Back to Basics : Economic Concepts Explained

International Monetary Fund

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 2017
• ISBN:
  9781484320921

NONE

Back to Basics: Economic concepts explained

Foreword

Maurice Obstfeld

I. THE BIG PICTURE

What Is Capitalism?

Free markets may not be perfect but they are probably the best way to organize an economy

Sarwat Jahan and Ahmed Saber Mahmud

What Is Keynesian Economics?

The central tenet of this school of thought is that government intervention can stabilize the economy

Sarwat Jahan, Ahmed Saber Mahmud, and Chris Papageorgiou

Micro and Macro: The Economic Divide

Economics is split into two realms: the overall economy and individual markets

G. Chris Rodrigo

Economic Models: Simulations of Reality

Economists build simplified descriptions to enhance their understanding of how things work

Sam Ouliaris

Econometrics: Making Theory Count

For economic theory to be a useful tool for policymaking, it must be quantifable

Sam Ouliaris

Supply and Demand: Why Markets Tick

Buyers and sellers meet and at the right price all products are sold

Irena Asmundson

Gross Domestic Product: An Economy’s All

When it is growing, especially if inflation is not a problem, workers and businesses are generally better of than when it is not.

Tim Callen

Monetarism: Money Is Where It’s At

Its emphasis on money’s importance gained sway in the 1970s

Sarwat Jahan and Chris Papageorgiou

II. HOW ECONOMIES FUNCTION

What Is Direct Investment?

Investors often seek profits from a long-term stake in a foreign operation

Tadeusz Galeza and James Chan

The Output Gap: Veering from Potential

Economists look for the difference between what an economy is producing and what it could produce

Sarwat Jahan and Ahmed Saber Mahmud

Structural Policies: Fixing the Fabric of the Economy

Monetary and fiscal policies deal with short-term economic fluctuations, but an economy’s problems often go deeper

Khaled Abdel-Kader

Money: At the Center of Transactions

Without it, modern economies could not function

Irena Asmundson and Ceyda Oner

Price: The Language of Exchange

A price is the amount of money a buyer gives a seller in exchange for a good or a service. But it can be more than that

Irena Asmundson

Inflation: Prices on the Rise

Inflation measures how much more expensive a set of goods and services has become over a certain period, usually a year

Ceyda Oner

Unemployment: The Curse of Joblessness

The number of people at work is generally closely related to whether an economy is growing at a reasonable rate

Ceyda Oner

Recession: When Bad Times Prevail

It is a sustained period when economic output falls and unemployment rises

Stijn Claessens and M. Ayhan Kose

Fiscal Policy: Taking and Giving Away

Governments use spending and taxing powers to promote stable and sustainable growth

Mark Horton and Asmaa El-Ganainy

Externalities: Prices Do Not Capture All Costs

There are differences between private returns or costs and the costs or returns to society as a whole

Tomas Helbling

International Trade: Commerce among Nations

Nations are almost always better of when they buy and sell from one another

Brad McDonald

What Are Real Exchange Rates?

What is the value of a country’s goods against those of another country, a group of countries, or the rest of the world, at the prevailing exchange rate?

Luis A. V. Catão

Purchasing Power Parity: Weights Matter

At what rate would the currency of one country have to be converted into that of another to buy the same goods and services in each country?

Tim Callen

Capital Accounts: Liberalize or Not?

There are both benefits and costs to easing restrictions on capital that flows across a country’s borders

M. Ayhan Kose and Eswar Prasad

Current Account Deficits: Is There a Problem?

There can be consequences when the amount a country spends abroad is wildly different from what it receives from the outside world

Atish Ghosh and Uma Ramakrishnan

III. FINANCE

Shadow Banks: Out of the Eyes of Regulators

Many financial institutions that act like banks are not supervised like banks.

Laura E. Kodres

LIBOR: World Reference Point

The London interbank rate is used widely as a benchmark but has come under fre

John Kiff

Banks: At the Heart of the Matter

Institutions that match up savers and borrowers help ensure that economies function smoothly

Jeanne Gobat

What Are Money Markets?

They provide a means for lenders and borrowers to satisfy their short-term financial needs

Randall Dodd

Markets: Exchange or Over the Counter

How securities are traded plays a critical role in price determination and stability

Randall Dodd

IV. ECONOMICS IN ACTION

Financial Services: Getting the Goods

How consumers and businesses acquire financial products such as loans and insurance

Irena Asmundson

Strategic Thinking

Game theory analyzes behavior when decisions must take into account the potential actions of opponents

Sarwat Jahan and Ahmed Saber Mahmud

68 Taxes in Practice

It is hard to design a fair and efficient revenue system

Ruud De Mooij and Michael Keen

Taxing Principles

Making the best of a necessary evil

Ruud De Mooij and Michael Keen

Inflation Targeting: Holding the Line

Central banks use interest rates to steer price increases toward a publicly announced goal

Sarwat Jahan

Regressions: An Economist Obsession

A basic statistical tool for distinguishing between correlation and causality

Rodney Ramcharan

What Are Remittances?

For many countries, money transfers from citizens working abroad are a lifeline for development

Dilip Ratha

Foreword

PITY THE ECONOMIST. Financial stock prices have recovered from the great financial crisis of 2007–09—and, in some countries, are touching all-time highs. But the stock of economists remains in the tank.

Not only did we fail to see the financial crisis coming—as Queen Elizabeth II memorably observed during a 2008 visit to the London School of Economics—but our economic policies seem to most people not to have restored the global economy quite to its bloom of earlier decades.

Thus, politicians these days scorn “experts” and encourage voters to ignore them. They feel free to disavow even their own economic analysts in favor of convenient alternative views. Economic forecasting is widely derided as useless—or worse. How often have I been asked by a journalist, “Why should we believe anything you say, when you were wrong about ___?”

There are sadly many ways to fill in that blank, and some criticism of economics is well justified. Yet, just as it is important not to overstate what economics can do, it is critical not to understate it. Economics is far from a precise science—who would expect to predict with any accuracy global outcomes that depend on the individual actions of about 5 billion working-age individuals, not to mention the intervention of natural and man-made disasters? At the same time, however, economics provides an essential tool for understanding, and to some degree shaping, those events.

The articles in this collection, all from the International Monetary Fund’s quarterly magazine Finance & Development and updated in 2017, illustrate the rich diversity of questions that economics can illuminate. The best economic analysis clarifies thought: it is a mental discipline that helps make sense of complex events, ranging from famines, to bank runs, to housing shortages. It can proceed from the bottom up—focusing on the decisions of individuals and how they hang together at the economy level—or from the top down—reminding us how an economy’s resources, its technology, and its trading opportunities limit what its people and government can consume over time.

As you will see reading these pages, economics is less than a science—which is what gets economists into trouble—but, looked at in another way, it is more. One of the architects of the International Monetary Fund, John Maynard Keynes, called economics “an easy subject at which few excel…. The paradox finds its explanation, perhaps, in that the master-economist must possess a rare combination of gifts. He must be mathematician, historian, statesman, philosopher—in some degree.” It may be the curse of economists that their subject cannot be reduced to a routine technical exercise—like dentistry, to use another example of Keynes’s. But that is also what makes economics so fascinating.

—Maurice Obstfeld

Economic Counsellor and

Director of Research Department

International Monetary Fund

I The Big Picture

What Is Capitalism?

Free markets may not be perfect but they are probably the best way to organize an economy

Sarwat Jahan

Ahmed Saber Mahmud

SARWAT JAHAN is a senior economist in the IMF’s Asia and Pacific Department, and AHMED SABER MAHMUD is associate director in the Applied Economics Program at Johns Hopkins University.

CAPITALISM is often thought of as an economic system in which private actors own and control property in accord with their interests, and demand and supply freely set prices in markets in a way that can serve the best interests of society.

The essential feature of capitalism is the motive to make a profit. As Adam Smith, the 18th century philosopher and father of modern economics, said: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” Both parties to a voluntary exchange transaction have their own interest in the outcome, but neither can obtain what he or she wants without addressing what the other wants. It is this rational self-interest that can lead to economic prosperity.

In a capitalist economy, capital assets—such as factories, mines, and railroads—can be privately owned and controlled, labor is purchased for money wages, capital gains accrue to private owners, and prices allocate capital and labor between competing uses (see “Supply and Demand,” p. 12).

Although some form of capitalism is the basis for nearly all economies today, for much of the past century it was but one of two major approaches to economic organization. In the other, socialism, the state owns the means of production, and state-owned enterprises seek to maximize social good rather than profits.

Pillars of capitalism

Capitalism is founded on the following pillars:

• private property, which allows people to own tangible assets such as land and houses and intangible assets such as stocks and bonds;

• self-interest, through which people act in pursuit of their own good, without regard for sociopolitical pressure. Nonetheless, these uncoordinated individuals end up benefiting society as if, in the words of Smith’s 1776 Wealth of Nations, they were guided by an invisible hand;

• competition, through firms’ freedom to enter and exit markets, maximizes social welfare, that is, the joint welfare of both producers and consumers;

• a market mechanism that determines prices in a decentralized manner through interactions between buyers and sellers—prices, in return, allocate resources, which naturally seek the highest reward, not only for goods and services but for wages as well;

• freedom to choose with respect to consumption, production, and investment—dissatisfied customers can buy different products, investors can pursue more lucrative ventures, workers can leave their jobs for better pay; and

• limited role of government, to protect the rights of private citizens and maintain an orderly environment that facilitates proper functioning of markets.

The extent to which these pillars operate distinguishes various forms of capitalism. In free markets, also called laissez-faire economies, markets operate with little or no regulation. In mixed economies, so called because of the blend of markets and government, markets play a dominant role, but are regulated to a greater extent by government to correct market failures, such as pollution and traffic congestion; promote social welfare; and for other reasons, such as defense and public safety. Mixed capitalist economies predominate today.

The many shades of capitalism

Economists classify capitalism into different groups using various criteria. Capitalism, for example, can be simply sliced into two types, based on how production is organized. In liberal market economies, the competitive market is prevalent and the bulk of the production process takes place in a decentralized manner akin to the free-market capitalism seen in the United States and the United Kingdom. Coordinated market economies, on the other hand, exchange private information through non–market institutions such as unions and business associations—as in Germany and Japan (Hall and Soskice 2001).

More recently, economists have identified four types of capitalism distinguished according to the role of entrepreneurship (the process of starting businesses) in driving innovation and the institutional setting in which new ideas are put into place to spur economic growth (Baumol, Litan, and Schramm 2007).

In state-guided capitalism, the government decides which sectors will grow. Initially motivated by a desire to foster growth, this type of capitalism has several pitfalls: excessive investment, picking the wrong winners, susceptibility to corruption, and difficulty withdrawing support when it is no longer appropriate. Oligarchic capitalism is oriented toward protecting and enriching a very narrow fraction of the population. Economic growth is not a central objective, and countries with this variety have a great deal of inequality and corruption.

Big-firm capitalism takes advantage of economies of scale. This type is important for mass production of products. Entrepreneurial capitalism produces breakthroughs like the automobile, telephone, and computer. These innovations are usually the product of individuals and new firms. However, it takes big firms to mass-produce and market new products, so a mix of big-frm and entrepreneurial capitalism seems best. This is the kind that characterizes the United States more than any other country.

The Keynesian critique

During the Great Depression of the 1930s, the advanced capitalist economies suffered widespread unemployment. In his 1936 General Theory of Employment, Interest, and Money, British economist John Maynard Keynes argued that capitalism struggles to recover from slowdowns in investment because a capitalist economy can remain indefinitely in equilibrium with high unemployme...