Vous êtes sur la page 1sur 230

Section 2 The National & International Economy and Macroeconomic Policy

Tutor2u Limited 2008 www.tutor2u.net

Chapters 1. o o o o 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. Advice on Exam Technique at A2 Level ..............................................................................................3 Knowledge ...............................................................................................................................................3 Application of knowledge .....................................................................................................................3 Analysis .....................................................................................................................................................3 Evaluation .................................................................................................................................................3 Nature and Causes of Fluctuations in Economic Activity ..................................................................5 Consumer spending and saving......................................................................................................... 13 Capital investment spending .............................................................................................................. 23 Cyclical fluctuations - demand and supply-side shocks ................................................................ 33 Theories of Economic Growth............................................................................................................. 41 Economic Growth Costs and Benefits ............................................................................................ 52 National Income and Changes in Living Standards ....................................................................... 58 Unemployment ...................................................................................................................................... 66 The Natural Rate of Unemployment ................................................................................................. 77 Flexible Labour Markets..................................................................................................................... 80 The Phillips Curve ................................................................................................................................. 85 Measuring Inflation .............................................................................................................................. 94 Causes of Inflation .............................................................................................................................100 Consequences of Inflation .................................................................................................................107 Deflation ..............................................................................................................................................110 Monetarism and the Quantity Theory of Money..........................................................................115 Government Macroeconomic Policy................................................................................................119 Monetary Policy .................................................................................................................................123 The Exchange Rate ............................................................................................................................133 Fiscal Policy - Taxation and Public Expenditure ..........................................................................144 Direct and Indirect Taxation ............................................................................................................146 The Economic Effects of Fiscal Policy ..............................................................................................154 The Pattern of International Trade .................................................................................................167 Trade and Developing Economies ..................................................................................................170 Trade and the Law of Comparative Advantage .........................................................................185 Protectionism .......................................................................................................................................192 The Balance of Payments .................................................................................................................200 Globalisation ......................................................................................................................................216 European Monetary Union ...............................................................................................................223

Tutor2u Limited 2008 www.tutor2u.net

1. Advice on Exam Technique at A2 Level


The A2 economics exams tests four types of objectives at four levels (Levels 1-4): o o o o Knowledge Application of knowledge Analysis Evaluation

Level 1 tests your knowledge of the syllabus and your ability to express that knowledge Level 2 test your ability to apply knowledge and understanding to particular problems and issues Level 3 tests your ability to use economic theories and concepts to analyse problems 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 of a policy decision. Evaluation must also be based on appropriate analysis for L4 marks to be awarded If you write good economics with clear definitions, relevant diagrams, sound explanations, an attempt to use supporting evidence and make a genuine attempt at evaluation then the examiners will treat your paper positively and give you high marks! Examples of key command words in exam questions Knowledge & Application of Knowledge Calculate Work out using the information provided Define Give the exact meaning Describe Give a description of Give (an account of) As `describe' Give (an example of) Give a particular example How (explain how) In what way or in what ways Identify Point out Illustrate Give examples/diagram Outline Describe without detail State Make clear Summarise Give main points, without detail Which Give a clear example/state what

Analyse Economic Problems and Issues Analyse Set out the main points Apply Use in a specific way Compare Give similarities and differences Consider Give your thoughts about Explain (why) Give clear reasons or make clear Justify/account for Give reasons for
Tutor2u Limited 2008 www.tutor2u.net

Evaluate Economic Arguments and Evidence, making Informed Judgements Assess Show how important something is Criticise Give an opinion, but support it with evidence Discuss Give the importance arguments, for and against Evaluate Discuss the importance of, making some attempt to weight your opinions To what extent Make a judgement Evaluation Economists draw on a toolkit of concepts and techniques to help to analyse and evaluate problems and potential policy solutions. For example, economists use AD-AS analysis when discussing macroeconomic issues and frequently used the tools of welfare economics when discussing issues relating to microeconomics. The highest marks in economics exams are reserved for students who think like an economist i.e. students who select the appropriate tool from the toolkit to analyse and evaluate. Evaluation means weighing up evidence and arguments, making reasoned judgements to present appropriate and well supported conclusions based on appropriate economic analysis. It also means reasoning your arguments and prioritising them. Many answers to questions requiring evaluation can usefully be assessed against these criteria: o Efficient i.e. does a particular policy result in a better use of scarce resources among competing ends? E.g. does it improve allocative, productive and/or static efficiency and therefore lead to an improvement in economic welfare? Consider two examples: Will higher indirect taxes on aircraft fuel be an efficient way of reducing some of the external costs linked to the rapid growth of aviation transport? Will entry into the single European currency improve the efficiency and competitiveness of markets ad industries in the UK economy? o Effective i.e. which policy is most likely to meet a specific economic objective? For example, which policies are likely to be most effective in reducing road congestion? Which policies in the long run are most effective in reducing the natural rate of unemployment? Or increasing the trend rate of economic growth? Evaluation can also consider which policies are likely to have an impact in the short term when a quick response from consumers and producers is desired. And which policies are likely to prove most cost-effective in the longer term? o Equitable i.e. is a policy fair or does one group in society gain more than another? Many aspects of government intervention in markets raise important issues of equity for example government spending on public and merit goods, changes to the system of direct and indirect taxation etc. o Sustainable i.e. does a policy reduce the ability of future generations to engage in economic activity? Inter-generational equity is an important issue in many current policy topics for example decisions on energy policy.

Tutor2u Limited 2008 www.tutor2u.net

2. Nature and Causes of Fluctuations in Economic Activity


In this chapter we consider in more detail the nature of and causes of cyclical fluctuations in economic activity. In particular we focus on the existence of demand-side and supply-side shocks to the economy. The economic cycle All countries experience business cycles where the pace of growth of production, incomes and spending fluctuates over time. The length and volatility of cycles changes over time partly because the structure of an economy evolves. Often, we find that previously observed relationships between different variables, for example between unemployment and inflation have changed. Short term economic growth for the UK The annual growth of UK real GDP between 1977 and 2007 is shown in the next chart. The data shows the annual percentage changes in national output at constant prices, in other words the figures have been adjusted to take into account changes in the general level of prices.

The Economic Cycle - Growth in UK National Output


Annual percentage change in GDP at constant prices
6 5 4 3 2
Percent
6 5 4 3 2 1 0 -1 -2 60 quarters of unbroken GDP growth! -3 -4 -5

1 0 -1 -2 -3 -4 -5 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

Source: Reuters EcoWin

The business cycle for the UK over the last thirty years

The UK last experienced a recession in 1990-92. Since 1993, the UK has enjoyed over fifteen years of sustained growth. The strongest years during the current cycle came in 1997 (3.3%) and in 2000 when real GDP expanded by nearly 4%. Taken as a whole, the UK economy has now enjoyed its longest period of sustained growth for over forty years and in July 2007; a landmark was reached 60 consecutive quarters of economic growth.

Tutor2u Limited 2008 www.tutor2u.net

Theories of the Economic Cycle In this section we consider some of the theories about the economic cycle and in particular how a country can move from one stage of a cycle to another. Endogenous models of the cycle try to explain cyclical fluctuations in terms of factors which lie within the economic system suggesting that, even if there were no shocks to an economy, there would still be variations in the growth of income, spending and output. Exogenous models of the cycle argue that cycles can be started by a range of demand-side or supply-side shocks from outside the economic system which then have ripple effects. 1. The Stock Cycle The stock cycle helps to explain some of the changes in national output. To see this we will look at what happened the last time that the economy had a recession. In 1989-90 the rate of growth in the economy slowed right down at the end of what had been a very strong consumer boom.

Endogenous models of the business cycle

Changes in stocks and the UK economic cycle


Evidence for the stock cycle in the UK
5 4 3 GDP growth 5 4 3 2 1 0 -1 -2 -3 3 Changes in stocks (a negative figure indicators that businesses were reducing their stock levels) 2 1 0 -1 -2 -3 89 90 91 92 93 94 Source: Reuters EcoWin

Percent (billions)

2 1 0 -1 -2 -3 3 2 1 0 -1 -2 -3

During the recession businesses cut back on production and tried to off-load stocks

Consider the effects of such a fall in consumer spending which initially (in the first half of 1989) caused an increase in stocks of goods and raw materials held by firms. Because holding stocks can be a drain on a companys finances (they must be stored somewhere and may have a limited shelf life), an unexpected rise in unsold stocks acted as a signal to firms to lower production - leading to a fall in demand for intermediate products such as components. This process of de-stocking then worked its way through the supply-chain. So companies providing raw materials and other supplies suffered a
Tutor2u Limited 2008 www.tutor2u.net

billions

downturn in demand. The result was a fall in production and the laying off of workers. Throughout 1991, 1992 and for most of 1993, businesses in the UK economy were seeking to reduce stock levels because of weak demand and low profits. One way of doing this is to try to sell unsold products at discounted prices; the effect being a fall in the rate of inflation. The economy climbed out of the recession in 1993 and growth strengthened considerably in 1994 partly on the back of a boom in exports overseas. Theory tells us that when AD starts to pick up at the start of a recovery and stock levels dip, this is a signal for firms to step up production to re-build inventories and meet an increase in consumer demand. Notice how, in the second half of 1994, stock levels started to rise quite strongly. The very act of increasing production to rebuild stocks helps to bring the economy further away from the low point of the recession.

Changes in stocks and the UK economic cycle


Evidence for the stock cycle in the UK
4.5 Real GDP Growth 4.0 3.5 4.0 3.5 3.0 2.5 2.0 1.5 Change in the value of stocks 3.0 2.5 2.0 4.5

Percent

3.0 2.5 2.0 1.5 3.0 2.5 2.0

(billions)

1.0 0.5 0.0 -0.5 -1.0 00 01 02 03 04 05 06 07

1.0 0.5 0.0 -0.5 -1.0

Source: Reuters EcoWin

Is there evidence in this chart for the sort of stock cycle explained in the previous section?

Is the stock cycle becoming less important? Is the stock cycle becoming less important in helping us to explain the economic cycle? Some economists believe that the answer is yes because improvements in information technology have changed the nature and importance of the stock cycle in most developed countries. For example, the use of just-intime (JIT) stock delivery systems common place in industries such as motor car manufacturing and widespread improvements in stock control has reduced the need for businesses to hold high levels of stocks of intermediate products. It is now easier for supply to match changes in demand. 2. Changes in aggregate demand Changes in the growth of real GDP in the short term are mainly caused by changes in the components of aggregate demand and shifts in short-run aggregate supply.
Tutor2u Limited 2008 www.tutor2u.net

billions

1.5

1.5

Consumer spending 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Government consumption billion 196 199 206 212 217 225 233 240 247 253

Gross Investment billion 139 159 163 167 172 178 179 189 195 208

581.5 604.4 631.7 660.8 680.5 704.0 724.3 748.8 759.4 774.8

billion

Exports of Imports of Real GDP goods and goods and services services billion billion billion billion 3 231 219 937 4 238 239 968 6 247 258 997 5 270 281 1035 6 278 294 1060 2 281 309 1081 4 285 315 1110 5 299 336 1147 4 323 359 1169 5 360 401 1201 Source: Office for National Statistics and HM Treasury

Change in stocks

The annual rates of growth of the components of demand are shown in the table below
Consumer spending 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 % change 3.5 3.8 4.7 4.5 3.1 3.6 3.0 3.5 1.4 2.0 Government consumption % change -0.5 1.1 3.7 3.1 2.4 3.5 3.5 3.2 3.0 2.4 Gross Investment % change 6.5 14.0 2.8 2.7 2.5 3.7 0.4 6.0 3.0 6.5 Exports of Imports of Real GDP goods and goods and services services % change % change % change % change 0.2 8.2 9.8 3.0 0.1 3.0 9.2 3.3 0.2 3.8 7.9 3.0 -0.1 9.1 9.0 3.8 0.1 2.9 4.8 2.4 -0.3 1.0 4.8 2.1 0.2 1.7 2.0 2.7 0.1 4.9 6.6 3.3 -0.1 7.9 7.0 1.9 0.0 11.6 11.8 2.7 Source: Office for National Statistics and HM Treasury Change in stocks

The key features of the above table to consider are: Strong consumption: Consumer spending (or consumption) has been the driving force behind the growth of the British economy over recent years. In the short term this has had beneficial effects in providing a boost to aggregate demand and growth. But there has been a price to pay because the consumer boom has been driven by rising house prices and an strong level of demand for credit and the big risk is that strong consumer demand has led to an unbalanced economy and an unsustainable debt mountain which will unravel in the years to come. Weak investment: Capital investment takes between 16-18% of GDP in the UK and is one of the more volatile components of aggregate demand. Over seventy five per cent of capital spending is done by private sector businesses and within this total the majority of new investment comes from the service sector which now accounts for nearly seventy per cent of total GDP. Some major infrastructural projects such as the new Wembley Stadium, Terminal 5 at Heathrow and the National Health Service and UK school building programme have contributed to a faster growth of investment in the economy over the years 2004-2006.

Tutor2u Limited 2008 www.tutor2u.net

High demand for imports: Import growth has exceeded exports in Britain in recent times leading to a further increase in the trade deficit which reached a record level in 2005 and 2006. The trade deficit in goods was a staggering 84bn in 2006 - import demand has been strong partly because of the high exchange rate and household spending.

Different stages of the economic cycle Economic Boom A boom occurs when real GDP grows much faster than the trend growth rate of about 2.5% per year. In a boom phase, AD is high and businesses respond by increasing production and employment. They may also raise profit margins by increasing prices and this can lead to cost-push and demand-pull inflation. The main characteristics of a boom are as follows: A tightening of the labour market: An expanding economy should lead to more jobs and an increase in real incomes of people in work. The tightness of the labour market can be measured in various ways for example the rate of unemployment or the number of unfilled job vacancies. Surveys of labour shortages also provide information about the balance of supply and demand. If labour shortages become severe, the risk is that wage inflation will accelerate leading to a rise in unit labour costs feeding through to higher retail prices. High demand for imports and a wider trade deficit: A common feature of a boom is that demand for imports increases because of a high marginal propensity to import. This is certainly true of the UK economy. Impact on government finances: A sustained period of economic expansion provides a fiscal dividend to the government because tax revenues will be rising as extra people are in work and they are earning and spending more. Business profits will be increasing and an expanding economy also helps to reduce state spending on welfare benefits such as the Jobseekers Allowance. Strong company profits and investment: A cyclical upturn normally leads to higher profits and an increase in investment. The link between demand and planned investment can be explained using the accelerator theory of investment. Cyclical boost to productivity: An expanding economy is good news for labour productivity because businesses are stretching to supply the extra demand by using their existing labour resources more intensively. The rise in productivity helps to keep unit labour costs under control. In current jargon productivity growth tends to be pro-cyclical i.e. it picks up speed when the economy is strong, but can falter when demand and production weakens. A risk of a pick-up in inflation: Both demand-pull and cost-push inflation can occur if AD exceeds potential GDP over a prolonged period.

The characteristics of a boom period depend in part on what has caused the expansion. During the 1990s and early half of the current decade, the expansion in the UK has been set against a favourable macroeconomic background of a growing world economy, low inflation, low interest rates and a high exchange rate. A period of cheap money from low interest rates has fuelled strong demand for borrowing from consumers, a housing boom and a sharp rise in business investment. But inflationary pressures have been modest compared to previous periods of fast growth inflation has been held down by cheaper imports, the effects of new technology and greater competition in numerous markets for goods and services.

Tutor2u Limited 2008 www.tutor2u.net

Economic Growth and Inflation


UK Real GDP Growth and Consumer Price Inflation. annual percentage change
9 8 7 6 5 4
Percent
9 8 7 6 5

Real GDP growth

4 3 2 1

3 2 1 0 -1 -2 -3 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Consumer price inflation

0 -1 -2 -3

Source: Reuters EcoWin

Since the early 1990s the UK economy has enjoyed stable inflation and continuous growth

Since the early 1990s, we have seen a favourable combination of steady growth and low, stable inflation. The picture has changed somewhat over the last few years with a rise in the rate of inflation indeed inflation has been above the 2% target for most of 2006 and 2007. The danger is that growth will slowdown whilst inflation remains fairly high this is known as stagflation. Showing economic growth using an AD-AS framework In the following diagram we see an outward shift in AD. Equilibrium national income rises from Y1 to Y2 and takes real national output closer to potential output (shown at level Yfc). If AD were to rise further beyond AD2, this risks creating excess demand (i.e. a positive output gap). At this stage of the business cycle, short run aggregate supply is drawn as inelastic and there is growing pressure on factor resources which might trigger an increase in commodity prices and wages putting upward pressure on inflation.

Tutor2u Limited 2008 www.tutor2u.net

Inflation LRAS

P3

P1

P2

AD3 AD1 SRAS AD2

Y1

Y2

Yfc

Real National Income (Y)

In the diagram below the outward shift of AD had taken the economy beyond potential GDP leading to a positive output gap measured by the distance AB. This may then cause higher wages and a rise in labour costs and also the prices of other factor inputs leading to an inward shift in SRAS. This takes the economy towards full-capacity output but with a higher price level (P3).
Inflation LRAS = potential GDP SRAS2
P3 P2

SRAS1

P1

AD1

AD2

Y1

Yfc

Y2

National Income

Tutor2u Limited 2008 www.tutor2u.net

Economic Slowdown A slowdown occurs when real GDP continues to expand but at a reduced pace. If a country can achieve growth without falling into a recession, this is termed a soft-landing whereas (maintaining the aeronautic analogy) a full recession is coined a hard-landing. Economic Recession A recession means a fall in real national output and a contraction in employment, incomes and profits. In technical terms a recession is a period of two quarters (six months) when real GDP declines. An alternative definition of a recession is that it occurs when the economy is operating persistently with a level of national output below its potential and that the gap between actual and potential GDP continues to widen.

United Kingdom, Output gap of the total economy


Actual GDP - Potential GDP, measured as a percentage of potential GDP source: OECD
4 3 2 1
Percentage of potential GDP
4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7

0 -1 -2 -3 -4 -5 -6 -7 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source: Reuters EcoWin

The output gap has remained within around 1% or -1% of GDP since 1980

We can see the output gap in the chart above. Can you see the effects of the recession in the early 1980s and also in 1990-92 which left the economy with a large negative output gap, i.e. national output was well below its estimated potential? The recovery during the mid 1990s caused the output gap to narrow and by 1997 the UK had reached potential GDP. Since then, although there have been cyclical variations, the output gap itself has remained very small ranging between +1% and -1% of GDP. This is one of the reasons that the British economy has managed to continue its current growth phase.

Tutor2u Limited 2008 www.tutor2u.net

3. Consumer spending and saving


The basic determinants of consumer spending and saving were covered as part of the AS course. In this section we delve deeper into the determinants of consumption exploring in particular the Keynesian approach and alternative theories of consumption and saving. The consumption function The consumption function is simply a relationship between income and consumer expenditure. The Keynesian theory describes a consumption function where household spending is directly linked to peoples disposable income. A simplified consumption function diagram is shown below.
Consumption = Disposable Income Consumer spending

C2 C1

C3 Change in consumption Change in income

The gradient of the consumption line shows us the marginal propensity to consume out of a change in income

Disposable Income

The standard Keynesian consumption function is written as follows: C = a + c (Yd) Where o C is total consumer spending o a is autonomous spending o And c (Yd) is the propensity to spend out of disposable income Autonomous spending (a) is consumption which does not depend on the level of income. For example people can fund some of their spending by using their savings or by borrowing money from banks and other lenders. A change in autonomous spending would in fact cause a shift in the consumption function leading to a change in consumer demand at all levels of income.
Tutor2u Limited 2008 www.tutor2u.net

The key to understanding how a rise in disposable income affects household spending is to understand the concept of the marginal propensity to consume (mpc). The marginal propensity to consume is the change in consumer spending arising from a change in disposable income. If for example your disposable income rises by 5,000 and you choose to spend 3000 of this on extra goods and services, then the mpc is 3000/50000 or 0.66. If you chose instead to spend only 2500 of the increase in income, then the mpc would be 0.5. The gradient of the consumption function shown in the previous diagram is determined by the value for marginal propensity to consume. A change in the mpc (shown in the next diagram) would cause a pivotal change in the consumption function. For example, a decision to save less of any increase in income would lead to a rise in the mpc and a steeper consumption curve. The consumption function - a simple numerical example Disposable Income (Yd) 10000 20000 30000 40000 50000 Consumption (C) 8500 16000 23600 29450 33200 Average Propensity to Consume = C/Yd 0.85 0.80 0.79 0.74 0.66 Marginal Propensity to Consume = change in C from a 1 change in Yd 0.75 0.76 0.59 0.38

In our example above, as disposable income rises in blocks of 10,000, so does total consumption. But the rate at which consumer spending is increasing is declining. The marginal propensity to consume is falling and this brings down the average propensity to consume. The Keynesian theory did actually argue that the marginal propensity to consume would fall as income increases, but the evidence for the UK over many years disputes this. The Savings Function We assume that any disposable income that is not spent is saved, so we can deduce from our numerical example above, that because the marginal propensity to consume is falling, then the marginal propensity to save must be rising as is the average propensity to save (otherwise known as the household savings ratio). This is shown in the table below which is drawn from the data on consumption and income used in the first table. The Savings Function - a simple numerical example Disposable Income (Yd) 10000 20000 30000 40000 50000 Saving (= Yd C) 1500 4000 6400 10550 16800 Average Propensity to Save = S/Yd 0.15 0.20 0.21 0.26 0.33 Marginal Propensity to Save = change in S from a 1 change in Yd 0.25 0.24 0.41 0.62

Tutor2u Limited 2008 www.tutor2u.net

Household Savings Ratio


Percentage of disposable income that is saved, quarterly data
14 13 12 11 10 9 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Percent

8 7 6 5 4 3 2 1 0

Source: Reuters EcoWin

The savings ratio is quite volatile but what have been the main trends since 1990?

Looking at the data for the household savings ratio we find that it has been quite volatile over the last twenty years ranging from over 13.5% of disposable income in 1992 to just 2% of disposable income in the first half of 2007. It is noticeable that in recent years, households have chosen to save a much lower percentage of their after-tax income than in previous periods. Much of this has been the result of the boom in consumer borrowing, including a huge level of mortgage equity withdrawal from the housing market.
Household Consumption % change Real Disposable Income Savings Ratio House Price Inflation (Halifax) % change -0.8 4.2 10.9 10.2 9.1 9.3 13.4 25.3 15.5 13.9 3.3 9.3 Short Term Interest Rate % 6.5 6.4 7.5 6.2 5.9 5.8 4.0 3.9 4.0 4.8 4.6 5.0 Growth of Consumer Credit % change 13.4 15.9 17.1 17.2 15.8 14.5 13.4 15.9 14.9 14.2 12.5 7.6

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

1.6 3.9 3.5 3.8 4.7 4.5 3.1 3.6 3.0 3.5 1.5 1.9

% of income % 2.6 2.4 3.8 1.5 2.8 4.5 4.3 1.7 2.4 1.7 2.9 1.1

10.2 9.4 9.5 7.0 5.3 5.1 6.4 5.0 4.9 3.7 5.5 5.0

Tutor2u Limited 2008 www.tutor2u.net

2007 forecast Average 1995-2007 Standard Deviation

2.7 3.2 1.0

1.8 2.6 1.1

3.9 6.2 2.2

7.7 10.1 6.4

5.8 5.4 1.1

14.4 2.6

Savings, Interest Rates and Unemployment


Two factors that influence the rate at which households save their disposable income
15 14 13 12 11 10 9 Savings Ratio
Household savings ratio (% of disposable income) Base Interest Rate Unemployment (Claimant count, seasonally adjusted)

15 14 13 12 11 10 9 8 7 6 Unemployment Interest rates 5 4 3 2 1 0 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Percent

8 7 6 5 4 3 2 1 0

Source: Reuters EcoWin

Unemployment and interest rates both influence savings decisions

In the chart above we track the household savings ratio, the base rate of interest set by the Bank of England and the seasonally adjusted rate of unemployment as measured by the claimant count. The general trend is that the savings ratio has declined over the last decade or more, a time when both unemployment and interest rates have also fallen. If people have reasonable expectations of job security and if the rate of return on their savings is lower than in the past, here are two reasons to save less and borrow more. The issue of consumer debt is a long-standing one. It certainly raises risks for the UK economy in the years ahead because the accumulation of debt creates the cost of servicing this debt, thousand of people have problems in simply paying the interest on their loans and the number of personal insolvencies in the UK has reached a record high. Reading on the savings ratio A 2% savings ratio (Economics UK, David Smith, June 2007) Savings rate hits 47 year low (Guardian, June 2007) Britons savings rate drops to lowest level since 1960 (The Times, June 2007)
Tutor2u Limited 2008 www.tutor2u.net

Annual Growth of Consumer Borrowing


Annual percentage change in consumer borrowing in the UK
20.0
20.0

17.5

Consumer credit

17.5

15.0

15.0

12.5
Percent

12.5

10.0

10.0

7.5

Total lending

7.5

5.0 Lending secured on property 2.5

5.0

2.5

0.0
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

0.0

Source: Reuters EcoWin

Tutor2u Limited 2008 www.tutor2u.net

Insolvencies and Consumer Debt Outstanding


Individual insolvencies, seasonally adjusted
30000 25000
Insolvencies
30000

Personal Insolvencies (number per quarter)

25000 20000 15000 10000 5000 0 225

20000 15000 10000 5000 0 225 200


(billions)

Outstanding Consumer Credit bn


200 175 150 125 100 75

175 150 125 100 75 97 98 99 00 01 02 03 04 05 06 07

Source: Reuters EcoWin

Personal insolvencies are now at a record high too much borrowing? Or is it now too easy to declare oneself bankrupt and avoid repaying existing debts?

Tutor2u Limited 2008 www.tutor2u.net

billions

Real Disposable Income and Consumer Spending


Real income and spending at constant 2001 prices, billion per year
800 750 700
Constant 2001 prices (billions)
800 750 700 650 600 550 500 450 400 350

650 600 550 500 450 400 350 80 82 84 86 88 90 92 94 96 98 00 02 04 06

Real households disposable income

Household Expenditure Source: Reuters EcoWin

There is a strong relationship between peoples disposable income and their spending

Tutor2u Limited 2008 www.tutor2u.net

billions

Shifts in the Consumption Function


Consumption = Disposable Income

Consumption = a2 + c(Yd)

Consumption = a + c(Yd) C2

C1

a2

Y3

Disposable Income Billion

A change in any factor affecting consumption other than a change in income is said to lead to a shift in the consumption function. These factors include the following: o A change in interest rates for example a cut in interest rates will boost consumption at each level of income and cause an upward shift in the consumption function. Lower interest rates act to lower the cost of servicing the debt on a mortgage and thereby increase the effective disposable income of homeowners. In contrast a period of higher interest rates is designed to curb consumer spending. o A change in household wealth for example a rise in house prices or in share prices encourages higher levels of borrowing and an upward movement in the consumption curve o A change in consumer confidence for example, expectations of rising unemployment and worsening expectations of changes in income might lead to a reduction in confidence and a fall in spending at each level of income. Conversely an improvement in consumer expectations about the health of the economy will increase confidence and planned spending

Tutor2u Limited 2008 www.tutor2u.net

Consumption and Interest Rates


Annual percentage change in household spending and GDP at constant 2000 prices
16
Interest rates - per cent
16 Base Interest Rates 14 12 10 8 6 4 2 0 7 6 5 4 3 2 1 0 -1 -2 -3

14 12 10 8 6 4 2 0 7 6 5 4 3 2 1 0 -1 -2 -3 90

Real GDP

Annual % change

Consumer spending

91

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

Source: Reuters EcoWin

Consumption

1997 2005

Real Real GDP Disposable Income billion at constant 2002 prices 558.1 625.2 936.7 731.1 768.6 1167.8

Average Propensity to Consume =C/Yd 0.89 0.95

Consumption / GDP Ratio of consumption to real GDP 0.60 0.63 Source: ONS, Blue Book

Tutor2u Limited 2008 www.tutor2u.net

We now turn to some non-Keynesian theories of what determines consumer spending. Alternative theories of consumption The lifecycle model The life-cycle model of consumption was developed by Franco Modigliani who argued that households form a view about their likely or expected income over a large slice of their life-cycle, and then base their spending decisions around this. This helps to explain why people in reasonably well paid jobs in their early twenties are prepared to borrow heavily to finance current consumption (a new car, furnishings for a property) because they expect to be able to repay loans as their disposable income increases. Similarly people reaching middle age frequently tend to become net savers because they are anticipating saving for their retirement. One of the results of the life-cycle model is that changes in the age structure of the population can have sizeable effects on total consumer spending in the economy. The permanent income model This model of consumption is associated with the US economist Milton Friedman and it is, in many ways, a development of the life-cycle mode. Friedman believed that people base their spending decisions on expectations of permanent income. Permanent income might be described as the average income that people can earn over their lifetime. A distinction is made between transitory income (e.g. a windfall gain in income which has not been earned) and permanent income. Friedman believed that changes in transitory income would not fundamentally affect spending and saving decisions. But that shifts in permanent income would be important in shaping our spending levels. For example, a rise in household wealth increases the ability of people to spend perhaps through borrowing secured on the value of a property. Lower interest rates tend to increase both share and house prices adding to household wealth. That said lower interest rates also cut the income flowing to people with net savings. According to the permanent income model, only changes in permanent income have any long term effect on consumption. But transitory changes in spending power can lead to a more volatile pattern for the propensity to consume. Key Points Keynesian theories of consumption focus on current disposable income as the main determinant of household spending Other theories argue that expectations of income and wealth in the future also affect peoples spending decisions Borrowing allows people to spend more than their current income. Borrowing is dis-saving The consumer borrowing boom has lasted more than a decade Household debt is now at a record high although interest rates remain low by historical standards Rising house prices have boosted personal wealth and consumer confidence Personal insolvencies are rising, debt is likely to be a major constraint on consumer demand for goods and services in the years ahead

Tutor2u Limited 2008 www.tutor2u.net

4. Capital investment spending


In this chapter we consider the Keynesian theory of investment and look at some of the evidence on business investment spending in the UK economy. The meaning of investment to an economist Investment to an economist is a precise term which involves the acquisition of capital goods designed to provide us with consumer goods and services in the future. Investment spending involves a decision to postpone consumption and to seek to accumulate capital which can raise the productive potential of an economy. But investment is similar to consumption as it is an important component of aggregate demand. It is important to remember that investment has important effects on both the demand-side and the supply-side of the economy. Net and gross investment Net investment in any given year = gross investment minus an estimate for replacement investment i.e. that investment required to replace obsolete capital. The level of net investment in any one year tells us what is happening to the final stock of fixed capital available for production. Gross fixed investment is spending on fixed assets. The biggest single item of investment spending is on new buildings, plant and machinery and vehicles. The real value of business investment in the UK economy over recent years is shown in the next data chart.

Autonomous and induced investment Autonomous investment is capital expenditure on producer goods unrelated to the level of national income. For example, the cost of purchasing new items of capital equipment would affect autonomous investment. Induced investment is related to levels of national income. An increase in GDP increases induced investment but leaves autonomous investment unaffected. The accelerator theory of investment which we will consider shortly is an example of this.

Factors that affect investment demand As with consumption and saving, we find that there are plenty of theories as to the main factors driving investment decisions in the economy. For example, a detailed survey of these theories published by the UK Treasury in 2003 argued that: Expectations the key to understanding investment decisions The central message of economic theory and the evidence from business surveys is that capital investment is determined by the relationship between the expected returns from investment and the expected cost of financing the investment.
Source: DTI Economics Research Paper on competitiveness and investment

In other words, profit-seeking businesses operating in the private sector of the economy will be prepared to go ahead with an investment if they believe that the project will over its projected lifetime yield a real rate of return greater than if the money tied up in an investment project had been invested in the next best alternative way.
Tutor2u Limited 2008 www.tutor2u.net

Motivations for Capital Investment - CBI Surveys


% of firms identifying this as a factor behind new investment in the next 3 months
80
80

70

70

Increase efficiency
60
60

Per cent

50

50

Replace capital equipment


40
40

30

30

Expand capacity
20
20

10
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

10

Source: Reuters EcoWin

Efficiency improvements seem to dominate the investment aims of industrial businesses

For government sector investment, the priorities may be a little different. Public sector investment projects are still subject to tests about their expected rates of return, but the cost-benefit analysis will normally also include estimates of the social costs and benefits of the investment rather than a narrow focus on private costs and benefits. Capital investment spending in the UK economy
Total investment as a share of national income UK USA Japan

Gross Investment bn 2000 2001 2002 2003 2004 2005 2006 167.5 171.6 178.1 178.8 189.5 195.1 207.7

Whole economy % of GDP 16.9 16.6 16.5 16.1 16.5 16.8 17.3

Services % of GDP 8.4 7.9 7.5 6.9 6.9 6.9 6.9

Manufacturing % of GDP 1.9 1.7 1.3 1.2 1.1 1.1 1.1

Government % of GDP

% of % of GDP % of GDP GDP 1.5 16.9 17.1 25.3 1.6 16.6 16.3 24.7 1.6 16.5 15.0 23.3 2.0 16.1 15.3 23.0 2.0 16.5 15.6 22.7 2.0 16.8 16.3 23.1 17.3 16.3 23.8 Source: Office of National Statistics

Tutor2u Limited 2008 www.tutor2u.net

Between the years 1997-2005, the real level of gross investment spending in the UK increased by 40% although, when measured as a share of national income, total investment remained fairly static at around 17%. This is similar to that of the United States but much lower than countries such as Japan and China where investment in recent years has run at a staggering rate of over 40% of her national income! Indeed the Chinese government has sought recently to bring this level of investment down because of fears that the economy is over-investing, risking creating too much capacity and also raising fears that much of the super-charged investment has been of fairly low quality and financed by risky lending. The bulk of capital investment in the UK economy is done by service sector businesses, hardly surprising when services account for over seventy per cent of our GDP.

Value of UK Capital Investment Spending


Quarterly value of capital spending at constant 2003 prices, bn
60
60

55

55

50
2003 GBP (billions)

50

45

45

40

40

35

35

30

30

25
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

25

Source: Reuters EcoWin

Business investment has risen as the economy has expanded but has it increased quickly enough?

The majority of capital investment spending is done by the private sector, although there has been a sizeable increase in government investment in recent years because of infrastructural projects in transport and the NHS building programme. Because of the dominance of the private sector, it makes sense to focus on investment decisions made by UK-based businesses. At the heart of whether or not to go ahead with a project is the expected return from this investment. Returns to an investment project The expected returns from capital investment are determined by the demand for and the price of the output of goods or services generated by an investment and also by the costs of production. A rise in demand for the output that capital is purchased to supply will increase the potential revenue streams that a business can expect from a new project. Similarly, a change in the costs of purchasing the
Tutor2u Limited 2008 www.tutor2u.net

billions

capital inputs the costs of training workers to use new capital and in maintaining the capital stock will also affect the expected rate of return. The importance of business expectations and uncertainty Expectations of demand, prices and costs over the lifetime of the investment are key determinants of expected returns. There is always uncertainty about the expected rate of return particularly when demand is volatile and sensitive to changes in interest rates, the exchange rate and incomes. The rate of return from an investment is also influenced by the rate at which an investment project is assumed to depreciate over time and the effects of changes in corporation tax on company profits. The cost and availability of internal and external finance is important, as higher costs of finance (e.g. higher interest rates) require greater returns from the investment to ensure that it is profitable. The marginal efficiency of capital (MEC) the demand curve for investment
If the rate of interest (r) is less than the expected rate of return on an investment, then a profit maximising business is unlikely to go ahead with a project note the importance of expectations in determining the likely returns and costs of a project

Real Interest Rate

R3

R1

R2

Investment Demand (MEC)

I3

I1

I2

Planned Capital Investment (Id)

Expected rates of return on investment matter when businesses are making investment decisions and this is where the concept of the marginal efficiency of capital comes in. The marginal efficiency of capital (MEC) is defined as the rate of interest which makes a proposed investment project viable at the margin. This is illustrated in the diagram above. At lower rates of interest (i.e. R2 rather than R1) more capital projects appear financially viable because the cost of borrowing money to finance the investment is lower and the opportunity cost of using retained profits as an internal source of investment finance is also reduced. A fall in interest rates should (ceteris paribus) lead to an expansion along the investment demand curve. Similarly higher interest rates (R3) may lead to some projects being postponed or cancelled.
Tutor2u Limited 2008 www.tutor2u.net

The limited statistical evidence available for the UK is that the demand for new capital goods tends to be interest inelastic i.e. there is only a weak link between changes in interest rates and fluctuations in planned capital investment by businesses. Partly this is because many firms prefer to use the capital market through the issue of new shares and bonds to raise funds for investment rather than relying on bank loans. That said the rate of interest can and does affect capital investment decisions perhaps through its effect on business confidence and also expectations of changing demand and the links between interest rates and the exchange rate. So a period of lower interest rates might stimulate more investment because of expectations of rising consumer demand and a lower exchange rate which will boost export demand.
Real Interest Rate

An outward shift of the marginal efficiency of capital curve represents an increase in demand for investment goods at each rate of interest. It might be caused by an improvement in business confidence, expectations of higher future demand, or a fall in the tax on company profits

R1

MEC1 I1 I2

MEC2

Planned Capital Investment (Id)

Changes in business confidence, the costs of capital and demand lead to shifts in the investment demand curve. For example, an increase in export sales overseas might be an increase in the expected rates of return on capital investment and thus an outward shift of the investment demand schedule.

Tutor2u Limited 2008 www.tutor2u.net

CBI Trends Survey - Factors limiting capital spending


Quarterly survey evidence, percentage of respondents
70 Uncertainty about demand 60
60 70

50

50

Net balances

40

Inadequate profitability

40

30 Shortage of internal finance 20

30

20

10

Inability to raise external finance Cost of finance

10

0 00 01 02 03 04 05 06 07

Source: Reuters EcoWin

Concerns about demand and profits act as constraint on investment plans

The data shown in the previous chart is taken from the quarterly survey of business confidence by the Confederation of British Industry. It suggests that uncertainty about the strength of future demand and the absence of a satisfactory level of profit are consistently the two biggest factors likely to constrain the level of capital investment by businesses. Certainly in recent years, the cost of finance influenced by the level of interest rates has come firmly at the bottom of the ranking of key factors, although this may not be the case for smaller manufacturing businesses that may not have the opportunity to borrow at the same rate of interest as larger multinational operations. The Accelerator Model of Investment This is another theory of investment. Put simply, the accelerator model suggests a positive relationship between investment and the rate of growth of demand or output. Accelerator theories of investment assume that there is a desired capital stock for a given level of output and interest rates. A rise in output or a fall in interest rates may prompt increased levels of investment as firms adjust to reach the new optimal capital stock level.

Tutor2u Limited 2008 www.tutor2u.net

Inflation

Rate of Interest (%)

SRAS

R%

AD3

AD2 ID2

AD1 Y3

ID

Y1

Y2

I1

I2 Planned investment spending

Real National Income

The accelerator model works on the basis of a fixed capital to output ratio which implies that in order to produce extra goods and services a business needs to adjust its investment to meet changes in demand. For example if demand in a given year rises by 4 million and each extra 1 of output requires an average of 3 of capital inputs to produce this output, then the net level of investment required will be 12 million. One criticism of this simple accelerator model is that the capital stock of a business can rarely be adjusted immediately to its desired level because of adjustment costs and time lags between an investment project being given the go-ahead and it coming on stream to produce the extra output. The adjustment costs include the cost of lost business due to installation of new equipment or the financial cost of re-training workers. Firms will usually make progress towards achieving an optimum capital stock rather than moving smoothly from one optimal size of plant and machinery to another. A further criticism of the basic accelerator model is that it ignores the level of spare capacity that a business might have at their disposal. For example in the latter stages of an economic recession, most businesses are operating below their capacity limits (i.e. there is a sizeable negative output gap in the economy). If demand then picks up in the recovery phase of the cycle, there is little immediate need for businesses to increase their investment because they can make more intensive use of whatever existing capacity is available now. Investment is more likely to be strong when businesses are operating close to their production limits, and when they need to boost their capacity in order to meeting rising demand from consumers.

Tutor2u Limited 2008 www.tutor2u.net

Percentage of industrial firms working below capacity


CBI Industrial Trends Survey, quarterly data
75 70 65
Per cent of firms below capacity
75

70

65

60 55 50 45 40 35 30
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

60

55

50

45

40

35

30

Source: Reuters EcoWin

If businesses are working below full capacity they may not need to invest in lots of new capital goods

The chart above shows the percentage of industrial firms operating below full capacity. The data series is highly cyclical; notice for example how low the figure was during the boom of the late 1980s but then shot up to over 70 per cent during the recession of the early 1990s. There is no automatic link between the level of spare capacity and planned investment because other factors will come into play when businesses are making investment decisions. Summary of the key factors driving capital investment spending o Interest rates: Interest rates play a role in shaping investment decisions but the demand for capital goods tends to be inelastic after changes in interest rates at least in the short term. In other words, the marginal efficiency of capital curve can be drawn as inelastic. o Expectations and confidence: Expectations of demand and expectations of the costs of buying and running new capital goods are an important factor in the investment decision. Thus the state of business confidence cannot be ignored in understanding investment theory. Interest rates do have an effect on these expectations. o Profits: The level of business profitability is a major factor driving investment demand. Higher profits suggest a more favourable business climate which boosts business confidence. Higher profits also make it easier for firms to reinvest their producer surplus to fund capital projects. o External economic factors: The health of the global economy is becoming an important factor influencing capital spending decisions. For example, businesses will consider where to locate their new investments focusing on factors such as relative cost levels, corporate taxation
Tutor2u Limited 2008 www.tutor2u.net

regimes in different countries, expectations of income and demand growth in different regions and nations and the volatility of exchange rates Business profitability Business profits play an important role in allocating resources for example, higher profits provide the funds for capital investment and also for research and development projects. Profits tend to follow a cyclical pattern they fall during a recession or an economic slowdown. And they recover during phases of stronger economic growth

Net Profit for Manufacturing and Service Businesses


Net percentage rate of return on capital employed, seasonally adjusted
22.0 20.0 18.0 16.0
Rate of return (%)
22.0 20.0 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0

Services

14.0 12.0 10.0 8.0 6.0 4.0 2.0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Manufacturing

Source: Reuters EcoWin

Manufacturing industry has suffered a profits squeeze in recent years

The chart above shows the percentage rate of return on capital a measure of business profitability. Throughout the period shown, the profit made by service sector businesses has been higher than for manufacturing industries. Firstly, manufacturing industry in the UK has been in relative decline for many years because it faces much greater competition from lower-cost overseas producers this decline is known as a process of deindustrialisation. This tough global competition affects the level of demand but it also means that British manufacturing businesses have less pricing power in their own markets. UK markets have become more contestable and this has dampened profit margins. In the last few years, there has been a downward trend in business profits the result of A strong exchange rate which hits the profit margins of exporters. Rising costs e.g. oil prices for firms that use oil as an essential input. Higher labour costs including several rises in the national minimum wage.
Tutor2u Limited 2008 www.tutor2u.net

Capital investment accounts for just under a fifth of UK national income and it is a volatile component of aggregate demand that impacts on both the demand & supply side of the economy Net investment = gross investment replacement investment Positive net investment increases a countrys productive capacity and contributes to a faster trend rate of growth in the long run Firms invest to increase current supply capacity in the expectation that selling more products increases revenues and profits or leads to lower costs (economies of scale) and improvements in productivity and efficiency. New investment also helps to exploit new technologies and is an important factor keeping firms competitive in the global economy. The Marginal Efficiency of Capital is the rate of return on each extra unit of capital invested. Private sector businesses have an incentive to continue to invest if the returns they anticipate from each additional capital project exceed the current market rate of interest rate. Lower interest rates should lead to an expansion along the planned investment demand curve. Improved business confidence increases expected rates of return, shifting the MEC curve to the right. Any anticipated slow down or a possible recession in the economy that lowers expectations causes an inward shift in the MEC curve. The accelerator model predicts a positive relationship between the rate of growth of demand and planned investment. But much depends on the capital to output ratio; the amount of spare capacity that a business has, and also the supply-side capacity of businesses that produce the capital goods.

Tutor2u Limited 2008 www.tutor2u.net

5. Cyclical fluctuations - demand and supply-side shocks


A shock is an unexpected or unpredictable event that affects an economy. In this chapter we look at some of the shocks that hit countries at different points in time and how macroeconomic policy can be used to act as a shock absorber for an economy. Open economies and macroeconomic shocks The UK is an open economy, one that is highly integrated within the global economy. From one perspective this increases the sensitivity of our economy to outside events for example a recession or slowdown in key export markets will inevitably have downside effects on demand, output and employment in the UK. However the integration of the economy with other nations also provides opportunities to smooth our own economic cycle depending on what is happening to cycles, exchange rates and policy changes elsewhere. Much rests on the flexibility of our economy to be able to absorb external economic shocks and then bounce back when the opportunity arises. The table below provides a listing of some of the worlds major economies. Clicking on each countrys name will send you to a country profile, either at the Economist website or the BBC news web site. This will allow you to find out a little more about the economic structure and recent performance of each country. European Union (25 countries) Countries in italics joined in 2004 Germany Austria France Italy Netherlands Belgium Luxembourg Ireland Finland Portugal Spain Sweden Emerging Markets including China India Russia Brazil South Africa Greece Czech Republic Poland Slovenia Slovakia Latvia Lithuania Malta Cyprus Hungary Estonia Denmark UK NAFTA (3 countries) North American Free Trade Area United States Canada Mexico Other OECD (but non-EU) Norway Switzerland Iceland Turkey Australia New Zealand Japan South Korea

OPEC nations inc Saudi Arabia Nigeria


Tutor2u Limited 2008 www.tutor2u.net

Shocks to the system! Like all economies, Britain is susceptible to exogenous shocks i.e. unexpected economic events which originate independently from outside our own system and which may have the effect of driving the economy off course. The past decade does not seem especially tranquil or the British economy, for instance we have seen: The integration of China, India and the former Communist countries of Eastern Europe into the world economy The ICT revolution and the associated dotcom boom-bust The emerging-market debt crisis and the collapse of LTCM in 1998 The correction in international equity prices and the associated global slowdown in 2001 The attacks on the World Trade Centre and subsequent conflicts in Afghanistan and Iraq The tripling of oil prices over the past three years. The effects of the 25% rise in sterling between 1996 and 1998 The tripling in house prices between 1997 and 2006 Ongoing labour market reforms, including the introduction of a National Minimum Wage Substantial, and highly uncertain, net inward migration, particularly from the Accession countries The possible contagion from the sub-prime crisis in the United States and risks of a global credit crunch.

Exogenous shocks can be split into two main groups Demand side shocks these are shocks affecting the rate of growth of demand both in the UK and other countries Supply-side shocks these are shocks affecting costs and prices in different countries

Possible demand-side shocks might include: A capital investment boom e.g. a construction boom or rapid growth of spending on ICT A pre-election government spending spree (e.g. the government opting for a fiscal policy expansion before an election) A sudden and significant 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 A change in the rate of economic growth in one or more of the countries of our major trade partners which affects the demand for our exports of goods and services An unexpected cut or an unexpected rise in interest rates (i.e. a monetary policy shock)

Changes in aggregate demand brought about by a demand-side shock will then translate into changes in the short term rate of growth as measured by the annual change in real GDP. This can create disequilibrium in the economy which takes growth, prices and incomes away from their projected levels.
Tutor2u Limited 2008 www.tutor2u.net

The ripple effects of an external shock can take some time to work their way through the circular flow of income and spending. The government and/or the central bank may decide to make policy changes in order to absorb the shock effects. For example their might tighten monetary policy if demand is expected to rise too quickly; or they might inject some liquidity /spending power into the economy if a negative demand shock raises the risk of a deflationary recession.

United States - GDP and Interest Rates


Percentage rate of growth year on year at constant prices
5.0 4.0
Percent
5.0 4.0 3.0 Economic Growth 2.0 1.0 0.0 7

3.0 2.0 1.0 0.0 7 US Base Rates 6 5


Percent

6 5 4 3 2 1 0

4 3 2 1 0 98 99 00 01 02 03 04 05 06 07

Source: Reuters EcoWin

Cyclical fluctuations in the USA the worlds largest economy

Supply-side shocks to the economy oil prices There are many possible supply-side shocks to the global economy. Some of them prove to have longterm beneficial effects, for example the emergence, adoption and take-up of a new production technology arising from invention and innovation that has the effect of reducing cost for producers and prices for consumers. Often it takes several years for the full impact of such supply-side shocks to become apparent and for their full significance to be recognised. We will focus here on the effects of volatile prices in the global oil market and in particular, the dramatic rise in oil prices in recent years. The financial pages of the press have been full of commentaries on the possible impact of this inflationary oil price shock in the global economy. What follows below is a discussion of some of the macroeconomic effects of rising oil prices. The macroeconomic implications of rising oil prices depend on several factors 1. The extent to which rising oil prices are temporary (i.e. lasting only a few months before falling back) or more permanent (e.g. a period of 3-4 years of high prices). In general, the impact of
Tutor2u Limited 2008 www.tutor2u.net

higher oil prices will be larger the longer the price rise lasts. The possibility exists of superspikes in oil prices, short but sharp movements in prices driven higher or lower by speculative buying and selling. 2. Whether a country is a net importer or exporter of oil Britain is still a net exporter of oil (though we import a lot too!) whereas Germany is a large importer of oil. 3. The scale of oil dependency of an economy i.e. the ratio of oil used per unit of national output produced. Some countries have a reliance on high-energy using industries and are therefore more susceptible to changing commodity prices. Others have a much smaller manufacturing base and their national output is dominated by industries that are less energy intensive 4. The extent to which oil users (consumers) can switch their demand away from oil towards alternative energy substitutes. In the short term, demand is said to be inelastic (i.e. Ped<1). 5. The macro-economic policy response to rising oil prices from central banks (e.g. changes in monetary policy) and the government (e.g. changes in fiscal policy) 6. The effects of exchange rate changes arising from oil price movements e.g. the pound might rise against the US dollar which could absorb some of the effects of higher oil prices on the British economy. 7. The extent to which the labour market is flexible (in particular the flexibility of real wages) and the ways in which businesses react to higher oil costs

World Consumption and Production of Oil


Millions of barrels per day, source: IEA
70 60 70 60 50 40 World Oil Price (Monthly Average) 30 20 10 88 30 20 10 88 83 78 73 68 63 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

USD/Barrel Barrels/Day (millions)

50 40

83 78 73 68 63

Consumption, Total Demand

Production, Total Supply Source: Reuters EcoWin

How high can oil prices rise? What are their main macroeconomic effects?

Main disadvantages of higher oil prices for the UK economy


Tutor2u Limited 2008 www.tutor2u.net

millions

1. A fall in aggregate supply and higher inflation: The main effect of rising oil prices in the short term is on aggregate supply. A higher price causes an inward shift in SRAS and puts upward pressure on the general price level. This is an example of an exogenous inflationary shock. Research carried out by the International Energy Agency suggests that if world oil prices were to remain 10% above a base forecast level for two years this would add 0.4% to the average rate of inflation for leading economies in each year. The effects on inflation can be increased if wages follow prices because if inflation expectations rise, this can cause an increase in wage demands as people seek to protect their real incomes. Higher oil costs work their way through the supply chain. So manufacturers pass on higher costs to wholesalers who do the same to retailers. Consumers often end up paying the price for higher oil prices when they make their final purchase. Air fares rise and petrol prices increase these are two most obvious symptoms of higher oil prices in the immediate term. Higher prices for consumers reduces their purchasing power in real (inflation adjusted) terms. But gradually higher oil prices filter their way through most parts of our economy. 2. Slower economic growth: Higher oil prices act as a dampening effect on the rate of growth of real GDP. According to the IEA research mentioned above, a sustained $10 per barrel increase in oil prices from $25 to $35 would result in the OECD as a whole losing 0.4% of GDP in the first and second years of higher prices. This is because higher prices cut into peoples real incomes and their real purchasing power. And because companies are making less profit (because of higher costs) this can lead to a reduction in planned capital investment. Both consumption and investment are important components of aggregate demand. The result can be a slowdown in growth leading to actual GDP falling below potential i.e. a negative output gap. And slower growth will hit jobs, not just in those industries that depend on oil but across the whole economy. Another effect of rising oil prices could be to erode business confidence. This too will have a negative effect on output and investment intentions. Similarly a reduction in company profits might have a negative effect on share prices, falling share valuations effectively increases the cost of capital for firms wanting to issue new shares to finance an expansion and a decline in equities would also hit consumer confidence. The actual effect of higher oil prices on world economic growth depends in part on what those countries that are accumulating huge trade surpluses as a result of being oil exporters, decide to do with these surpluses. 3. A worsening of the terms of trade the terms of trade measure the relative price of imports compared to the prices that exporters receive for selling their output overseas. An oil-price increase leads to a transfer of income from importing to exporting countries through a shift in the terms of trade i.e. the terms of trade for oil importing countries gets worse because they are now having to pay more per barrel for their oil and therefore having to export a greater volume of exports to pay for this. Conversely, higher oil prices improve the terms of trade for the leading oil-exporting countries. Their oil is worth much more on the global market, their potential export revenues are much higher as a result and this is will be an injection of income and demand into their circular flow. 4. Impact on the balance of payments - the effects of higher oil prices on the balance of payments are somewhat different for the UK compared to most other Western European countries. The UK has large reserves of North Sea Oil and we have run surpluses in trade in oil for over twenty years as the next chart shows. Higher oil prices will increase the cost of out imports of crude, but the value of our exports of Brent crude also rise. The net effect is probably positive for the current account of the balance of payments. However exporters of non-oil products may suffer from the oil price shock. Since higher oil prices reduce real incomes of oil consumers around the world, firms suffer not only from a drop in demand in their home market but from overseas as well. So exports fall causing a reduction in aggregate demand and exacerbating the fall in GDP growth.
Tutor2u Limited 2008 www.tutor2u.net

So how great is the current world oil price shock?


Oil Market Supply and Demand Demand for Oil OECD of which: North America Europe Pacific Non-OECD Total Supply of Oil OECD OPEC total Former USSR Other non-OECD Total Trade in Oil OECD net imports Former USSR net exports Other non-OECD net exports Prices Brent crude oil import price ($ per barrel) 2000 2005 (in million barrels per day) 47.9 24.1 15.1 8.7 28.7 76.6 21.9 30.9 7.9 16.2 76.9 26.2 4.3 21.9 49.7 25.4 15.6 8.6 34.0 83.7 20.3 33.9 11.6 18.2 84.1 29.6 7.8 21.7

28.4 54.4 Source: International Energy Agency

The recent rise in the real oil price has been not been as large as the surges seen in 1972-74 and 1978-80. Even after the recent rise, oil prices are still lower in real terms than they were in 1981 and the major developed countries are less dependent on oil now than at the time of the 1979-80 oil shock, reflecting both improved energy efficiency and the shift away from energy-intensive industries towards the service sectors.
Higher oil prices have supply and demandside effects on the UK and the international economy thus far the sharp rise in oil prices has not led to an acceleration in inflation and a high risk of a recession.

Oil prices and interest rates Will higher oil prices lead to an increase in interest rates? In theory it might well be the case because higher crude oil prices will feed through to an increase in the general price level and may threaten to take consumer price inflation above the Government target of 2.0%. A tightening of monetary policy designed to dampen down the threat of cost-push inflation would then have negative effects on aggregate demand and GDP growth.
Tutor2u Limited 2008 www.tutor2u.net

Crude and the world economy Sharp rises in oil prices have been linked to the global economic downturns of the mid-1970s, the early 1980s and the early 1990s, but in recent years the connection appears to have been broken. As oil prices neared $80 a barrel in the summer of 2006, and remained above $50 in the subsequent 12 months, the world economy went from strength to strength. In April the International Monetary Fund published a study that drew a distinction between oil price rises caused by a restriction to supply, such as the 1973-74 oil shock, and ones caused by strong demand, as in the past five years. In the latter case, with fast-growing emerging economies led by China responsible for much of the increased demand, a high oil price could be accompanied by faster, not slower, growth. Recent weeks suggest that sanguine verdict may have been over-optimistic. High oil prices have put pressure on US consumers, undermining confidence and reducing their spending power, contributing to the fears about household budgets at the root of the subprime lending crisis. Another possibility is that while a high oil price may not necessarily cause a recession, it is an indicator of economic excess, which must inevitably be followed by a downturn. Source: Ed Crooks in the Financial Times, August 2007

Higher oil prices the challenge facing monetary policy


Risk of a wage-price spiral Higher inflation

Policy response: Raise interest rates

1st-round effects

Uncertainties: timing, magnitude & exchange rate effects Rise in oil prices Consumers: 2nd-round effects Real income falls Companies: Lower economic growth; Lower inflation pressure

What to do, and when?

Policy response: Cut interest rates

But a rise in interest rates is not automatic, because the Bank of England takes a full range of inflation indicators into account when making decisions on the direction of monetary policy. It does not have a specific target for oil prices indeed the price of crude is only one part of a jigsaw of factors that they must consider when considering the likely path of inflation over the next two years. The evidence for the UK over recent years is that the volatility in crude oil prices is no longer as important in influencing the rate of inflation as it was in the past. Our oil-energy dependency ratio has declined and the flexibility of our labour and product markets has increased, which has the effect that pay is more flexible in response to changes in inflationary pressure (i.e. wages no longer automatically rise when inflation surges). To add to this, many businesses have experienced a decline in their ability to pass on increases in their input costs when there are changes in raw material prices this is partly due to the fierce competition in many industries arising from globalisation. We should be wary of analysts who exaggerate the likely impact of the current oil price shock on the British macro-economy both in the short and the medium term. There are risks to the whole global
Tutor2u Limited 2008 www.tutor2u.net

Lower profitability

economy from a period of much dearer oil, but the risk that higher oil prices will tip the global economy into a recession or slump are not as great as people often believe. Suggestions for further reading on the oil price issue Bio-fuels will push up oil prices (BBC, June 2007) How long can high oil prices endure? (Guardian July 2006) North Sea oil faces dark times (BBC) OPEC Oxford Institute for Energy Studies

Reading on economic shocks and cycles Financial crises- lessons from history (BBC news online, August 2007) 1993 The end of the UK recession (BBC news online archive)

Tutor2u Limited 2008 www.tutor2u.net

6. Theories of Economic Growth


Over the years, economists from different schools of thought have had plenty to say on what really drives economic growth for an economy. In this chapter we review some of these ideas. In particular we consider the importance of supply-side factors in determining the trend rate of growth for countries competing in the global economy. Trend growth Economic growth is best defined as a long-term expansion of the productive potential of the economy. Trend economic growth refers to the smooth path of long run national output. Measuring the trend rate of growth requires a long-run series of macroeconomic data (perhaps of 20 years or more) 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 an underlying speed limit for the economy. In other words, it is an estimate of how fast the economy can reasonably be expected to grow over a number of years without creating an unsustainable increase in inflationary pressure.
Growth rates for OECD countries 1990-2006 Average annual growth Average annual growth Rate from 1990-2006 (%) Rate from 1990-2006 (%) 6.7 Mexico 3.0 5.4 United Kingdom 2.7 4.7 Finland 2.7 4.5 Total OECD 2.7 4.3 Sweden 2.4 4.2 Denmark 2.3 3.8 Netherlands 2.2 3.6 Austria 2.2 3.4 Belgium 2.0 3.3 Portugal 1.9 3.3 France 1.9 3.2 Euro area 1.9 3.1 Germany 1.4 3.1 Japan 1.3 3.0 Italy 1.3 3.0 Source: OECD World Economic Outlook June 2006, data for 2006 is a forecast

Ireland Korea Slovak Republic Poland Turkey Luxembourg Hungary Australia Iceland New Zealand United States Canada Norway Czech Republic Greece Spain

Driving the trend growth rate Many factors influence the rate of economic growth. Some factors, such as changes in consumer and business confidence, aggregate demand conditions in the UKs trading partners, and monetary and fiscal policy, tend to have a mainly temporary effect on growth. Other factors, such as the rates of
Tutor2u Limited 2008 www.tutor2u.net

population and productivity growth, have more enduring effects, and help to determine the economy's average growth rate over long periods of time.
Source: HM Treasury

United Kingdom - Potential GDP and Trend Growth


Source: OECD World Economic Outlook
4.00 3.50 3.00 4.00 3.50 3.00 Trend Growth Rate 2.50 2.00 1.50 1.00 1.3 1.2

Percent

2.50 2.00 1.50 1.00 1.3

Real GDP (thousand billions)

1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 Potential GDP

1.0 0.9 0.8 0.7 0.6 0.5

Source: Reuters EcoWin

A question of potential the productive capacity of the UK economy grows each year

The chart above shows the estimated level of potential national income for the UK over the last thirty years. There are two main points to notice from the chart. Firstly, we expect that our real national income will rise each year. This is because of improvements in productivity; an expanding labour supply; the effects of capital investment spending and also the effects of technological change and innovation. Secondly, what matters is the long run average growth of potential national income. For the UK, we have a trend growth rate of around 2.5% per year. This can fluctuate depending on the overall strength of the economy and the health (or otherwise) of the supply-side of the economy. The OECD estimates that during the 1990s and early years of the current decade, our trend growth rate has been a little higher than 2.5%. But raising it to 3% per year seems to have been a bridge too far! For our trend rate of growth to be higher the UK economy needs to do a number of things: 1. Raise capital investment spending as a share of national income. 2. Achieve higher productivity from both capital inputs and from our labour supply. 3. Expand the size of the labour supply, perhaps through an increase in the migration of high productivity workers. 4. Increase the level of research and development and increase the pace and application of innovation across the economy.
Tutor2u Limited 2008 www.tutor2u.net

thousand billions

1.1

GDP per worker UK =100 France Germany UK USA GDP per hour worked UK = 100 France Germany UK USA 1992 142 128 100 128 2004 129 116 100 116 1992 130 115 100 137 2004 111 97 100 124

Many factor explain our productivity gap among them low capital investment and a skills shortage

Tutor2u Limited 2008 www.tutor2u.net

Estimated Trend Growth Rates


Annual percentage change in potential GDP, source: OECD World Economic Outlook
8
8

5
Percent

Ireland Hungary

4
Spain USA

3
UK

2
Euro Zone

Japan

0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: Reuters EcoWin

It is quite interesting to see how the estimated trend growth rates differ from country to country. The chart above is again drawn from the OECD figures. Notice how a country such as Ireland has a much faster growth of potential national income. During the mid 1990s when the Irish boom was at its peak, the trend growth rate was over 7% a year, enough for her GDP to double virtually every ten years. This trend rate has come down but remains more than double that of the average for the countries inside the Euro Zone. Spain is another country enjoying a relatively fast growth of potential GDP and this has been accompanied by a rise in her relative living standards over the last twenty years. Hungary, one of the ten countries that joined the European Union in 2004 when the EU enlarged, has a trend growth rate of 4% per year. This is typical of low to middle-income countries with fairly strong growth potential, as they experience high levels of inward investment and rising incomes.

Tutor2u Limited 2008 www.tutor2u.net

Output of Capital Goods Growth path for the economy B C2 C

C1

X2

X1

Output of Consumer Goods

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.

Inflation

An outward shift in LRAS helps to increase the economys underlying trend rate of growth it represents an increase in potential GDP

Pe

SRAS AD1 AD2

Y1

Y2

YFC2

National Income

Tutor2u Limited 2008 www.tutor2u.net

Government policies to improve the trend growth rate Over the last twenty years, government of different political persuasions, have put in place policies which they expect will be successful in raising investment, encouraging entrepreneurship and improving incentives to work. Potential output in the long run depends on the following factors (1) The growth of the labour force If the government can increase the number of people willing and able to seek paid work, then the employment rate increases leading to a higher output of goods and services. The Government has relied on a number of job schemes designed to raise employment including New Deal and changes 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 the UKs labour supply. Articles on labour migration International migration outlook (OECD) Migrant workers boost economy, says TUC report (Guardian, June 2007) Migrants 'benefit economy little' (BBC news, January 2007) OECD sees migration rise by 10% - (BBC news, July 2007)

(2) The growth of the nations stock of capital A rise in capital investment adds directly to a countrys 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 this is known as capital deepening. New capital also tends to include technological improvements which, providing workers have sufficient skills and training to make full and efficient use of their new capital inputs, should lead to higher 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 seen as essential if the UK is to improve its long run productivity for example increased spending on work-related training and improvement in the UK education system at all levels. (4) Technological improvements Changes in technology are important because they reduce the real costs of supplying goods and services which leads to an outward shift in a countrys production possibility frontier Economic growth and causation different schools of thought For many years, economists have been discussing the causes of growth and development. There is little sign of a consensus emerging! Here are some of the main lines of thought. Neo-Classical Growth
Tutor2u Limited 2008 www.tutor2u.net

The neo-classical model of growth was first devised by Nobel Prize winning Economist Robert Solow over 40 years ago. The Solow model believes that a sustained increase in capital investment increases the growth rate only temporarily: because the ratio of capital to labour goes up (i.e. there is more capital available for each worker to use). However, the marginal product of additional units of capital is assumed to decline and thus an economy eventually moves back to a long-term growth path, with real GDP growing at the same rate as the growth of the workforce plus a factor to reflect improving productivity. A steady-state growth path is eventually reached when output, capital and labour are all growing at the same rate, so output per worker and capital per worker are constant. Neo-classical economists who subscribe to the Solow model believe that to raise an economy's long term trend rate of growth requires an increase in the labour supply and also a higher level of productivity of labour and capital. Differences in the rate of technological change between countries are said to explain much of the variation in growth rates that we see. The neo-classical model treats productivity improvements as an exogenous variable, meaning that productivity improvements are assumed to be independent of the amount of capital investment. The significance of productivity as a source of supply-side performance and as a contributor to longterm growth is now widely accepted by many economists. A recent analysis of the long term prospects for Britain from the International Monetary Fund argued that the main challenge for the UK in the years ahead is to improve factor productivity since there remains a sizeable productivity gap between the UK and many of our major international competitors.
Growth of labour productivity for OECD countries 1988-2006 Annual average % change Poland 4.8 Slovak Republic 4.0 Korea 4.0 Hungary 3.3 Ireland 3.1 Czech Republic 3.1 Turkey 2.9 Norway 2.4 Finland 2.3 Sweden 2.2 Greece 2.1 Iceland 2.0 Austria 1.9 Denmark 1.8 United Kingdom 1.7 United States 1.7 Annual average % change 1.6 1.5 1.5 1.5 1.4 1.4 1.4 1.3 1.2 1.2 1.2 1.1 1.0 0.8 0.8 0.5

Total OECD Germany Australia Japan Portugal Belgium France Luxembourg Euro area Canada Italy New Zealand Netherlands Spain Switzerland Mexico

Endogenous Growth Theory Endogenous growth economists believe that improvements in productivity can be linked directly to a faster pace of innovation and extra investment in human capital. They stress the need for government and private sector institutions which successfully nurture innovation, and provide the right incentives for individuals and businesses to be inventive. There is also a central role for the accumulation of knowledge as a determinant of growth. We know for example that the knowledge
Tutor2u Limited 2008 www.tutor2u.net

industries (typically they are in telecommunications, electronics, software or biotechnology) are becoming increasingly important in many developed countries. Supporters of endogenous growth theory believe that there are positive externalities to be exploited from the development of a high valued-added knowledge economy which is able to develop and maintain a competitive advantage in fast-growth industries within the global economy. The main points of the endogenous growth theory are as follows: The rate of technological progress should not be taken as a constant in a growth model government policies can permanently raise a countrys growth rate if they lead to more intense competition in markets and help to stimulate product and process innovation. There are increasing returns to scale from new capital investment. The assumption of the law of diminishing returns which forms the basis of so much textbook economics is questionable. Endogenous growth theorists are strong believers in the potential for economies of scale (or increasing returns to scale) to be experienced in nearly every industry and market. Private sector investment in research & development is a key source of technical progress. The protection of private property rights and patents is essential in providing appropriate and effective incentives for businesses and entrepreneurs to engage in research and development Investment in human capital (including the quantity and quality of education and training made available to the workforce) is an essential ingredient of long-term growth. This is discussed next. Government policy should encourage entrepreneurship as a means of creating new businesses and ultimately as an important source of new jobs, investment and innovation.

The Importance of Human Capital The basis of human capital lies in the theories of the Theodore Schultz, an economist at the University of Chicago who was awarded the Nobel Prize for Economics in 1979. Schultz, an agricultural economist, produced his ideas of human capital as a way of explaining the advantages of investing in education to improve agricultural output. Schultz demonstrated that the social rate of return on investment in human capital in the US economy was larger than that based on physical capital such as new plant and machinery. Gary Becker, the 1992 Nobel Prize winner for economics, built on the ideas first put forward by Schultz, explaining that expenditure on education, training and medical care could all be considered as investment in human capital. He wrote that people cannot be separated from their knowledge, skills, health or values in the way they can be separated from their financial and physical assets." Innovation Innovation is the creation of new intellectual assets. We can make a useful distinction between: Process innovation: This relates to improvements in production processes, the more efficient use of scarce resources to produce a given quantity of output - leading to improvements in productive and technological efficiency Product innovation: This is the emergence of new products which better satisfy our everincreasing needs and wants - leading to improvements in the dynamic efficiency of markets in providing goods and services
Tutor2u Limited 2008 www.tutor2u.net

Indeed, it is often the drive to innovate which is the primary motive for capital investment in the first place, not least in international markets where a firm's competitive edge is determined by the success of strategies designed to find viable innovations that give it what is often called first mover advantage in a market. Innovation in the pharmaceutical industry; in telecommunications; in household goods and in biotechnology is good examples of sectors where successful innovation is the key to maintaining a competitive advantage. In short - successful innovation is a stimulus to long-run growth because: It acts as a catalyst for higher rates of investment in fixed capital and increased investment in human capital which helps to shift out the production possibility frontier It can act as a spur to faster productivity growth (with time lags) because of its impact on technological progress Innovation also creates a demand for new products from consumers for example in industries where existing products are nearing the end of their product life-cycle

Social benefits from innovation There are potentially huge positive externalities from technology spill-over effects arising from innovation for example in the pharmaceutical industry where new drugs improve the quality of life and increase life expectancy and also improvements in car manufacture and design that reduce the risk of serious injury from road accidents. Inter-firm collaboration in the creation and use of innovations can also act as a key contributor to industry-wide growth leading to external economies of scale. Indeed this form of co-operative behaviour between businesses is judged to be legal by the European competition authorities whereas price fixing and other forms of anti-competitive behaviour is now the subject of frequent investigations and legal action. The US economist William Baumol in his recent book The Free-Market Innovation Machine stresses that firms use innovation as a prime competitive weapon. However, firms do not wish to risk too much innovation, because it is costly, and can be made obsolete by rival innovation. So, firms have responded to this through the sale of technology licenses and participation in technology-sharing compacts with other firms that can pay huge dividends to the economy as a whole. According to Baumol, innovative activity becomes mandatory, in his words, a life-and-death matter for the firm. Social capital and economic growth We have seen in this chapter than investment in physical capital and human capital are both regarded as important sources of long term growth for modern countries competing in the global economy. There is also increasing interest in a concept known as social capital if you like, a third strand in the idea that capital promotes growth. Trust and Growth Being able to trust people might seem like a pleasant luxury, but economists are starting to believe that it's rather more important than that. Trust is about more than whether you can leave your house unlocked; it is responsible for the difference between the richest countries and the poorest. Source: Tim Harford, Forbes.com, October 2006 Social capital focuses on the value of social networks in improving productivity in an economy. According to the author Robert Putnam in a book entitled Bowling Alone, it refers to the collective
Tutor2u Limited 2008 www.tutor2u.net

value of all social networks and the inclinations that arise from these networks to do things for each other"? So, social capital cites the interrelationships between individuals as a major driver of growth. Putnam talks about bonding and bridging social capital, with the latter as the one which enhances productivity. This is the idea that social groups bridge from one to another through shared interests, such as ten-pin bowling. This creates an atmosphere of trust and friendliness between people, which has numerous benefits for society as whole, which some would term as positive externalities. For example, a sense of togetherness among the bowling fraternity will indeed increase the growth of the bowling sector of the economy, since more meetings will require more money to be spent on hiring bowling alleys and buying all the other ingredients for a great nights bowling. However, the atmosphere of trust and friendliness created may also allow people to be more amiable to the idea of sharing lifts to and from meetings, thus lowering car pollution. A trivial example it may be, but it suffices to show how social capital can have an impact on the society as a whole. Bonded social capital, on the other hand, creates exclusivity. Groups, such as gangs, are based on hierarchical patronage rather than meritocratic methods, potentially meaning that productivity falls. However, in both these examples social capital is being used for advantage. The problem with the latter is that this advantage is for a number of individuals rather than for collective society. Social networks can be used to spread beneficial ideas, causing individuals and society to simultaneously progress. An example of this would be, in times of low savings (which could potentially cause a pensions crisis in the future), social networks spreading the acceptability of saving, and thus benefiting the economy.

Sunrise in India how quickly will the emerging market countries including India, China, Mexico, Indonesia, Brazil and Russia come to dominate the global economy? Can they maintain their fast growth rates?

Key Points Economic growth is a long-run increase in the capacity of the economy to produce goods and services, and can be illustrated by an outward shift in the production possibility frontier. Trend growth is the long term non-inflationary increase in output (GDP) caused by an increase in productive capacity i.e. LRAS. Growth occurs because of an increase in the quantity and/or quality of factor resources. Human capital is the skill and knowledge level of the workforce, as well as their health. The higher the quality of human capital, the higher the productivity as workers adapt more
Tutor2u Limited 2008 www.tutor2u.net

effectively to new technologies and learns to perfect their respective specialised jobs. Actual skill levels, as opposed to educational qualifications, are now seen as powerful drivers of economic growth. Social capital represents the networks and shared values which lead to greater social cooperation and mutual trust Innovation is a major determinant of growth. It helps to lower costs and it also creates new markets, a source of demand, revenue and profits for businesses in the domestic and the international economy.

Suggestions for further reading on economic growth UK Productivity During The Blair Era (Centre for Economic Performance) PDF file UK productivity lags behind industrial rivals (The Guardian, June 2007) World Competitiveness Online

Tutor2u Limited 2008 www.tutor2u.net

7. Economic Growth Costs and Benefits


The advantages and disadvantages of growth are fiercely debated by economists, environmentalists and other commentators. In this chapter we consider some of the costs and benefits from expanding levels of production and consumption. In particular we focus on the idea of sustainability. The Benefits of Economic Growth According to the UK government, a healthy economy leads to higher living standards and greater prosperity for individuals. It also helps businesses to be profitable, which generates employment and income. This quote highlights some of the benefits of growth developed further below: Improvements in living standards: Growth is an important avenue through which better living standards and lower rates of poverty can be achieved. This is particularly true for countries who regard growth as a route for poverty reduction among their population. According to a report by the Asian Development Bank (ADB), in the Asian region, the number of people living on less than $1 a day fell to 22% of the region's population in 2002 with further progress made since. That compares with 34% in 1990 and shows "considerable progress in the fight against poverty." More jobs: Growth stimulates higher employment. As we can see from the chart below, the sustained growth in the British economy during the current decade has helped to bring about a large rise in total employment - the number of people in work has risen from 2.53 million at the start of 1993 to over 29 million fourteen years later. This is an impressive employment creation record, better than many other countries in the European Union.

Tutor2u Limited 2008 www.tutor2u.net

UK Employment
Employment - millions, All aged 16 and over, seasonally adjusted, source: Labour Force Survey
30
30

29

29

28
Persons (millions)

28

27

27

26

26

25

25

24

24

23 80 82 84 86 88 90 92 94 96 98 00 02 04 06

23

Source: Reuters EcoWin

The accelerator effect of growth on capital investment: Rising AD and output encourages investment in capital machinery this helps to sustain GDP growth by increasing LRAS. Greater business confidence: Growth has a positive impact on profits & business confidence good news for the stock market and for the growth of small and large businesses. The fiscal dividend to the government: Government finances are cyclical in nature because a growing economy boosts the tax revenues flowing into the Treasury and it also provides the government with more money to finance their spending projects. Potential environmental benefits richer countries have more resources available to invest in cleaner technologies. And, as nations move to later stages of development, energy intensity levels fall. Much depends on how many resources an economy is willing to devote to environmental improvement and protection. Over the last thirty years, the ratio of energy consumption per unit of GDP in the UK has fallen quite significantly. The reduction in energy intensity is a reflection of improvements in production technologies and also a gradual switch towards a low carbon economy. Much more progress needs to be made. Organisations such as the Carbon Trust sponsor research into low carbon technologies and many environmental groups believe that greater investment should be made in promoting alternative sources of energy.

We now expect to live on average 30 years longer, to work almost half the amount of time we used to every year, and to enjoy an array of new goods and services, including air travel, antibiotics, computers and televisions. Economic growth and rising living standards has also meant a cut in rates of carbon emissions and natural resource depletion never possible in the 20th century
Source: Professor Nick Crafts, 2002 Royal Economic Society Public Lecture, December 2002
Tutor2u Limited 2008 www.tutor2u.net

millions

The Disadvantages of Economic Growth Economic growth does not come risk-free. Although our material progress can be measured in part by the growth of national output, income and spending, if the economy grows too quickly, it can bring about short and long-term problems. Inflation risks: There is the danger of demand-pull and cost-push inflation if demand grows faster than long run productive potential High and rising inflation can be destabilizing for an economy because it puts pressure on interest rates to rise and can cause a loss of competitiveness for domestic businesses in international markets The environment: Growth cannot be separated from its environmental impact. Fast growth of production and consumption can create negative externalities such as increased noise and air pollution and road congestion. Environmental damage can have a negative effect on our quality of life. For example, road transport is responsible for 25% of UK CO2 emissions. Inequalities of income and wealth: Not all of the benefits of growth are evenly distributed. A rise in real GDP can often be accompanied by growing income and wealth inequality in society which is reflected in an increase in relative poverty. The Gini coefficient is one way to measure the inequalities in the distribution of income and wealth in different countries. The higher the value for the Gini co-efficient (the maximum value is 1), then greater the inequality. Countries such as Japan, Denmark and Sweden typically have low values for the Gini coefficients; whereas African and South American countries have an enormous gulf between the incomes of the richest and the poorest elements of the population. A good example of the uneven spread of the benefits from growth is the enormous wealth gap developing in China. Regional disparities: Although average living standards may be rising, the gap between rich and poor can widen leading to an increase in relative poverty and a widening of the gap between different regions. Growth is rarely balanced between regions and across industries and sectors. A recent report from the Centre for Cities highlighted the divide between economic growth rates in cities and regions of the UK.

Sustainability of Economic Growth Many of the worlds most valuable finite resources are being extracted at such a rapid rate that it questions the long-term sustainability of growth. Renewable resources are also being depleted because of over-consumption. 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. Some of the main environmental threats include: The depletion of the global resource base and the impact of global warming. There are plenty of examples around of the tragedy of the commons, the permanent loss of what should be renewable resources from over-extraction of some of our environmental resources. A huge expansion of waste and pollution arising from both production and consumption Over-population (particularly in urban areas) putting increased pressure on scarce land and other resources. More than half of the world's population will live in cities by 2008, most of them in developing countries according to the latest forecasts from the United Nations Population Fund.
Tutor2u Limited 2008 www.tutor2u.net

Species extinction leading to a loss of bio-diversity - Scientists predict that at least a third and as much as two-thirds of the world's species could be on their way to extinction by the end of this century, mostly because people are destroying tropical forests and other habitats, overfishing the oceans and changing the global climate.

Pollution in Guangzhou Chinas fast growth is creating huge environmental concern

China estimates the costs of pollution clean up The emergence of China as an economic powerhouse is one of the most significant macroeconomic developments of the age but the environmental costs of growth are clearly apparent. China is now introducing a long-term project to quantify the impact of growing pollution on their economy, estimating that environmental damage cost the equivalent of 3 per cent of economic output in 2004. Much of the environmental damage comes from transport emissions, 14,000 new cars join Chinas roads every day, 1,000 of which are in Beijing. China estimates that it will cost up to 72bn to clean up the deteriorating environment, equal to about 7 per cent of gross domestic product from the growth generated in 2004. The Chinese authorities are now becoming more committed to the idea of sustainable or balanced growth and development but questions remain over how the government can control reckless examples of environmental damage across such a vast country and with economic growth continuing apace.

Chinas Pollution Crisis A report from the World Bank highlights the scale of the pollution crisis facing the booming Chinese economy. Sixteen of the worlds 20 most polluted cities are in China and there are reports in the Financial Times that the draft World Bank report claims that hundreds of thousands of people are dying prematurely because of the impact of pollution. The Chinese have been criticised for wanting to leave out some of the most damaging conclusions from the report for fear of citing social unrest. The research project finds that high air-pollution levels in Chinese cities are leading to the premature deaths of 350,000-400,000 people each year. A further 300,000 people die prematurely each year from exposure to poor air indoors, according to advisers, but little discussion of this issue survived in the report because it was outside the ambit of the Chinese ministries which sponsored the research. Other 60,000-odd premature deaths were attributable to
Tutor2u Limited 2008 www.tutor2u.net

poor-quality water, largely in the countryside, from severe diarrhoea, and stomach, liver and bladder cancers. Suggestions for wider reading 750,000 a year killed by Chinese pollution (FT) Pollution kills 750,000 in China every year (Daily Telegraph) A great wall of waste (The Economist, 2004) China must come clean about its poisonous environment (FT) BBC news audio features on Chinese pollution Human sniffer team tracks pollution (The Times) Green National Income Accounts National income accounts have not, until recently, made any adjustment for the environmental impact of economic growth. Critics argue that because of this omission, the statistics misrepresent improvements in social welfare. For example, no allowance is made for environmental depletion or money spent on correcting environmental damage that is actually recorded as an addition to GDP. GDP only records marketed transactions - at present, there is no market for many important environmental resources and it is also difficult to place monetary values on them. Green accounting is starting to make progress in a number of countries. One measure is the Index of Sustainable Economic Welfare (ISEW) developed by economists at the New Economics Foundation. The ISEW adjusts official data on real national output and makes an allowance for defensive spending (i.e. that incurred in cleaning up for pollution and other forms of environmental damage, together with money spent commuting to work). Not surprisingly, the net growth of ISEW is well below that of the official data for national income, output and spending. What is Sustainable Development? The term 'sustainable' means 'enduring' and 'lasting' and 'to keep in being'. So, sustainable development is economic development that lasts! According to one of the finest environmental economists of his generation, the late David Pearce, sustainable development means that each generation should pass on at least as much "capital" as it inherits, the Pearce approach defines capital in broad terms, to include physical capital (machinery and infrastructure); intellectual capital (knowledge and technology) and also environmental capital (environmental quality and the stock of natural resources). In 1987 the Brundtland Commission on Environment and Development defined sustainable development as: "development that meets the needs of the present without compromising the ability of future generations to meet their own needs. The current Government supports the concept of sustainable development and focuses on four main objectives set out below: (1) Social progress which recognises the needs of everyone: Everyone should share in the benefits of increased prosperity and a clean and safe environment. Needs must not be met by treating others, including future generations and people elsewhere in the world, unfairly. (2) Effective protection of the environment: We must limit global environmental threats, such as climate change to protect human health and safety from hazards such as poor air quality and toxic chemicals and to protect things which people need or value, such as wildlife, landscapes and historic buildings. (3) Prudent use of natural resources: We need to make sure that non-renewable resources are used efficiently and that alternatives are developed to replace them in due course. Renewable
Tutor2u Limited 2008 www.tutor2u.net

resources, such as water, should be used in ways that do not endanger the resource or cause serious damage or pollution. (4) Maintenance of high and stable levels of economic growth and employment, so that everyone can share in high living standards and greater job opportunities. The UK government publishes an annual report on progress towards sustainable development. Indicators used include data on Greenhouse game emissions Energy sourced from renewables Waste Water stress

Growing interest in the impact of economic activity on our natural and man-made resource base has led to the development of concepts such as ecological footprints and carbon footprints. The BBC has recently focused on this issue with a series of reports on ethical man. Many environmentalists are inherently cautious about the long term impact of growth on our living environment. They are deeply sceptical about the effects that growth might have in preserving and or improving it. But others argue that the pessimists are over-stretching their case. Bjorn Lomborg in The Sceptical Environmentalist challenges beliefs that the environmental situation is getting worse and worse. Key points Economic growth provides important long-term benefits for the population of a country. It can be a route out of absolute poverty and it creates jobs and wealth. Inequalities in income and wealth mean that, in many countries, the benefits from growth are not distributed evenly. This raises important questions of equity (fairness). Sustainable growth meets the needs of the present without compromising the ability of future generations to meet their own needs. There are environmental benefits from countries becoming richer. However, there are major concerns about the impact of fast growth on the worlds environmental resources.

Suggestions for further reading Climate Change (BBC news online special) Green accounting Planet under Pressure (BBC news online special) Precision help is needed to close our economic gulf (The Times, 9 July 2007)

Tutor2u Limited 2008 www.tutor2u.net

8. National Income and Changes in Living Standards


What do we mean by the standard of living and can information on national income give us a reliable indication of our economic well-being. In this chapter we look at alternative measures of welfare and the quality of life. Defining and measuring the standard of living The standard of living is a measure of our material welfare. The baseline measure is real national output per head of population or real GDP per capita - the value of national output divided by the resident population. Other things being equal, a sustained increase in real GDP increases a nations standard of living providing that output rises faster than the total population. However it must be remembered that real income per capita is an inaccurate and insufficient indicator of true living standards both within and across countries. National income data can be used to make cross-country comparisons. This requires 1. Converting GDP data into a common currency (normally the dollar or the Euro). 2. Making an adjustment to reflect differences in the cost of goods and services in each country to produce data expressed at a purchasing power parity standard. Problems in using national income statistics to measure living standards Improving living standards is about poor families gaining access to what is available at the time to make life comfortable, healthy and rewarding. In the end, economic statistics only measure what they measure, which may not bear much relation to how well off we are.
Source: Adapted from the Independent Per Capita Incomes for EU CountriesEU-25 = 100 Luxembourg (Grand-Duch) Norway Ireland Netherlands Austria Denmark United Kingdom Belgium Sweden Finland Germany (inc ex-GDR from 1991) France Italy Spain 1997 2007 1997 2007

202.9 139.3 108.6 120.1 125.3 125.9 109.8 118.7 115.3 104.6 117.5 108.4 112.5 88.2

260.1 171.6 139.8 125.5 123.1 121.6 117.5 117.1 116.5 112.7 110.1 106.2 98.5 97.6

Cyprus Greece Slovenia Czech Republic Malta Portugal Estonia Hungary Slovakia Lithuania Latvia Poland Romania Bulgaria

81.1 71.4 71.5 68.9 76.1 71.9 38.8 48.6 49 36 32.7 44.2 : 25

87.6 85.6 84.7 78.1 74 69.5 69 63.9 63 57.5 57.2 53.4 37.5 36.3

The table below provides time series data on per capita national incomes for the twenty seven nations of the European Union plus Norway. Ireland has made huge strides in improving her relative standard of living. In 1994 Irelands GDP per capita was just 84% of the EU average but extremely rapid economic growth allowed the Irish economy to surge past the EU15 average in 1999 and this progress has been maintained. In contrast, Germanys relatively slow growth has seen erosion in her relative
Tutor2u Limited 2008 www.tutor2u.net

advantage in living standards from a level 17% above the EU average in 1997 to a level only 10% above the average in 2007. In 2007, Britain had a per capita income (adjusted for differences in living costs) nearly 18 per cent higher than the European average.

Income Per Head for selected EU Countries


Index GDP per head, EU (25 countries) average = 100 (source Eurostat)
140 Ireland Germany 120 UK
110 120 140

130

130

110
EU25=100

100

100

90

Spain

90

80 Slovenia 70

80

70

60 95 96 97 98 99 00 01 02 03 04 05 06 07 08

60

Source: Reuters EcoWin

DP and living standards - problems of accuracy

Official data on GDP tends to understate the true growth of real national income per capita over time due to the expansion of the shadow economy and also the value of unpaid work done by millions of volunteers and people caring for their family members. The "shadow economy" embraces a range of illegal activities such as drug production and distribution, prostitution, theft, fraud and concealed legal activities such as tax evasion on otherwise-legitimate business activities such as un-reported selfemployment income. The scale of the shadow economy varies across countries at different stages of development. According to the IMF, in developing countries it may be as high as 40% of GDP; in transition countries of central and Eastern Europe it may be up to 30% of GDP and in the countries of the OECD, the shadow economy may be in the region of 15% of GDP. Estimates are drawn from those published by the World Bank (2006 Development Report)
Country Year Ease of Doing Business Rank 37 131 81 99 65 GNI per capita (US$) 1,350 1,010 4,630 1,240 2,610 Informal economy estimate (% GNP) 67.3 67.1 64.1 60.6 59.9 France Singapore China Netherlands New Zealand Year Ease of Doing Business Rank 35 1 93 22 2 GNI per capita (US$) 34,810 27,490 1,740 36,620 25,960 Informal economy estimate (% GNP) 15.3 13.1 13.1 13 12.7

Georgia Bolivia Panama Azerbaijan Peru

2006 2006 2006 2006 2006

2006 2006 2006 2006 2006

Tutor2u Limited 2008 www.tutor2u.net

Zimbabwe Tanzania Nigeria Thailand Ukraine

2006 2006 2006 2006 2006

153 142 108 18 128

340 340 560 2,750 1,520

59.4 58.3 57.9 52.6 52.2

United Kingdom Japan Austria United States Switzerland

2006 2006 2006 2006 2006

6 11 30 3 15

37,600 38,980 36,980 43,740 54,930

12.6 11.3 10.2 8.8 8.8

GDP and living standards problems of interpretation Here are reasons why GDP data may give a distorted picture of living standards in a country: 1. Regional Variations in income and spending: National GDP data can hide regional variations in output, employment and income per head of the population. The table below provides some evidence for this with household disposable income per head in Inner London over seventy-five per cent higher than the national average and several of our major cities having disposable incomes per head at only three quarters of the average (or less). The Office for National Statistics provides a useful regional snapshot which offers economic and social information on each of the UKs major regions.
Household Disposable Income per head Index (UK=100) data is for 2003 Inner London - West Surrey Buckinghamshire Hertfordshire Outer London - West and North West Outer London - South Berkshire 177.6 Leicester 139.3 133.1 128.0 120.9 119.4 116.7 78.8

Kingston Upon Hull, City of 78.3 Nottingham 77.4 Stoke-on-Trent 76.9 West and South West of Northern Ireland 75.3 North of Northern Ireland 73.9 Blackburn With Darwen 73.3 Source: ONS Regional Trends

2. Inequalities of income and wealth: The Lorenz Curve and the Gini-coefficient are two ways of measuring inequality and relative poverty an outward shift in the Lorenz Curve would indicate a widening of income and wealth inequality. Since 1979, there has been a rise in inequality as the gap between the rich and poorer sections of society has widened. The distribution of wealth is even more unequal than that for income in the UK.
Distribution of real disposable household income in 2004 per week at 2004 prices 10th 1971 1979 1989 1999 2004 percentile 103.4 124.7 130.7 147.1 171.1 Median 188.0 217.2 268.9 292.5 335.7 90th percentile 328.0 372.8 526.9 604.6 673.9 Ratio of 90th to 10th percentile 3.2 3.0 4.0 4.1 3.9 Source: ONS, Low income households

3. Leisure and working hours: An increase in real GDP might have been achieved at the expense of leisure time if workers are working longer hours. Several reports have highlighted the fact
Tutor2u Limited 2008 www.tutor2u.net

that British workers have the longest working week in Europe which can cause stress and damage family life two social indicators that potentially create some negative externalities for society as a whole.

Working Hours in the European Union


Hours Worked per Week of Full-Time Employment
45
United Kingdom 45

44
Ireland

44

43
Hours worked per week
Spain Poland EU25 Sweden

43

42

42

41

France

41

40

Italy

40

39

39

38 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

38

Source: Reuters EcoWin

4. Imbalances between consumption and investment: If an economy devotes too many scarce resources to satisfying the short run needs & wants of consumers, there may be insufficient resources for capital investment and over-consumption can lead to an over-exploitation of scarce finite resources thereby limiting future growth prospects. 5. Changes in life expectancy: Improvements in life expectancy have a huge impact on peoples living standards but dont always show through in the GDP accounts. Reductions in infant mortality have been accompanied by the prevention or cure of diseases that might have led to the premature death of even the richest of our ancestors at any time. Putting a monetary value on the benefits of increased longevity is difficult, but surely it must be factored into any overall assessment of living standards and the quality of life. 6. The value of non-marketed output including work done in the home Much useful and valuable work is not produced and sold in markets at market prices. The value of the output of people working unpaid for charities and of housework might reasonably be added to national income statistics. 7. Innovation and the development of new products: One of the problems in comparing and contrasting living standards and the quality of life across different generations is that new goods and services become available because of competition, investment, invention and innovation that simply would not have been available to the richest person on earth less than fifty years ago. About half of what we spend our money on now was not invented in 1870.
Tutor2u Limited 2008 www.tutor2u.net

Examples include air travel, cars, computers, antibiotics, hip replacements, insulin and many other life-enhancing and life-saving drugs 8. Environmental considerations: Rising output might have been accompanied by an increase in air and noise pollution and other externality effects that have a negative effect on our social welfare. Faster economic growth may cause long term damage to our eco-systems, threatening the long-term sustainability of the economy. 9. Defensive expenditures: Much spending in an economy is on defensive expenditure not spending on tanks and armaments! But spending to defend yourself against an economic or social bad e.g. crime, or spending to recover the damage from externalities (e.g. cleaning up the effects of pollution, managing the huge and growing volume of waste; driving long distances to and from work. This spending adds directly to our GDP but does it really add to our material welfare? Some economists believe that adjustments should be made to officially published data for GDP to take into account items of this defensive spending. Purchasing power - differences in the cost of living between countries Data on relative standards of living is normally adjusted to reflect estimates of purchasing power parity to take account of differences in the cost of living so that each unit of currency has (approximately) the same purchasing power. One Euro of income in each country may not have the same real purchasing power because of differences in the average cost of living. For example, relative prices of a basket of goods and services for consumers in Britain are estimated in 2003 to be 18% higher than the EU15 average. The Scandinavian countries have significantly higher prices whereas Mediterranean countries have relative price levels less than four fifths of the EU average. As the following passage makes clear, movements in the exchange rate also have an effect on the relative cost of living in different locations around the world. The worlds most expensive cities Rank Mercer Consulting (2006) 1 2 3 4 5 6 7 8 9 =10 =10 Moscow Seoul Tokyo Hong Kong London Osaka Geneva Copenhagen Zurich Oslo New York Economist Intelligence Unit (2006) Oslo Tokyo Reykjavik Osaka Paris Copenhagen London Zurich Geneva Helsinki UBS Survey(2005) London Oslo New York Tokyo Copenhagen Hong Kong Zurich Paris Chicago Geneva

Limitations of the purchasing power parity adjustment At any given time, the current exchange rate for anyone nation is unlikely to be at PPP levels. Currency speculation or other factors may have driven the exchange rate above or below its estimated PPP level. The PPP calculation is also affected because: o Not all output is traded internationally some goods and services are produced only for domestic consumption and do not find their way onto international markets o Price differences in different countries may reflect product differentiation
Tutor2u Limited 2008 www.tutor2u.net

o Differences in degree of competition in local and national markets affect relative prices for example the high level of new car prices in the UK compared to most other countries in the EU is partly a result of oligopoly power among leading UK car retailers o Local indirect taxes and tariffs cause differences in the cost of living o Central bank intervention in the currency markets can take the actual exchange rate out of PPP alignment because they are trying to manage the value of the currency

Alternative measures of economic and social welfare Having focused on income as a key measure of living standards, we briefly consider some of the alternative approaches.
Year Cable television subscribers (per 1,000 people) Internet users (in 1000s) Mobile phones (per 1,000 people) Personal computers (per 1,000 people) 1990 3 19 108 1995 24 1100 98 201 2000 57 18000 727 338 2004 74 23505 883 367

One of the simplest ways of judging whether we are better off materially than we were a few years ago is to track ownership of consumer durables. The table above draws on some of the information provided over the years 1990 2004. Ownership levels are affected by the trend in price levels, household incomes, changes in tastes and preferences, the emergence of new general purpose technologies and factors such as consumer borrowing and confidence. The Human Development Index (HDI) The Human Development Index (HDI) has been published by the United Nations each year since 1990. The HDI is the average of three indices based on three different variables: o Life expectancy at birth o Education a weighted average of adult literacy (two-thirds) and average years of schooling (one third) o Real GNP per capita measured in US dollars, at purchasing power parity exchange rates. Clearly, this index gives us a better way of estimating standards of living than just GNP taken on its own. However, it is still far from perfect. Economists have recently been looking at ways to include other factors in the measurement, such as income distribution (perhaps using the Gini coefficient), gender inequalities, and inequalities by region or by ethnic group. Since 2001, Norway has come top of the international rankings for human development. Canada held the top spot from 1996 to 2000. Iceland and Australia also figure prominently at the top of the Human Development Index with Niger and Sierra Leone at the bottom.
World demographic indicators, 2004 Population (millions) Asia 3,860 Infant mortality rate (*) 53.7 Total Fertility Rate 2.47 Life expectancy at birth (years) Males Females 65.4 69.2

Tutor2u Limited 2008 www.tutor2u.net

Africa Europe Latin America & Caribbean North America Oceania World * Per 1,000 live births.

887 729 554 327 33 6,389

94.2 9.2 26.0 6.8 28.7 57.0

4.97 1.40 2.55 1.99 2.32 2.65

48.2 69.6 68.3 74.8 71.7 63.2

49.9 78.0 74.9 80.2 76.2 67.7

Source: United Nations Statistics Division

The Human Poverty Index (HPI) The Human Poverty Index (HPI) published annually by the United Nations focuses on four basic dimensions of human life - longevity, knowledge, economic provisioning and social inclusion. The latest published data shows the UK ranked only 15th out of 17 leading industrialised countries with only Ireland and the United States below us. The most recent data for the Human Poverty Index is shown in the table below together with the factors that go into creating the Human Poverty Index ranking.
Country Human Poverty Index Ranking 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Probability at birth of not surviving to age 60 (% of cohort) 2000-05 7.3 8.3 10.2 8.7 11 9.2 9.7 10 8.8 7.5 8.6 8.7 9.4 8.8 8.9 9.3 12.6 People lacking functional literacy skills (% age 16-65) 1994-98 c 7.5 8.5 10.4 10.5 9.6 14.4 .. .. .. .. .. 16.6 18.4 17 21.8 22.6 20.7 Long-term unemployment (as % of labour force) 2001 1.1 0.2 2.4 1.6 0.9 4.2 0.5 3.3 4.6 1.4 6.1 0.7 3.2 1.4 1.3 3.2 0.3 Proportion of the population living on less than 50% of median income 1990-2000 6.6 6.9 5.4 8.1 9.2 7.5 3.9 8 10.1 11.8 14.2 12.8 8 14.3 12.5 12.3 17

Sweden Norway Finland Netherlands Denmark Germany Luxembourg France Spain Japan Italy Canada Belgium Australia United Kingdom Ireland United States

The Measure of Domestic Progress The Measure of Domestic Progress (MDP) is published by economists at the New Economics Foundation and is designed to reflect progress in Britons' quality of life and progress towards a sustainable economy by factoring in the social and environmental costs of growth, and benefits of unpaid work such as household labour, that are currently excluded from official GDP. According to their data, over the last thirty years UK GDP increased 80 per cent, but MDP fell sharply in the 1980s and has never regained its 1976 peak. Social costs have increased 600 per cent, with a 13-fold increase in the costs of crime and a four-fold increase in the costs of family breakdown
The Gross National Happiness Index
Tutor2u Limited 2008 www.tutor2u.net

Bhutan, the Himalayan kingdom the size of Switzerland with no McDonalds, no ATM machines, no traffic lights, and until five years ago no TV, is for many people a species of Shangri-La. Bhutan is ranked 130th in the UN Development Program's ratings, close to Haiti and Bangladesh. Most visitors rate it almost infinitely higher, however, and the measure they use is one let fall by the country's king in 1987 "Gross National Happiness." Un Happy Planet Index The South Pacific island nation of Vanuatu is the happiest place on the planet according to the Happy Planet Index, has been constructed by the New Economics Foundation and Friends of the Earth using three factors: life expectancy, human wellbeing and damage done via a country's "environmental footprint". The UK's heavy ecological footprint, the 18th biggest worldwide, is to blame for the country's low rating in the index. Life satisfaction varies greatly from country to country: questioned on how satisfied they were with their lives, on a scale of one to 10, 29% of Zimbabweans, who have a life expectancy of 37, rate themselves at one and only 6% rate themselves at 10. Source: Adapted from the Guardian, 12th July 2006 and BBC news online

Key Points The basic measure of the standard of living refers to per capita real GDP. It is found by dividing real GDP by the size of the population. This figure is an average and gives no indication of the distribution of income To ensure purchasing power parity between countries, the current exchange rate is adjusted so that a basket of goods and services can be bought for the same amount of dollars. GDP data can then by expressed at purchasing power standard (PPS) Omissions and inaccuracies suggest that officially published GDP figures are a debatable guide to the quality of life and the standard of living A range of alternative composite measures of economic welfare and the quality of life have been developed happiness is now a firm part of the agenda of public policy! These include the Human Development Index, the Human Poverty Index, the Index of Sustainable Economic Welfare and the newly established Happy Planet Index!

Reading: World rich 'keep getting richer' (BBC news online, June 2007)

Tutor2u Limited 2008 www.tutor2u.net

9. Unemployment
In this chapter we consider in more depth the causes and consequences of unemployment. After over a decade of falling unemployment, the number of people out of work in the UK economy is rising again, and this highlights some of the economic and social effects of people being unable to find paid work. Measuring unemployment in the UK Claimant Count The claimant count includes those people who are eligible to claim the Job Seeker's Allowance (JSA). Claimants who satisfy the criteria receive the JSA for six months before moving onto special employment measures. One problem with the claimant count is that it excludes many people who are actually interested in finding work and who might have searched for work in the recent period but they dont meet all of the criteria for claiming and therefore are not included in the unemployment count. In 2006, the claimant count averaged 945,000 or just fewer than 3.0% of the labour force. Labour Force Survey The labour force survey (LFS) measure of unemployment covers those people who have looked for work in the past month and are able to start work in the next two weeks. On average, the labour force survey measure has exceeded the claimant count total by about 600,000 in recent years.
Labour Force Survey Unemployment Claimant Count Unemployment

Level 000s 1990 1993 1997 2000 2001 2002 2003 2004 2005 2006 2,004 2,953 2,045 1,638 1,431 1,533 1,476 1,426 1,425 1,650

(seasonally adjusted) Annual change Rate Level Annual change Rate 000s % 000s 000s % -102 6.9 1,648 -120 5.5 157 10.5 2,877 135 9.7 -299 7.2 1,585 -503 5.3 -121 5.6 1,088 -160 3.6 -207 4.9 970 -119 3.2 102 5.2 947 -23 3.1 -57 5.0 933 -14 3.0 -50 4.8 854 -80 2.7 -1 4.7 862 8 2.7 5.4 947 2.9

Some basic labour market definitions Unemployment rate: The labour force: Participation rate: = = = the percentage of the workforce that is registered as unemployed the number of people in employment + the registered unemployed the population of working age (estimated in 2002 to be 36.5 million) the percentage of working population who are in the labour force

Working population: =

You can find our information about unemployment in your own local area by using the Nomis data
Tutor2u Limited 2008 www.tutor2u.net

Unemployment in the UK Economy


people aged 16-59 (women) / 64 (men), seasonally adjusted
13 12 11 10
per cent of the labour force
13 12 11 10 9 8 7 Labour Force Survey 6 5 4 Claimant Count 3 2

9 8 7 6 5 4 3 2 80 82 84 86 88 90 92 94 96 98 00 02 04 06

Source: Reuters EcoWin

Trends in the two main measures of unemployment for the UK economy

The Causes of Unemployment Frictional Unemployment This is voluntary or transitional unemployment due to people moving between jobs. For example, newly redundant workers, or those entering the labour market for the first time such as graduates and school-leavers can take time to find jobs at wage rates they are prepared to accept. Many of the frictionally unemployed are out of work for a short time whilst engaged in job search. Imperfect information may lead to frictional unemployment if the jobless are unaware of the available jobs. Often this information failure is localised for few workers scan the vacancies available across the whole economy, they tend to restrict their search for work to a local area. Geographical mobility in the UK and in the EU is lower than it is in the USA for example. Incentives to look for work are also important! Some people may opt not to accept jobs at prevailing market wage rates if they believe the income tax and benefit system will reduce the net increase in income people can expect from taking paid work. This problem is referred to as the unemployment trap. Structural Unemployment Structural unemployment occurs when people are made jobless because of capital-labour substitution which reduces the demand for labour in an industry, or when there is a long run decline in demand which causes redundancies and worker lay-offs. Structural unemployment exists where there is a mismatch between their skills and the requirements of the new job opportunities.
Tutor2u Limited 2008 www.tutor2u.net

Skills are required to cope with structural changes in output and employment Structural change is a constant feature of a flexible economy. As some sectors decline, so other sectors requiring different skills will expand. The pace of technological change and global integration will increase demand for a more highly skilled workforce with the ability to adapt to changing technologies and shifting product demand. Source: HM Treasury, the Benefits of a Flexible Economy, April 2004

Many of the unemployed from coal, steel and heavy engineering have found it difficult to gain reemployment without re-training. This problem is one of the occupational immobility of labour. The long-term decline in industrial employment has continued (a process known as deindustrialisation) and there has been a huge shift into service-based employment, especially in banking, finance and insurance, other business services and distribution, hotels and restaurants.

The Changing Pattern of Employment, By Industry


Millions, seasonally adjusted
8
8

Distribution, hotels and restaurants

6 Manufacturing industries

Persons (millions)

4 Banking, finance and insurance 3 Transport and Communication

0 80 82 84 86 88 90 92 94 96 98 00 02 04 06

Source: Reuters EcoWin

The changing pattern of jobs in the UK Employment change in the UK economy Banking, finance and insurance Education and health Distribution, hotels & restaurants Transport & communication 1990 000s 4442 6470 6463 1680
Tutor2u Limited 2008 www.tutor2u.net

2005 % change 000s 6097 7790 7078 1839 1990-2005 27.1 16.9 8.7 8.6

millions

Construction Agriculture & fishing Manufacturing Mining, electricity, gas & water

2357 641 5203 398

2099 -12.3 446 -43.7 3383 -53.8 171 -132.7 Source: UK Labour Market Statistics

Employment programmes to reduce unemployment The Labour Government's New Deal programme was launched in 1997 and, over the last ten years, it has sought to reduce long-term unemployment by increasing the human capital of the unemployed by improving their employability in the eyes of potential employers. The New Deal is designed to bring back into the labour market people who have given up the active search for work. These discouraged workers are long- term unemployed who have been out of formal employment for a long period and whose motivation to look for work has declined to low levels. There is often a catch-22 in the labour market since is difficult to find new work without relevant experience but experience can only come from having a relevant job. Cyclical Unemployment Cyclical unemployment is involuntary or "demand deficient" unemployment due to a lack of aggregate demand. When there is a recession we see rising unemployment because of plant closures and worker lay-offs. The fall in AD shown in the next diagram takes the economy further away from full-capacity national output and leads to a negative output gap where actual GDP lies below potential GDP. Because labour has a derived demand, a fall in real national output leads to a contraction in total employment. Voluntary and Involuntary Unemployment An important distinction is to be noted between voluntary unemployment when a worker chooses not to accept a job at the going wage rate and involuntary unemployment which occurs when a worker would be willing to accept a job at the going wage but cannot get an offer.

Tutor2u Limited 2008 www.tutor2u.net

Inflation

LRAS

P2

P1 SRAS

AD1

AD2

Y1

Y2

YFC Real National Income

E1

E2

An outward shift of AD causes an expansion of short run aggregate supply and a rise in equilibrium national income from Y1 to Y2 To produce the extra output, we can expect to see a rise in the demand for labour. The required increase in employment depends in part on the productivity of labour and other factor resources In this diagram we see an expansion in the employment of labour an example of the concept of the derived demand for labour
Employment of labour

Tutor2u Limited 2008 www.tutor2u.net

Classical Unemployment
Wage Rate (W) W min Labour Supply

Minimum Wage (Wage Floor)

W1

Demand = MRPL Q3 Q2 Q1 Employment of Labour (E)

Classical unemployment is the result of real wages being above their market clearing level leading to an excess supply of labour. Some economists believe that the national minimum wage risks creating unemployment in industries where global competition from low-cost producers is severe. Consequences of Unemployment To many economists, persistent unemployment is a sign of market failure because unemployment is a waste of scarce resources and leads to a loss of potential output and a reduction in allocative efficiency. The economy is operating below the maximum output it could achieve. This might be illustrated by making use of a PPF or using the concept of the output gap.

Tutor2u Limited 2008 www.tutor2u.net

Output of Capital Goods

Inflation

LRAS

C2

B P1

P2 C1 C A AD1

Unemployment when the economy is operating below the PPF

SRAS AD2

X2

Output of X1 Consumer Goods

Y2

Y1

Yfc

Real National Income

When unemployment is rising for example during a recession, real national output will be contracting and the economy will be operating well below full-capacity. This is shown in the chart below, notice how during the depression during the early 1990s, the output gap became negative as the unemployment rate climbed towards 10 per cent of the labour force. Once the recovery had become well established, unemployment began its descent and the economy moved towards macroeconomic equilibrium with the negative output gap closing. Around the turn of the decade, the UK economy was estimated to be running pretty close to its potential level, with real GDP growing just above the trend rate of 2.5% per year. Unemployment drifted lower, mainly as a result of successful attempts to bring down structural and frictional unemployment. In 2005 there was an economic slowdown, the output gap became negative again and in 2006 the rate of unemployment edged higher. No recession, but we again saw the cyclical relationship between the growth of output and the rate of unemployment. Slightly stronger growth in 2007 caused a fresh downturn in the level of unemployment.

Tutor2u Limited 2008 www.tutor2u.net

The Output Gap and Unemployment in the UK


Output Gap (Difference between actual and potential GDP), Unemployment - claimant count me
12.5
12.5

10.0

10.0

7.5

7.5

Per cent

5.0

Unemployment Output gap

5.0

2.5

2.5

0.0

0.0

-2.5

-2.5

-5.0 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

-5.0

Source: Reuters EcoWin

There are further costs associated with high or rising unemployment besides simply the lost output. Redundancies waste resources invested in training and educating workers and the longer each persons period of time out of work, the greater the loss of skill and motivation. A high rate of long term unemployment can therefore have a negative effect on a countrys economic growth potential. High unemployment also affects government finances with higher spending on unemployment benefits and other welfare payments plus falling revenues from income tax, national insurance and VAT. There is also a strong link between unemployment and consumer spending. As consumers confidence falls, so the willingness of people to spend declines and people build up their precautionary savings. Hysteresis effects The Hysteresis effect describes a possible consequence of a country experiencing persistently high rates of long term unemployment. Hysteresis means to be behind and it relates to the economic costs of unemployment because of the damage that unemployment does to the skills and employability of those people out of work. The longer someone remains out of a paid job, the less attractive they become to a potential employer. Technical and social skills can become eroded. The incentives to prolong the search for work are damaged and the end result can be an increase in core structural unemployment and a consequent rise in the natural rate of unemployment. Overcoming the problem of hysteresis is now a major policy issue within the European Union where several countries are suffering from extremely high and damaging rates of unemployment, much of which is long term in nature. Social Costs of Unemployment

Tutor2u Limited 2008 www.tutor2u.net

Rising unemployment is linked to social deprivation leading to negative externalities. There is some relationship with crime, and other aspects associated with social dislocation (for example via increased divorce rates, worsening health and lower life expectancy). Areas and regions of persistently high unemployment see falling real incomes and a worsening in inequalities of income and wealth. It can become very difficult and expensive to reverse the decline of localities where unemployment rates are incredibly high and where employment opportunities are poor. This remains a major social and political problem for the UK despite the general progress in reducing unemployment.

UK Unemployment, By Duration
Millions, seasonally adjusted, using Labour Force Survey data
1.3 1.2 1.1 1.0 0.9
Persons (millions)
1.3 1.2

Unemployed for up to six months

1.1 1.0 0.9 0.8 0.7

0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Unemployed for over 24 months Unemployed for over 12 months

0.6 0.5 0.4 0.3 0.2 0.1 0.0

Source: Reuters EcoWin

There has been a welcome reduction in long term unemployment over the last twelve years

Possible benefits from unemployment One benefit of rising unemployment is that it helps to keep the rate of inflation down since high unemployment is often associated with a reduction in the bargaining power of workers to bid for higher wages and salaries. There might also be an environmental gain if unemployment is linked to a slower rate of growth of consumption and production, reducing the pressures on scarce environmental resources. Having some people unemployed in a frictional sense might also be regarded as beneficial in that it means that there is a pool of unemployed workers who can take up new jobs as they become available. But this depends on these workers having sufficient geographical and occupational mobility. Full-employment in any economy is highly unlikely to be achieved. Government Policies to Reduce Unemployment The government does not have a specific target for any particular rate of unemployment. Instead its objective for the labour market is expressed in terms of a broad ambition to keep employment high and provide employment opportunities for all.
Tutor2u Limited 2008 www.tutor2u.net

millions

Distinction can be made between demand-side and supply-side policies to improve the working of the labour market in matching people to the available jobs and to the changing demands and requirements of different industries. There are inevitably limits to what the government can do to achieve sustainable reductions in unemployment. And often the policies that are introduced to boost employment can be costly and involve an opportunity cost. Reducing occupational immobility of labour (supply-side policy) Immobility of labour is a cause of labour market failure and structural unemployment. Policies aimed at reducing this problem aim to provide the unemployed with the skills they need to find reemployment and also to improve the incentives to find work. Improvements in the availability and quality of education and work-place training will increase the human capital of unemployed workers and help to ensure that more of the unemployed have the right skills to take up the available job opportunities. For many years the relative paucity of work-place training has been seen as a weakness in the UK labour market. Both employers and employees may actually underestimate the long-term value of training in terms of the potential benefit to a business and the long term gains to a worker. The free-rider problem may also contribute to a sub-optimal level of training from societys point of view. Benefit and tax reforms (supply-side policy) To some economists, a policy that reduces the value of welfare benefits might increase the incentive for the unemployed to take a job. The evidence drawn from recent experience in the UK is that simply cutting the value of state welfare payments in reality makes little difference to the level of unemployment in the long run. It is rare that the root cause of someone staying out of work is the prospect of generous out of work welfare handouts. Instead, targeted measures to improve peoples incentives, including the linking of welfare benefits to participation in genuine work experience programmes which is part of the New Deal programme or the introduction of lower marginal income tax rates for people on low incomes might by contrast have a noticeable impact. Reflating aggregate demand (demand-side policy) The government can use the traditional weapon of macro-economic policies designed to increase AD and thereby generate a higher level of national income and employment. Reflationary policies can help to mitigate the effects of an economic recession but there are risks involved in using both fiscal and monetary policy simply to boost demand when output is low. The government might also make more active use of regional policies to encourage inflows of foreign investment from multinational companies particularly to those areas and regions where unemployment is persistently above the national average. The main weakness of relying too heavily on demandmanagement policies to reduce unemployment is that much unemployment is not cyclical; rather it is frictional and structural in origin and cannot be solved simply by injecting vast amounts of money into the circular flow of income and spending. Employment subsidies (demand-side policy) Government subsidies for businesses that take on the long-term unemployed will create an incentive for firms to increase the size of their workforce. Employment subsidies may also be available for overseas firms locating in the UK in regions of below-average economic prosperity. Summary: The governments current labour market strategy is firstly to rely on monetary and fiscal policy to maintain a stable rate of economic growth as a pre-condition for high and stable rates of employment. Macroeconomic stability is regarded as essential for creating the right climate in which new jobs become available. Secondly, supply-side policies and in particular active labour market
Tutor2u Limited 2008 www.tutor2u.net

strategies such as New Deal and other welfare and education reforms are given a higher weighting in seeking to reduce structural aspects of the unemployment problem. The British economy has made substantial and significant progress in reducing unemployment over the last fifteen years. Despite a recent upturn in unemployment (the result of a slowdown in growth) the UK still has one of the lowest unemployment rates in the European Union.

Euro Zone and UK Unemployment


Percentage of the labour force, seasonally adjusted; 2007-08 forecast is from the OECD
11 Euro Zone average 10
10 11

PERCENT

UK unemployment rate

4 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: Reuters EcoWin

Key Points Unemployment occurs when individuals are jobless but willing and able to work at the going wage rate. Official government figures only count people who register as unemployed and are actively searching for work. Discouraged workers who want a job but have given up looking because they have decided the search is hopeless many are suffering from long-term structural unemployment. Unemployment in the UK fell almost continuously from the summer of 2003 to the start of 2005.Since then there has been a modest upturn in unemployment on both the claimant count and the labour force survey measure. By the summer of 2006, unemployment had risen to a four year high. Unemployment has both demand and supply-side causes. Some unemployment can be due to the voluntary decisions of people in the labour market, but most unemployment is involuntary There are strong links between high unemployment and inequality and risk of relative poverty for households where no-one is in paid work. The unemployed tend to have some of the lowest incomes in society.
Tutor2u Limited 2008 www.tutor2u.net

10.

The Natural Rate of Unemployment

At A2 level, students are expected to understand the idea of an equilibrium rate of unemployment. We now turn to the concept of the natural rate. Equilibrium unemployment in an economy The natural rate of unemployment is defined as the equilibrium rate of unemployment i.e. the rate of unemployment where real wages have found their free market level and where the aggregate supply of labour is in balance with the aggregate demand for labour. At the natural rate, all those wanting to work at the prevailing real wage rate have found employment and thus there is assumed to be no involuntary unemployment. There remains some voluntary unemployment as some people remain out of a job searching for work offering higher real wages or better conditions. It is worth stating at this point that some economists simply do not believe in the validity of a simple natural rate of unemployment when the labour market is in balance and where a rate of unemployment settles at a level consistent with stable wage and price inflation. The natural rate concept is supported by economists who believe in the power of markets to clear at an equilibrium price and who view the labour market much as any other market in the economy. Consider the next diagram which shows some labour demand and supply analysis. At the real wage rate W1, E1 workers are employed. But at this prevailing wage rate, the total labour force exceeds than the employed labour force. The natural rate of unemployment = AB and consists of frictional and structural unemployment. The government might attempt to reduce the natural rate by bringing down the horizontal distance between the supply of labour and the labour force curve.
Real Wage Rate

Labour Supply Labour Force

a W1

Labour Demand

E1

E2

Employment

Tutor2u Limited 2008 www.tutor2u.net

Any supply-side policy that can increase the number of people willing of working age that are willing and able to find employment in the labour market will shift the labour supply curve to the right, thus narrowing the gap. This is shown in the second diagram.
Real Wage Rate

LS1 LS2

Labour Force

a W1

Labour Demand

E1

E3

E2

Employment

Policies to reduce the natural rate of unemployment normally focus on improving the efficiency of the labour market be removing what are called labour market imperfections. For example a government wanting to achieve a lower equilibrium rate of unemployment might do the following: o Reform the system of welfare benefits so as to reduce the risk of the poverty trap o Reforming trade unions to reduce their collective bargaining power and also reducing some of the barriers to labour mobility put up by professional bodies and associations which have the effect of limiting the supply of labour into an occupation o Reducing income tax to improve the incentives to look for and accept paid work o Adopting a more relaxed approach to labour migration In general terms, economists who believe that the natural rate of unemployment can be reduced argue that government policies should seek to make labour markets more competitive and flexible. We now move on to discuss the nature of flexible labour markets as part of strategies to boost employment and thereby reduce unemployment. Economic activity and inactivity
Total economically active 1980 1990 26.9 28.9 Total in employment 25.2 26.9 Millions Economically inactive 15.8 15.9

Tutor2u Limited 2008 www.tutor2u.net

1993 2000 2005

28.2 29.1 30.1

25.3 27.4 28.7

16.8 17.0 17.6 Source: ONS

Data is for the spring of each year. Includes people aged 16 and over

The economically active are those in work or actively searching for work. As we can see from the table above, since the end of the last recession in 1993 the number of economically active in the UK has grown by nearly two million people. But over the same time period, there has also been a rise in the number of people classified as economically inactive. There are various reasons for inactivity. People may choose to return to or stay in full-time education beyond the age of 16; others will leave the labour market to raise a family or look after ill relatives. Others may choose to take early retirement. And for some, the experience of long term unemployment is enough for them to give up the search for work; they move into the welfare system and become almost permanent claimants of a variety of state welfare benefits. If the economy can reduce the number of inactive people, the benefit would be an expansion in the active labour supply and a boost to our long-term growth potential. The importance of human capital in raising employment and reducing unemployment
Employment rate: by sex and highest qualification, 2005 Men 89 87 81 83 79 75 54 79 Women 87 84 73 73 71 63 42 70 Percentages All 88 85 77 81 75 69 48 74

Degree or equivalent Higher education GCE A level or equivalent Trade apprenticeship GCSE grades A* to C or equivalent Qualifications at NVQ level 1 and below No qualifications All Percentage of the working-age population in employment

Source: Labour Force Survey, ONS

Upgrading and improving the skills of people is really important in raising employment rates. The data in the table above is taken from 2005 and shows that employment rates among people of working age is significantly higher for people with a good base of GCSE qualifications or above or vocational qualifications at level 1 or above. Key Points Equilibrium in the labour market is when labour demand equals labour supply Even when the labour market is in equilibrium there will still be frictional and structural unemployment and also some seasonal unemployment The natural rate of unemployment can be reduced mainly through supply-side labour market policies which improve work incentives and re-skill people looking for work It is very difficult to observe the natural rate of unemployment directly because it is rare for the labour market to be in a state of equilibrium!

Tutor2u Limited 2008 www.tutor2u.net

11.

Flexible Labour Markets

Over the last twenty-five years, governments of both political persuasions appear to have become wedded to the concept of labour market flexibility. In this chapter we look at the meaning of a flexible labour market and consider its pros and cons. What is a Flexible Labour Market? Economists who believe in the power of freely functioning markets for goods, services, capital and people are frequently strong supporters of flexible labour markets. But there is no unique definition of the term. In fact we find that a flexible labour market has several characteristics Occupational (functional) flexibility this refers to the ability of the workforce to perform different tasks and also to acquire and apply transferable skills. The benefit of this is that a worker with transferable skills will be able to move easily from one job to another in other words they will be occupationally mobile. Flexibility can also be encouraged by increase their level of training, and provide incentives for them to adapt their skills. It is clear that there is still a skills gap between the UK and many of our main international competitors. Rapid technological change and the pressures of globalization are putting a premium on raising the skills of the workforce and increasing the adaptability of people in work. Ease and cost of hiring and firing workers: Reforms to UK employment laws now make it easier to hire and fire workers - this reduces the costs to the employer of making modifications to the size of their employed labour force. Output and employment can more easily be matched during the different stages of an economic cycle. Contractual flexibility: In many industries, workers are now offered jobs on six months, sometimes on month-to-month contracts. There are even some instances of zero hour contracts where the number of hours that someone is asked to work will vary from week to week but with no guarantee of any hours being available at all! Part-time workers now make up around 25 per cent of the UK workforce this is high in comparison to much of Europe. Compared to the EU as a whole there are also a relatively high number of employees with flexible working patterns in the UK, such as shift and weekend working. Wage flexibility: Wage flexibility refers to the ability of changes in real wages to eliminate imbalances between the supply of and demand for labour. This can be seen in the expansion of performance related pay (where some part of the total pay package is linked to productivity, company profits or to other indicators of performance. In many industries there is evidence of regionalization of pay awards so that payment can reflect differences in regional demand for and supply of labour and also variations in regional living costs Geographical flexibility: Many businesses now expect their workers to be able to move within and across different regions and countries as part of their career development. Geographic mobility in the EU is still much lower than in the United States an issue that has become more important in the context of the single European currency and the desire to reduce high rates of unemployment within the EU. There are always natural barriers to geographic mobility of labour, particularly across national borders, but also within individual countries. These barriers relate to family commitments, career progression and benefits and property (for example the costs involved in moving home and the constraints imposed by wide regional variations in house prices).
Tutor2u Limited 2008 www.tutor2u.net

The UK is generally regarded as having a flexible labour market with the United States measured as having the highest degree of flexibility. But not every country has to follow the same labour market model! There is no unique template for success in raising employment and reducing unemployment whilst at the same time protecting the employment rights of people in work. The Danish economy has recently been praised for its model of flexicurity!

Total Part-Time Employment in the UK Economy


Millions, seasonally adjusted
7.50
7.50

7.25

7.25

7.00
Persons (millions)

7.00

6.75

6.75

6.50

6.50

6.25

6.25

6.00

6.00

5.75 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

5.75

Source: Reuters EcoWin

Flexibility as a broad economic idea is basically the ability to respond to economic change efficiently and quickly while safeguarding a degree of fairness. Changes include the impact of innovation and changing technology, shifts in consumer preferences and external shocks to the UK economy, such as the recent global slowdown or the surge in world oil prices. According to the Treasury, a high degree of flexibility means that the British economy will be more resilient in the face of such exogenous shocks and will therefore minimise the costs in terms of lost output and jobs. The table below summarises different aspects of labour market flexibility with examples for each:
Price (wage) Flexibility Regional and local pay agreements rather than national wage settlements Pay packets reflecting skill differentials Numerical Flexibility Expansion of short term employment contracts Growth of home working Temporal Flexibility Flexibility of working time i.e. overtime and weekend working Increased use of part-time staff to meet changes in demand Functional Flexibility Ability of labour force to use varied technology Transferable skills within the workplace Location Flexibility Geographical flexibility

Tutor2u Limited 2008 www.tutor2u.net

millions

Wider use of performance related pay as an incentive to boost labour productivity

Core of full-time employees on contracts

Employment Rates in the UK economy Men 91.8 82.1 79.9 79.0 Women 56.3 59.1 66.2 70.1 Percentages of adults aged 16+ All 74.8 71.0 73.3 74.7 Source: Labour Force Survey

1971 1981 1991 2005

Has the flexible labour market model developed in the UK been beneficial to our growth prospects? There is certainly no consensus on this answer, some economists believe that the labour market flexibility has led to an increase in wage inequality but other analysts argue that continued low levels of unemployment and inflation are testimony to a better performance.
OECD hails UK flexible labour as key to success The UKs flexible labour market has led to employment levels that are the envy of Europe and the USA, according to new research from the OECD. The UK came seventh out of 30 OECD countries in terms of employment levels, with 74% of the working age population having jobs. Source: OECD and Personnel Today, July 2005 Do the Danes have the answer? Due to its outstanding success, the Danish flexicurity model is much discussed at EU and member states' level. The model was introduced in 1993 by a Social-Democrat government and has resulted in a decline of unemployment from 12% to 5%, while keeping the growth of wages at a steady 3% to 5% per year. A flexible labour market makes it easy for employers to hire and fire, but high unemployment benefits of up to 90% of the latest wage make transition from one job to another easy. The concept of employment security thus replaces traditional job security. An active labour market policy includes the right and the duty to training and job offers. Source: adapted from the Euroactiv website

Advantages of a flexible labour market Neo-classical Economists believe that flexible wages and flexible employment helps to ensure that markets clear rapidly eliminating any excess supply or demand, so economies automatically move into long run equilibrium at potential output. Improved occupational mobility of labour leading to less structural unemployment and a reduction in the natural rate Stronger employment creation during an economic upturn Flexibility makes the British economy more attractive to inward investment Higher productivity growth in the long run (which then helps to improve competitiveness)

Tutor2u Limited 2008 www.tutor2u.net

Contributes to an improvement in the inflation-unemployment trade off (see the next chapter on the Phillips Curve) The economy can respond more flexibly to an external economic shock because wages and employment are more flexible

Disadvantages of a flexible labour market There are concerns about a lack of training for workers on short term contracts which has a long term effect on their ability to regain employment if they lose their jobs. This ties in with broader concerns about skills gaps in the economy. The Leitch Review on Skills has reported on the critical need to upgrade the skills of the workforce given the challenges from the current wave of globalization. Shorter term contracts might lead to job insecurity for some people, the concept of job security is being gradually replaced by the concept of employability. Frequent job changes for workers can be unsettling for them and for their families. There are concerns about the link between a flexible labour market and relative poverty because of the reduction in trade union membership and less employee-bargaining power. Shorter term employment contacts and eligibility for occupational pensions may lead to increased pensioner poverty in the long run, many people on short term contracts do not enter into any occupational pension. There is a risk of slash and burn during an economic slowdown / recession as companies seek to cut their workforces aggressively during a downturn. What of the longer term social implications of labour market flexibility the 24 hours per day work culture and the possible effects on family life?

Barriers to labour market flexibility Although workers in the UK and the USA are probably subject to fewer government regulations than in most other Western European countries, there remain plenty of laws and regulations affecting workers which limit the flexibility of the labour market. Each of them can be justified either on economic or social grounds. The National Minimum Wage The European Union Working Hours Directive Minimum holiday entitlements, maternity and paternity leave and health and safety at work. Employment laws which protect workers from unfair dismissal.

Reforms to national labour markets remains an important economic policy topic at the moment as many European countries look to increase their employment rates (partly as a solution to the impending pensions crisis) and reduce what, for many countries, has become a deeply-rooted unemployment problem. Suggested reading on the labour market Skills shortages threaten Scottish economic growth (BBC news, July 2007) Key Points
Tutor2u Limited 2008 www.tutor2u.net

Flexible labour markets are a supply-side policy designed to increase employment, raise productivity and keep labour costs under control. The strongest supporters of flexile labour markets are neo-classical economists who believe in the power of free markets and argue for less government intervention in the labour market The UK labour market has undoubtedly become more flexible in the last twenty years with rising part-time employment for most of this period; greater localization of pay agreements and a shift toward short-term contracts in many (but not all) occupations and industries There are plenty of barriers and imperfections in the UK labour market

Tutor2u Limited 2008 www.tutor2u.net

12.

The Phillips Curve

The essence of the Phillips Curve is that there is a short-term trade-off between unemployment and inflation. But the original Phillips Curve has come under sustained attack in particular from monetarist economists, and when we consider the data for unemployment and inflation in Britain over the last fifteen years, we will find that the nature of the trade-off has certainly changed for the economy and others as well. The basic Phillips Curve concept In 1958 AW Phillips from whom the Phillips Curve takes its name plotted 95 years of data of UK wage inflation against unemployment. It seemed to suggest a short-run trade-off between unemployment and inflation. The theory behind this was fairly straightforward. Falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemployment to rise. If a Government wanted to reduce the unemployment rate, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the product markets. The key to understanding this trade-off is to consider the possible inflationary effects in both labour and product markets arising from an increase in national income, output and employment. The labour market: As unemployment falls, some labour shortages may occur where skilled labour is in short supply. This puts pressure on wages to rise, and since wages are usually a high percentage of total costs, prices may rise as firms pass on these costs to their customers. Other factor markets: Cost-push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass. When an economy is booming, so does the derived demand for components and raw materials. Product markets: Rising demand and output puts pressure on scarce resources and can lead to suppliers raising prices to increase their profit margins. The risk of rising prices is greatest when demand is out-stripping supply-capacity leading to excess demand (i.e. a positive output gap.)
Unemployment (LFS Measure) 000s 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Average 1995-2006 Standard Deviation 2470.0 2344.0 2045.0 1783.0 1759.0 1638.0 1431.0 1533.0 1479.0 1429.0 1426.0 1657.0 1749.5 358.1 Unemployment (Claimant Count) 000s 2289.7 2087.5 1584.5 1347.8 1248.1 1088.4 969.9 946.6 933.0 853.5 861.8 945.0 882.0 1233.7 477.3 RPI Inflation Consumer Price Inflation % change 3.4 2.4 3.1 3.4 1.6 2.9 1.8 1.6 2.9 3.0 2.8 3.2 4.2 2.8 0.8 2.6 2.5 1.8 1.6 1.4 0.8 1.2 1.3 1.4 1.4 2.0 2.3 2.4 1.7 0.6

% change

Tutor2u Limited 2008 www.tutor2u.net

Explaining the Phillips Curve concept using AD-AS and the output gap Let us consider the explanation for the trade-off using AD-AS analysis and the concept of the output gap. In the next diagram, we draw the LRAS curve as vertical - this makes the assumption that the productive capacity of an economy in the long run is independent of the price level. We see an outward shift of the AD curve caused by higher consumer spending which takes the equilibrium level of national output to Y2 beyond potential GDP (Yfc). This creates a positive output gap and it is this that is thought to cause a rise in inflationary pressure as described above. Excess demand in product markets and factor markets causes a rise in supply costs and this leads to an inward shift in short run aggregate supply from SRAS1 to SRAS2. The fall in supply takes the economy back towards potential output but at a higher price level.
Inflation LRAS = potential GDP SRAS2 P3 P2 P1 SRAS1

AD1

AD2

Y1

Yfc

Y2

Real National Income

We could equally use a diagram that uses a non-linear SRAS curve to demonstrate the argument. The next diagram shows the short-run Phillips Curve and the trade-off between unemployment and inflation

Tutor2u Limited 2008 www.tutor2u.net

Wage Inflation (%) W3

Trade-off is worsening as the economy comes up against capacity constraints leading to excess of aggregate demand over aggregate supply

W2

Favourable trade-off because the economy has plenty of spare capacity SRAS is elastic when unemployment is high

W1

Short Run Phillips Curve (SRPC)

U3

U2

U1

Unemployment Rate (%)

The NAIRU Milton Friedman, who criticised the basis for the original Phillips Curve, introduced the concept of the NAIRU. It has been further developed by economists both in the United States and the UK. Leading figures developing the concept of the NAIRU in the UK include Sir Richard Layard and Prof. Stephen Nickell at the LSE. The NAIRU is defined as the rate of unemployment when the rate of wage inflation is stable. The NAIRU assumes that there is imperfect competition in the labour market where some workers have collective bargaining power through membership of trade unions when they are seeking higher wages. Set against the industrial muscle of trade unions, some employers have a degree of monopsony power when they purchase labour inputs. According to proponents of the concept of the NAIRU, the equilibrium level of unemployment is the outcome of a bargaining process between firms and workers. In this model, workers have in their minds a target real wage. This target real wage is influenced by what is happening to unemployment it is assumed that the lower the rate of unemployment, the higher workers wage demands will be. Employees will seek to bargain their share of a rising level of profits when the economy is enjoying a cyclical upturn. Whether or not a business can meet that target real wage during pay negotiations depends partly on what is happening to labour productivity and also the ability of the business to apply a mark-up on average cost in product markets in which they operate. In highly competitive markets where there are many suppliers battling for market share, one would expect lower profit margins. In markets dominated by businesses with monopoly power, the mark-up on cost is usually higher and potentially there is an increased share of the producer surpluses that workers might opt to bargain for. If actual unemployment falls below the NAIRU, theory suggests that the balance of power in the labour market tends to switch to employees and away from employers. The consequence can be that the economy experiences acceleration in pay settlements and the growth of average earnings. Ceteris paribus, an increase in wage inflation will cause a rise in cost-push inflationary pressure.

Tutor2u Limited 2008 www.tutor2u.net

The expectations-augmented Phillips Curve The original Phillips Curve idea was subjected to fierce criticism from the Monetarist school among them the late American economist Milton Friedman. Friedman accepted that the short run Phillips Curve existed but that in the long run, the Phillips Curve should be drawn as vertical and, as a result, there was no trade-off between unemployment and inflation. He argued that each short run Phillips Curve was drawn on the assumption of a given expected rate of inflation. So if there were an increase in inflation caused by a monetary expansion and this had the effect of driving inflationary expectations higher this would cause an upward shift in the short run Phillips Curve. The monetarist view is that attempts to boost AD to achieve faster growth and lower unemployment have only a temporary effect on jobs. Friedman argued that a government could not permanently drive unemployment down below the NAIRU the result would be higher inflation which in turn would cost jobs but with inflation expectations increased along the way. Friedman introduced the idea of adaptive expectations if people see and experience higher inflation in their everyday lives, they come to expect a higher average rate of inflation in future time periods. And they (or the trades unions who represent them) may then incorporate these changing expectations into their pay bargaining. Wages often follow prices. A burst of price inflation can trigger higher pay claims, rising labour costs and ultimately higher prices for the goods and services we need and want to buy. This is illustrated in the next diagram inflation expectations are higher for SPRC2. The result may be that higher unemployment is required to keep inflation at a certain target level.

Tutor2u Limited 2008 www.tutor2u.net

Wage Inflation (%)

An increase in inflation expectations 5% SRPC2 SRPC1

5%

7%

Unemployment Rate (%)

The Monetarist school believes that inflation is best controlled through tight control of money and credit. Credible policies to keep on top of inflation can also have the beneficial effect of reducing inflation expectations causing a downward shift in the Phillips Curve.

The long run Phillips Curve The long run Phillips Curve is normally drawn as vertical but the curve can shift inwards over time

Tutor2u Limited 2008 www.tutor2u.net

Wage Inflation (%) LRPC2

Long Run Phillips Curve (LRPC1)

A fall in the NAIRU means that the economy can operate at a lower rate of unemployment consistent with achieving a given rate of inflation

4% SRPC1

SRPC2 Decline in inflation expectations

5%

7%

Unemployment Rate (%)

An inward shift in the long run Phillips Curve might be due to supply-side improvements to the economy and in particular a reduction in the natural rate of unemployment. For example labour market reforms might be successful in reducing frictional and structural unemployment perhaps because of improved incentives to find work or gains in the human capital of the workforce that improves the occupational mobility of labour. What has happened to the inflation-unemployment trade off for the UK?
The disappearing Phillips Curve Conventional economic wisdom suggests that higher economic activity measured by rising real GDP growth and falling unemployment will lead to higher inflation and, furthermore, that any attempt to hold activity above its sustainable long-run level indefinitely is likely to result in inflation accelerating. But, over the last decade, consumer price inflation has been both subdued and unusually stable, fluctuating between just 0.8% and 2.6%, while the unemployment rate has fallen from double-digit levels to just 4.6% of the labour force today. So, as unemployment has fallen, inflation has remained low and stable, suggesting that any positive relationship between economic activity and inflation has all but disappeared. Charles Bean, Chief Economist of the Bank of England, speech given in November 2004

The evidence is that the supposed trade-off for the UK has improved over the last fifteen years. Indeed since the early 1990s, Britain has enjoyed a long period of falling unemployment and stable, low inflation. The next chart provides some supporting data for this view.

Tutor2u Limited 2008 www.tutor2u.net

Unemployment and Inflation - A Favourable Trade Off?


unemployment and inflation rates - per cent
10 9 8 7 6
Percent
10 9 8 7 6

5 4 3 2 1 0 89 90 91

Inflation

Unemployment

5 4 3 2 1 0

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

Source: Reuters EcoWin

For several years during the mid and late 1990s, the UK saw falling inflation and falling unemployment at the same time! Then from 2002 onwards, there was a slight acceleration in inflation and a flattening out of the unemployment total. In 2005-06 we saw a gradual upturn in inflation and rising unemployment a worsening of the trade-off between these two important variables. But during 2007 the situation has improve once more with inflation in July 2007 back below 2% and the unemployment rate (measured in our chart by the claimant count) dipping once more below 3% of the labour force. Factors that might explain the improved trade-off between unemployment and inflation No single factor on its own is sufficient to explain the changing (or improving) trade-off. Some of the key ones are highlighted and explained below: 1. The flexibility of the UK labour market - A more flexible labour market has increased the size of the labour supply and a reduction in trade union power has reduced the collective bargaining power of many workers. Falling long-term unemployment is a sign of a reduction in structural unemployment rates. We can be pretty certain that the NAIRU (the non accelerating inflation rate of unemployment) has come down. Although the NAIRU is not something we can observe and measure directly, it is estimated that the NAIRU has fallen from nearly 10% of the labour force in 1992 to around 5% in the last few years. 2. Benefits of immigration although the precise effects of a high level of labour migration are hard to quantify with any accuracy, a rise in the size of inward migration, from the new EU member states and elsewhere, may have helped to relieve labour shortages in some sectors of the economy and therefore help to control upward pressures on wage inflation.
Tutor2u Limited 2008 www.tutor2u.net

3. The effect of credible inflation targets: The use of inflation targets which were introduced in1992 has helped to reduce inflation expectations. For Britain, the adoption of inflation targets has been an important step in establishing a credible monetary policy framework as a way of embedding low-inflation in the British economy. 4. Low inflation in the global economy: External factors are important too! For a decade or more, cost and price inflation in many parts of the world economy has been on a downward path. Indeed the buzz word has been the threat of deflation in many developed countries. The rapid advance of globalization has increased the intensity of competition between nations and reduced the prices of many imported products. The pricing power of manufacturing businesses in a huge number of international markets has been greatly diminished by the pressures of globalisation. It has become much harder to make price increases stick when there so many competing suppliers in different countries. Despite the recent sharp rise in the prices of many soft and hard commodities, world inflation remains relatively low. 5. Technological change and innovation has raised labour productivity and cut production costs. This big change in the supply-side of the British and international economy has been a key factor keeping inflation down even though unemployment has been low. 6. Increased competition in domestic and international markets the British economy has been affected greatly by deregulation in many domestic markets and by the increased competitive pressures that come from globalisation. There is strong evidence that shifts in comparative advantage may have worked in our favour in recent years. According to research from the Bank of England, the international terms of trade that is the price of the goods and services we export relative to the price of those we import has moved in Britains favour. That means that if the earnings of people in work were merely to rise in line with the price of UK output, the purchasing power of UK workers who buy imported goods as well as goods produced here would nevertheless be rising. That in turn has reduced the pressure for higher wages. This is known as the real-product wage effect. Cheaper imports increase the real purchasing power of the wages earned by people living and working in the UK. Why does a change in the Phillips Curve / NAIRU matter? Our focus here is the possible consequences for the operation of government macroeconomic policy. Setting interest rates: Firstly a reduction in the NAIRU will have implications for the setting of short term interest rates by the Monetary Policy Committee. If they believe that the labour market can operate with a lower rate of unemployment without the economy risking a big rise in inflation, then the Bank of England may be prepared to run their monetary policy with a lower rate of interest for longer. This has knock-on effects for the growth of aggregate demand as lower interest rates work their way through the transmission mechanism. Forecasts for economic growth: Secondly the trade-off between unemployment and inflation affects forecasts for how fast the economy can comfortably grow over the medium term. This information is a vital for the government when it is deciding on its key fiscal policy decisions. For example how much they can afford to spend on the major public services education, health, transport and defence. Forecast growth affects their expected tax revenues which together with government spending plans then determine how much the government may have to borrow (the budget deficit).

Tutor2u Limited 2008 www.tutor2u.net

NAIRU for the UK Economy


Percentage of the labour force, source: OECD World Economic Outlook
10.0
PERCENT
UK NAIRU 10.0 8.0 6.0 4.0 12 11 Unemployment Rate (%) 10 9 8 7 6 Average Earnings 5 4 3 2

8.0 6.0 4.0 12 11 10 9 8 7 6 5 4 3 2 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: Reuters EcoWin

Key Points o The potential for a short run trade off between unemployment and inflation continues to exist! If aggregate demand is allowed to grow well above an economys potential output, then unemployment will fall but there is a risk of rising inflation o Changes in inflation expectations alter the position of the short run Phillips Curve in the x-y axis space a fall in expectations of inflation causes a downward shift of the SRPC o Monetary policy is probably most influential in affecting expectations of inflation the success of the BoE since 1997 has influenced the unemployment-inflation trade off for the UK. Low global inflation rates have also had the effect of reducing inflation expectations. o Supply side policies that raise productivity and increase potential output can help to cause an inward shift in the long run Phillips Curve o There has been a fall in the NAIRU in the UK over the last fifteen years because of a decline in the equilibrium rate of unemployment o By most estimates, the UK has a lower NAIRU than most of the twelve countries inside the single currency (Euro Zone). The NAIRU is probably around 5% of the labour force o Although unemployment has remained low, some external factors have kept inflationary pressures in check (including the strong exchange rate and falling commodity prices)

Tutor2u Limited 2008 www.tutor2u.net

13.

Measuring Inflation

Inflation is best defined as a sustained increase in the general price level leading to a fall in the value of money. In this section we will concentrate on the measurement of inflation in the UK.

UK Consumer Prices - all items - annual index


1987 = 100
200
200

175

175

150

150

125
1987:1=100

125

100

100

75

75

50

50

25

25

0 30

35

40

45

50

55

60

65

70

75

80

85

90

95

00

05

Source: Reuters EcoWin

The UK consumer price index since 1930 notice the high inflation during the 1970s and the 1980s. The effects of inflation on the value of money A good research piece has come from Halifax Bank of Scotland which looks at the effect of inflation on the purchasing power of money. According to their figures, someone would need 85.6 million today to enjoy the equivalent lifestyle of a person with 1 million in 1907. Viewed the other way, 11,700 in 1907 would have had the equivalent spending power to 1 million today. Even the relatively low inflation of the past 10 years has had a marked effect on the value of money so that someone would need 1.3 million to have the same spending power as 1 million in 1997. Today's equivalent to 1m in the past 1907 1927 1947 1957 1967 1977 1987 1997 85.6m 44.7m 27.9m 17.2m 12.9m 4.4m 2.0m 1.3m

Tutor2u Limited 2008 www.tutor2u.net

The Consumer Price Index The consumer price index (CPI) is a weighted price index which measures the monthly change in the prices of goods and services. The spending patterns on which the index is weighted are revised each year, using information from the Family Expenditure Survey. The expenditure of some higher income households, and of pensioner households mainly dependent on state pensions, is excluded. As spending patterns change over time, the weightings used in calculating the CPI are altered. The consumer price index is now used as the main official measure of inflation in the UK. The current weights used in the calculation of the price level are summarised in the table below: Weights used in the consumer price index
Food & NonAlcoholic Drinks 1988 2004 184 106 Transport 1988 2004 159 151 Alcohol and Tobacco 67 46 Communication 20 26 Clothing & Footwear 84 62 Recreation & Culture 94 150 Housing, water & fuels 134 103 Education 9 16 Household furnishings 76 75 Hotels, Cafes 118 137 Health Transport

5 22 Miscellaneous 50 106

159 151

The changes in these weights reflect significant shifts in spending patterns of households in the British economy. The weighting attached to food and non alcoholic drinks has declined from 184/1000 in 1988 to just 106/1000 this year. In contrast families are spending proportionately more of their budgets on recreation and cultural activities, hotels and cafs! In 2007, DVD recorders, satellite navigation (satnav) systems and digital (DAB) radios were included for the first time in the CPI measure. Background: Sat nav guide to inflation basket (BBC news online, March 2007)

Tutor2u Limited 2008 www.tutor2u.net

Selected Weights in the UK Consumer Price Index


Total weights for the CPI = 1000. Source: Office of National Statistics
150
150

125 Housing, water and fuels 100


1996=100

125

100

Foods 75
75

Clothing and footwear 50 Alcohol, tobacco and narcotics 25 Education 0 98 99 00 01 02 03 04 05 06 07


0 25 50

Source: Reuters EcoWin

Calculating a weighted price index The following hypothetical example shows how to calculate a weighted price index.
Category Food Alcohol & Tobacco Clothing Transport Housing Leisure Services Household Goods Other Items Price Index 104 110 96 108 106 102 95 114 Weighting 19 5 12 14 23 9 10 8 100 Price x Weight 1976 550 1152 1512 2438 918 950 912 10408

Weights are attached to each category and then we multiply these weights to the price index for each item of spending for a given year. The price index for this year is: the sum of (price x weight) / sum of the weights So the price index for this year is 104.1 (rounding to one decimal place)

Tutor2u Limited 2008 www.tutor2u.net

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

Consumer Price Inflation for the UK Economy


Annual percentage change in the Consumer Price Index
9 8 7 6 5 4 3 2 1 0 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
9

Percent

Source: Reuters EcoWin

The inflation target for the UK economy is consumer price inflation of 2.0%. This inflation target is set each year by the Chancellor and it is the task of the Bank of England (BoE) to meet this target. There is a permitted band of fluctuation of +/- 1%. The inflation target was changed in December 2003. Between May 1997 and December 2003 the inflation target was for CPIX (retail price inflation excluding mortgage interest rates) and the target was 2.5%. The Bank has (thus far) only once failed to meet the inflation target when CPI inflation hit 3.1% in April 2007. The Governor wrote an open letter to the Chancellor explaining the inflation over-shoot and interest rates were raised at the next meeting of the Monetary Policy Committee. Since then, the rate of CPI inflation has fallen back into target range at the time of writing UK inflation was 1.8% in July 2007. Limitations of the Consumer Price Index as a measure of inflation The CPI is a thorough indicator of consumer price inflation for the British economy but there are some weaknesses in its usefulness for some groups of people. The CPI is not fully representative: Since the CPI represents the expenditure of the average household, inevitably it will be inaccurate for the non-typical household, for example, 14% of the index is devoted to motoring expenses - inapplicable for non-car owners. Single people have different spending patterns from households that include children, young from old, male

Tutor2u Limited 2008 www.tutor2u.net

from female, rich from poor and minority groups. We all have our own weighting for goods and services that does not coincide with that assigned for the consumer price index. Housing costs: The housing category of the CPI records changes in the costs of rents, mortgage interest, property and insurance, repairs. It accounts for around 16% of the index. Housing costs vary greatly from person to person, from the young house buyer, mortgaged to the hilt, to the older householder who may have paid off his or her mortgage. The CPI does not include house prices in its calculation. Changing quality of goods and services: Although the price of a good or service may rise, this may be accompanied by an improvement in quality as the good. It is hard to make price comparisons of, for example, electrical goods over the last 20 years because new audio-visual equipment is so different from its predecessors. In this respect, the CPI may over-estimate inflation. The CPI is slow to respond to the emergence of new products and services.

Since 2007, people have been able to log on to the Office of National Statistics website to use their own personal inflation calculator!
Recent evidence on UK Inflation (% Change on a year earlier, source: UK Treasury) Consumer Prices RPI 3.1 3.4 1.6 2.9 1.8 1.6 2.9 3.0 2.8 3.2 CPI 1.8 1.6 1.4 0.8 1.2 1.3 1.4 1.4 2.0 2.3 Input -8.2 -9.0 -1.3 7.4 -1.3 -4.4 1.4 4.0 11.6 9.6 Producer Prices Manufacturing Output 0.9 0.0 0.4 1.5 -0.3 0.0 1.5 2.5 2.8 2.5

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Tutor2u Limited 2008 www.tutor2u.net

Retail Price and Consumer Price Inflation in the UK


Annual percentage change in the retail price index and CPI
5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 Consumer price index 1.0 0.5 97 98 99 00 01 02 03 04 05 06 07
1.0 5.0

4.5

4.0

All items retail price index (RPI)

3.5

Percent

3.0

2.5

2.0

1.5

0.5

Source: Reuters EcoWin

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

Tutor2u Limited 2008 www.tutor2u.net

14.

Causes of Inflation

Cost Push Inflation Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins. There are many reasons why costs might rise: Rising imported raw materials costs perhaps caused by inflation in countries that are heavily dependent on exports of these commodities or alternatively by a fall in the value of the pound which increases the UK price of imported inputs. A good example of cost push inflation was the decision by British Gas and other energy suppliers to raise substantially the prices for gas and electricity that it charges to domestic and industrial consumers at various points during 2005-07. Commodity price inflation has been very high in the last few years. For example, the world price of wheat more than doubled during 2007 and hard metals such as copper, tin, rhodium and nickel have also see very fast rates of inflation. Rising labour costs - caused by wage increases which exceed gains in productivity. This cause is important in those industries which are labour-intensive. Firms may decide not to pass these higher costs onto their customers if they can achieve some cost savings in other areas of the business. But in the long run, wage inflation tends to move closely with price inflation because there are limits to the extent to which any business can absorb higher wage expenses. Higher indirect taxes imposed by the government for example a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the rate of Value Added Tax or an extension to the range of products to which VAT is applied. These taxes are levied on suppliers who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers.

Tutor2u Limited 2008 www.tutor2u.net

LRAS Inflation An inward shift of short run aggregate supply e.g. caused by a rise in crude oil prices or an increase in unit wage costs puts upward pressure on the general price level and might cause a contraction along the aggregate demand curve

P2 P1

SRAS2

SRAS1 Aggregate Demand

Y2

Y1

Yfc

Real National Income

Our chart below tracks the price of Brent crude oil and the overall CPI inflation rate for the UK. Despite oil prices climbing from around $20 per barrel in 2001-2002 to well over $60 per barrel in 2006-07, the CPI inflation rate has stayed pretty low, only once breaching the inflation limit of 3%. This suggests that high oil (and gas) prices no longer seem to have the same impact on the UK economy as they did during the 1970s and 1980s. Have oil prices lost their power to shock?

Tutor2u Limited 2008 www.tutor2u.net

UK Inflation and Crude Oil Prices


Annual percentage change in the Consumer Price Index and monthly average for Brent Crude
80 60
USD/barrel

Crude Oil Price

80 60 40 20 0

40 20 0 4.0 Consumer Price Inflation

4.0

3.0
Percent

3.0

2.0

2.0

1.0

1.0

0.0

0.0

00

01

02

03

04

05

06

07

Source: Reuters EcoWin

Demand Pull Inflation Demand-pull inflation is most likely when there is full employment of resources and when SRAS is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise for a number of reasons some of which occur together at the same moment of the economic cycle o 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 foreigners buy more exports, AD will rise. o A reduction in direct or indirect taxation. If direct taxes are reduced, consumers have more real disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater volume of goods and services. o The rapid growth of the money supply perhaps a consequence of increased bank and building society borrowing if interest rates are low. Monetarist economists believe that the root causes of inflation are monetary in particular when the central bank permits an excessive growth of the money supply in circulation beyond that needed to finance the volume of transactions produced in the economy. o Rising consumer confidence and an increase in the rate of growth of house prices both of which would lead to an increase in total demand for goods and services. o Faster economic growth in other countries providing a boost to UK exports overseas. In the next chart we track the estimated output gap for the UK economy and the rate of inflation. The last time there was genuine demand-pull inflation was in the late 1980s when a runaway economy
Tutor2u Limited 2008 www.tutor2u.net

created the conditions for rising inflation. Over the last ten years it is note-worthy that aggregate demand has been growing more or less in line with potential output curbing inflation risks.

The Output Gap and Consumer Price Inflation


Output Gap = Actual GDP - Potential GDP. CPI inflation - annual % change in prices
9 8
Excess demand in the economy

9 8 7 6
Excess supply in a recession

7 6 5 4
Per cent

5 4 3

3
Inflation

2 1 0 -1 -2 -3 -4 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
Output gap

2 1 0 -1 -2 -3 -4

Source: Reuters EcoWin

Tutor2u Limited 2008 www.tutor2u.net

Inflation LRAS

P3

P2

P1

AD3 SRAS AD1 AD2

Y1

Y2

Yfc

Real National Income

The wage price spiral expectations-induced inflation Rising expectations of inflation can be self-fulfilling. If people expect prices to continue rising, they are unlikely to accept pay rises less than their expected inflation rate because they want to protect the purchasing power of their incomes. When workers are looking to negotiate higher wages, there is a danger of a wage-price spiral that then requires the introduction of deflationary policies such as higher interest rates or an increase in direct taxation. Inflation influences in the British economy

Tutor2u Limited 2008 www.tutor2u.net

Basic Pay

Bonuses + overtime

Import Prices

Exchange rate / profit margins

+ Commodity Prices Average Earnings Unit labour costs + + Productivity Taxes + Economic Cycle Secular Influences (e.g. ICT impact) Fiscal Policy Consumer price inflation

Profit Margins

Economic Cycle

The diagram summarises some of the key influences on inflation. Reading from left to right: o Average earnings comprise basic pay + income from overtime payments, productivity bonuses, profit-related pay and other supplements to earned income. o Productivity measures output per person employed, or output per person hour. A rise in productivity helps to keep unit costs down. However, if earnings to people in work are rising faster than productivity, then unit labour costs will increase. o The growth of unit labour costs is a key determinant of inflation in the medium term. Additional pressure on prices comes from higher import prices, commodity prices (e.g. oil, copper and aluminium) and also the impact of indirect taxes such as VAT and excise duties. o Prices also increase when businesses decide to increase their profit margins. They are more likely to do this during the upswing phase of the economic cycle.

Tutor2u Limited 2008 www.tutor2u.net

Earnings and Prices


Annual percentage change in earnings and consumer prices
6
6

Average Earnings

Percent

Consumer price inflation

0 97 98 99 00 01 02 03 04 05 06 07

Source: Reuters EcoWin

RPI Inflation % change

Consumer Price Inflation 3.4 2.4 3.1 3.4 1.6 2.9 1.8 1.6 2.9 3.0 2.8 3.2 4.2 2.8 0.8 % change 2.6 2.5 1.8 1.6 1.4 0.8 1.2 1.3 1.4 1.4 2.0 2.3 2.4 1.7 0.6

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 forecast Average 1995-2007 Standard Deviation

Short Term Interest Rate % 6.5 6.4 7.5 6.2 5.9 5.8 4.0 3.9 4.0 4.8 4.6 5.0 5.8 5.4 1.1

Sterling Oil Prices Exchange Rate Index Jan 2005=100 $ per barrel 82.5 16.99 83.8 20.61 96.4 19.11 100.0 12.80 99.4 17.87 101.1 28.43 99.5 24.45 100.5 24.99 96.9 28.87 101.6 38.33 100.5 54.18 101.2 65.03 96.9 6.6 29.3 15.8

Bank of England on what causes inflation?

Tutor2u Limited 2008 www.tutor2u.net

15.

Consequences of Inflation

High and volatile inflation is widely seen by economists to have economic and social costs hence the continued importance attached to the control of inflationary pressure in an economy by both the government and also the central bank (in the UKs case, the Bank of England). This chapter considers some of the effects of inflation on an economy.

Why does inflation matter? The impact of inflation depends in part on whether inflation is anticipated or unanticipated: o Anticipated inflation: When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects. For example, trade unions may exercise their collective bargaining power to negotiate with employers for increases in money wages to protect the real wages of union members. Households may be able to switch savings into deposit accounts offering a higher nominal rate of interest or into other financial assets such as housing or equities where capital gains over a period of time might outstrip price inflation. In this way, people can help to protect the real value of their financial wealth. Businesses can adjust prices and lenders can adjust interest rates. Businesses may also seek to hedge against future price movements by transacting in forward markets. For example, most of the major airlines buy their fuel several months in advance in the forward market, partly as a protection or hedge against fluctuations in world oil prices. o Unanticipated inflation: When inflation is volatile from year to year, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future. Unanticipated inflation occurs when economic agents (i.e. people, businesses and governments) make errors in their inflation forecasts. Actual inflation may end up well below, or significantly above expectations causing losses in real incomes and a redistribution of income and wealth from one group in society to another. Money Illusion It is a fact of life that people often confuse nominal and real values in their everyday lives because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income. Money illusion is most likely to occur when inflation is unanticipated, so that peoples expectations of inflation turn out to be some distance from the correct level. When inflation is fully anticipated there is much less risk of money illusion affecting both individual employees and businesses The Main Costs of Inflation What are the main costs of inflation? Why is the control of inflation given such a high priority in macroeconomic policy-making? Supporters of tough inflation control would support the arguments made in this quote in a speech delivered a few years ago from Mervyn King.
The case for maintaining price stability It is clear that very high inflation in extreme cases hyperinflation can lead to a breakdown of the economy. There is now a considerable body of evidence that inflation and output growth are negatively correlated in high-inflation countries. For inflation rates in single figures, the impact of inflation on growth is less clear. Source: Mervyn King, Governor of the Bank of England
Tutor2u Limited 2008 www.tutor2u.net

In explaining and assessing the costs of inflation, we must be careful to distinguish between different degrees of inflation, since low and stable inflation is less damaging than hyper-inflation where prices are out of control. Another important part of your evaluation is to be aware that inflation will have varying effects both on individuals and also the performance of the economy as a whole. Impact of Inflation on Savers: Inflation leads to a rise in the general price level so that money loses its value. When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if nominal interest rates are lower than inflation leading to negative real interest rates. For example a saver might receive a 3% nominal rate of interest on his/her deposit account, but if the annual rate of inflation is 5%, then the real rate of interest on savings is -2%. Inflation Expectations and Wage Demands Inflation can get out of control because price increases lead to higher wage demands as people try to maintain their real living standards. Businesses then increase prices to maintain profits and higher prices then put further pressure on wages. This process is known as a wage-price spiral. Arbitrary Re-Distributions of Income Inflation tends to hurt people in jobs with poor bargaining positions in the labour market - for example people in low paid jobs with little or no trade union protection may see the real value of their pay fall. Inflation can also favour borrowers at the expense of savers as inflation erodes the real value of existing debts. And, the rate of interest on loans may not cover the rate of inflation. When the real rate of interest is negative, savers lose out at the expense of borrowers. Business Planning and Investment Inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs - and this may reduce planned investment spending. Lower investment then has a detrimental effect on the economys long run growth potential Competitiveness and Unemployment Inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance. If inflation in the UK is persistently above our major trading partners, British exporters may struggle to maintain their share in overseas markets and import penetration into the UK domestic market will grow. Both trends could lead to a worsening balance of payments. The UK government believes that monetary stability (i.e. low inflation) is a pre-condition for sustained economic expansion.

Tutor2u Limited 2008 www.tutor2u.net

Consumer Price Inflation in Selected Countries


Annual percentage change in consumer prices
5 4 3 2 1
Percent
5

United States

4 3 2 1

0 -1 -2 -3 -4 -5

UK Japan

0 -1 -2 -3 -4 -5

China

00

01

02

03

04

05

06

07

Source: Reuters EcoWin

Suggestions for further reading on inflation China inflation hits ten year high (BBC news, August 2007) India moves to cool inflation (BBC news, August 2007) Zimbabwe inflation climbs over 7,500% (BBC news, August 2007) Inflation sends Kiwi to new high (BBC news, July 2007) Bank of England Inflation Report Tim Harford on the effects of inflation are we ruined or are we in clover (June 2006) Tim Harford on why it is so hard to measure inflation Slate magazine, (May 2006) Tim Harford what is the perfect rate of inflation? (Financial Times, August 2007)

Tutor2u Limited 2008 www.tutor2u.net

16.

Deflation

Increasing attention is now being placed on deflationary pressures in modern economies. What causes deflation and why are economists and policy-makers concerned about it?

What is deflation? Deflation is defined as a period when the general price level falls. It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP. But deflation can also be caused by an increase in a nations productive potential which leads to an excess of aggregate supply over demand.
A fall in aggregate demand
LRAS Inflation Inflation

A rise in long run aggregate supply


LRAS1 LRAS2

Pe

P1 P2

P2

SRAS AD1 AD2 Y2 Ye Yfc

SRAS AD1 AD2

Y1

Y2

YFC2

Real National Income

Deflation is a sustained period over which the general price level is falling. But just as there are many different strains of influenza, some of them lethal, and some of them producing just temporary discomfort, so it is with deflation. And just as a bad cold may generate 'flu-like symptoms, so economies may exhibit some of the symptoms of deflation without suffering from the virus. Charles Bean, Bank of England Chief Economist, October 2002

Possible Economic Costs of Deflation o Holding back on spending: Consumers may opt to postpone demand if they expect prices to fall further in the future. If they do, they might find prices are 5 or 10% cheaper in 6 months. o Debts increase: The real value of household, corporate and government debt rises when the general price level is falling and a higher real debt mountain can be a drag on consumer confidence and peoples willingness to spend. o The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices another factor driving spending lower.
Tutor2u Limited 2008 www.tutor2u.net

o Lower profit margins: Company profit margins come under pressure unless costs fall further than prices paid by consumers this can lead to higher unemployment as firms seek to reduce their costs. Weaker profit margins can also have a negative effect on stock markets because of a fall in expected profits and dividends to shareholders. o Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector financial wealth and confidence leading to further declines in aggregate demand and a rise in precautionary savings (i.e. the average and marginal propensity to save will tend to rise.) Difference between Benign and Malign Deflation Deflation is not necessarily bad! If falling prices are caused by higher productivity, as happened in the late 19th century, then it can go hand in hand with robust growth. On the other hand, if deflation reflects a slump in demand and excess capacity, it can be dangerous, as it was in the 1930s, triggering a downward spiral of demand and prices. If the falling prices are simply the result of improving technology or better managerial practices, that is fine. Consider what has happened to the costs of transport and telecommunications over the years. Today we have something of that benign deflation. When you make a telephone call to the United States for 3p a minute or fly on a low cost airline to European destinations for less than 30, the consumer is getting the benefit of technology and increased competition in the form of lower prices leading to an improvement in economic welfare! Malign Deflation Malign deflation occurs when prices fall because of a structural lack of demand which creates huge excess capacity in an economic system. If there is a slump in demand, companies go out of business and sack people, and hence demand falls again the negative multiplier effect starts to have its effect. The Situation in the UK Although there has been genuine deflation in several industries within the UK over the last few years, notably in textiles and clothing, audio-visual equipment and airline transport, the economy as a whole has experienced low but positive inflation as measured by the consumer price index. The risks of deflation are mitigated by the symmetrical inflation target given to the Bank of England recognition that deflation can be as costly and dangerous to the health of the British economy as a sharp acceleration in inflation. The Bank of England stands ready to boost aggregate demand through interest rate cuts if there is a serious threat of inflation under-shooting the target. Another factor to consider is that inflationary expectations in Britain remain positive at or around 2.5% per year people do not yet consider outright deflation to be a probable outcome for the economy. Low and stable inflation which does not affect the day to day decisions of businesses and consumers is known as price stability.

Tutor2u Limited 2008 www.tutor2u.net

Consumer Price Inflation and Interest Rates for the UK


Annual percentage change in the UK Consumer Price Index, the inflation target is 2%
8 Base Interest Rates 7
7 8

5
Percent

3 Inflation 2

0 97 98 99 00 01 02 03 04 05 06 07

Source: Reuters EcoWin

Can economic policy reduce the risk of deflation? Monetary Policy Cuts in interest rates can be made to stimulate the demand for money and thereby boost consumption. But this is not always an effective strategy for reducing the risks of deflation: o If consumer confidence is low, the impact of a monetary stimulus might be small as people are more likely to save any increment to their income perhaps to enable them to pay off some of their accumulated debt. o If asset prices are falling, the demand for cash savings will remain high therefore consumption may not respond to lower interest rates. o There are limits to how far monetary policy can go in boosting demand because nominal interest rates cannot fall below zero. The liquidity trap When cuts in interest rates have little or no impact on demand, then the economy is said to be experiencing a liquidity trap. When interest rates are close to zero, people may expect little or no real rate of return on their financial investments, they may choose instead simply to hoard cash rather than investing it. If monetary policy is ineffective in stimulating demand, the solution may be to use fiscal policy as a means of kick-starting demand and output. One possible solution is to seek to monetise the economy by large scale buy-backs of government debt by the central bank to inject cash or liquidity into the economy. This was an option considered by the Japanese government during their deflationary recession in the late 1990s.
Tutor2u Limited 2008 www.tutor2u.net

Fiscal Policy A fiscal expansion of AD can come directly through higher government spending and/or an increase in public sector borrowing. Secondly the threat of deflation might be reduced through lower direct taxes to boost household disposable incomes. Both of these strategies seek to boost incomes and inject extra spending power into the circular flow of income and spending. The tax cuts might be announced as temporary to deal with a specific deflationary threat. But again there may be some limits to the effectiveness of fiscal policy in these circumstances: o There are long term consequences for the size of the national debt and the interest payments on this debt if the fiscal expansion package is too large. The government might end up providing a short term boost to demand, but have to cope with a significant increase in debt repayments in future years. o Low consumer and business confidence might again reduce the impact of any fiscal stimulus. o Lower taxes and higher public spending might stoke up some inflationary pressure if too much stimulus is applied for too long (once the economy starts to recover.) o If tax cuts or public-works programmes are seen as temporary, while confidence is low, then extra incomes tend to be used to re-paying debt or restoring savings. Households may see this as their priority, rather than fuelling increases in consumption.

Price Deflation for Selected Items


Consumer price index, monthly value, 2005=100
170 170

160

160

150

150

140 Audio-Visual Equipment

140

2005=100

130

130

120 Clothing and Footwear 110

120

110

100

100

90

90

80 00 01 02 03 04 05 06 07

80

Source: Reuters EcoWin

Although there is a great deal of press and academic interest in the causes and consequences of deflation and the likelihood of it occurring in the UK, the risks of deflation are fairly small.

Tutor2u Limited 2008 www.tutor2u.net

We must be careful to make a distinction between disinflation in specific industries due to technological change, excess supply, regulatory intervention or productivity improvements such as in telecommunications, motor vehicles and audio-visual equipment, and deflation across the whole economy which in theory poses much greater risks. Providing that economic policy-makers are alert to the possible causes of genuine deflation, and respond at the right time when those risks are clear, then they should have enough flexibility in their monetary and fiscal policy armouries to counter the threat posed by deflation.

Japan's Zero Interest Rate Policy!


Per cent
1.00 0.75
Percent
Official Policy Interest Rates (%) 1.00 0.75 0.50 0.25 0.00 -0.25 -0.50 104.0 Consumer Price Index 103.0 102.0 101.0 100.0 99.0

0.50 0.25 0.00 -0.25 -0.50 104.0 103.0

2005=100

102.0 101.0 100.0 99.0 99 00 01 02 03 04 05 06 07

Source: Reuters EcoWin

Suggestions for further reading and research on deflation Consumers enjoy falling prices (Evan Davis, BBC, January 2005) Japan price rise means end to deflation (BBC) see also Japan scraps zero interest rates

Tutor2u Limited 2008 www.tutor2u.net

17.

Monetarism and the Quantity Theory of Money

In this section we consider briefly the main principles of the monetarist theory of inflation and the role that monetary policy can play in stabilising prices and output in an economy. The basics of monetarism The key features of monetarist theory are as follows: o The main cause of inflation is an excess supply of money leading to in the words of Monetarist Economist Milton Friedman, too much money chasing too few goods. We will see graphically how this can lead to a build up of inflationary pressure in an economy. o Tight control of money and credit is required to maintain price stability o Attempts by the government to use fiscal and monetary policy to fine-tune the rate of growth of aggregate demand are costly and ineffective. Fiscal policy has a role to play in stabilising the economy providing that the government is successfully able to control its own borrowing. o The key is for monetary policy to be credible perhaps in the hands of an independent central bank so that peoples expectations of inflation are controlled.
An increase in the money supply

Increased demand for goods and services

Increased demand for financial assets including housing and bonds

Higher bond prices pushes down long term interest rates

Rising house prices stimulate wealth effect Higher level of AD C+I+G+(X-M)

AD may rise above the economys potential output positive output gap

Rise in inflationary pressure

Tutor2u Limited 2008 www.tutor2u.net

A simple way of explaining how a surge in the amount of money in circulation can feed through to higher inflation is shown in the flow chart. Excess money balances held by households and businesses can affect demand and output in several directions. Consumers will often increase their own demand for goods and services adding directly to aggregate demand (although a high proportion of this extra spending may go on imports). Secondly some of the excess balances will be saved in bonds and other financial assets, or invested in the housing market. An increase in the demand for bonds causes a downward movement in bond interest rates (there is an inverse relationship between the two) and this can then stimulate an increase in investment. Similarly money that flows into housing will push house prices higher, and we know understand quite well how a booming housing market stimulates consumer wealth, borrowing and an increase in spending. The Quantity Theory of Money The Quantity Theory was first developed by Irving Fisher in the inter-war years as is a basic theoretical explanation for the link between money and the general price level. The quantity theory rests on what is sometimes known as the Fisher identity or the equation of exchange. This is an identity which relates total aggregate demand to the total value of output (GDP). MxV=PxY Where o M is the money supply o V is the velocity of circulation of money o P is the general price level o Y is the real value of national output (i.e. real GDP) The velocity of circulation represents the number of times that a unit of currency (for example a 10 note) is used in a given period of time when used as a medium of exchange to buy goods and services. The velocity of circulation can be calculated by dividing the money value of national output by the money supply. In the basic theory of monetarism expressed using the equation of exchange, we assume that the velocity of circulation of money is predictable and therefore treated as a constant. We also make a working assumption that the real value of GDP is not influenced by monetary variables. For example the growth of a countrys productive capacity might be determined by the rate of productivity growth or an increase in the capital stock. We might therefore treat Y (real GDP) as a constant too. If V and Y are treated as constants, then changes in the rate of growth of the money supply will equate to changes in the general price level. Monetarists believe that the direction of causation is from money to prices (as we saw in the flow chart on the previous page). The experience of targeting the growth of the money supply as part of the monetarist experiment during the 1980s and early 1990s is that the velocity of circulation is not predictable indeed it can suddenly change, partly as a result of changes to peoples behaviour in their handling of money. During the 1980s it was found that direct and predictable links between the growth of the money supply and the rate of inflation broke down. This eventually caused central banks in different countries to place less importance on the money supply as a target of monetary policy. Instead they switched to
Tutor2u Limited 2008 www.tutor2u.net

having exchange rate targets, and latterly they have become devotees of inflation targets as an anchor for the direction of monetary policy.

Measuring the money supply

Growth of the Money Supply - M4 and M0


Annual percentage change, seasonally adjusted
16 15 14 13 12 11
Percent
16 15

M0

14 13 12 11 10 9 8

10 9 8 7 6 5 4 01 02 03 04 05 06 07

M4

7 6 5 4

Source: Reuters EcoWin

There is no unique measure of the money supply because it is used in such a wide variety of ways. M0 (Narrow money) - comprises notes and coins in circulation banks' operational balances at the Bank of England. Over 99% of M0 is made up of notes and coins as cash is used mainly as a medium of exchange for buying goods and services. Most economists believe that changes in the amount of cash in circulation have little significant effect on total national output and inflation. At best M0 is seen as a co-incident indicator of consumer spending and retail sales. If people increase their cash balances, it is mainly a sign that they are building up these balances to fund short term increases in spending. M0 reflects changes in the economic cycle, but does not cause them. M4 (Broad money) is a wider definition of what constitutes money. M4 includes deposits saved with banks and building societies and also money created by lending in the form of loans and overdrafts. M4 = M0 plus sight (current accounts) and time deposits (savings accounts).
Tutor2u Limited 2008 www.tutor2u.net

When a bank or another lender grants a loan to a customer, bank liabilities and assets raise by the same amount and so does the money supply. Again M4 is a useful background indicator to the strength of demand for credit. The Bank takes M4 growth into account when assessing overall monetary conditions, but it is not used as an intermediate target of monetary policy. Its main value is as a signpost of the strength of demand which can then filter through the economy and eventually affect inflationary pressure.

Tutor2u Limited 2008 www.tutor2u.net

18.

Government Macroeconomic Policy

Targets, instruments and goals of macroeconomic policy


Policy Goals

Policy Targets

Policy Instruments

The Exchange Rate The Money Supply Aggregate Demand Real GDP Growth Budget Deficit

Monetary Policy Fiscal Policy Supply-side Policy Exchange controls

Stable Prices High Employment Sustained Growth Rising Living Standards Reduction in Poverty Higher Productivity

Policy goals are the objectives of macroeconomic policy. The main policy goals of the current government are listed below: o Sustained economic growth o High employment o Stable prices (low inflation) o Sustainable position on the balance of payments Policy Instruments Policy instruments are the main options available to a government for managing the economy. There are broadly speaking three main policy groups: Fiscal Policy Fiscal policy involves changes in the composition and level 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 Monetary policy involves the use of changes in short-term interest rates to control the level and rate of growth of aggregate demand in the economy mainly by changing the cost of borrowing money, influencing the rate of return on savings and thereby changing the overall demand for and supply of money Monetary policy also involves the effects of changes in the exchange rate the external value of one currency against another on the wider economy. The government (through the central bank) may choose to intervene in the foreign exchange market to influence the value of one currency against another. Supply-side Policies
Tutor2u Limited 2008 www.tutor2u.net

Supply-side economic policies are 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.

Is the Golden Age of UK Macro Stability under Threat?


Inflation, jobs and growth
10 Unemployment 9 8 7 6 5
Percent
10

Inflation

9 8 7 6 5 4 3 2 1 0 -1

4 3 2 1 0 -1 -2 -3 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 GDP growth

-2 -3

Source: Reuters EcoWin

The Misery Index Economists are often fond of finding novel ways of measuring the overall performance of a country both over time and relative to that of her major competitors. One indicator is known as the Misery Index. It is thought to have been first used by the economist Robert Barro from the University of Chicago although some people credit the Misery Index to another American economist Arthur Okun. Writing in the 1970s, Barro simply added the rate of inflation to the rate of unemployment to give a crude measure of macroeconomic misery! Assuming that rising consumer price inflation and increasing rates of unemployment were both bad things, the measure quickly gained some currency especially during an age of stagflation, a combination of slow growth, fast-rising prices and more people out of work. This measure of the misery index has often come under criticism. Firstly it tends to imply that price deflation is a good thing, try asking that to Japanese consumers and businesses who have struggled to come to terms with a decade or more of deflationary recession that only now appears to be coming to an end. And secondly the measure ignores other possible indicators such as interest rates. Measuring the misery index for the UK economy
1 Unemployment 2 Inflation 3 Interest rates 4 Budget deficit 5 Current account 6 GDP growth 7 Misery Index

Tutor2u Limited 2008 www.tutor2u.net

Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

LFS measure % of labour force 6.9 8.5 9.8 10.5 9.8 8.8 8.3 7.2 6.3 6.1 5.6 4.9 5.2 5 4.8 4.7 5.4

CPI % change 7 7.5 4.3 2.5 2 2.6 2.5 1.8 1.6 1.4 0.8 1.2 1.3 1.4 1.4 2 2.3

3 month rate per cent 14 10.9 7.2 5.3 6.5 6.5 6.4 7.5 6.2 5.9 5.8 4 4 3.7 4.5 4.6 4.7

net borrowing % of GDP 0.3 -2.0 -5.7 -6.3 -4.8 -3.3 -2.8 -0.1 1.1 2.3 2.5 1.1 -1.0 -1.6 -1.5 -1.2 -0.4

% of GDP -4 -1.8 -2.1 -1.9 -1 -1.3 -1 -0.2 -0.5 -2.7 -2.6 -2.2 -1.6 -1.3 -1.6 -2.4 -3.4

per cent 0.7 -1.4 0.3 2.4 4.4 2.9 2.7 3.1 3.4 3 3.8 2.4 2.1 2.8 3.3 1.8 2.8 31.5 28.1 17.4 11.5 10.1 13.0 12.7 13.5 12.3 15.4 13.5 11.0 9.0 7.0 7.5 10.7 12.6

Misery Index (7) = column 1 + 2 + 3 + 4 - (5) 6 The higher the number the worse in the state of economic misery! A negative current account deficit is assumed to add to the Misery Index Source of data: UK Treasury, OECD

Economists at the US investment bank Merrill Lynch have recently published their own updated version of the misery index. Their calculation contains six macroeconomic indicators: 1. Unemployment - measured as a percentage of the labour force 2. Inflation measured by the annual percentage change in consumer prices 3. Interest rates the measure I have taken is the annual average for 3-month inter-bank lending 4. The budget deficit e.g. government net borrowing as a percentage of national income 5. The current account balance taken from annual balance of payments statistics 6. Economic growth measured by the annual percentage change in real GDP According to the Merrill Lynch methodology, higher interest rates are assumed to add to our misery (is this true for people who are net savers?) and they assume that a rising budget deficit is also bad news because it implies higher taxes in the future if government borrowing leads to an unsustainable rise in the accumulated national debt. A country running a current account deficit on its balance of payments is also considered a bad factor for the misery index because it suggests that a country is not paying its way in international trade with other countries. (A counter argument to this is that a deficit in trade is not necessarily bad since it might reflect increased imports of new technology or simply a preference among domestic consumers to enjoy lower priced foreign-produced goods and services). Finally the Merrill Lynch calculation takes away from the index the annual rate of growth of GDP. So faster growth reduces the overall state of misery (no account is taken of the sustainability of this short term growth in the years to come).
Tutor2u Limited 2008 www.tutor2u.net

Taking data from the last fifteen years, the year 2003 appears to have been the sweet-spot for the UK macroeconomy over recent times. In that year a combination of strong growth, falling unemployment, low inflation and low interest rates were instrumental in reducing the misery index. Since then there has been a gradual but noticeable deterioration in the index. Growth has been weaker and the economy has experienced a widening of the current account of the balance of payments and also a higher government budget deficit. Unemployment has stopped falling but inflation and interest rates remain low. Here are some questions that you might want to think about and discuss: 1. Does the Merrill Lynch misery index exclude factors that are potentially useful in measuring the degree of economic misery? Can you think of other indicators? Personal bankruptcies? House prices, share valuations? Perhaps we might include a factor that combines these and considers the annual change in peoples wealth? 2. In the calculation used in this article we assign no weightings between the various indicators, so a 0.5% increase in consumer price inflation has the same effect as a 0.5% decrease in the percentage of the labour force out of work. What case is there, if any, for applying some form of weighting to the calculations? Of course the Misery Index in reality is really a light hearted way of expressing how well or how badly a country is doing in meeting some of the important macroeconomic indicators. Inevitably there will be some trade-offs between these objectives over time, although the trade-offs themselves can change as we have seen in Britain over the last twenty years. But the Misery Index does have some validity in my opinion. Britain has built up a fairly enviable record for macroeconomic stability over the last ten years or more and this is shown clearly both in a lower Misery Index for the UK and our high rankings when compared to other leading countries. Suggestions for further reading on the misery index US misery index: www.miseryindex.us/ The Economist: Revamping the misery index www.economist.com/displaystory.cfm?story_id=5389316

Tutor2u Limited 2008 www.tutor2u.net

19.

Monetary Policy

How does monetary policy work? What does the Bank of England consider when setting interest rates and how effective has the Bank been in handling monetary policy since it was made independent of government in May 1997. These are some of the issues that we consider in this chapter. A recap on the basics of monetary policy

Monetary Policy - Base Rate of Interest for the UK


Percentage, since May 1997 base rates have been set by the Bank of England
8.0 7.5 7.0 6.5 6.0
Percent
8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0

5.5 5.0 4.5 4.0 3.5 3.0 97 98 99 00 01 02 03 04 05 06 07

Source: Reuters EcoWin

Monetary policy involves changes in the base rate of interest to influence the growth of aggregate demand, the money supply and price inflation. Monetary policy works by changing the rate of growth of demand for money. Changes in short term interest rates affect the spending and savings behaviour of households and businesses and therefore feed through the circular flow of income and spending. The transmission mechanism of monetary policy works with variable time lags depending on the interest elasticity of demand for different goods and services. Because of the time lags involved in setting an appropriate level of short-term interest rates, in the UK the Bank of England sets rates on the basis of hitting the inflation target over a two year forecasting horizon. Independence for the Bank

Tutor2u Limited 2008 www.tutor2u.net

The Bank of England has been independent of the Government 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 through the decisions of the Monetary Policy Committee prefers a gradualist approach to monetary policy believing that a series of small movements in interest rates is a more effective strategy in achieving their aims rather than sharp and unexpected jumps in the cost of borrowing money. Knee jerk changes in monetary policy can be very unsettling for both consumers and businesses throughout the economy. The role of monetary policy A summary of the role that monetary policy plays is provided in this quote from the Government of the Bank of England, Mervyn King.
The role of monetary policy the Governors view What is the mechanism by which monetary policy contributes to a more stable economy? I would argue that monetary policy is now more systematic and predictable than before. Inflation expectations are anchored to the 2% target. Businesses and families expect that monetary policy will react to offset shocks that are likely to drive inflation away from target. In the jargon of economists, the policy reaction function of the Bank of England is more stable and predictable than was the case before inflation targeting, and easier to understand. More simply, monetary policy is not adding to the volatility of the economy in a way that it did in earlier decades. Adapted from The Inflation Target Ten Years On, Mervyn King in October 2002

Monetary Policy and the Exchange Rate There is no official exchange rate target for the British economy. The UK operates within a floating exchange rate system and has done ever since we suspended our membership of the European exchange rate mechanism (the ERM) in September 1992. The Monetary Policy Committee has occasionally discussed the relative merits and de-merits of intervening in the current markets to influence the external value of the pound but no official intervention has occurred for over a decade. There are in any case doubts about the effectiveness of direct intervention in the foreign exchange markets as a means of achieving a desired exchange rate. Monetary policy and the money supply There are currently no targets for the growth of the money supply measured by MO and M4. Data on the growth of the stock of money provides useful information for the MPC on the strength of aggregate demand but interest rates are not determined with reference to specific targets for the money supply. In addition the UK no longer imposes supply-side controls on the growth of bank lending and consumer credit. Instead monetary policy in the UK is designed to control the growth in the demand for money through changing the cost of loans and influencing the incentive to save via changes in interest rates. The determination of interest rates how the Bank gets to work in the markets It is important to understand how the BOE influences interest rates via daily intervention in the London money markets. Each day there are huge flows of money from the government to banks and vice versa. Usually more money flows from the banks to the government (for example people and companies paying their income tax) so, each day there is a shortage in the market.

Tutor2u Limited 2008 www.tutor2u.net

The BOE is the main provider of liquidity to the wider financial system, in the markets it is known as the lender of last resort. It can choose the interest rate it wishes to charge to financial institutions requiring money. The interest rate at which the BOE is prepared to lend to the financial system is quickly passed on, influencing interest rates in the whole economy - for example the rate of interest on mortgages and the rates on offer to savers. Monetary policy in Britain is designed to be pro-active and forward-looking because changes in interest rates always take time to work through the economy. The reaction of businesses and consumers to interest rate movements is uncertain, as are the time lags involved. The belief is that by making interest rate changes in a pre-emptive fashion, for example raising rates before the rate of growth of AD becomes too fast, or cutting rates to reduce the risks of recession, then the scale of interest rate changes needed to meet the inflation target will be reduced. The thinking is that a monetary policy regime that offers the prospects of relatively stable interest rates over time can help to promote consumer and business confidence. Factors considered by the Monetary Policy Committee Before each meeting of the Monetary Policy Committee, a huge raft of economic information is put before members of the MPC rate-setting board. Much of the data that is considered will be information that you may have become familiar with during your AS and A2 economics courses. The economic data considered each month by the MPC includes the following: o GDP growth and spare capacity: The rate of growth of real national output and the estimated size of the output gap are central to discussions within the MPC about setting the appropriate level of interest rates. Their main task is to set monetary policy so that demand grows more or less in line with the increase in the countrys productive potential. o Bank lending and consumer credit figures including the levels of mortgage equity withdrawal from the housing market and also monthly data on credit card lending. o Equity markets (share prices) and house prices - both are considered important in determining household wealth which then feeds through to borrowing and retail spending. The state of play in the UK housing market has been influential in shaping interest rate decisions over the last two to three years although we must remember that the monetary policy committee has no official target for the annual rate of house price inflation. o Consumer confidence and business confidence indicators confidence surveys are thought to provide useful advance warning of possible turning points in the economic cycle. So for example, a sharp dip in consumer optimism might herald a retrenchment of spending which could lead to slower GDP growth and a weakening of inflationary pressure. o The growth of wages, average earnings and unit labour costs in the labour market these are considered important as indicators of demand pull and cost push inflationary pressure. The Monetary Policy Committee might become concerned if the annual rate of wage inflation surged above the 5% mark as this might eventually feed through into a rise in consumer prices. o Unemployment figures and survey evidence on the scale of shortages of skilled labour these are also labour market indicators as was mentioned in the last bullet point. o Trends in global foreign exchange markets for example the trend in the value of sterling against the Euro or the US dollar. A weaker exchange rate could be seen as a threat to inflation because it raises the prices of imported goods and services.

Tutor2u Limited 2008 www.tutor2u.net

o Forward looking indices such as the Purchasing Managers Index and quarterly surveys of business confidence including data from the Confederation of British Industry and the British Chambers of Commerce o International economic data including recent macroeconomic developments in the twelve member nations of the Euro Zone and the worlds largest economy, the United States.

UK Output Gap and Base Interest Rates


Base interest rates set by the MPC since M97, data for 2008 is a forecast from the OECD
17.5 15.0 12.5 10.0 7.5
Per cent
17.5

Base Interest rates

BoE made independent

15.0 12.5 10.0 7.5 5.0 2.5 0.0

5.0 2.5 0.0


Zero output gap along this line

-2.5 -5.0 -7.5 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

-2.5 -5.0 -7.5

Source: Reuters EcoWin

The neutral rate of interest One important feature of interest rate setting both in the UK and overseas is the concept of a neutral rate of interest. The idea behind this is that there might be a rate of interest that neither deliberately seeks to stimulate aggregate demand and growth, nor deliberately seeks to weaken growth from its current level. In other words, a neutral rate of interest would be that which is set at a level which encourages a rate of growth of demand close to the estimated trend rate of growth of real GDP. There cannot be an exact measure of the neutral rate, and it will certainly differ from country to country. Students who want to explore this further might want to read up on something called the Taylor Rule In Britain over most of the present decade, interest rates set by the Bank of England have almost certainly been below the estimated neutral rate. Why? Well the Bank has been careful to maintain economic growth given the absence of any serious threat from higher inflation. In the summer of 2003, the MPC cut interest rates to 3.5% and it was quite clear at the time that monetary policy was being expansionary. This means that monetary policy was actively seeking to stimulate confidence and spending in the domestic British economy at a time of great global economic uncertainty.

Tutor2u Limited 2008 www.tutor2u.net

A recent survey of city economists (admittedly a small but pretty high-powered sample!) puts the neutral rate of interest in the UK at between 4.5 5.5%. At the time of writing UK official short-term interest rates are at 5.75%. This suggests that monetary policy in the UK is now erring on the side of caution in trying to limit any upside inflationary risks. The monetary policy transmission mechanism The transmission mechanism of monetary policy is illustrated in the flow chart below:
Mapping out the transmission mechanism the effects of changes in interest rates

Market interest rates E.g. savings rates & credit cards Domestic Demand I.e. C + I + G Asset prices E.g. house prices Official Interest Rate Net External Expectations and Demand Confidence i.e. X - M Businesses & consumers Import Prices Consumer Price Exchange rate Inflation Aggregate Demand Domestic Inflationary Pressure

Time lags and asymmetries in the transmission mechanism Although a change in interest rates affects the macro-economy in several ways, there are inevitable time lags in involved. It is also worth stressing that some sectors of the economy are more affected by base interest rate changes than others and some regions are also more exposed to a change in the direction of interest rates. For example industries that export a high percentage of their output will be more exposed to movements in the exchange rate that might follow from a change in monetary policy. Similarly markets where consumer demand is sensitive to interest rate changes will be affected to a greater extent than markets where the interest elasticity of demand is lower. Consider for example the effect of a 2% rise in interest rates over a period of 6 months. The demand for basic foods and clothing is unlikely to be influenced much by this whereas the demand for new cars, expensive household durable goods and other interest sensitive products will probably experience a much greater change in demand from consumers.
Tutor2u Limited 2008 www.tutor2u.net

The impact of interest rate movements is not uniform throughout the economy. But the Bank of England sets interest rates to meet a national inflation target of 2.0%, and cannot be expected to determine interest rates to meet the particular needs of an individual industry, sector or region of the country. Macro-policies that seek to raise the level of aggregate demand and output are called accommodatory policies. In other words, they boost demand beyond what would normally happen through the working of the automatic stabilisers. The Role of Inflation Targets Inflation targets have been in place in the UK since the autumn of 1992 and they have also become a frequent feature of macroeconomic policy-making in many other countries. They were first introduced following the UKs departure from the ERM because it was believed that a credible anti-inflation economic policy needed a clear anchor by which the policy could be judged. The inflation target that has been introduced in Britain is symmetrical this means that temporary deviations of inflation below the target are treated with the same degree of importance as deviations above the target. The main reason for this design of the inflation target is that monetary policy should not only deliver price stability, but also seeks to support the broader aims of sustained economic growth and high employment. If the inflation target was set at 2% or below, there might be a tendency for the Bank of England to drive inflation as low as possible to ensure they meet the inflation target. But this would risk creating deflationary pressures in many sectors of the economy to such an extent that unemployment might be higher and national output lower than desired. The Bank of England is as concerned to avoid some of the economic and social costs of deflation as it is the well documented implications of a surge in inflation. Inflation has been remarkably stable since the early 1990s. The next table provides long-term data for UK inflation since 1950. The average annual rate of inflation fell from 13.1% during the 1970s to just 2.5% since the introduction of the inflation targets. Notice too that the standard deviation of inflation (a measure of variance) has also come down sharply over the last ten years. The 1970s and 1980s were by and large, decades of high and volatile inflation. By contrast, the last fifteen years has been a period of much greater stability, leading to a sustained fall in inflationary expectations Long Term Inflation Data for the UK
Annual average percentage change in retail prices Mean Inflation 1950-59 4.1 1960-69 3.7 1970-79 13.1 1980-92 6.4 1993-02 2.5 Standard Deviation 1.06 0.72 1.81 1.14 0.21 Source: Bank of England www.bankofengland.co.uk

There is now a consensus that low and stable inflation can contribute to growth and employment creation in the long run. To that end, many countries have put in place inflation targets. Main Advantages of a Credible Inflation Target Business planning and investment: Businesses are better able to plan ahead if they believe that the inflation target will be met. They will be more certain about their costs and expected rates of return on investment
Tutor2u Limited 2008 www.tutor2u.net

Policy transparency: An inflation target provides improved transparency and accountability for the conduct of monetary policy the general public can see for themselves whether the target is being achieved and whether economic policies are being effective. The target provides clear rules for monetary policy which in the long term enhances policy-making effectiveness. Controlling inflationary expectations: A credible target lowers expectations of inflation and this helps to control the growth of wages, in other words, a well designed inflation target can be seen as a key policy anchor.

The Problems involved in Forecasting Inflation Inflation in any economy can never be forecast with perfect accuracy! For a start, the published inflation measure is the result of millions of pricing decisions made by businesses large and small operating in thousands of different markets and sub-markets. The calculation of the consumer price index in the UK although extremely thorough, is always subject to error and omission. Furthermore, the complex nature of the inflation process makes it difficult to forecast, even when inflationary conditions appear to be benign. External shocks can make forecasts inaccurate. For example, a jump in world oil prices or the falls in global share prices both have feedback effects through the economic system. The exchange rate can fluctuate leading to volatile import prices. The Bank of England in its quarterly Inflation Report does not even attempt to forecast a precise rate of inflation over its two year forecasting horizon. Instead it produces a colourful fan-chart which encompasses its central forecast for inflation based on the probabilities of inflation falling within certain ranges over the next twenty-four months. The central projection is always that the inflation target will be met. But it could not be otherwise, for if the Bank was to say that its current interest rates were not appropriate to meeting the inflation target going forward, and then a change in policy would be required! The Banks latest projection for inflation The Banks latest projection for GDP growth

Source: BoE Inflation Report, August 2007


Tutor2u Limited 2008 www.tutor2u.net

Price stability Inflation has been low and stable in recent years. The former Chairman of the US Federal Reserve, Alan Greenspan has defined price stability as follows:
We will be at price stability when households and businesses need not factor expectations of changes in the average level of prices into their decisions. Price stability" implies that business and household decision-making should be able to proceed on the basis that "real" and "nominal" values are substantially the same over the planning horizon Source, Chairman of the US Federal Reserve, in a speech made in 2000 The current chairman of the US Federal Reserve is Ben Bernanke

There is no hard and fast numerical rule for price stability but steady inflation of 1-3% must come close to meeting the requirements in this sense, the British economy has enjoyed a return to price stability in recent years.

Reasons for low inflation in the UK in recent years


Average Earnings % change 2000 2001 2002 2003 2004 2005 2006 Unit Labour Costs % change Producer Output Prices % change Retail Price Index (CPI) % change Consumer Price Index (CPI) % change

4.5 4.9 4.0 3.6 4.2 4.0 3.7

3.4 3.6 2.0 2.3 1.8 3.6 1.9

1.5 -0.3 0.0 1.5 2.5 2.8 2.5

2.9 1.8 1.6 2.9 3.0 2.8 3.2

0.8 1.2 1.3 1.4 1.4 2.0 2.3

Tutor2u Limited 2008 www.tutor2u.net

World Inflation
Annual percentage change in consumer prices, source IMF World Economic Outlook

35

30

25
Percent per Annum

20

15

10

0
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

Source: Reuters EcoWin

Among the factors helping to keep inflation in Britain low, we can identify the following: o Low wage inflation from the labour market: There has been a very subdued growth of wages and earnings which have grown at a fairly modest rate in recent years, staying close to and below the Bank of Englands desired upper limit of approximately 4.5% per year despite the sustained fall in unemployment. o Low global inflation and deflation in some countries: The absence (until recently) of major external global inflationary shocks such as a sharp jump in international commodity prices. o The effectiveness of monetary policy in the UK: The success of the Bank of England in keeping aggregate demand under control through interest rate changes. o Increased contestability of many markets: Microeconomic supply-side reforms has led to much greater competitive pressure in many industries 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. In some industries there has been a huge reduction in the pricing power of businesses, globalisation has accelerated this process. o Strength of the exchange rate: The recent strength of the pound over the years 1996-2002 has undoubtedly helped to keep inflation under control because it lowers the sterling cost of imported products and also squeezes demand for UK exporters. o Information technology effects: The rapid expansion of information and communication technology has helped to reduce costs and has made prices more transparent for consumers.
Tutor2u Limited 2008 www.tutor2u.net

o Price cuts within the utilities: Cuts in the prices charged by many of the privatised utilities under the regulatory regime of bodies such as OFTEL and OFGEM. o Sharp decline in inflation expectations: Expectations of inflation have fallen leading to a fall in inflationary wage demands. The wage price spiral has been largely absent from the British economy over the last decade or more. The Governor of the Bank of England, Mervyn King has coined the 1990s as the nice decade a period of time when a combination of favourable factors has kept inflation in check allowing continued economic growth and a fall in unemployment!

Suggestions for Further Reading on Monetary Policy Bank of England fact sheet on the transmission mechanism of monetary policy Bank of England Inflation Report BBC news reports on the Bank of England Faced with uncertain outlook, rate setters slip into neutral (The Guardian, August 2007) Guardian special reports on interest rates and UK monetary policy Houses, inflation and interest rates (The Times, November 2006) How interest rates help to stop prices going out of control (The Times, October 2006) How pound's rise or fall hits prices (The Times, November 2006) Inside the Bank of England (Edmund Conway slideshow August 2007) Mervyn King is too tough on interest rates (Telegraph, August 2007) Record numbers face debt meltdown (Telegraph, August 2007) The markets' vital rate-setting role (The Times, January 2007) The MPC ten years on lecture by Mervyn King (BoE) How do interest rates affect inflation? (Bank of England web-site)

Tutor2u Limited 2008 www.tutor2u.net

20.

The Exchange Rate

We now turn to focus to the effects of exchange rates on the macroeconomy and in particular to the economics of fixed versus floating exchange rate systems as part of the operation of macroeconomic policy in a country.

Measuring the exchange rate Exchange rate prices are expressed in various ways: o Spot Exchange Rate - the spot rate is the actual exchange rate for a currency at current market prices. This is determined by the FOREX market on a minute-by-minute basis on the basis of the flow of supply and demand for any one particular currency. o Forward Exchange Rate - a forward rate involves the delivery of currency at some time in the future at an agreed rate. Companies wanting to reduce the risk of exchange rate uncertainty by buying their currency forward on the market often use this. o Bi-lateral Exchange Rate - this is simply the rate at which one currency can be traded against another. Examples include: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro o Effective Exchange Rate Index (EER) - the EER is a weighted index of sterling's value against a basket of international currencies the weights used is determined by the proportion of trade between the UK and each country. o Real Exchange Rate - this measure is the ratio of domestic price indices between two countries. A rise in the real exchange rate implies a worsening of competitiveness for a country. Exchange rate systems System Free Floating Exchange Rate Main Characteristics Recent UK History

The value of the pound is determined purely Rare for pure free floating to exist by market demand and supply of the Sterling has floated freely on the currency foreign exchange markets since the Both trade flows and capital flows affect the UK suspended membership of the exchange rate under a floating system ERM in September 1992 No target for the exchange rate is set by the The Bank of England has not Government intervened officially in the markets to influence the pounds value since it There is no need for official intervention in became independent the currency market by the central bank

Managed Floating Exchange Rate

The value of the pound determined by Governments normally engage in market demand for and supply of the managed floating if not part of a currency fixed exchange rate system. Central banks may to try to iron out big changes in exchange rates on a day-to-day basis Some currency market intervention might be Managed floating was a policy considered as part of macro-economic pursued from 1973-1990
Tutor2u Limited 2008 www.tutor2u.net

demand management (e.g. a desire for a slightly lower currency to boost export demand or the desire for a strong currency to control inflationary pressures)

Semi-Fixed Exchange Rates

The exchange rate is given a specific target

The last time the UK operated a semifixed system was during October The currency can move between permitted 1990 - September 1992 the period bands of fluctuation on a day-to-day basis of the UKs short-lived period of ERM Exchange rate becomes an target of membership economic policy-making (interest rates are Sterling was allowed to vary set to meet the exchange rate target) between 6% either side of DM2.95 The Bank of England might have to intervene Sterling eventually forced out of the to maintain the value of the currency within ERM by a wave of speculative selling the set targets if it moves outside the agreed range Re-valuations are seen as a last resort

Fully-Fixed Exchange Rates

The government makes a commitment to a The Bretton Woods System which fixed exchange rate lasted from 1944-1972 was a fixed rate system where currencies were The exchange rate is pegged tied to the US dollar There are no fluctuations from the central Gold Standard in the inter-war years rate with currencies linked to gold System achieves exchange rate stability but Countries joining EMU fixed their perhaps at the expense of domestic stability exchange rates until 1st Jan 2002 A country can automatically improve its when the Euro came into common competitiveness by reducing its costs below circulation that of other countries knowing that the exchange rate will remain stable

Tutor2u Limited 2008 www.tutor2u.net

United Kingdom Effective Exchange Rate Index


Trade-weighted index value for sterling in the foreign exchange market, daily value
110
110

105

105

100

100

Index

95

95

90

90

85

85

80 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

80

Source: Reuters EcoWin

Fixed versus floating exchange rates which is best for an economy? Each country must decide on the most appropriate currency regime or system. There is an ongoing debate in economics about the merits and de-merits of fixed versus floating exchange rates. 1. 1973-1990: UK operated with a managed floating exchange rate. There was some intervention by the central bank to influence the exchange rate and government was in control of interest rates 2. October 1990- September 1992: UK a member of the European exchange rate mechanism (ERM) the exchange rate was a specific target of economic policy. Interest rates had to be set at a level consistent with keeping sterling within the agreed ERM bands (limits) 3. September 1992 present day: the UK has operated with a free-floating exchange rate no intervention by the Bank of England. Exchange rate is purely market determined. Since 1999, the Euro has been in existence as twelve nations have established a single currency. Sterling floats freely against the Euro and also against the dollar, yen etc. The case for floating exchange rates: The main arguments for adopting a floating exchange rate system are as follows: 1. Reduced need for currency reserves: There is no exchange rate target so there is little requirement for the central bank (e.g. the Bank of England) to hold large scale reserves of gold and foreign currency to use in possible official intervention in the markets 2. Useful instrument of macroeconomic adjustment: A floating rate can act as a useful tool of macroeconomic adjustment for example depreciation should provide a boost to net export
Tutor2u Limited 2008 www.tutor2u.net

demand and therefore stimulate growth. This assumes that the gains from a lower exchange rate are not dissolved in higher wage claims or export prices. The countries inside the Euro Zone for example might be hoping for a more competitive exchange rate as a means of creating an injection of demand into their slow-growing economies. 3. Partial automatic correction for a trade deficit: Floating exchange rates offer a degree of adjustment when the balance of payments is in fundamental disequilibrium i.e. a large trade deficit puts downward pressure on the exchange rate which should help the export sector and control demand for imports because they become relatively expensive 4. Reduced risk of currency speculation: The absence of an explicit exchange rate target reduces the risk of currency speculation. Often, currency market speculators target an exchange rate target that they believe to be fundamentally over or undervalued. 5. Freedom (autonomy) for domestic monetary policy: The absence of an exchange rate target allows short term interest rates to be set to meet domestic macroeconomic objectives such as stabilising growth or controlling inflation. The Bank of England has enjoyed the autonomy that a floating exchange rate gives since it was made independent in May 1997. 6. Floating exchange rates are not always volatile exchange rates - although the sterling exchange rate has been floating, the volatility has not been that great. Businesses have learnt to cope with modest fluctuations helped by having a flexible labour market.

Sterling - US Dollar Exchange Rate


Pounds sterling per US dollar, daily closing exchange rate
0.750 0.725 0.700 0.675 0.650
per $1
0.750 0.725 0.700 0.675 0.650 0.625 0.600 0.575 0.550 0.525 0.500 0.475

0.625 0.600 0.575 0.550 0.525 0.500 0.475 00 01 02 03 04 05 06 07

Source: Reuters EcoWin

The Case for Fixed Exchange Rates The main arguments for adopting a fixed exchange rate system are as follows:
Tutor2u Limited 2008 www.tutor2u.net

1. Trade and Investment: Currency stability can help to promote trade and investment because of lower currency risk this is one of the reasons why currencies were locked within the Euro Zone in preparation for the launch of the Euro. 2. Some flexibility permitted: Some adjustment to the fixed currency parity is possible if the economic case becomes unstoppable (i.e. the occasional devaluation or revaluation of the currency if agreement can be reached with other countries). That said, countries with fixed exchange rates are often reluctant to make parity adjustments these decisions are often see as politically damaging. 3. Reductions in the costs of currency hedging: Because we can never predict what will happen to the market value of a currency, many businesses hedge against this volatility by buying the currency they need in the forward currency markets. With fixed exchange rates, businesses have to spend less on currency hedging if they know that the currency will hold its value in the foreign exchange markets (hedging involves risk) 4. Disciplines on domestic producers: A stable (fixed) currency acts as a discipline on producers to keep their costs and prices down and may lead to greater pressure for exporters to raise labour productivity and focus more resources on research and innovation. In the long run, with a fixed exchange rate, one countrys inflation must fall into line with another (and thus put substantial competitive pressures on prices and real wages) 5. Reinforcing gains in comparative advantage: If one country has a fixed exchange rate with another, then differences in relative unit labour costs will quite easily be reflected in changes in the rate of growth of exports and imports. Consider the example of China and the United States. China has a $100 billion trade surplus with the United States and it has also fixed its exchange rate against the US dollar. The pegged exchange rate between the Yuan and the dollar has been in place for several years. Most estimates indicate that the Chinese currency is undervalued against the dollar. This makes Chinese products cheaper than they would otherwise be and has led to a surge in import penetration from China into the US economy. This has led to numerous calls from US manufacturers for the Chinese to be persuaded to switch to a floating exchange rate or to adjust their currency by appreciating against the dollar. Finally in July 2005, the Chinese authorities did revalue their currency against the dollar and announced a new policy of allowing the Yuan to move against a basket of currencies, dominated by the dollar.

Tutor2u Limited 2008 www.tutor2u.net

China Spot Exchange Rate against the US Dollar


Chinese Yuan to the US Dollar
8.5 8.4 8.3 8.2 8.1
USD/CNY
8.5 8.4 8.3 8.2 8.1 8.0 7.9 7.8 7.7 7.6 7.5

8.0 7.9 7.8 7.7 7.6 7.5 95 96 97 98 99 00 01 02 03 04 05 06 07

Source: Reuters EcoWin

The relationship between interest rates and the exchange rate In a floating exchange rate system relative interest rates do have an influence on the market value of one currency against another. To understand this, consider the risks and returns that face investors when deciding in which country to allocate their financial investments. If UK interest rates are relatively higher than rates on offer in the Euro Zone, then ceteris paribus we expect to see a net inflow of currency into UK banks and other financial institutions. The higher the interest rate differential, the greater is the incentive for funds to flow across international boundaries and into the economy with the higher interest rates. Speculative flows of currency will also flow into those economies where the expected returns on other types of investment are also higher. For example, money may flow into the UK as investors look to put their money into property or the stock and bond markets. Such a wall of speculative funds can have a powerful effect in the currency markets. You could show this by drawing an outward shift in the demand for sterling, leading to an appreciation in the value of the currency. There are inevitable risks in shifting funds across international markets. What might happen to the currency if you leave $200,000 worth of cash in a UK bank account? What happens to the value of your investment if sterling depreciates against the US dollar? What are the risks in exchanging a similar value of US dollars and putting it into the UK stock market or into government bonds?
Tutor2u Limited 2008 www.tutor2u.net

Investors often consider the risk-adjusted relative rate of return from different financial investments. Thus if UK interest rates are persistently above those in other countries, and the risks are pretty similar, then we would expect to see a rising demand for sterling and an appreciation of the currency. Interest rates are not the only factor that drives the external value of a currency in the foreign exchange markets but they undoubtedly do have some effect. Can you see any relationship between UK and Euro Zone interest rates and the /Euro exchange rate in the chart below?

Euro - Sterling Exchange Rate and Interest Rates


Value of one Euro, daily closing exchange rate, policy interest rates (%)
0.725 0.700
Pence per Euro1
0.725 0.700 0.675 0.650 0.625 0.600 0.575 0.550 6.5 UK Interest Rates 6.0 5.5 5.0 4.5 4.0 3.5 3.0 Euro Zone Interest Rates 2.5 2.0

0.675 0.650 0.625 0.600 0.575 0.550 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 99 00

Pence per Euro1

01

02

03

04

05

06

07

Source: Reuters EcoWin

How the exchange rate influences policy objectives, such as inflation, unemployment and the balance of payments. For A2 economics, it is important to understand the transmission mechanism between a change in the exchange rate and its impact on the wider macro-economy. Recent trends in currencies and currency forecasts certainly figure prominently in the assessment of economic conditions made each month by the Monetary Policy Committee, although the Bank does not formally target the exchange rate since the UK operates with a floating exchange rate system.
Time lags of exchange rate changes For evaluation, remember that the macroeconomic effects of exchange rate movements are always subject to a time lag. Research from the Bank of England suggests that the effects take two years to feed through.

The exchange rate and inflation:


Tutor2u Limited 2008 www.tutor2u.net

Inflation and the Exchange Rate for the UK


Exchange rate index (top pane) and inflation (lower pane)
110
Sterling Exchange Rate Index 110 105 100 95 90 85 80 Consumer Price Inflation 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

105 100
Index Percent

95 90 85 80 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

95

96

97

98

99

00

01

02

03

04

05

06

07

Source: Reuters EcoWin

The exchange rate affects the rate of inflation in a number of direct and indirect ways: 1. Changes in the prices of imported goods and services this has a direct effect on the consumer price index. For example, an appreciation of the exchange rate usually reduces the sterling price of imported consumer goods and durables, raw materials and capital goods. The effect of a changing currency on the prices of imported products will vary by type of import and also the price elasticity of demand whichServices Inflation in is influenced by the extent of competition within individual markets. 2. Commodity prices and the CAP: Many internationally traded commodities are priced in dollars so a change in the sterling-dollar exchange rate has a direct impact on the price of commodities such as oil. The operation of the Common Agricultural Policy (CAP) can also help to absorb fluctuations in the prices of imported foodstuffs because of the variable import tariff. If world prices rise, the import tariff can fall to insulate the EU from the effects of higher import costs. 3. Changes in the growth of UK exports movements in the exchange rate affect the competitiveness of UK export industries in global markets. A higher exchange rate makes it harder to sell overseas because of a rise in relative UK prices. If exports slowdown (price elasticity of demand is important in determining the scale of any change in demand), then exporters may choose to cut their prices, reduce output and cut-back employment levels. A fall in export demand will reduce real national income relative to potential output and thus might lead to a negative output gap. This puts downward pressure on inflation 4. The exchange rate and wage bargaining some economists believe that the exchange rate influences the power of employees to bargain for increases in real wages. When the exchange
Tutor2u Limited 2008 www.tutor2u.net

rate is high, there is pressure on businesses to control their costs of production in order to remain competitive this may lead to downward pressure on wage inflation. Bank of England research suggests that a10% depreciation in the exchange rate can add up to 3% to the level of consumer prices three years after the initial change in the exchange rate. But it is important to realise that the impact on inflation of a change in the exchange rate depends on the cause of the fluctuation and on what else is going on in the economy.
Interest rate response: The final effects on inflation depend also on the response of economic policies to exchange rate movements. For example if a rising value of sterling causes inflation to drop below target, the Monetary Policy Committee might opt to reduce short term interest rates in order to stabilise demand and prevent the risk of price deflation.

The exchange rate and unemployment To the extent that movements in the exchange rate affect the growth of demand, output and investment in those sectors of the economy exposed to international trade, the rate of unemployment can also be influenced by currency fluctuations. In broad terms: An exchange rate appreciation tends to cause a slower rate of growth of real GDP (e.g. because of a fall in net exports) A reduction in demand and output may cause job losses as businesses seek to control costs. Some job losses are temporary reflecting short term changes in export demand and import penetration. Others are permanent if domestic industries move out of some export markets or if imports take up a permanently higher share of the UK market Some industries are more exposed than others to currency fluctuations e.g. sectors where a high percentage of total output is exported and where demand is highly price sensitive (price elastic)

AD-AS analysis can be used to illustrate the effects. In the first diagram, we see an inward shift in the AD curve due to a rise in net imports and in the second diagram we draw the effects of a reduction in production costs arising from cheaper raw material and component prices.

Tutor2u Limited 2008 www.tutor2u.net

Inflation LRAS

Inflation

LRAS

SRAS1 SRAS AD1 SRAS2 AD2 AD

Y2

Y1

Real National Output

Y1 Y2

Real National Output

A fall in export demand - lower GDP negative output gap

A fall in the cost of importing raw materials - Increase in GDP reduction in inflation

The Economic Benefits of a Strong Pound The strong pound has been largely positive for the UK, playing to the strengths of the British economy. The recent fall in the dollar not withstanding, the pound has enjoyed continuous strength on a trade-weighted basis for 10 years. When sterling was ejected from the European exchange rate mechanism in 1992, the withdrawal prompted a drastic fall of the trade-weighted pound by 15 per cent. It then rose back to pre-1992 heights between late 1996 and May 1997 - a level it has kept ever since. The strong pound helped speed a far-reaching move from manufacturing to a service economy, which now accounts for 75 per cent of UK gross value added - up from 65 per cent 10 years ago. High exchange rates in the UK made imported goods cheap and kept domestic prices in check. This allowed the Bank of England to keep interest rates down. Manufacturers struggling to keep up would consider this a small consolation. Their share of the economy decreased from one-fifth to a little over one-10th within 10 years. But the transition to a service economy was already under way. The high pound was but a catalyst. Those manufacturers that have survived, moreover, have had to re-engineer their businesses and become highly competitive. Often, they are in multinationals, importing material to keep costs down, with the UK labour component a small part of overall costs. That, incidentally, partly explains the deterioration in the trade deficit. No one knows where the pound is heading - it is not even clear why it rose so precipitously in 1996 and 1997. But it is hard to imagine a similarly fortunate set of circumstances for the UK: a swift transition to a modern service economy, with cheap trips abroad thrown in. Adapted from a Financial Times leading article, April 2007

Suggestions for further reading on the exchange rate High Euro eats into BMW profits (BBC news, August 2007) Dollar falls to record Euro low (BBC news, July 2007)
Tutor2u Limited 2008 www.tutor2u.net

Pound reaches 26 year dollar high (BBC news, April 2007) Is the $2 pound a good thing? (Telegraph, April 2007)

Tutor2u Limited 2008 www.tutor2u.net

21.

Fiscal Policy - Taxation and Public Expenditure

The governments handling of its own spending taxation and borrowing is the key component of fiscal policy. In this chapter we delve deeper into some aspects of fiscal policy drawing on the concepts covered at AS level.

What is 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. A rise in government expenditure, or a fall in the burden of taxation, should increase aggregate demand and boost employment. The size of the resulting final change in equilibrium national income is determined by the multiplier effect. The larger the national income multiplier, the greater the change in national income will be. However fiscal policy is also used to influence the supply-side performance of the economy. For example, changes in fiscal policy can affect competitive conditions individual markets and industries and change the incentives for people to look for work and for companies to invest and engages in research and development. Government capital spending on transport infrastructure and public sector investment in education and health can also have a direct but unpredictable effect in the long run on the competitiveness and costs of businesses in every industry. Government Spending Government spending can be broken down into three main categories: o General government expenditure - consists of the combined capital and current spending of central government including debt interest payments to holders of government debt o General government final consumption - is government expenditure on current goods and services excluding transfer payments o Transfer payments transfers are transfers from taxpayers to benefit recipients through the working of the social security system. The total welfare bill now exceeds 140 billion per year Government Spending and Fiscal Policy Objectives The Treasury has outlined the main goals of fiscal policy to be the following: o Equity concerns: To ensure that government spending and taxation impact fairly within and across generations fiscal policy should be equitable to current and future generations o Funding government spending: To meet the governments spending and tax priorities without a damaging rise in the burden of government debt o The benefit principle: This principle seeks to ensure that those who benefit from public services such as the benefits from education, health and transport also meet as far as possible the costs of the services they consume o Macroeconomic stability: Fiscal policy in the UK is now designed to support monetary policy in smoothing the path of aggregate demand over the economic cycle and in contributing to an environment of sustainable growth and stable inflation this is the main macroeconomic objective of fiscal policy. Gordon Brown has introduced two fiscal rules to support this objective

Tutor2u Limited 2008 www.tutor2u.net

General Government Expenditure In Real Terms


billion per year, source: Public Finance Statistics
500 450
(billions)
Total UK Government Spending 500

450

400 350 300 300 250

400

350

300 300 250

(billions)

Govt spending on goods and services

150 100
Govt spending on social security

150 100 50

50 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Source: Reuters EcoWin

With the total level of government spending rising above 480 billion in 2005 and 500bn in 2006, much concern has been given to the actual results from this level of public sector spending. In particular the size of the state sector has been criticised by those who claim that public sector spending is open to a high level of waste and lack of efficiency. The media often talk of the need for the public services to deliver value for money in terms of meeting peoples needs and wants. Successive governments have striven to improve the efficiency with which public services are provided. This has included the widespread use of contracting-out and competitive tendering where private sector businesses compete with the public sector for the contracts to provide services such as NHS catering, laundry and cleaning services, together with maintenance of the road network and aspects of the prison service. The government has also introduced value for money audits for each major government spending department together with a huge and growing number of performance targets.

Tutor2u Limited 2008 www.tutor2u.net

billions

200

200

billions

22.

Direct and Indirect Taxation

We now focus on taxation. Taxation is any compulsory levy from private sector households and businesses to the government in the form of direct or indirect taxes. The main objectives of the UK tax system The current government's objectives for the British tax system are broadly as follows: 1. The burden of tax: To keep the tax burden as low as possible (the burden of tax for a country can be measured by the % of GDP taken in taxes and is shown in the chart above) 2. To improve incentives: The government believes that reducing tax rates on income and business profits helps to sharpen incentives to work and create wealth in the economy as a strategy to enhance long-run growth 3. Tax spending rather than income: To shift the balance of taxation away from taxes on income towards taxes on spending this is because it is thought that taxes on income have a greater effect on work incentives 4. Equitable taxes: To ensure taxes are applied equally and fairly to everyone. Equality is not always the same as fairness see the notes below on the canons of taxation 5. Correct for market failure: As with many other governments in other countries, the UK government believes in the use of taxes to make markets work better (including taking account of externalities) this is an important microeconomic objective. The government is committed to using the tax system as an instrument of correcting for market failures.

Tutor2u Limited 2008 www.tutor2u.net

Revenues from Income Tax, VAT & Corporation Tax


Current Prices, billion. Source: HM Treasury
150
150

125

125

100
GBP (billions)

100

75

Income tax

75

50
VAT

50

25
Corporation tax

25

0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Source: Reuters EcoWin

The table below shows the main sources of direct and indirect tax revenues for the UK for 2005. Income tax and national insurance contributions together account for over 205 billion of government tax revenues each year. VAT is the biggest single source of indirect tax revenue although over 40 billion of revenue comes each year from excise duties.
Income from taxation for the UK government Income tax National Insurance contributions VAT Corporation tax Fuel duties Council Tax Business rates Other taxes Stamp duties Tobacco duty Vehicle excise duty Beer & cider duties Inheritance tax Spirits duties Insurance Premium tax Capital gains tax Wine duties
Tutor2u Limited 2008 www.tutor2u.net

1999-00 billion 95.7 56.1 56.4 34.3 22.5 13.1 15.4 8.1 6.9 5.7 4.9 3.0 2.1 1.8 1.4 2.1 1.7

2005-06 billion 135.0 85.5 73.0 42.0 23.4 20.9 18.7 11.7 10.9 8.0 5.0 3.2 3.5 2.3 2.4 2.3 2.3

billions

Customs Duties & levies Betting & Gaming duties Petroleum revenue tax Air Passenger duty Climate Change Levy Land fill tax Aggregates levy Oil royalties

2.0 1.5 0.9 0.9 0.0 0.4 0.0 0.4

2.2 1.4 1.3 0.9 0.8 0.7 0.3 0.0

What are the principles of a good tax system? If you were creating a new tax system from scratch, what would be the main principles on which your system might be based? One set of principles known as the canons of taxation was developed by classical economist Adam Smith in his famous work on the Wealth of Nations published in the late 18th century. When you are asked to discuss the justification for different forms of taxation, it is often worth coming back to these principles when evaluating the relative merits and de-merits of alternative forms of taxation 1. Efficiency - an efficient tax system raises sufficient revenue to pay for government spending, without creating negative distortions such as reducing work-incentives for individuals and investment incentives for companies 2. Equity the principle of equity is that taxes should be fair and based on people's ability to pay. Income tax satisfies this condition because it is a progressive tax system, the marginal and average rate of tax rises with income but some indirect taxes may not for example the duty on cigarettes is said to have a regressive effect on the overall distribution of income 3. The benefit principle of taxation this principle is that taxes paid by people have a link with the benefit that the person paying the tax actually receives from government spending. However, there are some problems with too much emphasis on the benefit principle. Firstly if ignores the redistributive aims of taxation. For example, the government might introduce a new tax or raise an existing one with purely redistributive aims in mind i.e. a desire to reduce relative poverty. The benefit principle is mainly concerned with allocative efficiency rather than equity. A second problem is that the benefit principle assumes correct revelation of preferences by consumers whereas in reality many consumers do not have to pay for the public goods and services provided for them (consider the free rider problem). It is also difficult for the government to assess individual benefits from public goods. 4. Transparency and certainty - taxpayers should understand how the system works and should be able to plan their tax affairs with a reasonably degree of certainty. Taxes should also be difficult to evade we know that in many countries there is a fast-growing industry that provides information to people on how to reduce their tax liabilities. Collection costs should be kept to an acceptable level so that the costs of collection are very low relative to the total tax revenues collected. The progressivity of the income tax system in the UK To what extent does the income tax system work to reduce the gap between the highest and lowest paid households in the UK? In a progressive tax system the average rate of tax rises with income. And we see from the table below that income tax is indeed progressive in its effects on disposable income. The average rate of tax rises from around 5% on incomes of 7,500 - 9,999 to three times for people in the 20-30k income bracket. For people earning over 50,000 per year, over a quarter of their income is paid directly in income tax.
Tutor2u Limited 2008 www.tutor2u.net

But the system is not as progressive as it might be and as it was over twenty years ago. The extent of the "progressivity" of the income tax system has been reduced over the years. Before 1979, the top rate of income tax was 83 per cent, with a 15 per cent supplement for investment income. Now most taxpayers face a similar marginal tax rate of 22% compared with a top rate of 40 per cent but on top of the basic rate there is national insurance contributions (NICs) at 11 per cent and 1 per cent extra on NICs for higher earners, making the overall rates 33 per cent, and 41 per cent. This is not such a great progression. If a government wanted to use the income tax system to achieve a more even final distribution of income, it could Raise the top rate of income tax above 40% Increase the tax free allowance for people Introduce lower marginal rates of tax for lower-income households
Number of taxpayers (millions) 4,8954,999 5,0007,499 7,5009,999 10,00014,999 15,00019,999 20,00029,999 30,00049,999 50,00099,999 100,000 and over All incomes 0.1 2.9 3.5 6.1 5.1 6.4 4.3 1.5 0.5 30.5 Total tax Average Average liability rate of tax amount ( (percentages) of tax million) () 1 0.1 5 369 2.0 126 1,580 5.1 445 7,560 9.8 1,220 11,500 13.0 2,260 24,000 15.4 3,760 28,900 17.9 6,690 25,900 25.7 17,000 34,200 33.4 71,100 134,000 18.2 4,390 Source: Social Trends 36, ONS

Income tax payable: by annual income, in 2006

The easiest thing to do would be to increase the higher rate of income tax but this might create incentive problems in the labour market. Direct versus Indirect Taxation o Direct taxes are paid directly to the Exchequer by the individual taxpayer usually through pay as you earn. The same is true of corporation tax. Tax liability cannot be passed onto someone else o Indirect taxes include VAT and a range of excise duties on oil, tobacco, alcohol. The burden of an indirect tax can be passed on by the supplier to the final consumer depending on the price elasticity of demand and supply for the product. In the last twenty years there has been a shift towards indirect taxation economists differ in their views about what is the optimum mix of taxation between indirect and direct taxes
Arguments For Using Indirect Taxation 1. Changes in indirect taxes are more effective in changing the overall pattern of demand for particular goods and services i.e. in changing relative prices and thereby Arguments Against Using Indirect Taxation 1. Many indirect taxes make the distribution of income more unequal (less equitable) because indirect taxes are more regressive

Tutor2u Limited 2008 www.tutor2u.net

affecting consumer demand (e.g. an increase in the real duty on petrol) 2. They are a useful instrument in controlling and correcting for externalities all governments have moved towards a more frequent use of indirect taxes as a means of making the polluter pay and internalizing the external costs of production and consumption 3. Indirect taxes are less likely to distort the choices that people have to between work and leisure and therefore have less of a negative effect on work incentives. Higher indirect taxes allow a reduction in direct tax rates (e.g. lower starting rates of income tax)

than direct taxes 2. Higher indirect taxes can cause cost-push inflation which can lead to a rise in inflation expectations

3. There is no hard evidence that cutting direct tax rates has much of an incentive effect on peoples decisions about whether or not to work. If indirect taxes are too high this creates an incentive to avoid taxes through boot-legging a good example of this would be attempts to evade the high levels of duty on cigarettes 4. Revenue from indirect taxes can be uncertain particularly when inflation is low or there is a recession causing a fall in consume spending

4. Indirect taxes can be changed more easily than direct taxes this gives economic policy-makers more flexibility when setting fiscal policy. Direct taxes can only be changed once a year at Budget time 5. Indirect taxes are less easy to avoid by the final tax-payer who might be unaware of how much indirect tax they are paying 6. Indirect taxes provide an incentive to save (and thereby avoid the tax)- a higher level of savings might be used by the economy to finance a higher level of capital investment 7. Indirect taxes leave people free to make a choice whereas direct taxes leave people with less of their gross income in their pockets

5. There is a potential loss of economic welfare (taxes can create a deadweight loss of consumer and producers surplus) 6. Higher indirect taxes affect households on lower incomes who are least able to save in the first place 8. Many people are unaware of how much they are paying in indirect taxes this goes against one of the basic principles of a good tax system namely that taxes should be transparent

Flat Rate Taxes


In the eyes of many fiscal conservatives, the flat-tax is the Holy Grail of public policy: One low income tax rate paid by all but the poorest wage-earners, who are exempt. No loopholes for the rich to exploit. No graduated rates that take a higher percentage of income from people who work hard to earn more. No need for a huge bureaucracy to police fiendishly complex tax laws. Source, Allston Mitchell, January 2005

A flat tax means that everyone is taxed at just one rate. I.e. everyone pays the same percentage (%) tax on any income earned above the tax threshold (the tax-free allowance. A similar system is often used for corporate taxes taxes on company profits and also on indirect taxes such as VAT.
Tutor2u Limited 2008 www.tutor2u.net

The size of the tax free allowance is an important issue it needs to be large enough to persuade people to prefer paying taxes rather than avoiding them. But if it is set too high, then the government may not get enough tax revenue to pay for government spending. Some theorists in favour of flat taxes have suggested the countries should introduce a large personal allowance, with the most detailed research by the Adam Smith Institute hinted at a 12,000 personal allowance up from the current rate of 4895. Examples of countries that have moved towards flat rate tax systems include Estonia, Latvia, Poland, Lithuania, Russia, Slovakia and most recently, Hungary. From being a theoretical curiosity in the lecture halls for university economics courses, flat taxes are now being applied in different countries and there is an active debate about their merits and demerits. Why have flat rate taxes? Supply-side economists are often fans of flat rate taxes because they think that they will 1. Help reduce red tape and reduce the resources wasted on tax forms, chasing up non-payers and enforcing complex tax laws. This would reduce the money spent on administering the tax system. 2. Reduce inequity (because there is the same tax rate for all) and having a generous tax free allowance is good news for low income families, improving their incentives to earn extra income. 3. Boost incentives for people to work, to save (e.g. for retirement) and for companies to use profits to invest - both of which could increase the countrys potential growth rate. 4. Generate increased tax revenue based on the idea of the Laffer Curve that cutting tax rates can actually boost the supply-side so much that the government ends up with more tax revenue coming in allowing it to finance increased spending on priority areas. 5. A flat tax may make the British economy more attractive to foreign investment. In a global economy in which investors can move freely across country borders, a simple fiscal system attracts inward investment. 6. A lower level flat rate tax on savings will positively impact the household savings ratio and thereby have a positive impact on future economic growth. Increased saving would help protect developed economies from threats, such as huge pension deficits, one of the biggest structural threats to developed economies. It can also help to provide the funds for future investment strengthening growth and raising living standards. Currently, income tax is considered to hamper saving and the introduction of a flat rate tax is expected increase the saving rate. The key reason for this is the double taxation of personal savings, firstly on income and secondly on investment income or, once on company profits then on dividends.

Arguments against 1. Flat rate taxes are no longer progressive (at least as far as the 'marginal' rates are concerned) and so the distribution of income will become more unequal certainly in the short and medium term. 2. Flat rate taxes tend to favour the wealthy at the expense of the poor because the wealthy are no longer taxed at high rates on their savings, their dividend incomes and their inheritance wealth.
Tutor2u Limited 2008 www.tutor2u.net

3. Flat taxes can form part of a race to the bottom with governments competing with each other to offer the lowest rates of tax to entice inward investment and skilled workers. The result is a widening gap between the wealthy and the poor and less revenue for the government to commit to social welfare spending. 4. There is no guarantee that people will look to work more if tax rates are lower, indeed some people may choose to work less because they can earn the same income from working fewer hours. 5. There is no guarantee that businesses will engage in more investment and R&D if company taxes are lower they may simply offer more in the way of dividends to their shareholders! 6. Tax reforms such as flat taxes are not the only key factor in determining flows of foreign investment around the world economy. John Chambers CEO of Cisco Systems has been quoted as saying that Jobs are going to go where the best-educated workforce is with the most competitive infrastructure and environment for creativity and supportive government. In addition people living in those respective countries do not want to see a reduction in spending on their services at the benefit of reduced taxation. IMF report suggests that flat-rate taxes may not have worked A new research working paper from the International Monetary Fund (IMF) has cast doubt on the effectiveness of flat-rate tax systems in boosting labour market incentives and raising total tax revenues. A sizeable group of countries, among them some of the eastern European nations that joined the European Union in 2004 have introduced tax reforms and have adopted the flat-rate tax principal. Estonia was the first country within the European Union to move towards a flat rate tax system and Russia also moved towards the idea with their tax changes of 2001 and in recent times, Slovakia and Romania have joined the flat-tax revolution!
Country Flat Tax adopted Personal income tax rates (%) After tax reform 26% 13% 19% 16% Before tax reform 18-33% 12-30% 10-38% 18-40% Corporate tax rate (%) after reform 26% 37% 19% 16%

Estonia Russia Slovakia Romania

1994 2001 2004 2005

Flat-rate taxes represent an attempt to use fiscal reform to boost the supply-side performance of the economy through improving the incentive to work, reduce the incentive to evade taxation and to encourage entrepreneurship and risk-taking. But the IMF study provides a counter-weight to the arguments of flat-rate tax supporters. The summary of their findings says: One of the most striking tax developments in recent years, and one that continues to attract considerable attention, is the adoption by several countries of a form of flat tax. Empirical evidence on their effects is very limited but several lessons emerge. There is no sign of Laffer-type behavioural responses generating revenue increases from the tax cut elements of these reforms. The distributional effects of the flat taxes are not unambiguously regressive, and in some cases they may have increased progressivity. Looking forward, the question is not so much whether more countries will adopt a flat tax as whether those that have will move away from it.

Tutor2u Limited 2008 www.tutor2u.net

The Laffer Curve is the idea that cutting tax rates can actually increase total tax revenues if there is a sufficiently large supply side response, not least through more people entering the labour market and working longer hours. The IMF study casts doubt on the concept, indeed in Russia, total tax revenues from income taxes have declined since 2001. Suggestions for further reading and research Flat tax creator turns critic (BBC news) East Europeans opt for flat-rate tax (BBC news) Flat tax, the British case (Adam Smith Institute) Flat rate tax no panacea (Management Issues, July 2006)

The Laffer Curve The Laffer Curve is a theory built on the incentive effects of lower taxation which suggests that total tax revenue coming into the government may increase at a lower tax rate. As the tax rate further increases, the marginal revenue from lower taxes may tend to fall at an increasing rate up to optimal tax revenues, at tax rate X. After this point, any increase in the tax rate prompts people to work less, or to do more to avoid the tax, thereby reducing total revenue as the opportunity cost of paying the tax rises. Hypothetically at a 100 percent tax rate, nobody would have any incentive to work at all, since the Government collects everything people earn. Laffers ultimate prediction is if you cut taxes you can increase tax revenues and create a virtuous circle.

Tutor2u Limited 2008 www.tutor2u.net

23.

The Economic Effects of Fiscal Policy

Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour of individual households and businesses hence in this section we consider some of the microeconomic effects of fiscal policy before considering the links between fiscal policy and aggregate demand and key macroeconomic objectives.

The microeconomic effects of fiscal policy 1. Taxation and work incentives Can changes in income taxes affect the incentive to work? This remains a controversial subject in the economic literature! Consider the impact of an increase in the basic rate of income tax or an increase in the rate of national insurance contributions. The rise in direct tax has the effect of reducing the post-tax income of those in work because for each hour of work taken the total net income is now lower. This might encourage the individual to work more hours to maintain his/her target income. Conversely, the effect might be to encourage less work since the higher tax might act as a disincentive to work. Of course many workers have little flexibility in the hours that they work. They will be contracted to work a certain number of hours, and changes in direct tax rates will not alter that. The government has introduced a lower starting rate of income tax for lower income earners. This is designed to provide an incentive for people to work extra hours and keep more of what they earn. Changes to the tax and benefit system also seek to reduce the risk of the poverty trap where households on low incomes see little net financial benefit from supplying extra hours of their labour. If tax and benefit reforms can improve incentives and lead to an increase in the labour supply, this will help to reduce the equilibrium rate of unemployment (the NAIRU) and thereby increase the economys non-inflationary growth rate. 2. Taxation and the Pattern of Demand Changes to indirect taxes in particular can have an effect on the pattern of demand for goods and services. For example, the rising value of duty on cigarettes and alcohol is designed to cause a substitution effect among consumers and thereby reduce the demand for what are perceived as demerit goods. In contrast, a government financial subsidy to producers has the effect of reducing their costs of production, lowering the market price and encouraging an expansion of demand. The use of indirect taxation and subsidies is often justified on the grounds of instances of market failure. But there might also be a justification based on achieving a more equitable allocation of resources e.g. providing basic state health care free at the point of use. 3. Taxation and labour productivity Some economists argue that taxes can have a significant effect on the intensity with which people work and their overall efficiency and productivity. But there is little substantive empirical evidence to support this view. Many factors contribute to improving productivity tax changes can play a role - but isolating the impact of tax cuts on productivity is extremely difficult. 4. Taxation and business investment decisions Lower rates of corporation tax and other business taxes can stimulate an increase in business fixed capital investment spending. If planned investment increases, the nations capital stock can rise and the capital stock per worker employed can rise.
Tutor2u Limited 2008 www.tutor2u.net

The government might also use tax allowances to stimulate increases in research and development and encourage more business start-ups. A favourable tax regime could also be attractive to inflows of foreign direct investment a stimulus to the economy that might benefit both aggregate demand and supply. The Irish economy is often touted as an example of how substantial cuts in the rate of corporation tax can act as a magnet for large amounts of inward investment. The very low rates of company tax have been influential although it is not the only factor that has underpinned the sensational rates of economic growth enjoyed by the Irish economy over the last fifteen years. Capital investment should not be seen solely in terms of the purchase of new machines. Changes to the tax system and specific areas of government spending might also be used to stimulate investment in technology, innovation, the skills of the labour force and social infrastructure. A good example of this might be a substantial increase in real spending on the transport infrastructure. Improvements in our transport system would add directly to aggregate demand, but would also provide a boost to productivity and competitiveness. Similarly increases in capital spending in education would have feedback effects in the long term on the supply-side of the economy.
Lower company taxes linked to faster economic growth A new study from KPMG argues that reductions in corporate tax rates can give a country a competitive advantage over economic rivals and are linked to higher than average trend economic growth. But low taxes on their own are insufficient to cement the effects of rising investment since countries must also have the right infrastructure and labour market policies in place to take full advantage of the boost to corporate investment that flows from a lower tax burden. And if taxes on corporate profits are being lowered, then governments have to find some extra revenue from somewhere, typically by seeking to close tax loopholes which permit businesses to avoid paying tax in other areas. The KPMG study highlights the success of Ireland and several Scandinavian countries that have experienced high economic growth rates while cutting corporate tax and it noted a trend of greater tax competition over the last decade. The survey has recorded a consistent and dramatic reduction in corporate tax rates over that 14-year period. This reduction began in the mid-1980s in the United Kingdom when the government of Margaret Thatcher lowered the corporate tax rate from 52 percent to 35 percent between 1982 and 1986, forcing other countries to follow suit. Once one major industrialized economy cuts its rates, others seem compelled to do the same, in a process of international tax competition that continues and intensifies over time. In the past 14 years, the average corporate tax rate of countries surveyed by KPMG declined nearly 29 percent (28.7), dropping from an average of 38 percent to 27.1 percent. This competition suggests that there must be some benefit in having low corporate taxes, and indeed it appears that countries that adopt comparatively low tax rates tend to do better in terms of growth and inward investment than those that do not. Corporations are sensitive to income tax rates, and the enhanced mobility of capital and labour all over the world increases their ability to transfer functions from a high tax regime to a low-tax country.

Tutor2u Limited 2008 www.tutor2u.net

Fiscal Policy and Aggregate Demand Traditionally fiscal policy has been seen as an important instrument of demand management. This means that changes in government spending, direct and indirect taxation and the budget balance can be used counter-cyclically to help smooth out some of the volatility of real national output particularly when the economy has experienced an external shock. Discretionary changes in fiscal policy and automatic stabilisers 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 fiscal changes are changes in tax revenues and state spending arising automatically as the economy moves through different stages of the business cycle. These changes are also known as the automatic stabilisers of fiscal policy 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. Estimates from economists at the OECD have found that the effects of the automatic stabilisers of fiscal policy can reduce the volatility of the economic cycle by up to 20%. In other words, if the government is prepared to allow the automatic stabilisers to work through fully, then fiscal policy can help to curb the excessive growth of demand during a boom and provide an important support for income and demand during an economic downturn.
Tutor2u Limited 2008 www.tutor2u.net

UK Government Spending and the Economic Cycle


Annual % change in government spending at constant prices, 2007-08 is forecast from OECD
5
Growth of Real GDP 5

Percent

1
Fiscal stimulus

-1

Growth of Govt Spending Govt spending chart does not include capital spending

-1

-2 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

-2

Source: Reuters EcoWin

Measuring the fiscal stance A neutral fiscal stance might be shown if the government runs with a balanced budget where government spending is equal to tax revenues. Adjusting for where the economy is in the economic cycle, a neutral fiscal stance means that policy has no impact on the level of activity. A re-flationary fiscal stance happens when the government is running a large deficit budget (i.e. G>T). Loosening the fiscal stance means the government borrows money to inject funds into the economy so as to increase the level of aggregate demand and economic activity. A deflationary fiscal stance happens when the government runs a budget surplus (i.e. G<T). The government is injecting fewer funds into the economy than it is withdrawing through taxes. The level of aggregate demand and economic activity falls.

The table below summarises the main changes in government spending and tax revenues and government borrowing during recent years.
Govt Spending 1993 1997 2000 2004 2006 277.8 318.5 363.9 491.6 550.4 % of GDP 42.6 38.8 37.9 41.1 41.7 Tax Revenues 232.3 308.7 378.8 453.1 520.0 % of GDP 35.7 37.6 39.5 38.5 39.4

Tutor2u Limited 2008 www.tutor2u.net

From 2001-2006 there was a deliberate 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. The real level of government spending grew from 364 billion in 2000 to 550 billion in 2006. The share of GDP taken up by government spending increased from 38% in 2000 to nearly 42% in 2006. This significant increase in government spending has helped to maintain Britains short-term growth at a time when some components of AD (notably export demand and investment) have been weaker. The Keynesian school argues that fiscal policy can have powerful initial 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 justified role for the government to make active use of fiscal policy measures to manage or fine-tune 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 AD and inflationary pressure. They are much more sceptical about the wisdom of relying on fiscal policy as a means of demand management. We will consider below some of the criticisms of using fiscal policy as a tool of stabilising demand and output in the economy.
Fiscal policy can be used to stimulate aggregate demand either through tax cuts or a rise in planned government spending. The government needs to be careful not to boost AD too much otherwise there is a risk that an inflationary gap will emerge. In the diagram below, AD shifts out beyond potential output (shown by the LRAS curve) and leads to rising inflation causing an inward shift of the SRAS curve

Inflation

LRAS

SRAS2 SRAS1

P3 P2 P1

AD1

AD2

Y1

Yfc

Y2

Real National Income

Tutor2u Limited 2008 www.tutor2u.net

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

USA and UK Government Budget Balance


As a percentage of GDP
4 3 2 1 0
PERCENT
4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 -8

-1 -2 -3 -4 -5 -6 -7 -8 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

United States

United Kingdom Source: Reuters EcoWin

Problems with Fiscal Policy as an Instrument of Demand Management In theory a positive or negative output gap can be overcome by the fine-tuning of fiscal policy. However, in reality the situation is complex and many economists argue for ignoring fiscal policy as a tool for managing aggregate demand focusing instead on the role that monetary policy can play in stabilising demand and output. Different types of lag o Recognition lags: Inevitably, it takes time to for government policy-makers to recognise that AD is growing either too quickly or too slowly and a need for some active discretionary changes in spending or taxation o Response lags: It then takes time to implement an appropriate policy response government spending plans are subject to a three year spending review and cannot be changed immediately. Likewise the tax system is highly complex for example income tax can only normally be changed once a year at the time of the Budget. Indirect taxes can be changed more quickly but they have less of an effect on the level of aggregate demand o Impact on consumer and business behaviour: It then takes time for the change in fiscal policy to work, as the multiplier process on national income, output and employment is not instantaneous.
Tutor2u Limited 2008 www.tutor2u.net

The importance of the national income multiplier imperfect information Suppose a government wanted to eliminate a deflationary gap of 1000m. The increase needed in government expenditure will depend on the size of the multiplier. The problem lies in knowing the exact size of the multiplier. If the multiplier is 2, then government expenditure would have to rise by 500m. However, if the multiplier was 4, a rise of only 250m would be needed. Without knowing the precise value of the national income multiplier it is difficult to fine-tune the economy accurately. Fiscal Crowding-Out The crowding-out hypothesis became popular in the 1970s and 1980s when free market economists argued against the rising share of national income being taken by the public sector. The essence of the crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector. For example, if the government seeks to reflate AD by reducing taxation, or by increasing state spending, this can lead to a budget deficit. To finance the deficit the government will have to sell debt to the private sector and getting individuals and institutions to purchase the debt may require higher interest rates. A rise in interest rates may crowd out private investment and consumption, offsetting the fiscal stimulus. This type of crowding out is unlikely to make fiscal policy wholly ineffective since crowding out is never likely to be 100%, but large budget deficits do require financing and in the medium term, this requires a higher burden of taxation. Higher taxes affect both businesses and households neo-liberal economists believe that higher taxation acts as a drag on business investment, labour market incentives and productivity growth all of which can have a negative effect on economic growth potential in the long run.

Tutor2u Limited 2008 www.tutor2u.net

Yields on Govt Bonds and the UK Budget Balance


per cent of GDP, data for 2007-08 is a forecast from the OECD
15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5
Cyclically adjusted budget balance (% of GDP) Interest rate on 10 year government bonds (per cent) 15.0

12.5

10.0

7.5

5.0

Fiscal stimulus

2.5

0.0

-2.5

-5.0 -7.5 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

-5.0

-7.5

Source: Reuters EcoWin

The Keynesian response to the crowding-out hypothesis is that the probability of 100% crowding-out is remote, especially if the economy is operating well below its productive capacity and if there is a plentiful supply of savings available that the government can tap into when it needs to borrow money. There is no automatic relationship between the level of government borrowing and the level of short term and long term interest rates. We can see from the previous chart that there has been a downward trend in long term interest rates over the last tent to twelve years. Indeed in 2003 the yield (rate of interest) on ten year government bonds dipped below 4 per cent one of the lowest long term interest rates in recent history. The evidence during the current decade is that the UK government has been able to run sizeable budget deficits without triggering large rises in long term interest rates and thereby squeezing the private sector. That said, there has been a rise in the economys tax burden (tax revenues as a share of GDP). And this tax hike may well be causing some damage. Reaction to Tax Cuts The Rational Expectations View According to a school of economic thought that believes in rational expectations, when the government sells debt to fund a tax cut or an increase in expenditure, a rational individual will realise that at some future date he will face higher tax liabilities to pay for the interest repayments. Thus, he should increase his savings as there has been no increase in his permanent income. The implications are clear. Any change in fiscal policy will have no impact on the economy if all individuals are rational. Fiscal policy in these circumstances may become impotent. Government borrowing

Tutor2u Limited 2008 www.tutor2u.net

Government Borrowing and the National Debt


Budget Balance = Tax revenues - Total Government Spending, billion
55.0 50.0 45.0 40.0 35.0 20 10 0
(billions)
55.0 50.0 45.0 40.0 35.0 20 10 0

Government Debt as a % of GDP

-20 -30 -40 -50 -60 93 94 95 96 97 98 99 00 01 02 03 04 05 06


UK Government Budget Balance bn

-20 -30 -40 -50 -60

Source: Reuters EcoWin

1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08

( billion) -41.7 -33.5 -24.6 -21.7 -1.2 9.9 21.4 24.5 11.6 -11.1 -17.7 -18.3 -15.4 -5.5 -4

Current budget surplus (% GDP) -6.3 -4.8 -3.3 -2.8 -0.1 1.1 2.3 2.5 1.1 -1.0 -1.6 -1.5 -1.2 -0.4 -0.3

( billion) 51.1 43.3 34.7 27.2 6.4 -3.4 -16.0 -20.2 -0.6 24.5 33.1 38.5 38.2 30.5 34

Net borrowing (% GDP) 7.8 6.2 4.7 3.5 0.8 -0.4 -1.7 -2.1 -0.1 2.3 2.9 3.2 3.1 2.3 2.4

Net debt (% GDP) 37.0 40.7 42.6 43.3 41.3 39.2 36.4 31.4 30.3 31.5 32.7 34.7 36.1 36.9 38.2

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 expenditure exceeds total tax revenue. As a result, the state has to borrow through the issue of debt such as Treasury Bills and long-term Bonds. The issue of debt is done by the central bank and involves selling debt to the bond and bill markets.
Tutor2u Limited 2008 www.tutor2u.net

billions

-10

-10

Government finances have moved from surplus in the late 1990s to a deficit in each of the last six years. The emergence of a rising budget deficit has been due to a weaker economy and the effects of substantial increases in government spending on priority areas such as health, education, transport and defence. Both current and capital spending are rising sharply in real terms. Does a budget deficit matter? There is a consensus that a persistently large budget deficit can be a 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 debt to domestic or overseas investors can do this. In a world where financial capital flows freely between countries, it can be trouble-free to finance a deficit. But if the budget deficit rises to a high level, in the medium term the government may have to offer higher interest rates to attract sufficient buyers of debt. This in turn will have a negative effect on economic growth 2. A government debt mountain? In the long run, government borrowing adds to the accumulated National Debt. This means that the Government has to spend more each year in debt-interest payments to holders of government bonds and other securities. There is an opportunity cost involved here because this money might be used in more productive ways, for example an increase in spending on health services or extra investment in education. 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. In 2006, the value of the national debt climbed above 500 billion for the first time. 3. Crowding-out - the need for higher interest rates and higher taxes. If a larger budget deficit leads to higher interest rates and taxation in the medium term and thereby has a negative effect on growth in consumption and investment spending, then a process of fiscal crowdingout is said to be occurring. 4. 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 1. Government borrowing can benefit 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, spending on the transport infrastructure improves the supply-side capacity of the economy. And increased investment in health and education can bring positive effects on productivity and employment. 2. The budget deficit as a tool of demand management: Keynesian economists would support the use of changing the level of government borrowing as a legitimate instrument of managing aggregate demand. An increase in borrowing can be a useful stimulus to demand when other sectors of the economy are suffering from weak or falling spending. The fiscal stimulus given to the British economy during 2002-2006 has been important in stabilizing demand and output at a time of global economic uncertainty. Perhaps Keynesian fiscal demand management has once more come back into fashion! 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.

Tutor2u Limited 2008 www.tutor2u.net

UK Government Spending and Taxation


Measured as a percentage of national income
47 46 45 44
Per cent of GDP
47 46 45

Government Spending

44 43 42 41 40 39 38

43 42 41 40 39 38 Total Tax Revenue 37 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

37

Source: Reuters EcoWin

The current situation 1. Government borrowing in the UK has rise to over 3% of GDP, in excess of the 3.0 percent limit set by Europe's Stability and Growth Pact. But as the UK is not participating in the single currency, the UK is not bound by the terms of the fiscal stability pact and this gives it more flexibility in terms of how much the UK government can borrow 2. The government has allowed the automatic stabilisers to work during the current cycle. In other words, it has allowed an increase in government borrowing brought about by a slowdown in domestic demand and output. 3. Gordon Brown has introduced his own fiscal rules including the golden rule that government spending on currently provided goods and services should be financed by taxation over the course of the economic cycle. Government capital spending (public sector investment) can be financed by borrowing because it results in the accumulation of capital which has long term economic benefits for the country 4. Although government borrowing is currently high, there is little upward pressure on long-term interest rates (indeed they are low). Financing the budget deficit is not a major problem for the UK as it seems able to attract inflows of financial capital from overseas and foreign investors are happy to purchase new issues of government debt. This reduces the risk of the crowding out effect taking place 5. Total government debt as a percentage of GDP remains low by historical standards (less than 40% of GDP). And with interest rates remaining low, the government is not facing up to a huge cost of servicing this debt
Tutor2u Limited 2008 www.tutor2u.net

Inter-relationships between Fiscal & Monetary Policy For most of the last thirty years, the operation of fiscal and monetary policy was in the hands of just one person the Chancellor of the Exchequer. However the degree of coordination the two policies often left a lot to be desired. Even though the BoE has independence that allows it to set interest rates, the decisions of the MPC are taken in full knowledge of the Governments fiscal policy stance. Indeed the Treasury has a non-voting representative at MPC meetings. The government lets the MPC know of fiscal policy decisions that will appear in the budget. Impact of fiscal policy on the composition of 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. Fiscal policy changes can to a degree 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 and more generous investment allowances for businesses in certain regions) Consider 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) o Monetary policy expansion: Lower interest rates will (ceteris paribus) lead to an increase in both consumer and business capital spending both of which increases equilibrium 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. o Fiscal policy expansion: An expansionary fiscal policy (i.e. an increase in government spending or lower taxes) adds directly to AD but if this is financed by higher 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. Effectiveness of Monetary and Fiscal Policies When the economy is in a recession, monetary policy may be ineffective in increasing spending and income. In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree they argue that changes in monetary policy can impact quite quickly and strongly on consumer and business behaviour. However, there may be factors which make fiscal policy ineffective aside from the usual crowding out phenomena. Future-oriented consumption theories based round the concept of rational expectations hold that individuals undo government fiscal policy through changes in their own behaviour for example, if government spending and borrowing rises, people may expect an increase in the tax burden in future years, and therefore increase their current savings in anticipation of this Differences in the Lags of Monetary and Fiscal Policies Monetary and fiscal policies differ in the speed with which each takes effect the time lags are variable Monetary policy in the UK is flexible since interest rates can be changed by the Bank of England 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
Tutor2u Limited 2008 www.tutor2u.net

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.

Government Borrowing and Interest Rates


Bank of England Policy Rates (top pane), Fiscal Balance (bottom pane)
7.5 7.0 6.5
per cent
Interest Rates (%) 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 20 Government Budget Balance (bn) 10 0

6.0 5.5 5.0 4.5 4.0 3.5 20 10 0

(billions)

-20 -30 -40 -50 -60 93 94 95 96 97 98 99 00 01 02 03 04 05 06

-20 -30 -40 -50 -60

Source: Reuters EcoWin

Suggestions for wider reading on fiscal policy Tories urged to scrap inheritance tax (BBC news online, August 2007) HM Treasury Budget Statements 2007 Budget In-Depth (BBC news) Institute for Fiscal Studies Fiscal Facts for the UK

Tutor2u Limited 2008 www.tutor2u.net

billions

-10

-10

24.
Open economy

The Pattern of International Trade

An introduction to the importance of trade for the UK within the global economic system

The UK can be described as an open economy meaning that it is open to trade in goods and services, and allows inflows and outflows of financial and other forms of capital from around the world. A rising share of UK produced output is exported overseas and a high proportion of aggregate demand is satisfied by imports. The UK currently is the worlds 8th largest exporter of goods and the 2nd largest exporter of services. In terms of capital flows, Britain has the highest ratio of inward and outward investment to GDP of any leading economy. In an age of rapid globalisation, it is inevitable that, over time, the pattern of trade in goods and services changes, reflecting shifts in comparative advantage and movements in relative prices of traded products in international markets. The pattern of trade is also affected by the growth and development of particular countries or regions and by foreign investment decisions of UK and overseas companies. Trade profile for the United Kingdom in 2004
Share in world total exports Exports of goods By main commodity group Agricultural products Fuels and mining products Manufactures By main destination 1. European Union (25) 2. United States 3. Japan 4. Canada 5. Switzerland Trade in services Share in world total exports Breakdown in economy's total exports Transportation services Travel services Other commercial services 15.7 15.9 68.4 6.4 11.6 80.8 57.8 15.1 2.0 1.8 1.6 3.79 Share in world total imports Imports of goods By main commodity group Agricultural products Fuels and mining products Manufactures By main origin 1. European Union (25) 2. United States 3. China 4. Norway 5. Japan 10.3 8.6 77.9 55.4 9.2 5.7 3.3 3.3 4.88

2004 8.08

Share in world total imports Breakdown in economy's total imports Transportation services Travel services Other commercial services

2004 6.50

24.2 41.0 34.8

The majority of UK trade in goods and services is with the twenty-six partner countries in the European Union. There has been a long-term shift in our trade with EU since the UK joined in 1973. The growth of trade has been encouraged by the enlargement of the Single Market which has led to trade creation and trade diversion effects. The share of UK trade with North American countries has declined, but the United States remains the largest single export market accounting for 15% of total UK exports. Trade with oil exporting countries has fallen in relative importance over the last fifteen
Tutor2u Limited 2008 www.tutor2u.net

years In 1979, 10% of UK exports went to oil exporting countries, this has now declined to just over 3% as has the share of imports from these countries. The other significant change in the geographical pattern of trade for the UK is an increasing share of trade with emerging economies in Asia including China, Singapore, Malaysia, South Korea, Taiwan and Thailand and also now with fast-growing countries in the Indian Sub-Continent. In 2006, the UK ran a 10 bn trade deficit in goods and services with China and a 14bn deficit with Germany. Our trade in heavily in deficit with the European Union but we have a large and rising trade surplus with the USA.

UK Balance of Trade with Selected Countries


billion
20
USA 20

10
India

10

0
GBP (billions)
China

-10
Germany

-10

-20
EU

-20

-30

-30

-40 99 00 01 02 03 04 05 06

-40

Source: Reuters EcoWin

Tutor2u Limited 2008 www.tutor2u.net

billions

UK Balance of Trade in Selected Goods


Annual trade balance, billions
10
Semi-manufactures Crude oil 10

0
Food, beverages & tobacco

-10

-10

GBP (billions)

-20

-20

-30

-30

-40

-40 Finished manufactures

-50

-50

-60 80 82 84 86 88 90 92 94 96 98 00 02 04 06

-60

Source: Reuters EcoWin

Building Comparative Advantage - UK Trade Surpluses


Annual trade balance, billion, source: UK Pink Book
25.0 22.5 20.0 17.5
GBP (billions)
25.0 22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0 2.5 0.0

15.0 12.5 10.0 7.5 5.0 2.5 0.0 95 96 97 98 99 00 01 02 03 04 05 06

Chemicals Personal,Cultural & Recreation Royalties & License Fees Insurance Services

Financial Services Advertising & Market Research Research & Development Architectural, Engineering Source: Reuters EcoWin

Tutor2u Limited 2008 www.tutor2u.net

billions

billions

25.

Trade and Developing Economies

Trade has often been viewed as an integral part of economic development for poorer countries. But the merits and de-merits of different trade policies for developing countries remains a controversial issue.

Trade and growth During the 1990s, the annual growth of GDP for developing countries as a whole increased to 4.3% from 2.7% in the 1980s, and some of this acceleration in growth is attributed to the success of a number of countries in liberalising their economies, becoming more open to global trade and successfully competing and integrating with the global economy. Global trade expanded rapidly during the 1990s with exports growing at an average rate of 6.4 per cent, reaching $6.3 trillion in 2000. Trade in manufactured goods and in services has continued to expand at rates well ahead of national output leading to an increased dependency on trade for countries rich and poor. Trade in manufactured goods has risen by a huge amount in the last fifteen years and the share of manufactured exports taken up by developing countries has continued to rise reflecting their success in building up manufacturing production and export capacity. Despite this change, many of the worlds poorest countries remain partially dependent on exports of primary commodities and therefore vulnerable to price volatility in world markets. In 2004 global trade amounted to $8.9 trillion with $6.6 trillion accounted for by manufacturing and $783 billion of agricultural products. The remainder is taken up by fuels and mining products. $2.1 trillion worth of commercial services were exported around the world economy in 2004. World trade in goods
Leading exporters and importers in world merchandise trade in 2006 (Billion dollars and percentage) Rank Exporters Value Share Rank Importers Value 1 Germany 1112 9.2 1 United States 1920 2 United States 1037 8.6 2 Germany 910 3 China 969 8.0 3 China 792 4 Japan 647 5.4 4 United Kingdom 601 5 France 490 4.1 5 Japan 577 6 Netherlands 462 3.8 6 France 533 7 United Kingdom 443 3.7 7 Italy 436 8 Italy 410 3.4 8 Netherlands 416 9 Canada 388 3.2 9 Canada 357 10 Belgium 372 3.1 10 Belgium 356 Share 15.5 7.4 6.4 4.9 4.7 4.3 3.5 3.4 2.9 2.9

Source: World Trade Organisation, world trade statistics 2006 edition World trade in services
Leading exporters and importers in world service trade in 2006 Rank Exporters Value Share Rank 1 2 3 4 5 6 7 United States United Kingdom Germany Japan France Italy Spain 387 223 164 121 112 101 100 14.3 8.2 6.1 4.5 4.1 3.7 3.7 1 2 3 4 5 6 7 Importers United States Germany United Kingdom Japan France Italy China Value 307 215 169 143 108 101 100 Share 11.7 8.2 6.5 5.5 4.1 3.9 3.8

Tutor2u Limited 2008 www.tutor2u.net

8 China 9 Netherlands 10 India

87 82 73

3.2 3.0 2.7

8 Netherlands 9 Ireland 10 Spain

78 77 77

3.0 3.0 2.9

Source: World Trade Organisation, world trade statistics 2005 edition Trade and Economic Development Import Substitution and Export Promotion One common aim of developing countries is to pursue industrialisation by expanding their industrial sector. And trade provides a means by which this development strategy can be pursued. Import substitution: The idea here is to domestically produce what was previously imported from elsewhere. There are some economically sound reasons for doing this; producing rather than importing will save valuable foreign exchange and ease the balance of payments deficit that most poor countries have. Moreover, there is obviously a ready-made market for the product, because people are already buying it from abroad. In theory, new firms would start by importing capital goods - plant and machinery and the latest technology - intermediate goods [raw materials and other components], and technical expertise. Once off the ground, the industry would be able to import capital goods to make all the necessary machinery themselves. The government would remove the tariffs once the industry was ready to compete with producers from around the world (see the later section on import protectionism and the infant industry argument). In reality, firms have rarely got beyond the first stage. Import tariffs have remained in place, since producers were unprepared to face global competition and so they had no incentive to become efficient and competitive. Export Promotion This was the approach adopted by the East Asian Tiger economies in their expansion of hi-tech manufacturing industries. Countries try to find markets in which they can successfully exploit their comparative advantages and sell their products to buyers elsewhere in the world. o Production centred on labour-intensive technologies (for the comparative advantage!) I.e. production has been based on much lower unit labour costs. o Industry made up of private-sector firms driven by the profit motive. o Government provides incentives for firms to export. Many of the Asian Tiger economies have been incredibly successful in implementing export promotion strategies and for them the process of globalisation has been a huge stimulus to their economic growth and development over the last ten twenty years. The New Globalizers Many developing countriessometimes known as the new globalizers have made huge progress in building and sustaining a strong position in world markets for manufactured goods and services. For example there has been a sharp rise in the share of manufactured goods in the exports of developing countries: from about 25 percent in 1980 to more than 80 percent today and a decline in the dependency of some countries on exporting primary commodities. These new globalizers have managed to exploit their competitive advantage in manufacturing based on a fast growth of labour productivity, much lower unit labour costs, high levels of capital
Tutor2u Limited 2008 www.tutor2u.net

investment, (much of it linked to inward investment) and crucially a reduction in the tariff levels imposed by industrialised economies. Technological progress has also speeded up the expansion of trade in manufactured goods from developing economies with improvements in containerisation and airfreight reducing the costs of transportation.

Developing countries have become important exporters of manufactures Many developing countries have successfully exploited the rapid growth in demand for transistors, valves, semi-conductors, telecommunications equipment, electrical power machinery, office machines, computer parts and other electrical apparatus. These are all fast-growing industries, although in many cases, price levels are falling as production shifts across the globe to lower cost production centres. The huge increase in out-sourcing of manufacturing production has been a major factor behind the speedy growth of export industries in many developing countries, not least the emerging market economies of south East Asia and more recently in eastern Europe. Further evidence on the extent to which developing countries are building and then harnessing new comparative advantages in many manufacturing industries is shown in the following table of data again drawn from information published by UNCTAD. Two industries where this global shift in manufacturing production has become ever more transparent are in the transport equipment sector and in textiles and clothing. The expansion of trade from developing countries is not focused solely on manufactured goods the share of services in developing country exports has grown from 9% in the early 1980s to 17% at the end of the 1990s. For rich countries, the share of services in total exports is only a little higher at 20%. Relatively low-income countries such as China, Bangladesh, and Sri Lanka have manufactures shares in their exports that are above the world average of 81 percent. Others, such as India, Turkey, Morocco, and Indonesia, have shares that are nearly as high as the world average. The BRICs BRIC is a term used to refer to the combination of Brazil, Russia, India, and China and, according to a major piece of research from Goldman Sachs, a US investment bank; these are four countries that are likely to become major if not dominant players in the global economy over the next twenty to thirty years. The Goldman Sachs forecast for size of GDP is as follows:
Largest economies in 2003 USA Japan Germany UK France China Largest economies in 2025 (forecast) USA China Japan Germany India UK Largest economies in 2050 (forecast) China USA India Japan Brazil Mexico

Tutor2u Limited 2008 www.tutor2u.net

Italy India Brazil

France Russia South Korea

Russia Germany UK

2000-05: BRICs contributed 28% of global economic growth 2005: BRICs had 15% share of global trade, double the level of 2001 2005: BRICs held 30% of global reserves of gold and foreign currency 2005: BRICs received 15% of global foreign direct investment and took 3% of FDI outflows Since 2003, their stocks markets have increased by approximately 150%

Projected real growth in GDP, GDP per capita and working age population: 2005-50 (% per annum) Source: PriceWaterhouseCoopers GDP in US $ GDP per capita at terms PPPs

GDP (PPP terms) in 2005 US=100 30 7 76 5 13 9 12 9 9 5 100 9 16 15 14 20 32

GDP (PPP terms) in 2050 US=100 100 19 143 10 25 17 14 8 9 6 100 8 15 13 10 15 23

GDP at market exchange rates in 2005 Percentage of US level 6 2 18 3 5 6 5 6 8 5 100 9 18 17 14 23 39

GDP at market exchange rates in 2050 Percentage of US level 58 19 94 10 20 17 13 8 9 6 100 8 15 13 10 15 23

% change pa India Indonesia China Turkey Brazil Mexico Russia S. Korea Canada Australia US Spain UK France Italy Germany Japan 7.6 7.3 6.3 5.6 5.4 4.8 4.6 3.3 2.6 2.6 2.4 2.3 1.9 1.9 1.5 1.5 1.2

% change pa 4.3 4.2 3.8 3.4 3.2 3.3 3.3 2.6 1.9 2 1.8 2.2 2 2.1 1.9 1.9 1.9

The new workshop of the world China The basic statistics of Chinas recent economic growth are staggering although such rapid expansion in output and investment is inevitably creating social, environmental, economic and political pressures along the way. Production of factory goods in China has surged by 5-10 per cent a year for over a decade and China now contributes an estimated seven per cent of global manufacturing production. Since the mid 1990s, hundreds of billions of dollars of foreign direct investment has found its way into the Chinese economy. China joined the World Trade Organisation in December 2001.
Tutor2u Limited 2008 www.tutor2u.net

Annual growth in export and import volumes

2000

2001

2002

2003

2004

2005

2006

China World Australia, Japan, Korea and New Zealand OECD Europe (inc the UK) NAFTA

25.3 12.2 12.3 11.6 11.5

6.9 0.2 -2.9 2.6 -3.8

25.7 28.2 22.7 19.4 21.7 3.5 5.4 10.4 7.5 9.3 7.1 8.1 12.8 6.8 8.3 1.5 2.6 6.9 5.1 7.3 1.1 2.8 9.4 6.4 7.1 Source: OECD World Economic Outlook

Growth Rates for selected Countries


Annual percentage change in real national output
12 11 10 9 China 8 7
Percent
8 7 12 11 10 9

India 6 5 4 3 2 1 0 00 01 02 03 04 05 06 07 UK USA
6 5 4 3 2 1 0

Source: Reuters EcoWin

Tutor2u Limited 2008 www.tutor2u.net

China's Export Boom


Annual percentage change in the volume of exports
25
25

20

20

15

15

Percent

10

10

-5

-5

-10 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

-10

Source: Reuters EcoWin

Tutor2u Limited 2008 www.tutor2u.net

China's Trade Balance in Goods and Services


$ billion, annual data
225 200 175 150
USD (billions)
225

200

175

150

100 75 50 25 0 95 96 97 98 99 00 01 02 03 04 05 06

100

75

50

25

Source: Reuters EcoWin

Suggested reading on the Chinese economy: Briefing on the Chinese economy (Economist) China and India emerging giants (BBC news special report) China plan to protect the environment (BBC news, July 2006) China set to be largest economy (BBC news, July 2006) Chinas growth soars to fastest for a decade (Guardian, July2006) Chinese economy could overheat (BBC news, July 2006) Downsides to Chinas runaway growth (BBC news special, January 2006) Economist country profile on China Guardian special report on China Is this Chinas century? (BBC Open University programme) Economist articles on China and Hong Kong China raises interest rates to cool economy (August 2006)

Tutor2u Limited 2008 www.tutor2u.net

billions

125

125

Globalisation and African Countries


Exports of the least developed countries by major product in 2003 Source: World Trade Organisation Others Textiles Other semi-manufactures Raw materials Food Clothing Fuels Per cent 2003 21.6 1.7 3.5 5.4 11.9 19.9 36.0 2000 15.3 1.9 6.5 5.9 13.3 21.4 35.6

The African continent remains by and large marginalized in the world economy, with over half of the population living under US$1 a day per person. If the major Millennium Development Goal of reducing poverty by half by the year 2015 is to be achieved in Africa, a major policy shift is required, both at the national and international levels, to help boost growth and development in Africa. Source: UNCTAD web site

Some regions and countries have struggled to make any sustained progress in using trade as an instrument for long term growth and development. Africa, for example, experienced marginal economic growth during the 1990s leading to an ever-widening gap between living standards in Africa and the rest of the world. Its share of world trade continued to fall, from only 2.7 per cent in 1990 to 2.1 per cent in 2000, and critics argue that the global trading system continues to discriminate against the world's poorest countries. They argue that high-income countries continue to protect their agricultural industries against imports from low-income economies, pointing in particular to the inequities created by the European Union Common Agricultural Policy whereas developing countries' markets have been liberalised opening them up to exports from the developed world. Developed nations spent 154bn on agricultural support in 2005 according to the Organisation for Economic Cooperation and Development (OECD). In fact Average tariff levels on agricultural products coming into developed countries are far higher than those set for industrial products. Inequities in the global trading system In a recent report on Global Poverty and Fair Trade, Oxfam argued that "global trade has the potential to act as a powerful motor for the reduction of poverty, as well as for economic growth, but that potential is being lost. The problem according to Oxfam is not that international trade is inherently opposed to the needs and interests of the poor, but that the rules that govern it are rigged in favour of the rich. Barriers to imports in the advanced countries are, argues Oxfam, biased against the exports of developing countries at a cost to the latter of $100bn (or nearly 70bn) a year. The Make Poverty History campaign also focuses on some of the barriers to fair trade that holds back the growth and development of many of the worlds poorest countries. Many development economists claim that the current asymmetry of international trade barriers is actually biased against high-income countries. Tariffs on industrial products set by high-income countries average 3% whereas poor countries' tariffs average 13%. Dependence on Primary Exports

Tutor2u Limited 2008 www.tutor2u.net

The least developed countries have a greater dependence on exports of primary commodities despite attempts at import substitution. For many of the poorest African countries, primary exports account for over 90% of total exports

Africa - unit value of exports


Index of export prices, 2000=100
150
150

140

140

130
Index Number

130

120

120

110

110

100

100

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

90

Source: Reuters EcoWin

Demand for fair access Low-income countries should look to the international system to meet their reasonable demandsnot for special preferences to some markets and exemptions from rules, but for non-discriminatory market access to every market in products in which they have a comparative advantage Source: Adapted from Global Trade Prospects 2004, World Bank www.worldbank.org

For many developing countries, free market access to the high income and spending markets of developed countries remains the most important objective in trade negotiations with other countries. Domestic markets for lower income nations can often be small-scale so producers have little chance of achieving important economies of scale that would reduce their average costs and allow them to generate a higher rate of profit from their production. This, added to the fact that foreign markets in developed countries are often protected by high tariffs, means that industries and firms based in developing economies will find it difficult to become competitive in the international market. The passage below provides an example of a current issue that relates to the fairness of market access for smaller nations seeking to promote their exports in overseas markets.

Tutor2u Limited 2008 www.tutor2u.net

Export subsidies promote cotton dumping A decision by the World Trade Organisation that found the USs $3 billion financial support for cotton growers violates global trade rules. The WTO has found in favour of a complaint from Brazil that US subsidies distorted world cotton prices, allowing the US to dump cotton on world markets at the expense of growers in poor countries, such as Mali and Burkina Faso, which supported the Brazilian claim. The scale of the American subsidy for some 25,000 US cotton growers is gigantic, allowing the high-cost American growers in the southern states to gain market share at the expense of farmers in the developing world. The WTO also found that $1.6 billion of US export credits, which include price support for corn, Soya beans and oil-seed products were distorting trade and must be removed. Source: Adapted from newspaper reports, June 2004

That said it is often the case that tariffs on trade between developing countries are in fact much higher than between developing and developed nations. There is much to do to bring tariff rates down and to gradually erode the wide range of non-tariff barriers that exist all of which distort the nature of free trade based on the principle of comparative advantage.

Suggested reading Africa after the promises (BBC news) Economy of Africa (Wikipedia) United Nations Human Development Reports Human development in animation (United Nations) How fair is fair trade? (BBC Money Programme) Make Poverty History
Tutor2u Limited 2008 www.tutor2u.net

Oxfam Make Trade Fair African countries in tariff move (BBC news, May 2007) The bottom billion bite back, Paul Collier, The Times, July 2007

Trade agreements in the international economy Trade agreements and trade liberalisation are two essential components in the drive to increase the rate of growth of world trade. o Trade agreements can involve two countries reducing tariffs on each others goods, or perhaps reducing bureaucracy by simplifying import/export procedures. o Trade liberalisation might involve creating free-trade areas. This creates larger markets, greater access to raw materials, and more competition. The happy ending should be lower unit costs, since firms are able to gain economies of scale. From the consumers point of view, lower prices and greater choice should make them happy too. Briefly now we consider the emergence of regional trading agreements between countries. Growth of Regional Trade Agreements An important feature of international trade arrangements between countries over the last two decades has been a significant expansion of regional trade agreements (RTAs) across the global economy. Some of these agreements are simply free-trade agreements which involve a reduction in current tariff and non-tariff import controls so as to liberalise trade in goods and services between countries. The most sophisticated RTAs go beyond traditional trade policy mechanisms, to include regional rules on flows of investment, co-ordination of competition policies, agreements on environmental policies and the free movement of labour. Examples of Regional Trade Agreements: o The European Union (EU) a customs union, a single market and now with a single currency o The European Free Trade Area (EFTA) o The North American Free Trade Agreement (NAFTA) created in 1994 o Mercosur - a customs union between Brazil, Argentina, Uruguay, Paraguay and Venezuela o The Association of Southeast Asian Nations (ASEAN) Free Trade Area (AFTA) o The Common Market of Eastern and Southern Africa (COMESA) o The South Asian Free Trade Area (SAFTA) created in January 2006 and containing countries such as India and Pakistan Economic Integration between Countries There are many different types of economic integration between countries and these are summarised below. A free trade area is a fairly loose form of integration where countries simply agree to remove tariff and non-tariff barriers between them to promote free trade in goods and services. The North
Tutor2u Limited 2008 www.tutor2u.net

American Free Trade Area (NAFTA) is a good example of this as is the European Free Trade Area (EFTA). ASEAN (Association of South East Nations), the Andean Pact, and Mercosur are other examples.

Stage of Economic No Internal Common Integration Trade External Tariff Barriers 1. Free Area Trade X X X X X X X X X

Factor and Common Asset Mobility Currency

Common Economic Policy

2. Customs Union 3. Single Market 4. Monetary Union 5. Economic Union

X X X X X X

Customs Union The EU is a customs union. A customs union comprises two (or more) countries which agree to: o Abolish tariffs and quotas between member nations to encourage free movement of goods and services. Goods and services that originate in the EU circulate between Member States duty-free. However these products might be subject to other charges such as excise duty and VAT. o Adopt a common external tariff (CET) on imports from non-members countries. Thus, in the case of the EU, the tariff imposed on, say, imports of Japanese TV sets will be the same in the UK as in any other member country. The important point about a common external tariff is that it prevents individual countries imposing their own unilateral tariffs on different products that differ from other nations in the customs union. o Preferential tariff rates apply to preferential or free-trade agreements which the EU has entered into with third countries or groupings of third countries.
Average import tariffs imposed by the European Union Product groups Dairy products Sugars and confectionery Cereals & preparations Animal products Beverages & tobacco Clothing Fish & fish products Fruit, vegetables, plants Coffee, tea Textiles Oilseeds, fats & oils Chemicals Leather, footwear, etc. Transport equipment
Tutor2u Limited 2008 www.tutor2u.net

Average Tariff Per cent 56.9 32.6 29.1 26.7 23.2 11.5 11.2 10.7 6.5 6.5 5.8 4.6 4.2 4.1

Minerals & metals Petroleum Non-electrical machinery Wood, paper, etc. Cotton

2.0 2.0 1.7 0.9 0.0 Source: WTO web site, accessed August 2007

The EU, as well as all its member states are a member of the World Trade Organisation and, officially at least, subscribes to its free trade ethos. The EU certainly argues in principle for more free trade, but mainly in areas where free trade is to the advantage of the EU! For example, the EU is ready to use the WTO appeals mechanism in its frequent disputes with the USA (the recent battle over the introduction of US steel tariffs is a good example to quote) A customs union shares the revenue from the CET in a pre-determined way in this case the revenue goes into the main EU budget fund. The EU receives its revenues from customs duties from the common tariff, agricultural levies and countries paying 1% of their VAT base. Payments are also made through contributions made by member states based on their national incomes. Thus relatively poorer countries pay less into the EU and tend to be net recipients of EU finances. A single market represents a deeper form of integration than a customs union. It involves the free movement of goods and services, capital and labour and the concept are broadened to encompass economic policy harmonisation for example in the areas of health and safety legislation and monopoly & competition policy. Deeper economic integration requires some degree of political integration, which also requires shared aims and values between nations The economic effects of the creation and development of a customs union can be analysed both in the short term and the long term. We make an important distinction between trade creation and trade diversion effects Trade Creation This involves a shift in domestic consumer spending from a higher cost domestic source to a lower cost partner source within the EU, as a result of the abolition tariffs on intra-union trade. So for example UK households may switch their spending on car and home insurance away from a higherpriced UK supplier towards a French insurance company operating in the UK market. Similarly, Western European car manufacturers may be able to find and then benefit from a cheaper source of glass or rubber for tyres from other countries within the customs union than if they were reliant on domestic supply sources with trade restrictions in place. Trade creation should stimulate an increase in intra-EU trade within the customs union and should, in theory, lead to an improvement in the efficient allocation of scarce resources and gains in consumer and producer welfare.

Tutor2u Limited 2008 www.tutor2u.net

Price

Domestic Supply

Trade creation access to cheaper supplies allows a lower price which benefits consumers P1

Supply price from non EU

Supply price from EU supply EUp Lower price leads to an expansion of demand and a rise in consumer surplus + a net improvement in economic welfare

Domestic Demand

Qs2

Qs1

Qd1

Qd2

Output (Q)

Trade Diversion Trade diversion is best described as a shift in domestic consumer spending from a lower cost world source to a higher cost partner source (e.g. from another country within the EU-15) as a result of the elimination of tariffs on imports from the partner. The common external tariff on many goods and services coming into the EU makes imports more expensive. This can lead to higher costs for producers and higher prices for consumers if previously they had access to a lower cost / lower price supply from a non-EU country. The diagram next illustrates the potential welfare consequences of imposing an import tariff on goods and services coming into the European Union.

Tutor2u Limited 2008 www.tutor2u.net

Price

Domestic Supply

Revenue from Tariff Pw + T

Deadweight loss of welfare from the tariff Pw + Tariff

Pw

World Price M

Domestic Demand

Qs

Qs2

Qd2

Qd

Output (Q)

In general, protectionism in the forms of an import tariff results in a deadweight social loss of welfare. Only short term protectionist measures, like those to protect infant industries, can be defended robustly in terms of efficiency. The common external tariff will have resulted in some deadweight social loss if it has in total raised tariffs between EU countries and those outside the EU. The overall effect of a customs union on the economic welfare of citizens in a country depends on whether the customs union creates effects that are mainly trade creating or trade diverting. Suggestions for further reading on trade agreements Asean and Japan 'in trade pact' (BBC news, August 2007) World trade talks collapse (BBC news, June 2007) The Battle over Trade (BBC news, special report) A Guide to World Trade Blocs (BBC news, December 2005) Guardian Special Report on the World Trade Organisation

Tutor2u Limited 2008 www.tutor2u.net

26.

Trade and the Law of Comparative Advantage

International trade now accounts for nearly 25% of world GDP. The liberalisation (opening-up) of trade in goods and services, and the rapid increase in foreign direct investment across national boundaries have been and will continue to be hugely important for the development of the global economy. In this chapter we look at the theory of international trade.

The virtues of international trade and exchange Economists are normally positive about the economic consequences of trade. Granted there are those who highlight the inequities of the global trading system and in particular, the marginalisation of developing countries who have struggled to build and maintain a competitive advantage in key markets? But taken as a whole, the consensus among economists is that there are significant gains in economic welfare and efficiency arising from the continued expansion of trade and investment between nations. In this section we consider some of the theory of free trade and then analyse and evaluate the arguments for and against import protectionist policies.
If there were an Economists Creed, it would surely contain the affirmations I believe in the Principle of Comparative Advantage and I believe in Free Trade. Paul Krugman, Professor of Economics at MIT, Cambridge

The concept of comparative advantage First introduced by David Ricardo in 1817, comparative advantage exists when a country has a margin of superiority in the production of a good or service i.e. where the marginal cost of production is lower. Countries will usually specialise in and then export products, which use intensively the factors inputs, which they are most abundantly endowed. If each country specialises in those goods and services where they have an advantage, then total output can be increased leading to an improvement in allocative efficiency and economic welfare. Put another way, trade allows each country to specialise in the production of those products that it can produce most efficiently (i.e. those where it has a comparative advantage). This is true even if one nation has an absolute advantage over another country. So for example the Canadian economy which is rich in low cost land is able to exploit this by specialising in agricultural production. The dynamic Asian economies including China have focused their resources in exporting low-cost manufactured goods which take advantage of much lower unit labour costs. In highly developed countries, the comparative advantage is shifting towards specialising in producing and exporting high-value and high-technology manufactured goods and high-knowledge services. Comparative advantage for the UK Using trade data drawn from our balance of payments with other countries, the UKs comparative advantage now lies in the following areas: oil, chemicals & pharmaceuticals, aerospace and medical technology, insurance, financial services, computer services & software, other business services, and entertainment. We have lost much if not all of our comparative advantage in textiles, steel, coal and many other areas of traditional manufacturing industry where we run structural trade deficits. Worked example of comparative advantage
Tutor2u Limited 2008 www.tutor2u.net

Consider two countries producing two products digital cameras and vacuum cleaners. With the same factor resources evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below.

Pre-specialisation UK United States Total

Digital Cameras 600 2400 3000

Vacuum Cleaners 600 1000 1600

Working out the comparative advantage To identify which country should specialise in a particular product we need to analyse the internal opportunity costs for each country. For example, were the UK to shift more resources into higher output of vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television. For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners. If the UK chose to reallocate resources to digital cameras the opportunity cost of one extra camera is still one vacuum cleaner. But for the United States the opportunity cost is only 5/12ths of a vacuum cleaner. Thus the United States has a comparative advantage in producing digital cameras because its opportunity cost is lowest. Output after Specialisation UK United States Total Digital Cameras 0 (-600) 3360 (+960) 3000 3360 Vacuum Cleaners 1200 (+600) 600 (-400) 1600 1800

o The UK specializes totally in producing vacuum cleaners doubling its output to 1200 o The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners o As a result of specialisation according to the principle of comparative advantage, output of both products has increased - representing a gain in economic welfare. For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another. There are gains from trade between the two countries. If the two countries trade at a rate of exchange of 2 digital cameras for one vacuum cleaner, the post-trade position will be as follows: o The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras o The USA exports 840 digital cameras and imports 420 vacuum cleaners Post trade output / consumption UK Digital Cameras 840
Tutor2u Limited 2008 www.tutor2u.net

Vacuum Cleaners 780

United States Total

2520 3360

1020 1800

Compared with the pre-specialisation output levels, consumers in both countries now have an increased supply of both goods to choose from.

Assumptions behind trade theory This theory of the potential benefits from trade and exchange using the law of comparative advantage is based on a number of underlying assumptions: 1. Occupational mobility of each of the factors of production (land, labour, capital etc.) -this means that switching factor resources from one industry to another involves no loss of relative efficiency and productivity. In reality of course we know that factors of production are not perfectly mobile labour immobility for example is a root cause of structural unemployment 2. Constant returns to scale (i.e. doubling the inputs used in the production process leads to a doubling of output) this is merely a simplifying assumption. Specialisation might lead to diminishing returns in which case the economic benefits from trade are reduced. Conversely, increasing the scale of production can generate increasing returns to scale - in which case the benefits from trade are even stronger than the numerical example we have considered 3. No externalities arising from production and/or consumption meaning that there is no divergence between private and social costs and benefits. Again this is a simplifying assumption. No discussion about the overall costs and benefits of specialisation and trade should ignore many of the environmental considerations arising from increased production and trade between countries. What Determines Comparative Advantage?
A country's place in the global economy seems neither predestined nor predictable. Comparative advantage is almost impossible to spot in advance. Source: The Economist, April 2004

Comparative advantage is best viewed as a dynamic concept meaning that it can and does change over time. Some businesses find they have enjoyed a comparative advantage within their own market in one product for several years only to face increasing competition as rival producers from other countries enter their markets and under cut them on price or take market share through non-price competition. For a country, the following factors are often seen as important in determining the relative costs of production: 1. The quantity and quality of factors of production available (e.g. the size and efficiency of the available labour force and the productivity of the existing stock of capital inputs.) 2. Investment in research & development (this is important in industries where patents give some firms a significant market advantage) there is quite strong evidence that an emerging comparative advantage often comes from entrepreneurial trial and error the never ending process of engaging in research and innovation to find more efficient processes and new products. 3. Fluctuations in the real exchange rate which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers.
Tutor2u Limited 2008 www.tutor2u.net

4. Import controls such as tariffs, export subsidies and quotas can be used to create an artificial comparative advantage for a country's domestic producers. 5. The non-price competitiveness of producers (e.g. covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support.)

Gross domestic expenditure on Research & Development As a percentage of GDP, data is for 2003, source: OECD 2003 Sweden 3.98 EU15 Finland 3.48 United Kingdom Japan 3.15 Netherlands United States 2.68 Norway Korea 2.63 China Denmark 2.62 Russian Federation Germany 2.52 Czech Republic France 2.18 Ireland Canada 1.95 Spain

2003 1.91 1.88 1.84 1.75 1.31 1.29 1.26 1.19 1.05

Comparative advantage is often a self-reinforcing process. Entrepreneurs in a country develop a new comparative advantage in a product (either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets). Rising demand and output encourages the exploitation of economies of scale; higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry and so on. The wider benefits of international trade One way of expressing the gains from trade in goods and services between countries is to distinguish between the static gains from trade (i.e. improvements in allocative and productive efficiency) and the dynamic gains (the gains in welfare that occur over time from improved product quality, increased choice and a faster pace of innovative behaviour) Some of the broader gains from free trade are outlined below: 1. Welfare gains allocative efficiency: Free trade can be shown under certain conditions to lead to significant increases in welfare. Neo-liberal economists who support the liberalisation of trade between countries believe that trade is a positive-sum game in other words, all counties engaged in open trade and exchange stand to gain. 2. Economies of scale - trade allows firms to exploit scale economies by operating in larger markets. Economies of scale lead to lower average costs of production that can be passed onto consumers. 3. Competition / market contestability trade promotes increased competition particularly for those domestic monopolies that would otherwise face little real competition. For example, Corus faces competition from overseas steel producers and is effectively a price-taker in the world market. The Royal Mail will have to fight hard to maintain its market position during the phased liberalization of the European postal services market between now and 2007.
Tutor2u Limited 2008 www.tutor2u.net

4. Dynamic efficiency gains from innovation - trade also enhances consumer choice and international competition between suppliers help to keep prices down. Trade in ideas stimulates product and process innovations that generates better products for consumers and enhances the overall standard of living. 5. Access to new technology: Trade, like investment, is also an important mechanism by which countries can have access to new technologies. Although the importation of new technology may have negative employment consequences for those workers who lose their jobs because of capital-labour substitution, provided that an economy is flexible enough to be able to reemploy these workers, there should be no net loss of jobs as a result. To the contrary, new technology creates new jobs in support industries. 6. Rising living standards and a reduction in poverty - James Wolfeson (Head of the World Bank) has argued that trade can be a powerful force in reducing poverty and raising living standards. A growing body of evidence shows that countries that are more open to trade grow faster over the long run than those that remain closed. And growth directly benefits the world's poor. A one percentage point increase in growth on average reduces poverty by more than 1.5 per cent each year.
Virtuous trade Trade's virtuous effects are of two distinct kinds. First, trade helps countries make the most of what they already have. It frees countries to allocate their resourceswhether they are cheap labour, fertile land or educated mindsas efficiently as possible. But, secondly, trade can also allow countries to accumulate resources more quickly. Indeed, the biggest prizes lie in faster growth, not heightened efficiency; in accumulation and innovation, not allocation. Source: Adapted from the Economist, July 20th 2006 Exporting to the world economy raises the productivity of UK businesses New research by Professor David Greenaway and Dr Richard Kneller published in the February 2007 issue of the Economic Journal finds that businesses focused on exporting their products to other countries are more likely to improve productivity levels than firms concentrating solely on the domestic market place. The research will be welcome news for those who believe that open trade is a means by which the supply-side of the economy can be improved. Selling goods and services into foreign markets clearly has a direct effect on aggregate demand since exports represent an injection into the circular flow of income and spending. There are also multiplier effects arising from the income generated from producing an output for consumers overseas. But this new research provides a good example of some of the supply-side benefits from exporting. If productivity is raised, then the trend growth rate for the economy can be lifted and this has important implications for competitiveness and living standards going forward. Many of the productivity gains need to be made before a business breaks into the export sector. There are often natural entry barriers to selling profitably in overseas markets and increased efficiency is a necessary pre-condition to raising the profits needed to cover market research costs and refinement of existing products ready to sell to overseas buyers. The research claims that exporting is also a catalyst for wider productivity gains across the whole industry hinting at positive spill-over effects for the economy. Source: Adapted from the Economic Journal, February 2007

The Terms of Trade The terms of trade measures the rate of exchange of one good or service for another when two countries trade with each other. For international trade to be mutually beneficial for each country, the
Tutor2u Limited 2008 www.tutor2u.net

terms of trade must lay within the opportunity cost ratios for both countries. We calculate the terms of trade as an index number using the following formula: Terms of Trade Index (ToT) = 100 x Average export price index / Average import price index If export prices are rising faster than import prices, the terms of trade index will rise. This means that fewer exports have to be given up in exchange for a given volume of imports. If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services. The terms of trade fluctuate in line with changes in export and import prices. Clearly the exchange rate and the rate of inflation can both influence the direction of any change in the terms of trade.

United Kingdom Terms of Trade for Goods


Terms of trade index, 2001=100
103 102 101 100
2003=100
103

102

101

100

99 98 97 96 95 94 00 01 02 03 04 05 06 07

99

98

97

96

95

94

Source: Reuters EcoWin

World Trade Review for 2006 The world economy and trade grew vigorously in 2006 according to the latest annual review from the World Trade Organisation. There was an impressive 8% expansion in merchandise trade and GDP growth was "stronger than expected" in Europe and Japan. Least-developed countries trade grew by about 30%, fuelled by higher prices for petroleum and other primary commodities. They and developing countries as a whole saw their shares of world merchandise trade reach record proportions. And for some of the smaller suppliers, fear of a setback in textiles and clothing in the face of competition from China proved unfounded in 2006. Among the main results from the WTO review was the following 1. The dollar value of world merchandise exports increased by 15% to $11.76 trillion in 2006. 2. Services exports were up by an estimated 11% and reached $2.71 trillion in 2006.
Tutor2u Limited 2008 www.tutor2u.net

3. Chinas merchandise exports grew by 27%! 4. Developing countries share of world exports reached an all time record of 36%. The 0.9% share for least-developed countries was also a record, the highest level since 1980. 5. Global FDI inflows surged by one-third to $1.23 trillion, the second highest level ever 6. Debt levels, measured by the outstanding debt to GDP ratios, decreased in all developing regions partly due to debt forgiveness 7. The world export prices of minerals and non-ferrous metals increased by 56%, those of fuels by 20% and those of food and agricultural raw materials by 10%.

Tutor2u Limited 2008 www.tutor2u.net

27.

Protectionism

Why are there so many trade disputes around the world economy? Can protectionism ever be justified? This chapter considers the issue of import controls.

Over many years, the world economy has seen a rise in the volume and value of trade. Most countries recognise the long-term benefits of free trade in goods and services between nations although there are disputes about what free trade actually means! Trade is widely regarded as a catalyst for growth both on the demand and supply-side of their economies. But frequently there are trade disputes between countries as often as not because one or more parties believes that trade is being conducted unfairly, on an uneven playing field, or because they believe that there is an economic or strategic justification for some form of import control. Whether or not there is ever a fully persuasive justification for protectionist measures from a purely economics vantage point is open to discussion and debate. In this section we consider some of the options for controlling imports; the arguments for introducing them and an evaluation of their economic consequences.
Expanding trade in the global economy All merchandise trade, annual average % change 1950-63 1963-73 1973-90 1990-01 2000-05 Trade Production

7.7 5.2 9.0 6.1 3.8 2.6 5.7 2.1 4.5 2.5 Source: World Trade Organisation

Free trade produces winners and losers - not all countries benefit at the same time from trade particularly those with poor competitiveness, although it is true that trade still offers potential gains for all countries involved. If a country believes that it is not benefiting fairly from participating in free international trade, it is more likely to want to introduce some form of import control or protectionist measure. What is protectionism? Protectionism represents any attempt by a government to impose restrictions on trade in goods and services between countries: o Tariffs - import taxes. o Quotas - quantitative limits on the level of imports allowed. o Voluntary Export Restraint Arrangements where two countries make an agreement to limit the volume of their exports to one another over an agreed period of time. o Embargoes - a total ban on imported goods. o Intellectual property laws (patents and copyrights). o Export subsidies - a payment to encourage domestic production by lowering their costs. o Import licensing - governments grants importers the license to import goods.
Tutor2u Limited 2008 www.tutor2u.net

o Exchange controls - limiting the amount of foreign exchange that can move between countries. Quotas, embargoes, export subsidies and exchange controls are all examples of non-tariff barriers to international trade. Tariffs A tariff is a tax that raises the price of imported products and causes a contraction in domestic demand and an expansion in domestic supply. The net effect is that the volume of imports is reduced and the government received some tax revenue from the tariff. Import Quotas The Government might seek to limit the level of imports through a quota. Examples of quotas were found in the textile industry under the terms of the Multi-Fibre Agreement which expired in January 2005 and which led, in 2005, to a trade dispute between the EU and China over the issue of textile imports. Quotas introduce a physical limit of the volume (number of units imported) or value (value of imports) permitted Administrative Barriers Countries can make it difficult for firms to import by imposing restrictions and being 'deliberately' bureaucratic. These trade barriers range from stringent safety and specification checks to extensive hold-ups in the customs arrangements. A good example is the quality standards imposed by the EU on imports of dairy products. Preferential Government Procurement Policies and State Aid Free trade can be limited by preferential behaviour by the government when allocating major spending projects that favour domestic rather than overseas suppliers. These procurement policies run against the principle of free trade within the EU Single Market but they remain a feature of the trade policies of many developed countries within Western Europe. Good examples include the award of contracts to suppliers of defence equipment or construction companies involved in building transport infrastructure projects. The use of financial aid from the state can also distort the free trade of goods and services between nations, for example the use of subsidies to a domestic coal or steel industry, or the widely criticized use of export refunds (subsidies) to European farmers under the Common Agricultural Policy (CAP) which is criticized for damaging the profits and incomes of farmers in developing countries. Economic justifications for protectionism Infant Industry Argument The essence of the argument is that certain industries possess a potential (latent) comparative advantage but have not yet exploited the potential economies of scale. Short-term protection from established foreign competition allows the infant industry to develop its comparative advantage. At this point the trade protection could be relaxed, leaving the industry to trade freely on the international market. The danger of this form of protection is that the industry will never achieve full efficiency. The short-term protectionist measures often start to appear permanent.

Tutor2u Limited 2008 www.tutor2u.net

United Nations urges trade support for infant industries The United Nations has urged developing countries to subsidise their young businesses and protect them with tariffs, saying that free-market reforms have failed the poor. Governments of poor countries have been told to prop up growing strategic industries until they are strong enough to compete with the West. The United Nations Conference on Trade and Development, in its annual Trade and Development Report, said that the market-based liberalisation foisted on developing countries since the 1980s had led to unsatisfactory outcomes. Governments should foster domestic business and avoid being overly restricted by international trade rules. The report said that it rejected protectionism, but argued that countries such as the Asian tiger economies had been able to strengthen the creative power of their markets through proactive industrial policies. Implementing some temporary protection . . . should be considered a key element of a policy aimed at strategic trade integration, it said. Source: The Times, 4th September 2006

Protection a reaction against import dumping The nature of dumping Dumping is a type of predatory pricing behaviour and is also a form of price discrimination. The concept is used most frequently in the context of trade disputes between nations, where businesses in one or more countries may seek to produce evidence that manufacturers in another country are exporting products at a price below the true cost of production. True dumping according to the definitions employed by the World Trade Organisation is illegal under WTO rules. But it can be difficult, time-consuming and costly to prove allegations of dumping, not least the problems in calculating the production costs of a supplier in their own domestic market. Export subsidies and dumping in developing countries Many developing countries have complained about the effects of dumping caused by the system of export refunds (subsidies) offered to producers by the European Union. These subsidies have the effect of reducing the costs of suppliers and allow them to offload their surplus production into overseas markets. This can have a very damaging effect on prices, demand and profits for the domestic producers of developing countries trying to compete in their home markets. The charity Oxfam has been especially vocal in its criticism of the effects of the trade policies of the developed world in sustaining high levels of poverty in many of the worlds poorest nations. You can read more about their current campaign on trade by accessing this site: http://www.oxfam.org.uk/what_we_do/issues/trade/
Protection against dumping Anti-dumping is designed to allow countries to take action against dumped imports that cause or threaten to cause material injury to the domestic industry. Goods are said to be dumped when they are sold for export at less than their normal value. The normal value is usually defined as the price for the like goods in the exporters home market. Source: DTI web site www.dti.gov.uk

Anti-dumping tariffs - recent examples


Tyres: India has initiated anti-dumping investigations against imports of bus and truck tyres from China and Thailand Norwegian salmon:

Tutor2u Limited 2008 www.tutor2u.net

The European Union (EU) has imposed anti-dumping measures on Norwegian farmed salmon in the form of a minimum import price of 2.80 Euro per kilogram. The EU acted in response to complaints from EU salmon farmers, mainly in Scotland and Ireland, that a sudden surge in imports from Norway was driving them out of business. Television picture tubes The European Commission has opened an investigation into claims that Chinese, Korean, Malaysian and Thai companies are selling cathode-ray colour television picture tubes in Europe at prices below their cost. The EU industry group provided evidence that cathode ray imports had increased volume and market share. In the recent past, the EU has antidumping duties against a range of Chinese products from aluminium foil to zinc oxides. China is the EU's second largest trading partner after the United States, accounting for 12 percent of all EU imports in 2004 - mostly machinery, vehicles and other manufactured goods. Shoes: European shoemakers have alleged that China and Vietnam shoe producers are illegally dumping leather, sports and safety shoes on the European market. The EU Trade Commissioner Peter Mandelson has said that China has a responsibility to ensure that illegal dumping does not take place and an investigation is now underway.

Candle makers allege dumping in bid to have tariffs imposed on China Four of Europe's biggest candle manufacturers are calling on Peter Mandelson, the EU trade commissioner, to impose anti-dumping tariffs on cheap Chinese candles that they believe are being dumped on the European market. The group wants the EU to impose tariffs on cheap imports from the Far East, which they believe could result in 20,000 jobs being put at risk. It also believes that imports are threatening the quality of Europeanproduced candles. European candle-makers have seen the volume of imports from China and Vietnam rocket in recent years. However, European producers still make around 450,000 tonnes of candles a year, compared with the 100,000 tonnes that are imported into Europe. Britain is the largest importer of candles from China. However, British candle makers had been holding their own in the face of Far Eastern imports. They have diversified away from the cheap end of the market, which is most affected by imports, and moved towards making scented or personalised candles, areas that Chinese producers have yet to tap.

If a company exports a product at a price lower than the price it normally charges on its own home market, it is said to be dumping the product. In the short term, consumers benefit from the low prices of the foreign goods, but in the longer term, persistent undercutting of domestic prices will force the domestic industry out of business and allow the foreign firm to establish itself as a monopoly. Once this is achieved the foreign owned monopoly is free to increase its prices and exploit the consumer. Therefore protection, via tariffs on 'dumped' goods can be justified to prevent the long-term exploitation of the consumer. The World Trade Organisation allows a government to act against dumping where there is genuine material injury to the competing domestic industry. In order to do that the government has to be able to show that dumping is taking place, calculate the extent of dumping (how much lower the export price is compared to the exporters home market price), and show that the dumping is causing injury. Usually an anti-dumping action means charging extra import duty on the particular product from the particular exporting country in order to bring its price closer to the normal value. Externalities, Market Failure and Import Controls Protectionism can also be used to take account of externalities and dealing with de-merit goods. Goods such as alcohol, tobacco and narcotic drugs have adverse social effects and are termed de Tutor2u Limited 2008 www.tutor2u.net

merit goods. Protectionism can safeguard society from the importation of these goods, by imposing high tariff barriers or by banning the importation of the good altogether. Non-Economic Reasons Countries may wish not to over-specialise in the goods in which they possess a comparative advantage. One danger of over-specialisation is that unemployment may rise quickly if an industry moves into structural decline as new international competition emerges at lower costs The government may also wish to protect employment in strategic industries, although clearly value judgements are involved in determining what constitutes a strategic sector. The recent trade dispute arising from the decision by the United States to introduce a tariff on steel imports is linked to this objective. The US steel tariff was declared unlawful by the WTO in July 2003 and eventually the United States was pressurized into withdrawing these tariffs in the late autumn of 2003. Tariffs are not a major source of tax revenue for the Government that imposes them. In the UK for example, tariffs are estimated to be worth only 2 billion to the Treasury, equivalent to only around 0.5% of the total tax take. Developing countries tend to be more reliant on tariffs for revenue. Economic Arguments against Import Controls
Protectionism Hurting Consumers Tariffs, non-tariff barriers and other forms of protection serve as a tax on domestic consumers. Moreover, they are very often a regressive form of taxation, hurting the poorest consumers far more than the better off. In the EU for instance, the nature of existing protection means that the heaviest taxes tend to fall on the necessities of life such as food, clothing and footwear. Source: DTI Economics Report on Trade Liberalisation and Investment, April 2004 www.dti.gov.uk

According to Professor Jagdish Bhagwati, the fact that trade protection hurts the economy of the country that imposes it is one of the oldest but still most startling insights economics has to offer. The folly of protection has been confirmed by a range of studies from around the world. These indicate that that it has brought few benefits but imposed substantial costs. 1. Market distortion: Protection has proved an ineffective and costly means of sustaining employment. a. Higher prices for consumers: Trade barriers in the form of tariffs push up the prices faced by consumers and insulate inefficient sectors from competition. They penalise foreign producers and encourage the inefficient allocation of resources both domestically and globally. In general terms, import controls impose costs on society that would not exist if there was completely free trade in goods and services. It has been estimated for example that the recent tariff and other barriers placed on imports of steel into the US increased the price of every car produced there by $100 b. Reduction in market access for producers: Export subsidies, depressing world prices and making them more volatile while depriving efficient farmers of access to the world market. This is a major criticism of the EU common agricultural policy. 2. Loss of economic welfare: Tariffs create a deadweight loss of consumer and producer surplus arising from a loss of allocative efficiency. Welfare is reduced through higher prices and restricted consumer choice.
Tutor2u Limited 2008 www.tutor2u.net

3. Regressive effect on the distribution of income: It is often the case that the higher prices that result from tariffs hit those on lower incomes hardest, because the tariffs (e.g. on foodstuffs, tobacco, and clothing) fall on those products that lower income families spend a higher share of their income. Thus import protection may worsen the inequalities in the distribution of income making the allocation of scarce resources less equitable 4. Production inefficiencies: Firms that are protected from competition have little incentive to reduce production costs. Governments must consider these disadvantages carefully 5. Little protection for employment: One of the justifications for protectionist tariffs and other barriers to trade is that they help to protect the loss of relatively low skilled and low paid jobs in industries that are coming under sever international competition. The evidence suggests that, in the long term, tariffs are a costly and ineffective way of protecting such jobs. 6. Trade wars: 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. Retaliatory actions increase the costs of importing new technologies 7. Negative multiplier effects: If one country imposes trade restrictions on another, the resultant decrease in total trade will have a negative multiplier effect affecting many more countries because exports are an injection of demand into the global circular flow of income. The negative multiplier effects are more pronounced when trade disputes boil over and lead to retaliation.
Price Domestic Supply

Revenue from Tariff

Deadweight loss of economic welfare from the tariff Pw + Tariff

Pw + T World Price Pw M

Domestic Demand

Qs

Qs2

Qd2

Qd

Output (Q)

In a new study of the benefits of global trade and investment published in May 2004, the UK Department of Trade of Industry outlined their opposition to import controls (protectionism)
Higher taxes and higher prices Protectionism imposes a double burden on tax payers and consumers. In the case of European agriculture, the cost to tax payers is about 50 billion a year, plus around 50 billion a year to consumers via artificially high
Tutor2u Limited 2008 www.tutor2u.net

food prices together the equivalent of over 800 a year on the annual food budget of an average family of four. Furthermore huge distortions in international agriculture markets prevent the worlds poorest countries from trading in the products they are best able to produce. Continuing barriers to trade are costing the global economy around $500 billion a year in lost income. Source: www.dti.gov.uk (Economics Paper 10)

Protectionist policies rarely achieve their aims. They are costly to administer and they provide domestic suppliers with a protectionist shield that encourages inefficiencies leading to higher costs. Protectionism is a second best approach to correcting for a countrys balance of payments problem or the fear of rising structural unemployment. And import controls go against the principles of free trade enshrined in the theories of comparative advantage. In this sense, import controls can be seen as examples of government failure arising from intervention in markets. Economic nationalism Economic nationalism is a term that has become used more frequently in recent years. It is used to describe policies which are guided by the idea of protecting a country's home economy, i.e. protecting domestic consumption, jobs and investment, even if this requires the imposition of tariffs and other restrictions on the movement of labour, goods and capital. Economic nationalism may include such doctrines as protectionism and import substitution. Examples of economic nationalism include China's controlled exchange of the yuan, and the United States' use of tariffs to protect domestic steel production. The term gained a more specific meaning in 2005 and 2006 after several European Union governments intervened to prevent takeovers of domestic firms by foreign companies. In some cases, the national governments also endorsed counterbids from compatriot companies to create 'national champions'. Such cases included the proposed takeover of Arcelor (Luxembourg) by Mittal Steel (India). And the French government listing of the food and drinks business Danone (France) as a 'strategic industry' to pre-empt a potential takeover bid by PepsiCo (USA).
Vietnam joins the WTO what about her economy? On the 10th of January 2007, a significant milestone was reached for the World Trade Organisation with the accession of Vietnam to the WTO, the 150th country to be accepted into the organisation that polices trade in goods and services throughout the global economy. The accession came at the end of over a decade of preparation and Vietnam becomes the first country to join since Saudi Arabia came on board in 2005. It was the second most populous country in the world not to be a member of the WTO. Russia remains outside for the near future although negotiations are in place. Membership of the WTO will, it is hoped, act as a catalyst for increased trade and foreign direct investment from and into Vietnam. But, as with any exclusive club, there are rules and responsibilities as well. While communist ruled Vietnam will have to gradually reduced and withdraw a number of government subsidies and tax breaks previously granted to Vietnamese companies. Tariffs on imports will have to come down and this poses a competitive threat to the economic viability of many of Vietnams domestic industries.

Further reading on trade and protectionism BBC special report on the Battle over Trade China faces Indian dumping allegations (BBC news July 2006)
Tutor2u Limited 2008 www.tutor2u.net

Foreign lesions (James Surowiecki The Guardian) Guardian special report on fair trade OECD international trade and investment research articles Oxfam campaign for fair international trade Patriotism and protectionism in the European Union (BBC news March 2006) US steel tariffs (2002) Why developing countries should liberalise their trade (Globalisation Institute) World Trade Organisation 2006 World Trade Report Brazil claims WTO victory on cotton subsidies (BBC, July 2007)

Tutor2u Limited 2008 www.tutor2u.net

28.

The Balance of Payments

In this chapter we consider the numbers which tell us something about how well Britain is doing in paying her way in the international economy.

The balance of payments records financial transactions between Britain and the international economy. The accounts are split into two sections with the current account measuring trade in goods and services and net investment incomes and transfers whilst 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. UK current account balances 1997-2006
Trade in goods 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 billion -12.3 -21.8 -29.1 -33.0 -41.2 -47.7 -48.6 -60.9 -68.8 -83.6 Trade in services billion 14.1 14.7 13.6 13.6 14.4 16.8 19.2 25.9 24.6 29.2 Total trade billion 1.8 -7.1 -15.5 -19.4 -26.8 -30.9 -29.4 -35.0 -44.2 -54.4 Total income billion 3.3 12.3 1.3 4.5 11.7 23.4 24.6 26.6 25.7 18.6 Current transfers billion -5.9 -8.4 -7.5 -10.0 -6.8 -9.1 -10.1 -10.9 -12.0 -11.9 Current balance billion -0.8 -3.2 -21.7 -24.8 -21.9 -16.5 -14.9 -19.3 -30.5 -47.8

Tutor2u Limited 2008 www.tutor2u.net

UK Balance of Trade in Goods


Balance of exports minus imports of goods at current prices, billion
0 -10 -20 -30
GBP (billions)
0

-10

-20

-30

-50 -60 -70 -80 -90 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

-50

-60

-70

-80

-90

Source: Reuters EcoWin

Tutor2u Limited 2008 www.tutor2u.net

billions

-40

-40

UK Balance of Trade in Services


Balance of exports minus imports of services, current prices, billion
30.0 27.5 25.0 22.5 20.0
GBP (billions)
30.0 27.5 25.0 22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0 2.5 0.0

17.5 15.0 12.5 10.0 7.5 5.0 2.5 0.0 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Source: Reuters EcoWin

Tutor2u Limited 2008 www.tutor2u.net

billions

UK Balance of Trade in Services


Quarterly trade balance, seasonally adjusted
7 6 5 4 3
GBP (billions)
7 6 5 4

Financial services

3 2

2 1 0 -1 Transportation -2 -3 -4 -5 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Travel Royalties and license fees Communications

1 0 -1 -2 -3 -4 -5

Source: Reuters EcoWin

Tutor2u Limited 2008 www.tutor2u.net

billions

Components of the UK Balance of Payments


Annual balances for each component, billion
30 20 10 0 -10
Billion (billions)
30

Trade in Services

20 10

Investment income Transfers

0 -10 -20 -30 -40

-20 Current account -30 -40 -50 -60 -70 -80 -90
97 98 99 00 01 02 03 04 05 06

Trade in Goods

-50 -60 -70 -80 -90

Source: Reuters EcoWin

The causes of a trade deficit It is useful to group the explanations for a 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 supplyside of the economy can deliver, leading to a high level of demand for imported goods and services. Research 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 Profess or Mike Kitson 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. The strong sterling exchange rate has helped to reduce the UK price of imports causing an expenditure-switching effect away from domestically produced output. In technical terms, the high pound has improved the terms of trade between the UK and other countries, allowing us to buy and consume more imports with each pound we earn. Consumers have taken advantage of the high pound! UK trade balances have been affected by important shifts in comparative advantage in the international economy for example the rapid growth of China as a source of exports of
Tutor2u Limited 2008 www.tutor2u.net

ii

Medium-term factors
i

billions

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

UK Trade Balance in Goods & Services with China


billions per year
0 -1 -2 -3 -4
GBP (billions)
0 -1 -2 -3 -4 -5 -6 -7 -8 -9 -10 -11 -12

-5 -6 -7 -8 -9 -10 -11 -12 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Source: Reuters EcoWin

Much of our trade deficit is due to structural rather than cyclical factors - our trade performance has been hindered by supply-side deficiencies which impact on the price and non-price competitiveness 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 industrialised countries o The persistence of a productivity gap with our major competitors measured by differences in GDP per person employed or per hour worked this is linked to low investment and also to the existence of a skills-gap between UK workers and employees in many other countries o A relatively weak performance in terms of product innovation linked to a low rate of business sector spending on research and development

ii

The UK manufacturing sector has been in long-term decline for more than twenty years. 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
Tutor2u Limited 2008 www.tutor2u.net

billions

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. Does a current account deficit really matter? Should we be concerned if, as an economy, we are running a large current account deficit? The UK has run large current account deficits in recent years with barely any effect on the overall performance of the economy. The United States economy is also experiencing a huge trade deficit at the moment. What are the implications of this?

USA and UK Balance of Payments - Current Account


As a percentage of GDP
1 0 -1
Per cent of national income
UK 1

-1

-2 -3 -4 -5 -6 -7 -8 95 96

USA

-2

-3

-4

-5

-6

-7

-8

97

98

99

00

01

02

03

04

05

06

07

08

Source: Reuters EcoWin

In the 1950s, 60s and 70s, small balance of payments deficits in the UK caused economic crises with periods of strong speculative selling of sterling on the foreign exchange markets and much political instability. The devaluation of the pound in 1967 led directly to the resignation of the then Chancellor, James Callaghan. These days, trade deficits of enormous proportions seem to have little effect in global currency markets. Some policymakers and economists believe the balance of payments no longer matters because of globalisation and financial liberalisation: in other words, trade and current account deficits can be more easily financed by globally integrated capital markets freed from the capital controls that have been dismantled since the end of the 1970s.
Tutor2u Limited 2008 www.tutor2u.net

This free movement of global financial capital has allowed countries, in principle, to increase their domestic investment beyond what could be financed by a countrys own savings. Increasingly what we want to consume is produced abroad and if a country wants to operate with a sizeable current account deficit, then provided there is a capital account surplus, there is no fundamental economic constraint. Britain has been a favoured venue for inward investment (an inflow of capital) and our relatively high interest rates compared to the USA and the Euro Zone has also attracted large-scale inflows of money into our banking systems. In this way the current account has been financed with little obvious economic pain. The main arguments for being relaxed about a current account deficit are as follows:
i ii

Partial auto-correction: If some of the deficit is due to strong consumer demand, the deficit will partially-self correct when the economic cycle turns and there is a slowdown in spending Investment and the supply-side: Some of the deficit may be due to increased imports of new capital and technology which will have a beneficial effect on productivity and competitiveness of producers in home and overseas markets Capital inflows balance the books: Providing a country has a stable economy and credible economic policies, it should be possible for the current account deficit to be financed by inflows of capital without the need for a sharp jump in interest rates. The UK has run an average annual current account deficit of 10 billion from 1992-2004 and yet the economy has also enjoyed one of the longest sustained periods of growth and falling unemployment during that time

iii

But
i

Structural weaknesses: The trade / current account deficit may be a symptom of a wider structural economic problem i.e. a loss of competitiveness in overseas markets, insufficient investment in new capital or a shift in comparative advantage towards other countries. An unbalanced economy too much consumption: A large deficit in trade is a sign of an unbalanced economy typically the consequences of a high level of consumer demand contrasted with a weaker industrial sector. Eventually these macroeconomic imbalances have to be addressed. Consumers cannot carry on spending beyond their means for the danger is that rising demand for imports will be accompanied by a surge in household debt. Potential loss of output and employment: A widening trade deficit may result in lost output and employment because it represents a net leakage from the circular flow of income and spending. Workers who lose their jobs in export industries, or whose jobs are lost because of a rise in import penetration, may find it difficult to find new employment. Potential problems in financing a current account deficit: Countries cannot always rely on inflows of financial capital into an economy to finance a current account deficit. Foreign investors may eventually take fright, lose confidence and take their money out. Or, they may require higher interest rates to persuade them to keep investing in an economy. Higher interest rates then have the effect of depressing domestic consumption and investment. The current situation in the United States is very interesting in this respect. Such is the size of the current account deficit that the USA must rely on huge capital inflows each year and eventually investors in other countries may decide to put their money elsewhere this would put severe downward pressure on the US dollar (see below)

ii

iii

iv

Tutor2u Limited 2008 www.tutor2u.net

Downward pressure on the exchange rate: A large deficit in trade in goods and services represents an excess supply of the currency in the foreign exchange market and can lead to a sharp fall in the exchange rate. This would then threaten an increase in imported inflation and might also cause a rise in interest rates from the central bank. A declining currency would help stimulate exports but the rise in inflation and interest rates would have a negative effect on demand, output and employment.

The UK has run a current account deficit in each year since 1998 but that the size of the deficit expressed as a percentage of national income (GDP) has actually been falling in the last three years it is now less than 2% of GDP a manageable level with few obvious painful consequences. Hopefully our trade balances will improve if (a) UK businesses successfully improve their cost and price competitiveness (b) The exchange rate depreciates to provide the export sector with a competitive boost (c) The UK manages to take advantage of a forecast acceleration in the rate of growth of world trade in the next few years

United Kingdom Stock of International Investment


Annual investment position, inward and outward investment, billion at current prices
800 700 600 500
GBP (billions)
800 700 600 500 400 300 200 100 0 -100

300 200 100 0 -100 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Balance of FDI

UK Outward investment

UK Inward Investment Source: Reuters EcoWin

In contrast the US economy is operating with a current account deficit on an enormous scale and this is part of the twin deficit problem that will have to be addressed in the near term (The US government is facing up to huge current account and budget deficit problems).
Risks from a current account deficit The economic history of Britain has been heavily influenced by its balance of payments position. For policymakers, it's always difficult working out how much of any current account deficit is sustainable and how much may be contributing to future economic difficulties. Nowadays, it's quite possible to run current account
Tutor2u Limited 2008 www.tutor2u.net

billions

400

deficits for a long time, reflecting a country's ability to attract the world's increasingly mobile capital. The problem, though, is that the very same capital can swiftly head for the exit at the first sign of trouble. Source: Stephen King, Independent, December 2004

National income and the balance of payments What are the links between the rate of growth in an economy and movements in the balance of payments? Normally, as domestic incomes rise we expect to see an increased demand for imports. This can come from both consumers and firms. The extent to which imports rise when incomes grow is shown by the income elasticity of demand for imports. In the diagram below, spending on imports is assumed to be directly linked to the level of national income. The higher the marginal propensity to consume the steeper will be the gradient of the import function. Exports are assumed to be exogenous of the level of domestic national income.
LRAS Inflation Imports (M)

Exports (X)

P2 P1 National Income

AD1 SRAS AD2 Balance of Trade (X-M)

Y1

Y2

Yfc

National Income

If the marginal propensity to import is high then imports will rise quickly when the economy experiences economic growth. Unless there is a corresponding rise in the volume of exports sold overseas, the balance of trade will worsen.

Tutor2u Limited 2008 www.tutor2u.net

Consumer Spending and Trade in Goods and Services


Consumer spending, GDP growth and the balance of trade
2.5
Trade Balance (billions)
2.5 0.0 -2.5

0.0 -2.5 -5.0 -7.5 -10.0 -12.5 -15.0 -17.5 7 6 5 4 3 2 1 0 -1 -2 -3 90 91 92 93 94 95 96 97 98 99 Consumer spending

-7.5 -10.0 -12.5 -15.0 -17.5 7 6 5 4 3 2 1 0 -1 -2 -3

Annual % change

Real GDP

00

01

02

03

04

05

06

07

Source: Reuters EcoWin

The balance of payments and living standards A 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 acts as a short-term boost to living standards since it allows consumers to buy a higher level of household durables and other items. A widening trade deficit might also be the result of an increase in imports of capital equipment and technology which will provide a boost to a countrys potential national output. If imports of investment goods improve our competitiveness, this raises the prospect of an increase in employment and real incomes arising from a better supply-side economic performance. However in the long term, if the trade deficit is a symptom of a weakening domestic economy and a lack of international competitiveness then living standards may decline. Policies to control / reduce a balance of payments deficit Which policies are likely to be most effective in improving the current account deficit of the balance of payments? We need to make a distinction between demand and supply-side causes of the problem. If the root cause of a high trade deficit is an excessive level of aggregate demand, the deficit may improve automatically in the event of an economic downturn or recession, when real incomes and spending slow down. However if the deficit is largely the consequence of supply-side economic weakness, then policies need to be effective in improving our cost and non-price competitiveness and in expanding the economy's productive potential is essential - particularly the tradable sector, to allow it to grow without its external position continuing to deteriorate.

Tutor2u Limited 2008 www.tutor2u.net

billions

-5.0

Central to improving the UKs trade performance is the health of the manufacturing sector: although services are a growing part of the economy, manufacturing still accounts for about 75% of exports. The government's growth strategy is focused on improving the supply side of the economy such policies may be effective but they will take time to work. Expenditure Reducing Policies These are policies that aim to reduce the real spending power of consumers Fiscal policy can be used (e.g. a rise income tax that reduces disposable income) Higher interest rates would dampen consumer spending and reduce economic growth

Expenditure Switching Policies These are policies that attempt encourage consumers to switch their spending away from imports towards the output of domestic firms. Expenditure-switching occurs if the relative price of imports can be raised, or if the relative price of UK exports can be lowered. Measures might include: o A depreciation of the exchange rate which has the effect of increasing the UK cost of imports and reduces the foreign price of UK exported goods and services. A lower exchange rate also increases the profitability of exporting products overseas, and this profit signal should, over time, act an as incentive for UK businesses to reallocate factor resources towards potential export markets o Tariffs or other import controls can occasionally be used but the UK is bound by its commitments to the World Trade Organisation. Protectionist policies are not a viable option for an economy wishing to control its total trade deficit o Policies that reduce the rate of inflation in the economy below that other international competitors leading to a gradual improvement in price competitiveness The key to controlling the BoP deficit in the long term is for the economy to achieve relatively low inflation with sufficient productive capacity to meet the domestic demand from consumers. Often, price is not the deciding factor in winning the demand from buyers in highly competitive international markets. Competitiveness in global markets is driven by many factors, one of which is the level of research and development spending, an area where the UK continues to lag behind.
The UK continues to lag behind in research and development Despite numerous attempts by the government to stimulate research and development spending, the level of R&D investment by UK companies is continuing to the Department of Trade and Industry's "2005 R&D scoreboard". Total R&D spending by British industry fell 1 per cent last year to 17bn. By contrast the scale of R&D investment by the world's top 1,000 companies climbed by 5 per cent to 220bn. It seems that the introduction of tax incentives launched in 2000 and 2002 that allow businesses to offset more than 100 per cent of their research investment against tax has yet to cause the surge in R&D that the government wants. Is this a case of government failure? Internationally, spending on R&D was equivalent to 3.8 per cent of turnover but in the UK the figure was only 2 per cent. Of the 31 UK industrial sectors covered in the scoreboard, 19 reported a decline in spending and ten showed an increase. The biggest R&D spenders worldwide were DaimlerChrysler and the United States drugs company Pfizer, each with research budgets of about 4bn. The highest spending UK company was GlaxoSmithKline on 2.8bn, putting it in 11th place. There is some good news contained within the data. R&D investment among small and medium-sized companies is picking up and in 2005 there are 116 UK-owned companies where R&D spending exceeds 4 per cent of sales, compared with 108 last year and 88 in 2001. 100 more firms invested over 300,000 of R&D this year mainly among the small to medium size business sector. The Government this week announced yet another initiative designed to promote research and innovation among smaller enterprises.
Tutor2u Limited 2008 www.tutor2u.net

The DTI R&D scoreboard provides a succinct explanation of the importance of research spending both to the competitiveness of a single business operating in a particular market and also to the health of the economy as a whole: R&D generates the new products, processes and services that give companies a competitive edge in the market. A company that consistently under-invests in R&D relative to its best competitors will lose its competitive edge and find it is competing on price in the area of lower value added products and services. (Source: DTI) Top 10 UK companies by size of R&D investment Company Position in 2000 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. GlaxoSmithKline AstraZeneca BAe Systems Ford ** Unilever Pfizer** Airbus** Shell Rolls-Royce BT 2 1 4 8 5 10 -* 11 12 9 R&D 2839m 1981m 1110m 763m 736m 598m 345m 288m 282m 257m Growth of R&D (1 year) +2% +10% +1% -12% -2% +8% -1% -5% 0 -23% Sector Pharmaceuticals Pharmaceuticals Aerospace Automotive Food Producers Pharmaceuticals Aerospace Oil & Gas Aerospace Telecoms

UK productivity still trails competitors Gordon Brown's ambition of matching the growth in productivity of the world's big economies appears as elusive as ever after research by the Centre for Economic Performance at the London School of Economics showed that in terms of output per hour worked, Britain still lags behind Germany by 13 per cent, the US by 18 per cent and France by 20 per cent. "This means that if we could reach French productivity levels, we could award ourselves 20 per cent higher wages or take a day off and still earn the same. Or we could spend the extra resources on schools and hospitals," according to Raffaella Sadun, the report's author. The lag in UK productivity was mainly due to "deficits in innovation, skills and management practices, as well as regulatory constraints in the retail sector," according to the report. The proportion of low-skilled people in the UK was three times higher than in the US and almost double the proportion in Germany and Japan. Adapted from Financial Times, June 2007

Limits to the impact of a depreciation of the currency The risks of inflation A lower exchange rate can lead to an increase in the costs of imported goods and services risking higher cost-push inflation. It is important to remember that a depreciation or devaluation of the exchange rate will not normally be enough on its own to correct a balance of payments deficit for an economy. This is particularly the case if the causes of the deficit are long term and structural. Other policies are required that improve the supply-side performance of the economy and make domestically produced goods and services more competitive in international markets The J-Curve effect
Tutor2u Limited 2008 www.tutor2u.net

In the short term a depreciation of the exchange rate may not improve the current account deficit of the balance of payments. This is due to the low price elasticity of demand for imports and exports in the immediate aftermath of an exchange rate change. Initially the volume of imports will remain steady partly because contracts for imported goods will have been signed. However, depreciation raises the sterling price of imports causing total spending on imports to rise. Export demand will also be inelastic in response to the exchange rate change in the short term. Therefore the earnings from exports may be insufficient to compensate for higher spending on imports. The balance of trade may worsen in the immediate aftermath of a fall in the external value of the currency. This is widely known as the JCurve effect.

Surplus on the current account

Time

Net improvement in the current account balance Deficit on the current account Point in time at which currency depreciation depreciates

Tutor2u Limited 2008 www.tutor2u.net

Trade in Goods and Services & the Exchange rate


Quarterly trade balance, billion (bottom pane) and exchange rate index (top pane)
105.0 100.0
Sterling index
105.0 102.5 100.0 97.5 95.0 92.5 90.0 87.5 85.0 82.5 80.0 2.5 0.0 -2.5 -7.5 -10.0 -12.5 -15.0 -17.5 -5.0

95.0 90.0 85.0 80.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0 -12.5 -15.0 -17.5 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Quarterly balance (billions)

Effective Exchange Rate Index United Kingdom, Current Account, Goods and Services, Net, SA, GBP Source: Reuters EcoWin

Providing that the elasticity of demand for imports and exports are greater than one, then the trade balance will improve over time. This is known as the Marshall-Lerner condition.
Export and Import Volumes - the importance of Elasticity of Demand Original exchange rate Exports of Pocket PCs from the UK UK price () US price ($) Demand Export revenue () New exchange rate Ped for UK exports = 1.4 UK price () US price ($) Demand Export revenue () % change in ex rate % change in demand Net trade balance Original exchange rate 1 = $1.80
Tutor2u Limited 2008 www.tutor2u.net

1 = $1.80 Imports of US DVD players 350 630 40,000 14,000,000 1 = $1.60 Ped for US imports = 0.5 350 560 46,220 16,177,000 11.1 15.55 USA price ($) UK price () Demand Import spending () % change in ex rate % change in demand -1,000,000 Deficit 450 281.25 56670 15,938,438 11.1 5.55 USA price ($) UK price () Demand Import spending () 450 250 60000 15,000,000

billions

New exchange rate

1 = $1.60

+238,562.5 Surplus

Combined elasticity of demand for X and M + 1.4 + 0.5 = 1.9

Tutor2u Limited 2008 www.tutor2u.net

29.

Globalisation

The global economy is in the midst of a radical transformation, with far-reaching and fundamental changes in technology, production, and trading patterns. Faster information flows and falling transport costs are breaking down geographical barriers to economic activity. The boundary between what can and cannot be traded is being steadily eroded, and the global market is encompassing ever-greater numbers of goods and services. Treasury: Long-term global economic challenges and opportunities for the UK, December 2004

What is Globalisation? Globalization is an issue that rouses strong emotions among people. The first step in understanding the topic is to define what it means. We are hampered by the reality that there is no one single agreed definition indeed the term globalisation is used in slightly different ways in different contexts by various writers and commentators. What is common to all usages is an attempt to explain, analyse and evaluate the rapid increase in cross-border (trans-national) business that has take place over the last 10/15 years. The OECD defines globalization as The geographic dispersion of industrial and service activities, for example research and development, sourcing of inputs, production and distribution, and the cross-border networking of companies, for example through joint ventures and the sharing of assets Globalisation is essentially a process of deeper international economic integration that involves: o A rapid expansion of international trade in goods and services between countries. o A huge increase in the value of transfers of financial capital across national boundaries including the expansion of foreign direct investment (FDI) by trans-national companies. o The internationalization of products and services by large firms. o Shifts in production and consumption from country to country for example the rapid expansion of out-sourcing of production. The current wave of globalisation is characterised by a fast growth of world trade in goods and services. In 2006 there was an 8% expansion in merchandise trade - the second highest since 2000. Trade to GDP ratios continue to rise for the majority of countries. For the UK, the value of trade (exports and imports) as a share of GDP is now 65% - the highest ever. According to the WTO, the dollar value of world merchandise exports increased by 15% to $11.76 trillion in 2006. The data table above drawn from statistics published by the World Trade Organization shows how the annual growth in merchandise trade (trade in manufactures, agricultural products, fuels and mining products) has consistently out-paced the growth of output. This means that trade as a share of output in the global economy has continued to increase marking an increase in trade integration within the world economic system. Another way of describing globalisation is to describe it as a process of making the world economy more interdependent. The expansion of trade in goods and services, the huge increase in flows of financial capital across national boundaries and the significant increase in multinational economic activity means that most of the worlds economies are increasingly dependent on each other for their macroeconomic health.
Tutor2u Limited 2008 www.tutor2u.net

Shares in world exports Canada France Germany Italy Japan United Kingdom United States Non-OECD Asia inc China Latin America

1991 2006 Change 1991-2006 3.4 3.4 -0.1 6.2 4.0 -2.1 10.8 8.6 -2.2 4.9 3.5 -1.4 8.0 5.0 -2.9 5.5 4.4 -1.1 13.7 10.1 -3.6 11.5 19.3 7.8 2.6 3.0 0.4 Source: OECD World Economic Outlook, June 2006

For example, a deflationary monetary or fiscal policy introduced in one country which leads to changes in AD inevitably affects the ability of other countries to export to that economy. Consider for example a decision by the Federal Reserve Bank in the United States to raise their interest rates in response to the threat of a rise in inflation. This could conceivably have important feedback effects throughout the international economy. The rate of growth of the US economy is likely to slow and this will then have an effect on the strength of demand from US consumers for overseas products. Secondly, changes in the structure of company taxation and personal taxation from country to country tends to influence flows of investment and have feedback effects in the long term on national income, employment and wealth.
Trends in global capital flows Stock of Foreign Direct Investment (% of GDP) Foreign assets (% of GDP) 1989 8.0 62.6 1999 2003 16.0 22.1 139.6 186.1 Source: International Monetary Fund

Different Waves of Globalisation Globalisation is not new! Indeed there have seen several previous waves of globalisation. Nick Stern, Chief Economist of the World Bank has identified three major stages of globalization: o Wave One: Began around 1870 and ended with the descent into global protectionism during the interwar period of the 1920s and 1930s. This period involved rapid growth in international trade driven by economic policies that sought to liberalize flows of goods and people, and by emerging technology, which reduced transport costs. This first wave started the pattern which persisted for over a century of developing countries specializing in primary commodities which they export to the developed countries in return for manufactures. During this wave of globalisation, the level of world trade (defined by the ratio of world exports to GDP) increased from 2 per cent of GDP in 1800 to 10 per cent in 1870, 17 per cent in 1900 and 21 per cent in 1913. o Wave Two: After 1945, there was a second wave of globalization built on a surge in world trade and reconstruction of the world economy. The rapid expansion of trade was supported by the establishment of new international economic institutions. The International Monetary Fund
Tutor2u Limited 2008 www.tutor2u.net

(IMF) was created in 1944 to promote a stable monetary system and so provide a sound basis for multilateral trade, and the World Bank (founded as the International Bank for Reconstruction and Development) to help restore economic activity in the devastated countries of Europe and Asia. Their aim was to promote lasting multilateral economic co-operation between nations. The General Agreement on Tariffs and Trade (GATT) signed in 1947 provided a framework for progressive mutual reduction in import tariffs. o Wave Three: The current wave of globalisation which is demonstrated for example by a sharp rise in the ratio of trade to GDP for many countries and secondly, a sustained increase in capital flows between counties and trade in goods and services

Decline in tariff and non-tariff restrictions Rising Real Living Standards Fall in Sea Transport Costs

Liberalisation of Domestic Markets Fall in communications costs

Declining Air Freight Costs

Main Motivations and Drivers for Globalisation As the well respected commentator Hamish McRae has argued, Business is the main driver of globalization! The process of globalisation is motivated largely by the desire of multinational corporations to increase profits and also by the motivation of individual national governments to tap into the wider macroeconomic and social benefits that come from greater trade in goods, services and the free flow of financial capital. Among the main drivers of globalisation are the following: o Improvements in transportation including containerisation the reduced cost of shipping different goods and services around the global economy helps to bring prices in the country of manufacture closer to prices in the export market, and adds to the process where markets are increasingly similar and genuinely contestable in an international sense. o Technological change reducing massively the cost of transmitting and communicating information - sometimes known as the death of distance this is an enormous factor behind the growth of trade in knowledge products using internet technology. Advances in transport technology have lowered the costs, increased the speed and reliability of transporting goods
Tutor2u Limited 2008 www.tutor2u.net

and people extending the geographical reach of firms by making new and growing markets accessible on a cost-effective basis. o De-regulation of global financial markets: The process of deregulation has included the abolition of capital controls in many countries. The opening up of capital markets in developed and developing countries facilitates foreign direct investment and encourages the freer flow of money across national boundaries o Differences in tax systems: The desire of multi-national corporations to benefit from lower labour costs and other favourable factor endowments abroad and therefore develop and exploit fresh comparative advantages in production o Avoidance of import protection: Many businesses are influenced by a desire to circumvent tariff and non-tariff barriers erected by regional trading blocs to give themselves more competitive access to fast-growing economies such as those in the emerging markets and in eastern Europe o Economies of scale: Many economists believe that there has been an increase in the estimated minimum efficient scale associated with particular industries. This is linked to technological changes, innovation and invention in many different markets. If the MES is rising this means that the domestic market may be regarded as too small to satisfy the selling needs of these industries. Overseas sales become essential.
Division of labour on a global scale The ease with which goods, capital and technical knowledge can be moved around the world has increasingly enabled the division of labour on a global scale, as firms allocate their operations in line with countries comparative advantage. As a result, there has been a significant increase in the number of firms that locate, source and sell internationally, reflecting the new opportunities presented by the ICT revolution, alongside falling transport costs and easing trade and capital restrictions. Source: Treasury Report on Global Economic Challenges, December 2004

Globalization no longer necessarily requires a business to own a physical presence in terms of either owning production plants or land in other countries, or even exports and imports. For instance, economic activity can be shifted abroad by the processes of licensing and franchising which only needs information and finance to cross borders. And increasingly we are seeing many examples of jointventures between businesses in different countries e.g. businesses working together in research and development projects. Globalisation Opportunities and Threats As we have mentioned already, there are hugely diverging viewpoints on the costs and benefits of the current process of globalisation. One thing is certain, globalisation is here to stay. Employment effects Concern has been expressed in some quarters that economic activity and employment in the advanced economies will drain away to the developing countries. Inevitably some jobs are lost as firms switch their production to countries with lower unit labour costs. But the neo-classical theory of international trade and most past experiences suggest that all nations in the globalization process will gain in the long run as trade is an important determinant of long run growth and rising living standards That has not allayed concerns that certain sections of the population in richer countries - notably relatively unskilled workers - will lose as an abundance of low-skilled labour in developing countries makes itself available to the world's companies at much cheaper costs leading to a fall in the
Tutor2u Limited 2008 www.tutor2u.net

demand for lower skilled workers in industrialised countries. Critics of globalisation in some developed countries point to the risks of increasing income equalities and greater job insecurity together with the threat of structural unemployment in industries where demand for labour falls.
Unemployment in the World 1995 2000 2002 2005 Total million 157.3 177.2 191.4 191.8 Male Female million million 92.7 64.7 104.7 72.5 113 78.5 112.9 78.9 Source: International Labour Office

Static and Dynamic Efficiency Gains For consumers and capitalists, the rapid expansion of international trade and foreign investment is a normally considered good thing. Textbook theory suggests that increased competition from overseas leads to improvements in static and dynamic efficiency and gains in economic welfare. Vigorous trade has made for more choice in the High Street, greater spending, rising living standards and a growth in international travel. Expansion of Multinational Activity The growth of multinational activity throughout the world is the result of a mix of economic and political factors. Most outward investment from one country to another takes places between developed countries. The main motivations for the rapid expansion of multinational activity are as follows: o Higher profits and a stronger position and market access in global markets o Reduced technological barriers to movement of goods, services and factors of production o Cost considerations a desire to shift production to countries with lower unit labour costs o Forward vertical integration (e.g. establishing production platforms in low cost countries where intermediate products can be made into finished products at lower cost) o Avoidance of transportation costs and avoidance of tariff and non-tariff barriers o Extending product life-cycles by producing and marketing products in new countries o The urge to merge the financial incentives created by the global deregulation of capital markets is making it easier to achieve acquisitions and mergers and thereby encouraging the external growth of a business Impact of Globalisation on the UK Economy The UK is a highly open economy. Openness to the global economy can increase the size of commercial markets available to domestic producers, encourage the transfer of technology and knowledge and also permit countries to specialise in those goods and services they produce efficiently by exploiting their comparative advantage.

Tutor2u Limited 2008 www.tutor2u.net

In 1979, the UK abolished its foreign exchange controls were abolished and the major financial markets have been gradually deregulated. This means that each day there is a huge amount of trade within our stock markets, the short-term money markets and the bond markets. UK trade with other countries continues to take a high and rising percentage of our total national output. Clearly, the globalisation process impacts significantly on the British economy with benefits and costs along the way: The UK has been a favoured venue for overseas direct investment indeed a large percentage of total investment into the European Union from non-EU countries has come into the UK. Many factors explain this trend including improvements in the supply-side performance of the economy, a favourable tax system and a much improved record on industrial relations. At the same time, UK investment overseas has soared partly as a result of a high level of merger and takeover activity. o Rising level of import penetration particularly in those industries where Britains previous comparative advantage has been eroded such as textiles and clothing and the manufacture of lower-valued added electronic products o Competitive forces for nearly all sectors: Globalisation increases the importance for Britain of continuing to develop a competitive advantage in industries with major growth-potential as a means of improving living standards in the long term. Globalisation has involved a speeding up of the process by which comparative advantage can change over time not least because of the faster diffusion of technological progress. Greater investment is needed in high value goods and services for example in high and medium-high technology manufacturing and in knowledge-intensive service sectors o Structural change in industries for example the long-term loss of output and employment in industries such as textiles. This creates problems where factor resources are occupationally and geographically immobile The current wave of globalisation places increasingly heavy emphasis on the importance of human capital as a factor determining long-run economic growth. The UK has probably lost forever its comparative advantage in producing low-value added manufacturing products. Other countries with significantly lower labour costs can now meet global demand for many textile and clothing products and cheaper electronic products at much lower cost than we can. Whereas the global demand for high skill services and high value-added manufacturing output remains strong and a rising share of UK exports overseas are in hi-tech manufacturing industries and knowledge-intensive services. Maintaining this emerging comparative advantage in a globalised economy requires a substantial improvement in the skills and flexibility of the workforce a point emphasized in this statement from a recent CBI research report.
We should no longer be trying to compete in international markets on the basis of low cost, low value-added manufacturing, but rather through innovative, high technology products and processes Source: CBI Policy Statement on Manufacturing and Globalization, March 2002 www.cbi.org.uk

Impact of Globalisation on the UK Government Globalisation is also having an effect on the British government for example in prompting pressure for changes in the corporate tax regime and demands for further reforms of our labour markets and the welfare system. Some economists believe that globalisation reduces the ability of governments to levy business taxes because multinational corporations can move their production to countries offering the lowest tax base and the taxation of knowledge products transmitted across international boundaries becomes ever-more difficult.
Tutor2u Limited 2008 www.tutor2u.net

But this issue ignores the fact that many complex factors influence business location decisions (including proximity to growing emerging markets) and relative tax burdens between different countries are often not the decisive factor in determining where financial capital flows to Globalisation has increased competitive pressures on British businesses in tradable goods industries. Has this helped to improve the trade-off between unemployment and inflation illustrated by the Phillips Curve? Cheaper prices for many international commodities and finished manufactured goods have certainly helped to control inflation in recent years and therefore reduce inflationary expectations. Suggestions for reading on globalisation Tiger economies go head to head (BBC news online, July 2007) For richer for poorer globalisation and inequality (BBC, May 2007) India Rising (BBC World Service special report) The cost of cotton and the cost of coffee (BBC) Brazil the gentle giant awakes (BBC) Globalisation the new rules of the game (BBC, July 2006) Globalisation backlash in rich nations (Financial Times, August 2007) Guardian special report on globalisation All roads lead to China No Logo BRICs and the Global Economy (Jim ONeill, Goldman Sachs)

Tutor2u Limited 2008 www.tutor2u.net

30.

European Monetary Union

In this chapter we take a look at the economics of the Euro. Britain is outside of the Euro Zone and there is no prospect of her joining it in the near term. There is little pressure at all for the UK to become a member. Instead the focus of attention has been on some of the macroeconomic problems facing member nations inside the Euro Zone including high unemployment and slow economic growth. There are some who claim that, within a few years, some countries may decide to leave the single currency and return to having their own exchange rate and domestic interest rate setting procedures.
Some Landmarks on the Journey Towards Monetary Union 1928 1944 1973 1979 1991 1998 1999 2000 2002 2003 2007 2008 Europe returns to the Gold Standard Bretton Woods system of fixed exchange rates based on dollar-gold standard is created Breakdown of the fixed exchange rate system move to floating exchange rates European Monetary System (EMS) is created a forerunner to the single currency The Maastricht Treaty creates convergence process for countries wanting to join the Euro Eleven countries satisfy criteria for joining 1st wave of nations inside the Euro Zone Euro is launched and the European Central Bank sets official interest rates Denmark votes in a referendum not to join the Single Currency Greece becomes the 12th member of the Euro Zone Euro notes and coins come into common circulation on the 1st of January, 2002 Sweden votes in a referendum not to join the single currency The UK publishes its assessment of the 5 tests deciding that the time is not right to join the Euro Slovenia becomes the 13th member state to enter the single currency area Malta and Cyprus likely to join the single currency

Monetary Policy in the Euro Zone - The European Central Bank o The European Central Bank is responsible for setting monetary policy through the Euro Zone countries. o As of January 2007 there are thirteen nations within the Euro Zone. o The European Central Bank (ECB) is in charge of setting a common interest rate for the Euro Zone countries. Their objective is to achieve price stability defined as a year-on-year increase in consumer prices of 2%. o The ECB targets the growth of the broad money supply as a guide to the future direction of interest rates. Broad money is basically determined by the growth of bank deposits the majority of which are created through bank loans and over-drafts. o The ECB does not currently have an exchange rate target, although it has intervened on a few occasions to influence the external value of the Euro in the global currency markets. But day-to Tutor2u Limited 2008 www.tutor2u.net

day the value of the Euro against say the US dollar or the pound is left free to float on the markets. For some further background on the ECBs work please use this web link: The main differences between the ECB and the Bank of England are summarised in the table below: European Central Bank Location Web site Goal Chairman Inflation Target Policy Tool Voting Frankfurt European Central Bank Price stability Jean-Claude Trichet Euro-Zone price inflation below 2% Inflation target is non-symmetrical Euro Zone interest rate Votes split between countries who each have representation on the ECB Council Bank of England London Bank of England Price stability Governor: Mervyn King Consumer price inflation of 2% Permitted band of fluctuation = +/- 1% Short term base interest rates Nine member MPC - meets monthly - one vote each governor has casting vote

A common currency requires a common interest rate. But arguments continue to rage as to whether the thirteen countries within the Euro Zone are benefiting from a one-size fits all monetary policy. Comparing and contrasting the Euro Zone with the United States Economy (data is for 2005) Population Share of World GDP GDP per capita Sectors of Production Agriculture, fishing, forestry Industry Services Unemployment rate Share of world exports % of GDP % of GDP % of GDP % of labour force % 2.2 26.6 71.3 8.6 29.9 0.7 21.1 78.2 5.1 8.7 Unit millions % thousands Euro area 313.2 14.8 25.5 United States 296.7 20.1 35.6

Joining the Euro Meeting the Convergence Criteria Countries wishing to join the single currency must meet four convergence criteria. 1. Stable prices: Inflation must not be more than 1.5 percentage points higher than the average in the three member countries with best price stability, i.e. lowest inflation. 2. Stable exchange rate: The national currency must have been stable relative to other EU currencies for a period of two years prior to entry into the monetary union (ERMII entry). 3. Sound government finances: a. Total government debt must not exceed 60 per cent of GDP. b. The annual government budget deficit must not be greater than 3 per cent of GDP. 4. Low interest rates: The 5-year government bond interest rate must not be more than 2 percentage points higher than in the three member countries where inflation is lowest.
Tutor2u Limited 2008 www.tutor2u.net

The Case for UK Membership of the Euro


"The main economic purpose of the single currency is to deepen integration among its members, by reducing the costs of cross-border commerce." Adapted from the Economist, "Growing Apart", October 2004

The main justifications for the UK participating in the single currency are as follows: o A boost to trade, investment and productivity: Euro membership for the UK might enhance our productivity by increasing trade between us and other EU nations. Trade provides a competitive stimulus to businesses and it is this that could help to raise productivity levels. o Increased price transparency: Membership of the Euro should make it easier for consumers and businesses to compare relative prices between countries. This will encourage an expansion in cross-border trade and increase competition. There are gains to be had in consumer welfare if price transparency leads to improvements in allocative efficiency. o Business uncertainty and transactions costs: Joining the Euro would reduce exchange rate uncertainty for UK businesses and also lower transactions costs for companies, consumers and tourists. Nearly 60% of our trade in goods and services is conducted with other members of the European Union a figure that is likely to grow further in future years. o Single Market: The Euro is seen by its supporters as an important complement to the longerterm success of the Single Market. This should lead to an increase in intra-European trade flows and higher inward investment. o Foreign investment: Britain has been a major recipient of foreign direct investment (FDI) in recent years. Some commentators believe this would be threatened if the UK remained outside the system over the long term. By removing a currency barrier to trade membership of the Euro could also facilitate the development of UK-owned multinational enterprises. o Political and economic influence: Britain stands to lose political and economic influence in shaping future economic integration if it remains outside the monetary system in the long term. Transactions costs and price transparency explained Transactions Costs When each country has its own currency, transactions between two countries will incur currency conversion costs. A round trip of 40,000 Belgian Francs, through 10 European countries finished as 21,300 Belgian Francs: 47% of the funds were lost through currency conversion costs. By forming a common currency area the transactions and reporting costs are eliminated. Price Transparency The price of the same good can differ between countries, shielded by the price of the good being given in different currencies. While must of the price difference is due to differences in VAT, some is due to the use of difference currencies. Such price differences can be eliminated by forming a common currency area, which increases price transparency. Firms that charge a higher price due to inefficient production methods may lose business by the price transparency and resulting increase in competition. Source: Richard Ashlin, LSE

Tutor2u Limited 2008 www.tutor2u.net

The Case against UK Participation Critics of the Euro argue that it does not come close being an optimal currency area and that structural differences between member nations threatens to undermine the success of the project. Here are some of the main arguments for continuing to stay outside the single currency area: o Past history and deflationary bias: Currency unions have collapsed in the past and there can be guarantees that monetary union will prove to be a success. It may indeed turn out to be a recipe for relative economic stagnation if the ECB sets interest rates too high to keep inflation within the 2% limit. Many economists have been critical of the reluctance of the ECB to cut interest rates in a more aggressive manner to boost demand and jobs during its first seven years in operation. o The Euro is not an optimal currency area: The Euro Zone does not meet the conditions required for an optimal currency area (OCA). For more on optimal currency areas see below. o Lack of one-size fits all: In a currency union comprising many countries, it is impossible for interest rates to be at a level than is optimum for any one country. o Loss of domestic monetary policy autonomy: Joining a single currency reduces Britains freedom to set her own interest rates based on her own internal (domestic) macroeconomic objectives. o Constraints of the fiscal stability pact: Countries joining the Euro signed up initially to the fiscal stability pact which limited the scale of government borrowing to 3% of national income. Several nations have already broken the conditions of the pact and it has now effectively been abandoned. But remaining outside the Euro Zone gives the UK a degree of fiscal policy freedom not available fully to Euro Zone member states. o Monetary policy asymmetry between the UK and the Euro Zone: There is evidence that the British economy may be more sensitive to the effects of interest rate changes than other EU countries. In part this is because of the high level of owner-occupation in the housing market on variable-rate mortgages. o Joining the Euro the adjustment costs: The change-over process to the introduction of the Euro will involve substantial menu costs for businesses and banks. These menu costs night bear most heavily on smaller and medium sized enterprises. o Foreign investment issue: Opponents of Euro membership argue that Britain can continue to attract capital investment inflows outside of the Euro Zone. Favourable supply-side factors in both product and labour markets make the UK attractive for foreign investment regardless of which currency is in circulation. o The performance of the Bank of England since 1997: The Bank of Englands success in keeping inflation within target and at the same time changing interest rates to keep the economy on track for sustained growth, may have undermined the case for UK entry into the Euro Zone for the UK. Would macroeconomic performance under the ECB be noticeably better?

Tutor2u Limited 2008 www.tutor2u.net

Economic Growth and Inflation


UK Real GDP Growth and Consumer Price Inflation. annual percentage change
9 8 7 6 5 4
Percent
9 8 7 6 5

Real GDP growth

4 3 2 1

3 2 1 0 -1 -2 -3 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Consumer price inflation

0 -1 -2 -3

Source: Reuters EcoWin

Optimal Currency Areas An optimal currency area (OCA) tends to work best when the countries within it are already highly integrated with each other and where each has a sufficiently flexible labour market to cope with unexpected external economic shocks such as rising oil prices or a major demand-side shock in the world economy. The OCA is also likely to work well when the impact of interest rate changes have a broadly similar effect on businesses and households from country to country. In most important respects, the Euro Zone of thirteen countries is not close to being an OCA although a small group of countries within it are probably closely convergent in a structural sense. An OCA is better placed to succeed with a small cluster of countries rather than the coalition of thirteen nations that count themselves as founder members of the single currency.

Fiscal federalism (i.e. fiscal transfers to economically depressed regions)

Lots of trade within the area

Similar monetary transmission mechanisms in response to changing interest rates

OPTIMAL CURRENCY AREA


Similar industrial structures and housing and financial markets

Requires
Symmetric economic shocks

Flexible Labour Markets When wages change, labour moves

Tutor2u Limited 2008 www.tutor2u.net

One of the obvious reasons why the Euro Zone is not an optimal currency zone is because of labour immobility. Europe does not have a mobile labour force. Not only is there little migration between European countries in response to an economic shock, there is little migration between regions within a single country. Such immobility may arise because of language, cultural or cost barriers. Staying outside the Euro Zone retaining the freedom to choose Another important issue for the UK is illustrated in the next figure. The basic argument is this. A country might want all three of the features shown in the boxes below: Firstly - free capital mobility helps to attract inward investment and permits the free flow of investment capital overseas to take advantage of overseas investment opportunities. Secondly the freedom to pursue an independent domestic monetary policy (i.e. set your own interest rates to meet an inflation target or some other objective). Thirdly the benefits that flow from having a stable fixed exchange rate.
Free Capital Mobility

United States and Japan and the UK

ERM and Euro Countries

Independent Monetary Policy

Stable (Fixed) Exchange Rate

Only two of the three features can be chosen at any one time. If a country desires exchange rate stability and also capital mobility, it must use monetary policy to set interest rates in order to meet an exchange rate target. This was the case when the UK was a member of the exchange rate mechanism from October 1990 to September 1992. Once the UK had left the ERM and moved to a free-floating exchange rate, interest rates could now be set to keep the growth of aggregate demand in line with aggregate supply so that the economy continued to grow but keeping inflation within target. At the moment the Government is keen to retain these two elements a floating currency and an independent monetary policy. It believes that the Bank of England has done a good job in setting interest rates and the free flow of capital allows the balance of payments deficit on the current account to be financed whilst the sterling exchange rate is left to find its own level in the foreign exchange markets. Joining the Euro - the 5 Economic Tests
A long-term decision The Government's decision on EMU membership reflects what it believes is best for the long-term economic interests of the British people and the performance of the UK economy. Source: Treasury Statement of Policy on the 5 Economic Tests, June 2003
Tutor2u Limited 2008 www.tutor2u.net

Gordon Brown has outlined five tests to be met before he will consider membership of the single currency. His successor as Chancellor of the Exchequer is likely to keep these tests in place under a new Prime Minister. 1. Economic convergence: This test revolves around the following question. Are UK and Euro Zone business cycles and economic structures compatible so that we and others could live comfortably with Euro interest rates on a permanent basis? 2. Economic flexibility: The second test considers whether there is sufficient flexibility in the economy to cope with external shocks. This includes flexibility in the labour market so that an adverse shock to output and demand in the economy does not lead to too heavy a rise in unemployment. 3. Investment: This test focuses on whether membership of the single currency has a beneficial effect on capital investment across many sectors of the economy. Would joining EMU create better conditions for overseas firms making long-term decisions to invest in Britain? Or can the UK do just as well by staying outside of the system? 4. The financial services industry: The fourth test is definitely not the most important one! It considers the likely impact of Euro participation on the health of the UK's financial services industry. But why have a test for a single industry? Why not have tests for the fishing sector or for coalmining? 5. Employment: The fifth and final test considers whether the Euro is good in the long term for raising employment and reducing unemployment. There is of course a sixth test and perhaps the most important one of all that of public opinion. The UK government is committed to having a binding referendum on the single currency before any decision is made. Denmark voted in 2000 to stay outside of the Euro Zone. Would the UK do the same if the electorate was given a chance? The Importance of Economic Convergence Why is the idea of convergence apparently so central to the Euro debate? Three different types of convergence can be identified: 1. Cyclical convergence: This is whether the business cycles of the UK and the Euro Zone are aligned. 2. Structural convergence: Do we have a similar supply-side structure to other countries operating with the same currency? Are we affected in the same ways to unpredictable economic shocks? 3. Endogenous convergence: Endogenous convergence is a term that describes convergence that may occur as a result of actually joining the Euro for example the extent to which wage bargaining between firms and workers and the price-setting strategies of businesses in product markets might be affected by being inside a single currency area. Cyclical Convergence The main indicators of cyclical convergence are 1. National output: I.e. rate of real GDP growth. 2. Short-term interest rates: Variations in short-term interest rates indicate could reflect differences inflation targets or perceived inflationary pressures. 3. The output gap: This is the difference between the actual and potential output of an economy. The output gap is used as an indicator of future inflationary pressure and is often at the forefront of decisions of central banks when setting interest rates.
Tutor2u Limited 2008 www.tutor2u.net

4. Labour market conditions: Labour market indicators might include the annual growth of wages and earnings; the rate of unemployment and also business surveys which tell us about the scale of skills shortages. 5. Long-term interest rates and inflation expectations these indicate the success and credibility of monetary policy. For example, the long term rate of interest on ten year Government bonds is widely regarded as the bond markets best forecast of inflation expectations for a country going forward. 6. The exchange rate - a further important indicator of the economy because changes in the exchange rate can have a big effect on the demand for exports and imports (directly affecting AD) and also on the rate of inflation through changes in export and import prices. Suggestions for further reading and research on European Monetary Union A doomed currency (Daily Telegraph December 2006) Benefits of the Single Currency (linking to the working of the Single Market) Euro aspirants fall short of requirements (EurActive, December 2006) Euro still shining in the east (Observer, December 2006) Guardian special reports on the Euro Official Euro Site (EU Commission) Slovenia joins the Euro (European Commission) Sterlings lucky escape from the Euro (David Smith, October 2006) The pain in Spain is there for all to see (June 2006) What has four letters, begins with E and is slowly killing half of Europe? (Anatole Kaletsky The Times, October 2006) Why break-up of faltering Euro could be the way ahead (September 2006)

Overview of the Performance of the British Economy Bank of England Inflation Report Deloitte UK Economic Review RBS UK Economic Analysis IMF reports on the UK economy OECD reports on the UK economy UK Treasury UK economy page Times articles on the UK economy Independent articles on the UK economy BBC news articles on the UK economy Blair's surprising economic legacy (Evan Davis, May 2007) The Blair Years in statistics (BBC news online, May 2007) Blairs Economic Legacy (LSE Centrepiece Magazine, June 2007)
Tutor2u Limited 2008 www.tutor2u.net