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398 Chapter 10 . Government policies: instruments and objectives

Both these reasons imply that as the general price level r ises , real wages wil l fal l,

reducing costs of production and raising profitability, thereby encouraging firms to

raise output.

InFigure 10.6(b) a rise in the productivity of any factor input or fallin its cost will

shift the AScurve rightwards and downwards to ASl.Aggregate supply isnow higher

(Y3) at any given price level (PI)' Put another way, any given output (Y1) can now be

supplied at a lower price level (P2).

long-run aggregate supply

In the long run i t i s often assumed that factor markets are more f lexible and bet ter

informed so that input prices (e.g, money wages) fully adjust to changes inthe general

price level and vice versa. If thi s i s the case, then wehave the verticallongHrun aggre-

gate supply (AS)curve in Figure 10.7.

AS

P2 1-------1

Of course, a short -run aggrega te suppl y curve might b e ver ti ca l if no

exists. Alternatively, a long-run aggregate supply curve could itself

to right if i llusion' persi st s into the long-run t ime period.

I nf la ti on 399

AD /AS a nd e qui li br ium na ti on al o u tp u t

I twi ll beuseful a t this s tage tolook athow ADand ASschedules can be usedto f ind

the equilibrium levelsfor the general price level and for national output.

We ini ti al ly assume that wages and other input costs do not ful ly adjus t to price

level changes to that the aggregate supply (AS)curve slopes upwards from leftto rightand is not vertical.

Only where AD and AS intersect at a general price level ofP1 and national output

Y1 in Figure 10.8 do we have an equil ibrium outcome for the economy. Any other

combination of price level and nat ional output i s unsusta inable , with an excess ofeither aggregate demand or aggregate supply.

AS

a:;>.$

P1'"u~

AD

0 Y l National

output

•.F~~10~8~Cf~iIIbriUin \falUe~for.th~prf celeve I an dnati 0hal output

For example, for price levelsabove PI. ASexceeds AD, putting downward pressure

on prices and national output. Asthe general price level falls, aggregate demand (AD)

expands (positive 'real balance effect' , via increase in real value of wealth holdings

rai sing C and l ikely reductions in interes t rates , rai sing C and I etc .) and aggregatesupply (AS)contracts (profitability is squeezed as prices fall faster than the lessflexi-

ble input costs for producers). Only at Pl!Y 1do wehave an equilibrium outcome .

. •(evels .b~ldWP1•.renofsu~ta ir i~bleh i F i g l l r ~ 1 ( ) . 8 ? · · · · · · · · · · · · · · ·

Aswe consider the various policyissues involving inflation, unemployment, economic

growth, the balance ofpayments and exchange rates, we shall use aggregate demandand aggregate supply analysis wherever appropriate.

Inflation is a term often applied to a situation in which there is a persistent tendency

for the general level ofprices to rise. The 'rate ofinflation' over the past 12months is,

inef fect , t e ll ing ushow much ext ra money wewould need now inorder to beable topurchase the same 'basket ' ofgoods and services aswe did 12months ago.



400 Chapter 10 .Government policies: instruments and objectives

Measuring infla tion

A number ofmeasures have been used to calculate the rate of inflation inthe UK.

B!. The Retail Price Index (RPI). This has been the main off ic ia l measure in the

showing the change from month to month in the cost ofa representative 'basket '

goods and services bought by a typical household. The rate of inflation measuredf

using the RPI isoften referred to asthe headline rate of inflation. In September 2007·

the RPI stood at 208.0 which means that average priceshaverisen by 108% between.

January 1987 and January 2007. Asthe index isan average, this figure conceals the . .. ..

fact that some priceshave increased more rapidly (alcohol and tobacco 158.2%, rent

189.9%, water and other charges 277%) whilst other prices have fallen (telephone!

telemessages 14.5%, women's outerwear 32.1 %, CDsand tapes 85.8%).

Once the RPI has been constructed, the rate of inflation can then be calculated,with the most usual measure being the 12-monthly change inthe RPI. For e.xaiupre,

the RPI stood at 208.0 in September 2007. In September 2006 itstood at 200.1

therefore the annual rate ofinflation over the period to September 2007 was:

208. 0 ~ 200 .! X 100% = 3.9%200.1

iIII RPlX. For policy makers in the UK, however, the RPI has been superseded by

RPIX (the RPI excluding mortgage interest payments). The RPIX is referred to

measuring 'underlying' inflation and this was (until 2003 - see below) the subject

the government's 2.5% inflation target. Excluding mortgage interest rates from

RPI eliminates a rather perverse effect, namely that raising the interest rate to

erate inflationary pressure will actually increase the RPImeasure of inflation!

III RPIY. However, both the RPI and the RPIX are influenced by increases in .

taxes and in the council t ax. If these taxes increase, for example, a rise in

duty on cigarettes to discourage smoking, then the RPIX measure of inflation

increase without any increase in inflationary pressure inthe economy. The Bank

England publishes the RPIY (RPIX minus VAT,local authority taxes and

duty) to eliminate this effect.

III Consumer Price Index (CPl). This was adopted in December 2003 as the

measu re o f i nf la tion i n the UKand is bas ed on Harmonised Index of

Prices (HIep), the official measure in the EU. The European Central Bank

keep EUinf la tion bel ow 2% as measured by t he HICP, and 2% is now a lso

target for UKinflation using the CPI.

Box 10.3 considers the RPI inmore detail.

TheRPImeasures the change from month to month in the cost of a representative 'basket'

goods and services ofthe type bought bya typical household.

A number of stages areinvolved inthe calculation ofthe RPJ.Thefirst stage isto select

i tems to be inc luded in t he index and to weigh t t hese i tems according t o t he ir 'o">T\/"··

I nf la ti on 401

importance inthe average family budget. Obviously, i tems onwhich a family spends a large

proport ion o f i ts i ncome are g iven heavier weigh ts t han those i tems on which t he f am il y

spends relatively llttle, For example, in 2003 t he weigh t g iven to t ea in t he index was 1,

whereas that forelectricity was 14 (outof atotal 'al l i tems weight' of 1,000).Theweights used

arechanged annually to reflect the changes in the composition of family expenditure.

Theweights usedforgroups of i tems are shown inTable 10.4.I tcanbe seenthat food has

been replaced asthe largest i tem byhousing (rent , mortgage interest, rates and council tax,

water charges, repairs and dwelling insurance). This is part of a longer-run trend associated

with differing income elasticities of demand forthe items in the 'basket'.

Table10;4 General lndex'of retallprlces: group weights

1987 2007

Food 16 7 10 5

Catering 46 47

Alcoholic drink 76 66

Tobacco 38 29

Housing 15 7 23 8

Fueland light 61 39

Household goods 73 66

Household services 44 65

Clothing and footwear 74 44

Personal goods and services 40 39

Motoring expenditure 12 7 13 3

Faresand other travel costs 22 20

Leisure goods 47 41

Leisure services 30 68

Source: A d ap te d f ro m O N S ( 20 0 ?) E co n om ic a n d L a bo u r M a rk e t

Review, V o l. 1 , N o .4 . C ro w n c o py ri gh t m a te ri a l i s r e pr od u ce d w it h t he

p e rm i s si o n o f t h e C o n tr o ll e r of H M SO a n d t he Q u ee n 's P ri nt er f orS c o tl a nd u n d er t h e C l ic k -U s e L i ce n c e.

Thesecond stage in deriving the RPIinvolves collecting the price data. Formost items, prices

are col lected on a speci fic day each month, usual ly the Tuesday nearest the middle of the

month. Pricesareobtained from a sample of retail outlets insome 18 0 different areas.Careis

taken to make sure a representat ive range of retai l out lets, small retai lers, supermarkets,

department stores, etc. aresurveyed. In all, around 150,000 price quotations are collected

each month. Anaverage price isthen calculated for each item inthe index.

Thef inal stage isto calculate the RPI f rom all these data. All index numbers must relate to

some base per iod or ref erence date. I n t he case o f t he RPI t he base per iod i s January

1 9 8 7' " 1 0 0 .

(PI and RPI

I t i s wor th not ing that the CPI and the RPI are dif ferent ina number ofways .

III The RPI excludes the richest 4% of households and the poorest pensioner house-

holders when calculating theweights to be used inthe index, believingthese patterns

of expenditure to be 'unrepresentative'. However, the Cl'I includes everyone.



~l The basket of goods also differs mainly inits treatment ofhousing and related costs.

A number of i tems inc luded in the RPI are exc luded from the CPI, such ascounci l

tax, mortgage interest payments, house depreciation and buildings insurance.

402 Chapter 10. Governmentpolicies:instruments andobjectivesInflation 403

Benefits of inflation

Of course, there are also beneficiaries from inflation.

The Cl'I measure of inflation for the UKhas systematically been below that of both the

RPI and RPIX. For example, between September 2006 and September 2007 the cp rgave an inflation rate inthe UK ofonly 1.8% compared to around 2.8% using RPIX.

Businesses have expressed some concern that the lower recorded figure for inflation

us ing the Cl 'I might encourage the UK Chancel lo r to raise VAT and o ther taxes on

goods and services without breaching the 2.5% inflation target! However, when the

government changed from RIPX to CPI inDecember 2003 it also reduced the inflation

target under the new index from 2.5% to 2%.

I ! ! I ~usinesses w~llfi~d it easier to pass on cost increases (e.g. higher wages) as price

increases during tnnes of modest inflation.

I ! ! I Businesses and individuals who owe money (i.e, are debtors) will gain since inflation

reduces the real value of their debt.

Whi ls t there may be benefits from modes t inflat ion, few would argue that there are

any benefits from periods of excessive inflation. Case Study 10.2 uses the experience

of Germany to givea useful insight into the costs of accelerating rates of inflation.

I f inf lation is a period of r ising prices, people assume that deflation is a period of faUing'

prices. This isactually incorrect Def lation is usual ly usedto refer to aneconomy which is

slowing down, in which output isfall ing and unemployment rising, Prices might or might

not f an in a s it ua ti on o f 'deflation'. Disinflation is technically the correct word to use for

falting prices.

. .\\7henpeople discuss inflation ...•..........•roblemsitheyoften exarnineinflation in..ts

'more'modetate' forms . H()wever, i finf lationgetsoutofhand ,then i tcan take on the.'

··.·.extrellleJotm· sOmetimesdescribedas'hyperinflation\\Vhilst this word does not have.

.,a.~l1ec~ficdefiniti~n~ittendstobeusedJorextreme Situations •.where;. say; prices.··are.'

rrsmgm double-digit. figures ana d~ilyor weekly basis . .The exarnpleof Gerrnany in

the early years of t hel920s isofteri used as a n example. . . . .

·X~~~f~~,~fi~i~·~i~e~~~i~e~ld~k.~)C~~~"i~~'r '5~bf~.f?'~~'.

T ~ ~ ~ r j C e ? f a ~ c i ~ t ~ g ~ ~ t ~ f u P i h ~ ~ r n " a n Y , i 9 2 1 t ~ i 9 2 3 .·····D~~t~cll~~~ks .

Governments are anxious to curb the rate of inflation because ofthe 'costs' " R>dL::U ...

with a high inflation rate.

Costsof inflation

! 1 ! 1 'Shoe leather costs' whereby individuals and businesses make more frequent trips

banks etc. since holding cash is more expensive (e.g. higher opportunity cost

terms of interest forgone) .

. I l I 'Menu costs ' whereby businesses have to change price tags, cash tills , vending

chines and price lists more frequently.

i ! ! i 'Decision-taking costs' whereby future contracts become less certain, with ousmesses

now requiring a higher future return (i.e. higher risk premium) to cover

future uncertainties from inflation.

~ 'Inflation illusion' whereby businesses lose customers who think that prices

r isen excessively when in fac t money incomes have risen even more rapidly

that real incomes have inc reased. By cutting back on consumer spend ing in

(mistaken) belief that prices have risen too rapidly, aggregate demand may fall

an economic slowdown occur.

II 'Redistribution costs' whereby businesses on fixed contracts or individuals on

money incomes lose out. Also, creditors lose since the real value of repayments

the lender isreduced in the future.

II 'Fiscal drag' whereby if the government fails to increase tax allowance in line

inflation, then even with tax rates unchanged more tax ispaid by businesses

corporation tax) and ind iv iduals (e.g. income tax) than before. The extra

drawals from the circular flow may then discourage economic activity.

100

.·300t .o oo .20,000

.15,000

250.000

2,000,000

5;000;000.......'10,000,000

....•....•...•00.000,000.

. · .· .l , OO ( ); O OO.OOO .

10.000,000.000 ..··.20;000,0()0,000

··········80.000,000,000··

'. 100,000,000,000



1Why do some suggest that i t is useful for usto careful ly consider historical cases

hyperinflation, such asthat inGermany,even though hyperinflation rarelyoccurs?

2 Howmight agovernment seek to bring a situation of hyperinflation under control?


Employment and unemployment 405

.. , - '

Many stories come from this period in Germany to illustrate theproblems ofhypetin: . .. ..

flation. A fanious one tells ofa man who filledup hiswheelbarrow with deutschmarks .:

to gothe shops , only to bemugged enroute to his des tination; the robber t ipped out ithe notes and stole .the wheelbarrow. Another refers to the Ber linSymphony 0 . . .

which walked out halfway through an afternoon performance because they.had just.••

been paid, knowing that i f they wai ted to the end of the per formance their wages

would be able to buy so much less. Yet another refers to coffee drinkers in Ber lin' s

cafes who ins is ted on paying before they drank their cup of coffee, aware that one

hour later they might beunable to afford i t. Itdoesn't take very much imagination to

realise that everyday lifewould simply break down iffaced by such dramatic falls in

the value ofmoney.

His torically, annual price increases of less than 5% have not been considered

much ofa problem, though lower figures than this have becomethe stated aim of

advanced industrialised economies. For example, the UK government has for

years.instructed the Bank ofEngland to keep inflation (RPIX)below 2.5% per

and the European Central Bank aims to keep its official measure of inflation

below 2% per annum.

Price

levelPrice

level

XS2

- ' "__ ~_¥ASl

.>.>,I I AD

Nationaloutput

Nationaloutput

o

(a) Demand-pull inflation (b) Cost-push inflation

Cost-push inflation

This i sseen as being caused mainly by an increase inthe costs ofproduction, which

o~curs independent ly of the level of aggregate demand. Firms then pass on these

higher costs to consumers inthe form ofhigher prices. The rise incosts reduces profit

margins and results in some firms becoming insolvent so that they exitthe market. As

~.result, the aggre.gatesupply curve shifts upwards and to the left from AS1t oAS

2in

FIgure to.9(b), With less output supplied at any given price. This raises the average

level of prices from PI to P2 but reduces national output from Y1to Y2.

With cost-push inf la tion we move along the aggregate demand curve to a pointwhere output islower and price levelsare higher.

T ypes o f i nf la t io n

Various types of inflation are often discussed, in particular 'demand-pull' and

push' inflation, though in practice inflation may involve elements of both types.

can use our earlier aggregate demand and aggregate supply analysis to consider

two types of inflation.

The analysis has assumed throughout that prices adjust more rapidly than input costs, sothat there issome profi t incentive for higher prices toresul t inextra output. Inother words,

the AScurves slope upwards f rom lef t to right inour diagrams.

inflation

This i s seen as being caused mainly by an increase in the components of azzrezat

demand (e.g. consumption, investment, public expenditure, exports). A rise in

these components will shift aggregate demand upwards and to the right from

AD2 in Figure to.9(a). This raises the average level of prices from P1 toP2 and

nat ional output f rom Y1 to Y2. The rise in aggregate demand results in many

consumers buying products, but a r ise in aggregate output to Y2 requires a

price to cover the ext ra product ion costs (marginal and average) incurred.

demand-pull inf la tion we move along the aggregate supply curve to a point

both output and price levelsare higher.

We have already considered government policy affecting unemployment and inflation

in our discussion of inflationary and deflationary gaps (Chapter 9,pp. 365-367). Here

we consider various aspects of employment and unemployment in rather more detail.

O u tp ut a n d em pl oym en t

As national output/income rises, so too will employment s ince, for a given level of

technology, more labour input will be needed to produce more output. It thereforefol lows that a r ise in nat ional output ( income) can be expected to resul t in a r ise in



406 Chapte r 10· Government policies: instruments and objectives

employment. In 2004 employment in theUK was at an all-time high of 27.8 million

people.Of course asemployment rises,unemploymen~~ill usually~al1. .

Whilst unemployment in theUK reached over 3 million people Inthe mld-1980s,

some 11% of the workforce, today the unemployment rate has fallen to around

4% of the workforce, well below the EU average of over 10% of the workforce

unemployed.

jobless growth

Nevertheless, many economies have been expressing concern in recent years at what

they fear may be'jobless growth'. Inother words, a situation where a risein national

output does not seemto beassociated with higherlevelsofemployment (and therefore

fallinglevels of unemployment), aswas previously the case.

A number ofpossible explanations have been suggested.

1 New technologies have raised the productivity of labour significantly in

activities,so that fewerworkers arerequired for evenhigher levelsof output. This

often referred to as 'technological unemployment' (seep. 407).

2 Outsourcing of jobs (see p.635) by multinational

relocating labour intensive processes to lower wage

Employment maybe growing worldwide but not in the

developedeconomies as 'footloose' multinationals reconfigure

valuechains.

Measuring unemployment

There are two main methods for counting the unemployed in the UK, the first

which is nowthe official measure ofUK unemployment.

iii! Survey method. The UK's quarterly Labour Force Survey (LFS) uses the

national Labour Office (ILO) definition of unemployment: people without a j

who were available to start work within the next two weeks and who had .

looked for work within the four weeks prior to interview or who were

to start a job. The LFS samples around 61,000 households in any tnrec-montr

period and interviews are taken from approximately 120,000 people aged

over.

i ! I I I Claimant count. Amonthly count by the BenefitsAgencyof thenumber of

claiming unemployment-related benefits.

Many regard thesurveymethod asthe more accurate; For example, women and

erswho areactivelyseekingwork butwho maynot qualifyfor benefit willnot

in the claimant count.

Types of unemployment

The various types of unemployment are outlined inTable 10.5.

Employment and unemployment 407

Table 10.5 Typesof unemployment

Term Definition-------~------~--~~----~----- - .~-.-- -- .~~~ ---~------------------.~-------.----.---.-.- ---- -~-----

Frictional (search) unemployment There is alwaysthis type of unemployment assome

workers wil l always bein the process ofchanging jobs

This results from longer-term changes in the demand for,

and supply of, labour inspeci fic industr ies asthe

structure ofthe economy changes (e.g, decline in

shipbui lding and intext iles inthe UK)

This resul ts f rom changes indemand for the outputs of

industr ies which tend to belocated inspeci fic regions ofa

country, e.g. shipbuilding in Clydeside (Scotland) and

Tyneside (NEEngland)Technological changes mayleadto significant changes in

labour and capital productivity, resulting in job losses

This results from rigidities in the labour market which

prevents the realwage from fal ling to a level that would

'clear' the market

Where the major cause isexcess supply (l.e. lack of

demand) inthe product market: often associated with

economic recessions

Def ined asthe rateof unemployment atwhich there isno

excessor deficiency of demand for labour

Structural unemployment

Regional unemployment

Technological unemployment

Realwage unemployment

Demand deficient unemployment

Natura! rate of unemployment

---_._---"----"-"----------"---------- .---~-~--.----

Frictional, structural andregional unemployment areclearlydefined in Table 10.5 but

wemight usefullyconsider the other types of unemployment in a littlemore detail.

Technological unem ployrnent

New technologies can both create and destroy jobs. Where the new technologies

involveprocess innovation then labour is often replaced by capital equipment in the

production process and the term 'technological unemployment' is often used. For

example, a USInternet banking company has introduced 'smart' technologies into

every aspect ofits operations, so that its$2.4bn of deposits are now managed byjust

180 people, compared to the 2,000 peoplerequired to manage deposits of this sizein

lesstechnologically advanced banks.

However, thenew technologiesmay lower product pricesand raise product quality,

thereby increasing product demand and creating new jobs, even if these are different

from the original jobs displaced. The 'employment multiplier' effect of the initial in-

vestment in new technologies (seep. 365) will further support this outcome. The net

effectmay bepositiveor negative for jobs.

Technological unemployment may, however, beabout to enter a newphase! Rifkin

(2004) reports that newtechnologies are increasing productivity at ever-accelerating

rates in both industrial and service sectors, so much so that job destruction is

outweighing job creation. He points to an astonishing 10% growth in USproductiv-

ity in 2003, the steepest rise since 1950, accompanied by increasing, not falling,unemployment.



408 Chapter 10· Government policies: instruments and objectives Employment and unemployment 409

Greatly increased productivity has been at the expense of more workers being

marginalized into part-time employment or given notice to quit. A shrinking

workforce, however, means diminishing income, reduced consumer demand

and an economy unable to grow.

willreduce the equilibrium levelof national output from Y1 to Y2 and with itthe levelof employment (i.e. unemployment will result).

Excess supplySupply of workers---------A---

W2 __..- -- -----

'" t/}

Wi'";:m'"::

Demand for workersI unemployment I

0 l2 l3 Workers

The labour market diagram shown in Figure 10.12 can be used to i llustrate the idea of the

'na tu ra l rat e o f unemployment' (NRU) ,wh ich was int roduced by M il ton F ri edman. Herelabour demand, LD, reflects the marginal revenue product (MRP)of workers, i .e. the ext ra

revenue earned from employing the last worker (see Chapter 7, p.253). This is downward

sloping, in l ine with the assumpt ion of a diminishing marginal physical product (MPP) forworkers.

(J . Rifkin, 2004)Natural rate of unemployment

Box 10.4 uses some rather more technical analysis to investigate the so-called 'naturalrate of unemployment'.

Realwage unemployment

Real wage unemployment issometimes called 'classical unemployment', as shown in

Figure 10.10.

The natural

rate of

unemployment

Demand deficient unemployment

Onlyat the realwage rate W1does the supply oflabour exactly match the demand

labour (i.e. the market clears). If t he r ea l wage is too h igh (W2), then more

will offer themselves for work (L3) but employers will only be willing to have

workers (L 2) at this higher real wage. The result isexcess supply ofworkers ( L3 ~i. e. unemploymen t caused by a f ai lur e o f the labour market t o r each t he

clearing' real wage W 1.

In Figure 10.11 a decrease in aggregate demand resul ting f rom a fal l in C, I , G

(X- M) wil l shi ft the aggregate demand curve downwards f rom ADl to AD2.

Employment

Il Labour supply, Ls, represents all those workers wil ling and able (i.e, they have the right

ski lls and are inthe right locat ion) to accept jobs ata given realwage.

Il Thelabour force, LF, shows the total number of workers who consider themselves to be

members of the labour force atanygiven realwage;of course, not all of these arewi ll ing or

able t o accep t j ob o ff ers, perhaps because they are s ti ll searching f or a bet te r o ff er o r

because they have not yet acquired the appropriate skil ls or are not in an appropriate

location.>

Pi

> t'" P 2 AD i·c0..

o National

At the equilibrium real wage (W/P)in Figure10.12, N1 workers arewi l ling and able to accept

job offers whereas N 2 workers consider themselves to be members of the labour force. That

part of the labour force unwil ling or unable to accept job offers at the equil ibrium real wage

(N2 - Ni) isdefined asbeing the natural rate of unemployment (NRU).Interms of our earlier

dassification ofthe unemployed the NRUcan be regarded as including the frictionally, struc-

turally and regionally unemployed.



410 Chapter 10· Government policies: instruments and objectivesEmployment and unemployment 411

It can beseenthat anything that reduces thelabour supply (the numbers willing and able

to accepta job ata given realwage)wi l l, other things being equal . :au~: the NRUtoincrease.

Possible factors might include an increase in the level or availabil ity of unempl.oyment

benef its thereby encouraging unemployed members of the labour force to engage In more

prol0ng~d search activity. An increase in trade union power.mig~t also reduce.the.numbers

wil ling and able to accept a job at a given rea!wage. especially If the trade union IS able to

restr ict the effective labour supply as part of a strategy for raising wages. A reduced labo~r

supply might also result from increased technological change or increased global cornpeti-

t ion, both ofwhich change the nature of the labour market ski lls required for emp!oyment.

Higher taxes on earned income are also l ikely to reduce the labour supply at any given real

wage.

Similarly. anything that reduces thelabour demand will, other things equ~l, cause ~heNRUto increase.A fall inthe marginal revenue product of labour, viaa fall in marginal physical pro-

ductivi ty orin the product price. might be expected to reduce labour dem~nd. Many ~cono·

mists bel ieve that the two sharp oil price increases in the 1970s had thiS.ef fect , w~ththe

resulting fall inaggregate demand causing firms to cut back on capital spending, reducing the

overall capital stock and hence the marginal physical productivity of labour.

This simple statistical 'trade-off' between unemployment and inflation was seen to

break down inthe 1960s. From that time onwards, variable and often higher levelsofinflation seemed to be associated with any given level of unemployment.

One of the reasons suggested for thi s breakdown in the Phillips

curve isthe growing importance of 'cost-push' inflation (seep. 405).

Increases in the costs of raw mater ia ls and components or in wage

r ate s ( e. g. t rade un ion p re ssure s) may push cos ts and pric es upirrespective of the pressure of demand.

Case Study 10.3 looks at unemployment from a global perspective.

In.J~ne.··i006allla jot···stlldy·.·"'aspublished .·.·by••he. Q E C j ) • • •(()ECp·· 1()06).••revie'Ving•.he ...prog~ess that had. beenimade in improving the labollrll1arkets since..1994 ..Itsconclu-.·

·sionsi'vere·that someprogress· ...as.beenmade·. inmost ·.but•.uot·aU·c()uIltries..1-t.the •.•

...same tiITiethe challenges and.dangets have become broadet.and ..ticludea~()rerapid •.

paceofrechn()Iogicalad vance,.globalisatiou ..with..he·associated increase inc:oinpeti~ ...

tioll from the extra labour forceinChina and India and the demographic problem ofan ageing wcirkforteinmany countries; .

= : In 1?94,ata.timeof high and persistentlmemploYfi1ent, the OEeD had published its

......nitialJobsStu4~.1'hiSstUdy,togetheL~iththe()F:CDlobsiStrategy(1998),made

.more than 60 policy recommendations .·andprOvided a blueprint aimedat·creatirig

jobs and reducing. unel1i.ployment~whilst at.the same lime maintaining· social cohe-

sion'.The.strategyViTasa mixture ofKeYnesi~ln..demand management (deficit spending

in recessions and fiscal consolidation in booms), growth theory (with its emphasis on

entrepreneurship and research and development) and labour market flexibility (with

its emphasisorr job skills). \

Un em p lo ym ent a n d i nf la ti on

It is often suggested that if employment rises too high (i.e. une~ployme~t falls

low) then inflationary pressures will build up in the economy. ThIS suggestron

pins the so-called 'Phillips curve'.

cu rve

The Phi ll ips curve (Figure 10.13) i s based on f inding a ' line of bes t f it ' for UK

series data relating unemployment to inflation over almost 100 years (1861-1957).

suggested that lower levelsof unemployment will result in hi?he: wage i~fla.tion asresult of higher demand for labour, which in turn will result in hIg~er . pnce .

The Phillips curve has often been seen assupporting a 'demand-pull VIewof infla

( see p .404 ). It s ugges ts t hat we can onl y have le ss wage and pri ce in fla tion

accepting a lower level of demand and therefore more unemployment.

. , .

b\rerthepa~tthirteerlYe<trs the ()ECDnotedthatthe· trelldriseinlHlemploymenthas

been reversed brat biststabilised. In somecountries, nbtablyFinlaiid, Spain and

Ireland, therehavebeensubstantial reductions( 9.3, 11.2 and IO.Opercentage points

respectively between 1994 and 2006). Other c()untries that adoptedmaiiy, ifnatalI, of

the .Jobs Strategy recommendations have also done well. The UK , for example, reduced

un~mployment. overthe-same period ..by 4.1 percentage points. However, other coun-

tries.thathaveadoptedtheNotdic'flexicurity'apptoach such asDenmark with itseasy

hire-and-fire·culture but sti:C)flgsuPPOrtfor the.llnemployed(who· receive 65% of their

work incomecomparedwithonly18~ inthe UK),Austria andthe Netherlands all of

which have.similar approaches, .havfalso done relatively well. Other countries that

the OECI)regard . .<lsnot.~a>'ingrefoFll1edtheir.labour markets sufficiently, such as .Germany,Franceandltalyhave,d()ne less well despite strong global growth.

J ; ; e . r ~ C D " ,gue , t h " n e w · . . . i f~:nd!~~J! '~:~~; : :~: ;~; :~. . tojobcreat ion, The OECD does, however ,

> -

+'"'"u·c0-

S

'" lcIII

.c.. ,>R .0

0"iO::> % unemploymentcc

-= c

.....,



412 Chapter 10· Government policies: instruments and objectives

argue that experience since 1994 confirms the view that some social benefits carr aetas.

a d isi ncen tivet owork. lt ar gues t hat t oo many peop le i n some . •. . .sively attractive early retirement or sickness benefit schemes andthat •.

schemes needs tightening. The evidence, they argue; also points-to

and other sources ofhigh labour costs (heal th costs , for example) . . . . . . > 'H. ' " ' .• '':J

for low-skilled workers ..The OEeD also continues to hold the view . r igid

wages that do not adju st to changes in supply and demand i n t he l abou r nH LL" .

increase unemployment.

As in the ear lier s tudy the need for competi tive goods markets i s s tressed as

appropriate macroeconomic policies. Stableeconomies with low inflation and low

rates of interest facilitate investmentrproductivity growth and the.creation of ."1" + •.sIdlled.jobs. to support such outcomes, policies to encourage investment in humancapital arealso emphasised.

" . : " - : . " . : : . . ".-

.Whafconclltsionsmightvaudraw fromthe case study materials?

The balance ofpayments situation for a country will both influence the exchange

for its currency and in turn beinfluenced bythat exchange rate.

As wel l as a high level of employment ( low unemployment) and low UH."'''V'~

government policy will seek to contain within reasonable limits any deficit on

balance ofpayments and may even seek a surplus.The UKbalance ofpayments isoften broken down into the current account,

account and financial account.

Current account

This consists oftwo main sub-accounts, the 'balance on goods' (formerly 'visible

balance') and the 'balance on services' (formerly 'invisible trade balance'). Exports

given a positive sign, imports a negative sign: when exports exceed imports, we

of a 'surplus' and when imports exceed exports, a 'deficit' .

Ii Balance on goods issplit into oil goods and non-oil goods.

!III Balance on services includes shipping, insurance, finance etc.

The current account iscompleted by adding two further items: the 'investment

balance' (i.e. net income from interest, profits and dividends) and the 'transfer

ance' ( i. e. net value of government t ransfers to ins ti tutions such as the EU,

Bank etc.). Table 10.6 presents the components of the UK current account

past ten years.

Balance of payments 413

.....able 1().6Carnponellts(}f lJJ( current acc()unt,1996"-2006 (£ni) ......•.•.•

Trade in goods and services

Balance on goodsB al an ce B al an ac e I nv es tm en t

Non- on on goods Income! Transfer Current

Year Total Oi l Oi l Services and services balance bal an ce bal an ce

1996 -13,722 +4.810 -18,532 +11.208 -2,518 +463 -4,755 -6,717

1997 -12.342 +4.560 -16,902 +14.106 +1.764 +3.231 -5,918 -840

1998 -21,813 +3,042 -24,855 +14,672 -7.141 +1,069 -7,533 -21.717

1999 -29,051 +4,448 -33,499 +13,597 -15.454 +2,101 -7,574 -9,015

2000 -32,976 +6,536 -39 .512 +13.615 -19.361 +4.390 -10 ,012 - 24,833

2001 -41.212 +5,290 -46.502 +14,423 -26,789 +11,598 - 6,759 - 21.884

2002 -47,705 +5 .108 -48 .213 +16,830 -30,875 +23,376 -9,081 -16,513

2003 -48 ,607 +3.376 -51,983 +19,162 -29,445 +24,587 -10,122 -14.921

2004 -60 ,893 +893 -61,682 +25,198 -34.975 +26,525 -10.949 -19,328

2005 -68 ,789 -2.195 -70 ,984 +24,611 -44,178 +26.344 -12.008 -30,452

2006 -83 ,631 -3.905 - 87 .536 +29,194 - 54.437 +19.293 -11.899 -47,781

1h is total inc ludes both 'compensat ion to employees' and ' investment income' but instat is t ical terms i t is

nearly all investment income.

Source: Adapted from ONS(2007) UK B a l a nc e o f P a ym e nt s; ONS (2007) Dat a Re leas es (various),London: HMSO.

Crowncopyright material isreproduced withthe permission ofthe Controller ofHMSOandthe Queen's Printer for

Scotland underthe Click-Use Licence.

Capital account

This records the flow ofmoney into the country (positive sign) and out ofthe country

(negative s ign) resul ting f rom the purchase or sale of f ixed asset s (e.g. land) and

selected capital transfers.

Financial account

This records the flows ofmoney into the country (positive sign) and out ofthe country

(negative sign) resulting from investment-related or other financial activity.

III Direct investment usual ly involves physical asset s of a company (e.g. plant ,

equipment).

I ! I I Portfolio investment involves paper assets (e.g. shares, bonds).

!III 'Other financial flows' may involve the movement of deposits between countries.

If the net value of the i tems mentioned in the three accounts sofar are negat ive, we

speak o f a balance of payments deficit; ifpositive, of a balance of payments surplus.

Balancing item

The overall accounts are constructed so that they must balance (accounting identity),

with thi s balance achieved by either drawing on reserves ( if def ic it ) or· adding to

reserves (ifsurplus). The 'balancing item' represents these values, which are required

to maintain the accounting identity.




This can be quo ted as t he numbe r o f unit s of the foreign currency that i sneeded to

purchase one unit of the domestic currency: e.g. £1 = €1.50. Alternatively, it can bequoted asthe number ofunits ofthe domestic currency needed to purchase one unit of

the foreign currency: e.g. €1 =£0.666.

The exchange rate isa key 'price' affecting the competitiveness of UKexporters and

UK producers of import substitutes.

i ! I I I A fall (depreciation) in thesterling exchange rate makes UKexports cheaper abroad

(in the foreign currency) and imports into the UKdearer at home (in £ sterling).

I I l I I A rise (appreciation) in the sterling exchange rate makes UK exports dearer abroad

( in the foreign currency) and impor ts into the UKcheaper athome ( in £ sterling).

Wecan i llus trate the lat ter using the £ :$ exchange rate. Inrecent t imes s terl ing hasi

risen (appreciated) significantly in v alue against the U S dollar. .

£1 = $1.50 (2002)£1 = $2.05 (November 2007)

Asa resul t, a £100 expor t f romthe UKcosting $150 inthe USAin 2002 costs $205 .

2007. Similarly,an import from the USAcosting $150 would sellfor £100 inthe UK

in2002 but £73.17 in2007.

The change invalue ofUKexport s and UKimpor ts after a change inthe <:;A ><U1);<::

rate will depend crucially on the price elasticity of demand (PED)for both exports

imports. The more elastic the demand for exports and imports, the greater the 1!11Ud.L

on the balance ofpayments of any change in the exchange rate, and viceversa.

Example:

Types of exchange rate

S! Nominal exchange rate. This istherate at which one currency isquoted againstother currency. The nominal exchange rate is therefore a bilateral (two r"'''''j·......\

exchange rate.

I I 1 I I Effective exchange rate (EER).This is a measure which takes into account the

that s terl ing var ies in value by dif ferent amounts against other cur rencies. I t

calculated as a weighted average of the bilateral rates against all other .

and isexpressed asan index number relative to the base year. The EER is

a multilateral (many country) exchange rate, expressed as an index number.

S! Real exchange rate (RER) isdesigned to measure the rate at which home

exchange for products f rom other count ries , rather than the rate at which

currencies themselves are traded. It is thus a measure of competitiveness. When

consider multilateral UKtrade, it isdefined as:

RER = EER X P(UK)/P(F)

In other words , the real exchange rate for the UK (RER) is equal to the

exchange rate (EER) multiplied by the ratio ofhome price, P(UK),to foreign

P(F), of products.

Exchange rate !;15

- 1 £ UKprices rise relative to foreign prices, thereal exchange rate (RER) will rise,

unless the sterling effective exchange rate (EER) falls sufficiently to offset thisimpact.

- Similarly, if the sterling effective exchange rate (EER) rises, the real exchange

rate will rise, unless UK prices fall sufficiently relative to foreign prices.

Table 10.7 outlines thenominal rate ofexchange forsterlingagainst other currencies and

the overall sterling effectiveexchange rate (EER)against a 'basket' of other currencies.

Table 10.7 Sterling nominal exchange rates, 1997-2007

Sterling effective

us French Japanese German exchange rate

Year dollar Franc Yen mark (2005 = 100) Euro----------- ....... --.--. ~~-- .......... - ....~~~,~---- _ m _ .~ _

. - ...- ..~-~ -----~-.-.--.

1997 1.64 9.56 198.12 2.84 96.371998 1.66 9.77 216.75 2.91 100.001999 1.62 9.97 183.94 2.97 99.37 1.522000 1.52 10.77 163.27 3.21 101.15 1.642001 1.44 10.55 174.84 3.15 99.49 1.612002 1.50 187.87 100.56 1.592003 1.64 189.32 96.88 1.452004 1.83 198.10 101.60 1.472005 1.82 200.16 100.43 1.462006 1.84 214.33 101.22 1.472007 (Sept) 2.00 235.71 103.53 1.46

-~~~------. -----"---~~~~--Notes: Figures have been rounded to 2 decimal places. Theannual sterling effective exchange rate figures

were calculated byaveraging the daily values sourced from the Bank of England's Interactive Database.

Source: Adapted from Bank ofEngland (2008) Statistics/nteractive Database: Interest andexchange rates,February 12th. Reprinted with permission.

Notice the rapid appreciation in the nominal exchange rate ofsterling against the US

dollar since 2002 (i.e, the US dol lar has depreciated significantly against sterling).

However, sterling has depreciated invalue against the euro in the last few years.

The impact ofexchange rate changes are considered inmany chapters

ofthis book, since they clearly have an important impact on the com-

petitiveness of exports in foreign markets and of imports in domestic

markets.

Wenow turn to an impor tant i ssue inthe UK, namely whether ornot to join the singlecurrency.

Single currency (euro)

Elevencountries formally replaced their national currencies with the euro on 1January

1999, with Greece becoming the twelfth member ofthis eurozone in2001.



416 Chapter 10· Government policies: instruments and objectives

Exchangerate 417

Advantages of a single currency

ii!I Lower costs of exchange: i mpor te rs n o l onge r h av e to obt ain f or eig n cur re ncy to

pay expor te rs f rom the eurozone.

! ! I I Reduced exchange rate uncertainty: a ll members face f ixed exchange rat es wit hi n

the eurozone,

! I i i Eliminates competitive depreciations/devaluations: historical ly countries have tried

to m atc h any f all in t he e xchang e r ate s o f r iv al c ountr ie s, w it h s uch ' compet it iv e

depreciations' creating uncertainty and discouraging trade.

I I I i I Prevents speculative attacks: speculators can sometimes force individual currencies

t o depreci at e/ deva lue t he ir currency by sel li ng l arge amounts of t ha t currency. The

euro, b ei ng suppo rte d by a ll m embe r c ountr ie s, i smuch b ett er e qu ip ped to r es is t

such speculative attacks.

Disadvantages of a single currency

l 1 l i Loss of independent exchange rate policy: gov ernment s c an no l onge r s ee k to r em- .. •

edy a balance of payment deficit with a member of the euroz one by lowering .

e xchang e r at e, t he re by mak in g expor ts c he ap er in t ha t c ountr y a nd impo rt s

from that country.

II Loss of independent monetary policy: t he e ur ozon e h as a Europ ean Cen tr al

whi ch det ermines t he money supply and int eres t rat e pol icy for a ll member



ins Chapter 10· Government policies: instruments and objectivesEconomic growth 419

Economic growth isusually defined asthe rate ofchange ofnational output (income).

When this i s negat ive, we often use the term economic recession, although

speaking we should only use this term when national output has fallen in value

two successive quarters. Economic growth is usually expressed in 'real' terms, i.e. after

taking inflation into account.

Governments rarely announce growth targets. However, historically GDP has

grown intheUK atan average rate of jus t over2 % per annum (inreal terms) over the

past so or soyears.

In terms of the production possibility frontier of Chap te r 1 (Fi gu re 1 .1 , p . 4 ), .•

economic growth can involve either:

! III cutting government expenditure in order to release resources to the private sector;

iii abolishing exchange controls in order to allow capital to move freely.

Anyincrease in labour or capital productivity resulting from these supply-side policies

would then shift outwards the production possibility frontier of Chapter 1.Successful

supply-side policies would also increase the aggregate supply curve in Figure 10.14,

.shifting itdownwards and to the right from AS1 toAS2. The result isshown asraising

the equilibrium level of national output (e.g. GDP) from Y1 to Y2 and reducing theaverage price levelfrom P1 to P2.

! I ! I a move from a point ins idethe f ront ier towards a point nearer to or actually on

unchanged frontier; or

!iii a move from a point ins ide or on an exist ing f ront ier to a point previously vU,>1U;

the frontier, as a result of an outward shift in the frontier itself.

Q P1AS 2

>

•OJP2

&

In the first case, recorded economic growth involves a fuller useof existing UHJUU-U

resources. For example, higher aggregate demand may have contributed

economic growth, allowing a fuller use of existing productive capacity.

In the second case, recorded economic growth involves some increase in

productive capacity ofthe economy as a whole. Whilst higher aggregate demand

a lso have p layed a part i n such g rowth, there would s eem al so t o have been

improvement in the 'supply side' ofthe economy. It i s to thi s i ssuethat we now

o National

output

Suppl y- s id e po li ci e s

Some people have suggested that the UKexperienced a supply-side 'revolution'the 1980s and 1990s , which included a wide range ofpolicies which sought to

the productivity of both labour and capital.

Such 'supply side' policies have included, amongst others:

Many of these supply-side policy issuesare considered elsewherein the book, especially

in Chapter 7 on labour and other factor markets.

Activity 10.2 givesyou an opportunity to check your understanding of policyinstru-

ments and approaches to unemployment, inflation and the balance ofpayments.

!!Il assistance with investment;

!!Il trade union reform;

Ii! deregulation/privatisation;

l 1 l i making more training grants available;

I ! ! I I increasing the number of people at universities;

1 ! ! l helping people to set up new firms;

1 ! ! l income tax cuts to increase incentives to work;

1 ! ! l cuts inwelfare payments to encourage people to return to work;

1m a government commitment to keep inflation low in order to aid investment



420 Chapter 10 .Government pol icies: instruments and objectlves KeyTerms 421

lower. .... -. .

Arisein the rate ofinf tatlon means that the percentage risein average

prices ishtgherthan previously, ',

Orieof the costs of inf lation isthat those onvariable incomes dobet ter

than those on fixed incomes, ."......; ..... .. '.' '.' '.

. I fa risein rawmaterial costs feeds through to higher priceswe usethe

" i7I'i>~"tpsupply Thetotal output inthe economy.

. short run ar i se in t he average pri ce level i s .

. . .. l l y assumed to exceed rises in input costs,'.. fi tab il it y a nd p ro vi di ri g an i n centi ve fo r

nslon in aggregate supply. . :

)DrieCi<ltio,n' A rise inthe exchange rateafone

. against another. Often used inthe context

exchange rates.

goods Netva lueo ft ~de int angibl e . :

. rts+s l rnp o rt s - ) . Previously known as.Ietrade balance',

. services Netvalue oftrade inservices

+, imports -). Previously known asthe

trade balance'.

Built-in stabl lsers Resul t in a net increase in

withdrawals in'boom' condi tions and a net increase

in injections during recession;. . .

Business cyc le Thetendency foreconorntas to move

from economic boom into economic recession and

vice versa,

Capital account Recordsthe flows of money into the

.country (positive sign) andout ofthe country

(riegative sign) resulting from the purchase orsale of

fixed assets(e.g,land) andselected capital transfers.

Consumer Pr ice Index (CPl). Since December 2003

this hasreplaced RPIXasthe official measure of

inflation intheUk.:

Cost-push inflation Inflation seen asbeing caused

mainly byan increase iqthe costs of production,

which firms pass on ashigher prices.

Current account Consists oftwo main sub-accounts,

the 'balance on goods' (formerly 'visible trade

balance')ahd the'balanceon services' (formerly

'invisible trade balance').. .

Depreciation Afal l inthe exchangerateof one

currericy against another. Often used in the context

offlcating exchange rates.

economics reading matter topic 9 (1)

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