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1. Introducing Macroeconomics

What is macroeconomics?

Macroeconomics considers the economy as a whole – i.e. the quantity of goods and services produced by all businesses and the government sector. Macroeconomics also studies relationships between one country and another.

The scope of macroeconomics includes looking at the success or failure of government policies. Here are some examples of recent news headlines covering macroeconomic issues:

‗Pound rises to a 26 year high against the US dollar‘

‗Interest rates put a break on house prices‘

Food prices to hit the UK economy hard

‗China set to overtake Germany as economic growth quickens‘

‗UK runs her highest ever trade deficit in 2006‘

Introduction to the UK economy

The City of London is a centre for global finance and a major source of income for our balance of

payments

The spending decisions of millions of consumers add up to affect the performance of

the whole economy

Searching for work – unemployment has been

Anticipating demand – Businesses need to

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low in the UK recently – but it is now starting to rise again

forecast demand changes when setting production levels

Brief background on the UK economy

The UK is one of the world‘s advanced economies. It has the second largest economy in the European Union behind Germany and it is the second biggest exporter of services in the world. In 2008 the UK will contribute around 3 per cent to global output.

In terms of per capita income, the UK is ranked in the top fifteen nations and in 2006 the UK had a per capita income of $34,370.

Britain has enjoyed continuous economic growth that stretches back to 1992, the longest sustained expansion for over forty years. That may come to an end in 2009!

Over a quarter of the UK‘s GDP comes from exports of goods and services. Imports are around 30 per cent of national income which means that the UK runs a large trade deficit with other countries.

The UK joined the European Union (EU) in January 1973 and it is a founder member of the World Trade Organisation (WTO) which it joined in 1995. The UK retains its own currency (sterling) having decided not to consider entry to the EU single currency area, the Euro Zone.

What are the main sectors of the macro-economy?

Whereas microeconomics deals with individual markets such as oil, housing and farming and the behaviour of households and individual businesses, in macroeconomics we tend to look at things ‗in the whole‘ and, in doing so, we tend to use these terms when describing different groups:

Households: receive income from their jobs and from their investments and then buy the output of firms (this is known as consumption or consumer spending and is labelled as C)

Firms: Businesses hire land, labour and capital inputs to produce goods and services for which they pay wages and rent etc (income). Firms receive payment from consumers and profitable businesses may choose to invest (I) a percentage of profits in new producer goods.

Government: collect direct and indirect taxes (T) to fund spending on public services such as education, healthcare and defence. Government spending is given the label (G).

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International sector: The UK buy overseas products known as imports, (M) and overseas businesses and consumers buy UK products – known as exports (X). International trade is important for the UK. Millions of jobs depend directly or indirectly on the UK remaining competitive in overseas markets.

This table provides links to country profiles of each nation from the Economist website – this is a highly recommended resource for students of AS macroeconomics.

European Union (27 countries) NAFTA (3 countries)

North American Free Trade Area

Germany Greece United States

Austria Czech Republic Canada

France Poland Mexico

Italy Slovenia

Netherlands Slovakia Other OECD (but non-EU)

Belgium Latvia

Luxembourg Lithuania Norway

Ireland Malta Switzerland

Finland Cyprus Iceland

Portugal Hungary Turkey

Spain Estonia Australia

Sweden Denmark New Zealand

Bulgaria UK Japan

Romania

Emerging Markets include South Korea

China South Africa

India OPEC Nigeria

Russia inc

Brazil Saudi Arabia

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2. Measurement of Macroeconomic Performance

Macroeconomic performance is a term that is used frequently in the media and in exam questions! It refers to an assessment of how well a country is doing in reaching some of the objectives of government policy. The main aim of policy is usually an improvement in the real standard of living for the majority of the population. The term „real‟ means that we have taken into account the effects of rising prices so that we measure how many goods and services we can afford to buy.

But, as we shall see, macroeconomic policy is not solely concerned with living standards. The bigger picture would take into account some of the following:

1. Jobs – are more people finding work in the jobs that they are suited to and which pay a living wage? How high is unemployment? Is the economy creating enough new jobs for people entering the labour market each year?

2. Prices –are price rises under control creating the conditions for price stability?

3. Trade – is the economy performing well in trading goods and services with other countries? Is the economy living within its means by exporting enough to pay for imported products?

4. Growth – how successful has the economy been in achieving growth in the short term and in laying the foundations for expansion in the future?

5. Public services – have the benefits of growth flowed through into greater and improved provision of key public services such as education, health and transport?

6. The environment – the effects of economic activity on our natural and built environment have become ever more important over the years. Many economists now focus on whether an expanding economy is sustainable in terms of its environmental impact.

Big numbers!

We have to deal with some big numbers when we study macroeconomics! For example, the value of national output in the UK is now well above £1.3 trillion! But we still stand well below the United States, whose national output (GDP) accounts for over a quarter of world output each year. China is fast catching up and is now the 4th largest country by GDP measuring in US dollars.

Ranking of the World‘s Biggest Economies

Data is for 2007

Gross Domestic Product

(Million US dollars)

Gross Domestic Product

(PPP adjusted)

United States 13,811,200 13,811,200

Japan 4,376,705 4,283,528

Germany 3,297,233 2,751,843

China 3,280,053 7,055,079

United Kingdom 2,727,806 2,081,549

France 2,562,288 2,053,695

Italy 2,107,481 1,780,135

Spain 1,429,226 1,372,717

Canada 1,326,376 1,178,205

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Brazil 1,314,170 1,833,601

Russian Federation 1,291,011 2,088,207

India 1,170,968 3,092,126

Source: World Bank web site accessed 7th July 2008

http://siteresources.worldbank.org/DATASTATISTICS/Resources/GDP.pdf

The Economic Cycle

The national output of a country does not rise in a steady fashion from one year to the next! All countries experience what is called an economic cycle which tracks the fluctuations in the rate of growth of a country‘s Gross Domestic Product (GDP). Have a look at the chart below:

Annual percentage change in GDP at constant prices

The Economic Cycle - Growth in UK National Output

Source: Reuters EcoWin

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

Pe

rce

nt

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

The cycle is also known as the business or the trade cycle. The chart shows the annual rate of growth of national output for the UK since 1980. We can see that the rate of growth varies from year to year (the data is published every three months, so we get four data points in any one year showing how fast the economy has expanded over the previous twelve months.)

Notice that there have been two recessions in the last twenty-eight years. The early 1980s downturn was a particularly deep recession – in fact it was the worst in the UK‘s post-war history. There was another recession in the early 1990s before the UK climbed out of the downturn in 1993.

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From 1993 through to the time of writing (the summer of 2008) our economy has continued to expand. Indeed national output has risen in every quarter of the year for the last sixteen years – which is a remarkable achievement! This is known as sustained growth and it is an important target of government policy.

This is not to say that we will not suffer another recession! The economic cycle is still with us and we will learn more about it as we get further into this macroeconomics course. There are some pessimistic economists who are predicting a recession for the UK in 2009!

Our chart shows the beginning of a slowdown but the economy is still some way off a recession. Keep an eye on the news in the papers to see how our cycle develops over the next few years!

UK growth forecast is cut

UK economic growth will slow to its lowest level since 1992 in 2009 according to a new forecast from the Confederation of British Industry - a leading employers' group.

Gross Domestic Product is now forecast to rise by just 1.3% next year as households tighten belts due to higher food and fuel prices. The CBI said a "prolonged period of sluggish growth" was in prospect for the UK but it was not predicting a full-scale recession.

There are a number of definitions of a recession, with economists often differing on what is required. However, the most-used definition of a recession is when there are two quarters in a row of economic contraction, or negative growth.

High oil prices have caused a rise in inflation and have given the Bank of England less room to cut official interest rates. Increased prices for essentials such as food, electricity, gas and fuel has squeezed household incomes and companies' profit margins.

Source: Adapted from news reports, June 2008

Key terms

Economic cycle Variations in the annual rate of growth of an economy over time

Forecast A prediction made about the likely future performance of an economy

Macroeconomic performance

The overall performance of an economy in terms of output, prices, jobs, global trade and living standards.

Recession A period of at least six months when an economy suffers a fall in output

Slowdown A fall in the rate of growth of an economy but not a full-scale recession

Sustainable growth Sustainable economic growth is known as the rate of economic growth ―which meets the needs of the present without compromising the ability of future generations to meet their own needs‖.

Sustained growth Growth of output that is sustained for several years in succession

Target A target is an objective of government policy e.g. low inflation

Suggestions for further reading on introductory macroeconomics

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Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on an introduction to macroeconomics.

Latest news on the UK economy (BBC news)

Latest news on the UK economy (The Guardian)

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3. The Circular Flow of Income

A basic model of the economy can be developed using the idea of the circular flow of income and spending. The circular flow of income is a simple model showing the connections between different sectors of our macroeconomic system. It revolves around flows of goods and services and factors of production between firms and households.

Leakages from the circular flow

Not all income will flow from households to firms directly. The circular flow shows that some part of household income will be:

(1) Put aside for future spending, i.e. savings (S) (2) Paid to the government in taxation (T) (3) Spent on foreign made goods and services, i.e. imports (M)

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a multiplied contraction of output.

Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output.

(1) Capital spending by firms, i.e. investment expenditure (I) (2) The government, i.e. government expenditure (G)

Households

Firms

Consumption of goods and services (household spending)

Flows of factor incomes e.g. wages, rent, interest and dividends

LEAKAGES

Savings (S)

Taxation (T)

Imports (M)

INJECTIONS

Investment (I)

Government Spending (G)

Exports (X)

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(3) Overseas consumers buying UK produced goods and service, i.e. UK export expenditure (X)

Economic event Change in an injection or change in a leakage

in the circular flow

(circle your preferred answer)

Likely effect on the level of national income –

expansion or contraction (ceteris

paribus)

1. A fall in business confidence among UK manufacturing firms

Injection / Leakage / Both

Expansion / Contraction

2. The pound rises by over 5% against the US dollar in the global currency markets

Injection / Leakage / Both

Expansion / Contraction

3. The government announces an above-inflation pay rise for nurses in the NHS

Injection / Leakage / Both

Expansion / Contraction

4. Nissan decides to reduce investment spending at their main Sunderland plant and shift some car production to the Czech Republic

Injection / Leakage / Both

Expansion / Contraction

5. A survey shows that consumers expect to see a sizeable rise in unemployment over the next twelve months

Injection / Leakage / Both

Expansion / Contraction

6. The government announces a fall in the rate of taxation applied to the interest paid on savings in bank accounts

Injection / Leakage / Both

Expansion / Contraction

7. The UK reduces the size of an import tariff imposed on imports of Chinese clothing and footwear

Injection / Leakage / Both

Expansion / Contraction

8. The annual rate of economic growth in the United States increases following a fall in US interest rates

Injection / Leakage / Both

Expansion / Contraction

9. The government decides to increase the UK road-building programme by £600m

Injection / Leakage /Both

Expansion / Contraction

10. The Bank of England‘s Monetary Policy Committee decides to cut interest rates from 5% to 4%

Injection / Leakage / Both

Expansion / Contraction

11. Ahead of a general election, the government announces a reduction in the basic rate of income tax from 22% to 20%

Injection / Leakage / Both

Expansion / Contraction

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12. The government increases revenues from taxes on high-income earners by £2bn and uses the money to increase spending on welfare payments to low-income families at £2bn

Injection / Leakage / Both

Expansion / Contraction

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4. Measuring National Income

To measure how much output, spending and income has been generated in an economy over a given time period we use national income accounts. These measure three things:

1. Output: i.e. the total value of the output of goods and services produced.

2. Spending: i.e. the total amount of demand.

3. Incomes: i.e. the total income earned by the factors of production from supplying goods and services

What is National Income?

National income measures the monetary value of the flow of output of goods and services produced over a period of time. Measuring the level and rate of growth of national income (Y) is important for seeing:

The rate of economic growth

Changes over time to average living standards

Changes over time to the distribution of income between groups within the population

Consumer spending accounts for over two thirds of total spending in the UK economy. Consumer spending has been strong in recent years, a reflection of rising living standards and low unemployment, but this may now be coming to an end because of the mountain of household debt and the recession in the housing market.

Were there to be a sharp fall in household spending, the risks of a recession would increase considerably.

Gross Domestic Product

Gross Domestic Product (GDP) measures the value of output produced within the domestic boundaries of the UK over a given time period.

An important point is that our GDP includes the output of foreign owned businesses that are located in the UK following foreign direct investment. For example, the output of motor vehicles produced at the giant Nissan car plant on Tyne and Wear and by the many foreign owned restaurants and banks all contribute to the UK‘s GDP.

There are three ways of calculating GDP - all of which should sum to the same amount since the following identity must hold true:

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National Output = National Expenditure (Aggregate Demand) = National Income

Firstly we consider total spending on goods and services produced within the economy:

(i) The Expenditure method - aggregate demand

This is the sum of spending on UK produced goods and services measured at current prices. The full equation for GDP using this approach is GDP = C + I + G + (X-M) where

C: Household spending

I: Capital Investment spending

G: Government spending

X: Exports of Goods and Services

M: Imports of Goods and Services

The Income method – adding factor incomes

Here GDP is the sum of the incomes earned through the production of goods and services. This is:

Income from people in jobs and in self-employment

+

Profits of private sector companies

+

Rent income from land

=

Gross Domestic product

Only those incomes that are come from the production of goods and services are included in the calculation of GDP by the income approach.

We exclude the following items:

o Transfer payments e.g. the state pension paid to retired people; income support for families on low incomes; the Jobseekers‘ Allowance given to the unemployed and other welfare assistance including child benefit and housing benefit.

o Private transfers of money from one individual to another.

o Income not registered with the Inland Revenue or Customs and Excise. Every year, billions of pounds worth of activity is not declared to the tax authorities. This is known as the shadow economy where goods and services are exchanged but the value of these transactions is hidden from the authorities. It is impossible to be precise about the size of the shadow economy but perhaps 8 – 15 per cent of income is unrecorded by the official figures.

Output method of calculating GDP – using the concept of value added

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There are three main wealth generating sectors of the economy – manufacturing, farming & fishing and service-sector industries. This measure of GDP adds together the value of output produced by each of the productive sectors in the economy using the concept of value added.

Value added is the increase in the value of a product at each stage of the production process. We use this approach to avoid the problems of double-counting the value of intermediate inputs.

The UK is an advanced economy where the majority of GDP comes from the service industries such as banking and finance, tourism, retailing, education and health and a vast range of other businesses services. In 2008 less than half of one per cent of our GDP came from the agricultural sector. Manufacturing accounted for only 15% of GDP and construction a further 6%. In contrast, the service industries now contribute nearly three quarters of national income.

Index of

production

All

Production

industries

Manufacturing

Oil and gas

extraction

Chemicals and man-made fibres

Engineering and allied

industries

Food, drink and

tobacco

Textiles, leather

and clothing

2003 100.0 100.0 100.0 100.0 100.0 100.0 100.0

2004 100.8 102.0 91.6 103.4 104.3 101.6 90.1

2005 98.8 100.8 82.0 103.5 103.2 102.5 88.2

2006 99.1 102.4 74.3 106.1 107.9 101.6 89.6

2007 99.4 103.0 72.5 104.9 109.7 100.7 87.7

Source: http://www.statistics.gov.uk/elmr/07_08/downloads/Table4_01.xls

Our table above provides evidence of the difficulties that the industrial sector has had in recent years. It shows an index of production with a base year for the index of 2003. Since then the output of oil and gas extraction businesses has declined by over a quarter and production in textiles, leather and clothing has also contracted by more than 12 per cent. Some industries have expanded including engineering and chemicals and man-made fibres. But overall, the production sector was supplying less in 2007 than it had been four years earlier.

It is important to remember that manufacturing and service industries are not completely separate! The health of a car exporting business will have a direct bearing on demand, output, profits and jobs in many service businesses such as transportation, design, marketing and vehicle retailing. Equally service businesses such as online banking require plenty of physical inputs such as machinery and infrastructure to be successful.

The rise of the service industries

Nonetheless, as our chart below indicates, the service industries have enjoyed strong growth, leading to a process of structural change away from heavy industries towards service businesses.

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The main service sector industries in the UK are as follows:

Distribution

Hotels and restaurants

Transport, storage and communication

Business services and finance

Government and other services

Motor trades

Wholesale trades

Retail trade

Land transport

Air transport

Post and telecommunications

Real estate activities

Computer and related activities

Education

Health and social work

Sewage and refuse disposal

Recreational, cultural and sporting activities

Index of Value Added, Constant Prices, Seasonally Adjusted

Manufacturing and Service Industry Output

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

60

70

80

90

100

110

120

Ind

ex o

f o

utp

ut,

20

02

=1

00

60

70

80

90

100

110

120

Services

Manufacturing

A decline in the contribution that manufacturing industry makes to national income, trade and employment is called de-industrialization. Many other countries have seen a similar process although it seems to have run further in the UK than elsewhere. In the summer of 2008, figures

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show that only three million people are now working in manufacturing businesses – many of which are foreign owned. What has happened is a switch in production and jobs away from the UK towards other centres of manufacturing in the world economy. This is especially true in industries such as textiles and clothing, footwear and the mass production of many household goods and toys.

GNP (Gross National Product)

Gross National Product (GNP) measures the final value of output or expenditure by UK owned factors of production whether they are located in the UK or overseas.

In contrast, Gross Domestic Product (GDP) is concerned only with the incomes generated within the geographical boundaries of the country. Fr example the value of the output produced by Toyota and Deutsche Telecom in the UK counts towards our GDP but some of the profits made by overseas companies with production plants here in the UK are sent back to their country of origin – adding to their GNP.

GNP = GDP + Net property income from abroad (NPIA)

NPIA is the net balance of interest, profits and dividends (IPD) coming into the UK from our assets owned overseas matched against the flow of profits and other income from foreign owned assets located within the UK. There has been an increasing flow of direct investment into and out of the UK. Many foreign firms have set up production plants here whilst UK firms have expanded their operations overseas and become multinational organisations.

In recent years, the figure for net property income for the UK has been positive meaning that our GNP is above the figure for GDP. For other countries who have been net recipients of overseas investment (a good example is Ireland) their GDP is higher than their GNP.

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Gross Domestic Product (GDP) and Gross National Product (GNP) annual data, at constant prices, £ trillion

GDP and GNP for the UK

Gross national income at market prices Gross Domestic ProductSource: Reuters EcoWin

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

tho

usand

bill

ion

s

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

£s (

thou

san

d b

illio

ns)

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

Measuring Real National Income

Say you read a newspaper article which says ―the economy has grown by 5% this year‖. How much of that might be simply the effects of rising prices which leaves very few people better off and how much is actually the result of a rise in the economy‘s output of goods and services?

When we want to measure growth in the economy we have to adjust for the effects of inflation.

Real GDP measures the volume of output. An increase in real output means that AD has risen faster than the rate of inflation and therefore the economy is experiencing positive growth. Consider this example

The money value of a country‘s GDP is calculated to be $4,000m in 2007

In 2008, the money value of GDP expands to $4,500m but during the year, inflation is 3% causing the general index of prices to rise from a 2007 base year value of 100 to 103 in 2008.

The real value of GDP in 2008 is calculated thus:

Real GDP = money value of GDP in 2008 x 100 / general price index in 2008

= £4,500 x 100/103 = $4,369 (measured at constant 2007 prices)

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Note here that the real GDP data is expressed at constant prices which mean that we have made an inflation adjustment. Look for this in the data response questions in the exam.

Income per capita

How much does each person earn on average? We use per capita measures to give us a guide to this. Income per capita is a way of measuring the standard of living for the inhabitants of a country. The table below shows incomes per head for a selection of OECD countries – the data is for 2005.

GDP per capita $s GDP per capita $s

Luxembourg 57 704 EU (established 15 countries) 28 741

United States 39 732 Germany 28 605

Norway 38 765 Italy 27 699

Ireland 35 767 Spain 25 582

Switzerland 33 678 Korea 20 907

United Kingdom 31 436 Czech Republic 18 467

Canada 31 395 Hungary 15 946

Australia 31 231 Slovak Republic 14 309

Sweden 30 361 Poland 12 647

Japan 29 664 Mexico 10 059

France 29 554 Turkey 7 687

Source: OECD World Economic Factbook, 2006 edition

By international standards, the UK is a high-income country although we are not at the top of league tables for per capita incomes – countries such as Norway, Japan, the USA and Switzerland has much higher per capita incomes than we do. We do have an income per head that is about ten per cent higher than the average for the established EU countries. But we are some distance behind countries such as the United States (where productivity is much higher).

Key terms

Constant prices Constant prices tells us that the data has been inflation adjusted

De-industrialization A decline in the share of national income from manufacturing industries

GDP The monetary value of the output of goods and services produced inside a country – regardless of ownership

GNI Gross National Income – income generated from the resources owned by inhabitants and businesses of a given country

Nominal GDP A measure of national income, output and expenditure. This is the monetary value of all goods and services produced in the economy expressed at current prices.

Per capita incomes Income per head of the population – a measure of average living

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standards

Real income Nominal income adjusted for the effects of price changes (inflation) and expressed at constant prices

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5. The Standard of Living

The standard of living is a measure of our material welfare. The baseline measure is real national output per head of population or real GDP per capita - the value of national output divided by the resident population. Other things being equal, a sustained increase in real GDP increases a nation‘s standard of living providing that output rises faster than the total population. However it must be remembered that real income per capita is an inaccurate and insufficient indicator of true living standards both within and across countries.

National income data can be used to make cross-country comparisons. This requires

1. Converting GDP data into a common currency (normally the dollar or the Euro).

2. Making an adjustment to reflect differences in the cost of goods and services in each country to produce data expressed at a ‗purchasing power parity‘ standard.

Is income the same as wealth?

No! Income is a flow concept, for example your monthly salary cheques or the interest and dividends from your savings and stock market investments.

Financial wealth is a stock concept – wealth can be held in many different forms such as pension funds, ownership of property and deposits in savings accounts. Income can flow from wealth.

Problems in using national income statistics to measure living standards

‗Improving living standards is about poor families gaining access to what is available at the time to make life comfortable, healthy and rewarding. In the end, economic statistics only measure what they measure, which may not bear much relation to how well off we are.‘

Source: Adapted from the Independent

Per Capita Incomes for EU Countries EU-25 = 100

1997 2007 1997 2007

Luxembourg (Grand-Duchy) 202.9 260.1 Cyprus 81.1 87.6

Norway 139.3 171.6 Greece 71.4 85.6

Ireland 108.6 139.8 Slovenia 71.5 84.7

Netherlands 120.1 125.5 Czech Republic 68.9 78.1

Austria 125.3 123.1 Malta 76.1 74

Denmark 125.9 121.6 Portugal 71.9 69.5

United Kingdom 109.8 117.5 Estonia 38.8 69

Belgium 118.7 117.1 Hungary 48.6 63.9

Sweden 115.3 116.5 Slovakia 49 63

Finland 104.6 112.7 Lithuania 36 57.5

Germany (inc ex-GDR from 1991) 117.5 110.1 Latvia 32.7 57.2

France 108.4 106.2 Poland 44.2 53.4

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Italy 112.5 98.5 Romania : 37.5

Spain 88.2 97.6 Bulgaria 25 36.3

The table above provides time series data on per capita national incomes for the twenty seven nations of the European Union plus Norway. Ireland has made huge strides in improving her relative standard of living. In 1994 Ireland‘s GDP per capita was just 84% of the EU average but rapid economic growth allowed the Irish economy to surge past the EU15 average in 1999 and this progress has been maintained. In contrast, Germany‘s slow growth has seen erosion in her relative advantage in living standards – from a level 17% above the EU average in 1997 to a level only 10% above the average in 2007. Britain has a per capita income (adjusted for differences in living costs) nearly 18 per cent higher than the European average.

Official data on GDP tends to understate the true growth of real national income per capita over time due to the expansion of the shadow economy and also the value of unpaid work done by millions of volunteers and people caring for their family members.

The "shadow economy" embraces a range of illegal activities such as drug production and distribution, prostitution, theft, fraud and concealed legal activities such as tax evasion on otherwise-legitimate business activities such as un-reported self-employment income. The scale of the ―shadow economy‖ varies across countries at different stages of development. According to the IMF, in developing countries it may be as high as 40% of GDP; in transition countries of central and Eastern Europe it may be up to 30% of GDP and in the countries of the OECD, the shadow economy may be in the region of 15% of GDP.

Estimates are drawn from those published by the World Bank (2006 Development Report)

Country Year GNI per capita (US$)

Informal economy

estimate (% GNP)

Year GNI per capita (US$)

Informal economy

estimate (% GNP)

Georgia 2006 1,350 67.3 France 2006 34,810 15.3

Bolivia 2006 1,010 67.1 Singapore 2006 27,490 13.1

Panama 2006 4,630 64.1 China 2006 1,740 13.1

Azerbaijan 2006 1,240 60.6 Netherlands 2006 36,620 13

Peru 2006 2,610 59.9 New Zealand 2006 25,960 12.7

Zimbabwe 2006 340 59.4 UK 2006 37,600 12.6

Tanzania 2006 340 58.3 Japan 2006 38,980 11.3

Nigeria 2006 560 57.9 Austria 2006 36,980 10.2

Thailand 2006 2,750 52.6 United States 2006 43,740 8.8

Ukraine 2006 1,520 52.2 Switzerland 2006 54,930 8.8

Here are reasons why GDP data may give a distorted picture of living standards in a country:

1. Regional Variations in income and spending: National GDP data can hide regional variations in output, employment and income per head of the population.

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2. Inequalities of income and wealth: The Lorenz Curve and the Gini-coefficient are two ways of measuring inequality and relative poverty– an outward shift in the Lorenz Curve would indicate a widening of income and wealth inequality. Since 1979, there has been a rise in inequality as the gap between the rich and poorer sections of society has widened. The distribution of wealth is even more unequal than that for income in the UK.

3. Leisure and working hours: An increase in real GDP might have been achieved at the expense of leisure time if workers are working longer hours. Several reports have highlighted the fact that British workers have the longest working week in Europe which can cause stress and damage family life – two social indicators that potentially create some negative externalities for society as a whole.

4. Imbalances between consumption and investment: If an economy devotes too many scarce resources to satisfying the short run needs & wants of consumers, there may be insufficient resources for capital investment and over-consumption can lead to an over-exploitation of scarce finite resources thereby limiting future growth prospects.

5. Changes in life expectancy: Improvements in life expectancy have a huge impact on people‘s living standards but don‘t always show through in the GDP accounts. Reductions in infant mortality have been accompanied by the prevention or cure of diseases that might have led to the premature death of even the richest of our ancestors at any time. Putting a monetary value on the benefits of increased longevity is difficult, but surely it must be factored into any overall assessment of living standards and the quality of life.

6. The value of non-marketed output including work done in the home

Much useful and valuable work is not produced and sold in markets at market prices. The value of the output of people working unpaid for charities and of housework might reasonably be added to national income statistics.

7. Innovation and the development of new products: One of the problems in comparing and contrasting living standards and the quality of life across different generations is that new goods and services become available because of competition, investment, invention and innovation that simply would not have been available to the richest person on earth less than fifty years ago. About half of what we spend our money on now was not invented in 1870. Examples include air travel, cars, computers, antibiotics, hip replacements, insulin and many other life-enhancing and life-saving drugs

8. Environmental considerations: Rising output might have been accompanied by an increase in air and noise pollution and other externality effects that have a negative effect on our social welfare. Faster economic growth may cause long term damage to our eco-systems, threatening the long-term sustainability of the economy.

Defensive expenditures: Much spending is on defensive expenditure – not on tanks and armaments! But spending to defend yourself against an ―economic or social bad‖ e.g. crime, or spending to recover the damage from externalities (e.g. cleaning up the effects of pollution, managing the huge and growing volume of waste; driving long distances to work etc.)

Alternative measures of economic and social welfare

Year 1990 1995 2000 2004

Cable television subscribers (per 1,000 people) 3 24 57 74

Internet users (in 1000s) 1100 18000 23505

Mobile phones (per 1,000 people) 19 98 727 883

Personal computers (per 1,000 people) 108 201 338 367

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One of the simplest ways of judging whether we are better off materially than we were a few years ago is to track ownership of consumer durables. The table above draws on some of the information provided over the years 1990 – 2004. Ownership levels are affected by the trend in price levels, household incomes, changes in tastes and preferences, the emergence of new general purpose technologies and factors such as consumer borrowing and confidence.

The Human Poverty Index (HPI)

The Human Poverty Index (HPI) published annually by the United Nations focuses on four basic dimensions of human life -– longevity, knowledge, economic provisioning and social inclusion. The latest published data shows the UK ranked only 15th out of 17 leading industrialized countries with only Ireland and the United States below us. The most recent data for the Human Poverty Index is shown in the table below together with the factors that go into creating the Human Poverty Index ranking.

Country Human Poverty Index

Ranking

Probability at birth of not

surviving to age 60

(% of cohort) 2000-05

People lacking functional

literacy skills (% age 16-65)

1994-98 c

Long-term unemployment

(as % of labour force)

2001

Proportion of the

population living on less than 50% of

median income

1990-2000

Sweden 1 7.3 7.5 1.1 6.6

Norway 2 8.3 8.5 0.2 6.9

Finland 3 10.2 10.4 2.4 5.4

Netherlands 4 8.7 10.5 1.6 8.1

Denmark 5 11 9.6 0.9 9.2

Germany 6 9.2 14.4 4.2 7.5

United Kingdom 15 8.9 21.8 1.3 12.5

Ireland 16 9.3 22.6 3.2 12.3

United States 17 12.6 20.7 0.3 17

The Measure of Domestic Progress

The Measure of Domestic Progress (MDP) is designed to reflect progress towards a sustainable economy by factoring in the social and environmental costs of growth, and benefits of unpaid work such as household labour. According to their data, over the last thirty years UK GDP increased 80 per cent, but MDP has never regained its 1976 peak.

The Gross National Happiness Index

Bhutan, the Himalayan kingdom the size of Switzerland with no McDonalds, no ATM machines, no traffic lights, and until five years ago no TV, is for many people a species of Shangri-La. Bhutan is ranked 130th in the UN Development Program's ratings, close to Haiti and Bangladesh. Most visitors rate it almost infinitely higher, however, and the measure they use is one let fall by the country's king in 1987 "Gross National Happiness."

“Un” Happy Planet Index

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The South Pacific island nation of Vanuatu is the happiest place on the planet according to the Happy Planet Index which uses three factors: life expectancy, human wellbeing and damage done via a country's "environmental footprint". Life satisfaction varies greatly from country to country: questioned on how satisfied they were with their lives, on a scale of one to 10, 29% of Zimbabweans, who have a life expectancy of 37, rate themselves at one and only 6% rate themselves at 10.

Source: Adapted from the Guardian, 12th July 2006 and BBC news online

Suggestions for further reading on measuring the standard of living

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on measuring living standards:

Bhutan - Gross National Happiness (BBC news, February 2008)

Briton‘s grow richer but wealth gap widens (Financial Times, April 2008)

Grossly distorted picture (The Economist, March 2008)

UK top for length of working hours (June 2007)

Very rich get richer under Labour (Financial Times, January 2008)

Wealth may not lead to health (BBC news, February 2008)

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6. What are the objectives of macroeconomic policy?

All governments have targets or aims whilst they are in charge of running the economy – in this chapter we consider the main objectives of macroeconomic policy.

What are objectives and how are they different from instruments?

1. Objectives are the aims or goals of government policy

2. Instruments are the means by which these aims might be achieved

So for example, the government might want to achieve an objective of a low rate of inflation. The main instrument to achieve this might be the use of base interest rates and since May 1997 they have been set by the Bank of England. Fiscal policy could be another instrument to achieve this aim.

The government might have another objective – namely to make the distribution of income and wealth more equal. It would then choose the policy instruments it thinks are best suited to reaching to this aim, perhaps a change in the income tax system or a rise in the national minimum wage.

Only a limited number of policies can be used to achieve the government‘s objectives. There is a huge amount of research conducted in trying to determine the effectiveness of different policies in meeting key objectives.

The main policy instruments available to meet macroeconomic objectives are

Monetary policy –changes to interest rates, the supply of money and credit and also changes to the value of the exchange rate

Fiscal policy – changes to government taxation, government spending and borrowing

Supply-side policies designed to make markets work more efficiently

The Objectives of UK Economic Policy

―The Government‘s economic objective is to build a strong economy and a fair society, where there is opportunity and security for all. Macroeconomic stability, characterised by sustainable rates of output growth and low inflation, allows businesses, individuals and the Government to plan more effectively for the long term, improving the quality and quantity of investment in physical and human capital, and helping to raise productivity.‖

Source: UK Budget Statement, March 2008

The Labour Government has set several macroeconomic objectives:

o Stable low inflation - the Government‘s inflation target is 2.0% for the consumer price index. The Monetary Policy Committee sets interest rates at a level it thinks will meet the inflation target over a two year forecasting horizon. Inflation targets were first introduced into the UK in1992 and have played a role in keeping inflation expectations under control.

o Sustainable economic growth – as measured by the growth of real gross domestic product – sustainable both in terms of maintaining low inflation and also in terms of the environmental impact of growth.

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o Improvements in capital investment and labour productivity – this is designed to improve the UK‘s competitiveness and boost our trade performance. The pressures of globalisation and the increasing competition within the European Union Single Market make this one of the most important long-term objectives of the government.

o High employment - the government wants to achieve full-employment – a situation where all those able and available to find work have the opportunity to work. At the time of writing, unemployment in the UK is at low levels, with less than three per cent of the labour force out of work and claiming the Jobseeker‘s Allowance.

o Rising living standards and a fall in relative poverty – for example the objective of cutting child poverty and reducing pensioner poverty over the next few years.

o Sound government finances - including control over the size of government borrowing and the total national debt.

We have focused here on the UK but it is important to remember that the aims of macro policy will vary from one country to another. Much depends on the stage of development that they have reached and also where a country is in its economic cycle. For many of the emerging market countries, economic growth and development has been a top priority. For Japan, the major problem in recent years has been a combination of slow growth, rising unemployment and price deflation. And for countries newly integrating into the European Union, high inflation and a huge loss of migrant workers to other countries have become dominant macro-policy concerns.

An end to boom and bust

The 1970s and 1980s were often described as years of stop-go and boom and bust meaning that growth and inflation from one year to the next was often highly volatile and unpredictable. The government always emphasizes macroeconomic stability as one of its main aims – it believes that the stability of the economy is necessary for encouraging increased investment, productivity, company profits and employment. For many years the UK has enjoyed economic stability – but in 2007-08 this has come under threat partly because of the credit crunch and the steep increase in global commodity prices.

Of course uncertainties in the global economy make this a difficult objective to pursue. A dose of good luck as well as sound judgement is required given the unpredictable shocks that can affect the British economy at any time!

Key terms

Credit crunch A fall in the willingness of financial institutions such as banks to (a) lend to themselves and (b) lend to businesses and households.

Economic shocks Unpredictable events such as volatile prices for oil, gas and foodstuffs.

Economic stability When the main indicators such as growth, prices and unemployment do not change much from one year to another.

Globalisation The deepening of relationships between the countries of the world reflected in an increasing level of trade and investment between countries.

Government finances The amount the government must borrow to finance its own spending. The government has introduced its own rules on how much it can afford to borrow over the course of an economic cycle. See the chapter on fiscal policy.

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Price stability Price stability occurs when there is low inflation and the price changes that do occur have little impact on day-to-day decisions of people in the economy.

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7. Interpreting Economic Data

In this chapter we will look at some of the ways that macroeconomic data can be presented. In particular we will consider:

1. Tables of data 2. Graphs and index numbers 3. The difference between percentages and percentage changes 4. Distinguishing between real and nominal economic data

Tables of data

A lot of the information that you might encounter during your study of the subject comes in table format. We will look at an example using data linked to aspects of consumer income and spending.

The table below is known as time series data showing what has happened to a data series over time, in this case the eight years covering the period 2000-2007.

Column 1

New car registrations

Column 2

Household saving ratio

Column 3

Real Disposable

Income

Column 4

Growth of consumer credit

Number Annual % change % of disposable income Annual % change Annual % change

2000 2,337 5.1 4.5 14.5

2001 2,578 10.3 6.4 4.3 13.4

2002 2,682 4.0 5.0 1.7 15.9

2003 2,646 -1.3 4.9 2.4 14.9

2004 2,599 -1.8 3.7 1.7 14.2

2005 2,444 -6.0 5.6 2.9 12.5

2006 2,340 -4.3 4.8 0.9 7.6

2007 2,390 2.9 1.8 6.1

Source: UK economic indicators, HM Treasury website, accessed July 2008

Column one shows the number of new car registrations and is presented in two ways. Firstly the actual number each year and secondly the year-on-year change measured as a percentage. When we want to calculate a percentage change from one year to another, we take the change in the value and divide by the original value and then multiply by one hundred.

So if we take the % change from 2006 to 2007 as an example

The change in new car registrations is 60,000 / divided by the 2006 figure and then multiplied by 100 to give us a percentage change.

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= (60,000 / 2,340,000) 100 = 2.6% (to one decimal place)

We can see that in most years the number of new car registrations has been falling. Is this a longer term trend? We would need to have data covering a larger number of years for a trend to emerge.

Column 2 provides information on the household saving ratio. Notice here that the data is measured in a different way, namely the amount of saving that households are doing expressed as a percentage of people‘s disposable income. It would seem from the data that the saving ratio has fallen between the years 2000 and 2007 and this is indeed the case! But the data needs to be described carefully:

1. Although the savings ratio has fallen, over the same time period, average incomes have grown so we should be cautious about saying that the total amount that people save has declined.

2. The figure is an average across the whole economy – and average values must always be treated with care because for most people, their own savings ratio will either be higher or lower than the published figure, depending on their own financial situation, how much income they have. And also what stage they have reached in their life-cycle.

Columns 3 and 4 show the annual growth of real disposable income and consumer credit – two important variables that affect how much people have available to spend on goods and services.

A quick comparison of the two data series shows that consumer credit has been rising more strongly in each of the years shown. If you are given this data in an exam it might be worth doing a rough estimate of the average growth each year for your answer.

But the main point of using this particular data is to warn you of the difference between a change in the level of a variable and a change in the rate of growth of a piece of economic data.

Consider the change in real disposable income between the years 2005 and 2006. In 2005, real take-home incomes rose by 2.9% but in 2006 that growth dipped to just 0.9%. Does this mean that, on average, real disposable incomes fell in 2006? Lots of students assume that they did – but the answer is NO! What happened was that the growth of real disposable income fell but that growth was still positive! We saw a slowdown in real incomes rather than an actual fall.

Index numbers

Index numbers are a useful way of expressing pieces of information and collections of data. This section shows you how to express data in index number format and some examples of data which is commonly presented as an index number.

In economic data, an index number is a figure reflecting price or quantity compared with a standard or base value. The base value usually equals 100 and the index number is usually expressed as 100 times the ratio to the base value.

Examples of data expressed in index number format

We start with a simple data chart that is expressed in index number format.

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Our example is a topical one given the rising demand for rail travel at a time of record high fuel prices. It tracks the average index of rail fares and compares it with the change in the overall consumer price index that is used to measure inflation.

Monthly fare index, Jan 1987 = 100

Index of Rail Fares in the UK

Source: Reuters EcoWin

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

100

125

150

175

200

225

250

275

300

100

125

150

175

200

225

250

275

300

Rail Fares

Overall Consumer Price Index

Note that the base year for both data series is January 1987 so the index for each has a base value of 100. One of the advantages of presenting the data in this way is to make it easier to see whether rail fares have increased more quickly that consumer prices – they have – and also to calculate quickly the percentage change. By the summer of 2008 the rail fares index was at 275 – a % rise of 175% over the 1987 level. Consumer prices on the other hand were only around 120% higher than twenty one years earlier. In real terms, it has become more expensive to travel by train! And this is likely to continue in the years ahead.

Converting data in index number format: Measuring the level of real national output

When we are measuring the level of national income we often make use of index numbers to track what is happening to real GDP. In the table below we see the value of consumer spending and also real GDP expressed in £ billion. I have chosen 1997 as the base year for our index of spending and output. So the data for consumer spending and real GDP has an index value of 100.0 in 1997.

To calculate the index number for consumer spending in 1998 we use the following formula

Index (1998) = (consumer spending (1998) / base year consumer spending) x 100

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Household Consumption

Index of Household Consumption Real GDP Index of Real GDP

£ bn 1997 = 100 £ bn 1997 = 100

1997 558.1 100.0 942.2 100.0

1998 579.3 103.8 973.7 103.4

1999 606.6 108.7 1003.4 106.5

2000 633.7 113.5 1041.5 110.5

2001 653.3 117.1 1066.2 113.2

2002 676.8 121.3 1088.1 115.5

2003 697.2 124.9 1118.2 118.7

2004 721.4 129.3 1154.7 122.6

2005 732.0 131.2 1175.9 124.8

2006 746.0 133.7 1209.3 128.4

Using 1997 as our base year for the index, we can see that consumer spending has grown more quickly than real national income over the period 1997-2006.

Calculating a price index

We will now see how information on prices can be used to create a weighted price index for the economy – this is the sort of data which is then used to calculate the rate of inflation

Category Price Index Weighting Price x Weight Food 106 18 1908 Alcohol & Tobacco 110 6 660 Clothing 97 12 1164 Transport 103 15 1545 Housing 106 22 2332 Leisure Services 112 9 1008 Household Goods 95 7 665 Other Items 105 11 1155 100 10 437

A weighted price index calculates changes in the average level of prices. In the data shown in the table above we have split consumer spending into eight categories and given each a ―weighting‖ based on the share of total spending given over to each category. So for example, housing and food costs are assumed in our example to take up 40% of the total. These two items will have a heavy influence on the overall price index.

The price index for shows what has happened to the price level since a base year value.

To generate a weighted price index we multiply the price index for each category by its weight and then sum these.

We then divide by the sum of the weights (100) to find an overall price index (104.37) or 104.4 rounded to one decimal place.

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You will discover lots of index numbers in your study of macroeconomics – including the consumer price index, the sterling exchange rate index and also the Financial Times Stock Exchange index!

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8. Understanding Aggregate Demand

You won‘t spend too long on a macroeconomic course before you come across the term aggregate demand! Aggregate means ‗total‘ and in this case we use the term to measure just how much is being spent by all of the major players in the economy – consumers, businesses, the government and people and firms overseas.

The Components of Aggregate Demand

Aggregate demand measures total spending on goods and services. The identity for calculating aggregate demand (AD) is as follows:

AD = C + I + G + (X-M)

Where

C: Consumers' expenditure on goods and services: Also known as consumption, this includes demand for durables e.g. washing machines, audio-visual equipment and motor vehicles & non-durable goods such as food and drinks which are ―consumed‖ and must be re-purchased. Consumer spending is the biggest single component of aggregate demand.

I: Capital Investment – This is investment spending on capital goods such as new plant and equipment and buildings which will allow us to produce more consumer goods in the future. Investment also includes spending on working capital such as stocks of finished goods and work in progress.

Capital investment spending in the UK accounts for between 16-20% of GDP in any given year. Of this investment, 75% comes from private sector businesses such as Tesco, British Airways and British Petroleum and the remainder is spent by the government – for example investment in building new schools or in improving the railway or road networks. So a mobile phone company such as O2 spending £100 million on extending its network capacity and the government allocating £15 million of funds to build a new hospital are both counted as capital investment. Investment has important effects on the supply-side as well as being an important although volatile component of aggregate demand.

A small part of investment spending is the change in the value of stocks –i.e. unsold products. Producers may find either than demand is running higher than output (i.e. stocks will fall) or that demand is weaker than expected and less than current output (in which case the value of unsold stocks will rise.)

G: Government Spending – This is spending on state-provided goods and services including public goods and merit goods. Decisions on how much the government will spend each year are affected by developments in the economy and the political priorities of the government.

Government spending on goods and services is around 18-20% of GDP but this tends to understate the true size of the government sector in the economy. Firstly some spending is on investment and a sizeable slice (nearly £190 billion in 2007) goes on welfare state payments. Transfer payments in the form of benefits (e.g. state pensions and the job-seekers allowance) are not included in general government spending because they are a transfer from one group (i.e. people in work paying income taxes) to another (i.e.

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pensioners drawing their state pension having retired from the labour force, or families on low incomes).

The next two components of aggregate demand relate to international trade between the UK economy and the rest of the world.

X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and spending adding to aggregate demand.

M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending.

Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD). The UK has been running a large trade deficit for several years now as has the United States.

Our table below shows the components of aggregate demand that we have covered in this chapter.

Components of Aggregate Demand for the UK Economy

Consumer spending

Government consumption

Gross Investment

Change in stocks

Exports of goods

and services

Imports of goods

and services

Real GDP

£ billion £ billion £ billion £ billion £ billion £ billion £ billion

1999 579.3 198.6 164.2 4.3 238.3 238.8 973.7

2000 606.6 205.9 169.1 5.8 247.3 257.8 1003.4

2001 633.7 212.3 173.7 4.6 269.8 281.1 1041.5

2002 653.3 217.4 178.2 5.6 277.7 294.4 1066.2

2003 676.8 224.9 184.7 2.3 280.6 308.7 1088.1

2004 697.2 232.7 186.7 4.0 285.4 314.8 1118.2

2005 721.4 240.1 197.7 4.6 299.3 335.7 1154.7

2006 732.0 246.5 200.7 3.6 323.7 359.6 1175.9

2007 745.7 250.6 216.0 2.4 358.4 394.8 1210.3

Source: Office for National Statistics and HM Treasury

Consumer spending as a share of GDP has grown from 59.4% of real GDP in 1999 to 61.6% in 2007. Although this might seem like a small percentage change, because the scale of consumer demand is so huge (in 2007 it amounted to over £2 billion per day!) then a shift in the share of GDP towards household spending has had a major impact on the economy. Much of this extra demand has gone on imported products leading to a rising trade deficit. But it has also been spent on domestically supplied goods and services providing a boost to the home economy. If consumer

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spending was to fall in real terms, then the risks of a recession in the UK would be much higher.

We will return to this in our chapter on consumer spending.

Shocks to the level of aggregate demand

One of the really interesting things about being a macroeconomist is that lots of unexpected events can happen which cause changes in the level of demand, output and employment. The headwinds can alter direction with great speed leading to uncertainty about where the economy is heading.

These unplanned events are called “shocks” and many of them happen in other countries or parts of the global economy but they have an effect across many different countries.

One of the causes of fluctuations in the level of macroeconomic activity is the presence of demand-side shocks.

Some of the main causes of demand-side shocks are as follows:

o A capital investment boom e.g. a construction boom to increase the supply of new houses or to build new commercial and industrial buildings.

o A big rise or fall in the exchange rate – affecting net export demand and having follow-on effects on output, employment, incomes and profits of businesses linked to export industries.

o A consumer boom abroad in the country of one of our major trading partners which affects the demand for our exports of goods and services.

o A large slump in the housing market or a slump in share prices.

o An event such as the international credit crunch – involving a sharp fall in the amount of credit available for borrowing by households and businesses.

o An unexpected cut or an unexpected rise in interest rates or change in government taxation.

These shocks will bring about a shift in the aggregate demand curve – and we turn to this next.

The Aggregate Demand Curve

The AD curve shows the relationship between the general price level and real GDP. In most macroeconomics textbooks the aggregate demand curve is drawn as a straight line but you can draw a curve as well. Don‘t worry the examiners will accept both versions!

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Aggregate demand and the price level

There are several explanations for an inverse relationship between AD and the price level in an economy. These are summarised below:

1. Falling real incomes: As the price level rises, so the real value of people‘s incomes fall and consumers are less able to buy the items they want or need. Imagine that over the course of a year all prices rose by 10 per cent whilst your nominal income remained the same. This would put a squeeze on your real purchasing power.

2. The balance of trade: A high and persistent rise in the price of level of Country X could make foreign-produced goods and services more attractive (cheaper) in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in net trade (X-M) and a contraction in AD.

3. Interest rate effect: if the price level rises, this causes inflation and an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the economy. This assumes that the central bank (in our case the Bank of England) is setting interest rates in order to meet a specified inflation target.

Shifts in the AD curve

A change in the factors affecting any one or more components of aggregate demand i.e. households (C), firms (I), the government (G) or overseas consumers and business (X) changes planned spending and results in a shift in the AD curve.

Consider the diagram below which shows an inward shift of AD from AD1 to AD3 and an outward shift of AD from AD1 to AD2. The increase in AD might have been caused for example by a fall in interest rates or an increase in consumers‘ wealth because of rising house prices.

General

Price

Level

Real National Income

AD

P1

Y1

P2

Y3 Y2

P3

1. A rise in the general price level from P1 to P2 causes a contraction in aggregate demand

2. A fall in the general price level from P1 to P3 causes an expansion of aggregate demand

The AD curve shows the relationship between aggregate demand and the UK price level, usually measured in terms of the consumer price index

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Short exercise on aggregate demand

State whether each factor is likely to increase or decreases the level of aggregate demand for the UK economy (other factors remaining the same).

Economic Event

Likely impact on aggregate demand

(rise / fall / uncertain)

1 The government decrease the rate of income tax from 22% to 20%

2 There is a 20% fall in average UK house prices over a two year period

3 There is a consumption boom in the countries of the Euro Zone

4 The exchange rate between sterling and the Euro appreciates by 15% (i.e. goes up in value) over the course of a year

5 A new survey finds that business confidence has hit a 5-year low

6 The government announces a £400m plan to build a series of wind farms across the UK

7 Consumers decide to increase their savings ratio

8 Bank of England signals rise in interest rates of ½%

9 The government increases government spending by £1 billion but raises the amount it takes in income tax by £1 billion

Price Level

Real National Income

AD1

P1

Y1

AD2

P2

Y2

AD3

Y3

P3

In the short run, shifts in aggregate demand cause fluctuations in the economy‘s output of goods and services.

In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

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10 A Scottish distillery announces that it will now source its bottles from Sweden rather than a bottling manufacturer in the West Midlands

11 Chancellor announces tax exemption scheme on new investments for small to medium sized businesses.

12 Government increase tax burden to highest level for 50 years

Factors causing a shift in AD

Changes in Expectations

Current spending is affected by anticipated future income, profit, and inflation

The expectations of consumers and businesses can have a powerful effect on planned spending. E.g. expected increases in consumer incomes, wealth or company profits encourage households and firms to spend more – boosting AD.

When confidence turns lower, we see an increase in saving and some companies postpone capital investment projects because of worries over a lack of demand and a fall in the expected rate of profit.

Changes in Monetary Policy

– i.e. a change in interest rates

(Note there is more than one interest rate in the economy, although borrowing and savings rates tend to move in the same direction)

An expansionary monetary policy will cause an outward shift of the AD curve. If interest rates fall – this lowers the cost of borrowing and the incentive to save, thereby encouraging consumption. Lower interest rates encourage firms to borrow and invest.

There are time lags between changes in interest rates and the changes on the components of aggregate demand.

Changes in Fiscal Policy

Fiscal Policy refers to changes in government spending, welfare benefits and taxation, and the amount that the government borrows

For example, the Government may increase its expenditure e.g. financed by a higher budget deficit - this directly increases AD

Income tax affects disposable income e.g. lower rates of income tax raise disposable income and should boost consumption.

An increase in transfer payments increases AD – particularly if welfare recipients spend a high % of the benefits they receive.

Economic events in the international economy

International factors such as the exchange rate and foreign income (e.g. the economic cycle in other countries)

A fall in the value of the pound (£) (a depreciation) makes imports dearer and exports cheaper - the net result should be that UK AD rises – the impact depends on the price elasticity of demand for imports and exports and also the elasticity of supply of UK

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exporters in response to an exchange rate depreciation.

An increase in overseas incomes raises demand for exports and therefore UK AD rises. In contrast a recession in a major export market will lead to a fall in UK exports and an inward shift of aggregate demand.

Changes in household wealth

Wealth refers to the value of assets owned by consumers e.g. houses and shares

A rise in house prices or the value of shares increases consumers‘ wealth and allow an increase in borrowing to finance consumption increasing AD. In contrast, a fall in the value of share prices or a recession in the housing market ca lead to a decline in household financial wealth and a fall in consumer demand.

Let us look at the components of demand for the UK economy. These are presented in the chart below. Notice first that the data has been adjusted for the effects of inflation; we confirm this because the figures are expressed at constant 2003 prices.

£bn per year at constant 2003 prices

The Components of Aggregate Demand

Source: Reuters EcoWin

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Consumer spending is overwhelmingly the biggest single part of AD. A large and rising share of spending goes on imported goods and services but the UK economy has also managed to achieve a sizeable increase in the real value of our exports. However, the value of imports has exceeded exports leading to a trade deficit. This means that net trade has had the effect of reducing total aggregate demand, in this sense it has acted as a pressure valve taking away some of the excess demand for goods and services in the British economy.

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Key terms

Budget deficit When the government is spending more than it receives in tax revenue – the effect is a rise in aggregate demand

Consumption Consumer spending on goods and services

Expectations How we expect the future to unfold – this can have powerful effects on the spending decisions of households, businesses and the government

Exports Goods and services sold overseas – an injection of demand

Government spending Government provided goods and services and social security payments

Household wealth The value of assets owned by households – including property, shares, savings and pension fund assets

Imports Goods and services bought from overseas – a withdrawal of demand

Investment Spending on capital goods including plant & machinery and infrastructure

Net Trade The balance between the value of exports and imports

Time lags The time it takes for one change e.g. a change in interest rates to affect other variables e.g. consumer confidence and spending

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9. Consumer Spending

Consumption accounts for 65% of aggregate demand. There are many factors that affect how much people are willing and able to spend, we will consider many of them in this chapter.

The economist John Maynard Keynes (pictured on the right) developed a theory of consumption that depended mainly on the level of people‘s disposable income. You would expect that there is a positive relationship between income and demand – no surprises there! But what matters more is the rate at which consumers increase demand as income rises. This is called the marginal propensity to consume.

Say that someone receives an increase in their pay of £2000 and they spend £1500 of this, thus the marginal propensity to spend is £1500 / £2000 = 0.75. The remainder is saved – so the marginal propensity to save would be 0.25.

A simple rule to remember is that the marginal propensity to consumer added to the marginal propensity to save must always equal 1.

The marginal propensity to consume and to save differs from person to person. Generally, people on lower incomes tend to have a higher propensity to spend. This matters when the government announces changes in direct taxation and the level of welfare benefits. A good recent example of this was the decision by the United States government to offer a rebate to taxpayers which was part of a $160 billion fiscal stimulus to the economy designed to reduce the risk of a recession. In the short term, the tax cut did seem to provide a boost to household spending. But some economists warned that such a measure could not provide a lasting effect on the economy because many taxpayers would decide to save their rebates during a time of great uncertainty.

Incomes matter in determining spending

The Bank of England has an economic model that seeks to predict what will happen to consumer spending after various shocks. In the long term, the thing that matters most is people's real incomes. Changes in the amount we earn are by far the most important feature determining how much we spend. Other features, such as the value of our homes or our financial savings, matter a bit but their effect is dwarfed by changes in our earnings.

Source: Hamish McRae, the Independent, 8th August 2004

The most important factors that determine consumer spending can be summarized as follows:

1. The level of real disposable household income.

2. Interest rates and the availability of credit.

3. Consumer confidence and expectations.

4. Changes in household wealth.

5. The number of people in work and expectations of changes in unemployment.

Like most advanced economies, consumer spending is the main driver of short-run economic growth and, from the UK‘s point of view; it has been one of the main reasons why Britain has avoided a recession in recent years. That said there are fears that household spending has been

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too high, and that much of it has been financed by borrowing leading to record levels of household debt. At the time of writing in the summer of 2008, it has become clear that consumer demand is set to be weaker in the months ahead. After a decade of strong growth, low inflation, cheap borrowing and high percentage increases in house prices, the fortunes of the economy have started to turn.

Over the last twelve to fifteen months, the British economy has suffered from the fall-out of the sub-prime mortgage crisis in the United States and the ensuing credit-crunch. Closer to home, house prices have started to fall, unemployment is expected to move higher and rising prices for essential items such as fuel, electricity and foods have eaten in people‘s real incomes. The likelihood is that, for millions of households in the UK, there will be some difficult decisions to make on how much to spend and save over the next year or two.

Annual percentage change in household spending and GDP at constant 2000 prices

Consumer Spending and GDP growth in the UK

Source: Reuters EcoWin

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Spending on consumer durables

In contrast to spending on everyday items such as a loaf of bread or a newspaper, consumer durables are items that provide a flow of services and provide a flow of utility to a consumer over time. Examples include new cars, household appliances, audio-visual equipment and furniture etc. The real level of spending among on durables has surged in the last decade as our next chart shows.

What explains this surge in spending on so-called ‗big ticket items‘? Among the explanations are

(i) Falling prices for many durable products – arising from advances in production technology and the effects of globalisation which means that we can now import many of these durables more cheaply from overseas.

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(ii) Prices of durables have fallen relative to people‘s income. Thus the number of hours one has to work in order to afford for example a new freezer or a plasma-TV screen has come down.

(iii) Lower interest rates have encouraged people to spend more on ―big ticket items‖ – there has been a surge in demand for consumer credit used to finance such purchases.

(iv) Rising incomes. Here we can make use of a concept drawn from microeconomics namely income elasticity of demand. The demand for consumer durables is more income elastic than for non-durables which are usually staple items in people‘s monthly budget. So when average living standards are improving, so too does the market demand for durable items.

Real spending at constant prices, seasonally adjusted, £ billion per quarter

Consumer Expenditure on Durable Goods

Source: Reuters EcoWin

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The Wealth Effect

How much does the level of the wealth that we own affect our willingness and ability to spend? Remember that the Keynesian theory emphasised income. But income is different to wealth, and for many macroeconomists, changes in wealth can have a powerful impact on our spending decisions.

Wealth represents the value of a stock of assets owned by people. For most people the majority of their wealth is held in the form of property, shares in quoted companies on the stock market, savings in banks, building societies and money accumulating in occupational pension schemes.

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The consensus view among economists is that there is a positive wealth effect between changes in financial wealth and total consumer demand for goods and services. For example when house prices are rising strongly, confidence grows and home-owners can also borrow some of the equity in their homes to finance major items of spending. The Bank of England publishes data on mortgage equity withdrawal and their data shows that in recent years millions of property-owners have re-mortgaged their homes and released some of their housing equity.

FTSE 100 index (bottom pane) Average UK house price (top pane)

The Housing Boom Ends - Will Shares Follow?

Source: Reuters EcoWin

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The last five or six years saw a double-boom in household wealth with property prices and share values surging ahead following the collapse of the dot.com bubble in 2001-03. Was this the creation of a ‗money for nothing economy‘? Average house prices more than doubled between 2001 and 2007 whilst the value of the FTSE-100 index of leading blue-chip companies climbed from a low of 3500 to peak at 6,600 in the summer of 2007. 2008 has been a different story with share prices and housing valuations declining as the economy seems to have hit the buffers. This means that household wealth has started to decline and it will be interesting to see what impact it has on our spending decisions going forward.

We should remember that not everyone owns shares and many people are priced out of the property market and must rely on finding rented accommodation. For them, such wealth effects are far less likely to influence their day-to-day spending. And wealth is not simply a matter of property and shares. For millions of people, assets in the form of savings and occupational pension schemes are very important. So the real value of their savings and the income that flows from deposit accounts from interest payments will have a direct effect on their spending power.

The importance of confidence

The main factors affecting consumer confidence are summarised as follows:

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o Expectations of future income and employment.

o The current level of interest rates and expectations of future interest rate movements.

o Trends in unemployment and changes in perceived job security.

o Anticipated changes in government taxation.

o Changes in household wealth including movements in house and share prices.

Overall index of consumer confidence, seasonally adjusted

United Kingdom Consumer Confidence

Source: Reuters EcoWin

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The chart above shows the net % balance of people who are optimistic about the future path for the economy i.e. if there are 45% optimists, 25% pessimists and 30% of people who are neutral, then the net balance would be recorded as +20%! You might see in the chart that the net balance is rarely that positive (perhaps this is just part of the natural caution of consumers in Britain!). But for most of the last decade, consumer has been fairly stable despite the occasional ups and downs such as in late 2001 after the terrorist attacks on the United States.

What is noticeable is the steep collapse in confidence since the start of 2008. Indeed, by the time this study companion was being written, consumer sentiment had worsened to its lowest level since the last recession in the early 1990s. Will this be a lead indicator of a downturn in household demand? Only time will tell.

Consumer borrowing

Most of us at some time in our lives need to borrow money to finance spending. From taking out a mortgage to making frequent use of bank credit cards, borrowing is a normal feature of life and not necessarily something to be worries about. What matter is whether building up debt is sustainable – in other words, can those who rely on debt pay it back?

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Credit basically means being able to buy now and pay later. The credit market for individuals is complex at the best of times. Broadly speaking we can distinguish between:

Unsecured borrowing – that is a loan or an overdraft which is not tied to the value of another asset. Good examples of this are student overdrafts, bank loans and money borrowed on store and credit cards

Secured borrowing – is lending where the borrower must use another asset as collateral for the loan. The best understood example of this is a mortgage with a bank or building society. Home buyers are at risk if they fail to keep up with monthly mortgage repayments and ultimately, the lender may foreclose and seek a repossession of the property.

Without question, one of the most important features of the British economy in recent years has been the high levels of borrowing. Many billions of pounds have been added to credit card debts and the scale of re-mortgaging in the housing market has been huge. To use a technical term, what we have seen is a „leveraging up‟ of the consumer sector – which in lay person‘s terms means that people seem to have been happy to increase the ratio of their debt to income. Indeed, such has been the scale of the borrowing binge, that the UK has one of the highest debt-to-income ratios of any of the leading economies.

Annual percentage change in consumer borrowing in the UK

Annual Growth of Consumer Borrowing

Source: Reuters EcoWin

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To put things into some perspective, by May 2008 total personal debt in the UK had reached £1.44 trillion and the average consumer owed £4,900 on credit cards, motor and retail finance deals, overdrafts and unsecured personal loans. The average interest paid by each household on their total debt is approximately £3,774 each year.

The double-digit annual growth in consumer credit lasted from 1997 through to the end of 2005. Likewise there was a sustained increase in lending secured on property (so-called mortgage equity

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withdrawal) which only started to decelerate during 2008. The end to the boom was the result of a series of factors including:

1. A rise in mortgage interest rates brought about by the credit crunch – this has squeezed property-owners who have found that their mortgage interest repayments have climbed

2. A sharp decline in consumer confidence which should, with a time lag, cause people to cut back on taking on new credit and opt to save more instead

3. Possible consumer satiation effects – surely there are limits to how many televisions or DVD players people need!

4. Fears of a rise in unemployment due to the slowdown

How far will the fall in borrowing go? Much depends on what else in happening in the economy and specifically the cost of credit and whether there is a sustained rise in unemployment.

Consumer spending and the UK balance of payments

Consumers in Britain have a high marginal propensity to import goods and services so that, when their real incomes are rising and their spending increases, so too does the demand for imports. Unless there is a corresponding increase in UK exports overseas, then the balance of trade in goods and services will move towards heavier deficit. This has been the case in the UK over the last five or six years.

In the medium term if demand for imports rises and the level of import penetration into the domestic economy continues to rise, then national output and employment will weaken and this will work its way through the circular flow to reduce real incomes. Living standards are reduced in the long run if our export industries are unable to compete with output produced in other countries

Key terms

Consumer confidence Expectations about the future including interest rates, incomes and jobs

Consumer durables Products such as washing machines that are not used up immediately when consumed and which provide a flow of services over time

Consumer non-durables

Items used up in consumption such as a loaf of bread or a pint of beer

Discretionary income Disposable income adjusted for spending on essential bills such as fuel

Leveraging The use of borrowed funds to increase your capacity to spend or invest

Marginal propensity to consume

The proportion of any change in income that is spent rather than saved

Real disposable income

Income after taxes and benefits, adjusted for the effects of inflation

Unsecured credit Credit not secured by another asset – i.e. money borrowed on credit cards

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Wealth effect The supposed link between changes in wealth and household spending

Further reading on consumer spending and borrowing

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on consumer spending and borrowing

BBC news special on consumer borrowing and debt

Consumer confidence near all-time low (BBC news, June 2008)

Families have £8 less disposable income per week (BBC news, June 2008)

Millions spend more than their income (BBC news, January 2008)

Squeeze on consumer spending (BBC news, June 2008

UK personal wealth tops £6 trillion (BBC news, September 2007)

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10. Household Saving

Our decisions about how much to save from our income can have a big effect on the future direction of the economy both in the short term and the longer run.

Saving represents a decision by people to postpone their consumption. Why do people choose to save? Everyone is different, but economists have come up with several motivations and incentives for saving:

1. Precautionary saving: People might choose to save because they fear being made unemployed. A ‗nest-egg‘ of savings may allow people to smooth their spending for a while even when incomes are fluctuating.

2. Building up potential spending power: Saving now is a choice to defer spending today to finance one or more major spending commitments in the future such as the deposit on a mortgage, a new car, home improvements or to help finance a family wedding. Since the 2007-08 credit crunch many mortgage lenders have withdrawn the sale of 100% mortgages and this means that a first-time buyer will typically need to provide 15% or more of the purchase price with a deposit. People are also becoming increasingly aware of the need to save in order to build up assets in occupational pension schemes because of fears that the relative value of the UK state retirement pension will not be sufficient to allow a decent lifestyle.

3. Interest rates and saving: There might be a greater willingness to save because of the incentives of high interest rates from banks, building societies and other financial institutions. Much depends on the real rate of interest i.e. the nominal rate of interest adjusted for inflation. If prices are rising at 3% and the best savings rate on offer is 6%, then saving now will bring an expected real return of +3%.

4. Inheritance: Many people have a desire to pass on wealth to future generations. It is worth noting that planned changes to inheritance tax can have a big bearing on this type of saving decision.

5. Saving and the life-cycle of consumers: Younger people are often net borrowers of money because they need to fund their degrees, purchase a property and expensive consumer durables. As people grow older, their incomes from work tend to rise and spending commitments decline leading to an increase in net saving ahead of retirement. The Life-Cycle model of saving and spending is an attempt to model this kind of saving behaviour.

6. Consumer confidence: When confidence is high, people are more likely to borrow rather than save and thus the savings ratio will tend to fall. The opposite is the case when there are fears of a recession.

The savings ratio

The household savings ratio is the level of people‘s savings as a percentage of their disposable income. The savings ratio was high during the early 1990s as a result of mass unemployment and high interest rates. In recent years there has been a fall in the savings ratio in part because consumer borrowing has reached record levels, fuelled by booming house prices.

By the summer of 2008, the savings ratio had fallen to a record low of just one per cent of disposable income raising concerns that millions of households are not saving enough in case of worse times ahead. At some point the savings ratio in the UK will need to rise again as people rein

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back on their spending in order to repay debts on credit cards and other forms of secured and unsecured borrowing.

Another evaluation point is that a high level of borrowing and the associated low level of saving make people more exposed to changes in interest rates on bank loans and mortgages etc - a rise in interest rates has a significant impact on increasing interest repayments

Percentage of disposable income that is saved, quarterly data

Household Savings Ratio

Source: Reuters EcoWin

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Pensioner poverty threatened because of a lack of saving

The living standards of people who cannot afford to save for their retirement are likely to be severely threatened if these households carry on saving at the current rate according to a new report. The annual Scottish Widows Pensions Report, which analyses the savings habits of British adults, has estimated that the average worker will have to survive on a pension of just £12,000 a year as things stand with people putting just 8.7 per cent of their annual income into savings.

With the cost of mortgage payments and utility bills rising and millions of people struggling to meet their monthly bills, there looks to be even less scope for regular saving. Indeed the report found that a third of people said they could not afford to put anything more aside.

Scottish Widows estimates its savings ratio by interviewing more than 6,000 full-time workers, all of whom are over the age of 30 and could realistically be expected to be saving for retirement. Half of Britons are failing to save enough towards their retirement, with more than a third of people worried about how they will cope when they give up work.

Source: Press Association web site and Scottish Widow’s web site accessed 2nd July 2008

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Two factors that influence the rate at which households save their disposable income

Savings, Interest Rates and Unemployment

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Household savings ratio (% of disposable income) Base Interest Rate Unemployment (Claimant count, seasonally adjusted)

There does appear to be a correlation between the rate of unemployment and the savings ratio. If saving does rise sharply (reflecting cut-backs in consumer demand), this will have a negative effect on aggregate demand and could conceivably make an economic slowdown worse in the short term.

Key terms

Saving ratio The percentage of disposable income that is saved rather than spent

Real interest rate The nominal rate of interest adjusted for inflation

Precautionary saving Saving because of fears of a loss of real income or employment

Inheritance tax Inheritance Tax may be payable on an estate when someone dies

Life cycle model A theory that says that savings rates depend on how old someone is

Marginal propensity to save

The change in total saving as a result of a change in income

Suggested background reading on saving

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on saving.

Britons‘ savings rate drops to lowest level since 1960 (The Times, June 2007)

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Credit union rules to be eased (BBC news, June 2008)

One in four people fails to save at all (BBC news online, August 2007)

Saving statistics for the UK (Office of National Statistics)

Savings rate hits 47 year low (Guardian, June 2007)

Third of Britons unable to save (BBC news, June 2008)

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11. Capital Investment

Investment is spending by businesses and the government on capital goods such as new factories, machinery & vehicles. Much new investment embodies advances in technology. Investment (I) is an important component of AD, but as we shall see, it also has an impact on the supply-side and is a key factor driving the competitiveness of a country in a globalising world.

Different Types of Investment

1. Capital investment is spending on capital goods such as new machinery, buildings and technology so that the economy can produce more consumer goods in the future.

2. A broader definition of investment includes spending on improving the human capital of the workforce through training and education to improve the skills and competences of workers.

3. Infrastructure is spending on new sewers, wind farms, telecommunications networks, motorways and ports – this can be done by the private and the public sector.

4. Most economists agree that investment is vital to promoting long-run growth through improvements in productivity and capacity, shown by an outward shift in the production possibility frontier.

Gross and Net Investment

Gross investment spending is the total amount that the economy spends on new capital. But this figure includes an estimate for the value capital depreciation since some investment is needed each year just to replace technologically obsolete or worn out plant and machinery. If gross investment is higher than depreciation, then net investment will be positive and this means that businesses will have a higher productive capacity and can meet a higher level of AD in the future.

Thus gross investment – capital depreciation = net investment

Economic Importance of Capital Investment

In most theories of economic growth and competitiveness, investment has an important role to play. In this section we look at some of the major advantages from the accumulation of a bigger stock of capital.

Businesses often invest in new capital goods to exploit economies of large scale production. This, together with technological advances is vital to improving the UK's competitiveness and to causing a shift in the country‘s production possibility frontier.

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In the short run, devoting more of a country‘s scarce resources to the production of investment might require a reduction in today‘s output of consumer goods and services. This would be shown by a movement along the PPF from point A to B.

But if the investment is successful and leads to an increase in a country‘s productive capacity then the PPF can shift out and allow an increased output of consumption goods to meet people‘s needs and wants in the future. This is shown by a movement from point B to point C which lies on the new PPF.

Investment and Aggregate Demand

Investment is a component of AD i.e. (C+I+G+X-M). Businesses involved in developing, manufacturing, testing, distributing and marketing the capital goods themselves stand to benefit from increased orders for new plant and machinery.

A rise in capital spending will therefore have important effects on both the demand and supply-side – including a positive multiplier effect on national income.

o Demand side effects: Increase spending on capital goods – affects industries that manufacture the technology / hardware / construction sector

o Supply side effects: Investment is linked to higher productivity, an expansion of a country‘s productive capacity, a reduction in unit costs (e.g. through the exploitation of economies of scale) – and therefore a source of an increase in LRAS (trend growth)

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An outward shift in the production possibility frontier shows that there has been either an improvement in productivity or an increase in the total stock of resources available to produce different goods and services. The outward shift represents an improvement in economic efficiency. Capital investment is an important source of long-run growth.

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Quality of investment

A high level of investment on its own may not be sufficient to create an increase in LRAS since workers need to be trained to work the new machinery and there may be time lags between new capital spending and the knock-on effects on output and productivity in particular. Also, if there is insufficient demand, a growing capital stock may lead to excess capacity putting downward pressure on prices and profits

Investment and jobs

There are some investment projects that cost people their jobs – this is particularly true when a business is looking to achieve greater efficiency and cost savings perhaps by replacing labour with capital inputs. That said most new investment creates fresh demand for workers, both in producing, designing and installing new plant and equipment and in working with it. And if the investment is successful in creating extra demand, so the demand for labour will expand.

Here are a couple of recent examples drawn from newspaper reports of business investment announcements that reinforce the positive link between investment and job creation.

"Moyola Precision Engineering in Castledawson, Northern Ireland has announced a £6.5m investment for high-tech machinery and equipment, creating 22 new jobs." News story

"A major spending programme has halted a decline in the number of people using buses in Sheffield, new figures show. Passenger numbers have edged up in the 12 months since the city council, transport executive and bus operator First agreed to spend £17m on services." News story

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One way to remember the importance of investment is to consider the 3 Cs - capacity, costs and competitiveness. Higher investment should allow British businesses to lower their production costs per unit, increase their supply capacity and become more competitive in overseas markets.

Cross-Rail – Infrastructure and Economic Performance

The £16bn Crossrail scheme to build a railway link through the centre of London has been given the go-ahead by Prime Minister Gordon Brown. Construction for the link - from Maidenhead, Berkshire, through to Essex - is expected to start in 2010. It will provide 24 trains an hour into the heart of London from the east and west, improving rail links to the West End, the City and Docklands. Crossrail services are due to be running in about 10 years.

Crossrail is regarded by many as the most ambitious transport infrastructure project in the UK since the Channel tunnel rail link. The 74-mile route runs from Maidenhead and Heathrow in the west to Abbey Wood and Shenfield in the east, via central London and Canary Wharf.

Construction work on Crossrail, which will bore two mainline rail tunnels underneath central London, is expected to begin in 2010 and will employ 14,000 people.

The City of London predicted that the project would create 90,000 more jobs in the capital's financial district. London's overloaded transport system is cited by businesses as a major constraint on economic growth, with the underground network already near its limit and carrying 3 million passengers on its busiest days. Crossrail will carry about 70,000 people an hour and relieve the congestion on London's main tube lines.

Funding of the project is being split between a government grant, contributions from major businesses and future fare revenues.

Source: Adapted from BBC news and Guardian and Independent reports, November 2007

Key Factors Determining Capital Investment Spending

Capital spending by private sector businesses tends to be volatile from year to year and is one of the reasons why there is an economic cycle. What are the main factors that affect how much businesses are prepared to commit to investment projects? Here are a few of the most important ones to be aware of:

1. Real interest rates: Interest rates affect the cost of borrowing money to finance investment. If the rate of interest increases, the cost of funding investment increases, lowering the expected rate of return on a capital project. A second factor is that higher interest rates raise the opportunity cost of using profits to finance investment – i.e. a business might decide that the cost of financing new capital is too high and that it could earn a better return by simply investing the cash.

2. The rate of growth of demand: Investment tends to be stronger when consumer spending is rising. A good example of this is the need for fresh investment in expanding the capacity of the rail network in the UK. In the past decade, passenger numbers have risen by about 40% with more people travelling by rail than at any time since 1946. In June 2008, the government announced that it was looking into plans to build five new mainlines by 2025. Higher expected sales also increase potential profits – in other words, the price mechanism should allocate extra funds and factor inputs towards capital goods into those markets where consumer demand is rising.

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3. Corporate taxes: Corporation tax is paid on profits. If the government reduces the rate of corporation tax (or increases investment tax-free-allowances) there is a greater incentive to invest.

4. Technological change and degree of market competition: In markets where technological change is rapid, companies may have to commit themselves to new capital simply to remain competitive.

5. Business confidence: When confidence is strong then planned investment will rise. In contrast, during a downturn many businesses may opt to postpone investment because they feel that demand will not be high enough to give them the rate of profit they need.

We have focused here on private sector investment decisions where capital spending depends on whether sufficient profit will be made. In the public sector, a different set of criteria may be used. Typically local and central government will use cost-benefit analysis when assessing the likely economic and social effects of investment; this is often used for major new infrastructural projects.

Business investment and the economic cycle

Investment depends critically on the health of the economy. When GDP growth is strong and inflation is under control, then business investment invariably picks up. There is often a time lag involved – it takes time for businesses to reach capacity constraints and give the go ahead for new projects. And the completion of new investment schemes inevitably is subject to the risk of delay.

Investment at constant 2001 prices, £ billion

Gross Fixed Capital Investment by Businesses

Source: Reuters EcoWin

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Our chart above tracks total business investment in the UK over the last two economic cycles. Notice how investment slumped during the recession of the early 1990s. Indeed capital spending

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(in real terms) was lower in 1995 than it had been in 1989. More recently, the British economy has seen a surge in private sector capital investment – and this is a hopeful sign for the future. The 2007 figure of £143 billion was a record. Can it last when the economy turns a corner?

Foreign investment into the UK

The UK has remained a favoured venue for foreign direct investment. A number of factors have contributed to the UK‘s status as a leading avenue for investment

o Many years of sustained growth of the British economy since 1992.

o A cost effective labour supply and attractiveness of the UK‘s flexible labour market.

o An excellent industrial relations record over the last 20 years.

o A favourable corporate tax regime + low personal taxes (by international standards) – many countries are now using corporate tax rates as a policy to attract inward investment from multinationals. The majority of the new EU member states have focused on cutting corporation tax as a way of attracting inward investment.

o Attractive regional incentives packages.

o An efficient and deregulated telecommunications system.

o The success of previous FDI projects i.e. positive feedback from other overseas firms.

Important evaluation points on investment

Key terms

Business confidence Expectations about the future of the economy – vital in business decisions about how much to spend on new capital goods

Capital depreciation The fall in the value of capital goods due to age and wear and tear

Capital stock The value of the total stock of capital inputs in the economy

Capital-labour substitution

Replacing workers with machines in a bid to increase efficiency

Net investment Gross investment minus an estimate for capital depreciation

Productive potential The productive capacity of the economy – boosted by high quality investment

Suggestions for further reading on investment

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on investment spending.

Corus invests £60m in Welsh steel plant (BBC news, February 2008)

Cross rail work to start in 2010 (BBC news, November 2007)

Does North Sea Oil have a future? (BBC news, June 2008)

From boom to gloom and doom (Guardian, July 2008)

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Inward investment success for UK (BBC news, July 2008)

London rail link upgrade approved (BBC news, June 2008)

Major new rail lines considered (BBC news, June 2008)

Severn tidal power plan moves ahead (Guardian, January 2008)

Tories urge cut in Corporation Tax (BBC news, March 2008)

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12. Understanding Aggregate Supply

What do we mean by aggregate supply?

Aggregate supply (AS) measures the volume of goods and services produced within the economy at a given price level. In simple terms, AS represents the ability of an economy to deliver goods and services either in the short-term or in the long-term. The nature of this relationship will differ between the long run and the short run

Short run aggregate supply (SRAS) shows total planned output when prices in the economy can change but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are assumed to be held constant.

Long run aggregate supply (LRAS): LRAS shows total planned output when both prices and average wage rates can change – it is a measure of a country‘s potential output and the concept is linked strongly to that of the production possibility frontier

o In the long run, the AS curve is assumed to be vertical (i.e. it does not change when the general price level changes)

o In the short run, the AS curve is assumed to be upward sloping (i.e. it is responsive to a change in aggregate demand reflected in a change in the general price level)

This all sounds a bit technical at the moment – but as we will see, the easiest way to think about AS is simply to think about the costs of producing different goods and services in the economy.

The short run aggregate supply curve

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A change in the price level brought about by a shift in AD results in a movement along the short run AS curve. If AD rises, we see an expansion of SRAS; if demand falls we see a contraction of SRAS.

The slope of SRAS curve depends on the degree of spare capacity in the economy.

1. Negative output gap: At low levels of real national income where actual GDP < potential GDP, many businesses have a lot of spare capacity and can easily and quickly expand production without paying their workers overtime or coming up against other supply bottlenecks. The SRAS curve is therefore drawn as elastic (in the diagram this might be a movement from Y1 to Y2).

2. Positive output gap: As national output expands and the economy heads towards full capacity, so producers may find it harder to raise production. Workers receive the same basic wage rate but require payment of overtime and bonuses to work longer hours and increase GDP – SRAS is becoming more inelastic (e.g. shown from the movement between Y2 and Yfc where Yfc is drawn as a full-capacity level of national output).

3. Diminishing returns? As national output expands, older less productive machinery may be used and less efficient workers hired.

4. Full-capacity output at LRAS. Eventually the economy cannot increase the volume of output further in the short-term. At this point SRAS is perfectly inelastic at Yfc – the economy has reached full-capacity (the LRAS curve)

General

Price

Level

Real National Income

SRAS

P1

Y1

LRAS

Yfc

P2

Y2

P3

An expansion of national output

A contraction of national output

The short run AS curve is upward sloping because higher prices for goods and services make output more profitable and enable businesses to expand their production by hiring less productive labour and other resources

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Shifts in short run aggregate supply (SRAS)

Shifts in the SRAS curve can be caused by the following factors

1. Changes in unit labour costs: Unit labour costs are defined as wage costs adjusted for the level of productivity. For example a rise in unit labour costs might be brought about by firms paying higher wages or a fall in the level of productivity. If unit wage costs rise, this will feed through into higher prices (this is known as ―cost-push inflation‖)

2. Commodity prices: Changes to raw material costs and other components e.g. the world prices of oil, copper, aluminium and other inputs will affect a firm‘s costs.

3. Exchange rates: Costs might be affected by a change in the exchange rate which causes fluctuations in the prices of imported products. A fall (depreciation) in the exchange rate increases the costs of importing raw materials and component supplies from overseas

4. Government taxation and subsidies: Changes to producer taxes and subsidies have effects on the costs of nearly every producer – for example an increase in taxes designed to meet environmental objectives will cause higher costs and an inward shift in the SRAS curve. Conversely a reduction in the duty on petrol and diesel might lower costs and cause an outward shift in SRAS.

5. A change in the level of international trade: An increased availability of cheaper imports from a lower-cost country has the effect of shifting out SRAS. In a similar fashion, a reduction in a tariff on imports or an increase in the size of an import quota will also boost the supply available at each price level.

6. Education and skills changes: A more highly skilled labour force can affect production costs and supply as can decisions made by people about when to enter the labour force.

7. Regulation changes: Government regulations can in some circumstances have an effect on aggregate supply. An example might be the deregulation of a market which encourages the entry of new producers either from the domestic or the international economy.

Real National Income

SRAS

P1

Y1

LRAS

Yfc

P2

Y2

P3

Short run aggregate supply is inelastic here – a rise in AD will have more of an effect on the general price level than it will on the volume of real national output

Short run aggregate supply is elastic here because there is plenty of spare productive capacity (i.e. the output gap will be negative). A rise in AD will lead easily to an expansion of real national output

General

Price

Level

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Changes in global commodity prices have been much in the news over the last couple of years. Producers not just in the UK but throughout the world have been affected by sizeable increases in the costs of many inputs such as copper, steel, rubber, oil and gas, other metals and foodstuffs. The result has been a major squeeze on costs and profits. Some firms have been able to pass on higher costs to customers further down the supply-chain. Others have not leading to fears of a sharp rise in cost-push inflation contributing to a wider economic slowdown.

Shifts in the short run aggregate supply curve are illustrated in the diagram below

The current state of the world economy means that study of what brings about shifts in short run aggregate supply is particularly relevant. We have seen a major change in the prices of many essential inputs as shown by the sharp rise in the Economist‘s Commodity Price Index. Oil and gas prices are the obvious sign of this with the price of crude oil more than doubling during 2007-08.

Have we now reached an end to the era of cheap energy? Will global food prices fall or will they stay high for the foreseeable future? If this is the case, businesses in many different sectors of the economy are going to have to adjust to a world where the prices of many of their components

and other inputs are much higher than before.

Short test exercise on aggregate supply

Here is a series of economic events. Decide whether they are likely to cause an outward or an inward shift in SRAS. Or (if you think the event affects aggregate demand) a movement along the SRAS curve.

Real National Income

SRAS3

LRAS

Yfc

SRAS1

SRAS2

SRAS1 – SRAS2: A fall in aggregate supply caused by an increase in costs – less output can be supplied at each and every price level

SRAS1 – SRAS3: A rise in aggregate supply caused by a fall in production costs – more output can be supplied at each and every price level

General

Price

Level

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Economic Event

Impact on SRAS

Outward shift / inward shift / movement along SRAS

1 An increase in wage costs due to a rise in the National Minimum Wage from £5.00 per hour to £5.80 per hour

2 A fall in the price of oil from $145 a barrel to $100 a barrel

3 An increase in consumer demand for consumer durables caused by lower interest rates

4 An increase in the rate of value added tax imposed on producers from 17.5% to 20.0%

5 An appreciation (rise) in the value of the pound against the US dollar by 15%

6 Fall in unit wage costs brought about by an influx of migrant workers into the UK economy

7 A sharp rise in the price of gas and electricity in the wholesale energy markets caused by a period of severe winter weather

8 A fall in the cost of semi conductors used in the computer industry and other industries

Long run Aggregate Supply (LRAS)

We now turn our attention to aggregate supply in the long run.

In the long run, the ability of an economy to produce goods and services to meet demand is based on the state of production technology and the availability and quality of factor inputs.

A long run production function for a country is often written as follows:

Y*t = f (Lt, Kt, Mt)

o Y* is a measure of potential output

o t is the time period

o L represents the quantity and ability of labour input available

o Kt represents the available capital stock

o Mt represents the availability of natural resources

LRAS is determined by the stock of a country‟s productive resources and by the productivity of factor inputs (labour, land and capital). Changes in the technology also affect potential real national output.

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The vertical long-run aggregate supply curve (LRAS)

LRAS is assumed to be independent of the price level and is drawn vertical. Neo-classical economists view the LRAS curve as being perfectly inelastic at a level of output where actual GDP has achieved its potential. There will be no unused labour in that all those who are available for employment at the prevailing wage rate will have work – in other words, a full-employment level of national income has been reached.

Keynesian economists disagree – they believe that an economy can settle at a level of output where there are many people still unemployed because of a lack of AD. They argue for active demand-management using tools such as fiscal and monetary policy.

Causes of shifts in the long run aggregate supply curve

Any change in the economy that alters the natural rate of growth of output shifts LRAS.

Improvements in productivity and efficiency or an increase in the stock of capital and labour resources cause the LRAS curve to shift out. This is shown in the diagram below.

Policies to increase LRAS

Real National Income

LRAS1 LRAS2

YFC2 YFC1

SRAS1

SRAS2

LRAS3

SRAS3

YFC3

General

Price

Level

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1. Expanding the labour supply - e.g. by improving incentives for people to search for and then accept jobs as they become available. The UK government has also been encouraging an influx of migrants which has added to the supply of labour although it has created concerns about some of the social and political effects. There are some signs that the big influx of migrant workers into the UK is coming to an end. In the long term many countries must find ways of overcoming the effects of an ageing population

2. Increase the productivity of labour – e.g. by investment in training of the labour force and improvements in the quality of management of human resources.

3. Improve mobility of labour to reduce certain types of unemployment for example structural unemployment which is caused by occupational immobility of labour. If workers have better skills and increased flexibility, they will find it easier to get work when economic conditions change. Conversely when unemployment remains high, the economy loses out on potential output and there is a waste of scarce economic resources.

4. Expanding the capital stock – i.e. increase the level of investment and research and development.

5. Increase business efficiency by promoting greater competition within markets.

6. Stimulate a faster pace of invention and innovation – this will hopefully in the long term promote lower production costs and also improvements in the dynamic efficiency of markets.

For most advanced nations it is indeed the growth of productivity that is critical to raising the long term growth of real GDP. The following article refers to what is commonly known as the “productivity gap” between the UK and other leading industrialized economies.

UK productivity still trails competitors

Gordon Brown's ambition of matching the growth in productivity of the world's big economies appears as elusive as ever after research by the Centre for Economic Performance showed that in terms of output per hour worked, Britain still lags behind Germany by 13 per cent, the US by 18 per cent and France by 20 per cent. "This means that if we could reach French productivity levels, we could award ourselves 20 per cent higher wages or take a day off and still earn the same. Or we could spend the extra resources on schools and hospitals," according to the report‘s author. The lag in productivity was mainly due to "deficits in innovation, skills and management practices, as well as regulatory constraints in the retail sector," according to the report. The proportion of low-skilled people in the UK was three times higher than in the US and almost double the proportion in Germany and Japan.

Source: Adapted from Financial Times, June 2007

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Aggregate supply shocks

We saw in our chapter on AD that external events in the world economy can cause shocks to the level of demand for goods and services. Unpredictable shocks are even more frequent when it comes to aggregate supply.

Aggregate supply shocks might occur when there is

o A sudden rise in oil prices or other essential inputs such as foodstuffs used in food-processing industries. Foodstuffs are an example of intermediate products – items that are used up in manufacturing goods for consumers to buy

o The invention and diffusion of a new production technology

o A major change in the movement of migrant workers from one economy to another

The obvious recent example is what has happened to the world price of crude oil. Our chart tracks the daily price for West Texas Intermediate, widely regarded as one of the benchmarks for international oil prices. Having been remarkably low in the early years of this decade reaching as low as $17 a barrel in the autumn of 2001, we have seen a dramatic rise in the price of crude. At the time of writing, a barrel of crude oil was selling for just over $145!

US dollars per barrel, one month futures price, NYMEX

West Texas Intermediate Crude Oil

Source: Reuters EcoWin

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How much of this incredible increase in price has been due to speculative buying of oil by investors such as hedge funds. And how much can be explained by fundamental demand and supply-side reasons which drive the equilibrium price higher, is open to question. Global oil demand has been rising strongly largely on account of the rapid economic growth in emerging market countries such as China and India. But prices have risen because of shortages of oil refining capacity and signs that OPEC and non-OPEC oil producers are finding it more expensive to extract oil from known fields. The result has been a spike in world oil prices that has had huge

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consequences around the global economy. We may be less dependent on oil than we were thirty or more years ago when the first of the big oil-price shocks occurred. But oil remains a key input into many industries and had a direct impact on the prices we pay for transport and heating. This has been a major supply-side shock for the UK economy with demand-side consequences too!

The effects of supply-side shocks are normally to cause a shift in the SRAS curve. But there are also occasions when changes in production technologies or step-changes in the productivity of factors of production that were not expected, feed through into a shift in the long run aggregate supply curve.

Natural disasters and political conflicts including civil wars can also have a significant effect on a country‘s productive potential and therefore affect the LRAS although it is often difficult to measure accurately just how damaging these events have been.

Key terms

Classical LRAS The classical LRAS curve is drawn as vertical because classical economists argue that the productive capacity of the economy is determine by factors other than price and demand.

External shock An unpredictable event which creates a disturbance for the economy

Innovation Changes to products or production processes – innovation is very important in delivering improvements in dynamic efficiency

Intermediate goods Products used up in manufacturing a final good or service for example wheat used in manufacturing cereals or steel used in supplying new cars

Productive potential How many goods and services an economy can supply in the long run

Productivity A measure of efficiency e.g. measured by output per person employed or output per person-hour

Trend growth The long run average growth rate – mainly determined by changes in the stock of available factor inputs and also improvements in productivity

Unit wage costs Labour costs per unit of output

Suggestions for further reading on short run aggregate supply

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on aggregate supply.

Dry cleaners hit by rising costs (BBC news, June 2008)

Fuel costs push up inflation (BBC news, June 2008)

High oil prices hit global economies (BBC news, June 2008)

The end of cheap clothes is near (BBC news, April 2008)

UK manufacturers raising prices (BBC news, June 2008)

Suggestions for further reading on long run aggregate supply

Building BRICS of growth (The Economist, June 2008)

Contrasting views on EU migration (BBC news, April 2008)

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Innovation in the National Health Service (BBC news, July 2008)

Inward investment success for the UK (BBC news, July 2008)

UK plans big wind power expansion (BBC news, June 2008)

US workers top productivity table (BBC news, October 2007)

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13. Macroeconomic Equilibrium

You may already be familiar with the concept of equilibrium from your study of microeconomics – equilibrium occurs at a market clearing price which balances supply and demand. Now we look at the concept of equilibrium at a macroeconomic level.

In this chapter, we will be using the neo-Keynesian version of the long run aggregate supply curve – which is drawn as a non-linear curve. This shape of the LRAS curve shows that increases in aggregate demand may increase real output and employment in the short term though when SRAS is upward sloping, this may be at the expense of higher inflation.

Equilibrium for the whole economy

Some people naturally question whether it can ever be the case that a whole economy can come close to reaching equilibrium since it would only take one market to be out of equilibrium for this to be blocked?

Our interpretation of the idea of equilibrium is a little different from a microeconomic level. What matters here is whether the total demand for goods and services is close to the actual level of production from domestic and external sources. We will come back to this when we look at excess demand and excess supply in the economy and the concept of the output gap.

Macro-economic equilibrium is established when AD intersects with SRAS. This is shown in the diagram below. At price level P1, AD is equal to SRAS – i.e. at this price level, the value of output produced within the economy equates with the level of demand for goods and services. The output and the general price level in the economy will tend to adjust towards this equilibrium position.

If the general price level is too high, there will be an excess supply of output and producers will experience an increase in unsold stocks. This is a signal to cut back on production to avoid an excessive level of inventories. If the price level is below equilibrium, there will be excess demand in the short run leading to a run down of stocks – a signal for producers to expand output.

Equilibrium is where the level of income flowing round the system is constant in successive time periods.

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Real National Income

AD1

SRAS1

P1

LRAS

P2

P3

AD2

AD3

AD1 – AD2 is an outward shift of AD causing an expansion of short run aggregate supply, a rise in real national output and an increase in the general price level

AD1 – AD3 is an inward shift of AD causing a contraction of short run aggregate supply, a fall in real national output and a decrease in the general price level

Y1 Y2 Yfc Y3

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Level

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AD

SRAS

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Ye

Macroeconomic Equilibrium Point

LRAS

Yfc

At the equilibrium output in this example, the

economy is still operating below full capacity

At price level P2 – there would be excess supply

P2

Macroeconomic equilibrium – when AD equates to short run aggregate supply. The short run equilibrium for an economy may be higher or lower than potential GDP

P1

At price level P1 – there would be excess demand

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Changes in short-run aggregate supply (SRAS)

Suppose that lower raw material costs causes the short run aggregate supply curve to shift outwards. (Assume that there is no shift in AD). The next diagram shows what is likely to happen. SRAS1 shifts outwards to SRAS3 and a new equilibrium will be established at Y3.

Equilibrium using a linear aggregate supply curve

In the next diagram we see the effects of two inward shifts in AD. This might be caused for example by a decline in business confidence or perhaps a fall in exports of goods and services following a global downturn. It might also be caused by a cut in government spending or a rise in interest rates.

The result of the inward shift of AD is a contraction along the SRAS curve and a fall in national output (i.e. a possible recession). This causes downward pressure on the general price level and takes the equilibrium level of national output further away from full capacity as indicated by the LRAS curve. We would expect to see a possible rise in unemployment because businesses may not be able to afford to keep as many workers on when demand, output and profits are all heading lower. This would lead to a rise in cyclical unemployment.

Real National Income

Aggregate Demand (AD)

SRAS1

P1

LRAS

SRAS2

P2

SRAS3

Y1 Y3 Yfc Y2

SRAS1 – SRAS3 is an outward shift of AS causing an expansion of AD, a rise in real national output and a decrease in the general price level

SRAS1 – SRAS2 is an inward shift of AS causing a contraction of AD, a fall in real national output and an increase in the general price level

General

Price

Level

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The Output Gap

How much spare capacity does an economy have to meet a rise in demand? How close is an economy to operating at its productive potential? These sorts of questions link to an important concept – the output gap.

The output gap is the difference between the actual level of national output and its potential level and is usually expressed as a percentage of the level of potential output.

Real National Income

AD1

SRAS

P1

Y1

LRAS

Yfc

P2

Y2

AD2

Positive Output Gap

Y2 > Yfc

Negative Output Gap

Y1 < Yfc

Real National Income

SRAS

AD3 AD1

P1

P3

AD2

P2

Y1 Y2 Y3 Yfc

General

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Level

General

Price

Level

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Negative output gap – downward pressure on inflation

The actual level of real GDP is given by the intersection of AD & SRAS – the short run equilibrium. If actual GDP is less than potential GDP (e.g. real output level Y1) there is a negative output gap. Some factor resources are under-utilised and the main problem is likely to be higher than average unemployment.

A rising number of people out of work indicate an excess supply of labour in the factor market which means there is downward pressure on real wage rates. In the next time period, a fall in real wage rates shifts SRAS downwards until actual and potential GDP are identical – assuming labour markets are flexible.

Positive output gap – upward pressure on inflation

If actual GDP is greater than potential GDP i.e. a level of real GDP of Y2 then there is a positive output gap. Some resources including labour are likely to be working beyond their normal capacity e.g. making extra use of shift work and overtime. The main problem is likely to be an acceleration of demand pull and cost-push inflation. Shortages of labour put upward pressure on wage rates, and in the next time period, a rise in wage rates shifts SRAS upwards until actual and potential GDP are identical – assuming labour markets are flexible.

Actual GDP - Potential GDP, measured as a percentage of potential GDP source: OECD

United Kingdom, Output gap of the total economy

Source: Reuters EcoWin

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The boom in the late 1980s left the UK with a large positive output gap, one of the reasons why we saw a big rise in inflation before the recession of the early 1990s. Indeed the loss of control over inflation was a key factor causing the recession since high inflation required high interest rates to control it and this squeezed business and consumer confidence and spending. At the end of the slump in 1992 the output gap was highly negative – giving scope for the economy to grow for several years without the fear of demand-pull inflationary pressure.

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Since the mid 1990s the evidence we see in the chart - which is drawn from research published by the OECD - is that the estimated output gap for the UK has remained low ranging between -1% and 1% of potential GDP. This suggests that the Bank of England has managed successfully through its interest rate strategy to keep AD growing more or less in line with the economy‘s productive potential. Government fiscal policy has also contributed to this, for example the government chose to increase spending and run with a larger budget deficit from 2002 onwards at a time when the world economy was weak. This boosted AD and kept the UK growing close to the trend rate.

Output Gap, Unemployment - claimant count measure

The Output Gap and Unemployment in the UK

Source: Reuters EcoWin

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The recent global slowdown is starting to show through in the figures for the UK output gap. Notice how the OECD forecasts that in 2009 the UK is likely to be operating below its potential GDP with an output gap heading towards -2%. This figure will be even lower if fears of a recession are realised. Indeed the OECD forecast in the summer of 2008 that the weakening economy would experience a rise in unemployment of between up to 300,000 people from 2008-2010.

Key terms

Full capacity output A level of national output where all available factor inputs are fully employed

Labour shortages When businesses find it difficult to recruit the workers they need

Output gap The difference between actual and potential national output

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14. Understanding the Economic Cycle

All countries experience regular ups and downs in the growth of output, jobs, income and spending. These fluctuations form what is known as the economic or business cycle. This chapter focuses on the different stages of the cycle and some of the causes.

―The UK economy has grown on average by 2.5% over many decades it is rare for gross domestic product (GDP) to fall on an annual basis. There have been only five such years since the end of the second world war: 1974, 1975, 1980, 1981 and 1991.‖

Source: Larry Elliott, the Guardian, July 2008

Gross Domestic Product at constant 2001 prices, source: Office of National Statistics

National Income for the UK Economy

Source: Reuters EcoWin

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Our opening chart in this chapter shows the level of real national income for the UK. The data is presented in two different ways – the top pane of the chart tracks the quarterly value of real GDP expressed at constant 2001 prices. To get an estimate for the annual value of GDP you just need to multiply the value for a given quarter by four. The bottom pane shows how fast or slow the economy is growing i.e. the annual rate of change.

As you can see, national output rarely rises or falls at a constant rate! All countries experience a cycle where the pace of growth of national production, incomes and spending fluctuates over time. The length and volatility of each cycle tends to change over time as the structure of an economy evolves and previously observed relationships appear to change. There are different stages of a cycle, each of which has several characteristics – but no cycle is ever the same!

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Boom

A boom occurs when real national output is rising at a rate faster than the trend. Some of the main characteristics of a boom include:

o A fast growth of consumption helped by rising real incomes, strong confidence and perhaps a surge in house prices and other personal wealth.

o A pick up in the demand for capital goods as businesses look to invest in expanding their capacity to meet rising demand and to make higher profits. The link between the growth of demand and the planned level of investment is known as the accelerator effect and is discussed in the next chapter.

o More jobs and falling unemployment and higher real wages for people in jobs.

o A high demand for imports which may cause the economy to run a larger trade deficit because it cannot supply all of the goods and services that consumers are demanding

o Government tax revenues will be rising quickly as people are earning and spending more and companies are making larger profits – this gives the government the option of raising its own spending in priority areas such as education, the environment, health and transport

o A danger of an increase in demand-pull and cost-push inflationary pressures if the economy overheats and experiences a positive output gap.

The UK economy has enjoyed sustained growth over the last fifteen years rather than an out-and-out boom which is definitely unsustainable! For examples of booming countries we have to look overseas. The obvious example is China whose growth has been astonishing. And many other emerging market countries have experienced a decade or more of phenomenally rapid increases in the size of their economies.

The BRIC countries have aroused particular interest from economists interested in understanding their very fast rates of growth and development. In addition to China, the BRIC nations include Brazil, Russia and India.

Among the group of leading advanced nations that form the OECD, the fastest growing countries have been South Korea and Ireland. Ireland‘s growth gave her the name of Europe‘s ―Celtic Tiger‖ economy. But over the last couple of years that growth has slipped away. Indeed there are fears that Ireland may soon suffer a recession.

Slowdown

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A slowdown occurs when the rate of growth decelerates – but national output is still rising! If the economy continues to grow without falling into recession, this is known as a soft-landing. It is often the case that, in a slowdown, some sectors of the economy suffer a slump in demand and profits – but not sufficient to drag down GDP as a whole. In the UK during the summer of 2008 it was retailing, housing-related industries and financial services that were suffering the brunt of a dip in spending and activity.

Recession

A recession is a hard-landing and means a fall in the level of real national output i.e. a period when the rate of growth is negative, leading to a contraction in employment, incomes and profits. There is in fact more than one definition and measurement of a recession.

The simple definition: A fall in real GDP for two consecutive quarters i.e. six months

The more detailed definition: The NBER in the United States defines a recession thus: ―A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.‖

This second interpretation of recession is subtly different from the first and alerts us to an important point. It may well be that some parts of an economy are experiencing recessionary conditions, for example the housing market or the car industry. But for it to be a full-scale recession the decline in demand, production, income and jobs has to be spread across the economy – covering most sectors and regions.

The last recession in Britain lasted from the summer of 1990 through to the autumn of 1992. When real GDP reaches a low point, the economy has reached the trough – and with hope (and perhaps some luck!) a recovery is imminent.

In Western advanced economies, recessions are unusual. Take the world‘s largest economy the United States - it has suffered only two official downturns, in 1990-91 and 2001. When they happen, they tend to be short-lived lasting perhaps no more than two or three years. If a country fails to emerge from a downturn then it is likely to be in a deeper depression.

A slump or a depression is a prolonged and deep recession leading to a significant fall in output and average living standards. The main characteristics of an economic recession are:

o Declining aggregate demand for goods and services.

o A fall in business confidence & profits leading to a decrease in capital investment spending – although some businesses do quite well out of a recession!

o Cut-backs in employment as businesses look to reduce their costs – this is known as labour shedding.

o De-stocking and heavy price discounting from businesses left with excess capacity and who decide to cut their prices to generate much needed cash flow and maintain output.

o Reduced inflationary pressures and falling demand for imports.

o Increased government borrowing leading to an increase in the size of the national debt.

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o Lower interest rates from central bank – who might decide to relax monetary policy but cutting interest rates in a bid to stimulate confidence and spending.

No recession is ever the same as they have different causes. But one common feature of them is a slide in consumer and business confidence which then turns into a downturn in spending. Once demand starts to fall away, businesses find themselves with unsold goods and stocks start rising. This is a signal either to cut back on production and perhaps shed some labour, or to cut prices in a bid to kick-start sales and improve the cash-flow of a business.

Whether a slowdown turns into a recession depends on the conditions prevailing at the time. The decisions taken by businesses have a major

influence on this outcome.

It is a huge challenge to make money and protect margins in a time when cost pressures are enormous, when demand might be slipping away and productivity growth is slowing down as capacity utilisation drops. Economist Roger Bootle highlighted this point in an article written in the summer of 2008 on the worsening economic situation in the UK.

“Companies take four sets of decisions that are vital to macro-economic performance: about wages and prices; the level of investment spending (on plant and machinery and R&D); levels of stocks (inventories), and employment levels.”

The Credit Crunch

Put simply, a credit crunch happens when there is a sharp decline in the supply of credit available from banks and other lenders - that that is abnormally large for a given stage of the business cycle. The reduction in the volume of available loans means that tougher credit rationing is being applied by commercial banks often accompanied by a rise in the cost of borrowed money.

The main cause of the recent credit crunch has been the huge rise in sub prime lending by mortgage lenders both here in the UK and particularly in the United States. This means that money or income which has been secured to borrow vast amount of money is no longer being paid by the borrower. The banks then start to report huge losses and they have had to announce a massive increase in bad debt provision. Credit that once was easily available at an attractive rate of interest has simply dried up with damaging economic confidence for all. The collapse of Northern Rock and the troubles of lenders such as Bradford and Bingley have been the most high profile of the problems facing the UK financial sector.

What are the main causes of a recession?

Many factors can contribute to a recession, there is rarely one single cause, instead a combination of events come together to bring about a downturn.

1. Major ―negative‖ demand-side shocks hitting one or more of the components of AD:

a. A global slump or recession in the country of a major trading partner such as the countries of the EU (60% of UK trade) and the United States (15% of UK trade)

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b. A sharp fall / collapse in asset prices e.g. share prices, property prices

c. A credit crunch where financial institutions cut the amount of credit they are prepared to lend to households and businesses and raise the interest rate on these loans

d. A large appreciation of the exchange rate which hits the demand for exports, raises import demand and causes the trade balance to worsen

2. Major inflationary supply-side shocks which affect SRAS, cost-push inflation, business profits and investment

a. Higher crude oil and gas prices – leading to increased input costs, driving inflation higher and causing a fall in real incomes for households (less consumption) and a fall in profits for businesses (less investment and possible employment cut-backs) – this is known as stagflation

b. Higher prices for metals and other non-fuel inputs whose demand is inelastic

c. Surges in foodstuff prices which increase costs and lower profits for food manufacturers

d. Other inflationary effects globally such as a sharp rise in inflation in the USA or China, leading to a burst of imported inflation

3. Risks of recession arising from the introduction of deflationary policies such as higher interest rates or increased direct and indirect taxation

a. If interest rates are raised to counter higher inflation from the domestic economy or from overseas – this can cause a fall in confidence, less spending and a downturn in output and jobs

b. Taxes may have risen to counter a budget deficit – squeezing real disposable incomes and demand or perhaps damaging business investment

A severe slowdown can quite easily become a recession because of

1. Negative multiplier effects arising from less consumption on goods and services

2. The accelerator effect – less consumption ► less incentive to invest in new capital

3. A drop in consumer and business confidence / worsening expectations can lead to more saving and cost-cutting by firms ► rising unemployment

Oil and economic shocks

Oil at $146 a barrel will have dramatic effects. It will depress profitability across a host of industries, from obvious examples such as airlines to retailers and leisure companies affected by lower consumer spending. Much capital – old aircraft, cars and machinery – will have to be scrapped. Oil importers will have to export more and consume less.

The economic adjustment may be achieved only through a long period of slow growth.

Source: Financial Times, July 2008

An important evaluation point is that, in a recession, some businesses are affected more than others. The extent of the effects will depend on the type of business, the market it operates in and the nature of the product sold. When average incomes are falling, we would expect to see a decline in demand for products with a high income elasticity of demand – typically these goods and services are regarded as luxury items by consumers, things that they might choose to do

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without when the economy is going through a bad time. The demand for products with a negative income elasticity of demand (i.e. inferior goods) might actually rise during a recession!

That said the income elasticity of demand for any one product is an individual choice. For some of the most expensive goods out of the reach of people on middle incomes, demand for top quality products such as designer jewellery or speed-boats might be regarded as a necessity!

Recovery

A recovery occurs when real national output picks up from the trough reached at the low point of the recession. The pace of recovery depends in part on how quickly AD starts to rise after a downturn. And, the extent to which producers raise output and rebuild their stock levels in anticipation of a rise in demand. The state of business confidence plays a key role here. Any recovery in production might be subdued if businesses anticipate that a recovery will be only temporary or weak in scale.

Key terms

Hard landing A full-scale recession shown by a decline in real national output

Income elasticity Responsiveness of demand to a change in the real income of consumers

Labour shedding Cut backs in employment often seen in a slowdown or a recession

Lagging indicators Indicators which tend to follow economic cycles e.g. unemployment

Lead indicators Indicators which predict future economic trends e.g. consumer confidence

Peak The high point of the economic cycle beyond which a recession starts

Real wage The nominal wage adjusted for the effects of inflation

Slump A sustained decrease in real GDP and a persistent rise in unemployment

Soft landing A slowdown in economic activity but which does not result in a recession

Trough The low point of the economic cycle beyond which a recovery starts

Suggestions for Further Reading on the Economic Cycle

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on the business cycle:

A painful recovery for the UK (BBC news, June 2008)

Are we plunging towards a recession? (Sunday Times, June 2008)

Bank chief Mervyn King raises spectre of British recession (The Times, May 2008)

Can the UK avoid recession? (BBC news, July 2008)

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Companies hold the key as UK recession looms (Telegraph, June 2008)

Economic growth and recession (Guardian special reports)

How bad will the economic slowdown be? (BBC news, April 2008)

Recession looming for UK firms (BBC news, July 2008)

Report warns of UK recession risk (BBC news, March 2008)

The Big Squeeze (The Guardian, June 2008)

What is a recession? (BBC news, July 2008)

Will the credit crunch lead to recession? (LSE Centrepiece Magazine, May 2008)

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15. Multiplier and Accelerator Effects

In this chapter we look at two ideas, the multiplier and the accelerator, both of which help to explain how we move from one stage of a cycle to another

The multiplier process

An initial change in AD can have a much greater final impact on equilibrium national income. This is known as the multiplier effect and it comes about because injections of demand into the circular flow of income stimulate further rounds of spending – in other words ―one person‘s spending is another‘s income‖ – and this can lead to a bigger effect on output and employment.

Consider a £300 million increase in business capital investment – for example created when an overseas company decides to build a new plant in the UK. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are purchased will experience an increase in their incomes and profits. If they and their employees in turn, collectively spend about 3/5 of that additional income, then £180m will be added to the incomes of others.

At this point, total income has grown by (£300m + (0.6 x £300m).

The sum will continue to increase as the producers of the additional goods and services realize an increase in their incomes, of which they in turn spend 60% on even more goods and services.

The increase in total income will then be (£300m + (0.6 x £300m) + (0.6 x £180m).

The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.

Multiplier effects can be seen when new investment and jobs are attracted into a particular town, city or region. The final increase in output and employment can be far greater than the initial injection of demand because of the inter-relationships within the circular flow.

The Multiplier and Keynesian Economics

The concept of the multiplier process became important in the 1930s when John Maynard Keynes suggested it as a tool to help governments to achieve full employment. This macroeconomic ―demand-management approach‖, designed to help overcome a shortage of capital investment, measured the amount of government spending needed to reach a level of national income that would prevent unemployment.

The higher is the propensity to consume domestically produced goods and services, the greater is the multiplier effect. The government can influence the size of the multiplier through changes in direct taxes. For example, a cut in the rate of income tax will increase the amount of extra income that can be spent on further goods and services.

Another factor affecting the size of the multiplier effect is the propensity to purchase imports. If, out of extra income, people spend their money on imports, this demand is not passed on in the form of fresh spending on domestically produced output. It leaks away from the circular flow of income and spending, reducing the size of the multiplier.

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The multiplier process also requires that there is sufficient spare capacity in the economy for extra output to be produced. If short-run aggregate supply is inelastic, the full multiplier effect is unlikely to occur, because increases in AD will lead to higher prices rather than a full increase in real national output. In contrast, when SRAS is perfectly elastic a rise in aggregate demand causes a large increase in national output.

The construction boom and multiplier effects

A study has found that the British construction sector alone has driven a fifth of UK GDP growth in the past year and 34% of net job creation in the past two years. The construction boom has been caused by the combination of large projects like Terminal 5, the Channel Tunnel Rail Link, Wembley Stadium and the Scottish Parliament with a revival in house building, heavy expenditure by the public sector on new schools and hospitals and a surge in home improvement expenditure.

The study provides compelling evidence on the multiplier effects of major capital investment projects. 'One characteristic of construction activity is that it feeds through to many other related businesses. It has "backward linkages" into the likes of building materials; steel, architectural services, legal services and insurance, and most of these linkages tend to result in jobs close to home. This makes a boom in construction peculiarly powerful in fuelling expansion in the economy - for a given lift in building orders, the multiplier effect may be well over two. This means that every building job created will generate at least two others in related areas and in downstream activities

Real National Income

AD2

SRAS1

P2

LRAS

P3

Inflation

P1 AD3

AD1

Differences in the size of the multiplier effect

AD1 – AD2 is an outward shift of AD when short run aggregate supply is highly elastic. This leads to a large rise in national output and a large multiplier effect

AD3 – AD4 shows a further outward shift in aggregate demand, but where aggregate supply is inelastic – the multiplier effect is smaller because there is less spare capacity available to meet the increase in demand

Y2 Y3 Yfc Y1

AD4

P4

Y4

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such as retailing, which benefits when building workers spend their wages. Other industries, particularly those where much of the output value comes in the form of imported components, might have a multiplier of less than 1.5 for new projects'.

Adapted from a report from the Centre for Economics and Business Research

The accelerator effect

Planned capital investment by private sector businesses is linked to the growth of demand for goods and services. When consumer or export demand is rising strongly, businesses may increase investment to expand their capacity and meet the extra demand. This process is known as the accelerator effect. But the accelerator effect can work in the other direction! A slowdown in demand can create excess capacity and may lead to a fall in planned investment demand.

Aggregate demand and the accelerator effect

The strength of demand for goods and services and in particular the level of consumer spending has an impact on the planned level of capital investment spending by private sector businesses.

When consumption grows strongly, this increases short run output and it can lead to higher prices and profits for producers who will be operating with less spare capacity. If business confidence and profits are high, we can see an accelerator effect at work with a rise in planned capital investment at each prevailing rate of interest. This is shown in the right hand diagram above.

General

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Quarterly survey evidence, percentage of respondents

CBI Trends Survey - Factors limiting capital spending

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Key terms

Accelerator effect Theory that planned capital investment is linked positively to the past and expected growth of consumer demand

Multiplier effect If there is an initial injection (e.g. a rise in exports) into the economy then the final increase in AD and Real GDP will be greater.

Marginal rate of tax The rate of tax on the next unit (£) of income earned

Planned investment Planned spending by businesses on new capital goods

Propensity to import The proportion of any change in income that is spent on overseas products

Propensity to save The proportion of any change in income that is saved rather than spent

Spare capacity When a business is not making full use of its available capacity – there are spare factors of production including land, labour and capital. When an economy has plenty of spare capacity, short run aggregate supply tends to be elastic.

Suggestions for further reading on the multiplier and accelerator effects

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on multiplier and accelerator effects:

Coal past still scars the Welsh economy (BBC news, May 2008)

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Housing slump and negative multiplier effects (Tutor2u Blog, July 2008)

Jobs boost from airport expansion (BBC news, March 2008)

Jobs boost to Barrow from investment in new aircraft carriers (BBC news, July 2008)

Music to ears of Glastonbury entrepreneurs (BBC news, June 2008)

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16. Economic Growth and Development

Growing economies provide the means for people to enjoy better living standards and for more of us to find work. But what is growth and how best can a country achieve it?

President pledges economic growth as a priority

The President of China, Hu Jintao had pledged that maintaining China‘s rapid growth is the ruling Communist party‘s top priority. Growth has averaged over ten per cent per a year over the last decade transforming the country into a global trading power and one of the fastest growing markets in the world for many products. But the growth has been built on a surge in energy-intensive industries and has been accompanied by widespread air and water pollution that has drawn growing public anger. Growth has created enormous wealth especially in costal regions but there has also been a sharp rise in the income and wealth gap between rich and poor in Chinese society and great social pressures resulting from a mass migration of people from rural to urban areas.

Source: Adapted from the Financial Times, November 2007

What is economic growth?

Economic growth is best defined as a long-term expansion of the productive potential of the economy.

How do we measure economic growth?

Short term growth is measured by the annual % change in a country‘s real national output. In the long run, growth is shown by the increase in trend or potential GDP. In the table below we track annual growth of GDP for the seven current members of the Group of 7 (UK, USA, Japan, Germany, France, Italy and Canada) and also for the 27 nations of the European Union.

% change in real GDP

Per annum

EU27 UK USA Japan Germany France Italy Canada

2001 2.0 2.4 0.8 0.2 1.4 1.8 1.7 1.8

2002 1.2 2.1 1.6 0.3 0.0 1.1 0.5 2.9

2003 1.3 2.8 2.5 1.5 -0.2 1.1 0.0 1.9

2004 2.3 3.3 3.6 2.7 1.0 2.3 1.4 3.1

2005 1.9 1.8 3.1 1.9 0.4 1.8 0.7 2.9

2006 3.1 2.9 2.9 2.4 3.1 2.2 1.9 3.1

2007 2.9 3.1 2.2 2.0 2.6 2.3 1.9 2.7

Average growth rate

1995-2007

2.9 2.9 3.0 1.4 1.6 2.1 1.6 3.2

Source: OECD World Economic Outlook, June 2008

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There is a lot of data in the table but can you spot any major differences in growth performance among these countries during the current decade?

How well has the UK performed in terms of the Group of 7‘s growth record?

Which country has seen the most stable growth from year to year?

Are there any examples that you can spot of countries that experienced a recession?

What is the difference between growth and development?

The dictionary definition of ‗development‘ is to improve, to progress, or to grow – but economic development is not just about growth!

Development is concerned with the improvement of human welfare within an economy, and so it encompasses such concepts as standard of living, cultural identity and political freedom. The most common measurement of development is the Human Development Index.

Dudley Sears defined development as ―the reduction and elimination of poverty, inequality and unemployment within a growing economy‖. Under this definition, development is essentially about improving the incomes of those living in poverty.

Amartya Sen, in ―Development as Freedom‖, sees development as being concerned with improving the freedoms and capabilities of the disadvantaged, thereby enhancing the overall quality of life. Development should be about increasing political freedom, economic freedom, and social freedom and not just about raising incomes.

In essence: development economics is concerned with the study of the causes of problems facing those economies where the majority of the population are in absolute poverty, and with finding solutions to those problems in order to raise the quality of life.

Michael Todaro specified three objectives of development:

1. To increase the availability and widen the distribution of basic life-sustaining goods such as food, shelter, health and protection.

2. To raise levels of living, including, in addition to higher incomes, the provision of more jobs, better education, and greater attention to cultural and human values, all of which will serve not only to enhance material well-being but also to generate greater individual and national self-esteem

3. To expand the range of economic and social choices available to individuals and nations by freeing them from servitude and dependence not only in relation to other people and nation-states but also to the forces of ignorance and human misery.

Note the emphasis on ‗cultural and human values‘, ‗self-esteem‘ and freedom from ignorance; it is important to remember that economic development is about much more than simply achieving economic growth.

The Human Development Index

―People are the real wealth of nations. Development is thus about expanding the choices people have to lead lives that they value. And it is thus about much more than economic growth, which is

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only a means —if a very important one —of enlarging people‘s choices.‖ Source: UNDP Report 2007

The United Nations Human Development Index (HDI) measures the average achievements in a country in three basic dimensions of human development:

1. A long and healthy life, as measured by life expectancy at birth.

2. Knowledge, as measured by the adult literacy rate (with two-thirds weight) and the combined primary, secondary and tertiary gross enrolment ratio (with one-third weight).

3. A decent standard of living, as measured by GDP per capita (PPP USD).

Each year, countries are ranked according to these measures. In the 2007-08 HDI report, the top five ranked countries were Iceland, Norway, Australia, Canada and Ireland. The bottom five ranked countries were Mali, Niger, Guinea-Bissau, Burkina Faso and Sierra Leone

The HDI notably fails to take account of qualitative factors, such as cultural identity and political freedom.

The GNP per capita figure – and consequently the HDI figure – takes no account of income distribution. If income is unevenly distributed, then the GNP per capita will actually be an inaccurate measure of the monetary well-being of the people.

HDI is intended to allow economists to draw broad conclusions about which countries enjoy relatively high standards of living, and which are, by comparison, under-developed.

Other measures of economic development:

1. The percentage of adult male labour in agriculture 2. Combined primary and secondary school enrolment figures 3. Access to clean water; 4. Energy consumption per capita 5. Access to mobile phones per thousand of the population.

Economic Growth and the Production Possibility Frontier

An increase in long run aggregate supply is illustrated by an outward shift in the production possibility frontier.

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In our diagram we see how a rise in a nation‘s productive capacity causes the PPF to shift out and this allows increased supply both of consumer and capital goods. Where the economy ends up depends on the decisions made about the allocation of scarce resources between products to be bought and consumed today for example restaurant meals and holidays, and the production of capital goods such as new technology, plant and equipment and buildings.

The costs, benefits and sustainability of economic growth

In this section we consider some of the consequences of economic growth from both an economic and social perspective.

Advantages of Economic Growth

Sustained growth is a major objective of policy for most government. The aim is to achieve a rate of growth that can be maintained without risking an acceleration of inflation or too big a damaging effect on our environmental resource base.

(1) Higher living standards – for example measured by an increase in real national income per head of population.

(2) Employment effects: Growth stimulates higher employment. The British economy has been growing since autumn 1992 and we have seen a large fall in unemployment.

(3) Fiscal dividend: Growth has a positive effect on government finances - boosting tax revenues and providing the government with extra money to finance spending projects and improve access to key public services such as education and healthcare.

(4) The accelerator effect: Rising demand and output encourages investment in capital machinery – this helps to sustain the growth in the economy by increasing long run aggregate supply.

(5) Growth and business confidence: Economic growth normally has a positive impact on company profits & business confidence – good news for the stock market and also for the growth of small and large businesses alike.

Output of Consumer Goods

Output of Capital Goods

C2

C1

X1 X2

A

B C

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Percentage growth in GDP and percentage of the labour force unemployed

UK Economic Growth and Unemployment

Source: Reuters EcoWin

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Real GDP growth

Unemployment rate (%)

Living standards and life expectancy

―We now expect to live on average 30 years longer, to work almost half the amount of time we used to every year, and to enjoy an array of new goods and services, including air travel, antibiotics, computers and televisions. Economic growth and rising living standards has also meant a cut in rates of carbon emissions and natural resource depletion never possible in the 20th century‖

Source: Professor Nick Crafts, 2002 Royal Economic Society Public Lecture, December 2002

Benefits of growth for the environment

Growth can also create benefits to the economy which could help protect the environment such as more investment, innovation and research and development, resulting in more efficient production processes to reduce costs. This could reduce the amount of waste and resources needed for the same output and with few defects.

Consumers and businesses also play a large part in protecting the environment. Attitudes towards ―green‖ products have changed over the years which have become the new ―in‖ thing, from foods to clothes to cars. Firms are now showing off their green credentials at every opportunity because there is a market for it. Toyota‘s Prius was the first mainstream hybrid which became fashionable after celebrities in Hollywood started purchasing them, and sales took off. In the UK, Sainsbury‘s now ensures that its plastic bags are made up of 33% recycled plastic. Ethical consumerism and

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deeper corporate social responsibility when it comes to environmental issues has undoubtedly become more widespread in recent years.

Disadvantages of economic growth

There are some economic and social costs of a fast-expanding economy. The two main concerns are firstly that growth can lead to a pick up in inflation and secondly, that it can have damaging effects on our environment, with potentially long-lasting consequences for future generations.

(1) Inflation risk: If demand races ahead of aggregate supply.

(2) Environmental concerns: Growth cannot be separated from its environmental impact. Fast growth can create negative externalities for example increased noise and lower air quality arising from air pollution and road congestion, increased consumption of de-merit good and the huge increase in household and industrial waste. These externalities reduce social welfare and can lead to market failure.

Growth that leads to environmental damage can have a negative effect on people‘s quality of life and may also impede a country‘s sustainable rate of growth. Examples include the destruction of rain forests through deforestation, the over-exploitation of fish stocks and loss of natural habitat created through the construction of new roads, hotels, retail malls and industrial estates.

In the case of deforestation, it releases more CO2 into the atmosphere each year than all of the world's planes, trains and automobiles put together.

Globally, an area almost the size of England and Wales is cut down every year releasing billions of tons of CO2 into the atmosphere.

Using up scarce resources

The world‘s resources are limited, and recognizing this fact and trying to preserve them for future generations is one of the underlying conditions of sustainable growth. Our rampant use of oil has run many reserves dry and each year it becomes more difficult to find new oil fields. Even water, which so many people take for granted will become a scarce resource, like many other raw materials. According to the United Nations, by 2025 1.8bn people will be affected by water scarcity. The pollution caused by economic growth is another concern.

The 1st Stern Report published in the autumn of 2006 highlighted the potential dangers of our blatant disregard for the environment, especially our large amounts of CO2 emissions. It is also predicted that many species will become extinct as forests and jungles, homes for many animals, are cut down to pave way for the growing world population.

At present 16,000 species are threatened today. In 1900 according to the UN‘s Global Environmental Outlook, there were 7.91 hectares per person, while it is estimated that there will only be 1.63 by 2050 if present trends continue.

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Trend Growth

The trend rate of growth is the long run average rate for a country over a period of time. Measuring the trend requires a long-run series of data to identify the different stages of the economic cycle and then calculate average growth rates from peak to peak or trough to trough.

Another way of thinking about the trend growth rate is to view it as a safe speed limit for the economy. In other words, an estimate of how fast the economy can reasonably be expected to grow over a number of years without creating an increase in inflationary pressure.

Above trend growth – positive output gap: If the economy grows too quickly (much faster than the trend) – then aggregate demand will eventually exceed long-run aggregate supply and lead to a positive output gap emerging (excess demand in the economy). This can lead to demand-pull and cost-push inflation.

Below trend growth – negative output gap: If the economy experiences a sustained slowdown or recession (i.e. growth is well below the trend rate) then output will fall short of potential GDP leading to a negative output gap. The result is downward pressure on prices and rising unemployment because of a lack of aggregate demand.

For the UK, the trend rate of growth is estimated to be between 2.5 – 2.7% per year. Obviously it is much higher for many emerging market countries that are enjoying rapid growth and major economic change. China‘s trend growth rate is probably closer to 8 or 9% per year whilst for India the long run average growth rate is well above 6% a year.

This short extract taken from a research paper produced by economists working at the UK Treasury provides a neat summary of some of the key factors that can shape how quickly a country can grow.

Demand and supply factors influence growth of GDP

Many factors influence the rate of economic growth. Some factors, such as changes in consumer and business confidence, aggregate demand conditions in the UK‘s trading partners, and monetary and fiscal policy, tend to have a mainly temporary effect on growth. Other factors, such as the rates of population and productivity growth, have more enduring effects, and help to determine the economy‘s average growth rate over long periods of time.

Source: Adapted from a HM Treasury paper www.hm-treasury.gov.uk

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Annual percentage change in real national output

Growth Rates for selected Countries

Source: Reuters EcoWin

00 01 02 03 04 05 06 07 08

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India

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The effects of an increase in long run aggregate supply are traced in the diagram below.

Potential output depends on the following factors

General

Price

Level

Real National Income

AD1

SRAS

Pe

Y1

An outward shift in LRAS helps to increase the economy‘s trend rate

of growth – it represents an increase in potential GDP

LRAS1 LRAS2

YFC2 Y1

AD2

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(1) The growth of the labour force -- those people able available and willing to find employment: The Government has invested heavily in a number of schemes designed to raise employment including New Deal and reforms to the tax and benefit system. Changes in the age structure of the population also affect the total number of people seeking work. And we must also consider the effects that migration of workers into the UK from overseas, including the newly enlarged European Union, can have on our total labour supply.

(2) The growth of the nation‟s stock of capital – driven by the level of fixed capital investment.

(3) The trend growth of productivity of labour and capital. For most countries it is what happens to productivity that drives the long-term growth. The causes of improved efficiency come from making markets more competitive and achieving increased output per work within individual plants and factories.

(4) Technological improvements are important because they reduce the costs of supplying goods and services which leads to an outward shift in a country‘s production possibility frontier

Science the key to economic growth

Lifting the number of science graduates is important for the future success of Northern Ireland a leading figure in the UK science world has claimed. Dr Norman Apsley said that encouraging more students to take Science, Technology, Engineering, and Mathematics would send a positive message to new businesses and potential inward investors. "If increasing exports can help to rebalance the economy, it makes sense to increase the flow of skilled, qualified people into key export areas,‖ he said.

Source: Adapted from an article in Belfast Today, July 2008

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Source: OECD World Economic Outlook

United Kingdom - Potential GDP and Trend Growth

Source: Reuters EcoWin

76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

10**

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Trend Growth Rate

Key terms

Ecological debt Ecological debt is the concept that people‘s demands have exceeded the Earth‘s ability to cope with the rising consumption of its resources.

Sustainable growth Growth which meets the needs of the present without compromising the ability of future generations to meet their own needs. It is the idea that we don‘t live ―beyond our means‖.

World Bank Provides technical advice, loans. Credits and grants for poverty reduction and the improvements of living standards.

Tragedy of the Commons

A conflict over finite resources between individual interests and the common good which can lead to irreversible damage to the stock of natural resources available to current and future generations.

Suggestions for further reading on economic growth

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on economic growth:

Growth and the environment

Can China make the polluter pay? (BBC news, September 2007)

Commission on Growth and Development

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Images reveal 'rapid forest loss' (BBC news, June 2008)

Map reveals extent of deforestation in tropical countries (Guardian, July 2008)

Nature loss 'to hurt global poor' (BBC news, May 2008)

Paying the price for global growth (Guardian, July 2008)

The Amazon in graphics (BBC news, May 2008)

The Green Room (BBC)

UK exporting emissions to China (BBC news, October 2007)

Articles on fast-growing economies

Fast economic growth in Africa (BBC news, October 2007)

Goldman Sachs and the BRIC economies

Hong Kong tax cut to boost growth (BBC news, October 2007)

India urged to focus on farming (BBC news, June 2008)

India‘s economy – reasons to be cheerful (BBC news, June 2008)

Korea heads for new growth paths (BBC news, June 2008)

Articles on innovation and economic growth

Sainsbury Review of Science and Innovation

New boom time for British technology? (BBC news, September 2007)

Innovation 'starts in education' (BBC news, March 2008)

UK Productivity During The Blair Era (Centre for Economic Performance) – PDF file

UK productivity lags behind industrial rivals (The Guardian, June 2007)

World Competitiveness Online

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17. Inflation and Deflation

What causes rising prices in an economy? And what tools are available to keep inflation under control? This chapter focuses on the causes of inflation and some of the consequences.

What is inflation?

Inflation is a sustained increase in the general price level leading to a fall in the purchasing power of money. The greatest falls in the value of money came during the late 1970s and again in the late 1980s when there was acceleration in the rate of inflation in the UK. In contrast, the last fifteen years have seen much lower rates of inflation – and money has held its value better.

The next chart shows the UK consumer price index since 1930.

1987 = 100

UK Consumer Prices - all items - annual index

Source: Reuters EcoWin

30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05

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The rate of inflation is measured by the annual percentage change in the level of consumer prices. The British Government has set an inflation target of 2% using the consumer price index (CPI).

It is the job of the Bank of England to set interest rates so that AD is controlled and the inflation target is reached. Since the Bank was made independent, inflation has stayed comfortably within target range for most of the time. Indeed the first time the target was over-shot was in March 2007 and then again in June 2008. At the time of writing the annual rate of inflation is well above the 2% target and even the Bank of England has forecast that it is likely to stay above 3% for some time to come. Has the inflation problem come back to haunt the UK economy? Time will tell!

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Annual percentage change in the Consumer Price Index

Consumer Price Inflation for the UK Economy

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

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Falling inflation does not mean falling prices!

Please remember that a fall in the rate of inflation is not the same thing as a fall in prices! Have a look at the chart above which measures the rate of consumer price inflation for the UK. Notice how in 1992 there was a steep drop in inflation from 7 per cent to 2.5% over the course of the year. Inflation was falling – but the rate remained positive – meaning that prices were rising but at a slower rate! A slowdown in inflation is not the same as deflation!

The process of calculating the rate of inflation in the UK

The consumer price index (CPI) is a weighted price index which measures the monthly change in the prices of goods and services. The spending patterns on which the index is weighted are revised each year, using information from the Family Expenditure Survey. The expenditure of some higher income households, and of pensioner households mainly dependent on state pensions, is excluded. As spending patterns change over time, the weightings used in calculating the CPI are altered. The consumer price index is now used as the main official measure of inflation in the UK

The changes in these weights reflect shifts in spending patterns of households in the British economy.

Calculating a weighted price index

The following hypothetical example shows how to calculate a weighted price index.

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Weights are attached to each category and then we multiply these weights to the price index for each item of spending for a given year.

The price index for this year is: the sum of (price x weight) / sum of the weights

So the price index for this year is 104.1 (rounding to one decimal place)

The rate of inflation is the % change in the price index from one year to another. So if in one year the price index is 104.1 and a year later the price index has risen to 112.5, then the annual rate of inflation = (112.5 – 104.1) divided by 104.1 x 100. Thus the rate of inflation = 8.07%.

Limitations of the Consumer Price Index as a measure of inflation

The CPI is a thorough indicator of consumer price inflation for the economy but there are some weaknesses in its usefulness for some groups of people.

The CPI is not fully representative: Since the CPI represents the expenditure of the ‗average‘ household, inevitably it will be inaccurate for the ‗non-typical‘ household, for example, 14% of the index is devoted to motoring expenses - inapplicable for non-car owners. Single people have different spending patterns from households that include children, young from old, male from female, rich from poor and minority groups. We all have our own ‗weighting‘ for goods and services that does not coincide with that assigned for the consumer price index.

Housing costs: The ‗housing‘ category of the CPI records changes in the costs of rents, mortgage interest, property and insurance, repairs. It accounts for around 16% of the index. Housing costs vary greatly from person to person, from the young house buyer, mortgaged to the hilt, to the older householder who may have paid off his or her mortgage. The CPI does not include house prices in its calculation.

Changing quality of goods and services: Although the price of a good or service may rise, this may be accompanied by an improvement in quality as the good. It is hard to make price comparisons of, for example, electrical goods over the last 20 years because new audio-visual equipment is so different from its predecessors. In this respect, the CPI may over-estimate inflation. The CPI is slow to respond to the emergence of new products and services.

Since 2007, people have been able to log on to the Office of National Statistics website to use their own personal inflation calculator!

Category Price Index Weighting Price x Weight

Food 104 19 1976

Alcohol & Tobacco 110 5 550

Clothing 96 12 1152

Transport 108 14 1512

Housing 106 23 2438

Leisure Services 102 9 918

Household Goods 95 10 950

Other Items 114 8 912

100 10408

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Annual percentage change in the retail price index and CPI

Retail Price and Consumer Price Inflation in the UK

Source: UK Statistics Commission

97 98 99 00 01 02 03 04 05 06 07 08

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Consumer price index

All items retail price index (RPI)

One of the big issues during 2007 and 2008 has been the difference in measured inflation between the Consumer Price Index (CPI) and the Retail Price Index (RPI). The latter includes mortgage interest costs in its calculation and, as our chart above shows the RPI has been persistently above that of the CPI over recent years. Perhaps the RPI is tracking more accurately the true rate of price inflation in the economy? With rising oil prices, energy bills, transport fares, insurance premiums, food costs and holiday prices, many people have been bemused that the official inflation data seems to bear little resemblance to their own experience.

Deflation

Price deflation is the opposite of inflation and happens when the rate of inflation becomes negative. I.e. the general price level is falling and the purchasing power of say £1,000 in cash is increasing. Some countries have experienced bouts of deflation in recent years; perhaps the most well-known example was Japan during the late 1990s and into the current decade. In Japan, the root cause of deflation was slow growth and a high level of spare capacity in many industries that was driving prices lower.

There has been some price deflation in the UK – not for the whole economy – but for items such as clothing and textiles where many prices of clothing on the high street have been driven lower by cheaper imports; audio-visual equipment, computers and many other household goods. The effects of technological change in increasing supply at lower costs are important when explaining deflation in some UK markets. Rapid advances in technology help to explain for example the sharp fall in the prices of state of art digital cameras and plasma televisions, which has made the digital age accessible to millions of consumers.

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Hyperinflation

Hyperinflation is extremely rare. Recent examples include Yugoslavia Argentina, Brazil, Georgia and Turkey (where inflation reached 70% in 1999). The classic example of hyperinflation was of course the rampant inflation in Weimar Germany between 1921 and 1923. When hyperinflation occurs, the value of money becomes worthless and people lose all confidence in money both as a store of value and also as a medium of exchange. The current hyperinflation in Zimbabwe is a good example of the havoc that can be caused when price inflation spirals out of control. It has made it virtually impossible for businesses to function in any kind of normal way and led in part to the desperately critical political situation that Zimbabwe now faces.

Often drastic action is required to stabilize an economy suffering from very high and volatile inflation – and this leads to political and social instability. The International Monetary Fund is often brought into the process of implementing economic reforms to reduce inflation and achieve greater financial stability.

For Britain the worst inflation experienced in modern times happened during the mid to late 1970s when prices were rising at an annual rate of over twenty per cent. At the same time the economy was suffering from slow growth and rising unemployment and this gave rise to stagflation.

Inflation rose again in the late 1980s following an economic boom that was allowed to get out of control. By the start of the 1990s inflation was over ten per cent and it required a painful recession to get rid of most of the inflationary pressures in the economy.

Inflation winds hit the UK economy

―Over this year the west wind of a credit crunch emanating from the United States and the east wind of higher energy and food prices resulting from the strength of Asian economies have been stirring up the waters through which our economic ship must pass.‖

―The ‗non-inflationary consistently expansionary‘ decade, has drawn to a close. Inflation is set to increase over the next few months. Oil prices have doubled since the beginning of last year, and, in real terms, are now as high as they were in the 1970s. And further sharp increases in domestic gas and electricity prices are probably on their way.‖

Source: Mervyn King, Governor of the Bank of England, Mansion House speech, June 2008

The main causes of inflation

Inflation can come from both the demand and the supply-side and also from internal and external economic events.

Home and Away

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Some inflationary pressures direct from the domestic economy, for example the decisions of the utility businesses providing electricity or gas or water on their tariffs for the year ahead, or the pricing strategies of the food retailers based on the strength of demand and competitive pressure in their markets. A rise in the rate of VAT would also be a cause of increased inflation because it increases a firm‘s production costs.

Inflation can also come from external sources, for example a sustained rise in the price of crude oil or other imported commodities, foodstuffs and beverages.

Fluctuations in the exchange rate can also affect inflation – for example a fall in the value of the pound against other currencies might cause higher import prices for items such as foodstuffs from Western Europe or technology supplies from the United States – which feeds through directly or indirectly into the consumer price index.

At AS level we usually make a distinction between demand-pull inflation and cost-push inflation. In the next section we focus on these two causes:

Demand-pull inflation

Demand pull inflation occurs when aggregate demand and output is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap. When there is excess demand in the economy, producers are able to raise their prices and achieve bigger profit margins because they know that demand is running ahead of supply.

Typically, demand-pull inflation becomes a threat when an economy has experienced a strong boom with GDP rising faster than the long run trend growth of potential GDP. The last time this happened to any great extent in the UK economy was in the late 1980s under Chancellor Nigel Lawson.

General

Price

Level

Real National Income

AD1

SRAS

P1

Y1

LRAS

Yfc

P2

Y2

AD2

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Demand-pull inflation is likely when there is full employment of resources and aggregate demand is increasing at a time when SRAS is inelastic as shown in the diagram above. We can also show it using a similar AD-AS diagram below.

In the diagram above we see a large outward shift in AD perhaps caused by a consumer boom. This takes the equilibrium level of national output beyond full-capacity national income (Yfc) creating a positive output gap. This would then put upward pressure on wage and raw material costs – leading the SRAS curve to shift inward and causing real output and incomes to contract back towards Yfc (the long run equilibrium for the economy) but now with a higher general price level (i.e. there has been some inflation).

General

Price

Level

Real National Income

AD1

SRAS1

P1

Y1

LRAS

Yfc

P2

Y2

AD2

SRAS2

P3

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Output Gap = Actual GDP - Potential GDP. CPI inflation - annual % change in prices

The Output Gap and Consumer Price Inflation

United Kingdom, Output gap of the total economy Consumer Price Inflation [ar 4 quarters]Source: Reuters EcoWin

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Inflation

Excess supply in a recession

Excess demand in the economy

The main causes of demand-pull inflation

1. A depreciation of the exchange rate which increases the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while exports grow, AD in will rise – and there may be a multiplier effect on the level of demand and output

2. Higher demand from a fiscal stimulus e.g. via a reduction in direct or indirect taxation or higher government spending. If direct taxes are reduced, consumers will have more disposable income causing demand to rise. Higher government spending and increased government borrowing feeds through directly into extra demand in the circular flow

3. Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand – for example in raising demand for loans or in causing sharp rise in house price inflation. Monetarist economists believe that inflation is caused by ―too much money chasing too few goods‖ and that governments can lose control of inflation if they allow the financial system to expand the money supply too quickly.

4. Faster economic growth in other countries – providing a boost to UK exports overseas. Export sales provide an extra flow of income and spending into the UK circular flow – so what is happening to the economic cycles of other countries definitely affects the UK

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Cost-push inflation

Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit margins. There are many reasons why costs might rise:

1. Component costs: e.g. an increase in the prices of raw materials and other components used in supplying goods and services. This might be because of a rise in world commodity prices such as oil, copper and agricultural products used in food processing. A good recent example is the surge in the world price of wheat

2. Rising labour costs - caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low because skilled workers become scarce and this can drive pay levels higher and also happen when people expect higher inflation so they bid for higher pay in order to protect their real incomes.

3. Expectations of inflation are important in shaping what actually happens to inflation! When people see prices are rising for the everyday items they purchase they rightly start to get concerned about the effects of inflation on their real standard of living. One of the dangers of a pick-up in inflation is what the Bank of England calls ―second-round effects‖ i.e. an initial rise in prices triggers a burst of higher pay claims as workers look to protect their way of life. The UK government has been very keen in 2007 and 2008 to keep pay agreements under control, not least with millions of public sector workers such as teachers, nurses and people working in the protective services (fire, police and ambulance staff).

4. Higher indirect taxes imposed by the government – for example a rise in the specific duty on alcohol and cigarettes, an increase in fuel duty or a rise in the standard rate of Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers.

5. A fall in the exchange rate – this can cause cost push inflation because it normally leads to an increase in the prices of imported products. For example during 2007-08 the pound fell heavily against the Euro leading to a jump in the prices of imported materials from Euro Zone countries.

Cost-push inflation such as that caused by a large and persistent rise in the world price of crude oil can be illustrated by an inward shift of the short run aggregate supply curve. The fall in SRAS causes a contraction of national output together with a rise in the level of prices.

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Quick True or False Quiz on Inflation

1. When the rate of inflation rises, all goods and services become more expensive

2. If the rate of inflation falls from 6% to 2% then pensioners on fixed incomes will be

able to buy goods and services more cheaply

3. If the consumer price index for a country was 116 in 2007 and 108 in 2008 we can

calculate that the rate of inflation between 1997 and 1998 was –8%

4. Inflationary pressures tend to fall during an economic recession

5. Other things remaining the same, falling prices lead to a rise in people‘s real

incomes

Demand pull or cost push inflation?

1. Higher retail sales spending and consumer credit figures are announced

2. A fall in the value of the exchange rate causes an increase in the price of imported

components for the UK motor car industry

3. The number of people unemployed in the UK falls to a twenty five year low

General

Price

Level

Real National Income

AD

SRAS1

P1

Y1

LRAS

Yfc

SRAS2

P2

Y2

An important note:

Many of the causes of cost-push inflation come from external economic shocks – e.g. unexpected volatility in the prices of commodities and movements in the exchange rate.

A country can also import cost-push inflation from another country that is suffering from rising inflation of its own.

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4. Oil prices increase as OPEC cuts it‘s supply

5. Skills shortages in engineering industries lead to higher wages

6. A wet summer raises the price of vegetables in the supermarkets

7. A rise in the world price of copper used in the telecommunications industry

8. The government announces a rise in the standard rate of Value Added Tax (VAT) from

17.5% to 20%

Which government policies are most effective in reducing inflation?

Most governments now give a high priority to keeping control of inflation. It has become one of the key objectives of macroeconomic policy. The Governor of the Bank of England, Mervyn King gave this defence of the need to keep a lid on price increases in a speech in June 2008.

Maintaining price stability

"The lesson of the past fifty years is that, when inflation becomes embedded, the cost of getting it back down again is a prolonged period of sluggish output and high unemployment. Price stability – returning inflation to the target – is a precondition for sustained growth."

Source: Mervyn King, Governor of the Bank of England, Mansion House speech, June 2008

Inflation can be reduced by policies that (i) slow down the growth of AD or (ii) boost the rate of growth of aggregate supply (AS). The main anti-inflation controls available to a government are:

1. Fiscal Policy: If the government believes that AD is too high, it may reduce its own spending on public and merit goods or welfare payments. Or it can choose to raise direct taxes, leading to a reduction in real disposable income. Normally when the government wants to “tighten fiscal policy” to control inflation, it will seek to cut spending or raise tax revenues so that government borrowing (the budget deficit) is reduced. This helps to take money out of the circular flow of income and spending.

2. Monetary Policy: A tightening of monetary policy involves higher interest rates to reduce consumer and investment spending. Monetary policy is now in the hand of the Bank of England –it decides on interest rates each month. The Bank was made independent in May 1997.

3. Supply side economic policies: Supply side policies include those that seek to increase productivity, competition and innovation – all of which can maintain lower prices. These are important ways of controlling inflation in the medium to long term.

The most appropriate way to control inflation in the short term is for the government and the central bank to keep control of aggregate demand to a level consistent with our productive capacity. The consensus among economists is that AD is probably better controlled through the use of monetary policy rather than an over-reliance on using fiscal policy as an instrument of demand-management. But in the long run, it is the growth of a country‘s supply-side productive potential that gives an economy the flexibility to grow without suffering from acceleration in cost and price inflation.

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Why has inflation remained low in the UK over recent years?

For most of the last decade or more, the UK economy has enjoyed a period of low and stable inflation with prices rising on average by no more than a couple of percentage points each year. No one factor accounts for this period of low inflation – some are demand-side and others are supply-side factors - but among them we can highlight the following:

1. Low wage inflation from the labour market: Wages have been growing at a fairly modest rate in recent years despite a large fall in unemployment.

2. Low global inflation and deflation in some countries: Inflation among leading economies has been lower than in the 1970s and 1980s and this decline in global inflation has filtered through to the UK.

3. The effectiveness of monetary policy in the UK: The success of the Bank of England through monetary policy in keeping aggregate demand under control through interest rate changes

4. Increased competition: Partly as a result of globalisation, many markets have seen more intensive competition, placing discipline on businesses to control costs, reduce their profit margins and seek improvements in efficiency.

5. Information technology effects: The rapid expansion of information and communication technology has helped to reduce costs and has made prices more transparent for consumers – e-commerce has contributed to falling prices in many markets for example the rapid expansion of price comparison sites and new online businesses competing for sales with established ―bricks and mortar‖ firms.

Annual Percentage Change, source: ONS

Consumer Price Inflation for Goods and Services

Source: Reuters EcoWin

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Goods and Services Together

Inflation in Services

Inflation in Goods

2008 – The return of rising inflation to the UK economy

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2008 was a year when rising inflation came to dominate the newspaper headlines and TV news bulletins almost on a daily basis and the UK economy was not alone in that! In May 2008, the International Monetary Fund (IMF) warned that ―global inflation had re-emerged as a major threat to the world economy due to soaring energy and food prices.‖ And in a pessimistic report published in June 2008, the Bank for International Settlements reported that that there was ―a clear and present danger of rising global inflation and inflationary expectations.‖ Figures suggested that global inflation had risen by a full two percentage points in the space of just one year.

In the UK inflation jumped above the government‘s target range of 1%-3% in June 2008 and the Bank of England issued a series of warnings that the official measure of inflation would stay above target well into 2009.

So what has caused this pick-up in the rate of inflation? As we have seen in this chapter, there are numerous reasons why prices move higher. Here are some of the main influences in the last couple of years.

1. A rise in world oil prices: Between May 2007 and May 2008, the price of a barrel of crude oil (measured in US dollars) more than doubled. A new high of over $145 a barrel was seen on July 3rd, well beyond the previous inflation-adjusted peak of $101.70 in April 1980, a year after the Iranian revolution. Higher oil prices feed through to more expensive goods and services because oil remains an essential input into so many different production processes. It also affects directly the price of petrol and diesel at the pumps and also the price that households and business have to pay for their heating oils.

2. A surge in global food prices. Between the start of 2002 and early 2008, basic global food commodity prices including wheat, rice and corn rose by 220%. Many factors have caused this including a shift towards bio-fuel production which has affected the acreage of crops made available for foods together with fast-growing demand for wheat and meat among consumers in emerging market countries at a time when global supply of food has become more inelastic. In 2008, ethanol production is forecast to consume 30% of 2008's entire US corn crop.

3. Inflation has been increasing in a number of emerging countries over the past year notably countries such as China, Vietnam, the Philippines and India. For much of the past decade, Chinese manufacturers have been exporting price deflation to other parts of the world economy as prices of their output have been falling. But increased energy prices and more expensive food have turned this situation around. The rise in inflation was made worse because food tends to account for a larger proportion of consumer price indexes. Vietnam reported a year-on-year inflation rate of 25% in May 2008 and India saw inflation rise to a new high of 12% in July 2008.

4. A booming world economy has put increasing pressure on scarce resources – many of the fastest-growing countries have been working close to full capacity as capital investment has not kept up with economic growth, thus pushing up wage inflation.

5. Booming property prices – in many of the richer advanced nations the last decade has seen a remarkable boom in property values driven higher in large part by a period of very low real interest rates and easy availability of credit. Cheap money has fuelled a borrowing boom which has kept demand for consumer goods and services high and risking an increase in demand-pull inflation. That boom came to an abrupt end with the credit crunch of 2007 and the subsequent collapse in property markets in many countries including the USA, Spain and the UK. But the wider inflationary effects on costs and prices will take longer to work through.

6. Exchange rate pegging: Some emerging market countries have also pegged their currencies to the US dollar. Successive cuts in US interest rates have helped to bring the dollar down (e.g. against the Euro) and caused the exchange rates of pegged currencies to depreciate as well. This has exacerbated inflation problems in these countries, which were

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already struggling with over-heating of their economies because a falling exchange rate leads to higher prices for imported goods and services.

Annual percentage change in the Consumer Price Index and monthly average for Brent Crude

UK Inflation and Crude Oil Prices

Source: Reuters EcoWin

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Looking through these factors, we see that many of the reasons for rising inflation in the UK economy have come from external events – indeed some economists have claimed that our inflation is not really home made but the result of a combination of outside economic influences over which we have little direct control.

Other economists have been more critical of UK macroeconomic policy in particular the Bank of England for not moving to dampen the property and credit boom earlier on during the current decade.

And the government has been criticized for running a persistently large budget deficit which has also stimulated domestic demand.

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Annual percentage change in earnings and consumer prices

Earnings and Prices

Source: Reuters EcoWin

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Consumer price inflation

Average Earnings

The big fear for the UK is that rising cost-push and demand-pull inflation will feed through into a jump in inflation expectations and a wage-price spiral where workers look for higher pay settlements to compensate them for a loss of real income. This danger is made more acute because, for many people, the official rate of inflation seems to be little resemblance to the changes in their own cost of living. Whilst the economic data shows price increases running at around 3% a year, for millions of households experiencing much higher gas, electricity, fuel and food prices, inflation is probably running at more than twice this figure. Little wonder that they are worried about sizeable reductions in the real purchasing power of their incomes.

One important evaluation point is that the rate of inflation tends to lag the economic cycle. What this means is that once inflation starts to pick up and the economy enters into a slowdown, inflation can carry on rising well after the downturn has started. Indeed the peak in inflation might come at least a year after growth has begun to moderate. This was the case in the late 1980s and early 1990s - - the last time we experienced a full-on recession - - and it is possible it will happen this time as well.

The current surge in inflation is a long way short of what happened in the 1970s and late 1980s – - the era of stagflation - - but the events of 2007 and 2008 are a reminder that, rather like the disease malaria, inflation can be controlled but it rarely goes away for good!

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Key terms

Consumer price index CPI is based mainly on a ―basket‖ of food and other consumer goods such as furniture, along with transport costs such as fuel. It does not include housing costs, particularly mortgage interest payments. Also, its methodology is based on an international classification system, which makes it more useful to compare rates with other countries.

Inflation target The Government sets the Bank of England a CPI inflation target, which is currently 2 per cent. When inflation rises or falls more than 1 per cent above or below the target, the Governor of the Bank of England must write an open letter to the Chancellor of the Exchequer to explain why.

Inflationary pressures Occurrences likely to lead to price rises. These can come from both the demand and the supply-side.

Stagflation A combination of slow economic growth and rising inflation, can lead to stagflation. The most notable recent period of stagflation occurred during the 1970s, when world oil prices rose dramatically, and UK inflation rose at one point to nearly 30 per cent.

Wage price spiral A situation where workers bid for higher wages because they have seen their real income eroded by rising prices. This can lead to a further burst of cost-push inflation in an economy.

Retail Price Index (RPI) The RPI is broadly similar to the CPI but includes mortgage repayments and some taxes, and excludes the top 4 per cent of earners. It is used to calculate increases in wages, state benefits and pensions.

Suggestions for Further Reading on Inflation

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on inflation.

Measuring inflation

Measuring Inflation - Changes to CPI and RPI shopping baskets (UK Statistics Commission)

Muffins enter typical UK 'basket' (BBC news, March 2008)

True cost of living gets personal (Guardian, July 2008)

Whose wallet is being hit by inflation? (BBC news, June 008)

Inflation in the UK economy

Back to the 1970s (BBC news, July 2008)

Consumer price inflation could top 4% (BBC news, June 2008)

Inflation fears of a 1970s comeback (Guardian, June 2008)

Inflation woe set to worsen (BBC news, May 2008)

Rise in food prices sends inflation to 18-year high (Guardian, June 2008)

Understanding inflation – a user‘s guide (The Times, June 2008)

Unwelcome surge in inflation (The Economist, March 2008)

What keeps prices rising? (BBC news, June 2008)

Inflation in the world economy

Appetite for bio-fuels starves the poor (Guardian, July 2008)

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China tries to tackle inflation as growth exceeds 10% for 5th year (Guardian, May 2008)

Indian inflation at record levels (BBC news, June 2008)

Inflation in the Euro Zone at a new high (BBC news, June 2008)

Mexico caps prices of basic foods (BBC news, June 2008)

Zimbabwe inflation at 2,200,000% (BBC news, July 2008)

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18. Employment and Unemployment

We now turn our attention to the labour market and consider why people may find themselves out of work and cannot find a job. Having many people out of work leads to large economic and social costs; we look at which economic policies are likely to be most effective in keeping unemployment as low as possible.

Defining unemployment

The unemployed are people who are registered as able, available and willing to work at the going wage rate but who cannot find a job despite an active search for work. This last point is important for to be classified as unemployed, one must show evidence of being active in the labour market.

Measuring unemployment

There are two main measures of unemployment in the UK:

o The Claimant Count measure of unemployment includes those unemployed people who are eligible to claim the Job Seeker's Allowance (JSA). The Claimant Count is a ―head-count‖ of people claiming unemployment benefit.

o The Labour Force Survey covers those who are without any kind of job including part time work but who have looked for work in the past month and are able to start work in the next two weeks. The figure also includes those people who have found a job and are waiting to start in the next two weeks.

On average, the labour force survey measure has exceeded the claimant count by about 400,000 in recent years. Because it is a survey - albeit a large one and one that provides a rich source of data on the employment status of thousands of households across the UK - there will always be a sampling error in the data. The Labour Force Survey uses the internationally agreed definition of unemployment and therefore best allows cross-country comparisons of unemployment levels.

No measure of unemployment is completely accurate since there are some people out of work but looking for a job who are not picked up by the official statistics. An example of this are discouraged workers who may have been out of employment for a lengthy time and who have lost the will and the motivation to keep applying for jobs.

Under-counting the true level of unemployment

Unemployment in Britain may be twice as high as official statistics show. Research on the UK labour market by economists at HSBC bank takes into account anybody who is 'economically inactive', but looking for a job, not just those who are eligible for unemployment benefits. The report estimates that there are 3.4m Britons who are unemployed, as opposed to the International Labour Organisation's estimate of 1.4m people. Britain's official unemployment rate is 4.8% - one of the lowest rates of unemployment in the European Union.

Source: Adapted from newspaper reports, July 2004

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people aged 16-59 (women) / 64 (men), seasonally adjusted

Unemployment in the UK Economy

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

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Labour Force Survey

The most recent changes in claimant count and labour force survey measures of unemployment are summarised in the chart above and the table below.

Labour Force Survey Unemployment

(seasonally adjusted)

Claimant Count Unemployment

(seasonally adjusted)

Level Annual change Rate Level Annual change Rate

000s 000s % 000s 000s %

2000 1,588 -140 5.4 1,088 -160 3.6

2001 1,490 -98 5.1 970 -119 3.1

2002 1,529 39 5.2 947 -23 3.1

2003 1,489 -40 5.1 933 -14 3.0

2004 1,424 -65 4.8 853 -80 2.7

2005 1,465 41 4.9 862 9 2.7

2006 1,671 206 5.4 945 83 2.9

2007 1,652 -19 5.4 863 -81 2.8

During the current decade, the level of unemployment as measured by the labour force survey has stayed fairly constant at or around 5per cent of the labour force. The claimant count measure has continued to edge lower and has been less than 3 per cent over the last five years. That said the rate of unemployment in the UK is set to rise during 2009 because of the effects of the economic slowdown. Thousands of jobs are being lost in sectors linked to the housing market and also in

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financial services and retailing – both of which have been hit hard by the effects of the credit crunch.

We now turn to looking at some of the underlying causes of unemployment.

Frictional Unemployment

Frictional unemployment is transitional unemployment due to people moving between jobs:

For example, redundant workers or people joining the labour market for the first time such as university graduates may take time to find the types of work they want at wage rates they are prepared to accept. Many are unemployed for a short time whilst involved in job search.

Imperfect information in the labour market may make frictional unemployment worse if the jobless are unaware of the available jobs. Incentives problems can also cause some frictional unemployment as some people looking for a new job may opt not to accept paid employment if they believe the tax and benefit system will reduce the net increase in income from taking work. When this happens there are disincentives for the unemployed to accept work.

In short, frictional unemployment happens when it takes time for the labour market to match the available jobs with those people seeking work. The chart below is linked to this cause of unemployment because it shows the monthly level of unfilled vacancies in the UK. Stripping out the effects of seasonal variations in the demand for labour, we see that in the summer of 2008 there were still well over 600,000 vacancies at a time when unemployment was 1.65 million. If the economy was better at filling these jobs, it could achieve a much lower level of unemployment.

Three month average, non and seasonally adjusted

Unfilled Vacancies in the UK Labour Market

Source: Reuters EcoWin

01 02 03 04 05 06 07 08

525000

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Unfilled Vacancies

Seasonally adjusted

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Structural Unemployment

Structural unemployment occurs when there is a long run decline in demand in an industry leading to a reduction in employment because of international competition. Globalisation is a fact of life and inevitably it leads to changes in the patterns of trade between countries from year to year. Britain has probably now lost forever, its cost advantage in manufacturing goods such as motor cars, household goods and audio-visual equipment, indeed our manufacturing industry has lost over 400,000 jobs in the last five years alone as production has shifted to lower-cost centres for example in Eastern Europe and emerging market countries in Far East Asia. Many of these workers may suffer from a period of structural unemployment, particularly if they are in regions of above-average unemployment rates where job opportunities are scarce.

Structural unemployment exists where there is a mismatch between their skills and the requirements of the new job opportunities.

Many of the unemployed from manufacturing industry (e.g. in coal, steel and engineering) have found it difficult to find new work without an investment in re-training. This problem is one of occupational immobility of labour and it is a supply-side cause of unemployment.

Cyclical Unemployment:

Cyclical unemployment is involuntary unemployment due to a lack of demand for goods and services. This is also known as Keynesian "demand deficient" unemployment. When there is a recession or a slowdown in growth, we see a rising unemployment because of plant closures, business failures and an increase in worker lay-offs and redundancies. This is due to a fall in demand leading to a contraction in output across many industries.

An important evaluation point to note is that the economy does not have to go into a full-scale recession for cyclical unemployment to start rising. Many jobs can be lost even in a mild slowdown phase and one reason for this is because of rising productivity. Say for example that a country‘s GDP is expanding at 1 per cent a year but output per worker is growing by 3 per cent. This means that the same national output can be produced using fewer workers.

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Having said that, a full-on recession is the main cause of big rises in demand-deficient unemployment and the previous charts try to show how you can illustrate this using AD-AS analysis and a simple labour market diagram. The demand for labour is derived from the goods and services that the economy needs to supply. So when there is an inward shift of AD, this feeds through into weaker demand for workers in manufacturing and supply-chain industries. The slowdown of 2008 and possible downturn in 2009 is likely to create extra cyclical unemployment for the UK.

Real wage unemployment:

This can happen when real wages are above their market clearing level leading to an excess supply of labour. Some economists believe that the minimum wage risks creating unemployment in industries where competition from low-labour cost producers is severe. As yet, there is relatively little evidence that the minimum wage has created rising unemployment on the scale that was feared.

Hidden unemployment

Undoubtedly there are thousands of people who by any reasonable definition are unemployed, but who are not picked up by the official statistics. Many have become discouraged workers and have stopped actively searching for work.

Rover – a mini case study in structural unemployment

MG Rover went into administration on the 8th April 2005 when the car deal with the Chinese company Shanghai Automotive Industry Corporation (SAIC) collapsed and the company did not

General

Price

Level

Real National Income

AD1

SRAS

P1

Y1

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Yfc

AD2

Y2

P2

Real Wage Level

LD2

W1

E2 YFC2 E1

Demand for Labour

W2

Employment of Labour

Supply of Labour

Fall in AD causes a negative output gap – with GDP well below potential

Slowdown or recession in the economy can lead to an inward shift in labour demand and a fall in total employment

The relationship between national output and demand for labour – when there is an economic recession or slowdown in growth, the demand for labour may fall as businesses look to cut back on employment in order to control costs. The result is a fall in employment and a rise in cyclical unemployment. This will affect some industries more than others depending on how severe the recessionary effects are in a particular sector of the economy.

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have sufficient cash to continue trading. The subsequent closure of the Longbridge site in the West Midlands on 15th April 2005 led to the loss of almost 6000 jobs.

Over three years later, the vast majority of the people formerly employed at the MG Rover plant have found new work but for many it has required periods of re-training, perhaps a move to another part of the country and not always a job offering the same wages as before. In April 2008, a BBC news report claimed that of the more than 6,000 workers who lost their jobs, only 139 were still registered as out of work. Plans for mass car manufacturing to return to the Longbridge site seem to have fallen through. But an ambitious regeneration programme has been launched. It will cost £750m and could create up to 10,000 jobs

Source: Adapted from news reports including: http://news.bbc.co.uk/1/hi/business/7371164.stm

Unemployment and the Production Possibility Frontier

If there are unemployed resources in the economy, this means that an economy will be operating within its production possibility frontier.

If the economy is successful in reducing unemployment, then output of goods and services can move closer to the frontier of the PPF – e.g. towards combinations marked by the letters A and B

The Consequences of Unemployment

High unemployment is widely recognised to create costs for individuals and for the economy as a whole. Some of these costs are difficult to value and measure, especially the longer-term social costs.

Output of Consumer Goods

Output of Capital Goods

C2

C1

X2 X1

A

B

C

Any point on the PPF represents a productively and allocative efficient allocation of resources. Points that lie within the curve represent an under-utilisation of scarce resources – including labour

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1. Loss of income: Unemployment normally results in a loss of income. The majority of the unemployed experience a decline in their living standards and are worse off out of work.

2. Negative multiplier effects: The closure of a local factory with the loss of hundreds of jobs can have a large negative multiplier effect on both the local and regional economy. One person‘s spending is another‘s income so to lose well-paid jobs can lead to a drop in demand for local services, downward pressure on house prices and ‗second-round employment effects‘ for businesses supplying the factor or plant that closed down.

3. Loss of national output: Unemployment involves a loss of potential national output (i.e. GDP operating below potential) and is a waste of scarce resources. If some people choose to leave the labour market permanently because they have lost the motivation to search for work, this can have a negative effect on long run aggregate supply and thereby damage the economy‘s growth potential.

4. Fiscal costs: The government loses out because of a fall in tax revenues and higher spending on welfare payments for families with people out of work. The result can be an increase in the budget deficit which then increases the risk that the government will have to raise taxation or scale back plans for public spending on public and merit goods.

5. Social costs: Rising unemployment is linked to social deprivation. For example, there is a relationship with crime and social dislocation including increased divorce rates, worsening health and lower life expectancy. Regions that suffer from persistently high unemployment see falling real incomes and a widening of inequality of income and wealth.

Government policies to reduce unemployment

Some countries are more successful than others in reducing the scale of unemployment. In the long term, effective policies are required for both the demand and the supply side of the economy so that enough new jobs are created and that people possess the skills and incentives to take those jobs.

In general the most effective policies are those that:

1. Improve the human capital of the workforce – so that more people have the skills to take the available jobs. Policies normally concentrate on improving the occupational mobility of labour. The pattern of employment in any modern economy is always changing, so people need to be flexible and willing to adapt to structural changes in industries.

2. Improve incentives for people to search and accept paid work – this may require reforms of the tax and benefits system for example a reduction in the basic rate of income tax. Or perhaps a change in welfare benefits such that people who find work do not experience a sharp withdrawal of benefits because they are now earning more. Targeted measures to improve incentives, including the linking of welfare benefits to participation in work-experience programmes which is part of the New Deal programme can have an impact.

3. Employment subsidies: Government subsidies for those firms that take on the long-term unemployed will create an incentive for businesses to expand their workforce. Subsidies may also be available for overseas firms locating in the UK as part of regional policy.

4. Achieve sustained growth – this requires that AD is sufficiently high for businesses to be looking to expand their workforce. The Keynesian theory of unemployment emphasises the argument that if monetary and fiscal policy does not keep demand at a high enough level, then the economy is less likely to be able to sustain high employment. However, not every increase in AD and production has to be met by employing more labour. Each year we expect to see a rise in labour productivity (more output per worker employed).

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Policies used in the UK to reduce unemployment

Demand side policies Supply-side policies

1. Employment subsidies for employers who take on the long-term unemployed (New Deal)

1. Welfare reforms – including lower starting rates of income tax and the introduction of tax credits

2. Financial assistance for inward investment from overseas

2. Policies to promote entrepreneurship and the growth of small-medium size enterprises

3. Monetary policy – low interest rates has allowed aggregate demand to grow despite a global economic slowdown. Fiscal policy is also boosting AD as the budget deficit increases

3. Increased spending on education and attempts to increase private sector spending on training

Evaluation points on unemployment policies

1. There are always cyclical fluctuations in employment. If growth can be sustained and monetary and fiscal policy can avoid a large negative output gap then it should be possible to create a steady flow of new jobs

2. Demand and supply-side policies need to work in tandem for unemployment to fall in the long term. Simply boosting demand if the root cause of unemployment is structural is an ineffective way of tackling the problem. If demand is stimulated too much, the main risk becomes one of rising inflation (i.e. the trade-off between these two objectives may worsen)

3. Full-employment does not mean zero unemployment! There will always be some frictional unemployment – it may be useful to have a small surplus pool of labour available. Most economists argue that in a modern economy there will always be some frictional unemployment of perhaps 2-3% of the labour force.

4. There are still large regional differences in unemployment levels which causes significant economic and external costs. Urban and regional regeneration can take decades to achieve.

Recent trends in UK unemployment

The main explanation behind the decline in unemployment has been economic growth. Other factors that have helped bring down the unemployment rate include:

1. Expansion of further and higher education - there is a trend for more young people choosing to delay their entry into the labour market and remain in full-time post-16 further and higher education to boost their qualifications. Government policies have an explicit aim of increasing the participation rate of 18 year-olds in higher education. This puts less pressure on the number of new entrants into the labour force looking for work.

2. "Discouraged worker effects" due to structural unemployment: Some workers have given up active job search, in the process become economically inactive and moved onto permanent sickness and invalidity benefits or early retirement. The precise number of people involved is difficult to calculate with accuracy – it probably affects several thousand people.

3. Employment creation from foreign investment: The British economy has been successful in attracting billions of pounds worth of inward investment from overseas

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companies. A high proportion of this has gone into building new plants in the UK and this has created thousands of new jobs helping to offset some of the regional disparities in unemployment.

4. Increased investment in worker training: This seems to have reduced structural unemployment. Labour shortages are problematic in some industries, notably in areas where house prices are high and unemployment rates have fallen below 2%. But taking the economy as a whole, it seems that shortages of labour have not proved to be as difficult as in previous phases of economic expansion. The main shortages are in highly skilled jobs and in areas where living costs are well above the national average. The government has suffered from a shortage of workers in key public sector jobs.

5. Increased flexibility in the labour market: This has made it easier for businesses to hire workers and match their desired labour input to planned production. The number of part-time workers on short-term contracts has grown by many thousands. There has also been greater functional flexibility with workers expected to perform a number of tasks within the business.

Can the UK achieve full-employment?

The British labour market has performed well over the last decade and more raising hopes that low unemployment be maintained for the foreseeable future. There is still much to be done to reduce unemployment in economically depressed areas. Although the average rate of unemployment has come down, jobless rates in excess of 10% are a feature of many towns and cities. And youth unemployment remains a serious problem. The sustained fall in unemployment has encouraged optimism that Britain can reach full-employment in the near future. Indeed, in some regions and towns and cities, full-employment is already a reality.

Percentage of the labour force, seasonally adjusted; 2008 forecast is from the OECD

Euro Zone and UK Unemployment

Source: Reuters EcoWin

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Economists agree that unemployment cannot fall to zero since there will always be frictional unemployment caused by people moving into the labour market and others switching between jobs. Full-employment might be defined as when the labour market has reached a state of equilibrium - i.e. when those who are willing and able to work at going wage rates are able to find work.

Skills Shortages

The prospect of reaching full-employment is diminished by the continuing problem of skills shortages. Skills shortages have been a recurrent problem in manufacturing jobs, but the problem has widened to new economy businesses and also the public services (including education and the NHS)

Closing the skills gap

Literacy, numeracy and skills levels in the UK are so poor that a quarter of employers struggle to fill job vacancies. A study by the national Skills Task Force backs up previous research by suggesting that nearly one in five adults - about seven million - have a lower level of literacy than the average 11 year old. Because of skills shortages, employers are lowering their expectations when recruiting people and cutting back on capacity and quality level.

The report finds that a quarter of adults are "functionally innumerate", and that one in three have less than five GCSE exam-passes. And it says employers believe almost two million of their staff is not fully proficient at their jobs

Adapted from news reports on the Skills Gap

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Unemployment as a percentage of the labour force, data for the 2007 comes from the OECD

Selected Unemployment Rates for EU Countries

United Kingdom Sweden

Spain Italy

Ireland Hungary

France Denmark

Source: Reuters EcoWin

96 97 98 99 00 01 02 03 04 05 06 07 08

2.5

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Key Concepts

Full employment When there enough job vacancies for all the unemployed to take work

Discouraged workers People often out of work for a long time who give up on job search

Immobility of labour Barriers to the movement of people between areas and between jobs

Keynesian unemployment

Unemployment caused by a lack of aggregate demand in the economy

Unemployment trap Disincentive effect if people are better off on benefits than working

Under-employment When people want to work full time but find that they can only get part-time work – the result is a loss of hours that the economy can use

Suggestions for further reading on unemployment

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on unemployment.

Claimants to work for benefits (BBC news, July 2008)

Jobs blow as haulage firm crashes (BBC news, July 2008)

Jobs go at rubber factory (BBC news, May 2008)

Jobs shortage for unskilled youths (BBC news, July 2008)

New jobs success for sacked staff (BBC news, April 2008)

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OECD predicts 100,000 rise in UK unemployment (Guardian, June 2008)

Starbucks cuts 500 shops and 12,000 jobs (BBC news, June 2008)

The end of Derry‘s shirt industry (BBC news, June 2008)

Unemployment blights Glasgow‘s children (Times, March 2008)

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19. Migration and the UK labour market

During the first half of the current decade, the UK economy experienced a significant increase in the level of net inward migration, where many more people were coming into the UK to live and work than were leaving. Many of these people have come to the UK from other EU countries especially the new member states of Eastern Europe. In this section we consider the significance of these migration trends for employment and unemployment in the UK labour market.

Factors affecting the direction and scale of migration

Many economic and social factors have combined to increase the rate of migration. Some of them are summarised below. In general, the incentive to migrate is strongest when the expected increase in earnings exceeds the cost of relocation.

1. Differences between countries in wages and salaries on offer for equivalent jobs

2. Access to the benefits system of host countries plus state education, housing and health care

3. Employment opportunities vary between nations

4. Desire to travel, learn a new language, pick up new skills and qualifications

5. Desire to escape political repression

6. The impact of satellite television in changing people‘s expectations

7. The effects of cheaper trans-national phone calls and the internet

8. Cheaper air travel and coach travel for example within the European Union

9. The unwillingness of people within the domestic economy to take certain ―drudge-filled‖ jobs such as porters, cleaners and petrol attendants

The effects of labour migration on the labour markets of richer nations inside the European Union including the UK depend on where the main source of competitive advantage lies, according to research from Marques and Metcalf in a paper delivered to the Royal Economic Society. They argued that industries that source their competitive advantage from a large, skilled workforce will have gained from an influx of younger, well-educated workers. Industries such as high-knowledge manufacturing, transportation and financial services may well gain from an increase supply of skilled workers from Eastern Europe.

In contrast industries that rely on low-educated labour-intensive workers will lose out because production will gravitate to countries where unit labour costs are lower. Examples of include textiles and clothing and leisure sectors where there has been a shift of production towards emerging market countries in the Far East.

The impact of migration on the UK economy

Have migrant workers provided a boost to the competitiveness and supply-side capacity of the UK economy? The debate will rage on for many years and I have provided some links to recent research reports and newspaper articles on this topic at the end of this chapter. It is important to be aware that with this kind of controversial issue, many of those putting forward evidence will be using normative economics heavily laden with value judgements and will often use data selectively to push their own point of view.

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Supporters of unrestricted inward migration have argued some of the following points:

1. Diversity: Greater economic and social diversity.

2. Fresh skills: Migrants can provide complementary skills to those of domestic workers, which can raise the productivity of both (a Brazilian child minder provides good quality child care at an affordable price which might then allow a highly paid female magazine editor to continue to work.)

3. Driver of innovation and entrepreneurship: Inward migration can also be a driver of technological change and a fresh source of potential entrepreneurs. Much innovation comes from the work of teams of people who have different perspectives and experiences. If migration promotes this diversity, there are positive externalities from the innovation that might flow.

4. Pressure on government to reform: Labour migration can also put political pressure on failing governments and regimes e.g. a mass exodus of productive workers from Zimbabwe.

5. Multiplier effects: New workers create new jobs, there is a multiplier effect if they find work and contribute to a nation‘s gross domestic product through a higher level of aggregate demand.

6. Reducing labour shortages: Migration can help to relieve labour shortages and thereby help to control wage inflation. In technical terms, this can reduce the non-accelerating inflation rate of unemployment (the NAIRU.)

7. Income flows: Remittances sent home by migrants can add substantially to the GNP of the home nations. And if these remittances boost spending in these countries, this creates a fresh demand for the exports of other nations. In April 2008 the World Bank reported that global remittances from migrants are now three times as large as the flows of official government aid to developing countries. Total global remittances in 2007 were estimated by the World Bank to be $318bn of which $240bn went to people in developing countries.

8. Tax revenues: Legal immigrants in work pay direct and indirect taxes and are likely to be net contributors to the government‘s finances.

Opponents of high levels of migration focus on what they consider to be some of the economic and social costs of allowing in many thousands of new workers and their families:

Supporters of allowing free movement of labour argue that labour mobility is a positive-sum game rather than a zero-sum game. On the other side there are several pressure groups campaigning for tighter restrictions on migrant workers. Some of the arguments include:

1. Welfare costs: Increasing cost of providing public services as migrants come into a country.

2. Worker displacement: Possible displacement effects of domestic workers (this too is mentioned briefly in the extract.)

3. Wage cuts: Migrant workers may lower the wages of people in other jobs.

4. Social pressures: Social tensions arising from the problems of integrating hundreds of thousands of extra workers into local areas and regions.

5. Pressure on property prices: Rising demand for housing which forces up prices and rents.

6. Benefit claims: Many immigrants find it hard to get regular work and are a drain on the welfare system.

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7. Who really gains? The benefits of migration are focused mainly on employers, especially those who take on illegal workers at low wages.

8. Poverty risk: Migration may have the effect of worsening the level of relative poverty in a society. And many migrant workers have complained of exploitation by businesses that have monopsony power in a local labour market.

The benefits and costs of increased labour migration are hard to quantify and estimate. Much depends on

The types of people who choose to migrate from one country to another. Evidence suggests that migrants from the new EU states are much more likely to find work and therefore not act as a drain on a government‘s welfare state.

The ease with which they assimilate into a new country and whether they find regular full-time employment.

Whether a rise in labour migration stimulates capital spending by firms and by government.

Whether workers who come into a country decide to stay in the longer term (this may involve members of their extended family joining them) or whether they regard migration as essentially a temporary exercise (e.g. to gain qualifications, learn some English) before moving back to their country of origin.

Real Wage Rate

Employment

Labour Supply

W2

E1

W1

Labour Demand

d

Labour Supply with migration

E2

Strong inflows of labour into the economy can have the effect of increasing the labour supply – this puts downward pressure on real wages (for a given level of labour demand) e.g. through helping to relieve labour shortages in particular industries and occupations

If migration provides a boost to the labour supply and to average labour productivity, there is the prospect of an outward shift in a country‘s long run aggregate supply

AD

LRAS1

P1

LRAS2

P2

Real National Income (Y)

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Another important evaluation point is that inward migration into the UK from Eastern European countries has affected not just the UK labour market but also the labour markets in the countries from which these migrants have come. Many eastern European countries are suffering from a sustained reduction in the size of their populations – migration is one factor behind this although not the only one.

There are many potential negative consequences among them the following:

1. A reduction in the size of the available labour supply

2. A possible reduction in the quality of the labour supply if skilled migrants leave

3. A fall in aggregate demand for goods and services

4. A worsening problem of labour shortages which could drive up wages, costs and prices

5. A decline in the size of the tax-paying population which will hit government revenue and spending plans

6. These countries may become less attractive to foreign investment

7. Many eastern European cities will become less dynamic and existing infrastructure will be under-utilized

Europe‟s Disappearing Workers

It has been heralded as one of the great success stories of the last twenty years. Twelve nations have joined the European Union single market and have made sizeable economic progress both before and since their accession. But there are signs that many of the Eastern European countries and Baltic States are now suffering from severe labour shortages resulting in rates of wage inflation that, in some cases, now exceed 30% pa.

The employment ministers of countries such as Poland, Latvia and Lithuania might well be asking ―where have all the workers gone?‖ Accession to the EU has opened up relatively free movement of workers and the consequence has been outward migration on a scale few predicted. It is estimated that 1% of the working population of Poland and Estonia left between May 2004 and December 2005. The outflow of people has been greater in Lithuania (2.4%) and Latvia (3.3%) and migration has continued right up to the present day.

As workers have left, so worker shortages in industries such as construction, retailing, hotels and restaurants have become more acute. The number of unfilled job vacancies has surged and wage inflation has accelerated as domestic businesses bid to attract and retain a shrinking pool of employees. In the Baltic States, year on year wage inflation is running at over 30% and, with wages rising much quicker than productivity, inevitably these nations are experiencing a sharp rise in unit labour costs and consumer price inflation.

Higher wages are good news for those in work helping to finance a consumer boom in the short run but there are other less desirable macroeconomic effects. Many of Europe‘s new member states are now running enormous current account deficits on their balance of payments accounts. And with cost-push inflationary pressures on the rise, so interest rates are heading higher. Many of these countries have entered into currency pegs with the Euro and this attempt at fixing exchange rates at a time when domestic inflation is high is threatening their competitiveness inside the single European market.

Labour shortages have highlighted the difficulties countries face when they have a low percentage of their working population in work. In Poland, less than 55% of the population aged 15-64 is in

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paid work, ten per cent lower than the average for the well established EU nations. Younger workers tend to be most geographically mobile and their exodus from the economy has the effect of leaving an older resident population, perhaps less attractive in the long run for potential flows of foreign direct investment. Ultimately, rising inflation, higher labour costs and more expensive borrowing costs will all act to dampen economic growth across Europe‘s new member nations.

What can be done to offset the impact of the worker exodus? To some extent, rising wages in countries such as Poland may help to stem to outflow of workers. And with economic growth set to slow in the UK and Ireland (two nations that have willingly accepted large flows of migrant workers), the number of job opportunities in advanced EU nations may start to diminish. The Polish government is actively looking at ways to boost their own domestic labour supply including measures to reduce a trend towards early retirement. If this and other measures fail to have much impact, Poland may themselves start to look eastwards to countries such as China, India, Russia and the Ukraine for a fresh supply of workers.

Source: EconoMax, November 2007

Key Concepts

Labour supply The number of people able, available and willing to work at prevailing wage rates

Monopsony Buying power in a market – businesses who are major ‗buyers‘ of labour may be able to use their monopsony power to drive down wages

Net inward migration When the number of migrants coming into a country is greater than those leaving in a given time period

Purchasing power How many goods and services a given amount of currency can buy – this will vary from country to country depending on factors such as the cost of living and the value of the exchange rate

Remittances Sending of money to people in another country

Suggestions for further reading on the labour migration issue

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on the economics of migration.

£7 per hour job that locals don't want (BBC news, March 2008)

Contrasting views on EU migration (BBC news, April 2008)

EU free movement of labour map (BBC news, November 2006)

Europe‘s changing borders (BBC special guide)

France to let in migrant workers (BBC news, May 2008)

Healthy economy is impossible with closed borders (Observer, April 2008)

Joining the immigrant underclass (BBC news, April 2007)

Labour market effects of immigration (LSE Centrepiece magazine, February 2008)

Migrant workers leave the UK (BBC Politics Show, June 2008)

Migrants 'shape globalized world' (BBC news, December 2006)

Record immigration from eastern Europe (Daily Telegraph, August 2006)

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Record trends in UK migration (BBC news, November 2007)

Skilled migrants are vital to economy, study says (Guardian, March 2008)

UK bans non-EU unskilled workers (BBC news, December 2007)

UK growth boosted by immigration (BBC news, December 2007)

What jobs are EU migrants doing in the UK? (BBC news, May 2007)

Workforce fears as migrants leave (BBC news, July 2008)

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20. International Trade

All of us are affected by global trade in goods and services. Your flight to an overseas holiday destination; your purchase of a music download from an overseas web site or perhaps the export of this study companion to a school or college in another country. Trade is huge and, over the last decade, international transactions have been growing far quicker than expansion of the internal economies of countries around the world.

We now consider the impact that trade has on our economic performance. Britain is a highly „open economy‟. This means that a large and rising share of our output of goods and services is tied to trade with other countries around the world. Indeed in 2007 the total value of our global trade (including both exports and imports) amounted to nearly 60% of national income!

According to the trade profile for the UK published by the World Trade Organisation:

1. The UK is the 7th largest exporter of goods in the world economy ad the 4th biggest importer of goods.

2. The UK is the 2nd biggest exporter of commercial services globally and the third.

3. The UK has a 3.7% share of world exports and 5% share of world imports

4. The UK exports 8% of the world‘s commercial services

5. 78% of our exports come from the manufacturing sector of the economy and 15% from fuels and mining products

6. 62% of our exports go to other members of the EU; 13% to the United States.

7. 50% of our imports come from the EU; 8% from the United States and 6% from China.

Trade and the economic cycle

The British economy is sensitive to fluctuations in the global cycle and also changes in the exchange rate. No economist can afford to ignore the effects that international trade and the free flow of financial capital has both on the demand and supply-side of the economy. And it is certainly true that the UK economy is not immune to economic events in different countries around the world.

The pattern of merchandise trade (trade in goods for the UK)

Breakdown in economy's total exports

Breakdown in economy's total imports

By main commodity group By main commodity group

Agricultural products 5.3 Agricultural products 8.8

Mining products 13.0 Mining products 11.7

Manufactures 77.6 Manufactures 65.3

By main destination By main origin

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1. European Union (15) 55.8 1. European Union (15) 50.2

2. United States 14.9 2. United States 11.4

3. Japan 1.9 3. Japan 3.6

4. Switzerland 1.7 4. China 3.0

Source: World Trade Organisation International Trade Statistics www.wto.org

The Advantages of International Trade

o Financing our imports: Britain needs to export sufficient goods and services to finance the imports of products that we cannot supply. Exports represent an injection of demand into the circular flow of income and create growth potential as businesses look to expand beyond the confines of their national boundaries.

o Improving consumer welfare: Economic welfare can improve if countries specialize in the products in which they have a comparative advantage and then trade. This allows a country to consume goods and services at a level beyond what the domestic production possibility frontier would permit. Trade and exchange also provides greater choice for consumers and competition helps to keep prices down.

o Exploiting economies of scale: Trade allows firms to exploit economies of scale by operating in larger markets. For example, the European Union now has a single market with over 480 million consumers. Economies of scale lead to lower average costs – a gain in efficiency that might be passed onto consumers through lower prices.

o Increased efficiency: Trade between businesses stimulates higher allocative and productive efficiency. Trade in ideas also stimulates product and process innovation.

o Safety valve for excess demand: Imports can help to satisfy excess demand from consumers – in effect acting as a safety valve for the economy. A trade deficit during a boom helps to reduce demand-pull inflation.

The importance of trade – Vietnam looks to increase rice exports

Vietnam has announced that it plans to increase the volume of rice exports as it tries to maximise the benefits of rising global prices while, at the same time, guarantee domestic supplies. The world's second biggest rice producer raised its 2008 export target from 4 million to 4.5 million tonnes. The world price of rice traded on the Chicago Board of Trade has jumped 75% over the past year and rice inflation has made it more profitable for farmers to grow more. Asia's key rice

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producers have had to weigh up the needs of their own people, such as the amount and cost of rice available, and global demand for the staple crop.

Asia's other top rice producers are also increasing output, with Thailand - the world's biggest rice exporter - harvesting 30% more crops.

Rice prices have increased because of a mixture of demand and supply-side factors including higher energy and fertiliser costs, rising global demand, loss of land to bio-fuel crops and drought conditions.

Source: Adapted from news reports, June 2008

Percentage of world trade

Share of World Trade in Goods and Services

Source: Reuters EcoWin

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

22.0

Pe

rcen

t

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

22.0

Asian Emerging Nations (Inc China)

United Kingdom

Britain‘s share of world trade has been declining gently over the years and is now just 4% of the total. Note the steep increase in the share of global trade taken by the emerging nations of Far East Asia. Although our share has fallen, the total value of global exchange of goods and services has grown quickly – so we have a slightly smaller share of a much bigger cake!

The World Trade Organization (WTO)

The World Trade Organisation helps to promote free trade by persuading countries to abolish import tariffs and other barriers to open markets. The WTO was established in 1995 and was preceded by the General Agreement on Tariffs and Trade (GATT). Membership of the WTO has expanded to 153 countries (the latest to join was Cape Verde) – with the recent successful admission of China to the WTO ranking as an event of potentially huge significance. Russia and Iran are examples of countries that have not yet entered the WTO system.

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The WTO oversees the rules of international trade. It helps to settle trade disputes between governments, for example the recent dispute between the United States and Europe over the introduction of tariffs by the USA on imported steel. Increasingly, the global economy is being concentrated into trading blocs where free trade is encouraged within each bloc, but import controls are established for products entering a trade bloc.

Protectionism - Import Controls

Import controls are defined as any barriers to the free movement of goods and services that seek to distort the pattern of trade between countries.

(a) Tariffs:

A tariff is a tax on imports and is used to restrict the demand for imports and at the same time raise revenue for the government.

The effects of the import tariff depend on the price elasticity of demand of home-based consumers and the elasticity of supply of domestic producers. A tariff will have a greater effect the more elastic the demand and supply. If the demand is inelastic then the imposition of a tariff will have little effect on the level of imports. The introduction of tariffs by one country can lead to retaliation responses from other countries. This retaliation can lead to damaging trade-wars.

(b) Import Quotas

An import quota directly reduces the quantity of a product that is imported and indirectly reduces the amount of money that the export producers receive. The main beneficiaries of quotas are the domestic producers who then face less competition in their respective markets.

(c) Voluntary Export Restraint

A voluntary export restraint is similar to an import quota. With a VER, the exporting country voluntarily restricts the number of goods that it ships to its trading partner. Foreign exporters must purchase licences from its government and then exports its allotted amount.

(d) Export Subsidy

An export subsidy is a payment to a domestic producer who exports a good abroad. If receiving an export subsidy, a firm can remain competitive abroad by exporting up to the foreign price (because the subsidy will cover some of the difference) yet receive the higher price domestically. The effects of a subsidy are the opposite of those of a tariff. Export subsidies are controversial. A high profile example is the export refund system used by the EU as part of the Common Agricultural Policy (CAP). It is argued that export refunds for European farmers undermines the domestic agricultural industries of developing countries and distorts the fundamental principles of free trade.

Economic Case for Import Controls

1. Infant Industry Argument: Certain industries possess a potential comparative advantage but have not yet exploited potential economies of scale. Short-term protection from foreign competition allows the industry to develop its comparative advantage. The danger is that the industry will never achieve full efficiency.

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2. Protection against “dumping”: Dumping' refers to the sale of a good below its cost of production. In the short term, consumers benefit from the low prices of the foreign goods, but in the longer term, undercutting of domestic prices will force the domestic industry out of business and allow the foreign firm to establish itself as a monopoly. Once this is achieved the foreign owned monopoly is free to increase its prices and exploit the consumer.

3. Externalities and Import Controls: Protectionism can deal with de-merit goods such as alcohol, tobacco and narcotic drugs that have adverse social effects. Protectionism can safeguard society from the importation of these goods, by imposing high tariff barriers or by banning the importation of the good altogether.

4. Non Economic Reasons for Protectionism: Countries may wish not to over-specialize in the goods in which they possess a comparative advantage. One of the potential dangers of over-specialisation is that unemployment may rise quickly if an industry moves into structural decline as new international competition emerges at lower costs. The Government may also wish to protect against high levels of imports to protect domestic employment. Protection may also be used to prevent trade with certain countries on political grounds. The UK government currently has trade sanctions with numerous countries, including Iraq and Nigeria.

James Wolfeson on gains from trade and the costs of protectionism

Expanding trade by collectively reducing barriers is the most powerful tool that countries, working together, can deploy to reduce poverty and raise living standards. Evidence shows that countries that are more open to trade grow faster over the long run than those that remain closed. And growth directly benefits the world's poor. A 1% increase in GDP growth reduces poverty by more than 1.5% each year.

Increased trade also benefits consumers and efficient producers, through lower prices and access to a wider variety of goods. This is because trade encourages specialization - which lowers costs - and more intense competition, which is central to innovation.

In sharp contrast, trade barriers can impose high costs on society - and particularly on those that can least afford them. For example, it has been estimated that barriers to imports in the 1990s saved 226 jobs in the US luggage industry, but at a cost to American consumers of nearly $1.3m per year for each job. And taxpayers in the European Union spend over $500m annually to subsidize the production of peas and beans.

Source: World Trade Organization

Problems with Import Protection

1. A loss of efficiency and welfare: Trade barriers restrict competition leading to a loss of economic welfare and inefficiency because of higher prices and less consumer choice

2. Disincentive to innovate: Firms that are protected from competition have little incentive to reduce production costs. These disadvantages must be considered carefully by governments

3. Risks of retaliation: There is the danger that one country imposing import controls will lead to retaliatory action by another leading to a decrease in the volume of world trade

Key Concepts

Comparative advantage Comparative advantage refers to the relative advantage that one country or producer has over another. Countries can benefit from specializing in and exporting the product(s) for which it has the lowest opportunity cost of production

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Dumping When a producer in one country exports a product to another country at a price which is either below the price it charges in its home market or is below its costs of production

Free trade When trade between nations is allowed to occur without any form of import restriction.

Protectionism Restricting trade through tariffs and other forms of import controls

Quota A quota imposes a physical limit on the quantity of a good that can be imported into a country in a given period of time.

Specialisation Is the opposite of generalisation and means focusing the use of factor resources in a particular task or occupation. The division of labour is an example of specialisation in production.

Tariff A tax on imported products which may be ad valorem (%) or a specific tax (a set amount per unit imported).

World Trade Organisation The WTO oversees trade agreements, negotiations and disputes between member countries

Suggestions for Further Reading on Trade and Protectionism Issues

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on international trade and protectionism.

African countries in tariff move (BBC news, May 2007)

Brussels trade war with US looms over bio-fuel (Guardian, May 2008)

Chinese steel imports 'injure' US (BBC news, June 2008)

Economists rethink international trade (Business Week, January 2008)

EU suffers defeat in banana wars (BBC news, April 2008)

EU tariff offer for ex-colonies (BBC news, April 2007)

EU warns China of retaliation as trade surplus nears £160bn (Guardian, June 2007)

Mexico to cut food import tariffs (BBC news, May 2008)

Profile of the World Trade Organisation (BBC news, January 2007)

The battle over trade (BBC news, special report)

Ukraine joins the WTO (BBC news, February 2008)

US alleges Chinese trade barriers (BBC news, October 2007)

US targets EU over hi-tech goods (BBC news, May 2008)

Vietnam counts cost of shoe penalties (BBC news, October 2006)

WTO scrutinises US trade policy (BBC news, May 2008)

WTO sides with Seoul in chip row (BBC news, November 2007)

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21. Balance of Payments on Current Account

What is the Balance of Payments?

The balance of payments (BOP) records all of the many financial transactions that are made between consumers, businesses and the government in the UK with people across the rest of the World.

The BOP figures tell us about how much is being spent by British consumers and firms on imported goods and services, and how successful UK firms have been in exporting to other countries and markets. It is an important measure of the relative performance of the UK in the global economy.

At AS level, we focus on one part of the balance of payments accounts. This section is known as the current account. We will go through the make-up of this account in a later section.

The importance of exports for the economy

Why is the export sector of the economy vital for the UK?

1. Aggregate demand and the multiplier: An increasing share of Britain‘s national output is exported overseas as the nation becomes ever more integrated into the global economy. Export earnings are an injection of AD into the circular flow. If British companies can successfully sell goods and services overseas, the rise in exports boosts national income and should have a positive multiplier effect on output and employment.

2. Manufacturing industry: Export sales are particularly important for manufacturing industry where exports are a high % of total production. Thousands of jobs depend directly on the performance of the export sector and even more are affected in supply industries.

3. Regional economic health: The relative success of failure of export industries is important for certain regions of the UK. When export sales dip, output, employment and living standards come under threat and threaten to widen the existing north-south divide.

Measuring the current account

The current account comprises the balance of trade in goods and services plus net investment incomes from overseas assets and net transfers.

Net investment income comes from interest payments, profits and dividends from external assets located outside the UK. For example a UK firm may own a business overseas and decide to send back some of the operating profits from that asset to the UK. This would count as a credit item for our current account as it is a stream of profits flowing back into the UK. Similarly, an overseas investment in the UK might generate a good rate of return and the profits are remitted back to another country – this would be a debit item in the balance of payments accounts.

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Transfers into and out of the UK include foreign aid payments and funds brought by migrants to the UK. For the UK the net transfers figure is negative each year, mainly on account of the UK being a net contributor to the budget of the European Union. As a relatively rich nation, the UK makes sizeable foreign aid payments to many other countries.

The Current Account

The current account balance is essentially a reflection of whether the British economy is paying its way with other countries. The annual balance is volatile from year to year, because each of the four component parts is subject to fluctuations.

Trade in goods

Trade in services

Total trade

Total Net Investment

Income

Current transfers

Current balance

Current balance

£ billion £ billion £ billion £ billion £ billion £ billion % of GDP

1997 -12.3 14.1 1.8 3.3 -5.9 -0.8 -0.1

1998 -21.8 14.7 -7.1 12.3 -8.4 -3.2 -0.4

1999 -29.1 13.6 -15.5 1.3 -7.5 -21.7 -2.4

2000 -33.0 13.6 -19.4 4.5 -10.0 -24.8 -2.6

2001 -41.2 14.4 -26.8 11.7 -6.8 -21.9 -2.2

2002 -47.7 16.8 -30.9 23.4 -9.1 -16.5 -1.6

2003 -48.6 19.2 -29.4 24.6 -10.1 -14.9 -1.3

2004 -60.9 25.9 -35.0 26.6 -10.9 -19.3 -1.6

2005 -68.8 24.6 -44.2 25.2 -12.0 -31.0 -2.5

2006 -77.6 31.0 -46.5 7.8 -5.6 -50.7 -3.9

2007 -89.5 38.8 -51.2 5.3 -13.8 -59.7 -4.3

The current account balance saw it‘s highest ever deficit in 2007 at just under £60 billion. Just ten years ago the current account was broadly in balance but ever since then the UK economy has been running a deficit with the rest of the world. Looking at the table above, please note that the data are presented in nominal terms and is not adjusted for the effects of inflation – which can mean that a deficit of just under £90 billion for the year 2007 might give a slightly distorted view of the position. A better guide to the scale of the current account deficit is shown in the far right-hand column which expresses the current account balance as a share of UK GDP.

What are the main questions that concern economists regarding these figures?

i Causation: Why does the UK now run a large trade deficit in goods?

ii Consequences: Does it really matter if the economy is running persistent current account deficits?

iii Correction: Which demand and supply-side economic policies are likely to be most effective in improving our trade balances in the years ahead?

Trade in goods includes items such as:

Manufactured goods

Trade in services includes:

Banking, insurance and consultancy

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Semi-finished goods and components

Energy products

Raw Materials

Consumer goods

(i) Durable goods

(ii) Non-durable goods e.g. foods

Capital goods (e.g. equipment)

Other financial services including foreign exchange and derivatives trading

Tourism industry

Transport and shipping

Education and health services

Research and development

Cultural arts

Trade in goods includes exports and imports of oil and other energy products, manufactured goods, foodstuffs, raw materials and components. Until recently this was known as visible trade – i.e. exporting and importing of tangible products. Since 1986 the net balance of trade in goods for the UK has been in deficit. And as the following chart shows, the trade deficit in goods has increased enormously in the last few years.

In 2007 there was a record trade deficit of £89 billion, over four times the deficit seen in 1998. The biggest single cause of this was a near £60 billion trade gap in manufactured products such as DVD players, televisions, motor cars and oil.

Balance of exports minus imports of goods at current prices, £ billion

UK Balance of Trade in Goods

Source: Reuters EcoWin

80 82 84 86 88 90 92 94 96 98 00 02 04 06

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ions

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Trade in services

Overseas trade in services includes the exporting and importing of intangible products – for example, Banking and Finance, Insurance, Shipping, Air Travel, Tourism and Consultancy. Britain has a strong trade base in services with over thirty per cent of total export earnings come from services. Indeed the success of our service sector industries has been one of the strong points in the UK‘s economic performance during the current cycle.

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As the next chart illustrates, the UK balance of trade in services has been in surplus for many years. In 1999 the UK became the second largest exporters of services in the world and in 2007 a record surplus was achieved. Strong surpluses are especially common in financial and business services and hi-tech knowledge services.

Balance of exports minus imports of services, current prices, £ billion

UK Balance of Trade in Services

Source: Reuters EcoWin

80 82 84 86 88 90 92 94 96 98 00 02 04 06

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40

But the UK runs a deficit in international travel and transportation in part because of the growth of demand for overseas holidays as living standards have improved. Once again, rising incomes have caused a large rise in the demand for leisure and business travel and the strength of the exchange rate – for example against the US dollar and the rapid expansion of low cost airlines offering short haul overseas breaks has also played its part.

It will be interesting to see how this deficit in overseas travel is affected over the next couple of years by the economic downturn, big increases in airline fuel surcharges and also by the fall in the value of the pound against the Euro. Will there be a large drop in the number of British people travelling overseas for their holidays? If it does, this part of the balance of payments accounts will be affected.

Britain has a comparative advantage in selling financial services to the rest of the world. London is one of the three main financial centres in the world and has the largest share of trading in many international financial markets. For example, around one third of all of the currency dealing takes place in London‘s trading platforms and many overseas banks have established themselves in London‘s money and capital markets. And numerous British financial businesses have world class status in their areas of expertise.

Our UK based commercial banks, fund managers, securities dealers, futures and options traders, insurance companies and money market brokerage businesses are part of a complex network of

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financial and business services that represent a huge asset for the UK balance of payments accounts.

The next chart provides a summary of the four components of the current account balance

1. Trade in goods 2. Trade in services 3. Net investment income 4. Net transfers of money

Note that the data is presented as an annual total and is measured in £billion.

Annual balances for each component, £ billion

Components of the UK Balance of Payments

Source: Reuters EcoWin

97 98 99 00 01 02 03 04 05 06 07

bill

ions

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Trade in Goods

Current account

Trade in Services

Transfers

Investment income

The causes of the UK trade deficit

Why do some countries including the UK and the United States run persistently large trade deficits? Whilst other nations including China, Germany and Japan achieve big trade surpluses each year? This is an example of the economics of causation – i.e. looking at an issue and trying to unravel some of the main causes.

It is good for your evaluation skills to group the explanations for the record trade deficit in goods into short-term, medium-term and long-term factors. In general, shorter-term explanations tend to focus on demand-side factors whereas longer-term causes are often the result of supply-side factors.

Short-term factors

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i Strong consumer demand: One of the features of the British economy over the last decade has been a period of very strong consumer demand fuelled by rising incomes, low interest rates and rising property wealth. If household demand is greater than what home-based producers can supply, then the demand for imports tends to grow to meet this excess demand. Linked with this is the second point below about income elasticity.

ii High income elasticity of demand for imports: Evidence suggests that UK consumers have a high income elasticity of demand for overseas-produced goods – demand for imports grows quickly when consumer demand is robust. Economists Nicholas Fawcett and Michael Kitson in an article in the Guardian estimated that the income elasticity is around +2.3 (i.e. highly elastic) suggesting that a 2% increase in real incomes boosts demand for imports by 4.6%. Because the overseas demand for UK exports rarely keeps pace with the surging demand for imported products, so the trade deficit widens when the economy enjoys a period of consumption-led growth.

iii The strong exchange rate has helped to reduce the UK price of imports causing an ‗expenditure-switching effect‟ away from domestically produced output. In technical terms, the high pound has improved the terms of trade between the UK and other countries, allowing us to buy and consume more imports with each pound we earn. Consumers have taken advantage of the high pound and have been happy to buy lots of foreign produced goods and enjoy more travel overseas. Both have added to the current account deficit.

iv Rising commodity prices: Another factor affecting our trade balance in the short term has been the rising cost of importing fuels, foods and other commodities used in production. The demand for many of these inputs is price inelastic so that as the global price rises, so total spending on them must also increase. Britain tends to be a net importer of many foodstuffs and beverages together with metals such as iron ore, copper and fuel such as coal, gas and now oil.

Imports of goods and services as a percentage of GDP

United Kingdom Import Penetration

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

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The share of our national spending taken up by imports has grown steadily over the last fifteen years.

Medium to long-term factors

i UK trade balances have been affected by big shifts in comparative advantage in the world economy – for example the growth of China as a source of exports of household goods and other emerging market countries in South-east Asia who have a labour cost advantage in exporting manufactured products. The availability of imports from other countries at a lower price inevitably causes a substitution effect from British consumers.

ii Our trade performance has been hindered by supply-side deficiencies which impact on the price and non-price competitiveness of British products in global markets - non-price competitiveness factors such as design and product quality are now more important for trade than merely price alone.

o A relatively low rate of capital investment compared to other countries.

o The persistence of a productivity gap with our major competitors – measured by differences in GDP per person employed or per hour worked – this is linked to low investment and also to the existence of a skills-gap between UK workers and employees in many other countries.

o A relatively weak performance in terms of product innovation – linked to a low rate of business sector spending on research and development.

ii The UK manufacturing sector has been in long-term decline for more than twenty years. This is known as a process of deindustrialisation. Although we still have some world class manufacturing companies, the size of our manufacturing sector is not large enough both to meet consumer demand in the UK and also to export sufficient volumes of products to pay for a growing demand for imports.

iii The switch from being a net oil and gas exporter to being an importer: For nearly thirty years the UK economy enjoyed the bonanza of revenues from the oil and gas industry centred in the North Sea. Indeed there strong flow of oil export revenues tended to hide some of the deeper problems emerging in our trade statistics. In recent years, North Sea oil and gas production has peaked and is now declining at quite a rapid rate. A reduction in exploration and extracting investment has not helped and even the steep rise in world crude oil prices since 2006 has done little to arrest the decline in production. Britain has seen North Sea Oil production drop by around 40% since its peak of 4.5m barrels a day in 1999.

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Trade Balance £bn and Brent Crude ($s per barrel)

UK Trade in Oil and Brent Crude Oil Price

Source: Reuters EcoWin

97 98 99 00 01 02 03 04 05 06 07

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Annual average price for Brent crude oil

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Annual UK balance of trade in oil

What does a current account deficit mean?

Running a sizeable deficit on the current account basically means that the UK economy is not paying its way in the global economy. There is a net outflow of demand and income from the circular flow of income and spending. The current account does not have to balance because the balance of payments also includes the capital account. The capital account tracks capital flows in and out of the UK. This includes portfolio capital flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows arising from foreign investment.

The Effects of Changes in the Balance of Payments on the UK Economy

Consider the effects of a slowdown in exports and a faster growth in imports of goods and services caused by a rise in the value of sterling against other currencies that leads to a worsening of the balance of payments. This has further effects on the economy as a whole:

o Reductions in demand in the circular flow: There will be a fall in AD because more money is leaving the circular flow of income (through imports) than is coming into the economy from exports. An inward shift of AD would lead to a contraction along the SRAS curve and a reduction in economic growth.

o Lost jobs: There will be a loss of employment if exporting industries require less labour and if UK businesses lose market share and output to cheaper imports from overseas.

o Dip in business confidence and investment: A fall in business confidence and a decline in planned capital investment spending by UK exporting firms whose order books are less full and whose profits take a hit from a fall in demand from overseas.

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o Reductions in inflationary pressure: Lower inflation because imports coming into the UK are cheaper and a fall in AD takes the economy further away from full capacity national output.

The exchange rate and the balance of payments

Changes in the exchange rate can have a big effect on the balance of payments although these effects are subject to uncertain time lags. When sterling is strong then UK exporters found it harder to sell their products overseas and it is cheaper for UK consumers to buy imported goods and services because the pound buys more foreign currency than it did before.

The balance of payments and the standard of living

A common misconception is that balance of payments deficits are always bad for the economy. This is not necessarily true. In principle, there is nothing wrong with a trade deficit. It simply means that a country must rely on foreign direct investment or borrow money to make up the difference.

And in the short term, if a country is importing a high volume of goods and services this is a boost to living standards because it allows consumers to buy more consumer durables. However, in the long term if the trade deficit is a symptom of a weak economy and a lack of competitiveness then living standards may decline.

Economic policies to reduce a large trade deficit

There are a number of policies that can be introduced to achieve an improvement in a country‘s trade balance – some of them focus on changing the growth of demand, others look to improve the supply-side competitiveness of an economy. As with any macroeconomic ‗problem‘ effective policies are those that target the underlying causes.

1. Demand management: Reductions in government spending, higher interest rates and higher taxes could all have the effect of dampening consumer demand and reducing the demand for import.

2. Natural effects of the economic cycle: If a country‘s trade deficit worsens during a time of strong economic growth, one would expect to see the deficit fall during an economic slowdown or recession – so some of the deficit is partially self-correcting as an economic cycle works itself through

3. A lower exchange rate: The central bank of a country might decide that a lower exchange rate provides a suitable way of improving competitiveness, reducing the overseas price of exports and making imports more expensive. To bring the exchange rate down it might opt to intervene in the currency markets although this strategy is by no means certain to work. Some economists argue that a large trade deficit will eventually cause an exchange rate depreciation anyway because a deficit means that there is an excess supply of a country‘s currency being used to pay for imports.

4. Supply-side improvements: Policies to raise productivity, measures to bring about more innovation and incentives to increase investment in industries with export potential are all supply-side measures designed to boost a country‘s export performance and perhaps build domestic industries that can compete better with imported products. The time-lags for supply-side policies to have an impact on the trade figures can be very long!

5. Protectionist measures such as import quotas and tariffs are rarely used by countries such as the UK because of our commitments to the World Trade Organisation and our membership of the European Union.

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£ billion per month, trade in goods and services

UK, Exports to and Imports from China

Source: Reuters EcoWin

96 97 98 99 00 01 02 03 04 05 06 07 08

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Exports to China

Imports from China

Key Concepts

Current account The overall balance of credits minus debits for trade in goods, trade in services, investment income and transfers.

International Monetary Fund (IMF)

Monitors countries; economic and financial development, and provides lending for balance-of-payments difficulties.

Investment income Interest, profits and dividends from assets owned and located overseas.

Overseas assets Assets such as businesses, shares, property which are owned in overseas countries and which might generate a flow of investment income which is a credit item on the current account of the balance of payments.

Trade deficit A trade deficit occurs when a country imports a greater value of goods and services than it exports.

Suggestions for further reading on the balance of payments

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on the balance of payments.

China‘s trade surplus jumps 48% in 2007 (BBC news, January2008)

More UK firms re-locating production abroad (BBC news, July 2008)

North Sea Oil – an industry ebbing away (Economist, July 2008)

Robust trade aids German economy (BBC news, June 2008)

Toast to whisky industry as exports boom! (The Scotsman, June 2008)

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UK economy loses competitive edge to rival nations (Times, May 2007)

UK Trade Deficit – does it matter? (Money week, November 2007)

US annual trade deficit narrows in 2007 (BBC news, February 2008)

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22. Monetary Policy

Monetary policy influences the decisions that we make about how much we save, borrow and spend. Decisions made by the central banks that operate monetary policy can have a powerful effect on individual consumers and businesses. In this chapter we look at how interest rate changes work their way through the economy to affect variables such as aggregate demand, output and inflation.

What is Money?

Money is defined as any asset that is acceptable as a medium of exchange in payment for goods and services. The main functions of money are as follows:

1. A medium of exchange used in payment for goods and services

2. A unit of account used to relative measure prices and draw up accounts

3. A standard of deferred payment – for example when using credit to purchase goods and services now but pay for them later

4. A store of value - money holds its value fairly well unless there is a situation of accelerating inflation. As the general price level in the economy rises, so the internal value of a unit of currency decreases.

Interest Rates

The media often talks about interest rates going up, or interest rates going doing as if there was one single or unique rate of interest in the economy. That simply isn‘t true – indeed there are literally thousands of different rates in the financial markets – it can get very confusing!

For example we distinguish between savings rates and borrowing rates. However we find that interest rates tend to move in the same direction. For example if the Bank of England cuts the base rate of interest then we expect to see banks cutting the rates on their overdrafts and loans and also lower rates are offered on savings accounts with Banks and Building Societies.

The Real Rate of Interest

The real rate of interest is important to businesses and consumers when making spending and saving decisions. The real rate of return on savings, for example, is the money rate of interest minus the rate of inflation. So if a saver is receiving a money rate of interest of 6% on his savings, but price inflation is running at 3% per year, the real rate of return on these savings is only + 3%.

Real interest rates become negative when the nominal rate of interest is less than inflation, for example if inflation is 5% and nominal interest rates are 4%, the real cost of borrowing money is negative at -1%.

The Bank of England and the operation of Monetary Policy

The Bank of England has been independent since 1997 when an incoming Labour government decided that in future, decisions on interest rates would be taken out of the hands of politicians and given to the Bank who then established the Monetary Policy Committee (MPC).

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The MPC has nine members, some of whom are appointed by the government and some by the Bank of England. The Governor of the Bank (currently Mervyn King) has the casting vote if there is an equally split decision on interest rates – he is never on the losing side!

Percentage, since May 1997 base rates have been set by the Bank of England

Monetary Policy - Base Rate of Interest for the UK

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

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Each month the MPC meets to consider the latest news on the UK and global economy. Their job is to make a judgement on what is the appropriate level of base interest rates for the UK economy consistent with the need to meet an inflation target set by the government. That inflation target is consumer price inflation of 2%. The MPC also has one eye on keeping the economy growing (although a set rate of GDP growth is not part of their target) and the rate of inflation is allowed to vary by 1% either side of the 2% target – so they have a little leeway.

At the time of writing in July 2008, the inflation target has been breached on two occasions, firstly in April 2007 and again in June 2008. On both occasions inflation was above 3% requiring the Governor to exchange open letters with the Chancellor to explain the inflation ‗over-shoot‘ and identify how the Bank of England expects inflation to fall back into target range in the months ahead.

Setting interest rates – “fine tuning” the economy

The evidence from the first ten years of independence from government is that the Bank of England prefers a gradualist approach to monetary policy – believing that a series of small movements in interest rates is a more effective strategy in controlling inflationary pressures than sharp jumps in the cost of borrowing money.

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For example, when demand is thought to be rising too quickly and threatening higher prices, the aim is not to shock consumers and businesses to control their spending, but to gradually increase the cost of borrowing money and increase the incentive to save, so that the pace of growth moderates and the economy can continue to grow without causing rising inflation.

Factors considered when setting interest rates

1. How strong is aggregate demand? The MPC look at each of the components of aggregate demand (C+I+G+X-M) and decide whether total demand for goods and services is growing at a sustainable rate. Too much demand might lead to demand-pull inflationary pressures; but if demand is weak there is a risk of a recession and perhaps deflation.

2. The housing market: What are the signals coming from the housing market? If house prices rising too strongly, this might feed through into increased consumer demand and the risk of a surge in demand-pull inflation. Equally a housing market recession (which began in earnest in the UK during 2008) could be a sign of a wider slowdown and less inflationary risks. The current inflation target does not include asset prices such as housing.

3. The labour market: Are their inflationary signals coming from the labour market in the form acceleration in wages and average earnings well above the growth of labour productivity? If so the MPC might decide to raise interest rates as a signal to workers and businesses that it does not want ‗inflation-busting‘ pay rises.

4. Inflation from overseas: Is there a risk from import costs such as a rise in oil and food prices? This key external factor has weighed heavily with the Bank of England when setting interest rates during 2008. They have had to decide how much of the sharp rise in oil prices to above $140 a barrel and the big increase in global food prices is temporary and likely to be reversed – and how much the economy will have to adjust to a world where energy is no longer cheap and food prices will remain high.

5. Trends in the exchange rate: What is happening and what is projected to happen to the sterling exchange rate? A rising pound will help to keep import prices down and reduce pressure on domestic inflation. But an appreciating currency might also damage export orders and employment in industries facing tough competition from imports.

The key point is that the Monetary Policy Committee looks at a wide range of economic indicators from both the demand and the supply-side of the economy. They then have to make a judgement about what this evidence says about inflationary pressures over a two year forecast horizon. Why do they have to look up to two years ahead? Because when interest rates are changed, it takes time for them to have an effect on aggregate demand and prices. Uncertain time lags in a world of many external economic shocks make the handling of monetary policy a difficult job!

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Annual percentage change in the UK Consumer Price Index, the inflation target is 2%

Consumer Price Inflation and Interest Rates for the UK

Source: Reuters EcoWin

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Consumer Price Inflation

Base Interest Rates

Effects of Changes in Interest Rates

As an enthusiastic student of economics, you pick up your morning newspaper and read on the front page that the Bank of England has decided to cut interest rates by 0.25% (or 25 basis points to use the technical jargon … 1000 basis points = 1%!). So how will this cut in interest rates affect the economy?

The first point to make is that one small change in interest rates is unlikely to make much difference at all! If you refer back to our previous chart showing the interest rate decisions of the Bank of England since 1997 you will see that base rates do tend to change by a small amount each time but that these changes tend to come together in clusters – for example the Bank might

Interest Rate

Change

Financial Markets

& Expectations

Aggregate

Demand

& Output

Time = 0 6 - 12 months

12-24 months

Final effect on CPI

inflation / meeting the

inflation target

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reduce rates by 1% in a series of four monthly steps. So when discussing ‗changes in interest rates‘ – bear in mind that single rate changes rarely happen in isolation.

Before we look at the impact of rate changes, it is also worth remembering that when the Bank is making a decision, there will be lots of other events and policy decisions being made elsewhere in the economy, for example changes in fiscal policy by the government, or perhaps a change in world oil prices or the exchange rate. In macroeconomics the ceteris paribus assumption (all other factors held equal) rarely applies!

How might the following people be affected by a rise in interest rates in the UK?

(1) A homeowner with a variable rate mortgage of £280,000

(2) A pensioner couple who have paid off their mortgage and have some savings in a building society account

(3) A travel agent, 70 per cent of the holidays they sell are to British consumers traveling abroad

(4) Workers in a UK based factory that manufactures and exports sports clothing to the United States

The Transmission Mechanism of Monetary Policy

There are several ways in which changes in interest rates influence aggregate demand. These are collectively known as the transmission mechanism of monetary policy.

One of the principal channels that the MPC can use to influence aggregate demand, and therefore inflation, is via the lending and borrowing rates charged by the market.

When the Bank‘s base interest rate rises, banks and building societies will typically increase the rates that they charge on loans and the interest that they offer on savings. This tends to discourage businesses from taking out loans to finance investment and encourages the consumer to save rather than spend — and so depresses aggregate demand. Conversely, when the base rate falls, banks tend to cut the market rates offered on loans and savings. This will tend to stimulate AD.

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The Bank‘s view of the transmission mechanism resulting from a change in official base interest rates is shown in the flow chart above – the key to it is that changes in official base interest rates (known as the Repo rate) feed through fairly quickly to the rest of the UK financial system - resulting in changes in mortgage interest rates, rates of interest on savings accounts and also credit card rates - and then start to influence the spending and savings decisions of millions of households and businesses.

A key influence played by rate changes is the effect on confidence – in particular household‘s confidence about their own personal financial circumstances.

1. Housing market & house prices: Higher interest rates increase the cost of mortgages and eventually reduce the demand for most types of housing. This will slow the growth of household wealth and put a squeeze on equity withdrawal (consumers borrowing off the back of rising house prices) which adds directly to consumer spending.

2. Effective disposable incomes of mortgage payers: If interest rates increase, the income of homeowners who have variable-rate mortgages will fall – leading to a decline in their effective purchasing power. The effects of a rate change are greater when the level of existing mortgage debt is high as this makes property owners more exposed to higher costs of repaying debts.

3. Disposable income of savers: On the other hand, a rise in interest rates boosts the disposable income of people who have paid off their mortgage and who have positive net savings in bank and building society accounts.

4. Consumer demand for credit: Higher interest rates increase the cost of servicing debt on credit cards and should lead to a deceleration in the growth of retail sales and spending on consumer durables.

Market interest rates

E.g. savings rates & credit cards

Asset prices

E.g. house prices

Expectations and

Confidence

Businesses & consumers

Exchange rate

Official Interest

Rate

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economic

growth

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Inflationary

Pressure

i.e. changes

in the output gap

(actual GDP relative

to potential GDP)

Import

Prices

Consumer Price

Inflation

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5. Business capital investment: Firms often take the actual and expected level of interest rates into account when deciding whether or not to go ahead with new investment spending. A rise in short term rates may dampen confidence and lead to a reduction in planned capital investment. However, many factors influence investment decisions other than rate changes.

6. Consumer and business confidence: The relationship between interest rates and business and consumer confidence is complex, and depends crucially on prevailing economic conditions. For example, when businesses and consumers are worried about the risk of a recession, an interest rate cut can boost confidence because it reassures the public that the Bank is alert to the dangers of an economic slump. There are circumstances, however, where a cut in rates could undermine confidence. For example, were the Bank of England to cut interest rates too quickly, the fear might be that the Bank is worried about the prospects of a recession. The setting of interest rates nearly always calls for a finely balanced judgement, particularly when the effects on consumer and business confidence are concerned.

7. Interest rates and the exchange rate: Higher UK interest rates might lead to an appreciation of the exchange rate particularly if UK interest rates rise relative to those in the Euro Zone and the United States attracting inflows of “hot money” into the British financial system. A stronger exchange rate reduces the competitiveness of UK exports in overseas markets because it makes our exports appear more expensive when priced in a foreign currency leading to a decline in export volumes and market share. It also reduces the sterling price of imported goods and services leading to lower prices and rising import penetration. If the trade deficit in goods and services widens, this is a net withdrawal of demand from the circular flow and acts to reduce excess demand in the economy.

Per cent, source: Bank of England

The Cost of Borrowing

Source: Bank of England

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Base Interest Rates (set by BoE)

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Monetary Policy Asymmetry

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Fluctuations in interest rates do not have a uniform impact on the economy. Some industries are more affected by interest rate changes than others for example exporters and industries connected to the housing market. And, some regions of the British economy are also more sensitive to a change in the direction of interest rates.

The markets that are most affected by changes in interest rates are those where demand is interest elastic in other words, demand responds elastically to a change in interest rates or indirectly through changes in the exchange rate.

Good examples of interest-sensitive industries include those directly linked to demand conditions in the housing market¸ exporters of manufactured goods, the construction industry and leisure services. In contrast, the demand for basic foods and utilities is less affected by short term fluctuations in interest rates and is affected more by changes in commodity prices such as oil and gas.

The rate of interest is under the control of the Bank of England, but most other economic variables are not! The MPC‘s decisions can influence consumer and business behaviour but it cannot determine directly the rate of inflation. Ultimately it is businesses large and small that set the prices we pay rather than the Governor of the Bank of England and his Monetary Policy Committee!

Between a rock and a hard place! - The interest rate dilemma in 2008

At the time of writing, 2008 was proving to be a difficult year for the Bank of England when making interest rate decisions. This was because of a series of challenging circumstances including the effects of the credit crunch, a recession in housing, depreciation of the pound against the Euro and strong inflationary pressures from the global economy.

On the one hand, rising inflation caused in part by high world commodity prices was giving the Bank less freedom to cut interest rates. Indeed the Bank was concerned that wages may pick up as people reacted to a steep increase in their cost of living. On the other hand, the Bank was concerned of the risks of a recession created by the credit crunch and housing recession.

What to do, and when?

Rise in oil prices

Lower economic growth;

Lower inflation pressure

Consumers:

Real income falls

Companies:Lower profitability

Policy response:

Raise interest rates

Risk of a wage-price spiral

Higher inflation

Policy response:

Cut interest rates

Uncertainties: timing, magnitude & exchange rate effects

1st-round effects

2nd-round effects

Higher oil prices – the challenge facing monetary policy

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Percentage, since May 1997 base rates have been set by the Bank of England

Base Interest Rates and UK GDP Growth

Source: Reuters EcoWin

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Evaluation Points on Interest Rates

1. Time lags should always be considered when analyzing the effects of rate changes.

2. Over the last sixteen years, interest rates have been used to manage aggregate demand, with the exchange rate left for the currency market to determine.

3. Many homeowners have fixed rate mortgages and are not affected in the immediate period after an interest rate change.

4. Consider how a change in mortgage interest rates affects people in rented properties.

5. Consider the effect of ▲ or ▼ in interest rates on people with positive savings.

6. Demand can be interest inelastic – making rate changes less effective in managing the level of aggregate demand.

7. A ▲ or ▼ in interest rates will affect different parts of the economy in different ways.

8. Monetary policy does not work in isolation! Always consider how the government‘s handling of fiscal policy is affecting demand and inflationary pressures.

9. By transferring responsibility for day-to-day economic management to the MPC, the Chancellor of the Exchequer is now able to concentrate on the longer-term issues related to the performance of the economy – specifically by focusing on supply-side policies.

Key Concepts

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Interest elasticity of demand The responsiveness of demand to a change in interest rates

Monetary Policy Committee The MPC is a Bank of England committee of nine people which meets every month to set interest rates. Over half or five members, are from the Bank of England, including its Governor and two Deputy Governors. The other four are economists from outside the Bank

Policy asymmetry When a given change in interest rates affects different groups or different countries to a lesser or greater degree.

Real interest rate The nominal rate of interest adjusted for inflation

Repo Rate The official 'base' rate of interest that is set by the Monetary Policy Committee and which, when changed, sends a signal to the rest of the financial markets about a desired change in the direction of other borrowing and savings interest rates. Repo is the rate of interest at which the Bank of England is prepared to lend to banks.

Transmission mechanism How a change in interest rates affects the various sectors of the economy

Suggestions for Reading on Monetary Policy

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on monetary policy.

Australian interest rates at 12 year high (BBC news, March 2008)

Guardian special reports on interest rates and UK monetary policy

How interest rates work (Evan Davis Blog, January 2008)

Mortgage interest rates soar to eight-year high (The Times, July 2008)

The Bank of England‘s interest rate dilemma (BBC news, July 2008)

The markets' vital rate-setting role (The Times, January 2007)

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23. The Exchange Rate

This chapter looks at the currency markets where the value of one currency against another is determined on a daily basis

The exchange rate measures the external value of sterling in terms of how much of another currency it can buy. For example - how many dollars or Euros you can buy with £5000.

The daily value of the currency is determined in the foreign exchange markets (FOREX) where billions of $s of currencies are traded every hour.

The global currency markets are open 24 hours a day allowing businesses and individuals to trade in currencies.

Sterling exchange rate against major currencies

Sterling effective exchange rate index January

2005=100

Japanese yen US dollar Euro

2000 163 1.52 1.64 100.9

2001 175 1.44 1.61 99.2

2002 188 1.50 1.59 100.4

2003 189 1.63 1.45 96.9

2004 198 1.83 1.47 101.6

2005 200 1.82 1.46 100.4

2006 214 1.84 1.47 101.2

2007 236 2.00 1.46 103.5

Source: http://www.statistics.gov.uk/elmr/07_08/downloads/Table5_01.xls accessed 07/07/08

The UK operates with a floating exchange rate system where the forces of market demand and supply for a currency determine the daily value of one currency against another. If, for example, overseas investors want to buy into sterling to take advantage of higher interest rates on offer in UK bank accounts, they will swap their own currencies for pounds. This causes an increase in the demand for sterling in the foreign exchange markets, and in the absence of other offsetting factors, this will force sterling higher against other currencies.

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The value of the pound on the foreign exchange markets depends in how strong is demand for the currency relative to supply. Currencies tend to go up in value (appreciate) either when a country is running a large trade surplus – which brings in extra demand for a currency from sales of exports – or when overseas investors regard the currency as a good one to buy. This might be because attractive interest rates are on offer by putting money into savings accounts in that currency. Or because there are high expected returns from other types of investment notably property, stocks and shares and so on.

Sterling expected to fall as economy weakens

The British pound has held up well against major world currencies in the face of some of the worst news about the British economy in recent memory, but economists in the currency markets expect sterling to buckle eventually. The pound has fallen sharply from its 26-year high set in November above $2.11 and the consensus forecast for the pound is at $1.90 in six months and $1.87 in a year from now.

One factor that has been supporting the pound is inflation which is preventing the Bank of England cutting rates from 5 percent - the highest in the Group of Seven industrialised nations. But fears of a full-blown recession mean that the city expects the Bank of England to be cutting interest rates before the end of 2008.

The high level of the UK trade deficit is another indicator that the currency needs to fall further to provide the British economy with a competitive boost.

Adapted from the Guardian, July 2008

How does a change in the exchange rate influence the economy?

Changes in the exchange rate can have powerful effects on the macro-economy affecting variables such as the demand for exports and imports; real GDP growth, inflation, business profits and jobs – but as with most variables in economics, there are time lags involved. The impact of movements in currencies on the wider economy depends in part on:

1. The scale of any change in the exchange rate.

2. Whether the change in the currency is short term or long term.

3. How businesses and consumers respond to exchange rate fluctuations – the concept of price elasticity of demand is important here.

4. The size of any multiplier and accelerator effects.

5. When the currency movement takes place – i.e. at which point of an economic cycle.

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US dollars per £1, daily closing exchange rate

Dollar-Sterling Exchange Rate

Source: Reuters EcoWin

00 01 02 03 04 05 06 07 08

1.3

1.4

1.5

1.6

1.7

1.8

1.9

2.0

2.1

2.2

GB

P/U

SD

1.3

1.4

1.5

1.6

1.7

1.8

1.9

2.0

2.1

2.2

Value of one Euro, daily closing exchange rate

Euro - Sterling Exchange Rate

Source: Reuters EcoWin

Jan

06

Mar May Jul Sep Nov Jan

07

Mar May Jul Sep Nov Jan

08

Mar May Jul

0.650

0.675

0.700

0.725

0.750

0.775

0.800

0.825

Pe

nce p

er

Euro

1

0.650

0.675

0.700

0.725

0.750

0.775

0.800

0.825

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Advantages of an appreciation in the currency

1. Cheaper imports for consumers: A high pound leads to lower import prices – this boosts the real living standards of consumers at least in the short run – for example an increase in the real purchasing power of UK residents when travelling overseas or the chance to buy cheaper computers or motor vehicles from the United States or Europe.

2. Lower costs for producers: When the sterling exchange rate is high, it is cheaper to import raw materials, component parts and capital inputs such as plant and equipment – this is good news for businesses that rely on imported components or who are wishing to increase their investment of new technology from overseas countries. A fall in import prices has the effect of causing an outward shift in the short run aggregate supply curve. And if a country can now import more productive technology, the LRAS curve may shift out.

3. Lower inflation: A strong exchange rate helps to control the rate inflation because domestic suppliers now face stiffer international competition from cheaper imports and will look to cut their costs and prices accordingly in order not to suffer from a loss of international competitiveness. Cheaper prices of imported foodstuffs and beverages will also have a negative effect on the rate of consumer price inflation.

4. If inflation is lower, then interest rates will be lower than if the exchange rate was weaker – and cheaper money will eventually stimulate higher consumer spending and capital spending in the circular flow.

Disadvantages of a Strong Pound

1. Increase in the trade deficit: The lower price of imports leads to consumers increasing their demand and this can cause a large trade deficit. Exporters lose price competitiveness because they will find it more expensive to sell in foreign markets and face losing market share – this can damage profits and employment in some sectors and industries.

2. Slower economic growth: If exports fall, this causes a reduction in aggregate demand and reduces the short-term rate economic growth as measured by the % change in real GDP. Some regions of the economy are affected by this more than others. In the North east for example, manufacturing industry accounts for over 28% of regional GDP whereas the percentage for the UK as a whole is just 19%.

3. If exports fall, then so will business confidence and capital investment – because investment is partly dependent on the strength of demand.

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Exchange rate index (top pane) and inflation (lower pane)

Inflation and the Exchange Rate for the UK

Source: Reuters EcoWin

95 96 97 98 99 00 01 02 03 04 05 06 07 08

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Pe

rce

nt

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Consumer Price Inflation

80

85

90

95

100

105

110

Ind

ex

80

85

90

95

100

105

110

Inflation in ServicesInflation in Services

Sterling Exchange Rate Index

Showing the effects of currency movements using AD-AS analysis

Real National Output

Real National Output

SRAS

AD2

AD1

AD

SRAS2

SRAS1

LRAS LRAS

Y2 Y1 Y1 Y2

A fall in export demand

Lower GDP level – negative output gap

A fall in the cost of importing raw materials

Increase in GDP – reduction in inflation

General

Price

Level

General

Price

Level

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Why the pound is crucial to the economy?

The exchange rate is the price of one currency expressed in terms of another and is crucial to businesses selling goods and services abroad as well as those firms who import products from other countries. When the exchange rate rises in value (i.e. an appreciation), this makes exporters' goods, priced in sterling, more expensive in foreign currency. So demand for these dearer exports can be expected to fall, depending on the price elasticity of demand for UK exports and also whether there have been changes in other factors influencing demand.

A decline in exports reduces overall aggregate demand and should lower inflationary pressure - so a higher exchange rate could lead to the Monetary Policy Committee deciding to reduce official base interest rates.

A higher exchange rate also makes imports cheaper when sold in the UK. This is good news for the real purchasing power of British consumers, and also for UK firms who need to import raw materials, components and finished products. But higher prices feed into the consumer price index and can have a direct effect on our rate of inflation.

So a strong pound is good news for keeping inflation under control, but can have negative effects on exports which account for around thirty per cent of aggregate demand.

Changes in the exchange rate have quite a powerful effect on the economy but we tend to assume ceteris paribus – all other factors held constant – which of course is highly unlikely to be the case

1. Counter-balancing use of fiscal and monetary policy: For example the government can alter fiscal policy to manage the level of AD and the Bank of England has the flexibility to change interest rates (e.g. lower interest rates if they felt that a high exchange rate was damaging export sectors and causing much lower inflation)

2. Low elasticities of demand: In the short term, the effects of exchange rates on export and import demand tends to be low because of low price elasticity of demand

3. Business response to the challenge of a high exchange rate: Businesses can and do adapt to a high exchange rate. There are several ways in which industries can adjust to the competitive pressures that a strong pound imposes. Some of the options include:

a) Cutting their export prices when selling in overseas markets and therefore accepting lower profit margins to maintain competitiveness and market share

b) Out-sourcing components from overseas to keep production costs down

c) Seeking productivity / efficiency gains to keep unit labour costs under control or perhaps trying to negotiate a reduction in pay levels

d) Investing extra resources in new product lines where demand is price inelastic and less sensitive to exchange rate fluctuations. This involves producing products with a higher income elasticity of demand, where non-price factors such as product quality, design and effective marketing are as important in securing orders as the actual price

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London is the major centre for foreign exchange trading in the world economy – the market is nearly wholly screen based and billions of dollars worth of currencies is traded every hour

Key Concepts

Appreciation A rise in the market value of one exchange rate against another

Depreciation A fall in the market value of one exchange rate against another

Hot Money Money that flows freely and quickly around the world economy looking to earn the best available rate of return. It might be invested in any asset whose value is expected to rise (e.g. property or shares) or simply be placed in an account offering the best real rate of interest.

Sterling exchange rate index The external value of sterling calculated using a weighted index of a basket of currencies – the weightings are based on the pattern of trade between the UK and other countries

Suggestions for wider reading on the exchange rate

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on exchange rates.

Dollar slides to fresh Euro low (BBC news, March 2008)

Firms get a boost from the weaker pound (BBC online, June 2008)

How pound's rise or fall hits prices (The Times, November 2006)

Living with a two-dollar pound (BBC news, November 2007)

Pound falls against Euro countries (BBC news, April 2008)

Weaker US dollar helps to narrow trade deficit (BBC news, May 2008)

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24. Fiscal Policy

Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern of economic activity and also the level and growth of aggregate demand, output and employment. It is important to realise that changes in fiscal policy affect both aggregate demand (AD) and aggregate supply (AS).

Fiscal Policy and Aggregate Demand

Traditionally fiscal policy has been seen as an instrument of demand management. This means that changes in government spending, direct and indirect taxation and the budget balance can be used “counter-cyclically” to help smooth out some of the volatility of real national output particularly when the economy has experienced an external shock.

The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand, output and employment when the economy is operating well below full capacity national output, and where there is a need to provide a demand-stimulus to the economy. Keynesians believe that there is a clear and justified role for the government to make active use of fiscal policy measures to manage the level of aggregate demand.

Monetarist economists on the other hand believe that government spending and tax changes can only have a temporary effect on aggregate demand, output and jobs and that monetary policy is a more effective instrument for controlling demand and inflationary pressure. They are much more sceptical about the wisdom of relying on fiscal policy as a means of demand management.

The fiscal policy transmission mechanism

How does a change in fiscal policy feed through the economy to affect variables such as aggregate demand, national output, prices and employment? This simple flow-chart identifies some of the possible channels involved with the fiscal policy transmission mechanism.

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The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the economy has; how much of any increase in disposable income is spent rather than saved or spent on imports. And also the effects of fiscal policy on variables such as interest rates

Government spending

Government (or public) spending each year takes up over 40% of gross domestic product. Spending by the public sector can be broken down into three main areas:

1. Transfer Payments: Transfer payments are government welfare payments made available through the social security system including the Jobseekers‘ Allowance, Child Benefit, the basic State Pension, Housing Benefit, Income Support and the Working Families Tax Credit. These transfer payments are not included in the national income accounts because they are not a payment for output produced directly by a factor of production. Neither are they included in general government spending on goods and services. The main aim of transfer payments is to provide a basic floor of income or minimum standard of living for low income households in our society. And they also provide a means by which the government can change the overall distribution of income in a country.

2. Current Government Spending: i.e. spending on state-provided goods & services that are provided on a recurrent basis every week, month and year, for example salaries paid to people working in the NHS and resources used in providing state education and defence. Current spending is recurring because these services have to be provided day to day throughout the country. The NHS claims a sizeable proportion of total current spending – hardly surprising as it is the country‘s biggest employer with over one million people working within the system!

3. Capital Spending: Capital spending would include infrastructural spending such as spending on new motorways and roads, hospitals, schools and prisons. This investment

Cut in personal income tax

Boost to disposable income

Adds to consumer demand

Cut in indirect taxes Lower prices – leads to higher real incomes

Adds to consumer demand

Adds to business capital spending

Cut in corporation tax Higher ―post tax‖ profits for businesses

Cut in tax on interest from saving

Boost to disposable income of people with net savings

Adds to consumer demand

Expansionary Fiscal Policy

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spending by the government adds to the economy‘s capital stock and clearly can have important demand and supply side effects in the medium to long term.

The main items of government spending are as follows

Total managed spending by the government

£ billion

Social protection (social security benefits) 169

Health 111

Education 82

Other 67

Defence 33

Public order and safety 33

Debt interest 31

Personal social services 27

Housing and environment 23

Industry, agriculture, employment & training 22

Transport 21

Source: HM Treasury 2008-09 near-cash projections, published for the March 2008 Budget

Government spending is justified on economic and social grounds including the desire to correct for perceived market failure when the market mechanism might fail to provide sufficient public and merit goods for social welfare to be maximized.

Therefore we justify government spending on these grounds:

1. To provide a socially efficient level of public goods and merit goods

2. To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society – this is also part of the process of redistributing income and wealth

3. To provide necessary infrastructure via capital spending on transport, education and health facilities – an important component of a country‘s long run aggregate supply

4. As a means of managing the level and growth of AD to meet the government‘s main macroeconomic policy objectives such as low inflation and high levels of employment

The Private Finance Initiative (PFI)

The Private Finance Initiative is a way of funding expensive infrastructure without running up debts. Rather than borrowing to fund new projects, John Major's government in the early 1990s began to enter into long-term leasing agreements with private contractors and this has continued during the decade in which Labour has been in power. Under a PFI, companies borrow the cash to build and run new hospitals, schools and prisons for a period of up to 60 years. So far, about 150 PFI contracts have been signed, worth more than £40bn, with more in the pipeline. PFI is often portrayed as using private money to pay for improvements in public services. But, critics argue, it is still paid for through the public purse. It is not new money. Furthermore, the critics say, private finance is, by its nature, more expensive than public capital. The government of the day may feel it is getting a hospital or school at a bargain price but the country will pay more in the long run.

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Automatic stabilisers and discretionary changes in fiscal policy

Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending – for example a decision by the government to increase total capital spending on the road building budget or increase the allocation of resources going direct into the NHS.

Automatic stabilisers include those changes in tax revenues and government spending that come about automatically as the economy moves through different stages of the business cycle

1. Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which takes money out of the circular flow of income and spending

2. Welfare spending: A growing economy means that the government does not have to spend as much on means-tested welfare benefits such as income support and unemployment benefits

3. Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of money from the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a larger budget deficit.

Taxation

Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, national insurance contributions, capital gains tax, and corporation tax.

Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many different goods and services

By far the biggest source of income for the government is income tax. In the last tax year the state received over £135 billion in income tax receipts, nearly fifty billion pounds higher than the income from national insurance contributions.

Income from taxation for the UK government 2006-07

£ billion

Income tax (gross of tax credits) 147.8

National insurance contributions 87.3

Value Added Tax 77.4

Corporation Tax 44.3

Fuel duties 23.6

Council Tax 22.2

Business rates 21.0

Stamp duties 13.4

Tobacco duty 8.1

Interest & dividends 6.3

Vehicle excise duty 5.1

Capital gains tax 3.8

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Inheritance tax 3.6

Beer & cider duties 3.3

Wine duties 2.4

Spirits duties 2.3

Current Prices, £ billion. Source: HM Treasury

Revenues from Income Tax, VAT & Corporation Tax

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

bill

ions

0

25

50

75

100

125

150

GB

P (

bill

ion

s)

0

25

50

75

100

125

150

VAT

Corporation tax

Income tax

Progressive, proportional and regressive taxes

With a progressive tax, the marginal rate of tax rises as income rises. I.e. as people earn more income, the rate of tax on each extra pound earned goes up. This causes a rise in the average rate of tax (the percentage of income paid in tax). The UK income tax system is progressive. Everyone is entitled to a tax-free income. Thereafter, as income grows, people pay the starting rate of tax (10%) before moving onto the basic tax rate (22%). Higher income earners pay the top rate of tax (40%) on each additional pound of income over the top rate tax limit. This is the highest rate of income tax applied.

With a proportional tax, the marginal rate of tax is constant. For example, we might have an income tax system that applied a standard rate of tax of 25% across all income levels. If the marginal rate of tax is constant, the average rate of tax will also be constant. National insurance contributions are the closest example in the UK of a proportional tax, although low-income earners do not pay NICs below an income threshold, and NICs also do not rise for income earned above a top threshold.

With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate of tax is lower for people of higher incomes. In the UK, most examples of regressive taxes come from excise duties of items of spending such as cigarettes and alcohol. There is well-

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documented evidence that the heavy excise duty applied on tobacco has quite a regressive impact on the distribution of income in the UK.

Income tax in 2007-08

Taxable income

(Equals gross income minus the individual tax allowance)

rate of tax

0 - £2,230 10%

£2,231- £34,600 22%

Over £34,600 40%

Income tax in 2008-09

Taxable income

(Equals gross income minus the individual tax allowance)

rate of tax

£0 - £36,000 20%

Over £36,000 40%

Notice here that the government decided to abolish the starting rate of tax – a highly controversial move!

Fiscal Policy and Aggregate Supply

Changes to fiscal policy can affect the supply-side capacity of the economy and therefore contribute to long term economic growth. The effects tend to be longer term in nature.

1. Labour market incentives: Cuts in income tax might be used to improve incentives for people to actively seek work and also as a strategy to boost labour productivity. Some economists argue that welfare benefit reforms are more important than tax cuts in improving incentives – in particular to create a ―wedge‖ or gap between the incomes of those people in work and those who are in voluntary unemployment.

2. Capital spending. Government capital spending on the national infrastructure (e.g. improvements to our motorway network or an increase in the building programme for new schools and hospitals) contributes to an increase in investment across the whole economy. Lower rates of corporation tax and other business taxes might also be used as a policy to stimulate a higher level of business investment and attract inward investment from overseas

3. Entrepreneurship and new business creation: Government spending might be used to fund an expansion in the rate of new small business start-ups

4. Research and development and innovation: Government spending, tax credits and other tax allowances could be used to encourage an increase in private business sector research and development – designed to improve the international competitiveness of domestic businesses and contribute to a faster pace of innovation and invention

5. Human capital of the workforce: Higher government spending on education and training (designed to boost the human capital of the workforce) and increased investment in health and transport can also have important supply-side economic effects in the long run. An enhanced transport infrastructure is seen by many business organisations as absolutely essential if the UK is to remain competitive within the European and global economy

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Free market economists are normally sceptical of the effects of government spending in improving the supply-side of the economy. They argue that lower taxation and tight control of government spending and borrowing is required to allow the private sector of the economy to flourish. They believe in a smaller sized state sector so that in the long run, the overall burden of taxation can come down and thus allow the private sector of the economy to grow and flourish.

However targeted government spending and tax decisions can have a positive impact even though fiscal policy reforms take a long time to feed through. The key is to help provide the right incentives for individuals and businesses – for example the incentives to find work and incentives for businesses to increase employment and investment.

Key Concepts

Automatic stabilisers Automatic fiscal changes are changes in tax revenues and government spending arising automatically as the economy moves through different stages of the business cycle - for example a fall in the level of tax that the government takes out of the circular flow when the economy suffers a slowdown or a recession.

Balanced budget When total government spending equals the amount coming in from tax revenues in any given year.

Contractionary fiscal policy Any change in fiscal policy that aims to reduce either the level of or the growth of aggregate demand. Traditionally used to smooth the economic cycle by reducing private sector spending during a boom or when inflation is rising.

Demand-side fiscal policy Changes in government spending, taxation and borrowing aimed at changing one or more of the components of aggregate demand.

Flat rate tax

Suggestions for further reading on fiscal policy and the economy

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on government spending and taxation.

Death and taxes (BBC news, October 2007)

Property prices fuel inheritances (BBC news, May 2008)

Scottish councils vote in favour of a local income tax (BBC news, June 2008)

Taxing time to stabilise the climate (BBC news, June 2008)

UK government plans spending cuts (BBC news, March 2008)

UK government‘s fiscal rules explained (BBC news, July 2008)

US tax rebates may have stimulated consumer spending (BBC news, June 2008)

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25. Government Borrowing – the Budget Deficit

The level of government borrowing is an important part of fiscal policy and management of aggregate demand in any economy. When the government is running a budget deficit, it means that in a given year, total government expenditure exceeds total tax revenue.

If the government is running a budget deficit, it has to borrow this money through the issue of government debt such as Treasury Bills and long-term government bonds. The issue of debt is done by the central bank and involves selling debt to the bond and bill markets. Most of the government debt is bought up by financial institutions but individuals can buy bonds, premium bonds and buy national savings certificates.

Government finances have moved from surplus in the late 1990s to a deficit of over 3% of GDP in 2007. As our chart below shows, the UK government has run a sizeable budget deficit in each of the last six years. The emergence of a rising budget deficit has been due to a weaker economy and the effects of increases in government spending on priority areas such as health, education, transport and defence. Both current and capital spending have risen sharply in real terms.

Budget Balance = Tax revenues - Total Government Spending, £ billion

Government Borrowing and the National Debt

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

bill

ions

-60

-50

-40

-30

-20

-10

0

10

20

£ (

bill

ions)

-60

-50

-40

-30

-20

-10

0

10

20

UK Government Budget Balance £bn

32.5

35.0

37.5

40.0

42.5

45.0

47.5

50.0

52.5

£

32.5

35.0

37.5

40.0

42.5

45.0

47.5

50.0

52.5

Government Debt as a % of GDP

Does a budget deficit matter?

A persistently large budget deficit can turn out to be a major problem for the government and the economy. Three of the reasons for this are as follows:

1. Financing a deficit: A budget deficit has to be financed and day-today, the issue of new government debt to domestic or overseas investors can do this. But it may be that if the budget deficit rises to a high level, the government may have to offer higher interest rates to attract buyers of government debt. In the long run, higher government borrowing today may

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mean that taxes will have to rise in the future and this would put a squeeze on spending by private sector businesses and millions of households.

2. A government debt mountain? In the long run, a high level of government borrowing adds to the accumulated National Debt. This means that the Government has to spend more each year in debt-interest payments to holders of government bonds and other securities. There is an opportunity cost involved here because interest payments might be used in more productive ways, for example an increase in spending on health services. It also represents a transfer of income from people and businesses that pay taxes to those who hold government debt and cause a redistribution of income and wealth in the economy

3. Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of government spending. They believe that a rising share of GDP taken by the state sector has a negative effect on the growth of the private sector. They are sceptical about the benefits of higher spending believing that the scale of waste in the public sector is high – money that would be better off being used by the private sector.

Total tax revenues, as a percentage of GDP

Differences in the tax burden

United Kingdom, Total receipts, as a percentage of GDP United States, Total receipts, as a percentage of GDP Sweden, Total receipts, as a percentage of GDP Poland, Total receipts, as a percentage of GDP Slovak Republic, Total receipts, as a percentage of GDP Denmark, Total receipts, as a percentage of GDP

Source: Reuters EcoWin

96 97 98 99 00 01 02 03 04 05 06 07 08 09

30

35

40

45

50

55

60

65

Ta

x B

urd

en a

s %

of G

DP

30

35

40

45

50

55

60

65

Potential benefits of a budget deficit

What are the main economic and social justifications for a higher level of government spending and borrowing? Two main arguments stand out

1. Government borrowing can benefit economic growth: A budget deficit can have positive macroeconomic effects in the long run if it is used to finance extra capital spending that leads to an increase in the stock of national assets. For example, higher spending on the transport infrastructure improves the supply-side capacity of the economy promoting long-run growth. And increased public-sector investment in health

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and education can bring positive effects on labour productivity and employment. The social benefits of increased capital spending can be estimated through use of cost-benefit analysis.

2. The budget deficit as a tool of demand management: Keynesian economists would support the use of borrowing as a way of fine-tuning or managing AD. An increase in borrowing can be a stimulus to demand when the economy is suffering from weak spending. The argument is that the government can and should use fiscal policy to keep real national output closer to potential GDP so that we avoid a large negative output gap. Maintaining a high level of demand helps to sustain growth and keep unemployment low.

Key Concepts

Balanced budget When total government spending equals the amount coming in from tax revenues in any given year.

Budget deficit A budget deficit occurs when government spending is greater than tax revenues.

Discretionary fiscal policy Deliberate attempts to manage the level and growth of aggregate demand using changes in government spending, direct and indirect taxation and the level of government borrowing.

Golden Rule A rule introduced by Gordon Brown which says that government borrowing on state provided goods and services should be zero over the course of one economic cycle. Borrowing is allowed when it finances investment.

National debt The total (cumulative ) amount of debt that the government owes the private sector

Suggestions for further reading on government borrowing

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on government borrowing.

EU to act over size of UK budget deficit (BBC news, June 2008)

Gordon Brown‘s economic options (BBC news, May 2008)

Government finances face a shortfall (Press Association, July 2008)

Northern Rock rescue adds £100bn to the national debt (This is Money, February 2008)

Public finances meet their target (BBC news, April 2008)

Spain turns to public works to save economy (Guardian, April 2008)

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26. Supply-side Policies

The ―supply side‖ refers to factors affecting the quantity or quality of goods and services produced by an economy such as the level of productivity or investment in research and development.

What are supply-side policies?

Supply-side economic policies are mainly micro-economic policies designed to improve the supply-side potential of an economy, make markets and industries operate more efficiently and thereby contribute to a faster rate of growth of real national output

Most governments now accept that an improved supply-side performance is the key

to achieving sustained growth without a rise in inflation. But supply-side reform on its own is not enough to achieve this growth. There must also be a high enough level of AD so that the productive capacity of an economy is actually brought into play.

Different approaches to the supply side

Neo-Liberal, Free-market Approach

(1) Cut government spending and taxes (2) Laws to control trade union powers (3) Keep government intervention to a minimum (4) Tough competition laws and laws to protect intellectual property

Interventionist Approach

(1) State has key role in investing in public services (2) Tax incentives and welfare reforms (3) Regional policy to boost under-performing areas (4) Perhaps some case for controlling trade to allow domestic industries to expand

There are two broad approaches to the supply-side. Firstly policies focused on product markets where goods and services are produced and sold to consumers and secondly the labour market – a factor market where labour is bought and sold.

Supply Side Policies for Product Markets

Product markets refer to markets in which all kinds of commodities are traded, for example the market for airline travel; for mobile phones, for new cars; for pharmaceutical products and the markets for financial services such as banking and occupational pensions.

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Supply-side policies in product markets are designed to increase competition and efficiency. If the productivity of an industry improves, then it will be able to produce more with a given amount of resources, shifting the LRAS curve to the right.

Privatisation

Over the last twenty-five years, many former state-owned businesses have been privatised – i.e. they have transferred from the public to private sector. Examples in Britain include British Gas, British Telecom, British Airways, British Steel, British Aerospace, the regional water companies, the main electricity generators and distributors, and the Railways.

British Rail was privatised in 1994 but the failure of Railtrack led to the creation of Network Rail, a ‗not for profit‘ company in 2002. And in 2008 the government was forced into taking Northern Rock into state ownership following the collapse of the bank.

Privatization is designed to break up state monopolies and create more competition. The government also created utility regulators who have imposed price controls on many of these industries and who are now over-seeing the move towards competitive markets in areas such as gas and electricity supply and telecommunications.

Deregulation of Markets

De-regulation or liberalisation means the opening up of markets to greater competition. The aim of this is to increase market supply (driving prices down) and widen the range of choice available to consumers. The discipline of competition should also lead to greater cost efficiency from producers – who are keen to hold onto their existing market share. Good examples of deregulation to use include: urban bus transport, parcel delivery services, mortgage lending, telecommunications, and gas and electricity supply.

Toughening up of Competition Policy

Most supply-side economists believe in the dynamic effects of greater competition and that competition forces business to become more efficient in the way in which they use scarce resources. This reduces costs which can be passed down to consumers in the form of lower prices. A tougher competition policy regime includes policies designed to curb anti-competitive practices such as price-fixing cartels and other abuses of a dominant market position – in other words – intervention to curb some of the market failure that can come from monopoly power

A commitment to free international trade

Trade between nations creates competition and should be a catalyst for improvements in costs and lower prices for consumers. The UK government is committed to an expansion of free trade within the European Single Market and also to negotiating a liberalisation of trade in the global economy as part of its membership of the World Trade Organisation. For example, it wants to see further reforms of the Common Agricultural Policy as a stepping-stone to global trade agreements between Europe, the United States and developing countries.

Measures to encourage small business start-ups / entrepreneurship

The small businesses of today can often become the larger businesses of tomorrow, adding to national output, employing more workers and contributing to innovative behaviour that can have

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positive spill-over effects in other industries. Governments of all political persuasion argue that they want to promote an entrepreneurial culture and to increase the rate of new business start-ups. Supply side policies include loan guarantees for new businesses; regional policy assistance for entrepreneurs in depressed areas of the country; advice for new firms

Capital investment and innovation:

Capital spending by firms adds to aggregate demand (C+I+G+(X-M)) but also has an important effect on long run aggregate supply. Supply side policies would include tax relief on research and development and reductions in the rate of corporation tax. Ireland is a good example of a country inside the EU that has benefited hugely from cutting company taxes which has led to a large rise in foreign direct investment. One of the new countries that joined the EU in 2004, Estonia, has cut its corporation tax rate to zero per cent (0%) in a deliberate attempt to attract new investment and stimulate economic growth and employment. There are now big differences in corporation tax rates among the twenty five nations of the European Union.

Corporate Tax Rates in the European Union in 2005

Estonia 0.0% Luxembourg 30.0%

Ireland 12.5% Denmark 30.0%

Lithuania 15.0% Czech Rep. 31.0%

Cyprus 15.0% Portugal 33.0%

Latvia 19.0% Austria 34.0%

Slovakia 19.0% Belgium 34.0%

Poland 19.0% Italy 34.0%

Hungary 20.0% Netherlands 34.5%

Slovenia 25.0% Spain 35.0%

Sweden 28.0% Greece 35.0%

Finland 29.0% France 35.4%

UK 30.0% Germany 38.7%

The issue of incentives is crucial for if inventions and innovations can be widely and easily copied and implemented, then the rewards to those engaged in cutting-edge research might be diluted leading to a decrease in the willingness of entrepreneurs to take risks.

Innovation and Economic Growth

‗A dynamic environment with opportunities for enterprise and innovation is vital to improving economic performance. New businesses entering the marketplace increase competitive pressures facilitating the introduction of new ideas and technologies. The Government is therefore committed to supporting enterprise and innovation throughout the economy, including in Britain‘s most disadvantaged areas.‘

Source: Government Spending Review Statement, July 2002

Supply side policies for the Labour Market

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These policies are designed to improve the quality and quantity of the supply of labour available to the economy. They seek to make the British labour market more flexible so that it is better able to match the labour force to the demands placed upon it by employers in expanding sectors thereby reducing the risk of structural unemployment. An expansion in the UK‘s total labour supply increases the productive potential of an economy. That expansion in the supply of people willing and able to work can come from several sources for example: encouraging older people to stay in the workforce; a relaxed approach to labour migration and measures to get non-working parents to actively look for work.

Trade Union Reforms

Many of the traditional legal protections enjoyed by the trade unions have been taken away – including restrictions on their ability to take industrial action and enter into restrictive practices agreements with employers. The result has been a decrease in strike action in virtually every industry and a significant improvement in industrial relations in the UK.

Increased Spending on Education and Training

Economists disagree about the scale of the likely economic and social returns to be earned from higher spending on education – but few of them deny that ―investment in education‖ has the potential to raise the skills within the work force and improve the employment prospects of thousands of unemployed workers. The economic returns from extra education spending can vary according to the stage of development that a country has achieved.

Government spending on education and training improves workers‘ human capital. Economies that have invested heavily in education are those that are well set for the future. Most economists agree, with the move away from industries that required manual skills to those that need mental skills, that investment in education, and the retraining of previously manual workers, is absolutely vital.

It should also be noted that improved vocational training, especially for those who lose their job in an old industry should improve the occupational mobility of workers in the economy. This should help reduce the problem of structural unemployment. A well-educated workforce acts as a magnet for foreign investment in the economy.

The focus in recent years seems to have shifted to encouraging more firms to invest in apprenticeship schemes especially for younger workers who have not fared well either in education or employment. A topical concern is the job prospects of NEETs – a group of young people not in employment, education or training.

Income Tax Reforms and the Incentive to Work

Economists who support supply-side policies believe that lower rates of income tax provide a short-term boost to demand, and they improve incentives for people to work longer hours or take a new job – because they get to keep a higher percentage of the money they earn.

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Do lower taxes really help to increase the active labour supply in the economy? It seems obvious that lower taxes should boost the incentive to work because tax cuts increase the reward from a job. But some people may choose to work the same number of hours and simply take a rise in their post-tax income! Millions of other workers have little choice over the hours that they work.

Showing the effects of supply-side improvements in the economy

Supply-side factors often help to explain why it is that some countries grow faster than others. In a world of globalisation, it is becoming clearer that maintaining and improving competitiveness is vital in achieving success in international markets. A rising share of GDP in most countries is devoted to international trade. Markets are becoming more competitive and those countries whose supply-side lets those down can find a rising level of import penetration into their domestic markets and a weak export performance in goods and services.

Supply side improvements can also be shown using a production possibility frontier

Supply side policies and productivity

It is important to recognise that the supply-side does not operate in isolation from changes in aggregate demand. If there is insufficient AD, it is unlikely that better supply-side performance can be achieved over a number of years. Equally, if aggregate demand grows too quickly, acceleration in wage and price inflation might require deflationary policies that ultimately harm a country‘s productive potential.

Evaluating the UK‟s supply-side performance

Poor productivity costs UK economy £340bn a year

Real National Income

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An outward shift in LRAS helps to increase the economy‘s underlying trend rate of growth – it represents

an increase in potential GDP

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The lack of motivation and productivity among UK employees is costing £340bn every year, according to research. Only 15% of UK workers consider themselves to be 'highly motivated' and a quarter (24%) admit to just 'coasting' at work, according to what‘s My Motivation survey by the Hay Group consultancy. Just one in five (21%) of the 500 UK employees surveyed thought they were 'very effective' in their current job role and less than half (48%) rated themselves as ambitious.

Emmanuel Gobillot, director of leadership services at Hay and author of the report, said: "Companies are failing to engage their employees - and paying a heavy price in terms of productivity. British business leaders must focus on gaining the buy-in of workers if the UK is to be competitive in an increasingly global economy." Some 45% of respondents said they would be more productive if they were doing a job they loved and 28% said they could be more productive with better training and management.

Source: Adapted from Personnel Today, October 2006

Annual % change in output per worker for the whole economy

UK Labour Productivity and the Economic Cycle

Source: Reuters EcoWin

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Improvements in the Supply Side Supply-Side Weaknesses

Sustained economic growth. The UK has maintained its position as the 4th largest economy in the world and has weathered the global economic downturn well

There remains a large productivity between the UK and other leading economies – this is now a major focus of supply side policies

There has been a large fall in unemployment and a record level of

Sharp rise in the balance of payments deficit in goods and services –

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employment. The UK currently has the highest employment ratio in the EU

suggesting continued problems of international competitiveness

Falling unemployment and continued low inflation – suggesting an improvement in the trade-off between these two important macroeconomic objectives

Few signs that the underlying rate of economic growth has improved above 2.5% per year – other countries have a faster rate of growth of potential output

The UK labour market is seen as one of the most flexible among leading economies, with a rising level of occupational flexibility of labour

Still an investment gap (including under-investment in public sector services such as education, health and transport) and the UK devotes a falling share of GDP to business research and development

There is a general consensus that the supply-side of the British economy has improved over the last twenty years even though there are still weaknesses in several sectors and the UK must face up to increasingly fierce competition from other countries as the effects of globalisation take hold. Our product and labour markets are more flexible than they were a decade ago but many businesses complain that government intervention places too heavy a cost of administration and other forms of red-tape and that this acts as a barrier to future investment and growth. Increasing amounts of regulation both from the UK and the European Union can add to business costs and reduce competitiveness.

UK economy makes productivity gains

A group of successful British manufacturers has found a secret for increasing productivity at a faster rate than many of their international rivals according to a new study.

Increasing the resources invested in designing and developing new products and handing more power to shop-floor workers to decide how to boost output has worked wonders for parts of the manufacturing sector, the research reveals. However, the slide in the numbers working in manufacturing since 2001 has been steeper in the UK than in the US, France, Japan, -Germany and Italy.

Manufacturing productivity, expressed as output-per-person-per-hour, rose between 2000 and 2005 by nearly 4 per cent, below the USA at 5.5 per cent, but above the average increases in Germany, France, Italy and Spain. However, employment in UK manufacturing has fallen by more than 20 per cent in the past six years.

The studies were carried out by the Engineering Employers Federation and the University of Sheffield's Institute of Work Psychology.

Source: Adapted from the Financial Times, November 2007

Key Concepts

Deregulation Reducing barriers to entry in order to make a market more competitive.

Privatisation Selling state owned assets to the private sector.

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Productivity growth The rate of growth of output per worker or per worker hour

Suggestions for further reading on the supply-side of the UK economy

Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on supply-side economics.

18% of 16-to-17s 'doing nothing' (BBC news, July 2008)

Action urged on broadband future (BBC news, June 2008)

Apprenticeship scheme launched (BBC news, July 2008)

Blair‘s economic legacy (LSE Centrepiece magazine, summer 2007)

British roads not fit for purpose (BBC news, January 2008)

Bus de-regulation is not working (BBC news, October 2006)

China plans huge increase in grain output (BBC news, July 2008)

Long-term jobless must do community work say Tories (Guardian, January 2008)

Ministers plan cash incentives to encourage young to train (Guardian, January 2008)

Plans to improve skills of the young in Scotland (BBC news, March 2008)

Transatlantic price war might follow Open Skies agreement (BBC news, February 2008)

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27. Issues in Managing the Economy

Demand Management

Demand management occurs when the government or the central bank attempts to change the level and growth of AD and thereby affect the levels of GDP, employment, the rate of inflation, growth and the balance of payments position.

1. Reflationary policies seek to increase AD and raise the level of planned expenditure at or near the level of potential GDP. They are typically used during a recession or slowdown.

2. Deflationary policies decrease AD if it is running ahead of AS and posing inflationary risks or leading to an unsustainable deficit on the balance of payments.

Problems in Managing the Economy

The government‘s task of managing the economy is made difficult by several factors:

1. Inaccurate economic data: All of the main indicators are subject to a margin of error. They rely on statistical information collected from tax returns and surveys and data is often revised many months after its first release.

2. Conflicting objectives: A policy of stimulating AD may reduce unemployment in the short term but bring about higher inflation and worsen the current account of the balance of payments. Choices may have to be made between objectives and frequently such choices are unpalatable.

3. Selecting the right policy instrument: Each objective requires a separate instrument: The usual ‗rule of thumb‘ is that one main instrument should be assigned to one objective. So, for example, interest rates might be assigned as the main instrument for keeping control of inflation, whilst fiscal policy might be allocated to achieving some supply-side objectives such as increasing productivity. There are disagreements between economists (who belong to different ‗schools of thought‘) as to which policies are most effective to meet a certain objective.

4. Uncertain time lags: Changes in economic policies are subject to uncertain time lags e.g. a change in interest rates is estimated to take some 18-24 months to work its way fully through to filter through to a change in prices. The length of the time lags can change over the years as economic circumstances change.

5. Policy asymmetry: This is especially important when a policy change is being applied to more than one country. For example, when the European Central Bank decides to change official interest rates for the countries inside the Euro Zone, a 1 per cent change in interest rates will have a different impact in one country compared to another – this is called an asymmetric response and it can make it difficult to find a ‗one size fits all‘ interest rate for a group of very different economies.

6. External shocks: Unexpected external shocks such as the events surrounding Sept 11th 2001, the 2007-08 credit crunch or volatility in exchange rates and commodity prices can upset forecasts and take the economy a big distance from the expected path. The Government might under-estimate or exaggerate the potential impact of a shock to either the demand or supply-side of the economy and therefore apply too little or too much of a policy response.

In short, managing the economy is often a matter of judgement rather than a precise science.

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The Effects of Monetary and Fiscal Policy on the Economy

There are some differences in the effects of monetary and fiscal policy, on the composition of output, the effectiveness of the two kinds of policy in meeting the government‘s macroeconomic objectives, and also the time lags involved for fiscal and monetary policy changes to take effect. We will consider each of these in turn:

(1) Effects of Policy on the Composition of National Output

Monetary policy is often seen as something of a blunt policy instrument – affecting all sectors of the economy although in different ways and with a variable impact.

In contrast, fiscal policy can be targeted to affect certain groups e.g. increases in means-tested benefits for low income households, reductions in the rate of corporation tax for small-medium sized enterprises, or investment allowances for businesses in certain regions.

(2) Time Lags of Monetary and Fiscal Policies

Monetary policy in the UK is flexible (interest rates can be changed each month) and emergency rate changes can be made in between meetings of the MPC, whereas changes in taxation take longer to organize and implement. Because capital investment requires planning for the future, it may take some time before decreases in interest rates are translated into increased investment spending. Typically it takes six months – twelve months or more before the effects of changes in UK monetary policy are felt firstly through the components of AD and then affecting growth and inflation.

With fiscal policy, the impact of increased government spending is felt as soon as the spending takes place and cuts in direct and indirect taxation feed through into people‘s pockets pretty quickly. The tax cuts (or fiscal rebates) introduced by George Bush in May 2008 as part of his fiscal strategy to avoid a recession in the USA have been an interesting example of whether such boosts to demand have much impact in the short term. However, considerable time may pass between the decision to launch a new project and it coming to fruition.

Consider as examples a cluster of new infrastructure projects announced by the UK government in the spring and summer of 2008 – Cross Rail, the possibility of five new hi-speed rail lines in the UK, a possible commissioning of new nuclear reactors and the building of two new warships. All of these are major items of capital spending but the lead-times for the projects run into several years at least.

It is rare for any government to be able to meet all its objectives at the same time. The complexity of the economy and the limitations of economic policies make this a really tough task! In this chapter we consider possible trade-offs between the key policy objectives.

Trade-offs

There are potential trade-offs between objectives imply that choices between different goals may have to be made.

Should the highest priority be given to keeping inflation firmly under control?

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Or can the British economy now operate at a higher level of GDP growth and lower unemployment without worrying too much about the inflationary consequences?

Should the government be concerned about a large and rising trade deficit with other countries?

Unemployment and Inflation – the Phillips Curve

Is there a trade-off between unemployment and inflation?

Arguments for a trade-off:

When unemployment falls to low levels, there is a risk that wage and price inflation will pick up. The demand for labour is increasing and labour shortages can put upward pressure on pay as employers offer extra to recruit and retain their key workers.

Falling unemployment leads to an increase in AD which can lead to demand pull inflation if SRAS is inelastic and the output gap has become positive. As the economy heads towards full-employment, there is a danger than inflation will accelerate and that economic policy will have to be tightened (for example a rise in taxation or an increase in interest rates).

Wage

Inflation (%)

Unemployment Rate (%) U1

P1

U2

P2

U3

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Short Run Phillips Curve

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The diagrams below illustrate an outward shift of the demand for labour during an economic boom and an increase in AD from AD1 to AD2 when SRAS is inelastic.

Counter-arguments

per cent

UK Unemployment and Consumer Price Inflation

Source: Reuters EcoWin

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Inflation

Unemployment has many causes and there is no automatic rule that falling unemployment must lead to rising inflation. It is widely acknowledged that the relationship between unemployment and inflation in the UK (and some other countries) has altered over the last fifteen years. As a consequence, the British economy has enjoyed a long period of falling unemployment without any

Real National Income

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significant acceleration in inflation. It has only been in 2008 that the trade-off seems to have returned with signs of a major pick-up in inflation – although much of this has not come from the home (or domestic) economy but as a result of external forces.

Why has the “trade-off” between unemployment and inflation changed?

Some economists point to the effect of supply side improvements in the British economy such as higher capital investment; increases in productivity, lower labour costs and the benefits of rapid innovation. All of these factors have helped to increase the supply-side potential of the economy which has contributed to a period of non-inflationary growth.

But it would be wrong to automatically assume that inflation is now dead! There are plenty of possible causes of a return to higher inflation. For example, the UK is not immune to fluctuations in global commodity prices, or the effects of a sharp fall in the exchange rate. And too much domestic demand for goods and services, perhaps driven by the continued boom in house prices and consumer borrowing, might also bring about a return of demand-pull inflationary pressure.

Economic growth and inflation

Arguments for the trade-off

Sustained growth caused by rising aggregate demand can lead to acceleration in inflation as the economy uses up scarce resources and short run aggregate supply becomes inelastic. When SRAS is elastic, an outward shift of aggregate demand can easily be met by a rise in real GDP (there is plenty of spare capacity and supply responds elastically to the higher level of AD). But when SRAS becomes inelastic, the trade-off between growth and inflation worsens – an increase in AD tends to lead to higher prices rather than increased output and employment.

Counter-arguments

The trade off between growth and inflation can be avoided if an economy is able to increase potential output by improving their supply-side performance. For example, LRAS can be increased by achieving sustained improvements in productivity, advances in technology and the benefits that come from product and process innovations. Potential output is also increased by expanding the stock of capital goods (via higher investment) and through an increase in the available labour supply.

An outward shift in LRAS means that the economy can meet a higher level of aggregate demand without putting upward pressure on the general price level. This is shown in the diagram below. LRAS has moved to the right (an increase in potential GDP). Aggregate demand has also shifted out (perhaps due to lower interest rates or higher real incomes for consumers). Equilibrium national output increases from Y1 to Y2 – the level of output Y2 would not have been feasible without a shift in LRAS.

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Clearly those countries that grow very quickly are at risk of rising inflation. The key is to keep control of aggregate demand (using monetary and fiscal policy) whilst at the same time seeking to increase aggregate supply through improvements in efficiency and the stock of available resources.

If we look at the data for economic growth and inflation in the UK over the last fifteen years, we see that there has indeed been an improvement in the trade-off between these two objectives. In the late 1980s, an economic boom got out of control and excess demand led to a sudden and sharp rise in cost and price inflation. The rate of inflation peaked at over 10% in 1990 and interest rates were increased up to a maximum of 15% in order to bring aggregate demand under control. The result of this was a deep recession lasting for nearly two years – the effect of which was to reduce inflation but which also caused a huge rise in unemployment.

Since the early 1990s the British economy has enjoyed a period of relative macroeconomic stability, with a sustained phase of economic growth allied to continued low inflation. There have been some years of very strong growth (for example in 1997 when real GDP increased by 3.4% and also in 2000 when the economy expanded by 3%). But on the whole the economy has avoided excessive growth of demand which can cause inflation.

Part of the reason for this has been the management of aggregate demand using monetary policy by the independent Bank of England. They have kept the output gap to very low levels (indicating an economy close to macroeconomic equilibrium) whilst a combination of other favourable factors on the demand and supply side of the economy has contributed to low inflation. In the absence of a major external inflationary shock from the global economy, there is every reason to believe that the British economy can continue to enjoy a combination of steady growth and low inflation. But this requires the supply-side of the economy to continue to deliver higher levels of productivity and investment to give the economy the productive capacity to meet demand and to maintain the competitiveness of UK producers in global markets.

AD1

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UK Real GDP Growth and Consumer Price Inflation. annual percentage change

Economic Growth and Inflation

Source: Reuters EcoWin

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Stagflation

Stagflation refers to a combination of stagnant output and high and rising inflation. (Some economists also through rising unemployment into the dangerous stagflation mix!) In this situation it becomes difficult to manage the economy because, on the one hand, companies and employees are suffering from slow-growing or falling production (which can lead to lower profits and job losses), whilst prices are rising more quickly which threatens our real standard of living.

Stagflation was widely scene in the mid 1970s and also in the late 1980s. But for most of the last fifteen to twenty years the UK economy, along with many other countries, has enjoyed a period of remarkable macroeconomic stability. However in 2007 and 2008 we saw the re-emergence of this idea due to a combination of economic events from home and overseas.

1. The credit crunch, a slump in property prices and the effects of soaring commodity prices have caused a fall in consumer confidence and hit our real disposable incomes. A sharp rise in global food prices and oil and gas prices has hit millions of people and caused the economy to slow down raising fears of a recession.

2. Inflation has been stoked up by big increases in the prices of petrol, diesel, electricity, gas, basic foods and other products that use oil and foodstuffs as essential inputs. A fall in the value of the sterling exchange rate has exacerbated inflationary pressures because it increases the costs of importing goods and services.

When stagflation starts to appear, this makes life very difficult for the Monetary Policy Committee of the Bank of England. They are pulled between the need to fight inflation (and keep inflation within target range) and avoid an economic slump – both of which can cause huge damage.

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Economic Growth and the Balance of Payments

Is there a trade off between fast economic growth and a worsening of the balance of trade in goods and services?

Arguments for the trade-off

When aggregate demand is high and domestic producers are unable to meet all of this demand, so the demand for imported goods and services will increase leading to an increase in the trade deficit. This trade-off is evident when the main source of rising AD is a high level of consumer spending. British consumers have a high propensity to import goods and services. As their incomes increase, so too does their demand for imports. The trade-off is worsened by the lack of international competitiveness of many UK industries compared to other leading countries.

The experience of the UK in recent years shows that the size of the trade deficit is largely cyclical. The strong growth of GDP and consumer demand has led to a large increase in the trade deficit in goods and services. This suggests that if the government wants to reduce the trade deficit, then it must accept that consumer demand (and GDP) must eventually grow at a slower rate in order to reduce the imbalance between exports and imports.

Counter-arguments

Economic growth can be achieved without a worsening of the balance of payments in goods and services. The causes of a trade deficit are not solely cyclical – there are structural explanations too – indeed in the long run, the main causes of imports out-pacing exports relate to the competitiveness of UK producers in their own domestic markets and when trying to export overseas.

Much depends on the strength of the exchange rate. When sterling is strong, the relative prices of imports coming into the UK falls, and British exports because more expensive in international markets – these causes a slowdown in export sales and a rise in the demand for imports. Depreciation in the exchange rate would provide a competitive boost to UK producers and might lead to an improvement in our balance of payments. However, a low exchange rate would also lead to an increase in the costs of imported goods and services risking higher ―cost-push‖ inflation.

Exports can also be increased if our domestic industries increase their competitiveness in other ways: higher productivity helps to reduce unit costs; greater investment in new capital and research and development can lead to a faster pace of innovation and new products in export sectors. Non-price competitiveness can also be improved by better design, after sales service, guaranteed delivery dates and more effective marketing.

Export-led growth (i.e. increases in aggregate demand brought about by an increase in the value of exported goods and services) can bring about economic growth without deterioration in a country‘s trade balance.

A worsening of the trade balance in goods and services acts as a drag on short term economic growth for a country because imports are counted as a withdrawal from the circular flow of income and spending – so a surge in demand for overseas-produced goods and services leads to a flow of income and demand out of the economy.

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Miracle or mirage

The Brown "miracle" was a mirage, founded on a sea of debt and resting on an illusion of prosperity created by rampant house price growth and a yawning balance of payments deficit.

Source: Roger Bootle, Capital Economics, the Telegraph, July 2008

Key Concepts

Fine-tuning Changes in monetary policy or fiscal policy designed to gradually manage the level of aggregate demand and prices

Misery index A measure of welfare calculated by adding together the unemployment rate and the rate of inflation.

Non-inflationary growth Sustained growth of real national output whilst maintaining price stability

Phillips Curve A statistical relationship between unemployment and inflation

Tight labour market When demand for labour is high and there are shortages of labour. Businesses may have to offer higher wages to attract and keep the workers they need.

Trade-off A trade-off implies that choices have to be made between different objectives of economic policy

Getting a flavour for the best of economic journalism

There are many writers who offer comment and analysis on the major macroeconomic issues of the day – here is a selection of recommended journalists who have an expertise in writing about the economy. Many of their articles will be useful for you to develop your synoptic understanding.

Ashley Seager of the Guardian

David Smith of the Sunday Times

Gary Duncan of the Times

Hamish McRae of the Independent

Paul Mason from BBC‘s Newsnight

The BBC programme ―Working Lunch‖ also carries regular reports on the state of the economy together with the BBC news home page for economic news.

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28. China and the UK Economy

Events in one country inevitably have spill-over effects onto others. This chapter considers how the rapid growth and development of the Chinese economy has affected the UK in recent years

A change in the balance of economic power

―Convincing evidence is emerging that an inexorable shift in economic power from West to East is underway. It is unlikely that any national economy will follow a steady and predictable growth path over a twenty to fifty year period, but there is a strong likelihood that western economies, including that of the United Kingdom, will play a diminishing role in the global economy over time, and that China, India and other emerging nations will play a growing role.‖

Source: Treasury Select Committee Report on Globalisation, January 2008

China‟s macro-economy

Economic indicator Unit 2004 2005 2006 2007 2008F

GDP growth % Year 10.1 10.2 11.1 11.4 11

Consumer spending % Year 7.2 8.5 8.7 9 8.9

Capital investment % Year 21.5 22.3 21.5 20.7 18.6

Exports % Year 32 29 25 23.5 18

Inflation % Year 3.9 1.8 1.5 4.8 4.1

Manufacturing wages % Year 12.3 12.3 14.5 15 14

BoP Current Account % of GDP 3.6 7.2 9.4 9.7 10

Official Interest Rates per cent 1.7 1.7 1.7 2.6 3.6

Source: HSBC Economics. Data for 2008 is a forecast from HSBC

Interpreting the information in this table:

1. Growth in China continues to exceed 10% per year – a phenomenal trend growth rate but one that is likely to slow down in the next few years.

2. Consumer spending has also risen strongly – though less quickly than GDP – but rising demand is having a huge effect on global demand for metals and foodstuffs.

3. Notice the incredibly strong data for capital investment – some of linked to the 2008 Beijing Olympics – but also huge investment in transport and energy infrastructure.

4. Export growth remains super-charged – one of the key questions is whether Chinese economic growth has become ‗de-coupled‘ from the economic cycle of the USA – i.e. can China find new export markets if the USA suffers a deep recession?

5. Inflation is picking up – less than 2% in 2005-06 but now more than 4% - the highest inflation for a decade – signs of an over-heating economy.

6. Look how quickly manufacturing wages are rising – higher wages boost real incomes and spending power, but they also add to supply costs if wages rise faster than productivity

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7. The balance of payments surplus on the current account is enormous – forecast to be 10% of China‘s GDP this year – leading to huge accumulations of foreign exchange – allowing the Chinese sovereign wealth funds to make major strategic stakes in overseas businesses. (China has established a company – the Chinese State Investment Bank - to invest the profits of its booming economy in foreign firms.)

8. Interest rates are being raised – but will this be enough to control inflation and engineer a softer-landing for the Chinese economy?

China‘s emergence as a superpower has undoubtedly had some important demand and supply-side effects on the UK in recent years. This revision note considers some of those links.

Index of disposable income, 1978=100

China - Real per Capita Incomes

Rural Households, Per capita annual net income Urban Households, Per capita annual disposable income

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

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Originally the ―China Effect‖ was used to describe the deflationary effects on the price level in the UK and other countries that has come from China‘s huge export-led growth. The seismic shift in manufacturing of shoes, clothing, iPods and household appliances to a lower labour cost country has helped to keep inflation down in the UK. And to this extent, mortgage payers in Britain have China to thank in part for their cheaper borrowing costs whilst consumers with a faulty kettle can simply pop down to Tesco to replace it rather than find the money for it to be repaired down the high street.

Professor Richard Freeman of Harvard University has estimated that the opening up of China and India, together with the collapse of the iron curtain in Europe, had resulted in a doubling of global labour supply – perhaps the biggest positive supply-side shock to the global economy in decades.

For the UK, the ―China Effect‖ has until recently:

Reduced the real prices of many staple household goods and appliances

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Put severe competitive pressure on UK manufacturing businesses struggling to compete with Chinese producers in international markets

Caused a bigger trade deficit with China – this has a negative effect on AD (C+I+G+X-M)

Caused a fall in the price of many imports thereby shifting out SRAS to the right

Lower import prices make incomes stretch further and help to dampen down pay claims. The China effect has until recent times reduced both the actual and the expected rate of consumer price inflation in the UK

Annual data, $ billion

China - Balance of Trade In Goods in Services

Source: Reuters EcoWin

00 01 02 03 04 05 06 07

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But in some ways the China Effect has and is proving to have inflationary consequences for the UK.

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China‘s rapid growth has been a key factor behind the surge in global commodity prices – there has been rampant price inflation in many hard and soft metals and also in foodstuffs such as wheat and rice.

Part of the reason is that China‟s demand for meat is increasing (the income elasticity of demand for meat is strongly positive) and this is driving up the demand for the grain used in producing cattle feed. Food prices in China are rising at more than 20% per year.

China has contributed heavily to the extra global demand for oil and other sources of energy – driving crude oil prices high and delivering an inflationary shock to the world economy – China is engaged in a determined search to secure the supplies of essential fuels and other minerals it needs to keep her growth strong in the years ahead.

China appears to be growing too fast for its own good, there is demand-pull inflation in the economy and the era of Chinese price deflation exported to advanced nations has come to an end.

The huge Chinese trade surplus with the US is contributing to dollar weakness – this is driving sterling higher and making many of our export industries less competitive.

Chinese deflation has kept UK interest rates lower than they might otherwise have been – and this helped to stoke the housing boom / bubble - now at an end following the credit crunch. Indeed one can argue that China‘s contribution to globalisation has been a driving force behind the surge in global savings and the boom in credit and debt in advanced nations.

So what can we expect? Much depends on what happens to:

(1) The Chinese-US dollar exchange rate – will the Chinese authorities allow the Yuan to appreciate and rebalance some of the trade between the two countries? A weaker US dollar will stimulate their economy but make our commodity imports (priced in dollars) more expensive. There are signs that the Chinese currency is now appreciating at a faster rate against the dollar – in part to help control inflationary pressure in China

(2) The China effect may be followed by an ―African effect‖ or a ―Bangladesh effect‖ – for as manufacturing in China becomes more expensive, production may start to relocate towards lower cost centres e.g. other emerging market countries such as Vietnam, Indonesia or Nigeria.

(3) If the Chinese economy slows down (they have started to raise interest rates but with little or no effect thus far), then world commodity and energy prices may fall back, reducing some of the inflationary threat to the rest of the world economy

Suggestions for further reading on China and the UK economy

China in numbers (Independent, May 2008)

China plc needs new foreign formula (BBC news, May 2008)

China‘s export slow as exchange rate rises (BBC news, July 2008)

Cracks in China‘s economy (BBC news, June 2008)

Guardian special reports on China

In 2050 the world will be run by a new middle class – based in Asia (Independent, July 2008)

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The China Effect (LSE Centrepiece magazine, autumn 2006)

The dragon awakens, China – how did it happen (Hamish McRae, Independent, May 2008)