Continuing from wordings of C...
Ceteris paribus
Other things being equal. Economists use this Latin phrase to cover their backs. For example, they might say that “higher interest rates will lead to lower inflation, ceteris paribus”, which means that they will stand by their prediction about INFLATION only if nothing else changes apart from the rise in the INTEREST RATE.
Classical economics
The dominant theory of economics from the 18th century to the 20th century, when it evolved into NEO-CLASSICAL ECONOMICS. Classical economists, who included Adam SMITH, David RICARDO and John Stuart Mill, believed that the pursuit of individual self-interest produced the greatest possible economic benefits for society as a whole through the power of the INVISIBLE HAND. They also believed that an economy is always in EQUILIBRIUM or moving towards it.
Equilibrium was ensured in the LABOUR market by movements in WAGES and in the CAPITAL market by changes in the rate of INTEREST. The INTEREST RATE ensured that total SAVINGS in an economy were equal to total INVESTMENT. In DISEQUILIBRIUM, higher interest rates encouraged more saving and less investment, and lower rates meant less saving and more investment. When the DEMAND for labour rose or fell, wages would also rise or fall to keep the workforce at FULL EMPLOYMENT.
In the 1920s and 1930s, John Maynard KEYNES attacked some of the main beliefs of classical and neo-classical economics, which became unfashionable. In particular, he argued that the rate of interest was determined or influenced by the speculative actions of investors in BONDS and that wages were inflexible downwards, so that if demand for labor fell, the result would be higher UNEMPLOYMENT rather than cheaper workers.
Closed economy
An economy that does not take part in inter¬national trade; the opposite of an OPEN ECONOMY. At the turn of the century about the only notable example left of a closed economy is North Korea.
Collateral
An ASSET pledged by a borrower that may be seized by a lender to recover the value of a loan if the borrower fails to meet the required INTEREST charges or repayments.
Commoditization
The process of becoming a COMMODITY. Micro¬chips, for example, started out as a specialized technical innovation, costing a lot and earning their makers a high PROFIT on each chip. Now chips are largely homogeneous: the same chip can be used for many things, and any manufacturer willing to invest in some fairly standardized equipment can make them. As a result, COMPETITION is fierce and PRICES and profit margins are low. Some economists argue that in today's economy the faster pace of innovation will make the process of commoditization increasingly common.
Commodity
A comparatively homogeneous product that can typically be bought in bulk. It usually refers to a raw material – oil, cotton, cocoa, silver – but can also describe a manufactured product used to make other things, for example, microchips used in personal computers. Commodities are often traded on commodity exchanges. On AVERAGE, the PRICE of natural commodities has fallen steadily in REAL TERMS in defiance of some predictions that growing CONSUMPTION of non-renewable such as copper would force prices up. At times the oil price has risen sharply in real terms, most notably during the 1970s, but this was due not to the exhaustion of limited supplies but to rationing by the OPEC CARTEL, or war, or fear of it, particularly in the oil-rich Middle East.
Comparative advantage
Paul Samuelson, one of the 20th century’s greatest economists, once remarked that the principle of comparative advantage was the only big idea that ECONOMICS had produced that was both true and surprising. The theory underpins the economic case for FREE TRADE. But it is often misunderstood or misrepresented by opponents of free trade. It shows how countries can gain from trading with each other even if one of them is more efficient – it has an ABSOLUTE ADVANTAGE – in every sort of economic activity. Comparative advantage is about identifying which activities a country (or firm or individual) is most efficient at doing.
To see how this theory works imagine two countries, Alpha and Omega. Each country has 1,000 workers and can make two goods, computers and cars. Alpha’s economy is far more productive than Omega’s. To make a car, Alpha needs two workers, compared with Omega’s four. To make a computer, Alpha uses 10 workers, compared with Omega’s 100. If there is no trade, and in each country half the workers are in each industry, Alpha produces 250 cars and 50 computers and Omega produces 125 cars and 5 computers.
What if the two countries specialize? Although Alpha makes both cars and computers more efficiently than Omega (it has an absolute advantage), it has a bigger edge in computer making. So it now devotes most of its resources to that industry, employing 700 workers to make computers and only 300 to make cars. This raises computer output to 70 and cuts car production to 150. Omega switches entirely to cars, turning out
250.
World output of both goods has risen. Both countries can consume more of both if they trade, but at what PRICE? Neither will want to import what it could make more cheaply at home. So Alpha will want at least 5 cars per computer, and Omega will not give up more than 25 cars per computer. Suppose the terms of trade are fixed at 12 cars per computer and 120 cars are exchanged for 10 computers. Then Alpha ends up with 270 cars and 60 computers, and Omega with 130 cars and 10 computers. Both are better off than they would be if they did not trade.
In essence, the theory of comparative advantage says that it pays countries to trade because they are different. It is impossible for a country to have no comparative advantage in anything. It may be the least efficient at everything, but it will still have a comparative advantage in the industry in which it is relatively least bad.
There is no reason to assume that a country’s comparative advantage will be static. If a country does what it has a comparative advantage in and sees its INCOME grow as a result, it can afford better education and INFRASTRUCTURE. These, in turn, may give it a comparative advantage in other economic activities in future.
Complementary goods
When you buy a computer, you will also need to buy software. Computer hardware and software are therefore complementary goods: two products, for which an increase (or fall) in DEMAND for one leads to an increase (fall) in demand for the other. Complements are the opposite of SUBSTITUTE GOODS. For instance, Microsoft Windows-based personal computers and Apple Macs are substitutes.
Consumer surplus
The difference between what a consumer would be willing to pay for a good or service and what that consumer actually has to pay. Added to PRODUCER SURPLUS, it provides a measure of the total economic benefit of a sale.
Consumption
What consumers do. Within an economy, this can be broken down into private and public consumption. The more resources a society consumes, the less it has to save or invest, although, paradoxically, higher consumption may encourage higher INVESTMENT. The LIFE-CYCLE HYPOTHESIS suggests that at certain stages of life individuals are more likely to be saving than consuming, and at other stages they are more likely to be heavy consumers. Some economists argue that consumption taxes are a more efficient form of TAXATION than taxes on wealth, CAPITAL, property or INCOME.
Contagion
The domino effect, such as when economic problems in one country spread to another.
Cost of capital
The amount a firm must pay the owners of CAPITAL for the privilege of using it. This includes INTEREST payments on corporate DEBT, as well as the dividends generated for shareholders. In deciding whether to proceed with a project, FIRMS should calculate whether the project is likely to generate sufficient revenue to cover all the costs incurred, including the cost of capital. Calculating the cost of EQUITY capital can be tricky.
Credit creation
Making loans. Often the amount of credit creation is subject to REGULATION. Lenders may have limits on the amount of loans they can make relative to the ASSETS they have, so that they run little RISK of BANKRUPTCY. A CENTRAL BANK tries to keep the amount of credit creation below the level at which it would increase the MONEY SUPPLY so much that INFLATION accelerates. This was never easy to get right even when most lending was by BANKS, but it has become much harder with the recent growth of non-bank lending, such as by credit-card com¬panies and retailers. Missing text
Credit crunch
When BANKS suddenly stop lending, or BOND market LIQUIDITY evaporates, usually because creditors have become extremely RISK AVERSE.
Crony capitalism
An approach to business based on looking after yourself by looking out for your own. At least until the crisis of the late 1990s, some Asian companies, and even governments, were notable for awarding contracts only to family and friends. This was often a form of CORRUPTION, resulting in economic inefficiency.
Currency board
A means by which some countries try to defend their currency from speculative attack. A country that introduces a currency board commits itself to converting its domestic currency on demand at a fixed EXCHANGE RATE. To make this commitment credible, the currency board holds RESERVES of foreign currency (or GOLD or some other liquid ASSET) equal at the fixed rate of exchange to at least 100% of the value of the domestic currency that is issued.
Unlike a conventional CENTRAL BANK, which can print MONEY at will, a currency board can issue domestic notes and coins only when there are enough foreign exchange reserves to back it. Under a strict currency board regime, INTEREST RATES adjust automatically. If investors want to switch out of domestic currency into, say, US dollars, then the SUPPLY of domestic currency will automatically shrink. This will cause domestic interest rates to rise, until eventually it becomes attractive for investors to hold local currency again.
Like any fixed exchange rate system, a currency board offers the prospect of a stable exchange rate and its strict discipline also brings benefits that ordinary exchange rate pegs lack. Profligate governments, for instance, cannot use the central bank’s printing presses to fund large deficits. Hence currency boards are more credible than fixed exchange rates. The downside is that, like other fixed exchange rate systems, currency boards prevent governments from setting their own interest rates.
If local inflation remains higher than that of the country to which the currency is pegged, the currencies of countries with currency boards can become overvalued and uncompetitive. Governments cannot use the exchange rate to help the economy adjust to an outside SHOCK, such as a fall in export prices or sharp shifts in capital flows. Instead, domestic WAGES and prices must adjust, which may not happen for many years, if ever.
A currency board can also put pressure on banks and other financial institutions if interest rates rise sharply as investors dump local currency. For emerging markets with fragile banking systems, this can be a dangerous drawback. Furthermore, a classic currency board, unlike a central bank, cannot act as a LENDER OF LAST RESORT. A conventional central bank can stem a potential banking panic by lending money freely to banks that are feeling the pinch. A classic currency board cannot, although in practice some currency boards have more freedom than the classic description implies. The danger is that if they use this freedom, governments may cause currency speculators and others to doubt the government’s commitment to living within the strict disciplines imposed by the currency board.
Argentina's decision to devalue the peso amid economic and political crisis in January 2002, a decade after it adopted a currency board, showed that adopting a currency board is neither a panacea nor a guarantee that an exchange rate backed by one will remain fixed come what may.
Currency peg
When a GOVERNMENT announces that the EXCHANGE RATE of its currency is fixed against another currency or currencies.
