11.2 Risks Associated with Different Economic Systems

What Is an Economic Risk?

An economic risk is the possibility that changes in macroeconomic factors will negatively impact a company or an investment.

Macroeconomic factors to consider include the following:

• gross domestic product (GDP)
• inflation
• unemployment rate
• policy interest rates

Gross Domestic Product

Gross domestic product (GDP) is the monetary value of finished goods and services within a country’s borders during a specific time period, a quarter, or a year. GDP encompasses goods and services produced for sale in the market, as well as non-market production, services, and goods provided by the government, such as education services and defence products.

The “official” figure for GDP does not include all activities produced in a country. For example, cash (black-market) transactions, unpaid work (performed by households or by volunteers), and barter exchange agreements are not included because they are difficult to measure (Callen, n.d.). That means if one valuable product, such as a basket of fruits, is exchanged for a loaf of bread under the barter agreement, this exchange will not contribute to the GDP and will not be recorded.

Since GDP is collected in current or nominal prices, one cannot compare two periods without making adjustments for inflation. When determining whether an economy is growing or shrinking from one period to another, economists want to know the real GDP value. Real GDP helps them understand whether the GDP is up because the production of goods and services has increased or simply because prices are up due to inflation.

Comparing the GDP of Two Countries

When calculating the GDP, the currency used is the currency of the country for which the GDP is being calculated. Therefore, when comparing the GDP of two or more countries using different currencies, the currency needs to be converted. The usual method is to convert the value of the GDP of each country into U.S. dollars and then compare them.

The conversion to dollar can be done in two ways:

• Using the prevailing exchange rate in the foreign exchange market
• Using the purchasing power parity (PPP) exchange rate

The PPP exchange rate is the rate at which one country’s currency is exchanged for another country’s currency to purchase the same basket of goods and services. For example, if a basket of goods costs $200 in the United States and €150 in Spain, the PPP theory predicts that the dollar/euro exchange rate should be $200/€150 or 1.33 per Euro (i.e., $1 = €0.75).

There is always a large gap between the market exchange rate and the PPP exchange rate because the PPP rate accounts for the difference in the cost of living in different countries.

Inflation

Inflation is the rate at which the value of a currency is falling and, consequently, the general level of prices for goods and services is rising. In other words, inflation is the increase in the cost of living in a country.

The consumer price index is a measure of the total value of goods and services consumers have bought over a specific period (Oner, n.d.a). For example, if one year, the basket of consumer goods costs $100 and the next year, that same basket of goods costs $102, it means that the inflation has risen by 2%, and thus, the rate of inflation is 2%.

Is Inflation Good or Bad?

Inflation is caused by the increased prices of goods and services. However, the household nominal income which consumers receive in current money does not increase as much or at the same pace as prices of goods and services. This uneven rise in prices reduces the purchasing power of consumers. In other words, their real income (inflation-adjusted income) falls, and they can afford less. Low purchasing power and low affordability mean low demand for, or consumption of, goods, which translates into low economic activities, low production, and overall slower economic growth.

Inflation also affects those who pay and receive fixed income. If a pensioner receives 2% annual increase in their pension but the inflation rate increases by 5%, the purchasing power of the pensioner will decrease. On the other hand, a borrower who pays a fixed interest of 5% on his or her mortgage would benefit from 5% inflation. The real interest rate (nominal rate – inflation) would be zero. For the lender (the bank or other financial institution), however, the real income would be lower (Tretina, 2022).

High inflation has a negative impact on the economy in general, but deflation or falling prices are not a desirable scenario either. When consumers anticipate prices to fall, they delay their purchases if they can. This also translates into less economic activity and lower economic growth.

Japan is a good example of falling prices and deflation. For a long period of time, Japan had no economic growth due to deflation (Nishizaki et al., 2012).

In order to prevent deflation during the global financial crisis of 2007, the U.S. Federal Reserve and other central banks around the world kept interest rates low for a long period of time and implemented other monetary policies to keep financial institutions liquid. Low interest rates encourage consumers and businesses to borrow and spend, which then results in increased economic activities.

Economists believe that inflation at a lower and predictable rate is good for the economy and helps economic growth. Also, knowing that prices will be slightly higher in the future, consumers will have the incentive to make purchases sooner. This again helps with an increase in economic activities and consequently boosts economic growth (Oner, n.d.a).

Unemployment Rate

The unemployment rate is the percentage of the labour force that is unemployed. The uniform definition of unemployed includes those people who are of working age, available for work, and have taken specific steps to find work. Some countries use different definitions of “unemployment” when calculating national statistics. So, when this uniform definition is applied to estimate the unemployment rate, that estimate can be more internationally comparable than the estimates based on the national definition of unemployment. Unemployment rate rises or falls due to changes in economic conditions.

As two sides of the same coin, unemployment and economic growth go hand in hand. With high economic activity, there is an increase in the level of production. To satisfy the increased production level, the demand for the workforce rises, and the unemployment rate falls. When the level of economic activity is low, the demand for the workforce falls, which causes a rise in the unemployment rate.

One of the fundamental macroeconomic laws that present the connection between growth and unemployment is the Okun Law, named after U.S. economist Arthur Okun. It defines the negative correlation between the rate of growth and the unemployment rate, which, in the case of the U.S. economy, postulates that a decline in unemployment by 1 percentage point corresponds to a 3 percent rise in production output (Oner, n.d.). This Okun correlation coefficient is not universal for all economies. The estimates in Japan, for example, indicate a relatively low level of the Okun coefficient compared to the US, which is caused by the difference in the tightness of the labour market and the tradition of “lifetime employment” in Japan (Ball, 2012). Varied values of these differences reflect the specific characteristics of the domestic market, which are influenced by a country’s institutional factors such as labour standards and other labour laws and regulations.

Policy Interest Rate

Policy interest rate, also known as the “overnight” rate, is set by central banks and is used by financial institutions for one-day lending transactions among themselves. Financial institutions also use this key interest rate to determine and set interest rates for mortgages, business and consumer loans and other lending instruments (Bank of Canada, n.d.).

As part of monetary policy, interest rate is a tool that central banks use to preserve the value of money by keeping inflation low, stable, and predictable and to maintain economic growth.

For example, the Bank of Canada is mandated to keep inflation at a target rate of 2 percent, the midpoint of a 1 to 3 percent target range. To achieve this inflation target, the bank adjusts (raises or lowers) its key policy rate. If inflation is below target, the bank may lower the policy rate to encourage banks and other financial institutions to, in turn, lower their interest rate on their mortgages and loans and stimulate economic activity. The bank may raise the key interest rate if inflation is above the target rate. In other words, the bank is equally concerned about inflation falling below or rising above the target. This approach guards against both deflation and high inflation (Mathai, n.d.).

Other Economic Risk Factors

Other risk factors arise from rules and regulations countries impose to improve their economies, and they are:

• government exchange controls
• local content laws
• tariffs on foreign goods

Government Exchange Controls

These are restrictions imposed by the government to control and limit the exchange of foreign currency by residents of a country. Exchange controls are used when a country has low foreign currency reserves and cannot meet its debt obligations. Another reason for exchange controls is to protect domestic currency value. For the government to successfully control foreign currency exchange, it is mandatory for all businesses and residents to sell their currencies at a designated facility, such as a central bank and at a predetermined rate (Encyclopedia Britannica, n.d.). Depending on the stage of the economy, political situation, and foreign currency reserve levels of the country, governments can implement control and limits on the following transactions:

• Purchase or sale of foreign currency by residents of the country.
• Purchase or sale of local currency by non-residents.
• Any currency crossing national borders.
• Import of non-essential goods

The risk to international trade is associated with the latter two restrictions, limits on currency crossing national borders and import of non-essential goods (CFI Team, n.d.). Doing business in a country where the government can impose restrictions may result in non-payment for the seller of the goods.

Countries that are allowed to impose exchange controls are those that have developing or transitional economies. Under the International Monetary Fund’s governing documents, these countries are known as “Article 14 countries.”

Local Content Law

These are restrictions undertaken by governments around the globe to protect their national interests. They range from the mandate of hiring locally to sourcing goods and services from domestic suppliers. These requirements must be followed by international companies in the local market. Local content laws have become more widespread since the 2008 financial crisis, with governments trying to improve the employment and industrial performance of their countries (Hestermeyer & Nielsen, 2014). A study done by the Organization for Economic Cooperation and Development (OECD) found that local content laws cause international businesses to incur additional costs and, therefore, lose their international competitiveness (OECD, n.d.).

Tariffs on Foreign Goods

These are fees implemented by the government of a country for certain products. (See Chapter 15). Companies doing business internationally have to consider the possibility of being hit by unexpected tariffs if their products pose a threat to local industries in the host country or if there is political tension between their domestic and host country governments.

References

Ball, L., Leigh, D. &, Loungani, P. (2012). Okun’s Law: Fit at 50? Presented at 13th Jacques Polak Annual Research Conference. International Monetary Fund. Abstract. https://www.imf.org/external/np/res/seminars/2012/arc/pdf/bll.pdf

Bank of Canada. (n.d.). Monetary policy. Bank of Canada. https://www.bankofcanada.ca/core-functions/monetary-policy/

Callen, T. (n.d.). Gross domestic product: An economy’s all. Finance & Development Magazine. International Monetary Fund. https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/gross-domestic-product-GDP

CFI Team. (n.d.). Exchange control. Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/economics/exchange-control/

Encyclopaedia Britannica. (n.d.). Exchange control. https://www.britannica.com/money/exchange-control

Hestermeyer, H. & Neilsen, L. (2014, June). The legality of local content measures under WTO law. Journal of World Trade, 48(3): 553-591. https://www.researchgate.net/publication/279321597_The_Legality_of_Local_Content_Measures_under_WTO_Law

Mathai, K. (n.d.). Monetary policy: Stabilizing prices and output. Finance & Development Magazine. International Monetary Fund. https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Monetary-Policy

Nishizaki, K., Sekine, T., Ueno, Y. & Kawai, Y. (2012). Chronic deflation in Japan. BIS Papers, (70). Abstract. https://www.bis.org/publ/bppdf/bispap70c.pdf

OECD. (n.d.). Local content requirements impact global economy. OECD. Organisation for Economic Co-operation and Development. https://www.oecd.org/en/publications/local-content-requirements_5b1c38d5-en.html

Oner, C. (n.d.a.). Inflation: Prices on the rise. Finance & Development Magazine. International Monetary Fund. International Monetary Fund. https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Inflation

Tretina, K.(2022, September 14). Is inflation good or bad? Forbes Advisor. https://www.forbes.com/advisor/investing/is-inflation-good-or-bad/

Attributions

“Comparing the GDP of Two Countries” is adapted from “The Macroeconomic Perspective: Comparing GDP among Countries” in “OpenStax Macroeconomics 2e” available from Lumen Learning, under a CC BY 4.0 International license. Download for free from Openstax.