MACRO Unit 2 The UK Economy

Transcription

1 MACRO Unit 2 The UK Economy The performance of the economy can have a major impact upon people s lives. It will influence the type of jobs people have and the goods and services available to them, and whether they can afford to buy them. The government has 4 macro-economic objectives: 1) low unemployment 2) low and stable inflation 3) sustainable Economic growth 4) balance of payments equilibrium A number of key indicators can be used to illustrate the success of an economy: 1) the level of output, and Economic growth 2) the inflation rate 3) level and rate of unemployment 4) the Balance of Payments If the economy is growing it can normally be judged as successful. In addition the government will also consider: a more equal the distribution of income protection of the environment & sustainability of growth The Circular Flow of Income and Injections & Leakages In the simple, closed economy, it is assumed that households own all factors of production, which they then sell to firms for financial rewards. It is these rewards which enable households to carry out their day to day purchases. Unit 2 The UK Economy 6EC02 1 St Paul s School 2011

2 However the simple circular flow, as depicted in Figure 7, is too simplistic to be of any real use. In the open economy there are 3 injections into the circular flow. Investment by firms Government spending Exports (I) (G) (X) Each represents an autonomous addition to the circular flow income. Leakages on the other hand represent withdrawals from the circular flow and are: Savings Taxes Imports (S) (T) (M) TP Transfer Payments are payments received for no corresponding level of output, such as unemployment benefit or Job Seeker s Allowance. For an economy to be in equilibrium, injections must equal leakages. If injections are greater, then the economy will overheat and inflation may result. However, if the leakages are greater than injections, then the economy will shrink in size and an economic downturn or recession will ensue. ECONOMIC GROWTH An economy s growth can be measured in terms of its Gross Domestic Product (GDP) or its Gross National Product (GNP). GDP is the total output of goods and services produced by domestic factors in production (in the UK) over a period of time usually 1 year. It is also the sum of all incomes earned in one year and all expenditure in one year. Consider this in terms of the circular flow where for everything that is earned Unit 2 The UK Economy 6EC02 2 St Paul s School 2011

3 (income), there must be an output produced, and equally something must be spent (expenditure). The government measures all three money flows, goods & services, expenditure and income and they should be identity be equal. The preferred measure is the expenditure method which takes spending by consumer (C), government spending (G), spending by firms (I) and the net trade the UK enters into (X-M). The Expenditure Method: C + I + G + (X - M) For this method to be accurate the value of subsidies must be added and taxes on goods deducted. This converts the product s value from market prices to factor cost. Converting from Nominal to Real Nominal GDP is GDP measured in terms of money values, and so is influenced by the level of inflation. This can give a misleading impression of a country s performance. If inflation is running at 20%, then at the end of a year, GDP will have risen by 20%, this will suggest that output has remained the same but the value of the output has risen as prices rise. Thus to overcome such calculation difficulties GDP figures are returned to a base year to remove the affects of inflation. This is known as converting to real GDP. Real GDP is Nominal GDP x price index in base year. 100 Nominal GDP 1048 x = Real GDP = 873m 120 It is often suggested that as a measure of the standard of living, GDP per capita has its weaknesses. This is undoubtedly true; however, whilst many criticisms exist, and there are also alternative measures, GDP per capita is still the most widely used measure of economic performance. Concerns exist as to what is meant by Standard of Living. It is subjective, and therefore can only mean different things to different people. Thus a purely monetary measure such as GDP will not deal with the issue of Standard of Living as comprehensively as many economists would like. Other areas that may be considered: When dealing with standard of living, it is worth considering some of the factors outlined. (1) Birth Rates. (6) No. of doctors. per head. (2) Mortality Rates. (7) Distribution of Income. (3) Life Expectancy. (8) Climate. (4) % of Population in Agric. (9) Political Freedom. (5) Literacy Rates. (10) % of GDP spent on Military. Unit 2 The UK Economy 6EC02 3 St Paul s School 2011

4 HUMAN DEVELOPMENT INDEX HDI is an index which measures national socio-economic development developed by the United Nations. Up until 2009, it was based on measures of life expectancy, educational attainment and was adjusted for real per capita income. The HDI combined three basic dimensions: Life expectancy at birth, as an index of population health and longevity Knowledge and education, as measured by the adult literacy rate (with two-thirds weighting) and the combined primary, secondary, and tertiary gross enrollment ratio (with one-third weighting). Standard of living, as measured by the natural logarithm of gross domestic product (GDP) per capita at purchasing power parity (PPP) in United States dollars. In 2010, the measures of knowledge and living standards were changed so that now HDI is defined as: Access to knowledge: mean years of schooling and expected years of schooling Standard of living: measured by GNI per capita (PPP US $) Life expectancy at birth (as an index) However HDI is not perfect as a measure of development: Advantages Broader measure than GNI or GDP. The data is compiled regularly by the UN and is relatively easy to construct, as the three elements can be easily found on their own and exist independently, and the fact it is put together by the UN suggests neutrality. Takes into account income but adjusts for PPP and so living costs. Focused on government policies and so it is a good target for governments to aim towards, and is obtainable. Disadvantages It gives no indication of income distribution, or by region or gender. There may be problems of data accuracy, especially with some developing countries that will have an incentive to paint a rosier picture of their citizens' well being. This could undermine the HDI's validity in practice. Its weightings of 1/3 each seem arbitrary and one might argue that rising incomes have a diminishing impact the richer a country becomes. Limited in its inclusion of only three quality of life indicators when other measures like access to clean water omitted. Unit 2 The UK Economy 6EC02 4 St Paul s School 2011

5 ECONOMIC GROWTH If a country s output is rising, this suggests that a country s citizens are experiencing higher living standards. The most common indicator of economic growth is a rise in real GDP. Actual and Potential Growth An increase in the productive capacity of an economy increases the potential growth, whilst an increase in output results in an actual increase in output. A shift in the PPF illustrates an increase in productive potential. However a movement in the actual amount of output from A to B illustrates an increase in economic growth. There is however still potential to increase actual output from B to the boundary of PPF 2 by employing previously unemployed sources. Production and Productivity A country s output can increase either because greater resources are employed or because of a rise in productive potential. However an increase doesn t necessarily result in an increase in output, this will depend upon whether this increase in productive capacity is matched by an increase in actual output or a great level of employment. Output gaps Growth above the trend growth rate, where AD grows faster than LRAS, leads to a positive output gap and demand-pull inflation, as well as cost-push inflation Unit 2 The UK Economy 6EC02 5 St Paul s School 2011

6 Growth below the trend growth rate, where AD and so actual growth is below LRAS and the economy s potential growth rate. This leads to a negative output gap and so unemployment and downward pressure on prices. GDP Measurement Problems 1. Black Economy: This exists because when the output of some goods and services is deliberately not declared. This can be for 2 reasons, to avoid tax, for example cash in hand deals with plumbers etc. In addition some people may not declare economic activity if that activity is illegal, for example drug dealers will not declare their income. As people will spend any income they might receive in this undeclared way, a gap will tend to exist between the final figures for the expenditure method and income method of calculating GDP. The gap that exists will give an indication as to the size of the black economy. 2. Non-Marked Goods and Services: GDP figures only include those goods that are bought and sold and so have a price attached to them. Services which are produced and which either are not traded, or which are exchanged without money being exchanged. For example homegrown products, DIY or voluntary work are not included in the official figures. 3. Government Spending: Some government spending goes on financing some services which are not sold, such as Defence, and the Police. The cost of production is therefore used, however this can be misleading. If productivity in the Police Force were to rise as a result of the introduction of some new technology, staff numbers and so cost could be reduced. This overall reduction will result in a fall in the Police services contribution to the final GDP figures. To overcome this problem the government has introduced a method for estimating output based on key performance indicators. Cost and Benefits of Economic Growth Benefits Standard of Living Improves: This is usually measured by per-capita real income. If the economy is growing faster than the population then per-capita incomes are rising and the standard of living is said to be improving as households can buy more goods and services than before. There are problems with this notion; mainly the belief that standard of living is more than a monetary factor. GDP ignores factors such as the distribution of income, the size of the informal economy, the nature of public spending, such as on health or education, the size of negative externalities & political freedom. Unit 2 The UK Economy 6EC02 6 St Paul s School 2011

7 Increased Tax Revenue: Greater economic growth could result in higher tax revenue allowing the government to increase spending on health, education or whatever else is seen to be a priority. Higher Employment: Economic growth can result in greater demand and therefore greater employment. Increased investment as confidence improves, or due to the accelerator, or higher profits for firms. This means the economy will have more capital per worker and so higher productivity and more future growth. Costs Inflation: Increases in demand, without a rise in supply can create demandpull inflation (see AD2 and AD3 on LRAS1, causing a rise in average prices), or alternatively if wage pressures persist cost-push inflation may occur. Non-Renewable resources: The use of non-renewable resources to produce goods and services for use in the current time period means that these are unavailable in the future and so growth may not be sustainable. Environmental Costs: As the economy grows, and output increases, manufacturing firms may increase pollution, resulting in a decline in the ozone layer for example. As living standards rise, the number of cars, or other consumables rises, further increasing pollution and also the need for landfill sites to deal with rubbish. Structural Unemployment: As an economy grows its structure changes and demand for certain skills decreases, resulting in structural unemployment. Stress & Psychological problems: Professor Yew Nwang Ng has suggested that Economic Growth can create competitive pressures between families trying to outdo each other materially. This can result in, suicide, stress and depression. Sustainable Economic Growth Governments are keen to encourage sustainable economic growth rather than rapid economic growth which results from the rapid depletion of scarce resources. Sustainability in part implies the need for recycling of natural resources such as aluminium, paper and glass, whilst encouraging the use of renewable sources of energy for power. Unit 2 The UK Economy 6EC02 7 St Paul s School 2011

8 INFLATION Inflation can be defined as a sustained rise in the agreed general price level. A low and steady inflation rate allows business to maintain confidence in the economy. A high level of inflation, in excess of a country s main trading partners can create problems in competitiveness resulting in a decline in trade. The main measure of inflation in the UK is calculated through the use of the Retail Price Index (RPI). This is a measure of changes in the prices of consumer goods bought in the UK. Calculating the RPI The RPI is a weighted price index, so not only must price variations be obtained, but also weights must be attributed to various goods and services. In order to establish appropriate weights the Office for National Statistics (ONS) uses the Expenditure and Food survey to establish what items people buy in what quantities. Approximately 7000 families are asked to keep a record of what they spend over a 2 week period, and to give details of other major spending such as the telephone bill. Expressed as a fraction the weights are draw from the information gathered by the ONS. The ONS will then record how much the price of some 650 goods and services have changed by. This is due in a variety of locations throughout the country. In total approximately 180,000 price quotations are collected from 150 areas around the UK each month. Finally the percentage change in price for each item is multiplied by its weight. Unit 2 The UK Economy 6EC02 8 St Paul s School 2011

9 Other measures of inflation RPI X: This measure is the RPI minus mortgage interest payments. There are 2 arguments for excluding mortgage interest. 1. For comparison purposes a number of other countries do not include it 2. Mortgage interest payments are influenced by changes in interest rates, so a rise in interest rates designed to reduce inflation may have opposite effect of raising it. The Bank of England target is 2.0% ± 1% (was 2.5% ± 1% until Dec 2003) using the CPI measure of inflation. RPI Y: This measures the RPI minus mortgage interest payment and also both indirect and local authority taxes. This shows the underlying rate of inflation undistorted by changes in tax or interest rates. CPI: This measure excludes a number of items that are included in RPI, mainly related to housing. These included council tax and a range of owner-occupier housing costs such as mortgage interest payments, house depreciation, buildings insurance, estate agents and conveyancing fees. The CPI covers all households, while the RPI excludes the top 4% of income earners. The CPI also includes university accommodation and foreign students university tuition fees. Measurement Problems 1. Changes in Quality: Measures of price change do not take into account changes in quality. For example a computer is less expensive now in comparison to 15 years ago, but is also a great deal more powerful and better in quality. 2. Special Offers: the retail price index doesn t make special account for out of season discounts or special offers. This may act to reduce the rate of inflation. 3. Changes in expenditure: although the weights are reviewed each year, even this might not be enough. Spending patterns can change more quickly as new products become available. 4. Due to the limited number (6785) of households surveyed, there is potential for sampling error. Unit 2 The UK Economy 6EC02 9 St Paul s School 2011

10 Causes of Inflation There are two main causes of inflation: Demand-pull inflation - This occurs when AD increases (due to greater consumption, investment, government spending or net exports), pushing against the limits imposed by the AS curve at full employment. In the diagram (left), as AD shifts from AD to AD 1, the price level rises to P 2. Cost-push inflation - This is when costs of production increase (for example due to high wage demands or a weakening exchange rate which makes imported raw materials more expensive), and are then passed on to consumers in the form of higher prices. In the diagram (right), this is shown by a shift to the left in the AS curve, which sees prices rise to P 2. Consequences of Inflation Anticipated and unanticipated inflation Anticipated inflation is when the rise in the general price level is the one, or close to the one expected. If firms workers, consumers and governments can correctly anticipate the inflation rate, then they can take measures to avoid the harmful effects. However, anticipated inflation can bring with it a number of problems. As a result of being caught unawares people will be unsure what to expect about future inflation. This can result in a fall in consumption. Fiscal drag may also occur, for example with no adjustment for tax thresholds, higher minimal pay will drag incomes into higher tax bands and therefore workers disposable income will actually fall. Borrowers tend to gain and lenders to lose, whilst state pensions rise with the rate of price change, they tend to fall behind wages, which rise faster than prices. Costs of Anticipated Inflation Menu Costs - Prices become out of date and need to be updated; the costs of doing so are menu costs. This would include the costs of reprinting catalogues/menus, updating vending machines etc. Unit 2 The UK Economy 6EC02 10 St Paul s School 2011

11 Shoe Leather Costs - As inflation increases, the opportunity cost of holding cash increases. People will hold more money in interest-bearing accounts, and more trips to the bank will become necessary. Costs of Unanticipated Inflation Confusion of Market Mechanism - Consumer sovereignty relies on producers responding to changes in prices. Inflation means that producers may believe that demand for their good has risen (and hence increase production) when, in fact, only the general price level has increased. As a result, scarce resources may not be allocated in the most efficient way. Uncertainty - Inflation creates uncertainty, particularly amongst the business community and when inflation fluctuates, firms cannot predict costs and revenues and may be deterred from investment projects. Redistributional Costs - Income is distributed, away from those on fixed incomes and those in a weak bargaining position (e.g. pensioners), to those who can use their economic power to gain large increases in income. Furthermore, borrowers benefit as the real value of debt is eroded; savers lose out. International Costs - Exports lose their competitiveness, whilst imports become relatively cheaper. The trade position will therefore deteriorate, unless the exchange rate deteriorates to compensate, other countries have higher inflation, or exports do not sell on the basis of price alone. Accelerating Inflation If for example inflation was rising at a faster rate each year, i.e. 80% in year 1, 12% in year 2 and 18% in year 3 people would naturally expect prices to continue to rise. As a result they will demand higher wages, and firms may raise prices to cover expected higher costs, and consumers may bring forward consumption before prices rise. All of this will contribute to increasing inflation. Unit 2 The UK Economy 6EC02 11 St Paul s School 2011

12 EMPLOYMENT AND UNEMPLOYMENT Unemployment will result in output being less than potential output, tax revenue will be reduced and greater state benefits will have to be paid. The unemployed may experience increased incidence of divorce, and mental breakdown in addition to falling behind in training, so making it harder to get employment in the future. Measures of unemployment In the UK there are two main measures of unemployment. The claimant count, and the labour force survey. The claimant count is the number of people claiming the jobs seekers allowance. It is easy and cheap to collect, however it has been criticised for a number of reasons. It might actually overstate the number of people unemployed. For example some of those collecting benefit may not be actively seeking work. In addition there are groups of people who have productive potential, who would like to work but are excluded from the calculations. For example those over 60, and those under 18, in addition to those on government training schemes. The alternative method adopted in 1998 is the Labour Force Survey. This is based on the International Labour organisations definition of unemployment; this includes all people of a working age who are without work during a specified period and available to work in the next two weeks, having sought work in the previous four weeks. Typically the ILO/LFS measure of unemployment is greater than the claimant count measure, as it includes a greater number of the unemployed, as illustrated below. This method is based on a survey of sixty thousand households ( people), asking whether they have a job, and what steps they have taken to seek employment. As a result of this method being based on all international standards, comparisons with other countries are easier. Unit 2 The UK Economy 6EC02 12 St Paul s School 2011

13 Measurement Problems 1. If the Claimant count is used, everytime government changes the eligibility for claims, the unemployment figures will change e.g. as occurred when males over the age of 60 were excluded. 2. If the Labour Force Survey is used, the sample questioned may not be truly representative. 3. Whichever measure is used it can be difficult to assess whether those included in the unemployment figures are genuinely unemployed. Consequences of Unemployment To the Individual Loss of earnings means a lower standard of living. An unemployed person loses work skills, thus decreasing their chances of becoming employed again. The unemployed tend to feel useless and not a part of society. This can lead to problems such as depression, worse health, lower life expectancy. To the Economy There is lost tax revenue to the government but more spending on benefits. This could lead to a budget deficit. There can be a negative multiplier effect and so lower demand for local goods and services, housing etc. Loss of national output this could lead to a negative output gap or if people lose skills or leave labour market then hysteresis could occur and LRAS shift inwards. Areas of high unemployment tend to suffer from increased crime, violence and vandalism. Unit 2 The UK Economy 6EC02 13 St Paul s School 2011

14 BALANCE OF PAYMENTS The Balance of Payments is a record of all monetary payments between one country and the rest of the world over a period of time. The Balance of Payments is made of 3 sections: a) The Current Account b) The Capital Account c) The Financial Account In addition to these there is also the International Investment position, which shows the level of external assets and liabilities at the end of the calendar year. Current Account The current account is made up of 4 main parts. a) Trade in Goods: This covers the export and import of goods and services. b) Trade in Services: This covers the export and import of services such as shipping, financial services, insurance and tourism. c) Income flows: income from investments is the main component - interest, profits and dividends (IPD) from overseas assets such as bank deposits, UK owned companies overseas, shares quoted on foreign stock markets but held by UK residents (less IPD earned in the UK by foreign held assets). d) Current transfers: These include central government transfers, including for example the UK s net contribution to the European Union and aid which Unit 2 The UK Economy 6EC02 14 St Paul s School 2011

15 is provided to developing countries, and net remittances from migrants and immigrants. In this category, no goods or service is being exchanged, just a flow of money. The Capital Account This is a minor part of the Balance of Payments, and includes government investment grants, and the purchase or sale of non-produced, non financial assets such as patents, trademarks and land for foreign embassies. The Financial Account This was previously known as the capital account, and refers to the flows of money entering and leaving the country. This can take a number of forms, including the purchase and sale of companies and foreign exchange. Net errors and omissions Formerly known as the balancing item, this figure is included to ensure that the current account, plus the capital account plus the financial account equals zero. In other words to ensure that the Balance of payments always balances. International Investment Position This account reflects the total of external assets held by the UK government, companies and individuals and the total of UK assets held by foreign governments, companies and individuals. Causes of a Current Account deficit 1. High levels of income (economic growth) in the domestic economy. Imports tend to have a high income elasticity of demand so that, in a boom, imports are 'sucked' into the economy. The UK has a high marginal propensity to import (MPM), therefore economic growth usually results in greater demand for imports. 2. An overvalued exchange rate which makes exports less price competitive in foreign currency and imports more price competitive in Sterling. 3. High unit labour costs the average cost of labour per unit of output (perhaps a reflection of low investment in capital and labour in the past and hence lower productivity) means that average production costs may be higher than our competitors, again making UK goods seem less price competitive. Higher wage costs in the UK than in low cost LEDC manufacturers would also raise our unit labour costs. Unit 2 The UK Economy 6EC02 15 St Paul s School 2011

16 4. Poor non price competitiveness of UK goods in terms of quality, design, reliability, delivery times, after sales service may mean the 'taste' for UK goods is low. However, the current deficit is not such a problem if: it is only short term and is caused by high rates of economic growth which should subside if it can be easily financed, perhaps by investment inflows on the financial account the deficit is caused by the import of raw materials and capital equipment which will be used to produce final goods for export or helps to raise productivity Policies to remove the Current Account deficit Although there are several policy options, including reducing AD and consumption and so import spending, or devaluating the exchange rate or being protectionist, the policy favoured by the UK government is to focus on increasing competitiveness by applying Supply Side policies these policies will aim to boost productivity and so lower the UK s unit labour costs: increase investment (perhaps through lower corporation tax) and thus capital per worker and productivity increase spending on education and training to improve human capital encourage R & D spending to promote the use of new technology, perhaps by giving tax breaks on profits reinvested into R & D EXCHANGE RATES A fixed exchange rate system, is one determined by the government or an international body. The rate is maintained through the purchase or sale of the currency on the money market, and through the manipulation of interest rates. On the other hand a managed rate is one which is permitted to move within bands. Whilst a floating exchange rate is allowed to float, and so is determined by changes in the demand and supply of the currency. Consequences of unstable exchange rates 1. Planning frequent changes in the exchange rate may create a number of problems with firms trading abroad finding it difficult to plan ahead, particularly as they will not know how much they are to receive or owe in terms of their domestic currency. Unit 2 The UK Economy 6EC02 16 St Paul s School 2011

17 2. Trade uncertainty about the amount to be paid may mean that trade will be reduced, cheaper imports may be sought. 3. Productive potential productive potential may decline as a result of firms going out of business when the exchange rate is high, as they find it hard to export goods. Investment may also fall as the chances of additional output being sold declines. CONFLICTS IN MACROECONOMIC POLICY Governments will find it hard to achieve all four macro-economic objectives at once. For example a government may wish to reduce unemployment by raising aggregate demand. This will have the desired effect, but also encourage firms to expand output, accelerating economic growth. This may however result in demand-pull inflation. The increase in growth may result in an increase in the demand for goods from abroad and raise imports causing a deficit. For the government to reduce inflationary pressure and correct any deficit that exists on the current account a government might decide to reduce aggregate demand. This policy of inflating the economy, followed by deflation is referred to as the stop-go cycle. Governments often decide that sacrificing one policy objective is a price worth paying to satisfy the others. For example if unemployment is high, then a rise in AD will act to reduce unemployment, but result in raised prices. The trade-off between unemployment and inflation exists. Unit 2 The UK Economy 6EC02 17 St Paul s School 2011

18 AGGREGATE DEMAND Aggregate demand can be defined as the total demand of goods and services in an economy. It consists of 4 components, and is usually expressed as: AD = C + I + G + (X-M) where C = consumer spending I = investment expenditure G = government spending (X-M) = The net expenditure on exports and imports The AD curve depicted in Figure 2, shows the level of output or Real GDP at a given price level. The AD curve is downward sloping for 3 main reasons: 1. Exports of goods and services are likely to be higher when the price level is low as they are more internationally competitive. Imports, on the other hand are likely to appear more expensive, domestic demand may therefore transfer into domestically produced goods adding to the increase in AD. 2. If the average price level were to fall, then people s purchasing power with their disposable income would increase, allowing them to raise their spending and so adding to AD. 3. People s expectations also play a part in the shape of the AD curve. If prices are low people will tend to expect prices to rise in the future, and so bring forward their spending. This will act to raise AD. On the other hand, if prices are high, and expected to fall, people will delay spending and so demand will be low. Unit 2 The UK Economy 6EC02 18 St Paul s School 2011

19 Determinants of Consumer Spending Consumer spending is the most significant component of Aggregate Demand. A key determinant of this spending is the level of disposable income, in other words income after the addition of state benefits and deduction of direct. The marginal propensity to consume (MPC) is the amount of new income that is spent on consumption. At low levels of income any increase in income is taken up entirely on increased consumption, the MPC is 100 per cent. So if a family is very poor, and it receives some additional money, this will be spent on food, clothing and other essential items. As living standards and income rises the MPC will fall, yet remain high, reflecting the ability to save, so the MPC may be 80%. As incomes increase, the very rich are unconcerned by increases in their income, as they are already spending to meet their needs. Most of the new income received is therefore saved. Ultimately as depicted in figure 3 as income rises so does consumption, even if it is at a slower rate, thus the MPC steadily declines. where a = Autonomous consumption spending which occurs at 0 income financed by borrowing, using savings or state benefit on basic food, clothing and shelter Other factors affecting consumption If the government increases old age pensions and increases tax thresholds for low income earners, whilst increasing taxes for the highest income earners, total disposable income may remain the same. However consumer spending will increase, as will aggregate demand. This will result in a rightwards shift of AD. Unit 2 The UK Economy 6EC02 19 St Paul s School 2011

20 Higher interest rates will reduce consumer spending, and require those with a mortgage to make higher monthly repayments, therefore consumer spending falls, as does aggregate demand, which results in a leftwards shift of the AD curve. Determinants of Investment Expenditure Investment by the private sector, varies inversely with the rate of interest, i.e. the cost of borrowing money. If interest rates rise, businesses find that fewer projects yield a sufficient rate of return for the investment to be profitable. This concept is referred to over the Marginal Efficiency of Capital (MEC). If rates of interest rise and investment falls, the AD curve will shift to the left. The accelerator principle also influences the level of investment. It is felt that will react to increases in demand and national income by increasing their demand for capital goods to meet this growth. The result of this increase in I is a shift in the AD curve to the right. Accelerator: I = a (Y t -Y t-1 ) I = a = Y t = Y t-1 = Investment by firms Capital output ratio Income in current time period Income in previous time period Investment is therefore a function of a, where the capital-output ratio represents the amount of capital i.e. machinery required to meet a level of output. For example should 3 be required to raise output by 1 per year then the capital-output ratio is equal to 3. Unit 2 The UK Economy 6EC02 20 St Paul s School 2011

21 Therefore I = a (Y t -Y t-1 ) or ie I = 3 ( 100m - 80m) I = 3 ( 20m) therefore I = 60m Another factor which has an impact on investment is the role of expectations in the future. Keynes referred to this as Animal Spirits, with firms often basing investment plans on all sorts of external factors which may affect business well being. Determinants of Government Spending Government spending is particularly sensitive to a change in economic policy on the part of government in order that many achieve their particular macro-economic objectives. On the other hand it is important to remember that the pattern of taxation and expenditure may be manipulated in line with political beliefs and aspirations. Determinants of expenditure on Exports and Imports One of the key determinants of a country s trade position, is the value of its currency, its exchange rate. For example if Japanese importers are purchasing Scottish whisky they will be offering Yen for the goods, whilst the Scots will seek payment in. The relative strength of the Yen will determine how much whisky the Japanese will demand, and therefore the amount the Scots can export. Interest rate changes can have an influence on the exchange rate, a rise in the UK rate of interest will result in Hot Money flowing in, (Hot Money is money that is highly liquid, seeking out the highest rates of return anywhere in the world) and therefore an increase in the demand for, thus raising the value of the and the exchange rate. This rise in the value of the means that it is easier (and cheaper) to import goods and more expensive to export goods and services, hence it is likely our Balance of Trade will deteriorate. Beyond this the other main determinant of imports is the level of overall demand in the economy. The UK has a relatively high Marginal Propensity to Import (MPM) therefore as the level of income in the economy rises, the demand for imports rises. Unit 2 The UK Economy 6EC02 21 St Paul s School 2011

22 AGGREGATE SUPPLY Aggregate supply can be defined as the total output of the economy. The aggregate supply curve shows the relationship between the total quantity supplied in the economy and the price level. It is therefore upward sloping, as at low prices businessmen collectively do not feel that it is worth producing commodities, because they do not expect to be able to sell them and make a profit. However, as the price level rises entrepreneurs feel that it is worthwhile to start producing, or produce more and therefore supply increases. In the short-run changes in the price level result in a movement along the AS curve. If there is spare capacity in the economy, any increase in demand will result in a rise in output rather than a rise in prices. Using Figure 4, this is shown by the movement along the AS curve from A to B. Beyond B as the economy reaches full capacity, costs rise and diminishing marginal returns set in, so the AS curve becomes steeper. In the long-run there are many factors, which can cause a shift in the entire curve. There are referred to over Supply Side policies (see section below on Supply Side policies for further information) and include: 1. Education and Training 2. Technological change 3. Increasing geographical mobility of both employees and employers The period since 1979 has seen a strong commitment on the part of the government to create economic candidates which favour such a shift. The problem with supply side policies, is that their actions are relatively uncertain in impact and can take a long time to have any effect. In addition, their use is likely to impinge on other government policies because they may involve greater government expenditure, interfere with other social objectives, involve foregoing tax revenue, or Unit 2 The UK Economy 6EC02 22 St Paul s School 2011

23 require the reduction of interest rates, when other objectives require the opposite. Therefore supply side policies are difficult to introduce, uncertain in their impact and may take a long time to have an impact. Long-Run Aggregate Supply Keynesian The Keynesian Long-Run Aggregate Supply curve contains two main elements, an area which represents unemployed resources and the economy operating below full capacity (region A-B in Figure 6) the second element corresponds to the economy operating close to or at full capacity. With little or no unemployed resources (region B-C in Figure 6). The economy operates at equilibrium, where aggregate demand intersects with aggregate supply. It is clear at AD, the economy is not operating at full capacity, a shift to the right in the AD curve will cause output to rise, but with unemployed resources still in existence prices remain stable. It is only when the economy reaches full employment and the AD curve continues to shift to the right that prices will rise P 1 to P 2 ), as a result of the economy s inability to increase supply at fast enough a rate to meet the rise in demand. At this point, the only way to expand the economy without experiencing inflation is to employ supply side policies and shift the AS curve to the right, LRAS 1 to LRAS 2. Classical The classical long-run aggregate supply curve is vertical, as a result of the belief that the economy always operates at full employment. Any unemployment which exists is voluntary unemployment, in other words the market left to itself would be able to Unit 2 The UK Economy 6EC02 23 St Paul s School 2011

24 clear this unemployment, however workers who remain unemployed, according to this theory, do not wish to take the available jobs at the prevailing wage rate. Classical economists argue that any expansion in AD, such as AD 1 to AD 2 will only result in price rises (inflation) from P 1 to P 2. Therefore if demand management policies employed to shift the AD curve are to be successfully utilised they must be accompanied by supply side policies, which will shift the LRAS to the right, LRAS 1 to LRAS 2. The accepted relationship between output and employment is that, as output increases, employment increases. However, in the long-run if aggregate supply increases, as a result of an improvement in technology or a better educated workforce, output may increase without an increase in employment. THE MULTIPLIER EFFECT Changes in AD or AS may actually have a larger total effect on GDP than the particular tax reduction or expenditure that set it off. This is known as the multiplier effect. The multiplier can be defined as the factor by which an increase in one of the factors of aggregate demand is multiplied by to calculate the total rise in national income. The multiplier, in a closed economy can be calculated through the formula 1 1 MPC 1 or MPS Where MPC is the marginal propensity to consume, and the MPS is the marginal propensity to save. In a closed economy the MPC and MPS must always total 1. Therefore if the MPC = 0.8 then the multiplier can be calculated as 5. Unit 2 The UK Economy 6EC02 24 St Paul s School 2011

25 1 1 MPC or = 1 = Therefore a rise in AD of 200m will result in a total rise in national income of 1000m. In the more realistic open economy the multiplier formula follows the same principle but includes both leakages and injections. (1 1 MPJ ) or (1 MPC 1 MPI MPG MPX ) 1 or MPL or ( MPS 1 MPT MPM ) If for example the government were to increase expenditure on health and education, this will not only mean that the salaries of nurses and teachers increase but also there is an increase in expenditure on school buildings, computers, hospitals and scanners. This increase in expenditure is referred to as the first round effect. However with their increased salaries, teachers and nurses will increase their spending on clothing, cinemas and restaurants. This increase in demand results in a second round effect, which is added to by the builders of the schools, hospitals, computes and scanners. Furthermore, the owners of the clothing manufacturers, cinemas and restaurants see their income rise and their purchasing power increase, this is the third round effect. These successive rounds of expenditure carry on and would seem to have the potential to carry on forever, however their impact diminishes with each round because of the leakages inherent in the system. However the multiplier works, its impact must be taken into account by policymakers when investigating the impact on the economy of a change in AD. Unit 2 The UK Economy 6EC02 25 St Paul s School 2011

26 MACROECONOMIC POLICY INSTRUMENTS Fiscal Policy Fiscal policy refers to the manipulation of taxation and government spending to achieve macroeconomic objectives. It is used by governments to influence the level of AD in the economy and it can also affect aggregate supply through changing incentives facing firms and individuals. A boom in the economy will raise employment, but at the same time, because of increased incomes and expenditures, the government automatically receives more revenue from income tax, excise duty and VAT. In addition, government spending on social security for the unemployment falls. On the income side the key areas that may be manipulated are income tax, VAT, excise duties and national insurance contributions. An increase in almost all types of government expenditure will have an impact on aggregate demand, but other increases may have a greater impact on aggregate supply. To boost aggregate demand the government has two main options, either cutting taxes or increasing expenditure. Consumers will have greater disposable incomes than before, and as a result consumer expenditure rises and aggregate demand is boosted. Disposable incomes rising will result in a high proportion being dependent upon the marginal propensity to consume. If on the other hand, government were to cut excise duties, the price of petrol, on inelastic goods will fall. As a result consumers will have more money to spend on other goods and services, raising consumer spending and aggregate demand. Monetary Policy Monetary Policy is the manipulation of interest rates, the money supply and exchange rates to achieve government s macro-economic objectives. The importance of monetary policy over the last 20 years has risen, as successive governments have sought to combat inflation. All three monetary variables (money supply, interest rates and exchange rates) are inter-related and furthermore have an impact on aggregate demand. If the government were to print money, for example, to finance an increase in spending, the money supply would increase. The rate if interest would fall and as a consequence AD would shift to the right. The impact of too much money being printed, and not enough goods to meet this increase in demand is inflation. However, as the rate of interest falls, the exchange rate will depreciate as hot money flows out of the economy. Exports will become more competitive and rise, and imports more expensive, with wither delayed falling or if they are inelastic the price of the imports rising. Either way the impact of this change will place added pressure on aggregate demand. Unit 2 The UK Economy 6EC02 26 St Paul s School 2011

27 This same series of events would apply if the government were to lower the interest rate, or sell on the foreign exchange market and depreciate the. Supply Side Policies A wide-range of supply side policies are potentially available, these policies are much more focussed in their objectives, although they can be expensive to introduce and have limited and relatively uncertain long-run effects on the economy. The aim of government when using supply side policies is to remove market imperfection and restrictive practices so that the economy can operate in a more efficient manner. Providing incentives to work The guiding principle here has been to encourage more people to join the labour force and bring about an increase in output. The Labour government has introduced the working families tax credit to supplement working families income and increase the number participating in the labour market. By reducing income tax, the government can also raise the incentive for individuals to provide their labour. Laffer suggested that individuals would be willing to offer more hours of labour if taxes fell, whilst enabling the government to take in more revenue, as illustrated in Figure 10. Education and Training Many people who are unemployed lack the skills necessary to obtain a job, particularly those 16 year olds leaving school with few if any qualifications or those who have unemployed for some time. The provision of training opportunities will reduce skill shortages in the economy, making the workforce more effective. Recent years have seen many schemes designed to promote educational opportunities for the young, through Training and Employment Agencies, the New Deal, and Youth Training Scheme. Unit 2 The UK Economy 6EC02 27 St Paul s School 2011

28 Trade Union Reform By restricting the supply of workers, trade unions seek to increase wages for their members, but at the cost of unemployment. It is argued that the existence of trade unions seeks only to increase costs, reduce efficiency and international competitiveness. During the last 20 years there has been a succession of employment acts designed to reduce the impact of trade unions. This has seen the number of days lost through strike action fall dramatically from the watershed era of the late 1970s. Privatisation and Deregulation Under private ownership, companies are more efficient, more competitive and felt to be less of a drain on the public purse. In the period since 1979 privatisation has been extensive and including some high profile programmes of denationalisation, such as BT, BGas, and the railways. Through privatisation there has been a greater movement toward private individuals owning shares, adding to the incentive for these firms to improve their efficiency, and maintain growing profits. Deregulation, the removal of barriers to enter an industry, has also taken place, creating a greater competitive environment, or indeed has contracting out of activities normally undertaken by the private sector, such as hospital and school cleaning and catering. Application of the AD/AS model The policies employed to influence AD and AS do not operate independently. If the government tries to boost aggregate demand in the economy by lowering taxes, this will raise consumption and the demand for money, with the result that interest rates must rise. The rise in interest rates will result in a fall in AD as both investment and consumption are hit by the rise in interest rates. So a policy designed to raise AD can have the opposite effect, or at the very least see its positive impact mitigated by the effects of other variables. The interest rate rise will also have an impact on the exchange rate, causing exports to fall and imports to rise. Furthermore if the government were to attempt to influence AD by increasing spending through borrowing this may also cause interest rates to rise. By borrowing the government is entering the money market, and reducing the available funds for private firms to borrow, which means that firms must compete to borrow for investment projects, causing the price, i.e. the rate of interest to rise. This is referred to as crowding out, and is a concern of many monetarist economists when advising government not to increase the public sector net cash requirement (PSNCR: Government borrowing). The application of any policies to influence AD or AS, such as fiscal, monetary or supply side policies involves a time lag. Some policies will undoubtedly have a more immediate effect, such as changes in fuel duties and VAT, while changes to government spending or direct taxes, take much longer to have an effect on the Unit 2 The UK Economy 6EC02 28 St Paul s School 2011

29 macro-economy. The Bank of England estimates it can take between 18 months and 2 years to witness the impact of a change in interest rates. Supply side policies tend to be a long-term measure and can be difficult to predict the outcome of successfully, as they require structural changes to be made to increase aggregate supply in the economy. Table 1, below provides a summary of the policies a government might adopt to achieve their macro-economic objectives. Objective SR Policies LR Policies Problems Reduce Unemployment. Aim to shift: AD to right and AS to right 1. cut direct and indirect tax 2. raise Govt spending 3. cut the rate of interest 1. Education and training for structurally unemployed 2. Reduce social security payments 1. Short run the rise in AD may cause inflation 2. Not all the unemployed can realistically be retrained Reduce Inflation Aim to shift: AD to left and AS to right 1. Raise direct and indirect tax 2. Cut Govt spending 3. Raise the rate of interest 1. Remove restrictive practices 2. Privatisation 1. Appreciation of Exchange rate = fall in exports 2. Reduced demand in economy = unemployment i.e. The Phillips curve relationship Reduce Balance of Payment deficit Aim SR: Shift AD to left to cut D for M, but Shift AR to right in the LR as X rise Shift the AS to right 1. Raise direct taxation cutting D for M 2. Cut rate of interest: 3. Depreciate currency and raise X Promote international competitiveness Unemployment in SR Policies to reduce unemployment Fiscal and monetary policies can be applied in the short-run to increase aggregate demand and so reduce unemployment. However this can result in a rise in prices, ie. inflation. This trade-off is referred to as the Phillips Curve, and suggests that it is virtually impossible to have both low unemployment and inflation, and certainly this is the case if supply side policies are not used. Unit 2 The UK Economy 6EC02 29 St Paul s School 2011