This is the classic case of inflation, the situation in which aggregate demand (consumption plus investment plus government plus net export spending) exceeds the capacity of the economy to produce goods and services. The economy is at anytime only physically capable of producing goods and services at a certain (capacity) rate; should total spending exceed this level, the only possible outcome is that prices will rise as a result of the excess demand.
It is generally agreed among economists that excess demand is the most basic cause of inflation. The most common examples of demand-pull inflation are periods of wartime, when heavy government spending drives prices upward. Another case occurred after the Second World War, when house-holds cashed in their war bonds and went on a spending spree. In the second half of the 1960′s, US government spending on the Vietnam War and major domestic social security programs generated increasingly severe inflation, and in the 1972-73 worldwide economic boom – the strongest peacetime economic boom ever – prices rose at record rates as output simply could not keep up with booming demand. Each of these cases of inflation was accompanied by another phenomenon with which we will deal shortly – unusually rapid increases in the volume of money in circulation (the money supply).
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In the heyday of Keynesian fiscal policy in the 1950s and 1960s many economists throughout the world advocated the use of fiscal policy to remove even minor fluctuations in national income around its full-employment level. These economists felt that G and T could be changed frequently and by relatively small amounts to hold national income almost exactly at its full employment level. When this is attempted, fiscal policy is said to be used to “fine tune” the economy.
The feasibility of fine tuning depends on, among other things, the length of the so-called decision lag – the lag between perceiving a problem and getting a decision to initiate the answer is no. The extra government expenditure is a new injection and income will rise until a matching flow of withdrawals has been generated. Since taxes are only one of several withdrawals, it follows that the rise in taxes must be less than the rise in government expenditure.
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Assume for the moment, as did most economists of 70 years ago, that full employment is the natural state of the economy, that any lapses from this state will be temporary and self-correcting, and that the full-employment income, changes only slowly. Total output will thus usually be the full-employment output. If quantity produced is constant at the full-employment level, variations in aggregate demand can cause variations only in prices. If there is excess aggregate demand, prices must rise until the money value of aggregate output is made equal to aggregate demand measured in money terms. If aggregate demand is not sufficient to purchase full-employment output valued at existing prices, then the price level will fall until once again the value of total output is equal to the value of aggregate demand.
Now assume that in this sort of situation there is an increase in the supply of money. Firms and households do not wish to hold this additional money, so they spend it. This adds to aggregate demand at full employment and bids up prices. As prices rise, more money is required for transactions purposes. Eventually the price rise will be sufficient so that all of the extra money will be absorbed into transaction balances. When this happens, aggregate desired expenditure will no longer exceed income and the pressure for further price rises will be gone.
Now assume a drastic fall in the money supply. According to the quantity theory, firms and households will try to cut their spending in order to build up their holdings of cash. This reduces aggregate demand below income and in turn causes price to fall (assuming output remains at the full-employment level). As prices fall, smaller transactions balances are required. Eventually prices will fall sufficiently so that the existing supply of money will be enough to satisfy everyone’s transactions needs. People will then no longer be trying to hold their spending below their income in order to add to their cash balances, and the downward pressure on prices will cease.
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“Business cycle” has proven to be a very durable term, and economists use it interchangeably with “business fluctuation” with no intention of implying any such mechanical regularity.
There is a fairly general consensus among students of economic fluctuations that:
There is a common pattern of variation that more or less pervades all economic series.
There is a substantial difference from cycle to cycle in duration and in amplitude.
There are differences among economic series in their particular patterns of fluctuation.
Seasonal Variation
When economic time series are observed at monthly or quarterly intervals rather than annually, many exhibit marked seasonal patterns. This is illustrated by the monthly unemployment rates. For purposes of analyzing cyclical movements in economic activity it is common to make use of seasonally adjusted series. For example, between May and October 1977, the unadjusted unemployment rate fell from 7.7 to 7.3 percent. However, according to the calculations of Statistics Canada based on observation of past seasonal variation, this was a smaller fall than is usual at this time of the year. Thus, when seasonal influences have been removed, the seasonally adjusted rate shows a rise from 7.9 to 8.3 percent.
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In this chapter we have considered the nature of the “business sector” of the economy, which produces the supply of goods and services. In Chapters 6 through 10, we will see how supply and demand interact to determine prices. This task is complicated somewhat by the fact that supply – the production of goods and services by businesses – occurs under various conditions, ranging from industries comprised of large numbers of small firms to industries dominated by a few large firms to industries in which there is only one producer (a monopoly). These different conditions – referred to as “market structures” by economists – are of great significance to the supply of goods and services. If there is only one firm in an industry (a monopoly), it is in a position to control the supply of the product, thereby raising the price of the product and increasing its profits. In industries dominated by a few large firms, it is sometimes possible for these firms to get together to avoid competing on prices and thus increase their profits. On the other hand, in industries in which there are a large number of small firms, such collective action is very difficult or impossible to achieve; as a result, competition in such industries tends to be more intense, ad profits lower, than in either of the first two cases. In Chapter 6, we will examine the concept of “demand,” then in Chapter 7, we will begin our examination of “supply” (and its interactions with “demand”) in those industries in which there are a large number of small firms – industries that economists call “competitive”.
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From China to the Czech Republic, from Portugal to Peru, foreign stock markets are on a tear. They have trounced the S&P 500 over the past five years, and most are on track to do it again in 2007. As of early December, Morgan Stanley Capital International’s index of 21 major non-U.S. markets had posted a 12% gain, vs. 4.4% for the S&P. And that covers just large nations. Emerging markets were up 36% – the kind of returns that will tempt any investor to look beyond America’s shores. Next year, though, international markets could very well face a critical test: Can they continue to run even if the U.S. economy limps?
There’s a lively debate among analysts and economists nowadays, and a phrase that’s getting plenty of use is “global decoupling.” The idea is that unlike a decade ago, economies in Europe and Asia can thrive regardless of the strength of the U.S., propelled instead by the purring engine of China and other developing dynamos. China’s economy, for example, is expected to grow more than 10% next year – on top of 12% in 2007 – and remain a key driver of global expansion. Audrey Kaplan, manager of the Federated InterContinental fund, describes what she sees as the new reality: “What was once a single-engine economy now has multiple engines.”
Global investing, of course, comes with particular challenges. China’s markets could already very well be too hot, for instance. And the benefits of the weakening U.S. dollar, which helped propel many stocks in Europe and the Far East in 2007, might not continue, eliminating some of the appeal of foreign stocks for U.S. investors. In other words, global success in 2008 is going to require some stock-picking acumen. “We can’t just count on a rising tide to lift all boats,” says analyst Vladimir Milev of Metzler/Payden, a money management firm that specializes in European companies.
To find stocks with exceptional potential, we spoke to top foreign-fund managers and analysts, looking for great investments from Europe to the Far East. The five picks we highlight below all present opportunities to capitalize on vibrant economies and rising prosperity. The shares all trade an American depositary receipts (ADRs) on the New York Stock Exchange, making them as easy to buy or sell as any blue-chip domestic stock.
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