Two of the key supranational institutions, the International monetary Fund (IMF) and the World Bank, were established following a conference of leading countries held at Bretton Woods in the USA in 1944 to establish a post-war framework to facilitate currency and economic stability. The IMF now has nearly 200 member countries. Both organizations are centered in Washington. The objectives of the two organizations were always clearly delineated. The IMF was intended to provide relatively short-term financing to stabilize economies that had got into trouble with their foreign currency debts and reserves. The World Bank to provide long-term financing to support development.
Both organizations have their own agendas and this has led to significant controversy over their roles, objectives and policies. I will tr y to avoid being judgmental and simply describe what their principal objectives are and how they seek to achieve them. In this day and age it is usually safer to talk about sex than it is about politics. Most people are more interested in the former than the latter in any case.
The third key supranational financial institution is the Bank for International Settlements (BIS). This is based in Basel, Switzerland and its establishment predates that of the IMF and World Bank.
Bretton Woods
October 20th, 2009The Bank of England
October 12th, 2009The Bank of England is wor th a mention because it was the first modern central bank. It was established in 1694 but it is only in the nineteenth centur y that its operations star ted to differ greatly from central banks in continental Europe such as the Bank of France and the German Reichsbank. The latter both had branch networks and made loans directly to businesses. They accounted for a substantial propor tion of the banking business in each country.
The Bank of England was different because it had no direct lending to companies. It influenced credit conditions indirectly through its actions in tr ying to control, or at least have an impact on, the behavior of commercial banks. It did this primarily by adjusting the rate at which it would lend to commercial banks.
The Bank of England was established to act on behalf of the government. In the post Second World War period this meant that politicians effectively made many of its decisions. By way of contrast the German Bundesbank and US Fed both enjoyed a high degree of independence from political interference.
Political control meant that the Bank of England was usually required to increase money supply in the run-up to a general election by the party in power. This was intended to give the economy a short-term boost and the electorate the “feel-good” factor. Such an increase in money supply, without a corresponding increase in the real productive capacity of the economy, usually fed through to higher inflation, a depreciation (or devaluation) of the currency and a subsequent tightening of money supply. This gave rise to a period characterized by what became known as “stop-go” economics.
Around the turn of the century the Bank of England was given effective operational independence, being free to set sterling base interest rates and manage supply as it saw fit to keep inflation within a target range defined by Parliament. It also lost its responsibilities as a bank super visor to a newly established, unitar y financial ser vices regulator, the Financial Ser vices Authority (FSA).
The European Central Bank
October 3rd, 2009The European Central Bank (ECB) was established following the decision of a number of European countries, including Germany, France and Italy, to adopt a common European currency.
Individual central banks had to relinquish their powers to manage money supply and set domestic interest rate levels. A few countries, such as the UK, opted out although in time that may well change.
There are clear advantages and disadvantages of having a common European currency. Cross-border transaction costs are reduced in part because there are no foreign exchange related charges for business conducted between members. Risks arising from companies having foreign exchange positions are also reduced. Business travelers and tourists in Europe no longer have to carry cash in a dozen different currencies.
The disadvantages stem from a lack of labor mobility and variations in national fiscal policies. In a unified economy such as the US workers will react to a downturn in one part of the country by moving to a part of the countr y with better economic prospects. This is much harder to accomplish in a continent with many different languages and where there is a limited tradition of cross-border labor movement.
National central banks’ ability to use monetary policy to influence economic growth, the level of unemployment and inflation have been largely subjugated to the ECB. They cannot cut interest rates, for example, to give a boost to a local economy in recession or hike rates to choke off inflation. The extent to which this lack of flexibility will result in future problems remains to be seen.
The ECB has specific quantitative inflation targets to meet but also has the power to take action against countries that fail to keep their government’s financing deficit as a percentage of GDP below a predetermined level.
The US Federal Reserve
September 28th, 2009The US Federal reserve, usually referred to as the Fed, acts as both the central bank and one of the key regulators of the commercial banking system. The main board is based in Washington but there are also 12 regional reserve banks operating in what are referred to as Federal reserve Districts.
The main board has seven members drawn from the reserve banks in the Federal reserve Districts. The US President appoints these members with the appointments being ratified by the Senate. The members serve 14-year terms. This appointment system means that political interference is very limited and that the Fed has effective day-to-day political independence. Inevitably the board does work closely with whoever is the current incumbent of the position of secretary of the Treasur y even though they do not always see eye to eye.
The board is responsible for setting bank reserve requirements. It also shares responsibility with the regional reserve banks for establishing discount rate policy. Combined with open market operations these provide the principal tools for managing US monetary policy. It should be obvious that as the US Federal reserve is the world’s most powerful national central bank its monetary policies can have wide reaching effects in other countries, particularly those with currencies linked to the US$. The Federal Open-Market Committee (FOMC) meets on a regular basis, normally about once every six weeks, to establish a target Federal Funds rate and hence monetary policy necessary to achieve it. The Federal Funds rate is the rate that banks with surplus reserve deposits with a Federal reserve Bank charge on overnight funds to banks with a shortfall.
The Fed is able to influence the actual Federal Funds rate through open market operations by buying or selling Treasur y bills and notes in the market. Minutes of the meetings are published as are the voting records of the individual members in terms of their bias towards interest rate and monetary policy. In this context hawks favor tightening monetary policy and a bias towards higher rates and doves the opposite. The minutes and statement from the chairman are closely watched for signals on likely future Fed monetary and interest rate policies as they may have a significant impact on equity and bond markets not only in the US but around the world. The Fed is very careful of language and does not actually issue a formal bias statement but rather a “balance of risks” statement. Most people inter pret the latter as a statement of bias in any case.
The chairman of the Fed is also authorized by the FOMC to act if necessary between meetings. Such occasions are relatively rare, it is difficult to see when an emergency tightening of money supply would be necessary. There have only been three instances in recent memory when the Fed has pumped short-term liquidity into the market. One of those was flagged well in advance in the case of the Y2K switchover. The other two followed the collapse of the Long Term Credit Management group, a highly leveraged US hedge fund, which failed in dramatic style in 1998 largely due to positions it took in Russian instruments, and the reopening of US financial markets after the events of September 11th 2001.
Producer surplus
September 20th, 2009We previously used the demand curve to illustrate consumer surplus, the net gains of buyers from market exchanges. The supply curve can be used in a similar manner to illustrate the net gains of producers and resource suppliers. Suppose that you are an aspiring musician and are willing to perform a two-hour concert for $500. If a promoter offers to pay you $750 to perform the concert, you will accept, and receive $250 more than your minimum price. This $250 net gain represents your s. In effect, producer surplus is the difference between the amount a supplier actually receives (based on the market price) and the minimum price required to induce the supplier to produce the given units (their marginal cost).
It’s important to note that producer surplus represents the gains received by all parties contributing resources to the production of a good. In this respect, producer surplus is fundamentally different from profit. Profit accrues to the owners of the business firm producing the good, whereas producer surplus encompasses the net gains derived by all people who help produce the good, including those employed by or selling resources to the firm.
Market supply schedule
September 13th, 2009How will producer-entrepreneurs respond to a change in product price? Other things constant, a higher price will increase the producer’s incentive to supply the good. Established producers will expand the scale of their operations, and over time new entrepreneurs, seeking personal gain, will enter the market and begin supplying the product, too. The law ly states that there is a direct (or positive) relationship between the price of a good or service and the amount of it that suppliers are willing to produce. This direct relationship means that price and the quantity producers wish to supply move in the same direction. As the price increases, producers will supply more-and as the price decreases, they will supply less.
Like the law of demand, the law of supply reflects the basic economic principle that incentives matter. Higher prices increase the reward entrepreneurs get from selling their products. The more profitable producing a product becomes, the more of it they will be willing to supply. Conversely, as the price of a product falls, so does its profitability and the incentive to supply it. Just think about how many hours of tutoring services you would be willing to supply for different prices. Would you be willing to spend more time tutoring students if instead of $5 per hour, tutoring paid $50 per hour? The law of supply suggests you would, and producers of other goods and services are no different.
Because there is a direct relationship between a good’s price and the amount offered for sale by suppliers, the supply curve has a positive slope. It slopes upward to the right. Read horizontally, the supply curve shows how much of a particular good producers are willing to produce and sell at a given price. Read vertically, the supply curve reveals important information about the cost of production. The height of the supply curve indicates both (I) the minimum price necessary to induce producers to supply that additional unit and (2) the opportunity cost of producing that additional unit. These are both measured by the height of the supply curve because the minimum price required to induce a supplier to sell a unit is precisely the marginal cost of producing it.
Supply and the entrepreneur
September 6th, 2009Entrepreneurs organize the production of new products. In doing so, they take on significant risk in deciding what to produce and how to produce it. Their success or failure depends upon how much consumers eventually value the products they develop relative to other products that could have been produced with the resources. Entrepreneurs figure out which projects are likely to be profitable and then try to persuade a corporation, a banker, or individual investors to invest the resources needed to give their new idea a chance. Studies indicate, however, that only about 55 to 65 percent of the new products introduced are still on the market five years later. Being an entrepreneur means you have to risk failing.
To prosper, entrepreneurs must convert and rearrange resources in a manner that will increase their value. A person who purchases 100 acres of raw land, puts in a street and a sewage-disposal system, divides the plot into 1-acre lots, and sells them for 50 percent more than the opportunity cost of all resources used is clearly an entrepreneur. This entrepreneur profits because the value of the resources has increased. Sometimes entrepreneurial activity is less complex, though. For example, a 15-year-old who purchases a power mower and sells lawn services to his neighbors is also an entrepreneur seeking to profit by increasing the value of his resources-time and equipment.
Profits and losses
August 29th, 2009Firms earn a profit when the revenues from the goods and services that they supply exceed the opportunity cost of the resources used to make them. Consumers will not buy goods and services unless they value them at least as much as their purchase price. For example, Susan would not be willing to pay $40 for a pair of jeans unless she valued them by at least that amount. At the same time, the seller’s opportunity cost of supplying a good will reflect the value consumers place on other goods that could have been produced with those same resources. This is true precisely because the seller has to bid those resources away from other producers wanting to use them.
Think about what it means when, for example, a firm is able to produce jeans at a cost of $30 per pair and sell them for $40, thereby reaping a profit of $10 per pair. The $30 opportunity cost of the jeans indicates that the resources used to produce the jeans could have been used to produce other items worth $30 to consumers (perhaps a denim backpack). In turn, the profit indicates that consumers value the jeans more than other goods that might have been produced with the resources used to supply the jeans.
The willingness of consumers to pay a price greater than a good’s opportunity cost indicates that they value the good more than other things that could have been produced with the same resources. Viewed from this perspective, profit is a reward earned by entrepreneurs who use resources to produce goods consumers value more highly than the other goods those resources could have produced. In essence, this profit is a signal that an entre- preneur has increased the value of the resources under his or her control.
Business decision makers will seek to undertake production of goods and services that will generate profit. However, things do ot always turn out as expected. Sometimes business firms are unable to cover their costs. ossw occur when the revenue derived from sales is insufficient to cover the opportunity cost of the resources used to produce a good or service. Losses indicate that the firm has reduced the value of the resources it has used. In other words, consumers would have been better off if those resources had been used to produce something else. In a market economy, losses will eventually cause firms to go out of business, and the resources they previously utilized will be directed toward other things valued more highly.
Profits and losses play a very important role in a market economy. They determine which products (and firms) will expand and survive, and which will contract and be driven from the market. Clearly, there is a positive side to business failures. As our preceding discussion highlights, losses and business failures free up resources being used unwisely so they can be put to a use producing other things that people value more highly.