Investment and Shift of LRAS

There seem to be some confusion among some students with regard to shifting the long run aggregate supply (LRAS). Some students mentioned in their essays that a fall in investment would lead to a leftward shift of the LRAS which would mean a fall in productive capacity. Is this correct?

We know that the LRAS is determined by the productive capacity of the economy (ie the total output of goods and services possible when resources are fully employed). Investment refers to the acqiusition of fixed capital and addition to inventories. With more capital stock, the productive capacity of the economy would increase and hence LRAS shifts to the right. Does a fall in investment then mean a fall in productive capacity and a leftward shift of LRAS?

The concepts of gross and net investment would apply here. As capital is utilised, it is subject to wear and tear. This is what we call “depreciation” of capital or “capital consumption”. Hence part of the investment is to replace worn out capital. This is known as “Replacement Investment”. Gross Investment is the total investment ie acquisition of capital. Since part of it is used to replace worn out capital, the remaining part is called Net Investment. Hence Net Investment = Gross Investment – Replacement Investment (capital consumption).

As long as gross investment exceeds replacement investment (ie Net investment is positive), there is a net addition to capital stock and hence an increase in productive capacity. So LRAS will still shift to the right. So even if investment falls, (eg. due to fall in foreign direct investment inflow), LRAS can still shift to the right as long as it is still greater than replacement investment. It is therefore not correct to say that a fall in investment would cause LRAS to shift to the left, unless we qualify that it falls below replacement investment (which is quite unusual in most cases).

What is more likely is that the LRAS shifts rightward by a smaller extent due to the fall in investment ie the increase in productive capacity is smaller – which is what we refer to as a fall in potential growth of the economy. (Note there is still positive growth but at a slower rate).


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Economics Humour

For students who are getting examination stress, here are some economics jokes to lighten up your day!

I’m a walking economy,” a man was overheard to say.
“My hairline’s in recession, my waist is a victim of inflation, and together they’re putting me in a deep depression.”

An economist is someone who gets rich explaining others why they are poor.

A woman hears from her doctor that she has only half a year to live. The doctor advises her to marry an economist and to live in South Dakota. The woman asks: will this cure my illness? Answer of the doctor: No, but the half year will seem pretty long.

Economics is the only field where there can be 2 Nobel Prize winners saying opposite things.

The First Law of Economics – Every economy tends to remain at full employment equilibrium unless acted upon by an economist

The Second Law of Economics – For every economist, there is an equal and opposite economist.


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Fun Video on Market Failure – Externalities

Here is an interesting and funny video on Externalities in production:

Huck the Duck and Fin the Fish

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Singapore’s economy grows 15.5 percent in Q1: govt

On Thursday 20 May 2010, 10:47 SGT

AFP: Singapore’s economy grew by a better-than-expected 15.5 percent in the first quarter year-on-year, spurred mainly by strong demand for electronics, government data showed Thursday.

 On a seasonally adjusted quarter-on-quarter basis, Singapore’s gross domestic product (GDP) surged 38.6 percent in the three months to March period, the Ministry of Trade and Industry (MTI) said.

 Initial government estimates released in April showed the economy expanded an annual 13.1 percent and 32.1 percent on a quarter-on-quarter basis.

 The MTI said the first quarter display was driven by the manufacturing sector’s annual 32.9 percent surge amid buoyant global demand for electronics products, especially semiconductor ships.

 “The strong momentum seen in the first quarter was broad-based, led by the manufacturing sector… The electronics cluster enjoyed the strongest growth, underpinned by strong global demand for semiconductor chips,” the MTI said.

 Other key industries also showed strong performance during the first quarter, it said.

 These included construction, which expanded 13.7 percent annually, wholesale and retail trade, which was up 17.7 percent while financial services surged 18.1 percent, the MTI said.

 Singapore’s economy has expanded for three straight quarters as the city-state stages a strong recovery from a recession triggered by the global economic and financial crisis that struck in late 2008.

 The MTI is maintaining its 2010 forecast for growth of 7.0-9.0 percent, a dramatic turnaround from last year, when GDP shrank a revised 1.3 percent.

 Despite the strong economic recovery, the ministry said Europe’s debt crisis and worries of excessive asset price increases in Asia were some of the downside risks that could derail the global economy, thereby hitting Singapore.

 Singapore, one of Asia’s wealthiest countries, has one of the world’s most open economies, which makes its vulnerable to volatility in the global economy.

Comment:  The confirmed figures for Singapore’s Q1 growth are better than expected, showing signs of a recovery –  the key driving force being the upturn in global electronics demand, notably semiconductor chips which Singapore exports.  Of course, there are downside risks such as what is happening in Europe and the growing asset bubbles.

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To Bail or not To Bail – That is the Question

Bailouts often present a moral dilemma. If the bailout is not given, the collapse of the firm could have drastic consequences both locally and globally – the so-called “Too big to fail” syndrome. If the government chooses to bail out the firm, there is no guarantee that the firm will use the bailout funds prudently and be responsible enough not to commit the same error again. It might even promote more risky behaviours as firms think that they can always rely on the government to bail them out should they run into trouble.

The recent bailout given to Greece by the EU is yet another example. Will it lead to more responsible fiscal spending by the government and to what extent will the auterity measures materialise?

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Cathay says it has immunity in price-fixing case

Fri, Apr 23, 2010

HONG KONG – Cathay Pacific said Friday it had been granted immunity from any fine by British regulators in a price-fixing case with Virgin Atlantic, on condition that it offered full cooperation.

Britain’s Office of Fair Trading (OFT) said Thursday it was investigating whether the Hong Kong-listed airline and Virgin had infringed pricing law over the lucrative London to Hong Kong route.

The OFT said the matter had been brought to its attention by Cathay under the its leniency policy, which says a firm may be given immunity from penalties for being the first to report its participation in possible cartel conduct.

“Cathay Pacific has applied for and been granted immunity from any financial penalty by the OFT in relation to this matter, conditional upon Cathay Pacific’s full cooperation with the investigation,” the airline said in a statement posted to the Hong Kong stock exchange on Friday.

The statement said Cathay “has a policy of full compliance with competition law and will cooperate in full with requirements of any relevant authorities”.

The case concerns a number of alleged contacts between employees of the two airlines over a number of years, a statement issued by the British competition watchdog said.

Sir Richard Branson’s Virgin Atlantic has strongly denied the allegations.

“Virgin Atlantic intends to robustly defend itself against these allegations dating from 2002-2006,” it said in a statement.

“The airline does not believe that it has acted in any way contrary to the interests of consumers.”

It is alleged that the contacts “had the object of coordinating the parties’ respective pricing strategies regarding passenger fares through the exchange of commercially sensitive information on pricing and other commercial matters,” according to the OFT.

Comment: An interesting case of Game Theory “Prisoner’s Dilemma” at work?  The first party to report on the price fixing or anti-competitive behaviour gets away with it, while the other party(ies) get punished. If you don’t report, you don’t know if the other party will “play you out”. Seems like an interesting and effective way of breaking up tacit collusion among firms.

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IMF Urges Stronger Chinese Yuan; Japan Might Need More Stimulus

By Aki Ito

April 22 (Bloomberg) — The International Monetary Fund said China should let the yuan gain to cool growth, while Japan must be prepared to widen its stimulus measures as Asia’s two biggest economies diverge.

Japan, with its “tentative” economic recovery, is an exception in a region that’s leading the global rebound, the IMF’s semiannual World Economic Outlook, released yesterday, showed. The Washington-based lender that offered rescue packages to countries from Iceland to Ukraine during the crisis raised its projections for growth in Asia’s economies for 2010 and 2011.

Asia’s strengthening expansion, fueled by consumer spending and investment in China and India, means policy makers in several countries should embrace stronger exchange rates, the fund said. The Group of 20 emerging and developed nations, whose finance chiefs meet tomorrow in Washington, should discuss coordinating policies to strengthen the global recovery, the IMF said.

“Currencies of a number of emerging Asian economies remain undervalued, substantially in the case of the renminbi,” the IMF said in the report. Renminbi is a name for China’s currency, a denomination of which is the yuan. It’s “essential” for China to address excess demand pressures by “reining in credit growth and allowing exchange-rate appreciation,” it said.

The IMF’s comments reinforce calls from economic leaders from the U.S. to India, Brazil and Europe for China to allow the yuan to rise. U.S. lawmakers have proposed restrictions on Chinese imports to counter what they call the unfair export subsidy of an undervalued yuan.

Yuan Peg

Premier Wen Jiabao’s government has kept the Chinese currency at about 6.83 against the dollar since July 2008, after allowing it to rise 21 percent in the previous three years. China’s growth will accelerate to 10 percent this year from 8.7 percent in 2009, according to the IMF, which raised its 2011 projection to 9.9 percent from 9.7 percent previously. India will expand 8.8 percent this year and 8.4 percent next, compared with estimates from January of 7.7 percent and 7.8 percent.

Japan, which is projected to be surpassed by China as the world’s second-biggest economy this year, will expand 1.9 percent in 2010 and 2 percent in 2011 after a 5.2 percent contraction in 2009, the report shows. While Prime Minister Yukio Hatoyama’s government has urged the central bank to help whip deflation this year, the IMF sees consumer prices falling through 2011.

 BOJ Measures

 “For Japan, with the reemergence of deflation, the current accommodative monetary policy stance remains appropriate, but additional easing measures may be necessary if deflation persists,” the IMF said. The Bank of Japan in March doubled the size of a special three-month program providing loans to banks, to 20 trillion yen ($214 billion).

By contrast, central banks in India, Malaysia and Vietnam have started raising interest rates. India’s central bank on April 20 raised borrowing costs for the second time in a month and ordered lenders to set aside more cash as reserves. While China’s central bank has yet to increase rates, the government has stepped up measures to damp property prices in 70 cities that jumped a record 11.7 percent last month.

“Given the region’s strong recovery, planning the speed and sequencing of the exit from stimulative macroeconomic policies must become a policy priority,” the IMF said. “In China, the withdrawal of the exceptional monetary stimulus introduced in 2009 will also minimize the risks from excessively easy credit conditions.”

Other priorities for officials in Asia include preventing the development of “speculative booms” as the region’s growth outperformance attracts a surge of capital from abroad, the IMF said. Finance Ministers from the Association of Southeast Asian Nations said this month they are “cognizant” of the risks that foreign funds bring and the need to strengthen their “monitoring system” of such trends.

Last Updated: April 21, 2010 11:00 EDT

Comment:  Everyone is expecting China to revalue the Yuan, and Asian currencies to appreciate in tandem with the renminbi, spurred by the rapid economic recovery in the region.

Exchange rate appreciation is, however, a double-edged sword that can cut both ways, and its ultimate effects are by no means certain. While it may help to correct trade imbalances by making the country’s exports more expensive and imports relatively cheaper, it may also attract capital inflow giving rise to asset bubbles and inflationay pressure.  To some extent, the lowering of import prices resulting from currency appreciation may help control domestic price levels, but this depends on the country’s propensity to import. On the other hand, there could be other forces driving the country’s export growth (eg. input prices, productivity…) which may not be stemmed by exchange rate revaluation. So, revaluation is no magic pill for correcting trade imbalance.

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