World Economy - The Dual Challenge

The world economy faces dual challenges over the next few years to assure financing of the huge payment imbalances arising from the major oil price increases that have taken place and to promote fundamental adjustment to the changing world energy situation, which is at the heart of global economic difficulties. Rising cost of food items are also putting national economies under severe pressure. Whether a coordinated effort on the part of various nations succeeds in restoring a strong and stable global economy has a critical and direct bearing on the economic well-being of the world. The health of the world economy directly affects markets for the production of farm and factory products and the employment situation of the world. Nations are learning fast that in collective well-being lies the essence of personal well-being. Everybody's stake in a healthy world economy is growing stronger and stronger. 

International investment has become very important both at home and abroad. Exchange of capital outlay among nations is important, as through it production centres can be located at desired places and production can be carried on in the most economical way. Thereby exchange of technology also can be promoted, which again contributes to bring down the overall global cost of production. Labour may be less costly somewhere. Proximity to market reduces the transportation cost. Everybody then will be able to get things at a low cost.

Political and economic unrest in certain areas are putting a serious pressure on the well-being of the world economy. The political turmoil is the Middle East has contributed to uncertainty about future oil supplies at a time when the world economy is already facing a difficult situation since the 2008 recession, effects of which are still lingering. During the past 30-35 years widespread fluctuations in oil prices, which always remain very sensitive to changes, economic or non-economic, have given the world economy several jolts. Increase in oil prices during the past two years, a climbing inflation, balance of payments deficit, and lowering of income from foreign investments continue to disturb the major economies of the world. The changing face of the world economic environment is likely to make it not only more difficult for nations to obtain the much-needed financing, but more difficult also for them to make the economic adjustments required by changing external circumstances. Oil-importing nations are facing a deteriorating position in their current accounts.

As growth rates slow down, unemployment rises and trade deficits widen, many countries keep on feeling the pressure to keep their internal economy in fine tune. A coordinated and cooperative international response to the problems of the world economy, both political and economic, is needed to assure an effective solution, and maintain the essential economic framework. Oil price increase imposes serious hardship on the poorest nations, whose development plans need to be altered to accommodate increased payments for oil. Some individual countries are facing serious financial difficulties.

Over the next few years the world faces a dual task of assuring not only that growth in gross domestic product is achieved keeping the price level within a controllable limit, but also that basic economic adjustments are initiated and carried through to restore a sustainable basis for future world economic growth and development.

Finding out alternative sources of energy is what is needed the most, as a time will come when world fossil fuel reserves will start their steep downward swing. We have to keep in mind that world consumption of energy keeps on increasing. Nuclear energy is being considered hazardous and unsafe by many because of the disasters that have taken place. Harnessing solar energy, wind and water energy, using hydrogen as fuel to produce energy, or inventing some other synthetic fuel are the major options open. Some innovative technology needs to be developed which will be cost-effective or economically viable as well as clean and pollution-fee.

Protecting the world environment is also a serious challenge for everyone. Even way back in 1981 it was a known fact that energy use at such a large scale, mainly fossil fuel, even if otherwise feasible, could raise the average surface temperature of the earth with potentially catastrophic global effects. That has started happening and now we need to put a check on fossil fuel consumption to minimize emission of greenhouse gases. Burning of fossil fuels has contributed to the increase in carbon dioxide in the atmosphere. Global warming, a recent warming of the Earth's surface and lower atmosphere, is believed to be the result of a strengthening of the greenhouse effect mostly due to human-produced increases in atmospheric greenhouse gases. We still rely heavily on fossil fuel.

The Kyoto Protocol(adopted on December 11, 1997, and entered into force on February 16, 2005), aimed at fighting global warming, is an international environmental treaty with the goal of achieving the stabilization of greenhouse gas concentrations in the atmosphere at a level that would protect the climate system. The objective of the Kyoto climate change conference was to establish a legally binding international agreement, whereby all the participating nations commit themselves to tackling the issue of global warming and greenhouse gas emissions. The target agreed upon was an average reduction of 5.2% from 1990 levels by the year 2012.

The Copenhagen Accord (December 18, 2009) recognized the scientific issue for keeping temperature rise to no more than 2 degree C but did not contain commitments to emissions reduction to achieve that goal. The agreement was a vital first step and accepted that there was a lot more work to be done to get assurances so that it would become a legally binding treaty. It endorsed the continuation of the Kyoto Protocol, but was not legally binding and did not commit countries to agree to a binding successor to the Kyoto Protocol, whose present round ended in 2012.

The 2012 United Nations Climate Change Conference took place during November-December 2012, at the Qatar National Convention Centre in Doha. The conference reached an agreement to extend the life of the Kyoto Protocol, which had been due to expire at the end of 2012, until 2020, and to make a more concrete and real successor to the Kyoto Protocol,  set to be developed by 2015 and implemented by 2020. For the first time the concept of "loss and damage" has been incorporated,  an agreement in principle, which says that richer nations could be financially responsible to other nations for their failure to reduce carbon emissions.

In the actual field, nothing much has changed during the past 30 years. Now some clean, pollution-free source of energy, which will fulfill our long-term energy requirements, is needed to keep the earth and its atmosphere cool. The energy base of industrial civilization has to include some new energy source. The chances of success in creating a new energy base are reasonably good. Only the length of time available and the scale of resources devoted to the task will help determine the outcome.

World Economy - 2012 onwards

The world economy is currently undergoing a radical change, possibly for the better. The traditional ways of trade, industry and commerce are changing. Privatization is taking place in certain key sectors. Governments are trying to concentrate on more important areas like defence, disaster management, social and cultural uplifting etc. However, the changes themselves are not taking place very fast. These are undergoing at a moderate pace.

Art and culture are getting industrialized. The world is undergoing a thorough cultural change, and when art and culture changes, everything else changes.  Now we have the notion that a poet or a dramatist is not only born, he can be groomed up into also; he can be made.

Technological changes are also taking place at a fast pace, though certain technological advancements are being assumed to bring some potential adverse effects on life and living.

The small artisans who were catering the local, or at the most the regional market are finding markets at far off places. Transport and communication has improved dramatically. Tele-communication is still advancing by leaps and bounds making the world a very closely-knit network. It has now become very easy to showcase ones' products at distant markets.

The small industries, which were, until the turn of this century, operating at a very small scale with moderate profit margins are attracting big investors. The small scale manufacturers are getting orders, which are thousand times bigger than what is was previously. Big players are entering into micro cottage industry sectors, which never had dreamt of entering the international market.

The basic and heavy industries are operating at a low ebb. There is comparatively less demand for steel and chemicals. Automobile industry will sooner or later get saturated. So unless new sectors are boosted up creating more income for the moderate and relatively weaker sections, the basic and heavy industries will continue to suffer. Real estate business will fail to get revived. But a real estate boom will no longer possibly be looked upon with great optimism by the experts. 

The whole money multiplier cycle needs to be energized with potentially prospective endeavours so that the whole economy gets charged up.

Investors are on the look out for new, prospective sectors, which promises a steady and secured flow of income.

Energy charges are rising fast. Need for renewable, cheaper sources of energy are necessary. Unless energy is made cheap, it is difficult to control cost-push inflation in a situation where demand-pull inflation is already having its daily share everywhere. Changes in lifestyle for less consumption, general awareness about the pollution of nature and its drastic changes, conservation of natural resources and more dependence on nature by curtailing artificial means of comforts and luxuries are needed the most. A mass realization about balancing the world economy with its natural resources will surely go a long way to remove the problems the world is facing currently and will ensure a much better tomorrow.

Destabilized economy and corrective measures

Fiscal Policy

When the economy does not function properly under the influence of unemployment, depression or inflation, the government tries to make certain changes in its expenditure policy to bring in the desired changes, and to eliminate the forces that are destabilizing the economy.

There are two basic measures that a government can undertake to stabilize the economy.

1. Government Expenditure

Increase in government expenditure acts as an investment. It gets added to the private investment that is prevailing in the economy. Thus, more government expenditure generates more employment and income, and takes the economy to a new equilibrium position.

2. Taxation

Government Expenditure expands the economy, whereas taxation contracts the economy. More taxation reduces the disposable income of individuals. This reduces their capacity to spend on consumer goods. A rise in taxes lowers the demand curve of the economy. This reduces income and employment. This is necessary during periods of inflation, when prices are moving upwards.

A reduction in taxes will give more income in the hands of consumers. Demand will increase, and new investment and income will be generated. This is necessary during periods of depression. Cut in taxes helps the economy to recover from a depressed state.

Monetary policy is aimed to control the supply of money in an economy. The central bank, which acts as the agent for the government, determines and controls the money supply according to the need of the economy.
Monetary policy is a tool or a process through which a government, central bank, or monetary authority of a country controls
(a) the supply of money,
(b) availability of money, and
(c) cost of money or rate of interest to attain certain sets of objectives to promote the growth and stability of the economy.

Cash reserve Ratio (CRR) is the amount of money or funds that the banks have to keep with the central monetary authority, mainly the central bank of the country.  If the central bank decides to increase the CRR, commercial banks are left with lesser money in hand.  The central banking authority uses the CRR to pull out excess money from the economy or put in more money into the economy.

Commercial banks are always required to maintain with the central monetary authority an average cash balance, the amount of which shall not be less than a certain percentage (say 4-5%) of their total demand and time Liabilities.

Repo(ssession) rate or discount rate is the rate at which the central bank of a country lends money to commercial banks. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the central bank. A reduction in the repo(ssession) rate helps banks to get money at a cheaper rate and vice versa. 

Reverse Repo(ssession) rate is the rate is at which the central monetary authority of a country borrows money from commercial banks, or the rate at which the central monetary authority pays to commercial banks for keeping surplus funds with it (above CRR-determined amount).

An increase in reverse repo. rate can prompt banks to deposit more funds with the central bank to earn higher returns on idle cash. It is also a tool, which can be used by the central bank to pull out excess money from the banking system or the country's economy as a whole.
Repo(ssession) rate, reverse repo(ssession) rate and Cash Reserve Ratio are all determined by the central monetary authority of a country.
 
When the growth rate of an economy slows down abnormally, it is an indication there is possible dearth of liquid capital. Along with this there may be a great decrease in optimism among investors. This affects the supply side of the economy due to lower and lower rates of production of goods and services. As a resultant effect inflation sets in. Too much money starts chasing too few goods causing a spiraling price rise. Dearth or scarcity of capital may be caused by sinking of capital in assets, which are absolutely non-performing, like gold and silver, or are non-performing in relation to the current economic scenario. Less optimism increases the dampening effect. An acute imbalance of excess government expenditure over government income, including foreign trade (balance of payments) deficits (imports exceeding exports) destabilizes the economy further and pushes it towards possible stagflation, which is stagnation (abnormally slow growth rate) and inflation (price rise) combined.

But the peculiar aspect of this whole depressing economic affair might have been initially caused by an excess demand for goods and services created in one or more sectors of the economy, causing excess income in the hands of people working in those sectors. This excess income, mainly due to over-caution, gets invested and consequently sunk in relatively secured non-performing assets, causing a drain out of effective, production-oriented capital from the economy.

Under such circumstances, an effective combination of monetary (short term measure) and fiscal policy (long term measure) has to be adopted by the government to gear up the economic growth rate and bring down the rate of price rise.

Demand-pull Inflation

The classical theory states that inflation or constant price rise takes place when the quantity of money in circulation increases. The price rise is directly related to the percentage increase in the quantity of money.

Under a full-employment situation, when investment demand increases, there arises a total demand for goods, which outstrips the aggregate supply that is available. Prices then start going up. Consumer demand is dependent on disposable income. Sale of goods and services at higher prices creates more money income, and hence more demand. So the excess demand never gets checked.

Some price rise would occur even with a constant money supply. This price rise would increase the transaction demand for money, which will push up the interest rates. Higher interest rates would discourage extra investment demand. This would eliminate the inflationary effect.

We can explain demand-pull inflation with the help of inflationary gap. Inflationary gap may be defined as that part of government expenditure that is not covered by taxation or borrowing from the general public, and which is covered by borrowings from banks or other financial institutions, or by creation of money by the Government. Revenue spending of the Government then overruns revenue earning.

C+I+G shows the different expenditure levels at different levels of income. Equilibrium exists at point E, where the C+I+G cuts the income line. If, under a full-employment situation, the real income cannot reach Yo, but reaches only up to Yn, it gives rise to an inflationary gap, measured by XY.

If there is insufficient aggregate demand, there will be a fall in the C+I+G schedule. This is represented by the (C+I+G)' schedule. This will give rise to a deflationary gap, measured by YZ.

A boom in investment, technological advancements, opening up of new prospective territory etc. may give rise to some demand-pull inflation. However, increase in Government Expenditure, especially for the progress of backward areas, high defence expenditure etc. may also give rise to demand-pull inflation.

The inflationary gap may be eliminated in several ways.

1. Rate of interest can be increased by keeping the money supply constant. This will reduce investment, income and consumption. Prices will come down.

2. High prices will reduce the real value of wealth. This will reduce consumption expenditure and consequently prices. This is called the Pigou Effect.

3. If redistribution of income can be done in favour of the higher income group, consumption expenditure will come down. Higher income people will spend lesser portion of this redistributed income on consumption than the lower income group. The inflationary gap may come down in this way.

4. Extra tax collections will reduce the net disposable income. This will lower the consumption. Reduction in Government subsidies or welfare expenditure will also reduce disposable income and consumption.

5. Higher prices in the domestic market may discourage exports. This will increase supply in the domestic market. As a result, prices will come down. This may happen on its own.

Also read: Inflation and Deflation Cost-Push Inflation Effects of Inflation