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Introduction This resource is designed as a complement to your studies in AS Economics and should not be regarded as a substitute for taking effective notes in your lessons. Points raised and issues covered in class analysis and discussion invariably go beyond the narrow confines of this guide. Economics being the subject that it is, events and new economic policy debates will inevitably surface over the next twelve months that take you into new and exciting territory. Providing you understand many of the core concepts and ideas available to an economist, you will be in a good position to understand many of the new issues that arise and you will build an awareness of the problems in developing strategies and policies to combat some the main economic and social problems of our time. Each chapter of this Guide contains a core set of notes, key definitions and diagrams together with a series of short case study readings and web links designed to encourage you to read widely and explore many aspects of the course in greater detail. Economics is a dynamic subject, the issues change from day to day and there is a wealth of comment and analysis in the broadsheet newspapers, magazines and journals that you can delve into. The more reading you manage on the main issues of the day the wider will be your appreciation of the theory and practice of economics. Here are some resources on the Internet that you should make a point of visiting on a regular basis:

Web Resource Recommendation

BBC Business and Economics News Incredible coverage of domestic and international issues

Economist Leading international business magazine

Economist A-Z of Economics Useful background glossary with external links

Economist Country Briefings Series of short background briefings on all major economies

Ernst and Young Economic Update Excellent quarterly research on the UK and global economy

Guardian Great site for research and special reports – see their special archive section on economics using this link

Halifax Bank of Scotland Research Excellent reviews on the UK economy

HM Treasury The web site of the Treasury – superb for data

Independent Strong coverage of current business/industrial trends

Institute for Fiscal Studies Super resource for aspects of government fiscal policy

International Monetary Fund Excellent for global economic research and policy issues

Office of National Statistics The main site if you need economic statistics for essays! The monthly Economic Trends is a superb resource for teachers

Organisation of Economic Co-operation and Development

Superb for in depth analysis of the global economy from the OECD including country surveys and economic reports. For information on the UK use this link:

Royal Bank of Scotland Web site offering economic research on the UK and international economy including recent presentations

Tim Harford – Undercover Economist Lively writing on economics each week – well worth it

Tutor2u Economics The leading AS and A Level economics portal! The daily economics blog is available here.

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Table of Contents 1. Introduction to Macroeconomics and Indicators of Economic Performance.........................................4 2. Measuring National Income.........................................................................................................................8 3. Macroeconomic Objectives....................................................................................................................... 12 4. Using Index Numbers................................................................................................................................. 14 5. Aggregate Demand................................................................................................................................... 16 6. Consumer Spending and Saving.............................................................................................................. 21 7. Capital Investment...................................................................................................................................... 27 8. Aggregate Supply ..................................................................................................................................... 31 9. Macroeconomic Equilibrium ...................................................................................................................... 37 10. The Macroeconomic Cycle ........................................................................................................................ 42 11. Multiplier and Accelerator Effects........................................................................................................... 45 12. Economic Growth ........................................................................................................................................ 49 13. Inflation ........................................................................................................................................................ 54 14. Employment and Unemployment ............................................................................................................. 61 15. International Trade .................................................................................................................................... 70 16. Balance of Payments ................................................................................................................................. 73 17. Government Macroeconomic Policy........................................................................................................ 78 18. Monetary Policy.......................................................................................................................................... 81 19. The Exchange Rate..................................................................................................................................... 85 20. Fiscal Policy ................................................................................................................................................. 89 21. Government borrowing – the budget deficit ........................................................................................ 94 22. Supply-side Policies ................................................................................................................................... 96 23. Trade-Offs between Objectives ...........................................................................................................101 24. Exam Technique for your macroeconomics paper..............................................................................106

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1. Introduction to Macroeconomics and Indicators of Economic Performance In this chapter we consider what macroeconomics is and we look at some of the key indicators of interest to students of macroeconomics. What is macroeconomics? Macroeconomics considers the economy as a whole and relationships between one country and others for example we focus on changes in economic growth; inflation; unemployment and our trade performance with other countries (i.e. the balance of payments). The scope of macroeconomics also includes looking at the relative success or failure of government policies. Introduction to the UK economy

The City of London, an important centre for international finance and a major source of income for

our balance of payments

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

whole economy

Searching for work – unemployment has been low in the UK for over ten years – but it is now starting to rise

again

Anticipating demand – stocks of products in a warehouse. Businesses need to anticipate demand

changes when setting production levels

• The United Kingdom is one of the world’s leading advanced economies. It has the second largest economy in the European Union (EU) behind Germany and just ahead of France and it is the second biggest exporter of services in the global economy and ranked eighth in global exports of goods. In 2006 the UK will contribute 3 per cent to global output.

• In terms of per capita national income, the UK is ranked in the top fifteen nations of the world and in 2006 it is forecast that the UK will have a per capita income (PPP adjusted) of $31,529 some distance behind that of the United States and also Norway and Ireland, two of Europe’s richest countries.

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• Britain has enjoyed a period of continuous growth that stretches back to 1992, the longest sustained expansion for over forty years. However, in 2005, real GDP grew by 1.8%, the slowest pace of growth for twelve years.

• Over 27 per cent of the UK’s GDP in 2005 came from exports of goods and services. Imports amounted to 31.5 per cent of national income leading to a large trade deficit in goods and services with other countries.

• The UK joined the European Economic Community (now known as the EU) in January 1973 and it is a founder member of the World Trade Organisation. The UK retains its own currency having decided for the time being not to consider entry to the EU single currency area, the Euro Zone.

The main sectors of the economy

• Households: receive income for their services and then buy the output of firms (consumption) • Firms: hire land labour and capital to produce goods and services for which they pay wages rent etc

(income). Firms receive payment. Firms invest (I) in new producer goods • Government: collect taxes (T) to fund spending on public services (G) • International: The UK buy overseas products, imports, (M)) and overseas economic agents buy UK

products, exports (X) The world economy The global economy is undergoing huge changes at the moment as the effects of the current wave of globalisation become more apparent each day. To broaden your awareness and understanding of macroeconomics, it is a good idea to become familiar with some of the world’s leading economies and perhaps see how they compare and contrast with that of the UK. The links below will help you to find out more. European Union (25 countries) Countries in italics joined in 2004

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 UK Japan Emerging Markets include South Korea China India OPEC Russia inc Brazil Saudi Arabia South Africa Nigeria Targets and objectives of macroeconomic policy Government management of the economy is a key political issue and each government sets targets and objectives when it assumes power – and often, economic objectives and priorities lie right at the heart of a government’s overall political strategy. We focus on large number when we undertake the study of macroeconomics. For example, the value of national output in the UK, expressed at constant prices so that we eliminate the effects of inflation on the value of what we produce and consume, edged above £1 trillion in 2003. But we still stand well below the United States, whose national output (GDP) accounts for over a quarter of world output each year. No wonder that people often say “when the United States catches sneezes, the rest of the world catches a cold!”

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What are the main indicators we use when making cross-country comparisons of economic performance? Traditionally we have tended to focus on four key indicators of achievement. They are

1. Growth: The rate of growth of real national output (i.e. real GDP)

2. Inflation: The rate of price inflation (i.e. the annual percentage change in the price level)

3. Unemployment: The rate of unemployment in the labour market

4. Trade: The balance of payments in trade in goods and services and net flows of investment income – representing the effects of trade and investment between countries

The UK economic cycle

Annual percentage change in GDP at constant pricesGrowth of National Output for the UK

ar 4 quartersSource: Reuters EcoWin

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Per

cent

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

The economic cycle is also known as the business cycle. The chart above shows the annual rate of growth of national output for the UK economy since 1980. There have been two recessions in the last twenty-five years. The early 1980s downturn was a deep recession – the worst downturn in the UK’s post-war history. We can see the descent into recession in 1990 and 1991 and then a recovery which was maintained throughout the remainder of the 1990s. Further positive rates of growth have been sustained in the first six years of the current decade, allowing the UK economy to claim one of the longest periods of expansion in our modern history. After a slowdown in 2005 the British economy looked to be enjoying stronger growth in the first half of 2006. As we shall see later, all countries go through a business or economic cycle leading to fluctuations in national output and unemployment. The chart below shows what has happened to the US economy over recent years. The United States enjoyed a period of fast growth during the second half of the 1990s. But a combination of rising interest rates (the US central bank raised the cost of borrowing to curb the growth of consumption) and of course the fallout from the events of 9-11 which severely affected consumer and business confidence brought about a sharp slowdown in their growth rate. The USA economy went into a steep slowdown – but although, for a short period, national output did fall, the annual growth rate stayed positive before a recovery emerged in 2002 and 2003. In 2003, the US economy grew by 3% and growth climbed above 4% in 2004 before edging lower in 2005. The United States has been running a policy of low interest rates for most of the current decade. But between 2004 and 2006, they have been gradually increasing interest rates in a bid to control demand and inflationary pressures. As a result, the speed of growth in the USA is now starting to slowdown.

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Per centUSA Interest Rates and Real GDP Growth 1995-2005

Official Interest Rate (Set by the Federal Reserve) Annual growth of real national output [ar 1 year]Source: Reuters EcoWin

95 96 97 98 99 00 01 02 03 04 05

Per

cent

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Economic Growth

Per

cent

0

2

4

6Interest Rates

We can compare and contrast the relative performance of different countries by making use of the economic data published for each nation. The main source of data for the UK is via the Office for National Statistics where there is a wealth of information not just on Britain but also for each of our regions and for other countries as well.

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2. Measuring National Income We need information on how much spending, income and output is being created in an economy over a period of time. National income data gives us this information as we see in this chapter. Measuring national income To measure how much output, spending and income has been generated in a given time period we use national income accounts. These accounts measure three things:

1. Output: i.e. the total value of the output of goods and services produced in the UK. 2. Spending: i.e. the total amount of expenditure taking place in the economy. 3. Incomes: i.e. the total income generated through production of goods and services.

What is National Income? National income measures the money value of the flow of output of goods and services produced within an economy over a period of time. Measuring the level and rate of growth of national income (Y) is important to economists when they are considering:

• The rate of economic growth

• Changes over time to the average living standards of the population

• Changes over time to the distribution of income between different groups within the population (i.e. measuring the scale of income and wealth inequalities within society)

Consumer spending accounts for over two thirds of total spending. 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 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 in the UK economy. 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: Nissan at Sunderland – Celebrating 20 years of production The Nissan plant at Washington, Tyne and Wear is celebrating its 20th anniversary in July 2006, the first car having rolled off the line on July 8th, 1986. In that first year of production 470 staff had a production target of 24,000 Bluebirds. Twenty years on, more than 4,200 employees produce around 310,000 Micras, C+Cs, NOTEs, Almeras and Primeras each year. That car has been followed by 4.3 million others thanks to a total investment of £2.3 billion. Production is set to rise from 310,000 per year last year to 400,000 in 2007 with the introduction of a new small 4x4, and Sunderland has been rated as Europe's most productive car factory for the last eight years.

Sources: Reuters News, Sunderland Echo, July 2006 (i) The Expenditure Method of calculating GDP (aggregate demand) This is the sum of spending on UK produced goods and services measured at current market 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 of calculating GDP (the Sum of Factor Incomes) Here GDP is the sum of the incomes earned through the production of goods and services. The main factor incomes are as follows:

Income from people employment and in self-employment + Profits of private sector companies + Rent income from land

= Gross Domestic product (by factor income)

It is important to recognise that only those incomes that are actually generated through the production of output of goods and services are included in the calculation of GDP by the income approach. We exclude from the accounts the following items:

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

o Private transfers of money from one individual to another.

o Income that is not registered with the Inland Revenue or Customs and Excise. Every year, billions of pounds worth of economic 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 and therefore does not show up in the official statistics!). It is impossible to be precise about the size of the shadow economy but some economists believe that between 8 – 15 per cent of national output and spending goes unrecorded by the official figures.

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

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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 successive stage of the production process. We use this approach to avoid the problems of double-counting the value of intermediate inputs. The table below shows indices of value added from various sectors of the economy in recent years. We can see from the data that manufacturing industry has seen barely any growth at all over the period from 2001-2004 whereas distribution, hotels and catering together with business services and finance have been sectors enjoying strong increases in the volume of output. These figures illustrate a process of structural change, with a continued decline in manufacturing output and jobs relative to the rest of the economy. By far the largest share of total national output (GDP) comes from our service industries. Index of Gross Value Added by selected industry for the UK

Mining and quarrying, inc

oil & gas extraction

Manufacturing Construction Distribution, hotels, and catering; repairs

Business services and

finance

2001 weights in total GDP (out of 1000)

28 172 57 159 249

2001 100 100 100 100 1002002 100 97 104 105 1022003 94 97 109 108 1062004 87 98 113 113 111 We can see from the following chart how there have been divergences in the growth achieved by the manufacturing and the service sectors of the British economy. Indeed by the middle of 2006, the index of manufacturing output was below the level achieved at the start of 2000. In contrast the service industries have enjoyed strong growth, leading to a continued process of structural change in the economy – away from traditional heavy industries towards service businesses.

Index of Value Added, Constant Prices, Seasonally AdjustedOutput of Manufacturing and Services

Gross, Service industries, Total Gross, ManufacturingSource: Reuters EcoWin

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

Inde

x of

out

put,

2002

=100

65

70

75

80

85

90

95

100

105

110

115

Services

Manufacturing

GDP and GNP (Gross National Product)

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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 factor incomes generated within the geographical boundaries of the country. So, for 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. In recent years 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. The figure for net property income for the UK is strongly positive meaning that our GNP is substantially above the figure for GDP in a normal year. For other countries who have been net recipients of overseas investment (a good example is Ireland) their GDP is higher than their GNP. Measuring Real National Income 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 produced within the economy. An increase in real output means that AD has risen faster than the rate of inflation and therefore the economy is experiencing positive growth. Income per capita Income per capita is a basic way of measuring the average standard of living for the inhabitants of a country. The table below is taken from the latest edition of the OECD World Factbook and measures income per head in a common currency for the year 2005, the data is adjusted for the effects of variations in living costs between countries. GDP per capita $s GDP per capita $sLuxembourg 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 in the very top of the league tables for per capita incomes. We do have an income per head that is about ten per cent higher than the average for the 15 established EU countries. But we are some distance behind countries such as the United States (where productivity is much higher). And Ireland’s super-charged growth over the last twenty years means that she has now overtaken us in terms of income-based measures of standards of living.

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3. Macroeconomic Objectives All governments have targets and aims for the economy – in this chapter we consider the main objectives of macroeconomic policy. Objectives are the aims or goals of government policy whereas instruments are the means by which these aims might be achieved and targets are often thought to be intermediate aims – linked closely in a theoretical way to the final policy objective. So for example, the government might want to achieve low inflation. The main instrument to achieve this might be the use of interest rates (now set by the Bank of England) and a target might be the growth of consumer credit or perhaps the exchange rate. 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. Indeed the debates about which policies are most suitable lie at the heart of differences between economic schools of thought. The main policy instruments available to meet the objectives are

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

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

• Supply-side policies designed to make markets work more efficiently

• Direct controls or regulation of particular markets Find out more about schools of thought If you want to delve a little deeper into the differences between schools of thought in Economics here are a few links to resources available on the Wikipedia web site:

• Keynes and Keynesian Economists: http://en.wikipedia.org/wiki/Keynes • Monetarists: http://en.wikipedia.org/wiki/Monetarist • Classical economists: http://en.wikipedia.org/wiki/Classical_economics

The Objectives of UK Economic Policy The Labour Government has several current 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. The Bank of England has been independent since May 1997 but inflation targets pre-date the decision to hand over control of monetary policy to the BoE. Inflation targets were first introduced into the UK in October 1992 and have played a role in keeping inflation expectations under control.

o Sustainable economic growth – as measured by the rate of growth of real gross domestic product – sustainable both in terms of maintaining low inflation and also in terms of the environmental impact of growth (for example the impact of growth on levels of pollution, household and industrial waste and the use and depletion of our scarce resources).

o Higher levels of capital investment and labour productivity – this is designed to improve the UK’s international competitiveness and boost our trade performance in goods and services. The pressures of globalisation and the increasing competition within the European Single Market make this one of the most important long-term objectives of the government. Britain needs to be competitive in an increasingly globalized world.

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. But unemployment can never fall to zero since there will always be a degree of frictional and structural unemployment in the labour

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market. 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 – this will require a continuation of economic growth together with taxation and benefit changes to make the distribution of income more equal

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

The Bank of England was made independent in May 1997 and has the job of setting interest rates as part of

monetary policy. Interest rates are viewed as a key weapon in keeping control of demand and inflationary pressures in the economy. Most economists are in favour of Bank of England independence because economists are likely to make better judgements on interest rates than politicians seeking re-election!

The government always emphasizes macroeconomic stability as one of its main aims – it believes that the stability of the economy is a pre-condition for improvements in capital investment, productivity, company profits and employment. Of course the vagaries of and uncertainties in developments 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 domestic and external shocks that can affect the British economy at any time!

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4. Using Index Numbers Index numbers are a useful way of expressing pieces of information and collections of data. This brief chapter shows you how to express data in index number format and some examples of data which is commonly presented as an index number 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 1995 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 1995. To calculate the index number for consumer spending in 1996 we use the following formula Index (1996) = (consumer spending (1996) / base year consumer spending) x 100 Consumer spending Index of consumer

spending Real GDP Index of real GDP

£ billion 1995 = 100 £ billion 1995 = 100

1995 (Base) 512.6 100.0 857.5 100.0 1996 531.9 103.8 880.9 102.7 1997 551.1 107.5 908.7 106.0 1998 572.3 111.6 938.1 109.4 1999 598.8 116.8 966.6 112.7 2000 625.1 121.9 1005.5 117.3 2001 644.9 125.8 1027.9 119.9 2002 667.4 130.2 1048.5 122.3 2003 684.8 133.6 1074.9 125.3 2004 710.2 138.5 1108.9 129.3

One of the advantages of index numbers is that it allows us to compare and contrast more easily different sets of economic data. Consider the information in the table above. Using 1995 as our base year for the index, we can see that consumer spending has grown more quickly than real national income over the period 1995-2003. Of course the two sets of data are closely linked because consumption accounts for more than 60% of GDP. But the data indicates that consumer demand has been a key factor behind the continuing growth of the economy, indeed consumption as a share of GDP has grown from 60% in 1995 to nearly 65% in 2003 – a record level. Can this consumer boom continue? Much of it has been financed by high rates of borrowing linked to low interest rates and the recent UK housing boom. 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

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Housing 106 22 2332

Leisure Services 112 9 1008

Household Goods 95 7 665

Other Items 105 11 1155

100 10437 A weighted price index calculates changes in the average level of prices in the economy. In the hypothetical 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 consumer spending given over to each category. So for example, housing and food costs are assumed in our example to take up 40% of total consumer spending. These two items will have a heavy influence on the overall price index. The price index for each category 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. Here is some real world data on a selected of price indices for goods and services in the UK.

All items Health Transport Communication Tobacco Clothing New Cars Second Hand Cars

1996 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

2000 105.6 111.6 112.7 89.3 141.2 82.2 99.8 91.2

2003 109.8 124.2 116.9 84.5 158.8 66.8 95.7 85.1 Over the period 1996-2003 there has been a 10% rise in the general price level. But this hides major changes in average prices for different products. The average cost of purchasing tobacco products has jumped by nearly sixty per cent whereas the prices of clothing, second hand cars and communication have been falling.

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5. Aggregate Demand This section gives you a platform for understanding issues such as inflation, economic growth and unemployment. Aggregate demand (AD) and aggregate supply (AS) analysis provides a way of illustrating macroeconomic relationships and the effects of government policy changes. Aggregate Demand The identity for calculating aggregate demand (AD) is as follows:

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

Where

C: Consumers' expenditure on goods and services: This includes demand for consumer 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). Household spending accounts for over sixty five per cent of aggregate demand in the UK. I: Capital Investment – This is investment spending by companies on capital goods such as new plant and equipment and buildings. Investment also includes spending on working capital such as stocks of finished goods and work in progress. Capital investment spending in the UK typically accounts for between 15-20% 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 public (government) sector – for example investment by the government in building new schools or investment 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 part of capital investment. Investment has important long-term effects on the s supply-side of the economy as well as being an important although volatile component of aggregate demand. G: Government Spending – This is government spending on state-provided goods and services including public and merit goods. Decisions on how much the government will spend each year are affected by developments in the economy and also the changing political priorities of the government. In a normal year, government purchases of goods and services accounts for around twenty per cent of aggregate demand. We will return to this again when we look at how the government runs its fiscal policy. Transfer payments in the form of welfare benefits (e.g. state pensions and the job-seekers allowance) are not included in general government spending because they are not a payment to a factor of production for any output produced. They are simply a transfer from one group within the economy (i.e. people in work paying income taxes) to another group (i.e. 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 in goods and services 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 therefore add to the demand for UK produced output. M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending. Goods and services come into the economy for us to consume and enjoy - but there is a flow of money out of the economy to pay for them. Net exports (X-M) reflect the net effect of international trade on the level of aggregate demand. 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 economy has been running a large trade deficit for several years now as has the United States.

Aggregate demand shocks

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Economic events such as changes in interest rates and economic growth in the United States can have a powerful effect on other countries including the UK. This is because the USA is the world’s largest economy.

15 per cent of our exports go to the USA. Lots of unexpected events can happen which cause changes in the level of demand, output and employment in the economy. These unplanned events are called “shocks” One of the causes of fluctuations in the level of economic 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 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 boom in the housing market or a slump in share prices.

o An unexpected cut or an unexpected rise in interest rates.

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The Aggregate Demand Curve The AD curve shows the relationship between the general price level and real GDP.

Why does the AD curve slope downwards? There are several explanations for an inverse relationship between aggregate demand 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 then less able to afford UK produced goods and services.

2. The balance of trade: As the price level rises, foreign-produced goods and services become more attractive (cheaper) in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in trade (X-M) and a contraction in aggregate demand.

3. Interest rate effect: if in the UK the price level rises, this causes an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the entire 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 factors affecting any one or more components of aggregate demand, households (C), firms (I), the government (G) or overseas consumers and business (X) changes planned aggregate demand 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.

Inflation

Real National Income

AD

P1

Y1

P2

Y3 Y2

P3

A rise in the general price level from P1 to P2 causes a contraction in aggregate demand 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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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 in the economy E.g. expected increases in consumer incomes, wealth or company profits encourage households and firms to spend more – boosting AD. Similarly, higher expected inflation encourages spending now before price increases come into effect - a short term boost to AD.

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

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 raises 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

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

Inflation

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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income (e.g. the economic cycle in other countries)

exports and also the elasticity of supply of UK 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.

The UK is an open economy, meaning that a large and rising share of our national output is linked to exports of goods and services or is open to competition from imports.

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 will lead to a decline in household financial wealth and a fall in consumer demand.

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6. Consumer Spending and Saving Consumption accounts for 65% of aggregate demand. There are many factors that affect how much people are willing and able to spend. It is important to understand these factors because changes in consumer spending have an important effect on path of the economic cycle.

Annual percentage change in household spending and GDP at constant 2000 pricesReal Consumption Expenditure and Real GDP growth

Consumer spending [ar 4 quarters] Real GDP growth [ar 4 quarters]Source: Reuters EcoWin

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

Annu

al %

cha

nge

-3

-2

-1

0

1

2

3

4

5

6

7

Real GDP

Consumer spending

John Maynard Keynes developed a theory of consumption that focused primarily on the level of people’s disposable income in determining their spending. The rate at which consumers increase demand as income rises is called the marginal propensity to consume. For example if someone receives an increase in income of £2000 and they spend £1500 of this, the marginal propensity to spend is £1500 / £2000 = 0.75. The remainder is saved – so the propensity to save would be 0.25. The marginal propensity to spend and to save differs from person to person. Generally, people on lower incomes tend to have a higher propensity to spend. This has important implications when the government announces changes in direct taxation and the level of welfare benefits. 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 key factors that determine consumer spending in the economy can be summarized as follows:

1. The level of real disposable household income

2. Interest rates and the availability of credit

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3. Consumer confidence

4. Changes in household financial wealth

5. Changes in employment and unemployment The strength of consumer spending has been one of the main reasons why Britain has avoided a recession in recent years – but at the same time, there are fears that household spending has been too high, and that much of it has been financed by a surge in borrowing leading to record levels of household debt. One key reason for this has been the strength of the housing market which has allowed millions of home-owners to borrow extra money secured on the value of their property. This is known as mortgage equity withdrawal. A large percentage of this demand has also fed into demand for imported goods and services, causing a sharp increase in the UK’s trade deficit with other countries. Spending on consumer durables

Real spending at constant prices, seasonally adjusted, £ billion per quarterConsumer Expenditure on Durable Goods

Source: Reuters EcoWin

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

£s a

t con

stan

t 200

2 pr

ices

(bill

ions

)

7.5

10.0

12.5

15.0

17.5

20.0

22.5

25.0

Consumer durables are items that provide a flow of services to a consumer over a period of time. Examples include new cars, household appliances, audio-visual equipment, furniture etc. The real level of spending on durables has surged in the last eight years. Among the explanations are

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

(ii) Low interest rates which have encouraged people to spend more on “big ticket items” – there has been a surge in demand for consumer credit

(iii) Strong consumer confidence and borrowing levels. The demand for consumer durables is more income elastic than for non-durables which are usually staple items in people’s monthly budget.

The Wealth Effect 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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Index of the UK's 100 leading shares - daily closing valueFTSE-100 Index

Source: Reuters EcoWin

96 97 98 99 00 01 02 03 04 05 06

Inde

x

3000

3500

4000

4500

5000

5500

6000

6500

7000

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, consumer confidence grows and home-owners can also borrow some of the equity in their homes to finance major items of spending.

Percentage of disposable income that is saved, quarterly dataHousehold Savings Ratio

Source: Reuters EcoWin

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

Per

cent

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

The Savings Ratio Saving represents a decision to postpone consumption by saving money out of disposable income. Why do people choose to save their incomes? There are many motivations for saving:

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1. Precautionary saving: People might save more because of a fear of being made unemployed. A nest egg of savings allows people to smooth their spending even when incomes are fluctuating.

2. Building up potential spending power: Saving more now is a choice to defer spending today to finance major spending commitments in the future (e.g. saving for the deposit on a mortgage, a new car or a wedding). 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 state retirement pension will fall in the years ahead.

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.

4. Inheritance: Many people have a desire to pass on bequests of wealth to future generations.

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 their spending commitments decline leading to an increase in net saving ahead of retirement.

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 the high levels of unemployment and also 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 in part by the rapid acceleration in house prices. At some point the savings ratio will need to rise again as people rein back on their spending in order to repay debts on credit cards and other forms of secured and unsecured borrowing. We have started to see a gradual rise in the savings ratio during 2005 and the first half of 2006. The importance of consumer confidence The willingness of people to make major spending commitments depends on how confident they are about both their own financial circumstances, and also the general state of the economy. Consumer confidence is quite volatile from month to month. Some of the fluctuations are seasonal – but the underlying trend is what really matters. One interesting aspect of recent data is that people have remained more optimistic about their own financial situation than they have about prospects for the UK economy as a whole. This perhaps helps to explain why people have continued to be prepared to make big-ticket purchases on new consumer durables (many of which have been imported). The main factors affecting consumer confidence are summarised as follows:

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 The consumer borrowing boom of recent years

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6 month % growth rates for lending to individuals, source: Bank of EnglandGrowth of Consumer Borrowing

Total lending to individuals, 6 mth% Total lending to individuals, secured on dwellings, 6 mth% Total lending to individuals, consumer credit, 6 mth%

Source: Reuters EcoWin

Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May00 01 02 03 04 05 06

Per

cent

5

6

7

8

9

10

11

12

13

14

15

16

17

Borrowing secured on the value of dwellings (housing)

Total

Credit card borrowing

The British economy has seen high consumer borrowing in recent years. This has been the result of a number of factors summarised below:

1. Low unemployment – has led to rising consumer confidence.

2. Strong growth of house prices – has encouraged mortgage equity withdrawal.

3. Expectations of rising real incomes – people have expected their incomes to rise each year as pay levels have grown more quickly than inflation.

4. Low interest rates – reducing the opportunity cost of borrowing money.

5. Falling prices of consumer durables – many of which are bought using credit.

The consumer credit boom has lasted nearly a decade, but there are signs that people in the UK are falling

out of love with their credit card

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Strong demand for loans has boosted consumer spending and helped to keep the UK economy growing at a time of global uncertainty. Borrowing has also contributed to the rising trade deficit in goods and services. By the summer of 2006, the consumer borrowing boom appeared to be coming to an end. The slowdown in credit demand has been the result of a number of factors:

1. Rising interest rates – the Bank of England has been raising interest rates from 3.5% to 4.75% – this has helped to curb demand for new loans (interest rates currently at 4.5%).

2. Weakness in the housing market and fears of a possible fall in average house prices which may expose homeowners to a high level of mortgage debt.

3. Unemployment has started to edge higher and more people now expect rising unemployment, expectations of what might happen tomorrow affects our behaviour today!

4. The consumer debt mountain has reached high levels – well over £1 trillion – and many people are now scaling back their borrowing and saving more as a precaution against a future downturn.

5. Possible consumer satiation – how many plasma TV screens or digital cameras do you need? There are limits to how many consumer durables people need to buy!

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.

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7. Capital Investment Investment is spending by UK firms on capital goods such as new factories, plant or buildings, machinery & vehicles. It is an important component of demand, but as we shall see, it also has an impact on the supply-side of the economy. Definition of Capital Investment

1. Capital investment is defined as 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 would encompass spending on improving the human capital of the workforce - for example extra investment in training and education to improve the skills and competences of workers.

3. Most economists agree that investment is vital to promoting long-run economic growth through improvements in productivity and a country’s productive capacity.

Gross and Net Investment Gross investment spending includes an estimate for capital depreciation since some investment is needed to replace technologically obsolete plant and machinery. Providing that net investment is positive, businesses are expanding their capital stock giving them a higher productive capacity and therefore meet a higher level of demand in the future. The Economic Importance of Capital Investment Firms often invest in new capital goods to exploit internal economies of scale. This, together with technological advances that are often built into new machinery, is vital to improving the UK's competitiveness and to causing an outward shift in the country’s production possibility frontier.

The amount of capital equipment available for each worker to use and whether this capital is up to date has a bearing on the productivity of the labour force. The quality of business training also matters to make the

most of investment in new capital and technology

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In the short run, devoting more a country’s scarce resources to the production of investment goods (a process known as capital accumulation) might require a reduction in today’s output of consumer goods and services (lower consumption would be accompanied by a rise in saving). The re-allocation of resources towards capital goods would be shown by a movement from point A to B on the production possibility frontier. But if the extra investment is successful and leads to an increase in a country’s productive capacity then the PPF can shift out and open up the potential for an increased output of consumption goods to meet people’s needs and wants. This is shown by a movement from point B on the PPF to point C which lies on the new PPF after the effects of an increase in investment. Investment affects AD as well as Aggregate Supply (AS) It should be remembered that investment is also a component of AD. 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 investment will therefore have important effects on both the demand and supply-side of the economy – 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)

Output of Consumer Goods

Output of Capital Goods

C2

C1

X2 X1

A

B

PPF1

PPF2

CC3

X3

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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It is not just the level of capital investment which is important but also the quality of the increase in the capital stock. A high level of investment on its own may not be sufficient to create an increase in LRAS – 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 in a market, a high level of capital investment may lead to excess capacity emerging in industries – putting downward pressure on prices and profits

Investment at constant 2001 prices, £ billionGross Fixed Capital Investment by Businesses

Source: Reuters EcoWin

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

2001

GB

P (b

illio

ns)

0

10

20

30

40

50

60

70

80

90

100

110

120

AD1

P1

Y1

LRAS1 LRAS2

YFC2 Y2

AD2

P2

Real National Income

Inflation

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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.

Key Factors Determining Capital Investment Spending Several factors influence how much businesses are prepared to commit to investment projects:

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, reducing the expected rate of return on capital projects. 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 higher rate of return by simply investing the cash. Low interest rates are not always good news for business investment. Recently economists have become concerned that low interest rates has reduced the cost of capital for businesses to such an extent that some low quality capital investment projects have been given the go ahead and much of this investment has proved to be disappointing.

2. The rate of growth of demand: Investment tends to be stronger when consumer demand is rising, giving businesses an extra incentive to invest to expand their capacity to meet this demand. Higher expected sales also increase potential profits – in other words, the price mechanism should allocate extra funds and factor inputs towards investment goods into those markets where consumer demand is rising.

3. Corporate taxes: Corporation tax is paid on profits. If the government reduces the rate of corporation tax (or increases investment tax-allowances) there is a greater incentive to invest. Britain has relatively low rates of company taxation compared to other countries inside the EU. This is a factor that helps to explain why Britain has been a favoured venue for inward investment from overseas during the last decade.

4. Technological change and degree of market competition: In markets where technological change is rapid, companies may have to commit themselves to higher levels of investment to keep pace with the shifting frontier of technology and remain competitive. In markets where there is a premium on a business keeping costs down but at the same time, achieving year on year gains in efficiency and quality of service, there is also an incentive to keep capital investment spending high.

5. Business confidence: Business confidence can be vital in determining whether to go ahead with an investment project. When confidence is strong then planned investment will rise. The Confederation of British Industry (www.cbi.org.uk) publishes a quarterly survey of confidence that gives economists an insight into likely trends in investment from manufacturing industry – although it must be remembered that over 70% of total GDP now comes from the service sector. In recent years, capital spending by service businesses has grown strongly – but manufacturing investment has weakened.

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.

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8. Aggregate Supply Having looked at the components of aggregate demand, we now turn to the supply-side of the economy. Aggregate supply tells us something about whether producers across the economy can supply us with the goods and services that we need. A definition of aggregate supply Aggregate supply (AS) measures the volume of goods and services produced within the economy at a given price level. In simple terms, aggregate supply represents the ability of an economy to produce goods and services either in the short-term or in the long-term. It tells us the quantity of real GDP that will be supplied at various price levels. The nature of this relationship will differ between the long run and the short run

o In the long run, the aggregate-supply curve is assumed to be vertical

o In the short run, the aggregate-supply curve is assumed to be upward sloping 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 The short run aggregate supply curve

A change in the price level (for example brought about by a shift in AD) results in a movement along the short run aggregate supply curve. The slope of SRAS curve depends on the degree of spare (under-utilised) capacity within the economy.

Inflation

Real National Income

SRAS

P1

Y1

LRAS

Yfc

P2

Y2

P3

An expansion of national output

A contraction of national output

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1. Negative output gap: At low levels of real national income where actual GDP < potential GDP, firms have a large amount of spare capacity and can expand their output without paying their workers overtime. The SRAS curve is therefore drawn as elastic

2. Positive output gap: As national output expands and the economy heads towards full capacity, so “supply bottlenecks and shortages” may start to appear in some sectors and industries. Workers receive the same wage rate but require payment of overtime and bonuses to work longer hours and increase GDP – SRAS is becoming more inelastic

3. Diminishing returns? As national output expands, older less productive machinery may be used and less efficient workers hired. This means that while wage rates remain constant, unit costs of production may rise and thus the SRAS slopes upwards

4. Full-capacity output at LRAS. Eventually the economy cannot increase the volume of output further in the short-term no matter what bonus or overtime payments on offer, at this point SRAS is perfectly inelastic – the economy has reached full-capacity (the LRAS curve)

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 agreeing to pay higher wages or a fall in the level of worker productivity. If unit wage costs rise, this will eventually feed through into higher prices (this is known as an example of “cost-push inflation”)

2. Commodity prices: Changes to raw material costs and other components e.g. the world price of oil, copper, aluminium and other inputs in many production processes will affect a firm’s costs. These 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

3. Government taxation and subsidy: Changes to producer taxes and subsidies levied by the government as part of their fiscal policy have effects on the costs of nearly every producer – for example an increase in taxes designed to meet the government’s environmental objectives will cause higher costs and an inward shift in the short run aggregate supply curve. A rise in VAT on raw materials will have the same effect.

Inflation

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

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

The most important single cause of a shift in the short run aggregate supply curve is a change in wage rates. Higher wage rates without any compensating increase in labour productivity cause a rise in production costs, leading businesses to produce less and the aggregate supply curve will shift to the left (i.e. SRAS1 shifts to SRAS2). Conversely a fall in raw material prices or component costs will reduce production costs, encouraging firms to produce more and the short run aggregate supply curve moves to the right (i.e. SRAS1 shifts to SRAS3).

Inflation

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

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Long run aggregate supply (LRAS) 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 an aggregate measure of potential output in an economy

o T is the time period under consideration

o L represents the quantity and ability of labour input available to the production process

o K represents the available capital stock, i.e. machinery, buildings and infrastructure

o M represents the availability of natural resources and materials for production i.e. land LRAS is determined by the stock of a country’s productive resources and also by the productivity of factor inputs (labour, land and capital). Changes in the state of technology also affect the potential level of real national output. The vertical long run aggregate supply curve In the long run we assume that aggregate supply is independent of the price level. As a result we draw the long run aggregate supply curve as vertical. In drawing the LRAS as vertical, we are saying that there is a maximum level of physical output that the economy can produce. 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 be in employment – in other words, a full-employment level of national income has been reached. There will remain the problem of voluntary unemployment. According to the neo-classical school of economics, real GDP will in the long run always return to the level at which all available labour resources have found employment. Causes of shifts in the long run aggregate supply curve Any change in the economy that alters the natural rate of growth of output (i.e. trend growth) shifts the long-run aggregate-supply curve. 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. The result is that a great volume of national output can be produced at any given price level.

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The fundamentals of increasing long run aggregate supply These all relate to the supply-side of the economy

1. Expanding the labour supply - e.g. by improving incentives for people to search for and then accept new jobs as they become available. Government policies seek to expand the available labour supply by encouraging more people to join the labour force and become economically active. The UK government has also been encouraging an influx of migrant labour which has added to the supply of labour although it is also causing concern about some of the social and political effects.

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

3. Increase the occupational and geographical mobility of labour to reduce certain types of unemployment for example the level of structural unemployment which is caused by occupational immobility of labour. A reduction in structural unemployment will reduce the scale of unemployment and provide the economy with a great supply of available labour.

4. Expand the capital stock – i.e. increase the level of capital investment and research and development spending by firms

5. Increase business efficiency by promoting greater competition within and between 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

Aggregate supply shocks Aggregate supply shocks might occur when there is

o A sudden rise in oil prices or other essential inputs

o The invention and diffusion of a new production technology

Inflation

Real National Income

LRAS1 LRAS2

YFC2 YFC1

SRAS1

SRAS2

LRAS3

SRAS3

YFC3

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Closing daily price, US dollars per barrel of oilBrent Crude Oil Prices

Source: Reuters EcoWin

01 02 03 04 05 06

USD

/Bar

rel

10

20

30

40

50

60

70

80

The effects of supply-side shocks are normally to cause a shift in the short run aggregate supply curve. But there are also occasions when significant 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. In the long-run In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”

John Maynard Keynes, 1936

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9. Macroeconomic Equilibrium We now put aggregate demand and supply to together to consider the idea of equilibrium for the economy. 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. 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 for example, 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.

Inflation

Real National Income

AD

SRAS

Pe

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 higher productivity of labour and capital inputs together with lower raw material costs such as cheaper oil and steel 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 macroeconomic equilibrium will be established at Y3.

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

Inflation

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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 (reducing planned investment demand) and a fall in exports following a global downturn. It might also be caused by a cut in government spending or a rise in interest rates (announced by the Bank of England). The result of the inward shift of AD is a contraction along the short run aggregate supply curve and a fall in national output (i.e. a recession). This causes downward pressure on the general price level and takes the equilibrium level of national output further away from the full capacity level of national income as indicated by the LRAS curve. We would expect to see a rise in unemployment.

Real National Income

AD

SRAS1

P1

LRAS

SRAS2

P2

SRAS3

Inflation

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

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The Output Gap The output gap (or GDP gap) is an important concept in macroeconomics. It is defined as 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.

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) then there is a negative output gap. Some factor resources including labour are under-utilised and the main economic problem is likely to be higher than average unemployment. High unemployment indicates an excess supply of labour in the factor market which

Inflation

National Income

AD1

SRAS

P1

Y1

LRAS

Yfc

P2

Y2

AD2

Positive Output Gap Y2 > Yfc

Negative Output Gap Y1 < Yfc

Showing a negative and a positive output gap using an AS – AD diagram

Real National Income

SRAS

AD3 AD1

P1

P3

AD2

P2

Y1 Y2 Y3 Yfc

Inflation

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means there is downward pressure on real wage rates. In the next time period, a fall in 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 working beyond normal capacity e.g. shift work and overtime. The main economic problem is likely to be demand pull and cost-push inflation. The shortage of labour puts upward pressure on wage rates. 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 percenage of potential GDPUnited Kingdom, Output gap of the total economy

Source: Reuters EcoWin

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

PE

RC

EN

T

-4

-3

-2

-1

0

1

2

3

The last boom in the late 1980s left the UK with a large positive output gap, one of the reasons why we say a sharp acceleration in inflation before the recession of the early 1990s (high inflation required very high interest rates to control it and this squeezed business and consumer confidence and spending). At the end of the recession in 1992 the output gap was negative – allowing the economy to grow for several years without the fear of demand-pull inflationary pressure. Over the last six or seven years, the output gap has remained close to zero. The Bank of England has managed quite successfully through its interest rate strategy to keep aggregate demand growing more or less in line with the economy’s productive potential. The recent global economic slowdown has hit GDP growth in the UK (leading to weak exports and falling investment) – but the economy continues to operate fairly close to its potential.

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10. The Macroeconomic Cycle All countries experience regular fluctuations 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.

United Kingdom, Gross Domestic Product

Source: Reuters EcoWin

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

GD

P at

con

stan

t 200

1 pr

ices

(bill

ions

)

125

150

175

200

225

250

275

300

National output rarely rises or falls at a constant rate. All countries experience a business cycle or economic cycle where the rate of growth of national production, incomes and spending fluctuates. The length and volatility of each cycle changes over time as the structure of an economy evolves and previously observed economic relationships appear to change. There are different stages of an economic cycle, each of which has observed characteristics – but no economic cycle is ever the same! Boom A boom occurs when real national output is rising at a rate faster than the trend rate of growth. In boom conditions, national output and employment are expanding and aggregate demand is high. Some of the main characteristics of an economic boom include:

o A fast growth of consumption of durable and non-durable goods helped by rising real incomes, strong consumer confidence and perhaps a surge in house prices and other forms of personal wealth

o A pick up in the demand for capital investment goods as businesses look to expand their capacity in order to meet rising demand and to achieve higher profits

o Rising employment (falling unemployment) and higher real wages for people in jobs

o A high and rising demand for imported products which may cause the economy to run a larger trade deficit and 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, health and transport

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o A danger of an increase in demand-pull and cost-push inflation if the economy overheats (i.e. if the economy ends up with a large positive output gap)

All countries experience regular business cycles – some are more volatile than others! Slowdown A slowdown occurs when the rate of growth decelerates – but national output is still rising. If the economy continues to grow without falling into outright recession, this is known as a soft-landing. Recession A recession 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. 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. An economic 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 Contracting employment and rising unemployment due to plant closures and an increased level of worker redundancies

o A fall in business confidence & profits leading to a decrease in capital investment spending

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 inflation and falling demand for imports

o Increased government borrowing (i.e. a rising budget deficit) because spending rises on welfare payments and tax revenues from individuals and companies fall

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

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 the economic downturn. And, the extent to which producers raise output and rebuild their stock levels in anticipation of a

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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. The last recession in the UK ended in the autumn of 1992.The main stimulus for an increase in aggregate demand was a much lower exchange rate following sterling’s departure from the EU exchange rate mechanism, plus a sharp fall in UK interest rates – both of which provided a big stimulus to demand. National output in the UK grew by more than 3% in 1993 and over 4% in 1994 – a vigorous rebound from the 1990-92 recessions. The recovery gathered momentum in the mid – late 1990s and the expansion has been maintained now for over thirteen years.

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11. 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 an economic cycle to another The multiplier process An initial change in aggregate demand can have a much greater final impact on the level of equilibrium national income. This is commonly 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 much bigger effect on equilibrium output and employment. Consider a £300 million increase in business capital investment – for example created when an overseas company decides to build a new production 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 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 business 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 basic 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 money on imports, this demand is not passed on in the form of extra spending on domestically produced output. It leaks away from the circular flow of income and spending.

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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 new Terminal 5 building at Heathrow airport

Over an estimated five to six-year period some 6,000 construction jobs will be created at Heathrow Terminal 5. The new Heathrow terminal is expected to open in 2008, when it is expected to provide an extra 50 per cent passenger capacity at the airport. The estimated construction costs are £160 million.

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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 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

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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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 production 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 consumer demand can create excess capacity and may lead to a fall in planned investment demand. A good example of this in recent years is the telecommunications industry. Capital investment in this sector surged to record highs in the second half of the 1990s, driven by a fast pace of technological advance and huge increases in the ICT budgets of corporations, small-to-medium sized businesses, and extra capital investment by the public sector (including education and health). The telecommunications industry invested giant sums in building bigger and faster networks, but demand has slowed in the first three of the decade, leaving the industry with a vast amount of spare capacity (an under-utilisation of resources). Capital investment spending in the telecommunications industry has fallen sharply in the last three years – the accelerator mechanism working in reverse.

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.

Inflation

Real National Income

Rate of Interest (%)

AD1

AD2

AD3

Y1 Y2 Y3

SRAS

I1 I2

Investment demand (2) ID1

Demand for capital investment (I)

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12. Economic Growth Growing economies provide the means for people to enjoy better living standards and for more of us to find work. But what is economic growth and how best can a country achieve it? Defining economic growth Economic growth is best defined as a long-term expansion of the productive potential of the economy. Sustained economic growth should lead higher real living standards and rising employment. Short term growth is measured by the annual % change in real GDP. Growth and the Production Possibility Frontier An increase in long run aggregate supply is illustrated by an outward shift in the PPF.

Advantages of Economic Growth Sustained economic growth is a major objective of government policy – not least because of the benefits that flow from a growing economy.

(1) Higher Living Standards – for example measured by an increase in real national income per head of population – see the evidence shown in the chart below

(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 and a rise in the number of people employed.

(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

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

Output of Consumer Goods

Output of Capital Goods

C2

C1

X2 X1

A

BC

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(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

Rising national income boosts living standards And an expanding economy provides the impetus for a rising level of employment and a falling rate of unemployment. This has certainly been the case for the British economy over the last decade.

Percentage growth in GDP and percentage of the labour force unemployedReal GDP and Claimant Count Unemployment

Real GDP growth [ar 4 quarters] United Kingdom, Unemployment, Rate, Claimant count, SASource: Reuters EcoWin

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

Perc

ent

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

Real GDP growth

Unemployment

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

(1) Inflation risk: If the economy grows too quickly there is the danger of inflation as demand races ahead of aggregate supply. Producer then take advantage of this by raising prices for consumers

(2) Environmental concerns: Growth cannot be separated from its environmental impact. Fast growth of production and consumption can create negative externalities (for example, increased noise and lower air quality arising from air pollution and road congestion, increased consumption of de-merit goods, the rapid growth of household and industrial waste and the pollution that comes from increased output in the energy sector) 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, the over-exploitation of fish stocks and loss of natural habitat created through the construction of new roads, hotels, retail malls and industrial estates.

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Many economists and environmentalists are concerned about the impact that rapid economic growth can have on our limited scarce resources and our environment.

The trend rate of economic growth The trend rate of growth is the long run average growth rate for a country over a period of time. Measuring the trend requires a long-run series of macroeconomic data in order 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.

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.

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

The importance of the supply-side of the economy The trend rate of growth is determined mainly by the supply-side capacity of a country – i.e. the extent to which LRAS increases year-on-year to meet a higher level of demand for goods and services. Potential output in the long run depends on the following factors

o The trend growth of the working population i.e. the size of the active labour supply (e.g. those people able available and willing to find paid employment)

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o The growth of the nation’s stock of capital – driven by the level of capital investment in new buildings, machinery, plant and technology

o The trend rate of growth of factor productivity (including labour productivity) – a measure of gains in factor efficiency

o Technological improvements driven by innovation and invention which reduce the costs of supplying goods and services and which lead to an outward shift in a country’s production possibility frontier

Long Run Aggregate Supply and the Trend Rate of Growth The effects of an increase in long run aggregate supply are traced in the diagram below. An increase in LRAS allows the economy to operate at a higher level of aggregate demand – leading to sustained increases in real national output.

Potential output in the long run depends on the following factors (1) The growth of the labour force e.g. those people able available and willing to find employment If the government can increase the number of people willing and able to actively seek paid employment, then the employment rate increases leading to a higher output of goods and services. The Government has invested heavily in a number of employment 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 might 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. A rise in capital investment adds directly to GDP in the sense that capital goods have to be designed, produced, marketed and delivered. Higher investment also provides workers with more capital to work with. New capital also tends to embody technological improvements which providing workers have sufficient skills and training to make full and efficient use of their new capital inputs, should lead to a higher level of productivity after a time lag. (3) The trend rate of growth of productivity of labour and capital. For most countries it is the growth of productivity that drives the long-term growth. The root causes of improved efficiency come from making markets more competitive and achieving better productivity within individual plants and factories. Increased investment in the human capital of the workforce is widely seen as essential if the UK is to

Inflation

National Income

AD1

SRAS

Pe

Y1

An outward shift in LRAS helps to increase the economy’s underlying trend rate of growth – it represents

an increase in potential GDP

LRAS1 LRAS2

YFC2 Y1

AD2

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improve its long run productivity performance – for example – increased spending on work-related training and improvement in the UK education system at all levels. (4) Technological improvements are important because they reduce the real costs of supplying goods and services which leads to an outward shift in a country’s production possibility frontier The current growth phase for the UK is the longest period of continuous growth for over forty years.

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13. Inflation 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 best defined as a sustained increase in the general price level leading to a fall in the purchasing power or value of money. The greatest falls in the value of money came during the mid-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 as a result, money has held value better. The next chart shows the UK consumer price index since 1970.

1987 = 100UK Consumer Prices - all items - annual index

Source: Reuters EcoWin

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

1987

:1=1

00

0

25

50

75

100

125

150

175

200

The value of money refers to the amount of goods and services £1 can buy and is inversely proportionate to

the rate of inflation. Inflation reduces the value of money. When prices are increasing, then the value of money falls.

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 of England was made independent, inflation has stayed comfortably within target range. Indeed Britain has one of the lowest rates of inflation inside the EU.

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Annual percentage change in the Consumer Price Index, the inflation target is 2%Consumer Price Inflation for the UK

ar 12 monthsSource: Reuters EcoWin

95 96 97 98 99 00 01 02 03 04 05 06

Perc

ent

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

2.75

3.00

CPI Inflation target = 2%

There has been a fall in average inflation rates in most of the world’s developed countries including the UK over the last fifteen years. Indeed lower inflation seems to have become a global phenomenon. Japan has experienced negative inflation (i.e. price deflation) over recent years (although in 2006, this period of price deflation came to an end) and the German economy has also come close to experiencing deflation with inflation of less than one per cent. Deflation Price deflation is when the rate of inflation becomes negative. I.e. the general price level is falling and the value of money is increasing. Some countries have experienced deflation in recent years – good examples include Japan and China. In Japan, the root cause of deflation was slow economic growth and a high level of spare capacity in many industries that was driving prices lower. In China, economic growth has been rapid – but the huge amount of capital investment and rising productivity has led to economies of scale being exploited and a fall in production costs. There has been some price deflation in the UK economy – not for the whole economy – but for items such as clothing (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 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 televisions, which has made the digital age accessible to millions of consumers.

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Annual percentage change in the consumer price index for selected itemsPrice deflation in many markets for UK consumers

Source: Reuters EcoWin

Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct01 02 03 04 05

1996

=100

-16.0

-14.0

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

Audio-visual and photo equipment

Clothing and Footwear

Hyperinflation

A 500 billions bill with most zeros in the economy history. The product of hyperinflation in Yugoslavia 1993 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. Often drastic action is required to stabilize an economy suffering from 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. The main causes of inflation

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Inflation can come from several sources: Some come direct from the domestic economy, for example the decisions of the major utility companies providing electricity or gas or water on their prices for the year ahead, or the pricing strategies of the leading food retailers based on the strength of demand and competitive pressure in their markets. A rise in government VAT would also be a cause of increased domestic inflation because it increases a firm’s production costs. Inflation can also come from external sources, for example an unexpected 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 sterling might cause higher import prices – which feeds through directly into the consumer price index. We make a simple distinction between demand pull and cost push inflation. Demand-pull inflation Demand-pull inflation is likely when there is full employment of resources and aggregate demand is increasing at a time when SRAS is inelastic. This is shown in the next diagram:

In the diagram above we see a large outward shift in AD. 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). The main causes of demand-pull inflation Demand pull inflation is largely the result of the level of AD being allowed to grow too fast compared to what the supply-side capacity can meet. The result is excess demand for goods and services and pressure on businesses to raise prices in order to increase their profit margins. Possible causes of demand-pull inflation include:

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

Inflation

National Income

AD1

SRAS1

P1

Y1

LRAS

Yfc

P2

Y2

AD2

SRAS2

P3

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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 a sharp rise in house price inflation

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

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 the production processes of different industries. This might be because of a rise in world commodity prices such as oil, copper and agricultural products used in food processing

2. Rising labour costs - caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low (skilled workers become scarce and this can drive pay levels higher) and also when people expect higher inflation so they bid for higher pay claims in order to protect their real incomes. Expectations of inflation are important in shaping what actually happens to inflation!

3. Higher indirect taxes imposed by the government – for example a rise in the specific duty on alcohol and cigarettes, an increase in fuel duties 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

Cost-push inflation 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.

Which government policies are most effective in reducing inflation?

Inflation

Real National Income

AD1

SRAS1

P1

Y1

LRAS

Yfc

SRAS2

P2

Y2

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Most governments now give a high priority to keeping control of inflation. It has become one of the dominant objectives of macroeconomic policy. 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 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.

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.

The most appropriate way to control inflation in the short term is for the British government and the Bank of England 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. Why has inflation remained low in the UK over recent years? The last twelve years has been a period of very low and stable inflation. No one factor explains this – 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. This has been helped by a fall in expectations of inflation

2. Low global inflation and deflation in some countries: There has been a clear fall in the average rate of consumer prices inflation among leading economies, and this decline in global inflation has filtered through to the UK. World inflation has stayed low despite the recent increases in the prices of many of the world’s globally traded commodities.

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: Many markets have become more contestable in the last decade and this extra competition has placed a discipline on businesses to control their costs, reduce profit margins and seek improvements in efficiency. Many UK businesses face severe pressure from foreign competition as the process of globalisation continues

5. The strength of the exchange rate: The recent strength of the pound has lowered the cost of imported products and also squeezes demand for UK exporters

6. 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

In short, low inflation is the result of a combination of demand and supply-side factors.

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Annual Percentage ChangeConsumer Price Inflation for Goods and Services

All items (CPI), Chg Y/Y All goods, Index [ar 12 months]

All services, Index [ar 12 months]

Source: Reuters EcoWin

00 01 02 03 04 05 06

Perc

ent

-3

-2

-1

0

1

2

3

4

5

6

Goods and Services Together

Inflation in Services

Inflation in Goods

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14. Employment and Unemployment We now turn our attention to the labour market and consider why people find themselves out of work and cannot find a paid job. Unemployment imposes heavy economic and social costs; we look at which policies are likely to be most effective in keeping unemployment as low as possible. Defining and measuring unemployment Officially, the unemployed are people who are registered as able, available and willing to work at the going wage rate but who cannot find work 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. 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) or who have enough National Insurance Credits. People who satisfy the criteria receive the JSA for six months before moving onto special employment measures including the New Deal Programme. 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), we must remember that there will always be a sampling error in the data. The Labour Force Survey measure is the internationally agreed definition of unemployment and therefore the measure that best allows cross-country comparisons of unemployment levels. 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

Adapted from newspaper reports, July 2004

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people aged 16-59 (women) / 64 (men), seasonally adjustedUnemployment in the UK

Labour Force Survey measure Claimant Count measureSource: Reuters EcoWin

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

per c

ent o

f the

labo

ur fo

rce

2

3

4

5

6

7

8

9

10

11

Labour Force Survey

Claimant Count

The most recent changes in claimant count and labour force survey measures of unemployment are summarised in the chart above and the table below. Claimant Count

Labour Force Survey Unemployment Unemployment (seasonally adjusted)

Level Annual change Rate Level Annual change Rate 000s 000s % 000s 000s % 1990 2,004 -102 6.9 1,648 -120 5.51993 2,953 157 10.5 2,877 135 9.71997 2,045 -299 7.2 1,585 -503 5.31998 1,783 -262 6.3 1,348 -237 4.51999 1,759 -24 6.1 1,248 -100 4.12000 1,638 -121 5.6 1,088 -160 3.62001 1,431 -207 4.9 970 -119 3.22002 1,533 102 5.2 947 -23 3.12003 1,476 -57 5.0 933 -14 3.02004 1,426 -50 4.8 854 -80 2.72005 1,425 -1 4.7 862 8 2.7 In 2005, the UK had one of the lowest rates of unemployment among the major developed nations. Although the Netherlands and Ireland both have unemployment rates below that of the UK, we have one of the lowest rates in the European Union. Indeed for the Euro Zone as a whole the rate of unemployment has been persistently high in recent years – never lower than eight per cent and now rising to nearly nine per cent. Unemployment is a major economic, social and political problem in countries such as Poland, Germany, Spain and France – although the Spanish have succeeded in bringing their unemployment down from high levels over the last few years.

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Percentage of the Labour Force (Source: OECD World Economic Outlook)Unemployment Rates in selected European Countries

Germany United Kingdom Ireland Spain ItalySource: Reuters EcoWin

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 060.0

5.0

10.0

15.0

20.0

25.0

Spain

Germany

UK Italy

Ireland

The main causes of unemployment We now consider some of the main underlying causes of people being out of work Frictional Unemployment Frictional unemployment is transitional unemployment due to people moving between jobs: For example, redundant workers or workers entering the labour market for the first time (such as university graduates) may take time to find appropriate jobs 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 actively 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. Structural Unemployment Structural unemployment occurs when there is a long run decline in demand in an industry leading to a reduction in employment perhaps because of increasing international competition. Globalisation is a fact of life – and inevitably it leads to changes in the patterns of trade between countries over time. Britain for example has probably now lost for good, its cost advantage in manufacturing goods such as motor cars, household goods and audio-visual equipment. Manufacturing industry has lost over 400,000 jobs in the last five years alone. 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. The decline in manufacturing industry jobs is shown in the next chart.

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There is often a mismatch between the skills required for job vacancies and the skills and experience that unemployed workers have – this is a problem associated with structural unemployment

Millions, seasonally adjustedEmployment in UK Manufacturing Industry

Source: Reuters EcoWin

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

Per

sons

(mill

ions

)

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

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 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 severe slowdown in economic growth, we see a rising unemployment because of plant closures, business failures

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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. A downturn in demand is often the stimulus for businesses to rationalise their operations by cutting employment in order to control costs and restore some of their lost profitability. Cyclical unemployment and the output gap

Real wage unemployment: This is considered to be the result of real wages being 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 international 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 unemployment statistics. Many have become discouraged workers and have stopped actively searching for work.

Inflation

Real National Income

AD1 SRAS

P1

Y1

LRAS

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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Unemployment and the production possibility frontier

The economic and social costs of unemployment High unemployment is widely recognised to create substantial costs for individuals and for the economy as a whole. Some of these costs are difficult to measure, especially the longer-term social costs of a high level of unemployment. Some of the costs are summarised below:

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. Loss of national output: Unemployment involves a loss of potential national output (i.e. GDP operating below potential) and represents an inefficient use 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 (LRAS) and thereby damage the economy’s growth potential

3. 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

4. Social costs: Rising unemployment is linked to social deprivation. There is a relationship with crime, and social dislocation (increased divorce rates, worsening health and lower life expectancy). Areas of high unemployment see falling real incomes and a worsening in inequalities of income and wealth

Output of Consumer Goods

Output of Capital Goods

C2

C1

X2 X1

A

B

C

If there are unemployed resources in the economy, this means that an economy will be operating within its

production possibility frontier. Unemployment represents a waste of scarce labour

resources and leads to output being below potential and a loss of allocative efficiency for the economy

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 production possibility frontier shows the combinations of output that can be produced using all available factor resources efficiently. Any point on the PPF represents a productively efficient allocation of resources. Points that lie within the curve represent an under-utilisation of scarce resources – including labour

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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. Stimulate an improvement in the human capital of the workforce – so that more of the unemployed have the skills to take up 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 have sufficient flexibility to adapt to structural changes in industries over the years

2. Improve incentives for people to search and then accept paid work – this may require reforms of the tax and benefits system for example a reduction in the starting rate of income tax (an incentive for people in lower paid jobs). 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. The reality is that simply cutting welfare benefits across the board makes little difference to the unemployment figures – because of the complex nature of most unemployment. But 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 or lower tax rates for people on low incomes might 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 increase the size of their workforce. Employment subsidies may also be available for overseas firms locating in the UK as part of the government’s regional policy. Labour’s New Deal programme works by offering subsidised jobs and training to the long-term unemployed. It differs from previous job creation schemes, in that people who refuse to comply can have their benefits stopped. According to the government's own figures, more than 40% of the jobs gained through the New Deal are short-term.

4. Achieve a sustained period of economic growth – this requires that aggregate demand 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 a high rate of employment. However, not every increase in aggregate demand 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). And, businesses may decide to increase production by making greater use of capital inputs such as extra units of machinery. A growing economy creates jobs for people entering the labour market for the first time. And, it provides employment opportunities for people unemployed and looking for work.

Policies used in the UK to reduce unemployment

Demand side policies Supply-side policies

Employment subsidies for employers who take on the long-term unemployed (New Deal)

Welfare reforms – including lower starting rates of income tax and the introduction of tax credits

Financial assistance for inward investment from overseas

Policies to promote entrepreneurship and the growth of small-medium size enterprises

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

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

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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

4. There are still large regional differences in unemployment levels and pockets of deep-rooted long-term unemployment in many areas, which causes significant economic and external costs

Recent trends in UK unemployment The main explanation behind the decline in unemployment has been economic growth. Labour as a factor input has a derived demand - so rising production generates a higher demand for labour. These employment-creation effects have not been uniform throughout regions and industries. Other factors that have helped bring down the unemployment rate include:

1. Demographic factors – there has been a slower growth of the population of working age than at a similar stage of the last economic cycle in the early 1980s. This has lead to a slowdown in the numbers of people of working age entering the UK labour market.

2. 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.

3. "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.

4. Employment creation from foreign investment: The British economy has been successful in attracting billions of pounds worth of inward investment from overseas 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.

5. 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.

6. 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 in the last decade 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. The UK unemployment rate started to rise again in 2005 and 2006 albeit at a gentle rate. 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.

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Another interpretation of full-employment is when the total of people out of work matches the number of unfilled job vacancies. The problem with this is that estimates of the scale of job vacancies vary considerably. The true number of jobs available is probably three times the official published figure. 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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15. International Trade 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. The British economy is sensitive to fluctuations in the global economic 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. 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 5.8 Agricultural products 9.9Mining products 10.4 Mining products 8.9

Manufactures 82.6 Manufactures 80.4 By main destination By main origin

1. European Union (15) 55.8 1. European Union (15) 50.22. United States 14.9 2. United States 11.4

3. Japan 1.9 3. Japan 3.64. 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 goods and services to finance imports of products we cannot supply in this country. Exports represent an injection of demand into the circular flow of income and therefore create growth potential for many industries as businesses look to expand beyond the confines of their domestic (national) boundaries).

o Improving consumer welfare: There is a potential improvement in economic welfare if countries specialize in the products in which they have a comparative advantage and then trade with other nations. Trade between nations also provides greater choice for consumers and competition helps keep prices down

o Exploiting economies of scale: Trade allows firms to exploit economies of scale by operating in larger markets – for example, the EU has over 450 million consumers with a massive purchasing power and this is set to grow further now that the European Union has enlarged with the addition of ten new member countries. Economies of scale lead to lower average costs – a gain in efficiency that might be passed onto consumers through lower prices

o Increased efficiency: International competition stimulates higher allocative and productive efficiency. Trade in ideas stimulates product and process innovations that generates better products

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o Safety valve for excess demand: Imports can help to satisfy excess demand from consumers - acting as a safety valve for the economy. A trade deficit during a boom helps to reduce demand-pull inflation

Source: OECD World Trade Statistics - data is for trade in goods onlyUnited Kingdom, Shares in world exports of goods

Source: Reuters EcoWin

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

Per

cent

3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75

5.00

5.25

5.50

5.75

6.00

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 another international organization known as the General Agreement on Tariffs and Trade (GATT). Membership of the WTO has expanded to over 140 countries – with the recent successful admission of China to the WTO ranking as an event of potentially huge significance. It has evolved into a complex web of agreements covering everything from farm goods and textiles to banking and intellectual property. 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. 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 price 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.

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(c) 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, free of the disciplines of competition, will never achieve full efficiency.

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.

3. Externalities and Import Controls: Protectionism can deal with de-merit goods such as alcohol, tobacco and narcotic drugs that have adverse social effects.

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.

Problems with Import Protection

1. A loss of efficiency and welfare: Trade barriers restrict competition leading to a loss of economic welfare and increased 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

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16. Balance of Payments The balance of payments provides us with important information about whether or not a country is “paying its way” in the international economy. 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 only 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. 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 more goods and services overseas, the rise in exports boosts national income and should have a positive multiplier effect on the national income, 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. Select this link for more articles on British manufacturing industry

3. Regional economic health: The relative success of failure of export industries is important for certain regions of the UK. When export sales dip (for example as a result of a global downturn or the impact of the strong exchange rate), output, employment and living standards come under threat and threaten to widen the existing north-south divide.

Trade in goods includes items such as:

Manufactured goods Semi-finished goods and components Energy products Raw Materials Consumer goods (i) Durable goods e.g. DVD recorder and

new cars (ii) Non-durable goods e.g. foods and

beverages Capital goods (e.g. new plant and

equipment)

Trade in services includes: Banking, insurance and consultancy

services Other financial services including foreign

exchange and derivatives trading Tourism industry Transport and shipping Education and health services Services associated with research and

development Cultural arts

Trade in goods 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 2005 there was a record trade deficit of £66 billion, over three times the deficit seen in 1998.

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Balance of exports minus imports of goods at current prices, £ billionUK Balance of Trade in Goods

Source: Reuters EcoWin

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

GBP

(billi

ons)

-70

-60

-50

-40

-30

-20

-10

0

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.

Balance of exports minus imports of services, current prices, £ billionUK Balance of Trade in Services

Source: Reuters EcoWin

92 93 94 95 96 97 98 99 00 01 02 03 04 05

GBP

(billi

ons)

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

25.0

27.5

The balance of trade in services has been positive for many years. In 1999 the UK became the second largest exporters of services in the world and in 2004 the UK achieved its highest ever annual trade surplus in services although there was a smaller surplus in 2005 partly because of higher insurance payouts arising

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from the effects of Hurricane Katrina in the United States. Strong surpluses are especially common in financial and business services and hi-tech knowledge services. 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 overseas leisure and business travel and the sustained strength of the exchange rate against most European currencies and the rapid expansion of low cost airlines offering short haul overseas breaks has also played its part. 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. 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 financial and business services that represent a huge asset for the UK balance of payments accounts.

Measuring the current account The current account balance comprises the balance of trade in goods and services plus net investment incomes from overseas assets. Net investment income arises from interest payments, profits and dividends from external assets located outside the UK. We also add in the net balance of private transfers between countries and government transfers (e.g. UK government payments to help fund the various spending programmes of the European Union). The net investment income flow for the UK is positive – a reflection of the heavy investment overseas in recent years by British businesses and individuals. The transfer balance is negative – one reason is that the British government is a net contributor to the EU budget. The current account of the balance of payments 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 wide fluctuations.

Balance of trade in goods

Balance of trade in services

Net Investment Income

Current transfers

Current account balance

£ billion £ billion £ billion £ billion £ billion 1996 -13.7 11.2 0.6 -4.8 -6.7 1997 -12.3 14.1 3.3 -5.9 -0.8 1998 -21.8 14.7 12.3 -8.4 -3.2 1999 -29.1 13.6 1.3 -7.5 -21.7 2000 -33.0 13.6 4.5 -10.0 -24.8 2001 -41.2 14.4 11.7 -6.8 -21.9 2002 -47.7 16.8 23.4 -9.1 -16.5 2003 -48.6 19.2 24.6 -10.1 -14.9 2004 -60.9 25.9 26.6 -10.9 -19.3 2005 -67.3 17.9 29.9 -12.2 -26.6

Source: Office of National Statistics What are the main questions that concern economists regarding these figures?

i Causation: Why does the UK now run such large trade deficits in goods?

ii Consequences: Does it really matter if the British 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?

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The underlying causes of the UK trade deficit It is useful to group the explanations for the record trade deficit in goods into short-term, medium-term and long-term factors. Some relate to the demand-side of the economy, others to supply-side economic influences Short-term factors

i Strong consumer demand: Real household spending has grown more quickly than the supply-side of the economy can deliver, leading to a very high level of demand for imported goods and services

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. Nicholas Fawcett and Michael Kitson in a recent article in the Guardian estimated that the income elasticity is around +2.3 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.

iv The weakness of the global economy and in particular the slow growth in the Euro Zone has damaged UK export growth. Nearly 60% of UK manufactured goods exports and over 50% of our exports of services are to fellow members of the European Union.

Medium-term factors

i UK trade balances have been affected by shifts in comparative advantage in the international economy – for example the rapid growth of China as a source of exports of household goods and other countries in South-east Asia who have a cost advantage in exporting manufactured products

ii The availability of imports from other countries at a relatively lower price inevitably causes a substitution effect from British consumers.

Longer-term factors

i Much of our trade deficit is due to structural rather than cyclical factors

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

iii 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

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

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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 net fall in AD because more money is leaving the circular flow of income (through imports) than is coming in from exports. An inward shift of AD would lead to a contraction along the SRAS curve.

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 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.

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. Reduced inflationary pressure might then persuade the Bank of England to reduce interest rates to provide a boost to macroeconomic activity.

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 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.

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17. Government Macroeconomic Policy In this chapter we consider the ways in which government economic policies can be used to achieve aims such as low inflation, stable growth and high levels of employment. Is there a need for macroeconomic policy? A central issue in macroeconomics is whether or not markets, left alone, automatically bring about long run economic equilibrium. If the free operation of market forces eventually resulted in a full employment level of national income with stable prices and economic growth, there would be no need for government intervention in the macro economy - no need for fiscal monetary exchange rate and supply side policies. The reality is that all governments intervene through their macroeconomic policies in a bid to achieve certain policy objectives and improve the overall performance of the economy. Main Objectives of Government Economic Policy

1. Sustained economic growth

2. Stable prices (low inflation)

3. A high level of employment

4. A rise in average living standards

5. Sustainable position on the balance of payments

6. Sound government finances Demand Management Demand management occurs when the government attempts to influence the level and growth of AD hence the levels of national income, employment, 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

2. Deflationary policies decrease AD in the event of aggregate demand running ahead of AS and posing inflationary risks or leading to an unsustainable deficit on the balance of payments

We will focus on fiscal and monetary policies as the main instruments of demand management The Main Problems of Managing the Macroeconomy The government’s task of managing the economy is made difficult by several factors some of which are discussed below:

1. Inaccurate economic data: All of the main macroeconomic indicators are subject to a margin of error. They rely on statistical data collected from tax returns and surveys and data is often revised many months after its first release

2. Conflicting policy objectives: A policy of stimulating aggregate demand may reduce unemployment in the short term but initiate a period of higher inflation and exacerbate the current account of the balance of payments. Choices have to be made between objectives i.e. there exist trade-offs between them

3. Selecting the right policy instrument: Each macroeconomic objective requires a separate policy instrument: The usual ‘rule of thumb’ is that one main policy instrument should be assigned to one policy objective. So, for example, interest rates might be assigned as the main instrument for keeping control of inflation, whilst fiscal policy instruments such as changes to the tax system might be allocated to achieving some supply-side objectives such as increasing the labour supply, boosting incentives, raising investment and increasing productivity. There are quite deep-rooted disagreements between some economists (who belong to different ‘schools of thought’) as to which policies are most effective to meet a certain objective

4. Uncertain time lags when running a policy: 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

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through the whole economy to filter through to a change in prices. The length of the time lags can change over the years as the reactions of consumers and businesses to policy measures alters

5. External shocks: Unexpected external shocks to economy such as the events surrounding Sept 11th 2001 or unexpected volatility in exchange rates and commodity prices can upset economic forecasts and take the economy some distance from the expected path. The Government might under-estimate or exaggerate the potential impact of an economic shock to either the demand or supply-side of the economy and therefore apply too little or too much of a policy response.

Changes in direct and indirect taxes have an impact on people’s disposable incomes – this feeds through to

the wider economy and affects demand, growth and employment The main policies of economic management

• Fiscal Policy

o 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.

• Monetary Policy

o Monetary policy involves the use of interest rates to control the level and rate of growth of

aggregate demand in the economy. The Bank of England is charged with the task of 'maintaining the integrity and value of the currency'. The Bank pursues this objective through the use of monetary policy. Above all, this involves maintaining price stability, as defined by the inflation target set by the Government, as a precondition for achieving a wider goal of sustainable economic growth and high employment. Since 1997, the BoE has had operational independence in the setting of interest rates. The Bank aims to meet the Government's inflation target - currently 2.0 per cent for the consumer price index- by setting short-term interest rates. Interest rate decisions are taken by the Monetary Policy Committee (MPC) at their monthly meetings. Monetary policy also involves the effects of changes in the exchange rate – the external value of one currency against another – on the wider economy 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 economic 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 aggregate demand so that the productive capacity of an economy is actually brought into play.

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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 supply-side policies applied to the labour market – a factor market where labour is bought and sold. The effects of Monetary and Fiscal Policy on the economy There are some differences in the economic 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: 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, investment allowances for businesses in certain regions) Consider as an example the effects of using either monetary or fiscal policy to achieve a given increase in national income because actual GDP lies below potential GDP (i.e. there is a negative output gap)

(i) Monetary policy expansion Lower interest rates will lead to an increase in consumer and business capital spending both of which increases national income. Since investment spending results in a larger capital stock, then incomes in the future will also be higher through the impact on LRAS. (ii) Fiscal policy expansion An expansion in fiscal policy (i.e. an increase in government spending) adds directly to AD but if financed by higher government borrowing, this may result in higher interest rates and lower investment. The net result (by adjusting the increase in G) is the same increase in current income. However, since investment spending is lower, the capital stock is lower than it would have been, so that future incomes are lower.

Time Lags of Monetary and Fiscal Policies Monetary and fiscal policies differ in the speed with which each takes effect 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. 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 the economy pretty quickly. However, considerable time may pass between the decision to adopt a government spending programme and its implementation. In recent years, the government has undershot on its planned spending, partly because of problems in attracting sufficient extra staff into key public services such as transport, education and health.

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18. Monetary Policy Monetary policy influences the decisions that we make about how much we save, borrow and spend. 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 There is no unique rate of interest in the economy. For example we distinguish between savings rates and borrowing rates. However 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 lower mortgage rates and lower rates on savings accounts with Banks and Building Societies. The Real Rate of Interest The real rate of interest is often 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%. The Job of Monetary Policy “…to deliver price stability (as defined by the Government’s inflation target) and, subject to this objective, to support the Government’s economic policy, including its objectives for economic growth and employment…” The Bank of England has been independent since 1997. In that time there has been a cycle of small changes in interest rates. They have varied from 3.75% (in the late autumn of 2003) to 7.5% in the autumn of 1997. Generally though, the UK economy has experienced a sustained period of low interest rates over recent years. And, this has had important effects on the wider economy. 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 rather than sharp jumps in the cost of borrowing money. Their 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. The State of Demand: Is aggregate demand too strong – for example is household spending booming at an unsustainable rate?

2. The Housing Market: What are the economic 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.

3. The Labour Market: Are their inflationary signals coming from the labour market in the form of acceleration in wages and average earnings well above the growth of labour productivity?

4. Inflation from overseas: Is there a risk from import costs such as a rise in oil prices?

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5. Trends in the Exchange Rate: What is happening and what is projected to happen to the sterling exchange rate?

It is important to note that monetary policy in Britain is designed to be pro-active and forward-looking. This means that the MPC is aware that changes in interest rates take time to work through the economic system. Making decisions on interest rates on the basis of today’s inflation data simply does not make sense. The teams of economists at the Bank must make regular forecasts of inflation and consider whether the current level of UK interest rates is appropriate in order to meet the inflation target. Interest rate changes since 1997

Percentage, since May 1997 base rates have been set by the Bank of EnglandBase Rate of Interest for the UK

Source: Reuters EcoWin

97 98 99 00 01 02 03 04 05 06

Perc

ent

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Effects of Changes in Interest Rates 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 will typically increase both 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 aggregate demand. Changes to the level of interest rates take time to have an impact on overall economic activity - i.e. there is a time lag involved. A change in interest rates can have wide-ranging effects on the economy.

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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 short-term changes in interest rates feed through fairly quickly to the rest of the UK financial system (e.g. 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 down 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 and can fuel inflation

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, leading to a rise in debt-servicing burdens for home-owners. 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.

3. 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. Much depends on the impact of a rate change on consumer confidence.

4. Business capital investment: Firms often take the actual and expected level of interest rates into account when deciding whether or not to proceed with new capital investment spending. A rise in short term rates may dampen business confidence and lead to a reduction in planned capital investment. However, many factors influence investment decisions other than rate changes.

5. 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 (and therefore aggregate demand) because it reassures the public that the Bank is alert to the dangers of an economic slump. There are circumstances, however, where a cut

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

Set by the MPC

Domestic Demand

I.e. C + I + G

Net External Demand i.e. X - M

Aggregate Demand

AD Drives short-term

economic growth

Domestic Inflationary Pressure

i.e. changes in the output gap

(actual GDP relative to potential GDP)

Import Prices

Consumer Price Inflation

Mapping out the transmission mechanism – the effects of changes in interest rates

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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 particularly 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.

6. Interest rates and the exchange rate: Higher UK interest rates might lead to an appreciation of the sterling 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.

Usually a UK interest rate cut will tend to weaken the pound as it makes it less attractive for foreign investors to hold their money in Britain. When the pound rises, British exports become more expensive, while imported goods from abroad become cheaper. So a rising pound leads to a fall in demand for UK exports and a fall in demand for domestically produced goods that compete with imports from overseas. A rising pound therefore reduces aggregate demand, and so can dampen down the rate of inflation. An increase in the pound also affects the inflation rate directly by bringing down the price of imported goods. Monetary Policy Asymmetry 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 exposed (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, market 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. 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.

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19. 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, banks, individuals to trade in the currencies that they need.

Recent trends in the exchange rate

Daily value for the trade-weighted value of sterling in the foreign exchange marketsUnited Kingdom Exchange Rate Index

Source: Reuters EcoWin

90 92 94 96 98 00 02 04 06

Inde

x

80

85

90

95

100

105

110

115

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. How does a change in the exchange rate influence the economy? Changes in the exchange rate can have a powerful effect on the macro-economy affecting variables such as the demand for exports and imports; real GDP growth, inflation and unemployment – but as with most variables in economics, there are time lags involved.

1. The scale of any change in the exchange rate.

2. Whether the change in the currency is short term or long term.

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3. How businesses and consumers respond to exchange rate fluctuations – the concept of price elasticity of demand is important here.

Pounds sterling per US dollar, daily closing exchange rateUS Dollar Sterling Exchange Rate

Source: Reuters EcoWin

00 01 02 03 04 05 06

£ pe

r $1

0.500

0.525

0.550

0.575

0.600

0.625

0.650

0.675

0.700

0.725

0.750

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.

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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

Showing the effects of currency movements using AD-AS analysis

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 elasticity 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

Real National Output

Real National Output

Inflation

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

Inflation

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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

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

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20. 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 to help smooth out some of the volatility of real national output particularly when the economy has experienced an external shock. For example, from 2001-2005 there has been a fiscal stimulus to the UK economy through substantial increases in government spending on transport, and in particular heavier spending in the twin areas of health and education. This fiscal stimulus will come to an end in the next couple of years as the government slows down the rate of which its own spending is increasing.

• 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 above identifies some of the possible channels involved with the fiscal policy transmission mechanism. 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

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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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 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.

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)

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The Private Finance Initiative is a way of funding expensive infrastructure developments without running up debts. Rather than borrowing to fund new projects, John Major's government entered into a long-term leasing agreement with private contractors. 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. 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 We now turn to the revenue that flows into the government’s accounts from taxation. There are so many different kinds of taxation and the tax system itself often appears to be horrendously complex! But one important distinction to make is between direct and indirect taxes.

• 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 £127 billion in income tax receipts, nearly fifty billion pounds higher than the income from national insurance contributions. For more on taxation in the UK, click here. Income from selected range of taxes for the UK government 1999-00 2004-05 £ billion £ billion Income tax 95.7 127.2 National Insurance contributions 56.1 78.1 VAT 56.4 73.0 Corporation tax 34.3 34.1 Fuel duties 22.5 23.3 Council Tax 13.1 20.1 Business rates 15.4 18.7 Other taxes 8.1 11.7 Stamp duties 6.9 9.0 Tobacco duty 5.7 8.1 Vehicle excise duty 4.9 4.7 Beer & cider duties 3.0 3.3

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Inheritance tax 2.1 2.9 Spirits duties 1.8 2.4 Capital gains tax 2.1 2.3 Wine duties 1.7 2.2 Customs Duties & levies 2.0 2.2 Betting & Gaming duties 1.5 1.4 Petroleum revenue tax 0.9 1.3 Air Passenger duty 0.9 0.9

Source: HM Treasury Public Finance Statistics

Current Prices, £ billion. Source: HM TreasuryRevenues from Income Tax, VAT & Corporation Tax

Income Tax VAT Corporation TaxSource: Reuters EcoWin

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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-documented evidence that the heavy excise duty applied on tobacco has quite a regressive impact on the distribution of income in the UK.

Fiscal Policy and Aggregate Supply

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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

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.

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21. Government borrowing – the budget deficit In this chapter we consider the effects that government borrowing to finance their spending can have on the wider performance of the economy. 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 2% of GDP in 2006. 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. Critics of Gordon Brown argue that he risks losing control of the budget deficit if tax revenues continue to come in below forecast whilst public sector spending remains high. Gordon Brown’s reputation of fiscal prudence has come under pressure over the last few years. He is forecast to be running a budget deficit of over 3% of GDP (in excess of £32 billion) in 2006.

£ billionUnited Kingdom Government Budget (Fiscal) Balance

Source: Reuters EcoWin

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Does a budget deficit matter? There is a consensus that 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 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

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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 of the economy. 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.

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 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 changing the level of borrowing as a way of fine-tuning or managing the level of aggregate demand. An increase in borrowing can be a stimulus to demand when other sectors of the economy are suffering from weak spending. The fiscal stimulus given to the British economy during 2002-2005 has been important in stabilizing demand and output at a time of global uncertainty. 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.

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22. Supply-side Policies In this chapter we take a walk on the supply-side of the economy. 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 economic 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 aggregate demand so that the productive capacity of an economy is actually brought into play. 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. 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 sector into the 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. The Labour Government has continued to privatise or part-privatise other parts of the UK public sector since it came to power in 1997. 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

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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 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 joining 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 2004

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 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. 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. Attention has focused in recent years on lower income households. In the mid 1990s, a lower starting rate of tax of 10% was introduced and the band of income on which this is paid has been widened in recent Budgets. Cutting tax rates for lower paid workers may help to reduce the extent of the ‘unemployment trap’ – where people calculate that they may be no better off from working than if they stay outside the labour force. 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.

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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.

Inflation

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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

LRAS1 LRAS2

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Evaluating the UK’s supply-side performance On the right tracks “There has been a remarkable structural improvement in the British economy. This began under Margaret Thatcher and has largely been maintained under Tony Blair. Deregulation, privatisation, reductions in trade union power and reform of unemployment benefits have transformed the business environment.”

Source: Ed Crooks, Economics editor of the Financial Times. June 2004 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 employment. The UK currently has the highest employment ratio in the EU

• Sharp rise in the balance of payments deficit in goods and services – 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

• Service sector has been strong but manufacturing industry has suffered three recessions in the last ten years

• 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.

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23. Trade-Offs between Objectives 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. There are potential trade-offs between objectives imply that choices between different goals may have to be made in the short and medium run.

Should the highest priority be given to keeping inflation firmly under control?

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? Or can the trade deficit be ignored because it is the result of a high level of short term growth and strong consumer spending?

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 in many industries and occupations may arise. This puts upward pressure on pay as employers offer higher pay both 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). 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.

Wage Inflation

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Short Run Phillips Curve

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Counter-arguments 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 very long period of falling unemployment without any significant acceleration in inflation. This is shown in the data chart on the next page.

unemployment and inflation rates - per centUnemployment and Inflation

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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.

Inflation

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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. Is there a trade-off between 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.

AD1

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YFC2Y2

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Real National Income

Inflation

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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.

UK Real GDP Growth and Consumer Price Inflation. annual percentage changeEconomic growth and inflation

Real GDP growth (%) [ar 4 quarters] Consumer Price Inflation (%)Source: Reuters EcoWin

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

Perc

ent

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

Consumer Price Inflation (CPI)

Real GDP growth

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

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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 the development of 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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24. Exam Technique for your macroeconomics paper The AS macroeconomics exam on the National and International economy tests four types of assessment objectives, knowledge, application of knowledge, analysis and evaluation:

o Level 1 tests your knowledge of the syllabus and your ability to express that knowledge e.g. there are two main methods of measuring unemployment and different ways of measuring the rate of inflation using the Retail Price Index

o Level 2 test your ability to apply your economics knowledge and understanding to particular

problems and issues

o Level 3 tests your ability to use economic theories and concepts to analyse macroeconomic problems e.g. use Aggregate Demand & Aggregate Supply to show a unemployment caused by a negative output gap

o Level 4 tests your ability to evaluate problems and policies and make informed judgements based

on theory and evidence e.g. short term and long term implications Evaluation must be based on appropriate analysis for L4 marks to be awarded

To help students give the right type of answer exam boards give command words. E.g. Describe means a level 1 answer is required demonstrating knowledge; Discuss is level 4 - requiring candidates to evaluate.

Knowledge & Application of Knowledge

Analyse Economic Problems and Issues

Calculate Work out making use of the information provided

Analyse Set out the main points

Define Give the exact meaning Apply Use in a specific way

Describe Give a description of Compare Give similarities and differences

Give (an account) As `describe' Consider Give your thoughts about

Give (an example) Give a particular example Explain (why) Give clear reasons

How (explain how) In what way(s) Justify/account for Give reasons for

Identify Point out

Illustrate Give examples/diagram

Evaluate Economic Arguments and Evidence - making Informed Judgements

Outline Describe without detail Assess Show how important something is

State Make clear Criticise Give an opinion, but support it with evidence

Summarize Give main points, without detail

Discuss Give the importance arguments, for and against

Which Give a clear example / state what

Evaluate Discuss the importance of, making some attempt to weight your opinions

To what extent Make a judgement