but cheaper substitutes for good X . After the introduction of import duty T , consumption declines from QWD to QTD. Consumers lose (a + b + c), since the same amount of goods X costs them more. In addition, they lose area d, as their consumption decreases. In . Fig. 22.3b, area a (producers’ gain from introducing import duty T ) is divided into two parts. Area a1 is a gain from selling at a higher price PT of that volume of goods QWS that would be sold anyway under free trade, but at a lower world price PW . In addition to such a pure price-driven gain, the introduction of import duties increases domestic production from QWS to QTS. The benefit from supplying this additional quantity of domestic goods is the product of the tar-

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iff-driven gain in domestic output (QTS − QWS ) by new price PT , or (a2 + b + e). The employment of additional inputs (e + b) required to expand domestic output up to QTS generates additional producers’ gain a2. With no import duty T , the same quantity of goods (QTS − QWS ) could have been sold on the world market at price PW . Therefore, area e is a potential producers’ gain from expanding output under the free trade regime. Consequently, area b is the cost of inputs aimed at expanding domestic output at price PT (more expensive than foreign goods) rather than increasing imports at price PW or relocating resources to other sectors of the economy. If country A is so large (size of the economy) that its demand significantly affects world prices, then the imposition of an import tariff affects the structure of the tariff-driven gain. It breaks down into domestic revenues (redistribution of gain from domestic consumers to the budget of a large country – area c) and the effect of terms of trade (redistribution of gain from foreign producers to the budget of a large country – area e) (. Fig. 22.4). The effect of the introduction of import duty T is similar to that illustrated in . Fig. 22.3—the domestic price of imported goods rises from PW to PWT . The aggregate supply curve shifts upwards by the amount of tariff T , domestic output increases from Q1 to Q2, domestic consumption falls from Q4 to Q3, and imports’ share in domestic supply shrinks from (Q4 − Q1 ) to (Q3 − Q2 ). Because country A is large, such a reduction in its imports depresses the demand for good X in the world market and pushes world price PW down to PW 1. Area c between the old world price PW and tariff-driven domestic price PWT turns into the gain from domestic consumers who pay a higher price, while area e between old and new world prices PW and PW 1 represents the gain received from foreign producers who pay higher tax to sell their goods in country A. The outcome of introducing an import tariff in a large country depends on the ratio of the effect of terms of trade (area e) to the sum of the protection (area b) and consumption (area d) effects. If e > (b + d), then the economic situation in a country improves (a gain from foreign producers exceeds the additional cost of inputs required to expand domestic output and the deadweight loss of consumption). If e < (b + d), a country loses from its commitment to protectionism. It should also be noted that the excessive use of tariffs on imports may lead to a fall, rather than an increase in domestic prices of imports in the event of a substantial decrease in the new world price PW 1 due to the introduction of import duty T in a large country (see Metzler’s paradox in 7 Sect.  22.2.1). Therefore, it is essential to find the optimal tariff level. Optimum Tariff is one that ensures the achievement of the maximum economic welfare of a given country, while not further increasing its net benefit from taxing imports. An optimum tariff generates gains for one country, but losses for the global economy as a whole, as wealth is redistributed unequally from smaller countries to larger economies (those where changes in foreign trade policy affect the global market the most as illustrated in . Fig. 22.4). The optimum tariff rate is inversely proportional to the price elasticity of imports. Additional benefits due to a fall in the world price and additional losses due to a curtailing of imports should balance. The greater the elasticity of foreign supply, the higher the optimum tariff rate.

835 22.2 · Foreign Trade Policy

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. Fig. 22.4  Effects of import duties on the public wealth (large economy). Source Authors’ development

22.2.3  Non-tariff Regulation

Since the 1950s, the average level of tariff protection has significantly reduced globally as a result of a series of multilateral negotiations, agreements, and regulations within the frameworks of the General Agreement on Tariffs and Trade (GATT) and then the World Trade Organization (WTO) (further detailed in 7 Sect.  22.3). On the one hand, tariff-related regulations have been unified, while on the other, non-tariff tools have emerged as governments still seek opportunities to support domestic markets and improve the competitive advantages of domestic producers. Non-Tariff Trade Regulations are foreign trade policy tools other than customs tariffs and duties, including direct restriction of imports in order to protect certain domestic industries or sectors (quotas, licenses, compensation fees, import deposits, and anti-dumping and countervailing restrictions) and administrative measures not directly aimed at restricting foreign trade (customs formalities, technical and sanitary standards and norms, packaging and labeling requirements). The following seven categories of non-tariff barriers are distinguished: 5 para-tariff measures, i.e., payments other than customs duties levied on imports (customs fees and clearance and special targeted charges); 5 price controls aimed at protecting the interests of domestic producers (countervailing and anti-dumping procedures and fees); 5 financial measures providing for special rules for foreign exchange transactions to regulate foreign trade; 5 quotas and other quantitative restrictions on imports; 5 licensing, control, and monitoring of volumes and directions of commodity flows; 5 state monopoly of foreign trade (all trade or certain industries or goods); 5 technical barriers and control over the compliance of imported goods with national standards, including quality and safety.

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. Fig. 22.5  Effects of import quotas on the public wealth. Source Authors’ development

The most widely adopted non-tariff regulations are quotas and licenses. Quota is a restriction in monetary or physical terms imposed on the import or export of goods during a certain period of time. When a quota is zero, there is an embargo, i.e., a ban on import or export. A quota can be set at a level above current imports or exports to control the movement of particular goods, but not restrict the flow until it reaches a certain threshold. Suppose that country A imports (QWD − QWS ) of good X under the free trade regime (. Fig. 22.5). To protect the domestic market from foreign competition, the government introduces import quota Q in the amount equal to QWSQ − QWS . Since within the established quota, domestic output and imports do not meet domestic demand at world price PW , domestic price rises to PQ. At this new price, domestic demand is satisfied by domestic production plus imported goods within the quota. The supply curve S shifts to (S + Q), and market equilibrium is reestablished at the intersection of price PQ and supply QQD. The effects of introducing import quotas are similar to those of import duties. Area a represents a producers’ gain (consumers’ lost benefit at the same time) due to an increase in the price of restricted good X from PW to PQ. Consumers’ loss is equal to (b + c + d). Areas b and d are net losses of the economy and consumers, i.e., the production-related and consumption-related deadweight costs of protectionism, respectively. Unlike the effects of import duties illustrated in . Fig. 22.3, area c denotes quota rent, i.e., a gain received by an economic entity authorized to import goods   and  sell them in the domestic market protected by quota Q. Since QWSQ − QWS = Q − Q QS ,area c is equal to the product of the quantity  QD of imported goods QWSQ − QWS under quota Q by the difference between the new domestic price PQ and the old world price PW . If permits for the import of goods under quota are distributed by the government at auctions, then the quota rent c is collected by the state. Quotas seldom apply to exports, only in cases of an acute shortage of certain products in a country (or as a means of economic and

837 22.2 · Foreign Trade Policy

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political pressure on trading partners). Import quotas are used to protect the domestic market from foreign competition, reduce unemployment, improve the balance of payments, and control the movement of goods. Quotas are usually allocated through Licenses which are export or import permits issued by authorized organizations and administrative bodies. Automatic (general) licenses authorize the unimpeded import or export of certain goods for a certain period of time. Non-automatic (one-time) licenses apply to individual consignments of goods of a certain quantity, quality, value, country of origin or destination, and other parameters. A country’s economic policy may aim at maintaining relatively stable domestic prices at a relatively high level compared to the world price (for example, to ensure a certain stable level of income for domestic producers in certain industries). In this case, tariff regulations fail to guarantee stability, since introducing import duties does not eliminate price fluctuations. Domestic price follows the world price and fluctuates accordingly. To loosen this link between domestic prices, world prices, and prices on third markets, the government applies compensation fees equal to the difference between the relatively low price of a good abroad and its relatively high price on the domestic market. Compensation fees can be applied in conjunction with duties or independently, since they automatically adjust prices. If domestic prices remain constant and world prices change, then compensation fees adjust by the amount of change in world prices, but in the opposite direction. In this way, they differ from fixed import duties. If world prices are stable, domestic prices depend on the rates of duties applied. In the case of compensatory fees, their value depends on the domestic price. In other words, a domestic price is a function of import duty that remains unchanged, while a compensation fee is a function of a domestic price. As compensation fees adjust domestic prices in the automatic mode depending on changes in world price, they set up an effective hurdle on the way of foreign goods into the domestic market. Import deposits are contributions to a special account in a certain proportion to the value of imports. Depositing squeezes out resources and increases importers’ expenditures. Imports become more expensive as importers compensate for higher costs by rising prices. Ultimately, domestic consumers reduce demand for pricier import goods, and imports shrink. Commonly, import deposits are used as a means of reducing imports when the government wants to improve the balance of payments. Public health issues and environmental protection are not foreign trade tools, but they can be used indirectly to regulate trade flows when special technical requirements apply to imported goods. Such regulations entail additional costs associated with adjusting production processes and technology and obtaining appropriate quality certificates. Extra charges include administrative, customs clearance, and stamp duties. They apply in cases where import duties can not be implemented (for example, due to political reasons) or where multilaterally agreed import duties are too low to protect the domestic market. In the latter case, the government may unilaterally introduce extra customs charges or fees to add up to the overall level of customs protection. In many developing countries, governments establish currency regulations, restrict foreign currency use within a country (forced sale of foreign currency to the state), and issue permits for pay-

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ments in foreign currency. Other non-tariff regulations also apply, such as a state monopoly of foreign trade or mandatory use of domestic raw materials or intermediary products, as a result of which the demand for imports of resources declines. As a rule, governments in both developed and developing countries put emphasis on regulating imports and access of foreign goods to the domestic market. However, the export of raw materials and goods is also subject to regulation, including by means of diverse non-tariff methods. Along with quotas considered above, a widely used tool for non-tariff regulation of exports (rather, supporting exporters and strengthening their competitiveness) is export subsidies. Export Subsidies are monetary and non-monetary benefits provided to domestic businesses to stimulate exports and increase the competitiveness of domestic products on foreign markets. Subsidizing lowers production and distribution costs (government fronts part of the cost) and thus allows domestic producers to cut export prices without losing profits. The government provides direct subsidies to exporters in the three following forms: 5 payment of a certain amount of money in a certain proportion to exports; 5 return to an exporter of the difference between domestic and world prices, if the former is higher; 5 public financing of some of the exporter’s expenses, such as expenditures for research of foreign markets, advertising, transport, etc. Direct subsidies are too explicit, which greatly increases the likelihood of introducing retaliatory measures by trading partners. Moreover, most of the direct subsidies are forbidden or substantially restricted by multilateral agreements and regulations in the frameworks of the WTO and other international and regional organizations. Therefore, exporters are primarily supported indirectly. Indirect subsidies are provided in the form of various benefits in order to reduce exporters’ expenditures or obtain additional income in other areas: 5 Tax benefits. Governments provide various benefits for income tax, corporate profit tax, and payroll deductions, exclude certain revenues from taxable profit, allow accelerated depreciation, reimburse duties on imported raw materials for the subsequent export of goods produced from these raw materials; 5 Government lending. Governments grant preferential loans to exporters (low interest rates, favorable terms) and loans to foreign countries and companies for the purchase of domestic goods. The state takes on non-payment risks (both commercial and political risks) by offering public insurance of export credits at a reduced rate. Subsidies are as essential protectionist tool as import duties. However, while the latter are imposed to protect domestic products on the domestic market in order to expand output in import-substituting sectors, export subsidies are imposed to promote domestic goods on foreign markets. Export subsidies stimulate export-oriented production and thus divert resources from industries competing with imports. Economic losses arise from the fact that the value of export-oriented output exceeds gains received from export sales. The government bridges

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this gap by subsidizing exporters. In addition, since export subsidies increase the outflow of goods from the domestic market to foreign markets, domestic prices for goods in export-oriented sectors rise. Consumers face higher taxes required to finance export subsidies. At the same time, export subsidies contribute to the stabilization of the domestic market and can strengthen the positions of domestic companies in global production and supply chains. 22.3  Multilateral Regulation of International Trade

In addition to the national-level foreign trade policies, multilateral regulations of international trade emerged in the second half of the XX century. Since that time, the international trade agenda has been increasingly defined by regional economic and trade organizations, customs unions, and other trade-related establishments (for example, the EU originated from the free trade area created in the 1950s), as well as global organizations such as the GATT and the WTO. Trade protectionism persists despite the prevalence of liberalization trends in international trade not only at the level of individual states, but also at the level of trade and economic blocs and unions. On the one hand, these blocs and unions contribute to the liberalization of international trade by removing hurdles to mutual trade between member markets. On the other hand, they erect new barriers for third non-member countries and other regional trade and economic unions. Although all countries pursue their own national economic interests when implementing foreign trade policies (or group interests of a particular trade and economic bloc), they are increasingly deeply involved in the internationalization of production and supply chains and globalization of markets. The need for harmonized regulation of international trade on a multilateral basis is therefore essential. It makes it possible to smooth out the contradictions between countries in foreign trade, as well as to unify trade-related regulations applied by individual countries and make them more transparent, predictable, and rule-based. According to the scale and profile, international organizations that regulate world trade can be divided into the two following groups: 5 International organizations dealing with regulating world trade in general (General Agreement on Tariffs and Trade (GATT), World Trade Organization (WTO), United Nations Conference on Trade and Development (UNCTAD), United Nations Commission on International Trade Law (UNCITRAL), International Chamber of Commerce (ICC)); 5 International organizations involved in regulating trade in related categories of resources and goods (Organization of the Petroleum Exporting Countries (OPEC), Association of Iron Ore Exporting Countries (APEF), Intergovernmental Council of the Copper Exporting Countries (CIPEC)). Until 1995, the General Agreement on Tariffs and Trade (GATT) remained the largest international organization that regulated customs and tariff issues of world trade. It was established in 1947 in Geneva, Switzerland, after the World War II, when many developed countries, primarily the USA, started advocating

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elaborating internationally-agreed stable, predictable, and transparent conditions of world trade and exchange. GATT was a multilateral agreement on the basic principles, norms, and rules of conduct and regulation of mutual trade between participating countries. The fundamental principles were developed in accordance with the international practice and not only determined the multilateral terms of international trade, but also laid down the basis for transforming national foreign trade policies in the GATT member countries. The following five principles were postulated: 5 tariff measures are the only acceptable means of foreign trade regulation; 5 tariffs must be fixed at the level agreed by the GATT member states and not changed unilaterally; 5 tariffs should be progressively reduced through conducting periodic rounds of multilateral trade negotiations; 5 granting trade and political concessions is reciprocal; 5 the most-favored-nation principle, meaning that when reducing or eliminating import and export duties in favor of any one GATT member country, a country is obliged to accord similar favorable conditions to all other members. Since 1947, eight rounds of trade negotiations were held. They all aimed at liberalizing world trade and eliminating trade barriers between markets. At the eighth Uruguay Round (1986–1994), delegates stressed the need for a fundamental transformation of the GATT regulation framework by capturing such emerging areas as international trade in services, protection of intellectual property rights, trade-related issues of international investment, and many more. The regulation framework was expanded by adopting the General Agreement on Trade in Services (GATS), the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS), and the Agreement on Trade-Related Investment Measures (TRIMS). The General Agreement on Trade in Services (GATS) contains three sections of rights and obligations: 5 main body of the agreement which formulates the fundamentals and concepts applicable to all types of services; 5 sectoral annexes which define how certain articles apply to regulating various categories of services (maritime and air transport, telecommunications, financial services, etc.) and which exemptions from the most-favored-nation regime are allowed; 5 specific obligations of WTO member countries in respect of certain types of services. The GATS captures foreign trade policy measures implemented by ­central, regional, and local authorities, as well as by non-governmental institutions through which the government’s jurisdiction is exercised in particular countries. The agreement applies to all services and all sectors of the services market, including domestic and cross-border trade in services, but excluding services related to the government’s operations. According to the GATS, trade in services includes a cross-border exchange of services, their consumption within the customs

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territory, their supply through the commercial presence regime in other countries, and as the supply of services by moving individuals producing and selling services from abroad. There are two sets of obligations to be undertaken by the member countries: general (horizontal) covering all types of services and specific applied for certain sectors. Individual countries’ obligations and market access parameters are aggregated in their schedules of concessions and commitments. The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) establishes standards and procedures for the protection and enforcement of intellectual property rights. The agreement stipulates that each member country complies with obligations arising from other international agreements on intellectual property rights, complements them with TRIPS obligations, and ensures that strict enforcement procedures are applied domestically to protect intellectual property rights. The agreement consists of seven parts which formulate founding principles, outline standards for the protection of various categories of intellectual property rights (copyright and related rights, trademarks, geographical indications, industrial designs, patents, integrated circuits layouts, and trade secrets), regulate enforcement of intellectual property rights, and detail procedures for acquiring and proving such rights. The TRIPS requires member countries to comply with the provisions of the Paris Convention for the Protection of Industrial Property (1967), the Berne Convention for the Protection of Literary and Artistic Works (1971), the Rome Convention (1962), and the Washington Treaty (1989). Member states are also obliged to adhere to the principles of national treatment and most-favored-nation regime (see the paragraph on the WTO below for their contemporary definitions). An essential novelty of the TRIPS that distinguishes it from the GATT is the obligation to create national-level mechanisms for the protection of intellectual property rights. The agreement gives the customs authorities the right to suspend customs clearance of goods deemed to infringe intellectual property rights (for example, forgery of goods or trademarks). To this end, TRIPS members should elaborate national legislation. The implementation of the agreement requires all countries to significantly expand national juridical and administrative systems in the area of trade-related aspects of intellectual property rights. The Agreement on Trade-Related Investment Measures (TRIMS) applies to a limited number of measures incompatible with GATT Article III (National Treatment on Internal Taxation and Regulation) and Article XI (General Elimination of Quantitative Restrictions). The agreement recognizes that investment measures and related provisions may violate the above articles and distort trade in goods. TRIMS members agree not to apply such measures and to eliminate those already practiced. Such inconsistent measures include the following: 5 internal quantitative restrictions—a domestic producer must use a certain amount of domestic intermediate goods, resources, and other inputs in producing final goods; 5 balance-of-payments restriction—an increase or a decrease in either a value or a volume of imports must be linked with the associated change in the use of domestic goods;

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5 foreign exchange costs equilibrium—a value (volume) of goods purchased from abroad and then used in domestic production is restricted by a value (volume) of domestic goods exported to foreign markets; 5 currency restrictions—import flows are regulated by liberalizing or restricting access to foreign currency for businesses; 5 export potential—a value (volume) of goods exported abroad depends on a value (volume) of similar goods supplied domestically. Within the GATT, the world’s average level of trade protection was reduced from 40% in 1947 to below 10% in the 1990s. Along with the GATT, the new agreements established the umbrella framework of the World Trade Organization (WTO) that came into force starting from January 1, 1995. The WTO functions in much the same way as the GATT, but it captures a wider range of trade and political agreements. WTO’s central task is to further promote liberalization of world trade through reducing import duties and eliminating various non-tariff barriers. Founding principles of the WTO establish the contemporary system of multilateral regulation of international trade in goods, services, intellectual property rights, and other forms of exchange. Many of them have migrated from the GATT and evolved to address the WTO’s multi-sectoral approach: 5 Most-favored-nation regime (non-discrimination)—preferences granted by a WTO country to any one member state immediately apply to all WTO member countries. Goods, services, and service providers, when imported into a customs territory of another country, should enjoy the same regulations, privileges, advantages, and other benefits as goods, services, and service providers of any other country. 5 National treatment—domestic taxes and other domestic charges, laws, regulations, and requirements for domestic trade, distribution, and use of goods shall apply equally to foreign and domestic goods. In the case of services, this requirement means that foreign services and service providers for which a WTO member has made commitments contained in its national schedules of concessions and commitments should enjoy the same treatment as domestic services and service providers. 5 Priority employment of tariff regulations and elimination of non-tariff, administrative, and political hurdles to trade. Quantitative import restrictions are generally prohibited. Exceptions are the use of quantitative measures to protect the balance of payments and prevent the leakage of foreign exchange reserves caused by the demand for imports. 5 Freer, more transparent, and more predictable regulation framework, which implies that basic tariff regulations should be respected and reduced through multilateral negotiations. Tariffs cannot be raised and non-tariff barriers cannot be introduced unilaterally. 5 Promoting fair competition by addressing subsidies and dumping issues. The GATT contains rules for regulating dumping detected in domestic markets and international trade. 5 Extraordinary circumstances—special regulations that allow exemptions (waiving specific WTO obligations) and the use of safeguard measures (im-

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posing import restrictions or the temporary waiver of tariff concessions on increasing imports that may threaten or harm domestic producers). 5 Regional trade arrangement—an exception to the general most-favored-nation treatment for regional trade groupings in the form of a customs union or a free trade area, when member countries eliminate duties and other barriers in mutual trade. Regional integration complements the multi-level global trading system. 5 Special arrangements for developing countries. According to this principle, WTO members which promote assistance to developing countries and provide them with more favorable conditions for access to world markets. Also, there are exemptions from reciprocity for commitments to reduce or eliminate tariffs and other trade barriers. Commonly, newly accepted developing countries enjoy longer transition periods and a higher level of trade protection compared to developed economies. 5 Peaceful resolution of trade disputes through consultations and negotiations. By joining the WTO, member countries undertake to implement all multilateral trade agreements and regulations. Therefore, the WTO is a kind of a multilateral consensus (package of agreements) between 164 member states which now applies to over 90% of the world’s total trade in goods and services. The United Nations Conference on Trade and Development (UNCTAD) was established in 1962 by the decision of the Economic and Social Council (ECOSOC) of the United Nations. Its creation was initiated by developing and socialist countries in order to compensate for the gap in addressing trade-related issues in the developing world. The UNCTAD aims to promote the development and growth of international trade, ensure stable peace and mutually beneficial collaboration between developed and developing countries, elaborate recommendations, principles, organizational and legal conditions, and mechanisms for regulating trade and other forms of exchange, and coordinate activities of other UN agencies in the sphere of economic development. In the context of the new normal instability, the UNCTAD particularly emphasizes the need for addressing inclusive growth and sustainable development at the regional and local levels, regionalization and changes in the international trading system, digital economy, and improving the resilience of developing and least developed economies to external shocks. Core UNCTAD’s objectives are: 5 promoting international trade in order to accelerate economic growth and development, particularly in developing countries; 5 elaborating principles and policies in the sphere of international trade and related economic development issues, in particular, finance, investment, and technology transfer. 5 reviewing and facilitating activities of other agencies within the UN system in the sphere of international trade and related economic development issues. 5 taking measures to negotiate and approve multilateral foreign trade regulations; 5 harmonizing trade and development policies of individual countries and regional economic groupings.

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The UNCTAD plays the role of a focal point within the UN system for development and related issues of trade, finance, technology, investment, and sustainable development. Its main objective is to promote the integration of developing countries and economies in transition into the world economy through trade and investment. In pursuit of its objectives, UNCTAD conducts research and policy analysis, organizes intergovernmental meetings, and provides technical cooperation and interaction with civil society organizations and the business sector. The work is carried out by five divisions: 5 Division for Africa, least developed countries, and special programs, 5 Division on globalization and development strategies, 5 Division on investment and enterprise, 5 Division on international trade and commodities, 5 Division on technology and logistics. UNCTAD’s committees specialize in working in various areas, such as merchandise trade, trade in finished and intermediate goods, transport, investment for international trade and development, trade preferences, and transfer of technologies. UNCTAD distinguishes four groups of countries: Africa and Asia (group A), developed Western economies (group B), Latin America (group C), and countries of Central and Eastern Europe (group D). The Group of 77 (A and D developing countries of Africa, Asia, and Eastern Europe) has no formal status with UNCTAD, but it makes a significant contribution to its agenda. Most of countries preliminary define and discuss their positions on particular issues within the respective group and then jointly advocate their unified position at the UNCTAD sessions. The United Nations Commission on International Trade Law (UNCITRAL) was established in 1964 to promote the progressive harmonization and unification of international trade law and reduce or eliminate obstacles to trade development caused by differences in trade-related legislation of individual countries. At its first session in 1968, the UNCITRAL adopted nine priority spheres of its work: international merchandise trade, international commercial arbitration, transport, insurance, international payments, intellectual property right, elimination of discriminatory provisions from the law that adversely affect international trade, cross-border representation and coordination, and legalization of documents. Some of these topics, in particular insurance, elimination of discriminatory provisions, representation, and legalization of documents, have been underemphasized and not addressed by the commission. Priority was initially given to the international merchandise trade, international commercial arbitration, and international payments. Other topics were subsequently added to the agenda, such as trade finance, transport, electronic commerce, procurement, international commercial conciliation, insolvency, security interests, online dispute resolution, and microfinance. The UNCITRAL takes a flexible and functional approach to the methods it uses to fulfill its mandate to modernize and harmonize international trade law. These methods fall into three broad categories (norms and standard-setting measures, contractual measures, and explanatory measures), which relate to different levels and involve the achievement of various kinds of compromises. To a

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certain extent, these methods also reflect processes of modernization and harmonization of legislation at different stages of business activities. Modernization and harmonization imply the convergence of different types of established practices. However, preventive harmonization can also apply. It involves the introduction of new principles and practices that minimize gaps between newly adopted national regulations in emerging spheres (for example, electronic commerce, arbitration, or procurement). The International Chamber of Commerce (ICC) is a non-governmental international organization aimed at strengthening the market economy, integrating all countries into the world economy, and facilitating commercial exchange across borders. The ICC was established in 1919 on the initiative of the business circles of the USA, the UK, France, Belgium, and Italy. They wanted to create a body that would exercise the concerted influence on national governments and ­promote the interests of national companies. Nowadays, national committees bring together major companies and business associations from more than 120 ­countries. The scope of activities includes a wide range of topics, such as arbitration and amicable dispute resolution, banking, commercial law and practice, ­competition, corporate responsibility and anti-corruption, customs and trade facilitation, digital economy, environment and energy, intellectual property, marketing and advertising, taxation, and trade and investment policy. The ICC promotes the creation of favorable conditions for trade in goods and services and attraction of investment on developed and developing markets, provides services for the settlement of disputes on trade and other economic issues, summarizes national foreign trade regulations, and develops international trade and commercial terms (Incoterms). The ICC is an advisory body to the UN, the WTO, the World Bank, and other major international organizations (however, the ICC recommendations are non-obligatory). Alongside intergovernmental organizations, various integration associations play a pivotal role in facilitating and regulating national, regional, and global markets. There are over 100 regional trade, financial, and economic associations in the world that cover more than 60% of world trade. The largest and the most influential are the European Union (EU), the Association of Southeast Asian Nations (ASEAN), the Southern Common Market (MERCOSUR), the Common Market of Eastern and Southern Africa (COMESA), the Shanghai Cooperation Organization (SCO), and the Organization of the Petroleum Exporting Countries (OPEC). 22.4  The New Rise in Protectionism

The comprehensive system of multilateral regulation of international trade established in the second half of the XX century has evolved since then against the background of increasing globalization. It has allowed the global community of countries to reduce substantially the average level of tariff and non-tariff barriers. As previously noted in 7 Sect.  22.1, there are many arguments in favor of free trade which explain how the liberalization and intensification of trade can gener-

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ate stronger economic growth. Larger markets account for greater returns on investment in research and development, suggesting that a global free-trade regime brings about higher overall growth rates. On a larger market, the variety of i­nput costs may increase, which not only maintains performance and productivity, but also accelerates innovations. All of these arguments suggest the importance of knowledge, learning, and human capital. Therefore, countries can gain advantages by supporting and promoting more advanced and dynamic sectors. Certain corrections and adjustments to the free market mechanism may be needed on the side of the government to change the development accents and focus on strengthening dynamic competitive advantages for the future rather than exploiting current comparative advantages. When considering the economic development from this angle, one can feel that the focus on accelerated liberalization since the 1950s has been based on a number of wrong premises. Let us reconsider the liberalization-protectionism agenda from the point of view of the new normal development trends: 5 First premise is the fullest and best possible exploitation of all resources. Under free trade, the overall level of performance increases. Foreign competition eliminates low-efficient domestic producers. Factors of production and resources flow from underperforming protected sectors to export-oriented industries. However, when factors of production are underemployed, there is no need to redistribute resources. Attracting idle ones would be enough to spur growth. In practice, it is often the case that trade liberalization harms local industries which compete with imports. Domestic exporters can not increase their capacity fast enough to absorb released factors of production. As a result, a substantial part of labor and other resources that outflow from underperforming protected sectors may remain unclaimed. 5 Second, the free trade models assume perfect risk insurance markets. In the absence of trade, producers are protected from the most damaging impact of fluctuations in output by a sort of built-in insurance: a decrease in output can be compensated by an increase in prices. Free trade weakens and even eliminates such insurance, since domestic prices are determined by the world market rather than domestic output. Amid the increasing external volatility, producers cut investment in highly dynamic riskier sectors. As the economy shifts towards more stable lower-return industries, the gross domestic output shrinks. Therefore, a critical issue is whether trade liberalization takes place before or after the launch of risk insurance and social insurance programs. 5 Third, the government may introduce import tariffs or fees to increase budget revenues. According to the classical theory of production efficiency in a small open economy, the optimal way to boost revenues is to increase taxes on net household demand, rather than collect taxes at the customs border. However, this theoretical postulate is based on assumptions seldom evidenced in developing countries, where customs fees may add up substantially to the government revenue. Reducing taxes on trade and replacing them with indirect taxation of goods (such as a value-added tax) could help the government to increase the collection of taxes. However, the large shadow sector (a problem for many developing economies) remains beyond the reach of indirect taxation. In such circumstances, a turn from taxing imports can threaten public wealth.

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5 Fourth, trade liberalization affects inequality. The competition-driven free trade redistributes income unevenly between winners and losers. The standard economic argument is that trade liberalization generates net gains, so the winners are able to compensate for the losses of losers, and the economic situation in a country as a whole improves. However, such compensation is rare, especially in the developing world, where income inequality gaps are particularly wide. 5 Fifth, entrepreneurship is of great importance to developing countries. Entrepreneurs are involved in identifying sectors and economic activities that could potentially promote growth and development. However, if a businessman fails, they bears all the costs of the failure. If a business succeeds, it shares its success (know-how, technologies, management practices, etc.) with those entering the new market niche. Therefore, in low-income countries, entrepreneurs are underdeveloped compared to higher-income economies. Thus, both liberalization and protectionism can either improve the competitive advantages of domestic producers or harm certain industries. Due to this dualism, governments individualize foreign trade policies by studying the consequences of free market failures and protection-related distortions in various countries. Market failures and externalities may require government intervention, but they alone do not mean that active protectionism is more efficient than free trade. Contemporary foreign trade policy fluctuates between the protectionism and liberalization poles depending on the degree of government intervention in regulating foreign trade in individual countries. In the wake of the evolution of the global market, the benefits of free trade for consumers, producers, and entire countries have been repeatedly evidenced, but this principle has never been applied directly in its classical interpretation advocated by Adam Smith and David Ricardo. Inability to control and regulate markets in times of ­increasingly frequent volatilities and fierce foreign competition has facilitated a drift in national-level trade policies away from liberalization to the new protectionism. The New Normal Protectionism is a proactive government policy expressed in a set of measures aimed at protecting national economic and business interests not only within the domestic market, but also in foreign markets and global value chains. The new protectionism features are determined by the contradictions of contemporary economic globalization (see 7 Chap. 23, 7 Sect.  23.3 for the controversies of globalization). Rising protectionism is a reaction to the failures and externalities of globalization characterized by increased international competition and the struggle for economic dominance. Essential features of the new protectionism can be summarized as follows: 5 Integral character. In the context of interconnected financial and commodity markets, the effectiveness of protective measures often depends on the flexibility and direction of central banks’ monetary policies, including those that affect currency exchange rates. 5 Intensification of protection on the side of the most developed economies, which consider emerging developing countries a threat to their dominance in the global market.

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5 Protectionism goes beyond the economic sphere. Measures aimed at protecting economic sovereignty are complemented by the protection and promotion of certain national, historical, and cultural values. Within the framework of such national protectionism, politicians often make economically unsound decisions to please their voters. 5 Non-tariff measures, including hidden non-trade regulations, emerge as more influential means of foreign trade policy compared to tariffs. 5 Goal setting changes. Traditionally, protectionism is seen as a protection of the domestic market from foreign competition. The development of global value chains strengthens international cooperation, intertwines domestic markets, and increases the role of imports in the domestic production of goods. Therefore, there are no more separate domestic and foreign markets for local producers. They compete within chains, not territorial markets, and they need support and protection within these chains both domestically and internationally. 5 New normal protectionism becomes extraterritorial. Protection measures applied domestically are no more effective if they are not supplemented by comprehensive support of domestic businesses in the global market. Rivals are to be defeated in their markets, not the domestic market. This goal can be achieved both through concluding intergovernmental trade and economic agreements and exerting economic and political pressure on competitors and trading partners. Therefore, conventional reactive and defensive protectionism turns into new proactive and offensive protectionism. Case box One of the most striking examples of the novel extraterritorial protectionism is the trade confrontation between the USA and China which began in 2019. The USA complained about the persistent negative trade balance with China and wanted to improve it by raising tariffs and introducing other barriers on the way of Chinese goods. By 2020, the two countries managed to find a compromise and take a step towards resolving the trade conflict by signing an agreement on the first phase of the trade deal. The USA agreed to halve duties on Chinese goods in the amount of $120 billion, while China responded with a commitment to increase imports from the USA in the amount of $200 billion. China’s obligations to purchase finished products from the USA provide for the unconditional use of market prices, which creates objective conditions for fair competition between producers within the US domestic market. This issue strengthens the importance of the agreement, because China’s trade-related obligations are tantamount to the support for the most efficient and competitive US producers, which can potentially strengthen their positions in the global market by increasing exports to China.

To summarize, it is essential to stress that there are no more Chinese or American or any other national goods on the global market. Within global production and supply chains, intermediate goods such as raw materials and components

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ultimately form any final product of a particular chain, not a country. Major businesses are transnational, and their chains integrate producers and suppliers from all over the world. Therefore, when protecting a national company, the government actually protects and promotes a certain group of domestic and foreign producers, either domestically or internationally. Setting barriers to imports, restricting foreign competition, and encouraging domestic products on the domestic market, the government ultimately favors foreign companies within chains established by domestic producers. That is why conventional domestic-oriented protectionism makes no much sense anymore. It evolves into offensive protectionism aimed at promoting certain corporations and chains on the global market, rather than simply defending them locally. Due to the ever-tighter interconnectedness of markets through global production and supply chains, tariff and non-tariff restrictions in one country (chain link) affect the entire chain. The transmission of economic signals through such a disrupted chain slows down, output and supply become more expensive, and factors of production and resources underperform. Ultimately, a protection effort aimed at establishing an advantage for domestic producers may result in losses. Therefore, in the new normal economic environment, trade protectionism requires a far more flexible approach that goes beyond tariff and non-tariff regulations and captures the integration of domestic producers into global value-added chains, investment for development, and other nontrade measures of economic and political support. Chapter Questions: 5 Summarize the most essential advantages and disadvantages of free trade and protectionism for individual countries and the global economy as a whole. 5 Discuss the case of your country of residence: does the government pursue a free trade or a protectionist policy? What benefits does your country receive and what losses does it experience due to the current trade policy? 5 Explain the fundamental difference between the theories of internal effects and theories of external effects of foreign trade policy. 5 How would you distinguish distortions from divergences? Compare Bhagwati’s theory of distortions and Corden’s theory of domestic divergences. 5 Define ad valorem and specific duties. How are they applied in regulating imports? 5 Illustrate the effects of tariffs and quotas on public wealth. How do they manifest themselves in small and large countries? 5 What is the effect of export subsidies on international trade? Why is the use of export subsidies largely restricted? 5 Formulate fundamental principles of multilateral regulation of international trade. Track their evolution through the GATT and the WTO frameworks. Are they shared by other international organizations? 5 Explain the difference between the most-favored-nation regime and national treatment. 5 Share your understanding of the essence of the new normal protectionism. Are there any other manifestations of the contemporary rise in protectionism not captured in this chapter.

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Subject Vocabulary:

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Compensation Fee: a fee equal to the difference between the relatively low price of a good abroad and its relatively high price on the domestic market. Customs Tariff: a systematized list of customs duty rates, i.e., taxes on import or export of goods at the time they cross the customs border of a country or a customs union. Export Subsidy: a monetary or non-monetary benefit provided to domestic businesses to stimulate exports and increase the competitiveness of domestic products on foreign markets. Extra Charges: administrative, customs clearance, and stamp duties applied in cases where import duties can not be implemented or where multilaterally agreed import duties are too low to protect the domestic market. Foreign Trade Policy: an element of public economic policy aimed at regulating export and import of goods and services by using customs duties and tariffs, non-tariff regulations, and financial transactions related to foreign trade. Free Trade: a type of foreign trade policy that assumes reducing or eliminating trade barriers, such as export and import duties, quotas, subsidies, and other tariff and non-tariff regulations. Import Deposit: a contribution to a special account in a certain proportion to the value of imports. License: an export or import permit issued by authorized organizations and administrative bodies. New Normal Protectionism: a proactive government policy expressed in a set of measures aimed at protecting national economic and business interests not only within the domestic market, but also on foreign markets and global value chains. Non-Tariff Trade Regulations: foreign trade policy tools other than customs tariffs and duties, including direct restriction of imports in order to protect certain domestic industries or sectors and administrative measures not directly aimed at restricting foreign trade. Optimum Tariff: a tariff that ensures the achievement of the maximum economic welfare of a given country, while not further increasing its net benefit from taxing imports. Protectionism: a type of foreign trade policy aimed at supporting the domestic production of goods and services and restricting foreign competition and imports by introducing tariff and non-tariff barriers. Quota: a restriction in monetary or physical terms imposed on the import or export of goods during a certain period of time. Special Technical Requirements: non-trade regulations such as public health issues and environmental protection used to indirectly restrict or stimulate trade flows.

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References Baldwin, R. (1969). The case against Infant Industry Protection. Journal of Political Economy, 77(3), 295–305. Bardhan, P. (1971). On optimum subsidy to a learning industry: An aspect of the theory of infant-industry protection. International Economic Review, 12(1), 54–70. Bhagwati, J. (1969). The generalized theory of distortions and welfare. Massachusetts Institute of Technology. Corden, W. M. (1974). Trade policy and economic welfare. Clarendon Press. Hamilton, A. (1791). Report on the Subject of Manufacturers. 7 https://assets.nationbuilder.com/larouchepac/legacy_url/19566/hamilton_subject_of_manufactures.pdf ?1612573693 Hillman, A. (1989). The political economy of protection. Harwood Academic Publishers. Johnson, H. (1953). Optimum tariffs and retaliation. Review of Economic Studies, 21(2), 142–153. Kemp, M., & Wan, H. (1976). An elementary proposition concerning the formation of customs unions. Journal of International Economics, 6(1), 95–97. Lipsey, R. (1960). The theory of customs unions: A general survey. Economic Journal, 70, 496–513. Lipsey, R., & Lancaster, K. (1956). The general theory of second best. Review of Economic Studies, 24(1), 11–32. Maggi, G., & Rodrigues-Clare, A. (2007). A political-economy theory of trade agreements. American Economic Review, 97(4), 1374–1406. Meade, J. (1955a). The theory of customs unions. North-Holland Publishing. Meade, J. (1955b). Trade and welfare. Oxford University Press. Metzler, L. (1949). Tariffs, the terms of trade, and the distribution of national income. Journal of Political Economy, 57(1), 1–29. Mitra, D. (1999). Endogenous lobby formation and endogenous protection: A long-run model of trade policy determination. American Economic Review, 89, 1116–1134. Tinbergen, J. (1957). Customs unions: Influence of their size on their effect. Journal of Institutional and Theoretical Economics, 113(3), 404–414. Vanek, J. (1965). General equilibrium of international discriminations. The case of customs unions. Harvard University Press. Viner, J. (1950). The customs union issue. Carnegie Endowment for International Peace. Wonnacott, P., & Wonnacott, R. (1981). Is unilateral tariff reduction preferable to a customs union? The curious case of the missing foreign tariffs. American Economic Review, 71(4), 704–714.

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© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2_23

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Learning Objectives: 5 Explore the history and major milestones of contemporary globalization 5 Study approaches to measuring globalization 5 Discuss effects, consequences, and controversies of the new normal internationalization and globalization 5 Go over a range of anti-globalization narratives (regionalism, nationalism, westernization, cultural protection) 5 Look into the specifics of inequality and social policy in the new normal globalization 23.1  Globalization Through the Ages

Diversifying issues of economic, social, and cultural globalization entered the global agenda in the 1960–1970s and gained a prominent relevance in the 1990s. The very terms “globalization” and “globality” are attributed to Roland Robertson, who introduced and popularized them in the early 1980s (further reading: “Interpreting Globality”1). Globalization is the process of changing the world space by transforming and unifying various spheres of the world economy, production, trade, and society and removing barriers for the unimpeded movement of goods, services, information, capital, and people. The unification spurs the exchange of ideas and cultural values between countries and societies and thus contributes to the development of relevant institutional formations at the national and international levels and setting up closer interactions between them. Globalization results in the emergence of a single cultural, informational, legal, and economic space at the international level (see 7 Sect.  23.3 below for the effects of globalization). In other words, although this book focuses on revealing the macroeconomic features of contemporary global processes, the new globalization is not limited to the economic sphere, but largely affects all key sectors of everyday life of billions of people, such as consumption, welfare, education, entertainment, communication, culture, or politics. Without a doubt, it is globalization that has gained a central role in shaping the new normal world economy by testing out economic, social, cultural, and political ties between countries and catalyzing global controversies. The new normal approach to interpreting globalization is to see this process as a complex economic, social, political, and cultural phenomenon that has a decisive impact on all aspects of the life of countries, businesses, and individuals. For the proponents of neoliberal ideas, globalization is a new era in the history of human civilization, due to the spread and global sharing of liberal, democratic, and humanitarian values. Representatives of the realistic school recognize that fundamental changes are taking place in the world, but at the same time they are not inclined to consider globalization a qualitative leap in the development

1

Robertson (1983).

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of mankind, considering it rather as a rapid evolutionary process. The realistic school argues that the state remains the decisive subject of international relations, and power in all its reincarnations (economic, financial, political, military, etc.) is the most important factor in the implementation of national interests. On the opposite, the transnationalism stresses a decrease in the role of individual countries (former global powers) and the transfer to a more balanced polycentric world against the background of the degradation of national identity. Neo-Marxists interpret modern globalization as the final stage of capitalism, a form of super-imperialism that generates an increasing polarization of the world and leads to a new redivision of the world. Such a multifaceted and contradictory phenomenon as globalization cannot have an unambiguous interpretation. In its extreme interpretations, globalization is viewed either too narrowly (for example, the activities of TNCs or the formation of international supply chains) or too broadly (a comprehensive economic, political, and cultural picture of the modern world). Still, several essential features of contemporary globalization could be singled out: 5 globalization manifests itself in the growing interconnectedness and interdependence of countries and peoples in various spheres of life, which results in the establishment of a global community of people; 5 globalization is inseparable from the formation of the global financial and economic space, the emergence of the global market and cross-continental production and supply chains, and the merging of national economies into a global system governed by internationally accepted rules and standards; 5 globalization has been triggered by the unprecedented progress of information technologies, which determines the expansion of the global communication network in various spheres (economy, finance, society, culture, politics); 5 globalization involves the transformation of administrative functions of individual states, the blurring of national borders, and a radical increase in the role and scope of activities of supranational organizations and transnational bodies; 5 the ongoing blurring of borders presupposes the homogenization and universalization of the world accompanied by the spread of liberal, democratic, and humanitarian values. One should distinguish between natural (horizontal) globalization and artificial (vertical) globalization. The former is caused by the gradual assimilation of certain achievements of some cultures by other cultures as contacts and communications between peoples expand. The latter is the result of attempts by some force (a political party or social or religious movement) to forcibly introduce certain ideas into certain societies or regions. In both cases, individual local communities transform and merge into a global community based on the sharing of common values. The new community incorporates certain features of the cultural and civilizational heritage of peoples and establishes basic values (social structure, polity, cultural values, security, national and international law, etc.) in a new way. The new civilization presupposes the development of a global consciousness and worldview and the establishment of universal ethics.

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Chapter 23 · Globalization and Regionalization

Although, as noted above, the term “globalization” itself was introduced into the academic and media discourse relatively recently, the very idea of pushing the boundaries of the surrounding world by disparate communities in order to achieve a certain degree of unity (combining productive and military forces, obtaining new resources, expanding markets, and other motivations for integration) is not at all new. The origins of globalization can be traced back to the great empires of the past—Ancient Egypt, Ancient Greece, the Empire of Alexander the Great, the Roman Empire, the Chinese Empire, and other mega-states of the past, which united remote territories, extremely diverse societies, languages, cultures, and religions, melted them down, and thereby formed prototypes of common markets and common social and cultural values shared by large communities of people. However, the relationship of ethnic groups does not always lead to their integration. There are numerous examples of extermination, extremely aggressive attitude, and suppression of particular communities and entire races. At the same time, there are much more prosperous examples of the win–win interactions. Sometimes, complementary relations are limited to symbiosis (such are the relations of nomads and farmers), but the integration processes leading to the formation of a single space are of the greatest interest for understanding the essence of globalization. It is important to distinguish between concepts such as territory and space. A community may be extraterritorial, i.e., not directly related to a particular territory. Such a situation refers to the spatial existence of a community. People of the same ethnic group living in separated territories still preserve a single cultural space. Therefore, they keep a special connection with their kinsmen for a long time. However, there are also special relations between different ethnic groups that form single social, political, economic, and cultural territorial communities. Mental space as opposed to physical one (territory) is more susceptible to various kinds of influences, but it is still relatively more stable in general, since it affects the very roots of national identity and culture. In addition, the mental space is inalienable. Territories can be captured or lost, but at the same time, the mentality can persist for a long time. Thus, the conquests of Alexander the Great or the Roman emperors created such powerful empires of the spirit that they retained their significance long after the death of the conquerors, and even after the collapse of the ancient empires. Case box In ancient times, rivalries were mainly based on the capturing of slaves and the preservation of security. The seizure of foreign territories resulted in the creation of giant empires, whose existence was founded on force. The example of the empire built by Alexander the Great is indicative. The once peripheral Macedonian kingdom extended its influence not only to the neighboring Greek polis, but also captured territories in Asia, the Middle East, Egypt, and even India. Thus, Alexander the Great connected the Mediterranean and the vast areas of Asia into a single cultural space, in which the Mediterranean and Indo-European cultures fused. Alexander’s idea of cultural exchange was of fundamental importance. It was expressed in the cooperation with the conquered peoples—intermarriages, education of children in Greek schools, building of cities, and the promotion of Greek culture.

857 23.1 · Globalization Through the Ages

23

One of the most characteristic signs of the modern times is the ideas of globalization that have recently become widespread. Contemporary globalization is associated with an explicit and implicit fear of independent communities either erasing differences (standardization) or subordination to a single center (a kind of the world government) dictating its will to countries and governments. In simple terms, globalization can be defined as the increasing role of external factors (economic, social, and cultural) in the reproduction of all participating countries, the formation of a single world market without national barriers, and the creation of uniform legal conditions for all countries. The formation of multiethnic communities involves the universalization and diversification of space. Monoethnism, i.e., the existence of an ethnos at least in relative isolation, seems to be the exception rather than the rule. The most favorable habitats (agricultural lands, forests, river basins, etc.) have long been the subject of an acute struggle between tribes, and then states. Contacts with other communities give rise to either confrontation or cooperation. But in both cases, the determining factor is the combination of the interests of interacting communities. In both cases, two communities affect each other, the once balanced system develops, and a new reinforcement happens. It seems that the continued equilibrium existence of any community is impossible, since it prevents development. Case box Over two millenniums ago, Romanization was a kind of global project. It partly used the achievements of Hellenism, but mostly touched Europe. At the earliest stages of its history, Rome encountered tribes and communities at different stages of social and cultural development. Roman culture had a decisive impact on the consolidation of Western European ideology and its opposition to Eastern Europe and Asia. This can be noticed in the spread of Christianity. Western Europe turned out to follow Roman Catholicism, while Eastern Europe accepted Greek Orthodoxy. The history of world religions may well be considered as a kind of global projects. Christianity, Buddhism, and Islam first existed in an orthodox form. Due to the assimilation, they acquired peculiar features that did not affect the fundamentals, but somehow transformed patterns. Despite their extreme diversity, world religions form a common cultural space, but in different regions: Christianity—mainly Europe and the Americas, Islam—the Middle East, Central Asia, and North Africa; Buddhism—East Asia. This distribution demonstrates the importance of considering not only regional aspects of certain cultural patterns, but also their influence on neighbor communities.

Colonization (in the broadest sense of the word) has contributed essentially to the globalization of markets and communities. Ancient Egypt, Mesopotamia, Assyria, and other great powers of the past all wanted to expand their territories along with their influence. The expansion of influence through the seizure of new territories was claimed by the empire of Alexander the Great, the Roman Empire, Byzantium, as well as Arab, Mongol, and Turkic conquests. The Viking Age in

858

23

Chapter 23 · Globalization and Regionalization

Europe and relatively local conflicts in India and China are also the examples of early colonialism. However, colonization is often associated in our minds with the European penetration into Asia and Africa, i.e., the European colonialism, which began already with the Crusades in the XI–XV centuries. The colonial empires as a whole demonstrated a new type of multiethnic communities. Despite the negative consequences they brought to local communities, they also contributed to a certain extent to the development of the colonies. In many cases, they acted as a consolidating factor by integrating new territories to the global market, incentivizing the development of education and healthcare, and triggering cross-cultural exchanges. The role to which the metropolis condemned local communities could not but cause resistance. However, the influence of the metropolis, despite the successes of the national liberation struggle and the actual collapse of the colonial system, remained, since the cultural patters were preserved. Case box Colonialism is characterized by a clear distinction between the metropolis (center) and colonies (periphery). The very nature of colonization is largely determined by the peculiarities of the development of the metropolis and the colonized peoples. Thus, Spain and Portugal aimed at natural benefits (the export of valuables and, accordingly, the extermination of the peoples who possessed them). It was a feudal type of colonization through the military expansion. A different approach was used by the Netherlands and the Great Britain. For them, the most important tool was the fiscal system. Export of capital and resources from colonies facilitated a capitalist type of colonization.

Although globalization has a long history, until recently, the processes of globalization proceeded relatively separately in separate regions (macro-regions) of the world. The first stage of the establishment of the modern world economy (early 1300s–late 1800s) stands out due to the emergence of international trade and world markets, which became the first building blocks of globalization. At the second stage of global economic development (late 1800s–early 1900s), early capitalism transitioned to the monopolization of production and trade. Major powers, such as Great Britain, Spain, Germany, and other European countries, seized new territories and divided the zones of economic influence between themselves. Cross-border capital flows from colonies to metropolises boomed. A variety of forms of economic relations between countries increased: in addition to the exchange of goods, there emerged the migration of individual factors of production between countries. The fundamentals of the international division of labor and the future globalization of world trade were laid. Global turmoil between and during the two world wars in the first half of the XX century destroyed the past achievements in establishing world economic relations. Although economic development accelerated significantly (first international corporations appeared), the financial system at the transnational level was extremely unstable, and long-term capital was leaving industrial countries

859 23.2 · Measuring Globalization

23

(see 7 Chap. 7, 7 Sect.  7.3 for major economic and financial crises in the 1920– 1940s). The series of socialist revolutions and transformations across Eurasia and Asia (Russia, Eastern Europe, Latin America, Central Asia, China, Southeast Asia) established confronting groups of countries and resulted in the emergence of the Cold War between the communist (socialist) and the capitalist blocs. The controversies of the past have revived and evolved to the new tension between Russia and the West the world has been evidencing since the mid-2010s—a kind of the civilizational breakup between the two value systems and development paradigms. The fourth stage (mid-1940s–early 1990s) is the period of a new restructuring of economic relations between countries and attempts to find a new economic development pathway that would never lead the world back to the devastating military conflicts of the past. Since the 1950s, global markets are increasingly shaped by the ongoing liberalization of foreign trade policy, the growth of labor productivity, the progress in science and technology, and, as a result, an unprecedented economic growth. At this stage, the foundation for the globalization of world finance was laid and a macro system of financial and economic organizations regulating the world economic development was built (the UN, the IMF, the World Bank, the WTO, and other international and organizations and supranational blocs of countries). The world economy became a relatively integral system only in the late 1990s– early 2000s. The contemporary world economy is characterized by a number of features, such as the liberalization of foreign economic relations, transnationalization of capital and production, regional economic integration, internationalization of economic relations, unification of regulations and standards in various spheres, and interstate regulation of world markets and most kinds of economic, trade, financial, social, and political relations between countries. However, with more than 200 independent countries and territories in the world today, contradictions never cease. The new normal nature of contradictions is that they outgrow certain spheres, such as trade or finance, and emerge into the clash between the national sovereignty of individual countries and progressing globalization as a global trend. 23.2  Measuring Globalization

Globalization is one of the most difficult to measure and ambiguously interpreted phenomena in contemporary macroeconomics. As argued above, globalization can be characterized in relation to the economic, trade, financial, social, political, technological, and cultural aspects of global interactions of countries, companies, and people. Due to such a multidimensionality of the concept, a quantitative measurement of globalization is challenging. The set of variables used for measuring various dimensions of globalization is rather conditional and varies significantly depending on the measurement goals and bodies conducting measurements. In addition, countries are highly heterogeneous in terms of the degree of their involvement in supply chains and the global market. Their domestic institutions (economic, social, politi-

860

23

Chapter 23 · Globalization and Regionalization

cal, and other regulations) differ in their reactions to the effects of globalization. On the one hand, responses of individual economies to the challenges of globalization naturally differ, because the behavior patterns of a particular country are largely determined by the level of its economic development. On the other hand, it is also indisputable that it is the difference in the levels of development that acts as the source of both income inequality and poverty in households’ categories established according to certain criteria. One of the most widely used approaches to measuring the level of a country’s involvement in global processes is the KOF Globalization Index (KOFGI), a decomposable index, all elements of which are grouped equally in three dimensions (economic, social, and political) on a scale of 1 (least) to 100 (most globalized). The index distinguishes between de facto and de jure measures (. Table 23.1). While the former measures actual international flows and activities (such as trade in goods and services), the latter ranks countries on policies and conditions (such as tariffs) that affect flows and activities (further reading: “The KOF Globalization Index”2). The level of economic globalization is measured by the volume of international trade and indicators of financial globalization. The trade globalization dimension includes trade in goods and services and trade partner diversity (the de facto parameters) and trade regulations, trade taxes, tariffs, and trade agreements (the de jure parameters). The financial globalization dimension is measured along such de facto variables as foreign direct investment, portfolio investment, international debt, international reserves, and international income payments and the jure variables (investment restrictions, capital account openness, and international investment agreements). Singapore is ranked #1 in the world on the economic globalization dimension (. Table 23.2). To measure the degree of social globalization of a country, ­macroeconomists employ the parameters of interpersonal globalization, informational globalization, and cultural globalization. The de facto indicators of interpersonal globalization include international voice traffic, transfers, international tourism, international students, and migration. The de jure international globalization is measured along the parameters of telephone subscriptions, freedom to visit, and international airports. The informational globalization dimension includes such variables as used Internet bandwidth, international patents, high technology exports (all three are the de facto parameters), television access, Internet access, and press freedom (the de jure variables). Cultural globalization is one of the most challenging spheres to be measured. The de facto variables are trade in cultural goods, trade in personal services, international trademarks, McDonald’s restaurants, and IKEA stores. The de jure dimension is assessed by gender parity, human capital, and civil liberties. In 2021, small European countries such as Luxembourg, Monaco, and Liechtenstein were named the most globalized economies in the social sphere (. Table 23.3). EU states are at the top of the political globalization list (. Table 23.4). The de jure political globalization ranks are exceptionally high for France, Germany,

2

Haelg (2020).

Finland

France

9

10

Comoros

Guinea-Bissau

Burundi

West Bank and Gaza

Afghanistan

201

203

204

205

Bhutan

200

202

Turkmenistan

199

…

Austria

Denmark

7

Germany

6

8

Sweden

UK

4

Belgium

3

5

Netherlands

Switzerland

1

2

Countries

Ranka

38.39

39.54

39.55

39.68

40.55

41.02

41.23

87.63

87.68

87.80

88.61

88.73

89.31

89.44

90.33

90.45

90.91

89.24

39.01

34.78

37.59

41.59

37.96

35.13

41.76

86.43

85.85

88.34

88.39

87.18

89.04

88.85

90.04

88.50

23.61

30.59

25.73

30.13

30.67

25.79

39.31

84.56

85.51

87.92

87.27

85.42

87.26

88.61

88.10

88.90

87.82

31.08

34.18

38.17

35.64

29.09

43.22

30.21

84.66

83.52

86.03

87.19

86.57

86.37

86.06

89.68

90.38

90.12

2021

2021

2011

De facto

Globalization, overall 2001

33.01

31.67

34.69

37.41

32.28

34.28

34.04

82.91

81.13

86.68

88.00

84.78

85.39

86.67

89.83

88.36

87.76

2011

. Table 23.1  KOF Globalization Index (overall): top and bottom economies in 2001–2021

27.14

29.71

20.22

23.72

25.67

28.16

35.48

79.26

79.13

83.58

84.56

79.99

81.84

83.82

87.06

85.70

85.77

2001

46.49

46.82

40.93

43.73

54.87

38.77

52.83

90.61

91.74

89.58

90.03

90.89

92.25

92.82

90.97

90.52

91.69

2021

De jure

45.56

38.87

40.48

45.96

44.96

35.99

50.00

89.95

90.57

90.01

88.78

89.57

92.69

91.03

90.26

88.64

90.71

2011

861

(continued)

19.80

31.72

31.24

36.78

36.79

23.38

43.36

89.86

91.88

92.26

89.98

90.86

92.67

93.39

89.20

92.10

89.86

2001

23.2 · Measuring Globalization

23

3

Central African Republic

Eritrea

Somalia

206

207

208

30.49

30.88

38.32

27.75

30.20

36.73

27.46

24.60

29.62

28.34

30.74

39.41

2021

2001

2021

2011

De facto

Globalization, overall

KOF Swiss Economic Institute (2022).

23.15

31.21

34.84

2011

26.47

27.40

25.69

2001

32.23

31.05

37.31

2021

De jure

31.60

28.96

38.49

2011

23

Note a Rank in 2021, overall Source Authors’ development based on KOF Swiss Economic Institute (2022)3

Countries

Ranka

. Table 23.1  (continued)

28.27

21.17

33.24

2001

862 Chapter 23 · Globalization and Regionalization

Luxembourg

Malta

United Arab Emirates

Switzerland

Estonia

Denmark

5

6

7

8

9

10

Central African Republic

Chad

193

194

…

Belgium

Ireland

3

4

Singapore

Netherlands

1

2

Countries

Ranka

32.41

32.48

84.53

86.13

86.33

86.55

87.18

87.77

88.14

88.75

90.12

94.28

94.00

32.21

29.21

81.91

85.60

80.26

84.53

88.22

89.75

89.05

86.91

87.95

36.33

29.26

84.34

84.19

84.14

71.97

69.47

93.05

91.42

88.53

87.78

91.99

43.48

41.79

82.61

83.37

87.45

90.29

88.69

83.84

88.77

89.20

91.67

98.59

2021

2021

2011

De facto

Economic globalization 2001

42.52

33.64

81.01

85.06

80.11

86.07

93.12

88.22

89.74

88.31

89.15

98.11

2011

. Table 23.2  KOF Globalization Index (economic): top and bottom economies in 2001–2021

47.08

34.73

75.83

78.09

77.74

67.95

86.34

89.50

91.64

85.28

82.56

96.82

2001

19.54

23.17

86.44

88.89

85.20

84.14

85.68

92.65

87.50

88.30

88.58

89.97

2021

De jure

20.37

24.78

82.81

86.14

80.41

83.57

83.32

91.63

88.36

85.31

86.75

89.88

2011

(continued)

23.75

23.78

92.84

90.29

90.53

74.35

52.60

97.39

91.19

92.33

93.00

87.16

2001

23.2 · Measuring Globalization 863

23

4

Burundi

Bangladesh

Nepal

Iran

199

200

201

202

28.80

28.97

29.14

30.98

31.11

31.30

31.81

32.18

30.33

27.21

34.54

30.85

41.07

31.47

–

39.02

27.87

22.15

23.87

26.18

32.78

28.96

–

30.95

23.31

23.85

24.97

35.02

26.66

29.52

–

34.10

KOF Swiss Economic Institute (2022).

Note in 2021, economic globalization Source Authors’ development based on KOF Swiss Economic Institute (2022)4

a Rank

Ethiopia

Afghanistan

Somalia

196

197

Democratic Republic of the Congo

195

2021

2001

2021

2011

De facto

Economic globalization

20.48

21.78

29.03

34.84

38.58

39.74

–

47.63

2011

20.61

23.39

19.91

28.04

39.71

33.13

–

28.22

2001

34.30

34.09

33.32

26.93

38.81

33.08

17.76

30.26

2021

De jure

40.17

32.63

40.06

26.86

45.33

23.21

–

30.42

2011

23

198

Countries

Ranka

. Table 23.2  (continued)

35.14

20.92

27.83

24.32

20.96

24.79

–

33.68

2001

864 Chapter 23 · Globalization and Regionalization

Singapore

Hong Kong SAR, China

9

10

Niger

Sudan

Angola

Central African Republic

Burundi

Chad

204

205

206

207

208

209

…

UK

San Marino

7

Norway

6

8

Switzerland

Canada

4

Liechtenstein

3

5

Luxembourg

Monaco

1

2

Countries

Ranka

30.67

31.22

32.56

33.72

33.90

35.17

88.02

88.30

88.62

88.71

89.34

89.35

89.58

90.16

90.55

90.97

91.68

27.96

26.84

28.12

34.27

30.41

31.76

87.91

87.10

86.95

89.33

91.40

89.99

90.61

90.43

89.99

17.04

14.88

21.31

19.04

19.36

17.43

83.62

81.98

86.33

84.66

90.08

86.62

89.08

89.04

89.11

86.93

27.76

27.65

34.63

32.58

31.44

32.39

90.59

97.08

87.91

87.87

88.65

91.55

91.02

86.02

86.97

91.52

2021

2021

2011

De facto

Social globalization 2001

2011

23.79

19.24

20.67

33.65

26.20

27.00

94.28

97.44

89.35

88.31

91.86

91.19

92.87

87.41

86.93

90.16

. Table 23.3  KOF Globalization Index (social): top and bottom economies in 2001–2021

13.82

10.61

17.90

17.52

16.94

9.06

90.36

93.51

84.29

84.46

88.55

86.47

89.13

84.98

87.16

89.73

2001

27.76

27.65

34.63

32.58

31.44

32.39

90.59

97.08

87.91

87.87

88.65

91.95

91.02

86.02

86.97

91.52

2021

De jure

31.15

34.44

33.90

34.83

34.61

35.83

80.81

76.77

84.95

90.35

90.93

88.78

88.36

92.55

92.56

93.21

2011

865

(continued)

19.42

19.15

23.89

20.38

21.78

24.41

76.12

70.45

88.04

84.86

91.60

86.77

89.03

91.83

90.76

84.14

2001

23.2 · Measuring Globalization

23

5

Democratic Republic of the Congo

Eritrea

Ethiopia

Somalia

210

211

212

213

27.17

27.92

28.14

29.35

23.41

22.84

25.53

26.70

16.16

12.48

20.17

14.82

20.99

24.96

27.93

22.48

2021

2001

2021

2011

De facto

Social globalization

KOF Swiss Economic Institute (2022).

15.69

18.85

24.92

20.64

2011

10.33

7.26

16.59

11.25

2001

20.99

24.96

27.93

22.48

2021

De jure

27.93

26.83

26.14

32.00

2011

23

Note a Rank in 2021, social globalization Source Authors’ development based on KOF Swiss Economic Institute (2022)5

Countries

Ranka

. Table 23.3  (continued)

19.56

17.71

23.57

17.97

2001

866 Chapter 23 · Globalization and Regionalization

Switzerland

Austria

9

10

Monaco

Tonga

Saint Kitts and Nevis

Liechtenstein

194

196

197

Maldives

193

195

Timor-Leste

192

…

Netherlands

Sweden

7

Belgium

6

8

UK

Spain

4

Italy

3

5

France

Germany

1

2

Countries

Ranka

23.09

23.58

23.81

25.90

26.10

26.91

95.27

95.44

96.43

96.59

96.63

96.85

97.65

97.68

97.72

97.99

98.47

24.02

19.39

25.12

27.36

18.36

32.94

96.03

94.63

95.81

94.77

97.21

97.06

97.05

98.26

97.09

23.03

14.36

22.53

21.30

14.96

–

95.29

93.49

95.22

95.77

94.22

93.79

97.04

96.04

96.09

96.74

10.16

13.04

13.80

15.78

14.13

17.08

93.89

92.67

94.15

94.54

94.66

95.05

95.67

95.67

95.80

96.30

2021

2021

2011

De facto

Political globalization 2001

11.43

12.63

13.75

17.92

12.56

32.35

95.44

92.10

93.30

91.68

96.45

95.85

94.81

97.19

94.54

97.27

2011

. Table 23.4  KOF Globalization Index (political): top and bottom economies in 2001–2021

10.14

6.12

12.35

12.33

9.43

–

95.27

90.24

92.94

94.27

92.23

91.69

95.15

94.01

93.99

94.47

2001

36.02

36.75

33.81

36.01

38.07

36.74

96.65

98.21

98.71

98.64

98.60

98.65

99.64

99.69

99.64

99.67

2021

De jure

36.61

26.14

36.50

36.81

24.15

33.53

96.62

97.15

98.32

97.87

97.96

98.26

99.28

99.34

99.64

99.66

2011

(continued)

35.91

22.60

32.71

30.26

20.49

–

95.32

96.74

97.51

97.27

96.21

95.89

98.93

98.07

98.18

99.01

2001

23.2 · Measuring Globalization 867

23

6

Andorra

Marshall Islands

Kiribati

Puerto Rico

198

199

200

201

12.95

13.61

16.90

21.84

12.68

14.63

12.12

21.17

13.25

12.43

10.99

20.85

21.61

KOF Swiss Economic Institute (2022).

8.53

6.99

11.59

2021

2001

2021

2011

De facto

Political globalization

21.85

10.43

7.83

13.79

2011

21.47

8.38

6.91

12.07

2001

4.28

18.68

26.82

32.10

2021

De jure

3.51

18.82

16.41

28.55

2011

23

Note a Rank in 2021, political globalization Source Authors’ development based on KOF Swiss Economic Institute (2022)6

Countries

Ranka

. Table 23.4  (continued)

5.02

16.49

15.06

29.62

2001

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and the UK. The de jure parameters include membership in international organizations, international treaties, and treaty partner diversity. The de facto political globalization is measured by the number of embassies, UN peace keeping missions, and international non-governmental organizations. The KOFGI allows for comparing the levels of involvement of different countries in global relations (in this particular case, in the system of economic relations), but it still fails to produce an unambiguous quantitative measure of economic globalization of a country. Nevertheless, the KOFGI is used to identify both the presence and the strength of relationship between globalization and economic, social, and political variables. Non-economic KOFGI parameters act as control variables, although some components of non-economic KOFGI measures affect economic and social parameters (for example, economic inequality or social policy) in a particular country indirectly through multi-link chains of relationships. Alternatives to the KOFGI are the A.T. Kearney/Foreign Policy Globalization Index (KFP), the CSGR Globalization Index, and the McKinsey Global Institute Index. Unlike the KOFGI, alternative indexes focus on certain dimensions of multidimensional globalization. Thus, the KFP index is calculated on the basis of twelve indicators (fourteen variables in some variations) of economic, technological, social, and political globalization. The KFP elements are grouped into four dimensions (economic integration, global technologies, interpersonal international contacts, and involvement in global political processes) (further reading: “Measuring Globalization”7). The core KFP variables establish four groups: economic globalization (international trade, foreign direct investment), technological globalization (number of Internet users, number of Internet hosts, number of secure servers), globalization of interpersonal relations (international business travel and tourism, international telephone traffic, international money transfers), and political globalization (membership in international organizations, participation in UN missions, the number of international treaties, the amount of financial assistance to other countries). Similar to the KOFGI, the KFP variables are decomposed into sub-components. At the same time, the KFP is different from the KOFGI in reflecting the sphere of technological globalization. The CSGR index is produced by the Centre for the Study of Globalization and Regionalization (further reading: “The CSGR Globalisation Index”8). The index is used for conducting annual comparisons of the degree of globalization of countries in the three-dimensional mode (economic, social, and political dimensions). The results obtained for the three measures are combined into a single composite index. All variables are standardized and are subjected to panel normalization so that they remain comparable regardless of the period they relate to or individual features of a particular country.

7 8

Kearney and Foreign Policy (2001). Lockwood and Redoano (2005).

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The MGI Connectedness Index was elaborated by McKinsey Global Institute to measure the flows of goods, services, finance, people, and data and communication (further reading: “Global Flows in a Digital Age”9). The index is decomposed into seven groups of indicators: global politics (mainly includes the measurement of the volume and closeness of diplomatic relations and other political ties with other countries), organized violence (the degree of participation of the country’s military and industrial complex in operations conducted in other countries), international trade (the intensity of exports and imports of goods and services as a percentage of GDP), international finance (FDI and private capital flows as a percentage of GDP), cross-border movements of people (migration and tourism, international communications, and infrastructure institutions serving the movement of people between countries), technology (Internet users, international telephone traffic), and the environment (the degree of environmental degradation due to the economic activity, trade in goods that damage the environment). The MGI index is largely tailored to assessing non-economic forms of globalization and is therefore rarely used to study the links between globalization and economic and social parameters of development. Thus, both quantitative and qualitative measurements of contemporary globalization are mainly based on the assessment of quantitative parameters of four interrelated structural aspects, such as the internationalization of markets and the permeability of national borders for economic transactions; fair competition between countries; integration of individual economies into a single economic space through the use of new information and communication technologies; growing interdependence and instability in global markets. 23.3  Effects and Controversies of Globalization

The manifestations of globalization are extremely diverse, depending on whether one considers economic, industrial, financial, social, or cultural globalization. Among the most obvious effects are the international division of labor, migration of people and capital, and the penetration of international regulation into the critical spheres, such as economy, trade, finance, social policy, intellectual property, public health, environment and climate change, sustainable development, and many more. Countries import and export certain categories of goods based on the principles of comparative and competitive advantages (previously discussed in 7 Chap. 19). The international trade has grown dramatically in recent decades, not only in absolute terms, but also in the range of traded goods. Even despite the relatively short-term restrictions imposed on most types of cross-border mobility due to the COVID-19 pandemic, the international mobility of both capital (see 7 Chap. 20) and labor (see 7 Chap. 21) is growing rapidly. Globali-

9

Manylka et al. (2014).

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zation transforms regulations of international processes. Examples of the unification of regulations in trade and finance are the WTO and the World Bank, respectively. Sovereign states sacrifice part of their own sovereignty in favor of the creation of international institutions and appropriate international regulations. A striking example is the UN system of international organizations which extend their regulations to many areas. The examples of the influence on global world politics are informal clubs of countries, such as the Group of Seven (G7) and the Group of Twenty (G20), which are designed to discuss and resolve global problems. Globalization in culture is manifested through the growth of international business communication, the popularization of certain cultures, the development of international tourism, and the global distribution of individual works of culture and art. As demonstrated in 7 Chaps. 15–17 above, globalization is facilitated by objective factors of economic and social development, the international division of labor, scientific and technological progress in transport and communications, and the reduction of the so-called economic distance (inequality in the level of economic development) between countries. Today’s efficient telecommunications systems allow users to receive real-time information wherever they are, which makes it possible to make decisions quickly and easily, manage international capital investment, and cooperate in marketing and production. At the current pace of globalization and integration of information, sharing of business experience and technologies across national and social borders accelerates tremendously. Economic and social processes that have remained local now becomes global. Despite the new rise in trade protectionism which has emerged recently (previously discussed in 7 Chap. 22), trade liberalization and other forms of economic liberalization in general have made world trade significantly freer and more predictable than it used to be a few decades ago. International trade is now the subject to unified international regulation. Within the WTO, as well as regional trade associations and formats of trade and economic cooperation between countries, a significant part of non-tariff trade barriers was eliminated, while the overall level of customs tariffs was reduced. In addition, due to the application of other liberalization measures, the exchange of capital, labor, and other factors of production between countries has intensified. One of the most striking manifestations of the contemporary globalization is transnationalization. Nowadays, a certain part of any country’s ­consumption, production, income, and trade is generated beyond its borders by t­ransnational corporations and cross-continental production and supply chains. The bigger the share of such an extraterritorial value, the deeper a particular country is integrated into the global economy. TNCs shape and lead the globalization processes in production and distribution of goods, services, and other assets across the world. They are the major drivers of internationalization and the fruits of the contemporary globalization (see 7 Chap. 4, 7 Sect. 4.3.2 for the characteristic features of transnational business). Economic globalization affects all countries and all people, regardless of whether they wish it or not. The new

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globalization is an overarching process as it determines the development and dissemination of technologies between countries, the use of labor, the production of goods, the supply of services, investments, and all other kinds of exchanges. Globalization transforms the very patterns of competitiveness, labor productivity, and production efficiency that have developed in the past. Thus, global globalization has become the main trigger for the emergence of international competition and the penetration of international competition to the local markets. Today, all producers (even those who never deal with foreigners) and consumers (even those who never travels abroad and buys products from local groceries only) still face international competition when they compete with imported goods in local supermarkets or use devices supplied by global technological tycoons. Globalization has been particularly accelerating since the 1990s. Since then, TNC networks have become fused with the regional and world markets, and the links between corporations and the markets of goods, technologies, services, and labor have become extremely tight. Despite the fact that some TNCs limit their activities to the trade sector, most of them require industrial restructuring in the countries they locate their facilities (predominantly, developing and least developed markets) through the modernization of conventional industries (food, textile, etc.) and the development of new sectors (electronic, petrochemical, automotive, mechanical engineering). New generation TNCs (known as global corporations) operate primarily in financial and information markets, which distinguishes them from production and trade TNCs of the past. Thus, markets get linked on a global scale, and the financial and information space becomes global. As a result, the importance of TNCs and international economic organizations and structures associated with them (IMF, IFC, IBRD) is growing. Case box Today, TNCs accumulate a significant portion of the global gross output of new technologies and hi-tech goods (80%). Their revenues have already outgrown the GNI of many countries, even quite large ones. For the most part, these companies are engaged in the creation of meta-technologies, including software, networks, computers, and public relations technologies. Such giants as Meta (former Facebook), Google, or Twitter shape public opinions and consumer preferences and thus spread their influence on all spheres of everyday life of the billions of people, governments, and countries.

Transnational corporations exert their influence on the country-level parameters of globalization in three directions: 5 The growth rate of foreign direct investment is incredibly high today. It significantly exceeds world trade turnover. Largely due to the emergence of FDIs and the penetration of TNCs to various sectors in domestic markets, industrial restructuring, technology transfer, the establishment of global enterprises, and other structural shifts directly affect national economies. 5 Due to the international competition it fuels, globalization particularly affects the sectors of innovations and technologies. In turn, technological develop-

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ment acts as the driving force for the globalization of the world economy itself (for example, see 7 Chap. 16, 7 Sect. 16.1 for technologies in the new normal economy). 5 Globalization advances trade in services (managerial, legal, information, financial, etc.). Intellectual capital has emerged into the critical asset in the world market. As a result of deepening internationalization, macroeconomists observe increased interaction and interdependence between individual economies. A single international economic system is a new structure that has been developing as a result of progressing globalization. Despite the unification, the new globalization has aggravated numerous hidden controversies and has polarized countries and societies in terms of the level of economic and social development. This especially concerns the distribution of opportunities and economic power in the global system. Only a few major economies are able to control a large share of consumption and production without applying any economic or political pressure. The internal values and priorities of such countries cannot but leave their mark in various areas of internationalization. The majority of TNCs are headquartered in developed countries, although since the 2000s, transnational businesses have particularly emerged across the developing world, for example, in China, India, Brazil, and other emerging markets. At the same time, host countries acquire partners in THCs to be reckoned with (sometimes even rivals in the sphere of influence on the country’s economy and society). The practice of signing agreements between national governments and TNCs on the terms of cooperation is generally accepted. Non-governmental organizations have also advanced to the global level. The role of international bodies like the IMF, the WTO, the UN, and the World Bank has increased in the context of the globalization of world finance and trade. That is, both public and private companies and organizations have become key actors and stakeholders in the globalized world economy. In the late 1990s and early 2000s, projected the achievement of a kind of a global consensus and agreement on the optimal trajectory of social and economic development based on the principles of market economy and economic and social liberalization and democratization. At the end of the XX century, such a vision of the role of globalization was fueled by a series of transitions of former socialist countries to the market economy and the convergence of socialist and market ideologies. The transition processes began in China in the late 1970s, when China started introducing market-oriented reforms. The collapse of the Soviet Union in the early 1990s triggered the transition of the former socialist countries of Eastern Europe, Russia, the South Caucasus, and Central Asia to the market economy. Among the main conditions for the market transition were price liberalization, privatization of state-owned companies, and macroeconomic stabilization of the national economy. At the same time, the creation of conditions for competition and specific market institutions was delayed, and the unique role assigned to the government in a mixed economy was not taken into account.

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Case box

23

In contrast to the rather unambiguous processes of liberal economic reforms at the end of the XX century and the massive commitment of many countries to the principles of a market economy (often much greater and much more ardent commitment to economic and social liberalization than it was in the leading developed economies of that time—the USA and Europe), the new normal global development is largely driven by political factors. Some developing countries do not want to blindly follow market agenda. Despite the decades of reforms, certain societies have failed to fully accommodate the principles of economic and social liberalism and free competition. Thus, by combining soft power and administrative regulations, China demonstrates alternative examples of successful economic development through the administration and centralized smoothing of market volatilities, mass social support of the population, and the government-led leveling of economic and social inequalities. On the contrary, Russia is pursuing an aggressive policy and is trying to establish new competitive advantages and gain new markets by forcefully asserting the country’s role and importance in the world with a relatively modest share on the global market. Due to this intertwining of economics and politics, an unequivocal saying that globalization does contribute to the liberalization of society and the economy would be cheating. Like any transformation, globalization causes rejection, which is the stronger and fiercer the more radical forces oppose it (further discussed in 7 Sect. 23.4 below).

Another feature of the new normal globalization is the unprecedent interlacing of financial markets (previously addressed in 7 Chap. 20). The globalization-driven transformations of credit, currency, and stock markets have affected the entire world economy. A couple of decades ago, the pivotal task of financial markets was to meet the needs of the real sector. Contemporary financial sector is less dependent on the manufacturing. Together with the liberalization of the economy, this shift has led to the increased speculation in the market and has resulted in a multiplication of the global turnover of money and financial assets. In other words, the reproduction of money has become much easier, because it no more requires the material production of goods or services. Profit can be generated more easily and faster by playing on currency fluctuations (see 7 Chap. 20, 7 Sect. 20.4 for currency trading) and speculation with derivative financial instruments, such as options or futures (see 7 Chap. 20, 7 Sect. 20.5 for foreign exchange market). Internationalization in the financial market can be recognized as the most advanced and most complex of the processes taking place within the contemporary economic globalization. It has resulted from the strengthening of financial relationships between countries, the formation of trade and financial groups operating globally, more liberal rules for pricing, and the cross-border movement of investment flows. The USA, the EU, Japan, and China are the centers of contemporary financial globalization. However, financial speculations extend far beyond these regions. Due to the influx of speculative capital into a country, the situation in the financial market (the entire economy) may be destabilized, since the amount of funds received may substantially exceed that a

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national economy is able to digest. The pace of globalization in the financial sector is still a key cause of risks and vulnerabilities in the global economy (previously discussed in 7 Chap. 7, 7 Sect. 7.3). In particular, the unprecedented integration of markets increases the likelihood of systemic failures. The effects of globalization outlined above can be considered both positive aspects of the global economic and social development and threats to such development from the point of view of ensuring stability of the entire system of the world market and the world economy. Summarizing the gains of globalization, one should note that international competition (a direct outcome of globalization and the international division of labor) has emerged to one of the decisive drivers of contemporary economic development. Fierce competition improves the quality of goods and services on the market along with decreasing their prices and making them more available to consumers across diverse income segments. Globalization favors the economies of scale, which allows producers to lower prices (see 7 Chap. 19, 7 Sect. 19.2.5 for Krugman’s economies of scale on the global market). Until recently, globalization has been driven by the establishment of trade unions, but this process has slowed amid the COVID-19 outbreak and the new rise in trade and economic protectionism (previously discussed in 7 Chap. 22, 7 Sect. 22.4). Developing countries have the opportunity to catch up with the leading economies. Due to globalization, they have some head start and time to strengthen their advantages and positions on the world market. Meanwhile, the gains of globalization are distributed unevenly. Certain industries, sectors, and even countries benefit from integrating to the global production and supply chains (new markets, sources of funds and qualified labor, etc.), while others lose (brain drain, outflow of capital, loss of the competitive edge). The latter ones need time and resources for restructuring and adaptation to the competition, but globalization reduces the adaptation opportunities. The loss of competitiveness in certain sectors under the influence of globalization affects the economies and leads to an increase in unemployment and forced structural shifts in domestic markets. Nevertheless, the losses in certain sectors may trigger the development of alternative areas. One of the examples is deindustrialization, which shifts the balance from the manufacturing industries to the service sector. Local personnel often need to retrain in order to adapt to the changes caused by globalization and improve or completely change their qualifications in order to find a new job in another sector. The wage gap between workers with and without qualifications is growing. While the salaries of educated employees are growing, unskilled personnel are forced to settle for very modest pay, if there is any work left for them at all. The unemployment generated by this process has a bad effect on the reputation of globalization. However, in a different view, it acts as an incentive for the retraining and professional and personal development of employees. Global corporations are striving to reduce the guarantees of workers’ labor rights to be able to reduce production costs and increase profits. In such conditions, a shadow labor market emerge. At the same time, the ongoing and interrelated processes of regionalization and globalization aggravate social and economic contradictions not only within

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countries, but also between them. Opponents of globalization particularly stress out the fact that developed countries in North America and Europe gain from getting access to developing markets, while developing economies of the Global South lose from draining all kinds of their natural and human resources. The “periphery” countries (discussed above in 7 Chap. 15, 7 Sects. 15.3.4 and 15.6.1) are thus turning into a kind of hostages of the new normal version of globalization (according to the international dependence model addressed in 7 Chap. 15, 7 Sect. 15.6.3), as the development gap between them and the Global North is growing. Case box Many of the contemporary anti-globalist movements and organizations stay against the neoliberal version of globalization somehow associating all the controversies and failures of globalization with the dominance of developed countries and the so-called “westernization” of the global agenda (for example, the spread of values, such as liberalization or democratization). Therefore, anti-globalization movements are actually the anti-Western movements. Paradoxically, the new anti-globalism sets itself quite a global goal, such as opposing or counteracting the Western civilization as a whole, and not so much correcting certain contradictions and shortcomings of globalization. No wonder that such an agenda attracts many supporters throughout the world, not only in the developing world. The propaganda of radicalism in politics and political populism do not miss the opportunities provided by the media today in terms of global audience accessibility and promoting the populist ideas. Check 7 Sect. 23.4 for the summary of the new anti-globalization.

A global market architecture in which a liberal market of qualified labor is located in the center, and a much less free market of lower-qualified workers is located on the periphery (similar to the center-periphery model outlined in 7 Chap. 15, 7 Sect. 15.6.1) is fundamental for capitalism system in the globalized world economy. As demonstrated in 7 Chaps. 14 and 19, the fact is that without a certain degree of inequality between the market actors (between the elements of the system), the market never functions properly. Simply, evenness provides no ground for integration (international division of labor). Among the critical contradictions of the new normal is the dilemma of matching a post-industrial development path with high employment. The emergence of information technologies and digitalization in the post-industrial era has been driving certain categories of hand labor from the market. However, labor is exactly the resource that the Global South countries are abundant with. The processes of globalization, modernization, and nation-building take place in developed and developing countries simultaneously, the accompanying contradictions and problems overlap and mutually reinforce each other. As a result, many of the “periphery” countries lag behind the Global North economies in both economic and social terms. The following reasons for the emerging problems can be identified:

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5 depletion of resources that can be allocated to implementing economic, social, and political reforms and conducting public policies to contain social stratification within countries; 5 increasing economic and financial dependence of developed and developing countries on each other (and developing markets on themselves); 5 increasing inefficiency of public administration on a country level as a consequence of economic rationalization and standardization of regulations carried out at the global level; 5 the media-driven influence of Western consumption standards and lifestyle patterns, which lead to a “revolution of growing expectations”, since in fact such consumption standards can not be achieved in most of developing economies. Today, humanity is being transformed into a new all-encompassing social integrity. The concept of globality unites many factors and elements that make up the world system, humanity as a whole and an individual, the future and the present, and the results and actions that caused them. Globalization unites separate societies into a single system through cultural, political, and economic relations. In politics, this trend is manifested in the formation of supranational communities. These are regional or continental associations, military and political blocs, international organizations, and coalitions of ruling elites. In cases where certain administrative functions are transferred from the national level to supranational organizations, anti-globalists refer to the formation of a world government (for example, the UN or the European Parliament). There is a noticeable correlation between the new rise of mass nationalism and protectionism (not only trade or economic one, but even the cultural protectionism) and the globalization of world development, the protection of basic freedoms worldwide, and the spread of democracy in general. Nationalism is the ideology of the nation-state, which stands for the sense of togetherness of people in terms of ethnic, religious, linguistic, territorial, and other unities. Cultural Protectionism is one of the most demonstrative forms of the new protectionism. It relates to the attempts of the government, ruling elites, or social movements to promote national culture (national identity, traditions, language, cultural production) and limit the effects of foreign culture (global culture) on the domestic audience. Since democratic institutions in developing countries (especially in the economies in transition) are immature at the early stages of such a transition, nationalist sentiments may flourish amid the rise in political populism (the most striking example of the recent time is Donald Trump in the USA). In particular, such a conflict scenario is most likely true in a situation where the perception of rapidly occurring changes in the political system is inadequate—the elite see a threat to the current privileged position (for instance, Putin’s presidency and the status of Putin’s inner circle in Russia for over past two decades). Other components of the new nationalism are the increase in the participation of people in the political process (immature civil society institutions) and the political mobilization of people on a discriminatory basis (for example, on ethnic or religion grounds). On the

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contrary, the competent policy of the elite in the development of civil nationalism and liberal civil institutions can restrain the nationalism-globalization conflicts. Civil society is more important, as even with weak institutions, but mature civil nationalism, democratic reforms likely success. The new nationalism and regionalism are largely reactions not only to the economic dominance of certain TNCs or even countries, but also in general to the formation of a global culture. For some societies, certain elements of such a unified westernized culture are alien and even unacceptable. In most developing countries (even those that both share and contribute to establishing global values), Western-style global culture is adopted with significant local modifications, which triggers internal contradictions. Anti-globalists particularly emphasize the ongoing degeneration of culture, which manifests itself in the replacement of interpersonal relations with technological ones, the emergence of multiculturalism, the departure from the basic regulators, such as religion or morality, and the spread of mass culture. Nevertheless, globalization can not be blamed as the direct and only reason for the internationalization of culture and the rising nationalism and cultural protectionism as responses to the unification. Such a reaction is stimulated by the increasing mobility and instability of the social structure of contemporary societies and their value systems, the rapidity of cultural shifts, the growth of social, professional, and territorial mobility of people, and the new individualization of work and workplaces (particularly, the unprecedent emergence of remote work during the COVID-19 pandemic—see, for example, 7 Chap. 16, 7 Sect. 16.2.3 for the new normal technological trends in labor markets). Globalization mediates these processes and catalyzes them. Multiplying the volume of an individual’s functional social ties, often anonymous and quickly transient, it thereby weakens the psychological significance for an individual of stable ties with rich value-spiritual and emotional content. The interaction of globalization and individualization in human consciousness is extremely multifaceted. In essence, these are two multidirectional and simultaneously complementary processes that take an individual out of the framework of ideas limited by the national state, place of residence, family, or the usual habitat. An individual gets off the grid and gets aware of themselves as a citizen of the world. Another crucial consequence of cultural globalization is personal identity. Amid the lack of conventional communication between people, an individual may feel aggressive uncertainty, fatigue, and alienation. In the globalizing and rapidly digitalizing world, it is getting hard to distinguish real life events from the virtual reality (mass media, fakes in the Internet, virtual games, etc.). These processes may result in the atomization of a personality, orientation to the role models (celebrities, key opinion leaders, or social media influencers), loss of connection with one’s own social or ethnic group, or even nation. Such a situation can lead to the establishment of a one-dimensional unified view, devoid of the values of religious, cultural, and national identity. With the ever closer interweaving of previously disparate societies and the globalization of an increasing number of spheres of everyday life, the range of problems is also growing. Local incidents emerge into global cataclysms as

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never before. Only the last couple of years have brought vivid manifestation of the new globalization—the relatively common coronavirus outbreak in China turned into a devastating pandemic within a couple of months, the regional conflict in eastern Ukraine has emerged into a confrontation between Russia and the entire Western world and is now escalating into a humanitarian catastrophe. There are only some examples, not counting the old global problems that many have forgotten about against the background of extremes of our time—environmental pollution, climate change, poverty and hunger, global inequality, and many more. Despite the international efforts on curbing harmful emissions and mitigating climate change, globalization has been affecting ecosystems for many decades and even centuries since the emergence of industrialization, international trade, and communications between the continents. The likelihood of conflicts over natural resources (hydrocarbons, fresh water for drinking and irrigation, agricultural land, rare earth elements) is increasing due to the irrational use and pollution of scarce resources. The unprecedent growth of industrial production in developing countries is accompanied by rather moderate environmental protection regulations and constraints. Modern weapons systems have reached a level of technological perfection sufficient to destroy all the life on earth. More than ever before, it is now necessary to coordinate joint efforts of all countries in the fields of environmental protection, climate change response, and peacekeeping. In order to address global problems, the efforts of all countries must be united to establish a new effective decision-making mechanism that allows approaching to solving problems in the context of growing global interdependence of countries on each other. Unilateral actions are no more responsible in the new globalizing world, only cooperation and collaboration matter. The new mechanism should be fundamentally different from the previous versions of conflict resolution, aimed at blocking or restricting the room for unilateral activities of countries (for example, potentially leading to an escalation of tensions around nuclear weapons). Thus, the new decision-making mechanism should aim at solving the contemporary issues of entire humanity, including the consequences of economic, social, technological, cultural, and political globalization. Globalization is a given. Isolation degrades development opportunities, while integration allows to improve the quality of life of people. However, the degree of integration should be determined taking into account individual conditions and national interests. States have every right not to sacrifice their own sovereignty for the dubious strengthening of certain economic and political ties. Domestic producers, workers, markets, and the environment should not suffer. The real causes of the current crisis of globalization and the new rise in nationalism and protectionism should be sought not so much in the short-term effects of the COVID-19 pandemic (the world has almost forgot about it already in 2022), when each country tried to isolate itself from its neighbors, close borders, and thus enable national public health systems to pass relatively smoothly through periods of peak loads. The reason is not even that individual states seek to protect or increase their advantages on the world market through trade confrontations (the USA and China) or ephemeral restructuring of the world order to suit their interests

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(Russia’s aggressive actions against Ukraine and the anti-West rhetoric of recent years). The root cause of the contemporary contradictions of the new globalization is often unsuccessful attempts by countries to combine the benefits of globalization with the goals of ensuring national sovereignty. Conflicts of interests are growing between conventional actors (national states, alliances of countries, and international organizations) and new powerful forces (TNCs and the media) that determine the contours and trends of globalization. Due to their gigantic capital assets, global corporations dominate not only the world market, but also the global social and political agenda and all kinds of narratives (for instance, Elon Musk’s tweets that ruin and rise again the stocks). Establishing a balance between national interests and globalization is the only way a country can develop successfully and steadily, but finding the balance is the hardest part of the puzzle. Few states have succeeded, while a lot more have failed. 23.4  The New Anti-globalization

In 7 Chap. 22, we discussed the rise in protectionism as one of the demonstrative features of the new normal economic development. In terms of globalization, it is safe to say about such anti-globalization trends of the modern times as regionalization, nationalism, and anti-globalization. Globalization and the associated Westernization and unification of cultures force traditional societies to strengthen their national identities. Despite their dissimilarity, individual national communities or social groups are forced to unite in order to resist common threats, such as pervasive globalization, internationalization of all kinds of regulations, standardization, unification, and loss of identity. The new Regionalization is the response of countries (groups of influence within countries, political parties) and communities (economic and cultural elites and opinion leaders) to the rapid and unsustain globalization of recent decades, which, along with obvious economic benefits and advantages, has inevitably entailed certain losses and inconveniences. Regionalization is a consequence of the deepening international division of labor and an increase in the influence of external factors on reproduction, requiring domestic businesses to go beyond national borders to remain competitive. On the other hand, regionalization is a tool for optimizing the economy, increasing production efficiency, and leveling regional structures. Therefore, regionalization is a kind of self-balancing of the global economic system, which serves as a means of maintaining relative equality in the world of huge inequality of the potentials of individual countries. In fact, contemporary regionalization is both a product of globalization and a tool to counteract its negative consequences. Regionalization is carried out in two forms: regional powers and development triangles. Due to economic and demographic reasons, as well as to a certain extent due to historical traditions, the economic and/or political center of a certain region becomes the regional power. As a rule, a regional power emerges if neighboring states (a periphery) lag behind the center. In the event of development triangles, certain territories can significantly overtake the rest of a country. As a result, economic, trade, and financial ties are established not between countries,

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but between territories within the development triangle. This process can lead to both adverse economic consequences and the growth of separatist movements in the area. Uneven development is one of the crucial determinants of globalization, as it contributes to the specialization of large regions. By now, developed countries have specialized in rendering various kinds of services, where most of the labor is employed in the service sector and the bulk of GDP is generated in the services industries. On the contrary, developing countries are increasingly turning into industrial societies. As a result of the new division of labor, the products of non-productive activities of developed countries are exchanged for the material resources of developing countries. In other words, in this case, developed economies (consumers) benefit from globalization, while many of developing markets (suppliers) lose. Case box Under these conditions, the maneuverability of a regional power (or a power claiming this role) is limited. Since it has to deal not only with individual states, but also with their associations of various types, it turns out to be more difficult for a regional power to impose its interests on other countries, alliances of countries, or international organizations. Integration associations have noticeably strengthened and expanded, the economic and political strength of major powers, especially China and India, has grown, and the ties of regional powers with their areas of influence have strengthened. Therefore, a monopolar world can be built only by limiting or eliminating the existing organizational structures, which will require the world leader to confront a multitude of states. Today, such unambiguous leadership is not only impossible, but also impractical—even world leaders, such as the USA or China, benefit significantly more from cooperation than from trying to win in competition with each other.

The deeper globalization penetrates into diverse spheres of everyday life, the sharper the contradictions, the stronger the opposition, and the broader the anti-globalist agenda. In many ways, this opposition is explained by the peculiarities of human consciousness, which seeks to schematize the polyphony of life. Perceptions do not keep up with the rapid course of life—both individuals and entire societies may get stuck in the past and cling to comfortable traditional values, trying to slow down or even deploy a sports car of globalization. The hegemony of developed countries expanding their sphere of influence has faced opposition from the “new periphery”, which has resulted in the establishment of regional centers of power (previously discussed in 7 Chap. 15, 7 Sect. 15.6, in relation to the center-periphery models of economic development). On the other hand, the ideological opposition of the liberal West to the undemocratic, autocratic, or even totalitarian East could not but affect the consolidation within these two worlds. Attempts to unify human and cultural values have brought to life an appeal to traditional values, which are generally opposed to Western ones. But such an artificial revival creates problems for fundamentalists as well. In fact, we can-

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not talk about a return to tradition, but only about its modern replica, a kind of simulacrum. It is built not by recreating to conventional values, but as a counterculture opposed to modern culture of unified and globalized world. In fact, such counter-globalization is an alternative version of globalization. The overwhelming majority of anti-globalist movements are not at all as radical as the media or public opinion are trying to present them. Anti-globalization is not about a return to disparate national communities and minimal cross-border communications. Certainly, it is not about a technical regression and rejection of the technological achievements. Anti-globalism is a social movement directed against certain aspects of the contemporary globalization, in particular, against the dominance of transnational corporations and international economic, trade, financial, and political organizations. Anti-globalization is rather a different globalization, more humane, more democratic, and more controlled by the public. Paradoxically, the ideal alternative globalization is a kind of economic, social, and political formation that guarantees the existing freedoms, the achieved level of wellbeing, life benefits, and amenities, and a high level of economic, social, and personal security with minimal control by governments and corporations. The classification of the anti-globalist movement is conditional, as, indeed, any categorization applied to such an intertwined economic, social, political, and cultural phenomenon as globalization. Conventionally, there are such forms of anti-globalism as economic, financial, political, informational, humanitarian, and environmental anti-globalization. The main manifestations of economic anti-globalism are the confrontation between governments that support the economic interests of TNCs as opposed to national interests, confrontation with the activities of international organizations (political agents of globalization), promotion of the national ideology of resistance to globalization that attracts new supporters, and actions against TNCs (judicial, law enforcement, boycotting of certain goods and services). The most well-known form of economic-type anti-globalism is expressed by rallies and demonstrations during the summits of the G7, the World Economic Forum, the World Bank, and the IMF. The future of anti-globalism can be projected in two formats: an established political movement and a multipolar social movement. In the first case, anti-globalization implies the gradual transformation of national anti-globalist movements into political parties or integration into existing parties and social movements. In many countries, anti-globalism is becoming an important component of the political narrative, especially among populist politicians. In the second case, anti-globalization can grow into a social movement, where anti-globalists will be able to gain a certain degree of control over government bodies, international organizations, and TNCs. In this case, their activities will be successful only if a developed civil society is established on a global scale. In general, moderate anti-globalism is a movement that is able to either smooth or correct the controversies of globalization, making them fairer and more humane, thereby avoiding conflicts in the future development of the world political system.

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23.5  Globalization and Social Policy in the New Normal

Globalization and transnationalization are changing the social environment of economic activities, leading to the formation of uniform international standards, norms, and requirements for working conditions, social responsibility, social protection, and sustainable development. They all exert a significant influence on the national economy. The impact of globalization on social policy is also manifested through the expansion of the international economic and political organizations, such as the UN, IMF, WTO, WHO, ILO, OECD, and UNESCO in the social sphere. The social dimension of globalization can also be tracked in the promotion of international legislative initiatives, such as the Universal Declaration of Human Rights10 (1948), the European Social Charter11 (1961), the International Covenant on Economic, Social and Cultural Rights12 (1966), and the UN Global Compact13 (1999). These regulations outline fundamental social, economic, and cultural values and human and business rights. They are based on the principles of sustainable development, freedom, equality, fraternity, and wellbeing of all people, as well as on the environmental responsibility and the fight against corruption. As demonstrated above, the consequences of globalization for the world community are extremely ambiguous and contradictory. On the one hand, it contributes to the increase in the overall productivity and efficiency of the world economy by facilitating the international division of labor, intensifying various types of exchanges between markets, accelerating the spread of new technologies, and joining forces of developed and developing countries to eradicate poverty and increase living standards of people worldwide. On the other hand, globalization provokes income differentiation and migration flows and contributes to the emergence of technological unemployment, a situation where certain jobs disappear due to the development of technology and widespread automation. Globalization undermines the basis of the existence of welfare states, exacerbating their competition with each other, since under the influence of globalization, the world economy is experiencing greater economic, social, and even territorial (spatial) polarization. Globalization encourages a global movement of peoples that challenges the established territorial structures and social institutions of individual states (labor migration from developing countries to the Global North economies and the refugee crisis in Europe in 2015). The erosion of the role of national social protection institutions due to globalization is a potential source of risks, social tensions, and armed conflicts. Today, global social risks aggravate due to the deformation of the demographic and social structure of society, a decline in the birth rate in developed countries and a rise in life expectancy across the developing world, an unprece-

10 11 12 13

United Nations (1948). Council of Europe (1961). United Nations (1966). United Nations (1999).

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dented pressure on health care and social protection institutions due to the globalization of health and social crises, and a permanent danger of social destabilization in vulnerable areas (Central Asia, Middle East, Eastern Europe, North Africa). Reducing the severity of these risks and the use of social policy as a tool for ensuring stable and sustainable social and economic development at the national and the global levels are becoming increasingly relevant. From this point of view, as globalization deepens, the importance of public institutions as guarantors of social stability increases. The opposite trend of globalization is regionalization. It forms independent territorial, social, and cultural communities characterized by common historical, spatial, geographical, ethnic, and cultural features and rising national identity, solidarity, and economic and cultural protectionism. According to Rodrik,14 a welfare state is the reverse side of an open economy. Social insurance dampens the blow of liberalization among those most seriously affected. It helps to maintain the legitimacy of social and economic reforms. This averts backlash against the distributional and social consequences of integration into the world economy. In the absence of such institutions, openness would most likely generate internal social conflicts that could be destructive. Within regionalization, there take place social integration and the formation of social capital within the regional space. New opportunities for influencing social and economic processes go beyond national borders. Modern social policy should be built taking into account global risks. As shown in 7 Chap. 16, globalization is closely connected with modernization, which, in turn, affects the economic and social policy of any country. Thus, the modernization of social policy acts as a mandatory and even natural process conditioned by renewal and subsequent transformations of economic and social pillars communities rest upon. The post-pandemic economic and social situation in most countries of the world force national governments to tighten budget policy and adjust social security programs to the new economic circumstances. This makes it imperative to search for alternative models of social policy in the context of the post-pandemic revival and the new normal development paradigm. One of the approaches to ensuring social and economic equality is the Universal Basic Income (UBI), an amount sufficient to meet the basic needs unconditionally paid by the state to all citizens. On the one hand, it can serve as the basis for ensuring social and economic freedoms of a person, the realization of free creative work, and work without coercion. Basic income implements the basic principles of social policy, such as non-discrimination, equality, and fairness of the social protection system. It universally covers all citizens of a country and reduces administration costs and losses during its distribution. On the other hand, UBI can give rise to paternalism and dependency. The middle class, a social engine of a market economy, may shrink. Not all countries, however, can afford to implement the concept of basic income. The impact of globalization on income distribution varies for different coun-

14 Rodrik (1998).

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tries and communities. To a large extent, these differences are related to the individual peculiarities of macroeconomic policy and labor market policy across countries. The widening of the income inequality gap is one of the side effects of accelerating economic growth (discussed in 7 Chap. 14, 7 Sect. 14.5). Due to globalization (i.e., the international division of labor and international competition), salaries in certain sectors grow faster than those in lower-competitive industries. As a result, the gap in wages (and, accordingly, in household incomes) increases. In the worst-case scenario, the incomes of low-skilled and low-wage workers fall as a result of a reduction in demand for their labor, while the incomes of highly qualified workers grow. Different forms of globalization exert different impacts on labor markets and, accordingly, wages and other sources of income: 5 The growth of international trade and offshore outsourcing as the most direct manifestations of globalization expand markets for producers, allowing them to minimize costs, including labor costs, by building more efficient cross-border production and supply chains. International trade affects the structure and scale of demand for labor in developed countries—the preference is increasingly given to more skilled than less skilled labor. 5 In addition to the rapid growth of international trade, another important consequence of economic globalization, which directly affects income inequality within and between countries, is the increase in foreign direct investment. The elimination (or significant easing) of restrictions on FDI not only reduces the costs of producers, but also stimulates consumption and pushes up purchasing power in domestic and international markets. Intensification of competition and removal of trade barriers opens up new markets for TNCs. Through FDI, globalization promotes the movement of capital to emerging markets. More and more companies are seeking to invest abroad where labor costs are lower, employment regulations are less restrictive, unemployment insurance systems are immature, and tax regimes are more favorable than in developed countries. As a result, domestic production in developed countries curtails and jobs “migrate” to third countries. Despite the new trends towards reformatting the current model of globalization that have emerged recently (with recent Trump’s presidency in the USA, increasing turbulence on the global capital market due to the COVID-19 outbreak in 2020–2021, and the Russia-Ukraine war in 2022–2023), both investment and jobs keep moving to emerging markets with more favorable conditions for making business. 5 The fundamental feature of the new globalization is the unprecedented interconnectedness of people due to the progress in information and communication technologies. Most scholars consider information and communication technologies as an integral component of globalization. Some macroeconomists, however, view technologies as a side factor that certainly speeds up globalization, but hardly determines its content. Anyway, the prevailing view is that the rapid development of new information and communication technologies not only accelerates financial transactions and provides more stable communications between individuals and companies, but also allows for the rapid exchange of information within international production and supply chains and the unification of various kinds of standards and regulations.

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5 Globalization opens up opportunities for the use of existing differences between countries and regions in a form of international division of labor, thereby contributing to developing specialization of individual countries and regional associations in producing certain goods (coffee in Latin America) or rendering certain services (tourism in Southeast Asia). As discussed above in 7 Chap. 19, the deepening and development of transnational and cross-border economic ties allow more effective use of the relative advantages of individual countries or regions and thereby contribute to the overall increase in the gross global product. Because of the differences in the structure of economies, skilled labor is generally more demanded in developed countries (hi-tech industries and service sector), while the demand for unskilled labor is relatively higher in emerging markets (industrial production and agriculture). Therefore, those developing countries which are abundant with labor may be attractive to companies in labor-intensive sectors. The inequality facilitates the specialization of countries in certain sectors (the theoretical interpretations of specialization and its determinants are summarized in 7 Chap. 19). As a result, in developed countries, the demand for unskilled labor is stagnating, while that in developing countries is growing, thereby pushing up the overall level of wages in the developing world. Apparently, this trend may well contribute to widening the wage inequality between skilled and low-skilled labor not only in developing, but also in developed economies. 5 From the point of view of labor supply, factors such as population growth and migration, as well as an increase in the proportion of people who have received vocational education, undoubtedly affect the dynamics and structure of wages. In developed countries, population growth has slowed down significantly in recent decades. Therefore, it cannot explain significant shifts in household income structure observed across the developed world today. Income inequality is almost as much an integral essence of any community as genetic inequality, age inequality, inequality in living conditions, and inequality in types of behavior, habits, or preferences. But if the above kinds of inequalities hardly depend on globalization, then why should income inequality depend on it? Income inequality is clearly a social characteristic, not an individual one. Economically and socially unjustified income inequality (just like inequality in income levels) is a characteristic feature of the social landscape in most countries. At the same time, inequality within countries (primarily, income inequality) has not only remained high for decades, but also continues to increase in the long run. Analyzing the country-level data, some scholars conclude that the poorest are most discriminated in terms of their access to the fruits of globalization. Others, on the contrary, argue that the positive effects of globalization are distributed rather evenly in society. One of the possible explanations for such contradictory visions of the role of globalization in reducing inequalities is an underestimation of the government intervention in the economy and the use of public policy instruments to correct the unwanted effects of economic liberalization. There is a prevailing opinion that the deepening of globalization and changes in the structure and scale of inequality are closely related to each other. Neverthe-

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less, many macroeconomists note that the relationship between these two trends is indeed extremely complex and ambiguous. The complexity of the relationship results in the inaccuracy of estimates of mutual influence of globalization and inequality on each other. Obviously, there is a correlation, since not only globalization forms patterns of inequality in a particular country, but also the structure of income distribution determines the extent of a country’s involvement in the global market and global economic relations. Studies which acknowledge the globalization-inequality relationship can be conditionally divided into three groups. The first group includes studies which demonstrate that globalization contributes to the widening of the inequality gaps both within countries and between them. Some researchers who rather negatively assess the impact of globalization on changes in the structure of household income distribution argue that for decades, globalization has been one of the primary reasons for the growth of inequality. Although global income inequality has been decreasing recently, it is hardly possible to unambiguously assess the impact of globalization on inequality (further reading: “Accounting for the Recent Decline in Global Income Inequality”,15 “Global Income Inequality by the Numbers”,16 and “The World Distribution of Income”17). Some economists believe that since the 2000s, not only global inequality has been declining, but the effects of globalization on inequality have weakened (further reading: “The New Geography of Global Income Inequality”18), while other scholars express doubts about the reliability of empirical evidence confirming the impact of neoliberal globalization on the formation of positive trends to reduce the level of global inequality and inequality between countries (further reading: “Is Globalization Reducing Poverty and Inequality?”19). The second group includes those who, based on the results of other empirical studies, conclude that globalization plays an important role in reducing income inequality between developed countries and emerging markets, but at the same time, it widens gaps between segments of the population in developed countries (further reading: “Globalization and Inequality”20). Some researchers argue that the claims about the negative impact of globalization on the distribution of household income are at least not entirely correct, since it is globalization that has made the world closer and has facilitated the international division of labor. It is assumed that due to the integration into an intertwined economic network that many developing economies have been able to largely get rid of poverty. The integration into the international value chains allowed developing economies to reduce the income gap between the richest and the poorest and thereby mitigate extreme inequality within countries (further

15 Firebaugh and Goesling (2004). 16 Milanović (2012). 17 Sala-i-Martin (2006). 18 Firebaugh (2014). 19 Wade (2004). 20 Mills (2009).

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reading: “Spreading the Wealth”21). Some proponents of the third vision of globalization emphasize that by blurring national borders and stimulating economic integration, the new global economic order makes it possible to lift millions of people out of poverty and thereby reduce the income gaps worldwide. Obviously, the inequality parameters are influenced by numerous exogenous and endogenous factors aside globalization (see 7 Chap. 14, 7 Sect. 14.5 for the general discussion of inequality in the new normal and 7 Chap. 17, 7 Sect. 17.4 for inequalities in human capital development). Such global problems as poverty and inequality, while certainly associated with the contemporary processes of globalization and internationalization, nevertheless represent independent problems that require separate consideration. Most researchers still agree that globalization exert interrelated, but often contradictory effects on income inequality and, broadly, social inequality within and between countries. For example, by contributing to an increase in economic growth rates in such populous countries as China and India, globalization thereby contributes to reducing income inequality in the world economy as a whole. On the other hand, however, globalization can provoke an increase in income inequality within countries between “competitive” and “non-competitive” industries or between urban and rural areas. Available methods do not allow one to find out which factor does affect the inequality gap in a particular case. However, it is widely believed that such globalization-related factors as the internationalization of economic activity, openness to international trade and exchanges, the spread of new communication and information technologies, and the growth of migration affect the inequality trends in both developed and developing countries. Therefore, one of the most pressing issues on the new normal global agenda should be the development of an efficient set of measures to cope with the consequences of socially dangerous and economically counterproductive inequality trends. The measures should include not only the revision of existing tools, but also the creation of new global institutions that would facilitate the development of a more socially balanced global community. Chapter Questions: 5 Distinguish globalization from internationalization. Which of the two phenomenon is older? Which is more complicated? 5 Which characteristics of globalization in ancient times could you outline? Do they fundamentally differ from the new version of globalization the world is experiencing now? 5 Compare the most widely used measures of globalization. Which of them produces the most adequate picture of countries’ integration on the global market? 5 Summarize the pros and cons of globalization. How do the gains and the controversies of globalization manifest themselves in your country of residence? 5 What is cultural protectionism? Do you feel it around? How does it differ from nationalism and national identity? 5 What critical challenges does globalization bring to the social sphere? What are the determinants of an efficient social policy in the new normal globalization? 21 Dollar and Kraay (2002).

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Subject Vocabulary: Anti-Globalism: a social movement directed against certain aspects of the contemporary globalization, such as the dominance of transnational corporations and international economic, trade, financial, and political organizations. Cultural Protectionism: a form of the new protectionism based on the attempts of the government, ruling elites, or social movements to promote national culture (national identity, traditions, language, cultural production) and limit the effects of foreign culture (global culture) on the domestic audience. Globalization: a process of changing the world space by transforming and unifying various spheres of the world economy, production, trade, and society and removing barriers for the unimpeded movement of goods, services, information, capital, and people. Internationalization: an action of becoming (domestic companies integrate in global value chains) or making something become (designing products or making services adaptable to enter foreign markets) international. KOF Globalization Index: a decomposable index, all elements of which are grouped equally in economic, social, and political dimensions. Monoethnism: an existence of an ethnos at least in relative isolation. Nationalism: the ideology of the nation-state, which stands for the sense of togetherness of people in terms of ethnic, religious, linguistic, territorial, and other unities. Regionalization: an intensification of intra-regional economic, trade, financial, social, and cultural interactions between countries to compensate for potential losses and disadvantages brought by globalization. Universal Basic Income: an amount sufficient to meet the basic needs unconditionally paid by the state to all citizens. Westernization: the adaptation or influence of western culture (global culture) among societies across the globe.

References Council of Europe. (1961). European Social Charter. 7 https://www.coe.int/en/web/european-social-charter Dollar, D., & Kraay, A. (2002). Spreading the wealth. Foreign Affairs, 81, 120–133. Firebaugh, G. (2014). The new geography of global income inequality. In D. Grusky (Ed.), Social stratification: Class, race, and gender in sociological perspective (pp. 1139–1150). Boulder, CO: Westview Press. Firebaugh, G., & Goesling, B. (2004). Accounting for the recent decline in global income inequality. American Journal of Sociology, 110(2), 283–312. Haelg, F. (2020). The KOF globalisation index—A multidimensional approach to globalisation. Jahrbücher für Nationalökonomie und Statistik, 240(5), 691–696. Kearney, A. T., & Policy, F. (2001). Measuring globalization. Foreign Policy, 122, 56–65. KOF Swiss Economic Institute. (2022). KOF Globalisation Index. 7 https://kof.ethz.ch/en/forecasts-and-indicators/indicators/kof-globalisation-index.html Lockwood, B., & Redoano, M. (2005). The CSGR globalisation index: An introductory guide. University of Warwick.

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Manylka, J., Bughin, J., Lund, S., Nottebohm, O., Poulter, D., Jauch, S., & Ramaswamy, S. (2014). Global flows in a digital age: How trade, finance, people, and data connect the world economy. McKinsey Global Institute. Milanović, B. (2012). Global income inequality by the numbers: In history and now (an overview). The World Bank. Mills, M. (2009). Globalization and inequality. European Sociological Review, 25(1), 1–8. Robertson, R. (1983). Interpreting globality. In World realities and international studies today (pp. 7–20). Pennsylvania Council on International Education. Rodrik, D. (1998). Why do more open economies have bigger governments? Journal of Political Economy, 106(5), 997–1032. Sala-i-Martin, X. (2006). The world distribution of income: Falling poverty and... convergence, period. The Quarterly Journal of Economics, 121(2), 351–397. United Nations. (1948). Universal Declaration of Human Rights. 7 https://www.un.org/en/about-us/ universal-declaration-of-human-rights United Nations. (1966). International Covenant on Economic, Social and Cultural Rights. 7 https:// www.ohchr.org/en/instruments-mechanisms/instruments/international-covenant-economic-socialand-cultural-rights United Nations. (1999). The United Nations Global Compact. 7 https://www.unglobalcompact.org/ Wade, R. H. (2004). Is globalization reducing poverty and inequality? World Development, 32(4), 567–589.

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Supplementary Information

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 V. Erokhin et al., Contemporary Macroeconomics, Springer Texts in Business and Economics, https://doi.org/10.1007/978-981-19-9542-2

892

Glossary

Glossary Absolute Advantage:  A country’s capacity to produce certain goods at the lowest cost compared to other countries. Absolute Poverty:   A condition where individuals’ or households’ income level is below the poverty line expressed through the cost of a minimum consumer basket corresponding to the minimum standard of living in a particular country. Accelerator Effect:   A change in sales of finished goods leads to a change in demand for inputs that are used in the production of those goods. Active Operations:   Banking operations for placing previously accumulated financial resources. Active Public Policy:   A set of legal, organizational, and economic measures carried out by the government in order to reduce unemployment in a country. Aggregate Demand:  The total amount of demand for all finished goods and services produced in an economy at any given price level in a given period. Aggregate Supply:  The total supply of goods and services produced within an economy at a given overall price in a given period. Agrarian Crisis:  A situation of overproduction of agricultural products and the accumulation of substantial unsold stocks. Anti-Globalism:  A social movement directed against certain aspects of the contemporary globalization, such as the dominance of transnational corporations and international economic, trade, financial, and political organizations. Anti-Inflationary Policy:  A set of tools for managing effective demand by adjusting money supply through monetary and fiscal measures. Appreciation:  A market-driven growth of the currency exchange rate under the floating exchange rate regime. Asset:  A resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit.

893 Glossary



Asymmetrical Information:  A market situation that occurs when one party to a market transaction possesses greater knowledge about the situation on the market or particular qualities of goods, services, firms, etc., than the other party. Automatic Fiscal Policy:  An automatic change in government spending and taxes in accordance with the changes taking place in the economy. Autonomous Consumption:  The expenditures that consumers must make when they receive no disposable income. Average Propensity to Consume:  The ratio of the part of disposable income spent on consumption to the total disposable income. B Balanced Growth:  A type of economic growth when growth rates of factors of production, technology, technical progress, and domestic product remain steady and inputs and output increase by the same proportional amount. Bank:  A financial and credit organization that has the exclusive right to attract funds, place them on its own behalf and for its account on conditions of maturity, repayment, serviceability, and purposefulness, and open and maintain bank accounts of legal entities and individuals. Bank Credit:  A credit provided by banks and other licensed credit and financial institutions to economic entities in the form of money and other monetary values. Banking Multiplier:  A mechanism for increasing money on deposit accounts of commercial banks during their movement between the clients’ accounts. Basic Macroeconomic Identity:  The equality between output and the sum of all planned expenditures, including consumer spending, business investment, government spending, and net exports. Biflation:  A simultaneous occurrence of inflation and deflation in the economy. Bimetallism:  A monetary system in which two or more metals or other materials coact as universal equivalents of value. Biocapacity:  Biologically productive areas and water areas located in a particular territory that can fully provide ecosystem services to people within this territory.

894 Glossary

Blue Economy:  A set of economic sectors and related activities that ensure sustainable use of all kinds of water resources and contribute to economic growth and social development, while improving the environmental sustainability of oceans, seas, inland waterways and resources, and coastal areas. Budget Policy:  A set of government regulations aimed at managing budget revenues, government expenditures, and the budget deficit. Built-in Stabilizer:  A measure that increases the public budget deficit during a recession and reduces it during a recovery automatically, without any special actions on the part of a government. Business Migration:  A migration of entrepreneurs in order to find better conditions for doing business. C Coase Theorem:  When bargaining costs are negligible, externalities can be internalized by establishing the government ownership of resources and allowing those rights to be freely exchanged on the market. Commercial Bank:  A credit organization that attracts and accumulates temporarily idle financial resources and grants loans for profit. Commercial Credit:  A type of credit granted by enterprises to each other in the form of deferral of payment for supplied goods, services, or other values. Commuting Migration:  A daily or weekly cross-border movements of people from places of residence to places of work. Comparative Advantage:  A country’s capacity to produce certain goods at lower opportunity costs compared to its trading partners. Compensation Fee:  A fee equal to the difference between the relatively low price of a good abroad and its relatively high price on the domestic market. Competition:  An economic rivalry on the market between producers for the right to get the maximum profit, as well between buyers for a greater benefit. Consumer Basket:  A set of basic consumer goods and services common for certain communities, territories, or countries.

895 Glossary



Consumer Credit:  A type of credit used by specialized credit organizations or other economic entities to finance individuals. Consumer Price Index:  A weighted average of prices of a basket of consumer goods and services. Contractionary Fiscal Policy:  A type of fiscal policy aimed at restricting money supply by cutting government expenditures, raising tax rates, and introducing new taxes. Contractionary Monetary Policy:  A type of monetary policy aimed at restricting money supply by limiting credit, toughening bank reserve requirements, increasing interest rates, tightening foreign exchange control, and decelerating money velocity. Corrective Subsidy:  A subsidy granted to economic entities that generate positive externalities to bring marginal private benefits closer to marginal social benefits. Corrective Tax:  A tax on the output of goods that generate negative externalities imposed to equalize the marginal private costs and marginal social costs. Cost:  Expenses incurred in a production process, the cost of resources and factors of production in a monetary form. Country-Based Theories:  Theories of international trade that focus on studying imports and exports of standardized and undifferentiated goods for a country or a group of countries. Creative Destruction:  A permanent improvement of the economy through the introduction of new technologies, due to which obsolete and unprofitable companies or entire industries are displaced from the market and resources are redistributed in favor of more efficient new companies and industries. Credit:  A system of economic relations arising from the mobilization of temporarily available funds and lending them on conditions of maturity, repayment, serviceability, security, and purposefulness. Credit Money:  A form of money that implies exchange on credit. Credit System:  A network of credit and financial institutions serving the entire sphere of credit relations. Crowding Out Effect:  A situation in the economy when rising government spending drives down or even eliminates investment expenditures and private sector spending.

896 Glossary

Cultural Protectionism:  A form of the new protectionism based on the attempts of the government, ruling elites, or social movements to promote national culture (national identity, traditions, language, cultural production) and limit the effects of foreign culture (global culture) on the domestic audience. Currency:  A way national monetary units operate to mediate international trade, economic, and financial activities through exchanging monetary units of different countries in established proportions. Currency Restrictions:  A set of administrative, economic, and organizational regulations of foreign exchange introduced at the national and international levels. Currency Risk:  A risk associated with changes in the exchange rate in the period between the contract date and the delivery (payment) date. Customs Tariff:  A systematized list of customs duty rates, i.e., taxes on import or export of goods at the time they cross the customs border of a country or a customs union. Cyclical Unemployment:  A type of unemployment that implies repeated deviations of the actual unemployment rate from the natural one. Cyclicity:  A form of economic development when the market transitions from one macroeconomic equilibrium to another. D Deflation:  An increase in the purchasing power of a currency manifested in a reduction of prices due to the rising value of money or undersupply of money in circulation. Deflationary Gap:  A gap between the current amount of demand and the amount of demand expected by producers. Demand:  A form of expression of a need measured by the amount of money that consumers are willing to pay for the goods and services they need. Demand Price:  The maximum price that consumers agree to pay for a certain quantity of a given product or service. Demand-Pull Inflation:  A type of inflation generated by excessive growth of aggregate demand compared to aggregate supply.

897 Glossary



Demonetization:  A withdrawal of gold from circulation and the cessation of the functions of money. Depreciation:  A market-driven decline of the currency exchange rate under the floating exchange rate regime. Deprivation:  A social process of reduction and/or deprivation of opportunities to meet the basic needs of an individual. Devaluation:  An administered depreciation of the currency exchange rate by a central bank under a fixed exchange rate regime. Discretionary Fiscal Policy:  A targeted regulation of public expenditures and taxation in order to affect the macroeconomic equilibrium. E Ecological Footprint:  A biologically productive land and water area required to produce and restore the resources consumed by people and absorb waste produced by people. Economic Cycle:  A transition of the economy from one state of macroeconomic equilibrium to another. Economic Development:  A transition of the economy from one state to another qualitatively new state due to structural and institutional shifts. Economic Growth:  An increase in the total and/or per capita value of real GDP/ GNP. Economic Hysteresis:  A situation in the labor market when unemployment caused by past disruptions tends to persist even after these disruptions have been eliminated. Economic Inequality:  A difference between individuals and social groups in the level of income, wealth, and standard of living. Economic Reproduction:  Recurrent (or cyclical) processes by which the initial conditions necessary for economic activity to occur are constantly re-created. Economic Surplus:  A mass of resources that society could have at its disposal to facilitate economic growth.

898 Glossary

Economies of Scale:  A reduction of production costs that is a result of making and selling goods in large quantities. Economies of Scale Theory:  Countries with similar factor endowment benefit from foreign trade when specializing in those industries in which economies of scale occur. Elasticity:  A measure of how sensitive a quantity supplied or a quantity demanded is to the change in price or income. Emigration:  An outflow of people from a country. Emission:  The issue of money, which results in an overall increase in the money quantity. Exchange Rate:  A price of a country’s monetary unit expressed in monetary units of other countries Exchange Value:  An ability of a commodity to be exchanged in certain proportions for other commodities. Expanded Reproduction:  A permanent increase in the quantity and quality of goods. Expansionary Fiscal Policy:  A type of fiscal policy aimed at boosting money supply by increasing government expenditures or cutting tax revenues. Expansionary Monetary Policy:  A type of monetary policy aimed at boosting money supply by stimulating credit, relaxing bank reserve requirements, decreasing interest rates, liberalizing foreign exchange control, and accelerating money velocity. Expected Years of Schooling:  A number of years of schooling that a child of school entrance age can expect to receive if prevailing patterns of age-specific enrolment rates persist throughout the child’s life. Export Subsidy:  A monetary or non-monetary benefit provided to domestic businesses to stimulate exports and increase the competitiveness of domestic products in foreign markets. Extensive Growth:  An increase in GDP due to the attraction of additional factors of production and resources while not changing technologies.

899 Glossary



External Debt:  A part of the total debt of economic entities in a country attributable to foreign creditors (international organizations, countries, or private capital). External Environment:  A set of exogenous factors that affect activities of an economic entity (consumers, competitors, suppliers, intermediaries, economic, social, and political situation in the country, the level of science and culture). Externality:  A cost of individuals or society not reflected in price (negative externality) or a benefit enjoyed by economic entities not involved in the transaction (positive externality). Extra Charges:  Administrative, customs clearance, and stamp duties applied in cases where import duties can not be implemented or where multilaterally agreed import duties are too low to protect the domestic market. F Factor-Intensity Reversal:  A situation in which the same good can be capital-intensive in a capital-abundant country and labor-intensive in a labor-abundant country. Finance:  A system of economic relations arising in the process of formation, distribution, and use of financial resources in order to ensure economic reproduction and meet the needs of society. Financial Crisis:  A sharp decline in the value of financial instruments. Financial Policy:  A set of government policies aimed at mobilizing, distributing, and using financial resources on the basis of the financial legislation of a country. Financial System:  A set of financial relations on the formation, distribution, and use of centralized and decentralized financial resources. Firm:  A macroeconomic entity, which represents the aggregation of all firms and enterprises operating within a country or in the global market. Firm-Based Theories:  Theories of international trade that capture firm-level determinants of international exchange. Fiscal Policy:  A set of government regulations aimed at establishing the rules for the withdrawal of taxes and spending of public funds.

900 Glossary

Fiscal System:  A set of principles, forms, and methods of establishing, changing, collecting, and abolishing taxes in accordance with the national legislation. Flow:  A transfer of values by economic actors to each other in the process of economic activity; the creation, transformation, exchange, transfer, or extinction of economic value that involve changes in the volume, composition, or value of assets and liabilities. Forced Migration:  A removal or deportation of people from a country based on a decision of the judiciary, police, or other authorities. Foreign Direct Investment:  An acquisition of a long-term interest by a resident of one country (direct investor) in a resident asset of another country (an enterprise with direct investments). Foreign Exchange Market:  The sphere of economic relations that accommodates purchasing and selling of currencies and investment of foreign exchange capital. Foreign Portfolio Investment:  An investment in the form of a group of assets (portfolio), including operations with equity and debt securities. Foreign Public Debt:  A debt of a government to foreign countries, foreign banks, and international organizations. Foreign Sector:  The totality of all economic entities that have a permanent location outside a country; a macroeconomic entity through which the economic communication of all countries is carried out. Foreign Trade Policy:  An element of public economic policy aimed at regulating export and import of goods and services by using customs duties and tariffs, non-tariff regulations, and financial transactions related to foreign trade. Free-Rider Problem:  A situation when people benefit from a public good/service without paying for it. Free Trade:  A type of foreign trade policy that assumes reducing or eliminating trade barriers, such as export and import duties, quotas, subsidies, and other tariff and non-tariff regulations. Frictional Unemployment:  A predominantly short-term voluntary unemployment that arises due to discrepancies between the number of employees and vacant jobs. Full Employment:  A situation on the labor market when the number of jobs available in the economy corresponds to the number of people looking for work.

901 Glossary



Full-Fledged Money:  A money made from a material that has the same value both in circulation in a form of money and in accumulation in a form of wealth. G Global Hectare:  A conventional unit denoting a hectare of biologically productive territory or water area with a world’s average level of biological productivity for a given year. Globalization:  A process of changing the world space by transforming and unifying various spheres of the world economy, production, trade, and society and removing barriers for the unimpeded movement of goods, services, information, capital, and people. Golden Age:  A situation of full employment, when wages grow proportionally to productivity, profit remains stable, the government does not interfere the market, and expectations and the propensity to save both correspond to the growth in output. Golden Rule of Capital Accumulation:  An equilibrium at which both consumption and output reach their maximums. Government Budget:  An annual plan of public expenditures and sources of financial resources to cover these expenditures. Government Credit:  A credit in which the government acts as one of the parties in the person of executive authorities at the central, territorial, or municipal levels. Government Failure:  A situation where the state cannot ensure the efficient allocation and use of public resources. Government Multiplier:  The ratio of GDP growth to the increase in government spending. Government Regulation of the Economy:  A purposeful impact of the government on the economy through a system of legislative, executive, and control measures in order to increase the efficiency of certain market processes. Gravity Model:  The volume of trade between countries is directly proportional to their size and inversely proportional to the distance between economic centers of trading countries.

902 Glossary

Green Growth:  A growth that stimulates economic development, while ensuring the preservation of natural assets and sustainable use of resources and ecosystem services. Gross Domestic Product:  An aggregate economic indicator that expresses in market prices the total value of goods and services produced within a country, and only using the factors of production of a given country. Gross Domestic Product Deflator:  A measure of the level of prices of all new, domestically produced, final goods and services in an economy in a year. Gross Domestic Product Gap:  The ratio of the difference between actual GDP and potential GDP to potential GDP. Gross National Income:  The total amount of money earned by a nation’s people and businesses, including investment income, regardless of where it was earned, and money received from abroad such as foreign investment and economic development aid. Gross National Product:  A market value of goods and services intended for final consumption, produced during a year with the help of production factors belonging to a given country. H Health Capital:  An investment in an individual made in order to maintain and improve health and performance. Health Potential:  An individual’s ability to achieve the best possible health status with allowances made for individual psychosomatic qualities, physiological properties, lifestyle, and investment in health. Heckscher-Ohlin Theorem:  The relative factor endowment is determined by the degree of availability in comparison to other factors of production, not the physical amount of available factors of production. Heckscher-Ohlin-Samuelson Theorem:  The international exchange of goods and services bridges the differences in prices not only for traded goods, but also for factors of production. Household:  One person living alone or a group of people who live together or share living arrangements in a house or a flat; a typical individual macroeconomic entity, whose activities are aimed at meeting their own needs.

903 Glossary



Human Capital:  a set of knowledge, skills, competencies, and abilities used to meet the diverse needs of an individual and society as a whole while making a profit and ensuring economic reproduction. Human Development Index:  A combined indicator of human development built on four human capital metrics, such as life expectancy at birth, expected years of schooling, average years of schooling, and GNI per capita. I Immigration:  An inflow of people into a country. Imperfect Competition:  A market in which at least one of the assumptions of perfect competition is not met. Import Deposit:  A contribution to a special account in a certain proportion to the value of imports. Inequality-Adjusted Human Development Index:  A human development index value adjusted for inequalities in three dimensions of human development, such as decent standard of living, a long and healthy life, and access to knowledge. Inflation:  An excessive growth of money supply (aggregate demand) in comparison with the aggregate supply of goods and services, which results in the depreciation of money and a long-term increase in commodity prices. Inflation Inertia:  A situation where economic entities get used to the permanent increase in prices and expect them in the future based on their past experience. Inflationary Gap:  A situation in which the equilibrium volume of output is above the potential level; a gap between the potential amount of demand and the amount of demand that can be met at a certain point in time. Inflationary Spiral:  A process of interdependent growth in prices and wages, in which an increase in prices calls forth a compensatory rise in wages, and the latter triggers a new rise in prices. Innovation:  An outcome of innovative activity embodied in the form of a new or improved product on the market, a new or enhanced technological process or equipment, or a new approach to rendering services. Innovation-Driven Economic Growth:  An increase in the gross domestic output and wealth through the continuing introduction of innovations in all spheres of economic activity.

904 Glossary

Innovation Process:  A sequential chain of events during which an innovation matures from an idea to a product, technology, or service and spreads through its practical use. Innovative Pessimism:  A denial of the pivotal role of technologies in economic development and the interpretation of technology as the cause of depersonalization and the decline in the role of individuals in ensuring economic growth. Institutional Development:  A creation or strengthening of a network of real institutions to generate, distribute, and use labor, material, and financial resources in order to affect abstract institutions. Institutionalism:  The school of economic thought that studies the economic reactions of individuals on the evolution of social and economic institutions, including behavioral patterns, perceptions, habits, traditions, and ethical norms. Integration Migration:  A migration between member countries that establish an integration association that allows trans-border movement of people. Integration Organization:  An economic grouping created to regulate integration processes between its members. Intensive Growth:  An increase in GDP due to the use of more efficient and qualitatively advanced factors of production. Interbank Credit:  A type of credit provided by banks to each other when some banks have surplus funds, while others lack them. Interest Rate:  A price of money as a means of saving reflected by the relative value of interest payments on loan capital over a certain period of time; a ratio of the annual income received on the loan capital to the amount of the loan provided, expressed as a percentage. Internal Environment:  An environment that determines technical and organizational conditions of an economic entity and that is the result of management decisions (resources, organizational and management structure of a firm, technologies, information). Internal Migration:  A migration that occurs within a country or a territory. Internal Public Debt:  A debt of the government to the economic entities and residents of a country established due to borrowing money on the domestic market to cover the budget deficit.

905 Glossary



Internalization of Expenditures:  A turning of external environmental costs into individual internal costs. International Borrowing and Lending:  The issuance and receipt of funds to/from foreign lenders with interest payment for the use of these funds for an agreed period of time. International Capital Flows:  The movement of value in monetary and/or commodity form from one country to generate higher profits in a recipient country, or the counter-movement of capital between countries. International Credit:  A set of credit relations in which the state acts as a borrower or a lender, or one country lends to or borrows from another country. International Economic Integration:  A process of merging national economies into a single economic complex based on deep and stable economic, trade, financial, and other ties. International Economic Organization:  An organization created on the basis of an international agreement or by a decision of an existing international organization for the purpose of analyzing, discussing, and resolving various issues of the international economic, trade, financial, or social agenda. International Migration:  A migration that occurs between countries. International Migration of Labor:  A resettlement of the employable population from one country (territory) to another for an extended period of time (over a year) due to economic or non-economic reasons. International Product Life Cycle Theory:  The development of international trade in finished goods is associated with the stages of the product life cycle: new product, mature product, and standardized product. Internationalization:  An action of becoming (domestic companies integrate in global value chains) or making something become (designing products or making services adaptable to enter foreign markets) international. Intertemporal International Trade:  An exchange of goods and services today for those in the future. Intra-Industry Trade:  An international exchange of goods and services within one industry.

906 Glossary

Investment:  A profit-oriented injection of capital or other resources or property in the creation of new value or the replacement of worn-out production facilities or factors of production on the domestic market or abroad. Investments in Human Capital:  Investments in education, training and developing individual skills and competencies, and maintaining health. Irregular Migration:  An illegal or unreported movement of people between countries. Issue of Money:  An injection of money into circulation in the form of the transfer of certain amounts of money in cash and non-cash forms from banks to economic entities. J Johnson’s Theorem:  A change in external factors of trade leads to a disproportionate increase in internal factors of trade. Juglar Fixed-Investment Cycle:  A medium-term economic cycle (7-12 years) caused by changes in capacity utilization coincided with fluctuations in investment in fixed assets. K Keynesian Cross:  The model where the equilibrium is achieved when expenditures (aggregate demand) equalize real output (aggregate supply). Kitchin Inventory Cycle:  The short-term economic cycle (2-4 years) caused by time lags in the movement of information that affect the decision-making of economic agents. Knowledge Economy:  An economy where the intellectual component outweighs conventional material factors of production and resources. KOF Globalization Index:  A decomposable index, all elements of which are grouped equally in economic, social, and political dimensions. Kondratiev Cycle:  A long-term economic wave (45-60 years) caused by technology life cycles and radical shifts in technology paradigm. Kuznets Infrastructural Investment Cycle:  A long-term economic cycle (15-20 years) caused by demographic processes and changes in mobility of labor.

907 Glossary



L Labor Market:  A system of economic mechanisms, institutions, and regulations that facilitate the use and reproduction of labor. Labor Migration:  A movement of people between countries in search of employment, higher remuneration for their labor, or career development. Law of Increasing Opportunity Cost:  With an increase in the output of one good, the production of each additional unit of this good requires the rejection of more and more units of another good (that is, the opportunity cost of producing each additional unit increases). Legal Monopoly:  A situation on the market when the state empowers certain companies or individuals to serve as exclusive producers, suppliers, or buyers of certain goods or services. Lending Rate:  A payment received by a lender from a borrower as a result of the transfer of loaned funds for temporary use. Leontief Paradox:  Capital-intensive economies export labor-intensive goods and import capital-intensive ones. License:  An export or import permit issued by authorized organizations and administrative bodies. Life Cycle of Innovation:  A period that starts with the implementation of fundamental and applied research and ends with replacing equipment or technology by qualitatively new, more efficient innovative solutions. Life Expectancy at Birth:  A number of years a newborn infant could expect to live if prevailing patterns of age-specific mortality rates at the time of birth stay the same throughout the infant’s life. Liquidity:  The ability of material assets to turn into money and perform the functions of money. Liquidity Trap:  A situation, which occurs when the interest rate is so low that any increase in the supply of money ends up in speculative transactions without affecting either the interest rate or national income.

908 Glossary

M Macroeconomic Equilibrium:  A state of the economy when both the use of scarce resources and their distribution among economic actors are balanced. Macroeconomic Policy:  A regulation of the behavior of macroeconomic agents in the market to ensure and maintain stable macroeconomic equilibrium and growth of the national economy. Macroeconomics:  A branch of economics that studies the economic behavior of aggregate economic actors (sectors of the economy) in aggregated markets and considers economic issues that affect the entire economy (not individual industries) and society as a whole. Marginal Efficiency of Investment:  The interest rate at which the estimated value of income from investment (the expected rate of return) is equal to the current value of the investment. Marginal Propensity to Consume:  The ratio of the increase in disposable income that goes to consumption to the increase in that income. Marginal Propensity to Invest:  A measure of change in investment depending on the change in the difference between marginal efficiency of investment and interest rate. Market:  A system of economic interactions between economic entities, directly or through middlemen, which is based on the exchange of goods and services. Market Concentration:  A role of certain companies and their individual shares of the total production in a particular market. Market Equilibrium:  A situation on the market when supply and demand balance each other and market supply of goods or services matches the demand for these goods or services. Market Failure:  A situation when the market mechanism fails to arrange and coordinate economic processes in such a way as to ensure the efficient use of all available resources at the level of full employment. Market Price (Equilibrium Price):  A price that satisfies both producers and consumers, when the quantity of goods or services consumers intend to buy is equal to that producers intend to supply.

909 Glossary



Market Segment:  A part of the market, a group of consumers of products or enterprises that are formed on the basis of certain common characteristics or criteria. Market Structure:  A set of interrelated qualitative and quantitative interactions between separate market elements, which characterizes stable certainty of the market and ensures its operation. Mercantilism:  An international trade pattern in which a country seeks to become wealthier by increasing exports and restricting imports. Microeconomics:  A branch of economics that studies the implications of economic behavior of individual economic actors in the markets of certain goods, services, and factors of production in various types of market structures. Minimum Wage:  A statutory minimum wage, which commonly corresponds to the subsistence minimum. Model of Heterogeneous Firms:  The development of international trade is the cumulative effect of individual decisions of individual firms different in size and productivity. Monetary Aggregate:  An element of a certain group of liquid assets that refers to the particular volume and structure of the money supply. Monetary (Banking) Crisis:  A situation when banks face a sudden withdrawal of deposits by depositors. Monetary Policy:  A set of public measures aimed at regulating the monetary system and the loan market in order to achieve certain macroeconomic goals. Monetary System:  A set of all forms and methods of money emission, money circulation, and money exchange historically emerged in a country and legally established by the government. Money:  A commodity used as a universal equivalent of the value of all other goods. Money Circulation:  The movement of money in cash and non-cash forms in the process of serving the exchange of goods and services and other settlements in the economy.

910 Glossary

Money Market:  A market in which an equilibrium value of the money quantity and an equilibrium interest rate are established as a result of the interaction of demand for money and money supply. Money Quantity:  A sum of all funds in cash and non-cash forms in the economy. Money Sterilization Policy:  A type of monetary policy through which a central bank offsets a rise in net foreign assets by reducing net domestic equity, thereby keeping the money supply within an economy constant. Money Velocity:  A number of transactions that money serves during a period of time. Monoethnism:  An existence of an ethnos at least in relative isolation. Monometallism:  A monetary system founded on one monetary commodity. Monopolistic Competition:  A market structure in which the features of perfect competition coexist with certain elements of a pure monopoly. Monopoly:  A situation on the market when a single company controls the whole supply on a certain market with its product offerings that have no substitutes. Monopoly Power:  An ability of a firm to influence prices and profits by manipulating its output and sales. Monopsony:  A situation on a market in which there is only one buyer and many sellers. Mortgage Credit:  A long-term credit secured by real estate granted by banks or specialized financial and credit institutions for the purchase or construction of housing or the purchase of land. Multiplier:  An economic factor that shows how the increase or change in aggregate demand affects the equilibrium income. N National Wealth:  The total value of all of the money, investments, goods, and property held in a country at a particular time. Nationalism:  The ideology of the nation-state, which stands for the sense of togetherness of people in terms of ethnic, religious, linguistic, territorial, and other unities.

911 Glossary

Natural Capital:  A natural resources pool, including minerals, water, land, air, flora and fauna, and all living matter and ecosystems. Natural Growth:  A type of economic growth when the growth rate is equal to the sum of growth rates of labor supply and labor productivity. Natural Monopoly:  A market situation where a minimum of average production costs is achieved when only one firm supplies a given product or service. Natural Unemployment:  An equilibrium in the labor market established under the combined influence of factors raising and lowering wages, demand for labor, and supply of labor. Neocolonialism:  A socioeconomic system of elements connected by social, economic, and political relations between developed and developing countries. New Normal Protectionism:  A proactive government policy expressed in a set of measures aimed at protecting national economic and business interests not only within the domestic market, but also on foreign markets and global value chains. Nominal Exchange Rate:  A direct expression of one currency’s price through the price of another currency. Non-Excludability:  A feature of public goods that means no one can be forbidden from consuming a public good, even if one refuses to pay for it. Non-Rivalry:  A feature of public goods that means that consumption of a public good by one person does not diminish the ability of others to get the same amount of the same good. Non-Tariff Trade Regulations:  Foreign trade policy tools other than customs tariffs and duties, including direct restriction of imports in order to protect certain domestic industries or sectors and administrative measures not directly aimed at restricting foreign trade. O Okun’s Law:  The law that establishes the relationship between the GDP lag and the level of cyclical unemployment (unemployment rises in times of economic downturn and decreases in times of economic revival). Oligopoly:  A market in which a relatively small number of sellers serve many buyers.



912 Glossary

Oligopsony:  A market for a product or service which is dominated by a few large buyers. Opportunity Cost:  The value of one good, expressed in the value of another good, the production of which must be reduced in order to free up resources required to produce one more unit of the first good. Optimum Tariff:  A tariff that ensures the achievement of the maximum economic welfare of a given country, while not further increasing its net benefit from taxing imports. Organized Migration:  A migration carried out by authorized firms or organizations in accordance with national or international legislation. Quantity Demanded:  The total quantity of goods or services that consumers want and can purchase on the market at a given price at a given time. Quantity Supplied:  The total quantity of goods or services that producers or sellers want and can sell on the market at a given price at a given time. P Paper Money:  Banknotes of certain face value issued by the state to cover public expenditures. Pareto Optimality:  An equilibrium point at which an increase in welfare of one party is impossible without reducing the welfare of another party. Passive Operations:  Banking operations for establishing bank liabilities. Passive Public Policy:  A support for the unemployed in the form of unemployment benefits, material assistance, and other social payments. Perfect Competition:  A type of market structure where there is an extensive number of producers and consumers competing with one another, who all have full and symmetric information about the market. Permanent Migration:  A departure of people abroad for permanent residence. Phillips Curve:  An inverse relationship between inflation and unemployment. Pigouvian Tax:  An output tax that raises individual costs of businesses engaged in creating negative externalities to the maximum permissible level of social costs.

913 Glossary



Poverty:  A socially induced inability to get access to the goods, services, and utilities people require (material, social, and cultural) and the inability to comply with certain standards of living and consumption patterns. Price Index:  A ratio of price in the current year to price in the base year. Producer Price Index:  A measure that takes the number of goods and services produced in the current year as price weights. Production Possibility Frontier:  A maximum amount of goods and services an economic entity (the economy as a whole) is able to produce with full and efficient use of all available resources and the current level of technology. Profit:  The difference between the total revenue from the sale of goods or services and the total costs of the production and sale of goods or services. Protectionism:  A government policy that implies establishing trade barriers to protect domestic producers from foreign competition; a type of foreign trade policy aimed at supporting the domestic production of goods and services and restricting foreign competition and imports by introducing tariff and non-tariff barriers Public Debt:  A sum of the budget deficits accumulated by the government during a certain period of time. Public Good:  A good that is non-excludable from consumption (consumers who do not want to pay for such goods cannot be deprived of the possibility of consuming them) and does not reduce the amount available for others when consumed (non-rivalry characteristic). Public Procurement:  An expense of the state for the maintenance of public administration bodies, the carrying out of state orders for the industry, the production of public goods. Purchasing Power Parity:  An exchange rate that equalizes purchasing powers of national and foreign currencies. Q Quality of Life:  A set of characteristics reflecting the material, physical, social, and cultural wellbeing. Quota:  A restriction in monetary or physical terms imposed on the import or export of goods during a certain period of time.

914 Glossary

R

Ratchet Effect:  A situation when prices do not respond to a decrease in aggregate demand. Rate of Unemployment:  The ratio of the number of unemployed people to the total labor force expressed as a percentage. Rational Behavior:  A decision-making process that is based on making choices that result in the optimal level of benefit or utility for an economic entity. Real Exchange Rate:  A ratio in which domestic goods can be exchanged for foreign goods calculated based on the correlation of the nominal exchange rate and the change in the price levels in the trading countries. Recessionary Gap:  A situation when aggregate expenditure is insufficient to achieve output at full employment. Reemigration:  A return of emigrants to their home countries. Refugees:  People forced to emigrate from their countries due to threats to their lives, activities, freedoms, or rights. Regionalization:  An intensification of intra-regional economic, trade, financial, social, and cultural interactions between countries to compensate for potential losses and disadvantages brought by globalization. Relative Poverty:  A condition where individuals’ or households’ income level is below the poverty threshold that corresponds to a fixed share of average income. Repatriation:  A return of immigrants to their countries of origin. Revaluation:  An administered appreciation of the currency exchange rate by a central bank under a fixed exchange rate regime. Revenue:  The amount of money that a company earns by selling products or services at market prices during a period of time. Rybczynski Theorem:  An increase in the supply of an input results in an increase in output and export in industries that most intensively use this input and a simultaneous decrease in output and export in industries that least intensively use this input.

915 Glossary



S Samuelson-Jones Theorem:  Differences in production costs due to different factor endowments of trading countries result in the growth of return on those factors that are specifically employed in export-oriented industries. Say’s Law:  The law that says that production generates income exactly equal to the value of output, i.e., supply generates its own demand. Seasonal Migration:  A migration to a foreign country in a certain period of a year and for a certain period of time. Seasonal Unemployment:  A type of unemployment caused by seasonal fluctuations in demand for labor in certain industries. Simple Reproduction:  A steady production with no qualitative or quantitative changes. Situational Monopoly:  A market situation in which a firm obtains exclusive access to resources or facilities critical to producing certain goods, for which this firm establishes a monopoly. Social Insurance:  A system of cash benefits organized on the basis of mandatory special contributions, which ensure the establishment and redistribution of trust funds to protect the property interests of individuals and legal entities and compensate them for damage in case of adverse events. Social Justice:  A correspondence of economic relations (i.e., distribution of wealth and income in a country) to the needs and interests of a given society. Social Policy:  An activity of the state in managing social processes, ensuring material and cultural needs, regulating social and economic differentiation, and allowing each member of society to realize their social and economic rights vital for the optimal reproduction and development. Social Protection:  A system of measures aimed at preventing, reducing, or eliminating the consequences of social risks by ensuring a decent standard and quality of life. Social Stability:  A situation when society maintains stable standards of living, fundamental rights of people, and uninterrupted access to major goods, services, and other tangible and intangible values.

916 Glossary

Spatial Theory of Trade:  International trade arises when regions specializing in producing intermediate goods and those manufacturing finished products are located in different countries. Special Technical Requirements:  Non-trade regulations such as public health issues and environmental protection used to indirectly restrict or stimulate trade flows. Stabilization Policy:  A set of macroeconomic policy measures aimed at stabilizing the economy at the level of full employment of all factors of production, i.e., the level of potential output. Stagflation:  A situation in the economy when production stagnates or falls amid rising unemployment and a continuous increase in prices. State:  A macroeconomic entity that acts simultaneously as an entrepreneur through managing public-owned assets, as a consumer through placing orders and public procurements on the market, and as a regulator through establishing the rules and carrying out economic, trade, monetary, fiscal, and social policies. Steady-State Growth:  An even and proportional economic growth when major macroeconomic parameters remain unchanged. Stock Market Crisis:  A sharp drop in securities prices due to the excessive supply of securities. Stolper-Samuelson Theorem:  An increase in the price of a good due to international trade results in an increase in return on the factor most intensively used in producing this good. Structural Crisis:  A long-term non-cyclical phenomenon expressed in the decline of individual industries or groups of industries (sectors) of the economy that violates the key macroeconomic proportions. Structural Unemployment:  A type of unemployment that occurs when a surplus of labor in one sector coexists with a shortage of labor in another. Structuralism:  The school of economic thought that studies global economic structures, barriers to development, and market imbalances. Subjective Poverty:  A financial situation of individuals and households according to their own estimates.

917 Glossary



Subsistence Minimum:  A physiological minimum of consumption, i.e., a minimum set of benefits that guarantees the satisfaction of basic needs. Supply:  The amount of goods or services that a producer (seller) offers on the market or can supply on the market, depending on the prices of these goods or services and other factors. Supply Price:  The minimum price at which a producer agrees to sell a certain quantity of a given product or service. Supply-Push Inflation:  A type of inflation driven by a rise in production costs in the conditions of underutilization of factors of production Supranational Organization:  An organization, in which member countries cede authority and sovereignty on at least some internal matters to the group, whose decisions are binding on its members. Surplus Value:  A difference between total value added in the production process and the cost of labor. Sustainable Development:  A development that meets the needs of the present without compromising the ability of future generations to meet their own needs; a set of measures aimed at meeting the current needs of the present generation while preserving the environment and natural resources to ensure the ability of future generations to meet their own needs. Sustainable Development Bond:  A debt instrument used exclusively to finance or refinance sustainable development programs, social projects, or a combination of environmental and economic projects in the green or blue economy or related sectors. Sustainable Development Goals:  A universal United Nations’ call to action to end poverty, protect the planet, and improve the lives and prospects of everyone, everywhere. Sustainable Development Model:  A type of the civilization development model based on the synchronous ensurance of economic efficiency and economic security, social justice and social security, and environmental security and co-evolutionary development. Sustainable Economic Development:  A type of economic development that provides balanced forward-oriented solutions to present economic and social problems and

918 Glossary

ensures the preservation of the country’s environmental and natural resource potential in order to meet the vital needs of present and future generations. Sustainable Growth:  An economic growth aimed at full satisfaction of the growing needs of the present generation without compromising the needs of future generations. T Targeting:  An approach to anti-inflation regulation which implies restraining the growth of money supply within a predetermined threshold. Tax:  A mandatory fee or payment levied by the state from legal entities and individuals in the amounts determined by the law and within the established period of time. Technological Gap Theory:  Trade in novel products grows regardless of factor endowments in individual countries due to technological gaps between countries. Technological Trend:  A relevant and potentially promising direction for the development of technology in any field (either a unique development venue within the traditional sector or a completely new technology that creates its own sector). Technology:  A set or a system of algorithmically or procedurally organized influences on an object or resource in order to obtain desired (expected) result. Temporary Migration:  A migration of people of active working age to get a job in another country for a certain period of time. Theory of Competitive Advantage:  The involvement of countries and individual firms in global value chains is determined by the quantity and quality of factors of production, demand in the domestic market, the availability of related and supported industries, and the firm's strategy and competition. Theory of Incomplete Contracts:  Trade in intermediate products depends on the production of and demand for final goods. Theory of Overlapping Demand:  A good can be exported only when demand for this good on the domestic market is fully met.

919 Glossary



Theory of Technological Progress:  International trade is facilitated by different combinations of labor and capital as factors of production through neutral, labor-saving, and capital-saving types of technological progress. Token Money:  A form of money whose intrinsic value does not exceed its face value set by the issuing body or accepted by people. Transfer:  A non-reciprocal irrevocable payment made by the state to address economic, social, or other issues. Transnational Corporation:  A company that organizes cross-border value chains with the use of foreign direct investment, produces goods or renders services internationally, and carries out income and asset management in more than one country.

U Unemployment:  A social and economic phenomenon consisting in the fact that a certain part of the population in active working age does not have a job and, accordingly, income (those who want to work cannot find work at an adequate wage rate). Unemployment Gap:  The difference between the potential gross product at full employment (or natural equilibrium unemployment rate) and the actual gross product at cyclical unemployment. Universal Basic Income:  An amount sufficient to meet the basic needs unconditionally paid by the state to all citizens. Use Value:  A value that expresses the utility of a commodity, i.e., the ability to satisfy needs as an object of consumption or a means of production.

V Voluntary Migration:  A non-forced resettlement of people.

W Warranted Growth:  A type of growth that guarantees the full use of existing production capacities (capital). Welfare:  A social and economic category that reflects the overall level of an individual’s capabilities used to implement a life strategy and meet the full range of needs.

920 Glossary

Wellbeing:  An overall performance parameter of the social sphere, which aggregates the measures of public welfare, quality of life, and social security. Westernization:  An adaptation or influence of western culture (global culture) among societies across the globe. Wholesale Price Index:  A ratio of the price of a set of goods produced in the current year to its price in the base year.

921

Further Reading Akhtaruzzaman, M. (2019). International capital flows and the Lucas paradox: Patterns, determinants, and debates. Springer Nature. Alary, P., Blanc, J., Desmedt, L., & Theret, B. (Eds.). (2020). Institutionalist theories of money: An anthology of the French school. Palgrave Macmillan. Alexander, S., Chandrashekeran, S., & Gleeson, B. (Eds.). (2022). Post-capitalist futures: Paradigms, politics, and prospects. Palgrave Macmillan. Ali, H., & Cederman, L. E. (Eds.). (2022). Natural resources, inequality and conflict. Palgrave Macmillan. Ali, M. S. B. (Ed.). (2022). Key challenges and policy reforms in the MENA region: An economic perspective. Springer Nature. Andreosso-O’Callaghan, B., Rey, S., & Taylor, R. (Eds.). (2022). Sustainable development in Asia: Socioeconomic, financial, and economic perspectives. Springer Nature. Andreucci, M. B., Marvuglia, A., Baltov, M., & Hansen, P. (Eds.). (2021). Rethinking sustainability towards a regenerative economy. Springer Nature. Angeles, L. (2022). Money matters: How money and banks evolved, and why we have financial crises. Palgrave Macmillan. Antoniades, A., Antonarakis, A., & Kempf, I. (Eds.). (2022). Financial crises, poverty and environmental sustainability: Challenges in the context of the SDGs and Covid-19 recovery. Springer Nature. Aquino, Jr., P., & Jalagat, Jr., R. (Eds.). (2022). Effective public administration strategies for global “New Normal”. Springer Nature. Arestis, P. (Ed.). (2018). Alternative approaches in macroeconomics: Essays in honour of John McCombie. Palgrave Macmillan. Arestis, P., & Sawyer, M. (2017). Economic policies since the global financial crisis. Springer. Arestis, P., & Sawyer, M. (Eds.). (2019). Frontiers of heterodox macroeconomics. Springer. Arestis, P., & Sawyer, M. (Eds.). (2022). Economic policies for sustainability and resilience. Palgrave Macmillan. Arnold, R. (2018). Macroeconomics. Cengage Learning. Arnon, A. (2022). Debates in macroeconomics from the great depression to the long recession: Cycles, crises and policy responses. Springer. Arnon, A., Marcuzzo, M. C., & Rosselli, A. (Eds.). (2022). Financial markets in perspective: Lessons from economic history and history of economic thought. Springer. Ashraf, M. (2020). Money: Understandings and misunderstandings. Palgrave Macmillan. Assous, M., & Carret, V. (2022). Modeling economic instability: A history of early macroeconomics. Springer. Azis, I. (2022). Periphery and small ones matter: Interplay of policy and social capital. Springer Nature. Azmanova, A., & Chamberlain, J. (Eds.). (2022). Capitalism, democracy, socialism: Critical debates. Springer Nature. Bade, R., & Parkin, M. (2017). Foundations of macroeconomics. Pearson. Bagchi, B., Chatterjee, S., Ghosh, R., & Dandapat, D. (2020). Coronavirus outbreak and the great lockdown: Impact on oil prices and major stock markets across the globe. Springer Nature. Bandyopadhyay, S., & Dutta, M. (Eds.). (2019). Opportunities and challenges in development: Essays for Sarmila Banerjee. Springer Nature. Bas, E. (2022). Sharing and collaborative economy: Future scenarios, technology, creativity and social innovation. Springer Nature. Basco, S., Domenech, J., & Roses, J. (2022). Pandemics, economics and inequality: Lessons from the Spanish Flu. Palgrave Macmillan. Batas, S., Kuivalainen, O., & Sinkovics, R. (Eds.). (2022). Megatrends in international business: Examining the influence of trends on doing business internationally. Palgrave Macmillan. Battilossi, S., Cassis, Y., & Yago, K. (Eds.). (2020). Handbook of the history of money and currency. Springer Nature.

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Belaid, F., & Cretì, A. (2021). Energy transition, climate change, and COVID-19: Economic impacts of the pandemic. Springer Nature. Bellomo, N., & Chaplain, M. (Eds.). (2022). Predicting pandemics in a globally connected world, Volume 1: Toward a multiscale, multidisciplinary framework through modeling and simulation. Springer Nature. Betzy, J. (2022). Development policy: An introduction to objectives and results. Springer. Biswas, R. (2018). Emerging markets megatrends. Palgrave Macmillan. Boado-Penas, M. C., Eisenberg, J., & Sahin, S. (Eds.). (2022). Pandemics: Insurance and social protection. Springer Nature. Bovi, M. (2022). Why and how humans trade, predict, aggregate, and innovate: An economist’s lessons on the role of human behavior and economic systems. Springer Nature. Boyer, R. (2022). Political economy of capitalisms. Palgrave Macmillan. Brans, M., & Timmermans, A. (Eds.). (2022). The advisory roles of political scientists in Europe: Comparing engagements in policy advisory systems. Palgrave Macmillan. Caetano, J., Vieira, I., & Caleiro, A. (Eds.). (2021). New challenges for the Eurozone governance: Joint solutions for common threats? Springer Nature. Cai, F., & Zhang, X. (2022). Constructing political economy with Chinese characteristics. Springer Nature. Cao, J., & Illing, G. (2019). Money: Theory and practice. Springer. Causevic, F. (2020). Global financial centers, economic power, and (in)efficiency. Palgrave Pivot. Chaiechi, T., & Wood, J. (Eds.). (2022). Community empowerment, sustainable cities, and transformative economies. Springer Nature. Chandra, R. (2022). Endogenous growth in historical perspective: From Adam Smith to Paul Romer. Palgrave Macmillan. Charles, V., & Emrouznejad, A. (Eds.). (2022). Modern indices for international economic diplomacy. Palgrave Macmillan. Chen, Y. (2020). New economic engine: Effective government and efficient market. Springer. Conway, Jr., R. (2022). Empirical regional economics: Economic base theory, models and applications. Springer Nature. Cord, R., Anderson, R., & Barnett, W. (Eds.). (2019). Paul Samuelson: Master of modern economics. Palgrave Macmillan. Cortez, F. K. (Ed.). (2021). The political economy of international agreements: A collection of essays. Springer Nature. Crespo, R. (2022). The nature of the economy: Aristotelian essays on the philosophy and epistemology of economics. Palgrave Macmillan. Das, R. C. (Ed.). (2022). Microfinance to combat global recession and social exclusion: An empirical investigation. Palgrave Macmillan. Das, S., Mourmouras, A., & Rangazas, P. (2018). Economic growth and development: A dynamic dual economy approach. Springer. De Gorter, H., McCluskey, J., Swinnen, J., & Zilberman, D. (Eds.). (2022). Modern agricultural and resource economics and policy: Essays in honor of Gordon Rausser. Springer Nature. De Holanda Barbosa, F. (2018). Macroeconomic theory: Fluctuations, inflation and growth in closed and open economies. Springer. De Holanda Barbosa, F., & De Lima Junior, L. A. (2020). Workbook for macroeconomic theory: Fluctuations, inflation and growth in closed and open economies. Springer. De Souza Guilherme, B., Ghymers, C., Griffith-Jones, S., & Hoffmann, A. R. (Eds.). (2021). Financial crisis management and democracy: Lessons from Europe and Latin America. Springer Nature. Diatkine, D. (2021). Adam Smith and the wealth of nations: The discovery of capitalism and its limits. Palgrave Macmillan. Dobado-Gonzalez, R., & Garcia-Hiernaux, A. (Eds.). (2021). The fruits of the early globalization: An Iberian perspective. Palgrave Macmillan. Domitrovic, B. (2021). The emergence of Arthur Laffer: The foundations of supply-side economics in Chicago and Washington, 1966–1976. Palgrave Macmillan. Dorr, P. (2018). The impact of monetary policy on economic inequality. Springer Gabler. Dufrenot, G., & Matsuki, T. (Eds.). (2021). Recent econometric techniques for macroeconomic and financial data. Springer Nature.

923 Further Reading



Dutta, M., Husain, Z., & Sinha, A. K. (Eds.). (2022). The impact of COVID-19 on India and the global order: A multidisciplinary approach. Springer Nature. Dutta, N., & Williamson, C. (Eds.). (2019). Lessons on foreign aid and economic development: Micro and macro perspectives. Palgrave Macmillan. Elson, A. (2021). The global currency power of the US Dollar: problems and prospects. Palgrave Macmillan. Erdem, O. (2020). After the crash: Understanding the social, economic and technological consequences of the 2008 crisis. Springer. Erokhin, V. (Ed.). (2016). Global perspectives on trade integration and economies in transition. IGI Global. Erokhin, V. (Ed.). (2018). Establishing food security and alternatives to international trade in emerging economies. IGI Global. Erokhin, V. (Ed.). (2022). New innovations in economics, business and management. B P International. Erokhin, V., & Gao, T. (Eds.). (2020). Handbook of research on globalized agricultural trade and new challenges for food security. IGI Global. Erokhin, V., Gao, T., & Andrei, J. V. (Eds.). (2020). Sustainable economic development: Challenges, policies, and reforms. MDPI. Erokhin, V., Gao, T., & Andrei, J. V. (Eds.). (2021). Shifting patterns of agricultural trade: The protectionism outbreak and food security. Springer Nature. Faghih, N., & Forouharfar, A. (Eds.). (2022). Socioeconomic dynamics of the COVID-19 crisis: Global, regional, and local perspectives. Springer Nature. Fahimi, M., Flatschart, E., & Schaffar, W. (Eds.). (2022). State and statehood in the global south: Theoretical approaches and empirical studies. Springer Nature. Farjoun, E., Machover, M., & Zachariah, D. (2022). How labor powers the global economy: A labor theory of capitalism. Springer Nature. Ferrara, L., Hernando, I., & Marconi, D. (2018). International macroeconomics in the wake of the global financial crisis. Springer. Filho, W. L. (2021). COVID-19: Paving the way for a more sustainable world. Springer. Filho, W. L., Azul, A. M., Brandli, L., Salvia, A. L., Ozuyar, P. G., & Wall, T. (Eds.). (2021). Reduced inequalities. Springer Nature. Filho, W. L., Krasnov, E., & Gaeva, D. (Eds.). (2021). Innovations and traditions for sustainable development. Springer Nature. Fiori, S. (2021). Machines, bodies and invisible hands: Metaphors of order and economic theory in Adam Smith. Palgrave Macmillan. Forder, J. (2019). Milton Friedman. Palgrave Macmillan. Frangipane, M., Poettinger, M., & Schefold, B. (Eds.). (2022). Ancient Economies in comparative perspective: Material life, institutions and economic thought. Springer Nature. Gao, T., Erokhin, V., Zaikov, K., Andrei, J. V., & Subic, J. (Eds.). (2021). Blue economy and resilient development: Natural resources, shipping, people, and environment. MDPI. Gawronska-Nowak, B., Lis, P., & Konieczna-Salamatin, J. (2021). Trade wins or trade wars: The perceptions and knowledge in the free trade debate. Palgrave Pivot. Ghosh, C., & Ghosh, A. N. (2019). Keynesian macroeconomics beyond the IS-LM model. Springer Nature. Glasner, D. (2021). Studies in the history of monetary theory: Controversies and clarifications. Palgrave Macmillan. Glawe, L., & Wagner, H. (2021). The economic rise of East Asia: Development paths of Japan, South Korea, and China. Springer Nature. Goerres, A., & Vanhuysse, P. (Eds.). (2021). Global political demography: The politics of population change. Palgrave Macmillan. Goutte, S., Guesmi, K., & Urom, C. (Eds.). (2022). Financial market dynamics after COVID 19: The contagion effect of the pandemic in finance. Springer Nature. Growiec, J. (2022). Accelerating economic growth: Lessons from 200,000 years of technological progress and human development. Springer. Guerard, J. (2022). The leading economic indicators and business cycles in the United States: 100 years of empirical evidence and the opportunities for the future. Palgrave Macmillan. Guttmann, R. (2018). Eco-capitalism: Carbon money, climate finance, and sustainable development. Palgrave Macmillan. Guttmann, R. (2022). Multi-polar capitalism: The end of the dollar standard. Palgrave Macmillan.

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Hafner, M., & Tagliapietra, S. (Eds.). (2020). The geopolitics of the global energy transition. Springer Nature. Hail, S. (2018). Economics for sustainable prosperity. Palgrave Macmillan. Harrison, D. (2021). Capitalism and the dark forces of time and ignorance: Economic and political expectations. Palgrave Macmillan. Haunschmied, J., Kovacevic, R., Semmler, W., & Veliov, V. (Eds.). (2021). Dynamic economic problems with regime switches. Springer Nature. Heckel, M., & Waldenberger, F. (Eds.). (2022). The future of financial systems in the digital age: Perspectives from Europe and Japan. Springer Nature. Heer, B. (2019). Public economics: The macroeconomic perspective. Springer. Heise, M. (2019). Inflation targeting and financial stability: Monetary policy challenges for the future. Springer. Hens, T., & Elmiger, S. (2019). Economic foundations for finance: From main street to Wall Street. Springer. Hill, S., Yagi, T., & Yamash’ta, S. (Eds.). (2022). The Kyoto post-COVID Manifesto for global economics: Confronting our shattered society. Springer Nature. Hosono, A. (2022). SDGs, transformation, and quality growth: Insights from international cooperation. Springer Nature. Inshakova, E., & Inshakova, A. (Eds.). (2022). New technology for inclusive and sustainable growth: Perception, challenges and opportunities. Springer Nature. Iqbal, A. (2022). Foreign exchange: Practical asset pricing and macroeconomic theory. Palgrave Macmillan. Jaggi, C. (2022). Tourism before, during and after Corona: Economic and social perspectives. Springer Nature. James, J. (2021). New perspectives on current development policy: Covid-19, the digital divide, and state internet regulation. Springer Nature. James, J. (2022). Gender, internet use, and Covid-19 in the global south: Multiple causalities and policy options. Springer Nature. Jinji, N., Zhang, X., & Haruna, S. (2022). Deep integration, global firms, and technology spillovers. Springer Nature. Kaiser, D. (2020). Economic theory in the 21st century: Towards a renewed understanding of money and capital from a system-wide perspective. Springer Gabler. Karagiannis, N., & King, J. (Eds.). (2022). Visions and strategies for a sustainable economy: Theoretical and policy alternatives. Palgrave Macmillan. Karim, S. A. A. (Ed.). (2022). Shifting economic, financial and banking paradigm: New systems to encounter COVID-19. Springer Nature. Kempf, H. (2022). Monetary unions: Institutions and policies. Springer. Kim, J., & Raswant, A. (2022). International business and security: Geostrategy in perspective. Palgrave Macmillan. Kokores, I., Pantelidis, P., Pelagidis, T., & Yannelis, D. (Eds.). (2021). Money, trade and finance: Recent trends and methodological issues. Palgrave Macmillan. Kolodko, G. (2022). Political economy of new pragmatism: Implications of irreversible globalization. Springer Nature. Krugman, P., & Wells, R. (2021). Macroeconomics. Worth Publishers. Kuijper, H. (2022). Comprehending the complexity of countries: The way ahead. Springer Nature. Lai, C. C., & Ho, T. K. (2022). History of economic ideas in 20 talks. Springer Nature. Lakhanpal, P., Mukherjee, J., Nag, B., & Tuteja, D. (2021). Trade, investment and economic growth: Issues for India and emerging economies. Springer Nature. Langdana, F. (2022). Macroeconomic policy: Demystifying monetary and fiscal policy. Springer. Langergaard, L. L. (Ed.). (2022). New economies for sustainability: Limits and potentials for possible futures. Springer Nature. Lazareva, E., Murzin, A., Rivza, B., & Ostrovskaya, V. (Eds.). (2023). Innovative trends in international business and sustainable management. Springer Nature. Lazzarini, A., & Melnik, D. (Eds.). (2022). Economists and COVID-19: Ideas, theories and policies during the pandemic. Palgrave Macmillan.

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Lebedeva, M., & Morozov, V. (Eds.). (2022). Turning points of world transformation: New trends, challenges and actors. Palgrave Macmillan. Li, C. (2022). To establish a supra-sovereign international currency: The reform of international monetary system. Springer Nature. Lopez-Fernandez, A. M., & Teran-Bustamante, A. (Eds.). (2022). Business recovery in emerging markets: Global perspectives from various sectors. Palgrave Macmillan. Lundahl, M. (2022). Twelve figures in Swedish economics: Eli Heckscher, Bertil Ohlin, Gunnar Myrdal, Ingvar Svennilson, Axel Iveroth, Jan Wallander, Erik Höök, Bo Södersten, Rolf Henriksson, Ingemar Ståhl, Villy Bergström and Göte Hansson. Palgrave Macmillan. Ltd, M. P. (Ed.). (2018). The new Palgrave dictionary of economics. Palgrave Macmillan. Magnuson, J. (2018). Financing the apocalypse: Drivers for economic and political instability. Palgrave Macmillan. Mahmood, M. (2018). The three regularities in development: Growth, jobs and macro policy in developing countries. Palgrave Macmillan. Mankiw, G. (2021). Brief principles of macroeconomics. Cengage Learning. Mankiw, G. (2017). On welfare economics in the principles course. Journal of Economic Education, 48(1), 27–28. Mankiw, G., & Reis, R. (2018). Friedman’s presidential address in the evolution of macroeconomic thought. Journal of Economic Perspectives, 32(1), 81–96. Mansour, N., & Vadell, L. B. (Eds.). (2022). Finance, law, and the crisis of COVID-19: An interdisciplinary perspective. Springer Nature. Mariolis, T., Rodousakis, N., & Soklis, G. (2021). Spectral theory of value and actual economies: Controllability, effective demand, and cycles. Springer Nature. Masini, F. (2022). European economic governance: Theories, historical evolution, and reform proposals. Palgrave Macmillan. Mathis, K., & Tor, A. (Eds.). (2022). Law and economics of the coronavirus crisis. Springer Nature. Matsubayashi, Y., & Kitano, S. (Eds.). (2022). Global financial flows in the pre- and post-global crisis periods. Springer Nature. Matyas, L. (Ed.). (2022). Emerging European economies after the pandemic: Stuck in the middle income trap? Springer Nature. McConnell, C., Brue, S., & Flynn, S. (2021). Macroeconomics. McGraw Hill. McKinney, S. (2021). An introduction to Latin American economics: Understanding theory through history. Palgrave Macmillan. Melchior, A. (2018). Free trade agreements and globalisation: In the Shadow of Brexit and Trump. Palgrave Macmillan. Mercangoz, B. A. (Ed.). (2021). Handbook of research on emerging theories, models, and applications of financial econometrics. Springer Nature. Merchant, H. (Ed.). (2022). The new frontiers of international business: Development, evolving topics, and implications for practice. Springer Nature. Michalopoulos, C. (2022). Aid, trade and development: The future of globalization. Palgrave Macmillan. Mithani, M., Narula, R., Surdu, I., & Verbeke, A. (Eds.). (2022). Crises and disruptions in international business: How multinational enterprises respond to crises. Palgrave Macmillan. Molander, P. (2022). The origins of inequality: Mechanisms, models, policy. Springer Nature. Morroni, M. (2018). What is the truth about the great recession and increasing inequality? Dialogues on disputed issues and conflicting theories. Springer. Moss, D. (2014). A concise guide to macroeconomics, second edition: What managers, executives, and students need to know. Harvard Business Review Press. Munoz-Bandala, J. (2022). Keynes’s evolutionary spirit: A philosophical journey through his work. Palgrave Macmillan. Nayak, B. S. (2022). Political economy of development and business: Towards decolonisation, transformation and alternative perspectives. Palgrave Macmillan. Nhamo, G., Togo, M., & Dube, K. (Eds.). (2021). Sustainable development goals for society Vol. 1: Selected topics of global relevance. Springer Nature. Nwogugu, M. (2021a). Geopolitical risk, sustainability and “cross-border spillovers” in emerging markets, Volume I: Constitutional law, economic psychology and quasi-labor issues. Palgrave Macmillan.

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Nwogugu, M. (2021b). Geopolitical risk, sustainability and “cross-border spillovers” in emerging markets, Volume II: Constitutional political economy, pandemics-governance and labor-oriented bail-outs/bailins. Palgrave Macmillan. Novales, A., Fernandez, E., & Ruiz, J. (2022). Economic growth: Theory and numerical solution methods. Springer. Oberholzer, B. (2022). Fighting global poverty: Economic policy strategies for developing countries. Springer Fachmedien Wiesbaden GmbH. Officer, L. (2022). Essays in economic history: Purchasing power parity, standard of living, and monetary standards. Palgrave Macmillan. O’Hara, P. A. (2022). Principles of institutional and evolutionary political economy: Applied to current world problems. Springer Nature. Orlando, G., Pisarchik, A., & Stoop, R. (Eds.). (2021). Nonlinearities in economics: An interdisciplinary approach to economic dynamics, growth and cycles. Springer Nature. Ortmann, A., & Walraevens, B. (2022). Adam Smith’s system: A re-interpretation inspired by Smith’s lectures on rhetoric, game theory, and conjectural history. Palgrave Macmillan. Osipov, V. (Eds.). (2021). Post-COVID economic revival, Volume I: Sectors, institutions, and policy. Palgrave Macmillan. O’Sullivan, A., Sheffrin, S., & Perez, S. (2016). Macroeconomics: Principles, applications, and tools. Pearson. Oswald, M. (Ed.). (2022). The Palgrave handbook of populism. Palgrave Macmillan. Paleri, P. (2022). Revisiting national security: Prospecting governance for human well-being. Springer Nature. Pan, J. (2022). Climate change economics: Perspectives from China. Springer Nature. Papyrakis, E. (Ed.). (2022). COVID-19 and international development. Springer Nature. Pauly, R. (2021). Economic instability and stabilization policy: on the path from crises to state directed economies. Springer. Pereira, L. B., Mata, M. E., & de Sousa, M. R. (Eds.). (2021). Economic globalization and governance: Essays in honor of Jorge Braga de Macedo. Springer Nature. Pittaluga, G. B., & Seghezza, E. (2021). Building trust in the international monetary system: The different cases of commodity money and fiat money. Springer Nature. Pohoata, I., Diaconasu, D. E., & Crupenschi, V. M. (2020). The sustainable development theory: A critical approach, Volume 1: The discourse of the founders. Palgrave Macmillan. Popkova, E., & Sergi, B. (Eds.). (2022). Geo-economy of the future: Sustainable agriculture and alternative energy. Springer Nature. Poufinas, T. (Ed.). (2021). Debt in times of crisis: Does economic crisis really impact debt? Palgrave Macmillan. Prabhakar, A. C., Kaur, G., & Erokhin, V. (Eds.). (2020). Regional trade and development strategies in the era of globalization. IGI Global. Pringle, R. (2019). The power of money: How ideas about money shaped the modern world. Palgrave Macmillan. Puu, T. (2018). Disequilibrium economics: Oligopoly, trade and macrodynamics. Springer. Pyka, A., & Lee, K. (Eds.). (2021). Innovation, catch-up and sustainable development: A schumpeterian perspective. Springer Nature. Qudrat-Ullah, H. (Ed.). (2022). Understanding the dynamics of new normal for supply chains: Post COVID opportunities and challenges. Springer Nature. Quirico, O. (Ed.). (2022). Inclusive sustainability: Harmonising disability law and policy. Springer Nature. Ramlall, I. (2022). Central bank ratings: A new methodology for global excellence. Palgrave Macmillan. Ramrattan, L., & Szenberg, M. (2022). The purpose of life in economics: Weighing human values against pure science. Palgrave Macmillan. Rana, P., & Ji, X. (Eds.). (2022). From centralised to decentralising global economic architecture: The Asian perspective. Palgrave Macmillan. Ray, S., Chambers, R., & Kumbhakar, S. (Eds.). (2022). Handbook of production economics. Springer Nature.

927 Further Reading



Razin, A. (2021). Globalization, migration, and welfare state: Understanding the macroeconomic trifecta. Palgrave Macmillan. Rikap, C., & Lundvall, B. A. (2021). The digital innovation race: Conceptualizing the emerging new world order. Palgrave Macmillan. Roselli, A. (2021). Economic philosophies: Liberalism, nationalism, socialism: Do they still matter? Palgrave Macmillan. Rudskoi, A., Akaev, A., & Devezas, T. (Eds.). (2022). Digital transformation and the world economy: Critical factors and sector-focused mathematical models. Springer Nature. Schiller, B., & Gebhardt, K. (2021). The macro economy today. McGraw Hill. Seifi, S. (2021). The world’s future crisis: Extractive resources depletion. Springer Nature. Shahbaz, M., Mubarik, M. S., & Mahmood, T. (Eds.). (2021). The dynamics of intellectual capital in current era. Springer Nature. Shahbaz, M., Soliman, A., & Ullah, S. (Eds.). (2021). Economic growth and financial development: Effects of capital flight in emerging economies. Springer Nature. Silva, C. N. (Ed.). (2022). Local government and the COVID-19 pandemic: A global perspective. Springer Nature. Singh, R. B., Chatterjee, S., Mishra, M., & de Lucena, A. J. (Eds.). (2021). Practices in regional science and sustainable regional development: Experiences from the global south. Springer Nature. Smirnov, S., Ozyildirim, A., & Picchetti, P. (Eds.). (2019). Business cycles in BRICS. Springer. Stahel, A.W. (2022). Regenerative Oikonomics: A new perspective on the economic process. Springer Nature. Stellinga, B., de Hoog, J., van Riel, A., & de Vries, C. (2021). Money and debt: The public role of banks. Springer. Szepanski, A. (2022). Financial capital in the 21st century: A new theory of speculative capital. Palgrave Macmillan. Talani, L. S. (2021). The international political economy of migration in the globalization era. Palgrave Macmillan. Talapatra, J., Mitra, N., & Schmidpeter, R. (Eds.). (2022). Emerging economic models for sustainable businesses: A practical approach. Springer Nature. Teipen, C., Dunhaupt, P., Herr, H., & Mehl, F. (Eds.). (2022). Economic and social upgrading in global value chains: Comparative analyses, macroeconomic effects, the role of institutions and strategies for the global south. Palgrave Macmillan. Thomas, G. (2018). The creators of inside money: A new monetary theory. Palgrave Macmillan. Tombazos, S. (2019). Global crisis and reproduction of capital. Palgrave Pivot. Torabian, J. (2022). Wealth, values, culture & education: Reviving the essentials for equality & sustainability. Springer Nature. Vidakovic, N., & Lovrinovic, I. (2021). Macroeconomic responses to the COVID-19 pandemic: Policies from Southeast Europe. Palgrave Macmillan. Vogel, H. (2021). Financial market bubbles and crashes: Features, causes, and effects. Palgrave Macmillan. Wagner, R. (2020). Macroeconomics as systems theory: Transcending the micro-macro dichotomy. Springer. Wang, P. (2020). The economics of foreign exchange and global finance. Springer. Wang, S. (2021). China’s rise and its global implications. Palgrave Macmillan. Wang, Z. (2019). The principle of trading economics. Springer Nature. Weissenbacher, R. (2019). The core-periphery divide in the European Union: A dependency perspective. Palgrave Macmillan. Williams, S., & Taylor, R. (Eds.). (2022). Sustainability and the new economics: Synthesising ecological economics and modern monetary theory. Springer. Yao, O. (2022). Large countries’ development path: Experience and theory. Springer Nature. Yadav, P. (2021). Geographical perspectives on international trade. Springer Nature. Yoshino, N., Paramanik, R., & Kumar, A. (2022). Studies in international economics and finance: Essays in honour of Prof. Bandi Kamaiah. Springer Nature. Young, W., & Fuller, E. (2022). Reinterpreting Mr. Keynes: The IS-LM Enigma revisited. Springer.

928

Further Reading

Yu, M. (2022). China’s miracle in foreign trade. Springer Nature. Yuki, T. (2021). Socialism, markets, and the critique of money: The theory of “labor notes.” Palgrave Macmillan. Zhang, Y. (2022). The change of global economic governance and China. Springer Nature. Zheng, Q., & Bao, C. (2022). Regional innovation evolution: An emerging economy perspective. Springer Nature. Zhou, T. (2021). China’s renaissance: Global strategies in 21st century. Springer Nature.

929

A–C

Index A Absolute advantage  537, 569, 698, 700–705, 721, 735, 736, 892 Absolute poverty  504–507, 524, 892 Accelerator effect  201, 221, 250, 251, 550, 892 Aggregate demand  4, 5, 8, 10, 12, 15, 20, 21, 34, 117, 147, 155–158, 160, 176, 177, 180– 182, 184–186, 199, 200, 203–207, 210, 214, 215, 217, 218, 221, 222, 225–228, 230, 231, 233, 246, 250, 251, 253, 254, 266, 276–278, 284–288, 296–298, 300, 302, 305, 307, 310– 318, 325, 327–329, 331, 337, 363, 364, 387, 391, 398, 405, 406, 460–464, 471, 473–475, 482, 486, 532, 892, 896, 903, 906, 910, 914 Aggregate supply  5, 8–12, 15, 18, 21, 34, 155, 158–160, 176, 177, 180–182, 184, 185, 199, 200, 203, 204, 214, 221, 227, 228, 249, 251, 254, 266, 286, 296, 298, 300, 302, 305, 306, 311–318, 320, 325–327, 329, 331, 337, 398, 461, 486, 532, 539, 834, 892, 896, 903, 906 Agrarian crisis  241–243, 256, 892 Akerlof, G.  349 Anti-globalism  876, 882, 889, 892 Anti-inflationary policy  101, 325, 326, 330, 892 Appreciation  315, 327, 421, 468, 768, 771, 778, 779, 822, 892, 914 Asset  9, 11, 12, 14, 19, 25–27, 33, 34, 54, 61–63, 73, 85, 103, 111, 112, 115, 119, 129, 139, 156, 208, 213, 226, 234, 244, 256, 319–321, 346, 374, 379, 381, 385–387, 390, 391, 394, 396, 404, 409, 412, 415, 418, 425, 430, 431, 436– 438, 450, 512, 516, 561, 565, 587, 605, 615, 618, 621, 625, 629, 660, 666, 670, 692, 748, 751, 755, 758, 759, 765, 766, 768, 769, 776– 778, 871, 873, 874, 880, 892, 900, 902, 906, 907, 909, 910, 916, 919 Asymmetrical information  234, 336, 349, 368, 660, 893 Atkinson index  521, 522 Automatic fiscal policy  444, 466, 476, 893 Autonomous consumption  195–197, 221, 250, 893 Average propensity to consume  196, 221, 893

B Balanced growth  530, 534, 555, 556, 565, 567, 576, 893 Balassa, B.  120, 726, 827

Baldwin, R.  824 Bank credit  64, 250, 384, 415–417, 423, 429, 441, 893 Banking multiplier  413, 439–441, 893 Baran, P.  546 Bardhan, P.  824 Basic macroeconomic identity  20, 203, 221, 312, 893 Baumol, W.  118 Becker, G.  613, 618, 619, 629 Bentham, J.  497 Berkeley, G.  376 Bhagwati, J.  825 Biflation  297, 298, 330, 893 Bimetallism  383, 384, 408, 893 Biocapacity  676, 677, 692, 893 Blue economy  656, 667, 669, 689–692, 894, 917 Bodin, J.  379, 445 Botero, G.  445 Budget policy  451, 460, 461, 476, 884, 894 Built-in stabilizer  466, 476, 894 Business migration  784, 815, 894

C Cambridge school  380, 381 Caraffa, D.  445 Chamberlin, E.  80 Chenery, H.  749 Clark, J.  108 Classical school  8, 9, 183–185, 204, 228, 260, 275, 391, 535–537, 541, 543, 617, 625, 698 Coase theorem  358, 359, 368, 894 Commercial bank  21, 71, 216, 254, 255, 312, 385, 396, 397, 412, 415, 418, 421, 422, 424– 441, 452, 745, 774–776, 893, 894 Commercial credit  416, 417, 430, 440, 441, 894 Commuting migration  783, 784, 815, 894 Comparative advantage  28, 120, 400, 537, 538, 569, 571, 580, 600, 623, 698, 703–706, 708, 711, 715, 719–724, 726, 727, 732, 735, 736, 742, 743, 746, 750, 761, 819, 821, 823, 846, 894 Compensation fee  835, 837, 850, 894 Competition  4, 29, 70–73, 75–78, 80–82, 84–87, 90–93, 95, 96, 101, 103, 114, 123, 125, 132, 133, 136, 146, 149, 154, 184, 186, 242, 246, 254, 265, 279, 280, 287, 290, 291, 304, 315, 319, 337, 340, 342, 348, 349, 358, 365, 382, 394, 430, 448, 487, 490, 492, 536, 537, 542,

930

Index

546, 552, 553, 564, 570, 572, 575, 580, 584, 585, 587, 605, 608, 609, 612, 630, 631, 660, 699–701, 710, 711, 714, 719, 720, 732, 733, 737, 746, 759, 766, 770, 790, 804, 805, 819– 821, 823, 824, 828, 830–832, 836, 837, 842, 845–850, 870, 872–875, 881, 883, 885, 894, 913, 918 Competitive advantage  90, 347, 366, 545, 564, 565, 588, 604, 607, 614, 674, 710, 732, 733, 736, 752, 761, 818, 821, 835, 846, 847, 870, 874 Consumer basket  321, 322, 487–489, 504, 505, 510, 524, 892, 894 Consumer credit  412, 417, 418, 440, 441, 895 Consumer price index  321, 322, 324, 330, 895 Contractionary fiscal policy  216–218, 221, 308, 463, 465, 476, 895 Contractionary monetary policy  214–216, 253, 278, 307, 372, 395, 396, 399, 402, 407, 408, 453, 895 Corden, M.  825 Corrective subsidy  355–357, 368, 895 Corrective tax  355–357, 368, 895 Country-based theories  698, 709, 726, 736, 895 Cournot, A.  70, 89 Creative destruction  580, 605–609, 895 Credit money  254, 374, 375, 377, 379, 380, 383–385, 408, 413, 414, 424, 432, 895 Credit system  412, 423–426, 429, 430, 440, 441, 757, 895 Crowding out effect  217, 218, 220, 221, 895 Cultural protectionism  877, 878, 884, 888, 889, 896 Currency restrictions  775, 778, 842, 896 Currency risk  765, 766, 774, 776–778, 896 Customs tariff   120–123, 150, 310, 311, 734, 828, 830–832, 835, 850, 871, 896, 911 Cyclical unemployment  60, 225, 229, 269–271, 277, 278, 283, 284, 288, 289, 292, 293, 804, 896, 911, 919 Cyclicity  224, 227, 228, 230, 234, 236, 238, 243, 246, 248, 249, 253, 255, 256, 896 Cyert, R.  108

D Deflation  239, 244, 245, 278, 296–299, 319, 324, 330, 465, 893, 896 Deflationary gap  202, 203, 318, 319, 330, 331, 896 Demand  4, 6–10, 15, 18, 20–23, 31, 34, 49, 52, 60, 71, 72, 74, 75, 78–83, 87, 88, 90, 91, 93, 95, 104–106, 117, 138, 144–156, 160, 163, 165, 167–174, 176, 177, 180, 181, 183, 184,

186, 187, 189, 190, 193, 194, 196–208, 210– 216, 221, 222, 224–228, 230, 231, 233, 235, 236, 239, 241, 246, 248, 250, 251, 254, 260– 262, 264–267, 269–279, 281, 284–287, 290– 293, 297, 298, 300, 301, 303, 305–309, 311, 312, 315–318, 325, 326, 328–331, 336–338, 340, 350, 357, 360, 362, 363, 365, 366, 377, 379, 381, 387, 388, 390–394, 397, 399–401, 405–407, 409, 416–418, 420–422, 431, 433, 434, 447, 449, 452, 455, 457, 468, 471, 484, 487, 489, 495, 523, 538, 539, 544, 545, 550, 552, 561, 564, 566–568, 570, 581, 584, 586, 587, 594, 595, 615, 622, 664, 686, 702–704, 707, 709–715, 717–719, 721, 723–726, 730– 734, 736, 737, 745–748, 752, 757, 760, 761, 764, 765, 767–772, 774, 775, 777, 784, 787, 791–793, 795, 796, 802–804, 806, 807, 819, 822, 825, 827, 832–834, 836–838, 842, 846, 885, 886, 892, 896, 903, 908, 910, 911, 915, 918 Demand price  79, 80, 144, 154, 177, 896 Demand-pull inflation  226, 296, 303, 306, 307, 309, 311–314, 316, 317, 329, 331, 390, 896 Demonetization  309, 375, 408, 897 De Montchrestien, A.  698 Depreciation  33, 39, 54–56, 59, 60, 103, 193, 194, 227, 251, 270, 279, 296, 304, 314, 319– 321, 326, 331, 393, 406, 407, 453, 467, 468, 474, 558, 561, 575, 626, 643, 768, 770, 774, 777, 778, 838, 897, 903 Deprivation  504, 509, 511, 512, 524, 897 Devaluation  254, 305, 321, 327, 404, 467, 768, 777, 778, 897 Discretionary fiscal policy  465, 466, 476, 897 Domar, E.  549

E Ecological footprint  656, 665, 667, 671, 675– 677, 679, 687, 691, 692, 897 Economic cycle  4, 7, 200, 204, 224–232, 236, 241, 245, 247–249, 251–253, 255, 256, 269, 271, 279, 342, 377, 380, 387, 397, 461, 466, 531, 533, 535, 540, 604–606, 672, 709, 733, 799, 897, 906 Economic development  6, 7, 16, 27, 30, 53, 57, 59, 65–67, 100–103, 115, 117, 118, 124, 127, 137, 138, 154, 159, 218, 220, 224, 225, 228, 231, 237, 240, 247, 249, 253, 255, 256, 269, 272, 275, 278, 289, 304, 309, 310, 320, 329, 365–367, 380, 382, 385, 391, 402, 428, 447, 466, 480, 481, 486–488, 503, 515, 524, 530– 533, 535–540, 543, 545, 546, 557, 562, 564, 565, 567–572, 574–576, 580, 584, 586, 588,

931 Index

589, 600, 601, 603, 605, 607, 610, 612, 617, 622, 625, 630, 633, 634, 638, 644, 649, 652, 653, 656, 657, 659, 660, 664–667, 672–675, 692, 693, 698, 700, 715, 733, 744, 749, 762, 764, 769, 785, 790–792, 795, 796, 800–802, 806, 809, 814, 818–821, 828, 843, 846, 858– 860, 871, 873–875, 880, 881, 884, 896, 897, 902, 904, 917 Economic growth  4–7, 10, 11, 30, 32, 33, 38, 58, 63, 65, 71, 100–102, 117, 122, 128, 129, 131, 195, 213–216, 218–221, 228, 236, 237, 240, 245, 250, 253, 269, 275, 283, 285, 290, 297, 305, 307–309, 320, 340, 342, 344, 345, 383, 387, 394–398, 426, 444, 447, 461, 463, 465, 466, 480, 482, 485–487, 507, 530–540, 542–546, 548, 549, 551–559, 561, 562, 564– 566, 568, 569, 573, 575–577, 580, 581, 587, 589, 594, 599–601, 603, 609, 610, 612, 613, 617–619, 623, 624, 630, 633, 641, 652, 656, 657, 660, 662, 667, 671–675, 685, 691, 692, 708, 709, 743, 748, 749, 777, 823, 843, 846, 859, 885, 888, 893, 894, 897, 903, 904, 911, 916, 918 Economic hysteresis  286, 292, 897 Economic inequality  480, 515–518, 521, 524, 574, 622, 630, 653, 748, 869, 897 Economic reproduction  28, 31–34, 61, 62, 300, 391, 444, 445, 447, 456, 457, 476, 613, 652, 653, 897, 899, 903 Economic surplus  546, 575, 576, 897 Economies of scale  38, 41, 50–52, 67, 83–85, 346, 355, 698, 718–720, 726–729, 736, 743, 752, 821, 824, 828, 875, 898 Economies of scale theory  719, 736, 898 Edgeworth box  495, 496, 524 Elasticity  72, 74, 75, 78, 81, 95, 144, 165, 170, 171, 173–177, 185, 212, 213, 217, 297, 305, 521, 532, 558, 568, 570, 710, 711, 722, 723, 730, 825, 827, 834, 898 Emigration  782, 785, 802, 803, 806, 808, 811, 815, 898 Emission  211, 296, 297, 301, 302, 309, 311, 312, 314, 320, 321, 326, 343, 352, 355, 358– 360, 375, 377, 379, 383, 385, 387, 408, 409, 424, 426–428, 431, 452, 461, 546, 663, 665, 668, 670–672, 680–682, 689, 690, 814, 879, 898, 909 Exchange rate  4, 5, 21, 22, 57, 58, 101, 112, 157, 301, 304, 305, 309–311, 326, 327, 375, 376, 397, 398, 401–408, 415, 421, 425, 426, 428, 429, 435, 467–476, 548, 734, 742, 745, 751, 762–779, 847, 892, 896–898, 913, 914 Exchange value  378, 540, 576, 898 Expanded reproduction  30, 32, 34, 62, 180, 297, 444, 540, 542, 576, 759, 898

F–F

Expansionary fiscal policy  216–219, 308, 461, 471, 472, 474–476, 898 Expansionary monetary policy  214–216, 219, 221, 298, 395, 403–408, 898 Export subsidy  838, 839, 849, 850, 898 Extensive growth  33, 532, 576, 580, 672, 898 External debt  398, 453, 742, 758, 759, 761, 762, 764, 777, 778, 899 External environment  107, 138, 240, 501, 899 Externality  336–338, 350–360, 362, 367, 368, 492, 560, 564, 565, 567, 568, 626, 629, 660– 664, 666, 670, 691, 692, 805, 826, 828, 847, 894, 895, 899, 912

F Factor-intensity reversal  698, 722, 723, 736, 899 Financial crisis  128, 130, 219, 234, 241, 243– 245, 256, 270, 382, 402, 859, 899 Financial policy  101, 398, 446–449, 460, 461, 476, 744, 767, 899 Financial system  127, 130, 134, 444, 449, 476, 757, 858, 899 Firm-based theories  698, 709, 718, 736, 899 Fiscal policy  11, 59, 100, 102, 103, 112, 120, 124, 180, 206, 208, 216, 218–220, 248, 249, 253, 254, 276, 299, 308, 325, 326, 343, 398, 400, 401, 407, 426, 444, 447–449, 451, 456, 458, 460–462, 466, 467, 470–476, 519, 773, 825, 895, 898, 899 Fiscal system  451, 457, 466, 476, 858, 900 Fischer index  323 Fisher, I.  191, 306, 380, 390 Fleming, M.  398 Forced migration  784, 815, 900 Foreign direct investment  26, 111, 129, 139, 699, 729, 730, 750–753, 755, 778, 860, 869, 872, 885, 900, 919 Foreign exchange market  21, 22, 119, 403–406, 425, 472, 764, 768, 769, 772–778, 874, 900 Foreign portfolio investment  27, 755, 778, 900 Foreign public debt  444, 452, 453, 476, 900 Foreign trade policy  122, 326, 475, 818, 820, 824, 826, 828–830, 834, 835, 839, 840, 847– 850, 859, 900, 911, 913 Free-rider problem  360, 363, 364, 367, 368, 663, 900 Free trade  120–123, 125, 138, 166, 167, 169, 537, 708, 770, 818–821, 823, 825, 828–830, 832–834, 836, 839, 843, 845–847, 849, 850, 900 Frictional unemployment  268, 269, 271, 272, 274, 286, 288, 289, 292, 900 Friedman, M.  285, 309

932

Index

Full employment  5, 8, 10–12, 56, 60, 100, 136, 158, 159, 182–184, 190, 201, 202, 204–206, 222, 228–231, 252, 256, 267, 270, 271, 273, 274, 276–278, 281, 283, 284, 292, 293, 307, 313–315, 317, 318, 326, 336, 368, 394, 398, 399, 444, 451, 460, 467, 468, 538, 551, 553, 576, 703, 705, 706, 721, 900, 901, 908, 914, 916, 919 Full-fledged money  383, 408, 901

G Giffen goods  146, 176 Gini, C.  518 Gini coefficient  64, 65, 518–521, 524 Global hectare  676, 677, 692, 901 Globalization  7, 114, 119, 125, 126, 134, 246, 247, 329, 346, 407, 485, 501, 502, 523, 569, 580, 586, 587, 673, 709, 742, 782, 789, 793– 796, 800, 806, 808–810, 821, 839, 844, 845, 847, 854–860, 864, 868–889, 892, 901, 914 Golden rule of capital accumulation  556, 557, 560, 575, 576, 901 Government budget  5, 444, 449, 458, 460, 476, 480, 483, 505, 901 Government credit  419, 441, 455, 901 Government failure  336, 339–341, 367, 368, 901 Government multiplier  462–464, 476, 901 Government regulation  66, 115, 118, 241, 246, 249, 336, 339–344, 358, 360, 364, 365, 367, 368, 421, 447, 448, 460, 461, 476, 567, 574, 708, 770, 778, 799, 819, 894, 899, 901 Gravity model  698, 713, 733, 734, 736, 901 Green growth  664, 666–668, 692, 902 Gross domestic product  4, 53, 67, 155, 236, 320, 444, 734, 902 Gross domestic product deflator  902 Gross domestic product gap  902 Grossman, S.  731 Gross national income  59, 67, 632, 761, 902 Gross national product  14, 53, 56, 59, 68, 902 Grubel, H.  726

H Haberler, G.  720 Hamilton, A.  824 Hansen, A.  208, 250 Harrod-Domar model  551, 552, 554, 555 Harrod, R.  250, 748 Hart, O.  731 Health capital  614, 643, 644, 647, 652, 653, 902 Health potential  647, 653, 902 Heckscher, E.  706, 746

Heckscher-Ohlin-Samuelson theorem  708, 737, 801, 902 Heckscher-Ohlin theorem  698, 706, 707, 722, 735, 736, 801, 902 Hicks, J.  208, 250, 716 Higgs, R.  182 Hirschman, A.  564 Household  4, 6, 10, 13, 14, 16–24, 28, 31, 45, 57, 60, 62, 71, 100, 101, 103–105, 109, 136, 138, 147, 158, 161, 163, 164, 185, 187, 192, 195, 204, 262–264, 266, 276, 322, 433, 452, 480, 490, 503–507, 509–512, 516, 521, 523– 525, 536, 594, 620, 621, 627, 629, 633, 642, 649, 662, 675, 676, 793, 794, 825, 846, 860, 885–887, 892, 902, 914, 916 Human capital  61–63, 261, 266, 290, 353, 367, 448, 480, 486, 487, 489, 490, 534, 557–560, 580, 612–633, 641–644, 647, 652, 653, 657, 659, 685, 701, 782, 786, 791, 792, 796–799, 805, 846, 860, 888, 903, 906 Human development index  489, 531, 612, 632, 653, 903 Hume, D.  379, 701

I Immigration  557, 782, 786, 787, 791, 793, 802, 804–808, 812, 814, 815, 819, 903 Imperfect competition  9, 44, 70, 83, 84, 95, 96, 183, 184, 608, 630, 801, 828, 903 Import deposit  835, 837, 850, 903 Inequality-adjusted human development index  653, 903 Inflation  4–7, 10, 11, 13–15, 18, 58, 63, 64, 100, 101, 103, 105, 107, 116, 117, 182, 184, 193, 196, 197, 206, 207, 213–216, 218–221, 226, 230, 234, 239, 253–255, 276, 278, 285, 287, 288, 290–293, 296–331, 338, 341–345, 374, 375, 377, 382–384, 387, 390, 391, 394–398, 415, 420–422, 426, 446, 451–453, 463, 465– 467, 484, 486, 503, 506, 512, 551, 553, 700, 706, 756, 770–772, 792, 793, 804, 893, 896, 903, 912, 917, 918 Inflationary gap  202, 203, 221, 318, 330, 331, 903 Inflationary spiral  202, 315–318, 331, 451, 903 Inflation inertia  327, 331, 903 Innovation  42, 46, 71, 83, 86, 92, 106, 119, 127, 130, 133, 134, 237–239, 251, 269, 284, 310, 326, 349, 430, 448, 457, 530, 532, 534, 544– 546, 570, 575, 580–589, 593, 594, 600–607, 609, 610, 612, 615, 618, 625, 641, 662, 666, 668, 669, 685, 710, 711, 714, 732, 757, 784, 796, 809, 819, 821, 846, 872, 903, 904

933 Index

Innovation pessimism  580, 600 Institutional development  531, 533, 573, 576, 904 Institutionalism  278, 530, 533, 571, 572, 574, 576, 904 Integration migration  783, 815, 904 Integration organization  119, 120, 124, 138, 904 Intensive growth  532, 576, 904 Interbank credit  418, 441, 904 Interest rate  5, 8, 9, 12–14, 16, 18, 21, 22, 100, 107, 112, 120, 156, 158, 184, 185, 191–194, 197–199, 205, 206, 208–220, 222, 225, 228, 230, 231, 234, 239, 243, 245, 250, 253–255, 302, 307, 310, 311, 315, 319, 324–327, 336, 387, 390–409, 413–415, 418–422, 425, 430, 432–434, 441, 448, 451–453, 455, 471–476, 486, 550, 553, 561, 743, 745, 746, 748, 755, 757, 760, 761, 765, 770, 772, 773, 838, 895, 898, 904, 907, 908, 910 Internal environment  107, 108, 110, 138, 904 Internalization of expenditures  663, 691, 692, 905 Internal migration  783, 786, 800, 812, 815, 904 Internal public debt  452, 477, 904 International borrowing and lending  742, 759– 761, 778, 905 International capital flows  402, 548, 743, 744, 746, 751, 778, 905 International credit  418, 419, 441, 744, 759, 760, 905 International economic integration  120, 138, 733, 905 International economic organization  125–128, 131, 134, 138, 872, 905 Internationalization  111, 238, 246, 336, 402, 407, 430, 447, 448, 733, 744, 766, 839, 854, 859, 870, 871, 873, 874, 878, 880, 888, 889, 905 International migration  247, 290, 627, 782–784, 786–793, 796, 798–803, 805, 808–810, 812, 813, 815, 816, 905 International product life cycle theory  709, 737, 905 Intertemporal international trade  760, 778, 905 Intra-industry trade  698, 709, 726–728, 736, 737, 743, 827, 905 Investment  6, 7, 11, 14, 15, 19–21, 23, 24, 26, 27, 32, 34, 53, 54, 59, 61, 66–68, 73, 79, 81, 95, 103, 105, 113, 114, 117, 128, 129, 133, 136, 137, 180, 183, 185, 186, 190, 194, 197– 201, 203–206, 208–214, 216, 217, 221, 222, 226, 227, 229–231, 234, 235, 239, 243, 245, 248, 250, 251, 253–256, 270, 275, 276, 289, 290, 297, 301, 307, 310–312, 315, 317, 320,

J–K

327, 336, 342, 353, 366, 391, 399, 401, 403, 406, 412, 415, 421–423, 426, 429–432, 434– 436, 447–449, 451, 452, 455, 457, 461–465, 471, 472, 474, 482, 490, 516, 532, 537, 543– 546, 548–553, 555–557, 562–568, 570, 587, 591, 593, 599, 601, 604, 605, 612, 613, 615, 617–623, 625–631, 641, 643, 647, 652, 653, 659, 661, 666, 668, 672, 674, 689, 690, 699, 709, 728–731, 742, 744–753, 755–758, 760, 761, 763, 767, 770–772, 774, 777, 778, 792, 796, 797, 820, 824, 825, 840, 841, 843–846, 849, 860, 871, 872, 874, 885, 893, 895, 900, 902, 906, 908, 910 Irregular migration  784, 813, 816, 906 Issue of money  385, 408, 898, 906 Iversen, C.  746, 747

J Johnson, H.  825 Johnson’s theorem  708, 737, 906 Jones, R.  724 Juglar, C.  234 Juglar fixed-investment cycle  234, 906 Justi, J.  445

K Kaldor, N.  561 Kemp, M.  827 Keynesian cross  15, 24, 199, 202, 221, 318, 906 Keynesian school  9–12, 190, 206, 213, 215, 218, 221, 229, 230, 246, 253, 254, 260, 275, 277, 288, 290, 306–308, 311, 377, 390, 391, 447, 747 Keynes, J.M.  184 Kindleberger, C.  748 Kitchin inventory cycle  232, 233, 256, 906 Kitchin, J.  232 Knapp, G.  376 Knies, K.  376 Knowledge economy  530, 531, 587, 610, 613, 906 KOF globalization index  860, 861, 863, 865, 867, 889, 906 Kojima, K.  750 Kondratiev cycle  231, 232, 238, 240, 256, 906 Kondratiev, N.  238 Krugman, P.  718, 734 Kurihara, K.  749 Kuznets infrastructural investment cycle  236, 237, 256, 906 Kuznets, S.  9, 236 Kydland, F.  11

934

Index

L Labor market  8, 14, 21, 22, 92–94, 205, 242, 247, 260, 261, 264–279, 281, 285–287, 289– 292, 296, 306, 341, 343, 482, 484, 515, 573, 615, 625, 628, 630, 782, 786–793, 795, 796, 799, 801, 802, 804–806, 812–815, 875, 878, 885, 897, 900, 907, 911 Labor migration  123, 782, 784, 786, 793, 796, 801, 811, 816, 883, 907 Laffer, A.  11, 459 Lancaster, K.  826, 828 Laspeyres index  322, 323 Law of increasing opportunity cost  597, 598, 609, 610, 907 Leakages-injections model  23–25 Lee, E.  790 Legal monopoly  346–348, 367, 368, 907 Lending rate  412, 419, 420, 425, 440, 441, 907 Leontief paradox  708, 722, 723, 737, 907 Leontief, W.  708 Lewis, W.A.  562 Life cycle of innovation  584, 610, 907 Limits theory  673 Linder, S.  712 Lipsey, R.  826–828 Liquidity  15, 128, 137, 198, 208, 307, 373, 381, 386, 387, 390, 391, 403, 409, 424, 427, 434, 436, 439, 472, 583, 748, 755, 766, 777, 907 Liquidity trap  213, 215, 216, 221, 222, 907 Litan, R.  118 Lorenz curve  517, 518, 521, 524 Lorenz, M.  517 Lucas, R.  8, 11

M Machiavelli, N.  445 Machlup, F.  747 Macroeconomic equilibrium  5, 12, 13, 20, 24, 100, 102, 117, 138, 180–186, 191, 196, 199, 205, 206, 208, 216, 219, 221, 222, 224, 225, 227–229, 248, 256, 273, 306, 312, 318, 336, 337, 341, 352, 372, 377, 382, 400, 402, 426, 444, 453, 460, 465, 466, 472–476, 486, 535, 538, 540, 567, 698, 896, 897, 908 Macroeconomic policy  5, 6, 100–103, 137, 138, 180, 224, 249, 252–254, 256, 402, 407, 455, 471, 824, 828, 885, 908, 916 Malthus, T.  538, 656 Mankiw, G.  557 Mankiw-Romer-Weil model  530, 557, 558, 575 March, J.  108

Marginal efficiency of investment  197, 199, 222, 908 Marginal propensity to consume  192, 196, 199, 200, 222, 231, 251, 463, 464, 908 Marginal propensity to invest  199, 222, 463, 908 Market concentration  70, 73, 75–77, 96, 304, 908 Market equilibrium  144, 150, 151, 153, 154, 160–166, 177, 203–205, 208, 260, 261, 264, 273, 274, 276, 277, 300, 314, 355, 362, 372, 393, 394, 402, 620, 769, 836, 908 Market failure  62, 86, 101, 117, 118, 234, 267, 279, 289, 336–339, 342, 343, 345, 347, 349– 351, 353, 355, 358, 359, 363–368, 451, 487, 656, 663, 684, 691, 757, 794, 801, 820, 828, 847, 908 Market price  8, 22, 44, 53, 56, 57, 60, 67, 68, 79–81, 83, 87, 88, 90, 93–95, 150, 154, 170, 174, 177, 356, 418, 714, 769, 848, 902, 908, 914 Market segment  72, 73, 76, 77, 96, 607, 710, 909 Market structure  4, 35, 70, 72, 78, 80, 83, 95, 96, 342, 909, 910, 912 Marshall, A.  8, 70, 108, 154, 189, 306, 381 Marxian school  260 Marx, K.  8, 30, 227, 274, 378, 538, 540, 605, 617 Meade, J.  826, 828 Melitz, M.  729 Mercantilism  375, 445, 698–700, 735, 737, 909 Metzler’s paradox  818, 824, 834 Microeconomics  4–6, 13, 21, 34, 35, 38, 46, 181, 190, 273, 345, 786, 791, 793, 909 Mill, J.  379 Minhas, B.  722 Minimum wage  103, 274, 285, 289, 301, 342, 484, 487–489, 520, 524, 550, 554, 799, 909 Mitchel, W. C.  9 Model of heterogeneous firms  698, 728–730, 737, 909 Monetarism  10–12, 248, 260, 309, 381, 383 Monetary aggregate  309, 385, 386, 392, 409, 909 Monetary crisis  241, 243, 244, 762 Monetary policy  10, 12, 66, 100, 124, 202, 206, 211, 214, 216, 219, 249, 253, 254, 298, 299, 306, 308–310, 326, 328–330, 343, 375, 377, 382, 387, 392, 394–398, 401, 402, 404–409, 424–426, 432, 444, 448, 449, 461, 465, 467, 469, 471, 553, 823, 847, 895, 898, 909, 910 Monetary system  128, 244, 296, 374, 376, 379, 383–385, 387, 394, 408, 409, 766, 767, 893, 909, 910

935 Index

Money market  5, 8, 9, 11, 12, 14, 21, 22, 180, 198, 205, 208–210, 212, 215, 219, 244, 248, 372, 382, 386–388, 392–395, 402, 407, 409, 426, 427, 755, 763, 910 Money quantity  156, 379–382, 384–387, 390, 392, 397, 408, 409, 440, 898, 910 Money sterilization policy  404, 409, 910 Money velocity  379–382, 385, 386, 390, 395– 397, 408, 409, 895, 898, 910 Monoethnism  857, 889, 910 Monometallism  383, 384, 408, 409, 910 Monopolistic competition  75–77, 80–83, 85, 96, 718–720, 726, 910 Monopoly  4, 21, 46, 49, 59, 70, 72, 75–77, 80, 81, 83–86, 92, 94, 96, 101, 103, 116, 123, 174, 184, 185, 243, 260, 298, 304, 307, 321, 326, 337, 340–342, 345–347, 368, 424, 446, 457, 546, 609, 714, 721, 819, 822, 823, 835, 838, 910, 915 Monopoly power  73–76, 79, 85, 86, 96, 307, 336, 345, 348, 367, 910 Monopsony  77, 83, 92–94, 96, 910 Montesquieu, C.  380 Moore, J.  731 Mortgage credit  418, 440, 442, 910 Multiplier  180, 186, 190, 200, 201, 203, 210, 222, 248, 250–252, 419, 440, 462–464, 550, 551, 565, 910 Mundell, R.  398 Mun, T.  698 Myrdal, G.  572

N Nationalism  854, 877–880, 888, 889, 910 National wealth  14, 61, 62, 64, 67, 68, 188, 263, 413, 481, 486, 617, 699, 821, 910 Natural capital  62, 63, 65, 535, 643, 658, 666, 668, 670, 671, 673–676, 691, 692, 911 Natural growth  551, 575, 576, 911 Natural monopoly  84, 86, 346–348, 368, 911 Natural unemployment  11, 12, 267, 268, 270, 271, 283–286, 288, 289, 291, 292, 300, 911 Neoclassical school  190, 192, 198, 212, 229, 246, 253, 316, 571 Neocolonialism  547, 576, 911 New normal protectionism  818, 823, 847, 848, 850, 911 New toxics theory  673 Nominal exchange rate  769, 779, 911, 914 Non-excludability  360–362, 364, 367, 368, 911 Non-rivalry  360, 361, 367, 368, 911, 913 Non-tariff trade regulations  835, 850, 911 North, D.  701

N–P

Nurkse, R.  565, 746

O Ohlin,B.  706, 746 Okun, A.  283, 284 Okun’s law  283, 284, 292, 911 Oligopoly  4, 70, 72, 75–77, 83, 86, 87, 89–92, 95, 96, 174, 184, 304, 330, 721, 911 Oligopsony  77, 83, 92, 95, 96, 912 Opportunity cost  38, 39, 47, 67, 145, 262, 310, 363, 391, 393, 537, 597, 609, 610, 628, 629, 698, 704, 705, 720–722, 736, 737, 760, 894, 907, 912 Optimum tariff   825, 834, 850, 912 Organized migration  784, 815, 816, 912

P Paasche index  323 Paper money  296, 306, 311, 374–378, 380, 383– 386, 390, 408, 409, 427, 912 Pareto optimality  493, 495, 524, 912 Pareto, V.  189, 493, 517 Passive operations  432, 434, 442, 912 Passive public policy  290, 292, 912 Perfect competition  8, 12, 44, 48, 49, 75, 77–84, 93–96, 146, 184, 187, 260, 276, 337, 345, 708, 719, 903, 910, 912 Permanent migration  783, 804, 816, 912 Petty, W.  617 Phillips, A.  287 Phillips curve  15, 287, 288, 291, 293, 912 Pigou, A.  190, 273, 306, 381, 663 Pigouvian tax  664, 692, 912 Piore, M.  792 Porter, M.  732 Posner, M.  714 Poverty  6, 24, 128, 129, 134–137, 451, 480, 481, 485, 486, 489, 490, 502–513, 515, 516, 522– 524, 533, 539, 547–549, 567, 572, 573, 657, 658, 660, 662, 667, 684, 692, 789, 790, 860, 879, 883, 887, 888, 892, 913, 914, 917 Prebisch, R.  569 Prescott, E.  11 Price index  58, 322–324, 326, 331, 380, 769, 913 Producer price index  322, 323, 330, 331, 913 Production possibility frontier  159, 189, 314– 316, 494, 595, 597–600, 609, 610, 671, 672, 691, 702, 704, 705, 720, 721, 913 Profit  4, 6, 11, 13, 19, 31, 38–40, 44–49, 55, 60, 62, 68, 71, 74, 75, 77, 78, 81–83, 85, 86, 90, 91, 94, 96, 106, 108–112, 115, 116, 138, 150, 186–189, 192, 193, 197, 204, 205, 215, 225,

936

Index

227, 229, 243, 260, 298, 303, 304, 307, 312, 315, 318, 337, 338, 340, 348, 358, 359, 363, 412, 413, 416, 420, 425, 426, 430, 432, 434, 436, 437, 441, 446, 448–450, 457, 458, 489, 536–538, 541, 542, 550–554, 561–563, 576, 581, 601, 604, 609, 613, 618, 625, 627, 653, 656, 661, 663, 669, 689, 702, 714, 715, 728, 730–732, 744–747, 749–751, 756, 772, 776– 778, 791, 795, 811, 822, 838, 874, 875, 894, 901, 903, 905, 906, 910, 913 Protectionism  247, 308, 329, 699, 700, 737, 752, 818, 820–824, 826, 829, 832–834, 836, 839, 845–850, 871, 875, 877, 879, 880, 889, 896, 913 Public debt  5, 54, 309, 311, 321, 419, 425, 449– 455, 461, 475, 477, 913 Public good  19, 24, 35, 116, 336–338, 340, 348, 360–364, 367, 368, 445, 448–450, 803, 900, 911, 913 Public procurement  11, 12, 14, 19, 20, 24, 35, 54, 102, 103, 139, 161, 165, 204, 290, 364, 461, 913, 916 Purchasing power parity  58, 322, 770, 772, 779, 913

Regionalization  120, 247, 329, 398, 523, 587, 843, 869, 875, 880, 884, 889, 914 Relative poverty  104, 504, 506, 507, 524, 914 Repatriation  774, 782, 807, 816, 914 Revaluation  404, 768, 779, 914 Revenue  11, 19, 21, 22, 24, 31, 38, 39, 41, 44– 49, 54, 55, 59, 68, 74, 75, 79, 81, 82, 90, 93– 95, 107, 109, 110, 113, 114, 122, 134, 165, 202, 204, 235, 254, 260, 265, 308, 309, 316, 318, 319, 326, 359, 419, 430–432, 434, 436, 446, 447, 450–453, 455–461, 465–467, 476, 567, 601, 602, 604, 621, 629, 662, 699, 707, 727, 728, 730, 761, 803, 804, 822, 825, 826, 829–831, 834, 838, 846, 872, 894, 898, 913, 914 Ricardo, D.  8, 181, 188, 446, 537, 617, 703, 746, 847 Robertson, R.  854 Robinson, J.  551 Romer, D.  557 Rosenstein-Rodan, P. N.  567, 749 Rossi-Hansberg, E.  735 Rostow, W.  543 Rybczynski theorem  708, 737, 914

Q

S

Quality of life  64, 483, 484, 493, 501, 506, 512, 524, 525, 531, 581, 586, 641, 647, 652, 662, 666, 814, 879, 913, 915, 920 Quantity demanded  144–147, 155–157, 163, 164, 167–173, 177, 898, 912 Quantity supplied  148–150, 154, 161–165, 167, 170, 174, 175, 177, 392, 898, 912 Quesnay, F.  29 Quota  79, 84, 103, 122, 123, 129, 132, 150, 167, 168, 321, 343, 346, 561, 699, 700, 735, 807, 818, 820, 835–838, 849, 850, 900, 913

Samuelson-Jones theorem  698, 724, 737, 915 Samuelson, P.  250, 448, 708, 724 Sargent, T.  8, 11 Savings paradox  5 Say, J.-B.  183 Say’s law  9, 183, 205, 206, 222, 228, 336, 538, 566, 915 Schramm, C.  118 Schultz, T.  613, 618 Schumpeter, J.  234, 605 Seasonal migration  329, 783, 784, 816, 915 Seasonal unemployment  269, 271, 293, 915 Simon, H.  108, 110 Simons, H.  310 Simple reproduction  29, 30, 32, 542, 576, 661, 915 Situational monopoly  346–348, 368, 915 Smith, A.  8, 154, 181, 188, 229, 273, 446, 536, 617, 701, 745, 847 Social insurance  31, 45, 60, 482–485, 524, 796, 846, 884, 915 Social justice  480, 482, 485–487, 489, 491, 492, 503, 524, 525, 660, 692, 915, 917 Social policy  102, 120, 121, 139, 253, 343, 451, 480–482, 485, 503, 505, 512, 523, 525, 589, 664, 668, 854, 869, 870, 883, 884, 888, 915, 916

R Race to the bottom model  674 Ratchet effect  182, 222, 914 Rate of unemployment  267, 278, 288, 293, 914 Rational behavior  110, 138, 914 Rau, K.  446 Ravenstein, E.  786 Rawls, J.  499 Real exchange rate  467, 469, 767, 769, 771–773, 779, 914 Recessionary gap  201, 202, 222, 914 Reemigration  782, 807, 808, 816, 914 Rees, W.  675

937 Index

Social protection  136, 337, 340, 342, 481–486, 493, 520, 523, 525, 668, 803, 883, 884, 915 Social stability  107, 338, 466, 486, 487, 524, 525, 659, 884, 915 Solow, R.  8, 554 Solow-Swan model  554–560 Sonnenfels, J.  445 Spatial theory of trade  735, 737, 916 Stabilization policy  10, 102, 213, 224, 231, 246, 248, 252, 253, 255, 256, 278, 336, 342, 745, 916 Stagflation  10, 11, 207, 298, 316, 330, 331, 382, 916 Steady-state growth  533, 576, 916 Steuart, J.  376, 698 Stock market crisis  241, 245, 256, 777, 916 Stolper-Samuelson theorem  707, 737, 801, 916 Stolper, W.  707 Stone, R.  9 Strout, A.  749 Structural crisis  241, 256, 336, 382, 451, 916 Structuralism  305, 530, 569, 571, 574, 576, 577, 795, 916 Structural unemployment  117, 268–271, 285, 286, 289–291, 293, 307, 551, 916 Subjective poverty  504, 507, 524, 525, 916 Subsistence minimum  188, 487, 489, 501, 505, 506, 509, 516, 524, 525, 539, 909, 917 Supply  4, 5, 8, 9, 11, 12, 15, 20–22, 31, 34, 48, 51, 52, 55, 71, 72, 78, 79, 83, 84, 87, 88, 93, 95, 96, 105, 112, 116, 124, 130, 136, 138, 144–146, 148–154, 156, 159–161, 163–170, 174–177, 180, 181, 183, 184, 187, 189, 190, 193, 196, 199, 202, 204–208, 210–215, 219, 220, 222, 224, 225, 228, 229, 233, 235, 238, 239, 245, 246, 248, 249, 251, 253, 254, 256, 260, 262–267, 269, 271–279, 286–288, 291, 292, 296–301, 303, 305–307, 309–314, 316, 317, 320, 321, 325–328, 330, 331, 336–338, 340, 341, 346, 357, 360–368, 376, 377, 379– 382, 384–387, 390, 392–397, 403–409, 412, 416, 418, 420–422, 426, 431, 432, 439, 440, 444, 448, 451, 453, 461, 463, 465, 472, 475, 476, 487, 506, 523, 530, 532, 535, 539, 541, 545, 551, 552, 556, 561–563, 566, 568–570, 573, 575, 576, 580, 594, 615, 622, 662, 665, 667, 679, 685–687, 689, 700, 703, 705, 707, 708, 710, 711, 713, 717, 718, 721, 723, 725, 730, 732–734, 736, 737, 745–747, 750, 752, 757, 758, 760, 761, 764–771, 773–775, 784, 787, 791, 792, 795, 802, 806, 809, 811, 819, 823, 832–834, 836, 839, 841, 848, 849, 855, 859, 871, 872, 875, 885, 886, 892, 895, 898, 903, 907–911, 914–918 Supply price  93, 148, 154, 177, 917

T–T

Supply-push inflation  315 Supranational organization  124, 128, 139, 855, 877, 917 Surplus value  31, 32, 46, 186, 420, 536, 541, 542, 575, 577, 619, 625, 917 Sustainable development  65, 133, 134, 367, 516, 531, 534, 577, 588, 656–661, 670, 684–692, 813, 843, 844, 870, 883, 917 Sustainable development goals  134, 243, 540, 588, 656, 684, 689, 690, 692, 917 Sustainable economic development  253, 367, 452, 480, 503, 533, 588, 633, 656, 660–662, 676, 685, 693, 748, 917 Sustainable growth  129, 534, 575, 577 Swan, T.  468, 554 Sweezy, P.  90

T Targeting  309, 326, 331, 397, 428, 615, 660, 918 Tax  11–13, 15, 16, 18, 19, 23, 24, 31, 39, 45–47, 53, 55, 57, 59, 60, 64, 66, 79, 102, 113, 114, 116, 117, 119–122, 125, 148, 150, 157, 158, 160–162, 167–169, 186, 192, 204, 206, 210, 213, 216, 217, 219, 220, 231, 253, 254, 279, 280, 289, 302, 303, 309, 314, 315, 325, 326, 328, 342, 343, 345, 354–357, 363–365, 367, 368, 436, 437, 444–446, 449–452, 456–461, 463–467, 476, 477, 484, 487, 488, 490, 491, 518–520, 548, 585, 662, 664, 666, 692, 711, 750, 751, 790, 798, 799, 803, 804, 807, 826, 830, 831, 834, 838, 839, 842, 846, 850, 860, 885, 893, 895, 896, 898–900, 912, 918 Taylor, J.  310 Technological gap theory  698, 714, 737, 918 Technological trend  580, 586, 592, 594, 610, 878, 918 Temporary migration  783, 784, 804, 816, 918 Theory of competitive advantage  698, 732, 737, 918 Theory of incomplete contracts  698, 731, 732, 737, 918 Theory of overlapping demand  698, 712, 737, 918 Theory of technological progress  698, 715, 716, 738, 919 Tinbergen, J.  120, 713, 733, 827 Token money  383, 409, 919 Townsend, P.  509 Transnational corporation  100, 111, 112, 114, 115, 138, 139, 246, 298, 321, 417, 430, 547, 548, 709, 719, 742, 744, 745, 748, 784, 800, 809, 811, 821, 822, 871, 872, 882, 889, 892, 919

938

Index

U Unemployment  4–7, 10–15, 18, 19, 24, 60, 101, 103, 113, 115, 117, 185, 205–207, 225–230, 236, 245, 246, 254, 255, 260, 266–293, 296– 298, 312, 313, 316, 319, 327, 331, 338, 342, 344, 345, 415, 426, 451, 452, 465, 466, 483, 486, 503, 511, 512, 548, 549, 551, 554, 565, 567–569, 632, 662, 790, 792, 799, 801, 803– 805, 821, 822, 837, 875, 883, 885, 892, 896, 897, 900, 911, 912, 915, 916, 919 Unemployment gap  270, 271, 274, 281, 291, 293, 919 Universal basic income  884, 889, 919 Use value  372, 420, 540, 541, 577, 919

V Vanek, J.  827 Veblen goods  146, 176 Vernon, R.  709 Viner, J.  826 Voluntary migration  784, 816, 919

W Wackernagel, M.  675 Wage-price spiral  304, 316, 330 Wallace, N.  8, 11

Wallerstein, I.  794 Walras, L.  8, 758 Wan, H.  827 Warranted growth  550, 551, 577, 919 Warren, B.  548 Weil, D.  557 Welfare  18, 19, 24, 65, 73, 80, 85, 86, 94, 96, 100–102, 116, 117, 157, 163–166, 177, 192, 220, 279–281, 285, 301, 306, 314, 326, 330, 337, 339, 340, 366, 381, 466, 480, 488, 491– 501, 503, 505, 507, 515, 522, 524, 525, 534, 630, 663, 664, 700, 799, 818, 822, 825–827, 830, 834, 850, 854, 883, 884, 912, 919, 920 Wellbeing  5, 6, 45, 64, 66, 101, 103, 121, 157, 263, 323, 342, 345, 351, 480, 486, 487, 489, 491–493, 497, 501–503, 507, 509, 512, 515, 520, 522, 524, 525, 532, 535, 539, 571, 614, 616, 623, 652, 657, 664, 717, 730, 794, 801, 803, 807, 827, 828, 830, 882, 883, 913, 920 Westernization  854, 876, 880, 889, 920 Wholesale price index  323, 331, 920 Williamson, O.  108 Wonnacott, P.  827 Wonnacott, R.  827