Chapter 7

Stability and Instability of an

Economic System
 In this chapter:
We will discuss the following topics:

• Economic System
• The concept of stability and instability
• Economic crisis
• Economic fluctuations and business cycles
• Responses to the crises
• Modeling monetary policy
• Modeling fiscal policy
• Central Bank Independence
• Global inflation (current economic issue)
• Debt crisis (current economic issue)
10-2
 Economic System
• An economic system is an organized way in which a country
allocates resources and distributes goods and services
across the whole nation. It includes the combination of the
various of institutions and entities and consumers that
comprise the economic structure of a given community.

• The study of economic systems includes how these various

agencies and institutions are linked to one another, how
information flows between them, and the social relations
within the system (including property rights and the structure
of management and culture).

• There are multiple components to economic systems. Their

interaction may be coherent or result in instability.

10-3
 Economic System
• An economic system may involve production, allocation of
economic inputs, distribution of economic outputs, landlords
and land availability, households (earnings and expenditure
consumption of goods and services in an economy),
financial institutions, firms, and the government.

• Alternatively, an economic system is the set of principles by

which problems of economics are addressed, such as the
economic problem of scarcity through allocation of finite
productive resources.

10-4
 Historical review
• All over the economic history of the world, recessions,
depressions and economic downturns or (economic crisis) have
been experienced.

• There are several theories about economic fluctuations which

are developed during the past centuries.

• Economists like Schmpeter (Schmpeter, 1939) are arguing that

business cycles can be predicted, but some others like Mankiw
(Mankiw, 1997) and Romer (Romer, 2006) are saying no.

• Karl Marx (1818-1883) and sociologist believed in that

recessions and economic crisis are the nature of the capitalism
economic system.
10-5
10-6
 Types of economic crises
• A sudden stop is the sudden reduction of capital flows into a nation's
economy, which are often accompanied by economic recessions and
market corrections. Sudden stops may also be followed by a currency
crisis, as foreigners lose faith in a nation's economy.

• A currency crisis involves the sudden and steep decline in the value of a
nation's currency, which causes negative effects throughout the economy.
Unlike a currency devaluation, a currency crisis is not a purposeful event
and is to be avoided.

• Banking crisis reflects the crisis of liquidity and insolvency of one or

more banks in the financial system.

• Debt crisis, a situation in which a country is unable to pay back its

government debt. A country can enter into a debt crisis when the tax
revenues of its government are less than its expenditures for a prolonged
period.
10-7
 Stability & Instability

The stability inside an economic system can be defined as the natural state
in
which:
1) Positive economic growth
2) Stable prices
3) Low unemployment rate

We can therefore define the instability as the economic system unnatural

state that:
1) weakens the development potential;
2) induces tensions within the price system;
3) imposes a cyclical character to the economy, with a tendency to depression if
the instability is becoming persistent.

10-8
 Stability & Instability

• Crisis or (instability) is a very important concept in discussions of economics

science, political and strategic and has many examples.

• In the economic, it involves rapid and dramatic rise of prices, production

expanded reducing, sharp rise of unemployment, a sharp reduction in income,
sharp reduction in the value of securities and etc..

• In the political field, it contains social revolts increasing, developed gap between
government and citizens.

• Large fluctuations in economic activity impose significant short-term costs, such as

job losses, poor returns from investment decisions, and business failures.
Fluctuating economic activity can also be detrimental to long-term growth rates,
because uncertainty discourages investment.

10-9
 Stability & Instability

• Economic crisis usually entail two components, a financial crisis and

a real economic crisis developing in its wake.

• The financial crisis stems from a failure in the functioning of the

financial system. It is manifested in tremendous monetary losses, in
the crash of financial institutions, in the loss of trust in the system,
and in low financial supply (a slowdown in the flow of money).

• Thus the real economic crisis is created, expressed in a sharp

downturn of consumption and product, a rise in business
bankruptcies, a reduction in the nations’ income from tax revenues, a
sharp increase in unemployment, a rise in poverty, and so on.

10-10
 Economic fluctuations and business cycles

Economic fluctuations are referring to the business cycle, which occur over
longer periods and cover periods of economic expansion and economic
stagnation. Usually, these fluctuations are measured by the growth of real
GDP (gross domestic product). .

As the term implies, a business cycle is a period of up and down motion in

aggregate measures of current economic output and income .

10-11
 Economic fluctuations and business cycles

• When most businesses are operating at capacity level, the real GDP is
growing rapidly, and the unemployment is low, boom condition exists. Boom
conditions result in a high level of economic activity.
• As aggregate business conditions slow, the economy begins the
contraction phase of a business cycle. During the contraction, the sales of
most business will fall, real GDP will grow at slow rate perhaps decline,
and unemployment in the aggregate labor market will raise .

• When economic activity is low and unemployment is high, these

conditions are referred as e recession, or if they are quite serious a
depression .

• After the rescission reaches bottom and economic conditions begin to

improve, the economy begins an expansionary stage. During the
expansion phase, business sales will rise, GDP will grow rapidly, and the
unemployment rate will decline
10-12
 THREE DIFFERENT VIEWS
OF THE BUSINESS CYCLE
• What are the causes of economic instability? Why does the rate of
unemployment fluctuate? Since economists are not in complete
agreement about the answers to these questions, we will outline three
alternative theories of economic instability.

• Classical View: (Most pre-1930 economists) they thought that a

business recession indicated only a temporary disequilibrium. Many
pre-1930 economists stressed the importance of technological
advances as the source of economic expansion.

• Keynesian View: for Keynesians, the primary source of economic

instability is the instability in the level of private capital investment.
When business is good, investors respond by expanding their
operations. The increased investment leads to still more expansion
and economic boom. 10-13
10-14
 THREE DIFFERENT VIEWS
OF THE BUSINESS CYCLE

• Monetarist View: Instability in the money supply is the most

important variable according to the monetarists. In a modern
exchange economy, money plays a very significant role because it is
a part of almost every transaction. Consumers buy food, clothing,
housing, transportation, and many other commodities with money.
Individuals sell labor services and other productive resources for
money. The monetarist view stresses that changes in the money
supply.

10-15
10-16
 Responses to the Crises ?
• The government's spending and monetary policies exert a powerful influence on
economic stability. If properly conducted, they can contribute to economic
stability, full and efficient utilization of resources, and stable prices. However,
improper stabilization policy can cause massive unemployment, rapidly rising
prices, or perhaps both.

• The main goals of any government usually include economic growth, price
stability and low unemployment. The most important means of moving towards
these goals are the detailed policies on tax, spending, regulation and government
management, which are discussed in this briefing.

• Economists are not in complete agreement on the extent to which public policy can
stabilize the economy and promote full employment. They often debate the impact
of various policy tools.

10-17
 Responses to the Crises ?
Monetary policy: measures employed by
governments to influence economic activity,
specifically by manipulating the supplies of money
and credit and by altering rates of interest.

Goals of Monetary Policy:

• Provide sufficient money to the economy so

that it may grow at a sustainable rate.
• Dampen the impact of the business cycle.
• Control Inflation
10-18
 Modeling Monetary Policy
• If the CB wants to expand the economy it can

– buy bonds (OMO)

– decrease the Discount Rate
– lower the reserve ratio.

This increases the supply of loanable funds. This lowers

interest rates which increases aggregate demand.

10-19
 Modeling Monetary Policy
• If the CB wants to contract the economy it can
– sell bonds (OMO)
– increase the Discount Rate
– raise the reserve ratio.

This decreases the supply of loanable funds.

This raises interest rates which decreases
aggregate demand.

10-20
 Central Bank Independence
• Countries with Central Banks that are more independent of
political control have higher rates of economic growth.

In fact, it encompasses three factors:

1.The independence of its members, which is simply the limits
imposed on politicians not to influence the composition of the
central bank’s board of directors or its decisions.
2.Financial independence, that is, central banks’ autonomy in
order to manage their operations and not be captive to
government decisions.
3.The independence of policies, it must not be forced to
finance government spending and it must be able to set its
own objectives or determine which instruments it uses.

10-21
 Responses to the Crises ? Fiscal Policy
• Fiscal Policy is the purposeful movement in
government
spending or tax policy designed to direct an economy.

Fiscal policy refers to the use of government spending and tax

policies to influence economic conditions,
especially macroeconomic conditions. These include aggregate
demand for goods and services, employment, inflation, and
economic growth.

During a recession, the government may lower tax rates or

increase spending to encourage demand and spur economic
activity.

Conversely, to combat inflation, it may raise rates or cut spending

to cool down the economy.
10-22
 laffer curve
• The Laffer Curve is a theory
formalized by supply-side
economist Arthur Laffer to show
the relationship between tax rates
and the amount of tax revenue
collected by governments.

• The curve is used to illustrate the

argument that sometimes cutting
tax rates can result in increased
total tax revenue.

10-23
 The Mistiming of
Fiscal Policy
• Recognition Lag: the time it takes to measure the
state of the economy.

• Administrative Lag: the time it takes for Congress to

agree on a course of action with the president.

• Operational Lag: the time it takes for the full impact of

a government program or tax change to have its
effect on the economy.

10-24
 Types of Fiscal Policies
Expansionary Policy and Tools
To illustrate how the government can use fiscal policy to affect the
economy, consider an economy that's experiencing a recession.
The government might issue tax stimulus rebates to
increase aggregate demand and fuel economic growth.

Contractionary Policy and Tools

In the face of mounting inflation and other expansionary
symptoms, a government can pursue contractionary fiscal policy,
perhaps even to the extent of inducing a brief recession in order to
restore balance to the economic cycle. The government does
this by increasing taxes, reducing public spending, and cutting
public sector pay or jobs.
 Fiscal Policy Example
During the Great Depression of the 1930s, U.S. unemployment
rose to 25% and millions stood in bread lines for food. The misery
seemed endless. President Franklin D. Roosevelt decided to put
an expansionary fiscal policy to work. He launched his New Deal
soon after taking office. It created new government agencies,
the Works Progress Administration (jobs program), and the
Social Security program, which exists to this day. These spending
efforts, combined with his continued expansionary policy
spending during World War II, pulled the country out of the
Depression.
10-27
 Global Inflation
• Today's inflationary surge is being felt not just by the
advanced economies but also by the majority of emerging
markets and developing economies.

• In 15 of the 34 countries classified as AEs by the International

Monetary Fund’s World Economic Outlook, 12-month inflation
through December 2021 was running above 5%. Such a
sudden, shared jump in high inflation (by modern standards)
has not been seen in more than 20 years.

• Emerging markets and developing economies have been hit

by a similar wave, with 78 out of 109 EMDEs also confronting
annual inflation rates above 5%. That share of EMDEs (71%)
is about twice as large as it was at the end of 2020. 10-28
 Global Inflation
• The current wave of inflation indicates a high rate of inflation in
40 years.

• The US Federal Reserve is heading towards a tighter

monetary policy whose effects extend beyond the borders of
the United States.

• Based on the report, the inflation rate in the Arab countries is

expected to remain at a high level during 2022, reaching about
6%, while expectations indicate a decline in the inflation rate
during 2023 .

10-29
 Measuring Inflation
• The inflation rate is the annual percentage change in the
price level.

Price level measurements:

• The GDP Deflator

• The Consumer Price Index (CPI)

10-30
 Measuring Inflation

1. GDP Deflator = (Nominal GDP/ Real GDP)* 100

2.The Consumer Price Index

The Consumer Price Index, or CPI, measures the

average of the prices paid by urban consumers for a “fixed”
basket of consumer goods and services.

10-31
The Figure shows that the inflation rate is High when the price level is
rising rapidly and Low when the price level is rising slowly.

10-32
 Measuring Inflation
The main purpose of the CPI is to measure inflation.
The inflation rate is the percentage change in the price level
from one year to the next.
The inflation rate formula is:
Inflation rate = [(CPI this year – CPI last year)/CPI last year] 
100. That is:
Inf rate = {(CPI t – CPI t-1 )/ CPI t-1 } *100

10-33
 Measuring Inflation

➢ A high inflation rate is a problem because it diverts resources

from productive activities to inflation forecasting.

➢ From a social perspective, this waste of resources is a cost of

inflation.

➢ At its worse, inflation becomes hyperinflation—an inflation rate

that is so rapid that workers are paid twice a day because
money loses its value so quickly.

10-34
10-35
Why Inflation Is a Problem ?

10-36
10-37
10-38
FIGURE 1: Money Supply and Price Level in the German
Hyperinflation

10-39
10-40
 The Couse of Global Inflation
• It has been clear since the start of the Corona epidemic crisis in 2020 that it
will lead to inflationary pressures through challenges on the demand side
and the supply side. With the government’s focus on solving the demand
side problem, by injecting liquidity into the economy and direct cash
assistance to Individual, demand rose without being matched by an
increase in supply.

• Another major issue affecting advanced and developing economies alike is

global supply chains, which continue to be severely affected by the events
of the past two years. Transport costs have skyrocketed. And unlike the oil-
based supply shock of the 1970s, the COVID-19 supply shocks are more
diverse and unclear, and therefore more uncertain, as the World Bank’s
most recent Global Economic Prospects stresses.

10-41
 The Couse of Global Inflation

• Global Inflation is primarily driven by higher energy

costs that are pushing up prices across many
sectors, as well as higher food prices.

• The increase in government spending in the form of

"cash distributions" is the main reason for the high
inflation rates.

10-42
 Debt Crisis
• Debt crisis, a situation in which a country is unable to pay back
its government debt. A country can enter into a debt crisis
when the revenues of its government are less than its
expenditures for a prolonged period.

• How Debt Grows? Debt accumulation equation states that:

CHANGE IN DEBT = BUDGET DEFICIT.

• A government with a good reputation and little debt or an

established track record of paying back what it has borrowed
usually does not face much difficulty in finding investors who
are willing to lend to it.

10-43
 Debt Crisis
• However, if the debt load of a government becomes too large,
investors begin to worry about its ability to pay back, and they
start demanding higher interest rates to compensate for the
higher risk.

• That results in an increase in the cost of borrowing for that

government. As investor confidence deteriorates further over
time, pushing the cost of borrowing to higher levels, the
government may find it more and more difficult to roll over its
existing debt and may eventually default and enter into a debt
crisis.

10-44
 Debt Crisis: International Comparisons

• USA and Japan two countries by far are the world's

largest borrowers.

• Italy, Brazil and France, each of which is expected to

borrow $250 billion in 2020.

• These four countries will constitute about 17% of the

global total date.

10-45
International Comparisons
Debt as a % of GDP

10-46
 Debt Crisis: International Comparisons

• The Institute of International Finance that global debt

may have exceeded a record 255 trillion dollars last
year, equivalent to about 32 thousand and 500
dollars for each of the world’s population of 7.7 billion
people.

• This number is more than three times the annual

economic output of the world.

10-47
 Debt and the Ability to Pay It
• Economists insist that the absolute
magnitude of the debt is less
important than a nation’s ability to
pay it.

• The measure that does this is the

Deficit/GDP ratio.

10-48
 Indicators regarding public debt
• Public debt / Gross domestic product (GDP) The most
generally used and common indicator is the debt-to-GDP ratio.
It is calculated by dividing the total public debt outstanding at a
point in time by the country’s GDP.

• It measures the indebtedness level relative to the country’s

economic activity and assumes that all GDP resources are
available to finance the debt burden, which may not be
necessarily true. However, this indicator is recognized as the
most relevant in measuring degree of indebtedness, stressing
the government’s solvency capability.

10-49
 Indicators regarding public debt
• Public debt / domestic government revenue.
This measures indebtedness level relative to
the government’s payment capacity. It shows
the number of required years to pay the total
debt balance.

• This ratio shows the Government’s

possibilities to collect revenues compared to
the debt burden.

10-50
 Indicators regarding public debt
• Indicators regarding public debt service
a) Debt service / domestic government revenue: This indicator measures
the government’s ability to service the debt using domestic sources of
revenue. It highlights the extent to which debt service hampers debtor
countries in the use of their financial resources.

b) Debt service / exports. The public debt service to export revenues ratio
is a useful measure of the external repayment ability of a government and
of its economy. Where public debt is predominant in an economy (as in
heavily indebted countries) the public debt service (including government
guaranteed debt obligations) measured against export revenues could
also be used as a predictor of potential public sector vulnerability.

10-51
 What is the safe level of public debt?
• Some studies indicate that the safe ratio of public
debt to GDP in emerging countries is estimated at
about 35%, IMF = 70% of GDP.

• other studies have indicated that this percentage is

not a sufficient indicator alone.

10-52
 What is the safe level of public debt?

• Many countries tended to set a certain percentage that

should not be exceeded in order to control the deficit and
achieve financial stability.

• For example, the Maastricht Agreement set this percentage

in the European Union countries at 60% GDP and the same
is the case in Jordan according to the Public Debt Law of
2008.

• Despite this, the reality of the situation indicates that a

number of European countries have exceeded this
percentage as a result of the consequences of the global
financial crisis!
10-53
 What is the safe level of public debt?
• Although the ratio of public debt to GDP is considered one of
the most important economic indicators.

• The economic literature does not agree on a standard ratio

that can be used to determine the safe level of this debt!

• Therefore, it is not easy to say that the amount of debt at a

certain time poses a threat to the government's ability to fulfill
its obligations towards creditors, or that it is on the verge of
bankruptcy!

10-54
 What is the safe level of public debt?

• Mexico failed to pay its debts in 1982, the mentioned

ratio in Mexico did not exceed 47%.

• Argentina also was unable to pay its debts in 2001

when the mentioned percentage was around 50%!

• And not only that, but historical data show that 16% of
default cases in emerging countries during the period
1970-2008 were in countries where the percentage
exceeded 100%, while nearly 52% of these cases
occurred in countries where the percentage was less
from 55%!
10-55
 What is the safe level of public debt?

Therefore, there are other factors that must be

taken into consideration when talking about the safe
level of public debt, foremost of which is the:

• Structure of the public debt in terms of maturity dates,

• Size of official foreign exchange reserves,
• Structure of government finance,
• The ability to access international financial markets,
• Government administration and transparency in preparing
and publishing economic data because of their impact on
the behavior of officials and their ability to take the
necessary measures in a timely manner.

10-56
 DEBT MANAGEMENT
• Guiding Principles:
• Borrowing for operating expenditures is generally unsound.
• Borrowing for capital projects is considered essential
financial decision-making
• Borrowing for capital projects requires effective debt
management.
• Effective debt management can minimize interest costs and
even stabilize local government financial positions.
• Periodic review of debt and re-financing when conditions
are favorable are essential to effective debt management
and capital planning.

10-57
 DEBT MANAGEMENT
• Facts
– Countries get into debt problems because of lax
fiscal policies.
– Countries have an incentive to default on their
external debt obligations.
• Policies
– Debt crises should always be followed by a fiscal
deflation.
– We need to implement policies that reduce a
country's incentive to default.

10-58
 DEBT MANAGEMENT
Before a governmental body decides to borrow or sell
debt, it needs to determine its financial status, i.e.
whether it can afford to incur debt:

◼ Is the General Fund balance adequate?

◼ How close to the Constitutional debt limits are you
before incurring additional debt?
◼ What is your ability to borrow, such as bond rating?

10-59
 DEBT MANAGEMENT

• General Fund balance must be adequate to ensure

continued positive cash flow.

• A common guideline is to maintain six (6) months

operating expenditures as a reserve.

• If you have an insufficient General Fund balance, you

cannot be assured of your ability to continue operations
and service new debt.

10-60
 Bond ratings
• Bond ratings are an evaluation of the insurer's
credit quality rated by:

• Moody’s Investors Service

• Standard & Poor’s (S&P)

• Fitch Ratings

10-61
• A credit rating is an evaluation of the credit risk
of a prospective debtor, predicting their ability
to pay back the debt, and an implicit forecast
of the likelihood of the debtor defaulting.

10-62
 Jordan’s credit rating
• International credit rating agency Standard and
Poor’s (S&P) has affirmed Jordan’s B+
sovereign credit rating, maintaining a stable
outlook despite global uncertainty, with crude
oil and food prices pushing higher amid the
recent Ukrainian crisis and the impacts of the
COVID-19 pandemic.

10-63
10-64